Coca-Cola’s Reported $3 Billion Tax Bill

On Seeking Alpha, a Coca-Cola investor wrote that he sold 11,000 shares of Coca-Cola stock after reading a headline about its $3.3 billion tax bill, arguing that it turned the stock into dead money for a long time and reveal lack of controls at best and dishonesty at worst on behalf of Coca-Cola’s management.

I agree that it would be a concern for Coca-Cola shareholders if: (1) Coca-Cola had to actually come up with $3.3 billion in cash to pay tax bills to the IRS, and (2) the oversight was indicative of dishonesty or lack of controls at Coca-Cola.

Even in a worst-case scenario, I would find this news forgivable under both scenarios as a $3.3 billion bill represents about four months of Coca-Cola profits. It would be an unpleasant amount of money for the company to cough up, but it would still sail along over the long run. And if the dispute involved dishonesty or lack of oversight, it would still be forgivable as the company has operations in 212 countries and has over 300 men and women making critical decisions worth hundreds of millions of dollars at different points in the chain of command. If you are going to hold a stock for a long period of time, failures in controls or oversight are to be expected from time to time.

But yet, none of these worst-case scenarios come even close to describing the reality of this news story.

This dispute is about the characterization of licensing fees for foreign profits that involves an ambiguous interpretation of American tax law. A judgment call made by Coca-Cola executives and management teams across the globe involve determining the price of licensing fees that Coca-Cola’s subsidiaries must pay to the parent Coca-Cola company headquartered in Atlanta.

These fees are taxable in the United States in addition to profits generated abroad that get repatriated to the United States. It is in the interest of Coca-Cola for these licensing fees to be low, as it means that Coca-Cola profits in Ireland will be higher and can be further invested into Ireland and the rest of the non-United States world without having to pay any taxes to the U.S. government (of course, taxes must be paid to the Irish government on Coca-Cola sales in Ireland).

It is in the interest of the IRS, however, for these licensing fees to be high as this would give the U.S. Treasury a chunk of Coca-Cola’s profits even as it uses foreign earnings to make other foreign investments.

The difficulty of determining a license price is that the specific Coca-Cola product is unique to the company as there is no true analogous product that would make benchmark pricing easy. If you license the sale of straws, the licensing fee is pretty straightforward because there is no brand-name straw in the world and the market value of the other straws sold in the country could determine the fair market value of the licensing fees that must be paid to the parent company.

The IRS argues that Coca-Cola is low-balling the licensing fees by using low quality sodas as a pricing benchmark, and a higher licensing fee should be charged to reflect the intangible value of the Coca-Cola brand. Coca-Cola argues that licensing fees are based on the fair market value of similar products, and it can therefore use the low end value of other soda companies as a benchmark for charging licensing fees because their products are similar. If you want to learn more about the legal requirements for this stuff, you should get a 2011 book called “International Business: Theory and Practice” by Ehud Menipaz and Amit Menipaz and start your reading on page 486.

None of this involves dishonesty. None of this involves a lack of controls at Coca-Cola. The management team knows exactly what it is doing, and it is acting in the shareholders interest by trying to interpret the legal requirements in a way that favors its shareholders. It is also fair for the IRS to question aggressive tactics. This is how the system should work–both sides seeking to enforce their interests.

This is also an example of newspaper headlines providing inflated figures. A $3.3 billion fine would occur if Coca-Cola was committing fraud or doing something to involve deliberate deception regarding the licensing fees. That worst-case scenario is not going to happen. When it is all said and done, I would be surprised if Coca-Cola spent more than $300 million settling this dispute. It’s nature of newspapers to anchor on the maximum possible amounts, but the downside is that it can scare shareholders and frighten them into doing something stupid if they do not study what is actually going on.

This news item regarding Coca-Cola is quite misleading, both in terms of the substance of the accusations and the likely amount that Coca-Cola will pay. There is no dishonesty or lack of controls here, but rather, aggressive accounting that is going to be challenged in the courts. It is also quite unlikely that this will cost Coca-Cola anywhere near a billion dollars, and I would say it is close to a zero probability that Coca-Cola would actually pay the full $3.3 billion reported in the headlines. This ordeal speaks to the dangers of the 24/7 news cycle, and is yet another reminder of the catastrophized headlines that is common in financial journalism. That said, I would keep my eye out to see if people overreact and Coca-Cola investors a nice discount in the coming days or weeks.