The Tax Times: The Eighth Circuit Delivers a Game-Changer: IRS Blocked on Foreign Royalty Income in 3M Transfer Pricing Fight

In a major win for multinational businesses, the Eighth Circuit Court of Appeals has overturned the IRS’s $24 million transfer pricing adjustment against 3M, ruling that the IRS cannot force U.S. companies to recognize and pay tax on royalty income they were legally prevented from receiving under foreign law.

What Happened in the 3M Case?

The dispute centered on income from 3M’s Brazilian subsidiary, which was subject to strict local limits on royalty payments to foreign parent companies. The IRS tried to use Section 482 to increase 3M’s U.S. taxable income by the amount it felt 3M should have received, despite the fact that Brazilian law prevented the subsidiary from making those payments.

8th Circuit’s Take: Reality Over Theory

The Appeals Court rejected both the IRS’s regulatory approach and the earlier U.S. Tax Court’s decision, emphasizing that U.S. tax law is grounded in economic reality. The court found that attributing income to 3M that it could not legally receive runs counter to Section 482’s requirement that income allocations “clearly reflect income.” The fact that Brazilian restrictions, not 3M’s own actions, stopped those payments was a decisive factor.

Key Legal Reasoning

· The Court referenced the Supreme Court’s First Security Bank precedent, confirming that income blocked by law, whether foreign or domestic, cannot be forced into a taxpayer’s gross income if the taxpayer never had actual or practical control over it.

· The “commensurate with income” standard for intangibles (the second sentence of § 482) did not convert uncollectible or legally blocked royalty payments into taxable U.S. income.

· Attempts by the IRS to claim that dividends or other creative workarounds could substitute for true royalties were also dismissed by the Eighth Circuit, which refused to reward hypothetical transactions over actual, legal ones.

Why This Matters for Multinationals and Practitioners

This ruling dramatically curtails IRS authority to make transfer pricing adjustments based on so-called “blocked income.” Multinational companies with foreign subsidiaries in countries that restrict payment of royalties or service fees are directly affected. U.S. tax professionals should view this as strong new precedent limiting the government’s reach over cross-border income shifting when payments are genuinely prevented by foreign law.

The Bottom Line

The Eighth Circuit’s decision is poised to change the landscape for transfer pricing litigation and royalty payment disputes. With the IRS’s “blocked income” rule now struck down, for now, multinationals can breathe easier where foreign law truly stands in the way of payments, while the IRS may be forced to rethink its approach to enforcing transfer pricing in the global economy.

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