In Uncategorized on 06/26/2013 at 22:56

A very hot topic in the impenetrable thicket that is transfer pricing is the concept of the Advance Pricing Agreement. This is a deal akin to a PLR, where a taxpayer (and its parent and siblings) with international or transnational ramifications makes a deal with IRS or other taxing authorities, whereunder certain payments to offshore or near-shore affiliates (whose tax domiciles accord more favorable tax treatment to the recipient of the payments) will not be denied deductibility to the payor taxpayer by its tax domicile; likewise, income to such affiliates will not be aggregated or reallocated to the onshore parent or sibling.

Eaton Corporation and IRS made such deals. IRS claimed Eaton welshed on the deals, relying on certain Rev. Procs., and cancelled them retroactive to Day One, hitting Eaton with a Section 482 reallocation and  hefty deficiencies.

Eaton said that contract law determines whether there was a sufficiently substantial breach to allow IRS to call off the deals. IRS says the much lower barrier to cancellation is abuse of discretion, like a NOD on a CDP where taxpayer had a chance to contest the underlying deficiency. In other words, arbitrary, capricious or without sound basis in fact or law.

Clearly, this is a big deal. Abuse of discretion is a tough road for a taxpayer to walk; breach of contract is a lot easier by comparison. And this is a case of first impression.

And that’s all Judge Kroupa has to decide in Eaton Corporation, 140 T. C. 18, filed 6/25/13. And while it isn’t equal to what the Supremes did today with same-sex marriage, it’s certainly a big deal to Eaton and IRS.

Judge Kroupa: “We note that we decide the motions on a limited record. We will therefore decide only the legal standard to be used in reviewing the cancellations. We do not determine here whether respondent abused his discretion in canceling the APAs at issue.” 140 T. C. 18, at p. 3.

Now since the record is limited, Judge Kroupa can’t tell how Eaton is alleged to have welched, and how the two governing Rev. Procs. were breached, if in fact they were. The issue that APAs were supposed to resolve is what Eaton’s offshore subsidiaries were to be paid for certain circuit breakers they manufactured, using a comparable arms’-length standard.

Some quick background: “An APA is an agreement between the Commissioner and a taxpayer in which the parties set forth, in advance of controlled transactions, the best transfer pricing method within the meaning of section 482 and related regulations. Rev. Proc. 2004-40, sec. 2.04(1), 2004-2 C.B. at 51. Congress enacted section 482 to ensure that taxpayers clearly reflect income attributable to controlled transactions and to prevent the avoidance of taxes with respect to such transactions. Sec. 482; sec. 1.482-1(a)(1), Income Tax Regs. The Commissioner developed the APA program to resolve highly factual transfer pricing issues in a principled, cooperative manner. Announcement 2012-13, 2012-16 I.R.B. 805, 806; Rev. Proc. 2006-9, sec. 2.02, 2006-1 C.B. 278, 279; Rev. Proc. 2004-40, sec. 2.04(1). A taxpayer voluntarily participates in the APA program in exchange for the Commissioner limiting his discretion under section 482 to make transfer pricing adjustments. See Rev. Proc. 2006-9, secs. 2.01, 2.04, 10.02, 2006-1 C.B. at 279, 289.” 140 T. C. 18, at p. 6.

Now exactly what can Tax Court decide? “Petitioner invoked this Court’s jurisdiction by filing a petition challenging respondent’s deficiency determinations that adjusted petitioner’s income. Respondent’s deficiency determinations resulted from the cancellations. Petitioner assumes that our deficiency jurisdiction includes jurisdiction to review the APAs at issue. Respondent emphasizes that the Court’s jurisdiction is to redetermine the deficiencies. He contends that we may review the cancellations under our deficiency jurisdiction for abuse of discretion because the cancellations were administrative determinations that are necessary to determine the merits of the deficiency determinations. We agree with respondent.” 140 T. C. 18, at p. 9.

Remember, Tax Court is a court of limited jurisdiction. If you learn nothing else from these essays of mine, remember that: too many high-priced lawyers, and a lot of cheap ones, have come seriously unglued by forgetting or ignoring that fact.

Judge Kroupa rams the lesson home: “The Tax Court is a court of limited jurisdiction and may exercise jurisdiction only to the extent authorized by Congress. See Kasper v. Commissioner, 137 T.C. 37, 40 (2011); Naftel v. Commissioner, 85 T.C. 527, 529- 530 (1985). The Tax Court is without authority to enlarge upon that statutory grant. See Phillips Petroleum Co. v. Commissioner, 92 T.C. 885, 888 (1989). We have jurisdiction to redetermine the correct amount of a deficiency. Sec. 6214(a). Our deficiency jurisdiction includes the authority to determine whether the Commissioner’s section 482 allocation was correct. That allocation must be sustained absent a showing of abuse of discretion. See, e.g., Veritas Software Corp. & Subs. v. Commissioner, 133 T.C. 297, 318 (2009); Sundstrand Corp. & Subs. v. Commissioner, 96 T.C. 226, 353 (1991). To succeed, therefore, petitioner must show that respondent’s section 482 allocations were arbitrary, capricious or without sound basis of law or fact. Veritas Software Corp. & Subs. v. Commissioner, 133 T.C. at 318.” 140 T. C. 18, at pp. 9-10.

Obviously, not wanting to pay the $368 million of deficiencies, plus interest, additions to tax and penalties, and then sue for a refund in US District Court or Court of Federal Claims, Eaton took the cheaper route.

“Here, the cancellations are administrative determinations necessary to determine the merits of the deficiency determinations. We will review the cancellations for abuse of discretion. The parties agree that respondent established the APA program pursuant to his authority to administer the Code and ‘prescribe all “needful rules and regulations”.’ 140 T. C. 18, at p. 11.

“We hold that our deficiency jurisdiction includes reviewing the cancellations because they are necessary to determine the merits of the deficiencies.   The relevant inquiry is whether respondent abided by the self- imposed limitations set forth in the applicable revenue procedures. We consequently will review respondent’s cancellations for abuse of discretion.” 140 T. C. 18, at p. 14. (Footnote omitted).

Here’s the footnote that sinks Eaton: “Petitioner’s assertion that general contract law governs the APAs at issue conflicts with the parties’ agreement that the legal effect and administration are governed by the applicable terms of the revenue procedures. Petitioner ignores the fact that the applicable revenue procedures reserve respondent’s discretion to administer the APAs at issue.” 140 T. C. 18, at p. 14, footnote 4.

And Eaton can’t shift the burden of proof to IRS; Eaton must show there is no sound basis in fact or law for IRS to abrogate the APAs, and good luck with that.

So beware, multinational, before entering into an APA; IRS has a powerful ace up its sleeve. If you wish to advance, prepare your line of retreat.


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