Federal appeals court calls for redo of $1.4B tax ruling in Medtronic’s favor

A federal appeals court has thrown out a previous tax court ruling favoring Medtronic on procedural grounds, reigniting a years-long dispute with the IRS over the payment of nearly $1.36 billion in back taxes.

Initially, the IRS took issue with Medtronic’s allocations of incomes between its subsidiaries through royalties and licensing agreements. Using methods such as transfer pricing, the IRS said the medtech giant shifted too much of its profits to its Puerto Rican subsidiary in an attempt to avoid a higher rate.

Though part of the U.S., Puerto Rico is considered international for tax purposes, with the IRS describing the move as a "classic case" of companies trying to move profits offshore. Medtronic has since moved to Ireland, following its $50 billion merger with Covidien.

The agency had first demanded payments of $548 million and $810 million in missed federal taxes for 2005 and 2006, respectively, but a ruling in the IRS’ favor could open the company up to billions more in taxes from the following years—not to mention other transnational companies using similar accounting methods.

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The U.S. Tax Court, however, had called the IRS’ calculations "arbitrary, capricious or unreasonable," and rejected both the federal government’s and Medtronic’s methods for determining the proper tax amount before conducting its own analysis in 2016. It later concluded Medtronic owed $26.7 million for 2005, but had overpaid its 2006 taxes by $12.5 million. The IRS appealed.

In its opinion (PDF), the Eighth Circuit Court of Appeals said the lower tax court would need to revisit the case after failing to address a variety of circumstances, including the amount of risk and product liability expenses that should be allocated in the devicemaker’s licensing arrangements between its companies.

RELATED: Medtronic to pony up funds in $525M IRS tax settlement

The IRS contended that Medtronic Puerto Rico bore only 11% of the device manufacturing costs, including product liability expenses, and its allocation of profits should be similar. But the tax court said that did not give enough weight to the risks incurred in ensuring quality.

The tax court ended up allocating almost 50% of the company’s device profits to the island subsidiary—but the appeals court said those conclusions were reached without specifically detailing amounts of risk and liability expenses, and would need to be reevaluated.

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