When are government restrictions arm's length? A lesson from 3M!

​​​​​​​​​A recent tax case involving payments by a Brazilian affiliate of 3M for IP it was licensed to use has cast some light on the complexities of determining an arm’s length price for intra-group services.

Many companies operating in Africa are continually faced with both tax and non-tax restrictions which prohibit tax deductions for and even and payment of certain fees for services rendered and intellectual property (IP) licensed. Historically, ways to manage these restrictions have involved combining such payments into franchise-style arrangements, which fit into the non-tax regulations and allow a certain percentage of revenue to be extracted through the charge.

As African revenue authorities have become more sophisticated, these arrangements have been challenged. The authorities are challenging service arrangements which are typically priced using a cost-plus approach, even though the non-tax regulators continue to limit the payments that should be made to a specific percentage of revenue.

The OECD Transfer Pricing Guidelines1 recognise this challenge. Paragraph 1.152 states:

"There are some circumstances in which a taxpayer will consider that an arm’s length price must be adjusted to account for government interventions such as price controls (even price cuts), interest rate controls, controls over payments for services or management fees, controls over the payment of royalties, subsidies to particular sectors, exchange control, antidumping duties, or exchange rate policy."

The question is how these adjustments should be considered when applying an arm's length test to a charge for services or IP made to a recipient based in a country which has such regulations. The key test should be whether payments of fees to a third party rendering the same services, or providing the same or similar IP, would be subject to the same restrictions. The OECD Transfer Pricing Guidelines endorse this view at paragraph 1.154:

"As a general rule, where the government intervention applies equally to transactions between associated enterprises and transactions between independent enterprises (both in law and in fact), the approach to this problem where it occurs between associated enterprises should be the same for tax purposes as that adopted for transactions between independent enterprises."

If the restrictions apply equally to third party transactions as well as to transactions between related parties, the restricted amount should be viewed as the arm's length position. This was tested in the recent case of 160 T.C. No. 3 3M COMPANY AND SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent 9 February 2023 (3M).

This article examines the case and its impact on similar challenges found in Africa.

Case summary and commentary

3M owned IP and provided this through a licence arrangement to a Brazilian affiliate. The provision of the IP was governed by three trademark licences executed in 1998. Each licence concerned a separate set of trademarks. In accordance with the licences, the Brazilian affiliate paid a royalty to 3M equal to 1% of its sales of the trademarked products.

The Commissioner for Internal Revenue (IRS) determined that the income of 3M should be increased under I.R.C. section 482 to an arm’s-length rate of 6% of the sales, which arguably corresponded to the maximum amount that the Brazilian affiliate could have paid for the intellectual property in question under the laws of Brazil, less related expenses.

3M argued that this adjustment did not consider the effect of Brazil’s legal restrictions, which limited the amount the Brazilian affiliate could pay. The IRS maintained that the restrictions did not comply with I.R.C. s482, which specifies the conditions to be met before such restrictions could be considered.

Unlike the OECD Transfer Pricing Guidance, the rules in I.R.C. s482 allow a foreign legal restriction to be taken into account in making allocations under s482, if it meets the following seven requirements:

  1. the restriction affected uncontrolled taxpayers under comparable circumstances for a comparable period of time;
  2. the restriction was publicly promulgated;
  3. the restriction was generally applicable to all similarly-situated persons (both controlled and uncontrolled);
  4. the restriction was not imposed as part of a commercial transaction between the taxpayer and the foreign government;
  5. the taxpayer exhausted all remedies prescribed by foreign law or practice for obtaining a waiver of the restriction (other than remedies that would have a negligible prospect of success);
  6. the restriction expressly prevented the payment or receipt, in any form, of all or part of the arm’s-length amount; and
  7. the taxpayer and related parties did not engage in any arrangement with controlled or uncontrolled parties that circumvented the restriction and did not materially violate it.

Both parties agreed that the fixed ceilings on the amounts payable as royalties for the licensing of patents, unpatented technology, and trademarks are Brazilian legal restrictions that apply only to payments made by a Brazilian company to a controlling foreign company. There was no evidence put forward to support that the legal restrictions affected “an uncontrolled taxpayer under comparable circumstances for a comparable period of time." That meant the first and third requirements listed above were not met. This supports the guidance provided by the OECD, that in considering whether a restricted amount represents the arm's length amount, the restriction should apply equally to similar transactions between third parties and related parties.

Interestingly, the matter did not stop there. The parties also disagreed on the meaning of the term “publicly promulgated”. The IRS maintained that to be publicly promulgated, a foreign legal restriction must be in writing. 3M disagreed and contended that a foreign legal restriction need not be in writing to be publicly promulgated. The court held that a foreign legal restriction is “publicly promulgated” only if the restriction is in writing. "Taking unwritten restrictions into account in determining section 482 allocations would foster disputes between taxpayers and the Internal Revenue Service as to the substance of unwritten rules made by foreign governments." It is interesting that the Brazilian legal restrictions include both limits on technology-transfer payments and limits on patent royalties. The restrictions are not detailed enough to determine whether the specific restriction applying to 3M was publicly promulgated. The OECD Transfer Pricing Guidelines do not contain a similar requirement, but a taxpayer would need to prove that the restrictions apply equally to related and third-party arrangements, making some degree of general publication implicit.

This suggests that restrictions specific to the transaction need to be made public to meet the requirements. This could be an important precedent for dealing with non-tax regulators in Africa, where there are widely known general limitations affecting the amounts of cross-border payments of service fees or licence fees that can be made, as well as applications that need to be made for specific arrangements which would be available to the applicant but not necessarily available as comparable third-party evidence.

Author’s viewpoint

Within a group, there are usually certain centralised functions. These functions typically provide support activities for the benefit of all members of the group and, if they provide a commercial benefit to the recipient entities, they are charged for.

The OECD member countries have grappled with determining an arm's length position for the recovery of fees relating to such activities for years. The activities are far from the main operational activities of the group but require significant time and effort, often disproportionate to the charges levied. For instance, a group may provide several centralised activities, eg, finance, human resources, IT support etc., all of which arguably require a separate benchmark to be undertaken to support that any charge for the service provided is at arm's length. This issue led to the OECD member countries adopting a simplified approach for supporting the arm's length charge for such non-core back-office support services without the need for comprehensive documentation support and benchmarking through comparable analyses. This simplified approach has been a welcome development for multinationals, however, most African revenue authorities have chosen not to adopt it. Why not?

Most African countries rely heavily on withholding taxes to protect their tax base. Services fees which are often not subject to a withholding tax present a significant risk to African revenue authorities and are generally perceived to be a profit-shifting practice. Comprehensive documentation and support is important to satisfy the tax authority that any such charge is commensurate with the benefit received from the service. Non-tax regulations also provide a layer of protection for the country, ensuring that the funds charged cannot flow freely. Sadly, many of the African countries have not aligned the tax treatment with the non-tax regulation. Even when a multinational can show evidence that the charge is at arm's length, the payment is still blocked by non-tax restrictions. This poses a real problem for a multinational. To comply with home country transfer pricing rules, the service-providing entity is often faced with making a unilateral transfer pricing adjustment or accruing for an amount which will probably never be received.

From a tax perspective, this could be alleviated either through raising a bad debt provision against the charge levied but not received or by applying to have the matter resolved through the Mutual Agreement Procedure (MAP), to try and eradicate any risk of double taxation.

The 3M case has helped to give some clarity on the application of the OECD Transfer Pricing Guidelines where regulatory restrictions impede the payment of certain fees. Such restrictions need to be public and apply consistently to both related party arrangements as well as third party arrangements.

The challenge arises when such restrictions only apply to transactions between related parties, which is the case in many African countries. How should multinationals deal with the risk of non-deductibility and/or non-payment? While using the MAP could resolve the double taxation issue that arises from non-deductibility, it is onerous, time-consuming and the outcome is not guaranteed. Nor does it resolve the non-payment issue.

Can the multinational entity providing the service build an argument that not charging the recipient entity for the service is arm's length? Could reliance be placed on the core subsidiary versus non-core subsidiary concept aired in both the Chevron Case and the earlier GE Electric case ? The fact that a subsidiary is strategically important and requires the support of the multinational’s services, irrespective of whether the subsidiary can secure a tax deduction for a fee, or remit a fee, should not drive the commercial decision of whether or not to support that business. Commercially, the business, which is a core activity will be fully supported, irrespective of whether a charge is made for such support.

The OECD Transfer Pricing Guidelines also offer some degree of support for this argument at Paragraph 1.155:

"it seems unlikely that an independent enterprise would willingly subject itself to a substantial risk of non-payment for products or services rendered by entering into an arrangement when severe government interventions already existed unless the profit projections or anticipated return from the independent enterprise’s proposed business strategy are sufficient to yield it an acceptable rate of return notwithstanding the existence of the government intervention that may affect payment."

This suggests an argument could be made that not charging service fees where support is rendered to a strategically important subsidiary is an arm's length arrangement. Provided there are wider commercial reasons for supporting that entity and a return is generated from that entity to benefit the provider of the services (often the parent entity), the non-charging of the fees should be viewed as arm's length, both according to international precedent and the OECD Transfer Pricing Guidance.


The 3M case has provided some endorsement for the application of the OECD Transfer Pricing Guidelines when government restrictions impact the ability of an entity within a multinational enterprise to pay for certain group charges. Whether this assists multinational enterprises facing similar restrictions across Africa remains to be seen. In many cases, such restrictions only apply in the context of a group. A more creative approach may be needed to protect both the recipient entity and the service-providing entity from double taxation as a result of restrictions on the tax deductibility of such payments as well as on the actual making of the payment.

1 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations – OECD 2021.

2 Chevron Australia Holdings Pty Ltd v Commissioner of Taxation (No 4) [2015] FCA 1092.

3 General Electric Capital Canada Inc v The Queen, 2009 TCC 563.


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