Recent off its success in thwarting an IRS try and cancel two advance pricing agreements, the emboldened Eaton Corp. has filed Tax Court docket petitions claiming the suitable to make use of the APA-approved switch pricing methodology indefinitely.

In response to a pair of Tax Court docket petitions filed March 3, Eaton has discovered itself preventing the IRS in courtroom but once more. Lower than a yr in the past, the corporate got here away with a decisive win over the IRS in Eaton Corp. v. Commissioner, 47 F.4th 434 (sixth Cir. 2022), aff’g partly, rev’g partly, T.C. Memo. 2017-147. In Eaton, the Tax Court docket and Sixth Circuit every held that the IRS couldn’t cancel Eaton’s APAs based mostly on important, however inadvertent, computational errors contained within the firm’s annual compliance reviews.

However there was no APA for the IRS to cancel for the tax years now at problem, and the financial stakes are significantly greater than they have been in Eaton. One petition challenges $172 million in deficiencies and penalties for the 2011 tax yr, and the opposite challenges a complete of $687 million for 2012 and 2013. The deficiencies relate to a big selection of earnings changes, which vary from subpart F inclusions to part 482 allocations regarding curiosity funds, assure charges, and intercompany royalty prices. Collectively, complete deficiencies and penalties assessed by the IRS for 2011 by way of 2013 are practically seven instances the corresponding quantity in Eaton.

However the highest-stakes problem within the dispute is the pricing of what Eaton’s petitions consult with because the “islands manufacturing transactions.” These changes rise from about $196 million in 2011 to about $258 million in 2013 — by far, the biggest class of changes challenged by Eaton in its two petitions. Of the $1.8 billion in complete changes reported within the petitions for 2011 by way of 2013, $672 million (37 %) is attributable to the islands manufacturing transactions. It will not be coincidental that these are the identical managed transactions coated by the 2 APAs that the IRS tried to cancel in Eaton: one APA issued in 2003 masking the 2001 by way of 2005 tax years and a 2006 renewal APA for 2006 by way of 2010.

One other Finest Technique Case?

The Eaton group’s islands manufacturing transactions fall into one in every of two classes, the primary of which is Eaton’s buy of business electrical breakers, controls, and associated tools manufactured in Puerto Rico or the Dominican Republic by Cutler-Hammer Electrical Co. (CHEC). The opposite is the license of intangibles from Eaton or another U.S. group entity concerned within the group’s U.S. electrical sector (EEUS) to CHEC.

The $672 million in complete part 482 changes for the islands manufacturing transactions doubtless displays a stark distinction within the events’ views on the suitable switch pricing methodology. Evidently undeterred by the IRS’s repudiation of the strategy it had as soon as accredited within the two APAs or the litigation that ensued, Eaton claims to have correctly priced its islands manufacturing transactions for 2011 by way of 2013 utilizing the identical methodology accredited by the APAs for 2001 by way of 2010.

The APA-approved method utilized the comparable uncontrolled value methodology to cost breakers product purchases and corroborated the outcomes utilizing the comparable income methodology. The corroborative CPM evaluation used EEUS because the examined get together and the Berry ratio (gross revenue divided by working bills) because the profit-level indicator, reflecting the premise that EEUS was a routine U.S. distributor whereas CHEC was the extra complicated get together to the transaction. To find out the royalty for EEUS’s license of intangibles to CHEC beneath the APAs, Eaton utilized the comparable uncontrolled transaction methodology utilizing what the petitions characterize as dependable transactional comparables.

Though Eaton persevered in utilizing the APA-based method even after the renewal APA expired, the IRS clearly didn’t. The petitions state the corporate’s perception that the IRS utilized the CPM to cost all of Eaton’s manufacturing transactions on an mixture foundation, utilizing CHEC as an alternative of EEUS because the examined get together and the markup on complete prices because the profit-level indicator. This method would doubtless be extra dependable than the APA-approved methodology if CHEC carried out solely routine manufacturing actions and was the much less complicated get together to the transactions. It could even have the impact of allocating all residual returns to the US.

Eaton’s Tax Court docket petitions, like most others, don’t delve into the corporate’s arguments in exhaustive element. However the petitions increase acquainted claims for this type of switch pricing methodological dispute. CHEC, naturally, has what Eaton portrays as an unparalleled mastery of the delicate and high-stakes artwork {of electrical} tools manufacturing, rendering it inappropriate as a CPM examined get together. Additionally, the petitions predictably recommend that the IRS resorted to a crude profit-based methodology when a extra dependable and theoretically pure transactional methodology was obtainable to cost EEUS’s license of intangibles to CHEC.

These claims warrant a wholesome diploma of skepticism, nevertheless it’s definitely attainable that they may very well be at the least partially legitimate beneath the information and circumstances. Nevertheless, this isn’t the case for what seems to be Eaton’s main, and definitely its most outlandish, argument for its favored methodology. In response to the petitions, the IRS’s methodology violated constitutionally protected and indefinite reliance pursuits granted to the corporate by the expired APAs:

Respondent’s changes referring to the Islands Manufacturing Transactions are illegal as a result of Eaton fairly relied upon a switch pricing methodology that had been expressly accredited by Respondent in two prior APAs, which Eaton persistently utilized since its 2001 taxable yr, and which have since been upheld by the Sixth Circuit. . . . Respondent’s try to use a radically completely different switch pricing methodology beneath these circumstances is bigoted, capricious, and unreasonable and violates the Due Course of Clause of the U.S. Structure’s Fifth Modification. [Emphasis added.]

In different phrases, the strategy accredited by the IRS within the APAs acquired a definitive stamp of judicial approval in Eaton. The corporate’s proper to use this APA-approved and judicially endorsed methodology allegedly survived the expiration of the underlying APAs as a result of the Fifth Modification’s due course of clause extends that proper in perpetuity, if the related information stay materially the identical. For a lot of causes, this far-fetched argument must be summarily dismissed.

Redefining Reliance

It could be stunning if attorneys from the identical agency that litigated Eaton failed to know the authorized foundation for his or her win in an attraction determined lower than a yr in the past, however the petitions’ cheap reliance argument rests, partly, on a evident distortion of the holding in Eaton as an endorsement of Eaton’s switch pricing methodology. Neither the deserves of the APA-approved methodology nor these of the IRS’s post-cancellation methodology have been examined in Eaton by the Tax Court docket or the Sixth Circuit. Each courts held that the IRS had no proper beneath the relevant income procedures to cancel the APAs in response to Eaton’s computational errors, mooting any additional evaluation of the events’ strategies. The relative reliability of the competing strategies was completely irrelevant.

Acceptance of the APA-approved methodology got here solely from the IRS Giant Enterprise and Worldwide Division’s APA program, later subsumed into the broader advance pricing and mutual settlement program, and this approval had an expiration date. The IRS granted Eaton an APA for 2001 by way of 2005 beneath Rev. Proc. 96-53, 1996-49 IRB 1, and later granted a renewal APA for 2006 by way of 2010 in accordance with Rev. Proc. 2004-40, 2004-29 IRB 1. The income procedures, every included into the phrases of the corresponding APA, are clear that the APAs apply solely to the coated transactions for the coated tax years.

Part 9.03 of the 1996 income process usually states that, until laws point out in any other case, “an APA shall don’t have any authorized impact besides with respect to the taxpayer, taxable years and transactions to which the APA particularly relates.” Apart from the removing of the introductory subordinate clause, “besides to the extent supplied by laws,” part 10.03 of the 2004 income process is similar to its 1996 counterpart. The omitted caveat is moot: No regulatory provision binds the IRS to indefinitely settle for a technique accredited in an APA.

The 2 income procedures are additionally practically similar relating to the events’ means to consult with the phrases of an expired APA in litigation. Part 9.04 of Rev. Proc. 96-53 and part 10.04 of Rev. Proc. 2004-40 bar the IRS and taxpayers from introducing an APA “as proof in any judicial or administrative continuing” for uncovered years, until in any other case supplied by laws, a income process, or a written settlement. No regulatory, administrative, or contractual exception covers Eaton’s indefinite use of the APA-approved methodology to cost its manufacturing transactions. By their very own phrases, the APAs upheld in Eaton bar the corporate from making the cheap reliance argument that seems within the petitions.

Eaton’s reliance argument additionally stretches the that means of reliance to the purpose of absurdity. Eaton submitted, and later withdrew, a request for a second APA renewal in 2009. In response to the Tax Court docket’s 2017 opinion, the corporate withdrew its request exactly as a result of the APA program made clear that the strategy accepted within the first two APAs wouldn’t be accepted for a 3rd time. Eaton knowledgeable the APA program of its choice to withdraw its renewal utility in a September 2009 letter, the Tax Court docket’s 2017 opinion says, explaining that “the APA group clearly said that the IRS . . . wouldn’t use the methodology contained within the present APAs as even a place to begin for functions of the Supplemental and APA renewal submissions.”

This means that Eaton had ample discover no later than September 2009 that the APA program not thought of the beforehand accredited methodology acceptable. And any unrealistic lingering hopes that the IRS would relent on examination would absolutely have been dashed after the IRS determined to cancel the APAs after which redetermine Eaton’s taxable earnings utilizing a distinct switch pricing methodology in December 2011.

This sequence of occasions raises the query of what, precisely, Eaton can plausibly declare to have relied on. How might it have fairly relied on the IRS’s acceptance of a technique through the 2011 by way of 2013 tax years when the APA program flatly refused to simply accept the strategy, whilst a place to begin for renewal negotiations, in 2009? And the way might Eaton nonetheless have fairly relied on the strategy in 2012 and 2013 after the IRS determined to cancel the primary two APAs and apply a completely completely different methodology in December 2011? Based mostly on the IRS’s course of conduct, the one factor Eaton might have fairly relied on was the company’s future rejection of the APA-approved methodology.

Acceptance of Eaton’s reliance argument would additionally result in absurd outcomes. If a technique’s approval in an APA vests the taxpayer with the suitable to use the strategy indefinitely, then negotiating and expressly stipulating the time period of an APA could be a superfluous train. And plenty of APA renewal requests, which account for a big share of complete APAs negotiated and granted by the IRS, could be nothing greater than a really pricey and labor-intensive approach to reaffirm an immutable constitutional proper that taxpayers already take pleasure in.

Mischaracterizing Eaton as judicial affirmation of the reliability of the APA-approved methodology, as an alternative of affirmation of the APAs’ contractually binding impact, doesn’t add something to the corporate’s flimsy reliance declare. Reliance pursuits can’t venture backward in time. Even when the Tax Court docket had endorsed the APA-approved methodology in 2017 and the Sixth Circuit affirmed that endorsement in 2022, Eaton couldn’t presumably have relied on both opinion through the 2011 by way of 2013 tax years. Doing so would have required that the corporate name on supernatural skills which can be unsubstantiated by the report in Eaton.

The applicability of part 6662 accuracy-related penalties to the manufacturing transactions, which doubtless account for a good portion of the whole penalties disputed in Eaton’s petitions, could also be one other matter. Beneath the part 6662 laws, reliance on an earlier APA might weigh in favor of excluding an quantity from the “web part 482 adjustment” used to find out whether or not substantial or gross valuation misstatement penalties apply. To be excluded in accordance with the required methodology requirement in reg. part 1.6662-6(d)(2)(ii), the taxpayer should have chosen and utilized the chosen switch pricing methodology in an inexpensive method. And beneath reg. part 1.6662-6(d)(2)(ii)(A)(6), one of many standards which will assist set up reasonableness is “the extent to which the taxpayer relied on a switch pricing methodology developed and utilized pursuant to an Advance Pricing Settlement for a previous taxable yr.”

Reliance on the phrases of an expired APA doesn’t definitively settle what’s in the end an all-facts-and-circumstances evaluation beneath the laws. And Eaton’s insistence on making use of the previously accredited methodology, regardless of the strategy’s disavowal by the APA program in 2009 and its definitive rejection by the IRS in 2011, would seemingly undermine any try to make use of the APAs as proof of reasonableness. Nonetheless, Eaton has a believable argument that its constant use of an APA-approved methodology ought to excuse it from part 6662 penalties — however that is most likely probably the most the corporate can realistically hope to achieve from its cheap reliance argument.

Discovering Due Course of Rights in Odd Locations

Eaton’s invocation of the Fifth Modification’s due course of clause as the idea for its reliance declare is probably the most placing and doubtful a part of the corporate’s case and does nothing to additional its anti-penalty argument. It’s extremely unlikely that state delegates, whereas negotiating the phrases of the brand new Structure in Philadelphia within the late 1780s, contemplated indefinite APA-approved switch pricing methodology reliance once they ratified the Fifth Modification’s safety of (some) individuals’ proper to “due strategy of regulation.” And, although it might come as a shock to some, the subject of perpetual APA reliance rights by no means got here up in any of the good exchanges between Alexander Hamilton and James Madison in The Federalist Papers.

This criticism could also be unfair within the sense that delegates to the Constitutional Conference had no method of predicting the introduction of an APA program in any respect. However the Fifth Modification due course of clause’s principal relevance to tax regulation has traditionally been the possibly self-incriminating impact of taxpayers’ authorized obligation to report their earnings to the federal government. The premise {that a} contractual or quasi-contractual settlement between a person taxpayer and the IRS stays binding after its expiration, regardless of the settlement’s expressly finite time period and the IRS’s clear unwillingness to resume the settlement on comparable phrases, is a extremely unorthodox tackle the due course of clause.

However as far-fetched because the argument could appear in isolation, it’s the subsequent logical step in a development of more and more grandiose reliance claims that started 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 emphasised the phrases of an earlier memorandum of understanding with the IRS in its 2011 Tax Court docket petition, and it might not have been coincidental that the Tax Court docket’s 2016 opinion reached a end result that aligned properly with the MOU. However Coca-Cola extra insistently asserted its proper to indefinitely apply a revenue allocation system accredited in an expired closing settlement, which the IRS had accepted for years after the settlement’s expiration in 1996 however rejected starting with the 2007 tax yr.

Coca-Cola’s reliance declare started as an estoppel-like argument at trial. The Tax Court docket rejected this declare in its 2020 Coca-Cola opinion, noting that the taxpayer “can’t estop the Authorities on the idea of a promise that the Authorities didn’t make.” However Coca-Cola’s reliance argument later mutated right into a full-blown constitutional declare. As Coca-Cola gravely declared in a June 2021 movement for reconsideration:

[The IRS] is making an attempt to retroactively impose billions of {dollars} in further tax legal responsibility on Coca-Cola based mostly upon a distinct tax calculation methodology from the one it had beforehand agreed was the suitable methodology for Coca-Cola to make use of. The IRS’s actions right here name into query that basic constitutional promise of American authorities — that our authorities is not going to deal with Individuals arbitrarily and capriciously. The Supreme Court docket has made clear that every one governmental entities and businesses — together with the IRS — are in the end accountable to the Individuals beneath this precept.

The Tax Court docket was unmoved by Coca-Cola’s constitutional theatrics, which Choose Albert Lauber characterised as a futile try and repackage the estoppel argument rejected in 2020. Lauber wrote in an October 2021 order that Coca-Cola’s due course of declare had already been raised, “though clothed in barely completely different clothes and unencumbered by the constitutional baggage that petitioner’s new attorneys search to inject into the case.” Citing Dickman v. Commissioner, 465 U.S. 330 (1984), Lauber wrote that Supreme Court docket precedent regarding “reliance and retroactivity in tax regulation is emphatic” that the IRS has no obligation to indefinitely comply with its earlier interpretations of the regulation.

The due course of clause argument firmly rejected by Lauber in Coca-Cola and the declare raised in Eaton’s petitions are comparable in essential respects, together with their novelty and nebulous authorized foundation. Two APAs masking the 2001 by way of 2010 tax years, like a closing settlement masking the 1987 by way of 1995 tax years, makes no guarantees relating to the years that comply with the settlement’s expiration. And there’s nothing to recommend the existence of some hitherto-undiscovered constitutional dictate that imputes post-expiration guarantees or nullifies the time period specified within the settlement.

The constitutional reliance declare that Eaton tries to inject into its case for 2011 by way of 2013 is even weaker than Coca-Cola’s argument, which drew on the IRS’s “course of conduct” after the closing settlement’s expiration. Though in the end irrelevant, it was stipulated in Coca-Cola that the IRS abruptly reversed its place relating to the system accepted within the expired closing settlement. In Eaton’s case, nevertheless, there was no sudden reversal that would have affected the 2011 by way of 2013 tax years.

The corporate was on clear discover as of September 2009 that the APA-approved methodology would, on the very least, be acquired skeptically by the IRS. And the company unambiguously rejected the strategy when it issued a discover of deficiency in December 2011. For the 2011 tax yr, and unquestionably for the 2012 and 2013 tax years, the IRS’s conduct couldn’t presumably have granted Eaton any reliance curiosity in continued use of the APA-approved methodology.

Eaton might in the end be capable of present that the IRS abused its discretion and that the APA-approved methodology actually is one of the best methodology to cost the manufacturing transactions beneath reg. part 1.482-1(c). And even when the corporate can’t set up that the underlying part 482 changes have been an abuse of discretion, its APA-reliance concept might assist it keep away from accuracy-related penalties in accordance with reg. part 1.6662-6(d)(2)(ii)(A). However both method, Eaton must make its case on the deserves beneath the relevant laws. Contesting the changes by layering a baseless due course of clause assault on prime of a flimsy estoppel declare, particularly beneath the related information, will do little to assist Eaton’s trigger.