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Divided Tax Court: IRS's Section 482 Income Allocation is Valid; Foreign Legal Restriction Exception Doesn't Apply

(Parker Tax Publishing February 2023)

A majority of a divided Tax Court held that under Reg. Sec. 1.482-1(h)(2), which governs the effects of foreign legal restrictions on Code Sec. 482 adjustments to the income, deductions, credits or allowances of commonly controlled taxpayers to prevent evasion of taxes or to clearly reflect income, restrictions under Brazilian law on payments by a U.S. parent company's Brazilian subsidiary for the use of the parent company's intellectual property under trademark licenses were properly disregarded by the IRS. The court found that the Brazilian legal restrictions at issue did not meet the requirement of Reg. Sec. 1.482-1(h)(2)(ii)(A) that foreign legal restrictions be taken into account only if they are publicly promulgated; the court also rejected the taxpayer's challenges to the validity of the regulations under Code Sec. 482 under Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984), and Motor Vehicle Mfrs. Ass'n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983). 3M Company and Subs. v. Comm'r, 160 T.C. No. 3 (2023).


3M Company is a U.S. corporation and the common parent company of an affiliated group of corporations that filed a consolidated federal income tax return for the 2006 tax year. 3M Company and its U.S. and foreign subsidiaries engage in manufacturing, research, development, marketing and sales of products in the United States and throughout the world.

3M do Brasil Ltda. (3M Brazil) is a wholly owned subsidiary of 3M Company. During 2006, 3M Brazil used in its business operations trademarks owned by 3M Company. 3M Brazil's use of these trademarks was governed by three trademark licenses that 3M Company and 3M Brazil had executed in 1998. Each license concerned a separate set of trademarks. In accordance with the licenses, 3M Brazil paid a royalty to 3M Company equal to 1 percent of its sales of the trademarked products. Some products sold by 3M Brazil were subject to trademarks covered by more than one of the three trademark licenses. For such products, 3M Brazil and 3M Company 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 percent of the sales of the product. Computing the royalties using this stacking principle, 3M Brazil paid 3M Company trademark royalties in 2006.

In 2012, the IRS determined in a notice of deficiency that the 3M consolidated group had an income tax deficiency of $4,847,004 for 2006. One adjustment in the notice, labeled "Brazil Royalties," was a net $23,651,332 increase in the income of the 3M consolidated group. The notice stated that in order to clearly reflect the income of the entities in accordance with Code Sec. 482, the IRS allocated royalty income to 3M Company from 3M Brazil in connection with 3M Brazil's use of intellectual property. The IRS determined that Brazilian legal restrictions were not taken into account for purposes of computing the arm's length amount of royalty income from 3M Brazil because the Brazilian legal restrictions did not satisfy the conditions in Reg. Sec. 1.482-1(h)(2). 3M Company petitioned the Tax Court to challenge the adjustments in the notice.

Under Code Sec. 482, the IRS may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among related corporations if it 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 the corporations. The effect of foreign legal restrictions on Code Sec. 482 adjustments is addressed in Reg. Sec. 1.482-1(h)(2). Under the regulation, a foreign legal restriction will be taken into account under Code Sec. 482 if seven requirements are met:

(1) the restriction affected uncontrolled taxpayers under comparable circumstances for a comparable period of time;

(2) the restriction was publicly promulgated;

(3) the restriction was generally applicable to all similarly situated persons (both controlled and uncontrolled);

(4) the restriction was not imposed as part of a commercial transaction between the taxpayer and the foreign government;

(5) the taxpayer exhausted all remedies prescribed by foreign law or practice for obtaining a waiver of the restriction (other than remedies that would have a negligible prospect of success);

(6) the restriction expressly prevented the payment or receipt, in any form, of all or part of the arm's-length amount; and

(7) the taxpayer and related parties did not engage in any arrangement with controlled or uncontrolled parties that circumvented the restriction, and did not materially violate the restriction.

3M Company argued that the IRS was precluded from making an allocation under Code Sec. 482 because Brazilian law precluded 3M Brazil from paying any royalties to 3M Company other than one-percent royalties on the licensed trademarks, which were paid and which 3M Company included in its income. According to 3M Company, the IRS's Code Sec. 482 allocation should correspond to the maximum amount that 3M Brazil could have paid for the intellectual property in question under the laws of Brazil, less related expenses.

3M also challenged the validity of the rules in Reg. Sec. 1.482-1(h)(2) as an impermissible interpretation of an unambiguous statute. In Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984) (Chevron), the Supreme Court set forth a two-step test for determining the validity of a regulation: (1) whether the statute is unambiguous expression of Congress's intent; and (2) if not, whether the regulation is a permissible interpretation of the statute. 3M Company asserted that Reg. Sec. 1.482-1(h)(2) failed step one of Chevron because the Supreme Court held in Comm'r v. First Security Bank of Utah, N.A., 405 U.S. 394 (1972) held that predecessors to Code Sec. 482 unambiguously provided that there can be no allocation of unreceived income if receiving the income is prohibited by legal restrictions. 3M also argued under step two of Chevron that the requirements set forth in Reg. Sec. 1.482-1(h)(2) are incompatible with Code Sec. 482. For example, 3M Company contended that the public-promulgation requirement of Reg. Sec. 1.482-1(h)(2) is an unreasonable interpretation of the statute because many countries rely on unpromulgated administrative guidance that is nonetheless considered binding.

In addition, 3M Company argued that Reg. Sec. 1.482-1(h)(2) is invalid under Motor Vehicle Mfrs. Assn. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983) (State Farm). In that case, the Supreme Court held that the Department of Transportation failed to present an "adequate basis and explanation" for rescinding a regulatory requirement and held that the requirement therefore "may not be abandoned." 3M Company argued that Reg. Sec. 1.482-1(h)(2) is invalid under State Farm because the Treasury Department did not explain its rationale for the regulation and did not respond to comments objecting to aspects thereof and requesting that changes be made to the proposed regulations.


In a divided opinion, a majority of the Tax Court held that the Brazilian restrictions on payments by 3M Brazil were disregarded under Reg. Sec. 1.482-1(h)(2) because the first three of the seven requirements under the regulation (i.e., that the foreign legal restriction must affect uncontrolled taxpayers, be publicly promulgated, and be generally applicable) were not met with respect to the Brazilian legal restrictions. The court also upheld the validity of Reg. Sec. 1.482-1(h)(2) as a permissible interpretation of Code Sec. 482 and found that the Treasury Department adequately explained its rationale in issuing the regulation.

The Tax Court held that a foreign legal restriction is "publicly promulgated" within the meaning of Reg. Sec. 1.482-1(h)(2)(ii)(A) only if the restriction is in writing. The court reasoned that taking unwritten restrictions into account in determining Code Sec. 482 allocations would foster disputes between taxpayers and the IRS as to the substance of unwritten rules made by foreign governments. Applying this rule, the court found that the Brazilian legal restrictions on payments for technology transfers consisted of the Brazilian Patent and Trademark Office's (BPTO's) unwritten interpretation of Brazilian law. Thus, the court concluded that the BPTO's interpretation has not been "publicly promulgated."

The Tax Court rejected 3M Company's challenges to the validity of Reg. Sec. 1.482-1(h)(2) under Chevron. Under step one, the court disagreed with 3M Company's argument that the plain meaning of Code Sec. 482 precluded the interpretation adopted in Reg. Sec. 1.48-1(h)(2), because it found that First Security Bank did not hold that the predecessor of Code Sec. 482 unambiguously precluded an allocation of income that could not be legally received. The court also considered whether Code Sec. 482 actually is ambiguous and determined that it is, because neither the actual words of the statute nor the legislative history surrounding its enactment showed an unambiguous expression of Congress's intent on how to account for foreign legal restrictions. Under step two of Chevron, the Tax Court determined that the rules set forth in Reg. Sec. 1.482-1(h)(2) are a reasonable interpretation of Code Sec. 482. With respect to the public-promulgation requirement, for example, the court reasoned that this requirement is reasonable because it avoids uncertainty about, and litigation over, the existence of a foreign legal restriction.

The Tax Court also rejected 3M Company's State Farm arguments after finding that the rationale for Reg. Sec. 1.482-1(h)(2) is expressed in the text of the regulation itself. The court also found that that the comments to the proposed regulations that 3M Company claimed the Treasury Department failed to respond to were either insignificant or irrelevant to the current case.

Observation: Three judges dissented from the majority's conclusions. In two separate dissenting opinions, two judges agreed with 3M Company's contention that under First Security Bank, "blocked income" - income that a taxpayer is prohibited by law from receiving - cannot be taxed, and Reg. Sec. 1.482-1(h)(2) contravenes this rule. The third judge opined that the Treasury Department and the IRS failed to comply with the Administrative Procedure Act's notice and comment procedures in promulgating Reg. Sec. 1.482-1(h)(2).

For a discussion of the rules for allocating income and expenses among related corporations, see Parker Tax ¶241,597.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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