How Coca-Cola’s earnings are able to hide a tax dispute worth $16bn

Coca-Cola’s dispute with US tax authorities, which has lasted for a decade, could now amount to $16bn, or enough to wipe out an entire year and a quarter of profits. The figure is expected to rise by $1bn per year.

According to a harsh court ruling, the soft drink maker has hidden “astronomical” levels of profits in countries with low taxes, including Ireland, to hide it from the US Internal Revenue Service. The company plans to appeal the judgment later this year.

In recent years the increasing stakes were only visible in the fine print in Coke’s regulatory submissions, due to an oddity of accounting regulations.

Coke, which last week received the final in a string of four-year tax court rulings, will soon have to pay an initial $6bn to cover unpaid taxes for 2007-2009. Coke’s earnings will not be affected by the $6bn in cash it has to pay, or the $10bn that could be owed for the next 15 years.

Payments do not need to go through the company’s profit and loss account as long as EY, its long-time auditor and the Atlanta-based firm agree there is more than a 50-50 chance that Coke will win on appeal.

The IRS could impose higher US taxes for years to follow if Coke misjudged the chances of winning. According to the company, the global tax was 17.4 percent last year.

Stakes are high for the US Government as well. The $16bn would cover the IRS’s budget for an entire year. And the standoff with Coke will test the IRS’s ability at a time it has pledged to be tougher on corporate tax avoidance.

Alex Martin, a transfer pricing specialist with the tax advisory group KBKG said that other companies were closely watching. This decision could serve as a model for other US companies that have profitable subsidiaries.

The dispute centers on Coke subsidiaries located in Ireland, Brazil and Eswatini, as well as four other countries, which manufacture concentrate syrup, which is mixed with carbonated drinking water to produce drinks like Coca-Cola Fanta Sprite. The subsidiaries are located between the US parent, which owns brands, and the bottling firms that produce the final product.

The US tax court determined that the company regularly shifted concentrate production to countries with lower tax rates. The subsidiary in Ireland had a tax of as little as 1.4% and shipped to bottlers from 90 different countries.

IRS analysis showed that unlike independent contract manufacturers who typically have low profit margins, these Coke subsidiaries had a return of assets that was two-and-a half times higher than the US parent company which owns the iconic brand. Coke’s control over how much its subsidiaries have to pay for the use of Coke brands and marketing and the prices that they can charge bottlers is what determined their profitability.

In a first ruling of 2020, Judge Albert Lauber stated that these profit levels were “astronomical”.

He asked, “Why is it that the supply points are the most profitable companies in the food and beverage industry, despite the fact that they engage in contract manufacturing?” “And why is their profitability dwarfed by that of Coca-Cola Company which owns intangibles on which the profitability of the company depends?”

Coke’s tax treatment for its concentrate producers has been an ongoing sore between Coke, the IRS and other government agencies. In 1996, the IRS and Coke settled a similar dispute by reallocating the profits of its subsidiaries to the US parent.

Coke continued to use the same formula for calculating its tax returns without any objections until the IRS ruled in 2015 that the company had suppressed US profit improperly. It said that the concentrate manufacturers shouldn’t be earning a higher percentage than Coke bottlers. Any amounts above this should be taxed by the US as US income.

Lauber’s 2020 judgment and subsequent ones did not give much credence to Coke’s claim that the IRS had acted arbitrarily by shifting the goalposts. In one of his judgments, Lauber wrote that Coke had never requested, and IRS never agreed, to have the 1996 settlement apply to future tax years.

Lauber wrote that Coke “choose to take its chances” with IRS examiners in the hope they wouldn’t disturb the status-quo. “But it was just a hope. Hope is not a legal or constitutional right.”

Coke argues, too, that the new IRS formula does not take into account the valuable intellectual property created by concentrate manufacturers. This includes the benefits of marketing Coke brands locally.

The company only set aside $456mn on previous earnings statements for what it believes it will owe. It has also maintained that it is likely to beat the IRS in all of the major issues.

Some experts remain unconvinced. Martin, KBKG, said: “If an experienced court goes out of their way to tell Coca-Cola that they are relying solely on ‘hope,’ I find it difficult to believe the IRS will settle for pennies per dollar.”

John Murphy, Coke’s chief financial officer said that the report had been approved by their advisers.

He said: “We have outside attorneys who, every quarter, have continued to evaluate the case based on the facts they have available and continue to give us an opinion which gives us greater than not chance of winning,” he added. “EY will then do their own independent evaluation to be comfortable with this opinion,” he said.

EY noted in its last annual report for Coke that the assessment of Coke’s tax situation was subject to “a degree of subjectiveness and significant judgment”, but it also said that they had consulted their own experts. EY has served as Coke’s auditor since 103 years. It has signed off on annual accounts which include tax provisions made by Coke over the years.

EY and the IRS declined to comment on this article.

Murphy stated that because the company is confident in its ability to win, the $6bn payment “will not at this time” affect the profit and loss statement. Murphy added that the money will “come back” if Coke succeeds on appeal.

Cash outlays will impact Coke’s ability to make large acquisitions and share buybacks. The amount of the cheque sent to the IRS is equal to what the company pays out in dividends over the next year and a quarter.

The company raised $4bn of new debt in May to cover the bills due. Murphy was bullish on Coke’s last earnings call when he answered a question about the balance sheet. “All in, it will be an interesting 18-month period to work through,” said Murphy. “But we feel very confident the work we’ve already done prepares us.”