International Tax Monthly June Issue


Coca-Cola’s Challenge to Huge Tax Bill Is Closely Watched

The Coca-Cola Company is disputing a $3.3 billion tax bill related to transfer pricing. The case in U.S. Tax Court is being watched by tax experts and is considered a sign of increasing tension between tax authorities around the world and multinational corporations.

According to media reports, Coca-Cola states in court filings that the IRS approved the company’s method for setting its transfer prices based on how much the company charged foreign affiliates for the rights to make and sell Coke products abroad. But the company claims that the IRS later withdrew that approval and issued the bill for back taxes. The agreement with the IRS was not an Advance Pricing Agreement (APA), but was described as an APA-like “audit closing agreement,” which was reaffirmed in later audits.

Resolving Disputes

An APA is an agreement between the IRS and a taxpayer determining a transfer pricing method for a transaction. The IRS developed the APA program to resolve highly factual transfer pricing issues in a principled, cooperative manner. A taxpayer voluntarily participates in the program in exchange for the IRS limiting its discretion to make transfer pricing adjustments.

In September 2015, Coca-Cola received a letter from the IRS with a bill for $3.3 billion in back taxes. The IRS contends that Coca-Cola charged several foreign affiliates royalties that were too low from 2007 to 2009, which reduced the parent company’s U.S. income and resulted in underpayment of its U.S. income taxes by $3.3 billion.

Coca-Cola sued the IRS, disputing the bill. The case is being tried now in the Tax Court. A verdict is not expected until some time after the trial ends.

Broader Implications?

Transfer pricing is under more scrutiny than ever before from tax agencies worldwide because of strict new global standards, which raise legal risks for companies and their investors. The Coca-Cola case goes to trial as interest among corporations seeking multiyear deals with the IRS covering transfer pricing arrangements has fallen in the past two years.

The IRS states that it received 101 applications in 2017 for APAs, and 98 in 2016, both well below the 2015 peak of 183. According to reports, anecdotal evidence suggests that the APA process, designed to prevent conflict, is under strain in many countries, with some tax lawyers citing Mexico, Italy and China as challenging. Corporate tax directors have complained that APAs are taking longer to negotiate and government tax agencies are less willing to engage in them.

FBAR Violation Can Be Proved by a Preponderance of Evidence, Court Rules

The U.S. District Court of Connecticut has held that the IRS may prove that a taxpayer failed to timely file a Foreign Bank and Financial Accounts Report (FBAR) by a “preponderance of evidence” — rather than a higher “clear and convincing” standard. The court also determined that the IRS needn’t show that the failure was willful. (Garrity, 121 AFTR 2d, 2018-629)

Facts of This Case

The IRS filed suit to reduce to judgment a civil penalty, which it assessed against the taxpayer for his alleged willful failure to report his interest in a foreign account that he held in 2005. Under the Bank Secrecy Act, U.S. citizens must file FBARs with the U.S. Treasury disclosing that they have a financial interest in, or signatory or other authority over, any foreign financial account with assets exceeding $10,000.

In anticipation of trial, the parties submitted briefs addressing the legal question of what standard of proof governs: preponderance of the evidence or clear and convincing evidence. The IRS argued that the standard of proof was preponderance of the evidence. The taxpayer (represented by fiduciaries of his estate) argued that the standard of proof was clear and convincing evidence.

The parties also briefed the separate question of whether the IRS must show that the taxpayer intentionally violated a known legal duty to establish a “willful” FBAR violation (as the taxpayer’s representatives contended) or whether the IRS may satisfy its burden of proof by showing that the taxpayer acted recklessly (as the IRS contended).

Court’s Conclusion

The court determined that the IRS must prove the elements of its claim for a judgment by a preponderance of the evidence and that proof of reckless conduct would satisfy the IRS’s burden on the element of willfulness.

The civil FBAR penalty didn’t implicate important individual interests or rights, the court concluded. It reasoned that the fact that the taxpayers might be liable for a substantially larger sum of money for a willful FBAR violation than if the IRS had pursued a civil tax fraud action didn’t warrant a higher standard of proof. The court determined that it was the type of interest or right involved that triggered a higher standard of proof, not the amount in controversy. The court cited Herman & MacLean v. Huddleston and Grogan v. Garner.1

The district court reasoned that the sanction that the taxpayer might be exposed to, regardless of how “draconian” it might be, was monetary only.2 Despite characterizing the taxpayer’s exposure to a monetary sanction as implicating a “property interest that require[s] protection,” the taxpayer’s representatives hadn’t demonstrated how the penalty the IRS sought would affect important individual interests or rights to warrant a higher standard of proof.

The taxpayer’s representatives also argued that the IRS’s proof of willfulness likely would involve allegations of fraud, which could tarnish the taxpayer’s reputation, implicating a more important interest than those involved in typical civil cases. But the court, looking to Huddleston and Grogan, noted that even allegations of fraud did not necessitate a higher standard of proof. Unlike a large number, and perhaps the majority, of the states, Congress had chosen the preponderance standard when it created substantive causes of action for fraud.

No Need to Deviate from Supreme Court Precedent

The taxpayer’s representatives conceded that numerous courts had found that willfulness in the civil FBAR context included reckless conduct, relying principally on criminal cases. However, they maintained that the IRS, in order to satisfy the element of willfulness, must prove that the taxpayer intentionally violated a known legal duty, and that proof of reckless conduct was insufficient.

The district court found that the taxpayer’s representatives ignored the clear distinction that the Supreme Court had drawn between willfulness in the civil and criminal contexts (Ratzlaf v. U.S. (S. Ct. 1994)).3 The taxpayer’s representatives pointed to no other authority that would warrant deviating from the Supreme Court’s holdings that statutory willfulness in the civil context covered reckless conduct. (Safeco Insurance Company of America v. Burr, 2007)

1 In Grogan v. Garner ((S. Ct. 1991) 498 U.S. 279), the Supreme Court rejected arguments that the higher standard of clear and convincing evidence applies to particular civil actions (where the Court held that the preponderance of the evidence standard applied to exceptions to the discharging of debt for fraud in certain bankruptcy actions).

2 Except in the case of willful failures, the amount of any civil penalty imposed for violating this rule won’t exceed $10,000. However, those who willfully fail to file their FBARs on a timely basis (on or before June 30 of the following year) can be assessed a penalty of up to the greater of $100,000 or 50% of the balance in the unreported bank account for each year they fail to file. The IRS has discretion as to the amount of the penalty, subject to these limits.

A “reasonable cause” exception exists for nonwillful violations, but not for willful ones.

3In a case dealing with a fraudulent misrepresentation claim, the Supreme Court held that a heightened clear and convincing burden of proof applies in civil matters “where particularly important individual interests or rights are at stake.” (Herman & MacLean v. Huddleston (S. Ct. 1983) 459 U.S. 375)3 Such interests include parental rights, involuntary commitment, and deportation. The lower, more generally applicable preponderance of the evidence standard applies, however, where “even severe civil sanctions that do not implicate such interests” are contemplated.

IRS Determines Housing Cost Allowances for High-Cost Cities

In Notice 2018-33, the IRS has announced 2018 adjustments to the limitation on housing expenses under the housing cost exclusion for specific locations.

The guidance further provides that some taxpayers may elect to apply the 2018 limitation for tax years beginning in 2017.

The excludable housing cost amount is the excess, if any, of:

1. The individual’s allowable housing expenses for the year (that is, the housing expense limitation)

2. Divided by a base amount.

For 2018, a taxpayer’s allowable housing expenses, assuming he or she is eligible for the exclusion during the entire year, generally can’t exceed $31,230. The base amount is $16,656. Therefore, the maximum housing cost exclusion for 2018 is generally $14,574 ($31,230 − $16,656).

However, the IRS is permitted to issue regulations or other guidance that provides for an adjustment to the maximum allowable housing expense limitation based on geographic differences in housing costs relative to housing costs in the U.S.

Waiver of Residency and Presence Tests for Turkey

Separately, in a Revenue Procedure, the IRS has waived the 2016 residency and presence tests that apply for purposes of foreign earned income and foreign housing cost exclusions for certain U.S. individuals in Turkey.

The IRS, in consultation with the Secretary of State, has determined that war, civil unrest or similar adverse conditions precluded the normal conduct of business in Turkey beginning on October 29, 2016.

Accordingly, an individual who left Turkey on or after that date will be treated as a qualified individual for the period during which that individual was present in, or was a bona fide resident of Turkey, if the individual establishes a reasonable expectation of meeting the requirements for those conditions.

To qualify, an individual must have established residency, or have been physically present, in Turkey on or before Oct. 29, 2016, the date that the IRS determined that individuals were required to leave the country.

The foreign earned income exclusion applies only to income resulting from performing services as an employee or as an independent contractor. “Earned income” means salaries, wages, professional fees and other amounts received as compensation for personal services. Self-employment income can qualify for the foreign earned income exclusion.

Limit on Exclusions

The amount of foreign wages and salary a taxpayer can exclude each year is limited to actual foreign earned income or the annual maximum dollar limit, whichever is less. The maximum foreign earned income exclusion for 2016 is $101,300.

In addition to the foreign earned income exclusion, you can also claim an exclusion or a deduction from gross income for your housing amount if your tax home is in a foreign country and you qualify for the exclusions and deduction under either the bona fide foreign residence test or the physical presence test.

The Tax Code exempts “qualified individuals” from taxation of their foreign earned income and the housing costs.

A qualified individual is an individual whose tax home is in a foreign country and who meets one of two tests:

1. The bona fide foreign residence test, which applies to a U.S. citizen (or, in certain situations, a U.S. resident alien) who satisfies the IRS that he or she has been a bona fide resident of one or more foreign countries for an uninterrupted period that includes an entire tax year, or

2. The foreign physical presence test, which applies to a U.S. citizen or resident alien who, during a period of 12 consecutive months, is present in one or more foreign countries for at least 330 full days.

Under certain circumstances, the time requirements of the two tests may be waived. When that happens, the taxpayer is treated as having met the tests for the period during which he or she was a bona fide resident of the foreign country, even though the relevant time requirements haven’t been met.

Three conditions must be met for the waiver to apply:

1. The taxpayer must have been a bona fide resident of, or present in, a foreign country for a period of time.

2. Before the taxpayer meets the time requirements for either test, he or she must have left the foreign country during a period in which the IRS determines, after consultation with the State Department, that individuals had to leave because of war, civil unrest or similar adverse conditions that prevented the normal conduct of business.

3. The taxpayer must establish to the IRS’s satisfaction that he or she could reasonably have been expected to meet the time requirements but for the adverse conditions.

Previous 2016 Waiver

The IRS had previously waived the requirements for certain U.S. individuals in South Sudan, due to adverse conditions beginning on July 10, 2016.

For 2017, the IRS, in consultation with the Secretary of State, has determined that no country has experienced war, civil unrest or similar adverse conditions that precluded the normal conduct of business.