INCOME TAXES

9 Months Ended

Sep. 30, 2021

Income Tax Disclosure [Abstract]

INCOME TAXES

INCOME TAXES

The effective income tax rate for the third quarter of 2021 was expense of 43.4% compared to expense of 14.8% for the third quarter of 2020. The effective income tax rate for the first nine months of 2021 was expense of 29.8% compared to expense of 21.3% for the first nine months of 2020. The increase in the effective tax rates in the third quarter and first nine months of 2021 was primarily due to the tax impact on the gain from the sale of the Hydraulics business in 2021 discussed in Note 2.

In 2011, the United States Internal Revenue Service (“IRS”) issued a Statutory Notice of Deficiency (the “2011 Notice”) for the Company’s United States subsidiaries (“Eaton US”) for the 2005 and 2006 tax years. The 2011 Notice proposed assessments of $75 million in additional taxes plus $52 million in penalties related primarily to transfer pricing adjustments for products manufactured in the Company's facilities in Puerto Rico and the Dominican Republic and sold to affiliated companies located in the United States. Eaton US has set its transfer prices for products sold between these affiliates at the same prices that Eaton US sells such products to third parties as required by two successive Advance Pricing Agreements (APAs) Eaton US entered into with the IRS that governed the 2005-2010 tax years. Eaton US has continued to apply the arms-length transfer pricing methodology for 2011 through the current reporting period. Immediately prior to the 2011 Notice being issued, the IRS sent a letter stating that it was retrospectively canceling the APAs. Eaton US contested the proposed assessments in United States Tax Court. The case involved both whether the APAs should be enforced and, if not, the appropriate transfer pricing methodology. On July 26, 2017, the United States Tax Court issued a ruling in which it agreed with Eaton US that the IRS must abide by the terms of the APAs for the tax years 2005-2006. The Tax Court’s ruling on the APAs did not have a material impact on Eaton’s consolidated financial statements. On May 24, 2021, the IRS filed a notice to appeal the Tax Court’s ruling to the United States Sixth Circuit Court of Appeals, and on October 7, 2021 the IRS formally filed its appeal. The Company continues to believe it will prevail on appeal and does not expect the final resolution to have a material impact on its consolidated financial statements.

During the second quarter of 2021, the IRS completed its examination of the consolidated income tax returns of Eaton US for tax years 2014 through 2016 and has proposed a number of adjustments primarily related to certain transfer pricing tax positions, including adjustments similar to those proposed and previously disclosed for prior audit periods for products manufactured in the Company’s facilities in Puerto Rico and the Dominican Republic and sold to affiliated companies located in the U.S., and adjustments related to intercompany financing. The Company intends to pursue its administrative appeals alternatives. The Company believes that final resolution of the proposed adjustments will not have a material impact on its consolidated financial statements.

During 2010, the Company received a tax assessment, which included interest and penalties, in Brazil for the tax years 2005 through 2008 that relates to the amortization of certain goodwill generated from the acquisition of third-party businesses and corporate reorganizations. In 2018, the Company received an unfavorable result at the final tax administrative appeals level. In August 2021, the Company was notified of a recalculation from an original alleged tax deficiency of $24 million plus $67 million of interest and penalties to a revised alleged tax deficiency of $31 million plus $99 million of interest and penalties (translated at the September 30, 2021 exchange rate). During 2014, the Company received a tax assessment, which included interest and penalties, for the 2009 through 2012 tax years (primarily relating to the same issues concerning the 2005 through 2008 tax years). In November 2019, the Company received an unfavorable result at the final tax administrative appeals level, resulting in an alleged tax deficiency of $26 million plus $92 million of interest and penalties (translated at the September 30, 2021 exchange rate). The Company is challenging both of the assessments in the judicial system. Challenges in the judicial system are expected to take up to 10 years to resolve and require provision of certain assets as security for the alleged deficiencies. As of December 31, 2020, the Company pledged Brazilian real estate assets with net book value of $10 million (translated at the September 30, 2021 exchange rate). During 2021, the Company pledged additional Brazilian real estate assets with net book value of $9 million and provided additional security in the form of a bond of $75 million and cash deposit of $10 million (translated at the September 30, 2021 exchange rate). The Company continues to believe that final resolution of both of the assessments will not have a material impact on its consolidated financial statements.

The ultimate outcome of these matters cannot be predicted with certainty given the complex nature of tax controversies. Should the ultimate outcome of these matters deviate from our reasonable expectations, they may have a material adverse impact on the Company’s consolidated financial statements. However, Eaton believes that its interpretations of tax law, and application of tax laws to our facts, are correct and that its accrual of unrecognized income tax benefits is appropriate with respect to these matters.