Coca Cola’s Recent IRS Statutory Notice of Deficiency – a Tipping Point in International Transfer Pricing Enforcement

In Coca Cola’s SEC 8-K filing last week we learned that the IRS issued a $3.3 Billion statutory notice of deficiency against the company as the result of a 5 year long transfer pricing audit covering tax years 2007-09. This is very BIG when it comes to enforcement of IRC 482 – Allocation of Income and Expenses Among Taxpayers because of both the size of the proposed deficiency AND the fact that the IRS did not assert penalties in the deficiency notice.

It seems that every five years or so the IRS flexes its muscle when it comes to prosecuting large multinational corporations in regards to 26 CFR 1.6662-6 – Transactions between persons described in section 482 and net section 482 transfer price adjustments but their non assertion of penalties leads to a whole swath of opines from the nefarious (political motivations) to the subtle (IRS procedure).

Either way Coke’s most recent disclosure to the SEC is the most significant development in the transfer pricing arena since the IRS settled with Western Union in 2011 for $1.2 billion and before that Glaxo Smith Kline in 2006 for $3.4billion.

The question is whether this is another case in the IRS’ five year cycle of reasonably substantial transfer pricing victories or maybe the start of something bigger.

When you drill down into the publicly available information on this case to date, Coke states that they “followed the same transfer pricing methodology for (certain intangible) licenses that was agreed to with the IRS in a 1996 closing agreement that applied back to 1987.”

Coca-Cola’s present opinion that their defact-o ‘agreement’ is supposed to be applicable so long as the company follows the same procedures agreed to in 1996 moving forward, is IMHO arguably the misguided effect of entrenched, disengaged and perhaps arrogant international tax counsel.

Clearly the IRS has enough substantiation to issue a statutory notice of deficiency. This file will be fun to watch develop and I hope it actually goes to US Tax Court.

WHY?

• Transfer pricing is a tricky concept to understand and harder still to practice incident free, particularly when it comes to intangibles like in the Coca Cola case involving foreign licensing agreements to manufacture, distribute, sell, market and promote products in overseas markets.
• In a ‘typical’ international organization, a parent company may set up a number of subsidiary companies all over the world and move goods, services and assets from one to another.
• Those transactions are supposed to be “arm’s length” meaning that the goods, services and assets are transferred for the same price as they would have between unrelated parties.
• In reality transactions are structured in order to shift profits from high tax countries to low tax countries to cut overall world wide income taxes paid.
• IMHO Transfer pricing is one of the most important issues intersecting politics and tax law today and few people understand this practice used by ‘multinational’ companies to legally avoid billions if not arguably trillions in tax dollars annually as long as their practices are not abusive.
• I’ve seen estimates that as much as 60-70% of all world trade happens within, rather than between, multinational organizations. Goods and/or services are crossing national borders but within the same corporate group in a related party type transaction.
• This of course draws reference to the old school adage that the difference between avoidance and evasion particularly with regards to transfer pricing of goods and services is in the thickness of the walls.
• This is a core issue of international tax justice.

How is it that Penalties were NOT asserted against Coca Cola by the IRS?

My guess is that penalties were not asserted because Coca Cola must have been operating within the spirit of their 1996 ‘agreement’ but simply not keeping up with the changing nature of transfer pricing practices to the IRS’ satisfaction.

The purpose and scope of26 CFR 1.6662-6 – Transactions between persons described in section 482 and net section 482 transfer price adjustments states:

“Pursuant to section 6662(e) a penalty is imposed on any underpayment attributable to a substantial valuation misstatement pertaining to either a transaction between persons described in section 482 (the transactional penalty) or a net section 482 transfer price adjustment (the net adjustment penalty).

The penalty is equal to 20 percent of the underpayment of tax attributable to that substantial valuation misstatement. Pursuant to section 6662(h) the penalty is increased to 40 percent of the underpayment in the case of a gross valuation misstatement with respect to either penalty.”

What is Transfer Pricing?

According to the transfer pricing audit road map transfer pricing happens whenever two related companies trade goods and or services with each other. This could be a parent company and a subsidiary, or two subsidiaries controlled by the same parent organization or any other of a variety of defined related parties.

For example, when a US-based subsidiary of Coca Cola buys something from a French-based subsidiary of Coca Cola. The subsidiaries, deemed related parties, establish a price for the transaction. This transfer price between related parties is supposed to be generally speaking commensurate with a free market exchange between a willing buyer and a willing seller.

Transfer pricing is not necessarily illegal or abusive. In fact it is an ordinary and necessary means of transacting business to a certain degree. It most definitely crosses the line and becomes abusive using a procedure called reinvoicing.

In between the “arms length” transaction of a willing buyer and a willing seller establishing a market price and reinvoicing there seems to be a multitude of ways in which the fundamental precepts of transfer pricing are substantiated to be within the enforceable confines of IRC 482.

How Transfer Pricing Works in Reality?

When two related companies trade with each other, the transaction is supposed to be the equivalent of being at an “arm’s length” and representative of supply/demand market forces. However two related companies may be compelled for a wide variety of non market related purposes to distort the price at which the trade is recorded.

The major motivating factor behind this distortion is to minimize the entity’s overall tax bill for both the related companies and its parent organization. Distorting transfer pricing disproportional to low income tax countries allows multinational operations to pay as little income tax as possible.

For example:Company A produces “food product 1” as defined by the FDA in a third world country with low labor costs and lax environmental laws;Company A ultimately sells the finished product in the United Statesusing three subsidiaries: A1 operating in the third world country, B1 operating in a tax haven country with little or no taxes and C1 in the United States. In this scenario:

• A1 sells “food Product 1” to B1 in the tax haven country at an artificially low price, A1 in the third world country will report artificially low profits – and consequently an artificially low tax bill
• B1 in the tax haven country resells or perhaps repackages and resells the product to C1 in America at a very high price – sometimes almost as high as the final retail price
• C1 then sells the final product in America resulting in artificially low profits for C1 in America and subsequently low taxes in America
• B1 in the tax haven country has bought at a very low price, and sold at a very high price, artificially creating very high profits in a country with low income tax rates

The general rule of thumb when it comes to transfer pricing through tax haven countries it seems is that baseline improvement to production, distribution or other processes in the exchange of goods or services helps mitigate the argument that the only end result is tax dollars being shifted away from America to a tax haven country merely to capture higher profits for the multinational organization as a whole.