As discussed in an earlier post, 3M Co. v. Commissioner, T.C. Dkt. No. 5816-13, involves 3M Company’s (3M) challenge to the Internal Revenue Service’s (IRS) determination that Brazilian legal restrictions on the payment of royalties from a subsidiary in that country to its US parent should not be taken into account in determining the arm’s-length royalty between 3M and its subsidiary under Treas. Reg. § 1.482-1(h)(2). The case has been submitted fully stipulated under Tax Court Rule 122. We discussed the parties’ opening briefs, filed on March 21, 2016, here. Reply briefs were filed on June 29, with the IRS filing an amended reply brief on August 18.

3M returns to its argument that Treas. Reg. § 1.482-1(h)(2) is “procedurally invalid” because Treasury and the IRS failed to satisfy the requirements of section 553 of the Administrative Procedure Act (the APA) when they promulgated the regulations. 3M notes that the IRS completely ignored this argument in its opening brief. Citing the Supreme Court’s recent opinion in Encino Motorcars, discussed in more detail here, 3M points out that Treasury and the IRS made significant changes to the regulation, but offered no explanation for the changes. This, 3M argues, renders the regulation invalid. 3M observes that compliance with the two-step Chevron test would not save a regulation that is procedurally invalid, noting that such compliance is “a necessary but not a sufficient condition for a regulation to be upheld.”

In any event, 3M argues, Treas. Reg. § 1.482-1(h)(2) fails the Chevron test, because the Supreme Court definitively settled the “blocked income” issue in its First Security opinion. 3M rejects the IRS’s “change in the statute” argument. Citing the legislative history relating to the “commensurate with income” standard, the Section 482 White Paper and the Tax Court’s Xilinx opinion, 3M argues that the addition of the “commensurate with income” standard to Internal Revenue Code (Code) Section 482 was “intended to supplement and support, not supplant” the arm’s-length standard.

Finally, 3M rejects the IRS’s argument that First Security is no longer controlling because it was decided under a prior version of the regulation. The Supreme Court’s holding in First Security, 3M argues, was based on the meaning of “income” in Code Section 482; the Court’s reference to the regulation was merely “additional support” for its principal holding that, where a taxpayer is legally precluded from receiving a payment, such a payment is not “income” in the first instance and, therefore, the taxpayer cannot be allocated such a payment under Code Section 482.

As noted in our prior post, the IRS’s opening brief did not address the APA. Instead, it appears that the IRS consciously chose to wait to see what 3M had to say before laying its cards on the table. In its reply brief, the IRS argues that Treas. Reg. § 1.482-1(h)(2) is valid under the APA because the principle of State Farm does not apply. It is limited, the IRS says, to “whether an empirical-based rule that rescinded a prior agency policy was ‘arbitrary or capricious’ under the APA.” Thus, “[w]here an agency rule does not require fact-finding or empirical analysis, the data-based factors under State Farm do not apply,” and “[u]nlike the rule that the Court found to be empirical in Altera, section 1.482-1(h)(2) reflects Treasury’s interpretation of section 482.”

The IRS argues that First Security is not relevant, first, because “[t]he Supreme Court did not decide First Security based upon the unambiguous text of section 482, but rather upon a (now obsolete) Treasury Regulation.” Citing Brand X, it notes that “only a judicial precedent that follows from the unambiguous language of the statute forecloses a later agency interpretation.” Thus, “First Security is not a Chevron step one holding.” Further, the IRS says, Congress amended Code Section 482 in 1986 to add the “commensurate with income” standard, which effectively supersedes the arm’s-length standard in cases involving intangible assets.

Finally, the IRS argues that, to the extent that 3M reads First Security and the cases following it as exceptions to the arm’s-length standard where income is subject to foreign legal restrictions, that reading conflicts with Treas. Reg, § 1.482-1(b)(1), which provides that “the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.” Thus, “[i]f a foreign legal restriction does not affect pricing between uncontrolled taxpayers operating at arm’s length, the restriction will not prevent the Commissioner from achieving an arm’s length result for US tax purposes.”

Ordinarily, the story would end at this point – at least until the Tax Court issues its opinion in the case. However, on August 1, 3M filed a motion asking Judge Morrison to order oral argument, presumably to afford 3M an opportunity to respond to the IRS’s arguments regarding the validity of the regulation which, as it noted in its reply brief, were raised for the first time in the IRS’s reply brief. Not surprisingly, the IRS objected. In an order issued on August 23, Judge Morrison granted 3M’s motion without affording the IRS an opportunity to explain its objection and set oral argument for November 3. We will provide an update following the oral argument.