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US: Approach to TP and blocked income

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The core of the US transfer pricing framework is the arm’s-length standard

Mark Martin and Thomas Bettge of KPMG describe the US approach to transfer pricing issues involving blocked income, a problem highlighted by recent and upcoming developments.

The core of the US transfer pricing (TP) framework is the arm’s-length standard. What is a taxpayer to do when a legal restriction forbids the payment or receipt of what would otherwise be an arm’s-length amount? 

Treasury regulations issued in 1994 supply an onerous framework for navigating issues involving foreign legal restrictions. Litigation in Coca-Cola v. Commissioner and 3M Co. v Commissioner calls the validity of those regulations into question, and new developments are expected soon.

Legal framework

Courts in the US have grappled with the relevance of legal restrictions on the payment or receipt of funds (commonly referred to as ‘blocked income’) for TP since the 1950s, and have consistently held in favour of taxpayers. 

In the only TP case to reach the US Supreme Court, Commissioner v First Security Bank of Utah (1972), two banks sold insurance policies to their retail customers, and those policies were insured by a related party. While commissions of approximately 40% would ordinarily have been paid to the parties generating the policies, US Federal Law prohibited the banks from receiving insurance premium income, and thus no commissions were charged. 

The IRS argued that certain income earned by the related party insurer should be allocated to the banks. The Supreme Court held that the legal restriction prevented the IRS from allocating commission income to the banks.

In the 1990s, the principle of First Security was extended to foreign legal restrictions in Procter & Gamble Co. v Commissioner (Sixth Circuit, 1992) and Texaco, Inc. v Commissioner (Fifth Circuit, 1996). 

Around the same time, the government – apparently dissatisfied with its consistent losing streak in the courts – issued new regulations addressing the blocked income problem. While the 1994 regulations do not cover cases involving US legal restrictions, they effectively overrule Procter & Gamble and Texaco in most circumstances.

The regulations provide that a qualifying foreign legal restriction will be respected if the taxpayer can show it affected a third party under comparable circumstances for a comparable amount of time. Absent such a showing, deferred accounting treatment is permitted, but again only if there is a qualifying restriction. 

The rub is that almost no restrictions, with the exception of increasingly uncommon exchange controls, qualify. Among other things, a qualifying restriction must prohibit the payment or receipt of the income in any form. Many restrictions, such as the Brazilian limitations on royalty payments at issue in Coke and 3M, limit a taxpayer’s ability to make a deductible payment without prohibiting the payment of non-deductible dividends, and thus do not qualify under the regulation. In most cases, therefore, income has to be taken into account in the US notwithstanding the foreign legal restriction.

New challenges

Both Coke and 3M have challenged the validity of 1994 blocked income rules, and both cases involve Brazilian restrictions that limit that royalties that can be paid by Brazilian entities. In a prior article, we noted that the US Tax Court had reserved ruling on the blocked income issue in Coke, opting instead to wait for the issuance of an opinion in 3M. 

The petition in 3M was filed in 2013, and oral arguments were held in 2016. Both parties fully stipulated the facts, so no trial will be held. Instead, the challenge in 3M turns on whether the blocked income regulations are valid under the Administrative Procedure Act, the Chevron framework for review of Treasury regulations, and the prior cases (First Security and its progeny) that respected legal restrictions for transfer pricing purposes.

Given the Tax Court’s decision to reserve ruling on the blocked income issue in Coke, it seems likely that an opinion in 3M is expected sometime soon. Of course, the Tax Court’s decision in both cases would be appealable, and appeals may be more likely given that both cases hinge on legal rather than factual issues, but we are nonetheless on the cusp of a development two and a half decades in the making. 

The 1994 regulations directly contradict sound caselaw, and are difficult to reconcile with the arm’s-length standard. Multinational enterprises with transactions that are affected by foreign legal restrictions should watch this area with interest.


Mark Martin

Principal, KPMG



Thomas Bettge

Manager, KPMG




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