US Outbound: Cancellation of APAs by IRS, abuse of discretion

Mark Martin	Mark Horowitz

On July 26 2017, the US Tax Court issued a memorandum opinion in Eaton Corp. v. Commissioner, TC Memo 2017-147 that concluded, in part, that cancellation by the IRS of advance pricing agreements (APAs) was an abuse of discretion.

The taxpayer and the IRS entered into two APAs establishing a transfer pricing methodology for covered transactions between the taxpayer and its subsidiaries:

• The first APA (APA I) applied for the 2001-2005 tax years.

• The second APA (APA II) applied for the 2006-2010 tax years.

The taxpayer and the IRS agreed that the legal effect and administration of APA I and APA II were governed by Rev. Proc. 96-53 and by Rev. Proc. 2004-40, respectively.

In 2011, the IRS determined that the taxpayer had not complied with the terms of the revenue procedures and canceled APA I, effective January 1 2005, and cancelled APA II, effective January 1 2006. As a result of cancelling the APAs, the IRS determined that, under code section 482, an adjustment was needed to reflect an arm's-length result for the taxpayer's intercompany transactions. The taxpayer countered and contended that the cancellation of APA I and APA II by the IRS was an abuse of discretion because there was no basis for the cancellation under the applicable revenue procedures.

The IRS asserted that cancelling APA I and APA II was not an abuse of discretion because the taxpayer did not comply in good faith with the terms and conditions of either APA I or APA II and because the taxpayer had failed to satisfy the APA annual reporting requirements. Specifically, the IRS arguments in support of cancellation of the APAs fell into two categories: (1) misrepresentations, mistakes as to a material fact, and failures to state a material fact during the APA negotiations and (2) improper implementation and non-compliance with the APAs.

The Tax Court held that the IRS's determination to cancel APA I and APA II was an abuse of discretion. In reaching this decision, the Tax Court did not see any additional material facts, mistakes of material facts, or misrepresentations that would have resulted in a significantly different APA or no APA at all. Furthermore, the Tax Court found that while the taxpayer made errors in complying with the APAs, these errors were inadvertent and were not deliberate attempts to alter the underlying transfer pricing methodology and would not have resulted in significantly or materially different APAs, thereby concluding that there was good-faith compliance with terms of the APAs.

As an alternative ground for an adjustment, the IRS also argued that the taxpayer had transferred intangible property compensable under section 367(d) to the taxpayer's controlled foreign affiliates for tax year 2006. The Tax Court also held that the taxpayer did not transfer intangibles subject to section 367(d).

The Tax Court's decision is an important validation of the integrity of the APA process. Hundreds of US taxpayers who have entered into APAs with the IRS have wondered whether the IRS position in the Eaton case undercuts the level of certainty regarding the transfer pricing issues covered by their APAs. The Tax Court decision indicates the IRS would need a stronger case than the errors the IRS found in Eaton in order to cancel an APA.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG.

Mark Martin (mrmartin@kpmg.com) and Mark Horowitz (mhorowitz@kpmg.com), Houston

KPMG

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