Eaton Wins Big on Appeal in Long-Running Contentious Litigation Over APAs (8/27/22)

In Eaton Corp. v. United States, 47 F.4th 434 (6th Cir 8/25/22), here and GS here, the Court gave Eaton a victory on all points of contention in long-running and highly contentious litigation over the Advance Pricing Agreement (APA). The APA is an advance agreement as to how the taxpayer will report its covered transfer pricing products or intangibles in future years so that, provided the taxpayer reports pursuant to the agreement, the IRS will not audit except to confirm reporting consistent with the agreement. (At least in earlier audits I handled, the APA methodology could be spread to past open years, if appropriate, but past years were not in issue in Eaton.)  The Court signals its holdings in its opening short paragraph:

            Taxes may well be “what we pay for civilized society,” Compania Gen. de Tabacos de Filipinas v. Collector of Internal Revenue, 275 U.S. 87, 100 (1927) (Holmes, J., dissenting), but that doesn’t mean the tax collector is above the law. This case arises from the IRS’s efforts to circumvent basic contract law.

Not an auspicious start for the IRS.

In holding for Eaton, the Court resolved the following issues.

1. In a section captioned “Wrongful Cancellation: Burden of Proof,” the Court resolved a burden of proof issue. (Slip Op. 8-12.) The IRS argued that, since it made the § 482 adjustments in the notice of deficiency because Eaton violated the APA agreement, the standard was “arbitrary and capricious.”  The Court held that, because the predicate issue was whether Eaton violated the APA, the issue is one of contract interpretation as to whether Eaton breached the contract. (Under that notion, only If Eaton breached the contract, would Eaton then have the burden to prove that the IRS’s § 482 adjustments were arbitrary and capricious.)  As to the contract interpretation issue, the IRS bore the burden of proving that Eaton had breached the contract.

2. On the issue of whether Eaton violated the contract, the Court held (Slip Op. 12), applying contract law, that Eaton had not breached the agreement and therefore the IRS did not have the right to cancel the contract and issue the notice of deficiency with § 482 adjustments.

3. The Court held that the IRS could not impose the § 6662(h) penalty (asserted 18 months after trial) based on Eaton's self-corrections by amended returns to adjust for unintentional errors in the original return calculations for the agreements in the APA. (Slip Op. 19- .) Before trial, the IRS had asserted § 6662(h) penalty based on its own § 482 adjustments in the notice of deficiency; the penalty asserted after trial relied on Eaton’s calculations in the amended returns. The issue turned, according to the Court, on whether the penalty asserted after trial was the same as the penalty asserted before trial. (I won’t get into why that was important.) The Court held that the penalty asserted after trial was not based on the same adjustments (IRS adjustments vs. Eaton’s self-correcting adjustments) and therefore could not be raised after trial. By raising the § 6662(h) penalty on Eaton’s self-correction amended returns, the IRS had forfeited the right to assert the penalty.

4. In the course of holding in paragraph 3, Court held that Eaton’s self-corrections are § 482 adjustments, reasoning (Slip Op. 20.)

             Section 482. The threshold question is whether Eaton’s self-corrections count as § 482 adjustments. They plainly do. Treasury Regulation § 1.6662-6(c)(1) defines “net section 482 adjustment” as “the sum of all increases in the taxable income of a taxpayer for a taxable year resulting from allocations under section 482” minus “collateral adjustments.” Section 482, of course, is what gives the IRS the power to compel transfer-price adjustments in the first place, which is what this case is all about. In ruling otherwise, the Tax Court offered only a perfunctory explanation: Eaton’s self-corrections could not constitute § 482 adjustments because they were made under APAs that remained in effect. (R. 807, Oct. 28, 2019 Order, pp. 11-12 (holding that because “the APAs remained in effect,” “[t]here was no allocation of income and deductions by the Secretary pursuant to section 482”).)

            But the Tax Court never explained why that distinction matters. Nor did it cite any authorities to that end. In fact, the APAs themselves confirm they are extensions of the IRS’s allocation authority under § 482. Each says it “contains the Parties’ agreement on the best method for determining arm’s-length prices of the Covered Transactions under I.R.C. section 482.” (R. 41, APA-I, p. 2 (emphasis added); R. 41, APA-II, p.1 (emphasis added).) Section 482 has one function: to allow the IRS to “distribute, apportion, or allocate gross income, deductions, credits, or allowances . . . if [it] determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes.” 26 U.S.C. § 482. The IRS used the APAs to effectuate this allocation authority, and Eaton’s corrections were based on those same APAs. It stands to reason that the corrections were § 482 adjustments, which means the analysis reaches the forfeiture inquiry.

4. The Court held that Eaton was entitled to double tax relief with respect to the self-corrections on the amended returns. Double tax relief prevents double taxation by treating the extra cash in the foreign subsidiaries as loans that are then repaid when Eaton repatriated the funds. The IRS denied the relief because, it claimed, the relief is available for § 482 adjustments only and the self-corrections on the amended returns arose from the APA rather than § 482 adjustments. As noted, the Court held that the APA adjustments were § 482 adjustments even though formally initiated by the taxpayer rather than the IRS.

JAT Comments:

1. I left out a lot of nuance to only hit the key points. I hope I have given enough and fairly presented enough that practitioners in this area will be able to understand and use as a guide to further plumbing the opinion.

2. I am not deep enough in the case to make meaningful in-depth comments. As the case is presented, the contract analysis seems rather straightforward. The IRS simply failed to prove that it was entitled to make adjustments beyond the adjustments required by the contract, the APA. I do have some discomfort with the Court’s holding that reporting consistent with the APA is a § 482 adjustment. I have always understood § 482 adjustments to be adjustments to the taxpayer’s reporting of transfer pricing transactions. In this case, the taxpayer had reported as it was contractually required to do, initially on the original returns and then on the amended returns. Those were not IRS-initiated § 482 adjustments. I am not sure that the Court’s analysis treating reporting consistent with the APA is a § 482 adjustment. I will not attempt further discourse on that issue. I have not reviewed the Government’s brief(s) to see how the Government addressed that issue, but those wanting to pursue the issue might want to do so (available on PACER).