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By Craig A. Sharon, Esq.
Bingham McCutchen LLP, Washington, DC
As most transfer pricing professionals know, Eaton Corporation filed a petition with the Tax Court in February 2012 contesting up to $370 million in proposed IRS audit adjustments (plus §6662 penalties) under §§482 and 367(d) relating to its 2005-06 taxable years.1 For the most part, the Eaton case is just "another" §936 restructuring case, a topic of significant, ongoing controversy between the IRS and taxpayers that had Puerto Rican operations prior to the phase-out of the §936 credit for taxable years beginning after 2005. These cases deal principally with two issues: (1) whether or not the value of the Puerto Rican goodwill, going-concern, and workforce-in-place was compensable under §367(d) when transferred to the taxpayer's new foreign corporation as part of a restructuring of the taxpayer's former U.S. "936 corporation;" and (2) an evaluation of the pricing of the taxpayer's post-restructuring transactions between U.S. affiliates and its new foreign corporation under §482 (typically, procurement, distribution, manufacturing, and licensing).
The Eaton case is particularly notable because it also involves the cancellation by IRS Chief Counsel of part or all of two Eaton APAs: the last year of Eaton's original APA (2005) and the company's entire renewal APA (2006-10). If the Tax Court upholds the IRS cancellations, the transactions covered by the APAs would become subject to a substitute IRS analysis that produces the proposed adjustments at issue in the Tax Court.2 But if the Tax Court reverses the cancellations, the odds are high that most of the IRS adjustments will go away.
Given the stakes, it is not surprising that Eaton is attacking the APA cancellations in the Tax Court. In June, the company filed a motion for partial summary judgment asking the Tax Court to enforce the APAs as "binding contracts" and apply "ordinary contract principles" to allocate the burden of proof on the APA cancellation issue to the IRS. In early August, the IRS filed a set of documents opposing Eaton's summary judgment motion and asking the Tax Court, in a cross-motion for partial summary judgment, to impose on Eaton the burden of proving that the IRS "abused its discretion" in canceling the APAs.
The basic issue raised by the dueling motions for partial summary judgment deals with the "finality" of APAs. That issue is virgin territory for APAs, but well-trod ground in other contexts, e.g., letter rulings, Forms 870 and 870-AD, and closing agreements under §7121. Each of these settlement processes has its own governing rules that address, among other things, the "legal effect" of the process and the circumstances in which an executed agreement can be modified, revoked, or set aside by a taxpayer, the IRS, or the courts. The applicable rules can be found in the Code, regulations, revenue procedures, definitive agreements, and other IRS documentation.
The principal operative rules for APAs are found in the APA document itself and the APA revenue procedure incorporated by reference into an APA - currently, Rev. Proc. 2006-09,3 but Rev. Proc. 96-534 in the case of Eaton's original APA and Rev. Proc. 2004-40 in the case of Eaton's renewal APA.5 The provisions in the two APA revenue procedures applicable to Eaton's APAs are virtually identical. Of particular relevance, Rev. Proc. 2004-40 provides as follows:
Section 9.01: An APA is a binding agreement between the taxpayer and the Service. …
Section 9:02: If the taxpayer complies with the terms and conditions of the APA, the Service will not contest the application of the [transfer pricing method] to the subject matter of the APA except as provided in this revenue procedure. …
Section 10.06(1): [IRS Chief Counsel] may cancel an APA due to the failure of a critical assumption, or due to the taxpayer's misrepresentation, mistake as to a material fact, failure to state a material fact, failure to file a timely annual report, or lack of good faith compliance with the terms and conditions of the APA. [IRS Chief Counsel] will consider facts as material if, for example, knowledge of the facts could reasonably have resulted in an APA with significantly different terms and conditions. …
Section 10.06(2): [IRS Chief Counsel] may waive cancellation if the taxpayer can satisfactorily show good faith and reasonable cause and agrees to make any adjustment proposed to correct for the misrepresentation, mistake as to a material fact, failure to state a material fact, or noncompliance. [IRS Chief Counsel] is not required to cancel the APA and may require the taxpayer to continue abiding by it.
The APA administration rules set forth in the APA revenue procedures, e.g., Rev. Proc. 2004-40, §10, are detailed and comprehensive.
So where do APAs fit into the existing stable of IRS settlement agreements?
Most importantly, for all the reasons set forth in the IRS' objection to Eaton's summary judgment motion, APAs are not closing agreements under §7121.6 That determination is critical because §7121 closing agreements are the only "final and conclusive" IRS settlement agreement and, as such, may not be reopened, modified, disregarded, or set aside in any legal suit or administrative proceeding, except on a showing of fraud, malfeasance, or misrepresentation on the part of the IRS or the taxpayer. No question, if an APA constitutes a closing agreement under §7121, Eaton's APAs would be cancelable only if the IRS could establish that Eaton had engaged in near-criminal behavior, a much tougher threshold to satisfy than the cancellation criteria set forth in Rev. Proc. 2004-40, §10.06(1), as set forth above.
Eaton does not claim in its motion that APAs are closing agreements, although the various references to such agreements in the motion obscure the issue. Specifically, Eaton argues that an APA, as characterized by the IRS, is a "binding agreement," that such an "agreement" is equivalent to a "contract," and that an APA, as a "binding contract," should be interpreted and enforced applying "ordinary contract principles." Eaton then limits the implications of these arguments to the burden of proof issue, omitting any discussion of the broader legal consequences that turn on the characterization of an APA as something other than a formal closing agreement. With an eye on the larger effects, the IRS argues, first and foremost, that APAs are not closing agreements under §7121.
Under the IRS analysis, APAs should be treated like any other settlement process that does not qualify as a formal closing agreement under §7121. These informal settlement processes include, as noted above, letter rulings and Forms 870 and 870-AD, along with certain pre-filing agreements (PFAs).7 As common and important as these "non-statutory" processes are to tax administration, none is binding as a matter of law on the IRS, taxpayers, or the courts unless incorporated into a closing agreement. That's true even when the settlement terms are incorporated into a writing that would otherwise seem to qualify as an enforceable promise under common-law contract principles.
The IRS objection to Eaton's motion describes the finality (or not) of APAs as follows: The fact that the Original and Renewal APAs are not closing agreements has real consequences for [the IRS] as well as for Eaton. For the same reasons that Eaton cannot secure [Tax] Court enforcement of the Original and Renewal APA against [the IRS, the IRS] could not secure Court enforcement … against Eaton. In the latter circumstance, [the IRS] would have to do precisely what [it] did here: exercise [its] discretion to cancel the Original and Renewal APAs, and thereafter make I.R.C. §482 adjustments by notice of deficiency and defend those adjustments in litigation, without relying upon either the canceled APAs or any non-factual oral or written representations or submissions made by Eaton during the APA process.8
A similar characterization of Forms 870 and 870-AD as non-statutory closing agreements has led to considerable controversy. Both forms are used to settle non-docketed cases at IRS Appeals, but they differ in at least one relevant respect: The Form 870 functions merely as a waiver of restrictions on assessment and does not prevent: (1) a taxpayer from subsequently filing a claim for refund; or (2) the IRS from subsequently making an additional assessment of tax. In contrast, the Form 870-AD contains language that precludes both the taxpayer and the IRS from reopening the case except in specified circumstances more similar to closing agreements than APAs (e.g., fraud, malfeasance, or concealment or misrepresentation of a material fact). Despite the clear language in the Form 870-AD prohibiting refund claims, many taxpayers have filed subsequent claims and refund suits. The outcomes of these cases have varied, with most courts barring such claims on equitable estoppel grounds,9 but with some allowing taxpayers to proceed on the ground that Forms 870-AD are not closing agreements under §7121 and that closing agreements are the only legal means for settling tax issues with finality.
Similar controversy has surrounded the finality of letter rulings, which are no more binding on the IRS or taxpayers than a Form 870-AD.10
Based on the foregoing, and given the absence of any clear limiting language in the IRS quotation above, the IRS position could be interpreted to mean that the IRS or a taxpayer could terminate an executed APA almost at will. That is not true, and it is also not what the IRS was suggesting.
There are at least two recognized limits on the right of the IRS or a taxpayer to disregard an informal settlement. As noted above, the first limit is the potential application of equitable estoppel, which affects both the IRS and taxpayers. In general, if one party to an APA could demonstrate significant prejudice from the other party's failure to abide by the APA, the other party may be estopped from disregarding the agreement on equity grounds. This argument may be harder to assert in an APA setting than for Form 870-ADs, given that the statute of limitations for assessment for all years in an APA (unlike years covered by a Form 870-AD) are supposed to remain open until after the full APA term has expired.11 Thus, if the IRS or a taxpayer disregards an APA mid-term, the other party should have the ability to protect its interests, as described in the IRS response to Eaton's summary judgment motion.
The "equities" might play out differently, however, in a bilateral context because the termination of a U.S. APA, absent a correlative agreement with the foreign tax authority, would likely produce double taxation on the taxpayer or double non-taxation from the IRS perspective. That "prejudice" may be enough to hold the terminating party to the APA.12 Although the Eaton APAs are unilateral, about 80% of all APAs are now bilateral, so an effective estoppel argument for bilateral APAs would significantly limit the number of potentially cancelable APAs.
A second potential limit applies to retroactive cancellations by the IRS, as happened to Eaton. Section 7805(b) has been interpreted as limiting the IRS's ability to cancel or revoke rulings retroactively.13 Courts have generally upheld retroactive cancellations as long as the IRS has not "abused its discretion." In general, the IRS' own pronouncements as to when it will honor a ruling circumscribe its permissible discretion. In the case of APAs, the relevant pronouncement would be the provisions in the APA revenue procedure that identify the circumstances in which the IRS may amend, cancel, or revoke an APA (e.g., §10 in Rev. Proc. 2004-40).
The IRS's cross-motion for partial summary judgment discusses the §7805(b) limitation, both in referencing the "abuse of discretion" standard as the operative standard of review and in referring to the specific criteria in the APA revenue procedures as justification for the IRS's cancellation of the APAs. The IRS Chief Counsel letter to Eaton canceling the APAs also makes clear (even if insufficiently detailed) that the IRS was applying the APA revenue procedure criteria in canceling the APAs.14 Together, the IRS documents confirm that the IRS is not walking away in the Eaton case from the specific terms and conditions of the actual APAs, and thus is not following a new, unannounced policy to cancel APAs even if none of the criteria prescribed in the APA revenue procedure for cancellation is present.
That is good news for taxpayers and the APA process. Still, many taxpayers and transfer pricing professionals will react to the IRS analysis by arguing that the IRS has become an unreliable partner in the APA process and that taxpayers with APAs are now at risk of losing the certainty and other benefits of their agreements. The mere disclosure of the APA cancellations has already led some commentators to predict the demise of the program.15 I would be sympathetic to those arguments if the IRS had not been rigorously enforcing the terms and conditions of APAs for the past 20 years, with only a handful of cancellations to date (and no litigation about such cancellations until now). As APA Director, I told many taxpayers, especially in the aftermath of the economic downturn in 2008-09, that a "deal is a deal" in rejecting their requests to re-open an existing APA in the absence of a special critical assumption on point - i.e., we strictly followed the terms of the APAs, as the APA Program has always done.
I cannot predict how the Tax Court will rule, if given the chance, on the merits of the IRS's cancellations of the Eaton APAs. Nor do I care much about how the Tax Court rules on the burden of proof issue since I am certain that the court will find a way, as it always does, to reach the merits if it wants to do so. My principal concern is that the Tax Court, whether it upholds or reverses the cancellations based on the specific facts and circumstances, will adopt a legal position that allows taxpayers or the IRS (less likely) to back out too easily from their APAs. After all, a deal is a deal.
This commentary also will appear in the October 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Levey, Carmichael, van Herksen, Patton, Levi, Krupsky, and Kellar, 890 T.M., Transfer Pricing: Alternative Practical Strategies (Chapter 8, "Advance Pricing Agreements"), and in Tax Practice Series, see ¶3600, Section 482 - Allocations of Income and Deductions Between Related Taxpayers.
1 Eaton Corp. v. Comr., T.C. Docket No. 5576-12, petition filed Feb. 29, 2012. The IRS Answer was filed on May 7, 2012. In the interest of full disclosure, I was APA Director when the IRS began the 2005-06 audit, but I was only peripherally involved in the internal IRS discussions and left the APA Program before the IRS canceled the APAs. This commentary expresses no opinion about the likely outcome of the litigation.
6 To the extent consistency matters, it is worth noting that more than a decade ago the IRS agreed in the midst of "APA disclosure" litigation with BNA and Tax Notes to characterize APAs as a form of letter ruling. Before the IRS could disclose any agreement, Congress stepped in to create a new category of "return information" protecting APAs from disclosure. See §6103(b)(2)(C). The IRS could have argued (but did not, to my knowledge) that APAs are closing agreements, a separate category of return information not required to be disclosed. See §6103(b)(2)(D).
7 Unlike the APA revenue procedure, which describes an APA only as a "binding agreement," the revenue procedure for PFAs characterizes a PFA as: (1) a formal closing agreement if applicable only to the current year or past years for which no return has been filed; or (2) a "non-statutory … binding contract" if applicable to any future year. Rev. Proc. 2009-14, 2009-3 I.R.B. 324, at §7.02.
9 In Botany Worsted Mills v. U.S., 278 U.S. 282, 289 (1929), the Supreme Court held that a Form 870-AD was not final on a taxpayer or the IRS, but left open whether or not the form, "though not binding in itself, may when executed become, under some circumstances, binding on the parties by estoppel."
11 In some of the Form 870-AD cases, courts have estopped a taxpayer from disregarding a Form 870-AD solely because the statute of limitations on assessment had run. See, e.g., Stair vs. U.S., 516 F.2d 560 (2d Cir. 1976); Union Pacific Railroad v. U.S., 847 F.2d 1567 (Fed. Cir. 1988).
12 In the case of a bilateral APA, it is clear that a taxpayer could not enforce the terms of the mutual agreement between the IRS and a foreign tax authority as an alternative to enforcing the APA, because the taxpayer is not a party to the mutual agreement. Indeed, even the IRS lacks any formal legal means (as opposed to informal arm-twisting based on treaty relations) to challenge a foreign tax authority that walks away from a mutual agreement; hence, the need in bilateral cases for an APA between the IRS and the taxpayer separate and apart from the mutual agreement. Thus, the finality issue for APAs is the same for bilateral APAs as for unilateral APAs.
14 A copy of the IRS cancellation notice, dated Dec. 16, 2011, is attached as Exhibit B to the Declaration of Michael Y. Chin, which was included in the IRS's objection to Eaton's summary judgment motion.
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