Tax Notes legal reporter Ryan Finley discusses the IRS’s major victory in the Coca-Cola case and its future implications for transfer pricing cases.
For additional coverage, read these articles in Tax Notes:
Economist Andrew Hughes talks about his upcoming series in Tax Notes on transfer pricing benchmarks.
This episode is sponsored by Avalara. For more information, visit avalara.com/taxnotes.
This episode is sponsored by University of California, Irvine Law School’s Graduate Tax Program. For more information, visit law.uci.edu/gradtax.
Host: David D. Stewart
Executive Producers: Jasper B. Smith, Faye McCray
Showrunner: Paige Jones
Audio Engineers: Derek Squires, Jordan Parrish
Guest Relations: Nicole White
Welcome to the podcast.I'm David Stewart,editor in chief of Tax Notes Today International.This week:share a Coke decision.In November,the U.S.Tax Court served up a major victory to the IRS when it upheld the agency's nearly$10billion transfer pricing adjustment against the Coca-Cola company.This decision is worth about$2.5billion in additional taxes from the company.So,here to talk about this case and what it could mean for the future of transfer pricing disputes is Tax Notes legal reporter Ryan Finley.Ryan,welcome back to the podcast.Ryan Finley:
Now,it feels a bit strange talking about IRS wins on transfer pricing cases.Can you tell listeners a bit about the U.S.government's track record?Ryan Finley:
Yeah.Up until recently,it has not been great.Probably the three recent highest profile cases were Amazon,Medtronic,and Altera.And the Tax Court decided all three against the IRS.Now,Altera dealt with a very specific issue that doesn't come up in Coca-Cola,but Amazon and particularly Medtronic do have some similar issues that play particularly whether the IRS's selection of method was right.But things started to maybe turn around a little bit in2018when the Tax Court's Medtronic decision was vacated,remanded,and Altera was later reversed.And even though the IRS lost Amazon on appeal,the opinion suggests that the IRS would have won that case under current law.So,obviously this case is a bigger win,but it's arguably been trending in the IRS's favor for a couple years now.David Stewart:
All right.Well,then let's turn to this case.Could we start with some background?What are the main issues here in this case?Ryan Finley:
Sure.So,the main issue,the transaction at issue,is Coca-Cola,the U.S.parent's license of its core intangible property,including its trademarks,brand names,product formulas,all the key things that go into its products to foreign subsidiaries that the company called its supply points.The issue was whether the pricing for these licenses was arm's-length.The decision also deals with the taxpayer's ability to rely on the terms of an old closing agreement,which had expired,and whether it could support a transfer pricing arrangement that was seemingly inconsistent with its own intercompany contracts.So,there are a lot of issues in the case,but the main dispute was about the selection of transfer pricing method and whether the facts supported the IRS's chosen method,which was the comparable profits method or the CPM.The CPM usually determines an arm's-length return,operating profit divided by some denominator cost sales or assets that the party to the transaction that performs relatively routine functions ought to earn.And it does this based on financial data from comparable independent companies.By default,when you apply this method,all the remaining residual profit goes to the other party.So,in this case,if you apply the CPM to the supply points,all the remaining residual profit goes to the U.S.parent in the form of a royalty.So,applying the CPM instead of Coca-Cola's formula,which was a profit allocation formula set by the closing agreement,led to an initial reallocation of about$9.5billion,and during the litigation,a further$385million.So,because the CPM is generally only reliable when the tested party owns few,if any,unique intangibles,a lot of the case deals with whether these supply points had any unique or valuable intangibles.Coca-Cola said that they did,but their position was arguably at odds with their own contracts.David Stewart:
Now,how did the Tax Court come down on these issues?Ryan Finley:
Other than a secondary dispute over whether these transfer pricing adjustments could be offset by repatriated dividends,the court decided every major issue in the IRS's favor.They first quickly dismissed the argument that Coca-Cola had any right to rely on the formula in the closing agreement,which had expired a decade before the tax years at issue.But,onto the main point,the court also rejected this claim that the supply points held valuable intangibles,which according to the company were so-called marketing intangibles that were developed by these supply points'local sales and marketing expenses.The opinion emphasizes that the contracts between Coca-Cola and the supply points did not convey any rights to any marketing intangibles or anything like that.And that the company was bound by its own contracts under the482regulations.As noted in the opinion,the section482regulations,they have a provision that allows the IRS to set aside legal arrangements that are inconsistent with economic substance,but it does not provide any parallel right to taxpayers.But the opinion goes further than that.It says that even if the company had been able to argue economic substance,they still would have lost because the economic substance did not support any such intangibles.Basically the opinion says that these marketing activities,which the supply points themselves didn't actually perform,they were just allocated the costs associated with those activities.That those activities don't automatically create some valuable intangible that any unrelated party would pay for,especially when,as in this case,exploiting these intangibles would infringe Coca-Cola's trademarks.So,the court rejected the various transfer pricing methods,which included the comparable and controlled transaction method,residual profits method,and an unspecified method that were applied by Coca-Cola's expert witnesses,all of which were premised on the assumption that the supply points owned these alleged marketing intangibles.And so,after a pretty detailed discussion,the CPM regs,the court held that the IRS's approach was reasonable.So,overall was a pretty resounding defeat for Coca-Cola.Although,the company did succeed in persuading the court that$1.8billion in dividends,which under the closing agreement had been allowed to be credited against the royalties that it had to pay,that it should be allowed to offset that nearly$10billion adjustment by the amount of those dividends.David Stewart:
So,here we have what seems to be a big win for the IRS.And as you noted earlier,they've not had the best track record in litigating transfer pricing cases.So,why is the outcome here different?Ryan Finley:
The most obvious reason is that the facts are different in this case than they were in other cases.You know,this doesn't involve a party that's clearly contributing to intangible development.The supply points functions were basically just routine manufacturing.And as I said before,they didn't actually perform the activities associated with the marketing expenses that were allocated to them.So,it was a lot harder to argue that the supply points created intangibles in the same way as parties to a cost-sharing arrangement,which was the type of transaction at issue in some of these major past cases that the IRS lost.So,all of that undermined Coca-Cola's economic substance argument.And,since the court held that taxpayers can't make an economic substance argument in the first place,the inconsistency between the company's position and its contractual arrangements really hurt its case.David Stewart:
So,is there anything that we can read into this case to sort of look at what the future of transfer pricing litigation might be?Ryan Finley:
Yeah.Well,first of all,you know,the IRS's success in a major transfer pricing case by itself is a big deal.And it's certainly possible that that would embolden the IRS to be more assertive in future litigation.It's also possible that since the Tax Court's Medtronic decision was vacated-remanded by the Eighth Circuit in2018,that there's been a slight shift in the way the court's looking at transfer pricing cases.This opinion contains a detailed discussion of the482regulations comparability standards,which hasn't typically been the case in past Tax Court decisions,especially not in Medtronic.The Coca-Cola opinion even cites the Eighth Circuit's Medtronic decision,which was pretty critical of the Tax Court's opinion in support of its own comparability analysis.The decision it's also different from a lot of previous transfer pricing cases in that the court accepted a profit-based method over the taxpayer's comparable uncontrolled transaction method analysis.Previous Tax Court decisions have pretty consistently favored transactional methods over profit-based methods.But,after a pretty lengthy explanation of the history of section482and the regulations'best method rule,the opinion pointedly rejects the taxpayer's claim that the CPM is somehow generally inferior to these transactional methods.But we'll have to wait for the next line of cases to see if there really has been any long-term shift in approach.David Stewart:
All right,so,we're talking about a pretty large amount of money.What's the likelihood that there'll be an appeal?And Coca-Cola,do they have a chance at winning?Ryan Finley:
Well,an appeal seems likely.The company suggested at least a strong possibility of an appeal in a public statement it released the day after the decision.And as you said,the amount of money is so large that an appeal would probably make sense.But the company will probably face an uphill battle appealing a decision that really relies heavily on the facts of the case.You know,it's not clear from the opinion how any of the Tax Court's factual findings could be successfully challenged in an appeal.And the case doesn't really present many complex legal questions that an appeals court could use to reverse or vacate the decision.You know,we won't know what the company's arguments would be unless and until it files an appeal,but at this point its prospects don't look especially promising.David Stewart:
Well,all right.If we do see an appeal then we'll have to have you back to talk about that.Ryan,thank you for being here.Ryan Finley:
Thank you.David Stewart:
And now,coming attractions.Each week we highlight new and interesting commentary in our magazines.Joining me now from her home is Acquisitions and Engagement Editor in Chief Faye McCray.Faye,what will you have for us?Faye McCray:
Thank you,Dave.In Tax Notes Federal,W.Eugene Seago and Edward Schnee examine the five-year-period-of-ownership requirements in section355.Ross Riskin addresses the tax dilemma that college students may face if they receive a refund during the pandemic from their school.In Tax Notes State,Jennifer White and George I.Tsoflias examine state and local tax consequences for the income of high earners who have relocated their work environments in response to the COVID-19pandemic.Adam Thimmesch explores the Paycheck Protection Program and the federal and state tax treatment of funds received by taxpayers under it.On the Opinions page,Robert Goulder sits down with the authors of the Tax Notes article“A Simple Regulatory Fix for Citizenship Taxation.”Joseph Thorndike argues that Grover Cleveland’s nonconsecutive presidential terms suggest for President Trump a possible political future.And now,for a closer look at what's new and noteworthy in our magazines,here is Tax Notes Executive Editor for Commentary Jasper Smith.Jasper Smith:
Thanks,Faye.I'm joined by Andrew Hughes,an economist who specializes in transfer pricing,valuation,and risk management based in Brussels.Welcome to the podcast,Andrew.Andrew Hughes:
Hey.Thanks,Jasper.Thanks so much for having me today.Jasper Smith:
So,we're here to discuss Andrew's upcoming series on transfer pricing benchmarks that can be replicated by all tax practitioners using readily available public data.Andrew,can you tell us a little bit about this series?Andrew Hughes:
Yeah.Actually,so,it's exactly about what you just stated.So,it's going to be about transfer pricing benchmarking.In particular,I'd say the goal of this series is to publish a set of North American transfer pricing benchmarkings that would cover some of the most common,I would say,intercompany transactions today.So,basically we're talking about your really classic transactions,like IT services,strategic consulting,back office services,various distribution sets,et cetera.It's still pretty fresh in terms of the direction that it's going to be taking and I'm still working on actually building out a bit more.But,I think that the goal would be to cover as many different kinds of routine intercompany transactions as possible.Certainly we're not publishing what I would call a full benchmarking analysis per se that would be used for documentation purposes for transfer pricing practitioners,but rather more of a secondary publicly available source for tax practitioners to go to for their transfer pricing transactions.It may be that a tax practitioner wants a second independent resource to back up the benchmark that they already have.Or maybe they just want to kind of perform a sanity check or use this document series as a jumping off point for their own benchmarking analysis that maybe they're doing in house.But regardless of what the actual end use might be for the practitioner,the point is to publish our take on potentially comparable companies for a broad set of standard intercompany transactions.Jasper Smith:
OK,fantastic.And I'm biased,but I think you found the perfect home for that here at Tax Notes.So,can you tell us what inspired you to write about the topic?Andrew Hughes:
Yeah.I'm not really sure that I had like a eureka moment for this idea,per se.To be honest,I'm really a big transfer pricing nerd.And it's something that I actually think about quite a bit in my free time.Basically the deal is everyone who's ever done transfer pricing in a tax consultancy has done a transfer pricing benchmark.And in the past,these were all done manually.So,I was even told stories that before my time and when I started,people would actually have books where they would look up all the company data and information and do these things by hand.And then,after a while,CDs came along where people would basically have a subscription to a data service and they'd receive these CDs of data every month.But they'd still be doing these calculations by sets of hand and kind of manually looking through and screening these databases that they're receiving every month.So,it's really incredible,if you think about it,that we've come such a long way.Basically,when we talk about North American comparable companies,everything is online now.I spent time at two tax consultancy firms,and I can tell you that over the past few years,benchmarking has become very commoditized.So,firms are basically publishing standard benchmarking sets that are basically agreed upon at a national level.And then,more or less come off the shelf for practitioners.Now,not all benchmarking analysis are going to be like this,but a good portion of them might be slightly customized as well,depending on the client's industry or specificities.But,when I think of really the transformation that's happened over the past,let's say10or12years,it's really kind of astounding that all these consultancies still make so much money off of benchmarking.And I think it's surprising at multiple levels since this data has really become highly publicly available.And the concept of a benchmark itself has started to become more and more commoditized.So,basically I just thought that I could actually hugely add potential value here at multiple levels and put the time into doing these sets myself for tax practitioners.And I think,first of all,it puts a little bit of power back in the hands of the taxpayer.Because this article series would provide them essentially with an independent resource to corroborate their current benchmarking analyses.But not only for the taxpayer,I also think that potentially this could benefit consultancies as well.Because we may have actual different outcomes and differences between my benchmarking set and their benchmarking set.And I think that having an independent view on the benchmarking analysis could in fact actually help them identify where differences are and even double-check their work.They're probably perfectly comfortable with their benchmarking set that they already have,but maybe it causes them to say,"Hey,look,we have six companies in this routine distribution set and Tax Notes has eight."So,it might cause them to take just a second look at companies that they've otherwise rejected for years.So,I think to go back,I've come really a long way from your original question of where the idea came from.But I would just say that it came from my own questioning of why aren't there already available resources out there for taxpayers given the availability of all this data already.Jasper Smith:
Yeah,Andrew,and I appreciate that actually.I think that you provided a fascinating history and some really good context that will help listeners to see the service that you're providing.And really,if they didn't already,the real value of that service.So,maybe you could also give us a quick preview of what the first article in the series is about?Andrew Hughes:
Yeah.So,the first article in this series is actually going to be specifically geared towards IT services.The article basically keys up in a few different sections exactly how I just outlined it.So,first giving that kind of background about how benchmarking has become more and more standardized,how we're really coming into really today entering a day and age of commoditized,data and availability,very readily of publicly available information.And then secondly,the article will just kind of talk through the process.So,the tools that I use are a little bit different from the ones that let's say tax consultancies might be using.So,first of all,my approach and actually identifying the industries that I target for identifying comparable companies.And then actually going through the analysis and the results and presenting everything to just also give the practitioner an idea as well of the things that they should keep in mind if they do decide to,for example,perform the benchmarking analysis from their own point of view.And then,of course,the article is going to summarize the actual profit level indicators and the companies that were accepted in that benchmark.Jasper Smith:
Well,that sounds like something that we can definitely look forward to Andrew.And I'm sure listeners are as well.So,thank you so much for joining us today and giving us a little bit more detail into the upcoming series.My pleasure,Jasper.Thanks so much for having me.For listeners,you can find Andrew's series online at taxnotes.com.And be sure to subscribe to our YouTube channel Tax Analysts for more in-depth discussions on what's new and noteworthy in Tax Notes.Again,our YouTube page is Tax Analysts with an s.Back to you,Dave.Speaker 5:
You can read all that and a lot more in the pages of Tax Notes Federal,State,and International.That's it for this week.You can follow me online@TaxStew,that's S-T-E-W.And be sure to follow@TaxNotes for all things tax.If you have any comments,questions,or suggestions for a future episode,you can email us at email@example.com.And as always,if you like what we're doing here,please leave a rating or review wherever you download this podcast,we'll be back next week.For another episode of Tax Notes Talk.