Blocked Income Ruling Reframes IRS Reach in Cross-Border Transactions

A recent decision by the Eighth Circuit in 3M Co. v. Commissioner drew significant attention to the use of the “blocked income” provision (Treas. Reg. §1.482-1(h)). This provision previously allowed the IRS to disregard foreign legal restrictions, such as Brazil’s prohibition on the limit of outbound royalty payments, when reallocating income for U.S. tax purposes. In the 3M case, the IRS reallocated an additional $23.7 million in royalty payments due to the U.S. taxpayer, resulting in an adjustment to its income even though doing so would have required its foreign subsidiary to violate foreign law.

The Eighth Circuit disagreed with the IRS’s broad application of the “blocked income” rule, clarifying that U.S. tax authorities cannot override foreign law through Section 482 reallocations. The decision was, in significant part, driven by the legal principles governing the reach of the IRS, which was preceded by the contentious transfer pricing position on whether the royalty transaction was indeed conducted at arm’s length between 3M Company and 3M do Brasil Ltda.

Key Takeaways

• Aggressive Transfer Pricing Audits: The IRS and foreign tax authorities have invested significant resources and technology to focus on the review and audits of intercompany transactions, requiring taxpayers to proactively plan their transfer pricing strategies that align with the operational realities of their business.
• Strategic Transfer Pricing Reviews and Planning: An ongoing review of transfer pricing policies is essential to address both U.S. and foreign requirements, particularly in jurisdictions with restrictions on certain outbound payments (e.g., limits imposed by legislation in Brazil or the “blocked income” provision in the case of 3M Company).
• Up-to-Date and Relevant Intercompany Agreements: All agreements must be formally executed to serve as effective legal documents (i.e., signed). They should accurately reflect up-to-date business realities to withstand regulatory scrutiny and support proper allocation of income.
• Alignment with Operational Realities: Transfer pricing policies and their implementation, including accounting and tax adjustments, should be aligned with business operations to remain defensible.
• Robust Transfer Pricing Documentation: Contemporaneous transfer pricing documentation (e.g., documentation prepared to meet the penalty protection requirements of IRC Section 6662(e)), tailored to specific tax years and operational circumstances, is critical to maintain defensible taxpayer positions in audits or disputes.
• Proactive Controversy Management: Early involvement of legal counsel may be a strategic consideration that could reduce significant litigation with the tax authority in question.

Looking Forward

Recent developments underscore the need for an ongoing strategic review of intercompany transactions, their pricing basis, the consistency of transfer pricing policies with operational realities, and the documentation of such arrangements. This is particularly important as local country tax and transfer pricing legislation evolves, along with tax authority administrative interpretation and practices, resulting in conflicting rules and audit outcomes in the U.S. and foreign jurisdictions. Engaging with advisors early can help manage risk and anticipate potential pressure points, thereby reducing the costs associated with protracted litigation and subsequent adjustments.

CBIZ has a national practice in international tax, including transfer pricing, with specialist transfer pricing practitioners. This practice is supported by a team serving clients across the continental United States, who work extensively with our international networks. We are available to provide you with current, practical insights.

Key Contacts

Jan Smallenbroek, Managing Director
David Whitmer, Managing Director
Avinash S. Tukrel, Managing Director