Tax Court in Reviewed Opinion Rejects Chevron and State Farm Attack on § 482 Blocked Income Regulation (2/10/23; 2/15/23)

In 3M Companies v. Commissioner, 160 T.C. ___ No. 3 (2/9/3) (reviewed), TA here and GS here, the Court sustained the IRS so-called blocked income regulations. The opinions (opinion of the court and concurring and dissenting opinions) cover 346 pages. The following is the page breakdown.

• Opinion of the court by Morrison, joined by Kerrigan, Gale, Gustafson, Nega, Ashford, and Marshall): pp. 1-273, with 208 footnotes
• Kerrigan concurring (joined by Gale, Paris, Ashford and Copeland): pp. 275-280, no footnotes
• Copeland concurring in the result joined by Kerrigan, Gale and Paris: pp. 281-286, 1 footnote
• Buch dissenting joined by Urda, Jones, Toro, and Greaves: pp. 287-305, 9 footnotes
• Pugh dissenting, joined by Foley, Buch, Urda, and Toro: p. 306, 1 footnote
• Toro dissenting, joined by Buch, Urda, Jones, Greaves, and Weiler (307-346, 33 footnotes

Judge Toro offers (p. 309 n. 2) this helpful and short statement describing the function of the opinion of the court: “Following the Court’s tradition, I refer to the opinion by Judge Morrison, which received 7 votes (out of 17) from active judges, as the opinion of the Court.” The opinion of the court is not a majority opinion, so what gives? For more on this phenomenon, see Kandyce Korotky, All for One, and Five for Sixteen? When the Tax Court’s “Majority” Opinion Isn’t (Procedurally Taxing Blog 4/10/18), here. [Note: in a subsequent Order in Coca-Cola v. Commissioner (Dkt. No. 31183-15 Order dated 2/14/23), a case on hold pending the outcome of 3M, Judge Lauber asked the Coca-Cola parties to file briefs addressing some issues remaining open after the 3M opinions and describing the 3M split among the judges as follows: "On February 9, 2023, a Court-reviewed opinion was issued in the 3M case, rejecting by a 9-8 vote the taxpayer's Chevron and APA arguments and upholding the validity of the “blocked income” regulation. See 160 T.C. No. 3 (2023)."]

I think it will be most helpful to readers just to offer the Syllabus at the beginning of all the opinion of the court. The Syllabus summarizes the opinion of the court (not the concurring and dissenting opinions): 

P is the common parent company of the P consolidated group. As among the members of the P consolidated group (and among P’s foreign  affiliates), ownership of trademarks had been centralized in P. Other intellectual property, including patents and nonpatented technology, was owned by S, a second-tier wholly owned U.S. subsidiary of P. S is a member of the P consolidated group.

B is a wholly owned Brazilian subsidiary of S. During 2006, B used in  its business operations the trademarks owned by P. B’s use of these trademarks was governed by three trademark licenses that P and B had executed in 1998. Each license concerned a separate set of trademarks. In accordance with the licenses, B paid a royalty to P equal to 1% of its sales of the trademarked products. Some products sold by B were  subject to trademarks covered by more than one of the three trademark licenses. For such products, B and P calculated the trademark royalties using a stacking principle under which, for example, if a particular product used trademarks covered by all three trademark licenses, the royalties were 3% of the sales of the product. Computing the royalties using this stacking principle, B paid P trademark royalties in 2006.

B also used in its business operations patents and nonpatented technology owned by S. B paid no patent royalties and made no technology-transfer payments to S. No patent license and no technology-transfer agreement was in effect between S and B.

On its 2006 consolidated federal income-tax return, the P consolidated group reported as income the trademark royalties that B paid to P in 2006.

In the notice of deficiency, R determined that the income of the P consolidated group should be increased under I.R.C. sec. 482 to account for B’s use of the intellectual property of P and S. The increase in  income determined in the notice of deficiency represents an arm’s-length rate of compensation for the intellectual property used by B.

P’s position is that the I.R.C. sec. 482 allocation should correspond to the maximum amount that B could have paid for the intellectual property in question under the laws of Brazil, less related expenses.

R’s I.R.C. sec. 482 adjustment does not take into account the effect of the Brazilian legal restrictions. A 1994 regulation, 26 C.F.R. sec. 1.482-1(h)(2) (2006), sets forth the requirements that must be met before R “will take into account the effect of a foreign legal restriction” under I.R.C. sec. 482. T.D. 8552, 59 Fed. Reg. 34971 (July 8, 1994). The Brazilian legal restrictions do not meet the requirements.

P contends that some of the requirements are invalid because they fail either the Chevron step 2 test or the part of the State Farm test that requires the agency to adequately respond to comments. See Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837, 844 (1984); Motor Vehicle Mfrs. Ass’n of the U.S., Inc. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983); Altera Corp. & Subs. v. Commissioner, 145 T.C.  1, 120, 130 (2015), rev’d, 926 F.3d 1061 (9th 2019). P also contends that the entire regulation addressing foreign legal restrictions, 26 C.F.R. sec. 1.482-1(h)(2) (2006), is invalid under the part of the State Farm test that requires the agency to give a satisfactory explanation for the regulation and the part of the State Farm test that requires the agency to respond to comments. Furthermore, P contends that the entire regulation is invalid under Chevron step 1 because Commissioner v. First Security Bank of Utah, N.A., 405 U.S. 394 (1972), and its progenitor and progeny held that under predecessors to I.R.C. sec. 482 R cannot make an allocation of income to a taxpayer who did not receive income and could not legally receive the income.

Held: The requirement of 26 C.F.R. sec. 1.482-1(h)(2)(i) (2006) that “a foreign legal restriction will be taken into account only to the extent that it is shown that the restriction affected an uncontrolled taxpayer  under comparable circumstances” is not invalid under Chevron step 2.

Held, further, the requirement that foreign legal restrictions be taken into account under I.R.C. sec. 482 only if they are publicly promulgated, 26 C.F.R. sec. 1.482-1(h)(2)(ii)(A) (2006), means that the foreign legal restrictions must be in writing.

Held, further, the Brazilian legal restrictions at issue do not meet the requirement in 26 C.F.R. sec. 1.482-1(h)(2)(ii)(A) (2006) that foreign legal restrictions be taken into account under I.R.C. sec. 482 only if they are publicly promulgated.

Held, further, the requirement that foreign legal restrictions be taken into account under I.R.C. sec. 482 only if they are publicly promulgated, 26 C.F.R. sec. 1.482-1(h)(2)(ii)(A) (2006), is not invalid under Chevron step 2.

Held, further, the requirement that foreign legal restrictions be taken into account under I.R.C. sec. 482 only if they are “generally applicable to all similarly situated persons (both controlled and uncontrolled)”, 26 C.F.R. sec. 1.482-1(h)(2)(ii)(A) (2006), is not invalid under Chevron step 2.

Held, further, the 1994 regulation, 26 C.F.R. sec. 1.482-1(h)(2) (2006), is valid under Chevron step 1.

Held, further, the 1994 regulation, 26 C.F.R. sec. 1.482-1(h)(2) (2006), is not invalid under P’s State Farm theory.

 JAT Comments:

1. Reading the summary should alert readers that the opinion is heavily laden with APA and Chevron deference issues. Of course, the “elephant in the room”, so to speak is Commissioner v. First Security Bank of Utah, N.A., 405 U.S. 394 (1972), which did not in any way involve the APA or Chevron (or pre-Chevron) deference. As to that elephant, the regulations do adopt an interpretation of § 482 that is inconsistent with First Security, but there was an intervening change in the law with the addition of the commensurate with income language in § 482. In any event, at least in theory, Nat’l Cable & Telecomms. Ass’n v. Brand X Internet Servs., 545 U.S. 967, 982 (2005) permits a subsequent agency interpretation to trump a prior opinion, even a Supreme Court opinion unless the prior opinion closes the potential Chevron ambiguity space in the statute by declaring the text unambiguous. I don’t propose to analyze how the various judges danced through that minefield. Suffice it to say, that the opinion of the court and the concurring judges saw their way through; the dissenting judges did not.

2. On an issue I have addressed many times on this blog, it appears that all judges operated on the assumption that the regulation in issue was a legislative regulation rather than an interpretive regulation. (See particularly Judge Toro’s dissenting opinion 309 n. 3 and 341-342.) In promulgating the regulation in 1994, Treasury undertook notice and comment but noted that it was not required to do so because the regulation was interpretive rather than legislative. Treasury’s understanding that the regulation was interpretive rather than legislative was rock solid on the law at the time. Only developments post-1994 have allegedly expanded the scope of the legislative regulation (which must use notice and comment) and diminished the scope of interpretive notice and comment regulations (so that, Professor Hickman claims, the interpretive notice and comment regulation no longer exists). As I have discussed before, that notion is spurious. Courts such as the Tax Court, have bought into that notion that because they mistakenly think that you get to Chevron’s framework only if the regulation is legislative; but Chevron involved an interpretive regulation and created the Chevron framework to test interpretive regulations. Jack Townsend (Guest Blogger), More On The Confusion Surrounding The Difference Between Legislative And Interpretive Rules (Procedurally Taxing Blog 6/14/22), here. But, as I note in the blog, the spurious labeling as legislative a regulation that does no more than interpret ambiguous statutory text is harmless error—still error, but harmless error—because they apply Chevron (just as the Court did in Chevron).  (As a related aside, the Tax Court did a similar legislative regulation analysis in Altera, but the Ninth Circuit on appeal ignored the need to address the legislative-interpretive issue and went straight to Chevron as is entirely correct. See Ninth Circuit Reverses Unanimous Tax Court in Altera (6/7/19; 6/20/19; 7/2/19), here (JAT Comment #2).

3. I just made a claim that I think some, particularly Professor Hickman, would dispute—that Chevron involved an interpretive regulation. I was on a panel with Professor Hickman last October and asked her whether she took the position that Chevron involved a legislative regulation. She said yes. I then asked her why Justice Scalia said Chevron involved an interpretive regulation. She professed unawareness of that. Here is my authority: Christensen v. Harris County, 529 U.S. 576, 589-90 (2000) (Scalia, concurring in part and concurring in the judgment.) (“Chevron in fact involved an interpretive regulation”). And, as to Professor Hickman’s claim, consistent with her claim about Chevron, that there are no longer notice and comment interpretive regulations, see John A. Townsend. The Report of the Death of the Interpretive Regulation Is an Exaggeration (SSRN December 14, 2021), https://ssrn.com/abstract=3400489. ; and Reply to Professor Hickman's Response to My PT Article (Federal Tax Procedure Blog 6/17/22; 6/24/22), here.

4. To close the loop, having promulgated the interpretive regulation with notice and comment (although it did not have to), Treasury was then required as an administrative agency to do it right procedurally within the commands of the APA for notice and comment regulations. That is, Treasury must have considered comments and properly responded in adopting final regulations. So characterizing the regulation as legislative in order to reach the State Farm issue was harmless error. Courts doing that (including the Tax Court) get to the right place, just for the wrong reason and once the Tax Court got there the various judges engaged the right issues as to whether the regulation was procedurally regular.  I should note that, unless the notice and comment regulation is properly promulgated (whether notice and comment was required or not), it will not be entitled to Chevron deference (whatever Chevron deference means).

5. One interesting aspect of the Syllabus is the way it blesses the regulation under Chevron.  The syllabus pronounces the regulation “not invalid” four times and “valid” one time. It is not clear to me that there is or should be a difference between “not invalid” and “valid.” Although the “not invalid” formulation is used four times in the Syllabus, it is only used once in the opinion of the court (p. 267): “We conclude that the regulation is not invalid for want of explanation.”  This refers to the State Farm requirement of that the agency adequately explain the reason for the regulation. It seems to me that the Court could have said that the explanation was adequate and thus the regulation is valid. The difference in phraseology is, I think, too obvious not to mean something. Perhaps there is something subtle going on that goes over my head.