Transfer Pricing: Finite Valuation and Ranges (8/20/22)

        I have just started reading a tax, more or less, history, at least anecdotal history. Michael Keen, & Joel Slemrod, Rebellion, Rascals, and Revenue, (Princeton University Press 2021), here.   Early in my reading, something caught my eye because of a case I perused earlier in the day, Medtronic, Inc. v. Commissioner, T.C. Memo. 2022-84 (Decided 8/18/22), T.C. docket entry 74 at docket entries for the case here and GS here). I say I perused because the opinion is 75 pages (with three-page appendix of the experts’ brief biographies). I read closely only certain parts, including the part I discuss here. Medtronic involves transfer pricing for intangibles, which most commonly involve transactions between a U.S. taxpayer and a foreign affiliate offering opportunities to manipulate (lower) the U.S. tax base and thus achieve major U.S. tax “savings.”  The drill in these cases for the taxpayer is to lower the U.S. tax base and for the IRS to increase the U.S. tax base. That’s an oversimplification, but not much of one. The theoretical mechanism for achieving that is to peg the tax results of the related party transaction to a standard of an uncontrolled transaction between unrelated parties. This standard is notoriously difficult for intangible assets.

           Professors Keen and Slemrod offer a good tongue-in-cheek description (pp. xvi-xvii):

Many of the tax episodes we look at may at first seem far-fetched or ridiculous. Some are stories of disastrous missteps and cruelty. Some, we admit, teach no useful lesson that we can discern, but are just pleasingly gaudy and preposterous. But along with the follies there are also episodes of remarkable wisdom. For it is a theme of the book that, when it comes to designing and implementing taxes, our ancestors were addressing fundamentally the same problems that we struggle with today. And they were no less ingenious—not just in creating taxes, but also in avoiding and evading them—than we are. We should not feel too superior to our forebears, given the taxes we have nowadays. The idea of taxing chimneys may seem quaint to us. But we suspect our descendants will find some of the things that we do today more than a little peculiar, such as taxing multinationals by trying to figure out what some entirely different and hypothetical set of companies would have done in the unlikely (possibly inconceivable) event that they found themselves in the same circumstances. And they would be right.

        My observation of transfer pricing over the years is that these transfer pricing cases are just valuation cases, with a lot of zeroes to justify litigation with a lot of commotion to prompt a lot of legal and expert fees. My anecdotal observation of this type of case over the years is that many unnecessary legal and expert fees are generated in litigating them. But that is another story. 

        For now, I want to focus on Medtronic (this opinion rather than the earlier Tax Court and Eighth Circuit opinions, Medtronic, Inc. v. Commissioner, T.C. Memo. 2016-112 (sometimes Medtronics I), vacated and remanded, T.C. Memo. 2016-112, 900 F.3d 610 (8^th Cir. 2018) (sometimes Medtronic II). As an aside, the petition in the Medtronic case was filed in 2011, Medtronic I was decided in 2016, Medtronic II was decided on August 18, 2018, and Medtronic III was decided 8/16/18, and Medtronic III was decided on remand is dated 8/18/22. Interesting.

        I don’t propose a detailed analysis of Medtronic III. I don’t think that would be particularly enlightening to readers (or to me). I will focus on the bottom line claim of Chief Judge Kerrigan in her final conclusions. (T.C. Memo. 2022-84, Slip Op. pp. 65-72.)  Judge Kerrigan concludes (p, 72, bold-face supplied):  “In Medtronic I we concluded that the blended wholesale royalty rate was 38%, and after further trial, we conclude that the wholesale royalty rate is 48.8%, which we believe is the right answer.”

        Yep, there you have it, Judge Kerrigan reached a finite “right answer.”  

        I recently published an article on valuation in tax cases, John A. Townsend, Townsend, Burden of Proof in Tax Cases: Valuation and Ranges — An Update (2020). 73 Tax Lawyer 389, 2020, Available at SSRN: https://ssrn.com/abstract=3599481. In that article, I argue that, in complex valuation cases, determining a finite valuation (including finite transfer pricing royalty rates) is an impossible or certainly a rare phenomenon. I argue that a court may be able to determine reasonable ranges for bottom-line valuations or the components entering the bottom-line valuations. Consider that in the context of the quote above: “we conclude that the wholesale royalty rate is 48.8%, which we believe is the right answer.”

        My conclusion is based on my experience in handling this type of valuation, starting with Liberty Loan Corporation v. United States, 498 F.2d 225 (8th Cir. 1974) (§482 issue), while in DOJ Tax Appellate and Columbia Products Company v. United States, 404 F. Supp. 276 (D. S.C. 1975) (constructive sales price for manufacturer’s excise tax – similar to §482) (briefing and oral argument on motion for summary judgment), while in DOJ Tax Refund 2, and then carrying forward to representing taxpayers in 482 cases in audits and litigation, all of which settled without litigation.

        Early in the article (p. 394), I quote this astute observation from the Delaware Court of Chancery, which handles many high-profile valuation cases (Cede & Co. v. Technicolor, Inc., 2003 WL 23700218, at *2 (Del. Ch. Dec. 31,  2003, as revised July 9, 2004), aff’d in part, rev’d in part, and remanded, 884 A.2d 26 (Del. 2005) (emphases in the original):

[I]t is one of the conceits of our law that we purport to declare something as elusive as the fair value of an entity on a given date . . . . [V]aluation decisions are impossible to make with anything approaching complete confidence. Valuing an entity is a difficult intellectual exercise, especially when business and financial experts are able to organize data in support of wildly divergent valuations for the same entity. For a judge who is not an expert in corporate finance, one can do little more than try to detect gross distortions in the experts’ opinions. This effort  should, therefore, not be understood, as a matter of intellectual honesty, as  resulting in the fair value of a corporation on a given date. The value of a corporation is not a point on a line, but a range of reasonable values, and the judge’s task is to assign one particular value within this range as the most reasonable value in light of all the relevant evidence and based on considerations of fairness.

        I then say (pp. 394-395, footnotes omitted):

Conventions can be used to determine the fair market value within a range. An oft used convention is to split the difference. But the split and the result are arbitrary, not an actual finding of the fair market value. It is simply a convention to determine what serves, at best, as an approximation that might be deemed the fair market value. That or some other convention could be adopted for judicial determinations of value, but, as far as I am aware, no such convention has been adopted to resolve tax cases (other than in some [*395] contexts such as publicly-traded stock noted above). Rather, in tax cases (and I suspect nontax cases) the quest is to determine the value based on persuasion, rather than using a  convention to force the value. Ranges do not express the value, but, instead, provide the high and low values based on persuasion.

When a jury is the trier of fact as to value, the jury may pick the value from within a range of values based on the evidence introduced and need not explain its  choice. If the jury determines a value outside the range the trial court or appellate court believes a reasonable jury could find, the jury’s determination will and should be rejected, but the jury can pick any value within the range for any reason without explanation or risk of reversal.

When judges are triers of fact, however, they must explain their determinations of value. But, the concept of a range necessarily means that the judge cannot determine and explain a persuasive reason for selecting a particular value inside that range. In such a situation, the judge should select the value at one of the ends of the range based on the allocation of the burden of persuasion between the parties. Consequently, the judge need only determine the  appropriate range for valuation. The case can then be resolved simply by deciding which party bears the burden of persuasion.

I then develop the argument in the balance of the article.

To illustrate the concept, assume Judge Kerrigan determined that the range of reasonable royalty rates based on persuasion was between 50% and 47%, with the phenomenon of equipoise between those two ends of the range. Keep in mind that the ends of the range is illustrative only. She could (and I think should) then pick the end of the range favoring the party not bearing the burden of persuasion. The argument is more complex than that, but that is the guts of it.

I question whether Judge Kerrigan determined a finite rate without some arbitrary determination, perhaps picking a point between the parties’ contentions as refined on reconsideration on remand. She said that she did make a finite determination, and I am sure that she thinks she did. I wonder if that is what she did rather than deploying some convention or just a gut feeling to split the difference, perhaps not in the middle (too obvious) but at a point she could not (certainly did not) articulate based on persuasion.