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Aug. 17 — Eaton Corp. plans to call a former high-ranking Internal Revenue Service official to bolster its arguments that the agency abused its discretion in canceling two advance pricing agreements with the company.
Former APA Director Sean Foley is one of seven experts Eaton will call to testify during its transfer pricing trial, which starts Aug. 24 in Chicago.
Foley, who served as APA director from 2000 to 2002, will testify that the IRS had “no permissible basis for canceling the APAs,” the company said in a pretrial memorandum filed Aug. 10 in the U.S. Tax Court. Foley is now global transfer pricing leader at KPMG LLP.
According to the memorandum, Foley's expertise includes “the processes the IRS follows in reviewing and negotiating APA applications, responding to mistakes made by taxpayers in their APA annual reports and approaching APA, amendment, and revocation.”
He will testify that the IRS typically responds to mistakes in an APA annual report by requiring taxpayers to amend the reports or to amend the APA itself, rather than canceling the agreement outright.
Eaton, a $16 billion manufacturer of heavy equipment, is challenging the cancellation of its APAs for tax years 2001-05 and 2006-10.
Under an APA, a taxpayer enters into an agreement with one or more taxing authorities to establish a pricing method a specific set of related-party transactions to show the arrangements don't improperly shift taxable income to other jurisdictions. In Eaton's case, the APA was unilateral—with the IRS alone—and covered the production and sale of circuit breakers and electrical control products manufactured in Puerto Rico by a Cayman Islands affiliate.
As a result of the cancellations, the company is subject to an income adjustment of $368.5 million for tax years 2005-06 and a potential deficiency of $127 million in tax and penalties.
The tax bill could be even higher if the IRS prevails. In a separate action filed Nov. 25, Eaton is challenging income adjustments of more than $1 billion for tax years 2007 through 2010; the bulk of the adjustments are related to the cancellation of the APAs.
The IRS claims that Eaton intentionally deviated from the terms of the APAs and deliberately misstated its transfer pricing. In an April 5, 2014, court filing, the agency cited discrepancies between the transfer prices reported in Eaton's APA annual reports and the transfer prices reported on its federal tax returns.
• the IRS was aware of the allegedly omitted or misstated facts during the APA negotiations and debated these issues with the company and internally among its APA teams;
• none of the allegedly omitted or misstated facts could have been material because “it is undisputed” that the facts the IRS relies on in supporting its alternative transfer pricing method were disclosed and reviewed by the agency during the negotiations for the APAs;
• the company previously identified and corrected the errors it made in computing the transfer pricing under the agreed-upon APA method—but those errors only affected the price by immaterial amounts, ranging from an understatement of 0.9 percent to an overstatement of 3.5 percent in the 2005-08 tax years; and
• the remaining alleged implementation errors aren't mistakes and don't indicate any deliberate effort by the company to improve its tax position.
“The objective evidence strongly suggests that the IRS just changed its mind about participating in the APA,” Eaton said, noting that both APA teams—which included members of the IRS exam team—had members with strong dissenting views.
On Aug. 10 the IRS also filed a pretrial memorandum in which it took issue with Eaton for what it described as ongoing failures during discovery.
It also charged that Eaton had violated an April 24 court order to submit an issues memorandum that included a “statement in narrative form of what each party expects to prove” at trial. The issues memo filed by Eaton in June didn't include that narrative, the IRS said.
However, the expert reports submitted by the company show that it plans to present testimony that goes far beyond the scope of its issues memorandum, the IRS said, noting that it planned to raise objections or seek evidentiary sanctions if Eaton did so.
The IRS also identified half a dozen expert witnesses for trial, including a forensic accounting expert, John Garvey, who the IRS said will testify to errors of method and logic in Eaton's original APA annual reports for 2005 and 2006.
When corrected, the calculations changed results for the company and put it outside the agreed-on range of profitability, the IRS said.
• relevant Eaton consolidated financial statements for financial reporting and statutory tax purposes don't include the errors, alterations and assumptions applied to the data used in the company's APA reports;
• a consolidated view and analysis of system profit overcomes potential distortions within entity level accounts that can be affected by intercompany prices and value generating activities not properly reflected at the entity account level; and
• under most scenarios in 2005 and 2006, the manufacturing operations in Puerto Rico realized more than 100 percent of system profits associated with the electrical products, while the U.S. operations within the value chain experienced significant losses in both years.
Eaton is represented by Raj Madan of Skadden, Arps, Slate, Meagher & Flom LLP and by Joel V. Williamson of Mayer Brown LLP. The IRS is represented by John M. Altman, deputy area counsel with the IRS Office of Chief Counsel.
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Eaton Corp.'s pretrial memorandum, including its fact and expert witnesses, is at http://pub.bna.com/ptcj/txc15081801.pdf.
The IRS's pretrial memorandum, including the list of fact and expert witnesses, is at http://op.bna.com/der.nsf/r?Open=dhan-9zhsne .
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