Eaton Corp. and Subsidiaries v. Commissioner of Internal Revenue,
No. 21-1569 (6th Cir. 2022)
The Sixth Circuit Court of Appeals in Eaton Corp. v. Commissioner has resolved a longstanding dispute over the cancellation of two advance pricing agreements (APAs) by the Internal Revenue Service (IRS). While this ruling was from August 2022, given the increased focus by the IRS (and foreign taxing jurisdictions) in the transfer pricing area, this ruling has widespread applicability during the planning phase of strategic tax initiatives.
Specifically, the Sixth Circuit sided with Eaton on all fronts, marking a victory for taxpayers who seek certainty in their transfer pricing through unilateral APAs. The case stemmed from a contract dispute between Eaton and the IRS, where the latter canceled the APAs after Eaton discovered calculation errors and filed amended tax returns. While the errors decreased Eaton’s tax liability, the annual reports it filed pursuant to the APAs contained the correct prices calculated in accordance with the transfer pricing methodology (TPM) in the APAs.
The Tax Court initially reviewed the case and held that it was an abuse of discretion for the IRS to cancel the APAs. While the Sixth Circuit agreed with the Tax Court’s decision, it imposed a higher burden of proof on the IRS. The court found that an APA is a contract and required the IRS to prove the exception that allows it to back out of contractual promises under contract law principles. Thus, the terms of the APAs controlled, and the IRS failed to show that the cancellation of the Eaton APAs was authorized by reference to their terms.
The Sixth Circuit’s ruling established that the grounds for cancellation were found in the exhaustive lists provided under the “Canceling the APA” section of each Revenue Procedures, which governed the APAs. The court also looked to the definition of material facts in the Revenue Procedures and contract law principles to conclude that none of Eaton’s errors or purported omissions rose to the requisite materiality level.
The case also addressed whether the IRS forfeited its imposition of penalties based on Eaton’s self-adjustments and whether Eaton was entitled to relief from double taxation resulting from its self-adjustments. The Sixth Circuit found that the IRS forfeited its penalties claim based on Eaton’s self-initiated adjustments by failing to raise it before or at trial.
This is a significant win for taxpayers seeking certainty in their transfer pricing through advance pricing agreements (APAs). The Sixth Circuit held that the IRS did not carry its burden of proving that cancellation of the APAs was authorized under contract law principles, thereby confirming that once the IRS enters into an APA, it is bound by the terms of the agreement it negotiated. This decision serves as an important reminder that the terms of the APA, including applicable Revenue Procedures, control in determining whether the IRS had grounds to cancel the agreement. Moreover, this case clarifies the high bar that the IRS must meet when seeking to cancel an APA and highlights the importance of maintaining accurate calculations and reporting under APAs to avoid potential disputes with the IRS.
If you have any questions about global business or transfer pricing issues, please do not hesitate to reach out to McGuire Sponsel’s Global Business Services team.
Jason Rauhe, CPA is a Principal in the firm’s Global Business Services practice and is responsible for assisting clients and adding depth in all areas of the firm’s international tax consulting services including transfer pricing, and the firm’s compliance expertise.
Rauhe previously served as Director of International Tax at a Top 100 CPA Firm, where he was responsible for the firm’s international tax division and major industry alliance networks.