Introduction
On 18 November 2020, the Tax Court upheld the IRS’s $9 billion adjustment in Coca-Cola’s transfer pricing case2. At the time, the Court reserved ruling on arguments regarding Treas. Reg. § 1.482-1(h)(2) (the “Blocked Income Regulation”) and its application to adjustments of income from the operations of Coca-Cola’s Brazilian manufacturing affiliate (“Brazilian Supply Point”). The Court declined to rule on the blocked-income issue until a decision had been entered in then-pending 3M Co. v. Commissioner, in which the taxpayer also challenged the validity of the Blocked Income Regulation3. Then, on 9 February 2023, the Tax Court published the long-awaited opinion in 3M, which upheld the validity of the Blocked Income Regulation. Following 3M, on 8 November 2023, the Court issued a supplemental opinion in Coca-Cola that sustained the full amount of the IRS’s adjustment regarding the Brazilian Supply Point4.
Coca-Cola Supplemental Opinion
During the relevant years (2007-2009), the Brazilian Supply Point did not pay any royalties to The Coca-Cola Company (TCCC) for its use of trademarks and other intangibles needed to produce and market the Coca-Cola family of beverages. Instead, the Brazilian Supply Point compensated TCCC for the use of the intangibles by paying dividends, which were computed using a “10-50-50 method"5. The Tax Court determined that the 10-50-50 method did not reflect arm’s-length pricing in its November 2020 opinion. Accepting the IRS’s comparable profits method, the Court determined that the arm’s-length compensation payable by the Brazilian Supply Point was significantly higher.
In its supplemental decision, the Tax Court identified two separate bases for sustaining IRS’s adjustments regarding the Brazilian Supply Point. First, it found that because the Brazilian Supply Point could have paid—and did, in fact, pay—compensation for the use of intangibles in the form of dividends (rather than royalties), the Brazilian legal restrictions did not actually “block” payment of arm’s-length compensation. While the Court agreed that, “as a general proposition,” dividends are different than royalties, it observed that TCCC itself had treated the dividends “as a substitute” for royalties for federal tax purposes. By effectively arguing that Brazilian law permitted dividends in lieu of royalties up to the amount it viewed as arm’s length—but not beyond—Coca-Cola was, in the Court’s view, “attempting to use Brazilian law as both a shield and a sword”.
Second, the Court found that even if the Brazilian restrictions posed an obstacle to arm’s-length payment, the restrictions did not meet the requirements of the Blocked Income Regulation, which was upheld as valid in 3M. While the Blocked Income Regulation includes a grandfather clause that exempts certain transfers or licenses from its application, the Court determined that a significant number of the intangibles at issue were not exempt under that clause, and, in any event, TCCC had failed to produce evidence to determine the amount of the royalty attributable the grandfathered portion. Therefore, the Court held for the IRS.
Implications of the Coca-Cola Decision
Coca-Cola has signaled its intent to appeal the Tax Court decision, which will be reviewed by the Eleventh Circuit. To the extent the Eleventh Circuit picks up the parties’ dispute regarding the Blocked Income Regulation, its review will overlap with that of the Eighth Circuit, which is set to hear 3M’s appeal on the same issue.
As discussed in a previous article, the Tax Court in 3M sustained the validity of the Blocked Income Regulation in the face of apparently conflicting Supreme Court precedent, but only by the slimmest of margins and with eight judges joining in biting dissents. Perhaps for this reason, the Court in Coca-Cola, after the issuance of the 3M opinion, directed the parties to submit supplemental briefs that explained their views “if one were to assume arguendo that the ‘blocked income’ regulation is invalid.”
The stark divisions showcased in the 3M opinion might also explain why Judge Lauber decided to identify an alternative basis for sustaining the adjustment in Coca-Cola: that TCCC was not actually blocked from receiving arm’s-length compensation under the Brazilian legal regime. While the Tax Court’s decision suggests that it reached this conclusion based on “the peculiar facts of [Coca-Cola’s] case,” its holding on this point—arguably dicta—could impact other taxpayers facing similar issues.
It will be interesting to see how the Eleventh Circuit addresses the Tax Court’s dividends-in-lieu-of-royalties theory on appeal. How it discusses and applies the concept in Coca-Cola’s case may influence the IRS’s approach in future cases, particularly if the circuit court endorses the theory but fails to identify any “peculiar facts” that make Coca-Cola’s case unique. Moreover, with Judge Lauber’s decision now on the books, it is at least possible that the Eighth Circuit will engage with the dividends issue in considering 3M’s appeal. In both cases, the dividends theory presents an opportunity for the circuit courts to dispose of the cases without addressing the more difficult regulatory validity issue. If not, the Blocked Income Regulation will be subject to a searching (and precedent setting) review under principles of administrative law.
1 See our earlier analysis of the 3M decision, Tax Court topples Supreme Court precedent in favor of agency deference.
2 Coca-Cola Co. & Subs. v Commissioner, 155 T.C. 145 (2020).
3 160 T.C. No. 3 (2023).
4 T.C. Memo. 2023-135.
5 Coca-Cola began utilizing the 10-50-50 method to price transactions with its foreign supply points in or around 1996, after entering into a closing agreement with the IRS that used the same method to resolve transfer pricing disputes for 1987-1995. The 1996 closing agreement specifically provided that supply points could satisfy their royalty obligations under the method either by paying actual royalties or by paying dividends. Even though the 1996 closing agreement was only valid for 1987-1995, Coca-Cola followed the 10-50-50 method and the dividends approach with respect to the Brazilian Supply Point for all subsequent years, including the years at issue in the case.
