The U.S. Court of Appeals for the Eighth Circuit (court) reversed and remanded a Tax Court decision in 3M Co. v. Commissioner,¹ holding that the IRS could not reallocate under IRC Section 482 unpaid royalties that Brazilian law prevented the Brazilian subsidiary from paying.

The court applied Loper Bright,² which allows the court to apply independent judicial review without deferring to US Treasury regulations, in examining the text of IRC Section 482.

Facts

A Brazilian subsidiary paid 3M Co., which files a consolidated federal tax return in the United States, $5.1 million in royalties to use 3M Co.'s intellectual property (IP). The Brazilian subsidiary paid that amount because, at that time, Brazilian law capped the amount a Brazilian subsidiary could pay in royalties to a non-Brazilian controlling company at what the Brazilian subsidiary could legally deduct. 3M Co. reported the $5.1 million on its federal tax return for 2006.

In a Notice of Deficiency, the IRS reallocated nearly $23.7 million in extra royalty income to 3M Co. under the "blocked income" regulation (Treas. Reg. Section 1.482-1(h)(2)) on the grounds that this amount reflected what 3M Co. should have received from its Brazilian subsidiary in an arm's-length transaction.

3M Co. asserted that IRC Section 482 precluded the IRS from taxing what Brazilian law blocked 3M Co. from receiving. 3M Co. also asserted that the IRS did not follow the Administrative Procedure Act when it adopted the "blocked-income" regulation.

A plurality decision by the Tax Court's 17-judge panel deferred to the blocked-income regulation as a reasonable interpretation of an ambiguous statute.

Court analysis

The court examined the IRS's position that, despite 3M Co.'s compliance with Brazilian law and the absence of any attempt to evade taxes, the IRS could reallocate additional royalty income to 3M Co. on the basis that an unrelated party would have paid more for the IP. Referring to Loper Bright, the court said, "[t]he legal landscape has changed since the case's last stop." Looking only at the text of IRC Section 482, the court said "[t]he 'best reading' of it rules out what the IRS did here."

Under IRC Section 482, the IRS may "distribute, apportion, or allocate gross income, deductions, credits, or allowances" between "two or more … businesses" that are "owned or controlled … by the same interests" only when it is "necessary in order to prevent evasion of taxes or clearly to reflect the income." The court emphasized that, under Commissioner v. First Security Bank of Utah,³ this authority is limited by the requirement that the taxpayer must have "complete dominion" over the income in question, meaning the taxpayer must be able to legally receive it.

On this point, the court clarified that 3M Co. could not legally receive the additional amount the IRS sought to reallocate because Brazilian law capped the royalties 3M Co.'s subsidiary could pay. Thus, attributing $23.7 million in extra royalties to 3M Co. was "inconsistent with reality," as it would have forced the Brazilian subsidiary to violate local law and did not "clearly reflect" 3M Co.'s income. The court also noted that the fact that First Security Bank concerned a US federal law blocking the income and the 3M Co. case concerned a foreign law did not make a difference, as both can deprive a taxpayer of dominion over income.

The court further rejected the IRS's argument that the second sentence of IRC Section 482 refers to "any" income attributable to intangible property and requires that income to be "commensurate with the income attributable to the intangible." In the IRS's view, this language authorizes the reallocation of any income related to IP, regardless of whether foreign law restricts payment. The court said that the word "income" in this context is anchored to the "gross income" referenced in the first sentence of the statute and is therefore limited to amounts over which the taxpayer has complete dominion. As a result, the court concluded that IRC Section 482 does not permit the IRS to reallocate income that is blocked by foreign legal restrictions, such as those imposed by Brazilian law in this case.

The court went on to note that the IRS had argued in a post-Loper Bright supplemental briefing that IRC Section 482 delegates to the IRS discretionary authority to make the proposed reallocation. The court clarified that it does not have to defer to the IRS's interpretation when there is a better reading of the statute.

Finally, the court rejected the IRS's argument that the Brazilian subsidiary could have paid dividends in lieu of royalties. The court "firmly" disagreed with any suggestion that 3M Co. should evade Brazilian law, and explained that dividends and royalties are fundamentally different, in both form and function. The court concluded that treating these income sources as interchangeable would result in reallocation that distorts a company's true income.

Implications

Narrowly, the court's opinion clarifies that the IRS must respect foreign legal restrictions when determining a US tax liability and cannot reallocate income that a taxpayer residing in the Eighth Circuit is legally barred from receiving. The court's approach emphasizes the importance of statutory language and limits the scope of IRS discretion, particularly in cross-border transactions.

More broadly, the Eighth Circuit is the first U.S. Court of Appeals to rule on the validity of an IRC Section 482 regulation under Loper Bright. The U.S. Court of Appeals for the Eleventh Circuit currently has before it a validity challenge to the same blocked-income regulation. An opinion in favor of the IRS would create a circuit split that could lead to Supreme Court review of the blocked-income regulation, or even more generally on regulations under IRC Section 482. Taxpayers should closely monitor developments in this area as this case and its successors may significantly affect US Treasury regulations under IRC Section 482.