Coca-Cola's Challenge to IRS Transfer Pricing Adjustments Fizzles Out in Tax Court

(Parker Tax Publishing December 2020)

The Tax Court held that (1) the IRS did not abuse its discretion under Code Sec. 482 by reallocating income to a U.S. parent corporation from its foreign manufacturing affiliates where the foreign affiliates undercompensated the parent for use of its intellectual property, and (2) the IRS properly recomputed the parent's Code Sec. 987 losses after changing the income allocable to one of the parent's foreign branches. The Tax Court also held that the parent corporation made a timely election to employ dividend offset treatment with respect to dividends paid by the foreign affiliates in satisfaction of their royalty obligations, resulting in a reduction of the reallocations of income to the parent by the amount of those dividends. The Coca-Cola Company & Subsidiaries v. Comm'r, 155 T.C. No. 10 (2020).

Background

The Coca-Cola Company (TCCC), a U.S. corporation, is the parent company of a group of entities that do business in more than 200 countries throughout the world. During 2007-2009, the years at issue, TCCC licensed foreign manufacturing affiliates, referred to as "supply points," to use TCCC's intangible property, including trademarks, brand names, logos, patents, secret formulas, and proprietary manufacturing processes. These supply points produced "concentrate" (i.e., syrups, flavorings, powder, and other ingredients) used in the production of TCCC's branded soft drinks (including Coca-Cola, Fanta, and Sprite) and other beverages. The supply points sold and distributed concentrate to hundreds of Coca-Cola bottlers in Europe, Africa, Asia, Latin America, and Australasia, and the bottlers used this concentrate to produce finished beverages that they marketed to millions of retail establishments throughout the world (excluding the United States and Canada).

During the years at issue, the supply points compensated TCCC for the use of its intellectual property using the "10-50-50 method," as it had done for the previous 11 years. This was a formulary apportionment method to which TCCC and the IRS had agreed in a closing agreement executed in 1996, which resolved TCCCs tax liabilities for 1987-1995. This method permitted the supply points to retain profit equal to 10 percent of their gross sales, with the remaining profit being split 50-50 with TCCC. The closing agreement did not address what transfer pricing methodology would be used for years after 1995. But TCCC continued to employ the 10-50-50 method, from 1996 onwards, to report income from its foreign supply points.

The amounts due TCCC under the 10-50-50 method were in the nature of royalties. However, the closing agreement permitted the foreign supply points to satisfy their royalty obligations by paying dividends to TCCC. During 2007-2009 more than $1.8 billion of the income TCCC received from its foreign supply points pursuant to the 10-50-50 method took the form of dividends rather than royalties. TCCC claimed "deemed paid" foreign tax credits (FTCs) under Code Sec. 902 with respect to these dividends, as the closing agreement had permitted for 1987-1995.

Under Code Sec. 482, the IRS may allocate gross income, deductions, credits, or allowances between or among related organizations if it determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or to clearly reflect income. A taxpayer challenging a Code Sec. 482 adjustment must show that the IRS abused its discretion by making allocations that are arbitrary, capricious, or unreasonable. Reg. Sec. 1.482-1(b)(1) provides that the 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. When the IRS reallocates income under Code Sec. 482, Reg. Sec. 1.482-1(g) provides that it may also make collateral adjustments. Code Sec. 987 provides rules for determining the taxable income of a taxpayer that has foreign branches with a functional currency other than the U.S. dollar. Under Reg. Sec. 1.987-5(d), the taxpayer must determine its foreign exchange gain or loss when the foreign branch remits cash or property to it, e.g., by paying dividends or royalties. Thus, a Code Sec. 482 adjustment may result in a recomputation of a taxpayer's Code Sec. 987 foreign exchange income or loss as a collateral adjustment.

After examining TCCC's 2007-2009 returns, the IRS made adjustments that increased TCCC's aggregate taxable income by more than $9 billion. The IRS determined that TCCC's use of the 10-50-50 method did not reflect arm's length pricing because it overcompensated the supply points and undercompensated TCCC for the use of its intangible property. Invoking Code Sec. 482, the IRS reallocated income to TCCC using a comparable profits method (CPM), treating independent Coca-Cola bottlers as comparable parties. The IRS regarded these bottlers as comparable to the supply points because they operated in the same industry, faced similar economic risks, had similar contractual relationships with TCCC, employed many of the same intangible assets (TCCC's brand names, trademarks, and logos), and ultimately shared the same income stream from sales of TCCC's beverages. The IRS also made correlative allocations that reduced the income of TCCC's branch in Mexico, reducing the branch's income and causing TCCC's Code Sec. 987 losses to be incorrect. TCCC's Code Sec. 987 losses were therefore recomputed to reflect the collateral allocations to the Mexican branch.

TCCC challenged the IRS's reallocations in the Tax Court. TCCC contended that the IRS acted arbitrarily by abandoning the 10-50-50 method, having acquiesced in the use of that method during five prior audit cycles spanning a decade. TCCC further argued that the IRS erred in employing the bottler CPM to reallocate income, reasoning that independent Coca-Cola bottlers were not comparable to the supply points because the latter owned immensely valuable intangible assets that did not appear on their balance sheets or in any written contract. TCCC further argued that, if the Tax Court upheld the IRS's position in whole or part, the adjustments should be reduced to reflect dividends paid by the supply points, to the extent those amounts were repatriated to satisfy the supply points' royalty obligations. Although TCCC elected "dividend offset" treatment on timely filed returns for 2007-2009, it did not include in those returns explanatory statements as directed by Rev. Proc. 99-32. The IRS contended that TCCC's failure to include these statements was fatal to its claim to dividend offsets.

Tax Court's Analysis

The Tax Court held that the IRS did not abuse his discretion in reallocating income to TCCC, under Code Sec. 482, by employing a CPM that used the supply points as the tested parties and the bottlers as the uncontrolled comparables. In the court's view, TCCC failed to show that the IRS's determination was purely arbitrary and the court found that there was substantial evidence supporting the IRS's determination. The court rejected TCCC's argument that the supply points owned valuable off-book assets in the form of marketing intangibles. Rather, the court found that under Reg. Sec. 1.482-3(f)(3)(ii)(A), legal ownership was the test for identifying the intangible, and TCCC did not dispute that it was the registered legal owner of virtually all of the trademarks and other intangible assets needed to manufacture and sell TCCC-trademarked beverages in foreign markets.

The court also held that the IRS did not err by recomputing TCCC's Code Sec. 987 losses after the CPM changed the income allocable to TCCC's Mexican supply point. The court reasoned that the IRS's allocations did not change the consolidated group's overall income, but did reduce the income of the Mexican branch, which changed the Mexican branch's taxable income for purposes of computing TCCC's foreign currency gain or loss under Code Sec. 987. However, the court found that the primary allocations, correlative allocations, and Code Sec. 987 recomputations taken together produced the same result that would have occurred if TCCC and its Mexican branch had reported income consistently with the arm's length standard from the outset.

Finally, the Tax Court further held that TCCC made a timely election to employ dividend offset treatment with respect to dividends paid by the supply points during 2007-2009 in satisfaction of their royalty obligations, and the IRS's reallocations to TCCC accordingly had to be reduced by the amounts of those dividends. The court found that TCCC elected dividend offset treatment on its 2007-2009 tax returns as permitted under Rev. Proc. 99-32. Although TCCC did not include an explanatory statement with its returns as directed by Rev. Proc. 99-32, the court found that TCCC substantially complied with the essential requirements of the procedure since the explanatory statement requirement was procedural rather than essential and would have added nothing to the IRS's sum of knowledge.

For a discussion of the rules for allocating income and expenses among related corporations, see Parker Tax ¶241,597. For a discussion of foreign currency gains and losses, see Parker Tax ¶202,500.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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