Tax Court transfer pricing case has big implications


The U.S. Tax Court recently ruled in favor of the IRS in a major transfer pricing case involving 3M (3M Co. v. Commissioner, 160 T.C. 3). The case is significant due to its broader impact on transfer pricing allocations and uncertain tax positions (UTPs) with respect to countries that impose foreign restrictions on royalties, including China and Brazil.


Though the case was narrowly decided and can still be appealed, companies should take note as to how their transfer pricing positions will be viewed by the IRS, as well as their financial auditors.






Globally, 3M Company (“3M”) has license arrangements with its related-party manufacturers at 6% of local entity net sales. In 1997, 3M and its Brazilian subsidiary, 3M do Brasil Limitada (“3M Brazil”) tried to enter into similar arrangements. However, the Brazilian Patent and Trademark Office (BPTO)—the agency in Brazil responsible for recording intellectual property (IP) licensing agreements—argued that this rate was too high and not in line with local regulations. Because of this, 3M and 3M Brazil entered into three license agreements in 1998 in which 3M Brazil agreed to pay 3M a 1% royalty for each of the three trademark license arrangements. Thus, the maximum amount of royalty that 3M Brazil would remit 3M was lower than royalties remitted by other related-party manufacturers.


In 2006, 3M Brazil paid $5.1 million in royalties to 3M, in addition to $64.5 million in dividends.


The IRS argued that the royalty rate should have been 6%, in line with the other related-party manufacturing arrangements, and asserted a transfer pricing adjustment.




Items at issue


There were two primary issues litigated in the case. The first was whether the IRS could use Section 482 to allocate additional royalty income to 3M. The second was whether Treas. Reg. Sec. 1.482-1(h)(2), which specifies when and how foreign legal restrictions will be taken into account for purposes of a Section 482 adjustment, was invalid.


On the first issue, 3M cited Brazilian restrictions and regulations to argue that the IRS cannot allocate income to a taxpayer that has not received nor can receive that income because local law prevents its payment or receipt. On the second issue, 3M argued that Treas. Reg. Sec. 1.482-1(h)(2) was invalid because proper administrative procedures were not followed.


The IRS contended that both of 3M’s arguments were invalid. First, the IRS argued that 3M Brazil had benefited greatly from the IP granted by 3M. The illustrative point was that due to the $64.5 million dividend payment by 3M Brazil, there was excess profit in 3M Brazil due to the below arm’s length transfer prices.


Grant Thornton Insight: Taxpayers paying less than arm’s length rates due to foreign legal restrictions should review the additional payments made by that affiliate. If there are additional payments made (e.g., dividends, interest) by that same affiliate, there may be a need to review the original transfer price.


On the second point , the IRS contended that Section 482 gives it broad authority to “[d]istribute, apportion, or allocate gross income, deductions, credits, or allowances between and among such organizations, trades, or businesses…” As such, the IRS argued it has the authority to make such transfer pricing adjustments.


The IRS claimed that the arm’s length standard applies in every case, citing Treasury Regulation Sec. 1.482-1(b). The IRS also claimed that Treas. Reg. Sec. 1.482-1(h)(2) is a reasonable construction of Section 482, within the authority Congress delegated to Treasury.


The IRS further noted that in order to comply with Section 1.482-1(h)(2), only foreign restrictions that meet all of the following conditions are considered valid:

  • The restrictions expressly prevent the payment or receipt, in any form, of part or all of the arm’s length amount that would otherwise be required under Section 482 (e.g., a restriction that applies only to the deductibility of an expense for tax purposes is not a restriction on payment or receipt for this purpose).
  • The restrictions are publicly promulgated, generally applicable to all similarly situated persons (both controlled and uncontrolled), and not imposed as part of a commercial transaction between the taxpayer and the foreign sovereign.
  • The taxpayer (or other members of the controlled group with respect to which the restrictions apply) has exhausted all remedies prescribed by foreign law or practice for obtaining a waiver of such restrictions, other than remedies that would have a negligible prospect of success if pursued.
  • The related parties subject to the restriction did not engage in any arrangement with controlled or uncontrolled parties that had the effect of circumventing the restriction, and the related parties have not otherwise violated the restriction in any material respect.


The IRS contended that 3M did not establish that any of these requirements were satisfied.




Outcome and ramifications


The Tax Court ruled in favor of the IRS in a narrow 9-8 decision. Although it was a close vote and 3M could appeal, the ruling provides insight into how companies should review their transfer pricing allocations, as well as any UTP as it relates to ASC 740-10. This ruling also could have an impact on other court case decisions.


In the case of transfer pricing allocations, companies have sometimes refrained from allocating management service fees/charging royalties to subsidiaries, citing foreign restrictions. This case encourages a closer review of the application of Treas. Reg. Sec. 1.482-1(h)(2). If a company were to not allocate and not include in income these intercompany charges, it should ensure that all points are covered prior to making this assertion.


From an ASC 740-10 perspective, companies have also asserted that these foreign restrictions prohibited the payment of such allocations/charges. Companies have sometimes not put up a UTP as a result. Companies should be aware of this case and the impact it could have upon their financial audits. UTPs may need to be reviewed if below transfer pricing results occurred and if the company did not follow the points in Treas. Reg. Sec. 1.482-1(h)(2) in asserting no UTPs.


Finally, there could be a broader impact from this case in other cases. The existing Coca-Cola transfer pricing case (T.C. 31183-15)—in which the IRS asserted that Coca-Cola Co. limited its royalty income in the U.S., causing it to underpay taxes by more than $3.4 billion—was put on hold by the Tax Court pending the outcome of this case. Given that the 3M case is now decided at the Tax Court level, the court will now proceed with the Coca-Cola case.




Next steps


With this Tax Court opinion, companies should review all transfer pricing positions relating to countries that impose foreign restrictions, including China and Brazil. Ensuring that foreign restrictions apply is not sufficient; all of the requirements under Treas. Reg. Sec. 1.482-1(h)(2) must apply. 


For more information, contact:

Samit Shah

Samit serves as a Principal of the Firm’s Transfer Pricing Practice based in the Atlanta, Georgia.

Atlanta, Georgia

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