Trade secrets: Coca-Cola’s hidden formula for avoiding taxes

The hotel door was the dividing line: inside, a first world fantasy of starched uniforms, low voices, and crisp cool air; outside, color and heat, vendors selling knickers, groundnuts and sunglasses along cracked sidewalks. I sat atop my father’s shoulders, holding his ears, taking in this snapshot of Lusaka in the late 1980s. Zambia was a country in the throes of hunger riots caused by massive reduction in the public budget, a chain reaction that engulfed most of Africa during a period known as the “lost decade.” One country toppled after another like a game of dominos playing to the rules of the Washington Consensus. My father was on the board of a Gulf development bank, assisting–or so they were under the impression–efforts to alleviate poverty in various African countries. The doors between the inside and outside of the Lusaka hotel where we stayed were as much symbolic as they were tangible; made of money, race and social class. But the inside and outside had something in common: Coca-Cola, whether dragged by vendors on small carts or poured with a flourish in swanky restaurants.

Back in South Africa, my home country, Coke was a household name since the 1940s. South Africa’s insider and outsider divide, apartheid, seemed an even more impenetrable barrier. Companies like Coke financed the makings of the regime, investing in its earlier legitimacy by sponsoring landmarks like the Voortrekker Monument, commemorating European pioneers. Historically, the country was a key supplier of cheap labor, critical resources like gold and platinum, and a bastion in the rhetorical anti-communist foreign policy of countries like the US and UK. For companies like Coke, South Africa was a market others were less willing to enter. Prime Minister John Vorster singled out these multinationals as “bricks in the walls of the regime’s continued existence.” But a vocal portion of American and European citizens took the struggle inside to the doorsteps of power abroad. By 1978, the pressure was enough for the US Senate’s Foreign Relations Subcommittee, assessing 250 companies active in South Africa, to specifically rebuke Coca-Cola for perpetuating the apartheid system. The company refused to disclose, on several occasions, key information about hiring, pay scales and other critical issues, citing confidentiality. At the time, Coke controlled more than 75 percent of the South African market and 10 cents of every 80-cent bottle sold was claimed by the regime as tax.

By the mid-1980s global pressure grew in some of Coke’s biggest markets. In fact, like SABMiller and other companies using a host of tax havens, trusts and neighboring countries to circumvent South Africa as provenance, Coke had reorganized business affairs from the late 1970s to ensure that a management presence external to the country could still hold the market through selective divestment. In other words, Coke wanted in–just not from the inside. The company circumvented the problem of selling its Durban-based concentrate plant–its syrup manufacturer–by developing another in neighbouring Swaziland. The company’s primary business, after all, is selling concentrate to bottlers.

Jay Naidoo, then general secretary of the Congress of South African Trade Unions (Cosatu), described these reorganizations as “not divestment,” but “warehousing,” adding that, “Foreign companies have maintained their operations on a franchise basis.”

Swaziland, ruled as Africa’s last absolute monarchy since independence in 1968, was already suffering from a voided Constitution, imprisoned opponents and the banning of all political parties. Coke stepped into Swaziland, incorporating Coca-Cola Conco (1986), almost in tandem with the entrance of a new King, Mswati. A year later, the company had a concentrate plant up and running, exporting to its biggest regional buyer – South Africa. Mswati would gift Coke with the desired proximity, total legal and financial secrecy and a 6 percent corporate tax rate – essentially providing tax haven-like services to the company. (Swaziland’s revenue agency and Coca-Cola declined to comment).

These days, Coca-Cola is the single most powerful private entity in Swaziland; at last count, the source behind over 22 percent of GDP and 38 percent of the country’s foreign exchange earnings, closely following sugar exports. It is also the most powerful brand in the world, boasting a market capitalization of $177 billion and sold in over 200 countries. Which is, to say, more countries than the UN has members.

Coca-Cola claims the world’s largest beverage distribution system through Coke-owned or controlled bottlers and distribution systems and an impressive network of independent bottlers and other partners.

Coke informed us that the company uses no sugar produced in Swaziland (the actual list of countries supplying sugar to Coca-Cola is confidential), but the company is part of the system generating unaccountable billions for the monarchy through intertwined interests, such as a minority shareholding in the State-owned sugar exporter, the Royal Swaziland Sugar Corporation (RSSC); Coke’s Swaziland-based CEO Manqoba “MK” Khumalo is a member of the board.

The actual value of Coca-Cola’s business in Swaziland – its operating costs, profits and losses, intra-company loans and interest rates, etc., is just one of Coke’s many trade secrets.

HIDDEN VALUES

But there is another Conco, this one disclosed by Coke based in the Cayman Islands, a notoriously secretive tax haven. It forms part of the machinery behind Coca-Cola’s lucrative nectar: the actual value of the brand. The US Securities and Exchange Commission (SEC) requires multinationals to identify – at the risk of a small penalty for non-disclosure – subsidiaries that are financial or tax related entities. (Often, when comparing company disclosures from one year to the next, subsidiaries that remain active, disappear.)

The Cayman-based Conco is one of more than 25 entities located in tax havens – just over 30 percent of the company’s total “financial” subsidiary disclosures, exposing a strategy explained by the company in the annual report as “tax planning.” (“Our annual tax rate is based on our income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate.”) Of those based in tax havens, almost half use Delaware, including the parent Coca-Cola company, incorporated there since 1919. (The re-incorporation shift to Delaware was a legal, though not physical move, from Atlanta where the company was incorporated in 1892 and where it continues be physically headquartered.)

Delaware’s secret formula is the total tax exemption for all income related to intangible capital. In fact, the Delaware Code specifically highlights the advantages of holding companies for intangible capital that “charge” their own global subsidiaries a “fee” for use of the trademarks and other intangible capital. This occurs through a technique known as “arms length pricing” or intra-company trading, based on the transactions that might have occurred between two different companies. But the process is self-regulated by companies and transaction details are confidential even to national revenue agencies. We just have to take their word for it. Global Financial Integrity (GFI), a Washington-based nonprofit, estimates that an average 77 percent of the $528 billion (2002-2012) in illicit flows from sub-Saharan Africa takes place through transfer mispricing.

Traditional studies tend to focus on the undervaluation of minerals like diamonds or gold. Yet, in the case of intangible-heavy companies Coca-Cola, there exists no market equivalent against which to compare assigned value.

Costs related to use of the company intangible capital are logged in financial statements as expenses as “selling, general and administration” or SG&A – the latest, for 2014, at $17.2 billion. But here’s the catch: internally imputed intangible capital (all of Coca-Cola’s own brands, like Coke, Coke Zero, Sprite, Diet Coke, etc.) cannot be financially valued or included on the balance sheet – at all. According to the International Accounting Standards Board (IASB) which sets global financial reporting standards, the only brands that can be listed are those that have been acquired. Simply put, if Coke bought Pepsi, only Pepsi would be listed on Coke’s own financial statements. In Coca-Cola’s case, intangible capital with indefinite lives (such as brands) is valued $6.5 billion or 7 percent of assets. The company statements paint an interesting picture: $92 billion book value, about $61 billion in liabilities, and assets of just $30.5 billion. Half, or $14.6 billion, are tangible assets, like plants and property. Coke’s net tangible assets–the company’s total assets less intangibles, preferred equity and liabilities–or its book value, is less than $4 billion (2014). More than 96 percent of the company’s value derived from intangibles, if the metric of market capitalization (less net assets) is used.

Coke is not alone. “Over the past thirty years,” said Professor Roger Sinclair, a marketing specialist based at Wits University, “the value of the intangible portion of world stock markets has increased. In the early 1970s the balance between tangible and intangible was 80:20 in favour of tangibles. Today that is reversed–80 percent of the value of most stock markets is intangible.” Sinclair explained that Coke’s hidden value was $152 billion, after deducting net value from market capitalization data. “That is how, and where, investors incorporate the brand,” he told us. “But that value is not admitted on the balance sheet.”

The value, however, holds sway.

INTANGIBLE GOLDMINE

Interbrand, a leading brand consultancy, usually ranks Coca-Cola in the top three brands, alongside Google, and Microsoft – companies that make their business from intangible capital. These same companies are renowned for very low tax rates and very high undistributed income–example, Microsoft’s $108 billion ‘offshore’ cash stash or Google’s 17 percent tax rate. Ironically, this hidden value is an open secret. Brand Finance acknowledges that “most high value, internally generated, intangible assets never appear in conventional balance sheets.” By 2009, this meant that only 7 percent, or $3.8 trillion of an estimated $27.3 trillion, in corporate intangible capital (excluding goodwill) value was disclosed to investors and governments. Over 60 percent of global trade is conducted within multinational companies, rather than between them. The latitude for intra-company transfer pricing manipulation is vast.

Despite this growth, the IASB’s Wayne Upton maintained there is no real demand for information on the value set for intangible assets. “In financial reporting, we identify our customers as investors and creditors,“ Upton said.

“I am not persuaded that intangible assets were unimportant in 1900 or 1950,” Upton added. “Our understanding and, with it, utilization has changed.” While “hardly a new phenomenon,” Upton described transfer pricing as “a taxation or policy issue, rather than a financial reporting issue.”

Once a brand is acquired by another company, it is automatically listed on the financial sheets at the price acquired–for example, Gillette bought at $24 billion by Proctor and Gamble. The book value of the brand will never increase even if, in real life, it does. In fact, Gillette’s value–whatever the reality–can only decrease as another odd aspect of financial reporting allows only for impairment. Accretion or added value has yet to be allowed. The IASB itself has “paused” any research on intangible capital inclusion in financial reporting until…no date given. (Major accounting firms declined to respond after requesting that we send questions).

The reason for excluding intangible assets that are self-valued by companies is pretty simple: companies can, if they choose, set to their own advantage the value of their own products, particularly where there is no market equivalent.

The bigger question being that a considerable part of the value actually inheres in the company’s overall functions–where does a company draw the line, for instance, between real labour and sales networks producing intangible capital?

In other words, how much is it really worth?

The dangers of exclusion, however, are more lethal for governments, small shareholders and ultimately, the taxpayer: quite simply, self-regulated space leaves room to fudge the numbers. From 2010- 2014, Coca-Cola has logged over $82 billion in expenses under Selling, General and Administrative costs, deducted from pre-tax profits. These expenses include advertising ($16 billion), bottlers and distribution ($38 billion) and other expenses ($27 billion). How much of this in (dollar value and percentage) were payments to their own subsidiaries for use of their own brands, and, in the absence of any disclosed valuations, how were these payments determined? Coca-Cola declined to comment.

What has not been said – and arguably the reason behind the closely guarded secret of Coca-Cola’s own concentrate, known mysteriously as Merchandise 7x, is simply that so much of it is air and sweet nothings: the cost of Coke’s formula for instance, is sugar, water and bits of cinnamon, neroli and coriander. Not too expensive.

While not disclosing the actual details, the company concedes, “We derive a significant portion of our net operating revenues from sales of concentrates and syrups to independent bottling partners” – estimated at 38 percent from 2012-2014. The company also concedes, without disclosing details, that the profits from concentrate revenue is high.

Alongside Pepsi, but far in advance, Coca-Cola’s concentrate has created a collusive and oligopolistic market structure, with bottlers globally dependent on concentrate produced only by Coke (and Pepsi). The company not only sets the prices of concentrate (varying according to market) but controls or determines the entire process, including how much the end products may sell for and whether rival products in any category–such as still, sparking, juice, coffee, iced tea, etc.–can be sold. Coca Cola’s gross profit margins usually rank above 60 percent. Though the economics with bottlers are interdependent, the power rests with Coca-Cola – the owner of the brand. Bottlers are capable of generating profit and adding value largely through this relationship. An assessment of earnings before tax (EBT) margins between Coca-Cola and the US’s leading independent bottler, the US’s Coca Cola Bottling Company Consolidated, over the past decade reveals Coca-Cola averaging 25 percent, reaching highs of 40 percent. The bottler, on the other hand, hit 3 percent highs, averaged 2.5 percent and reached lows of 0.5 percent. Revenue growth sometimes evidenced bottlers overtaking the company (example 2004, 2005 and 2006 – Coca Cola grew at 2.1 percent, 2.5 percent, 2.7 percent; bottlers’ revenue increased at 5.3 percent, 6.8 percent, 7 percent). The company concedes, “most of our branded beverage products outside of North America are manufactured, sold and distributed by independent bottling partners,” with the company actually owning about 79 bottling and canning plants worldwide.

The total absence of defined and disclosed costs for a company’s internally developed intangibles could not be more significant: it also allows multinationals to reduce, with little or no external scrutiny, pre-tax profits with the accompanying effect of setting their own tax rates. The New York Times assessed the varying tax rates between industries, finding that pharmaceuticals and other industries dependent on intangibles, and therefore able to shift to low-tax jurisdictions, pay much less. Coke’s effective tax rate, globally, was listed at just 15 percent (2007-2012) or $9.4 billion, far below the nominal top tax rate of 35 percent.

The company declined to answer most of our questions, requesting a teleconference, in which Coke’s media and public affairs director instead asked reporters to explain the interest in Coke’s financial and tax structures.

Coca-Cola further declined to detail the substance of $26.9 billion it claimed in “other operating expenses” and how this line item, in addition to bottling and distribution expenses, concerns transfer pricing of intangible capital. No doubt, some of these expenses are legitimate. The question is, how much and how is it verified? The lack of market equivalent, documented value of intangible capital and total secrecy allows the company tremendous latitude with virtually no outside oversight. It is an issue that spans Coke’s corporate character from Africa to the Atlantic, and that of any number of companies that claim tax breaks on intangible capital, potentially using one location or system to undercut the other.

This brings to mind the $33 billion question.

FROM AFRICA TO THE ATLANTIC

Coca-Cola justifies its relatively low tax rate in the US by reporting that 80 percent or so of the company’s business takes place outside the US, based on volumes sold. But there exists another yardstick: revenue. Almost 50 percent of the company’s total revenue is generated in the North America. In contrast, Europe, Asia Pacific, Eurasia and Africa, each generated an average of 10 percent of total revenues from 2012 to 2014. Logically, it makes sense that North America would be the highest: Coca-Cola’s main business is concentrates and the value of intangibles – not necessarily the same jurisdiction where value is allocated – primarily operates through the US.

And that suggests something, somewhere, is wrong.

Recently, Coca-Cola disclosed a $3.3 billion tax-related dispute concerning transfer pricing with the US’s Internal Revenue Service (IRS). The IRS alleged that Coca-Cola underreported income related to intangibles. The company maintains it does what it always does, pursuant to “the same transfer pricing methodology for these licenses since the methodology was agreed with the IRS.”

Responding to our questions on Coke’s financial structure and tax rate in totality, Coke stated, “In 2014 the Company paid approximately $2 billion (USD) in corporate income tax globally – as stated in our annual filing with the US Securities and Exchange Commission (SEC) the effective global tax rate for the Company was 23.6% in 2014.”

It is clear from the way Coca-Cola does business that a hefty portion of the $33 billion in Coca-Cola’s offshore cash comes from selling the rights of intangible capital use to its subsidiaries in tax havens. (The company declined to comment on the source of income.) The barrier to formal repatriation of the funds is the US tax code triggering tax in the US. Companies can choose when to repatriate. But whatever the linguistic framing, the cash is already deposited in US banks and being used by the companies – onshore in the most real sense of the word.

“This is the general practice,” said Rudolf Elmer, a whistleblower and former Cayman Islands-based CEO of Swiss mega-bank Julius Baer. “Companies hold their bank accounts in critical financial centers such as London, New York, Zurich to continue operations. The use of tax havens, he explained, is simple: “Tax-free income is generated in tax havens to ensure that taxable profits are minimised in countries where the tax rates are high.” Previously an auditor with KPMG and Credit Suisse, Elmer emailed us various tax structures outlining the practices of major multinationals, particularly where it related to intangible capital.

In 2004, in a bid to capture the offshore pile, and taking the multinationals and Republican Party at their word — with promises of creating 660,000 jobs, increased intangible capital development and much else, the US Congress passed the Job Creation Act, allowing for an 85 percent deduction of taxes from repatriated assets. The new tax rate? 5.25 percent.

The 15 companies that accounted for half the total sum repatriated, – $155 billion — ended up slashing over 20,000 jobs. Nor was there much evident difference between repatriating and non-repatriating firms on later spending on research and development, according to reports cited in Senator Carl Levin’s 2004 Senate investigation on offshore funds. Many were kings of intellectual property: Coca-Cola, Pepsi, Pfizer, Proctor & Gamble, Merck, IBM, Intel, Eli Lilly, Bristol-Myers Squibb, with pharmaceutical and tech companies accounting for over 40 percent. The majority of the top 15 derived their income almost wholly from tax havens: Pepsi (91.1 percent), Eli Lilly (92.6 percent), Bristol-Myers (94.2 percent), Merck (96 percent), Microsoft (97 percent) etc. Coca-Cola listed a maximum of $6.1 billion available for repatriation and has, since then, continued to amass offshore. The primary sources, according to the IRS, included the Netherlands, Bermuda, Ireland, Luxembourg, and the Cayman Islands – an economy that hosts 547 percent US company profits relative to its GDP. The tax-free Caymans was the source of almost all of Coke’s repatriated cash – three times the Cayman Islands’ own GDP in 2004, via en entity – allegedly Atlantic Industries — whose role the company described as “legal insulation.”

Coca-Cola did not respond to questions related to Atlantic Industries, or to the source, entities and jurisdiction involved in the prior and current undistributed income. The company also declined to discuss potential tax liability related to the $33 billion in undistributed income, which could reach as high as $11.5 billion, calculated against the US’s 35 percent corporate tax rate that could be triggered on repatriation. Nevertheless, an assessment of Coca-Cola’s capital expenditures from 2012, for instance, shows the company investing over 50 percent in the US, where the company generates a similar revenue, both of which are four or five times higher than any other region.

“These arrangements are not legitimate. But they are also not illegal and very common,” said Elmer, the former auditor. “It is uncommon for companies like Coca-Cola to repatriate offshore income – part of which will likely be invested as high interest loans to subsidiaries.”

But, aren’t shareholders negatively impacted if the process also withholds dividends?

According to experts in corporate finance consulted for this article, withholding dividends may affect the average trader, but major shareholders comprising part of the ‘insider club’ could, if they opted, use the information to their advantage, by learning when and how to exit the market.

“Keeping liquidity levels high is a smart technique and provides bigger compensation to management,” said Elmer. “Joe in the street who has a few shares will be affected but the big shareholders, who influence the company’s decisions, are mainly concerned with how large their payouts will be in the long-term.”

(Meanwhile, Coke’s management benefits generously from the cash-flush status via shares, bonuses, salaries and other perks. Coca-Cola led the pack in management bonuses, awarding $83 million (1991) to Roberto Goizueta, who died in 1997. His shares were worth over $1 billion.)

PROFITING FROM PATRIOTISM

In his book The Making of Black Revolutionaries, civil rights leader James Forman draws on his early childhood memory of being told by a “sympathetic” but annoyed shopkeeper that “niggers” couldn’t drink Coca-Cola on the stools. “I could not understand why I was crying,” he wrote, “…what right he had to tell me where I had to drink my Coke.” It could have been any other product – and probably was, over and over again, in young Forman’s life. But the chapter, Childhood and Coca-Cola, spoke to the impression made on Forman’s mind – of a citizen removed from his birthright; symbolic of what it meant to be excluded, or included, in America. The Coca-Cola brand, in the breadth and depth of what it has signified to people over time, is unique.

That the value of a brand so ubiquitous that it straddles both the in and outside of society is kept off its books is one of the wonders of the accounting world. Yet when Coke and other large multinationals involved in pharmaceutical, consumer and technology services are allowed to withhold, or hold in secrecy, the value of core business intangibles while charging confidential expenses against these assets, it not only distorts the market. It facilitates gross transfer pricing manipulation, and drastically undermines taxes owed, and paid, to governments. Ultimately, it is the citizen taxpayer, the Coca-Cola consumer, who suffers the outcome. The secrecy of intra-company trading between subsidiaries of the same parent company facilitates this particularly where it relates to intangibles, developed by companies, and kept off their books.

To claim rightful revenues, governments must make country-by-country reporting mandatory, disclosing the substance of corporate form and function involving both subsidiaries and transactions. Internally developed intangible capital must be located on financial statements not simply as expenses but also, as assets, where the value really inheres – such as sales lists; and geographically, where the patents, trademarks, formulas, and the like, were really developed – both financially articulated at fair value rate. Finally, the use of legal and financial secrecy jurisdictions where economic activity does not occur must be disallowed. Failure to do this, under the guise of trade secrets, violates the goodwill that gives Coca-Cola’s the billions behind its brand.

* Khadija Sharife is the lead Africa forensics researcher for Investigative Dashboard (ID) and a senior investigator for African Network of Centers for Investigative Reporting (ANCIR). She is the author of Tax Us If You Can: Africa.

* THE VIEWS OF THE ABOVE ARTICLE ARE THOSE OF THE AUTHOR AND DO NOT NECESSARILY REFLECT THE VIEWS OF THE PAMBAZUKA NEWS EDITORIAL TEAM

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