Month: February 2023

Tax Notes contributing editor Ryan Finley discusses the IRS’s major win in 3M and how it may affect other transfer pricing cases.

This transcript has been edited for length and clarity.

David D. Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: the very model of a modern major milestone.

On February 9, the U.S. Tax Court released its long-awaited transfer pricing decision in 3M v. Commissioner. The case, which had been pending in the Tax Court since 2013, was yet another win for the IRS after what had been a long streak of losses. But the importance of the decision goes beyond 3M.

To tell us more about what the court decided and what it means for transfer pricing litigation is Tax Notes contributing editor Ryan Finley.

Ryan, welcome back to the podcast.

Ryan Finley: Thanks for having me.

David D. Stewart: What are the basics of this 3M case? What is it about?

Ryan Finley: The 3M case is about a very specific set of regulations called the blocked income regulations, and they’re part of the transfer pricing regulations under section 482 more generally. But they basically set the conditions under which the IRS will respect the effect of a foreign law that blocks a payment or receipt of an arm’s-length amount.

Ordinarily, you’d have to pay an arm’s-length amount in a controlled transaction under the transfer pricing regs. But these regulations basically set out the requirements under which the IRS will accept that OK, you were not legally able to make that payment.

David D. Stewart: OK. In what sort of cases would you not be legally able to make a payment?

Ryan Finley: The specific restriction at issue here is Brazil’s former regime of maximum on the royalty rate that a local subsidiary could pay a foreign controlling parent. It was essentially written into the tax law, but as a matter of unwritten practice, it was picked up by the Brazilian patent and trademark office and the Brazilian central bank. Between the two, the rules prevented the payment of the royalties that the parties stipulated in 3M would’ve been arm’s length.

David D. Stewart: About how much money are we talking about here?

Ryan Finley: We’re looking at about $24 million.

David D. Stewart: All right. Now, this has been going on for quite a while. What all has been happening?

Ryan Finley: Well, yes, that’s a question that many have raised, especially since November 2016, which is when the case was fully argued and briefed. There isn’t really any clear answer as to why it took 6 1/2 years to get an opinion in this case. I would say that it was fully … it was reviewed by 16 other Tax Court judges, and there were two concurring opinions and three dissenting opinions. That may have made it take a little bit longer than usual, but the extent of the delay is, to my knowledge, unexplained.

David D. Stewart: All right. Well then, let’s get into what they actually decided. You’re mentioning this isn’t a unanimous decision, but how did the majority come out?

Ryan Finley: The opinion was written by Judge Richard Morrison. Six other Tax Court judges joined that opinion. Two concurred in the result only, and eight joined one or more of the three dissents. It was 9 to 8 in terms of the outcome, but only seven signed on to the controlling opinion. So it wasn’t really a majority.

David D. Stewart: OK. This is fairly confusing, but I’ll trust you to sort through which ones are most important. So in the controlling decision, how did they come out?

Ryan Finley: The main issue — whether 3M actually satisfied these regulations — was in most cases stipulated. It was really about the validity of these regs. There’s the sort of substantive validity under Chevron and the procedural validity under the Administrative Procedure Act. The court ultimately upheld the validity of the regulations under both.

In terms of the Chevron analysis, the question was really whether a 1972 Supreme Court decision, First Security Bank of Utah v. Commissioner, was controlling precedent in terms of the meaning of section 482 and whether that basically dictated the outcome. The court held that it was not because that case was decided on the basis of an old regulatory provision — it wasn’t enforced during the tax years at issue — and an older version of the statute that didn’t have the commensurate with income standard added in 1986.

Basically, the court held that under Chevron, these regulations were a reasonable way to implement the sort of tax parity policy of the first section of section 482, and also independently a reasonable interpretation of the commensurate with income standard in the second sense.

In terms of the Administrative Procedure Act, the controlling opinion basically says that the policy behind it is self-evident by the text of the regulation. And because there was a satisfactory notice and comment period and the IRS heard the objections of taxpayers but went forward with the regulation anyway, that it was more or less clear why they were doing it and that they rejected the comments, sort of objecting to these regulations when they were issued in ’94.

David D. Stewart: OK. Before we continue on with this case, I do want to ask about the commensurate with income idea. Where does it come from and how has it been interpreted until now?

Ryan Finley: Yeah. This is a good question, and I think it played an unexpectedly critical role in the Tax Court’s opinion and particularly in the concurring opinions.

Before the Tax Reform Act in 1986, there was only one section to section 482. In 1986 they added this sentence, and it’s kind of awkwardly worded, but it says, “The income attributable to a transfer license of a tangible property shall be commensurate with the income attributable to the intangible.” Interpreting this sentence and its significance has been a major point of contention and a major point of, I would say, uncertainty in the case law for decades now.

Some basically argue that it really didn’t do anything except elucidate the arm’s-length standard and how it applies to intangibles. Some think it only is meant to authorize sort of periodic adjustments to the transfer price for intangibles. Some judges, including those who joined Morrison’s opinion and the two concurrences, think the commensurate with income standard is sort of a broader provision meant to kind of draw in more kind of economic concepts and less focused on specific comparables.

The relevance in this case was that the allegedly blocked income was an arm’s-length royalty for the license of intangible property. So it’s not the normal situation in which this arises, which usually comes up when you’re dealing with transfer pricing methods. It came up in the Altera v. Commissioner case. But this was an application of that provision that I don’t think a lot of people expected.

David D. Stewart: So it was this commensurate with income idea that brought the concurring opinions along?

Ryan Finley: Yeah, that’s right. Even though it was independently cited as statutory authorization in the controlling opinion, the commensurate with income standard was the focus of the two concurrences written by Judges Kathleen Kerrigan and Elizabeth Copeland. Copeland’s in particular was fairly striking in that it said that you don’t even need these regulations in place to get to the same result, that the text of the commensurate with income standard by itself dictates the outcome and would require disregarding this Brazilian royalty rate cap.

David D. Stewart: All right. So as I understand it to this point, we have the main opinion which says that these regs are valid. You have concurring opinions that say the commensurate with income standard allows this. Where did the dissenting opinions come down?

Ryan Finley: Well, one of the dissents, written by Judge Ronald Buch, and I apologize if I mispronounce that, is basically arguing that this commensurate with income amendment is irrelevant, that it was basically added to address entirely different policy concerns, and really has no bearing on the blocked income issue, and consequently that the First Security Bank of Utah decision remains controlling precedent.

In another dissent, Judge Cary Pugh argued that this First Security Bank opinion rested on the definition of income in general and therefore no amendment to section 482 could overturn it. And Judge Emin Toro basically focused on the Administrative Procedure Act and what he believed was a complete failure in the preamble to the 1994 regulations and to the 1993 temporary regulations to in any way explain the basis for these rules and to basically rebut comments that argued that the regulations violated First Security Bank.

David D. Stewart: Now, on a previous episode, you were here talking about the Coca-Cola decision and how there is some relationship between that and this 3M case. Could you tell us about that?

Ryan Finley: Sure. There’s a very direct connection. In the Tax Court’s 2020 opinion in the Coca-Cola case, they explicitly reserved ruling on a similar blocked income issue because the opinion noted that 3M was pending and therefore that the court wasn’t going to rule on that issue there. Shortly after the 3M opinion came out though, Judge Albert Lauber, who’s presiding over the Coca-Cola case, issued an order for supplemental briefing, and that presumably will lead to a supplemental opinion on, among other things, how 3M will apply to the Coca-Cola case and the blocked income issue that arose there.

David D. Stewart: Now, does this look like it works to the favor of the IRS in that case as well?

Ryan Finley: Well, yes it does. Now, I would note that the controlling opinion does not assess every condition under the blocked income regulations. It only assesses, depending on how you count them, essentially three, which are the requirements that the restriction apply generally to all comparably situated taxpayers, that it affect controlled and uncontrolled taxpayers alike, and that it be publicly promulgated. And it was the failure to meet those three requirements which the Tax Court upheld as valid that decided the case in 3M.

There are two other requirements. One in particular is important. It’s the requirement that the taxpayer cannot make an arm’s-length payment in any form, such as in the form of a dividend. The validity of that was not specifically examined in 3M, and that could come up in subsequent cases including Coca-Cola.

Having said that, it’s certainly a win for the IRS that the parts of the regulations that were assessed were upheld. But given the narrow margin of victory, given the obviously wide diversity of views on the issue, I think we’re only in the sort of early days of how this issue is really going to be decided.

David D. Stewart: What are the broader implications of this decision?

Ryan Finley: Well, a lot of taxpayers have encountered this issue with blocked income in Brazil, specifically royalty income. However, Brazil’s passed a number of reforms to their tax laws over the past couple years, including a provisional measure at the very end of 2022 that adopts essentially OECD-aligned transfer pricing rules.

The specific blocked income issue that came up in this case should not arise in the future, but obviously there could always be other situations where a blocked income situation arises. I think, more than anything, it’s the broader interpretation of the commensurate with income amendment and its application to an area that maybe wasn’t immediately obvious or evident to many people that’ll probably be the broadest sort of consequence of 3M, assuming it’s upheld, which it very well may not be.

David D. Stewart: Well, that does bring me to my last question, which is that we have this closely divided court decision here. Even though we’ve spent six years waiting for this opinion, do you expect that this’ll drag out longer through an appeals process?

Ryan Finley: I think that is a very safe assumption, and there will probably be multiple appeals, actually. 3M would be appealed to the Eighth Circuit and Coca-Cola, assuming that the 3M opinion is applied in a way that hands the IRS a victory on the blocked income issue in that case, Coca-Cola would likely include that in its appeal to the Eleventh Circuit.

So you very well could have, and in my opinion probably will have, two appeals of the blocked income regulations that’ll take place over the next year or so. How the appeals court judges will see the issue is really hard to predict. Obviously, it’s not something that’s seen as an easy question to answer, at least by the 17 Tax Court judges who were involved in the case.

David D. Stewart: All right. Well, thank you for taking us through this thicket of transfer pricing decision, and I’m sure we’ll have you back to talk about the appeals.

Ryan Finley: Sounds good.

When the NCAA issued its “interim” policy statement in June 2021 suspending rules that had prevented college athletes from monetizing their rights of publicity – and despite the fact that the “interim” statement and more recent supplemental guidance both emphasized that “pay-for-play and improper recruitment” incentives were still prohibited – it was perhaps inevitable that boosters would organize “collectives” to pool funds to maximize the leverage of NIL opportunities for player recruitment and retention. These began to appear immediately.

There are now well over a hundred collectives in operation, many of them overtly geared toward recruiting and retaining the best players for a specific school. It remains to be seen whether and/or how the NCAA will attempt to intervene, particularly given the patchwork of state statutes that have been enacted in recent months, many of which purport to overrule the NCAA’s authority in this matter.

The tax-exempt collective

Quite a number of collectives have sought, and several have secured, tax exempt status as 501(c)(3) charities, including some classified as “publicly supported.”

It should be obvious that creating and managing opportunities for student athletes to monetize their “name, image, and likeness” (“NIL”) is not in itself an exempt charitable purpose. Nor is pooling money to recruit and retain players for a particular athletic program.

So what is the charitable purpose these collectives are articulating to justify their claim to tax-exempt status?

In the typical case, it looks something like this: funds contributed to the collective will be used to pay stipends to student athletes to compensate them for public appearances, social media posts, etc. that are geared to raising funds for specified charities, usually local to the community in which the college is located.

While this may appear to be entirely different from the nonexempt collectives that are arranging six and seven figure endorsement deals for star athletes to promote commercial products and services, there are at least a handful of tax-exempt collectives that are proposing to pay “base salaries” to entire teams in exchange for some minimum commitment to publicizing local charitable efforts.

These arrangements arguably run afoul of the May 2022 NCAA guidance, which requires that compensation be based on “an independent, case-by-case analysis of the value each athlete brings” to the table, “as opposed to,” for example, merely “being on [the] roster.”

But it remains to be seen whether the NCAA will pursue enforcement on this issue. They may have their plate full with nonexempt booster-sponsored collectives that are actively engaged in recruiting transfers, in some cases with at least the tacit cooperation of the affected athletic programs.

In any event, there are some issues specific to tax-exempt collectives, apart from compliance with state law and NCAA rules. These have to do with securing and maintaining exempt status.

As a threshold matter, of course, the collective must state an exempt purpose, and must conduct its affairs consistently with the assumptions under which exempt status is granted. A stated purpose to recruit athletes to play for a particular school or to connect athletes with commercial opportunities will not qualify a collective for exempt status.

Private inurement

The fundamental difference between a for-profit and a not-for-profit entity is that the latter does not have identifiable equity stakeholders.

Section 501(c)(3) of the federal tax code literally requires that “no part of the net earnings of [the tax exempt organization] inures to the benefit of any private shareholder or individual.” But, in fact, this so-called “private inurement” or “private benefit” doctrine applies more broadly, not only to “net earnings,” but to any assets of the exempt organization, and not only to insiders or “disqualified persons,” but to anyone who is not a member of a charitable class, selected by objective criteria.

However, there is an exception for arm’s-length transactions at fair market value.

In the particular context of the tax exempt NIL collective, a useful analogy might be to a scholarship fund. The IRS and courts have made it clear that a scholarship fund established for a specific individual(s), or for a narrowly defined class, or for recipients to be selected by the donor, will not qualify as a tax exempt fund (nor will gifts to it be tax deductible).

Similarly, if a booster contributes to a tax-exempt NIL collective with the expectation that she will be able to direct distributions to particular athletes, or to pay stipends out of proportion to services the athletes actually render, the directors of the collective should clearly and consistently communicate that this is not allowed.

Quid pro quo

Among tax-exempt NIL collectives established to date, it is quite common to see perquisites attached to various membership “levels” offered to boosters who contribute — such as invitations to private events at which the member can meet face to face with the supported athletes, limited edition paraphernalia, etc.

While it may be possible for a tax-exempt NIL collective to offer “token” perks of nominal value to booster donors, anything provided over that minimal value would reduce the charitable contribution deduction dollar for dollar, and the collective’s written acknowledgment of the gift would be required to reflect that fact. The IRS updates the value for token gifts that will not reduce the donor’s tax deduction under the “quid pro quo” rules each year. For 2023, the limit is the lesser of 2% of the gift or $125.

Conclusion

In short, there are difficulties to be navigated to secure and preserve tax exempt status for an NIL collective. Many smaller collectives will likely seek to place their operations under the administration of a larger exempt organization which has the expertise and administrative capacity to manage costs (initial and annual) and compliance, not only with state law and NCAA rules, but also with state and federal tax law.

Watching the explosion of activity in the name, image, and likeness “collective” space, one might easily forget that neither the 2015 decision of the 9th Circuit federal appeals court in O’Bannon nor the 2021 decision of the Supreme Court in Alston, affirming another decision of the 9th Circuit, had anything to do with third party payments to college athletes.

At issue in both those cases was the validity of NCAA rules limiting payments colleges themselves might make to athletes, and both decisions accepted that it was reasonable to limit those payments to the “cost of attendance,” albeit more broadly defined than the NCAA had previously allowed.

But even while Alston was still pending Supreme Court review, state legislatures had begun enacting statutes that would forbid colleges or the NCAA or its constituent conferences to enforce rules that would penalize college athletes for being compensated by third parties for the use of their rights of publicity.

And the NCAA capitulated, announcing in its June 2021 “interim” policy statement that it would defer to state legislation, while still at least nominally holding onto a prohibition against boosters using NIL compensation as an inducement to an athlete to enroll or remain at a particular school or to transfer to another. This is an inherently inconsistent position.

Some of the recently enacted state statutes forbid a college to pay current or “prospective” athletes for their publicity rights. Other statutes expressly allow this. None replicates the NCAA policy against boosters using NIL as a recruitment tool, and some directly override that policy.

Flag on the play

The NCAA has indicated that it does want to take enforcement action against booster collectives or athletic departments that engage in improper recruitment activity.

It will be “interesting,” at least for lawyers and legal academics, to see how this will play out if and when the NCAA attempts to impose sanctions on a player or a team in a state where the statute seems to permit what the association’s policies forbid.

Without naming names, and maybe changing some of the facts, let us take as an example a booster-sponsored collective based in Florida, securing NIL opportunities for athletes playing for a team based in California. And let us suppose that the collective is openly promoting these opportunities as a recruitment tool, going so far as to provide a “base salary” to every member of the team, regardless whether she provides any actual services exploiting her individual publicity rights.

On its face, this arrangement would violate the NCAA’s guidance issued in May 2022, saying NIL compensation arrangements cannot be contingent on enrolling in any particular school, and payments must be based on a case by case determination of the actual value an athlete brings to the arrangement.

The California athletic department does want to recruit some of these players, but does not want to incur NCAA penalties, possibly disqualifying the very players they are trying to reach. But the California statute says the college cannot interfere with the NIL compensation arrangement.

The California statute also says the NCAA cannot sanction the student athletes for accepting NIL compensation from the Florida booster collective, but this raises one of those “interesting” questions. Ostensibly the NCAA is a voluntary association of colleges who have agreed to uphold certain standards of amateurism in college sport. And the NCAA as a corporate entity is based in Indiana — which, as a footnote to this discussion, has not enacted an NIL statute. Can the California statute actually prevent the NCAA enforcing its rules?

Maybe the California college would like to offer an alternative to what the Florida collective has on offer, to deter their recruiting targets from getting involved in a sanctionable arrangement. Unfortunately, the California statute says the college cannot directly pay players for use of their publicity rights, but maybe the college could align itself with a collective that more closely adheres to the NCAA guidance.

If we were to turn the tables, a Florida college facing a similar dilemma would not have that alternative available. Under the Florida statute, a college may not be involved in NIL compensation arrangements even indirectly. One “interesting” question here is whether a Florida college can offer “soft credits” to boosters who contribute to a collective that provides NIL compensation opportunities to its athletes.

The tax exempt collective

Several dozen of these NIL “collectives” have secured tax exempt status from IRS. Presumably none of these sought exemption by reciting as their purpose recruiting athletes to enter or refrain from entering the transfer portal or connecting athletes with commercial opportunities.

At the moment, apart from the NCAA’s own rules and pronouncements, there is not anything resembling national public policy on any of the questions implied by the scenario sketched above. The Congress has failed repeatedly to step in with legislation, and state laws are a patchwork.

But there may nonetheless be some limits beyond which a tax exempt collective cannot engage in recruitment or “pay to play” without endangering its exempt status.

Note: As this article was posted, the Florida legislature enacted and the governor signed H7B, repealing many of the restrictions on colleges working directly with athletes on NIL opportunities. Meanwhile, the NCAA has issued its first, albeit very mild, sanctions order relating to a recruitment violation arising from contact between a booster and a transfer prospect.