In November 2020, the US Tax Court released its opinion in Coca-Cola v. Commissioner. If the Tax Court decision is upheld on appeal, it will join the Internal Revenue Service (IRS) victory in Altera Corp. v. Commissioner as a rare win for the government in a transfer pricing (TP) case. The Tax Court upheld $9.8 billion in TP adjustments, while giving Coca-Cola credit – over the IRS’s objection – to $1.8 billion in dividend offsets.
Coca-Cola’s foreign operations were structured through supply points, which manufactured soft drink concentrate, and service companies or ServCos, which performed marketing functions. Concentrate manufactured by the supply points was turned into finished beverages by unrelated bottlers. A portion of the ServCos’ marketing costs were borne by the supply points, and Coca-Cola took the position that the supply points owned valuable foreign marketing intangibles.
Under a 1996 closing agreement, Coca-Cola and the IRS agreed that the supply points would be compensated for taxable years 1987–95 using the so-called 10-50-50 method, which provided the supply points a 10% return on sales and allocated the remaining profits 50/50 between the supply points and Coca-Cola in the US Coca-Cola applied, and the IRS accepted, the 10-50-50 method for all the years after the settlement period through 2006.
Yet when the IRS audited Coca-Cola’s taxable years 2007 through 2009, it took issue with the method, instead proposing a comparable profits method (CPM) analysis that benchmarked the supply points by looking to the returns earned by the independent bottlers, some of which were large public companies.
The Tax Court accepted the IRS’s CPM analysis, notwithstanding Coca-Cola’s arguments that the supply points owned invaluable intangibles. The court emphasised the role of legal ownership under the US TP regulations, noting that no legal agreements provided ownership of marketing intangibles to the supply points, and rejecting the notion that simply funding marketing activities, without contractual rights or the performance of marketing functions, results in intangible ownership.
In doing so, the court noted that Coca-Cola had terminated supply points or shifted production away from them without compensation, which the court believed was inconsistent with the claim that the supply points own intangibles.
A separate issue in the case raised the IRS’s power to allocate income to Coca-Cola from its Brazilian supply point, which was unable under Brazilian law to pay Coca-Cola royalties in excess of a certain amount. Because the Brazilian legal restriction did not prevent the payment of the blocked royalties as dividends, the US regulations did not take the restriction into account, requiring Coca-Cola to include the full amount in income notwithstanding the Brazilian subsidiary’s legal inability to pay.
Coca-Cola challenged the blocked income regulation, but the court declined to address this point, noting that it would await the decision in 3M v Commissioner, which involves a similar issue.
The court did hold that dividends paid by supply points in lieu of royalties qualified for dividend offset treatment – and thus counted towards the supply points’ obligation to pay royalties – notwithstanding a return filing foot fault on Coca-Cola’s part. This saved Coca-Cola $1.8 billion in additional adjustments. However, because this section of the opinion focuses on the unusual facts of this case, it is not clear that similar compliance lapses by other taxpayers would be excused.
While Coca-Cola has announced its intent to appeal, and the ultimate outcome of the case will depend on its specific facts, the Tax Court’s reasoning has important implications for other taxpayers.
Multinational enterprises should review their inter-company agreements and how they align with the functions performed by the parties, especially if the agreements are old and have not been recently updated. Aligning functions and legal agreements with positions regarding economic ownership is particularly important.
Even for taxpayers without inter-company transactions, Coca-Cola has important lessons. Taxpayers should use caution when relying on prior closing agreements, aged memoranda of understanding, audit history, and/or expired advance pricing agreements or tax rulings, no matter what tax issue they pertain to.
While agreements for prior periods may provide valuable evidence of the correct result for later years, such agreements do not in themselves protect against adjustments for later years. It appears that Coca-Cola was taken by surprise when the IRS, after more than a decade of having accepted the 10-50-50 method, departed from it for the 2007–09 audits. Other taxpayers should take heed that the IRS may suddenly revisit what seem to be settled issues.
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