Congress needs to be in charge of tax legislation, not the IRS and the Department of the Treasury.
Congress needs to be in charge of tax legislation, not the IRS and the Department of the Treasury.
T he U.S. tax system is premised on voluntary compliance by taxpayers paying what they owe to the IRS by Tax Day. For this system to work, taxpayers should pay what they owe and nothing more. If taxpayers are taxed on more income than what they actually have, the system collapses — you get tax avoidance and tax evasion. Unfortunately, an unprecedented decision by the U.S. Tax Court just gave the green light to a Treasury regulation that leaves U.S. companies with foreign subsidiaries vulnerable to having the same profits taxed twice, but on a different basis, once by the foreign country in which they are doing business and again by the U.S. If companies cannot rely on the courts to reverse the decision, Congress should step in and repeal the Treasury’s regulation to avoid harmful economic consequences.
The Tax Court’s decision was in 3M v. Commissioner of Internal Revenue, a transfer-pricing case concerning royalties from a Brazilian subsidiary to its Minnesota-based parent company. Brazilian law mandated that the maximum royalty the Brazilian company could pay its U.S. parent company was 1 percent of net sales. By contrast, the IRS believes that the Brazilian company should have paid 6 percent of its sales to the American company. The result of the IRS’s position is that more money should have been paid to the U.S. company and taxed in the U.S.
Despite Brazilian law making a 6 percent royalty illegal, the IRS won in Tax Court in a split 9–8 decision because of a Treasury regulation that states that the agency will only respect a foreign law if it applies to non-related companies too.
The only reason foreign countries have these laws is to limit inter-company transactions — so, of course these will never apply to non-related parties. Royalty agreements with parties other than the parent company are already negotiated fairly with third parties, so there’s no reason to regulate them. The Tax Court ignored this fact, and the regulation disregards it.
The regulation is also inconsistent with the keystone of U.S. transfer-pricing regulations: that income in these inter-company transactions should be allocated as if both companies were negotiating with a non-related company. In this case, the U.S. company had no choice but to accept the 1 percent royalty because of foreign law. This represents an arm’s length price in Brazil.
The Tax Court’s decision allows double taxation for all U.S. companies operating in Brazil because the IRS will determine royalty income received by the American company irrespective of the Brazilian law controlling how much was paid, and Brazil will not allow the Brazilian company to deduct more than 1 percent. In the end, the U.S. company will be taxed on royalty income that it has not received.
The policy consequences of this decision will be severe. Brazil is the largest market in South America, and the Tax Court decision discourages American companies from setting up subsidiaries in Brazil. They’re technically still allowed to do so, but why would they? If a company is being double-taxed on its Brazilian income, why do business in Brazil at all? The result is lost market access for U.S. companies, more expensive products, fewer jobs, and less economic growth in both the U.S. and Brazil.
The U.S. is putting severe constraints on American companies’ business in any countries that have similar laws to Brazil’s. Historically, both Spain and Saudi Arabia have had laws similar to those in Brazil that restrict transactions between U.S. parent companies and their foreign subsidiaries. This is not the approach to take if we want (as we should) to encourage U.S. companies to expand internationally.
3M can appeal this decision to the Eighth Circuit. Congress, however, should overturn this regulation by mandating that the IRS respect foreign law in transfer-pricing cases. This legislative fix ought to attract substantial bipartisan support given the absurdity of taxing “phantom” income and of double taxation. However, this Tax Court decision should send a signal to Congress that it needs to be more aggressive in reviewing tax regulations because taxpayers cannot always rely on the courts to strike down regulations that are unfairly damaging to U.S. business interests. Congress needs to be in charge of tax legislation, not the IRS and the Department of the Treasury.