Coca-Cola Case: The Central Company vs. The Tel Aviv District Tax Officer
In recent years, rulings on transfer pricing have been accelerating globally as various tax authorities scrutinize the pricing policies of leading multinational groups. This trend is also present in Israel, highlighted by several judgments, including the Coca-Cola case.
Recently, the Tel Aviv District Court ruled that the central beverage manufacturing company in Israel (“Coca-Cola Israel”), which is the official marketer and seller of Coca-Cola beverages in Israel, must pay additional taxes estimated in the hundreds of millions of shekels. This court decision has significant implications for transfer pricing.
Background of the Ruling
Coca-Cola Israel is engaged in marketing and selling Coca-Cola beverages in Israel. The business model operates such that Coca-Cola Israel purchases concentrates from the global Coca-Cola company, prepares the beverages, and then sells them in Israel. The agreement between Coca-Cola Israel and the global Coca-Cola company addressed the payment for the concentrates but did not explicitly cover payment for the use of Coca-Cola’s intangible assets.
The ruling’s background involves a decision by the Israeli tax authority to change a policy that had been in place for nearly two decades. This policy change involved addressing the royalty component for using Coca-Cola’s intellectual property. Until the change, the tax authority did not view Coca-Cola Israel’s payments to the global company as including a royalty element but merely as payment for the beverage concentrate.
However, the Israeli tax authority now argues that the payments also include a royalty component under the logic that the concentrates themselves embody the value of Coca-Cola’s intangible property, and not just the price of the physical material (since the concentrates cannot be purchased from competitors, and it is clear that the physical material itself is not costly). This decision by the tax authority has implications both for Coca-Cola’s taxation, which is expected to increase by hundreds of millions of shekels, and for other companies in the field.
Parties’ Arguments
The Israeli tax authority argued that the reason for the change is that Coca-Cola Israel is not purchasing a final product but is involved in production, storage, advertising, distribution, and sales, all in accordance with the directives of the global Coca-Cola company. Therefore, the Israeli tax authority does not view the company merely as an importer of a product. Moreover, Coca-Cola Israel did not make payments to the global company for the use of its intangible assets, namely trademarks and intellectual property rights. Therefore, the tax authority views the payment for the beverage concentrates as including a significant component of payment for the use of Coca-Cola’s intangible assets.
However, Coca-Cola Israel argued that for the tax authority to change its position or decision on a particular issue, there needs to be a significant change in circumstances, a policy change, or a relevant legislative change. Furthermore, the company claimed that the business model, in which the company does not purchase a final product but is involved in a wide range of related activities, has existed for decades. This model is based on high transportation costs for a final product. Thus, according to the company, the reason for choosing this operational model is not an attempt to reduce or evade tax payments.
Court’s Ruling
The judge determined that since the tax authority had not acted until now, there is no justification to maintain the status quo, and the tax authority is entitled to examine each tax year separately (a claim that recurs (rightfully) in various judgments). Moreover, the judge determined that although the agreement between the companies does not explicitly state that the payment pertains to royalties, there is an exception established in Section 85A of the Israeli Income Tax Ordinance, according to which if there are special relationships between the companies, then the tax officer has the authority to intervene in the agreement between the companies and in setting the price. That is, if there are special relationships between Coca-Cola Israel and the global Coca-Cola company, the tax assessing officer is authorised to classify the income from the transaction differently than the classification agreed upon by the parties, and may also adjust the price allocated by the parties to each component of the transaction in a way that leads to additional tax payment.
The “fabric” of the term “special relationships” established in Section 85A of the Income Tax Ordinance is an “open fabric” that requires examining the entire circumstances and relationships between two parties to determine if indeed “special relationships” exist between two parties to a transaction. Thus, the definition in Section 85A for special relationships: “including relationships between a person and his relative, as well as control of one side of the transaction over the other, or control of one person over the parties to the transaction, directly or indirectly, alone or together with others” is not a closed definition. Examining the relationships between the parties can lead to a determination that there are special relationships between them.
Indeed, the court analyzed the nature of the relationships between the parties and determined that there are special relationships: “… This is given the form of the transaction that was woven between the appellant and Coca-Cola, creating ‘special relationships’ of connection and mutual involvement of the two companies in the production and marketing of Coca-Cola beverages in Israel, a kind of ‘joint venture’…” Thus, the reason the judge based the special relationships between the parties is the form of the transaction that was woven between the companies. That is, due to the fact that Coca-Cola Israel is not just importing and marketing a final product but is purchasing raw material from Coca-Cola and producing a new product while using Coca-Cola’s trademarks and reputation, thereby creating mutual involvement in production and marketing between the companies.
In conclusion, the judge determined that there are special relationships between the companies, and therefore Coca-Cola Israel must pay additional tax for the royalties from Coca-Cola. This determination leads to an additional tax payment in the hundreds of millions of shekels.
Conclusions from the Ruling – Defining Special Relationships in Section 85A The main conclusions include reference to the exception in the law that allows the tax officer to intervene in the nature of the transaction and reclassify it. In general, the tax officer should respect the agreement forged between two parties. However, as stated in the ruling, there are exceptions in the law. The relevant exception for our purposes stipulates that the tax officer is authorized to disregard the provisions of the existing agreement between the involved parties and to set new provisions in their place.
In order for the tax officer to use this exception, the international transaction must occur between parties that have “special relationships,” and the terms of the transaction must be less profitable compared to a transaction that would occur between parties that do not have special relationships. Thus, the tax officer is authorized to intervene in the provisions agreed upon between two parties, according to his exclusive discretion. This exception illustrates the significant power the tax authority has in matters of setting transfer prices.
As mentioned, in order to activate the exception, there needs to be special relationships between the parties involved in the agreement. The classic interpretation of the term special relationships is directed at relationships between related companies in the corporate structure, such as a subsidiary and a parent company or sister companies. However, despite the fact that there is no connection between Coca-Cola Israel and the global Coca-Cola company in terms of corporate structure, the judge determined that there are special relationships.
The judge based his ruling on the terms of the agreement that was made between the parties and on the mutual involvement that was formed between them, which was based, among other things, on the manner of accounting. This determination illustrates that the definition appearing in Section 85A of the Israeli tax ordinance is not a closed definition, but rather a broad definition that can include even transactions between parties that are not related in the simple sense. It is important to pay attention to such issues when conducting international transactions with parties with whom there is a possibility that the tax authority may claim that they are related parties and may be able to alter the transaction.
Rulings Worldwide on the Topic
It should be noted that the Israeli tax authority is not the only authority in the world that has dealt with this issue. The issue has also been discussed in Australia and Spain. In addition, the discussion on this topic is not exclusive to Coca-Cola. The Australian court dealt with a similar claim by the tax authority against Coca-Cola’s main competitor, Pepsi.
The Israeli tax authority even used the Australian ruling to strengthen its claim. According to the tax authority, the ruling dealt with a company that performs similar actions to those of Coca-Cola Israel, and in the ruling, it was determined that payments transferred from this company for beverage concentrates included a component of royalties. In its ruling, the judge determined that although it is possible to use this ruling, he does not see a need for it to establish his determination, which was similar to the determination in the Australian court.
However, after the proceeding in Israel, the Australian ruling reached the Federal Court, where the ruling was overturned. The Federal Federal Court in Australia determined that the payment received by the company did not include a component of royalties. This ruling could greatly assist the central company in changing the ruling of the district court.
A similar case also occurred in Spain, where the court made a similar determination to the decision in Israel. Thus, it seems that other legal systems in the world have yet to decide on an issue that may arise for additional international companies in tax payments estimated in the hundreds of millions of shekels.
This ruling illustrates the great power the tax officer has in intervening in the classification of a transaction when it involves related parties, even if they are not related in the simple sense of the definition. Therefore, it is necessary to consult relevant experts in the field in order to regulate the relationship between the parties as accurately as possible. Our firm offers our clients a professional envelope in the field of transfer prices. For an initial consultation with a representative from our firm, click here.
