chevron-down Created with Sketch Beta.

The Tax Lawyer

The Tax Lawyer: Winter 2024

Blocked Income & 3M Company & Subsidiaries v. Commissioner—Round One—The Chevron Step One Argument

Phillip Cohen

Summary

  • The Tax Court, in 3M Company & Subsidiaries v. Commissioner, in which it concluded, by a razor-thin 9-8 margin, that the Service had the authority, under Regulation section 1.482-1(h)(2), to reallocate foreign income that was allegedly restricted under Brazilian law.
  • The 3M Company’s contentious opinions have raised a host of thought-provoking questions.
  • In this author’s opinion, the taxpayer in 3M Company should have prevailed on its argument that Regulation section 1.482-1(h)(2) is substantively invalid under the Chevron step one test.
  • The author bases this conclusion on the Supreme Court’s 1972 decision in First Security Bank of Utah.
  • The author expands on this argument throughout the article.
Blocked Income & 3M Company & Subsidiaries v. Commissioner—Round One—The Chevron Step One Argument
fhm via Getty Images

Jump to:

Abstract

More than six years after the case was tried, the Tax Court issued its voluminous, reviewed decision in 3M Company & Subsidiaries v. Commissioner, in which it concluded, by a razor-thin 9-8 margin, that the Service had the authority, under Regulation section 1.482-1(h)(2), to reallocate foreign income that was allegedly restricted under Brazilian law. In reaching that conclusion, the Tax Court upheld both the substantive and procedural validity of that regulation, which was issued in 1994 and is often referred to the “blocked income” regulation. The various opinions in the case, totaling 346 pages, consist of a 274-page opinion of the Tax Court, to which six other judges joined, two concurring opinions, and three separate dissenting opinions.

Not surprisingly, the 3M Company’s contentious opinions have raised a host of thought-provoking questions. In this author’s opinion, the taxpayer in 3M Company should have prevailed on its argument that Regulation section 1.482-1(h)(2) is substantively invalid under the Chevron step one test. This Article explains the reasoning for that conclusion and leaves to others to comment on the additional challenges—primarily focused on various Administrative Procedure Act (APA) challenges to the promulgation of that regulation—that the taxpayer made in that case.

I base this conclusion on the Supreme Court’s 1972 decision in First Security Bank of Utah. Irrespective of the correctness of that decision—and there are a fair amount of critics in this regard—the Supreme Court’s decision there clearly held that section 482 does not permit the Service to allocate income to someone who is prohibited by law from receiving it.

While not entirely free from doubt, there is a strong argument that the Court’s decision in First Security Bank was based on the statute and did not rely on a regulation in reaching its decision. In the absence of a statutory change, lower courts are bound to follow it, and the Treasury Department should not be permitted to usurp that authority through regulations or otherwise.

While sound tax policy mandates that the Service should vigorously enforce arms-length transfer pricing between related parties, including the robust use of the commensurate-with-income amendment to section 482 to address abuses in this area, there are no compelling reasons, from a judicial standpoint at least, to limit the holding of First Security Bank to domestic—as opposed to foreign—legal restrictions. This was the conclusion of the courts in Procter & Gamble, Exxon and Texaco. The Tax Court in 3M Company should have followed that precedent absent a statutory amendment that limited the scope of First Security Bank. Although an argument could be made that the Chevron step one test was satisfied in 3M Company, either because the First Security Bank holding was based on regulations no longer in effect or because the fact-pattern in that case was so different from 3M Company that the former decision should not be deemed binding, the more persuasive view is to the contrary. Furthermore, there is a convincing case that the plain text of the commensurate-with-income amendment to section 482 did not constrain the First Security Bank holding, and there is no evidence in the legislative history that this was the Congressional intention.

I. Introduction

More than six years after the case was tried, the Tax Court issued its voluminous, reviewed decision in 3M Company & Subsidiaries v. Commissioner, in which it concluded, by a razor-thin 9-8 margin, that the Internal Revenue Service (the Service) had the authority, under Regulation section 1.482-1(h)(2), to reallocate foreign income that was allegedly restricted under Brazilian law. In reaching that conclusion, the Tax Court upheld both the substantive and procedural validity of that Regulation, which was issued in 1994 and is often referred to the “blocked income” Regulation. The various opinions in the case, totaling 346 pages, consist of a 274-page opinion of the Tax Court, to which six other judges joined, two concurring opinions, and three separate dissenting opinions.

Among many other interesting questions, the 3M Company decision addresses the applicability of the Chevron deference doctrine, whose scope and even its validity is currently under consideration by the Supreme Court in Loper Bright Enterprises v. Raimondo. 3M Company raises many thorny issues, including the question whether the Supreme Court decision in Commissioner v. First Security Bank of Utah should be applicable to foreign legal restrictions. Moreover, what is the effect of Congress’s 1986 enactment of the so-called “commensurate-with-income” addition to section 482? Does it warrant the Treasury’s promulgation of Regulation section 482-1(h)(2)? If not, why not?

3M Company thus has no shortage of thought-provoking questions to go along with lengthy (and dueling) opinions from the various Tax Court judges. While this Article will address these and other issues, the Article’s primary focus is explaining why 3M Company is correct in its argument that Regulation section 1.482-1(h)(2) should be invalidated on substantive grounds because it fails the Chevron step one test. It leaves to others to comment on the other challenges made by 3M Company to the regulation.

II. Blocked Income—Some Significant Pre-3M Company Case Law

Should the Service’s authority under section 482 to clearly reflect the income of related parties be limited in cases where there are legal restrictions, also referred to as blocked income, imposed on payments by one of the parties? Furthermore, does it make a difference if such constraints are created by domestic or foreign authorities, and if the latter should it matter if such curbs were applicable only to related party compensation? There is a significant body of case law in this area that predates the 3M Company decision.

The leading legally restricted income case is the 1972 Supreme Court decision First Security Bank of Utah that held, in a wholly domestic context, that section 482 did not permit the Service to attribute income to a related party where the related party “was [legally] prohibited from receiving” it. That case involved a legal restriction under federal banking law.

The taxpayers in that case were two federally chartered banks, First Security Bank of Utah, N.A. and First Security Bank of Idaho, N.A (“the Banks”). They were, in the years at issue, wholly owned subsidiaries of a holding company, First Security Corp. (“Holding Company”). Holding Company owned other subsidiaries including a management company, First Security Co. (“Management Company”), an insurance agency, Ed D. Smith & Sons (“Smith”), and, beginning in 1954, a life insurance company, First Security Life Insurance Company of Texas (“Security Life”). The Supreme Court noted that “[b]eginning in 1948, the Banks offered to arrange for borrowers, credit life, health, and accident insurance (“credit life insurance”).”

The Supreme Court indicated that “[u]ntil 1954, any borrower who elected to purchase this insurance was referred by the Banks to two independent insurance companies.” It explained that during this period “[i]f the customer desired the coverage, the necessary form was completed, a certificate of insurance was delivered, and the premium was collected or added to the customer’s loan. The Banks then forwarded the completed forms and premiums to Management Company, which maintained records of the insurance . . . .” Management Company then “forwarded the premiums to the insurance carrier.”

The Court also explained that “[i]t was the custom in the insurance business (although not invariably followed), regardless of the cost of incidental paperwork, to pay a ‘sales commission’—ranging from 40% to 55% of net premiums collected—to a party who originated or generated the business.” The Banks, however, were “advised by counsel that they could not lawfully conduct the business of an insurance agency or receive income resulting from their customers’ purchase of credit life in-surance.” Accordingly, “the Banks received no commissions or other income on or with respect to the credit insurance generated by them. During the period from 1948 to 1954 commissions were paid by the independent companies writing the insurance directly, to Smith . . . .” During the 1948–1954 period, “[t]hese commissions were reported as taxable income, not by Smith, but by Management Company . . . . [and] the Commissioner did not attempt to allocate the commissions to the Banks.”

After Security Life was organized in 1954, “[a] new procedure was . . . adopted with respect to placing life insurance.” The Banks had one independent company, American National Insurance Company (“American National”), underwrite the policy but “American National then reinsured the policies with Security Life [with] Security Life retain[ing] 85% of the premiums . . . . No sales commissions were paid [to the Banks].” The reinsurance income was reflected in its entirety with Security Life. “Because the income of life insurance companies then was subject to a lower effective tax rate than that of ordinary corporations, the total tax liability for Holding Company and its subsidiaries was less than it would have been had Security Life paid a part of the premium to the Banks or Management Company as sales commissions.”

The Service asserted that “[p]ursuant to [section] 482 . . . [it was proper] to allocate . . . 40% of Security Life’s premium income . . . to the Banks as compensation for originating and processing the credit life insurance.” In analyzing the application of section 482 to the case before it, the Court observed that “[t]he parties agree that § 482 is designed to prevent ‘artificial shifting, milking, or distorting of the true net incomes of commonly controlled enterprises.’” The Supreme Court indicated that “[t]he question we must answer is whether there was a shifting or distorting of the Banks’ true net income resulting from the receipt and retention by Security Life of the premiums above described.”

Significantly, the Court determined “that the Banks were [legally] prohibited from receiving insurance related income . . . .” Furthermore, “[t]he penalties for violation of the banking laws include possible forfeiture of a bank’s franchise and personal liability of directors.”

In finding section 482 to be inapplicable, the Supreme Court stated that “[w]e know of no decision of this Court wherein a person has been found to have taxable income that he did not receive and that he was prohibited from receiving.” The Court observed that “[i]n cases dealing with the concept of income, it has been assumed that the person to whom the income was attributed could have received it. The underlying assumption always has been that in order to be taxed for income, a taxpayer must have complete dominion over it.”

In its analysis, the Court cited a then-existing section 482 regulation—the importance of which was hotly disputed by the parties in 3M Company—that provided that “[t]he interests controlling a group of controlled taxpayers are assumed to have complete power to cause each controlled taxpayer so to conduct its affairs that its transactions and accounting records truly reflect the taxable income from the property and business of each of the controlled taxpayers.” It commented that the “regulation is consistent with the control concept heretofore approved by th[e] Court . . . .”

The Court determined that the Banks should not have to report this income since “[i]t is only where this power exists [by Holding Company to shift income], and has been exercised in such a way that the ‘true taxable income’ of a subsidiary has been understated, that the Commissioner is authorized to reallocate under § 482.” Here, the Court reasoned, “Holding Company had no such power unless it acted in violation of federal banking laws. The ‘complete power’ referred to in the regulations hardly includes the power to force a subsidiary to violate the law.”

The Supreme Court certainly implied that even absent the then-existing regulation, its analysis would still apply when it stated that “[a]part from the inequity of attributing to the Banks taxable income that they have not received and may not lawfully receive, neither the statute nor our prior decisions require such a result.” It stated “that fairness requires the tax to fall on the party that actually receives the premiums rather than on the party that cannot.” The Court also pointed out that even prior to the incorporation of Security Life, “the Banks . . . were careful never to place themselves in . . . [a] position” that would violate banking laws by receiving income resulting from their customers purchase of credit life insurance.

There were two dissenting opinions in First Security Bank. Justice Marshall wrote that the Banks “have already violated the federal statute and regulations by soliciting insurance premiums” and that “[t]here is nothing in the history of the provision to indicate that Congress was more concerned with banks’ actually receiving money than with their performing the activities that generated the money.” At a later point in his dissent, Justice Marshall reasoned that “[t]he substance is either that the respondents violated federal law, earned illegal income, attempted to avoid taxation on the income by channeling it elsewhere, and were caught by the Commissioner; or, that they did not violate federal law by soliciting sales of insurance and that there is no legal bar to their receiving the proceeds from their sales.” According to Justice Marshall, “[i]n either case, the result is the same, and respondents cannot prevail.”

There was also a dissenting opinion from Justice Blackmun, which was joined by Justice White. Justice Blackmun asserted that the Court “link[s] legality with taxability or, to put it better oppositely, that it ties illegality to receive with inability to tax. I find in the Internal Revenue Code no authority for the concoction of a restrictive connection of that kind.” Justice Blackmun reasoned that the allocation by the Service was proper because “the Banks were responsible force behind the premium income.” The Banks “did what was necessary, and all that was necessary, to sell the insurance. Clearly, services were rendered by that bank on behalf of its commonly controlled affiliate. Just as clearly, those services would have been compensated had the corporations been dealing with each other at arm’s length.”

The majority decision in First Security Bank of Utah has been subject to both criticism and praise. One commentator, David Pratt, summed up his disapproval of the Court’s reasoning as follows: “the majority in First Security Bank . . . failed [to realize] . . . that the statute, regulations, and legislative history are devoid of any requirement that the organization to which the commissioner [sic] seeks to allocate income must have the legal ability to receive that income.”

This Article takes no position as to the correctness of the holding in First Security Bank. It does, however, assert that until the Court overturns that decision or Congress revises section 482 specifically to reverse or limit its holding, the holding controls and its reasoning should apply to foreign as well as domestic legal restrictions, contrary to the Tax Court’s determination in 3M Company. This Article also contends that Regulation section 1.482-1(h)(2) should not alter this conclusion.

The Court in First Security Bank also cited a prior “closely analogous” decision by the Tax Court, L. E. Shunk Latex Products, Inc. v. Commissioner. There, the Court explained, “[t]he same interest controlled a manufacturer and a distributor of rubber prophylactics. . . . Prior [to an Office of Price Administration (“OPA”) price regulation being instituted] . . . the distributor had raised its prices to retailers, but the manufacturer had not increased the prices charged to its affiliated distributor.” The Service, pursuant to its powers under section 482, “attempted to allocate some of the distributor’s income to the manufacturer on the ground that a portion of the distributor’s profits was in fact earned by the manufacturer, even though the manufacturer was prohibited by the OPA regulations from increasing its prices.” The Tax Court held that the Service “had ‘no authority to attribute to petitioners income which they could not have received.’”

It should be noted that prior to the Court’s decision in First Security Bank, there was a decision permitting the Service to reallocate income involving insurance commissions even though the related entity was barred from earning the commission under state law. In Local Finance Corp. v. Commissioner, the Service was permitted to employ section 482 to reallocate credit insurance commissions from one entity to related finance companies, even though “the insurance laws of the State of Indiana prohibited the payment of income in the form of commissions on life insurance to corporations.” The Tax Court opined that “even though[] the insurance laws of Indiana prohibited payment by a life insurance company of commissions to a corporation, we are of the opinion that the respondent is not foreclosed from allocating to the finance companies under section 482 of the Code the income which they earned and over which they exercised the power of disposition.” The court indicated that this was necessary “so as to give uniform application to a nationwide scheme of taxation.” It reasoned that ignoring state legal restrictions was consistent with the fact “that Congress establishes its own criteria for the application of tax statutes, that State law may control only when the Federal taxing act by express language or necessary implication makes its operation dependent upon State law . . . .”

In Revenue Ruling 82-45 the Service distinguished First Security Bank of Utah as only applying to domestic legal restrictions. The Service’s position was that “when the prohibition on the receipt of income is based not on the laws of the United States but rather on restrictions imposed by foreign governments, the decision in First Security Bank of Utah does not foreclose the Service from applying section 482 in order to clearly reflect income.”

Foreign legal restrictions upon the ability of the Service to invoke section 482 was before the Tax Court and ultimately the Sixth Circuit in Procter & Gamble Co. v. Commissioner. There, the courts applied the blocked income concept, validated by the Supreme Court in First Security Bank, to foreign legal restrictions. (As will be discussed further below, because of the years in question neither Regulation section 1.482-1(h)(2) nor the commensurate-with-income amendment to section 482 was relevant to the Procter & Gamble decisions.)

By way of background, in Procter & Gamble, the U.S. corporation, Procter & Gamble Company (P&G), owned a Swiss entity, Proctor & Gamble A.G. (“AG”). For the tax years at issue in the case, P&G “and AG were parties to a License and Services Agreement, known as a ‘package fee agreement,’ under which AG paid royalties to petitioner [i.e., P&G ] for the nonexclusive use by AG and its subsidiaries of petitioner’s patents, trademarks, tradenames, knowledge, research, and assistance . . . .” The royalty was determined principally by net sales of P&G group products made by AG and its subsidiaries in certain countries. During this same timeframe, “AG executed technical assistance and other service agreements, similar to package fee agreements, with its directly owned active subsidiaries.” AG marketed P&G group products, “generally in those countries in which petitioner did not have a marketing subsidiary or affiliate.”

AG was the parent company of P&G Espana S.A. (“Espana”). Espana was established for the “manufacture and sale of high quality consumer and industrial products, including synthetic detergents, soaps and toiletries, and other cleaning and washing products.” When Espana was organized, and its ownership approved by letter from the Spanish government, that “letter expressly provided that Espana could not pay any amounts for royalties or technical assistance.” P&G’s Spanish legal advisor counseled it that the Spanish government’s position was “within [its] power . . .and reflected normal practice . . . [and] that there was no realistic possibility of appealing or protesting the decision . . . .” This position of the Spanish government regarding prohibition of the payment of royalties or for technical assistance was subsequently reiterated when applications were made to increase investment in Espana.

As the taxpayer in 3M Company indicated in its opening Tax Court brief, “[i]n 1973, the Spanish government issued a decree requiring recordation of license agreements before royalties could be paid to foreign shareholders owning more than 50 percent.” (As will be discussed further below, this is somewhat similar to Brazil’s practice in the 3M Company fact pattern.) Both before and after this decree, Espana was (except for limited engineering services) not permitted to pay any amounts for royalties or technical assistance to AG during the years at issue. The Tax Court observed that while there were discussions by “the officers of P&G, AG, and Espana” regarding “the payment of royalties with their counsel from the time of Espana’s organization through the years in issue, informal discussions with Spanish officials dissuaded a formal appeal and Espana never formally applied for a reversal of the prohibition.” The court also noted that while Espana had not paid royalties nor other amounts for technical assistance to AG during the years at issue in the case, “AG paid a royalty to P&G which was based in part on a percentage of Espana’s sales,” and as a result “these royalty payments reduced AG’s income.”

The Service asserted that pursuant to section 482, it was proper for it to adjust AG’s income to reflect a two-percent royalty it should have received from Espana, resulting in an increase of “$1,232,653 and $1,795,005 for the years 1978 and 1979 respectively. . .in order to clearly reflect AG’s income.” If the adjustment had been sustained, P&G would have reflected this income under Subpart F.

Near the beginning of its analysis, the Tax Court acknowledged that “[i]t is well established that respondent’s authority to make allocations under section 482 is broad and that respondent’s section 482 determination must be sustained absent a showing that he has abused his discretion.” P&G argued that the Service’s adjustment was improper because it fell under the exception for being “arbitrary, capricious or unreasonable.” Relying on First Security Bank, P&G asserted that “because Spanish law prohibited or blocked royalty payments from Espana to AG, [it] did not improperly utilize its control to shift income, and thus section 482 does not apply.”

The Service contended, first, “that Spanish law did not prohibit the payment of royalties by Espana to AG during the years at issue and accordingly First Security Bank does not impact his allocation.” In the Service’s “view, the prohibition on the payment of royalties from Espana to AG was merely an administrative decision, arbitrarily determined and subject to appellate review which Espana voluntarily waived.” Alternatively, the Service argued that if the Tax Court found “that Spanish law did prohibit Espana from paying royalties to AG, . . . that First Security [Bank did] not control this case because it [was] factually distinguishable.” The Service maintained that “it [was] significant that in First Security Bank, Federal law served to prohibit absolutely the taxpayers from receiving the income in question under any circumstance.” In contrast, according to the Service, in the case at bar, “Spanish law only prohibited royalty payments from a Spanish company to its foreign parent.” That is, under the Service’s theory, “because AG could have received royalty payments from an unrelated Spanish company, and would have demanded royalties if bargaining at arm’s length, the transaction cannot withstand the analysis associated with the second prong of section 482.”

The Tax Court indicated that the issue that they needed to decide, which was one “of first impression,” was “whether a section 482 allocation is appropriately applied under the circumstances to correct the ‘shifting’ of income associated with Spain’s policy of prohibiting or blocking royalty payments from a Spanish subsidiary to its foreign parent.” In reaching its conclusion on the issue, the court indicated that it found First Security Bank, and a Sixth Circuit decision in Salyersville National Bank v United States, to be “compelling with respect to the issue before the Court.”

Salyersville National Bank, like First Security Bank, dealt with the Service’s allocation of insurance premium income to a bank, but in that case from the bank president who was a licensed insurance agent. In that case, however, the bank “could have qualified to act as an insurance agent under State law, and thus could have received insurance commissions as income.” In determining that the Service’s allocation was improper, the Sixth Circuit “found that the bank had legitimate business reasons for avoiding insurance agent status and concluded that the bank was not obligated to exercise its rights [to attain this qualification].” Under these circumstances, “the bank could not legally receive the premiums . . . .”

In Procter & Gamble, the Tax Court based its conclusion that Spanish law blocked royalty payments from Espana to AG on (among other things) “the express prohibitions respecting royalty payments contained in the original approval letter, issued at the time of Espana’s organization, and the several approval letters Espana received between 1970 and 1978 permitting capital increases.” The court also pointed out “that no companies comparable to Espana were permitted to pay royalties. Espana’s competitors were also prohibited from making royalty payments to their foreign parents.” It determined that “[i]n light of the consistency with which the royalty prohibition was applied, there is no need to identify a specific constitutional or statutory provision codifying the prohibition in order to treat the prohibition as law.”

The Tax Court determined that “[b]ecause Spanish law prohibited or blocked Espana from paying royalties to AG, it effectively precluded AG from receiving the same. . . . Consequently, we agree with petitioner that respondent’s allocation is unwarranted. Section 482 should not be applied to correct ‘a deflection of income imposed by law.’” It determined that “section 482 does not impel the violation of a legal prohibition solely for the sake of matching income and expense.” Furthermore, “[b]ecause the deflection of income in this case arose as a direct consequence of petitioner’s valid business purposes and good faith compliance with Spanish law, an allocation under section 482 is inappropriate.” The court emphasized that it found that “as was the case in First Security Bank, there is no evidence whatsoever that petitioner utilized its control over its subsidiaries to manipulate or shift income amongst them. . . . Although petitioner possibly could have organized Espana so that royalties could be paid, it was not obligated to do so.”

The Tax Court, in Procter & Gamble, rejected the Service’s attempt to distinguish First Security Bank. The Tax Court indicated that there was no reason or authority for limiting that Court decision “to instances in which the section 482 allocation is contrary to Federal law.” According to the Tax Court, the key was not whether the legal restriction involved was due to domestic or foreign law but rather the concept that “[w]here the controlling interest has not utilized its power to shift income, a section 482 allocation is inappropriate.”

Similarly, the Tax Court dismissed the Service’s proposed distinction of First Security Bank as a case that addressed prohibition on receipt of income, not on payment, as a “distinction without a difference.” Finally, it refuted the Service’s assertion that by holding section 482 inapplicable, it rendered “meaningless” a regulation that “permit[ted] deferral of the allocated income, where the payments allocated could not be effected under foreign law.” The Tax Court responded that “[b]y virtue of our holding that section 482 does not apply, the regulations underlying section 482 likewise do not apply.”

The Sixth Circuit, in Procter & Gamble Co. v Commissioner, affirmed the Tax Court’s decision. The Court of Appeals observed that “P&G did not have the power to shift income between Espana and its other interests unless it violated Spanish law.” In its rejection of the Service’s argument that First Security Bank was not controlling, the Sixth Circuit opined that “[t]he Supreme Court focused on whether the controlling interests utilized their control to distort income. We see no reason to alter this analysis because foreign law, as opposed to federal law, prevented payment of royalties.” The court reasoned that “[t]he purpose of section 482 is to prevent artificial shifting of income between related taxpayers. Because Spanish law prohibited royalty payments, P&G could not exercise the control that section 482 contemplates, and allocation under section 482 is inappropriate.”

A legitimate policy concern resulting from the Procter & Gamble decisions that was raised by Gaetano C. Lanciano, (as well as others) was that “[a]llowing foreign governments to determine U.S. tax liability has numerous potential detrimental effects.” His fear was collusion between the taxpayer and the foreign government. He wrote that “[i]f the government cannot prove that the taxpayer had a private arrangement with the foreign government, which often will be the case, U.S. taxation power would be at the mercy of the foreign government.” The Sixth Circuit acknowledged the potential problem in its Procter & Gamble decision when it indicated that in circumstances where “foreign law is involved [in imposing the restriction, this] may require a heightened scrutiny to be sure the taxpayer is not responsible for the restriction on payment.” Lee Sheppard voiced a similar apprehension about the impact of the decisions, writing “[d]oes the Procter & Gamble decision leave it open to taxpayers to get private laws from malleable host governments?” While this is indeed a valid worry, requiring “heightened scrutiny” by the courts, I do not think it should serve to bar application of the Court’s decision in First Security Bank for foreign legal restrictions. If this distinction is an important one, it is a matter for Congress—not the courts—to address.

Mark A. Rome has opined that Procter & Gamble was correctly decided because “[n]otwithstanding the criticisms of First Security, . . . the doctrine of stare decisis . . . requires lower courts to faithfully apply controlling precedent. . . .” and “[t]he Supreme Court’s concerns [about the Service’s use of section 482] are no less prevalent in cases involving foreign restrictions.” He added that “[w]hen foreign restrictions effectively foreclose the taxpayer’s opportunity to exercise such control, the IRS should recognize First Security as an insurmountable roadblock.”

After the Procter & Gamble decisions were rendered, the Tax Court, in Exxon Corp. v. Commissioner, considered once more the issue of the Service’s ability to assert section 482 where there were foreign legal restrictions on payments. In Exxon, the Tax Court again disallowed the Service’s use of section 482 to reallocate income among related parties where foreign legal restrictions were involved. Exxon was affirmed by the Fifth Circuit in Texaco, Inc. v. Commissioner.

In Exxon, “the Tax Court addressed the effect of a restriction imposed by Saudi Arabia[Letter 103/z (January 23, 1979) ] whereby companies which bought oil from Saudi Arabia at a below-market price could not resell the oil at a greater price.” The Saudi legal restriction, which impacted a number of companies, including Exxon Corp. (“Exxon”) and Texaco, Inc. (“Texaco”), both of whose cases were consolidated in the Tax Court in Exxon, required the entities affected to resell the Saudi Arabian crude oil at the official selling price (“OSP”). The OSP, which was below the market price during the time periods in question, only applied to crude oil and not to oil that had been refined. What transpired was that U.S. subsidiaries of Texaco and Exxon “purchased oil from Saudi Arabia at a below-market price and resold the oil to foreign affiliates at the same price.” The foreign affiliates, in turn, sold the refined oil products that were made from the Saudi crude oil, and earned large profits that escaped federal income taxation. The Service asserted “that income should be allocated from the foreign affiliates to the U.S. subsidiar[ies] under section 482 . . . to reflect that the price at which the U.S. subsidiary sold the oil to the foreign affiliates was below the market price.” The Tax Court held for the taxpayers relying on both First Security Bank and Procter & Gamble.

The Tax Court, in Exxon, rejected the Service’s attempt to distinguish Procter & Gamble. One contention made by the Service, as to why the cases should be decided differently, was “the existence of a statute in Procter & Gamble, the Spanish Law of Monetary Crimes, which could have exposed the parent and the subsidiary to criminal prosecution . . . .” In contrast, the Service contended that “in the case before us there was no enabling legislation, operative statute, or other formal statutory provision under which the restriction was issued and under which criminal penalties could have been imposed.” The Tax Court rejected this argument, however, writing that “[t]his . . . is merely a formal rather than a substantive distinction.” The Tax Court opined, consistent with its holding in Procter & Gamble and elsewhere, that “we see no reason here not to acknowledge the restriction solely because it was not a formally issued law.” That is, according to the Tax Court, since it reached the determination that “the Saudi system constituted a system whereby petitioners lacked such control because they were required by the Saudi Government to comply with Saudi requirements or suffer the dire consequences of reduced supplies or worse, then the holding of Procter & Gamble is appropriately applied in this case.”

In Exxon, the Service also attempted to argue that Procter & Gamble, which until then was the only prior case to apply the holding of First Security Bank to situations involving foreign law restrictions, was erroneously decided because of “[t]he history of section 482, the difficulty of applying foreign law, and the policy argument that foreign governments should not dictate U.S. tax policy.” As to the first assertion, the Tax Court concluded that “there is no evidence that would indicate that Congress directly considered the question and intended to preclude a foreign law from affecting proposed reallocations under section 482.” As to the difficulty of applying foreign law, the Tax Court acknowledged that, as the Sixth Circuit indicated in Procter & Gamble, “particularly in light of the possibility that the taxpayer be responsible for the restriction on payment, a ‘heightened scrutiny’ of the evidence might be required.” This was not, however, a reason to refuse application of the First Security Bank precedent to foreign legal restrictions. As to the Service’s assertion that “foreign governments should not be permitted to dictate U.S. law,” the argument was unavailing because “we look to foreign law as a means of implementing U.S. law, not as a means of usurping it.” The Tax Court also determined that “there is no evidence of . . . collusion [between the taxpayer and the Saudi government] in this case.”

As a result of its rejection of the Service’s arguments that Procter & Gamble was wrongly decided, the Tax Court concluded that “we see no reason not to apply the First Security doctrine to the facts of this case in the context of a foreign restriction . . . .” After a detailed review of the specific facts of the case, the Tax Court concluded that “the 1979 [Saudi] restriction precluded a section 61 or section 482 adjustment . . . .” The Tax Court decision was affirmed by the Fifth Circuit in Texaco.

In Texaco, the Fifth Circuit determined that “[b]ased on the Tax Court’s factual findings, which are not clearly erroneous, we agree that Letter 103/z had the effect of a legal restriction in Saudi Arabia.” Furthermore, the court “also agree[d] with the Tax Court’s legal conclusion that the teaching of [First Security Bank] bars the Commissioner from allocating income to Textrad on its sales of Saudi crude under § 482.” Textrad, whose official name was Texaco International Trader, Inc., was the U.S. affiliate of Texaco, Inc, that “purchased Saudi crude oil from the Saudi government by way of the Arabian American Oil Company (Aramco) and resold that crude to both affiliates and unrelated customers.”

In reaching its decision in Texaco, the Fifth Circuit relied on both First Security Bank and Procter & Gamble. The court reasoned that Texaco lacked the “ability to control the flow of its income . . . .” It observed that “[t]he Tax Court found, and we agree, that Letter 103/z had the force and effect of law, that Textrad was obligated to comply with its requirements, and that it did so comply. Because Textrad lacked the power to sell Saudi crude above the OSP, reallocation under § 482 is inappropriate.” “In sum,” the Fifth Circuit concluded, “the Tax Court did not err in concluding that Textrad sold the Saudi crude to both its affiliates and its unrelated customers at the below-market OSP to avoid violating Letter 103/z and the severe economic reprisal that would have flowed from such a violation.”

III. 3M Company Factual Background

3M Company (“3M Company”), “is the common parent company of an affiliated group of corporations (referred to herein as “3M Company and Subsidiaries” or the “Taxpayer”) that filed a consolidated federal income tax return for the tax year ending December 31, 2006.” 3M Company, which is incorporated in Delaware and whose principal place of business is in Minnesota, with its subsidiaries is “engaged in the manufacturing, research, development, marketing, and sales of products in the United States and throughout the world.” (3M Company and its domestic and foreign subsidiaries will be referred to as “3M Global” or simply “3M.”) 3M Global, in the year in question before the court (2006), “was one of the largest technology and manufacturing businesses in the world, with more than 40 major technology platforms that formed the basis for about 50,000 different products, $23 billion in gross sales, and $21 billion in assets.”

There was one ultimate question before the Tax Court in 3M Company: whether there should have been an increase in the taxable income of the “3M consolidated group… by $23,651,332 to reflect the arm’s-length compensation that 3M Brazil should have paid for intellectual property under section 482.” 3M Company asserted that “[a] consistent body of case law (including a decision by the Supreme Court) holds that the Commissioner cannot employ section 482 to allocate income that the taxpayer has not received and cannot receive because the law prevents its payment or receipt.” The Service relied upon Reg. § 1.482-1(h)(2) “which governs the effect of foreign legal restrictions on section 482 adjustments . . . .” The Tax Court ultimately held that Regulation section 1.482-1(h)(2) properly applied, and it thus upheld the Service’s adjustment to the Taxpayer’s income.

Some background regarding 3M’s Brazilian operations is beneficial to a full understanding of the Tax Court’s decision. In 1946, a company, originally known as “Durex, Lixas e Fitas Adesivas Ltda. was established in Campinas, Brazil.” It was, at the time of its establishment (and still was in 2006) an indirect subsidiary of the 3M Company and eventually was renamed “3M do Brasil Ltda.,” which is the name it used during the 2006 tax year.” It was referred to by the Tax Court (and in this Article) as “3M Brazil.” In 2006, 3M Brazil “reported approximately $563 million in sales . . . [and maintained] three manufacturing sites . . . [and] a research and development facility located at one of its manufacturing sites.”

The Tax Court indicated that “3M Brazil’s primary business operations included the manufacturing and distribution of 3M Global’s products.” In 2006, 3M Brazil manufactured, marketed, and/or sold a wide variety of products. These “included abrasives, adhesives and adhesive tapes, automotive products, office and consumer products, medical-and-dental-care products, graphic communication products, electrical products, telecommunication products, tapes . . . , labels, respirators, and hearing-protection products.”

In 2006, 3M Innovative Properties Co. (“3M IPC”) “own[ed] substantially all of the intellectual property used or developed by 3M Global, with the exception of trademarks, which are owned by 3M Company.” In that year, “3M Global’s products were sold under various trademarks owned by 3M Company.” Furthermore, in 2006 “3M Company and 3M IPC jointly licensed [their intellectual property] to most of the affiliates of 3M Global (but not to 3M Brazil) and . . . to third parties.” In licensing intellectual property to most foreign affiliates a “standard licensing agreement [was utilized whereby], the licensors (3M Company and 3M IPC, individually and collectively) grant[ed] to the licensee (a foreign affiliate) a license to manufacture goods using the licensor’s intellectual property and to exercise all rights that are protected by or arise under the licensor’s intellectual property.” As was stipulated by the parties in 3M Company, “3M Brazil was one of the few [3M Global affiliates] that did not use [this standard licensing agreement].”

As to the royalty charged for licensing intellectual property under the standard licensing agreement, the practice employed by 3M was that intellectual property was split between production intangibles (“Production Intangibles”) and marketing intangibles (“Marketing Intangibles”), with the former including “any intellectual property used in manufacturing products and proving services.” The latter, i.e., Marketing Intangibles, “include any intellectual property used in conducting the affiliate’s general business operations other than those involving manufacturing products, providing services, or involve software or certain special value products.” With respect to Production Intangibles, the standard licensing agreement provided that “the affiliate pays 3M a royalty of 6% of the invoiced amount (less taxes and other costs, including certain intercompany costs of goods) for any product processed, made, or converted by the affiliate (excluding software and certain special value products) and for any services provided by the affiliate.” As to Marketing Intangibles, the standard licensing agreement provided that “the affiliate pays 3M a royalty of 1% of the invoiced amount (less taxes and other costs, including certain intercompany costs) of any product sold, licensed, leased, or otherwise disposed of by the affiliate.”

Furthermore, pursuant to 3M’s standard licensing agreement, 3M Company agreed “to reimburse the licensee its actual costs incurred for laboratory work undertaken by the licensee or performed by an entity other than the licensor for the licensee at the licensee’s request, and related to product development or modification, or research, including basic and applied research.” In addition, 3M Company also agreed “to pay a markup of 10% (or other agreed markup) [to the foreign affiliate].” The quid pro quo for the foregoing was that “[a]ll types of intellectual property developed by the licensee through this arrangement would become the property of 3M IPC, except for the trademarks, which would become the property of 3M Company.”

Returning to the situation in Brazil, during “the 2006 tax year, 3M Brazil had access to and used in its business operations, intellectual property owned or licensed by…[3M Company and/or 3M IPC], including patents, trademarks, software, and non-patented technology, such as technical know-how and trade secrets.” Beginning “[i]n 1952, 3M Brazil agreed with 3M Company to pay royalties for the use of 3M Company’s intellectual property and for support services. [Under this agreement, 3M Brazil] would pay a royalty equal to 10% of the gross selling price of products sold by 3M Brazil.” This was reduced in 1966 “to cover only a fee for technical assistance services, which was equal to 5% of the gross selling price of 3M Brazil’s products.”

This arrangement for 3M Brazil to use 3M and 3M IPC intellectual property and access technical assistance services further changed “throughout the years [and] was sometimes governed by one or more licensing agreements.” In 1982, there was a trademark licensing agreement entered into between 3M Company and 3M Brazil in which the former granted the latter “a nonexclusive license to use in Brazil certain trademarks . . . .” Royalties were waived under the 1982 trademark licensing agreement “for as long as subsidiaries are prevented from paying royalties to parent companies [under Brazilian law].”

The following year, i.e., 1983, “3M Company and 3M Brazil entered into a licensing agreement that replaced the 1952 licensing agreement.” This 1983 agreement covered certain patents as well as technical know-how and assistance. It contained language which indicated that “3M Company ‘hereby waives any right to compensation for the patent license and other licenses and rights granted herein, and grants same free of charge to . . . [3M Brazil] for as long as subsidiaries are prevented from paying compensation to parent companies for industrial property in accordance with legislation currently in force in Brazil.’” There was “no other provision regarding payments by 3M Brazil [in the 1983 agreement].”

In 1997, a proposed licensing agreement was drafted “to replace the 1983 licensing agreement . . . .” This proposed agreement “was similar to licensing agreements that it had entered into with other foreign affiliates.” Had it been executed, the agreement would have covered both the use of Production Intangibles and Marketing Intangibles, as well as technical assistance services. The proposed agreement contained “a royalty of 4% of the net selling price of licensed products manufactured in Brazil (excluding sales to 3M Company and its affiliates).” It was, however, never signed by 3M Brazil and thus never went into effect.

The reason the proposed agreement was never executed was that the Brazilian Patent and Trademark Office (“BPTO”) “notified 3M Company that the 1997 proposed licensing agreement was not in compliance with ‘the legislation and/or rules usually adopted by’ the BPTO for recordation purposes.” The BPTO “is an agency of the Brazilian government that has regulatory authority over industrial property in Brazil, including the recordation of certain licensing agreements providing for the transfer of industrial property. The BPTO exercised this regulatory authority during the 2006 tax year.”

The notification letter from the BPTO “identified deficiencies in the agreement that required amendment or removal.” As a result of this letter, 3M Company opted not to “submit the 1997 proposed licensing agreement to the BPTO for formal recordation. Had it done so without addressing the deficiencies identified in the BPTO’s . . . letter, the BPTO would not have recorded the 1997 proposed licensing agreement for the reasons identified in that letter.”

In its consideration of addressing the BPTO issues that were raised regarding the 1997 proposed agreement, “3M Company reviewed the intellectual property supporting approximately 40 of the biggest selling products manufactured by 3M Brazil . . . [and] concluded that only a small number of these products was supported by Brazilian patents.” As to unpatented technology used by 3M Brazil, “3M Company was advised by its Brazilian attorneys that, in order to enter into such an agreement, 3M Company would be required to disclose certain trade secrets to the BPTO.” It decided against doing so because it “fear[ed] that its trade secrets might be disclosed by the BPTO to 3M Company’s competitors and that disclosure could weaken trade secret legal protections for its unpatented technology under the laws of the various countries where 3M Global does business.” As a result 3M decided against pursing both a new patent and unpatented technology licensing agreement with 3M Brazil and instead elected “to enter into royalty-bearing trademark licensing agreements.”

With respect to trade secrets, the Tax Court pointed out that “[t]he advice that 3M Company received in this regard was not entirely accurate because 3M Company was not, in fact, required to disclose its trade secrets to the BPTO. Rather, the BPTO requires only a general description of the technology being transferred, such as the field or industry to which the technology relates.” In any event, in 1998 3M Company terminated both a prior 1982 trademark licensing agreement as well as the 1983 agreement discussed above. In their place, 3M Company “entered into three separate licensing agreements for the purpose of licensing 3M Company trademarks to 3M Brazil…” Pursuant to those agreements, “3M Brazil agreed to pay 3M Company a royalty of 1% of the net selling price of the products sold bearing a trademark identified in the license.” These agreements were amended in 1999 but the royalty rate was not revised, and these agreements, as amended, were recorded by the BPTO in 1999 and “were in effect during the 2006 tax year.”

There were countless stipulations between the parties that are not addressed herein. Many of these lead to the parties agreeing “that under Brazilian law the maximum amount that 3M Brazil could have paid to 3M IPC as patent royalties or technology-transfer payments in 2006 was $4,283,153.” There was further concurrence by the Service and the Taxpayer that “the 3M consolidated group is entitled to a ‘setoff against any section 482 adjustment for royalties from 3M Brazil’ in an amount equal to $4,117,370 for research-and-development expenses incurred by 3M Brazil that 3M Company did not reimburse but would have reimbursed had the standard agreement been in effect.” The result of the foregoing is that an adjustment of “$165,783 (equal to $4,283,153 minus an offset of $4,117,370 for unreimbursed research-and-development expenses (R & D offset)) . . . would be made if petitioner were to prevail in its argument that the Brazilian legal restrictions should be taken into account.”

In its 2006 consolidated federal income tax return, 3M Company and Subsidiaries “reported as income $5,104,756 in trademark royalties paid by 3M Brazil to 3M Company.” 3M Brazil, however, “made no payments to 3M Company for consulting services or technical assistance services. Nor did 3M Brazil pay 3M IPC for the use of patents, trade names, name recognition, copyrights, software, or unpatented technology.”

The Service issued a notice of deficiency for 2006 that included an adjustment of $23,651,332 labeled “Brazilian Royalties.” The parties stipulated that this figure “was calculated by ‘[a]pplying the royalty rates under the Standard Licensing Agreement to the intercompany licensing transactions between 3M Company, 3M IPC, and 3M Brazil at issue in this case.’” As the Tax Court pointed out “[t]he $23,651,332 adjustment made by the notice of deficiency did not include any adjustment related to the $5,104,756 of trademark royalties paid by 3M Brazil to 3M Company and reported as income by the 3M consolidated group (of which 3M Company was a member).” That is the adjustment at issue before the Tax Court relates solely to “(1) 3M Brazil’s use of 3M Company’s patents and (2) the transfer of technology from 3M IPC to 3M Brazil.”

IV. The Opinion of the Tax Court and the Concurring and Dissenting Opinions

A. The Opinion of the Tax Court

Writing for the Tax Court was Judge Morrison, who was joined by six others: Judges Kerrigan, Gale, Gustafson, Nega, Ashford and Marshall. Judges Paris and Copeland concurred in the result only. There were eight dissenting judges, so that more than one-half of the Tax Court judges disagreed with the Court’s reasoning. But disagreement with the Court’s reasoning did not affect the bottom line; the government prevailed by a 9-8 margin.

Judge Morrison began the Tax Court’s opinion with a detailed discussion of the facts followed by a brief review of some procedural matters. He then turned to a very extensive review of the relevant authorities before he explained his reasoning.

The Tax Court observed that among the Taxpayer’s authorities were: “(1) the text of section 482, (2) the legislative history of section 482, and (3) four cases that, interpreting prior versions of section 482 and the regulations thereunder, held that respondent did not have authority to allocate income to a taxpayer that the taxpayer did not receive and could not legally receive.” Those four cases were: L. E. Shunk, First Security Bank, Procter & Gamble (both Tax Court and the Sixth Circuit decisions), and Exxon (both the Tax Court decision and its affirmance by the Sixth Circuit in Texaco). As to the Service’s support for its position, the Tax Court indicated that the Service argued “that the legal principles that govern this dispute are found in the 1994 regulation [i.e., Regulation section 1.482-1(h)(2)] that is applicable for the 2006 tax year at issue in this case . . . (setting forth rules regarding the effect of foreign legal restrictions).”

As to the applicability of Regulation section 1.482-1(h)(2), the Taxpayer “contend[ed] that [it] is invalid under various administrative-law principles and therefore does not control the outcome of this case.” The latter assertion is discussed extensively below. The Tax Court then noted that “[t]he parties arguments implicate a century’s worth of legal materials, such as statutes, amendments to statutes, legislative history, regulations, public comments on regulations, preambles to regulations, and caselaw.” It covered this material in chronological order, only some of which will be discussed herein.

The opinion set forth the version of section 482 of the Internal Revenue Code of 1954, which was relevant to First Security Bank:

In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary or his delegate may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, 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 of such organizations, trades, or businesses.

After examining various proposed and final Regulations with respect to section 482, as it was written under the Internal Revenue Code of 1954, including what the Tax Court referred to as the “1968 final regulations,” the Tax Court discussed First Security Bank. The Tax Court observed with respect to that decision that the Taxpayer “contend[ed] that First Security Bank found section 482 [of the Internal Revenue Code of 1954] to be clear in light of the longstanding and consistent interpretation of the concept of income.” In contrast, the Service maintained “that First Security Bank did not determine that the text of section 482 of the Internal Revenue Code of 1954 was clear.” Instead, the Service maintained that this Supreme Court decision “relied on the text of a regulation . . . .”

One item in the opinion’s overview of relevant authorities that was not examined earlier was the commensurate-with-income amendment to section 482 as part of the Tax Reform Act of 1986. The Tax Court indicated that “The Tax Reform Act of 1986 … added a second sentence to section 482 of the Internal Revenue Code of 1986.” This sentence provides:

In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.

The Tax Court pointed out that the Service asserted that this commensurate-with-income addition to “section 482 applies to the intangibles transactions at issue . . . [in] this case.” In contrast, the Tax Court observed that the Taxpayer did “not argue that the effective-date provision makes the second sentence of section 482 inapplicable for the case. Rather, . . . that neither [i.e., the first nor the second] sentence of section 482 governs the intangibles transactions because of the effect of the Brazilian legal restrictions.”

As part of its discussion of relevant authorities, the Tax Court examined the regulatory developments under section 482 beginning in 1992. This included the background to the foreign legal restriction proposals and the ultimate finalization, in 1994, of Regulation section 1.482-1(h)(2).

After it completed its review of pertinent sources, the Tax Court undertook its analysis of why it reached its decision. The opinion began by addressing “[w]hether the Brazilian legal restrictions satisfy the seven requirements of 26 C.F.R. sec. 1.482-1(h)(2) (2006) for taking into account foreign legal restrictions.” (In so doing, it assumed the validity of the regulation, which it addressed later.) While Regulation section 1.482-1(h)(2)(ii) lists four subsections of requirements with respect to when foreign legal restrictions will be taken into account, the Tax Court said that, in fact, there were seven regulatory provisions that needed to be satisfied for the restriction to be effective—that is, to preclude application of section 482.

These requirements, according to the Tax Court, are as follows:

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.

All the requirements needed to be met to qualify for the regulatory relief. The Taxpayer asserted that it met some of the requirements and that the rest were invalid. As noted infra in this Part IV.A, the Tax Court found that none of the conditions of the Regulations were satisfied with respect to two of the exceptions. With respect to the exhaustion-of-remedies requirement, the Tax Court opined that it was “not necessary for us to resolve the question of whether 3M Company exhausted the remedies for obtaining a waiver of the Brazilian legal restrictions.” It similarly decided “not [to] determine whether 3M Brazil materially violated the Brazilian legal restrictions . . . .”

The more contentious issue followed. This was whether Regulation section 1.482-1(h)(2) met the tests set forth by the Supreme Court under Chevron, starting with step one. This is where I think (and will explain more fully below) that the Tax Court’s reasoning was flawed. The Tax Court stated with respect to this test: “Under Chevron step one, a court must ‘applying the ordinary tools of statutory construction, . . . determine whether Congress has directly spoken to the precise question at issue.’” The Tax Court quoted Chevron with respect to step one: “[i]f the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress.” The Tax Court observed that only if the regulation satisfied the test in Chevron step one, that is “the statute is ambiguous,” then it is subject to the second test in Chevron, i.e., Chevron step two, which is that “a court must defer to the agency’s interpretation of the statute if the interpretation is reasonable.”

The Tax Court observed that the Taxpayer contended that Regulation section 1.482-1(h)(2) was “invalid under Chevron step one because . . . judicial precedents have held that predecessors to section 482 unambiguously provided that there can be no allocation of unreceived income under these statutes if receiving the income is prohibited by legal restrictions.” The court indicated that while the Taxpayer cited other cases for its position, i.e., L. E. Shrunk, Procter & Gamble and Exxon/Texaco, it “primarily relie[d] on First Security Bank.

The Tax Court, however, rejected the Taxpayer’s reliance on First Security Bank. The court began by noting that the initial passage of the Supreme Court’s opinion there stating “that no decision of the Supreme Court had found that a person had ‘taxable income that he did not receive and that he was prohibited from receiving’ . . . involved the interpretation of the predecessors of section 61, not the predecessors of section 482.” The Tax Court then explained that “the ultimate question in . . . [that case] involved respondent’s authority under the predecessors of section 482, not section 61. Thus, the initial passage does not constitute the complete explanation of First Security Bank’s holding.” According to the Tax Court, the holding in First Security Bank was dependent on then-existing Regulations, specifically Regulation section 1.482-1(b)(1) (1971)—”the complete power regulation.” The Tax Court quoted from First Security Bank that pursuant to this regulation “as applied to the facts in this case, contemplates that Holding Company—the controlling interest—must have complete power to shift income among its subsidiaries. . . . But Holding Company had no such powers unless it acted in violation of federal banking laws.”

The Tax Court opined that First Security Bank “relied on a regulation rather than the text of the relevant statute [which] indicates that First Security Bank did not hold that the statute was ‘unambiguous.’” Thus, under the Tax Court’s reasoning, the Supreme Court opinion “did not hold that the predecessor of section 482 of the Internal Revenue Code of 1954 unambiguously precluded an allocation of income that could not be legally received.” As will be explained below, however, there is other language in First Security Bank that is very supportive of the view that the Supreme Court’s decision there was, in fact, based on section 482 and not just Treasury’s regulation.

L. E. Shunk was also dismissed as a basis for a Chevron step one determination. The Tax Court did so, in part, because L. E. Shunk “did not suggest that [its] holding stems from unambiguous statutory text.” The Tax Court also indicated that it was “not persuaded by petitioner’s view that the regulation containing the ‘complete power’ sentence was not effective for, or in existence for, the years at issue in L. E. Shunk.”

The Tax Court also rejected the Taxpayer’s claim that “Procter & Gamble was a Chevron step one opinion.” It reasoned that “[t]he holding of Procter & Gamble did not encompass a view that the text of section 482 of the Internal Revenue Code of 1954 was unambiguous. Rather, Procter & Gamble relied on First Security Bank’s interpretation of section 482 of the Internal Revenue Code of 1954.” The Tax Court similarly dismissed Taxpayer’s contention that Texaco was the basis for a Chevron step one determination, commenting that “[t]he Fifth Circuit Texaco opinion did not state that its holding was based on the unambiguous text of section 482 of the Internal Revenue Code of 1954. Rather, the Fifth Circuit relied on the First Security Bank opinion.” This aspect of the Tax Court’s Chevron step one analysis is certainly valid. The Procter & Gamble, Exxon, and Texaco decisions all stem from First Security Bank.

As an additional justification for its rejection of the Taxpayer’s Chevron step one assertion, the Tax Court stated that the cited opinions of the Taxpayer “are distinguishable because they construed the pre-1986 statutory provision that lacked the commensurate-with-income sentence.” This point, it noted, was disputed by the Taxpayer, which had argued that based on the legislative history “the 1986 statutory change is irrelevant to the effect of legal restrictions on section 482 allocations . . . .”

In particular, the Taxpayer referred to a House Ways & Means Committee report that “the committee intended the 1986 amendment to ‘make it clear that industry norms or other unrelated party transactions do not provide a safe-harbor minimum payment for related party intangibles transfers’ and that ‘consideration . . . [must] be given the actual profit experience realized as a consequence of the transfer.’” That is, according to the Taxpayer, the addition of the commensurate-with-income provision “was to require that ‘income from intangibles be commensurate with income over an extended timeframe.’” In further support of its position, the Taxpayer referenced the Blue Book explanation that the commensurate-with-income “amendment had been intended to ensure that ‘consideration also be given to the actual profit experience realized as a consequence of the transfer’ of intangibles and that ‘payments made for the intangible be adjusted over time to reflect changes in the income attributable to the intangible.’” The Taxpayer also pointed out “that neither the House report, the conference committee report, nor the Blue Book mentions legal restrictions on the payment or receipt of income and that none of these publications refers to First Security Bank or L. E. Shunk Latex.”

The Tax Court, however, was unpersuaded by the Taxpayer’s assertions regarding the intent and scope of this addition to section 482. It first referred to “the remarkably broad wording in the commensurate-with-income sentence.” The Tax Court added that “[i]t was the text of the 1986 amendment that was enacted by Congress, not the purpose behind the amendment.” It also remarked as to the lack of legislative history to the commensurate-with-income provision: “[i]t is reasonable to think that Congress would have expected that the interpretive questions posed by section 482 as amended in 1986 would be resolved by subsequent regulations, not by pre-amendment legislative history.”

The Tax Court also found improper the Taxpayer’s reliance on the Supreme Court’s decision in Home Concrete in support of its argument that Regulation section 1.482-1(h)(2) is invalid. In that case, the Supreme Court settled a conflict between a prior opinion it had rendered in Colony, Inc. v. Commissioner and a regulation issued thereafter. The Tax Court in 3M Company stated that “[a]ccording to Home Concrete, the opinion in Colony had held that Congress ‘had directly spoken to the question at hand’ and therefore ‘left [no] gap for the agency to fill.’” The Tax Court said that Home Concrete was “distinguishable. Unlike Colony, First Security Bank did not hold that Congress had ‘directly addressed the precise question at issue.’” In addition, according to the Tax Court, unlike the situation with Home Concrete, and “the changed statutory text in Colony, the addition of the commensurate-with-income sentence to the statute in 1986 has stronger ‘interpretive force’ because respondent’s position—of allocating income to 3M IPC commensurate with income from intangibles—is supported by the text of the 1986 amendment.” It thus determined that “caselaw has [not] held that section 482 is unambiguous . . . .”

The Tax Court then determined section 482, itself, was not unambiguous. In reaching this conclusion, it first noted that, under Chevron step one, in determining “whether Congress has ‘directly addressed the precise question at issue’, a court is to consult the plain language of the statute, and, if the intent of Congress is not clear, the legislative history.” It first found that “the actual words of section 482 do not reveal that Congress unambiguously intended to prevent respondent from making the allocation at issue.” It also rejected the Taxpayer’s assertions that the legislative history to section 482 evidences that the statute is unambiguous on the issue before the court.

While the Tax Court’s analysis regarding Chevron step one is not entirely unreasonable, I think the more persuasive view is that, regardless of the correctness of its analysis, the Supreme Court’s decision in First Security was an unambiguous determination—based on the statute itself—that section 482 did not authorize the Service to reallocate income to a taxpayer who was not legally permitted to receive it, whether the restriction was imposed under domestic or foreign law. Prior to the issuance of the 3M Company opinion, both the Tax Court and the Fifth and Sixth Circuits had so held. There is no reason to ignore stare decisis absent a statutory modification that effectively alters the implications of First Security Bank. While it is true that those court decisions all concerned years before the commensurate-with-income language was added to section 482, for the reasons explained later on (see infra Part V), there is no reason why that fact should make any difference.

The Tax Court next addressed whether Regulation section 1.482-1(h)(2) was invalid, as the Taxpayer maintained, because it failed to satisfy Chevron step two, i.e., it was not a “‘reasonable interpretation’ of the statute.” The court concluded that Chevron step two was satisfied.

As the Tax Court described it, the Taxpayer’s position with respect to Chevron step two centered on its argument that the requirement in Regulation section 1.482-1(h)(2)(i) that “a foreign legal restriction will be taken into account only to the extent that it is shown that the restriction affected an uncontrolled taxpayer under comparable circumstances for a comparable period of time” was “incompatible with the purpose of section 482 . . . .” The Tax Court quoted the Taxpayer’s articulation of its position as follows: “When a legal restriction prevents the exercise of control, then the transaction is not a controlled transaction. This is so even if the legal restriction applies only to related party transactions.”

The Tax Court characterized that argument as consisting of two parts. According to the court, “[t]he first part of the argument—that section 482 is aimed at controlled transactions—is based directly on regulations under section 482.” As to the second part of the Taxpayer’s argument, the Tax Court described it as “a transaction is a not a controlled transaction if payment for the transaction is controlled by law [and] is founded on a Supreme Court opinion, First Security Bank.”

With respect to what the Tax Court described as the second part of the Taxpayer’s Chevron step two assertion, the court said it was erroneous because the decision in First Security Bank “rested upon a regulatory provision from 1934 that is no longer in effect.” As to what the Tax Court described as the first part of Taxpayer’s argument, the court concluded that the Service’s “section 482 adjustment to the income of the 3M consolidated group fits the . . . purpose of section 482 to achieve clear reflection of income from controlled transactions. In short, the regulation’s focus on a ‘controlled transaction’ . . . is not inconsistent with the section 482 allocation at issue.”

Aside from its dismissal of the Taxpayer’s contention with respect to the Chevron step two test, the Tax Court added that the regulatory requirement “that foreign legal restrictions are taken into account only if those restrictions affect uncontrolled taxpayers . . . [is] [i]n our view . . . a reasonable interpretation of section 482.” The court stated “[t]hat statutory text—authorizing respondent to allocate income between controlled businesses ‘in order . . . clearly to reflect’ their income—is broad enough to accommodate the interpretation.” The Tax Court also endorsed the Service’s position that “[a]s applied to the facts of this case . . . the effect-on-uncontrolled-taxpayer requirement of 26 C.F.R. sec. 1.482-1(h)(2)(i) (2006) is a reasonable interpretation of the second sentence of section 482.”

The Tax Court then addressed the Taxpayer’s dispute with the requirement in Regulation section 1.482-1(h)(2)(ii)(A) “that a foreign legal restriction is taken into account under section 482 only if it is ‘publicly promulgated.’” The court opined that “[t]he public-promulgation requirement is a reasonable interpretation of section 482 . . . .” The Taxpayer had asserted that this regulatory requirement “does not ‘take into account the fact that many countries rely on unpromulgated administrative guidance that is nonetheless considered binding.’” This contention was rejected by the Tax Court “because the requirement avoids uncertainty about, and litigation over, the existence of a foreign legal restriction.”

The Tax Court also rejected the Taxpayer’s challenge to the requirement in Regulation section 1.482-1(h)(2)(ii)(A) that “the foreign legal restriction . . . be ‘generally applicable to all similarly situated persons (both controlled and uncontrolled).’” The Tax Court, however, did not rule on the Taxpayer’s challenges to the requirement in Regulation section 1.482-1(h)(2)(ii)(C) “that a foreign legal restriction will be taken into account only if the restriction ‘expressly prevented the payment or receipt, in any form, of part or all of the arm’s length amount that would otherwise be required under section 482 . . .’” nor to the requirement in Regulation section 1.482-1(h)(2)(2)(D) “that a foreign legal restriction will be taken into account only if the related parties did not engage in an arrangement that had the effect of circumventing the restriction and did not violate the restriction in a material respect.” In both cases, the Tax Court found the challenges to be moot because it determined that the Brazilian legal restrictions had failed three other requirements of the Regulation.

The final section of the Tax Court opinion dealt with the Taxpayer’s procedural challenge to the regulation and the possible application of the Supreme Court test enunciated in Motor Vehicle Manufacturers Association of the U.S., Inc. v. State Farm Mutual Automobile Insurance Co. (“State Farm”). The Tax Court noted that, in State Farm, “the Supreme Court held that the Department of Transportation failed to present an ‘adequate basis and explanation’ for rescinding its regulatory requirement that car manufacturers equip cars with either airbags or automatic seatbelts.” As a result of “[t]his failure . . . the requirement ‘may not be abandoned.’” The Tax Court recounted that it had utilized the State Farm test in Altera Corp. & Subsidiaries v. Commissioner with respect “to the 2003 amendments to the section 482 regulations regarding stock compensation in the context of cost-sharing arrangements.” In Altera, the Tax Court “held that the 2002 regulatory amendments failed the State Farm test . . . [, and] were invalid.” While the Ninth Circuit reversed the Tax Court decision in Altera, the Tax Court noted that the appellate court “did not disagree that the 2003 regulatory amendments had to meet the State Farm test.”

While the Service maintained that the State Farm test was inapplicable to Regulation section 1.482-1(h)(2), the Tax Court said it did not have to resolve “whether . . . [the Regulation] is reviewable under the State Farm test, [because] this review would not result in a decision for petitioner.” In reaching this decision, it considered and dismissed the Taxpayer’s challenges “that the Treasury Department did not ‘explain[] its choices with respect to Treas. Reg. § 1.482-1(h)(2)’; and . . . that the Treasury Department did not ‘respond[] to the comments it received objecting to aspects thereof and requesting that changes be made to the proposed regulations.’”

As to the Taxpayer’s first State Farm objection, relating to the requirement that the agency “‘articulate a satisfactory explanation for its action, including a rational connection between the facts found and the choices made,’” the Tax Court reasoned “that…[t]he words of the requirement itself” mandating that “the foreign legal restriction affect uncontrolled taxpayers . . . express its rationale . . . .” The Tax Court further noted that “the Treasury Department satisfactorily explained that one of the reasons it promulgated section 1.482-1(h)(2) of the 1994 final regulations (26 C.F.R. sec. 1.482-1(h)(2) (2006)) was to advance the goal of arm’s-length comparisons.” As to the goal of advancing tax parity, the Tax Court opined that “the effect-on-uncontrolled-taxpayers requirement of section 1.482-1(h)(2)(i) of the 1994 final regulations . . . articulates a link to the goal of tax parity between controlled and uncontrolled taxpayers found in section 1.482-1(a)(1).”

The court then turned its attention to the Taxpayer’s other State Farm dispute with the regulation, i.e., the alleged failure to adequately respond to comments. It determined “that comments about inconsistency with prior caselaw [referencing First Security Bank and Procter & Gamble] were not significant.” This was because it was “apparent that the Treasury Department was already aware that the proposed regulation was inconsistent with the caselaw.” The Tax Court likewise rejected the Taxpayer’s assertion that the Treasury Department did not adequately address comments “that some foreign legal restrictions apply only to payments between related persons.” It reasoned that “these comments did not bring to the Treasury Department’s attention something of which the Treasury Department was not already aware and did not require a change to the regulation.”

The Tax Court further determined that a comment by the American Petroleum Institute “that some foreign restrictions with the practical force and effect of law may not be traceable to a specific published source . . . [was not significant].” This was also because “[t]he Treasury Department was aware that some legal restrictions are not publicly promulgated, as is shown by its insistence that only publicly promulgated restrictions be taken into account.”

The Tax Court additionally dismissed the Taxpayer’s State Farm objection to the Treasury Department’s failure to respond to “commentators [that] had expressed concern that it would be difficult for a taxpayer to establish the satisfaction of the requirement, in section 1.482-1T(f)(2)(ii)(B) . . . that the taxpayer exhaust all remedies.” It rationalized that in the case at bar, “other requirements of . . . [Regulation section] 1.482-1(h)(2) . . . are not met: i.e., the effect-on-uncontrolled-taxpayers requirement, the public-promulgation requirement, and the general-applicability requirement.” Thus, the court opined that “any failure by the Treasury Department to appropriately respond to comments regarding the exhaustion-of-remedies requirement is irrelevant to the current case.” The Tax Court reached the same conclusion with respect to the Treasury Department’s allegedly inadequate response to “commentators [that had] expressed concern that the no-circumvention requirement found in section 1.482- 1T(f)(2)(ii)(D) . . . could be interpreted to mean that the payment of dividends might be considered a way to circumvent a legal restriction.”

Finally, the Tax Court addressed the Taxpayer’s State Farm contention of inadequate response with respect to “commentators [that] had stated that they preferred that taxpayers be allowed to continue to make the deferral election within the timeframe permitted by the 1968 regulations.” It concluded that this was irrelevant to this case because “the 3M consolidated group did not elect the deferred income method of accounting. Nor does petitioner assert that the group is entitled to use that method.”

As discussed infra Part IV.F, the Tax Court’s analysis of the Taxpayer’s procedural objections to the validity of Regulation section 1.482-1(h)(2) was subject to a scathing dissent by Judge Toro. This Article, however, confines itself to examining the correctness of the Tax Court’s Chevron step one determination, which I think was wrong.

B. Concurring Opinion – Chief Judge Kerrigan

Tax Court Chief Judge Kerrigan, who was joined by Judges Gale, Gustafson, Nega, Ashford and Marshall, wrote a concurring opinion “mainly in response to the dissents.” First, she asserted that Judge Buch was incorrect in his dissenting opinion’s determination “that section 482, as interpreted by the Supreme Court in Commissioner v. First Security Bank of Utah, N.A. . . .is unambiguous, thereby foreclosing the promulgation of regulations interpreting it.” Chief Judge Kerrigan maintained “that First Security Bank is distinguishable on its face and therefore does not control this case.” Additionally, she argued that “the law considered in First Security Bank was one of general application whereas the blocked income regulation has a specific use: It is aimed at restrictions that bar payments only to foreign companies affiliated with the local business.” Furthermore, Judge Kerrigan contended that the commensurate-with-income amendment to section 482 after First Security Bank was decided resulted in a “version of section 482 . . . that differs significantly” from the statutory text that applied when the Supreme Court rendered its decision.

Judge Kerrigan was also critical of Judge Buch’s reliance on Procter & Gamble [as well as First Security Bank] because the decision [in Procter & Gamble] was “relying upon a case that was grounded in the complete power provision, which is no longer part of the regulations.” She added that “[n]one of the cases cited in Judge Buch’s dissent interpreted the version of section 482 that controls this case.” In other words, the court decisions cited in Judge Buch’s dissent, according to Judge Kerrigan, “did not have the opportunity to consider whether the sentence added to section 482 addressing ‘commensurate with the income attributable to the intangible’ would affect their interpretation of section 482.”

Judge Kerrigan also indicated her agreement with the Tax Court’s determination “that Treasury adhered to the APA’s [Administrative Procedures Act’s] procedural requirements in promulgating the blocked income regulation.” She added that “[i]n promulgating the 1994 regulations—which include the blocked income regulation—Treasury issued proper notice, received comments from various interested persons, and held a public hearing.”

She specifically voiced her disagreement with Judge Toro’s dissent to the effect that Regulation section 1.482-1(h)(2) should be invalidated because “the Treasury erred …in failing to adequately respond to the four comments relating to [it] . . . .” Judge Kerrigan wrote that “[t]he parties’ own stipulations make it clear that Treasury reviewed the comments. I believe that the preamble included in the 1994 regulation acknowledges that the comments were considered.” She added that she believed that “the preamble is sufficient to respond to the four comments regarding the proposed blocked income regulation.”

Finally, she asserted that while the Tax Court’s opinion indicated that the comments to the regulation were “insignificant,” she did not “think the determination of whether the comments are significant affects our outcome under the second step of Chevron, which requires us to consider whether the regulation ‘is based on a permissible construction of the statute.’” For her, what was noteworthy was that “[t]he parties stipulated that Treasury considered all comments to the 1994 regulations in their proposed form.” Thus, “[e]ven assuming the comments went to the relevant factors and raised significant problems—they arguably did not—Treasury considered them and therefore the regulations cannot be invalidated on the grounds that it failed to specifically respond.” She was troubled “that Judge Toro’s dissent would create a slippery slope whereby courts would be constantly faced with determining whether comments are significant and whether the agency responded appropriately to them.”

C. Concurring Opinion – Judge Copeland

Judge Copeland authored another concurring opinion that was joined by Chief Judge Kerrigan and Judges Gale and Paris. For Judge Copeland, the key consideration was the fact that the blocked income case law all dealt with section 482 prior to the commensurate-with-income amendment. She wrote that “each of these cases [referring to First Security Bank, Procter & Gamble, and Exxon] was decided with respect to tax years prior to 1986, the year Congress amended section 482. And it appears that no cases on this issue have been decided between Exxon and the case before us today.”

Judge Copeland stated that the legislative history of the commensurate-with-income amendment supported her reasoning, although there was no mention of foreign legal restrictions there. For example, she cited to paragraphs from reports from the House Committee on Ways and Means that explained the thinking behind the 1986 amendment to section 482, including that “‘the profit or income stream generated by or associated with intangible property is to be given primary weight.’” She added that since both Procter & Gamble, and Exxon involved tax years before the 1986 amendment to section 482, “there is no reason to construe our decision in the present case as overturning either of our precedents, as there we were dealing with a different version of the law as it relates to income from intangibles.”

D. Dissenting Opinion – Judge Buch

Judge Buch wrote a dissenting opinion that was joined by Judges Urda, Jones, Toro, and Greaves in which he disagreed with the Tax Court’s decision “[b]ecause the opinion of the Court is contrary to established Supreme Court precedent prohibiting the taxation of blocked income . . . .” As discussed further below, I think Judge Buch makes a very solid—though certainly not airtight—argument as to why the Taxpayer should have prevailed in the case.

Judge Buch began by noting that “[s]ection 482 is silent as to blocked income, and the regulations in effect from 1934 through 1993 did not explicitly purport to tax blocked income. But the Commissioner repeatedly attempted to use section 482 (and its predecessor, section 45) in an effort to tax blocked income.”

Importantly, in his discussion of First Security Bank Judge Buch observed that “[t]he Court did not rely on that regulation, but merely cited it for the proposition that even the Commissioner recognized that blocked income could not be taxed. Indeed, the Court was clear that it was interpreting the statute, not the regulations . . . .” He cited the following from the First Security Bank opinion: “Apart from the inequity of attributing to the Banks taxable income that they have not received and may not lawfully receive, neither the statute nor our prior decisions require such a result.”

Judge Buch observed that this conclusion was reinforced in subsequent Supreme Court decisions. He first cited United States v. Basye. Referring to First Security Bank, the Court in Basye wrote that “‘[w]e held there that the Commissioner could not properly allocate income to one of a controlled group of corporations under 26 U. S. C. § 482 where that corporation could not have received that income as a matter of law.’” Judge Buch also referred to Commissioner v. Banks. He quoted the Court there as having “cited First Security Bank for the proposition that ‘attribution of income is resolved by asking whether a taxpayer exercises complete dominion over the income in question.’”

Judge Buch also pointed out that, in a case decided a few years after First Security Bank, the Sixth Circuit decided Salyersville National Bank v. United States, where the Service unsuccessfully attempted to utilize section 482 to allocate commission income to a bank where the bank, which was prohibited by law from itself selling insurance, instead had its president sell the insurance and receive the commission. Judge Buch pointed out that, in that case, “[t]he court found that First Security Bank prohibited such an allocation, describing the Supreme Court as having ‘held that income could not be reallocated to a taxpayer who did not receive the income and who could not lawfully have received it.’” In addition, he mentioned that the Sixth Circuit indicated that bank there was under no obligation to qualify to handle insurance, noting that “because ‘the fact taxpayer may have had the power to enable it to receive the income legally does not require that it exercise that power.’”

Judge Buch then discussed the importance of Procter & Gamble. He quoted from the Tax Court’s opinion there, referring to First Security Bank and Salyersville National Bank, that “‘[a]s we understand these cases, section 482 simply does not apply where restrictions imposed by law, and not the actions of the controlling interest, serve to distort income among the controlled group.’” Furthermore, again citing the Procter & Gamble Tax Court opinion, he added “when it is a law that blocks income, the taxpayer is not using its control over its subsidiaries to manipulate or shift income among them.”

Judge Buch pointed out that, in its denial of the Service’s motion for reconsideration in Procter & Gamble, the Tax Court provided an even “more emphatic statement of our interpretation of First Security Bank. In its decision denying reconsideration, the Tax Court stated that, in First Security Bank, “the Supreme Court interpreted section 482 so that an allocation cannot be made when the taxpayer’s receipt of the allocated income is prohibited by law.” He also cited the Sixth Circuit’s affirmance of the Tax Court decision in Procter & Gamble, where the Court of Appeals determined that, under First Security Bank, “the Commissioner is authorized to allocate income under section 482 only where a controlling interest has complete power to shift income among its subsidiaries and has exercised that power.’”

Judge Buch next reviewed Exxon and Texaco. Referring to the Tax Court’s opinion in Exxon, he wrote that “[w]e understood that the Supreme Court [in First Security Bank] reached this conclusion [that the Service lacked the authority to reallocate blocked income] without relying on the regulations under section 482.” He pointed out that the Tax Court’s decision there was affirmed by the Fifth Circuit in Texaco, where (Judge Buch observed) “the Fifth Circuit did not rely on the complete power regulation but instead described it as merely explaining the purpose of section 482.” As Judge Buch added: “like the courts before it, the Fifth Circuit [in Texaco] concluded that ‘where, as here, the taxpayer lacks the power to control the allocation of the profits, reallocation under § 482 is inappropriate.’”

Judge Buch also mentioned another case that was decided after First Security Bank and Salyersville National Banki.e., Tower Loan of Mississippi, Inc. v. Commissioner. There the Tax Court faced a fact pattern again involving the reallocation of commissions from “the sale of insurance to a financial institution that was prohibited from receiving those commissions.” He quoted from the Tax Court decision in Tower Loan that “[w]e understand the Supreme Court’s [First Security Bank] opinion to forbid allocation of income to a taxpayer when restrictions imposed by law prohibit the taxpayer from receiving such income.”

Judge Buch then turned his attention to Regulation section 1.482-1(h)(2) and the question of “what if the agency promulgates a regulation that is contrary to existing caselaw?” He indicated that pursuant to the Supreme Court’s decision in Brand X, “we look to prior cases interpreting a statute to determine whether those cases held that the statute was unambiguous.” He noted that this becomes complicated “when trying to apply this standard to pre-Chevron cases [such as First Security Bank].” After reviewing the Supreme Court’s Home Concrete decision and its analysis of Colony, discussed supra, he opined that “[t]he Supreme Court, in deciding First Security Bank, foreclosed the allocation, and thus the taxation, of blocked income.” He added that “[w]ithout using the word ‘unambiguous,’ the Court made clear that blocked income is not, and cannot be, allocated to someone who did not and cannot receive it. It said so directly: ‘[I]ncome received by Security Life could not be attributable to the Banks.’” This, he noted, was “reiterated” in Basye. Furthermore, “[e]very court to have considered First Security Bank in the context of blocked income has understood it as describing a limit on the Commissioner’s power to allocate income.”

What about the determination, in both the Tax Court’s decision and the concurring opinions that, even if the above analysis was correct (which they did not acknowledge), the commensurate-with-income amendment to section 482 nullifies the foregoing? Judge Buch responded that “[n]othing in this sentence addresses blocked income. It addresses the transfer or license of intangible property, which may be wholly unrelated to blocked income.” He further stated that “[l]ikewise, blocked income may be wholly unrelated to the transfer or license of intangible property.”

Judge Buch pointed out that “[w]hen amending a statute, Congress is presumptively aware of existing judicial interpretations of that statute.” Furthermore, he added that “[n]othing about the sentence added to section 482 indicates that Congress intended to change the longstanding precedent that blocked income cannot be allocated and taxed.” He also noted that “insofar as blocked income is concerned . . . the legislative history [of the commensurate-with-income amendment to section 482] is silent.”

E. Dissenting Opinion – Judge Pugh

Judge Pugh also wrote a brief dissenting opinion, which was joined by Judges Foley, Buch, Urda and Toro. She concluded that Regulation section 1.482-1(h)(2) “itself is blocked by Supreme Court and Tax Court precedent.” She added that “[t]he 1986 amendment to section 482 did not modify the meaning of ‘income’ in that section, so it could not open the door to the Treasury Department to issue a regulation that contravenes First Security Bank and Procter & Gamble.”

F. Dissenting Opinion – Judge Toro

In his dissent, which was joined by Judges Buch, Urda, Jones, Greaves and Weiler, Judge Toro focused on what he thought was the Service’s failure to meet the procedural requirements of the APA in promulgating Regulation section 1.482-1(h)(2). He noted that Chevron “‘deference . . . is not warranted where the regulation is procedurally defective—that is, where the agency errs by failing to follow the correct procedures in issuing the regulation.’”

In concluding that the Regulation was invalid, Judge Toro indicated that he went through a process requiring the answers to three questions: “First, is Treasury subject to the same APA procedural rules as other agencies? Second, do those rules require Treasury to explain its reasoning and respond to significant comments when adopting regulations? And third, did Treasury comply with these requirements in promulgating [the Regulation]?”

Judge Toro first determined that “Treasury is subject to the same APA procedural rules as other agencies.” As to the second question, he stated that “Supreme Court precedent, uniform court of appeals authorities, and hornbook administrative law have long recognized that an agency must both explain its reasoning and respond to significant comments submitted in response to its proposed rulemaking.” With respect to his third question, he was of the view that “the record here leaves no doubt that Treasury failed to comply with these requirements.”

Judge Toro believed that:

Treasury provided no explanation of why the existing rule on foreign legal restrictions (or, more colloquially, blocked income) needed to be changed, failed to even mention that its new position was contrary to judicial opinions on point, failed to explain how its new rule was consistent with the text of the statute or related to the factors set out in the statute, and neither acknowledged nor responded to significant comments challenging Treasury’s authority to promulgate the regulation and pointing out flaws in its proposed approach. These failings resulted in an arbitrary and capricious action that cannot be sustained.

He was critical of the Tax Court’s opinion for, in a lengthy opinion, “spend[ing] little time on the APA’s procedural requirements. . . . And in each step of that analysis, the opinion of the Court draws the wrong conclusions.” He responded to the Tax Court’s 274-page opinion with his own 39-page explanation as to why he believed the Tax Court got it wrong with respect to the Taxpayer’s procedural challenge to the validity of Regulation section 1.482-1(h)(2).

Judge Toro commented that “[i]n 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.” He suggested that “Treasury’s position appears to have been based on its historical view that the regulations were interpretative and therefore not subject to notice and comment under the APA.”

As part of his dissenting opinion, Judge Toro also addressed the question of the impact, on the blocked income matter, of the commensurate-with-income amendment to section 482. He wrote that “[c]onnecting the dots between the second sentence of section 482 and Treasury Regulation § 1.482-1(h)(2) requires explanation; it is neither obvious nor reasonably discernable.” This is further elaborated upon below.

V. The Taxpayer Has a Persuasive Argument That Regulation Section 1.482-1(h)(2) Should Be Invalidated on Substantive Grounds Because It Fails the Chevron Step One Test

It is, of course, possible that the Tax Court’s 3M Company decision will be affirmed on appeal, and by the same token it is also possible that it will be reversed on appeal on strictly procedural grounds—i.e., on the basis that Regulation section 1.482-1(h)(2) is invalid because of Treasury’s failure to meet the requisite APA requirements in promulgating the regulation. (Indeed, the Taxpayer’s initial argument in its Tax Court brief centered on this procedural challenge to the Regulation.) It is, moreover, also possible that the 3M Company decision will be reversed on appeal on the grounds that the challenged regulation is void under Chevron step two—i.e., that it is not “a permissible construction of the statute.” This Article takes the position, however, that Regulation section 1.482-1(h)(2) should instead be invalidated on substantive grounds because it fails the Chevron step one test. As an added complication, it is unclear at this writing as to whether or not the Supreme Court will continue to hew to the Chevron analysis, given the Court’s grant of review in Loper Bright Enterprises v. Raimondo, which presents a direct challenge to the traditional understanding of what Chevron entails when the validity of administrative pronouncements is at issue. This Article nevertheless proceeds under current judicial precedent, which includes (for now) the Chevron two-step analysis.

The Taxpayer’s Chevron step one contention rests primarily on the Supreme Court’s First Security Bank decision. Procter & Gamble, Exxon and Texaco clearly flow from that decision. To be sure, the decision in First Security Bank may well be wrong, as many tax law scholars have concluded. As noted earlier, this criticism is perhaps best illustrated by commentator David Pratt’s observation that “the majority in First Security Bank . . . failed [to realize] . . . that the statute, regulations, and legislative history are devoid of any requirement that the organization to which the commissioner [sic] seeks to allocate income must have the legal ability to receive that income.” But as another observer, Mark A. Rome, has remarked, “[n]otwithstanding the criticisms of First Security, the backbone of our common law jurisprudence-the doctrine of stare decisis-requires lower courts to faithfully apply controlling precedent.” While Mr. Rome was referring to Procter & Gamble in making this observation, the comment is equally applicable to 3M Company.

Ignoring for a moment both the enactment of the commensurate-with-income amendment to section 482 and the promulgation of Regulation section 1.482-1(h)(2), First Security Bank can certainly be read as holding that the Service was not permitted under the statute to utilize section 482 to allocate “taxable income that [one] did not receive and that [one] was prohibited from receiving.” This understanding of the Court’s holding was confirmed by the Court itself in Bayse, where (as noted above) the Court said that “[w]e held there that the Commissioner could not properly allocate income to one of a controlled group of corporations under 26 U. S. C. § 482 where that corporation could not have received that income as a matter of law.” Similarly (as also noted above), this understanding was endorsed again by the Court in Banks and was followed by the Sixth Circuit in Salyersville National Bank, which described First Security Bank as having “held that income could not be reallocated to a taxpayer who did not receive the income and who could not lawfully have received it.”

It should not matter from a judicial, rather than a tax policy, standpoint, that the legal restriction in question was foreign rather than domestic. This was the conclusion of the courts in Procter & Gamble, Exxon and Texaco. In Procter & Gamble, the Sixth Circuit reasoned as follows:

The Supreme Court focused on whether the controlling interests utilized their control to distort income. We see no reason to alter this analysis because foreign law, as opposed to federal law, prevented payment of royalties. The purpose of section 482 is to prevent artificial shifting of income between related taxpayers.

But what about the argument of the Service, embraced by the Tax Court in 3M Company, that First Security Bank should be viewed as an interpretation of now defunct regulations rather than section 482? While not completely free from doubt, there is persuasive evidence that the Supreme Court’s holding rested on the text of statute, not the existing Regulation. After all (and as noted above), the Court in First Security Bank stated that that “[a]part from the inequity of attributing to the Banks taxable income that they have not received and may not lawfully receive, neither the statute nor our prior decisions require such a result.”

As Judge Buch pointed out in his thoughtful dissent, until the 3M Company decision, this seemed to be the uniform judicial interpretation of First Security Bank. For example, Judge Buch observed (referencing Procter & Gamble) that “[b]oth this Court and the Sixth Circuit [in rejecting the Service’s arguments] . . . described section 482, and not any regulation thereunder, as prohibiting the Commissioner’s proposed allocation.” This was equally true of Exxon, as to which Judge Buch commented that “[w]e understood that the Supreme Court reached this conclusion [regarding the inability of the Service to allocate income to a party that was legally restricted from receiving it] without relying on the regulations under section 482.” In Texaco, the Fifth Circuit also (according to Judge Buch) “agreed that First Security Bank stands for the proposition that ‘§ 482 did not authorize the Commissioner to allocate income to a party prohibited by law from receiving it.’” “Like other courts before it,” Judge Buch remarked, “the Fifth Circuit did not rely on the complete power regulation but instead described it as merely explaining the purpose of section 482.”

That being so, it simply does not matter what Regulation section 1.482-1(h)(2) says. That is because, once the Supreme Court has spoken on a question of statutory interpretation, there is no “wiggle room” left for administrative embellishment.

This is classic Brand X analysis. As Judge Buch put it in his dissenting opinion in 3M Company, the Court in Brand X “held that a ‘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.’” As Judge Buch correctly observed, “[u]nder Brand X and predicated on Chevron, we look to prior cases interpreting a statute to determine whether those cases held that the statute was unambiguous.”

To be sure, and as correctly recognized by Judge Buch, there is a potential problem “when trying to apply this standard to pre-Chevron cases,” such as First Security Bank. He quoted from Justice Scalia’s concurring opinion in Home Concrete that “[i]n cases decided pre-Brand X, the Court had no inkling that it must utter the magic words ‘ambiguous’ or ‘unambiguous’ in order to (poof!) expand or abridge executive power, and (poof!) enable or disable administrative contradiction of the Supreme Court.”

Home Concrete itself addressed this difficulty. The Supreme Court there dealt with the validity of a 2010 Regulation addressing when the normal three-year statute of limitations to assess federal income tax is extended to six years under section 6501(e)(1)(A). This applies in certain circumstances, including the situation when a taxpayer “omits from gross income an amount properly includible therein . . . in excess of 25 percent of the amount of gross income stated in the return.” The Regulation at issue there, Regulation section 301.6501(e)-1, “defined an omission as including a situation in which a taxpayer reported an overstated basis resulting in an understatement of income.” This Regulation “in effect overturn[ed]” a pre-Chevron Supreme Court decision, Colony Inc v. Commissioner, which had interpreted the same statute at issue. In holding the Regulation to be invalid under Chevron step one, the Court stated in Home Concrete that, “[i]n our view, Colony has already interpreted the statute, and there is no longer any different construction that is consistent with Colony and available for adoption by the agency.” It did so despite the fact that the Court in Colony, as Judge Buch pointed out, “expressly stated that “it cannot be said that the language [of the statute] is unambiguous.’”

In an article written long before the 3M Company opinion was handed down, Patrick J. Smith similarly described how Brand X should be applied to First Security Bank:

The principle established by Brand X is that a Chevron step 2 interpretation by a court (determining the best reading of the provision) can be overruled by a subsequent contrary agency interpretation, but that a Chevron step 1 interpretation by a court (determining that the provision has only one permissible reading) cannot.

Mr. Smith indicated that “[a] principal question in applying Brand X to 3M is whether the First Security Bank holding represented the Court’s view of the only permissible reading of section 482, or instead its view of the best reading of section 482.” Otherwise, the Service would be “free under the Brand X test to issue regulations adopting a different view of section 482, as long as that view was reasonable.” He observed that “[a]lthough the First Security Bank opinion does not refer to the text of section 482 in discussing why the IRS’s action was impermissible, the Court’s reasoning appears to be based on the authority given to the IRS by section 482 . . . .” Mr. Smith believed that:

The reasoning from First Security Bank can only be read to mean that the Court concluded (in Brand X parlance) that the only permissible interpretation of the statutory term ‘income’—not merely the best interpretation—could not include amounts that the taxpayer was legally prohibited from receiving. Accordingly, the holding in First Security Bank should be viewed as, in effect, a Chevron step 1 holding that therefore cannot be overruled by an IRS regulation to the contrary.

Judge Buch correctly (in my view) determined that, in light of Brand X and Home Concrete, the proper conclusion was that “[t]he Supreme Court, in deciding First Security Bank, foreclosed the allocation, and thus the taxation, of blocked income.” As in another pre-Chevron decision, Colony, the Court in First Security Bank did not describe the statute in question as “unambiguous.” Nevertheless, “the Court made clear that blocked income is not, and cannot be, allocated to someone who did not and cannot receive it. It said so directly: ‘[I]ncome received by Security Life could not be attributable to the Banks.’” This was the only permissible reading of section 482, foreclosing a regulatory override pursuant to the Court’s guidance in Brand X. The conclusion was, as noted above “reiterated” by the Supreme Court in Basye as well as in Banks, and by other courts in Salyersville National Bank, Tower Loan, Procter & Gamble, Exxon, and Texaco.

Thus, in the appeal of 3M Company, the court of appeals should reject the notion that the Chevron step one test was satisfied either because the First Security Bank holding was based not only on the statute then in effect but also on regulations then (but no longer) in effect, or because the fact pattern in First Security Bank was so markedly different from 3M Company that the former decision should not be deemed binding.

But what about the commensurate-with-income modification to section 482? If the statute at issue in First Security Bank is not the same—and it is, indeed, not the same given the 1986 amendment—then doesn’t that mean that First Security Bank does not control? After all, nine judges of the Tax Court thought so. As Chief Judge Kerrigan stated in her concurring opinion, “the version of section 482 that the Supreme Court interpreted in First Security Bank differs significantly from the statutory text that controls this case.” In other words, the commensurate-with-income modification to section 482 did not exist when First Security Bank was being decided. She added that “[n]one of the cases cited in Judge Buch’s dissent interpreted the version of section 482 that controls this case.” She added that “[t]hose courts did not have the opportunity to consider whether the sentence added to section 482 addressing ‘commensurate with the income attributable to the intangible’ would affect their interpretation of section 482.”

But Chief Judge Kerrigan and her colleagues have misinterpreted the importance of the commensurate-with-income amendment to section 482 insofar as foreign legal restrictions are concerned. According to renowned international tax law expert Professor Reuven S. Avi-Yonah:

CWI [commensurate with income] [is not] relevant to the result [in 3M]. The point of CWI was to ensure that income from the transfer of intangibles be taxed to the transferor even if there were no arm’s-length comparables that would require this outcome. CWI does not refer to blocked income, and there is no basis for assuming that Congress had blocked income in mind when it enacted CWI, as is clear from the legislative history cited extensively in 3M.

There is nothing in the plain meaning of the text or legislative history of the commensurate-with-income amendment to section 482 supporting the position that the law on blocked income enunciated in First Security Bank was intended to be altered. As discussed above, this was explained in the dissenting opinions of Judges Buch, Toro and Pugh. As Judge Pugh put it, “[t]he 1986 amendment to section 482 did not modify the meaning of ‘income’ in that section, so it could not open the door to the Treasury Department to issue a regulation that contravenes First Security Bank and Procter & Gamble.”

Judge Buch similarly concluded that “[n]othing in this sentence [i.e., the commensurate-with-income amendment to section 482] addresses blocked income. It addresses the transfer or license of intangible property, which may be wholly unrelated to blocked income.” Furthermore, he noted that “[l]ikewise, blocked income may be wholly unrelated to the transfer or license of intangible property.”

Judge Toro provided his own rejection of the notion that the commensurate-with-income amendment nullified the holdings of First Security Bank, Procter & Gamble, Exxon and Texaco. He wrote that “[t]o state the obvious, nothing in this sentence expressly mentions blocked income. For example, the sentence does not specify whether legal restrictions should be taken into account in deciding whether income is ‘commensurate.’” He added that “the sentence seems perfectly consistent with what may be viewed as a central lesson of the blocked income cases: that income for purposes of section 482 does not include amounts that a taxpayer is legally prohibited from receiving.”

Judge Toro also pointed out that the commensurate-with-income amendment “addresses income from transfers of intangibles only, whereas blocked income can be present in many types of transactions. . . . In short, if one wants to rely on the second sentence of section 482 to support the rule reflected in Treasury Regulation § 1.482-1(h)(2), one must show why that is so.”

With respect to the legislative history surrounding the 1986 amendment to section 482, Judge Buch wrote that “[b]ut insofar as blocked income is concerned . . . the legislative history is silent.” He, however, questioned the use of legislative history in this instance, reasoning that “[w]hen a plain reading of the statute is sufficient, we need not look to legislative history.”

While Judge Toro may have shared Judge Buch’s skepticism on the need to review the 1986 amendment’s legislative history, he seemed compelled to examine it, perhaps to address, among other things, Judge Copeland’s concurring opinion. As previously discussed, he noted that “the legislative history suggests that Congress was focused on a problem other than blocked income—namely, the transfer of high profit potential intangibles offshore for compensation that did not reflect their true value.” This is evidenced by the fact that “neither the discussion in the Conference Report nor that in the House Report mentioned blocked income, even though both included detailed explanations of the purpose and effect of adding the second sentence to section 482.”

Judge Toro also commented that this revision to section 482 “makes perfect sense as a response to the intangible valuation issue and little sense as a response to blocked income concerns. . . . [T]he second sentence says nothing about cases in which a taxpayer is legally prohibited from receiving income.” He further pointed out that there is no mention of “First Security or any other blocked income case [in the legislative history].”

Finally, it is important to note that the analysis and conclusions of this Article, i.e., that the Taxpayer has a persuasive argument that Regulation section 1.482-1(h)(2) should be invalidated on the ground that it fails the Chevron step one test, should not be construed as negating the notion that sound tax policy mandates that the Service should vigorously enforce arms-length transfer pricing between related parties, including the robust use of the commensurate-with-income amendment to section 482. Nor does it suggest that Congress should refrain from enacting legislation that either overrules First Security Bank or alternatively limits its holding to domestic legal restrictions. It simply opines as to what an appellate court should decide given the existing case law.

VI. Conclusion

The Taxpayer has a persuasive argument that Regulation section 1.482-1(h)(2) should be invalidated on substantive grounds because it fails the Chevron step one test. Even if First Security Bank was incorrectly decided (a matter that is beyond the scope of this Article), the decision there is governing precedent for the notion that section 482 does not permit the Service to allocate income to one prohibited by law—whether foreign or domestic—from receiving it.

While not entirely free from doubt, there is a strong argument that the Court’s decision in First Security Bank was based on the statute and did not rely on a regulation in reaching its decision. While that decision may be questionable on the merits, it is the law of the land and, absent a clear statutory change, the Treasury Department should not be permitted to usurp that authority through regulations or otherwise.

While the Service should continue to vigorously enforce arms-length transfer pricing between related parties, including the robust use of the commensurate-with-income amendment to section 482, there is no compelling reason to limit the holding of First Security Bank to domestic legal restrictions. This was the conclusion of the courts in Procter & Gamble, Exxon and Texaco. The Tax Court in 3M Company should have followed that precedent absent a statutory amendment that specifically cabined the scope of First Security Bank. There is persuasive evidence that the commensurate-with-income amendment to section 482 did not do so, and nothing in the legislative history surrounding the enactment of that amendment demonstrates otherwise.

The author thanks Michael Schler for his helpful comments on an earlier draft. He is also very grateful to his former student Aishun Chen for his assistance with this article.  All errors, omissions, and views, however, are only those of the author. 

    Author