Transfer Pricing and Foreign Legal Restrictions: 3M Co. v Commissioner Ruling
March 27, 2023
Foreign legal restrictions have often been a source of confusion for multinational taxpayers, particularly in countries such as Brazil, whose transfer pricing regulations seemingly depart from the arm’s-length principal by capping royalties and setting ranges for tangible transfers. This has led to disagreements between taxpayers and the Internal Revenue Service (IRS) about the impact of foreign legal restrictions on the arm’s-length amount to be recognized in controlled transactions. On February 9, 2023, the Tax Court sided with the IRS in 3M Co. v Commissioner, upholding requirements in Treas. Reg. Sec. 1.482-1(h)(2) regarding when a taxpayer may consider foreign legal restrictions for determining the arm’s-length amount in a transaction between controlled taxpayers.
Background on 3M
The issue arose due to a licensing arrangement 3M Company (3M) had with their Brazilian subsidiary beginning in 2006, that allowed 3M to use certain trademarks. Brazilian domestic law capped the royalty permitted at 1% as the maximum amount allowable for the Brazilian subsidiary to remit to its related party licensor, 3M. The IRS argued that pursuant to Section 482 regulations, an arm’s-length royalty was 6% and 3M should have reported an additional $27.8 million of royalty income from its Brazilian subsidiary.
Treas. Reg. Sec. 1.482-1(h)(2) provides that the IRS will respect the effect of a foreign legal restriction only if the foreign legal restriction:
- Is publicly promulgated.
- Applies equally to controlled and uncontrolled taxpayers.
- Prevents the payment or receipt of an arm’s-length amount in any other form.
This so-called blocked income regulation further requires that the taxpayer exhausts all available remedies for obtaining a waiver of the foreign legal restriction and may not enter any arrangement with the effect of circumventing the restriction.
Tax Court Ruling
The Tax Court was split (9-8) on their decision that upheld the requirements under Treas. Reg. Sec. 1.482-1(h)(2), which must be met before the IRS “will take into account the effect of a foreign legal restriction” under Section 482 and found that Brazilian legal restrictions at issue in the case did not satisfy such requirements. Given the closeness of the decision, the case will likely be appealed and the long-running dispute over blocked income will continue.
Future International Transfer Pricing Impacts
It should be noted that in late December 2022, the Brazilian government announced drafted legislation that would radically change their transfer pricing rules, conforming them to the internationally accepted arm’s-length principle under the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines. If passed into law, the new rules would come into effect on January 1, 2024, and may mitigate the blocked income issue for many taxpayers going forward, at least regarding intercompany transactions in Brazil.
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