In a petition recently filed in the U.S. Tax Court, a taxpayer has challenged the Internal Revenue Service (IRS) regulation that provides that the IRS can reallocate income between affiliates even when foreign law prohibits making the payment or receipt in question.  The dispute is important for several reasons outlined in this newsletter.  Taxpayers may want to examine their positions on prior tax returns.

On March 3, 2013, the 3M Company filed a petition in the U.S. Tax Court challenging the validity of an Internal Revenue Service (IRS) transfer pricing regulation stating that the IRS can reallocate income between related parties even if foreign legal restrictions prohibit the payment or receipt (Treas. Reg. §1.482-1).  An exception to this precludes an IRS reallocation if the foreign restrictions are generally applicable to all similarly situated persons, whether controlled or uncontrolled.  The IRS adopted this regulatory approach in 1994, shortly after losing, in 1992, Procter & Gamble Co. (961 F.2d 1255 (6th Cir. 1992), affirming 95 TC 323 (1990)) and, in 1993, Exxon Corp. (TC Memo 1993 – 616 (1993)).  

Procter & Gamble established to the satisfaction of the Tax Court and the U.S. Court of Appeals for the Sixth Circuit that the IRS could not use Internal Revenue Code (Code) section 482 to reallocate income, because Spanish law, not control over an affiliate, created the alleged distortion of income by prohibiting the payment of the amount in question (961 F.2d at 1258).  In reaching their conclusions, the Sixth Circuit and the Tax Court relied in part on an earlier Supreme Court of the United States decision, Commissioner v. First Security Bank, that held that the IRS cannot use section 482 to reallocate income between related parties when federal law precludes the payment of the amount at issue.  (See Procter & Gamble Co., 961 F.2d at 1258 (citing Comm. v. First Security Bank, 405 U.S. 394 (1972)).)   

The 3M case, which appears to be the first docketed case challenging the validity of the 1994 regulations (though there may be other controversial and potentially vulnerable parts of Treas. Reg. §1.482-1 that could be challenged), arises in the context of Brazilian industrial property law requirements that in 2006 prevented the payment of certain royalties by a Brazilian subsidiary of 3M.  Although the taxpayer's petition is silent on this, the Brazilian rules may not have applied similarly to both controlled and uncontrolled persons, as the IRS regulation requires.  The IRS Form 886-A (Explanation of Adjustments) issued to 3M alleges "it has not been established that the Brazilian legal restrictions affected an uncontrolled taxpayer under comparable circumstances for a comparable period of time ...".

The foreign legal requirement regulation was controversial when the IRS first proposed it in 1993 and then finally adopted it in 1994.  It remains a cause for concern for taxpayers subject to different types of foreign legal restrictions.  The regulation, if it is valid, would narrow, if not override, the successful argument in First Security Bank of Utah and Procter & Gamble Co. that when U.S. or foreign law prevents a payment that causes an alleged distortion of income, as opposed to the taxpayer using its own control to create a distortion of income, then one of the Code's threshold principles for the use of section 482 to reallocate income has not been satisfied.

It is worth noting that the language of Code section 482 is, in relevant part, the same today as it was during the tax years at issue in First Security Bank of Utah, Procter & Gamble Co. and Exxon Corp., which go back to 1955.  Thus, the prior  statutory interpretations and basic holdings of the courts appear to be equally valid under the Code in the year at issue in the 3M controversy (2006) and today.

Of course, the 1994 IRS regulation introduces a new issue because it adds the prerequisite that the foreign legal restriction preventing payment must apply similarly to controlled and uncontrolled parties.  As 3M has challenged the validity of the foreign legal requirement part of the 1994 IRS regulation, this brings into play how much deference the Tax Court should give to the regulation. 

As indicated, the "control" requirement of the statute that the Supreme Court interpreted in 1972 for tax years 1955 through 1959 in First Security Bank and that the Sixth Circuit interpreted in 1992 for tax years 1978 and 1979 in Procter & Gamble Co., is the same as it is in 2006, the tax year at issue in the 3M petition.  Consequently, 3M could be asking the Tax Court whether the IRS can interpret the same statutory requirement differently from the Supreme Court (and the Sixth Circuit) by issuing a regulation after losing the issue several times in the courts. 

In these circumstances, does the 1994 regulation have to give way to the prior judicial interpretations of the same statutory provision?  One would hope that is the result under the most recent Supreme Court views on the level of deference that the courts must give to an IRS regulation.  (See Mayo Foundation for Medical Ed. & Research v. United States, 131 S. Ct. 704 (2011) and United States v. Home Concrete & Supply, LLC et al., 132 S. Ct. 1836 (2012).)  In Home Concrete & Supply, the Supreme Court held that the IRS could not by regulation overrule the Supreme Court's prior interpretation of the same statute.

In our view, [the prior Supreme Court decision] has already interpreted the statute, and there is no longer any different construction that is consistent with [the prior Supreme Court decision] and available for adoption by the agency.  (132 S. Ct. at 1843)

In closing, the 3M controversy could lead to interesting jurisprudence not only on the substantive question of when legal requirements preclude IRS reallocations, but on the amount of deference to be given to an IRS regulation that conflicts with how the statute has been long interpreted by the courts.  Should the 3M case be decided by the Tax Court, rather than settled, the Tax Court may have to wrestle with whether it can uphold the Supreme Court's section 482 principles in First Security while complying with the recent Supreme Court standards on regulatory deference.  This should be possible, as illustrated by Home Concrete & Supply

In the meantime, taxpayers may want to take another look at their tax return positions in cases where foreign legal restrictions that applied to them may have run afoul of the narrowed standard of the 1994 regulations, but could satisfy the principles established in the prior court cases.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.