Fresh off its success in thwarting an IRS attempt to cancel two advance pricing agreements, the emboldened Eaton Corp. has filed Tax Court petitions claiming the right to use the APA-approved transfer pricing method indefinitely.
According to a pair of Tax Court petitions filed March 3, Eaton has found itself fighting the IRS in court yet again. Less than a year ago, the company came away with a decisive win over the IRS in Eaton Corp. v. Commissioner, 47 F.4th 434 (6th Cir. 2022), aff’g in part, rev’g in part, T.C. Memo. 2017-147. In Eaton, the Tax Court and Sixth Circuit each held that the IRS couldn’t cancel Eaton’s APAs based on significant, but inadvertent, computational errors contained in the company’s annual compliance reports.
But there was no APA for the IRS to cancel for the tax years now at issue, and the monetary stakes are considerably higher than they were in Eaton. One petition challenges $172 million in deficiencies and penalties for the 2011 tax year, and the other challenges a total of $687 million for 2012 and 2013. The deficiencies relate to a wide array of income adjustments, which range from subpart F inclusions to section 482 allocations concerning interest payments, guarantee fees, and intercompany royalty charges. Together, total deficiencies and penalties assessed by the IRS for 2011 through 2013 are nearly seven times the corresponding amount in Eaton.
But the highest-stakes issue in the dispute is the pricing of what Eaton’s petitions refer to as the “islands manufacturing transactions.” These adjustments rise from about $196 million in 2011 to about $258 million in 2013 — by far, the largest category of adjustments challenged by Eaton in its two petitions. Of the $1.8 billion in total adjustments reported in the petitions for 2011 through 2013, $672 million (37 percent) is attributable to the islands manufacturing transactions. It may not be coincidental that these are the same controlled transactions covered by the two APAs that the IRS tried to cancel in Eaton: one APA issued in 2003 covering the 2001 through 2005 tax years and a 2006 renewal APA for 2006 through 2010.
Another Best Method Case?
The Eaton group’s islands manufacturing transactions fall into one of two categories, the first of which is Eaton’s purchase of industrial electrical breakers, controls, and related equipment manufactured in Puerto Rico or the Dominican Republic by Cutler-Hammer Electrical Co. (CHEC). The other is the license of intangibles from Eaton or some other U.S. group entity involved in the group’s U.S. electrical sector (EEUS) to CHEC.
The $672 million in total section 482 adjustments for the islands manufacturing transactions likely reflects a stark difference in the parties’ views on the appropriate transfer pricing method. Evidently undeterred by the IRS’s repudiation of the method it had once approved in the two APAs or the litigation that ensued, Eaton claims to have properly priced its islands manufacturing transactions for 2011 through 2013 using the same method approved by the APAs for 2001 through 2010.
The APA-approved approach applied the comparable uncontrolled price method to price breakers product purchases and corroborated the results using the comparable profits method. The corroborative CPM analysis used EEUS as the tested party and the Berry ratio (gross profit divided by operating expenses) as the profit-level indicator, reflecting the premise that EEUS was a routine U.S. distributor while CHEC was the more complex party to the transaction. To determine the royalty for EEUS’s license of intangibles to CHEC under the APAs, Eaton applied the comparable uncontrolled transaction method using what the petitions characterize as reliable transactional comparables.
Although Eaton persisted in using the APA-based approach even after the renewal APA expired, the IRS clearly did not. The petitions state the company’s belief that the IRS applied the CPM to price all of Eaton’s manufacturing transactions on an aggregate basis, using CHEC instead of EEUS as the tested party and the markup on total costs as the profit-level indicator. This approach would likely be more reliable than the APA-approved method if CHEC performed only routine manufacturing activities and was the less complex party to the transactions. It would also have the effect of allocating all residual returns to the United States.
Eaton’s Tax Court petitions, like most others, don’t delve into the company’s arguments in exhaustive detail. But the petitions raise familiar claims for this kind of transfer pricing methodological dispute. CHEC, naturally, has what Eaton portrays as an unparalleled mastery of the sophisticated and high-stakes art of electrical equipment production, rendering it inappropriate as a CPM tested party. Also, the petitions predictably suggest that the IRS resorted to a crude profit-based method when a more reliable and theoretically pure transactional method was available to price EEUS’s license of intangibles to CHEC.
These claims warrant a healthy degree of skepticism, but it’s certainly possible that they could be at least partially valid under the facts and circumstances. However, this isn’t the case for what appears to be Eaton’s primary, and certainly its most outlandish, argument for its favored method. According to the petitions, the IRS’s method violated constitutionally protected and indefinite reliance interests granted to the company by the expired APAs:
Respondent’s adjustments relating to the Islands Manufacturing Transactions are unlawful because Eaton reasonably relied upon a transfer pricing methodology that had been expressly approved by Respondent in two prior APAs, which Eaton consistently applied since its 2001 taxable year, and which have since been upheld by the Sixth Circuit. . . . Respondent’s attempt to apply a radically different transfer pricing methodology under these circumstances is arbitrary, capricious, and unreasonable and violates the Due Process Clause of the U.S. Constitution’s Fifth Amendment. [Emphasis added.]
In other words, the method approved by the IRS in the APAs received a definitive stamp of judicial approval in Eaton. The company’s right to apply this APA-approved and judicially endorsed method allegedly survived the expiration of the underlying APAs because the Fifth Amendment’s due process clause extends that right in perpetuity, if the relevant facts remain materially the same. For many reasons, this far-fetched argument should be summarily dismissed.
Redefining Reliance
It would be surprising if attorneys from the same firm that litigated Eaton failed to grasp the legal basis for their win in an appeal decided less than a year ago, but the petitions’ reasonable reliance argument rests, in part, on a glaring distortion of the holding in Eaton as an endorsement of Eaton’s transfer pricing method. Neither the merits of the APA-approved method nor those of the IRS’s post-cancellation method were examined in Eaton by the Tax Court or the Sixth Circuit. Both courts held that the IRS had no right under the applicable revenue procedures to cancel the APAs in response to Eaton’s computational errors, mooting any further assessment of the parties’ methods. The relative reliability of the competing methods was entirely beside the point.
Acceptance of the APA-approved method came exclusively from the IRS Large Business and International Division’s APA program, later subsumed into the broader advance pricing and mutual agreement program, and this approval had an expiration date. The IRS granted Eaton an APA for 2001 through 2005 under Rev. Proc. 96-53, 1996-49 IRB 1, and later granted a renewal APA for 2006 through 2010 in accordance with Rev. Proc. 2004-40, 2004-29 IRB 1. The revenue procedures, each incorporated into the terms of the corresponding APA, are clear that the APAs apply only to the covered transactions for the covered tax years.
Section 9.03 of the 1996 revenue procedure generally states that, unless regulations indicate otherwise, “an APA shall have no legal effect except with respect to the taxpayer, taxable years and transactions to which the APA specifically relates.” Other than the removal of the introductory subordinate clause, “except to the extent provided by regulations,” section 10.03 of the 2004 revenue procedure is identical to its 1996 counterpart. The omitted caveat is moot: No regulatory provision binds the IRS to indefinitely accept a method approved in an APA.
The two revenue procedures are also nearly identical regarding the parties’ ability to refer to the terms of an expired APA in litigation. Section 9.04 of Rev. Proc. 96-53 and section 10.04 of Rev. Proc. 2004-40 bar the IRS and taxpayers from introducing an APA “as evidence in any judicial or administrative proceeding” for uncovered years, unless otherwise provided by regulations, a revenue procedure, or a written agreement. No regulatory, administrative, or contractual exception covers Eaton’s indefinite use of the APA-approved method to price its manufacturing transactions. By their own terms, the APAs upheld in Eaton bar the company from making the reasonable reliance argument that appears in the petitions.
Eaton’s reliance argument also stretches the meaning of reliance to the point of absurdity. Eaton submitted, and later withdrew, a request for a second APA renewal in 2009. According to the Tax Court’s 2017 opinion, the company withdrew its request precisely because the APA program made clear that the method accepted in the first two APAs would not be accepted for a third time. Eaton informed the APA program of its decision to withdraw its renewal application in a September 2009 letter, the Tax Court’s 2017 opinion says, explaining that “the APA team clearly stated that the IRS . . . would not use the methodology contained in the existing APAs as even a starting point for purposes of the Supplemental and APA renewal submissions.”
This indicates that Eaton had ample notice no later than September 2009 that the APA program no longer considered the previously approved method acceptable. And any unrealistic lingering hopes that the IRS would relent on examination would surely have been dashed after the IRS decided to cancel the APAs and then redetermine Eaton’s taxable income using a different transfer pricing method in December 2011.
This sequence of events raises the question of what, exactly, Eaton can plausibly claim to have relied on. How could it have reasonably relied on the IRS’s acceptance of a method during the 2011 through 2013 tax years when the APA program flatly refused to accept the method, even as a starting point for renewal negotiations, in 2009? And how could Eaton still have reasonably relied on the method in 2012 and 2013 after the IRS decided to cancel the first two APAs and apply an entirely different method in December 2011? Based on the IRS’s course of conduct, the only thing Eaton could have reasonably relied on was the agency’s future rejection of the APA-approved method.
Acceptance of Eaton’s reliance argument would also lead to absurd results. If a method’s approval in an APA vests the taxpayer with the right to apply the method indefinitely, then negotiating and expressly stipulating the term of an APA would be a superfluous exercise. And many APA renewal requests, which account for a significant share of total APAs negotiated and granted by the IRS, would be nothing more than a very costly and labor-intensive way to reaffirm an immutable constitutional right that taxpayers already enjoy.
Mischaracterizing Eaton as judicial confirmation of the reliability of the APA-approved method, instead of confirmation of the APAs’ contractually binding effect, doesn’t add anything to the company’s flimsy reliance claim. Reliance interests can’t project backward in time. Even if the Tax Court had endorsed the APA-approved method in 2017 and the Sixth Circuit affirmed that endorsement in 2022, Eaton couldn’t possibly have relied on either opinion during the 2011 through 2013 tax years. Doing so would have required that the company call on supernatural abilities that are unsubstantiated by the record in Eaton.
The applicability of section 6662 accuracy-related penalties to the manufacturing transactions, which likely account for a significant portion of the total penalties disputed in Eaton’s petitions, may be another matter. Under the section 6662 regulations, reliance on an earlier APA may weigh in favor of excluding an amount from the “net section 482 adjustment” used to determine whether substantial or gross valuation misstatement penalties apply. To be excluded in accordance with the specified method requirement in reg. section 1.6662-6(d)(2)(ii), the taxpayer must have selected and applied the chosen transfer pricing method in a reasonable manner. And under reg. section 1.6662-6(d)(2)(ii)(A)(6), one of the criteria that may help establish reasonableness is “the extent to which the taxpayer relied on a transfer pricing methodology developed and applied pursuant to an Advance Pricing Agreement for a prior taxable year.”
Reliance on the terms of an expired APA doesn’t definitively settle what is ultimately an all-facts-and-circumstances assessment under the regulations. And Eaton’s insistence on applying the formerly approved method, despite the method’s disavowal by the APA program in 2009 and its definitive rejection by the IRS in 2011, would seemingly undermine any attempt to use the APAs as evidence of reasonableness. Still, Eaton has a plausible argument that its consistent use of an APA-approved method should excuse it from section 6662 penalties — but this is probably the most the company can realistically hope to gain from its reasonable reliance argument.
Finding Due Process Rights in Odd Places
Eaton’s invocation of the Fifth Amendment’s due process clause as the basis for its reliance claim is the most striking and dubious part of the company’s case and does nothing to further its anti-penalty argument. It is highly unlikely that state delegates, while negotiating the terms of the new Constitution in Philadelphia in the late 1780s, contemplated indefinite APA-approved transfer pricing method reliance when they ratified the Fifth Amendment’s protection of (some) persons’ right to “due process of law.” And, though it may come as a surprise to some, the topic of perpetual APA reliance rights never came up in any of the great exchanges between Alexander Hamilton and James Madison in The Federalist Papers.
This criticism may be unfair in the sense that delegates to the Constitutional Convention had no way of predicting the introduction of an APA program at all. But the Fifth Amendment due process clause’s principal relevance to tax law has historically been the potentially self-incriminating effect of taxpayers’ legal obligation to report their income to the government. The premise that a contractual or quasi-contractual agreement between an individual taxpayer and the IRS remains binding after its expiration, despite the agreement’s expressly finite term and the IRS’s clear unwillingness to renew the agreement on similar terms, is a highly unorthodox take on the due process clause.
But as far-fetched as the argument may seem in isolation, it is the next logical step in a progression of increasingly grandiose reliance claims that began with Medtronic v. Commissioner, T.C. Memo. 2016-112, vacated by 900 F.3d 610 (2018), and gained momentum in Coca-Cola Co. v. Commissioner, 155 T.C. 145 (2020). Medtronic emphasized the terms of an earlier memorandum of understanding with the IRS in its 2011 Tax Court petition, and it may not have been coincidental that the Tax Court’s 2016 opinion reached a result that aligned well with the MOU. But Coca-Cola more insistently asserted its right to indefinitely apply a profit allocation formula approved in an expired closing agreement, which the IRS had accepted for years after the agreement’s expiration in 1996 but rejected beginning with the 2007 tax year.
Coca-Cola’s reliance claim began as an estoppel-like argument at trial. The Tax Court rejected this claim in its 2020 Coca-Cola opinion, noting that the taxpayer “cannot estop the Government on the basis of a promise that the Government did not make.” But Coca-Cola’s reliance argument later mutated into a full-blown constitutional claim. As Coca-Cola gravely declared in a June 2021 motion for reconsideration:
[The IRS] is trying to retroactively impose billions of dollars in additional tax liability on Coca-Cola based upon a different tax calculation method from the one it had previously agreed was the appropriate method for Coca-Cola to use. The IRS’s actions here call into question that fundamental constitutional promise of American government — that our government will not treat Americans arbitrarily and capriciously. The Supreme Court has made clear that all governmental entities and agencies — including the IRS — are ultimately accountable to the People under this principle.
The Tax Court was unmoved by Coca-Cola’s constitutional theatrics, which Judge Albert Lauber characterized as a futile attempt to repackage the estoppel argument rejected in 2020. Lauber wrote in an October 2021 order that Coca-Cola’s due process claim had already been raised, “although clothed in slightly different garments and unencumbered by the constitutional baggage that petitioner’s new attorneys seek to inject into the case.” Citing Dickman v. Commissioner, 465 U.S. 330 (1984), Lauber wrote that Supreme Court precedent concerning “reliance and retroactivity in tax law is emphatic” that the IRS has no obligation to indefinitely follow its earlier interpretations of the law.
The due process clause argument firmly rejected by Lauber in Coca-Cola and the claim raised in Eaton’s petitions are similar in important respects, including their novelty and nebulous legal basis. Two APAs covering the 2001 through 2010 tax years, like a closing agreement covering the 1987 through 1995 tax years, makes no promises regarding the years that follow the agreement’s expiration. And there is nothing to suggest the existence of some hitherto-undiscovered constitutional dictate that imputes post-expiration promises or nullifies the term specified in the agreement.
The constitutional reliance claim that Eaton tries to inject into its case for 2011 through 2013 is even weaker than Coca-Cola’s argument, which drew on the IRS’s “course of conduct” after the closing agreement’s expiration. Although ultimately irrelevant, it was stipulated in Coca-Cola that the IRS abruptly reversed its position regarding the formula accepted in the expired closing agreement. In Eaton’s case, however, there was no sudden reversal that could have affected the 2011 through 2013 tax years.
The company was on clear notice as of September 2009 that the APA-approved method would, at the very least, be received skeptically by the IRS. And the agency unambiguously rejected the method when it issued a notice of deficiency in December 2011. For the 2011 tax year, and unquestionably for the 2012 and 2013 tax years, the IRS’s conduct couldn’t possibly have granted Eaton any reliance interest in continued use of the APA-approved method.
Eaton may ultimately be able to show that the IRS abused its discretion and that the APA-approved method really is the best method to price the manufacturing transactions under reg. section 1.482-1(c). And even if the company can’t establish that the underlying section 482 adjustments were an abuse of discretion, its APA-reliance theory could help it avoid accuracy-related penalties in accordance with reg. section 1.6662-6(d)(2)(ii)(A). But either way, Eaton will have to make its case on the merits under the applicable regulations. Contesting the adjustments by layering a baseless due process clause attack on top of a flimsy estoppel claim, especially under the relevant facts, will do little to help Eaton’s cause.