Transfer pricing and foreign tax credits

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Publication February 20, 2018

Transfer pricing issues led to being whipsawed on foreign tax credits.

Coca-Cola operates in more than 200 countries and collects royalties from its foreign branches and subsidiaries for use of its drinks formulas, brand and other intellectual property.

It worked out an agreement with the IRS about the appropriate level of royalty payments to settle an audit of its 1987 to 1995 tax returns. The agreement was that Coca-Cola licensees in other countries would pay the US parent company royalties using a 10-50-50 formula where 10% of the gross sales revenue is treated as a normal return to the licensee and the rest of the revenue is split evenly between the licensee and the US parent, with the part going to the US parent paid in the form of a royalty.

The closing agreement expired in 1995, but Coca-Cola continued to use it for transfer pricing, and the IRS accepted it, for the next 11 years.

Meanwhile, Mexico adopted an arm’s-length standard in 1997 for payments between affiliates. Coca-Cola and the Mexican government agreed on the same formula that Coca-Cola had worked out with the IRS. Mexico kept renewing the transfer price agreement through 2004. Coca-Cola continued to use it after that on the advice of Mexican counsel.

The IRS selected the company’s 2007 to 2009 tax returns for audit in 2011 and made an adjustment in 2015. It said Coca-Cola should have paid a higher royalty to the US parent.

Because Coca-Cola did business in Mexico directly (meaning through a branch office of the US parent), there was no direct effect on its US income. The effect was in Mexico where the IRS said the company reported too much income on its tax returns because it should have been deducting higher royalty payments.

The IRS disallowed $43.5 to $50 million in foreign tax credits in each of the three years for taxes that the IRS said Coca-Cola overpaid in Mexico due to failure to deduct the right amount of royalty payments.

This made the extra taxes Coca-Cola paid in Mexico voluntary taxes, the IRS said. Voluntary tax payments cannot be claimed as a foreign tax credit in the United States.

Coca-Cola asked both governments to work out the proper royalty using a process called a competent authority proceeding. The IRS declined to engage with Mexico on the issue.

The company and the IRS are locked in a larger dispute over $3.3 billion in foreign tax credits that the IRS disallowed for the three years in question on account of adjustments that the IRS made to transfer price payments from Coca-Cola affiliates in Brazil, Chile, Costa Rica, Egypt, Ireland, Mexico and Swaziland. That case goes to trial on March 5.

In the meantime, the court sided with Coca-Cola in December on the narrow question whether any part of the Mexican taxes the company paid were voluntary. The court said the company had exhausted all practical remedies to reduce its Mexican tax bill. The only practical remedy is the competent authority process in which the IRS refused to participate.

The case is Coca-Cola Company v. Commissioner.

The company complained to the US Tax Court in mid-February about the government’s plan to call 121 witnesses.


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