Paul L. Caron

Friday, February 26, 2021

Weekly SSRN Tax Article Review And Roundup: Kim Reviews The IRS's Decisive Transfer Pricing Victory In Coca Cola By Avi-Yonah & Mazzoni

This week, Young Ran (Christine) Kim (Utah; Google Scholar) reviews a new work by Reuven Avi-Yonah (Michigan; Google Scholar) & Gianluca Mazzoni (Michigan SJD), Coca Cola: A Decisive IRS Transfer Pricing Victory, at Last, 169 Tax Notes Fed. 1739 (2020).


Coca-Cola has offshore manufacturing facilities that produce beverage concentrate in low tax countries, such as Brazil, Ireland, and Egypt. Because the beverage concentrate is a Coca-Cola product, though it is not a final product, the US Parent co. licenses its intangibles, such as trademarks and secret formulas, and the manufacturing facilities pay royalties and dividends. But the role of offshore manufacturing facilities stops there. The final products are made by third party entities, called “Bottlers,” and the marketing activities of the Coca-Cola brand and the final products are conducted by another foreign subsidiary (ServCos). Given such a limited role of offshore manufacturing facilities, called "Supply Points," what portion of profits under the transfer pricing rules should be allocated to those Supply Points compared to the US Parent co.? Probably not much.

But Coca-Cola has been allocating significant profits—more than 50%—generated in the market countries to the Supply Points. In a previous audit in 1996, the IRS and Coca-Cola settled with a closing agreement that permitted this generous profit allocation method for the taxable years of 1987-1995. Does this audit settlement bless the continuous use of that method that allocates significant profits to Supply Points in subsequent years? To answer this question, we have to look at the closing agreement between the IRS and Coca-Cola, and the Tax Court held that the answer is the negative. See Coca-Cola Co. v. Comm'r, 155 T.C. No. 10 (2020).

On this important transfer pricing case, Reuven Avi-Yonah (Michigan) and Gianluca Mazzoni (Michigan SJD) offer a thorough analysis in their recent article, Coca Cola: A Decisive IRS Transfer Pricing Victory, at Last, 169 Tax Notes Fed. 1739 (2020).

Let's turn to the facts and issues more closely. The first issue is whether Coca-Cola can rely on the profit allocation method agreed in the closing agreement. The method allocated profit equal to 10% of the Supply Point's gross sales to Supply Points first, and then the remaining profit is split 50-50 between the US Parent co. and Supply Points. The IRS argued that this pricing for the licensing from US Parent co. to Supply Points were not at arm's length because it overcompensated Supply Points, which will be further discussed in the second issue. On the other hand, Coca-Cola argued that the closing agreement in 1996 audit blessed this formula for the use in subsequent years, including the relevant tax years of 2007-2009. The Tax Court found that the fact that the closing agreement with the IRS did not address what transfer pricing method would have been used after 1995 indicated that the IRS has never agreed on the future application of the method in the closing agreement, and thus, the agreement expired and does not bind the transfer pricing method for relevant tax years of 2007-2009.  

After denying Coca-Cola's profit allocation method from 2007-2009 under sec. 482, the IRS has chosen the comparable profits method (CPM) and allocated all the remaining residual profit to the US Parent co. This led to a $3.3 billion deficiency of the US Parent co. for the tax years of 2007-2009, and it could cost Coca-Cola more if the IRS applies the same methodology to the subsequent years. So, the second and the main issue is whether the CPM chosen by the IRS is the most appropriate alternative, aka. the best method under sec. 482.

The CPM is usually used when the tested foreign affiliate performs relatively routine functions and there exists comparable independent companies. As to the comparable independent companies, the IRS treated the third-party Bottlers as comparable parties and found that Supply Points retained too many profits compared to Bottlers. However, if the tested party owns few, if any, unique intangibles, the CPM would not be a proper method. In fact, Coca-Cola is a manufacturing multinational enterprise, but Coca-Cola has always been the world's most famous soft drinks brand and its secret formula is invaluable. And the company also does its best to maintain its top position through various marketing strategies and advertisement campaigns. This hybrid nature of Coca-Cola's business—manufacturing giant with invaluable IP—raises an important question on the function of Supply Chains in determining appropriate transfer pricing method. If Supply Chains own any unique or valuable intangibles, they may be entitled to retain more residual profits because other methods, such as the Residual Profit-Split Method (RPSM), which is more proper to compensate each party's contribution to the value of marketing intangibles, should be used instead of CPM.

Thus, the question boils down to the issue of whether, under the IP licensing agreement, Supply Points are the legal owners of IP or hold any contractual rights that can constitute IP. The IP licensing agreement between the US Parent co. and Supply Points was scrutinized by expert witnesses of both parties, including a respected colleague of mine, Jorge Contreras as a government witness, and the Court found that the contract did not convey any rights to marketing intangibles to Supply Points, Supply Points did not have any territorial exclusive right or ownership interest in the IP, and thus, the CPM is the best method.

Furthermore, the court discussed the economic substance of the transaction. If Supply Points perform any economic functions to create valuable IP, such as implementing advertisement campaign and engaging in franchise leadership with Bottlers, they may have certain rights to the intangibles and Coca-Cola may allocate more profits and marketing expenses to Supply Chains. The Court denied such economic substance argument, finding that ServCos, not Supply Chains, did all those activities.

The Court also rejected other alternative transfer pricing methods, such as the Comparable Uncontrolled Transaction Method and Asset Management Methods, as the best method under sec. 482. Instead of discussing them all in this review, I highly recommend reading the authors' article that offers a detailed yet concise explanation of many other issues of this case.  

As Avi-Yonah and Mazzoni describe, this is a decisive victory of the IRS. However, Coca-Cola does not intend to stop fighting and in my humble opinion is likely reinforce its argument on the procedural issues and general legal principles, such as estoppel. In January 2021, the company hired a well-known, influential former federal judge, J. Michael Luttig, signaling that it would frame the fight as a governmental overreach, rather than a technical tax argument. This week, the company announced that Laurence Tribe, a constitutional law professor at Harvard Law School, will represent the company as constitutional counsel in its tax disputes. In its form 8-K filed with the SEC on February 10, 2021, Coca-Cola argues that the Tax Court decision is unconstitutional because the IRS imposed tax liability retroactively using a method different from that previously agreed-upon between the IRS and the Company. The company still seems to insist that the IRS had blessed its TP method at issue during an earlier dispute.

Avi-Yonah wrote a letter to Tax Notes International last week to criticize the company's statement in the SEC document, pointing out that the prior closing agreement expired in 1996 and would not bind the IRS in subsequent years. Judge Albert Lauber also rejected the company’s argument in the decision, stating that the parties agreed to that method only to settle the earlier dispute at that point.

This case is expected to impact other high-profile transfer pricing cases, including cases involving Facebook and Medtronic. It will be interesting to observe how the U.S. Court of Appeals for the Eleventh Circuit, now that the majority of judges have been appointed by Republican presidents, would decide this case, if or when the company appeals.   

Here’s the rest of this week’s SSRN Tax Roundup:

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