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The 3M ‘blocked income’ TP litigation, and the impact of legal restrictions on TP policies

Intercompany Agreements

24 April 2023

In February, the US Tax Court ruled in favour of the IRS in a transfer pricing case involving 3M (3M Co. v. Commissioner, 160 T.C. 3). The case will have important implications for ongoing TP litigation and historic tax positions.

It involved legal restrictions (as opposed to tax restrictions) on the payment of royalties by a 3M entity in Brazil to the 3M licensor in the US. The US entity had originally wanted to sign a licence agreement with a manufacturing subsidiary in Brazil, and charge a 6% royalty on net sales. But the Brazilian Patent and Trademark Office objected to the level of the royalty. So the 3M entities instead entered into three license agreements, applying a royalty of 1% each. The maximum combined royalty if the three licences were ‘stacked’ was therefore 3%.

The IRS applied a transfer pricing adjustment, assessing 3M US based on a 6% royalty.

The relevant US Treasury Regulations are very prescriptive. Local legal restrictions are only to be recognised from a TP perspective if seven specific conditions are satisfied. 3M conceded that only some of those conditions were satisfied, yet it challenged both the transfer pricing adjustment and the validity of the ‘blocked income’ restrictions.

The US Tax Court ruled in favour of the IRS by a narrow margin of 9-8. Of those nine judges, seven were represented in the majority opinion, while two others agreed with the result on different grounds.

The OECD's Transfer Pricing Guidelines address this kind of scenario in paras 1.154 to 1.156. They recognise that this is a ‘special problem’ for which there is ‘no simple solution’ – see the quote in the slide above.

There are several lessons for MNEs as regards the legal structuring of intra-group transactions.

1. Legal restrictions need to be clearly identified and addressed up front – in the same way that the regulatory environment, IP ownership and contracting model of a group needs to be understood, before any meaningful TP policies can be created.

2. In some cases, a deeper form of localisation may be needed, including adapting the structure so as to accommodate both the legal environment and the requirements of the ALP and applicable tax rules.

3. It’s not always possible to achieve perfect alignment between tax rules and the ‘actual transaction’ from a legal point of view. In which case significant TP / tax risks may remain, and an appropriate accounting provision / disclosure may need to be made.

If you'd like to read more about this case, I recommend the articles and posts of Steven Wrappe and Andy Bubb, which I found informative and useful.


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Article by
Paul Sutton
LCN Legal Co-Founder

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