Reasonable Cause Defense for Penalty Waives Privilege

In Eaton Corporation & Subsidiaries v. Commissioner, the U.S. Tax Court concluded that raising the reasonable cause/good faith defense to tax penalties waived the work product, attorney-client, and federal tax practitioner privileges. This is a serious issue that has to be considered when submitting penalty abatement requests based on a reasonable cause defense.

APA (Advance Pricing Agreements) 

Eaton had entered into Advance Pricing Agreements (“APAs”) for tax years 2001-2005. APAs are voluntary agreements that taxpayers and the IRS enter into to agree to the best transfer pricing method to be used for controlled transactions, as in the case of a U.S. parent entity and one or more of its wholly owned foreign subsidiaries. The goal of APAs is to resolve transfer pricing issues in a cooperative manner without the need for litigation. APAs are generally binding on the IRS and the taxpayer; however, the IRS can revoke an APA if there was a misrepresentation, mistake as to a material fact, failure to state a material fact, or lack of good faith in compliance with the terms and conditions of the APA.

In Eaton, the IRS conducted an audit and requested various documents prepared during the time leading up to the execution of the APAs, including emails, memorandums, and data exchanged between Eaton and its outside tax attorneys. Eaton refused to turn over the records, asserting that they were protected by the work product, attorney-client, and federal tax practitioner privileges. The IRS then concluded that Eaton did not comply with the terms and conditions of the APA. The IRS adjusted Eaton’s income for the transactions and imposed accuracy related penalties. Eaton filed a petition to ask the U.S. Tax Court to consider the issue. Eaton raised the reasonable cause/good faith defense for the penalties in its petition.

The U.S Tax Court Conclusion 

On review, the U.S. Tax Court noted that raising the reasonable cause/good faith defense to the penalties “puts into contention the subjective intent and state of mind of those who acted for petitioner and petitioner’s good-faith efforts to comply with the tax law.” The U.S. Tax Court concluded that it would be unfair to deprive the IRS of knowledge of the legal and tax advice that petitioner received in the course of requesting and negotiating the APA and ordered Eaton to turn the documents over to the IRS.

This presents a serious procedural issue that is likely to come up in other cases. The IRS almost always asserts penalties in cases where it makes significant tax adjustments and the amount of the penalties are typically quite significant as they are computed based on the amount of the tax adjustments.

Other than prevailing on the underlying tax issue that gave rise to the penalties, the reasonable cause/good faith defense is the only real defense to these penalties. So it may be that the taxpayer who raises this defense may prevail on the penalties, but then be obligated to turn over records that could cause it to lose the underlying tax issue that gave rise to the penalties.

This should give taxpayers reason to pause to consider the risk in raising the reasonable cause/good faith defense to penalties.