8th Circuit Blocks IRS Blocked-Income Regulation

Complex international businesses file complicated tax returns, and the IRS often uses regulations to reallocate income among subsidiaries to reflect the company’s true income. But a recent 8th Circuit Court of Appeals decision says it can’t do that anymore, at least not when that subsidiary’s royalty income was limited by foreign laws.

When the IRS Can Reallocate Income Between Subsidiaries

The heart of 3M Company, and Subsidiaries v Commissioner of Internal Revenue lies in a specific section of the Internal Revenue Code. Section 482 says that when 2 or more businesses, organizations, or trades are owned or controlled by the same interests, the IRS “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.”

In other words, the IRS is authorized to untangle any complicated webs corporate parent companies may weave to try to avoid paying taxes. It can reassign the subsidiary companies’ income to combat tax gamesmanship and avoid distortion of the enterprise’s total gross income. To do so, the IRS typically looks at how “uncontrolled taxpayers” would have structured their contracts and transactions, if negotiated at “arm’s length.”

Brazilian Laws Limit Royalty Incomes

The international company 3M has subsidiaries all over the world, but it files one consolidated tax return with the IRS every year including all of them. This is exactly the kind of complicated tax situation that Section 482 is designed to manage. But what if the web is tied, not by the company, but by another country’s laws?

The IRS in this case attempted to reallocate income between the 3M parent company and its Brazilian subsidiary, 3M do Brasil Ltda. Brazilian law caps the amount local subsidiaries were allowed to pay to foreign controlling companies like 3M. To comply with federal law, 3M do Brasil only paid $5.1 million to the 3M parent company as royalties for the use of the brand’s intellectual property. The IRS said that number should have been $23.7 million higher based on the income earned by 3M do Brasil using that intellectual property, and what an unrelated entity would have had to pay in royalties for the same use. It issued a Notice of Deficiency to the parent company, using Section 482 to reallocate income and collect the additional corporate taxes.

United States Tax Court Divided Over Blocked-Income Regulation

3M Company challenged the IRS’s Notice of Deficiency in the United States Tax Court. It raised two main arguments:

1. The IRS could not tax income the Brazilian law prevented 3M from receiving (the substantive argument)
2. The IRS’s blocked-income regulation did not follow the Administrative Procedure Act and could not be enforced (the procedural argument)

According to the 8th Circuit, “The vote in the Tax Court could not have been closer.” Seven judges rejected 3M’s procedural argument, and deferred to the IRS’s blocked-income regulations as a reasonable interpretation of an ambiguous statute. Two more believed the statute required the IRS to reallocate income, regardless of the regulation. But eight other judges dissented, saying either that the statute prohibited the reallocation of income 3M could not legally receive, or that the blocked-income regulation had been improperly adopted. In a 9-to-8 ruling, the United States Tax Court held that 3M needed to pay the deficient taxes on the $23.7 million reallocated income.

Supreme Court Tells Judges to Use “Best Reading of the Statute” Not Agency Regulations

After the Tax Court issued its split decision, in 2024, the United States Supreme Court decided Loper Bright Enterprises v Raimondo. In a landmark decision, the Supreme Court overruled the so-called “Chevron Doctrine” and took away the discretion traditionally given to government agencies like the IRS when interpreting the statutes controlling them. After Loper Bright, federal courts are now required to apply the “best reading of the statute” and “use every tool at [their] disposal to … resolve [any] ambiguity,” rather than applying the interpretation of the government agency involved.

8th Circuit Says IRS Can’t Reallocate Income of 3M Subsidiaries Limited by Brazilian Law

In light of Loper Bright, the question before the 8th Circuit in 3M Company shifted. Now, the question was less about how the regulation was passed and what degree of deference the IRS should be given in interpreting Section 482. Instead, the 3-judge panel focused on whether the IRS had the authority to reallocate 3M’s royalty income in the first place.

An earlier Supreme Court decision, Comm’r v. First Sec. Bank of Utah, N.A., said that a person (or company) cannot “have taxable income that he did not receive and that he was prohibited from receiving.” Where the taxpayer was legally prevented from receiving the income (in that case insurance commissions), the IRS could not reallocate income in ways that were against the law. The 8th Circuit said this, rather than the IRS blocked-income regulation, was the “best reading of the statute.” It held that the source of the restriction on income did not matter. Whether it was a federal statute or foreign law, the cap on royalty payments was also a limit on the IRS’s ability to reallocate income and recover additional taxes.

The fact that royalties are intangible property did not matter. Even though Section 482 included a sentence defining the income attributable to transfers and licensing of intangible property, the 8th Circuit said this sentence only more clearly defined the term “gross income” in the context of property that is hard to measure. The Court declined to interpret “the income” in the intangible property sentence differently than “gross income” in the first sentence. The 8th Circuit therefore held that the IRS’s Notice of Deficiency improperly reallocated income that 3M was not entitled to, and sent the case back to the IRS to redo its math.

Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 35 years experience. If the IRS is trying to collect unpaid taxes and penalties from you or your clients, contact Joe Viola to schedule a free consultation.