[Opinion] Revisiting Historical Transfer Pricing – Lessons from a $9 Billion IRS Dispute

Amer Qureshi & Poojan Choudhary – [2025] 174 taxmann.com 922 (Article)

1. Introduction

Transfer Pricing (“TP”) lies at the heart of international taxation, governing the pricing of transactions between related entities within a Multinational Enterprise (“MNE”). These inter-company transactions, ranging from the sale of goods and services to the licensing of Intangible Property (“IP”), must adhere to the “arm’s length principle,” ensuring that the terms reflect what unrelated parties would agree upon in similar circumstances. However, determining the appropriate allocation of income and expenses across jurisdictions is often complex and subjective, especially when IP and varying functional profiles are involved.

The Organisation for Economic Co-operation and Development TP Guidelines 2022 (“OECD TPG”) emphasise the need for economic substance when determining the arm’s length nature of inter-company transactions. Accordingly, TP methods should reflect the actual economic substance of the transactions, rather than relying solely on past practices or contractual arrangements that may no longer be aligned with current market realities or evolving tax policy. This shift towards economic substance highlights the importance of understanding the risks, functions, and assets involved in a transaction, rather than relying on historical pricing practices that may have been acceptable in the past but do not fully reflect the current economic landscape. In this context, Revenue authorities in some countries have been increasingly scrutinising arrangements that may have previously been deemed compliant, challenging assumptions behind longstanding TP policies and their alignment with the arm’s length standard. This evolving perspective reflects broader international efforts to prevent Base Erosion and Profit Shifting (“BEPS”), which underscores the need for MNEs to regularly reassess their TP policies in light of prevailing market conditions and regulatory expectations.

This article examines a recent case which exemplifies this tension and shows how long-standing pricing policies, even those once sanctioned by the Revenue authorities, may come under scrutiny in a changing enforcement landscape. The dispute centers around the allocation of profits from IPs which was historically accepted by the relevant Revenue authorities and subsequently challenged, leading to significant TP adjustments and prolonged litigation.

2. US Tax Court Ruling

Factual matrix of the case

The case concerned a US-headquartered MNE group, wherein a US corporation(hereinafter referred as “ABC US”) was the legal owner of the IP necessary to manufacture, distribute, and sell some of the best-known beverage brands in the world. This IP included trademarks, brand names, logos, patents, secret formulas, and proprietary manufacturing processes. ABC US licensed such IP to its foreign manufacturing affiliates (hereinafter referred as “Supply Points”) to produce concentrate that the Supply Points sold to bottlers (most of the bottlers being independent of ABC US), who used this concentrate to produce finished beverages for sale to distributors and retailers throughout the world. The contracts of ABC US with its Supply Points gave the latter limited rights to use the IP in performing their manufacturing and distribution functions and granted the Supply Points no ownership interest in that IP.

During 2007-2009, the Supply Points compensated ABC US for use of latter’s IP by adopting a formulary apportionment approach using the “10-50-50 method”, as it had done for over a decade. This method permitted the Supply Points to retain profit equal to 10% of their gross sales, with the remaining profit being split 50%-50% with ABC US. Further, under this method, the Supply Points were permitted to satisfy their royalty obligations by paying actual royalties or by remitting dividends. This method was agreed between ABC US and US Internal Revenue Service (“IRS”) in a closing agreement executed in 1996 to resolve the tax liabilities of ABC US for the period 1987-1995. However, the closing agreement did not address what TP methodology would be used for years after 1995 and ABC US continued to employ the 10-50-50 method, from 1996 onwards, to report income from its foreign Supply Points.

3. Issue Involved and the Ruling

Upon examination of returns of ABC US for 2007-2009, the IRS changed its historical stand and concluded that the 10-50-50 method did not reflect arm’s-length pricing because it overcompensated the Supply Points and undercompensated ABC US for the use of the latter’s IPs. The primary contention was that ABC US owned virtually all the IPs needed to produce and sell the soft-drink beverages and that the Supply Points functioned essentially as contract manufacturers. The IRS used Comparable Profits Method (“CPM”), adopted Return on Assets as the Profit Level Indicator, and used independent bottlers as parties comparable to the Supply Points, thereby making an adjustment. The adjustment by IRS increased the aggregate taxable income of ABC US for 2007-2009 by more than US$9 Billion.

On its part, among other things, ABC US contended that the Supply Points invested significant amounts in marketing to cultivate consumer demand for the beverages (thereby generating marketing intangibles) and therefore the CPM was not the best TP method. Further, ABC US argued that bottlers were not comparable to Supply Points since bottlers operate at different levels of the marketplace, have different functional profile, etc.
Despite adhering to the 10-50-50 approach for over a decade in accordance with the closing agreement, the US Tax Court observed that the parties executed the closing agreement to settle a dispute at that point in time, which could be potentially for various reasons such as to avoid the hazards of litigation, to minimize litigation costs, or other considerations. Further, there was no evidence in the closing agreement that the parties intended it to be binding for future years.

The US Tax Court ruled in favor of IRS that the US-based income of ABC US should be increased by about US$9 Billion in a dispute over the appropriate royalties by its foreign-based licensees for the years from 2007-2009. However, the Tax Court reduced the IRS’ adjustment by US$1.8 Billion because ABC US made a timely choice to use an offset treatment when it came to dividends paid by foreign manufacturing affiliates to satisfy royalty obligations.

ABC US has filed an appeal before the Eleventh Circuit Court of Appeals and the matter is currently pending adjudication.

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