Tax Court holds that IRS’s cancellation of APAs was abuse of discretion

Tax Court holds that IRS’s cancellation of APAs was abuse of discretionOn July 26, 2017, in Eaton Corp. v. Commissioner, T.C. Memo. 2017-147, (July 26, 2017), the Tax Court held that the IRS’s decision to cancel two advance pricing agreements (APAs) was an abuse of discretion. The U.S. Tax Court further held that the taxpayer, Eaton Corporation, did not transfer intangibles subject to Section 367, and that certain bonus payments to executives were deductible under Section 162(a).

An APA is an agreement between the IRS and a taxpayer on a transfer pricing methodology. This methodology may be applied to any apportionment or allocation of income, deductions, credits, or allowances between or among two or more organizations, trades, or businesses owned or controlled, directly or indirectly by the same interests.

The case involved two unilateral APAs entered into by Eaton Corporation and its subsidiaries. The first APA, from 2001 through 2005, covered the sale of circuit breakers, the license of intangible property and a cost-sharing payment. The other, from 2006 through 2010, covered the sale of circuit breakers. Eaton’s transfer pricing computations under the APAs contained several errors. However, when Eaton discovered these errors, it made the IRS aware of them.

The IRS contended that Eaton did not comply in good faith with the terms and conditions of the APAs and failed to satisfy certain other requirements. Eaton contended that the errors were not significant enough to merit the cancellation of the APAs under the applicable revenue procedures. The Tax Court agreed with Eaton, finding that the errors were “immaterial and inadvertent” and did not constitute “material” errors as provided under the relevant revenue procedures.

The Tax Court decision is yet another in a string of transfer pricing-related defeats for the IRS. The Tax Court’s decision emphasizes the need for taxpayers to carefully manage their transfer pricing data and prepare and retain quality transfer pricing studies. Although the decision underscores the high bar that must be overcome by the IRS when revoking an APA, it nevertheless highlights the importance of meticulous transfer pricing documentation.

Contact David Bowen
Principal, International Tax
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David Sites
Partner, Washington National Tax Office
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Cory Perry
Senior Manager, Washington National Tax Office
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