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PepsiCo Wins US Debt-vs-Equity Dispute In Tax Court

by Leroy Baker,, New York

28 September 2012

PepsiCo Inc has obtained a United States Tax Court judgment against the Internal Revenue Service (IRS), which had claimed the firm owed it some USD363m in unpaid tax relating to its investments in subsidiaries in the Netherlands.

The unpaid corporate income tax alleged by the IRS related to the years from 1998 to 2002, inclusive, on payments made by PepsiCo’s Netherlands subsidiaries to certain PepsiCo domestic subsidiaries and PepsiCo Puerto Rico.

Judge Joseph Goeke, in a long and complex 100-page decision, held that the hybrid securities, from which those payments originated, could be treated as debt in the Netherlands and, at the same time, characterized as equity for federal tax purposes. The upshot of this was that payments made to PepsiCo's US parent company were not taxable in the US.

It was said that, by the mid-1990s, PepsiCo recognized certain business opportunities were materializing in Eastern Europe, following the fall of the Berlin Wall, and previously-dormant Asian markets, in which its primary competitor, Coca-Cola, was not the dominant soft-drink brand. PepsiCo also understood that billions of dollars in capital investments would be necessary for the company to successfully establish its brand in those markets.

For those business reasons, but also recognizing the tax implications, PepsiCo restructured its international operations such that its overseas investments were made by Netherlands holding companies and funded through ‘advance agreements’, which were considered to be debt instruments under a Dutch ruling, the payments under which were tax-free.

From a US tax perspective, PepsiCo anticipated that payments to its US subsidiaries pursuant to the advance agreements would be treated as distributions on equity. With earnings and profits of the Dutch companies predicted to be drastically reduced or eliminated by losses on their investments in the foreseeable future, it appeared unlikely that PepsiCo would be subject to US repatriated income or dividend treatment on distributions.

In fact, during the years in question, PepsiCo treated the interest payments on the advance agreements as distributions on equity on its US federal income tax returns, as any obligation of the Dutch companies to pay that interest or repay principal was subordinated to all the return on their investments.

Judge Goeke agreed, holding that “the advance agreements are more appropriately characterized as equity for Federal income tax purposes.” He cited the long and conditional maturity dates of the advance agreements, considered in the light of PepsiCo’s investments in foreign markets, which subjected repayment to the success of such ventures, and the overall subordination of those payments.

In addition, he noted that PepsiCo was not afforded legitimate creditor remedies to ensure repayment of principal or interest under the agreements, while, perhaps most convincingly for the judge, “the ‘independent creditor test’ underscored that a commercial bank or third party lender would not have engaged in transactions of comparable risk.”

As a means by which to ascertain the intentions of the parties, he considered that “a significant consideration in our inquiry is whether the funds were advanced with reasonable expectations of repayment regardless of the success of the venture or were placed at the risk of the business. Many of the general debt-versus-equity factors may bear on the degree of the risk associated with a financial instrument at issue.”

Judge Goeke also pointed out that “where a corporation uses an advance of funds to acquire capital assets, the advance is more likely to be characterized as equity,” However, “the use of advances to meet the daily operating needs of the corporation, rather than to purchase capital assets, is indicative of bona fide indebtedness.” He held the former to be applicable in the PepsiCo case.

TAGS: court | compliance | tax | business | tax compliance | Netherlands | interest | law | corporation tax | group taxation | agreements | manufacturing | corporate headquarters | controlled foreign corporations (CFC) | tax planning | withholding tax | Puerto Rico | United States

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