The IRS and Coca-Cola are locked in a battle regarding the proper allocation of income between Coca-Cola and its foreign affiliates pursuant to trademark and trade secret licenses. However, the IRS seems to overlook a significant economic component of the license agreement by not recognizing the benefit Coca-Cola receives in the form of more valuable foreign trademark rights.

Last September, the U.S. Internal Revenue Service (IRS) issued a notice of deficiency to soft-drink giant Coca-Cola, increasing its federal income tax due for the years 2007-2009 by over U.S. $3 billion. The alleged deficiency arose from the IRS’ disagreement with the accounting for Coca-Cola’s royalty income for its trademark and trade secret (formula rights) licenses with seven foreign affiliate companies. Last December, Coca-Cola petitioned the U.S. Tax Court to reject the deficiency (Coca-Cola Co. v. Commissioner, T.C. No. 031183-15), the IRS filed its Answer in February, and the case was assigned to Judge Albert Lauber in March.

It appears that Coca-Cola’s foreign affiliates paid royalties totalling $6 billion for the tax years at issue. The IRS alleged that the foreign affiliates paid less than fair market value for those rights and, consequently, a disproportionate amount of Coca-Cola’s global profits were assigned to (i.e., earned by) the foreign affiliates. Coca-Cola argues that its affiliates are paying fair-market royalties because they also pay for all of the operating expenses of making concentrate for sale to bottlers and all of the marketing expenses in their respective markets.

To show that the royalties paid are less than fair market value, the IRS argues that Coca-Cola’s foreign affiliates earned more than they should have as demonstrated by their profits being higher than those of allegedly comparable beverage bottlers. However, by taking the position that the comparable transactions – i.e., benchmarks transactions for determining the “correct” tax result – are bottling agreements between a beverage company and a beverage bottling company, instead of licensing and marketing agreements between a beverage company and company that manufactures and sells concentrate to bottling companies, the IRS overlooks, inter alia, some important trademark and marketing aspects of those licenses. In its licensing arrangements with foreign affiliates, Coca-Cola profits both from royalty payments and from the increase in the value of its foreign trademarks. By focusing solely on the amount of royalties Coca-Cola receives, the IRS is ignoring important economic aspects of the licenses at issue. Because trademark rights are territorial in nature, Coca-Cola’s brand value resides not in a single worldwide trademark, but in a portfolio of country-specific trademarks. Coca-Cola reportedly owns its trademark but the foreign affiliates are responsible for the operational and marketing expenses in their respective territories. Therefore, Coca-Cola receives the benefit of owning a more valuable “Coca-Cola” trademark in that foreign country, while its affiliate pays for the marketing expenses. The increase in value of the local “Coca-Cola” trademark due to those marketing expenditures would belong to the U.S. company. A rational foreign affiliate presumably would not agree to such an arrangement unless it received compensation, e.g., a lower royalty rate. In this scenario, Coca-Cola pays U.S. taxes on less royalty income but has no corresponding foreign marketing expense deductions because those expenses were paid by the affiliate. Coca-Cola would not immediately realize any income from the appreciation of its trademark.

Setting aside the different payment structures for marketing expenses, the IRS seems to ignore that value is being stored in the foreign trademark rights. That appreciation in value is not immediately taxable under U.S. federal tax law. Regardless of which entity pays for the marketing expenses, appreciation in the value of Coca-Cola’s foreign trademarks would not be taxed in the U.S. as long as there is no change in ownership.