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IRS, Coca-Cola Continue Fight Over Transfer Pricing Analysis

Posted on Apr. 19, 2019

Nearly a year after trial in Coca-Cola’s $3.3 billion Tax Court case, the parties are still trading post-trial filings debating the validity of the comparable profits method analysis used by the IRS.

In a reply brief filed April 10, the IRS defended the reliability of the transfer pricing analysis it used to adjust the Coca-Cola Co.’s taxable income by $9.4 billion for the 2007-2009 period in a case (No. 031183-15) that was tried from March to May of 2018. (Prior analysis. Coca-Cola's 2015 petition to the Tax Court.) According to the IRS, the foreign “supply points” — the foreign subsidiaries that licensed trademarks, formulas, and other intangibles from the Coca-Cola Co. — were entitled to only a routine return determined using the CPM. Under the section 482 regulations (T.D. 8552), the CPM generally should be applied only to a tested party that performs benchmarkable functions and holds few unique and valuable intangibles.

The recent IRS filing is a response to Coca-Cola’s March 15 reply brief, which challenges the admissibility and relevance of arguments contained in the IRS’s post-trial answering brief filed in February. According to Coca-Cola's reply brief, the CPM improperly allocated all returns on intangibles — the residual profit remaining after attributing routine returns to the licensees — to the U.S. parent. The IRS rejected this interpretation in its reply brief, which says the CPM left the supply points with a return consistent with its functions, assets, and risks.

“Petitioner's argument rests on the false premise that respondent attributes to [the Coca-Cola Co.], the legal owner of most trademarks used by supply points, ‘all returns related to the licensed intangibles.’ Instead, respondent's CPM attributes to supply points the profits attributable to the functions, risks, and assets — including intangibles — that comparable bottlers bring to the table,” the IRS brief says.

The IRS brief also faults the method used by Coca-Cola’s expert witness for failing to account for the value of the Coca Cola Co.’s product formulas, frameworks and guidelines, global campaigns, and global sponsorships. “Petitioner's unreliable relative contribution approach is another reason that comparing supply points to bottlers is the best method for determining the supply points' arm's-length profits,” the brief says.

One of the alleged shortcomings in the IRS’s analysis — which used independent bottling companies’ return on assets — is that the ratio of intangible assets to tangible operating assets was significantly higher for the supply points than for the bottlers used as comparables. To use return on capital as the profit-level indicator, the section 482 regulations generally require that the composition of assets held by the tested party and comparables must be similar. According to Coca-Cola's brief, the IRS’s attempt to reconcile the intangible intensity by capitalizing the marketing service costs of related-party service providers was improperly withheld during trial and “irreparably flawed.”

“Respondent is stuck with what his experts did not challenge — the twelve-to-one difference between the bottlers' and foreign licensees' tangible operating assets. There is no evidence that the bottlers had twelve times or more intangible assets than the six foreign licensees,” the Coca-Cola brief says.

The briefs also dispute the relevance of the impairment testing for the “Joya” trademark performed by Coca-Cola for financial accounting purposes. The analysis, according to the IRS, showed that more than 50 percent of Coca-Cola’s cash flows were attributable to the trademarks licensed to the supply points. Coca-Cola rejected this inference, noting that the 79.2 percent royalty rate used for impairment testing was greater than total operating income from Joya products.

Although it does not explicitly challenge the validity of the CPM, the Coca-Cola brief also questions the validity of pricing a license using the licensee’s profit margins. The IRS rejected the relevance of this point in its reply.

“Petitioner's assertion is not a section 482 analysis. The regulations do not require that the CPM or any other transfer pricing method mimic how uncontrolled parties would reach a price,” the IRS brief says. “Rather, the method need only reliably determine the result that uncontrolled parties would have agreed upon.”

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