Coca-Cola recently lost a case in tax court against the IRS on a transfer pricing matter to the tune of $3 billion. A landmark case that had been ongoing for over five years and a massive win for the IRS. Given the high profile nature and the huge success the IRS had in this case, it may open the door for audits of other multinationals and scrutiny of their transfer pricing methods.
Transfer pricing can be a complex area of the tax law. How a company employs its transfer pricing strategy can have a significant impact on its profit allocation between its domestic operation in the US and its foreign subsidiaries located in low tax jurisdictions across the world. The Coca-Cola case involved the IRS claiming that Coca-Cola had shifted too much profit away from the US and to subsidiaries that operate in lower tax countries including Brazil, Mexico, Ireland, Chile, and Costa Rica.
Transfer pricing in its simplest sense deals with the price that is charged between two related legal entities that operate in different tax jurisdictions. It is likely easiest to demonstrate with an example:
- Company A has two subsidiaries – Subsidiary X and Subsidiary Y
- Subsidiary X operates in the US and manufactures hard drives for PCs.
- Subsidiary Y operates in Mexico and purchases the hard drives from Subsidiary X. Subsidiary Y then finishes the manufacturing process and sells the finished PCs to customers.
The price that Subsidiary Y pays to Subsidiary X for the hard drives is a transfer price. Based on this price, Subsidiary X will have revenue and Subsidiary Y will have an expense.
So, logic would tell us that we would want the price paid from X to Y for the hard drives to be as low as possible. Why? Because X operates in the US, which has a higher corporate tax rate than Mexico, where Y operates. If the transfer price as low as possible, then the revenues earned by X are as low as possible and in turns, profits for X are low. Additionally, Y’s costs are lower, which would allow Y to report more income in Mexico, taxed at a lower rate.
Since both X and Y are subsidiaries of Company A, the total profit for Company A from a financial reporting standpoint is the same. The revenue/expenses simply cancel each other out on the consolidated financial statements as they are just costs paid from one subsidiary to another. Although overall profit is the same, the shift between the subsidiaries is key as the profit is taxed at different rates.
Now that we know what transfer pricing is and how multinational companies are motivated to shift profits amongst subsidiaries, let’s take a look at how transfer prices are determined.
The Organization for Economic Cooperation and Development (OECD) has developed an extensive list of transfer pricing methods. Many of the methods involve examining a comparable uncontrolled transaction. Essentially, what would the price be for a transaction between two unrelated parties?
A key aspect of the comparable transaction involves the risks assumed by both side of the transaction.
In transfer pricing situations, intangible assets are often involved, as in the case of Coca-Cola. When intangibles are involved, there tends to be valuation work involved to determine the value of those intangibles, which can support payments to the owner of those intangibles for their use by the foreign subsidiary.
In the Coca-Cola case, the transfer price issue is related to Coca-Cola conducting its international business through controlled foreign licensees. The intangible value of Coca-Cola’s product, the intellectual property (trademarks, brand names, secret formulas, etc.), is owned by the US Company. The foreign subsidiaries license this intellectual property in order to produce and sell Coca-Cola. The IRS claimed that Coca-Cola’s foreign subsidiaries were paying a royalty on the US company’s IP that was too low. Essentially, there was more value in the IP than the US Company was being compensated for through the license agreement with Coca-Cola’s foreign subsidiaries.
The valuation issues here deal with the risks associated with the operations of the foreign entities and how the domestic entity is compensated for the use of its intangible assets. The IRS argued and won on the point that the value of Coca-Cola’s IP was higher than what was reflected in the transfer price paid from the foreign entities to the US entity. This allowed profits to be shifted to lower tax countries.
This post just scratches the surface of the Coca-Cola case and the issues surrounding transfer pricing. If you are a business operating both in the US and abroad, the need for help in the transfer pricing area is paramount, and even more so based on the IRS’ victory in the case against Coca-Cola. There is risk even for small and medium-sized businesses operating in foreign jurisdictions. As we have seen from this case, the cost can be significant for dropping the ball.
Contact a member of DKB’s Valuation and Litigation Services team today to find out how we can help.