Tax Court in Brief | 3M Company v. Comm’r | Allocation of Income for Subsidiary License or Use of Intellectual Property; Validity of Treas. Reg. 1.482-1(h)(2))

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The Tax Court in Brief – February 6th – February 10th, 2023

Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

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Tax Litigation:  The Week of February 6th, 2022, through February 10th, 2023

3M Company and Subsidiaries v. Comm’r, 160 T.C. No. 3| February 9, 2023 |Morrison, J. | Dkt. No. 5816-13

Summary: In this 346-page opinion (including multiple concurring opinions and dissents) the Tax Court addresses federal income tax issues arising from 3M Company (3M) and its domestic and foreign subsidiaries’ (Subs) consolidated ownership of trademarks in 3M. Other intellectual properties, such as patents and non-patented technology, was owned by a second-tier wholly owned U.S. subsidiary of 3M (Sub-IP).

Pursuant to three separate licenses—dating back to 1952 but amended over the many decades—a Brazilian subsidiary (Sub-Brazil) paid royalties to 3M for Sub-Brazil’s sales of products involving 3M’s trademarks. The operative license agreements were entered into in 1998. Under those agreements (generally), if a product sale involved trademarks covered by multiple of the three licenses, 3M and Sub-Brazil calculated the royalties owed by a “stacking principle.” Based on legal counsel 3M received from its Brazilian lawyers that 3M would have to disclose non-patented technology and other intellectual property to the Brazilian Patent and Trademark Office (thus risking disclosure of such information to competitors), 3M did not require Sub-Brazil to pay 3M or Sub-IP for Sub-Brazil’s use of other intellectual property. On its 2006 consolidated tax return (Form 1120, U.S. Corporation Income Tax Return), 3M reported the trademark royalty income.

The IRS determined that 3M’s income should be increased by $23,651,332 to reflect an arm’s length rate of compensation under section 482 to account for Sub-Brazil’s use of 3M and Sub-IP’s other intellectual property. The IRS’s determination did not take into account the effect of Brazilian legal restrictions. See 26 C.F.R. § 1.482-1(h)(2) (Effect of foreign legal restrictions; setting forth the requirements that must be met before the IRS “will take into account the effect of a foreign legal restriction” under I.R.C. § 482).

3M challenged that determination, claiming that the IRS’s allocation should have corresponded to the maximum amount that Sub-Brazil could have paid for the intellectual property under the laws of Brazil. 3M asserted that the requirements of section 1.482-1(h)(2) of the Treasury Regulation are invalid under regulatory-approval test (“step 2 test”) developed by the United States Supreme Court. Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984) (determining, under Justice John Paul Stevens’ lead, the extent to which a court reviewing agency action should give deference to the agency’s construction of a statute that the agency has been delegated to administer); Motor Vehicle Mfrs. Ass’n of the U.S., Inc. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983) (determining, under Justice Byron White’s lead, that an “arbitrary and capricious” standard for reviewing agency actions applied to rescind regulations as that to enact regulations); Commissioner v. First Security Bank of Utah, N.A., 405 U.S. 394 (1972). 3M also claimed that, under those precedents, the IRS failed to adequately respond to comments to the applicable regulations thus rendering it invalid, and that, under “step 1 test” of Chevron, the IRS cannot make allocation of income to a taxpayer, like 3M, who did not receive income and could not legally receive the income.

Key Issues: Whether the IRS’s section 482 adjustment was improper to the extent that payments were barred by Brazilian law and that therefore the proper section 482 adjustment is only a fraction of the amount determined, specifically, $165,783 as asserted by 3M.

Divided Tax Court:

The main, 273-page opinion was penned by Tax Court Judge, Morrison, and that opinion was agreed upon by Judges Kerrigan, Gale, and Paris.

Judge Copeland presented a 7-page concurrence, and that concurrence was agreed to by Kerrigan, Gale, and Paris, JJ.

Chief Judge Kerrigan provide a 6-page concurrence, agreeing with the outcome in the main opinion but providing a concurrence mainly to respond to the dissents’ focus on the validity of Treasury Regulation § 1.482-1(h)(2) (blocked income regulation). Judges Gale, Paris, Ashford, and Copeland agreed with this concurring opinion.

Judge Buch provided a 19-page dissent, which was agreed to by Judges Urda, Jones, Toro, and Greaves.

Judge Pugh provided an additional 1-page dissent, which was agreed to by Judges Foley, Buch, Urda, and Toro.

Judge Toro provided a 40-page dissent, which was agreed to by Judges Buch, Urda, Jones, Greaves, and Weiler.

Main Opinion Primary Holdings: Under 26 C.F.R. §1.482-1(h)(2) (2006), which governed the effect of foreign legal restrictions on section 482 adjustments, the Brazilian restrictions on payments by Sub-Brazil are disregarded. The Tax Court rejected 3M’s various arguments that the regulation is invalid.


Judge Buch’s Dissent. Judge Buch provided a 19-page dissent. Buch, J. based his dissent on the concept of “blocked income,” being income that a taxpayer is prohibited by law from receiving. According to this dissent, 3M had a blocked income problem in that its Brazilian subsidiary was compelled by foreign law to pay below-market royalty rates. The IRS sought to apply section 482 to allocate blocked income to 3M. Pursuant to First Security Bank, Buch, J. found that section 482 cannot be used to allocate blocked income to someone who did not receive it and could not receive it. And, to the extent the Treasury Regulations are inconsistent with limits on section 482, as described in First Security Bank, those regulations are invalid, according to Buch, J.

Judges Urda, Jones, Toro, and Greaves agreed with Buch, J.’s dissent.

Judge Pugh’s Dissent. Judge Pugh provided an additional 1-page dissent. Pugh, J. likewise leaned on the “blocked income” theory and “stare decisis” approach based on Commissioner v. First Security Bank of Utah, N.A., 405 U.S. 394, 407 (1972) and the Tax Court’s application of First Security Bank in Procter & Gamble Co. v. Commissioner, 95 T.C. 323, 336 (1990), that is, First Security Bank was controlling and therefore “section 482 simply does not apply” to reallocate income that a Spanish subsidiary could not pay under Spanish law. See Procter & Gamble Co., 95 T.C. at 336, aff’d, 961 F.2d 1255 (6th Cir. 1992).

Judges Foley, Buch, Urda, and Toro agreed with Pugh, J.’s dissent.

Judge Toro’s Dissent. Judge Toro provided a 40-page dissent. Toro, J. opined that the Department of the Treasury and the IRS failed to comply with procedural requirements of the Administrative Procedure Act (APA), 5 U.S.C. §§ 551–559, 701–706, in promulgating Treasury Regulation § 1.482-1(h)(2) (2006). Toro, J. noted, in part: “When it adopted Treasury Regulation § 1.482-1(h)(2), Treasury offered no explanation for its choices with respect to the rule. Not a single sentence. Treasury did not explain why a revision to the existing rule was needed. . . . Providing reasons for Treasury’s proposed approach was particularly important here, where several prior judicial decisions, including a Supreme Court decision, had rejected the approach Treasury adopted.”

Judges Buch, Urda, Jones, Greaves, and Weiler agreed with Toro, J.’s dissent.

Key Points of Law:

COMMENT 1: Inasmuch as the 346-page opinion (including concurrences and dissents) addresses multiple iterations of the Code sections in issue, Treasury Regulations that have changed over time, and Brazilian laws in effect and repealed, this blog contains but a snippet of legal principles addressed in the monster opinion. Reference is made to the opinion itself for further and detailed information.

COMMENT 2: After 2006 (the tax year at issue)—specifically, in 2017 and 2018—operative section 482 was affected by several amendments, including with respect to the meaning of “intangible property” as defined in the also-applicable section 936(h)(3)(B). Because those amendments did not retroactively apply to 3M, the Tax Court applied section 482 as it existed before the 2017 and 2018 changes.

Section 482 (eff. for tax year in issue). Section 482 authorizes the IRS to apportion or allocate income between organizations controlled by the same interests “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 . . . .” 26 U.S.C. § 482 (1994). The relevant regulation explains that the purpose of § 482 is “to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer” and to ensure that controlling entities conduct their subsidiaries’ transactions in such a way as to reflect the “true taxable income” of each controlled taxpayer. 26 C.F.R. § 1.482-1A(b)(1) (1996). The regulation further explains that “[t]he standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm’s length with another uncontrolled taxpayer.” Id.

Insights: Given the divide on this opinion amongst the judges within the Tax Court, and given the increased income for taxation in issue (approximately $26,000,000), an appeal of the main holding is likely. 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 26 U.S.C. § 7482(a), (b)(1)(B), (2); 28 U.S.C. § 41 (2018). Stay tuned…