| İ. Enes DERELİ Trainee Lawyer | Ömer Faruk ERİM Tax Consultant |
ABSTRACT
Although transfer pricing rules ultimately take their final form in accordance with the arm’s length principle, taxpayers may encounter certain obstacles. The aforementioned rules constitute merely one element of transfer pricing, and as a result of certain domestic or foreign regulations, pricing may have been dictated, restricted, or entirely prevented. This matter, which is not regulated in Turkish legislation, is known in foreign literature as “Blocked Income”. The aforementioned concept can be translated into Turkish as “engellenmiş gelir” (blocked income). In this article, the concept of blocked income has been examined in light of the recent decisions rendered by the United States Tax Court and the Danish Eastern High Court on the aforementioned subject. Finally, it has been concluded that there is a need for further case law from state courts regarding this matter.
Keywords: Transfer Pricing, Blocked Income, Tax, Royalty.
INTRODUCTION
The rapid proliferation of globalisation has enabled multinational corporations to assume a more active role in international trade, while this situation has also brought along numerous new problems between countries in terms of income sharing and taxation. Transfer pricing emerges as a critical instrument in the resolution of these problems. This practice aims to ensure that intra-group transactions of multinational corporations are priced fairly and in accordance with market conditions, as if they had occurred between independent parties. Thus, while regulating inter-country income distribution, it is aimed to protect tax bases and prevent adverse situations such as double taxation.¹
Transfer pricing determines not only the pricing of intra-group trade but also how the value created by companies in each country where they operate shall be distributed for tax purposes. In this context, numerous transactions such as intellectual property, financing activities, service provisions, and product trade fall within the scope of transfer pricing rules. In practice, companies must price their intra-group transactions based on independent comparables. This approach aims to prevent companies from shifting their income to countries with lower tax rates for tax planning purposes, particularly due to the existence of different tax rates between countries.²
However, although transfer pricing provides a clear framework in theory, it faces various difficulties in practice. One of these difficulties is the concept of blocked income. Blocked income refers to the situation where companies cannot transfer the income they have earned or cannot freely utilise such income due to legal regulations, currency restrictions, or economic policies in a country. For instance, foreign exchange control policies, restrictions on capital outflows, or regulations favouring local partners may give rise to blocked income situations. This situation significantly affects not only the financial management of companies but also the applicability of transfer pricing policies.
The subject of blocked income can create serious problems in the cash flow management, cost calculations, and financial reporting processes of multinational corporations. Furthermore, this situation also poses challenges for tax authorities in terms of income allocation, accurate determination of the tax base, and prevention of tax loss risks. Therefore, the relationship between blocked income and transfer pricing stands out as one of the complex and controversial subjects of the international tax system. In this article, through the Denmark-based EAC Invest and the US-based 3M cases concerning the subject of blocked income, the litigation processes related to these cases, the decisions rendered by the courts, and their compatibility with transfer pricing regulations will be examined.
1. 3M v. IRS
One of the significant rulings expected to be established regarding the concept of blocked income is the decision rendered by the United States Tax Court in 2023 in the blocked income case between 3M and the Commissioner of Internal Revenue. In the decision, the court rejected the claims of the 3M Group by a majority of nine judges and approved the tax assessment established by the IRS. This decision was reiterated by the Court in the case between Coca-Cola and the Commissioner.
In the case, there are two companies where the trademark rights of the US-based 3M group are concentrated and where technological intellectual and industrial rights such as patents are concentrated (3M USA), and there is a 3M subsidiary resident in Brazil (3M Brazil) that uses the rights of this company. 3M Brazil, by using the trademark rights under three separate licence agreements, paid a 1% royalty to 3M USA in 2006. On the other hand, there was no agreement regarding the use of rights with the other US-based company, and no payment was made by 3M Brazil in return for the use of patents and patent-like technological intellectual rights. Nevertheless, the use of intellectual rights continued.
The existing legal restrictions in Brazil limited the royalty rate paid by the subsidiary resident in Brazil in return for the trademark rights used to 1%. For this reason, the royalty payment of the 3M Brazil subsidiary was limited to USD 5.1 million. On the other hand, it was understood from the case file that if there had been an agreement between 3M Brazil and 3M USA regarding the use of other intellectual rights and a royalty payment had been made in this regard, this hypothetical royalty payment could have been USD 4.6 million.
The payments made were not found sufficient by the American Internal Revenue Commissioner on the grounds that they were contrary to the arm’s length principle, and taxation was conducted as if 3M USA had received the payments it should have received (USD 23.7 million). The main claim of the 3M Group was that not only was this payment not collected from the Brazilian subsidiary in the first place, but making a royalty payment contrary to arm’s length standards constituted a necessity pursuant to Brazilian national legislation.
The 3M Group argued that, pursuant to the first stage of the Chevron test, Section 482 of the US Internal Revenue Bulletin clearly prohibited the reallocation of the taxpayer’s income whose legal acquisition was blocked. In particular, it referred to a series of court decisions, including the Court’s First Security Bank decision, which appeared to support this view. In the First Security case, the Court ruled that the Commissioner could not allocate insurance premium income under Section 482 to two banks that were prohibited by US law from collecting insurance premiums. Following this decision, in the Procter & Gamble case, the Tax Court interpreted the First Security decision as follows: “Section 482 is invalid where the circumstances distorting income allocation within the controlled group arise solely from legal restrictions, and these restrictions are applied independently of the actions of the controlled group.” 3M claimed that these and similar cases created a judicial interpretation, and this interpretation revealed that the attitude of Section 482 regarding blocked income was clear before the aforementioned regulation was published. In this context, 3M alleged that the Treasury exceeded its authority.³ Secondly, even assuming that Section 482 was ambiguous regarding blocked income, 3M argued that the regulation published by the Treasury on this matter was not a reasonable interpretation pursuant to the second stage of Chevron. 3M questioned the reasonableness of several conditions stipulated in Section 482. Among these were provisions such as the legal restriction needing to “affect an independent taxpayer in similar circumstances for a similar period” and being “publicly published and generally applicable to all persons in similar situations”.⁴
Thirdly, 3M alleged that the Treasury did not comply with the administrative procedures stated by the Court in its State Farm decision while publishing Section 482. In particular, it claimed that the Treasury did not respond to comments regarding regulations that were essentially identical in content to the final regulations submitted concerning temporary regulations. These comments expressed concerns, among other matters, that certain foreign legal restrictions (as in Brazilian law) did not apply to independent taxpayers and were mostly brought through informal policies or interpretations that did not meet the condition of public publication. However, while implementing the final regulation, the Treasury neither defined nor discussed these interpretations.⁵
The United States Tax Court approved the income allocation regulation made by the Internal Revenue Service (IRS) regarding the royalty payments that 3M and its subsidiaries could not realise due to legal restrictions in Brazil, and rejected 3M’s claims. The Court first evaluated that when Section 482 was considered within the scope of the Chevron doctrine, it was not clear regarding blocked income, and therefore the Treasury acted within its authority to interpret. The Court emphasised that the regulation was appropriate for the purpose of Section 482 to reflect arm’s length standards and income allocation accurately. Furthermore, it was determined that the legal restrictions in Brazil affected only certain related-party transactions and did not have general validity. It was concluded that the “Blocked Income Regulation” applied by the IRS was compatible both with the second stage of Chevron and with the spirit of transfer pricing rules. The Court also rejected 3M’s claims that the regulation was not published in accordance with administrative procedures and exceeded legal authority, confirming that the aforementioned regulation was in compliance with the laws. Thus, it was emphasised that transfer pricing rules must be applied by strictly adhering to the arm’s length principle between independent parties in intra-group transactions.
2. EAC Invest v. Denmark
The case arose due to EAC’s inability to transfer the income it obtained from its affiliate to Denmark as a result of hyperinflation in Venezuela and the political conditions affected thereby. Whether these incomes would be evaluated in accordance with transfer pricing rules constituted the main point of contention in the case.
The Court accepted that the legal restrictions in Venezuela similarly affected independent parties as well, and therefore these restrictions did not distort the income distribution within the controlled group. In particular, it was emphasised that foreign exchange controls and regulations limiting capital movements were not limited to related-group transactions but had the nature of a general application. Unlike the file in the assessment of the United States Tax Court, in this case concerning the EAC Group, there was a categorical regulation concerning every taxpayer.
The Danish Tax Authority argued that the incomes that EAC could not collect from its subsidiary in Venezuela should be included in the tax base. However, the Danish Council of State, drawing attention to the fact that such restrictions were beyond the control of companies and that these incomes were not actually obtained, found the request of the tax authorities unfounded. The Court evaluated the income allocation only in light of commercial realities and actual circumstances, and in the evaluation made by the court, it was emphasised that the existing situation constituted force majeure for the taxpayers.
The Court also stated that transfer pricing rules concerned not only how incomes should be allocated but also whether these incomes were economically obtained or not. The prevention of the transfer of incomes obtained from Venezuela by EAC was not regarded as a situation distorting the allocation of incomes. This clearly demonstrated that commercial reality was a priority element in transfer pricing practices.
The decision also contains an important message regarding how international transfer pricing rules should be applied by the tax authorities of countries. The Court emphasised that the effects of local legal restrictions on independent parties needed to be evaluated in detail. This constitutes an important precedent both for international tax policies and local practices.
Consequently, the Danish High Court ruled that it was incorrect to include the incomes that EAC Invest A/S could not collect due to restrictions in Venezuela in the Danish tax base. This decision demonstrates that transfer pricing rules must be based not only on legal requirements but also on commercial realities and economic restrictions. The arm’s length principle must be applied taking into account local and international restrictions.
CONCLUSION
In conclusion, the attitudes of courts towards the concept of blocked income in the matter of transfer pricing are not definitive as of the current situation. While the United States Tax Court rendered a decision that tax assessment pursuant to Section 482 of the aforementioned Bulletin in royalty restriction cases realised under US tax legislation (First Security Bank and Procter & Gamble) would constitute a misinterpretation of the law; it did not follow its previous interpretation when the royalty payment restriction stemmed from Brazilian tax legislation. On the other hand, the Danish Council of State rendered a decision that the foreign exchange and royalty payment restrictions existing in Venezuela constituted force majeure on behalf of the taxpayers. In summary, in the matters of transfer pricing discussed in this article, there is a need for further case law in cases concerning the concept of blocked income.
¹ OECD, “2022 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations”, Access Date: 30.12.2024 https://www.oecd.org/tax/transfer-pricing/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations.htm
² United Nations, “2021 Practical Manual on Transfer Pricing for Developing Countries”, Access Date: 30.12.2024 https://financing.desa.un.org/document/un-practical-manual-transfer-pricing-developing-countries-2021
³ Baker McKenzie, “United States: Tax Court topples Supreme Court precedent in favor of agency deference”, Access Date: 03.01.2025 https://insightplus.bakermckenzie.com/bm/attachment_dw.action?attkey=FRbANEucS95NMLRN47z%2BeeOgEFCt8EGQJsW-JiCH2WAXENnrNzNVLuijcMXl%2BqjH0&nav=FRbANEucS95NMLRN47z%2BeeOgEFCt8EGQbuwypnpZjc4%3D&attdocparam=pB7HEsg%2FZ312Bk8OIuOIH1c%2BY4beLEAe5keLIOwnHuo%3D&fromContentView=1
⁴ Baker McKenzie, “United States: Tax Court topples Supreme Court precedent in favor of agency deference”, Access Date: 03.01.2025 https://insightplus.bakermckenzie.com/bm/attachmentdw.action?attkey=FRbANEucS95NMLRN47z%2BeeOgEFCt8EGQJsW-JiCH2WAXENnrNzNVLuijcMXl%2BqjH0&nav=FRbANEucS95NMLRN47z%2BeeOgEFCt8EGQbuwypnpZjc4%3D&attdocparam=pB7HEsg%2FZ312Bk8OIuOIH1c%2BY4beLEAe5keLIOwnHuo%3D&fromContentView=1
⁵ Baker McKenzie, “United States: Tax Court topples Supreme Court precedent in favor of agency deference”, Access Date: 03.01.2025 https://insightplus.bakermckenzie.com/bm/attachmentdw.action?attkey=FRbANEucS95NMLRN47z%2BeeOgEFCt8EGQJsW-JiCH2WAXENnrNzNVLuijcMXl%2BqjH0&nav=FRbANEucS95NMLRN47z%2BeeOgEFCt8EGQbuwypnpZjc4%3D&attdocparam=pB7HEsg%2FZ312Bk8OIuOIH1c%2BY4beLEAe5keLIOwnHuo%3D&fromContentView=1