DOJ Argues Tax Court Erred in Eaton Corp. Transfer Pricing Case

EATON CORPORATION AND SUBSIDIARIES,
Petitioner-Appellee Cross-Appellant
v.
COMISSIONER OF INTERNAL REVENUE,
Respondent-Appellant Cross-Appellee

IN THE UNITED STATES COURT OF APPEALS
FOR THE SIXTH CIRCUIT

ON APPEAL FROM THE DECISION OF
THE UNITED STATES TAX COURT

BRIEF FOR THE APPELLANT CROSS-APPELLEE

DAVID A. HUBBERT
Acting Assistant Attorney General

FRANCESCA UGOLINI
(202) 514-3361
ARTHUR T. CATTERALL
(202) 514-2937
JUDITH A. HAGLEY
(202) 514-8126
Attorneys
Tax Division
Department of Justice
Post Office Box 502
Washington, D.C. 20044

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TABLE OF CONTENTS

Table of contents

Table of authorities

Statement regarding oral argument

Glossary

Jurisdictional statement

Statement of the issues

Statement of the case

Summary of argument

Argument

I. The IRS did not abuse its discretion in canceling the APAs Standard of review

II. The Tax Court erred in holding that there was no “net section 482 transfer price adjustment” in this case

Conclusion

Certificate of compliance

Certificate of service

TABLE OF AUTHORITIES

Cases:

Akhtar-Zaidi v. Drug Enf't Admin., 841 F.3d 707  (6th Cir. 2016)

Altera Corp. v. Commissioner, 926 F.3d 1061  (9th Cir. 2019), cert. denied, 141 S. Ct. 131 (2020)

Badaracco v. Commissioner, 464 U.S. 386 (1984)

Canton Police Benevolent Ass'n of Canton, Ohio v. United States, 844 F.2d 1231 (6th Cir. 1988)

Fed. Prop. Mgmt. Corp. v. Harris, 603 F.2d 1226  (6th Cir. 1979)

JPMorgan Chase & Co. v. Commissioner, 530 F.3d 634  (7th Cir. 2008)

JPMorgan Chase & Co. v. Commissioner, 458 F.3d 564  (7th Cir. 2006)

Medtronic, Inc. v. Commissioner, T.C. Memo. 2016-112, vacated and remanded by 900 F.3d 610 (8th Cir. 2018)

Thor Power Tool Co. v. Commissioner, 439 U.S. 522  (1979)

Statutes:

Internal Revenue Code of 1986 (26 U.S.C.):

Treasury Regulations and Rulings:

Treasury Regulations (26 C.F.R.):

Rev. Proc. 65-17, 1965-1 C.B. 833

Rev. Proc. 91-22, 1991-1 C.B. 526

Rev. Proc. 96-53, 1996-2 C.B. 375

Rev. Proc. 99-32, 1999-2 C.B. 296

Rev. Proc. 2004-40, 2004-2 C.B. 50

Other authorities:

IRS-Announcement 2000-35, 2000-1 C.B. 922

Tax Court Rule 155

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STATEMENT REGARDING ORAL ARGUMENT

This appeal presents legal issues of first impression in the courts of appeals regarding the IRS's discretion to cancel an advance-pricing agreement and the applicability of penalties when reported transfer prices are adjusted to conform to such an agreement. Counsel for the Commissioner believe that oral argument would be beneficial.

GLOSSARY

APA	advance-pricing agreement
APA Price	transfer price computed under the APAs' transfer-pricing methodology and reported on the APA Reports
Apx	7-volume appendix filed by appellant/cross-appellee
COGS	cost-of-goods-sold
Eaton	appellee/cross-appellant Eaton Corporation and its U.S. subsidiaries
Eaton-Islands	Eaton's foreign subsidiaries operating in Puerto Rico and the Dominican Republic that manufactured the products at issue in the appeal
Eaton-US	Eaton Electrical, Inc. (referred to by the Tax Court as “EEI”), Eaton's U.S. subsidiary that distributed the products at issue
R.	record documents as numbered by the Tax Court
TPM	transfer-pricing methodology

 JURISDICTIONAL STATEMENT

A. Tax Court jurisdiction

Eaton Corporation is the common parent of an affiliated group of U.S. corporations that filed consolidated income-tax returns for 2005 and 2006. On December 19, 2011, the IRS issued a notice of deficiency to Eaton for those years. (R.41 (Notice-of-Deficiency), Apx 463.) See §6212 (a).¹ On February 29, 2012, within 90 days of that notice, Eaton timely filed a petition for redetermination in the Tax Court. (R.1 (Petition), Apx 120-182.) See §6213 (a). The Tax Court had jurisdiction under §6213 (a). See §7442.

B. Appellate jurisdiction

The Tax Court entered a decision on February 25, 2021. (R.843 (Decision), Apx 183.) That decision constituted a final judgment, disposing of all claims of all parties. See §7459 (a). On May 24, 2021, within 90 days after entry of the decision, the Commissioner timely filed a notice of appeal with the Tax Court. (R.846 (Notice-of-Appeal), Apx 417.) See §7483. This Court has jurisdiction under §7482 (a)(1).

STATEMENT OF THE ISSUES

1. Whether the Tax Court erred in holding that the IRS abused its discretion in canceling two advance-pricing agreements (APAs) it had entered into with Eaton, where it is undisputed that the transfer prices Eaton incorporated into its 2005-2008 tax returns were over $165 million higher than the amounts Eaton reported in its 2005-2008 APA annual reports, producing an equivalent reduction in income.

2. Whether the Tax Court erred in holding that there was no “net section 482 transfer price adjustment” in this case for purposes of the §6662 penalty applicable to such adjustments.

STATEMENT OF THE CASE

A. Procedural history

Section 482 of the Internal Revenue Code grants the IRS broad authority to reallocate income among related parties to reflect the arm's-length price for intercompany transactions. That authority includes the ability to enter into APAs with taxpayers whereby the IRS agrees to limit its discretion under §482 in exchange for the taxpayer's agreement to (among other things) file tax returns that report prices determined pursuant to an agreed-upon pricing methodology. If the taxpayer fails to do so, the IRS has the discretion to cancel the APA and exercise its full authority under §482.

The IRS and Eaton entered into two APAs that applied to Eaton's 2001-2005 and 2006-2010 tax years. After discovering that Eaton's tax returns filed for those years failed to report APA-compliant prices, the IRS canceled the agreements and determined the arm's-length price for the transactions at issue using a different pricing methodology. As a result, the IRS determined substantial deficiencies in Eaton's federal income tax for 2005 and 2006, and it further determined that accuracy-related penalties were applicable under §6662 (e)(1)(B)(ii), (h)(2)(A)(iii).²

Eaton filed a petition in the Tax Court challenging the deficiency and penalty determinations. After a trial, the court determined that the IRS abused its discretion in canceling the APAs. The court further determined that penalties were not applicable. The Commissioner has appealed.

B. Regulatory overview

U.S. corporations operating through related enterprises, including affiliated foreign corporations, have long attempted to manipulate their intra-group transactions in order to avoid U.S. tax. “If, for example, the parent business entity is in a high-tax jurisdiction, and the foreign subsidiary is in a low-tax jurisdiction, the business enterprise can shift costs and revenue between the related entities so that more taxable income is allocated to the lower tax jurisdiction.” Altera Corp. v. Commissioner, 926 F.3d 1061, 1067 (9th Cir. 2019), cert. denied, 141 S. Ct. 131 (2020). To illustrate, assume a U.S. corporation pays $100 million to its foreign subsidiary for products that parties dealing at arm's length would pay only $80 million for, and then sells the products for $105 million. By paying an inflated transfer price, and thereby increasing its cost-of-goods-sold, the U.S. corporation decreases its U.S. taxable income by $20 million (i.e., the amount by which the intercompany transfer price ($100 million) exceeds the arm's-length transfer price ($80 million)), a clear distortion of income.

To combat such abuse, Congress — for almost 100 years — has given the IRS “broad authority” to evaluate the pricing of transactions between related parties (R.735 (Opinion), Apx 323), and to allocate certain tax items (including gross income) between or among the parties “if [it] determines that such . . . allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any such” entities. §482. Under regulations implementing §482, the taxable income of related parties is determined as if they had conducted their affairs in the manner of unrelated parties “dealing at arm's length.” Treas. Reg. §1.482-1 (b)(1). Thus, applying §482 to the example above, the IRS could adjust the U.S. company's transfer price of $100 million to the arm's-length price ($80 million) for tax purposes, increasing the company's taxable income by $20 million.

To deter taxpayers from filing tax returns that require material transfer-price adjustments, Congress enacted accuracy-related penalties for “net section 482 transfer price adjustment[s]” of a certain size; adjustments that exceed $5 million are subject to a 20% penalty, and adjustments that exceed $20 million are subject to a 40% penalty. §6662 (e)(1)(B)(ii), (h)(2)(A)(iii)(I). The term “net section 482 transfer price adjustment” means the “net increase in taxable income” resulting from “adjustments under section 482.” §6662 (e)(3)(A).

In 1990, the IRS established its APA Program to resolve §482 transfer-pricing disputes with taxpayers prospectively by entering into APAs. Rev. Proc. 91-22, 1991-1 C.B. 526. Pursuant to a taxpayer's application, the parties seek agreement on a method for pricing the intercompany transactions at issue and, if successful, enter into a formal agreement in that regard covering a term of years. The administration of such agreements is governed by a Revenue Procedure published (and periodically updated) by Treasury. In exchange for the taxpayer's agreement to utilize the APA's methodology to calculate intercompany prices for tax-reporting purposes, the Commissioner agrees to “limit[ ] his discretion under section 482 to make transfer pricing adjustments.” (R.76 (Opinion), Apx 191.) As long as the APA is in effect, any §482 adjustment must be consistent with the APA.

Under the APA Program, the IRS retains the authority to cancel an APA if certain events occur, including certain material mistakes. Rev. Proc. 96-53, §11.03 (2)& (3), §11.06 (1), 1996-2 C.B. 375; Rev. Proc. 2004-40, §10.03 (2)& (3), §10.06 (1), 2004-2 C.B. 50. If the taxpayer later corrects the mistake, the IRS has the discretion to waive cancellation and require the taxpayer to continue abiding by the APA. Rev. Proc. 96-53, §11.06 (2); accord Rev. Proc. 2004-40, §10.06 (2).

Entering into an APA, however, does not immunize taxpayers from penalties for tax underpayments. As noted above, the Code generally imposes an accuracy-related penalty on any “net increase in taxable income . . . resulting from adjustments under section 482.” §6662 (e)(3)(A). If a taxpayer's tax reporting fails to fully comply with the APA, penalties may apply to transfer-price adjustments that are required to bring the taxpayer into compliance with §482 as implemented by the APA. Rev. Proc. 96-53, §11.02 (3); Rev. Proc. 2004-40, §10.02 (1).

C. Eaton

Eaton is the parent corporation of a multinational enterprise that manufactures electrical and industrial products. (R.735 (Opinion), Apx 212.) During the relevant time period (2001-2010), one of Eaton's U.S. subsidiaries (Eaton-US) purchased circuit breakers and related products (the Products) from Eaton's foreign manufacturing subsidiaries operating in Puerto Rico and the Dominican Republic (Eaton-Islands) and then sold the Products to Eaton affiliates and third-party customers. (R.735 (Opinion), Apx 215-218.) This case concerns the intercompany price (referred to as the transfer price) that Eaton-US paid Eaton-Islands for the Products it distributed.

Eaton allocated profit among its subsidiaries primarily through its transfer pricing. (R.530 (Internal-Eaton-Memo), Apx 609.) The more that Eaton-US paid for the Products, the greater the profit allocated to Eaton-Islands; paying more for the Products increased the revenue earned by Eaton-Islands and decreased the revenue earned by Eaton-US (by increasing its cost-of-goods-sold). (R.735 (Opinion), Apx 232.) The more profit that Eaton allocated to Eaton-Islands, the less it paid in U.S. tax because income earned by Eaton-Islands was subject to no (or reduced) U.S. tax. Eaton has a long history of using its “transfer pricing methodology” to “shift[ ] all of the profit to Puerto Rico” and other Island manufacturing operations outside the full U.S. taxing jurisdiction. (R.530 (Internal-Eaton-Memo), Apx 609.)

D. Eaton's APAs

After an extensive tax audit of its transfer pricing regarding the Products, Eaton applied for an APA in 2002. (R.735 (Opinion), Apx 235-236.) In 2004, Eaton and the IRS entered into APA-I, which covered Eaton's 2001-2005 tax years. (R.41 (APA), Apx 423-441.) Eaton later filed a renewal application, and, in 2006, Eaton and the IRS entered into APA-II, which covered Eaton's 2006-2010 tax years. (R.41 (APA), Apx 443-458.) The APAs incorporated, and are governed by, Treasury's Revenue Procedures.³

The APAs specified the transfer-pricing methodology to be used to calculate for tax purposes the aggregate transfer price Eaton-US paid Eaton-Islands for the Products it distributed in any year covered by the APA (the APA Price).⁴ (R.41 (APAs), Apx 430, 449.) The APA methodology involved several steps and was designed to allocate to Eaton-US a certain amount of profit on its distribution of the Products.  (Id.; R.609 (Transcript), Apx 720-721; R.611 (Transcript), Apx 730-731.) The amount of profit generated by Eaton's transfer pricing was evaluated under what is called “the Berry ratio,” which is gross profit divided by operating expenses.⁵ (R.735 (Opinion), Apx 248-249.) APA-I required Eaton to report on its tax returns a transfer price that allocated Eaton-US an amount of profit that fell within a Berry-ratio range of 1.20-1.27. (R.41 (APA), Apx 430.) APA-II had the same requirement, except it narrowed the Berry-ratio range to 1.20-1.24. (R.41 (APA), Apx 449.) If the actual (book) price paid by Eaton-US to Eaton-Islands was insufficient to provide Eaton-US that APA-specified return, Eaton was required to make an adjustment to that price for tax purposes and to report the adjusted price on its return. (R.41 (APAs), Apx 426, 431, 445, 449.) See Rev. Proc. 96-53, §11.02 (referring to required adjustments as “Compensating Adjustments”); Rev. Proc. 2004-40, §10.02 (referring to such adjustments as “Primary Adjustments”).

The Berry ratio was a critical component of the APA transfer-pricing methodology. (R.735 (Opinion), Apx 261-263; R.611 (Transcript), Apx 730-731; R.615 (Transcript), Apx 744-745; R.620 (Transcript), Apx 750-751; R.601 (Transcript), Apx 715-716.) It was the mechanism by which the IRS ensured that a sufficient amount of income related to the Products was reported on Eaton's U.S. tax return. (Id.) During the initial APA negotiations, Eaton had to agree to a higher Berry ratio than it originally proposed in order to reach an agreement with the IRS.⁶ (R.735 (Opinion), Apx 357.) Although the IRS had reservations about agreeing to Eaton's proposed transfer-pricing methodology, it did so on the condition that the transfer price reported on Eaton's tax return achieve a Berry ratio that was at least 1.20. (R.735 (Opinion), Apx 359.)

The APAs required Eaton to utilize the APA Price when reporting its taxable income on its tax returns, but they did not require Eaton to utilize the APA Price on its books. (R.41 (APAs), Apx 426, 445.) If the transfer price recorded on Eaton's books was more than the APA Price, Eaton had to use the lower APA Price when calculating taxable income and disclose any book-tax difference on the return's Schedule M. (R.735 (Opinion), Apx 268; R.602 (Transcript), Apx 719.)

The APAs also required Eaton to file annual APA reports with the APA Program. (R.41 (APAs), Apx 435-436, 451-453.) Each year's APA Report was due after Eaton filed its tax return for that year and was designed to demonstrate that the transfer pricing reported on the return complied with the APA. Rev. Proc. 96-53, §11.01 (1)& (2); Rev. Proc. 2004-40, §10.01 (1)& (2). In each report, Eaton had to detail its “TPM calculations” to “allow the IRS to determine whether [Eaton] has complied with the TPM” and satisfied the APA's Berry-ratio test when reporting Eaton-US's income on its tax returns. (R.41 (APAs), Apx 436, 452.) Eaton also had to verify whether its tax reporting required compensating adjustments to comply with the APAs. (Id.)

The IRS agreed to accept the APA's transfer-pricing methodology for determining an arm's-length price under §482 so long as Eaton “complie[d] with the terms and conditions of [the] APA.” (R.41 (APAs), Apx 424-425, 444-445.) If Eaton did not comply, the IRS retained the discretion to (among other sanctions) “cancel” the APAs under the relevant Revenue Procedure and apply a different transfer-pricing methodology to Eaton's intercompany transactions. (R.41 (APAs), Apx 425, 446.) Under those Procedures, the IRS could cancel an APA if Eaton was unable to demonstrate (among other things) that the “data and computations” used to apply the APA methodology “were correct in all material respects” or that the “material representations” in its APA Reports were “valid.” Rev. Proc. 96-53, §11.03 (2)& (3); Rev. Proc. 2004-40, §10.03 (2)& (3). The IRS could also cancel an APA if it “determine[d] that there was a misrepresentation, mistake as to a material fact, failure to state a material fact, or lack of good faith compliance with the terms and conditions of the APA . . . in connection with the request for the APA, or in any subsequent submissions (including the annual report).” Rev. Proc. 96-53, §11.06 (1); Rev. Proc. 2004-40, §10.06 (1).

E. Eaton's APA Reports

After entering into the APAs, Eaton filed annual APA Reports that purported to demonstrate that Eaton's tax reporting complied with the APAs. (R.851 (APA-Reports), Apx 891-1076.) The APA Reports for 2005-2008 represented that:

• Eaton's tax returns reported transfer prices for the Products that complied with the APA transfer-pricing methodology;

• these prices “achieved a Berry ratio” that satisfied the relevant APA; and

• “no compensating adjustment” was required, thus representing that the transfer pricing on Eaton's books was the same as the pricing described in the APA Report.

(R.851 (APA-Reports), Apx 900-906, 958-961, 994-1000, 1038-1044.) The Reports also detailed how the transfer price was computed each year. (Id.)

F. Eaton's tax reporting

Contrary to the representations in its APA Reports, Eaton's “tax returns failed to reflect the transfer price computed under the APA TPM.” (R.735 (Opinion), Apx 301.) Instead, Eaton's tax returns for 2005-2008⁷ reported transfer prices that exceeded the price computed under the APA transfer-pricing methodology and reported in its APA Reports (the APA Price), as set out below⁸:

Chart-I

	2005	2006	2007	2008
Tax Return	$660 million	$734 million	$767 million	$799 million
APA Report	$611 million	$696 million	$704 million	$783 million
Difference	$49 million	$38 million	$63 million	$16 million

As Chart-I illustrates, the transfer price on Eaton's tax returns was inflated by over $165 million in 2005-2008, reducing Eaton's taxable income for those years by an equivalent amount. When filing its tax returns, Eaton understood that using a transfer price that exceeded the APA Price to compute its taxable income generated a “Tax Benefit.” (R.901 (Eaton-Tax-Spreadsheet), Apx 1582; R.646 (Transcript), Apx 764-768.)

The APAs also required Eaton to file tax returns that allocated Eaton-US an amount of profit on the sale of the Products that was sufficient to satisfy the APAs' Berry-ratio range. Although Eaton's APA Reports represented that Eaton's tax returns for 2005-2008 used transfer prices that satisfied that requirement, in reality, they did not do so. (R.735 (Opinion), Apx 304; R.611 (Transcript), Apx 740-741.)

Rather, the transfer prices reported on Eaton's tax returns resulted in Berry ratios below the Berry-ratio range required by the APAs and reported in the APA Reports, as set out below⁹:

Chart-II

	2005	2006	2007	2008
APA Berry-ratio range	1.20-1.27	1.20-1.24	1.20-1.24	1.20-1.24
Berry ratio reported on APA Report	1.22	1.20	1.20	1.20
Berry ratio reflected in tax return	0.70	0.80	0.64	1.06
Tax return compliance with APA Berry-ratio requirement	No	No	No	No

 G. Eaton's use of the APA Multiplier

The large discrepancies between the prices reported on Eaton's tax returns and the prices reported on Eaton's APA Reports were due to the fact that Eaton used two different calculations to compute those prices. (R.735 (Opinion), Apx 264-266, 301, 304.) To compute the price reported on its APA Reports, Eaton utilized the APA transfer-pricing methodology.¹⁰ (R.851 (APA-Reports), Apx 905-906, 960-961, 999-1000, 1043-1044.) In contrast, to compute the price reported on its tax returns, Eaton utilized what it called an “APA multiplier.” (R.735 (Opinion), Apx 301; R.864 (Internal-Eaton-Memo), Apx 1450.) To calculate the APA Multiplier, Eaton would take the “tax transfer price” used for its APA Report (the APA Price) and divide it by Eaton-Islands' manufacturing-costs data. (R.627 (Transcript), Apx 762-763; R.534 (Eaton-Expert-Report), Apx 672.) Eaton would then multiply Eaton-Islands' actual costs by the APA Multiplier and use the resulting number as the transfer price on its tax return.¹¹ (R.735 (Opinion), Apx 301-303; R.864 (Internal-Eaton-Memo), Apx 1450; R.534 (Eaton-Expert-Report), Apx 672-673; R.611 (Transcript), Apx 729; R.627 (Transcript), Apx 757-763.)

In theory, the product of the APA Multiplier and Eaton-Islands' costs would be the mathematical equivalent of the transfer price computed under the APA transfer-pricing methodology.  (R.735 (Opinion), Apx 351; R.602 (Transcript), Apx 717; R.626 (Transcript), Apx 756.) In practice, that did not occur, as illustrated in Chart-I above. A reoccurring problem with Eaton's APA-Multiplier calculations resulted in a “higher transfer price being reported on [Eaton's] tax returns” than reported on Eaton's APA Reports (resulting in less taxable U.S. income).¹² (R.735 (Opinion), Apx 303.) The overstated transfer price for the Products was not listed as a separate line item on Eaton's tax returns but was instead subsumed in a larger calculation of Eaton-US's cost-of-goods-sold. (R.735 (Opinion), Apx 368.) Accordingly, the large discrepancy between the transfer price included in Eaton's tax returns and the transfer price reported in its APA Reports was not readily discernible to the IRS. (Id.)

The APAs did not include or otherwise permit the use of the APA Multiplier to calculate the transfer price to be reported on Eaton's tax returns. (R.41 (APAs), Apx 423-458.) Moreover, the APA-Multiplier calculation differed from the APA transfer-price calculation in two fundamental respects. First, the APA transfer-price calculation was based on Eaton-US's revenues, whereas the APA-Multiplier calculation was based on Eaton-Islands' costs. (R.735 (Opinion), Apx 264-266, 290-291, 294-296, 300; R.851 (Technical-Explanation-Amended-APA-Report), Apx 1274.) Second, the transfer price generated by the APA transfer-price calculation was tested against the APA's Berry-ratio range to ensure that sufficient profit was allocated to Eaton-US, whereas the transfer price generated by the APA-Multiplier calculation was not so tested. (Id.)

Eaton did not disclose in its APA applications or any other APA submission that it would use the APA Multiplier to generate the transfer price used in its tax reporting. (R.611 (Transcript), Apx 729; R.393 (Application-for-APA-I), Apx 494-608; R.858 (Application-for-APA-II), Apx 1329-1448; R.851 (APA-Reports), Apx 891-1076.) In particular, Eaton's APA Reports extensively detailed Eaton's transfer-pricing calculations but did not explain (or even mention) the APA Multiplier. (Id.) The APA Program first learned about Eaton's use of the APA Multiplier in late 2010, after initiating a review of Eaton's APA implementation, described below. (R.851 (Technical-Explanation-Amended-APA-Reports), Apx 1254-1255, 1274-1275, 1295-1296, 1316-1317.)

H. Cancellation of APAs

In 2007, the IRS initiated an examination of Eaton's 2005 and 2006 tax returns. (R.1 (Petition), Apx 164.) In 2009, and concurrent with that examination, the APA Program initiated a review of Eaton's APA implementation. (R.735 (Opinion), Apx 314.) The following year, in April 2010, Eaton contacted the APA Program (by telephone) and informed it that calculations reported in its APA Reports contained several inaccurate data inputs and would need to be revised. (R.735 (Opinion), Apx 300-301; R.610 (Transcript), Apx 722.) In October 2010, Eaton filed amended APA Reports for 2005-2008, along with separate “Technical Explanations” of the various errors and corrections thereof.¹³ (R.851 (Amended-APA-Reports), Apx 1077-1245; R.851 (Technical-Explanation-Amended-APA-Reports), Apx 1246-1328.) The Technical Explanations described the APA Multiplier, its role in Eaton's transfer pricing, and errors in the APA-Multiplier calculations. (R.851 (Technical-Explanation-Amended-APA-Reports), Apx 1254-1255, 1274-1275, 1295-1296, 1316-1317.) The revised APA Prices set out in the amended APA Reports generally increased the APA Price (as compared to the original APA Reports) but still left large discrepancies (exceeding $130 million) with Eaton's pricing on its tax returns¹⁴:

Chart-III

	2005	2006	2007	2008
Tax Return	$660 million	$734 million	$767 million	$799 million
Amended APA Report	$626 million	$698 million	$728 million	$775 million
Difference	$34 million	$36 million	$39 million	$24 million

After discovering that Eaton had failed to use the APA Price on its tax returns and had inaccurately represented on its APA Reports that it had done so, the IRS Associate Chief Counsel (International) canceled the APAs. (R.41 (Cancellation-Letter), Apx 460-461.) By letter dated December 16, 2011, he informed Eaton that, pursuant to the applicable Revenue Procedures and the cancellation provisions of the APAs, the IRS was canceling APA-I and APA-II effective January 1, 2005, and January 1, 2006, respectively. (Id.) He explained that cancellation was “based on numerous grounds” permitted by the applicable Revenue Procedures, including “mistake as to a material fact,” “failure to state a material fact,” and “errors in the supporting data and computations used in the transfer pricing methodologies.” (Id.) He emphasized Eaton's “material deficiencies in APA compliance related to discrepancies between the transfer price reported by Eaton in its APA Annual Reports and the transfer price reflected on Eaton's books and in Eaton's tax returns.”¹⁵ (Id.)

After canceling the APAs, the IRS issued Eaton a notice of deficiency for 2005 and 2006,¹⁶ determining (among other things) that Eaton's intercompany transfer pricing required adjustments under §482 that substantially increased its income subject to U.S. taxation.  (R.41 (Notice-of-Deficiency), Apx 483.) That determination was based on the application of a different transfer-pricing methodology than the one set forth in the canceled APAs. (R.735 (Opinion), Apx 315-316.) The IRS further determined that the §6662 penalty for “net section 482 transfer price adjustment[s]” applied to both years. (R.41 (Notice-of-Deficiency), Apx 467.)

I. Tax Court proceedings

Eaton petitioned the Tax Court for a redetermination of the tax deficiencies set forth in the deficiency notice. (R.1 (Petition), Apx 120-182.) It argued that the transfer pricing for the Products should be redetermined under the APA transfer-pricing methodology, not the methodology utilized by the IRS in the notice. (R.1 (Petition), Apx 128-153.)

Prior to trial, the Tax Court addressed certain threshold issues regarding the cancellation of the APAs. It agreed with the Commissioner that the court had jurisdiction to review the IRS's cancellation decision as part of its deficiency jurisdiction, and that Eaton bore the burden of proving that the IRS acted arbitrarily in canceling the APAs. (R.76 (Opinion), Apx 194-200.) Citing the governing Revenue Procedures, the court concluded that the IRS retained the discretion to cancel the APAs for “any” of the grounds set out in those Procedures, including Eaton's failure to establish “the validity and accuracy of material representations in the annual reports.” (R.76 (Opinion), Apx 197.)

1. Cancellation opinion

The Commissioner argued that he did not act arbitrarily in canceling the APAs. In support thereof, he relied on (among other things) the undisputed fact that Eaton failed to report the APA Price on its tax returns, understating its taxable income by over $165 million during 2005-2008. (R.731 (Commissioner-Brief), Apx 784-793; R.732 (Commissioner-Reply-Brief), Apx 799-801.) The Commissioner argued that this repeated failure (i) invalidated material representations in the APA Reports and (ii) resulted in mistakes of material fact in those Reports, both grounds for cancellation under the Revenue Procedures. (Id.) The Commissioner further argued that Eaton's failure to disclose its use of the APA Multiplier to the APA Program constituted an omission of material fact, another basis for cancellation under the Revenue Procedures. (R.731 (Commissioner-Brief), Apx 781, 794-796; R.732 (Commissioner-Reply-Brief), Apx 798-799.)

Eaton conceded that it made numerous errors in implementing the APAs. (R.728 (Eaton-Brief), Apx 770-773.) In particular, Eaton conceded that its “tax returns erroneously did not reflect the transfer price computed under the APA TPM,” but argued that the “discrepancy” “was due to a data error involving the computation of the APA Multiplier.” (R.728 (Eaton-Brief), Apx 773, 777-778.) Eaton argued that “data and computational errors” — no matter how material — could never merit cancellation. (R.728 (Eaton-Brief), Apx 774-775.)

The Tax Court first divided the Commissioner's arguments in support of cancellation into two categories, those related to APA negotiations and those related to APA implementation. (R.735 (Opinion), Apx 336.) The court concluded that there were no misrepresentations, mistakes as to a material fact, or failures to state a material fact during the APA negotiations and that therefore “[c]anceling the APAs on grounds related to the APA negotiations was arbitrary.” (R.735 (Opinion), Apx 363.)

Turning to the Commissioner's arguments regarding APA implementation, the Tax Court noted that, in addition to cancellation provisions, the Revenue Procedures contained audit provisions that also implicated cancellation. (R.735 (Opinion), Apx 364-365.) Under those audit provisions, the IRS could require the taxpayer to establish (among other things) that “the supporting data and computations used in applying the [transfer-pricing methodology] were correct in all material respects” and that “material representations” in the APA Reports were “valid.” Rev. Proc. 96-53, §11.03 (2); see Rev. Proc. 2004-40, §10.03 (2). The court further noted that if the taxpayer failed to satisfy that requirement, then the “IRS may decide to enforce, revise, cancel, or revoke the APA.” (R.735 (Opinion), Apx 365 (citing Rev. Proc. 96-53, §11.03 (3); Rev. Proc. 2004-40, §10.03 (3)).)

The Tax Court characterized Eaton's “numerous” implementation errors as “data and computations” errors and divided them into two categories: (i) Eaton's failure to report the APA Price on its tax returns, (R.735 (Opinion), Apx 366), and (ii) Eaton's errors in computing the APA Price under the APA transfer-pricing methodology. (R.735 (Opinion), Apx 372-376.) The court rejected Eaton's argument that errors pertaining to “data and computations” could never support cancellation, even if they were “material.” (R.735 (Opinion), Apx 378.)

The Tax Court first addressed Eaton's largest error, its tax-reporting error. (R.735 (Opinion), Apx 366-372.) While noting that “the size of [that] error may be considered” in determining whether it was “material,” the court concluded that “[w]e also need to look at how the error occurred.” (R.735 (Opinion), Apx 370.) The court attributed the tax-return error to Eaton's use of the APA Multiplier, finding that an “error affecting the APA multiplier caused the transfer price on Eaton's books and records to be inconsistent with the transfer price computed under the APA TPM.”¹⁷ (R.735 (Opinion), Apx 366.) The court found that the APA-Multiplier error was “inadvertent” and that Eaton “discovered [it] and attempted to rectify it.” (R.735 (Opinion), Apx 370-371.) Based on those findings, the court concluded that the APA-Multiplier error “was not a material mistake” and “should have been addressed through adjustments” rather than cancellation. (R.735 (Opinion), Apx 371.) The court separately concluded that the error did not “qualif[y] as lack of good-faith compliance” with the APAs and did not “represent[ ] a mistake [as to] a material fact or a misrepresentation.” (R.735 (Opinion), Apx 371-372.) The court did not address whether Eaton's use of the APA Multiplier was a material fact that should have been disclosed in Eaton's APA submissions.  (R.735 (Opinion), Apx 366-372.)

The Tax Court then addressed Eaton's seven data errors that impacted the transfer prices reported in its APA Reports and concluded that they “were not material.”¹⁸ (R.735 (Opinion), Apx 380.) The court again focused on Eaton's intent, finding that these errors “were not deliberate” but were due instead to “inadvertence.”¹⁹ (R.735 (Opinion), Apx 377-380.)

2. Penalties opinion

Although the Tax Court disagreed with the Commissioner's cancellation decision, it agreed that Eaton's transfer pricing required adjusting. It directed the parties to compute the correct amount of the adjustments and the resulting tax liability under Tax Court Rule 155.²⁰ The parties agreed that Eaton had overstated the transfer prices for the Products on its 2005-2006 returns, which (after taking into account offsetting §482 adjustments related to intercompany royalty payments) produced net transfer-price adjustments for those years of $32 million and $27 million. (R.783 (Commissioner-Supplemental-Brief), Apx 813; R.600 (Amended-Returns), Apx 1458-1459, 1527-1530.) But they disputed whether the resulting tax deficiencies were subject to the gross-valuation-misstatement penalty for “net section 482 transfer price adjustment[s].” §6662 (b)(3), (e)(1)(B)(ii), (h)(2)(A)(iii)(I).

The Tax Court concluded that the penalty did not apply. (R.807 (Opinion), Apx 405-416.) In so ruling, the court reasoned that, because “the APAs remained in effect” during the years at issue, “[t]here was no allocation of income and deductions by the [IRS] pursuant to section 482” to support imposition of the penalty under §6662 (b)(3), (e)(1)(B)(ii), (h)(2)(A)(iii)(I). (R.807 (Opinion), Apx 415.)

SUMMARY OF ARGUMENT

This appeal presents an issue of first impression that is critical to tax administration: the extent of the IRS's discretion to cancel an advance-pricing agreement (APA) when a taxpayer fails to comply with its terms. By entering into the APAs here, the IRS agreed to limit its broad authority under §482 in exchange for Eaton's agreement to (among other things) report on its tax returns APA-compliant transfer prices. It is undisputed that Eaton did not keep its end of the bargain. Eaton's tax returns repeatedly failed to report prices that complied with the APAs, overstating the prices as set forth in Eaton's APA Reports by over $165 million for 2005-2008 alone. After learning of this fundamental failure in Eaton's tax reporting, and the related errors in Eaton's APA Reports, the IRS exercised its retained discretion to cancel the APAs pursuant to the governing Revenue Procedures. The Tax Court rejected the IRS's cancellation decision, concluding that the IRS should have permitted Eaton to simply correct its errors. That conclusion rewrites the governing Revenue Procedures and usurps the IRS's choice of sanction for noncompliance, a choice that — as a matter of law — can be displaced only if arbitrary.

1. The IRS did not act arbitrarily in canceling the APAs. Under the governing Revenue Procedures, the IRS retained the discretion to cancel the APAs if (as relevant here) the taxpayer (i) made a material mistake in its data and computations, (ii) included invalid material representations in its APA Reports, (iii) made a mistake of material fact in its APA Reports, or (iv) omitted a material fact in its APA submissions. Each of those events occurred here, any one of which supports cancellation. The Tax Court's conclusion that an error is not “material” if it is unintentional and “inadvertent” is baseless. Under the Revenue Procedures, the origin of a mistake has no bearing whatsoever on its materiality. Although the court believed that the IRS should have elected to adjust Eaton's transfer-pricing errors instead of canceling the APAs, the Revenue Procedures gave the IRS — and only the IRS — the discretion to determine the sanction for APA violations. Because the IRS did not act arbitrarily in canceling the APAs, the court erred as a matter of law in overriding the IRS's decision.

2. The Tax Court also erred in concluding that the Code's penalty for inaccurate transfer pricing does not apply to Eaton's inaccurate transfer pricing. Under the Code, a penalty applies to increases in income “resulting from adjustments under section 482” that exceed a statutory threshold (a 20% penalty for increases of $5 million or more and a 40% penalty for increases of $20 million or more). §6662 (e)(1)(B)(ii), (h)(2)(A)(iii)(I). It is undisputed that Eaton's erroneous transfer pricing exceeded the statutory threshold for the 40% penalty. And §482 is the only provision in the Code that authorizes the adjustments needed to correct that pricing. Therefore, under the plain language of the statute, the penalty applies here. The court's contrary conclusion ignores the statutory text and is based on the erroneous assumption that transfer-price adjustments pursuant to an APA are not transfer-price adjustments under §482. Any adjustment to a taxpayer's transfer pricing as reported on its tax return is an adjustment under §482 — even those pursuant to an APA, and whether “initiated” by the IRS or the taxpayer — as the parties' APAs and the governing Revenue Procedures make clear.

ARGUMENT

I The IRS did not abuse its discretion in canceling the APAs

Standard of review

The Tax Court was tasked with reviewing the IRS's cancellation decision under the abuse-of-discretion standard. Under that standard, the IRS's decision “is not to be set aside unless shown to be 'plainly arbitrary.'” Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532-533 (1979) (citation omitted). Whether the court correctly applied that standard is a legal question, reviewed de novo. Fed. Prop. Mgmt. Corp. v. Harris, 603 F.2d 1226, 1230-1231 (6th Cir. 1979) (reversing trial court that incorrectly applied the abuse-of-discretion standard by “inquir[ing] into the wisdom of the [agency's] action”).

A. Introduction

This case presents an issue of first impression regarding the scope of the IRS's discretion to cancel an APA under the governing Revenue Procedures. By entering into an APA, the IRS agrees to limit its broad authority under §482 in exchange for the taxpayer's reporting on its tax returns intercompany prices that comply with the APA's transfer-pricing methodology. If the taxpayer fails to do so, the IRS has several options for sanction, including cancellation. The IRS's selection of sanction is subject to the highly deferential abuse-of-discretion standard and may be set aside only if the IRS acted arbitrarily.

As demonstrated below, the IRS did not act arbitrarily in determining that Eaton's repeated representation that its tax returns complied with the APAs' transfer-pricing methodology, when the pricing on Eaton's tax returns for 2005-2008 in fact exceeded the APA Price by over $165 million, qualified as a material mistake. Moreover, Eaton's rationale for this material mistake — that the error was due to a mechanism not sanctioned by the APAs (the APA Multiplier) — only highlights another basis supporting the IRS's cancellation decision: Eaton failed to disclose a material fact — its reliance on the APA Multiplier — to the APA Program. See, below, §B. The Tax Court's contrary ruling usurps the IRS's decision-making authority and allows taxpayers to disregard the terms of an APA unless and until their compliance is reviewed by the IRS, when the taxpayer can make an eleventh-hour confession of compliance failure that will preclude the IRS from exercising its retained discretion. See, below, §C.

B. The Revenue Procedures provide the IRS the discretion to cancel an APA based on the undisputed facts here

The applicable Revenue Procedures authorize the IRS to “cancel” an APA if the taxpayer is unable to establish (i) that the “supporting data and computations used in applying the [transfer-pricing methodology] were correct in all material respects” or (ii) that “material representations” in the “annual reports remain valid.” Rev. Proc. 96-53, §11.03 (2)& (3) (applicable to Eaton's 2005 tax year); accord Rev. Proc. 2004-40, §10.03 (2)& (3) (applicable to Eaton's 2006 tax year). The Revenue Procedures also authorize the IRS to cancel an APA if it “determines” that there was a “mistake as to a material fact” or a “failure to state a material fact” in connection with the request for the APA or “in any subsequent submissions (including the annual report).” Rev. Proc. 96-53, §11.06 (1); accord Rev. Proc. 2004-40, §10.06 (1).

The IRS's decision that the undisputed facts satisfied the regulatory basis for cancellation is definitive unless the taxpayer demonstrates that it is “'plainly arbitrary.'” Thor Power Tool, 439 U.S. at 532-533 (citation omitted). See, e.g., Canton Police Benevolent Ass'n of Canton, Ohio v. United States, 844 F.2d 1231, 1238 (6th Cir. 1988)  (holding that the IRS did not “abuse” its “discretion” in retroactively revoking a taxpayer's exemption where there was a “regulatory basis” to do so). As demonstrated below, the IRS's cancellation decision is not plainly arbitrary.

1. The supporting data and computations for the transfer pricing on Eaton's tax returns were not correct in all material respects

As the Tax Court recognized, the governing Revenue Procedures permit the IRS to cancel an APA where the supporting “data and computations” used by the taxpayer to apply the APA are not “correct in all material respects.” (R.735 (Opinion), Apx 370-371, 378 (citing Rev. Proc. 96-53, §11.03 (2)& (3); Rev. Proc. 2004-40, §10.03 (2)& (3)).) Here, it is undisputed that Eaton's tax returns “failed to reflect the transfer price computed under the APA TPM” (R.735 (Opinion), Apx 301), and the court attributed that failure to Eaton's “data and computational errors” (R.735 (Opinion), Apx 298).

The IRS did not act arbitrarily in determining that these errors were material. The discrepancy between the APA Price reported in Eaton's APA Reports and the non-APA Price reported on its tax returns exceeded $165 million during 2005-2008. See Chart-I, above (p.15).

Even after Eaton filed amended APA Reports in 2010 and increased the APA Price for those years, the resulting discrepancy (between the amended APA Price and the price utilized in the original tax returns) remained substantial, exceeding $130 million during 2005-2008. See Chart-III, above (p.22).

The Revenue Procedures do not provide a “bright-line test” for determining whether computational errors are material. (R.735 (Opinion), Apx 370.) But since a computational error is numerical, common sense suggests that the primary — if not exclusive  — factor bearing on the materiality of such an error is its size. As pertinent here, Congress has concluded that computational transfer-pricing errors the size of Eaton's computational errors merit substantial accuracy-related penalties. In this regard, Congress has categorically determined that a $5 million misstatement of a transfer price can merit a 20% penalty and that a $20 million misstatement of a transfer price can merit a 40% penalty. §6662 (a), (b)(3), (e)(1)(B)(ii), (h)(1)& (2)(A)(iii)(I). Given Congress's determination that a $5 million transfer-price misstatement can merit a substantial penalty, the IRS's determination here that misstatements far greater than that are material is in no sense arbitrary.

2. Eaton's APA Reports contained several invalid representations and mistakes as to material facts

In addition to the right to cancel an APA for computational errors determined to be material, the governing Revenue Procedures also permit the IRS to cancel an APA where a taxpayer's annual APA report contains (i) “material representations” that are invalid, Rev. Proc. 96-53, §11.03 (2)& (3); Rev. Proc. 2004-40, §10.03 (2)& (3), or (ii) a “mistake as to a material fact,” Rev. Proc. 96-53, §11.06 (1); Rev. Proc. 2004-40, §10.06 (1). Eaton's APA Reports for 2005-2008 contained three critical representations that are invalid and constitute mistakes as to material facts.

First, Eaton represented in its APA Reports that “Taxpayer complied with all APA terms and conditions.” (R.851 (APA-Reports), Apx 951, 953, 1032, 1076.) That representation was invalid. Eaton failed to comply with the single most important APA term and condition  — the requirement to report the APA Price on its tax returns. In this regard, the APAs expressly provided that Eaton “[m]ust report its taxable income in an amount that is consistent with the TPM and all other requirements of this APA on its timely filed U.S. Return.” (R.41 (APAs), Apx 426, 445.) It is undisputed, however, that Eaton did not comply with that fundamental requirement. (R.610 (Transcript), Apx 723-728.) See Chart-I, above (p.15). As the Tax Court found, Eaton's “tax returns failed to reflect the transfer price computed under the APA TPM.” (R.735 (Opinion), Apx 301.)

Second, Eaton represented in its APA Reports that its transfer pricing satisfied the APAs' Berry-ratio requirement, providing a detailed computation to demonstrate Eaton's allocation of “Operating Profit” sufficient to satisfy that requirement. (R.851 (APA-Reports), Apx 905-906, 960-961, 999-1000, 1043-1044.) That representation was invalid. (R.735 (Opinion), Apx 303-304.) Contrary to the representation in the APA Reports, the transfer pricing on Eaton's 2005-2008 tax returns fell far short of the required Berry-ratio range. See Chart-II, above (p.16). Indeed, Eaton admitted at trial that the transfer pricing in its tax returns failed to satisfy the APAs' Berry-ratio profit-allocation requirements. (R.611 (Transcript), Apx 740-741.)

Finally, Eaton represented in its APA Reports that its transfer pricing for the Products required “no compensating adjustments.”  (R.851 (APA-Reports), Apx 900-901, 958, 994, 1038.) That representation was invalid. (R.735 (Opinion), Apx 303-304.) As noted above, if Eaton's transfer price for the Products recorded in its books did not satisfy the APA's transfer-pricing methodology, Eaton was required to adjust the price for purposes of its tax reporting and disclose that compensating adjustment on its APA Report. (R.41 (APAs), Apx 436, 452.) See Rev. Proc. 96-53, §11.02 (1); Rev. Proc. 2004-40, §10.02 (1). Although Eaton's APA Reports for 2005-2008 represented that “no compensating adjustment” was needed, there is no dispute that significant compensating adjustments were actually required to bring Eaton's 2005-2008 transfer pricing into compliance with the APAs. After the IRS initiated a compliance review of Eaton's APAs in 2009, Eaton filed amended APA Reports in 2010, conceding that substantial compensating adjustments ($34 million, $36 million, $45 million, and $17 million, respectively) were needed to “bring [Eaton-US's] Berry ratio into compliance with the APA TPM calculation” for those years. (R.851 (Amended-APA-Reports), Apx 1085, 1130, 1169-1170, 1210-1211.)

Each of the three invalid representations described above is material. Although the Revenue Procedures do not define “material representations” for purposes of Rev. Proc. 96-53, §11.03 (2)& (3); Rev. Proc. 2004-40, §10.03 (2)& (3), they assume that an annual report contains some material representations, and, given the context here, nothing could be more material than the representations that the transfer pricing on Eaton's tax returns complied with the APA transfer-pricing methodology. Eaton's own expert acknowledged that the entire “purpose of the APA” is to “ensure that [Eaton] determine[s] the arm's length-price” to “establish the tax transfer price and then carry that into [Eaton's] tax returns.” (R.626 (Transcript), Apx 754.) As she explained, the price “that's calculated under the APA method” and reported on the APA report “is intended to wind up on the tax return.” (R.626 (Transcript), Apx 755; see R.620 (Transcript), Apx 748-749.) The fact that the prices reported in the APA Reports did not in fact “wind up on the tax return” — despite representations to the contrary in the APA Reports — is perhaps the most material mistake that could have been made. At a minimum, the IRS did not act arbitrarily in determining that these invalid representations were material.

Similarly, the IRS did not act arbitrarily in determining that these invalid representations constituted mistakes of material fact for purposes of the cancellation provision in Rev. Proc. 96-53, §11.06 (1); Rev. Proc. 2004-40, §10.06 (1). Revenue Procedure 2004-40 provides  (i) that the IRS “will consider facts as material if, for example, knowledge of the facts could reasonably have resulted in an APA with significantly different terms and conditions,” and (ii) that with “regard to annual reports,” the IRS will “consider facts as material if, for example, knowledge of the facts would have resulted in” (among other things) “a materially different allocation of income, deductions, or credits than reported in the annual report.” §10.06 (1). Revenue Procedure 96-53 has a similar description of material facts, although it does not provide the latter example. See Rev. Proc. 96-53, §11.06 (1) (“Material facts are those that, if known by the Service, would have resulted in a significantly different APA (or no APA at all).”).

The Revenue Procedures' descriptions of material fact are broad enough to include the invalid representations in Eaton's APA Reports. If the IRS had known about Eaton's actual transfer pricing during 2005-2008, there would have been a “materially different allocation of income” — in the form of a compensating adjustment — than “reported in the annual report” for each year. Rev. Proc. 2004-40, §10.06 (1).

Eaton acknowledged as much in its amended APA Reports, stating that  — contrary to the compensating adjustments reported in its original APA Reports ($0) — Eaton's transfer pricing for those years actually required compensating adjustments of $34 million, $36 million, $45 million, and $17 million, respectively, to comply with the APAs' transfer-pricing methodology. (R.851 (Amended-APA-Reports), Apx 1085, 1130, 1169-1170, 1210-1211.)

Indeed, if the IRS had known that the transfer pricing on Eaton's tax returns would repeatedly (i) vary so wildly from the pricing in its APA Reports, (ii) fall far short of the required Berry ratio, and (iii) lack the necessary compensating adjustments, there likely would have been “no APA at all.” Rev. Proc. 96-53, §11.06 (1). The parties' negotiation history makes this clear. Securing the Berry ratio set out in the APA was imperative for the IRS.²¹ Eaton had to agree to a “higher Berry ratio than originally proposed in order to reach an agreement,” as the Tax Court found. (R.735 (Opinion), Apx 357.) Eaton originally proposed  — and the IRS rejected — a Berry ratio of 1.13 (R.612 (Transcript), Apx 742), an amount far higher than the Berry ratios generated by Eaton's tax reporting in 2005-2008 (0.64-1.06). See Chart-II, above (p.16). If the IRS would not enter into an APA with Eaton that resulted in a Berry ratio of 1.13, it most certainly would not have entered into an APA that resulted in a Berry ratio of 0.64.

Given this history, Eaton's mistake of fact regarding the Berry ratio plainly is material. The IRS agreed to limit its broad discretion under §482, and to make only §482 adjustments consistent with the APA's terms, precisely because Eaton represented — year after year — that its U.S. subsidiary was earning a Berry-ratio-compliant return.

3. Eaton omitted a material fact in its APA Reports and other APA submissions

The governing Revenue Procedures also permit the IRS to “cancel” an APA where the taxpayer “fail[s] to state a material fact” in its “annual report” and other APA “submissions.” Rev. Proc. 96-53, §11.06 (1); accord Rev. Proc. 2004-40, §10.06 (1). Here, Eaton failed to disclose in its submissions to the APA Program that it planned to use  (and did use) the APA Multiplier to incorporate the APA Price into its tax returns, a material fact.

The Tax Court's findings demonstrate that Eaton's use of the APA Multiplier was a material fact. In this regard, the court found that the large discrepancy — over $165 million during 2005-2008 — between  (i) “the transfer price computed under the APA TPM” (the APA Price) and (ii) the “transfer price recorded in Eaton's books” and tax returns was due to an “error affecting the APA multiplier.” (R.735 (Opinion), Apx 298, 366.) As the court concluded, Eaton's use of the APA Multiplier “resulted in the wrong transfer price's being reported on [Eaton's] tax returns” (R.735 (Opinion), Apx 367) and in Eaton's failure to satisfy the APAs' Berry-ratio range (R.735 (Opinion), Apx 304). If Eaton had not used the APA Multiplier, but had simply followed the APA methodology in preparing its tax returns, as it did in creating its APA Reports, its tax reporting would have complied with the APAs and the representations in the APA Reports detailed above would have been valid and accurate.

Although the APA Multiplier served an outsized role in its tax reporting, Eaton failed to disclose that material fact to the APA Program. To begin with, the APA Multiplier was not authorized by the APAs. (R.41 (APAs), Apx 423-458.) As Eaton's Vice President in charge of tax conceded, the APA Multiplier “is not part of the APA agreement.” (R.620 (Transcript), Apx 752.) Moreover, Eaton did not refer to the APA Multiplier, or otherwise disclose its role in Eaton's tax reporting, in the APA applications or original APA Reports. (R.393 (Application-for-APA-I), Apx 494-608; R.858 (Application-for-APA-II), Apx 1329-1448; R.611 (Transcript), Apx 729; R.851 (APA-Reports), Apx 891-1076.) To the contrary, to demonstrate that Eaton's tax reporting complied with the APA, the APA Reports set out a detailed analysis that tracked the steps of the APA transfer-pricing methodology, suggesting that no additional computations — like that entailed by the APA Multiplier — were used in its purportedly APA-compliant tax reporting. (R.851 (APA-Reports), Apx 905-906, 960-961, 999-1000, 1043-1044.) It was only after the APA Program began to investigate Eaton's APA implementation that Eaton acknowledged the pivotal role played by the APA Multiplier, detailing that role in the Technical Explanations to its amended APA Reports that it filed with the APA Program in October 2010.²² (R.851 (Technical-Explanation-Amended-APA-Reports), Apx 1254-1255, 1274-1275, 1295-1296, 1316-1317.)

Given the critical role that the APA Multiplier played in the grossly inflated transfer pricing on Eaton's tax returns, the IRS did not abuse its discretion in determining that Eaton's factual omission regarding the APA Multiplier was material and warranted cancellation of the APAs. If the IRS's APA Program had known about Eaton's use of the APA Multiplier, it would have — at a minimum — required the use of safeguards to ensure that errors of the magnitude here (over $165 million during 2005-2008) did not arise. Indeed, Eaton itself purportedly implemented a “Process Improvement” in 2010 to “ensure” that the errors that occurred on the 2001-2008 tax returns did not reoccur on future tax returns. (R.864 (Eaton-Internal-Memo), Apx 1452  (describing new “Internal Audit [that] will periodically review the APA calculation process and the reconciliation of the APA data to the general ledgers”).)

More likely, the IRS would have prohibited the use of the APA Multiplier for tax reporting altogether, requiring Eaton's tax reporting to follow the steps — and only the steps — permitted by the APA transfer-pricing methodology. By entering the APAs, the parties agreed that Eaton-US should be the tested party under the APA transfer-pricing methodology and its profitability the focus of that method. The APA Multiplier is patently incompatible with that agreed-upon approach because it treats Eaton-Islands as the tested party and provides it a costs-based return, much like the transfer-pricing methodology used by Eaton in pre-APA years that the IRS deemed unacceptable under §482. (R.735 (Opinion), Apx 236-237.)

C. The Tax Court erred as a matter of law in overriding the IRS's cancellation decision

The Tax Court concluded (i) that Eaton's failure to file tax returns that complied with the APA's transfer-pricing methodology was due to an “error affecting the APA multiplier” and (ii) that error was “inadvertent” and therefore not “material.” (R.735 (Opinion), Apx 366-371.) As such, the court further concluded, any related misrepresentation, mistake of fact, or incorrect “supporting data and computations” “was not a ground for canceling the APAs under the abuse of discretion standard.” (R.735 (Opinion), Apx 370-372.) The court's analysis cannot withstand scrutiny.

1. The predicate for the Tax Court's analysis is logically flawed

As a preliminary matter, the Tax Court's analysis proceeds from an unsound premise. The court concluded that Eaton's tax returns did not reflect the APA Price because an “error affecting the APA multiplier caused the transfer price recorded in Eaton's books and records to be inconsistent with the transfer price computed under the APA TPM.” (R.735 (Opinion), Apx 366 (emphasis added).) But, in so concluding, the court ignored the fact that Eaton's books and records do not dictate the transfer price that must be reported on its tax returns. (R.620 (Transcript), Apx 748.) Rather, §482 and the APAs dictate the transfer pricing on Eaton's tax returns. Pursuant to those authorities, Eaton was required to report a price on its tax returns that complied with the APA transfer-pricing methodology, even if that price deviated from the price in Eaton's books. And, if there was a deviation, the difference between the price on Eaton's tax returns (APA Price) and the price on Eaton's books should have been (i) recorded on the tax return's Schedule M (which lists book-tax differences) and (ii) described as a compensating adjustment in the APA Report.

Moreover, in focusing on the cause of the error in Eaton's books, the Tax Court ignored that Eaton did not merely repeat that error on its tax returns. Rather, Eaton also affirmatively verified in its annual APA Reports (i) that its tax returns complied with the APA's transfer-pricing methodology and reflected the pricing depicted in the APA Reports,  (ii) that the pricing on its tax returns allocated sufficient profit to Eaton-US to satisfy the APA's Berry-ratio requirement, and (iii) that compensating adjustments were not needed. It is undisputed that each of those APA-required verifications was incorrect. The court, however, never came to grips with the repeated and multiple failures in Eaton's APA Reports — as opposed to the failures in Eaton's tax reporting — which independently support the IRS's cancellation decision.

In glossing over the invalid representations and material mistakes and omissions in the APA Reports — attributing every failing to an unintentional error in Eaton's APA Multiplier — the Tax Court minimized and undermined the essential role the APA Report is designed to serve. The entire point of having a taxpayer file the APA Report shortly after filing the tax return is to demonstrate to the IRS's APA Program that the taxpayer's tax reporting complies with the APA. (R.41 (APAs), Apx 436, 452; R.610 (Transcript), Apx 723.) The requirement to file APA Reports thus imposed on Eaton the affirmative obligation to actually verify that its tax reporting complied with the APAs.

Moreover, Eaton's APA Reports purported to make transparent what was otherwise obscured on the tax returns themselves. Eaton's tax returns were complex and enormous — each thousands of pages long — and did not separately list the transfer price for the Products at issue. (R.619 (Transcript), Apx 746-747.) Instead, the Products' transfer price was combined with other cost figures on the return. (R.735 (Opinion), Apx 368.) Failing to establish that the transfer price recorded as a separate line on the APA Report was actually the transfer price embedded in the tax return was a material mistake. That Eaton could not “[c]onfirm[ ] that the tax transfer price was correctly reflected on the tax returns . . . by visually verifying a line on the tax return” (id.) does not absolve Eaton's mistake. It could have — and should have — verified the tax returns' accuracy in some other manner before swearing under penalty of perjury in its APA Reports that the pricing incorporated in its tax returns complied with the APAs' transfer-pricing methodology.

2. The Tax Court's analysis conflicts with the plain language of the applicable Revenue Procedures

The Tax Court agreed with the Commissioner that Eaton “made numerous errors in complying with its APAs.” (R.735 (Opinion), Apx 366.) The court nevertheless concluded that these errors did not merit cancellation because they were — in the court's view — “inadvertent” and therefore not “material.” (R.735 (Opinion), Apx 370-372.) The court's analysis conflicts with the plain language of the Revenue Procedures and gives controlling weight to irrelevant factors.

Whether an error is intentional or inadvertent is irrelevant to its materiality under the Revenue Procedures. As detailed above, cancellation is appropriate where a taxpayer is unable to prove its “data and computations used in applying the TPM were correct in all material respects.” Rev. Proc. 96-53, §11.03 (2)& (3); Rev. Proc. 2004-40, §10.03 (2)& (3). Nothing in that provision refers to a taxpayer's intent.

Indeed, evaluating the correctness of data is a purely objective, numerical matter and a taxpayer's good faith cannot change the evaluation. A wrong number is a wrong number.

Similarly, the Revenue Procedures permit cancellation for any “mistake as to,” or “failure to state,” “a material fact,” without regard to whether the mistake or failure was inadvertent or intentional. Rev. Proc. 96-53, §11.06 (1); Rev. Proc. 2004-40, §10.06 (1). Again, the question of materiality is an objective one that focuses on what the APA Program knew and whether “knowledge of the facts” would have changed the terms of — or even foreclosed — the “APA” or resulted in a “materially different allocation of income” than reported by the taxpayer in its “annual report.” Id. A taxpayer's intent is wholly irrelevant. Under the Revenue Procedures, and as agreed by a taxpayer entering into an APA, if the taxpayer makes a material mistake or omission — inadvertent or not — the IRS may cancel the APA.

The Tax Court concluded that, to determine whether an error was “material,” it had to “look at how the error occurred.” (R.735 (Opinion), Apx 370.) That conclusion is baseless. Nothing in the Revenue Procedures predicates materiality on the origin of the mistake  (including data errors) or omission. The court's conclusion also conflates separate grounds for cancellation. In this regard, the Revenue Procedures permit cancellation based on several alternative grounds, including a taxpayer's “lack of good faith compliance” with the APA's terms, “mistake as to a material fact,” and “failure to state a material fact.” Rev. Proc. 2004-40, §10.06 (1); Rev. Proc. 96-53, §11.06 (1). Although the first ground for cancellation may depend on taxpayer intent, the latter two do not.

Similarly misplaced is the Tax Court's reliance on its finding that Eaton “attempted to rectify [its errors] by filing amended tax returns and amended APA annual reports.” (R.735 (Opinion), Apx 370.) Error correction does not provide immunity from cancellation under the Revenue Procedures. To the contrary, those Procedures expressly provide that the IRS “may” — but need not — “waive cancellation” for taxpayers who take steps to “correct” inadvertent mistakes and omissions. Rev. Proc. 96-53, §11.06 (2) (emphasis added); Rev. Proc. 2004-40, §10.06 (2) (emphasis added). That language would be meaningless if inadvertent mistakes and omissions were not grounds for cancellation in the first instance.

By retaining discretion to cancel an APA for inadvertent but material mistakes and omissions, the IRS incentivizes taxpayers to have safeguards in place to ensure that such errors do not occur. The Tax Court's rewriting of the Revenue Procedures to pardon inadvertence rewards taxpayers who fail to use such safeguards. When Eaton entered into the APAs, it was on notice that if it made a material mistake or omission on its tax return or annual APA Reports, the IRS could cancel the agreement. The IRS only agreed to limit its broad authority to make adjustments under §482 — pursuant to which it could allocate more of Eaton's income to its U.S. tax base — because Eaton assured the IRS that its tax reporting would comply with the APAs.²³ The onus was on Eaton to ensure that it had procedures in place to prevent mistakes of the magnitude that occurred here.

Finally, the Tax Court's suggestion that a “fact” is not “material” unless the disclosure of that fact would “result in a change to the TPM” (R.735 (Opinion), Apx 355) is unfounded. In describing what types of facts are deemed material, the Revenue Procedures do not even refer to the transfer-pricing methodology; rather, the procedures refer more broadly to changes in the “terms and conditions” or existence of the “APA” itself and changes in the contents of the “annual report.” Rev. Proc. 96-53, §11.06 (1); Rev. Proc. 2004-40, §10.06 (1). And Revenue Procedure 2004-40 makes clear that these descriptions are merely “example[s]” — not limits — on the term “material fact.” Id. The explication of “material fact” in the Revenue Procedures is broad enough to include facts that, if known, may not impact the transfer-pricing methodology itself, but would impact other terms and conditions in the APA, such as the need for additional compliance and reporting requirements. An obvious example here would be safeguards regarding the APA Multiplier, as described above. The Tax Court committed legal error by failing to consider the significance of the APA Multiplier in that light.

3. The Tax Court erroneously substituted its judgment for that of the IRS

In addition to giving controlling weight to factors that are irrelevant under the governing Revenue Procedures, the Tax Court also misapplied the abuse-of-discretion standard by “'substitut[ing] its judgment for that of the agency.'” Akhtar-Zaidi v. Drug Enf't Admin., 841 F.3d 707, 710-711 (6th Cir. 2016) (citation omitted). That the court cited the correct standard (R.735 (Opinion), Apx 333) does not mean that the court actually applied it. See JPMorgan Chase & Co. v. Commissioner, 458 F.3d 564, 571 (7th Cir. 2006) (reversing decision where Tax Court correctly “cit[ed] the arbitrary and unlawful standard” but “did not analyze the Commissioner's method under this standard”).

The Tax Court evidently “believe[d]” that any mistake contained in Eaton's tax returns or “APA annual reports” “should have been addressed through adjustments” rather than cancellation. (R.735 (Opinion), Apx 370-371.) The court, however, was not permitted to impose its beliefs on the IRS in this context. “'Determination of a sanction to be applied by an administrative agency, if within bounds of its lawful authority, is subject to very limited judicial review.'” Akhtar-Zaidi, 841 F.3d at 712 (citation omitted). Under the Revenue Procedures, the IRS had the option to “waive cancellation” for inadvertent mistakes that were corrected by a taxpayer. Rev. Proc. 96-53, §11.06 (2); Rev. Proc. 2004-40, §10.06 (2). It chose not to exercise that option here. The Tax Court exceeded its authority by second-guessing that choice. Whatever the court believed it would have done if the cancellation decision had been its to make, the only question before the court was whether the IRS acted arbitrarily in canceling the APAs. Given the language of the Revenue Procedures and the undisputed facts, the answer is “no,” as demonstrated above.

II The Tax Court erred in holding that there was no “net section 482 transfer price adjustment” in this case

Standard of review

The Tax Court's interpretation of §6662 (e)(3)(A) is a legal question reviewed de novo.

A. Introduction

The Tax Court's penalty ruling is predicated on its cancellation ruling. (R.807 (Opinion), Apx 415.) Therefore, if the Court agrees with the Government that the IRS did not abuse its discretion in canceling the APAs, then the Court need not address the court's penalty ruling, which should be vacated on remand.

Section 6662 imposes a 20% accuracy-related penalty for certain types of underpayments of tax, including underpayments attributable to a taxpayer's “substantial valuation misstatement.” §6662 (b)(3). As pertinent here, “substantial valuation misstatement” includes any “net section 482 transfer price adjustment” that “exceeds the lesser of $5,000,000 or 10 percent of the taxpayer's gross receipts.” § 6662 (e)(1)(B)(ii). An enhanced penalty of 40% applies for “gross valuation misstatements,” which include any “net section 482 transfer price adjustment” that “exceeds the lesser of $20 million or 20 percent of the taxpayer's gross receipts.” §6662 (e)(1)(B)(ii), (h)(1)& (2)(A)(iii). The Code generally defines a “net section 482 transfer price adjustment” as “the net increase in taxable income for the taxable year . . . resulting from adjustments under section 482 in the price for any property or services.” §6662 (e)(3)(A) (emphasis added).

The Code provides limited defenses to this penalty for taxpayers that can prove that their §482 adjustments are excluded in determining whether the penalty threshold is satisfied.²⁴ §6662 (e)(3)(B); see Treas. Reg. §1.6662-6 (d). It does not, however, exclude from the scope of “net section 482 transfer price adjustment” §482 adjustments governed by an APA.²⁵ See §6662 (e)(3)(A)& (B).

The Revenue Procedures applicable to Eaton's APAs make clear that the Code's penalty provisions apply to transfer-price adjustments made pursuant to APAs. As Revenue Procedure 2004-40 expressly states, “[t]he generally applicable Code rules, including additions to tax, penalties and interest, apply” to such transfer-price adjustments. §10.02 (1) (emphasis added); accord Rev. Proc. 96-53, §11.02 (3).

As demonstrated below, Eaton is liable for penalties under §6662 (b)(3), (e)(1)(B)(ii), (h)(2)(A)(iii)(I) because the adjustments to Eaton's transfer pricing upheld by the Tax Court are “net section 482 transfer price adjustment[s]” within the meaning of the statute. See, below, §B. The court's unprecedented ruling to the contrary conflicts with the statute, the APAs, and the governing Revenue Procedures. See, below, §C.

B. The adjustments to Eaton's 2005-2006 transfer prices upheld by the Tax Court are “net section 482 transfer price adjustment[s]” within the meaning of §6662 (e)(3)

Under the plain language of the statute, the valuation-misstatement penalties for a “net section 482 transfer price adjustment” apply if two conditions are met. §6662 (b)(3), (e)(1)(B)(ii), (h)(2)(A)(iii). First, there must be a “net section 482 transfer price adjustment.” Id. Second, the adjustment must increase the taxpayer's taxable income in an amount that exceeds the applicable statutory threshold, i.e., “the lesser of $5,000,000 or 10 percent of the taxpayer's gross receipts” (for the 20% penalty) or “the lesser of $20 million or 20 percent of the taxpayer's gross receipts” (for the 40% penalty). Id. Both statutory conditions are met here.

The first condition is met because this case involves “net section 482 transfer price adjustment[s].” The term “net section 482 transfer price adjustment” means a net increase in taxable income “resulting from adjustments under section 482 in the price for any property or services.” §6662 (e)(3)(A); see Treas. Reg. §1.6662-6 (c)(1) (defining a “net section 482 adjustment” as “the sum of all increases in the taxable income of a taxpayer for a taxable year resulting from allocations under section 482” less any decrease from collateral adjustments). It is undisputed that the transfer pricing reported on Eaton's 2005-2006 tax returns required adjustments that increased Eaton's taxable income. (R.735 (Opinion), Apx 301-304.)

The second condition is also met. Pursuant to Rule 155, the parties agreed that Eaton's 2005-2006 tax returns had grossly overstated the transfer prices for the Products, which (after taking into account collateral §482 adjustments related to intercompany royalty payments) produced net transfer-price adjustments for those years of $32 million and $27 million. (R.783 (Commissioner-Supplemental-Brief), Apx 813; R.600 (Amended-Tax-Returns), Apx 1458-1459, 1527-1530.) As Eaton has acknowledged, each of those net adjustments “was large enough to exceed the statutory threshold for the Section 482 Adjustment Penalty.” (R.784 (Eaton-Supplemental-Brief), Apx 834.)

Consistent with the language of the statute, the APAs expressly recognize that APA adjustments are §482 adjustments. In this regard, each APA provides that it “contains the Parties' agreement on the best method for determining arm's-length prices of the Covered Transactions under I.R.C. section 482,” and that, to the extent that the pricing on Eaton's tax returns does not fully comply with the APA, the IRS may “make or propose allocations or adjustments under I.R.C. section 482 consistent with this APA.” (R.41 (APAs), Apx 424-425, 444-446 (emphasis added).) Eaton itself acknowledged the source of the adjustments when it submitted amended returns to correct its transfer-pricing errors and stated that the APA adjustments reflected on the amended returns were made “pursuant to §1.482-1 (a)(3).” (R.600 (Amended-Tax-Returns), Apx 1460, 1530.) See Treas. Reg. §1.482-1 (a)(3) (describing taxpayers' limited ability to make §482 adjustments).

That these §482 adjustments were based on the APAs' transfer-pricing methodology, rather than the transfer-pricing methodology proposed by the IRS in its notice of deficiency (R.807 (Opinion), Apx 408), is irrelevant. The critical point for purposes of §6662's §482 penalties is that Eaton's taxable income as reported on its tax return was understated due to erroneous transfer pricing. The specific methodology under which the correct transfer pricing is to be computed is irrelevant under the statute. In §482 cases, the Tax Court sometimes rejects the Commissioner's transfer-pricing methodology, which necessitates a redetermination of the transfer-price adjustments set out in a deficiency notice. E.g., Medtronic, Inc. v. Commissioner, T.C. Memo. 2016-112, vacated and remanded by 900 F.3d 610 (8th Cir. 2018). In that sense, this case is no different than any other §482 case, in which the court first determines the correct transfer-pricing methodology and then determines — or has the parties determine pursuant to Rule 155 — the adjustments that flow from applying that methodology.

Although the Tax Court's cancellation ruling altered the methodology to be applied to calculate the correct transfer pricing — replacing the methodology proposed by the IRS in its deficiency notice with the methodology adopted by the parties in the APAs — the cancellation ruling did not alter the nature of the errors on Eaton's tax returns. Those errors related to the transfer pricing of the Products, as both the IRS and the Tax Court determined. The only difference between the IRS's determination and that of the Tax Court is the extent of the transfer-pricing errors and the resulting amounts of income that needed to be reallocated between Eaton's U.S. and foreign subsidiaries under §482. In other words, by agreeing with the Commissioner that Eaton's transfer pricing had to be adjusted, the court effectively agreed that the IRS's transfer-price adjustments were correct in part (i.e., were correct up to the amount of the parties' agreed-upon computations). And, as Eaton acknowledged in its original petition, transfer-pricing adjustments that are correct “in part” are nevertheless “transfer pricing adjustment[s]” within the meaning of §6662 (e)(1)(B)(ii). (R.1 (Petition), Apx 174.)

C. The Tax Court's analysis cannot withstand scrutiny

The Tax Court concluded that the §6662 penalty for net §482 transfer-price adjustments did not apply. Its rationale was brief. The court stated that “there was no net section 482 transfer price adjustment” because “the APAs remained in effect” and “[t]here was no allocation of income and deductions by the Secretary pursuant to section 482 and no 'net increase in taxable income for the taxable year resulting from adjustments under section 482 in the price for any property or service.'” (R.807 (Opinion), Apx 415-416 (quoting §6662 (e)(3)(A)) (omission in original).) The court's ruling that transfer-price adjustments made pursuant to an APA are not adjustments made under §482 is baseless.

The Tax Court's ruling conflicts with the statute. The statutory definition of “net section 482 transfer price adjustment” — “the net increase in taxable income . . . resulting from adjustments under section 482 in the price for any property or service” — is broad enough on its face to include adjustments for taxpayers who have entered into an APA. The correction of Eaton's errors in implementing the APAs necessitated downward adjustments to the transfer price that Eaton-US paid Eaton-Islands for the Products and those adjustments increased Eaton's taxable income. Nothing more is required by the statute's text. Moreover, and as noted above, there is no blanket exclusion for §482 adjustments governed by an APA. See §6662 (e)(3)(B); Treas. Reg. 1.6662-6 (d)(2)(ii)(A)(6). Indeed, there is no reason — as a matter of logic or tax policy — why Congress would have enacted such an exclusion. A taxpayer with an APA and a taxpayer without an APA who both inflate their transfer pricing by over $20 million have engaged in the exact same conduct that Congress sought to deter and penalize — grossly inaccurate transfer pricing.

The Tax Court's ruling also conflicts with Treasury's APA Revenue Procedures. Revenue Procedure 96-53 provides that where the taxpayer or the IRS makes an adjustment, including a “correction of computational errors,” to bring a taxpayer's tax reporting into compliance with an APA, “generally applicable Code rules relating to assessment, collection and refund of tax and the principles of Rev. Proc. 65-17” and its “successor” will “apply to any resulting change in Federal income tax liability.” Rev. Proc. 96-53, §11.02 (3). Penalties are part of those “generally applicable Code rules.” See Revenue Procedure 2004-40, §10.02 (1) (“generally applicable Code rules, including additions to tax, penalties and interest, apply”) (emphasis added). Moreover, one of the “principles” provided by the “successor” to Revenue Procedure 65-17 (Revenue Procedure 99-32) is that “taxpayer-initiated adjustment[s]” are subject to “possible imposition of the section 6662 (e) or (h) penalty, by the Service.” Rev. Proc. 99-32, §2, 1999-2 C.B. 296.

The Tax Court's ruling also conflicts with the APAs. The APAs incorporate by reference Revenue Procedure 96-53 (APA-I) and Revenue Procedure 2004-40 (APA-II). (R.41 (APAs), Apx 425, 445.) Accordingly, by entering into the APAs, Eaton agreed that the Code rules, including penalties, would apply to any APA-based adjustments, including computational adjustments, that increased its taxable income. Indeed, the APAs expressly provide that transfer-price adjustments made pursuant to the APAs are “adjustments under I.R.C. section 482.” (R.41 (APAs), Apx 425, 446.) By ruling that these adjustments are not “under section 482,” §6662 (e)(3)(A), the Tax Court failed to enforce the very agreements it purported to uphold.

The Tax Court's assumption that APA adjustments are not §482 adjustments not only conflicts with the statute, Revenue Procedures, and APAs, it also undermines the foundation for the entire APA Program. The APA Program is authorized by, and implements, §482. There is no other statutory provision — and the court cited none — that supports adjusting a taxpayer's pricing of its intercompany transactions. Reflecting that undisputed fact, Treasury's APA Revenue Procedures, the parties' APAs, and Eaton's APA applications, APA Reports, and amended tax returns all repeatedly invoke §482 as their animating authority. (R.41 (APAs), Apx 424, 444; R.393 (Application-for-APA-I), Apx 505-507; R.858 (Application-for-APA-II), Apx 1329-1448; R.851 (APA-Reports), Apx 891-1076; R.600 (Amended-Tax-Returns), Apx 1460, 1530.) E.g., Rev. Proc. 96-53, §3.03; Rev. Proc. 2004-40, §2.01. As these sources evidence, an adjustment of transfer pricing as reported on a return is — by definition — a “section 482 adjustment” and thus within the scope of §6662's transfer-pricing penalty.

Finally, the Tax Court's suggestion that §6662's transfer-pricing penalty does not apply because the adjustments at issue were (in the court's view) proposed by Eaton rather than “by the Secretary” (R.807 (Opinion), Apx 415) is both incorrect and irrelevant. First, the nature of the litigation indicates that the adjustments at issue were proposed “by the Secretary.” This case is a deficiency proceeding, whereby the taxpayer seeks review of adjustments determined by the IRS. In the deficiency notice issued to Eaton, the IRS determined that the transfer prices that Eaton reported on its 2005-2006 returns required adjustments and that §6662 (h)'s gross-valuation-misstatement penalty applied to the resulting tax deficiencies. Importantly, the notice did not limit or condition the penalty's applicability on whether the IRS properly canceled the APAs. (R.41 (Notice-of-Deficiency), Apx 467.)

The Tax Court had jurisdiction to review the IRS's determination and to sustain it — in whole or in part — or conclude that there was no deficiency. §6214 (a). The court partially sustained the IRS's determination when it found that the prices reported on Eaton's tax returns were overstated and did not comply with the APA's transfer-pricing methodology. The parties then worked out the amount of the required transfer-price adjustments pursuant to Rule 155, starting with the adjustments set out in the IRS's deficiency notice. See JPMorgan Chase & Co. v. Commissioner, 530 F.3d 634, 638 (7th Cir. 2008) (“[T]he 'starting point for the [Rule 155] computation is the statutory notice of deficiency from which the parties compute the redetermined deficiency based upon matters agreed by the parties or ruled upon by the Court.'”) (citation omitted). Therefore, the adjustments proposed in the notice, and partially upheld by the Tax Court, were in fact “allocation[s] of income and deductions by the Secretary” (R.807 (Opinion), Apx 415).

But even if one views the adjustments upheld by the Tax Court as having been proposed by Eaton, they nevertheless are §482 transfer-price adjustments subject to the penalty. Nothing in §6662 (e) limits the penalty's applicability to adjustments proposed by the IRS, in a deficiency notice or otherwise. To the contrary, the penalty for transfer-pricing errors applies — without qualification — to “adjustments under section 482,” §6662 (e)(3)(A), whether the adjustment is proposed by the IRS or the taxpayer. The statute looks to the fact of the price adjustment, not to its origin. The Tax Court's suggestion that adjustments must be initiated by the IRS rewrites the statutory text.

The Tax Court's suggestion also conflicts with Treasury's APA Revenue Procedures. The applicable Revenue Procedures expressly provide that penalties apply to all transfer-price adjustments under §482, whether initiated by the “taxpayer or the Service.” Rev. Proc. 96-53, §11.02 (3) (contemplating “subsequent compensating adjustment[s]” by “the taxpayer or the Service” — including “computational errors” — and providing that such adjustments are subject to “generally applicable Code rules,” including penalties, and to the “principles” of “any successor” of Rev. Proc. 65-17, which includes Rev. Proc. 99-32); Rev. Proc. 99-32, §2 (providing that “taxpayer-initiated adjustment[s]” are subject to “possible imposition of the section 6662 (e) or (h) penalty”); Rev. Proc. 2004-40, §10.02 (1) (providing that “generally applicable Code rules, including . . . penalties and interest, apply with respect to” transfer-price adjustments initiated by a “taxpayer”). As these rules make clear, any pricing adjustments that are necessary to bring a taxpayer's reporting position into compliance with the APA, and thus with §482, are subject to the §6662 penalty for erroneous transfer pricing, even if the adjustment is initiated by the taxpayer.

CONCLUSION

The Tax Court's decision should be vacated, and the case remanded to address the Commissioner's transfer-pricing methodology or, alternatively, to compute the amount of penalties that apply to the agreed-upon transfer-price adjustments.

Respectfully submitted,

DAVID A. HUBBERT
Acting Assistant Attorney General

Judith A. Hagley
FRANCESCA UGOLINI
(202) 514-3361
ARTHUR T. CATTERALL
(202) 514-2937
JUDITH A. HAGLEY
(202) 514-8126
Attorneys
Tax Division
Department of Justice
Post Office Box 502
Washington, D.C. 20044

OCTOBER 7, 2021