In a recent decision, the Sixth Circuit Court of Appeals held in Eaton Corp. v. Commissioner that the IRS wrongfully cancelled two advance pricing agreements (APAs) issued by the IRS to Eaton Corporation (Eaton). The Sixth Circuit held that APAs are contracts that are subject to contract law principles and that the IRS had the burden of proving it had grounds to cancel the APAs.
Eaton is a manufacturer of electrical and industrial products whose foreign subsidiaries in Puerto Rico and the Dominican Republic manufactured electrical components such as circuit breakers that were sold to Eaton’s other affiliates as well as third-party customers.
Eaton entered into two APAs with the IRS, one for 2001 through 2005 and one for 2006 through 2010. For both APAs, Eaton adopted a two-step transfer pricing method that used (1) the comparable uncontrolled price (CUP) method to calculate hypothetical profits and (2) the comparable profits method (CPM) to calculate the CUP.
In 2009, Eaton discovered that it had made inadvertent calculation errors in implementing the transfer pricing method in the APAs. In 2010, Eaton informed the IRS of the unintended errors and filed corrected returns. In 2011, the IRS notified Eaton that the IRS was cancelling the APAs for the 2005 and 2006 tax years due to Eaton’s noncompliance with the requirements set forth in the IRS Revenue Procedures (Rev. Proc.) 96-53 and 2004-40 that govern the APA process and are incorporated into the APAs by reference. After canceling the APAs, the IRS issued a deficiency notice to Eaton for $19.7 million for 2005 and $55.3 million for 2006. Further, the IRS assessed section 6662(h) penalties for $14.2 million for 2005 and $37.3 million for 2006 for gross valuation misstatements.
Eaton then challenged the deficiencies in the Tax Court.
Tax Court Found IRS Abused Its Discretion in Canceling Eaton's APAs
In 2013, the Tax Court held its deficiency jurisdiction includes reviewing APA cancellations under the abuse-of-discretion standard that requires Eaton to prove that the IRS’s cancellation of the APAs was arbitrary and capricious.
In 2017, the Tax Court held that Eaton had met this burden to show the abuse of discretion and rejected all grounds advanced by the IRS for canceling the APAs.3 The Tax Court held that Eaton’s errors were inadvertent and not “material” within the meaning of the APA revenue procedures that are incorporated into the APA by reference. As a result, the Tax Court concluded it was an abuse of discretion for the IRS to cancel the APAs.
The Tax Court further rejected the IRS's claim for penalties under section 6662(h) holding that such penalties only apply to section 482 adjustments and Eaton’s self-corrections did not constitute section 482 adjustments. In addition, the Tax Court rejected Eaton's request for relief from double taxation under Rev. Proc. 99-32 for its self-corrections, holding that Rev. Proc. 99-32 also only applies to section 482 adjustments and not self-corrections.
The IRS appealed to the Sixth Circuit the Tax Court’s decisions setting aside the APA cancellations and setting aside the application of 6662 penalties. Eaton cross-appealed the Tax Court's decision denying Rev. Proc. 99-32 relief.
Sixth Circuit Held IRS Bears the Burden of Proof to Cancel an APA and Upheld the Tax Court Decision That the IRS Wrongfully Canceled Eaton’s APAs
Reaching the same decision as the Tax Court, the Sixth Circuit held the IRS wrongfully canceled Eaton’s APAs. The Sixth Circuit reviewed the Tax Court’s opinion in four areas: (a) burden of proof, (b) merits of the wrongful cancellation, (c) section 6662 penalties, and (d) double taxation relief.
The Sixth Circuit affirmed that the IRS had the burden of proof and noted that the Revenue Procedures in place at the time, Rev. Proc 96-53 and Rev. Proc. 2004-40, as well as the language of the APAs made clear that the APAs are contracts and are governed by the same contract law principles that apply to contracts between private parties. As a result, the Sixth Circuit stated that the IRS is required to prove an exception that allows it to back out of a contractual promise. The Sixth Circuit rejected the IRS’s claim that administrative deference applies to grant the IRS discretion to cancel an APA.
Next, the Sixth Circuit held that the grounds for cancellation do not extend beyond the four corners of the cancellation section of the APA. As a result, the IRS could only cancel the APA for the failure of a critical assumption, failure to state a material fact, or a mistake of material fact. The Sixth Circuit held that none of Eaton’s inadvertent errors and omissions were material.
In addressing the section 6662 penalties, the Sixth Circuit reversed the Tax Court to hold that Eaton’s self-corrections were section 482 adjustments, but held that the IRS could not impose penalties because the IRS forfeited the penalty claim by not raising it before or during the trial.
In addressing Eaton’s claim for relief from double taxation, the Sixth Circuit considered Rev. Proc. 99-32, which allows taxpayers that make section 482 adjustments to treat the original overpayment as a loan or advance and the repatriation of excess cash as a repayment of a loan rather than taxable income. The Tax Court rejected Eaton’s claim for relief, but the Sixth Circuit reversed and held that Eaton was entitled to relief due to the court’s finding, noted above, that the self-corrections were section 482 adjustments.
Impact on Taxpayers
The unique facts in Eaton Corp. likely limit the relevance and scope of the Sixth Circuit’s decision.
Before the decision in Eaton Corp., the IRS indicated it is in the process of rewriting Rev. Proc. 2015-41, which currently governs the APA process. The IRS may rewrite the language governing its authority to cancel an APA to afford itself the power it claimed in Eaton Corp., but which the Sixth Circuit found lacking based on the language in the prior revenue procedures.
In the future, taxpayers may face APAs with different contract terms that are more favorable to the IRS. However, these terms will not be material to most taxpayers because they will rarely be invoked, as the IRS is unlikely to undermine taxpayer interest in the APA process by canceling APAs.