On February 9, the US Tax Court recently ruled in favor of the IRS in the “3M vs. the Tax Administration” case related to Transfer Pricing.
1. Background
The company has licensing agreements with its manufacturers related to 6% of the net sales of the local entity. In 1997, 3M and its Brazilian subsidiary, 3M Brasil, attempted to enter into similar agreements. In response, the Brazilian Patent and Trademark Office (INPI: Instituto Nacional da Propriedade Industrial – National Institute of Industrial Property), which registers intellectual property licensing agreements, argued that the fee a local subsidiary could pay to a foreign parent company was too high.
Therefore, both companies entered into three licensing agreements the following year, in which 3M Brazil agreed to pay 3M a 1% royalty for each of the three trademark licensing agreements. Consequently, the maximum amount of royalties that 3M Brazil would remit to 3M was less than the royalties remitted by other related manufacturers.
In 2006, 3M Brazil paid $5.1 million in royalties to 3M along with $64.5 million in dividends. Therefore, the IRS argued that the royalty rate should have been 6%, aligned with the other related party manufacturing agreements, and applied a Transfer Pricing adjustment.
2. Relating Matters
In this case, two main issues were in dispute:
- Can the IRS use Section 4822 to allocate additional royalty income to 3M?
- Was the Treasury Regulation, Article 1.482-1(h)(2), which specifies when and how foreign legal restrictions will be considered to adjust Section 482, valid or not?
3. Company’s Position
First, 3M cited Brazilian restrictions and regulations to argue that the IRS cannot allocate income to a taxpayer that has not received and cannot receive that income due to domestic law precluding its payment. Second, 3M argued that the aforementioned article was invalid due to non-compliance with proper administrative procedures.
4. IRS Position
First, the IRS argued that 3M Brazil had greatly benefited from the intellectual property granted by 3M. Due to the $64.5 million dividend payment by 3M Brazil, there was excess profit in 3M Brazil due to the lower transfer prices than at Arm’s Length.
Second, the IRS argued that Section 482 authorizes to “allocate, apportion, or allocate gross income, deductions, credits, or allowances among such organizations, trades, or businesses…”. As such, the IRS argued that it is authorized to make such Transfer Pricing adjustments.
5. Tax Court Decision
By majority decision, nine of 17 Tax Court judges ruled that the regulation of section 482 on foreign statutory restrictions was valid.
Eight judges dissented on various grounds, reflecting divided views on the application of the Arm’s Length Principle and the scope of the IRS’s authority under section 482.
The case is significant due to its impact on transfer pricing allocations and uncertain tax positions regarding countries imposing foreign royalty restrictions, including China and Brazil.
Source: Forbes 02/03/23
