The Eighth Circuit Court of Appeals, in 3M Company, and Subsidiaries v. Commissioner of Internal Revenue, has reversed a closely divided U.S. Tax Court, holding that the Internal Revenue Service (IRS) lacks the authority under Internal Revenue Code (IRC) § 482 to allocate royalty income to a U.S. parent company that its foreign subsidiary was legally prohibited from paying under foreign law. This significant decision, one of the first to apply the Supreme Court’s holding in Loper Bright Enterprises v. Raimondo, 603 U.S. 369 (2024), reaffirms the "dominion and control" standard established in Commissioner v. First Security Bank of Utah, N.A., 405 U.S. 394 (1972).

Factual Background

The case centered on 3M Company’s 2006 consolidated federal tax return. 3M, a U.S. parent company with global subsidiaries, licenses its significant intellectual property to those subsidiaries. For the 2006 tax year, 3M’s Brazilian subsidiary, 3M do Brasil Ltda., paid and deducted royalties of $5.1 million for the use of 3M’s intellectual property. This amount was the maximum permitted under Brazilian law, which capped the amount of royalties a Brazilian subsidiary could pay to a non-Brazilian controlling parent company. 3M reported this $5.1 million as royalty income on its U.S. return.

Following an audit, the IRS issued a Notice of Deficiency, asserting that 3M owed substantially more tax. Pursuant to its authority under IRC § 482, the IRS reallocated an additional $23.7 million in royalty income to 3M from its Brazilian subsidiary. Both 3M and the IRS agreed that this reallocated amount represented the arm’s length compensation an unrelated party would have paid for the use of the same intellectual property. The core dispute was whether the IRS could lawfully reallocate income that Brazilian law explicitly prevented 3M’s subsidiary from paying.

Taxpayer’s Position and Tax Court Proceedings

3M challenged the IRS’s determination in the U.S. Tax Court, advancing two primary arguments. First, 3M argued that IRC § 482 does not permit the allocation of income that a taxpayer was legally blocked from receiving. Second, 3M made a procedural argument that the IRS failed to comply with the Administrative Procedure Act (APA), 5 U.S.C. § 553, when it adopted the "blocked-income" regulation, 26 C.F.R. § 1.482-1(h)(2), which the IRS relied upon to justify its allocation.

The Tax Court’s decision was fragmented and could not have been closer. A seven-judge plurality rejected 3M’s APA argument and deferred to the IRS’s regulation as a reasonable interpretation of an ambiguous statute, following the framework of Nat’l Cable & Telecomms. Ass’n v. Brand X Internet Servs., 545 U.S. 967 (2005). A majority was formed with two concurring judges who believed IRC § 482 itself required the allocation, regardless of the regulation. The eight dissenting judges would have ruled for 3M, with some concluding that IRC § 482 unambiguously prohibits allocating income a taxpayer could not legally receive, citing First Security Bank, and others believing the regulation was procedurally invalid. The Tax Court’s judgment, if upheld, would have required 3M to pay tax on the nearly $23.7 million in unreceived royalty income.

The Eighth Circuit’s Legal Analysis

The Eighth Circuit reviewed the Tax Court’s legal conclusions de novo. A critical development between the Tax Court’s decision and the appeal was the Supreme Court’s ruling in Loper Bright, which instructed courts to abandon deference and adopt the "best reading of the statute" without regard to an agency’s interpretation.

The First Sentence of § 482 and the First Security Bank Precedent

The court began its analysis with the text of IRC § 482, which authorizes the Secretary to "distribute, apportion, or allocate gross income" among commonly controlled entities when "necessary in order to prevent evasion of taxes or clearly to reflect the income" of such entities. The court noted that the purpose of this authority is to prevent the "artificial shifting, milking, or distorting of the true net incomes" of related enterprises (First Sec. Bank, 405 U.S. at 400).

Because the IRS did not allege tax evasion, its authority rested on the need to "clearly... reflect" 3M’s income. The court, however, immediately invoked a crucial limitation established in First Security Bank: for income to be allocated under § 482, "a taxpayer must have complete dominion over it," meaning it is money that "could have [been] received" (First Sec. Bank, 405 U.S. at 403). When a law (in this case, foreign law) prohibits the transaction, the taxpayer lacks the requisite "complete power" to shift income, and therefore the IRS is not authorized to make a reallocation.

The court found the facts in 3M to be remarkably similar to those in First Security Bank, where the Supreme Court held that the IRS could not allocate insurance commission income to banks that were prohibited by federal law from receiving it. The Eighth Circuit concluded that attributing the blocked royalties to 3M was "just as inconsistent with the reality that it could not receive them," and therefore, such an allocation would not "clearly... reflect [its] income" under IRC § 482.

The Second Sentence of § 482 (The "Commensurate with Income" Standard)

The IRS argued that the second sentence of § 482, added by Congress in 1986, superseded the First Security Bank holding for transfers of intangible property. This sentence states: "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". The IRS contended that this language mandates that any income "attributable" to the intangible property must be allocated, regardless of legal restrictions on payment.

The Eighth Circuit rejected this interpretation based on established principles of statutory construction. The court reasoned that the term "the income" in the second sentence refers back to "gross income" in the first sentence. The use of the definite article "the" signals a reference to the previously introduced concept of "income," which, under First Security Bank, is limited to amounts over which the taxpayer has "dominion or control". The court found no textual basis to conclude that Congress intended "the income" to have a different meaning in the second sentence than "gross income" in the first.

Therefore, the court held that the second sentence does not expand the type of income subject to allocation but rather provides a measurement method for it. It answers the "how much" question for intangible property transfers, not the antecedent "what gets allocated" question, which remains governed by the "dominion or control" test.

Application of the Law and Rejection of IRS Arguments

The Eighth Circuit systematically dismantled the IRS’s attempts to distinguish First Security Bank.

Foreign vs. Domestic Law: The IRS argued that the legal restriction in 3M came from foreign law, whereas in First Security Bank it was federal law. The court found this to be "a distinction, but not one that matters," stating that a foreign legal restriction can deprive a company of control just as effectively as a domestic one (Procter & Gamble Co. v. Comm’r, 961 F.2d 1255, 1259 (6th Cir. 1992)).
Reliance on Repealed Regulation: The IRS claimed the holding in First Security Bank was based on a now-repealed regulation. The court dismissed this, noting that the Supreme Court’s opinion framed its holding squarely around the statute, IRC § 482, and merely used the regulation as further support for its statutory interpretation.
Dividends as a Substitute: The IRS made a final argument that 3M retained "dominion or control" because its Brazilian subsidiary could have paid the equivalent of the blocked royalties in the form of dividends. The court rejected this argument on several grounds. First, it stated that it would "firmly" disagree with any suggestion that 3M should have its subsidiary "purposely evade" Brazilian law by disguising royalty payments as something else (Procter & Gamble, 961 F.2d at 1259). Second, it noted the fundamental legal and economic differences between royalties (deductible, contractual payments) and dividends (discretionary, non-deductible returns on capital), asserting that the power to pay one has no bearing on the other. Finally, the court warned that treating all income sources as interchangeable would give the IRS breathtakingly broad authority, allowing it to distort, rather than clearly reflect, true taxable income.

Conclusion

The Eighth Circuit reversed the Tax Court’s decision, concluding that the IRS’s reallocation of nearly $23.7 million in royalty income was not authorized by IRC § 482. The court held that the "dominion and control" test from First Security Bank remains the dispositive standard for all § 482 allocations, including those involving intangible property. A legal prohibition on payment, whether foreign or domestic, deprives a taxpayer of the necessary control to have income allocated to it. The case was remanded to the Tax Court for a redetermination of 3M’s 2006 tax liability consistent with this opinion. This ruling serves as a reminder for tax professionals that the IRS’s authority under § 482, while broad, is not unlimited and is constrained by the statutory text as interpreted by the judiciary.

Prepared with assistance from NotebookLM.