The 3M Case: Can The IRS Overrule The Supreme Court?

3M Company's challenge to the validity of Treas. Reg. § 1.482-1(h)(2), if successful, could result in refunds for taxpayers that previously followed the Internal Revenue Service's regulatory guidance purporting to overrule judicial precedent if they timely file protective refund claims.

In March 2013, 3M filed a petition with the U.S. Tax Court challenging the Internal Revenue Service's (IRS) determination that $23.6 million in additional royalty income should be allocated to 3M's U.S. headquarters from its Brazilian subsidiary. See 3M Co. v. Commissioner, T.C. Dkt. No. 5186-13. Specifically, the IRS determined that Brazilian legal restrictions on the payment of royalties to the U.S. parent should not be taken into account in determining the arm's-length price between 3M and the subsidiary under Treas. Reg. § 1.482-1(h)(2). 3M's position will require the Tax Court to revisit its earlier, pre-regulations holdings on the subject and to decide whether the Supreme Court of the United States has already resolved the issue. (For prior coverage of this issue, see McDermott's April 18 publication " Taxpayer Challenges Validity of IRS Transfer Pricing Regulation.")

Section 482 provides the IRS with broad authority to allocate income among commonly controlled corporations to prevent the artificial shifting of net incomes of controlled taxpayers and to place them on a parity with uncontrolled, unrelated taxpayers. More than 40 years ago, the Supreme Court in Commissioner v. First Sec. Bank of Utah, 405 U.S. 394 (1972), rejected the IRS's attempt to apply section 482 where federal law prohibited the taxpayer from receiving the income the IRS was seeking to allocate to it. Relying on longstanding and basic principles of taxation, the Supreme Court noted that "[w]e know of no decision of this Court wherein a person has been found to have taxable income that he did not receive and that he was prohibited from receiving." The Supreme Court invoked the "complete dominion" doctrine, first enunciated in 1955 in the seminal case of Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955), wherein it defined income to include all "accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." In other words, the Supreme Court held that the taxpayer could not have "income" due to the legal restrictions, and, therefore, the IRS could not use section 482 as a tool to reallocate the restricted amounts to the taxpayer.

The Supreme Court...