“In this current state of uncertainty, companies should proactively engage in measures to monetize their intangible rights more efficiently by tailoring their licensing strategy to Brazil’s unique transfer pricing rules.”
During a 2019 Tax Executives Institute conference in Washington, D.C., the Commissioner of the U.S. Internal Revenue Service (IRS), Charles Rettig, proclaimed, “[I am] not a commissioner who believes that the IRS loses because a judge rules against us in a transfer pricing case, . . . [I am] a commissioner who thinks the IRS loses if it doesn’t keep bringing [transfer pricing] cases.” (see Lydia O’Neal, Rettig Doubles Down on Transfer Pricing Cases, Bloomberg Tax: Daily Tax Report (Apr. 1, 2019). This declaration speaks volumes to Rettig’s intention of closing down in transfer pricing cases. Specifically, the IRS under Rettig, has targeted improper transfer pricing of intellectual property (IP) royalties remitted from foreign subsidiaries to U.S.-based parent companies (for instance, Coca Cola Co. v. Comm’r, 149 T.C. 446, 446 (U.S. T.C. 2017; Medtronic, Inc. v. Comm’r, 900 F.3d 610, 610, 8th Cir. 2018). This focus is particularly alarming for international companies with subsidiaries in Brazil because Brazil’s IP royalty remittance laws directly conflict with the United State’s transfer pricing policies.
As far as controlled transactions – i.e., transactions between related parties – of intangibles, Brazil is not aligned with most jurisdictions and has not based its rules on Organisation for Economic Co-operation and Development (OECD) guidelines. Instead of basing itself on the OECD’s “arm’s length” principle, Brazil has restrictive rules limiting foreign-based companies’ ability to determine the royalty fee charged from the company’s Brazilian subsidiaries. If on one hand, article 18 of Brazilian Law no. 9,430/96 establishes the transfer pricing rules and the methods of calculation applied to the exchange of services or goods between intragroup companies, paragraph 9 of the same article provides that these rules do not apply when determining royalties in controlled transactions, which “remain subject to the deductibility conditions provided in the concerning statutes.”
For context, in the late 1950s, a study made by tax authorities revealed that some Brazilian subsidiaries of foreign-based companies were remitting significant amounts of royalties abroad to avoid taxes related to the distribution of profits (see Romero SOARES, Lobão. Marcelo Gustavo Silva SIQUEIRA, BPTO Normative Ruling N. 70/2017: Deductibility and Royalties Remittances in view of BPTO’s new understanding (March-April 2019). At that time, expenses related to acquisition of IP rights could be deducted from income taxes. Consequently, tax authorities found that some companies were inflating their royalty remittances to obtain further deductions and avoid paying a higher income tax in Brazil.
In an effort to counter this issue, legislation was introduced to limit royalties paid by Brazilian subsidiaries in exchange for industrial property rights from their mother companies (i.e. Law no. 3,470/58, Law no. 4,131/62 and Law no. 4,560/64). Specifically, this law established that Brazilian subsidiaries could only remit abroad and deduct royalties up to the limit of 5% of the net sales of the licensed goods. By the same token, the Ministry of Finance issued Ordinance no. 436/58 fixing the deductibility ceilings for each type of industrial property right being licensed and the field of activity of the concerned products. For trademark licensing, regardless of the field of activity, the remittance and deduction ceilings were set at 1% of the net sales. On the other hand, for patent licensing or know-how transfer, the ceilings varied from 1% to 5%, depending on the field of activity (e.g.: for the automotive, oil, communication, chemical industry, etc., the ceiling is 5%; for pharmaceutical, food and clothing the ceiling is 4%, for shoes the ceiling is 3.5%).
It is noteworthy that the 5% ceiling was established by considering the average fee charged in uncontrolled transactions and the fields of industry relevant to the Brazilian national interest at the time. Since the enactment of these policies, other countries have moved towards knowledge-based economies, where intellectual property rights play a key role. However, Ordinance no. 436/58 has never been updated, and the 5% ceiling has never been reviewed, causing Brazilian intangible transfer pricing rules to drift further away from international standards.
Meanwhile, section 26 C.F.R. § 1.482-1(b) (2015), the Code of Federal Regulations, written by the United States IRS, adopts the “arm’s length” principle. This principle determines that the fees charged in a controlled transaction must be consistent with the results of a comparable uncontrolled transaction. Under section 26 C.F.R. § 1.482-4(a)(1)-(4) (2011), the Code of Federal Regulations only allows three methods for calculating IP royalty prices that foreign subsidiaries must remit to U.S.-based parent companies, but in any case, unlike Brazil, there are no pre-set royalties, and for every controlled transaction the royalty remittance rate must be tailored to the transaction’s specificities.
U.S. tax law prescribes troublesome sanctions for companies that are not using one of the three aforementioned methods. According to U.S. laws, specifically, under sections 26 U.S.C. § 482 (2018); 26 C.F.R. § 1.482-1(b) (2015), if U.S. parent companies do not use one of the three methods, the IRS can (1) calculate what the IRS believes the IP royalty rates should be, (2) reallocate the reported income on the U.S. parent company’s tax returns to match the newly calculated royalty rates, and (3) charge the U.S. parent company deficiencies in the company’s income taxes based on the reallocated income value. The purpose behind these laws, as stated in the statute, is to curb tax evasion by giving the IRS power to correct any alleged tax evasion. The only way for a U.S. parent company to overrule an IRS reallocation is to sue the IRS in U.S. tax court.
The conflict between U.S. and Brazilian law occurs when the calculation of royalties using the IRS’s three methods does not result in the trademark royalties of 1% and patent royalties of up to 5% that Brazilian Law no. 4,131/61 requires. When this happens, international companies are presented with two choices: (1) calculate a U.S. IP royalty price and break Brazilian law or (2) use the Brazilian flat royalty rate and risk U.S. sanctions.
How Does This Conflict Play Out in U.S. Courts?
In a 2013 court proceeding (3M Company and subsidiaries v. Commissioner. Docket No. 005816-13), 3M challenged the IRS’s power to reallocate royalties from 3M’s Brazilian subsidiary. The IRS alleged that for the year 2006 the IP royalties 3M was receiving from 3M’s Brazilian subsidiary were less than fairly priced because they were not calculated using one of the IRS’s three methods. The court fillings showed that 3M remitted $5.1 million in trademark royalties to the United States on about $563 million in Brazilian sales in 2006. The IRS claimed 3M should have remitted an additional $27.8 million, which would cause 3M to pay an additional $4.8 million in taxes.
3M sued to undo the IRS’s reallocation, arguing that the IRS’s proposed IP royalty payments were against Brazilian law and therefore out of the IRS’s jurisdiction for reallocation.
While arguing this, 3M cited Commissioner v. First Sec. Bank, 405 U.S. 394, 405 (1972). In that case, the U.S. Supreme Court ruled that the reallocation power was given to the IRS to curb tax evasion, but a company could not be evading taxes with “uncontrolled” money. The court clarified that uncontrolled money included income that a company was not legally allowed to receive from their subsidiaries.
3M coupled their argument with a U.S. Sixth Circuit Court of Appeals case that further clarified situations in which the IRS could not use their reallocation power. In that case (Procter & Gamble Co. v. Commissioner, 961 F.2d 1255, 1257-58, 6th Cir. 1992), the Sixth Circuit ruled that The Supreme Court’s holding in First Sec. Bank also applied to income prohibited by foreign laws. The court reiterated that the IRS can only reallocate controlled income; companies do not have control over income that foreign laws prohibit the company from receiving.
3M argued that because of these two cases, the IRS could not reallocate their Brazilian subsidiary royalty income because it was against Brazilian law for 3M to receive the extra income. 3M maintained that the courts believed it impossible to commit tax evasion with income that is out of a company’s control, even foreign income.
The IRS countered these arguments with references to a federal regulation, namely, 26 C.F.R. § 1.482-1(h)(2) (2015), which the IRS wrote after the court decisions in First Sec. Bank and Proctor & Gamble. The IRS’s federal regulation states that only foreign laws that meet certain IRS standards can prohibit the IRS from using their reallocation power. The IRS argued that the Brazilian law did not meet the IRS’s “equal treatment” standard. The “equal treatment” standard requires the same royalty calculations be used for wholly-controlled subsidiaries and uncontrolled companies. In Brazil, 3M cannot charge their subsidiary more than the royalty ceiling, but they can charge any amount of royalties to any other Brazilian company they do not own. The IRS argued that this quality of the Brazilian law allows them to use reallocation on 3M’s income, regardless of whether 3M was in adherence to the Brazilian royalty calculation law.
3M argued against the “equal treatment” standard saying that the IRS had written federal regulations that were against the intentions of Congress and therefore invalid. In the U.S. law-making procedure, Congress passes statutes known as U.S.C.s, such as the 26 U.S.C. Section 482 that grants the IRS reallocation power (see Wrightslaw, What’s the Difference? U.S. Code and Code of Federal Regulations, (Feb. 8, 2018). Executive administrations, such as the IRS, are then allowed to write federal regulations or C.F.R.’s that further explain how Congress’s U.S.C.s will be implemented and enforced. Executive administrations have certain limits on what they are allowed to write in C.F.R.s. The Supreme Court, in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., (468 U.S. 837, 838-39 (1984) established a two-part test that might render a C.F.R. invalid: (1) does the C.F.R. ignore an unambiguous expression of Congressional intent or (2) is the C.F.R. not a reasonable interpretation of an ambiguous Congressional intent. 3M argued that the C.F.R. failed step one of the test. Before the IRS wrote the C.F.R. that allowed them to reallocate regardless of Brazilian law, Congress had expressed the intent of Section 482 to prevent tax evasion. 3M argued this intent was unambiguous and clarified in case law of First Sec. Bank and Proctor & Gamble, cases that preceded the IRS’s C.F.R.
Unfortunately, the arguments from both sides ended because, shortly after 3M’s rebuttal, the case settled out of court. No official decision was rendered. The IRS maintained their C.F.R. and companies with subsidiaries in Brazil received no clarification as to how they can adhere to both countries’ royalty remittance policies.
Minimizing Risk Exposure
In this current state of uncertainty, companies should proactively engage in measures to monetize their intangible rights more efficiently by tailoring their licensing strategy to Brazil’s unique transfer pricing rules.
Often, companies have a large portfolio of products that range across different types of industries. To facilitate the contract management, companies tend to execute a single umbrella agreement, comprising all their IP rights and all goods manufactured by their Brazilian affiliate, just like it is done in other jurisdictions. But, as we have seen, Brazilian law treats different industrial property rights across different industries distinctly, and so should the companies.
Instead of building the licensing program around the IP portfolio, companies should first focus on the products that will be licensed, segregate them and analyze where each of them fits within Brazil’s Ministry of Finance’s Ordinance no. 436/58. This initial step would allow companies to determine each product’s maximum royalty rate, if they are different.
Once this is completed, companies should turn their attention to the intangible rights attached to each product. Knowing that trademark licensing is limited to 1% of the goods’ net sales, regardless of the field of industry, companies should prioritize executing a royalty-bearing agreement-based on the license of a patent, design or know-how. Only for products that have no patent, design or know-how attached, should companies consider receiving royalties via a trademark license agreement.
Naturally, the procedure above, with potentially multiple agreements, is more time- consuming than drafting one document, but this shouldn’t discourage companies.
By diligently exploring every particularity of Brazilian legislation, companies will not only increase their revenue but could potentially reach, or get close to reaching, a fair-priced, controlled transaction that satisfies the U.S. IRS. And maybe, just maybe, that would be enough to avoid an IRS reallocation of income, and consequently, a time and resource-consuming lawsuit. And, let’s not forget, the Brazilian affiliate would also benefit, since the amount remitted abroad would be deducted from its Brazilian taxable income.
The abrupt end to 3M v. Comm’r leaves Brazilian subsidiaries of U.S. parent companies and tax lawyers who represent these subsidiaries with many questions. Brazilian royalty remittance to the United States represents uncharted legal waters, as no cases addressing the issue have made it through the U.S. court system. The only certainty is that every subsidiary that remits to the United States needs to develop a strategy on how to deal with this conflict of U.S. and Brazilian laws. It is important that companies design comprehensive IP agreements. After all, the current U.S. IRS commissioner believes the IRS loses if it doesn’t keep bringing transfer-pricing cases.