The main attraction in the US Tax Court (Tax Court) is just a few weeks away. On March 5, 2018, The Coca-Cola Company (TCCC) and the Internal Revenue Service (IRS) square-off for a much anticipated six-week trial before Judge Lauber. The parties recently filed their Pretrial Memoranda in the case, although the IRS’s memorandum was filed under seal. TCCC’s Pretrial Memorandum gives us deep insight into the issues and how the trial will be conducted. The primary issue in the $3 billion transfer pricing case is the proper amount of the arm’s length royalties payable by six foreign licensees to TCCC for the licenses of TCCC’s trademarks and certain other intangible property for exploitation in international markets. In its Pretrial Memorandum, TCCC contends that the IRS’s application of an approximately 45 percent royalty rate using a bottler-based Comparable Profit Margin (CPM) that allocates to TCCC more than 100 percent of the aggregate operating (after accounting for the amounts paid pursuant to the Royalty Closing Agreement) profits of the six foreign licensees is arbitrary and capricious.

The IRS has audited TCCC’s royalty income with respect to its foreign businesses regularly since the 1960s. A long-running dispute on the royalty rates in the 1990s was resolved in 1996 by virtue of a Royalty Closing Agreement for TCCC’s 1987 – 1995 tax years. The agreed-upon “10-50-50 Method” was in the nature of a residual profit split method, allowing any foreign licensee “supply point” to retain 10% of its gross sales with the remaining residual intangible-related operating profit split evenly between the supply point and TCCC. Foreign licensees could satisfy their 10-50-50 amounts by paying a combination of actual royalties, dividends and payments for administrative and headquarter service contributions to the international markets. TCCC has consistently applied the Royalty Closing Agreement from 1996 – 2009.

In 2011, the IRS first informed TCCC that it was reconsidering whether to continue to apply the 10-50-50 Method for future tax years. On brief, TCCC explained it as: “[The IRS] abruptly ended this decades-long pattern of successful resolutions by designating the case for litigation and terminating petitioner’s pending APA requests.”

TCCC believes that the IRS’s strategy is to selectively target its adjustments to foreign licensees resident in non-treaty countries, to avoid having to seek competent authority assistance for its extreme position, while continuing to accept TCCC’s application of the Royalty Closing Agreement in numerous foreign licensees residing in treaty countries including France, China and India. Additionally, in its Pretrial Memorandum, TCCC highlights the inconsistent position taken by the IRS with respect TCCC’s Canadian affiliate which is the registered owner of the Canadian trademarks for the most recognized products and performs marketing and other related services in Canada. TCCC argues that once it pointed out the contradiction, the IRS “rushed to resolve the Canada issue via the competent authority process in order to remove it from the case.”

Although the CPM is understood to be a non-transactional transfer pricing method of last resort, TCCC contends that it has become the IRS’s “one-sided” default in outbound intangible licensing cases, in order to assign all intangibles-related returns to the licensor and leave the licensee with only a modest routine return. In criticizing the use of the CPM under its facts, TCCC maintains that a bottler-based CPM is flawed because the bottlers and foreign licensees have neither functional comparability nor similarity of asset composition. At trial, TCCC intends to establish that the bottlers and foreign licensees operate in different levels of the market with distinct roles and responsibilities that cause them to have different tangible and intangible profit profiles.

TCCC further contends that the IRS fails to recognize that the CPM method, which was first included in the 1994 transfer-pricing regulations, is not applicable to the 1960s licenses between TCCC and the Brazil licensee, which are grandfathered under the 1968 transfer-pricing regulations. The 1968 regulations differ substantially from their successors in determining the ownership of intangible property. Under the 1968 regulations, the developer (generally the one responsible for expenditures in developing the intangible) of intangible property owns it for transfer pricing purposes. Legal ownership is unimportant. See, e.g., Treas. Reg. §1.482-2(d)(1)(ii)(a) (1968). TCCC alleges that the Brazil licensee has born nearly all costs associated with developing Coca-Cola, Sprite and Fanta trademarks in Brazil, and thus, the Brazil licensee has the ownership of the intangible.

Practice Point: By using its authority to designate this case for litigation, the IRS foreclosed TCCC’s ability to negotiate a settlement with IRS Appeals. Interested taxpayers and counsel should follow the suit brought by Facebook in federal district court to test whether the IRS has the authority to deprive a taxpayer of the right to go to Appeals. Facebook, Inc. v. IRS, No. 4:17-cv-06490 (N.D. Cal. 2017).