Coca-Cola Appeals $6 Billion IRS Decision in Prolonged Tax Dispute

How could a company like Coca-Cola underpay its taxes by $2.7 billion, resulting in a total impact of $6 billion after interest is imposed? What gave rise to this transfer pricing income adjustment and astonishing tax bill?

Of course, these are all hypothetical since none of us are privy to the full details, but our money is confidently on all of the above.

The tax court decision on the Coca-Cola case demands the reallocation of profits to Coca-Cola’s U.S. headquarters from its foreign affiliates in Brazil, Chile, Costa Rica, Egypt, Eswatini (formerly known as Swaziland), Ireland, and Mexico (collectively referred to as the “Supply Points”). The IRS argued that Coca-Cola’s transfer pricing position resulted in an improper allocation of profits, leading to an understatement of income to Coca-Cola U.S. headquarters and, consequently, an underpayment of U.S. taxes.

This practice of tax authorities reallocating profits among cross-border related companies is triggered when there is a dispute as to the “Transfer Pricing” used between the entities. To simplify complex transfer pricing regulations, all tax authorities expect related parties to operate as if they were total strangers, demanding arm’s length – or market rate – pricing for the intercompany transactions between the related entities. Essentially, each tax authority expects a piece of the profit (or loss) to compensate it for the functions, assets, and risks attributable to the entity in that market. While multinationals typically report as a consolidated global business, local tax authorities view them as pre-consolidated, stand-alone entities in each country to determine the tax bill due there.

At the heart of the dispute was the transfer pricing methodology used by Coca-Cola to determine the royalties paid by its foreign Supply Points to the U.S. parent company for the use of Coca-Cola’s valuable intellectual property, including trademarks and formulas. Essentially, Coca-Cola characterized the Supply Points as intangible owners, along with the U.S. headquarters, due to the localization of both syrup formulation and marketing. Well-traveled people have discovered that a Coke does not taste the same in every country, as it is localized to meet the tastes and regulations in each market. They have also noticed that the advertising/marketing campaigns can differ significantly to appeal to local consumers.

Coca-Cola seemed to apply a residual profit split method, where the supply points would retain 10% of gross profit and then allocate the remaining profit 50/50 to the U.S. headquarters. It felt confident in doing so since it’s an appropriate method when there is more than one intangible owner and since the IRS accepted this position and methodology in its closing agreement for five prior audit cycles. Coca-Cola had relied on a perceived long-standing agreement with the IRS regarding its transfer pricing method, and the company argued that the IRS’s abrupt change in position was unjustified and created uncertainty for businesses relying on such agreements. The IRS seems to take the position that the supply points in the six countries were routine entities, not intangible owners, thus applying the comparable profits method (also known as the transactional net margin method), determining a return on assets calculation as the profitability target for those supply point entities. This dramatically reduced the profit potential in non-U.S. markets, resulting in the IRS deeming underpaid royalties to the U.S. headquarters for the use of the proprietary formula.

In hindsight, had it not been so confident in past audit experiences with the IRS, Coca-Cola may have been able to protect itself better with prospective actions such as formal legal agreements with tax authorities, Advanced Pricing Agreements, Competent Authority negotiations, and other alternatives to tax court.

U.S. transfer pricing rules are grounded in the arm’s length principle, which requires that intercompany transactions be priced as if they were conducted between unrelated parties in the open market. This principle is designed to prevent profit shifting and ensure that taxable income is accurately reported in the jurisdictions where value is created.

However, this alignment becomes challenging when other countries employ transfer pricing methodologies that deviate from the arm’s length principle. The fixed rules previously used by Brazil [1] is just one example of how local regulations can conflict with U.S. standards, creating a risk of double taxation or prolonged disputes with tax authorities. The Brazilian and Irish subsidiaries accounted for roughly 85% of the disputed income adjustments. There is no U.S. – Brazil tax treaty, and the U.S. – Ireland tax treaty was not signed until 1998, so the risk of double taxation and prolonged tax authority disputes is clearly magnified.

In the Coca-Cola case, the IRS’s focus was on ensuring that the royalty payments reflected the economic value of the intellectual property being licensed by reallocating income to Coca-Cola U.S. using a comparable profits method, regardless of the local laws that may have set arbitrary limits on these payments. The court found that the IRS’s reallocation of income was reasonable and consistent with the applicable regulations.

This case also highlights the challenge of applying this principle to intangible assets such as brand and market assets, which are inherently difficult to value, especially if more than one entity is contributing to their development.

Transfer pricing might sound like a niche topic, but it is making front-page news these days as it plays a crucial role in many high-profile tax disputes. The Coca-Cola case [2] underscores the critical importance of multinational corporations reassessing their transfer pricing practices, ensuring compliance with current standards, and being prepared for potential disputes with tax authorities. This case also highlights the very real fact that just because the IRS (or any of the world’s tax authorities) accepted a certain transfer pricing method and outcome in prior years’ audits with no income adjustment, taxpayers can’t rely on this same result year after year. It’s critical for multinationals to assess the health of their global transfer pricing on an annual basis.

For multinational corporations, the Coca-Cola case stands as a warning of potential risks. The IRS has made it clear that it will scrutinize transfer pricing arrangements that do not align with the arm’s length principle, even if those arrangements comply with local regulations in other countries and even if those arrangements received their blessing in the past. This scrutiny of multinational operations extends beyond royalties to other forms of intercompany transactions, including the pricing of goods, services, and financial instruments.

Authors: Ana Carolina Salvador Groninger | [email protected]; Marina Gentile, Partner and Lead, Global Transfer Pricing Strategies | [email protected]; and Chaya Siegfried, CPA, Partner and Lead, International Business Tax | [email protected]

[1] On June 15, 2023, Law 14,596/23 entered into force and established a new Brazilian Transfer Pricing regulations aligned with the OECD Guidelines.

[2] Docket No. 31183-15