IRS Defends Comparable Profits Method in Coco-Cola Case

THE COCA-COLA COMPANY & SUBSIDIARIES,
Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent.

UNITED STATES TAX COURT

Judge Lauber

Filed Electronically

RESPONDENT'S RESPONSE TO PETITIONER'S SERIATIM REPLY BRIEF

In accordance with the Court's March 18, 2019 Order, respondent submits the following response.

I. Respondent's Arguments Regarding the Canadian Adjustments Are Not False or Misleading, New Matter, Inconsistent with His Notice Position, or Arbitrary.

Petitioner's argument rests on the false premise that respondent attributes to TCCC, the legal owner of most trademarks used by Supply Points, "all returns related to the licensed intangibles." PRBr. at 1. 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 reliability of Dr. Newlon's CPM depends on whether Supply Points' contributions are comparable to Bottlers'.

To support its argument that respondent was arbitrary as a result of his allegedly inconsistent Notice adjustments, petitioner relies on cases that do not apply to a de novo deficiency proceeding.¹ PRBr. at 1, 9-10 n.12 (referencing PBr. at 474). Petitioner alleges that the reasoning supporting the Canadian adjustments is inconsistent with the reasoning supporting the Supply Point adjustments. But under section 482, the issue is whether the results of the Supply Point adjustments were consistent with the results of uncontrolled comparables. Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 581 (1989); Eli Lilly & Co. v. United States, 372 F.2d 990, 997 (1967); see also Treas. Reg. § 1.482-1 (b) (1) (a controlled transaction meets the arm's length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances). The reasoning contained in a NOPA about a different transaction has no place in the analysis.²

Petitioner also failed to show that the results of respondent's Canadian adjustments were arbitrary and inconsistent with the substance of TCCC's arrangement with CCL. The Canadian transfer-pricing analysis petitioner submitted in the Competent Authority proceeding treats CCL as a limited-risk service provider consistent with respondent's Notice position. Ex. 2923-J at 1326.

Petitioner disputes respondent's account of CCL's acquisition of trademark rights. PRBr. at 2-3. Petitioner asserts that the $1 sale of the trademark was in exchange for stock in the Canadian affiliate. Id. But the source of the allegation on how CCL acquired trademark rights — petitioner's Canadian transfer-pricing analysis — does not mention such an exchange. It states that the Coca-Cola trademark was transferred to CCL in 1923 and that CCL registered additional trademarks over time. Ex. 2923-J at 1322.

Petitioner improperly contends that its stipulated trademark records are inaccurate based largely on unidentified, outside-the-record trademark registrations that no trademark expert had the opportunity to examine. T.C. Rule 143(c); Perkins v. Commissioner, 40 T.C. 330, 340 (1963) (Court will not examine ex parte statements made on brief as evidence in adjudicating factual disputes); see PRBr. at 5-6 n.7. The stipulated trademark records showing TCCC's — and not CCL's — ownership of associated trademarks for subsequent years are consistent with petitioner's prior representations in the Competent Authority proceeding. RABr. at 700 n.85 ("After Canadian trademark law changed, TCCC began to register and hold Canadian trademarks itself." (citing Ex. 2923-J at 1322)). This unexplained inconsistency with petitioner's argument on brief raises more questions than it answers, another reason why evidence about the Canadian adjustments is inadmissible under FRE Rules 401 and 403 (confusion and waste of time).

Respondent has always maintained that the results of arm's length pricing should compensate TCCC for all of its contributions (even where it does not legally own the trademarks). The profit split between TCCC and Supply Points is driven by control rights, bargaining power, and risk. RBr. at Arg. A.5.c) (4). In addition to its trademarks, TCCC brought other intangibles to the table, including its Bottler distribution network, its global initiatives, and the cost savings created by its scale and stature. Ex. 8407-R at ¶¶22-23, 25-29, 31-39 (Ailawadi & Farris). Dr. Cragg failed to account for TCCC's formulas, frameworks and guidelines, global campaigns, and global sponsorships. Exs. 8503-R at ¶¶21, 44, 82-86 (Reibstein), 8486-R at ¶¶41-42 (Metrick). Dr. Cragg admitted that he attributed no profit to TCCC for the Coca-Cola formula, logos, bottle, or Spencerian script and agreed that an uncontrolled party would receive profits for performing TCCC's global marketing activities. Tr. 4512:23-25, 4513:8-11, 4516:8-11, 4691:1-19 (Cragg). Petitioner's unreliable relative contribution approach is another reason that comparing Supply Points to Bottlers is the best method for determining Supply Points' arm's length profits.³

II. Respondent's Objections Properly Responded to Petitioner's Contentions and Did Not Raise New Arguments.

A. Petitioner's Ratio Analyses Are Flawed.

Both Drs. Metrick and Newlon challenged multiple assumptions impacting the reliability of Dr. Willig's calculations of Bottler and Supply Point intangible assets.⁴ See RBr. at 395-404; Ex. 8295-R at 3-17, 20-26, 32-35, 46-53 (Newlon). Petitioner first presented the alleged 12:1 tangible-asset ratio when cross-examining Dr. Newlon.⁵ He did not agree that the tangible-asset ratio was accurate; he had not verified it. Tr. 8539:16-8543:14 (Newlon). Petitioner asked Dr. Metrick to assume the ratio was correct. Tr. 10199:10-10200:11 (Metrick). Addressing problems with the 12:1 tangible-asset ratio in response to petitioner's contentions on brief is not a new matter. First Specialty Ins. Corp, v. 633 Partners, Ltd._r No. 07-14922, 2008 WL 4996848, at *3, *9 (11th Cir. November 25, 2008) (affirming district court's denial of a surreply because arguments were not "new" where they were responsive to plaintiff's contentions).

The accuracy of the 12:1 ratio is also not a new matter because petitioner had the opportunity to present evidence on the issue. See Ware v. Commissioner, 92 T.C. 1267, 1268 (1989), aff'd, 906 F.2d 62 (2d Cir. 1990). Respondent cross-examined petitioner's financial-ratio expert, Dr. Luehrman, about the exclusion of Service Company assets from his revenue-to-asset (asset turnover) ratio analysis. Tr. 6187:13-6189:9, 6191:14-6192:9, 6285:9-23 (Luehrman). Dr. Luehrman agreed that including Service Companies' assets in financial ratios "does make sense." Tr. 6283:19-6285:23 (Luehrman). Petitioner had the opportunity to redirect Dr. Luehrman and cross-examine respondent's other experts on the issue.

Dr. Willig, like Dr. Luehrman, did not include Service Company tangible assets in his analysis. He used all concentrate revenues, but excluded Service Company assets even though such assets were used to generate concentrate revenues for the markets at issue. Ex. 7251-P at Ex. 11 (Willig). Respondent has consistently maintained that Supply Points and Service Companies should be treated as separate entities; it is petitioner that is inconsistent.⁶ See PRBr. at 11 n.14. Further, because Dr. Willig capitalized Service Company costs to determine Supply Point intangible assets (a method disputed by respondent, see RBr. at 406-08, Tr. 10095:6-11 (Metrick)), all Service Company as well as Supply Point tangible assets should be included in petitioner's tangible-asset ratio.

Petitioner suggests on brief that excluding Service Company assets would not materially impact its experts' analysis. PBr. at 440 n.48. Petitioner produced no contemporaneous Service Company balance sheets. But cross-examination of Dr. Luehrman based on his financial data, showed that integrated Supply Points (which would need assets similar to Service Companies to perform their functions) had similar revenue-to-asset ratios as Bottlers. Tr. 6183:4-6189:9 (Luehrman); Ex. 8445-R. If integrated Supply Points and Bottlers have similar revenue-to-asset ratios, the ratio of Bottler revenue to integrated Supply Point revenue would be similar to the ratio of Bottler assets to integrated Supply Point assets. Dr. Willig adopted Dr. Newlon's conclusion that Bottler revenues are about five times Supply Points' revenues.⁷ Thus, Bottlers would have about five, not twelve, times the tangible assets as integrated Supply Points.

Petitioner claims that if securities and other investments in nonoperating assets (investments) were removed from Dr. Luehrman's asset computations, the revenue-to-asset ratios for the Chile and Brazil Supply Points would be significantly higher than the Bottlers' ratios. PRBr. at 12-13. But as the attached appendix shows, removing investments changes the revenue-to-asset ratios for the Chile, Brazil and Egypt Supply Points to 1.61, 1.64 and 1.55, respectively (a median of 1.61 for the three integrated Supply Points), not much different from the Bottlers' original ratio of 1.26.⁸ Moreover, making the same asset adjustment for Bottlers — necessary for an apples-to-apples comparison — increases the Bottlers' ratio to 1.52, very similar to the 1.61 median ratio for integrated Supply Points.⁹

B. Uncontrolled Parties, Petitioner, and Petitioner's Transfer-Pricing Expert Benchmark Royalties Using Profit Margins.

Petitioner asserts that arm's length licensing parties "do not use margins from one transaction to benchmark a licensee's profits in another." PRBr. at 13. 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. Rather, the method need only reliably determine the result that uncontrolled parties would have agreed upon. Treas. Reg. § 1.482-1(f)(2)(v).

Petitioner's transfer-pricing expert, Dr. Barbera, considered an approach like Dr. Becker's method in proposing to use the profitability of a Dr. Pepper licensee as a PLI:

Tr. 7486: 9-20, Ex. 7376-P at ¶¶49-54, App.D. (Barbera). Petitioner also ignores substantial evidence showing that uncontrolled parties, including the Company, look at licensee's profits to test royalty rates. OPFF ¶¶823, 819 (the Company considered third-party margins in setting the royalty rate in the Godiva, Cadbury, Honest Tea, and Caribou transactions), 429-30; RF ¶¶798-800 (Bottlers and the Company analyzed Bottlers' ROIC in setting concentrate prices and evaluating the Bottlers' business).¹⁰

Petitioner disputes the relevance of a Company template document "used to calculate the fair value of a trademark," in this case Joya. PRBr. at 14-15; see Ex. 8787-R Tab "Template Instructions" under the header "Trademarks." The Company performed similar impairment exercises for all its trademarks. Tr. 3976:13-23 (Gioe); see, e.g., Ex. 8783-R, Tab "Trademarks." The example shows that the Company assigned significant portions of the cash flows — more than 50% — to its trademarks, consistent with its statement that the "value in beverage businesses is predominantly governed by brand value."¹¹ Ex. 8787-R Tab "Memo" header "Discount Rate on Trademarks."

Petitioner does not disagree with the royalty-rate computations in respondent's request for additional findings of fact, but objects to presenting the experts' royalty rates at the wholesale level. PRBr. at 16 n.21. Dr. Unni as well as Dr. Becker presented royalties as a percentage of both concentrate and Bottler retail revenue. Exs. 7330-P at ¶¶153–57, Ex. 5.3.E. and F. (Unni), 8288-R at Table 13 (Becker). Mr. Gioe testified that the Company looked at royalty rates — generally in the low-to-mid single digits of wholesale prices — as petitioner points out. PRBr. at 5 n.5. Respondent requested additional findings in its reply brief to present royalties on a consistent base, across all experts.

III. Respondent's Intangible Property Ownership Arguments Involving the Brazil Supply Point Are Proper.

A. The Brazil Supply Point Was Not the Developer of the 15 Pre-1985 Registered Trademarks Under the 1968 Regulations.

In arguing that TCCC, not the Brazil Supply Point, was the developer under the 1968 regulations,¹² respondent addressed whether the Brazil Supply Point was capable of developing the 15 Pre-1985 Registered Trademarks. RBr. at 491-92. TCCC fully developed and registered all 15 trademarks before licensing them to the Brazil Supply Point, and it developed nine of the trademarks before the Brazil Supply Point existed. RBr. at 492-94. As such, the secondary factors are relevant only to determine the Brazil Supply Point's assistance. RABr. at 760; see also Treas. Reg. § 1.482-2(d)(1)(ii)(b),(c) (1968). Respondent's Notice adjustment adequately compensates the Brazil Supply Point for its role. RABr. at 759 (citing Tr. 8054:8-8058:10 (Newlon) (explaining why his method accounts for all the Brazil Supply Point functions)).

B. The Brazil Supply Point Was Not the Owner of Kuat and Other Brazil Local Product Trademarks Under Section 1.482-4T(f) (3) (2006).

Brazil Local Products, including Kuat, accounted for only 4% of the Brazil Supply Point's gross revenues. RBr. at 483 n.188; RABr. at 753.¹³ TCCC's legal ownership of the Brazil Local Product trademarks is consistent with the economic substance of the licensing transaction. RBr. at 495; RABr. at 763. Petitioner asserts that "corporate headquarters played no role" in those products' development. PRBr. at 20-21. To the contrary, TCCC approved all new products and formulas, and contributed valuable intangible assets that were critical to product sales. RBr. at Arg. A.2.b)-c); RABr. at 763-64. By contrast, the Brazil Supply Point's contributions were routine, replaceable functions. RBr. at Arg. A.2.b)-c), B.l.b); RABr. at 763-64.

Separately, petitioner argues that Pre-1985 Registered Trademarks not listed in written licenses before November 17, 1985, were nevertheless licensed and grandfathered. See PRBr. at 19-20 n.23; PABr. at 153. To support its argument, petitioner suggests that Brazilian law recognized implied licenses before 1997. PABr. at 153. Prof. Franklyn could not identify any Brazilian statute or authority to support that conclusion. RABr. at 774 (citing Tr. 7975:18-7976:17, 7989:8-7990:5 (Franklyn)). Dr. Viegas testified that Brazilian industrial property law did not recognize implied licenses until a 1997 change in the law. After that change, an owner could show that its registered marks were actually used in Brazil under an implied license to avoid forfeiture for lack of use. RABr. at 774 (citing Tr. 8492:23-8493:20 (Viegas)); Tr. 8457:16-25 (Viegas). Moreover, the Company changed its licensing practice in 1997 — no longer listing registered trademarks in BPTO-recorded license agreements and amendments — suggesting that implied licenses were recognized only after the 1997 change in Brazilian law. RABr. at 774. While petitioner provided no explanation for why the Company changed its practice, Dr. Viegas opined that the Company stopped recording licenses because of the change in the law. Tr. 8492:23-8493:20 (Viegas).

Date: April 4, 2019

MICHAEL J. DESMOND
Chief Counsel
Internal Revenue Service

By: Julie Gasper
for JILL A. FRISCH
Special Trial Attorney
(SL) (LB&I)
Tax Court Bar No. FJ0677
One Newark Center, 15th Floor
Newark, NJ 07102-5224
Telephone: 973-681-6623
Email: Jill.A.Frisch@irscounsel.treas.gov

OF COUNSEL:
ROBIN L. GREENHOUSE
Division Counsel (LB&I)
KATHRYN F. PATTERSON
Deputy Division Counsel (Operations) (LB&I)
ELIZABETH P. FLORES
Senior Level Deputy Area Counsel, Strategic Litigation (LB&I)