Nearly six years ago, the IRS notified Coca-Cola (KO), a beverage company, it was seeking $3.3 billion in additional federal income tax for the years 2007-09 stemming from Coca-Cola’s transfer pricing with foreign affiliates. The notice came as a surprise, Coca-Cola says, because the company and IRS had previously agreed upon a transfer pricing methodology that would exempt the company from penalties going forward.

In its latest 10-Q, Coca-Cola disclosed the IRS repeatedly verified the company was abiding by the agreement:

“The IRS audited and confirmed the Company’s compliance with the agreed-upon Closing Agreement methodology in five successive audit cycles for tax years 1996 through 2006.”

But Coca-Cola says the IRS went back on its word, retroactively applied a new methodology without warning that shifted $9 billion in income from foreign affiliates to the U.S. parent, and triggered the additional $3.3 billion tax bill. Five years later in tax court, a judge sided predominantly with the IRS:

“...the Company believes that the retroactive imposition of such tax liability using a calculation methodology different from that previously agreed upon by the IRS and the Company, and audited by the IRS for over a decade, is unconstitutional.”

The details were disclosed as part of Coca-Cola’s explanation of why it adjusted its tax reserve down from $438 million to $390 million in the quarter. Though Coca-Cola believes it will ultimately prevail on appeal, the company did quantify the potential back taxes it might owe should the IRS win. Remember, the matter outlined thus far applies only for the tax years 2007-2009. If the IRS, according to Coca-Cola, were to apply its tax calculation methodology to subsequent years up to 2020:

“... the Company currently estimates that the potential aggregate incremental tax and interest liability could be approximately $12 billion.”

In the current quarter, Coca-Cola says the IRS’s tax calculation method would’ve increased the company’s tax liability by approximately $250 million, which is 11.1% of reported net income or 1.5 years of cash flow from operations. Should the methodology be applied going forward, Coca-Cola estimates its incremental tax liability would increase the company’s effective tax rate by 3.5%.

Once a ruling is made in a related foreign affiliate case, the tax court will issue a final opinion though Coca-Cola is not estimating when that will occur. At that time, though it plans to appeal, Coca-Cola will be required to pay back taxes and interest for the years 2007-2009 in the amount of $4.7 billion, which is included in the aforementioned $12 billion total potential back tax liability.

The penalties, respectively, amount to 14.2% and 36.3% of Coca-Cola’s 2020 sales.