In transfer pricing analysis, which prevails: the contractual terms of a related party transaction, or the economic substance?
The general view expressed by many TP professionals is that economic analysis is king.
The Court’s decision in the recent Coca-Cola case shows that this view is at best simplistic – and for practical purposes as a guide to compliance, wrong.
As you’re probably aware, one of the central issues in the case related to the taxpayer’s assertion that valuable intellectual property (including marketing intangibles) was owned by the local ‘supply points’ rather than the ‘HQ’. The ‘supply points’ in question engaged in the manufacture and distribution of concentrate, which was supplied to separate ‘bottlers’. The bottlers produced and distributed the actual beverages.
The intercompany agreements in place during the relevant period (2007 to 2009) were (to put it mildly) unsupportive of the taxpayer’s position regarding the ownership of IP and marketing intangibles. The Court made extensive comments on the legal analysis, including the following:
“The parties often did not spell out the details of their relationships in formal contracts but left these details to be governed by mutual understanding. In some cases, System participants operated under outmoded contracts that included terms inconsistent with their actual behavior.” (p 41)
“Although [The Coca-Cola Co. or ‘TCCC’] used the 10-50-50 method to compute royalties payable by the supply points, it never incorporated any aspect of that formula into its written supply point agreements. Agreements with the Chilean and Costa Rican supply points included no discussion of payment whatever. … It does not appear that TCCC or the supply points paid much if any attention to these remuneration clauses.” (pp 47, 48)
In relation to the taxpayer’s assertion that marketing intangibles were owned by the local ‘supply points’ rather than the ‘HQ’, the Court said this:
“[P]etitioner owned virtually all the intangible assets needed to produce and sell the Company’s beverages. Petitioner was the registered owner of virtually all trademarks covering the Coca-Cola, Fanta, and Sprite brands and of the most valuable trademarks covering the Company’s other products. Petitioner was the registered owner of nearly all of the Company’s patents, including patents covering aesthetic designs, packaging materials, beverage ingredients, and production processes. Petitioner owned all rights to the Company’s secret formulas and proprietary manufacturing protocols. Petitioner owned all intangible property resulting from the Company’s R&D concerning new products, ingredients, and packaging. Petitioner was the counterparty to all bottler agreements, giving it ultimate control over the distribution system for the Company’s beverages. And most ServCo agreements executed after 2003 explicitly provided that “any marketing concepts developed by third party vendors are the property of Export,” thus cementing petitioner’s ownership of marketing intangibles subsequently developed outside the United States."
“The supply points, by contrast, owned few (if any) valuable intangibles. Their agreements with petitioner explicitly acknowledged that TCCC owned the Company’s trademarks, giving the supply points only a limited right to use petitioner’s IP in connection with manufacturing and distributing concentrate.” (pp 116, 117)
Pausing here for a moment, it is interesting to wonder why one of the largest companies in the world – presumably with well-resourced tax and legal functions – would fail to implement its TP polices through coherent intercompany agreements.
One possible explanation is that Coca-Cola’s tax function considered that agreements were unimportant, based on the belief that the contractual position would always be trumped by economic arguments. And indeed, the taxpayer attempted to argue, amongst other things, that the ‘economic substance’ of the arrangements should determine the ownership of intangibles for TP purposes.
The Court firmly rejected the contention that, in economic substance, the supply points should own valuable marketing intangibles.
However, it went further in saying that as a matter of principle, this argument was not available to the taxpayer to overcome the unfavourable contractual terms, even if the economic analysis had been favourable.
See for example p 160:
“[O]nly the Commission, and not the taxpayer, may set aside contractual terms inconsistent with economic substance.”
When referring to the relevant US income tax regulation, the Court commented as follows:
“Notably absent from this regulation is any provision authorizing the taxpayer to set aside its own contract terms or impute terms where no written agreement exists. That is not surprising: It is recurring principle of tax law that setting aside contract terms is not a two-way street. In a related-party setting such as this, the taxpayer has complete control over how contracts with its affiliates are drafted. There is thus rarely any justification for letting the taxpayer disavow contract terms it has freely chosen.” (p 161)
One of the many valuable lessons from the Coca-Cola case is therefore the necessity for multinational groups to implement their TP policies legally, through coherent intercompany agreements, and to keep those agreements updated.
Based on the number of corporates we’ve helped over the years, including household name groups, we’re no longer surprised when we find intercompany agreements which:
- Provide for IP to flow in the wrong direction
- Are incoherent and internally inconsistent
- Contain pricing clauses which lack legal certainty
- Contain no pricing clauses at all
- Cover only some of the significant transaction and entities within the group, and not all
- Don’t match the operations of the group
- Don’t reflect the group’s current legal structure
- Are not signed and dated
- Are not kept in a central, audit-ready archive
For Coca-Cola, as for every other corporate group, what’s done is done. We can’t go back in time and change the intercompany agreements which existed in historic periods.
But we can fix things going forwards, and help ensure that TP policies for 2021 and later years are legally substantiated.
That’s why we provide an outsourced maintenance service for intercompany agreements, which ensures that the group’s intercompany agreements are aligned with their TP policies, kept up to date, and maintained in a central, tax-audit ready archive.
If you’d like to discuss how this could benefit a group you look after, please email us at firstname.lastname@example.org or contact us here.
We also publish a free suite of checklists for reviewing and designing intercompany agreements, covering the most common intercompany transaction types. You can access the checklists here.