In December last year the IRS cancelled two agreements it had made with Eaton regarding how the company carried out its transfer pricing. Such agreements are known as ‘Advanced Pricing Agreements’ or APA’s. This case involving Eaton is the first time in 4 years the IRS has revoked APA’s. The outcome of Eaton’s case is eagerly awaited as it could become a precedent for other APA’s involving multinationals. Of late, multinational companies have become increasingly uneasy over the length of time it takes to finalize APA’s and the cost to negotiate one. Furthermore, APA’s may not be as effective as hoped for in preventing disputes with the IRS over transfer pricing.
It is common practice for multinational companies to move goods, assets and money cross border between their branches in different countries to save on taxes. Eaton announced in May that it plans to relocate its headquarters to Ireland where the corporate tax rate is only 12.5% as compared to the 35% it has to pay in the US. There is nothing illegal about such a move as long as it is accounted for in ways that reflect the separate legal status of the different subsidiaries.
The way multinational companies like Eaton save on taxes is by managing the pricing of these transfers. In 1991, the IRS started offering APA’s where the agency and a company make an agreement ahead of time on how transfer prices would be determined. At first companies liked the idea as it offers certainty in terms of taxes, usually for a period of 5 years. The number of APA’s applied for grew steadily until last year when there was a sharp drop accompanied by a corresponding drop in the number of APA’s approved by the IRS. The number of applications for APA’s in 2011 fell to only 96, the lowest in 4 years. In 2010, the IRS approved 69 APA’s while in 2011, the number dropped to 42.
Before Eaton’s the IRS has made void 9 other APA’s since the program’s inception in 1991. Eaton Corp is not the first company to take the IRS to tax court over revocation of APA’s. In 2009, the IRS was taken to court by Veritas Software where it lost the case. The IRS also lost a 2005 case and subsequent appeal in 2010 against semiconductor maker Xilinx Inc. It was seen as widening the scope for multinationals to manipulate transfer-pricing rules. In Eaton’s case, the company is alleging that the IRS had made premature conclusions about potential transfer pricing abuse when the company was trying to negotiate a third APA with the IRS.