The Tax Court in Eaton Corporation and Subsidiaries v. Commissioner, T.C. Memo, 2017-147 determined that the IRS abused its discretion in cancelling two unilateral advanced pricing agreements (APAs) covering the transfer of certain products, the license of intangible property, and cost sharing between Eaton's US subsidiaries and foreign subsidiaries in Puerto Rico and the Dominican Republic (the Island Subs).
The Tax Court also rejected an alternative IRS position that if the two APAs were valid, Eaton owed additional tax on account of a non-APA covered transfer of intangibles to the Island Subs that enable the subs to earn excess profits.
Eaton Corporation and subsidiaries entered into two APAs establishing transfer pricing methodologies for covered transactions between Eaton's US subsidiaries (Eaton US) and the Island Subs. The first APA (APA I) applied to tax years 2001-2005, and the second APA (APA II) applied to tax years 2006-2010. Eaton Corporation and its subsidiaries are collectively referred to as Eaton.
The APAs covered Eaton US's purchase of circuit breakers, switches and push-button controls manufactured by its Island Subs. The APAs generally adopted as the transfer pricing method (TPM) a Comparable Uncontrolled Price (CUP) method per product sold by the Island Subs to Eaton US, with an aggregate adjustment, if necessary, to ensure Eaton US achieved a Berry ratio on its distribution activities. Under the CUP method agreed in the APAs, the profits of the Island Subs were not specially tested. During the APA process, some members of the IRS APA team had argued for use of the comparable profits method (CPM), under which the profits of the Island Subs would have been tested as well as limited.
After the APAs were executed, Eaton discovered a number of transfer pricing computational errors, which it then corrected by amended APA annual report filings and amended tax returns. Some of the errors favored the taxpayer, while others favored the IRS. In the aggregate, the errors resulted in about a 2 percent increase in the reported US APA related income.
After reviewing those filings, in 2011, the IRS determined that Eaton had not complied in good faith with the terms of the applicable APA revenue procedures. The IRS cancelled APA I effective January 1, 2005 and APA II effective January 1, 2006. IRS used the computational errors as one basis for cancelling the APAs.
Immediately following the APA cancellations, the IRS issued deficiency notices determining that §482 income adjustments were necessary to reflect arm's-length results for Eaton's intercompany transactions between Eaton US and the Island Subs for tax years 2005 and 2006, in the amounts of $102 million and $266 million, respectively, plus penalties The deficiencies were determined using methods that the IRS APA teams had considered, but not adopted, during the negotiations of APA I and APA II.
As an alternative, if the Tax Court rejected the §482 adjustments, the IRS proposed to increase Eaton US’s 2006 income by approximately $231 million based on a deemed §367(d) transfer of intangibles to the Island Subs. The IRS' position was that the high profitability of the Island Subs could only be justified by the Island Subs' exploitation of non-routine intangibles. Because the Island Subs did not create any non-routine intangibles, the IRS concluded that intangibles must have been transferred from Eaton US to the Island Subs in a §367(d) transfer.
The Tax Court's opinion: key points
In opposing the APA cancellations, Eaton initially argued that the APAs were contracts and that under ordinary contract law principles that apply to the US as a contracting party, the IRS had the burden of proving that Eaton had violated the terms of the APAs, which IRS had failed to do. This argument was rejected by the court in pre-trial proceedings and in the trial opinion. Alternatively, Eaton argued that the APA cancellations were an abuse of discretion because there was no factual basis for the cancellation under the applicable revenue procedures.
The IRS argued that the cancellations were not an abuse of discretion because Eaton did not comply in good faith with the terms and conditions of either APA and failed to satisfy the APA annual reporting requirements. The IRS relied upon nine specific errors or omission made by Eaton to support the cancellations.
The standard of review applied by the Tax Court was whether it was an abuse of discretion for the IRS to cancel the APAs. Thus, Eaton was required to show that the cancellations were arbitrary, capricious, or without sound basis in fact. In considering whether there was an abuse of discretion, the court considered whether the IRS abided by the self-imposed limitations set forth in the applicable revenue procedures. Applying the standards set forth in the APA revenue procedures, the court focused on whether Eaton had made misrepresentations, made mistakes as to a material fact, or failed to state a material fact. In making its determinations, the court looked at nine disputed factual issues.
Based on an individual review of each issue and an aggregate assessment of all the issues, the court concluded that for each particular issue, the information was either known by the APA teams, the APA teams had the opportunity to inquire about the information before agreeing to the APAs (but failed to do so), or the information was corrected or disclosed during APA negotiations and did not impact the choice of the APA TPM. Ultimately, the court concluded that any misrepresentations, mistakes or failures were not material.
Specifically, the opinion stated that "Respondent [IRS] had many opportunities not to agree to APA I and APA II…. After completing the APA II negotiations, respondent should have had a clear understanding of petitioner's transactions and should not have entered into APA II if the APA II team was concerned that petitioner was omitting or misrepresenting information."
In concluding, the court noted that an "APA is a binding agreement and it should be cancelled only according to the terms of the revenue procedures." The revenue procedures define material facts as facts that, if known by the IRS, would have resulted in a significantly different APA or no APA at all.
Eaton made immaterial and inadvertent errors that did not fit the APA governing revenue procedures' definition of material. The court further noted that a desire to change the TPM after the negotiations concluded (i.e., buyer's remorse) is not a reason for cancellation and therefore the cancellation was arbitrary, capricious and unreasonable.
The court also rejected the alternative argument presented by the IRS under §367(d). The court found that no intangible assets were transferred in 2006. The court disagreed with the IRS' position that an intangible transfer could be inferred solely due to the excess profits of the Island Subs. The IRS did not identify any intangibles that should be subject to §367(d). The foreign subsidiaries had access to intangibles through licenses and therefore the court concluded that no intangibles were transferred subject to §367(d).
Takeaways and observations
A rare situation. As set forth in the opinion, APA cancellations are rare. There were only 11 APA cancellations or revocation between 1991 and 2015. In addition, Eaton had negotiated two unilateral APAs. Most APAs are bilateral and in such cases a treaty partner would be consulted before an APA was revoked or cancelled. The Eaton case is the first occasion when a taxpayer has judicially challenged an APA revocation or cancellation.
Contract law principles may not be applied to disputes with APAs. APAs may not be reviewed under principles of contract law. The Tax Court will apply the abuse of discretion standard and focus on the "self-imposed" guidelines in the relevant revenue procedures. Notwithstanding what appears to be a higher burden of proof, the taxpayer was able to convince the court that it had not made misrepresentations of material facts or engaged in other conduct that justified the cancellations.
APAs are negotiations and trust should be established when negotiating with the IRS. The court noted that APAs are negotiations designed to solve complex transfer pricing issues. "The goal is to reach a mutually acceptable understanding of the appropriate application of the arm's-length standard to the taxpayer's facts." The conclusion of the negotiation is an "acceptable negotiated instrument" reached through compromise. During APA negotiations, taxpayers should keep in mind the delicate nature of negotiations to ensure goals are achieved and mistrust is not created.
If the taxpayer discovers errors during the APA negotiations or afterwards, it is important to bring them to the attention of the IRS and maintain a cordial relationship. However, in the rare instance of a revocation or cancellation, judicial relief is available.
Rejection of the IRS Section 367(d) position. The Tax Court will not support arguments that §367(d) transfers occur solely as a result of having excess profits in a particular entity. Generally, the theory that excess profits are attributable to an intangible transfer underlies many IRS Exam adjustments and is the theoretical basis for the income method. In rejecting the IRS' position, the court looked to the statutorily defined list of intangibles that are applicable to §§ 367(d), 482, and 936. The court rejected the IRS position because there was no actual transfer of intangibles listed in the statute. The Tax Court's holding on this issue is consistent with the court's holdings rejecting similar IRS arguments in the Amazon and Veritas cases.
As a final comment, the APA program is designed to serve as a non-adversarial alternative to the traditional adversarial procedures for resolving transfer pricing. Based on the grounds argued by the IRS to support the APA cancellations, which the Tax Court found were individually and collectively immaterial or known to the IRS when the APAs were negotiated, it remains factually unclear why the IRS cancelled the two APAs in the first place.