Tax Court sides with IRS in long-running dispute over blocked income regulation
On February 9, 2023, the Tax Court issued its opinion in 3M Co. v Commissioner, upholding requirements in Treas. Reg. § 1.482-1(h)(2) regarding when a taxpayer may take into account foreign legal restrictions for determining the arm’s-length amount in a transaction between controlled taxpayers (the blocked income regulation).
The Tax Court’s opinion reflected a 9-8 split with Judge Richard T. Morrison writing for the majority, with two judges concurring in the result only. An appeal in the case is highly likely given the split decision and the vastly divergent analyses offered by the multiple opinions, including two concurring opinions and two dissenting opinions.
The Court’s opinion will directly affect other pending Tax Court litigation involving similar issues, including Coca-Cola Co. & Subs. v Commissioner, in which case the Court had reserved ruling on the related issue until the 3M case was decided.
The dispute at issue in 3M arose from a 2006 licensing arrangement whereby 3M Co. made certain intangible property – including 3M trademarks – available to its Brazilian subsidiary. Brazil domestic law imposed a one-percent cap on the royalties that a Brazilian licensee could remit to a foreign related party licensor. In 2006, Brazil domestic law limited 3M’s Brazilian subsidiary to paying $5.1 million in trademark royalties to its US parent company, with respect to approximately $564 million in Brazilian sales.
Having determined that the arm’s-length royalty rate was six percent, the IRS stated that, pursuant to section 482 and the regulations promulgated thereunder, 3M should have reported an additional $27.8 million of royalty income from the Brazilian subsidiary, notwithstanding that Brazilian domestic law prohibited 3M’s Brazilian subsidiary from remitting such amounts to 3M.
Before the Tax Court, the IRS argued that its royalty rate determination reflected the rate that a company would have paid to a separate, unrelated company for the intellectual property and technical services to which 3M’s Brazilian subsidiary gained access. The amount of tax in dispute is $4.8 million.
Tax Court’s narrow majority upholds validity of the blocked income regulation
The blocked income regulation provides that, when it is assessing whether a payment between controlled taxpayers occurs at an arm’s-length price, the IRS will take into account the effect of foreign legal restrictions on the amount of such payment only if certain restrictions are met. Specifically, Treas. Reg. § 1.482-1(h)(2) provides that the IRS will respect the effect of a foreign legal restriction only if the foreign legal restriction (1) is publicly promulgated, (2) applies equally to controlled and uncontrolled taxpayers and (3) prevents the payment or receipt of an arm’s-length amount in any other form. The blocked income regulation further requires that the taxpayer exhaust all available remedies for obtaining a waiver of the foreign legal restriction and may not enter into any arrangement with the effect of circumventing the restriction.
3M acknowledged that some of the conditions of the blocked income regulation were not satisfied but argued that US Supreme Court and other precedents prohibited the IRS from reallocating income under section 482 that a controlled party was legally unable to pay or receive. Notably, 3M relied on Commissioner v First Security Bank of Utah and a line of subsequent lower court decisions where courts rejected the IRS’s section 482 adjustments because legal restrictions prevented payments between related companies. Specifically, 3M argued that the Supreme Court in First Security Bank found section 482 to be unambiguous in prohibiting the allocation of income to a taxpayer if receipt of the income is prohibited by law.
In relying on Chevron U.S.A. Inc. v Natural Resources Defense Council Inc., 3M further argued that, since section 482 unambiguously prohibited taking blocked income into account (ie, Chevron Step One, as described below), there was no statutory gap for the Treasury Department to fill with the blocked income regulation (which regulation would only be permissible under Chevron Step Two). Accordingly, 3M argued that the blocked income regulation is substantively invalid under the Chevron framework.
Chevron provides a two-step test for determining whether to defer to an agency’s interpretation of a statute. At Chevron Step One, a court must apply “the ordinary tools of statutory interpretation,” to determine whether Congress has directly spoken to the precise question at issue. If Congress has addressed the precise question at issue and Congressional intent is clear, then that is the end of the court’s inquiry. However, if a statute is ambiguous, then under Chevron Step Two a court considers whether the agency’s interpretation of the statute is reasonable. If the answer at Step Two is yes, a court should defer to an agency’s interpretation of the statute.
Writing for the majority, Judge Morrison rejected the taxpayer’s reliance on the Supreme Court’s First Security Bank opinion on the basis that 3M’s interpretation of First Security Bank was inconsistent with the portion of the opinion explaining the reasons for the Court’s holding and concluding that the Supreme Court did not find section 482 to be unambiguous for purposes of Chevron. The majority opinion noted that the Supreme Court in First Security Bank did not “pars[e] the text of [section 482] as to link the text of the statute to the principle that income cannot be attributed to a taxpayer who cannot legally receive it.” Thus, the majority found that the Supreme Court in First Security Bank did not address whether section 482 “unambiguously precluded an allocation of income that could not be legally received.”
Ultimately, the majority concluded that section 482 did not establish Congress’s intent to prevent the allocation of blocked income and that the statute was therefore not unambiguous under Chevron Step One. The majority’s view contrasts starkly with the dissent of Judge Ronald L. Buch, who found First Security Bank to be directly on point, writing that the majority’s opinion is “contrary to established Supreme Court precedent prohibiting the taxation of blocked income” and that, under National Cable & Telecommunications Ass’n v Brand X Internet Services, the Supreme Court’s prior judicial construction of section 482 trumps the Treasury Department’s later promulgation of Treas. Reg. § 1.482-1(h)(2) since the Supreme Court already held that section 482 prohibited the allocation of income if receiving the income would be prohibited by foreign legal restrictions.
After concluding that section 482 was not unambiguous (and thus the analysis did not stop at Chevron Step One), the Tax Court’s majority evaluated the blocked income regulation under Chevron Step Two to determine whether the regulation reflects a reasonable interpretation of the statute and its purpose. In this regard, the majority held that the blocked income regulation satisfied Chevron Step Two by ensuring tax parity between controlled and uncontrolled taxpayers and ensuring arm’s-length results.
The Tax Court’s majority opinion also stated that the blocked income regulation was consistent with the section 482’s commensurate with income standard (the CWI standard) for intangible property transfers and that the conditions imposed by the blocked income regulation is consistent with the IRS’s statutory authority under section 7805(a). Once again, however, Judge Buch’s dissent disagreed with the majority on these points, stating that the CWI standard contained in section 482 has “nothing” to do with blocked income and that the 1986 codification of the CWI standard does not “change the longstanding precedent that blocked income cannot be allocated and taxed.”
The taxpayer also challenged the blocked income regulation on procedural grounds, arguing that, when promulgating the regulation, the Treasury Department failed to adequately address certain public comments. The Tax Court’s majority opinion dismissed this argument, explaining its view that the blocked income regulation complied with the Administrative Procedure Act (APA) because the Treasury Department adequately explained the reason for the blocked income regulation and had no obligation to respond to public submissions that did not constitute “significant comments.”
At trial, 3M presented public comments provided to Treasury during the notice and comment period for Treas. Reg. § 1.482-1T(h)(2), which 3M argued the Treasury Department did not give an adequate response. The Tax Court’s majority opinion found that any failure to respond to these comments were either (1) irrelevant to 3M’s case, (2) did not bring anything new to the Treasury Department’s attention or (3) did not require a change to the regulation.
Judge Emin Toro’s dissent disagrees and asserts that the majority opinion analyzes the APA’s procedural requirements incorrectly. In this regard, Judge Toro found that the comments at issue in 3M were significant and required a response because the comments expressed the view that the blocked income regulation “contradicted the Supreme Court’s decision” in First Security Bank and questioned whether, under judicial precedent, the Treasury Department had the authority to promulgate Treas. Reg. § 1.482-1(h)(2).
In particular, Judge Toro noted that “the record here leaves no doubt that Treasury failed to comply with [the APA] requirements. In promulgating Treasury Regulation § 1.482-1(h)(2) (and the entire regulation package of which it was a part), Treasury repeatedly expressed the view that it did not have to follow the APA’s notice and comment procedures.” Judge Toro attributed the Treasury’s failure to adequately explain the basis for adopting the blocked income regulation to the Treasury’s misguided view that it was not required to follow the APA and would find the regulation invalid on this basis alone.
Judge Toro’s observation on this point is remarkable because (1) he expressed the same view regarding the judicial extinguishment regulation in Oakbrook Land Holdings, LLC v Commissioner, which the Court of Appeals for the Eleventh Circuit cited with approval when it invalidated that regulation on APA grounds in Hewitt v Commissioner and (2) Judge Toro’s statement seems to call into question the validity of other parts of the section 482 regulations that were promulgated along with the blocked income regulation.
Given five of the eight dissenting judges agreed with Judge Toro’s dissent, challenges to the procedural validity of regulations will be seriously considered by the Tax Court in the future.
What multinationals can expect going forward
For decades, taxpayers and the IRS have disagreed about the impact of foreign legal restrictions on the arm’s-length amount to be recognized in controlled transactions. While the IRS may have won the latest battle in this long-running conflict, the closeness of the Tax Court’s decision means that 3M v Commissioner is unlikely to be the last word on this subject.
For example, the majority’s conclusion that the blocked income regulation ensures tax parity between controlled and uncontrolled taxpayers may be at odds with the arm’s-length standard “to be applied in every case” under section 482 and the regulations thereunder. Under that standard, whether an amount is arm’s-length is determined by reference to the results of comparable transactions under comparable circumstances. Because the foreign legal restrictions at issue in 3M did not apply to similar payments between unrelated parties, it arguably strains the language and the purpose of section 482 to conclude that ignoring the payment restriction somehow places the controlled taxpayer on tax parity with uncontrolled taxpayers where – solely due to those restrictions – the taxpayers would receive different payment amounts.
Multinationals are encouraged to consider how the IRS’s treatment of foreign legal restrictions may affect their intercompany relationships, especially as more companies have repatriated, or are considering repatriating, intangible property to the US due to changes in US law and for other business reasons.
While 3M appears to have strong grounds for having the Tax Court opinion reversed on appeal, other taxpayers raising this issue before the Tax Court may also have an opportunity (or need) to pursue an appeal in their own circuit, potentially creating a circuit split to be resolved at the Supreme Court.
Thus, we expect that disputes over the treatment of blocked income will continue for the foreseeable future. In that regard, it is worth noting that the Tax Court’s (Judge Albert G. Lauber) February 14, 2023 request for supplemental briefs in Coca-Cola Co. & Subs. v Commissioner, based on the 3M opinion, specifically “invite[s] the parties’ views as to how the remaining issue in this case should be decided if one were to assume arguendo that the ‘blocked income’ regulation is invalid.”
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 160 T.C. No. 3 (2023).
 155 T.C. 145 (2020).
 The amount of tax at issue in Coca-Cola Co. & Subs. v Commissioner is approximately $3.4 billion.
 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. v Commissioner, T.C. Memo. 1993-616, aff’d sub nom. Texaco, Inc. v Commissioner, 98 F.3d 825 (5th Cir. 1996).
 467 U.S. 837 (1984).
 Id. at 842-843.
 545 U.S. 967 (2005) (“prior judicial construction of a statute trumps an agency construction otherwise entitled to Chevron deference only if the prior court decision holds that its construction follows from the unambiguous terms of the statute and thus leaves no room for agency discretion”).
 3M Co., 160 T.C. No. 3, slip op. at 304 (Buch, J., dissenting).
 Id., slip op. at 322 (Toro, J., dissenting).
 Id., slip op. at 308-309 (Toro, J., dissenting) (emphasis added).
 154 T.C. 180, 222 and 224 (2020) (Toro, J., concurring).
 Hewitt v Commissioner, 21 F.4th 1336, 1348 (11th Cir. 2021).
 See Coca-Cola Co. & Subs. v. Commissioner, T.C. Dkt. No. 31183-15, Dkt. Entry No. 773. Supplemental briefs in Coca-Cola Co. & Subs., are due on or before March 27, 2023, with supplemental reply briefs due on or before April 18, 2023.