A Look Into the IRS’s Reasoning in the Eaton Corp. Case


 


As the Eaton Corp. case moves toward trial, Transfer Pricing Report staff writer Dolores W. Gregory examines several U.S. Tax Court documents that may shed some light on the IRS’s decision to cancel the company’s advance pricing agreement. An excerpt from her story appears below.

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.

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.

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.

 

 The full story appears in the Feb. 20 issue of Transfer Pricing Report. For a free trial of the publication, visit http://www.bna.com/Transfer-Pricing-Report-p7899/