In Uncategorized on 09/22/2012 at 15:42

Some few of my older readers may remember, in the dim recollection of a long-ago time, an advertising tune that began thus. But Pepsico, successor-in-interest to the ancient hawker of “twice as much for a nickel, too”, definitely gets twice as much, both from Judge Goeke in Pepsico Puerto Rico, Inc., T. C. Memo. 2012-269, filed 9/20/12 (and the reason it took me so long to blog this case is that the decision is 100 pages of tightly-written corporate finagling of the highest order, with five lawyers for Pepsi and four for IRS).

Pepsi wants to expand into emerging markets during the 1990s, but doesn’t want to export any US cash, so it uses cash flow from notes issued by Frito-Lay to Pepsi’s Netherlands Antilles subs that are taxed at a minimal rate in the Netherlands Antilles, and are exempt from US tax. This works until the Netherlands Antilles preference in the Netherlands treaty with the US expires, and Pepsico has to restructure.

So Pepsico transfers some of its high-risk overseas subsidiaries from N.V.s to B.V.s, Dutch corporations. The notes get restructured, and finally are sold to an indirect Pepsi sub in exchange for advance agreements.

Now it gets amusing. For Dutch tax purposes, these advance agreements have to be debt, so that interest paid by the Dutch subs to its parent are deductible for Dutch tax purposes, but must be equity for the Pepsi subs that hold them.

IRS calls a halt and hits the convoluted Pepsi corporate structure with about $370 million in deficiencies, claiming the advance agreements are debt, Pepsi got taxable interest, and substance controls form.

Not so fast, says Judge Goeke. “Respondent asks this Court to disregard the objective form of the advance agreements and examine the substance of the transactions in discerning their proper characterization for Federal income tax purposes. It is axiomatic that the substance of a transaction governs for tax purposes. This principle is equally applicable in debt-versus-equity inquiries.

“While cognizant that the substance-over-form doctrine permeates tax law jurisprudence, we believe it prudent to emphasize that the form of a transaction often informs its substance. See e.g., Hewlett Packard Co. v. Commissioner, T.C. Memo. 2012-135 (dismissing the labels afforded to transactional instruments, but examining their terms to discern the true substance of the economic arrangement). An analysis focused myopically on the ‘substance’ of a transaction, but devoid of any consideration of the obligations engendered by the terms of the governing instruments, would typically result in deficient, or wholly flawed, determinations.” T. C. Memo. 2012-269, at pp. 49-50 (Some citations omitted).

However, see my blogpost, “We Don’t Need No Stinkin’ Factors”, 5/15/12, wherein I discuss the Hewlett-Packard case.

Since all the parties to the deal are related and are under common control, Tax Court must take a hard look at the documents, because fudging is so easy when you’re on both (or all) sides of the table.

But Judge Goeke gives Pepsi a bye. “However, notwithstanding the greater scrutiny afforded to related-party transactions, we believe that disregarding petitioners’ international corporate structure based solely on the entities’ interrelatedness is, without more, unjustified.” T. C. Memo. 2012-269, at p. 52.

So we have a voyage through the papers, with testimony concerning how Pepsi’s lawyers got what amounts to a PLR from the Dutch Revenooers saying the advance agreements were debt for Dutch purposes.

At the end, after an exhaustive review of the terms of the advance agreements, Judge Goeke finds them to be equity. Pepsi has indeed hit the spot.

This case has to go to Second Circuit, and I’ll bet we get interesting learning there. Follow.

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