The Tax Court held that the Mexican corporate taxes paid by Coca-Cola's Mexican subsidiary during the period at issue were compulsory taxes for which Coca-Cola could take a foreign tax credit.
Background
Since the early 20th century, the Coca-Cola Co. has established subsidiary foreign licensee companies in countries around the world to manufacture and sell concentrates, beverage bases, and syrups in those countries. It formed a licensee corporation in Mexico in 1950. For the tax years at issue the Mexican licensee was a branch of the Coca-Cola Export Corp., a domestic subsidiary of Coca-Cola and a member of the company's affiliated group that files consolidated federal income tax returns. As a Mexican corporation, it paid Mexican corporation tax on its net income from operations.
Coca-Cola's licensee corporations generally pay it a royalty for use of the company's intangible property. Based on a closing agreement from an IRS examination, from 1995 to 2006, Coca-Cola calculated the royalty payments for use of the intangible property for all its licensees using a method known as the "10-50-50 method." However, prior to 1998, the Mexican licensee did not pay royalties for the use of Coca-Cola's intangible property because Mexican tax law did not include an arm's-length standard for related-party transactions. In 1997, Mexico incorporated the arm's-length standard into its tax law. In response, Coca-Cola and the Mexican licensee entered into an agreement under which the licensee would pay royalties under the 10-50-50 method.
Upon executing this agreement, the Mexican licensee requested permission from the Mexican tax authorities to use the 10-50-50 method to calculate the royalties. The Mexican authorities issued two resolutions, one in 2000 and the second in 2001, that approved the use of the method through the end of 2004. After the second resolution expired, the Mexican licensee continued to use the 10-50-50 method on the advice of a Mexican tax attorney, Luis Ortiz Hidalgo. Ortiz based the advice on his belief that there had been no changes in Coca-Cola's operations or transactional relationship with the Mexico subsidiary sufficient to justify a higher royalty rate, and that the Mexican tax authorities would not allow a higher royalty deduction.
The IRS examined Coca-Cola's consolidated returns for 2007 through 2009. The Mexican licensee's taxable income was included in these returns. The returns also included $254 million in foreign tax credits Coca-Cola took for corporate taxes the Mexican licensee had paid to Mexico.
Although the IRS had approved of Coca-Cola's use of the 10-50-50 method through 2006, in the 2007-2009 examination, it determined that the royalty payments made by Coca-Cola's licensee corporations were not arm's length and should have been substantially higher. Therefore, in its notice of deficiency from the examination, the IRS, under Sec. 482, substantially increased the royalty amounts paid to Coca-Cola by its foreign licensees, including the Mexican licensee.
Because of this determination, the IRS also determined that the Mexican licensee had not claimed the proper deductions for royalty payments on its Mexican tax returns and had therefore overpaid its Mexican corporate income tax. It further determined that the overpayments of Mexican tax due to the understated royalty deductions, for purposes of the foreign tax credit, were not compulsory and thus were not creditable taxes. Consequently, in its notice of deficiency from the examination, the IRS decreased Coca-Cola's foreign tax credits by the amounts by which it claimed Coca-Cola had overpaid its Mexican taxes.
Because of the potential of double taxation that might result from the adjustments to the royalty payments by the IRS, Coca-Cola requested, under the United States—Mexico tax treaty, that the United States initiate competent authority proceedings with Mexico. Likewise, the Mexican licensee requested that Mexico initiate a competent authority proceeding with the United States. However, the IRS notified Coca-Cola that it would not participate in competent authority proceedings with Mexico because it had "designated for litigation the issue pertaining to the transfer pricing adjustments for tax years 2007, 2008, and 2009."
Coca-Cola petitioned the Tax Court to challenge, among other things, the IRS's determination regarding the foreign tax credits for the taxes paid by the Mexican licensee. In Tax Court, the IRS moved for summary judgment on the issue.
Governing legal framework
Sec. 901(b) allows a credit for "the amount of any income . . . taxes paid or accrued during the taxable year to any foreign country." Under Regs. Sec. 1.901-2(a)(2)(i), in order to be a creditable tax, a foreign levy must be a "compulsory payment pursuant to the authority of a foreign country to levy taxes."
Under Regs. Sec. 1.901-2(e)(5)(i), a tax payment is not considered compulsory to the extent "the amount paid exceeds the amount of liability under foreign law for tax." Two requirements must be satisfied for a foreign tax payment to be considered "compulsory." First, the payment must be "determined by the taxpayer in a manner that is consistent with a reasonable interpretation and application of the . . . provisions of foreign law (including applicable tax treaties) in such a way as to reduce, over time, the taxpayer's reasonably expected liability under foreign law for tax." Second, "the taxpayer [must] exhaust[] all effective and practical remedies, including invocation of competent authority procedures available under applicable tax treaties, to reduce, over time, the taxpayer's liability for foreign tax."
The Tax Court's decision
The Tax Court held that the Mexican taxes paid by Coca-Cola in 2007 through 2009 met the reasonable interpretation of the law and exhaustion-of-remedies standards set out in Regs. Sec. 1.901-2(e)(5)(i) and were compulsory levies. Thus, the company could take foreign tax credits for the full amount of the Mexican taxes it paid in those years.
Reasonable interpretation of foreign law: The Tax Court explained that the regulations do not specify what constitutes a "reasonable interpretation and application" of foreign law. However, the court noted that they provide a safe harbor for taxpayers if the taxpayer, in interpreting the law, relies on the advice that it obtains in good faith from a competent foreign tax adviser to whom the taxpayer has disclosed the relevant facts, and the taxpayer does not have actual or constructive notice that the interpretation or application of the law is likely to be erroneous.
The Tax Court determined that Coca-Cola had met this standard by relying on the advice of its Mexican tax attorney, Ortiz, whom the court described as a competent and experienced tax lawyer. Furthermore, the court found that at the time it got the advice from Ortiz, Coca-Cola did not have actual or constructive notice that his advice was incorrect because the IRS had through the entire period at issue continued to approve royalty payments calculated under the 10-50-50 method. The court found that the earliest Coca-Cola could be thought to have been aware that Ortiz's advice was incorrect was on Jan. 26, 2011, when the IRS informed the company that it was examining the royalty payments, long after the company had filed its returns for 2007-2009.
The IRS's principal argument on this point was that the interpretation was not reasonable because there was a dispute of material fact as to whether Ortiz had based his advice on facts that were fully disclosed to him. In particular, the IRS claimed there was a question as to whether Ortiz had taken into account that Coca-Cola had shifted a significant amount of the Mexican licensee's manufacturing operations to its Irish licensee, resulting in a very large sales decrease for the Mexican subsidiary.
The Tax Court rejected this argument, finding that during the 20-year period (1987 to 2006) during which the IRS had explicitly or implicitly approved of the use of the 10-50-50 method, the revenues and profits of the company's foreign licensees might have undergone significant year-to-year changes, but there was nothing in the original closing agreement that established the 10-50-50 method or in subsequent IRS audit activity that suggested that the method should change depending on these variables. To the contrary, the court observed, given how the calculations under the method worked, the production shifts cited by the IRS were totally irrelevant. Thus, whether Ortiz was informed of, or evaluated the effect of, the production shift to Ireland was not a material fact.
The IRS also argued that Coca-Cola had not disclosed the relevant facts to Ortiz because the descriptions of the Mexico licensee's functions, assets, and risks that Coca-Cola supplied to the Mexican tax authorities when obtaining approval of the 10-50-50 method of royalty calculations in 2000 and 2001 might differ from the facts ultimately found at trial. The court disagreed, stating that it was "hard to see" how this factual uncertainty, if it had been known to the Mexican tax authorities, would have supported a higher royalty payment to Coca-Cola. Further, the court concluded that regardless of what effect the information might have had, the determination of whether Ortiz's interpretation of Mexican law was reasonable had to be made on a prospective basis, as he obviously could not have known at the time he gave his advice what facts would be established at trial in 2018.
Exhaustion of remedies: Coca-Cola contended that the IRS's reliance on Sec. 482 adjustments that have not yet been adjudicated, combined with its refusal to participate in competent authority proceedings, meant that the company had exhausted its available remedies for foreign tax credit purposes. The Tax Court agreed, finding that there was no effective and practical remedy that the company could presently pursue to reduce its liability for Mexican tax.
The Tax Court found that Coca-Cola had two possible remedies: filing a refund claim in Mexico for the overpaid taxes or seeking competent authority relief under the United States-Mexico tax treaty. Although the company could currently file a refund claim in Mexico, according to the court, the claim would be held to be premature because the IRS's proposed Sec. 482 adjustments, which would be the basis of the claim, had not yet been adjudicated. In addition, the court concluded that even if a refund claim were not premature, based on the Mexican tax authority's two resolutions approving the 10-50-50 method for the royalty payments, there was no reason to believe that the Mexican government would agree with the IRS's reallocation of income. The court noted that in Schering Corp., 69 T.C. 579 (1978), it had held that a taxpayer is not required to take futile administrative steps, and the pursuit of a refund claim in Mexico by Coca-Cola before the IRS's Sec. 482 claims had been adjudicated would be futile.
The Tax Court also noted that a taxpayer in some circumstances may be required to invoke competent authority relief to demonstrate exhaustion of remedies. However, Coca-Cola and the Mexican subsidiary had attempted to initiate competent authority proceedings, only to have the IRS refuse to participate. The court would not find that Coca-Cola had failed to exhaust its remedies when the IRS had unilaterally made "it impossible for [Coca-Cola] to pursue the only remedy that exists."
The IRS, perhaps seeing the weakness in its effective remedies argument caused by its refusal to immediately participate in a competent authority procedure, also claimed that Coca-Cola still had an effective remedy because the IRS would participate in the future, after the Tax Court had rendered its decision on the Sec. 482 adjustments. If, as a result of that procedure, Coca-Cola's Mexican tax bill was higher than the liability presupposed by the Tax Court's opinion, the IRS would allow a credit for the incremental Mexican tax at that time.
The Tax Court found that this was not the procedure Congress envisioned when it enacted the Code. Rather, under Sec. 905(c), a procedure is provided when a foreign tax liability ultimately varies from the amount claimed. Under this procedure, the taxpayer is allowed to take a foreign tax credit for the amount of foreign tax paid, and, if it is later determined that foreign tax was overpaid, the taxpayer must file an amended return with information sufficient to allow redetermination of the amount of tax owed. Any additional tax owed by the taxpayer is not subject to deficiency procedures and must be paid on notice and demand by the IRS. As the Tax Court pointed out, this procedure under Sec. 905(c) of dealing with uncertain foreign tax amounts was explicitly endorsed by the IRS in Rev. Rul. 70-290.
The Tax Court therefore found that, in Coca-Cola's case, the procedure under Sec. 905(c) should be followed. Accordingly, Coca-Cola should be allowed foreign tax credits for the Mexican tax paid, and if, as a result of future competent authority proceedings, some or all of the Mexican taxes paid by the company were refunded, Coca-Cola would be required to pay on notice and demand any taxes due to the United States because of the corresponding reduced foreign tax credits. As the Tax Court stated, "Congress did not intend that [foreign tax credits] would be denied up front because of the possibility that foreign taxes might in the future be refunded. Rather, Congress envisioned that the accounts would be squared if and when foreign taxes are in fact refunded."
Reflections
Although Coca-Cola won the first round, its fight with the IRS over the royalties paid by its foreign licensees for intangibles is far from over. In its notice of deficiency to Coca-Cola, the IRS increased Coca-Cola's tax liability for the years 2007 through 2009 by $3.3 billion based largely on transfer-pricing adjustments of $9 billion for those years. The IRS determined the adjustments using the comparable-profits method (CPM) set out in Regs. Sec. 1.482-5.
Besides objecting to the IRS's unexplained change to the CPM from the non-CPM 10-50-50 method, which it had repeatedly approved over a 20-year period, Coca-Cola claims that the IRS improperly used beverage bottlers as comparables in its CPM analysis. According to Coca-Cola, beverage bottlers should not have been used in the analysis because their functions, assets, and risks are not comparable to those of its foreign licensees.
The Coca-Cola Co., 149 T.C. No. 21 (2017)
