Taxpayer Challenges Validity of IRS Transfer Pricing Regulation
In a petition recently filed in the U.S. Tax Court, a taxpayer has challenged the Internal Revenue Service (IRS) regulation that provides that the IRS can reallocate income between affiliates even when foreign law prohibits making the payment or receipt in question. The dispute is important for several reasons outlined in this newsletter. Taxpayers may want to examine their positions on prior tax returns.
On March 3, 2013, the 3M Company filed a petition in the U.S. Tax Court challenging the validity of an Internal Revenue Service (IRS) transfer pricing regulation stating that the IRS can reallocate income between related parties even if foreign legal restrictions prohibit the payment or receipt (Treas. Reg. §1.482-1). An exception to this precludes an IRS reallocation if the foreign restrictions are generally applicable to all similarly situated persons, whether controlled or uncontrolled. The IRS adopted this regulatory approach in 1994, shortly after losing, in 1992, Procter & Gamble Co. (961 F.2d 1255 (6th Cir. 1992), affirming 95 TC 323 (1990)) and, in 1993, Exxon Corp. (TC Memo 1993 - 616 (1993)).
Procter & Gamble established to the satisfaction of the Tax Court and the U.S. Court of Appeals for the Sixth Circuit that the IRS could not use Internal Revenue Code (Code) section 482 to reallocate income, because Spanish law, not control over an affiliate, created the alleged distortion of income by prohibiting the payment of the amount in question (961 F.2d at 1258). In reaching their conclusions, the Sixth Circuit and the Tax Court relied in part on an earlier Supreme Court of the United States decision, Commissioner v. First Security Bank, that held that the IRS cannot use section 482 to reallocate income between related parties when federal law precludes the payment of the amount at issue. (See Procter & Gamble Co., 961 F.2d at 1258 (citing Comm. v. First Security Bank, 405 U.S. 394 (1972)).)
The 3M case, which appears to be the first docketed case challenging the validity of the 1994 regulations (though there may be other controversial and potentially vulnerable parts of Treas. Reg. §1.482-1 that could be challenged), arises in the context of Brazilian industrial property law requirements that in 2006 prevented the payment of certain royalties by a Brazilian subsidiary of 3M. Although the taxpayer's petition is silent on this, the Brazilian rules may not have applied similarly to both controlled and uncontrolled persons, as the IRS...
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