8th Circuit sides with 3M in IRS royalty tax dispute

The 8th U.S. Circuit Court of Appeals has resolved a dispute between 3M and the IRS over the reach of Section 482 of the Internal Revenue Code. Reversing a closely divided U.S. Tax Court, the panel held in a ruling filed Oct. 1 that the IRS cannot reallocate royalty income that a taxpayer lacks the legal power to receive.

Maplewood-based 3M owns intellectual property that is used by its foreign subsidiaries. One of those its foreign subsidiaries is 3M do Brasil Ltda. In 2006, 3M do Brasil Ltda. paid only about $5.1 million in royalties to 3M, when the royalty amount should have been much higher. The reason for this is that 3M do Brasil Ltda. was constrained by Brazilian tax law’s restriction on how much a non-Brazilian parent may deduct.

On its consolidated U.S. return, 3M reported that limited royalty amount. However, after an audit, the IRS issued a Notice of Deficiency asserting that 3M should have recognized approximately $23.7 million more in royalty income. The IRS cited Section 482, which it claimed empowers it to reallocate income among related entities to prevent evasion and to more accurately reflect income.

Section 482 reads: “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 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 the case of any transfer (or license) of intangible property…, the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.”

There was no dispute over what an uncontrolled party would pay under arm’s-length standards, which is what the IRS generally uses when determining how “uncontrolled taxpayers” would have structured the transaction. Rather, the dispute centered on whether the IRS may reallocate royalties in excess of what the foreign subsidiary legally could pay.

The dispute went to the U.S. Tax Court. 3M disputed the IRS’s position, claiming that Section 482 did not permit the IRS to tax 3M on what it could not receive under Brazilian law. It was an extremely close vote, but ultimately, the majority would have 3M pay taxes on nearly $24 million in royalty income.

“After more than a decade of litigation, 3M is entitled to a definitive judicial determination that it should not be required to pay millions of dollars of additional taxes simply because it followed the law,” Jonathan Bond, partner at Gibson, Dunn & Crutcher LLP, who represented 3M, stated at oral argument.

As the panel noted, however, the legal landscape changed dramatically since the Tax Court ruling. The panel was guided by applying the U.S. Supreme Court’s holding in Loper Bright Enterprises v. Raimondo (2024). In that case, the court held that courts must independently construe statutes, arriving at their best reading of the statute without being tethered to how an agency construed the statute.

Francesca Ugolini, former chief of the Justice Department Tax Division’s appellate section, pointed to the language of the second sentence of Section 482. “There is no dispute that this case involves a transfer of intangible property,” Ugolini argued. “There is no dispute that the income from those intangibles paid to 3M was not commensurate with the income that 3M Brazil earned from using the intangibles. And there is also no dispute that the IRS’s allocation of $23 million is an appropriate amount.”

Turning to the language of the statute itself, the panel found that, while dense, the “‘best reading’ of it rules out what the IRS did here.” The pivotal question was whether the taxpayer must have dominion or control over the income. The panel drew parallels to Commissioner v. First Security Bank, a case in which the U.S. Supreme Court held that taxpayers cannot have taxable income that it was legally prohibited from being received.

The panel — Judges David R. Stras, Jane Kelly and Bobby E. Shepherd — explained that the first sentence of the statute concerns reallocating “gross income,” which presupposes dominion or control. The second sentence’s reference to “the income” ties back to that same concept. The panel concluded that the second sentence supplies only a formula for measuring intangibles-related income when the taxpayer controls it. Therefore, it cannot override the threshold requirement of control.

3M could not compel payment of the royalties at issue under Brazilian law. The panel held that the IRS cannot reallocate blocked royalty payments that the foreign subsidiary could not legally transmit. The case was remanded for a revised determination of 3M’s 2006 tax liability.