United States – Case No. 23-3772, 3M Company and Subsidiaries v. Commissioner of Internal Revenue
Case Overview
This report analyses the United States Court of Appeals for the Eighth Circuit decision in Case No. 23-3772, 3M Company and Subsidiaries v. Commissioner of Internal Revenue. The judgment was filed on 1 October 2025, following submission on 22 October 2024. The decision was delivered by Circuit Judge Stras, with Circuit Judges Shepherd and Kelly presiding.
Executive Summary
The Court of Appeals reversed the Tax Court’s decision, holding that the IRS cannot tax a domestic parent company on royalties it could not legally receive from a foreign subsidiary, following the principle established in Procter & Gamble Co. v. Comm’r, 961 F.2d 1255, 1259 (6th Cir. 1992). The court determined that whilst the IRS had previously authorised by regulation what a statute had not, this strategy no longer works following Loper Bright Enters. v. Raimondo, 603 U.S. 369, 400 (2024).
Transfer Pricing Issues
This case centres on critical transfer pricing matters involving international royalty payments and the application of Section 482 of the Internal Revenue Code.
Background Facts
3M Company has subsidiaries worldwide and files a single consolidated federal tax return each year, with this case concerning whether its 2006 return should have reported more royalty income from its Brazilian subsidiary, 3M do Brasil Ltda.
One of 3M’s most important assets is its intellectual property, for which its foreign subsidiaries generally pay to use. At the time, 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, 3M do Brasil paid only $5.1 million for the intellectual property it used, which 3M then reported on its federal tax return for 2006.
Several years later, the IRS sent a Notice of Deficiency, reallocating nearly $23.7 million in extra royalty income to reflect what, in its view, 3M should have received from its Brazilian subsidiary under 26 U.S.C. § 482. Both sides agreed that the amount reflected the compensation an unrelated entity would have paid to use 3M’s intellectual property under the arm’s length standard set out in 26 C.F.R. § 1.482-1(h)(2).
The dispute focused on whether the IRS can reallocate unpaid royalties that Brazilian law prevented 3M do Brasil from paying.
Transfer Pricing Methodology
The IRS typically uses the “arm’s length” standard when exercising its reallocation power to approximate how “uncontrolled taxpayers” would have structured the transaction. The problem, as the court noted, is that reallocation can be arbitrary because it answers a hypothetical question: what would two unrelated and independent entities have done?
The “Blocked Income” Issue
3M challenged the IRS’s determination on two grounds: (1) statutory – the IRS could not tax what Brazilian law blocked 3M from receiving under 26 U.S.C. § 482; and (2) procedural – the IRS did not follow the Administrative Procedure Act when it adopted the blocked-income regulation, 26 C.F.R. § 1.482-1(h)(2).
Legal Analysis
Section 482 Authority and Limitations
The IRS has the authority to “distribute, apportion, or allocate” income amongst commonly controlled companies under 26 U.S.C. § 482, which provides that the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or amongst such organisations if necessary to prevent evasion of taxes or clearly to reflect the income of any of such organisations.
The statute further provides that in the case of any transfer or licence of intangible property, the income with respect to such transfer or licence shall be commensurate with the income attributable to the intangible.
The court identified two key limitations on the IRS’s authority:
First Limitation: Necessity Requirement
The IRS can only use its reallocation power when “necessary” to (1) “prevent evasion of taxes” or (2) “clearly… reflect the [controlled entities’] income” under 26 U.S.C. § 482. Given that 3M was just following Brazilian law, the IRS did not suggest it was trying to evade taxes on its 2006 return. Rather, its position was that Brazilian law distorted 3M’s income because an unrelated entity would have paid a little over five times as much for use of its intellectual property.
Second Limitation: Dominion and Control
For income to qualify, “a taxpayer must have complete dominion over it,” meaning it is money that “could have [been] received” according to First Sec. Bank, 405 U.S. at 403. If the law says otherwise, then the taxpayer lacks “‘complete power’ to shift income amongst its [companies]” as stated in First Sec. Bank, 405 U.S. at 404-05.
Application of First Security Bank Precedent
In First Security Bank, multiple related entities structured a transaction to avoid a federal law prohibiting banks from receiving commissions from the sale of insurance products. The IRS, using its § 482 reallocation power, assessed additional taxes on the theory that two banks in the group had artificially shifted their income to a non-bank subsidiary, making no difference that they could not legally receive the income.
The Supreme Court concluded that the group of companies could not have “shift[ed] or distort[ed]” their income by structuring the transactions to follow federal law, starting from the foundational principle that a person cannot “have taxable income that he did not receive and that he was prohibited from receiving”.
The court found 3M’s position no different, noting that swapping the National Bank Act with Brazilian tax law, and insurance commissions with royalty payments, made the resemblance uncanny. The court concluded that attributing almost $23.7 million in extra royalties to 3M was inconsistent with the reality that it could not receive them without placing its Brazilian subsidiary in legal jeopardy.
Statutory Interpretation: The Two-Sentence Analysis
The court conducted a detailed grammatical and contextual analysis of Section 482’s two sentences:
The “Commensurate with Income” Provision
The IRS argued that whatever First Security Bank says about other types of income, the rules changed when it comes to “intangible property” under 26 U.S.C. § 482. Post-amendment, the amount “shall be commensurate with the income attributable to the intangible,” meaning any income “attributable” to intellectual property counts, including whatever 3M’s Brazilian subsidiary earned from it, even if it cannot legally pay for what it used.
Grammatical Analysis
The court noted that the statute tells us what the IRS may “apportion” or “allocate”: “gross income” under 26 U.S.C. § 482. The second sentence refers not once, but twice to “the income.” The court applied the “presumption that a given term… mean[s] the same thing throughout a statute” from Mohamad v. Palestinian Auth., 566 U.S. 449, 456 (2012), which is particularly strong when a word like “the” precedes a previously used noun.
The first sentence introduces a mass noun, “gross income,” that has no article in front of it, whilst the second sentence with the carveout for “intangible property” refers twice to “the income.” The grammatical implication is that the shorthand references to “the income” in the second sentence are a callback to “gross income,” the only possible antecedent in the statute.
Court’s Interpretation
The court concluded that the best reading is that the IRS can “allocate” income, but only when the taxpayer has “dominion or control” over it. The second sentence then says how to do it when it involves “intangible property”: it “shall be commensurate with the income attributable to the intangible” under 26 U.S.C. § 482. The meaning of the word “income” does not change, and the power of reallocation always depends on a taxpayer’s “complete dominion” over the funds, regardless of the type of property involved.
The second sentence provides a measurement method for the income produced by intangible property. “Commensurate,” as used here, means “equal in measure or extent,” “proportionate,” or “corresponding in size, extent, amount, or degree.” The second sentence answers the how-much question, not the what-gets-allocated question that the first already answers.
Impact of Loper Bright Decision
After the Tax Court decision, the 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” (603 U.S. at 400). The court’s task, post-Loper Bright, is to “use every tool at [its] disposal to… resolve [any] ambiguity”.
When the case started, it was all about the blocked-income regulation that the IRS claimed was a reasonable interpretation of a silent statute. The shifting sands of administrative law brought a change in the IRS’s position, with the blocked-income regulation now in the background. The IRS’s current position that § 482 requires reallocation under the second sentence is both inconsistent with its prior litigating position and the regulations.
The Blocked-Income Regulation
According to the regulation at 26 C.F.R. § 1.482-1(h)(2), the agency could “take into account the effect of a foreign legal restriction” if it “affected an uncontrolled taxpayer under comparable circumstances.” Whether it did depended on several non-statutory criteria, like whether the restriction was publicly promulgated, it expressly prevented the payment or receipt of the money, and the taxpayer had exhausted all remedies prescribed by foreign law. None singled out intangible property for a bright-line always-reallocate rule.
IRS Arguments Rejected
Foreign vs. Federal Law Distinction
The IRS argued a factual distinction based on the source of the restriction: in First Security Bank, federal law blocked two banks from receiving commissions, whereas here, foreign law blocks the royalty payments to 3M. The court held this was a distinction, but not one that matters. If dominion or control is the dividing line for income under § 482, it is not clear why the source of the restriction makes a difference. A foreign restriction can deprive an American company of control over potential income just as effectively as a federal one.
The Regulation-Based Argument
The IRS spotted a legal distinction based on a now-repealed regulation, arguing that the Supreme Court would have come out differently in First Security Bank in the absence of the regulation. The court rejected this, noting that the Supreme Court framed the issue around the statute from the beginning and that scattered references to the now-repealed regulation only provided further support for the idea that the statute imposed a dominion-or-control requirement.
The Dividend Alternative Argument
In a last-ditch effort, the IRS argued that 3M had “dominion or control” because its subsidiary could have paid dividends in lieu of royalties, pointing to the fact that 3M do Brasil paid $64.5 million in dividends in 2006.
The court firmly disagreed with any suggestion that 3M had a duty to “purposely evade” Brazilian law, citing Procter & Gamble, 961 F.2d at 1259, which rejected the suggestion that a taxpayer should purposefully evade foreign law by making royalty payments under the guise of calling the payments something else. As the Supreme Court put it, “‘complete power’… hardly includes the power to force a subsidiary to violate the law”.
The court noted practical problems with the suggestion: dividends and royalties are different, both in form and function. Declaring dividends, which take the form of non-deductible returns on contributed capital, is discretionary, whilst paying royalties, which are fixed by contract and deductible as business expenses, is not. The power to do one has no bearing on the other.
The court found the IRS’s argument breathtaking in its potential reach, noting that treating income sources as interchangeable would mean that “the tax” would no longer “fall on the party that actually receives the [income] rather than on the party that cannot,” and IRS reallocation would start “distort[ing] their true… incomes,” not “truly reflect” them.
Tax Court Decision
The vote in the Tax Court could not have been closer. A seven-judge plurality rejected 3M’s procedural argument and deferred to the blocked-income regulation as a reasonable interpretation of an ambiguous statute under Brand X, 545 U.S. at 982. Reaching a majority required adding the votes of two concurring judges, who thought the statute required the IRS to make the reallocation, regardless of what the regulation said. The patchwork judgment would have required 3M to pay taxes on nearly $23.7 million more in royalty income.
The eight dissenters would have come out the other way. Some thought the statute unambiguously prohibited the IRS from reallocating income that 3M could not legally receive. Others believed that even if the statute was ambiguous, the blocked-income regulation was unenforceable because the IRS had failed to follow the Administrative Procedure Act when adopting it. Six judges agreed with both points.
Holding and Disposition
The Court of Appeals reversed and remanded for the Tax Court to redetermine the taxes owed by 3M for 2006.
Transfer Pricing Implications
This decision has significant implications for transfer pricing practice:
- Foreign Legal Restrictions: Foreign restrictions can deprive an American company of control over potential income just as effectively as federal restrictions, and the source of the restriction does not matter for purposes of the dominion-and-control test.
- Arm’s Length Standard Limitations: The case demonstrates that the arm’s length standard cannot override the fundamental requirement that a taxpayer must have dominion and control over income for it to be reallocated under Section 482.
- Intangible Property: The “commensurate with income” provision for intangible property does not change the meaning of “income” or eliminate the dominion-and-control requirement; it merely provides a measurement method for determining how much income should be allocated.
- Blocked Income Regulation: The blocked-income regulation at 26 C.F.R. § 1.482-1(h)(2) does not create a bright-line always-reallocate rule for intangible property and allows the IRS to pick and choose its battles based on specific criteria.
- Post-Loper Bright Environment: Following Loper Bright, courts must adopt the “best reading of the statute” without deferring to agency interpretations, fundamentally changing the landscape for transfer pricing disputes involving statutory interpretation.
Conclusion
This landmark decision establishes clear boundaries on the IRS’s authority to reallocate income under Section 482 in transfer pricing cases. The court’s holding that foreign legal restrictions preventing payment of royalties preclude the IRS from reallocating such income represents a significant victory for multinational taxpayers facing similar circumstances. The decision reinforces that transfer pricing adjustments must be grounded in economic reality and legal possibility, not merely hypothetical arm’s length transactions that cannot lawfully occur.