IRS can’t tax parent on royalties foreign subsidiary can’t legally pay, 8th Circuit holds

The Internal Revenue Service (IRS) cannot tax a domestic parent company on royalties it could not legally receive from a foreign subsidiary, a panel of the 8th U.S. Circuit Court of Appeals ruled on October 1.

3M Company files a single consolidated federal tax return each year including its subsidiaries all over the world.

In 2006, Brazilian law capped the amount a subsidiary could pay in royalties to a non-Brazilian controlling company like 3M.  Limited to what it could deduct, subsidiary 3M of Brazil paid $5.1 million for the intellectual property it used and 3M reported that amount on its federal tax return for 2006.

Several years later, the IRS sent a Notice of Deficiency letting 3M know it owed considerably more. The agency reallocated nearly $23.7 million in extra royalty income to reflect what it believed 3M should have received from its Brazilian subsidiary.

3M challenged the IRS’ determination that it could reallocate unpaid royalties that Brazilian law prevented the subsidiary from paying.

A seven-judge plurality of the Tax Court deferred to an IRS regulation as a reasonable interpretation of an ambiguous statute and upheld the Notice of Deficiency. 3M appealed.

In the interim, the U.S. Supreme Court decided Loper Bright Enterprises v. Raimondo, which frees courts to adopt the “best reading of the statute”: the one “the court would have reached if no agency were involved.”

Post Loper Bright, the court reversed in an opinion authored by Judge David R. Stras and joined by Judges Bobby E. Shepherd and Jane Kelly.

The case “strikes at the intersection of the IRS’s authority and the safeguards built into the statute,” the court explained. The IRS has the authority to “distribute, apportion, or allocate” income among commonly controlled companies, subject to safeguards including that the IRS can only use this power when “necessary” to prevent evasion of taxes or “clearly … reflect the [controlled entities’] income.”

A second limitation requires that to qualify, “a taxpayer must have complete dominion over it,” meaning it is money that “could have [been] received].” 3M claimed that it lacked power over the ability to shift the income because of Brazilian law, and the court agreed.

“In our view, attributing $23.7 million in extra royalties to 3M is just as inconsistent with the reality that it could not receive them without placing its Brazilian subsidiary in legal jeopardy,” the court wrote. “The point is that, from a plain-and-ordinary-meaning standpoint, shifting income to 3M here would not ‘clearly … reflect [its] income.’”

The IRS responded by pointing to a 1980s amendment to the statute: “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.”

According to the agency, this meant any income “attributable” to intellectual property counts, including whatever 3M’s Brazilian subsidiary earned from it, even if it could not legally pay for what it used.

For context, the court looked to the sentence before the amendment, which says that the IRS may apportion or allocate “gross income,” which refers to amounts over which the taxpayer has “dominion or control.”

The court relied upon the presumption that a given term means the same thing throughout the statute, reading any references to “the income” as a callback to “gross income.”

“From this grammar lesson comes the statute’s true meaning,” the court said. “The best reading — if not the only one — is that the IRS can ‘allocate’ income, but only when the taxpayer has ‘dominion or control’ over it.”

The statute then explains how to do it when it involves intangible property: “it shall be commensurate with the income attributable to the intangible,” so that “[t]he power of reallocation always depends on a taxpayer’s ‘complete dominion’ over the funds,” the court added.

While the IRS also argued that 3M had “dominion or control” because its subsidiary could have paid dividends in lieu of royalties, the court rejected this position.

“To the extent the IRS is suggesting that 3M had a duty to ‘purposely evade’ Brazilian law, we ‘firmly’ disagree,” the court said. “As the Supreme Court put it, ‘complete power’ … hardly includes the power to force a subsidiary to violate the law.’”

Charitably reading the argument as a choice for 3M that it receive the royalties as dividends or have its Brazilian subsidiary stop using the intellectual property, the court found practical problems. Dividends and royalties are different, both in form and function; and the argument from the IRS was “also breathtaking in its potential reach,” the court pointed out.

“Why stop at dividends? If a parent company could force a foreign subsidiary to liquidate to get the royalties it thinks should have been paid, what would prevent the IRS from reallocating under § 482 in those circumstances too? Treating income sources as interchangeable, like the IRS proposes, would mean that ‘the tax’ would no longer ‘fall on the party that actually receives the [income] rather than on the party that cannot.’ In short, IRS reallocation would start distort[ing] their true … income,’ not ‘truly reflect’ them.”

The court reversed and remanded for the Tax Court to redetermine the taxes owed by 3M for 2006.

Jonathan Bond of Gibson & Dunn in Washington, D.C., who represented 3M, did not respond to a request for comment.

Neither did the Department of Justice, with Jacob E. Christensen representing the IRS.

The case is 3M Company and Subsidiaries v. Commissioner of Internal Revenue, No. 23-3772.