Coca-Cola Faces $16 Billion Tax Battle: Ongoing Dispute with IRS Puts Profit and Liquidity at Risk
Coca-Cola has chosen to bet everything on winning. It’s a high risk wager where investors have been provided with minimal disclosure.
Coca-Cola (Ticker: KO) issued a press release on August 2, 2024, just a few days after its 10-K filing, warning investors that the U.S. Tax Court took the next step in the ongoing tax dispute between Coca-Cola and the IRS. The court’s latest decision may cost the Company as much as $16 billion in back taxes. The dispute focuses on an alleged $9 billion misallocation of income between the US parent and subsidiaries in low-tax jurisdictions including obscure African continent locations like Eswatini.
The Financial Times, citing court documents, reported:
“The soft-drink maker has been hiding “astronomical levels” of profit in low-tax countries including Ireland to shield it from the US Internal Revenue Service, according to a withering court judgment, which the company is planning to appeal against later this year.”
(The Dig covered the history of the dispute and related legal developments in detail .)
According to the press release and Coca-Cola’s 10-Q filing with the SEC on July 29, 2024, the famous soft drink manufacturer has 90 days to file a notice of appeal to the U.S. Court of Appeals for the Eleventh Circuit. Notably, the Company will need to pay the agreed-upon liability of $6 billion — comprised of $2.7 billion in tax assessment and $3.3 billion in interest — to continue with the appeal. The magnitude of this and potential future payments, and the structure of the appeal process, will likely materially impact Coke’s net income and liquidity for the next several years.
Accounting treatment and impact on financial statements
Generally Accepted Accounting Principles (GAAP) require companies to record a liability reserve for uncertain tax positions if it is more-likely-than-not — typically interpreted as at least a 50% probability — that the position will stand in court if litigated.
“An entity shall initially recognize the financial statement effects of a tax position when it is more-likely-than-not, based on the technical merits, that the position will be sustained upon examination. The term more-likely-than-not means a likelihood of more than 50 percent; the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any.”
Based on that interpretation, Coke set aside $438 million as a tax liability during the year ended December 31, 2020. The liability was updated to $456 million in the quarter ended June 30, 2024 — still a very small fraction of the $16 billion total assessed by the IRS:
“The Company’s conclusion that it is more likely than not the Company’s tax positions will ultimately be sustained on appeal is unchanged as of June 28, 2024. However, we updated our calculation of the methodologies we believe the federal courts could ultimately order to be used in calculating the Company’s tax. As a result of the application of the required probability analysis to these updated calculations and the accrual of interest through the current reporting period, we updated our tax reserve as of June 28, 2024 to $456 million.”
Say it differently — despite several unfavorable rulings since 2020, Coke still believes that it has sufficient grounds to prevail in the appellate court, and that the amount owed would not exceed the already accrued $456 million. According to Coke’s statement to FT, this position has been “blessed” by Coke’s outside advisers and its independent accounting firm, E&Y:
“We have outside counsel who have, each quarter, continued to evaluate the case on the facts that are available to them and they continue to offer an opinion that gives us a greater-than-not chance of prevailing,” he said. “And then EY will do their own independent assessment to be comfortable with that opinion.”
Coca-Cola did not reveal the outside counsel which, at Coke’s request, provided this opinion. However, E&Y has acknowledged the complexity, subjectivity, and judgment calls involved in coming to its conclusion and making the estimates that appear in the financial statements. As such E&Y included the following Critical Audit Matter (CAM) language in the most recent audit opinion (and has been providing a similar CAMs since 2019):
“Auditing management’s evaluation of uncertain tax positions, including the uncertain tax position associated with the IRS notice and opinion, was especially challenging due to the level of subjectivity and significant judgment associated with the recognition and measurement of the tax positions that are more likely than not to be sustained.
We evaluated evidence of management’s assessment of the opinion, including inquiries of tax counsel, inspection of technical memos, and written representations of management. We involved professionals with specialized skill and knowledge to assist in our evaluation of the tax technical merits of the Company’s assessment, including the assessment of whether the tax positions are more likely than not to be sustained, the amount of the potential benefits to be realized, and the application of relevant tax law.”
To provide a clean opinion, E&Y — Coke’s auditor for more than 100 years – must be familiar, at an excruciatingly detailed level, with all the nuts and bolts of Coke’s tax accounting. The depth and breadth of work E&Y had to perform to become comfortable with the Company’s tax estimates — including inquiries of the tax advisors and assembling a team of experts with specialized tax knowledge — reminds investors about the complexity of the case and why Coke’s position is “uncertain”.
Let’s go back to accounting.
The FT—quoting Coke’s CFO—reported that the payment of $6 billion “would not impact the profit and loss account”.
The determination that its “more-likely-than-not will prevail position” still holds and the absence of the P&L impact imply that Coca-Cola may elect to record an asset to offset the outgoing cash and the accompanying tax expense.
“Courts in some jurisdictions require that taxes in question be paid as a prerequisite to petition the court. If the taxpayer’s position meets the recognition threshold, the taxpayer should record an asset for the prepaid tax in excess of the previously-recorded unrecognized tax benefits and accrue interest income (if applicable).”
The interpretation above suggests that the Company may record a tax receivable for most, if not all, of the $6 billion payment. For investors, this means that the balance sheet will be distorted by a material non-operations receivable that will not be collected any time soon or, perhaps, not ever.
In the best-case scenario, Coke will get this money back after prevailing in litigation—which could take years. In the worst-case scenario, Coke will finally take the hit when it writes off this receivable and will be liable for an additional $10 billion in payments that keep growing annually because of additional interest.
Brett Whitaker, a professor at Indiana University in Bloomington and a former Senior Tax Manager at E&Y, believes that a more conservative approach would be to record a liability and reverse it once the Company prevails:
“Certainly, putting up a liability, paying it to the IRS, and then waiting to see how it pans out in the courts would be the more conservative approach. For Coca Cola to offset the impact by putting up a receivable would not be outside the guidance, but it’s not as common. In fact I cannot recall a company putting up a receivable in much smaller disputes. To me this is especially true when considering the dollar amount and the facts as I’ve read them. Coca Cola putting up a receivable would signify they disagree with the IRS and the lower courts so much that they are willing to tell investors they will not only win, but the IRS will pay it all back. And their auditors must agree otherwise they wouldn't be doing it. Should be interesting to see how the SEC views that.”
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