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September 6, 2022 US Sixth Circuit rules in favor of Eaton in appeal from Tax Court regarding APA cancellation
Executive summary On August 25, 2022, the United States (US) Sixth Circuit Court of Appeals (Sixth Circuit) held in Eaton Corp. & Subs. v. Commissioner1 that the IRS had the burden of proving that there were grounds to cancel the APAs under generally applicable contract-law principles and the IRS failed to meet that burden. The Sixth Circuit also held the IRS could not impose Internal Revenue Code (IRC) Section 6662 penalties on Eaton Corporation’s (Eaton) self-reported adjustments. Eaton was thus eligible to claim relief from double taxation under Revenue Procedure 99-32. Detailed discussion Background Eaton and its worldwide group manufacture a wide range of electrical components. The group had facilities in Puerto Rico and the Dominican Republic, where, until mid-2006, they manufactured Breaker Products (i.e., safety components, such as circuit breakers) that Eaton sold to both related and unrelated parties. Eaton and the IRS entered into an APA for Eaton’s 2001-2005 tax years (APA I) and another one for 2006-2010 tax years (APA II). In both APAs, the parties agreed upon a transfer pricing method using two steps: (1) the comparable uncontrolled price (CUP) method to calculate hypothetical profits, and (2) the comparable profits method (CPM) to calibrate the CUP.2 In 2007, the IRS began auditing Eaton’s 2005 and 2006 tax returns and then expanded the review to Eaton’s APA implementation. In 2009, Eaton’s tax department became aware of several inadvertent miscalculations in computing the transfer pricing methodology (TPM) for the Breaker Product sales that resulted in inaccuracies in its APA annual reports and tax returns. Eaton informed the IRS of the errors, corrected them and filed amended tax returns. Notwithstanding, in 2011, the IRS cancelled APA I and APA II for Eaton’s failure to comply with the terms of Revenue Procedure 96-53 and Revenue Procedure 2004-40 (the APA Revenue Procedures)3 and made transfer pricing adjustments to Eaton’s income. Based on its determinations, the IRS issued notices of deficiency for approximately US$20 million and $55 million with corresponding IRC Section 6662 penalties of $14 million and $37 million for 2005 and 2006, respectively. In an initial 2013 decision, Eaton Corp. & Subs. v. Commissioner, 140 T.C. 410 (2013), the Tax Court dismissed two threshold questions before trial. The Tax Court held that: (1) its “deficiency jurisdiction”4 extended to reviewing cancellation of the APAs, and (2) with respect to cancelling an APA, the relevant standard of review was “abuse-of-discretion,”5 with Eaton bearing the burden of proof. In a later 2017 decision, Eaton Corp. & Subs. v. Commissioner, T.C. Memo. 2017-147, the Tax Court concluded that Eaton satisfied its burden of proof and rejected all 17 grounds advanced by the IRS as justifications for cancelling the APAs. The Tax Court found that the errors were “inadvertent” and did “not fit the APA governing revenue procedures’ definition of ‘material.’” The Tax Court held that the IRS abused its discretion by cancelling the APAs. In a follow-up order, the Tax Court rejected the IRS’s claim of 40% penalties for Eaton’s self-reported corrections. The Tax Court found that penalties apply only to IRC Section 482 adjustments and the self-corrections did not constitute such adjustments. Based on the same reasoning, the Tax Court denied double taxation relief sought by Eaton, reasoning that relief under Revenue Procedure 99-32 applies only to IRC Section 482 adjustments. The IRS appealed to the Sixth Circuit, challenging the Tax Court’s holdings on cancellation of the APAs and penalties. Sixth Circuit opinion The Sixth Circuit reviewed four areas of the Tax Court’s opinion. First, the Sixth Circuit discussed which party had the burden of proof. The Sixth Circuit stated that the language in Revenue Procedure 2004-40 and Revenue Procedure 96-53, as well as language in the APAs, made it clear that APAs are contracts. According to the Sixth Circuit, prior case law has held that contracts with the United States are governed by generally applicable contract-law principles, which require the party backing out of the contract to prove the exception that allows its action and “[t]his principle naturally extends to the IRS’s dealings with taxpayers.”6 The IRS argued that administrative deference should govern and that the IRS had discretion to cancel an APA under the applicable APA Revenue Procedures. The Sixth Circuit found that the APA Revenue Procedures reserved discretion to cancel an APA when a certain condition occurred, not the discretion to determine that the necessary condition had been satisfied. Thus, the Sixth Circuit held that the IRS had the burden to demonstrate that there were grounds to cancel the APAs under contract-law principles. Second, the Sixth Circuit addressed whether the IRS had established grounds to cancel the APAs. Under contract-law principles, a party must prove an exception that allows it to back out of a contract. The APA Revenue Procedures each have sections called “Cancelling the APA,” which provide a list of reasons for which the IRS may cancel an APA. The IRS argued that the APAs could be canceled due to Eaton’s errors and omissions (i.e., failure to state or mistake as to a material fact). The analysis thus turned on the meaning of “material.” The APA Revenue Procedures, which mirror the contract-law definition, state that material facts are those that would have caused the IRS to reach a significantly different APA. The Sixth Circuit dismissed as non-material facts (1) Eaton’s use of an APA multiplier to translate the TPM-calculated prices into its books, (2) the miscalculation of the APA multiplier and (3) the mistakes in Eaton’s APA annual reports. The Sixth Circuit thus held that the IRS had not met its burden and could not cancel the APAs. Third, the Sixth Circuit addressed the IRC Section 6662 penalties. The IRS made the penalties assessment 18 months after the Tax Court held that the IRS could not cancel the APAs. The Sixth Circuit disagreed with the Tax Court and found that the self-corrections constituted IRC Section 482 adjustments. The Sixth Circuit agreed with the Tax Court, however, that the IRS could not impose the penalties. The IRS’s pre-trial penalties claim differed from the post-trial penalties claim because they were based on different underlying adjustments (i.e., the IRS’s calculations with its own TPM versus Eaton’s self-corrections based on the TPM in the APAs). The Sixth Circuit said that the IRS is not allowed to “mix and match” infinite penalty theories with assessment theories before, during, and after trial. The Sixth Circuit concluded that because the IRS’s post-trial penalties claim were not placed in the Tax Court’s purview, the IRS forfeited those claims. The final issue the Sixth Circuit addressed was double taxation relief. Revenue Procedure 99-32 allows taxpayers to treat cash that it repatriates due to an IRC Section 482 adjustment as a loan or advance, preventing the money from being taxed upon repatriation. The Tax Court originally stated Revenue Procedure. 99-32 did not apply because the adjustments were not IRC Section 482 adjustments. However, as noted above, the Sixth Circuit disagreed on that point, and determined that Eaton was eligible to claim relief from double taxation. Implications The Sixth Circuit’s opinion likely has limited applicability to other taxpayers. The Sixth Circuit relies on Eaton’s unique facts within the confines of the APAs and the APA Revenue Procedures in effect during the years at issue. Although the IRS very rarely cancels an executed APA, taxpayers must be careful not to apply the conclusions in this case to any scenario in which an APA is cancelled.7 The facts underlying each APA stand on their own. Even when a taxpayer makes a mistake that is discovered in an APA annual report, it is often able to agree to a resolution with the IRS while keeping the APA intact. This ruling, however, confirms that APAs are binding under contract-law principles and the IRS has the burden of proof to show the grounds supporting an APA cancellation. _________________________________________ For additional information with respect to this Alert, please contact the following: Ernst & Young LLP (United States), National Tax Department, International Tax and Transactions Services, Transfer Pricing
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