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On March 3, 2023, Eaton filed two petitions in Tax Court, arguing the IRS erred in calculating Eaton’s tax deficiency and asserting penalties for 2011, 2012 and 2013.¹ The petitions were filed one month after the Tax Court approved an agreement between Eaton and the IRS for adjustments to Eaton’s 2005 and 2006 tax liabilities (see Tax Alert 2023-0255) and a little more than six months after the Sixth Circuit Court of Appeals (Sixth Circuit) held that the IRS had inappropriately canceled two of Eaton’s Advance Pricing Agreements (APAs) for 2001--2010 (see Tax Alert 2022-1334). The tax years in dispute fall immediately after the applicable years of the APAs at issue in the Sixth Circuit’s opinion.

In its petitions, Eaton disputed the IRS’s adjustments to profits from its Puerto Rican and Dominican manufacturing operations as well as royalty income from the use of intangibles in those countries. Eaton stated that the transactions at issue were materially identical to those covered under the APAs. The company used the transfer pricing method and profit level indicator authorized under its APAs to determine the arm’s-length prices with the entities in Puerto Rico and the Dominican Republic. Because the facts did not change for 2011 through 2013, Eaton argued, the IRS could not apply a “radically different” transfer pricing method because it would be arbitrary, capricious, and unreasonable and violate the Due Process Clause of the Fifth Amendment.

Eaton also argued the IRS erroneously modified a royalty agreement with a Switzerland-based related party and inappropriately asserted penalties. Although the Swiss entity has performed the same function since 2001, the IRS argued that the entity made only routine contributions for the years at issue and should receive a routine manufacturing return. Eaton stated that the IRS’s assessment failed to consider the Swiss entity’s contributions and applied penalties despite Eaton utilizing a reasonable transfer pricing method and complying with IRC Section 6662’s documentation requirements.

Finally, Eaton disputed the IRS’s disallowance of deductions for a portion of Eaton’s payments relating to intercompany guarantees provided to finance an acquisition. The IRS justified the disallowance by taking into account “implicit support” to modify issuer credit ratings despite the existence of explicit guarantees. The IRS also made a downward adjustment to the interest rates and corresponding deductions for interest paid on the intercompany debt issued to facilitate the acquisition, again citing implicit support. Eaton indicated that the IRS failed to consider the proper cash flows in determining the issuer credit ratings.

Implications

This case may clarify whether a taxpayer can rely on transfer pricing arrangements made under a prior agreement with the IRS, here an APA, when applying the transfer pricing method post-agreement. This case also calls into question whether the IRS can assert penalties where a taxpayer relies on the transfer pricing under an APA in post-APA years, given the penalty protection available under Treas. Reg. Section 1.6662-6(d)(2)(ii)(A)(6). That provision generally allows penalty protection when:

• The taxpayer relies on the transfer pricing method developed and applied under an APA covering a prior tax year
• The taxpayer applies the method reasonably and consistently with its prior application
• The taxpayer’s facts and circumstances have not changed

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Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor

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ENDNOTE

¹ Eaton et al. v. Commissioner, No. 2607-23 (T.C. March 3, 2023). The IRS also made adjustments to non-transfer pricing issues not covered in this Alert.