FORM OR FIZZ?

COCA-COLA
TRANSFER PRICING DECISION
The 2020 decision of the Tax Court in The Coca-Cola Company and Subsidiaries1
Author
(“Coca-Cola”) $3 billion transfer pricing case may cause Coca-Cola to petition the
Michael Peggs
appropriate U.S. Court of Appeals for the same reason it petitioned the Tax Court. A
Tags large amount of tax is at stake over a number of open tax years. But in comparison
10-50-50 to other transfer pricing cases, this may be one of the only reasons this controversy
Coca Cola went to trial and may yet again proceed to trial. The Tax Court’s decision highlights
C.P.M. several themes in transfer pricing best practice and global policy development.
C.U.T.
C.U.P. BACKGROUND
Intangible Property
Transfer Pricing During the years in issue, Coca Cola products were produced by independent bot-
tlers around the world using trademarks, product names, logos, patents, secret
formulas, and proprietary manufacturing processes licensed by Coca-Cola to sev-
en controlled companies or Supply Points. The Supply Points produced beverage
concentrate for sale to bottlers, and granted bottlers the right to use the Coca-Cola
trademarks, product names, and logos to package beverages. Supply Points were
allocated advertising, marketing and head office costs by Coca-Cola, but did not
develop or execute territorial marketing or advertising. The task of local market
advertising and consumer marketing and maintaining relations with bottlers fell to
approximately 60 Service Companies (“ServCos”). As advertising and marketing is
an important, concerted worldwide undertaking for Coca-Cola, external ad firms and
marketing firms were engaged, in some cases by the ServCos.

The issue in dispute was the pricing of the licensed rights between Coca-Cola and
the Supply Points. A secondary issue was whether dividends paid to Coca-Cola by
the Supply Points should be regarded as payment for the licensed rights, thereby
reducing the I.R.S. income reallocation to Coca-Cola.

THE VALUE OF CERTAINT Y

Coca-Cola settled an I.R.S. transfer pricing examination of its 1987-1995 tax years
using a residual profit split agreed with the I.R.S. The closing agreement for the
examination of the 1987-1995 tax years stipulated an allocated 50% of Supply Point
residual profit in excess of 10% of gross sales to Coca-Cola in satisfaction of the
company’s Code §482 requirement. This arrangement came to be known as the 10-
50-50 method, and was used to allocate income between Coca-Cola and the Supply
Points in tax years subsequent to 1995. The closing agreement allowed the Supply
Points to meet their licensing payment requirements by repatriating funds in a vari-
ety of forms, including the payment of dividends from Supply Points to Coca-Cola.

1
Coca-Cola Co. & Subsidiaries v. Commr., 155 T.C. __, No. 10, (2020).

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The 10-50-50 method was agreed after a lengthy I.R.S. examination and represent-
ed what appeared to Coca-Cola to be a reliable authority on which to base its trans-
fer pricing position for future tax years. The closing agreement did not make the 10-
50-50 method binding on the I.R.S. or Coca-Cola for tax years after 1995, lacking
the certainty otherwise obtainable under a unilateral A.P.A. Coca-Cola nonetheless
placed a high future certainty value on the I.R.S. position without contemplating the
future income effect of the compliance mechanism that performs annual tests of
the key assumptions underlying a typical unilateral A.P.A. A.P.A.’s and Competent
Authority agreements did vary the 10-50-50 method to resolve select controversies,
but the perceived wisdom of the 1995 closing agreement endured. It is unclear why
variation of the 10-50-50 method by Competent Authority was not a clearer signal to
Coca-Cola or a question dealt with in more depth in the Tax Court decision.

Coca-Cola argued that the I.R.S. abandoned the 10-50-50 method in the 2007-2009
tax years, but was unsuccessful in its argument as the Tax Court found there was no
agreed method to abandon.

WRIT TEN AGREEMENTS

The inter-company agreements that could be located served as the court’s basis
for understanding the intent of Coca-Cola and the Supply Points, the rights and
obligations of the parties, and the terms used in the controlled transaction. First
impressions were not entirely favorable, as the court characterized the agreements
as terse and incomplete.

The court’s review of the agreements pointed out several gaps that would other-
wise be absent in an agreement between independent parties, but focused on the
rights and obligations of the Supply Points concerning the use and development of
licensed intangible property. The court’s analysis noted the inclusion of Coca-Cola
in bottler agreements when ordinary sublicensing arrangements would render this
unnecessary, but most importantly traced the history of cancellation and assignment
of Supply Point licensing agreements through company reorganizations. This re-
organization history demonstrated that Supply Point agreements were terminated
without remuneration to the exiting Supply Point.

The nil terminal value of the rights granted to the Supply Points undermined Co-
ca-Cola’s argument that the Supply Points had accumulated the right to earn high
returns from valuable intangible property by funding marketing and advertising ac-
tivity. Ordinarily, an arm’s length party with a defensible claim to intangible property
rights and resulting expected returns would be paid a positive amount to give up
such rights. The consolidation of Supply Point operations around the world over
time provided a narrative of Supply Points with limited intangible property rights at
arm’s length.

The other series of company agreements that were examined by the court were
those between Coca-Cola and its subsidiaries concerning the allocation of U.S.
headquarters expenses or “pro-rata.” Though the court suggested that the terms
of the pro-rata allocations were often unclear, together with the evidence from the
licensing agreements, the allocations of advertising and marketing expenses under
the pro-rata agreements were used by the I.R.S. to argue that allocations of expense

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 to the Supply Points did not result in the right to earn high returns to licensed in-
tangible property. This line of argument was accepted by the court, following the
intangible asset ownership conditions of Treas. Reg. §1.482-4(f).

The Coca-Cola agreements largely stood on their own and were used extensively
to evaluate the issue in dispute. This stands in contrast to other transfer pricing
cases where fact witnesses were required to complete the court’s understanding
of the interpretation by the parties of key inter-company agreements and the
division of duties, risks, and rights in intangible assets that followed from that
interpretation.

“The factual IMPR ACTICALIT Y OF A RESIDUAL PROFIT SPLIT

underpinning of a
residual profit split Coca-Cola used the residual profit split method and other transfer pricing methods
is critical to method to support its position at trial, but relied principally on the 10-50-50 method or resid-
selection, best ual profit split method to determine income in its 2007-2009 tax years.
method analysis, The factual underpinning of a residual profit split is critical to method selection, best
and selection of a method analysis, and selection of a reliable split metric when applying the meth-
reliable split metric od. The court’s decision describes a consolidation of Supply Point operations over
when applying the time, a variability in pro-rata allocations, and some fluidity in operational managerial
method.” responsibilities between Coca-Cola and its Supply Points over time. All of these
factors point at minimum to a reconsideration of the validity of the assumptions un-
derlying the 10-50-50 method in each tax year. From the court’s decision, it seemed
that the force of attraction to the method owing to the assumed precedent value of
the 1987-1995 closing agreement dominated the annual requirement to select and
apply the best method.

The residual profit split method is a two-sided method often employed when reliable
data and uncomplicated fact patterns concerning intangible property rights are not
present. The I.R.S. position adopted by the court suggests that an objective annual
review of the facts and available comparable data might have resulted in a Co-
ca-Cola income result much closer to its own. Once the assumption of Supply Point
ownership of valuable intangible assets could be relaxed based on factual evidence,
the way was open to apply a one-sided method such as the C.P.M.

C.U.T.’S BOTH WAYS

The court’s decision marks the departure from the methodological dominance of the
comparable uncontrolled transaction or C.U.T. method that has served taxpayers
well in past cases tried before the Tax Court.2 The court’s thorough best method
analysis and evaluation of comparability factors allowed a robust application of the
C.P.M. or comparable profits method to define the I.R.S. income adjustment sus-
tained by the court.

2
The persuasive nature of a CUT is discussed in M. Peggs, “Amazon Makes
the C.U.T. – an Important Taxpayer Win, a Reminder to Consider Transactional
Evidence,” Volume 4, Number 5 Insights p.45 (2017).

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Coca-Cola did introduce an expert report that used an application of the C.U.T. to
support the company position. The expert’s C.U.T. analysis was found by the court
to rest on shaky factual foundations and to resemble a “Rube Goldberg machine.”3
An unkind C.U.T.

CORROBOR ATION BY A SECONDARY METHOD

For any economist that finds graphs to be persuasive visual support for ordinarily
not-so-visual or exciting modes of communication, the Coca-Cola decision includes
a handy rejoinder to attorney colleagues’ variously-deployed graph and economist
jokes. This section is presented without a graph. Consider how much better it could
be with a graph as you read the next paragraph.

To motivate the I.R.S. reason for investigating the 10-50-50 method, the expert hired
by the I.R.S. considered the question of the profitability of a sample consisting of
large, public manufacturers of food and beverages, Coca-Cola, and the seven Sup-
ply Points. He then produced a striking histogram, plotting the 2007-2009 return on
assets in 5% bins on the Y axis at left, and the number of companies in each of the
defined bins on the X axis. Coca-Cola and all but one supply point (Egypt) were
found in bins considerably above the sample mean (the Y-axis reading at the point
the histogram extends furthest to the right). How considerably? Between 90% and
205% in ROA terms. This served as a convincing reason for further investigation of
the reason for relatively high profitability, as opposed to investigation of the similarity
of royalty rates.

Graphical inspiration received, a line of inquiry about factors effecting profitability

and measurement of profitability began. Ordinarily this might be an analysis per-
formed as part of the application of a secondary method (a best method criterion
under Treas. Reg. §1.482-1(c)), but with the 10-50-50 method having been agreed
only as a way of settling a dispute, the C.P.M. became the primary transfer pricing
method the court relied on to decide the case.

E VIDENTI ARY VALUE OF INTERNAL AND OTHER

TR ANSACTIONS
Coca-Cola differs from many multinational companies in that its final product is man-
ufactured by bottlers around the world that are third parties. Moreover, these bot-
tlers are in many cases public companies owing to the large capital requirements of
bottling plants and distribution infrastructure. Many bottlers have raised capital on
public securities markets and therefore report their financial results publicly.

While it is unclear whether Coca-Cola documented its reasons for not applying
a transfer pricing method using bottlers financial data, the I.R.S. seized on the

3
Wikipedia explains a Rube Goldberg machine in the following language:

A Rube Goldberg machine, named after American cartoonist

Rube Goldberg, is a machine intentionally designed to perform
a simple task in an indirect and overly complicated way. Usually,
these machines consist of a series of simple unrelated devices;
the action of each triggers the initiation of the next, eventually
resulting in achieving a stated goal.

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 availability of bottler data and apply the C.P.M. A considerable portion of the dis-
pute between Coca-Cola and the I.R.S. concerned comparability of the independent
bottlers and the Supply Points. After a detailed presentation of arguments from
each side, the court acknowledged several shortcomings of the C.P.M. using bottler
data and allowed in most cases that identified differences between the controlled
transaction terms and the attributes of the independent bottlers were not sufficiently
significant to disqualify the C.P.M. In respect of certain differences where estimation
of partial effects was not possible or reliable, the court reasoned that any resulting
bias owing to a lack of comparability would serve to benefit Coca-Cola and therefore
not overstate the proposed I.R.S. income adjustment.

WHEN AN INTANGIBLE ASSET IS NOT A

VALUABLE INTANGIBLE ASSET
Many modern transfer pricing controversies concern the attribution of returns to
valuable intangible assets as distinct from returns to more ubiquitous intangible
assets used in business operations. A considerable share of the current policy de-
velopment effort of the O.E.C.D. in respect of the digital economy is occupied with
a similar question, and is seeking a relatively more mix-in-the-pan method of resolu-
tion than the Tax Court appeal and trial process conducted to decide the Coca-Cola
issues. This article may inadvertently contribute to the debate by encouraging, of
all things, a graphical approach.

Though exhaustive, the court’s decision applies the regulations to the facts of the
Coca-Cola controlled transactions and arrives at its conclusion in a principled man-
ner. A combination of critical factors led to the court to side with the I.R.S., and
hold that the Supply Points used intangible assets in their businesses, but were not
entitled to a return to valuable intangible property at arm’s length as a result of legal
ownership or exercise of Supply Point control over the intangible property.

While many O.E.C.D. member market jurisdictions seek to argue for the equivalent
of Coca-Cola’s position and the attribution of profit resulting from intangible assets
in name only using profit split methods, an objective view of value capture as was
“This article may argued by the I.R.S. provides an instructive view of future talks between treaty
inadvertently partners.
contribute to
the debate by
encouraging, of all
things, a graphical
approach.”

Disclaimer: This article has been prepared for informational purposes only and is not intended to constitute advertising or solicitation and should not
be relied upon, used, or taken as legal advice. Reading these materials does not create an attorney-client relationship.

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