Executive summary: Sixth Circuit Issues ruling in Eaton Case
On Aug. 25, 2022, the Sixth Circuit Court of Appeals issued its decision in Eaton Corp. & Subs. v. Commissioner, ruling in favor of Eaton Corporation. The Sixth Circuit held the IRS did not have grounds for canceling the advance pricing agreements it made with the corporation and provided Eaton the opportunity to file for relief under Rev. Proc. 99-32. The Court also denied the issuance of penalties section 6662 against Eaton.
On Aug. 25, 2022, the Sixth Circuit Court of Appeals (“Sixth Circuit”) issued its decision in Eaton Corp. & Subs. v. Commissioner,1 ruling in favor of Eaton Corporation (“Eaton”). The case came before the Sixth Circuit after the IRS appealed the Tax Court’s decision that the IRS wrongfully canceled the advanced pricing agreements (“APAs”) it entered with Eaton. In its decision, the Sixth Circuit held that the IRS had the burden of proof in showing there were grounds to cancel Eaton’s APAs and failed to meet that burden. As a result, the Sixth Circuit held the IRS could not impose section 6662 penalties on Eaton and that Eaton could file for relief under Rev. Proc. 99-32.
At issue in the case were a pair of APAs between the IRS and Eaton that governed Eaton’s tax calculations for related party transactions from 2001 through 2010. Eaton, an Ohio corporation, manufactures electrical and industrial products both in the U.S. and abroad. During 2005 and 2006, the tax years at issue in the case, the products were manufactured offshore by Eaton’s foreign subsidiaries in Puerto Rico and the Dominican Republic and then sold to both related and unrelated customers. These transactions were governed by two separate APAs that laid out the agreed upon transfer pricing methodology and appropriate returns. In 2007, the IRS began auditing Eaton’s 2005 and 2006 tax returns. Two years later, the IRS extended its review to the two APAs. Eaton conducted its own review and found a series of inadvertent miscalculations that translated into deflated tax liability, which it disclosed to the IRS and subsequently corrected by filing amended returns. Despite the remedial steps taken by Eaton, the IRS canceled the APAs for 2005 and 2006 citing “material deficiencies in APA compliance” for the miscalculations and sent a notice of deficiency to Eaton for over $75 million. Additionally, the IRS assessed penalties under section 6662 of over $50 million.
Eaton filed a petition in United States Tax Court in early 2012. In early proceedings, the Tax Court held that Eaton bore the burden of proving the IRS abused its discretion in canceling the APAs, rejecting Eaton’s argument that contract law principles applied that would have shifted the burden to the IRS. When the case finally went to trial in 2017, the IRS raised 17 justifications for canceling the APAs. In its 202-page opinion, the Tax Court rejected all 17 grounds advanced by the IRS for canceling the APAs and found Eaton met its burden of showing that the inadvertent calculation errors did not rise to the requisite level of materiality. The Tax Court also rejected the IRS’s claim for penalties under Section 6662 because the self-reported corrections did not constitute section 482 adjustments as required by law. Consistent with that ruling, the Tax Court also denied Eaton’s motion for relief under Rev. Proc. 99-32. The IRS appealed this ruling, and Eaton cross-appealed to reassert its claim for relief under Rev. Proc. 99-32.
The Sixth Circuit reached the same conclusions as the Tax Court on both the wrongful cancellation and penalties issues but came to its decision under different reasoning. On the wrongful termination claim, the Court held that the burden of proof for canceling APAs lies with the government. In its ruling, the Sixth Circuit agreed with Eaton’s original argument that general contract law principles should govern the termination of APAs. Under those contract law principles, the IRS does not have unilateral discretion to conclude a condition for cancellation is satisfied, and instead must prove a condition exists before canceling an agreement. Under this new approach, the IRS failed to advance proof that Eaton’s inadvertent miscalculations rose to the level of materiality needed to justify canceling the APAs.
With respect to the penalties under section 6662, the Sixth Circuit held that the Tax Court erred in holding self-reported corrections were not section 482 adjustments. The Court found that self-reported corrections did constitute section 482 adjustments because the APAs are extensions of the IRS’ allocation authority under section 482. However, in this case, the IRS forfeited its right to impose penalties because it asserted the claim post-trial based on an entirely different set of calculations than what was articulated during the original trial. Based on this new reasoning, the Sixth Circuit ultimately concluded that since the self-reported corrections were in fact section 482 adjustments, Eaton was entitled to relief under Rev. Proc. 99-32. The relief under Rev. Proc. 99-32 would provide Eaton relief from double taxation.
APAs continue to offer a proactive approach for taxpayers to gain greater certainty regarding tax exposure and mitigate costs associated with the preparation of transfer pricing documentation and audit defense. In recent years, taxpayers have increasingly utilized APAs as the preferred transfer pricing dispute mechanism as they provide taxpayers with a non-adversarial alternative and proactive process to resolve transfer pricing disputes. While the ruling in Eaton Corp. is fact-specific and should not be used to draw conclusions on other canceled APAs, it does provide several key takeaways for individuals with APAs. The ruling does confirm that APAs are in fact contracts between the taxpayer and the IRS, and as such general contract law principles govern. It also affirms the IRS has the burden of proving grounds exist to cancel an APA, and that it does not have unilateral discretion to do so. These takeaways should encourage taxpayers to continue to seek APAs in the future.