This news analysis was originally published in Tax Notes Today on July 16, 2012.
The IRS's advance pricing agreement program has generally been well reviewed during its existence. But the increased time needed to complete APA requests has displeased taxpayers, contributing to decreases in the number of submitted APAs. Perhaps most disconcerting to taxpayers is that the IRS recently canceled two APAs it had entered into with Eaton Corp. -- a rarity in the two-decade-old program.
The cancellations are likely to make taxpayers cautious about using the APA program in the future, practitioners say, diminishing its appeal despite recent government efforts to attract more participants. "There is no question that canceling APAs weakens the reputation of the program," said David B. Blair of Crowell & Moring LLP.
Eaton and its subsidiaries are fighting back after the IRS last December canceled the APAs it had with the company. In a petition filed with the Tax Court, Eaton alleged that the APAs are valid with no grounds for cancellation, because the IRS has made only blanket statements regarding noncompliance without providing specific allegations of fact. In the court filing, Eaton said it complied with the terms of the original APA and its first renewal and that the IRS accepted all of the company's annual reports under the agreements before abruptly canceling them. Eaton said that the Service's transfer pricing adjustments are arbitrary and capricious because they ignore the arm's-length standard set out in the statute and Treasury regulations. (For Eaton's petition, see Doc 2012-14868.)
The IRS proposed assessments of $75 million in additional taxes and $52 million in gross valuation misstatement penalties, primarily based on transfer pricing adjustments, for Eaton's 2005 and 2006 tax years, according to the company's Form 10-K and court documents. Eaton, a Cleveland-based industrial manufacturer, manufactures products in Puerto Rico and the Dominican Republic, which it then sells to affiliates in the United States at prices that are net of agreed credits and deductions. In its SEC filing, Eaton reported that it sold products to its affiliates at the same prices that it extended to third parties, but the IRS notice of deficiency alleges that Eaton's transactions with its Puerto Rican subsidiaries did not meet the arm's-length standard.
Eaton said in its Form 10-K and court petition that the IRS had accepted the company's transfer pricing method under two successive APAs for the years 2001-2005 (the original APA) and 2006-2010 (the renewed APA), but that on December 16, 2011, the IRS sent a letter to the company stating that it was canceling both APAs.
The IRS claims that Eaton failed to meet the compliance obligations set out in the APAs. Eaton acknowledged that data errors with its pricing calculations were discovered but said it promptly amended its APA annual reports and that the errors did not change the transfer pricing method adopted in the APAs. (For the IRS's answer, see Doc 2012-14870.)
While having no bearing on the resolution of the tax dispute, recent events initiated by Eaton reveal an appetite for drastic tax minimization. Eaton's CEO, Alexander Cutler, has publicly advocated for a territorial tax system as a "far more competitive" regime than the U.S. worldwide tax system. In May the company announced that it was buying an Irish company and planned on inverting to Ireland. The move, once completed, could substantially cut Eaton's U.S. tax bill by shielding foreign profits. (For prior analysis, see Tax Notes, June 11, 2012, p. 1302, Doc 2012-12279, or 2012 TNT 112-2.)
Reneging on an APA
Given that few taxpayers have had their APA agreements revoked or canceled by the IRS, it is uncertain how courts will view the Service's action. Since 1991, the IRS has executed 1,015 APAs, but in that same period, it has revoked or canceled only 11. The two cancellations noted in the IRS's 2011 APA annual report reference the action taken with regard to Eaton. (For Announcement 2012-13, 2012-16 IRB 805, see Doc 2012-6950 or 2012 TNT 64-7.)
Cancellation of an APA is distinguishable from revocation. A cancellation is typically retroactive to the beginning of the year in which the critical assumption failed or to the beginning of the year to which the misrepresentation, mistake, failure, or noncompliance relates. In a revocation, the APA is void ab initio and is treated as if it never existed. It is unclear from public IRS data whether an APA has ever been revoked.
Government officials responsible for the APA program have characterized the agreements as nearly ironclad. In 2002 Sean Foley, then-director of the program, remarked that when a taxpayer seeks to amend an APA, the IRS's position is that "a deal is a deal" because APAs are about certainty, which entails living by the contract. (For prior coverage, see Tax Notes, Jan. 28, 2002, p. 429.)
Under section 11.06 of Rev. Proc. 2006-9, the IRS can cancel an APA based on the taxpayer's misrepresentation, mistake as to a material fact, failure to state a material fact, failure to file a timely annual report, or lack of good-faith compliance with the terms and conditions of the APA. The IRS will also cancel an APA in the event of a failure of a critical assumption or a material change in governing case law, statute, regulation, or a treaty, but cancellation under those circumstances occurs only if the parties don't agree to a revision. (For Rev. Proc. 2006-9, 2006-1 C.B. 278, see Doc 2005-25514 or 2005 TNT 243-8.)
Rev. Proc. 2006-9 indicates that the IRS will seek to coordinate any action concerning the cancellation of a bilateral or multilateral APA with the foreign competent authority. Eaton's APAs with the IRS were unilateral.
Challenging the Cancellation
Eaton appears to be the only taxpayer so far that has challenged an APA cancellation in court. Without judicial precedent for guidance, Eaton has asserted that common law contract principles apply, with the IRS bearing the burden of proof to establish its right to cancel the APAs.
In its motion for partial summary judgment, Eaton argued that an APA constitutes a binding contract that the government must honor absent a specific showing that the company violated its obligations under the terms of the APA. The company's brief, quoting Winstar Corp. v. United States, 64 F.3d 1531 (Fed. Cir. 1995), states that "the government has the power to enter into contracts which confer vested rights -- rights which the government has a duty to honor." The executed APAs contain all the hallmarks of binding agreements under traditional contract law standards, Eaton wrote, noting that the agreements were written documents signed by an authorized government representative and contain specific agreements as a result of consideration by both parties. (For Eaton's motion, see Doc 2012-14679.)
Eaton is arguing that the terms of the revenue procedure allowing for the IRS to cancel an APA are a condition subsequent, meaning there is first and foremost a valid contract between the IRS and the company. If the court adopts the Service's position that the defined cancellation terms are a condition precedent, that would "convert the APAs from ongoing treatment" into annual agreements tied to accepted compliance -- an approach that "would defeat the entire purpose of an APA, i.e., avoiding expensive and unnecessary transfer pricing disputes," Eaton wrote.
Eaton stated that, like in settlement and closing agreements, the IRS bears the burden of proof as the party seeking to cancel tax settlements.
Determining a Violation
Ramon Camacho of McGladrey LLP said the central issue in the Eaton case is whether a substantive violation of the APA occurred that allowed for cancellation, and if so, whether it had been acquiesced to in the past. "No taxpayer is static, so assumptions and practices are always changing," he said. "If the IRS accepted minor noncompliance in past years, the abrupt cancellation makes it look like the IRS simply changed its mind, to the taxpayer's detriment."
Given the extensive access to records that a taxpayer in the APA program must provide the IRS, "it's hard to pull a fast one on the government," Camacho said. "In my experience advising taxpayers on APA matters, those types of agreements lift up the skirt and ensure that companies can't skate by with questionable tactics," he said.
"I think that fundamentally, this fight seems to be over how to interpret the agreement," Camacho said.
The IRS can be difficult to work with on APA issues that don't follow what's been done before, Camacho said. "It is hard for the IRS to adjust to APA requests that require new models; they like to stick to a template," he said.
Blair agreed that the abruptness of the cancellation raises questions. "It is surprising that after accepting the taxpayer's methodology for two APA cycles, the IRS suddenly changed course, seemingly after intense influence from the exam function," he said. "That is an undesirable outcome, and the IRS will need to have a strong justification for taking this action."
Blair said that the nearly simultaneous cancellation of the agreements and issuance of a notice of deficiency were disappointing. "There was no opportunity for discussion with Appeals," he said. "It would be helpful in the future for such a process to be vetted at Appeals before teeing up litigation."
Similar suggestions have been made before. When the IRS in 1995 proposed revisions to the APA process, the Tax Executives Institute suggested the government provide an avenue for administrative appeal to the internal APA Policy Board if the Service proposed revoking or canceling an APA. The IRS never adopted the suggestion. (For the comment letter, see Doc 95-8845 or 95 TNT 189-47 .)
Tarnishing a Reputation
An APA cancellation, even if rare, could cast doubt on the usefulness of the APA program. "This case has the potential to do real damage to the APA program," Blair said. "It doesn't look good for the IRS to pull out of an APA, as it tarnishes the reputation of that agreement process."
For the taxpayer, pursuing an APA can mean "substantial costs for outside consultants as well as the diversion of internal resources," with the government also using substantial resources on negotiations, Blair said. "Both sides may be leery of incurring these costs if it is uncertain that the APA will be respected," he said.
According to Camacho, few taxpayers are willing to go through the APA process because of the expense and uncertainty involved in executing an agreement. "There are many more wild cards to deal with than in seeking a ruling," he said, "and there is much more uncertainty over the outcome."
Blair said that the application and renewal process for APAs makes cancellation a rare and drastic measure by the IRS. Because the revenue procedures governing APAs characterize the program as a binding agreement, if the taxpayer complies with the terms, "the IRS is not supposed to contest the methods on the return," he said. "But the big question now is how binding is an APA? It's not an actual closing agreement."
At issue is not only the extent to which the IRS can bind itself through an APA but also the extent to which a taxpayer can rely in good faith on the finalized agreement, Blair said. Because the Eaton case focuses on the parties' conduct in agreeing to and performing under, the APA, "there are a whole host of pre-notice-of-deficiency administrative issues" involved in the litigation that don't typically arise in tax cases, he said.
Regarding the contractual nature of APAs, Camacho said the traditional view is that they are made in the context of treaty authority. Whether an APA can be analogized to a closing agreement is unclear, because "any attempt to squeeze APAs into that framework is simply trying to fit a new type of agreement into an already accepted model with legal consequences," he said. "I think the comparison can be helpful because it provides some measure of certainty for taxpayers," he said, adding that there is no question that interpreting an APA requires invoking contract law.
"As a matter of statutory law, an APA is not a closing agreement, but when a taxpayer enters into an agreement with the IRS, the government has a responsibility to treat it as a binding contract," Blair said. "Taxpayers are sure to have strong feelings about the Service reneging without setting forth detailed reasons why it was proper to do so under the terms of the contract."
Blair said he doubts the cancellation indicates that the IRS is likely to renege on other APAs. "It is not in anybody's interest to ratchet up uncertainty over the APA program," he said. "But the IRS has certainly announced that it won't tolerate perceived abuses of carefully negotiated agreements."
Drop in Applications
Even before the cancellation of Eaton's APA, growing skepticism of the benefits of the program might have contributed to the significant drop in the number of APA applications over the past few years. In 2011, 96 applications were filed with the IRS (20 unilateral, 76 bilateral), slightly more than the historical average of 91 applications per year from 2000 to 2007. The APA program reached a high-water mark with 144 applications in 2010, and it had strong years in 2009 (127) and 2008 (123).
Earlier this year, the IRS announced the consolidation of the previously separate APA program and the competent authority functions related to transfer pricing and other allocation issues into the new advance pricing and mutual agreement program. The prior location of the APA program within Treasury and its coordination with the IRS competent authority function had been a source of intermittent conflict since the APA program's inception 20 years ago, but the IRS decided that prioritizing international tax issues required more coordinated resources. (For an IRS release (IR-2012-38) on the new APMA program, see Doc 2012-6409 or 2012 TNT 60-13.)
IRS officials have touted the reorganized office as an effective way to reduce case backlogs and increase certainty. (For prior coverage, see Tax Notes, June 11, 2012, p. 1312, Doc 2012-12241, or 2012 TNT 110-4.)
While the IRS acknowledges that the APA program is struggling, it remains to be seen how it intends to improve its reputation among taxpayers. It seems to companies that the agency wants APAs to serve as another avenue for enforcement. With the IRS having been reproached for giving away the store through its past APA practices, transfer pricing professionals think the Service is now demanding perfection from multinational companies with complex business dealings.
Although it is clever of Eaton to put the onus on the IRS to justify the APA cancellation, the case could go either way. It's an untested proposition that the IRS has the authority to construe APAs as binding agreements. One may suspect that the government's initial decision to characterize APAs as obligatory contracts arose from its fear that taxpayers would exit the agreements if they later believed they could get a better tax result under traditional administrative procedures.
However, the IRS might find that its early casting of APAs as binding is a double-edged sword when it's now the one trying to wriggle out from under the agreement. The only way to decisively unite the IRS and taxpayer is by having a closing agreement. The Tax Court must determine how close an APA comes to a final bargain, as the unique negotiations that go into putting an APA together provide justification for either outcome. At least in a bilateral APA, the reliance and approval of a foreign tax administrator make the agreement more definitive; the weight of a unilateral APA is less clear.
Regardless of the judicial outcome in the case, the IRS APA program has been harmed in the short term by the public fight. The litigation foreshadows an uphill battle that the newly reorganized APMA unit will have in attracting taxpayers and working through the negotiation process with them. If participating in the APA process is seen as equivalent to talking to an exam team, taxpayers will choose not to participate.
More facts will eventually come to light over why the IRS canceled Eaton's APAs and whether it was justified in doing so, but increased fear among taxpayers that the IRS will renege on time-consuming transfer pricing agreements will doubtless detract from the program's success so far.