Documents Filed in Eaton Indicate IRS Economists Debated Adequacy of Taxpayer Documentation, Treatment of Intangibles

By Dolores W. Gregory  

Feb. 18 --On Dec. 16, 2011, the Internal Revenue Service notified Eaton Corp. that it intended to retroactively revoke two advance pricing agreements it had negotiated with the taxpayer half a dozen years before. The basis for doing so, the agency informed Eaton, was “material deficiencies in compliance,” including “distortive accounting” and misrepresentations of material facts.

Exactly what facts were misstated the IRS did not say. Nor has the IRS ever stated, in its myriad filings in the Eaton litigation, exactly what actions the company took that the agency believed amounted to a deliberate effort to deceive. Documents filed recently in U.S. Tax Court, however, may shed some light on the agency's dissatisfaction with the deals it struck with Eaton. [Eaton Corp. v. Comr., T.C., Docket No. 5576-12, exhibits filed 12/13/13]

For other taxpayers, two compelling questions raised by the litigation are whether the IRS can unilaterally revoke an APA and what steps they can take to avoid such a result. None of the IRS documents examined by Bloomberg BNA answers those questions, but they do show that the IRS believed an excessive level of profits was going to Eaton's Cayman Islands subsidiaries from the sale of electrical components to its U.S. affiliate, even as the related-party end-users of those products recorded losses on the transactions.

One memo suggests that an internal dispute arose over the APA team's willingness to accept the company's attribution of intangibles. Another report shows that the IRS challenged a fundamental presumption of the APAs--that the company's U.S. manufacturing subsidiary, and not its Cayman Islands affiliates, was the appropriate tested party. But it does not explain why the IRS accepted that presumption in the first place.

The documents discussed in this article were submitted by Eaton as exhibits to its Dec. 13, 2013, second motion for partial summary judgment. A hearing on the motion is scheduled for May 12, when the tax court also will consider a motion by the IRS to divide the trial into two proceedings--the first dealing with Eaton's charge that the agency abused its discretion in canceling the APAs, and the second addressing whether the resulting income allocation and deficiency notice are appropriate

Transfer Pricing Study

Among the documents are:

• a Dec. 15, 2011, transfer pricing study conducted for the IRS by economist John Hatch that shows the profits in Eaton's Cayman Islands subsidiaries were literally off the charts during the tax years at issue, with a return on capital employed of 10 times the median return reported by comparable manufacturers;

• a transcript of a Sept. 27, 2013, deposition of Hatch, in which he defended his use of the comparable profits method (CPM) in analyzing the transactions at issue;

• a May 11, 2006, memo from IRS economist Richard Bauman to members of the APA renewal team, laying out concerns about Eaton's characterization of intangibles and questioning Eaton's allocation of profits to its Cayman Islands subsidiaries; and

• a Dec. 16, 2011, report by IRS International Issue Specialist Larry E. Gearhart that questions the functional analyses performed by Eaton and suggests that the taxpayer was less than forthcoming in the documentation it provided. Gearhart concludes that, in contrast to what was provided in the APAs, the tested party should be the Cayman Islands subsidiaries together, which would leave “profits and losses associated with non-routine functions and intangibles” with the U.S. affiliate.

 

Hatch conducted his analysis as part of an audit of Eaton's 2005 and 2006 tax years. On the basis of Hatch's analysis and Gearhart's subsequent report, the IRS on Dec. 19, 2011, issued Eaton a deficiency notice for $127 million in taxes and penalties arising from an income reallocation of $368.6 million. Based on Hatch's recommendation, the IRS reallocated, to the U.S. subsidiary, 90 percent of the operating profits of Eaton's Cayman Islands operations.

The company filed suit Feb. 29, 2012.

Eaton's Operations

Eaton is a globally diversified industrial manufacturer, with product lines that include electrical power products and electrical distribution and control products. At the time it negotiated the APAs, its worldwide headquarters was in Cleveland.

According to Hatch's analysis, Eaton had manufacturing facilities in 32 countries and employed 60,000 people worldwide. Its electrical division was the largest of its four divisions, with sales of $4.2 billion in 2006.

In 1994, the company acquired the distribution and control business unit of Westinghouse Corp., which included five plants in Puerto Rico and the Dominican Republic. The APAs at issue cover intercompany sales of breaker products--electrical components--produced at those plants. Cutler-Hammer Co. (CHC) and Cutler-Hammer Electrical Corp. (CHEC), subsidiaries based in the Cayman Islands, operate the four manufacturing plants in Puerto Rico and contract with a related party for assembly in the Dominican Republic.

CHC and CHEC sell the breaker products to Eaton Electrical Inc. (EEI), their U.S. affiliate. EEI is their only customer for the breaker products. In turn, EEI transfers roughly half of the breaker products to affiliated U.S. assembly plants and foreign affiliates for use as components in the production of other equipment. It sells the remainder “as is” to third-party distributors and original equipment manufacturers.

Terms of the APAs

In April 2004, the IRS and Eaton executed the initial APA for tax years 2001-05; in December 2006, the parties signed a renewal APA covering years 2006-10. Under the terms of the APAs, the breaker products line of business was segregated from EEI's other business.

The APAs set out a two-step transfer pricing method, under which EEI constructed an income statement for the breaker products using internal comparable uncontrolled prices (CUPs). It applied CPM to test the constructed income statement, using a Berry ratio--gross profits from the sale of the product divided by product operating expenses--as a profit-level indicator.

According to Eaton's motion for partial summary judgment, the APAs set the transfer price for CHC/CHEC sales of breaker products by using “actual third-party transaction prices to generate EEI's gross revenue from the sales of those products.” The company then subtracted from gross revenue an amount “guaranteed to allow EEI to earn at least 20 percent profit on its operating expenses” related to the distribution of those products.

According to Eaton's motion, the Puerto Rican plants originally were operated by Eaton Electrical de Puerto Rico (EEPR), formerly known as Cutler-Hammer de Puerto Rico (CHPR), a possessions corporation under Section 936. As the benefits for Section 936 manufacturing operations were phased out, EEPR transferred its Puerto Rican operations to CHC and CHEC in a series of Section 351 transactions.

Thus, the original APA also included a Section 936(h)(5)(C)(i) cost sharing payment from CHPR to EEI--then known as Cutler-Hammer Inc.--for its share of research and development costs, but that provision was dropped from the renewal APA.

Further, under the initial APA, the U.S. affiliate received a royalty for the licensing of breaker product intangibles. The renewal APA makes no reference to a royalty payment for intangibles.

Cancellation of the APAs

In its tax court petition, Eaton argued that the cancellation of the APAs and the subsequent income adjustment represent an abuse of discretion by the IRS. The reallocation of income was premised entirely on Hatch's analysis, which Eaton maintains is fundamentally flawed.

In the deposition of Hatch, attorneys for Eaton made clear they intend to call the economist's work and qualifications into question at trial. And in Eaton's Dec. 13 motion, the taxpayer pointed out that Hatch's “only experience presenting an analysis to a court was in Veritas Software Corp. v. Comr.” and that the tax court “severely criticized” Hatch's work in that case.

“In the present case, Dr. Hatch's analysis underlying the notice demonstrates the same lack of care he showed in Veritas and is obviously demonstrably flawed,” the motion said. But Hatch stated in his report that he was retained by the IRS not to test the assumptions of the APAs, but to determine whether the intercompany transactions at issue were conducted at arm's length. For that reason, he stated in the deposition, he did not consider the provisions of the APAs as they were irrelevant to his analysis.

In its motion for partial summary judgment, Eaton also maintained that Hatch erroneously assumed that the foreign subsidiaries held no nonroutine intangible assets--a conclusion the company said is inconsistent with an analysis he conducted in a separate report.

Hatch Analysis

Hatch's report noted that he was charged with analyzing transactions among EEI, CHC, CHEC and a third Cayman Islands subsidiary--Cutler-Hammer Industrial Ltd. (CHIL). According to his report, CHC and CHEC operate the manufacturing plants in Puerto Rico, while CHIL operates an assembly plant in the Dominican Republic, and functions as a contract assembler for CHC and CHEC.

Hatch stated that his conclusions are based on information provided by the IRS, as well as his own research of publicly available documents, interviews with Eaton personnel, interviews with individuals knowledgeable of the industry, and site visits to Eaton facilities.

Hatch noted that he was asked to review three different categories of transactions involving EEI, CHC, and CHEC during the audit period:

• the sale of parts, including printed circuit boards, from several EEI manufacturing plants in the U.S. to CHC and CHEC for incorporation into the breaker products;

• the production and sale of circuit breakers, switches, push-button control and similar items by CHC and CHEC to EEI and EEI's subsequent distribution of those products to related and unrelated parties; and

• EEI's licensing of intellectual property to CHC and CHEC for use in the manufacture of the breaker products.

 

Hatch compared the profits of CHC and CHEC, combined with CHIL, to profits earned by 14 other electrical manufacturers that were geographically diverse. He noted that this set of comparables included a “peer group” of five manufacturers that Eaton itself had identified.

To measure the profits, he used return on capital employed (ROCE), or the ratio of operating income to the average level of capital employed by the company. For the 14 comparables, Hatch found a median ROCE of 40.4 percent for the years 2004-06. In contrast, CHEC recorded a ROCE of 365 percent in tax year 2006, while CHC recorded a ROCE result of 447.2 percent in 2005 and 370.4 percent in 2006. (CHEC did not become operational until 2005.)

Hatch also compared the ROCE ratios of CHI and CHEC to a broader set of U.S. manufacturers in 2004-06 and found that of 1,548 manufacturing companies, the three-year median ROCE ratio was 14.4 percent. Only 140 companies reported ROCE ratios of greater than 50 percent, and of those, only 18 reported ROCE ratios higher than 100 percent.

“Not one of the 1,548 companies recorded a higher ROCE than CHC or CHEC,” Hatch wrote.

Further, he wrote, “manufacturers with comparably high profits tend to invest heavily in R&D and attribute their returns to proprietary technology in combination with other factors. Not one of these firms attributed its profitability to comparative manufacturing efficiencies in a commodity market.”

Under the APA, Eaton provided financial results for nine assembly plants that used the breaker products or provided product to CHC and CHEC, Hatch said. He noted that those plants consistently posted losses--in 2005 and 2006, respectively, they reported operating losses of $65.4 million and $70 million on sales exceeding $2 billion.

Hatch's conclusion: “These income levels are a result of transfer prices that cannot be supported with reliable arm's length evidence.”

A Curious Fact

Hatch's study reveals a curious fact that is not evident in the APA agreements themselves, according to Valerie Amerkhail of Economic Consulting Services LLC, who examined some of the documents. With respect to the product sales, she said, the APAs identify two sets of intercompany transactions:

• the purchase of breaker products by EEI from CHC and CHEC, the Cayman Islands affiliates; and

• the sales of breaker products from EEI to affiliated U.S. assembly plants.

 

But Hatch's report also refers to a third intercompany transaction--the sales of parts from EEI to the Cayman Islands affiliates. Such transactions would be consistent with the way many offshore plants are used to produce products that incorporate high-technology components, Amerkhail said. Yet the APAs make no mention of them.

“It certainly would be necessary to test those transactions, and as both Hatch and the IRS report point out, there are no appropriate CUPs for them,” she noted. “So it would probably be necessary to use CPM.”

She noted that in contrast to the APAs, which provide that EEI is the tested party, Hatch began his functional analysis on the premise that CHC and CHEC are the appropriate tested parties because EEI owns the intangibles and bears most of the risk. Under this presumption, the sales of parts by EEI to the Cayman Islands subsidiaries and its purchase of breaker products from those subsidiaries can be tested by applying the comparable profits method to CHC and CHEC, she said.

The third transaction--sales of breaker products to U.S. affiliates--“presumably were ignored [in Hatch's analysis] because it is within the U.S. consolidated return.”

Issues Over Intangibles

Another point of contention for the IRS is the treatment of intangibles, according to a May 11, 2006, memo from economist Richard Bauman to the APA renewal team leader, Richard Osborne, and the APA economist, Mark Bronson. Bauman's memo indicates that the IRS already was concerned about the profits being earned by the Cayman Islands subsidiaries.

Under the subject line “Problems With the Selection of Eaton Electrical Inc. as the Tested Party for Eaton's APA Renewal,” Bauman set out his concerns that Eaton “indicates CHC owns 'foreign goodwill and going concern value' ” and had “attempted to parlay these goodwill and going concern intangibles into something that entitles CHC to the lion's share of the profits” from the covered transactions.

He raised the following objections:

• Eaton claimed location savings accounted for CHC's profitability, but if CHC and EEI were operating at arm's length, “it would be prudent if it would share more of its profits with EEI to prevent further or more rapid erosion of its market.”

• Eaton claimed that the “high degree of regulation and the complexity of CHC's manufacturing processes are reasons why it should be highly profitable,” but many other products produced under the same conditions do not generate “supernormal profits.”

• Eaton claimed that CHC was entitled to high profits because it participated in product development through its engineering function, but “that does not seem to be an unusual function for a manufacturing licensee.”

• Eaton claimed that CHC was operating at capacity and that this fact accounts for its profitability, but CHC showed the same high profits during the 2001-02 recession.

• Eaton claimed that EEI does not hold material marketing intangibles when, in fact, the U.S. subsidiary holds trademarks, trade names, contracts, customer lists, and technical data as well as goodwill and going concern value.

• As a leader in the U.S. circuit breaker oligopoly, CHC-EEI is sustained by high barrier to entry. Thus, “EEI is entitled to a larger share of the profits than those represented by the Berry ratio 'bone' offered by the taxpayer.”

 

Functional Analysis Under Scrutiny

On Dec. 16, 2011, the date of the letter notifying Eaton that the APAs would be canceled, IRS International Issue Specialist Larry E. Gearhart submitted a transfer pricing report on Eaton Corp. that relied heavily on Hatch's analysis and took issue with many of the elements fundamental to the APAs.

First, Gearhart cited the high profit margins enjoyed by the Cayman Islands subsidiaries. He noted that in 2005, CHC reported sales of $227.6 million, cost of goods sold equal to $146.7 million and operating expenses of $20.7 million, leaving it with an operating income of $110.1 million. In 2006, CHC reported sales of $350.9 million, cost of goods sold equal to $198.7 million, and operating income of $123.9 million.

CHEC in 2006 showed sales of $385.4 million and operating income of $163.3 million. The company had no 2005 results as it was established in the Cayman Islands in that year.

In terms of ROCE, each company reported ratios above 350 percent; in tax year 2005, CHC showed a ROCE ratio of 447 percent.

The focus of Gearhart's report is the functional analysis provided to the IRS by Eaton in support of its APAs. Eaton, he said, failed to consider and adjust for certain comparability factors in conducting its transfer pricing analysis.

He noted that when Eaton purchased Westinghouse's distribution and control business unit in 1994, the company contracted with Ernst & Young to prepare fair market value studies of its tangible and intangible assets. EY used those studies as the basis for a 1995 transfer pricing report, which drew conclusions similar to those of the Hatch report. Eaton used the E&Y analysis as the basis for its transfer pricing with the Puerto Rican operations until the end of 2000, he noted.

New Transfer Pricing Method

However, when Eaton conducted a functional analysis for the purpose of its APAs, Gearhart said, it switched to a new transfer pricing method. From 1995 through 2000, Eaton characterized EEI as the entrpreneurial risk-taker entitled to residual profits and designated its Puerto Rican operations as the tested party.

From 2001 through 2006, Eaton characterized the Puerto Rican operations as the entrepreneurial risk-taker entitled to residual profits and designated EEI as the tested party.

That change was based on Eaton's functional analysis conducted in 2002, he said, but that analysis “does not appear to be complete or reliable.”

Gearhart pointed out that in preparing that analysis, Eaton relied on interviews with only four employees, while Hatch conducted an exhaustive study, interviewing more than 90 employes in a dozen locations.

The four employees interviewed by Eaton “may not have had enough knowledge and experience in the functional areas to complete a reasonably accurate functional analysis,” he said. But even if they were knowledgeable, he said, Eaton had “refused to divulge the questions asked or the answers to those questions.”

Similarly, he said, Eaton updated its functional analysis in 2005 and 2006, in support of the renewal APA, but it declined to provide documentation for those updates.

The most significant change to the updated functional analysis, he said, was that all the technology intangibles were now owned by EEI and licensed to CHC and CHEC. Because of the sunset of Section 936, he noted, the manufacturing intangibles that Eaton subsidiary EEPR had purchased directly from Westinghouse were owned by EEI as of the end of 2005.

Gearhart noted that in the EY transfer pricing study, the manufacturing intangibles were considered a “significant value driver” and additional profits were allocated to the Puerto Rican operations because of them.

Issue With APA Fundamentals

Ultimately, Gearhart took issue with a fundamental aspect of the APAs. He concluded that the EEI U.S. distribution function and tangible property transactions could not be “carved out” from EEI and viewed in isolation. Doing so ignores the fact that EEI bears “the vast majority” of its electrical products portfolio burden, he said. Further, he said:

• EEI manages and controls the worldwide business;

• it owns key brand intangible assets, and directs and invests in all other marketing and brand-related activities and assets for the U.S. market;

• it is not properly characterized as a routine distributor, but is the owner of the valuable electrical distributor network; and

• allocating the high-volume, high-profit breaker products to CHC and CHEC reduces their economic risk and increases the risk borne by EEI.

 

“The Taxpayer selected and applied what it referred to as the CUP and the CPM method in determining the appropriate targeted profit for EEI associated with the importation and resale of CHC and CHEC Products,” Gearhart said. “As noted earlier, the Taxpayer's functional analysis documentation identified the specific transactions using ostensibly acceptable methods when viewing these transactions in isolation. However, as we have determined in this report and Dr. Hatch's report, the functional analysis documentation presented by the Taxpayer was incomplete or unreliable.”

Yet nothing in Gearhart's report explains why the IRS accepted the fundamental presumptions of the APAs in the first place. Given the breadth of the objections, the IRS documents leave two key questions unanswered:

• How was it that the IRS failed to identify any of these issues in reviewing either Eaton's initial or renewal applications?

• Why did the IRS pay little heed to economist Richard Bauman's May 11, 2006, memo questioning the attribution of profits to the Cayman Island's subsidiaries?

 

More than seven months later, on Dec. 20, 2006, the IRS signed off on Eaton's renewal APA. This time the document was restricted to a single transaction--the sale of breaker products from CHC to EEI--but Eaton's two-step transfer pricing method for the tangible goods was virtually unchanged.

 

To contact the reporter on this story: Dolores W. Gregory in Washington at dgregory@bna.com

To contact the editor responsible for this story: Molly Moses at mmoses@bna.com