IRS Files Opening Brief in Medtronic Transfer Pricing Case

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

UNITED STATES TAX COURT

Judge Kathleen Kerrigan

AMENDED OPENING BRIEF FOR RESPONDENT ON REMAND

DRITA TONUZI
Deputy Chief Counsel (Operations)
Internal Revenue Service

OF COUNSEL:
ROBIN GREENHOUSE
Division Counsel (Large Business & International)
JOHN M. ALTMAN
National Strategic Litigation Counsel
ELIZABETH P. FLORES
Senior Level Strategic Litigation Counsel

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CONTENTS

PRELIMINARY STATEMENT

QUESTIONS PRESENTED

RESPONDENT'S REQUEST FOR SUPPLEMENTAL FINDINGS OF FACT

ULTIMATE FINDINGS OF FACT

POINTS RELIED UPON

ARGUMENT

CONCLUSION

CITATIONS

Cases

Ainsley Corp, v. Commissioner, 332 F.2d 555 (9th Cir. 1964)

Altera Corp, v. Commissioner, 926 F.3d 1061 (9^th Cir. 2019), cert, denied, 141 S.Ct. 131 (2020)

 

Amazon.com, Inc, v. Commissioner, 148 T.C. 108 (2017), affd on other grounds, 934 F.3d 976 (9th Cir. 2019)

Atlas IP, LLC v. Medtronic, 2014 WL 5741870 (S.D. Fia. 2014)

Borchers v. Commissioner, 943 F.2d 22 (8th Cir. 1991), aff g 95 T.C. 82 (1990)

Borchers v. Commissioner, T.C. Memo. 1988-349, vacated and remanded, 889 F.2d 790 (8th Cir. 1989)

Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930)

Eaton Corp, v. Commissioner, T.C. Memo. 2017-147

Eli Lilly & Co. v. Commissioner, 84 T.C. 996 (1985), afFd in part and rev'd in part, 856 F.2d 855 (7th Cir. 1988)

ePlus, Inc, v. Lawson Software, Inc., 764 F. Supp. 2d 807 (E.D. Va. 2011)

Exxon Corp, v. United States, 931 F.2d 874 (Fed. Cir. 1991)

G.D. Searle & Co. v. Commissioner, 88 T.C. 252 (1987)

Gen. Elec. Co. v. Joiner, 522 U.S. 136 (1997)

Greenlaw v. United States, 554 U.S. 237 (2008)

Guidant LLC v. Commissioner, 146 T.C. 60 (2016)

In re Mahurkar Double Lumen Hemodialysis Catheter Patent Litig., 831 F. Supp. 1354 (N.D. Ill. 1993)

Lucent Technologies, Inc, v. Gateway, Inc., 580 F.3d 1301 (Fed. Cir. 2009)

Marshall v. Anderson Excavating & Wrecking Company, 8 F.4th 700 (8th Cir. 2021)

Medtronic, Inc, v. Commissioner, 900 F.3d 610 (8th Cir. 2018), vacating and remanding T.C. Memo. 2016-112 

Medtronic, Inc, v. Commissioner, T.C. Memo 2016-112

National Hydro Sys, v. M. A. Mortenson Co., 529 N.W.2d 690 (Minn. 1995)

New Orleans, La., Saints, LP v. Commissioner, T.C. Memo. 1997-246

New York v. Grasso, 54 A.D.3d 180, 861 N.Y.S.2d 627 (1st Dept. 2008)

Pandolfo v. United States, 128 F.2d 917 (10th Cir. 1942)

Panduit Corp, v. Stahlin Bros. Fibre Works, Inc., 575 F.2d 1152 (6th Cir.1978)

Peterson v. Bendix Home Sys., Inc., 318 N.W.2d 50 (Minn. 1982)

Podd v. Commissioner, T.C. Memo. 1998-231, 1998 WL 345513 (1998)

Quern v. Jordan, 440 U.S. 332 (1979)

Rude v. Westcott, 130 U.S. 152(1889)

Seagate Tech., Inc, v. Commissioner, 102 T.C. 149 (1994)

Sprague v. Ticonic Nat. Bank, 307 U.S. 161 (1939)

The Coca-Cola Company & Subs, v. Commissioner, 155 T.C. 145 (2020)

Uniloc, USA, Inc, v. Microsoft Corp., 632 F.3d 1292 (Fed. Cir. 2011)

United States v. Castellanos, 608 F.3d 1010 (8th Cir. 2010)

Wang Labs., Inc, v. Mitsubishi Elecs. Am., Inc., 860 F. Supp. 1448 (C.D. Cal. 1993)

West, Weir & Bartel v. Mary Carter Paint Co., 25 N.Y.2d 535 (1969)

Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158 (1946), aff d, 162 F.2d 513 (10th Cir. 1947)

Internal Revenue Code

I.R.C. § 367(d)

I.R.C. § 482

Treasury Regulations

Treas. Reg. § 1.482-1

Treas. Reg. § 1.482-1(b)(1)

Treas. Reg. § 1.482-1(c)(1)

Treas. Reg. § 1.482-1(c)(2)

Treas. Reg. § 1.482-1(c)(2)(i)

Treas. Reg. § 1.482-1(c)(2)(ii)

Treas. Reg. § 1.482-1(d)

Treas. Reg. § 1.482-1(d)(1)

Treas. Reg. § 1.482-1(d)(2)

Treas. Reg. § 1.482-1(d)(3)

Treas. Reg. § 1.482-1(d)(3)(ii)

Treas. Reg. § 1.482-1(d)(3)(ii)(A)

Treas. Reg. § 1.482-1(d)(3)(ii)(A)(1)

Treas.Reg. § 1.482-1(d)(3)(ii)(B)(1)

Treas. Reg. § 1.482-1(d)(3)(iii)(A)(5)

Treas. Reg. § 1.482-1(d)(3)(iii)(B)

Treas. Reg. § 1.482-1(d)(3)(iii)(B)(l)

Treas. Reg. § 1.482-1(d)(3)(iii)(B)(3)

Treas.Reg. § 1.482-1(d)(3)(iii)(C)

Treas. Reg. § 1.482-1(d)(3)(iv)(H)

Treas. Reg. § 1.482-1(d)(4)(iii)(A)(1)

Treas.Reg. § 1.482-1(d)(4)(iii)(B)

Treas. Reg. § 1.482-1(e)

Treas. Reg. § 1.482-1(e)(2)(iii)(B)

Treas. Reg. § 1.482-1(e)(2)(iii)(C)

Treas. Reg. § 1.482-1(e)(3)

Treas. Reg. § 1.482-1(f)(2)(ii)(A)

Treas. Reg. § 1.482-4(a)

Treas. Reg. § 1.482-4(a)(2)

Treas. Reg. § 1.482-4(c)

Treas. Reg. § 1.482-4(c)(2)

Treas. Reg. § 1.482-4(c)(2)(iii)

Treas. Reg. § 1.482-4(c)(2)(iii)(A)

Treas. Reg. § 1.482-4(c)(2)(iii)(B)(2)

Treas. Reg. § 1.482-4(c)(2)(iii)(B)(2)(i)

Treas. Reg. § 1.482-4(c)(2)(iii)(B)(2)(ii)

Treas. Reg. § 1.482-4(c)(2)(iii)(B)(2)(iii)

Treas. Reg. § 1.482-4(c)(2)(iii)(B)(2)(v)

Treas. Reg. § 1.482-4(c)(2)(iii)(B)(2)(vi)

Treas. Reg. § 1.482-4(c)(2)(iii)(B)(2)(vii)

Treas. Reg. § 1.482-4(c)(2)(iii)(B)(2)(viii)

Treas. Reg. § 1.482-4(c)(4)

Treas. Reg. § 1.482-4(d)

Treas. Reg. § 1.482-4(d)(1)

Treas. Reg. § 1.482-4(d)(2)

Treas. Reg. § 1.482-4(d)(2)(i)

Treas. Reg. § 1,482-4(d)(2)(ii)

Treas. Reg. § 1.482-4(f)(3)(ii)(A)

Treas. Reg. § 1.482-5

Treas. Reg. § 1.482-5(a)

Treas. Reg. § 1.482-5(b)(2)

Treas. Reg. § 1.482-5(b)(2)(i)

Treas. Reg. § 1.482-5(b)(4)

Treas. Reg. § 1.482-5(c)(2)(ii)

Treas. Reg. § 1.482-5(c)(2)(iii)

Treas. Reg. § 1.482-5(c)(2)(iv)

Treas. Reg. § 1.482-5(c)(3)

Treas. Reg. § 1.482-5(d)(6)

Treas. Reg. § 1.482-5(e)

Treas. Reg. § 1.482-6

Treas. Reg. § 1.482-6(c)(3)(i)(A)

Treas. Reg. § 1.482-6(c)(3)(i)(B)

Treas. Reg. § 1.482-8

Other Statutes

21 U.S.C.A. § 360e

Legislative and Regulatory History

H.R. Conf. Rep. No. 99-841, 2d Sess

H.R. Rep. No. 99-426 (1985)

T.D. 8552, 1994-2 C.B. 93

Other Authorities

2 Owen & Davis on Prod. Liab. § 16.16 (4th ed. 2015)

Notice 88-123, 1988-2 C.B. 458

ABBREVIATIONS

ADM	Arizona Device Manufacturing
App.	Appendix
COP	Comparable Operating Profit
CPM	Comparable Profits Method
CRM	Cardiac Rhythm Management
CRT	Cardiac Resynchronization Therapy
CRT-D	CRT defibrillator
CUT	Comparable Uncontrolled Transaction
ICD	Implantable Cardioverter Defibrillators
IPG	Implantable Pulse Generators
IQR	Interquartile Range
Medtronic US	Medtronic, Inc.
MPROC	Medtronic Puerto Rico Operations Co.
MPROC Agreement	The license agreements for the years in issue for intangible property used in manufacturing devices and leads. Exs. 9-J, 10-J, 13-J, and 14-J.
Neuro	Neurological
Pacesetter Agreement	Settlement and License Agreements between Siemens Aktiengesellchaft and Medtronic US dated August 26, 1992
PFF	Petitioner's Finding of Fact
PLI	Profit level indicator
PMA	Premarket Approval
PP&E	Property, Plant, and Equipment
QMS	Quality Management System
QSR	Quality System Regulations
ROA	Return on Assets
RFF	Respondent's Finding of Fact
RTr.	Trial Transcript from 2021 Remand trial
Stip.	Stipulation of Facts
St. Jude	St. Jude Medical, Inc.
Tr.	Trial Transcript from 2015 trial

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PRELIMINARY STATEMENT

This case was tried before the Honorable Kathleen Kerrigan at a special trial session between June 14, 2021 and June 25, 2021. The case was remanded for further proceedings pursuant to a mandate by the Eighth Circuit Court of Appeals following its opinion, Medtronic, Inc, v. Commissioner, 900 F.3d 610 (8th Cir. 2018) (Medtronic II), vacating and remanding Medtronic, Inc, v. Commissioner, T.C. Memo. 2016-112 (Medtronic I). On May 3, 2019, this Court, over respondent's objection, issued an order reopening the record to a limited degree to permit expert testimony and setting forth the scope of the remand.¹ The evidence consists of seven stipulations of fact, trial testimony, and exhibits admitted at the Medtronic I trial, and trial testimony and exhibits admitted on remand. Simultaneous Opening Briefs are due on November 12, 2021. A Rule 155 computation will be required.

QUESTIONS PRESENTED

Whether petitioner's comparable uncontrolled transaction (CUT) method or respondent's comparable profits method (CPM) is the best method to determine the arm's-length price for the intangible property licensed by Medtronic, Inc. (Medtronic US) to Medtronic Puerto Rico Operations Co. (MPROC).

RESPONDENT'S REQUEST FOR SUPPLEMENTAL FINDINGS OF FACT

Respondent respectfully requests that the Court find the following facts to supplement its previous findings in Medtronic I at*7-71. Respondent also respectfully requests that this Court modify four of the findings made in Medtronic I for the reasons described in RFF ¶¶796, 815, 867, and 876, below.

I. RESPONDENT'S EXPERT WITNESSES ON REMAND²

690. Dr. Heimert is an expert in economics and transfer pricing. RTr. 2352:16-18, 2355:12-17 (Heimert). He has spent almost 30 years working on transfer pricing matters at Coopers & Lybrand, Ernst & Young, Ceteris, and Duff & Phelps, and has prepared or reviewed hundreds of transfer pricing studies. He recently retired as global head of transfer pricing at Duff & Phelps but continued there as a senior advisor. During his transfer pricing career, Dr. Heimert has represented 10 to 20 medical device companies. He has testified in court twice — both times in the proceedings in this case. RTr. 2350:6-52:15, 2353:23-54:23, 2355:5-9 (Heimert); Ex. 6203-R at 6085-6090 (App. 1) (Heimert).

691. Dr. Cockburn is an expert in the economics of innovation and intellectual property. RTr. 2041:25-42:9 (Cockburn). He is the Chair of the Strategy and Innovation Department at the Questrom School of Business of Boston University. He has extensive consulting and expert experience including in the fields of discriminatory pricing, breach of contract, antitrust, and patent infringement. Ex. 6201-R at ¶¶ 1-5, Apps. A & B (Cockburn).

692. Dr. Meyer is an expert in applied microeconomics and the economic analysis of licenses, patents, and other intellectual property. RTr. 1743:14-23 (Meyer). She is the Managing Director and Chair of the Intellectual Property Practice at NERA Economic Consulting. She has extensive experience in areas of complex commercial litigation involving intellectual property, antitrust claims, and commercial damages. Ex. 6205-R at ¶¶ 1-3 & Ex. 1 (Meyer).

693. Dr. Becker is an expert economist with a specialization in transfer pricing. RTr. 2592:22-24 (Becker). He has spent 65% to 70% of his time in transfer pricing over his career, both as a testifying expert and consultant. RTr. 2587:23-89:4 (Becker); Ex. 6207-R at App. A (Becker).

694. Mr. Crosby is an expert in the medical device industry. RTr. 2815:22-24 (Crosby). He has been the CEO of six medical device companies, both public and private, in several countries. He is a biomedical engineer with business experience including raising capital, company formation, intellectual property, R&D, quality systems, manufacturing, clinical and regulatory activities, market launch, and sales management. Ex. 6208-R at ¶¶ 1-11, App. A (Crosby).

II. THE PACESETTER AGREEMENT

695. Dr. Heimert compared the Pacesetter Agreement³ to the MPROC Agreement by evaluating the comparability factors required by the transfer pricing regulations. RTr. 2363:4-21 (Heimert); see Ex. 6410-RD at p. 2. Based on this evaluation, he concluded that the Pacesetter Agreement is not a reliable CUT. RTr. 2362:18-20, 2363:25-64:1 (Heimert).

A. The Scope of the Intangible Property Licensed Under the MPROC and Pacesetter Agreements

696. The Pacesetter Agreement was a patent cross license which conveyed no more than a freedom to operate. Under the agreement, Medtronic was not obligated to help Pacesetter but it agreed to not sue Pacesetter for patent infringement if Pacesetter manufactured or sold its independently developed products. RTr. 2048:15-49:5; Exs. 6201-R at ¶¶ 11, 25, 30-31, 34, 6202-R at ¶¶ 7.a, 20-22 (Cockburn).⁴

697. The MPROC Agreement was a turnkey technology transfer agreement. Medtronic US gave MPROC absolutely everything it needed in terms of information, access to intangibles, and Medtronic US' expertise. On day one, the agreement permitted MPROC to produce Medtronic-designed products under Medtronic's regulatory approvals. RTr. 2049:6-24; Exs. 6201-R at 11, 25, 6202-R at 19, 21-22 (Cockburn).

1. MPROC Licensed All Product Intangibles.

698. Under the MPROC Agreement,⁵ MPROC licensed the exclusive right to use, develop, and enjoy Medtronic US' 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. PFF 23; Stip. ¶¶ 28, 33; Exs. 10-J & 11-J at § 2.1; Tr. 3476:5-16 (Albert); Medtronic I at *35.

699. The intangible property licensed under the MPROC Agreement included inventions, secret processes, technical information, technical expertise relating to the design of the devices and leads manufactured by MPROC, and all legal rights associated therewith, including without limitation, patents, trade secrets, know-how, copyrights, and all regulatory approvals associated with the devices and leads manufactured by MPROC. “Know-how” included any and all technical information available or generated during the terms of the MPROC Agreement that related to devices and leads or improvements and included all manufacturing data and any other information relating to devices and leads or improvements useful for the development, manufacture, or effectiveness of devices and leads. PFF ¶ 24; Exs. 10-J & 11-J at §§ 1.4, 1.5.

700. The MPROC Agreement defined “improvements” as “any findings, discoveries, inventions, additions, modifications, formulations, or changes” made during the terms of the licenses by either Medtronic US or MPROC to product designs that relate to the Devices and Leads. PFF ¶ 24; Exs. 10-J & 11-J at § 1.3.

701. The MPROC Agreement requires both parties to disclose and share all Know-How and Product Improvements with the other party. Exs. 10-J & 11-J at §§ 4.1, 4.2. If the Agreement is terminated, MPROC is prohibited from using or disclosing any confidential Know-How or other information it receives from Medtronic US for six years unless the information is public or was documented by MPROC before the agreement commenced. Exs. 10-J & 11-J at § 4.3.

2. The MPROC Agreement Licensed a Broader Suite of Patents and Other Intangibles than the Pacesetter Agreement.

702. The total number of patents available to MPROC under the MPROC Agreements exceeded 1,600 patents by May 2004 and topped 1,800 patents through April 2006. Ex. 6201-R at ¶ 33 (Cockburn).

703. On the effective date of the Pacesetter Agreement in August 1992, Pacesetter licensed 342 existing Medtronic Cardiac Rhythm Disease (CRM)⁶ U.S. patents. Principally among these were the set of patents on “rate adaptive pacer” technology that prompted Medtronic's patent litigation against Pacesetter. Exs. 6201-R at ¶ 33 (Cockburn), 2504-J at Ex. A.

704. As of May of 2004, only 9% of the patents licensed by Medtronic US to MPROC were also licensed by Pacesetter in 1992. Ex. 6201-R at ¶ 33 (Cockburn).

705. As of April of 2006, only 6.2% of the patents licensed to MPROC were licensed to Pacesetter in 1992. Ex. 6201-R at Chart 1 (Cockburn).

706. Trade secrets and know-how can be preferable to and more valuable than patents. RTr. 1764:17-65:11 (Meyer); Ex. 6206-R at ¶¶ 56-57 (Meyer).

707. Medtronic US' technical community refers to the collection of knowhow developed over Medtronic's history as “implantology.” Ex. 1671-J at 7201.

708. As Medtronic informed the FDA, process development for products manufactured in the CRM area was conducted at Medtronic US' Arizona Device Manufacturing (ADM). Ex. 1811-J at 6560.

709. Medtronic US' ADM was also responsible for manufacturing technology, process development, production of prototypes, product engineering, and ensuring that all the finished device manufacturing facilities manufacturing processes were standardized. Tr. 2013:12-14:8, 2045:1-20 (Watson), 2366:5-25 (Davila); Exs. 668-J at 2797, 693-J at 0564.

710. In 2005, ADM initiated the “Virtual Factory” concept that allowed Medtronic US to operate as one factory across three global device manufacturing sites. Ex. 568-J at 0896.

711. For implantable cardioverter defibrillators (ICDs), MPROC conducted all operations following specifications developed at Medtronic US' Rice Creek facility. Ex. 1811-J at 6581.

712. Medtronic US engineering at Rice Creek developed the processes for leads and tooling. Ex. 685-J at 3024.

713. Medtronic US documented its specifications, trade secrets and knowhow, allowing them to be transferred to existing or new manufacturing facilities. RTr. 2831:22-32:14, 2836:21-37:18 (Crosby), 327:8-15 (McCoy); Exs. 6413-RD at p. 18, 1356-J at 4684, 4686, 4692, 4697-98, 1811-J at 6562, 568-J at 0883-84, 6289-R at 5254, 5317, 5342, 2481-J at 1562, 1571-72, 685-J at 3024-25, 2779-J at 8616-17, 2790-J at 9373, 1350-J at 8361-62, 8364, 1352-J at 8481.

714. An entity in MPROC's position operating at arm's length would pay handsomely for access to trade secrets or know-how. RTr. 2305:14-25 (Cockburn); Ex. 6317-R at 5598-5602 (discussing Nervicon case).

715. Medtronic US and MPROC entered into a Trademark and Trade Name License, effective as of September 30, 2001 (Trademark License). PFF ¶ 30; Stip. ¶ 38; Ex. 15-J; Tr. 3476:17-20 (Albert). Pursuant to this license, MPROC licensed the Medtronic trademark and trade name and other Devices- and Leads-related trade names from Medtronic US. PFF ¶ 31; Ex. 15-J at 5720.

716. Information processing and software technology is a core competency of the CRM industry and required to be competitive in CRM markets. Exs. 1671-J at 7184, 2944-P at 0049. CRM software is essential copyrighted material and a device without software is a non-functioning piece of electronics of no value. RTr. 2830:12-17; Ex. 6208-R at ¶ 94. (Crosby). Software provides Medtronic with a competitive advantage over its competitors. Tr. 432:14-21 (Mahle).

717. Medtronic US' regulatory approvals licensed to MPROC are a special type of intellectual property and can be immensely valuable, as they are crucial in the product development cycle: without FDA approval, no Class III medical device can be put on the market. Exs. 10-J at §§ 1.10, 2.4, 6208-R at ¶ 83 (Crosby), 6202-R at ¶ 144 (Cockburn), 6206-R at ¶¶ 58, 66 (Meyer), 5517-R at ¶¶ 46-47 (Evans).

718. Medtronic's ability to efficiently design and complete clinical trials and effectively interface with the regulatory agencies was a key determinant in reducing time-to-market and ensuring ultimate product success. Ex. 1671-J at 7160, 7184. These capabilities were pivotal to maintaining a leadership position and to sustain growth. Exs. 416-J at 0068, 30-J at 7930.

719. During the years at issue, Medtronic US' strategy incorporated a paradigm shift. Where historically, product development efforts had been directed toward improving device therapy, future products would incorporate advanced patient diagnostics and monitoring capabilities (Patient Management). This chronic disease management strategy was intended to further Medtronic's competitive advantage, while improving medical outcomes and providing more cost-effective care. Exs. 416-J at 0083, 1671-J at 7164, 7184.

720. Patient Management's role in CRM was to drive growth, profitability, and market share. Patient Management changed the nature of patient care and enabled the strategic shift from "life-saving alone” to "life-saving and quality-of-life-improving” chronic care. Exs. 416-J at 0084; 6208-R at ¶ 46 (Crosby).

721. Medtronic considered CRM Patient Management to be a “game changer.” Exs. 101-J at 9248, 78-J at 8554.

B. Difference in CRM and Neuro Products and Markets from 1992 to 2005/2006

722. The products covered by the 2005 MPROC Agreement and the 1992 Pacesetter Agreement differ markedly, illustrating that the profit potentials of the intangibles are not similar. Ex. 6201-R at ¶ 38 (Cockburn).

1. Change in CRM and Neuro Products

723. The successful development of new products and therapies has long been the lifeblood of Medtronic and its industry. Invention and innovation are the cornerstones of the value proposition that enable Medtronic to ultimately achieve its mission. Exs. 1671-J at 7171, 6208-R at ¶ 18 (Crosby).

724. Successful new product development has driven Medtronic's growth since the company's early years. Approximately two-thirds of Medtronic's current revenues are generated from products or therapies introduced within the past two years with product cycles of 18 to 24 months. Exs. 30-J at 7929-30, 32-J at 7434, 94-J at 9057, 101-J at 9241, 416-J at 0068, 419-J at 0195, 1671-J at 7158, 3063-J at 7589; RTr. 145:24-46:2, 282:17-23 (McCoy), 2856:20-57:2 (Crosby).

725. More than 80% of Medtronic's growth between 1996 and 2006 was attributable to new product introductions and expansion of therapies for new patient groups. Exs. 32-J at 7434, 41-J at 7375, 96-J at 9139, 3063-J at 7589.

726. Truly innovative products can significantly change a company's market share. For example, breakthrough innovations that satisfy an unmet clinical need (e.g., rate-responsive pacemakers) often lead to rapid increases in market share, while incremental innovations (e.g., improvements in device size or battery life) might increase market share more slowly. Falling behind in product technology quickly results in a loss of market position and a drop in customer satisfaction. New products also help mitigate downward pressure on prices and gross margins. Exs. 6208-R at ¶ 31 (Crosby), 1671-J at 7158, 419-J at 0195.

727. Innovation is one of the primary bases for competition in CRM. Ex. 1670-J at 7070; RTr. 314:23-15:3 (McCoy).

728. Technology has changed a great deal since the early years of Medtronic; most of the technology it used in 2003 was hardly in existence 20 years before. Ex. 1671-J at 7201.

729. Since inception, the CRM industry has been characterized by breakthrough innovations driving rapid market share change. Exs. 6208-R at ¶ 32, 29-J at 1250; RTr. 2822:12-18 (Crosby).

730. Cardiac resynchronization therapy (CRT) is a method of pacing both sides of the heart to treat heart failure. At the time of CRT's introduction, it was a completely new product, serving a completely new patient population, and it significantly expanded the market for CRM devices. Ex. 6208-R at ¶ 26 (Crosby).

731. CRT was considered revolutionary. Its introduction represented perhaps the most fundamental paradigm shift for treatment of heart failure. Tr. 4341:4-10 (Lee); Ex. 6208-R at ¶ 46 (Crosby).

732. Medtronic's InSync ICD CRT defibrillator (CRT-D) was approved in 2002. People with heart failure are often susceptible to ventricular fibrillation (VF). This paradigm shift added biventricular pacing to an ICD to treat both heart failure and susceptibility to VF in one device. Ex. 6208-R at ¶ 46 (Crosby).

733. Incremental innovations such as improved longevity, programmability, data storage, automaticity, rate-adaptive pacing, and remote monitoring have driven market expansion. Ex. 6208-R at ¶ 41 (Crosby). An example of incremental innovation is the gradual but relentless improvement in the size of ICDs, pacemakers, and neurostimulation devices. RTr. 2822:18-23 (Crosby).

734. Incremental innovation in capacitor technology during the 1990s helped shrink the size of ICDs over several models. This development, combined with endocardial defibrillation leads, enabled the change from abdominal implant (in the belly) to pectoral implant (just under the collarbone in the chest) which shifted the medical procedure paradigm from a complex and risky surgical procedure performed by a surgeon in an operating room to a simple and lower risk procedure performed by an electrophysiologist in a cardiac catheter lab. RTr. 323:16-24:9 (McCoy), 525:15-26:5, 527:5-30:8 (Cohen), 2823:7-24:3 (Crosby); Exs. 417-J at 6927, 6208-R at ¶ 40 (Crosby), 2944-P at 0070-71.

735. Going from a 210-cc device implanted into the abdomen to a 50-cc device implanted under the collarbone is a dramatic paradigm shift driven by incremental innovation. It was a significant change both for the industry and the patient. RTr. 2867:3-24 (Crosby); Ex. 2944-P at 0070-71.

736. Leads and stimulation electrodes are an integral part of a CRM device and are a special category of innovation in the industry. From the 1990s there have been multiple developments in bradycardia pacing leads directed towards reducing size, easing implantation, and increasing reliability. Clinical improvements include anchoring the tip in the correct place and steroid elution to reduce inflammation at the stimulation site following implant. Ex. 6208-R at ¶ 42 (Crosby).

737. In the early 2000's, Medtronic believed there was revolutionary change underway in neuroscience. It was at the forefront of this revolution with an innovative pipeline of products and therapies that targeted some of the most debilitating diseases. Exs. 1669-J at 7035, 2331-J at 4872, 1671-J at 7248-49.

738. In the late 1990s, the first Premarket Approval (PMA) was granted to Medtronic for neurostimulation to treat incontinence. In 2002, the FDA approved the first PMA for deep-brain stimulation to treat movement disorders like Parkinson's disease. In 2004, the first rechargeable spinal cord stimulator (SCS) was approved. RTr. 2824:22-25:16; Ex. 6208-R at ¶ 49 (Crosby).

739. Medtronic estimated in its 2004-2009 strategic plan that over the next five years the Neurological (Neuro) businesses would launch over 30 major new products. It outlined plans to innovate entirely new product categories for brain stimulation and gastric stimulation. Exs. 6208-R at ¶ 50 (Crosby), 1671-J at 7248.

2. Change in CRM and Neuro Markets and Industry

740. CRM market revenues grew from $1,969 million in 1992 to $9,310million in 2006. This growth corresponds to a 372% increase in revenues. It was fueled by steady growth in the pacemaker market, rapid growth in the ICD market, and the new CRT-D market. Exs. 6208-R at ¶ 27 (Crosby), 29-J at 1238-40, 31-J at 1390-91, 6101-P at 2294-95 (McCoy).

741. Neuro market revenues increased from $77 million in 1991 to $777 million by 2005. Exs. 423-R at 0259, 416-J at 0112.

742. Market shares of Pacesetter and Medtronic products were drastically different. Pacesetter expected a 19% share of the U.S. CRM market in 1993. Medtronic had a CRM market share of 49% in 2005 and 53% in 2006. Medtronic had even higher market share in Neuro with 77% in 2005 and 73% in 2006. Exs. 6201-R at ¶ 39 (Cockburn), 471-J at 4996, 2507-J at 3882, 445-J at 5297.

743. Sustained revenue growth in the CRM industry was driven by changes in the paradigm to the types and numbers of patients that could be treated, the technologies that were available to treat them, who implanted the devices, where that was done, and how it was paid for. RTr. 3021:9-15 (Crosby).

744. Growth in the CRM industry was even greater than forecasted in 1992. RTr. 310:2-7 (McCoy).

745. CRM revenues in the early 1990s were almost exclusively from pacemakers. By 2005/2006, ICDs and CRT devices were the dominant source of revenue in CRM. Exs. 2960-P at 1876, 6385-R at Tab “CRHF Market”; RTr. 523:9-24:3 (Cohen).

746. In 1992, the top five CRM companies held approximately 95% market share measured by worldwide sales revenue. Market shares were Medtronic: 45%, Pacesetter: 20%, Intermedies: 12%, Teletronics: 11%, Cardiac Pacemakers: 8%, and Other: 4%. Ex. 6101-P at 2289 (McCoy).

747. By 2005, 95% worldwide sales revenue market share had concentrated to three companies: Medtronic, Boston Scientific Corp, (after acquiring Guidant), and St. Jude Medical, Inc. (St. Jude). RFF ¶ 21; Exs. 29-J at 1241, 31-J at 1392-93, 6101-P at 2294 (McCoy).

748. Medtronic had the largest share of the U.S. market for Neuro spinal cord stimulators and had no U.S. competitors for deep brain stimulators. Tr. 2954:4-13, 2963:20-22 (Witala); Exs. 29-J at 1246.

749. ICDs and pacemakers were originally indicated to treat tachycardia (ICDs) and bradycardia (pacemakers) and ICDs served as a secondary prevention for patients who had survived a sudden cardiac arrest. Ex. 3043-P at 3678-79.

750. Clinical trials increased the potential ICD patient population. The Multicenter Unsustained Tachycardia Trial (MUSTT) and the Multicenter Automatic Defibrillator Implantation Trial (MADIT) demonstrated reduced mortality by 50%, increasing patient population by over 300,000 patients. Exs. 3043-P at 3678-79, 2944-P at 0074-76. The Antiarrhythmics Versus Implantable Defibrillator Trial increased patient population by 100,000 patients. Exs. 3043-P at 3679, 2944-P at 0074-7. The MADIT II study increased patient population by 150,000 to 300,000 patients. Exs. 3043-P at 3679, 2944-P at 0074-76, 6208-R at ¶ 44 (Crosby). The Comparison of Medical Therapy, Pacing, and Defibrillation in Heart Failure clinical trial showed the benefit of CRT for treatment of heart failure which drove market expansion. RTr. 524:4-9 (Cohen); Exs. 3043-R at 3679-80, 6208-R at ¶¶ 44-46 (Crosby). The SCD-HeFT trial increased the patient population for heart failure by 500,000 to 600,000 patients. Exs. 94-J at 9071, 416-J at 0085, 488-J at 9315, 3043-P at 3680.

751. Approvals for CRT-D ICDs expanded the market through number of patients and higher priced products. Ex. 3043-J at 3679.

C. Profit Potential of the Pacesetter and MPROC Agreements

752. Higher profit potential should, all else equal, translate to higher royalty rates. Licensees are willing to pay more to access more valuable exploitation rights, and licensors can command higher royalties for more valuable rights. Exs. 6203-R at ¶ 12 & n.23 (Heimert), 6207-R at 6290-91; RTr. 2607:22-08:9 (Becker).

753. Licensors and licensees consider profit potential when setting royalty rates. RTr. 2607:10-08:9 (Becker), 222:21-23:16 (McCoy).

754. In 1992, the expected profit margin for the products covered by the Pacesetter Agreement was about 29%. From 2005 to 2006, the profit margin for the products covered by the MPROC Agreement was approximately 54%. Exs. 6204-R at 6129, Table 3, 6203-R at ¶¶ 13-14, Table 2 (Heimert), 6201-R at ¶ 40 (Cockburn).

755. Revenue for Pacesetter products was projected at $233 million to $361 million in 1993 to 1995. In 2005 and 2006, revenue for the CRM and Neuro products at issue was $2.68 billion and $3.54 billion, respectively. Exs. 6203-R at Table 2 (Heimert), 2528-J.

756. Projected operating profits of Pacesetter products in 1993 to 1994 was $68 million to $105 million. The operating profit for the products at issue was $1.37 billion in 2005 and $1.97 billion in 2006. Exs. 6203-R at Table 2 (Heimert), 2528-J, 2507-J at 3883.

757. Pacesetter devices' average unit sales price was $3,400-$6,400 in 1993. The unit price for the Medtronic devices at issue in 2005 was $3,100-$22,200. Exs. 6201-R at ¶ 41 (Cockburn), 2528-J, 2530-J, 471-J at 4982, 1664-J at 4705.

758. After adjustments to account for the different functions performed by MPROC and Pacesetter, the products manufactured by MPROC using intangibles licensed under the MPROC Agreement have profit margins of 63.6% in 2005. On an apples-to-apples basis, the products covered by the MPROC Agreement have profit potential 34.6 percentage points greater than that of Pacesetter products. Exs. 6207-R at 6284-85, Table 3, 6411-RD at p. 6; RTr. 2608:13-2609:11 (Becker).

D. Differences In Circumstances Between the MPROC and Pacesetter Agreements

1. Different Economic Circumstances

759. Pacesetter was a horizontal competitor of Medtronic. MPROC and Medtronic US were in a cooperative buyer-supplier vertical relationship. Exs. 6202-R at ¶¶ 6, 7.b, 27 (Cockburn), 6204-R at ¶¶ 24, 26 (Heimert); RTr. 2432:23-33:2 (Heimert).

760. The relationship between competitive and cooperative suppliers is different. Competitors would not call each other, did not share know-how, worried about antitrust risks, and only cooperated under very narrow circumstances. Exs. 6204-R at ¶¶ 24-26 (Heimert), 6202-R at ¶¶ 6, 7.b, 27 (Cockburn); RTr. 92:20-93:16, 272:16-21, 274:16-18, 276:21-77:5, 329:25-30:11 (McCoy).

761. Medtronic was eager to move the competition with Pacesetter out of the courts and into the marketplace. Exs. 6205-R at ¶ 49 (Meyer), 623 8-R at 0047; Tr. 3858:12-19 (Ellwein).

762. Medtronic US did not look for opportunities to license out its patents. Tr. 3852:14-18 (Ellwein). It only licensed its patents as a way to “buy peace” in patent disputes. Tr. 3852:19-23, 3855:16-21 (Ellwein); Ex. 2525-J at 4420.

763. The Pacesetter Agreement settled nine pieces of litigation and resulted in the dismissal of all litigation with prejudice. Ex. 2505-J at Recitals A-C, § 1.

764. The Pacesetter litigation included patent, employment, and antitrust suits. Exs. 6205-R at ¶ 19 (Meyer), 2525-J at 4421, 2505-J at Recitals A-C, § 1.

765. There was the possibility of treble damages against Medtronic as a result of the antitrust lawsuit. RTr. 1749:24-50:3 (Meyer).

766. Medtronic faced the risk that the Medtronic patents at issue in the litigation would be declared invalid. RTr. 1750:4-9 (Meyer); Ex. 6205-R at ¶¶ 26-27 & n.53 (Meyer).

767. A settlement was financially attractive to Medtronic US as it was almost crippling to have that kind of ongoing litigation. The ability to “buy peace,” avoid uncertainty of result, end a litigation “war” with Siemens, and be free of litigation costs and distractions were all factors in Medtronic's decision to enter into the Pacesetter Agreement. RTr. 2078:24-80:22 (Cockburn), 1870:21-23 (Meyer); Tr. 3858:9-19 (Ellwein); Exs. 2525-J at 4418, 4423-25, 6201-R at 50, 6202-R at ¶ 6 (Cockburn), 6205-R at ¶ 49, 6206-R at ¶ 68 (Meyer).

768. Factors other than the value of the licensed intangibles played major roles in determining the terms and conditions of the negotiated settlement outcome. RTr. 2055:4-15, 2118:14-19:19 (Cockburn); Exs. 6201-R at ¶¶ 47, 49, 51 (Cockburn), 6205-R at ¶¶ 20-22, 35-36, 47, 6206-R at 10, 20, 24-25, 68 (Meyer), 6203-R at ¶¶ 20-23, 6204-R at 24-27 (Heimert), 2525-J at 4423-25. None of these factors impacted the MPROC Agreement. Entire record.

2. Differences in Bargaining Power

769. Bargaining power is the ability to credibly threaten to prolong negotiations until a desirable outcome is reached. Ex. 6206-R at ¶ 30 (Meyer).

770. In an arm's-length negotiation, profits will accrue differentially to the party that has the most important assets. RTr. 2070:16-71:15 (Cockburn), 1755:15-18 (Meyer), 2620:20-23 (Becker); Ex. 6206-R at ¶ 32 (Meyer).

771. MPROC would not have been able to manufacture products for Medtronic without the licensed intangibles. RTr. 1757:8-14 (Meyer), 2445:1-16 (Heimert); Ex. 6206-R at ¶ 39 (Meyer).

772. Pacesetter had considerable leverage in its negotiation against Medtronic. RTr. 1756:16-18, 1757:2-6 (Meyer), 2312:19-14:1 (Cockburn); Exs. 6206-R at ¶¶ 35-39 (Meyer), 6238-R at 0046-47.

773. Pacesetter could have continued to sell products because it had the ability to design around the Medtronic patents. RTr. 1756:16-57:1 (Meyer); Exs. 6206-R at ¶ 36 (Meyer), 2522-J at 4399.

774. The injunctions Medtronic obtained against Pacesetter had limited effect on Pacesetter. Pacesetter's new products were not enjoined. Only the older products that were being phased out were enjoined at the time of the agreement. RTr. 1957:2-58:8 (Meyer); Exs. 6206-R at ¶ 36 (Meyer), 6203-R at ¶ 37 (Heimert).

775. The three Pacesetter products (Sychrony, Sensolog and Sensolog II)ruled to infringe on Medtronic's patents constituted 10% of Pacesetter's total U.S. revenue. Exs. 6206-R at ¶ 36 (Meyer), 2530-J.

3. Differences in Functions

776. As a matter of economics, the value of a licensed intangible is impacted by what additional activities need to be undertaken by the licensee to commercialize products enabled by the intangibles. Exs. 6201-R at ¶ 58 (Cockburn), 6207-R at 6291-92 (Becker); RTr. 2601:25-02:17 (Becker).

777. The functions of the parties in the Pacesetter and MPROC Agreements are not comparable. RTr. 2601:25-05:15 (Becker), 2052:1-18 (Cockburn); Exs. 6201-R at ¶¶ 11, 53 (Cockburn), 6411-RD at pp. 2-3 (Becker).

778. As licensor under the MPROC Agreement, Medtronic US performed R&D with respect to MPROC products, at $220 million in 2005 (8.2% of revenues) and $320 million in 2006 (9.0% of revenues). Medtronic US also spent $116 million in 2005 (4.3% of revenues) and $178 million in 2006 (5.0% of revenues) on business management activities for CRM and Neuro businesses. Exs. 6201-R at ¶¶ 54, Table 5 (Cockburn).

779. As the licensor in the Pacesetter Agreement, Medtronic US did not perform any R&D to develop Pacesetter products, nor did it perform any other activities to help Pacesetter market its products. Pacesetter performed these functions as a licensee. Exs. 6201-R at ¶ 54, 6202-R at ¶ 49a (Cockburn); RTr. 2601:25-02:17, 2603:2-25 (Becker), 2052:1-18 (Cockburn).

780. MPROC, as licensee in the MPROC Agreement, performed one function, finished manufacturing. Under the Pacesetter Agreement, Pacesetter performed all the functions, including finished manufacturing. RTr. 2601:25-02:17, 2603:1-25 (Becker); RTr. 1508:23-09:1 (Hubbard).

4. Differences in Contract Terms

781. The 7% royalty rate from the Pacesetter Agreement cannot be a starting point for determining an arm's-length rate to be paid by MPROC because it does not reflect the difference in the form of payments, exclusivity, duration of the agreements, and the royalty sales base. RTr. 2115:13-17; Exs. 6203-R at ¶¶ 25-26, 34-41 (Heimert), 6201-R at ¶¶ 61-71 (Cockburn), 6205-R at ¶¶ 37-46 (Meyer).

782. Pacesetter agreed to pay Medtronic US $50 million in cash up-front and $25 million which was to be credited against the incremental 1.8% rate (above the 7%) to be paid under the Pacesetter Agreement. Both were characterized by Medtronic as portfolio access royalty payments. Exs. 6205-R at ¶¶ 43-44 (Meyer), 2527-J at 4431-32, 2528-J, 2523-J, 2524-J at 4415, 2504-J at § 3.02; PFF ¶ 154; Pet. Br. at 230.

783. The $75 million in up-front cash reduced the running royalty rate. Exs. 6205-R at ¶ 43 (Meyer), 6203-R at ¶¶ 34-35, 6204-R at ¶¶ 64-66 (Heimert), 2504-J at § 3.02; RTr. 291:11-15 (McCoy).

784. An exclusive right to use a technology is more valuable than the nonexclusive license to that same technology, all else equal. There is no formula or generally accepted methodology for estimating or adjusting for this difference. Exs. 6201-R at ¶¶ 27, 68, 6202-R at ¶¶ 11.b, 82-84 (Cockburn), 6203-R at ¶ 40 (Heimert), 6105-P at ¶ 249 (Putnam).

785. The Pacesetter Agreement provided Pacesetter a non-exclusive license to certain Medtronic US patents. Ex. 2504-J at § 2.01; Medtronic I at *122.

786. Under the MPROC Agreement, MPROC obtained an exclusive license to Medtronic US patents as well as its entire portfolio of technology intangibles. Exs. 10-J, 14-J; Medtronic I at *35-36.

787. Medtronic would not cross license its patents to competitors until after a period of exclusivity gave it the opportunity to establish market share. Ex. 2525-J at 4419.

788. The duration of a license agreement significantly impacts its value to a licensee. Ex. 6201-R at ¶ 62 (Cockburn); RTr. 2780:3-13, 2780:23-81:8 (Becker).

789. The Pacesetter Agreement had a 10-year term commencing in August 1992. Exs. 2504-J at § 2.01, 6201-R at ¶ 62 (Cockburn). The 2005 MPROC Agreement had a one-year term. The 2006 MPROC Agreement had a three-year term. Exs. 9-J & 13-J at § 3, 10-J & 14-J at §§ 1.2, 7.1, 6201-R at ¶ 62 (Cockburn). The 2006 MPROC Agreement was executed on May 9, 2007. Exs. 10-J at 4195, 14-Jat4373.

790. The Pacesetter Agreement's running royalty was on all products — those enjoined and those not enjoined. RTr. 1766:17-25, 1767:20-68:6, 1976:4-24 (Meyer); Exs. 6205-R at ¶¶ 6, 46 (Meyer), 6203-R at ¶ 37 (Heimert).

791. Because the base for the 7% royalty rate includes non-enjoined (in addition to enjoined) products, the royalty rate does not accurately reflect the value of Medtronic US patents used in Pacesetter's products. Exs. 6205-R at ¶ 46 (Meyer), 6203-R at ¶¶ 38-39 (Heimert).

5. The Value of Pacesetter's Patent Portfolio

792. The balancing payment of the Pacesetter cross license provides no information regarding the absolute value of a one-way license to either the Medtronic or Pacesetter CRM patent portfolios; it is just the difference in the values. Because the net rate does not reflect the value of either side's patents, it cannot be used as a starting point to value the MPROC Agreement. Exs. 6205-R at ¶ 37 (Meyer), 6201-R at ¶ 64 (Cockburn); RTr. 1759:11-16, 1988:4-22 (Meyer).

793. A patent does not have one value to everybody; it is not a commodity. RTr. 1956:8-10 (Meyer); Ex. 6206-R at ¶ 50 (Meyer).

794. If a third-party company wanted to enter the CRM business, it would find the Pacesetter portfolio extremely valuable, and the Medtronic portfolio would be incrementally more valuable. Ex. 6208-R at ¶ 53 (Crosby).

795. Lacking its own patents, MPROC would have needed to pay the gross royalty, rather than the net 7% agreed to by Pacesetter. Ex. 6208-R at ¶ 53 (Crosby).

796. Pacesetter's patents were valuable to Medtronic. Exs. 6208-R at 53-54, 60-64 (Crosby), 6205-R at ¶ 38 (Meyer), 6201-R at ¶ 66 (Cockburn), 6108-P at ¶¶ 159-61 (Hubbard). This Court's finding in Medtronic I that “Medtronic attributed no value to the Pacesetter patents it received in the cross license” should be revised. Medtronic I at *58. The Pacesetter Agreement had an option value, reflected in Medtronic being awarded rights four years after the Pacesetter Agreement to valuable patents owned by Angeion as a result of the Pacesetter Agreement. Exs. 6108-P at ¶ 161 (Hubbard), 6202-R at 166 (Cockburn), 6206-R at ¶¶ 68-69; RTr. 1760:22-62:21 (Meyer), 1477:8-21 (Hubbard). Further, Medtronic's extensive citation of Pacesetter's patent in its patents reflect that Medtronic attributed value to the Pacesetter patents. Exs. 6208-R at ¶¶ 54-55, 62 (Crosby), 6202-R at ¶¶ 119-20 (Cockburn).

E. Future Patent Rights Termination Provision

797. Section 9.02(d) of the License Agreement made on August 26, 1992 (Ex. 2504-J at § 9.02(d)) (Pacesetter License Agreement) provides in part:

In the event of an assignment or transfer of The Agreement [the License and Settlement Agreements] as permitted in this subsection (d), the rights granted by Medtronic and its Affiliates to Siemens and its Affiliates or Siemens and its Affiliates to Medtronic and its Affiliates under this License Agreement shall terminate with respect to Future Patents issued after the date of such assignment or transfer. . . .

798. Section 12.B(d) of the Settlement Agreement made on August 26, 1992 (Ex. 2505-J at § 12.B(d)) (Pacesetter Settlement Agreement) provides in part:

In the event of an assignment or transfer of The Agreement [the License and Settlement Agreements] as permitted in this subsection (d), the rights granted by Medtronic and its Affiliates to Siemens and its Affiliates or Siemens and its Affiliates to Medtronic and its Affiliates under this License Agreement shall terminate with respect to Future Patents applied for or issued after the date of such assignment or transfer. . . .

799. Effective September 30, 1994, St. Jude acquired all of the assets of the worldwide CRM business of Siemens AG pursuant to two Asset Purchase Agreements entered into as of June 26, 1994. Ex. 6398-R at 7396.

800. Pursuant to section 9.02(d) of the Pacesetter License Agreement and 12.B(d) of the Pacesetter Settlement Agreement, rights with respect to future patents terminated after St. Jude acquired the assets. Exs. 2504-J at § 9.02(d), 2505-J at § 12.B(d).

801. The Asset Purchase Agreement between Siemens-Pacesetter, Inc. and St. Jude, entered into as of June 26, 1994 refers to a “Medtronics [sic] Assignment and Assumption Agreement.” Ex. 6398-R at 7399, 7407-08, 7447, 7453, 7461, 7488, 7493.

802. Petitioner is not able to produce a copy of the “Medtronics [sic] Assignment and Assumption Agreement.” RTr. 1072:12-74:2.

803. Petitioner can identify no document substantiating that the rights to future patents in the Pacesetter License and Settlement Agreements were assigned to St. Jude. Entire record.

F. The Mirowski License

804. Effective January 30, 1973, Dr. Michael Mirowski, the inventor of ICD patents, licensed his two issued patents and a patent application to Medrad, Inc. Exs. 6252-R at 4244 (Mirowski License); RTr. 263:24-64:21 (McCoy).

805. Dr. Mirowski's ICD inventions were not proven at the inception of the Mirowski License. A product was not developed until years after the inception of the Mirowski License. RTr. 2307:5-14 (Cockburn), 265:5-9, 267:13-15 (McCoy), 678:3-16 (Cohen); Exs. 6208-R at ¶ 115 (Crosby), 6252-R.

806. In addition to a running royalty, Dr. Mirowski received equity of unknown value in Medrad, Inc. as additional compensation at the inception of the Mirowski License and later, multiple times, when the Mirowski License was amended. Exs. 6252-R at 4248-49, 4274, 6208-R at ¶¶ 109, 114 (Crosby); RTr. 2309:2-25 (Cockburn), 676:14-77:9 (Cohen).

807. The copy of the Mirowski License petitioner provided its experts and respondent is missing page 8 which sets forth the parties' obligations under the agreement. Ex. 6252-R at 4251-52.

808. In contrast to the MPROC Agreement, the intangibles licensed under the Mirowski License related to potential products without regulatory approval or even a regulatory submission. Royalty rates vary considerably depending on stage of product development at the time a license is negotiated. Ex. 6202-R at ¶ 95 (Cockburn); RTr. 1765:12-66:3 (Meyer), 2307:8-09:1 (Cockburn).

809. Just months before the inception of the Mirowski License, Medtronic owned and transferred to Dr. Mirowski the two patents and the patent application he licensed to Medrad. The consideration was $1.00. Exs. 6208-R at ¶ 113 (Crosby), 6254-R at 4562-63; RTr. 265:10-66:22 (McCoy), 694:15-22 (Cohen).

810. Eli Lilly through Cardiac Pacemakers, Inc. (CPI) acquired Medrad in 1985. As part of the acquisition, CPI acquired the Mirowski License. Exs. 6208-R at ¶ 116 (Crosby); 6255-R; RTr. 678:24-79:14, 694:23-95:10 (Cohen).

III. THE CPM

811. Dr. Heimert reevaluated his CPM methodology after Medtronic I. RTr. 2362:8-13, 2369:3-70:22 (Heimert).

A. Application of Dr. Heimert's CPM

1. MPROC As the Tested Party

812. Dr. Heimert continued to select MPROC as the tested party. RTr. 2372:4-15 (Heimert).

813. Dr. Heimert's functional analysis did not identify any nonroutineintangibles owned by MPROC, and neither additional facts from the 2015 Medtronic trial nor Medtronic I changed his view that MPROC did not possess nonroutine intangible assets. RTr. 2489:24-92:9 (Heimert).

814. For the period 1974 through the end of 2006, the U.S. Patent Office had 3,855 patents for Medtronic US and none for MPROC. Of Medtronic US's patents, three listed Puerto Rico. Tr. 5338:2-12 (Rausch); Ex. 5506-R at 3606.

815. In Medtronic I at *27, the Court found that “MPROC employees were not all line employees. There were also numerous engineers, including some who focused on product development.” This finding is incomplete. MPROC had between 76 to 97 engineers or 4-5% of total Medtronic engineers over the years at issue compared to the 1,771 to 2,011 engineers in the United States. Exs. 5502-R, 2738-J; Tr. 5309:24-11:14 (Rausch).

816. MPROC employed 6 and 14 quality employees (those designated in company records with a quality function) in 2005 and 2006, respectively. There were 78 and 81 Medtronic quality employees in the United States for 2005 and 2006, respectively. Exs. 6203-R at Table 1 (Heimert), 5502-R; RFF 400.

817. Medtronic US incurred 99.8% of R&D costs in 2005 and 2006, while MPROC incurred 0.2%. Ex. 6203-R at App. 2 (Heimert).

818. Before the 2002 restructuring, Med Rel, Inc. and Medtronic Puerto Rico, Inc., had access to Medtronic US intangibles to manufacture and sell Medtronic's medical devices. The section 936 Possession Corporations did not independently own any intangibles and could not contribute any intangibles to MPROC. PFF ¶ 48; Stip. ¶ 11; Tr. 3449:24-50:7, 3618:23-20:6 (Albert).

819. The MPROC financial data Dr. Heimert used in his CPM was provided by Medtronic. Its reliability is not in dispute. RTr. 2373:5-8 (Heimert), 1570:12-71:1 (Hubbard).

2. Selection of Comparables

820. Dr. Heimert selected the same 14 manufacturers as comparables (Comparables) as in Medtronic I. All except Greatbatch Inc. (Greatbatch) were classified under SIC Code 384 as manufacturers of surgical, medical, and dental instruments and supplies. SIC Code 384 includes manufacturers of medical devices and vertically integrated companies such as Medtronic. RTr. 2365:20-67:4; Ex. 5543-R at p. 187 & n.309 (Heimert).

821. Dr. Heimert considered each Comparable in light of the comparability criteria in the section 482 regulations. Ex. 6203-R at ¶ 83, Table 10 (Heimert).

822. Like MPROC, the Comparables (1) performed high-quality manufacturing at scale; (2) managed inventory and bore market risk; and (3) frequently introduced new products. Exs. 6203-R at ¶ 83, Table 10 (Heimert), 6208-R at ¶¶ 156-67, 6413-RD at pp. 26-27; RTr. 2839:17-41:7 (Crosby).

823. Like MPROC, all the Comparables except Greatbatch were subject to direct FDA regulation and manufactured finished medical products at high volume. Ex. 6203-R at ¶¶ 83-84, Table 10; RTr. 2480:4-8 (Heimert).

824. Greatbatch was subject to FDA manufacturing standards by contract. RTr. 2379:22-81:25 (Heimert); Ex. 1262-J at 9146.

3. Profit Level Indicator (PLI) and Financial Data

825. Dr. Heimert used a return on assets (ROA) as the PLI in his CPM analysis. RTr. 2365:17-67:4; Ex. 6203-R at ¶¶ 76-79 (Heimert).

826. Dr. Heimert measured operating assets for his ROA analysis using net book value but excluded any intangible assets recorded on the GAAP financials of the Comparables. RTr. 2395:14-24, 2486:25-87:17; Exs. 6203-R at ¶ 77 & n.94 (Heimert); 5543-R at p. 204 (App. 5.C) (Heimert).

827. Reliable financial data for the Comparables is reported in their Forms 10-K. RTr. 2372:17-73:4 (Heimert), 75:2-9, 141:1-12 (McCoy).

828. Differences among the Comparables are smoothed out due to the larger size of the group. RTr. 2506:13-07:14 (Heimert), 2058:16-24 (Cockburn).

829. Use of an interquartile range (IQR) is a statistical tool used in the transfer pricing regulations to reduce comparability issues between a tested party and comparable companies when applying the CPM. Dr. Heimert used an IQR. RTr. 2373:24-74:10 (Heimert); Ex. 6203-R at ¶¶ 66, 71-72, Table 8 (Heimert).

830. The use of a larger data set and an IQR yields more reliable results than a flawed CUT based on a single agreement because differences between each comparable and the tested party are mitigated by the existence of other comparables that do not exhibit the same degree of difference. The use of an IQR narrows the results by eliminating outliers. Ex. 6203-R at ¶ 66 (Heimert).

831. The problem with using a single agreement as a CUT is that any idiosyncrasies or special circumstances are going to be amplified rather than averaged out, which is not the case with multiple transactions. RTr. 2058:19-24, 2059:4-11; Ex. 6201-R at ¶ 88 (Cockburn).

4. Dr. Heimert's Calculation of MPROC's Arm's-Length Operating Profits

832. Applying the Comparables' ROAs to MPROC's operating assets provides a range of Comparable or implied operating profits (Comparable Operating Profits or COPs) as shown below. Ex. 6203-R at Tables 23-24 (Heimert).

$ Millions	ROA	MPROC Operating Assets	Comparable Operating Profits
2005
Lower Quartile	22.0%	$393.0	$86.5
Median	28.1%	$393.0	$110.5
Upper Quartile	39.9%	$393.0	$157.0
2006
Lower Quartile	21.7%	$424.2	$92.0
Median	26.0%	$424.2	$110.4
Upper Quartile	39.3%	$424.2	$166.7
Formula	A	B	C = A*B

833. Dr. Heimert's calculation of the arm's-length royalties for intangible property licensed under the MPROC Agreement (sometimes Technology Royalties) takes into account this Court's opinion in Medtronic I, which found that the price of MPROC's purchases of components from Medtronic US, MPROC's intercompany sales of finished products, and MPROC's payment of an 8% trademark royalty were all arm's length. Ex. 6203-R at ¶ 72, Table 8 & n.89, App. 5; RTr. 2509:19-24, 2511:8-15 (Heimert).

834. Based on the Court's pricing in Medtronic I, the total royalties under the Trademark and MPROC Agreements are approximately $837.9 million and $1,245.3 million in 2005 and 2006, respectively. Ex. 6204-R at Tables 12-13 (Heimert). The 8% trademark royalty rate results in royalties of $146.5 million and $215.9 million in 2005 and 2006, respectively. Ex. 6109-P at Ex. 5.c (Hubbard). Thus, the Technology Royalties based on the Court's pricing in Medtronic I were $691.5 million and $1,029.4 million for 2005 and 2006, respectively.

$ Million	2005	2006	Formula
Total Royalties	$837.9	$1,245.3	A
Trademark Royalties	$146.5	$215.9	B
Technology Royalties	$691.5	$1,029.4	C = A - B

835. Based on the Court's pricing of the other controlled transactions at issue in Medtronic I, MPROC's Pre-Technology Operating Profits (profits after accounting for the other controlled transactions and before the Technology Royalty) are approximately $1.29 billion in 2005 and $1.96 billion in 2006, as computed below. Exs. 6203-R at Table 17, 6204-R at Tables 12-13 (Heimert); RFF 834.

$ Million	2005	2006	Formula
MPROC Operating Profit	$595.8	$926.1	A
Technology Royalties	$691.5	$1,029.4	B
MPROC Pre-Technology Operating Profit	$1,287.3	$1,955.5	C = A + B

836. MPROC's Pre-Technology Royalty Operating Profits, as calculated by Dr. Hubbard using Mr. Kennelly's data and Dr. Putnam's CUT's maximum Technology Royalty, closely approximate Dr. Heimert's calculation at $1.26 billion for 2005 and $1.93 billion for 2006. Ex. 6109-P at Ex. 5.a (Hubbard).

$ Million	2005	2006	Formula
MPROC Operating Profit	$667.6	$1,052.6	A
Technology Royalties	$596.7	$874.5	B
MPROC Pre-Tech. Royalty Operating Profits	$1,264.3	$1,927.1	C = A + B

837. Under Dr. Heimert's CPM, MPROC's Technology Royalties are equal to the difference between MPROC's Pre-Technology Royalty Operating Profits and the median of the COPs as shown below. Ex. 6203-R at Tables 23-24 (Heimert); RFF 835.

$ Millions	2005	2006	Formula
MPROC Pre-Tech. Royalty Operating Profits	$1,287.3	$1,955.5	A
Comparable Operating Profits (Median)	$110.5	$110.4	B
Technology Royalties	$1,176.7	$1,845.1	C = A - B

838. As the applicable ROA increases, MPROC's COPs increase, and the total amount to be paid as a Technology Royalty decreases by the same amount. Ex. 5544-R at p. 14-15; RTr. 2387:23-24 (Heimert).

839. To calculate the retail royalty rate under the CPM, MPROC's Technology Royalties are divided by third-party sales of $2,680.1 million in 2005 and $3,543.6 million in 2006. To calculate the wholesale royalty rate under the CPM, MPROC's Technology Royalties are divided by MPROC's sales of $1,831.1 million and $2,698.8 million in 2006. Ex. 6204-R at Tables 12-13 (Heimert). The retail and wholesale royalty rates under Dr. Heimert's CPM are set forth below. RFF1837.

$ Millions (Except %)	2005	2006	Formula
Technology Royalties	$1,176.7	$1,845.1	A
Third-Party Sales	$2,680.1	$3,543.6	B
Technology Royalty Rate (Retail)	43.9%	52.1%	C = A / B
MPROC Sales	$1,831.1	$2,698.8	D
Technology Royalty Rate (Wholesale)	64.3%	68.4%	E = A / D

840. Based on the pricing determined in Medtronic I, MPROC's operating profits are $595.8 million in 2005 and $926.1 million in 2006, and MPROC's ROAs are 151.6% in 2005 and 218.3% in 2006. The Comparables' upper quartile ROAs are 39.9% in 2005 and 39.3% in 2006. The COPs based on these upper quartile ROAs are $157.0 million in 2005 and $166.7 million in 2006. Both MPROC's operating profits and ROAs under the pricing determined in Medtronic I exceed the upper quartile of the Comparables' COPs and ROAs. Exs. 6203-R at 103-04, Fig. 4 & Tables 17, 23-24 (Heimert), 6201-R at^[ 103 (Cockburn), 6108-P at Exs. 10.a-10.b (Hubbard). Petitioner's are even higher. See RFF 841.

$ Millions Except %	2005	2006	Formula
MPROC's Operating Assets	$393.0	$424.2	A
Tax Court Opinion
MPROC's Operating Profits	$595.8	$926.1	B
ROA	151.6%	218.3%	C = B / A
Dr. Putnam's Low Royalty
MPROC's Operating Profits	$871.1	$1,350.7	D
ROA	221.6%	318.4%	E = D / A
Dr. Putnam's Max Royalty
MPROC's Operating Profits	$667.6	$1,052.6	F
ROA	169.9%	248.1%	G = F / A

841. Under Dr. Putnam's proposed royalties, MPROC's operating profits range from $668-3871 million in 2005 and $1,503-$1,351 million in 2006, and MPROC's ROAs range from 169.9%-221.6% in 2005 and 248.1%-318.4% in 2006. These MPROC operating profits and ROAs far exceed the COPs and the ROAs based on the Comparables. Exs. 6202-R at ¶ 140 & Fig. 2 (Cockburn), 6203-R at ¶¶ 103-04, Fig. 4 & Table 17 (Heimert), 6108-P at Exs. 10.a-10.b (Hubbard); RTr. 2064:20-65:25 (Cockburn); RFF ¶ 840.

B. Dr. Heimert's Comparables

842. The universe of potential comparable companies that reported financial information for the years at issue is fixed. RTr. 2371:3-10 (Heimert). Companies closer in comparability to MPROC than the 14 selected by Dr. Heimert have not been found or do not exist. RTr. 2371:11-16 (Heimert).

843. In the transfer pricing world, there is no such thing as a perfect comparable. RTr. 2473:20-74:24 (Heimert), 2293:5-94:22 (Cockburn). Comparability is a matter of degree. RTr. 2543:22-44:25, 2464:8-15 (Heimert).

844. MPROC falls within the range of all Comparables based on the scale of manufacturing activity as reflected by revenues. Exs. 6203-R at ¶ 98, Table 11, 6204-R at ¶ 92 (Heimert). Dr. Hubbard accepted all the Comparables under his sales screen. RTr. 1518:19-19:4 (Hubbard), 2388:2-14 (Heimert). Pacesetter falls within the range of the Comparables' revenues but its revenues are much lower than MPROC's. RTr. 2388:23-89:4; Ex. 6410-RD at p. 11 (Heimert).

845. While the Comparables had more non-U. S. sales than MPROC and varying levels of non-U. S. sales, there was no direct relationship between geographic market and ROA. For example, the Comparable with the highest percentage of U.S. sales in 2005 (Encore Medical Group) had one of the lowest ROAs (17.1% for 2005 and 17.5% for 2006). RTr. 2397:15-98:9; Ex. 6410-RD at p. 15 (Heimert).

1. The Comparables Perform Quality Manufacturing Similar to MPROC.

846. Quality manufacturing means manufacturing to the product design specifications and tolerances. Tr. 441:21-42:11 (Mahle).

847. The quality challenges faced by the Comparables, although not identical, are similar to those faced by MPROC. RTr. 2845:2-4 (Crosby).

848. High-quality manufacturing is not a differentiator in the CRM industry because every company must manufacture at a high quality to enter and stay in the business. RTr. 2993:24-94:11 (Crosby); Tr. 6681:11-19 (Kruger). Excessive quality capability does not increase market share or company growth. Tr. 6711:8-15; Ex. 5529-R at p. 3 (Kruger).

849. The U.S. Food and Drug Administration (FDA) employs Quality System Regulations (QSR) to govern the design, manufacture, packaging, and servicing of all finished medical devices intended for human use. Exs. 6203-R at ¶ 86 (Heimert), 29-J at 1253, 31-J at 1405.

850. All the Comparables, except Greatbatch, were subject to the FDA QSR. Ex. 6203-R at ¶ 86; RTr. 2480:4-8 (Heimert); RFF ¶ 629.

851. FDA QSR and good manufacturing practices requirements do not differ based on class of product. RTr. 2842:2-18 (Crosby). The class of product (Class I, II or III) only affects pathway to market and the clearance required (Class II products require 510(k)s and Class III products require PMAs) and not the quality of manufacturing. RTr. 2842:11-44:23 (Crosby).

852. Life-improving products such as neuro and orthopedic products and life-sustaining CRM products require similar high-quality manufacturing and face similar quality risks. RTr. 2838:5-39:13 (Crosby); Ex. 6103-P at 2367-68 (Cohen).

853. By the years at issue, most pacemakers were life-improving, not life-sustaining, products. About 2% of patients are at risk of injury or death if there is no output from a pacemaker, and pacemaker failures with no output are a tiny proportion of recalls. Most devices subject to recall have not, and probably will not fail. RTr. 2838:16-25 (Crosby).

854. Under the FDA's QSR, quality is a requirement of all medical device manufacturers, as implemented in a quality management system (QMS). Ex. 6208-R at ¶ 123; RTr. 2841:18-23 (Crosby).

855. MPROC's facility QMS is a subset of Medtronic US' QMS and is not a complete QMS. For example, it does not include design control. RTr. 2835:1-7, 2836:13-15 (Crosby); Exs. 837-J at 9892-96, 873-J at 7345, 7347, 7363.

856. MPROC was not solely responsible for Medtronic's QMS. RTr. 2992:2-20, 2990:10-13, 2993:24-94:11 (Crosby). Design control, material selection and various aspects of the QMS are Medtronic US' responsibility. RTr. 2992:2-20 (Crosby). Many parts of Medtronic's CAPA system are handled by Medtronic US. RTr. 2995:14-96:14 (Crosby); Ex. 1811-J at 6558, 6561-62, 6581, 6587-88.

857. Like MPROC, the Comparables have to manufacture at high quality and maintain a QMS. RTr. 2845:2-15 (Crosby).

2. The Product Liability Risks Faced by the Comparables are Similar to Those Faced by MPROC.

858. Forms 10-K for each comparable confirm that like MPROC, all the Comparables incur product liability risk, quality risk, and market risk in connection with their manufacturing activities. RTr. 2370:17-22; Exs. 6203-R at ¶¶ 85, 91-92, Table 10, 6410-RD at p. 5 (Heimert).

859. All the Comparables bore significant product liability risk and purchased insurance and/or maintained reserves to manage such risk. Like Medtronic US, many of the Comparables disclose the “inherent risk” of product liability with respect to medical devices in their public financials. Exs. 6203-R at ¶ 91, Table 10, 6204-R at ¶ 193 (Heimert); RFF ¶ 628; RTr. 187:24-88:9, 201:5-14 (McCoy).

860. No real difference exists in product liability risk for a company that manufactures hip implants, like Smith & Nephew, that faced a several billion-dollar product liability class-action lawsuits, and Medtronic that faced a few hundred million dollar lawsuits. The consequences to the firms are the similar. RTr. 2845:2-12 (Crosby).

861. Any difference in product liability risk between MPROC and the Comparables is quantifiable. RTr. 2392:1-16, 2537:20-24 (Heimert), 2292:19-93:4, 2298:6-18 (Cockburn), 1649:15-21 (Hubbard); Exs. 5522-R at ¶¶ 2, 8, Table 1 (Braithwaite), 2272-J at 9229-30, 2271-J at 9221, 2301-J at 9099.

862. MPROC's product liability risks are “routine” as they can be benchmarked using the financial results of comparable manufacturers. Treas. Reg. § 1.482-6(c)(3)(i)(A); Ex. 6203-R at ¶¶ 75, 91; RTr. 2372:4-10, 2488:16-89:23 (Heimert).

863. A company with product liability insurance continues to bear risk for a retention amount (similar to a deductible) as well as any catastrophic losses above the level of coverage provided by its insurance. RTr. 2390:15-91:13; Exs. 6410-RD at p. 12; 6204-R at ¶¶ 93-96 (Heimert).

864. Pacesetter bore all of the product liability risk for its products. If MPROC was less than 100% responsible for product liability, then that is another difference between the Pacesetter and MPROC Agreements. Exs. 2504-J at § 4.03, 6201-R at ¶ 69 (Cockburn).

865. All products, package labels, product manuals, and warranties bear only the Medtronic name and logo. They do not identify MPROC. The labels indicate that manufacture occurred in Puerto Rico but none of the labels, manuals, or warranties indicates that MPROC is the manufacturer. Exs. 1910-J at 1521-22 (label), 152-J at 1938 (implant manual), 171-J at 5204 (product information manual), 185-J at 1566 (technical manual), 199-J at 8090 (reference manual), 281-J at 8288 (patient manual), 2658-J at 7306, 7308-09 (warranties).

a. Medical Devices' Sources of Defects and Recalls

866. The Fidelis Leads were designed by Medtronic US in the United States and assembled by MPROC in Puerto Rico. Tr. 555:7-16, 630:2-23 (Santiago). In October 2007, Medtronic voluntarily suspended distribution of the Fidelis Leads, due to indications that they could fracture and cause inappropriate shocks. Medtronic I at *62-63; Ex. 2929-P at 6727; Tr. 5399:18-21 (McConnell). Litigation followed. Tr. 5399:22-400:8 (McConnell). Medtronic ultimately paid a little more than $200 million to settle the litigation. Tr. 3805:5-8 (Nelson). The Leads met their manufacturing specifications. Tr. 630:13-17 (Santiago). Medtronic determined that design failures caused the premature fractures. Tr. 630:18-20 (Santiago), 4183:4-17 (Hughes), 5669:5-18 (Bergman).

867. In Medtronic I at *64, the Court found that the cause of the Fidelis Lead problems was both design and manufacturing. That finding is contradicted by the testimony of Manny Santiago. Tr. 630:18-19. Petitioner's industry expert Ed Hughes agreed that design failures caused the problem. Tr. 4183:7-17.

868. The Marquis family of ICDs was designed by Medtronic US. Tr. 629:15-30:5 (Santiago). Components for the Marquis Devices, including circuits and batteries, were supplied to MPROC for assembly. Tr. 567:8-18 (Santiago). In February 2005, Medtronic instituted a Field Action for Marquis Devices, due to indications of premature battery depletion. Ex. 2652-J at 7146. Litigation followed. Ex. 2663-J. Medtronic ultimately sought coverage from XL Insurance based on about $280 million in costs related to the Marquis issue in the United States and Canada, including settlement payments, defense costs, and costs of providing replacement Devices. Ex. 2652-J at 7146-47; Tr. 5395:18-96:10 (McConnell). When MPROC delivered the Marquis Devices, they met all manufacturing requirements. Tr. 629:21-24 (Santiago). The root cause for the malfunction was determined to be battery design. Ex. 1420-J at 4077.

869. The largest product liability losses in Medtronic's history were from the Marquis and Fidelis products. Tr. 3804:14-18 (Nelson).

870. Most product liability cases involve design or warning defects. Manufacturing defects are relatively rare. Tr. 7074:4-11 (Green); Ex. 6208-R at ¶¶ 127-30 (Crosby).

871. Both Class III non-CRM devices and non-Class III medical devices have faced significant product liability costs including $112 million for bone screws, $780 million for hip replacements, $3 billion for IUDs, and $10 billion for breast implants. Ex. 2922-P at 8554-56; RTr. 202:9-06:9 (McCoy).

b. Medtronic US' Risk Management and Control, and Self-Insurance

872. Rather than looking at complicated insurance products for answers to certain types of insurable business risk, Medtronic US instead worked to develop better business resiliency through loss prevention and business continuity management. Exs. 2272-J at 9228, 2300-J at 4890.

873. Effective May 1, 2002, Medtronic discontinued its property and liability insurance program and became self-insured. Exs. 2301-J at 98, 2272-J at 29, 2270-J at 54. It continued to be self-insured through 2005-2006. Tr. 3694:21-24, 3741:2-5 (Nelson).

874. The decision to self-insure was not a big change for Medtronic US as it had operated its insurance program to absorb normal losses using a high level of self-insured retention for the prior 15 years. Strong loss control practices across Medtronic and its strategic approach to key litigation enabled Medtronic US to successfully manage its loss costs better than it could have through insurance. Exs. 2300-J at 4890, 2270-J at 9154, 2269-J at 9093. The core strategy of Medtronic's risk management program is based on self-insurance. Ex. 2272-J at 9229; Tr. 3777:13-16 (Nelson).

875. Medtronic US rejected product liability insurance, as it continued to believe these prices were too high in comparison to the relatively small value insurance brought to Medtronic. Exs. 2272-J at 9228-30, 2271-J at 9220-21, 2270-J at 9154, 2301-J at 9098-99, 2298 at 6190; Tr. 3774:7-76:25 (Nelson).

876. In Medtronic I at *12, the Court found that “[o]nce 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.” This finding is incomplete. Medtronic faced retention risk and “catastrophic risk” even when it was insured, and it believed that there was an extremely low chance that it would experience any negative financial impact from eliminating its insurance program, as it only covered a small portion of Medtronic's business risk. See Exs. 2271-J at 9220, 2272-J at 9228-29, 9233-35, 2304-P at 9762.

877. Medtronic US' corporate Litigation Department was responsible for managing litigation on behalf of every Medtronic business unit worldwide. Tr. 5387:18-21 (McConnell); Stip. ¶ 1114. It managed a variety of cases, including IP and product liability cases, and government investigations. Stip. ¶ 1114. It was responsible for assessing the risk of litigation, litigation strategy, retaining and managing outside counsel, and managing cases to resolution. Tr. 5415:4-5417:4 (McConnell); Stip. ¶ 1115.

878. MPROC has no legal group and relied for advice on Medtronic US' legal staff and a Puerto Rico law firm for local issues such as labor and local taxes. Tr. 590:9-15 (Santiago), 3607:14-21 (Albert), 5419:1-16 (McConnell).

879. Medtronic rejected the $3 billion proposal Berkshire Hathaway floated as “beyond reason.” Ex. 2301-J at 9100; Tr. 3785:13-25 (Nelson).

880. Annually, Medtronic US revisits its decision to self-insure. Tr. 3741:2-20, 3775:2-11 (Nelson); Exs. 2269-J, 2270-J, 2271-J, 2272-J.

881. MPROC did not consider purchasing product liability insurance. Tr. 622:3-9 (Santiago), 3775:2-11 (Nelson).

882. Changes to ICD and CRT batteries, capacitors, or any electrical components of the hybrids, including changes to the pacing agent, firm algorithms, the microprocessor, or to circuits, are “invisible” to MPROC. They are entirely handled by Medtronic US. Ex. 1811-J at 6581-82.

c. Product Liability Risks Were Historically Low.

883. Medtronic has a long history of a steady payout pattern for product liability easily covered through normal operations. From 1995 to 2002, its annual payouts as a percent of worldwide revenue were between about 0.13% and 0.37%, or between $4 million and $16 million. Ex. 2302-J at 6198. From 2002 to 2004, and as estimated for 2005, its annual product liability payouts as a percent of U.S. revenue were between about 0.12% and 0.23%, or between $7 and $17 million. Ex. 2271-J at 9226. From 2001 to 2005 and as estimated for 2006, its annual product liability payouts were between 0.04% and 0.12% of U.S. revenue. Ex. 2272-J at 9234. This covered all products worldwide. Tr. 3791:20-92:17 (Nelson).

884. Medtronic had the insurance firm AON perform actuarial analyses of its product liability exposure. Tr. 3765:4-22, 3768:21-70:11 (Nelson); Exs. 2635-J at 0607,2634-J at 0631-33. AON's product liability forecasts were based on Medtronic's historical product liability claims and industry data, assuming no class action lawsuits nor catastrophic scenarios. Tr. 3765:8-22, 3767:4-23, 3797:23-98:25, 3800:6-12 (Nelson); Ex. 2635-J at 0609, 0612.

885. From 1988 to 2003, AON's estimates of Medtronic's expected product liability losses averaged about $7 million per year and covers worldwide losses. Ex. 2631-J at 5147-57, 5159; RFF ¶ 570.

886. As of 2005-06, federal preemption had substantially reduced the liability for which Medtronic would otherwise have been liable. Tr. 7073:3-20; Ex. 5536-R at ¶¶ 41-77, 82-83 (Green).

887. The Medtronic Risk Management group determined the appropriate product liability reserve balance for Medtronic. The balances were then allocated to the legal entity that bore the risk. Ex. 2724-J at 3951. The table below shows the CRM/Neuro product liability accruals allocated by Medtronic to Medtronic US and MPROC from 2005-08. Each year, Medtronic allocated the majority of CRM/Neuro product liability accruals to Medtronic US. Ex. 2727-J at 4477.

	2005	2006	2007	2008
Medtronic US	$11,922,703	$8,147,668	$5,008,114	$3,557,963
MPROC	$3,873,149	$2,912,399	$1,532,437	$2,097,976
Medtronic Europe	$1,087,288	$1,412,022	$1,618,622	$1,441,554
Total	$16,883,140	$12,472,089	$8,159,173	$7,097,493

888. As the end of fiscal years 2004 and 2005, respectively, MPROC had total equity (assets less liabilities) of about $410 million and $485 million, and liquid assets (cash, cash equivalents, short-term investments) of about $28 million and $22 million. Ex. 5549-P at Ex.B.II.b (Ciancanelli).

889. Paul Braithwaite is an actuary and insurance industry expert. Exs. 5522-R at ¶ 1, App. 1, 5524-R; Tr. 6520:4-9 (Braithwaite). Mr. Braithwaite concluded that if MPROC bore all product liability risk for CRM and Neuro, its expected product liability costs (settlement costs and legal fees) in 2005 and 2006 would have been about $25.2 million and $26.2 million, respectively. Ex 5522-R at ¶¶ 2, 8, Table 1; Tr. 6522:11-24:23 (Braithwaite).

3. The Comparables' Other Functions Result in Similar or Higher ROAs.

890. In selecting comparables for the CPM, information in a company's SEC filings is used to gauge comparability and eliminate those considered not sufficiently comparable in function. RTr. 2464:16-66:8 (Heimert).

891. The Comparables' SIC code and significant manufacturing assets in the form of property, plant, and equipment (PP&E) confirm that their substantial manufacturing function is similar to MPROC's. RTr. 2556:11-57:5, 2396:8-19, 2485:11-86:6 (Heimert). The PP&E asset ratios for a number of the Comparables are quite high, indicating heavy manufacturing activity. RTr. 2396:8-19 (Heimert).

892. Pacesetter must manage a cost structure that is five times the cost structure of MPROC, implying that Pacesetter performs five times the functions performed by MPROC. Pacesetter has to do a lot more things than MPROC. RTr. 2604:6-24; Exs. 6207-R at 6283-84, Table 1, 6411-RD at p. 4 (Becker).

893. MPROC's manufacturing activities are very important but are aligned with other medical device manufacturers. The subset of Comparables that manufacture implantable medical devices (Implantables) align with MPROC and, except for Greatbatch, with the Class III medical device manufacturers identified by Dr. Hubbard. RTr. 2491:15-92:9; Ex. 6203-R at ¶¶ 70, 100 (Heimert).

894. While all of the Comparables perform significant manufacturing of medical products, some perform functions, such as distribution and research, that are not performed by MPROC. RTr. 2396:8-19 (Heimert); Ex. 6204-R at ¶¶ 98-102 (Heimert); RFF ¶ 630.

895. Distribution activities performed by the Comparables do not distort Dr. Heimert's CPM results. An analysis showed that the ROA for stand-alone distributors is similar to the ROA earned by the Comparables so removing the distribution activities of the Comparables would not change the CPM results. Exs. 6204-R at ¶ 102 & n.158, 6410-RD at p. 13; RTr. 2392:24-94:4 (Heimert).

896. Research activities performed by the Comparables could distort Dr. Heimert's CPM results but would do so by creating a higher ROA that would favor petitioner. RTr. 2295:5-96:8 (Cockburn), 2394:9-22 (Heimert); Exs. 6204-R at ¶¶ 98, 101, 6410-RD at p. 13 (Heimert), 6108-P at ¶ 118 (Hubbard).

4. The Comparables Have Assets Similar to MPROC's.

a. Manufacturing Assets

897. Differences in the level of accounts receivables owned by MPROC and the Comparables do not distort Dr. Heimert's CPM results. Ex. 6204-R at ¶¶ 107-08, Table 7; RTr. 2396:20-97:13 (Heimert);; RTr. 1543:14-21 (Hubbard).

898. Dr. Heimert did not originally adjust for differences in accounts receivables because in his experience, such adjustments are effectively de minimis. RTr. 2396:20-97:3 (Heimert).

899. MPROC has relatively less PP&E than the Comparables. RTr. 1541:1-5 (Hubbard). PP&E is riskier than current assets like accounts receivable to a firm. RTr. 1541:15-23 (Hubbard).

b. Routine Intangible Assets

900. The intangible assets recorded on a company's balance sheet are acquired intangibles and not self-developed intangibles. RTr. 2395:14-24,2486:25-87:18; Ex. 6203-R at ¶ 77 (Heimert).

901. MPROC's balance sheets did not record any intangible assets owned by MPROC. Ex. 5543-R at App. 8, Tables 33-39 (Heimert).

902. The Comparables have goodwill, workforce in place, knowledge embedded in people and processes, know-how, and other intangibles. Dr. Heimert considered these intangibles in his CPM analysis. RTr. 198:16-199:6 (McCoy), 2477:11-78:23; Ex. 6203-R at ¶¶ 76-79, 93 (Heimert).

903. Dr. Heimert refers to the Comparables' and MPROC's intangibles as routine, not because they are not important, but because they are benchmarkable. The record does not establish that the activities and intangibles of MPROC were significantly more valuable and unique than the activities and intangibles of the Comparables. Ex. 6203-R at ¶¶ 74-75; RTr. 2489:24-91:24 (Heimert).

904. Dr. Heimert's CPM ROA analysis does not ignore intangible assets. Any returns to intangibles possessed by the Comparables are captured in their operating profits, included in Dr. Heimert's ROA calculations, and thereby attributed to MPROC under the CPM. Ex 6203-R at ¶ 77 & n.94; RTr. 2377:15-78:3 (Heimert).

905. A company's market-to-book ratio can indicate that the company owns non-book intangible assets like high-quality manufacturing capabilities. Ex. 6203-R at ¶ 78 (Heimert); RTr. 1648:2-15 (Hubbard).

906. When the market value of a company (based on its stock price) divided by its book value (based on its balance sheet) is greater than one, a significant component of the value in excess of the book value is typically due to intangible assets of that company. RTr. 2376:9-77:10; Ex 6203-R at ¶ 79 & n.96 (Heimert).

907. Dr. Heimert calculated each Comparables' market-to-book ratio and determined that all Comparables used in his CPM ROA analysis had market-to-book ratios greater than one, and that the median market-to-book ratio of the Comparables was approximately 4.5 in 2005, indicating that the Comparables owned significant intangible assets. Exs. 6203-R at ¶ 79, Table 9, 6410-RD at p. 7; RTr. 2375:21-77:10 (Heimert).

5. Product Comparability for Subsets of the Comparables, Including the Implantables.

908. Dr. Heimert's CPM can be adjusted by excluding companies as Comparables. RTr. 2551:11-52:7, 2386:19-88:1 (Heimert).

909. In response to the Court's critique that the Comparables did not produce medical products subject to the same level of FDA scrutiny as MPROC's Class III implantable medical products, Dr. Heimert divided his Comparables into two groups — Implantables that manufactured medical products designed to be put into the human body for a period of time, and those that did not. RTr. 2370:6-16, 2378:4-79:21; Exs. 6203-R at ¶¶ 99-100 & n.144, 6410-RD at p. 8 (Heimert).

910. Six of the Comparables are Implantables: (1) Stryker Corp; (2) Zimmer Holdings Inc.; (3) Bard (C.R.) Inc.; (4) Wright Medical Group Inc.; (5) Orthofix Inti NV; and (6) Greatbatch. Exs. 6203-R at Table 10, 6410-RD at p. 5 (Heimert). Except for Greatbatch, Dr. Hubbard classified the Implantables and several other Comparables as manufacturers of Class III medical products. RTr. 2379:2-19, 2525:3-26:14 (Heimert), 1529:16-30:5, 1528:3-8 (Hubbard); Ex. 6410-RD at p. 8 (Heimert).

911. Mr. McCoy suggested that manufacturers of interventional cardiology products be considered as comparables for a CPM analysis. RTr. 384:14-20 (McCoy). Several of the Comparables, including Bard, Arrow International, and Merit Medical Systems, manufacture interventional cardiology products. RTr. 2382:1-19; Ex. 5543-R at pp. 204-05, 212 (Heimert).

912. Mr. McCoy considered orthopedic companies like Stryker, Zimmer, Wright, and Orthofix, to be close cousins of CRM companies. RTr. 113:11-14:7; Ex. 6101-P at 2300-01 (McCoy).

913. Greatbatch is a manufacturer of components used in implantable medical products. RTr. 2379:23-80:9 (Heimert). Dr. Heimert included Greatbatch as a Comparable and as an Implantable because its products are used as components in implantable products, and because a senior Medtronic employee informed him during an audit interview that Greatbatch was considered by Medtronic for outsourcing leads. RTr. 2380:12-23, 2493:6-97:19 (Heimert); Ex. 5543-R at p. 104 & n.250 (Heimert).

914. In Medtronic I at *8, this Court found that “[t]he PMA process is lengthy and can often take 5 to 10 years” and that “Class III medical devices are higher risk and more novel than are those of Classes I and II.” This latter finding that Class III medical devices are higher risk and more novel than are those of Classes I and II is incomplete and fails to quantify the impact on the royalty at issue in this case. Like the Comparables, MPROC faced manufacturing risks, but the design, development, clinical, and technological risks of the business are borne by Medtronic US. Manufacturing risk borne by MPROC is comparable to that of Dr. Heimert's Comparables and standard manufacturing practices are similar across classes of devices. Exs. 6202-R at ¶¶ 23, 28-37 & n.10 (Cockburn); 6208-R at ¶¶ 25, 158-68 (Crosby), 3060-J at 7557-58; RTr. 2480:4-8 (Heimert), 2841:18-23, 2845:2-17, 2842:11-44:23, 2993:24-94:11 (Crosby); RFF ¶ 629.

C. Reasonableness of Dr. Heimert's CPM Results

915. Dr. Cockburn reviewed the 2005 and 2006 RO As of firms in manufacturing sectors other than SIC Code 384 that require precision manufacturing and are subject to significant (even fatal) consequences in case of a product failure. The firms included airplane, automobile, and pharmaceutical manufacturers. RO As as high as the MPROC RO As derived from petitioner's, the Court's, and Dr. Putnam's CUTs are truly extraordinary and almost never seen. Ex. 6201-R at ¶¶ 107-08, Table 10; RTr. 2068:6-69:19 (Cockburn).

916. Pacesetter's ROA (35.7%) falls within the IQR of the Comparables (21.8%-39.6%). Medtronic's overall ROA is higher (55.9%), although reasonable for the industry. RTr. 2368:1-69:2; Exs. 6203-R at Table 13, Fig. 4, 6410-RD at p. 4, 5544-R at pp. 124, 129 (Heimert).

917. MPROC's two-year average RO As under petitioner's and the Court's CUTs (255.5% and 185.0%, respectively) are orders of magnitude higher than the IQRs of the Comparables' ROAs (21.8%-39.6%), Pacesetter's ROA (35.7%), the ROAs earned by Greatbatch of 21.9% (2003-2005) and 21.1% (2004-2006) and Accellent (23.7% and 31.1% in 2005 and 2006, respectively), and Medtronic's overall ROA (55.9%). They are also higher than any other medical device manufacturer's three-year average ROA for 2005 to 2006 within SIC Code 384. RTr. 2366:1-69:2, 2399:12-22; Exs. 6203-R at Table 13, Fig. 4, 6410-RD at p. 4, 5543-R at n.287, 5544-R at Table 10 (Heimert).

918. Dr. Heimert tested the reasonableness of his results by analyzing the relative functional contributions by MPROC and Medtronic's US entities and how they align with the overall profit splits of the combined entities. RTr. 2540:17-41:25.

919. Dr. Heimert's CPM analysis results in a profit split of 92% in 2005 and 94% in 2006 to the United States, and 8% in 2005 and 6% in 2006 to Puerto Rico. Ex. 6204-R at Tables 8-9; RTr. 2404:1-7 (Heimert).

920. The split of value-added costs incurred by Medtronic US entities (91% in 2005, 88% in 2006) as compared to MPROC (9% in 2005, 12% in 2006) is in line with the profit split resulting from Dr. Heimert's CPM analysis. Exs. 6204-R at ¶ 119, Tables 8-9, 6410-RD at p. 18; RTr. 2401:13-05:5 (Heimert).

921. The split of employees involved in the CRM and Neuro value chains who were employed by Medtronic US entities (83% in 2005, 84% in 2006) as compared to MPROC (17% in 2005, 16% in 2006) is in line with the profit split resulting from Dr. Heimert's CPM analysis. Exs. 6204-R at ¶¶ 117, 119, Tables 10-11, 6410-RD at p. 18; RTr. 2401:13-05:5 (Heimert).

922. The split of base salaries paid to Medtronic US entities' employees (94% in 2005-2006) as compared to MPROC employees (6% in 2005-2006) is in line with the profit split resulting from Dr. Heimert's CPM analysis. Exs. 6204-R at ¶ 119, Tables 10-11, 6410-RD at p. 18; RTr. 2401:13-05:5 (Heimert).

923. Under Dr. Heimert's CPM, for 2006, the profit per employee in Puerto Rico is $62,500, and the profit per employee in the United States is $203,711. The difference between these two values is rational because Puerto Rico employees tend to be factory and line workers, while scientists and executives tend to be in the United States. Under Dr. Putnam's CUT low royalty for 2006, the profit per employee in Puerto Rico is $764,853, and the profit per employee in the United States is $52,648. RTr. 2405:6-06:9, 2542:2-43:11; Exs. 6410-RD at p. 19, 6204-R at ¶ 118, Table 11 (Heimert).

924. The share of profits allocated to MPROC under Dr. Heimert's CPM are better aligned to proxies for relative functional contributions by MPROC and Medtronic US entities than the share of profits allocated to MPROC under petitioner's CUT. Ex 6204-R ¶ 119; RTr. 2404:1-05:5 (Heimert).

925. Dr. Putnam's CUT method allocates to MPROC 50-66% of profits in 2005 and 57-74% of profits in 2006. These profit splits do not align with the relative functional contributions of Medtronic US entities and MPROC. Exs. 6204-R at ¶ 119, Tables 10-11, 6410-RD at p. 18; RTr. 2404:8-05:5 (Heimert).

926. MPROC's ROA based on the petitioner's reported position of 255.5% was over 7 times greater than Pacesetter's average ROA for 1993 (31.1%) and 1994 (40.3%) of 35.7%. Ex. 6203-R at Table 13, Fig. 4 (Heimert); RFF ¶¶ 917, 939. Dr. Putnam's low royalty results in MPROC's simple average ROA for 2005 (221.6%) and 2006 (318.4%) of 270.0%, again over 7 times greater than Pacesetter's average ROA. RFF ¶¶ 840-41.

927. For 2005, MPROC would earn a return on its costs of 169.9% and 222.6% at Dr. Putnam's maximum and low royalty rates, respectively. Pacesetter was projected to earn a return on its costs of 28.3% after paying the royalty under the Pacesetter Agreement. Using return on costs as a PLI, MPROC's projected return is six to eight times larger than Pacesetter's projected return. RTr. 2624:19-25:13; Exs. 6207-R at 6286, 6299, Tables 4 & 8, 6411-RD at p. 13 (Becker).

928. Dr. Hubbard's analysis regarding MPROC's ability to bear product liability costs (or “wherewithal analysis”) assumes that MPROC would earn a return on costs of 289%. RTr. 2628:20-29:3; Ex. 6411-RD a tp. 15 (Becker).

D. Application of Dr. Heimert's CPM with Potential Adjustments

929. Dr. Heimert's CPM can be adjusted if there is a basis under the transfer pricing regulations for doing so by (1) using an ROA based on a limited subset of the Comparables, (2) choosing an ROA within the IQR other than the median, and (3) adjusting for product liability risk. RTr. 2551:11-52:7, 2545:1-46:17 (Heimert), 2290:22-92:14, 2298:6-18 (Cockburn), 2745:5-48:17 (Becker).

1. Calculation of MPROC's Arm's-Length Profits Based on Selected Comparables' ROAs

930. Although unnecessary, Dr. Heimert's CPM can be adjusted by removing from his set of Comparables companies deemed less comparable to MPROC or selecting an ROA other than the median from within the IQR. Changesto a set of comparables and/or the selection of the upper quartile ROA is common in transfer pricing and does not create bias if properly made. RTr. 2551:11-52:7, 2386:19-88:1 (Heimert), 2290:22-91:23 (Cockburn), 2748:4-17 (Becker).

931. The chart below shows the RO As representing the lower quartile (LQ), the median, and the upper quartile (UQ) for the Comparables and two subsets of the Comparables. Exs. 6203-R at ¶ 100, Tables 15-16 (Heimert), 6109-P at Exs. 2-3 (Hubbard).

	2005			2006
Set Chosen	LQ	Median	UQ	LQ	Median	UQ
Comparables	22.0%	28.1%	39.9%	21.7%	26.0%	39.3%
Implantables	21.9%	40.4%	43.6%	21.1%	40.5%	47.4%
Implantables w/o GB	39.9%	40.9%	43.6%	39.3%	41.7%	47.4%

932. The upper quartile of the RO As for the Implantables excluding Greatbatch (Implantables w/o GB) are 43.6% and 47.4% for 2005 and 2006, respectively. Multiplying MPROC's operating assets by these RO As generates COPs of $171.4 million and $201.1 million in 2005 and 2006, respectively. Exs. 6203-R at Tables 23-24 (Heimert), 6109-P at Exs. 2-3 (Hubbard).

$ Millions (Except %)	2005	2006	Formula
MPROC Operating Assets	$393.0	$424.2	A
ROA — Implantables w/o GB (Upper Quartile)	43.6%	47.4%	B
Comparable Operating Profit	$171.4	$201.1	C = A*B

933. The COPs of $372.5 million ($171.4 + $201.1) for 2005 and 2006 using the upper quartile RO As for the Implantables w/o Greatbatch is more than 65% greater than the COPs of $220.9 million ($110.5 + $110.4) using the median RO As for the Comparables. Ex. 6203-R at Tables 23-24 (Heimert); RFF ¶ 932.

2. Adjusting MPROC's Profits for Product Liability Risk

934. Dr. Heimert's CPM can be adjusted for potential product liability differences between MPROC and the relevant comparables by treating MPROC as if it paid a product liability insurance premium, increasing COPs by the amount of the premium to cover these costs, and concomitantly decreasing the technology royalty by the same amount. RTr. 2559:6-8, 2563:1-64:15 (Heimert), 2291:24-92:14, 2298:6-18 (Cockburn), 2768:6-25 (Becker); Ex. 5544-Ratpp. 14-17 (Heimert).

935. Assuming MPROC bore 100% of the product liability risk, the difference in product liability risk between MPROC and a Comparable with product liability insurance is the cost of insuring losses in the amount of the difference between a comparable's retention amount (akin to a deductible) and its policy limit. RTr. 2389:13-91:25; Exs. 6204-R at ¶ 96, 6410-RD at p. 12 (Heimert).

936. Any difference in MPROC's and a comparable companies' product liability risk can be quantified by an actuary based on the cost savings from self-insurance. RTr. 2392:1-16, 2561:17-64:15 (Heimert).

937. In 2005-2006, Medtronic estimated that it could purchase $500-$700 million in product liability insurance at a cost of $20 million-$35 million a year with a deductible or retention amount of $150 million-$200 million. This retention amount and pricing was in line with industry peers. Exs. 2272-J at 9229-30, 2271-J at 9220-21, 2301-J at 9099.

938. Calculating COPs under the CPM using the upper quartile ROA for the Implantables w/o Greatbatch and adjusting for the difference in the cost of product liability insurance based on Mr. Braithwaite's estimates of $25.2 million and $26.2 million in 2005 and 2006, respectively, results in COPs of $196.6 million and $227.3 million in 2005 and 2006, respectively. RFF ¶¶ 889, 932, 937.

$ Million	2005	2006	Formula
Comparable Operating Profit (Implantables w/o GB)	$171.4	$201.1	A
Product Liability Adjustment	$25.2	$26.2	B
Comparable Operating Profit (Implantables w/o GB + Product Liability Adjustment)	$196.6	$227.3	C = A+B

939. The table below calculates COPs under Dr. Heimert's CPM based on various alternative Comparables with and without a product liability adjustment (the grey-shaded row includes the data used for the example above) and compares them to the implied RO As using the Court's and Dr. Putnam's CUT methods. Exs. 6203-R at Tables 13, 15, 17, 23-24, 5545-R at p. 29 (Heimert), 6202-R at ¶ 140 (Cockburn), 5522-R at p. 3, Table 1 (Braithwaite), 6109-P at Exs. 2, 3, 5.a-5.b (Hubbard).

	2005			2006
CPM Methodology ($ Million Except %)	ROA	PL Adjust.	MPROC Profit	ROA	PL Adjust.	MPROC Profit
Comparables (median)	28.1%	—	$110.5	26.0%	—	$110.4
Pacesetter ('93, '94)	31.1%	—	$122.2	40.3%	—	$170.9
Comparables (UQ)	39.9%	—	$157.0	39.3%	—	$166.7
Implantables (median)	40.4%	—	$158.8	40.5%	—	$171.8
Implantables (median) + PL	40.4%	$25.2	$184.0	40.5%	$26.2	$198.0
Implant, w/o GB (median)	40.9%	—	$160.7	41.7%	—	$176.9
Implant, w/o GB (median) + PL	40.9%	$25.2	$185.9	41.7%	$26.2	$203.1
Implant, w/o GB (UQ) + PL	43.6%	$25.2	$196.6	47.4%	$26.2	$227.3
Medtronic ('05, '06)	55.3%	—	$217.3	56.4%	—	$239.2
Implied from CUT
Tax Court	151.6%	—	$595.8	218.3%	—	$926.1
Putnam (Max Royalty)	169.9%	—	$667.6	248.1%	—	$1,052.6
Putnam (Low Royalty)	221.6%	—	$871.1	318.4%	—	$1,350.7
Formula	A	B	C = A*$393.0+B	D	E	F = D*$424.2+E

3. Calculation of the MPROC Agreement's Royalties and Royalty Rates

940. To calculate the Technology Royalties and the associated royalty rates based on third-party sales, the COPs are first subtracted from MPROC's PreTechnology Royalty Operating Profits. Ex. 5544-R at pp. 14-17 (Heimert); RTr. 2653:16-54:15 (Becker).

941. For example, MPROC's Pre-Technology Royalty Operating Profits were $1,287.3 million in 2005 and $1,955.5 million in 2006. Based on the upper quartile RO As of the Implantables w/o Greatbatch and a product liability adjustment (see RFF ¶ 938), the adjusted COPs are $196.6 million in 2005 and $227.3 million in 2006. Subtracting the adjusted COPs from MPROC's Pre-Technology Royalty Operating Profits results in Technology Royalties under the MPROC Agreement of $1,090.7 million in 2005 and $1,728.2 million in 2006. RFF ¶ 835.

$ Millions	2005	2006	Formula
MPROC Pre-Tech. Royalty Operating Profits	$1,287.3	$1,955.5	A
Comparable Operating Profit (Implantables w/o GB + Product Liability Adjustment)	$196.6	$227.3	B
Technology Royalties	$1,090.7	$1,728.2	C = A-B

942. To calculate the royalty rates based on the upper quartile RO As of the Implantables w/o Greatbatch and a product liability adjustment, MPROC's Technology Royalties are divided by third-party sales of MPROC products of $2,680.1 million in 2005 and $3,543.6 million in 2006 for retail royalty rates, and MPROC's sales of $1,831.1 million and $2,698.8 million in 2006 for wholesale royalty rates. Exs 6203-R, App. 5 (Step 5), 6204-R at Tables 12-13 (Heimert). The retail royalty rates for the above illustration are 40.7% for 2005 and 48.8% for 2006. The wholesale royalty rates are 59.6% for 2005 and 64.0% in 2006. RFF ¶ 941.

$ Millions (Except %)	2005	2006	Formula
Technology Royalties	$1,090.7	$1,728.2	A
Third-Party Revenues	$2,680.1	$3,543.6	B
Technology Royalty Rate (Third-Party)	40.7%	48.8%	C = A/B
MPROC Revenues	$1,831.1	$2,698.8	D
Technology Royalty Rate (Wholesale)	59.6%	64.0%	E = A/D

943. MPROC's share of system operating profits based on the upper quartile RO As of the Implantables w/o Greatbatch and a product liability adjustment is 14.4% in 2005 and 11.6% in 2006. Ex. 6204-R at Tables 12-13 (Heimert); RFF ¶ 938.

$ Million (Except %)	2005	2006	Formula
Comparable Operating Profit (Implantables w/o GB + Product Liability Adjustment)	$196.6	$227.3	A
Medtronic System Profits for Products at Issue	$1,366.2	$1,967.6	B
MPROC's Split of System Profits	14.4%	11.6%	C = A/B

E. Realistic Alternatives for Medtronic US and MPROC

944. Basic negotiation theory says that a party will consider its next best alternative. If a licensor can do better elsewhere, that alternative will be the minimum amount it would accept. A licensee's willingness to pay will also be defined by its next best alternative. RTr. 2265:1-25 (Cockburn), 1998:10-24 (Meyer), 2374:11-75:17, 2398:19-99:9 (Heimert), 1686:25-87:19 (Hubbard); Ex. 6202-R at ¶ 155 (Cockburn).

945. It is not necessary that the realistic alternative have occurred. Rather, the analysis looks at the results of a party's controlled transaction and asks whether the costs and benefits of a realistic alternative would produce a better outcome, i.e., more profit, for that party. RTr. 2512:8-14:3, 2516:13-17:14 (Heimert).

946. None of petitioner's experts address MPROC's and Medtronic US' realistic alternatives to entering into the MPROC Agreement. Ex. 6204-R at ¶ 4; RTr. 2399:23-2400:1 (Heimert); Entire record; RTr. 1457:2-58:3, 1481:14-82:17; Exs. 6108-P, 6109-P (Hubbard).

947. A possible realistic alternative to MPROC would be to redeploy its manufacturing capacity to manufacture some other product. As MPROC did not own any patents, did not perform full product and clinical development functions, and relied on Medtronic US for its intangible assets and other business support, this alternative would have required MPROC to replace or build these assets and functions. Ex. 6204-R at ¶¶ 5-7 (Heimert); RTr. 355:24-56:9 (McCoy).

948. Medtronic's industry competitors would not have had any incentive to enter into a patent license with MPROC. These competitors were all vertically integrated and did not outsource the manufacturing of Class III medical devices. Ex. 6204-R at ¶ 6 (Heimert); RTr. 2001:16-02:5 (Meyer), 354:14-55:16 (McCoy).

949. Medtronic US had realistic alternatives to using MPROC for manufacturing. It could have manufactured in a different Medtronic facility, built new manufacturing facilities, or outsourced some of the manufacturing to unrelated parties. RTr. 2398:19-99:9, 2511:25-19:24 (Heimert), 1998:14-24 (Meyer).

1. Alternative Medtronic Facilities Available to Medtronic US

950. Medtronic US could have turned to other internal manufacturing facilities to complete the finished manufacturing of its products. RTr. 1836:2-38:13, 1998:14-99:23 (Meyer); Exs. 6206-R at ¶¶ 32-34 (Meyer), 693-J at 0564, 6289-R, 502-J at 9768, 1350-J at 8361-62, 1354-J at 8538, 1370-J at 3045.

951. Medtronic US' ADM was registered as a finished device manufacturer with the FDA and produced some finished devices. ADM was also qualified as one of Medtronic's manufacturing facilities to supply CRM devices in the United States and designated as a back-up facility for some products. Tr. 2194:24-95:25 (Samsel), 2343:22-44:23 (Davila); Exs. 3141-R, 3142-R, 502-J at 9768, 693-J at 0564, 1350-J at 8361-62, 1354-J at 8538, 1370-J at 3038, 3045-46.

952. Medtronic's Swiss Manufacturing Operations produced CRM devices and had 363 employees involved in manufacturing in 2006. Exs. 693-J at 0564, 505-J at 9818, 502-J at 9768, 6289-R at 5225-26, 20-J at 6760, 436-J at 5701.

953. The Swiss facility was an alternative to MPROC that Medtronic US could have turned to for manufacturing. It was built for disaster back-up and to provide Medtronic the flexibility to meet U.S. customer needs. RTr. 2515:1-13 (Heimert), 1998:14-99:23 (Meyer); Exs. 6204-R at ¶ 15 (Heimert), 6206-R at ¶¶ 32-33 (Meyer), 6208-R at ¶ 146 (Crosby), 6289-R at 5225-27, 20-J at 6760.

954. Medtronic US' Sullivan Lake facility provided disaster back-up capabilities for pumps, leads, extensions, implantable neurostimulators, and catheters. It was fully capable of performing all facets of production including sterilization and final packaging operations. RTr. 2514:4-15:20 (Heimert); Exs. 441-J at 5203, 443-J at 5273.

955. Medtronic actively considered moving manufacturing to tax advantaged and low-cost labor jurisdictions (e.g., Puerto Rico, Mexico, and Ireland). Exs. 419-J at 0239-40, 1670-J at 7062.

2. Medtronic US's New Manufacturing Facilities

956. Medtronic analyzed the cost and steps required to build CRM facilities in Singapore and Switzerland that performed comparable activities to MPROC. Building a plant comparable to MPROC was a realistic alternative for Medtronic US. Exs. 6204-R at ¶¶ 8-9 (Heimert), 6289-R at 5225-31.

957. Medtronic established new manufacturing facilities in Switzerland (CRM and Neuro devices) in 1997, Puerto Rico (CRM and Neuro devices) in 2004, and Singapore (CRM devices and leads) in 2011. RTr. 2400:2-24, 2514:4-15:20 (Heimert), 1836:2-38:13 (Meyer); Exs. 20-J at 6759, 6204-R at ¶¶| 8-19 (Heimert), 6206-R at ¶¶ 32-34 & n.63 (Meyer), 6208-R at ¶¶ 146, 150 & n. 170 (Crosby).

958. Medtronic US was able to transfer the major functions and associated know-how required to support manufacturing of devices at the Switzerland facility, and devices and leads at Singapore facilities. Exs. 6204-R at ¶¶ 10-13, 16 (Heimert), 6208-R at ¶ 148 (Crosby), 6289-R at 5215, 5225-27, 5248-56, 5280.

959. Both the Swiss and Singapore facilities were opened with new workforces. A new workforce could be trained and certified in a matter of months. Exs. 6208-R at ¶¶ 146, 148 (Crosby), 6204-R at ¶ 16 (Heimert), 6289-R at 5320, 5227, 5251, 5254, 5256, 5259-61, 5316-17; Medtronic I at *28.

960. Manufacturing in Switzerland began 13 months after construction commenced. It was initially estimated that the Puerto Rican plant would require 16 months to build and begin operations and that the Singapore plant would be ready in 18-24 months. Ex. 6206-R at ¶ 32, nn.63, 67 (Meyer).

961. To implement the Swiss manufacturing operations, Medtronic planned to invest $18.1 million. Medtronic actually invested $22.2 million. Exs. 6204-R at ¶ 14 & n.23 (Heimert), 6208-R at ¶ 149 (Crosby), 6289-R at 5231.

962. The proposed investment for the Singapore plant was $57.3 million. Ex. 6204-R at ¶ 16 (Heimert).

963. Total committed capital related to the new Puerto Rican device plant was $33.6 million, of which $5.6 million was for equipment and $28 million for the building. Ex. 6204-R at ¶ 17 (Heimert).

964. The new Puerto Rican device plant had similar capacity to the previous MPROC manufacturing plant. Ex. 6204-R at ¶ 18 (Heimert).

965. Medtronic US could have built a new device manufacturing facility to replace MPROC's device manufacturing in 1.5 to 2.5 years for approximately 6% ($33.6 million) of the device profits earned by MPROC in 2006 ($616.8 million). Ex. 6204-R at ¶ 18; RTr. 2400:2-01:7, 2518:2-18 (Heimert).

966. An evaluation of this realistic alternative asks whether a party would be willing to spend $33.6 million to retain a larger share of the hundreds of millions of profits earned each year by MPROC. RTr. 2400:21-01:7 (Heimert).

3. Outsourcing Alternatives Available to Medtronic US

967. Greatbatch, Oscor, Accellent, and Gore were identified as companies capable of producing leads. Ex. 5543-R at p. 104 (Heimert); RTr. 2399:12-18, 2495:1-97:19 (Heimert). Oscor made leads for Guidant. RTr. 352:11-23 (McCoy).

968. Greatbatch was a large manufacturer operating on a scale similar to Medtronic that appeared to be developing the capability to make medical devices and did make some finished products. RTr. 2499:1-5, 2519:25-20:10 (Heimert), 2960:21-2961:1 (Crosby).

ULTIMATE FINDINGS OF FACT

969. The Pacesetter Agreement fails to meet the standards for a CUT under the transfer pricing regulations. Entire record.

970. Based on tests of reasonableness, an analysis of realistic alternatives, and the reliability of the CPM comparables as compared to the reliability of the Pacesetter Agreement as a comparable, the CPM is the best method to price the intangibles licensed to MPROC. Entire record.

971. Medtronic US legally owned virtually all the intangible assets necessary to manufacture Medtronic products. Entire record.

972. The scope of intangible property transferred under the 2005 and 2006 MPROC Agreement was much broader than the bare patents licensed under the 1992 Pacesetter Agreement. Entire record.

973. The MPROC Agreement licensed rights to all copyrighted technical information necessary to make the products including computer software. Entire record.

974. The profit potential of the intangibles licensed in the Pacesetter Agreement was not similar to that of the intangibles licensed in the MPROC Agreement. Entire record.

975. The CRM products, market, and industry in 1992 were not comparable to the products, market, and industry in 2005. Entire record.

976. The Pacesetter Agreement was not entered into in the ordinary course of business. Entire record.

977. There were important differences in economic circumstances between the MPROC and Pacesetter Agreements, particularly that the Pacesetter Agreement was a cross license that settled years of litigation while the MPROC Agreement permitted MPROC to manufacture medical devices that were designed and developed by Medtronic US. Entire record.

978. There were differences in the functions performed by the parties to the Pacesetter and MPROC Agreements. Entire record.

979. Pacesetter had greater bargaining power with Medtronic than MPROCwould have had with Medtronic US. Entire record.

980. It is not possible to make reliable adjustments to address all the material differences between the Pacesetter and the MPROC Agreements. Entire record.

981. MPROC is the best choice of a tested party in applying a CPM. Entire record.

982. It is not reasonable that a company like MPROC, even with capabilities such as quality control, assistance with FDA compliance, and manufacturing skills, could make returns on assets in excess of 250%, magnitudes more than Medtronic or all other companies in the industry this magnitude. Entire record.

983. The Comparables faced similar risks as MPROC. Entire record.

984. The quality manufacturing requirements for the Comparables and MPROC are similar, including the requirements for high-scale manufacturing. Entire record.

985. MPROC had no non-routine intangibles. Entire record.

986. Product liability risk did not rest exclusively with MPROC under the intercompany agreements. Medtronic US remains liable for damages caused by its own design or other failures. Entire record.

987. MPROC does not have the financial capacity to bear more than $450 million of product liability risk. This and MPROC's lack of control over Medtronic's product liability risk makes the purported shift of the risk to MPROClack economic substance. Entire record.

POINTS RELIED UPON

Respondent's CPM is the best method to establish arm's-length royalties for the technology intangibles licensed by Medtronic US to MPROC. The regulations preclude using Pacesetter as a CUT. Pacesetter and MPROC do not license the same or comparable intangibles. Under the MPROC Agreement, MPROC was granted access to all technology intangibles in addition to patents — including designs, processes, know-how, regulatory approvals, copyrights, trade secrets, improvements, and other non-patent intangibles. Under the Pacesetter Agreement, Pacesetter was granted access only to patents, and only 6% to 8% of those patents overlapped with the patents licensed to MPROC 13 years later. The regulations do not permit petitioner to use an adjustment to circumvent these material differences in the scope of the intangible property licensed.

The regulations also preclude using the Pacesetter Agreement as a CUT because it lacks similar profit potential to the MPROC Agreement. At the time of the Pacesetter settlement in 1992, the products covered by the Pacesetter Agreement were projected to earn an operating profit margin of 29%. In 2005-06, the products covered by the MPROC Agreement had an operating profit margin of 54%. After adjustments to account for the different functions performed by MPROC and Pacesetter, there is an even greater difference in profit potential. The regulations do not permit petitioner to circumvent these material differences in profit potential through an adjustment.

The MPROC and Pacesetter Agreements were negotiated under very different circumstances. The Pacesetter Agreement was a cross license which ended a multi-year litigation war with Siemens, Pacesetter's parent, and a market competitor of Medtronic. The royalty rate was influenced by factors in addition to the value of the intangible property and was not a transaction in the ordinary course of Medtronic's business. Such differences preclude using the 7% net running royalty as even a starting point for petitioner's purported CUT method.

Petitioner acknowledges 17 differences between the Pacesetter and MPROC Agreements that might require adjustments, including scope of intangibles, economic conditions, functions, profit potential, and several contractual terms. Yet petitioner's expert Dr. Putnam proposes only five adjustments. These five adjustments — which when summed almost triple the 7% starting rate — are ad hoc, unreliable, and inconsistent with petitioner's prior trial position and the Court's opinion in Medtronic I. Dr. Putnam's build-up method seems to be programmed to reach the same royalty rate advanced by petitioner from the get-go. The Pacesetter Agreement does not meet the regulatory definition of a CUT, but even if it did, reliable comparability adjustments have not been made and therefore the Court should reject it as the best method on that basis alone.

Further, the results of petitioner's CUT method are not reasonable. The technology royalty rates advanced by petitioner on remand, as well as those determined in Medtronic I, result in MPROC receiving returns multiple times higher than those earned by other firms in the industry, by Pacesetter, and by Medtronic itself. Under petitioner's purported CUT, MPROC's profitability dwarfs that of Medtronic even though Medtronic owns the crown-jewel intangibles upon which the profitability depends.

Medtronic's ownership of the crown-jewel intangibles needed to produce and sell the medical devices at issue make this case particularly susceptible to a CPM because the CPM avoids the need to perform the impossible task of valuing these intangibles directly, and instead measures returns and the resulting royalty based on actual profits. It is undisputed that Medtronic US owns the intangibles and MPROC has only a short-term right to use them. Dr. Heimert followed the regulations in applying the CPM, and determined technology royalty rates that left MPROC with robust returns in line with other firms in the industry.

Petitioner claims that MPROC's high-quality manufacturing distinguishes it from Dr. Heimert's Comparables and that manufacturers of Class III medical devices bear greater risk than manufacturers of Class I and II devices and should earn greater returns. In response, Dr. Heimert showed that limiting his comparables to those firms producing implantable medical devices (Implantables) confirmed his CPM results but provided a basis for a slightly higher technology royalty rate. More importantly, MPROC's returns under petitioner's purported CUT still far exceed the range of CPM results for the Implantables.

Petitioner proposes a standard for CPM comparability that is impossible to meet, not consistent with the regulations, and much more stringent than it applies to its own CUT. CPM comparables do not have to be perfect and may perform functions in addition to those performed by a tested party. Dr. Heimert's Comparables are all finished-product manufacturers of medical devices, except Greatbatch, which manufactures device components. The Comparables and MPROC bore similar product liability and market risks. Unlike petitioner's CUT analysis which is based on a single (but flawed) data point, the CPM analysis uses multiple data points. All else equal, the larger data set and use of an interquartile range yields more reliable information about arm's-length outcomes.

Petitioner advances no alternative methods or sensitivity analyses that support the Pacesetter Agreement as a CUT. The reasonableness tests advanced by respondent's experts not only establish that petitioner's pricing is not arm's length, but also corroborate Dr. Heimert's analysis. Dr. Heimert's CPM results align with Medtronic US owning virtually all the intangibles and with the relative economic contributions of Medtronic US and MPROC as measured through various metrics including value added costs, R&D investment, number of employees, type of employee, and employee compensation.

Petitioner's experts suggest a bargaining scenario in which Medtronic US would willingly give up the lion's share of its profits to MPROC. But without Medtronic US there would be no Medtronic CPM and Neuro products. As the owner of the crown-jewel IP, Medtronic US is in a commanding negotiation position as it could and did build alternative manufacturing plants itself. Given MPROC's demonstrated assets and capabilities, it could be expected to make a good rate of return on its assets, but it would not expect a return that is magnitudes greater than Dr. Heimert's Comparables, the Implantables, the entire medical device industry, Medtronic, or other manufacturing sectors selling life-impacting products. Dr. Heimert's CPM results in robust returns to MPROC based on multiple observations, objective data, and corroborated by reasonableness tests and reaches a more reliable result than petitioner's repackaged CUT. The CPM is the best method in this case.

ARGUMENT

I. INTRODUCTION

The “best method rule” requires the Court to determine the arm's-length result of a controlled transaction like the MPROC Agreement using “the method that, under the facts and circumstances, provides the most reliable measure of an arm's length result.” Treas. Reg. § 1.482-1 (c)(l).⁷ There is no strict priority of methods. Medtronic II at 613; The Coca-Cola Company & Subs, v. Commissioner, 155 T.C. 145, 212-13 (2020); Treas. Reg. § 1.482-l(c)(l). When determining the “best method,” the two primary factors are (1) the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparables, and (2) the quality of the data and assumptions used. Treas. Reg. § 1.482-1(c)(2).

In applying the “best method rule,” the Court must determine the arm's-length result under one of the transfer pricing methods for intangible property set forth in the regulations, each of which must be applied in accordance with all of the provisions of section 1.482-1, and must result in an arm's-length transfer price that is commensurate with the income attributable to the intangible property.⁸ The four permissible methods are: (1) the CUT method (§ 1.482-4(c), relied on by petitioner); (2) the CPM (§ 1.482-5, relied on by respondent); (3) the “profit split method”⁹ (§ 1.482-6); and (4) “unspecified methods” (§ 1.482-4(d), alluded to by the Court). Thus, the arm's-length amount charged to MPROC for the intangibles licensed to it by Medtronic US must be determined under whichever of these methods satisfies the regulations and is the “best.” The CPM is the best method, and indeed, the only one that, based on the record, satisfies the regulations.

A. The CUT Method is Not the Best Method in this Case.

The 1992 Pacesetter Agreement is not a CUT under section 1.482-4(c)(2)(iii) because (1) it was a “naked” patent license related only to cardiac products, while the 2005-06 MPROC Agreement was a turnkey license providing a full suite of Medtronic's high value intangibles for both CRM and Neuro products; (2) the profit potential of the intangibles licensed to MPROC is not similar to that of the intangibles licensed to Pacesetter; and (3) it was not entered into in the ordinary course of business. In addition, reliable adjustments were not (and cannot be) made to account for the Pacesetter Agreement (1) being a litigation settlement; (2) including key contractual terms (such as a large upfront payment and a crosslicense) that were absent from the MPROC Agreement; and (3) requiring Pacesetter to perform far more functions than was necessary for MPROC to perform. Accordingly, the Pacesetter Agreement fails the threshold comparability test mandated by the regulations and cannot reliably be used to price the intangible property licensed to MPROC.

Petitioner's misuse of the Pacesetter Agreement as a CUT results in an allocation to MPROC of the lion's share of the profits earned from the sales of CRM and Neuro products. Under Dr. Putnam's CUT methodology, MPROC keeps50% to 74% of the overall system profits, a result that is at odds with any objective metric measuring the relative economic contributions of Medtronic US (and its subsidiary Medtronic USA) and MPROC. See Arg. III.D, infra. Petitioner's results are as extreme as the results this Court described as “economically inexplicable” in Coca-Cola, 155 T.C. at 215. Petitioner's “CUT” gives MPROC returns that are off the high end of the chart for its industry and multiples higher than Medtronic itself, as shown below. Id. at 216.

Exs. 6203-R at 104, Fig. 4,6410-RD; RTr. 2365:17-69:2 (Heimert). As in Coca-Cola, the results “prompt two obvious questions” — why is MPROC, a manufacturer with no R&D or sales and distribution functions and a short-term licensee of the crown-jewel intangibles, one of the most profitable medical device companies in the industry? And why does MPROC's profitability dwarf that of Medtronic's, who owns the crown-jewel intangibles upon which the profits depend? Coca-Cola, 155 T.C. at 216-17. Petitioner has offered nothing to answer these questions or explain its unreasonable results. As a threshold issue, the Court must confront these red flags.

B. The CPM is the Best Method to Price the Intangibles Licensed to MPROC.

The many problems with the Pacesetter Agreement cannot be overcome, and the CUT method is not the best method here, because transactions comparable to the MPROC Agreement involving the license of the full suite of Medtronic US' highly valuable intangibles, i.e., crown-jewel intangibles, do not exist. As this Court has acknowledged, however, a license like the MPROC Agreement presents an optimal scenario for the CPM. Id. at 218-19; see generally Treas. Reg. § 1.482-8, ex. 9 (where CPM is the best method).

Unlike the CUT method, the CPM does not depend on finding a comparable uncontrolled transaction. Instead, the CPM determines the arm's-length consideration for a controlled transaction “based on objective measures of profitability (profit level indicators) derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances.” Treas. Reg. § 1.482-5(a). In Coca-Cola, this Court held that the CPM was the most reliable method to price transactions involving a domestic parent who, like petitioner, owned and licensed a full suite of crown-jewel intangibles to its foreign manufacturing affiliates. Like Coca-Cola, the record here contains no uncontrolled pricing data for transactions between unrelated parties involving the licensing of the full suite of crown-jewel intangibles, namely, petitioner's U.S. patents, regulatory approvals, clinical data, technical designs, know-how, copyrights, and trade secrets. The parties agree that such comparable transactions do not exist. Given these facts, the most reliable transfer pricing method is often one like the CPM that avoids any direct valuation of those intangibles. Coca-Cola, 155 T.C. at 218 (high-value intangibles tend to defy easy valuation).

Petitioner's experts (Drs. Pindyck (in the first trial) and Hubbard) cast the CPM as an inferior method. This was a common taxpayer refrain until this Court put to bed that notion in Coca-Cola, where it reviewed the text and history of the regulations and determined that the CPM was equal in stature to other methods, and that the evaluation of the transfer pricing at issue should proceed “with no thumb on the scale in favor of or against” the CPM. Id. at 213.

By design, the CPM avoids many of the reliability and comparability concerns inherent in petitioner's purported CUT and any unspecified method based on that purported CUT. In contrast to petitioner's CUT analysis which is based on a single data point and numerous, larger adjustments, respondent's CPM analysis is based on multiple comparable data points selected from a larger data set. Ex. 6203-R at U 66 (Heimert). Petitioner's reliance on a single agreement amplifies the effect of any idiosyncrasy in that agreement rather than enabling it to be averaged out when blended with multiple other comparables as part of a CPM. RTr. 2058:16-24 (Cockburn); Ex. 6203-R at ¶ 66 (Heimert). In addition, using an interquartile range (IQR) (consistent with Treas. Reg. § 1.482-1(e)) is a simple and accepted statistical methodology that eliminates outliers. Ex. 6203-R at ¶ 66 (Heimert).

The CPM is the best method for this case. This does not mean that it is a perfect method. In this case, however, it can be reliably applied to evaluate the arm's-length nature of the royalty rates in the MPROC Agreement. As the licensee of Medtronic US, and not the owner of the valuable intangible property involved in the transaction, MPROC is the only option to use as the tested party. In addition, reliable comparables exist, reliable financial data for the comparables were reported in their Forms 10-K, financial data for MPROC was provided by Medtronic, and a reliable PLI is available to evaluate MPROC's results. RTr. 2371:21-73:8 (Heimert).

Dr. Heimert's CPM results in allocating 7% of overall system profits to MPROC. These results align with Medtronic US' ownership of all Medtronic's intangibles and with objective measures of the economic contributions of the parties. Based on tests of reasonableness, an analysis of realistic alternatives, and the reliability of the CPM comparables as compared to the reliability of the Pacesetter Agreement as a CUT, the CPM is the best method. RTr. 2406:17-23 (Heimert). In Medtronic I, this Court concluded that an allocation to MPROC of only 6% to 8% of the profits was not reasonable. Medtronic I at *118. In reconsidering the CPM, respondent respectfully requests the Court to consider that under the CPM, this share of profit leaves MPROC with a robust 26% to 28% return on its assets; that this return amounts to 7% of the system profits is the result of the extraordinary value of the crown-jewel intangibles and functional contributions of Medtronic US which have made it the industry leader.

C. An Unspecified Method Must Qualify as the “Best Method” and Provide the Most Reliable Measure of an Arm's-Length Result.

In its closing remarks, the Court expressed reservations about both petitioner's CUT and respondent's CPM and requested input about certain of its impressions and ideas for resolving the controversy. See generally RTr. 3050:20-58:21. Specifically, the Court requested input from the parties about a “catch-all” adjustment to the CUT and/or the averaging of the CPM and CUT results to arrive at what the Court described as a “fair place” using an “unspecified method” for intangible property. RTr. 3056:1-57:14. Such an unspecified method would fail as a best method on both legal and evidentiary grounds.

First, an unspecified method must be shown to provide “the most reliable measure of an arm's length result under the principles of the best method rule,” including the degree of comparability between the controlled and uncontrolled transactions, and the quality of the data and assumptions used. Treas. Reg. § 1.482-4(d). While averaging results from the CUT and the CPM or adding a “catch-all” adjustment might achieve a result the Court views as more fair, that is not the regulatory standard. Neither approach is grounded in reliable data or objective measures of profitability, and there is no evidence that either approach will produce a more reliable arm's-length result than the CPM. At some point, a purportedly comparable price ceases to be that under the weight of the required adjustments (those made and those ignored) to that price, such that the final price becomes an engineered artifice wholly lacking in reliability. See Treas. Reg. § 1.482-1(c)(2)(i). That point was reached — and exceeded here — with petitioner's purported CUT. Adjusting it further with a “finishing” adjustment that averages results from other methods or with an ad-hoc “catch-all” adjustment will make that result less reliable, and definitely not more reliable than respondent's CPM.

Second, petitioner's failure to present evidence as to realistic alternatives in support of its results also dooms the Court's averaging and “catch-all” adjustment suggestions. Treas. Reg. §§ 1.482-4(d), -1(c)(1). A bedrock principle to be considered in the evaluation of any “unspecified method” for the transfer of intangible property is the concept of realistic alternatives:

an unspecified method should take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, and only enter into a particular transaction if none of the alternatives is preferable to it. . . . Therefore, in establishing whether a controlled transaction achieved an arm's length result, an unspecified method should provide information on the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction.

Treas. Reg. § 1.482-4(d)(1).

Thus, in selecting the “best method,” an unspecified method involving the averaging of the CUT and CPM results or a “catch-all” adjustment to the CUT should be evaluated in the context of realistic alternatives to the MPROC Agreement. The only evidence of realistic alternatives in the record supports the CPM. The regulatory example provided to illustrate “unspecified methods” for intangibles compels the conclusion that given Medtronic US' realistic alternatives such as building a new plant, the results of any appropriate unspecified method would not be very different from those under the CPM.¹⁰

In contrast to using methods inconsistent with the principles of the regulations under the guise of an “unspecified method,” there are reliable and simple ways to adjust the results under a CPM to improve comparability if needed — selecting the upper quartile instead of the median, eliminating less comparable companies from the set of comparables used, and, in this case, making adjustments with respect to product liability risks. Arg. III.B.4.c.iii, infra. For example, an adjustment for product liability risk increases MPROC's arm's-length income by more than $25 million each year, a more than 20% increase in Dr. Heimert's arm's-length result. While respondent continues to maintain that Dr. Heimert's CPM is the best method and no product liability adjustment is warranted, these types of adjustments to the CPM are permitted by the regulations and would produce a more reliable result than ad hoc adjustments to petitioner's purported CUT.

II. THE PACESETTER AGREEMENT FAILS THE REGULATORY STANDARDS FOR COMPARABILITY.

The specified CUT method set forth in section 1.482-4(c) includes various comparability and reliability requirements that must be satisfied before an uncontrolled transaction such as the Pacesetter Agreement may be used as a CUT. As the proponent of the CUT method, it is petitioner's burden to establish that the requirements were met.

The Pacesetter Agreement fails to qualify as a CUT under all critical components of comparability, including intangibles licensed, profit potential, circumstances, and contractual terms. Dr. Putnam's attempt to adjust the Pacesetter Agreement to eliminate just a few of its more obvious flaws is not based on commercial transactions, statistical data, or economic principles, but on unreliable and unsupported testimony. He acknowledges at least 17 differences between the Pacesetter and MPROC Agreements. Ex. 6106-P at ¶ 7 & Table 1 (Putnam).¹¹ He opines that no adjustments are necessary for most of the differences and proposes five adjustments that increase the base royalty rate by 200%-300%. The magnitude of his adjustments — which are two to three times more important to his conclusion than the actual rate in the Pacesetter Agreement — shows the lack of comparability. Dr. Putnam's purported CUT analysis does not stand up under the rules for assessing reliability and comparability under the regulations.¹²

A. The MPROC and Pacesetter Agreements License Different Intangible Property.

The intangible property licensed in the two agreements are not comparable because: (1) vastly different intangibles, and categories of intangibles, were licensed; (2) the intangibles were used in connection with different products and different industries and markets; and (3) the intangibles did not have similar profit potential. Each reason alone justifies rejecting the Pacesetter Agreement as a CUT.

1. The Scope of the Intangible Property Licensed in the MPROC and Pacesetter Agreements is Different.

To use the specified CUT method, the intangible property licensed in an uncontrolled transaction must be the “same” or “comparable” to that in the controlled transaction. Treas. Reg. § 1.482-4(c)(2). Conceding that the intangible property licensed in the Pacesetter and MPROC Agreements are not the same, petitioner argues that the two agreements licensed comparable intangibles under comparable circumstances. Pet. Trial Memo, at pp. 33-36. This is incorrect. In the cross-license, Pacesetter received only patent rights for Medtronic US' existing 1992 CRM patents, which provided Pacesetter nothing more than the freedom to operate in the CRM space without fear of further infringement litigation. In contrast, MPROC received a turnkey technology license encompassing an expansive bundle of intangible property of which the still-unexpired 1992 CRM patents were only a small part. The MPROC Agreement licensed a different and larger set of patents plus know-how, regulatory approvals, improvements, copyrights, trade secrets, manufacturing specifications and processes, and designs, providing MPROC everything it needed to operate its business. RTr. 1753:5-55:10 (Meyer), 2048:13-49:24 (Cockburn); RFF ¶¶ 696-97.

The patents licensed had little overlap because there was a 13-year gap between the agreements. In 1992 Pacesetter licensed 342 then-existing Medtronic CRM U.S. patents and no Neuro patents. In contrast, the number of patents available to MPROC exceeded 1,600 patents by May 2004 and topped 1,800 patents in April 2006 including both CRM and Neuro patents. Only 6%-9% of the active Medtronic US patents licensed to MPROC were also licensed by Pacesetter in 1992. Ex. 6201-R at ¶ 33, Chart 1 (Cockburn). This is consistent with Mr. Spadea's opinion that the “patent families” licensed to Pacesetter in 1992 still in existence as of 2005 represented only 13% of the patent families licensed to MPROC. Ex. 6206-R at If ¶ 15 (Meyer); RTr. 1228:9-16 (Spadea). These results show minimal patent overlap in the Pacesetter and MPROC Agreements. RTr. 1810:5-18 (Meyer), 2052:22-53:24 (Cockburn); Ex. 6202-R at ¶¶ 10, 45, 47, 62-68 (Cockburn).

Ignoring the absence of patent overlap, petitioner proposes to cure the lack of comparability between the different sets of intangible property transferred in the agreements with a 1%-3% “know-how” adjustment. The description used by petitioner's expert — “know-how adjustment” — is inadequate to describe the broad category of intangibles that includes trade secrets, know-how, copyrights, product designs, and all regulatory approvals. Exs. 10-J at § 1.4, 14-J at § 1.4.

The CUT regulations do not permit an adjustment for categorical differences in intangible property, only for “differences in contractual terms, or the economic conditions in which transactions take place” that “could materially affect the amount charged.” Treas. Reg. § 1.482-4(c)(2)(iii)(A). In that case, adjustments may be made “to account for material differences in such circumstances,” subject to the general comparability provisions under section 1.482-1(d). No analogous provision permits adjustments as an antidote for the lack of comparability here. The regulations mandate that intangible property must be the “same” or “comparable” to be a CUT. Treas. Reg. § 1.482-4(c)(2)(iii)(A).

Petitioner's attempt to make adjustments to account for differences in the intangibles licensed under the Pacesetter and MPROC Agreements without offering comparables for the additional intangibles is not permitted and cannot make the full suite of intangibles and rights licensed to MPROC “comparable” to the limited CRM patents licensed to Pacesetter. While petitioner relies on patent licenses to value many different categories of non-patent intangibles, Dr. Putnam concedes that he would not use one category of intangible property to value a different category. RTr. 815:23-16:22 (Putnam). To avoid this roadblock, he categorizes all the non-patent intangibles as “know-how,” but admittedly has no transactional agreement for a know-how transfer. Ex. 6105-P at ¶¶ 35, 227-28 (Putnam); RTr. 964:16-65:5 (Putnam). Mr. Spadea and Dr. Putnam reviewed over a thousand Medtronic agreements but found none that support a know-how CUT or an adjustment. RTr. 1339:7-41:10 (Spadea); Ex. 6105-P at App. 2 (Putnam). Petitioner's know-how adjustment is unsupported.

a. Petitioner's Experts Ignore and Minimize Valuable Copyrights and Regulatory Approvals.

In the first trial, both parties agreed that Medtronic US licensed copyrights under the MPROC Agreement and trademarks and trade names under the Trademark Agreement. PFF ¶ 24, 31; RFF ¶¶ 81, 83.¹³ The Court adopted this finding. Medtronic I at *35-36. But on remand, petitioner's experts assume that copyrights are licensed under another intercompany agreement. RTr. 328:10-14 (McCoy), 518:11-19:21, 619:24-21:5 (Cohen), 981:8-83:4 (Putnam), 1470:7-13, 1471:2-22 (Hubbard). Petitioner is wrong.

The MPROC Agreement explicitly licenses copyrights associated with the products at issue. It defines intangible property as “[licensor developed inventions, secret processes, technical information, and technical expertise relating to the design of Product and all legal rights associated therewith, including without limitation, patents, trade secrets, know-how, copyrights and all Regulatory Approvals associated with Product.” Exs. 10-J, 11-J, & 14-J at § 1.4 (emphasis added). Thus, the unambiguous terms of petitioner's own license agreement with MPROC explicitly includes all “copyrights . . . associated with [the] Product.” Id.

Copyrights are valuable legally protected intangible property and are found in the software in medical devices and in petitioner's manuals and other works. RTr. 2830:9-31:8 (Crosby) (“Software is essential copyrighted material and hardware without software has no value.”), 519:13-21, 623:13-17 (Cohen); Exs. 1671-J at 7184 (“The following technologies represent core competencies of CRM . . . Information Processing & Software technology. . . .”), 6202-R at ¶ 144 (Cockburn) (“Copyrighted material . . . are sources of substantial value.”). RFF ¶ 716. Petitioner's experts do not attempt to price Medtronic US' copyrights.

The MPROC Agreement also specifically licenses Medtronic US' regulatory approvals defined as “any approval, permit, license or other authorization that is required in order to sell [Devices or Leads] in any part of the Territory in accordance with then prevailing law and regulations.” Exs. 10-J at § 1.10, 11-J at § 1.10, 14-J at § 1.10. The agreement covers FDA approvals and the underlying applications containing trade secrets, all of which are required to manufacture and sell the products at issue.¹⁴ Ex. 6208-R at ¶¶ 83-86 (Crosby). Regulatory approvals¹⁵ can literally last forever, provide a significant competitive advantage, and are valuable. RTr. 319:1-20:18, 315:9-14 (McCoy), 2843:21-44:23 (Crosby) (“[A] PMA approval is a very important barrier to entry . . .”); Exs. 6208-R at ¶¶ 85-86, 88 (Crosby), 6202-R at 144 (Cockburn) (“Regulatory approvals are immensely valuable . . .”), 1671-J at 7160 (“. . . regulatory approvals are pivotal to sustained growth.”); RFF ¶¶ 717-18.

Dr. Putnam analogizes regulatory approvals to driver's licenses and opines that regulatory approvals are not valuable assets but rather, a mere routine “function” that can be outsourced. RTr. 966:25-70:9, 974:2-11 (Putnam). But at trial, Mr. McCoy and Dr. Cohen agreed that regulatory approvals are assets and acknowledged the difference between outsourcing services and owning assets. RTr. 401:20-02:15 (McCoy), 669:8-19 (Cohen) (“[R]egulatory affairs is a business function which requires certain types of expertise to conduct. And then the regulatory approval is an asset.”). Medtronic's regulatory approvals, without which it could not legally manufacture and sell its products in the United States, are valuable intangible assets that Dr. Putnam incorrectly concludes are of little value and ignores in analyzing comparability. See G.D. Searle & Co. v. Commissioner, 88 T.C. 252, 374-75 (1987) (holding that intangibles that include “regulatory approvals” are “significantly more valuable than,” and therefore not “comparable” to, intangibles without regulatory approvals).

b. Petitioner's Experts Ignore and Minimize Trade Secrets and Other Non-Patent Intangibles.

To further diminish the value of know-how, Drs. Cohen and Putnam both assert that “know-how” has a short life, claiming products can be quickly reverse engineered, and thus, know-how is not a long-term deterrent to competitors. RTr. 798:7-14 (Putnam), 459:10-15 (Cohen); Exs. 6105-P at ¶ 240 (Putnam), 6103-P at 2359 (Cohen).

Drs. Cohen and Putnam greatly overstate a competitor's ability to reverse engineer complex medical devices such as electronic integrated circuits, software, and polymers. There is a big difference between knowing what to build versus knowing how to build it. Ex. 6208-R at ¶¶ 97-101 (Crosby). Medtronic's knowledge of how to build products — referred to by Medtronic US as “Implantology” in business plans and developed over its corporate history — is responsible for many of its significant innovations. Ex. 1671-J at 7201. And even if able to reverse engineer products, competitors would also need to develop their own designs, conduct clinical trials, and secure FDA approvals.¹⁶ Any medical device companies that relied upon reverse engineering would always be one step behind in an industry that is constantly innovating. Ex. 6202-R at 40 (Cockburn).

Petitioner's experts assume that the value of the know-how licensed by Medtronic US is offset by the value of know-how transferred by MPROC to Medtronic US. RTr. 110:15-22 (McCoy), 984:24-85:18 (Putnam), 1344:12-45:1 (Spadea); Pet. Trial Mem. at p. 74. Petitioner argues that because the MPROC Agreement requires the parties to disclose know-how to each other, MPROC only owes a royalty to the extent that the know-how Medtronic US provides is more valuable than the know-how MPROC provides. Petitioner offers no analysis to support its relative exchange theory other than the suppositions of Mr. McCoy and Dr. Cohen. RTr. 330:12-20 (McCoy) (“I don't know the relative quantities . . .”), 672:3-9 (Cohen) (“[T]here were flows in both directions. I don't think I try to quantitate it. . . . I don't even know how you would measure equal.”). The MPROC Agreement is a one-way license from Medtronic US, not a cross-license. Ex. 10-J at 4186-92. Know-How is owned by Medtronic US. See Treas. Reg. § 1.482-1(d)(3)(ii)(B) (written intercompany agreements will be respected unless the District Director uses its authority to disregard terms that lack economic substance); Coca-Cola, 155 T.C. at 246.

c. Dr. Putnam's Know-How Adjustment is Unreliable.

The regulations require a comparability analysis. Treas. Reg. §§ 1.482-1(d)(1) (“the comparability of transactions and circumstances must be evaluated considering all factors that could affect prices or profits in arm's-length dealings. . . .”), -1(d)(3) (each factor must be considered in determining the degree of comparability); see also Medtronic II at 613-15. The relative reliability of a method depends on the degree of comparability. Treas. Reg. § 1.482-1(c)(1). The regulations therefore prohibit using unadjusted industry averages themselves to establish an arm's-length rate. Treas. Reg. § 1.482-1(d)(2).

To account for the differences between the intangibles licensed under the MPROC and Pacesetter Agreements, Dr. Putnam proposes a “know-how” adjustment for non-patent intangibles but concedes that “[g]iven the absence of transactional data regarding know-how and Regulatory Approvals,” he must limit his supporting analysis to “qualitative evidence.” Ex. 6105-P at ¶¶ 35, 245 (Putnam). Dr. Putnam's qualitative evidence is nothing more than conclusory references to industry benchmarks or averages, with no consideration to the comparability factors in the regulations necessary to evaluate the arm's-length nature of petitioner's results. Dr. Putnam also relies on the opinions of other witnesses on the royalty rate of a “typical know-how license.” Id. at ¶ 243 (Putnam). But petitioner offers no comparable transaction that licenses the assets it calls “know-how” to support a price for “know-how.” Id. at ¶ 245. Dr. Putnam's know-how adjustment is also not supported by any comparability analysis and therefore violates the regulatory standard.

For example, Dr. Putnam and petitioner's other experts use the Mirowski 1973 patent license not as a comparable but as an industry benchmark to establish a 3% ceiling for his know-how adjustment. Exs. 6103-P at 2358 (Cohen), 6105-P at ¶¶ 242, 245(c) (Putnam); see also RTr. 246:20-47:5 (McCoy), 677:21-78:2, 702:25-03:6 (Cohen). There are numerous reasons why the Mirowski license is irrelevant to valuing the know-how licensed under the MPROC Agreement. Foremost, the Mirowski license was a patent license and not a license of comparable know-how or other non-patent intangibles.¹⁷ Exs. 6252-R at 4244 (Mirowski license), 6208-R at 116 (Crosby), 6206-R at ¶ 59 (Meyer); RTr. 815:23-16:22 (Putnam).

Second, there is no comparability as to “the stage of development including, where appropriate, necessary governmental approvals, authorizations, or licenses” between the Mirowski license and the know-how licensed to MPROC. Treas. Reg. § 1.482-4(c)(2)(iii)(B)(2)(ii). While Mirowski's ICD inventions were eventually successful, their potential for success was unproven in 1973 when the patents were licensed. Exs. 6208-R at ¶ 116 (Crosby), 6202 at ¶ 95 (Cockburn); RFF ¶¶ 805, 808. Indeed, Medtronic itself did not recognize their worth: It transferred the patents to Mirowski for a mere $1 just months before the Mirowski license with Medrad was executed. Ex. 6254-R at 4562-63.

Third, the Mirowski license also included “collateral transactions or ongoing business relationships between the transferee and transferor” that were not present in the MPROC Agreement. Treas. Reg. § 1.482-4(c)(2)(iii)(B)(2)(vii). When Dr. Mirowski licensed his patents to Medrad in 1973, he received, in addition to a running royalty, compensation in the form of equity in the corporate licensee. He received additional equity in Medrad during the term of the Mirowski license. The Mirowski royalty rate would have to be increased to account for that additional consideration but its value is unknown. Exs. 6252-R at 4248, 6208-R at ¶ 109 (Crosby); RTr. 676:14-677:9 (Cohen); RFF ¶ 806. Finally, Mirowski was an individual negotiating with a firm, a fact that impacted the parties' bargaining position in that agreement relative to the parties in the MPROC Agreement. In Medtronic I, Dr. Berneman, petitioner's expert, rejected the Mirowski license as a CUT on this ground alone. Ex. 5496-P at n.30.¹⁸

2. The 1992 Products, Markets, and Industries were Unrecognizable by 2005.

To establish comparability of intangible property under the Pacesetter and MPROC Agreements, petitioner must establish that the intangible property is used in connection with similar products or processes within the same general industry or market. Treas. Reg. § 1.482-4(c)(2)(iii)(B)(1)(i). Petitioner has not met this burden. Dr. Putnam fails to mention this regulation, relies on contractual category descriptions and not an analysis of actual products to conclude that there is product similarity, and offers nothing to establish industry and market “sameness,” except to say both Pacesetter and MPROC competed in CRM. Ex. 6105-P at ¶¶ 89, 91 & n.71 (Putnam). The regulations require more. See Treas. Reg. § 1.482-4(c)(4), ex. 4. Petitioner's own industry experts offer nothing that supports product similarity.¹⁹

a. 1992 CRM Products are Different from the 2005 CRM and Neuro Products.

Even a superficial comparison of the products used with the intangibles covered by the Pacesetter and MPROC Agreements shows that the products are not similar, and, accordingly, that the Pacesetter Agreement is not a CUT under section 1.482-4(c)(2)(iii). The products Pacesetter used with the intangibles it licensed were 1992 CRM products, and did not include Neuro products at all. More than 80% of Medtronic's growth between 1996 and 2006 was attributable to new product introductions and expansion of therapies for new patient groups. Two-thirds of Medtronic's annual revenues were generated from products or therapies introduced within the past two years with product cycle times of 18 to 24 months. Such success with new product development has driven Medtronic's growth since the company's early years and is attributed to innovation. Exs. 1671-J at 7158, 7171, 6208-R at ¶ 118 (Crosby); RFF ¶¶ 723-26.

It is not enough to look at the general categories of products to show comparability. RTr. 2004:20-05:11 (Meyer). Products within these groups have changed dramatically from 1992 to 2006:

CRTs: Cardiac resynchronization therapy (CRT), a method of pacing both the left and right side of the heart to treat heart failure, did not exist in 1992. When Medtronic's CRT-D device was approved in 2002, it was a completely new product category, serving a completely new patient population, and significantly expanded the market for CRM devices. Ex. 6208-R at ¶ 46 (Crosby). The introduction of CRT devices represented a fundamental shift for treatment of heart failure. Tr. 4341:4-10 (Lee); Exs. 6208-R at ¶ 26, 46 (Crosby), 1671-J at 7241 (“Acceptance of CRT therapy has been dramatic. . . .”).

Pacemakers: Pacemakers available in 2005 and 2006 were not the same products as those available in 1992. By 2005-06, pacemakers changed their engineering foundation, the type of electronics used, and clinical indications and became software-based. RTr. 3014:2-15:3 (Crosby); Ex. 2944-P at 0049.

ICDs: ICDs changed dramatically from 1992 to 2005. Incremental innovation in capacitors during the 1990s helped shrink the size of ICDs. Combined with the introduction of endocardial defibrillation leads, this enabled the change from abdominal implant (in the belly) to pectoral implant (just under the collarbone in the chest). Implantation changed from a complex and risky surgical procedure performed by a surgeon in an operating room to a simple and lower risk procedure performed by an electrophysiologist in a cardiac catheter lab. Exs. 6208-R at ¶ 40 (Crosby), 417-J at 6927-28, 2944-P at 0070-71; RTr. 3015:4-17 (Crosby).

Leads: Medtronic in 2000 introduced a pacing lead that became the most prescribed lead in the history of pacing, combining active fixation (reducing the risk of lead dislodgement), steroid elution (for stable pacing thresholds), small diameter (for easier placement), and silicone insulation (for ease of installation). Ex. 6208-R at ¶ 46 (Crosby).

Neuro Devices and Leads: The Pacesetter Agreement was only for CRM devices while the MPROC Agreement was for CRM and Neuro. Neuro products and applications changed dramatically from 1992 to 2005. RTr. 3015:18-16:10 (Crosby); Exs. 1669-J at 7034-35, 1671-J at 7248-49, 2331-J at 4872, 6208-R at ¶¶ 48-50 (Crosby).

Many 1992 products were obsolete by 2005. The dramatic difference in CRM and Neuro products manufactured by MPROC in 2005 as compared to CRM products manufactured by Pacesetter in 1992 prevents the intangibles in the Pacesetter and MPROC Agreements from being considered comparable. RTr. 2855:11-19, 3014:2-16:10 (Crosby). The 1992 products bore little similarity to the products 13 to 14 years later in these continually evolving industries and markets.

b. The CRM and Neuro Markets and Industries Changed between 1992 and 2005.

The products covered by the Pacesetter and MPROC Agreements are not being used within the same “general industry or market.” The CRM market and industry underwent such sweeping change between 1992 and 2005 — it even changed its name — that the two would be barely recognizable to observers, and the significant differences prevent the Pacesetter Agreement from being a CUT under section 1.482-4(c)(2)(iii)(B)(1)(i). Dr. Cohen uses a newer term “CRHF” to account for heart failure therapies that only began to be treated by Medtronic and industry devices in the early 2000s. CRM revenues grew from $1,969 million in 1992 to $9,310 million in 2006 or by 372%. This significant difference in market revenues was fueled by steady growth in the pacemaker market, rapid growth in the ICD market, and the new CRT-D market. For example, in the early 1990s, revenue in the CRM market relied almost exclusively on revenue from pacemakers. By 2005 and 2006, however, ICDs and CRT devices were the dominant source of revenue in the market. RFF ¶ 745; Exs. 29-J at 1238-39, 31-J at 1390, 6208-R at ¶ 27 (Crosby), 6101-P at 2294 (McCoy), 2960-P at 1876, 6385-R at Tab “CRHF Market”; RTr. 523:9-17 (Cohen). The Neuro market grew even faster, with revenues increasing from $77 million in 1991 to $777 million by 2005. Exs. 423-R at 0259, 416-J at 0112.

Further, data from post-1992 clinical trials significantly changed the markets by increasing the indications for ICDs and opening market opportunities that included treating patients with congestive heart failure and atrial fibrillation. RTr. 524:4-9 (Cohen); Exs. 92-J at 8979, 416-J at 0085, 3043-P at 3678, 6208-R at ¶¶ 44-46 (Crosby). Clinical trials expanded the patient population by hundreds of thousands of patients. Exs. 3043-P at 3679-80, 2944-P at 0074-76, 6208-R at ¶¶ 44-46 (Crosby). The newer CRT-D devices were sold to customers for almost 50% more than conventional ICDs and expanded the market size through greater revenues. Ex. 3043-P at 3679.

Consolidation of the industry through mergers and acquisitions created additional market changes from 1992 to 2005. Exs. 416-J at 0070, 488-J at 9284. In 1992, the top five CRM companies held approximately 95% of the worldwide sales revenue market share; by 2005, 95% of the worldwide sales revenue market share had concentrated to three companies. RFF ¶¶ 746-47. The 1992 and 2005 CRM and Neuro markets were dramatically different in terms of revenues, patient population, product mix and market structure.

To circumvent the regulations' focus on similar products, markets, and intangible property, Dr. Putnam relies on what he terms “patent law jurisprudence” to establish technological and economic comparability. He concludes that the Pacesetter and MPROC “agreements address substantially the same patents, markets, and products, with substantially similar terms.” Ex. 6105-P at ¶ 94 (Putnam). Dr. Putnam admits that he lacks expertise in the medical device industry or its technology to support this claim and relies on other experts and a strained interpretation of the terms of the Pacesetter Agreement to support his claim of comparability. RTr. 747:19-48:2 (Putnam); Ex. 6105-P at ¶¶ 78-94 (Putnam). He relies on Dr. Cohen's conclusion that there has not been a “paradigm shift” in technology between 1992 and 2005. Ex. 6105-P at ¶ 78 (Putnam).

Dr. Cohen concludes that the absence of a paradigm shift supports treating the Pacesetter Agreement as a CUT, even though it was executed 13 years before the MPROC Agreement. But the dramatic growth in the CRM and Neuro markets, new patient populations, and the significant differences in the products between 1992 and 2005 must be considered in determining whether the products, markets, and industry were similar, and ultimately whether the Pacesetter Agreement is a CUT. See Treas. Reg. § 1.482-4(c)(2)(iii)(B)(1)(i). Dr. Cohen's paradigm shift theory avoids the intentionally rigorous regulatory standards in favor of a standard that compels a conclusion that the intangibles in the uncontrolled agreement are comparable to the intangibles in the controlled agreement.

In any event, Dr. Cohen's opinion that CRM technology had not undergone a “paradigm shift” is undermined by the opinions of others in the medical device industry (RTr. 534:8-14, 687:11-17 (Cohen)), including Medtronic itself and petitioner's other experts — they describe the changes in the industry between 1992 and 2005 as revolutionary.

• When asked if CRT would be what he would call a “revolutionary” type of innovation, petitioner's expert at the first trial, Mr. Lee, responded “Absolutely.” Tr. 4341:4-10 (Lee).

• The New England Journal of Medicine proclaimed that 50 years after the introduction of pacing, the CRM field is undergoing “a tremendous revolution.”²⁰

• In Medtronic's 2005-2010 Strategic Plan, Medtronic states “that its CRM strategy incorporates an important paradigm shift.” Ex. 416-J at 0083.

• Medtronic's 2004-2009 Strategic Plan notes that most of the technology Medtronic used today was hardly in existence 20 years before. Ex. 1671-J at 7201.

• Medtronic Strategic Plans state that there was revolutionary change underway in neuroscience and tout Medtronic as in the forefront of this revolution with an innovative pipeline of products and therapies that targeted some of the most debilitating diseases. Exs. 1669-J at 7035, 2331-J at 4872, 1671-J at 7248-49.

To further support his opinion of “technological comparability,” Dr. Putnam, as instructed by petitioner's counsel, assumes that Medtronic permitted the assignment of the future patents provision to St. Jude in 1994. Because he observes no evidence of a key patent designation, he reached a conclusion that no significant patents were developed by Medtronic in 1992 through 2005. There is no support for his assumption that the future patent provision did not terminate and the contract directly provides that the future patents provision terminates upon a change in control.

Terms in both the Pacesetter Settlement and License Agreements specifically provide that the future patent provision of the Pacesetter Agreement terminates upon the transfer of the business. See Exs. 2504-J at § 9.d, 2505-J at § 12.B(d). Petitioner presented no corroborating evidence that the future patent provision continued after the St. Jude acquisition — there is no evidence that Medtronic conducted an annual review of future patents or key patents. RTr. 857:19-58:5 (Putnam). Petitioner never produced an assignment agreement or consent allowing for the continuation of the future patent provisions. RTr. 1071:11-74:2 (Putnam) (“I have never heard of [the Assignment Agreement].”). Given Medtronic's concerns about granting its future patents to an unknown competitor if the Pacesetter business were sold, it is not surprising that the future patent provision terminated when that scenario played out. Ex. 2526-J at 4427-28. Medtronic's inability to locate or produce an important corporate document supports the inference that no consent to the continuation of the future patent provision was ever executed. See Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158 (1946), aff'd, 162 F.2d 513 (10th Cir. 1947) (negative inference appropriate where party fails to present evidence).

Dr. Putnam further bases his opinion on “technological comparability” on the overlap in the time-periods of the Pacesetter and MPROC Agreements. This is a red herring. The timing of the negotiations must be comparable; whether the term of the earlier agreement extends into the term of the later agreement is largely irrelevant. Ex. 6202-R at ¶ 47 (Cockburn). Prices are informed by what is known at the time of the negotiations. The MPROC Agreement was executed 13 years after the Pacesetter Agreement. All the differences in the relevant product markets and technologies that materialized in the intervening years would impact the negotiations and hamper comparability. Ex. 6202-R at  ¶ 47 (Cockburn). During the intervening period, the patents changed, profit margins were very different, the market expanded, and the products revolutionized.

3. Differences in Profit Potential Preclude the Use of the Pacesetter Agreement as a CUT.

To establish that the intangible property in a controlled transaction and uncontrolled transaction are comparable, the profit potential in both transactions must be similar. Treas. Reg. § 1.482-4(c)(2)(iii)(B)(1)(ii). There is no regulatory or other exception to this mandatory requirement. Adjustments are not permitted to account for the differences. See Treas. Reg. § 1.482-4(c)(4), ex. 2 (rejecting transaction as a CUT where the profit potential is not similar to the controlled transaction due to higher demand for the drug); Treas. Reg. § 1.482-4(c)(4), ex. 4 (rejecting transaction as a CUT where projected and actual profits of drugs were not similar, despite other indicia of comparability)²¹; see also Amazon.com, Inc. v. Commissioner, 148 T.C. 108, 190 (2017), aff'd on other grounds, 934 F.3d 976 (9th Cir. 2019) (rejecting a comparable because the products covered by that trademark license were high-margin items whereas the controlled party was not a high-margin retailer). The CUT regulations only sanction adjustments for differences in contractual terms and economic conditions. See Treas. Reg. § 1.482-4(c)(2)(iii)(A).

Petitioner and its experts ignore the regulatory mandate. The failure of proof on this point alone is sufficient grounds to reject the Pacesetter Agreement as a CUT. Moreover, respondent's experts all showed that there was a difference in profit potential of the intangibles under the agreements.

a. The Profit Potential of the MPROC and Pacesetter Agreements is Not Similar.

Respondent's experts evaluated whether the profit potential of the intangibles licensed under the MPROC and Pacesetter Agreements was similar. Dr. Heimert concluded that the profit potential of the products was materially different because MPROC's and Pacesetter's product profit margins were markedly different at 54% and 29%, respectively — MPROC's products were nearly twice as profitable. RFF ¶ 754. Dr. Heimert also considered the discrepancy between Pacesetter's projected operating profits from FYE 1993 to 1995, ranging from $68 million to $105 million, and the actual profits from the products at issue of $1.37 billion and $1.97 billion for 2005 and 2006, respectively. Similarly, projected revenues for 1993 to 1995 for Pacesetter products were $233 million to $361 million versus Medtronic products of $2.68 billion and $3.54 billion for the products at issue in 2005 and 2006, respectively. Treas. Reg. § 1.482-4(c)(4), ex. 4; Ex. 6203-R at ¶¶ 13-14 (Heimert); RFF  ¶¶ 755-56. The sheer magnitude of the revenue and profit variation establishes materially different profit potentials.

Respondent's expert Dr. Cockburn examines numerous factors that play a role in determining the profit potential of intangible property, including the much higher revenues, operating profits, and market share for Medtronic's products in 2005 and 2006 compared to Pacesetter's products around 1992. He also concludes that the profit potential of the two sets of intangibles was not similar. Ex. 6201-R at ¶¶ 38-42, Table 2 (Cockburn).

Dr. Becker measures the profit potential of the intangibles licensed to MPROC. After adjustments to account for the different functions performed by MPROC and Pacesetter, he shows that the products licensed under the MPROC Agreement would have operating profit margins of 63.6% in 2005 — resulting in a difference in profit potential between the two agreements of 34.6%. RTr. 2608:13-09:11; Ex. 6207-R at 6283-85, Table 3 (Becker). The products licensed under the MPROC Agreement were more than twice as profitable as those licensed under the Pacesetter Agreement. Ex. 6207-R at 6283-85 (Becker).

The large difference in profitability demonstrated by respondent's experts (and not reliably attributed to other factors by petitioner's experts) precludes using the Pacesetter Agreement as a CUT. Treas. Reg. § 1.482-4(c)(2)(iii)(B)(1)(ii).

b. Petitioner's Experts Ignore the Regulatory Mandate.

In the first trial, petitioner's expert, Dr. Berneman, acknowledged profit potential as a factor to be considered under the regulations, and in conclusory fashion opined that the profit potential of the intangibles licensed in the Pacesetter Agreement (and other alleged CUTs) was similar to that in the MPROC Agreement. Ex. 5496-P at 23, 27 (Berneman). The Court found Dr. Berneman's conclusion was flawed because “Berneman's analysis unacceptably lacks an examination of the profit potential of his comparable transactions, including the Pacesetter agreement as defined by regulations.” Medtronic I at *129, 135.²²

On remand, petitioner argues that that “there was no need to make a profitability adjustment to address any differences in the underlying CRM patents.” Pet. Trial Memo. at p. 69; RTr. 1448:21-49:1 (Hubbard). Petitioner's lead CUT expert Dr. Putnam disregards the profit potential requirement altogether. While he was assigned the task of determining an arm's-length rate using Pacesetter as a CUT and his report is replete with citations to the transfer pricing regulations, he never cites the -4 regulations, which mandate similar profit potential, nor did he consider them in writing his opening report.²³ RTr. 749:9-14, 922:1-7 (Putnam). This was not a mere oversight; it was based on the instruction of counsel. RTr. 922:8-23:22, 926:15-27:5 (Putnam).

Petitioner bears the burden of establishing comparability by showing that the intangibles licensed in both the uncontrolled and controlled transactions had similar profit potential. Petitioner fails to offer any direct evidence that the intangibles had similar profit potential. See Treas. Reg. § 1.482-4(c)(2)(iii)(B)(1)(ii) (The profit potential of an intangible is “most reliably measured by directly calculating the net present value of the benefits to be realized (based on prospective profits to be realized or costs to be saved) through the use or subsequent transfer of the intangible. . . .”).²⁴ The regulation recognizes that differences in market size impact profit, and, thus, the amount of royalties a licensee would be willing to pay.²⁵ In example 2 of the regulation, the difference in the size of the market based on disease incidence results in the rejection of the CUT. Treas. Reg. § 1.482-4(c)(4), ex. 2. The same conclusion holds in this case as the number of patients in the CRM market differed by hundreds of thousands between 1992 and 2005 due to successful clinical trials which expanded the available therapies and patient populations. RTr. 218:1-19:16 (McCoy), 531:17-33:22 (Cohen) (“[T]hese studies over time increased the indicated population for ICD therapy.”). RFF ¶¶ 750-51.

Petitioner also relies on the opinions of Mr. McCoy and Dr. Cohen to argue that Medtronic's CRM patent portfolio was not the cause of higher profitability in 2004. Pet. Trial Memo, at pp. 68-69. But, its primary expert, Dr. Putnam readily concedes he cannot identify the reason for the difference in profitability between the Pacesetter and MPROC Agreements. Ex. 6105-P at ¶ 272 (“I have been unable to identify the source of the difference in profitability.”); RTr. 904:18-905:14, 931:18-23 (Putnam). In fact, neither Mr. McCoy nor Dr. Cohen considered the relative profitability of the products at issue or the Pacesetter products in formulating their opinions. RTr. 705:3-22, 564:3-5 (Cohen), 232:16-20 (McCoy).

Petitioner also asserts there is no need for a profitability adjustment because the 5.3% trademark royalty (8% based on MPROC revenues) compensates Medtronic US. Pet. Trial Memo, at p. 69. Petitioner provides no support for this claim and does not explain how a 5.3% trademark royalty could cover a profit margin difference of 25% to 35%. The Court in Medtronic I considered the profit potential issue independent from the trademark. Medtronic I at *129.

There can be no real dispute that the profit potential between the Medtronic and Pacesetter Agreements is not similar. RTr. 2610:7-17 (Becker). Petitioner proposes an error-ridden adjustment to account for the difference, contrary to the requirements of the regulations.

c. Dr. Putnam's Proportional Economic Condition Analysis is Inconsistent with the Regulations and Riddled with Errors.

Dr. Putnam tries to adjust for differences in profitability in section X of his report. He does so under the rubric of an adjustment for economic conditions, citing the section 1.482-1(d)(3) comparability standards, thereby attempting to circumvent the requirement that the profit potential of the intangibles in the controlled and uncontrolled transactions must be similar.

Dr. Putnam concedes that he “lacks an algorithm, proportional or otherwise, for reliably adjusting royalty rates between [firms].” Ex. 6105-P at ¶ 271; RTr. 908:4-17 (Putnam). He also admits that he lacks the data to apportion the difference to specific types of intangible property. RTr. 906:4-08:3 (Putnam). Despite these obstacles, Dr. Putnam proposes “a proportional adjustment to the royalty rate” of between 0.9% and 4.9% based on the relative difference in Pacesetter's and Medtronic's gross margins and EBIDTA margins multiplied by the 7% running royalty rate.²⁶ Ex. 6105-P at ¶ 42 (Putnam). His rule of thumb method has not been adopted by other courts or in economic literature. Ex. 6105-P at ¶ 269 (Putnam), cf. Uniloc, USA, Inc. v. Microsoft Corp., 632 F.3d 1292, 1315 (Fed. Cir. 2011) (rejecting the 25% rule of thumb, i.e., the assumption that any license of a patented product should be 25% of profits, as “fundamentally flawed”). Dr. Putnam's sole ground for his proportional approach was a flawed relative profitability calculation. RTr. 792:22-95:1 (Putnam). Even without addressing all the methodological and application issues, Dr. Putnam's method must be rejected as ungrounded. See Gen. Elec. Co. v. Joiner, 522 U.S. 136, 146 (1997) (rejecting expert opinion supported only by the expert's ipse dixet).

Dr. Putnam never opines that the intangibles' profit potential is similar — and for good reason. His own analysis leads to the opposite conclusion. He proposed an upper adjustment of 4.9% to the 7% Pacesetter running royalty rate, based on an 18 percentage point difference in EBITDA margins (which itself is not accurate²⁷). An 18 percentage point difference in margins is not similar under any possible definition of the word. Even if adjustments were permitted for profit potential, one that increases the royalty rate by 70% is highly suspect under section 1.482-1(c)(2)(i) principle that the greater “the number, magnitude, and reliability” of adjustments, the less reliable the results. (Emphasis added).

Dr. Putnam also argues that the 15% future patent provision of the Pacesetter Agreement is a cross-check for his adjustment and that the aggregate adjustment for differences in the Agreements could not exceed 8% (the difference between what Pacesetter was paying and the maximum rate). To support this “maximum rate” analysis, he contends he does not need to include a profitability adjustment because it was built-in to the 15%. However, Dr. Putnam admits that the 15% cap rate does not cover intangible property other than patents (RTr. 933:5-35:11). But his conclusion assumes that the difference in profitability is attributable solely to patents despite his admission that he does not know the source of the profits to make such a determination. See Arg. II.A.3.b., supra. Dr. Putnam's conclusion is based on unwarranted assumptions.

Finally, as with the 7% royalty rate, neither Dr. Putnam nor any other of petitioner's experts show that the 15% cap accounts for the significant difference in profit potential between the Pacesetter and MPROC Agreements. Both the 7% base and 15% maximum royalty rates would be dependent on the profit potential of the intangibles at the time the agreements were signed. But profit potential of the intangibles dramatically changed over the 13 years between the agreements from 1992 to 2005/2006. Exs. 6202-R at ¶ 110 (Cockburn), 6204-R at 62 (Heimert). That difference in profit potential disqualifies the Pacesetter Agreement as a CUT.

B. As a Litigation Settlement, the Pacesetter Agreement was Not Transacted in the Ordinary Course of Business.

Section 1.482-1(d) of the regulations provides general comparability standards applicable to all transfer pricing methods. The regulations provide that transactions “not made in the ordinary course of business” will “ordinarily not [be] accepted as comparables” and “ordinarily will not constitute reliable measures of an arm's length result.” Treas. Reg. § 1.482-1(d)(4)(iii)(A)(1). This provision of the regulations acts to generally exclude a transaction even if it meets the other comparability standards. Id. As an example, the regulations exclude a bankruptcy liquidation sale as a comparable transaction because it was not a sale in the ordinary course of business. Treas. Reg. § 1.482-1(d)(4)(iii)(B), ex.1.

The Pacesetter Agreement was negotiated to settle nine lawsuits, spanning various jurisdictions including the federal district courts in Illinois, Minnesota, and California as well as Federal Circuit Court of Appeals. The agreement resulted in a dismissal of all cases with prejudice. RTr. 1748:4-9 (Meyer), 2054:3-15; 2075:17-22 (Cockburn); Ex. 2505-J at Recitals A-C. These lawsuits involved a variety of issues, ranging from patent infringement to antitrust claims, as well as separate lawsuits regarding allegations of employee poaching, unfair competition, and misappropriation of trade secrets. RTr. 1749:16-18 (Meyer); Exs. 2534-J at 3879, 2525-J at 4421, 6201-R at ¶ 45 (Cockburn), 6205-R at ¶¶ 19-20 (Meyer).

The Pacesetter Agreement was the end result of all this litigation. Ex. 6201-R at ¶ 45 (Cockburn); Medtronic I at *57. It was not a transaction Medtronic made in the ordinary course of its business. Ordinarily, Medtronic did not look for opportunities to license out its patents. Tr. 3852:14-18 (Ellwein). Nor was the agreement prompted by Medtronic US' desire to do business with Pacesetter. Rather, Medtronic only licensed its patents as a way to “buy peace” in patent disputes. Tr. 3852:19-23 (Ellwein).

As with a liquidation sale in bankruptcy, the royalty rate in the Pacesetter Agreement was not set as a result of negotiations conducted in the ordinary course of business. A license entered in the ordinary course of business reflects only the value of the property licensed, and not the distractions of litigation. RTr. 1752:2-7, 1959:11-60:4 (Meyer); Ex. 6206-R at ¶¶ 11-12, 20, 25 (Meyer). As highlighted by the Board documents and Mr. Ellwein's testimony, the royalty rate negotiated in the Pacesetter Agreement reflected not only the value of the licensed patents, but also the value of buying peace between two competitors engaged in a state of litigation war that the chief negotiator for Medtronic described as “crippling.” Exs. 2525-J at 4420, 4423-24, 6238-R at 0046-47; Tr. 3855:16-24, 3858:9-19 (Ellwein).

Petitioner asserts that patent litigation occurs frequently and therefore the Pacesetter Agreement was within the ordinary course of its business. But litigation is frequent for all large corporations just like many companies file for bankruptcy. The regulations ordinarily exclude non-ordinary course transactions like the Pacesetter Agreement because the price may deviate from the price of an uncontrolled transaction under circumstances similar to the controlled transaction. In patent infringement cases, courts have generally rejected settlement agreements as comparables for this reason. See, e.g., Panduit Corp, v. Stahlin Bros. Fibre Works, Inc., 575 F.2d 1152, 1164 n. 11 (6th Cir.1978) (“[l]icense fees negotiated in the face of a threat of high litigation costs 'may be strongly influenced by a desire to avoid full litigation'”); In re Mahurkar Double Lumen Hemodialysis Catheter Patent Litig., 831 F. Supp. 1354, 1379 (N.D. Ill. 1993) (“The terms of a settlement reflect [litigation] costs as well as the parties' estimates about the probable outcome on the merits if the case proceeds. It is risky to use the parties' predictions as a reason to decide some other case on the merits.”); Wang Labs., Inc. v. Mitsubishi Elecs. Am., Inc., 860 F. Supp. 1448, 1452 (C.D. Cal. 1993) (“It is a century-old rule that royalties paid to avoid litigation are not a reliable indicator of the value of a patent, and they should therefore be disregarded when determining reasonable royalty rates.”); RTr. 1751:23-53:4, 1959:1-60:17; Exs. 6205-R at ¶¶ 10-14, 47-49, 6206-R at ¶¶ 20-22 (Meyer).

In its own patent litigation, Medtronic has successfully argued that settlement agreements are not appropriate comparables. Atlas IP, LLC v, Medtronic, 2014 WL 5741870 at *6 (S.D. Fla. 2014) (Atlas' expert “employs royalty rates involving Medtronic products derived as the result of threatened litigation, not the result of a hypothetical arm's-length negotiation. . . . Such rates do not provide proper evidence of comparable royalty rates in the marketplace.”). Further, in its transfer pricing documentation for the years at issue, Medtronic concluded that agreements that were the result of litigation or the threat of litigation were not comparable. Ex. 2827-P at 4633. The same conclusion applies here.

C. The Pacesetter and MPROC Agreements' Circumstances and Contract Terms were Different and Not Comparable Under the Regulations.

The Pacesetter Agreement fails to meet the comparability standards required for a CUT under section 1.482-4(c)(2)(iii)(B)(2).

1. The Pacesetter Agreement Ended Multiple Lawsuits.

Because the Pacesetter Agreement was part of a settlement agreement, the circumstances surrounding the Pacesetter and MPROC Agreements are too different to render the Pacesetter Agreement a CUT. See Treas. Reg. § 1.482-4(c)(2)(iii)(B)(2); see Amazon.com, 148 T.C. at 189 (rejecting a license executed as part of a litigation settlement as a CUT), aff'd on other grounds, 934 F.3d 976 (9th Cir. 2019); Podd v. Commissioner, T.C. Memo. 1998-231, 1998 WL 345513 at *15 (1998) (holding that “[l]icense fees negotiated in settlement of litigation” did not occur under “the same or similar circumstances” and therefore was not a comparable transaction); cf. Rude v. Westcott, 130 U.S. 152, 164 (1889) (“It is clear that a payment of any sum in settlement of a claim for an alleged infringement cannot be taken as a standard to measure the value of the improvements patented [because] [m]any considerations other than the value of the improvements patented may induce the payment in such cases.”). Given the stricter comparability requirements for the CUT method that apply in this case, as compared to the pre-1994 regulations applied in Podd, the Tax Court should reach the same conclusion here.

While settling with a license was financially attractive to Medtronic, petitioner's experts fail to analyze the impact of the litigation on the parties in agreeing to the Pacesetter Agreement royalty rates. RFF ¶¶ 767. Petitioner simply claims the impact to be symmetric with no support. RTr. 1008:11-09:8 (Putnam), 1258:23-59:8 (Spadea). The effect of these pressures on Siemens is unknown and not evaluated by the experts. Thus, the 7% royalty rate and other payment terms of the Pacesetter Agreement — including the 15% royalty cap on future patents — reflect not only the value of the licensed intangible property but also the substantial litigation risk, uncertainty, and costs faced by both parties.²⁸ RTr. 1749:14-51:22, 1971:7-15 (Meyer); Exs. 2525-J at 4423-25, 6205-R at ¶¶ 19-20 (Meyer). Those payment terms, therefore, cannot reliably represent the arm's-length value of the intangibles licensed in the agreement. Exs. 6201-R at ¶ 47 (Cockburn), 6205-R at ¶¶ 17-18 (Meyer); RFF ¶768.

2. The Relationship between the Parties to the MPROC and Pacesetter Agreements was Different.

In determining the best method, the regulations require consideration of the differences in circumstances — including in the “ongoing business relationships between the transferee and the transferor.” Treas. Reg. § 1.482-4(c)(2)(iii)(B)(2)(vii). Differences in the relationship between the parties to the controlled and uncontrolled transaction is also relevant to an evaluation of the parties' alternatives under sections 1.482-1(d)(3)(iv)(H) and -1(f)(2)(ii)(A).

The relationship between Pacesetter and Medtronic US was far different from that of MPROC and Medtronic US. Pacesetter and Medtronic US were horizontal product market competitors, whereas MPROC and Medtronic US were in a vertical supplier-purchaser relationship. Exs. 6201-R at 59 (Cockburn), 6204-R at ¶¶ 26-28 (Heimert), 6106-P at ¶¶ 31-32 (Putnam); RFF ¶¶ 759-60. In Medtronic I, the Court adjusted the Pacesetter royalty rate to address the difference in cooperation. Medtronic I at *127, 135.

Petitioner claims that section 1.482-4(c) does not require a comparison of the relationship between the controlled and uncontrolled parties in determining comparability. Ex. 6106-P at ¶ 33 (Putnam); Pet. Trial Memo, at pp. 82-83. But section 1.482-4(c)(2)(iii)(B)(2)(vii) provides differently. Pacesetter and Medtronic were cross-licensees but did not otherwise engage in any business relationship. Unlike Pacesetter, MPROC did not have the capability of becoming an industry competitor without the rights granted by the MPROC License. Exs. 6204-R at 26 (Heimert), 6202-R at ¶ 27 (Cockburn). The regulations look to the results uncontrolled parties would realize in the same transaction under the same circumstances. Treas. Reg. § 1.482-1(b)(1). The circumstances of the controlled transaction in this case are different from those of the horizontal Pacesetter transaction — they impact the bargaining power of the parties and the resulting price and are relevant inquiries under section 482. RFF ¶¶ 760, 769-75.

3. Pacesetter and MPROC Performed Different Functions.

“[P]articularly relevant” under the CUT method is whether the “functions” performed by the licensors and licensees in the controlled and uncontrolled transactions are comparable. Treas. Reg. § 1.482-4(c)(2)(iii)(B)(2)(viii); Cf. Coca Cola, 155 T.C. at 221, 229 (the determination of the degree of comparability under all transfer pricing methods requires consideration of general comparability factors including functions performed). As a matter of economics, the value of a licensed intangible is impacted by what additional activities need to be undertaken by the licensee to commercialize products enabled by the intangibles. Ex. 6201-R at 58 (Cockburn). The functions of the parties in the Pacesetter and the MPROC Agreements are not comparable. Ex. 6201-R at ¶¶ 53-60 (Cockburn); RFF ¶ 777. Dr. Putnam fails to even analyze the difference in functions in his opening report. Ex. 6105-P at ¶ 86 (Putnam).

a. Pacesetter Performed Significantly More Functions Under the Pacesetter Agreement Than MPROC Did Under the MPROC Agreement.

As the licensor in the Pacesetter Agreement, Medtronic US did not perform R&D nor management activities for Pacesetter products. In contrast, as licensor under the MPROC Agreement, Medtronic US performed R&D, quality control, clinical, and regulatory and strategic management with respect to MPROC products. Ex. 6201-R at ¶ 54 & Table 4 (Cockburn). Thus, while both Pacesetter and MPROC were licensees that manufactured products, Pacesetter performed many additional functions. For example, Pacesetter was expected to incur substantial R&D expenses (amounting to 8% of revenues). Ex. 2507-J at 3883. In contrast, MPROC's R&D activities and expenditures were limited. MPROC spent less than $1 million on R&D in both 2005 and 2006 — while Medtronic US (as licensor) spent $220 million on R&D for the products at issue in 2005 (8.2% of revenues) and $320 million in 2006 (9.0% of revenues). Ex. 6201-R at ¶ 55 & Table 5 (Cockburn).

To quantify this difference, Dr. Becker looked at the operating costs incurred by Pacesetter and MPROC as a proxy for functional contributions. RTr. 2785:2-19, 2604:25-05:12 (Becker); Ex. 6411-RD at pp. 2-4. For every $100 of MPROC product sales, MPROC incurs $14.8 of operating costs. In comparison, Pacesetter incurs $71 of operating cost for every $100 of sales, almost five times the costs or operations of MPROC. Ex. 6207-R at 6283 (Table 1); RTr. 2604:4-25 (Becker). Because of the vast differences in functions between the parties to the two agreements, the Pacesetter Agreement cannot be a CUT.

b. Dr. Putnam's Portfolio Access Adjustment Does Not Cover the Right to Receive New and Improved Products.

Rights to receive updates, revisions, or modifications of the intangible must be considered when evaluating comparability. Treas. Reg. § 1.482-4(c)(2)(iii)(B)(2)(iii). Dr. Putnam argues that MPROC's access to Medtronic US' ongoing R&D activities and patents are paid for through his 1.8% royalty rate adjustment. Ex. 6106-P at ¶ 46; RTr. 994:4-96:19 (Putnam). This is wrong.

Only existing patents are licensed in the Pacesetter Agreement. Future patents were not available without additional negotiations and royalties, and subject to blockage by the right to designate certain key patents as off-limits for a stated period. Exs. 2504-J at § 2.04, 6204 at ¶¶ 39-42 (Heimert), 6202-R at ¶ 127 (Cockburn). In the MPROC Agreement, Medtronic US licensed both its existing intangible assets — both patents and non-patent intangibles — and provided ongoing rights to any improvements. These improvements resulted from Medtronic US' continued investment in R&D, a function not provided by Medtronic US to Pacesetter under the Pacesetter Agreement. RFF ¶¶ 700, 778.

The 1.8% portfolio access fee in the Pacesetter Agreement is a payment for existing patents (and applications) over and above the 7% and not ongoing R&D activities and associated improvements. Dr. Putnam's 1.8% adjustment would provide no incentive for Medtronic US to invest in its R&D — which amounted to 8%-9% of its retail sales. RFF ¶ 778. No uncontrolled party would license intangibles for a price that would not at the least cover its expected expenses. Tr. 1593:7-10 (Hubbard). Dr. Putnam's 1.8% adjustment to cover all future patents licensed to MPROC is baseless.

Medtronic US also performs business management activities, some for MPROC, spending $116 million in 2005 (4.3% of revenues) and $178 million in 2006 (5.0% of revenues). Ex. 6201-R at ¶ 54 (Cockburn). Medtronic performs none of these activities for Pacesetter, which runs its own business. With no actual analysis, Dr. Putnam simply assumes business management activities “have been priced one way or another . . .” through one or more of the transactions, including through the MPROC Agreement. Ex. 6106-P at ¶ 49 (Putnam); RTr. 989:20-91:12 (Putnam). As Medtronic US does not make its business strategies available to Pacesetter — which runs its own business — an adjustment is required. An adjustment that merely covers the functional cost difference — with no profit — would amount to 4.3% to 5.0% of retail sales, again showing Dr. Putnam's 1.8% adjustment is insufficient.

4. Different Terms Make the Agreements Not Comparable.

The contractual terms of the Pacesetter and MPROC Agreements differed in critical dimensions that impact royalty rates including: (1) the structure of royalties, (2) cross-licensing, (3) exclusivity, (4) the term of the agreement, (5) indemnification against product liability, (6) the applicable sales base, and (7) sublicensing rights. Treas. Reg. §§ 1.482-4(c)(2)(iii)(A), -1(d)(3)(ii) (comparability depends on similarity in contractual terms); see Seagate Tech., Inc, v. Commissioner, 102 T.C. 149, 278-80 (1994) (rejecting agreements as comparables based in part on differences in contractual terms including advance payments, exclusivity, and cross-licensing).

a. The Structure of the Royalty Payments Under the Pacesetter and MPROC Agreements are Not Comparable.

The regulations require a comparison of “significant contractual terms that could affect the results of the two transactions” including “the form of the consideration charged or paid.” Treas. Reg. § 1.482-1(d)(3)(ii)(A) and (A)(1); see also § 1.482-4(c)(2)(iii)(B)(2)(i) (comparable circumstances that may be particularly relevant include terms of transfer). Under the MPROC Agreement, MPROC paid Medtronic US running royalties equal to a fixed percentage of sales. Under the Pacesetter Agreement, Pacesetter paid Medtronic running royalties equal to a fixed percentage of sales plus lump sum payments of $25 million and $50 million upon execution. In the first trial, petitioner characterized the $50 million as an upfront payment and the $25 million as a royalty prepayment but it proposed no adjustment to the 7% royalty rate to account for the additional amounts. PFF ¶ 154, Pet. Br. at 230. The Court of Appeals found that this Court did not address how the lump sum payments affected the degree of comparability between the MPROC and Pacesetter Agreements. Medtronic II at 614. Drs. Cockburn and Heimert calculated the necessary adjustment, converting the amount to a running royalty rate, which when added to the 7% rate increases the royalty to between 10% and 10.9%. Exs. 6203-R at ¶¶ 34-36 (Heimert), 6201-R at ¶ 67 (Cockburn).

Acknowledging that in patent cases, differences in payment terms renders an agreement noncomparable,²⁹ Dr. Putnam opines that the $50 million up-front cash payment can be ignored because it represents damages for past infringement. He asserts that the $25 million up-front cash payment, which he translates to a 1.8% adjustment, covers future patents and on-going R&D. Ex. 6105-P at ¶¶ 104-08 (Putnam); RTr. 991:11-21 (Putnam). Dr. Putnam's opinions are mere speculation.

First, under New York law, the law governing the Pacesetter Agreement, the construction of a plain and unambiguous contract is for the court to review, and a court should not consider extrinsic evidence. West, Weir & Bartel v. Mary Carter Paint Co., 25 N.Y.2d 535, 540 (1969); New York v, Grasso, 54 A.D.3d 180, 188, 861 N.Y.S.2d 627, 635 (1st Dept. 2008); Ex. 2504-J at § 9.04. The Pacesetter Agreement does not characterize the $50 million as compensation for past infringement. It does not characterize the $25 million as an ongoing access fee to Medtronic's intangible assets. The agreement simply treats both payments as “royalties” with no further break down. Exs. 2504-J at § 3.02(a)-(b), 6202-R at ¶ 127 (Cockburn). The unambiguous contract terms speak for themselves.

Second, petitioner's experts claim that it is “clear” from the Board documents and other contemporaneous documents that the $50 million lump-sum payment is for past infringement and therefore should not be added to the running royalty rate. Exs. 6105-P at ¶ 309 (Putnam), ¶ 6107-P at ¶ 63 (Spadea), 6108-P at ¶ 156 (Hubbard). Dr. Putnam argues that the $25 million was for future patents because the Board documents referred to it as a “portfolio access fee.” Ex. 6105-P at ¶ 30. However, in analyzing the deal, Medtronic's Board did not distinguish between the two payments and referred to both as “Portfolio Access Royalty Payments.” Ex. 2528-J at 4435; RTr. 1031:15-33:12 (Putnam). Petitioner's experts cherry-pick just a subset of the documents related to the $50 million lump-sum payment to arrive at the result they seek. RTr. 1767:3-17, 1892:25-94:6 (Meyer); Ex. 2526-J at 4427.³⁰ The more complete set of documents studied by Dr. Meyer reveal that the $50 million is characterized by the parties differently at different points in time. Exs. 2524-J at 4413, 2527-J at 4431-32 (“up front cash payment”), 2523-J at 4410 (“Portfolio Access Royalty Payments”), 2528-J at 4435 (same), 6238-R at 0049 (“access to Medtronic patents and for past royalties”); RFF ¶ 782.

Third, in the first trial, petitioner called Michael Ellwein, who was in charge of the Pacesetter negotiations for Medtronic. He testified that “Siemens would pay Medtronic $50 million to sign an agreement.” Tr. 3843:7-12 (Ellwein). He offered no testimony supporting petitioner's theory that the amount represented damages for past infringement.

Finally, Dr. Putnam and Mr. Spadea attempt to support their opinion that the $50 million prepayment is compensation for past infringement by backing into the amount. They reach remarkably similar results based on vastly different assumptions (RTr. 1296:24-1321:14 (Spadea), 1036:5-52:5 (Putnam); Exs. 6399-R, 6151-P at ¶¶ 309-11, Exs. 6.1-6.2, 6 Sch. A-B (Putnam)):

Differing Assumptions Underlying $50 Million Lump Sum Computations

Assumption	Spadea	Putnam
Period Start	FY87	FY88
Period End	Q1 FY92	Q1 FY93
Sales Base for Lump Sum	Worldwide	US
Royalty Rate Applied	3.5% to 7.0%	7.1% to 9.4%
Differentiate Royalty Rate by Enjoined Product	No	Yes
Weighted Adjusted Sales (1.33)	No	Yes
Includes Interest	No	Yes
Probability Adjust for Litigation	No	Yes
Net Present Value	No	Yes
Lump Sum Calculation	$50.7	$50.0

It is impossible to reliably reconcile their conclusions given the vast differences in basic assumptions.³¹ The weight of the evidence shows that the lump sum payments represented significant compensation that was agreed to in exchange for a lower royalty rate.

b. Cross-Licensing Makes the Net Running Royalty Meaningless.

Pacesetter is a cross-license, and MPROC is not. This difference must be accounted for under the regulations. See Treas. Reg. § 1.482-1(d)(3)(ii)(A)(l); Medtronic II at *614, 615, 617: cf. Podd v. Commissioner, T.C. Memo. 1998-231, 1998 WL 345513 at *15 (1998). The royalty paid in the Pacesetter Agreement is the net payment to “balance” the cross-license to each party's patents. Exs. 6201-R at ¶¶ 63-66, 6202-R at ¶ 111 (Cockburn), 6205-R at ¶ 37 (Meyer); RTr. 1758:24-59:23, 1860:21-66:22, 1972:1-74:6, 2008:12-09:21 (Meyer), 2113:7-25 (Cockburn), 2976:8-78:1 (Crosby).

In the first trial, petitioner attempted to avoid an adjustment by claiming that Medtronic attributed no value to the Pacesetter patents it received as part of the cross-license. The Court in Medtronic I adopted this finding. Medtronic I at *58. The Court of Appeals found that the Court did not address how the Pacesetter Agreement's cross-license affected the degree of comparability with the MPROC Agreement, “which did not include a lump sum or cross-license.” Medtronic II at 614. On remand, petitioner continues to claim that the cross-license had little to no value to Medtronic US, and hence, the difference in contract terms due to the cross license is immaterial. Ex. 6103-P at 2328 (Cohen); Pet. Trial Memo, at p. 70.

The record shows otherwise. Medtronic knew that it was risky to operate without a license for the patent portfolio of Pacesetter, one of its most formidable competitors. One of the “cons” Medtronic US listed in Board presentations used to decide whether to continue to litigate was that it “[c]ould be shut out by Siemens' patent.” Ex. 2525-J at 4423. The factual record shows that Medtronic considered Pacesetter's patent portfolio valuable.

Petitioner's expert Dr. Hubbard agrees that the cross-license had an option value, meaning that the cross-license could prove valuable in the future althoughhe testified he was unable to quantify that value. Ex. 6108-P at ¶ 161; RTr. 1477:8-21 (Hubbard). Evidence of Medtronic's option value materialized four years after the Pacesetter Agreement. Medtronic was awarded rights to valuable patents owned by Angeion as a result of the Pacesetter Agreement. Thus, even if Medtronic did not view Pacesetter's patents as valuable at the time of settlement, the cross-license could and did prove to be valuable in the future. Exs. 6202-R at 66 (Cockburn), 6206-R at ¶¶ 68-69; RTr. 1760:22-62:21 (Meyer); RFF 796.

Further, although Dr. Cohen concludes that the Pacesetter patent portfolio was of immaterial value to Medtronic, his analyses show otherwise. Exs. 6208-R at 54-55, 59-69 (Crosby), 6202-R at 118 (Cockburn). For example, Dr. Cohen uses patent citations as a measure of value and there was a sudden uptick in Medtronic's citations to Pacesetter patents after the parties entered into the Pacesetter Agreement. Exs. 6208-R at ¶¶ 54-55, 62 (Crosby), 6202-R at ¶¶ 119-20 (Cockburn). By citing Pacesetter patents, Medtronic acknowledged their value. Ex. 6202-R at ¶121 (Cockburn). Moreover, based on Dr. Cohen's patent citation analysis, four of the top ten cited patents in the combined portfolio were Pacesetter patents.³² Ex. 6208-R at 63, Table 1 (Crosby); RTr. 2826:10-23 (Crosby).

Patent Number	Owner	# Citations within 10 Years of Grant
4,953,551	Medtronic	102
5,052,388	Medtronic	80
4,727,877	Medtronic	62
4,428,378	Medtronic	61
4,940,052	Pacesetter	59
4,712,555	Pacesetter	59
4,809,697	Pacesetter	54
4,708,145	Medtronic	51
4,944,299	Pacesetter	49
5,117,824	Medtronic	48

At bottom, Dr. Cohen's citation and first claim analyses proves at most that Medtronic US' patents were more valuable than Pacesetter's — a fact not in dispute. It does not prove that the Pacesetter patents had immaterial value. Moreover, his analyses fail to address the issue in this case — the value of Medtronic's patent portfolio (or the Pacesetter portfolio) to a hypothetical MPROC with no patent portfolio of its own. Exs. 6208-R at ¶ 53 (Crosby), 6202-R at ¶¶ 118 (Cockburn).

Contrary to petitioner's position at the first trial, Dr. Putnam does make an ad hoc adjustment of 0.5%-1% for cross-licensing, claiming “conservatism.” Ex. 6105-P at ¶ 196-200 (Putnam). The sole basis for his adjustment is, again, the Mirowski agreement, an early stage, pre-commercial product license with collateral equity transactions from 1973 that is not comparable to the MPROC Agreement. See Arg. II.A.1.c., supra. Ad hoc adjustments are not permitted under the regulations. Treas. Reg. § 1.482-1(d)(2).

c. The Exclusivity Provisions in the Two Agreements are Not Comparable.

The CUT regulations provide that exclusivity may be particularly relevant to determining the comparability of circumstances. Treas. Reg. §§ 1.482-4(c)(2)(iii)(B)(2)(i) (relevant factors include “[t]he terms of the transfer, including . . . the exclusive or nonexclusive character of any rights granted”), -1(d)(3)(ii)(A); see also Coca-Cola, 155 T.C. at 266 (rejecting agreements as CUTs in part because uncontrolled agreements granted territorial exclusivity whereas controlled agreements did not); Seagate Technology Inc., 102 T.C. at 280 (rejecting comparables with differing provisions on exclusivity). The parties do not dispute that an exclusive license is more valuable than a non-exclusive license: an exclusive agreement grants a licensee a market advantage. RTr. 805:8-12, 1052:11-20 (Putnam); Ex. 6105-P at ¶ 249 (Putnam); Cf. Ex. 6203-R at ¶¶ 40-41 (Heimert); RFF ¶ 784.

Dr. Berneman, petitioner's expert in the first trial, testified that the runningroyalty should be adjusted by 7% — a magnitude of 100% — to reflect the value of exclusivity.³³ Tr. 5010:9-10 (Berneman). Petitioner offered no transactional or commercial data to support this adjustment. The Court found this difference significant and adopted the adjustment, noting that it took into account the downward pressure on the rate “because Medtronic had already granted licenses to major market competitors for some of the patents.” Medtronic I at *124, 134-36 (“Without exclusivity the licenses would have significantly less value.”).

Petitioner now abandons the opinion of Dr. Berneman and asserts that no exclusivity adjustment is necessary. Petitioner presents no data or agreements supporting its position; its experts simply opine that the “downward pressure” from granting cross licenses to competitors would take the exclusivity adjustment — that petitioner and the Court found to be 7% after the first trial — to zero. Ex. 6105-P at ¶¶ 36, 251-54 (Putnam).

Further, MPROC was not granted access only to patents — it also received exclusive access to all of Medtronic US' non-patent intangibles, including the know-how, trade secrets, and regulatory approvals that permit it to sell products. Medtronic I at *35. MPROC, and no other third party, was the exclusive licensee of Medtronic US’ bundle of IP required to manufacture Medtronic US’ market leading products. Ex. 6202-R at ¶ 83 (Cockburn).

In addition, by 2005, the vast majority (314 out of 438) of the patents and patent applications licensed by Medtronic US to Pacesetter had expired. An additional 1,504 patents had been granted to Medtronic US that were licensed to MPROC under the MPROC Agreement. Ex. 6202-R at ¶ 83 (Cockburn). Thus, any cross licenses to third parties had largely expired at the time of the MPROC Agreement and could not put downward pressure on the rate.

Finally, in resolving patent disputes, Medtronic followed the philosophy of not cross-licensing patents “until after a period of exclusivity has given us the opportunity to establish market share.” Ex. 2525-J at 4419. Thus, an uncontrolled MPROC could rest assured that Medtronic US would not cross-license patents to competitors until after it had the opportunity to establish market share.

The exclusivity provided to MPROC is a critical term that differentiates it from the Pacesetter Agreement, and without adjustment disqualifies it as a CUT.

d. The Duration of the Agreements are Not Comparable.

The regulations require significant contract terms such as the duration of the contract to be considered in determining comparability. Treas. Reg. §§ 1.482-1(d)(3)(ii)(A)(5); -4(c)(2)(iii)(B)(2)(v). The Pacesetter Agreement specified a duration of ten years, with a fixed running royalty, while the 2005 and 2006 MPROC Agreement had a duration of one and three years, respectively. RFF ¶ 789.

The duration of an agreement has a significant impact on value, and the difference in the term of the Pacesetter and MPROC Agreements shows lack of comparability. Ex. 6201-R at ¶ 62 (Cockburn). Petitioner disregards the short-term nature of the contract, arguing that MPROC and Medtronic US had a long-term relationship. Dr. Putnam asserts that the MPROC Agreement was potentially renewable, and no adjustment is merited. Ex. 6105-P at ¶ 49 (Putnam).

In Coca-Cola, the Court relied on the difference in the term of the controlled and uncontrolled contracts in rejecting the taxpayer's comparable agreements. 155 T.C. at 266. The short-term nature of a contract permits the parties to reset or alter the terms of an agreement that a party deems economically unfavorable. See Arg. III. B.1.b., infra. The duration impacts the parties' bargaining power and is a significant factor that differentiates the Pacesetter and MPROC Agreements. The short-term nature of the MPROC Agreement preserves Medtronic US' bargaining power relative to the longer-term Pacesetter Agreement.

e. Pacesetter Bears Full Product Liability Whereas MPROC Does Not.

As licensor, Medtronic US does not bear product liability risk with respect to Pacesetter's products. Ex. 2505-J at § 3. To the extent that product liability risk did not rest exclusively with MPROC under the intercompany agreements — an issue indispute — any material product liability risk borne by Medtronic US would give rise to a material difference in the contractual terms between the MPROC and Pacesetter Agreements. As such, an upward adjustment would be required to compensate Medtronic US for bearing additional product liability risk. Treas. Reg. § 1.482-4(c)(2)(iii)(B)(2)(vi).

i. No Intercompany Agreement Requires MPROC to Provide Insurance or Indemnify Medtronic US.

None of the intercompany agreements require insurance or indemnification by MPROC in favor of Medtronic US for product quality problems other than manufacturing defects. Under applicable tort law principles, an injured patient could sue and recover from MPROC and any other “seller” in the chain of distribution, including Medtronic US. Tr. 7068:4-70:19 (Green); see also 2 Owen & Davis on Prod. Liab. § 16.16 (4th ed. 2015). Apportionment of the verdict or settlement cost between MPROC and Medtronic US would depend on which party was responsible for the problem. Here, the intercompany agreements fail to provide the specific provisions necessary under Minnesota law to shift the cost of failures in a product liability action, as among the group, from Medtronic US to MPROC.³⁴

Petitioner relies on the Supply Agreement to support its argument that product liability risk was shifted to MPROC. But that agreement, governed by Minnesota law, lacks language providing that MPROC is assuming all liability for defects in the components or materials supplied by Medtronic US — particularly those defects attributable to the conduct of Medtronic US. Minnesota law requires that indemnification for a culpable party's own negligence be clear and unambiguous. See National Hydro Sys, v. M. A. Mortenson Co., 529 N.W.2d 690, 694 (Minn. 1995). Interpreting the Supply Agreement's indemnification clause under the Minnesota standard results in a sensible and reasonable interpretation: MPROC must indemnify Medtronic US for damages caused by MPROC's manufacturing failures as well as damages beyond MPROC's ability to pay. Medtronic US remains liable for damages caused by its own design or other failures. This interpretation harmonizes the indemnity clause of Article IV with other provisions of the Supply Agreement, in particular the warranties clause in Article III. In the warranties' clause, Medtronic US agrees to provide “all standard Supplier warranties,” i.e., that the “Components and Materials” would be free of defects. See Peterson v. Bendix Home Sys., Inc., 318 N.W.2d 50, 52-53 (Minn. 1982). That promise would be meaningless if MPROC were required to indemnify Medtronic US for problems inherent in the components as petitioner suggests.

ii. The Purported Risk Allocation Lacks Economic Substance.

Even if the intercompany agreements could be read to support petitioner's interpretation, any purported allocation of risk to MPROC under the Supply Agreement must be disregarded for lacking economic substance. See Treas. Reg. §§ 1.482-1(d)(3)(ii)(B)(1), -1(d)(3)(iii)(B). First, MPROC has no managerial or operational control over the business activities that directly influence the amount of risk related to design and components. See Treas. Reg. § 1.482-1(d)(3)(iii)(B)(3). Medtronic US, not MPROC, controls the overall design of the products, including the hybrids, batteries, and capacitors, as well as the component manufacturing. Ex. 1811-J at 6582 (“[CJhanges to the pacing agent, firmware algorithms, the microprocessor, or to circuits, are invisible to [MPROC].”). When the Fidelis leads and Marquis devices injured patients, there was nothing MPROC did or could have done to cause or avert those injuries. Relatedly, MPROC does not have a legal department, or any personnel with legal risk management responsibility. All responsibility for addressing product recalls and lawsuits relating to product quality failures is borne and controlled by Medtronic US, not MPROC. RFF 865-67, 872-75, 877-78.

Second, petitioner's conduct is inconsistent with its position that MPROC bears the risk; it allocated actual product liability costs to Medtronic US. Treas. Reg. § 1.482-1(d)(3)(iii)(B)(1) (whether pattern of conduct over time is consistent with the purported allocation of risk). That ex-post conduct shows that Medtronic US retained the ability to shift risk. Indeed, the 2006 MPROC Agreement was backdated from May 2007 to the start of the 2006 fiscal year to reflect a reallocation of risk. RFF 789. But “risk is not something that can be assigned after the fact.” Coca Cola, 155 T.C. at 227; Treas. Reg. § 1.482-1(d)(3)(iii)(B) (same).

Under the regulations, MPROC's lack of control over the product liability risk makes the purported shift of the risk to MPROC lack economic substance. See id. MPROC's lack of financial capacity (as discussed below, Arg. III.B.4.c.ii, infra) is an additional reason to reject the purported shift of liability from Medtronic US to MPROC for lack of economic substance. See id.

f. The Pacesetter Royalty Rate was Based on Sales of Noninfringed and Infringed Products.

The royalty rate in the Pacesetter Agreement was applied to more products than just those that allegedly infringed Medtronic US' patents. Ex. 2504-J at § 3.02(f), 2522-J at 4399; RTr. 1976:2-24 (Meyer). The parties recognized that abroad royalty base would avoid future litigation over disagreements as to which patents a product infringed and agreed to a lower royalty rate on all Pacesetter sales. As such, the agreed lower royalty rate on all Pacesetter sales factored in that non-infringed products would expect to have no associated royalties. Exs. 6205-R at ¶ 46 (Meyer), 6203-R at ¶¶ 37-39 (Heimert); RTr. 1767:18-68:6 (Meyer).

Because the 7% flat rate was applied to Pacesetter's sales of infringing and non-infringing products, the 7% royalty rate does not reflect the value of Medtronic US' patents used in Pacesetter's products. Consequently, the 7% royalty rate is not an appropriate starting rate without further analysis. RFF ¶ 791.

Petitioner has provided no expert analysis in this trial showing the royalty rate on just the infringed products. Ex. 6205-R at ¶ 46 (Meyer). But in the Pacesetter patent litigation — in complete contradiction of its position in this case — Medtronic asserted that the reasonable royalty rate for its infringed patents was 35%. Ex. 6220-R at 8832.

g. Dr. Putnam's Sub-Licensing Adjustments Highlight His Ad Hoc Approach to Adjustments.

The Pacesetter Agreement's contract terms differed significantly from the MPROC Agreement with respect to sub-licensing rights. Treas. Reg. §§ 1.482-4(c)(2)(iii)(A), -1(d)(3)(ii) (comparability depends on similarity in contractual terms). The ad hoc adjustments offered by petitioner's experts are unreliable, as illustrated by Dr. Putnam's Guidant sub-license adjustment. Medtronic US and Guidant entered into a royalty free cross-license but that does not mean that the Guidant and Medtronic patent portfolios had no value. To assess the one-way royalty rate Medtronic US was effectively paying, Dr. Putnam does not rely on transactional data, but instead relies on a series of ad-hoc assumptions without ever actual examining the value of any of the individual or collective patents in the respective portfolios.³⁵ Exs. 6202-R at ¶31 (Cockburn), 6204-R at 30 (Heimert), 6105-P at ¶ 222 (Putnam); RTr. 1094:6-95:2 (Putnam). His 1% to 2% adjustment is ad hoc and unsupported.

D. Petitioner's Reliance on the 15% Maximum Rate Provision is Unwarranted.

Relying on the Future Patent provision in the Pacesetter Agreement, Dr. Putnam caps the cumulative royalty rate at 15%, excluding his know-how and sublicensing adjustments. He treats this provision of the agreement as a cure for all ails of comparability, which limits the adjustments for differences in technology, markets, profits, purpose, and contract terms.³⁶ RTr. 762:22-66:11 (Putnam); Ex. 6105-P at ¶ 22. It does not.

First, the 15% cap in the Pacesetter Agreement is applied to a bare patent license, not the broad license of intangibles provided under the MPROC Agreement. Even if 15% were an appropriate cap for a comparable patent license, there is no showing that its application to the much broader set of intangibles would comply with the arm's-length standard. Exs. 6202-R at 110 (Cockburn), 6204-R at 62 (Heimert).

Second, the 15% cap does not account for the fact that there was substantially more profit to be earned under the MPROC Agreement than by the Pacesetter Agreement due to vastly greater profits in Medtronic's 2005 business than Pacesetter's 1992 business. Exs. 6204-R at 62 (Heimert), 6202-R at 110 (Cockburn). The rates were set in agreements with very different profit potentials.

Third, the 15% cap does not take into account differences in the functions of the parties to the agreements. MPROC did not incur the costs to develop new products, to obtain regulatory approvals, and to perform on-going R&D. Medtronic US bore these costs and additional business-support costs associated with the products produced by MPROC. Pacesetter had to incur all of these costs under the Pacesetter Agreement. Ex. 6204-R at ¶62 (Heimert).

Finally, the Pacesetter Agreement allows either party to withhold licenses of future “key patents” for up to three years after FDA approval or six years after the date on which the patent application was first filed. Ex. 2504-J at § 2.04(b). Thus, not all future patents were automatically covered by the 15% maximum royalty provision. Rather, the key, and presumably the most valuable, patents were not covered. Further, the 15% was negotiated as part of a larger settlement and is not reflective of the value an uncontrolled MPROC might place on these future patents in a different economic context. Exs. 2504-J at § 2.04(d), 6202-R at ¶ 110 (Cockburn).

E. The Tax Court's Adjustments were Not Appropriate and were Unreliable.

The Tax Court made five different adjustments to the 7% base rate in the Pacesetter Agreement. Two were based on Dr. Berneman's unsupported trial testimony. The adjustments made by the Court were not based on commercial practices, economic principles, or statistical analyses as required by the regulations. Treas. Reg. §§ 1.482-1(d)(2), -4(c)(2)(iii).

Petitioner also rejects certain of the Court's adjustments. Dr. Putnam identifies 17 differences between the Pacesetter and MPROC Agreement but makes different adjustments than Dr. Berneman and the Court made.

Build-up Adjustments Applied to the Pacesetter Royalty Rate

Adjustments As a Percent of Third-Party Retail Sales	Berneman (Trial)	Putnam (Range)	Court
Base Rate	7%	7%	7%
Court Adjustments — Medtronic I
Know-How	No	1-3%	7%
Future Know-How (Improvements)	2-3%	No	3%
Exclusivity	7%	No	7%
Profit-Potential	No	No	3.5%
Scope of Product	No	No	2.5%
Leads — 50% Device Royalty Rate	No	No	Yes
New Adjustments
Portfolio Access Fee	No	1.8%	—
Cross-Licensing	No	0.5-1%	—
Sub-Licensing	No	1-5%	—
Economic Conditions	No	0.9-4.9%	—
Max at 15% (Patents)	No	Yes	—

Ex. 6105-P at Table 3 (Putnam); Medtronic I at *134-37.

The differences in opinion confirm the difficulty of making reliable adjustments to the Pacesetter Agreement. And as Dr. Cockburn explained, there is a high probability that adjusting the CUT can go badly wrong. RTr. 2064:5-19, 2293:5-94:22 (Cockburn). For example, a one percentage point adjustment to the 2005 royalty rate proposed by petitioner increases the royalty by $26.8 million per year.³⁷ Thus, a 7% exclusivity adjustment impacts the yearly royalty by $187.6 million.³⁸ The number of adjustments proposed by petitioner, some of which are dependent on others, compound the chances of error. RTr. 2058:25-59:11 (Cockburn). In contrast, a one percentage point change in the ROA impacts the royalty by $3.9 million a year, almost one seventh of a 1% adjustment to the royalty rate from petitioner's purported CUT.³⁹

III. DR. HEIMERT'S CPM IS THE BEST METHOD IN THIS CASE.

Dr. Heimert's CPM is by far the most reliable and therefore, the best method in this case. Reliable comparables and a reliable PLI were identified. A statistical narrowing technique to eliminate the impact of more extreme observations was applied, and calculations were based on reliable financial data sourced from Forms 10-K (for the Comparables) and by petitioner (for MPROC). MPROC is the obvious choice for tested party, which permits an arm's-length price to be determined without the need to value the full suite of the hard-to-value intangible assets owned by Medtronic US. Treas. Reg. § 1.482-5(b)(2). The CPM is ideally suited to this scenario. Coca-Cola, 155 T.C. at 218-21. Dr. Heimert performed a best method analysis for the first trial and refined his analysis in response to this Court's May 3, 2019 Order defining the scope of the remand. Although his only judicial testimony has been in this matter, Dr. Heimert's deep knowledge of transfer pricing, vast experience in the field, and strong economics background, make him a particularly credible witness.

Petitioner's experts, none of whom are experts or even experienced in transfer pricing, offer superficial criticisms, ignore the applicable regulations, and relegate the CPM to a method of last resort consistent with petitioner's arguments in Medtronic I. These arguments were not addressed or adopted by the Court of Appeals for the Eighth Circuit and the latter argument has been unequivocally rejected by this Court. See Medtronic II, 900 F.3d at 613; Coca-Cola, 155 T.C. at 212-20, 265-69.

A. Dr. Heimert's Transfer Pricing Analysis Followed the Regulations.

The CPM is a specified method for pricing controlled transfers of intangible property. Treas. Reg. §§ 1.482-4(a)(2), -5. Under the CPM, an arm's-length result is determined by computing the profits that would have been earned by the “tested party” if its profitability (as measured by an appropriate “indicator” ratio) were the same as that of uncontrolled comparable companies performing similar activities under similar circumstances. Treas. Reg. § 1.482-5(a). Following the regulations, Dr. Heimert first selected MPROC as the tested party because it is the least complex of the controlled parties, reliable segmented MPROC financial data were available, and MPROC was the licensee and not the owner of the hard-to-value intangibles at the heart of this case. Treas. Reg. § 1.482-5(b)(2)(i). There is no dispute over the reliability of MPROC's segmented financials. RTr. 1559:20-60:5 (Hubbard).

The second step under the CPM is to select companies that are comparable to the tested party, focusing on the resources employed — including assets — and the risks incurred. Treas. Reg. § 1.482-5(c)(2)(ii). The regulations instruct that comparability of product and function is less important under the CPM than under other transfer pricing methods. Treas. Reg. § 1.482-5(c)(2)(ii) & (iii). Moreover, comparable companies under the CPM do not have to be perfect. Coca-Cola, 155 T.C. at 225 (“We find that the bottlers and the supply points were reasonably (albeit not perfectly) comparable in terms of 'resources employed.'”). Starting with companies classified as manufacturers of surgical, medical, and dental instruments and supplies under Standard Industry Classification (SIC) Code 384, Dr. Heimert selected 13 manufacturing companies with the greatest degree of comparability to MPROC given the available reliable information. Dr. Heimert also selected Greatbatch, a manufacturer of components used in implantable medical devices identified by petitioner on audit as an outsourcing alternative for leads, as a comparable for a total of 14 comparable manufacturers. He performed a detailed analysis based on the comparability factors in the regulations (see Ex. 6203-R at 83, Table 10 (Heimert)) and confirmed that the Comparables devoted most of their resources to manufacturing high-quality implantable or invasive medical products,and faced risks similar risks to MPROC's risks, including product liability. Like MPROC, the Comparables (1) performed high-quality manufacturing at scale; (2) managed inventory and bore market risk; and (3) rapidly and frequently introduced new products. Id.; RTr. 2839:17-40:16 (Crosby). All except one⁴⁰ were, like MPROC, subject to direct FDA regulation and manufacturers of finished medical products. RFF ¶¶ 820-24.

The third step under the CPM is to select a profit-level indicator (PLI) and apply it to the financial information of the comparable companies to determine their profitability. The regulations provide for several such PLIs, including the retum-on-operating-assets (ROA) ratio. Treas. Reg. § 1.482-5(b)(4)(i). The ROA PLI is most reliably applied when a company's operating assets play an important role in its ability to generate profits. Id.; see Treas. Reg. § 1.482-5(e), ex.4 (approving ROA as the PLI to determine an arm's-length royalty to be paid by foreign manufacturer licensee for use of parent's unique and valuable intangibles). Because manufacturers like MPROC depend heavily on operating assets to generate profits, Dr. Heimert selected the ROA as the PLI, and as permitted by the regulations, measured operating assets for MPROC and the Comparables using net book value. RFF ¶ 826; Treas. Reg. § 1.482-5(d)(6) (“operating assets may be measured by their net book value or by their fair market value, provided that the same method is consistently applied to the tested party and the comparable parties, and consistently applied from year to year”); see Coca-Cola, 155 T.C. at 218, 230, 232-33 (adopted ROA PLI using book values from Forms 10-K as the best method).

Next, using Forms 10-K and MPROC's financial information, Dr. Heimert computed the ROAs earned by each Comparable and MPROC. For the Comparables, Dr. Heimert used a three-year average of their financial results that the regulations recognize as a technique to ensure reliable ROAs. Treas. Reg. § 1.482-5(b)(4); Ex. 6203-R at App. 5, Table 22 (Step 1). Pursuant to section 1.482-1(e)(2)(iii)(B) & (C), Dr. Heimert used a statistical method referred to as an interquartile range (IQR) that eliminated outliers from his comparable set by only using the results that were greater than the lowest 25% of results, and less than the highest 25% of results. Ex. 5543-R at pp. 18-19 & n.19 (Heimert). Unlike petitioner's CUT analysis, which is based on a single (flawed) data point, the larger data set and use of an IQR by Dr. Heimert eliminates the impact of the more extreme observations and yields more reliable information about arm's-length outcomes because using the median of the multiple data points reduces the effect of any individual idiosyncrasy. Treas. Reg. § 1.482-1 (e)(2)(iii)(B); Ex. 6203-R at ¶¶ 66, 71-72, Table 8 (Heimert); RTr. 2062:21-63:8, 2301:7-02:16 (Cockburn)(influence of outliers limited through use of a median or averaging to reflect the economic returns of the industry). Thus, the chances of issues impacting individual members of the comparable set materially distorting Dr. Heimert's CPM is small, while the multiple adjustments to the Pacesetter Agreement present the risk that petitioner's proposed CUT may “go badly wrong” and be “far off base.” RTr. 2302:10-16; 2287:23-89:13, 2293:5-96:8 (Cockburn), 2474:11-24 (no perfect comparables), 2543:24-44:25 (Heimert).

Using the IQR of the Comparables, Dr. Heimert determined a range of arm's-length outcomes for MPROC. The IQR of the Comparables' RO As was 22.0% to 39.9% with a median of 28.1% for 2005 and 21.7% to 39.3% with a median of 26.0% for 2006. Under the CPM, multiplying these RO As by MPROC's operating assets produces a range of arm's-length operating profits (Comparable Operating Profits or COPs) that MPROC should have earned in 2005 and 2006. Dr. Heimert calculated that the range of COPs was $86.5 million to $157.0 million with a median of $110.5 million for 2005 and $92.0 million to $166.7 million with a median of $110.4 for 2006. Ex. 6203-R at 71, App. 5, Tables 22-24 (Heimert). Because MPROC's operating profits based on the pricing in Medtronic I for 2005 ($595.8 million) and 2006 ($926.1 million) fell well above these ranges, Dr. Heimert concluded that MPROC's results were not arm's length and adjusted MPROC's operating profits to the median of the Comparables' IQRs. Treas. Reg. § 1.482-1(e)(3); Ex. 6203-R at ¶¶ 71,103, Table 17 (Heimert).

Dr. Heimert's final step involved calculating MPROC's Technology Royalties and the associated royalty rates based on his CPM analysis. MPROC reported operating profits that were above the arm's-length range because MPROC's royalty payments for the intangibles licensed under the MPROC Agreement were too low. Ex. 6203-R at 71 (Heimert). Based on Dr. Heimert's CPM analysis, if Medtronic US and MPROC had been acting at arm's length, MPROC would have only earned $110.5 million and $110.4 million in COPs for 2005 and 2006, respectively. Subtracting these COPs from MPROC's pretechnology royalty operating profits of $1,287.3 million in 2005 and $1,955.5 million in 2006 results in Technology Royalties under the MPROC Agreement of $1,176.7 million in 2005 and $1,845.1 million in 2006. RFF 837. This amount may then be converted into a royalty rate either by dividing it by MPROC's sales to Medtronic US for a wholesale royalty rate, or by Medtronic US' third-party sales for a retail royalty rate.⁴¹ Ex. 6203-R at ¶ 72 & Table 8 (Heimert); RFF ¶839.

B. Petitioner's Criticisms of the CPM are Meritless.

In this remand proceeding involving expert testimony to determine the arm's-length pricing for MPROC's license of technology intangibles from Medtronic US, petitioner did not proffer an expert in transfer pricing. While Dr. Hubbard has provided expert testimony scores of times, he is not a transfer pricing expert, has no previous experience with transfer pricing, and he disregards the section 482 regulatory framework. His attempts to superimpose his economic theories on to this case ignore the regulations, avoid the required analysis, and result in the inappropriate conclusion that the CPM is not a reliable method to determine a transfer price for intangible property.

1. Dr. Hubbard Failed to Consider Medtronic US' Assets in Selecting the Tested Party.

Dr. Hubbard's opinion that there is no clear choice of tested party is incorrect, unsupported, and a direct result of his failure to consider assets owned by MPROC and Medtronic US as required by the regulations. Treas. Reg. § 1.482-5(b)(2)(i) defines tested party as:

the participant in the controlled transaction whose operating profit attributable to the controlled transactions can be verified using the most reliable data and requiring the fewest and most reliable adjustments, and for which reliable data regarding uncontrolled comparables can be located. Consequently, in most cases the tested party will be the least complex of the controlled taxpayers and will not own valuable intangible property or unique assets that distinguish it from potential uncontrolled comparables. (Emphasis added.)

MPROC, a finished manufacturing subsidiary, is the only appropriate choice of tested party because Medtronic US is the owner of virtually all the intangibles. To paraphrase this Court, it is only with MPROC as the tested party that an arm's-length price can be determined “without attempting a direct valuation of [Medtronic's] hard-to-value intangible assets.” See Coca-Cola, 155 T.C. at 220.

Dr. Hubbard's failure to reach this obvious conclusion is puzzling. See RTr. 2059:20-60:21 (Cockburn). Inexplicably, in describing the regulatory standard, he omits any reference to the “will not own valuable intangible property” clause of section 1.482-5(b)(2)(i). Ex. 6108-P at¶¶ 35-36 (Hubbard). Dr. Hubbard also suggests that his expert view of economics should trump the section 482 regulations. When asked whether he considered “the valuable intangible property that [Medtronic US] owns” in his tested party analysis, he replied that “I did not because I don't think it's relevant from an economic perspective.” RTr. 1505:22-06:2 (Hubbard).

The plain language of the regulations makes asset ownership extremely relevant.⁴² Under the regulations, the parties' ownership of valuable intangible property is a key consideration in the selection of a transfer pricing method and, if the CPM is chosen, in the identification of the appropriate tested party, the PLI, and the selection of comparables. Treas. Reg. § 1.482-5(b)(2)(i), -5(b)(4)(i), -5(c)(2)(i); Coca-Cola, 155 T.C. at 218-20. In this case, Medtronic US' ownership of the crown jewel intangibles makes MPROC the “clear choice” as tested party because it eliminates the need to value those intangible assets directly — Dr. Hubbard's conclusion that there was “no clear choice” of a tested party is based on unsubstantiated economic theories, not the relevant law.

a. Medtronic US is the Legal Owner of All Valuable Intangible Assets.

There can be no dispute that Medtronic US, not MPROC, is the legal owner of the crown-jewel, technology intangibles at issue including patents, copyrights, trade secrets, regulatory approvals, and know-how. See Treas. Reg. § 1.482-4(f)(3)(ii)(A) (legal owner of intangible is considered the sole owner unless such ownership is inconsistent with economic substance); Ex. 10-J; RFF ¶ 699. The MPROC Agreement makes plain that Medtronic US' ownership of the technology intangibles is expansive, comprehensive, and not in doubt. The MPROC Agreements specify that Medtronic US is the owner of all “Intangible Property” and “Know-How” relating to the “Products,” (Devices and Leads). See, e.g., Exs. 10-J & 14-J at §§ 5.1, 6.1, & Whereas Clause. Under the broad definitions of “Product” (medical device pulse generators in the businesses of bradycardia pacing, tachyarrhythmia management and neurological stimulation), “Intangible Property” (“Licensor developed inventions, secret processes, technical information, and technical expertise relating to the design of Product and all legal rights associate therewith, including without limitations, patents, trade secrets, know-how, copyrights and all Regulatory Approvals associated with Product”), and (all technical information available or generated during the term of the MPROC Agreement that relates to the products and improvements and specifically includes, without limitation, all manufacturing data) included in the MPROC Agreements, it is difficult to imagine a type of technology intangible that is not owned by Medtronic US. Exs. 10-J & 14-J at §§ 1.4, 1.5, 1.9.

b. MPROC's Short-Term License Rights Do Not Permit It to Extract the Residual Value of the Intangibles.

Petitioner asserts that MPROC's license to use Medtronic US' intangibles constitutes a valuable intangible asset. Pet. Trial Memo, at p. 9. But licensee rights do not create ownership rights in the underlying intangibles. Further, use rights under a license come with the obligation of paying arm's length royalties, and it is the net value of the license that is relevant.

Here, the short-term and limited nature of the rights granted to MPROC belie characterization as a valuable or unique asset that would prevent treating MPROC as a tested party. See Coca-Cola, 155 T.C. at 253-54; Ex. 6201-R at ¶ 99 (Cockburn); RTr. 2799:1-18 (Becker) (All else equal, a short-term agreement where the parties have the ability to reset the terms sooner than under a long-term agreement, lowers a licensee's profit margin risk and its expected return.) Additional terms of the MPROC Agreement also limit MPROC's ability to independently exploit the licensed intangibles. Both parties are required to disclose and share all Know-How and Improvements with the other party. Ex. 10-J at §§ 4.1, 4.2. Upon termination, MPROC is prohibited from using or disclosing any confidential Know-How, Improvements, or other information it received from Medtronic US for six years unless the information were public or in MPROC's possession “in documentary form” prior to its disclosure to MPROC. Id. at § 4.3. Thus, in the years at issue, Medtronic US could command substantially all the residual profits because it owned all of the Intangibles including the Know-How necessary to manufacture the products — and, if the agreement were terminated, MPROC could not use any of Medtronic US' manufacturing intangibles unless MPROC had documentation showing that it already possessed such information; and petitioner offered no evidence that MPROC had any such documentation.

In sum, MPROC's short-term license rights did not cause it to “own valuable intangible property or unique assets that distinguish it from potential uncontrolled comparables.” See Treas. Reg. §1.482-5(b)(2)(i); Eaton Corp, v. Commissioner, T.C. Memo. 2017-147 (“The license agreements did not transfer any intangible assets.”).

c. No Evidence Supports Petitioner's Theory That MPROC Has Self-Developed Intangible Assets that are More Valuable than Those of the Comparables.

Petitioner contends that MPROC “developed and accumulated” significant manufacturing-process related intangible property in the form of know-how, process improvements, and workforce in place,⁴³ and by trial, added goodwill. But petitioner offered no evidence of how MPROC could have developed decades' worth of nonroutine manufacturing intangibles during its 4-5 years of existence, or how such intangibles could have significant value given the terms of the MPROC Agreement limiting MPROC's ownership and use. And regardless, petitioner has offered no evidence as to how MPROC could generate profit from such purported self-developed nonroutine intangibles that somehow exceeds the significant returns already provided through Dr. Heimert's CPM, as reflected in the Comparables, which engaged in similar process manufacturing.

Further, petitioner claimed and the Court agreed that no intangibles were transferred to MPROC at its creation in 2001 that were subject to section 367(d) — including know-how. Medtronic I at *139-43; PF 191-91. Petitioner never shows how any other allegedly non-compensable intangibles were transferred to or could otherwise be exploited by MPROC much less permit it to reap the lion's share of the profits in 2005 and 2006.

Petitioner also fails to distinguish the value of any manufacturing-process related intangibles of MPROC from the value of the comprehensive suite of technology intangible assets owned by Medtronic US. Petitioner fails to demonstrate how, given Medtronic US' superior bargaining power and the strict limits on MPROC's use and retention of any self-developed intangibles, MPROC's intangibles could have any significant value as compared with Medtronic US' intangibles, or proportionately more value than the intangibles of the Comparables. RFF ¶¶ 701, 771, 947-49.

In any event, Dr. Hubbard also failed to consider the Comparables' assets in his analysis and offered no evidence that MPROC's so-called intangibles were more valuable than that of the Comparables. See Arg. III.B.1, supra.

2. Dr. Hubbard Failed to Follow the Best Method Rule.

a. Dr. Hubbard's Out-of-the-Gate Bias Against the CPM is Misplaced and His Requirement for Exact Comparability Violates the Regulations.

Under the best method rule, as discussed in the Introduction, “there is no strict priority of methods.” Treas. Reg. § 1.482-1(c)(1); Coca-Cola, 155 T.C. at 212. Again, either Dr. Hubbard's lack of transfer pricing knowledge or a notion that his expert view of economics should trump the section 482 regulations leads him out of the gate with an improper bias against the CPM and an erroneous opinion that the CUT method is superior. Ex. 6108-P at ¶ 8 (Hubbard); RTr. 1430:23-31:16, 1462:9-63:23 (Hubbard). Dr. Hubbard's CPM aversion may be attributable, in part, to his erroneous view, that the CPM requires exact comparability between comparables and a tested party as illustrated in the following colloquy:

[Respondent's Counsel] Q: Would you use a comparables method [the CPM] as a first choice in a transfer pricing case?

[Dr. Hubbard] A: I would think it's hard, because assuming you mean what I think you mean by the question, you're looking at data on firms, and firms are portfolios of things. And rarely am I going to find a portfolio [comparable] that looks exactly like the subject [tested partyl. So it would be hard to imagine wanting to start there unless I had to. . . .

RTr. 1463:13-23 (Hubbard) (emphasis added).

While not recognized by Dr. Hubbard, it is a fundamental tenet of transfer pricing that the CPM requires no such exactitude. Indeed, under the CPM “diversity in terms of the functions and products is permitted.” T.D. 8552, 59 FR 34,971 at 74, 1994-2 C.B. 93. In addition, the regulations permit adjustments, including adjustments to achieve accounting consistency, that can enhance comparability. Treas. Reg. § 1.482-5(c)(2)(iv).⁴⁴

Dr. Hubbard's erroneous view that a comparable should be “exactly like” the tested party (RTr. 1463:13-23) effectively precludes the use of the CPM to determine a royalty for the crown jewel intangibles in this case due to the vertically integrated nature of the medical device industry — but that interpretation is contrary to the regulations and the intent of the 1986 Act. The CPM regulations were promulgated in response to the Congressional concern that a recurrent problem is the absence of comparable uncontrolled transactions particularly where transfers of intangibles were concerned. Coca-Cola, 155 T.C. at 211; H.R. Rep. No. 99-426, at 423-24 (1985). In other words, the CPM was adopted because of the absence of comparable transactions — not to increase the bar for comparability. Coca-Cola, 155 T.C. at 225 (finding “the supply points were reasonably (albeit not perfectly) comparable in terms of 'resources employed'”); Treas. Reg. § 1.482-5(c)(2)(ii).

b. Dr. Hubbard Improperly Rejects the Comparables Without Properly Comparing Assets, Risks and Functions, and Never Performs the Required Best Method Analysis.

Dr. Hubbard performs a SIC code search for comparables to MPROC that mirrors Dr. Heimert's and finds no fault in Dr. Heimert's search methodology. However, he rejects the Comparables in one fell swoop because they are vertically integrated companies that perform functions in addition to those performed by MPROC. He never compared the additional functions, or the assets and risks of the Comparables to MPROC. He never performed any real transfer pricing analysis. RTr. 1598:9-99:6 (“[Y]ou were not asked to evaluate the difference in manufacturing quality between MPROC and [the Comparables]? A: Correct.”), 1601:2-02:2, 1604:24-05:4, 1627:18-28:9 (“[Y]ou never compared the risk borne by [the Comparables] to the risk borne by MPROC. . . . That's true.”), 1645:1-25 (Hubbard); see also RTr. 812:13-22 (Putnam). Thus, in addition to ignoring assets, Dr. Hubbard fails to perform a comparability analysis based on the factors set forth in section 1.482-1(d). As a direct consequence of these failures, Dr. Hubbard had no basis to consider the relative reliability of petitioner's purported CUT and the CPM, and no basis to perform the required “best method” analysis — an integral part of any transfer pricing analysis.

c. Dr. Hubbard Erroneously Applies an Expansive View of Comparability to Petitioner's Purported CUT and a Strict View of Comparability to Respondent's CPM.

Dr. Hubbard's critique of the size and scale of the Comparables illustrates his erroneous double standard on comparability. Dr. Hubbard claims that only one Comparable, C.R. Bard, has revenues comparable to MPROC's revenues and all the others have revenues that are too small or too large. Ex. 6108-P at ¶ 102 (Hubbard). However, in performing his own search, Dr. Hubbard uses a different standard and applies a $100 million sales screen, passing all the Comparables. RFF ¶ 844; RTr. 1518:20-24 (Hubbard).⁴⁵ Dr. Hubbard also finds no comparability issues when accepting the Pacesetter Agreement as a CUT even though MPROC's sales in 2005 ($2.6 billion) are more than 1,000% higher than Pacesetter's sales in 1994 ($231 million). RTr. 1519:17-20:15 (Hubbard).

Similarly, when criticizing Dr. Heimert's CPM, Dr. Hubbard argues he needs to “get at as close to the exact same business.” RTr. 1727:14-28:8 (Hubbard). With his own “wherewithal” analysis (see Arg. III.B.4.c.ii., infra) Dr. Hubbard applies his erroneous double standard again and finds it more than acceptable to use vertically integrated global companies that conduct research and distribution (in addition to manufacturing) to benchmark MPROC's credit rating and the interest rate it would pay on a loan. RTr. 1632:8-34:24 (Hubbard); Ex. 6330-R at 7394 (Hubbard). Along the same vein, Dr. Hubbard relies on Moody's research reports, and Moody's includes component manufacturers like Greatbatch in its comparability analysis of the medical device industry. RTr. 1634:25-35:13 (Hubbard); Ex. 6330-R at 7393. Dr. Hubbard has offered no reason why vertically integrated manufacturers can be used to benchmark arm's-length interest rates but not as comparables to benchmark a tested party under the CPM. RTr. 1726:10-28:8 (Hubbard).⁴⁶ In both cases, one is assessing how economic conditions of comparables impact risk.

Although concededly there are differences between MPROC and the Comparables, petitioner sets artificially high standards for comparability under the CPM that are inconsistent with the regulations.

3. No Evidence Supports Dr. Hubbard's Opinion that the R&D and Distribution Functions Performed by the Comparables Distort MPROC's Returns Under the CPM.

Dr. Hubbard asserts that because the Comparables perform more R&D and distribution activities than MPROC, the Comparables' ROAs may not reflect solely finished manufacturing returns and therefore, the CPM under-compensates MPROC. Dr. Heimert disproved this assertion. He showed that the ROAs for stand-alone distributors are so similar to the ROAs of the Comparables that removing the distribution activities would not significantly change the CPM results.

ROA (Range/Median) Results for Distributors vs. Comparables

	Range/Median (2005)	Range/Median (2006)
Distributors	10.1-44.8%/19.0%	13.2-45.3%/19.6%
Comparables	13.9-44.8%/28.1%	13.0-47.8%/26.0%

Ex. 6204-R at ¶¶ 101-02 and n.158; RTr. 2393:23-94:4 (Heimert).

In addition, as Dr. Hubbard agrees, R&D requires fewer assets than manufacturing, so R&D functions generate higher RO As than finished manufacturing, all else being equal, and thus, any distortion shows up as higher RO As that overcompensate MPROC. See also Coca-Cola, 155 T.C. at 226-29 (despite differences between comparables and tested parties, Court accepted IRS analysis that was conservative); Exs. 6204-R at ¶ 101, 6410-RD at p. 13; RTr. 2394:9-22 (Heimert).

In any event, petitioner has produced no analysis demonstrating that the difference in functions impacts comparability or operating profits earned. The Comparables passed an R&D screen that eliminated companies spending a high percentage of sales on R&D, and like MPROC, all the Comparables are manufacturers of medical devices and products. Ex. 5543-R atpp. 143, 187-90; RTr. 2458:20-24 (Heimert).

Finally, like the Comparables, Pacesetter performed sales and R&D activities. Ex. 6207-R at pp. 2-3 (Becker). Thus, any rejection of the Comparables based on these functional differences requires a rejection of the Pacesetter Agreement as a CUT because a CUT requires a higher level of functional comparability. Compare Treas. Reg. § 1.482-4(c)(2)(iii)(B)(2)(viii) (in assessing comparability of a proposed CUT, it is particularly relevant to consider the “functions to be performed by the transferor and transferee, including any ancillary or subsidiary services”) with Treas. Reg. § 1.482-5(c)(2)(ii) (comparability is particularly dependent on resources and risks, and less concerned about functions).

4. No Evidence Supports Petitioner's Critiques That MPROC Owns Assets, Incurs Risks, or Performs Functions Not Captured in Dr. Heimert's CPM.

a. Dr. Heimert's CPM Does Not Ignore Intangible Assets.

Petitioner criticizes Dr. Heimert's use of an ROA PLI on the ground that it fails to capture valuable intangible property that was developed by “MPROC and its predecessors [over the course of] three decades.” Ex. 6109-P at ¶ 53 (Hubbard); see also; Ex. 6103-P at 2362 (Cohen). As discussed above, MPROC's rights as a licensee under the MPROC Agreement are short term and do not rise to the level of an ownership interest of a valuable intangible asset. Arg. III.B.1.b. Heimert performed a market-to-book ratio analysis of the Comparables showing that all of them owned non-book intangible assets.⁴⁷ RFF ¶¶ 905-07. He explained that returns for intangible assets exploited by the Comparables (and any risks they assume) are embedded within the profits (the ROA numerator) earned by each Comparable whether those intangibles are acquired or self-developed. Therefore, the benchmark RO As calculated under the CPM include returns to intangible assets owned by the Comparables. Ex. 6203-R at ¶¶ 77-78; RTr. 2376:5-78:3 (Heimert).⁴⁸

Dr. Hubbard critiqued Dr. Heimert for following the regulations in relying on book values for his PLIs, but he failed to conduct an actual transfer pricing analysis and consider whether and to what extent the exclusion of non-book intangible assets from the calculation of operating assets impacted comparability between MPROC and the Comparables. Dr. Hubbard admitted that with the proper comparables, Dr. Heimert's CPM using an ROA that excludes intangibles from the denominator could be a workable solution that avoids measurement issues related to intangible assets (Ex. 6109-P at ¶ 57) and that he would expect MPROC's high-quality manufacturing ability to show up as part of the excess of its market over book value. RTr. 1648:9-15 (Hubbard). But he did no analysis to determine why the market to book ratio for the Comparables was greater than one (he testified that he didn't think he needed to) or otherwise analyze the Comparables' non-book or intangible assets. RTr. 1647:20-48:1. Dr. Hubbard also agreed that any returns to intangibles possessed by the Comparables are captured in Dr. Heimert's ROA calculation. RTr. 1646:1-8. Thus, these returns are attributed to MPROC under the CPM thereby treating MPROC as effectively owing a similar level of non-book intangibles. Ex. 6203-R at ¶¶ 76-79 (Heimert). Mr. McCoy agreed that Dr. Heimert's Comparables had goodwill and know-how embedded in their people and processes as well as workforce in place. RTr. 198:12-99:6 (McCoy). By relying on comparables with returns attributable to intangibles, Dr. Heimert's CPM reliably accounts for any intangibles possessed by MPROC.

b. Dr. Heimert's CPM Captures MPROC's Quality and Self-Insurance Contributions.

Petitioner argues that MPROC has two nonroutine contributions, quality manufacturing and product liability self-insurance (i.e., the assumption of product liability risk), but offers no transfer pricing analysis in support. RTr. 1595:13-19 (Hubbard). Dr. Hubbard never performed the required analysis to compare MPROC's quality manufacturing and self-insurance risks to the Comparables to determine whether the contributions were “routine” or “nonroutine” under the regulations. Because he rejected the Comparables for having distribution and research functions, he never reached that step in his analysis. RTr. 1597:10-98:3 (Hubbard).

A proper transfer pricing analysis demonstrates close comparability between MPROC and the Comparables for both quality manufacturing and product liability self-insurance. Section 1.482-6(c)(3)(i)(A) defines “routine contributions” as“contributions of the same or a similar kind to those made by uncontrolled taxpayers involved in similar business activities for which it is possible to identify market returns” and “ordinarily include contributions of tangible property, services and intangible property that are generally owned by uncontrolled taxpayers engaged in similar activities.” Section 1.482-6(c)(3)(i)(B) refers to all other contributions as “nonroutine.” A “routine” designation means that the contributions of the tested party can be benchmarked using comparable company financial outcomes. Ex. 6203-R at ¶ 74 (Heimert). The designation does not diminish the importance of a company's contributions or imply that a company does not possess any intangibles. Id. The evidence shows that MPROC's quality and product liability self-insurance contributions are routine risks or contributions that can be reliably benchmarked with the Comparables.

i. Quality is Key for Both MPROC and the Comparables.

Quality is a key driver of success for both MPROC and the Comparables, and indeed, a key driver of success for all companies that compete within the medical device field. The Comparables manufacture medical devices under the same FDA quality manufacturing standards as MPROC. Like MPROC and all medical device manufacturers, the Comparables must satisfy the high-quality manufacturing requirements imposed by the FDA's Quality System Regulations (QSR). RTr. 2839:21-40:3, 2841:18-42:18 (Crosby), 2480:4-8 (Heimert); Ex. 6203-R at ¶ 86 (Heimert). Quality manufacturing in the medical device industry is required of all and is not a unique contribution by MPROC. RFF ¶¶ 848, 854.

Petitioner's suggestion that respondent's experts contradict this Court's previous findings on quality is simply wrong. Medtronic I does not include findings that MPROC's Quality Management System (QMS) is unique or a differentiator in the medical device industry or that MPROC is solely responsible for product quality. RTr. 2986:19-90:15 (Crosby). Indeed, respondent's experts recognize MPROC's high level of manufacturing expertise. RTr. 2067:15-68:5 (Cockburn), 2631:23-32:12 (Becker), 2491:1-6 (Heimert), 2994:3-5, 2987:22-88:2, 2990:5-9 (Crosby).

Further, MPROC's role in product quality is not a valid basis for this Court's rejection of Dr. Heimert's CPM analysis.⁴⁹ The record does not support a finding that the Comparables were less concerned with quality than MPROC. Significantly, Dr. Heimert considered this Court's critique of his CPM in Medtronic I, reiterated his understanding that MPROC's manufacturing activities are “very important,” but maintained that such activities did not constitute a nonroutine contribution differentiating MPROC from the Comparables. RTr. 2491:21-24 (Heimert); RFF ¶¶ 847, 850, 854, 857. As discussed below, Dr. Heimert's CPM analysis of a subset of the Comparables that manufacture “implantable” medical devices confirms his CPM results.

Dr. Hubbard is not an expert in manufacturing or quality and either relies on assumptions⁵⁰ or other witnesses to support his opinion that MPROC's high-quality manufacturing is a nonroutine contribution. RTr. 1474:10-11 (Hubbard), 1474:12-76:23 (peer review of Putnam), 1605:20-24 (reliance on Collins); Ex. 6109-P at ¶¶ 28-29, 36 (reliance on Cohen). But Dr. Cohen is not a manufacturing expert either (RTr. 440:8-10, 448:4-50:6), and Mr. McCoy offered no opinion on the relative contributions of Medtronic US and MPROC to manufacturing high-quality products; he testified that R&D, including regulatory and clinical, were also required to manufacture at a high velocity. RTr. 148:1-49:3 (McCoy). Moreover, the opinions of petitioner's experts are inconsistent. Dr. Hubbard portends a difference between life-sustaining and life-improving devices, but petitioner's industry experts opined that manufacturing CRM (life-sustaining) and Neuro (life-improving) products is similar and that different royalty rates for these different categories would not be justified. Ex. 6103-P at 2368 (“Both sets of products require the highest level of quality manufacturing”); RTr. 706:10-08:5 (Cohen), 98:13-99:24 (McCoy). And there is no evidence that Greatbatch manufactured at a different level of quality than MPROC. Dr. Hubbard did not know what “different level of quality” means and admitted that quality is normally defined or measured with respect to some kind of defect rate or result rate, information none of petitioner's experts reviewed. RTr. 1614:22-15:25 (Hubbard); entire record. Most significantly, Dr. Hubbard never compared the quality functions of MPROC to those of the Comparables.

Finally, Dr. Hubbard excludes companies that were not manufacturers of Class III medical devices “comparable to those manufactured by MPROC.” RTr. 1529:16-21. (Hubbard). Even under Dr. Hubbard's assumptions, the 10 Comparables that pass this screen therefore must have the same high-quality manufacturing as MPROC. RTr. 2524:15-26:14 (Heimert). The record establishes no difference in quality standards to show that MPROC provides nonroutine contributions through its finished manufacturing operations that would preclude it from being benchmarked by the Comparables or any subset of the Comparables.

ii. The Implantables Confirm the Results of Dr. Heimert's CPM.

In response to the Court's critique that the Comparables did not produce medical products subject to the same level of FDA scrutiny as MPROC's Class IIIimplantable medical products (Medtronic I at *109), Dr. Heimert divided the Comparables into two groups — those that produced implantable medical products (Implantables), and those that did not. RTr. 2378:12-79:1; Ex. 6203-R at ¶¶ 99-100 (Heimert). Applying the CPM using the Implantables, Dr. Heimert determined that the arm's-length range of the ROAs and implied royalties was consistent with that of the full set of Comparables and that the Implantables have a limited impact on the royalty rates derived by his CPM.⁵¹ More importantly, MPROC's returns significantly exceed the range of returns earned by the Implantables:

ROA Results for Implantables vs. AU Comparables

ROAs (Min-Max)	Range/Median (2005)	Range/Median (2006)
Implantables	14-45%/40%	13-48%/41%
All Comparables	14-45%/28%	13-48%/26%
MPROC (Reported)	152%	218%

Exs. 6203-R at ¶¶ 100-101, 103, Tables 15-17, 6410-RD at p. 9; RTr. 2383:9-18 (Heimert).

c. MPROC's Risks are Similar to Those of the Comparables.

In applying the CPM, adjustments may be made if there are differences between a tested party and the comparables that would materially affect the profits determined under the relevant PLI. Treas. Reg. §§ 1.482-5(c)(2)(iv), -1(d)(2). This includes, if necessary, adjustments to reflect differences in risk, including product liability risks. See Treas. Reg. § 1.482-1(d)(3)(iii)(A)(5).

No such material difference exists here with respect to product liability risk. The parties' experts agree that all the Comparables bore product liability risk and that product liability events occur across the entire spectrum of medical device companies, not just CRM or Class III medical device companies. RTr. 187:22-88:9, 201:5-14 (McCoy), 3026:14-27:12 (Crosby). The record is replete with evidence concerning product liability events involving both Class III and nonClass III medical devices, including product liability amounts of $112 million for bone screws, $780 million for hip replacements, $3 billion for IUDs, and $10 billion for breast implants. Ex. 2922-P at 8554-56; RTr. 204:16-6:2 (McCoy).

In performing his CPM analysis, Dr. Heimert concludes that MPROC's product liability risk was “routine” because the risk can be benchmarked with the Comparables. RFF ¶ 862; RTr. 1596:14-24 (Hubbard). All the Comparables bore significant product liability risk and purchased insurance and/or maintained reserves to manage such risk. Indeed, just as Medtronic does, many of the Comparables disclosed the “inherent” product liability risk that existed with respect to medical devices in their public financials such as Forms 10-K. RFF ¶¶ 858-59.

i. Overall Product Liability Risk Does Not Differ Between Life Improving and Life Sustaining Products.

Petitioner makes bald assertions that manufacturers of Class III medical devices such as MPROC bear greater product liability risk than other medical device manufacturers suggesting that MPROC's self-insurance of such risk was nonroutine and not amenable to being benchmarked to the Comparables. See, e.g., Ex. 6108-P at ¶ 83 (Hubbard). Petitioner has offered no economic analysis or quantitative data to back up its claim that product liability risk differs based on FDA classification or to examine the probabilities associated with that risk. Mr. McCoy based his opinion that a product liability event is more likely with a CRM product solely on his “judgment,” knew little about large product liability risks associated with hip replacements and acknowledged that he failed to review any data regarding the product liability risks borne by the Comparables. RTr. 161:20-62:11 (McCoy). Similarly, Dr. Hubbard acknowledged that he did not know whether product liability claims differed between classes of medical products either in total costs or number of claims, and that he had not attempted to quantify the likelihood of a severe product liability event. RTr. 1406:25-07:6, 1626:3-30:17 (Hubbard).

The Comparables all manufactured high-quality medical devices based on the QSR standards. RFF ¶¶ 849-50. Risk difference in Class III devices relates to R&D risk — the risk that R&D will not lead to an FDA approved and successful product — not manufacturing. RTr. 2842:2-18 (Crosby). The risk associated with the R&D effort is borne by Medtronic US, which bears 99.8% of R&D costs. RFF ¶ 817.

Petitioner also confuses the issue by suggesting that the product liability risk faced by a firm is directly correlated to the risks to a patient. But the consequences of a product recall may impact a company differently than a patient. RTr. 3028:24-29:22 (Crosby). Companies that made orthopedic devices faced multi-billion-dollar class-action lawsuits, despite that there were only a couple hundred patients who were affected and these were not life-threatening defects. The risk that a hip implant will lead to a class-action lawsuit of several billion dollars as it did for Smith & Nephew is not less than the risk that an ICD lead will lead to a classaction lawsuit — which in Medtronic's case cost it a few hundred million dollars. RFF ¶ 860. Significant risks to the firm exist in both cases. Further, the distinction between life-improving and life-sustaining devices is artificial because by the years at issue, most pacemakers were life improving devices. RTr. 2838:5-39:13 (Crosby). All of the Comparables need to maintain quality manufacturing knowhow and a quality management system that can continuously produce high-quality products and control risk. RTr. 2845:2-17 (Crosby).

ii. Petitioner Overstates MPROC's Product Liability Risks.

Even if a product liability adjustment were required and MPROC incurred 100% of the product liability risk for Medtronic (see Arg. III.C.4.e.i., supra for why MPROC does not), this adjustment would be capped by: (1) MPROC's ability to take on Medtronic's product liability risk, and (2) Medtronic's expected insurance costs to offset that product liability risk in 2005 and 2006.

Mr. Braithwaite, an actuary and insurance industry expert, determines that MPROC's maximum limit of coverage for any large event would be equal to its book value of equity or $450 million. Ex. 5522-R at ¶¶ 5, 54 (Braithwaite); Tr. 6535:23-37:14 (Braithwaite) (“they are the most real numbers we have.”) At this maximum limit of coverage, Mr. Braithwaite estimates MPROC's product liability costs at $25.2 million in 2005 and $26.2 million in 2006. Ex. 5522-R at ¶ 8 (Braithwaite). In contrast, Dr. Hubbard, who is not a product liability expert, opines on MPROC's “wherewithal” to insure Medtronic's product liability risk. RTr. 1408:7-10 (Hubbard).⁵² Dr. Hubbard's conclusion that MPROC had the ability to pay a $3 billion dollar judgment depends on disregarding MPROC's payment of $1.5 billion in dividends to its Swiss parent. Ex. 6157-P at ¶¶ 74-75 (Hubbard) (Sealed); RTr. 1658:25-61:9 (Hubbard).⁵³ But the regulations reject allocating risk to an entity in excess of its present equity capital and borrowing capacity. Treas. Reg. § 1.482-1(d)(3)(iii)(C), ex. 2. The remainder of Dr. Hubbard's analysis is circular because MPROC's ability to pay also depends on Medtronic's transfer pricing. RTr. 2627:21-29:7 (Becker), 1671:21-72:13 (Hubbard).

Petitioner not only greatly overestimates MPROC's ability to bear risk, but also vastly overestimates the amount of product liability Medtronic would insure. In deciding on whether to self-insure, Medtronic US estimated that it could purchase about $500-700 million in liability insurance at a cost of $20-35 million a year with a deductible of $150-200 million in line with industry peers. RFF ¶ 937. Medtronic US rejected this product liability insurance, as it continued “to believe these prices are too high in comparison to the relatively small value they bring to Medtronic.” Exs. 2272-J at 9229-30, 2271-J at 9221, 2301-J at 9099.

Despite this low opinion of the value of product liability insurance, Mr. Dowden opined that MPROC would provide product liability self-insurance to Medtronic of $3 billion at a cost of $220-235 million per year based on a product liability insurance proposal floated by Berkshire Hathaway. Mr. Dowden's analysis has no economic basis because there is no evidence that anyone accepted Berkshire Hathaway's proposal to provide insurance. At the time, Medtronic rejected the offer as completely unreasonable, as it was “beyond reason.” Ex. 2301-J at 9100; Tr. 3785:13-25 (Nelson). Using an unaccepted offer as the basis for valuation is error.⁵⁴

Even if $3 billion were a real figure reflecting Medtronic's real risk (which it is not), Mr. Dowden's calculation of insurance cost of $200-$235 million did not reflect the commercial reality that companies purchasing product liability insurance only insure a middle tier of potential losses and self-insure for the rest.⁵⁵ A commercially insured company continues to bear the risk for a retention amount (which operates much like a deductible) as well as any catastrophic losses above the level of coverage provided by the product liability insurance. RFF ¶ 863. In essence, a company that purchases product liability insurance self-insures for the retention amount and catastrophic losses and pays for insurance only to cover losses between those two amounts. Exs. 6204-R at ¶¶ 94-96, 6410-RD at p. 12 (Heimert); RTr. 2389:13-91:25 (Heimert). MPROC, like any comparable manufacturers that purchased product liability insurance, would self-insure for losses up to the initial retention amount and for catastrophic losses above the policy limits. RFF ¶¶ 935, 937. Indeed, the Comparables actually bear more risk than MPROC, as Medtronic US shares that risk (RTr. 1686:8-24 (Hubbard)), whereas the Comparables bear 100% of the product liability risk that is not insured.

iii. The CPM Can Be Adjusted for Product Liability Risk Differences.

The routine nature of product liability risk is further evidenced by the fact that it can be readily priced. RTr. 2488:16-89:23 (Heimert); Exs. 5522-R at ¶ 8 (Braithwaite), 5525-R at pp. 32-34 (Reichert). In the first trial, petitioner itself offered the opinion of Mr. Dowden, who priced the risk. Ex. 5480-P. If the Court finds that differences between MPROC and the Comparables with respect to product liability risk require adjustment, the record contains information on which to base an adjustment. Mr. Braithwaite opined that MPROC saved $25.2 million and $26.2 million per year for 2005 and 2006, respectively, by self-insuring rather than purchasing product liability insurance from third-party insurers. RFF ¶ 1889. Mr. Braithwaite's opinion is also consistent with the yearly insurance costs faced by Medtronic's industry peers of $20-35 million. Exs. 2272-J at 9229-30, 9235, 2271-J at 9221, 2301-J at 9099. This amount is quite small in relation to MPROC's expenses overall (2% or less) and can easily be incorporated into the calculation of a royalty by increasing COPs, thus reducing the royalties payable by MPROC by the same amount. RFF ¶ 934; Arg. III.F, infra.

C. Consideration of Medtronic's Realistic Alternatives Confirms that the CPM is the Best Method.

The regulations require an evaluation of realistic alternatives to a controlled transaction and specifically highlight the critical role of realistic alternatives in the evaluation of an unspecified method. Treas. Reg. §§ 1.482-1(d)(3)(iv)(H) and -1(f)(2)(ii)(A); see Arg. I.D, infra. This realistic alternative analysis is based on an economic theory that says a party does not enter a transaction if there is a realistic alternative with a better economic outcome for that party. RTr. 2374:11-75:17, 2398:22-25 (Heimert). It is not necessary that the realistic alternative has occurred. Rather, the analysis looks at the result of the prices charged in a controlled transaction and whether the costs and benefits of a realistic alternative would produce a better outcome, i.e., more profit. RTr. 2512:8-14:3, 2516:13-17:14 (Heimert); Ex. 6204-R at ¶ 4; RFF ¶¶ 944-45.

Dr. Heimert considered realistic alternatives as part of his best method analysis. Medtronic US had multiple realistic alternatives to using MPROC for manufacturing. RFF ¶ 949. During 2005-2006, Medtronic's manufacturingfunction was split between its U.S., Puerto Rican, and Swiss operations, which provided disaster back up for one another. RFF ¶¶ 951, 953-54

While Medtronic US could not immediately switch manufacturing to a different supplier, it would be able to do so (and likely would do so promptly) if MPROC insisted on receiving outsized returns for its contributions. RTr. 352:6-10 (McCoy), 2518:19-19:24 (Heimert); Ex. 6202-R at ¶ 55 (Cockburn). It also could have manufactured in a different Medtronic facility or built new production facilities. RTr. 2399:3-9; Ex. 6204-R ¶¶ 10-19 (Heimert). Medtronic US had produced leads in the United States and other Medtronic facilities could produce products. RTr. 2514:4-15:20 (Heimert). Medtronic US had established new manufacturing facilities in Switzerland (various IPG and ICD devices), Puerto Rico (leads and devices), and Singapore (leads and devices). RTr. 2400:2-01:7, 2514:4-15:20; Ex. 6204 at ¶¶ 10-19 (Heimert). And Medtronic US could have built another such facility over the course of 1.5 to 2.5 years for approximately $33.6 million, a small percentage of the profits that it would forego in licensing its intangibles to MPROC at petitioner's proposed royalty rate. Cf. Coca-Cola at 254-55 (new manufacturing facility demonstrated the replaceability and limited bargaining power of licensee); Ex. 6204-R at ¶¶ 17-18, n.30 (Heimert); RFF ¶¶ 963-66.

D. The CPM, Not Petitioner's CUT, Produces Reasonable Results.

The payment for a transfer of intangibles “must be commensurate with the income attributable to the intangible,” as section 482 requires. Treas. Reg. § 1.482-4(a). To evaluate the reasonableness of such a payment, the Court must consider the value of the parties' relative contributions — particularly the ownership of crown-jewel intangible assets — in generating the profit at issue. Notice 88-123, 1988-2 C.B. 458, 472; H.R. Conf. Rep. No. 99-841, 2d Sess., at 11-637 (“the objective of these provisions — that the division of income between related parties reasonably reflect the relative economic activities undertaken by each. . . .”).

As Dr. Heimert's ROA analysis⁵⁶ shows, the CPM leaves MPROC with a robust 27.1% average median ROA, while under petitioner's return position MPROC's profits are out of the ballpark, coming in at a level that leaves MPROC with an average 255.5% ROA. Ex. 6203-R, Fig. 4 (Heimert). With a 255.5% ROA, MPROC outperformed all the other medical device companies in Dr. Heimert's analysis and was seven times more profitable than Pacesetter. Medtronic itself was very profitable, earning an ROA of 55.9% and outperforming almost all the companies studied, but MPROC's ROA was about five times higher than that, reflecting the tax-avoidance shift of profits to MPROC. RFF ¶¶ 916-17. To further assess the results, Dr. Cockburn reviewed the ROAs of firms in manufacturing sectors other than SIC 384 that require precision manufacturing and are subject to significant (even fatal) consequences in case of a product failure. Triple digit ROAs (an annual return greater than one's asset base), as implied for MPROC by petitioner's, the Court's, and Dr. Putnam's CUT methodologies are almost never seen. RFF ¶ 915. Given that Medtronic US owns the crown jewel intangibles and MPROC does not, the results with the purported CUT make no sense.

Another financial barometer to illustrate the reasonableness of respondent's CPM and the unreasonableness of the results under petitioner's CUT is Pacesetter itself. The results of petitioner's CUT imply a cost mark-up for MPROC that is 6 to 8 times higher than Pacesetter's actual cost mark-up. RFF ¶ 927. Thus, Pacesetter itself shows that petitioner's purported CUT produces unreasonable and economically implausible results.

Dr. Heimert analyzes additional financial metrics which look at the relative contributions by MPROC as compared to Medtronic US and its subsidiary, Medtronic USA, and how they align with the split of the overall profits earned by the combined entities. Dr. Heimert's CPM divides the income such that approximately 93% of the profit is in the United States and 7% is in Puerto Rico for the combined years 2005 and 2006. Ex. 6204-R ¶ 116, Tables 8-9 (Heimert). As set forth in the chart below, this 93%/7% split of profit reasonably aligns with the intangible ownership and economic functions of both parties.⁵⁷ RTr. 2401:8-06:9, 2540:5-41:7 (Heimert), 2070:14-71:15 (Cockburn); Exs. 6410-RD atp. 18, 6204-R at ¶¶ 115-119, Tables 1,8-11, 6203-R at App. 2 (Heimert); RFF ¶¶ 395, 815-17, 920-22.

Medtronic's Assets and Functions	United States	Puerto Rico
Crown Jewel Intangibles	100%	0%
Value-Added Costs	90%	10%
R&D Costs	99.8%	0.2%
Total Employees	83%	17%
Total Salaries	94%	6%
Quality Employees	89%	11%
Engineers	96%	4%

In contrast, the purported CUT method, as applied by the Court or by petitioner on remand, awards 44% to 74% of the profits to MPROC and does not align with any of these metrics. Ex. 6204-R at Tables 8-9 (Heimert). This is a particularly unreasonable result here, where Medtronic US owned and developed the crown-jewel intangible assets, incurred 99% of the ongoing R&D costs, and licensed its intangibles on a short-term basis under terms that permitted Medtronic US to promptly capture increases in their profitability. The CPM results align much more closely to the relative economic contributions of the parties.

Looking closer at employee metrics, Dr. Heimert again confirmed that the CPM produces reasonable results and that the purported CUT does not. Using the split of profits under the CPM, the profit per MPROC employee in 2006 is $62,500 while the profit per U.S. employee is $204,000. Because MPROC employees tended to be factory and line workers, while highly compensated executives, scientists, and engineers worked for Medtronic US, these results are reasonable. RTr. 2405:6-06:9; Exs. 6204-R at ¶ 118, Tables 10-11, 6410-RD at p. 19 (Heimert).

Using the profit split under petitioner's CUT, however, the profit per MPROC employee is $765,000, while the profit per U.S. employee is only $53,000. Such an extreme disparity between the profits attributable to MPROC's factory line workers and highly compensated scientists and executives in the United States is strong evidence that petitioner's CUT does not produce reasonable results. RTr. 2405:6-06:9, 2542:2-23 (Heimert). There is simply no factual basis to conclude that a profit split attributing almost 15 times more profits to an MPROCline worker than an executive or scientist at Medtronic is reasonable. RFF ¶ 923.

E. The Use of the CPM in this Case is Supported by the CWI Amendment and Legislative History.

Recognizing that an excessive focus on identifying comparable transactions could detract from section 482's purpose to require reliable measurement of income, Congress added the commensurate with income clause (the CWI Amendment) to section 482 in 1986. H.R. Rep. 99-426, 99th Cong., 1st Sess. at 423-25 (1985); see also Altera Corp, v. Commissioner, 926 F.3d 1061, 1070 (9th Cir. 2019), cert, denied, 141 S.Ct. 131 (2020).

The CWI Amendment addresses the problem of myopic reliance on imperfectly comparable transactions by requiring that any section 482 adjustment with respect to transfers of an intangible “shall be commensurate with the income attributable to the intangible.” I.R.C. § 482 (emphasis added).

The CPM regulations were promulgated in 1994 to implement the CWI Amendment through a regulatory alternative to the transaction-based transfer pricing methods that Congress found were likely to be inaccurate, particularly in analyzing transfers of high-profit potential intangibles like the ones at issue here. Properly applied, the CPM ensures that the income from the transfer of an intangible is “commensurate with the income attributable to the intangible,” as required by section 482 and Treas. Reg. § 1.482-4(a) (third sentence).

The selection of the CPM in this case is consistent with Congress' 1986 intent and addresses the problem that assets comparable to the crown-jewel intangibles licensed to MPROC are rare or nonexistent by removing the licensed intangibles from the comparability analysis: with the CPM, the tested party (MPROC) does not own hard-to-value intangibles (or other unique assets) and therefore an arm's length price can be determined indirectly based on actual profit experience by simply subtracting from system profits the tested party's benchmarked or routine returns. Arg. III.A & III.B.1, supra. As a result, the accuracy of the comparability analysis is not affected by the asset being of a type for which comparable transactions generally do not exist. See Coca-Cola, 155 T.C. at 218 (stating, “[w]here controlled transactions implicated high-value intangibles . . . the most reliable transfer pricing method is often one that avoids any direct valuation of those intangibles”).

Moreover, the 1994 regulations' implementation of the CWI Amendment addresses the lack of reliability inherent in adjusting imperfect CUTs by (1) requiring an arm's-length determination using the method for which the most reliable data is available, and (2) recognizing that the data required for the CPM is generally more reliable than the data required for a transaction-based method such as petitioner's purported CUT where the assets licensed and relevant circumstances differ between the controlled and uncontrolled transaction (such as in the case of a controlled transfer of a unique intangible). See Treas. Reg. §§ 1.482-1(c)(2)(ii), -4(c)(2)(iii)(B)(2), -5(c)(3).

In sum, the selection of the CPM in this case executes the intent of Congress in adopting the CWI Amendment and satisfies the regulatory requirement that the arm's-length consideration determined under Treas. Reg. § 1.482-4 be commensurate with income. Treas. Reg. § 1.482-4(a) (third sentence).

F. How to Adjust the CPM.

In response to questions from the Court, suggestions were offered as possible modifications to Dr. Heimert's CPM results including changing the list of Comparables, determining Comparable Operating Profits using an upper quartile ROA instead of a median,⁵⁸ and adjusting to account for perceived differences in product liability risk between MPROC and the comparables selected. RFF ¶¶ 930, 934.

While respondent does not consider modifications necessary, such modifications require only simple mathematical computations. To illustrate, the Court could select the Implantables without Greatbatch as its comparables. Using the upper quartile ROA for these comparables (43.6% for 2005 and 47.4% for 2006) and the value of MPROC's operating assets ($393.0 million for 2005 and $424.2 million for 2006), the Court would determine that COPs were $171.4 million for 2005 and $201.1 million for 2006. RFF ¶ 932. These COPs are more than 65% greater than the COPs using the median ROAs for Dr. Heimert's Comparables. RFF ¶ 933.

Assuming arguendo that MPROC bore all product liability risk, the Court could also adjust COPs by the cost of product liability insurance that MPROC did not bear because it self-insured. As discussed, infra, these amounts are $25.2 million and $26.2 million in 2005 and 2006, respectively. Using the upper quartile ROA for the Implantables without Greatbatch, COPs increase to $196.6 million in 2005 and $227.3 million in 2006.⁵⁹ RFF ¶ 938. Subtracting COPs from MPROC's pre-technology royalty operating profits results in Technology Royalties under the MPROC Agreement of $1,090.7 million in 2005 and $1,728.2 million in 2006. RFF ¶ 941.

$ Millions	2005	2006	Formula
MPROC Pre-Technology Operating Profits	$1,287.3	$1,955.5	A
Comparable Operating Profit (Implantables w/o GB (UQ) + Prod. Liab. Adjustment)	$196.6	$227.3	B
Technology Royalties	$1,090.7	$1,728.2	C = A-B

These resulting royalty payments, in turn, can be converted into retail royalty rates of 40.7% in 2005 and 48.8% in 2006 by dividing them by third-party sales for the products at issue of $2,680.1 million in 2005 and $3,543.6 million in 2OO6.⁶⁰ RFF ¶ 942. The resulting share of total system profits for MPROC would be 14% in 2005 and 12% in 2006. RFF ¶ 943.

MPROC's Technology Royalties, calculated using the upper quartile ROA for the Implantables without Greatbatch, would leave MPROC with robust profits at the high end of the medical device industry, well above Pacesetter's profits, and close to those of Medtronic. See Arg. I. A. (histogram), supra. MPROC's share of profits under this approach (12%-14%) is almost 100% higher than MPROC's share of profits (6%-8%) using the median ROAs of Dr. Heimert's Comparables. RFF ¶¶ 919, 943. Moreover, unlike the results under petitioner's purported CUT and like the results under Dr. Heimert's CPM, these results align with the economic contributions of MPROC based on its value-added costs, numbers of employees, employees' salaries, and R&D investments.

G. Respondent's Section 482 Allocations are Not Arbitrary, Capricious, or Unreasonable.

The Eighth Circuit's remand mandate requires this Court to make findings of fact and provide analysis to support a section 482 determination. Medtronic II at 614-15. On remand, petitioner has the same dual burden it had in Medtronic I. First, it must prove that respondent's section 482 allocations are arbitrary, capricious, or unreasonable. Second, petitioner must prove that its own transfer pricing satisfies the arm's-length standard. Guidant LLC v. Commissioner, 146 T.C. 60, 73 (2016). The standard of proof on remand is the same as in the first trial. The Court should weigh any gaps in the record heavily against petitioner, “whose inexactitude is of (its) own making.” Cohan v. Commissioner, 39 F.2d 540, 544 (2d Cir. 1930); Eli Lilly & Co. v. Commissioner, 84 T.C. 996, 1148 (1985), affd in part and rev'd in part, 856 F.2d 855 (7th Cir. 1988).

To avoid its burden, petitioner inaccurately claims that respondent did not appeal this Court's conclusion that “petitioner has met its burden of showing that respondent's allocations were arbitrary, capricious, or unreasonable.” See e.g., Pet. Trial Memo, at p. 10. However, on appeal, the Commissioner argued that the four grounds articulated by this Court to support its “arbitrary, capricious, or unreasonable” conclusion “conflict with section 1.482-5 and the objective evidence in the record.” Brief for Appellant, Commissioner of Internal Revenue (BCIR) at p. 55. Thus, respondent did appeal Medtronic I's “arbitrary and capricious or unreasonable” conclusion. Specifically, the following provides each of this Court's grounds for its conclusion and where the Commissioner addressed said grounds:(1) Dr. Heimert's CPM analysis did not give appropriate weight to MPROC's “role in quality.” Medtronic I at *117, BCIR at pp. 56-7; (2) Medtronic I's rejection of the Comparables. Medtronic I at *110-11, BCIR at pp. 58-64; (3) the rejection of Dr. Heimert's use of the return-on operating-assets as a PLI. Medtronic I at *113-14. BCIR, pp. 64-6; and (4) Dr. Heimert's “unreasonable” allocation of 6-8% of the profit to MPROC. Medtronic I at *39, BCIR at pp. 66-9.

There is simply no legal support to limit this Court's review of its Medtronic I findings, determinations, rationales, or conclusions. See, e.g., Pet. Trial Memo, at pp. 96-97 (misstating the law concerning the scope of remand). On remand a trial court is free to revisit any issue that the circuit court did not expressly or impliedly decide. Quern v. Jordan, 440 U.S. 332, 347 n.18 (1979) (“While a mandate is controlling as to matters within its compass, on the remand a lower court is free as to other issues.”); Sprague v, Ticonic Nat. Bank, 307 U.S. 161, 168 (1939); Borchers v. Commissioner, 943 F.2d 22, 23 (8th Cir. 1991), affg 95 T.C. 82, 83 (1990); see also Marshall v. Anderson Excavating & Wrecking Company, 8 F.4th 700, 711-12 (8th Cir. 2021) (the trial court was free to address an issue, as nothing in the prior appellate opinion limited consideration of issue on remand). Further, on remand a trial court is bound by its own prior rulings and factual findings only to the extent that the appellate court explicitly or implicitly adopted those findings in resolving the appeal. In Re Tri-State Financial, 885 F.3d 528, 533 (8th Cir. 2018) (permitting a trial court to revisit its prior rulings not adopted by appeals court); Exxon Corp, v. United States, 931 F.2d 874, 878 (Fed. Cir. 1991).

The Eighth Circuit did not resolve any transfer pricing issue involved in this litigation. It did not opine on a correct transfer pricing methodology, or adopt any rulings or findings of fact made in Medtronic I. Therefore, on remand this Court is free to revisit any issue in this case and should reevaluate all aspects of Medtronic I. Borchers, 943 F.2d at 23, aff'g 95 T.C. 82, 83 (1990) (on remand re-examining the record and reversing the result in Borchers v. Commissioner, T.C. Memo. 1988-349, vacated and remanded, 889 F.2d 790, 791 (8th Cir. 1989)). This Court can and should now find that the CPM is more reliable than the alternative put forth by petitioner, that the CPM is the best method, and that respondent was not arbitrary, capricious, or unreasonable in using the CPM to adjust petitioner's income.

CONCLUSION

It follows that the determination of the Commissioner of Internal Revenue, as modified herein, should be sustained.

Date: November 19, 2021

DRITA TONUZI
Deputy Chief Counsel (Operations)
Internal Revenue Service

By:CURT M. RUBIN
Special Trial Attorney
Tax Court Bar No. RC0327
33 Maiden Lane, 12th Fl.
New York, NY 10038
Telephone: 646-259-8053
Curt.M.Rubin@irscounsel.treas.gov

JILL A. FRISCH
Senior Level Special Trial Attorney
Tax Court Bar No. FJ0677
Jill.A.Frisch@irscounsel.treas.gov