Judge smacks down Ernst & Young's aggressive tax strategies for audit client Coca-Cola

It's not enough for auditor EY to be in the spotlight for frauds at Wirecard, NMC, and Luckin. EY is also defending dubious tax avoidance schemes in court.

Ernst & Young’s tax avoidance strategy consulting work for Coca-Cola, while also acting as its auditor, helped reduce Coca-Cola’s 2007-2009 taxable income by more than $9 billion, according to the Tax Court’s opinion in the case The Coca-Cola Co. v. Commissioner. The Tax Court on Wednesday upheld two IRS adjustments that reinstated the $9 billion in 2007-2009 taxable income. Coca-Cola Co. is liable for most of $3.4 billion in additional tax on that income that the IRS has been seeking. Coca-Cola could owe more if the IRS applies the successful legal argument to later tax years.

Coca-Cola Inc. has a long and strong relationship with its auditor, Ernst & Young.

EY, in one form or another, has been Coke’s auditor since 1921, even choosing the company over its rival PepsiCo, in 1990.

Ernst & Young will withdraw as auditor of PepsiCo Inc. because of concerns raised by rival Coca-Cola Co., another client of the accounting firm. The situation arose because of the recent merger of Ernst & Whinney, which has audited Coca-Cola since 1921, and Arthur Young & Co., which has worked for PepsiCo since 1965. Coca-Cola told Ernst & Young it couldn’t audit both companies, according to a federal filing by PepsiCo.

That extreme closeness may be why Coke asked EY in 2007 to help the company reduce its federal tax bill by creating a plan to shift profits to foreign affiliates in Brazil, Ireland, and several other countries. Those countries had lower corporate tax rates than the US.

EY’s tax avoidance strategy consulting services to Coca-Cola included a "master platform document” that would provide a basis for several transfer pricing reports. 

From the tax court’s decision:

In 2008 the Company contracted with Ernst & Young (E&Y) to analyze the services provided by ServCos to Export. E&Y agreed to prepare a “master platform document” that would provide a basis for transfer pricing reports that ServCos were required to file with their local taxing jurisdictions. 

E&Y ultimately produced two master platform documents from which it prepared about 30 local transfer pricing reports. E&Y concluded in these documents that the cost-plus compensation outlined in the ServCo agreements was within an arm’s-length range. In support of this conclusion E&Y noted that TCCC controlled the ServCos’ annual budgets, provided major inputs to their marketing efforts, and supplied final approval for all business plans.

What is transfer pricing?

A transfer price is the price charged between related parties (e.g., a parent company and its controlled foreign corporation) in an intercompany transaction. Although intercompany transactions are eliminated when consolidating the financial results of controlled foreign corporations and their domestic parents, for tax purposes such entities are not consolidated (Sec. 1504(b)(3)), and the transactions are therefore not eliminated. Transfer prices directly affect the allocation of groupwide taxable income across national tax jurisdictions. Hence, a company’s transfer-pricing policies can directly affect its after-tax income to the extent that tax rates differ across national jurisdictions.

When the IRS questioned the strategy, EY appeared in tax court on behalf of its audit client to defend its work. From the tax court opinion:

At trial an E&Y partner testified that all of these transfer pricing reports “were written based on the [ServCo] contract[s] and the cost-plus nature of the service provided” by the ServCos, which he described as “the exact standard required [under the] transfer pricing analysis paradigm in effect in every country at the time.”

(Unusual item: The IRS used an EY competitor as an expert witness. Keith Reams is a principal at Deloitte Tax who focuses his practice on transfer pricing.)

That combination of tax avoidance strategy consulting and advocacy activities goes beyond what is allowed under the Sarbanes-Oxley Act of 2002. In addition, Coca-Cola did not explicitly disclose in its proxies that EY had provided additional specialized tax strategy services in any year between 2008 and 2019.

From the SEC’s final auditor independence rules, effective May 6, 2003.

The Commission's principles of independence with respect to services provided by auditors are largely predicated on three basic principles, violations of which would impair the auditor's independence: (1) an auditor cannot function in the role of management, (2) an auditor cannot audit his or her own work, and (3) an auditor cannot serve in an advocacy role for his or her client.

The SEC’s final auditor independence rules also say that accountants may continue to provide tax services such as tax compliance, tax planning, and tax advice to audit clients, subject to the normal audit committee pre-approval requirements. But…

…merely labeling a service as a "tax service" will not necessarily eliminate its potential to impair independence under Rule 2-01(b).

Audit committees and accountants should understand that providing certain tax services to an audit client would, as described below, or could, in certain circumstances, impair the independence of the accountant. Specifically, accountants would impair their independence by representing an audit client before a tax court, district court, or federal court of claims. In addition, audit committees also should scrutinize carefully the retention of an accountant in a transaction initially recommended by the accountant, the sole business purpose of which may be tax avoidance and the tax treatment of which may be not supported in the Internal Revenue Code and related regulations.

Critical audit matters, a new audit report requirement beginning in 2019, are matters arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective or complex judgments.

If there were any doubt EY would be auditing its own tax avoidance strategy consulting work, and that its strategy was one that advocated for an uncertain strategy the IRS would challenge, it’s evidenced by EY’s selection of “accounting for uncertain tax positions” as a “critical audit matter” for 2019.

Accounting for uncertain tax positions

Description of the Matter, As described in Note 13 and Note 16 to the consolidated financial statements, the Company is involved in various income tax matters for which the ultimate outcomes are uncertain. As of December 31, 2019, the gross amount of unrecognized tax benefits was $392 million. Additionally, as described in Note 13, on September 17, 2015 the Company received a Statutory Notice of Deficiency (“Notice”) from the Internal Revenue Service for the tax years 2007 through 2009 in the amount of $3.3 billion for the period, plus interest.

While the Company continues to disagree strongly with the IRS' position, there is no assurance that the U.S. Tax Court will rule in the Company's favor, and it is possible that all or some portion of the adjustment proposed by the IRS Notice ultimately could be sustained.

Auditing management’s evaluation of uncertain tax positions, including the uncertain tax position associated with the IRS Notice, 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.

A Coca-Cola spokesperson and an EY spokesman did not respond to my request for comment.

An SEC spokeswoman declined comment on EY’s potential auditor independence violation at Coca-Cola.

This isn’t the first time EY has helped an audit client create a strategy to avoid tax where that client is now in litigation with the IRS over the strategy. In 2016 Bloomberg reported on EY’s audit client Facebook:

In the Facebook case, now being litigated in federal court in California, the company assigned some of its intellectual property to an Irish subsidiary in 2010. The IRS argues that EY used a “problematic” formula to drastically understate the value of this property, improperly lowering the company’s tax bill by hundreds of millions of dollars per year. Facebook didn’t respond to requests for comment. It said in court filings that the valuation it used was correct, and it’s said it should prevail.

In a July SEC filing, Facebook told investors that if it loses it could owe additional taxes, penalties, and interest of $3 billion to $5 billion…

Lynn Turner, a former chief accountant for the SEC, says the consulting work is a clear conflict, particularly when it involves tax planning. “When management requests an auditor create a tax scheme that the auditor must in turn audit as part of the financial statements, it destroys the auditor’s ability to be objective and free of conflict,” Turner says.

Facebook was supposed to be in court in Washington D.C. in June of 2020 but the trial was canceled due to COVID. A portion of the trial held in San Francisco wrapped up earlier this year in March.

ProPublica described EY’s involvement in Facebook’s tax avoidance strategies in a long piece in January 2020, while the San Francisco trial continued and in anticipation of the Washington DC portion of the trial.

To conjure the prices Facebook should pay in this deal with itself, Facebook hired the giant accounting firm Ernst & Young. The firm’s experts and economists worked for years on the project. In 2011, a year after the deal had officially closed, E&Y’s team was still crunching figures and generating reports.

In September 2011, an E&Y economist emailed 600 pages of analysis to Ted Price, Facebook’s head of tax, and offered to send him three printed copies: two for his team, and one for the IRS, should the agency ever come calling. Price said that he’d take three, but they’d all be for his team. “I doubt the IRS ever even audits us on this,” he wrote. The E&Y economist replied, “knock on wood.” (In a court filing, Facebook said Price’s comment was “sarcastic.”)

This Bloomberg piece does a great job in mentioning the conflict of EY creating Facebook’s tax avoidance strategy and then auditing it.

The IRS lost a similar transfer pricing case against Amazon on appeal, after initially winning it. Jill Frisch, the attorney for the IRS leading the Coca-Cola case, also led the case against Amazon.

EY is also Amazon’s auditor, but it was PwC that led the development of Amazon’s tax avoidance strategy. I wrote about the case when it was still pending:

Amazon’s tax advisor is not EY. Its sophisticated tax avoidance strategy using low-tax Luxembourg cost tens of millions to design and implement, more than the minuscule amount EY collects for tax services each year. For example, Caterpillar paid $55 million to advisors including PricewaterhouseCoopers for a scheme, criticized in public hearings by Sen. Carl Levin last April, that reroutes U.S. profits to low-tax Switzerland.

Based on media reports and PwC Luxembourg’s own horn-tooting, I believe PwC structured the Amazon Luxembourg 2005 restructuring deal that’s now under scrutiny by the IRS and continues to be its primary tax minimization strategy advisor. (Amazon did not respond to my request for comment or confirmation of its relationship with PwC.)

In September of 2014, Michigan Senator Carl Levin called global audit firms PricewaterhouseCoopers LLP and Ernst & Young LLP to testify about their roles in supporting in tax avoidance and alleged tax evasion by multinationals like HP, Microsoft, Google, Apple, Caterpillar, and Starbucks.

Both EY and PwC embarrassed themselves with disingenuous responses to Senator Levin’s questions. There are obvious auditor independence conflicts for both firms who continue to serve dual roles as HP’s and Caterpillar’s “independent” audit firms as well as tax avoidance strategy advisors. An auditor is supposed to be independent and objective, but advisory services, and especially lobbying, compromises that independence. This is not new since Enron and the Sarbanes-Oxley law. SEC v. Arthur Young, a decision in 1984, states, “[i]f investors were to view the auditor as an advocate for the corporate client, the value of the audit function itself might well be lost.” The SEC recently sanctioned EY for being a paid lobbyist for two audit clients.

On November 5, 2014, the International Consortium of Investigative Journalists (ICIJ) and its media partners released 28,000 Luxembourg tax ruling documents prepared by PwC for 340 corporate clients – 548 comfort letters issued from 2002 to 2010. More than 100 of those clients were PwC audit clients.

I wrote at the time:

These complicated tax schemes — PwC says they are too complicated for journalists to understand — don’t just make themselves up.

The main ICIJ LuxLeaks article highlights the advice PwC gave Amazon.

The commission argues that a generous 2003 tax ruling by Luxembourg authorities allows Amazon EU S.à.r.l. to funnel millions of euros in tax-deductible royalties each year to yet another Amazon company in Luxembourg, a limited partnership that is tax exempted. This tax break and others like it allow Amazon to pay little in taxes in the Grand Duchy on its European sales.

The leaked PwC documents show that in 2009 Amazon EU S.à.r.l. reported more than €519 million in royalty expenses while the limited partnership Amazon Europe Holding Technologies SCS had an influx of the same amount “based on agreements with affiliated companies.” Thanks to the royalty expenses and other deductions, Amazon EU S.à.r.l. posted a taxable profit of just €14.8 million and paid €4.1 million in taxes in Luxembourg.

In the Luxembourg Leaks case PwC sold non-audit tax services for transaction[s] initially recommended by the accountant, where the sole business purpose was tax avoidance and tax treatment that was challenged by the IRS.  The clients’ audit committees rubber stamped them.

The loophole left in SOx that allows auditors to give tax advice is huge. But EY and PwC cross the line, in my opinion, by designing and in some cases mass-market selling speculative, aggressive tax avoidance schemes to audit clients, too. That’s prohibited by SOx and general auditor independence principles.

A footnote to the SEC’s final auditor independence rule effective May 6, 2003:

The Commission on Public Trust and Private Enterprise recently concluded as a “best practice” that an accounting firm should not be providing “novel and debatable tax strategies and products that involve income tax shelters and extensive off-shore partnerships or affiliates” to audit clients. 

See The Conference Board Commission on Public Trust and Private Enterprise, Findings and Recommendations , January 9, 2003, p. 37.

Reuters reported on Thursday that someone issued an order for the Department of Justice to shut down a criminal tax investigation of Caterpillar, once Attorney General William Barr came on the job. Barr had represented Caterpillar in the matter before becoming Attorney General.

Potential conflicts of interest, whether real or apparent, often arise when high-powered lawyers switch between private practice and government service. Bruce A. Green, a former federal prosecutor who teaches at Fordham Law School, said it is not unheard of for attorney generals to have clients who had business before the DOJ. He noted that in 2009, President Barack Obama’s attorney general, Eric Holder, recused himself from a case involving Swiss Bank UBS, a prior client.

But Green said he could not recall a case where agents were told to take no further action on a matter involving an incoming attorney general’s former client without some kind of explanation. “Why would you just stop?” he asked.

A source familiar with the progress of the investigation, which is being conducted out of the U.S. Attorney’s Office for the Central District of Illinois, said that since December 2018, “it’s slowed, it’s stalled, it’s languishing. Not a lot of action is being taken.” But the source stressed the probe is not technically closed, and couldn’t be called “dead.”

A PCAOB investigation of PwC’s role, as Caterpillar’s tax avoidance strategy consultant and Caterpillar’s long-time auditor, is likely long gone by now, if it ever really existed.

Despite an enormous and recently successful effort by audit firms, their lobbyists, and now the SEC under Trump appointee Jay Clayton to “modernize” auditor independence rules, the independence rules regarding tax services remain the same as when they were passed in response to Enron’s failure and its auditor Arthur Andersen’s implosion. 

I reported on another potential auditor independence violation by EY in May, and summed up some of the recent violations the SEC has ignored in a four-part series in this newsletter in January.  

Postscript: The fees for EY’s tax work at Coke are high, certainly higher than they should be if you want independence and objectivity, but they are higher now as a percentage of the total than they were in 2007-2009 when EY did this transfer pricing extra work. (Data via Audit Analytics. Red flags are Audit Analytics’ designation.)

© Francine McKenna, The Digging Company LLC, 2020

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