The Coca-Cola Company and Subsidiaries v. Commissioner

155 T.C. No. 10

UNITED STATES TAX COURT

THE COCA-COLA COMPANY & SUBSIDIARIES, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 31183-15. Filed November 18, 2020.

P, a U.S. corporation, was the legal owner of the intellectual

property (IP) necessary to manufacture, distribute, and sell some of

the best-known beverage brands in the world. This IP included trade-

marks, product names, logos, patents, secret formulas, and proprietary

manufacturing processes. P licensed foreign manufacturing affiliates,

called “supply points,” to use this IP to produce concentrate that they

sold to unrelated bottlers, who produced finished beverages for sale

to distributors and retailers throughout the world. P’s contracts with

its supply points gave them limited rights to use the IP in performing

their manufacturing and distribution functions but gave the supply

points no ownership interest in that IP.

During 2007-2009 the supply points compensated P for use of

its IP under a formulary apportionment method to which P and R had

agreed in 1996 when settling P’s tax liabilities for 1987-1995. Under

that method the supply points were permitted to satisfy their royalty

obligations by paying actual royalties or by remitting dividends. Dur-

ing 2007-2009 the supply points remitted to P dividends of about $1.8

billion in satisfaction of their royalty obligations. The 1996 agree-

-2-

ment did not address the transfer pricing methodology to be used for

years after 1995.

Upon examination of P’s 2007-2009 returns R determined that

P’s methodology did not reflect arm’s-length norms because it over-

compensated the supply points and undercompensated P for the use of

its IP. R reallocated income between P and the supply points employ-

ing a comparable profits method (CPM) that used P’s unrelated bot-

tlers as comparable parties. See sec. 1.482-5, Income Tax Regs.

These adjustments increased P’s aggregate taxable income for 2007-

2009 by more than $9 billion.

1. Held: R did not abuse his discretion under I.R.C. sec. 482

by reallocating income to P by employing a CPM that used the supply

points as the tested parties and the bottlers as the uncontrolled compa-

rables.

2. Held, further, R did not err by recomputing P’s I.R.C. sec.

987 losses after the CPM changed the income allocable to P’s Mexi-

can supply point, a branch of P.

3. Held, further, P made a timely election to employ dividend

offset treatment with respect to dividends paid by the supply points

during 2007-2009 in satisfaction of their royalty obligations. R’s

reallocations to P must accordingly be reduced by the amounts of

those dividends.

John B. Magee, Kevin L. Kenworthy, Sanford W. Stark, Saul Mezei, Steven

R. Dixon, Carl Terrell Ussing, Lisandra Ortiz, Lamia R. Matta, Michael D.

Kummer, Hans D. Gerling-Ritters, and John F. Craig III, for petitioner.

-3-

Jill A. Frisch, Anne O’Brien Hintermeister, Julie Ann P. Gasper, Heather L.

Lampert, Curt M. Rubin, Lisa M. Goldberg, and Huong T. Bailie, for respondent.

CONTENTS

FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

I. International Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

A. Supply Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

B. Service Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15

C. Bottlers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

II. The Coca-Cola System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..18

A. Integrated Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

B. Functions Performed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

1. Manufacturing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

a. R&D . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

b. Quality Assurance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

c. Concentrate Production . . . . . . . . . . . . . . . . . . . . . . . . . 24

d. Beverage Production and Bottling. . . . . . . . . . . . . . . . . 25

e. Supply Chain Management . . . . . . . . . . . . . . . . . . . . . . 26

2. Marketing/Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

a. Consumer Marketing. . . . . . . . . . . . . . . . . . . . . . . . . . . 31

b. Trade Marketing and Distribution . . . . . . . . . . . . . . . . 37

III. Contractual Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

A. Supply Point Agreements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

1. Rights and Obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

a. Production and Sale of Concentrate . . . . . . . . . . . . . . . 43

b. Trademarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

2. Term Length and Exclusivity . . . . . . . . . . . . . . . . . . . . . . . . . 46

3. Remuneration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

B. Service Company Agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

1. Standard Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

-4-

2. Other Provisions . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . 52

3. Invoicing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

C. Bottler Agreements . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

1. Rights and Obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

a. Production and Sale of Finished Beverages . . . . . . . . . 57

b. Trademarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

2. Term Length and Exclusivity . . . . . . . . . . . . . . . . . . . . . . . . . 59

3. Remuneration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

IV. Assets and Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66

A. Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

1. HQ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

2. Supply Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

B. Income and Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .70

1. HQ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

2. Supply Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72

C. Brazilian Trademarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .76

V. Tax Reporting and IRS Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

OPINION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85

I. Burden of Proof . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85

II. Standard of Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . 86

III. Threshold Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

A. The 1996 Closing Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

B. Relevant Parties and Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . 98

C. The “Best Method Rule” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .102

IV. Respondent’s Bottler CPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .109

A. Reasonableness of CPM Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . 115

B. Selection of Bottlers as Comparable Parties. . . . . . . . . . . . . . . . . . .120

C. Data, Assumptions, and Comparability Adjustments . . . . . . . . . . . 133

1. Selection of Bottlers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134

2. Computational Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . 137

-5-

a. Operating Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

b. Operating Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140

3. Implementation of CPM/ROA . . . . . . . . . . . . . . . . . . . . . . . .143

V. “Split Invoicing”. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

VI. Petitioner’s Arguments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .150

A. Supposed “Marketing Intangibles” . . . . . . . . . . . . . . . . . . . . . . . . . 150

1. Legal Ownership. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .154

2. Economic Substance . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . 159

a. Setting Aside Contract Terms .. . . . . . . . . . . . . . . . . . 160

b. Consistency With Economic Substance . . . . . . . . . . . 167

B. Supposed “Long-Term Licenses”. . . . . . . . . . . . . . . . . . . . . . . . . . . 172

C. Royalties Payable by Brazilian Supply Point . . . . . . . . . . . . . . . . . 175

1. Ownership of Brazilian Trademarks . . . . . . . . . . . . . . . . . . . 175

2. Brazilian “Blocked Income”. . . . . . . . . . . . . . . . . . . . . . . . . . 1.84

D. Bottlers’ Ownership of Intangibles . . . . . . . . . . . . . . . . . . . . . . . . . 186

E. Proposed Alternative Transfer Pricing Methodologies . . . . . . . . . . 191

1. Proposed CUT Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191

2. Proposed “Residual Profit Split Method” . . . . . . . . . . . . . . 197

3. Proposed “Unspecified Method” . . . . . . . . . . . . . . . . . . . . . . 2.06

VII. Collateral Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208

A. Recomputation of Section 987 Loss . . . . . . . . . . . . . . . . . . . . . . . . 209

B. Dividend Offset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218

APPENDIX. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230

LAUBER, Judge: The Coca-Cola Co. (TCCC) is the ultimate parent of a

group of entities (Company) that do business in more than 200 countries through-

out the world. TCCC and its domestic subsidiaries (petitioner) joined in filing

consolidated Federal income tax returns for 2007, 2008, and 2009. Upon exami-

-6-

nation of those returns, the Internal Revenue Service (IRS or respondent) made

adjustments that increased petitioner’s aggregate taxable income by more than

$9 billion, resulting in tax deficiencies as follows:

Year Deficiency

2007 $1,114,116,873

2008 1,069,425,951

2009 1,121,220,625

By amendment to answer, respondent determined additional deficiencies attribut-

able to the use of “split invoicing” by certain of petitioner’s foreign affiliates. See

infra pp. 64-66. The additional deficiencies are as follows:

Increase in

Year deficiency

2007 $28,124,719

2008 43,314,595

2009 63,465,860

These deficiencies result from transfer pricing adjustments under section

482 by which the IRS reallocated substantial amounts of income to petitioner,

chiefly from its foreign manufacturing affiliates.1 These affiliates had plants in

1

Unless otherwise indicated, all statutory references are to the Internal Rev-

enue Code (Code) in effect at the relevant times, and all Rule references are to the

Tax Court Rules of Practice and Procedure. We round most monetary amounts to

the nearest dollar. Dollar amounts appearing in tables occasionally do not sum

exactly because of rounding.

-7-

Brazil, Chile, Costa Rica, Egypt, Ireland, Mexico, and Swaziland.2 The plants

produced “concentrate”--syrups, flavorings, powder, and other ingredients--used

in the production of petitioner’s branded soft drinks (including Coca-Cola, Fanta,

and Sprite) and other nonalcoholic, ready-to-drink beverages.

These affiliates sold and distributed concentrate to hundreds of Coca-Cola

bottlers in Europe, Africa, Asia, Latin America, and Australasia. The bottlers,

most of which were independent of petitioner, ranged from small family-owned

businesses to large multinational companies. The bottlers used this concentrate to

produce finished beverages that they marketed (directly or through distributors) to

millions of retail establishments throughout the world (excluding the United States

and Canada). Because the foreign manufacturing affiliates supplied concentrate to

bottlers, these affiliates are often called “supply points,” and we will generally

refer to them as such.

To enable the supply points to manufacture and sell concentrate, petitioner

licensed them to use petitioner’s intangible property, including trademarks, brand

names, logos, patents, secret formulas, and proprietary manufacturing processes.

This intangible property is extremely valuable: Coca-Cola is the best known

2

Swaziland has since changed its name to the Kingdom of Eswatini. We

refer to it as Swaziland in this Opinion to match the parties’ terminology.

-8-

brand in the world, recognized by more of the planet’s 7.7 billion inhabitants than

any other English word but “OK.” The gist of respondent’s position is that the

supply points paid insufficient compensation to petitioner for the rights to use

petitioner’s intangible property. The Irish and Brazilian supply points account for

roughly 85% of the disputed income adjustments.3

For 2007-2009 petitioner reported income from its foreign supply points us-

ing the “10-50-50 method,” as it had done for the previous 11 years. This was a

formulary apportionment method to which petitioner and the IRS had agreed in a

closing agreement executed in 1996, which resolved petitioner’s tax liabilities for

1987-1995. This method permitted the supply points to retain profit equal to 10%

3

All of the supply points except the Mexican supply point were controlled

foreign corporations (CFCs). See sec. 957(a). The Mexican supply point operated

as a branch, and its income was reported on petitioner’s U.S. consolidated return.

As applied to the Mexican supply point, therefore, the transfer pricing adjustment

did not increase petitioner’s gross income. Rather, the IRS sought to reduce peti-

tioner’s foreign tax credits on the theory that the Mexican branch had reported in-

sufficient royalty expenses for use of petitioner’s intangible property, thus artifici-

ally inflating the branch’s income and the Mexican corporate tax paid thereon.

Respondent contended that the Mexican taxes were to that extent noncompulsory

payments ineligible for the foreign tax credit. See sec. 901; sec. 1.901-2(a)(2)(i),

Income Tax Regs. We resolved that issue in petitioner’s favor on summary judg-

ment. See Coca-Cola Co. & Subs. v. Commissioner, 149 T.C. 446 (2017). The

tax liabilities attributable to the Mexican supply point for 2007-2009 have thus

been resolved, with the exception of a foreign currency adjustment under section

987. See infra pp. 209-218. But the operations of the Mexican supply point are

relevant to the overall transfer pricing analysis and were the subject of extensive

testimony at trial.

-9-

of their gross sales, with the remaining profit being split 50%-50% with petitioner.

The closing agreement did not address what transfer pricing methodology would

be used for years after 1995. But petitioner continued to employ the 10-50-50

method, from 1996 onwards, to report income from its foreign supply points un-

less an advance pricing agreement or competent authority proceeding dictated

otherwise.

Because the closing agreement specified the compensation due petitioner

for use of its intangible property, the amounts due petitioner under the 10-50-50

method were in the nature of royalties. However, the closing agreement permitted

the foreign supply points to satisfy their royalty obligations by paying actual royal-

ties or by repatriating funds to petitioner in other ways, e.g., by paying dividends.

During 2007-2009 more than $1.8 billion of the income petitioner received from

its foreign supply points pursuant to the 10-50-50 method took the form of divi-

dends rather than royalties. Petitioner claimed “deemed paid” foreign tax credits

(FTCs) under section 902 with respect to these dividends, as the closing agreement

had permitted for 1987-1995.

Upon examination of petitioner’s 2007-2009 returns the IRS concluded that

the 10-50-50 method did not reflect arm’s-length pricing because it overcompen-

sated the supply points and undercompensated petitioner for the use of its intan-

- 10 -

gible property. Invoking section 482, the IRS reallocated income to petitioner us-

ing a comparable profits method (CPM), treating independent Coca-Cola bottlers

as comparable parties. The IRS regarded these bottlers as comparable to the sup-

ply points because they operated in the same industry, faced similar economic

risks, had similar contractual relationships with petitioner, employed many of the

same intangible assets (petitioner’s brand names, trademarks, and logos), and ulti-

mately shared the same income stream from sales of petitioner’s beverages.

To implement its bottler CPM, the IRS determined the average return on

operating assets (ROA) for a group of independent Coca-Cola bottlers that it

deemed comparable. It applied that average ROA to the operating assets of each

supply point, generating a deemed arm’s-length operating profit. The IRS then

reallocated to petitioner all income received by each supply point in excess of that

benchmark. This methodology produced very substantial reallocations from the

Irish and Brazilian supply points and somewhat smaller reallocations from the

Costa Rican, Chilean, and Swazi supply points. The IRS methodology generated a

reverse allocation of income from petitioner to the Egyptian supply point, which

for historical reasons had endured many years of economic underperformance.

Petitioner challenges respondent’s section 482 reallocations as arbitrary and

capricious. It contends that the IRS acted arbitrarily by abandoning the 10-50-50

- 11 -

method, having acquiesced in the use of that method during five prior audit cycles

spanning a decade. In any event, petitioner argues that the IRS erred in employing

the bottler CPM to reallocate income.

Petitioner contends that independent Coca-Cola bottlers are not comparable

to the supply points because the latter own immensely valuable intangible assets

that do not appear on their balance sheets or in any written contract. These assets,

which petitioner calls “marketing intangibles” or “IP associated with trademarks,”

allegedly were created when the supply points financed consumer advertising in

foreign markets. Petitioner urges that the bottlers by comparison are “marketing-

light” businesses that operate at a different level of the market.

Petitioner urges that the supply points owned (in substance if not in form)

local rights to petitioner’s valuable brands and should thus enjoy supranormal

returns as “master franchisees” or long-term licensees. To implement that theory

petitioner offers, as alternatives to respondent’s bottler CPM, a comparable

uncontrolled transaction (CUT) model and a residual profit split method (RPSM)

as the best methods for determining the supply points’ true economic income.

Alternatively, if a bottler ROA is applied to the supply points, petitioner contends

that each supply point’s asset base should be increased to reflect the value of its

supposed “marketing intangibles.”

- 12 -

If we sustain respondent’s position in whole or part, petitioner urges that the

transfer pricing adjustments should be reduced to reflect dividends paid by the

supply points, to the extent those amounts were repatriated to satisfy the supply

points’ royalty obligations. Although petitioner elected “dividend offset” treat-

ment on timely filed returns for 2007-2009, it did not include in those returns ex-

planatory statements as directed by Rev. Proc. 99-32, 1999-2 C.B. 296. Respon-

dent contends that petitioner’s failure to include these statements is fatal to its

claim to dividend offsets. Petitioner urges that it substantially complied with the

revenue procedure’s requirements and that substantial compliance was sufficient.4

FINDINGS OF FACT

I. International Structure

In 1886 TCCC produced the first Coca-Cola beverage, which it sold initial-

ly at soda fountains. In 1899 it transferred to third parties, for $1, the exclusive

rights to bottle and distribute finished Coca-Cola beverages throughout the United

States. This created the “Coca-Cola System,” comprising the Company and its

4

Petitioner concedes that allowing dividend offsets would cause the divi-

dends to lose their character as such, necessitating forfeiture of the deemed-paid

FTCs petitioner had claimed with respect to those dividends. Respondent has

amended his answer to allege that FTCs of $40,717,804 for 2007, $65,941,179 for

2008, and $49,977,463 for 2009 should be disallowed in the event we permit peti-

tioner to offset, against a reallocation of royalty income, the dividends paid by the

supply points in satisfaction of their royalty obligation.

- 13 -

(largely independent) bottlers. At all relevant times petitioner has had its head-

quarters (HQ) and principal place of business in Atlanta, Georgia.

Petitioner expanded internationally in the early 1900s, arriving in Europe

and Latin America during the 1920s. As a vehicle for this growth petitioner estab-

lished in 1930 the Coca-Cola Export Corp. (Export), a wholly-owned domestic

subsidiary of TCCC. Export expanded aggressively, creating branches in 27 for-

eign countries by 1975. By 2008, 74% of the Company’s sales were made outside

the United States.

A. Supply Points

Petitioner engaged in significant restructuring as its international market

matured. During World War II it had built numerous plants in Europe and Asia to

supply Coca-Cola to U.S. soldiers. After the war petitioner sold the bottling

facilities to private-sector companies. As bottlers were divested to third parties,

Export began contributing its concentrate plants and other branch assets to foreign

subsidiaries. Export’s contributions to these subsidiaries generally consisted of

tangible operating assets, associated goodwill, and similar items. The subsidiaries

acquired via these transactions no meaningful intangible property in the form of

trademarks, tradenames, copyrights, franchises, licenses, or bottler agreements.

- 14 -

Export initially established affiliates in virtually every country to manufac-

ture and supply concentrate to local bottlers. Before 1988, for example, Export

had a fully integrated concentrate plant in every Western European country. Over

time the Company gradually consolidated its concentrate manufacturing into larger

plants that supplied concentrate to bottlers in diverse national markets. The Irish

supply point, which reported average annual gross revenues of $6.89 billion dur-

ing 2007-2009, ultimately sold concentrate to bottlers in more than 90 countries,

some as distant as New Zealand and Papua New Guinea.

Export owned (directly or indirectly) the seven supply points involved here.

The Mexican supply point was a branch of Export and its income was reported on

petitioner’s U.S. consolidated return. The Brazilian supply point5 and the Chilean

supply point6 were CFCs wholly-owned by Export. The Costa Rican, Egyptian,

5

The Brazilian supply point, Coca-Cola Indústrias Ltda. (CCIL), was the

parent of Recofarma Indústria do Amazonas Ltda. (Recofarma), which operated

the Brazilian manufacturing facilities. In August 2009 Recofarma acquired Coca-

Cola Concentrados e Refrigerantes Ltda. (CCRL), which it thereafter operated as a

flavoring plant. For U.S. tax purposes Recofarma and CCRL elected to be treated

as disregarded entities of CCIL, and we will refer to CCIL and its subsidiaries col-

lectively as the Brazilian supply point.

6

The Chilean supply point, Coca-Cola de Chile, S.A., formed Nuevas Beb-

idas de Colombia Ltda. as a wholly owned subsidiary in March 2009, and the lat-

ter elected for U.S. tax purposes to be treated as a disregarded entity. We will re-

fer to these entities collectively as the Chilean supply point.

- 15 -

Irish, and Swazi supply points were branches or disregarded subsidiaries of Atlan-

tic Industries (Atlantic), a Cayman Islands CFC wholly-owned by Export.

B. Service Companies

As concentrate manufacturing became consolidated into fewer and fewer

supply-point affiliates, the Company’s other foreign activities were typically taken

over by local service companies (ServCos). During 2007-2009 the Company ap-

pears to have had at least 60 foreign ServCos, each serving one or more national

markets. The ServCos were responsible for local advertising and in-country con-

sumer marketing, which they carried out with assistance from third-party media

companies and creative design firms. The ServCos were also responsible for liai-

son with local bottlers, a function petitioner called “franchise leadership.” A few

ServCos had research and development (R&D) centers, which served multiple

national markets.

The supply points had little or no direct ownership interest in the ServCos

that served these national markets. Most of the ServCos were owned by Export,

generally through a chain of subsidiary CFCs. Atlantic owned two ServCos (both

Irish entities) and 48% of the Mexican ServCo. TCCC itself owned (directly or

indirectly) CFCs that operated ServCos in Panama, Costa Rica, and Peru.

- 16 -

C. Bottlers

The vast bulk of the Company’s beverages were (and are) produced and

distributed by independent Coca-Cola bottlers. At the outset many bottlers were

small, often family-owned, enterprises that distributed to retailers within a narrow

geographic market. But bottlers were likewise transformed by consolidation, and

many became large multinational companies.

During 2007-2009 the Company had about 300 independent bottlers that

served (directly or indirectly) about 20 million retailers. The three largest inde-

pendent bottlers were Coca-Cola Enterprises (CCE), Coca-Cola FEMSA, and

Coca-Cola Hellenic (Hellenic). CCE, which operated in Western Europe and

North America, sold about 42 billion units of Coca-Cola beverages annually.

Coca-Cola FEMSA served more than 1.5 million retailers throughout Latin

America.7 Hellenic served 28 national markets in Western and Central Europe, the

Balkans, Russia, and Ukraine.

The bottlers produced numerous nonalcoholic ready-to-drink (NARTD)

beverages, generally (but not exclusively) under petitioner’s brands. These in-

cluded the Company’s iconic carbonated soft drinks (CSDs): original Coca-Cola

7

TCCC held minority equity interests in Coca-Cola FEMSA and certain oth-

er bottlers. In no case did these stock holdings permit petitioner to control those

bottlers’ activities or dictate their decisions.

- 17 -

(Coke Red), Fanta, Sprite, and variations and extensions of these brands (such as

Diet Coke and Coke Zero). In more recent years, as the Company expanded its

beverage portfolio, the bottlers produced an increasing array of noncarbonated

drinks (non-CSDs), including juices, teas, bottled waters, energy drinks, and

coffee-flavored beverages.

The bottlers produced most of these beverages using concentrate manufac-

tured by the supply points. As appropriate to the particular drink, the bottlers mix-

ed the concentrate with purified water, carbon dioxide, sweeteners, and/or flavor-

ings; injected the finished beverages into bottles and cans of various serving sizes;

packaged and warehoused these items pending distribution; and delivered the bev-

erages to retail establishments that included supermarkets, small retail stores, bars,

and restaurants. In certain European markets bottlers relied on intermediate dis-

tributors to deliver the beverages to those retail customers.

Although independent bottlers were crucial for the Coca-Cola System, peti-

tioner occasionally acquired bottlers and brought them temporarily “in house.”

This occurred (for example) when a bottler encountered financial difficulty or had

to be divested in a merger. In 2006 TCCC grouped these controlled bottlers into a

single management unit--the Bottling Investments Group (BIG), colloquially

known as the “bottler hospital”--and supervised their activities directly from

- 18 -

Atlanta. Generally, petitioner’s objective was to divest ownership of these con-

trolled bottlers as soon as they had recovered their footing operationally and finan-

cially. At any point in time, however, controlled bottlers could account for 10% or

more of the Company’s unit volume in foreign markets.

II. The Coca-Cola System

The Company and its authorized bottlers coordinated their functions in or-

der to manufacture, market, and distribute--every day of the year--about 1.6 billion

servings of NARTD beverages. This daily coordination created a shared identity

and synergistic relationship between the Company and its bottlers. Each regarded

itself as an integrated component of the Coca-Cola System.

A. Integrated Management

The Company used a flexible management structure that permitted local ad-

aptation and encouraged close coordination with bottlers. By 2007 the Company

had adopted a governance model called “Freedom within a Framework.” Through

its HQ function in Atlanta, TCCC set detailed guidelines for brand identity, visual

identity of products, quality assurance, business goals, and marketing strategies.

But it permitted local units to adapt these rules (within limits) to the cultural,

religious, linguistic, and culinary traditions of their particular foreign markets.

- 19 -

During 2007 TCCC delegated authority to regional operating groups (OGs)

for the following territories: North America, Latin America, the European Union

(EU), Eurasia, Africa, and the Pacific. (Eurasia and Africa were merged in 2008.)

Each geographical OG supervised multiple business units (BUs), formerly called

divisions, which typically had responsibility for one or more national markets, de-

pending on their size. The OGs and BUs were not legal entities. Rather, they

identified lines of managerial reporting from smaller to larger geographical terri-

tories and ultimately to HQ in Atlanta.

Almost all Company personnel involved in the manufacture of concentrate

worked for the supply points.8 The Irish, Mexican, Costa Rican, and Swazi supply

points had virtually no workers other than those engaged in producing concentrate

and their support staff. Most other personnel, including those holding leadership

positions in the OGs and BUs, were employed by the ServCos. During the years

at issue, the ServCos employed all of the OG leadership and about 90% of the 200

officers who made up the BU leadership.

The ServCo leadership teams acted as the liaison between the Company and

local bottlers. These teams acted in a day-to-day advisory role to bottlers, facilitat-

8

Personnel who worked for the Mexican supply point were nominally on the

payroll of the Mexican ServCo. This was apparently done to solve a Mexican

labor-law problem.

- 20 -

ing bottlers’ access to the Company’s statistical data, consumer insights, advertis-

ing plans, and marketing strategies. They shared with bottlers the responsibility

for creating coordinated annual business plans that fulfilled TCCC’s global strate-

gy and the needs of the local market.

These annual business plans reflected detailed discussions with bottlers con-

cerning beverage pricing, packaging, marketing, and distribution channels. The

ServCos and the bottlers relied on Company data and guidelines for the granular-

level details of these plans. But the budgets and overall strategies were reviewed

and approved by TCCC and the top leadership of each bottler.

B. Functions Performed

The Coca-Cola System required that its participants discharge two principal

functions: manufacturing and marketing/distribution. The Company and the bot-

tlers jointly discharged these functions, performing complementary tasks in a syn-

ergistic way.

1. Manufacturing

The Coca-Cola System relied on an integrated manufacturing supply chain

that employed personnel from all of the entities discussed above. TCCC, assisted

by the ServCos, took principal responsibility for R&D and quality assurance. Ac-

tual production was split between the supply points and the bottlers: The supply

- 21 -

points manufactured concentrate, and the bottlers used the concentrate to produce

Coca-Cola beverages. TCCC was chiefly responsible for supply chain manage-

ment regarding concentrate, and the bottlers were responsible for supply chain

management regarding finished products.

a. R&D

Much of the system’s value rested on familiar, consistently flavored drinks

delivered by well-established production processes. Perhaps for that reason, the

Company’s R&D budget was smaller (as a percentage of revenues) than the R&D

budgets of some of its competitors. But the Company maintained an active R&D

program to explore new beverages, ingredients, sweeteners, and packaging. The

annual budget for this program during 2007-2009 averaged about $200 million,

roughly 1% of the Company’s worldwide revenues.

The Company divided its R&D projects into two major subsets: research

projects and development projects. Most research projects were undertaken by

TCCC’s central R&D laboratory in Atlanta. These projects consisted of new, un-

proven methods that, if successful, could be implemented across many countries

and product lines. Examples included research into new sugar substitutes and

environmentally friendly packaging materials.

- 22 -

Development projects usually focused on customizing global products and

concepts for local implementation, taking account of local regulations, taste pref-

erences, and other variables. These projects were undertaken primarily by the

Company’s six regional R&D centers. Two of these were in the United States. As

far as the record reveals, the other four--located in Belgium, Brazil, China, and

Japan--were operated by ServCos.

TCCC and the ServCos were responsible for virtually all of the Company’s

R&D. TCCC owned and staffed the three domestic R&D centers and employed

roughly 60% of the Company’s researchers. ServCos employed all other R&D

personnel except for 20 employees who worked for the Brazilian supply point.

The other supply points had no R&D personnel on their staffs.

b. Quality Assurance

TCCC personnel discharged most of the Company’s quality control func-

tions. The Ingredient Quality Department, part of the HQ function in Atlanta,

worked with the regional R&D centers to ensure consistent production quality by

codifying recipes, creating global ingredient standards, and approving third-party

suppliers of raw materials. Because TCCC was ultimately responsible for all

formulations of Coca-Cola products, any reformulations of these beverages (e.g.,

to use new sweeteners) had to be approved by HQ. TCCC published quality assur-

- 23 -

ance information on a central database (Optiva in 2007 and Picasso in 2008 and

2009) that supply points and bottlers could easily access.

TCCC personnel, with assistance from outside professionals, performed reg-

ular quality control audits of supply points, flavoring plants, and other manufactur-

ing facilities, including plants owned by bottlers. TCCC audited supply point fa-

cilities every two or three years. Although the bottlers relied on the Company for

quality assurance with respect to concentrate, they were responsible for quality

assurance with respect to their own production processes. Bottlers engaged in

extensive testing of finished products in their own on-site laboratories.

The supply points, using their production personnel, engaged in day-to-day

quality control, e.g., by performing in-process and product release testing. They

performed this testing by following the Coca-Cola Management System, which

provided an outline of the Company’s quality control expectations. None of the

supply points (apart from the Brazilian supply point) had any employees specifi-

cally dedicated to quality assurance.9

9

During 2007-2009 the Brazilian supply point employed (on average) about

50 workers identified by petitioner as primarily engaged in quality assurance.

- 24 -

c. Concentrate Production

The supply points manufactured concentrate. Their manufacturing activity

consisted of procuring raw materials and using TCCC’s guidelines and production

technologies to mix and convert raw materials into concentrate. Their procure-

ment activities were limited: Many ingredients could be obtained only through

Company-owned flavor plants, and other ingredient purchases were negotiated by

bulk procurement specialists employed by TCCC or the ServCos. Only three sup-

ply point employees (one in Chile and two in Brazil) were specifically dedicated to

procurement. After completing the manufacturing process, the supply points

packaged the concentrate into kits tailored to the needs and capacities of the bot-

tlers to whom they distributed.

The manufacturing process entailed various forms of extraction, filtration,

mixing, blending, aging, and precision filing. In performing these activities the

supply points employed TCCC’s secret formulas, confidential ingredients, and

proprietary mixing specifications. All of these steps were governed by a detailed

manufacturing protocol dictated by TCCC. Petitioner’s experts agreed that this

manufacturing activity was a routine activity that could be benchmarked to the

activities of contract manufacturers. Two of petitioner’s experts, Drs. Michael

- 25 -

Cragg and Sanjay Unni, applied an 8.5% markup on costs to determine an appro-

priate return for the supply points’ concentrate manufacturing function.10

The vast majority of the people who worked at the supply points were en-

gaged solely in concentrate production. In 2009 the Irish supply point had 599

employees, at least 588 of whom were engaged in concentrate production. The

Costa Rican supply point had 60 employees, all of whom were engaged in concen-

trate production. The Swazi supply point had 153 employees, 135 of whom were

engaged in concentrate production. The Brazilian, Chilean, and Egyptian supply

points performed other business activities, including marketing, sales, and finance.

To the extent supply point employees engaged in such nonproduction activities,

they generally performed functions similar to those performed by ServCo employ-

ees and overseen by BU leadership. As explained infra p. 50, ServCos were com-

pensated for their services on a cost-plus basis.

d. Beverage Production and Bottling

Bottlers performed all finished product manufacturing. Having procured

concentrate from supply points, the bottlers prepared finished beverages by mixing

the concentrate with purified water, carbon dioxide (for sparkling drinks), sugar or

10

An alphabetical listing of the parties’ expert witnesses, together with a

brief résumé of each, appears in an appendix to this Opinion.

- 26 -

other sweeteners, and additional ingredients obtained from Company-approved

suppliers. The Company imposed strict standards for water quality, and each bot-

tling facility was equipped with an advanced water treatment system. As a rule,

each class of beverage (CSDs, juices, and table waters) ran on a specialized, high-

speed production line that typically could handle only one product in one package

size at a time. Bottlers thus needed multiple production lines to cover all bever-

ages in all forms of packaging. Bottlers printed and appended brand labels to the

cans and bottles before distributing or warehousing the products.

e. Supply Chain Management

The Company and the bottlers each performed supply chain management

over their respective shares of the production and distribution cycle. The Com-

pany managed the supply chain from the sourcing of raw ingredients through the

production of concentrate to the allocation of concentrate to bottlers. Bottlers

managed the supply chain from that point forward.

TCCC performed virtually all supply chain management for the Company

during 2007-2009. Many years earlier, when concentrate production was widely

dispersed on a country-by-country basis, the Company had delegated supply chain

management to local BUs. But that form of supervision became inefficient as con-

- 27 -

centrate manufacturing was consolidated into fewer plants that sold to hundreds of

bottlers worldwide.

In a bid to rationalize this system and reduce production costs, the Company

in the late 1990s centralized supply chain management into the Commercial Prod-

uct Supply (CPS) group. During the tax years at issue CPS was a subdivision of

BIG and (like it) was centrally managed by HQ in Atlanta. A Supply Point Com-

mittee, including CPS managers and top officials from TCCC’s tax and treasury

departments, made key recommendations about concentrate supply.

CPS leadership regularly shifted and reorganized concentrate production to

enhance efficiency, reduce costs, and ensure backup sources of concentrate in the

event of a supply disruption. On the basis of recommendations from CPS, the

Company constructed new supply points or expanded existing plants, often in

countries with low tax rates and favorable tariff regimes. CPS then shifted con-

centrate production away from established plants to these newer (and typically

larger) facilities. CPS sometimes shifted production among supply points to re-

flect its assessments of risks from political unrest and natural disasters (such as

earthquakes and typhoons).

The Company, which had 52 concentrate plants in the 1980s, has pursued a

steady policy of consolidating concentrate production. Between 1986 and 2006

- 28 -

the Company closed (or shifted substantial production away from) 15 concentrate

plants on five continents. During 2007-2009 the Company closed three concen-

trate plants (in Australia, Morocco, and Peru), leaving it with only 18 foreign sup-

ply points as of 2010. These closures and production shifts caused the supply

points that lost production to suffer a reduction in (or the total elimination of) their

manufacturing income. In virtually none of these instances was the losing supply

point compensated--by TCCC or by the supply point that took over its produc-

tion--for this loss of economic value.11

CPS leadership often shifted production to supply points located in jurisdic-

tions that offered tax or tariff incentives. The Irish supply point, which reported

an income tax rate of 1.4% during the period at issue, built a state-of-the-art plant

at Ballina in 1999. In 2001 the Company shifted to the Irish supply point, from

the Mexican supply point, roughly 50% of the latter’s production of concentrate

for Coke Red. The Irish supply point then exported that concentrate back to bot-

tlers in the Mexican market. CPS directed numerous other shifts of production to

the Irish supply point between 1984 and the tax years at issue. During 2007-2009

11

On three occasions between 1962 and 1994, when concentrate production

was shifted from supply points owned by Export, Export received some stock in

the supply point that took over its production. On no other occasion was the los-

ing supply point compensated when its production was shifted elsewhere.

- 29 -

the Irish supply point had by far the largest production of any foreign concentrate

plant, supplying bottlers in more than 90 national markets.12

On CPS’ recommendation the Company in 2008 began construction of a

new concentrate plant in Singapore. CPS caused the Irish supply point to ship to

Singapore 30 containers of second-hand equipment, including mixing tanks, drum

fillers, conveyers, racking systems, pumps, piping, and valves. The new Singa-

pore plant was completed in two years at a cost of about $60 million.

The Company consolidated concentrate production in Singapore to gain

economies of scale, leverage free trade agreements, and take advantage of tax and

tariff incentives. To qualify for these benefits, the Singapore plant had to meet

local authorities’ targets for production volume. TCCC satisfied these require-

ments by shifting concentrate production to Singapore from other supply points.

The Singapore supply point thereafter supplied concentrate to bottlers in 16 mar-

kets that had previously been served by 14 supply points in Asia and elsewhere.

The bottlers were responsible for supply chain management from their

receipt of concentrate through distribution of finished beverages to wholesalers

12

Although production shifts involving the Irish supply point show the hand

of centralized supply chain management, it is not always obvious what agenda

CPS was pursuing. For example, the Irish supply point was the primary supplier

of the French market during 1985-1990. In 1990 that market was given to a

French supply point, only to be given back to the Irish supply point in 1999.

- 30 -

and retailers. TCCC identified approved suppliers for most raw materials, as for

concentrate. But bottlers had responsibility for securing those materials, which

included aluminum, steel, plastic, and carbon dioxide.

Each bottler generally had a geographic territory within which it was the

exclusive supplier of Company products. This exclusivity allowed the bottlers to

cultivate an intimate understanding of the thousands of local retailers and whole-

salers, anticipate their needs, and build bottling and storage capacity to match.

2. Marketing/Distribution

To stimulate demand for its beverages the Coca-Cola System relied in part

on consumers’ past consumption experiences. But the Company and the bottlers

also conducted aggressive advertising and marketing campaigns to keep their pro-

ducts fresh and at the top of consumers’ minds. During the tax years at issue the

System expended billions of dollars annually for marketing, split about evenly be-

tween the Company and its bottlers. TCCC and its bottlers implemented an infor-

mal “true up” strategy to ensure that marketing expenses were split roughly 50-50

between them.

In the NARTD business, where purchases are often impulse driven, two

types of marketing are needed to stimulate new demand: consumer marketing and

trade marketing. Consumer marketing, coupled with past consumption experi-

- 31 -

ences, creates in the minds of consumers favorable associations with the product.

Trade marketing, which includes efficient distribution and product placement in

stores, makes the product readily available to consumers, reinforces their favorable

associations with the product, and stimulates purchase at the point of sale.

a. Consumer Marketing

The Company took principal responsibility for consumer marketing, that is,

advertising and other messages directed toward the individuals who were the final

consumers of its products. The Company aimed to create demand by maintaining

and exploiting its brands. The Company’s most important brand was Coca-Cola,

including Coke Red, Diet Coke, Coke Zero, and their lines and extensions (collec-

tively Trademark Coke). Trademark Coke products accounted for more than 50%

of the Company’s profits. The Company’s core brands consisted of Trademark

Coke, Fanta, Sprite, and their lines and extensions. These core brands accounted

for about 85% of total net revenue and 86% of total profits for the seven supply

points at issue.

Consumer marketing began with TCCC, which created a uniform system for

all global branding. With a few exceptions (mainly in Canada) TCCC was the reg-

istered legal owner of all worldwide trademarks related to Trademark Coke, Fanta,

Sprite, and their lines and extensions. For Trademark Coke products these trade-

- 32 -

marks covered the “Spencerian script,” the dynamic ribbon, the red-and-white col-

or palette, and the contour bottle shape. TCCC sustained and perpetuated each

global brand by maintaining rigorous standards for its core visual design elements

and messaging. These standards provided detailed guidance that ensured a consis-

tent look and feel for all global marketing.

TCCC maintained for each global brand a “brand vision and architecture”

that articulated what the brand aspired to stand for in consumers’ minds. The

brand vision included a visual identity system (VIS), a brand strategy, core design

principles, and a detailed marketing strategy. TCCC specified requirements con-

cerning the use of existing designs (e.g., the Coke logo and the Spencerian Script)

as well as instructions for the creation of new materials. TCCC uploaded all per-

missible designs and model photographs to an online database called the “Design

Machine.” It provided instructions concerning appropriate advertising copy (e.g.,

how to write an ad “in the Brand Voice”) and imaging (e.g., how photographs

should display condensation and ice). Major deviations from these standards

required explicit review and approval by TCCC.

Global marketing campaigns were designed by TCCC in Atlanta, with input

from ServCo personnel in various markets. A global campaign package typically

included a brand representation accompanied by suggested visual images and ad-

- 33 -

vertising messages. Each campaign had a “core creative idea” or “underlying con-

ceptual structure” that expressed what the brand stood for in the marketplace.

Some global campaigns, incorporating TV ads and memorable tag lines, were

launched to “refresh” Coke Red and other global brands. These included the

“Coke Side of Life” campaign, launched in 2006, and the “Open Happiness” cam-

paign, launched in 2009. The “Coke Side of Life” campaign ran in 200 national

markets that together represented 85% of worldwide Coke Red volume.

Other global campaigns centered on the Company’s sponsorship of major

sporting events, including the Olympics and the World Cup. TCCC negotiated the

financial terms of these sponsorships and set parameters for recommended slo-

gans, graphics, and visual images. TCCC then created a package of promotional

and advertising material that could be used on a global scale in association with

these events. One witness estimated that this toolkit gave local marketers “70% to

80% of the solution” but allowed them space to customize the campaign to their

local audience.

TCCC made these global campaign materials available to its marketing per-

sonnel around the world. The local marketers, nearly all of whom were employed

- 34 -

by ServCos,13 made the initial decision (in conjunction with bottlers) whether to

“activate” a particular campaign in their marketplace. Assuming an affirmative

answer to that question, they worked to customize the global campaign to meet lo-

cal conditions. A global ad would be customized (for example) by hiring local ac-

tors who spoke the local language, substituting songs and music that would be

popular in that country, and avoiding themes and images that might offend local

cultural and religious sensitivities. Marketing personnel in the ServCos generally

took responsibility for marketing material that promoted local brands (such as

Kuat, a Brazilian beverage derived from an Amazon fruit).

Although TCCC generated material for most global campaigns, ServCos

often played a leading role in regional marketing efforts. Under the “charter

model,” a BU with a special interest in a particular subject or event often devel-

oped platform material, including TV ads and point-of-sale promotions, that would

eventually be shared with other BUs. A campaign focused on the Christmas holi-

day, for example, might be generated by the Mexican ServCo; a campaign focused

on Ramadan might be generated by the Egyptian ServCo; a campaign focused on

Latin American teens might be generated by the Brazilian ServCo; and a campaign

13

Four supply points employed no marketing personnel whatever. The

Brazilian, Egyptian, and Chilean supply points employed an average of 44, 15, and

13 marketing-designated employees, respectively.

- 35 -

focused on a major soccer event might be generated by the ServCo in the host

country. In such cases TCCC would appoint a charter team, handle negotiations

with major stakeholders, and coordinate efforts between the charter team and other

BUs desiring to use the material. Those other BUs would then adapt the charter

campaign to suit their local needs.

TCCC provided local marketers with various tools to help them craft local

ads and improve local decision-making. The Knowledge & Insights unit (K&I) in

HQ performed data analysis about consumer behavior and made these data availa-

ble to bottlers and ServCos (e.g., by disseminating monthly “brand health perfor-

mance” reports to local managers). Customized marketing designs and tactics

were uploaded to the Design Machine. Spark City, created in 2007, was a compi-

lation of various training and information portals including Marketing Xchange,

CSD Portal, and “the DNA of Marketing.” These portals supplied local marketers

with access to an extensive database of processes and standardized frameworks for

marketing each of the Company’s global brands.

TCCC provided ServCos and bottlers with market research tools to help

them gauge the success of their advertising efforts. K&I created protocols and

metrics for measuring changes in “brand equity,” enabling marketers to assess

local consumers’ brand awareness and the effectiveness of advertising messages.

- 36 -

TCCC packaged these metrics into user-friendly tools such as the Marketing

Variance Analysis, Beverage Brand Barometer, and Consumer Beverage Land-

scape. These tools were implemented throughout the Company’s global distribu-

tion network, allowing ServCos and bottlers to spot trends discernible only from a

global perspective.

TCCC also provided tools and frameworks for training local marketers. The

Integrated Marketing Communications unit (IMC) at HQ developed the curricu-

lum for training marketers around the world. IMC maintained an online learning

platform--Coca-Cola University--that was used by ServCos to train marketers in

the field. IMC also supervised the Company’s contracts with the Olympics, FIFA

(which organizes the World Cup), and the National Basketball Association.

The ServCos generally hired third-party consultants (such as Nielsen) to

perform local market research and testing. They delegated to outside creative

firms the production of consumer advertisements. Outsourced functions included

hiring actors, selecting music, filming commercials, providing voiceovers for glo-

bal marketing materials, and purchasing advertising time in local media. Outside

consultants often convened focus groups to assess whether a new ad hit the de-

sired spot. TCCC maintained a list of approved agencies (such as Ogilvy) with

- 37 -

whom it had negotiated master service agreements. Local managers generally

used approved agencies but were permitted to use others if necessary.

Consumer marketing budgets were set in the Company’s annual business

plans. Following intense negotiations with local bottlers, each BU proposed a

marketing budget on a TCCC-mandated template. That proposal was reviewed by

the OG and ultimately approved by HQ in Atlanta. Local management generally

pegged direct marketing expenses (DME) to grow in line with gross profit targets.

b. Trade Marketing and Distribution

The bottlers took principal responsibility for trade marketing, that is, com-

munications and other efforts directed toward (and undertaken through) the retail

establishments (supermarkets, mom-and-pop stores, bars, and restaurants) that

sold the Company’s beverages to consumers. Trade marketing, often called “push

marketing,” increased consumers’ awareness of the Company’s brands and stimu-

lated consumer demand. It covered a wide range of activities designed to ensure

that the Company’s products were always “within arm’s reach of desire.”

Bottlers expended efforts to acquire and retain retail customers, sometimes

by creating loyalty programs. To ensure that the Company’s products were contin-

uously available to consumers, bottlers had to manage inventory and ensure timely

delivery. Bottlers were responsible for securing advantageous product placement

- 38 -

in stores, arranging point-of-sale promotions (such as floor decals and end-of-aisle

displays), and offering in-store samples of new products. Bottlers managed most

trade promotions (including coupons, product discounts, and digital redemption

codes), which often keyed off holidays and sporting events. Bottlers often inte-

grated these retail promotions with the Company’s global sponsorship activities

and consumer marketing themes. In Europe, where third-party distributors deliv-

ered most beverages to retailers, bottlers sent merchandisers into stores to assure

proper product placement and point-of-sale displays.

Responsibility for managing relationships with retail customers was divided

among TCCC, the ServCos, and the bottlers. For historical reasons, the relation-

ship with McDonald’s was managed directly by the Company’s chief operating

officer at HQ. TCCC’s Global Customer and Commercial Leadership group

maintained relationships with the system’s top 50 other customers, including Wal-

Mart, Tesco, and 7-Eleven. Management of smaller multinational accounts was

generally shared between the bottlers and marketing personnel in the ServCos.

The bottlers had sole responsibility for managing most customer relationships at

the country level.

Bottlers created marketing plans for key accounts, which aligned consumer

marketing with point-of-sale marketing. Bottler field service representatives, who

- 39 -

lived in the residential communities where retailers were located, formed close

relationships with mom-and-pop stores, enabling them to suggest marketing inno-

vations that included coolers, plasma TVs, and end-of-aisle displays. None of the

supply points--apart from the Brazilian and Chilean supply points--had any staff

devoted to sales.

Through the ServCos TCCC supplied bottlers with a variety of tools to

assist them with in-store marketing. Marketing professionals at HQ designed most

point-of-sale materials; by accessing the Design Machine, bottlers could secure

these images and photographs, then customize them for local consumption. The

“picture of success,” the apparent precursor to “Right Execution Daily” (RED),

supplied an ideal image of how a particular store should look to maximize sale of

the Company’s beverages. RED, which was developed by Coca-Cola FEMSA in

collaboration with the Company, provided bottlers with recommended point-of-

sale materials, suggested price points, inventory management tools, and metrics

for measuring the quality of bottler execution against set standards.

To encourage impulse purchases--which provided much higher margins

than purchases for future consumption--bottlers invested in coolers that were

strategically placed in retail outlets. These investments were significant: At one

point, coolers represented about one-third of CCE’s annual capital expenditures.

- 40 -

These coolers were typically used to chill and display the Company’s beverages

exclusively. About two-thirds of the System’s global sales were for immediate

consumption, and coolers were essential in stimulating impulse purchases in

warmer climates.

The bottlers owned all Coca-Cola coolers in retail stores. Larger cooler

capacity became necessary as the Company’s product line grew to include many

non-CSD beverages. To incentivize investment in coolers, the Company provided

financial support to bottlers through its “Jump Start” program, under which it paid

a percentage of the coolers’ cost. When negotiating marketing budgets with the

Company, bottlers generally viewed their costs of purchasing coolers (net of the

Company’s subsidy) as marketing expenses on their side of the ledger.

Bottlers also negotiated financial incentives to push sales. Price promotions

for the Company’s beverages were a sensitive subject, and such decisions were

generally made jointly by bottlers and ServCo marketing personnel. For large

retailers with greater market power, relationship managers negotiated discounts on

targeted product lines. Bottlers regularly engaged in trade promotions to encour-

age retailers to give the Company’s products optimal shelf space. For restaurants

and mom-and-pop retailers, bottlers promoted Coca-Cola products by supplying

in-kind benefits, such as coolers and Coca-Cola-branded awnings and napkins.

- 41 -

Bottlers reflected their marketing expenses in different ways, depending on

local accounting conventions. Such expenses might be shown as “marketing de-

ductions from revenue” or as “direct marketing expenses,” or they could be in-

cluded among “selling, delivery, and administrative” costs. However character-

ized, they were significant. During 2008 CCE had “marketing deductions from

revenue” of $2.5 billion, an amount equal to 11.5% of its net revenue. Other bott-

lers showed marketing deductions as high as 18% of their net revenue.

III. Contractual Relationships

Understanding the rights and obligations of entities within the Coca-Cola

System requires an examination of both written contracts and the parties’ course of

dealing. TCCC operated synergistically with its supply point and ServCo affili-

ates, and it had aligned financial interests with its independent bottlers. The par-

ties often did not spell out the details of their relationships in formal contracts but

left these details to be governed by mutual understanding. In some cases, System

participants operated under outmoded contracts that included terms inconsistent

with their actual behavior.

A. Supply Point Agreements

TCCC was the ultimate parent of the supply points, and the contracts it exe-

cuted with them often seem terse and incomplete. (Indeed, petitioner could not lo-

- 42 -

cate any written agreement with the Egyptian supply point.) The agreements that

existed during 2007-2009 reflected an amalgamation of several (often overlap-

ping) prior contracts and amendments thereto. Over time the text of most con-

tracts converged, making it possible to generalize about the parties’ rights and

obligations. We discuss below the prevailing terms of these agreements, noting

deviations where appropriate.

1. Rights and Obligations

The agreements granted the supply points the rights to produce and sell

concentrate in accordance with TCCC’s specifications. The supply points were

authorized to use TCCC’s intangible property in connection with their production

and selling rights. They generally lacked any contractual ownership interests in

TCCC’s trademarks or other intangible property, and they owned little or no intan-

gible property of their own.14

14

Atlantic, which owned the Costa Rican and Swazi supply points (as disre-

garded CFCs) and the Egyptian and Irish supply points (as branches), was the reg-

istered owner of some trademarks in some jurisdictions with respect to Canada

Dry, Crush, and Dr. Pepper beverages. Atlantic was also the registered owner of

the Schweppes and Cosmos trademarks in most jurisdictions. But none of these

supply points had any ownership interest (direct or indirect) in any trademarks

relating to the Company’s core brands. The Brazilian supply point at one time had

rights to sublicense TCCC’s trademarks to select bottlers. See infra p. 46.

- 43 -

a. Production and Sale of Concentrate

Supply point production rights consisted of the right to produce intermedi-

ary “Products,” variously defined as “concentrate,” “syrups,” and/or “beverage

base.” We use the terms “Products” and “concentrate” interchangeably. The

agreements distinguish “Products” from “Beverages,” which were produced by

bottlers using Products as an ingredient. At no time did any supply point produce

finished beverages.15

The supply points agreed to undertake production of concentrate in accord-

ance with TCCC’s standards and instructions. TCCC ensured compliance with its

standards by reserving the right to inspect “the methods of preparation and pack-

aging on the premises of [the supply point] at all reasonable times.” Compliance

with TCCC’s standards required the supply points to obtain secret ingredients,

formulas, and specifications from TCCC. Most contracts expressly granted the

supply point the right to purchase secret ingredients, but no agreement specified

any maximum price that TCCC could charge therefor. Most of the agreements

included a covenant requiring the supply point to protect the secrecy of TCCC’s

production know-how:

15

TCCC’s agreements with its Irish and Mexican supply points included a

provision nominally authorizing them to manufacture finished beverages. In prac-

tice neither they nor any other supply point ever did this.

- 44 -

[The supply point] shall not at any time reveal any information with

reference to the formulae or ingredients of the Products without the

prior written approval of the Company, and shall keep confidential all

such formulae, specifications, standards and instructions.

The contracts also authorized the supply points to sell concentrate. As a

rule, however, they were permitted to sell concentrate only to bottlers that had an

existing contract with TCCC.16 The contracts with the Mexican, Chilean, and

Costa Rican supply points permitted them to sell concentrate only as “requested by

the Company and at prices set and/or revised by the Company.” The contracts

themselves did not specify any formula or guidelines for pricing concentrate; we

discuss that subject in connection with TCCC’s agreements with its bottlers. See

infra pp. 61-66. Each supply point agreed to “keep a full and accurate account” of

“all Products sold by it” and to make that account and relevant invoices available

for inspection by TCCC “at all reasonable times.”

b. Trademarks

Except in the case of the Brazilian affiliate, the agreements granted the sup-

ply points no rights or ownership interest in TCCC’s trademarks. The agreements

identified TCCC as the “owner” or “registered proprietor” of the trademarks, and

16

The Irish and Swazi supply points were also permitted to sell concentrate

to “other parties authorized by the Company to use the Products and the Trade-

marks in connection therewith.”

- 45 -

TCCC expressly “reserve[d] the right to control all things and acts related to or

involving the use of [the] Trademarks.” The supply point agreed “not to do any

act or thing which may impair the ownership and protection” of the trademarks

owned by the Company. The supply point, in short, received only a limited right

to use the trademarks in connection with its production and sales activities.

Unlike the other supply points, the Brazilian supply point was originally al-

lowed to contract with bottlers, and to that end it was permitted to sublicense the

use of TCCC’s trademarks.17 The Brazilian supply point was authorized, with “the

approval of the Company and * * * Export,” to make contracts with bottlers “in

which the right to bottle the Beverage is granted, but only in conformity with the

specifications, formulae, instructions and standards given from time to time by the

Company.” Upon termination of the Brazilian supply point agreement, all con-

tracts and sublicenses executed with bottlers involving the use of the Company’s

trademarks were to “vest and inure to the benefit of the Company.” The Brazilian

supply point explicitly acknowledged that a sublicense “will not in any way affect

17

TCCC and the Brazilian supply point executed a number of agreements

(and amendments thereto) beginning in 1963. The terms of these agreements are

mutually inconsistent in some respects. In the text we express our understanding

of the salient terms prevailing during the tax years in issue.

- 46 -

the property rights of the Company concerning its * * * trademarks, which contin-

ue to be the Company’s exclusive property.”

The Brazilian supply point was the only supply point that executed agree-

ments sublicensing to bottlers the use of TCCC’s trademarks. In each case, TCCC

was listed in the agreement as a “Parte Interveniente” or “intervening party,” thus

acknowledging its consent to the sublicense. In October 2007 TCCC executed

new agreements with all bottlers that held outstanding contracts showing the Bra-

zilian supply point as a counterparty. These new agreements, which show TCCC

as the sole counterparty, appear to have displaced those earlier agreements and

thus effectively canceled the Brazilian supply point’s sublicensing authority.

2. Term Length and Exclusivity

The Brazilian supply point agreement ran indefinitely but could be terminat-

ed by TCCC’s unilateral action or either party’s breach of contract. The other sup-

ply point agreements had an initial 12-month term (except the Costa Rica agree-

ment, which had an initial two-month term), and all of them renewed automatical-

ly for one-year periods absent prior notice from TCCC or the supply point. Agree-

ments with three of the supply points (Mexico, Swaziland, and Ireland) provided

that, during any 12-month term, either party could terminate the agreement, for

any reason, upon giving 30 or 60 days’ notice to the other party.

- 47 -

No supply point was granted exclusive territorial rights. Each agreement

described a territory--usually the supply point’s domestic market--in which the

supply point was expected to operate.18 But during the tax years at issue (and for

many years previously) no supply point limited its concentrate sales to the geo-

graphical territory in which its manufacturing facility was located. Supply points

regularly sold concentrate to bottlers in other supply points’ domestic markets.

And due to the Company’s aggressive consolidation of concentrate production, the

seven supply points during 2007-2009 sold concentrate to bottlers doing business

in 150 different countries and autonomous regions (such as Hong Kong).

No supply point was granted any right, express or implied, to guaranteed

production of Coca-Cola products. The record reflects dozens of production shifts

among supply points between 1980 and 2011. In hardly any cases was the entity

that lost production compensated--by TCCC or by the supply point that took over

its production--for the loss of income it thus suffered.

3. Remuneration

Although TCCC used the 10-50-50 method to compute royalties payable by

the supply points, it never incorporated any aspect of that formula into its written

18

Only the Swazi agreement described a multinational territory, covering

much of sub-Saharan Africa. In practice, bottlers in that region purchased concen-

trate from the Irish and Egyptian supply points as well.

- 48 -

supply point agreements. Agreements with the Chilean and Costa Rican supply

points included no discussion of payment whatever. The Mexican supply point

agreement specified a royalty computed as a percentage of operating profit. The

Irish and Swazi supply point agreements specified a royalty computed as a per-

centage of concentrate sales. The Brazilian supply point had agreements that in-

consistently recited a one-time royalty of $100 (this version was registered with

the Brazilian trademark office) and an ongoing de facto royalty embedded in the

cost of ingredients purchased from TCCC. It does not appear that TCCC or the

supply points paid much if any attention to these remuneration clauses.

Several supply points paid petitioner a headquarters fee, dubbed “pro-rata.”

To calculate these payments petitioner quantified all HQ expenses that supported

multiple foreign affiliates.19 Petitioner then allocated these expenses to participat-

ing supply points under a complex formula, subject to the proviso that no supply

point would be allocated pro-rata in excess of the amount that would be tax-de-

ductible in its local jurisdiction.

The Brazilian and Egyptian supply points did not participate in the pro-rata

regime at all. The Irish supply point paid about $1 billion, and the other four sup-

19

Headquarters expenses that supported a specific foreign affiliate were

generally excluded from pro-rata and charged directly to that entity.

- 49 -

ply points collectively paid about $500 million, of pro-rata during the tax years at

issue. Petitioner credited all of these payments against the supply point’s royalty

obligation under the 10-50-50 method, as had been permitted under its 1996 clos-

ing agreement with the IRS. The details of the pro-rata arrangement were not

spelled out--and sometimes were not even mentioned--in the supply points’ agree-

ments with TCCC.

B. Service Company Agreements

TCCC contracted (typically through Export) with at least 60 ServCos doing

business throughout the world. The ServCos performed local consumer marketing

and supervised relationships with local bottlers. TCCC or Export generally exe-

cuted with each ServCo a written agreement employing a standard template that

was modified slightly over the years. Neither party disputes that these contracts

reflected arm’s-length terms and compensation.

1. Standard Terms

Virtually all of the agreements run between the ServCo and TCCC or Ex-

port.20 The standard template for these agreements included a boilerplate pream-

20

The only apparent exception to this rule involved the Costa Rican supply

point, which had agreements with eight ServCos through the end of 2009. One of

its counterparties, the Costa Rican ServCo, subcontracted to provide services to

the Ecuadorian ServCo and to receive services from the Colombian ServCo.

- 50 -

ble, a generic description of services provided, and a confidentiality clause. The

preamble typically stated that TCCC or Export engaged the ServCo because of its

“expertise and know-how on the production and marketing of the Beverages, in-

cluding sales, advertising, promotion and business development.” Most agree-

ments specified a one-year term, which was renewed indefinitely absent notice

from either party of its intent to terminate.

The ServCo typically agreed to supply services that included advice regard-

ing “marketing, advertising and sales promotion.” Most agreements executed after

2006 stated explicitly that the ServCo would discharge these tasks by “working

with third party marketing service providers.” ServCos agreed to make recom-

mendations as to whether the Company should participate in (i.e., make a financial

contribution to) bottlers’ trade marketing expenditures, and to perform research

concerning “regulatory, technical and marketing conditions” that might affect

beverage sales in the local jurisdiction. They also agreed to perform a variety of

computer-related and other back-office functions.

The standard agreement included two remuneration clauses, which together

provided ServCos with cost-plus compensation. The first clause generally stated

that the service recipient (typically Export) would “reimburse or cause to be reim-

bursed at cost the expenses incurred by * * * [the ServCo] attributable to the ser-

- 51 -

vices under this Agreement.” Generally speaking, expenses were netted against

any income of similar character before being reimbursed. Reimbursable expenses

were determined in accordance with local accounting principles and generally

excluded any income taxes incurred by the ServCo.

The second remuneration clause stated that the ServCo would be paid a

markup on certain expenses described in the first clause. These percentage mark-

ups varied among the agreements from a low of 5% to a high of 12%, with the

average markup being between 6% and 7%. These marked-up expenses, when

charged to Export or other service recipient, were typically denominated “fees and

commissions.”

Most agreements provided that the ServCo would be paid no markup on

“direct marketing expenses,” which included amounts paid to third-party market-

ing professionals such as advertising agencies, media companies, and creative de-

sign firms. The effect of this provision was generally to deny the ServCo any

markup on third-party marketing costs, which typically constituted its largest cate-

gory of expenses. For reasons not explained in the record, this provision is absent

from many Latin American ServCo agreements.

In 2008 the Company contracted with Ernst & Young (E&Y) to analyze the

services provided by ServCos to Export. E&Y agreed to prepare a “master plat-

- 52 -

form document” that would provide a basis for transfer pricing reports that Serv-

Cos were required to file with their local taxing jurisdictions. E&Y ultimately

produced two master platform documents from which it prepared about 30 local

transfer pricing reports.

E&Y concluded in these documents that the cost-plus compensation out-

lined in the ServCo agreements was within an arm’s-length range. In support of

this conclusion E&Y noted that TCCC controlled the ServCos’ annual budgets,

provided major inputs to their marketing efforts, and supplied final approval for all

business plans. At trial an E&Y partner testified that all of these transfer pricing

reports “were written based on the [ServCo] contract[s] and the cost-plus nature of

the service provided” by the ServCos, which he described as “the exact standard

required [under the] transfer pricing analysis paradigm in effect in every country at

the time.”

2. Other Provisions

Shortly before the tax years in issue, several new provisions were intro-

duced into ServCo agreements, chiefly in Europe. Petitioner attributed these

variations to local tax planning undertaken by the Company.

Many agreements executed after 2003 include a new clause explaining the

level of risk assumed by the ServCo and clarifying the ownership of assets gener-

- 53 -

ated by its marketing efforts and those of the third-party marketing professionals

with whom it contracted. A typical version of the clause read as follows:

ServCo acknowledges that it does not take entrepreneurial risk in

developing marketing concepts because the marketing advice

provided by ServCo is within the strategic guidelines established by

Export for the brands. ServCo also acknowledges that any marketing

concepts developed by third party vendors are the property of Export.

A variation of the first sentence, appearing in the more recent agreements, states

that the ServCo assumed no entrepreneurial risk “because the marketing is con-

tracted for by ServCo with third party service providers and is within [TCCC’s]

strategic guidelines.”

Petitioner’s witnesses testified that this reservation clause was added to the

agreements in order to minimize the risk that the ServCo would be treated by local

tax authorities as creating, in that country, a “permanent establishment” of TCCC

or a foreign supply point. Whatever its purpose, this reservation clause ultimately

appeared in 29 of the 37 ServCo agreements executed after 2004.

The Company added another layer of tax planning to agreements executed

with ServCos in the EU. Those companies were generally subject to value added

tax (VAT) in their home country and were required to include VAT on their in-

voices to Export (a U.S. company). Export would generally be eligible for refund

of the VAT, but such refunds could often be delayed for months or years.

- 54 -

To mitigate this problem Export internalized its intra-EU service transac-

tions by interposing a Belgian affiliate, S.A. Coca-Cola Services N.V. (CCS), be-

tween it and other ServCos in the EU. Export executed a “master service agree-

ment” with CCS, and CCS executed subcontracts with the ServCos doing business

in the EU. Steven Whaley, the Company’s general tax counsel during 1996-2008,

testified that the interposition of CCS between the ServCos and Export allowed

ServCos to “zero rate” their services, thus avoiding the need to file VAT refund

claims.

Export’s master service agreement with CCS generally resembled TCCC’s

standard ServCo contract. However, CCS was allowed no markup on the fees it

paid to the local ServCos for their services. And the master agreement included a

robust reservation clause concerning ownership of intangible assets generated by

the local ServCos’ marketing efforts and by the Belgian R&D unit:

ServCo [CCS] * * * acknowledges that any marketing concepts dev-

eloped by third party vendors or any affiliate of Coca-Cola that pro-

vides services to ServCo * * * are the property of EXPORT. * * *.

Any intangibles arising out of the research and development activities

of ServCo are the property of EXPORT.

3. Invoicing

Petitioner employed a complicated (and not entirely transparent) system to

make inter-company charges on account of services rendered by the ServCos.

- 55 -

Most ServCo agreements stated that the ServCo “shall invoice” the service recipi-

ent--typically Export--in the former’s local currency. The agreements specify no

deadlines, and it is unclear whether any actual invoices were ever prepared.

In practice, BU leadership and finance personnel initiated inter-company

charges that placed on the books of each supply point, as they determined to be ap-

propriate, an allocated portion of the amounts that the ServCos (including CCS)

charged to Export. Supply points were thus charged an allocated share of the

ServCos’ “fees and commissions” (marked-up costs) plus an allocated share of the

ServCos’ third-party marketing expenses. Petitioner has pointed to no document

in the record by which any supply point (except perhaps the Irish supply point) ex-

plicitly agreed to bear financial responsibility for these charges.21

21

The record includes a January 1, 1998, agreement whereby Atlantic

agreed, on behalf of the Irish supply point (its branch), “to make available funds to

* * * [Export] for reimbursement of the expenses of the ServCos and for payment

of the service fees charged by the ServCos.” The agreement also stated that

“Atlantic shall act as paymaster for defraying expenses such as marketing, ad-

vertising and promotional expenses incurred or to be incurred within the territory

serviced.” There is no evidence establishing that this agreement, which had a one-

year term, remained in effect during 2007-2009. As petitioner notes, the agree-

ment “is less than two pages long and [is] composed largely of WHEREAS

clauses.” Petitioner acknowledges that the agreement “does little to explain * * *

[the parties’] relationship or Atlantic Industries’ role” and asserts that it “was not a

valid contract because it lacked consideration.”

- 56 -

The method for allocating ServCo fees and DME to supply points is not

explained in any document. Petitioner’s witnesses testified that allocations were

based on “the matching principle,” i.e., on the principle that expenses should be

matched to revenues. In theory, a supply point was supposed to be allocated fees

and DME charged by a particular ServCo depending on how much concentrate

that supply point sold to bottlers in the geographic market(s) for which that Serv-

Co was responsible. Thus, if a supply point sold concentrate to bottlers in 30

geographic markets, it might be allocated fees and DME charged to Export by 30

separate ServCos. In practice, the allocations of “fees and commissions” and

DME to the seven supply points, as percentages of their gross revenue, varied

widely. See infra pp. 74-75. The record does not explain these discrepancies.

One way or another, most ServCo charges eventually found their way onto

the books of one or more supply point. But there is no evidence that the supply

points received invoices for these services, reviewed the propriety of the amounts

they were charged,22 or had any role in selecting or evaluating the services for

22

Petitioner cites only one instance of a supply point’s exercise of review

over ServCo charges billed to it. In that case the supply point had been billed for

charges from the Russian ServCo even though it sold no concentrate in Russia. As

one witness noted, this “really stood out and caused them to question.”

- 57 -

which they were made financially responsible. In essence, the supply points were

passive recipients of charges that HQ and BU leadership put on their books.

C. Bottler Agreements

Petitioner executed formal agreements with hundreds of Coca-Cola bottlers

throughout the world. In virtually all of the agreements TCCC is shown as the

legal counterparty to the bottler.23 These agreements, like the supply point

agreements, were based on templates that reflected standard terms and conditions.

The principal variations among the bottler agreements involved the length of the

contract term, notice periods, choice of law, and the exclusivity of rights granted.

Unlike the supply point agreements, TCCC’s contracts with its bottlers explicitly

granted them long-term and generally exclusive rights to produce and sell TCCC’s

products within their respective territories.

1. Rights and Obligations

a. Production and Sale of Finished Beverages

Through the bottler agreements TCCC licensed bottlers to use its trade-

marks and other intangible property to produce, sell, and distribute finished bever-

23

As noted supra pp. 45-46, the Brazilian supply point was shown as the

counterparty in certain agreements executed with Brazilian bottlers before October

2007, with TCCC appearing as a “Parte Intervenente.”

- 58 -

ages.24 Like the supply points, bottlers covenanted to adhere strictly to TCCC’s

production standards and to grant TCCC access to their facilities for periodic qual-

ity-assurance inspections. Like the supply points, bottlers were required to buy in-

gredients from TCCC affiliates or TCCC-approved suppliers. And like the supply

points, bottlers enjoyed no right to purchase these inputs at any predetermined

price.

Whereas the supply points were permitted to sell concentrate only to TCCC-

approved bottlers, bottlers had complete freedom to sell finished beverages to any

wholesaler or retailer within their respective territories. The bottler agreements

granted TCCC the right to review and approve bottlers’ annual business plans,

which were usually developed in coordination with the local BU. Once a business

plan was approved by HQ in Atlanta, the bottler agreed to “prosecute diligently”

the details of the plan and to update TCCC regularly on plan implementation (e.g.,

by submitting sales reports in a format specified by TCCC). Bottlers also made

softer commitments, e.g., “to satisfy fully the demand for each of the Beverages

within the [bottler’s] Territory” and “to spend such funds for the advertising and

24

Although some bottlers were authorized to produce “syrups,” such syrups

were used by the bottler internally in the course of producing finished beverages.

Bottlers invariably covenanted not to sell syrups or concentrate to third parties.

- 59 -

marketing of the Beverages as may be required to maintain and to increase the

demand * * * in the Territory.”

b. Trademarks

Bottlers had limited trademark rights similar to those granted to the supply

points. While bottlers could use TCCC’s trademarks in connection with the pro-

duction, sale, and distribution of finished beverages, they expressly acknowledged

that TCCC owned the trademarks together with any goodwill generated by the bot-

tlers’ use of the trademarks. TCCC reserved the right to control most aspects of

trademark use, and bottlers covenanted to seek approval from TCCC for most ad-

vertising, promotions, or other marketing that employed these trademarks. In

practice the local ServCo generally supplied such approval.

2. Term Length and Exclusivity

The specified term of most bottler agreements was between five and ten

years. The largest independent bottlers, including CCE, Coca-Cola FEMSA, Hel-

lenic, and Coca-Cola Amatil (which did business in Australia), had agreements

with ten-year terms. Explicit approval by TCCC was required to renew a bottler

agreement at the expiration of its stated term; the agreements generally precluded

automatic renewal based on tacit approval. As with supply point agreements,

TCCC reserved rights that allowed it to terminate bottler agreements on no more

- 60 -

than a few months’ notice. Bottlers would have preferred longer term contracts

granting TCCC more limited termination rights, but TCCC consistently refused to

agree to such modifications.

In practice, the mutual dependence between the Company and its bottlers

ensured that bottler agreements were almost always renewed. When a bottler per-

formed badly or encountered financial difficulties, TCCC’s solution typically was

not to terminate the bottler, but to acquire it, put it into the “bottler hospital,” and

supervise its operations from Atlanta until it had recovered its footing financially

and operationally. See supra pp. 17-18. TCCC would then divest the bottler to

new owners with its bottler contract intact.

Many of the Company’s major bottlers were public companies required to

disclose financial information in annual reports and public filings. CCE, one of

the top three Coca-Cola bottlers, described its relationship with TCCC as follows:

While the [bottler] agreements contain no automatic right of renewal

* * * we believe that our interdependent relationship with TCCC and

the substantial cost and disruption to that company that would be

caused by nonrenewals ensure that these agreements will continue to

be renewed.

For this reason most major bottlers, including CCE, Coca-Cola FEMSA, and

Hellenic, assigned to their bottling contracts an indefinite useful life for account-

ing and financial statement purposes.

- 61 -

Bottler agreements also differed from supply point agreements in the ex-

clusivity of the rights they granted. Supply points enjoyed no exclusivity what-

ever: They were always at risk of having TCCC shift their production to another

supply point, which could then sell to bottlers in their home country. By contrast,

TCCC’s agreements with most bottlers included a geographically defined market

in which the bottler was granted exclusive rights to produce and sell beverages.

The legal landscape was different in the EU and the European Economic

Area, where the Treaty of Rome guaranteed the free movement of goods among

member states. For that reason, explicit exclusivity clauses are generally absent

from European bottler agreements. But in practice bottlers respected each other’s

notional territories and rarely attempted to sell into them. As explained by John

Brock, a longtime industry veteran who formerly led CCE, there was within the

EU “an implied geographic exclusivity, but it was not spelled out.”

3. Remuneration

The bottlers remunerated the Company through the price they paid for con-

centrate. That price in effect bundled all of the Company’s valuable inputs into a

single bill, ostensibly for concentrate. By paying this bill, bottlers secured not

only the physical beverage base, but the entire package of rights and privileges

they needed to operate efficiently as Coca-Coca bottlers. This package included

- 62 -

the right to use TCCC’s trademarks, access to TCCC-approved suppliers, access to

critical databases and marketing materials, and the expectation of ongoing con-

sumer marketing support from TCCC and the ServCos.

TCCC reserved the unilateral right to set the concentrate price, which in

theory enabled it to determine the bottler’s profitability. But “in the real world,”

as petitioner notes, “concentrate prices were established through local negotia-

tions.” These local negotiations “aimed to equitably share System operating pro-

fit,” i.e., the total pre-tax operating profit accruing to the Company and the bottler

from that bottler’s sales of the Company’s beverages.

Generally, the parties’ goal was to achieve something like a 50%-50% split

of the System profit. In practice, the division usually ranged between 45% and

55% in favor of one party or the other. The bottler might negotiate for a share

near the high end of this range if (for example) it faced economic headwinds or

expected to incur large capital expenditures. By using estimates of future reve-

nues and expenses contained in budgets and business plans, TCCC and the bottler

could negotiate a concentrate price that was expected to deliver the intended share

of System profit to each party.

Adjustment to the concentrate price was a major undertaking that required

ultimate approval by HQ in Atlanta. An officer of one BU described it as “the

- 63 -

mother of all negotiations with a bottler.” Such negotiations were typically under-

taken only once every few years. Between those revisions, unexpected fluctua-

tions in consumer demand, local inflation rates, or currency exchange rates could

occur. If those risks materialized, use of a fixed concentrate price could throw off

the intended division of System profit.

TCCC and its bottlers devised two solutions to this problem. One solution

was some form of variable pricing. In Latin America and Eastern Europe in par-

ticular, bottler agreements increasingly adopted “incidence pricing,” whereby the

concentrate price was initially determined at a fixed price and then “trued up” to

reflect actual sales (incidences) when more complete financial data became avail-

able. In Western Europe, where currencies and inflation rates were generally less

volatile, TCCC and its bottlers employed a subtler version of variable pricing, key-

ed to bottlers’ prior-year sales or projected current-year revenues.

A second solution was to adjust, as compared with the original business

plan, the marketing expenditures that the Company and its bottlers were going to

make. For example, if the System profit split moved unexpectedly in the Com-

pany’s direction, it might agree to reimburse the bottler for certain trade marketing

expenses. Or the Company might agree to increase its consumer marketing ex-

penses in the bottler’s territory, which would be expected to increase the bottler’s

- 64 -

sales and profits. In 2005, for example, TCCC appeased calls by Latin American

bottlers for lower concentrate prices by (among other things) agreeing to reinvest

an additional 20% of concentrate revenues in mutually agreed marketing projects.

Conversely, if the System profit split moved unexpectedly in the bottler’s direc-

tion, the Company might reduce its support for local trade marketing, or the bottler

might increase its marketing expenditures, e.g., by accelerating placement of cool-

ers in retail stores.

Generally speaking, bottlers paid the full concentrate price to the supply

point(s) from which they purchased concentrate. In some markets, however, the

Company engaged in “split invoicing.” Under this practice, the supply point in-

voiced the bottler for a portion of the concentrate price, and the local ServCo is-

sued a separate invoice to the bottler for the remainder of the concentrate price.

Where split invoicing occurred, the ServCo wound up receiving a portion of the

revenues that the supply point would otherwise have received as payments for

concentrate.

“Split invoicing” was used chiefly with bottlers in countries that were sus-

ceptible to high inflation or exchange-rate volatility. By having the bottler direct a

portion of the concentrate price to a ServCo in the same country, the Company

- 65 -

was able to mitigate the effects of currency controls, delayed VAT refunds, and

related fiscal problems.25

ServCos used their “split invoicing” revenues to offset expenses that other-

wise would have been reimbursed (with markup where applicable) by Export un-

der a ServCo agreement. The Brazilian, Chilean, and Irish supply points, which

supplied concentrate to the bottlers in question, lost revenue as a result of this

practice. But they also avoided having the corresponding expenses of the ten

ServCos charged to their books. During the tax years at issue, the total “split in-

voicing” revenues received by the ServCos and the expenses they allocated to

these revenues were as follows:

Affected Revenue Total revenue Total expenses Markup on total

supply point recipient (2007-2009) (2007-2009) expenses (%)

Brazil Venezuelan ServCo $445,752,031 $158,607,901 181.04

Colombian ServCo 227,660,409 176,822,070 28.75

Ireland Mexican ServCo 420,224,666 424,563,141 -1.02

Turkish ServCo 84,028,435 45,405,027 85.06

Moroccan ServCo 70,298,612 66,359,121 5.94

Bulgarian ServCo 7,183,562 8,138,222 -11.73

Chile Peruvian ServCo-1 69,365,968 58,558,956 18.45

Peruvian ServCo-2 15,572,164 10,730,629 45.12

Ecuadorian ServCo 49,051,552 46,745,900 4.93

Bolivian ServCo 7,053,548 5,168,272 36.48

Total 1,396,190,946 1,001,099,239 39.47

25

Ten ServCos received “split invoicing” revenues during 2007-2009: two

ServCos in Peru and the ServCos in Venezuela, Bolivia, Ecuador, Colombia,

Mexico, Bulgaria, Turkey, and Morocco.

- 66 -

The markups that ServCos received from bottlers under split invoicing were

significantly higher (on average) than the markups ServCos normally enjoyed un-

der their contracts with Export. The average markup under Export’s contracts was

6% to 7%. And this markup generally did not apply to amounts ServCos paid for

third-party marketing services. See supra p. 51. As shown in the table above, the

average markup ServCos received under split invoicing was almost 40%.

Five of the ServCos had agreements with the bottlers from which they re-

ceived split-invoicing payments. These agreements required the ServCo to pro-

vide the bottler with services resembling those specified in contracts that ServCos

typically executed with Export. The agreements executed by the Venezuelan and

Ecuadorian ServCos specified no compensation formula. The agreement between

the Mexican ServCo and its bottler (Coca-Cola FEMSA) called for a 5% markup

on expenses other than DME. The agreement between the Turkish ServCo and its

bottler called for an 8% markup on expenses other than DME, plus a “success fee”

calculated on increases in year-over-year sales.

IV. Assets and Income

In 2000 the Company began using the Data Collection, Consolidation and

Reporting System (DACCARS) for its worldwide operations. DACCARS tracked

the financial performance of each subsidiary, branch, or other entity that prepared

- 67 -

and submitted data to HQ for consolidation purposes. Income and assets reported

in DACCARS were aggregated and reported under one or more data codes and

submitted as financial statements for various managerial units.

In the ordinary course of its business, the Company did not prepare financial

statements for the supply points, the most relevant units for purposes of transfer

pricing analysis. However, the DACCARS data codes can be manipulated to

generate separate balance sheets and income statements for the supply points. The

parties have prepared and stipulated pro forma balance sheets and income state-

ments, for 2007-2009, for each of the seven supply points involved here.

At the parent level, the relevant unit is a consolidation of TCCC and Export

that excludes the operations of the BUs that conducted the U.S. and Canadian bev-

erage businesses. We will refer to this consolidated unit as HQ. HQ owned the

trademarks and other intangible property at issue in this case, and it received the

royalties paid by the supply points. In the ordinary course of its business, the

Company did not prepare distinct financial statements for HQ, but the DACCARS

data codes can be manipulated to generate balance sheets and income statements

for it. The parties have prepared and stipulated pro forma balance sheets and

income statements for HQ for 2007-2009.

- 68 -

The ServCos presumably prepared financial statements in the ordinary

course of their business. But the parties have not introduced any ServCo financial

statements into evidence or made any stipulations concerning their assets or in-

come (apart from income earned by ServCos that received split invoicing reve-

nues). Most ServCos were compensated on a cost-plus basis, and it is a fair in-

ference that their reported assets and income were generally quite modest.

A. Assets

1. HQ

During 2007-2009 HQ showed average book assets of about $15 billion.

The bulk of these assets ($11.7 billion on average) consisted of investments in

subsidiaries and other affiliates. HQ’s balance sheets showed trademarks and oth-

er intangible assets of about $500 million. This figure does not reflect the market

value of the Company’s self-developed intangibles and beverage brands.

During 2007-2009 HQ was the registered owner of virtually all trademarks

covering the Coca-Cola, Fanta, and Sprite brands and of the most valuable trade-

marks covering the Company’s other products. HQ was the registered owner of

nearly all of the Company’s patents, including patents covering aesthetic designs

(such as bottle shapes and caps), packaging materials, beverage ingredients, and

production processes. HQ owned all intangible property resulting from the Com-

- 69 -

pany’s R&D concerning new products, ingredients, and packaging. And most

ServCo agreements executed after 2003 explicitly provided that “any marketing

concepts developed by third party vendors are the property of Export,” thus ce-

menting ownership in HQ of subsequently developed marketing intangibles.

2. Supply Points

The table below shows the average book assets appearing on the pro forma

balance sheets of the seven supply points during 2007-2009:

Average Assets Per Book (US$ millions)

Costa Swazi-

Brazil Chile Rica Egypt Ireland Mexico land

Cash and cash equivalents 724 102 27 31 196 61 76

Trade accounts receivable 183 57 24 37 348 56 122

Inventories 38 15 7 10 129 45 20

Prepaid exp. and other current assets 57 3 3 25 42 82 5

Investment in investees 53 479 -0- -0- -0- -0- -0-

Investments in consolidated affiliates 320 7 -0- -0- -0- 5 -0-

Other assets 82 -1 2 28 113 63 3

Property, plant & equipment 70 55 8 17 382 35 23

Trademarks and other IP 190 37 -0- -0- -0- 60 -0-

Total assets 1,715 753 70 148 1,209 407 249

As shown in the table, all of the supply points held significant amounts of

cash and trade accounts receivable. Virtually all of their trade receivables were

from Coca-Cola bottlers. The risk of bottler default was very low, and the supply

points on average reported allowances for doubtful accounts equal to 0.25% of

- 70 -

these receivables. The Brazilian, Chilean, and Irish supply points reported aver-

age allowances for doubtful accounts of less than 0.1%.

The Irish supply point showed an unusually large investment in property,

plant, and equipment (PPE), apparently attributable to the construction of the Bal-

lina plant in 1999. The Brazilian and Chilean supply points showed unusually

large investments in affiliates and investees, apparently attributable to acquisitions

they made in 2009. See supra notes 5 and 6. Four of the supply points--in Ireland,

Costa Rica, Egypt, and Swaziland--showed no trademarks or other intangible pro-

perty on their balance sheets. Only the Brazilian supply point showed significant

intangible property, representing about 11% of its book assets.

B. Income and Expenses

The Company derived its share of System profit through bottlers’ payments

for concentrate. The supply points received and retained the bulk of this income,

remitting to TCCC only what was needed to satisfy their royalty obligations as de-

termined under the 10-50-50 method. Most administrative and marketing expen-

ses were incurred by HQ or the ServCos. These expenses were placed on the

books of the supply points through inter-company charges.

Five of the supply points were charged pro-rata, which reimbursed HQ for

headquarters expense. All of the supply points were charged DME (incurred by

- 71 -

the ServCos) and most were charged “fees and commissions” (marked-up ServCo

expenses). These inter-company charges reimbursed Export for amounts that the

ServCos had billed to it. Although the supply points’ pro forma income state-

ments show DME as a direct expense, petitioner has not identified any supply

point that actually incurred out-of-pocket costs for DME. As far as the record re-

veals, all of the DME shown on the supply points’ pro forma income statements

reflects inter-company charges for DME incurred by the ServCos.

1. HQ

HQ’s income stream reflected its role as brand owner and administrator. Its

gross receipts for 2007-2009 consisted primarily of pro-rata and royalties for use

of its intangible property. HQ’s gross receipts for these years (in U.S. dollars

rounded to the nearest million) included the following:

Year IP royalties Pro-rata

2007 $1,394 $501

2008 1,536 513

2009 1,473 497

Total 4,403 1,511

These figures include royalties paid by 11 foreign supply points not at issue in this

case but exclude any dividends paid by supply points in partial satisfaction of their

royalty obligations under the 10-50-50 method.

- 72 -

HQ incurred numerous operating expenses, most of which were typical of

the costs one would expect to be incurred by a headquarters unit. After deduction

of these expenses and adjustments for nonoperating income and taxes, HQ re-

ported net income (in U.S. dollars rounded to the nearest million) as follows:

Year Net income

2007 $1,684

2008 1,425

2009 1,202

Total 4,311

2. Supply Points

The supply points showed fairly steady increases in revenue before and dur-

ing the tax years in issue. That revenue consisted almost entirely of payments

from bottlers for concentrate. (Occasionally supply points also sold concentrate to

one another.) The table below shows the revenues reported by the supply points

for 2001 through 2009:

Supply point revenue (US$ millions)

Costa Swazi-

Year Brazil Chile Rica Egypt Ireland Mexico land Total

2001 $626 $177 $8 $111 $3,184 $935 $284 $5,324

2002 447 167 93 104 3,586 930 359 5,685

2003 409 159 119 96 4,510 752 478 6,523

2004 481 170 130 100 5,075 647 638 7,242

2005 646 186 135 115 5,334 689 690 7,795

2006 849 223 157 129 5,760 772 696 8,586

2007 1,138 261 186 147 6,596 883 800 10,011

2008 1,286 313 220 216 7,276 941 773 11,025

2009 1,306 345 231 265 6,799 872 863 10,680

- 73 -

Against these revenues the supply points offset their “cost of goods and ser-

vices” (COGS) and certain minor items. Generally speaking, their COGS was

modest compared to their revenues: The supply points had relatively few manu-

facturing employees, and the materials needed to produce concentrate were inex-

pensive and often procured by the Company in bulk. After offsetting COGS and

other items the supply points reported gross profits (in US dollars rounded to the

nearest million) and gross profit margins for 2007, 2008, and 2009 as follows:

2007 2007 2008 2008 2009 2009

Supply point G/P Margin (%) G/P Margin (%) GP Margin (%)

Brazil $930 81.7 $1,044 81.2 $1,028 78.7

Chile 217 83.3 254 81.1 278 80.7

Costa Rica 149 80.0 176 79.9 172 74.6

Egypt 98 66.3 154 71.5 193 72.9

Ireland 5,282 80.1 5,829 80.1 5,430 79.9

Mexico 668 75.6 707 75.2 631 72.4

Swaziland 725 90.7 699 90.4 780 90.3

Total 8,069 8,863 8,512

From these gross profits the supply points deducted their business expenses.

These consisted of inter-company charges and direct expenses. Inter-company

charges, which varied greatly among the supply points, included royalties, pro-

rata, “fees and commissions,” and DME. Direct expenses, which were significant

only for the Brazilian supply point, included general and administrative expenses

(G&A), sales/service costs, and marketing expenses other than DME. The table

- 74 -

below shows the average annual business expenses, by category, reported by the

supply points during 2007-2009:

Average annual business expenses (US$ millions)

Supply Direct Fees & Inter-co

point expenses DME comms Pro-rata royalties Total

Brazil $121 $150 -0- -0- -0- $271

Chile 16 29 -0- $8 $2 55

Costa Rica 2 53 $39 11 -0- 104

Egypt 27 47 83 -0- -0- 157

Ireland 85 1,104 777 350 807 3,123

Mexico -0- 170 82 46 114 412

Swaziland 11 2 326 46 123 508

Total 4,630

As shown in the table above, the Brazilian, Costa Rican, Chilean, and Egyp-

tian supply points recorded minimal or no royalty payments to TCCC. Petitioner

represents that they fully satisfied their royalty obligations under the 10-50-50

method in other ways (i.e., by paying dividends and/or pro-rata). The Brazilian

and Egyptian supply points did not participate in the pro-rata regime, see supra

p. 48, so they showed no payments in this category.

The charges for “fees and commissions” and DME varied widely among the

supply points, with no clear relationship to their gross revenues. The Egyptian and

Swazi supply points during 2007-2009 were allocated “fees and commissions” that

averaged 40% of their gross revenue, whereas the Brazilian and Chilean supply

- 75 -

points reported zero “fees and commissions.”26 The DME charged to the supply

points during 2007-2009, as a percentage of their average gross revenues (GR),

likewise ranged widely, from 0.3% to 24.8%, as follows:

Supply point DME as % of GR

Brazil 12.1

Chile 9.5

Costa Rica 24.8

Egypt 22.4

Ireland 16.0

Mexico 18.9

Swaziland 0.3

After deducting inter-company charges and direct expenses as shown above,

the supply points reported operating profit for 2007, 2008, and 2009 as follows:

Operating profit (US$ millions)

Supply point 2007 2008 2009 2007-2009

Brazil $668 $762 $758 $2,188

Chile 167 197 220 584

Costa Rica 60 72 51 184

Egypt (45) 1 18 (25)

Ireland 2,185 2,530 2,456 7,172

Mexico 254 267 248 769

Swaziland 189 190 302 680

Total 3,478 4,019 4,054 11,551

26

The allocation of zero “fees and commissions” to the Brazilian and Chile-

an supply points might be explained in part by the local ServCos’ receipt of “split

invoicing” revenues from Venezuelan and Colombian bottlers. See supra pp. 65-

66. Where “split invoicing” occurred, the supply point(s) that sold to those bot-

tlers lost revenue, but they avoided having an equivalent amount of ServCo expen-

ses charged to their books. Petitioner has not quantified these effects.

- 76 -

The seven supply points involved here had a weighted average income tax

rate of 6.3%. After adjustments for taxes and nonoperating income, these seven

supply points reported total net income of $11.36 billion for 2007-2009. That

total (which excludes the income realized by the Company’s 11 other foreign

supply points) equaled 264% of the net income of $4.31 billion recorded by HQ

during 2007-2009 (which included all royalties paid by all foreign affiliates).

C. Brazilian Trademarks

TCCC initially did business in Brazil through a branch. It conducted branch

operations in Brazil beginning in 1945 or earlier. Those branch operations in-

cluded the manufacture of concentrate beginning in 1949 or earlier. Coca-Cola

bottlers have done business in Brazil since at least 1942.

TCCC registered its first Brazilian trademark in 1912. Between 1912 and

1962, when the Brazilian supply point was incorporated, TCCC registered nine

trademarks in Brazil. Five related to Coca-Cola, covering the product names

Coca-Cola and Coke, the stylized label, and the Spencerian script. Two related to

Fanta and two to Sprite, covering those product names and their stylized labels.

In February 1963 TCCC executed an agreement authorizing the Brazilian

supply point to manufacture concentrate and to use TCCC’s trademarks in doing

so. This agreement, which related solely to Coca-Cola products, stated that the

- 77 -

trademarks continued to be TCCC’s “exclusive property” and that TCCC had “the

exclusive right and jurisdiction * * * to control the use” of the trademarks. The

agreement did not require the Brazilian supply point to perform marketing activi-

ties or incur marketing expenditures.

Between 1963 and November 17, 1985, TCCC registered an additional six

trademarks in Brazil. Five related to Coca-Cola, covering the dynamic ribbon and

the product names Coke Light, Coca-Cola Light, and Coke Classic. The sixth was

a seemingly duplicative trademark for Sprite.

Between November 17, 1985, and the tax years at issue, TCCC registered at

least 53 additional trademarks in Brazil. These covered the Coca-Cola contour

bottle shape, secondary design features for TCCC’s core products, advertising slo-

gans, and composites of existing trademark elements. They also covered dozens

of newer products including Coke Zero, Diet Fanta, Dasani, Minute Maid, Power-

ade, Kuat, and numerous other local Brazilian brands.

The February 1963 agreement was amended often between 1981 and 1996

to refer to products other than Coca-Cola and to authorize the Brazilian supply

point to use the other trademarks described above. These amendments made clear

that all trademarks were TCCC’s “exclusive property” and that the Brazilian sup-

ply point was granted only a limited right to use them to manufacture and distri-

- 78 -

bute concentrate. None of the agreements as thus amended required the Brazilian

supply point to perform any marketing activities or incur any marketing expenses.

V. Tax Reporting and IRS Examination

During 2007-2009 petitioner used the 10-50-50 method to determine the

royalty obligations of its supply points. Under that method, supply points were

permitted to satisfy their royalty obligations by a combination of actual royalties,

dividends, and pro-rata payments. The Brazilian and Chilean supply points

remitted during these years, in satisfaction of their royalty obligations, aggregate

dividends of about $887 million and $233 million, respectively. Atlantic, which

operated the Costa Rican, Egyptian, Irish, and Swazi supply points as branches

(directly or indirectly), remitted aggregate dividends of about $682 million in

satisfaction of those supply points’ royalty obligations. For this purpose petitioner

treated Atlantic’s four supply points as a consolidated entity. Although petitioner

elected “dividend offset” treatment on timely filed returns for 2007-2009, it did

not include in those returns explanatory statements as directed by Rev. Proc.

99-32, 1999-2 C.B. 296.

The IRS selected petitioner’s 2007-2009 returns for examination. It deter-

mined that the 10-50-50 method did not reflect arm’s-length pricing because that

method overcompensated the supply points and undercompensated TCCC for the

- 79 -

use of its intangible property. The IRS retained an economist, Dr. Scott Newlon,

to analyze petitioner’s inter-company pricing and determine the best method to

reallocate income.

Dr. Newlon concluded that TCCC, as the legal owner of virtually all the

Company’s trademarks and intangible property, owned the vast bulk of its brand

value. But he found that the supply points, which functioned essentially as con-

tract manufacturers, retained most of the profits generated by sales of concentrate

to foreign bottlers. He concluded that a reallocation of income was necessary in

order to reflect clearly the income of TCCC and its supply-point affiliates.

Concluding that no uncontrolled transaction could accurately capture the

value of licensing the Company’s unique brands, Dr. Newlon rejected the “com-

parable uncontrolled transaction” (CUT) method as a transfer pricing methodolo-

gy. He likewise rejected a “profit split” method, finding it unreliable where one

party (TCCC) owned valuable intangible assets and the other parties (the supply

points) owned virtually none. Instead, he elected to apply a “comparable profits

method” (CPM) using independent Coca-Cola bottlers as parties comparable to the

supply points.

In the initial report that he prepared for the IRS, Dr. Newlon selected 18 in-

dependent Coca-Cola bottlers, headquartered in 10 different countries, that had

- 80 -

qualified auditors’ opinions for 2007-2009.27 He concluded that a “return on oper-

ating assets” (ROA) derived from these bottlers’ operations would yield appropri-

ate adjustments to the supply points’ income. He believed that such adjustments

would be conservative because the bottlers, which “possessed distribution net-

works and customer relationships,” had more bargaining power than the supply

points, which could be (and often were) terminated by petitioner at will.

Dr. Newlon began his analysis by calculating the 18 bottlers’ operating in-

come and operating assets, all of which he stated in their local currencies. He then

divided operating income by operating assets to determine an ROA for each bot-

tler. His results appear in the following table:28

A B C

Bottler Operating income Operating assets ROA%

home Bottler (% of net revenue) (% of net revenue) (A÷B)

Chile Embotelladora Andina S.A. 18.0 41.2 43.6

Mexico Coca-Cola FEMSA, S.A.B. de C.V. 17.5 43.1 40.6

Mexico Grupo Continental, S.A.B. 18.1 50.0 36.2

Chile Coca-Cola Embonor S.A. 19.5 60.2 32.5

Mexico Embotelladoras Arca S.A.B. de C.V. 18.8 59.1 31.8

Australia Coca-Cola Amatil Limited 18.4 67.1 27.3

Spain Compania Nortena de Bebidas Gaseosas, S.A. 9.3 38.2 24.5

Chile Embotelladoras Coca-Cola Polar S.A. 13.7 57.1 24.0

USA Coca-Cola Enterprises, Inc. 8.6 47.2 18.1

27

As discussed infra p. 136, Dr. Newlon in his expert witness report

expanded his analysis to include six additional independent Coca-Cola bottlers.

28

To avoid showing results in ten different currencies, the table shows each

bottler’s operating income and operating assets as a percentage of its net revenue.

- 81 -

Turkey Coca-Cola Icecek A.S. 12.3 68.4 17.9

Greece Coca-Cola Hellenic Bottling Company S.A. 11.1 66.2 16.8

USA Coca-Cola Bottling Co. Consolidated 6.1 42.4 14.4

Nigeria Nigerian Bottling Co. PLC 6.8 60.3 11.2

Japan Mikuni Coca-Cola Bottling Co., Ltd. 3.4 45.9 7.4

Japan Coca-Cola West Holdings Company, Ltd. 2.6 54.2 4.8

Japan Shikoku Coca-Cola Bottling Co., Ltd. 2.0 55.1 3.7

Thailand Haad Thip Public Company Ltd. 1.8 60.8 2.9

Japan Hokkaido Coca Cola Bottling Co., Ltd. 0.5 46.2 1.6

Dr. Newlon observed that the five East Asian bottlers had the lowest ROAs,

suggesting that they might be subject to uniquely local market conditions. He also

observed that Latin American bottlers tended to have very high ROAs. To test the

sensitivity of his analysis to regional differences, he segmented the bottlers as fol-

lows: (1) all 18 bottlers; (2) non-East Asian bottlers; (3) Latin American bottlers;

and (4) non-East Asian bottlers outside Latin America. He determined interquar-

tile range ROAs for the bottlers in each segment as follows:

Interquartile range ROA (2007-2009)

Bottler segment 25th Percentile Median 75th Percentile

All bottlers (18) 7.4% 18.0% 31.8%

Non-East Asian bottlers (13) 17.9% 24.5% 32.5%

Latin American bottlers (6) 31.8% 34.3% 40.6%

Non-East Asian bottlers outside

Latin America (7) 14.4% 17.9% 24.5%

Dr. Newlon then calculated ROAs for the supply points. He determined

their operating assets in essentially the same manner as for the bottlers but added

an imputed asset equal to an estimated average of the supply point’s inter-com-

- 82 -

pany receivables. He then divided operating income by operating assets to yield

ROAs as follows:

Return on operating assets (ROA)

2007-2009

Supply point 2007 2008 2009 Average

Ireland 189.5% 227.3% 227.9% 214.4%

Brazil 175.4% 198.4% 167.5% 179.7%

Chile 150.7% 159.2% 138.9% 148.6%

Costa Rica 128.0% 168.0% 132.7% 143.0%

Swaziland 103.7% 118.5% 161.8% 128.5%

Mexico 86.8% 100.2% 96.1% 94.1%

Egypt -38.8% 2.5% 17.9% -4.3%

Because the first six supply points had ROAs that dwarfed those of their

bottling counterparts, Dr. Newlon concluded that the supply points had received

compensation in excess of an arm’s-length amount. He accordingly recommended

that the IRS: (1) adjust the income of the Brazilian, Chilean, Costa Rican, and

Mexican supply points downward to reflect an ROA consistent with the ROAs of

the Latin American bottler segment; (2) adjust the income of the Irish and Swazi

supply points downward to reflect an ROA consistent with the ROAs of the bot-

tlers generally; and (3) adjust the income of the Egyptian supply point upward for

2007 and 2008.

The IRS implemented adjustments consistent with Dr. Newlon’s recommen-

dations. It adjusted the income of the Brazilian, Chilean, Costa Rican, and Mexi-

- 83 -

can supply points downward to reflect the median ROA of the Latin American

bottler segment. And it adjusted the income of the Irish and Swazi supply points

downward to reflect the median ROA of the 13 non-East Asian bottlers. To the

extent a supply point reported income that exceeded its benchmark, the IRS deter-

mined that additional royalty income should be allocated to petitioner from that

supply point. The IRS calculated the additional royalties due to petitioner (in

millions of U.S. dollars) as follows:

From

supply point 2007 2008 2009 2007-2009

Ireland $1,862 $2,223 $2,105 $6,190

Brazil 535 629 604 1,768

Swaziland 146 150 257 554

Mexico 155 180 160 496

Chile 126 152 161 439

Costa Rica 42 59 41 141

Egypt (67) (28) -0- (95)

Total 2,799 3,366 3,329 9,494

The IRS issued petitioner a timely notice of deficiency reflecting these ad-

justments, and petitioner timely sought review in this Court. Following discovery,

respondent amended his answer to assert additional deficiencies related to peti-

tioner’s practice of “split invoicing.” The ServCos that benefited from split in-

voicing received compensation from the participating bottlers at rates that were

higher (on average) than the rates specified in the agreements those ServCos had

executed with Export. See supra p. 66. Concluding that the ServCo agreements

- 84 -

with Export reflected arm’s-length norms, the IRS alleged that any “excess in-

come” that a ServCo received from a bottler--i.e., compensation in excess of a

modest markup on non-DME expenses--should be reallocated to petitioner.

In his amended answer respondent asserted increased deficiencies with re-

spect to six ServCos that had received split invoicing payments, were not branches

of TCCC or Export, and had received “excess income” from bottlers.29 For the

Turkish ServCo, respondent defined “excess income” as income in excess of the

8% markup specified in its bottler agreement. For the other five ServCos, which

lacked written agreements with their bottlers, respondent defined “excess income”

as income in excess of a 5% markup on non-DME expenses. Those adjustments

yielded reallocations of income from the ServCos to petitioner as follows:

Reallocations to TCCC

ServCo 2007 2008 2009 Total

Venezuelan ServCo $50,072,015 $75,126,507 $158,699,922 $283,898,445

Colombian ServCo 7,553,181 19,590,854 19,464,437 46,608,472

Turkish ServCo 17,096,848 23,312,865 N/A 40,409,713

Peruvian ServCo-1 5,634,297 2,190,786 1,310,070 9,135,154

Peruvian ServCo-2 N/A 2,994,835 1,656,940 4,651,774

Ecuadorian ServCo N/A 540,141 199,660 739,800

Total reallocation 80,356,341 123,755,988 181,331,029 385,443,358

29

Respondent made no adjustment on account of the Bolivian or Moroccan

ServCos, presumably because those entities were branches of Export, a U.S. cor-

poration, so that petitioner had already received any “excess income” the bottlers

had paid them.

- 85 -

These adjustments produced additional deficiencies totaling $134,905,174 for the

three years.

OPINION

I. Burden of Proof

The Commissioner’s determinations in a notice of deficiency are generally

presumed correct, and the taxpayer has the burden of proving them erroneous. See

Rule 142(a); Blohm v. Commissioner, 994 F.2d 1542, 1548-1549 (11th Cir. 1993),

aff’g T.C. Memo. 1991-636. Petitioner does not urge any shift in the burden of

proof under section 7491. For purposes of assigning the burden of proof in a

transfer pricing case, we have treated respondent’s “determination” as the aggre-

gate section 482 adjustment appearing in the notice of deficiency. See Seagate

Tech., Inc. v. Commissioner, 102 T.C. 149, 170-172 (1994).

The presumption of correctness does not extend to, and respondent bears the

burden of proof in respect of, “any new matter, increases in deficiency, and affirm-

ative defenses” pleaded in his answer. Rule 142(a)(1). In his amended answer, re-

spondent asserted increased deficiencies totaling $134,905,174 for 2007-2009, all

attributable to petitioner’s use of “split invoicing.” Respondent bears the burden

of proof with respect to these increases in deficiency.

- 86 -

II. Standard of Review

Section 482 has its genesis in a provision of the Revenue Act of 1926 that

authorized the Commissioner to “consolidate the accounts” of related parties. Sec-

tion 240(f) of that Act provided that “the Commissioner may and at the request of

the taxpayer shall” consolidate the accounts of related trades or businesses “if

necessary in order to make an accurate distribution or apportionment of gains,

profits, income, deductions, or capital between or among such related trades or

businesses.” Revenue Act of 1926, ch. 27, sec. 240(f), 44 Stat. at 46; see Ray-

mond Pearson Motor Co. v. Commissioner, 246 F.2d 509, 515 (5th Cir. 1957)

(Hutcheson, C.J., concurring), rev’g T.C. Memo. 1955-260. The Commissioner’s

determination to “consolidate accounts” was subject to judicial review. See Now-

land Realty Co. v. Commissioner, 47 F.2d 1018, 1021 (7th Cir. 1931), aff’g 18

B.T.A. 405 (1929). But in drafting section 240(f) Congress left “some discretion

* * * in the [C]ommissioner, and the exercise of that discretion c[ould] only be

disturbed when an abuse of it [wa]s shown.” Ibid.

In 1928 Congress repealed section 240(f) and replaced it with the predeces-

sor of section 482. See Revenue Act of 1928, ch. 852, sec. 45, 45 Stat. at 806.

Section 45 of the 1928 Act provided:

- 87 -

In any case of two or more trades or businesses * * * owned or

controlled directly or indirectly by the same interests, the Commis-

sioner is authorized to distribute, apportion, or allocate gross income

or deductions between or among such trades or businesses, if he de-

termines that such distribution, apportionment, or allocation is neces-

sary in order to prevent evasion of taxes or clearly to reflect the in-

come of any of such trades or businesses.

Whereas the “consolidated account” provision had permitted the Commis-

sioner to take action “if necessary” to apportion income accurately, section 45 au-

thorized him to take action “if he determines that such distribution, apportionment,

or allocation is necessary.” The Senate Finance Committee explained that, while

section 45 was “based upon section 240(f) of the 1926 Act,” the provision was

“broadened considerably in order to afford adequate protection to the Govern-

ment.” S. Rept. No. 70-960 (1928), 1939-1 C.B. (Part 2) 409, 426.

We addressed the proper interpretation of section 45 of the 1928 Act in Asi-

atic Petroleum Co. v. Commissioner, 31 B.T.A. 1152 (1935), aff’d, 79 F.2d 234

(2d Cir. 1935).30 We emphasized that “[t]he statute authorizes the Commissioner

to make an allocation of income or deductions ‘if he determines that such * * *

allocation is necessary.’” Id. at 1157 (alteration in original). This statement indi-

30

We have treated as our own the precedent established by the Board of Tax

Appeals, the predecessor of this Court. See Smith v. Commissioner, 91 T.C. 1049,

1053 (1988), aff’d, 926 F.2d 1470 (6th Cir. 1991); see also Tax Reform Act of

1969, Pub. L. No. 91-172, sec. 951, 83 Stat. at 730; Revenue Act of 1942, ch. 619,

sec. 504(a), 56 Stat. at 957.

- 88 -

cated that an allocation of this sort was “a matter of discretion with the Commis-

sioner.” Ibid. “In matters intrusted to the discretion of administrative officers,”

we said, “there is a heavy burden on him who claims error in its exercise.” Ibid.

In Asiatic Petroleum we analogized section 45 of the 1928 Act to section

22(c) of the same law. Section 22(c) provided, as section 471(a) currently pro-

vides, that inventories shall be taken “[w]henever in the opinion of the Commis-

sioner the use of inventories is necessary in order clearly to determine the income

of any taxpayer.” See Hamill v. Commissioner, 30 B.T.A. 955, 958 (1934) (quot-

ing sec. 22(c) of the 1928 Act). We concluded that the standard of review under

section 45 should resemble that under section 22(c), citing a passage from an

inventory case--Fin. & Guar. Co. v. Commissioner, 50 F.2d 1061, 1062 (4th Cir.

1931), aff’g 19 B.T.A. 1313 (1930)--as enunciating the appropriate test:

Where a statute commits to an executive department of the govern-

ment a duty requiring the exercise of administrative discretion, the

decision of the executive department, as to such questions, is final

and conclusive, unless it is clearly proven arbitrary or capricious, or

fraudulent, or involving a mistake of law. [Asiatic Petroleum Co., 31

B.T.A. at 1157.]

We held in Asiatic Petroleum that, because the Commissioner had “exercised the

discretionary power vested in him and determined that allocation [wa]s neces-

- 89 -

sary,” the taxpayer had “the burden of showing that such determination was purely

arbitrary.” Id. at 1158.

That standard of review continues to apply today. Section 482 provides,

similarly to section 45 of the 1928 Act, that “the Secretary may distribute, appor-

tion, or allocate gross income, deductions, credits, or allowances between or a-

mong * * * [related] organizations, trades, or businesses, if he determines that

such distribution, apportionment, or allocation is necessary in order to prevent

evasion of taxes or clearly to reflect the income of any such * * * [entities].” In

order to set aside such discretionary action by the Commissioner, “a taxpayer must

establish that the Commissioner abused his discretion by making allocations that

are arbitrary, capricious, and unreasonable.” Guidant LLC v. Commissioner, 146

T.C. 60, 73 (2016); accord Amazon.com, Inc. & Subs. v. Commissioner, 148 T.C.

108, 150 (2017) (“The Commissioner has broad discretion in applying section

482, and we will uphold his determination unless the taxpayer shows it to be arbi-

trary, capricious, or unreasonable.”), aff’d, 934 F.3d 976 (9th Cir. 2019); Bausch

& Lomb, Inc. & Consol. Subs. v. Commissioner, 92 T.C. 525, 582 (1989) (ruling

that the Commissioner’s “section 482 determination must be sustained absent a

showing that he has abused his discretion”), aff’d, 933 F.2d 1084 (2d Cir. 1991).

- 90 -

Our determination whether the Commissioner has abused his discretion gen-

erally turns upon questions of fact. See Amazon.com, Inc., 148 T.C. at 150 (citing

cases); Paccar, Inc. & Subs. v. Commissioner, 85 T.C. 754, 787 (1985), aff’d, 849

F.2d 393 (9th Cir. 1988). “If the record before this Court fails to support the allo-

cation, then we must conclude that the Commissioner abused his discretion.”

Marc’s Big Boy-Prospect, Inc. v. Commissioner, 52 T.C. 1073, 1092 (1969), aff’d

sub nom. Wis. Big Boy Corp. v. Commissioner, 452 F.2d 137 (7th Cir. 1971).

“But if there is substantial evidence supporting the determination, it must be aff-

irmed.” Ibid.; see Advance Mach. Exch., Inc. v. Commissioner, 196 F.2d 1006,

1007-1008 (2d Cir. 1952), aff’g 8 T.C.M. (CCH) 84 (1949).

In considering whether the Commissioner abused his discretion, we have of-

ten said that our review “focuses on the reasonableness of the [Commissioner’s]

result and not on the details of the methodology” he employed. Guidant LLC, 146

T.C. at 73.31 A taxpayer may show that the Commissioner reached an unreasona-

ble result by establishing that its income as reported reflects “the results that

would have been realized if uncontrolled taxpayers had engaged in the same trans-

31

Accord Altama Delta Corp. v. Commissioner, 104 T.C. 424, 457 (1995);

Sundstrand Corp. v. Commissioner, 96 T.C. 226, 354 (1991); Bausch & Lomb,

Inc., 92 T.C. at 582; Leedy-Glover Realty & Ins. Co. v. Commissioner, 13 T.C. 95,

107 (1949), aff’d, 184 F.2d 833 (5th Cir. 1950).

- 91 -

action under the same circumstances.” Sec. 1.482-1(b)(1), Income Tax Regs. But

that typically requires evidence of comparable uncontrolled transactions that sup-

port the taxpayer’s return position. See Lufkin Foundry & Mach. Co. v. Commis-

sioner, 468 F.2d 805, 807-808 (5th Cir. 1972), rev’g on other grounds T.C. Memo.

1971-101.

In cases such as this, involving unique and extremely valuable intangible

property, comparable uncontrolled transactions may not exist. In order to show

that the Commissioner has reached an unreasonable result in such a case, the tax-

payer typically will need to establish that the Commissioner employed an unrea-

sonable methodology to reach his result. A taxpayer may do this by showing that

the Commissioner’s methodology implicated significant legal error.32 Alternative-

ly, the taxpayer may show that the Commissioner implemented his methodology in

32

See, e.g., Commissioner v. First Sec. Bank of Utah, 405 U.S. 394, 407

(1972) (finding Commissioner’s allocation of income to bank unwarranted be-

cause bank’s receipt of that income would have violated banking laws); Ama-

zon.com., Inc., 148 T.C. at 157-158 (finding Commissioner’s enterprise valuation

method arbitrary because it included growth options and other residual business

assets that were not “intangibles” for purposes of sec. 482); Hosp. Corp. of Am. &

Subs. v. Commissioner, 81 T.C. 520, 595 (1983) (finding Commissioner’s 100%

reallocation unreasonable because “section 482 does not authorize an allocation

that would in effect disregard the separate corporate existence” of a related foreign

corporation); L.E. Shunk Latex Prods., Inc. v. Commissioner, 18 T.C. 940 (1952)

(finding Commissioner’s method arbitrary because it allocated income to an entity

prevented by wartime price controls from receiving such income).

- 92 -

an unreasonable manner, e.g., by employing erroneous assumptions, incorrect

data, or an analysis that is internally inconsistent.33

If the taxpayer demonstrates that the Commissioner’s allocation is arbitrary,

capricious, or unreasonable, but fails to prove an alternative allocation that meets

the arm’s-length standard, the Court, using its best judgment, “must determine

from the record the proper allocation of income.” Sundstrand Corp. v. Commis-

sioner, 96 T.C. 226, 354 (1991); see Hosp. Corp. of Am. & Subs. v. Commission-

er, 81 T.C. 520, 596-597, 601 (1983); Nat Harrison Assocs., Inc. v. Commissioner,

42 T.C. 601, 617-618 (1964) (determining a proper allocation “without the benefit

of any presumptions” after finding the Commissioner’s allocation unreasonable).

We may make partial allocations to the extent “the evidence shows that neither

side is correct.” Eli Lilly & Co. v. Commissioner, 856 F.2d 855, 860 (7th Cir.

1988), rev’g in part on other grounds 84 T.C. 996 (1985); see Amazon.com, Inc.,

33

See, e.g., Veritas Software Corp. & Subs. v. Commissioner, 133 T.C. 297,

323-327 (2009) (finding allocations based on a discounted cashflow methodology

unreasonable where the Commissioner “employed the wrong useful life, the wrong

discount rate, and an unrealistic growth rate”); Altama Delta Corp., 104 T.C. at

466 (finding allocations unreasonable where the Commissioner implemented his

cost-plus method by marking up operating profit margins instead of gross profit

margins); Seagate Tech., Inc., 102 T.C. at 192 (rejecting expert’s pricing of com-

ponent parts upon finding that his methodology “d[id] not meet the description of

the cost-plus method” in the regulations); Achiro v. Commissioner, 77 T.C. 881,

900 (1981) (rejecting the Commissioner’s allocation where he made no “reason-

able attempt[] to reflect arm’s-length transactions among the related entities”).

- 93 -

148 T.C. at 163-214 (making partial allocations with respect to buy-in payment for

taxpayer’s website technology, marketing intangibles, and customer information).

III. Threshold Considerations

A. The 1996 Closing Agreement

At the outset petitioner urges that the IRS acted arbitrarily by deviating from

the 10-50-50 method, to which the parties had agreed when executing the closing

agreement in 1996. Generally, the Commissioner’s discretion to reallocate income

under section 482 is limited only by the arm’s-length standard. But the Commis-

sioner may voluntarily limit his discretion in certain ways, e.g., by entering into an

advanced pricing agreement (APA). See Eaton Corp. v. Commissioner, 140 T.C.

410, 413 (2013). He may also restrict his discretion by executing a closing agree-

ment under section 7121. In 1996 the parties settled a transfer pricing dispute in-

volving petitioner’s 1987-1995 tax years and embodied the terms of that settle-

ment in a closing agreement.

Closing agreements are contracts and are “governed by the rules applicable

to contracts generally.” United States v. Lane, 303 F.2d 1, 4 (5th Cir. 1962); see

Long v. Commissioner, 93 T.C. 5, 10 (1989), aff’d, 916 F.2d 721 (11th Cir. 1990).

Closing agreements are construed according to the intent of the parties when exe-

cuting the agreement, and their intent will be inferred from the four corners of the

- 94 -

document unless it is ambiguous. Ibid. “Under section 7121 a court may not in-

clude as part of the agreement matters other than the matters specifically agreed

upon and mentioned in the closing agreement.” Analog Devices, Inc. v. Commis-

sioner, 147 T.C. 429, 445 (2016) (quoting Zaentz v. Commissioner, 90 T.C. 753,

766 (1988)).

The recitals to the 1996 closing agreement stated that: (1) petitioner owned

“intangible property that is used by Supply Points in connection with the manufac-

ture and marketing of concentrates”; (2) a dispute arose “regarding the allocation

of Product Royalty income between Supply Points and [petitioner]”; and (3) the

parties “have agreed on a method for computing the arm’s length amount of the

Product Royalties.” The body of the agreement details the 10-50-50 method as the

agreed formula for determining “Product Royalties” for tax years 1987-1995.

The short and (we think) the complete answer to petitioner’s argument is

that the closing agreement says nothing whatever about the transfer pricing meth-

odology that was to apply for years after 1995. Parties to a closing agreement may

(and sometimes do) bind themselves to particular tax treatments for specified fu-

ture years. For its part, petitioner may have desired the certainty that would arise

from indefinite future application of the 10-50-50 method. But there is no evi-

dence in the document that the IRS shared that desire or agreed to implement it.

- 95 -

Petitioner urges that the closing agreement was predicated on certain “fac-

tual underpinnings,” including a “recogni[tion]” by the IRS that the supply points

“were responsible for generating demand and were entitled to share in the result-

ing profits related to the * * * [Company’s] intangibles.” These “factual underpin-

nings,” petitioner says, are binding on the Commissioner unless he can show some

material change in underlying fact.

This argument is unpersuasive for at least two reasons. First, we do not dis-

cern in the closing agreement the “factual underpinnings” that petitioner seeks to

extract from it. The parties executed the closing agreement to settle a dispute.

Parties agree to settlements for all sorts of reasons--to avoid the hazards of litiga-

tion, to minimize litigation costs, or to seek other fish to fry. There is nothing

within the four corners of the closing agreement to suggest that the Commissioner

regarded the 10-50-50 method as the Platonic ideal of arm’s-length pricing for pe-

titioner and its supply points. The 10-50-50 method was simply a formula to

which the parties agreed in settling the dispute before them at that moment. The

only mention of “arm’s length” in the closing agreement appears in a preliminary

recital, which is not binding on the parties. See Analog Devices, Inc., 147 T.C. at

446; see also Rev. Proc. 68-16, sec. 6.05(3), 1968-1 C.B. 770, 779.

- 96 -

Second, even if we could confidently extract any factual underpinnings

from the closing agreement, there is no evidence that the parties intended them to

be binding for future years. Petitioner urges that “ordinary preclusion doctrines”

prevent parties “from revisiting a [settlement] agreement’s factual underpinnings

in later litigation when the parties intend their agreement to have that preclusive

effect.” But in so contending petitioner assumes what it needs to prove--that the

parties in 1996 intended to address the appropriate transfer pricing methodology

for years after 1995 and embodied that intent in the closing agreement. See Ari-

zona v. California, 530 U.S. 392, 414 (2000) (noting that “settlements ordinarily

occasion no issue preclusion * * * unless it is clear * * * that the parties intend

their agreement to have such an effect”), supplemented by 531 U.S. 1 (2000).

Petitioner notes that the closing agreement was intended to have some pro-

spective effect because it granted the Company penalty protection for future years,

providing:

For taxable years after 1995, to the extent the Taxpayer applies the

[10-50-50] method to determine the amount of its reported Product

Royalty income with respect to existing or any future Supply Points,

the Taxpayer shall be considered to have met the reasonable cause

and good faith exception of sections 6664(c) and 6662(e)(3)(D) * * *

and shall not be subject to the accuracy-related penalty under section

6662 * * * with respect to the portion of any underpayment that is

attributable to an adjustment of such Product Royalty.

- 97 -

We think this provision hurts, rather than helps, petitioner. It shows that the

parties knew how to make the closing agreement conclusive for future years when

they wished to do so. “[W]here the specificity and apparent comprehensiveness of

an agreement’s enumeration of a category of things * * * implies that things not

enumerated are excluded, we will apply the canon expressio unius est exclusio

alterius.” BMC Software, Inc. v. Commissioner, 780 F.3d 669, 676 (5th Cir.

2015), rev’g on other grounds 141 T.C. 224 (2013).34 Indeed, the agreement spe-

cifically recognizes the possibility that the IRS might make transfer pricing adjust-

ments for years after 1995, because it gives petitioner penalty protection “with re-

spect to the portion of any underpayment that is attributable to an adjustment of

such Product Royalty.”

Petitioner seeks to frame this issue as if the IRS has pulled the rug out from

under it. After executing the 1996 closing agreement petitioner took steps to mini-

mize its exposure to VAT and income tax in Europe and elsewhere. And it viewed

the closing agreement as “facilitat[ing] the shift of concentrate supply among for-

eign * * * [supply points] to meet [its] business exigencies.” Certain of these ac-

34

Accord, e.g., Smith v. United States, 850 F.2d 242, 245 (5th Cir. 1988)

(finding that closing agreement that did not address penalties was not ambiguous

and did not bar IRS from later demanding penalties); Analog Devices, Inc. &

Subs. v. Commissioner, 147 T.C. 409, 455 (2016), overruling BMC Software, Inc.

v. Commissioner, 141 T.C. 224 (2013).

- 98 -

tions are unhelpful to its central submission in this case--that the supply points

owned immensely valuable off-book intangible assets that justified the extraordi-

narily high profits they enjoyed. See infra pp. 157-158, 168, 186-187.

In essence, petitioner urges that it relied to its detriment on a belief that the

IRS would adhere to the 10-50-50 method indefinitely. But petitioner cannot es-

top the Government on the basis of a promise that the Government did not make.

See Union Equity Coop. Exch. v. Commissioner, 58 T.C. 397, 408 (1972) (“The

mere fact that * * * [the taxpayer] may have obtained a windfall in prior years

does not entitle it to like treatment for the taxable year[s] here in issue[.]”), aff’d,

481 F.2d 812 (10th Cir. 1973); see also ATL & Sons Holdings, Inc. v. Commis-

This text is long and has been trimmed here. Open the source document for the complete record.