A decade-long dispute between Coca-Cola and the US tax authorities has escalated to the point that the company could owe $16bn in back taxes, enough to wipe out a year and a half of profits, with the figure rising by more than $1bn a year.
The soft-drink maker has been hiding “astronomical levels” of profit in low-tax countries including Ireland to shield it from the US Internal Revenue Service, according to a withering court judgment, which the company is planning to appeal against later this year.
The mounting stakes have been visible only in the fine print of Coke’s regulatory filings in recent years, thanks to a quirk of accounting rules.
After the last in a four-year string of tax court decisions last week, Coke will shortly have to fork over an initial $6bn in cash to cover unpaid taxes and interest for the years 2007 to 2009. But neither that sum, nor the $10bn it could owe for the subsequent 15 years, will show up as a hit to its earnings any time soon.
As long as the Atlanta-based company and its longtime auditor EY agree that there is a better than 50-50 chance of Coke winning on appeal, payments do not have to be put through its profit and loss account.
If Coke has misjudged its chances of winning, a loss would not just wipe out the past year and half of net income; the IRS would be able to impose a higher US tax bill for years to come, adding 3.5 percentage points to a global tax rate that was 17.4 per cent last year, by the company’s estimate.
The stakes are also high for the US government. The $16bn could cover the IRS budget for a year, and the stand-off with Coke is a test of the agency’s ability to pursue complicated cases at a time when it has promised to get tough on corporate tax avoidance.
Alex Martin, transfer pricing specialist at the tax advisory group KBKG, said other companies were watching closely. “This decision could be a template for the IRS to audit other US companies with profitable subsidiaries.”
The dispute centres on Coke subsidiaries in Ireland, Brazil, Eswatini and four other countries that manufacture concentrate, the syrup that gets mixed with carbonated water to make drinks such as Coca-Cola, Fanta and Sprite. The subsidiaries sit between the US parent company, which owns the brands, and the bottling companies that make the final product.
The company routinely shifted production of concentrate to countries with favourable tax rates, the US tax court found. The subsidiary in Ireland, which had a tax rate as low as 1.4 per cent, at one point shipped to bottlers in 90 countries.
Unlike independent contract manufacturers, which typically have low margins, an IRS analysis found these Coke subsidiaries were unusually profitable — earning a return on assets two-and-a-half times that of the US parent company that owns the iconic brands. By controlling how much the subsidiaries must pay other parts of the Coke network for use of the brands and marketing, and by setting the prices they can charge bottlers, Coke itself in effect decided their profitability, the court heard.
Those profit levels were “astronomical”, Judge Albert Lauber wrote in an initial ruling in 2020.
“Why are the supply points, engaged as they are in routine contract manufacturing, the most profitable food and beverage companies in the world?” he asked. “And why does their profitability dwarf that of the Coca-Cola Company, which owns the intangibles upon which the company’s profitability depends?”
The tax treatment of its concentrate manufacturers has been a running sore between Coke and the IRS for decades. A similar dispute was settled in 1996 by reallocating some of the subsidiaries’ previous profits to the US parent company, based on a formula hashed out by negotiators.
Coke used the same formula to calculate its tax returns for another decade without objection, before the IRS decided in 2015 that it had improperly suppressed US profits. The concentrate manufacturers should in fact be making no higher percentage returns than Coke’s bottlers, it said, and amounts beyond that should be allocated to the parent company and taxed as US income.
Coke’s argument that the IRS acted capriciously by moving the goalposts was given short shrift by Lauber in 2020 and in subsequent judgments. In one, he wrote that Coke never asked, and the IRS never agreed, for the 1996 settlement to apply to all future tax years.
Coke “chose to take its chances with the IRS examiners, hoping that they would not disturb the status quo”, Lauber wrote. “But that was only a hope, and hope is not something that gives rise to legal or constitutional entitlements.”
Coke also argues that the IRS’s new formula fails to account for valuable intellectual property built up by the concentrate manufacturers, including the benefits of local marketing of Coke’s brands.
The company has provisioned just $456mn in previous earnings statements to cover what it thinks it will actually end up owing, and has stood by its assessment that it will probably beat the IRS on all the central issues.
Some experts are unconvinced. “If an experienced judge goes out of his way to tell Coca-Cola they are relying on ‘hope’, I struggle to see why the IRS would settle for pennies on the dollar,” said KBKG’s Martin.
But John Murphy, Coke’s chief financial officer, told the Financial Times the assessment had been blessed by its advisers.
“We have outside counsel who have, each quarter, continued to evaluate the case on the facts that are available to them and they continue to offer an opinion that gives us a greater-than-not chance of prevailing,” he said. “And then EY will do their own independent assessment to be comfortable with that opinion.”
EY wrote in a note to Coke’s last annual report that there was a “level of subjectivity and significant judgment” to the assessment of the company’s tax position, but that it had also consulted its own experts on the matter. EY has been Coke’s auditor for 103 years, signing off annual accounts that include the provisions Coke has made for taxes over the years.
EY declined to comment for this article, as did the IRS.
The upcoming $6bn payment would “not at the moment” impact the profit and loss account because of the company’s confidence in winning, Murphy said, adding that the money “comes back” if Coke wins on appeal.
The cash outlay will affect Coke’s balance sheet, however, crimping the capacity for big acquisitions or share buybacks. The cheque to the IRS will be as much as the company hands out in shareholder dividends in a year and a half.
In May, the company raised $4bn in new debt to help cover the bills coming due. On Coke’s earnings call last month, Murphy responded to a question on the balance sheet in bullish fashion: “All in all, it’s going to be an interesting 18 months to work through,” he said, “but we feel very confident that the work we’ve done to date prepares us well.”
