“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.
US vs 3M US TC Feb 2023