US IRS prevails in Coca-Cola transfer pricing dispute over intercompany royalties

By J. Harold McClure, New York City

The US Tax Court ruled on November 18 that Coca-Cola’s US-based income should be increased by about $9 billion in a dispute over the appropriate royalties owned by its foreign-based licensees for the years from 2007 to 2009.

This ruling addresses a classic issue under section 482 with respect to the appropriate evaluation of intercompany royalties for highly profitable multinationals.

The court reduced the IRS’s adjustment by $1.8 billion because the taxpayer made a valid and timely choice to use an offset treatment when it came to dividends paid by foreign manufacturing affiliates to satisfy royalty obligations.

The taxpayer made several arguments for its lower intercompany royalty rates, including providing evidence of a 1996 closing agreement between the taxpayer and the IRS. As discussed below, the court held that this closing agreement was not binding for years after 1996.

Coca-Cola’s transfer pricing position

Coca-Cola produces concentrate and sells it to third-party bottlers who convert the concentrate into soft drinks such as Coca-Cola, Fanta, and Sprite.

The relevant foreign production affiliates are located in Brazil, Chile, Costa Rica, Egypt, Ireland, Mexico, and Swaziland, while distribution affiliates and bottlers are located in various nations in Europe, Africa, and Latin America.

The US parent licenses intangible property, including trademarks, brand names, logos, patents, secret formulas, and proprietary manufacturing processes. Consolidated profitability in Europe, Africa, and Latin America was considerable, but the intercompany royalty rates were modest.

The testimony in this trial involved a multitude of witnesses and experts relying on various pieces of information.

Our following table provides a simplified version of Coca-Cola’s and the IRS’s positions, showing a licensee in a nation such as France, Germany, or the UK, where annual concentrate sales equal $1 billion.

An illustrative income statement for a Coca-Cola licensee

Millions	Taxpayer	IRS
Sales	$1000	$1000
Production costs	$175	$175
Selling costs	$275	$275
Marketing costs	$100	$100
Profits before royalties	$450	$450
Royalties	$175	$400
Income	$275	$50
Tangible assets	$500	$500
Intangible assets	$4000	$4000
Licensee ROA	55%	10%
Licensor ROA	4.375%	10%

Our table assumes production costs are 17.5 percent of sales, distribution costs are 27.5 percent of sales, and payments to third party marketing firms equal10 percent of sales. Thus, consolidated profits are 45 percent of sales.

Coca-Cola’s 10-50-50 closing agreement

The Tax Court noted:

For 2007-2009 petitioner reported income from its foreign supply points using the “10-50-50 method,” as it had done for the previous 11 years. This was a formulary apportionment method to which petitioner and the IRS had agreed in a closing agreement executed in 1996, which resolved petitioner’s tax liabilities for 1987-1995.

This method could be seen as a crude form of the residual profit split method where the licensee received a routine return for production and distribution equal to 10 percent of sales with residual profits split evenly between the foreign licensee and the US parent.

This method could be seen as a crude form of the residual profit split method where the licensee received a routine return for production and distribution equal to 10 percent of sales with residual profits split evenly between the foreign licensee and the US parent.

Our table, above, illustrates this approach as the taxpayer position where intercompany royalties equal $175 million with the foreign licensee retaining $275 million in income.

The taxpayer asserted that this closing agreement was binding for 2007 to 2009. The court disagreed, noting the 1996 agreement did not discuss any transfer pricing methodology or in any way bind the IRS for future years.

The taxpayer attempted to argue the closing agreement was predicated on factual understandings that the US parent owned only product intangibles while the foreign affiliates created marketing intangibles. The court also rejected this position.

The IRS position

The IRS position rested on two propositions.

The first proposition was that the overall routine return was only 5 percent of sales, which would suggest residual profits would be 40 percent of sales.

While the taxpayer representatives severely criticized the specific approach used by the IRS expert witness, the taxpayer’s expert witnesses agreed that the routine returns for distribution and production were very modest.

The other proposition is that the US parent is entitled to all of the residual profits in the form of intercompany royalties. This position more than doubles the intercompany royalty rate leaving income equal to only 5 percent of sales for both the production and distribution functions.

The IRS position was an application of the comparable profits method (CPM). The court decision noted that there were no third-party license agreements that could be deemed as comparable to the related party license arrangements for purposes of the comparable uncontrolled transaction (CUT) approach.

The court also noted:

This case is particularly susceptible to a CPM analysis because petitioner owned virtually all the intangible assets needed to produce and sell the Company’s beverages. Petitioner was the registered owner of virtually all trademarks covering the Coca-Cola, Fanta, and Sprite brands and of the most valuable trademarks covering the Company’s other products. Petitioner was the registered owner of nearly all of the Company’s patents, including patents covering aesthetic designs, packaging materials, beverage ingredients, and production processes. Petitioner owned all rights to the Company’s secret formulas and proprietary manufacturing protocols. Petitioner owned all intangible property resulting from the Company’s R&D concerning new products, ingredients, and packaging. Petitioner was the counterparty to all bottler agreements, giving it ultimate control over the distribution system for the Company’s beverages. And most ServCo agreements executed after 2003 explicitly provided that “any marketing concepts developed by third party vendors are the property of Export,” thus cementing petitioner’s ownership of marketing intangibles subsequently developed outside the United States. The supply points, by contrast, owned few (if any) valuable intangibles. Their agreements with petitioner explicitly acknowledged that TCCC owned the Company’s trademarks, giving the supply points only a limited right to use petitioner’s IP in connection with manufacturing and distributing concentrate.

The IRS reasoned that the intercompany royalties capture all of the residual profits since the US parent owned all valuable intangible assets.

Our table, above, also assumes that the European licensee owns $500 million in tangible assets, while the intangible assets located in the US and utilized by this licensee have a value equal to $4 billion. The relative value of intangible assets to tangible assets in our illustration is consistent with the expert testimony in this litigation.

If the intercompany royalty rate is less than 20 percent, the return to the licensor’s intangible assets is less than the risk-free rate, while the return to the licensee’s tangible assets is greater than 50 percent.

This result is implausible under arm’s length pricing if the licensor owns all of the intangible assets.

The taxpayer’s arguments

The primary taxpayer argument for lower royalty rates rested on the claim that the foreign licensees owned valuable marketing intangibles because the foreign affiliates paid the ongoing marketing expenses.

The primary taxpayer argument for lower royalty rates rested on the claim that the foreign licensees owned valuable marketing intangibles because the foreign affiliates paid the ongoing marketing expenses.

One of its expert witnesses used a capitalized cost version of the residual profit split method to assert that the value of foreign-owned intangible assets exceeded the value of US-owned intangible assets.

The court rejected this approach on several grounds. One of its criticisms related to the extreme assumptions with respect to the economic useful life needed to implement this version of the residual profit split model casts doubt on its reliability. The other criticisms undermined the foundation of this approach.

In the chart above, we have so far pretended that the licensee performed both production and distribution activities. The facts, however, note that European production was performed by an Irish affiliate, while distribution and marketing activities were performed by local affiliates in nations such as France, Germany, and the UK. The Irish affiliate did not engage in any marketing activities but was allowed to keep residual profits.

The facts, however, note that European production was performed by an Irish affiliate, while distribution and marketing activities were performed by local affiliates in nations such as France, Germany, and the UK. The Irish affiliate did not engage in any marketing activities but was allowed to keep residual profits.

While the distribution affiliates paid the third party marketing expenses, they were afforded only a routine return by the taxpayer’s own documentation reports. The assumption that the foreign distribution affiliates deserved only routine returns was justified by statements that the US parent bore all strategic guidance and entrepreneurial risk with respect to marketing activities.

The taxpayer also relied on a strange application of the CUT approach that used franchise agreements between McDonald’s and its major third-party licensee, Arcos Dorados. After noting several flaws with his analysis, the court noted:

Neither Dr. Unni nor petitioner identified any pricing data for transactions with unrelated parties that “involve the transfer of the same intangible”–viz., the trademarks, brand names, logos, secret formulas, and proprietary manufacturing processes used to produce Coca-Cola, Fanta, Sprite, and the Company’s other branded beverage products. Instead, Dr. Unni derived his CUT using data from an entirely different industry–the fast-food restaurant business.

The operating margins for fast-food restaurants are much lower than the profit margins enjoyed by Coca-Cola’s operations in Africa, Europe, and Latin America, while the capital intensity for fast-food restaurants is much higher.

The basic economics of these two sectors reject any notion that one could compare their arm’s length royalty rates.

The operating margins for fast-food restaurants are much lower than the profit margins enjoyed by Coca-Cola’s operations in Africa, Europe, and Latin America, while the capital intensity for fast-food restaurants is much higher. The basic economics of these two sectors reject any notion that one could compare their arm’s length royalty rates.

The evidence on royalty rates in this sector, however, could prove useful for a proposed intermediate view, discussed below.

An intermediate view

Earlier this year, I commented on various aspects of the testimony in the trial (“Coca-Cola’s Intercompany Royalty Rate: An Intermediate View,” Journal of International Taxation, February 2020).

Part of my discussion addressed whether the marketing intangibles should be seen as owned by the foreign licensee or by the US parent. The Tax Court decision captured my thoughts on this particular issue, but I also explored other reasons why foreign licensees would retain a portion of residual profits even if the licensor owned all of the valuable intangible assets.

Even if we accept the IRS premise that the US parent holds all of the valuable intangible assets, a lower royalty rate is suggested by a model grounded in sound financial economics that properly considers licensee risk and the implications for expected returns.

Even if we accept the IRS premise that the US parent holds all of the valuable intangible assets, a lower royalty rate is suggested by a model grounded in sound financial economics that properly considers licensee risk and the implications for expected returns.

My critique of CPM approaches notes that licensees deserve a portion of residual profits for two reasons: compensation for profits attributable to the value of intangible assets owned by the licensee; and compensation for the leverage risk of using valuable intangible assets owned by another entity.

The US regulation Section 1.482-6 acknowledges the first factor, but the IRS generally ignores the role of licensee risk.

While the taxpayer’s position appears to rest on the premise that the foreign licensees owned some of the valuable intangible assets, an alternative reason for the sharing of residual profits is that being compensation for bearing significant risk from the licensing of valuable intangibles.

Risk of using valuable intangibles owned by another

Assume a McDonald’s franchisee pays McDonald’s royalties equal to 5 percent of sales for the use of intangibles, including product, process, and marketing intangibles. These franchisees are also required to contribute mandatory advertising fees but do not retain ownership of the McDonald’s intangible assets.

 In addition to the valuable intangible assets licensed from McDonald’s, the franchisee must contribute the land and building as well as the equipment. Consider a franchisee with four stores where expected sales equal $10 million, operating costs equal $8 million, and the value of tangible assets equal $12 million. Consolidated profits before royalties equal 20 percent of sales.

If we assume a 10 percent cost of capital, routine profits represent 12 percent of sales with residual profits equal to 8 percent of sales.

While an application of CPM would argue for an 8 percent royalty rate, McDonald’s charges a royalty rate of only 5 percent to third-party licensees because these licensees utilize a valuable intangible asset owned by McDonald’s.

Market rates in the fast-food restaurant are consistent with the proposition that arm’s length royalty rates should be between 60 and 75 percent of residual profits.

The role of risks is noted in the BEPS discussion draft on Action 9 (paragraph 63):

Risks should be analyzed with specificity, and it is not the case that risks and opportunities associated with the exploitation of an asset, for example, derive from asset ownership alone. Ownership brings specific investment risk that the value of the asset can increase or may be impaired, and there exists risk that the asset could be damaged, destroyed or lost (and such consequences can be insured against). However, the risk associated with the commercial opportunities potentially generated through the asset is not exploited by mere ownership.

Licensees that utilize valuable intangibles owned by another entity are analogous to lessees that utilize tangible assets owned by a third party lessor. Financial economics would suggest that a third party licensee would receive a higher expected return to the assets it formally owns than a licensor would receive on the intangible assets it owns, as the latter bears only ownership risk and not commercial risk.

These concepts are illustrated in columns “A” and “B of the following chart:

An illustrative income statement for a Coca-Cola: an intermediate approach

Millions	Taxpayer	A	B	IRS
Sales	$1000	$1000	$1000	$1000
Production costs	$175	$175	$175	$175
Selling costs	$275	$275	$275	$275
Marketing costs	$100	$100	$100	$100
Profits before royalties	$450	$450	$450	$450
Royalties	$175	$250	$300	$400
Income	$275	$200	$150	$50
Tangible assets	$500	$500	$500	$500
Intangible assets	$4000	$4000	$4000	$4000
Licensee ROA	55%	40%	30%	10%
Licensor ROA	4.375%	6.25%	7.5%	10%

Column A of our table assumes a royalty rate of 25 percent, which is consistent with our McDonald’s scenario, where royalties represent 62.5 percent of residual profits. The return to the licensor’s intangible assets would be 6.25 percent, while the return to the licensee’s tangible assets would be 40 percent.

Column B assumes a royalty rate of 30 percent, which is consistent with royalties being 75 percent of sales. The return to the licensor’s intangible assets would be 7.5 percent, while the return to the licensee’s tangible assets would be 30 percent.

The range of expected returns suggested by intercompany royalty rates between 25 and 30 percent is consistent with what would be expected by a profits-based approach that incorporates the proposition that a licensee using valuable intangible assets owned by another entity under arm’s length pricing takes on more risk.

While this intermediate approach suggests royalty rates that are less than those derived under the CPM approach, they are consistent with arm’s length pricing. The taxpayer’s expert argued for more extreme positions on claims that the foreign licensees owned the valuable marketing intangibles; however, such claims were rejected by the court, given the factual record in this litigation.