The U.S. Court for the Northern District of Ohio (district court) enforced an IRS summons requesting annual performance evaluations for certain foreign employees as part of a transfer pricing audit (US v. Eaton Corp., No. 1:23-mc-00037 (N.D. Ohio, May 16, 2024)).

Background

The IRS is conducting a transfer pricing audit for 2017, 2018 and 2019, examining whether Eaton's sale of certain intellectual property to its Irish affiliate, Eaton Intelligent Power Limited (EIPL), was conducted on an arm's-length basis under IRC Section 482.

The IRS issued summonses under IRC Section 7602 on February 15, 2023, for employee evaluations for certain domestic employees and employees of Eaton's foreign related parties. On August 27, 2023, the IRS served a summons on Eaton with a similar request under IRC Section 6038A, which requires certain foreign-owned domestic corporations to maintain and provide the IRS with specified information on transactions and related parties.

Both the IRS and Eaton filed memorandums on the summonses on November 22, 2023.

The parties had previously resolved the domestic performance evaluations in the IRC Section 7602 summonses, so the remaining issue was whether to enforce the summons for the foreign employees' performance evaluations.

For the summons to be enforceable, the requested information must be relevant to a legitimate IRS purpose, meaning it must pertain to or bear upon the issues that the IRS is legally authorized to investigate, such as the correctness of a tax return or determining tax liability.¹

Parties' arguments

Eaton alleged in its opposition to the summons that it should not be required to produce the foreign employee evaluations because (1) the IRS has not met the court's heightened relevance standard (described later) to compel the disclosure of personnel records; (2) the IRS has not demonstrated that the relevant information could not be obtained by alternative means, including employee interviews, which Eaton offered and the IRS declined; (3) the summons process does not apply, even if the IRS could meet the heightened standard, because personnel records are not described in IRC Section 6038A(b); and (4) disclosing the personnel records would violate foreign privacy laws and expose Eaton and related parties to administrative fines and penalties for violating the European Union's General Data Protection Regulation (GDPR).

According to the IRS memorandum supporting its petition to enforce the summons, the employee evaluations, which relate to research and development personnel, would "shed light" on how the intellectual property was developed. The IRS asserted, among other things, that no heightened standard is required for the IRS's "prima facie" case (which would not require a "compelling showing of relevance").

Magistrate's ruling

In January 2024, a magistrate judge in the district court recommended denying the IRS's summons, finding that (1) the performance evaluations of the foreign employees were not shown to be relevant to a legitimate purpose and (2) the balance of the factors under the five-factor comity analysis² that is used when determining whether to order the production of evidence located in a foreign country weigh against disclosure.

District court ruling

The district court judge rejected the magistrate judge's recommendation and enforced the IRS's summons for foreign employees' performance evaluations. The district court found that (1) by applying the correct standard of considering what requested information "may be relevant," the IRS met its burden for enforcing the IRS summons and (2) under comity principles, EU privacy law (GDPR) does not prohibit Eaton from sending employee performance evaluations to the United States.

Prima facie case

The district court first said it disagreed with the ruling in the earlier decision Eaton I,³ which required a "compelling showing of relevance," and found that the IRS failed to persuasively demonstrate the relevance of the employee performance evaluations. The court said the earlier finding had relied on cases involving civil discovery, which "weighs relevance against burden." The IRS's summons authority is much broader and allows the IRS to request any documents that "may be relevant" to the IRS's investigation, the court said.

The district court said that by applying the correct "may be relevant" standard, the IRS made a prima facie showing that the foreign employee performance evaluations were relevant. In support of its decision, the court said the IRS agent declared that information from the performance evaluations could show how much work employees did on certain projects, how much control Eaton maintained over its intellectual property after it was transferred to EIPL, and how much of that intellectual property's value should be attributed to Eaton.

The district court said to negate the IRS's prima facie case, Eaton must show there was an abuse of process, which it failed to do in the case of this "legitimate disagreement." In addition, Eaton's assertion that it would make the employees available for interview does not help because "the IRS does not need to conduct its investigation in the least intrusive way," the district court said, noting that Eaton's suggested way might even be more intrusive.

Foreign law

The district court also found that the GDPR, which generally prohibits companies from transferring European citizens' personal data outside of EU member states, does not prohibit Eaton from producing the foreign employee performance evaluations.

The district court found that a GDPR exception (derogation) applies when the transfer is necessary for "important reasons of public interest." Public interest includes purposes including "in the spirit of reciprocity for international cooperation," such as the existence of an international agreement or convention. The court said the existence of a tax convention agreement between the United States and Ireland satisfies the public interest derogation.

The district court also found that the comity analysis weighs in favor of enforcing the IRS summons. The court analyzed the five factors and found that the fifth one, "the extent to which noncompliance with the request would undermine important interests of the United States, or compliance with the request would undermine important interest of the state where the information is located," was the most important and weighed strongly in favor of enforcement of the IRS summons.

Implications

The district court's opinion underscores that some courts may support the IRS's assertion that it can request documents that "may be relevant" to an audit and that foreign privacy laws, such as the GDPR, may not prohibit the production of such documents when exceptions for public interest apply. The district court's opinion could broaden the scope of IRS summons authority in similar contexts and clarify the applicability of international privacy laws in US transfer pricing audits. As a result, taxpayers should carefully consider the scope of information that is included in documentation such as personnel records.