Pepsico P.R., Inc. v. Commissioner
| Decision Date | 20 September 2012 |
| Docket Number | Docket No. 13677-09,T.C. Memo. 2012-269,Docket No. 13676-09 |
| Parties | PEPSICO PUERTO RICO, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent PEPSICO, INC. AND AFFILIATES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
Mario J. Verdolini Jr., D. Scott Wise, Leslie J. Altus, Craig A. Phillips, and Ethan R. Goldman, for petitioners.
Lyle B. Press, Daniel A. Rosen, Vincent J. Guiliano, and Michael S. Coravos, for respondent.
GOEKE, Judge: Respondent determined income tax deficiencies with respect to PepsiCo, Inc. (PepsiCo), and Affiliates for taxable years ended December 26, 1998, December 25, 1999, December 30, 2000, December 29, 2001, and December 28, 2002, of $53,683,731, $48,488,863, $20,497,493, $26,653,075, and $46,694,856, respectively. Respondent separately determined deficiencies for PepsiCo Puerto Rico, Inc. (PPR), for taxable years ended November 30, 1998, 1999, 2000, 2001, and 2002, of $38,348,937, $31,873,463, $31,698,661, $32,717,683, and $32,399,250, respectively. These cases were consolidated for trial, briefing, and opinion. The parties submit two issues for decision:
(1) whether advance agreements issued by PepsiCo's Netherlands subsidiaries to certain PepsiCo domestic subsidiaries and PPR are more appropriately characterized as debt than as equity; and,
(2) if the advance agreements are characterized as debt, whether, and to what extent payments on the advance agreements constitute original issue discount, relating to contingent payment debt instruments under section 1.1275-4(c), Income Tax Regs.1
We hold that the advance agreements are appropriately characterized as equity for Federal income tax purposes. Accordingly, we need not consider the remaining issue.
PepsiCo is incorporated under the laws of North Carolina. At the time of petition, the principal office of PepsiCo was in Purchase, New York. At all times during the years at issue, PepsiCo was the common parent of a group of affiliated corporations pursuant to section 1504.2 PepsiCo, together with its consolidated affiliates, is a leading global beverage, snack, and food company. It manufactures and markets carbonated and noncarbonated beverages and a variety of snack foods. PepsiCo also owned and operated an international restaurant business, which was spun off in 1997.
PPR is incorporated under the laws of Delaware. At the time of petition, PPR's principal office was in Purchase, New York. PPR was a wholly owned subsidiary of PepsiCo that elected the benefits of sections 936 and 30A for all thetax years in issue. PPR directly owned and operated concentrate and snack food manufacturing facilities and performed snack food distribution functions. Effective December 1, 2006, PPR's section 936 status expired. As of that date, PPR was a member of PepsiCo's consolidated group, which filed its return on a consolidated basis.
In 1996 PepsiCo's direct subsidiary, PepsiCo Capital Corp. N.V. (CapCorp), held stock in two separate subsidiaries: PepsiCo Finance (Antilles A) N.V. (PFAA) and PepsiCo Finance (Antilles B) (PFAB). CapCorp, PFAA, and PFAB (collectively, PepsiCo companies) were all corporations organized under the law of the Netherlands Antilles, each with single classes of equity outstanding, and all were treated as controlled foreign corporations for U.S. Federal income tax purposes. The PepsiCo companies each held interests in foreign entities that were treated as partnerships for U.S. Federal income tax purposes (foreign partnerships).3 The foreign partnerships operated in areas in which PepsiCo was developing its brand and a market for its products; many were generating losses.
The PepsiCo companies each held promissory notes (pre-1996 notes) issued before 1996 by Frito-Lay, Inc. (Frito-Lay), incorporated under the laws of Delaware; Pepsi-Cola Metropolitan Bottling Co., Inc. (Metro Bottling), incorporated under the laws of New Jersey; or PepsiCo.4 The notes were traceable to indebtedness that was originally incurred in the 1980s to finance various business acquisitions and investments. As a result of a "large capital ruling" (LCR) procured from the Netherlands Antilles taxing authority in 1989, any interest payments received by the PepsiCo companies were subject to de minimis taxation in the Netherlands Antilles.
Payments of interest on the pre-1996 notes were also exempt from U.S. withholding tax under the income tax treaty between the United States and the Netherlands then in effect (Dutch tax treaty), the interest article of which extendedto residents of the Netherlands Antilles for those years.5 Furthermore, deficits of the foreign partnerships reduced the earnings and profits of the PepsiCo companies, thereby reducing the amount of interest then includable by PepsiCo as "subpart F" income under sections 951 and 952. Interest due on the pre-1996 notes was also deductible for U.S. Federal income tax purposes by Frito-Lay, PepsiCo, and Metro Bottling pursuant to section 163.
By the mid-1990s PepsiCo recognized certain business opportunities were materializing in both new and existing international markets in which its primary competitor, Coca-Cola, was not the dominant soft-drink brand. PepsiCo perceived, in particular, a more level and competitive international business landscape in Eastern Europe following the fall of the Berlin Wall in 1989. Contemporaneously, once-dormant Asian markets began to appear more receptive to a greater Western business presence. PepsiCo also understood that billions of dollars in capital investments would be necessary for the company to successfully establish its brand in these areas.
In October 1995, as PepsiCo began to consider a large-scale investment in these emerging markets, the United States and the Netherlands signed a protocol which amended article VIII of the Dutch tax treaty, terminating its extension to residents of the Netherlands Antilles.6 As a result, any interest payments made by Frito-Lay, PepsiCo, or Metro Bottling to the PepsiCo companies pursuant to the pre-1996 notes would become subject to U.S. withholding tax as of September 28, 1996.
PepsiCo, recognizing the unique confluence of both tax and business factors, endeavored to undertake a global restructuring of their international operations. A main function of the restructuring, aside from the aforementioned considerations, was for PepsiCo to organize its international holdings to allow for a more effective use of overseas earnings and to avoid using cash from the United States to fund its overseas expansion.7
In implementing its new international business model, PepsiCo decided to reconfigure its existing overseas structure by transferring ownership of some of the foreign partnerships from various Netherlands Antilles holding companies to Netherlands holding companies, where the Dutch tax treaty remained in effect. The Netherlands, unlike the Netherlands Antilles, had cultivated an extensive treaty network with the countries in which the foreign partnerships were organized. This treaty network reduced or eliminated withholding taxes on dividends paid to Netherlands holding companies. The Netherlands corporate income tax laws also exempted distributions of profits to Netherlands holding companies from Dutch corporate income tax. PepsiCo was cognizant that this favorable tax environment would allow it to mobilize its cash more efficiently than had been possible with the initial Netherlands Antilles holding company structure.
As a preliminary step in PepsiCo's reorganization, on July 24, 1996, the PepsiCo companies each contributed their interests in some of the Foreign Partnerships to Senrab Limited (Senrab) and Bramshaw Limited (Bramshaw), both Irish corporations. Senrap and Bramshaw subsequently formed PepsiCo Worldwide Investments (PWI) and PepsiCo Global Investments (PGI), respectively, both beloten vennotschaps or private limited liability companiesorganized under Dutch law.8 Thereafter, Senrab and Bramshaw contributed their interests in the Foreign Partnerships to PWI and PGI .9
The PepsiCo Frito-Lay notes had initial maturities of 15 years, with an issuer option to extend the maturity for an additional 25 years. To the extent that the borrower failed to pay accrued interest when required, all of the PepsiCo Frito-Laynotes provided that the that the lender had the right to: (1) the immediate payment of all unpaid principal and accrued interest; or (2) the immediate execution of a new five-year note (baby note) for the full amount of the accrued or unpaid interest. The baby notes would thereafter accrue interest according to a separate rate calculation.
CapCorp and PFAB contributed their PepsiCo Frito-Lay notes to PFAA. PFAA thereafter transferred all the PepsiCo Frito-Lay notes to its indirect subsidiary, Kentucky Fried Chicken International Holdings, Inc. (KFCIH), a Delaware corporation.
On September 27, 1996, KFCIH contributed a portion of the PepsiCo Frito-Lay notes having an aggregate principal amount of $1,779,662,436 and $10,467,257.64 of accrued...
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