For many, 2020 was a year filled with strange occurrences and anomalies, from a pandemic to murder hornets. One more notable event to add to that list is the IRS winning a tax court case that involved a large transfer pricing adjustment. In November 2020, the U.S. Tax Court decided in favor of the IRS and against Coca-Cola, resulting in an additional tax payment of $3.3 billion. It was a large win for the IRS and poignant too, as the IRS’ track record is poor at best in winning tax court cases involving transfer pricing.
Brief Case Summary
The IRS claimed that Coca-Cola undercharged its foreign affiliates in connection with their intercompany licensing arrangements, thus leaving profits above an arm’s-length return in these foreign affiliates. Coca-Cola had based its transfer prices on a settlement of an IRS audit from the 1987 to 1995 tax years. As the IRS and Coca-Cola had come to a conclusion on an appropriate transfer price for this particular intercompany transaction to resolve that audit examination, Coca-Cola continued to use the same transfer price arrangement in future tax years.
The IRS’ position during the examination was the Comparable Profits Method (CPM) using a return on assets profit level indicator provided a better analysis for pricing the intercompany transaction than under the previously agreed-upon methodology of the licensees receiving a fixed profit margin and allocating the residual profit based on a 50/50 split between the U.S. parent company of Coca-Cola (licensor) and its related-party licensees. Coca-Cola rebutted that the CPM was the method of last resort, but the tax court pointed out the best method rule found in Treasury Regulation Section 1.482-1(c) should be applied, and therefore, the CPM was accepted.
Conclusions to Draw
While there are many additional nuances to this tax court case, the case summary above points out important facts by which to draw some basic conclusions. First, the IRS, a perennial loser in transfer pricing-related tax court cases, actually won a large judgment in the U.S. Tax Court. The victory will likely embolden them to take on more transfer pricing-related court cases. The IRS has been increasing staffing in certain key audit initiatives, including the Large Business and International division. It is doing a better job selecting cases to pursue in tax court and is now having success with those cases.
Another important lesson the Coca-Cola case demonstrates is that using a transfer price determined as the result of an IRS examination is not valid indefinitely. A transfer price agreed upon as part of an IRS examination is relevant to that tax year only and is not a precedent. A new or separate economic analysis to determine the arm’s-length transfer price (or even new methodology) will be needed in the future (preferably before the IRS comes back for a subsequent examination).
A third point is the best method rule should always be applied when determining the proper transfer pricing methodology to use in an analysis. When performing the best method selection, it is important to not only stipulate why a method was chosen as the best method, but also give reason(s) as to why the other methodologies were rejected. This is an essential requirement of the transfer pricing documentation rules as outlined in Treasury Regulation §1.6662-6(d)(2)(iii)(B).
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