# Medtronic, Inc. v. Comm'r

> United States Tax Court · June 9, 2016 · 111 T.C.M. 1515

URL: https://www.frixlaw.com/law-library/cases/4340342

## Case

- **Full name:** MEDTRONIC, INC. AND CONSOLIDATED SUBSIDIARIES v. COMMISSIONER OF INTERNAL REVENUE
- **Court:** United States Tax Court
- **Decided:** June 9, 2016
- **Citations:** 111 T.C.M. 1515; 2016 T.C. Memo. 112; 2016 Tax Ct. Memo LEXIS 111
- **Precedential status:** Unpublished
- **Opinion:** Opinion
- **Judges:** KERRIGAN
- **Cited by:** 2 later opinions in the Frix Law Library

## Citator (automated)

- No negative treatment found by the automated citator. That is not the same as a confirmation that the case is good law; read the citing cases.
- Full citator and citing cases: https://www.frixlaw.com/law-library/cases/4340342

## Opinion text

T.C. Memo. 2016-112

UNITED STATES TAX COURT

MEDTRONIC, INC. AND CONSOLIDATED SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 6944-11. Filed June 9, 2016.

Thomas V. Linguanti, Robert James Cunningham, Robert S. Walton, Jenny

A. Austin, Jason D. Dimopoulos, Emily J. Snyder, Katie M. Marcusse, and Kent P.

Stackhouse, for petitioner.

Curt M. Rubin, Halvor N. Adams III, John E. Budde, Michael J. Calabrese,

Paul L. Darcy, Laurie B. Downs, Frances Honecker Holmes, Rebecca J. Kalmus,

G. Roger Markley, Jeannette D. Pappas, and H. Barton Thomas, Jr., for

respondent.
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[*2] CONTENTS

FINDINGS OF FACT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

I. Overview of Medtronic. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
A. Class III Medical Devices.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
B. Industry Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1. Customers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2. Competitors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
C. Self-Insurance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

II. Entities and Roles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
A. Medtronic US. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1. Research and Development. . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2. Quality. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
3. Clinical. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
4. Regulatory.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
5. Component Manufacturing . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
a. MECC.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
b. MMC. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
c. ADM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
B. Med USA. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
C. MPROC.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
1. Background.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2. Puerto Rico Restructuring. . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
3. Operations During 2005 and 2006. . . . . . . . . . . . . . . . . . . . . . 25
4. Plants.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
5. Employees.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
6. FDA Approval Process.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
7. Quality. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
D. Medtronic Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

III. Intercompany Agreements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
A. Devices and Leads Licenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
B. Components Supply Agreement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
C. Distribution Agreement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
D. Trademark License. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
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[*3]
IV. Swiss Supply Agreement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

V. CRDM and Neuro Business Units. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
A. CRDM. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
1. Manufacturing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
a. Devices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
b. Leads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
c. Processes and Improvements. . . . . . . . . . . . . . . . . . . . . 44
d. Components. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
2. Research and Product Development. . . . . . . . . . . . . . . . . . . . 46
3. Marketing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
4. Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
B. Neuro.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
1. Manufacturing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
a. Devices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
b. Leads. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
c. Components. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
2. Research and Product Development. . . . . . . . . . . . . . . . . . . . 54
3. Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

VI. Pacesetter Agreement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

VII. Product Recalls .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

VIII. Audits and Notice of Determination. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
A. MOU. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
B. 2005 and 2006 Tax Returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
C. Audits for 2005 and 2006 Tax Returns. . . . . . . . . . . . . . . . . . . . . . . 69
1. First Audit.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
2. Second Audit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
3. Notice of Deficiency.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

OPINION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

I. Overview of Parties’ Positions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
A. Petitioner’s Position .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
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[*4] B. Respondent’s Position. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

II. Covered Transactions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

III. Applicable Statute and Regulations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
A. CPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
B. CUT Method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
C. Profit Split Method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
D. Aggregation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
E. Commensurate With Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
F. Taxpayer’s Burden. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85

IV. Abuse of Discretion.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
A. Abandonment of Notice Position. . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
B. Respondent’s Section 482 Allocations.. . . . . . . . . . . . . . . . . . . . . . . 88
1. Respondent’s Position. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
2. Heimert’s Economic Analysis. . . . . . . . . . . . . . . . . . . . . . . . . 90
3. Concerns With Heimert’s Economic Analysis.. . . . . . . . . . . . 97
a. Quality. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
i. Petitioner’s Position.. . . . . . . . . . . . . . . . . . . . . . 98
ii. Respondent’s Position. . . . . . . . . . . . . . . . . . . . . 98
b. Comparables.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
c. ROA. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
d. Aggregation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
4. Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
C. Commensurate With Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118

V. Petitioner’s Method.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
A. Devices and Leads Licenses Allocations. . . . . . . . . . . . . . . . . . . . . 120
B. Trademark License Allocations. . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

VI. Proper Allocation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
A. Respondent’s Failure To Provide an Adjustment to
Petitioner’s Methodology. . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
B. Adjustments to Petitioner’s CUT for Devices
and Leads Licenses.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
1. Starting Royalty Rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
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[*5] 2. Adjustments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
a. Know-How. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
b. Profit Potential. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
c. Scope of Products.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
3. Calculation of Revised Royalty Rate. . . . . . . . . . . . . . . . . . . 137

VII. Swiss Supply Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138

VIII. Transfer of Intangible Property.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139

MEMORANDUM FINDINGS OF FACT AND OPINION

KERRIGAN, Judge: Respondent determined deficiencies as amended by

answer in petitioner’s Federal income tax of $548,180,115 for 2005 and

$810,301,695 for 2006. Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect during the years at issue, and all Rule

references are to the Tax Court Rules of Practice and Procedure. We round all

monetary amounts to the nearest dollar.

The issues for consideration are: (1) whether income related to

intercompany licenses for the intangible property required to manufacture medical

device pulse generators (devices) and physical therapy delivery devices (leads)

should be reallocated under section 482 to Medtronic US from its Puerto Rican

subsidiary, Medtronic Puerto Rico Operations Co. (MPROC), for tax years 2005
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[*6] and 2006 (devices and leads transfer pricing issue);1 (2) whether Medtronic

Europe, S.a.r.L. (Medtronic Europe) made arm’s-length payments to Medtronic

US or accrued royalties in excess of arm’s length to manufacture devices sold to

Medtronic USA, Inc. (Med USA), pursuant to a supply agreement effective as of

May 1, 2002, among Medtronic US, MPROC, and Medtronic Europe (Swiss

supply agreement issue); and (3) alternatively, if the Court does not find

respondent’s adjustments for 2005 and 2006 to be reasonable, whether Medtronic

US, Med Rel, Inc., or Medtronic Puerto Rico, Inc.,2 transferred intangible property

compensable under section 367(d) to MPROC when Medtronic US restructured its

Puerto Rican operations in 2002 (section 367(d) issue).

On January 22, 2015, the Court issued a protective order to prevent

disclosure of petitioner’s proprietary and confidential information. The facts and

opinion have been adapted accordingly, and any information set forth herein is not

1
In 2005 and 2006 Medtronic US miscalculated the amount of royalties
owed by MPROC using an incorrect amount for intercompany sales of devices and
leads. Resolution of the devices and leads transfer pricing issue will determine the
correct amount of royalty income that Medtronic US should recognize on these
transactions.
Additionally, the parties have agreed to keep an issue involving the sec. 965
dividends received deductions for 2005 and 2006 in abeyance until the devices
and leads transfer pricing issue has been resolved.
2
Medtronic Puerto Rico, Inc., was MPROC’s predecessor.
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[*7] proprietary or confidential. Medtronic US is a Minnesota corporation with its

principal place of business in Minneapolis, Minnesota. During 2005 and 2006

Medtronic US was the parent corporation of a group of consolidated corporations

and multinational affiliated subsidiaries (collectively, petitioner).

FINDINGS OF FACT

I. Overview of Medtronic

Since the early 1960s petitioner has been a leading medical technology

company with operations and sales worldwide. By 2005 petitioner operated in

more than 120 countries and had approximately 33,000 employees worldwide.

During 2005 and 2006 petitioner operated through multiple business units; this

case, however, involves only the Cardiac Rhythm Disease Management (CRDM)

and Neurological (Neuro) business units. During the years at issue CRDM had

more employees and substantially more revenue than Neuro. Both business units

had devices and leads that are at issue in this case. The device operations across

both business units were larger and earned more revenues than the leads

operations. Medtronic maintained its operations in Puerto Rico through MPROC.

A. Class III Medical Devices

In order for certain medical devices to be legally marketed in the United

States, they must be approved by the Food and Drug Administration (FDA). The
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[*8] FDA requires all manufacturers of medical devices distributed in the United

States to register their facilities, list their medical devices, and follow certain

requirements. The FDA classifies medical devices according to the risks that they

pose to consumers. The Medical Device Amendments of 1976 to the Federal

Food, Drug, and Cosmetic Act classified medical devices that were on the market

at the time into one of three classes: class I, class II, and class III. Medical Device

Amendments of 1976, Pub. L. No. 94-295, sec. 513, 90 Stat. at 540-541. Class I

medical devices are subject to the fewest regulatory control, and class III medical

devices are subject to the most stringent controls. Class III medical devices must

comply with certain controls and go through a premarket approval (PMA) process.

The PMA process is lengthy and can often take 5 to 10 years. Class III medical

devices are higher risk and more novel than are those of classes I and II.

Class III medical devices generally cannot be classified as class I or class II

because there is insufficient information that existing controls are sufficient to

provide reasonable assurance of safety and effectiveness and they are “purported

or represented to be for a use in supporting or sustaining human life or for a use

which is of substantial importance in preventing impairment of human health”.

Id. subsec. (a)(1)(C). Class III medical devices require more scrutiny than those of

class I or class II. Class III medical devices include those which are life-
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[*9] supporting or life sustaining. Examples are implanted cerebellar stimulators,

heart valves, and certain dental implants. Examples of class I medical devices are

elastic bandages and examination gloves. Examples of class II medical devices

are powered wheel chairs and infusion pumps.

Class III medical devices must typically be approved by FDA before they

are marketed through the PMA process. The PMA process is rigorous, costly, and

time consuming. It requires a demonstration that the new medical device is safe

and effective. That demonstration is performed by collecting data, including

human clinical data, for the medical device.

The class III medical devices primarily at issue in this case are devices and

leads. The devices and leads are developed, manufactured, marketed, and sold

through Medtronic’s CRDM and Neuro business segments, which are described in

greater detail below.

B. Industry Background

During the years at issue the medical device industry was highly

competitive. Success depended on several factors such as product innovation,

sales proficiency and service, and product quality. Truly innovative products

could significantly change a company’s market share.
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[*10] Product quality, however, was the driving factor for success in the industry.

Without it, neither the innovativeness of a company’s products nor the

effectiveness of a company’s service professionals would ultimately matter. There

are several examples in the industry, discussed in greater detail below, of

companies that have been adversely affected, acquired by competitors, or driven

out of business because of actual or perceived product quality problems. Thus,

there was a significant focus on quality, which included quality product designs

and quality manufacture of components and finished products.

1. Customers

The customers in the medical device industry are generally surgeons,

electrophysiologists, interventional cardiologists, cardiovascular surgeons, heart

failure specialists, spinal surgeons, orthopedic surgeons, neurosurgeons, and

others who make decisions about what type of devices to purchase, implant, and

provide to patients. A key to a company’s reputation and its relationship with

physicians is how the company handles product flaws once they are known.

Physicians expect that companies will notify them about problems along with the

probability of occurrence so that they can decide how to best treat their patients.

A company’s failure to timely communicate to its customers can seriously harm its

reputation.
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[*11] 2. Competitors

The companies that competed successfully in the implantable medical

device industry met the needs of their customers and differentiated themselves

from their competitors by continuing to deepen the extent to which they met those

needs. These companies progressively grew their customer base through

deepening customer satisfaction and expanding their market share through product

diversification. Product quality, however, remained the foundation that

determined the extent to which companies met each of these goals.

CRDM’s primary competitors were Guidant Corp. (Guidant), Boston

Scientific Corp. (Boston Scientific) (after acquiring Guidant), and St. Jude

Medical, Inc. (St. Jude). From the late 1990s through 2005 and 2006 the CRDM

market was dominated by Medtronic, and then Guidant and St. Jude, with only

minor other players.

Neuro’s primary competitors were Johnson & Johnson, Boston Scientific,

Advanced Neuromodulation Systems, Inc. (Advanced Neuro), St. Jude (after its

acquisition of Advanced Neuro), and Stryker Corp. Medtronic had the largest

share of the U.S. market for neuro spinal cord stimulators and had no competitors

in the United States for neuro deep brain stimulators.
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[*12] C. Self-Insurance

The threat of class action lawsuits or multidistrict proceedings are frequent

consequences of product recalls in the medical device industry. The type of

insurance coverage that Medtronic needed to insure itself fully against its product

liability risk, namely “catastrophic insurance” on the order of billions of dollars,

was not available in the marketplace during the years at issue. Since 2002

Medtronic has been unable to obtain product liability insurance to insure against

losses at commercially acceptable premium amounts. Thus, Medtronic self-

insured against product liability risk, effective May 1, 2002, as well as during

2005 and 2006. The decision to self-insure increased the level of scrutiny placed

on quality. Once Medtronic made the decision to self-insure against product

liability risk and no longer had any other kind of insurance to pay for losses

associated with product quality, it was even more important that the finished

product function properly.

One aspect of Medtronic’s business and legal groups’ responsibilities

involved identifying and resolving customer complaints regarding product

problems as early as possible. Because Medtronic was self-insured during 2005

and 2006, its claim management process was intended to minimize the risk of

product liability litigation.
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[*13] II. Entities and Roles

A. Medtronic US

Medtronic US is the headquarters of the worldwide CRDM and Neuro

businesses. Medtronic US performs functions such as accounting, tax, finance,

treasury, legal and regulatory affairs, information systems, science and technology,

and general administration on behalf of itself and its affiliates.

In 2005 and 2006 Medtronic US owned Medtronic International

Technology, Inc. (MITI), a U.S. corporation. MITI owned Medtronic Holding

Switzerland GmbH (Swiss Holding), a Swiss entity. Swiss Holding owned

MPROC, Medtronic Europe, and Medtronic Vascular Galway Ltd. (Medtronic

Galway), which were all disregarded entities for U.S. Federal income tax

purposes. For U.S. tax purposes Swiss Holding conducts manufacturing in

Switzerland, Puerto Rico, and Ireland through manufacturing “branches.”

1. Research and Development

Medtronic US was responsible for research related to core products, which

focused on refinements to products already on the market. Medtronic US was also

responsible for research related to new therapies, which focused on new

indications and new products. As part of Medtronic US’ research function,

engineers and scientists performed feasibility work to determine whether an idea
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[*14] was viable for development. Medtronic US sometimes collaborated with

academics and third-party companies to perform research. Not all research

activities performed by Medtronic US led to commercial products.

Medtronic US developed products in several ways. Not all products were

created by engineers at the bench. Product development ideas often came from

physicians’ “bedside”, i.e., as they were working.

2. Quality

Quality was always the first topic discussed at Medtronic’s executive

committee meetings and quarterly reviews. Quality was of the utmost importance

in the devices and leads industry because the completed product would be

implanted in a human body. The failure of an implanted device or lead can result

in severe problems for the patient, and unfortunately even death.

Medtronic was concerned with what it referred to as a “doomsday scenario”,

in which a physician implanted a device and, because of poor quality, the patient

died. The goal of the device and lead products was to enhance or save lives.

Medtronic US’ corporate quality responsibilities included interpreting the

regulations promulgated by the FDA and international regulatory agencies to

ensure that Medtronic was in compliance with those regulations and to ensure that

Medtronic’s quality systems were aligned across its business units with the use of
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[*15] the applicable multisite “umbrella procedures”. Medtronic US had quality

manuals and policies for each of its business units, including CRDM and Neuro.

CRDM and Neuro both had quality officers in the United States. Each

manufacturing site, however, spent time developing and revising its own

respective quality policy and quality system manuals, as well as managing its

quality system within its site.

Medtronic US was the first in the industry to issue “product performance

reports”, which aggregate longevity and reliability data for both devices and leads,

as well as information concerning recalls or advisories for the use of physicians.

Many physicians scrutinized these product performance reports, which Medtronic

US first introduced in 1983 following a significant product recall, to ensure that

the products they implanted were reliable and of the highest quality. Physicians

would make their purchasing decisions accordingly.

3. Clinical

Medtronic US was responsible for clinical studies, which it designed,

oversaw, and used to support PMA submissions. Medtronic US also used contract

clinical research organizations to design and execute clinical trials.

Certain of Medtronic’s clinical trials benefited the entire industry because

companies could use the studies to support the safety and efficacy of their own
-16-

[*16] products, just as Medtronic might also have benefited from its competitors’

clinical trials.

4. Regulatory

Medtronic US was obligated to adhere to the highly stringent regulatory

requirements imposed on class III finished medical devices by the FDA and

international regulatory agencies and bore the significant costs related to these

regulatory requirements.

Medtronic US had global regulatory responsibilities generally relating to

three areas: safety and efficacy of new products before commercialization;

oversight and management of clinical studies of products that did not yet have

regulatory approval; and oversight and management of clinical studies in order to

expand indications for products already on the market. Additionally, Medtronic

US compiled information from the various functional groups for regulatory

submissions to the FDA and international regulatory agencies and reviewed

marketing materials to ensure that they aligned with regulatory approvals.

Medtronic US’ regulatory responsibilities included handling complaints and

medical device reports, totaling more than 10,000 per year during the years at

issue. Many of the complaints and reports related to products that MPROC

manufactured.
-17-

[*17] As part of its postmarket compliance function Medtronic US submitted

annual reports and PMA supplements, such as “30-day notices”, to the FDA that

described any changes that might affect the safety and effectiveness of products.

Medtronic US reviewed any changes that might affect safety and effectiveness of

the products it marketed and manufactured, in addition to maintaining device

listings and reviewing labeling information and promotional materials.

5. Component Manufacturing

Medtronic US also performed product research and development related to

devices and leads. It manufactured components through its vertically integrated

component manufacturing branches, Medtronic Energy & Component Center

(MECC), Medtronic Microelectronics Center (MMC), and Arizona Device

Manufacturing (ADM). MECC and MMC were responsible for meeting the

demand for component parts required by MPROC and Medtronic Europe. MMC

also supplied products to unrelated parties.

a. MECC

MECC is in Minnesota. During 2005 and 2006 MECC was responsible for

producing and selling, among other things, components, including batteries,

capacitors, and feedthroughs for devices and leads produced and sold by MPROC.

MECC also produced components for other Medtronic business units in addition
-18-

[*18] to CRDM and Neuro. MECC had responsibility for hiring, firing, recruiting

and training certain of its employees. MECC sold components only to entities that

Medtronic owned. MECC had its own quality manuals.

MECC operated high-volume manufacturing lines for batteries, capacitors,

feedthroughs, and connectors. MECC manufactured low-power batteries used in

pacemakers, and high-power batteries and capacitors used in implantable

cardioverter defibrillators (ICDs) and cardiac resynchronization therapy (CRT)

devices. MECC manufactured connectors (also called headers) and feedthroughs

used in devices.

Feedthroughs, which are the interconnects for the electronics inside the

device to the lead, were among the most important components. They are

complex, especially for ICDs, because there are up to six wires and a lot of

metallurgy related to them.

MECC also produced electrode tips used in leads, including pacing and ICD

leads. Electrode tips were critical components, and each lead product had a

unique electrode tip. Their design and composition required technology.

Improvements in these products require advanced technology.

MECC was Medtronic’s “Center of Excellence” for batteries and capacitors.

MECC assisted other units of Medtronic with problems within its expertise.
-19-

[*19] MECC employees participated on CRDM and Neuro development teams

and were on a product review committee.

b. MMC

MMC is in Arizona. During 2005 and 2006 MMC was a supplier of

component parts, including hybrid integrated circuits (hybrids), to MPROC and

Medtronic Europe. MMC was responsible for producing and selling components,

including, among other things, hybrid integrated circuits used in Medtronic

devices, which were sold by MPROC.

MMC designed and manufactured some integrated circuits in house and

purchased certain other integrated circuits, in addition to certain silicon wafers,

from third-party suppliers. MMC’s hybrid technology and manufacturing

equipment was not unique in the electronics industry. Thus, it competed against

many third-party suppliers who could manufacture identical, similar, or more

advanced component parts for devices. MMC also supplied products to unrelated

parties. MMC had its own quality manuals.

MMC also developed the testing systems used at MPROC to do interim and

final assembly testing of devices. MMC typically created a new tester for every

new device, which was an expensive and very complex process.
-20-

[*20] FDA regulations required that MMC have traceability to determine where a

problem originated. Medtronic had an integrated information technology function

for all of its manufacturing facilities. MMC used the PROMIS Network, which

was a traceability system that stored electronically all the information about which

suppliers and components were used, the processing time, who processed the

parts, and the test data.

c. ADM

Arizona Device Manufacturing (ADM) was in Arizona. During 2005 and

2006 ADM was in its final years as a supplier of component parts including shield

assemblies, to MPROC and Medtronic Europe. ADM also served as a middleman

between the engineering functions and high-volume manufacturing for devices.

ADM had its own quality manuals.

B. Med USA

Med USA is a Minnesota corporation with its principal place of business in

Minneapolis, Minnesota. Med USA was a member of Medtronic US’ consolidated

group. During 2005 and 2006 MPROC sold devices and leads to Med USA for

sale into the United States and other jurisdictions. Med USA’s CRDM and Neuro

sales organizations were responsible for: building relationships with and selling

products to customers including physicians; growing their respective markets by
-21-

[*21] educating physicians and patients; delivering products to customers for use

in surgery; and providing assistance to physicians and patients before, during, and

after surgery. Med USA’s sales representatives were not medical professionals;

rather, they played a support role in surgery by providing technical support for

devices and leads to implanting physicians as needed.

During the years at issue the CRDM sales organization consisted of

approximately 2,000 sales representatives, and the Neuro sales organization

consisted of approximately 200 to 300 sales representatives. Sales staff received

base pay and commissions.

C. MPROC

MPROC was incorporated on August 16, 2001, under the laws of the

Cayman Islands and is duly authorized to do business in Puerto Rico. MPROC

was responsible for, among other things, manufacturing and selling devices

(device operations) and leads (leads operations). MPROC manufactured class II

and class III medical devices, as defined and determined by the FDA.

MPROC also had a sales branch, known as the Puerto Rico Sales Office,

located in San Juan, Puerto Rico, which sold devices and leads in Central

America, South America, Puerto Rico, and the Caribbean.
-22-

[*22] 1. Background

Medtronic has maintained operations in Puerto Rico since 1974, with the

opening of the leads operations in Villalba, Puerto Rico. In 1999 the leads

operations expanded to a second facility in which it manufactured CRDM leads

and dedicated its older facility solely to the manufacturing of Neuro leads. In

1978 Medtronic opened its first device manufacturing facility in Humacao, Puerto

Rico. In 2004 MPROC moved its device manufacturing to a new, expanded

facility in Juncos, Puerto Rico. Before August 1, 2001, Med Rel, Inc., and

Medtronic Puerto Rico, Inc. (jointly, section 936 possession corporations), were

first-tier U.S. subsidiaries of Medtronic US operating as possession corporations

pursuant to elections under section 936. Medtronic Puerto Rico, Inc., was

incorporated on October 23, 1973, within the U.S. Med Rel, Inc., was

incorporated on November 1, 1977, within the United States.

The section 936 possession corporations had access to U.S. intangibles for

the purposes of manufacturing and selling Medtronic’s medical devices. The

section 936 possessions corporations did not independently own U.S. intangibles.

2. Puerto Rico Restructuring

In 2001, in response to Congress’ announcement of a phaseout of section

936 benefits, Medtronic US reorganized its Puerto Rico operations into a branch
-23-

[*23] of Swiss Holding, a controlled foreign corporation. To accomplish the

restructuring, the section 936 possession corporations each made capital

contributions in August 2001 to the newly formed MPROC in return for stock.

The goal was for MPROC to be one entity and to have the functions centralized.

Medtronic also realized there would be tax savings from remaining in Puerto Rico.

On September 30, 2001, Medtronic US made a contribution of capital of all

the stock of the section 936 possession corporations to MITI. The section 936

possession corporations each contributed substantially all of their operational

assets, including employees, machinery, equipment, land, contracts, and associated

liabilities to MPROC in exchange for MPROC stock in a section 351

nonrecognition transaction.

On or around January 25, 2002, Medtronic created a foreign holding

company structure to manage the cash earned by Medtronic’s foreign

manufacturing operations. Swiss Holding was created, under MITI, to own each

of Medtronic’s major foreign manufacturing locations, including Medtronic

Europe, Medtronic Galway, and MPROC. As part of the same transaction

Medtronic opted to “check the box” with respect to each of Medtronic Europe,

Medtronic Galway, and MPROC so that, although they were corporations from the
-24-

[*24] corporate law perspective of the countries in which they were organized,

they were “branches” of Swiss Holding for U.S. tax purposes.

During 2005 and 2006 MPROC operated through two local branches: Med

Rel Branch (Med Rel) and Medtronic Puerto Rico International (MPRI). Med Rel

operated in Humacao, Puerto Rico, and moved to a new facility in Juncos, Puerto

Rico, in 2004. MPRI operated two facilities in Villalba, Puerto Rico.

MPROC filed for, and received, a grant of industrial tax exemption from the

Office of Industrial Tax Exemption of the Secretary of State of Puerto Rico

(grant). The grant, as amended, provided that income from “pioneer products”

was not subject to Puerto Rico income taxes; dividends from such income were

not subject to income and withholding taxes if MPROC met the conditions in the

amended grant; and all income from other products was subject to an income tax at

a rate of 2%-7% depending on employment numbers.

During 2005 and 2006 MPROC met the condition in the amended grant and

paid no Puerto Rican income tax from CRDM and Neuro pioneer products at issue

in this case and no withholding or income taxes on the dividends received from

those products. MPROC paid 2% income tax on all other products.
-25-

[*25] 3. Operations During 2005 and 2006

MPROC’s device and leads operations were FDA-registered facilities that

manufactured class III finished medical devices. These facilities were subject to

regular premarket and postmarket inspection by the FDA, as well as by

international regulatory agencies, and were solely responsible for manufacturing

the products ultimately implanted in patients.

MPROC was responsible for its quality compliance, operational excellence,

business profitability, innovation, and establishment of annual and three-year

strategic goals and objectives. MPROC was responsible for preparing and

maintaining internal and management financial reports, monthly financial

statements, monthly financial forecasts, annual operating plans, and its general

ledger. MPROC also conducted cost accounting and budgeting activities,

developed financial and business proposals for capital expenditures, and managed

certain treasury and tax functions, including facility insurance, forecasting, cash,

tax compliance, and financing ongoing operations.

MPROC was responsible for its information technology systems. Its

employees developed software systems that improved the quality of its device and

leads operations. These systems were implemented in other Medtronic

manufacturing sites, including Medtronic US and Medtronic Europe. The leads
-26-

[*26] operations maintained a Therapies and Procedure Training Center which

offered onsite training and was used by physicians from South America, the

Caribbean, and, in certain instances the United States.

MPROC had a vice president of operations responsible for its management.

This individual was in touch with operations in Minnesota, but he ran the MPROC

facility. He did not need permission from Medtronic US to make hiring and firing

decisions. He made numerous key hires to help grow and unify MPROC. He was

able to purchase capital equipment with a price up to $450,000 without approval.

In addition, he could approve certain changes in the manufacturing process

without approval. If a change was significant, the design team would be notified.

Certain design changes would also need approval by the FDA. His role included

providing followup to the FDA after a site visit in Puerto Rico. For example, he

signed a response and sent it to the FDA after a visit. The response provided

detailed information to the FDA about testing issues discovered during the site

visit.

MPROC had an advisory council comprising the vice presidents of

operations from the various business units that operated in Puerto Rico, plus the

Puerto Rico general manager. The goal of the council was to bring the MPROC

business units together to communicate about how to best use the businesses in
-27-

[*27] Puerto Rico in order to maximize quality, cost, and training. For example,

the MPROC council facilitated improvement on Lean Sigma, which was an

objective aimed at improving quality while reducing waste in manufacturing.

4. Plants

MPROC operated through two branches, Med Rel and MPRI. Before

MPROC, Medtronic US’ sites in Puerto Rico were basically independent of each

other. MPROC served as an umbrella entity over the sites and reduced

redundancy by consolidating and managing the human resources, finance,

information technology, and supply chain functions so that the manufacturing sites

could concentrate on manufacturing.

5. Employees

During 2005 and 2006 MPROC employed almost 2,300 people across its

three sites, with approximately 500 in the device operations and 1,500 in the leads

operations. About 70%-75% of those employees worked on the manufacturing

lines. Turnover of MPROC’s employees was very low. Temporary employees

were hired sometimes to address workflow problems.

MPROC employees were not all line employees. There were also numerous

engineers, including some who focused on product development. These engineers

were involved with project implementation, technology harvesting, and process
-28-

[*28] development. They had input in the design review to make sure that a

design was possible for manufacturing. Design review frequently resulted in

numerous changes and refinements. Design review took place before a design

freeze, which occurs when there is agreement on the design. These engineers also

worked on new manufacturing technology to ensure that products would be of the

highest quality.

MPROC was responsible for its own talent acquisition and management,

compensation and benefits, organizational development, hiring, firing, training,

disciplinary proceedings, employee relations, and promotion decisions for

virtually all positions, including the device operations and the leads operations

managers. MPROC’s human resources function was also responsible for

integrating the employees across all three sites. Operators at MPROC had to

receive extensive training to become certified on the various manufacturing

processes related to the devices and leads that MPROC manufactured.

Certification could take up to three months, depending on the complexity of the

particular process.

The process for making devices and leads was very detailed. It required

skilled workers. MPROC would fire an employee if a defect could be traced back

to the employee’s work, even if it was the first mistake. MPROC tested and
-29-

[*29] sterilized finished devices and leads. MPROC had the responsibility for

inspecting and handling the finished devices or leads and ensuring that each and

every component was combined so that the device could provide the patient

therapy, repeatedly and reliably. As Medtronic’s senior vice president of medicine

and technology convincingly testified: “You can have all the essentially great

parts you want, but the critical stuff is in the systems engineering. Those things

put it together and manufacture it reliably at scale. It’s crucial. You don’t do that

you have no product.”

MPROC was involved in every aspect of the manufacturing process. The

manufacturing processes for both devices and leads was very detailed and took a

week or longer. The products were made in an FDA-regulated “cleanroom”

environment. Some processes could not be done automatically but required

skilled workers to complete them by hand.

MPROC was not only concerned with being able to produce products at a

high volume; it was also concerned that each product be of the highest quality and

suitable to place inside a patient. It was difficult to manufacture sensitive medical

equipment at a high volume and maintain quality. MPROC employees would

participate in core teams where they would partner with Medtronic US through

each development phase of new products to ensure that newly developed products
-30-

[*30] were manufacturable at commercial scale. The bottom line was that if a

finished product could not be made, it could not be sold.

6. FDA Approval Process

FDA regulations require all class III finished medical devices, including the

devices and leads manufactured by MPROC, to receive a PMA before they may be

marketed in the United States. To obtain a PMA, Medtronic US is required to

submit to the FDA an application for the class III finished medical device that

includes: full reports of all clinical studies and investigations of the device’s

safety and effectiveness that have been published or are known to Medtronic US;

the proposed labeling for the device; a full statement of the device’s components,

ingredients, and properties and of the principles of operation; a full description of

the methods used in, and facilities and controls used for, the manufacture,

processing, and, when relevant, packing and installation of the device; and

samples of device components. MPROC provided input for the manufacturing

sections of regulatory submissions. MPROC received the manufacturing section

of the PMA submission packet that had already been drafted, and then reviewed it

for accuracy and provided input. For postmarket submissions, MPROC noted,

investigated, and corrected deviations from the manufacturing processes that the

FDA had approved.
-31-

[*31] MPROC and its manufacturing facilities at Juncos and Villalba, Puerto

Rico, were subject to regular inspection by the FDA and international regulatory

agencies. All three sites were registered sites with the FDA. MPROC personnel

were responsible for managing and supervising each of these regulatory

inspections, for producing any documents requested during the regulatory

inspections, and for providing any written responses to questions arising from the

inspections. At the beginning of an inspection, the FDA issues Form 482, Notice

of Inspection, to the most responsible individuals at each manufacturing site to

ensure that the agency is getting the best information it can from a regulatory

perspective. During each inspection of MPROC, FDA Forms 482 were issued to

MPROC personnel.

7. Quality

Quality control was a critical aspect of the device and leads operations’

success. The device and leads operations had their own quality control teams that

developed, implemented, and monitored their quality control systems to ensure

that the devices and leads were manufactured to and satisfied all necessary

regulatory and quality standards and specifications. The device and leads

operations were solely responsible for developing the required validation,

inspection, and qualification steps and ensuring that the final manufactured
-32-

[*32] devices and leads met these established specifications. MPROC’s quality

personnel established manufacturing processes and instructions, incorporating

visual inspections, quality checks related to tolerances, and sterilization. The

quality assurance system had controls in place to prevent operators from

performing manufacturing processes without having been properly and fully

certified to do so. MPROC had the responsibility of determining whether a device

or lead met the applicable regulatory standards and whether it was ready for

implantation in the human body.

MPROC was responsible for its own quality organization. MPROC had its

own quality committee consisting of quality managers from the different facilities

in Puerto Rico. MPROC’s vice president of operations created the quality

committee in order to foster best practices and standardize processes.

MPROC wrote its own quality manual and had its own quality council. The

quality manual included processes to ensure compliance with FDA standards and

the European Medical Device Directive. Medtronic’s vice president of quality and

regulatory did not review or oversee the publication of this manual. The

Medtronic corporate office also did not have a role in creating this manual. The

MPROC quality committee was responsible for overseeing FDA site visits.
-33-

[*33] To comply with the requirements of 21 C.F.R. sec. 820 of the FDA’s

Quality System Regulation, MPROC’s quality systems were both extremely broad

in scope and detailed. Its systems covered numerous aspects of product quality,

including incoming inspection, sterilization, corrective and preventative action

(CAPA), and complaint handling, as well as the environmental, health and safety

function, process excellence, the product traceability process, nonconformance

evaluations, internal audits, product hold orders, management reviews, and the

management of material review requests.

The CAPA program was especially important. Each of MPROC’s sites

independently maintained a CAPA board, which managed the CAPAs and decided

whether to open or close a case on the basis of a quality complaint. If a CAPA

was opened, the goal was to investigate, understand, and resolve the problem.

Only the finished goods manufacturers, such as MPROC or Medtronic Europe,

would instigate a CAPA. The components manufacturers, such and MMC or

MECC, would become involved only if, through the CAPA investigation, MPROC

discovered a problem at the components manufacturing level. If the components

manufacturers became involved, MPROC would still manage the CAPA and the

interaction with the supplier.
-34-

[*34] The CAPA program ensured continuous improvement to the quality and

effectiveness of MPROC’s products as well as its manufacturing operations. By

understanding the cause of any reworked, defective, or rejected devices or leads,

or any problems that might arise with respect to a manufacturing process, similar

or related problems could be avoided in the future. MPROC was responsible for

conducting all investigations of CAPA events and complaints for product issues

that originate at MPROC.

MPROC plants participated in “Quality Days”. These events were

coordinated within CRDM. Patients would be invited to the plant where their

medical devices were made. These days were often viewed as a celebration of

achievement.

D. Medtronic Europe

Medtronic Europe was incorporated on September 25, 1995, establishing

operations in Tolochenaz, Switzerland, in the Canton of Vaud. Medtronic Europe

manufactured devices primarily for sale outside the United States market.

Medtronic Europe did not manufacture leads. The manufacturing operations of

Medtronic Europe were limited compared to MPROC’s, and it could not produce a

volume of devices similar to MPROC’s.
-35-

[*35] III. Intercompany Agreements

Medtronic US and Med USA entered into various agreements and

amendments with MPROC that were effective during 2005 and 2006.

A. Devices and Leads Licenses

Medtronic US and MPROC entered into license agreements, effective as of

September 30, 2001, for the intangible property used in manufacturing devices

(devices license, as amended over the years) and leads (leads license, as amended

over the years) (jointly, devices and leads licenses). The devices license was for

products in the following businesses: bradycardia pacing, tachyarrhythmia (tachy)

management, and neurological stimulation. The leads license was for products

that induce medical therapy delivery devices, which include electrode leads for

implantable pulse generators and implantable cardioverter defibrillators, and

neurostimulation electrode leads. Under the devices and leads licenses, MPROC

obtained the exclusive right to use, develop, and enjoy the intangible property

used in manufacturing devices for sale to customers in the United States and its

territories and possessions, and leads for sale to customers worldwide. The

intangible property comprised Medtronic US-developed inventions, secret

processes, technical information, and technical expertise relating to the design of

the devices and leads and all associated legal rights, including patents, trade
-36-

[*36] secrets, know-how, copyrights, and product regulatory approvals. The

devices and leads licences also defined “improvements” as “any finding,

discoveries, inventions, additions, modifications, formulations, or changes” made

during the terms of the respective licenses by either Medtronic US or MPROC.

MPROC agreed as part of these licenses to meet the quality control standards

established jointly by Medtronic US and MPROC.

The device and leads licenses specifically include requirements about

quality. Both agreements state:

Section 2.4 Quality

a. Product sold by Licensee shall meet the quality control
standards and specifications established jointly by
Licensor and Licensee, including any requirements of
any applicable regulatory agencies.

b. In the event that quality control of Licensee falls below
the agreed upon standards and specifications, Licensor
shall give Licensee written notice of such failures, and
Licensee shall, at its expense and within a reasonable
period set out in the notice, take such corrective action as
is necessary to restore quality to the appropriate level.

In accordance with the devices and leads licenses, MPROC agreed to pay

what Medtronic US and MPROC determined to be an arm’s-length royalty of 29%

to Medtronic US on its U.S. net intercompany sales of devices and 15% to

Medtronic US on its net intercompany sales of leads.
-37-

[*37] The initial terms of the device and leads licenses were through April 30,

2003, and were renewed effective May 1, 2003 and 2004. The amendments

effective May 1, 2003 and 2004, renewed the licenses through April 30, 2004 and

2005, respectively.

On May 22, 2007, Medtronic US and MPROC entered into amended and

restated license agreements effective May 1, 2005. The amendments were made to

reflect agreements reached in a memorandum of understanding (MOU) between

Medtronic and respondent, which will be discussed in detail in a later section. The

remaining terms of the devices and leads licenses remained in place. The amended

agreements included a profit split methodology that changed the royalty rates.

MPROC would pay a 44% royalty rate to Medtronic US on its net intercompany

sales of devices and a 26% royalty to Medtronic US on its net intercompany sales

of leads.

B. Components Supply Agreement

Medtronic US and MPROC entered into the components supply agreement,

effective September 30, 2001. The components supply agreement was in effect

during 2005 and 2006. Pursuant to the components supply agreement, MPROC

agreed to purchase certain components from Medtronic US, including from MMC

and MECC, for use in manufacturing devices and leads. “Components” include
-38-

[*38] hybrids, batteries, feedthrus, capacitors, connector modules, and electrode

tips. Pursuant to the components supply agreement, Medtronic US’ product

liability risk from the components made by MMC and MECC was limited to the

purchase price of the components it sold to MPROC. It stated that “[Medtronic

US] shall have limited responsibility for any claim for damages or breach of

warranty with respect to Components or Materials sold to [MPROC]. * * * Such

responsibility shall be limited to the price paid by [MPROC] for the Component or

Material.”

C. Distribution Agreement

MPROC and Med USA entered into an undated distribution agreement with

a stated effective date of September 30, 2001. The distribution agreement was in

effect during 2005 and 2006. Under the distribution agreement MPROC

appointed Med USA as a distributor in the United States for the devices that

MPROC manufactured and as a distributor in the United States, Central America,

South America, and Japan for the leads that MPROC manufactured. Pursuant to

the distribution agreement Med USA was protected from any product liability risk

potentially arising from products manufactured and sold by MPROC.
-39-

[*39] D. Trademark License

Medtronic US and MPROC entered into a trademark and trade name license

(trademark license) effective September 30, 2001, which granted MPROC the

right to use Medtronic US trademarks and trade names: (1) for devices in the

United States, its territories and possessions and (2) for leads in the entire world.

MPROC was to pay Medtronic US a royalty of 8% of MPROC’s net intercompany

sales of leads. MPROC agreed to pay Medtronic US a 5% royalty of product sales

by MPROC to unrelated parties. The trademark license was in effect during 2005

and 2006.

IV. Swiss Supply Agreement

Medtronic US, MPROC, and Medtronic Europe entered into the Swiss

supply agreement, effective as of May 1, 2002, which was in effect during 2005

and 2006. Under the Swiss supply agreement Medtronic Europe agreed to use its

manufacturing operations in Tolochenaz, Switzerland, to assist MPROC by

manufacturing and supplying the United States with devices when necessary to

meet excess demand in the United States. The Swiss supply agreement provided

that Medtronic Europe would pay Medtronic US directly an amount equal to the

royalty that MPROC would have paid to Medtronic US if MPROC had

manufactured the product and had made the sale itself. Medtronic Europe also
-40-

[*40] agreed to pay Medtronic US directly an amount equal to the MPROC

trademark royalty that MPROC would have paid to Medtronic US if MPROC had

made the sale itself.

V. CRDM and Neuro Business Units

A. CRDM

During 2005 and 2006 Medtronic’s CRDM unit was the world’s leading

seller of cardiac rhythm stimulation devices. Medtronic’s CRDM business

focused on managing the entire spectrum of cardiac rhythm disorders to improve

long-term patient care through products that restore and regulate a patient’s heart

rhythm and improve the heart’s pumping function. Its products were devices,

leads, and the associated delivery systems for the devices.

CRDM had a vice president for operations and quality who was responsible

for implantable manufacturing operations, supply chain, quality, and regulatory

compliance. During 2006 CRDM separated regulatory and quality from

operations and quality and created a vice president of CRDM quality and

regulatory. CRDM implemented quality guidelines.

1. Manufacturing

In general cardio devices have three primary components: implantable

pulse generators (IPGs), leads, and programmers. IPGs are battery-powered
-41-

[*41] computer-based devices that continually monitor the heart, analyze cardiac

signals, and apply therapeutic actions based on their programming algorithms.

Leads are flexible sets of wire that connect the IPGs to the heart. Leads connect at

one end to the heart and at the other end to the IPG. Programmers are external

devices that communicate through the skin to the IPG to obtain information from

the IPG regarding its activities. Programmers were manufactured by an outside

vendor and are not relevant to this case.

a. Devices

CRDM device products consisted primarily of: bradycardia pacemakers,

also known as IPGs; tachy devices, also known as ICDs; and CRT devices. IPGs

treat abnormally slow heart rates. ICDs treat abnormally fast heart rates. ICDs

also have capacitors as a component. CRTs treat insufficient blood flow and

uncoordinated pumping of the heart’s chambers.

During 2005 and 2006 the device operations at MPROC built more than 40

different models of devices and approximately 250,000 to 280,000 devices per

year; it was the primary or sole manufacturer of most models of devices sold in the

United States. Devices comprised approximately 750 individual components,

which were purchased from third parties as well as from MMC and MECC.

CRDM had its own quality manuals.
-42-

[*42] The device operations made complex pieces of electronic machinery that are

extremely difficult to manufacture. The process was labor and capital intensive

and time consuming and required numerous quality checks. Manufacturing a

device was a multistep process in which a hybrid, a battery, a capacitor, a

connector, and other components were constructed within a metal shield. There

were approximately 40 total steps in the manufacturing of a device. Depending on

the complexity of the particular device, manufacturing could take 7 to 14 days to

build a single device.

While the device operations used automated processes to manufacture

devices, they relied on employees to verify those automated processes, to perform

multiple quality inspections throughout each manufacturing stage, to complete

significant portions of the processes manually, and to oversee and troubleshoot all

manufacturing processes generally. Highly trained and skilled operators oversaw

all manufacturing processes. MPROC had to use extreme care to interconnect the

various components of the device, ensure that the device was hermetically sealed,

and sterilize the device. With regard to the interconnect welding step of the device

manufacturing process, for example, operators had to painstakingly inspect the

welding that took place at each and every preceding step of the device

manufacturing process for any discoloration or damage. On account of the
-43-

[*43] stringent quality standards that class III finished medical devices must meet,

the device operations maintained a detailed traceability system of each step of the

manufacturing process in the event that it needed to trace a quality problem to its

source in the manufacturing process.

MPROC was responsible for the sterilization of finished devices--a critical

process because none of the components were sterilized. Harmful microorganisms

had to be killed before a device could be implanted in a patient.

b. Leads

CRDM products included leads, highly complex “wiring” systems that

connect devices to the human body and deliver therapies. Leads are the devices

that transmit therapies from a device to the heart via electrical signals and

information about the heart’s activity from the heart to the device. Leads are thin

wires insulated with silicone or polyurethane and implanted into the right atrium,

right ventricle, or left ventricle of the heart.

Because CRDM leads are implanted in a patient’s heart, removing the lead

because of a product quality problem can be an extremely difficult procedure.

After implant, fibrous tissue forms around the lead, around the nearby blood

vessels, and within the heart. Leads were not designed to be extracted from the

human body. When a product quality problem occurs, the physician and the
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[*44] patient must determine whether to leave the lead in the patient’s body or, if

the severity of the problem requires it, or the patient demands it, to remove the

lead through an “extraction” procedure. In the case of CRDM leads, an extraction

was the most risky procedure an electrophysiologist could perform on a patient.

On average, there was a 1% chance that during an extraction the procedure would

tear a major vessel or make a hole in the patient’s heart, either of which can be

fatal.

c. Processes and Improvements

Even after a new product had been approved by the FDA and introduced

into the marketplace, MPROC continued to suggest and implement improvements

to the manufacturing process and product design in order to improve product

quality. MPROC was responsible for determining what manufacturing process

improvements were needed to make to the products it manufactured. MPROC was

also responsible for determining whether changes that it made to the

manufacturing process required reporting to the FDA and other regulatory

agencies and, if so, for reporting those changes to Medtronic US for submission to

the regulatory agencies. While FDA and other such regulatory approval may be

required before MPROC may implement a change, Medtronic US did not need to

approve the change and lacked the manufacturing expertise to do so. Medtronic
-45-

[*45] US’ role was limited to a review of the process improvement, and to

compiling the regulatory submission, if necessary.

Examples of MPROC’s manufacturing process improvement activities

during 2005 and 2006 included: implementing a laser ribbon bonder; resolving

manufacturing problems that caused damage to a molded component that included

a steroid drug on a particular lead; and eliminating wrinkling in leads. For

example, MPROC developed the second generation of the laser ribbon bonder, a

machine that connects components within devices through the use of laser welding

and indium ribbon. MPROC’s engineers also developed a method to translate the

manufacturing process from the first generation of the machine, which used older,

less accurate technology, to the newly developed machine, eliminating the need

for design assurance testing and thereby reducing considerably expenses. While

MPROC patented certain process innovations, many of its projects are protected

by Medtronic as trade secrets.

d. Components

MPROC was responsible for managing its supplier relationships. MPROC

worked to ensure that its suppliers were in compliance with FDA regulations.

MPROC’s device operations inspected incoming raw materials, components, and

other supplies purchased from its suppliers, including MECC, MMC, and third
-46-

[*46] parties, on behalf of itself, the leads operations, and Medtronic Europe. This

inspection function was an integral part of MPROC’s product quality control

process. MPROC worked with MMC, MECC, and third-party supplies to address

quality problems related to components.

MPROC was responsible for managing its manufacturing resources and

deciding how to fill each purchase ordered. MPROC managed its own production

schedules and forecasts to determine their raw materials and supplies. There was

no guaranty that Med USA would purchase all of MPROC’s products.

2. Research and Product Development

Core teams were in charge of Medtronic US’ product development, which

included several phases: business analysis, commitment, development, evaluation,

and market release. A Medtronic US core team, made up of specialists in

development, regulatory, clinical, manufacturing, quality, finance, human

resources, product planning and marketing, and supported by an extended team,

was responsible for the development of a new product, from the initial concept to

delivery to the patient. Design for Reliability and Manufacturability (DRM) was a

foundational concept for product quality and represented the interaction during

product development between the manufacturing engineers at MPROC and

product design engineers at Medtronic US. The interaction ensured that products
-47-

[*47] could be designed and manufactured at commercial scale repeatedly,

reliably, and at the highest levels of quality. Manufacturing products at a high-

volume, commercial scale in the implantable medical device industry was

particularly difficult and challenging. Thus, MPROC’s DRM input was critical to

ensuring that any new product could be commercially manufactured with

maximum reliability and quality. Even if a product could be manufactured during

the development phase, there was no guaranty that it could be manufactured

reliably at commercial scale in a high-volume manufacturing environment. This

“scale-up” of devices and leads to commercial levels took place at MPROC.

MPROC employees made key contributions during the business analysis

phase of product development. MPROC determined the technologies available to

manufacture the proposed product. These employees also helped develop new

technologies and performed assessments of cost and manufacturability.

Once a business analysis was completed and product development

progressed, the core team committed to developing the new product into a

commercially manufacturable product. MPROC employees helped develop the

manufacturing and implementation plan, including a timeline for all of the

activities required to bring the new product to market.
-48-

[*48] Once the development phase of a product began, MPROC employees were

responsible for developing repeatable, reproducible, and reliable manufacturing

processes with regard to each new product and developing appropriate tools and

fixtures. These employees provided guidance on product specifications and

helped develop process operations descriptions.

For example, MPROC helped develop an MRI-safe lead. This was an

important development because it allowed for an MRI to be taken safely of a

patient who had a lead inserted. MPROC’s engineers determined that a coiled

conductor was not reliably manufacturable at a high volume. They subsequently

developed a successful new conductor.

After a new product was developed, it was evaluated and tested. MPROC

helped with the evaluation phase by providing support for clinical trials. MPROC

wanted to ensure that the product developed in the development phase would be

effective over time. MPROC would run yield tests on the products to make sure

that they could be produced at a certain rate. The tests would be acceptable only if

they came back with a 100% success rate.

3. Marketing

Medtronic’s CRDM marketing function was responsible for product

planning, i.e., the marketing group determined the unmet needs in the market for
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[*49] CRDM therapies through market research, advisory groups, focus groups,

and engagement with the sales force in the field. The sales force received daily

feedback from physicians. Product innovation was important to Medtronic’s

mission. Marketing had a lot of input into determining the pricing for Medtronic’s

new products, which depended on the degree of innovation, reimbursement rates,

and the average selling price of existing technologies. Marketing helped estimate

revenue for new products and provided input on technological risk, competitive

features risk, and speed-to-market risk. Marketing also provided segmentations,

such as those explaining the differences between commodity buyers, who are more

focused on price, and technology buyers, who are more interested in additional

features, and cardiologists versus electrophysiologists. Marketing also evaluated

how Medtronic’s products stacked up against the competition’s.

When there was a recall, or “field action”, marketing was involved in

developing and was an approver of the field communication plan that conveyed

the information to the sales force and the physicians. The vice president of

marketing was personally involved in developing the materials used to brief the

doctors on the recalls.
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[*50] At the beginning of 2005 marketing had at least 255 employees, all of

whom were based in the United States. By the end of 2006, marketing had at least

293 employees, all of whom were based in the United States.

4. Sales

Sales representatives performed CRDM sales through the distribution

agreement with Med USA. Sales representatives underwent both initial sales and

technical training for about 18 months. Training involved study at home and at

Minnesota facilities. CRDM instructors and outside physicians participated in the

training at the Minnesota facilities by observing and working in the field with

experienced representatives during implants, taking qualifying tests, working with

a partner in the field before certification as “implant ready”, and getting

continuing education about new features and new products, which required more

certifications before getting permission to sell. Sales representatives and clinical

specialists reviewed a patient’s problems with a physician in order to support the

physician with the choice of a device, then supported the physician during the

implant and ensured that the device was working properly by taking electrical

measurements, and then provided postoperative followup support. CRDM clinical

specialists had similar roles as sales representatives in working directly with

physicians but did not have sales responsibility.
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[*51] CRDM devices and leads came with extensive manuals, which sales

representatives were required to be familiar with in order to answer any physician

questions. Sales representatives were expected to know CRDM products,

including product data and features. They were familiar with CRDM materials

that compared the capabilities of the CRDM devices and were able to explain the

differences to physicians. Sales representatives were also expected to know and

explain to physicians how the features of CRDM products compared to those of

competitors. Sales representatives were not responsible for ensuring that the

CRDM products worked before they were sterilized and put into the final

packaging.

B. Neuro

Medtronic’s Neuro business included implantable neurostimulation devices

(neuro devices) and leads that delivered electrical stimulation from neuro devices

to the spinal cord, nervous system, or brain. The devices and leads delivered

drugs or electrical stimulation to the spinal cord, brain, or other parts of the

nervous system to treat pain, movement and other disorders, including Parkinson’s

disease, essential tremor, chronic pain, and spasticity. Neuro devices included:

battery-operated generators; leads that connect the generators to the spinal cord,
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[*52] brain, or the nervous system; and programmers to communicate with the

generators or recharge the batteries.

Neuro’s products were often used to treat chronic back and leg pain,

complex regional pain, and neuropathy through spinal cord stimulation therapy.

In spinal cord stimulation therapy, neuro leads were attached to specific parts of

the spinal cord. The therapy functioned by blocking pain messages to the brain

with electrical impulses to the epidural space near the spinal cord.

Neuro’s products used in deep brain stimulation safely and effectively

managed some of the most disabling movement disorders, such as Parkinson’s

disease, essential tremor, and dystonia. Leads were placed in targeted areas of the

brain, and the amount of electrical stimulation was adjusted to meet the patient’s

needs. Neurosurgeons, neurologists, pain management specialists, and orthopedic

spine surgeons used these products.

1. Manufacturing

The manufacturing process for Neuro’s devices and leads was similar to the

process for CRDM. Changes in the processes were due to different specifications

of the products.
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[*53] a. Devices

Neuro’s devices were made in the Juncos facility in Puerto Rico. The

process was very similar to the process for CRDM’s devices. The specifications

and applications of Neuro’s devices were different from those of CRDM’s

devices.

b. Leads

The production of leads was extremely complicated and labor intensive.

The Villalba facility was the only Medtronic facility manufacturing leads in high

volume. Leads manufacturing was an almost completely manual process,

performed within tight tolerances, and required skilled labor to join raw materials

using lasers and adhesives. It could take up to several weeks to manufacture a

single lead, and there could be over 100 steps in the manufacturing process. Each

manufacturing step, after the first, began with a review of the quality of the work

performed in the prior step. The manufacturing process for even the subassembly

of a single portion of a lead, such as the outer assembly of the lead, comprised

approximately 20 steps. In addition to interim quality reviews, there were as many

as 50 quality tests throughout the leads manufacturing process, depending on the

complexity of the particular lead. The leads operations maintained a detailed
-54-

[*54] traceability system of each step of the manufacturing process in the event

that it needed to trace a quality problem back to its source.

The leads operations were responsible for specifying, purchasing,

validating, and installing the equipment needed to manufacture leads. Neuro leads

did not use any components from MMC or MECC. Some equipment used in

manufacturing leads was custom designed to specifications established by the

leads operations and built specifically for the leads operations. New equipment

was subject to testing and required not only Medtronic but FDA and other

regulatory agency approval before it could be used in the manufacturing process.

The leads needed to be sterilized upon completion in order to kill harmful

microorganisms before the leads were implanted in a patient.

c. Components

MPROC was responsible for specifying, purchasing, and installing the

equipment necessary to manufacture leads. Some of this equipment was designed

by MPROC and often required FDA approval.

2. Research and Product Development

Neuro’s product development efforts included developing new products and

improving existing products. Product Development and Technology (PD&T)

handled product development and research within Neuro. PD&T had over 100
-55-

[*55] employees, almost all in Minneapolis. For a new Neuro product, product

feature, or technology, Neuro research evaluated whether the desired outcome for

a physician and a patient could be obtained and then developed a product

platform. PD&T had engineers and others who worked on software and circuits

and participated on Neuro development teams. PD&T worked with core

operations on operational strategies for product development and manufacturing.

Neuro also did design verification in engineering laboratories in Minnesota. An

organization within PD&T handled technology projects, i.e. research and

exploratory activities on unproven ideas before formal product development.

3. Sales

Neuro sales representatives were hired on the basis of their level of

compassion, experience, and communication skills. Training for Neuro sales

representatives was extensive and included various stages, such as ongoing

continuing education and evaluations of up-to-date knowledge of current

technology. Multistage training was crucial for supporting physicians during

implants. The representatives had to be aware of clinical studies and product

specifications. Neuro sales representatives, who typically had seen more implants

than most physicians, were the clinical and technical experts with Neuro’s

technology.
-56-

[*56] Physicians consulted with the sales representatives about implants. Sales

representatives and physicians worked together to ensure that the device parts fit

together and were positioned properly. An implant did not take place without the

effective participation of a Neuro sales representative. These representatives

needed the courage to speak up during an implant if it was not being done

correctly. Neuro sales representatives participated in the postimplant

programming of a device and educated the patient on how to use the technology.

The quality of credible advice given by a trusted Neuro sales representative to

physicians was essential to maintaining Neuro’s brand and the physician’s

reputation for using safe and effective devices.

Sales representatives were not responsible for ensuring that Neuro products

worked before they were sterilized and put into the final packaging.

VI. Pacesetter Agreement

In the late 1980s and early 1990s Medtronic US and Siemens Pacesetter,

Inc. (Pacesetter), were engaged in patent litigation related to Medtronic US’

patents for many of its cardiac rhythm stimulation devices, including patents

underlying its pacemakers’ rate-responsive technology that monitors and adapts to

changes in cardiac rhythm. As part of the patent litigation, Medtronic US had won

a successful court ruling that its patents were valid and being infringed on by
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[*57] Pacesetter. Pacesetter was facing an injunction barring it from selling its

own rate-responsive pacemakers. In the fall of 1991 through spring of 1992

Medtronic US and Pacesetter reached a resolution of the lawsuits and negotiated

the Pacesetter agreement and the settlement agreement. After a tentative deal had

been reached on May 26, 1992, Medtronic US’ senior vice president and general

counsel presented the proposed terms to Medtronic’s board of directors,

recommending that Medtronic accept the deal. Medtronic US projected that it

would receive from Pacesetter total royalty payments of $200 to $300 million over

the life of the agreement. Medtronic US and Pacesetter finalized the terms of their

agreement in August 1992, and Medtronic’s board of directors approved it on

August 26, 1992.

At the time Medtronic US and Pacesetter negotiated the Pacesetter

agreement, Siemens AG (Siemens), Pacesetter’s parent company, had worldwide

revenue of approximately $50 billion, including medical revenue (pharmaceutical,

capital equipment, and medical device revenue) of approximately $5 billion.

Siemens competed against Medtronic as one of the largest medical device

companies in the world, manufacturing and selling cardiac pacing products as well

as other medical device products. Siemens operated its cardiac pacemaker

business through Pacesetter. In its 1993 fiscal year Pacesetter controlled
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[*58] approximately 20% of the IPG market (the second largest market share at

the time) and had revenues attributable to the sale of pacing devices of

approximately $314 million. Moreover, Pacesetter was expected to become a

more significant player in the tachy business by acquiring or developing its own

tachy technology.

As part of the Pacesetter agreement, and to “buy peace”, the parties agreed

to cross-license their pacemaker and patent portfolios. Medtronic US attributed no

value to the Pacesetter patents it received as part of the cross-license. Pacesetter

agreed to pay Medtronic US $50 million up front and $25 million in royalty

prepayments upon execution of the Pacesetter agreement. Thereafter, Pacesetter

agreed to pay Medtronic US a 7% royalty on the sale in the United States of all

cardiac stimulation devices or components (as defined by the Pacesetter

agreement) and a 3.5% royalty on all sales outside the United States.

The initial term of the Pacesetter agreement was for 10 years, beginning in

August 1992. The parties agreed to extend the term of the agreement if it was

transferred to another party. In September 1994 St. Jude acquired Pacesetter from

Siemens, and St. Jude became the assignee of Pacesetter’s rights under the

Pacesetter agreement. Accordingly, the term of the agreement was extended

beyond the initial 10-year term, and St. Jude continued to pay royalties to
-59-

[*59] Medtronic US under the Pacesetter agreement through Medtronic US’ 2005

fiscal year.

Pursuant to the agreed-upon 7% royalty rate, Medtronic US received

approximately $506 million in royalty payments over the life of the Pacesetter

agreement. The amount Medtronic US received exceeded its initial expectations

of the total royalty payments it would receive from the Pacesetter agreement. The

7% royalty rate achieved in the Pacesetter agreement was the “most lucrative” deal

Medtronic US had ever achieved and remains one of the highest royalty rates in

the pacemaker and defibrillator industry to date.

VII. Product Recalls

Companies in the implantable medical device industry that encounter

significant product quality problems face a number of direct and indirect expenses

as a result. These costs include: the inherent risk to patients; a negative effect on

the company’s reputation; loss of market share; a decrease in the affected

company’s stock price; a shrinkage of the overall size of the market; legal

settlement costs; direct product costs, such as writing off the affected inventory;

distracted sales representatives; potential defection of sales representatives to

competitors and related costs to keep sales representatives; other remediation costs

relating to the product recall; and the distraction of management from long-term
-60-

[*60] company goals. Reflecting the risk that product reliability poses, the history

of the implantable medical device industry is littered with companies that were

adversely affected, acquired by competitors, or driven out of business altogether

because of actual or perceived significant product quality problems.

The recall of Medtronic’s Xytron pacemaker in the 1970s was, for example,

a significant product quality problem that caused Medtronic’s IPG market share

percentage to fall from the mid-70s to the high-30s.

The experience of another company, Telectronics, is a further example of

significant product quality problems that had devastating effects on companies in

the implantable medical device industry. In 1994 Telectronics encountered a

quality problem related to its Accufix-J lead, which, in certain instances, literally

punctured the heart and caused patient deaths. Telectronics’ recall of its Accufix-J

lead caused its U.S. sales to fall by over 50% between 1994 and 1995 and its

market share to fall by almost 50% over that same period. In May 1995 the FDA

issued a consent decree to Telectronics that remained in effect until June 1996,

requesting that Telectronics halt the shipment of all of its IPGs and associated

leads to U.S. customers. Telectronics was no longer a viable company and was

eventually acquired by St. Jude.
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[*61] In 2005 Medtronic issued a recall of certain of its Marquis family of ICD

and CRT devices because of a problem that sometimes led to the battery’s draining

too quickly. This caused a concern that the Marquis ICD or CRT might fail to

deliver appropriate therapy when the patient needed it, a failure which could be

fatal. The Marquis recall forced Medtronic to divert significant research,

development, and other resources to address the underlying problem. Physicians

paid careful attention to Medtronic’s response to the Marquis problem to ensure

that it had been resolved and would not be “carried forward into other products

that * * * [they] were implanting.” The Marquis recall was the first significant

recall in the implantable medical device industry in almost a decade. The only

reason that Medtronic did not lose market share as a result of the Marquis problem

was that its competitor, Guidant, sustained a rash of recalls of its own as a result of

product quality problems during the same time period. Medtronic nevertheless

faced significant class-action litigation on account of the Marquis recall and

sustained substantial out-of-pocket product liability expenses per year during 2005

and 2006 (in addition to legal costs) related to that litigation. Medtronic

ultimately settled the Marquis class-action litigation. MPROC bore these out-of-

pocket costs for the Marquis devices it made.
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[*62] Shortly after the Marquis recall in 2005, Guidant, the clear-cut second-

leading implantable medical device manufacturer, issued a series of recalls related

to its Prizm family of ICDs. Guidant recalled over 60,000 ICDs following the

failure of these ICDs to deliver therapy appropriately to patients. Following these

recalls Guidant’s ICD and CRT market share declined from 38% to 25%, and

Guidant experienced a reduction of approximately 21% of its originally

anticipated sale price to Johnson & Johnson. While Boston Scientific ultimately

acquired Guidant, Boston Scientific’s market share then languished between 22%

and 28% through 2010. Boston Scientific also recorded goodwill impairment

charges of over $2 billion associated with its U.S. cardiac rhythm business unit,

and was forced to pay more than $550 million to settle the various civil and

criminal claims related to Guidant’s 2005 ICD recalls.

In 2007 Medtronic recalled its Sprint Fidelis ICD leads following the

discovery of a product quality problem that caused affected Fidelis leads to

inappropriately “shock” the heart. (ICDs monitor the heart for irregular heartbeats

and, if an irregular heartbeat is detected, shock the heart through the delivery of

electrical therapy via the lead to restore normal heart rhythm.) The inappropriate

shocks from the Fidelis leads were akin to “being kicked in the chest by a horse.”

Patients could be shocked hundreds of times as a result of the underlying product
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[*63] quality problem. One patient, for example, was shocked 42 times

consecutively during a camping trip and had to have his Fidelis lead “immediately

explanted”. Some patients died as a result of the inappropriate shocks.

Approximately 200,000 patients had been implanted with Fidelis leads at the time

of the recall. The product quality problem underlying the Fidelis leads posed

immense challenges to the physicians who had implanted the leads, as they were

forced not only to address the needs of their affected patients but also to explant

many of the affected Fidelis leads. Medtronic voluntarily suspended distribution

of the Fidelis leads.

The Fidelis recall had a profound effect on Medtronic, severely harming

Medtronic’s reputation with physicians. It caused Medtronic to reduce its sales

force significantly on account of the contraction in the overall ICD market due to

the collective product quality problems of Medtronic and Guidant. The Fidelis

recall further contributed to a marked decrease in the number of initial implants in

the ICD and CRT market, which had not yet recovered more than five years later.

The Fidelis recall also cost Medtronic vast sums of money attributable to increased

replacement implants. The Fidelis recall caused Medtronic to lose billions in

market capitalization in the days following the recall. While Medtronic had over a

50% market share in the CRT space just before the Fidelis problem transpired,
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[*64] following Fidelis, that percentage fell by approximately six percentage

points. Afterwards, physician-customers routinely split their purchases roughly

evenly among the three major medical device manufacturers, resulting in a loss of

sales for Medtronic.

MPROC suspected that there might be quality problems related to the

Fidelis leads when it began production, because it experienced much lower yields

in manufacturing Fidelis initially, which can be symptomatic of potential product

quality problems. Once high-volume production had commenced, MPROC’s

manufacturing engineers continued to suggest design and manufacturing

refinements that, although incorporated, were not enough to stave off the recall.

The Fidelis quality problems involved both design and manufacturing.

Following the Fidelis recall, MPROC played a significant role in ramping

up production of the predecessor Sprint Quattro lead to ensure that patient needs

were met. Before the recall, Fidelis leads constituted approximately 80%-90% of

the total volume of high-voltage leads that the leads operations manufactured,

while Sprint Quattro leads represented the remaining 10%-20%. The leads

operations were responsible for both developing and implementing the recovery

plan that substituted Sprint Quattro lead manufacturing for the former Fidelis leads

over the course of three months, ultimately meeting worldwide demand and
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[*65] achieving the recovery plan’s goals. MPROC bore responsibility for

stopping production of all Fidelis leads and issuing a product hold order to ensure

that no additional Fidelis leads were shipped out to the distribution sites.

Because of the recalls in the industry in the mid-2000s, physicians began to

increasingly divide their use of devices among the various companies. This was

referred to as the “splitter mentality”. Physicians did not want all their patients to

have the same device in case there was a recall.

The goal of Medtronic US’ claim management process was to minimize the

frequency and severity of litigation. The CRDM and business legal groups tried to

resolve claims by patients represented by counsel. This approach led to settling

more claims up front, and fewer claims went to litigation.

VIII. Audits and Notice of Determination

A. MOU

In an audit of petitioner’s 2002 tax return, respondent analyzed the devices

and leads intercompany transactions and the transfer prices among MPROC,

Medtronic US, and Med USA, as well as the 2002 restructuring of Medtronic’s

operations in Puerto Rico. At the conclusion of the examination, respondent

accepted the comparable uncontrolled transactions (CUT) identified by petitioner
-66-

[*66] and its adviser, Ernst and Young, LLP (EY), but adjusted the transactions to

increase their “profit potential”.

EY determined what petitioner considered to be an arm’s-length royalty rate

for the devices and leads licenses as well as for the trademark licenses. EY relied

on the CUT method to determine royalty rates of 29% on intercompany sales of

devices and 15% on intercompany sales of leads. EY determined that a royalty

rate of 8% for the trademarks was arm’s length.

Respondent was concerned that too much profit was being shifted to

MPROC. He made adjustments based on a report of IRS industry economist Jeff

Goodman titled “Economic Analysis of Intercompany Transactions between

Medtronic Inc. and Medtronic Puerto Rico Operations Company”. Goodman’s

report concluded that the CUT was not the best method for the intangibles licensed

to MPROC. In the light of respondent’s view, petitioner agreed to make changes

to its original CUT.

The Puerto Rico MOU reflected an agreement at the end of the audit which

was royalty rates of 44% for devices and 26% for leads to be paid by MPROC on

its intercompany sales. The Puerto Rico MOU also included a profit split

methodology that calculated the combined profit from manufacturing and

distribution (system profit) that Medtronic US, MPROC, and Med USA were to
-67-

[*67] earn on sales of products manufactured and sold by MPROC. The purpose

of the profit split methodology was to test the results of the transactions among the

related parties and ensure that MPROC’s profits were within a range agreed upon

with the Commissioner. Specifically, the agreed system profit for MPROC was

38% for devices and 45% for leads, with the acceptable range extending to 3% on

either side of the target--35%-41% for devices and 42%-48% for leads. Medtronic

and respondent agreed in the Puerto Rico MOU that they would apply the Puerto

Rico MOU to 2002 and all future years and that Medtronic would apply the

“agreed royalty rates on its as filed tax returns, and the Internal Revenue Service

would respect those royalty rates, as long as there are no significant changes in

any underlying facts”.

During respondent’s examination of petitioner’s 2002 tax return, he also

valued certain assets and liabilities contributing to the going concern business

value of Medtronic’s then U.S. subsidiaries, the section 936 possession

corporations. Respondent issued an engineering and valuation report prepared by

an Internal Revenue Service engineer, Victor Venske, titled “Fair Market Value of

Going Concern Business Assets of Med Rel and MPRI Branch Operations of

Medtronic, Inc. located in Puerto Rico”, dated June 24, 2005 (Venske report). In

reliance on the Venske report, respondent concluded that workforce-in-place,
-68-

[*68] goodwill, and going concern value were contributed to MPROC and had a

fair market value of $22,891,774. Respondent asserted that the assets that he

determined were received by MPROC should be amortized over their 20-year life

pursuant to section 367(d) and should be included proportionately in Medtronic

US’ income annually.

Medtronic accepted respondent’s section 367(d) adjustments and, in

accordance with the Venske report, included an additional $667,677 for 2002 for

seven months of amortization and $1,144,589 annually in income for 2003

through 2006.

Following the completion of respondent’s 2002 examination, petitioner

applied the royalty rates established by the Commissioner, and tested the system

profit of Medtronic US, Med USA, and MPROC, in reliance on and in accordance

with the methodology set forth in the Puerto Rico MOU. He examined

petitioner’s 2003 and 2004 tax returns and agreed to the application of the Puerto

Rico MOU. He did not identify any material changes in facts or law concerning

the parties’ operations.

B. 2005 and 2006 Tax Returns

Petitioner filed timely its 2005 and 2006 tax returns using the Puerto Rico

MOU. To implement the Puerto Rico MOU, petitioner first applied the original
-69-

[*69] CUT royalty rates of 29% for intercompany sales of devices and 15% for

intercompany sales of leads. Medtronic determined that the appropriate arm’s-

length royalty payments for devices and leads were $478,880,173 in 2005 and

$712,761,701 in 2006. Petitioner then applied the increased royalty rates (44% for

devices on intercompany sales and 26% for leads on intercompany sales) and the

profit split methodology in reliance on respondent’s determinations set forth in the

Puerto Rico MOU. After applying the profit split methodology petitioner reported

additional royalty income on its Schedules M-3 attached to its 2005 and 2006 tax

returns. Medtronic US’ total royalty income from the device and leads licenses as

reported in petitioner’s income tax returns was increased to $663,450,013 for 2005

and to $1,109,939,529 for 2006, a total of $581,747,668 greater than what

petitioner had originally determined to be an arm’s-length amount.

C. Audits for 2005 and 2006 Tax Returns

1. First Audit

Respondent’s first examination of petitioner’s 2005 and 2006 tax returns

began in approximately May 2007. During the course of the examination,

respondent proposed an initial $84 million adjustment as a result of revised

calculations under the Puerto Rico MOU. In March 2009, after completing his

initial examination, respondent proposed to increase the amounts of MPROC’s
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[*70] royalty payments to Medtronic US by another $455 million for 2005 and

2006. Petitioner protested respondent’s proposed adjustments for 2005 and 2006

to the Internal Revenue Service Appeals Office in May 2009. In his response to

petitioner’s protest at Appeals, respondent maintained that he was continuing to

follow the Puerto Rico MOU methodology and that his intent was to respect the

revised intercompany royalty rates of 44% and 26%.

2. Second Audit

In March 2010 Appeals, at respondent’s request, returned the case to the

Internal Revenue Service’s examination function, which reexamined Medtronic’s

2005 and 2006 tax returns.

3. Notice of Deficiency

On December 23, 2010, respondent issued petitioner a notice of deficiency

determining deficiencies in tax totaling $198,232,199 and $759,383,578 for 2005

and 2006, respectively.3 Respondent calculated these deficiencies in reliance on

the Heimert report, explained in greater detail below, which used the comparable

profits method (CPM). On July 10, 2014, respondent amended his answer to

exclude royalty amounts paid by MPROC for non-U.S. sales, asserting that his

3
These amounts include amounts attributable to issues that the parties have
settled.
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[*71] adjustments under section 482 were understated by $51,650,809 for 2005

and $59,560,314 for 2006. Thus, the amounts of the proposed deficiencies related

to the devices and leads transfer pricing issue are approximately $548,180,115 for

2005 and $810,301,695 for 2006.4

In the notice, respondent asserted several issues giving rise to the

deficiencies. The parties were able to settle several of these issues.5 The issues

that remain are: the devices and leads transfer pricing issue, the Swiss supply

agreement issue, and the section 367(d) issue.

OPINION

I. Overview of Parties’ Positions

We must determine whether the four intercompany agreements among

MPROC and Medtronic US and Med USA were at arm’s length during 2005 and

2006. We must also determine whether respondent’s allocation is arbitrary,

capricious, or unreasonable. If we find that respondent’s allocation was not

arbitrary, capricious, or unreasonable, in whole or in part, then we must

4
Since petitioner had increased its income to reflect the royalty rates agreed
upon for a prior tax year’s informal resolution, the adjustment does not include the
amount by which petitioner had increased its taxable income in reliance on the
MOU. Petitioner is now seeking a refund by returning to its book reporting
position.
5
The parties filed a stipulation of settled issues on January 16, 2014.
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[*72] alternatively determine whether Medtronic US, Med Rel, Inc., or Medtronic

Puerto Rico, Inc., transferred intangible property compensable under section

367(d) to MPROC when Medtronic US restructured its operations in Puerto Rico

in 2002.

Both parties presented experts to support their respective positions. For

experts, we focus on the degree to which their opinions are supported by the

evidence. Accordingly, our opinion is not based on comparing their

qualifications, and so we do not list or discuss their qualifications, as listing them

would unnecessarily lengthen the opinion. We do not use titles because we do not

wish to imply a greater deference to academic experts than to industry experts.

We do not discuss the opinion of any expert which does not pertain to our factual

conclusions.

A. Petitioner’s Position

Petitioner contends that the MOU royalty rates on the intercompany sales of

devices and leads from MPROC to Medtronic US were greater than arm’s length.

In 2005 the MOU royalty rate was 37.6% for devices and 25.5% for leads after the

profit split calculation. In 2006 the MOU royalty rate was 44% for devices and

26% for leads after the profit split calculation. Petitioner contends that, using the

CUT method, the proper arm’s-length royalty rates were 29% for devices and 15%
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[*73] for leads. Petitioner presented expert testimony that supported these rates.

Because of its downward adjustment of royalty rates, petitioner argues that it is

entitled to overpayments pursuant to section 6512(b) of $184,569,840 for 2005

and $397,117,827 for 2006.

Petitioner also contends that respondent’s allocations in the notice of

deficiency using the CPM are much greater than arm’s length and are therefore

arbitrary, capricious, and unreasonable. Specifically, petitioner argues that

respondent’s value chain approach fails to respect and view separately the

intercompany transactions between MPROC, Medtronic US, and Med USA.

Petitioner also contends that respondent did not adequately consider that product

quality determines success in the implantable medical device industry and that

MPROC is ultimately responsible as the manufacturer of class III finished

medical devices.

B. Respondent’s Position

Respondent’s position is that the CPM is the best method to determine the

arm’s-length royalty rates on the intercompany sales of devices and leads and that

making the accompanying section 482 adjustments did not result in an abuse of

discretion. Respondent contends that Medtronic US and Med USA performed all
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[*74] but one of the economically significant functions for CRDM and Neuro.6

Respondent contends that the only economically significant function that MPROC

performed was assembling finished products, with Medtronic US providing

significant oversight and help.

Respondent contends that petitioner’s use of the CUT method does not meet

the standard of section 482 and the accompanying regulations. Respondent rejects

petitioner’s argument that quality is the most important determinant of success in

the medical device industry. Respondent contends that petitioner’s experts’

uncontrolled license arrangements are not comparable to the Medtronic US-

MPROC royalty agreement.

II. Covered Transactions

MPROC and Medtronic US entered into four separate intercompany

agreements: (1) the components supply agreement, (2) the distribution agreement,

(3) the trademark license, and (4) the devices and leads licenses (collectively,

covered transactions.)

6
In post trial briefs respondent referred to Medtronic, Inc. and its U.S.
subsidiaries, which include activity taking place in the United States, as MED US.
We will not use the term MED US since it is not a legal entity. Medtronic US and
Med USA are separate legal entities with separate relationships with MPROC.
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[*75] Pursuant to section 482, all four of the intercompany agreements must be at

arm’s length. Petitioner separately priced each of the four covered agreements

between and among Medtronic US, MPROC, and Med USA. Respondent, on the

other hand, performed a functional analysis that looked at all four covered

agreements together.

The first agreement covers the sale of components. Although respondent

did not concede that it was made at arm’s length and included the agreement in the

transfer pricing analysis performed by respondent’s expert in conjunction with the

notice of deficiency, respondent’s expert concluded that the agreement was within

arm’s-length range for 2005 and above arm’s-length range for 2006.

The second agreement covers the distribution of devices and leads

manufactured by MPROC and sold by Med USA. Although respondent did not

concede that this agreement was made at arm’s length and included the agreement

in the transfer pricing analysis, respondent’s expert in conjunction with the notice

of deficiency concluded that the sales of finished goods were within the arm’s-

length range for both 2005 and 2006.

The third agreement covers the ability of MPROC to use trademarks and

trade names owned by Medtronic US. The parties dispute how to analyze this

agreement. Respondent’s analysis did not separate the trademark license from the
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[*76] devices and leads licenses. Petitioner’s analysis treats the trademark license

as separate from the other three and concludes that 8% is a proper royalty rate.

The fourth agreement covers the licensing of intangible property used by

MPROC in manufacturing devices and leads. This agreement is central to the

dispute. It will be our main focus as we look at the facts and circumstances to

determine whether respondent’s result was reasonable.

III. Applicable Statute and Regulations

Section 482 was enacted to prevent tax evasion and to ensure that taxpayers

clearly reflect income relating to transactions between controlled entities. Veritas

Software Corp. & Subs. v. Commissioner, 133 T.C. 297, 316 (2009). This section

gives the Commissioner broad authority to allocate gross income, deductions,

credits, or allowances between two related corporations if the allocations are

necessary either to prevent evasion of tax or to reflect clearly the income of the

corporations. See Seagate Tech., Inc. & Consol. Subs. v. Commissioner, 102 T.C.

149, 163 (1994).

To determine true taxable income, the standard to be applied in every case is

that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer. Sec.

1.482-1(b)(1), Income Tax Regs. The arm’s-length result of a controlled

transaction must be determined under the method that, under the facts and
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[*77] circumstances, provides the most reliable measure of an arm’s-length result.

Id. para. (c)(1).

The Commissioner will evaluate the results of a transaction as actually

structured by the taxpayer unless it lacks economic substance. Id. para.

(f)(2)(ii)(A). The Commissioner, however, may consider the alternatives available

to the taxpayer in determining whether the terms of the controlled transaction

would be acceptable to an uncontrolled taxpayer faced with the same alternatives

and operating under similar circumstances. Id. In this type of situation the

Commissioner may adjust the consideration charged in the controlled transaction

according to the cost or profit of an alternative, but the Commissioner will not

restructure the transaction as if the taxpayer had used the alternative. See id.

The regulations provide four methods to determine the arm’s-length amount

to be charged in a controlled transfer of intangible property: the CUT, the CPM,

the profits split method, and unspecified methods as described in section 1.482-

4(d), Income Tax Regs. See id. sec. 1.482-4(a).

There is no strict priority of methods, and no method will invariably be

considered more reliable than others. Id. sec. 1.482-1(c)(1). In determining which

of two or more available methods provides the most reliable measure of an arm’s-

length result, the two primary factors to take into account are the degree of
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[*78] comparability between the controlled transaction (or taxpayer) and any

uncontrolled comparables, and the quality of data and assumptions used in the

analysis. Sec. 1.482-1(c)(2), Income Tax Regs.

A. CPM

The CPM evaluates whether the amount charged in a controlled transaction

is arm’s length according to objective measures of profitability (profit level

indicators) derived from transactions of uncontrolled taxpayers that engage in

similar business activities under similar circumstances. Id. sec. 1.482-5(a). Profit

level indicators are ratios that measure relationships between profits and costs

incurred or resources employed. Id. para. (b)(4). The appropriate profit level

indicator depends upon a number of factors, including the nature of the activities

of the tested party, the reliability of available data with respect to uncontrolled

comparables, and the extent to which the profit level indicator is likely to produce

a reliable measurement of the income that the tested party would have earned had

it dealt with controlled taxpayers at arm’s length taking into account all facts and

circumstances. See id.

B. CUT Method

The CUT method evaluates whether the amount charged for a controlled

transfer of intangible property was arm’s length by reference to the amount
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[*79] charged in a comparable uncontrolled transaction. Id. sec. 1.482-4(c). If an

uncontrolled transaction involves the transfer of the same intangible under the

same or substantially the same circumstances as the controlled transaction, the

results derived generally will be the most direct and reliable measure of the arm’s-

length result for the controlled transfer of an intangible. Id. subpara. (2)(ii).

The application of the CUT method requires that the controlled and

uncontrolled transactions involve the same intangible property or comparable

intangible property as defined in the regulations. Id. subdiv. (iii)(A). In order for

intangibles to be considered comparable, both intangibles must: (i) be used in

connection with similar products or processes within the same general industry or

market and (ii) have similar profit potential. Id. subdiv. (iii)(B).

The profit potential of an intangible is most reliably measured by directly

calculating the net present value of the benefits to be realized (on the basis of

prospective profits to be realized or costs to be saved) through the use of

subsequent transfers of the intangible, considering the capital investment and

startup expenses required, the risks to be assumed, and other relevant

considerations. Id. subdiv. (iii)(B)(ii).
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[*80] C. Profit Split Method

The profit split method evaluates whether the allocation of the combined

operating profit or loss attributable to one or more controlled transactions is arm’s

length by reference to the relative value of each controlled taxpayer’s contribution

to that combined operating profit or loss. Sec. 1.482-6(a), Income Tax Regs.

Allocation under the profits split method must be made in accordance with either

the comparable profit split method or the residual profit split method. Id. para.

(c)(1).

The residual profit split method allocates the combined operating profit or

loss from the relevant business activity between the controlled taxpayers via a

two-step process: (1) allocate income to routine contributions, and (2) allocate

residual profit. Id. subpara. (3)(i)(A) and (B). Routine contributions ordinarily

include contributions of tangible property, services, and intangible property that

are generally owned by uncontrolled taxpayers engaged in similar activities. A

functional analysis is required to identify these contributions according to the

functions performed, risks assumed, and resources employed by each of the

controlled taxpayers. Id. subdiv. (i)(A). In cases where there is intangible

property, there will normally be an unallocated residual profit after the allocation

of income, and this residual profit is generally divided among the controlled
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[*81] taxpayers according to the relative value of their contributions of intangible

property to the relevant business activity. Id. subdiv. (i)(B).

D. Aggregation

Generally, transactions will be aggregated only when they involve related

products or services as defined in section 1.6038A-3(c)(7)(vii), Income Tax Regs.

Id. sec. 1.482-1(f)(2)(i)(A).7 Related products or services are defined as groupings

of products and types of services that reflect reasonable accounting, marketing, or

other business practices within the industries in which the related party group

operates. Id. sec. 1.6038A-3(c)(7)(vii).

E. Commensurate With Income

In 1986 Congress amended section 482 by adding: “In the case of any

transfer (or license) of intangible property (within the meaning of section

936(h)(3)(B)), the income with respect to such transfer or license shall be

commensurate with the income attributable to the intangible.” Tax Reform Act of

1986, Pub. L. No. 99-514, sec. 1231(e)(1), 100 Stat. at 2562-2563.

7
This regulation is no longer in effect and was replaced with sec. 1.482-
1T(f)(2)(i), Temporary Income Tax Regs., 80 Fed. Reg. 55541 (Sept. 16, 2015).
which applies for taxable years ending on or after September 14, 2015. This Court
held that the sec. 1.482-1(f)(2)(i)(A), Income Tax Regs. permits aggregation of
transactions involving services, tangible property, and intangible property.
Guidant LLC v. Commissioner 146 T.C. _ , _ (slip op. at 38) (Feb. 29, 2016).
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[*82] The House report that accompanied the House version of the 1986

amendment to section 482 explains the reason for change, in relevant part, as

follows:

There is a strong incentive for taxpayers to transfer intangibles
to related foreign corporations or possessions corporations in a low
tax jurisdiction, particularly when the intangible has a high value
relative to manufacturing or assembly costs. * * *

* * * * * * *

Many observers have questioned the effectiveness of the
“arm’s length” approach of the regulations under section 482. A
recurrent problem is the absence of comparable arm’s length
transactions between unrelated parties, and the inconsistent results of
attempting to impose an arm’s length concept in the absence of
comparables.

* * * * * * *

The problems are particularly acute in the case of transfers of
high-profit potential intangibles. Taxpayers may transfer such
intangibles to foreign related corporations or to possession
corporations at an early stage, for a relatively low royalty, and take
the position that it was not possible at the time of the transfers to
predict the subsequent success of the product. Even in the case of a
proven high-profit intangible, taxpayers frequently take the position
that intercompany royalty rates may appropriately be set on the basis
of industry norms for transfers of much less profitable items.

* * * * * * *

Transfers between related parties do not involve the same risks
as transfers to unrelated parties. There is thus a powerful incentive to
establish a relatively low royalty without the adequate provisions for
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[*83] adjustment as the revenues of the intangible vary. There are
extreme difficulties in determining whether the arm’s length transfers
between unrelated parties are comparable. The committee thus
concludes that it is appropriate to require that the payment made on a
transfer of intangibles to a related foreign corporation or possessions
corporation be commensurate with the income attributable to the
intangible. * * *

* * * * * * *

Where taxpayers transfer intangibles with a high profit
potential, the compensation for the intangibles should be greater than
industry averages or norms. * * *

* * * * * * *

In requiring that payments be commensurate with the income
stream, the bill does not intend to mandate the use of the “contract
manufacturer” or “cost-plus” methods of allocating income or any
other particular method. As under present law, all the facts and
circumstances are to be considered in determining what pricing
methods are appropriate in cases involving intangible property,
including the extent to which the transferee bears real risks with
respect to its ability to make a profit from the intangible or, instead,
sells products produced with the intangible largely to related parties
(which may involve little sales risk or activity) and has a market
essentially dependent, on, or assured by, such related parties’
marketing efforts. However, the profit or income stream generated by
or associated with intangible property is to be given primary weight.

H.R. Rept. No. 99-426, at 423-426 (1985), 1986-3 C.B. (Vol. 2) 1, 423-426.

The conference report that accompanied the 1986 amendment to section 482

states, in relevant part, as follows:
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[*84] The conferees are also aware that many important and difficult
issues under section 482 are left unresolved by this legislation. The
conferees believe that a comprehensive study of intercompany pricing
rules by the Internal Revenue Service should be conducted and that
careful consideration should be given to whether the existing
regulations could be modified in any respect.

H.R. Conf. Rept. No. 99-841 (Vol. II), at II-638 (1986), 1986-3 C.B. (Vol. 4) 1,

638.

The Department of the Treasury and the Internal Revenue Service did

conduct a comprehensive study that was published in 1988. See Notice 88-123,

1988-2 C.B. 458 (1988 White Paper). The 1988 White Paper concluded that the

arm’s-length standard is the norm for making transfer pricing adjustments. Id.,

1988-2 C.B. at 475. The 1988 White Paper concluded that Congress intended no

departure from the arm’s-length standard. Id. The 1988 White Paper explained

the following:

Looking at the income related to the intangible and splitting it
according to relative economic contributions is consistent with what
unrelated parties do. The general goal of the commensurate with
income standard is, therefore, to ensure that each party earns the
income or return from the intangible that an unrelated party would
earn in an arm’s length transfer of the intangible.

Id., 1988-2 C.B. at 472.

Treasury has repeatedly confirmed that Congress intended for the

commensurate with income standard to work consistently with the arm’s-length
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[*85] standard. See, e.g., Treasury Department Technical Explanation of the 2001

U.S.-U.K. Income Tax Convention, art. 9, Tax Treaties (CCH) para. 10,911 at

201,307 (“It is understood that the ‘commensurate with income’ standard for

determining appropriate transfer prices for intangibles, added to Code section 482

by the Tax Reform Act of 1986, was designed to operate consistently with the

arm’s-length standard.”); Treasury Department Technical Explanation of the 2006

Model Income Tax Convention, art. 9, Tax Treaties (CCH) para. 215, at 10,640-

10,641 (same); see also Altera Corp. v. Commissioner, 145 T.C. 91 (2015).

F. Taxpayer’s Burden

When the Commissioner has determined deficiencies based on section 482,

the taxpayer bears the burden of showing that the allocations are arbitrary,

capricious, or unreasonable. See Sundstrand Corp. & Subs. v. Commissioner, 96

T.C. 226, 353-354 (1991) (citing G.D. Searle & Co. v. Commissioner, 88 T.C.

252, 359 (1987), and Eli Lilly & Co. v. Commissioner, 84 T.C. 996, 1131 (1985),

aff’d on this issue, rev’d in part and remanded, 856 F.2d 855 (7th Cir. 1988)). The

Commissioner’s section 482 determination must be sustained absent a showing of

abuse of discretion. See Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 582

(1989), aff’d, 933 F.2d 1084 (2d Cir. 1991).
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[*86] Respondent’s determination as set forth in the notice of deficiency is

presumptively correct. See Sundstrand Corp. & Subs. v. Commissioner, 96 T.C. at

353. On July 10, 2014, respondent amended the answer to exclude royalty

amounts paid by MPROC for non-U.S. sales, which meant that the notice

adjustments for section 482 were understated by $51,650,809 for 2005 and

$59,560,314 for 2006. We look to both the notice of deficiency and the revision

as set forth in the amended answer to see whether respondent’s section 482

allocation is arbitrary, capricious, or unreasonable.8

“Whether respondent has exceeded his discretion is a question of fact. * * *

In reviewing the reasonableness of respondent’s determination, the Court focuses

on the reasonableness of the result, not on the details of the methodology used.”

Id. at 353-354; see also Am. Terrazzo Strip Co. v. Commissioner,

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Source: Frix Law Library, https://www.frixlaw.com/law-library/cases/4340342. Public record. Not legal advice.