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Coca-Cola’s U.S. Transfer Pricing Dispute May Cost $12 Billion

Posted on Feb. 11, 2021

If the IRS applies the transfer pricing method approved by the Tax Court to the Coca-Cola Co.’s post-2009 tax years, the total liability in its U.S. transfer pricing dispute could reach $12 billion.

Coca-Cola provided the estimate of its potential liability in a pair of exhibits to its February 10 Form 8-K, which notes that the company will “vigorously defend its position” in the wake of a Tax Court decision upholding $9.9 billion in transfer pricing adjustments concerning Coca-Cola’s license of intangibles to its foreign “supply points.” In a decision heralded as a major IRS victory, the Tax Court held in The Coca-Cola Co. v. Commissioner, 155 T.C. No. 10 (2020), that the adjustments to the company’s 2007-2009 taxable income — and the method with which they were calculated — were appropriate under the section 482 regulations.

The Tax Court decision provides the IRS’s section 482 reallocations by year, which total over $3.4 billion for 2007-2009, but does not specify what the company’s U.S. tax liability plus interest will be after offsetting the $9.9 billion in adjustments with about $1.8 billion in dividends repatriated under a 1996 closing agreement. The amount will depend in part on the resolution of the "blocked income" issue reserved until a decision is reached in 3M Company v. Commissioner, No. 5816-13.

The decision also provides no indication of what the company’s additional liability would be if the IRS’s comparable profits method analysis — which uses independent bottling companies’ return on assets to determine how much profit the supply points should earn — were applied to tax years after 2009.

Coca-Cola has provided its first public estimate of that amount in the exhibits to its latest Form 8-K, including an exhibit focused specifically on the Tax Court case. “The company calculated the potential tax impact of applying the Tax Court methodology to reallocate income from foreign licensees potentially covered within the scope of the opinion, assuming such methodology was ultimately to be upheld by the courts, and the IRS were to decide to apply that methodology to subsequent years, with consent of the federal courts,” the exhibit says. “The company currently estimates that the potential aggregate incremental tax and interest liability could be approximately $12 billion.”

The $12 billion figure includes the total tax liability and interest for 2007 through 2009 — estimated at $4.6 billion as of the end of 2020 — as well as the potential liability for 2010 through 2020. The amounts do not include penalties, reflecting a clause in the 1996 closing agreement providing the company protection from section 6662 penalties in connection with any underpayment resulting from the continued use of the agreement’s allocation formula after its term ended in 1995. Assuming no significant change in facts and circumstances, applying the IRS’s method after 2020 would increase the company’s effective tax rate by about 3.5 percent, the exhibit adds.

'Retroactive Imposition of Tax'

Although Coca-Cola’s $12 billion estimate was the product of applying a method that received the Tax Court’s unequivocal approval, the company announced a far lower figure of $438 million for its reserve under Accounting Standards Codification Subtopic 740-10. Under the accounting rules for uncertain tax positions — often referred to by its former designation, "FIN 48" — companies subject to the rules must book a reserve for any tax position that is more likely than not to be upheld on appeal or in litigation. The amount of the reserve must be based on an assessment of the probabilities of different outcomes.

The company cited confidence in its position as the basis for booking a reserve far less than $12 billion, noting that its appeal will at least partially consist of a constitutional challenge. “The company believes that it will ultimately prevail in the litigation based on the technical and legal merits of the company's position, its consultation with outside advisers, and the company's belief that the IRS's retroactive imposition of tax liability is unconstitutional. Accordingly, the company is not recording a provision for the full amount of the potential liability,” another exhibit to Coca-Cola’s Form 8-K said.

In an emailed statement, the company repeated its suggestion that the IRS violated Coca-Cola’s constitutional rights when it decided not to accept the company’s continued use of the allocation formula approved in 1996. “We believe the retroactive imposition of tax for years covered by our agreement, which was calculated using a different methodology than the one we agreed to with the IRS, is unconstitutional,” the company said.

The company has previously signaled its resolve to continue litigating the dispute by announcing its hiring of J. Michael Luttig, a former judge for the Fourth Circuit. It makes sense that an appeal spearheaded by Luttig, who is not known for specializing in highly technical transfer pricing cases, would focus on this constitutional argument, according to David Rosenbloom of Caplin & Drysdale. But Rosenbloom expressed skepticism regarding Coca-Cola’s prospects of success, noting that the dispute does not feature any of the arguably retroactive aspects of the Tax Cuts and Jobs Act.

“I don’t think there’s much of a constitutional case against retroactivity, but the [Coca-Cola] case isn’t even retroactive,” Rosenbloom said. “And moreover, relying on a closing agreement that by its terms didn’t apply after the years to which it formally applied — that’s what the judge they’ve brought in is going to argue — I find that kind of crazy. If the IRS is put in a position of saying once it goes into a closing agreement . . . it’s bound forever by what it does in the closing agreement, you’re not going to see any more closing agreements.”

Rosenbloom also noted that, in his experience, the IRS rarely completely reverses its position without at least informally indicating that it was likely to do so.

“The IRS generally — there are always exceptions — doesn’t do 180-degree turns on something like that without giving some kind of a signal. It might have been very informal,” Rosenbloom said. “Their international examiner might have talked to the international person at Coke and said, '[The IRS] is having second thoughts about this.'”

Reuven Avi-Yonah of the University of Michigan Law School questioned Coca-Cola’s position as well, arguing that the more striking aspect of the case is the IRS’s leniency.

“I don’t see a constitutional issue here. What I find surprising is that under the agreement with the IRS, the company faced no penalties if it continued to follow the previous method,” Avi-Yonah said. “So if it had simply put the tax saving aside, they could have earned more interest on it than the underpayment rate and come out ahead. Instead, they seemed to have simply assumed that they will win, and there is no constitutional right to doing that.”

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