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Tax Court rules for IRS in transfer pricing case

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Tax Hot Topics newsletterThe Tax Court issued its opinion in the transfer pricing case The Coca-Cola Co. v. Commissioner, 155 T.C. No. 10, on Nov. 18. The opinion upholds a substantial reallocation of income in the tax years 2007 through 2009, approximately $9 billion, from the IRS under Section 482. In addition, the court found for the taxpayer regarding the satisfaction of the royalty obligation with dividends paid by foreign manufacturing subsidiaries (“supply points”), reducing the total IRS adjustment by $1.8 billion.

The U.S. taxpayer owns intellectual property (IP) necessary to manufacture, distribute and sell the best-known beverage brands in the world. This IP included trademarks, product names, logos, patents, secret formulas and proprietary manufacturing processes. Supply points license the IP to produce concentrate that is then sold to unrelated bottlers for finalization and distribution. Taxpayer’s contracts with its supply points give limited rights to the IP in performing their manufacturing and distribution functions but does not provide the supply points with ownership interest in the IP.

For the years under examination, the supply points compensated the taxpayer for use of its IP using an apportionment method previously agreed upon with the IRS in a closing agreement in 1996 to cover tax years 1987-1995. The closing agreement also allowed the supply points to satisfy their obligations by either paying royalties or remitting dividends. Although the closing agreement did not dictate future use after the initial method established in 1996, the supply points remitted dividends of approximately $1.8 billion. The IRS rejected the taxpayer’s reliance on the closing agreement methodology and re-allocated income from the supply points to the taxpayer. IRS also rejected the taxpayer payment of dividends as not consistent with the rules governing that treatment.

The Tax Court ruled that the taxpayer could not rely upon the 1996 closing agreement, as it had no application in subsequent years. The court further determined that taxpayer’s methodology did not reflect arm’s-length pricing, and the supply points undercompensated taxpayer for the IP rights. The court employed a comparable profits method (CPM) using the bottlers’ returns to benchmark the appropriate return to the supply points, resulting in an adjustment to the taxpayer’s taxable income. The court found for the taxpayer on the issue of satisfaction of royalty obligation with dividends.

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Grant Thornton LLP
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Grant Thornton LLP
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Olivia Arnold
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Washington National Tax Office
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