Tax Update: Transfer pricing and foreign legal restrictions
- June 1, 2023: Vol. 10, Number 6

Tax Update: Transfer pricing and foreign legal restrictions

by Kirk Hesser and Brian Dill

Foreign legal restrictions have often confused multinational taxpayers, particularly in countries like Brazil, whose transfer pricing regulations seemingly depart from the arm’s-length principle by capping royalties and setting ranges for tangible transfers. This has spurred controversy between taxpayers and the Internal Revenue Service regarding the impact of foreign legal restrictions on the arm’s-length amount to be recognized in controlled transactions. On Feb. 9, 2023, the tax court sided with the IRS in 3M Co. vs. Commissioner, upholding requirements in Treas. Reg. Sec. 1.482-1(h)(2) regarding when a taxpayer may consider foreign legal restrictions for determining the arm’s-length amount in a transaction between controlled taxpayers.


The issue arose due to a licensing arrangement 3M Co. had with its Brazilian subsidiary, beginning in 2006, that allowed 3M’s Brazilian subsidiary to use certain trademarks. Brazilian domestic law capped the royalty permitted at 1 percent as the maximum amount allowable for the Brazilian subsidiary to remit to its related party licensor, 3M. The IRS argued that pursuant to Section 482 regulations, an arm’s-length royalty was 6 percent and 3M should have reported an additional $27.8 million of royalty income from its Brazilian subsidiary.

Treas. Reg. Sec. 1.482-1(h)(2) provides that the IRS will respect the effect of a foreign legal restriction only if the foreign legal restriction is publicly promulgated, applies equally to controlled and uncontrolled taxpayers, or prevents the payment or receipt of an arm’s-length amount in any other form.

This so-called blocked income ruling further requires that the taxpayer exhausts all available remedies for obtaining a waiver of the foreign legal restriction and may not enter any arrangement with the effect of circumventing the restriction.


The tax court was split (9-8) on its decision that upheld the requirements under Treas. Reg. Sec. 1.482-1(h)(2), which must be met before the IRS “will take into account the effect of a foreign legal restriction” under Section 482, and found that Brazilian legal restrictions at issue in the case did not satisfy such requirements. Given the closeness of the decision, the case will likely be appealed and the long-running dispute over blocked income will continue.


In late December 2022, the Brazilian government announced planned legislation that would significantly alter its transfer pricing rules, conforming them to the internationally accepted arm’s-length principle under the Organization for Economic Co-operation and Development (OECD) transfer pricing guidelines. If passed into law, the new rules would come into effect Jan. 1, 2024. Its passage may mitigate the blocked income issue for many taxpayers going forward, at least regarding intercompany transactions in Brazil.


Kirk Hesser is managing director and transfer pricing leader, and Brian Dill is partner and international tax leader at Cherry Bekaert.

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