The first part of Eaton's closely watched U.S. Tax Court trial over the company's financing of a 2012 acquisition has wrapped up, and the judge's questions to witnesses during the first two and a half weeks reveal that he's leaning the government's way on at least one of the central questions in the case.

A Tax Court judge's comments suggest he isn't likely to find that the IRS abused its discretion in the closely watched Eaton dispute. But the judge also effectively dismissed an argument raised by the IRS that Eaton's debt at the heart of the case was not real and should be considered equity. (Photo by Tim Boyle/Bloomberg via Getty Images) Eaton is defending the interest and guarantee fees charged by its new Irish parent, Eaton PLC, after the U.S. company acquired a global electrical products manufacturer for $13 billion and inverted. The Internal Revenue Service argues that the high interest rates U.S.-based Eaton Inc. paid on the debt to its parent, as well as the fees for guaranteeing third-party debt, allowed it to reap substantial tax savings.

Expert witnesses and former Eaton officials during the first weeks of trial addressed the company's lowered credit rating after the acquisition, which Eaton argues justified the high interest and guarantee fees. They also spoke about the data used to calculate the rating and the company's decision, as part of its restructuring, to transfer a $14 billion asset from a U.S. Eaton subsidiary to Eaton PLC.

Tax Court Judge Albert Lauber's questions seemed to indicate that while he viewed the guarantee fees as having some value, he considered the interest rates artificially high and was skeptical of the lowered credit rating assigned to the U.S. company after the acquisition. Other comments suggest he isn't likely to find that the IRS abused its discretion in the case — or give much weight to its alternative argument that the debt was not real and should be recharacterized as equity.

Here, Law360 offers five takeaways from the trial held Nov. 3-19, then resuming Dec. 4.

1: Guarantees From Eaton PLC Had Some Value

Eaton financed the acquisition of Ireland-based Cooper Industries in 2012 with a combination of intercompany debt and third-party debt. More than half of the $8.2 billion in third-party debt — $4.9 billion — came from bonds issued to the public.

Eaton Corp.'s former chief financial officer, on the second day of trial, described bond buyers as among the most risk-averse investors after the Great Recession of 2008. The company's advisers, Morgan Stanley & Co. and Citigroup Global Markets, had recommended obtaining guarantees from Eaton PLC on that debt, according to Rick Fearon, Eaton's CFO from 2002 to 2021.

Eaton argues that the credit rating the U.S. company received after the inversion, which was several notches below its parent's, necessitated the parent's guarantees. But Judge Lauber said that even if Eaton PLC and Eaton Inc. had the same credit rating, the guarantees still might have provided a benefit in the form of "ease of marketing" to potential investors.

When Eaton held a "road show" for potential buyers of the $4.9 billion in acquisition notes, the judge said, a number of investors asked questions about guarantees — even "repeat customers" who had previously invested with the company. Given those inquiries, he said, "I can imagine some benefit" from the guarantees, even if the company's credit rating had been as high as its parent's.

2: Interest Rate on Loans Was Too High

According to Eaton, the U.S. company needed cash in 2012 to finance its $13 billion purchase of Cooper Industries. The IRS, however, argues that Eaton Corp., the U.S.-headquartered company before the acquisition, had a $14 billion asset in the form of a European subsidiary that it planned to transfer to Eaton PLC when it inverted.

The IRS maintains that Eaton could have leveraged the subsidiary — Eaton Holding V Sarl, or Lux V — to finance the Cooper acquisition rather than moving it under Eaton PLC. Lux V, a subsidiary of the U.S. limited liability company Eaton Worldwide, was transferred through a capital contribution in which a foreign entity, Eaton Technologies Sarl, afterward claimed a controlling interest.

Judge Lauber asked Adam Lechman, Eaton's transfer pricing senior manager from 2011 to 2017, about the decision to make the U.S. company a minority owner of Lux V after the acquisition.

"Do you recall the business purpose for that?" he asked.

Lechman said he did not.

"Why, at arm's length, would an obligor want to put out of its reach an asset of $14 billion?" Judge Lauber asked. He added, "If you want to boost up the interest rate artificially you might do that."

3: Judge Skeptical of Credit Rating

Judge Lauber's interrogation of one witness suggested Eaton itself had requested a rating several notches below one that Standard & Poor's had given the company before it acquired Cooper and inverted.

William Chambers, a former S&P credit rating analyst, had examined the U.S. company's creditworthiness in a January 2013 report that considered the $3 billion of new intercompany debt taken on to finance the acquisition of the Irish company, Cooper.

Chambers in the report gave the U.S. company a BB-/B+ rating, six or seven notches below the A- rating S&P had given it in May 2012, when Eaton announced plans to acquire Cooper. His notes from a December 2012 telephone call with an Eaton official showed that he had written "low B."

The judge asked Chambers if "low B" was "the credit rating you had already agreed to assign to it, the rating that they asked for?"

Chambers said Eaton "never asked for a rating" and that he didn't know why he had written "low B" in his notes.

4: No Abuse of Discretion

To win its case, Eaton must show that the IRS abused its discretion when assessing deficiencies to the company for the interest payments and guarantee fees. Much of the expert testimony has been based on financial information that, as Judge Lauber pointed out, didn't exist at the time of the IRS' examination.

Eaton expert Jonathan Rush of Ankura Consulting Group LLC, one of those hired to assess the creditworthiness of the U.S. borrowing entities, created what the judge called "new financials" from historical financial statements of both Eaton Corp. and Cooper Industries. Rush's data also was used by another Eaton expert to develop cash flow projections.

On Nov. 19, the last day of the first part of the trial, Judge Lauber questioned whether the IRS could be said to have abused its discretion by not considering the Rush financials during the examination, given that they weren't created until much later.

5: IRS Alternative Argument Unlikely to Prevail

Also on Nov. 19, the judge effectively dismissed an alternative argument raised by the IRS that the debt was not real and should be considered equity.

He urged attorneys not to spend "undue amounts of time" on that argument when the trial resumes Dec. 4, saying, "Based on what I've heard, the chance that I'm going to find this is equity is microscopically small."

Eaton and the IRS declined to comment for this article.

The trial over the financing of the Cooper acquisition is just one part of Eaton's larger case against the government, in which it contests total deficiencies of more than $600 million and $76 million in penalties for 2012 and 2013. No penalties are at issue regarding the interest rates and guarantee fees, and the deficiency amount related to those items is roughly $291 million.

Eaton is represented by Rajiv Madan, Nathan Wacker, Royce L. Tidwell, Melinda H. Gammello, Juliana D. Hunter, Elizabeth J. Smith, Ryan K. Fackler, Dominic M. Reilly, Paige Levenberg, Tanushree Bansal and Rachel D. Harper of Skadden Arps Slate Meagher & Flom LLP.

The IRS is represented by Timothy L. Smith, Jeannine Zabrenski, Emily Snider, Elizabeth Turnbull, Steven Balahtsis, Shannon Bambery, Mark Frazer, Trevor Maddison, John Altman, Blake Corry, John Guarnieri and Ronald S. Collins Jr.

The cases are Eaton Corp. & Subsidiaries v. Commissioner of Internal Revenue, docket numbers 2607-23 and 2608-23, in the U.S. Tax Court.