by Jared Kluever and Adam Clardy

After nearly a decade of vigorous defense against the IRS’s transfer-pricing actions, the Coca-Cola Company (Coke) was handed another judicial defeat on November 8, and the company now owes taxes on an additional $882 million in income. The IRS reallocated income to Coke from its Brazilian manufacturing affiliate, and to the company’s dismay, the U.S. Tax Court’s memorandum opinion sustained the $882 million net transfer-pricing adjustment in full.[1]

This supplemental opinion is the epilogue to the landmark opinion from November 2020 where the Tax Court agreed with the IRS’s determination that Coke’s aggregate taxable income from 2007-2009 should be increased by more than $9 billion.[2]  This produced around $3.3 billion in tax deficiencies as a result of transfer-pricing adjustments under I.R.C. § 482.  The IRS reallocated income to Coke from its foreign manufacturing affiliates (which are referred to as “supply points”) by using a “comparable profits method” to calculate the supply points’ royalty obligations for use of Coke’s intangibles. 

Following the November 2020 opinion, one question remained – whether the $882 million net-transfer pricing adjustment to Coke from its Brazilian supply point was barred by Brazilian law.  Confirming what many expected to be the Tax Court’s decision, Judge Lauber wrote “we have no alternative but to sustain [the] adjustment in full.”

Background

This case involved a Brazilian legal restriction that caps trademark royalties and technology transfer fees paid by a Brazilian company to a foreign company by which it is controlled.  For 2007-2009, the parties stipulated that Brazilian law capped the royalties payable to Coke by the Brazilian supply point at about $16 million, $19 million, and $21 million, or roughly $56 million in the aggregate.  Therefore, Coke argued Brazilian law blocked the $882 million net transfer pricing adjustment treated as arm’s-length compensation for use of Coke’s intangibles.

However, the IRS relied on Treasury Regulation § 1.482-1(h)(2), commonly referred to as the “blocked income” regulation, and argued that Brazilian law should not apply in determining the arm’s-length transfer price.  The blocked income regulation provides that a foreign legal restriction will be considered for transfer pricing purposes only to the extent the restriction affects an uncontrolled taxpayer under “comparable circumstances for a comparable period of time.”[3]  This general rule specifies four conditions that must be satisfied before a foreign legal restriction will be given effect in determining the arm’s-length transfer price, including whether the restriction is “publicly promulgated [and] generally applicable to all similarly situated persons (both controlled and uncontrolled).”[4]

When the Tax Court issued its November 2020 opinion, challenges to the validity of the blocked income regulation had been taken under advisement by another Division of the Tax Court.[5]  Consequently, the court reserved ruling on Coke and the IRS’s arguments regarding the effect of the Brazilian legal restriction until an opinion in the 3M case had been issued (which involved a similar Brazilian legal restriction).  On February 9, 2023, the Court issued a reviewed opinion in 3M that sustained the validity of the blocked income regulation, held the Brazilian legal restriction failed to satisfy one or more of the conditions set forth in the regulation, and ruled in favor of the IRS.

Unsurprisingly, the November 8 Coca-Cola opinion reached the same conclusion for the same principal reason: The Brazilian law has no application to royalties paid to unrelated parties, but only to royalties paid to a controlling foreign corporation.  Thus, as Coke conceded, the legal restriction is not “generally applicable to all similarly situated persons (both controlled and uncontrolled).”

Therefore, the Tax Court held that the legal restriction capping trademark royalties and technology transfer fees paid by the Brazilian supply point to Coke must be disregarded in determining the arm’s length transfer price.

The Tax Court also considered whether the blocked income regulations effective date provision exempted or “grandfathered” the intangible assets exploited by the Brazilian supply point.  The court found eight of Coke’s original core-product trademarks to be covered by the grandfather clause, but because Coke failed to establish what portion of the aggregate transfer-pricing adjustment was attributable to exploitation of these trademarks, the court sustained the adjustment in full. 

Takeaways from the Opinion

There are several important takeaways from this opinion, but perhaps most noteworthy is that the Tax Court strongly indicated the Brazilian legal restriction did not block the payment of arm’s-length compensation for use of Coke’s intangibles.  In other words, had the Tax Court in 3M invalidated the blocked income regulation, Coke might have very well still lost this case.  This is because Coke took the position that Brazilian law permitted it to receive dividends in lieu of royalties as compensation for use of Coke’s intangibles, up to the dollar amount that that Coke viewed as representing arm’s length compensation – $886,823,232.  But Coke “seeks to use Brazilian law … to prevent the receipt of dividends in lieu of royalties in a larger dollar amount.”  The “dividends and royalties are different argument” sidesteps the economic substance of Coke’s internal structuring of royalty payments, and the opinion notes that “[t]his one-way ratcheting is not entirely convincing.”

Furthermore, 3M was a narrow 9-8 decision in favor of the IRS with widespread disagreement among the 17 Tax Court judges who reviewed the opinion.  3M could very well appeal to the Eighth Circuit and have the decision overturned.  By way of analyzing the Coca-Cola case outside of the blocked income regulation and stating that the IRS might prevail regardless of the regulation’s validity, Judge Lauber certainly undercut Coke’s prospects on appeal.

Another noteworthy subset of this opinion is that the court reinforces the idea that “only the Commissioner, and not the taxpayer, may set aside contractual terms as inconsistent with economic substance.”  Judge Lauber included from the November 2020 opinion:

“It is recurring principle of tax law that setting aside contract terms is not a two-way street.  In a related-party setting such as this, the taxpayer has complete control over how contracts with its affiliates are drafted.  There is thus rarely any justification for letting the taxpayer disavow contract terms it has freely chosen.  But because the terms of such contracts may be self-serving and tax-motivated, the regulations regularly authorize the Commissioner to set contract terms aside if they do not reflect economic reality.”

Therefore, it is increasingly important for companies to be vigilant when drafting their transfer-pricing agreements.  Companies must assure that any intercompany agreement would lead to desired transfer pricing results if enforced in accordance with its terms.  Especially where intangibles are involved, companies must clarify and document the economic realities of the intangible assets used.

If you would like to discuss anything contained in this alert or have questions, contact us.

The information provided in this communication is of a general nature and should not be considered professional advice.  You should not act upon the information provided without obtaining specific professional advice.


[1] The Coca-Cola Company and Subsidiaries v. Commissioner, T.C. Memo 2023-135 (2023)

[2] See Coca-Cola Co. & Subs. v. Commissioner, 155 T.C. 145 (2020)

[3] Treasury Regulation § 1.482-1(h)(2)(i) 

[4] Treasury Regulation § 1.482-1(h)(2)(ii)(A)

[5] See 3M Co. & Subs v. Commissioner, T.C. Dkt. No. 5816-13 (2023)