Eyal Bar-Zvi, LLB, LLM, BA (Eco), partner and head of the transfer pricing department, Herzog
Yossi Shebson, BA (Eco), transfer pricing department, Herzog

Coca-Cola has been at the center of several high-profile tax cases across the globe, including the Israeli tax courts, with rulings that have significant implications for international taxation and the concept of “special relationships”.

Transfer Pricing and Special Relationships

In many tax disputes, transfer pricing — the prices charged for goods and services between related entities within a multinational group — is a primary issue. However, the Coca-Cola case in Israel sheds light on a more nuanced concept: “special relationships” between entities, which goes beyond the typical related-party relationships defined in international tax laws. This additional focus on unrelated entities with a special relationship may be viewed as an extension of the arm’s length principle.

Under Israeli legislation, the arm’s length principle applies only to international transactions which fall under the transfer pricing regulations; however the Israeli Tax Authorities (“ITA“) have been applying the arm’s length principle also to transactions between related parties inside Israel (for example if the entities are under different tax rates due to their geographic locations inside Israel), either through the transfer pricing legislation or through other sections of the Israeli Tax Ordinance. This is somewhat similar the requirement in the US and the application of the arm’s length principle through transfer pricing, for transactions between related parties in different states.

The Israeli Transfer Pricing guidelines in Section 85A of the Israeli Tax Ordinance define a special relationship as including relationships between a person and his relative, as well as control of one party to a transaction over the other, or control of one person over the parties to the transaction, directly or indirectly, alone or together with another. However, as interpreted by the court, the term special relationships may also refer to situations where companies are not formally related through direct ownership or control but maintain interdependent or collaborative financial relationships that can influence their economic behavior, This notion is critical when assessing how profits are allocated between entities in different jurisdictions (and potentially within different tax zones in the same jurisdiction), particularly when one party may exert influence on another or be dependent upon the other, despite not having a formal related party connection.

The ITA argued that Coca-Cola’s business activities within Israel, through a privately held unrelated entity named the Central Bottling Company (the “Israeli Bottling Company” or “IBC“), its exclusive manufacturer and distributor in Israel, benefitted from special relationships that went beyond the contractual or legal obligations of a simple buyer-supplier relationship.

The crux of the case in Israel revolves around the pricing of the Coca-Cola concentrate, which is the base ingredient mixed with water and other components to create Coca-Cola’s soft drinks, that IBC purchases from an authorized U.S. Coca-Cola factory in Ireland. The ITA argued that the prices at which IBC buys the concentrate are artificially high or misaligned with market-based prices and include embedded royalties. Embedded royalties are payments made, for example for certain licenses or the use of a tradename or a trademark but are not defined as such and therefore allegedly circumvent the requirement to withhold taxes from payments of royalties.  Further, the ITA has suggested that the relationship between Coca-Cola and IBC reflects a special relationship. This notion encompasses not just the pricing of goods like the concentrate but also the economic dependencies and collaborative arrangements between the two companies.

The Coca-Cola concentrate is central to IBC’s operations, and this dependency, argues the ITA, gives Coca-Cola significant influence over IBC’s pricing strategies, market positioning, and even supply chain decisions. Further, the ITA claimed that part of the payments should be classified as consideration for the license to use Coca-Cola’s trademarks and intellectual property in marketing Coca-Cola drinks in Israel, as well as for example knowhow related to the manufacturing process. The court determined that, “In exchange for such a strong trademark with an accepted global reputation, it is customary to pay royalties.”.

Similarly, the Australian Tax Office (“ATO“) brought a case against Coca-Cola (and prior to this PepsiCo also faced a court-case on similar grounds which was appealed, and then overturned to ruled that PepsiCo was not liable at that case to royalty withholding tax), whereby Coca-Cola had an agreement with an Australian bottler, for the supply of the Coca-Cola concentrate used in the production of its beverages. The core issue was again, related to the pricing and supply terms of the concentrate, and alleged embedded royalties. The ATO prevailed in this ruling however this may be subject to an appeal.

Coca-Cola’s Global Tax Strategy Under Scrutiny

The Israeli case is part of a broader global scrutiny of Coca-Cola’s transfer pricing and supply chain practices. In other jurisdictions, like the United States, Coca-Cola’s method of allocating profits across its international subsidiaries has been challenged by tax authorities. Coca-Cola has been embroiled in cases in the United States and Ireland, as well as other jurisdictions worldwide, which provide important precedents for understanding how tax authorities approach multinational companies that operate across multiple jurisdictions.

For example, Coca-Cola’s operations in Ireland have long been a focal point in discussions about the role of low-tax jurisdictions in global tax strategies. The Irish subsidiary, Coca-Cola HBC, benefited from favorable tax rates, but the structure of its operations has led to scrutiny regarding how profits were reported. A similar case was brought by the IRS regarding the bottling company Coca-Cola owns in Mexico. In those cases too, the IRS claimed that Coca-Cola had improperly allocated profits to foreign subsidiaries, including through transfer pricing arrangements for the use of Coca-Cola’s intangible assets, such as trademarks, knowhow and brand value, not unlike the Israeli case.

Conclusion

In conclusion, the Coca-Cola ruling in Israel, as well as the rulings in other jurisdictions, highlight a potentially significant shift in the application of the arm’s length principle by extending its reach to include “special relationships” beyond traditional related-party dynamics. Whatever the ultimate final rulings after appeal, by merely recognizing the influence that interdependent financial relationships can have on profit allocation across jurisdictions, tax authorities may be on a path that could reshape international tax practices. As global scrutiny on transfer pricing intensifies, companies may face increased challenges in justifying their profit allocations even if the transaction is not between apparent related parties. Ultimately, this ruling could lead to more rigorous enforcement of tax compliance standards and an expansion of the arm’s length principle. Specifically, such rulings may question the normal distributorship practice of granting related parties’ and even unrelated parties, the right to (freely) use the owner’s tradename, trademark, and other intangibles, as part of the transaction itself and without the use of specific royalties’ payments.