On July 26, 2017, the United States Tax Court (Tax Court) handed a complete victory to Eaton Corporation (Eaton) relating to the Internal Revenue Service’s (IRS) cancellation of two Advance Pricing Agreements (APA). Eaton Corporation v. Commissioner, TC Memo 2017-147. The Tax Court held that the IRS had abused its discretion in cancelling the two successive unilateral APAs entered into by Eaton and its subsidiaries with respect to the manufacturing of circuit breaker products in Puerto Rico, and it found no transfer of any intangibles subject to Internal Revenue Code (Code) Section 367(d). In 2011, the IRS cancelled Eaton’s first APA effective January 1, 2005, and the renewal APA effective January 1, 2006, on the ground that Eaton had made numerous material misrepresentations during the negotiations of the APAs and during the implementation of the APAs. As a result of the APA cancellations, the IRS issued notice of deficiencies for 2005 and 2006 determining that a transfer pricing adjustment under Code Section 482 was necessary to reflect the arm’s-length result for the related party transactions. Eaton disputed the deficiency determinations, contending that the IRS abused its discretion in cancelling the two APAs.
The Tax Court considered whether Eaton made misrepresentations during the negotiations or the implementation. With respect to the APA negotiations, the court established the standard for misrepresentation as “false or misleading, usually with an intent to deceive, and relate to the terms of the APA.” Based on the evidence of the negotiations presented at trial, the court concluded that there were no grounds for cancellation of the APAs; “Eaton’s evidence that it answered all questions asked and turned over all requested material is uncontradicted.” Additionally, the court rejected the IRS’s contention that more information was needed; “The negotiation process for these APAs was long and thorough.” Thus, the IRS “had enough material to decide not to agree to the APAs or to reject petitioner’s proposed TPM and suggest another APA. Cancelling the APAs on the grounds related to the APA negotiations was arbitrary.”
Next, the Tax Court turned to the IRS’s claim that Eaton did not comply in good faith with the terms and conditions of the APAs and failed to satisfy the annual report requirements. Eaton admitted that it had made seven errors in its compliance but contended that these errors pertained to supporting data and computations and were inadvertent and immaterial. The court agreed that all of the errors were computational or related to inadvertence, and all were corrected in the amended APA annual reports; “These errors were not deliberate.” Further, the court held that “it is not enough to conclude that the aggregate of the errors resulted in a mistake as to a material fact, a lack of good faith or compliance, or failure to meet a critical assumption.”
Finally, the Tax Court considered and rejected the IRS’s alternative allocation under Code Section 367(d). Basically, the IRS contended that the subsidiaries “could not possibly be as profitable as they are unless intangibles were transferred to them.” The record simply did not support this argument such that the court “could not conclude that intangibles were transferred that should be subject to section 367(d).”
It is interesting to note that the opinion was released as a Memorandum Opinion and not a TC Opinion (for reference, we have previously discussed types of Tax Court opinions), despite the fact that there does not appear to be judicial precedent regarding the cancellation of an APA. Additionally, the opinion contains a headnote, which is normally reserved for TC Opinions (some judges use headnotes for all opinions, but Judge Kerrigan’s practice appears to be to only use headnotes for TC Opinions).
Practice Point: The Tax Court’s opinion in Eaton continues the recent trend of taxpayer victories in high-profile transfer pricing cases. The negotiation and execution of an APA can be a tremendous undertaking by a taxpayer and the IRS, and it is uncommon for an APA to be cancelled. Taxpayers with existing APAs would be well-advised to review this opinion in detail, particularly with respect to the Tax Court’s analysis of the materiality and critical assumptions standards governing APAs. Eaton demonstrates the importance of documenting negotiations with the government to create an easily understood picture of what has occurred.