The following article first appeared in IP Briefs, the journal of the South African Institute of Intellectual Property Law.
One might think that an organisation with one of the most recognised and valuable brands in the world, founded in 1892, might be a well-oiled machine when it comes to managing its intellectual property rights.
And yet the failure of the Coca-Cola Company to document its own IP appropriately was a key factor in the decision the US Tax Court in November 2020, when it ruled in favour of the IRS. According to the company’s own estimates, this decision will leave it with an incremental tax liability of approximately US$ 12 billion, unless its appeal is successful.
What happened? And what are the lessons for other corporates and their IP advisers?
To answer these questions, we need to take a glimpse into the world of international tax and transfer pricing.
What is transfer pricing?
Transfer pricing (‘TP’) is the international set of tax rules which determine the level of intercompany charges (e.g. service fees, royalties, prices for goods) which may be properly paid between associated entities within a multinational group. These rules are important because they determine in large part the taxable profits of associated enterprises in different countries.
There are significant differences in the interpretation and application of transfer pricing principles in different countries, and each country has its own set of national rules which modify or override general transfer pricing principles in various respects. However, there are a number of factors which tend to be common.
The OECD has adopted the arm’s length principle as an international standard for determining transfer prices for tax purposes. In essence, the arm’s length principle allows tax authorities to review the transfer prices affecting a particular subsidiary, and then tax that subsidiary based on the profits it would have made had the prices been negotiated between independent third parties.
For example, imagine a multinational group which provides software as a service. Let’s say that the software is developed and maintained in South Africa, and the parent company holds all the relevant intellectual property rights, including trade marks. Local subsidiaries in other countries act as principals in licensing the relevant software to customers in the relevant local markets.
Looking at the relationship between the parent company and a local subsidiary, one type of intercompany charge is a licence fee paid by the subsidiary for the right to sublicence the software, and to use associated know-how and materials. In general, the higher the licence fee paid by the subsidiary, the lower its taxable profits will be and, correspondingly, the higher the parent company’s revenue and taxable profits will be. The subsidiary may be subject to a transfer pricing challenge from the tax administration in its country of operation, which may argue that the amount of the licence fee exceeds that which would apply on an arms’ length basis. If the licence fee is subsequently lowered, the subsidiary’s liability to corporation tax may increase. However, the tax administration in the parent company’s country of operation may not agree the corresponding reduction in the parent’s revenue – and this may result in double taxation.
Other tax considerations may also be relevant, depending on the specific tax legislation in each relevant country.
The role of intercompany agreements in TP compliance
Intercompany agreements or ‘ICAs’ are legally binding agreements which define the terms on which services, products and financial support are provided between associated enterprises, such as members of a group of companies.
ICAs are a key part of transfer pricing compliance. They are the starting point for ‘delineating’ the transaction between related parties, as well as assessing the allocation of risk, which often affects an arm’s length price. They are also part of the formal documentation which multinational groups are required to maintain for the purpose of TP compliance.
Finally, from a practical perspective, ICAs are often among the first documents which tax inspectors ask for in a TP audit. If the ICAs don’t match the group’s claimed TP policies, the other TP documentation, or the actual conduct of the relevant entities, then the taxpayer is on the back foot. This may lead to protracted investigations and ultimately fines, penalties, adverse adjustment and double taxation.
What was the US Tax Court decision relating to Coca-Cola about?
One of the central issues in this particular case concerned the relationship between Coca-Cola’s ‘HQ’ in the USA, and local ‘supply points’ in countries such as Brazil, Chile, Costa Rica, Egypt, Ireland, Mexico and Swaziland. The supply points in question were companies within the Coca-Cola group which manufactured concentrate, which was sold to separate ‘bottlers’ in Europe, Africa, Asia, Latin America, and Australasia. The bottlers produced and distributed the actual beverages.
The group’s transfer pricing policies during the relevant period (2007 - 2009) provided for profits to be split between the HQ and the supply points. The group applied a ‘10-50-50’ profit split method. This permitted the supply points to retain profit equal to 10% of their gross sales, with the remaining profit being split 50%-50% with the HQ.
As part of the justification for this profit split, the group claimed that valuable intangible assets (including intellectual property and goodwill) was owned by the local supply points rather than the HQ.
The US Tax Court disagreed, and found that this profit split methodology did not reflect arm’s-length norms because it over-compensated the supply points and undercompensated the HQ for the use of its intellectual property. The Court’s adjustments increased the HQ’s aggregate taxable income for 2007- 2009 by more than US $9 billion.
What went wrong for Coca-Cola?
One of the problems faced by Coca-Cola was that the intercompany agreements in place during the relevant period (2007 - 2009) were entirely unsupportive of the taxpayer’s position regarding the ownership of intellectual property and marketing intangibles. In effect, the relevant ICAs said that all relevant intellectual property was owned exclusively by the HQ.
The Court made extensive comments on the legal analysis, including the following:
“The supply points … owned few (if any) valuable intangibles. Their agreements with [the] petitioner explicitly acknowledged that [The Coca-Cola Company in the US] owned the Company’s trademarks, giving the supply points only a limited right to use [the] petitioner’s IP in connection with manufacturing and distributing concentrate.” (pp 116, 117)
In other words, the group’s intercompany agreements directly contradicted the TP analysis put forward by the group.
The Court firmly rejected the contention that the taxpayer could bring economic evidence of the value of the functions performed by supply points, in order to overturn the unfavourable legal position. 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)
In addition to the lack of alignment with TP policies, the US Tax Court also identified other deficiencies in Coca-Cola’s intercompany agreements: in some cases, the contracts were “outmoded” and “inconsistent with … actual behaviour”. Certain of the agreements “included no discussion of payment whatever”, and the “10-50-50” profit split method did not appear to be reflected in any of the agreements.
It is fair to say that Coca-Cola’s defective intercompany agreements were not the only factor which lead to the IRS’s victory in the US Tax Court. It is also fair to say that the tax laws of different countries take differing approaches when assessing the form and content of ICAs, as opposed to the economic analysis of the arrangements. However, the case does illustrate how tax administrations are increasingly seeing ICAs as a weak point in the tax compliance of multinational groups, and are challenging taxpayers’ TP policies when they are not supported by intercompany agreements.
Key lessons for intellectual property professionals
For many intellectual property lawyers, it may be natural to be mainly concerned about helping their clients with the protection and enforcement of IP as against third parties. They may be less concerned about where IP sits within a corporate group, and they may assume that IP should be centralised within the parent company or IP holding company. This assumption may have lead to the situation that Coca-Cola found itself in, which proved to be a very costly mistake.
One of the many valuable lessons we can take from the Coca-Cola case is the importance of the internal management and governance of IP within a group: the ownership and licencing of IP as between members of the group needs to be reflected in intercompany agreements which are aligned with the group’s transfer pricing policies and which meet the needs of the wider stakeholders involved.
The key action points for IP professionals may be summarised as follows:
1. When working with multinational groups, question your own assumptions as to how IP should be owned and licensed within the group. Encourage your clients to take into account all the relevant considerations – these may include withholding taxes, VAT and GST, exchange control and asset protection, as well as TP compliance and IP enforcement.
2. Make sure that your clients have appropriate intercompany agreements in place regarding the ownership and use of IP. These agreements need to be aligned with TP policies as regards ownership of the rights involved and the extent of the rights granted, the functions (obligations) of the parties, the allocation of risk and the calculation of licence fees and royalties.
3. Exercise caution when using templates for third party agreements as a starting point for the drafting of intercompany agreements; in many cases, such templates lack the specific TP functionality required, contain inappropriate provisions, and reflect an inappropriate allocation of risk.
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