Eaton Corp. v. Commissioner is heating up. Not only has the IRS invalidated its APA, but now it is trying to exclude certain evidence from the trial over the transfer pricing. According to a BNA story:
“The IRS is seeking to prevent Eaton Corp. from presenting key testimony related to its business operations at a transfer pricing trial that begins Aug. 24 in Chicago …the Internal Revenue Service argued that Eaton should be sanctioned for not playing fair during discovery. The agency said Eaton blocked it from interviewing 39 key employees about the company’s business operations, all the while granting its own expert witnesses unfettered access to the same individuals.”
We shall return to the key factual and economic issues shortly but let’s note we have seen this before in a 1997 win for the IRS in ASAT v. Comr. As I noted in a discussion of limited function distributors, ASAT’s 6 percent commission rate was reasonable given that the U.S. affiliate was a commission agent with operating expenses that were less than 5.5 percent of sales. The IRS position that the commission rate should have been 15 percent was based on incredibly silly reasoning. As I have noted:
“The U.S. Tax Court, however, ruled in favor of the IRS even though its position was quite unreasonable. The court said it accepted the IRS’s position because the taxpayer refused to cooperate with the IRS examination. This fact precluded the taxpayer from presenting an analysis that it later hired Clark Chandler to perform….Under an audit, the taxpayer should provide the tax authorities with relevant information especially if its intercompany pricing policy is reasonable. In fact, the taxpayer would be well advised to provide the tax authorities with a well-articulated analysis of why its intercompany pricing policy is consistent with the arm’s-length answer. The case also reveals how silly a tax authority’s analysis can become when that tax authority is seeking a transfer pricing adjustment even in a situation where the original intercompany pricing policy was reasonable. The reason the IRS prevailed in ASAT is not because of the quality of its analysis, but because of the taxpayer’s refusal to cooperate with the original examination.”
ASAT foolishly ignored a request for documents under section 6038A and was later precluded from presenting its case that its transfer pricing was reasonable. Is Eaton making the same mistake?
Eaton’s foreign affiliates in Puerto Rico and the Dominican Republic manufacture electrical breaker products and sell them to the U.S. parent. Eaton was able to source a substantial amount of profits abroad under section 936 until these tax benefits expired in 2005. The cancelled APA was to cover the years from 2006 to 2010. IRS Examination suggested that the APA did not understand the facts and allowed the same transfer pricing policy to remain after the expiration of section 936.
The APAs based the price charged by the manufacturing affiliates on an analysis of the U.S. distributor’s gross margin that granted the U.S. affiliate profits attributable to its distribution functions. Under this transfer pricing policy, the profits for the manufacturing affiliate were substantial. These manufacturing affiliates paid the U.S. parent modest royalty rates for the use of certain intangible assets. The position of IRS Examination, however, was such that the manufacturing affiliates were merely contract manufacturers that were entitle to a modest markup over their production costs.
Eaton and the IRS are approaching the transfer pricing issues in fundamentally different ways. The appropriate transfer pricing approach depends on the facts including what are the valuable intangible assets and which affiliates should be seen as the owners. The push by the OECD in its Base Erosion and Profit Shifting initiatives are addressing the same concerns. Multinationals should see this Eaton dispute as a clear call to provided clear and consistent documentation. The OECD’s Action Plan 13 calls for a Master File and Country-by-Country Reporting approach. Had Eaton implemented such an approach one would hope that it could have avoided this particular controversy.
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