Tax Notes legal reporter Ryan Finley discusses the IRS’s major victory in the Coca-Cola case and its future implications for transfer pricing cases.
This post has been edited for length and clarity.
David Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: share a Coke
Here to talk about this case and what it could mean for the future of transfer pricing disputes is Tax Notes legal reporter Ryan Finley. Ryan, welcome back to the podcast.
Ryan Finley: Thanks.
David Stewart: It feels a bit strange talking about IRS wins on transfer pricing cases. Can you tell listeners a bit about the U.S. government’s track record?
Ryan Finley: Yeah. Up until recently, it has not been great. The three recent highest profile cases were Amazon
Altera dealt with a very specific issue that doesn’t come up in Coca-Cola, but Amazon and particularly Medtronic do have some similar issues, particularly whether the IRS’s selection of method was right.
But, things started to maybe turn around a little bit in 2018 when the Tax Court’s Medtronic decision was vacated, remanded, and Altera was later reversed. Even though the IRS lost Amazon on appeal, the opinion suggests that the IRS would have won that case under current law.
Obviously this case is a bigger win, but it’s arguably been trending in the IRS’s favor for a couple years now.
David Stewart: Let’s turn to this case. Could we start with some background? What are the main issues here in this case?
Ryan Finley: Sure. The main transaction at issue is Coca-Cola, the U.S. parent’s license of its core intangible property, including its trademarks, brand names, product formulas. All the key things that go into its products to foreign subsidiaries that the company called its supply points.
The issue was whether the pricing for these licenses was arm’s length. The decision also deals with the taxpayer’s ability to rely on the terms of an old closing agreement, which had expired, and whether it could support a transfer pricing arrangement that was seemingly inconsistent with its own intercompany contracts.
There are a lot of issues in the case, but the main dispute was about the selection of transfer pricing method and whether the facts supported the IRS’s chosen method, which was the comparable profits method, or the CPM. The CPM usually determines an arm’s length return, operating profit divided by some denominator cost sales or assets that the party to the transaction that performs relatively routine functions ought to earn. It does this based on financial data from comparable independent companies. By default, when you apply this method, all the remaining residual profit goes to the other party.
In this case, if you apply the CPM to the supply points, all the remaining residual profit goes to the U.S. parent in the form of a royalty. Applying the CPM instead of Coca-Cola’s formula, which was a profit allocation formula set by the closing agreement, led to an initial reallocation of about $9.5 billion, and during the litigation, a further $385 million.
Because the CPM is generally only reliable when the tested party owns few, if any, unique intangibles, a lot of the case deals with whether these supply points had any unique or valuable intangibles. Coca-Cola said that they did, but their position was arguably at odds with their own contracts.
David Stewart: How did the Tax Court come down on these issues?
Ryan Finley: Other than a secondary dispute over whether these transfer pricing adjustments could be offset by repatriated dividends, the court decided every major issue in the IRS’s favor. They first quickly dismissed the argument that Coca-Cola had any right to rely on the formula in the closing agreement, which had expired a decade before the tax years at issue.
For the main point, the court also rejected this claim that the supply points held valuable intangibles, which according to the company were so-called marketing intangibles that were developed by these supply points’ local sales and marketing expenses.
The opinion emphasizes that the contracts between Coca-Cola and the supply points did not convey any rights to any marketing intangibles or anything like that. The company was bound by its own contracts under the 482 regulations.
As noted in the opinion, the section 482 regulations have a provision that allows the IRS to set aside legal arrangements that are inconsistent with economic substance, but it does not provide any parallel right to taxpayers.
But, the opinion goes further than that. It says that even if the company had been able to argue economic substance, they still would have lost because the economic substance did not support any such intangibles.
Basically the opinion says that these marketing activities, which the supply points themselves didn’t actually perform, just allocated the costs associated with those activities to the supply points. Those activities don’t automatically create some valuable intangible that any unrelated party would pay for, especially when, as in this case, exploiting these intangibles would infringe Coca-Cola’s trademarks.
The court rejected the various transfer pricing methods, which included the comparable and controlled transaction method, residual profits method, and an unspecified method that were applied by Coca-Cola’s expert witnesses, all of which were premised on the assumption that the supply points owned these alleged marketing intangibles. After a pretty detailed discussion, the court held that the IRS’s approach was reasonable.
Overall it was a pretty resounding defeat for Coca-Cola. Although, the company did succeed in persuading the court that $1.8 billion in dividends, which under the closing agreement had been allowed to be credited against the royalties that it had to pay, should be allowed to offset that nearly $10 billion adjustment by the amount of those dividends.
David Stewart: Here we have what seems to be a big win for the IRS. As you noted earlier, they’ve not had the best track record in litigating transfer pricing cases. Why is the outcome here different?
Ryan Finley: The most obvious reason is that the facts are different in this case than they were in other cases. This doesn’t involve a party that’s clearly contributing to intangible development. The supply points functions were basically just routine manufacturing.
As I said before, they didn’t actually perform the activities associated with the marketing expenses that were allocated to them. It was a lot harder to argue that the supply points created intangibles in the same way as parties to a cost-sharing arrangement, which was the type of transaction at issue in some of these major past cases that the IRS lost.
All of that undermined Coca-Cola’s economic substance argument. Since the court held that taxpayers can’t make an economic substance argument in the first place, the inconsistency between the company’s position and its contractual arrangements really hurt its case.
David Stewart: Is there anything that we can read into this case to look at what the future of transfer pricing litigation might be?
Ryan Finley: Yeah. First of all, the IRS’s success in a major transfer pricing case by itself is a big deal. It’s certainly possible that that would embolden the IRS to be more assertive in future litigation.
It’s also possible that since the Tax Court’s Medtronic decision was vacated-remanded by the Eighth Circuit in 2018, there’s been a slight shift in the way the court’s looking at transfer pricing cases. This opinion contains a detailed discussion of the 482 regulations comparability standards, which hasn’t typically been the case in past Tax Court decisions, especially not in Medtronic. The Coca-Cola opinion even cites the Eighth Circuit’s Medtronic decision, which was pretty critical of the Tax Court’s opinion in support of its own comparability analysis.
The decision is also different from a lot of previous transfer pricing cases in that the court accepted a profit-based method over the taxpayer’s comparable uncontrolled transaction method analysis. Previous Tax Court decisions have pretty consistently favored transactional methods over profit-based methods.
After a pretty lengthy explanation of the history of section 482 and the regulations’ best method rule, the opinion pointedly rejects the taxpayer’s claim that the CPM is somehow generally inferior to these transactional methods. But we’ll have to wait for the next line of cases to see if there really has been any long-term shift in approach.
David Stewart: We’re talking about a pretty large amount of money. What’s the likelihood that there’ll be an appeal? Does Coca-Cola have a chance at winning?
Ryan Finley: An appeal seems likely. The company suggested at least a strong possibility of an appeal in a public statement it released the day after the decision. As you said, the amount of money is so large that an appeal would probably make sense. But, the company will probably face an uphill battle appealing a decision that really relies heavily on the facts of the case.
It’s not clear from the opinion how any of the Tax Court’s factual findings could be successfully challenged in an appeal. The case doesn’t really present many complex legal questions that an appeals court could use to reverse or vacate the decision.
We won’t know what the company’s arguments would be unless and until it files an appeal, but at this point its prospects don’t look especially promising.
David Stewart: If we do see an appeal then we’ll have to have you back to talk about that. Ryan, thank you for being here.
Ryan Finley: Thank you.
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