In High Stakes 3M Case, Eighth Circuit Should Rule IRS Must Follow Established Guidance

Taxpayers shouldn’t be punished retroactively because the IRS changed their mind on how to enforce a statute, our Taxpayer Defense Center argued this month, in a new amicus brief filed with the U.S. Court of Appeals for the Eighth Circuit. Our brief also points out that the IRS failed to follow the Administrative Procedure Act in writing the regulation in the first place: we’ve covered the IRS’s woes on following basic administrative law before

The case, 3M and Subsidiaries v. Commissioner of Internal Revenue, involves a law (26 U.S.C. § 482) that allows the IRS to reallocate corporate income between domestic and foreign related businesses to prevent tax evasion. In 1972, the U.S. Supreme Court held in Commissioner of Internal Revenue v. First Security Bank of Utah, N.A. that one limitation on this power is that the IRS could not reallocate income to a foreign source if that earning that foreign source income was illegal or impossible to earn in that country. In other words, “to be taxed for income, a taxpayer must have complete dominion over it.” The Fifth Circuit and Sixth Circuit have followed this same rule.

But in 1994 the IRS wrote a regulation disregarding this caselaw. Adopting what is now found at 26 C.F.R. § 1.482-1(h)(2), the IRS imposed an array of new criteria a taxpayer must meet to avoid the IRS imputing the income under § 482. Notably, even when a foreign subsidiary could not legally make a payment to the parent company, the IRS will nonetheless impute the income on the parent company and tax it. 

To be sure, the tax world knew that the IRS was trying to sidestep these cases, and filed comments objecting to the rule. The IRS gave little to no explanation for its departure from the established law or response to the commentators in its notice of  adopting the final regulations. The IRS only gave one sentence under the “Background” section which boilerplate acknowledged the comments and said it considered them. At no point did the IRS specifically address the commentators’ concerns or provide any explanation as to why it was departing from the established judicial precedent.

We argue that merely reciting that all comments were considered before adopting the regulation without any further changes, and not responding to comments, violates the APA and thus is not entitled to any deference. Because the IRS failed to follow the APA, we argue that its regulation should therefore be set aside as unlawful. 3M should not be on the hook for taxes based on funds it could never receive under Brazilian law. 

The Tax Court narrowly upheld the IRS’s position, in a fractured 9-8 opinion. The Tax Court opinion, with multiple concurrences and dissents, spanned 346 pages. 3M, based in Minnesota, appealed to the Eighth Circuit, which covers much of the Midwest.

We will continue to monitor for further developments in this case.