Eighth Circuit takes a textual approach

Parsing the text of section 482, the Eighth Circuit focused on the limitations to the IRS’s reallocation authority embedded in the statute. One such limit is the necessity of reallocation “in order to . . . clearly to reflect the income.” Relying heavily on another Supreme Court precedent, Commissioner v. First Security Bank of Utah, NA, 405 US 394 (1972), the Eighth Circuit confirmed that for the IRS to reallocate “income,” the taxpayer must have complete dominion over it or, in other words, could have received it. Because Brazilian law did not allow the transfer of the royalties at issue to the US parent, attributing this amount to the US taxpayer, which lacked complete power to shift income, would not clearly reflect income under section 482.

The “commensurate with the income” standard in the second sentence of section 482 also was of no avail to the IRS. This sentence was added to the statute after the Supreme Court’s decision in First Security, and the IRS argued that it therefore superseded that prior decision and required royalties paid with respect to IP to be commensurate with income attributable to such IP, regardless of whether such amount could be legally paid. Consulting grammatical rules to discern “the statute’s true meaning,” the Eighth Circuit found that the term “income,” used twice in the second sentence, necessarily relates back to the “gross income” in the first sentence, which is limited by the amount over which the taxpayer has dominion or control. Because the commensurate with income standard must be construed in the context of section 482’s first sentence, the requirement that the taxpayer has dominion or control over an amount in order for that amount to be considered income to that taxpayer still applies in the context of IP licenses.

IRS’s attempt to distinguish 3M from First Security fails

The Eighth Circuit also rejected as meaningless and irrelevant the IRS’s attempt to draw a distinction between First Security and 3M based on the source of restrictions and the now-defunct regulation that featured in First Security. The Eighth Circuit was similarly unconvinced by the IRS’s argument that the Brazilian subsidiary could have paid dividends in lieu of royalties, reasoning that 3M did not have the duty to evade Brazilian law, that it could not have been expected to structure its affairs to maximize the amount of taxes, and that dividends and royalties are substantively different.

Implications of the 3M reversal

The Eighth Circuit’s decision in 3M signals the changing landscape in regulatory challenges in the wake of Loper Bright. The Eighth Circuit explicitly declined to defer to the agency’s interpretation — which was presumably based on its specialized subject-matter experience — when the agency “recently invented” such interpretation and the court was able to identify a “better reading” of the statute. In doing so, the Eighth Circuit was unmoved by the IRS’s arguments in its post-Loper Bright supplemental briefing that the broad language of section 482 “delegate[d] discretionary authority” to the IRS to reallocate income.

More narrowly, the 3M decision is an encouraging development for taxpayers who are impacted by foreign restrictions that prevent arm’s-length transfer pricing. While its holding does not create a precedent for taxpayers outside of the Eighth Circuit, taxpayers in every stage of the dispute concerning the Block Income Regulation, including audit, Appeals, and litigation, should nevertheless reassess the merits of their case. While Appeals does not apply litigating hazards to taxpayer arguments regarding the validity of Treasury Regulations until there is an unreviewable decision from a federal court invalidating the regulation, the Eighth Circuit’s decision may soon qualify depending on the government’s decision to file a cert petition to the Supreme Court (and the Court’s willingness to take the case).

The validity of the Blocked Income Regulation is also at issue in Coca-Cola Co. & Subs. v. Commissioner, 155 T.C. 145 (2020), another Tax Court decision, which upheld the regulation following its prior ruling in 3M and is currently on appeal before the Eleventh Circuit. See our previous alert, Coca-Cola Supplemental Decision Follows 3M, With Added Twist.

i Treas. Reg. § 1.482-1(h)(2).