Medtronic, Eighth Circuit Ruling, Best Methods and the Theory of the Firm

October 7, 2025

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Scott Montopoli leads KBF’s International Tax Services with a focus on cross-border tax planning and compliance. Jonathan Voll leads KBF’s Transfer Pricing Services with a focus on intangible assets management and overall transfer pricing governance structures across global supply chains.

This information is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide accounting, tax, or other professional advice. Copyright © 2025 KBF Advisory LLC. All rights reserved.

The U.S. Court of Appeals for the Eighth Circuit (Eighth Circuit) has again remanded the Medtronic case back to the U.S. Tax Court (T.C.) in its September 2025 ruling. On appeal from the IRS and cross appeal by Medtronic, Inc., the Eighth Circuit has ruled that the T.C.’s latest ruling in 2022 exhibits legal errors, lacks sufficient factual findings, and indicates a misapplication of Section 482 in its reasonings for rejecting the IRS claim of the comparable profits method (CPM) as the best method for the setting of the royalty fees owed by Medtronic Puerto Rico Co. (MPROC) to its parent Medtronic, Inc.

The Eighth Circuit ruling focuses its critiques particularly on the following areas (among certain others):

The T.C.’s reference to a deficiency in Medtronic’s product comparability to uncontrolled companies as grounds to reject the CPM; and
The T.C.’s deficiencies in addressing Medtronic Inc.’s realistic alternatives to the terms of its arrangement with MPROC.

In this abbreviated discussion, we explore certain observations and potential implications of the next phase of this litigation.

Background:

The long-running Medtronic v. Commissioner litigation centers on how to allocate profit between Medtronic, Inc. and MPROC, which produced implantable medical devices using intangible property licensed from the U.S. parent. Medtronic’s position throughout the case was that the comparable uncontrolled transaction (CUT) method—based on its “Pacesetter Agreement” with Siemens Pacesetter, an unrelated party—was the most reliable way to price the intercompany royalty. The IRS, by contrast, maintained that the CPM, with MPROC as the tested party, is the “best method” under Treas. Reg. §1.482-1(c).

In T.C.’s first ruling in 2016 (T.C. Memo. 2016-112), it agreed with Medtronic, accepting the Pacesetter Agreement as an appropriate CUT and adjusting the royalty rates to produce an overall profit split of roughly 54 percent to Medtronic, Inc. and 46 percent to MPROC. On appeal, the Eighth Circuit in 2018 (900 F.3d 610) vacated and remanded that decision, finding the factual record inadequate to review whether the Pacesetter transaction was truly comparable or whether the T.C. had properly applied the best-method rule.

On remand, the T. C. (T.C. Memo. 2022-84) reversed course. It held that the Pacesetter Agreement was not a valid CUT, rejected the Commissioner’s CPM analysis, and instead devised an unspecified hybrid method that blended elements of each party’s model. That approach yielded a substantially different outcome—allocating about 69 percent of system profit to Medtronic, Inc. and 31 percent to MPROC. Both sides appealed once again.

In its September 2025 ruling, the Eighth Circuit vacated and remanded the T.C.’s 2022 ruling. This appellate court concluded that the T. C. had committed both legal and factual errors. First, it held that the T.C. could not use the Pacesetter Agreement as a “starting point” under an unspecified method after finding that the agreement failed the regulatory requirement that comparable intangibles possess similar profit potential. Second, it ruled that the T.C. misapplied the CPM comparability standards by overemphasizing product similarity and by failing to make specific findings on the asset bases, functions, and risk profiles of the proposed comparable companies. Third, the court directed the T.C. to quantify MPROC’s product-liability risk, assess whether differences among the comparable companies were material, and determine whether realistic manufacturing alternatives existed that would influence the arm’s length price.

Accordingly, the Eighth Circuit revived the viability of the CPM as a potentially reliable method and instructed the T.C. to reassess whether the IRS’s 12–14 percent profit allocation to MPROC was in fact reasonable.

The CPM:

As thoroughly briefed throughout the many filings of this long running case, the CPM is one of four prescribed methods under US Treas. Reg. 1.482; that include the CUT, the CPM as well the profit split and unspecified methods.

By the CPM, “the determination of an arm’s length result is based on the amount of operating profit that the tested party would have earned on related party transactions if its profit level indicator were equal to that of an uncontrolled comparable (comparable operating profit).”[1]

The comparability factors particular to the CPM include a focus on resources employed, and risks assumed, and “because resources and risks usually are directly related to functions performed, it is also important to consider functions performed in determining the degree of comparability between the tested party and an uncontrolled taxpayer.”[2]

A focus on asset specificity as comparability factor for the CPM:

Asset specificity in this context is defined as the degree to which an investment (or asset) has a higher value for a particular transaction or relationship than for any other purpose or by another user.

The theory of the firm[3] purports that factors driving a firm’s vertical integration, or decisions to outsource mission critical functions, follow from the influence of transactional costs[4] present in commercial relationships Moreover, this theory suggests that greater degrees of asset specificity can manifest in “hold-up” risks; whereby a party that has created mission critical assets could exploit the user’s need for these assets to extract pricing premiums. A dynamic that motivates vertical integration by firms to mitigate this risk.

These economic underpinnings are important to consider in the context of the Eighth Circuit’s reference to Medtronic, Inc. realistic alternatives to the terms set with MPROC in the case at hand. This interplay is reflected in the following stylized inquiries:

If credence is given to Medtronic’s view that MPROC developed a highly product-specific and sophisticated manufacturing quality protocol, together with related know-how, could Medtronic, Inc. feasibly navigate the transactional costs of engaging an unrelated manufacturer possessing such capabilities, without exposing itself to the uncontrolled party’s enhanced bargaining power and ability to command premium profits that exceed those observed under a CPM benchmark?
Concurrently, absent expectations of premium profits, what incentives would motivate an uncontrolled manufacturer to incur and sustain the costs and risks associated with developing and maintaining a sophisticated, bespoke quality-control system and related know-how dedicated to a single customer, and potentially of little or no value to future customers?
Could then the circumstances that led Medtronic, Inc. to forgo outsourcing a core manufacturing function, and instead vertically integrate it, serve as evidence of MPROC’s high asset specificity, which in turn motivated Medtronic, Inc.’s decision to internalize production so as to mitigate potential hold-up risks and transaction costs?

Potential outcomes:

While the above inquiries are not novel among transfer pricing practitioners, it bears repeating that the outcome of the T.C.’s next ruling on this matter could have material (and possibly unanticipated) implications for the very common use of the CPM by taxpayers with increasingly sophisticated global supply chains.

Specifically, if the T.C. follows in the spirit of the Eighth Circuit’s remit including with a further review of the realistic alternatives of Medtronic, Inc., taxpayers should pay particular attention to the potential outcomes. One of many interesting and possible outcomes is inferred by the following queries:

If the T.C. finds that the economics of Medtronic, Inc.’s realistic alternatives for outsourcing its manufacturing were not possible at rates suggested by the CPM; could this ruling then motivate the taxing authority of a controlled manufacturer to focus on asset specificity and the factors driving vertical integration of this activity into the taxpayer’s business, versus outsourcing?
And then therefore could this taxing authority claim a greater share of system profit for the controlled manufacturer by rejecting the CPM’s comparison of the benchmarked profits for what are deemed noncomparable know-how, and technical acumen that do not exhibit a similarly high degree of asset specificity as those of the tested party?

Delving further into the intricacies and permutations of the scenarios implied in the foregoing inquiries is beyond the scope of this limited discussion. However, we note that in today’s state of the real or perceived AI revolution, taxpayers should welcome a more granular focus by the T.C. on the relevant supply chain value drivers in this case as well as for future cases. Most pointedly given the likelihood of traditional value drivers, historically rooted in human input, now emerging from the growing use of machine learning and AI across the supply chain. With these dynamics, the theoretical boundaries of firm integration and comparability under existing transfer-pricing frameworks may require re-examination.

Accordingly, this timely revisit of the merits and challenges of the CPM may be a useful and enlightening outcome for the T.C.’s next round of analysis on these complex matters. Upon a final ruling (whenever that may come) taxpayers should carefully parse the outcome for its influence on future tax operating models and their related transfer pricing methods.

For personalized guidance, connect with our international tax services team here or connect with our transfer pricing services team here.

[1] Treas. Reg. §1.482-5(b)(1)
[2] Treas. Reg. §1.482-5(b)(2)(ii)
[3] The theory of the firm evolved with the inputs of economists Ronald Coase and Oliver Williamson among others.
[4] Transaction costs are those associated with making economic exchanges in a market, including costs of searching for partners, bargaining, writing and enforcing contracts, and monitoring performance. Further instances of transactions costs are manifest in the frictions arising from factors such as the quality of information flows and differences in corporate culture among a principal and vendor.