The Tax Court’s new opinion deciding the blocked income question raised in Coca-Cola v. Commissioner, T.C. Memo. 2023-135, suggests that Coca-Cola’s prospects of eventual success are dim, whether the blocked income regulations are upheld on appeal or not.
Judge Albert Lauber’s November 8 supplemental opinion in Coca-Cola is the epilogue to the landmark 2020 opinion (155 T.C. 145 (2020)) that handed the IRS a decisive victory in a case concerning transfer pricing method selection.
Lauber’s 2020 opinion upheld the section 482 allocations derived from the IRS’s comparable profits method analysis but set aside the parties’ blocked income dispute pending the outcome of a similar dispute in 3M Co. v. Commissioner, 160 T.C. No. 3 (2023).
The supplemental opinion, which also sides with the IRS, will likely be the last step in the Coca-Cola case before it heads to an inevitable appeal. Although the monetary stakes aren’t as high as they were in the broader method selection dispute, the blocked income issue in Coca-Cola determines the fate of $882 million worth of section 482 allocations for tax years 2007 through 2009.
The outcome in the supplemental Coca-Cola opinion was likely, if not necessarily inevitable, after the Tax Court narrowly upheld the blocked income regulations under reg. section 1.482-1(h)(2)(A) in 3M.
Under that section, a foreign legal restriction that blocks the payment of arm’s-length compensation in a controlled transaction must be generally applicable to all similarly situated taxpayers, both controlled and uncontrolled, to be respected. It was stipulated in both 3M and Coca-Cola that the Brazilian blocking provision at issue, a since-repealed intragroup royalty restriction, did not satisfy these conditions.
In light of this stipulated fact and the outcome in 3M, Lauber held that the IRS was not required to respect the Brazilian royalty restriction for intangibles that didn’t qualify for transitional treatment under reg. section 1.482-1(j)(4).
However, 3M didn’t assess the validity of reg. section 1.482-1(h)(2)(ii)(C)’s “payment in any form” requirement or reg. section 1.482-1(h)(2)(ii)(D)’s anti-circumvention condition. Together, those two sections require that the foreign controlled party be legally unable to pay arm’s-length compensation in any form — for example, as a dividend — and that it has not entered any arrangement to circumvent the restriction.
The two conditions, which are arguably more relevant in Coca-Cola than they were in 3M, are the regulations’ way of determining whether the allegedly blocked income was truly blocked.
Recognizing the possibility that some or all the conditions in reg. section 1.482-1(h)(2)(ii) may not withstand appeal, Lauber’s February supplemental briefing order instructed the parties to also make their cases assuming that the blocked income regulations are ultimately struck down. By so doing, the order implied that the blocked income regulations’ fate doesn’t necessarily dictate the fate of Coca-Cola’s blocked income claim.
In other words, even if reg. section 1.482-1(h)(2)(ii)(C) and (D) is invalidated, the allegedly blocked income must still be blocked by the foreign legal restriction for the IRS to be forced to respect it. It is this basic requirement, whether its legal basis is reg. section 1.482-1(h)(2)(C) and (D) or the common meaning of the word “blocked,” that poses what may prove to be an insurmountable obstacle to Coca-Cola’s claim that its Brazilian subsidiary (or “supply point,” in the company’s lingo) was legally barred from paying its U.S. parent an arm’s-length royalty.
Determining the validity of the blocked income regulations, which took the Tax Court over six years in 3M, is anything but straightforward. It requires careful parsing of the convoluted 1972 Supreme Court opinion in Commissioner v. First Security Bank of Utah, 405 U.S. 394 (1972), along with an assessment of the relevance of statutory changes motivated by very different policy concerns.
The extent of the challenge is evident from the widely differing interpretations endorsed by judges in 3M, a decision that was reviewed by the 17 active Tax Court judges.
The final tally in 3M was 9 to 8 in favor of the IRS, a razor-thin margin that still somehow fails to convey the full level of disagreement among the judges who decided the case. The plurality opinion written by Judge Richard Morrison was joined by only six of the 16 other Tax Court judges who reviewed the opinion.
Five others, two of whom declined to join in Morrison’s plurality opinion, signed on to at least one of two different concurring opinions. The remaining eight Tax Court judges joined in at least one of three dissents.
But as the supplemental opinion suggests, the knotty questions that caused the 3M schism may not really matter in Coca-Cola. The company, which in many ways is uniquely ill-situated to bring a blocked income challenge, has strenuously resisted the IRS’s attempt to compel it to do something it already freely chose to do — and on an industrial scale.
The likely result is that Coca-Cola’s blocked income argument will ultimately fail — regardless of the fate of the blocked income regulations.
An Uphill Battle
The recent outcome in Coca-Cola isn’t especially surprising considering the arguments before the court. Coca-Cola’s March 2023 supplemental brief, a long-shot attempt to get out from under the weight of the company’s fundamentally contradictory stance, was odd in many respects.
For example, the brief repeatedly insists that the “unambiguous” basis for the Supreme Court’s holding in First Security was the control requirement implicit in the general definition of taxable income rather than anything specific to section 482:
“The statutory definition of taxable income, as interpreted by the Supreme Court in First Security, unambiguously requires complete control over the income. That holding did not rest on (but merely found additional support in) regulatory text, and the 1986 amendment to section 482 did not change the statutory definition of income.”
The apparent purpose of making this claim was to moot the 1986 commensurate with income amendment to section 482, which played a more prominent role in the 3M opinion than many expected.
Logical as this tactic may seem, it entails a credibility cost: The prevailing interpretation, especially favored by taxpayers, has long been that First Security was the Supreme Court’s authoritative endorsement of the arm’s-length standard. “Unambiguous” is hardly the right word to describe a reading of First Security that clashes with the long-dominant interpretation of the case, and that 12 of the 17 active Tax Court judges involved in 3M (all except Judge Cary Pugh and the four judges who signed on to her dissent) rejected.
Another oddity is the brief’s repeated implication that the Tax Court has the power to impose “binding” precedent on itself; for example, when it claims that “this Court’s binding precedent interpreting the pre-amendment version of section 482 also applies” (emphasis added). The Tax Court obviously has the power to overrule its own precedent in appropriate circumstances. Precedents that can be overruled aren’t “binding.”
However vexing its poor adjective choices may be, the supplemental brief’s principal flaw was its inability to resolve the company’s fundamentally contradictory position.
The brief simply failed to explain why the Brazilian supply point was free to use dividends to pay whatever it owed Coca-Cola in royalties under the expired closing agreement at the center of the case, but not to pay the royalties the IRS and Tax Court believe it owed.
The closing agreement, which expired in 1996, established a profit allocation formula for pricing Coca-Cola’s license of trademarks, product recipes, manufacturing know-how, and related intangibles to the foreign supply points that manufactured beverage concentrate for sale to independent bottlers.
Under the closing agreement’s “10-50-50” formula, the supply points received a 10 percent return on sales and split the remaining system profit 50-50 with Coca-Cola. The agreement also expressly allowed Coca-Cola to collect the intercompany royalty payments required under the formula by offsetting taxable dividends paid by the supply points.
However, the closing agreement that offered Coca-Cola this dividend offset option expired over a decade before the tax years at issue in Coca-Cola. The company’s ability to claim dividend offset treatment was thus technically subject to the requirements of Rev. Proc. 99-32, 1999-2 C.B. 296, but Coca-Cola, undaunted by the closing agreement’s expiration, evidently assumed it didn’t need to fulfill them.
Coca-Cola’s sole consolation prize in a case that it otherwise resoundingly lost was the Tax Court’s 2020 decision that, notwithstanding technical noncompliance with Rev. Proc. 99-32, held that dividends paid by the supply points could still be credited against the required intercompany royalty charges.
The company thus fought for the right to use the dividends it received from its Brazilian supply point to satisfy the supply point’s royalty obligations, and it ultimately prevailed. Against this backdrop, one might think that Coca-Cola would be in no place to assume the mantle of guardian of income classifications.
Coca-Cola evidently sees things differently. Crediting what a foreign jurisdiction considers a dividend against what the United States requires in royalties was, according to both Coca-Cola and the Tax Court, a valid means to relieve the double taxation that would otherwise result.
But at least according to Coca-Cola, the IRS can’t require the company to do the same thing to ensure compliance with the arm’s-length standard.
When Blocked Income Isn’t Blocked
When Lauber ordered supplemental briefing days after the Tax Court issued its 3M opinion, he drew the parties’ attention to Procter & Gamble Co. v. Commissioner, 95 T.C. No. 23 (1990), aff’d, 961 F.2d 1255 (6th Cir. 1992).
Dealing with what may at first seem to be a comparable blocked income scenario, the Tax Court and Sixth Circuit both rejected the IRS’s insistence that a subsidiary (España) bound by a foreign royalty restriction should have paid a dividend that would be considered a royalty for U.S. tax purposes. As the Sixth Circuit explained:
“We firmly disagree with the Commissioner’s suggestion that [P&G] should purposely evade Spanish law by making royalty payments under the guise of calling the payments something else. Furthermore, the record reflects that España did not have distributable earnings from which to pay dividends. [P&G’s] federal income tax returns indicate that España had accumulated deficits during the years at issue and would be unable to distribute dividends.” [Emphasis added.]
The Spanish subsidiary’s legal inability to pay an arm’s-length royalty, even in the alternative form specified by the IRS, is the first important factual difference between Procter & Gamble and Coca-Cola.
In Coca-Cola the parties stipulated that the Brazilian supply point could have paid dividends to its U.S. parent in an amount necessary to cover all $1.77 billion in royalties it owed for 2007 through 2009 without running afoul of any local law.
Coca-Cola countered by claiming that the legal ability or lack thereof to pay a dividend is beside the point. The company has argued that even if a dividend could be paid without incident, the IRS has no authority to compel taxpayers to misclassify what, in substance, is a royalty.
The argument appears to be that requiring a dividend to be paid in place of the legally blocked portion of an arm’s-length royalty, even when no foreign legal obstacles would prevent paying the dividend, defies some sacred boundary between classes of income. Or, as the company’s March 2023 supplemental brief so eloquently explained, “dividends and royalties are different.”
According to Coca-Cola, disregarding this difference by compelling the Brazilian supply point to make dividend payments to cover the royalties it would otherwise owe would force the company to flout foreign law. After helpfully explaining to the court what dividends and royalties are, Coca-Cola’s supplemental brief goes on to allege that “recharacterizing dividend payments as royalties would thus merely circumvent Brazilian law.”
Coca-Cola may have had more success with this argument if the only difference had been the Brazilian supply point’s abstract right to pay dividends in an amount equal to the royalties it owed.
However, the Brazilian supply point’s ability to satisfy its royalty obligations with dividend payments wasn’t hypothetical. Coca-Cola’s Brazilian supply point not only had the unfettered legal ability to pay its royalty obligations through dividends, it actually exercised that right on a massive scale.
Over the three tax years at issue, Coca-Cola’s Brazilian supply point remitted a total of about $1.35 billion in dividends to its U.S. parent. By claiming dividend offset treatment for $887 million of this total under the closing agreement, Coca-Cola credited the bulk of its dividend receipts from its Brazilian supply point against the intercompany royalties it otherwise had to charge under the 10-50-50 formula.
The $887 million in claimed dividend offsets dwarfed the maximum allowable royalties under the Brazilian royalty cap, which totaled about $56 million over the same three-year period.
The best rationalization Coca-Cola could manage was the misleading and formalistic distinction in its brief between primary section 482 adjustments and secondary adjustments: The blocked income issue deals with the IRS’s authority to make a primary adjustment, while dividend offsets are used to avoid secondary adjustments once a primary adjustment has already been made.
Put another way, the argument is that dividend offset treatment deals with the characterization of payments that would otherwise have been taxable dividends, not with the transfer pricing adjustment that precipitated the dividend.
It’s certainly true that the purpose of dividend offsets under Rev. Proc. 99-32 is to allow taxpayers to avoid a secondary adjustment to conform their accounts after a primary adjustment. But Coca-Cola wasn’t using dividends from the Brazilian supply point to avoid secondary adjustments, which may help explain why it saw no need to comply with the technical requirements of Rev. Proc. 99-32.
As explained in the 2020 Coca-Cola opinion, the company simply used dividends to make up for any shortfall in intercompany royalty receipts at the end of the year:
“When preparing its return for 1996, petitioner used the 10-50-50 method to calculate the royalties due from its supply points for 1996. It compared that amount to the royalties it had actually received from those supply points during 1996 — viz., the “prices actually charged” — which were less than the 10-50-50 required amounts. Petitioner then initiated a section 482 adjustment against itself for the balance of the supply points’ royalty obligation. And it offset against that balance the taxable dividends it had received from the supply points during 1996, as the closing agreement had permitted for dividends paid during 1987-1995.”
Saying Coca-Cola used taxable dividends from the supply points to offset a self-initiated section 482 adjustment that increased its intercompany royalty income is just a fancy way to say the supply points were paying the royalties they owed in the form of dividends. At least under the facts in Coca-Cola, drawing a distinction between the two is hollow formalism.
Although Lauber didn’t directly criticize this argument, he evidently wasn’t impressed by it either. Without challenging the innocuous premise that dividends aren’t the same as royalties, Lauber’s opinion highlights the glaring disconnect evident in Coca-Cola’s practice of using dividends as a substitute for royalties:
“Petitioner took the position that, for Federal tax purposes, dividends from the Brazilian supply point could be used to satisfy the latter’s obligation to pay petitioner arm’s-length compensation for the use of [The Coca-Cola Company’s] intangibles. It seems inconsistent for petitioner to argue that dividends can be treated as deemed royalties up to the amount petitioner thought to be correct, but not in the larger amount that the Court has determined to be correct.”
The supplemental opinion rejects Coca-Cola’s forced circumvention argument on similar grounds. If the IRS’s position represents an attempt to coerce Coca-Cola into circumventing Brazilian law, then why was Coca-Cola — now so devoutly committed to following its Brazilian legal obligations — willing to claim 16 times as much in dividend offsets as it could have collected in royalties under Brazil’s royalty cap?
Unable to identify a satisfactory explanation, Lauber’s opinion notes, “It is hard to see how petitioner would be circumventing Brazilian law by causing the supply point to remit a larger volume of dividends as compensation for use of [The Coca-Cola Company’s] intangibles.”
The opinion also highlights in a footnote a further flaw in Coca-Cola’s circumvention claim. Compensating Coca-Cola for rights to use its intangibles in the form of nondeductible dividend payments poses no base erosion risk to Brazil. Put differently, making a nondeductible payment “circumvents” an anti-base-erosion measure in the same way that staying at home circumvents the highway speed limit.
A Bad Omen
After characterizing Coca-Cola’s arguments as an attempt to use the Brazilian royalty cap as both shield and sword, the opinion diplomatically observes that “this one-way ratchet is not entirely convincing.” The result, according to the opinion, is that Coca-Cola’s argument may fail even if reg. section 1.482-1(h)(2) is invalidated on appeal.
But the opinion stops short of actually ruling on the question because, at least for now, the outcome in 3M made doing so unnecessary:
“We think respondent advances a reasonable argument that the Brazilian legal restriction, which prevented the supply point from paying royalties in excess of $56 million during 2007-2009, did not actually “block” the payment of arm’s-length compensation for use of [The Coca-Cola Company’s] intangibles. If that is so, respondent might prevail under the law as it existed before 1994, when the Treasury Department promulgated [reg. section] 1.482-1(h)(2). Had this Court in 3M invalidated the regulation, we would need to decide this question.”
The opinion then proceeds to apply 3M, assuming the validity of reg. section 1.482-1(h)(2), to evaluate Coca-Cola’s claim that its most valuable trademarks weren’t subject to the 1994 regulations (T.D. 8552) because of the effective date provisions of reg. section 1.482-1(j).
Although Lauber agreed with Coca-Cola that some of its trademarks weren’t subject to the revised regulations, he found that non-trademark intangibles and newer trademarks covered by the 1994 regulations accounted for the bulk of the value of Coca-Cola’s supply point licenses. Because Coca-Cola failed to propose any sound basis for allocating value across its different trademarks or between its trademark and non-trademark intangibles, Lauber found that the company failed to carry its burden of showing that the IRS’s allocation was unreasonable.
Of course, the ability of reg. section 1.482-1(h)(2) to survive de novo appellate review after escaping invalidation by the Tax Court by the narrowest possible margin is uncertain. As the 17 Tax Court judges’ total of six 3M opinions — one plurality opinion, two separate concurring opinions, and three different dissents — make abundantly clear, even judges responsible for interpreting U.S. tax law can’t seem to agree on this issue. How the three Eleventh Circuit judges who hear Coca-Cola’s appeal will rule on the question is anyone’s guess.
However, Lauber’s opinion demonstrates that the potential future demise of reg. section 1.482-1(h)(2) would be no guarantee of victory for Coca-Cola.
If the Eleventh Circuit invalidates the blocked income regulations, it would have to remand the case to answer what Lauber’s opinion describes as “the question whether the Brazilian legal restriction . . . actually blocked the payment of arm’s-length compensation for the use of [The Coca-Cola Company’s] intangibles.”
If the opinion’s detailed analysis of a question that technically wasn’t even raised at this stage is any indication, Coca-Cola’s prospects for success in the event of a remand are decidedly bleak.