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A Win for Eaton at the Sixth Circuit in Dispute Over IRS's Cancellation of APAs

Tax Alert

The Sixth Circuit Court of Appeals recently issued its opinion in Eaton Corp. v. Commissioner, a long-running dispute over whether the Internal Revenue Service (IRS) wrongfully canceled two advance pricing agreements (APAs). Nos. 21-1569/2674, 2022 U.S. App. LEXIS 23853 (6th Cir. Aug. 25, 2022). The Sixth Circuit sided with Eaton on all fronts, holding that the IRS did not carry its burden under contract law principles of proving that cancellation of the APAs was authorized, thereby marking a win for taxpayers who seek certainty in their transfer pricing through unilateral APAs.

Eaton and the IRS entered into two APAs collectively covering Eaton's tax years 2001 through 2010. A few years after finalizing the second APA, Eaton discovered calculation errors and, after informing the IRS of the errors, corrected the mistakes and filed amended tax returns. The errors related to Eaton's calculation of the "APA Multiplier," a factor used to translate the prices calculated under the transfer pricing methodology (TPM) in the APAs to numbers Eaton used for accounting purposes. While the calculation errors impacted Eaton's tax returns (decreasing its tax liability), the annual reports Eaton filed pursuant to the APAs contained the correct prices calculated consistent with the TPM in the APAs. The IRS rejected the amended returns, canceled the APAs, and issued Eaton deficiency notices for two of the tax years covered under the then-canceled APAs. The IRS also assessed penalties under section 6662(h).

The Tax Court determined that the IRS's decision to cancel the APAs was subject to review under a deferential abuse of discretion standard, which required Eaton to show that the IRS's cancellation was arbitrary, capricious, or without sound basis in fact. See Eaton Corp. v. Commissioner, 140 T.C. 410 (2013). The Tax Court concluded that Eaton had carried its burden and thus held that it was an abuse of discretion for the IRS to cancel the APAs. See Eaton Corp. v. Commissioner, T.C. Memo. 2017-147. While the Sixth Circuit reached the same result as the Tax Court – that the IRS wrongfully canceled the APAs – the appellate court imposed a higher burden on the IRS. The Sixth Circuit reiterated that an APA is a contract, and as such, contract law principles applied and required the IRS "to prove the exception that allows it to back out of contractual promises." Eaton Corp., 2022 U.S. App. LEXIS 23853, at *14. The IRS has broad discretion to enter into APAs, but once it does, it is bound by the terms of the bargain it negotiated, and administrative law deference principles have no bearing on determining whether the IRS must keep to that bargain. Thus, the Sixth Circuit held that for purposes of determining whether the IRS had grounds to cancel the Eaton APAs, the terms of the APAs (including governing Revenue Procedures) controlled and concluded that the IRS did not meet its burden of showing that the APAs' cancellation was authorized by reference to their terms. 

The Sixth Circuit first examined the terms of the APAs, including applicable Revenue Procedures, to define the available grounds for cancellation. The APAs were governed by Revenue Procedures in effect at the time Eaton and the IRS entered into them: Rev. Proc. 96-53, 1996-2 C.B. 375 governed the first APA, and Rev. Proc. 2004-40, 2004-2 C.B. 50 governed the second.1 The court concluded that the grounds for cancellation were found in exhaustive lists provided under the "Canceling the APA" section of each of the Revenue Procedures, and rejected the IRS's invitation to look beyond the four corners of that section to find additional cancellation grounds elsewhere in the Revenue Procedures.2

The grounds for cancellation at issue on appeal depended on finding that Eaton's miscalculations and conduct were "material." The Sixth Circuit looked to the definition of material facts in the Revenue Procedures and under contract law principles, concluding that none of Eaton's errors or purported omissions rose to the requisite level of materiality because those errors or omissions would not have resulted in a significantly different APA.

There were other issues in dispute between Eaton and the IRS, namely 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. With respect to penalties, the IRS had raised penalties based on its adjustment before trial. About a year and a half after the Tax Court trial and after the Tax Court held that the IRS had wrongfully canceled the APAs, the IRS revised its penalties computation based on Eaton's self-initiated adjustments. The Sixth Circuit agreed with the Tax Court that penalties were unsupportable but did not adopt the Tax Court's reasoning that the IRS could not impose penalties because there were no net section 482 adjustments. See Eaton Corp. v. Commissioner, 153 T.C. 119 (2019). Instead, the appellate court held that the IRS forfeited its penalties claim based on Eaton's self-initiated adjustments by failing to raise it before or at trial. The Sixth Circuit rejected the IRS's argument that the pre-trial and post-trial penalties claims were the same. The IRS's pre-trial penalty claim was based on adjustments the IRS computed following a transfer pricing method that was different from the TPM in the APAs. The IRS's post-trial penalty claim, by contrast, was based on Eaton's self-initiated adjustments to correct its inadvertent miscalculations. The Sixth Circuit found these to be different claims, noting that "[i]f the penalty doesn't cover the same adjustments, it's a different penalty." Eaton Corp., 2022 U.S. App. LEXIS 23853, at *35. Finally, with respect to the last issue before the Sixth Circuit, both parties agreed by the time of the appeal that Eaton is entitled to relief from double taxation under Revenue Procedure 99-32.

After a long history at the Tax Court, Eaton obtained a very favorable result at the Sixth Circuit, which agreed with Eaton on all issues in dispute on appeal. This seems like a positive outcome for the APA Program, which provides taxpayers with a voluntary process to prevent or resolve transfer pricing disputes, including on a unilateral basis. The certainty afforded by an APA is one of the key benefits of entering the APA process. The Sixth Circuit's decision should bring relief to taxpayers with existing APAs and those considering an APA as it confirms that the IRS is bound by the terms of the APA. Indeed, the Sixth Circuit's decision imposes a higher burden on the IRS than the Tax Court decision had, ensuring taxpayers the benefit of their bargain. The Sixth Circuit decision on penalties also may have implications in cases where a court resolves a transfer pricing issue on a basis that differs from the one initially proposed by the IRS. 

For more information, please contact:

Rocco V. Femia, rfemia@milchev.com, 202-626-5823

Kevin L. Kenworthy, kkenworthy@milchev.com, 202-626-5848

Lisandra Ortiz, lortiz@milchev.com, 202-626-5841

Loren C. Ponds, lponds@milchev.com, 202-626-5832

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1Both of those Revenue Procedures have since been superseded; currently in effect is Rev. Proc. 2015-41, 2015-35 I.R.B. 263.

2Under Rev. Proc. 2004-40, the IRS may cancel an APA for failure of a critical assumption, a taxpayer 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 with the terms and conditions of the APA. See Rev. Proc. 2004-40, § 10.06(1). Rev. Proc. 2015-41, currently in effect, has similar language listing grounds under which the IRS may cancel an APA. See Rev. Proc. 2015-41, § 7.06(2). The current Revenue Procedure also provides that the IRS "will cancel an APA in the event of a failure of a critical assumption or a material change in governing case law, statute, regulation, or applicable treaty" unless the parties agree to revise the APA. Rev. Proc. 2015-41, § 7.06(3).
 



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