Eighth Circuit rules against IRS on blocked income in 3M dispute

Introduction

The U.S. Court of Appeals for the Eighth Circuit recently reversed a deeply divided Tax Court decision from 2023 that upheld the validity of the blocked-income regulation under section 482. The case is significant because it is one of the first major applications of the Supreme Court’s holding in Loper Bright Enterprises v. Raimondo, 603 US 369 (2024), and required the court to decide, without deference to Treasury Regulations, whether section 482 allows the IRS to reallocate royalty income that foreign law prohibits a U.S. taxpayer from receiving. This decision signals a shift toward greater judicial oversight of IRS regulatory authority, with courts now independently interpreting statutes in transfer pricing disputes.

Background

This case arises from the IRS’ allocation of additional royalty income to 3M Company, a U.S.-based multinational that licensed its intellectual property to foreign subsidiaries, including 3M do Brasil Ltda (3M Brazil). For the tax year at issue in the case, Brazilian law limited the amount of royalties that 3M Brazil could pay to its U.S. parent (3M US). As a result, 3M US reported only the royalties it actually received, which were capped by Brazilian law at 1% of the net revenue generated by the use of the intangible. Brazilian law treated payments above 1% as a non-deductible profit distribution (e.g., a dividend). The IRS and 3M US agreed that an arm’s-length royalty amount was in excess of the 1% allowed under the laws of Brazil.

Reg. section 1.482-1(h)(2) (the ‘blocked-income regulation’) generally allows a taxpayer to defer the recognition of blocked income only if certain conditions are met (e.g., that the foreign legal restriction applies both to related and unrelated parties and that the restrictions are not temporary). The Brazil legal restrictions in force for the year at issue in the case did not satisfy those conditions. Relying on Reg. section 1.482-1(h)(2), the IRS allocated nearly $24 million in additional royalty income to 3M US.

3M challenged the IRS’ adjustment in the Tax Court, arguing that the blocked-income regulation was invalid, and that section 482 does not permit the IRS to reallocate as income amounts that a taxpayer is legally prohibited from receiving.

The Tax Court, in a divided opinion, upheld the IRS adjustment and the validity of the blocked-income regulation. The Court’s plurality opinion relied on judicial deference to the Treasury’s regulation as a reasonable interpretation of section 482, consistent with Chevron U.S.A., Inc. v. Natural Resources Defense Counsel, Inc., 467 U.S. 837 (1984).

Following the Tax Court’s decision in 3M, the Supreme Court issued the Loper Bright opinion, overruling Chevron and concluding that courts may no longer defer to an agency’s interpretation of an ambiguous statute, even if it reflects a reasonable interpretation, absent a clear grant of discretionary authority to the agency in the text of the statute. Loper Bright instructs courts to identify the ‘best reading’ of a statute, based on an analysis of its text, structure and context.

The Eighth Circuit’s analysis and decision

3M appealed the Tax Court decision to the Eighth Circuit. On Oct. 1, 2025, in a post-Loper Bright decision without deference to the Treasury’s interpretation of section 482, the Eighth Circuit held for 3M and found the blocked-income regulation to be invalid under a textual interpretation of section 482.

The Eighth Circuit analyzed the text of section 482 and concluded that an allocation of blocked income to a taxpayer is inconsistent with section 482 because the statute only allows the IRS to reallocate ‘income’ and a taxpayer does not have income, as that term has been interpreted under case law, unless the taxpayer has ‘dominion and control’ over the amount.

The Eighth Circuit relied on the ‘dominion and control’ principle set out in the Supreme Court case of Commissioner v. First Security Bank of Utah, N.A., 405 U.S. 394 (1972), to conclude that a taxpayer cannot be taxed on amounts it does not have dominion and control over due to foreign legal restrictions, regardless of whether those foreign legal restrictions satisfy the conditions set out in the blocked-income regulations.

Reaffirming the hierarchy of legal authority that a statute controls over regulations, the Eighth Circuit found that the blocked-income regulation could not override the statutory limitation of ‘income’ as that term was defined in First Security Bank and its progeny. The court rejected the IRS’ argument that the 1986 amendment to section 482, which introduced the commensurate-with-income standard for intangibles, altered the meaning of ‘income’ as it was understood at the time the statute was amended. The Eighth Circuit held that the statutory amendment addressed valuation issues of intangibles, not the threshold question of whether an amount is income that can be reallocated.

Thus, the court found that the IRS’ reallocation of nearly $24 million in additional royalty income to 3M US, based on what the Brazilian subsidiary could have paid absent local law, was inconsistent with the requirement that an amount cannot be taxed as income unless it is within the taxpayer’s control.

The Eighth Circuit also addressed judicial deference to the Treasury’s interpretation of section 482. In light of the Supreme Court’s decision in Loper Bright that overturned Chevron deference, the Eighth Circuit explained that courts must now independently interpret statutes and are no longer required to defer to agency regulations, even if they reflect a reasonable interpretation of the statute, if the regulations conflict with the court’s interpretation of the ‘best reading’ of the text of the statute.

The Eighth Circuit did not rest its holding on procedural deficiencies under the Administrative Procedure Act (APA), as the Tax Court and some dissenting judges had discussed. The Eighth Circuit’s reversal was based on statutory interpretation and the meaning of the term ‘income’—not on a procedural invalidity of the regulation.

Finally, the court rejected the IRS’ argument that the Brazil subsidiary’s ability to pay dividends meant the income at issue was not truly blocked. The Eighth Circuit concluded that dividends and royalties are fundamentally different in both form and function, and that the IRS’ position would require taxpayers to disguise royalties as dividends to maximize tax, a result inconsistent with the statute and sound tax policy. This distinction is critical for taxpayers, as it clarifies that the mere ability to pay dividends does not equate to control over royalty income subject to foreign legal restrictions.