U.S. Tax Court Rules in Favor of the IRS in Royalties Dispute

On November 18, 2020, the U.S. Tax Court ruled in favor of the IRS in its transfer pricing dispute with The Coca-Cola Company (Coca-Cola Co.) over royalties it received from foreign subsidiaries. The decision upheld two of the IRS’s three adjustments, which had increased the Coca-Cola Co.’s taxable income by more than $9 billion for its 2007-2009 taxable years (the adjustment must be reduced by approximately $1.8 billion because the court found that the taxpayer’s decision to partially offset royalty obligations with dividends paid by foreign manufacturing affiliates was timely and valid). This case is a notable victory for the IRS, which has lost a number of high-profile transfer pricing cases in litigation over the past decade.

Background

Coca-Cola Co., a U.S. corporation, holds the rights to intellectual property, including trademarks, product names, logos, patents, secret formulas and proprietary manufacturing processes (IP), used to make, distribute and sell Coca-Cola products globally. This IP was licensed to foreign subsidiaries referred to as “supply points” located in Brazil, Chile, Costa Rica, Egypt, Ireland, Mexico and Swaziland so that they could make and sell drink concentrate, primarily to third-party bottlers. After purchasing concentrate from the supply points, the bottlers would produce finished beverages ready for consumers, and sell the final product to distributors and retailers in Africa, Asia, Australasia, Europe and Latin America. The bottlers are diverse, ranging from small family-owned businesses to large multinational companies, and are mostly unrelated to the Coca-Cola Group.  

The supply points compensated Coca-Cola Co. for the use of its IP using the same methodology as specified in a 1996 closing agreement with the IRS, which covered the tax years 1987-1995. Under this agreement, the supply points would either make royalty payments or remit dividends back to Coca-Cola Co. to compensate for use of the Coca-Cola IP using a “10-50-50” method. This method permitted the supply points to retain 10% of their gross sales as profit, and then evenly split the remaining 90% of profit between the supply points and Coca-Cola Co.
Both closing agreements with “roll-forward” provisions and advance pricing agreements provide taxpayers greater certainty over their transfer pricing arrangements for specific future taxable years. Although Coca-Cola Co. applied the terms of its closing agreement each year after the specific term of the agreement (1987-1995), that agreement did not contain a roll-forward provision, and, after agreeing to the use of the 10-50-50 methodology for 10 years, the IRS asserted that the agreement did not apply to the years 2007-2009. The Tax Court agreed with the IRS that since there was no formal agreement to extend the terms of the closing agreement, the IRS was not bound by its terms.

Further, the intercompany agreements between Coca-Cola Co. and the supply points generally specified that the supply points were authorized to use Coca-Cola IP to manufacture concentrates, but that they did not have any entrepreneurial interest in Coca-Cola trademarks or other IP. The agreements generally did not specify the intercompany pricing policy between the supply points and the Coca-Cola Co. or the calculation of the payments from supply points to Coca-Cola Co.

Application of the Comparable Profits Method to Determine an Arm’s-Length Royalty

Despite the agency’s previous agreement with Coca-Cola Co., the IRS alleged that the supply points’ compensation to Coca-Cola Co. for use of the Coca-Cola IP was not arm’s length (a price that an independent party would pay to another in the course of a business transaction). Specifically, the IRS asserted that all significant Coca-Cola product, manufacturing and marketing IP was owned by Coca-Cola Co. (or U.S. subsidiaries), while the supply points only undertook routine manufacturing functions.

To make its case, the IRS used the comparable profits method (CPM) to determine an arm’s-length royalty for the use of Coca-Cola Co.’s IP. The CPM computes a routine return for companies that have functions and risks that are comparable to the least complex entity, or tested party, taking part in an intercompany transaction. The IRS choose the supply points as the tested parties in the transaction with Coca-Cola Co., and selected third-party bottlers that bottled and sold finished Coca-Cola products as the independent comparables to benchmark the return that the supply points should earn. The IRS then reallocated to Coca-Cola Co. all of the supply points’ residual profit in excess of the routine return as royalties for use of its IP.

Though Coca-Cola Co.’s primary argument in the case was that the supply points owned valuable off-book marketing intangibles, and therefore the CPM was an inappropriate method to determine their profit, the court disagreed. It is also clear from the opinion that the court found Coca-Cola group’s intercompany agreements between the parent and the supply points to be in conflict with the argument that Coca-Cola Co. was advancing.

The Tax Court agreed with both the IRS approach and its selection of the bottlers as comparables, stating that the functions performed by the bottlers resembled those performed by the supply points. Though it is unusual in transfer pricing practice to benchmark a return for a tested party using independent companies that operate at a different market level, the court agreed with the IRS’s economist that the adjustments made were in fact conservative, pointing out that since the bottlers generally took on more complex distribution activities and greater risks, and benefitted from greater economies of scale, contractual rights and market power than the supply points, the bottlers should, if anything, be entitled to higher returns than the supply points.