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 Bank—i.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.