On November 18, 2020, the U.S. Tax Court ruled that Coca-Cola Co. owes more than $3.3 billion in taxes due to undercharging affiliates for the right to use Coca-Cola's intangible property during the examination period between 2007-2009.
Court decisions of this magnitude provide significant learning opportunities for both taxpayers and practitioners – even when the key issues may appear quite specific to a certain fact pattern, industry or type of intercompany charge. The court’s opinion provides careful and detailed insights into future Tax Court rulings that can be interpreted broadly.
While it is anticipated that Coca-Cola will likely appeal this decision it is still an opportune time to review the Tax Court decision.
This article will first provide a brief summary of the decision to provide context to a broader discussion of the practical implications for tax and transfer pricing professionals. For additional details, we recommend reading the court opinion in full.
Overview of Decision
The Internal Revenue Service reallocated more than $9 billion in income related to the use of intangible property from foreign affiliates that manufacture concentrate to Coca-Cola’s U.S. operations, resulting in a tax deficiency of more than $3.3 billion.
Penalties associated with the adjustments were not applied due to a closing agreement, executed between the IRS and Coca-Cola in 1996 resolving tax liabilities for 1987-1995, that stated that if Coca-Cola applies the method in the closing agreement in future years it shall not be subject to accuracy-related penalties under Treasury Regulations Section 6662.
The closing agreement would play a key role in Coca-Cola’s defense strategy but would ultimately fail to provide the tax certainty the taxpayer assumed of the agreement. A brief overview of the most pertinent factual considerations is discussed below to provide context to the observations that follow.
In 1899, Coca-Cola transferred the exclusive rights to bottle and distribute Coca-Cola beverages throughout the world to third parties, establishing what would become known as the “Coca-Cola system.” In the years under review, a simplistic view of the Coca-Cola system would include the following:1
- Coca-Cola’s U.S. headquarter operations and primary intellectual property owner responsible for global strategic decisions and approvals;
- Coca-Cola’s service companies responsible for local advertising and in-country consumer marketing, executing strategy on behalf of HQ and liaising with independent bottling companies;
- Coca-Cola’s supply points responsible for manufacturing concentrate sold to independent bottling companies; and
- Independent bottling companies responsible for localized sales and marketing to retail and consumer channels within their respective territories.
The IRS challenge focused on the arm’s-length nature of the transactions between HQ and the supply points. The assertion was that the supply points did not appropriately compensate HQ for the Coca-Cola IP exploited by the supply points in transactions with unrelated bottling companies. The result was a proposed reallocation of more than $9 billion total from various supply points – primarily the supply points in Brazil and Ireland.
The IRS and Coca-Cola had settled tax liabilities related to this transaction for the period between 1987 and 1995 in a 1996 closing agreement. The closing agreement between the IRS and Coca-Cola settled upon a formulaic approach to splitting profits between HQ and its various supply points globally. The settlement called for a 10-50-50 split between the supply points and HQ, where the supply points retained 10% of gross revenues and the remaining profit was split between the supply points and HQ.
The taxpayer continued to employ this formulary apportionment approach throughout the tax years under examination with the assumption that the 1996 agreement provided tax certainty for these transactions in future years.
The IRS challenged the arm’s-length nature of this arrangement for the period of 2007 through 2009. Ultimately, the court ruled that the 1996 closing agreement did not prevent the IRS from challenging the arm’s-length nature of the 10-50-50 split in the years following the agreement.
The IRS challenge to the arm’s-length nature of the transactions between HQ and the supply points centered on the factual assumption that the supply points were effectively routine contract manufacturers and that HQ owned all important intangibles made available to the supply points.
The IRS’s expert prepared an analysis under the comparable profits method, which provided a fixed return for the supply points based on a range of comparable companies’ return on assets. All remaining residual profits in excess of this routine return in the supply points were then reallocated to HQ. The court upheld the IRS adjustment.
Observations and Insights
When Is Tax Certainty Certain?
The taxpayer assumed that the 1996 closing agreement provided tax certainty regarding the pricing of the transactions between HQ and the supply points. An assumption that was likely reinforced by the lack of transfer pricing adjustments in the time between the closing agreement and the period under review.
However, the courts ruled that there was no evidence that the closing agreement explicitly provided indefinite tax certainty with respect to the 10-50-50 methodology in future years. Further, the Tax Court opined that it was not the desire of the IRS to provide such certainty due to the lack of specific binding language.
This highlights an important fact for all taxpayers – just because a taxing authority has agreed to pricing associated with specific transactions historically, there is no certainty that they will agree with the pricing in the future, even if the facts and circumstances surrounding those transactions remain similar.
It is important to assess whether intercompany pricing that has been historically implemented and passed audit still adheres to the arm’s-length standard annually.
While fact patterns within a company may remain the largely the same, changes in external factors –e.g., industry profitability changes, market demands shifting – should be examined in context of the arm’s-length standard.
Even taxpayers party to advanced pricing agreements, which are agreements intended to provide tax certainty, should take care to review the critical assumptions of their agreement and assess whether those have changed to avoid unexpected challenges.
A Major Win for the Comparable Profits Method
The comparable profits method is widely relied upon to test the arm’s length-nature of transactions in both transfer pricing documentation and when establishing advance pricing agreements. However, when it comes to U.S. Tax Court cases involving intangibles, the comparable profits method has been often dismissed as a method of last resort, with preference given to the comparable uncontrolled transaction method.
The comparable uncontrolled transaction method relies on more distinct transactional data to establish an arm’s-length price – most commonly through publicly available agreements covering the license of intangibles. The transactional nature of the data underlying a comparable uncontrolled transaction analysis often means the specific IP associated with these agreements is not sufficiently comparable to the IP under examination.
It is extremely rare for companies to license crown jewel IP like Coca-Cola’s brand and recipes to competitors. It is even rarer that the terms of those agreements are made public.
While prior U.S. Tax Court cases have relied on often less than desirable agreements as comparable, the court opinion in this case argued, “In cases such as this, involving unique and extremely valuable intangible property, comparable uncontrolled transactions may not exist.”2
From a practical perspective, taxpayers should take an opportunity to assess intercompany transactions that have historically relied upon comparable uncontrolled transaction agreements to establish a split of profits under corroborative approaches, potentially including the comparable profits method.
It is possible for a tax authority to challenge the characterization of an entity as entrepreneurial, as opposed to a routine provider, based upon facts and circumstances. An examination of the profits compared to a set of both routine and nonroutine comparables can provide a range of potential outcomes with which to assess the risk of current transactions.
The Importance of Intercompany Agreements
One of the key disputes in the case centered on the ownership of the economic rights to exploit the Coca-Cola IP. The taxpayer argued that through investments in local marketing and advertising made over time by its supply points, a large portion of the economic rights associated with the IP had been effectively transferred to the supply points.
The court disagreed that any IP had been shifted. A key fact pattern in the court’s opinion was that the intercompany agreements in place between HQ and the supply points at best provided for no such transfer of intangible rights, and in some cases, explicitly indicated that no intangible ownership would transfer through any of the activities of the supply points.
Whether the taxpayer intended those rights to transfer or not, the fact that their intercompany agreements did not provide for this transfer was a critical element to the court’s opinion on this matter.
The court also highlighted that the lack of compensation for the supply points when any production was shifted from one supply point to another implies that the supply points maintained no control or ownership over the IP. This underscores the importance of performing and documenting valuations of intangibles to reinforce economic ownership of intangible rights where applicable.
It is clear from this ruling that maintaining thorough intercompany agreements that accurately reflect the outcomes desired from transfer pricing planning and strategies is crucial to tax planning and transfer pricing. That said, it is also worth noting that the court reaffirmed the IRS’s ability to set aside contractual terms when they are inconsistent with actual economic activities.
This opinion also affirmed that the regulations do not provide any authority for taxpayers to disavow their own agreement terms – citing, “the taxpayer, has complete control over how contracts are drafted. There is thus rarely any justification for letting the taxpayer disavow contract terms it has freely chosen.”3
Taxpayers should take care in drafting the terms of their agreements to ensure they align the facts and the desired outcomes with the language of their agreements.
Simplicity Within Complexity
Transfer pricing can be messy, complex and unintuitive to even experts in the field. Often practitioners, taxpayers and tax authorities are working with imperfect data, difficult-to-solve problems and no clear, correct answers, which can lead to challenges in implementing an economically sound structure that produces rational results without overly complex assumptions.
When these overly complex structures produce results that appear inconsistent with expectations, it becomes a difficult hurdle to overcome no matter how theoretically sound it may be.
In this case, the court gravitated toward the IRS’s analysis, which was more intuitive and produced results more in line with expectations. The court opinion made a point to highlight the taxpayer’s experts “extremely complex series of calculations and assumptions”4 and included “dozens of assumptions, estimates, adjustments, and cost reallocations.”5
It appeared that the court was not overly impressed with the complexity of the taxpayer’s expert’s analyses.
On the other side, the IRS expert, Scott Newlon, prepared a histogram that distilled all the complexity of the issue under examination into a compelling story that was hard to overcome. The histogram was a simple comparison of the return on assets showing the Coca-Cola supply points against nearly 1,000 other food and beverage companies.
The chart emphasized that under the taxpayer’s model, the return on assets earned by the Coca-Cola supply points were often greater than those of every other food and beverage company in the world. The histogram clearly resonated with the court, which highlighted “But the profits the supply points enjoyed vastly exceeded that range. One needs no more than a back-of-the-envelope calculation to make this clear.”6
These types of simple calculations and sensitivity checks are important and should be performed.
When taking a step back, what story is your transfer pricing policy telling when viewed with a more simplistic, holistic and transparent approach? Can the supporting documentation be more succinct? Can the presentation of results and the factual underpinnings be clearer?
There are often very sound economic arguments to support results that appear unintuitive, but it is important to consider these alternative approaches and reflect upon what an overly complex analysis is truly accomplishing.
BEPS, DEMPE and Accurate Delineation of the Transaction
While this was a U.S. Tax Court ruling covering 2007 through 2009, there was no specific mention of the Organization for Economic Cooperation and Development Base Erosion and Profit Shifting, or BEPS, initiatives; the concept of development, enhancement, maintenance, protection and exploitation, or DEMPE, functions;7 or discussions of the accurate delineation of a transaction.
However, the conceptual framework is fundamentally in line with the court’s thinking throughout the opinion letter.
For example, the court dismissed notions of the field posed by the taxpayer’s experts, which combined the functions of the service companies and the supply points into a single consolidated group. Instead, the court took care to accurately delineate the specific contributions made by each of the legal entities involved in the transaction when arriving at their decision.
The court’s decision relied heavily on functional analysis, stressing the importance of the ability for entities to maintain control and decision-making abilities, which is similar to what is seen in the OECD DEMPE framework.
While the supply points were bearing expenses related to marketing activities, the court emphasized they maintained no control or decision-making related to expenses they were allocated, noting, “In essence the supply points were passive recipients of charges that HQ and [business unit] leadership put on their books.”8
This reaffirms the view of many practitioners that the Section 482 regulations and the concepts introduced through the BEPS initiative are not mutually exclusive. Taxpayers dealing with U.S. issues should not ignore the concepts from the OECD transfer pricing guidelines, as that guidance can be useful in establishing their own transfer pricing positions.
Summary of Takeaways
The Coca-Cola case offers many insights for taxpayers operating in unrelated industries and executing substantially different intercompany transactions. Much of the court’s decision focused on the core building blocks of transfer pricing and the opinion emphasized the following:
- It is important to establish clear intercompany agreements that align with the facts and desired outcomes
- The arm's-length standard is not a static concept and what was acceptable in prior years may no longer be acceptable going forward
- A closing agreement only provides as much certainty as is explicitly stated
Outcomes of any appeal may serve to further reinforce or alter these takeaways. As always, taxpayers and practitioners should continue to monitor court decisions as they progress and shape the tax landscape.
This article was originally published by Law360
1.Note multiple legal entities are presented together here to facilitate discussion.
2.The Coca-Cola Co. & Subsidiaries v. Commissioner of Internal Revenue, United States Tax Court, Page 91, (18 November 2020).
3.The Coca-Cola Co. & Subsidiaries v. Commissioner of Internal Revenue, United States Tax Court, Page 161, (18 November 2020).
6.The Coca-Cola Co. & Subsidiaries v. Commissioner of Internal Revenue, United States Tax Court, Page 110, (18 November 2020).
7.DEMPE is acronym for Development, Enhancement, Maintenance, Protection and Exploitation related to intangibles.