                       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. 96-
53, 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.
                                   -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.

       Held, further, P did not transfer intangibles subject to I.R.C.
sec. 367(d).

     Held, 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, Erin

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.      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

II.     Tax & Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         25
        A.   Financial Reporting System. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              26
        B.   The VISTA System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           27
        C.   Mirror Ledgers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     30

III.    Background to APA Negotiations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
        A.   The APA Program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
        B.   The 1994-97 Audit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
                                                        -4-

[*4]            1.       The Audit Team Members. . . . . . . . . . . . . . . . . . . . . . . . . . . .              34
                2.       Historical and Proposed Transfer Pricing Methods . . . . . . . .                           34
                         a.    Historical TPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         34
                         b.    Proposed TPM Provided to the 1994-97
                               Audit Team . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       35
                3.       Information Shared . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       37
                         a.    Mirror Ledgers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         37
                         b.    U.S. Assembly and Breaker Products . . . . . . . . . . . . . .                       38

IV.    The APAs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
       A.   Covered Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
       B.   APA I: 2001-05 Tax Years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
            1.     Participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
            2.     APA Negotiations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
                   a.        Prefiling Meeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
                   b.        APA I Team’s Questions. . . . . . . . . . . . . . . . . . . . . . . . 44
                   c.        APA I Application Submission . . . . . . . . . . . . . . . . . . 45
                             i.         Proposed APA I TPMs . . . . . . . . . . . . . . . . . . . . 45
                             ii.        Information Petitioner Provided With Its APA I
                                        Application Submission . . . . . . . . . . . . . . . . . . . 48
                   d.        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
            3.     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.     Critical Assumptions. . . . . . . . . . . . . . . . . . . . . . . . . . .               67
                4.   APA I Implementation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              68
                     a.     Canadian Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . .                 68
                     b.     Disclosure of Book-Tax Difference and
                            APA Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .            69
                     c.     2005 Tax Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             70
       C.       APA II: 2006-10 Tax Years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             72
                1.   Participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     72
                2.   APA II Negotiations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .            74
                     a.     Prefiling Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           74
                     b.     APA II Application . . . . . . . . . . . . . . . . . . . . . . . . . . . .              75
                     c.     APA II Team’s Due Diligence Questions. . . . . . . . . . .                              77
                            i.     Profit Split. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          78
                            ii.    Installed Base Marketing Intangible. . . . . . . . . .                           80
                            iii. Technology Intangibles . . . . . . . . . . . . . . . . . . .                       83
                            iv.    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
                3.   APA II Terms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        87
                     a.     SG&A Expenses and TPM for Breaker
                            Products Transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             88
                     b.     Compliance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          89
                     c.     Materiality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       90
                     d.     Critical Assumption . . . . . . . . . . . . . . . . . . . . . . . . . . .               90
                4.   2006 Tax Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          91

V.     Implementation of APAs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         91
       A.   Difference Between Mirror Ledgers and Constructed Income
            Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   91
       B.   APA Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        92
       C.   APA Annual Reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .            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.    International Sales Error . . . . . . . . . . . . . . . . . . . . . . . 106
                           e.    Error in Identifying Sales of Industrial Breakers
                                 Through Lincoln . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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. Cancellation of APAs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112

VIII. Notice of Deficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

IX.      Tractech Bonuses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114

OPINION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119

I.       Cancellation of APAs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
         A.   Overview of Parties’ Positions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
              1.     Petitioner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
              2.     Respondent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
         B.   History of the APA Program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
         C.   Applicable Revenue Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
              1.     Rev. Proc. 96-53 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
              2.     Rev. Proc. 2004-40 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
         D.   Background on Section 482 and Applicable Regulations. . . . . . . . 129
         E.   Scope and Standard of Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
         F.   APA Negotiations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
              1.     Profit Split . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
              2.     Tested Party . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
              3.     Business Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
                                                      -7-

[*7]           4.   Mirror Ledgers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
               5.   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.      APA Implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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
                    d.     International Sales Error . . . . . . . . . . . . . . . . . . . . . . . 171
                    e.     Sales of Industrial Breakers Through Lincoln . . . . . . 172
                    f.     Lincoln Multiplier Error . . . . . . . . . . . . . . . . . . . . . . . 173
                    g.     Error in Computation of Manufacturing Costs for
                           Nonexact Matches. . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
                    h.     Analysis of Errors Affecting the Computation of
                           the Transfer Price Under the APA TPM. . . . . . . . . . . 174
               3.   Compliance With the Terms of the APAs. . . . . . . . . . . . . . . 180
                    a.     Book-Tax Differences and Compensating
                           Adjustments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
                    b.     Forms 1120 and Compliance With the APA . . . . . . . 181
                    c.     Canadian Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . 184
                    d.     VISTA Data. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
                    e.     Analysis of Compliance . . . . . . . . . . . . . . . . . . . . . . . 187
               4.   Critical Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
               5.   Amended APA II Annual Reports. . . . . . . . . . . . . . . . . . . . . 189

       I.      Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192

II.    Transfer of Intangibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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.




       1
      The 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) Cutler-

Hammer Electrical Co. (CHEC).

      2
          The 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


      3
       As 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.

      4
     For 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/nrtl/nrtllist.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.


      5
          The 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 nonrecognition 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 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 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 operator-

interface 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: loadcenters, 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 third-

party 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 reporting 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

reporting 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

income.

      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’s-

length 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 determining 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 id. 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 third-

party 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’s-

length 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.

       6
           We 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


      7
      The 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, well-

established 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.

See 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

determining the SG&A expenses related to sales of the breaker products,

petitioner used the expense allocation methodology CHI used for management

reporting 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

         8
        APA 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

minimum 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 third-

party 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 cost-

sharing 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 terms 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 of 2001 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 of 2001. 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


      9
      The 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 of 28 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 high-

volume 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 cost-

plus 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 CHC-

manufactured 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.10 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

intercompany 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


      10
         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.xls” 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 full-

year 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 order-

entry 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.11

      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

      11
           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.




      12
           The 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 €107,120. 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 executive was required to execute a release, consenting to termination of
                                       -117-

[*117] any rights the bonus executive may have had to receive Tractech stock

option grants.

      The disclosure schedules that were part of the SPA include a provision that

the bonus executives were among employees eligible for discretionary annual

bonuses as a percentage of their annual base salaries. The bonus executives were

entitled to receive the following bonus amounts in accordance with the bonus

agreements: Carl Pittner, president and CEO, $681,955; Joseph Hige, vice

president of sales and marketing, $511,466; David Mead, vice president of

operations, $284,148; Robert Kress, vice president of engineering, $284,148; and

Denis O’Connell, operations director, $248,148. The bonus agreements stated:

“[Y]ou are entitled to receive a bonus * * * following the completion of the

transactions contemplated by the Purchase Agreement”. These agreements stated:

“Please be aware that this letter agreement does not constitute an offer or

guarantee of employment with the Company or any of its subsidiaries.” The bonus

agreements and attached releases were entered into on or before August 16, 2005.

      The SPA purchase price excluded the bonus amounts for the bonus

executives. The bonus agreements specified that the bonus executives would be

paid in a lump sum on November 16, 2005. Eaton agreed to place an amount into

an escrow account at closing and covenanted to negotiate an agreement reflecting
                                       -118-

[*118] the payments of the bonuses to the bonus executives on reasonably

acceptable terms.

      After petitioner’s acquisition Tractech became a member of its consolidated

group for tax year 2005. On November 17, 2005, petitioner, through Tractech and

the use of a third-party payroll processor, paid the bonus executives their bonus

amounts. The domestic bonus amounts paid totaled $2,306,144.

      Tractech withheld from the bonuses Federal and State income tax, as well as

Social Security and Medicare tax. Employment of five of Tractech’s bonus

executives was terminated on the following dates: Carl Pittner, August 18, 2005;

Joseph Hige, November 18, 2005; Richard Lindsay, January 30, 2006; David

Mead, November 18, 2005; and Robert Kress, September 29, 2006.

      For tax year 2005 petitioner filed a disclosure statement, Request to Treat

This Statement as a Qualified Amended Tax Return, under Rev. Proc. 94-69,

1994-2 C.B. 804, reporting $2,306,144 of an additional deduction for the bonus

amounts never deducted from the acquisition cost of Tractech. Petitioner’s request

for the additional deduction is equal to the sum of the net bonus amounts paid plus

the Federal and State income tax and Social Security and Medicare tax

withholdings. Respondent determined in the notice of deficiency that petitioner

was not entitled to the deduction because the bonus payments failed to meet the
                                       -119-

[*119] compensation rules of section 162(a) and the bonus payments should have

been capitalized under section 263.

                                      OPINION

      We must first consider whether it was an abuse of discretion for respondent

to cancel APA I as of January 1, 2005, and APA II as of January 1, 2006.

I.    Cancellation of APAs

      A.     Overview of Parties’ Positions

      Both parties presented experts to support their respective positions. We

focus on the degree to which the experts’ opinions are supported by the evidence.

Our opinion is not based on comparing experts’ qualifications, so we do not list or

discuss their qualifications, as listing them would unnecessarily lengthen the

opinion. We do not discuss the opinion of any expert that does not pertain to our

factual conclusions.

             1.    Petitioner

      Petitioner contends that it did not omit or misrepresent any material facts in

connection with its request for or negotiation of either APA I or APA II.

Petitioner argues that the IRS had knowledge of facts that could have led it to

implement a significantly different APA or no APA at all. Petitioner submits that
                                       -120-

[*120] it merely committed data and computational errors which did not affect the

validity of the TPM and that it corrected these data and computational errors on

its amended tax returns. It further contends that it did not commit implementation

or compliance errors warranting cancellation of the APAs.

             2.    Respondent

      Respondent contends that the cancellation of both APA I and APA II was

proper. Respondent contends that petitioner 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. Respondent further contends that petitioner

violated a critical assumption set forth in its APA I submission and APA II

application materials. Respondent believes that petitioner added favorable steps to

its TPM calculations that were not part of either APA I or APA II, failed to

disclose timely to respondent mistakes in its TPM calculations, failed to keep

adequate records, and failed to maintain adequate internal controls to ensure the

integrity of its APA calculations.

      B.     History of the APA Program

      Section 482 was enacted to prevent tax evasion and to ensure that taxpayers

clearly reflect income relating to transactions between controlled entities. Veritas

Software Corp. & Subs. v. Commissioner, 133 T.C. 297, 316 (2009). This section
                                        -121-

[*121] gives the Commissioner broad authority to allocate gross income,

deductions, credits, or allowances between two related corporations if the

allocations are necessary either to prevent evasion of tax or clearly to reflect the

income of the corporations. See Seagate Tech., Inc. & Consol. Subs. v.

Commissioner, 102 T.C. 149, 163 (1994). Before the issuance of Rev. Proc. 91-

22, 1991-1 C.B. 526, there was no formal mechanism for a taxpayer to request

advance rulings on transfer pricing questions that arose pursuant to section 482.

The Commissioner developed the APA program to resolve actual or potential

transfer pricing issues in a principled, cooperative manner, as an alternative to the

examination process. Announcement 2000-35, 2000-1 C.B. 922, 922.

      The APA program’s goal has been to make APAs more practical,

affordable, and available to more taxpayers. Id., 2001-C.B. at 923. Since 1991 the

APA program’s caseload has steadily grown. From 1991 through 2015, 2,147

APA applications were filed and 1,511 APAs were executed. Announcement

2016-12, 2016-16 I.R.B. 589, 591-592. From 1991 through 2015, 11 APAs were

revoked or canceled and 200 APA applications were withdrawn. Id. at 593.

      An APA is a binding agreement between the taxpayer and the

Commissioner on the TPMs within the meaning of section 482 and the

regulations. See Rev. Proc. 96-53, sec. 10.01, 1996-2 C.B. 375, 383; Rev. Proc.
                                        -122-

[*122] 2004-40, secs. 2.04, 9.01, 2004-2 C.B. 50, 51, 61. APAs can be

“unilateral”, “bilateral”, or “multilateral”. Announcement 2000-35, 2000-1 C.B. at

923. The APAs at issue in this case are unilateral, each representing an agreement

between only petitioner and the IRS. See id. Bilateral and multilateral APAs

combine agreements between the taxpayer and the IRS with an agreement between

the United States and one or more foreign competent authorities regarding an

appropriate TPM. Id. The APA program provides a voluntary process whereby

the Commissioner and the taxpayer may resolve transfer pricing issues under

section 482 and the income tax regulations prospectively. Rev. Proc. 96-53, sec.

3, 1996-2 C.B. at 376; Rev. Proc. 2004-40, sec. 2.01, 2004-2 C.B. at 51. The

prospective nature of an APA decreases the burden of compliance by providing

taxpayers greater certainty with respect to their transfer pricing methods and

promotes the principled resolution of these issues through discussion and

cooperation. Rev. Proc. 2004-40, sec. 2.01.

      The APA program is intended to supplement traditional administrative,

judicial, and treaty mechanisms and is designed as an alternative to the traditional

adversarial model. Id. sec. 2.04(1). Under the traditional adversarial model “the

data gathering, development, and interpretation of a transfer pricing issue is a

complex, time-consuming process that often results in an administrative appeal
                                       -123-

[*123] * * * [or] litigation”. See Announcement 2000-35, 2000-1 C.B. at 922. A

significant transfer pricing issue can take up to eight or more years to resolve,

which renders the facts in dispute many years old and can leave considerable

uncertainty regarding the proper transfer pricing of current transactions. Id.,

2001-C.B. at 922-923.

      The APA program evaluates each APA request in terms of developing an

arm’s-length TPM that is consistent with the regulations. Id. at 924. Because

transfer pricing cases generally involve complex facts and difficult issues, there is

room for disagreement between reasonable people, acting in good faith, about the

best method and proper application of this method. Id. The APA program team

leaders are willing to consider taxpayer positions to reach a mutually acceptable

understanding of the appropriate application of the arm’s-length standard to the

taxpayer’s facts in a manner consistent with the regulations. Id.

      In practice an APA is always the result of a voluntary decision by a

taxpayer to seek an APA. Id. at 923. The APA process is extensive and requires

a detailed submission. See Rev. Proc. 96-53, supra; Rev. Proc. 2004-40, supra.

Before filing a formal application, a taxpayer may request a prefiling conference.

Announcement 2000-35, 2000-1 C.B. at 923. The prefiling conference provides

the opportunity to discuss the IRS’ preliminary views of the taxpayer’s potential
                                        -124-

[*124] APA request and what types of information would be necessary to support

the request. Id. at 923-924.

      Each APA request and supplemental submission must include a declaration

under penalties of perjury that to the best of the taxpayer’s knowledge or belief,

the request contains all the relevant facts relating to the request and such facts are

true, correct, and complete. See Rev. Proc. 96-53, sec. 5.11, 1996-2 C.B. at 379;

Rev. Proc. 2004-40, sec. 4.09, 2004-2 C.B. at 56. The APA request is required to

include a statement describing all previous issues at the examination, Appeals, and

judicial levels related to the proposed TPM, including an explanation of the

taxpayer’s and the Government’s positions and resolutions to any issues. See Rev.

Proc. 96-53, sec. 5.03(11), 1996-2 C.B. at 377; Rev. Proc. 2004-40, sec.

4.03(14)(a), 2004-2 C.B. at 54. Any previous submitted documents that the

taxpayer wishes to associate with the APA request must be referenced. See Rev.

Proc. 96-53, sec. 5.01(2), 1996-2 C.B. at 377; Rev. Proc. 2004-40, sec. 4.01(3),

2004-2 C.B. at 53.

      For each taxable year covered by the APA, the taxpayer must file a timely

and complete annual report describing the taxpayer’s actual operations for the year

and demonstrating compliance with the APA’s terms and conditions. See Rev.

Proc. 96-53, sec. 11.01(1), 1996-2 C.B. at 383; Rev. Proc. 2004-40, sec. 10.01(1),
                                        -125-

[*125] 2004-2 C.B. at 61. An annual report must include a declaration under

penalties of perjury that all relevant facts relating to the APA agreement are true,

correct, and complete. Rev. Proc. 2004-40, sec. 10.01(6), 2004-2 C.B. at 61. If a

filed annual report contains incomplete or incorrect information, or reports an

incorrect application of the TPM, the taxpayer must amend its report within 45

days after becoming aware of the need to amend. The time may be extended for

good cause. Id. sec. 10.01(5). Revenue procedures provide guidelines for making

compensating adjustments and filing amended returns. See Rev. Proc. 96-53, sec.

11.02, 1996-2 C.B. at 383; Rev. Proc. 2004-40, sec. 10.02, 2004-2 C.B. at 61-62.

      If a return for a tax year covered by an APA is examined, the IRS may

require the taxpayer to establish that: (a) the taxpayer has complied in good faith

with the terms and conditions of the APA; (b) the material representations in the

APA and the annual reports remain valid and accurately describe the taxpayers’

operations; (c) the supporting data and computations used in applying the TPM

were correct in all material respects; (d) the critical assumptions underlying the

APA remain valid; and (e) the taxpayer has consistently applied the TPM and met

critical assumptions. See Rev. Proc. 96-53, sec. 11.03, 1996-2 C.B. at 384; Rev.

Proc. 2004-40, sec. 10.03, 2004-2 C.B. at 62. If the taxpayer complies with the

terms and conditions of the APA, the IRS will not contest the application of the
                                        -126-

[*126] TPM to the subject matter of the APA, and the taxpayer remains otherwise

subject to U.S. income tax laws. See Rev Proc. 96-53, sec. 10.02, 1996-2 C.B. at

383; Rev. Proc. 2004-40, sec. 9.02, 2004-2 C.B. at 61. If a critical assumption has

not been met, the APA director and the taxpayer will discuss revising the APA; if

an agreement cannot be reached, the APA will be canceled. See Rev. Proc. 96-53,

sec. 11.06, 1996-2 C.B. at 385; Rev. Proc. 2004-40, sec. 10.06(1), 2004-2 C.B. at

63. A taxpayer may request renewal of an APA using the same procedures as for

the initial APA request. Rev. Proc. 2004-40, sec. 11.01, 2004-2 C.B. at 64.

      C.     Applicable Revenue Procedures

      Revenue procedures provide the requirements and guidelines of the APA

program. Rev. Proc. 91-22, 1991-1 C.B. 526, provided the first guidelines for

APAs, and these guidelines have been replaced by a succession of revenue

procedures. Rev. Proc 96-53, supra, is effective for APA I and Rev. Proc. 2004-

40, supra, is effective for APA II. These revenue procedures are very similar, and

their provisions regarding cancellation differ only slightly.

             1.    Rev. Proc. 96-53

      Rev. Proc. 96-53, supra, is generally effective for an APA request received

on or after December 31, 1996, and before August 19, 2004. Rev. Proc. 96-53,
                                        -127-

[*127] sec. 14, 1996-2 C.B. at 386; Rev. Proc. 2004-40, supra.13 The Associate

Chief Counsel (International) may cancel the APA if the District Director, with the

concurrence of the Associate Chief Counsel (International), determines that there

was a misrepresentation, mistake as to material fact, failure to state a material fact,

or lack of good-faith compliance with the terms and conditions of the APA (but

not fraud, malfeasance, or disregard) in connection with the request for the APA,

or in any subsequent submissions (including the annual report). Rev. Proc. 96-53,

sec. 11.06(1). Material facts are facts that, if known by the IRS, would have

resulted in a significantly different APA or no APA at all. Id.

      If an APA is canceled the cancellation will be effective as of the beginning

of the year in respect of which the misrepresentation, mistake as to material fact,

failure to state a material fact, or noncompliance occurs. Id. sec. 11.06(3). If an

APA is canceled the APA will cease to have force and effect with respect to the

taxpayer and the IRS as of the effective date of the cancellation for U.S. income

tax purposes. Id. sec. 11.06(4). After the effective date of cancellation, the tax

treatment of the transactions covered by the APA is subject to all applicable U.S.

tax rules. Id.


      13
        Rev. Proc. 2004-40, 2004-2 C.B. 50, updated and superseded Rev. Proc.
96-53, 1996-2 C.B. 375.
                                           -128-

[*128]         2.     Rev. Proc. 2004-40

         Rev. Proc. 2004-40, supra, is generally effective for APA requests received

after August 19, 2004, and before February 1, 2006. See Rev. Proc. 2004-40, sec.

14, 2004-2 C.B. at 64; Rev. Proc 2006-9, 2006-1 C.B. 278.14 The Associate Chief

Counsel (International) or a designee may cancel an APA on account of the failure

of a critical assumption, or because of the taxpayer’s 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.

Rev. Proc. 2004-40, sec. 10.06(1). Material facts include facts that, if known by

the IRS, could have reasonably resulted in an APA with significantly different

terms and conditions. See id. For annual report purposes the Associate Chief

Counsel (International) will consider facts as material if the knowledge of the facts

would have resulted in a materially different allocation of income, deductions, or

credits than reported in the annual report or the failure to meet a critical

assumption. Id.

         If an APA is canceled, the cancellation is effective as of the beginning of

the year in which the critical assumption failed or the beginning of the year to


         14
       Rev. Proc. 2006-9, 2006-1 C.B. 278, updated and superseded Rev. Proc.
2004-40, 2004-2 C.B. 50.
                                        -129-

[*129] which the misrepresentation, mistake as to a material fact, failure to state a

material fact, or noncompliance relates. Id. sec. 10.06(3). The APA has no further

force and effect with respect to the taxpayer and the IRS for U.S. income tax

purposes as of the effective date of cancellation. Id. sec. 10.06(4).

      D.     Background on Section 482 and Applicable Regulations

      To determine true taxable income of a controlled taxpayer, the standard to

be applied in every case is that of a taxpayer dealing at arm’s length with an

uncontrolled taxpayer. Sec. 1.482-1(b)(1), Income Tax Regs. The arm’s-length

result of a controlled transaction must be determined under the method that, under

the facts and circumstances, provides the most reliable measure of an arm’s-length

result, which is referred to as the best method rule. Id. para. (c)(1). There is no

strict priority of methods, and no method will invariably be considered more

reliable than others. Id. An arm’s-length result may be determined under any

method without establishing the inapplicability of another method; but if another

method subsequently is shown to produce a more reliable measure of an arm’s-

length result, that method should be used. Id.

      The regulations provide six methods to determine the arm’s-length amount

to be charged in the transfer of tangible property: the CUP method, the resale

price method, the cost-plus method, the CPM, the profit split method, and
                                        -130-

[*130] unspecified methods. Sec. 1.482-3(a), 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 comparable uncontrolled

transactions. Id. para. (b)(1). 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 a comparable uncontrolled transactions. Id. para. (d)(1). The

CPM evaluates whether the amount charged in a controlled transaction is arm’s

length on the basis of objective measures of profitability (profit level indicators)

derived from uncontrolled taxpayers that engage in similar business activities

under similar circumstances. Sec. 1.482-5(a), Income Tax Regs.

      Under the CPM the determination of an arm’s-length result is based on the

amount of operating profit that the tested party would have earned on related party

transactions if its profit level indicator were equal to that of an uncontrolled

comparable. Id. para. (b)(1). In general the tested party will be the participant in

the controlled transaction whose operating profit attributable to the controlled

transaction can be verified using the most reliable data and requiring the fewest

and most reliable adjustments, and for which reliable data regarding uncontrolled

comparables can be found. Id. subpara. (2). Usually, the tested party will be the
                                       -131-

[*131] least complex of the controlled taxpayers and will not own valuable

intangible property or unique assets. Id.

      The regulations provide four methods to determine the arm’s-length amount

to be charged in a controlled transfer of intangible property: the CUT method, the

CPM, the profit split method, and unspecified methods as described in section

1.482-4(d), Income Tax Regs. See id. para. (a). The CUT method evaluates

whether the amount charged for a controlled transfer of intangible property was at

arm’s length by reference to the amount charged in a comparable uncontrolled

transaction. Id. para. (c).

      E.     Scope and Standard of Review

      We previously held in Eaton Corp. & Subs. v. Commissioner, 140 T.C. 410,

417 (2013), that the standard of review is whether it was an abuse of discretion for

respondent to cancel the APAs.15 The relevant inquiry is whether respondent

abided by the self-imposed limitations set forth in the applicable revenue

procedures. Id. at 418. Petitioner must show that respondent’s act of canceling

the APAs was arbitrary, capricious, or without sound basis in fact. Id. at 418. In


      15
        On June 9, 2016, petitioner filed a motion to reconsider the Court’s June
26, 2013, Opinion and order in this case. An oral argument on the motion to
reconsider was held on October 21, 2016. Petitioner contends respondent bears
the burden of proof for cancellation of the APAs.
                                        -132-

[*132] reviewing whether it was an abuse of discretion to cancel the APAs, we

review the evidence de novo. See Estate of Gardner v. Commissioner, 82 T.C.

989, 1000 (1984). Whether respondent committed an abuse of discretion is a

question of fact. Buzzetta Constr. Corp. v. Commissioner, 92 T.C. 641, 648

(1989).

      F.     APA Negotiations

      The APA process was designed to solve complex transfer pricing issues.

The goal is to reach a mutually acceptable understanding of the appropriate

application of the arm’s-length standard to the taxpayer’s facts. See

Announcement 2000-35, 2000-1.C.B. at 924. At the conclusion of an APA

negotiation, both parties might believe that a result is not the best method but

rather is an acceptable negotiated agreement. To reach agreement, parties often

compromise. No regulation requires the parties to reach an agreement; either party

can end negotiations at any point. Respondent’s expert Harlow Higinbotham

testified that an APA is a negotiation and “not a technician’s contest over best

method”. We do not review the APAs to determine whether the APA TPMs were

the best method under the section 482 regulations. To determine whether

respondent’s determination to cancel the APAs was an abuse of discretion, we

focus on whether there were any misrepresentations, mistakes as to a material fact,
                                        -133-

[*133] or failures to state a material fact. See Rev. Proc. 96-53, sec. 11.06(1);

Rev. Proc. 2004-40, sec. 10.06(1).

      The APA I negotiations began after the audit for petitioner’s 1994-97 tax

years was complete. During the audit petitioner discussed changing its TPM for

the transfer of tangible property from the cost-plus method, which used the Island

plants as the tested party, to the CUP method. Petitioner contended that the CUP

method, in combination with the CPM, was better than the cost-plus method and

that CHI/EEI’s U.S. distribution should be the tested party. One of the purposes

of beginning the APA negotiations was to give respondent time to review

petitioner’s CUP method proposal.

      The prefiling conference for APA I was held on May 8, 2002, and

agreement on the terms of the APA was not reached until November 14, 2003.

APA I covered three transactions: (1) the transfer of breaker products from

CHPR/EEPR to CHI/EEI; (2) CHI/EEI’s license of intangible property to CHC;

and (3) a cost-sharing payment made by CHPR/EEPR to CHI. Rev. Proc. 96-53,

supra, governs APA I.

      The APA II process began in January of 2005, and APA II was executed in

December 2006. Petitioner’s APA II application sought renewal of APA I. APA

II covered only one transaction, the transfer of breaker products from CHC to EEI.
                                          -134-

[*134] The APA II process included a de novo review of petitioner’s APA

materials. The APA II TPM for the transfer of breaker products differed slightly

from that of APA I. Unlike APA I, APA II did not include a minimum threshold

of SG&A expenses. Rev. Proc. 2004-40, supra, which updated and superseded

Rev. Proc. 96-53, supra, applies to APA II.

      On December 16, 2011, the IRS notified Eaton that it was canceling APA I

and APA II effective as of January 1, 2005 and 2006, respectively. The IRS

specifically stated that “[t]hese 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.”

      Respondent’s arguments in support of cancellation of the APAs fall into two

categories: (1) misrepresentations, mistakes as to a material fact, and failures to

state a material fact during the APA negotiations and (2) implementation and

compliance with the APAs.

      We look at the following nine areas of the APA negotiations to determine

whether it was an abuse of discretion to cancel the APAs: (1) profit split, (2)

tested party, (3) business losses, (4) mirror ledgers, (5) relationship between

breaker products and U.S. assembly, (6) SG&A allocation, (7) southbound
                                        -135-

[*135] transactions, (8) APA multiplier, and (9) Lincoln sales. Some of these

areas are also addressed later in our implementation and compliance with the

APAs analysis, but our discussion of these nine areas below focuses on their

relation to the APA negotiation process, which began with the first contact that

petitioner had with the IRS and lasted until the APAs became effective.

             1.     Profit Split

      During the APA I negotiations petitioner provided the APA I team with

information regarding the profit split between the Island plants and petitioner’s

U.S. operations. Petitioner provided this information to enable the APA team to

compare the relative amount of profit split between CHI/EEI and the Island plants

under Eaton’s proposed TPM. Petitioner’s information explained CHI/EEI’s

overall business unit operating profits for 1998-2001. Specifically, petitioner’s

information segmented CHI/EEI’s total overall business unit operating profits into

three categories: (1) the Island plants’ income, (2) CHI/EEI’s income from

distribution 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.
                                        -136-

[*136] The information provided established that the Island plants had the greatest

percentage of operating profits each year under the proposed TPM, and EEI’s

“other” operations, including U.S. assembly, incurred either losses or substantially

lower operating profits relative to the Island plants each year. Petitioner’s

information submitted to the APA I team also explained that the use of a profit-

split analysis instead of a CUP analysis would fail to reflect the excess costs that

petitioner sought to reduce in its non-Puerto Rico operations. Petitioner provided

a similar explanation to the IRS during its 1994-97 audit.

       A member of the APA I team prepared a spreadsheet analyzing the profit-

split that resulted from petitioner’s proposed TPM for 2001. The IRS’ profit split

analysis showed that over 80% of the profits were allocated to the Island plants.

There was some concern among the APA I team members that the Island plants

had significant profits and that EEI had small losses, warranting consideration of a

switch of the tested party. The APA I team further explained to petitioner that it

did not believe petitioner’s proposed TPM sufficiently compensated EEI for the

risks it assumed as a distributor.

       During the APA II negotiations the APA II team, which had a different APA

team leader, different members, and some of the APA I exam team members,

raised the profit split issue to petitioner. The APA II team leader asked petitioner
                                       -137-

[*137] to explain the “extraordinarily high operating margin” the Island plants

earned under the APA TPM in an industry that “faces strong competitive

pressures”. Petitioner responded that EEI had successfully established highly

efficient production in low cost locations in Puerto Rico and the Dominican

Republic, which achieved productivity levels that equaled or exceeded a

substantial margin typical of industry productivity levels.

      Respondent asked for a profit and loss statement showing the system profit

of the breaker products produced by the Island plants and sold by EEI to its

customers and constructive customers (EEI’s own domestic plants). Petitioner’s

response specifically acknowledged that the “IRS team has expressed concern

regarding split of profit between the factory operations of CHC and the

distribution operations of EEI under the CUP methodology”.

      Petitioner provided the APA II team leader with two separate analyses

supporting the use of the CUP method. Petitioner’s response contended that these

confirming analyses supported its decision to use a CUP method. The first

analysis looked at the gross margin on the sale of breaker products manufactured

in the Beaver plant and the sale of breaker products manufactured in the Island

plants. The response explained that the difference in margins was due to the

savings of the Island plants operating in a low-cost jurisdiction. The analysis
                                        -138-

[*138] supported the assertion that the bulk of the profits were properly

attributable to the manufacturers of the product and resulted from the

manufacturers’ ability to produce a diverse numbers of styles of complex high-

regulated products at low cost, in high volume while meeting quality product

standards. The second analysis was based on an activity based profit-split

analysis. Petitioner also provided an analysis of the actual system profit and profit

split resulting from the application of the APA TPM in 2004. This profit split

allocated 14.8% of the profit to EEI’s U.S. distribution and 85.2% of the profit to

the Island plants.

      The evidence supports a conclusion that the profit split between the Island

plants and EEI was not only known by both APA I and APA II teams, but was

subject to questioning by both APA teams. Respondent contends petitioner

misrepresented its profit splits as an “actual” profit split rather than one based on

constructed revenue. Respondent, however, was aware that the APA TPM used

constructed revenues.

             2.      Tested Party

      Regulations define the term “tested party” in connection with the CPM. The

term refers to the controlled party whose profitability is being tested. See sec.

1.482-5(b)(2), Income Tax Regs. Usually, the tested party will be the least
                                         -139-

[*139] complex of the controlled taxpayers and does not own valuable intangible

property or unique assets that distinguish it from potential uncontrolled

comparables. See, e.g., id.

      Respondent contends that petitioner failed to disclose material facts

regarding the use of EEI U.S. distribution as the tested party. During its 1994-97

audit petitioner proposed to use a CUP method which would have changed the

tested party from the Island plants to CHI’s U.S. distribution. Petitioner

responded to the IRS audit team’s concerns by providing the IRS with its 2001

CUP study. Petitioner further provided the IRS 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.

      The participants in the APA I negotiation included personnel from the IRS

audit team. The APA I team had access to the IRS audit team’s records. Some

members of the APA I team contended that the Island plants should be the tested

party, and conveyed to petitioner that it wanted to focus on treating the Island

plants as the tested party because the profit split that resulted from petitioner’s

proposed CUP method had resulted in “significant profits” in the Island plants and

“small profits or losses” in the United States. The APA I team further informed
                                        -140-

[*140] petitioner that it did not believe petitioner’s proposed TPM sufficiently

compensated CHI/EEI for the risks it assumed as a distributor. The APA I

agreement settled on CHI/EEI’s U.S. distribution as the tested party for the APA

TPM.

       The issue of who should be the tested party also arose during the APA II

negotiations. The APA II team economist sent the APA II team leader a

memorandum outlining his concerns about petitioner’s proposed use of EEI U.S.

distribution as the tested party. The APA II team economist’s concerns specified

that petitioner’s proposed method resulted in the Island plants’ receiving the

“lion’s share of profits” while petitioner has not proven that the Island plants are

entitled to such profits from location savings. The memorandum further explained

that petitioner’s proposed method resulted in EEI’s receiving a much smaller

portion of the profits, which was concerning considering that EEI had material

marketing intangibles.

       The APA II team leader provided petitioner with a draft memorandum that

he prepared for the Associate Chief Counsel (International). This memorandum

stated that the APA II team was “currently divided on whether the facts justif[ied]

treating EEI as the tested party on renewal”. The APA II team leader testified that

there were questions and communications regarding the tested party--
                                       -141-

[*141] approximately 25 questions were asked about the tested party. There is no

evidence that petitioner did not respond to these questions. The evidence supports

a conclusion that the APA teams were aware that the Island plants were not the

tested party and that some members of the APA teams did not support the

proposed TPM.

            3.     Business Losses

      Respondent contends that he was not aware that petitioner’s U.S. assembly

business earned low operating profits or incurred losses. On December 13, 2002,

petitioner provided a written response to a request for information from the APA I

team leader. The response provided a chart of operating profits, which included

an “other” category that included income derived from the manufacturing of

components outside Puerto Rico, the manufacture of assemblies, and sales and

distribution activities other than those specifically related to CHPR products. This

chart showed that the “other” category incurred losses for 1998 and 1999.

      The parties dispute the relevance of the financial performance of EEI’s other

businesses. Petitioner contends that whether EEI’s businesses performed well or

poorly has no bearing on the arm’s-length price for breaker products. Petitioner

further contends that the APA TPM applied only to EEI’s distribution function

and that EEI’s entire business was not part of the covered transaction. Respondent
                                         -142-

[*142] had information regarding petitioner’s other businesses and could have

inquired about how EEI’s other businesses affected the proposed TPMs before

agreeing to the APAs.

             4.     Mirror Ledgers

      Petitioner kept mirror ledgers, which were also referred to as distribution

ledgers. These mirror ledgers recorded the financial effects of the transfer of

breaker products from the Island plants to EEI. Respondent contends that

petitioner failed to disclose that the mirror ledgers reflected losses.

      The APA I and APA II negotiating teams were aware of the distinction

between the constructed income statements and the mirror ledgers. Petitioner had

disclosed and explained previously the losses reflected on the mirror ledgers.

During the 1994-97 audit the IRS audit team requested that petitioner explain the

losses reflected on the mirror ledgers. Petitioner provided a written explanation

regarding the losses. This response, dated October 31, 2000, explained that the

losses occurred because the arm’s-length price paid to the Island plants as

reflected on the mirror ledgers was higher than the price the mirror ledgers

recorded as revenue from U.S. assembly based on Eaton’s internal management

price. Petitioner’s response further explained that profits and losses recorded on

the mirror ledgers were unrelated to the economics of arm’s-length sales because a
                                          -143-

[*143] substantial portion of the revenue reflected on the mirror ledgers was

derived from the non-arm’s-length internal management price.

      Both APA I and APA II include specifications regarding the Berry ratio.

Respondent contends that compliance with the Berry ratio should be tested in part

on the basis of the mirror ledgers. The APAs defined the Berry ratio as the gross

profit from EEI’s sales of breaker products divided by its breaker product

operating expenses. For each APA year the APAs required that if EEI’s yearend

breaker product Berry ratio was not in compliance with the TPM, then EEI was

required to make an adjustment to the purchase price of breaker products to bring

the Berry ratio within the agreed-upon range.

      The APAs required that Eaton construct income statements. Respondent

contends that the constructed income statements included in Eaton’s APA annual

reports are not part of Eaton’s books and records. Respondent further contends

that the Berry ratio should be tested on the basis of the net profit reported on the

mirror ledgers, EEI’s consolidated income, or on Eaton’s Forms 1120. Petitioner

contends that its books and records were not organized in such a way that it could

isolate the profitability of its U.S. distribution functions.

      The constructive income statement brought together four key elements of

the profitability of the U.S. distribution function: (1) third party and international
                                        -144-

[*144] revenue, (2) CUP-method-based constructed intercompany revenue, (3)

related SG&A, and (4) the COGS paid to the Island plants at the transfer price.

The third-party and international revenue, and the related SG&A, were all from

Eaton’s financial records. The CUP-method-based intercompany revenue and the

COGS paid to the Island plants were computed under the APA TPM. The

components of the constructed income statement and the steps to calculate the

TPM were clearly explained in petitioner’s APA I application. Petitioners never

indicated that the mirror ledgers were being used to calculate the APA TPM.

      The losses reflected on the mirror ledgers were expected and did not violate

any term or condition of the APA. Petitioner’s expert witness Shannon W.

Anderson explained that large companies typically use many different internal

ledgers to record the financial transactions of different units or divisions within

the company. The transfer price at which EEI’s U.S. distribution purchased

breaker products from the Island plants was determined using a constructed

income statement derived from the mirror ledgers. Anderson explained that some

of the information on the mirror ledgers was not needed for the purposes of the

APA TPM. Neither the APA I nor the APA II TPMs addressed the mirror ledgers.
                                        -145-

[*145]       5.    Relationship Between Breaker Products and U.S. Assembly

      Respondent contends that petitioner misrepresented the relationship

between its U.S. assembly operations and breaker products. Specifically,

respondent contends that petitioner represented that there was effectively no

relationship between U.S. assembly and the breaker products. Respondent argues

that customers who have purchased and installed assembled products tend to

acquire EEI’s breaker products in the aftermarket instead of purchasing a

competitor’s product. The relationship between breaker products and U.S.

assembly has been described in various ways: marketing intangible, razors and

blades, installed base, and the aftermarket.

      The relationship between breaker products and U.S. assembly had been a

concern since the 1994-97 audit. This concern was the subject of an IDR dated

June 2, 2000. Petitioner response to the IDR explained that its electrical business

was an integrated business. A substantial portion of CHI’s distributor sales is

directly related to sales of components it previously made to OEMS and sales of

customized electrical assemblies (containing other CHPR products) that it

previously made to unrelated third parties. The response explained that third

parties regularly purchased additional CHPR products for these assemblies from
                                      -146-

[*146] unrelated distributors. This response compared distributor products to

blades and the sales to OEMs as analogous to razors.

      Petitioner explained in a response to the APA II team why the previous

analogy of razors and blades was incorrect. Petitioner also responded to the APA

II team’s concerns regarding the relationship between breaker products and U.S.

assembly in the context of marketing intangibles. This issue had been discussed

extensively during a prior meeting between petitioner and APA II team. The APA

II team’s questions regarding marketing intangibles specifically asked about the

1995 E&Y study and its conclusion that CHI was more than a simple distributor,

and that it owned valuable marketing intangibles.

      Petitioner’s response contended that no significant marketing intangibles

existed in the breaker product business. Petitioner further explained that the E&Y

study was out of date and referred to a time when the Wesco trademark was used.

      Petitioner provided inaccurate information during the APA I negotiations

concerning the relationship of breaker products with U.S. assembly. This

inaccuracy was corrected during the APA II negotiations. Even though incorrect

information was disclosed, the APAs’ TPMs for the transfer of tangible property

do not seem to have been affected by the disclosure of erroneous information. The
                                        -147-

[*147] APA II team focused questions on marketing intangibles, and it received

detailed responses.

             6.       SG&A Allocation

      Respondent contends that petitioner failed to disclose its SG&A allocation

method. Respondent further contends that there were SG&A expenses that were

not allocated to operated entities in the mirror ledgers and the U.S. assembly

ledgers. During the APA I negotiations the APA I team asked a series of

questions related to this issue. Petitioner responded to the APA I team leader in a

letter dated December 13, 2002.

      The APA I team inquired about how CHI allocated SG&A and received a

detailed response. According to petitioner SG&A allocations followed long-

standing business practices and were not affected by tax considerations. This

explanation identified the highest level of corporate expenses in the SG&A

allocation as coming from CHI’s division headquarters. SG&A was also

discussed at a meeting between petitioner and the APA I team on January 15,

2003. Petitioner contends that expenses incurred at the corporate parent of EEI

were not specifically included in the APA allocations unless they had already been

allocated to the electrical division in accordance with petitioner’s regular business

practice.
                                       -148-

[*148] During the APA II negotiations SG&A was addressed in petitioner’s APA

application and discussed with the APA II team leader. APA I required a

minimum threshold of a 13% floor for the allocation of SG&A to EEI’s

distribution function. APA II did not require a minimum threshold. Respondent

contends that additional facts regarding the SG&A allocation should have been

disclosed but does not identify what specific facts should have been disclosed.

            7.     Southbound Transactions

      Respondent contends that Eaton’s APA materials failed to disclose facts

concerning the scope of the subcomponents manufactured in Watertown and

Horseheads that CHI sold to the Island plants and which the Island plants

incorporated into breaker products.

      Southbound transactions cover the inputs and components that the Island

plants bought from CHI. This issue came up during the APA I negotiations. The

APA I economist inquired about what CHPR bought from CHI. Petitioner’s

economist communicated to the APA I economist that out of the Island plants’

$300 million COGS, approximately $8 to $10 million related to materials

purchased from CHI. The APA I economist testified that these transaction were

not related to the breaker products transactions covered by the APA.
                                        -149-

[*149]       8.    APA Multiplier

      Respondent contends that petitioner described its proposed TPM as a three-

step process: (1) identify third-party prices and revenues, (2) create an income

statement for EEI’s distributive activities, and (3) calculate EEI’s Berry ratio from

the income statement prepared in step 2. These three steps confirm the arm’s-

length nature of a transfer price for EEI U.S. distribution’s purchase of the breaker

products from the Island plants. Respondent contends that petitioner performed a

fourth step involving a multiplier--the numerator was the transfer price calculated

by petitioner under the TPM and the denominator was an estimate of the Island

plants’ manufacturing costs. Respondent further contends that petitioner did not

disclose in its APA materials the existence of a multiplier to calculate EEI’s

transfer prices for the breaker products reported on its Forms 1120. Respondent

argues petitioner’s use of a multiplier changed the APA TPM from a Berry ratio

return on a hypothetical distribution function to a cost-plus markup on the Island

plants’ manufacturing costs.

      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 cost was the mathematical equivalent of the transfer

price computed under the APA TPM. Although petitioner used the term “APA
                                        -150-

[*150] multiplier”, the multiplier was not used to compute or modify the transfer

price determined under the APA TPM. The multiplier was used by petitioner as

an implementation mechanism, incorporating the transfer price in its financials.

      Petitioner contends that it calculated the transfer price for the transfer of

tangible property using the CUP and CPM methods as provided by the APA TPM.

Petitioner further contends the APA multiplier did not change the APA TPM to a

cost-plus markup on manufacturing costs. The cost-plus method evaluates

whether the amount charged in a controlled transaction is arm’s length by

reference to the gross profit markup realized in comparable uncontrolled

transactions. Sec. 1.482-3(d)(1), Income Tax Regs. The APA multiplier was not

derived by reference to a third party’s cost-plus markups, and the Island plants’

markups were not compared to those of a comparable third party.

             9.    Lincoln Sales

      The Lincoln plant in Illinois produces a complete residential product

offering. Las Piedras and Haina were its primary supplier of breaker products.

Most of the Lincoln plant’s sales of Island plant products were made to

distributors, which were treated as distributor sales for the purposes of the APA I

filing. A small share of Lincoln sales was made directly to unrelated OEMs and

this information was included in the filed APA I submission. The APA I filing
                                        -151-

[*151] further explained that the Lincoln plant did not modify or physically alter

CHPR residential breaker products that CHI sold to unrelated distributors through

a warehouse in the Lincoln plant. Respondent contends that petitioner failed to

provide the Lincoln product line statement used to prepare its constructive income

statements.

      Petitioner disclosed during the APA II negotiation process that it would not

include sales of breaker products to OEMs through the Lincoln ledger in the CUP

computations. Petitioner explained that only a small share of the Lincoln sales is

made directly to unrelated OEMs. Information regarding Lincoln sales was

disclosed during the APA negotiations.

      G.      Analysis Regarding APA Negotiations

      According to respondent there are three primary controlled transactions:

(1) EEI’s licenses to the Island plants of intangible property, which the Island

plants used to manufacture breaker products; (2) the Island plants’ purchase of

subcomponents, which the Island plants then used to manufacture breaker

products; and (3) EEI’s purchase of Island plants’ manufactured breaker products.

We do not dispute that these controlled transactions took place. However, the

Island plants purchase of subcomponents is not a covered transaction in the APAs.
                                        -152-

[*152] Our analysis focuses on the APAs’ covered transactions, and whether

petitioner misrepresented information, as well as whether there existed a mistake

as to a material fact or whether petitioner failed to state a material fact. We must

analyze whether any mistakes or omissions were material to the APAs’ covered

transactions.

      The parties disagree about what should be considered a material fact. Rev.

Proc. 96-53, sec. 11.06(1), which is applicable to APA I, defines material facts as

those that would have resulted in a significantly different APA or no APA at all.

Rev. Proc. 2004-40, sec. 10.06(1), which is applicable to APA II, considers facts

material if knowledge of the facts could have reasonably resulted in an APA with

significantly different terms and conditions. Petitioner contends that a material

fact is a fact that could have resulted in a significantly different TPM being used in

the APA had the IRS known about it. Respondent contends that petitioner’s

interpretation is too narrow and argues that the relevant inquiry is whether the

APA itself, or the terms and conditions of the APA, would be different or result in

no APA at all.

      The primary purpose of an APA is to reach agreement on a TPM. See Rev.

Proc. 96-53, sec. 3.02, 1996-2 C.B. at 376; Rev. Proc. 2004-40, sec. 2.04. As part

of the APA process the taxpayer provides information to support its proposed
                                       -153-

[*153] TPM as the best method. See Rev. Proc. 96-53, sec. 3.03, 1996-2 C.B. at

376; Rev. Proc. 2004-40, sec. 2.07, 2004-2 C.B. at 51. For any fact to be material,

it needs to result in a significantly different APA or no APA at all. The TPM is

the essential part of the APA, and for a fact to be material it should have an impact

on the TPM. For example, if a taxpayer did not disclose certain aspects of its

business related to a product line that was not included in a covered transaction

under the APA, the failure to make such a disclosure would not likely be material

because it would not result in a change to the TPM.

      We must also address whether petitioner omitted a material fact.

Respondent contends that certain information was never presented to the APA

teams but rather was provided to an exam team in connection with a prior year

exam or in response to an IDR in conjunction with a specific exam. Petitioner

contends that it provided all the relevant materials, including materials provided

during the 1994-97 audit.

      The revenue procedure applicable to APA I specifically states that “[a]ny

previously submitted documents that the taxpayer wishes to associate with the

request must be referenced in the request”. See Rev. Proc. 96-53, sec. 5.01(2),

1996-2 C.B. at 377. We agree with respondent that information regarding the

mirror ledgers previously provided was not referenced in the APA materials.
                                        -154-

[*154] However, the purpose of the APA I submission was to request TPMs for

three covered transactions and to provide supporting information for why the

proposed TPMs were the best method under the section 482 regulations.

      Petitioner’s APA I submission explained clearly the proposed TPM for the

transfer of tangible property in specific steps. The second step explained how an

income statement would be constructed and what would be included in it. It is not

apparent why petitioner should have been required to explain the mirror ledgers,

which were not addressed in the TPM. Petitioner was required to submit

representative financial and tax data for the last three taxable years, with other

data in support of the proposed TPM. See Rev. Proc. 96-53, sec. 5.03(5), 1996-2

C.B. at 377. The APA I team had the opportunity to ask any questions that they

wanted. A prefiling meeting was held, and the member of the exam team that

received the October 2000 letter regarding the mirror ledgers was present.

      After the APA I submission the APA I team leader sent petitioner a letter

with due diligence questions. One of these questions addressed whether there was

an apparent inconsistency between numbers in the CHI income statement and the

consolidated income statement for the Eaton Industrial and Commercial Controls

Division. Petitioner’s response divided income data from the annual report into

three categories: (1) CHPR income; (2) CHI income from distribution of CHPR
                                        -155-

[*155] products; and (3) other consolidated industrial and commercial controls

operating income. This information showed that the third category of income had

losses. We realize this information is different from that in the mirror ledgers, but

the question raised inconsistencies in the income statements. If respondent had

questions about the mirror ledgers and their relationship to the constructed income

statements, they should have asked.

      A taxpayer should not rely on information disclosed previously and is

required to submit all information that supports its proposed TPM, as well as

provide any requested information. See Rev. Proc. 96-53, secs. 5.01(2), 6.01,

1996-2 C.B. at 377, 380. However, a taxpayer should not be expected to provide

information that is not requested and that the taxpayer reasonably believes is

unnecessary.

      The APA I request began with a prefiling conference, and the total APA I

process lasted 18 months. The formal due diligence process lasted about 13

months. There is no evidence of petitioner’s not answering a request for

information. During the APA I negotiations petitioner made concessions in order

to reach an agreement. For example, petitioner agreed to a higher Berry ratio than

originally proposed in order to reach an agreement. Respondent also made

concessions. Although some of the APA I team members expressed concern about
                                       -156-

[*156] using CHI/EEI U.S. distribution as the tested party, there was ultimately no

change to the tested party used in reaching the agreed-upon APA TPM.

      The APA II request was subject to a de novo review by a different APA

team leader and economist. However, some exam team members from the APA I

team were also on the APA II team. The APA II team leader testified credibly

about the APA process in general and the APA II negotiations. He explained that

each member of the APA team brings an expertise and that none of us has “to

shoulder the entire expertise by ourselves.” The team leader is responsible for the

team trying to achieve a consensus among the APA team members and for drafting

the APA.

      The APA II team leader explained that the APA process often begins with

the filing of an application, which is proceeded by a question and answer period

that lasts a few months. The questions often ask for more details about the facts

surrounding the APA application. He explained that prefiling conferences are

helpful and often result in the taxpayer’s providing a more complete initial

response. He further explained that if the APA team does not like a proposed

TPM, the APA team often provides an alternative.

      The APA II process began with a prefiling conference on February 2, 2005.

Petitioner submitted its application for renewal of APA I on June 23, 2005. The
                                       -157-

[*157] APA II team asked petitioner hundreds of questions. Petitioner provided

answers to all questions asked. Both APA teams agreed to petitioner’s proposed

TPM as it related to tangible goods. Each team did a thorough analysis and asked

petitioner for additional information. Both APA teams raised concerns about EEI

U.S. distribution being treated as the tested party. However, both teams accepted

EEI U.S. distribution as the tested party and deemed EEI’s payments to CHC for

breaker products to be arm’s length, provided that EEI correctly applied the TPM

and achieved a Berry ratio within a range from 1.20 to 1.27 for APA I and 1.20 to

1.24 for APA II. APA I also required a minimum floor threshold of 13%

allocation of SG&A, but this floor was not included in APA II.

      APA II had only one covered transaction--the transfer of breaker products

from CHC and CHEC to EEI. APA II did not include a transfer price for the

transfer of intangibles because of the APA II team’s concerns regarding section

367(d), which requires a U.S. person to recognize gain upon transferring certain

intangible property to a foreign corporation.

      Respondent contends that petitioner relied on documents that it never

presented to the APA I or APA II team. For example, respondent argues that

petitioner did not disclose information about the mirror ledgers because the

information was disclosed during the 1994-97 audit. Throughout the APA I and
                                        -158-

[*158] APA II negotiations the APA teams asked petitioner for additional

information. The teams were aware of the mirror ledgers, and they could have

asked about other ledgers. Respondent contends that petitioner should have

provided information about the mirror ledger process. It is doubtful that

information about the mirror ledgers would have resulted in significantly different

APAs or resulted in no APAs at all.

      Respondent argues that petitioner has focused its opposition to the

cancellation of the APAs on grounds concerning omission. Respondent argues

that any misrepresentation or misstatement is sufficient on its own to show that the

cancellation of the APAs was not an abuse of discretion. We disagree with this

argument. We agree that either a mistake as to a material fact or a failure to state a

material fact is a ground for cancellation. See Rev. Proc. 96-53, sec. 11.06(1);

Rev. Proc. 2004-40, sec. 10.06(1).

      The revenue procedures do not explain what constitutes a misrepresentation.

Merriam-Webster’s Collegiate Dictionary 794 (2003) defines “misrepresent” as

“to give a false or misleading representation of usually with an intent to deceive or

be unfair”. Black’s Law Dictionary 1152 (10th ed. 2014) defines

“misrepresentation” as “[t]he act or an instance of making a false or misleading

assertion about something, usually with the intent to deceive”. Throughout the
                                        -159-

[*159] APA process petitioner had one position regarding the TPMs of the

covered transactions and it provided information to support this position.

Respondent had ample opportunities to question petitioner’s position, come up

with respondent’s own position, or reject petitioner’s position and not agree to the

APAs. Cancellation of an APA is a rare occurrence and should be done only when

there are valid reasons that are consistent with the revenue procedures. We

conclude that a misrepresentation has to be false or misleading, usually with the

intent to deceive, and relate to the terms of the APA.

      We do not believe that a different viewpoint is the same as a

misrepresentation. For example, respondent contends that petitioner’s system

profit analysis was based on an incorrect transfer price and constructed revenues,

instead of actual revenues. Respondent further contends that there might have

been no APA or a different APA if the actual profit split had been disclosed. The

APA negotiations and the terms of the actual APAs made it clear that the TPM

was being based on a constructed income statement. Petitioners explained what

was included in a constructed income statement and why it was needed.

      Looking at the nine areas addressed in detail above in terms of

misrepresentations, mistakes as to a material fact, or failures to state a material

fact, we conclude that none of these nine areas addressed during the APA
                                       -160-

[*160] negotiations was a ground for cancellation. Petitioner’s evidence that it

answered all questions asked and turned over all requested material is

uncontradicted.

      Respondent now contends that more information was needed, such as

information pertaining to the southbound transactions, which were not covered

transactions. The negotiation process for these APAs was long and thorough.

Either party could have walked away at any time. Several areas of concern were

addressed in both APA negotiations. Members of both the APA I and APA II

teams raised concerns about the Island plants not being the tested party. There

were others who thought the proposed CUP method was appropriate. Each APA

team held its own deliberation and came to substantially the same conclusion

regarding the transfer of tangible property. More importantly, both APA teams

discussed an alternative method, using the Island plants as the tested party for

comparing profits. From testimony and evidence, it seems that the IRS was

considering that the CPM would be a better method. The section 482 adjustment

in the notice of deficiency, which was based on the Hatch report, relied on the

CPM with the Island plants as the tested party. Respondent’s expert witness

Newlon testified that the CPM was the best method and that the Island plants

should be the tested party.
                                       -161-

[*161] There is no evidence that either APA team proposed to petitioner an

alternative TPM. However, there is evidence that members of both APA teams

had specific concerns with the TPMs agreed upon in the APAs. Respondent had

enough information after two separate APA negotiations to decide whether to

enter into an APA instead of rejecting petitioner’s proposed TPM for the transfer

of tangible property. During both negotiations the APA teams had enough

information to consider whether an alternative method, such as the CPM with the

Island plants as the tested party, would be a better TPM; yet two separate APA

teams accepted petitioner’s proposed TPM. On the basis of evidence we do not

see any additional material facts, mistakes of material facts, or misrepresentations

that would have resulted in a significantly different APA or no APA at all.

Respondent had enough material to decide not to agree to the APAs or to reject

petitioner’s proposed TPM and suggest another APA. Canceling the APAs on

grounds related to the APA negotiations was arbitrary. Respondent did not abide

by respondent’s own guidance.

      H.     APA Implementation

      A taxpayer must file an annual report for each taxable year covered by the

APA. See Rev. Proc. 96-53, sec. 11.01; Rev. Proc. 2004-40, sec. 10.01. The

annual reports are required to demonstrate the taxpayer’s compliance with the
                                        -162-

[*162] APAs. Rev. Proc. 96-53, sec. 11.01; Rev. Proc. 2004-40, sec. 10.01. An

APA may be canceled for lack of good faith compliance with the terms and

conditions of the APA. See Rev. Proc. 96-53, sec. 11.06(1); Rev. Proc. 2004-40,

sec. 10.06(1). According to the revenue procedure applicable to APA I, an APA

may be canceled if there was a misrepresentation, mistake as to a material fact, or

failure to state a material fact in connection with any subsequent submission,

including the annual reports. See Rev. Proc. 96-53, sec. 11.06(1). According to

the revenue procedure applicable to APA II, an APA may also be canceled

because of the failure to timely file an annual report. See Rev. Proc. 2004-40, sec.

10.06(1). Rev. Proc. 2004-40, sec. 10.06(1), also provides that with regard to

annual reports, the Associate Chief Counsel (International) will consider facts as

material if, for example, knowledge of the facts would have resulted in an

allocation of income, deductions, or credits materially different from that reported

in the annual report, or failure to meet a critical assumption. Id.

      The IRS will contact the taxpayer regarding an annual report if it is

necessary to clarify or complete the information contained in the annual report.

See Rev. Proc. 96-53, sec. 11.01(3); Rev. Proc. 2004-40, sec. 10.01(3). According

to the revenue procedure applicable to APA I, if the IRS examines a return for a

tax year covered by an APA, the IRS may require the taxpayer to establish that:
                                       -163-

[*163] (a) the taxpayer has complied in good faith with the terms and conditions

of the APA; (b) the material representations in the APA and the annual reports

remain valid and accurately describe the taxpayer’s operations; (c) the supporting

data and computations used to apply the TPM were correct in all material respects;

(d) the critical assumptions underlying the APA remain valid; and (e) the taxpayer

has consistently applied the TPM and met the critical assumptions. Rev. Proc. 96-

53, sec. 11.03(2), 1996-2 C.B. at 384. According to the revenue procedure that is

applicable to APA II, the IRS may require the taxpayer to establish: (a)

compliance with the APA’s terms and conditions; (b) validity and accuracy of the

annual report’s material representations; (c) correctness of the supporting data and

computations used to apply the TPM; (d) satisfaction of the critical assumptions;

and (e) consistent applications of the TPM. Rev. Proc. 2004-40, sec. 10.03(2),

2004-2 C.B. at 62. If a taxpayer does not meet the examination requirements of

the revenue procedures, the IRS may decide to enforce, revise, cancel, or revoke

the APA. See Rev. Proc. 96-53, sec. 11.03(3); Rev. Proc. 2004-40, sec. 10.03(3).

      Respondent contends that petitioner did not comply in good faith with the

terms and conditions of the APAs and failed to satisfy the annual report

requirements. Respondent further contends that after filing its Forms 1120,

petitioner made irreconcilable statements under penalties of perjury, materially
                                        -164-

[*164] misrepresented facts, and failed to disclose information necessary to

demonstrate compliance with its APAs. According to respondent petitioner also

violated a critical assumption set forth in its APAs. Petitioner argues that it did

not fail to comply with the terms and conditions of the APAs. Petitioner argues

that its implementation errors were all computational errors that did not warrant

cancellation and instead should have been allowed to be corrected.

      Petitioner made numerous errors in complying with its APAs. Petitioner’s

expert Anderson calculated that the errors in the aggregate overstated the transfer

price by 2.5% and 0.3% for 2005 and 2006, respectively. According to the

revenue procedures an APA may be canceled for a misrepresentation or mistake of

a material fact. See Rev. Proc. 96-53, sec. 11.06(1); Rev. Proc. 2004-40, sec.

10.06(1). In addition to looking at the errors in the aggregate, we will look at each

error individually.

             1.       Error in Supporting Data and Computations

      Petitioner’s 2005 and 2006 tax returns did not reflect the transfer price

computed under the APA TPM. An error affecting the APA multiplier caused the

transfer price recorded in Eaton’s books and records to be inconsistent with the

transfer price computed under the APA TPM.
                                        -165-

[*165] The VISTA systems did not record actual manufacturing costs. VISTA’s

standard cost needed to be adjusted for variances in order to determine actual

manufacturing costs. Petitioner made this adjustment by using the Island plants’

ledgers to derive a PVFF that reflected how each plant’s actual manufacturing

costs varied from its expected standard costs. Petitioner’s tax department made an

error by assuming that the standard costs in the Island plants’ ledgers and the

VISTA system were the same. In 2010 petitioner confirmed that the standard

costs in the Island plants’ ledgers were not the same as the VISTA standard costs.

Petitioner contends that this error was not a deliberate act but the result of

inadvertence.

      Petitioner contends that the APA multiplier was used after the TPM

computations had been done to incorporate the arm’s-length price into petitioner’s

books and records. Petitioner contends further that had the APA multiplier been

correct, there would have been no discrepancy between the transfer prices on

petitioner’s tax return and the APA reports. Petitioner categorizes this error as

related to “supporting data and computations” because it cannot affect the validity

of the TPM. This error affected the proper incorporation of the tax transfer price

into the distribution ledgers, which resulted in the wrong transfer price’s being

reported on petitioner’s tax returns.
                                        -166-

[*166] Respondent contends that petitioner filed its 2005 and 2006 Forms 1120

with non-APA-compliant transfer prices. Respondent further contends petitioner’s

EEI COGS (transfer price) was not in compliance with the APAs because it

resulted in a Berry ratio outside the range specified in the APAs.

      The tax transfer price is not recorded as a separate line on the tax return.

Petitioner’s U.S. tax returns include many ledgers, and the COGS on all the

ledgers are combined. Included in EEI’s COGS are the mirror ledgers that were

adjusted to incorporate the tax transfer price according the TPM provided for in

the APAs. Confirming that the tax transfer price was correctly reflected on the tax

returns could not be done by visually verifying a line on the tax return.

      When petitioner’s tax department first found this error, it did not appear to

warrant further investigation because it fit the pattern of well-known timing

differences between when a breaker product was sold from the Island plants to

EEI’s U.S. distribution, which was recorded on the mirror ledgers, and the

subsequent sale to a third party. Petitioner’s expert Anderson explained that the

tax department personnel mistakenly attributed discrepancies to normal features of

accounting when in fact there was an incorrect calculation of the PVFFs that was

discovered after thorough review.
                                       -167-

[*167] Anderson calculated that the change in the tax transfer price from the

original return to the amended returns was 5.1% and 4.9% lower for 2005 and

2006, respectively. She concluded that an overstatement of the tax transfer price

reported on the tax returns of 5% is minimal. Petitioner contends that an error is

not material if the impact was 5% or less.

      Respondent does not agree with petitioner that an error is not material if it

has a 5% or less impact. Respondent contends that petitioner relies upon a rule for

accounting purposes and that safe harbors for financial accounting purposes do not

create safe harbors for tax purposes. See All-Steel Equip., Inc. v. Commissioner,

54 T.C. 1749, 1755 (1970), aff’d in part, rev’d in part on other grounds, 467 F.2d.

1184 (7th Cir. 1972). In All-Steel Equip., Inc., the taxpayer argued that the

financial standards of accounting materiality should apply to its method of

inventory valuation for income tax purposes. Id. at 1751. The taxpayer valued its

inventory by the use of the prime cost method and contended that its method could

also be used for income tax purposes. Id. at 1753. We rejected the argument that

financial standards of accounting materiality should apply to Federal income tax

reporting. Id. at 1756.

      Petitioner argues that financial standards of accounting materiality should

apply to determine whether an error is material, not to determine the amount of tax
                                        -168-

[*168] owed. Petitioner completed income tax returns that corrected the errors

and is not disputing what it owes in tax.

      We do not think a 5% test should be used to determine whether petitioner’s

error warranted cancellation of the APAs. We instead use the applicable revenue

procedures. These revenue procedures do not provide a bright-line test on whether

an error is material on the basis of its size. However, the size of error may be

considered. We also need to look at how the error occurred. Anderson’s report

concluded that this error flowed from human error; incorrect data was used to

calculate the APA TPM. Petitioner discovered this error and attempted to rectify

it by filing amended tax returns and amended APA annual reports.

      The revenue procedure applicable to APA I states that the IRS may, upon

request, require the taxpayer to ensure that the supporting data and computations

were correct in all material respects. See Rev. Proc. 96-53, sec. 11.03. For

purposes of this section the revenue procedure does not define “material”.

However, for purposes of cancellation, it defines “material facts” as those that if

known would have resulted in a significantly different APA or no APA at all. See

id. sec. 11.06(1). Petitioner’s error pertains to supporting data and computations.

At the time of filing its APA annual reports, petitioner believed that the correct

data was used for calculating the PVFF. Petitioner was not trying to change how
                                         -169-

[*169] the TPM was calculated. We believe this was an inadvertent error that

should have been addressed through adjustments. See id. sec. 11.03(4). The error

did not change petitioner’s calculations or the data needed to perform those

calculations. Petitioner used a wrong number when calculating the PVFF, and that

was not a material mistake.

      The revenue procedure applicable to APA II states that the IRS may, upon

request, require the taxpayer to establish the correctness of the support data and

computations used to apply to the TPM. Rev. Proc. 2004-40, sec. 10.03(2). Our

analysis remains the same, and we conclude that this was an inadvertent error;

petitioner thought that it was using the right information. The error should have

been addressed through appropriate adjustments.

      Both revenue procedures allow for cancellation because of lack of good-

faith compliance with terms and conditions of the APA. See Rev. Proc. 96-53,

sec. 11.06(1); Rev. Proc. 2004-40, sec. 10.06(1). We do not think the PVFF

mistake qualifies as lack of good-faith compliance. These revenue procedures also

allow for cancellation if there is mistake as to a material fact or a

misrepresentation. See Rev. Proc. 96-53, sec. 11.06(1); Rev. Proc. 2004-40, sec.

10.06(1). We do not think the PVFF calculation mistake represented a mistake of
                                       -170-

[*170] a material fact or a misrepresentation. This error was not a ground for

canceling the APAs under an abuse of discretion standard.

             2.    Errors Affecting the Computation of the Transfer Price Under
                   the APA TPM

                   a.     OEM Categorization

      For purposes of the CUP method, petitioner used data from its VISTA

order-entry system to identify sales to third-party OEMs. In 2010 petitioner

determined that its subcode label merely identified customers who purchased

breaker products from more than one Eaton salesperson and that sales to OEMs

were also captured by other codes. To correct this error petitioner amended its tax

returns and APA annual reports for 2005 and 2006. Petitioner’s expert Anderson

concluded that this error, in isolation, resulted in a 0.69% and 0.82%

understatement of the transfer price for tax years 2005 and 2006, respectively.

This error resulted in no tax advantage.

                   b.     Purchase Resale Error

      EEI purchases and resells products other than Island plants’ manufactured

products. These products are not subject to the APAs because they are not Island

plants-produced breaker products. Prices, revenue, and SG&A expenses related to

these products should be excluded from the TPM analysis by excluding their
                                        -171-

[*171] associated “billing line” field from the IRS report. Petitioner’s tax

department personnel believed initially that the 2005-08 relevant billing line had

been correctly excluded from the IRS reports. In 2010 petitioner discovered that

the billing lines were not correctly excluded for 2005-06 and 2008.

      Petitioner addressed this error by re-running the IRS reports and excluding

the correct purchase resale billing lines. The Anderson report concluded that the

quantitative effect of this error was a 1.29% and a 2.02% overstatement of the

transfer price for tax years 2005 and 2006, respectively.

                    c.    Operating Expenses Associated With Breaker
                          Products Not Manufactured by the Island Plants

      This error relates to the purchase resale error. SG&A that was allocated to

EEI’s U.S. distribution included a portion for purchase resales. This error had an

effect only on 2006 because APA II had no minimum requirement for SG&A. For

2006 this error overstated the required returns to EEI’s U.S. distribution and

resulted in an understatement of the tax transfer price, resulting in no tax

advantage.

                    d.    International Sales Error

      Petitioner excluded certain international sales from the revenue reported on

the constructed income statement resulting in the transfer price’s being
                                       -172-

[*172] understated. Petitioner discovered and corrected this error in 2010 by

using VISTA data to capture international sales. The Anderson report concluded

that the effect of this error was a 0.97% and 0.62% understatement of the transfer

price for tax years 2005 and 2006, respectively, eliminating a tax advantage to

petitioner.

                   e.    Sales of Industrial Breakers Through Lincoln

      The Lincoln plant sold an industrial breaker product line, which included

both Island plants manufactured breaker products and Lincoln plant manufactured

breaker products. The APA covered only breaker products manufactured in the

Island plants. Petitioner did not include revenue from the industrial breaker

products line in the constructed income statement for 2005 because it could not

segregate reliably the Island plant manufactured breaker products and the Lincoln

plant manufactured products.

      Beginning in 2006 breaker products in the industrial breaker product line

were manufactured only in the Island plants. In 2006, therefore, it was possible to

identify the APA-covered sales of these products through the Lincoln plant.

However, these sales were not included in the APA computations because

petitioner’s tax department was not aware of the change. Petitioner discovered

and corrected the error in 2010. The Anderson report concluded that the
                                        -173-

[*173] effect of the error in isolation was a 0.19% overstatement of the transfer

price for 2006.

                   f.     Lincoln Multiplier Error

      Petitioner made an error in computing the Lincoln multiplier, which was

used to determine the Island plants’ standard costs for the breaker products sold

through the Lincoln plant “as is” to third parties. These sales could not be

identified at the product level from the IRS reports created with the VISTA data.

To determine the quantity of product that went through the Lincoln plant,

petitioner backed the internal management price out of the standard cost at the

Lincoln plant. Petitioner contends that there was an error due to a

misunderstanding of the Lincoln plant’s controller’s inputs. Petitioner discovered

and corrected the error in 2010. The Anderson report concluded there were

understatements of 1.96% and 2.22% for transfer prices for 2005 and 2006,

respectively. This error did not result in a tax advantage.

                   g.     Error in Computation of Manufacturing Costs for
                          Nonexact Matches

      The PVFF error previously discussed affected the computation of

manufacturing products costs for product categories used in the CUP
                                        -174-

[*174] computations for nonexact match products. Correcting the PVFF error

corrected this error.

      The PVFF adjustment to the Island plants’ standard product cost

incorporates product cost variances and freight costs to yield the actual

manufacturing cost. The Anderson report concluded that the quantitative effect of

this error in isolation was a 0.03% understatement of the transfer price for 2005

and a 0.03% overstatement of the transfer price for 2006. This error resulted in no

tax advantage for 2005.

                    h.    Analysis of Errors Affecting the Computation of
                          the Transfer Price Under the APA TPM

      For an APA to be canceled because of an implementation error, there must

have existed a misrepresentation, a mistake as to a material fact, a failure to state a

material fact, or a lack of good-faith compliance with the terms and conditions of

the APA. See Rev. Proc. 96-53, sec. 11.06(1); Rev. Proc. 2004-40, sec. 10.06(1).

For APA II the failure of a critical assumption is also a reason for cancellation.

See Rev. Proc. 2004-40, sec. 10.06(1). The revenue procedures do not specifically

address data or computational errors.

      Petitioner contends that the decision to cancel the APAs on the basis of

implementation errors must be considered in the context of the applicable revenue
                                       -175-

[*175] procedures’ sections on administering the APA. Petitioner interprets the

revenue procedures in a manner which provides a major and clear dividing line for

what type of action the IRS is permitted to take. Petitioner’s interpretation asks

whether “the taxpayer’s compliance failure affect the validity of the transfer

pricing methodology selected or not”. Petitioner further argues that when the

taxpayer’s compliance encroaches upon this dividing line, the remedies are more

serious, including revision, revocation, or cancellation of the APA. When the

taxpayer’s compliance does not encroach upon this dividing line, such as data or

computational errors that can be corrected without affecting the selection of the

TPM, the errors should simply be corrected with an adjustment on audit.

      Respondent contends that petitioner admits failing to report the correct

transfer price on its Forms 1120, as well as seven other APA compliance failures,

which petitioner labels data or computational errors that do not implicate the APA

TPM itself. Respondent disagrees with petitioner’s labeling these errors data and

computational. Respondent also disagrees with petitioner’s interpretation that

there is a dividing line between data or computational errors and a compliance

failure which affects the validity of the TPM selected.

      All of petitioner’s seven errors were computational or related to

inadvertence, and all were corrected in the amended APA annual reports. These
                                       -176-

[*176] errors were not deliberate. The errors were discovered only because

petitioner did a comprehensive review after determining that its first error was not

an anomaly caused by interim calculations. Without petitioner’s reporting its

errors, they would not have been discovered.

      We do not agree with petitioner’s interpretation that the revenue procedures

provide a dividing line regarding the type of error and what type of action should

be taken. Each error needs to be analyzed to determine whether it is material. The

revenue procedures require, upon examination, that the taxpayer may be required

to show supporting data and computations; and if this does not occur, the

Associate Chief Counsel (International) may decide to enforce, revise, cancel, or

revoke the APA consistent with the revenue procedures. See Rev. Proc. 96-53,

sec. 11.03(2) and (3); Rev. Proc. 2004-40, sec. 10.03(2) and (3). Respondent’s

cancellation letter stated: “The material deficiencies in 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”.

      The revenue procedures allow cancellation for a misrepresentation, a

mistake as to material fact, or a lack of good faith compliance with regard to the

APA annual reports. See Rev. Proc. 96-53, sec. 11.06(1); Rev. Proc. 2004-40, sec.
                                       -177-

[*177] 10.06(1). All seven of the above errors were adjustments that were made

on petitioner’s amended APA annual reports. The Anderson analysis showed that

some of petitioner’s errors raised the transfer price and others lowered it. She

concluded that four of the seven errors lowered the transfer price and were not in

favor of petitioner. Her analysis looked at the difference between the originally

submitted tax transfer price and the amended tax transfer price on the annual

reports. She looked at all seven errors above and the APA multiplier error

described previously and testified that some of the errors interacted with other

errors. In her report Anderson concluded that

       the unpredictable effects of several of the errors diffuse
      responsibility for maintaining several data bases and associated
      information systems, and the separation of duties for maintenance and
      data use suggested that it would be very difficult to orchestrate an
      error that would consistently lower Eaton Breaker and Control
      Products’ overall tax liability in the United States.

      Material facts are those that would have resulted in a significantly different

APA, see Rev. Proc. 2004-40, sec. 10.06, or no APA at all, see Rev. Proc. 96-53,

sec. 11.06. Pursuant to the revenue procedure applicable to APA II, facts are

material if, for example, knowledge of the facts would have resulted in a

materially different allocation of income, deductions, or credits than reported in

the annual reports or failure to meet a critical assumption. Rev. Proc. 2004-40,
                                        -178-

[*178] sec. 10.06(1). We conclude that although petitioner made these seven

errors, they were not material.

      In Buzzetta Constr. Corp. v. Commissioner, 92 T.C. at 641, we held that the

Commissioner did not abuse his discretion in retroactively revoking a profit

sharing plan’s favorable ruling. In Buzzetta the taxpayers contended that their

overfunding and excess deductions were offset in later years and their operational

errors were voluntarily corrected. Id. at 650. We concluded that “the operational

errors in the instant case were a material change in the facts on which the plan’s

favorable ruling was based”. Id. at 653. The data and computational errors in this

instant case are different. These errors did not constitute a material change in the

facts on which the decision to enter the APA was based. These errors did not

change the transfer pricing methodology or the factors that were considered during

the APA deliberations.

      The errors resulted in a difference in the transfer price, but some of the

errors in isolation were not in petitioner’s favor. These errors were inadvertent

and were not deliberate attempts to alter the underlying TPM. These errors would

not have resulted in a significantly or materially different APA. We conclude that

there was good-faith compliance with terms of the APAs.
                                        -179-

[*179] In addition to analyzing the errors individually to determine whether they

merited cancellation of the APAs, we analyze the errors in the aggregate. As we

discussed above, there is one error which caused the wrong transfer price to flow

into Eaton’s tax returns. All the errors affected computation of the tax transfer

price under the APA TPM. Petitioner’s expert Anderson’s report shows that errors

in the aggregate increase the transfer price by 2.5% ,0.3% , 3.5%, and -0.9% for

2005-08, respectively. A higher transfer price benefits petitioner by reducing

taxable income. Conversely, a lower transfer price is not beneficial to petitioner

because it increases taxable income.

      Even though petitioner’s errors are numerous when they are considered in

the aggregate, it is not enough to conclude that the aggregate of the errors resulted

in a mistake as to a material fact, a lack of good faith or compliance, or failure to

meet a critical assumption. The errors in the aggregate did not consistently favor

petitioner, and the error amounts were inconsistent. If the errors in the aggregate

consistently favored petitioner by the same percentage, we would be more

concerned about the impact of the errors and whether petitioner committed a

misrepresentation. We conclude that the errors in the aggregate do not merit

cancellation of the APAs.
                                        -180-

[*180]       3.     Compliance With the Terms of the APAs

                    a.    Book-Tax Differences and Compensating
                          Adjustments

      Petitioner closed its accounting books at the end of the calendar year using

preliminary APA TPM computations and performed a true-up upon completion of

the APA TPM computations. Petitioner reported this true-up on its Schedules M

as a book-tax difference. Petitioner contends that it did not report this true-up in

its annual APA reports because this change did not affect its computation of the

APA TPM. Petitioner further contends that the difference between the estimated

transfer price and the final transfer price did not affect the computation of the

transfer price. Petitioner did disclose book-tax differences in its APA reports

when those differences affected the TPM.

      Respondent argues that the book-tax differences between the preliminary

and final APA TPM computations should have been part of the APA reports.

Respondent further argues that if this information had been included in the APA

reports, respondent would have noticed that petitioner had failed to report the

correct transfer price on its timely filed income tax returns. Respondent did,

however, have the information relating to the book-tax differences on the

Schedules M.
                                        -181-

[*181] Additionally, respondent contends that petitioner failed to disclose the

compensating adjustment made to its true-up that petitioner performed between

the estimated transfer price it booked at yearend and the final transfer price it

computed a few months later. Petitioner did disclose this information on its

Schedules M. The IRS routinely examined the Schedules M as part of its regular

audit. Two years before the execution of APA II the IRS audit team asked for an

explanation on this issue. Respondent did not ask petitioner to amend its annual

reports to include the reporting of the book-tax difference.

                    b.    Forms 1120 and Compliance With the APA

      Respondent contends that in all of its APA requests petitioner represented

that under the proposed TPM EEI would receive guaranteed a profit for its

distribution activities. Respondent further contends that the constructed income

statements in petitioner’s 2005 and 2006 annual reports reflect operating profits

sufficient to satisfy the Berry ratio requirements of the APAs. Respondent

contends that the operating profits reflected on the constructed income statement

were not captured within petitioner’s financial accounting ledgers and systems

used to prepare its Forms 1120, resulting in the Berry ratio profit from the

constructed income statements not being reported on its 2005 or 2006 Form 1120.
                                         -182-

[*182] Petitioner disagrees with respondent’s argument. Petitioner contends its

books and records are not organized in a way that isolates the profitability of the

U.S. distribution functions. The U.S. distribution function’s profitability, as

defined for purposes of the APA TPM, is not tracked on one specific ledger

because EEI’s U.S. distribution, which was the tested party in both APAs,

represented a function within EEI that sold and distributed breaker products

purchased from the Island plants. There was not a line item on petitioner’s tax

return that would have provided the information necessary to evaluate whether

Eaton complied with the Berry ratio. A constructed income statement was needed

to test the U.S. distribution function’s profitability under the Berry ratio.

Petitioner’s expert Anderson’s report showed that petitioner’s books and records

can be reconciled to produce the same profit that is shown on the constructive

income statement.

      EEI’s U.S. distribution profitability, as computed on the constructed income

statement, was part of EEI’s overall financial performance and therefore was

included with the income on Eaton’s Forms 1120. The amount of income

attributable to U.S. distribution’s third-party sales could not be isolated on any

ledger or group of ledgers. The computations done on the constructed income

statement were done to show that EEI retained a portion of third-party revenue
                                       -183-

[*183] that was equal to U.S. distribution function’s associated SG&A plus the

Berry ratio return.

      The constructed income statement also included computations on the

profitability of EEI’s U.S. distribution’s sales to U.S. assembly. The CUP

adjustment in the APA TPM treated EEI’s U.S. distribution as receiving a set

amount of arm’s-length sales revenue. This was a constructed amount computed

under the APA TPM’s CUP method by reference to prices that third parties paid

for the same products. EEI’s distribution function did not actually receive this set

amount in cash for selling breaker products to U.S. assembly. EEI did not receive

cash attributable to these products until after U.S. assembly incorporated them into

larger assembled products and sold them to third parties. The success or lack of

success of EEI’s U.S. assembly function in selling these assembled products did

not have an impact on what comparable third parties would have paid to purchase

the breaker products. The set amount derived from the APA TPM’s calculation is

not an actual amount of sales revenue. It is a proxy that U.S. assembly would have

paid to a third party at arm’s length to purchase breaker products, the amount of

which cannot be found on petitioner’s ledgers. Rather, EEI’s U.S. distribution

ledgers include the amount of revenue U.S. assembly received from selling its

assembled products to third parties.
                                        -184-

[*184] Respondent contends that petitioner “rolled up” to its Forms 1120

substantial operating losses for EEI’s distribution of breaker products as reflected

on mirror ledgers. Respondent contends that the interunit transfer of breaker

products always generates losses that are recorded on the mirror ledgers, which

later roll up to petitioner’s Forms 1120. Petitioner contends that respondent’s

interpretation of how the mirror ledgers works is incorrect.

      Petitioner’s expert Anderson explained that internal transactions are

eliminated and do not affect the consolidated tax return. For example, a $100 loss

recorded on the mirror ledgers generated from EEI’s U.S. distribution sales to U.S.

assembly would not result in a $100 loss on petitioner’s tax return. The $100 loss

is an internal loss that is eliminated upon consolidation--the “rolling up” of all

ledgers into one consolidated ledger. The internal losses recorded on the mirror

ledgers had no independent financial or economic significance. The amount of

profits or losses recorded on the mirror ledgers made no difference on petitioner’s

tax return.

                    c.    Canadian Adjustment

      Respondent contends that the Canadian adjustment was not allowed under

the APAs. Respondent further contends that petitioner’s annual adjustment to

EEI’s U.S. distribution international sales revenue was a postyear adjustment of
                                        -185-

[*185] EEI’s U.S. distribution sale of breaker products to Eaton Yale designed to

make Eaton Yale sales meet a higher benchmark level of profitability. Respondent

contends that Eaton’s addition of this adjustment to increase revenues on its

constructed income statement, which resulted in an increase in the transfer price

under the APAs, was contrary to the APAs.

      Petitioner contends that it was not an error for it to use sales revenue based

on the arm’s-length price for international sales to its Canadian affiliate on the

constructed income statement. The IRS questioned this adjustment in relation to

petitioner’s 2001 and 2002 APA annual reports. Respondent issued a notice of

proposed adjustment, and petitioner agreed to it. These were compensating

adjustments to the APA, which took into account the compensating adjustment to

the prices for sales to Eaton Yale.

      Respondent was aware of this issue and accepted compensating adjustments

pertaining to this issue. If respondent thought this violated the APA, this issue

should have been addressed back in 2004, or at least as part of the APA II

negotiations. We do not believe the Canadian adjustment is a ground for

cancellation.
                                       -186-

[*186]               d.   VISTA Data

      Respondent contends that petitioner failed to preserve its original VISTA

records that were necessary to demonstrate its compliance with the APA TPM.

Respondent contends that the Format1 files generated by petitioner’s mainframe

computer and job logs, which document critical information about the creation of

the Format1 files and were necessary to verify the authenticity of Eaton’s TPM

calculations, were not retained.

      Petitioner contends that the Format1 file is merely a work file that never

leaves the main frame. The primary source of VISTA data for the IRS report was

the MRSB, which is retained. The IRS report provided to petitioner’s tax

department was the Format3 file. Petitioner contends that it was under no

obligation to maintain the VISTA job logs, which were not used in the transfer

pricing computations. All master file data relevant to a transaction was retained in

the invoice files.

      Respondent’s expert John Garvey re-created the IRS reports using the

MRSB reports. He reviewed petitioner’s IRS report, which was then given to

KPMG, and KPMG generated a report which contained the underlying financial

data for the annual reports. Garvey noticed discrepancies between the KPMG

report and petitioner’s IRS report. For 2005 and 2006 he replicated the steps taken
                                        -187-

[*187] by petitioner to create the IRS reports using the MRSB extracts to produce

an IRS report substantially equivalent to petitioner’s IRS report. He concluded the

difference in his re-creation of petitioner’s IRS reports for 2005 and 2006 was

insignificant.

                     e.    Analysis of Compliance

         Respondent contends there was lack of compliance with the terms of the

APAs in the following areas: (1) book-tax differences; (2) Forms 1120 and

compliance with the APAs; (3) Canadian adjustment; and (4) VISTA data.

Petitioner contends that it was in compliance with the terms of the APAs in these

areas.

         Regarding book-tax differences and the Canadian adjustment, respondent

was aware of the information on these areas, which had arisen in the audit of

earlier APA years. If these areas created significant problems, the IRS should

have, during its audit, brought these issue to the attention of the Associate Chief

Counsel (International). See Rev. Proc. 96-53, sec. 11.03(2) and (3); Rev. Proc.

2004-40, sec. 10.03(2) and (3). Regarding the Forms 1120, except for the errors

that petitioner tried to correct, we conclude that petitioner was in compliance with

the terms of the APA. We agree with petitioner that the APAs apply to EEI’s U.S.

distribution and not all of EEI and therefore the Berry ratio was appropriately
                                       -188-

[*188] applied only to the profitability of EEI’s U.S. distribution. Regarding the

VISTA data, we conclude that petitioner retained enough information to meet the

retention requirements of the APAs. See Rev. Proc. 96-53, sec. 11.04(1), (3),

1996-2 C.B. at 384; Rev. Proc. 2004-40, sec. 10.04(1), 2004-2 C.B. at 62. We

conclude that these four areas are not grounds for cancellation.

             4.    Critical Assumptions

      The December 16, 2011, cancellation letter included the “failure of a critical

assumption” as one of the grounds for cancellation. The cancellation letter did not

explain what specific critical assumption petitioner had failed. Appendix B of

APA I included five critical assumptions and Appendix B of APA II included one

critical assumption.

      Respondent contends that petitioner’s correction of its PVFF and its change

regarding international sales revenue are examples of some of petitioner’s critical

assumption violations. In particular respondent contends that petitioner ignored

the critical assumption which pertains to its methods of estimation. This text

appears only in the critical assumption in APA II which states that “financial and

tax accounting methods and classification (and methods of estimation) of

Taxpayer in relation to the Covered Transaction will remain materially the same as
                                        -189-

[*189] described or used in Taxpayers APA Request”. The first critical

assumption in APA I is similar but does not include “and methods of estimation”.

      Petitioner contends that it did not fail any critical assumptions. Petitioner

contends that the APA II critical assumption refers to financial and tax accounting

methods and classifications of the taxpayer and does not refer to the classification

or description of products sold by the taxpayer.

      Under the revenue procedure that governs APA II, an APA can be canceled

because of the failure of a critical assumption. Rev. Proc. 2004-40, sec. 10.06(1).

For purposes of annual reports, a material fact is a fact the knowledge of which

would have resulted in the failure to meet a critical assumption. See id. We

disagree with respondent that these errors pertained to a material fact. We do not

believe a critical assumption was violated.

             5.    Amended APA II Annual Reports

      Under Rev. Proc. 2004-40, sec. 10.01(5), a taxpayer must, within 45 days of

becoming aware of incomplete or incorrect information, or an incorrect application

of the TPM, amend its annual report. The revenue procedure allows time to be

extended for good cause. Id. Failure to file the annual report is grounds for

canceling the APA. Id. sec. 10.01(1).
                                        -190-

[*190] Respondent contends that petitioner did not amend its annual reports

within the prescribed 45 days. In April 2010 petitioner informed the APA

program of the discovery of alleged errors. Petitioner did not submit an

amendment to its 2006 APA annual report until October 14, 2010, well past the

45-day deadline. Respondent contends that petitioner’s failure to timely file its

amendment to the 2006-08 annual reports is grounds for cancellation of APA II.

Respondent contends that the errors were known to petitioner in May 2009.

      Petitioner argues that to consider the amended APA annual reports as

untimely is unjustified because of the communications between petitioner and the

APA program. After petitioner informed the APA program of its errors, the

parties had a meeting on July 1, 2010, and petitioner followed up that meeting

with a letter. The letter explained the complexities in identifying the VISTA data

issues and petitioner’s ongoing efforts, including the details of the time-

consuming process. On September 8, 2010, the APA director sent petitioners a

letter, indicating that the APA program did not request that petitioner submit

amended APA annual reports. The letter explained that there appeared to be

unilateral modifications to petitioner’s APA TPMs and that these types of

modifications should not occur in APA annual reports or income tax returns
                                        -191-

[*191] because that would violate the APAs. The letter further explained that if

petitioner wished to modify its TPMs, it should request a revision to its APAs.

      The record establishes that petitioner filed amended APA annual reports as

soon it had the corrected information. It is unclear when the 45 days for

submitting the amended reports should have started. Under Rev. Proc. 2004-40,

sec. 10.01(5), a taxpayer must amend its report when it becomes aware of the need

to amend the report. The APA annual reports are not supposed to include

incomplete or incorrect information. It is unclear whether the APA program did

not want amended annual reports within a certain timeframe or that the APA

program believed that amended annual reports were not the appropriate solution

for correcting the errors. Between the notification of the errors and the filing of

amended annual reports, there were several communications between petitioner

and the APA program. None of these communications mentioned a 45-day

deadline for the amended reports. Petitioner contends that respondent was aware

that petitioner was working on correcting the errors and would consequently file

amended APA annual reports.

      The letter canceling the APAs states that the cancellations were “based on

numerous grounds”. The letter includes some of the grounds, but failure to timely

file an amended APA annual report is not mentioned. It is not clear from the facts
                                        -192-

[*192] whether there was an implied extension for submitting the annual reports.

Rev. Proc. 2004-40, sec. 10.01(1), states only that “[f]ailure to timely file the

annual report is grounds for canceling the APA”; it does not specify consequences

when an amended annual report is filed late. We conclude that petitioner’s

submission of the amended 2006 annual report on October 14, 2010 was not a

ground for canceling APA II.

      I.     Conclusion

      We conclude that it was an abuse of discretion for respondent to cancel

APA I for tax year 2005 and APA II for tax year 2006. Since the concept of doing

an APA was first discussed, petitioner had advocated the CUP method in

combination with the CPM to test the profits with EEI’s U.S. distribution as the

tested party. All of petitioner’s submissions to the IRS and APA teams supported

this TPM. Petitioner withdrew its APA III request because of concerns that the

methodology applied in APA I and APA II would not be a starting point.

Respondent had many opportunities not to agree to APA I and APA II. During the

APA I and APA II negotiations respondent never suggested a different TPM as an

alternative, even though some on the APA teams thought another method would

be a better method.
                                        -193-

[*193] Respondent entered into not one, but two APAs. Respondent had an

opportunity not to renew APA I and enter into APA II if respondent wanted to

change the TPMs. APA II provided an opportunity to look at the agreement de

novo. After completing the APA II negotiations, respondent should have had a

clear understanding of petitioner’s transactions and should not have entered into

APA II if the APA II team was concerned that petitioner was omitting or

misrepresenting information.

      Petitioner made immaterial and inadvertent errors that do not fit the APA

governing revenue procedures’ definition of “material”. Respondent should not

be able to use these errors as grounds for switching to a TPM that was

contemplated during the APA I and APA II negotiations.

      An APA is a binding agreement and it should be canceled only according to

the terms of the revenue procedures. It should not be canceled because of a desire

to change the underlying methodology of a method that would result in a

significantly different profit split. For these reasons the cancellation of the APAs

was arbitrary and unreasonable. We do not sustain respondent’s determination to

cancel APA I and APA II.
                                        -194-

[*194] II.   Transfer of Intangibles

      The notice of deficiency makes an alternative allocation under section

367(d) that may apply if we do not sustain respondent’s cancellation of the APAs

or respondent’s section 482 allocations in their entirety. The notice of deficiency

states alternatively “that such value transferred (exclusive of tangible assets

transferred) is taxable under IRC section 367(d). The notice of the taxable income

of Eaton Corporation and its U.S. subsidiaries is increased in an amount not to

exceed $230,630,598 for 2006.”

      Section 367(a) provides general rules for the taxation of outbound transfers

of property by U.S. persons to foreign corporation transferees in transactions that

would otherwise qualify as nonrecognition transfers, such as section 351 transfers.

There are exceptions to this rule, and section 367(d) provides special rules for the

taxation of outbound transfers of intangible property. Temporary regulations

provide guidance on how the transferor should take into income an amount that

represents an appropriate arm’s-length charge for the use of the transferred

property. See sec. 1.367(d)-1T(c)(1)(a), Temporary Income Tax Regs., 51 Fed.

Reg. 17954 (May 16, 1986).16 Section 367(d) applies “if a United States person

      16
        On December 16, 2016, the Secretary of the Treasury promulgated final
regulations relating to certain transfers of property by U.S. persons to foreign
                                                                        (continued...)
                                         -195-

[*195] transfers any intangible property (within the meaning of section

936(h)(3)(B)) to a foreign corporation in an exchange described in section 351 or

361”. Sec. 367(d)(1).

      Intangible property subject to section 367(d) is defined in section

936(h)(3)(B) as follows:

      (i)     patent, invention, formula, process, design, pattern, or know-how;

      (ii)    copyright, literary, musical, or artistic composition;

      (iii)   trademark, trade name, or brand name;

      (iv)    franchise, license, or contract;

      (v)     method, program, system, procedure, campaign, survey, study,
              forecast, estimate, customer list, or technical data;

              or

      (vi)    any similar item, which has substantial value independent
              of the services of any individual.

      Respondent contends that if we find in favor of petitioner on either the

cancellation of the APAs or its transfer pricing methodology, then we should find

as a logical corollary that EEPR transferred to CHC and CHEC intangible property


      16
         (...continued)
corporations in nonrecognition transactions described in sec. 367(d). 81 Fed. Reg.
91012 (Dec. 16, 2016). These regulations do not apply for the tax years at issue.
Id. at 91020.
                                        -196-

[*196] with an arm’s-length price not to exceed $3.2 billion as of January 1, 2006,

which is taxable under section 367(d). Respondent further contends that “[t]he

value of the intangibles transferred is logically and mathematically dependent on

the pricing of the transactions between * * * [CHC and CHEC] and EEI under

section 482.”

        Respondent’s position is that CHC and CHEC must be entitled to a

nonroutine return attributable to intangibles if we determine that respondent’s

cancellation of the APAs was an abuse of discretion, or if we determine that

respondent’s cancellation was not an abuse of discretion but we do not sustain

respondent’s section 482 adjustments. Respondent contends this implication leads

to the result that CHC and CHEC must have owned significant intangibles,

justifying the nonroutine return allocable to each of them, and these intangibles, in

turn, must have been transferred to CHC and CHEC during the 2000-06

restructuring. This argument seems to be based on the premise that if we do not

agree with respondent’s section 482 allocations, we must agree that intangibles

were transferred. The gist of respondent’s argument is that CHC and CHEC could

not possibly be as profitable as they are unless intangibles were transferred to

them.
                                       -197-

[*197] From the late 1960s and mid-1970s, breaker products were being made in

Puerto Rico. Before the 2000 transfer of assets, EEPR actively manufactured

breaker products. All of the tangible assets necessary to conduct EEPR’s

businesses were in Puerto Rico. As part of the transfer EEPR transferred assets to

CHC and CHEC in section 351 transactions. Employees were also transferred as

part of the tangible asset agreements. For each tangible asset transfer CHI/EEI

licensed certain intangible property related to the transferred assets to CHC or

CHEC. These licenses covered brand and manufacturing intangibles. The license

agreements did not transfer any intangible assets.

      Petitioner contends that respondent is arguing for a “per se rule” that if

CHEC and CHC are entitled to nonroutine returns, the returns must be attributable

to intangibles within the meaning of section 936(h)(3)(B). Petitioner further

contends that the only section 936(h)(3)(B) intangibles CHEC and CHC had were

pursuant to licensing agreements. Petitioner did indicate on some of its Forms 926

that intangible property within the meaning of section 936(h)(3)(B) was

transferred pursuant to the transactions; but the accompanying statements

explained that there was a licensing agreement covering these intangibles.

      Respondent did not specifically identify any intangible or explain the exact

value of any intangibles that should be covered by section 367(d). Before the
                                       -198-

[*198] restructuring EEPR had access to intangibles, and they continued to have

access through the licenses. On the record before us we do not conclude that

intangibles were transferred that should be subject to section 367(d).

III.   Tractech Bonuses

       Generally, the Commissioner’s determinations in a notice of deficiency are

presumed correct, and the taxpayer bears the burden of proving that those

determinations are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111,

115 (1933). In the relationship between deductions and capital expenditures, the

taxpayer bears the burden of showing the right to a claimed deduction.

INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); sec. 1.6001-1(a),

Income Tax Regs.

       Section 162(a)(1) allows a taxpayer to deduct “ordinary and necessary

expenses”, including a “reasonable allowance for salaries or other compensation

for personal services actually rendered”. Compensation is deductible only if it is

reasonable in amount and paid or incurred for services actually rendered. See sec.

1.162-7(a), Income Tax Regs. Bonuses paid to employees are deductible “when *

* * made in good faith and as additional compensation for the services actually

rendered by the employees, provided such payments, when added to the stipulated
                                        -199-

[*199] salaries, do not exceed reasonable compensation for the services rendered.”

Sec. 1.162-9, Income Tax Regs.

      Section 263 generally prohibits deductions for capital expenditures. Capital

expenditures are not “ordinary” expenses and are therefore not deductible. Sec.

263(a); Commissioner v. Lincoln Sav. & Loan Ass’n, 403 U.S. 345, 353 (1971).

Nondeductible capital expenditures include “Any amount paid out * * * for

permanent improvements or betterments made to increase the value of any

property”. Sec. 263(a).

      In 2003 the Secretary promulgated regulations addressing the capitalization

of transaction expenses related to acquisitions. See T.D. 9107, 2004-1 C.B. (Part

1) 447. Under those regulations a taxpayer must capitalize amounts paid to

facilitate an acquisition of ownership interest in a business entity if, immediately

after the acquisition, the taxpayer and the business entity are related within the

meaning of section 267(b). Sec. 1.263(a)-5(a)(2), Income Tax Regs. Employee

compensation (including salary, bonuses, and commissions) is treated as an

amount that does not facilitate an acquisition. Id. para. (d)(1) and (2)(i).

      In section 1.263(a)-5(l), Example (7), Income Tax Regs. (Example (7)), R

corporation acquired all of the stock of T corporation. Before the acquisition,

certain employees of T held unexercised options issued pursuant to T’s stock
                                       -200-

[*200] option plan. As a condition of the acquisition, T was required to terminate

its stock option plan. T agreed to pay its employees holding unexercised options

certain amounts in consideration of their agreement to cancel their unexercised

options. These options granted the employees the right to purchase T stock at a

fixed option price. Id. T was not required to capitalize the amounts paid to its

employees. Id.

      We must determine whether the bonus payments represent additional

compensation for services. Petitioner contends that it is entitled to a deduction

under section 162(a) for the bonus amounts paid to the bonus executives because

the bonus payments are compensation. Respondent contends that petitioner’s

expenses should have been capitalized under section 263.

      Petitioner contends that the bonus amounts were additional compensation

for services the bonus executives performed. The bonus agreements specified that

upon completion of petitioner’s acquisition of Tractech, the bonus executives

could receive cash in exchange for their release of claims related to any stock

options. The bonus agreements and the SPA are silent as to the nature of the

bonus amounts. Petitioner contends that the bonus amounts were paid in

cancellation of employee stock options and should receive treatment similar to that

of the taxpayer in Example (7). Petitioner contends that its bonus payments are
                                        -201-

[*201] deductible expenses regardless of whether Tractech had adopted a stock

option plan because Example (7) imposes no requirement that stock option grants

be reduced to writing. Respondent contends the bonuses did not serve to

extinguish any preexisting obligation to compensate the Tractech executives.

      On or before August 16, 2005, Tractech planned to give the bonus

executives stock option grants, but a stock option plan was never adopted and

approved by Tractech’s board of directors. There was no evidence of a fixed price

to purchase the stock options. Instead, Tractech resolved to enter into agreements

with the bonus executives to provide them with cash bonuses in exchange for their

release of any claims related to any stock options. The amounts paid to the

employees in Example (7) are different from the bonuses paid to the Tractech

executives because there was no fixed option price. The regulations do not

specifically require that the stock options have a fixed price.

      We do not need to rely on Example (7) to decide whether the bonuses

should be deductible because the bonuses do not need to be stock options to be

compensation. Even though it is unclear what specific services the employees

performed to earn the bonuses, there is evidence that the bonus executives were

employees at the time they entered into the bonus agreements. The bonus

executives were employees and were entitled to bonuses paid by the employer.
                                       -202-

[*202] Amounts paid to facilitate the acquisition of capital do not include

employee bonuses. See sec. 1.263(a)-5(d)(1), Income Tax Regs. Respondent

does not dispute that the compensation was reasonable. We conclude that the

bonus payments are deductible under section 162(a).

      Any contentions we have not addressed are irrelevant, moot, or meritless.


                                               Decision will be entered

                                       under Rule 155.
