November 4, 2019 / North America
On October 28, 2019, the U.S. Tax Court released a supplemental opinion regarding Eaton Corporation’s recent win in Eaton Corp. & Subs. V. Commissioner, T.C. Memo 2017.
The Eaton Corporation (“Eaton”) is the parent of a multinational group that manufactures electrical and industrial products. The Internal Revenue Service (“IRS”) audited Eaton’s 1995 to 1997 tax returns, rejecting Eaton’s proposal to use the comparable uncontrolled price (“CUP”) for its transfer pricing method (“TPM”). A settlement was reached and as a part of the settlement, Eaton applied for its first unilateral Advance Pricing Agreement (“APA I”) in 2002. In 2004, the IRS and Eaton reached an agreement on APA I, which covered Eaton’s 2001 to 2005 tax years. APA I covered intercompany transactions between Eaton and its related parties, including the sale of breaker products to Eaton from its manufacturing entities, the licensing of intellectual property (“IP”) by Eaton to its manufacturing entities and the manufacturing entities’ cost-sharing arrangement with Eaton.
In 2005, Eaton renewed APA I (referred to as “APA II”), which covered Eaton’s 2006 to 2010 tax years. APA II stated that if Eaton complied with the APA terms, then the IRS would not propose any section 482 adjustments; one of the key reasons for entering an APA. However, if Eaton failed to comply with the terms, then the IRS could propose Section 482 adjustments if appropriate or cancel the APA. In early 2010, Eaton had discovered it had made computational errors in the APA TPM calculations and in its tax reporting. The APA multiplier was miscalculated and resulted in an incorrect transfer price, which ultimately reflected in Eaton’s tax returns. Additionally, there were errors that affected the transfer price computations made under APA II. By October 2010, Eaton had corrected these errors, which amended both its APA annual reports and federal income tax returns. The IRS, however, rejected these self-corrections.
In December 2011, the IRS took an unexpected position and cancelled both APAs. The IRS contended that the decision to cancel Eaton’s APAs was on the basis that Eaton “did not comply in good faith with the terms and conditions of either APA I or APA II and failed to satisfy the APA annual reporting requirements.” Due to the cancellation, the IRS reviewed Eaton’s transfer pricing and determined that a Section 482 adjustment was necessary. The adjustments resulted in a notice of deficiency determining that Eaton owed $19.7 million and $55.3 million for the tax years 2005 and 2006, respectively.
Tax Court Ruling
In Eaton Corp. & Subs. V. Commissioner, T.C. Memo 2017-147, the IRS’s decision to cancel Eaton’s APAs was ruled an abuse of discretion. From 1991 to 2015, only 11 out of 1,511 executed APAs were cancelled; therefore, this case was placed under scrutiny after the highly unusual sequence of events. The U.S. Tax Court ruled Eaton’s errors did not warrant the cancellation of the APAs and that Eaton was in fact compliant with the terms of the APA. The U.S. Tax Court ruled that Eaton’s errors were “not enough to conclude the aggregate of the errors resulted in a mistake as to a material fact, a lack of good faith compliance, or failure to meet a critical assumption” and that these miscalculations were inadvertent as “the errors in the aggregate did not consistently favor the petitioner, and the error amounts were inconsistent.”
Following the ruling that the cancellation of the APAs was an abuse of discretion, the next step was addressing Eaton’s penalty liabilities. To address this issue, the IRS and Eaton were required to submit computations for the entry of decision under Tax Court Rule 155. The IRS’s position was that the computations should include 40 percent penalties pursuant to the Internal Revenue Code (“IRC”) Section 6662(h). Eaton’s position was that there were no adjustments pursuant to IRC Section 482 and thus the referenced penalty regime was also not required.
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