United States Tax Court

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160 T.C. No. 3

3M COMPANY AND SUBSIDIARIES,

Petitioner

COMMISSIONER OF INTERNAL REVENUE,

Respondent

—————

Docket No. 5816-13.

Filed February 9, 2023.

—————

P is the common parent company of the P

consolidated group. As among the members of the P

consolidated group (and among P’s foreign affiliates),

ownership of trademarks had been centralized in P. Other

intellectual property, including patents and nonpatented

technology, was owned by S, a second-tier wholly owned

U.S. subsidiary of P. S is a member of the P consolidated

group.

B is a wholly owned Brazilian subsidiary of S.

During 2006, B used in its business operations the

trademarks owned by P. B’s use of these trademarks was

governed by three trademark licenses that P and B had

executed in 1998. Each license concerned a separate set of

trademarks. In accordance with the licenses, B paid a

royalty to P equal to 1% of its sales of the trademarked

products. Some products sold by B were subject to

trademarks covered by more than one of the three

trademark licenses. For such products, B and P calculated

the trademark royalties using a stacking principle under

which, for example, if a particular product used

trademarks covered by all three trademark licenses, the

royalties were 3% of the sales of the product. Computing

the royalties using this stacking principle, B paid P

trademark royalties in 2006.

Served 02/09/23

B also used in its business operations patents and

nonpatented technology owned by S. B paid no patent

royalties and made no technology-transfer payments to S.

No patent license and no technology-transfer agreement

was in effect between S and B.

On its 2006 consolidated federal income-tax return,

the P consolidated group reported as income the trademark

royalties that B paid to P in 2006.

In the notice of deficiency, R determined that the

income of the P consolidated group should be increased

under I.R.C. sec. 482 to account for B’s use of the

intellectual property of P and S. The increase in income

determined in the notice of deficiency represents an arm’slength rate of compensation for the intellectual property

used by B.

P’s position is that the I.R.C. sec. 482 allocation

should correspond to the maximum amount that B could

have paid for the intellectual property in question under

the laws of Brazil, less related expenses.

R’s I.R.C. sec. 482 adjustment does not take into

account the effect of the Brazilian legal restrictions. A

1994 regulation, 26 C.F.R. sec. 1.482-1(h)(2) (2006), sets

forth the requirements that must be met before R “will take

into account the effect of a foreign legal restriction” under

I.R.C. sec. 482. T.D. 8552, 59 Fed. Reg. 34971 (July 8,

1994). The Brazilian legal restrictions do not meet the

requirements.

P contends that some of the requirements are

invalid because they fail either the Chevron step 2 test or

the part of the State Farm test that requires the agency to

adequately respond to comments. See Chevron, U.S.A.,

Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837, 844

(1984); Motor Vehicle Mfrs. Ass’n of the U.S., Inc. v. State

Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983); Altera Corp.

& Subs. v. Commissioner, 145 T.C. 91, 120, 130 (2015),

rev’d, 926 F.3d 1061 (9th 2019). P also contends that the

entire regulation addressing foreign legal restrictions, 26

C.F.R. sec. 1.482-1(h)(2) (2006), is invalid under the part of

the State Farm test that requires the agency to give a

satisfactory explanation for the regulation and the part of

the State Farm test that requires the agency to respond to

comments. Furthermore, P contends that the entire

regulation is invalid under Chevron step 1 because

Commissioner v. First Security Bank of Utah, N.A., 405

U.S. 394 (1972), and its progenitor and progeny held that

under predecessors to I.R.C. sec. 482 R cannot make an

allocation of income to a taxpayer who did not receive

income and could not legally receive the income.

Held: The requirement of 26 C.F.R. sec. 1.4821(h)(2)(i) (2006) that “a foreign legal restriction will be

taken into account only to the extent that it is shown that

the restriction affected an uncontrolled taxpayer under

comparable circumstances” is not invalid under Chevron

step 2.

Held, further, the requirement that foreign legal

restrictions be taken into account under I.R.C. sec. 482 only

if they are publicly promulgated, 26 C.F.R. sec. 1.4821(h)(2)(ii)(A) (2006), means that the foreign legal

restrictions must be in writing.

Held, further, the Brazilian legal restrictions at

issue do not meet the requirement in 26 C.F.R. sec. 1.4821(h)(2)(ii)(A) (2006) that foreign legal restrictions be taken

into account under I.R.C. sec. 482 only if they are publicly

promulgated.

Held, further, the requirement that foreign legal

restrictions be taken into account under I.R.C. sec. 482 only

if they are publicly promulgated, 26 C.F.R. sec. 1.4821(h)(2)(ii)(A) (2006), is not invalid under Chevron step 2.

Held, further, the requirement that foreign legal

restrictions be taken into account under I.R.C. sec. 482 only

if they are “generally applicable to all similarly situated

persons (both controlled and uncontrolled)”, 26 C.F.R. sec.

1.482-1(h)(2)(ii)(A) (2006), is not invalid under Chevron

step 2.

Held, further, the 1994 regulation, 26 C.F.R. sec.

1.482-1(h)(2) (2006), is valid under Chevron step 1.

Held, further, the 1994 regulation, 26 C.F.R. sec.

1.482-1(h)(2) (2006), is not invalid under P’s State Farm

theory.

—————

Walter A. Pickhardt and Michael J. Kaupa, for petitioner.

Justin L. Campolieta and William R. Peck, for respondent.

CONTENTS

FINDINGS OF FACT .................................................................. 10

3M do Brasil Ltda. (or 3M Brazil); its 1952 agreement

with 3M Company ............................................................. 11

The 1982 trademark licensing agreement ....................... 12

The 1983 licensing agreement .......................................... 12

The 1997 proposed licensing agreement .......................... 13

Termination of the 1982 trademark licensing agreement

and the 1983 licensing agreement; execution of the 1998

trademark licenses; stipulations related to Brazilian

law ...................................................................................... 18

Texts of certain Brazilian legal documents referred to in

the stipulations related to Brazilian law.......................... 35

1999 assignment agreement; corporate restructuring .... 42

Business operations during the 2006 tax year ................. 43

3M Global ................................................................ 43

3M Brazil ................................................................ 44

Intellectual property; services................................ 45

Payments by 3M Brazil .......................................... 47

Tax reporting ..................................................................... 48

10.

The notice of deficiency ..................................................... 48

11.

Closing agreement ............................................................. 51

12.

The petition ....................................................................... 51

13.

The stipulation that the rate of compensation under the

standard licensing agreement is an appropriate arm’slength rate under section 482 ........................................... 53

14.

The stipulation that the section 482 adjustment must

be reduced by $4,117,370 in unreimbursed researchand-development expenses incurred by 3M Brazil .......... 53

15.

The stipulation that under Brazilian law, the maximum

amount that 3M Brazil could have paid to 3M IPC as

patent royalties or technology-transfer payments in

2006 was $4,283,153 after reduction for the $5,104,756

in trademark royalties paid by 3M Brazil to 3M

Company in 2006 ............................................................... 53

16.

The stipulation that if the Court holds that the section

482 adjustment must take into account the Brazilian

legal restrictions, then the minimum section 482

adjustment should be $165,783 ........................................ 56

17.

Respondent’s position ........................................................ 56

18.

Petitioner’s position........................................................... 58

19.

Other stipulations ............................................................. 65

OPINION ...................................................................................... 65

Procedural matters ............................................................ 65

II.

Review of the authorities under U.S. law relevant to

the arguments by the parties............................................ 67

The Revenue Act of 1921 ........................................ 70

The Revenue Act of 1924 ........................................ 72

The Revenue Act of 1926 ........................................ 72

The Revenue Act of 1928 ........................................ 73

The Revenue Act of 1932 ........................................ 74

The Revenue Act of 1934 ........................................ 75

Regulations 86 ........................................................ 75

The Federal Register Act and the publication of

the first issue of the Federal Register ................... 79

The Revenue Act of 1936 ........................................ 83

Regulations 94 ........................................................ 83

The 1937 amendment to the Federal Register

Act ........................................................................... 83

The first edition of the Code of Federal

Regulations ............................................................. 84

The Revenue Act of 1938 ........................................ 86

Regulations 101 ...................................................... 86

Internal Revenue Code of 1939 .............................. 86

Regulations 103 ...................................................... 87

The 1942 amendment to the Federal Register

Act ........................................................................... 88

Regulations 111 ...................................................... 89

The Revenue Act of 1943 and the Treasury

Decision 5426 amendments to Regulations 111 .... 94

L.E. Shunk Latex v. Commissioner, 18 T.C. 940

(1952) (involving tax years 1942, 1943, and

1945) ........................................................................ 99

The Administrative Procedure Act ...................... 105

The lifting of the wartime suspension of the

Federal Register Act requirement that

regulations be codified every five years ............... 110

The second edition of the Code of Federal

Regulations ........................................................... 110

The 1953 amendment to the Federal Register

Act ......................................................................... 111

Regulations 118 .................................................... 114

The Internal Revenue Code of 1954..................... 115

AA.

The 1960 notice of proposed rulemaking ............. 119

BB.

The creation of a new title of the Code of

Federal Regulations.............................................. 120

CC.

The 1962 final regulations ................................... 120

DD.

The 1965 and 1966 notices of proposed

rulemaking ............................................................ 125

EE.

The 1968 final regulations ................................... 129

FF.

Commissioner v. First Security Bank,

405 U.S. 394 (1972) (involving tax years 1955 to

1959) ...................................................................... 135

GG.

The Tax Reform Act of 1976 ................................. 146

HH.

Procter & Gamble Co. v. Commissioner, 95 T.C.

323 (1990) (involving tax years ending

June 30, 1978 and 1979), aff’d, 961

F.2d 1255 (6th Cir. 1992); and Exxon Corp. v.

Commissioner, T.C. Memo. 1993-616, 66 T.C.M.

(CCH) 1707 (involving tax years 1979, 1980, and

1981), aff’d sub nom. Texaco, Inc. v. Commissioner,

98 F.3d 825 (5th Cir. 1996) .................................. 147

II.

The 1986 amendment to section 482 ................... 166

JJ.

The 1988 amendment to section 7805 regarding

temporary regulations .......................................... 178

KK.

The 1992 notice of proposed rulemaking ............. 178

LL.

The 1993 temporary regulations and the 1993

redesignation of the 1968 regulations ................. 183

MM. The 1993 notice of proposed rulemaking ............. 191

III.

NN.

The 1994 final regulations ................................... 200

OO.

Stipulations regarding the 1994 final

regulations ............................................................ 213

PP.

The 1996 amendment to section 7805(a)

regarding regulations relating to post-1996

provisions of the Internal Revenue Code ............. 214

QQ.

Post-2006 amendments to section 482................. 218

Whether the Brazilian legal restrictions satisfy the

seven requirements of 26 C.F.R. sec. 1.482-1(h)(2)

(2006) for taking into account foreign legal

restrictions ....................................................................... 222

Effect on uncontrolled taxpayers ......................... 223

Publicly promulgated ........................................... 224

Generally applicable ............................................. 229

Not part of commercial transaction ..................... 229

Exhaustion of remedies ........................................ 229

Restriction on payment in any form .................... 230

Circumvention or violation of restriction ............ 230

IV.

Chevron step one ............................................................. 231

Whether 26 C.F.R. sec. 1.482-1(h)(2) (2006) is

reasonable under Chevron step two ............................... 254

Effect on uncontrolled taxpayers ......................... 255

Publicly promulgated ........................................... 261

Generally applicable ............................................. 262

VI.

Not part of commercial transaction ..................... 262

Exhaustion of remedies ........................................ 262

Restriction on payment in any form .................... 262

Circumvention or violation of restriction ............ 263

The State Farm test for validity of regulations ............. 263

Satisfactory explanation....................................... 265

Adequate response to comments .......................... 267

1. Inconsistency with First Security Bank ........ 268

2. That some foreign legal restrictions apply

only to payments between related parties ........... 268

3. That some foreign legal restrictions are

unpublished (comment related to the second

requirement) ......................................................... 269

4. Difficulty of establishing that the remedies

were exhausted (comment related to the fifth

requirement) ......................................................... 269

5. Payment of dividends and the nocircumvention requirement (comment related

to the seventh requirement) ................................. 270

6. Time for making deferral election ................. 270

VII.

Conclusion ....................................................................... 270

MORRISON, Judge: 3M Company is the common parent

company of an affiliated group of corporations that filed a consolidated

federal income tax return for the tax year ending December 31, 2006. 1

This affiliated group is referred to here as the 3M consolidated group.

When we discuss 3M Company in its role as the representative of the

members of the 3M consolidated group, we refer to 3M Company as

1 The return was filed on Form 1120, U.S. Corporation Income Tax Return.

“petitioner”. See infra part I (discussing 3M Company’s status as

representative of the group).

Respondent mailed a notice of the deficiency on December 12,

2012, determining the 3M consolidated group had an income tax

deficiency of $4,847,004 for 2006. A timely petition for redetermination

of the deficiency was filed. We have jurisdiction to redetermine the

deficiency under section 6214(a). 2

Only one income adjustment in the notice of deficiency remains

at issue. Specifically, the notice of deficiency determined that the

income of the 3M consolidated group should be increased by $23,651,332

to reflect the arm’s-length compensation that 3M Brazil should have

paid for intellectual property under section 482. Petitioner contends

that the section 482 adjustment is improper to the extent that payments

were barred by Brazilian law and that therefore the proper section 482

adjustment is only $165,783. All other adjustments in the notice of

deficiency have been resolved by agreement of petitioner and

respondent.

We hold that under 26 C.F.R. sec. 1.482-1(h)(2) (2006), which

governs the effect of foreign legal restrictions on section 482

adjustments, the Brazilian restrictions on payments by 3M Brazil are

disregarded.

We reject petitioner’s various arguments that the

regulation is invalid.

FINDINGS OF FACT

Petitioner and respondent executed a stipulation of facts, which

they later replaced with an amended stipulation of facts. The amended

stipulation of facts is referred to here simply as the “stipulation”. The

Court adopts the statements in the stipulation as findings of fact. The

documents attached to the stipulation, Exhibits 1-J through 46-J, are

admitted as evidence.

At all relevant times, including when it filed the petition, 3M

Company was a U.S. corporation with its principal place of business in

2 Unless otherwise indicated, all references to sections are to the Internal

Revenue Code of 1986 as amended and in effect at all relevant times. All references to

Rules are to the Tax Court Rules of Practice & Procedure.

Minnesota. 3 When we use the term “3M Company”, we refer to this

specific legal entity.

At all relevant times, including during the 2006 tax year, 3M

Company and its U.S. and foreign subsidiaries engaged in

manufacturing, research, development, marketing, and sales of

products in the U.S. and throughout the world. We refer to 3M Company

and its U.S. and foreign subsidiaries as “3M Global”.

3M do Brasil Ltda. (or 3M Brazil); its 1952 agreement with 3M

Company

In 1946 Durex, Lixas e Fitas Adesivas Ltda. was established in

Campinas, Brazil. The corporation was organized as a sociedade

limitada under the laws of Brazil. The corporation was later operated

under the name Minnesota Manufactureira e Mercantil, Ltda. The

corporation was later renamed 3M do Brasil Ltda., which is the name it

used during the 2006 tax year. 4 We refer to the corporation as “3M

Brazil”. 3M Brazil has always been a subsidiary of 3M Company. 5

In 1952, 3M Brazil agreed with 3M Company to pay royalties for

the use of 3M Company’s intellectual property and for support services.

The agreement provided that 3M Brazil would pay a royalty equal to

10% of the gross selling price of products sold by 3M Brazil. The

agreement may not have included any license of trademarks.

In 1966, 3M Brazil’s payment obligation under the 1952

agreement was reduced to cover only a fee for technical assistance

services, which was equal to 5% of the gross selling price of 3M Brazil’s

products.

3M Company was originally named the Minnesota Mining and

Manufacturing Company. It is occasionally described or referred to by that name in

the record.

4 The corporation is occasionally referred to by its previous names in documents

in the record.

5 For the period before 1999, the record suggests that 3M Brazil was wholly

owned by 3M Company through direct or indirect ownership. However, the exact

ownership structure of 3M Brazil before 1999 is not clear.

In 1999, there was a corporate restructuring under which 3M Brazil becamea

wholly owned second-tier subsidiary of 3M Company. This 1999 restructuring and the

resulting ownership structure of 3M Brazil is described in detail infra part7.

In 1969, 3M Company and 3M Brazil agreed to temporarily

suspend all percentage-based payments under the 1952 agreement to

accommodate the then financial position of 3M Brazil. The percentagebased payment schedule under the 1952 agreement was permanently

replaced with a $1,000 per month fee effective July 1, 1969.

The 1982 trademark licensing agreement

In March 1982, 3M Company and 3M Brazil entered into a

trademark licensing agreement. Under its terms 3M Company granted

3M Brazil a nonexclusive license to use in Brazil certain trademarks

identified in the agreement. Article V, entitled “COMPENSATION”,

provided that 3M Company waived any right to receive royalties “for as

long as subsidiaries are prevented from paying royalties to parent

companies in accordance with legislation presently in force in * * *

Brazil.” 3M Company and 3M Brazil entered into amendments of the

1982 trademark licensing agreement dated February 9, 1983, June 21,

1983, October 2, 1984, July 16, 1985, May 16, 1990, and December 30,

1994. None of the amendments affected Article V of the 1982 trademark

licensing agreement.

The 1983 licensing agreement

In April 1983, 3M Company and 3M Brazil entered into a

licensing agreement that replaced the 1952 licensing agreement. Under

the terms of the 1983 licensing agreement, 3M Company granted 3M

Brazil a nonexclusive and nonassignable license to commercially exploit

certain patents identified in the agreement. The 1983 licensing

agreement also granted 3M Brazil a right to receive technical know-how

and technical assistance from 3M Company in connection with 3M

Brazil’s exploitation of the licensed patents. The 1983 licensing

agreement contained a provision, entitled “COMPENSATION”, which

stated that 3M Company “hereby waives any right to compensation for

the patent license and other licenses and rights granted herein, and

grants same free of charge to * * * [3M Brazil] for as long as subsidiaries

are prevented from paying compensation to parent companies for

industrial property in accordance with legislation currently in force in

Brazil.” The 1983 licensing agreement had no other provision regarding

payments by 3M Brazil.

The 1997 proposed licensing agreement

During 1997, 3M Company considered the possibility of entering

into a royalty-bearing licensing agreement with 3M Brazil to replace the

1983 licensing agreement, which did not provide for royalties. 3M

Company drafted and signed a licensing agreement that was similar to

licensing agreements that it had entered into with other foreign

affiliates.

The 1997 proposed licensing agreement was never

countersigned by 3M Brazil and never went into effect.

In Article II of the 1997 proposed licensing agreement, 3M

Company granted to 3M Brazil the following rights: (1) an exclusive and

nonassignable license to make, convert, process, and use certain

products in Brazil and (2) a nonexclusive and nonassignable license to

market, lease, distribute, and offer for sale the products.

In Article III of the 1997 proposed licensing agreement, 3M

Company granted to 3M Brazil an exclusive but nonassignable license

to use manufacturing know-how to manufacture the products in Brazil.

3M Company also agreed to make manufacturing data available to 3M

Brazil. 3M Brazil agreed to reimburse 3M Company for costs specially

incurred in preparing and furnishing drawings, samples, plans,

specifications, and other data.

In Article IV of the 1997 proposed licensing agreement, 3M

Company agreed to place at the disposal of 3M Brazil, on a nonexclusive

basis, technical service data in connection with marketing, leasing,

selling, and servicing of 3M Company products. 3M Company also

agreed to provide to 3M Brazil technical assistance services, including

instructing and training a reasonable number of technical and other

qualified trainer-personnel of 3M Brazil.

In Article V of the 1997 proposed licensing agreement, 3M

Company granted to 3M Brazil a nonexclusive and nonassignable

license to use certain trademarks in Brazil on all licensed products

converted, processed, or distributed by 3M Brazil. 3M Brazil agreed to

pay all items of expense as might arise in Brazil in connection with the

maintenance and upkeep of the trademarks, and to pay all items of

expense as might arise in Brazil in connection with the enforcement of

the trademarks.

In Article VI of the 1997 proposed licensing agreement, 3M

Company granted to 3M Brazil a nonexclusive license within Brazil to

use and to sublicense to the dealers and customers of 3M Brazil works

and documents covered by certain copyrights in connection with 3M

Brazil’s sales and marketing activities.

In Article VIII of the 1997 proposed licensing agreement, 3M

Brazil agreed, in consideration of and as compensation for the licenses,

undertakings, and other rights granted pursuant to Articles II, III, IV,

and VI, to pay 3M Company a royalty of 4% of the net selling price of

licensed products manufactured in Brazil (excluding sales to 3M

Company and its affiliates).

The Brazilian Patent and Trademark Office (BPTO) is an agency

of the Brazilian government that has regulatory authority over

industrial property in Brazil, including the recordation of certain

licensing agreements providing for the transfer of industrial property. 6

The BPTO exercised this regulatory authority during the 2006 tax year. 7

As part of the recordation process, the BPTO permits the parties to a

proposed industrial-property agreement to consult with the BPTO

before formally submitting an agreement for recordation. The purpose

of this informal consultation process is for the BPTO to identify issues

or deficiencies with a proposed agreement that could preclude

recordation if not appropriately addressed by the parties before formal

submission.

In July 1997, 3M Company engaged in the BPTO’s consultation

process and sought the BPTO’s views on whether the 1997 proposed

licensing agreement satisfied the legal requirements for recordation. To

this end, on July 30, 1997, 3M Company transmitted the 1997 proposed

licensing agreement to the BPTO for review.

By letter dated October 16, 1997, the BPTO notified 3M Company

that the 1997 proposed licensing agreement was not in compliance with

“the legislation and/or rules usually adopted by” the BPTO for

recordation purposes. The letter identified deficiencies in the agreement

that required amendment or removal. This is an English translation of

the body of the letter:

6 The BPTO is also known as the National Institute of Industrial Property, or

Instituto Nacional da Propriedade Industrial.

7 A more detailed discussion of Brazilian intellectual-property law, including

the relevant BPTO practices and procedures, is found in paragraphs 71 to 91 of the

stipulation, which are quoted infra part 5.

Concerning the request of this company’s letter of July 30,

1997, we inform that the agreement attached to the above

process, shows the following aspects which do not agree to

the legislation and/or rules usually adopted by this

Institute.

1--Inclusion of matters which are not provided by art. 211

of Law

n˚ 9279/96--Clause VI--LICENSED COPYRIGHTS and

items 1.12 and 1.13.

2--Lack of justification for the acquisition of the non

patented technology, since the agreement refers to the

license of several patents.

3--Establishment of a global remuneration for all the

licenses referred to in the agreement, which creates

difficulties for analysis, since the agreement includes

licenses which need not to be recorded at Patent Office

(copyrights) and licenses for which no remuneration is due

(use of trademark, according to Law 8383/91, art. 50 and

Act. n˚ 436/58, item II). We also remind that the payment

of royalties shall only be considered if derived from issued

patents.

4--The term of duration of the agreement has not been

fixed. We remind that said term, regarding licenses

concerning industrial property rights, shall not exceed the

term of validity of the licensed rights and, as for know how

acquisition, 5 years, according to Law n˚ 8383/91 art. 50

and Law n˚ 4131/62, art. 12, § 3˚.

5--Inclusion of clauses which may create difficulties for the

working of the company, such as:

a) restriction of the territory for commercialization--item

2.01

b) the licensee shall be in charge of taking all steps and

shall pay all the expenses concerning industrial property

rights (items 2.04, 5.11 and 7.04)

c) Prevision [sic] that all intellectual property rights,

resulting from patents modification work shall become

property of the licensor--item 13.06 c (art. 63 of Law n˚

6279/96).

Finally, we inform that, according to the provision of art.

50 of Law 8383/91, no additional payment is allowed for the

technical assistance since the maximum remuneration

allowed by Law is already established by the agreement.

3M Company did not submit the 1997 proposed licensing

agreement to the BPTO for formal recordation. Had it done so without

addressing the deficiencies identified in the BPTO’s October 16, 1997

letter, the BPTO would not have recorded the 1997 proposed licensing

agreement for the reasons identified in that letter.

After receiving the October 16, 1997 letter from the BPTO, 3M

Company considered whether it should attempt to record with the BPTO

an agreement narrower in scope than the 1997 proposed licensing

agreement. In particular, 3M Company considered two types of

agreements: (1) a licensing agreement for its patents and (2) a

technology-transfer agreement for its unpatented technology (such as

trade secrets and know-how).

With respect to patents, 3M Company reviewed the intellectual

property supporting approximately 40 of the biggest selling products

manufactured by 3M Brazil. The purpose of the review was to identify

which products in that group were supported by Brazilian patents. 3M

Company concluded that only a small number of these products was

supported by Brazilian patents. On the basis of that review, 3M

Company decided not to conduct a similar review for products having

smaller sales. 3M Company was aware that many of the products

manufactured and sold by 3M Brazil (such as abrasives, adhesives,

tapes, and scouring products) were mature products and therefore were

not likely to have any remaining patent protection. It was also aware

that many of the products manufactured and sold by 3M Brazil were

subject to the low royalty ceilings imposed under Brazilian law with

respect to payments between Brazilian companies (such as 3M Brazil)

and controlling foreign companies (such as 3M Company). 3M Company

decided not to enter into a patent licensing agreement and instead to

enter into royalty-bearing trademark licensing agreements.

With respect to unpatented technology, 3M Company was advised

by its Brazilian attorneys that, in order to enter into such an agreement,

3M Company would be required to disclose certain trade secrets to the

BPTO. As a result, 3M Company was unwilling to enter into an

agreement with respect to unpatented technology, for fear that its trade

secrets might be disclosed by the BPTO to 3M Company’s competitors

and that disclosure could weaken trade secret legal protections for its

unpatented technology under the laws of the various countries where

3M Global does business. The advice that 3M Company received in this

regard was not entirely accurate because 3M Company was not, in fact,

required to disclose its trade secrets to the BPTO. Rather, the BPTO

requires only a general description of the technology being transferred,

such as the field or industry to which the technology relates.

Nonetheless, on the basis of the advice it received at the time, 3M

Company decided not to enter into a technology transfer agreement and

instead to enter into royalty-bearing trademark licensing agreements.

After it received the October 16, 1997 letter, 3M Company

reevaluated its royalty-free arrangement with 3M Brazil regarding

trademarks. As explained in paragraph 65 of the stipulation (which we

adopt as findings of fact):

Following receipt of the October 16, 1997 letter from the

BPTO, 3M Company determined that it would change the

licensing of its trademarks to 3M Brazil. 3M Company

consulted Brazilian intellectual property counsel, who

advised 3M Company that it would be possible to obtain up

to a three percent trademark royalty on certain products

by entering into three separate trademark licenses

covering different sets of trademarks. Counsel advised 3M

Company that if a product used multiple trademarks

covered by three separate agreements, then 3M Brazil

could pay up to a three percent trademark royalty. That

advice was not accurate for the reasons discussed below at

paragraph 94.

The reference to “paragraph 94” in the above text is a reference to

paragraph 94 of the stipulation, which is quoted infra part 5.

Termination of the 1982 trademark licensing agreement and the

1983 licensing agreement; execution of the 1998 trademark

licenses; stipulations related to Brazilian law

On August 18, 1998, 3M Company and 3M Brazil entered into an

agreement terminating the 1982 trademark licensing agreement,

effective January 1, 1998.

On August 18, 1998, 3M Company and 3M Brazil entered into an

agreement terminating the 1983 licensing agreement, effective January

1, 1998.

Effective January 1, 1998, 3M Company and 3M Brazil entered

into three separate licensing agreements for the purpose of licensing 3M

Company’s trademarks to 3M Brazil (collectively, the “1998 trademark

licenses”). Each of the 1998 trademark licenses related to a separate set

of trademarks that was identified in the respective license. Under each

of the 1998 trademark licenses, 3M Company granted 3M Brazil an

exclusive, nonassignable license to use trademarks in Brazil. Under

each of the 1998 trademark licenses, 3M Brazil agreed to pay 3M

Company a royalty of 1% of the net selling price 8 of the products sold

bearing a trademark identified in the license.

Effective March 1, 1999, the 1998 trademark licenses were

amended. This amendment, which we refer to as the 1999 amendment,

did not affect the particular terms of the 1998 trademark licenses that

were discussed in the paragraph above.

In June 1999 the BPTO recorded each of the 1998 trademark

licenses, as amended by the 1999 amendment.

year.

The 1998 trademark licenses were in effect during the 2006 tax

Petitioner and respondent made the following stipulations

relating to Brazilian law and its effect on 3M Brazil, which we adopt: 9

8 The net selling price is defined not to include the price of any product sold by

3M Brazil to 3M Company or the price of a prepackaged product bought by 3M Brazil

from 3M Company and resold.

9 Some errors in punctuation have been corrected.

71. The BPTO, which is an agency of the Brazilian

government, was created by Law No. 5648/1970, dated

December 11, 1970, to replace the earlier National

Department of Industrial Property. During 2006, the

BPTO operated pursuant to the legal authority contained

in Law No. 9279/1996, dated May 14, 1996 (“the Brazilian

Industrial Property Law”). Under Law No. 9279/1996, the

BPTO was vested with regulatory authority over industrial

property in Brazil. Acting pursuant to Law No. 9279/1996,

the BPTO exercised regulatory control within Brazil over

the recordation of agreements providing for the licensing of

industrial property and the transfer of technology,

including agreements with foreign counterparties.

72.

The Ministry of Finance is an executive

department in charge of economic policy and the treasury

of the Brazilian federal government. During 2006, the

Ministry of Finance operated pursuant to the legal

authority set forth under Law No. 7739/1989, dated March

16, 1989, and was regulated by Decree 5510, dated August

12, 2005, the latter being revoked and replaced on October

31, 2006 by Decree 5949. Under Brazilian law, a Decree is

a binding rule issued by the executive branch of the

Brazilian government. The responsibilities of the Ministry

of Finance include monetary policy, including currency and

coinage; federal tax policy, including collection and

enforcement of tax laws; management of federal finances

and assets, including management of the Brazilian public

debt; public accounting; oversight and control of crossborder trade; and oversight of financial institutions.

73. During 2006, the Brazilian Central Bank was

the principal monetary authority in Brazil. Prior to the

establishment of the Brazilian Central Bank in 1964, the

monetary authority of Brazil was vested, in part, in the

Agency for Currency and Credit (“SUMOC”). In 1964, the

Brazilian Central Bank replaced SUMOC as the principal

monetary authority in Brazil.

74. Law No. 4131/1962, dated September 3, 1962

(also known as the “Foreign Capital Law”), was enacted by

the Brazilian government for the purpose of regulating

foreign capital and remittance of funds abroad. Article 9 of

Law 4131/1962 provided that before any royalties relating

to patents or trademarks, payments relating to the transfer

of technology, or fees for technical assistance services could

be remitted abroad, evidence of the agreement providing

for such payments had to be submitted to SUMOC.

“Technical assistance services” are those provided by

persons with technical backgrounds, such as engineers,

chemists and biologists. Such services provide expertise in

the use of patented or unpatented technology. They are

distinguished from “consulting services” which are not

directly related to the use of patented or unpatented

technology. Consulting services include advice relating to,

for example, management, finance, law, marketing,

logistics, and information technology.

75.

a. On February 16, 1972, the Inspection and

Registration of Foreign Capital of the Central Bank

(“FIRCE”), a regulatory agency under the Brazilian

Central Bank, issued Comunicado FIRCE No. 19, an

instruction regarding the application of Article 9 of Law

No. 4131/1962. That instruction, known as Regulation No.

19, required that a party seeking to remit payments in

foreign currency abroad pursuant to an agreement that is

subject to registration at the Brazilian Central Bank must

produce evidence establishing that the agreement has been

recorded by the BPTO.

b. Regulation No. 19 was later superseded by the

establishment of an electronic system of registration of

agreements at the Central Bank, which was implemented

by Circular No. 2816, dated April 15, 1998, and regulated

by Circular-Letter No. 2795, dated April 15, 1998. Under

Brazilian law, Circulars and Circular-Letters are binding

written orders issued by the Central Bank to government

employees and regulated entities. Circular-Letter No.

2795 expressly revoked Regulation No. 19. It required that

a party seeking to remit payments abroad pursuant to an

agreement that is subject to registration at the Brazilian

Central Bank must produce evidence establishing that the

agreement has been recorded by the BPTO.

This

requirement applied to all contracting parties, regardless

of relation, and remained in effect during 2006.

c. Before authorizing a remittance of funds abroad,

the Brazilian Central Bank does not conduct an

independent review of the terms and conditions of an

agreement recorded with the BPTO for purposes of

determining compliance with the applicable laws,

regulations, and BPTO policies or procedures.

76. Under Articles 62, 140, and 211 of the Brazilian

Industrial Property Law (which articles were included in

Law No. 9279/1996 and became effective on May 15, 1997),

as well as under Normative Act 135/1997, a binding

administrative regulation issued by the BPTO in 1997, the

following agreements are subject to recordation by the

BPTO:

a. patent/industrial design license;

b. trademark license;

c. technology transfer (relating to unpatented

technology);

d. technical assistance services; and

e. franchise.

77. Agreements related to consulting services,

the agreements specified in Articles 62, 140, and 211 of the

Brazilian Industrial Property Law as being subject to

recordation by the BPTO. Consulting services agreements,

by law to be recorded at the BPTO. Recordation is not

required for payments to be made under such agreements,

including payments by Brazilian subsidiaries to their

controlling foreign parent companies. This continued to be

the law during 2006.

78. Recording an agreement subject to recordation

by the BPTO is necessary for the following purposes:

a. To permit the remittance to a foreign person of

(i) royalties for patents or trademarks, (ii) payments for

technology transfer (relating to unpatented technology), or

(iii) payments for technical assistance services (according

to Law No. 4131/1962 and Circular-Letter 2795);

b. To qualify a licensee for deductions under

Brazilian tax law (according to Law No. 4131/1962 and

Law No. 4506/1964, dated November 30, 1964); and

c. To make the agreement effective against third

parties (according to Law No. 9279/1996).

Unless one or more of the foregoing purposes are desired

by the contracting parties, recordation by the BPTO is not

required or necessary under Brazilian law.

79. It is the BPTO’s internal policy to permit a party

to a license agreement that is subject to recordation by the

BPTO to initiate a consultation procedure, prior to

presenting the agreement for recordation, in order to

obtain the views of the BPTO regarding whether the

agreement satisfies the legal, regulatory, and BPTO policy

requirements for recordation.

80. Article 14 of Law No. 4131/1962 instituted a

complete prohibition of the ability of Brazilian subsidiaries

of foreign companies to remit royalties abroad to their

controlling parent companies for the use of patents and

trademarks. Given this prohibition, prior to January 1,

1992, the BPTO would not record royalty-bearing patent or

trademark license agreements. Although Article 14 of Law

No. 4131/1962 expressly imposed a prohibition that applied

only to royalties for the use of patents and trademarks, the

BPTO interpreted the prohibition as applicable to fees paid

for technical assistance services and payments for the

transfer of unpatented technology between Brazilian

subsidiaries and controlling foreign companies providing

for remittances abroad. No similar prohibition applied to

unrelated companies. At all relevant times, including

during the 2006 tax year, both 3M Company and 3M IPC

were controlling foreign companies with respect to 3M

Brazil for purposes of applying Brazilian law.[10]

81. Article 43 of Law No. 4131/1962 imposed

supplemental income taxes on dividends paid to foreign

shareholders prior to 1992 that were in addition to a 25

percent withholding tax imposed on the foreign recipient.

Article 43 of Law No. 4131/1962 also imposed a

supplemental income tax on the foreign recipient of

dividends whenever the average remittances in a threeyear period exceeded a specified percentage of the foreign

shareholder’s equity interest and capital reinvestments in

the Brazilian company. For average remittances of

between 12 percent and 15 percent, the supplemental

income tax rate was 40 percent; for average remittances of

between 15 percent and 25 percent, the supplemental

income tax rate was 50 percent; for average remittance in

excess of 25 percent, the supplemental income tax rate was

60 percent. In addition, Article 44 of Law No. 4131/1962

provided that the supplementary income tax on dividends

would be increased by an additional 20 percent in the case

of companies with economic activities that were deemed of

lesser importance to the national economy, as determined

by regulations.

82.

a. On December 30, 1991, the Brazilian government

enacted Law No. 8383/1991, which repealed in its entirety

the supplemental income tax on dividends under Articles

43 and 44 of Law No. 4131/1962, and repealed, in part, the

prohibition on the remittance of royalties between

Brazilian companies and controlling foreign companies

contained in Article 14 of Law No. 4131/1962.

particular, Law No. 8383/1991 permitted a Brazilian

company to remit royalties to its controlling foreign

company to the extent such payments were made

10 As described infra part 7, in 1999 3M Company created a second-tier wholly

owned U.S. subsidiary, 3M Innovative Properties Company (“3M IPC”) and transferred

much of its intellectual property to 3M IPC. 3M Brazil was a wholly owned subsidiary

of 3M IPC.

deductible for Brazilian tax purposes under Article 50 of

Law No. 8383/1991.

b. Accordingly, after December 31, 1991, the BPTO

began to record royalty-bearing patent and trademark

license agreements between Brazilian companies and

controlling foreign companies providing for remittances

abroad, provided that the amounts payable under such

agreements did not exceed the tax deductibility limitations

and provided that the agreements were otherwise in

compliance with the policies and procedures of the BPTO

and other applicable laws and regulations governing

industrial property transactions. The BPTO extended this

permission to technology transfer agreements and to

technical assistance services agreements between

Brazilian companies and controlling foreign companies.

c. After the enactment of Law No. 8383/1991, if the

BPTO recorded a royalty-bearing patent or trademark

license agreement or technology transfer agreement

between a Brazilian company and a controlling foreign

company, then the amounts payable under such an

agreement could be remitted abroad to the foreign

company, subject to the fixed ceilings discussed in

paragraphs 89 and 90 of this Stipulation of Facts. In

addition, the Brazilian company could deduct such

payments for Brazilian tax purposes in accordance with

Article 50 of Law No. 8383/1991, subject to the fixed

ceilings discussed in paragraphs 87 and 88 of this

Stipulation of Facts. This was the law in 2006.

83. The Brazilian Central Bank could impose a fine

on a Brazilian licensee of up to R$250,000 pursuant to

Article 58 of Law No. 4131/1962 and Provisional Measure

No. 2224, dated September 4, 2001, if the licensee made an

unauthorized remittance by either (a) making payments to

a foreign person (controlling or noncontrolling) without

prior recordation of an agreement required to be recorded

at the BPTO, or (b) making payments to a foreign

controlling entity in amounts exceeding the fixed ceilings

described in paragraphs 89 and 90 of this Stipulation of

Facts. The Brazilian Central Bank could also impose a

monetary penalty, pursuant to Article 23 of Law No.

4131/1962, of up to 300 percent of the non-authorized

remitted amount on the licensee, the bank involved in

remitting the funds, and any transactional broker. In

addition, the Brazilian Central Bank could require the

repayment of any such unauthorized remittance pursuant

to item 3, Chapter 7 Title 1 of Circulars 3280/2005 and

3325/2006, issued by the Brazilian Central Bank. This was

the law in 2006.

84. After the enactment of Law No. 8383/1991, the

BPTO adopted the administrative position that, if a certain

trademark or patent had been licensed prior to January 1,

1992, by means of an agreement recorded with the BPTO

on a royalty-free basis (because of the prohibition

instituted by Article 14 of Law 4131/1962), the same

trademark or patent could not be licensed on a royaltybearing basis under a new agreement signed and recorded

after January 1, 1992. This internal policy of the BPTO,

which was in effect during 2006, was amended in 2009

when the BPTO issued a formal opinion explaining that

royalty payments would be allowed on a prospective basis,

even if the licensed trademark or patent had been licensed

free of charge prior to January 1, 1992. Although this was

the policy of the BPTO during 1998, when the 1998

Trademark Licenses[11] were recorded, the BPTO through

an error did not apply this policy to the 1998 Trademark

Licenses.

The BPTO recorded the 1998 Trademark

Licenses although some of the covered trademarks had

been previously covered by the 1982 Trademark Licensing

Agreement.[12]

85. Brazil’s Industrial Property Law (Law No.

9279/1996) does not treat unpatented technology (such as

trade secrets and know how) as industrial property. The

BPTO does not consider unpatented technology to be a

proprietary right that can be licensed. The BPTO does,

however, record technology transfer agreements providing

11 Elsewhere in this Opinion, the 1998 Trademark Licenses are referred to as

the 1998 trademark licenses (i.e., without capitalization).

12 Elsewhere in this Opinion, the 1982 Trademark Licensing Agreement is

referred to as the 1982 trademark licensing agreement (i.e., without capitalization).

See supra part 4.

for the sale of unpatented technology.

internal policy of the BPTO in 2006.

This was the

86.

During the mid-1990’s, Brazil altered the

legislation related to the corporate income tax.

particular, Law No. 9249/1995, dated December 26, 1995,

established a worldwide income tax on the net profits of

corporations domiciled in Brazil. One of the corporate tax

regimes adopted in Brazil is a combination of (i) the socalled “real profit” regime, which adopts accounting records

of revenues and expenses, adjusted by additions and

exclusions determined by law, and (ii) a social contribution

payment based upon net profits. Taxable profits, if any,

are then taxed at a combined tax rate up to 34 percent.

b. Roughly a year after the enactment of Law No.

9249/1995, the Brazilian government enacted Law No.

9430/1996, dated December 27, 1996, which established a

system of transfer pricing rules in Brazil to address, among

other things, pricing and taxation of cross-border

transactions between related corporations. Although the

transfer pricing methodologies under the Brazilian tax

system are, in some respects, similar to the methodologies

set forth in the guidelines published by the international

Organization for Economic Cooperation and Development

(“OECD”), Brazil’s transfer pricing regime also deviates in

some respects from the OECD transfer pricing guidelines.

For example, instead of applying the general “arm’s length

principle” embodied in the OECD guidelines as the guiding

principle for pricing of intercompany transactions, a

number of Brazilian transfer pricing rules provide for

statutory-based tests, such as fixed profits margins,

maximum ceilings for deductibility of expenses on imports,

minimum gross income floors for exports, and limitations

on the deductibility of interest expenses based upon fixed

rates and ranges.

c. Under paragraph 9 of Article 18 of Law No.

9430/1996, transactions involving patent or trademark

royalties, technology transfer payments, or payments for

technical assistance services in connection with the

transfer of intangibles are exempt from the transfer pricing

regime. Deductibility of these amounts is governed by the

fixed ceilings discussed in paragraph 87 of this Stipulation

of Facts.

87. Brazilian tax law imposes fixed ceilings on the

deductibility of royalties for trademarks and patents and

for remuneration paid for technology transfer and

technical assistance services. The ceilings were initially

established by Article 74 of Law No. 3470/1958, dated

November 28, 1958, which introduced a cap on the amount

deductible as royalties for the license of trademarks and

patents, and also on the amount deductible for

remuneration paid for technology transfer and technical

assistance services. Law No. 3470/1958 established a

maximum deductibility limit of five percent of the gross

sales price of products manufactured and sold under

license, technology transfer, or technical assistance

services agreements. Law No. 3470/1958 also provided

that the maximum deductibility limit of five percent would

be reviewed periodically by the Brazilian Ministry of

Finance and adjusted according to the degree of

essentiality of the industries or activities involved, so that

it could be less than five percent.

88.

a. Acting pursuant to Law No. 3470/1958, the

Brazilian Ministry of Finance in 1958 promulgated

Portaria No. 436/58, which established decreasing

maximum deductibility ceilings, ranging from five percent

to one percent of gross sales, in connection with (i) royalties

paid for the license of patents; (ii) technology transfer

payments for unpatented technology (see paragraph 90 of

this Stipulation of Facts); and (iii) amounts paid for

technical assistance services.[13] Under Brazilian law, a

13 Petitioner and respondent have stipulated the English translation of the text

of Portaria No. 436/58. See paragraph 88c of the stipulation; Exhibit 28-J. We gather

from the English translation that Portaria No. 436/58 additionally established a

maximum deductibility ceiling of 1% for royalties for the use of trademarks. This may

be the same as the 1% cap that is referred to in paragraph 88.e of the stipulation.

Portaria is a binding

administrative agency.

rule

promulgated

b. By Article 6 of Decree-Law No. 1730/1979, dated

December 17, 1979, the percentage limitation on

deductions, which initially applied to gross sales of

products covered by licensed technology, was amended so

as to apply to net sales of such products. Under DecreeLaw No. 1598/1977, dated December 26, 1977, and

confirmed by Rule-Making Instruction No. 51, dated

November 3, 1978, net sales are calculated by reducing the

following amounts from gross sales: (1) products returned

and canceled sales; (2) discounts granted on an

unconditional basis; and (3) taxes levied thereon. This was

the law in 2006. In addition, it was the BPTO’s unwritten

policy in 2006 to require, for purposes of computing net

sales for patent royalties and technology transfer

agreements, that gross sales be reduced by the amounts set

forth in Decree-Law No. 1598/1977, as well as by the cost

of all inputs or components imported from the supplier of

technology or from parties related to the supplier,

regardless of whether such inputs or components were

manufactured by the supplier or third parties. A DecreeLaw is a binding law that was issued by the executive

branch during the military dictatorship that ruled Brazil

between 1964 and 1985.

c. The percentages under Portaria 436/58 were

applied to a comprehensive list of industries and products

identified in the Portaria. In 1959, 1970 and 1994, the

Ministry of Finance promulgated Portaria Nos. 113/59,

314/70 and 60/94, setting maximum deductibility ceilings

for the cement, glass and informatics industries,

respectively. Copies of these Portarias (in the original

Portuguese version followed by an English translation) are

attached as Exhibits 28-J, 29-J, 30-J and 31-J. These

Portarias were in effect during 2006. They apply to the

deductibility of any (i) royalty payments made for the

license of patents, (ii) technology transfer payments for

unpatented technology (see paragraph 90 of this

Stipulation of Facts), and (iii) amounts paid for technical

assistance services, regardless of whether such royalties

were paid in a related or unrelated party transaction.

Royalties paid that exceed the deductible amount, to the

extent such payments are otherwise permitted, are not

deductible for Brazilian tax purposes. This was the law in

2006.

d. To the extent that the contracting parties are not

able to determine to which product category a particular

product belongs, the parties may apply for an

administrative consultation, in which the Ministry of

Finance may indicate the appropriate rate ceiling for the

tax deduction under the Portarias. This practice was in

place during 2006.

e. The deduction permitted for the payment of

royalties for the license of trademarks is capped at one

percent of net sales, regardless of the type of industry or

product involved. This restriction was in effect during 2006

and applies to the deductibility of any royalty payments

made for the license of trademarks, regardless of whether

such royalties were paid in a related or unrelated party

transaction.

Royalties paid pursuant to trademark

licenses that exceed the deductible amount, to the extent

such payments are otherwise permitted, are not deductible

for Brazilian tax purposes. This was the law in 2006.

f. The Federal Revenue Service, which is a division

of the Ministry of Finance, interpreted Portaria 436/58 in

Decision No. 283 (November 30, 2000), a copy of which (in

the original Portuguese version followed by an English

transaction) is attached as Exhibit 32-J. According to

Decision No. 283, the deduction for royalties under a

license of trademarks is capped at one percent of net sales

for each product, even if more than one trademark is used

on the product. In addition, the Decision further provides

that no deduction for trademark royalties is allowable

when the use of the trademark derives from the use of a

patent, manufacturing process, or formula. As a result, the

Ministry of Finance will not permit a taxpayer to deduct

trademark royalties if a deduction was already claimed on

the same product for the license of patents, or for the use

of manufacturing processes or formulas. Under Brazilian

law, a Decision is a ruling by an administrative agency

made in the context of a particular case or consultation.

Although a Decision does not have any binding effect

beyond the parties to the case, a Decision functions as a

precedent to be followed by the administrative agency in

future cases involving similar facts.

89. Since January 1, 1992, and the enactment of

Law No. 8383/1991, the BPTO has imposed fixed ceilings

on amounts payable by a Brazilian company to a

controlling foreign company under a patent or trademark

license agreement. See paragraph 82 of this Stipulation of

Facts. The ceilings, which were in place during 2006,

correspond to the ceilings for tax deductibility set forth in

Portaria 436/58, as amended. See paragraph 88 of this

Stipulation of Facts. The BPTO will not record an

agreement between a Brazilian company and a controlling

foreign company that does not comply with these ceilings.

These ceilings do not apply to agreements and payments

between unrelated companies.

90. Under its interpretation of Law Nos. 4131/1962

and 8383/1991, the BPTO also applies the same fixed

ceilings that apply to royalties under a patent or trademark

license agreement to payments under an agreement

between a Brazilian company and a controlling foreign

company providing for the transfer of unpatented

technology (“technology transfer payments”) and also to

payments for technical assistance services.

This

interpretation is not published. The BPTO applied this

interpretation during 2006.

91. The base against which royalties are calculated

under licensing agreements recorded at the BPTO

generally differs between payments for trademark

royalties and payments for patent royalties or transfers of

unpatented technology.

With respect to trademark

royalties, it is the general practice for licensing agreements

to calculate the one percent royalty based upon the net

sales of all trademarked merchandise sold by the licensee

(whether or not manufactured by the licensee), using the

definition of net sales under [Decree-]Law No. 1598/1977.

Conversely, it is the general practice to calculate patent

royalties and technology transfer payments (which, as

described above, range from one percent of net sales to five

percent of net sales) based upon the net sales of products

manufactured and sold by the licensee that incorporate

patented or unpatented technology. These are general

practices that are not required by Brazilian law or BPTO

policy.

92. It is the BPTO’s policy to limit the duration of a

technology transfer agreement to a maximum of five years.

As an exception to the general rule, if the parties can

objectively demonstrate to the BPTO the need to continue

the technology transfer, the BPTO may allow duration of a

technology transfer agreement to be renewed for one

additional five-year term. At the end of the five or ten-year

period, the BPTO requires that the transferee be entitled

to use the unpatented technology without further payment.

This maximum term for a technology transfer agreement

is not established in the Industrial Property Law (Law No.

9279/1996) or in any other law or regulation, but results

from the application, by analogy, of Law No. 4131/1962,

which provides that technical assistance services fees paid

under technology transfer agreements may be deducted

during only the first five years of the agreement, renewable

for one additional five year term. Limiting the duration of

technology transfer agreements as described above was the

policy of the BPTO in 2006. This policy was not published.

93. The BPTO will not record one or more licensing

agreements between a Brazilian company and a controlling

foreign company providing for a license of patents or

trademarks or providing for the transfer of unpatented

technology if such agreement or agreements relate to the

same product and call for royalties or payments that,

combined, exceed the deductibility limits under Brazilian

tax law. In such a case, the deductibility limitation

represents the maximum allowable payment, even if more

than one category of royalty or payment is involved. The

BPTO normally requests that the parties precisely indicate

which category of royalty is being paid. This was the policy

of the BPTO in 2006. This policy was not published.

94.

a. If a product is covered by a patent license or by a

technology transfer agreement between a Brazilian

company and a controlling foreign company, then the

BPTO by unwritten policy requires that any trademark

license between the same Brazilian company and the same

controlling foreign company for that same product be

granted royalty-free. If a trademark royalty may be paid

under that policy, the BPTO by unwritten policy requires

that the royalties for the license of trademarks payable by

a Brazilian company to a controlling foreign company must

be capped at one percent of net sales for each product, even

if more than one trademark is used on the product. These

unwritten policies of the BPTO were in effect at the time

that the 1998 Trademark Licenses were recorded and

during 2006, and they remain in effect. These unwritten

policies of the BPTO correspond to the administrative

ruling set forth in Decision No. 283 (Exhibit 32-J),

described in paragraph 88.f, above.

b. As described above at paragraphs 65-68, 3M

Company and 3M Brazil entered into three licensing

agreements, the 1998 Trademark Licenses, covering three

separate sets of trademarks. The BPTO recorded them in

June 1999. 3M Company had received erroneous legal

advice that if a product used multiple trademarks covered

by three separate agreements, then 3M Brazil could pay a

royalty of up to three percent of net sales (one percent for

each trademark covered by a separate agreement, as

described in paragraph 65 above). That legal advice was

contrary to the BPTO’s unwritten policy that the maximum

trademark royalty for a product is one percent of net sales,

regardless of how many licensed trademarks are identified

on the product.

c. The three 1998 Trademark Licenses (Exhibits 20J, 21-J and 22-J) described the trademarks but did not

describe the products on which the trademarks would be

used. The parties have not been able to determine whether

3M Brazil submitted additional information to the BPTO

indicating that 3M Brazil would use trademarks covered

by different licensing agreements on a single product and

pay more than a one percent royalty. However, 3M Brazil

did pay 3M Company trademark royalties of up to three

percent on products bearing trademarks covered by more

than one licensing agreement based on the erroneous legal

advice that it received.

95. Article 63 of the Brazilian Industrial Property

Law (Law No. 9279/1996) provides that any improvement

introduced in a licensed patent belongs to the party that

made the improvement. The other party is entitled to a

right of first refusal to obtain a license of the improvement.

Although the law refers to patents (and not to unpatented

technology), the BPTO applies this rule to unpatented

technology by analogy. If an agreement contains a

provision contrary to this rule and does not require the

licensor to make additional payment for the improvements

or reciprocate in some equivalent fashion, the BPTO may

record the agreement but with a notation that such

provision is not enforceable. This was the policy of the

BPTO in 2006. This policy was not published.

96. If a license agreement contains one or more

provisions that the BPTO considers to be burdensome to a

licensee’s rights, the BPTO will generally notify the parties

that the BPTO considers such provisions to be burdensome,

but the inclusion of such provisions will not interfere with

the BPTO’s recordation of the agreement. This was the

policy of the BPTO in 2006. The policy was not published.

97. Based upon its interpretation of the Industrial

Property Law (Law No. 9279/1996), the BPTO does not

permit the payment of royalties for patent and trademark

applications. However, in the case of patent applications,

royalties can be charged and credited in a licensee’s

financial statements, but payment can be made only after

the grant of the patent. This was the policy of the BPTO in

2006. This policy was not published.

98. Brazilian law allows 3M Brazil, as a sociedade

limitada, to make two kinds of distributions out of its

profits to its shareholders in respect of its shares: dividends

and interest on net equity.

99. Dividends can be paid by a Brazilian sociedade

limitada to the extent of its current and retained earnings,

as determined using Brazilian generally accepted

accounting principles.

Apart from this limitation,

Brazilian law imposes no restriction on the ability of a

sociedade limitada to pay dividends abroad to its

shareholders, including to a controlling foreign company,

and authorization from the Central Bank of Brazil is not

required. Dividends of a sociedade limitada must be

declared by the shareholders. Dividends are not deductible

by the company paying the dividend under Brazilian tax

law. Dividends are not taxable income to the recipient

under Brazilian tax law. Brazil does not impose a

withholding tax on dividends paid by a Brazilian company

to a foreign shareholder. This was the law in 2006.

100. As a sociedade limitada, 3M Brazil is allowed

under Brazilian law to pay interest on net equity. Interest

on net equity must be declared by the shareholders of a

sociedade limitada. Interest on net equity is calculated by

applying a long term interest rate set by the Brazilian

government (the “Taxa de Juros de Longo Prazo”), to the

company’s equity (i.e., net assets). The amount that can be

paid as interest on net equity is limited to greater of: (i) 50

percent of the entity’s profits of the current year; or (ii) 50

percent of the entity’s accumulated profits (not including

profits of the current year). Apart from this limitation,

Brazilian law imposes no restriction on the ability of a

sociedade limitada to remit interest on net equity abroad

to its shareholders, including to a controlling foreign

company, and authorization from the Central Bank of

Brazil is not required. Under Brazilian tax law, interest

on net equity is (subject to the previous limitations)

deductible by the company paying the interest on net

equity, and is taxable income to the recipient. Brazil

imposes a withholding tax on interest on net equity paid to

foreign recipients. The withholding tax rate applicable to

payments to United States shareholders is 15 percent. The

Brazilian entity that makes the payment is required to

withhold the withholding tax, and the tax is not a credit

against any other tax imposed under Brazilian law. This

was the law in 2006.

101. Under Brazilian income tax law, withholding

is generally required on cross-border payments made by a

Brazilian company to a foreign company in the following

amounts: 25% with respect to payments for services; 15%

with respect to royalty payments for patents and

trademarks; 15% with respect to payments under

technology transfer agreements (i.e., unpatented

technology); and 15% with respect to payments for

technical assistance services. These are the withholding

rates applicable where the recipient of a payment is

resident in the United States because there is no tax treaty

between Brazil and the United States and the United

States is not considered a tax haven. The withholding

rates may differ where the recipient is a resident of a

country having a tax treaty with Brazil or of a country that

is considered a tax haven. The Brazilian entity that makes

the payment is required to withhold the withholding tax,

and the tax is a not credit against any other tax imposed

under Brazilian law. This was the law in 2006.

102. Brazil imposes a CIDE (Contribuição sobre

Intervenção no Domínio Econômico) tax. The CIDE tax is

imposed at the rate of ten percent on payments of royalties,

technical assistance services, copyrights, and other

compensation derived from contractual obligations

involving the transfer of technology, made by a Brazilian

company to a foreign company. The CIDE tax is not a

withholding tax. It is imposed on the Brazilian paying

company. This was the law in 2006.

103.

The BPTO’s authority does not include

supervision over the payment of dividends or interest on

net equity.

Texts of certain Brazilian legal documents referred to in the

stipulations related to Brazilian law

Certain Brazilian legal documents were referred to in the

stipulations that we quoted supra part 5:

Exhibit number of legal

document

Stipulation paragraph

that refers to legal

document

Title of legal document

28-J

29-J

30-J

31-J

32-J

88.c

88.f

Portaria No. 436/58

Portaria No. 113/59

Portaria No. 314/70

Portaria No. 60/94

Decision No. 293 (Nov. 30,

2000)

The original documents are in Portuguese. Petitioner and respondent

have stipulated the English translations of the documents, which we

reproduce below.

The English translation of Exhibit 28-J (Portaria 436/58) is:

MINISTRY OF FINANCE

OFFICE OF THE MINISTER

DIRECTIVE 436 of December 30, 1958

The Minister of Finance, exerting the authority

conferred upon him and in view of the provisions referred

to in Article 74, paragraphs 1 and 2 of Law 3470, of

November 28, 1958, pertaining to the deduction of royalties

for the use of trademarks and patents, expenses for

technical, scientific, administrative and similar assistance,

as well as amortization quotas for patents, in ascertaining

the real profits of legal entities, decides:

a) to establish the following maximum percentual

coefficients for the above mentioned deductions,

taking into consideration the types of production

or activity, according to their degree of

essentiality:

I--royalties for the use of invention patents,

manufacturing processes and formulas,

expenses

for

technical,

scientific,

administrative and similar assistance:

FIRST GROUP--BASIC INDUSTRIES

Type of production

Percentage

1. Electric Power

01--Production and distribution . . . . . . . . . . . . . . . . . 5%

2. Fuel

02--Petroleum and by-products . . . . . . . . . . . . . . . . . . 5%

3. Transportation

03--Street-car transportation . . . . . . . . . . . . . . . . . . . 5%

4. Communications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5%

5. Transportation materials

01--Automobiles, trucks and similar vehicles . . . . . . 5%

02--Parts thereof . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5%

03--Tires and tubes . . . . . . . . . . . . . . . . . . . . . . . . . . . 5%

6. Fertilizers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5%

7. Basic Chemicals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5%

8. Heavy Metallurgy

01--Iron and Steel . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5%

02--Aluminum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5%

9. Electrical Material

01--Transformers, Dynamos and Generators . . . . . . . 5%

02--Electric motors for industrial use . . . . . . . . . . . . 5%

03--Telephonic, telegraphic and signalling

equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5%

10. Miscellaneous

01--Tractors and Combines for agriculture . . . . . . . . 5%

02--Equipment for Road Construction, and parts

thereof . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5%

03--Equipment for the extractive and transformation

industries, and parts thereof . . . . . . . . . . . . . . . . 5%

11. Shipbuilding

01--Ships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5%

02--Equipment for ships . . . . . . . . . . . . . . . . . . . . . . . 5%

SECOND

GROUP—PROCESSING

ESSENTIALS

INDUSTRY—

Type of Production

Percentage

1. Packaging Equipment . . . . . . . . . . . . . . . . . . . . . . . . . 4%

2. Foodstuffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4%

3. Chemicals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4%

4. Pharmaceuticals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4%

5. Textile materials, yarn and thread . . . . . . . . . . . . . . . 4%

6. Footwear and similar goods . . . . . . . . . . . . . . . . . . . . 3.5%

7. Manufactured metal goods . . . . . . . . . . . . . . . . . . . . 3.5%

8. Manufactured cement and asbestos goods . . . . . . . . 3.5%

9. Electric material . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3%

10. Machinery and appliances

01--Household appliances, not classified as

sumptuary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3%

02--Office machinery and appliances . . . . . . . . . . . . 3%

03--Appliances for scientific use . . . . . . . . . . . . . . . . 3%

11. Rubber and plastic manufactured goods . . . . . . . . . . 2%

12. Sanitary and toilet goods

01--Shaving articles . . . . . . . . . . . . . . . . . . . . . . . . . . 2%

02--Toothpaste . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2%

03--Regular bathing soap . . . . . . . . . . . . . . . . . . . . . 2%

13. Other processing industries . . . . . . . . . . . . . . . . . . . . 1%

II--royalties for the use of industrial and

commercial trademarks or trade name, in any

type of production or activity, when the use of

the trademark or name does not derive from

the utilization of the patent; manufacturing

process, or formula: 1%

b) The maximum percentages established will incur

on the gross operating income, in the case of

public service concessionaries, or on the gross

receipt value of products referred to in the license

or assistance services contracts;

c) in cases of payment based on goods produced

each year, the coefficients established as a limit

for the deductions referred to in numbers I and II

of (a) will be applied on the sales value of the

goods;

d) should the situation in (c) occur, the gross receipt

shall be readjusted, including the corresponding

value of goods produced and not sold, on the basis

of the last invoiced price and excluding the

amounts that may have been added in the same

way to the gross receipt of the previous year;

e) for tax purposes, as of 1959, to each fiscal year

there shall be an addition of the following

differences:

I--between the amounts of royalties and other

expenses referred to in article 74 of the

mentioned Law, credited or paid during the

base-year, and the minimum percentages

established for the respective deduction,

according to (b) and (d);

II--between the quotas for the purpose of

forming depreciation reserves for industrial

patents evaluated in accordance with article

68 of the same Law, and the maximum limit

of the deduction allowed, with respect to the

gross receipt value of the goods sold, referring

to the patent incorporated in the assets of the

company;

f) the legal entities whose types of production are

not included in the aforementioned groups may have

them included by applying to the Director of the

Income Tax Division; until such application is made,

the minimum percentage allowed shall be applied to

such types of production.

LUCAS LOPES

(Official Gazette, December 30, 1958)

The English translation of Exhibit 29-J (Portaria 113/59) is:

MINISTRY OF FINANCE

OFFICE OF THE MINISTER

DIRECTIVE 113 of May 25, 1959

The Minister of Finance decides:

To include in Directive 436, of December 30, 1958,

number I -- First Group -- Basic Industry, the cement

industry, with a percentage of 5%, in view of its degree of

essentiality and in accordance with reports from the

Income Tax Division and the General Management of the

National Treasury.

LUCAS LOPES

File n˚ 9413-59.

(Official Gazette, May 29, 1959).

The English translation of Exhibit 30-J (Portaria 314/70) is:

Ordinance/MF n˚ 314/70. Includes the 2nd Group-processing industry

Eng. MF 314/70--Port.--Ordinance FINANCE MINISTER

OF--MF n˚ 314 of 25.11.1970

D.O.U.: 12/01/1970

(Includes the 2nd Group--Manufacturing Industry-Essential--of the table Ordinance No. 436, of December 30,

1958, with the percentage of 4%, glass and glass artifacts,

for the purposes referred to in the Article 12 of Law No.

4131 of 3 September 1962.)

The Minister of Finance, in exercise of the powers

conferred on it by Article 12, § 1 of Law No. 4,131, of

September 1962, and Considering the need to improve the

national glass industry by importing the latest technical

achievements in the sector; considering the wide range of

applications of the products of that industry.

RESOLVES:

Include in the 2nd Group -- Manufacturing Industry -Essential -- of the table Ordinance No. 436, of December

30, 1958, with the percentage of 4%, glass and glass

artifacts, for the purposes referred to in Article 12 of Law

No. 4,131, of September 3, 1962.

ANTONIO DELFIM NETTO

The English portion of Exhibit 31-J (Portaria 60/94) is:

MF Ordinance No. 60

D.O.U.: 2/01/1994

The MINISTER OF FINANCE, in exercise of its statutory

duties, taking into view the provisions of art. 50 of Law No.

8,383, of December 30, 1991 and Ordinance No. 303, of

November 25, 1959, decides:

Article 1. Include in the 2nd Group--Processing Industries-Essential, Ordinance No. MF 436, of December 30, 1958,

the following item:

Types of Production Percentage 14--INDUSTRIAL

COMPUTER

SYSTEMS,

AUTOMATION

AND

INSTRUMENTATION

01--Machinery,

equipment,

apparatus, instruments and devices based on digital or

analog technique with technical functions of collection,

treatment, structuring, storage, switching, retrieval and

presentation of information, its respective electronic inputs

and opto-electronics, parts, pieces and physical support for

the operation, as well as technological update sets and

performance optimization (. . .) 5% [ellipses are in the

original]

Art. 2. This Ordinance shall enter into force on the date of

its publication.

Fernando Henrique Cardoso

The English portion of Exhibit 32-J (Decision No. 283) is:

MINISTRY OF FINANCE

FEDERAL REVENUE SERVICE

DECISION N˚ 283 of November 30, 2000

SUBJECT: Corporate Income Tax

SYLLABOUS: ROYALTIES. The percentages established

over gross revenue to limit the deductibility of the amounts

due in connection with royalties, must be applied to each

product, and not to each trademark used on a same

product. In case of royalties for the use of industrial and

commercial trademarks or trade name, in any type of

production or activity, when the use of the trademark or

name does not derive from the utilization of the patent,

manufacturing process or formula, the maximum limit is

of 1% (one per cent).

1999 assignment agreement; corporate restructuring

In 1999, 3M Global had sales in more than 180 countries.

In 1999, 3M Company decided that much of its intellectual

property should be held and managed by a newly formed U.S.

subsidiary, 3M Innovative Properties Company (“3M IPC”). 3M

Company also added to its corporate structure another newly formed

U.S. corporation, 3M Financial Management Company (“3M Financial

Management”). The purpose of 3M Financial Management was to

facilitate currency management and intercorporate lending between 3M

Company and its affiliates. The ownership structure of the four

corporations was as follows: (1) 3M Company owned 3M Financial

Management, (2) 3M Financial Management owned 3M IPC, (3) 3M IPC

owned 3M Brazil.

In 1999, 3M Company executed an assignment agreement to

transfer certain intellectual property to 3M IPC to facilitate, through

standardization and centralization, the licensing, management,

enforcement, and control of 3M Company’s intellectual property. The

assignment agreement was effective April 1, 1999.

Under the

agreement, 3M Company assigned to 3M IPC all U.S. patents owned,

licensed to, or possessed by 3M Company; all copyrights owned, licensed

to, or possessed by 3M Company; all proprietary information (defined as

business, technical and other information of any kind, including both

confidential and nonconfidential information) owned, licensed to, or

possessed by 3M Company; and all other intellectual property (except

trademarks) owned, licensed to, or possessed by 3M Company.

As part of the assignment agreement, 3M Company also granted

an exclusive license to 3M IPC, including the right to sublicense, all

foreign patents controlled by 3M Company and to use any foreign

trademarks controlled by 3M Company. 3M Company retained

ownership of the trademarks.

As part of the assignment agreement, 3M Company also assigned

to 3M IPC its ownership interest in most licenses of intellectual property

from 3M Company to its affiliates or third parties.

Business operations during the 2006 tax year

3M Global

As of the 2006 tax year, 3M Global was one of the largest

technology-and- manufacturing enterprises in the world, reporting in its

annual report that it had over $23 billion in worldwide gross sales and

over $21 billion in worldwide assets. At the close of the 2006 tax year,

3M Global employed 75,333 people worldwide, with 34,553 employed in

the United States and 40,780 employed in foreign countries. 3M Global

derived roughly 60% of its annual revenues in the 2006 tax year from

sources outside the United States.

3M Global’s business operations are organized, managed, and

internally grouped into segments based on differences in products,

technologies, and services. During the 2006 tax year, 3M Global’s

business consisted of six primary segments: Industrial and

Transportation; Health Care; Display and Graphics; Consumer and

Office; Safety, Security and Protection Services; and Electro and

Communications. 3M Global sold more than 50,000 different products.

During the 2006 tax year, research and product development

constituted an important part of 3M Global’s business activities.

Research, development, and related expenses for 3M Global totaled

$1.522 billion in 2006, up from $1.274 billion in 2004 and $1.246 billion

in 2005.

3M Brazil

During the 2006 tax year, neither 3M Company nor 3M IPC

owned any plant, property, or equipment in Brazil. During the 2006 tax

year, 3M Brazil reported for U.S. income-tax purposes approximately

$563 million in sales and employed approximately 3,120 people at its

corporate headquarters and its three manufacturing sites throughout

Brazil, including a research and development facility at one of the

manufacturing sites.

At all relevant times, including during the 2006 tax year, 3M

Brazil’s primary business operations included the manufacturing and

distribution of 3M Global’s products. The products that 3M Brazil

manufactured, marketed, or sold during the 2006 tax year included

abrasives, adhesives and adhesive tapes, automotive products, office

and consumer products, medical-and-dental-care products, graphiccommunication products, electrical products, telecommunication

products, tapes (including masking tapes, packaging tapes, and diaper

tapes), labels, respirators, and hearing-protection products.

3M Brazil also engaged in research-and-development activities,

which led to the creation of intellectual property. During the 2006 tax

year, 3M IPC had 167 patent applications pending in Brazil. During

that year, Brazil granted 32 patents to 3M IPC. Two of those were

developed by 3M Brazil personnel, and four were developed in Brazil by

unrelated persons and were acquired by 3M Brazil from those persons. 14

A Form 5471 pertaining to 3M Brazil was attached to the

consolidated federal income tax return filed by the 3M consolidated

group for the 2006 tax year. The Form 5471 is titled “Information

Return of U.S. Persons with Respect to Certain Foreign Corporations”.

The consolidated federal income tax return was made on Form 1120.

The average exchange rate for converting U.S. dollars ($) to Brazilian

reais (R$) for the 2006 taxable year, as reported by the 3M consolidated

group on its Form 5471 for 3M Brazil, was 2.1705157. That exchange

rate is used in this Opinion unless otherwise indicated.

14 We describe infra part 14 paragraph 128 of the stipulation, which relates to

research-and-development expenses incurred by 3M Brazil.

Intellectual property; services

3M IPC owns substantially all of the intellectual property used or

developed by 3M Global, with the exception of trademarks, which are

owned by 3M Company. During the 2006 tax year, 3M IPC owned, or

held licenses to use, a wide variety of U.S. and foreign patents in

connection with 3M Global’s products. 15

During the 2006 tax year, 3M Global’s products were sold under

various trademarks owned by 3M Company.

The intellectual property of 3M Company and 3M IPC is

collectively referred to as the 3M Intellectual Property.

Including during the 2006 tax year, 3M Company and 3M IPC

had jointly licensed the 3M Intellectual Property (1) to most of the

affiliates of 3M Global (but not to 3M Brazil) and (2) to third parties.

During the 2006 tax year, 3M Company and 3M IPC jointly

licensed the 3M Intellectual Property to most affiliates of 3M Global

using a standard licensing agreement. 3M Brazil was not among those

affiliates. The standard licensing agreement recites that “[i]nstead of

negotiating separate agreements for different technologies, products,

services and intellectual property rights, the Parties wish to negotiate a

single agreement that will grant a license to Affiliate under the entire

portfolio of 3M IPC’s intellectual property rights, and will transfer

intellectual property rights developed or obtained by Affiliate to 3M

IPC.” The word “Affiliate” refers to a foreign affiliate. “Parties” refers

to the Affiliate, 3M Company, and 3M IPC. Under the standard

licensing agreement, the licensors (3M Company and 3M IPC,

individually and collectively) grant to the licensee (a foreign affiliate) a

license to manufacture goods using the licensor’s intellectual property

and to exercise all rights that are protected by or arise under the

licensor’s intellectual property. A licensee under the standard licensing

agreement agrees to pay a royalty to 3M IPC equal to 6% of the net price

charged by the licensee for products manufactured using the licensor’s

15 As explained before, the 1999 assignment agreement transferred U.S.

patents from 3M Company to 3M IPC. The record does not appear to show when or

how the foreign patents were transferred from 3M Company to 3M IPC.

intellectual property. 16 Trademarks are not used in the manufacture of

products, and therefore the royalty payment does not cover the use of

trademarks. The licensee also agrees to pay to 3M IPC 6% of the net

price charged by the licensee to any buyer other than a 3M Global

company for services provided by the licensee under the licensor’s

intellectual property. The licensee also agrees to pay to 3M IPC 1% of

the net price charged by the licensee for products sold, licensed, leased,

or otherwise disposed of by the licensee (using the licensor’s intellectual

property) to any buyer other than a 3M Global company. Under the

standard licensing agreement, 3M Company agrees to reimburse the

licensee its actual costs incurred for laboratory work undertaken by the

licensee or performed by an entity other than the licensor for the licensee

at the licensee’s request, and related to product development or

modification, or research, including basic and applied research. 3M

Company also agrees to pay a markup of 10% (or other agreed markup).

All types of intellectual property developed by the licensee through this

arrangement would become the property of 3M IPC, except for the

trademarks, which would become the property of 3M Company. The

types of intellectual property include (1) patents, trademarks, domain

names, copyrights, proprietary information, and (2) all intellectual

rights of any kind other than patents, trademarks, domain names,

copyrights and proprietary information.

The standard licensing

agreement does not relate to technical and support services, which are

the subject of a separate agreement, as described in the next paragraph.

With only a few exceptions, all of the foreign affiliates in 3M Global

operated under a version of the standard licensing agreement during the

2006 tax year. 3M Brazil was one such exception.

The standard services agreement is a reciprocal agreement under

which 3M Company and 3M IPC, on the one hand, and the foreign

affiliate, on the other, agree to provide technical and support services to

each other as may be agreed from time to time. The services include

technical assistance services and selling, marketing, and general and

administrative services. Under the standard services agreement, the

foreign affiliate agrees to compensate 3M Company and 3M IPC at cost,

and 3M Company and 3M IPC agree to compensate the foreign affiliate

at cost plus a 10% markup. Most of the foreign affiliates in 3M Global

operated under a version of the standard services agreement during the

2006 tax year. 3M Brazil was one exception. 3M Company and 3M

16 The calculation of the net price includes a reduction for the cost of

semifinished goods incorporated into the manufactured products that were purchased

from a 3M Global company.

Brazil entered into a version of the standard services agreement

effective January 1, 2009.

At all relevant times, including the 2006 tax year, 3M Brazil had

access to, and used in its business operations, the 3M Intellectual

Property, including patents, trademarks, trade names, name

recognition, copyrights, software, and nonpatented technology (such as

technical know-how and trade secrets). 3M Brazil’s right to 3M

Intellectual Property throughout the years was sometimes governed by

one or more licensing agreements. The only such arrangements in effect

during the 2006 tax year were the 1998 trademark licensing

agreements. At all relevant times, including during the 2006 tax year,

3M Company provided services to 3M Brazil. During the 2006 tax year,

those services consisted of consulting services and technical assistance

services. During 2006, 3M Company provided significantly more

consulting services and technical assistance services. The terms

“consulting services” and “technical assistance services” are defined in

paragraph 74 of the stipulation, which is quoted infra part 9.

Payments by 3M Brazil

The 1998 trademark licenses required 3M Brazil to pay 3M

Company 1% of its net sales. Brazil required that the maximum royalty

for a product be 1% of net sales, regardless of how many licensed

trademarks were used on the product. During 2006, 3M Brazil paid

$5,104,756 in royalties to 3M Company under the 1998 trademark

licenses. This $5,104,756 royalty payment, though calculated at 1% of

net sales, was calculated using a stacking principle under which if a

product used multiple trademarks covered by three separate

agreements, then the licensee (3M Brazil) should pay up to a 3%

trademark royalty. We make no finding as to what the royalty payment

would have been if computed without the stacking principle. 17

17 Petitioner contends that 3M Brazil’s net sales were $466,618,701 and that

therefore had 3M Brazil calculated the trademark royalties at 1% of sales without

stacking, 3M Brazil would have paid $4,666,187 in royalties. We do not find as fact

that 3M Brazil’s net sales were $466,618,701. First, petitioner failed to state this

contention in its proposed findings of fact, as it was required to do by Rule 151(e)(3).

Second, the only evidence supporting the contention is information in the tax return of

the 3M consolidated group. A tax return is a weak source of information in a deficiency

case such as this one. See Wilkinson v. Commissioner, 71 T.C. 633, 639 (1979).

During 2006, 3M Brazil paid $52,522,080 in dividends and

$11,978,720 in interest on net equity to 3M IPC. The total of these

payments is $64,500,800.

In 2006, 3M Brazil made no payments to 3M Company for

consulting services or technical assistance services. Nor did 3M Brazil

pay 3M IPC for the use of patents, trade names, name recognition,

copyrights, software, or unpatented technology.

Tax reporting

The 3M consolidated group reported on its consolidated federal

income tax return for 2006 that it had taxable income of $4,466,124,618

and a tax liability of $1,049,490,347.

The members of the 3M consolidated group included 3M Company

(the common parent of the group) and 3M IPC.

On its consolidated federal income tax return, the 3M

consolidated group reported as income the $5,104,756 in trademark

royalties paid by 3M Brazil to 3M Company.

The total of dividends and interest on net equity paid by 3M

Brazil in 2006 ($64,500,800) was reported by the 3M consolidated group

as dividends paid on Schedule M of the 3M Brazil Form 5471 for 2006.

10.

The notice of deficiency

In the notice of deficiency, respondent made 47 adjustments to

the income of the 3M consolidated group. 18

One adjustment in the notice of deficiency, labeled “Brazil

Royalties”, was a net $23,651,332 increase in the income of the 3M

consolidated group. Petitioner and respondent have stipulated, in

paragraph 120 of the stipulation, that this adjustment was calculated

by “[a]pplying the royalty rates under the Standard Licensing

Agreement to the intercompany licensing transactions between 3M

Company, 3M IPC, and 3M Brazil at issue in this case.” The phrase

18 Respondent mailed the notice of deficiency to 3M Company because 3M

Company was the common parent company of the 3M consolidated group. See 26

C.F.R. sec. 1.1502-77B(a)(2)(viii) (2018) (providing that notices of deficiency are mailed

to the common parent of a consolidated group and that mailing to the common parent

is considered a mailing to each member of the consolidated group).

“intercompany licensing transactions between 3M Company, 3M IPC,

and 3M Brazil at issue in this case” refers to the following: (1) the use

by 3M Brazil of trademarks owned by 3M Company, (2) the use by 3M

Brazil of patents owned by 3M IPC, and (3) the transfer of technology

from 3M IPC to 3M Brazil. 19

The royalty rate used by the notice of deficiency was 6% of net

sales. The notice of deficiency calculated that the royalty at the 6% rate

was $27,768,702 and that this amount should be reduced by $4,117,370

for 3M Brazil’s unreimbursed expenditures on research and

development.

Thus, the adjustment to the income of the 3M

consolidated group was $23,651,332, equal to $27,768,702 minus

$4,117,370. The notice of deficiency explained the $23,651,332 increase

as follows:

19 As the parties have stipulated, the adjustment in the notice of deficiency was

based on the terms of the standard licensing agreement. The standard licensing

agreement contained two major provisions: one was the license of intellectual property

at a 1% royalty; the other was the license of intellectual property other than

trademarks at a 6% royalty. The notice of deficiency applied a 6% royalty, rather than

a 1% royalty. This suggests that the notice of deficiency did not make an adjustment

for trademark royalties and that the adjustment in the notice of deficiency related to

intellectual property other than trademarks. The notice of deficiency did not expressly

say which types of nontrademark intellectual property bore the 6% imputed royalty.

On brief, respondent contends that the 6% imputed royalty is compensation for the use

of patents owned by 3M IPC and for technology transferred by 3M IPC. See infra part

17 (third paragraph). So far the adjustment in the notice of deficiency, as defended by

respondent in litigation, may not seem to be related to the use of trademarks.

However, further analysis shows that the use of trademarks is relevant to the

appropriate section 482 adjustment in this case, as we explain below. Petitioner

opposes the 6% royalty adjustment in the notice of deficiency on the ground that 3M

Brazil was prevented by Brazilian law from paying patent royalties and making

technology-transfer payments to 3M IPC in excess of ceilings of between 1% and 5%.

3M Brazil was also barred by Circular-Letter 2795 from paying any patent royalties

and technology-transfer payments to 3M IPC because 3M Brazil had failed to record

with the BPTO a licensing agreement with respect to such royalties and payments.

Petitioner recognizes, however, that 3M Brazil could have recorded such a licensing

agreement and that, had it done so, it could have paid patent royalties and technologytransfer payments to 3M IPC up to the 1%-5% ceilings. However, had 3M Brazil

recorded such a licensing agreement, it would have been prohibited from paying

trademark royalties to 3M Company. Thus, petitioner contends that the section 482

adjustment should be limited to the maximum amount 3M Brazil could have paid 3M

IPC under the 1%-5% ceilings for patent royalties and technology-transfer payments

minus the trademark royalty payments it actually made. In summary, the section 482

adjustment urged by petitioner partly implicates the use of 3M Company’s trademarks

by 3M Brazil and the Brazilian restrictions on the payment of trademark royalties.

It is determined that in order to clearly reflect the income

of the entities, in accordance with section 482 of the

Internal Revenue Code, we have allocated royalty income

to you from 3M do Brasil Limitada (“3M Brazil”) in

connection with 3M Brazil’s use of intellectual property.

We have determined that Brazilian legal restrictions are

not taken into account for purposes of computing the arm’s

length amount of royalty income from 3M Brazil because it

has not been established that the Brazilian legal

restrictions affected an uncontrolled taxpayer under

comparable circumstances for a comparable period of time,

and because it has not been established that the

restrictions satisfied the conditions pursuant to Treasury

Regulations sections 1.482-1(h)(2)(i) and (ii). In addition,

we have determined that you are ineligible to elect the

deferred income method of accounting pursuant to

Treasury

Regulations

section

1.482-1(h)(2)(iii).

Accordingly, your taxable income for the tax year ended

December 31, 2006 is increased by $23,651,332, as shown

in the computation below:

a. Total cost of goods sold of products

manufactured by 3M Brazil (from Form 5471,

Sch. C, line 2)

$332,547,422

Cost of goods sold (other than raw materials)

purchased from:

b. U.S. affiliates (from Form 5471, Sch. M,

Line 10(b)+(c))

(42,966,307)

c. Foreign affiliates (from Form 5471, Sch. M,

Line 10(d))

(16,537,910)

d. Net cost of goods sold for manufactured products

$273,043,205

e. Gross sales from Form 5471 (Sch. C, line 1a)

$563,672,096

f. Times: Ratio of net to total cost of goods sold

(d divided by a)

0.821065469

g. Net sales of manufactured products

$462,811,694

h. Times: Manufacturing royalty rate

i. Proposed manufacturing royalty

$27,768,702

j. Setoff for unreimbursed R & D expenses

(4,117,370)

k. Proposed net adjustment

$23,651,332

Another adjustment in the notice of deficiency was a $4,751,136

increase in income of the 3M consolidated group for “Support Service

Fee--3M do Brasil LTDA”. The notice of deficiency explained this

“Support Service Fee” adjustment as follows:

It is determined that an adjustment is required under

section 482 of the Internal Revenue Code to reallocate

$4,751,136 of income to you from 3M do Brasil LTDA [i.e.,

3M Brazil] relating to support services which were never

charged. Accordingly, your taxable income for the tax year

ended December 31, 2006 is increased by $4,751,136.

To calculate the adjustment, the notice of deficiency applied the rate of

compensation provided under the standard services agreement (which

was cost, if services were provided by 3M Company or 3M IPC; or cost

plus 10%, if services were provided by a licensee of intellectual property

owned by 3M Company or 3M IPC) to the intercompany services

transactions during 2006 between 3M Company and 3M Brazil.

11.

Closing agreement

After the notice of deficiency was issued, but before the petition

was filed, petitioner and respondent entered into a partial closing

agreement under section 7121. One of the terms of the closing

agreement was that petitioner agreed to the “Support Services Fee”

adjustment of $4,751,136. At that time, petitioner understood that

Brazilian law imposed no limits on what 3M Brazil could pay to 3M

Company for the services it provided (which consisted of consulting

services and technical assistance services). Petitioner subsequently

learned that its understanding was partially incorrect because, as

explained in paragraphs 74, 76, and 77 of the stipulation, Brazilian law

distinguishes between remuneration for technical assistance services (to

which the fixed ceilings described in paragraph 90 of the stipulation

apply) and remuneration for consulting services (to which such fixed

ceilings do not apply). As explained supra part 5, 3M Company provided

significantly more consulting services to 3M Brazil than technical

assistance services.

12.

The petition

On March 6, 2013, the petition was filed. It challenged only one

adjustment in the notice of deficiency, the $23,651,332 adjustment for

“Brazil Royalties”. The petition explained the basis for the challenge as

follows:

5.a.18. 3M Brazil’s Legal Inability to Pay Royalties.

Brazilian law precluded 3M Brazil from paying any

royalties to the Petitioner[20] other than one-percent

royalties on the licensed Trademarks, which were paid and

which Petitioner included in its income. In addition, under

no circumstances could the royalties payable by 3M Brazil

have been at a rate of six percent of net sales under

Brazilian law in addition to the one-percent royalty

payable on Trademarks.

5.a.19. The Allocation Was Erroneous. The Commissioner

has no authority under I.R.C. § 482 to allocate income to a

taxpayer from a related party where the related party is

legally prohibited from paying the income to the taxpayer,

and where the taxpayer did not in fact receive the income

from the related party. Because 3M Brazil could not legally

pay the imputed royalty income to Petitioner, and because

Petitioner did not receive the royalties, the Commissioner’s

allocation was erroneous.

5.a.20. The Commissioner’s Reliance on Treas. Reg.

§ 1.482-1(h)(2). In the Notice, the Commissioner stated

that restrictions on the payment of royalties under

Brazilian law would not be “taken into account for purposes

of computing the arm’s length amount of royalty income”

because the conditions under Treas. Reg. § 1.482-1(h)(2)(i)

and (ii) had not been satisfied.

5.a.21. Invalidity of Treas. Reg. § 1.482-1(h)(2)(i) and (ii).

Treasury exceeded its legal authority when, in Treasury

Decision 8552 (59 Fed. Reg. 34971-01, 1994-2 C.B. 93 (July

8, 1994)), it adopted Treas. Reg. § 1.482-1(h)(2)(i) and (ii).

That regulation is invalid.

In recognition of the binding effect of the closing agreement, the

petition did not dispute the “Support Services Fee” adjustment of

$4,751,136 in the notice of deficiency.

20 “Petitioner” meant the 3M consolidated group.

13.

The stipulation that the rate of compensation under the standard

licensing agreement is an appropriate arm’s-length rate under

section 482

As we previously observed, paragraph 120 of the stipulation

includes a stipulation that the $23,651,332 increase to the income of the

3M consolidated group in the notice of deficiency was calculated by

applying the royalty rates in the standard licensing agreement. See

supra part 10. In the same paragraph of the stipulation, petitioner and

respondent also agreed that the rate of compensation provided under

the standard licensing agreement is “an appropriate arm’s length rate

under section 482 for the intercompany licensing transactions between

3M Company, 3M IPC, and 3M Brazil at issue in this case”. The

combined effect of these two stipulations is that petitioner and

respondent agree that the $23,651,332 adjustment in the notice of

deficiency reflects an appropriate arm’s-length rate of compensation

under section 482. 21

14.

The stipulation that the section 482 adjustment must be reduced

by $4,117,370 in unreimbursed research-and-development

expenses incurred by 3M Brazil

In paragraph 128 of the stipulation, petitioner and respondent

agreed that, as determined in the notice of deficiency, the 3M

consolidated group is entitled to a “setoff against any section 482

adjustment for royalties from 3M Brazil” in an amount equal to

$4,117,370 for research-and-development expenses incurred by 3M

Brazil that 3M Company did not reimburse but would have reimbursed

had the standard agreement been in effect.

15.

The stipulation that, under Brazilian law, the maximum amount

that 3M Brazil could have paid to 3M IPC as patent royalties or

technology-transfer payments in 2006 was $4,283,153 after

reduction for the $5,104,756 in trademark royalties paid by 3M

Brazil to 3M Company in 2006

Petitioner and respondent have stipulated that under Brazilian

law the maximum amount that 3M Brazil could have paid to 3M IPC as

patent royalties or technology-transfer payments in 2006 was

21 Because the adjustment in the notice of deficiency reflects the royalty rate

in the standard licensing agreement, and because the royalty rate in the standard

licensing agreement is an arm’s-length rate of compensation, it follows that the

adjustment in the notice of deficiency reflects arm’s-length compensation.

$4,283,153. This amount equals $9,387,909, which is the maximum

amount of such payments calculated before application of the Brazilian

prohibition on a Brazilian company paying trademark royalties to its

controlling foreign company for a product covered by a patent license or

a technology-transfer agreement, reduced by the $5,104,756 of

trademark royalties as required by the prohibition.

Petitioner and respondent performed an analysis of 3M Brazil’s

net sales made during 2006 by commodity code 22 for the purpose of

computing the maximum amount of “additional royalties or technology

transfer payments” that 3M Brazil would have been permitted to deduct

under Brazilian tax law and to pay to 3M Company and 3M IPC. 23 We

refer to this analysis as the “maximum-deductibility analysis”. The

maximum-deductibility analysis assumed that all the products sold by

3M Brazil were manufactured by 3M Brazil and were covered by either

(1) a currently valid patent, (2) unpatented technology that was in use

for not more than five years, (3) or both. The maximum-deductibility

analysis was performed in 3M Brazil’s functional currency, Brazilian

reais.

The maximum-deductibility analysis was jointly conducted by

two Brazilian attorneys (one for petitioner and one for respondent) who

practice Brazilian intellectual-property law and who are knowledgeable

concerning the limitations on the deductibility under Brazilian tax law

of trademark and patent royalties and technology-transfer payments.

These Brazilian attorneys consulted with 3M Brazil to determine the

maximum deductions under Brazilian tax law for “patent royalties or

technology transfer payments” 24 with respect to the products sold by 3M

Brazil according to commodity code. The highest rates were then

applied to the net sales of products for each commodity code, not

including intercompany sales (because intercompany sales are not

subject to the payment of royalties under the standard licensing

agreement), to determine the maximum amount that 3M Brazil could

have deducted if it had paid 3M IPC for the “use [of] its patents or for

the transfer of its unpatented technology.” 25 Given that 3M Company

and 3M IPC, at all relevant times, were controlling foreign companies of

22 3M Brazil sold products having more than 100 product codes in 2006.

products were subdivided, within each product code, by commodity codes.

23 The quoted text is from the stipulation.

24 The quoted text is from the stipulation.

25 The quoted text is from the stipulation.

Those

3M Brazil, the maximum-deductibility analysis also determined the

maximum amount that the BPTO would have permitted 3M IPC and

3M Brazil to include as payable to 3M IPC in any recorded agreement

providing for the “use of patents or the transfer of unpatented

technology”. 26 See paragraphs 89 and 90 of the stipulation.

Consequently, the maximum-deductibility analysis also determined the

maximum amount that the Brazilian Central Bank would have

permitted 3M Brazil to remit to 3M IPC as “royalties or as technology

transfer payments”, 27 given that Circular-Letter No. 2795 requires such

payments to be made pursuant to a written agreement recorded by the

BPTO. See paragraph 75.b of the stipulation.

The maximum-deductibility analysis showed that the maximum

amount that 3M Brazil could have deducted as “patent royalties or

technology transfer payments” 28 in 2006 was $9,387,909 subject to the

following. To arrive at the maximum amount of “additional royalties or

technology transfer payments” 29 that 3M Brazil could have deducted in

2006, the above amount must be reduced by the royalties that 3M Brazil

paid and deducted under the 1998 trademark licenses during 2006,

because, if a product is covered by a patent license or by a technologytransfer agreement between a Brazilian company and controlling

foreign companies, then any trademark license between the same

Brazilian company and the same controlling foreign companies for that

same product must be granted royalty free. Therefore, because 3M

Brazil deducted 30 and paid trademark royalties in connection with

certain of the same products during 2006, the maximum amount that

could have been paid as “patent royalties or as technology transfer

payments” 31 must be reduced by the amount of trademark royalties paid

and deducted by 3M Brazil. Petitioner and respondent have stipulated,

in paragraph 126 of the stipulation, that, on the basis of the maximumdeductibility analysis, the “maximum amount of additional patent

royalties and technology-transfer payments for 2006, after reduction for

the trademark royalties actually paid by 3M” was $4,283,153.

26 The quoted text is from the stipulation.

27 The quoted text is from the stipulation.

28 The quoted text is from the stipulation.

29 The quoted text is from the stipulation.

30 Deducted for Brazilian tax purposes.

31 The quoted text is from the stipulation.

Petitioner and respondent have stipulated, in paragraph 127 of

the stipulation, that the “maximum additional amount” that 3M Brazil

could have deducted 32 and paid in 2006 to 3M IPC as “patent royalties

or as technology transfer payments”, in “excess of the trademark

royalties actually paid to 3M Company”, and using the assumptions

underlying the maximum-deductibility analysis, was $4,283,153, and

that the Brazilian Central Bank would have permitted 3M Brazil to

make such a payment had the BPTO recorded an agreement among 3M

Company, 3M IPC, and 3M Brazil providing for the payment of such

amounts.

16.

The stipulation that if the Court holds that the section 482

adjustment must take into account the Brazilian legal

restrictions, then the minimum section 482 adjustment should be

$165,783

Petitioner and respondent have stipulated, in paragraph 129 of

the stipulation, that the “minimum section 482 adjustment” with

respect to the intercompany licensing transactions among 3M Brazil,

3M Company, and 3M IPC for the 2006 year is $165,783 (equal to

$4,283,153 minus an offset of $4,117,370 for unreimbursed researchand-development expenses (R & D offset)). We interpret the term

“minimum section 482 adjustment” to be the minimum section 482

adjustment that would be made if petitioner were to prevail in its

argument that the Brazilian legal restrictions should be taken into

account. We refer to the $4,117,370 offset for unreimbursed researchand-development expenses as the $4,117,370 R & D offset.

17.

Respondent’s position

Respondent’s position is that the relevant adjustment in the

notice of deficiency is correct. The notice of deficiency adjusted the

income of the 3M consolidated group by $23,651,332, equal to

$27,768,702 minus $4,117,370. The latter two amounts have the

following significance:

●

The $27,768,702 amount corresponds to the 6% royalty

rate set forth in the standard licensing agreement for

intellectual property other than trademarks. 33

32 Deducted for Brazilian tax purposes.

33 This point was discussed supra part 10 note 18.

●

The $4,117,370 amount is the research-and-development

expenses incurred by 3M Brazil for which it was not

reimbursed. The standard licensing agreement requires

the licensor to reimburse the licensee for certain research.

Respondent’s position can be illustrated as follows:

Respondent’s position regarding appropriate sec. 482 adjustment for

3M Brazil’s use of 3M Company’s trademarks,

3M Brazil’s use of 3M IPC’s patents, and

technology transfers from 3M IPC to 3M Brazil

Explanation

Amount

6% royalty provided by standard licensing agreement for

intellectual property other than trademarks

$27,768,702

R&D offset, as provided by standard licensing agreement

–4,117,370

Equals the section 482 adjustment urged by respondent

23,651,332

As we have explained before, because the adjustment in the notice

of deficiency reflects the compensation in the standard licensing

agreement and because the standard licensing agreement reflects arm’slength compensation, it follows that the adjustment in the notice of

deficiency reflects arm’s-length compensation. See supra part 13. What

is disputed is whether arm’s-length compensation can serve as the basis

for the section 482 adjustment. Respondent contends that the arm’slength compensation results in the appropriate section 482 adjustment

because, respondent contends, the Brazilian legal restrictions should be

disregarded. By contrast, petitioner contends that the appropriate

section 482 adjustment is constrained by the amounts payable under

Brazilian law.

It bears emphasis that respondent contends that the 6% royalty

component of the section 482 adjustment is justified only by (1) 3M

Brazil’s use of 3M Company’s patents and (2) the transfer of technology

from 3M IPC to 3M Brazil. See supra part 10 note 18. Respondent’s

section 482 adjustment makes no adjustment directly concerning

compensation for 3M Brazil’s use of 3M Company’s trademarks. Recall

that 3M Company, which owned all of the trademarks of 3M Global,

allowed 3M Brazil to use its trademarks during the 2006 tax year.

Pursuant to the 1998 trademark licenses, 3M Brazil paid 3M Company

$5,104,756 of trademark royalties. This payment was reported as

income by the 3M consolidated group on its 2006 tax return. Respondent

does not argue that this reporting should be adjusted under section 482

for 3M Brazil’s use of 3M Company’s trademarks.

Although respondent’s main position is that the Brazilian legal

restrictions should not be taken into account in making the section 482

adjustment, respondent has an alternative position should petitioner

prevail in its argument that the Brazilian legal restrictions be taken into

account. As previously explained, paragraph 129 of the stipulation

means that respondent agrees that if petitioner prevails in its argument

that the Brazilian legal restrictions should be taken into account, the

minimum section 482 adjustment should be $165,783. See supra part

16. Although paragraph 129 says the minimum section 482 adjustment

was $165,783, and therefore does not technically limit respondent’s

claiming that the section 482 adjustment should be more than $165,783,

respondent’s briefs do not argue that the section 482 adjustment should

be more than $165,783 in the event that petitioner prevails in its

argument that the section 482 adjustment must take into account the

Brazilian legal restrictions. Thus, we consider respondent’s position to

be that the section 482 adjustment should be $165,783 in the event that

petitioner prevails in its argument that the section 482 adjustment must

take into account the Brazilian legal restrictions.

18.

Petitioner’s position

Petitioner concedes that the $23,651,332 allocation determined

by respondent reflects an arm’s-length compensation for the use of the

intellectual property. 34

However, it disputes respondent’s legal

authority to make an allocation under section 482 because 3M Brazil

was prevented under Brazilian law from paying more than $165,783 in

compensation. This $165,785 amount is equal to (1) $4,283,153 minus

(2) the R&D offset of $4,117,370. Petitioner contends that the

appropriate transfer-pricing adjustment is $165,785. We pause here to

explain petitioner’s computation of this adjustment more completely.

34 This concession is the result of paragraph 120 of the stipulation, which stated

two things: (1) respondent’s $23,651,332 sec. 482 adjustment was determined from the

royalty rates under the standard licensing agreement, and (2) the rate of compensation

under the standard licensing agreement is an arm’s-length rate for the transactions at

issue. Combining these two statements means that respondent’s $23,651,332 sec. 482

adjustment reflects an arm’s-length rate for the transactions at issue. See supra part

14.

The $4,283,153 amount is the maximum of patent-royalty

payments and technology-transfer payments 3M Brazil could make to

3M Company assuming it had recorded with the BPTO a licensing

agreement regarding such payments. Computation of the $4,283,153

amount starts with $9,387,909, an amount that does not account for the

Brazilian restriction that, if a product is covered by a patent license or

by a technology-transfer agreement between a Brazilian company and

its controlling foreign company, any trademark license between the

same companies for that same product must be granted royalty free. To

account for the restriction, the $9,387,909 amount would be reduced by

the $5,104,756 of trademark royalties to arrive at $4,283,153.

Finally, paragraph 128 of the stipulation requires that the section

482 adjustment be reduced by the $4,117,370 R&D offset. When

$4,283,153 is reduced by $4,117,370, the result is $165,783. This is the

correct section 482 adjustment in petitioner’s view. The adjustment

supposes that the Brazilian legal restrictions are taken into account.

Petitioner’s calculations of the adjustment can also be illustrated

in the table below:

Petitioner’s position regarding appropriate sec. 482 adjustment for

3M Brazil’s use of 3M Company’s trademarks,

3M Brazil’s use of 3M IPC’s patents, and

technology transfers from 3M IPC to 3M Brazil

Explanation

Amount

Maximum amount that 3M Brazil could pay 3M IPC as

royalties or as technology-transfer payments, before

application of the Brazilian restriction that, if a product is

covered by a patent license or by a technology-transfer

agreement between a Brazilian company and controlling

foreign companies, any trademark license for that same

product must be granted royalty free. (This maximum

amount implicitly assumes that 3M Brazil records an

agreement with 3M IPC regarding the use of 3M IPC’s patents

and the transfer of 3M IPC’s technology.)

$9,387,909

Reduction in trademark royalties paid, as required by the

Brazilian restriction referred to above

–5,104,756

Equals the sec. 482 adjustment urged by petitioner before

R&D offset

4,283,153

R&D offset, as required by paragraph 128 of the stipulation

–4,117,370

Equals final sec. 482 adjustment urged by petitioner

165,783

We now discuss petitioner’s position in the event it loses its

argument that the section 482 adjustment must take into account the

Brazilian legal restrictions. In its opening brief, petitioner takes the

position that if the Court agrees with respondent that the Brazilian legal

restrictions should be disregarded, then the proper section 482

adjustment is $23,651,332. This position is consistent with petitioner’s

concession, described supra part 14, that the $23,651,332 reflects arm’slength compensation for the use of the intellectual property.

Paragraph 128 of the stipulation states that the section 482

adjustment should be reduced by the $4,117,370 R&D offset. Taken

literally, paragraph 128 could be construed to mean that if the Court

sustains respondent’s position that the correct section 482 adjustment

is $23,651,332, then the $23,651,332 adjustment should be reduced by

the $4,117,370 R&D offset. But the $23,651,332 calculation already

incorporates the R&D offset. So a further reduction would not make

sense. Perhaps recognizing this, petitioner declines to argue that

paragraph 128 of the stipulation requires that the $23,651,332 should

be further reduced by the $4,117,370 R&D offset. In the event the

Brazilian legal restrictions are not taken into account, petitioner accepts

that the section 482 adjustment should be $23,651,332.

The $23,651,332 adjustment made by the notice of deficiency did

not include any adjustment related to the $5,104,756 of trademark

royalties paid by 3M Brazil to 3M Company and reported as income by

the 3M consolidated group (of which 3M Company was a member). The

$5,104,756 trademark royalty payment was equal to 1% of sales,

calculated using a stacking principle when multiple trademarks were

used on the same product. The use of the stacking principle to calculate

the 1% trademark royalty was improper under Brazilian law. Petitioner

asserts that if the 1% trademark royalty had been calculated without

using the stacking principle, the royalty would have been $4,666,187. If

true, this means that 3M Brazil overpaid the trademark royalty to 3M

Company by $438,569, which is the difference between $5,104,756 and

$4,666,187. But petitioner does not assert that the income of the 3M

consolidated group should be reduced by $438,569 to adjust for any such

overpayment. Thus, we need not consider whether such a reduction

would be warranted.

Thus far, we have described separately the calculations of

respondent’s and petitioner’s litigating positions. It is worth pointing

out that both positions incorporate an R&D offset of $4,117,373.

Additionally, petitioner’s position expressly accounts for, and

respondent’s position implicitly accounts for, the $5,104,756 of

trademark royalties paid by 3M Brazil to 3M Company and reported as

income by the 3M consolidated group. Petitioner’s position includes a

reduction for the trademark royalties paid of $5,104,756 to account for

the Brazilian restriction that, if a product is covered by a patent license

or by a technology-transfer agreement between a Brazilian company and

a controlling foreign company, a trademark license between the same

companies for that same product must be granted royalty free. 3M

Company reported the $5,104,756 trademark royalty it received from

3M Brazil as income; but under petitioner’s position the $5,104,756

should not have been reported as income by 3M Company because 3M

Brazil could not have paid the amount had it entered into a patent

license or technology-transfer agreement.

Respondent’s position

implicitly accounts for the $5,104,756 in that respondent did not make

an adjustment to 3M Company’s reporting of the amount in income.

Thus, respondent’s position on the tax treatment of the $5,104,756

trademark royalty payment can be viewed as a $0 adjustment because

respondent agrees with the tax reporting of this amount by the 3M

consolidated group. Equivalently, one can think of respondent’s position

on the tax treatment of the $5,104,756 trademark royalty payment as

comprising two separate steps: (1) a determination that $5,104,756

should be included in 3M Company’s income and (2) a $5,104,756 offset

to reflect that the reported income of the 3M consolidated group included

the $5,104,756 amount. The advantage of the two-step approach is that

it makes it easier to compare respondent’s position to petitioner’s

position. Such a comparison is made in the table below:

Petitioner’s and respondent’s computations of appropriate sec. 482 adjustment:

side-by-side comparison

Respondent

Petitioner

$27,768,702

$9,387,909

Compensation for use of trademarks 36

5,104,756

–0–

Reduction for trademark royalty reported by

3M Company 37

–5,104,756

R&D offset

–4,117,370

Sec. 482 adjustment

23,651,332

165,783

Compensation for use of patents and for

transfer of technology 35

The positions of petitioner and respondent can also be usefully

compared in the following diagram of the relevant transactions and

payments:

35 Respondent: adjustment justified by arm’s-length compensation.

law.

Petitioner: adjustment should not exceed maximum payment under Brazilian

Respondent: implicitly agrees that a 1% trademark royalty should be

included in the income of 3M Company.

Petitioner: 1% trademark royalty should not be included in the income of 3M

Company because Brazil requires that, if a product is covered by a patent license or by

a technology-transfer agreement between a Brazilian company and a controlling

foreign company, any trademark license between the same companies for that same

product must be granted royalty free.

37 Respondent: this adjustment accounts for the fact that 3M Company already

reported the 1% trademark royalty in its income.

Petitioner: this adjustment is necessary because the 1% trademark royalty

should not be included in the income of 3M Company and because 3M Company

reported the royalty as income.

1Although the sec. 482 adjustments favored by petitioner and respondent are

shown as running to 3M IPC, in actuality the adjustments are to the income of the 3M

consolidated group, which includes both 3M Company and 3M IPC.

2Explanation of respondent’s position:

(1) Respondent’s adjustment is stipulated to be equal to payments that would

have been required of 3M Brazil if it had executed the standard licensing agreement.

(2) The rate of compensation under the standard licensing agreement is the

appropriate arm’s-length rate under sec. 482.

(3) Thus, respondent’s adjustment (the 6% royalty and the R&D setoff) is based

on arm’s-length compensation. It does not account for Brazilian legal restrictions.

(4) Respondent’s adjustment reflects no adjustment for trademark royalties,

implying a judgment that no adjustment should be made to the $5,104,756 trademark

royalty.

3Explanation of petitioner’s position:

(1) 3M Brazil did not record any licensing agreements regarding patents and

technology transfers and was therefore barred from making payments for use of

patents and for technology transfers under Circular-Letter 2795.

(2) However, had 3M Brazil recorded licensing agreements regarding patents

and technology transfers, then (A) it would have been able to pay 3M IPC royalties of

up to 1% to 5%, resulting in total payments for use of patents and for technology

transfers of $9,387,909 (B) but 3M Brazil would have not been permitted to pay

trademark royalties.

(3) Petitioner and respondent have stipulated that $4,117,370 should be a

setoff against the sec. 482 adjustment.

(4) Petitioner does not argue that an adjustment should be made because 3M

Brazil overpaid its trademark royalty payment by calculating the payment using

stacking.

Brazilian legal restrictions referred to in explanation 2(A) of petitioner’s sec.

482 adjustment:

(1) Law No. 8383/1991, partly repealing Article 14 of Law No. 4131/1962,

permits a Brazilian company to pay patent and trademark royalties to its controlling

parent company to the extent such payments are deductible.

(2) Law No. 3470/1958 and Portaria No. 436/58 (as amended by Portaria Nos.

113/59, 314/70, and 60/94) sets maximum deductibility ceilings of 1% to 5% for patent

royalties and technology-transfer payments and 1% for trademark royalties.

(3) BPTO imposes fixed ceilings on royalties payable by a Brazilian company

to a controlling parent corporation under a patent or trademark license agreement that

are equal to the maximum deductibility ceilings on patent or trademark royalties.

(4) BPTO, by unpublished interpretation of Law Nos. 4131/1962 and

8383/1991, applies the same fixed ceilings that apply to royalties under a patent or

trademark license agreement to payments under an agreement between a Brazilian

company and a controlling foreign company providing for technology transfer.

4Licensors are 3M Company and 3M Brazil.

5100% owned by 3M IPC.

19.

Other stipulations

In addition to the stipulations discussed so far, petitioner and

respondent have stipulated that the rate of compensation provided

under the standard services agreement (which was cost, if services were

provided by 3M Company or 3M IPC; or cost plus 10%, if services were

provided by a licensee of intellectual property owned by 3M Company or

3M IPC) is an appropriate arm’s-length rate under section 482 for the

provision of services by 3M Company to 3M Brazil during the 2006 tax

year in this case. As explained before, the notice of deficiency calculated

the transfer-pricing adjustment for services performed for 3M Brazil

based on the rate of compensation provided under the standard services

agreement and petitioner does not challenge this adjustment. See supra

parts 10 & 11.

The parties have also stipulated that the operations of 3M Brazil

were “owned or controlled” by 3M Company and 3M IPC within the

meaning of section 482 during the 2006 tax year.

Some other stipulations are relevant to 26 C.F.R. sec. 1.4821(h)(2) (2006), a portion of the 1994 final regulations. These stipulations

are discussed infra part II.OO.

OPINION

Procedural matters

Petitioner and respondent submitted this case without trial under

Rule 122. The record in this case consists of the stipulation and the

documents attached to the stipulation. Our findings of fact are based on

the stipulation and the documents attached to the stipulation.

As a general rule, the petitioner in a Tax Court case has the

burden of proving that the determinations in the notice of deficiency are

incorrect. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).

The identity of the petitioner in this case requires some explanation.

An affiliated group is a group of corporations that are connected

through stock ownership with a common parent corporation. Sec.

1504(a)(1). An affiliated group does not include foreign corporations.

Sec. 1504(a)(1), (b)(3). An affiliated group of corporations may file a

consolidated return with respect to income tax. Sec. 1501. An affiliated

group that has filed a consolidated return for a year is referred to as a

consolidated group.

26 C.F.R. sec. 1.1502-1(h), (a) (2019).

consolidated group has only one income tax liability for the year. Sec.

1503(a); 26 C.F.R. sec. 1.1502-2(a) (2019).

Each member of a

consolidated group is severally liable for the income tax. Sec. 1503(a);

26 C.F.R. sec. 1.1502-6(a) (2019). The income tax of a consolidated group

is generally equal to the tax imposed by section 11 on consolidated

taxable income. 26 C.F.R. sec. 1.1502-2(a) (2019). Consolidated taxable

income is determined by taking into account (1) the separate taxable

income of each member of the consolidated group and (2) certain items

of income and deduction that are determined on a consolidated basis. 26

C.F.R. sec. 1.1502-11(a) (2019). Each member’s separate taxable income

is calculated as if the member were a separate corporation, with certain

modifications. 26 C.F.R. sec. 1.1502-12 (2019); Norwest Corp. & Subs.

v. Commissioner, 111 T.C. 105, 165 (1998).

As a general rule, the common parent corporation of a

consolidated group is the representative of all members of the

consolidated group with respect to the group’s tax liability. 26 C.F.R.

sec. 1.1502-77B(a)(1)(i) (2019). The notice of deficiency is mailed to the

common parent corporation of a consolidated group, and that mailing is

considered a mailing to each member of the consolidated group. 26

C.F.R. sec. 1.1502-77B(a)(2)(viii) (2019).

The common parent

corporation files petitions in the Tax Court; any such petition is

considered to have been filed by each member of the consolidated group.

26 C.F.R. sec. 1.1502-77B(a)(2)(x) (2019).

The common parent

corporation conducts proceedings before the Tax Court on behalf of the

members of the consolidated group. Id.

The common parent corporation of the 3M consolidated group is

3M Company. 3M Company was the company to which respondent

mailed the notice of deficiency. 3M Company filed the petition on behalf

of the members of the 3M consolidated group. See id. As stated at the

beginning of this Opinion, we use “petitioner” to refer to 3M Company

in discussing 3M Company in its role as the representative of the 3M

consolidated group.

In a Tax Court case, it is the petitioner that bears the burden of

proof unless an exception applies. Rule 142(a)(1). Petitioner in this case

does not contend that any exception applies. Nor does the record

indicate that any exception applies. Therefore petitioner has the burden

of proof. This conclusion is not altered by the case’s having been

submitted under Rule 122. See Rule 122(b).

In the case of a corporation seeking redetermination of a tax

liability, the venue for appeal is generally the U.S. Court of Appeals for

the circuit in which is located the corporation’s principal place of

business or principal office or agency. Sec. 7482(b)(1)(B). However, the

parties to the appeal may stipulate that venue is another circuit. Sec.

7482(a), (b)(2). This case involves a corporation (3M Company) seeking

a redetermination of tax liability (the tax liability of the 3M consolidated

group). See 26 C.F.R. sec. 1.1502-77B(a)(1)(i), (2)(x) (2019). It is

stipulated that 3M Company’s principal place of business was in

Minnesota when the petition was filed. Therefore the venue for appeal

in this case will be the U.S. Court of Appeals for the Eighth Circuit

unless the parties stipulate another circuit. See sec. 7482(a), (b)(1)(B),

(2); 28 U.S.C. sec. 41 (2018).

Rule 146 provides, in part: “The Court, in determining foreign

law, may consider any relevant material or source, including testimony,

whether or not submitted by a party or otherwise admissible. The

Court’s determination shall be treated as a ruling on a question of law.”

Our determinations regarding Brazilian law are based on the

stipulation.

II.

Review of the authorities under U.S. law relevant to the

arguments by the parties

In support of its argument that respondent’s section 482

allocation is improper because it ascribes income to 3M Company and

3M IPC that could not be paid to these companies by 3M Brazil under

Brazilian law, petitioner relies on various authorities. These authorities

include (1) the text of section 482; (2) the legislative history of section

482; and (3) four cases, that, interpreting prior versions of section 482

and the regulations thereunder, held that respondent did not have

authority to allocate income to a taxpayer that the taxpayer did not

receive and could not legally receive. These are the four cases:

●

L.E. Shunk Latex Prods., Inc. v. Commissioner, 18 T.C. 940

(1952)

●

Commissioner v. First Sec. Bank of Utah, N.A, 405 U.S.

394 (1972)

●

Procter & Gamble Co. v. Commissioner, 95 T.C. 323 (1990),

aff’d, 961 F.2d 1255 (6th Cir. 1992).

●

Exxon Corp. & Affiliated Cos. v. Commissioner, T.C. Memo.

1993-616, 66 T.C.M. (CCH) 1707 (1993), aff’d sub nom.

Texaco, Inc., & Subs. v. Commissioner, 98 F.3d 825 (5th

Cir. 1996).

In petitioner’s view, “these precedents control the outcome here.”

Respondent disagrees with this. He contends that the judicial opinions

did not determine the statutory text to be clear, that the reasoning of

the opinions was influenced by regulatory text that was not applicable

for tax years beginning after April 21, 1993, and that the operative

statutory text was changed in 1986. 38

38 The regulations related to sec. 482 contained two sentences, which, before

they were eliminated as to tax years beginning after Apr. 21, 1993, were as follows:

The interests controlling a group of controlled taxpayers are assumed

to have complete power to cause each controlled taxpayer so to conduct

its affairs that its transactions and accounting records truly reflect the

net income from the property and business of each of the controlled

taxpayers. If, however, this has not been done, and the taxable

incomes are thereby understated, the district director shall intervene,

and, by making such distributions, apportionments, or allocations as

he may deem necessary of gross income, deductions, credits, or

allowances, or of any item or element affecting taxable income,

between or among the controlled taxpayers constituting the group,

shall determine the true taxable income of each controlled taxpayer.

***

26 C.F.R. sec. 1.482-1A(b)(1) (2019) (applicable for tax years beginning on or before

Apr. 21, 1993).

The two sentences had appeared in 1962 regulations related to sec. 482 of the

Internal Revenue Code of 1954. T.D. 6595, 27 Fed. Reg. 3595, 3598 (Apr. 14, 1962); 26

C.F.R. sec. 1.482-1(b)(1) (1968). In 1968, when the regulations were substantially

revised, these two sentences were unaffected. T.D. 6952, 33 Fed. Reg. 5848-5857 (Apr.

16, 1968); 26 C.F.R. sec. 1.482-1(b)(1) (1969). In 1993, the regulations containing the

two sentences were redesignated and limited to tax years beginning on or before Apr.

21, 1993. T.D. 8470, 58 Fed. Reg. 5271 (Jan. 21, 1993). As redesignated and limited,

the two sentences continue to appear in the annual codifications of federal regulations.

26 C.F.R. sec. 1.482-1A(b)(1) (2019) (applicable for tax years beginning on or before

Apr. 21, 1993).

The two sentences also had a place in the regulations before 1962. Versions of

the two sentences appeared in the comprehensive income tax regulations promulgated

by the Treasury Department in 1934, 1936, 1939, 1940, 1943, and 1953:

Respondent argues that the legal principles that govern this

dispute are found in the 1994 regulation that is applicable for the 2006

tax year at issue in this case. T.D. 8552, 59 Fed. Reg. 34971 (July 8,

1994); 26 C.F.R. sec. 1.482-1(h)(2) (2019) (setting forth rules regarding

the effect of foreign legal restrictions). The 1994 regulation was

published on July 8, 1994. T.D. 8552, 59 Fed. Reg. 35000-35001 (July 8,

1994). It is generally effective for tax years beginning after October 6,

1994. 26 C.F.R. sec. 1.482-1(j)(1) (2019). Petitioner contends that the

1994 regulation is invalid under various administrative-law principles

and therefore does not control the outcome of this case.

The paragraph above is merely an overview of petitioner’s and

respondent’s major arguments. A detailed discussion of their arguments

takes place later in parts III, IV, and V of this Opinion. The parties’

arguments implicate a century’s worth of legal materials, such as

•

The relevant portion of the 1934 regulations is art. 45-1(b), Regulations

86, Regulations 86 Relating to the Income Tax Under the Revenue Act

of 1934, at 123 (Gov’t Prtg. Off. 1935).

•

The relevant portion of the 1936 regulations is art. 45-1(b), Regulations

94, Regulations 94 Relating to the Income Tax Under the Revenue Act

of 1936, at 157 (Gov’t Prtg. Off. 1936), 1 Fed. Reg. 1856 (Nov. 14, 1936);

26 C.F.R. sec. 3.45-1(b) (1939).

•

The relevant portion of the 1939 regulations is art. 45-1(b), Regulations

101, Regulations 101 Relating to the Income Tax Under the Revenue

Act of 1938, at 189-190 (Gov’t Prtg. Off. 1939), 4 Fed. Reg. 680 (Feb.

10, 1939); 26 C.F.R. sec. 9.45-1 (1939 Supp.).

•

The relevant portion of the 1940 regulations is sec. 19.45-1(b),

Regulations 103, Regulations 103 Relating to the Income Tax Under

the Internal Revenue Code 204 (Gov’t Prtg. Off. 1940), 5 Fed. Reg.

417 (Feb. 1, 1940); 26 C.F.R. sec. 19.45-1 (1940 Supp.).

•

The relevant portion of the 1943 regulations is sec. 29.45-1(b),

Regulations 111, Regulations 111 Relating to the Income Tax Under

the Internal Revenue Code 276 (Gov’t Prtg. Off. 1943); sec. 9.45-1,

Regulations 111, 8 Fed. Reg. 14968 (Nov. 3, 1943); 26 C.F.R. sec. 29.451(b) (Cum. Supp. 1944). There was a minor amendment to this portion

of the 1943 regulations in 1944. T.D. 5426, 10 Fed. Reg. 23, 24 (Jan. 2,

1945); 26 C.F.R. sec. 29.45-1, at 1905 (1944 Supp.); 26 C.F.R. sec. 29.451 (1949).

•

The relevant portion of the 1953 regulations was sec. 39.45-1(b)(1),

Regulations 118, Income Tax Regulations 118, Internal Revenue Code

Part 39 of Title 26, Code of Federal Regulations 5886 (Gov’t Prtg. Off.

1953), 18 Fed. Reg. 5886 (Sept. 26, 1953); 26 C.F.R. sec. 39.45-1(b)(1)

(1953).

The history of the two sentences is discussed more extensively infra part II.

statutes, amendments to statutes, legislative history, regulations,

public comments on regulations, preambles to regulations, and caselaw.

In this part II, we discuss these materials chronologically. Using

chronological order helps place the legal materials in their proper

context.

The Revenue Act of 1921

The central statutory provision involved in this case is section 482

of the Internal Revenue Code of 1986, as amended. As in effect for the

tax year at issue, 2006, section 482 of the Internal Revenue Code of 1986

contains only these two sentences:

In any case of two or more organizations, trades, or

businesses (whether or not incorporated, whether or not

organized in the United States, and whether or not

affiliated) owned or controlled directly or indirectly by the

same interests, the Secretary may distribute, apportion, or

allocate gross income, deductions, credits, or allowances

between or among such organizations, trades, or

businesses, if he determines that such distribution,

apportionment, or allocation is necessary in order to

prevent evasion of taxes or clearly to reflect the income of

any of such organizations, trades, or businesses. In the

case of any transfer (or license) of intangible property

(within the meaning of section 936(h)(3)(B)[39]), the income

with respect to such transfer or license shall be

39 Sec. 936(h)(3)(B) provided:

The term “intangible property” means any-(i) patent, invention, formula, process, design, pattern, or know-how;

(ii) copyright, literary, musical, or artistic composition;

(iii) trademark, trade name, or brand name;

(iv) franchise, license, or contract;

(v) method, program, system, procedure, campaign, survey, study,

forecast, estimate, customer list, or technical data; or

(vi) any similar item,

which has substantial value independent of the services of any

individual.

commensurate with the income attributable to the

intangible.

The first sentence quoted above had its statutory origins in

section 240(d) of the Revenue Act of 1921, ch. 136, 42 Stat. at 260. 40 See

G.D. Searle & Co. v. Commissioner, 88 T.C. 252, 356 (1987); Reuven S.

Avi-Yonah, “The Rise and Fall of Arm’s Length: A Study in the Evolution

of U.S. International Taxation”, 15 Va. Tax Rev. 89, 95 (1995). Under

section 240(d) of the Revenue Act of 1921, respondent had the power to

consolidate the accounts of affiliated corporations and other related

trades or businesses. Subsection (d) provided:

[I]n any case of two or more related trades or businesses

(whether unincorporated or incorporated and whether

organized in the United States or not) owned or controlled

directly or indirectly by the same interests, the

Commissioner [of Internal Revenue] may consolidate the

accounts of such related trades and businesses, in any

proper case, for the purpose of making an accurate

distribution or apportionment of gains, profits, income,

deductions, or capital between or among such related

trades or businesses.

Section 240(d) of the Revenue Act of 1921 was one of the Act’s

consolidated-return provisions, all of which were in section 240 of the

Act. The Senate Finance Committee explained section 240(d) of the

Revenue Act of 1921 as follows:

A new subdivision is added to this section giving the

Commissioner power to consolidate the accounts of related

trades or businesses owned or controlled by the same

interests, for the purpose only of making a correct

distribution of gains, profits, income, deductions, or capital,

among the related trades or businesses. This is necessary

to prevent the arbitrary shifting of profits among related

businesses * * *

40 Revenue acts such as the Revenue Act of 1921 have been explained as

follows: “There was no Internal Revenue Code before 1939. Instead each Congress

reenacted revenue laws with whatever amendments were necessary.” Gail Levin

Richmond & Kevin M. Yamamoto, Federal Tax Research: Guide to Materials and

Techniques 54 (10th ed. 2018).

S. Rept. No. 67-275, at 20 (1921), 1939-1 C.B. (Part 2) 181, 195.

Petitioner cites this committee report in support of its arguments. See

infra part IV (discussing the significance of the committee report).

The Revenue Act of 1924

After the Revenue Act of 1921, the next revenue act was the

Revenue Act of 1924, ch. 234, 43 Stat. 253. Section 240(d) of the Revenue

Act of 1924, 43 Stat. at 288, was similar to section 240(d) of the Revenue

Act of 1921; but whereas section 240(d) of the Revenue Act of 1921 had

allowed only respondent to consolidate accounts, section 240(d) of the

Revenue Act of 1924 allowed either respondent or the taxpayer to

consolidate accounts. It provided:

In any case of two or more related trades or businesses

(whether unincorporated or incorporated and whether

organized in the United States or not) owned or controlled

directly or indirectly by the same interests, the

Commissioner may and at the request of the taxpayer

shall, if necessary in order to make an accurate distribution

or apportionment of gains, profits, income, deductions, or

capital between or among such related trades or

businesses, consolidate the accounts of such related trades

or businesses.

Section 240(d) of the Revenue Act of 1924 was part of the consolidatedreturn provisions of the Act. These provisions were in section 240 of the

Act.

The Revenue Act of 1926

The next revenue act was the Revenue Act of 1926, ch. 27, 44 Stat.

9. Section 240(f) of the Revenue Act of 1926, 44 Stat. at 46, was the

same as section 240(d) of the Revenue Act of 1924. See G.D. Searle &

Co. v. Commissioner, 88 T.C. at 356. Section 240(f) of the Revenue Act

of 1926 was part of the consolidated-return provisions of the Act. These

provisions were in section 240 of the Act, 44 Stat. at 46. Section 240(a)

of the Revenue Act of 1926, 44 Stat. at 46, permitted affiliated

corporations to file consolidated returns.

The Revenue Act of 1928

The next revenue act was the Revenue Act of 1928, ch. 852, 45

Stat. 791. The text of section 240(f) of the Revenue Act of 1926, with

significant alterations, was placed into section 45 of the Revenue Act of

1928, 45 Stat. at 806. The other consolidated-return provisions of the

Revenue Act of 1926 were placed into sections 141 and 142 of the

Revenue Act of 1928, 54 Stat. at 831-832. See G.D. Searle & Co. v.

Commissioner, 88 T.C. at 356. 41 Section 45 of the Revenue Act of 1928

provided:

41 The complicated history of the Revenue Act of 1928 led some to think that it

did not reenact the other consolidated-return provisions of the Revenue Act of 1926.

For example, the U.S. Court of Appeals for the Third Circuit stated: “The Revenue Act

of 1928 entirely eliminated the right of affiliated corporations to file consolidated

returns and the provisions of Section 240 of the 1926 Act accordingly do not appear in

the 1928 Act.” Nat’l Sec. Corp. v. Commissioner, 137 F.2d 600, 602 (3d Cir. 1943), aff’g

46 B.T.A. 562 (1942). And the U.S. Court of Appeals for the Second Circuit stated:

“The Revenue Act of 1928 eliminated the right of affiliated corporations to file

consolidated returns”. B. Forman Co. v. Commissioner, 453 F.2d 1144, 1150 (2d Cir.

1972), aff’g in part, rev’g in part 54 T.C. 912 (1970). These statements are incorrect.

The history of the Revenue Act of 1928 began with a bill that was introduced in the

House and then referred to the House Ways & Means Committee. H.R. 1, 70th Cong.

(Dec. 6, 1927) (the bill introduced in the House and referred to the Ways & Means

Committee). This bill was passed by the House, and an identical bill was then

introduced in the Senate. H.R. 1, 70th Cong. (Dec. 17, 1927) (the identical bill that

was introduced in the Senate). The House bill (and the identical bill introduced in the

Senate) eliminated the consolidated-return provisions, except for the text of sec. 240(f)

of the Revenue Act of 1926, which would have been reenacted had the bill been enacted

as written. H.R. 1, 70th Cong., secs. 45, 141, 142 (Dec. 6, 1927) (the bill introduced in

the House and referred to the Ways & Means Committee); H.R. 1, 70th Cong., secs. 45,

141, 142 (Dec. 17, 1927) (the identical bill that was introduced in the Senate); see

Jasper L. Cummings, Jr., “Consolidating Foreign Affiliates”, 11 Fla. Tax Rev. 143, 188

(2011) (“[T]he House bill for the 1928 Revenue Act proposed to eliminate consolidated

returns”.).

Committee reports observed that the House bill eliminated the

consolidated-return provisions except for the text of section 240(f) of the Revenue Act

of 1926. H.R. Rept. No. 70-2, at 20 (Dec. 7, 1927), 1939-1 C.B. (Part 2) 384, 397 (“The

consolidated return is abolished in the bill for the taxable year 1929 and following

taxable years, and thereafter affiliated corporations are required to file separate

returns.”); S. Rept. No. 70-960, at 29 (May 1, 1928), 1939-1 C.B. (Part 2) 409, 429 (“The

House bill abolished the right to file consolidated returns for years after 1928.”); H.R.

Conf. Rept. No. 70-1882, at 16 (May 25, 1928), 1939-1 C.B. (Part 2) 444, 448 (“The

House bill made no provision for the filing by affiliated corporations of a consolidated

return after the taxable year 1928.”). However, the Senate approved an amendment

that preserved the consolidated-return provisions. See H.R. Conf. Rept. No. 70-1882,

at 16 (May 25, 1928), 1939-1 C.B. (Part 2) 444, 448 (“The Senate amendment permits

the filing of a consolidated return by an affiliated group * * *.”); Cummings, supra, 188

(“The Senate rejected the elimination of consolidated returns”.). It was this Senate

In any case of two or more trades or businesses

(whether or not incorporated, whether or not organized in

the United States, and whether or not affiliated) owned or

controlled directly or indirectly by the same interests, the

Commissioner is authorized to distribute, apportion, or

allocate gross income or deductions between or among such

trades or businesses, if he determines that such

distribution, apportionment, or allocation is necessary in

order to prevent evasion of taxes or clearly to reflect the

income of any of such trades or businesses.

There were two differences between section 45 of the Revenue Act of

1928 and section 240(f) of the Revenue Act of 1926. First, a taxpayer

did not have the power to invoke section 45 of the Revenue Act of 1928.

See G.D. Searle & Co. v. Commissioner, 88 T.C. at 356. Only respondent

could invoke the provision. Second, respondent did not have the express

authority to “consolidate” accounts under section 45 of the Revenue Act

of 1928. Instead, that provision gave respondent the power to distribute,

apportion, and allocate gross income or deductions.

The House Ways & Means Committee in its report explained that

the purpose of section 45 of the Revenue Act of 1928 was to allow

respondent “in the case of two or more trades or businesses owned or

controlled by the same interests” to make allocations “in order to prevent

evasion (by the shifting of profits, the making of fictitious sales, and

other methods frequently adopted for the purpose of ‘milking’), and in

order clearly to reflect their true tax liability.” H.R. Rept. No. 70-2, at

16-17 (1927), 1939-1 C.B. (Part 2) 384, 395. The Senate Finance

Committee made a similar statement in its own report leading up to

section 45 of the Revenue Act of 1928. S. Rept. No. 70-960, at 24 (1928),

1939-1 C.B. (Part 2) 409, 426. Petitioner cites the reports of both

committees. See infra part IV.

The Revenue Act of 1932

The Revenue Act of 1932, ch. 209, 47 Stat. 169, was the next

revenue act after the Revenue Act of 1928. Section 45 of the Revenue

Act of 1932 was the same as section 45 of the Revenue Act of 1928.

Revenue Act of 1932, sec. 45, 47 Stat. at 186.

amendment that made it into the Revenue Act of 1928 and became the law. Revenue

Act of 1928, secs. 141 and 142, 54 Stat. at 831-832. Thus, the Revenue Act of 1928 did

not eliminate the right of affiliated corporations to file consolidated returns.

The Revenue Act of 1934

The Revenue Act of 1934, ch. 277, 48 Stat. 680, was the next

revenue act after the Revenue Act of 1932. Section 45 of the Revenue

Act of 1934 was the same as section 45 of the Revenue Act of 1932, except

that the words “trades or businesses” in the 1932 act were replaced with

“organizations, trades, or businesses” in the 1934 act. Revenue Act of

1934, sec. 45, 48 Stat. at 695. Below is the text of section 45 of the

Revenue Act of 1934:

In any case of two or more organizations, trades, or

businesses (whether or not incorporated, whether or not

organized in the United States, and whether or not

affiliated) owned or controlled directly or indirectly by the

same interests, the Commissioner is authorized to

distribute, apportion, or allocate gross income or

deductions between or among such organizations, trades,

or businesses, if he determines that such distribution,

apportionment, or allocation is necessary in order to

prevent evasion of taxes or clearly to reflect the income of

any such organizations, trades, or businesses.[42]

Regulations 86

In 1934, the Treasury Department promulgated art. 45-1,

Regulations 86, which related to section 45 of the Revenue Act of 1934.

Regulations 86 Relating to the Income Tax Under the Revenue Act of

1934, at 122-124 (Gov’t Prtg. Off. 1935). 43 Reproduced below is art. 451, Regulations 86 (emphasis added):

42 The income-tax provisions of the Revenue Act of 1934, including section 45

of that Act, were applicable for tax years beginning on or after Jan. 1, 1934. Revenue

Act of 1934, sec. 1, 48 Stat. at 683.

43 In the days before the Federal Register and the Code of Federal Regulations,

the Treasury Department published its regulations in consecutively numbered

pamphlets. Henry Campbell Black, A Treatise on the Law of Income Taxation Under

Federal and State Laws sec. 71 (2d ed. 1915) (available at heinonline.org); Richmond

& Yamamoto, supra, 148. One of these numbered pamphlets was Regulations 86

Relating to the Income Tax Under the Revenue Act of 1934. This publication bears a

publication date of 1935. The last sentence of the regulations reads: “In pursuance of

the Act the foregoing regulations are hereby prescribed.” Underneath that sentence is

the name and title of the Commissioner of Internal Revenue. Underneath this are the

words “Approved February 11, 1935” and the name and title of the Secretary of the

Treasury. Although the year of publication (1935) and the date “Approved” (Feb. 11,

Art. 45-1. Determination of the taxable net income

of a controlled taxpayer.-(a) Definitions.--When used in this article-(1) The term “organization” includes any

organization of any kind, whether it be a sole

proprietorship, a partnership, a trust, an estate, or

a corporation (as each is defined or understood in the

Act or these regulations), irrespective of the place

where organized, where operated, or where its trade

or business is conducted, and regardless of whether

domestic or foreign, whether exempt, whether

affiliated, or whether a party to a consolidated

return.

(2) The terms “trade” or “business” include

any trade or business activity of any kind, regardless

of whether or where organized, whether owned

individually or otherwise, and regardless of the

place where carried on.

(3) The term “controlled” includes any kind of

control, direct or indirect, whether legally

enforceable, and however exercisable or exercised.

It is the reality of the control which is decisive, not

its form nor the mode of its exercise. A presumption

of control arises if income or deductions have been

arbitrarily shifted.

(4) The term “controlled taxpayer” means any

one of two or more organizations, trades, or

businesses owned or controlled directly or indirectly

by the same interests.

1935) would seem to indicate that Regulations 86 was promulgated in 1935, there is

authority it was promulgated in 1934. Commissioner v. First Sec. Bank of Utah, N.A,

405 U.S. 394, 400 n.10 (1972) (“[The] regulations * * * were issued in 1934.”); R.C.

Reynolds, Inc. v. Commissioner, 44 B.T.A. 356, 364 (1941) (“Respondent’s Regulations

86 were approved on September 6, 1934.”); Thomas E. Jenks, “Treasury Regulations

Under Section 482”, 23 Tax Lawyer 279, 279 (1970) (“The * * * regulations were issued

in 1934”.).

(5) “Group” or “group of controlled taxpayers”

means the organizations, trades, or businesses

owned or controlled by the same interests.

(6) The term “true net income” means, in the

case of a controlled taxpayer, the net income (or, as

the case may be, any item or element affecting net

income) which would have resulted to the controlled

taxpayer, had it in the conduct of its affairs (or, as

the case may be, in the particular contract,

transaction, arrangement, or other act) dealt with

the other member or members of the group at arm’s

length. It does not mean the income, the deduction,

or the item or element of either, resulting to the

controlled taxpayer by reason of the particular

contract, transaction, or arrangement, the

controlled taxpayer, or the interests controlling it,

choose to make (even though such contract,

transaction, or arrangement be legally binding upon

the parties thereto).

(b) Scope and purpose.--The purpose of section 45 is

to place a controlled taxpayer on a tax parity with an

uncontrolled taxpayer, by determining, according to the

standard of an uncontrolled taxpayer, the true net income

from the property and business of a controlled taxpayer.

The interests controlling a group of controlled taxpayers

are assumed to have complete power to cause each

controlled taxpayer so to conduct its affairs that its

transactions and accounting records truly reflect the net

income from the property and business of each of the

controlled taxpayers. If, however, this has not been done,

and the taxable net incomes are thereby understated, the

statute contemplates that the Commissioner shall

intervene, and, by making such distributions,

apportionments, or allocations as he may deem necessary

of gross income or deductions, or of any item or element

affecting net income, be

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