The recent ruling by the Eighth Circuit Court of Appeals in the case of 3M Company v. Commissioner of Internal Revenue (No. 23-3772) sets a significant precedent in the interpretation of Section 482 of the U.S. Internal Revenue Code. The Court determined that the Internal Revenue Service (IRS) cannot reassign to the taxpayer (3M) royalty income that a foreign subsidiary cannot legally transfer to its U.S. parent due to restrictions imposed by foreign law.
This case underscores the need to consider foreign legal restrictions when applying transfer pricing rules, especially in an increasingly interconnected and regulated global tax environment.
Case Facts
In fiscal year 2006, 3M Company, a U.S. parent company, reported royalty income from its Brazilian subsidiary, 3M do Brasil Ltda. However, Brazilian law imposed a cap of USD 5.1 million on royalty payments to foreign entities. As a result, 3M do Brasil paid only that amount to its parent company.
Subsequently, the IRS issued a Notice of Deficiency, arguing that 3M should recognize approximately USD 23.7 million in additional royalty income, based on what an unrelated entity would have paid for the use of 3M’s intellectual property. The IRS applied Section 482 of the Internal Revenue Code, which allows for the reallocation of income between related entities to reflect market prices.
3M challenged this determination in the U.S. Tax Court, arguing that Section 482 does not allow for the reallocation of income that cannot legally be received due to foreign restrictions.
Tax Court Decision
The U.S. Tax Court ruled in favor of the IRS, determining that Brazilian law did not prevent 3M from receiving the additional income. The Court applied IRS regulation 26 C.F.R. § 1.482-1(h)(2), which allows for the reallocation of blocked income if the foreign restrictions do not meet certain recognition criteria.
The Court also rejected 3M’s argument that the IRS regulation violated the Administrative Procedure Act (APA) by not being properly promulgated.
Eighth Circuit Court of Appeals Decision
The Eighth Circuit Court of Appeals reversed the Tax Court’s decision, ruling that Section 482 does not authorize the IRS to reallocate income that a company cannot legally receive due to foreign restrictions.
The Court based its decision on the principle that for “income” to exist under tax law, the taxpayer must have “complete control” over that income, i.e., it must be money that “could have been received.” Since 3M could not have received the additional income due to Brazilian law, the Court concluded that it could not be considered income subject to taxation in the U.S.
In addition, the Court applied the precedent set in Loper Bright Enterprises v. Raimondo (2024), which limited judicial deference to government agency interpretations, strengthening 3M’s position.
Implications for Transfer Pricing Practice
This ruling has important implications for transfer pricing practice and international taxation:
Restriction of IRS Authority
The ruling limits the IRS’s ability to reallocate income that a company cannot legally receive, establishing that it can only be done with income that the taxpayer has the legal ability to receive.
Review of Existing Regulations
The case suggests that IRS regulations must align with foreign legal restrictions and cannot impose taxes on income that cannot be legally received.
Precedent for Future Cases
This case sets a precedent for future tax disputes involving blocked income and the application of Section 482, especially in situations where foreign laws limit payments between related entities.
International Tax Planning
The decision reinforces the need to incorporate the legal and regulatory analysis of the receiving country as an integral part of transfer pricing documentation and strategy, minimizing the risk of subsequent adjustments.
Conclusion
The case of 3M Company v. Commissioner of Internal Revenue establishes an essential criterion for transfer pricing practice: the valuation and reallocation of income under Section 482 must consider not only economic and comparability principles, but also legal restrictions in the jurisdiction of origin of the income. This precedent reinforces the complexity of international taxation, demonstrating that transfer pricing policies cannot be designed exclusively from a domestic perspective, but must integrate a multinational legal and regulatory analysis.
Is your company ready to optimize its transfer pricing?
At TPC Group, we have specialized experience in transfer pricing and tax compliance in Latin America, the United States, and Spain. Our team supports multinational companies in interpreting complex regulations, integrating technical and strategic analysis, and optimizing their transfer pricing policies.
We boost your competitive advantage: protect your international operations and comply with global standards.
Contact us today for expert advice.
Source: TPCases