The IRS’s $3.4 billion victory against Coca-Cola Co. signals that the battle with multinationals over how to account for profits from intangible property, like brand trademarks, isn’t going away.
The IRS’s U.S. Tax Court win last week comes after a string of high-profile cases for the agency in recent years over transfer pricing issues—how companies should value their intercompany transactions—involving Amazon.com Inc., Facebook Inc., Altera. Corp, and Medtronic Inc.
The agency’s argument in the case wasn’t surprising, practitioners said, but it hammered home one of the fundamental principles of transfer pricing: Profits should reflect the location of valuable intangibles—intellectual property such as brand trademarks.
“The IRS went after and won on an intangible issue, a big one with a big company,” said Steven Wrappe, national transfer pricing technical leader at Grant Thornton LLP in Washington. “Now they’ll be a little bit bolder going after intangibles issues.”
And practitioners can expect more big transfer pricing cases, said Jill Weise, global leader of Duff & Phelps’ transfer pricing practice.
“I think there’s going to be certainly a trend around a desire to litigate, if necessary, large transfer pricing matters,” she said.
‘Where the Money Is’
The IRS argued that the company was attributing too much profit to its foreign entities, rather than in the U.S., though the U.S. was where those intangibles were held and developed. Intangibles can include brand assets and marketing campaigns that give consumer brands so much of their value.
The court agreed.
“Why are the supply points, engaged as they are in routine contract manufacturing, the most profitable food and beverage companies in the world?,” Judge Albert Lauber wrote in the Nov. 18 opinion. “And why does their profitability dwarf that of TCCC, which owns the intangibles upon which the Company’s profitability depends?” he added, referring to the Coca-Cola Company.
“It is clear that intangibles is where the money is,” which is nothing new, said Barbara Mantegani of Mantegani Tax PLLC.
When a company is licensing, transferring, or jointly developing IP, or creating IP over time—such as marketing—it needs to keep careful track of its transfer pricing, she said.
The takeaway for other taxpayers, practitioners said, is to pay close attention to their IP.
“When looking at your transfer pricing and thinking about where you think the value is along your value chain, do your legal agreements and arrangements actually tie to that perception of value creation?” Weise said.
Review Every Year
Coca-Cola had based its intercompany pricing on a closing agreement it made with the IRS in 1996 following a transfer pricing dispute. The agreement set out a formulaic method for allocating the company’s income.
The IRS said the agreement didn’t apply beyond the years covered, 1987 to 1995, and the court agreed.
“The short and (we think) the complete answer to petitioner’s argument is that the closing agreement says nothing whatever about the transfer pricing methodology that was to apply for years after 1995,” Lauber wrote.
Another lesson to take away from the case, practitioners said: Don’t rely on closing agreements for years or conditions not covered in the agreement.
“If you have intercompany transactions involving valuable intangibles, you need to be extremely vigilant and review things every single year,” Mantegani said. Companies can enter advance pricing agreements for more certainty, she said.
Transfer pricing calls on companies to base their intercompany pricing on the market value that unrelated parties would arrive at.
“This was a very big case focusing on, ‘Who gets the residual profit?’” Wrappe said.
To find a comparable for how much profit should be attributed to the company’s foreign affiliates, the IRS looked to the independent bottlers that work with Coca-Cola to distribute beverages.
The company argued that the bottlers were not a good comparable, but the court sided with the IRS.
“The problem is that such intangibles are so valuable because they are unique, and therefore there are no real comparables upon which to base a direct valuation of them,” said John Warner, a shareholder at Buchanan Ingersoll & Rooney PC in Washington.
“The valuation is indirect—measuring the residual income that the related party user of the intangibles should earn after paying such a royalty—in the case of Coca-Cola, through use of a CPM analysis of the ‘supply points’ that the court felt was straightforward because the those entities did not have any of their own valuable intangibles,” he added.
CPM refers to the comparable profits method, the transfer pricing methodology the IRS used in making its adjustment, which the court supported.
Coca-Cola could still choose to appeal the case.
“We are disappointed with the outcome of the U.S. Tax Court opinion, which we are reviewing in detail to consider its impact and potential grounds for its appeal. We intend to continue to vigorously defend our position,” the company said in a statement last week.
—With assistance from Jeffery Leon.