As noted in an earlier post, 3M Co. v. Commissioner, T.C. Dkt. No. 5816-13, involves 3M’s challenge to the Internal Revenue Service’s (IRS’s) determination that Brazilian legal restrictions on the payment of royalties from a subsidiary in that country to its US parent should not be taken into account in determining the arm’s-length royalty between 3M and its subsidiary under Treas. Reg. § 1.482-1(h)(2). The case has been submitted fully stipulated under Tax Court Rule 122, and the parties’ simultaneous opening briefs were filed on March 21, 2016.
Citing First Sec. Bank of Utah and cases following it, 3M first argues that “[c]ase law consistently holds that the Commissioner cannot employ section 482 to allocate income that the taxpayer has not received and cannot receive because a law prevents its payment or receipt.” Under this line of authority the IRS’s proposed allocation of royalty income to 3M is precluded by Brazilian law. This result is not changed by Treas. Reg. § 1.482-1(h)(2) because that regulation is invalid.
The regulation is “procedurally invalid,” 3M argues, because Treasury and the IRS failed to satisfy the requirements of § 553 of the Administrative Procedure Act (APA) when they promulgated the regulation. They did not respond to significant comments criticizing the proposed regulation; nor did they articulate a satisfactory justification or explanation for the regulation. They thus did not engage in the “reasoned decisionmaking” required by the APA and case law such as State Farm and Altera when an agency issues regulations.
According to 3M, Treas. Reg. § 1.482-1(h)(2) is also “substantively invalid” because it fails both Steps 1 and 2 of the Chevron test. It fails Step 1 because there is no “gap” for the IRS to fill. The Supreme Court’s holding in First Security definitively interpreted Congress’s intent, thereby eliminating any “gap.” Even if there were a “gap,” however, the regulation would fail Step 2 because the criteria set forth in Treas. Reg. § 1.482-1(h)(2) represent an unreasonable implementation of the statute. 3M buttresses this argument by pointing out that in Home Concrete, the Supreme Court recently held that once it has “interpreted the statute,  there is no longer any different construction that is consistent with [the prior interpretation] and available for adoption by the agency.”
Notably absent from 3M’s brief is any argument that the facts of its case satisfy the requirements of Treas. Reg. § 1.482-1(h)(2).
The IRS’s argument is based on two overriding principles: the “arm’s length standard” (see Treas. Reg. § 1.482-1(b) (“the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer”)), and the “tax parity objective.” According to the IRS, “[a] foreign legal restriction that purports to dictate an intercompany price that conflicts with the arm’s length standard and frustrates the ‘tax parity’ objective of section 482 may be disregarded by the Commissioner when making a section 482 adjustment.” Since that is the effect of the Brazilian restrictions, they can be ignored when the IRS determines whether the royalties 3M received from its Brazilian subsidiary should be adjusted under § 482.
The IRS distinguishes the cases cited by 3M on the ground that each dealt with a prior version of Treas. Reg. § 1.482-1, which had a different emphasis (“control”) than the current regulation (“an entirely objective economic determination”). These opinions, then, “do not limit [Treasury’s] authority to promulgate section 1.482-1(h)(2)” under the Supreme Court’s 2005 opinion in Brand X. The IRS argues that Treas. Reg. § 1.482-1(h)(2) is a valid regulation entitled to Chevron deference. It satisfies Chevron’s Step 1 because § 482 does not address this precise question and there is no case law that interprets it under the current statute. The regulation represents a reasonable interpretation of the statute. In fact, the IRS argues, the current regulation corrects earlier “misinterpretations” based on the prior regulation. It thus passes Chevron’s Step 2, and the regulation is valid.
The IRS finally notes that “3M has not established that the requirements of section 1.482-1(h)(2) are satisfied.” Indeed, it says, “3M fails every element of the regulation.” Accordingly, the IRS’s adjustments to 3M’s royalty income are appropriate.
Notably absent from the IRS’s brief is any argument regarding the validity of Treas. Reg. § 1.482-1(h)(2) under the APA’s procedural rules.
The parties’ simultaneous reply briefs are currently due on or before May 9, 2016; we will provide an update after those briefs are filed.