On Wednesday November 18, 2020, the United States Tax Court, via the pen of a very able Judge, issued the decision in a very important transfer pricing case, The Coca-Cola Company & Subsidiaries, Petitioner v. Commissioner of Internal Revenue, Respondent, 155 T.C. No. 10.
Caution is always required in reading the tax decisions of another country's court. In particular, attention and respect need to be paid to the tax legislation of that country as well as important doctrinal tax law - particularly where questions of avoided tax or tax avoidance (not the same thing) may arise directly or by implication.
This case concerns the allocation of profits from the manufacturing, distribution, and sale of Coca-Cola beverages in a number of specified countries. At the core of the case is where the return on valuable intellectual property and related "intangibles" should come to rest; in the U.S. as taxable U.S. income of the U.S. parent, or in the countries where the Coca-Cola groups marketing activities were said to have occurred autonomously by those so engaged and where the taxpayer asserted was commensurate entrepreneurial risk.
The Tax Court largely denied the taxpayer's contention that the revenue attributable to marketing outside the U.S. should be excluded from U.S. taxable income, subject to limited and relatively small collateral adjustments to the the IRS's assessments to account for the application of losses and the payment by way of dividends of compensation for the use outside the U.S. of U.S. parent - owned intellectual property. In short, the IRS was as close to completely successful in this case as, practically, is possible.
Leaving aside the unique features of U.S. statutory and regulatory law applicable to transfer pricing, the case is important regarding various issues that, notably, lie at the heart of transfer pricing debates as they have been orchestrated by the Organisation for Economic Co-operation and Development in the last decade or so, first in dealing with "business restructurings" to culminate in Chapter IX of the OECD Transfer Pricing Guidelines, then in revising the views expressed in Chapter VI of the Transfer Pricing Guidelines concerning "intangibles", next regarding Actions 8 - 10, principally, of the OECD's and the G20's examination of "base erosion and profit shifting" from late 2012 to the present and continuing, and presently as framed by the OECD's Pillar One and Pillar Two (and GloBE) proposals recently elaborated in "Blueprints" for each of the Pillars outlining for discussion ways to allocate "international income" of multinational enterprises largely broadly attributable to manifestations of intangible contributions or presence for digital and customer facing businesses. Lying at the core of the OECD's work is a concern that the intangible component of many transfers is significant and significantly value, but being intangible allows businesses to be "present" everywhere and nowhere at the same time in ways that elude the reliable application of typical nexus and attribution parameters of customary international tax jurisdiction. The loose notion of "intangibles" and the possibility of effectively being present without being "present" in international tax jurisdiction terms, is what an economic geographer might refer to as "time and space compression" - a phenomenon that digital business modalities readily enable, giving rise to a host of very difficult fiscal policy, tax policy, tax legislation and tax administration and reporting issues.
Back to Coca-Cola. The heart of this case is "marketing intangibles" - in transfer pricing parlance, business opportunities that arise for market awareness and ingenuity in the distribution of a product to appeal to the characteristics of particular markets. These were asserted by the taxpayer to have entailed significant efforts, activities and responsibilities of local service providers within the corporate family outside the Unites States, justifying a return that on the IRS's economic evidence made the various distribution points more profitable than the parent company and various other well-known food and beverage companies. The U.S. Tax Court said no to this, relying in large part to frame their views on specific features of U.S. transfer pricing regulations governing transfer pricing methodology and evidence based assessments of the parties actual functions and actual responsibilities in the context of the parent's continuing control of "its" intellectual property according to over-arching policies, practices and direction. It did this without disavowing or disregarding the legal relations among the affected parties, but rather by interpreting them in the tax context. While the Court - as might be expected in the U.S. and reflecting peculiarities of U.S. tax culture - made reference to "substance" and did carefully consider extensive industrial economic analysis, it did not apply a substance over form or-like analysis to recharacterize the contracts and relationships among the parties to which the tax law is accessory. Again, it applied an evidence based legal analysis to establish whether in its view otherwise taxable U.S. taxable income associated with intellectual property undeniably owned and carefully guarded by the U.S. parent somehow in the guise of compensation for the generation of "marketing intangibles" had been successfully shifted or directed or allocated outside the boundaries of the U.S. tax base. The disposition of this case effectively results in a "splitting" of relevant enterprise profits according to a legal analysis of the parties' entitlements informed by evidence - in short by way of legal and not economic prescription. It does this without applying a profit - splitting methodology, though, relying instead on a customary "comparables" - oriented analysis via the U.S. "Comparable Profits Method" (which, broadly, compares transactionally similar businesses at the corporate rather than particular transaction level, but nevertheless with reference functional analysis that is a mainstay of transfer pricing analysis using "comparables") with reference to arrangements involving third parties in functionally equivalent circumstances which were found to be much less generously compensated even though their counterparties in fact had more autonomy and responsibility, and corresponding entrepreneurial risk.
These sorts of issues fundamentally concern the "source" of income, which may overlap its "origin" or various geographic and territorial associations but is not the same thing. The BEPS project and its continuing progeny manifest in the Pillars, fundamentally are about the fundamentally elusive notion of the "source" of income as a legal notion where observable tangible connections may be hard to determine, though that debate is rarely framed so directly as a "source" inquiry. Famously, and often repeated, in the mid-1980 two distinguished U.S. tax scholars Hugh Ault and David Bradford observed to the effect that there is no natural law of "source"; in tax law, "source" is determined by or derived from particular tax determinations and otherwise the private law establishing the parties and relationships on which the tax law operates. Establishing a "universal" "source" notion not surprising has proved elusive in what might be regarded as the "modern era" of international tax, from the 1920s and the seminal work in this area sponsored by the League of Nations to that of the main present successor, the OECD, though not without others including the United Nations and the International Monetary Fund forcefully intervening from time to time.
The main conundrum is what to do about "intangible" business modalities - how business is conducted untethered from typical examples of a business presence, and how to give relevant definition to "intangibles" as if they are "property", leaving aside typical intellectual property" that generally is a form of property, both fashionably clad in the tax parade as "digital". In the transfer pricing context, this challenge is exacerbated by, as the Tax Court noted in passing, the possibly chameleon-like nature of contracts when the parties to them do not have adverse interests.
The Coca-Cola case, through the lens of "marketing intangibles" offers probing insight into these questions, even as off-shoots of the points directly in issue. Its importance, then, transcends its jurisdiction and the specific legal regime in which it has arisen. It bears watching - for next steps in the U.S., if there are any, and as inspiration for how transfer pricing cases may frame framed from the earliest stages of organizational and transactional planning through the dispute stage when arguments about law, practice and supporting evidentiary analysis are developed.
- Professor Scott Wilkie (Distinguished Professor of Practice, Osgoode Hall Law School)
Your comments on the Coca-Cola case made me wonder if, in addition to the digital giants, large consumer-facing businesses such as Coca-Cola would see their global profits re-allocated to market jurisdictions under Pillar One, which would mean less tax base for the United States. Such loss in the US tax base might exceed that associated with digital companies.
An interesting comment, but I think such a reallocation away from the US, as you suggest, may be less likely than the aspirations of the Pillars might suggest.
The Court's determination in this case in fact reflects a long standing assumption reaching back to the earliest examination of this issue, more or less in these terms but in the language of the day, under the auspices of both the International Chamber of Commerce and the League of Nations in the 1920s and 1930s. Mitchell B. Carroll's intensive examination of the allocation of taxing rights associated with the income of multinational businesses recognized, not as an aspiration but in his analysis a fact, that largely the intellectual aspects of such businesses were most closely connected with their home or residence jurisdictions, namely where the parent resided and operated.
More recently, in its reconsideration of "intangibles" and in the work on the Pillars, the OECD is cautiously guiding the tax world toward what amounts to a kind of unitary taxation of multinationals while still trying to respect at least the nomenclature of the arm's length principle. But the catalysts for this is the income associated with all manner of intangibles, though the OECD persists in trying to treat the intangibles aspect of transfers of goods and performance of services as implicit but separate or self-standing "transactions" to which the ALP can be applied in a more or less typical way. This reflects a number of difficulties not the least among which is the attempt to treat "intangibles" that are not property in any typical legal sense of that term as if they were, as the platform then to apply a transactions-oriented transfer pricing analysis.
The alternative, which is much more difficult but likely more realistic, is to see intangibles, whatever that may mean, as a way of describing the various benefits of "togetherness" as a unitary multinational business though diffracted to assume the shapes of a myriad of legal constructions the fiscal significances of which are in any event dubious. This is evident in the Pillar One analysis, which would unbundle the intangible element or otherwise separately recognize it, for both "automated digital services" and "customer facing businesses". As the density and complexity of the Pillar One Blueprint reflect, this is an enormous and inherently controversial task, that seemingly would require not only consistent enabling changes to all countries' domestic laws but also what amounts to a super transfer pricing regime for intangibles with its own pre-emptive controversy resolution mechanism, a kind of super advance pricing arrangement/agreement, on top of the rest of transfer pricing guidance, pertinent domestic law, and controversy resolution devices all of which would also continue to apply.
So, focusing on what is perceived to be the most valuable feature of property transfers and services in the world of "value creation", their implicit and usually seamless intangible aspects that in one way or another are associated with what commonly is called the "goodwill" value of a business - its unique and generally "secret" strategic, tactical, and indeed product features, the OECD proposes in Pillar One effectively to create a unique tax regime provided that it would be embraced by countries. We in Canada have our own experience with this, which largely sprung from the perception that so-called "marketing intangibles" should be associated with valuable taxable transfers; this is where the CRA's Transfer Pricing Memorandum TPM-06 may principally have originated ("Bundled Transactions", May 16, 2005).
In these respects, Pillar Two is closely associated with Pillar One. Pillar Two effectively envisages a minimum tax with market jurisdictions among other considerations in mind. Together, the expectation is that multinational businesses will have accountability to pay tax where they are considered to carry on their businesses, even if those businesses do not have or by their nature need typical business presences (associated with a "permanent establishment") in countries where they generate income, i.e., where the final leg of their supply chains that "create value" take place, where consumers and the markets they populate are located. In effect, the Pillars identify a long latent problematic distinction between carrying on business and carrying on business "in" a place, and also see the PE rules, which are essentially threshold rules to gauge the relative intensity of business conduct in relation to similarly situated "source" country residents, for what descriptively rather than prescriptively they are. That said, moving the jurisdictional markers of international tax is difficult, and the OECD's Pillars' approaches, at least to some degree, effectively would abandon them rather than probe their inherent significance and possibly encourage more enlightened analysis and enforcement of them.
Thinking further, though, about the early work of the League of Nations and the observations there that the intangibles aspects of businesses are likely most closely associated with the parent of a corporate group, this is the essence of the Coca-Cola decision despite the thoroughness of the Court's analysis. This does lead to focusing on another aspect of the OECD's Blueprints work, the Impact Assessment which by the OECD's acknowledgement when the Blueprints were released in October this year does not contain country specific assessments. One is prodded to wonder "how much is really in it" for the market jurisdictions in terms of income "allocation", when all is said and done - even applying the tenets of "accepted" transfer pricing analysis. If it is relatively little, this ties quite neatly to the other proposition that still some minimum degree of taxation should apply, to reflect even a limited degree of "allegiance" that engaging with residents of a source country means in business terms unobstructed by the highly navigable legal constructions which fragment multinational business unities.
Scott Wilkie