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SEC
T.C. Memo. 2017-147
UNITED STATES TAX COURT
EATON CORPORATION AND SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 5576-12.
Filed July 26, 2017.
P and R entered into two advance pricing agreements (APAs)
establishing a transfer pricing methodology for covered transactions
between P and its subsidiaries. The first APA (APA I) applied for P's
2001-05 tax years, and the second APA (APA II) applied for P's
2006-10 tax years. P and R agreed that the legal effect and
administration of APA I and APA II were governed by Rev. Proc. 9653, 1996-2 C.B. 375, and Rev. Proc. 2004-40, 2004-2 C.B. 50,
respectively.
In 2011 R determined that P had not complied with the
applicable terms of the revenue procedures and canceled APA I,
effective January 1, 2005, and APA II, effective January 1, 2006. As
a result of canceling the APAs, R determined that under I.R.C. sec.
482 an adjustment was necessary to reflect an arm's-length result for
P's intercompany transactions.
SERVED Jul 26 2017
-2[*2] P contends that R's cancellation of APA I and APA II was an
abuse of discretion because there was no basis for the cancellation
under the applicable revenue procedures. R contends that the
determination to cancel both APA I and APA II was not an abuse of
discretion because P did not comply in good faith with the terms and
conditions of either APA I or APA II and failed to satisfy the APA
annual reporting requirements.
As an alternative position, R determined that P transferred
intangible property compensable under I.R.C. sec. 367(d) to P's
controlled foreign affiliates for tax year 2006.
On July 15, 2005, P entered into a stock purchase agreement to
purchase all of the outstanding stock of THI. THI planned to enter
into bonus agreements with certain executives that provided for stock
option grants. THI entered into agreements with certain executives to
provide them with cash bonuses in exchange for their release of
claims related to any stock options.
For tax year 2005 P claimed a deduction for the bonus amount
payments. R determined that P was not entitled to the deduction and
that the bonus payments should have been capitalized under I.R.C.
sec. 263. P contends that it is entitled to a deduction under I.R.C. sec.
162(a) because the bonus payments represented additional employee
compensation.
Held: R's determination to cancel APA I and APA II was an
abuse of discretion.
H_eld, further, P did not transfer intangibles subject to I.R.C.
sec. 367(d).
H_eM, further, P's bonus payments represented employee
compensation, entitling P to a deduction under I.R.C. sec. 162(a).
-3[*3] Joel V. Williamson, John T. Hildy, Charles P. Hurley, Brian W. Kittle, M
G. Gladney, Geoffrey M. Collins, James B. Kelly, John W. Horne, Rajiv Madan,
Julia Kazaks, Royce L. Tidwell, Kiara L. Rankin, Christopher P. Murphy, Sonja
Schiller, Nathan P. Wacker, and Pamela C. Martin, for petitioner.
John M. Altman, Justin L. Campolieta, Ronald S. Collins, Jr., Matthew J.
Avon, Michael S. Coravos, Michael Y. Chin, Jennifer A. Potts, Laurie Nasky, and
William T. Derick, for respondent.
CONTENTS
FINDINGS OF FACT .............................................. 10
I.
II.
III.
Overview of Eaton............................................ 10
A.
Corporate Structure ...................................... 10
B.
Overview of Eaton's Breaker Products . . . . . . . . . . . . . . . . . . . . . . . 13
C.
The Island Plants........................................ 16
1.
Background and Restructuring . . . . . . . . . . . . . . . . . . . . . . . . 16
2.
Operations During 2005 and 2006 .. . . . ........ .. . . . . . . 22
D.
Domestic Assembly and Equipment Plants. . . . . . . . . . . . . . . . . . . . 23
E.
Domestic Component Plants ............................... 24
F.
Third-Party Distributors................................... 25
Tax & Financial Reporting ..................................... 25
A.
Financial Reporting System................................ 26
B.
TheVISTASystem......................................27
C.
MirrorLedgers.......................................... 30
Background to APA Negotiations................................ 32
A.
The APA Program....................................... 32
B.
The 1994-97 Audit....................................... 33
-4[*4]
1.
2.
The Audit Team Members............................ 34
Historical and Proposed Transfer Pricing Methods . . . . . . . . 34
a.
Historical TPM ............................... 34
b.
Proposed TPM Provided to the 1994-97
Audit Team .................................. 35
3.
IV.
Information Shared ................................. 37
a.
Mirror Ledgers ............................... 37
b.
U.S. Assembly and Breaker Products . . . . . . . . . . . . . . 38
The APAs................................................... 40
A.
Covered Transactions .................................... 40
B.
APAI: 2001-05TaxYears................................ 41
1.
Participants ....................................... 41
2.
APA Negotiations .................................. 43
a.
Prefiling Meeting ............................. 43
b.
APAITeam'sQuestions........................ 44
c.
APA I Application Submission . . . . . . . . . . . . . . . . . . 45
i.
ProposedAPAITPMs....................45
ii.
Information Petitioner Provided With Its APA I
Application Submission . . . . . . . . . . . . . . . . . . . 48
d.
3.
APA I Team's Due Diligence Questions . . . . . . . . . . . 50
i.
VISTA Response ........................ 51
ii.
Profit Split Response ....... . .. . . . ........ 51
iii.
Volume Discounts Response . . . . . . . . . . . . . . . 53
iv.
SG&A Expense Allocations . . . . . . . . . . . . . . . . 55
v.
Other Business Operations . . . . . . . . . . . . . . . . . 56
vi.
Markup Analysis......................... 57
vii.
Berry Ratio Negotiation . . . . . . . . . . . . . . . . . . . 59
viii.
Petitioner's Concessions. . . . . . . . . . . . . . . . . . . 61
APA I Terms ...................................... 62
a.
TPM and Berry Ratio for Breaker Product
Transfer..................................... 62
b.
SG&A Expenses .............................. 64
c.
APA I TPMs for Intangibles Transfer and
Cost-Sharing Payment. . . . . . . . . . . . . . . . . . . . . . . . . . 65
d.
Compliance.................................. 65
e.
Materiality. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
-5[*5]
f.
4.
C.
Critical Assumptions........................... 67
APA I Implementation............................... 68
a.
b.
Canadian Adjustment .......................... 68
Disclosure of Book-Tax Difference and
APA Multiplier ............................... 69
c.
2005 Tax Return .............................. 70
APA II: 2006-10 Tax Years ............................... 72
1.
Participants ....................................... 72
2.
APA II Negotiations ................................ 74
a.
Prefiling Process.............................. 74
b.
c.
APA II Application............................ 75
APA II Team's Due Diligence Questions. . . . . . . . . . . 77
i.
Profit Split.............................. 78
ii.
Installed Base Marketing Intangible. . . . . . . . . . 80
iii.
Technology Intangibles . . . . . . . . . . . . . . . . . . . 83
iv.
3.
Volume Discounts. . . . . . . . . . . . . . . . . . . . . . . . 83
d.
SG&A Expense Allocations . . . . . . . . . . . . . . . . . . . . . 84
e.
EEI U.S. Distribution as the Tested Party . . . . . . . . . . 85
f.
Licensing of Intangible Property Not Included . . . . . . 87
APAII Terms...................................... 87
a.
SG&A Expenses and TPM for Breaker
Products Transfer ............................. 88
4.
V.
b.
Compliance.................................. 89
c.
Materiality................................... 90
d.
Critical Assumption ........................... 90
2006 Tax Return ................................... 91
ImplementationofAPAs.......................................91
A.
Difference Between Mirror Ledgers and Constructed Income
Statement .............................................. 91
B.
APA Multiplier ......................................... 92
C.
APAAnnualReports..................................... 94
D.
APA Annual Reports and Book-Tax Differences . . . . . . . . . . . . . . . 95
E.
Petitioner's Data or Computational Errors . . . . . . . . . . . . . . . . . . . . 95
1.
Discovery and Reporting of Errors . . . . . . . . . . . . . . . . . . . . . 96
2.
APA Multiplier .................................... 99
-6[*6]
3.
Errors Affecting the Computation of the Transfer Price Under
the APA TPM .................................... 102
a.
OEM Categorization.......................... 102
b.
Purchase Resale Error......................... 103
c.
Operating Expenses Associated with Breaker Products
Not Manufactured by the Island Plants. . . . . . . . . . . . 105
d.
e.
International Sales Error . . . . . . . . . . . . . . . . . . . . . . . 106
Error in Identifying Sales of Industrial Breakers
ThroughLincoln............................. 107
f.
Lincoln Multiplier Error . . . . . . . . . . . . . . . . . . . . . . . 109
g.
Error in Computation of Manufacturing Costs for
Nonexact Matches............................ 110
VI.
Petitioner's Supplemental and Third APA . . . . . . . . . . . . . . . . . . . . . . . . 111
VII. CancellationofAPAs......................................... 112
VIII. Notice ofDeficiency ......................................... 113
IX.
Tractech Bonuses............................................ 114
OPINION ....................................................... 119
I.
Cancellation ofAPAs......................................... 119
A.
Overview of Parties' Positions ............................ 119
1.
Petitioner........................................ 119
2.
Respondent ...................................... 120
B.
History ofthe APA Program.............................. 120
C.
Applicable Revenue Procedures ........................... 126
1.
Rev. Proc. 96-53.................................. 126
D.
E.
2.
Rev. Proc.2004-40 ................................ 128
Background on Section 482 and Applicable Regulations. . . . . . . . 129
Scope and Standard ofReview ............................ 131
F.
APA Negotiations ...................................... 132
1.
Profit Split....................................... 135
2.
Tested Party...................................... 138
3.
BusinessLosses................................... 141
-7[*7]
4.
5.
MirrorLedgers.................................... 142
Relationship Between Breaker Products and
U.S. Assembly.................................... 145
6.
SG&A Allocation ................................. 147
7.
Southbound Transactions ........................... 148
8.
APA Multiplier ................................... 149
9.
Lincoln Sales..................................... 150
G.
Analysis Regarding APA Negotiations. . . . . . . . . . . . . . . . . . . . . . 151
H.
APAImplementation.................................... 161
1.
Error in Supporting Data and Computations. . . . . . . . . . . . . 164
2.
Errors Affecting the Computation of the Transfer Price
Under the APA TPM............................... 170
a.
OEM Categorization.......................... 170
b.
Purchase Resale Error......................... 170
c.
Operating Expenses Associated With Breaker
Products Not Manufactured by the Island Plants . . . . 171
International Sales Error . . . . . . . . . . . . . . . . . . . . . . . 171
Sales of Industrial Breakers Through Lincoln . . . . . . 172
Lincoln Multiplier Error . . . . . . . . . . . . . . . . . . . . . . . 173
Error in Computation of Manufacturing Costs for
Nonexact Matches. . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
Analysis of Errors Affecting the Computation of
the Transfer Price Under the APA TPM. . . . . . . . . . . 174
d.
e.
f.
g.
h.
3.
Compliance With the Terms of the APAs. . . . . . . . . . . . . . . 180
a.
Book-Tax Differences and Compensating
Adjustments................................. 180
I.
II.
b.
Forms 1120 and Compliance With the APA . . . . . . . 1 81
c.
Canadian Adjustment . . . . . ...... . . . . . . . ..... .. 184
d.
VISTA Data................................. 186
e.
Analysis of Compliance ....................... 187
4.
Critical Assumptions............................... 188
5.
Amended APA II Annual Reports..................... 189
Conclusion............................................ 192
TransferofIntangibles........................................ 194
-8[*8] III.
Tractech Bonuses....................................... 198
MEMORANDUM FINDINGS OF FACT AND OPINION
KERRIGAN, Judge: The Internal Revenue Service (IRS or respondent)
determined deficiencies in petitioner's Federal income tax of $19,714,770 and
$55,323,229 for tax years 2005 and 2006, respectively, and accuracy-related
penalties of $14,281,960 and $37,329,600 for tax years 2005 and 2006,
respectively.¹ Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect during the years at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure. We round all monetary amounts to
the nearest dollar.
Petitioner and respondent entered into two advance pricing agreements
(APAs). The first APA covered petitioner's 2001 through 2005 tax years (APA I),
and the second APA covered petitioner's 2006 through 2010 tax years (APA II).
In 2011 respondent canceled APA I effective January 1, 2005, and canceled APA
II effective January 1, 2006.
¹The notice of deficiency includes several adjustments that are
computational.
-9[*9] The first issue for our consideration is whether respondent's cancellation of
petitioner's APAs covering tax years 2005 and 2006 was an abuse of discretion.
The Court's resolution of this issue will determine whether additional issues need
to be considered. If we conclude that the cancellation of the APAs was not an
abuse of discretion, we must decide whether respondent's section 482 adjustments
to petitioner's intercompany transfer pricing for tangible and intangible property
between petitioner's U.S. affiliates and its controlled foreign affiliates were
arbitrary and capricious. Alternatively, if the Court does not hold for respondent
on the section 482 adjustments and the cancellation of the APAs for tax years
2005 and 2006, we must consider whether Eaton Electrical de Puerto Rico, Inc.
(EEPR), transferred intangible property compensable under section 367(d) to
petitioner's controlled foreign affiliates for tax year 2006. If we sustain
respondent's determination to cancel APA I and APA II for tax years 2005 and
2006, respectively, and we hold for respondent on the section 482 adjustments, we
will need to consider whether petitioner is liable for penalties pursuant to section
6662(e) and (h).
The unrelated remaining issue for our consideration is whether bonus
payments to Tractech executives were deductible for tax year 2005 pursuant to
section 162(a) or should have been capitalized pursuant to section 263.
-10[*10] On August 5, 2015, the Court issued a protective order to prevent disclosure
of petitioner's proprietary and confidential information.2 The facts and opinion
have been adapted accordingly, and any information set forth herein is not
proprietary or confidential.
FINDINGS OF FACT
I.
Overview of Eaton
Eaton Corp. is an Ohio corporation. Its principal place of business was in
Cleveland, Ohio, when it timely filed its petition. During 2005 and 2006 Eaton
Corp. was the parent corporation of a group of consolidated corporations and
multinational affiliated subsidiaries (collectively, Eaton or petitioner). Eaton is a
global manufacturer of electrical and industrial products. Eaton was incorporated
in Ohio in 1916 as a successor to a New Jersey company incorporated in 1911.
A.
Corporate Structure
During the tax years at issue Eaton was the publicly held parent corporation
of a group of U.S. and foreign companies, including: (1) Eaton Electrical, Inc.
(EEI); (2) EEPR; (3) Cutler-Hammer Industries, Ltd. (CHIL); (4) Eaton Industries
Manufacturing GmbH (EIMG); (5) Cutler-Hammer Co. (CHC); and (6) CutlerHammer Electrical Co. (CHEC).
2The Court amended paragraph 7(c) of this order on August 17, 2015.
-11[*11] EEI is a Delaware corporation formerly known as Cutler-Hammer, Inc.
(CHI). On August 23, 2003, CHI changed its name to EEI.3 During the tax years
at issue EEI was a first-tier, wholly owned subsidiary of Eaton. EEI supplied
electrical power and control products through a network of manufacturing and
distribution facilities. EEPR owned and operated a number of these
manufacturing and distribution facilities. EEPR is a Delaware corporation
formerly known as Cutler-Hammer de Puerto Rico, Inc. (CHPR). On October 23,
2003, CHPR changed its name to EEPR. During the tax years at issue EEPR was
a first-tier, wholly owned subsidiary of EEI and operated as a possession
corporation, pursuant to an election under section 936, through December 31,
2005. Effective January 1, 2006, the remainder of EEPR's operations functioned
as a branch of CHC.
CHIL is a Cayman Islands corporation. On December 31, 2002, CHIL
acquired all the assets of Cutler-Hammer, S.A., a corporation organized under the
laws of the Dominican Republic. During 2005 and until April 28, 2006, CHIL
was a direct subsidiary of EEI. On April 28, 2006, CHIL's stock was contributed
3As the exhibits did, we reference CHI and EEI with the understanding that
they refer to the same entity. We use CHI when referring to it before August 23,
2003. We use EEI when referring to it after August 23, 2003. We use CHI/EEI
when referring to years that cover before and after August 23, 2003.
-12[*12] to EIMG, a Swiss corporation and indirect subsidiary of Eaton. On April
29, 2006, CHIL elected to be treated as a disregarded entity for U.S. tax purposes.
During the tax years at issue CHIL conducted branch operations in the Dominican
Republic.4
CHC is a Cayman Islands corporation. From its organization on November
23, 2000, until July 31, 2006, CHC was a first-tier, wholly-owned subsidiary of
EEPR. On July 31, 2006, EIMG acquired CHC in a section 368(a)(1)(D)
reorganization. On August 26, 2006, for U.S. tax purposes CHC elected to be
treated as a disregarded entity, effective August 2, 2006. CHC conducted branch
operations in Puerto Rico.
On November 16, 2005, CHEC was organized under the laws of the
Cayman Islands. From November 16, 2005, until July 31, 2006, CHEC was a
first-tier, wholly owned subsidiary of EEPR. CHEC did not conduct any business
activity during tax year 2005. CHEC conducted branch operations in Puerto Rico
during tax year 2006. On July 31, 2006, the stock of CHEC was contributed to
EIMG, and on August 26, 2006, CHEC elected to be treated as a disregarded
entity for U.S. tax purposes, effective August 2, 2006.
4For the services CHIL provided on behalf of CHC and CHEC, CHIL was
compensated through a monthly fee equal to its costs plus a fixed markup. The
compensation to CHIL is not at issue.
-13[*13] B.
Overview of Eaton's Breaker Products
During the years at issue Eaton developed, manufactured, and sold circuit
breaker and electrical control products (collectively, breaker products) through
various manufacturing plants (collectively, Island plants) in Puerto Rico and the
Dominican Republic. The Island plants operated through EEPR, CHC, CHEC,
and CHIL, and manufactured most of petitioner's breaker products.
Breaker products are safety products, designed to regulate and manage the
flow of electricity. Breakers open and close electrical circuits safely upon
detection of abnormal circuit conditions. A breaker should trip when it detects too
much electricity being drawn through the attached wires or when it senses a short
circuit. Control products, such as starters, push buttons, and contractors, control
electricity that powers electrical or electromechanical devices. Control products
protect operators of equipment and the machinery itself by safely turning the
machinery on or off or by governing its speed.
Breaker products are heavily regulated because of their safety aspect. In the
United States, Underwriters Laboratories, Inc. (UL), is the organization that
evaluates and approves breaker products. The National Electrical Code (NEC)
specifies that certain devices used in an electrical system must be "listed" devices,
defined as devices that have been evaluated and approved by an organization with
-14[*14] the authority to make such a determination. See NEC 2005, NFPA 70:
National Electric Code, International Electric Code Series, at 70-29,
http://dsps.wi.gov/Documents/Industry%20Services/Forms/Elevator/HistoricalCo
des/2005%20NEC.pdf. UL is a private company, approved by the U.S.
Department of Labor as a Nationally Recognized Testing Laboratory. See United
States Department of Labor, Occupational Safety and Health Administration
(OSHA): OSHA's Nationally Recognized Testing Laboratory (NRTL) Program,
Current List of NRTLs, https://www.osha.gov/dts/otpca/nrt1/nrtilist.html. If a
breaker product meets UL requirements, it receives a UL label. If a breaker
product does not meet UL requirements, it cannot be sold in the United States.
During the tax years at issue the U.S. breaker product manufacturing
industry was composed of Eaton and four major competitors: Schneider Electric
(Schneider), General Electric Corp. (GE), Siemens A.G. (Siemens), and to a lesser
extent, ASEA Brown Boveri, Ltd. (ABB). These same competitors, as well as
Rockwell Automation, manufactured control products.
The Island plants manufactured a wide variety of breaker products on a
large scale. Eaton manufactured component parts used to make breaker products
in various feeder plants on the Islands. The feeder plants assembled the various
component parts into final breaker products. A single breaker product can have as
-15[*15] many as 100 component parts. In 2005 and 2006 the Island plants
manufactured most of the component parts that went into the breaker products.
Eaton's U.S. plants manufactured the component parts that were sold and shipped
to the Island plants for incorporation into the products that the Island plants
manufactured and assembled. Eaton's U.S. plants manufactured a small number
of the component parts used by the Island plants to assemble finished breaker
products.
Eaton sold the same breaker products both internally to its assembly
operations and to third parties. The Island plants sold the finished breaker
products to two parts of EEI in the United States: (1) EEI's assembly plants (U.S.
assembly), which inserted the breaker products into the electrical panelboards and
switchgear, and (2) EEI's distribution department (U.S. distribution), which was
responsible for selling breaker products to third parties. Third parties that
purchased breaker products could be categorized as original equipment
manufacturers (OEMs), distributors, or other large direct customers such as
retailers, large contractors, or industrial users. OEMs used the breaker products
that they purchased as components in larger products such as the panelboards and
switchgears. OEMs often competed with EEI's assembled products. Hundreds of
OEMs manufactured assembled products, and most of them did not manufacture
-16[*16] the components that they needed for assembly. Only a few companies, such
as Eaton, manufactured breaker products and produced assembled products.
Whether the breaker products were sold to U.S. assembly, OEMs, or any other
customer, the Island plants manufactured them in the same manner.
C.
The Island Plants
1.
Background and Restructuring
On January 31, 1994, petitioner acquired the Westinghouse Distribution and
Control Business Unit (DCBU) from Westinghouse Electric Corp. (Wesco).
Petitioner acquired facilities in Puerto Rico which manufactured three product
lines: miniature circuit breakers (MCBs), molded case circuit breakers (MCCBs),
and control products.
In connection with the DCBU acquisition from Wesco, CHPR purchased the
business owned and conducted by Westinghouse de Puerto Rico, a Delaware
corporation, including manufacturing intangible assets. The purchase agreement
defined manufacturing intangible assets as those defined by section
936(h)(3)(B)(i) and section 1.936-6(c), Income Tax Regs. As part of the purchase
agreement petitioner acquired the following three facilities in Puerto Rico: (1) an
MCB facility in Aguas Buenas, Puerto Rico, (2) an MCCB manufacturing facility
in Toa Baja, Puerto Rico, and (3) a control product manufacturing facility in
-17[*17] Coamo, Puerto Rico.5 The Toa Baja facility was moved and consolidated
with existing operations in Arecibo in 2001. The Island plants manufactured
different breaker products in different manufacturing plants because the
equipment, materials, and skills required to manufacture them varied among the
plants.
Westinghouse began manufacturing MCBs in Puerto Rico in 1973. It began
making MCCBs and control products in Puerto Rico in 1968 and 1976,
respectively. Before the DCBU merger CHPR had it own operations in Puerto
Rico. The Cabo Rojo facility opened in 1975.
In response to the phaseout of section 936 benefits, CHPR transferred assets
to CHC and CHEC in a series of transfers between December 29, 2000, and
January 1, 2006. CHPR/EEPR transferred assets to CHC and CHEC at various
times between December 29, 2000, and January 1, 2006. For each tangible asset
transfer, CHI/EEI licensed certain intangible property related to the transferred
tangible assets to CHC or CHEC. Licensing agreements were executed on the
following dates: (1) December 29, 2000, (2) December 1, 2001, (3) June 1, 2005,
and (4) January 1, 2006.
5The record does not explain what happened to the Aguas Buenas facility.
-18[*18] Effective December 29, 2000, CHI and CHC entered into a license
agreement whereby CHI granted a nonexclusive license to use, including the right
to sublicense, a broad class of intangible property that CHC used to manufacture
and assemble certain breaker products. The categories of intangible property that
CHI licensed to CHC included all patents, trademarks, copyrights, maskworks,
and "information" necessary to, or used in, the operation of CHC in manufacturing
breaker products.
In exchange for the license CHC agreed to pay CHI a royalty of 4% of
CHC's net sales of the licensed breaker products. CHC also granted back to CHI a
royalty-free exclusive license to use, including the right to sublicense, all patents,
trademarks, copyrights, maskworks, and information related to the breaker
products that were developed by CHC.
The CHI and CHC license agreement was amended on December 1, 2001,
and again on June 1, 2005, to include intangible property associated with
additional breaker products. The amendments increased the royalty rate from 4%
to 6.45% of net sales. All other terms and conditions generally remained the same.
Effective January 1, 2006, EEI and CHEC entered into a license agreement
whereby EEI granted to CHEC a nonexclusive license to use a broad class of
intangible property that CHEC used to manufacture certain additional breaker
-19[*19] products. The terms of the EEI and CHEC license agreement were
substantially similar to the terms of the CHI and CHC license agreement (as
amended), including the royalty rate of 6.45% of net sales, except that under the
terms of the EEI and CHEC license agreement: (1) EEI licensed to CHEC all
intangible property related to breaker products that was subsequently developed or
acquired by EEI and (2) CHEC agreed to reimburse EEI for the intangible
development costs associated with any subsequently developed or acquired
intangible property.
On December 29, 2000, CHPR transferred assets with a net book value of
$4,736,230 and a certain number of employees to CHC. CHC received the assets
as a contribution to capital and agreed to offer immediate employment to the
employees.
On December 1, 2001, CHPR agreed to transfer assets with a net book value
of $6,086,194 and a number of employees located and employed at the Coamo
facility to CHC. CHC received the assets as a contribution to capital and agreed to
offer immediate employment to the employees. The December 1, 2001, asset
transfer agreement listed that assets would be transferred to CHC on three
particular dates: December 17, 2001, January 29, 2002, and February 13, 2002.
-20[*20] On its 2001 Form 926, Return by U.S. Transferor of Property to a Foreign
Corporation, dated June 29, 2002, CHPR reported that on December 17, 2001, it
had transferred assets in a section 351 nonrecognition transaction. Petitioner
checked "yes" for the question whether intangible property within the meaning of
section 936(h)(3)(B) was transferred. The attachment to the Form 926 explained
that the transferee entered into an intellectual property license with CHI.
On January 2, 2002, CHPR agreed to transfer assets with a net book value
of $3,697,284 and a number of employees located and employed at the Las Piedras
facility to CHC. CHC received the assets as a contribution to capital.
On its 2002 Form 926 dated September 12, 2003, CHPR reported that it had
transferred assets to CHC on January 2, January 29, and February 13, 2002,
respectively, in three section 351 nonrecogmtion transactions. Petitioner checked
"yes" for the question whether intangible property within the meaning of section
936(h)(3)(B) was transferred. The attachment to the Form 926 explained that the
transferee entered into an intellectual property license with CHI.
On June 1, 2005, EEPR entered into two asset transfer agreements with
CHC. Pursuant to the first asset transfer agreement, EEPR transferred assets and
employees from the Arecibo, Cabo Rojo, and Las Piedras facilities as
contributions to the capital of CHC. Pursuant to the second asset agreement,
-21[*21] EEPR contributed an undivided joint interest in certain common assets
owned by EEPR and jointly used by CHC and EEPR since June 1, 2005, in
support of the manufacturing operations of the two companies at the Cabo Rojo,
Las Piedras, and Arecibo facilities.
On its 2005 Form 926 EEPR reported that it had transferred assets to CHC
on June 1, 2005, in a section 351 nonrecogmtion transaction. Petitioner checked
"yes" for the question whether intangible property within the meaning of section
936(h)(3)(B) was transferred. The attachment to the Form 926 explained that the
transferee entered into an intellectual property license with EEI .
On January 1, 2006, EEPR agreed to transfer assets and a number of
employees to CHEC. CHEC received the assets as a contribution to capital and
agreed to offer immediate employment to the employees. The asset agreement did
not provide a net book value amount for the transferred assets.
On its 2006 Form 926 EEPR reported that it had transferred various
operating assets to CHEC on January 1, 2006, in a section 351 nonrecognition
transaction. Petitioner checked "no" for the question whether intangible property
within the meaning of section 936(h)(3)(B) was transferred. The attachment to the
Form 926 made no mention of an intellectual property license.
-22[*22]
2.
Operations During 2005 and 2006
In 2001 MCCB operations took place in Puerto Rico, and those operations
remained there until 2007. During 2005 and 2006 petitioner had four
manufacturing facilities in Puerto Rico and an assembly plant in the Dominican
Republic. Starting in 2007 and ending in 2008, MCCB assembly operations were
transferred to the Dominican Republic, while manufacturing operations remained
in Puerto Rico. Since 1976 control products have been manufactured in Puerto
Rico.
During 2005 and 2006 the Island plants included an assembly plant in
Haina, Dominican Republic, and the following four manufacturing facilities in
Puerto Rico: the Las Piedras plant, the Arecibo plant, the Cabo Rojo plant, and
the Coamo plant. The Haina assembly facility had designated space for each of
the product types that it received from the Puerto Rico plants. In 2005 and 2006
the Las Piedras plant manufactured finished breaker products, parts, and
subassemblies for final assembly at the Haina facility. As of September 2005 the
Arecibo plant, along with its sister operations in Haina, produced, assembled, and
tested finished industrial MCCBs.
During 2005 and 2006 the Cabo Rojo plant manufactured industrial fuses
and switch-gear circuit breakers for low and medium voltage circuits. In 2005 and
-23[*23] 2006 the Coamo plant, along with its sister operation in Haina,
manufactured electromechanical relays, contractors, starters, and operatorinterface products, such as pushbuttons, indicating lights, and selector switches.
D.
Domestic Assembly and Equipment Plants
Eaton owned and operated a number of facilities that manufactured and/or
assembled products that incorporated Island plants manufactured products and
other products. These facilities were in Asheville, North Carolina, Lincoln,
Illinois, Cleveland, Tennessee, Fayetteville, North Carolina, Greenwood, South
Carolina, and Sumter, South Carolina.
The Lincoln plant produced a complete residential breaker product offering
that covered three primary product groups: loadeenters, meter products, and air
conditioning disconnects. The Lincoln plant's steel fabrication operation fed its
residential product offering business.
CHI sold industrial breaker products directly to unrelated OEMs and to
unrelated distributors through the Lincoln plant. These industrial breaker products
consisted of breaker products manufactured by the Island plants as well as the
Lincoln plant. The Lincoln plant stopped manufacturing industrial breaker
products in 2006. Starting in April 2006 industrial breaker products were
manufactured only in the Island plants.
-24[*24] E.
Domestic Component Plants
EEI operated domestic plants, which manufactured components and parts
that were sold and shipped to the Island plants for incorporation into the products
that the Island plants manufactured and assembled. These facilities were in
Horseheads, New York, Beaver, Pennsylvania, and Watertown, Wisconsin. The
Horseheads plant manufactured vacuum interrupters which were in systems that
distribute, protect, and control electricity. The Island plants purchased vacuum
interrupters from the Horseheads plant. The Beaver plant manufactured and
assembled MCCBs, automatic transfer switches, low-voltage power breakers, and
circuit breakers.
The Watertown plant manufactured count control products, specific purpose
control products, adjustable frequency drive, open and enclosed drives, metering
products, relays, printed circuit boards, and operator interface equipment. The
Watertown plant supplied printed circuit boards to the Island plants and to the
Lincoln and Beaver plants.
The Island plants purchased approximately $8 to $10 million of components
per year from CHI out of more than $300 million of cost of goods sold (COGS),
which the Island plants used to manufacture breaker products. These southbound
transactions included the Island plants' purchase of vacuum interrupters that were
-25[*25] manufactured in petitioner's Horseheads plant. The Island plants
incorporated the vacuum interrupters into the breaker products that it
manufactured. The Island plants purchased other raw materials and components
from unrelated third parties.
F.
Third-Party Distributors
Third-party distributors played a role in the sale of CHI/EEI products.
Third-party distributors resold the products they bought from CHI/EEI to smaller
OEMs and industrial or utility customers, as well as to contractors. Most thirdparty distributor sales involved large, well-established electronics distribution
companies. These companies offered broad lines of products and had developed
complete distribution networks in the United States. A national third-party
distributor typically carried a complete range of products from a large number of
various-sized suppliers, including CHI/EEI and its direct competitors. During the
years at issue the largest third-party distributor of CHI/EEI products was Wesco.
CHI/EEI also had sales relationships with a number of regional electrical product
distributors.
II.
Tax & Financial Reporting
For the tax years at issue petitioner was a calendar year taxpayer that filed
consolidated Federal income tax returns. Petitioner reported its income for
-26[*26] financial purposes on a calendar year and prepared its income statements
and balance sheets in accordance with U.S. Generally Accepted Accounting
Principles (GAAP).
A.
Financial Reporting System
Petitioner used a financial reporting and management system called
Hyperion for various purposes, including financial and legal consolidation of its
several accounting ledgers. Petitioner used Encore, a system that received data
from its ledgers, and Corptax, a system that consolidated its ledger data for U.S.
tax reportmg purposes. Accounting ledger data was maintained in an Oracle data
base system.
To prepare its tax returns petitioner ran a "Path8" Hyperion report, which
mapped individual ledgers into legal entities. Petitioner's financial reporting to
the Securities and Exchange Commission (SEC) included financial results
segmented by business area and geographic region. In 2005 and 2006 Eaton's
reported business segments included electrical, fluid power, truck, and automotive.
The electrical segment comprised numerous financial accounting ledgers,
including ledgers for EEI and the Island plants' operations.
-27[*27] B.
The VISTA System
VISTA is a comprehensive legacy electronic order management system,
which included sales and other functions that Eaton used for its electrical business.
Third parties, Eaton's salespersons, and Eaton's internal purchasers could place
product orders in VISTA. Westinghouse developed VISTA before Eaton acquired
DCBU in 1994.
Each VISTA invoice contained information relating to an invoice
transaction, including transactional data such as customer name, customer ID,
billing address, billing line, shipped-to address, invoice date, catalog number,
product description, product code, the quantity of product sold, the unit sale price,
the customer discount, and the total sale amount. Each VISTA invoice contained
information necessary to reprint a hard copy invoice. The VISTA database
recorded and retained transactional data.
VISTA functioned like a relational database in that various related pieces of
data on separate files were linked by key fields. The VISTA database stored
native VISTA data on a direct-access storage device. The native VISTA data was
stored and processed in extended binary coded decimal interchange code format,
which is an eight-bit character code used in computing and data transmission.
-28[*28] VISTA data was processed on a mainframe computer. Mainframe
computers are typically used by large organizations to perform large-volume
activity, such as bulk data processing, statistics, and transaction processing. In
2005 and 2006 an end user, such as a salesperson or customer, could communicate
with Eaton's mainframe computer by using a PC or Eaton's online order-entry
application.
When its mainframe executed a batch job or jobstream, the computer
created a job log that documented the job statistics and cataloged the name of any
files created from the successful or unsuccessful execution of the job. VISTA
contained numerous files within its system. Once booked, the invoice data records
within the invoice files did not change. To obtain annual invoice data, the
database was filtered on the booking date to extract data inclusive of the year.
EEI's invoice information for sales to third parties and interunits were
entered into VISTA. To create an invoice the VISTA system populated various
data fields in the VISTA invoice files. One field was the "billing line" field,
which included a three-digit code petitioner used to identify a set of financial
accounts associated with a product and plant location. A particular plant might
have multiple billing line codes associated with it. Each billing line code was
-29[*29] associated with a single Oracle ledger within petitioner's financial reporting
and accounting systems.
Some of the relevant master files used in the VISTA system to populate
certain fields in the VISTA invoice files included billing lines, country codes,
customer category, invoice type codes, product families, and warehouse codes.
The master files were dynamic and were updated in the ordinary course of
petitioner's business. The master files could change multiple times within the
same business day. Most of the information of the master files changed very little
over time. Petitioner did not archive copies of the VISTA system master files that
were used each day during 2005 and 2006.
During 2005 and 2006 petitioner's mainframe computer ran a daily data
extraction batch process called the daily billing wire to capture pertinent sales data
from selected fields of the VISTA transactional files. The daily billing wire was
appended daily to a weekly file, which was cataloged and permanently maintained
in the VISTA system. After the daily billing wire was appended to the permanent
weekly file, the daily billing wire was deleted.
The weekly billing wire file was appended to an annual file named the
market reporting sales billed extract (MRSB). Eaton used the MRSB data for
reporting purposes. The MRSB data was cataloged and permanently archived on
-30[*30] petitioner's mainframe systems. Eaton's MRSB file contained information
on EEI's sales to the Puerto Rico operations. The MRSB file did not contain
information on sales from the Puerto Rico operations to EEI. The sales invoices
from Puerto Rico operations to EEI were recorded manually in the Oracle
reportmg system.
Eaton's VISTA programmers were responsible for creating reports used to
show orders and sales specialists. These programmers generated reports used for
transfer pricing calculations.
C.
Mirror Ledgers
EEI maintained a group of ledgers that recorded EEI U.S. distribution's
purchase of breaker products from the Island plants and subsequent transfers of
those products (hereinafter, mirror ledgers). EEI recorded the arm's-length
transfer price for the breaker products as an expense on the mirror ledgers. These
expenses, or COGS, reduced the net income of EEI as reflected on the mirror
ledgers. For 2005 and 2006 EEI maintained six mirror ledgers related to the
Island plants' operations.
The mirror ledgers reflected revenue from sales of breaker products: (1) to
third parties, including OEMs and distributors, at arm's-length prices, and (2) to
internal assembly plants at the price petitioner set for internal management
-31[*31] purposes (internal management price). The revenue from the sales to third
parties at arm's-length prices was included in EEI's overall net U.S. taxable
mcome.
EEI sold or transferred breaker products as reflected on the mirror ledgers
through various channels, including domestic OEMs, domestic distributors,
domestic affiliates or operations, and international customers. For transfers of
breaker products to domestic affiliates or operations, the mirror ledgers recorded
the price paid for the breaker products at the internal management price.
For internal purposes only EEI set the price for breaker products transferred
internally within EEI to be approximately 1.3 times the cost of manufacturing the
products. Setting the internal management price consistently at a lower markup on
costs over time allowed EEI's management to evaluate and compare the ongoing
financial performance of different business segments within EEI. Maintaining a
consistent internal management price avoided unnecessary disagreements between
business units regarding the appropriate price for internal transactions. The
transfer price for EEI U.S. distribution's purchase of breaker products could be
expressed as a mathematical equivalent markup on the Island plants' cost for
manufacturing the breaker products. Generally, during the years at issue, the
transfer price computed under petitioner's APAs was equivalent to approximately
-32[*32] 1.8 times the cost of manufacturing the breaker products. Petitioner's
internal management price was less than the transfer price computed under
petitioner's APAs.
The mirror ledgers always showed operating losses because a significant
portion of the revenue resulted from sales to internal assembly plants at the lower
internal management price of 1.3 times cost, rather than 1.8 times cost--the arm'slength price. The fact that the mirror ledgers always reflected losses was not
indicative of the profitability of EEI or the breaker products. The profitability of
EEI could be assessed only when all of its business ledgers were consolidated and
all internal transactions--such as the sales of breaker products from EEI's U.S.
distribution to U.S. assembly at the internal management price--were eliminated
because they had no economic effect on EEI's overall profitability. The internal
transactions did not make EEI's total overall profits bigger or smaller.
III.
Background to APA Negotiations
A.
The APA Program
The APA Program is a dispute resolution process designed to resolve actual
or potential future transfer pricing disputes between the IRS and the taxpayer. See
Announcement 2000-35, 2000-1, C.B. 922. The ultimate goal of the process is to
enable taxpayers and the IRS to agree on three issues: (1) the intercompany
-33[*33] transactions to which the APA applies (covered transactions); (2) the
transfer pricing methodology (TPM) applicable to the covered transactions; and
(3) the expected arm's-length range of results after applying the agreed-upon TPM
to the covered transactions. See id., 2000-1 C.B. at 924.
Before detennining the appropriate APA TPM, the APA team and the
taxpayer must reach an understanding of the relevant facts through a due diligence
process, during which the APA team asks the taxpayer for any information it
thinks necessary to verify that the taxpayer's statements regarding the facts in the
taxpayer's APA application are true and complete. This due diligence process can
be lengthy, and it typically involves one or more meetings between the taxpayer
and the APA team over a period ranging anywhere between one and two years.
Due diligence questions relate mostly to the taxpayer's business, the mechanics of
the TPM, and the economic issues associated with the TPM.
B.
The 1994-97 Audit
Respondent audited petitioner's 1994-97 tax returns, rejecting its proposal
to use a comparable uncontrolled price (CUP) method for its TPM. Petitioner
agreed to apply for an APA for its 2001 tax year as part of the settlement reached
with respondent regarding the audit for petitioner's 1994-97 tax years, and
respondent agreed to work with petitioner in obtaining an agreement. The
-34[*34] settlement was finalized in February 2002. The APA process would provide
respondent with the opportunity to further review petitioner's proposed use of the
CUP method.
1.
The Audit Team Members
The IRS audit team for the 1994-97 audit (audit team) included, among
others, an international exam manager and two international examiners. Each of
those audit team members was also a member of the APA I exam team.
Petitioner's primary participants in the 1994-97 audit were its senior vice president
of tax, its vice president of Federal tax strategy, a senior manager from its tax
department, and an economic consultant.
2.
Historical and Proposed Transfer Pricing Methods
a.
Historical TPM
Before its proposal to use a CUP method, petitioner used the cost-plus
method. The cost-plus method evaluates whether the amount charged in an
intercompany sale is arm's length by reference to the gross profit markup realized
in comparable uncontrolled transactions. See sec. 1.482-3(d)(1), Income Tax
Regs. The CUP method evaluates whether the amount charged in a controlled
transaction is arm's length by reference to the amount charged in a comparable
uncontrolled transaction. See 4 para. (b).
-35[*35] Petitioner chose to use the cost-plus method as its preferred TPM for the
Island plants' transfer of breaker products to CHI. Part of the Island plants'
breaker product manufacturing process included manufacturing and assembling
electrical distribution and control equipment. The general manufacturing for the
Island plants' products involved processes that formed, manipulated and/or
assembled plastics and metals. These activities were generally routine activities
that were undertaken by many independent companies. Petitioner concluded that
the availability of financial information for companies comparable to the Island
plants' operations allowed for the use of the cost-plus method. According to
petitioner the cost-plus method treated the Island plants as the controlled party
whose profitability was tested.
b.
Proposed TPM Provided to the 1994-97 Audit Team
During the course of the 1994-97 audit petitioner proposed using the CUP
method for determining the level of profitability associated with the breaker
products manufactured in the Island plants and met with the IRS audit team to
discuss its proposal on January 17, 2001. Petitioner believed the CUP method was
better than the cost-plus method that it had used previously. The IRS audit team
was not familiar with petitioner's proposed model. They wanted the controlled
and uncontrolled transactions to involve identical products that were compared on
-36[*36] an individual basis rather than by groups of similar products. They also
wanted relevant uncontrolled sales for purposes of a CUP method to be limited to
sales to OEMs, rather than the combined sales to OEMs and U.S. distributors.
To address concerns raised about the CUP method petitioner provided the
audit team with a study on the CUP method dated March 19, 2001. Some of
petitioner's breaker products that were produced by the Island plants were sold to
EEI and some were integrated into other assembled products. Other breaker
products were sold to unrelated third-party OEMs. Petitioner's proposal
contemplated using an income stream from products the Island plants sold to thirdparty OEMs as the income CHI would have earned on the Island plants'
components that it integrated into its assembled products.
To determine an income stream petitioner's CUP method developed a
constructed income statement that was generated using CUPs it discovered and
assumptions regarding the allocation of costs. This constructed income statement
differed from the mirror ledgers. It was not an actual part of EEI's accounting
system. The income stream and a comparable profits method (CPM) would then
be used to determine whether the distribution profit was reasonable.
In its 2001 CUP method study petitioner took steps to make the CUP
method more precise, including using both catalog and style (or part) numbers to
-37[*37] more precisely match controlled and uncontrolled sales of the same product,
identifying 29 product groups of common products, and identifying sales
specifically to third-party OEMs, rather than all third parties. Petitioner provided
the audit team with an extract from its VISTA database identifying the 29 product
groups, the product codes within each group, and the standard costs for each
product sold to different categories of third parties in the United States, and a
sample extract of raw VISTA data that was used for application of the CUP
method. As part of the information about the CUP method proposal, petitioner
showed the audit team the mirror ledgers that recorded losses in their book income
line.
3.
Information Shared
a.
Mirror Ledgers
As part of the 1994-97 audit, the audit team requested that petitioner explain
the losses reported on the CHPR U.S. mirror ledgers. On October 31, 2000,
petitioner provided a written explanation to the audit team. Petitioner explained
that: (1) the losses occurred because the arm's-length price paid to the Island
plants for breaker products as reflected on the mirror ledgers was higher than the
amount recorded on the mirror ledgers as revenue from U.S. assembly based on
CHI's internal management price; (2) the mirror ledgers were just a few of CHI's
-38[*38] hundreds of ledgers, all of which must be combined--with intracompany
transfers eliminated--to determine the overall financial results of CHI; and (3) the
profits and losses on the mirror ledgers were unrelated to the economics of arm'slength sales because a substantial portion of the revenue recorded on the mirror
ledgers was calculated on the basis of the internal management price.
b.
U.S. Assembly and Breaker Products
Petitioner's October 31, 2000, response regarding its mirror ledgers
addressed the relationship between U.S. assembly and breaker products. This
response indicated that profit or loss generated by the assembly activities could
not control the price paid to the component plants. This response explained that
CHI's ability to sell its assembly products at a high profit would not justify the
Island plants' charging an above-market price for its components, and likewise,
U.S. assembly's inability to be profitable due to inefficiencies or market factors
would not justify paying CHPR a below-market price for the components it
manufactures.
On June 2, 2000, respondent issued a Form 4564, Internal Revenue Service
Information Document Request (IDR), to petitioner requesting an explanation of
the relationship between U.S. assembly and breaker products. In June 2000
petitioner provided the audit team with a written response explaining why it
-39[*39] believed the price paid by CHI to CHPR for breaker products was not
overstated. Petitioner's response explained that total U.S. sales were important for
both the CUP and the profit-split analysis. Petitioner's response further explained
that the suggestion that OEM sales were the most relevant comparable did not
reflect the fact that its electrical business is an integrated business.
This response explained that a substantial portion of CHI's distributor sales
were directly related to sales of components it previously made to OEMs and sales
of customized electrical assemblies that it previously made to unrelated third
parties. The response explained further that because of the nature and life cycle of
assembled products, third-party purchasers regularly purchased the Island plants'
products for customized electrical assemblies from unrelated distributors. The
response included a letter from petitioner's outside economic consultant which
described the many ways in which the distributor products are analogous to blades
and the sales to related or unrelated OEMs are analogous to razors.
Upon further review petitioner's outside economist discovered that his
description of the relationship between U.S. assembly and the breaker products
was inaccurate. Clarification of this inaccurate description was included in a letter
to the APA II team leader on April 21, 2006. This letter explained that there were
no volume replacements for breaker products because of a failure rate of less than
-40[*40] 2%. It explained further that the theory of an installed base is the classic
razor and blade situation in which a manufacturer sells only razors that can be
used only with its brand of replacements. Under this theory the blades can be sold
at a higher price, covering the low profitability on the razors. This response
explained that a profitable replacement market required the product compared to
the blade to be replaced frequently, which was not the case for breaker products.
IV.
The APAs
On November 14, 2003, petitioner and respondent reached an agreement on
the terms of petitioner's first APA, which covered petitioner's 2001-05 tax years.
APA I was executed on April 14, 2004. On June 23, 2005, petitioner submitted its
application for the renewal of APA I (APA II), which covered petitioner's 2006-10
tax years. APA II was executed on December 20, 2006.
A.
Covered Transactions
Petitioner's APA I applied to three covered transactions: (1) breaker
product transfers from CHPR/EEPR6 to CHI/EEI, (2) CHI/EEI's license of
intangible property to CHC, and (3) CHPR/EEPR's cost sharing payments to
CHI/EEI. APA II applied only to CHC's and CHEC's sale of breaker products to
EEI.
6We use CHPR/EEPR because in 2003 CHPR changed its name to EEPR.
-41[*41] CHI/EEI U.S. distribution purchased breaker products from the Island
plants and either resold those products to unrelated U.S. and foreign parties, or
transferred the breaker products to affiliated U.S. assembly plants and foreign
subsidiaries. During 2005 and 2006 EEI U.S. distribution purchased 100% of the
Island plants' manufactured breaker products.
CHI/EEI licensed intangible property to the Island plants, which the Island
plants used to manufacture breaker products, pursuant to two licensing
agreements. Under the licensing agreements, CHI/EEI licensed approximately
800 patents related to the breaker products. The patents related primarily to
modifications of existing technologies and breaker products. There was a cost
sharing arrangement between CHPR/EEPR and CHI/EEI that covered research
and development expenses.
B.
APA I: 2001-05 Tax Years
1.
Participants
The APA I team's participants in the APA I negotiations (APA I team)
included personnel from both the APA Program office and respondent's exam
team. The participants from the APA Program office included the APA I team
leader and several APA economists. The participants from the exam team
included three members of the 1994-97 audit team, including the 1994-97 audit
-42[*42] team's international exam manager. Although not employees of the APA
Program office,7 the exam team members constitute a portion of an APA team and
assist throughout the entire APA process, including negotiations with the taxpayer.
In general the role the exam team plays in the APA process is to support the APA
team by providing background information regarding the taxpayer and performing
needed calculations.
An APA team leader coordinates several team members for the APA
negotiations and initiates the APA application process. The APA team leader
communicates with the taxpayer's representatives to coordinate logistics,
including scheduling meetings. Before an initial meeting is conducted with the
taxpayer, a team leader will generally collect thoughts regarding questions that
should be asked of the taxpayer. The team leader is responsible for drafting the
APA, as well as drafting a memorandum to the Associate Chief Counsel
(International) explaining the reasons for accepting an APA.
Before working in the APA Program office, the APA I team leader was a
member in the office of the Associate Chief Counsel (International). In 2001 or
2002 she started in the APA Program office and worked there until moving back
7The exam team members generally come from the IRS field organization.
See Announcement 2006-22, 2006-1 C.B. 779, 780.
-43[*43] to the office of the Associate Chief Counsel (Tax Exempt and Government
Entities) in 2005. The APA I team leader worked as a team leader on several
APAs during her time in the APA Program office.
Petitioner's primary participants in the APA I negotiations were its senior
vice president of tax and its vice president of Federal tax strategy. Petitioner's
outside representatives in the APA I negotiations included employees of
PricewaterhouseCoopers, LLP (PwC), and KPMG, LLP, including two economists
and two attorneys. The PwC employees included a former Director of the APA
program and a former employee of the U.S. Department of the Treasury on
international tax matters, who later became head of transfer pricing at the
Organization for Economic Co-operation and Development (OECD) in Paris,
France.
2.
APA Negotiations
The APA I request began with a prefiling conference, and the total APA I
process lasted 18 months.
a.
Prefiling Meeting
Before making any commitment or filing a formal application, a taxpayer
may, through a prefiling conference, approach the APA Program to discuss its
preliminary views of the taxpayer's potential APA request, including whether an
-44[*44] APA would be appropriate under the facts, what types of information would
be necessary to support the request, and whether the taxpayer's proposed TPM
would be acceptable. See Announcement 2000-35, 2000-1 C.B. 924. The first
APA negotiations between petitioner and respondent began in the middle of 2002,
and on May 8, 2002, petitioner and the APA I team had a prefiling meeting to
discuss petitioner's anticipated APA I application.
During this meeting petitioner described the scope of CHI/EEI's business,
including its various operating divisions for both components and assembled
products, as well as its customer base. The APA I team indicated that if the CUP
method were to be used, the uncontrolled transactions would have to be limited to
the sales to OEMs, rather than sales to OEMs and distributors. The APA I team's
concerns were similar to those expressed by the 1994-97 audit team.
b.
APA I Team's Questions
Before petitioner formally submitted its APA I application, an APA I team
economist asked petitioner's economist about inputs that the Island plants
purchased from CHI/EEI, referred to as the southbound transactions. Petitioner's
economist communicated to the APA I team that out of the Island plants' $300
million COGS, approximately $8 to $10 million related to materials purchased
from CHI/EEI.
-45[*45]
c.
APA I Application Submission
On August 22, 2002, petitioner submitted its formal application for an APA.
Petitioner's APA I application responded to issues related to product
comparability, which echoed the issues that the 1994-97 audit team raised. This
application explained that most sales to distributors involved large, wellestablished distribution companies. These companies offered broad lines of
products and had developed complete distribution networks in the United States.
In its APA I application petitioner explained that CHI/EEI also manufactured and
distributed other electrical component products, but these functions, risks, and
assets were unrelated to CHI/EEI's intercompany transactions involving the Island
plants.
i.
Proposed APA I TPMs
Petitioner's APA I application included proposed TPMs for the covered
transactions.
(1).
Transfer of Tangible Property
CHI/EEI U.S. distribution purchased breaker products from the Island
plants that were either sold to unrelated U.S. and foreign parties or transferred to
affiliated U.S. assembly plants and foreign subsidiaries. Petitioner's proposed
arm's-length price that CHI/EEI paid the Island plants for breaker products
-46[*46] derived from a combination of the CUP and CPM methods. According to
petitioner the CUP and CPM methods were the best methods to evaluate the
arm's-length nature of prices paid by CHI/EEI to CHPR/EEPR because of the
availability and abundance of reliable unrelated transaction data. Petitioner's
proposed method combined the use of the CUP and CPM methods to determine
the revenues of CHI/EEI on the basis of prices paid by unrelated parties, and
compared CHI/EEI's resulting income with the income that CHI/EEI would have
received, on the basis of a Berry ratio--gross profit as a percentage of operating
expenses--which was determined using independent distributors.
Petitioner used a three-step process to test whether the prices CHI/EEI U.S.
distribution paid to CHPR/EEPR for breaker products were arm's length. The first
step was to identify third-party prices and revenues CHI/EEI U.S. distribution
earned on sales of breaker products to unrelated U.S. parties. On the basis of
prices paid by unrelated U.S. OEM customers, third-party equivalent arm's-length
revenues for CHI/EEI U.S. distribution's transfer of products to U.S. affiliated
manufacturing plants were constructed using a CUP method. The second step was
to create a constructed income statement for CHI/EEI's distribution activities
using: (1) third-party sales revenues, (2) the third-party equivalent intercompany
sales revenues calculated in the first step, (3) CHI/EEI's actual revenue from
-47[*47] international sales of CHPR/EEPR products, (4) the transfer prices paid by
CHI/EEI to CHPR/EEPR, and (5) the selling, general and administrative (SG&A)
expenses incurred by CHI/EEI in its distribution of CHPR/EEPR products. The
third step was to calculate CHI/EEI's Berry ratio from the data in the constructed
income statement created in the second step and compare it to an arm's-length
range of Berry ratios established by reference to a sample of comparable
independent distributors.
(2).
License of Intangible Property
To establish an appropriate royalty rate between CHI/EEI and CHC, the
comparable uncontrolled transaction (CUT) method was applied. On December 1,
2001, CHI/EEI and CHC amended the license agreement to cover additional
products. The amended license provided that effective January 2, 2002, CHC
would pay CHI/EEI a royalty of 6.45% of CHC's net sales of the licensed breaker
products.
In its APA I application submission, petitioner explained that it checked the
reasonableness of the results of the CUT method with the research and
development (R&D) cost capitalization method to establish the arm's-length
royalty rates for manufacturing intangibles in its electrical industry. The CUT
method analysis yielded a royalty rate range between 3.6% and 6.0%. The R&D
-48[*48] cost-capitalization method, however, resulted in a royalty rate of 6.9%. To
reconcile the different results, petitioner averaged the upper quartile CUT method
result (6%) with the royalty rate established by the R&D cost-capitalization
method (6.9%), yielding a royalty rate of 6.45%.
(3).
Cost-Sharing Methodology
There was a cost sharing arrangement between CHI/EEI and CHPR/EEPR.
The determination of the appropriate allocation of R&D costs between
CHPR/EEPR and CHI/EEI was in accordance with regulations under section 936.
S_e_e secs. 1.936-6 and 1.936-7, Income Tax Regs. Pursuant to regulations under
section 936(h)(5)(C)(I), CHPR/EEPR made a cost-sharing payment to CHI/EEI
based on the product area research expenses incurred by both parties and certain
related affiliates. Id.
ii.
Information Petitioner Provided With Its APA I
Application Submission
Petitioner provided the APA I team with a CD-ROM containing the data,
including VISTA data, used to derive third-party equivalent pricing for the exact
catalog number matching revenues. Petitioner also provided a data set referred to
as a VISTA extract, or the IRS report. The primary source of VISTA data for the
IRS report was the MRSB report, which provided certain annual sales and
-49[*49] cost data. Petitioner cataloged and permanently maintained each year's
MRSB report.
The IRS reports contained approximately 22,000 line items that summarized
sales and cost data for breaker and control products used in computing the APA I
TPM. Petitioner's IRS report provided the transaction pricing data for CHI/EEI
third-party sales of each breaker product, including manufacturing costs, net
extended sale prices, and quantity sold. These reports contained the intercompany
quantity sold. Petitioner explained in its APA I application that for purposes of
detenmining the SG&A expenses related to sales of the breaker products,
petitioner used the expense allocation methodology CHI used for management
reportmg purposes.
Petitioner included an income statement showing CHI net income with
respect to the breaker products from 1998-2001. On September 16, 2002,
petitioner provided the APA I team with an amended income statement, which
reflected finalized financial data for 2001 that had not been available at the time
petitioner submitted its APA I application. The income statement was constructed
to show that CHI net income related solely to the purchase and distribution of
breaker products to both third parties and internal assembly plants.
-50[*50] Petitioner's APA submission explained that most of the sales of the Lincoln
plant to the Island plants were made to distributors and were treated as distributor
sales for the analysis of determining the TPM. It further explained that a small
share of the Lincoln sales was made directly to unrelated OEMs. The submission
noted that the Lincoln plant did not modify or physically alter the Island plants'
manufactured breaker products in any way.
d.
APA I Team's Due Diligence Questions
As part of its APA I application due diligence, the APA I team requested
access to petitioner's VISTA database and asked a series of followup questions.
The APA I team's questions covered several areas, including: the intellectual
property license agreement between CHI/EEI and CHC; the sales functions and
rebate procedures of CHI/EEI; sales to OEMs; CHI/EEI's allocation of SG&A
expenses; the information, data and documents petitioner used in its 2001 CUP
study; the VISTA database; the profit split between CHI/EEI and the Island plants;
CHI/EEI's income statement data; and CHI/EEI's international sales. Petitioner
provided responses to all of the APA I team's due diligence questions on
December 13, 2002. The formal due diligence process lasted about 13 months.
-51[*51]
i.
VISTA Response
Petitioner provided the APA I team with a disk containing VISTA database
information in text file format relied upon for the analysis presented in its APA I
application submission. Petitioner provided a large extract of the VISTA database
that was in the same format that petitioner and the APA I team reviewed together
during several meetings they held regarding VISTA. In response to the APA I
team's request for a data dictionary for VISTA, petitioner provided a description
of each VISTA billing wire column heading. The data dictionary includes the
names and descriptions of various files and their contents plus additional details,
such as the type of format and length of each data element. The billing wire is a
program that records individual sales transactions for Eaton's domestic plants.
Petitioner explained that a team of forensic technology solution experts reviewed
the data for accuracy.
ii.
Profit Split Response
Petitioner provided the APA I team with financial information that allowed
the APA I team to compare the relative amount of profit split between CHI/EEI
and the Island plants under the proposed TPM. The response broke down
CHI/EEI's total overall business unit operating profits for 1998-2001 into three
categories: (1) the Island plants' income; (2) CHI/EEI's income from distribution
-52[*52] of the Island plants' products; and (3) other consolidated industrial and
commercial controls operating income, including income derived from the
manufacture of components outside Puerto Rico, the manufacture of assemblies,
and sales and distribution activities other than those specifically related to the
Island plants' products.
This response showed that the Island plants had the greatest portion of
operating profit in each year under both petitioner's old TPM and its proposed
TPM, and that "other" operations, including U.S. assembly, incurred either losses
or substantially lower operating profit relative to the Island plants each year. The
response explained that the publicly reported financials for its electrical business
segment included the results of U.S. and foreign operations relating to the
manufacture, assembly, sale, and distribution of industrial and commercial control
products.
Petitioner further explained that the financial performance of the business
activities in the "other" category, including U.S. assembly's activities, was
independent from the financial performance of the breaker products manufactured
in the Island plants and should not be aggregated with the Island plants' breaker
products. The response noted that applying a profit split analysis in lieu of a
proposed CUP method would result in a failure to reflect the excess costs that
-53[*53] petitioner was aggressively seeking to eliminate in its non-Island plant
operations. Petitioner provided a similar explanation to the 1994-97 audit team.
In March 2003 the APA I team prepared a spreadsheet analyzing the profit
split that resulted from petitioner's proposed TPM for its APA I application. The
APA I team's analysis showed that over 80% of the profits were allocated to the
Island plants. Some exam team members of the APA I team contended that the
Island plants should be treated as the tested party. The APA I team's international
exam manager, who was also the 1994-97 audit team's international exam
manager, was not convinced that petitioner's proposed TPM was the "best
method". In July 2003 the APA I team conveyed to petitioner that it wanted to
focus on treating the Island plants--rather than CHI/EEI U.S. distribution--as the
tested party, because the proposed TPM profit split resulted in the Island plants'
having significant profits and small profits or losses in the United States. The
APA I team further reported to petitioner that it did not believe that the proposed
TPM sufficiently compensated CHI/EEI for the risks it assumed as distributor.
iii.
Volume Discounts Response
Petitioner addressed volume discounts in its response to the APA I team's
due diligence questions about rebates, discounts, and deductions granted to
petitioner's customers. The response explained that CHI/EEI granted cash
-54[*54] discounts to all customers, whether they were OEMs or distributors, if those
customers paid for petitioner's products within a specified time. CHI/EEI also
granted specified and limited quantity discounts to distributors that purchased a
specified volume of products. The response explained that determining the exact
amount of cash and quantity discounts granted to each customer was difficult
because the discounts were either aggregated in the VISTA database with other
deductions or were recorded manually and separate from the VISTA database.
The response noted that the CUP analysis presented in its APA I submission took
into account all rebates, discounts, and deductions granted to all customers,
whether they were entered into VISTA or separately from VISTA, by subtracting
the rebate and aggregated deductions from the gross sale price to reach a net sale
price.
During a January 15, 2003, meeting between petitioner's advisers and the
APA I team, petitioner's advisers explained that no volume-based adjustments
were necessary to ensure the reliability of petitioner's CUP method, even where
there were differences in volume between uncontrolled and controlled sales. On
February 14, 2003, petitioner sent the APA I team a letter following up on its
discussion at the January 15, 2003, meeting. The letter explained that even if there
were a theoretical basis to apply a volume-based discount when comparing
-55[*55] CHI/EEI purchases to those of small companies, there was no justification
for an arbitrary assumption that CHPR/EEPR would extend a larger discount to
global corporations merely because a global corporation had sophisticated
purchasing organizations that purchased a large volume of products. More than
70% of CHPR/EEPR's OEM sales came from customers that purchased more than
$500,000 worth of product in 2001. The response noted that these customers had
sufficient bargaining power to ensure that they were obtaining prices comparable
to the price that CHI/EEI would pay the Island plants for similar products.
The response further explained that no bottom line prices existed for
CHI/EEI products. In some cases if a customer demanded a significant discount,
petitioner's sales personnel could discuss the transaction with product line
managers for approval, but prices were generally negotiated on a case-by-case
basis.
iv.
SG&A Expense Allocations
The APA I team inquired about how CHI/EEI allocated SG&A expenses.8
On December 13, 2002, petitioner provided an explanation and a diagram of how
8APA I defined SG&A expenses as "[o]perating costs within the meaning of
treasury regulation sec. 1.482-5(d)(3), specifically including depreciation and
excluding any interest expense, Product Area Research Expenses, and any items
characterized as extraordinary for financial statement purposes." SG&A expenses
are also referred to as breaker product operating expenses.
-56[*56] it allocated SG&A expenses. Petitioner's explanation noted that SG&A
expense allocations followed its longstanding business practices and were not
affected by tax considerations. The SG&A expense allocation process began with
three corporate cost centers located in Pittsburgh, Pennsylvania: Global Sales &
Solutions, Supply Chain, and Cutler-Hammer Group. Each cost center allocated
its expenses to three business units: (1) Power Control Systems Operations, (2)
Electrical Distribution Products Operations, or (3) CH Engineered Services and
Systems. The methodology used to distribute these expenses allocated field sales
expenses on the basis of U.S. third-party sales and the remainder of the expenses
on direct effort (individuals directed to a specific business unit). This explanation
identified the highest level of corporate expenses in the SG&A expense allocation
as coming from CHI's division headquarters. Petitioner further discussed its
response with a presentation about SG&A expense allocations at a January 15,
2003, meeting with the APA I team.
v.
Other Business Operations
The APA I team inquired about CHI/EEI's "other" business operations
during 1998-2001. Specifically, the APA I team asked petitioner to explain an
apparent inconsistency between CHI/EEI's income statement and the consolidated
data for petitioner's Industrial and Commercial Controls Division. Petitioner's
-57[*57] response, dated December 13, 2002, provided the APA I team with financial
information that segregated the consolidated line of business income data into
three categories: (1) CHPR/EEPR income; (2) CHI/EEI income from distribution
of CHPR/EEPR products; and (3) "other" consolidated industrial and commercial
controls operating income.
Petitioner's response explained that the "other" category, which incurred
small losses in 1998 and 1999 but positive profits in 2000 and 2001, included
income derived from the manufacture of components outside of Puerto Rico, the
manufacture of assemblies, and sales and distribution activities other than those
specifically related to CHPR/EEPR products. Petitioner explained that the gradual
improvement of results in the "other" category, with positive profits generated
during difficult economic periods in late 2000 and 2001, reflected petitioner's
efforts to reduce inefficiency and excess capacity in that part of its operations
outside of Puerto Rico. Petitioner further noted that not using its proposed CUP
method would fail to reflect the excess costs that petitioner was aggressively
seeking, with some success, to eliminate in its non-Puerto Rico operations.
vi.
Markup Analysis
In January 2003 the APA I team's economist prepared an analysis of the
markup on the manufacturing costs the Island plants would receive under
-58[*58] petitioner's proposed TPM. His analysis compared the markups the Island
plants received on sales to unrelated OEMs, affiliated assembly plants, and
unrelated distributors.
Petitioner updated and completed the markup analysis that the APA I team's
economist started and provided a final analysis on February 14, 2003. In
petitioner's markup analysis, 1998-2000 reflected the results of the historical
TPM, and 2001 reflected the proposed TPM for its APA I application. Petitioner's
analysis showed that its proposed TPM resulted in a markup on the Island plants'
costs of over 70% in 2001, whereas the historical TPM resulted in markups
ranging from 51% to 52.8%.
Petitioner further explained as part of the markup analysis that the transfer
price reported on its 1998-2001 tax returns differed somewhat from the transfer
price derived from the VISTA data because of timing differences between the
VISTA data (record of when product is sold by CHI/EEI) and the general ledgers
(record dated when product sold by Island plants to CHI/EEI). Petitioner's
economists explained the timing difference in an email to the APA I team's
economist.
An APA I team economist requested an explanation on how the VISTA data
was used in conjunction with petitioner's markup analysis. Petitioner provided a
-59[*59] memorandum detailing how the VISTA data provided to the APA I team
was used for the CUP method computations and the markup analysis. The
memorandum explained numerous formulas and calculations used in the CUP
method computations and identified how specific columns of data that had been
provided to the APA I team were used in these computations.
After receiving petitioner's markup analysis and additional explanation, the
APA I team's economist prepared a summary on his markup analysis. He
recognized twice in his summary that the Island plants' weighted average markup
on sales to petitioner's assembly plants under the CUP method was higher than the
weighted average markup for sales to third-party OEMs. His summary stated that
"[t]he difference between weighted averages is simply due to different product
mixes." His summary further stated that "[t]his analysis demonstrates
convincingly that the CUP * * * [method] proposed by the taxpayer is an
appropriate TPM in this case."
vii.
Berry Ratio Negotiation
The APA submission proposed a TPM for the transfer of tangible property
using a Berry ratio as part of its calculations. The Berry ratio represented
CHI/EEI's gross profit from sales of breaker products divided by breaker product
operating expenses (SG&A).
-60[*60] In June 2003 the APA I team informed petitioner that it wanted a more
detailed description of how petitioner computed SG&A. The APA I team
explained to petitioner that it was considering a formulary SG&A expense
mmimum requirement.
In July 2003 petitioner became concerned that some members of the APA I
team wanted to focus their attention on treating the Island plants, rather than EEI
U.S. distribution, as the tested party because the profit split that resulted from
petitioner's proposed TPM allocated significant profits to the Island plants and
small profits to the United States. One APA I team analysis showed that 80% of
the profits were allocated to the Island plants.
The APA I team leader set a deadline of September 30, 2003, for the APA I
team to either complete its analysis of petitioner's APA application and provide an
alternative TPM that did not use CHPR as the tested party or an arbitrary profit
split methodology, or have petitioner accept the conclusion of the APA Program
office. Petitioner learned that some exam team members of the APA I team
believed that petitioner's proposed TPM did not sufficiently compensate EEI for
the risks it assumed as a distributor.
In October 2003 representatives of the APA I team thought that a Berry
ratio of 1.13 might be sufficient, on the basis of work being done by the APA I
-61[*61] team's economist. A Berry ratio of 1.13 means that gross profit divided by
operating expenses equals 1.13, or the operating profit equals 13% of operating
expenses. At that time petitioner was proposing a Berry ratio of 1.18. In
November 2003 the APA I team informed petitioner that it sought to increase the
operating profit for EEI's distribution function in order to reach an agreement on
petitioner's proposed TPM. The APA I team proposed increasing the Berry ratio
to a range of 1.20 to 1.27, which had the effect of increasing the operating profit
for EEI's distribution functions. The final agreement included a range of 1.20 to
1.27.
viii.
Petitioner's Concessions
In addition to agreeing to a higher Berry ratio, petitioner made several
concessions during the APA I process. Petitioner agreed to use third-party OEM
prices to set the revenue in the CUP method instead of a blended price of thirdparty OEM and third-party distributor prices. Petitioner abandoned a cost-sharing
arrangement for CHI/EEI's technology and continued to maintain intangibles in
the United States. Petitioner agreed to include stock options for purposes of
calculating CHPR/EEPR's cost-sharing payments.
-62[*62]
3.
APA I Terms
On November 14, 2003, petitioner and the APA I team reached an
agreement on the terms of APA I for petitioner's tax years 2001-05 effective on
April 14, 2004. APA I applied to the covered transactions in petitioner's APA I
submission. Rev. Proc. 96-53, 1996-2 C.B. 375, governs the interpretation, legal
effect, and administration of APA I.
a.
TPM and Berry Ratio for Breaker Product Transfer
APA I defined breaker product transfer as CHI/EEI's purchase of breaker
products from CHPR/EEPR for distribution to affiliated U.S. assembly plants,
third-party U.S. OEM customers, and other related and third-party customers. The
TPM for CHPR/EEPR's transfer of breaker products to CHI/EEI was a two-step
method. In the first step CHI/EEI would apply the CUP method to determine its
constructed intercompany revenue. Then it would create a constructed income
statement, similar to petitioner's explanation in its proposed TPM, for its
distribution of breaker products based on the following: (1) U.S. third-party sales
revenue, (2) constructed intercompany revenue, (3) international sales revenue, (4)
cost of sales, and (5) breaker product operating expenses. APA I defined U.S.
third-party sales revenue as CHI/EEI revenue from the sale of breaker products
-63[*63] acquired from CHPR/EEPR and CHC and sold without incorporation into
other products to third-party customers in the United States.
APA I defined constructed intercompany revenue as the following:
For each APA year, the sum of the following three amounts:
(1) For Breaker Products with an Exact Catalog Number
Match, the average per unit OEM Sales Price for such a product
multiplied by the number of units transferred by CHI to Affiliated
U.S. Assembly Plants.
(2) For Breaker Products without an Exact Catalog Number
Match but within a given Product Category, the average OEM Sales
Price Markup for the Product Category multiplied by CH-Puerto
Rico's manufacturing costs of such products within the Product
Category transferred by CHI to Affiliated U.S. Assembly Plants.
(3) For any other products, the average OEM Sales Price
Markup for all Product Categories multiplied by CH-Puerto Rico's
manufacturing costs of such products transferred by CHI to Affiliated
U.S. Assembly Plants.
In the second step the CPM would be applied to test CHI/EEI's constructed
income statement using a Berry ratio as the profit level indicator. CHI/EEI was
required to achieve a Berry ratio between 1.20 and 1.27 for its distribution of
breaker products, and the ratio of SG&A expenses to CHI/EEI's sales revenue for
breaker products was to meet or exceed 13% for each APA year.
For each APA year, if CHI/EEI's yearend Berry ratio was not in compliance
with the TPM, APA I required CHI/EEI to make an adjustment to the purchase
-64[*64] price of the breaker products acquired from the Island plants that would
bring CHI/EEI's Berry ratio within the range of 1.20 to 1.27. Once this occurred,
the covered transaction would be considered to be in compliance with section 482
and would not be adjusted further by respondent. The APA defined the breaker
product Berry ratio as CHI/EEI's gross profit from sales of breaker products
divided by its breaker product operating expenses, which had the same meaning as
SG&A expenses.
b.
SG&A Expenses
APA I set a floor for the amount of SG&A expenses allocated to EEI's
distribution function equal to 13%, which acted as a floor for EEI's distribution
function's profit level. "SG&A expenses" was a metric used to calculate the Berry
ratio. Higher SG&A expenses resulted in higher profit that would be allocated to
EEI under the Berry ratio.
If the ratio of SG&A to CHI/EEI's sales revenue for breaker products was
below 13% or greater than 20% for each APA year, APA I required petitioner to
adjust SG&A so that ratio was between 13% and 20%. Once this occurred the
ratio would be considered to be in compliance with section 482 and would not be
adjusted further by respondent.
-65[*65]
c.
APA I TPMs for Intangibles Transfer and Cost-Sharing
Payment
Before APA I CHI/EEI entered into a license agreement, effective
December 29, 2000, in which CHI/EEI granted a nonexclusive license to use,
including the right to sublicense, a broad class of intangible property that CHC
used to manufacture and assemble breaker products. In exchange for the license
CHC agreed to pay CHI/EEI a royalty of 4% of CHC's net sales for the licensed
breaker products.
APA I required CHC to pay CHI/EEI a royalty payment of 6.45% of CHC's
sales revenue, which was consistent with the royalty rate in the amended CHI/EEI
and CHC license agreement that was in effect. The TPM for CHPR/EEPR's costsharing payment was the section 936 cost-sharing method.
d.
Compliance
APA I provided generally:
a.
For each APA Year, if * * * [petitioner] complies with
the terms and conditions of this APA, then the IRS will not make or
propose any allocation or adjustment under I.R.C. section 482 to the
Covered Transactions.
b.
If * * * [petitioner] does not comply, then the IRS may:
1.
enforce the terms and conditions of this APA and
make or propose allocations or adjustments under I.R.C.
section 482 consistent with this APA;
-66[*66]
2.
cancel or revoke this APA under Revenue
Procedure 96-53, section 11.05 or 11.06; or
3.
revise this APA, if the Parties agree.
APA I required petitioner to file an annual report for each APA year (APA
annual report) in accordance with the APA and Rev. Proc. 96-53, sec. 11.01,
1996-2 C.B. at 383. APA annual reports for 2003-05 were due no later than 90
days after the time prescribed by law (including extensions) for filing petitioner's
Federal income tax return for the year covered by the report. Petitioner's 2005
annual report was due on December 15, 2006. APA I also required an
independent certified public accountant to render an opinion that petitioner's
financial statements presented fairly, in all material respects, petitioner's financial
position under U.S. GAAP. Under the terms of APA I the IRS would review
petitioner's compliance with the APA using its U.S. tax returns, financial
statements, and other APA records, for the APA term and any other year necessary
to verify compliance. If petitioner's actual transactions did not result in
compliance with the TPM, petitioner was required to report its taxable income in
an amount that was consistent with the TPM and all other requirements of the
APA on its timely filed U.S. tax return.
-67[*67] APA I required petitioner to maintain its APA records in accordance with
Rev. Proc. 96-53, sec. 11.04, 1996-2 C.B. at 384, and make them available to the
IRS in connection with an examination under Rev. Proc. 96-53, sec. 11.03, 1996-2
C.B. at 384. APA I provided that compliance with the record maintenance
requirement constituted compliance with the record maintenance provisions of
sections 6038A and 6038C for the covered transactions for any taxable year
during the APA term.
e.
Materiality
For APA I the terms "material" and "materially" were to be interpreted
consistently with the definition of material facts in Rev. Proc. 96-53, sec. 11.05(1),
1996-2 C.B. at 385.
f.
Critical Assumptions
The critical assumptions of APA I were the following:
1.
The business activities and financial and tax accounting
methods and classifications of * * * [petitioner] in relation to the
Covered Transactions will remain materially the same as described or
used in * * * [petitioner's] APA Request. A mere change in business
results will not be deemed a material change.
2.
The tenus of * * * [APA I] shall not be negatively affected by
acts of God, fire, flood, strikes, labor troubles or other industrial
disturbances, acts of Government laws and regulations, riots,
insurrections, or any other cause beyond the control of the parties to
the APA.
-68[*68] 3.
CHC's projected and actual sales revenue and CHI's
projected and actual research and development costs will remain
within 20 percent of the amounts set forth in Exhibit 1 to * * * [APA
I]. In the event that CHC's actual sales revenue and CHI's actual
research and development costs are greater than 120 percent or less
than 80 percent of the amounts set forth in Exhibit 1 to * * * [APA
I], the royalty will be recalculated to comport with the revised
amounts in a manner consistent with the methodology presented in
Exhibit 1.
4.
CHPR will continue to qualify as a possessions corporation
pursuant to I.R.C. section 936 and will continue to make the required
cost-sharing payment through the term of the APA.
5.
Any transfer of ownership of intangibles from CHPR to CHC is
outside the scope of this APA. If such a transfer of ownership should
occur, the transfer of manufactured products to CHI related to the use
of such intangibles will not be covered by this APA.
4.
APA I Implementation
a.
Canadian Adjustment
In its 2001 and 2002 APA annual reports petitioner included an item labeled
"Canadian Adjustment--Eaton Yale" as an increase to revenue from international
sales in the TPM calculation table. Eaton Yale Ltd. (Eaton Yale) was Eaton's
Canadian affiliate, a Canada corporation and wholly owned subsidiary of Eaton.
On November 4, 2004, the IRS sent petitioner an IDR regarding an adjustment that
was not included in the original APA, the Canadian Adjustment--Eaton Yale.
Petitioner responded on December 1, 2004. This response explained that EEPR
-69[*69] sold its entire output of breaker products to EEI. EEI either resold the
EEPR-produced breaker products to U.S. and foreign unrelated parties or
transferred the breaker products to affiliated Eaton Electrical U.S. assembly plants
or foreign subsidiaries of Eaton Electric. Eaton Yale was among the related
parties to which EEI sold EEPR products. Eaton Yale purchased products from
EEI for resale into the Canadian market or for incorporation into custom
assemblies manufactured by Eaton Yale. This response explained that an increase
in the sale price was needed in accordance with the APA I TPM.
On May 4, 2005, respondent issued a notice of proposed adjustment related
to the Canadian adjustment. The adjustment was for the same amounts included in
APA I annual reports for 2001 and 2002. Petitioner agreed to the proposed
adjustments for 2001 and 2002. The Canadian adjustment was discussed during
the prefiling conference for APA II. The APA II submission mentioned the
Canadian adjustment as a relevant issue under audit and that relief from double
taxation could be needed.
b.
Disclosure of Book-Tax Difference and APA Multiplier
On December 9, 2004, petitioner responded to an IDR issued by
respondent's exam team regarding the transfer price for the breaker products in the
2001 tax year. The IDR inquired about an adjustment made on Schedule M-1,
-70[*70] Reconciliation of Income (Loss), that appeared to be included in the annual
report. The IDR requested an explanation of how the Schedule M-1 adjustment
conformed to APA I.
In its response petitioner explained that it had a book-tax difference with
respect to the transfer price for breaker products, because its accounting books
were closed at the end of2001 using an estimated transfer price that was computed
with the information available at that time. Petitioner's tax returns, which were
filed the following September 2002, reflected the finalized transfer price that was
computed using final financial information that was not available until the first
quarter after the close of2001. Petitioner provided the detailed computations to
show how the Schedule M-1 adjustment was computed and explained that the
purpose of the adjustment was to adjust book income reported in Puerto Rico to
the APA I TPM. Petitioner explained that its 2001 APA I annual report did not
mention the Schedule M-1 adjustment because the adjustment conformed to the
APA I TPM. As part of its response petitioner explained how the APA I
multiplier was computed and applied.
c.
2005 Tax Return
On September 6, 2006, petitioner filed electronically its Form 1120, U.S.
Corporation Income Tax Return, and Form 8453-C, U.S. Corporation Income Tax
-71[*71] Declaration for an IRS e-file Return, for its 2005 tax year. On its Form
1120, petitioner reported worldwide book income of $804,928,420. Petitioner
removed income and loss, including intercompany eliminations, from
nonincludible U.S. and foreign affiliates, subtracting a net income amount of
$603,138,308 from its worldwide income. For U.S. tax purposes, petitioner
reported net U.S. book income of $201,790,112.
Petitioner filed Schedules M-1 and M-2, Reconciliation of Income (Loss)
and Analysis of Unappropriated Retained Earnings per Books, and Schedule M-3,
Net Income (Loss) Reconciliation for Corporations with Total Assets of $10
million or More. It reported book-to-tax adjustments of $38,681,828, resulting in
taxable income of $240,471,940. The Schedules M adjustments reflected a timing
difference between petitioner's estimated APA I transfer price calculation at the
end of the 2005 taxable year and its final transfer price calculation, which could
not be determined until May 2006. Petitioner's 2005 Schedules M attached to its
tax return identified this difference. Petitioner did not include this adjustment in
the 2005 APA I annual report because the adjustment conformed to the APA I
TPM.
-72[*72] C.
APA II: 2006-10 Tax Years
1.
Participants
The APA II team's participants in the APA II negotiations included
personnel from both the APA Program office and the exam team, commonly
referred to as the field team. The participants from the APA Program office
included the APA II team leader and an APA II team economist. The participants
from the exam team included the team coordinator, a group international manager,
two international examiners, a computer audit specialist, an attorney, and an
economist. The APA II team was generally composed of personnel different from
the APA I team. However, some exam team members from the APA I team,
including the international examiner, the team coordinator, and an economist,
were also exam team members for the APA II team. The APA I exam team
economist acted as manager to the new economist assigned to the APA II team.
There is no rule specifying whether a new team leader is assigned to an APA
renewal request.
Before joining respondent's APA Program office the APA II team leader
had held various positions in respondent's National Office, working primarily with
the corporate groups in the Office of Chief Counsel. In 1999 he joined
respondent's APA Program office as a team leader. In 2002 he moved to Branch 4
-73[*73] of respondent's international group in the Office of Chief Counsel. In 2004
he moved back to the APA Program office as a team leader, and in 2007 he was
promoted to APA Program office branch chief.
During his time in the APA Program office, the APA II team leader worked
as a team leader for approximately 50 separate APAs. He rarely accepted the facts
included in a taxpayer's APA application at face value. In every APA that he
worked on, he or some member of his team saw something that required the team
to file additional questions about the facts presented in the taxpayer's APA
application. The major role of the team leader was to build consensus among the
APA team by holding discussions and determining whether there were
disagreements about the taxpayer's APA application.
The APA II team leader started a renewal APA application process by
generally reviewing the initial APA request. He reviewed the initial APA
submission, the resulting APA, and questions and answers that arose in the course
of the initial APA negotiations. The APA II team leader reviewed petitioner's
APA I request file and some of its annual reports.
Petitioner's primary participants in the APA II negotiations were its senior
vice president of tax and its vice president of Federal tax strategy. Petitioner's
outside representatives were mostly the same participants from the APA I
-74[*74] negotiations, including the former Director of the APA Program and
principal at PwC, a PwC partner who as a former employee of the U.S.
Department of the Treasury and later former head of transfer pricing at the OECD
in Paris, France, two economists, and an attorney.
2.
APA II Negotiations
The APA II team conducted a de novo review of APA I. An APA renewal
typically involves a completely independent review by a second APA team,
including different team leaders and economists.
a.
Prefiling Process
On January 26, 2005, petitioner sent the APA II team leader a letter before
formally filing its APA II application. Petitioner's prefiling letter provided
background on its structure with a focus on breaker products, including EEI's sale
and transfer of CHC products. This letter explained that petitioner was not aware
of any significant changes in facts of functionality of the original APA and that it
would be using the previously agreed-upon TPMs in its APA renewal request.
On February 2, 2005, petitioner and the APA II team held a prefiling
conference. Petitioner presented a detailed overview of its six operating divisions.
Petitioner further explained and illustrated EEI's TPM calculation for the
-75[*75] distribution of breaker products for 2001-03 and the TPM for CHC's license
of intangibles from EEI for 2001-03.
b.
APA II Application
On June 23, 2005, petitioner submitted its formal APA II application for the
renewal of APA I. Petitioner's APA II application requested renewal of TPMs for
the following covered transactions: (1) the transfer of breaker products from CHC
to EEI and (2) the amount of an arm's-length royalty payment from CHC to EEI
and EEPR for the right to use technology intangibles by CHC in its manufacturing
processes.9 Petitioner noted that its reference to EEI throughout its APA renewal
submission referred to EEI's distribution of CHC products, not EEI as a
diversified company.
The APA II application provided detailed information on EEI's electrical
business, including EEI's sale and transfer of CHC products from 2001-03. The
application noted that most of the sales of CHC products made by the Lincoln
plant were treated as distributor sales and not part of the CUP computations. The
application explained that only a small number of the Lincoln sales were made
directly to unrelated OEMs. It further explained that the breadth of product lines
9The cost-sharing payment made by CHPR to CHI was not included in the
APA renewal request because of the 2005 sunset of sec. 936.
-76[*76] and its ability to efficiently manufacture breaker products in high volume
were important profit drivers in the industry.
Petitioner's APA II application included responses to two particular issues
that the APA II team raised during the prefiling conference: (1) whether EEI had
marketing intangibles with respect to the breaker products and (2) the effect of
volume discounts on the CUP method.
The APA II team had concerns about the marketing intangibles issue from
the beginning of the APA II negotiations. Petitioner's response explained that no
valuable marketing intangibles existed with respect to EEI's breaker products,
primarily because these products were industrial, not consumer, products. The
response detailed how the name change from CHI to EEI did not have a significant
impact. The APA II team was concerned with whether petitioner's assembled
products created an installed base that was effectively a marketing intangible
because it generated an aftermarket for sales of breaker products to be used in the
assembled product. The APA II team's concern focused on whether petitioner's
assembled products created potential future sales of breaker product components
as a result of already having the products assembled and available in the market.
Petitioner reiterated in its APA II application that any rebates or customer
-77[*77] discounts granted to unrelated OEM customers were factored into the CUP
method analysis and therefore the CUP method accounts for volume discounts.
c.
APA II Team's Due Diligence Questions
The APA II team leader conducted a full due diligence investigation. The
process consisted of hundreds of questions.
After the submission of the APA II application and before a meeting with
the APA II team, the APA II team leader sent petitioner, on September 16, 2005, a
list of28 questions, which included numerous multipart questions. The APA II
team's questions generally focused on petitioner's transfer of tangible and
intangible assets from EEI to the Island plants, the Island plants' operating profits,
the Island plants' manufacturing process for breaker products and other highvolume products, EEI's sales process and customer base, SG&A allocation
methodology, and system profit for breaker products produced by the Island plants
and sold to EEI.
Additional questions were sent to petitioner on October 5, 2005. These
questions focused on system profit and CHC intangibles. On January 31, 2006,
petitioner responded to the APA II team's due diligence questions. On February
16, 2006, petitioner and the APA II team held a meeting to discuss petitioner's
responses. On March 13, 2006, the APA II team leader sent petitioner an
-78[*78] additional set of questions that focused on issues discussed during the
course of the February 16, 2006, meeting or arose afterwards as a result of
information discussed during the meeting. This additional set of questions
focused on whether EEI had any marketing intangibles with regard to its breaker
products, EEI's technology, the nature and importance of the Island plants'
manufacturing function, location savings in Puerto Rico, and the internal CUP for
intracompany sales.
i.
Profit Split
The APA II team asked about the profit split between the Island plants and
EEI. They asked petitioner to explain the Island plants' high operating margins in
an industry which, petitioner stated in its APA II submission, faced strong
competitive pressure.
In its response petitioner explained why it did not agree with the
characterization of the Island plants' operating profits and margins as being
extraordinarily high. Petitioner provided an analysis of the profitability of the
Beaver facility, which manufactured breaker products. The analysis stated that the
difference in profits between the Beaver facility and the Island plants reflected that
the Island plants operated in a low-cost jurisdiction. Petitioner believed that this
analysis confirmed the reliability of the CUP method in APA I. Petitioner's
-79[*79] response stated that the profit-split analysis confirmed that in their business
the bulk of profits was properly attributable to the manufacturers of the product
and resulted from the manufacturer's ability to produce a diverse number of styles
of complex, highly regulated products at low cost, in high volume, and with
absolute adherence to the exacting standards of product quality.
The APA II team also asked for information about whether, in concert, the
Island plants and EEI earned extraordinary intangible profits. The APA II team
wanted a profit and loss statement showing the system profit (consolidating the
operating profits of the Island plants and EEI) for the Island plants-produced
breaker products sold to EEI, which EEI then sold to its customers and own
domestic plants. This definition of system profit did not include sales from
assembled products that EEI's domestic plants manufactured, i.e., U.S. assembly
sales to third-party customers.
Petitioner's response acknowledged that the "IRS exam team has expressed
concern regarding the split of profit between the factory operations of CHC and
the distribution operations of EEI under the CUP methodology." To demonstrate
that the Island plants received an appropriate level of profit under the APA I TPM,
petitioner provided the APA II team with two separate confirming analyses. The
scope of the relevant business activity used in both analyses was consistent and
-80[*80] included the Island plants' manufacturing of breaker products and EEI's
sales of those breaker products to third parties and internal assembly plants. Other
business activities, such as EEI's assembly plants' sales of assembled products,
were not included in this analysis. The first analysis compared the gross profit
margin on the sale of breaker products manufactured at the Beaver plant and the
sale of breaker products manufactured at the Island plants' facilities.
The second analysis was an activity based profit-split analysis. Petitioner
provided an actual system profit resulting from an application of the APA I TPM
for 2004. This profit split yielded an allocation of 14.8% of profit to EEI and
85.2% to the Island plants. Other revenue and costs related to, for example,
assembly plants' sales of assembled products were not included in this analysis.
ii.
Installed Base Marketing Intangible
As a followup to a meeting held on February 17, 2006, between petitioner
and the APA II team, petitioner provided the APA II team with a letter, answering
specific questions and addressing concerns that were raised at the meeting. The
APA II team inquired whether petitioner had an installed customer base that
constituted a marketing intangible for the sale of CHC products. Petitioner's
response explained that, if applicable at all, the installed base affects no more than
4% of EEI's total sales of CHC breaker products. The letter further explained that
-81[*81] for there to be an installed base intangible, substantial aftermarket sales must
exist. Petitioner explained that while EEI had some aftermarket sales, there were a
large number of distributor sales that were initial sales to customers rather than
aftermarket sales. It also explained that for there to be an installed base intangible,
EEI would have to charge premium prices, and that many of these products were
competitive products that limited EEI's ability to charge higher prices for the
aftermarket sales than for initial sales to customers.
Its response further explained that if an installed base intangible was
applicable at all, it would apply to less than 10% of distributor sales. Petitioner's
response stated:
This must be the case because:
(1)
there is no volume replacement market for breaker products
because they have long lives and the products are engineered to
meet exacting Underwriters Laboratories, Inc., standards,
(2)
many breaker products from competing suppliers are
interchangeable, so that price premiums that might be created
by any installed base are competed away,
(3)
retrofitting and reconditioning of certain breaker products leads
to further erosion of the value of any installed base intangible,
and
(4)
the existence and growing importance of the grey market
further erodes the value of any installed base intangible that
might otherwise exist.
-82[*82] One of the APA II team's questions regarding installed based intangibles
addressed petitioner's 1995 Ernst & Young (E&Y) Study, which supported
petitioner's previous treatment of the Island plants as the tested party under a costplus method. The APA II team inquired how petitioner reconciled the conclusion
of the previous study and its position during the APA II negotiations that EEI
owned no nonroutine marketing intangibles. Petitioner's response explained that
the E&Y report was outdated and that the IRS had had prior concerns about the
report. Petitioner further explained that the E&Y report referred to a time when,
under the Wesco acquisition agreement, all breaker products that Eaton sold
carried the "circle W" trademark and benefited from Wesco's advertisement. At
the time of the response, petitioner had not used a Wesco trademark for nearly 10
years.
This response also addressed the classic razor and blade analogy and
clarified petitioner's erroneous information on this issue. The response explained
that Gillette sold razors that can only be used with Gillette brand replacement
blades. Once a sale of a razor is made, Gillette would continue to generate sales
volume and profits from the use of Gillette brand replacement blades customized
for its razors. The response further explained that because of the nature of circuit
breakers, the replacement market was not a volume business.
-83[*83]
iii.
Technology Intangibles
Petitioner provided the APA II team with information regarding the role of
its patented technology in the Island plants' breaker products. The response
explained that its patents have little impact on the economic performance of circuit
breakers because the breaker product industry was a highly regulated and mature
industry. Petitioner explained that most of its patented technology covered
primarily tweaks or modifications to existing technologies instead of innovative
technology. Petitioner explained that the electrical code policy for this regulatory
industry effectively precluded the use of patents to establish monopoly positions.
iv.
Volume Discounts
The APA II team addressed volume discounts as part of its due diligence
questions. This issue had been raised previously at the APA II prefiling meeting.
Petitioner's response directed the APA II team to the prefiling discussion included
in petitioner's APA II request, where petitioner explained that
[s]imilar to its competitors, EEI provides volume discounts to OEM
customers that purchase breaker products. The size of the orders
enables the OEM customers to negotiate volume discounts for their
purchases.
The analysis conducted to determine EEI's revenue attributable to
related party sales of breaker products for APA II * * * uses a CUP
analysis that draws on pricing related to OEM sales. Any rebates or
customer discounts are factored into the CUP analysis, and thus, the
-84[*84] CUP analysis presented herein implicitly accounts for volume
discounts.
[EEI] competes with other large companies such as GE, Schneider
Electric/Square D, Siemens, and ABB that sell the same or similar
electrical products as those sold by EEI. Each of these companies
have large worldwide operations, have competed within the
electrical products industry for as long, if not longer than, EEI, and
have larger marketing budgets compared to EEI. * * * Because there
are a number of sophisticated and successful companies selling
similar electrical products, EEI's third party customer pricing must
remain in-line with these OEMs, or else it risks losing orders to its
competitors. EEI's third party customer pricing is always
determined in a competitive market, which is reflected in the CUP
analysis.
*
*
*
*
*
*
*
[A]ny rebates or customer discounts granted to unrelated OEM
customers are factored into the CUP analysis, and thus, the CUP
analysis accounts for volume discounts. Consequently, based on the
fact that EEI operates in a competitive market and must keep its
prices on sales to third party customers in-line with other large, well
known competitors, * * * and given the CUP analysis used to
evaluate the arm's-length nature of EEI's intercompany tangible
goods transaction takes into account customer rebates and discounts,
it is believed that the CUP comparability requirements specified by
the section 482 regulations has been met.
d.
SG&A Expense Allocations
The APA II team asked petitioner to provide a description of the allocation
methodology used to assign SG&A expenses to EEI's distribution of CHCmanufactured products. In its January 31, 2006, response petitioner explained that
-85[*85] the SG&A expense allocation is the same as that agreed to in APA I and
contained in the APA I annual reports. The APA II team leader and one of
petitioner's representatives from PwC discussed SG&A expense allocations
during the APA II negotiations. The APA II team leader wanted to understand
why petitioner's APA II application did not include a minimum floor for SG&A
expenses as the APA I had required. According to the APA II team leader
petitioner's SG&A expense allocation methodology was not unusual but having a
floor was unusual. Petitioner's APA II proposal did not include an adjustment
where the ratio of breaker product operating expenses to EEI's sales revenue was
below 13% or above 20% for the APA year.
e.
EEI U.S. Distribution as the Tested Party
On May 11, 2006, an APA II team economist sent a memorandum, through
his manager who had been part of the APA I team, to the APA II team leader
analyzing problems with the use of EEI U.S. distribution as the tested party . He
disagreed with petitioner's assertion that EEI U.S. distribution owned no material
marketing intangibles. The economist's memorandum specified that petitioner's
proposed method resulted in the Island plants' receiving the "lion's share of
profits" while petitioner had not proven that the Island plants were entitled to such
profits from location savings. His memorandum further stated that "if CHC were
-86[*86] dealing with EEI at arm's length, it would be prudent if it would share more
of its profits with EEI to prevent further or more rapid erosion of its market."
The APA II team economist was concerned with petitioner's assertion that a
high degree of regulation and complexity of the Island plants' manufacturing
processes were reasons they should be entitled to high profits. His memo stated
that "there are many other products produced under heavy regulation and/or
complex manufacturing conditions that do not earn supernormal profits." He was
also concerned with petitioner's suggestion that the Island plants' participation in
the product development process, through its engineering function, was not an
unusual function for a manufacturing licensee that would attribute higher profits to
the Island plants.
His memorandum described EEI as "the leader of a U.S. circuit breaker
oligopoly, which is sustained by high barriers to entry." His memorandum
concluded that "EEI was entitled a larger share of the oligopoly profits than those
represented by the Berry ratio 'bone' offered by taxpayer."
During the APA II negotiations petitioners made it clear that their position
was to keep EEI U.S. distribution as the tested party, similar to APA I. The
January 31, 2006, letter sent to the APA II team stated that "EEI as the distributor
is the least complex party, and therefore, the appropriate tested party to the
-87[*87] covered transactions". According to the APA II team leader there was
concern about EEI U.S. distribution being the tested party because usually the
party that has the significant intangibles is not the party that is used as the tested
party. Petitioner argued for EEI U.S. distribution to be the tested party because
technology was not the driving force behind its considerable profits.
On July 27, 2006, the APA II team leader sent petitioner's representative a
draft of a memorandum he intended to send to the Associate Chief Counsel
(International) regarding an issue pertaining to section 367(d). The memorandum
stated that "the [APA II] team is currently divided on whether the facts justify
treating EEI as the tested party on renewal."
f.
Licensing of Intangible Property Not Included
Respondent's National Office reserved the right to assert the application of
section 367 to EEI's license of intangible property to the Island plants. This
reservation prevented the APA II team from agreeing to a royalty rate for licensed
intangible property.
3.
APA II Terms
APA II was executed on December 20, 2006. APA II applied only to EEI
U.S. distribution's purchase of breaker products from CHC and CHEC. Rev. Proc.
-88[*88] 2004-40, 2004-2 C.B. 50, governs the interpretation, effect and
administration of APA II.
a.
SG&A Expenses and TPM for Breaker Products Transfer
The APA II TPM was similar to the APA I TPM.¹° However, APA II did
not require petitioner to report a minimum threshold of SG&A expenses. As in
APA I the APA II TPM for CHC's and CHEC's sales of breaker products to EEI's
U.S. distribution function was a two-step method based on the CUP method and
the CPM. First EEI would apply the CUP method to determine its constructed
mtercompany revenue. APA II defined constructed intercompany revenue the
same as in APA I. Next EEI would construct an income statement for its
distribution of breaker products based on: U.S. third-party sales revenue,
constructed intercompany revenue, international sales revenue, cost of sales, and
SG&A expenses. The elements that EEI would use to construct the income
statement were the same as in APA I. APA II defined U.S. third-party sales
revenue the same as in APA I. EEI's U.S. distribution was the tested party for
¹°APA II did not list "breaker product transfer" as a defined term. In the
"Recitals" section, however, APA II explained that the breaker products transfer
reflected EEI's purchase of breaker products from CHC and CHEC and
manufactured by CHC and CHEC, for distribution to affiliated U.S. assembly
plants, third-party OEM customers, and other related and third-party customers-the same definition of breaker products transfer as in APA I.
-89[*89] purposes of applying the CPM. APA II required petitioner to achieve a
Berry ratio between 1.20 and 1.24 for its distribution of breaker products, whereas
APA I required a Berry ratio between 1.20 and 1.27.
For each APA year if EEI U.S. distribution's Berry ratio was not in
compliance with the TPM, then APA II required EEI U.S. distribution to make
adjustments to the purchase of breaker products acquired from CHC and CHEC to
bring EEI U.S. distribution's Berry ratio within the range of 1.20 to 1.24. Once
this occurred, the breaker products transfer would be considered to be in
compliance with section 482 and would not be adjusted further by respondent.
b.
Compliance
APA II provided that for each APA year, if petitioner complied with the
terms and conditions of the APA, then respondent would not make or propose any
allocations or adjustments under section 482 to the covered transactions. If
petitioner did not comply, then respondent could either: (1) enforce the terms and
conditions of the APA and make or propose allocations or adjustments under
section 482 consistent with the APA; (2) cancel or revoke the APA under Rev.
Proc. 2004-40, sec. 10.06 or 10.07, 2004-2 C.B. at 63; or (3) revise the APA, if the
parties agreed.
-90[*90] APA II required petitioner to file an APA annual report in accordance with
the APA and Rev. Proc. 2004-40, sec. 10.01, 2004-2 C.B. at 61. APA II required
petitioner to file its APA annual reports on December 15 of the year immediately
following the close of the APA year. APA II also required an independent
certified public accountant to render an opinion that petitioner's financial
statements presented fairly, in all material respects, petitioner's financial position
under U.S. GAAP. Respondent would review petitioner's compliance with the
APA on the basis of its U.S. tax returns, financial statements, and other APA
records, for the APA term and any other year necessary to verify compliance.
c.
Materiality
For APA II the terms "material" and "materially" were to be interpreted
consistently with the definition of "material facts" in Rev. Proc, 2004-40, sec.
10.07(1), 2004-2 C.B. at 63.
d.
Critical Assumption
The critical assumption of APA II was the following:
The business activities, functions performed, risks assumed, assets
employed, and financial and tax accounting methods and
classifications (and methods of estimation) of * * * [petitioner] in
relation to the Covered Transaction will remain materially the same as
described or used in * * * [petitioner's] APA Request. A mere
change in business results will not be deemed a material change.
-91[*91]
4.
2006 Tax Return
On its Form 1120 for 2006 petitioner reported worldwide income of
$950,329,098, which was the same amount it reported to its shareholders and the
SEC. Petitioner subtracted income and loss from nonincludible U.S. and foreign
affiliates equal to $605,832,668. Petitioner reported net U.S. book income of
$344,496,430 for 2006. Petitioner reported on Schedules M-1 and M-2, and
Schedule M-3 book-to-tax adjustments of $79,179,363, resulting in total taxable
income of $265,317,067. The Schedules M adjustments reflected a timing
difference between petitioner's estimated APA II transfer price calculation at the
end of the 2006 taxable year and its final transfer price calculation, which could
not be determined until May 2007. Petitioner's 2006 Schedules M attached to its
tax return identified this difference.
V.
Implementation of APAs
A.
Difference Between Mirror Ledgers and Constructed Income
Statement
Petitioner's mirror ledgers were distinct from the constructed income
statement in the APA TPM. Unlike the mirror ledgers, which exist as part of
EEI's accounting system, the constructed income statement did not actually exist
outside of the APA TPM. The APA TPM used a constructed or hypothetical
-92[*92] income statement that did not exist in the records but was created from
pulling pieces of information together.
There were a number of key differences between the mirror ledgers and the
constructed income statement. The most significant difference was that the
constructed income statement included revenue from sales to U.S. assembly based
on prices derived from the CUP method, whereas the mirror ledgers included
revenue from sales to U.S. assembly at the lower internal management price.
Another difference was that revenue from sales of the Lincoln plant were included
in the constructed income statement but not included on the mirror ledger, and
revenue from non-Island plants manufactured products were excluded from the
constructed income statement but included on the mirror ledgers.
APA I and APA II required that the operating profit on the constructed
income statement comply with the Berry ratio requirement. APA I and APA II did
not require that the operating profit on the mirror ledgers comply with the Berry
ratio requirement. APA I and APA II made no references to the mirror ledgers.
B.
APA Multiplier
The APA multiplier was a factor used to express the transfer price as a
percentage of manufacturing costs. The product of the APA multiplier and the
Island plants' manufacturing costs was the mathematical equivalent of the transfer
-93[*93] price computed for that year under the APA TPM. Although petitioner's
financial records used the term "APA multiplier", the multiplier was not used to
compute or modify the transfer price determined under the APA TPM. The APA
multiplier was an implementation mechanism that incorporated the transfer price
into petitioner's financial statements. The APA multiplier was calculated by
dividing EEI's COGS, as implied by the APA TPM analysis, by the associated
Island plants' manufacturing costs of the breaker products sold by EEI. For 2005
and 2006 petitioner used an APA multiplier of 1.86 and 1.88, respectively.
According to petitioner the APA multiplier is a different mathematical way
to express the transfer price that is determined by reference to third-party CUPs
and the CPM, as provided in the APA TPM. The APA multiplier was used in two
stages during the tax year. First, a preliminary APA multiplier based on estimated
APA TPM calculations was used to book the transfer price on sales of breaker
products from the Island plants to EEI U.S. distribution. Second, a final APA
multiplier based on a final APA TPM transfer price was computed in the first few
months of the following year when all data necessary for determining the final
APA TPM transfer price became available. At that time petitioner did a true-up of
its books and records for the difference between the estimated APA TPM
-94[*94] computations that it used to close its books for the year and the final APA
TPM computations.
C.
APA Annual Reports
APA I and APA II required petitioner to file an APA annual report for each
APA year. The APAs specified what should be included in the annual reports.
Petitioner filed timely APA annual reports for tax years 2001-10. For APA year
2005 petitioner submitted an amendment to its report on January 19, 2007. On
October 14, 2010, petitioner submitted amended APA annual reports for both
2005 and 2006. Along with the amended reports, petitioner submitted a technical
explanation of its adjustments.
Incorporated into petitioner's APA annual reports were petitioner's IRS
reports that it sent to KPMG for review. Petitioner's VISTA team first provided
the IRS reports to petitioner's Tax Department in Excel format and then
downloaded the mainframe file to a PC. The VISTA team saved the files on their
PCs, giving them a new name because the mainframe file name was not a valid PC
filename. For 2005 and 2006 the VISTA team named the IRS Report file "PR
2005 Format3.xis" and "PR 2006 Format3.xls". The mainframe files for 2005 and
2006 remained on the mainframe in their original format after the files were
extracted and transferred to the VISTA team's PCs.
-95[*95] D.
APA Annual Reports and Book-Tax Differences
APA I and APA II required that petitioner's APA annual reports, among
other things, fully identify, describe, analyze, and explain the amounts,
description, reason for, and financial analysis of any book-tax differences relevant
to the TPM for the APA year, as reflected on Schedule M-1, M-2, or M-3 of the
U.S. tax return for the APA year.
Petitioner's amendment to its 2005 APA annual report, filed on January 19,
2007, replaced two tables that provided incomplete supporting data. The letter
accompanying the amended report stated that the results of the analysis did not
change and Eaton remained in compliance with the terms of the APA.
Petitioner did not disclose book-tax differences that were subject to audit
before APA II in its APA annual reports. Petitioner did disclose book-tax
differences in the APA annual reports when those differences had an effect on the
methodology for computing the transfer price. In its 2006 APA annual report
petitioner disclosed a book-tax difference related to stock option compensation
because it had an effect on the SG&A allocations used in the APA TPM.
E.
Petitioner's Data or Computational Errors
In early 2010 petitioner discovered that it had made some errors in its APA
TPM computations and tax reporting. In October 2010 petitioner corrected those
-96[*96] errors with amended APA annual reports and technical explanations of the
amendments. On August 17, 2011, petitioner submitted Forms 1120X, Amended
U.S. Corporation Income Tax Return, for tax years 2005-09. Respondent did not
accept petitioner's Forms 1120X and disallowed petitioner's claims for refund on
its Forms 1120 for tax years 2005-09 in full.
Petitioner's data and computational errors can be divided into two
categories: (1) an error in the APA multiplier that caused the transfer price
computed under the APA TPM to be reflected incorrectly in petitioner's books and
records, and therefore reflected incorrectly on its tax returns, and (2) errors that
affected the computation of the transfer price under the APA TPM.
1.
Discovery and Reporting of Errors
Petitioner discovered its data and computational errors after two of its
transfer pricing managers took over responsibility for gathering the information
and data necessary for the APA TPM in early 2009, following the departure of the
prior tax manager. This prior tax manager had been responsible for the
information gathering process since the early 2000s. When petitioner's new
transfer pricing managers and their team began working on the APA TPM, they
noticed a difference between the manufacturing costs computed using the plant
variance and freight factor (PVFF) and the actual manufacturing costs reflected on
-97[*97] the Island plants' ledgers. A PVFF for a plant was equal to the sum of that
plant's standard costs, variances, and distribution costs divided by standard costs.
Such a difference could affect the accuracy of the APA multiplier.
When these transfer pricing managers first noticed this difference in 2009,
they had only just begun working on the data gathering process that had been in
place for at least four years. After reporting the difference to their supervisors-petitioner's director of transfer pricing and vice president of international tax-petitioner's transfer pricing managers decided to wait until data for all of 2009 was
available to determine whether any discrepancies still existed, or whether the
discrepancies were just an anomaly caused by the interim computations being run
during the course of the year. Petitioner's transfer pricing managers received fullyear data for 2009 in February 2010. After reviewing this data, they concluded
that there was still a difference between the manufacturing costs computed using
the PVFF and the actual manufacturing costs reflected on the Island plants'
ledgers. These transfer pricing managers did a full review which resulted in the
identification of additional errors.
Petitioner's director of transfer pricing and its vice president of international
tax wanted more information regarding the discrepancy in manufacturing costs.
They directed the transfer pricing managers to analyze the underlying data of the
-98[*98] calculations in order to determine the discrepancy. In March 2010
petitioner's transfer pricing managers began having conversations with the
controllers and finance teams in the Island plants to understand their accounting.
After their conversations petitioner's transfer pricing managers realized that there
were miscommunications or misinterpretations of the data that the Island plants
reported versus the data that petitioner's tax department personnel reported in its
VISTA system.
For the purpose of the APA multiplier calculation the transfer pricing
managers used a VISTA report that provided standard cost data for each of its
products. They multiplied the standard costs by a factor that transformed standard
costs into manufacturing costs. The factor was calculated using the individual
plant's comparison of its manufacturing costs to its standard costs. The error
occurred because there was a difference between the standard costs the Island
plants used and the VISTA standard costs. This error resulted in there being a
discrepancy between the tax transfer price reported on the APA and the tax
transfer price actually booked in the ledgers.
After the transfer pricing managers' analysis petitioner's tax director
convened a meeting with accounting, finance, and IT personnel to further review
the errors. In April 2010 petitioner notified respondent that it had identified
-99[*99] certain errors in its APA TPM computations and was in the process of
correcting them. According to petitioner's tax director they would never have
found the errors if a change of personnel had not occurred.
Petitioner and respondent met regarding the errors on July 1, 2010. As a
followup to the meeting petitioner submitted additional information in July and
August of 2010. Respondent sent petitioner a letter on September 8, 2010, which
stated that "neither the IRS Exam team nor the APA team request that Eaton
submit amended APA annual reports". This letter requested detailed and
comprehensive information concerning adjustments resulting from each specific
"VISTA Data Issue" for all the APA years 2001-2008.
2.
APA Multiplier
Petitioner's 2005 and 2006 tax returns failed to reflect the transfer price
computed under the APA TPM. The failure resulted from an error affecting the
APA multiplier. This failure caused the transfer price, as recorded in EEI's
COGS, to be inconsistent with the transfer price computed under the APA TPM.
The APA multiplier was incorrect because petitioner's computations of the Island
plants' manufacturing costs--the denominator in the APA multiplier calculation--
was incorrect.
-100[*100] To determine actual breaker product manufacturing costs for purposes of the
APA TPM computations, petitioner started with the projected standard costs for
the breaker products as recorded in its VISTA system. Because the VISTA system
did not record actual manufacturing costs, petitioner needed to adjust the standard
costs in VISTA by variances in order to determine actual manufacturing costs.
The PVFF was an adjustment factor reflecting cost variances between the Island
plants' actual costs and their expected standard costs of making breaker and
control products as well as freight costs. It was computed by dividing each plant's
actual costs by their expected standard costs. According to the new transfer tax
pricing manager, petitioner should have used the Island plants' ledgers, not the
VISTA system, to derive a PVFF that reflected how each plant's actual
manufacturing costs varied from its expected standard costs.
Using a PVFF derived from the plant's ledgers would correctly adjust
VISTA standard costs to actual manufacturing costs if the standard costs used in
the PVFF computation were the same as the standard costs recorded in the VISTA
system. Petitioner's tax manager, who computed the PVFF from 2005 to 2009
assumed that the standard costs from the Island plants' ledgers used to compute
the PVFF were the same as the VISTA standard costs.
-101[*101] In 2010 petitioner determined that the standard costs in the Island plants'
ledgers were not the same as the VISTA standard costs because the standard costs
in the Island plants' ledgers included additional items. The additional items
included invoices from petitioner's Haina plant and tack-on costs such as warranty
expenses, scrap allowance, shrinkage, and obsolescence reserves. Including
invoices from the Haina plant resulted in duplicate entries associated with the
transactions between the Puerto Rico plant and the Haina plant. Incorrect data
was gathered, but the data was correctly applied to arrive at the transfer price that
was reported on petitioner's tax returns and APA annual reports for 2005 and
2006.
Multiplying the VISTA standard costs by the PVFF resulted in an incorrect
manufacturing cost because the standard costs in the Island plants' ledgers used to
determine the PVFF were not the same as the VISTA standard costs. The
computation of an incorrect manufacturing cost in turn caused the computation of
the APA multiplier to be incorrect.
This error led to a higher transfer price being reported on petitioner's tax
returns. This error was corrected in petitioner's amended tax returns and amended
APA annual reports for 2005 and 2006. The technical explanations of the
adjustments in the amended APA annual reports for both 2005 and 2006 provided
-102[*102] a detailed explanation of this error. These explanations included
calculations using the correct PVFF and recalculations of the APA TPM. Because
EEI's U.S. distribution was the tested party for purposes of the APA TPM,
adjustments were needed to bring EEI's COGS recorded on the mirror ledgers to
an amount that resulted in a Berry ratio that fell within the APA's prescribed range
for the transfer of breaker products.
3.
Errors Affecting the Computation of the Transfer Price Under
the APA TPM
a.
OEM Categorization
For purposes of its CUP method petitioner used data from its VISTA orderentry system to identify sales to third-party OEMs. Petitioner originally identified
these sales using VISTA data for sales to customers. Its tax and information
technology departments believed that customers in the category "00" captured
"direct customers" that included OEMs as well as other customers that purchased
products from Eaton directly rather than through a third-party distributor, and that
the sub-channel "99", which was labeled OEM, captured all OEM transactions. In
2010 petitioner's transfer pricing managers determined that although subcode 99
was labeled OEM, it identified customers who purchased breaker products from
more than one of petitioner's salespeople and that sales to OEMs would also be
-103[*103] captured by other subcodes. To correct this misclassification in its
amended APA annual reports, EEI's U.S. director of OEM sales compiled a
correct and complete list of OEMs for each of the 2005-08 tax years. This error
occurred in both 2005 and 2006 and was corrected in the 2005 and 2006 amended
APA annual reports.
b.
Purchase Resale Error
EEI purchased and resold products (purchase resales) other than those
manufactured by the Island plants. These transactions were captured in the
VISTA database and on the mirror ledgers but were not subject to the APAs
because they were not Island plants manufactured breaker products. Purchase
resale transactions of Island plants manufactured products were identified in the
VISTA database by the "billing line" field. Billing lines represented groupings of
similar types of transactions, and all purchase resale transactions fell within a
number of billing lines that consisted exclusively of purchase resale transactions
of products not manufactured by the Island plants. Petitioner excluded the prices,
revenue, and SG&A related to the purchase resale products from the TPM analysis
by excluding their associated billing line field from the VISTA data extract.
In 2010 petitioner's transfer pricing managers conducted a detailed review
of potential errors. During the 2010 review petitioner's transfer pricing managers
-104[*104] discovered that the purchase resale billing lines were not always excluded
correctly from the VISTA data extract. The purchase resale error affected the
revenue amount and SG&A. SG&A was affected because there were certain
operating expenses that were related to purchase resale products but not related to
the breaker products from the Island plants, which needed to be excluded from the
billing lines. Petitioner's tax department personnel believed originally that from
2005 to 2008 the relevant purchase resale billing lines had correctly been excluded
from the VISTA data extract. The VISTA file output that petitioner's tax
department received did not have a billing line as a field. There was nothing in the
VISTA data that would have explained to petitioner's tax department whether the
billing lines were properly included or excluded.
The purchase resale error affected the APA annual reports for 2005 and
2006. The relevant purchase resale billing lines had been correctly excluded from
the VISTA data extract in 2007 because the VISTA MR team employee in charge
of the APA annual reports for 2005 and 2006 retired. Petitioner was not aware
that for 2007 the prices and revenue from the purchase resale billing lines, but not
the associated SG&A, had been correctly excluded from the VISTA data extract
until its detailed review in 2010.
-105[*105] Petitioner corrected its error by re-running the VISTA data extracts,
comparing the results with the original VISTA extract, and excluding the correct
purchase resale billing lines. Petitioner determined that only 13 billing lines were
intended to be excluded in 2005 and 2006. The non-Island plants purchase resale
transactions were $8.2 million and $11 million of standard costs for 2005 and
2006, respectively.
c.
Operating Expenses Associated with Breaker Products
Not Manufactured by the Island Plants
This error is related to the purchase resale error. Because of the erroneous
inclusion of purchase resales to third parties, the SG&A allocated to U.S.
distribution included a portion for purchase resales to third parties. The APA
covered only the SG&A related to breaker and control products manufactured by
the Island plants. This error had no effect for 2005 because APA I required a
minimum ratio of SG&A to sales revenue of 13%. APA II had no similar
requirement. The 2006 amended APA annual report reduced EEI U.S.
distribution's SG&A expenses by the same proportion as manufacturing expenses
to account for breaker products not manufactured by the Island plants.
-106[*106]
d.
International Sales Error
Petitioner determined a data error with respect to the accumulation of
aggregate data on its sales to international customers. For purposes of the APA
annual reports, international sales were recorded from "channel statements" that
petitioner's plant controllers prepared. The definition of international sales
differed between sales recorded in petitioner's VISTA system and the international
sales recorded by the Island plants' controllers in the channel statements. As a
result of this difference, certain international sales of breaker products were
mistakenly excluded from EEI's constructed income statement, and the exclusion
caused the total amount of revenue on EEI's constructed income statement to be
understated. This understatement affected the calculation of the APA TPM.
In 2010 petitioner corrected this error by using the VISTA data to capture
both domestic and international sales and no longer used the channel statements
for either purpose. Petitioner's use of the VISTA data to correct this issue was not
a change in the APA TPM, but rather was an improved way of collecting data for
use in the APA TPM. No additional SG&A expenses needed to be allocated due
to this error because SG&A expenses associated with this additional revenue were
already captured in the apportionment of SG&A expenses to the U.S. distribution
mirror ledgers. Petitioner estimated that the increases in international sales from
-107[*107] the original APA reports to the amended APA reports were $5.9 million
and $4.3 million for 2005 and 2006, respectively. International sales revenue was
not used in the CUP method analysis and was not interrelated with other errors
discussed in this section.
e.
Error in Identifying Sales of Industrial Breakers Through
Lincoln
One particular Island plants' manufactured product line, industrial breakers,
were sold to the Lincoln plant and then resold by the Lincoln plant "as is" with no
further processing or assembly. These Lincoln plant "as is" resales were primarily
to unrelated distributors. For petitioner's accounting purposes the transaction flow
for these "as is" products was as follows: (1) a sale from the Island plants to EEI
U.S. distribution, (2) a subsequent sale to Lincoln, and (3) a sale from the Lincoln
plant to its customers. Petitioner's IRS reports recognized the intercompany sales
from EEI U.S. distribution to Lincoln but did not include the subsequent sale from
Lincoln to its customers.
Under the APA TPM the actual revenue earned by Lincoln on these "as is"
sales of breaker products was used as a component of EEI's revenue because the
Lincoln sales represented actual third-party sales revenue. The Lincoln plant
maintained a product line statement, and specified product lines could be
-108[*108] identified as being "as is" sales of breaker products that were originally
manufactured by EEPR.
During 2005 Lincoln's industrial breakers product line reflected a mix of
sales of products purchased "as is" from the Island plants and products
manufactured at the Lincoln plant. Only the industrial breaker products
manufactured in the Island plants should have been included in the APA TPM.
For 2005 petitioner determined that there was no reliable way to segregate the
Island plants' manufactured industrial breaker products from the Lincoln
manufactured products. As a result sales of products in the industrial breakers
product line were not treated as "as is" sales of breaker products, and petitioner
did not include any revenue from the sales of this product line through Lincoln in
the 2005 constructed income statement. No change was made to the 2005
amended APA annual report regarding this issue."
In 2010 petitioner discovered an error in the categorization of the product
lines that were sold "as is" through Lincoln during 2006. Starting in April 2006
breaker products in the industrial breaker product line were manufactured only at
the Island plants. Because the Lincoln plant was no longer manufacturing breaker
products, it was possible to identify the sales of industrial breaker products
"Respondent contends that this error is not a ground for cancellation.
-109[*109] through the Lincoln plant, and they should have been included in the APA
TPM. Petitioner's 2006 APA annual report understated both EEI's distribution
revenue and the associated SG&A for these Island plants' manufactured industrial
breakers.
Sales of the industrial breaker products were not included in the original
2006 APA TPM computations because petitioner's tax department was not
informed of this change by the business. In 2010 petitioner amended its 2006
APA annual report and corrected the data error. Petitioner estimated that the
impact of this correction would be to increase EEI's breaker product operating
expenses by $1.3 million.
f.
Lincoln Multiplier Error
Petitioner erred in computing the "Lincoln multiplier" that it used to isolate
standard costs for the breaker products sold "as is" through the Lincoln plant. To
determine the quantity of product that went through the Lincoln plant, versus the
quantity used by the Lincoln plant, petitioner backed the internal management
price out of the standard cost at the Lincoln plant.
The Lincoln multiplier that petitioner originally used was incorrect because
of misunderstandings and miscommunications between petitioner's tax
department, and the accounting personnel responsible for providing the relevant
-110[*110] information. Petitioner's tax department expected they would receive a
markup ratio but instead received a margin ratio. A markup ratio has cost as the
denominator, whereas a margin ratio has sales as the denominator. Using a margin
ratio as the multiplier did not correctly determine standard costs.
For 2005 this error resulted in the Lincoln multiplier originally being 1.31
instead of 1.4. For 2006 this error resulted in the Lincoln multiplier originally
being 1.25 instead of 1.34.
g.
Error in Computation of Manufacturing Costs for
Nonexact Matches
The PVFF error described previously also affected the computation of
manufacturing costs for product categories used in the CUP computations for
nonexact match products. The PVFF being incorrect could alter the product
matching results because of an issue with the denominator in those calculations.
Petitioner's correction of the PVFF corrected this error. According to petitioner
the effect on the transfer price was minimal because the PVFF enters into two
separate parts of the CUP method adjustment for nonexact match sales in an
almost offsetting fashion.
-111[*111] VI. Petitioner's Supplemental and Third APA
On June 30, 2009, petitioner submitted a request for a second renewal of
APA I (APA III) On August, 10, 2009, petitioner submitted a request for a
supplemental APA (APA II supplemental request) which would cover the royalty
payment from CHEC to EEI for the right to use intangibles employed by CHEC in
its manufacturing process. The supplemental APA request covered petitioner's
2006-10 tax years. Petitioner anticipated that any agreement reached with respect
to the license of intangible assets from EEI to CHEC would also be relevant for
the purpose of the APA III request, which covered tax years 2011-15.
On September 17, 2009, petitioner informed the APA program that it had
decided to withdraw its APA III request and APA II supplemental application. On
September 30, 2009, petitioner sent respondent a letter following a meeting
referred to as a preopening conference, which was held on September 16, 2009.
The letter stated that it was clear from the meeting that petitioner and the IRS were
on a "different page" regarding the APA/exam process. The letter noted that "the
APA team clearly stated that the IRS * * * would not use the methodology
contained in the existing APAs as even a starting point for purposes of the
Supplemental and APA renewal submissions". The letter further explained that
-112[*112] petitioner had made the decision to withdraw from both the supplemental
APA and APA III.
VII. Cancellation of APAs
From September 2009 through December 2011, the APA Program reviewed
petitioner's compliance with APA I and APA II. On December 16, 2011,
respondent notified petitioner that APA I and APA II would be canceled effective
January 1, 2005 and 2006, respectively. Respondent's letter stated specifically:
These cancellations are based on numerous grounds, including the
failure of a critical assumption, 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 ("material deficiencies in APA compliance").
More specifically, as discussed with * * * [Eaton] during a
meeting on May 5, 2011, the material deficiencies in the APA
compliance include numerous examples of noncompliance with the
terms and conditions of APA I and APA II, errors in the supporting
data and computations used in the transfer pricing methodologies
("TPMs") specified in APA I and APA II, a lack of consistency in the
application of the TPMs, the use of distortive accounting, and
material facts that were misrepresented, mistakenly presented, or not
presented in Eaton's submissions to the APA office. In addition, as
discussed with * * * [Eaton] during a meeting on December 8, 2011,
the IRS has more recently identified additional 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, and the
failure by Eaton to identify, describe, and explain in its APA Annual
Reports relevant book-tax differences and Schedule M adjustments.
-113[*113] In reaching this conclusion to cancel APA I as of January 1,
2005, and APA II as of January 1, 2006, we have considered, inter
alia, statements made by Eaton and its counsel during our meeting on
December 8, 2011; the materials presented by Eaton during that
meeting in response to some of the specific material deficiencies in
APA compliance the IRS identified to Eaton during the May 5, 2011,
meeting; and information provided by Eaton during our review of
Eaton's 2005 and 2006 APA Annual Reports.
VIII. Notice of Deficiency
As a result of cancelling APA I and APA II, respondent determined that,
under section 482, an adjustment was necessary to reflect an arm's-length result
for intercompany transactions that petitioner and its U.S. subsidiaries entered into
with CHC, CHEC, CHIL and EIMG regarding breaker products and related
electrical components and products produced in the Island plants' manufacturing
and assembly operations. On December 19, 2011, respondent issued to petitioner
a notice of deficiency determining deficiencies in tax totaling $19,714,770 and
$55,323,229 for 2005 and 2006, respectively, and penalties pursuant to section
6662(h) of $14,281,960 and $37,329,600 for 2005 and 2006, respectively.
The notice made section 482 adjustments and stated that in order to properly
reflect an arm's-length result for intercompany transactions, Eaton's taxable
income for tax years 2005 and 2006 is increased by $102,014,000 and
$266,640,000, respectively. The notice includes an alternative position. If the
-114[*114] section 482 adjustments are not sustained, then it is determined that
significant value has been transferred to EEI and that pursuant to section 367(d)
the taxable income of petitioner is increased in an amount not to exceed
$230,630,598 for 2006.
Respondent calculated section 482 adjustments by relying on the report of
John A. Hatch. The Hatch report reviewed and considered three transactions
between EEI, CHC, and CHEC: (1) EEI's sale of components to either CHC or
CHEC for incorporation into the breaker products manufactured by CHC and
CHEC; (2) EEI's purchase of breaker products manufactured by CHC and CHEC;
and (3) EEI's license of intangible property to CHC and CHEC, which CHC and
CHEC then used to manufacture breaker products. Hatch used the CPM and
concluded that this method provided CHC and CHEC an arm's-length profit as a
manufacturer and licensee that is consistent with the profits earned by comparable
independent manufacturers selling to unrelated customers.
IX.
Tractech Bonuses
On August 17, 2005, petitioner acquired Tractech Holdings, Inc. (Tractech),
a Delaware corporation, for $54.25 million. Tractech owned all of the capital
stock of Tractech, Inc., a Delaware corporation, and TT (Ireland) Acquisition
Limited, a limited company organized under the laws of the Republic of Ireland.
-115[*115] TT (Ireland) Acquisition Limited owned all the capital stock of Tractech
(Ireland), Limited, a limited company organized under the laws of the Republic of
Ireland. Tractech manufactured branded traction, adding differentials, and
specialty centrifugal clutches to niche segments of the transportation market.
Before this acquisition the following entities and individuals held an interest in
Tractech: Peninsula Fund III, LP (51%); Tractech Acquisitions, LLC (45%); Carl
Pittner¹² (2.4%); David Mead (0.5%); Joseph Hige (0.4%); Rex Ogg (0.3%);
Robert Kress (0.3%); and Richard Lindsay (0.2%) (collectively, sellers).
On July 15, 2005, petitioner entered into a stock purchase agreement (SPA)
to purchase all of the outstanding stock of Tractech. The SPA required petitioner
to pay the sellers in accordance with their ownership percentage. Before the
acquisition Tractech's management team included seven individuals. Tractech
planned to give stock option grants to six of the seven: David Mead, Joseph Hige,
Richard Lindsay, Robert Kress, Denis O'Conell and Carl Pittner (bonus
executives). As of June 2005 Tractech, Inc., employed its bonus executives at the
following annual salaries: Carl Pittner, $191,280; Richard Lindsay, $133,056;
Joseph Hige, $149,640; David Mead, $138,648; and Robert Kress, $124,344.
¹²The stipulation spelled Pittner as Pitter. All exhibits spelled it as Pittner.
-116[*116] Tractech (Ireland) Limited employed Denis O'Connell at an annual salary
of 254107,120.
On or before August 16, 2005, Tractech planned to give the bonus
executives stock option grants as bonuses. Before petitioner's offer to purchase
Tractech, a stock option plan was not adopted and approved by Tractech's board
of directors .
The disclosure schedule in connection with the SPA regarding capital
provided the following about Tractech's plans to enter into bonus agreements with
the bonus executives:
[Tractech] entered into agreements with the * * * [bonus]
[e]xecutives that provided for certain stock option grants. A stock
option plan was never adopted and approved by * * * [Tractech's]
board of directors. In lieu of issuing options to the * * * bonus
[e]xecutives, * * * [Tractech] plans to enter into Sale Bonus
Agreements pursuant to which the * * * [bonus] [e]xecutives are
entitled to the Bonus Amount in accordance with the terms of the
Purchase Agreement.
Tractech resolved to enter into agreements with the bonus executives to
provide them with cash bonuses. The bonus agreements provided that upon
petitioner's acquisition of Tractech, the bonus executives could receive cash
bonuses in exchange for their release of claims related to any stock options. Each
bonus executiv
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