REFILE-Eaton, IRS tangle over cross-border pricing pacts

Sun Jun 17, 2012 1:13pm EDT

* Multinationals wary over agreements on asset transfers

* In first revocations in years, IRS voided 2 Eaton deals

* Pricing agreements take too long, cost too much-lawyer

By Patrick Temple-West

WASHINGTON, June 17 (Reuters) - Eaton Corp is challenging the Internal Revenue Service in U.S. Tax Court, arguing that the agency broke agreements dealing with how the company moves assets and money across international borders, a volatile issue in the tax world.

Eaton is contesting a $75 million tax bill that the IRS imposed on the company in a case that could have broad impact on other companies' "transfer pricing" practices, the industry term for shifting assets across borders to reduce taxes.

The diversified manufacturer, based in Cleveland, Ohio, and best known for making electrical components, awaits a court date in its case. On June 11, it filed a motion asking for a quick judgment on part of the case.

The IRS tax bill hit Eaton as the agency in December 2011 revoked two deals it had negotiated with the company. Known as "advance pricing agreements" (APAs), the pacts addressed how Eaton handled its transfer pricing issues.

Eaton's annulled agreements marked the first time in four years that the agency had canceled APAs, a worrisome sign for multinational corporations increasingly frustrated by costly IRS delays in negotiating these deals.

Businesses worry that APAs take too long to finalize, cost too much and may not be as air-tight as expected when it comes to preventing squabbles with the IRS over transfer pricing.

"I've had tax departments say to me, 'Should we spend $100,000 on outside advisers to have APAs withdrawn?'" said Michael Flaherty, a partner and head of the transfer pricing practice at WTP Advisors, a tax consultancy.

Some companies that recently signed APAs are growing reluctant to sign another. "One danger is you can spend a lot and not guarantee your APA is complete... We're moving in the direction of more tax controversy," Flaherty said.

Eaton declined to comment on the case. Attorneys from the law firm of Mayer Brown, which is representing the company, also declined to comment.

Eaton said in May that it will relocate its headquarters to Ireland, where the corporate tax rate is 12.5 percent, versus a top rate of 35 percent in the United States.

The IRS declined to comment on all its pending litigation.

'ARM's LENGTH' TRANSFERS

Transfer pricing is a thorny issue for tax authorities worldwide at a time when raising more tax revenue from businesses is a top priority for many governments.

Multinationals constantly move goods, services and assets between units in different countries. Related payments of royalties and such follow. These "transfers" are internal to the business, but have to be accounted for in ways that reflect the separate legal status of most foreign subsidiaries.

By managing the pricing of these transfers, companies can shift profits to low-tax countries from high-tax ones and reduce their tax costs. Transfer pricing management is legal, but sometimes the IRS rules that practices cross the line.

International "arm's length" standards targeted at preventing abuses in this area largely focus on getting businesses to set transfer prices resembling open market prices.

Rather than chasing companies after they set transfer prices, the IRS in 1991 started offering advance pricing agreements - deals in which the agency and a company would agree ahead of time on how transfer prices would be determined.

Businesses liked these deals because they provided tax certainty, usually for five years. Applications by businesses for APAs grew steadily through 2010, then dropped sharply last year, along with the number of APAs approved by the IRS.

In 2011, the agency completed 42 APAs, down from 69 in 2010, according to agency data. The number of businesses applying for APAs dropped to 96 in 2011, a four-year low.

Tellingly, the IRS's average processing time for a new APA hit an all-time high last year of 40.7 months, meaning that negotiating one of these deals could take well over three years.

SHAKE-UP IN IRS

The IRS said it has faced "transitional issues" in consolidating and hiring new transfer pricing staff. IRS Commissioner Doug Shulman made changes in mid-2010 that revamped transfer pricing operations. Samuel Maruca was hired last year as director of the IRS transfer pricing division.

Besides Eaton's, the IRS has revoked nine other APAs over the program's two decades, according to IRS data.

The agency heads into the Eaton case with an unimpressive record in transfer pricing disputes that land in court.

The agency lost a decision in 2009 involving Veritas Software. The ruling was viewed by some as a setback to IRS efforts to root out and enforce fair transfer pricing rules.

The IRS also lost a 2005 Tax Court decision and 2010 appeal involving semiconductor maker Xilinx Inc. It was seen as widening the scope for multinationals to manipulate transfer-pricing rules.

"Folks certainly believe they can beat the government on transfer pricing cases," said George Clarke, an attorney with the law firm of Miller & Chevalier.

On Eaton's prospects, Clarke said: "That seems to me to be a pretty good case for the taxpayer to win."

Eaton is arguing that IRS examiners jumped to conclusions about potential transfer pricing abuse when the company was trying to negotiate a third APA with the agency.

"The third APA Team Leader, in a meeting with Eaton's representatives, stated that she had already decided that Eaton was not in compliance with the APAs," Eaton said in a February Tax Court filing.

A win for Eaton would reinforce an IRS image as weak in the courtroom. Maruca has acknowledged the problem.

"We have a serious credibility gap," Maruca said at a transfer pricing tax conference in Washington this month.

"Fundamentally we have to produce winners," he said, "We need to take a litigator's approach from the very beginning."

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