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Transfer Pricing Update: Digging Into Facebook and Coca-Cola

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Tax Notes contributing editor Ryan Finley discusses the current transfer pricing landscape, including where things stand in the Facebook and Coca-Cola cases. 

For more coverage, read the following from Finley in Tax Notes:

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Credits
Host: David D. Stewart
Executive Producers: Jeanne Rauch-Zender, Paige Jones
Producers: Jordan Parrish, Peyton Rhodes
Audio Engineers: Jordan Parrish, Peyton Rhodes

David D. Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: transfer pricing litigation update.

It's been a while since we checked in on the status of the various pieces of transfer pricing litigation working their way through the U.S. courts. This time, we're taking a look at the latest that's happening with the disputes involving Facebook and Coca-Cola.

As usual, to help us make sense of where things stand and what they mean for the bigger picture of transfer pricing, I'm joined by Tax Notes contributing editor Ryan Finley. Ryan, welcome back to the podcast.

Ryan Finley: Thanks for having me.

David D. Stewart: Now, since we last talked, we've seen a decision in the Facebook case. First off, could you give us some background on what that case is all about?

Ryan Finley: Yeah. Facebook's a section 482 case about the value of the platform contribution transaction, or PCT, that Facebook's Irish subsidiary owed the U.S. parent company for the right to participate in this 2010 cost-sharing arrangement, or CSA. The PCT, it's the current regulatory term for what used to be called the buy-in payment under the pre-2009 regs. And it's supposed to represent the values of any resources which are usually, but not necessarily, unique IP rights that one of the parties contributes to the CSA, and that's then used as a platform for further cost-shared IP development.

The case is basically about which valuation method is most reliable and how it should be applied. Facebook, their method initially yielded a value of about $6.3 billion for the PCT, whereas the IRS, supplying its own method, came up with a value of almost $20 billion. The difference in the monetary amounts was huge depending on which method was applied.

David D. Stewart: So aside from the large amounts of money involved in this particular case, what are the bigger implications of it?

Ryan Finley: The biggest thing is that it's the first cost-sharing case decided under the cost-sharing regulatory regime that was introduced by the 2009 temporary regulations, which were pretty much the same as the 2011 final regulations, and they're pretty much the same as what's still in effect now.

It's important because the IRS lost some major high-profile cost-sharing cases involving the value of the buy-in payment, specifically Amazon v. Commissioner and Veritas v. Commissioner. But that was under the 1995 regulatory regime. The new regulations revamp the key terms that the regs rely on, definitions. And the biggest thing is that they introduced specified PCT evaluation methods. And one of those is the income method, which the IRS applied in the case. So really the case was about whether this new regulatory regime and the methods it introduced were sufficient to basically prevent the outcome in Amazon or Veritas.

David D. Stewart: So in the end, how did the IRS do?

Ryan Finley: Well, the IRS won and it lost. It won in the sense that Tax Court Judge Cary Pugh upheld the income method's general validity. So just some background on the income method: It's very similar to the discounted cash flow valuation methods that the IRS tried but failed to apply in Amazon and Veritas.

A big part of the litigation for Facebook was trying to discredit this income method as inconsistent with section 482 and the arm's-length standard. Basically, Facebook's argument was that the income method strips away all the rightful returns that the CSA participant that makes the PCT payment, in this case Facebook Ireland, should get. So the general vindication of the method was a very big deal for the IRS because, had the Tax Court invalidated the method, basically the whole cautionary and regulatory overhaul would have been for naught.

However, the IRS lost in the sense that, basically, just about every kind of methodological detail and assumption that went into its income method analysis was rejected. The income method, it requires that you basically compute the net present value of participating in the CSA from the perspective of, in this case, Facebook Ireland. And then you have to subtract the net present value to Facebook Ireland of entering the best, realistically available alternative transaction. And that difference is the PCT.

So the variables that have the biggest effect on the amount you end up with are the financial projections you use, the discount rates you apply, and what you choose as the best, realistically available alternative. Any changes to any one of these can have a drastic effect on the PCT. And according to Judge Pugh, the IRS basically botched every one of those things. And the effect was that even though the Tax Court upheld the method in general, these changes to the inputs and assumptions reduced the PCT from the $20 billion that the IRS came up with, all the way down to $7.8 billion, which is a lot closer to the $6.3 billion that Facebook initially came up with.

David D. Stewart: So are we likely to see an appeal in this case?

Ryan Finley: It's unclear. The result in monetary terms might be close enough for Facebook to decide it's not worth pursuing an appeal and running the risk of a cross-appeal from the IRS's side. It's impossible to say for sure. There is still a fair amount of money at stake, moving from $6.3 billion to $7.8 billion. And people will be watching closely in the meantime, but as long as it stands, it's a very significant win for the IRS.

David D. Stewart: So outside of Facebook, what other developments have we seen in transfer pricing litigation since we last spoke about them?

Ryan Finley: So one of the biggest concerns the Coca-Cola case, which is another very high-profile case involving a very well-known company and billions of dollars. The appeal of the Tax Court's 2020 decision in favor of the IRS, it was delayed because they were waiting for a decision in 3M. But that appeal is finally under way. Both parties have filed their opening briefs with the Eleventh Circuit.

The case is important because the Tax Court upheld the IRS's method, which was the comparable profits method, or CPM, which has really been a flashpoint for controversy. Historically, the IRS has struggled to apply methods like the CPM. They rely on profit instead of more traditional transactional methods like the comparable uncontrolled transaction method.

David D. Stewart: So what is it about these methods like the CPM that make them more difficult for the IRS to get upheld in litigation?

Ryan Finley: Well, there are a couple of variables. One of the reasons is that, historically, under the 1968 regulations, transactional methods like what would now be called the CUT method were explicitly favored over other methods. So that kind of legacy of an explicit preference for the CUT method probably is one factor.

Another factor is, and we saw this in the Medtronic case, which I think we'll get to, judges seem to think the CUT method is maybe easier to apply than the CPM and easier to make comparability adjustments to the extent the comparable transaction differs from the controlled transaction. But also, transactional methods are closer to the platonic ideal of an arm's-length method. You're pricing a controlled transaction directly based on the price charged in an arm's-length transaction. Something like the CPM, on the other hand, is more indirect. You back into the transactional price based on the amount of profit that one of the parties should earn.

David D. Stewart: So turning back to Coca-Cola, what was this case really about?

Ryan Finley: So the case, it was specifically about the royalties that Coca-Cola's foreign supply points, which were the subsidiaries that produced and sold beverage concentrate to independent bottlers, that they owed Coca-Cola U.S. for the rights to the company's brand names and product formulas.

Coca-Cola's argument was that the IRS's CPM analysis was flawed because it used, as comparables, the independent bottlers that the supply points sold to. And according to Coca-Cola, these were not comparable enough to use in a CPM analysis. The other major argument that Coca-Cola has made since the beginning is that an old closing agreement that provided for a simple profit allocation formula, that because the IRS accepted it in previous tax years and continued to accept it for subsequent audit cycles, that Coca-Cola was entitled to continue to rely on that allocation formula even after the closing agreement's term had long ended.

Whether Coca-Cola is entitled to rely on this closing agreement and the profit allocation formula that it endorsed, that's been part of the case since the beginning, but in the exchange of briefs with the Eleventh Circuit, Coca-Cola has really leaned on some Administrative Procedure Act arguments. This is novel because typically the APA applies in a formal rule-making context, not so much in terms of the individual deficiency determinations, which are subject to their own set of procedural rules. So the case, it's a test of the viability of a CPM in cases like this and also whether the Administrative Procedure Act can be invoked in this way.

David D. Stewart: You alluded to two other cases, Medtronic and 3M. What's happening with them?

Ryan Finley: Well, both cases are on appeal to the Eighth Circuit. And now, both cases are fully briefed and argued. 3M is about a specific and narrower issue, the validity of the blocked income regulations. Medtronic II, it's a broader case, also about the best method, and it's also about the CPM. So that's the case that will have the most significant repercussions.

Medtronic, in some ways like Coca-Cola, argues that the IRS's CPM analysis was flawed. The company argues that either the CUT method or this CUT-like, unspecified method that the Tax Court applied in its 2022 Medtronic II decision would be the best method rather than the CPM. The commissioner's counter argument is that you can't apply either the CUT method or this CUT-like unspecified method because the transaction that Medtronic relied on just isn't comparable under the applicable regulatory standard, specifically because of a major profit-potential discrepancy. Medtronic claims you can address this discrepancy by making comparability adjustments. But the commissioner's argument is that profit potential has to be intrinsically similar to clear this comparability threshold. So it's a tricky question. Regulations seem to favor the commissioner on this, but there is definitely some ambiguity there, and it'll be interesting to see what the Eighth Circuit says.

David D. Stewart: Are there cases out there that we might have discussed before that have just been doing nothing since we last spoke?

Ryan Finley: There are. I'm not sure you'd say they've done nothing, but Amgen, Microsemi, Abbott Labs, all these cases are just still making their way through the process of the Tax Court level. And then there is Perrigo that is still undecided for reasons that remain unclear.

David D. Stewart: Are there any new cases that we should be following?

Ryan Finley: There are. One major case involves McKesson, which filed a complaint in the northern district of Texas for a refund of taxes paid, basically the same issue we saw in Alterra v. Commissioner and the same issue that's involved in the ongoing Abbott Labs case: the cost-sharing regulations requirement that CSA participants share stock-based compensation costs, whether that requirement is procedurally valid under the APA, and whether it's substantively valid now under the standard set by Loper Bright.

McKesson's claim is, just like Alterra claimed, that forcing CSA participants to share stock option expenses in this way would be contrary to the arm's-length standard because independent enterprises would never agree to share stock option expenses at arm's-length. According to McKesson, this ignores the arm's-length standard and therefore exceeds Treasury's statutory authority. And the company also claims that by ignoring or overruling comments submitted during the rule-making procedure, these regulations are also procedurally invalid.

So it's a familiar issue; the new wrinkles are that the venue is different. This time it's the northern district of Texas instead of the Tax Court. And now we have a new substantive validity standard after the Supreme Court's Loper Bright decision. The Tax Court's Facebook opinion suggests that Tax Court has come around to the Ninth Circuit's reasoning in Alterra, which upheld the validity of these regulations. But obviously, the northern district of Texas isn't bound by either the Ninth Circuit or Tax Court precedent. The other variable, Loper Bright, McKesson seems to think that that strengthens their argument, but it's not entirely clear why that would be the case.

There is another interesting cost-sharing case involving Airbnb. It's also about the appropriate PCT valuation. Airbnb filed a petition in late 2024, and it's an interesting case because in this case, unlike in virtually every other litigated cost-sharing case, the foreign CSA participant seems to have lost money by participating in the cost-sharing arrangement. Usually what gets the IRS's attention would be intangibles that are much more profitable than the taxpayer expects or claims to expect when it enters a cost-sharing arrangement. So in essence it's an unusual posture, and the case raises some interesting methodological questions that are worth following.

David D. Stewart: Has transfer pricing litigation gotten a little more interesting now that the IRS seems to not lose every time?

Ryan Finley: Well, interesting is probably in the eye of the beholder, but I certainly think so. It doesn't seem like we're in a world where the IRS automatically loses anymore. They won at least on the legal questions in Facebook. They won at least at the Tax Court level in Coca-Cola. And they lost at the Tax Court level in Medtronic, but that's on appeal. It seems like a lot of these cases really could go either way. And they're either nuanced, factual questions, or tricky, legal, interpretative questions in a lot of the cases. And I would say it's a lot more interesting to know that the courts could go either way on these issues.

David D. Stewart: Well, Ryan, I thank you again for coming and helping us to understand where all these things stand. Thank you for being here.

Ryan Finley: Thank you.

David D. Stewart: That's it for this week. You can find 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 podcast@taxanalysts.org. 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 with another episode of Tax Notes Talk.

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David D. Stewart

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Ryan Finley

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