# UNITED STATES TAX COURT > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3Aee99b8535e34fe47 ## Record - **Collection:** Agency decision - **Document type:** Agency decision ## Text SD 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. SERVED Jun 09 2016 -2[*2] CONTENTS FINDINGS OF FACT................................................7 I. Overview of Medtronic.......................................... 7 A. Class III Medical Devices................................... 7 B. Industry Background...................................... 9 C. II. Customers......................................... 10 2. Competitors. ...................................... 11 Self-Insurance........................................... 12 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 D. III. 1. 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 Medtronic Europe. ...................................... 34 Intercompany Agreements. ..................................... 35 A. Devices and Leads Licenses................................ 35 B. Components Supply Agreement............................. 37 C. Distribution Agreement. .................................. 38 D. TrademarkLicense....................................... 39 -3[*3] IV. Swiss Supply Agreement. ...................................... 39 V. CRDM and Neuro Business Units. ............................... 40 A. CRDM................................................. 40 1. B. 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 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. ProductRecalls...............................................59 VIII. Audits and Notice of Determination............................... 65 A. MOU.................................................. 65 B. 2005and2006TaxReturns................................ 68 C. Audits for2005 and2006 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 -4[*4] B. Respondent's Position. ................................... 73 II. Covered Transactions. ......................................... 74 III. Applicable Statute and Regulations. .............................. 76 IV. 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 AbuseofDiscretion............................................ 87 A. Abandonment of Notice Position. . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 B. Respondent's Section 482 Allocations.. . . . . . . . . . . . . . . . . . . . . . . 88 1. Respondent's Position. .............................. 88 2. 3. Heimert's Economic Analysis. . . . . . . . . . . . . . . . . . . . . . . . . 90 Concerns With Heimert's Economic Analysis.. . . . . . . . . . . . 97 a. Quality. ..................................... 97 4. C. V. VI. i. Petitioner's Position.. . . . . . . . . . . . . . . . . . . . . . 98 ii. Respondent's Position. . . . . . . . . . . . . . . . . . . . . 98 b. Comparables................................. 109 c. ROA....................................... 112 d. Aggregation. ................................ 114 Analysis. ........................................ 116 Commensurate With Income. ..... . . . . ....... . . . . . . ..... .. 118 Petitioner's Method........................................... 120 A. Devices and Leads Licenses Allocations. . . . . . . . . . . . . . . . . . . . . 120 B. Trademark License Allocations. ... . .. . . . ..... . . . . . . . . . .... 129 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 -5[*5] 2. 3. VII. Adjustments. ..................................... 135 a. Know-How.................................. 135 b. Profit Potential............................... 135 c. Scope of Products............................. 136 Calculation of Revised Royalty Rate. . . . . . . . . . . . . . . . . . . 137 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 -6[*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 ¹In 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. 2Medtronic Puerto Rico, Inc., was MPROC's predecessor. -7[*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 -8[*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". Il 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- -9[*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. -10[*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. -11[*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. -12[*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 selfinsured 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. -13[*13] II. A. Entities and Roles 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 -14[*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 -15[*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 nonrecogmtion 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 of29% 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 -44[*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 highvolume, 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 -49[*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. -50[*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. -51[*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, -52[*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. -53[*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 -57[*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 -58[*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. -61[*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-ofpocket costs for the Marquis devices it made. -62[*62] Shortly after the Marquis recall in 2005, Guidant, the clear-cut secondleading 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 -63[*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, -64[*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 -65[*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'slength 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 -70[*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 3These amounts include amounts attributable to issues that the parties have settled. -71[*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 4Since 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. 5The parties filed a stipulation of settled issues on January 16, 2014. -72[*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% -73[*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 detenmine 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 -74[*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 USMPROC 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.) 6In 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. -75[*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 -76[*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 -77[*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 1.4824(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'slength result, the two primary factors to take into account are the degree of -78[*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. E sec. 1.482-5(a). Profit level indicators are ratios that measure relationships between profits and costs incurred or resources employed. R 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 -79[*79] charged in a comparable uncontrolled transaction. R 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'slength result for the controlled transfer of an intangible. R 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. R 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. R 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. E subdiv. (iii)(B)(ii). -80[*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. E 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. R 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. R 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 -81[*81] taxpayers according to the relative value of their contributions of intangible property to the relevant business activity. R 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. Il 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. E 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. 7This regulation is no longer in effect and was replaced with sec. 1.4821T(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). -82[*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 -83[*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: -84[*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. R, 1988-2 C.B. at 475. The 1988 White Paper concluded that Congress intended no departure from the arm's-length standard. R 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 -85[*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 10,64010,641 (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). -86[*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." Il at 353-354; see also Am. Terrazzo Strip Co. v. Commissioner, 56 T.C. 961, 971 (1971). If we hold that the adjustments set forth in the notice of deficiency are arbitrary, capricious, or unreasonable, then petitioner must next show that the 8Pursuant to Rule 142(a) the burden of proof is on respondent for increases in deficiencies. Therefore, respondent has the burden of proof for the increased deficiencies asserted in the amended answer. See Olive v. Commissioner, 139 T.C. 19 (2012), afÕl, 792 F.3d 1146 (9th Cir. 2015). Our resolution of whether respondent abused his discretion in reallocating royalty payments under sec. 482 is based on a preponderance of the evidence, and not on the burden of proof. -87[*87] allocations it proposes satisfy the arm's-length standard. Eli Lilly & Co. v. Commissioner, 856 F.2d at 860 (and the cases cited thereat). Where the evidence shows that neither side is correct, we must consequently determine the proper allocation. See Veritas Software Corp. & Subs. v. Commissioner, 133 T.C. at 318. IV. Abuse of Discretion We first consider whether there was an abuse of discretion when respondent reallocated the royalty payments under section 482. Petitioner sets forth two arguments for its contention that respondent abused his discretion. First, petitioner claims respondent abandoned a prior position. Second, petitioner claims that respondent's adjustments were unreasonable because they gave inadequate consideration to the importance of quality at MPROC. A. Abandonment of Notice Position In prior transfer pricing cases we have found respondent's actions to be arbitrary and capricious where respondent has abandoned the position in the notice of deficiency and argued a different position at trial. See id. at 319-320; Compaq Computer Corp. v. Commissioner, T.C. Memo. 1999-220, slip op. at 28 ("In most instances where respondent abandons his notice position at trial, courts conclude that allocation in the notice under section 482 are arbitrary and capricious."); see a_lso Nat'l Semiconductor Corp. v. Commissioner, T.C. Memo. 1994-195. -88[*88] Petitioner contends that respondent has had divergent views of the transactions at issue and of what constitutes an arm's-length transaction. Respondent has changed the position included in the MOU to the position reflected in the amended answer. Petitioner contends that there were no material changes in the facts or law between the time of the MOU and the issuance of the notice of deficiency. Respondent contends that the notice of deficiency and the position at trial are consistent. Petitioner counters that respondent abandoned a previous position that was an informal resolution based on the audit for tax year 2002. The Commissioner is not bound by positions taken for a previous year. Dinkins v. Commissioner, 378 F.2d 825, 829 (8th Cir. 1967), M, 45 T.C. 593 (1966). Respondent based the notice of deficiency and the arguments made at trial on the same CPM analysis made by A. Michael Heimert. We conclude that respondent did not abandon the position taken in the notice of deficiency, but this does not end our analysis of whether there was an abuse of discretion. B. Respondent's Section 482 Allocations 1. Respondent's Position Respondent contends that there was no abuse of discretion in making adjustments in the notice of deficiency as revised in the amended answer. -89[*89] Respondent does not contend that the covered transactions lacked economic substance. Rather, respondent contends that the CPM is the best method to determine the true taxable income of MPROC. As part of the CPM respondent used a value chain analysis, which segments a company's operations into functional activities, allowing qualitative assessment of each participant's economic contributions to the profits of the consolidated enterprise. Respondent contends that Medtronic US and Med USA performed most of the functions of the CRDM and Neuro value chain, and bore the risks related to the functions they performed. These functions related to the overall CRDM and Neuro businesses. Respondent's view is that MPROC performed only the final manufacturing steps, which were completed according to processes approved by Medtronic US. In the notice of deficiency respondent made adjustments based on the Heimert report, which contended that MPROC's pr [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3Aee99b8535e34fe47. Public record. Not legal advice.