149 T.C. No. 21
UNITED STATES TAX COURT
THE COCA-COLA COMPANY & SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 31183-15. Filed December 14, 2017.
P, a U.S. corporation, does business in Mexico through a branch (Licensee). For taxable years 2007-2009 Licensee paid royalties to P for the use of P’s intangible property and claimed deductions for those royalties on its Mexican corporate income tax returns. P reported all of Licensee’s income on its consolidated Federal income tax returns for 2007-2009 and claimed foreign tax credits (FTCs) under I.R.C. sec. 901 for the corporate income taxes Licensee had paid to Mexico.
The IRS selected P’s 2007-2009 returns for examination and, exercising its authority under I.R.C. sec. 482, determined that the royalties Licensee had paid to P were not at arm’s length, i.e., were too low. As a corollary of this determination, the IRS determined that Licensee had claimed insufficient deductions for royalty payments on its Mexican tax returns and to that extent had overpaid its Mexican corporate income tax. To the extent of these overpayments, the IRS determined that the taxes paid to Mexico were not “compulsory” and -2-
hence were not “taxes” within the meaning of I.R.C. sec. 901. See sec. 1.901-2(a)(2)(i), Income Tax Regs.
1. Held: P calculated its Mexican tax liabilities “in a manner that is consistent with a reasonable interpretation and application of the * * * provisions of foreign law (including applicable tax treaties) in such a way as to reduce, over time, * * * [its] reasonably expected liability under foreign law for tax.” Sec. 1.901-2(e)(5)(i), Income Tax Regs.
2. Held, further, P “exhaust[ed] all effective and practical remedies, including invocation of competent authority procedures available under applicable tax treaties, to reduce, over time, * * * [its] liability for foreign tax.” Sec. 1.901-2(e)(5)(i), Income Tax Regs.
3. Held, further, the Mexican taxes paid by Licensee for 2007- 2009 were “compulsory” levies for which P is entitled to FTCs under I.R.C. sec. 901(a).
John B. Magee, Kevin Lee Kenworthy, Sanford W. Stark, Saul Mezei,
Steven R. Dixon, Jarrett Y. Jacinto, Carl T. Ussing, and Lisandra Ortiz, for
petitioner.
Jill A. Frisch, Anne O’Brien Hintermeister, Julie Ann P. Gasper, Heather L.
Lampert, Curt M. Rubin, Lisa M. Goldberg, and Huong T. Bailie, for respondent. -3-
OPINION
LAUBER, Judge: With respect to petitioner’s Federal income tax for 2007-
2009, the Internal Revenue Service (IRS or respondent) determined substantial de-
ficiencies as a result of transfer-pricing adjustments under section 482.1 The case
is calendared for trial in Washington, D.C., beginning March 5, 2018. Currently
before the Court is petitioner’s motion for partial summary judgment with respect
to an issue the parties have labeled “the Mexico Foreign Tax Credit” issue.
During 2007-2009 petitioner did business in Mexico through the Coca-Cola
Export Corp. Sucursal Mexico (Mexico Licensee), a branch of one of its domestic
subsidiaries. The Mexico Licensee paid royalties to petitioner for use of petition-
er’s intangible property. After claiming deductions for these and other expenses,
the Mexico Licensee for 2007-2009 paid income taxes in excess of $250 million to
the Government of Mexico. Petitioner reported the Mexico Licensee’s taxable
income on its consolidated Federal income tax returns and claimed foreign tax
credits (FTCs) under section 901 for the Mexican income taxes paid.
1 All statutory references are to the Internal Revenue Code (Code) in effect for the years at issue, and all Rule references are to the Tax Court Rules of Prac- tice and Procedure. We round all monetary amounts to the nearest dollar. -4-
In 2015 the IRS issued petitioner a notice of deficiency determining (among
other things) that the royalties the Mexico Licensee had paid to petitioner were not
calculated at arm’s length, i.e., were too low. As corollaries of these proposed ad-
justments, the IRS determined that the Mexico Licensee had claimed insufficient
deductions for royalty payments on its Mexican corporate returns and to that ex-
tent had overpaid its Mexican income tax. To the extent of these alleged overpay-
ments the IRS determined that the taxes paid to Mexico were not “compulsory”
and hence were not “taxes” within the meaning of section 901. See sec. 1.901-
2(a)(2)(i), Income Tax Regs. (“A foreign levy is a tax if it requires a compulsory
payment pursuant to the authority of a foreign country to levy taxes.”).
On the basis of these determinations the IRS disallowed portions of the
FTCs that petitioner had claimed on its 2007-2009 returns. Petitioner contends
that the Mexican taxes it paid were “compulsory” levies and that the IRS erred as a
matter of law in disallowing credits therefor. We agree with petitioner and ac-
cordingly will grant its motion for partial summary judgment.
Background
The following facts are derived from the parties’ pleadings and motion pa-
pers, including the attached declarations and exhibits. The facts are stated for the
purpose of ruling on petitioner’s motion for partial summary judgment and not as -5-
findings of fact in this case. See Rule 1(b); Fed. R. Civ. P. 52(a); Cook v. Com-
missioner, 115 T.C. 15, 16 (2000), aff’d, 269 F.3d 854 (7th Cir. 2001). Petitioner
had its principal place of business in Georgia when it petitioned this Court.
Petitioner is the parent of a group of companies that manufacture, sell, and
distribute nonalcoholic ready-to-drink beverages in more than 200 countries. Pe-
titioner began to expand internationally in the early 20th century. To support its
international operations it established foreign licensees to manufacture Coca-Cola
concentrate for sale to bottlers outside the United States. The parties refer to peti-
tioner’s foreign licensees as supply points.
A. The Closing Agreement
Sometime before 1996 the IRS examined petitioner’s Federal income tax re-
turns for 1987-1989 to determine whether its supply points were paying royalties
at arm’s length for the use of petitioner’s intangible property. This examination
resulted in the execution of a closing agreement that covered petitioner’s 1987-
1995 tax years. This agreement established a method--the “10-50-50 method”--for
calculating royalties payable for use of petitioner’s intangible property. Under this
method each supply point would retain 10% of its gross sales as a routine return,
and the residual operating profit (after certain adjustments) would be split 50-50
between the supply point and petitioner. -6-
The closing agreement provided penalty protection for petitioner both dur-
ing the term of the agreement and for tax years after 1995. For tax years after
1995 the agreement provided that petitioner would meet the reasonable cause and
good faith exceptions of sections 6664(c) and 6662(e)(3)(D) if its supply points
continued to calculate royalties pursuant to the 10-50-50 method (or other method
to which it and the IRS subsequently agreed). This protection applied to all of
petitioner’s then-existing and future supply points, including supply points operat-
ing as branches of petitioner.
The closing agreement expired on December 31, 1995. But the IRS exam-
ined petitioner’s returns for each of the ensuing 11 years and concluded that “the
continuing application of the closing agreement’s terms and conditions to post-
1995 years seems appropriate.” Thus, as relevant here, the IRS limited its 1996-
2006 examinations to determining whether the royalty amounts petitioner received
from its supply points were consistent with the closing agreement. With one min-
or exception the IRS answered that question in the affirmative, making no adjust-
ments to the royalty payments that petitioner received from its supply points dur-
ing 1996-2006. All of these royalties were computed under the 10-50-50 method. -7-
B. The Mexico Licensee
Petitioner formed the Mexico Licensee in 1950. For the tax years at issue
the Mexico Licensee was a branch of the Coca-Cola Export Corp., a domestic
subsidiary of petitioner and a member of petitioner’s affiliated group that files
consolidated Federal income tax returns. Starting in 1950 and continuing through
the years at issue, petitioner licensed to the Mexico Licensee the rights to manu-
facture and sell Coca-Cola concentrates, beverage bases, and syrups used in the
preparation of finished beverages and to use petitioner’s trademarks in connection
with the sale of these products. The Mexico Licensee paid Mexican corporate tax
on the net income it derived from its operations.
Before 1998 Mexican tax law did not include an arm’s-length standard for
related-party transactions, and the Mexico Licensee before that time paid no royal-
ties to petitioner for use of its intangible property. But in 1997 Mexico amended
its tax law to incorporate the arm’s-length principle. In response petitioner and the
Mexico Licensee entered into an agreement, effective January 1, 1998, whereby
the Mexico Licensee agreed to pay petitioner for the use of its intangible property
a royalty calculated under the 10-50-50 method. The Mexico Licensee requested
permission from Mexico’s Federal taxing authority, the Servicio de Administra-
ción Tributaria (SAT), to pay petitioner royalties computed in this manner. -8-
In December 2000 the SAT notified the Mexico Licensee that it would per-
mit royalty payments to petitioner under the 10-50-50 method for the 2000 tax
year. On February 6, 2001, the SAT issued a formal Resolution (equivalent to a
U.S. advance pricing agreement) covering the 2000 year, ruling that the 10-50-50
method resulted in an arm’s-length royalty payment for Mexican tax purposes.
On January 1, 2001, petitioner and the Mexico Licensee executed a supple-
mental agreement, effective that day, stipulating the payment of royalties under the
10-50-50 method.2 In December 2001 the SAT issued a second Resolution, cover-
ing the 2001-2004 tax years. The SAT again concluded that the 10-50-50 method
represented a permissible application of the “residual profit split method” for
Mexican tax purposes and resulted in an arm’s-length royalty payment under Mex-
ican law. The second Resolution expired by its terms on December 31, 2004. But
the Mexico Licensee continued to pay royalties to petitioner consistently with the
10-50-50 method for all subsequent years, including the tax years at issue.
In continuing to calculate royalties in this manner, the Mexico Licensee and
petitioner relied on advice from Luis Ortiz Hidalgo, a Mexican tax attorney who
had helped obtain the two Resolutions described above. Mr. Ortiz had advised the
2 This agreement was amended again in 2005 and 2009. None of the amend- ments altered the Mexico Licensee’s use of the 10-50-50 method to compute its royalty payments. -9-
Mexico Licensee concerning its Mexican tax obligations since 1974. He com-
municated regularly with petitioner’s U.S. tax personnel, including Dennis A.
Carr, petitioner’s executive director for international taxes, to stay abreast of any
changes that might affect the Mexico Licensee’s royalty obligations. Mr. Ortiz
was fully apprised of the IRS’ examinations of petitioner’s 1996-2006 tax years
and the IRS’ ongoing approval of royalties calculated under the 10-50-50 method.
After the second Resolution expired, Mr. Ortiz advised the Mexico Licensee
to continue paying royalties to petitioner under the 10-50-50 method. He based
this advice on his belief that there had been no changes in petitioner’s operations
or transactional relationship with the Mexico Licensee sufficient to justify a higher
royalty rate. And he believed that the SAT would not have permitted the Mexico
Licensee to reduce its Mexican income tax by paying higher royalties, especially
since all of petitioner’s other supply points continued to pay (with IRS approval)
royalties calculated under the 10-50-50 method.
On the basis of Mr. Ortiz’s advice, the Mexico Licensee for 2007-2009 paid
petitioner royalties calculated under the 10-50-50 method. It deducted these pay-
ments on its Mexican tax returns and prepared appropriate transfer-pricing docu-
mentation to establish its compliance with the arm’s-length standard in Mexico. It
paid all taxes shown as due on its Mexican tax returns for these years. - 10 -
Mr. Ortiz has averred that, for years before 2010, the SAT’s only audit ac-
tivity with respect to royalties paid by the Mexico Licensee was an examination
for its 2008 tax year. During that examination the SAT inquired whether the
Mexico licensee was still making royalty payments calculated under the 10-50-50
method. After receiving confirmation that the answer to this question was “yes,”
the SAT made no adjustments to the royalty payments.
C. IRS Examination
Petitioner filed timely Forms 1120, U.S. Corporation Income Tax Return,
for 2007-2009. Because the Mexico Licensee was a branch, all of its taxable in-
come was reported on these consolidated returns. Petitioner included in these re-
turns Forms 1118, Foreign Tax Credit--Corporations, on which it claimed FTCs
for the taxes the Mexico Licensee had paid to Mexico. The FTCs thus claimed
totaled $87,409,718 for 2007, $80,332,190 for 2008, and $86,812,306 for 2009.
The IRS selected petitioner’s 2007-2009 returns for examination. On Janu-
ary 26, 2011, the IRS informed petitioner that it intended to examine petitioner’s
intercompany royalty payments. On April 12, 2011, it sent petitioner a letter stat-
ing that it was considering adjustments to the royalty payments due from the Mex-
ico Licensee for 2007-2009. Since the Mexico Licensee was a branch, such ad- - 11 -
justments would produce no net change to petitioner’s U.S. income, only a de-
crease to the claimed FTCs.
The IRS letter explained that any adjustments to the Mexico Licensee’s roy-
alty payments might result in double taxation for which petitioner would have the
right to seek competent authority relief under the U.S.-Mexico treaty. See Con-
vention for the Avoidance of Double Taxation and the Prevention of Fiscal Eva-
sion with Respect to Taxes on Income, Mex.-U.S., Sept. 18, 1992 (treaty), Treaty
Doc. No. 103-07, reprinted in 2 Tax Treaties (CCH) at 5903. On September 26,
2013, petitioner requested that the United States initiate, pursuant to article
XXVI(2) of the treaty, a competent authority proceeding with Mexico. The Mexi-
co Licensee concurrently requested that the SAT initiate a competent authority
proceeding with the United States.
On September 15, 2015, the IRS sent petitioner a notice of deficiency that
substantially increased, under section 482, the royalty amounts payable to petition-
er by its supply points, including the Mexico Licensee. The IRS made offsetting
income adjustments, increasing petitioner’s royalty income and decreasing the
Mexico Licensee’s income by the same amounts. Of concern here, the IRS made
“correlative adjustments” decreasing petitioner’s FTCs by $43,457,473 for 2007,
$50,453,126 for 2008, and $44,893,902 for 2009. - 12 -
The IRS based its disallowance of the FTCs on the contention that the Mex-
ico Licensee had claimed insufficient deductions for royalty payments on its Mex-
ican corporate returns and to that extent had overpaid Mexican income tax. To the
extent of these alleged overpayments, the IRS determined that the taxes paid to the
Government of Mexico were not “compulsory” and hence were not “taxes” within
the meaning of section 901. On October 15, 2015, the IRS notified petitioner that
it would not participate in competent authority proceedings with Mexico because
it had “designated for litigation the issue pertaining to the transfer pricing adjust-
ments for tax years 2007, 2008, and 2009.” On December 14, 2015, petitioner
timely petitioned this Court to challenge (among other things) the disallowance of
the Mexico FTCs.
Discussion
Summary judgment is intended to expedite litigation and avoid unnecessary
and expensive trials. See FPL Grp., Inc. & Subs. v. Commissioner, 116 T.C. 73,
74 (2001). Either party may move for summary judgment upon all or any part of
the legal issues in controversy. Rule 121(a). A motion for summary judgment or
partial summary judgment will be granted only if it is shown that there is no gen-
uine dispute as to any material fact and that a decision may be rendered as a matter - 13 -
of law. See Rule 121(b); Elec. Arts, Inc. v. Commissioner, 118 T.C. 226, 238
(2002).
Petitioner has shown that no genuine dispute exists as to any material fact.
As we explain in greater detail below, the facts respondent alleges to be in dispute
are irrelevant for purposes of determining whether the taxes paid to the Govern-
ment of Mexico were “compulsory.” We conclude that the Mexico Foreign Tax
Issue may appropriately be adjudicated summarily.
A. Governing Legal Framework
The United States taxes its citizens and domestic corporations on their
worldwide income. See, e.g., Cook v. Tait, 265 U.S. 47, 56 (1924); Huff v. Com-
missioner, 135 T.C. 222, 230 (2010). Because this policy creates the potential for
double taxation, the Code since 1918 has allowed U.S. citizens and domestic cor-
porations a credit for income taxes paid to a foreign country. Sec. 901(a); Am.
Chicle Co. v. United States, 316 U.S. 450 (1942); Vento v. Commissioner, 147
T.C. 198, 203-204 (2016). The extent to which a taxpayer is entitled to FTCs is
determined by applying domestic tax law. United States v. Goodyear Tire & Rub-
ber Co., 493 U.S. 132 (1989); Phillips Petroleum Co. v. Commissioner, 104 T.C.
256, 295 (1995). - 14 -
Section 901(b) allows a credit for “the amount of any income * * * taxes
paid or accrued during the taxable year to any foreign country.” A foreign levy is
creditable under section 901 only if its “predominant character * * * is that of an
income tax in the U.S. sense.” Sec. 1.901-2(a)(3), Income Tax Regs. The parties
agree that the Mexican corporate income taxes paid by the Mexico Licensee dur-
ing 2007-2009 met this requirement.
In order to be creditable, a foreign levy must also be a “compulsory payment
pursuant to the authority of a foreign country to levy taxes.” Sec. 1.901-2(a)(2)(i),
Income Tax Regs. “Whether a foreign levy requires a compulsory payment pur-
suant to a foreign country’s authority to levy taxes is determined by principles of
U.S. law and not by principles of law of the foreign country.” Ibid. A tax pay-
ment is not considered compulsory to the extent “the amount paid exceeds the
amount of liability under foreign law for tax.” Id. para. (e)(5)(i).
Two requirements must be satisfied in order for a foreign tax payment to be
considered “compulsory.” First, the payment must be “determined by the taxpayer
in a manner that is consistent with a reasonable interpretation and application of
the * * * provisions of foreign law (including applicable tax treaties) in such a way
as to reduce, over time, the taxpayer’s reasonably expected liability under foreign
law for tax.” Ibid. Second, “the taxpayer [must] exhaust[] all effective and prac- - 15 -
tical remedies, including invocation of competent authority procedures available
under applicable tax treaties, to reduce, over time, the taxpayer’s liability for for-
eign tax.” Ibid.
B. Analysis
Respondent’s disallowance of the Mexican FTCs is based on the transfer-
pricing adjustments set forth in the notice of deficiency. The IRS contends that
the effect of these adjustments, proposed in 2015, is to convert into noncompul-
sory payments more than half the taxes petitioner paid to the Government of Mexi-
co for 2007-2009. We evaluate this argument under the regulatory standards out-
lined above.
1. Reasonable Interpretation of Foreign Law
In ascertaining whether the amounts of tax petitioner paid to Mexico “ex-
ceed[ ] the amount[s] of liability under foreign law for tax,” we first consider
whether petitioner calculated its Mexican tax liabilities “in a manner that is con-
sistent with a reasonable interpretation and application” of Mexican law, so as to
minimize its reasonably expected liabilities for Mexican corporate income tax. See
sec. 1.901-2(e)(5)(i), Income Tax Regs. The regulations do not specify what con-
stitutes a “reasonable interpretation and application” of foreign law. But they do
provide a safe harbor by allowing taxpayers to rely on good-faith advice from a - 16 -
competent tax professional. “In interpreting foreign tax law, a taxpayer may gen-
erally rely on advice obtained in good faith from competent foreign tax advisors to
whom the taxpayer has disclosed the relevant facts.” Ibid. However, “[a]n inter-
pretation or application of foreign law is not reasonable if there is actual notice or
constructive notice * * * to the taxpayer that the interpretation or application is
likely to be erroneous.” Ibid.
In calculating the deductions for royalty payments that would be allowable
to the Mexico Licensee under Mexican law, petitioner relied on the advice of Mr.
Ortiz. There is no dispute that he is a competent and experienced tax lawyer who
has advised the Mexico Licensee for many years regarding its Mexican tax obliga-
tions. When Mexico adopted the arm’s-length standard in 1997, Mr. Ortiz assisted
the Mexico Licensee in securing two Resolutions from the SAT. In both instances
the SAT ruled that the 10-50-50 method resulted in arm’s-length royalty payments
for Mexican tax purposes and hence that the royalty payments were allowable
deductions under Mexican law.
After the second Resolution expired, Mr. Ortiz advised the Mexico Licensee
to continue paying royalties to petitioner under the 10-50-50 method. He based
this advice on his belief, derived from regular communications with petitioner’s
tax personnel, that there had been no change in petitioner’s operations or transac- - 17 -
tional relationship with the Mexico Licensee sufficient to justify a higher royalty
rate. Mr. Ortiz likewise concluded that the SAT would not have permitted the
Mexico Licensee to reduce its Mexican corporate income tax by paying higher
royalties, especially since all of petitioner’s other supply points continued to pay
royalties (with evident IRS approval) calculated under the 10-50-50 method. The
SAT in fact made no adjustments to the Mexico licensee’s royalty payments for
2007-2009 after confirming that those payments continued to be made in accord-
ance with the 10-50-50 method.
These facts show that petitioner, in interpreting Mexican tax law, “rel[ied]
on advice obtained in good faith from [a] competent foreign tax advisor[]” as to
the appropriate amounts of the royalty payments. See sec. 1.901-2(e)(5)(i), In-
come Tax Regs. At the time petitioner received this advice, moreover, it did not
have “actual notice or constructive notice” that Mr. Ortiz’s interpretation of
Mexican law was “likely to be erroneous.” Ibid. Petitioner received Mr. Ortiz’s
advice during 2007-2009; at that time, the IRS continued to approve royalty pay-
ments calculated under the 10-50-50 method, having informed petitioner that “the
continuing application of the closing agreement’s terms and conditions to post-
1995 years seems appropriate.” The earliest date on which the IRS could be - 18 -
thought to have informed petitioner that it might take a different view was January
26, 2011, well after petitioner filed its tax returns for 2007-2009.3
These facts establish that petitioner determined its Mexican tax liability for
2007-2009 in a manner consistent with a reasonable interpretation and application
of the provisions of foreign law. Respondent’s principal argument against this
conclusion is that there exists a dispute of fact as to whether Mr. Ortiz based his
advice on facts that were fully disclosed to him. See sec. 1.901-2(e)(5)(i), Income
Tax Regs. (allowing taxpayer to rely on advice from an adviser “to whom the tax-
payer has disclosed the relevant facts”).
Relying on one of his own declarations, respondent notes that petitioner be-
tween 2001 and 2006 shifted a significant portion of the Mexico Licensee’s manu-
facturing operation to a supply point in Ireland. Partly as a result of this shift, the
3 Respondent contends that the timing of his notice to petitioner is irrelevant and that, when he provided notice of possible section 482 adjustments to petitioner in 2011, petitioner was retroactively “on notice” as of 2007-2009. This argument is hard to take seriously. The regulations clearly indicate that the judgment as to whether an interpretation of foreign law “is likely to be erroneous” is to be made at the time the foreign tax is paid. Petitioner cannot have had actual or constructive notice of a fact during 2007-2009 when the communication that put it on notice of that fact did not occur until 2011. See sec. 1.901-2(e)(5)(ii), Example (2), Income Tax Regs. (concluding that taxpayers lacked notice that their interpretation of for- eign law was likely to be erroneous until the IRS made a section 482 reallocation); cf. Vento, 147 T.C. at 209-210 (concluding that taxpayers were notified that their interpretation of foreign law was likely erroneous when they received an IRS com- munication to that effect). - 19 -
Irish supply point’s sales of concentrate to the Mexican market increased from
zero in 2000 to $377.8 million in 2006, whereas the Mexico Licensee’s sales de-
creased from $889.6 million in 2002 to $395.5 million in 2004. Respondent as-
serts that there is a dispute of material fact about whether and how Mr. Ortiz took
this production shift into account when rendering his advice.
We are not persuaded by this argument. Explicitly or implicitly, the IRS ap-
proved use of the 10-50-50 method by all of petitioner’s supply points throughout
the world from 1987 through 2006. During this 20-year period the revenues and
profits of petitioner’s supply points may have undergone significant year-to-year
changes owing (among other things) to local economic recessions, worldwide fi-
nancial crises, and variations in production and efficiency. There is nothing in the
original closing agreement or in subsequent IRS audit activity to suggest that the
10-50-50 formula was supposed to change depending on such variables.
To the contrary, given how the 10-50-50 formula worked, the production
shifts cited by respondent are wholly irrelevant. The formula operated the same
way regardless of a particular supply point’s economic results: The supply point
kept 10% of gross sales (whatever they were) and split with petitioner the residual
operating profit (whatever it was). As a result of the production shifts cited by re-
spondent, the royalties payable by the Mexico Licensee went down, and the royal- - 20 -
ties payable by the Irish supply point presumably went up. If a particular supply
point departed from the 10-50-50 method without other supply points’ making ad-
justments in the opposite direction, the whole system would quickly go entropic.
It seems obvious that the 10-50-50 method that the IRS embraced before 2011 did
not countenance such ad hoc adjustments.
Mr. Ortiz was required to provide petitioner with a “reasonable interpreta-
tion and application” of Mexican law. See sec. 1.901-2(e)(5)(i), Income Tax Regs.
Mexican law required royalty payments to be made at arm’s length, and Mr. Ortiz
advised petitioner that royalties calculated using the 10-50-50 method would meet
Mexico’s arm’s-length standard. Annual variations in a supply point’s revenues or
profits were irrelevant under the 10-50-50 method. Whether Mr. Ortiz was in-
formed of, or evaluated the effect of, the production shift to Ireland is thus not a
material fact.
Respondent also contends that the descriptions of the Mexico Licensee’s
functions, assets, and risks that petitioner supplied to the SAT when obtaining the
two Resolutions may differ from the facts ultimately found at trial. This dispute
conceivably may affect the merits of the section 482 adjustments that the IRS has
proposed. But we fail to see the relevance of this dispute in ascertaining whether - 21 -
petitioner “disclosed the relevant facts” to Mr. Ortiz about the ongoing appropri-
ateness of the 10-50-50 method. See ibid.
Mr. Ortiz advised petitioner on several occasions that the SAT would not
have permitted the Mexico Licensee to pay royalties higher than those computed
under the 10-50-50 method. Especially was that so when all of petitioner’s other
supply points were paying (with evident IRS approval) royalties computed under
the 10-50-50 method. This advice was sufficient for petitioner to conclude that an
attempt by the Mexico Licensee to pay higher royalties would not enable it “to
reduce, over time, * * * [its] reasonably expected liability under foreign law for
tax.” Ibid.
The gist of respondent’s submission concerns a possible dispute at trial as to
whether the Mexico Licensee held more valuable assets (or retained more signifi-
cant risks) than the SAT understood in 2000. It is hard to see how this factual un-
certainty, if known to the SAT back then, would have supported the payment of
higher royalties to petitioner. In any event, the determination of whether Mr. Or-
tiz’s interpretation of Mexican law was reasonable must be made on a prospective - 22 -
basis. He obviously could not have known during 2007-2009 what facts would be
established at trial in 2018.4
In sum, we find that petitioner relied in good faith on advice that it obtained
from Mr. Ortiz in determining the royalties properly payable under Mexican law
for 2007-2009. At the time petitioner received this advice, it did not have “actual
notice or constructive notice” that the interpretation of Mexican law adopted by
Mr. Ortiz was “likely to be erroneous.” See sec. 1.901-2(e)(5)(i), Income Tax
Regs. And we find, contrary to respondent’s submission, that petitioner disclosed
to Mr. Ortiz all facts relevant to his assessment of the appropriateness under Mexi-
can law of royalties calculated under the 10-50-50 method. We thus conclude that
petitioner has satisfied the first half of the regulatory test by showing that it deter-
mined its Mexican tax liability “in a manner that is consistent with a reasonable
interpretation and application” of Mexican law. See ibid.
4 Respondent also contends that the penalty protection provision of the clos- ing agreement “is irrelevant as a matter of law.” In considering whether the Mexi- can taxes were “compulsory” we do not rely on the penalty protection provision. Rather, we rely on the fact (upon which Mr. Ortiz also relied) that the IRS for a 20-year period had explicitly or implicitly approved calculation of royalties using the 10-50-50 method. To the extent respondent contends that the closing agree- ment as a whole is irrelevant, we rejected that argument in our September 7, 2017, order denying respondent’s motion for partial summary judgment. - 23 -
2. Exhaustion of Remedies
The second half of the regulatory test for a “compulsory” tax requires that
the taxpayer must “exhaust[] all effective and practical remedies, including invo-
cation of competent authority procedures available under applicable tax treaties, to
reduce, over time, the taxpayer’s liability for foreign tax.” Sec. 1.901-2(e)(5)(i),
Income Tax Regs.; see Rev. Rul. 76-508, 1976-2 C.B. 225, 226. A remedy is con-
sidered effective and practical “only if the cost thereof * * * is reasonable in light
of the amount at issue and the likelihood of success.” Sec. 1.901-2(e)(5)(i), In-
come Tax Regs.
Petitioner contends that respondent’s reliance on section 482 adjustments
that have not yet been adjudicated, combined with his refusal to participate in
competent authority proceedings, means that petitioner has exhausted its available
remedies for FTC purposes. We agree with petitioner. Respondent cannot point
to any effective and practical remedy that petitioner could now pursue to reduce its
liability for Mexican tax. If the Mexico Licensee were to file a refund claim in
Mexico, that claim would be premature because respondent’s proposed section
482 adjustments have not yet been adjudicated. Cf. Rev. Rul. 92-75, 1992-2 C.B.
197; Rev. Rul. 80-231, 1980-2 C.B. 219 (holding that a taxpayer generally must
file a foreign refund claim in order to exhaust administrative remedies). - 24 -
Even if a refund claim were not premature, there is no reason to believe that
the Mexican Government would agree with the IRS’ reallocation of income. In-
deed, the SAT has issued two Resolutions ruling that the 10-50-50 method yielded
royalty payments that were consistent with the arm’s-length requirement of Mexi-
can tax law. Mr. Ortiz opined that Mexico would not have allowed the Mexico
Licensee to pay higher royalties under these circumstances.
A taxpayer “is not required to take futile additional administrative steps” in
order to satisfy the exhaustion-of-remedies requirement. Schering Corp. v. Com-
missioner, 69 T.C. 579, 602 (1978) (holding Swiss income tax creditable notwith-
standing disagreement between Switzerland and the United States concerning the
underlying tax issue). Whether a remedy is “effective and practical” must be
judged considering “the likelihood of success.” Sec. 1.901-2(e)(5)(i), Income Tax
Regs.; see id. subdiv. (ii), Example (3) (finding foreign tax payment compulsory
where pursuing a judicial refund remedy in foreign country “would be unreason-
able in light of the amount at issue and the likelihood of * * * success”). We con-
clude that petitioner’s pursuit of a refund claim in Mexico before respondent’s
section 482 claims have been adjudicated would be futile.
Since petitioner has no effective and practical remedies in Mexico, its only
possible remedy would be a competent authority proceeding. Depending on the - 25 -
facts and circumstances, a taxpayer may be required to invoke available competent
authority relief to demonstrate exhaustion of remedies for purposes of section
901.5 But petitioner did invoke competent authority procedures. It and the Mexi-
can Licensee both requested that the IRS initiate or participate in such a proceed-
ing, but the IRS refused to do so. Respondent is in a poor position to contend that
petitioner has failed to exhaust its remedies when respondent, by his unilateral ac-
tion, has made it impossible for petitioner to pursue the only remedy that exists.6
5 See, e.g., Proctor & Gamble Co. v. United States, 2010 WL 2925099, at *10 (S.D. Ohio July 6, 2010) (disallowing certain FTCs for failure to seek relief from the Japanese tax authority and to invoke competent authority proceeding in Japan); Rev. Rul. 92-75, 1992-2 C.B. 197 (ruling foreign tax noncompulsory where taxpayer was aware of, but failed to invoke, competent authority proceed- ing); Rev. Proc. 2015-40, secs. 1.04, 2.03, 6.04(3)(a), 2015-35 I.R.B. 236, 237, 241, 249. But see Schering Corp., 69 T.C. at 602-603 (holding that taxpayer’s failure to seek competent authority relief was not fatal where arguably “there was no double taxation from which it might have sought relief”). 6 Respondent errs in relying on Rev. Proc. 2006-54, 2006-2 C.B. 1035, superseded by Rev. Proc. 2015-40, 2015-35 I.R.B. 236, for the proposition that invocation of competent authority procedures, by itself, is insufficient to demon- strate exhaustion of remedies. The regulations explicitly list “invocation of com- petent authority procedures” as an example of exhaustion of remedies. Sec. 1.901- 2(e)(5)(i), Income Tax Regs. Under the facts hypothesized in Rev. Proc. 2006-54, sec. 11, “the taxpayer ha[d] sought competent authority assistance but obtained no relief, either because the competent authorities failed to reach an agreement or because the taxpayer rejected an agreement reached by the competent authorities.” 2006-2 C.B. at 1046. Here, the reason petitioner could obtain no relief is that the IRS unilaterally refused to participate. - 26 -
Lacking any plausible argument that petitioner has effective remedies avail-
able to it now, respondent contends that the Mexican taxes were not “compulsory”
because petitioner may have remedies available to it years from now. In respond-
ent’s view, petitioner must first litigate this case to conclusion. If this Court sus-
tains the proposed transfer-pricing adjustments in whole or in part, with corres-
ponding downward adjustments to the Mexican FTCs, petitioner must then seek
relief through a competent authority proceeding. If, as a result of that proceeding,
petitioner’s Mexican tax bill for 2007-2009 ends up being higher than the liability
presupposed by this Court’s Opinion, petitioner would be allowed a credit for the
incremental Mexican tax at that time.
This is not the procedure that Congress envisioned when it enacted the
Code. Congress anticipated the difficulty of ascertaining, at the time a taxpayer
files its U.S. return, the exact amount of foreign tax that will ultimately be allow-
able as a credit. It accordingly provided, in section 905(c), a special procedure for
adjusting the credit when the taxpayer’s ultimate foreign tax liability varies from
the amount claimed. Section 905(c)(1) specifies three situations, sometimes re-
ferred to as “foreign tax redeterminations,” in which a U.S. taxpayer’s foreign tax
credit must be adjusted. One of these situations is where “any tax paid is refunded
in whole or in part.” Sec. 905(c)(1)(C). - 27 -
If any foreign tax paid is refunded in whole or in part, the U.S. taxpayer
generally must file an amended return. See sec. 1.905-4T(b)(1), Temporary In-
come Tax Regs., 72 Fed. Reg. 62784 (Nov. 7, 2007).7 The taxpayer must include
with this amended return a revised Form 1118 and information sufficient to enable
the IRS to redetermine the taxpayer’s U.S. tax liability. Id. paras. (b)(1), (3), (c).
Any U.S. tax due as a result of the Secretary’s redetermination is not subject to de-
ficiency procedures but “shall be paid by the taxpayer on notice and demand by
the Secretary.” Secs. 905(c)(3), 6213(h)(2)(A); see Sotiropoulos v. Commission-
er, 142 T.C. 269 (2014); Sotiropoulos v. Commissioner, T.C. Memo. 2017-75, 113
T.C.M. (CCH) 1370, 1373-1374.
The Court of Federal Claims recognized the availability of this procedure in
IBM Corp. v. United States, 38 Fed. Cl. 661 (1997). Resolution of the question
there, whether an Italian corporate tax was a “compulsory” levy, depended in part
on whether the taxpayer had “exhaust[ed] all effective and practical remedies” to
reduce its Italian tax. Sec. 1.901-2(e)(5)(i), Income Tax Regs. The taxpayer had
initiated litigation in the Italian courts to determine its liability, but that litigation
was still ongoing. See IBM Corp., 38 Fed. Cl. at 664.
7 Because this temporary regulation was issued before November 20, 1988, it is not subject to section 7805(e)(2), which prescribes that temporary regulations issued after that date expire within three years from the date of issuance. - 28 -
The Government contended that the taxpayer should be deemed not to have
exhausted its available remedies until the Italian courts had conclusively deter-
mined its Italian tax liability. The Court of Federal Claims rejected that argument:
[A] taxpayer may claim a foreign tax credit for the year in which it pays the foreign tax, notwithstanding that the taxpayer continues to contest its liability in the foreign country. Should the taxpayer ultimately receive a refund from the foreign government, the taxpayer must reimburse the Secretary for the amount originally credited pursuant to I.R.C. § 905(c). [Id. at 674.]
Although the taxpayer’s ultimate Italian tax liability remained uncertain, the court
held that the taxpayer had satisfied the “exhaustion of remedies” requirement and
was entitled to FTCs for the Italian taxes paid.
The Secretary himself took the same position in an earlier revenue ruling.
See Rev. Rul. 70-290, 1970-1 C.B. 160. The taxpayer there had been assessed for-
eign income tax but had filed claims for overassessment with the foreign govern-
ment. Those claims were still pending. In stark contrast to respondent’s current
position, which asserts that “effective and practical remedies must be pursued to a
final conclusion,” the IRS ruled that the taxpayer was entitled to an FTC even
though its ultimate foreign tax liability remained uncertain:
It is not the intention of the law to deprive the taxpayer of the right to obtain credit for foreign taxes because of the fact that the taxpayer * * * protests the assessment and has made application for a refund. The tax assessed constitutes a liability against the taxpayer. In the - 29 -
instant case such liability was met by actual cash disbursements. If the protest by the taxpayers against the original assessment prevails, any difference can readily be adjusted pursuant to the provisions of section 905(c) of the Code. [1970-1 C.B. at 161.]
Respondent replies that petitioner “would have no incentive * * * to seek
correlative relief from Mexico” regardless of how the transfer-pricing adjustments
are ultimately resolved. If petitioner were to get a refund of Mexican tax, that re-
fund would likely be offset dollar-for-dollar by a reduction in its FTCs pursuant to
section 905(c). Since petitioner might find nothing to be gained by seeking com-
petent authority relief, respondent urges that petitioner’s position “would force the
United States to cede taxing rights to Mexico even if the Court were to uphold re-
spondent’s adjustments in full.”
We find this argument unpersuasive for at least two reasons. First, respond-
ent need not rely on petitioner or its Mexican branch to seek competent authority
relief. The IRS is perfectly capable of initiating competent authority proceedings
with the SAT directly if it believes that such proceedings are necessary to correct a
fiscal imbalance under the treaty. See treaty art. XVI(3) (“The competent auth-
orities of the Contracting States shall endeavor to resolve by mutual agreement
any difficulties or doubts arising as to the interpretation or application” of the
treaty); Rev. Proc. 2015-40, sec. 2.01(2), 2015-35 I.R.B. 236 (stating that U.S. - 30 -
competent authority may “consult generally with foreign competent authorities to
resolve difficulties or doubts regarding treaty interpretation or application, irre-
spective of whether the consultation relates to a current matter involving a specific
taxpayer”).
Second, the argument respondent is advancing is a policy argument that de-
rives no support from the text of section 901, the governing regulations, or prior
IRS rulings. The Mexican corporate income taxes petitioner paid for 2007-2009
were “compulsory” because petitioner determined its liability “in a manner that is
consistent with a reasonable interpretation and application” of Mexican law and
has “exhaust[ed] all effective and practical remedies * * * to reduce” its Mexican
tax liability. Sec. 1.901-2(e)(5)(i), Income Tax Regs. Nothing in the regulatory
framework requires petitioner to wait until the instant litigation and its aftermath
have finally concluded in order to claim FTCs for foreign taxes it has paid. “If the
IRS considers that protection of the public fisc requires prohibiting foreign tax
credits until the taxpayer exhausts its litigation remedies, the IRS should seek an
amendment to the final regulations. That is a task for the Secretary of the Treasu-
ry, not this court.” IBM Corp., 38 Fed. Cl. at 675.
This case presents a scenario that Congress anticipated when it enacted sec-
tion 905(c). Petitioner’s ultimate liability for Mexican tax cannot now be deter- - 31 -
mined because: (1) respondent’s section 482 adjustments have not yet been ad-
judicated and (2) if those adjustments are sustained in whole or in part, petitioner
may or may not receive a refund of Mexican tax. The U.S. competent authority
may seek correlative relief from a treaty partner after “a U.S. federal court’s final
determination” of the taxpayer’s tax liability. Rev. Proc. 2015-40, sec. 6.05(2).
The Secretary would be free to initiate a competent authority proceeding with
Mexico after the transfer-pricing adjustments at issue in this case have become
final. See sec. 7481(a).
If, as the result of a future competent authority proceeding, the Mexican tax
petitioner paid for 2007-2009 is ultimately “refunded in whole or in part,” sec.
905(c)(1)(C), the IRS will redetermine petitioner’s U.S. tax liability for those
years. The additional tax due will then be paid by petitioner “on notice and de-
mand by the Secretary.” See sec. 905(c)(3); Sotiropoulos, 113 T.C.M. (CCH) at
1373-1374. Congress did not intend that FTCs would be denied up front because
of the possibility that foreign taxes might in the future be refunded. Rather, Con-
gress envisioned that the accounts would be squared if and when foreign taxes are
in fact refunded.
In sum, we conclude that petitioner has exhausted all “effective and prac-
tical remedies” to reduce its liability for Mexican tax. See sec. 1.901-2(e)(5)(i), - 32 -
Income Tax Regs. Because respondent’s section 482 adjustments have not yet
been adjudicated, petitioner currently has no remedy before the Mexican tax
authorities. The only remedy that would be “effective and practical” at the moment
would be a competent authority proceeding, in which the IRS has refused to
participate. We accordingly hold that the Mexican taxes paid by the Mexico
Licensee for 2007-2009 were “compulsory” levies for which petitioner is entitled
to FTCs under section 901(a).
To reflect the foregoing,
An order will be issued granting
petitioner’s motion for partial summary
judgment.