Global Tax Alert | 28 June 2013
Tax Court holds it has jurisdiction to review cancellation of APAs under an abuse of discretion standard
In itsissued 26 June 2013, the Tax Court ruled that: (1) its deficiency jurisdiction extended to reviewing the cancellation of an original and a renewal Advance Pricing Agreement (APA) because “they constitute administrative determinations necessary to resolve the merits of a deficiency determination” and (2) the burden was on the taxpayer/petitioner to show that the IRS “abused its discretion” in making the cancellations, i.e., that the “cancellations were arbitrary, capricious or without sound basis in fact.”
Taxpayer and the IRS entered into an APA (the original APA) for years 2001 – 2005 which was later renewed for years 2006 – 2010 (the renewal APA). In 2011 the IRS cancelled both claiming that taxpayer had not complied with their terms. The IRS later issued a deficiency notice for years 2005 (the last year covered by the original APA) and 2006 (the first year covered by the renewal APA). In its petition to the Tax Court and in a motion for partial summary judgment, the taxpayer challenged the IRS's deficiency determinations, in part, by contending that APAs are enforceable contracts and therefore the deficiency determinations based on the APAs' cancellations could not be upheld unless “the party exercising a contractual cancellation provision” (the IRS) could “demonstrate that a factual predicate exists to cancel the contract.”
At issue in the case was whether it was necessary for the IRS to demonstrate that the APA cancellations were appropriate under contract law before the court could properly exercise its deficiency jurisdiction. The Tax Court concluded no.
Both parties agreed that the Court had jurisdiction to review the IRS's deficiency notice as part of the Court's deficiency jurisdiction. The taxpayer argued, however, that before exercising its deficiency jurisdiction, because the APAs were enforceable contracts, the IRS would first have to demonstrate that the cancellations were appropriate under contract law. In opposing the Taxpayer's motion for partial summary judgment and in support of its own such motion, the IRS contended that contract law was not relevant and that the Court “may review the cancellations under [the Court's] deficiency jurisdiction for abuse of discretion because the cancellations were administrative determinations that are necessary to determine the merits of the deficiency determination.” The Court found that “the terms and conditions in the APA” (which incorporated by reference Rev. Proc. 96-532 in the case of taxpayer's original APA and Rev. Proc. 2004-40 in the case of taxpayer's renewal APA3) provided the IRS with the authority to revoke or cancel an APA and therefore the cancellations were administrative procedures. In general, and consistent with decisions involving other administrative actions by the IRS, the Court held that an act of administrative procedure is subject to the Court's judicial review under an abuse of discretion standard. Consequently, the taxpayer's challenge to the propriety of the cancellations was governed by the abuse of discretion standard which placed on the taxpayer the burden to show that the IRS abused its discretion and acted in an arbitrary or capricious manner or without a sound basis in fact.
Rev. Proc. 2006-09,4 section 11, paragraph 06 lists the conditions under which the IRS may cancel or revoke an APA. In light of the Tax Court's finding that the IRS standard 'boilerplate language' providing that an APA's legal effect and administration is governed by the applicable APA revenue procedure making general contract law inapplicable to APAs, clients entering into an APA should pay special attention to the APA critical assumptions. Per the APA revenue procedure, a critical assumption is any fact the “continued existence of which is material to the taxpayer's proposed transfer pricing method, whether related to the taxpayer, a third party, an industry, or business and economic conditions.”5 Because an (alleged) failure of a critical assumption could constitute ground for the IRS to cancel or revoke an APA, the negotiations around what critical assumptions are stated in the APA merit heightened scrutiny.
1. Unless specifically indicated, all quotes correspond to the Tax Court's opinion in Eaton Corp. v. Comr., T.C., Docket No. 5576-12.
2. 1996-2 C.B. 375.
3. 2004-29 I.R.B. 50.
4. Rev. Proc. 2006-9 superseded Rev. Proc. 96-53 and Rev. Proc. 2004-40.
5. See Rev. Proc. 2006-9, Section 4, paragraph 05.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP, Transfer Pricing, Washington, DC
- • Dave Canale
+1 202 327 7653
- • Ken Christman
+1 202 327 7653
- • Carlos Mallo
+1 202 327 5689
Ernst & Young LLP, Transfer Pricing, Cincinnati
- • Karl Rothfuss
+1 513 612 1568
Ernst & Young LLP, TCRMS, Washington, DC
- • Richard D. Fultz
+1 202 327 6840
Ernst & Young LLP, TCRMS, Portland, OR
- • Alan Summers
+1 503 414 7967
EYG no. CM3581