In TC opinion of 18 November 2020 the US Tax Court agreed with the US tax authorities (IRS) that Coca-Cola’s US-based income should be increased by $9 billion in a dispute over royalties from its foreign-based licensees. The principal holding was that the Commissioner did not abuse his discretion in reallocating income to Coca-Cola using a “comparable profits method” (TNMM) that treated independent Coca-Cola bottlers as comparable parties. However, one question remained. Coca-Colas’s Brazilian subsidiary paid no actual royalties to Coca-Cola during 2007–2009. Rather, it compensated Coca-Cola for use of its intangibles by paying dividends of $886,823,232. The court held that the Brazilian subsidiary’s arm’s-length royalty obligation for 2007–2009 was actually about $1.768 billion, as determined by the IRS. But the court held that the dividends remitted in place of royalties should be deducted from that sum. This offset reduces the net transfer pricing adjustment to petitioner from the Brazilian supply point to about $882 million. Thus, the issue to be decided is whether this $882 million net transfer-pricing adjustment is barred by Brazilian law. During 2007–2009 Brazil capped the amounts of trademark royalties and technology transfer payments (collectively, royalties) that Brazilian companies could pay to foreign parent companies. Coca Cola contended that Brazilian law blocked the $882 million net transfer-pricing adjustment. IRS contended that the Brazilian legal restriction should be given no effect in determining the arm’s-length transfer price, relying on what is commonly called the “blocked income” regulation (Treas. Reg. § 1.482-1(h)(2)). According to tax authorities the “blocked income” regulation generally provides that foreign legal restrictions will be taken into account for transfer-pricing purposes only if four conditions are met, including the requirement that the restrictions must be “applicable to all similarly situated persons (both controlled and uncontrolled).” Judgement of the tax court The Tax Court sustained the transfer pricing adjustment in full. Excerpts “Allocation of Value Between Grandfathered Intangibles and Those Not Grandfathered Petitioner has shown that eight of TCCC’s trademarks were li-censed to the supply point before November 17, 1985. Those are the only intangibles in commercial use during 2007–2009 that were covered by the grandfather clause. We find that petitioner has failed to carry its burden of proving what portion of the Commissioner’s adjustment is at-tributable to income derived from this (relatively small) subset of the licensed intangibles. And the record does not contain data from which we could make a reliable estimate of that percentage.” “Because the supply point sold concentrate to preordained buyers, it had no occasion to use TCCC’s trademarks for economically significant marketing purposes. By contrast, the bottlers and service companies were much heavier users of TCCC’s trademarks. The bottlers placed those trademarks on every bottle and can they manufactured and on every delivery truck in their fleet. See id. at 264. And the service com-panies, which arranged consumer marketing, continuously exploited the trademarks in television, print, and social media advertising. See id. at 240, 263–64.” “We conclude that all non-trademark IP exploited by the Brazilian supply point was outside the scope of the grandfather clause. The blocked income regulation thus applies to that portion of the transfer-pricing adjustment attributable to exploitation of those intangible as-sets. We further find that this non-trademark IP represented the bulk of the value that the Brazilian supply point derived from use of TCCC’s intangibles generally. Petitioner has supplied no evidence that would enable us to determine, or even to guess, what percentage of the overall value was attributable to the residual intangible assets, i.e., the trademarks.” “In sum, petitioner has failed to satisfy its burden of proof in two major respects. It has offered no evidence that would enable us to determine what portion of the transfer-pricing adjustment is attributable to exploitation of the non-trademark IP, which we have found be the most valuable segment of the intangibles from the Brazilian supply point’s economic perspective. And petitioner has offered insufficient evidence to enable us to determine what portion of the transfer-pricing adjustment is attributable to exploitation of the 8 original core-product trademarks, as opposed to the 60 other core-product trademarks and the entire universe of non-core-product trademarks. Because petitioner has failed to establish what portion of the aggregate transfer-pricing adjustment might be attributable to exploitation of the eight grandfathered trademarks, we have no alternative but to sustain that adjustment in full.” ...

“3M Parent” is the parent company of the 3M Group and owns the Group’s trademarks. Other intellectual property, including patents and unpatented technology, is owned by “3M Sub-parent”, a second-tier wholly owned US subsidiary of 3M Parent. “3M Brazil” has used trademarks owned by 3M US in its business operations. 3M Brazil’s use of these trademarks was governed by three trademark licences entered into by 3M Parent and 3M Brazil in 1998. Each licence covered a separate set of trademarks. Under the terms of the licences, 3M Brazil paid 3M Parent a royalty equal to 1% of its sales of the trademarked products. Some products sold by 3M Brazil were covered by trademarks covered by more than one of the three trademark licences. For such products, 3M Brazil and 3M Parent calculated the trademark royalties using a stacking principle whereby, for example, if a particular product used trademarks covered by all three trademark licences, the royalties would be 3% of the sales of that product. By calculating royalties using this stacking principle, 3M Brazil paid trademark royalties to 3M Parent in 2006. 3M Brazil also used patents and unpatented technology owned by 3M Sub-parent in its operations. 3M Brazil paid no patent royalties and made no technology transfer payments to 3M Sub-parent. There was no patent licence or technology transfer agreement between 3M Sub-parent and 3M Brazil. On its 2006 consolidated federal income tax return, 3M Parent reported as income the trademark royalties paid by 3M Brazil to 3M Parent in 2006. In the notice of deficiency, the IRS determined that the income of the 3M Parent consolidated group under I.R.C. sec. 482 to reflect 3M Brazil’s use of intellectual property owned by 3M Parent and 3M Sub-parent. The increase in income determined in the notice of deficiency represents an arm’s length compensation for the intellectual property used by 3M Brazil. 3M Parent’s position was that the I.R.C. sec. 482 allocation should be the maximum amount 3M Brazil could have paid for the intellectual property in question under Brazilian law, less related expenses. 3M Parent also contended that the entire regulation was invalid because income could not be allocated to a taxpayer that did not receive income and could not legally receive the income. The IRS’s position was that the I.R.C. sec. 482 adjustment does not take into account the effect of the Brazilian statutory restrictions unless certain conditions are met, and that the Brazilian statutory restrictions did not meet those conditions. The blocked income rules in section 1.482-1(h)(2) require, among other things, that the foreign law restriction apply equally to controlled and uncontrolled parties, be publicly announced, and prevent the payment or receipt of an arm’s length amount in any form. Tax Court opinion The US Tax Court agreed with the IRS that 3M’s US income should be increased by royalties from 3M Brazil’s use of its trademarks and other intellectual property – without regard to the legal restrictions on related party royalty payments in Brazil ...

A cost sharing payment, for the purposes of section 936(h)(5)(C)(i)(I), is calculated using the provisions of section 936 and the regulations thereunder and the provisions of this paragraph (h)(3). The provisions relating to cost sharing under section 482 do not apply to payments made pursuant to an election under section 936(h)(5)(C)(i)(I). Similarly, a profit split payment, for the purposes of section 936(h)(5)(C)(ii)(I), is calculated using the provisions of section 936 and the regulations thereunder, not section 482 and the regulations thereunder ...

If a possessions corporation makes an election under section 936(h)(5)(C)(i)(I), the corporation must make a section 936 cost sharing payment that is at least equal to the payment that would be required under section 482 if the electing corporation were a foreign corporation. In determining the payment that would be required under section 482 for this purpose, the provisions of §§ 1.482-1 and 1.482-4 will be applied, and to the extent relevant to the valuation of intangibles, §§ 1.482-5 and 1.482-6 will be applied. The provisions of section 936(h)(5)(C)(i)(II) (Effect of Election – electing corporation treated as owner of intangible property) do not apply until the payment that would be required under section 482 has been determined ...

...

The facts are the same as in Example 1, except that Country FC law permits the payment of a royalty, but limits the amount to 5% of sales, and Sub pays the 5% royalty to Parent. Parent demonstrates the existence of a comparable uncontrolled transaction for purposes of the comparable uncontrolled transaction method in which an uncontrolled party accepted a royalty rate of 5%. Given the evidence of the comparable uncontrolled transaction, the 5% royalty rate is determined to be the arm’s length royalty rate ...

The facts are the same as in Example 1, except that the laws of FC do not prevent distributions from corporations to their shareholders. Sub distributes an amount equal to 8% of its sales in country FC. Because the laws of FC did not expressly prevent all forms of payment from Sub to Parent, Parent cannot validly elect the deferred income method of accounting with respect to any of the arm’s length royalty amount. In appropriate circumstances, the district director may permit the 8% that was distributed to be treated as payment by Sub of the royalty allocated to Parent, under the provisions of § 1.482-1(g) (Collateral adjustments) ...

(i) The facts are the same as in Example 1, except that Sub, although it makes no royalty payment to Parent, arranges with an unrelated intermediary to make payments equal to an arm’s length amount on its behalf to Parent. (ii) The district director makes an allocation of royalty income to Parent, based on the arm’s length royalty rate of 10%. Further, the district director determines that because the arrangement with the third party had the effect of circumventing the FC law, the requirements of paragraph (h)(2)(ii)(D) of this section are not satisfied. Thus, Parent could not validly elect the deferred income method of accounting, and the allocation of royalty income cannot be treated as deferrable. In appropriate circumstances, the district director may permit the amount of the distribution to be treated as payment by Sub of the royalty allocated to Parent, under the provisions of § 1.482-1(g) (Collateral adjustments) ...

Parent licenses an intangible to Sub. FC law generally prohibits payments by any person within FC to recipients outside the country. The FC law meets the requirements of paragraph (h)(2)(ii) of this section. There is no evidence of unrelated parties entering into transactions under comparable circumstances for a comparable period of time, and the foreign legal restrictions will not be taken into account in determining the arm’s length amount. The arm’s length royalty rate for the use of the intangible property in the absence of the foreign restriction is 10% of Sub’s sales in country FC. However, because the requirements of paragraph (h)(2)(ii) of this section are satisfied, Parent can elect the deferred income method of accounting by attaching to its timely filed U.S. income tax return a written statement that satisfies the requirements of paragraph (h)(2)(iii)(B) of this section ...

The following examples, in which Sub is a Country FC subsidiary of U.S. corporation, Parent, illustrate this paragraph (h)(2) ...

If the requirements of paragraph (h)(2)(ii) of this section are satisfied, any portion of the arm’s length amount, the payment or receipt of which is prevented because of applicable foreign legal restrictions, will be treated as deferrable until payment or receipt of the relevant item ceases to be prevented by the foreign legal restriction. For purposes of the deferred income method of accounting under this paragraph (h)(2)(iv), deductions (including the cost or other basis of inventory and other assets sold or exchanged) and credits properly chargeable against any amount so deferred, are subject to deferral under the provisions of § 1.461– 1(a)(4). In addition, income is deferrable under this deferred income method of accounting only to the extent that it exceeds the related deductions already claimed in open taxable years to which the foreign legal restriction applied ...

If a foreign legal restriction prevents the payment or receipt of part or all of the arm’s length amount that is due with respect to a controlled transaction, the restricted amount may be treated as deferrable if the following requirements are met – (A) The controlled taxpayer establishes to the satisfaction of the district director that the payment or receipt of the arm’s length amount was prevented because of a foreign legal restriction and circumstances described in paragraph (h)(2)(ii) of this section; and (B) The controlled taxpayer whose U.S. tax liability may be affected by the foreign legal restriction elects the deferred income method of accounting, as described in paragraph (h)(2)(iv) of this section, on a written statement attached to a timely U.S. income tax return (or an amended return) filed before the IRS first contacts any member of the controlled group concerning an examination of the return for the taxable year to which the foreign legal restriction applies. A written statement furnished by a taxpayer subject to the Coordinated Examination Program will be considered an amended return for purposes of this paragraph (h)(2)(iii)(B) if it satisfies the requirements of a qualified amended return for purposes of § 1.6664-2(c)(3) as set forth in those regulations or as the Commissioner may prescribe by applicable revenue procedures. The election statement must identify the affected transactions, the parties to the transactions, and the applicable foreign legal restrictions ...

Foreign legal restrictions (whether temporary or permanent) will be taken into account for purposes of this paragraph (h)(2) only if, and so long as, the conditions set forth in paragraphs (h)(2)(ii) (A) through (D) of this section are met. (A) 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; (B) The taxpayer (or other member 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); (C) The restrictions expressly prevented 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 (for example, 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); and (D) 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 have not otherwise violated the restriction in any material respect ...

The district director will take into account the effect of a foreign legal restriction to the extent that such restriction affects the results of transactions at arm’s length. Thus, a foreign legal restriction will be taken into account only to the extent that it is shown that the restriction affected an uncontrolled taxpayer under comparable circumstances for a comparable period of time. In the absence of evidence indicating the effect of the foreign legal restriction on uncontrolled taxpayers, the restriction will be taken into account only to the extent provided in paragraphs (h)(2) (iii) and (iv) of this section (Deferred income method of accounting) ...

...