Cancellation of APA for Failure to Meet Terms and Conditions Reviewed on Abuse of Discretion Standard (7/10/13)

One of the major IRS initiatives for a number of years is to enter Advance Pricing Agreements ("APAs) with taxpayers to determine, in advance, transfer pricing methodologies.  APAs require taxpayer representations as to underlying facts and conditions and taxpayer economic studies justifying the methodology requested.  The IRS reviews the presentations, performs such testing and economic studies as it deems appropriate, and then attempts to reach an agreement with the taxpayer.  Those agreements are contracts, but do incorporate the terms of the relevant Revenue Procedure (currently Rev. Proc. 2006-9, 2006 IRB 1).  Among the provisions of the Rev. Proc. is the IRS authority to terminate the APA is the terms and conditions are not met.

In Eaton Corp. v. Commissioner, 140 T.C. No. 18 (2013), here, the IRS revoked the taxpayer's Advance Pricing Agreement.  Tax Court was presented the following arguments:

Taxpayer argument:  The APA is a contract and, if the IRS terminates for failure to meet the terms and conditions, the IRS bears the burden of establishing that the taxpayer failed to meet the terms and conditions.

IRS argument:  The taxpayer must show abuse of discretion for the IRS decision to terminate the APA.

Holding:  For the IRS.  Taxpayer must establish abuse of discretion.

Here are the key excerpts that show the line of reasoning (some footnotes omitted):

Here, the cancellations are administrative determinations necessary to determine the merits of the deficiency determinations. We will review the cancellations for abuse of discretion. The parties agree that respondent established the APA program pursuant to his authority to administer the Code and "prescribe all 'needful rules and regulations.'" See sec. 7803(b)(2)(A); Commissioner v. Engle, 464 U.S. 206, 226-227 (1984) (quoting section 7805(a)). The Commissioner promulgated the applicable revenue procedures to administer the APA program. Petitioner and respondent each agreed by entering into the APAs at issue that the administration and legal effect of the APAs at issue would be governed by the applicable revenue procedures. The applicable revenue procedures provide that the Commissioner will not exercise his discretion under section 482 to adjust income if the taxpayer complies with the terms and conditions of the APAs. See Rev. Proc. 2004-40, sec. 9.02, 2004-2 C.B. at 61; Rev. Proc. 96-53, sec. 10.02, 1996-2 C.B. at 383. 

The applicable revenue procedures detail the limits on respondent's discretion to administer the APAs at issue. Respondent could require petitioner to establish good faith compliance with the terms and conditions of the APAs, the validity and accuracy of material representations in the annual reports required by the APAs and the satisfaction of critical assumptions set forth in the APAs. Rev. Proc. 2004-40, sec. 10.03(2), 2004-2 C.B. at 62; Rev. Proc. 96-53, sec. 11.03(2), 1996-2 C.B. at 384. Respondent could revoke, cancel or revise the APAs at issue if petitioner failed to comply with any of those requirements. Rev. Proc. 2004-40, sec. 10.03(3); Rev. Proc. 96-53, sec. 11.03(3). Respondent could also cancel the APAs at issue due to petitioner'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. Rev. Proc. 2004-40, sec. 10.06(1), 2004-2 C.B. at 63; Rev. Proc. 96-53, sec. 11.06(1), 1996-2 C.B. at 385. 

The APAs at issue are agreements subject to the discretion reserved to respondent by the applicable revenue procedures. Respondent exercised that administrative discretion by canceling the APAs at issue. The cancellations therefore were administrative determinations. The deficiencies resulted from the cancellations that disregarded the previously agreed to transfer pricing methodology for the covered transactions. Respondent then adjusted petitioner's income under section 482 and issued a deficiency notice. Respondent could not have altered the transfer pricing methodology had the APAs at issue remained effective. We hold that our deficiency jurisdiction includes reviewing the cancellations because they are necessary to determine the merits of the deficiencies.n4 The relevant inquiry is whether respondent abided by the self-imposed limitations set forth in the applicable revenue procedures. We consequently will review respondent's cancellations for abuse of discretion.
   n4 Petitioner's assertion that general contract law governs the APAs at issue conflicts with the parties' agreement that the legal effect and administration are governed by the applicable terms of the revenue procedures. Petitioner ignores the fact that the applicable revenue procedures reserve respondent's discretion  [*15] to administer the APAs at issue.

* * * * 

Petitioner nonetheless contends that respondent's discretion, reserved by the terms of the APAs at issue, is also subject to general contract law principles because respondent has described an APA as a "binding contract." See, e.g., Announcement 2011-22, 2011-16 I.R.B. 672. We disagree. Indeed, a taxpayer may rely on the Commissioner's revenue rulings. See, e.g., Alumax, Inc. v. Commissioner, 109 T.C. 133, 162 n.12 (1997), aff'd, 165 F.3d 822 (11th Cir. 1999). Petitioner and respondent are bound to the terms upon which they agreed. The APAs at issue provide that the applicable revenue procedures shall govern their legal effect and administration. The applicable revenue procedures reserve to respondent discretion to cancel the APAs at issue in certain circumstances. We are unpersuaded that the description of APAs as contracts renders ineffective the explicit terms and conditions that petitioner and respondent agreed govern the APAs at issue. 

Petitioner also contends we must apply general contract law principles to review the cancellations because we have done so to interpret other Commissioner-taxpayer agreements. See, e.g., Smith v. Commissioner, T.C. Memo. 1989-87. This argument is inapposite. Here, we are not asked to determine whether the parties entered into the APAs at issue or to interpret an ambiguous term. The parties agree that they entered into the APAs at issue and dispute only whether there was a factual predicate for the cancellations. The APAs at issue provide that their legal effect and administration are governed by the applicable revenue procedures. The applicable revenue procedures reserve to respondent discretion to cancel the APAs at issue in certain circumstances. Consequently, petitioner and respondent are bound to the terms and conditions of the APAs at issue. 

IV. Conclusion 

In toto, we agree with respondent that the cancellations of the APAs are reviewed for abuse of respondent's discretion. We will grant respondent's motion for partial summary judgment and concomitantly deny petitioner's motion for partial summary judgment. A trial will be scheduled in due course.

I have stated the holding as being that the taxpayer must establish the abuse of discretion rather than that the IRS must establish that it did not abuse its discretion.  The Court did not say it that way, but I think that is the way to state it crisply.