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Coca-Cola Failed to Charge Arm’s-Length Royalties to Affiliates

Dec. 15, 2020, 8:00 AM

Coca-Cola owes more than $3.3 billion in taxes after the U.S. Tax Court ruled in November that the royalties it charged to its affiliates were not commiserate with what it would have charged to unrelated parties.

The Internal Revenue Service in connection with its examination of The Coca-Cola Co.’s tax returns for 2007-2009, made adjustments that increased Coca-Cola’s aggregate taxable income by more than $9 billion. These adjustments produced tax deficiencies totaling more than $3.3 billion. The deficiencies result from “transfer pricing” adjustments under tax code Section 482 in which the IRS reallocated substantial amounts of income to Coca-Cola chiefly from its foreign manufacturing affiliates. These affiliates are referred to as “supply points.”

The gist of the IRS’s position was that the supply points paid insufficient compensation to Coca-Cola for the rights to use Coca-Cola’s intangible property. The court largely upheld the IRS’s adjustments (The Coca-Cola Co. v. Commissioner, 155 T.C. No. 10, 2020 BL 450233 (11/18/20)).

Coca-Cola established in 1930 the Coca-Cola Export Corp. (Export Corp.), a wholly-owned domestic subsidiary of Coca-Cola. Export Corp. established affiliates to manufacture and supply concentrate to local bottlers. Export Corp. owned the seven supply points involved here.

As concentrate manufacturing became consolidated into fewer and fewer supply point affiliates, Coca-Cola’s other foreign activities were typically taken over by local services companies (ServCos). The ServCos were responsible for local advertising and in-country consumer marketing. Most of the ServCos, similar to the supply points, were owned by Export Corp.

The vast bulk of Coca-Cola’s beverages were (and are) produced and distributed by independent Coca-Cola bottlers. The bottlers produced most of the beverages using concentrate manufactured by the supply points. The bottlers mixed the concentrate with purified water, carbon dioxide, sweetener, and/or flavorings; injected the finished beverages into bottles and cans; and delivered the beverages to retail establishments.

Functions Performed

The supply points manufactured concentrate. Their manufacturing activity consisted of procuring raw materials and using Coca-Cola’s guidelines and production technologies to mix and convert raw materials into concentrate. Bottlers performed all finished product manufacturing. Having procured concentrate from supply points, the bottlers prepared finished beverages by mixing the concentrate with purified water. During 2007-2009, the Irish supply point “had by far the largest production of any foreign concentrate plant,” supplying bottlers in more than 90 national markets. The Singapore supply point supplied concentrate to bottlers in 16 markets that had previously been served by 14 supply points in Asia and elsewhere.

Coca-Cola took principal responsibility for consumer marketing. Significantly, Coca-Cola was the registered legal owner of all worldwide trademarks related to Trademark Coke, Fanta, Sprite, and their lines and extensions. Global marketing campaigns were designed by Coca-Cola in Atlanta, with input from ServCo personnel in various markets. ServCos, in fact, often played a leading role in regional marketing efforts.

The bottlers took principal responsibility for “trade marketing,” that is, communications and other efforts directed toward the retail establishments that sold Coca-Cola’s beverages to consumers. None of the supply points—apart from the Brazilian and Chilean supply points—had any staff devoted to sales.

Contractual Relationships

Coca-Cola was the ultimate parent of the supply points, and the contracts it executed with them, the court observed, “often seemed terse and incomplete.” The agreements granted the supply points the rights to produce and sell concentrate in accordance with Coca-Cola’s specifications. The supply points were authorized to use Coca-Cola’s intangible property in connection with their production and selling rights. They generally lacked any contractual ownership interests in Coca-Cola’s trademarks or other intangible property. The supply points, in short, received only a limited right to use trademarks in connection with their production and sales activities. Although Coca-Cola used the so-called “10-50-50” method to compute royalties payable by the supply points, it never incorporated any aspect of that formula (which the court found wanting) into its written supply point agreements.

Coca-Cola contracted with at least 60 ServCos doing business throughout the world. The ServCos performed local consumer marketing and supervised relationships with local bottlers. The standard agreement included two remuneration clauses, which together provided the ServCos with “cost-plus” compensation. The percentage markups varied among the agreements from a low of 5% to a high of 12%, with the average markup being between 6% and 7%. Ernst & Young, the court noted, had concluded that the cost-plus compensation outlined in the ServCo agreements was within an arm’s-length range.

Supply points were charged an allocated share of the ServCos’ “fees and commissions” (i.e., marked-up costs) plus an allocated share of the ServCos’ third-party marketing expenses. The method for allocating fees and expenses to supply points, the court noted, is not explained in any document.

Coca-Cola executed formal agreements with hundreds of Coca-Cola bottlers throughout the world. In virtually all of the agreements, Coca-Cola was shown as the legal counter-party to the bottler. Through the bottler agreements, Coca-Cola licensed bottlers to use its trademarks and other intangible property to produce, sell, and distribute finished beverages. Bottlers had complete freedom to sell finished beverages to any wholesaler or retailer within their respective territories. Bottlers had limited trademark rights similar to those granted to the supply points. The specified term of most bottler agreements was between five and 10 years. In practice, however, the mutual dependence between Coca-Cola and its bottlers ensured that the bottler agreements were almost always renewed.

The bottlers remunerated Coca-Cola through the price they paid for concentrate. Generally, the parties’ goal was to achieve something like a 50%-50% profit split between the company and its bottlers (the “Coca-Cola System” or “System”). Generally speaking, bottlers paid the full concentrate price to the supply points from which they purchased concentrate. In some markets, however, Coca-Cola engaged in “split-invoicing.” Under this practice, the supply point invoiced the bottler for only a portion of the concentrate price; and the local ServCo issued a separate invoice to the bottler for the remainder of the concentrate price. The ServCos used their “split-invoicing” revenues to offset expenses that otherwise would have been reimbursed (with mark-up where applicable) by Export Corp. under a ServCo agreement.

Assets and Income

At the parent level, the relevant unit was a consolidation of Coca-Cola and Export Corp. The court referred to this consolidation as “HQ.” HQ owned the trademarks and other intangible property at issue in the case, and it received royalties, albeit inadequate royalties, paid by the supply points.

During 2007-2009, HQ showed average book assets of about $15 billion. The bulk of these assets consisted of investments in subsidiaries and other affiliates. HQ’s balance sheets showed trademarks and other intangible assets of about $500 million. This figure does not reflect the market value of Coca-Cola’s self-developed intangibles and beverage brands. HQ was also the registered owner of nearly all of Coca-Cola’s patents, including patents covering aesthetic designs, packaging materials, beverage ingredients, and production processes.

Coca-Cola derived its share of System profit through bottlers’ payments for concentrate. The supply points received and retained the bulk of this income, remitting to Coca-Cola only what was needed to satisfy to satisfy their royalty obligations as determined under the 10-50-50 method. The seven supply points involved here had a weighted average income tax rate of 6.3%. For 2007-2009, these seven supply points reported total net income of $11.36 billion. That total equaled 264% of the net income of $4.31 billion reported by HQ during 2007-2009 (which included all royalties paid by all foreign affiliates).

Tax Reporting and IRS Examination

During 2007-2009, Coca-Cola used the 10-50-50 method to determine the royalty obligations of its supply points. Under that method, supply points were permitted to satisfy their royalty obligations by a combination of actual royalties, dividends, and “pro-rata” payments.

The IRS selected Coca-Cola’s 2007-2009 tax returns for examination. It determined that the 10-50-50 method did not reflect arm’s-length pricing because that method over-compensated the supply points and under-compensated Coca-Cola for the use of its intangible property. The IRS retained an economist to analyze Coca-Cola’s inter-company pricing and determine the best method to reallocate income.

The IRS’s economist rejected the “comparable uncontrolled transaction” (CUT) method as a transfer pricing methodology. He likewise rejected a “profit split” method. He elected to apply a “comparable profits method” (CPM) using independent Coca-Cola bottlers as parties comparable to the supply points. He concluded that a “return on operating assets” (ROA) derived from these bottlers’ operations would yield appropriate adjustments to the supply points’ income. It is safe to say that the widespread use of CPM will lead to other multinationals experiencing Section 482 adjustments that may rival the adjustments the court endorsed in the instant case.

The IRS’s economist calculated ROAs for the supply points. Because the supply points had ROAs “that dwarfed those of their bottling counterparts” (owing to the modest royalty expense incurred by the supply points), the economist concluded that the supply points had received compensation in excess of an arm’s-length amount, i.e., income had been unduly “shifted” to the supply points which, as indicated above, enjoyed exceedingly low tax rates.

The IRS implemented adjustments consistent with the economist’s recommendations. It adjusted the income of the supply points downward. To the extent a supply point reported income that exceeded its benchmark, the IRS determined that additional royalty income should be allocated to Coca-Cola from the supply point. The IRS issued a timely notice of deficiency reflecting these adjustments, and Coca-Cola timely sought review in the Tax Court. The IRS asserted additional deficiencies related to Coca-Cola’s practice of split invoicing. The IRS alleged that any “excess income” that an ServCo received from a bottler, i.e., compensation in excess of a modest mark-up on non-DME expenses, should be reallocated to Coca-Cola.

Applicable Law

Section 482 provides that the IRS may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among related organizations, trades, or businesses, if the agency determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any such entities. In order to set aside such discretionary action by the IRS, a taxpayer must establish that the agency abused its discretion by making allocations that are arbitrary, capricious, and unreasonable. The IRS’s Section 482 determination must be sustained absent a showing that the agency abused its discretion.

A taxpayer may show that the IRS reached an unreasonable result by establishing that its income as reported reflects “the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.” In cases such as this, the court said, “involving unique and extremely valuable intangible property, comparable uncontrolled transactions may not exist. In order to show that the IRS has reached an unreasonable result in such a case, the taxpayer typically will need to establish that the”IRS employed an unreasonable methodology to reach its result. This would be a tall order. If the taxpayer, improbably, demonstrates that the IRS’s allocation is arbitrary, capricious, or unreasonable, but fails to provide an alternative allocation that meets the arm’s-length standard, the court, using its best judgment “must determine from the record the proper allocation of income.”

Closing Agreement Not Relevant

Coca-Cola argued that the IRS acted arbitrarily by deviating from the 10-50-50 method, to which the parties had agreed when a closing agreement was executed in 1996. The agreement details the 10-50-50 method as the agreed formula for determining “Product Royalties” for tax years 1987-1995. The closing agreement, the court observed, “says nothing whatever about the transfer pricing methodology that was to apply for years after 1995.” Coca-Cola maintained that it relied to its detriment on a belief that the IRS would adhere to the 10-50-50 method indefinitely. But, the court concluded, Coca-Colacould not bind the IRS on the basis of a promise that the agency did not make.

Relevant Parties and Transactions

The Section 482 regulations, the court noted, required that it determine the “true taxable income of a controlled taxpayer.” The IRS reallocated income to Coca-Cola from the supply points. The agency determined that the ServCos’ transactions with Coca-Cola, generally priced on a cost-plus basis, were conducted at arm’s-length. Except where “split invoicing” occurred, therefore, the IRS made no transfer pricing adjustments with respect to the ServCos. Coca-Cola did not (and could not) dispute that the supply points were “controlled taxpayers” within the meaning of Treasury Regulation 1.482-1(b)(1). A controlled taxpayer’s “true taxable income” is the income “that would have resulted had the controlled taxpayer dealt with the other member or members of the group at arm’s-length.” In assessing the appropriateness of any allocation, “the standard to be applied in every case is that of a taxpayer dealing at arm’s-length with an uncontrolled taxpayer.”

The rules governing the choice of methodology for applying the arm’s-length standard have changed over time. When promulgating detailed transfer pricing regulations in 1968, Treasury set forth a fixed hierarchy of methods, with the “comparable uncontrolled price” (CUP) method being the most highly prized. Congress later amended Section 482 to require that “in the case of any transfer (or license) of intangible property…the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.”

Treasury, therefore, in 1994, promulgated new regulations under Section 482 that superseded the 1968 regulations. These regulations eliminated the hierarchical approach of the 1968 regulations and replaced it with a “best method rule.” The best method rule requires that “the arm’s-length result of a controlled transaction must be determined under the method that…provides the most reliable measure of an arm’s-length result.” The regulations require that the arm’s-length result must be determined under one of the four methods listed in Treas. Reg. 1.482-4(a). The four permissible methods are: (1) the comparable uncontrolled transaction (CUT) method, (2) the comparable profits method (CPM), (3) the profit split method, and (4) an unspecified method, subject to the constraints set forth in the regulations.

The regulations indicate that the CUT method has an especially high degree of reliability only if an uncontrolled transaction involves the transfer of the same intangible under the same, or substantially the same, circumstances as the controlled transaction. It is very difficult to locate a comparable uncontrolled transaction, making the use of the CUT method a rare occurrence. Coca-Cola has identified no pricing data for transactions with unrelated parties that “involve the transfer of the same intangible.”

The arm’s-length compensation for the totality of the services performed by the supply points would seem to be somewhere between 6% and 8.5% above their costs. But the profits the supply points enjoyed vastly exceeded that range. With a few exceptions, their gross profit margins ranged between 75% and 90% each year. Thus, they enjoyed, on average, a mark-up on costs of about 57%. That return is about seven times higher than the 8.5% return that represents the arm’s-length value of the manufacturing activities they performed. The supply points, in fact, had much higher ROAs than Coca-Cola, “reflecting the shift of intra-company profits to them.”

Properly concluding that these results did not clearly reflect income, the IRS reallocated income between the “controlled taxpayers,” i.e., between the supply points and Coca-Cola, employing a CPM that treated independent Coca-Cola bottlers as the comparable parties. The CPM is a specified method for determining “the arm’s-length consideration for the transfer of an intangible.” Under the CPM, the determination of an arm’s-length result is based on the amount of operating profit that a controlled taxpayer would earn if its “profit level indicator were equal to that of an uncontrolled comparable.” An uncontrolled comparable is an unrelated taxpayer that engages in similar business activities under similar circumstances. Reported operating profits in excess of the benchmark profit level indicator are allocated to the other controlled party, here, Coca-Cola.

The IRS’s economist determined that the best profit level indicator was an ROA. The court concluded that the IRS did not abuse its discretion by using the bottler ROA to reallocate income between Coca-Cola and the supply points. In fact, the court noted, “this case is particularly susceptible to a CPM analysis because Coca-Cola owned virtually all the intangible assets needed to produce and sell the company’s beverages.” Coca-Cola was the registered owner of virtually all trademarks covering Coca-Cola, Fanta, and Sprite brands and of the most valuable trademarks covering the company’s other products. Coca-Cola was also the registered owner of nearly all of the company’s patents. Coca-Cola owned all rights to the company’s secret formulas and proprietary manufacturing products. The supply points, by contrast, owned few, if any, valuable intangibles.

The supply points “engaged in routine manufacturing.” In essence, they were wholly-owned contract manufacturers. The CPM was ideally suited to this scenario. Coca-Cola identified no pricing data for transactions with unrelated parties that “involved the transfer of the same intangible.” The reliability of any CUT method was thus considerably reduced here. Once it had been ruled out, the CPM was preferable in principle to the profit split method because Coca-Cola owned virtually all of the relevant intangibles.

Bottlers Are Comparable

The court agreed with the IRS’s conclusion that independent Coca-Cola bottlers serve as appropriate comparable parties for purposes of a CPM/ROA analysis. The bottlers were comparable to the supply points because they operated in the same industry, faced similar economic risks, had similar (but more favorable) contractual and economic relationships with Coca-Cola, employed in the same manner many of the same intangible assets, and ultimately shared the same income stream from sales of Coca-Cola’s beverages. In fact, because the bottlers in practice enjoyed more favorable contract terms both as to duration and exclusivity, the bottlers would be deserving of a higher ROA than the supply points. In this respect, the IRS’s economist’s selection of the bottlers as the applicable comparable was conservative.

The net revenue received by the supply points was artificially inflated because it represented compensation to Coca-Cola for its intangible contributions as well as to the supply points for their manufacturing activity. The IRS, the court concluded, did not abuse its discretion in re-allocating income from the supply points to Coca-Cola by use of the bottler CPM. Coca-Cola did not carry its burden of showing that such determination was purely arbitrary. We will, the court concluded, “sustain the re-allocations of income determined in the notice of deficiency.”

The IRS reallocated an additional $385 million to Coca-Cola from the six ServCos that benefited from split invoicing during 2007-2009. Where split invoicing was employed, a supply point invoiced the bottler for a portion of the concentrate price, and a local ServCo issued a separate invoice to the bottler for the remainder of the concentrate price. IRS determined that the ServCos received “excess income” as a result of this practice—that is, income in excess of the cost-plus compensation to which they were entitled under their normal contracts with Export Corp. or Coca-Cola. The court agreed.

The services for which the ServCos were compensated via split invoicing were indistinguishable from the services that they rendered directly to Coca-Cola and Export Corp. Coca-Cola agreed that the ServCos’ contracts with Coca-Cola and Export Corp. reflected arm’s-length terms. Coca-Cola accordingly conceded that the six ServCos received excess income from the bottlers, and it does not appear to dispute the amounts of excess income as ultimately calculated by respondent. Since the excess income received by the ServCos was in excess of arm’s-length income, and since it cannot be allocated to the supply points without exceeding their arm’s-length income, it must necessarily be allocated to Coca-Cola as the owner of the valuable intangibles. The IRS carried its burden with respect to split invoicing.

Marketing Intangibles

Coca-Cola’s principal contention is that the supply points owned “immensely valuable off-book assets, in the form of marketing intangibles,” that the IRS’s economist neglected to consider when performing the CPM analysis. The court disagreed. The supply points played no role in arranging consumer marketing and had no voice in selecting or evaluating the services for which they were financially made responsible. They were passive recipients of charges that HQ put on their books. Because Coca-Cola saw fit to put those charges on their books, Coca-Cola’s experts asserted that the supply points thereby acquired marketing intangibles worth tens of billions of dollars. The court found “no support for Coca-Cola’s argument in law, fact, economic theory, or common sense.” To the extent the ServCos’ consumer advertising expenditures added value, those expenditures did not create new intangible assets owned by the supply points.

Rather, the advertising enhanced the value of the trademarks and other intangible assets that were legally owned by Coca-Cola (and for the use of which it was woefully under-compensated). The agreements explicitly state that “any marketing concepts developed by the ServCos and the third-party marketing professionals with whom they contracted are the property of Export Corp., a domestic subsidiary of Coca-Cola.” In short, the supply points were not the owners of any marketing intangibles.

Dividend Offset

For the tax years at issue, as for all years after 1995, Coca-Cola calculated the supply points’ royalty obligation under the 10-50-50 method. As had been permitted by the closing agreement, the supply points discharged about $1.8 billion of their royalty obligation to Coca-Cola during 2007-2009 by remitting dividends rather than royalties. Coca-Cola contended that these dividends should be offset against, i.e., should reduce, the royalty obligations of the supply points as determined in this opinion. Failure to allow such an offset, Coca-Cola argued, would in substance require the supply points to repatriate income twice, subjecting it to tax each time—first when remitted as surrogates for royalties, and again when reallocated as actual royalties.

In a very real sense, failure to allow a dividend offset would punish Coca-Cola for adhering to the terms of its tax obligations as it understood them at the time. Coca-Cola urges that this result would be inequitable, and the court agreed. The court permitted the dividend offset sought by Coca-Cola, a minor victory within what turned out to be a debacle, by any standard, for Coca-Cola.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.

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