Analysis of and reflections on recent cases and rulings.

• Author: Beavers, James A.

Foreign Income & Taxpayers

Coca-Cola entitled to credits for overpaid Mexican taxes

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...