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  • Writer's pictureTulio Lira

Transfer Pricing – Part II

(This post is originally written in Portuguese)

In the last post we did a very general high-flight on the rules of transfer pricing, especially in Brazil. What they are, how they feed themselves, and what they crave.

Following in this vein, I think it is time to dwell a little more on the subject: "what are TP rules for".

We will do this through a practical example: open your refrigerator. Chances are good that you have already come across a red can labeled "Coca-Cola". If you turn the can over you will see that it was not produced and bottled in the United States - the country where the brand was founded and Headquarters of the brand (unless, of course, you are in the USA right now). Chances are that that liquid was produced and bottled in completely different places. All while the mysterious magic recipe and the directive controls of the brand still remain in the USA.

So far, so good. And the tax? To whom is it paid? The profit tax on the coke can that you bought (not to mention the ICMS, which certainly stays in Brazil) goes into the pocket of which government if the factory, the bottler and the head are all in different places?

The first answer is easier and I can give it right now: letter (d) everyone is correct. The problem expands exponentially when we put pencil to paper: how much will be paid to whom?

Enter transfer pricing (TP).

Last October 26 the US court reaffirmed its 2020 TP decision against Coca-Cola. This decision increased the brand's profit in the US for tax purposes by about $9 billion (which reflects in an increase of more than $3 billion in taxes to the United States). The decision in reference is from the end of last year: on November 18, 2020 the US Tax Court of Appeals ruled in favor of the IRS.

On November 18, 2020, the U.S. Tax Court ruled in favor of the IRS, which adjusted Coca-Cola's U.S. income by about $9 billion in a dispute over royalties received from its foreign-based licensees (2007 to 2009 period). Broadly speaking, the argument was that Coca-Cola undercharged royalties to the other group companies, and therefore inconsistently with the Arm's Length principle. Thus, the IRS effectively levied taxes based on the revenue it correctly had for this type of transaction[1].


The Arm's Length principle defeats what it appears to be: the minimum distance to be maintained between parties. Out of curiosity, if you search online you will see that the "Merriam-Webster" dictionary classifies it as "a distance that discourages personal contact or familiarity." As already mentioned in another post here, it is the basic principle governing transactions between related parties worldwide, as patronized by the OECD. In practice, however, the difficulty lies in determining the optimal price for this "distance" in each transaction. That is, the price that does not take into account the proximity and familiarity of the companies, allowing them to profit as if they were unrelated. By the OECD guidelines, the best method to figure out "arm's length" in applying the Arm's Length principle is to look outside to unrelated parties under analogous business conditions. But who can determine what analogous conditions are? And what is to be said of COVID times? You can tell that the problems only get wider, can't you? The pie is big. We can only take it in parts. The solution that is used is to look at the functions that each part performs, taking into account the assets used and the risks taken (and here enter the various methods to perform the comparison, which we will not access now).

Back to Coca-Cola.

The case resurfaced after the company filed a request for reconsideration in June 2021[2]. In the request for reconsideration, the giant repeated its argument that it had reasonable foundation in the TP method applied to divide royalties, because in 1996 it had concluded an agreement with the IRS to use the "10-50-50" transfer pricing apportionment in its agreements.

This method was a kind of residual profit split and the result of an agreement between Coca-Cola and the IRS. It allowed any foreign licensee or "supply point" to keep 10% of its gross sales. The remaining intangible operating profit would then be divided equally between the supply point and Coke HQ, and would then be taxed in the United States. In other words, roughly speaking, 10 (% of sales) + 50/50 on the remainder would be out of Uncle Sam's reach.

It turns out that this initial agreement, as pointed out by the IRS, was for the 1987-1995 tax period, and not 2007-2009 (the period under review in the 2020 judgment). The IRS's questioning of the nature of the transactions between headquarters and the supply points was then scrutinized again arriving at the assumption that the supply points were merely routine contracts. In the IRS's logic, since it is the US headquarters that owns all the important intangibles for the brand, it is to it that the profit from the foreign operations should be attributed; the supply points should therefore be remunerated by the same margins as any other distributor. In light of this reasoning the IRS prepared an analysis under the comparable profits method, which showed a much lower return for the supply points. Thus, any profit in excess of this 'routine return' at the supply points would be reallocated to the head office, amounting to a whopping 9 billion. The court agreed.

Combined came out expensive. Coca-Cola assumed that the agreement made there in 1996 was still valid, behold, there have been no challenges since then. The IRS says that it made it clear at the time, that the transfer pricing agreement would not be valid for periods beyond the adjusted one.

What is relevant for now is to note how ephemeral everything seems to be. The TP rules touch on the slippery slope of territoriality. As much as taxation has international reach, or even is directly on a worldwide/universal basis, there is no supranational body that determines how the tax division will be done, no matter how hard the OECD tries. In practice, these controls are done by double taxation agreements or multilateral instruments. It is the countries themselves that monitor each other.

As a lawyer, of course, this does not mean that I would advise my clients to only do business between treaty countries. However, one cannot forget that it is an important tie to insure against possible "fluctuations" in the understanding of the IRS. By the way, Coca-Cola, among other points, argued exactly this: that the IRS was being too selective and political in its tax assessment, since it had been more eagerly attacking transactions with countries with which the US does not have a double tax treaty, allowing the US to unilaterally tax those revenues without further control by the other country.

What is somewhat frightening about the example used is, in my view, the court's statement that the IRS is entitled to take different positions in different years ("each tax year stands on its own") and is "not required to give the taxpayer advance notice that it is planning to revise its position. In this way it is very difficult to maintain basic principles of cooperativism, transparency and legal security with lines like this. The negotiation in the past at least served to avoid the application of fines to the beverage giant.

Does this mean that transfer pricing in practice is negotiation? Is it a tax transaction? No. This means that the theme is still maturing. See that in Brazil they normally use pre-approved margins and everything runs much more objectively (for better or worse). Furthermore, much of the definition on the subject is factual, i.e., determining what is comparable or not; what is Arm's Length and what is not; what is the best method to be used according to the type of business developed by the company/group, etc. All this, worldwide, can be better protected by a prior agreement with the tax authority to avoid surprises later - especially when there is no double taxation agreement on the other side.

Legal assistance is always relevant in these cases to ensure the correct implementation of international principles and to ensure the correct agreement and implementation of terms with the various authorities and countries. Otherwise the deal will be costly, even if you are Coca-Cola.

Article also available in Portuguese at: Juridicamente.

[1] Allowed by "section 482" (or article 482) of the US tax code, which reads: “In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.” [2] The case is The Coca-Cola Co. v. Commissioner, T.C., No. 31183-15, motion for reconsideration 6/2/21, which you can access here.

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