United States

3M challenges regulations based on Altera and Chevron cases

Taxpayer invoked Altera to challenge validity of tax regulation

TAX ALERT  | 

On Sept. 6, 2016, 3M was granted a Nov. 3 trial date to challenge an IRS adjustment based on an assertion that royalties paid by 3M’s Brazilian subsidiary were too low even though Brazilian law prohibited higher royalties. The IRS argues that it can disregard a foreign legal restriction under Reg. section 1.482-1(h)(2).  However, 3M intends to challenge the validity of this regulation supporting the IRS adjustment using an Altera based argument. In particular, 3M intends to argue that Reg. section 1.482-1(h)(2) is invalid because the IRS failed to follow the requirements of the Administrative Procedures Act (APA). In its opening brief in the case, 3M cited the Tax Court opinion from Altera Corp. v. Commissioner to support the challenge.

In Altera Corp. v. Commissioner, Altera argued 2003 regulations requiring controlled parties to share stock-based compensation costs under qualified cost-sharing arrangements were arbitrary and capricious and, therefore, invalid. The Tax Court ruled in favor of Altera and concluded that in issuing the 2003 regulations, the Treasury Department:

  • Failed to rationally connect the choice it made with the facts found
  • Failed to respond to significant comments when it issued the final rule
  • Failed to recognize that its conclusion that the final rule is consistent with the arm's-length standard is contrary to all of the evidence before it

Ultimately, the Tax Court in Altera concluded that the final regulations failed to satisfy the reasoned decision making standard established under relevant Supreme Court precedent, and therefore, was invalid.

Although the Altera case is on appeal, the case is forming the basis of court challenges and positions taken by taxpayers regarding IRS regulations where the IRS failed to follow the strictures of the APA and administrative law precedent. Many taxpayers are examining whether they should file protective claims under Altera for prior open years to ensure their ability to claim a refund should Altera be upheld. In addition, taxpayers are considering whether Altera-related adjustments in prior years may be reflected in the current year. Moreover, taxpayers are also considering whether to apply Altera arguments to justify a position that other regulations (including nontransfer pricing rules) are invalid.

Whether 3M is successful in its litigation remains to be seen. However, taxpayers should more thoroughly consider the impact of the Altera case on their situations. As an initial matter, taxpayers should carefully examine their cost share agreements to identify provisions that are triggered by a successful challenge to the cost share regulations. The presence of specific language in a cost share agreement may provide support for a position that a taxpayer can make a self-initiated Altera based adjustment, possibly even in the current year. Taxpayers without such language may find it more challenging to recognize any benefit for open years for which a return has been filed. In any event, taxpayers should expect more challenges to IRS regulations based on Altera.

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