Coke Stock Already Reflects Worst Case Scenario for Tax Dispute

Reading Time: 5 minutes

Coke has taken a hit due to a long-battled tax dispute with the IRS. A recent court decision is saying Coca-cola needs to pay $3.4BN in additional taxes.

The tax dispute stems from the way Coke charges royalty-rates internally. Under the IRS’ method, Coke should have earned $9BN more in US taxable income and therefore owes $3.4BN (given tax rates were higher during the in-question years of 2007-2009).

In other words, the IRS is saying Coke was trying to shift US taxable income to lower tax areas to avoid paying higher taxes. Tax disputes are no joke and Coke stock has materially underperformed.

Coke tax dispute has caused the stock to underperform meaningfully

I’ll let Taft Law explain the situation (my emphasis):

The Coke tax dispute centered on whether the price or “royalty rate” charged to the licensee was consistent with the arm’s-length pricing standard…. For the years before the court case, Coca-Cola established its transfer price using the same methodology that resulted from a prior settlement with the IRS (executed in 1996, concerning taxable years 1987-1995). The methodology used to reach that settlement was consistently applied by the company in the intervening future years, including the years before the court case. The IRS’s litigating position was that the company’s pricing methodology “overpaid” the related foreign manufacturers and thereby shifted income from the U.S. parent group to the foreign jurisdictions.

…[T]he IRS proposed to adjust the transfer price owing from the U.S. to the foreign affiliates in order to conform with the so-called comparable profits method (CPM). Under the CPM, the IRS determined Coca-Cola’s foreign affiliates should essentially earn a profit comparable to unrelated bottling companies. Coca-Cola responded that the change in method was arbitrary and capricious, as evidenced by the fact that the IRS had previously examined and accepted the company’s existing method for a decade, and that the CPM method was misapplied by the IRS. Ultimately, the court sided with the IRS in allowing the adjustments, holding that the IRS determinations were not arbitrary, capricious, or unreasonable.

Look, I’m not a lawyer, but Coke probably has tons of them. And they actually hired a former US federal judge and general counsel for Boeing. I thought his statement was pretty strong:

For 20 years, The Coca-Cola Company reported U.S. taxable income from its non-U.S. operations under a methodology agreed to by the IRS and repeatedly audited and approved by the IRS. In an abrupt departure from its established position long after the tax years in question, the IRS reversed its position, disapproved that approved methodology, required a new tax calculation methodology, and now seeks to impose a retroactive tax increase on the company for past tax years.

It seems unfair to me that the IRS would agree to a methodology and then in the future say you weren’t paying enough. Indeed, the judge also has a comment on that:

American companies cannot run their businesses with the uncertainty of the retroactive application of newly minted IRS tax policies to prior tax years that are contrary to the IRS’ own previously approved policies and then be required to pay billions of dollars in unanticipated increased taxes that result from the retroactive application of these new tax policies.

Admittedly, the counter argument (i.e. the one made by the IRS) does have additional points as well.

The Judge that favored the IRS noted the transactions within Coke were clearly not arm’s length. Coke said the bottlers should not be taxed at similar returns on capital to others because of “immensely valuable intangible assets.” The Jude responded by asking then why their profitability “dwarfed” Coca-Cola’s even though Coca-Cola owned the intangibles which the profits depended.

So look, I have sympathy with Coke in this tax dispute. I bet you a lot of global American businesses are shuddering right now based on the precedent this tax dispute with Coke establishes.

But this ruling has gone against Coca-Cola so far so we need to frame the worst case scenario.

I think Coke will continue to battle this ruling, plus they will settle for a fraction of this amount owed. However, based on my estimates, I think the market is already pricing in the worst case.

Coke’s stock peaked out at around $54.84 in Dec 2020. That’s also below the $60/share it was pre-pandemic (as Coke has clearly been hit by COVID).

So at today’s price of $48.70 compared to $54.84, the market has priced in $26.4BN of lost value.

Lost value from coke tax dispute
Lost value from coke tax dispute

Wait, $26.4BN of lost value for a $3.4BN tax dispute? What else am I missing?

First, late interest. If Coke has to pay these taxes, it also has to pay interest because the government hasn’t had that money. So ~$3.4BN of back taxes from 2007, 2008 and 2009 would be roughly an additional $3BN dollars.

Ok, now we’re at $6.4BN in taxes + interest. Is that it?

If we want to estimate the worst case, then we also need to say this applies to all the other years: 2010 to 2020.

I’m going to do some estimates here:

  • I estimate the dollars of earnings misallocated to Non-US segments in the financials during 2007-2009. This amounts to ~43% of non-US pre-tax earnings (shown in the table below). I backed into this by taking the estimated back taxes owed during those years and using the 35% tax rate
  • I use that same 43% of non-US earnings going forward and 35% tax rate (except for the later years where the federal tax rate drops to 21%) to arrive at a rough number of what else was misallocated.

By my estimates, the worst case situation here is Coke owes $24BN consisting of back taxes + interest. So this is already more than priced into the market.

Estimate of Back Taxes + Interest for Coke Tax Dispute
Estimate of Back Taxes + Interest for Coke Tax Dispute

The market is pricing in much more than necessary. As the WSJ reported originally:

Mr. Willens, the tax consultant, said such transfer pricing disputes typically are resolved out of court, typically for a fraction of the amount that the IRS is seeking.

Coke will probably settle this tax dispute eventually and try to move on. If I’m thinking in probabilities, I bet it will be a lot lower than $24BN. With a price tag like that, the IRS knows that Coke is actually incentivized to “kick the can” as long as possible.



Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.