The US Tax Court issued a written opinion on October 28 regarding Eaton’s transfer pricing court case. The resolution of the case was in favor of Eaton, and it determined the IRS abused its discretion when canceling advance pricing agreements the company had in place.
Eaton’s transfer pricing dispute
Eaton and its subsidiaries entered into two advance pricing agreements, covering fiscal years 2001-2005 and 2006-2010, respectively, to establish the most appropriate transfer pricing methodologies for certain transactions.
However, in the year 2011, the IRS canceled the agreements stating they presented material deficiencies in the revenue procedures. The IRS determined a significant transfer pricing adjustment plus penalties.
The IRS challenged the transfer pricing methodologies used in the advance pricing agreement for the analysis of the arm’s length standard of Eaton’s intercompany transactions. The IRS also argued that Eaton committed material mistakes during the filing procedures and did not comply in good faith with the terms and conditions of the agreements.
Despite Eaton’s corrections of the errors and amendments to its advance pricing agreement annual reports and federal income tax returns, the IRS did not accept the amended returns.
The court’s initial verdict
The US Tax Court concluded that the IRS Commissioner committed an abuse of discretion when canceling the advance pricing agreements Eaton had in place.
The court determined the IRS had its chance to raise concerns regarding the transfer pricing methodology approved upon the first agreement when Eaton applied for its 2006-2010 agreement. Nevertheless, no concerns were discussed between the parties, and the second advance pricing agreement was approved.
Also, the court stated that Eaton did not commit material errors in the governing revenue procedures. These errors were, in fact, immaterial and inadvertent errors, not affecting the general results of the analysis. Furthermore, when Eaton detected the errors, it took action to correct them and amended the corresponding returns, the court observed.
In summary, the court’s verdict did not sustain the IRS determination to cancel the advance pricing agreements.
Transfer pricing penalties
After determining the advance pricing agreements did not merit cancelation, the court discussed whether Eaton was subject to penalties or liabilities pursuant to the section 6662(h) and 482 regulations. Once again, the Tax Court ruled in favor of Eaton and determined the taxpayer was not liable for any penalties nor transfer pricing adjustments since the advance pricing agreements remained in effect as per the previous verdict.
The takeaway
An advance pricing agreement is a binding contract between the taxpayer and the IRS. As such, it should be canceled only according to the terms of the revenue procedures and not because of the IRS’s wish to change or modify the agreed transfer pricing methodology to derive into a more favorable result for the government. It is still unclear why the IRS decided to cancel Eaton’s advance pricing agreements.
