More Coca-Cola - On Transfer Pricing and Blocked Income Regulation (11/23/20)

I recently wrote on burden of proof issues in The Coca-Cola Company v. Commissioner, 155 T.C. ___, No. 10 (2020), here.  Tax Court (Judge Lauber) Issues Significant Transfer Pricing Decision in Coca-Cola; Burden of Proof Issues (11/19/20; 11/21/20), here.  Coca-Cola is a transfer pricing case, meaning that it is a valuation case.  Valuation cases are generally humdrum on the issue of valuation, an issue raised in many contexts including in abusive tax shelters since the 1970s when I first began observing them.  Transfer pricing can be abusive as well because valuation can be abused.  I don’t propose to delve into the factual issues bearing on valuation Coca-Cola and whether the underlying valuations Coca-Cola used were abusive.  

I rather today point to this discussion of the “blocked income” issue.  The issue is described in high overview (pp. 184-185, beginning here):

2. Brazilian "Blocked Income"

Petitioner alternatively contends that, if TCCC owned the Brazilian trademarks, Brazilian law would have prevented the Brazilian supply point from paying, for use of those trademarks, royalties anywhere close to the amounts determined in the notice of deficiency. During 2007-2009 Brazilian law restricted the amount of trademark royalty and technology transfer payments that a Brazilian entity could pay to a foreign parent. The parties have stipulated that those maximum amounts were approximately $16 million for 2007, $19 million for 2008, and $21 million for 2009.

Relying on what is commonly called the "blocked income" regulation, respondent contends that these Brazilian legal restrictions should be given no effect in determining the arm's-length transfer price. See sec. 1.482-1(h)(2), Income Tax Regs. The regulation generally provides that foreign legal restrictions will be taken into account only if four conditions are met. See id. subdiv. (ii). Petitioner contends that this regulation does not apply here or that the necessary conditions were met. Alternatively, it contends that the blocked income regulation is invalid under the Administrative Procedure Act and/or Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984).

As the parties have observed, the validity of section 1.482-1(h)(2), Income Tax Regs., has been challenged by the taxpayer in 3M Co. & Subs. v. Commissioner, T.C. Dkt. No. 5816-13 (filed Mar. 11, 2013). The Court has granted a motion to submit the 3M case for decision without trial under Rule 122, and the case is still pending. We will accordingly reserve ruling on the parties' arguments concerning the blocked income regulation until an opinion in the 3M case has been issued.

The Blocked Income Issue as I recall it from my transfer pricing forays over the years hearkens back to Commissioner v. First Sec. Bank of Utah, 405 U.S. 394 (1972), here.  In that case, in high level summary, the Court held that § 482 did not authorize the IRS to allocate income from one related company to another if state law prohibited the income from being paid.  The Blocked Income Issue is whether the foreign law prohibition upon paying royalties prohibits the IRS from allocating the income to the U.S. party.  The underlying “Blocked Income” regulations, 26 CFR 1.482-1(h)(2), here, imposes the following conditions on the First Sec. Bank results (no allocation).

(ii) Applicable legal restrictions. Foreign legal restrictions (whether temporary or permanent) will be taken into account for purposes of this paragraph (h)(2) only if, and so long as, the conditions set forth in paragraphs (h)(2)(ii) (A) through (D) of this section are met.

(A) The restrictions are publicly promulgated, generally applicable to all similarly situated persons (both controlled and uncontrolled), and not imposed as part of a commercial transaction between the taxpayer and the foreign sovereign;

(B) The taxpayer (or other member of the controlled group with respect to which the restrictions apply) has exhausted all remedies prescribed by foreign law or practice for obtaining a waiver of such restrictions (other than remedies that would have a negligible prospect of success if pursued);

(C) The restrictions expressly prevented the payment or receipt, in any form, of part or all of the arm's length amount that would otherwise be required under section 482 (for example, a restriction that applies only to the deductibility of an expense for tax purposes is not a restriction on payment or receipt for this purpose); and

(D) The related parties subject to the restriction did not engage in any arrangement with controlled or uncontrolled parties that had the effect of circumventing the restriction, and have not otherwise violated the restriction in any material respect.

I don’t propose to develop the Blocked Income Issue further here, since I am sure it has been adequately developed in the 3M case to which the Coca-Cola both referred and deferred.  Readers should just be aware that further enlightenment is coming in 3M.

JAT Comments.

1. The 3M case was filed in 2013.  The docket sheet in the 3M is here.  It appears that nothing material has happened in the case since late 2016, when the Court (Judge Morrison) heard oral arguments and shortly thereafter an amended stipulation of facts was filed.  (An entry of appearance was filed on 5/13/19.)  The docket sheet appears to have around 51 entries.

2. Coca-Cola was filed in 2015.  The docket sheet in Coca-Cola is here.  The docket sheet appears to have over 575 entries.

3. I suppose that it is efficient use of judicial resources to defer to Judge Morrison who, presumably, may be close to rendering a decision in 3M. I suppose also that the delay in 3M may mean that the opinion will be a T.C. opinion and perhaps a reviewed opinion with significant opinions (majority, concurring or dissenting).  But that is speculation.  I would have liked to have Judge Lauber’s views on the Blocked Income Issue, but perhaps he may offer his analysis in 3M if it is reviewed.

4. Note that Judge Lauber's excerpt above refers to a Chevron issue under the Blocked Income Regulation.  I haven't reviewed the briefs in either Coca-Cola or 3M, but I would guess / speculate that one of the Chevron issues is the Brand X issue of whether First Sec. Bank prohibits the regulation.    See National Cable & Telecommunications Assn. v. Brand X Internet Services, 545 U.S. 967 (2005).  Brand X held that, unless a prior case foreclosed Treasury's subsequent regulations "interpretation," the regulations interpretation can supersede even the prior Supreme Court interpretation.  See United States v. Home Concrete & Supply, LLC, 566 U.S. 478 (2012) (holding that the subsequent regulation was foreclosed by the earlier Supreme Court opinion in Colony, Inc. v. Commissioner, 357 U.S. 28 (1958)).  (I think that there are material differences, in terms of § 482 analysis, between Coca-Cola and First Sec. Bank, but my thoughts on that are probably fairly characterized as non-mainstream, so I would test the readers' patience.)

5. As a side note, I was with DOJ Tax Appellate when First Sec. Bank went through the system to the Supreme Court.  I was not involved with the case, but one of my prominent colleagues, Ernest Brown, argued the case in the Supreme Court.  It was rare indeed that someone from DOJ Tax Appellate was offered an opportunity to argue a Supreme Court case.  But, Ernest Brown, who I generally called "Professor Brown," was not the ordinary DOJ Tax Appellate attorney.  He had a special status because he was a long-time professor of tax law at Harvard Law School and came to DOJ Tax Appellate after retirement from Harvard Law School.  I have many stories of my interactions with Professor Brown, who reviewed a couple of my briefs and was a mentor while I was in DOJ Tax Appellate.  Also Professor Brown figures prominently in the movie "On the Basis of Sex" that told the story of Ruth Bader Ginsburg's rise to prominence (with the help of her husband, a tax lawyer mensch, Marty Ginsburg).  I have written on that in this blog, Sex and Tax (Federal Tax Procedure Blog 1/7/19), here, which links to my longer blog entry, Sex and Tax (Including the Tax Division) in the Movies (DOJ Tax Division Alumni Blog 1/7/18; 1/19/19), here.

6. On the links to the items on the Tax Court web site (opinions and docket sheets), sometimes the link is denied access with a message:  "Access frequency exceeded. Please try again later."  Don't know why the Court would deny access on this basis.