Subsidiaries’ advance agreements are equity instruments


The Tax Court ruled that PepsiCo’s Netherlands subsidiary’s “advance agreements” (AAs) with certain other PepsiCo subsidiaries, newly formed as part of an effort to retain its tax position, were properly characterized as equity for U.S. tax purposes.

Prior to 1996, PepsiCo had a corporate structure that allowed separate Netherlands Antilles subsidiaries to treat interest paid on promissory notes (the pre-’96 notes) to them from PepsiCo and two other subsidiaries as subject to de minimis taxation in the Netherlands Antilles and exempt from U.S. withholding tax. The subsidiaries’ earnings and profits were reduced by foreign partnerships’ deficits in developing the Pepsi brand in new parts of the world, which in turn reduced the amount of interest PepsiCo was required to include under subpart F. In 1996 the subsidiaries transferred ownership of the foreign partnerships to Netherlands holding companies (later merged into a single one) to preserve the tax attributes prior to a Dutch tax treaty amendment that would have made interest on the pre-’96 notes subject to U.S. withholding tax as of Sept. 28, 1996.

Following the formation of these new entities under Netherlands law, PepsiCo issued  them new notes under the AAs, which the new entities had entered into with PepsiCo and its Puerto Rican subsidiary, in exchange for the pre-’96 notes. The AAs were intended to be classified as debt in the Netherlands and as equity in the United States. From a U.S. tax perspective, PepsiCo anticipated that payments to the U.S. entity pursuant to the AAs would be treated as distributions on equity. PepsiCo received a ruling from the Dutch Revenue Service supporting its intended treatment of the AAs.

The draft for the new notes specified that the principal amount was payable in 2011 but that the new, merged Netherlands company had an unrestricted option to extend the payment until 2021. The draft also stated that any “obligation” to pay the principal amount or “preferred return” would be subordinated to all indebtedness of the new company. The finalized AAs provided for payments of principal amounts after initial terms of 40 years, with unrestricted renewal options for 10 years and a separate option of delaying payment of principal for an additional five years. A preferred return that accrued unconditionally pursuant to the agreements would be capitalized into “capitalized base preferred return” and “capitalized premium preferred return” amounts, payment of which was limited by certain “aggregate net cash flow” restrictions. The obligation to repay these amounts was also subordinate to “all the indebtedness … without limitation.”

The IRS assessed deficiencies of approximately $196 million to PepsiCo and $167 million to PepsiCo Puerto Rico for tax years 1998 through 2002. The IRS argued that the substance of the transactions, revealed primarily through the negotiations with the Dutch Revenue Service, was a creditor-debtor arrangement, not the tax-free distributions with respect to stock that PepsiCo purported.

The Tax Court disagreed, citing factors used in resolving prior debt vs. equity inquiries (see Dixie Dairies Corp., 74 T.C. 476 (1980)). Among the reasons supporting equity over debt characterization were:

  • Repayment was not certain, given the “magnitude of the loans and the financially precarious nature of the foreign investments,” and that the foreign entities did not have an unqualified obligation to pay a fixed sum by a fixed maturity date.
  • No legitimate safeguards were afforded to the holders of the AAs to enforce payments.
  • The AAs unequivocally subordinated to its other debts and rights of all creditors any obligation of the new Netherlands company to pay principal or accrued preferred returns.
  • The taxpayers clearly designed the long and possibly perpetual terms of the AAs with the expectation that they would be characterized as equity for U.S. federal income tax purposes.
  • The new Netherlands company’s debt-to-equity ratios of 14.1 to 1 in 1996 and 26.2 to 1 in 1997 indicated that it would have been highly unlikely to get a loan as large as that under the AAs.

Companies need to carefully consider judicial constraints when issuing debt instruments with equity characteristics. Despite the outcome in this case, the IRS is usually successful when those constraints are ignored.

  PepsiCo Puerto Rico, Inc., T.C. Memo. 2012-269

By Laura Jean Kreissl, Ph.D., assistant professor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.


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