3M And The Renaissance Of The Commensurate With Income Standard From The Tax Reform Act Of 1986

The IRS’s victory in 3M v. Commissioner could be the latest sign that an era defined by judicial disinterest in section 482’s commensurate with income standard is finally drawing to a close.

The relevance of the commensurate with income standard — the contentious and widely misunderstood requirement set out in section 482’s second sentence since the enactment of the Tax Reform Act of 1986 — to the dispute recently decided in 3M Co. v. Commissioner, 160 T.C. No. 3 (2023), may not be immediately obvious. 3M concerns a challenge of the substantive and procedural validity of the blocked income regulations under reg. section 1.482-1(h)(2), which establish the conditions under which the IRS will respect a foreign legal restriction’s effect on a controlled taxpayer’s ability to comply with the arm’s-length standard. Among other things, the blocked income regulations require that the foreign legal restriction apply equally to controlled and uncontrolled parties, be publicly promulgated, and prevent the payment or receipt of an arm’s-length amount in any form.

Views differ widely, including among judges, on whether section 482’s requirement that “the income with respect to [any] transfer or license shall be commensurate with the income attributable to the intangible” has any bearing on the validity of the blocked income regulations under Chevron U.S.A. Inc. v. Natural Resources Defense Council Inc., 467 U.S. 837 (1984). The second sentence of section 482 and reg. section 1.482-1(h)(2) focus on different issues and were primarily motivated by different policy concerns. The blocked income issue has a long history that began decades before 1986, and nothing in the relevant case law or in reg. section 1.482-1(h)(2) suggests any particular link between blocked income and transfers of intangible property now subject to the commensurate with income standard. Similarly, the problems posed by blocked income do not appear to have played a significant role in motivating or shaping the commensurate with income amendment in 1986.

But that doesn’t mean the 1986 amendment has no bearing on 3M. The commensurate with income standard and the blocked income regulations intersect in 3M because of the character of the allegedly blocked income: an arm’s-length royalty payment for intangibles licensed by the U.S. parent to a Brazilian subsidiary. Until 2021, Brazil imposed a series of arbitrary caps on the royalty rates that domestic enterprises could pay to foreign parent companies. As stipulated by the parties, the arm’s-length royalty rate for the license exceeded the maximum rate that Brazilian law allowed.

According to Tax Court Judge Richard T. Morrison and half of the other Tax Court judges who reviewed his opinion, the 1986 amendment is relevant to the blocked income regulations’ validity — and potentially decisively so.

A Blank Slate

The relationship between the commensurate with income standard and the blocked income regulations became central in 3M, in part because the 1986 statutory amendment arguably severed the connection between 3M and prior blocked income case law. The commensurate with income standard may also serve as an independent source of statutory authority for the blocked income regulations under Chevron.

The canonical blocked income case is Commissioner v. First Security Bank of Utah, 405 U.S. 394 (1972), the Supreme Court opinion that served as the centerpiece of 3M’s Chevron challenge in the case. Although its grounds for doing so are still debated, the First Security Bank Court rejected a section 482 allocation of income that would have been illegal for the taxpayer to receive had it actually received it. Many observers believe, and many taxpayers (including 3M) have argued, that First Security Bank handed down an authoritative interpretation of section 482 that categorically bars allocations that disregard the effect of a legal prohibition.

Although this interpretation of First Security Bank is flawed, it became the reigning view after lower courts latched on to and extended it in Proctor & Gamble Co. v. Commissioner, 961 F.2d 1255 (6th Cir. 1992), and Texaco Inc. v. Commissioner, 98 F.3d 825 (5th Cir. 1996). But none of these cases dealt with section 482 as amended in 1986, and overturning the traditional interpretation of First Security Bank isn’t necessary to uphold the blocked income regulations if the commensurate with income amendment altered the statute’s meaning in some relevant way. As Judge Elizabeth Copeland noted in her concurring opinion, “there is no reason to construe our decision in the present case as overturning either of our precedents, as there we were dealing with a different version of the law as it relates to income from intangibles.”

Once the weight of First Security Bank and its progeny is lifted, the commensurate with income standard can figure directly in the Chevron analysis. This was reflected Morrison’s 3M opinion. The Tax Court held that the commensurate with income standard contained in section 482’s second sentence provides statutory authority for the conditions imposed by reg. section 1.482-1(h)(2)(ii)(A) and (B).

The opinion represents a major victory for the IRS, but the victory was a narrow one. Six of the 16 other Tax Court judges who reviewed Morrison’s opinion endorsed his analysis, and two others, Judges Elizabeth Crewson Paris and Copeland, concurred in the result only. Copeland’s concurring opinion, which was also joined by Judge Kathleen Kerrigan, insisted that the commensurate with income standard compelled the IRS to disregard the Brazilian royalty rate cap — with or without reg. section 1.482-1(h)(2). The remaining eight judges signed on to at least one of the three dissenting opinions written by Judges Ronald Buch, Cary Douglas Pugh, and Emin Toro.

More Than a Time Frame

In U.S. transfer pricing disputes concerning the pricing of a controlled intangible transfer, taxpayers have typically characterized the commensurate with income requirement as a meaningless or redundant appendage of the pre-1986 arm’s-length standard. And 3M is no exception. Citing Xilinx Inc. v. Commissioner, 125 T.C. No. 4 (2005), aff’d, 598 F.3d 1191 (9th Cir. 2010), 3M’s June 2016 reply brief claimed that the commensurate with income standard merely supplemented and clarified the arm’s-length standard.

There are, however, scattered instances in which taxpayers have begrudgingly or accidentally acknowledged that Congress may have really intended to change the law when it changed the statute. But such acknowledgements are generally confined to the periodic adjustment provisions of reg. sections 1.482-4(f)(2) and -7(i)(6), which authorize retrospective transfer pricing adjustments when realized profitability attributable to a transferred intangible or participation in a cost-sharing arrangement differs significantly from ex ante projections. Under this narrow interpretation of the commensurate with income standard, the 1986 amendment serves only what Morrison’s opinion refers to as a “timeframe purpose.”

However, as noted in the 3M opinion, the statutory text and legislative history of the 1986 amendment form the basis for far more than just the periodic adjustment regulations:

If petitioner is right that the scope of the commensurate-with-income sentence of section 482 is limited to remedying the “timeframe” concern, then only this small portion of the vast 1994 final regulations was authorized by the second sentence of section 482. The rest of the 1994 final regulations would be unauthorized, including the comparable-profits method, [reg. section] 1.482-5, and the profit-split method, [reg. section] 1.482-6. These methods have a strong conceptual tie to the commensurate-with-income standard.

Many other provisions of the section 482 regulations unrelated to periodic adjustments also give effect to the 1986 amendment, including the aggregation and realistic alternatives principles codified by the Tax Cuts and Jobs Act and the investor model adopted by the 2009 temporary and 2011 final cost-sharing regulations.

The Ninth Circuit recognized the broader significance of the statutory amendment in Altera Corp. v. Commissioner, 926 F.3d 1061 (2019), rev’g 145 T.C. 91 (2015), which drew heavily on the commensurate with income standard in upholding the regulations’ requirement that cost-sharing participants share stock-based compensation costs. After observing that Congress intended the 1986 amendment “to ensure that income follows economic activity,” the Ninth Circuit concluded that requiring the sharing of stock-based compensation costs was a reasonable way to implement legislative intent.

3M, however, has insisted over the course of the litigation that the commensurate with income amendment serves the time frame purpose and little (if anything) else. As the company argued in its 2016 reply brief:

It is abundantly clear that Congress, by adding a sentence to section 482, intended to modify the arm’s length standard in the case of intangibles by a requirement that payments be commensurate with the income produced by the intangible on an ongoing basis. But there is no evidence at all that Congress intended to overrule or modify the law as established by First Security and L.E. Shunk.

The Tax Court’s 3M opinion rejects this interpretation, and in doing so it explicitly endorses the premise implicitly recognized by the Ninth Circuit in Altera. Citing the expansive statutory text and the variety of policy concerns noted in the legislative history, the 3M opinion explains:

The commensurate-with-income sentence is worded too broadly to support an interpretation confining the operation of the sentence to such a purpose. We would add here that the proposition that the scope of the commensurate-with-income sentence is not confined to the “timeframe” purpose is supported by the Conference Committee report. The conference committee report stated that the sentence was added to ensure that “the division of income between related parties reasonably reflect[s] the relative economic activity undertaken by each.”

The court’s rejection of 3M’s narrow time frame interpretation means that the statutory text codifying the commensurate with income standard, and the policy objective it was intended to serve, must be considered when assessing the validity of reg. section 1.482-1(h)(2) under Chevron. This is most clearly evident in the 3M opinion’s assessment of reg. section 1.482-1(h)(2)(ii)(A)’s requirement that, for the effect of a foreign legal restriction to be respected, the restriction must apply equally to controlled and uncontrolled taxpayers (the effect-on-uncontrolled-taxpayers requirement).

After explaining that the holding in First Security Bank rested on the Supreme Court’s interpretation of section 61 and regulatory language removed long ago, the 3M opinion concludes that no unambiguous meaning of section 482’s first sentence can be derived from judicial precedent. Proceeding to step 2 of the Chevron test, the opinion says that the effect-on-uncontrolled-taxpayers requirement is a reasonable interpretation of the first sentence of section 482 and the tax parity objective attributed to it.

However, the 3M opinion goes on to confirm the validity of reg. section 1.482-1(h)(2)(ii)(A) as a reasonable interpretation of the commensurate with income standard. In an assessment that considers the second sentence of section 482 independently, the opinion explains:

In the case of a foreign legal restriction that affects only controlled taxpayers, the restriction would be disregarded by the effect-on-uncontrolled-taxpayers requirement. If such a foreign legal restriction prevents payment of compensation for the transfer or license of intangible property, the effect of disregarding the restriction is that the transferor or licensor of the intangible property could be allocated income commensurate with the income from the intangible. In such an instance, the commensurate-with-income goal of the second sentence of section 482 is achieved by the effect-on-uncontrolled-taxpayers requirement.

Because the royalty-rate ceiling at issue in 3M prevented the U.S. parent’s receipt of royalty income commensurate with the income attributable to the licensed intangibles, disregarding the Brazilian law was a reasonable interpretation of the second sentence of section 482, the opinion says.

That the commensurate with income standard, independently and in addition to the arm’s-length standard, conveys sufficient statutory authority to uphold reg. section 1.482-1(h)(2)(ii)(A) is clear from Morrison’s opinion. However, the two concurring opinions more directly and succinctly reinforce the point. Kerrigan, who also joined the opinion of the court, focuses her concurring opinion almost entirely on the 1986 amendment as the source of statutory authority for reg. section 1.482-1(h)(2).

As Kerrigan explains in her opinion, which was joined by Judges Joseph Gale and Tamara Ashford, as well as Paris and Copeland, neither First Security Bank nor the other blocked income cases cited by 3M can determine the outcome of a case controlled by an amended version of section 482. And the challenged regulations, at least as applied in 3M, achieve the objective intended by that amendment, Kerrigan says:

Those courts did not have the opportunity to consider whether the sentence added to section 482 addressing “commensurate with the income attributable to the intangible” would affect their interpretation of section 482. In this case the additional sentence is essential to our analysis because at issue is the amount of income to be allocated upon the transfer or license of intangible property.

Here the Brazilian blocking statute would prevent petitioner from receiving royalty income that is “commensurate with the income attributable to the intangible.” By preventing the application of the blocking statute, the challenged regulation accomplishes perfectly Congress’ purpose in enacting the 1986 amendment.

The other concurring opinion, written by Copeland and joined by Kerrigan, Gale, and Paris, goes further. Arguing that the plain text of section 482’s second sentence dictates the outcome, Copeland rejects the premise that disregarding the Brazilian royalty rate cap as required under reg. section 1.482-1(h)(2) was merely a reasonable interpretation of an ambiguous statute. According to Copeland, disregarding the Brazilian restriction was mandatory under the unambiguous statutory text:

The Court views the IRS’s allocation to the 3M consolidated group as “consistent with the 1986 statutory amendment” and “supported by the language of the 1986 amendment.” Such allocation is in fact required by the amended statute, with or without the clarifications of Treasury Regulation section 1.482-1(h)(2).

Copeland makes a strong point. A statute that says “the income with respect to [any] transfer or license shall be commensurate with the income attributable to the intangible” is probably best construed as requiring that the income with respect to any transfer or license be commensurate with the income attributable to the intangible. Nothing in the statutory text suggests an exception for idiosyncratic royalty rate restrictions imposed by a foreign jurisdiction’s unorthodox transfer pricing regime.

However, neither Copeland’s interpretation nor Morrison’s more measured holding was persuasive to eight other Tax Court judges. According to Pugh, the 1986 amendment did not diminish the precedential value of First Security Bank because it did not alter the meaning of the term “income.” Pugh’s analysis is based on the debatable view that the First Security Bank holding rests on the Supreme Court’s observations regarding the traditional meaning of “income,” and not the “complete power” language contained in the section 482 regulations in force at the time — a point on which the First Security Bank opinion could have been much clearer. Similarly, Buch concluded that “Congress has not amended section 482 in any way that would materially alter the Supreme Court’s holding in First Security Bank.”

Better Late Than Never

The protests of dissenting judges aside, 3M represents a significant — if tenuous — victory for the IRS. The majority and concurring opinions arguably construe the commensurate with income amendment more broadly than any court has in the past, which would likely strengthen the IRS’s hand in a wide range of section 482 disputes. This is a marked reversal of fortunes after years in which courts barely acknowledged the commensurate with income standard’s existence.

Cases potentially affected by the judicial endorsement of a broader interpretation of the commensurate with income standard may include those concerning some of the most contentious issues in U.S. transfer pricing litigation. For example, rejection of the restrictive time frame interpretation of the 1986 amendment has important implications for disputes concerning the selection of transfer pricing method. Under the broader interpretation endorsed in 3M, there is no plausible basis for suggesting that the comparable uncontrolled transaction method is inherently superior to profit-based methods when pricing intangible property transfers. A broader interpretation of the commensurate with income standard also solidifies the validity of regulatory provisions that endorse general economic concepts, including the realistic alternatives and aggregation principle and the cost-sharing regulations’ investor model.

Of course, the durability of 3M’s holding remains to be seen. The Tax Court will almost certainly not have the final word on the matter: There is every reason to expect that 3M will appeal to the Eighth Circuit, which will owe no deference to the Tax Court’s assessment of a pure question of law. The question will likely reach other appellate courts as well. In Coca-Cola Co. v. Commissioner, 155 T.C. 145 (2020), the Tax Court reserved ruling on a similar blocked income issue until 3M was decided, and Coca-Cola has already made clear its intention to appeal.

Regardless, the 3M opinion’s interpretation of the commensurate with income standard will stand as a major victory for the IRS unless and until an appeals court reverses it. The opinion does more than merely uphold the blocked income regulations as a reasonable interpretation of the commensurate with income standard. It expressly recognizes the significance of a 1986 legislative amendment that has largely been ignored, applies the relevant statutory text, and rejects 3M’s attempt to relegate the commensurate with income standard to a marginal role within the regulatory scheme.