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IRS Argues Advance Agreements Should Be Characterized as Debt

JUL. 8, 2011

PepsiCo Puerto Rico Inc. et al. v. Commissioner

DATED JUL. 8, 2011
DOCUMENT ATTRIBUTES

PepsiCo Puerto Rico Inc. et al. v. Commissioner

[Editor's Note: This brief is related to a news story published on November 15, 2013, 2013 TNT 221-4: News Stories.]

 

UNITED STATES TAX COURT

 

 

Judge Goeke

 

 

Filed Electronically

 

 

OPENING BRIEF FOR RESPONDENT

 

 

WILLIAM J. WILKINS

 

Chief Counsel

 

Internal Revenue Service

 

 

OF COUNSEL:

 

LINDA M. KROENING

 

Division Counsel

 

(Large Business & International)

 

 

ROLAND BARRAL

 

Area Counsel, Financial Services

 

(Large Business & International)

 

 

ELIZABETH P. FLORES

 

Deputy Area Counsel (SL)

 

(Large Business & International)

 

 

                            CONTENTS

 

 

 PRELIMINARY STATEMENT

 

 

 QUESTIONS PRESENTED

 

 

 RESPONDENT'S REQUEST FOR FINDINGS OF FACT

 

 

 I. BACKGROUND

 

 

 II. PEPSICO'S INCIDENCES OF TAXATION PRIOR TO THE 1996 GLOBAL

 

     RESTRUCTURING

 

 

      A. PepsiCo's Netherlands Antilles Subsidiaries

 

 

      B. Pre-1996 Promissory Notes

 

 

      C. United States Taxes Prior to the 1996 Global Restructuring

 

 

      D. Netherlands Antilles Taxes Prior to the 1996 Global

 

         Restructuring

 

 

 III. PEPSICO'S 1996 GLOBAL RESTRUCTURING

 

 

      A. Reasons Underlying the 1996 Global Restructuring

 

 

      B. Restructuring PepsiCo's Overseas Operations

 

 

           1. The Transfer of Ownership to the Netherlands

 

 

           2. The Frito-Lay Notes

 

 

           3. The 1996 Advance Agreements

 

 

           4. Subsequent Events Following the 1996 Global

 

              Restructuring

 

 

      C. PepsiCo's Internal Explanations for the 1996 Global

 

         Restructuring

 

 

           1. The Slobbe Memo

 

 

           2. Anthony Bryant

 

 

      D. The 1997 PPR Advance Agreement

 

 

 IV. DRAFTING THE 1996 ADVANCE AGREEMENTS

 

 

      A. Key Individuals Involved

 

 

      B. 1996 Dutch Tax Ruling Process

 

 

      C. PepsiCo's Intentions Under The Finance Ruling

 

 

      D. The First Draft of the 1996 Advance Agreements

 

 

      E. Negotiating With the Dutch Tax Authority

 

 

      F. Contemporaneous Correspondence Evidencing PepsiCo's

 

         Intentions During the Finance Ruling Process

 

 

 V. MAINTAINING THE BENEFITS OF THE 1996/97 ADVANCE AGREEMENTS

 

 

      A. Extending PepsiCo's Finance Ruling to 2005

 

 

      B. New Luxembourg Advance Agreements

 

 

 VI. KEY TERMS OF THE ADVANCE AGREEEMNTS

 

 

      A. Terms of the 1996 Advance Agreements

 

 

      B. Terms of the 1997 Advance Agreement

 

 

      C. Terms of the 2007 Luxembourg Advance Agreements

 

 

 VII. INCIDENCES OF TAXATION FOLLOWING THE 1996 GLOBAL

 

      RESTRUCTURING

 

 

      A. United States Taxes Following The 1996 Global Restructuring

 

 

      B. Netherlands Taxes Following the 1996 Global Restructuring

 

 

 VIII. PAYMENTS UNDER THE 1996/97 ADVANCE AGREEMENTS

 

 

 IX. PGI'S OPERATIONS DURING THE YEARS 1996 THROUGH 2002

 

 

      A. Willem Kuzee

 

 

      B. Calculating the "Spread"

 

 

      C. Calculating the Adjustment Necessary to Meet the Required

 

         Spread on the 1996 Advance Agreements

 

 

      D. Calculating the Adjustment Necessary for the Required Spread

 

         on the 1997 PPR Advance Agreements

 

 

 X. CIRCULAR FLOW OF FUNDS

 

 

 XI. PETITIONERS' EXPERT WITNESSES

 

 

      A. Paul Sleurink

 

 

      B. Christopher James

 

 

 XII. RESPONDENT'S EXPERT WITNESS: JEAN-PAUL R. VAN DEN BERG

 

 

 XIII. PEPSICO'S OVERSEAS EXPANSION5

 

 

      A. PepsiCo's Bottling Operations

 

 

      B. Funding Overseas Expansion

 

 

      C. ABN-AMRO Credit Facility

 

 

 RESPONDENT'S REQUEST FOR ULTIMATE FINDINGS OF FACT

 

 

 POINTS RELIED UPON

 

 

 ARGUMENT

 

 

 I. THE 1996/97 ADVANCE AGREEMENTS ARE DEBT FOR UNITED STATES TAX

 

    PURPOSES UNDER THE SUBSTANCE-OVER-FORM DOCTRINE

 

 

      A. The Substance Of The Payments Of Base PR Under The 1996/97

 

         Advance Agreements Is Different From Their Intentionally

 

         Vague Form

 

 

      B. PepsiCo Intended To Create A Debt

 

 

           1. PepsiCo's External Correspondence Indicates That

 

              PepsiCo Intended To Create A Debt

 

 

           2. PepsiCo's Internal Correspondence Further Indicates

 

              That PepsiCo Intended To Create A Debt

 

 

      C. BFSI And PPR Had A Reasonable Expectation Of Principal

 

         Repayment

 

 

      D. The Economic Realities Compelled Frito-Lay To Pay Interest

 

         And For PGI To Pay Forward That Interest As Base PR Under The

 

         1996/97 Advance Agreements

 

 

      E. Actual Flow Of Funds

 

 

      F. The 1996/97 Advance Agreements And Frito-Lay Notes Are Linked

 

 

      G. PGI's Payments Under The 1996/97 Advance Agreements Were Not

 

         Contingent

 

 

      H. STATUTORY FACTORS IN DECIDING DEBT VERSUS EQUITY FOR UNITED

 

         STATES TAX PURPOSES

 

 

      I. Use Of The Mixon Factors In Deciding Debt Versus

 

         Equity For United States Tax Purposes

 

 

           1. Summary Conclusion

 

 

           2. Name Given to the Instruments

 

 

           3. Presence or Absence of a Fixed Maturity Date

 

 

           4. Source of Payments

 

 

           5. Right to Enforce Payment

 

 

           6. Management Participation

 

 

           7. Subordinated to Other Creditors

 

 

           8. Intentions of the Parties

 

 

           9. Identity of Interest

 

 

      10. Inadequate Capitalization

 

 

      11. Ability to Obtain Loans From Third Parties

 

 

      12. Use of the Funds

 

 

      13. Failure to Repay When Due

 

 

      14. Risk Involved in Making Advances

 

 

 II. PETITIONERS' ALTERNATIVE OID ARGUMENT

 

 

 CONCLUSION

 

 

                           CITATIONS

 

 

 Cases

 

 

 A.R. Lantz Co. v. United States, 424 F.2d 1330 (9th Cir. 1970)

 

 

 Berkowitz v. United States, 411 F.2d 818 (5th Cir. 1969)

 

 

 Berthold v. Commissioner, 404 F.2d 119 (6th Cir. 1968)

 

 

 Calumet Industries Inc. v. Commissioner, 95 T.C. 257 (1990)

 

 

 Comtel Corp. v. Commissioner, 376 F.2d 791 (2d Cir. 1967),

 

 cert. denied, 389 U.S. 929 (1967)

 

 

 Court Holding Co. v. Commissioner, 324 U.S. 331 (1945)

 

 

 Dixie Dairies Corp. v. Commissioner, 74 T.C. 476 (1980)

 

 

 Estate of Mixon, 464 F.2d 394 (5th Cir. 1972)

 

 

 Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir.

 

 1968)

 

 

 Frank Lyon Co. v. United States, 435 U.S. 561 (1978)

 

 

 Geftman v. Commissioner, 154 F.3d 61 (3d Cir. 1998)

 

 

 Georgia-Pacific Corp. v. Commissioner, 63 T.C. 790 (1975)

 

 

 Gilbert v. Commissioner, 248 F.2d 399 (2d Cir. 1957)

 

 

 Gilbert v. Commissioner, 262 F.2d 512 (2d Cir. 1959)

 

 

 Gooding Amusement Co. v. Commissioner, 23 T.C. 408 (1954),

 

 aff'd, 236 F.2d 159 (6th Cir. 1956), cert. denied, 352

 

 U.S. 1031 (1957)

 

 

 Gregg Co. of Delaware v. Commissioner, 239 F.2d. 498 (2d Cir.

 

 1956)

 

 

 Gregory v. Helvering, 293 U.S. 465 (1935)

 

 

 Hambuechen v. Commissioner, 43 T.C. 90 (1964)

 

 

 Helvering v. Lazarus & Co., 308 U.S. 252 (1939)

 

 

 John Kelly Co. v. Commissioner, 326 U.S. 521 (1946)

 

 

 Kraft Foods Co. v. Commissioner, 232 F.2d 125 (2d Cir. 1956)

 

 

 Laidlaw Transp. v. Commissioner, T.C. Memo 1998-232, 1998 Tax

 

 Ct. Memo LEXIS 230

 

 

 Litton Bus. Sys., Inc. v. Commissioner, 61 T.C. 367 (1973)

 

 

 Malone & Hyde, Inc. v. Commissioner, 49 T.C. 575 (1968)

 

 

 Merck & Co., Inc. v. United States, 2011 U.S. App. LEXIS 12402

 

 (3d. Cir. 2011)

 

 

 Monon Railroad v. Commissioner, 55 T.C. 345 (1970)

 

 

 Nestle Holdings, Inc. v. Commissioner, T.C. Memo. 1995-441;

 

 1995 Tax Ct. Memo. LEXIS 439

 

 

 Piedmont Minerals Company v. United States, 429 F.2d 560 (4th

 

 Cir. 1970)

 

 

 Road Materials, Inc. v. Commissioner, 407 F.2d 1121 (4th Cir.

 

 1969)

 

 

 Slappey Drive Indus. Park v. United States, 561 F.2d 572 (5th

 

 Cir. 1977)

 

 

 Stinnett's Pontiac Serv., Inc. v. Commissioner, 730 F.2d 634

 

 (11th Cir. 1984)

 

 

 TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006)

 

 

 Trans-Atlantic Co. v. Commissioner, 469 F.2d 1189 (3d Cir.

 

 1972)

 

 

 Tyler v. Tomlinson, 414 F.2d 844 (5th Cir. 1969)

 

 

 Welch v. Helvering, 290 U.S. 111 (1933)

 

 

 Statutes

 

 

 I.R.C. § 385(a)

 

 

 I.R.C. § 385(b)

 

 

 I.R.C. § 7482(b)

 

 

 Rules

 

 

 T.C. Rule 142(a)

 

 

 Regulations

 

 

 Treas. Reg. § 1.1275-2(h)

 

 

 Treas. Reg. § 1.1275-4

 

 

 Treas. Reg. § 1.1275-4 (a)(2)(ii)

 

 

 Treas. Reg. § 1.1275-4(a)(5)

 

 

 Treas. Reg. § 1.1275-4(c)

 

 

 Treas. Reg. § 1.1275-5

 

 

 Treas. Reg. § 1.1275-5(a)(3)

 

OPENING BRIEF FOR RESPONDENT

 

 

PRELIMINARY STATEMENT

 

 

These consolidated cases1 were tried before the Honorable Joseph Robert Goeke, at a special session of the Court commencing on May 9, 2011, in Washington, D.C. At issue is whether payments received by PepsiCo Puerto Rico, Inc. ("PPR") and Beverages, Foods & Service Industries ("BFSI"), a consolidated subsidiary of PepsiCo, Inc. and Affiliates ("PepsiCo"), from PepsiCo Global Investments, B.V. ("PGI") should properly be treated as interest income received on indebtedness for United States federal income tax purposes. PPR, BFSI and PGI were all entities under PepsiCo's common control for the years at issue.

In each case, Respondent issued a notice of deficiency for the 1998, 1999, 2000, 2001, and 2002 taxable years, determining that certain instruments, titled "Advance Agreements," should be treated as debt for United States federal income tax purposes. In their petitions, Petitioners contend that the Advance Agreements should be treated as equity instruments for United States federal income tax purposes. Alternatively, Petitioners contend that if the Advance Agreements are properly treated as debt, they must be analyzed under Sections2 1271 through 1275, addressing instruments issued with original issue discount ("OID"), to determine the amount and timing of interest income inclusions.

The evidence consists of the pleadings, four stipulations of facts with accompanying exhibits, testimony, and the exhibits introduced at trial.

Opening briefs, with a page limit of 150 pages, are due on July 8, 2011. Reply briefs, with a page limit of 100 pages, are due on August 19, 2011.

 

QUESTIONS PRESENTED

 

 

1. Whether payments received by PPR and BFSI from PGI should be properly treated as interest income received on indebtedness for United States federal income tax purposes.

2. If these payments constitute interest on indebtedness, whether, and to what extent these payments constitute OID, relating to contingent payment debt instruments under Treas. Reg. § 1.1275-4(c).

 

RESPONDENT'S REQUEST FOR FINDINGS OF FACT

 

 

As set forth in the Stipulations of Facts, the use of descriptive transactional terms such as "debt," "agreement," "equity," and "liabilities," together with all related derivatives and synonyms, is for convenience only. Either party is permitted to contend that such transactions, agreements, classifications, etc., were not, in truth and substance, that which these terms suggest.

 

I. BACKGROUND

 

 

1. PepsiCo, Inc. is a corporation incorporated under the laws of North Carolina. At the time of the filing of the Petition at Docket Number 13677-09, the principal office and mailing address of PepsiCo, Inc. was 700 Anderson Hill Road, Purchase, New York 10577. (Stip. ¶ 1).

2. At all times during the years at issue, PepsiCo, Inc. was the common parent of a group of affiliated corporations within the meaning of Section 1504. (Stip. ¶ 1).

3. PepsiCo, Inc. filed a consolidated return for United States federal income taxes for each of the taxable years ended December 26, 1998, December 25, 1999, December 30, 2000, December 29, 2001, and December 28, 2002 (the "PepsiCo years at issue"). (Stip. ¶ 2).

4. PepsiCo Puerto Rico, Inc. ("PPR") is a corporation incorporated under the laws of Delaware. At the time of the filing of the Petition at Docket Number 13676-09, PPR's principal office and mailing address was c/o PepsiCo, Inc., 700 Anderson Hill Road, Purchase, New York 10577. (Stip. ¶ 5).

5. At all times during the years at issue, PPR was a wholly owned subsidiary of PepsiCo, Inc. that elected the benefits of Sections 936 and 30A. (PPR together with PepsiCo, Inc. and its consolidated affiliates, "Petitioners") (Stip. ¶ 5).

6. PPR filed a tax return for United States federal income taxes for each of the taxable years ended November 30, 1998, November 30, 1999, November 30, 2000, November 30, 2001, and November 30, 2002 (the "PPR years at issue" and together with the PepsiCo years at issue the "years at issue"). (Stip. ¶ 6).

7. PepsiCo, Inc., together with its affiliates ("PepsiCo"), is a beverage, snack and food company; it manufactures and markets carbonated and non-carbonated beverages and a variety of salty, convenient, sweet and grain-based snacks and foods that are sold in approximately 200 countries. (Stip. ¶ 9).

8. PepsiCo previously owned and operated an international restaurant business, which it spun off on October 2, 1997. (Stip. ¶ 9)

9. During the years at issue, PPR directly owned and operated concentrate and snack food manufacturing facilities and performed snack food distribution functions. (Stip. ¶ 9).

10. Effective December 1, 2006, PPR's Section 936 status expired. As of that date, PPR was included as part of the consolidated federal income tax return of PepsiCo. (Stip. ¶ 195).

 

II. PEPSICO'S INCIDENCES OF TAXATION PRIOR TO

 

THE 1996 GLOBAL RESTRUCTURING

 

 

A. PepsiCo's Netherlands Antilles Subsidiaries

11. In 1996, PepsiCo Capital Corporation N.V. ("CapCorp") was a direct subsidiary of PepsiCo, Inc. (Stip. ¶ 10).

12. In 1996, PepsiCo Finance (Antilles A) N.V. ("PFAA") and PepsiCo Finance (Antilles B) ("PFAB") were subsidiaries of CapCorp. (Stip. ¶ 10).

13. CapCorp, PFAA and PFAB were all corporations organized under the law of the Netherlands Antilles, were treated as controlled foreign corporations for United States federal income tax purposes, and had single classes of equity outstanding. (Stip. ¶ 11).

14. In 1996, CapCorp, PFAA and PFAB each held interests in entities that were treated as partnerships for United States federal income tax purposes, many of which were generating losses (the "Foreign Partnerships" or "Loss-Making Foreign Partnerships"). (Stip. ¶ 13; Ex. 49-J at PEPIRS000236).

15. Those Foreign Partnerships included Pepsi-Cola Trading Sp.zo.o (Poland), PepsiCola GmbH (Germany), Pepsi-Cola France Snc, KFC France Snc, Spizza 30 Snc, Pepsi-Cola CR s.r.o. (Czech), PepsiCo Restaurants Sea (Spain), Pepsi-Cola SR s.r.o. (Slovak Republic), SVE Trading & Manufacturing Limited (Hungary), PepsiCo Investments (China) Ltd., and PepsiCo Poland. (Stip. ¶ 13).

16. The Foreign Partnerships operated in markets in which PepsiCo was developing its brand and a market for its products. (Stip. ¶ 13).

17. As a result, Petitioners expected that these Loss-Making Foreign Partnerships would continue to generate losses during at years in issue. (Ex. 49-J at PEPIRS000228; Tr. 240).

B. Pre-1996 Promissory Notes

18. CapCorp, PFAA, and PFAB, along with PepsiCo Overseas Finance N.V. ("POF"), another PepsiCo related Netherlands Antilles subsidiary, each held promissory notes (the "Pre-1996 Notes") issued prior to 1996 by either Frito-Lay, Inc., a corporation incorporated under the laws of Delaware ("Frito-Lay"), Pepsi-Cola Metropolitan Bottling Company, Inc., a corporation incorporated under the laws of New Jersey ("Metro Bottling") or PepsiCo, Inc. (Stip. ¶¶ 11, 55 and 56; Exs. 8-J, 10-J, 14-J, 19-J, 23-J, 24-J, 27-J and 28-J).

19. The Pre-1996 Notes consisted of six promissory notes that had been issued by Frito-Lay, one promissory note that had been issued by Metro Bottling and one promissory note that had been issued by PepsiCo, Inc. (Stip. ¶ 36).

20. The one Pre-1996 Note issued by PepsiCo, Inc. consisted of a promissory note held by CapCorp in the principal amount of $118,393,106.86. Petitioners have not located this note. (Stip. ¶¶ 11, 15 and 56; Ex. 28-J).

C. United States Taxes Prior to the 1996 Global Restructuring

21. All interest due on the Pre-1996 Notes was deductible by Frito-Lay, PepsiCo, Inc. and Metro Bottling under Section 163. (Ex. 82-J at PEPIRS000096).

22. Payments of interest on the Pre-1996 Notes to CapCorp, PFAA, PFAB and POF were exempt from United States withholding tax under the 1948 United States-Netherlands Income Tax Treaty (the "Dutch Treaty"), the interest article of which extended to residents of the Netherlands Antilles in those years. (Stip. ¶¶ 12 and 15; Tr. 108-109).

23. The earnings and profits of each of CapCorp, PFAA and PFAB were reduced as a result of the losses incurred by the Loss-Making Foreign Partnerships. (Stip. ¶ 14).

24. PepsiCo's inclusions of Subpart F income in respect of interest income earned by CapCorp, PFAA and PFAB on the Pre-1996 Notes were limited by their respective earnings and profits. (Stip. ¶ 14).

D. Netherlands Antilles Taxes Prior to the 1996 Global Restructuring

25. On May 18, 1989, a group of PepsiCo Companies, including CapCorp, PFAA, PFAB and POF ("the PepsiCo Companies") obtained a Large Capital Ruling from the Netherlands Antilles taxing authority ("1989 LCR"). (Stip. ¶ 149; Ex. 89-J).

26. Under the 1989 LCR, the PepsiCo Companies were treated as a single consolidated group with PFAB considered the "parent company." (Ex. 89-J).

27. Under the 1989 LCR, the PepsiCo Companies had an aggregate equity ("aggregate equity") of approximately $2,850,000,000 as of 1989. This aggregate equity was divided into a basic equity of $35,000,000 ("basic equity") with the remainder treated as loan equity ("loan equity"). (Ex. 89-J).

28. The 1989 LCR was made applicable to the tax years 1995 and 1996 in a subsequent ruling approved by the Netherlands Antilles taxing authority on June 17, 1998. (Stip. ¶ 151; Ex. 91-J).

29. The subsequent ruling approved on June 17, 1998 also dealt with the tax treatment of the PepsiCo group's common shares that were treated as basic equity and loan equity for the bookyears 1997 through 2000, while retaining the concept of taxing basic equity and loan equity separately. (Stip. ¶ 151; Ex. 91-J).

30. Under the 1989 LCR, to the extent that the basic equity of $35,000,000 was invested in interest or dividend generating assets, the PepsiCo Companies would generally report annual income in the Netherlands Antilles in the amount of six percent of the basic equity. (Exs. 89-J, 91-J and 138-P; Tr. 353-366).

31. Under the 1989 LCR, to the extent that the loan equity was invested in interest or dividend generating assets, the PepsiCo Companies would generally report annual income on a narrower spread, a percentage varying from 1/8th to 1/16th of the loan equity. (Exs. 89-J, 91-J and 138-P; Tr. 353-366).

32. Under the 1989 LCR, the amount of tax due in the Netherlands Antilles was determined without regard to the actual amount of interest or dividends received from the corresponding interest or dividend generating assets, and without regard to any dividends paid or expenses incurred by the PepsiCo Companies. Therefore, any income which the PepsiCo Companies were able to generate on the aggregate equity would not be subject to additional tax in the Netherlands Antilles. (Exs. 89-J, 91-J and 138-P; Tr. 353-366).

33. As a result of the 1989 LCR, interest income earned by CapCorp, PFAA and PFAB on the Pre-1996 Notes was only subject to an agreed tax of $300,000 per year in the Netherlands Antilles. (Stip. ¶ 149; Exs. 64-J at PEPIRS003413 and 89-J).

 

III. PEPSICO'S 1996 GLOBAL RESTRUCTURING

 

 

A. Reasons Underlying the 1996 Global Restructuring

34. As previously discussed, prior to September 28, 1996, payments of interest on the Pre-1996 Notes were exempt from United States withholding tax under the Dutch Treaty (Stip. 12 and 15; Tr. 108-109) and subject to an extremely low agreed tax rate in the Netherlands Antilles pursuant to the 1989 LCR. (Stip. ¶ 149; Exs. 64-J and 89-J).

35. On October 10, 1995, the United States and the Netherlands signed a protocol (the "Protocol") which amended Article VIII of the Dutch Treaty. (Stip. ¶ 15).

36. As a result of the Protocol, any interest payments made by Frito-Lay, PepsiCo, Inc. or Metro Bottling to CapCorp, PFAA, PFAB and POF under the Pre-1996 Notes would have been subject to United States withholding tax as of September 28, 1996. (Stip. ¶ 15; Ex. 49-J; Tr. 108-109).

37. In response, PepsiCo decided to develop a new overseas structure by transferring ownership of some of the Loss-Making Foreign Partnerships from Netherlands Antilles holding companies to Netherlands holding companies, where the Dutch Treaty remained in effect (the "Restructuring" or "the 1996 Global Restructuring"). (Stip. ¶ 16; Exs. 49-J and 64-J).

38. Through the Restructuring, PepsiCo also wanted to use offshore cash more effectively and avoid using cash from the United States to fund its overseas expansions. (Exs. 4 9-J and 64-J; Tr. 70 and 245-246).

39. As part of the Restructuring, PepsiCo also transferred the amounts owed on the Pre-1996 Notes to newly created entities in the Netherlands. (Stip. ¶¶ 17-20).

40. In 1996, the tax cost of receiving interest income would have been markedly more significant in the Netherlands than the Netherlands Antilles, as interest was taxable at a general rate of 35% in the Netherlands. (Tr. 369; Exs. 64-J and 140-R).

41. To avoid having to incur an additional 35% Dutch corporate income tax on the receipt of interest from the Pre-1996 Notes in the Netherlands, PepsiCo sought to create an instrument that would give rise to an interest deduction for Dutch corporate income tax purposes and be treated as equity for United States federal income tax purposes. (Stip. ¶¶ 21 and 79; Exs. 46-J, 64-J, and 146-R; Tr. 124-125 and 157-158).

42. PepsiCo sought to achieve the Dutch tax result through the creation of instruments titled Advance Agreements ("Advance Agreements" or "1996/97 Advance Agreements"). (Stip. ¶ 80).

43. The Advance Agreements were designed by PepsiCo to be treated differently by the tax authorities in the United States and the Netherlands. (Exs. 46-J and 64-J; Tr. 124-125).

44. Specifically, PepsiCo sought to have the Advance Agreements classified as debt in the Netherlands and treated as equity in the United States. (Exs. 46-J and 64-J; Tr. 124-125).

B. Restructuring PepsiCo's Overseas Operations

 

1. The Transfer of Ownership to the Netherlands

 

45. On July 24, 1996, CapCorp, PFAA and PFAB each contributed their interests in some of the Loss-Making Foreign Partnerships to Senrab Limited ("Senrab") and Bramshaw Limited ("Bramshaw"), both Irish corporations. (Stip. ¶ 19).

46. Next, CapCorp, PFAA and PFAB contributed their interests in the following Loss-Making Foreign Partnerships to Senrab and Bramshaw as follows:

 

a. Of Pepsi-Cola Trading Sp.zo.o, PFAB contributed 48.68% to Bramshaw, and CapCorp contributed 46.32% to Bramshaw and 5% to Senrab.

b. Of Pepsi-Cola GmbH, PFAB contributed 60.52% to Bramshaw and 5.00% to Senrab, and PFAA contributed 34.48% to Bramshaw.

c. Of Pepsi-Cola France Snc, PFAB contributed 45% to Bramshaw, and CapCorp contributed 50% to Bramshaw and 5% to Senrab.

d. Of KFC France Snc, PFAB contributed 45% to Bramshaw and 5% to Senrab, and CapCorp contributed 50% to Bramshaw.

e. Of Spizza 30 Snc, CapCorp contributed its 50% interest to Bramshaw.

f. Of Pepsi-Cola CR s.r.o., PFAB contributed 25% to Bramshaw and 5% to Senrab, and CapCorp contributed 70% to Bramshaw.

g. Of PepsiCo Restaurants SCA, PFAB contributed 5% to Senrab and CapCorp contributed 95% to Bramshaw.

 

(Stip. ¶ 19; Ex. 64-J).

47. On July 31, 1996, as another step in the Restructuring, Bramshaw and Senrab each formed a corporate subsidiary, a Beloten Vennootschap ("BV") or private limited liability company, organized under Dutch law. (Ex. 138-P at 5).

48. Bramshaw formed PepsiCo Global Investments, BV ("PGI"), and Senrab formed PepsiCo Worldwide Investments, BV ("PWI"). (Stip. 20; Ex. 75-J).

49. Following their formation, Bramshaw and Senrab each contributed their interests in the Loss-Making Foreign Partnerships to PGI and PWI during 1996. (Stip. ¶ 20, Ex. 49-J at PEPIRS000236).

 

2. The Frito-Lay Notes

 

50. As part of the Restructuring, Frito-Lay, PepsiCo, Inc. and Metro Bottling issued six new notes as of September 1, 1996 to CapCorp, PFAA, PFAB and POF (the "Frito-Lay Notes") in exchange for the six Pre-1996 Notes, plus accrued interest. (Stip. ¶ 17; Exs. 3-J and 28-J).

51. In its United States federal income tax return for the taxable year ending in 1996, PepsiCo treated the exchange of the six Pre-1996 Notes for the six Frito-Lay Notes as a taxable transaction under Section 1001, realizing and reporting zero taxable income. (Stip. ¶ 17).

52. All of the Frito-Lay Notes provided that "Interest shall accrue on any unpaid Principal Amount at a rate on the date hereof and semi-annually hereafter (on each succeeding January 1 and July 1) and equal to the greater of (i) six-month LIBOR on the relevant date (11:00AM GMT, Telerate page 3750) plus 230 basis points or (ii) 7.5% per annum . . . [a]ccrued interest shall be payable on each December 31 (or the first business day following), annually in arrears, beginning in 1997." (Ex. 3-J).

53. All of the Frito-Lay Notes further provided that if the Borrower (Frito-Lay, Metro Bottling or PepsiCo, Inc.) failed to pay accrued interest when required, the Lender had the right to (i) the immediate payment of all unpaid principal and accrued interest or (ii) the immediate execution of a new 5 year promissory note for the full amount of the accrued but unpaid interest. (Ex. 35-J).

54. These new 5 year promissory notes (sometimes referred to as "Baby Notes" in correspondence with the Dutch Revenue Service) also carried an interest rate that generally would be higher than the initial interest under the Frito-Lay Notes. (Ex. 3-J).

55. Next, CapCorp, PFAB and POF contributed the Frito-Lay Notes that they held to PFAA. (Stip. ¶ 18).

56. PFAA then contributed all of the Frito-Lay Notes to its wholly owned subsidiary, Kentucky Fried Chicken Corporate Holdings, Ltd., a Delaware corporation ("KFCCH"), which in turn contributed the Frito-Lay Notes to its wholly owned subsidiary, Kentucky Fried Chicken International Holdings, Inc., a Delaware corporation ("KFCIH"). (Stip. ¶ 18).

 

3. The 1996 Advance Agreements

 

57. As of September 27, 1996, KFCIH contributed a portion of the Frito-Lay Notes, having an aggregate principal amount of $1,779,662,436 and $10,467,257.64 of accrued interest, to PGI in exchange for an Advance Agreement (the "KFCIH I Advance Agreement") having a face amount of $1,790,129,693.64. (Stip. ¶ 21; Ex. 4-J).3

58. As of September 27, 1996, KFCIH contributed the remaining Frito-Lay Notes, having an aggregate principal amount of $88,984,086.92 and $523,368.56 of accrued interest, to PWI in exchange for an Advance Agreement (the "KFCIH II Advance Agreement" and together with the KFCIH I Advance Agreement the "1996 Advance Agreements") having a face amount of $89,507,455.48. (Stip. ¶ 21; Ex. 4-J).4

59. In its United States federal income tax return for the taxable year ending in 1996, KFCIH treated each such transaction as a taxable transaction under Section 1001, realizing and reporting zero taxable income. (Stip. ¶ 21).

60. Under the terms of the 1996 Advance Agreements, a Preferred Return ("Preferred Return") accrues semi-annually on any unpaid principal amount at a rate equal to the sum of (i) the Base Preferred Return ("Base PR") under the applicable LIBOR-based rate and (ii) the Premium Preferred Return ("Premium PR") that is an aggregate of the applicable deferral and subordination premiums. To the extent any accrued Preferred Return is not paid when due, that amount is capitalized into Capitalized Base Preferred Return ("Capitalized Base PR") and Capitalized Premium Preferred Return ("Capitalized Premium PR") amounts, respectively. (Ex. 4-J).

 

4. Subsequent Events Following the 1996 Global Restructuring

 

61. On September 1, 1997, Petitioner caused PWI to merge into PGI. (Stip. ¶ 22; Ex. 75-J at PEP_00001879).

62. In 1997, Petitioner filed "check-the-box" elections to treat the Loss-Making Foreign Partnerships held by PGI as "disregarded entities" for United States federal income tax purposes. (Stip. ¶ 22).

63. In 1997, PepsiCo's operating companies with operations in China were transferred to PepsiCo Investments (China) Ltd. ("PICL") and PICL itself was transferred to PGI, which became its sole shareholder. (Stip. ¶ 58 k.).

64. On October 2, 1997, PepsiCo engaged in the public spin-off of its restaurant businesses, including KFCIH. (Stip. ¶ 23).

65. As part of the spin-off, KFCIH transferred its 1996 Advance Agreements to Beverages, Foods & Service Industries, Inc. ("BFSI"), a Delaware corporation and an indirect subsidiary of PepsiCo, which continued to hold such Advance Agreements throughout the years at issue. (Stip. ¶ 23, 208).

66. From at least 1996 through 2010, BFSI was an indirectly owned subsidiary of PepsiCo and was included in PepsiCo's consolidated group income tax returns for those years. (Stip. ¶ 208).

67. Immediately following the restaurant spin-off in October of 1997, PGI no longer held restaurant-related entities, including KFCG II, B.V., a subsidiary of PGI that held restaurant operating businesses in Germany. (Stip. ¶ 23).

68. As a result of the restaurant spin-off, PGI also no longer held the following Loss-Making Foreign Partnerships: (a) KFC France, SNC, which owned and operated KFC restaurants in France; (b) Spizza 30, SNC, which owned and operated Pizza Hut restaurants in France; and (c) PepsiCo Restaurants SCA which owned and operated Pizza Hut restaurants in Spain. (Stip. ¶¶ 23 and 58).

69. Each of PGI, PWI, CapCorp, PFAA, PFAB, BFSI, PPR, Metro Bottling, Frito-Lay, Bramshaw and Senrab was, at all times relevant to the above-captioned litigation, wholly owned (directly or indirectly) by PepsiCo, Inc. (Stip. ¶¶ 140, 207, 208, and 209).

70. KFCIH was wholly owned (directly or indirectly) by PepsiCo, Inc. prior to 1996, but was separated in connection with the spin-off of PepsiCo's global restaurant business. (Stip. ¶ 140).

71. Neither KFCIH nor PPR was a member of the consolidated group of which PepsiCo, Inc. was the common parent in 1996 or 1997. (Stip. ¶ 141).

C. PepsiCo's Internal Explanations for the 1996 Global Restructuring

 

1. The Slobbe Memo

 

72. In a memorandum dated October 29, 1996, Koen Slobbe ("Slobbe") prepared a document (the "Slobbe Memo") designed to summarize the relevant aspects of the Restructuring for distribution to certain persons involved in planning the Restructuring and to certain PepsiCo employees in compliance functions in tax, corporate finance and corporate accounting whose responsibilities were expected to be affected by the Restructuring. (Stip. ¶¶ 101 and 102; Ex. 64-J; Tr. 153-154).

73. In 1996, Slobbe was a PepsiCo employee and a Tax Manager within PepsiCo's Tax department in Richmond, UK. (Stip. ¶ 35).

74. Assigned by Jay Kushner ("Kushner"), Vice-President, International Tax Planning at PepsiCo, Slobbe, working as a project manager, oversaw the Restructuring on a nearly full-time basis during 1996. (Stip. ¶¶ 35 and 78; Tr. 79, 98-99 and 176).

75. Slobbe was the sole author of the Slobbe Memo and prepared the document in English. (Tr. 154, 157).

76. The Slobbe Memo summarized the desired tax results and noted that one main objective of "the Global Reorganisation is to ensure the tax efficient mobilisation and recycling of offshore cash in order to avoid trapped and one way cash from the US." (Ex. 64-J at PEPIRS003398-9).

77. At that time, PepsiCo wanted to use offshore cash more effectively and avoid using cash from the United States to fund its overseas expansions. (Exs. 49-J and 64-J; Tr. 70 and 245-246).

78. As was normal practice at PepsiCo, a deck of computer slides ("Deck") was prepared to explain the Restructuring to management. (Ex. 4 9-J; Tr. 222).

 

2. Anthony Bryant

 

79. At trial, Anthony Bryant ("Bryant"), a former PepsiCo employee, provided testimony regarding PepsiCo's reasons for the Restructuring and explained various slides in the Deck. (Tr. 221-244).

80. In 1996, Bryant was PepsiCo's Vice President of Tax and Treasury for the regions of Europe, Middle East, and Africa, and then the Asia/Pacific region beginning in 1997. He worked out of PepsiCo's Richmond, UK office and was involved in the Restructuring. (Tr. 184-185 and 196).

81. As Vice President of Tax and Treasury, one of Bryant's responsibilities was to make certain that there was sufficient cash available for PepsiCo's operations in international markets. (Tr. 189-190 and 214-215).

82. PepsiCo wanted to limit the amount of cash leaving the United States to fund its offshore investments, in part because of the tax cost involved in repatriating offshore cash back to the United States. (Tr. 191; 233-235).

83. PepsiCo generally had sufficient offshore cash to fund its new international operations and preferred not to borrow money from a bank due to the costs of third party borrowing. (Tr. 190-192).

84. If PGI needed to borrow cash to fund acquisitions, "that borrowing would be made from within the (PepsiCo) group" and that if PGI had borrowed from a third party, it would have been "done on a short-term basis" where there was "a requirement for emergency funding". (Tr. 204).

85. The Restructuring was designed, on part, to take advantage of losses while redeploying offshore cash as needed. (Tr. 223-225).

86. The term "Loss Utilization" in the Deck means offsetting profits from a business in one jurisdiction against losses from a business in another jurisdiction. (Ex. 49-J; Tr. 223 and 225).

87. The term "Offshore Cash Deployment" used in the Deck describes the process of using offshore cash to make new investments rather than using "fresh money" from the United States. (Ex. 49-J; Tr. 225).

88. The "New Structure III" slide of the Deck illustrates that PepsiCo expected that the funds SUN (7-Up Netherlands BV) and PIE I (PepsiCo International Europe I) received from holding profitable foreign entities would be used to fund the Loss-Making Foreign Partnerships held by PGI.5 (Tr. 228-229 and 235-240; Ex. 49-J at PEPIRS000233-236).

89. In describing its "Cash Flow" in its 1997 Annual Report, PepsiCo noted "[o]ne of PepsiCo's most alluring qualities, financially speaking, has always been cash. A powerful cash flow has fueled our growth and driven our stock for 32 years. More cash fuels more success" and "our total free cash flow for the year was more than $7.6 billion." (Stip. ¶ 83; Ex. 116-J at PEP00004478).

D. The 1997 PPR Advance Agreement

90. On May 29, 1997, PGI issued an Advance Agreement to PPR (the "1997 PPR Advance Agreement" and together with the 1996 Advance Agreements the "1996/97 Advance Agreements") in exchange for Frito-Lay notes previously held by PPR. (Stip. ¶ 26; Ex. 5-J).

91. As of the exchange date, the aggregate principal amount of the Frito-Lay notes equaled the face amount of the PPR Advance Agreement, which was $1,378,292,737.95. (Stip. ¶ 153).

92. The Frito-Lay notes that PPR exchanged with PGI for the 1997 PPR Advance Agreement were issued in 1994, 1995 and 1996 by Frito-Lay, and had initial terms of three to five years (the "Initial PPR Frito-Lay Notes"). (Stip. ¶ 26; Ex. 6-J).

93. On its United States federal income tax return for its taxable year ending in 1997, PPR treated the exchange of the Initial PPR Frito-lay Notes for the 1997 PPR Advance Agreement as a taxable transaction under Section 1001, realizing and reporting zero taxable income. (Stip. ¶ 27).

94. In 1998, one of the Initial PPR Frito-Lay Notes in the principal amount of $214,084,144.00 was repaid in full. (Stip. ¶ 28).

95. The maturities of the remaining four Initial PPR Frito-Lay Notes were subsequently extended through the issuance of new notes ("the Additional PPR Frito-Lay Notes" and, together with the Initial PPR Frito-Lay Notes, "the PPR Frito-Lay Notes"). (Stip. ¶ 28; Ex. 7-J).

96. One of the Additional PPR Frito-Lay Notes was issued to extend the maturities of two Initial PPR Frito-Lay Notes issued on October 19, 1995 and October 19, 1996, in principal amounts of $41,523,243.83 and $97,685,350.12, respectively. Petitioners have not located this Additional PPR Frito-Lay Note. (Stip. ¶ 28).

97. None of the Additional PPR Frito-Lay Notes had maturity dates past 2005 and Petitioners have not offered into evidence any notes that extend those maturity dates. (Stip. ¶ 28; Ex. 7-J; Entire Record).

 

IV. DRAFTING THE 1996 ADVANCE AGREEMENTS

 

 

A. Key Individuals Involved

98. The key individuals involved in drafting the 1996 Advance Agreements and their positions in 1996 were:

(i) Mariette Turkenburg ("Turkenburg") -- Turkenburg was a partner in the Rotterdam office of the Dutch tax advising firm of Loyens & Volkmaars, N.V., which subsequently became Loyens & Loeff N.V. (together with its predecessor "Loyens"). (Stip. ¶ 35).

(ii) Matthew Bartley ("Bartley") -- Bartley was a PepsiCo employee within PepsiCo's Tax and Treasury departments and worked in PepsiCo's international tax group in Purchase, New York. Bartley is deceased. (Stip. ¶ 35; Tr. 84, 217).

(iii) Bruce Meyer ("Meyer") -- Meyer was a Senior Tax Manager at KPMG LLP. (Stip. ¶ 35, Tr. 296).

(iv) Koen Slobbe ("Slobbe") -- As previously identified, Slobbe was a PepsiCo employee and a Tax Manager within PepsiCo's Tax department in Richmond, UK. Slobbe left PepsiCo in February of 2000. (Stip. ¶ 35; Tr. 71, 75-79, 98-99, and 176).

99. Other individuals kept apprised about the drafting of the 1996 Advance Agreements and their positions in 1996 were:

(i) Willem Kuzee ("Kuzee") -- From 1995 to 2007, Kuzee worked as a corporate accountant for PepsiCo Finance (UK) Limited and was responsible for the accounting of several PepsiCo entities located in the Netherlands, including PGI and PWI. Kuzee is a current PepsiCo employee and is now the Netherlands Controller for PepsiCo. (Stip. ¶ 35; Ex. 142-R at 12-15; Tr. 141 and 448).

(ii) Timo Munneke ("Munneke") -- Munneke was a Tax Inspector employed with the Dutch Revenue Service Large Enterprises in Rotterdam. (Stip. ¶ 35; Tr. 308).

(iii) Jay Kushner ("Kushner") -- As previously identified, Kushner was Vice President, International Tax Planning for PepsiCo and Bartley and Bryant's supervisor. (Stip. ¶ 35; Tr. 217).

(iv) Matthew McKenna ("McKenna") -- McKenna was Vice President, Taxes for PepsiCo and Kushner's supervisor. (Stip. ¶ 35; Tr. 218).

(v) Domingo Garcia ("Garcia") -- Garcia was a PepsiCo employee within PepsiCo's Tax department in Purchase, New York. (Stip. ¶ 35; Tr. 296).

(vi) Ron Harvey ("Harvey") -- Harvey was the KPMG engagement partner responsible for PepsiCo at the time. (Tr. 125).

B. 1996 Dutch Tax Ruling Process

100. In 1996, the tax ruling process in the Netherlands was to a certain extent centralized and formalized based on published Model Rulings. (Ex. 138-P at 14).

101. Aside from Model Rulings, during the 1990s taxpayers could also obtain "tailor made" rulings for non-standard transactions. (Ex. 138-P at 14 and Annex IV).

102. In many instances, the Model Rulings would provide a framework for the issuance of tailor made rulings. (Ex. 138-P at 14).

103. During the 1990s the Dutch Revenue Service was "quite cooperative" in issuing both Model Rulings and tailor made rulings provided that the transaction at issue would result in Dutch taxable profit. (Ex. 138-P at 14).

104. Paragraph 1.3 of the Model Rulings set forth the conditions for obtaining a Model Ruling on intra-group financing activities that involved the borrowing and on lending of funds within a group of related entities ("Finance Ruling"). (Ex. 138-P at 14).

105. In 1996, if a Dutch entity seeking a Finance Ruling agreed to report as net taxable profit per 12 months a percentage (a "spread") of the total amount of funds borrowed and on lent within the group of related entities, the Dutch Revenue Service would agree not to challenge such profit as failing to be at arm's length. (Ex. 138-P at 14).

106. The initial spread for a Finance Ruling was 1/8% of the total amount of funds borrowed and on lent and the spread decreased as the total amount of funds borrowed and on lent within the group of related entities increased. (Ex. 138-P).

107. Aside from agreeing to report the net taxable profit, the Dutch entity, as a condition of receiving a Finance Ruling, was not allowed to run any currency or debtor's risk. (Ex. 138-P at 14).

108. Under the Model Rulings, even though the spread was measured over a 12 month period, shortfalls in the amount of the taxable spread were allowed to be made up within a three year period. (Ex. 138-P at 14-15).

109. In 1995, the Dutch Under-Minister of Finance defined a ruling as: "an advanced opinion (within the scope of law, case law and regulations) from the Dutch Revenue Service that is binding on the Dutch Revenue Service and which described the tax consequences for multinationals on cross-border situations." (Ex. 138-P at 15).

110. Based on this definition, a taxpayer could rely on statements made in a ruling by the Dutch Revenue Service provided that the taxpayer continued to meet the terms and conditions of the ruling and the ruling did not conflict with Dutch tax law. (Tr. 372-373, 386, and 1616; Exs. 138-P at 15 and 140-R at 3).

111. While the Dutch Revenue Service ruling practice was formalized to a certain extent during 1996, Dutch tax inspectors still had some discretionary power in the formation of tax rulings. (Ex. 138-P at 15; Tr. 374).

C. PepsiCo's Intentions Under The Finance Ruling

112. As previously discussed, to avoid having PGI/PWI pay a 35% Dutch corporate income tax on the receipt of interest from the Pre-1996 Notes, PepsiCo sought to create an instrument that would be classified as debt for Dutch corporate income tax purposes. (Stip. ¶ 79; Exs. 46-J and 64-J; Tr. 124-125).

113. To obtain the corresponding interest deduction in the Netherlands and avoid additional tax in the United States, PepsiCo created Advance Agreements that were intended to be classified as debt in the Netherlands and treated as equity in the United States. (Stip. ¶ 79; Exs. 46-J and 64-J; Tr. 124-125).

114. In an effort to secure the corresponding interest deduction in the Netherlands, PepsiCo negotiated the terms of the 1996 Advance Agreements with the Dutch Revenue Service to obtain a Finance Ruling that treated a portion of payments due under the 1996 Advance Agreements as debt in the Netherlands. (Stip. ¶ 79; Ex. 64-J; Tr. 124-125, 265-267).

D. The First Draft of the 1996 Advance Agreements

115. Slobbe began the process of internally drafting the 1996 Advance Agreements by preparing and circulating a first draft. (Stip. ¶¶ 81 and 82; Exs. 45-J and 46-J; Tr. 84).

116. on January 29, 1996, Slobbe sent the first draft to Harvey and Meyer of KPMG, and PepsiCo employees Bartley, Bryant, Kushner and McKenna. (Stip. ¶ 35; Exs. 45-J and 46-J; Tr. 125).

117. The facsimile accompanying the first draft indicated that a PepsiCo controlled entity would seek an advance ruling from the Belastingdienst, the Dutch Revenue Service, addressing the Dutch tax treatment of the 1996 Advance Agreements. (Stip. ¶ 103; Ex. 46-J).

118. Bartley forwarded the first draft to Turkenburg on January 30, 1996. (Stip. ¶¶ 35 and 83; Ex. 46-J).

119. Both Turkenburg and Bartley doubted that the first draft met the criteria for creating a debt instrument under Dutch law. (Ex. 46-J; Tr. 295-296).

120. Early in the process of planning the Restructuring, it was recognized and acknowledged that the Advance Agreements would come under "intense scrutiny" from both the Internal Revenue Service and the Dutch tax authority, based on both the amount of money involved and the disparate treatment of the instrument by PepsiCo. (Ex. 46-J; Tr. 125-127).

E. Negotiating With the Dutch Tax Authority

121. In early 1996, PepsiCo hired Turkenburg to represent PepsiCo, PGI, and PWI in seeking a Finance Ruling that addressed the Dutch tax treatment of the eventual 1996 Advance Agreements. (Stip. ¶ 103; Ex. 46-J).

122. During the course of her career, Turkenburg has obtained approximately 50 Finance Rulings from the Dutch Revenue Service and is familiar with the concept of intergroup Finance Rulings. (Tr. 286-287).

123. One of the requirements to obtain a Finance Ruling was that the instrument had to be determined to be debt in the Netherlands and, to be considered debt, payments under the instrument could not be profit-dependent. (Tr. 292-293).

124. Turkenburg negotiated the Finance Ruling with Inspector Munneke. (Stip. ¶ 35; Tr. 261 and 263).

125. Turkenburg corresponded in Dutch with Munneke and sent copies of her correspondence with Munneke to Slobbe for his review. (Tr. 158-160).

126. Munneke had a preference "to keep things simple. (Tr. 271-272).

127. To keep the Finance Ruling request "simple", Turkenburg made it clear to Munneke that PGI would not use the proceeds from the Frito-Lay Notes to fund additional equity investments, since "a number of other" Dutch corporate income tax rules would start to apply and complicate the ruling process. (Tr. 269 and 301-302).

128. Slobbe, PGI's accountant, looked at PepsiCo's Dutch Finance Ruling process in "fairly simplistic terms" in "that we were, from a Dutch point of view, trying to achieve a payment in and a payment out, and there needed to be a certain -- certain spread." (Tr. 160).

F. Contemporaneous Correspondence Evidencing PepsiCo's Intentions During the Finance Ruling Process

129. Between January and July of 1996, Turkenburg negotiated the terms of a Finance Ruling for PGI and PWI on the 1996 Advance Agreements with Munneke. (Stip. ¶ 103; Exs. 46-J, 72-J, and 138-P; Tr. 55, 120, and 122).

130. During the course of this seven month period, numerous letters and facsimiles were exchanged between Turkenburg and Munneke, and internally between PepsiCo employees and their outside advisors. (Entire Record).

131. During the course of the negotiations, Turkenburg also had discussions and met with Munneke on several occasions. (Tr. 263 and 331).

132. The more difficult issues involved the term or length of the instruments involved and the drafting of a cash-flow definition acceptable to Munneke linking the payments of interest on the Frito-Lay Notes to PGI/PWI and PGI/PWI's payments of Base PR under the 1996 Advance Agreements. (Exs. 54-J, 65-J, 97-J, 102-J).

133. After meeting with Munneke on March 8, 1996, Turkenburg wrote a memorandum indicating that "PGI/PWI would like to fund these receivables (Frito-Lay Notes) with debt, as is generally the case with traditional flow-through financing companies." (Ex. 65-J).

134. The March 8, 1996 memorandum was written in Dutch and an unofficial English translation of this document was prepared by Loyens on May 28, 2010. (Tr. 264-265).

135. Turkenburg's March 8, 1996 memorandum, in describing PGI/PWI's investments in new market foreign subsidiaries, indicated that the investments ". . . will be funded with equity." (Ex. 65-J; Tr. 267-268).

136. This and later communications evidence the difficulty the drafters faced in trying to conceal the intended direct linkage between the use of the payments of interest from the Frito-Lay Notes to satisfy the payment of interest on the 1996 Advance Agreements. (Exs. 54-J, 102-J, and 134-J).

137. Despite the attempt to conceal this information, the March 8, 1996 memorandum was the first of several communications in which Turkenburg assured Munneke that the interest payments due from Frito-Lay would only be used by PGI/PWI to pay the amounts due on the 1996 Advance Agreements. (Exs. 66-J, 68-J, 69-J, and 71-J).

138. On April 24, 1996, Bartley sent Turkenburg two versions of a draft Advance Agreement designated "mtaudbv" and "mtaadbv". (Ex. 54-J).

139. The second version, mtaadbv, defined "net cash flow" to "include all interest payments received by the Company from related parties during such year." (Ex. 54-J).

140. Bartley noted that "[t]his change -- the addition of the clause '. . . but shall include all interest payments received by the Company from related parties during such year' -- is intended to provide the link between Frito-Lay interest payments made to PGI and PFI PR payments to KFCIH. The link is intentionally non-specific, to avoid giving the IRS any hook on which to hang a straight look-thru argument." (Ex. 54-J) (emphasis added).

141. Bartley further noted that "[w]e would nonetheless prefer to use mtaudbv, which creates no express link between the F-L loans and the AA. If you do not feel comfortable giving the inspector mtaudbv, we can live with mtaadbv." (Ex. 54-J).

142. In a May 7, 1996 facsimile, Bartley provided Turkenburg with a subsequent version of the draft Advance Agreement that included a further refinement of the definition of "net cash flow." The revised language provided that "[a]t the same time, the amount of net cash flow for purposes of that sentence shall in no event be less than the aggregate amount of all interest payments received by the Company from related parties during such year." (Ex. 56-J at LOY 00000131-132).

143. In a letter dated May 9, 1996, Turkenburg formally submitted PepsiCo's Finance Ruling request to Munneke. This letter included draft copies of the Frito-Lay Notes and the 1996 Advance Agreements. (Ex. 66-J).

144. The May 9, 1996 letter was written in Dutch and a contemporaneous English translation of this letter was prepared by Loyens under Turkenburg's review for PepsiCo. (Tr. 298-300).

145. The May 9, 1996 letter plainly indicates that payments of interest due on the 1996 Advance Agreements would come from the interest due on the Frito-Lay Notes and any money invested by PGI or PWI in foreign participations would be obtained from another source. (Ex. 66-J).

146. At that time, Munneke tested Turkenburg on the question of whether in actuality cash flow and profit would be identical for PGI/PWI. (Tr. 302-304).

147. To this end, Turkenburg testified that "if the [A]dvance [A]greement would be -- would be considered a profit participating loan, we would not have been able to get the deduction for the [B]ase PR. We argued to the tax inspector that the [B]ase PR was dependent on cash flow, which is not profit participating." (Tr. 303).

148. In further describing the "Cash-flow limitation" in the May 9, 1996 ruling request, the following statement appears: "The loan conditions of the Fritolay advances contain an incentive for Fritolay to actually pay interest. Deferral of payment incurs higher interest expenses and is also limited in time (5 years)." (Ex. 66-J).

149. Turkenburg testified that this provision was included to "explain to the tax inspector [Munneke] that PGI would have cash flow." (Tr. 305).

150. Turkenburg further stated that "there was a certain encouragement . . . through the higher interest expense for Frito-Lay to make payments on time" to PGI under the proposed Frito-Lay Notes, because, if Frito-Lay did not timely pay interest, PGI's taxable spread in the Netherlands would increase from 1/8 percent to 2 1/8 percent. (Tr. 305-307).

151. In a May 22, 1996 facsimile from Bartley to Turkenburg, Bartley provided his understanding of the "net cash flow" provision contained in draft 1996 Advance Agreements:

 

To review how the AA works: Remember that in Paragraphs 3(a) and 4(a) and (b) the definition of net cash flow (NCF) is not affected in any way by clauses (i) and (ii). This is important. Instead, those paragraphs provide that no payment is required unless NCF exceeds a separate number [that is, the amount of (i) plus (ii)]. Thus, two completely separate computations must be made for the year at issue: first, an identification of the NCF for that year (as NCF is defined under GAAP or as we otherwise provide); second, the sum of (i) plus (ii). Only if the first number exceeds the second is payment required. Please note: clauses (i) and (ii) have no bearing on the amount of NCF. Clauses (i) and (ii) do not modify NCF; they represent a separate amount that is compared to NCF.

 

(Ex. 102-J at LOY 00000224)(emphasis in original).

152. In that same facsimile, Bartley further noted: "As you know, we need clauses (i) and (i) as drafted to assure equity characterization for US tax purposes." (Ex. 102-J).

153. At trial, Turkenburg confirmed that the two clauses Bartley was referencing dealt with PGI/PWI's operating expenditures and capital expenditures, respectively. (Tr. 309-314).

154. On June 11, 1996, Munneke sent Turkenburg a letter conditionally approving the Finance Ruling. (Ex. 68-J).

155. The June 11, 1996 letter was written in Dutch and a contemporaneous English translation of this letter was prepared by Loyens under Turkenburg's review for PepsiCo. (Tr. 314-317).

156. In his June 11, 1996 letter, Munneke noted "that the interest payable should at least equal the interest received on the loans receivable from Frito Lay. This applies also (or should apply also) to the capitalised base interest in the form of the Capitalised Base PR Amount. This should also always be paid if the corresponding capitalized interest of Frito Lay (New Promissory Note Option) is paid by Frito Lay." (Ex. 68-J at PEP 00000134, Tr. 314-317).

157. Munneke's June 11, 1996 letter also noted that "[a] flow-through of funds form is intended." (Ex. 68-J at PEP 00000135).

158. This language was used by Munneke to indicate that the Finance Ruling should be construed similarly to a Model Ruling provided in situations involving a traditional flow-through financing company. (Tr. 317).

159. To obtain the Finance Ruling, PepsiCo had to agree to the conditions set forth in Munneke's June 11, 1969 letter. (Tr. 317-318).

160. On June 20, 1996, Bartley sent Turkenburg a facsimile making clear that PepsiCo expected all Frito-Lay interest payments to flow directly to KFCIH under the 1996 Advance Agreements. (Ex. 60-J at LOY 00000164).

161. Turkenburg responded to Bartley by sending him a facsimile dated June 21, 1996 that included the following statement:

 

the ultimate test is going to be the actual events as they are going to occur in the future, i.e. that indeed payments are going to be made as though a back-to-back arrangement existed. If we were to insert that only "some portion" of the fixed component may be paid, I expect serious opposition. Under this same factual test, we will have to ensure that operating expenses will not prevent the payment of interest. I have always understood that the financing arrangement odes [sic] not intend to export funds from the US and that you would therefore indeed always use every dollar received from FL towards payment to KFCIH.

 

(Ex. 62-J at LOY 00000180; Tr. 270-271).

162. Two days later, on June 23, 1996, Bartley sent Turkenburg another facsimile. (Ex. 62-J).

163. Attached to and made part of this facsimile were Bartley's handwritten comments to Turkenburg's June 21st facsimile indicating his agreement with her comments. (Ex. 62-J; Tr. 270-271).

164. On the coversheet to his June 23, 1996 facsimile, Bartley stated:

 

MESSAGE: Marietta -- mbb60623a

Thanks for your fax dated June 21.

1. Generally (and with specific reference to paragraph 2 of your fax), all of us [you, me, Bruce, and the inspector] appear to be in agreement. In practice, all interest paid by F-L to PGI/PWI will in turn be paid to KFCIH. The "flow-thru" result will be proved by actual events. (Any opinion you provide with respect to the AA and the Dutch ruling can and should assume this fact.)

2. I take your point about the suggested "all or some portion" change. I was trying to be clear about the fact that F-L may not (likely will not) pay the entire amount of accrued interest each year. You note that the inspector fully understands this.

3. Under no circumstances will either operating expenses or capital expenditures (no matter what definitional language we use in the AA) prevent the "flow-thru" payment of interest. Reiterate point 1 above.

 

(Ex. 62-J at LOY 00000169).

165. The "[you, me, Bruce, and the inspector]" in the above statement are Turkenburg, Bartley, Meyer, and Munneke, respectively. (Tr. 319-320).

166. On the coversheet to his June 23, 1996 facsimile, Bartley further noted that "the difficulty from a US tax perspective is that direct express linkage between F-L payment and PGI/PWI payment (and/or any requirement that cash received from F-L be paid to KFCIH) would create significant risk that the AA will be treated as debt rather than equity. If the terms of the AA either assure or require that any payment from F-L will or must be paid on to KFCIH, the IRS has a strong argument that the AA is nothing more than a linked (back-to-back) debt instrument." (Ex. 62-J at LOY 00000169).

167. On the coversheet to his June 23, 1996 facsimile, Bartley further stated, in explaining how operating expenses and capital expenses are utilized in defining Preferred Return in the draft Advance Agreement:

 

That is why we need to keep the net cash flow to opex plus capex test flexible and non-binary. (That is, we need to keep the test to some degree non-symmetrical .) We need to be able to argue compellingly that the test will not necessarily assure or require interest payments from related parties to be paid on to KFCIH under the AA. For this reason, the "wiggle" room provided by the "made or approved" language is critical. (Note that the original more expansive operating expense definition, which we have given up, was also helpful in this regard.)

 

(Ex. 62-J at LOY_00000170)(emphasis added).

168. On June 24, 1996, Bartley faxed a letter to Turkenburg that he signed on behalf of KFCIH. (Ex. 63-J).

169. In that letter, Bartley stated that he had reviewed Turkenburg's translation of Munneke's conditional approval letter of June 11th, along with a draft follow-up letter that Turkenburg proposed to send to Munneke. He then authorized Turkenburg to submit the draft follow-up letter to Munneke and "to take such other steps as are necessary to agree and complete the Dutch income tax ruling set forth in his (Munneke's June 11th) letter." (Ex. 63-J).

170. On June, 25, 1996, Turkenburg sent Munneke a follow-up letter in response to his conditional approval letter on June 11, 1996 along with a copy of Bartley's June 24, 1996 letter authorizing Turkenburg to complete the Finance Ruling process. (Ex. 69-J).

171. The June 25, 1996 letter was written in Dutch and an unofficial translation of this letter was prepared by Loyens on May 28, 2010. (Ex. 69-J).

172. In the June 25, 1996 letter, Turkenburg agreed that in order for the draft Advance Agreement is to qualify as debt in the Netherlands, the interest payments made on the Frito-Lay Notes must be "used each time for payment of, at least, the fixed component of the interest obligations vis-a-vis KFCIH, including the Capitalized Base PR Amount(s)." (Ex. 69-J at PEP 00000169).

173. In the June 25, 1996 letter, Turkenburg also stated that: "[i]n order to clarify this "flow-through" concept, it is included in the Advance Agreement that the amount of the net cash flow will not be lower than the interest payments and the payments of capitalized interest." (Ex. 69-J at PEP 00000169).

174. On July 1, 1996, Bartley faxed to Turkenburg a revised draft Advance Agreement adding an additional sentence to paragraph 6 addressing the term of the agreement should a related party default. According to the facsimile coversheet, this addition was made in response to "the inspector's recently-arising concern that PGI/PWI appear to bear 'debtor risk', which is apparently not normally the case in a classic back-to-back loan context." (Ex. 105-J at LOY 00000231).

175. On July 2, 1996, Turkenburg faxed to Munneke a revised last page to the draft Advance Agreement, adding an additional sentence to the end of paragraph 6 providing that if a related party defaults on their loans to PGI "the term of this Advance Agreement, as set forth in Paragraph 1 above, shall no longer apply." (Ex. 70-J at PEP 00000176 and 183).

176. Turkenburg inserted this sentence to satisfy Munneke's concern that PGI not have any debtor's risk. (Tr. 280-281).

177. If Frito-Lay defaulted on its notes to PGI, the 40 year term of the Advance Agreements would no longer apply and the Advance Agreements would be treated as equity in the Netherlands from that point forward. By treating the Advance Agreements as equity, PGI would lose subsequent interest deductions for the Base PR and would be prevented from taking a loss for the Frito-Lay default. (Tr. 323-327).

178. On July, 30, 1996, Turkenburg sent Munneke a follow-up letter to her June 25th letter. (Ex. 71-J; Tr. 329-330).

179. The July 30, 1996 letter was written in Dutch and an unofficial translation of this letter was prepared by Loyens on May 28, 2010. (Ex. 71-J).

180. In her July 30, 1996 letter to Munneke, Turkenburg reiterated much of what she said in her June 25th letter and included, for the first time, the following statement describing the synchronization between PGI/PWI's receipt of interest on the Frito-Lay Notes and PGI/PWI's payments under the draft Advance Agreements: "Upon a violation of the above-described synchronization the qualification of the funding switches to equity." (Ex. 71-J at PEP 00000225).

181. In effect, Turkenburg acknowledged that under the Finance Ruling if PGI/PWI made equity contributions to the Loss-Making Foreign Partnerships using interest income received from the Frito-Lay Notes, PGI/PWI would lose the synchronization between the interest income and the interest expense accruals and the Base PR would no longer be deductible in the Netherlands. (Tr. 281-283).

182. On July 31, 1996 Munneke sent Turkenburg a letter stating that in furtherance of his June 11, 1996 letter and Turkenburg's facsimile of July 2, 1996, he approves "that the spread of 1/8% will be applied" which percentage is the initial spread for a Finance Ruling in the Netherlands. (Exs. 72-J at PEP 00000231 and 138-P).

183. The July 31, 1996 letter was written in Dutch and an unofficial translation of this letter was prepared by Loyens on May 28, 2010. (Ex. 72-J).

184. Under the terms of the Finance Ruling: (i) the principal lent to PGI/PWI under the 1996 Advance Agreements constituted debt; (ii) the accrued Base PR and Capitalized Base PR were deductible as interest expenses; (iii) the Premium PR and Capitalized Premium PR were non-deductible dividends; and (iv) a spread of 1/8% of the total amount of funds borrowed would be considered "at arm's length" and taxable income to PGI/PWI, if PGI/PWI was not subject to either debtor's risk or currency risk. (Exs. 68-J, 71-J, 72-J and 138-P at 19-20).

 

V. MAINTAINING THE BENEFITS OF THE 1996/97 ADVANCE AGREEMENTS

 

 

A. Extending PepsiCo's Finance Ruling to 2005

185. On November 24, 2000, Turkenburg sent a letter to Munneke requesting a four year extension of the Finance Ruling until December 31, 2004. (Stip. ¶¶ 114, 115 and 116; Ex. 73-J; Tr. 334).

186. The November 24, 2000 letter was written in Dutch and a contemporaneous unofficial translation was prepared by Loyens. (Tr. 334).

187. In requesting the extension, Turkenburg reiterated what cash-flow meant, as used in the 1996/97 Advance Agreements, to the parties involved in the Finance Ruling. (Ex. 73-J).

188. Specifically, under the title "cash-flow limitation," the following statements appear:

 

The actual payment of the base return and the premium return is dependent on the cash-flow of PGI. Cash-flow is defined in the agreement. By referring to the cash-flow, the return does not become contingent on the results of PGI.

Subject to the terms of the Advance Agreement, the interest received on the loans made available to other group companies and/or the capitalised interest paid through a repayment of the New Promissory Notes (described below), will each time be used to pay, at least, the basis component of the Preferred return, including the Capitalized Base PR Amounts, towards BFSI and PPR.

The conditions of the loans that PGI granted to group companies contain an incentive for these group companies to actually pay interest. Deferral of payment (by the issuance of "New Promissory Notes") incurs higher interest expenses and is also limited in time (5 years).

 

(Ex. 73-J at PEP 00000279).

189. On March 29, 2001, J. Waardenburg, another Dutch Tax Inspector, approved a five year extension of the Finance Ruling until December 31, 2005 and noted that no additional extensions would be allowed. (Stip. ¶¶ 117 and 118; Ex. 74-J).

190. At trial, Turkenburg explained that the Finance Ruling was extended for five years, rather than four years, due to a change in the Dutch ruling process. (Tr. 335-336). Specifically, the Dutch changed the ruling process by requiring that taxpayers seeking a Finance Ruling produce a transfer pricing report to be used to determine the proper interest rate spread for intergroup financings. (Tr. 335-336).

B. New Luxembourg Advance Agreements

191. On August 13, 2007, BFSI and PPR contributed the 1996/97 Advance Agreements to a newly organized Luxembourg S.a.r.l. ("PGI S.a.r.l."), in exchange for new Advance Agreements of PGI S.a.r.l. with similar terms ("2007 Luxembourg Advance Agreements") in a transaction intended to be treated as a reorganization under Section 368(a)(1)(F). (Stip. ¶¶ 142, 143 and 144; Exs. 84-J and 85-J; Tr. 336).

192. As part of the same transaction, PGI filed a valid IRS Form 8832 electing to be treated as a "disregarded entity" for United States federal income tax purposes, effective August 14, 2007. (Stip. ¶ 145; Ex. 86-J).

193. As a result of that election, BFSI and PPR treated the new 2007 Luxembourg Advance Agreements as continuations of the newly disregarded 1996/97 Advance Agreements for United States federal income tax purposes. (Stip. ¶ 145; Ex. 86-J).

194. Loyens was involved in obtaining a ruling request from Luxembourg regarding the 2007 Luxembourg Advance Agreements similar to the Finance Ruling for the 1996/97 Advance Agreements. (Tr. 336-337).

195. There was no withholding tax payable in Luxembourg on the Premium PR payments on the 2007 Luxembourg Advance Agreements in 2008 or 2009. (Stip. ¶ 160; Tr. 336-337; Entire Record).

 

VI. KEY TERMS OF THE ADVANCE AGREEMENTS

 

 

A. Terms of the 1996 Advance Agreements

196. Under the 1996 Advance Agreements, the Preferred Return accrues semi-annually (on each January 1 and July 1) on any unpaid principal amount at a rate equal to the sum of (i) the Base PR under the applicable six-month LIBOR-based rate plus 230 basis points minus an adjustment rate and (ii) the Premium PR that is an aggregate of the applicable deferral premium (six-month LIBOR X 0.05) and subordination premium (six-month LIBOR X 0.45). To the extent any accrued Preferred Return is not paid when due, that amount is capitalized into Capitalized Base PR and Capitalized Premium PR amounts, respectively. (Ex. 4-J).

197. In defining Preferred Return for purposes of Base PR and Premium PR, along with Capitalized Base PR and Capitalized Premium PR, the 1996 Advance Agreements provide that:

 

. . . Preferred Return shall be payable only to the extent that the net cash flow of the Company (PGI or PWI) during the preceding year exceeded the sum of (i) the aggregate of all accrued but unpaid operating expenses incurred by the Company during such year and (ii) the aggregate amount of all capital expenditures made or approved by the Company during such year, including all capital investments (whether in the form of equity contributions, loans, or other capital investments) made or approved by the Company during such year. For purposes of the preceding sentence, the net cash flow of the Company shall be determined with reference to generally accepted accounting principals. At the same time, the amount of net cash flow for purposes of that sentence shall in no event be less than the aggregate amount of all interest payments and payments of capitalized interest received by the Company from related parties during such year."

 

(Ex. 4-J).

198. By including this cash flow formula/restriction in the 1996 Advance Agreements, PepsiCo purposefully left vague the intended direct linkage between the Frito-Lay payments to PGI and PGI's payments to KFCIH under the 1996 Advance Agreements. (Exs. 4-J and 54-J at LOY 00000107-108).

199. The 1996 Advance Agreements provide that any accrued Preferred Return shall be paid annually to the extent of net cash flow on December 31 of each year beginning in 1997. (Ex. 4-J).

200. The 1996 Advance Agreements are "governed by and construed in accordance with the laws of the State of Delaware." (Ex. 4-J).

B. Terms of the 1997 Advance Agreement

201. Under the 1997 Advance Agreement, the Preferred Return accrues semi-annually on any unpaid principal amount at a rate equal to the sum of (i) the Base PR under the applicable FIXED rate of 7.951% minus an adjustment rate and (ii) the Premium PR that is an aggregate of the applicable deferral premium (FIXED rate X 0.05) and subordination premium (FIXED rate X 0.45). To the extent any accrued Preferred Return is not paid when due, that amount is capitalized into Capitalized Base PR and Capitalized Premium PR amounts, respectively. (Stip. ¶ 26; Ex. 5-J).

202. The 1997 PPR Advance Agreement uses the exact same terminology as the 1996 Advance Agreements in defining Preferred Return. (Exs. 4-J and 5-J)

203. The 1997 PPR Advance Agreement and the 1996 Advance Agreements both provide that Preferred Return shall be payable only to the extent of the net cash flow of PGI. Specifically, in defining the term net cash flow, the following sentence is included in Section 3(a): "At the same time, the amount of net cash flow for purposes of that sentence shall in no event be less than the aggregate amount of all interest payments and payments of capitalized interest received by the Company from related parties during such year." (Exs. 4-J and 5-J).6

204. The 1997 PPR Advance Agreement provides that any accrued Preferred Return shall be paid annually to the extent of net cash flow on October 19 of each year beginning in 1997. (Ex. 5-J).

205. The 1997 PPR Advance Agreement is also "governed by and construed in accordance with the laws of the State of Delaware." (Exs. 4-J and 5-J).

C. Terms of the 2007 Luxembourg Advance Agreements

206. Under the 2007 Luxemburg Advance Agreement dated August 13, 2007 that PGI S.a.r.l. entered into with BFSI ("2007 BFSI Luxembourg AA"), the Preferred Return accrues semi-annually (on each January 1 and July 1) on any unpaid principal amount at a rate equal to the sum of (i) the Base PR under the applicable six-month LIBOR-based rate plus 230 basis points minus 0.03125% and (ii) the Premium PR that is an aggregate of the applicable deferral premium (six-month LIBOR X 0.05) and subordination premium (six-month LIBOR X 0.45). To the extent any accrued Preferred Return is not paid when due, that amount is capitalized into Capitalized Base PR and Capitalized Premium PR amounts, respectively. (Ex. 84-J).

207. Under the 2007 Luxemburg Advance Agreement dated August 13, 2007 that PGI S.a.r.l. entered into with PPR ("2007 PPR Luxembourg AA"), the Preferred Return accrues semi-annually on any unpaid principal amount at a rate equal to the sum of (i) the Base PR under the applicable fixed rate of 7.951% minus 0.03125% and (ii) the Premium PR that is an aggregate of the applicable deferral premium (fixed rate X 0.05) and subordination premium (fixed rate X 0.45). To the extent any accrued Preferred Return is not paid when due, that amount is capitalized into Capitalized Base PR and Capitalized Premium PR amounts, respectively. (Ex. 85-J).

208. The 2007 BFSI Luxembourg AA and 2007 PPR Luxembourg AA (together the "2007 Luxembourg AAs") use the exact same terminology as the 1996/97 Advance Agreements in defining Preferred Return and that the Preferred Return shall be payable only to the extent of the net cash flow of the Company, PGI S.a.r.l. Specifically, in defining the term net cash flow, the following sentence is included: "At the same time, the amount of net cash flow for purposes of that sentence shall in no event be less than the aggregate amount of all interest payments and payments of capitalized interest received by the Company from related parties during such year." (Stip. ¶ 142; Exs. 4-J, 5-J, 84-J and 85-J).

209. The 2007 BFSI Luxembourg AA provides that any accrued Preferred Return shall be paid annually to the extent of net cash flow on December 31 of each year beginning in 2007. (Ex. 84-J).

210. The 2007 PPR Luxembourg AA provides that any accrued Preferred Return shall be paid annually to the extent of net cash flow on October 19 of each year beginning in 2006. (Ex. 85-J).

211. The 2007 Luxembourg AAs are also "governed by and construed in accordance with the laws of the State of Delaware." (Exs. 4-J, 5-J, 84-J and 85-J).

 

VII. INCIDENCES OF TAXATION FOLLOWING THE 1996 GLOBAL

 

RESTRUCTURING

 

 

A. United States Taxes Following The 1996 Global Restructuring

212. All interest due on the Frito-Lay Notes and PPR Frito-Lay Notes was deductible by Frito-Lay, PepsiCo, Inc. and Metro Bottling under Section 163. (Entire Record).

213. Payments of interest on the Frito-Lay Notes and PPR Frito-Lay Notes to PGI and PGI S.a.r.l. were exempt from United States withholding tax under the Dutch Treaty and later under a United States Treaty with Luxembourg. (Ex. 64-J at PEPIRS003398; Entire Record).

214. Petitioners have reported the payments of Preferred Return on all of the Advance Agreements, including the 2007 Luxembourg AAs, as distributions on equity on their United States Federal income tax returns. (Stip. ¶ 29; Entire Record).

215. The earnings and profits of PGI and PGI S.a.r.l. were reduced as a result of the losses incurred by the Foreign Partnerships. (Stip. ¶¶ 193 and 194; Exs. 126-J through 131-J; Entire Record).

216. PepsiCo's inclusion of Subpart F income in respect of interest income earned by PGI and PGI S.a.r.l. was limited by PFG's respective earnings and profits. (Stip. ¶¶ 193 and 194; Entire Record).

217. In the 1998 through 2009 taxable years, PepsiCo's reported or corrected inclusions of PGI's and PGI S.a.r.l.'s Subpart F income were in the following amounts pursuant to Section 951:

 Taxable Year Ending                     Subpart F Inclusion

 

 ______________________________________________________________________

 

 

 Dec. 26, 1998                                         $0

 

 Dec. 25, 1999                                 $6,879,805

 

 Dec. 30, 2000                                $86,036,586

 

 Dec. 29, 2001                               $103,136,493

 

 Dec. 28, 2002                                         $0

 

 Dec. 27, 2003                                $23,072,249

 

 Dec. 25, 2004                                $38,865,815

 

 Dec. 31, 2005                                $61,178,665

 

 Dec. 30, 2006                               $137,201,109

 

 Dec. 29, 2007                               $197,987,655

 

 Dec. 27, 2008                               $207,605,843

 

 Dec. 26, 2009                               $165,959,993

 

 

(Stip. ¶ 193).

218. In the 1998 through 2006 taxable years, PPR's reported or corrected inclusions of PGI's Subpart F income were in the following amounts pursuant to Section 951:

 Taxable Year Ending                     Subpart F Inclusion

 

 ______________________________________________________________________

 

 

 Nov. 30,  1998                                       $0

 

 Nov. 30,  1999                                       $0

 

 Nov. 30,  2000                                       $0

 

 Nov. 30,  2001                                       $0

 

 Nov. 30,  2002                                       $0

 

 Nov. 30,  2003                                       $0

 

 Nov. 30,  2004                                       $0

 

 Nov. 30,  2005                              $47,825,732

 

 Nov. 30,  2006                              $64,881,455

 

 

(Stip. ¶ 194).

219. For the PepsiCo years at issue, PepsiCo filed a Form 5471 ("Information Return of U.S. Persons With Respect to Certain Foreign Corporations") for PGI with its consolidated Federal income tax returns. The Form 5471 filed for each those years indicates that PepsiCo, Inc. is PGI's only United States shareholder and PepsiCo, Inc. holds 122,337 shares of common stock in PGI. (Stip. ¶¶ 200 through 204; Exs. 126-J through 130-J).

220. For the years 1998 through 2001, PPR did not file a Form 5471 ("Information Return of U.S. Persons With Respect to Certain Foreign Corporations") regarding PGI. (Stip. ¶ 205).

221. For PPR's 2002 year at issue, PPR filed a Form 5471 ("Information Return of U.S. Persons With Respect to Certain Foreign Corporations") for PGI with its Federal income tax return for that year. The Form 5471 filed for 2002 indicates that PepsiCo, Inc. and PPR are United States shareholders of PGI and PepsiCo, Inc. holds 122,337 shares of common stock in PGI, while PPR holds zero shares of common stock in PGI. (Stip. ¶ 206; Ex. 131-J).

B. Netherlands Taxes Following the 1996 Global Restructuring

222. For Dutch corporate income tax purposes during the years at issue, all interest due on the Frito-Lay Notes and PPR Frito-Lay Notes was taxable income to PGI and would have been subject to a 35% or higher corporate income tax in the Netherlands without a corresponding interest deduction under the 1996/97 Advance Agreements. (Stip. ¶ 79; Exs. 46-J, 64-J, and 140-R; Tr. 157-158).

223. For Dutch corporate income tax purposes during the years at issue, PGI treated payments of Base PR on the 1996/97 Advance Agreements issued to both KFCIH/BFSI and PPR as interest expense and treated additional payments of Premium PR on the 1996/97 Advance Agreements as distributions on equity. (Stip. 30).

224. Payments of Premium PR on the 1996/97 Advance Agreements by PGI were immediately reportable as dividends to the Dutch Tax Administration and were subject to Dutch dividend withholding tax at a rate of 15%. (Stip. ¶ 30; Ex. 142-R at 161/4-15).

225. Under the Finance Ruling, only a spread of 1/8% or less of the total amount of funds borrowed under the 1996/97 Advance Agreements would be considered "at arm's length" and taxable income to PGI/PWI. The "arm's length" amount being the difference between the interest PGI received on the Frito-Lay Notes and PPR Frito-Lay Notes and PGI's payments to KFCIH/BFSI and PPR under the 1996/97 Advance Agreements. (Exs. 68-J, 71-J, 72-J and 138-P at 19-20; Tr. 368-369).

226. As a Dutch holding company, the dividends that PGI received from its subsidiaries were exempt from corporate income tax in the Netherlands. (Tr. 258-260).

 

VIII. PAYMENTS UNDER THE 1996/97 ADVANCE AGREEMENTS

 

 

227. Both PepsiCo and PGI respected the terms of the Finance Ruling by paying over nearly all of the amounts received under the Frito-Lay Notes to KFCIH/BFSI and PPR during the years 1997 through 2009. (Stip. ¶¶ 31, 33).

228. With respect to the 1996 Advance Agreements, PGI received $1,635,230,935 in interest payments from Frito-Lay during the years 1997 through 2009 and paid out Base PR and Premium PR7 totaling $1,626,114,719 to KFCIH/BFSI, a difference of less than 1.8%. (Stip. ¶¶ 31 and 33).

229. Each and every payment made to KFCIH/BFSI was made on the same day that the interest due on the Frito-Lay Notes was paid to PGI. (Stip. ¶¶ 31 and 33).

230. With respect to the 1997 PPR Advance Agreement, PGI received $1,395,603,173 in interest payments from Frito-Lay during the years 1997 through 2009 and paid out Base PR and Premium PR8 totaling $1,391,517,142 to PPR, a difference of less than 3.5%. (Stip. ¶¶ 214 and 34; Ex. 77-J at PEP00001941).

231. Each and every interest payment made to PPR was made on the same day that the interest due on the Frito-Lay Notes was paid to PGI. (Stip. ¶¶ 214 and 34).

 

IX. PGI'S OPERATIONS DURING THE YEARS 1996 THROUGH 2002

 

 

A. Willem Kuzee

232. As corporate accountant, Kuzee was responsible for maintaining the accounting records of several PepsiCo entities located in the Netherlands, including PGI and PWI, and reporting that information (i) to PepsiCo's corporate headquarters in Purchase, New York in accordance with United States generally accepted accounting principles and (ii) to the Dutch Chamber of Commerce,9 a Dutch governmental organization, in accordance with Dutch accounting principles. (Stip. ¶ 119; Ex. 142-R at 15 and 21).

233. Kuzee was also responsible for ensuring that the Dutch tax returns of PGI and PWI were filed by their advisors. (Stip. ¶ 119).

234. The Dutch Annual Accounts of PGI and, to the extent it was in existence, PWI, for the years ending 1996-2002 (the "Dutch Annual Accounts") were prepared in English, in accordance with Dutch law, by Kuzee and submitted to the Dutch Chamber of Commerce 13 months after year end. (Stip. ¶ 120; Exs. 75-J and 142-R at 53, 54, and 104).

235. Copies of the Dutch Annual Reports were provided to the directors of PGI and Loyens, but were not provided to PepsiCo's tax department in Purchase, New York. (Stip. ¶ 120; Ex. 142-R at 55/2-18).

236. The initials "bp" used in the Dutch Annual Reports means basis points. (Ex. 142-R at 61/12-14).

237. A "Long Term" liability under Dutch accounting is an obligation that has a term greater than one year. (Ex. 142-R at 61/23-25; 62/2-4).

238. PGI's Dutch Annual Report for the year ended December 31, 1996, the first year that PGI was in existence, reports that the "company activities are holding subsidiaries and the financing of other group companies." (Ex. 75-J).

239. Kuzee understood that the Restructuring was designed to create a structure using: (i) a holding company with profitable subsidiaries under it; and (ii) holding companies (PGI and PWI) with loss-making subsidiaries under them, so that the profitable companies could finance the loss-making subsidiaries. (Ex. 142-R at 40/9-24; 41/7-24).

240. PGI reported losses from business operations during the years 1996-2002. (Ex. 75-J; Ex. 142-R at 68/3-10; 70/12-15; 72/6-9; 78/2-5; 80/5-7).

241. During the years 1996-2002, Kuzee was not responsible for reviewing or monitoring PGI's interests in its subsidiaries. (Ex. 142-R at 82/12-25; 83/2).

242. Kuzee could not recall whether PGI held board of directors meetings during the years 1996-2002. (Ex. 142-R at 75/10-22).

243. Kuzee also could not recall whether PGI kept minutes from board of directors meetings during the years 1996-2002. (Ex. 142-R at 75/23-25; 76/2-6).

244. Kuzee could not recall the specific process for being elected a member of the board of directors of PGI in 1997 and had no input as to who was named a director of PGI. (Ex. 142-R at 92/6-9 and 91/19-22).

B. Calculating the "Spread"

245. As a condition of receiving the Finance Ruling, PGI had to report taxable income in respect of the 1996/97 Advance Agreements in an amount at least equal to a specified percentage, varying from 1/8% to 1/16%, of the total average funds borrowed by PGI during the relevant 12-month period. (Stip. ¶ 129; Exs. 49-J, 79-J, 80-J, 81-J, 142-R at 146/2-9; Tr. 117-119).

246. This amount was supposed to be equal to the difference between the interest PGI received on the Frito-Lay Notes and PPR Frito-Lay Notes and PGI's payments to KFCIH/BFSI and PPR under the 1996/97 Advance Agreements. (Stip. ¶ 130; Exs. 49-J at PEPIRS000238, 79-J, 80-J, 81-J, 138-P at 19-20 and 142-R at 146-147; Tr. 117-119).

247. Kuzee calculated the amounts due as Base PR on the 1996/97 Advance Agreements and compared those amounts to the interest due under the Frito-Lay Notes and PPR Frito-Lay Notes using Excel spreadsheets. (Stip. ¶¶ 130 and 132; Exs. 78-J, 79-J, 80-J, 81-J, 94-J and 142-R at 121-122 and 174-175).

248. At no time did Kuzee take into account PGI's operating expenses or capital expenditures in calculating the amounts due as Base PR on the 1996/97 Advance Agreements. (Exs. 78-J, 94-J and 142-R at 121-122).

249. The spreadsheets that Kuzee prepared to calculate the required spread under the Finance Ruling are titled "Calculations For The Promissory Notes." (Stip. ¶ 125; Exs. 78-J and 94-J).

C. Calculating the Adjustment Necessary to Meet the Required Spread on the 1996 Advance Agreements

250. As part of the Restructuring, eight Frito-Lay Notes were exchanged by PGI/PWI for the 1996 Advance Agreements. (Stip. ¶ 21; Exs. 3-J, 4-J and 28-J).

251. All eight of the Frito-Lay Notes provided that interest on any unpaid principal shall accrue semi-annually on January 1 and July 1 at a rate equal to the greater of (i) six-month LIBOR plus 230 basis points or (ii) 7.5% per annum. (Ex. 3-J).

252. The 1996 Advance Agreements, however, provided that the Base PR on the unpaid principal amount shall accrue semiannually on January 1 and July 1 at a six-month LIBOR rate plus 230 basis points minus an adjustment rate. (Ex. 4-J).

253. During 2001, the six-month LIBOR rate dramatically fell and was at 3.9% on July 2, 2001. Therefore, the interest rate on the Frito-Lay Notes should have been 7.5%, while the Base PR on the 1996 Advance Agreements should have been 6.2% (3.9% plus 230 basis point) minus an adjustment, creating a significant imbalance between the payment of interest on the Frito-Lay Notes and the payment of Base PR on the 1996/97 Advance Agreements. (Stip. ¶¶ 165 and 159; Exs. 3-J and 4-J).

254. Kuzee ignored the falling six-month LIBOR rate and used a 5.69% rate, instead of 3.9%, in calculating the Base PR due under the 1996 Advance Agreements for the second half of 2001. (Stip. ¶ 126; Ex. 78-J at PEP 00003997-3998).

255. PepsiCo corrected this diverging interest rate problem by amending all eight Frito-Lay Notes on March 1, 2002 ("Amended Frito-Lay Notes"). Under these amendments, as of January 1, 2002, the interest rate was changed to only a six-month LIBOR plus 230 basis points to be consistent with the Base PR rate under the 1996 Advance Agreements. (Exs. 3-J and 4-J).

256. Of the eight Frito-Lay Notes, six were issued by Frito-Lay and, of those six amendments, at least five were executed by Thomas Salcito ("Salcito"). (Ex. 3-J; Tr. 451-454).

257. Petitioners were unable to locate the signed second page to the 2002 amendment of Frito-Lay's promissory note in the principal amount of $42,002,015.44, and Salcito could not recall signing it. (Ex. 3-J; Tr. 453-454).

258. The seventh Frito-Lay Note in the principal amount of $78,952,792.53 was issued by Metro Bottling and the 2002 amendment was executed on behalf of Metro Bottling by Christine Griff, who was a tax attorney in PepsiCo's Tax Department at the time. (Ex. 3-J; Tr. 455).

259. The final Frito-Lay Note in the principal amount of $131,670,885.08 was issued by PepsiCo, Inc. Petitioners were unable to locate the signed second page to the 2002 amendment of this promissory note and Salcito could not recall signing it. (Ex. 3-J; Tr. 454).

260. Salcito began his employment with PepsiCo in 1986 and since 2000, he has held the position of Vice President, Tax Administration. (Stip. ¶ 35; Tr. 447-448).

261. In 2002, Salcito was also an Assistant Treasurer for Frito-Lay with signatory authority "mainly for tax return filing purposes." (Stip. ¶ 35; Tr. 455-456).

262. In 2002, Salcito had "absolutely" no responsibilities for the Frito-Lay business and the "only reason" he was "an officer of Frito-Lay was for the Frito-Lay state tax returns that needed to be filed or prepared." (Tr. 457).

263. Salcito could not recall how he came to sign the amendments to the Frito-Lay Notes or the reasons why these amendments were made in 2002. (Tr. 458-459).

D. Calculating the Adjustment Necessary for the Required Spread on the 1997 PPR Advance Agreements

264. During the years in issue, it also became necessary for PepsiCo to make prospective adjustments to the interest rates of the Initial PPR Frito-Lay Notes to make up for an interest shortfall as compared to the Base PR on the 1997 PPR Advance Agreement for the period 1998-2001. (Stip. ¶¶ 132 and 133; Exs. 79-J, 80-J, 81-J and 142-R at 138).

265. Because the required spread under the Finance Ruling had not been achieved, Kuzee calculated the interest rate that would be required for renewals of the maturing Initial PPR Frito-Lay Notes, so that PGI would have income in excess of the Base PR due under the 1997 PPR Advance Agreement, which would make up for prior-year shortfalls on a prospective basis. (Stip. ¶¶ 131 and 132; Exs. 79-J, 80-J, 81-J and 142-R at 138).

266. Kuzee proposed a number of options to deal with the shortfall of the required spread between the interest rate under the Initial PPR Frito-Lay Notes and the Base PR under the 1997 PPR Advance Ruling. (Stip. ¶¶ 131, 132 and 133; Exs. 79-J, 80-J, 81-J and 142-R at 138).

267. Relying on Kuzee, the maturities of the remaining four Initial PPR Frito-Lay Notes were subsequently extended through the issuance of three new Additional PPR Frito-Lay Notes with adjusted interest rates. (Stip. ¶¶ 28, 132, 133 and 134; Exs. 7-J, 79-J, 80-J, 81-J and 142-R at 138-154).

268. One Additional PPR Frito-Lay Note was issued to extend the maturities of two Initial PPR Frito-Lay Notes in principal amounts of $41,523,243.83 and $97,685,350.12. (Stip. ¶ 28).

269. Petitioners have not located this Additional PPR Frito-Lay Note. (Stip. ¶ 28).

270. None of the Additional PPR Frito-Lay Notes had maturity dates past 2005 and Petitioners have not provided evidence of new notes extending those maturity dates. (Stip. ¶ 28; Ex. 7-J; Entire Record).

271. Although Kuzee calculated the interest rate required to correct for the shortfall in the spread, neither he nor anyone else at PGI was responsible for negotiating issuance of new promissory notes with Frito-Lay. (Ex. 142-R at 53/7-10; 130/4-8; 15-18; 131/19-25; 132/2-6).

272. In fact, Kuzee had no contact with anyone at Frito-Lay during the years at issue and had no idea who at Frito-Lay would have been responsible for executing new promissory notes. (Ex. 142-R at 53/7-14).

273. Despite the fact that Petitioners cannot locate one Additional PPR Frito-Lay Note and that all Additional PPR Frito-Lay Notes apparently matured by 2005, Frito-Lay continued to pay interest on these promissory notes until at least 2009. (Stip. ¶ 34).

 

X. CIRCULAR FLOW OF FUNDS

 

 

274. PGI maintained a bank account at Citibank, Amsterdam during the years at issue. (Stip. ¶ 152).

275. On November 14, 2000, Kathi Dolan, an employee in PepsiCo's Treasury Department with responsibilities for PepsiCo's cash desk, sent an e-mail with attachments to Peter Zagrobelny, an employee in PepsiCo's Treasury Department with responsibilities for PepsiCo's cash operations, along with copies to Kuzee, Salcito and others. (Stip. ¶¶ 155 and 156; Exs. 92-J and 93-J).

276. The November 14, 2000 e-mail described the transfer of funds related to PPR's intercompany loans payable on October 19, 2000 that would take place on November 16, 2000. (Exs. 92-J and 93-J).

277. One of a number of PPR intercompany loan fund transfers discussed in the November 14, 2000 e-mail was PGI's receipt of $90,567,601.67 in interest under the PPR Frito-Lay Notes and PGI's immediate payment of that exact same amount to PPR under the 1997 PPR Advance Agreement, all on November 16, 2000. (Stip. ¶¶ 32 and 34; Exs. 77-J at PEP 00001929, 93-J and 142-R at 105-117).

278. The attachment to the November 14, 2000 e-mail also included "Flow of Funds" charts, one of which illustrated that the following would all occur on November 16, 2000: (1) PepsiCo, Inc. was to transfer $144,331,210.61 to Frito-Lay; (2) Frito-Lay was to then transfer $90,567,601.67 of that amount to PGI; (3) PGI was then to transfer that same $90,567,601.67 to PPR; (4) PPR was then to transfer that same $90,567,601.67 to Metro Bottling; and (5) Metro Bottling was then to transfer that same $90,567,601.67 back to PepsiCo, Inc. ("PPR Flow of Funds Chart"). (Stip. ¶¶ 32 and 34; Exs. 77-J at PEP 00001929, 93-J at PEP 00001374-1376, and 142-R at 105-117).

279. The PPR Flow of Funds Chart illustrates that on least one occasion, PepsiCo, Inc. funded the interest payment of the PPR Frito-Lay Notes to PGI and PGI used those same funds to pay PPR the Base PR under the 1997 PPR Advance Agreement, and those exact same funds were then returned to PepsiCo, Inc. on the same day. (Stip. ¶¶ 32 and 34; Ex. 77-J at PEP 00001929; 93-J at PEP 00001374-1376 and 142-R at 105-117).

 

XI. PETITIONERS' EXPERT WITNESSES

 

 

A. Paul Sleurink

280. Paul Sleurink ("Sleurink") is a Dutch tax lawyer with the Dutch law firm of De Brauw Blackstone Westbroek N.V. (Tr. 340 [1-6], Ex. 138-P at 3).

281. Sleurink was hired by Petitioners to provide his opinion as to whether the 1996/97 Advance Agreements constituted debt for Dutch tax purposes in 1996, and to provide a summary of the Netherlands Antilles ruling process in 1996. (Ex. 138-P at 1 and 3).

282. According to Sleurink, for Dutch tax purposes a financial instrument is treated as debt if the instrument is considered debt for Dutch civil law purposes. (Ex. 138-P).

283. Under Dutch civil law, a financial instrument is treated as debt if the borrower has an obligation to repay the borrowed amounts, whether at the end of a stated term or upon bankruptcy or liquidation of the borrower. (Ex. 138-P at 1, 5, and 10).

284. In 1996, there were three circumstances where a debt instrument would be reclassified as equity: (1) the "simulation exception"; (2) the "participating loan exception"; or (3) the "bottomless pit exception." (Ex. 138-P at 5, 7, and 10).

285. Under the participating loan exception, a debt instrument would be reclassified as equity if the following three criteria were met: (1) the interest was profit dependent; (2) the loan was subordinated; and (3) the loan had no fixed repayment date and only needed to be repaid in the event of bankruptcy, liquidation, or moratorium. (Ex. 138-P at 7-10 and 13).

286. Sleurink could not come to a definitive conclusion as to the Dutch tax treatment of the 1996/97 Advance Agreements. (Ex. 138-P at 11).

B. Christopher James

287. Christopher James ("James") is a Professor of Finance at the University of Florida. (Ex. 139-P).

288. James was hired by Petitioners to "assess whether a third party lender -- either a bank or capital markets lender group -- would have made loans in similar amounts to the funds in the Advance Agreements to PGI" on similar financial terms. (Ex. 139-P).

289. James concluded that no third party commercial lending institution would have loaned funds in the amounts of the 1996/97 Advance Agreements to PGI under similar terms. (Ex. 139-P).

290. In preparing his report and reaching this conclusion, James consulted two different databases that contain loan data collected from commercial lenders. (Ex. 139-P; Tr. 412-413).

291. Neither of these databases contained information on intercompany loans. (Tr. 413-414).

292. James testified that there is no good commercial source of data on intercompany loans for the period 1997 through 2002. (Tr. 414-418).

293. As part of his report, James calculated that PGI received $1,515,638,574 in intercompany loans during the years 1997 through 2002. (Ex. 139-P at Exhibit 4; Tr. 420-421).

294. Of this amount, $753,494,160 was originally borrowed from PFAB. (Ex. 139-P at Exhibit 4).

295. No part of the $1,515,638,574 was borrowed from commercial parties, third party lenders or banks. (Tr. 420).

296. James acknowledged that PGI had a line of credit with ABN-AMRO during the years in issue fully guaranteed by PepsiCo. (Tr. 424-425).

297. James further acknowledged that the total amount of intercompany borrowings during the years in issue dwarfed the amounts that PGI borrowed from ABN-AMRO. (Tr. 424).

298. As part of his report, James also determined that PGI made intercompany loans to affiliates totaling $550,665,460 during the years 1997 through 2002. (Ex. 139-P; Tr. 420-421).

299. James also calculated that during the years 1997-2002 PGI made new equity contributions in affiliates totaling $864,572,499. (Ex. 139-P; Tr. 420).

300. Based on the data provided by James, during the years 1997-2002 PGI received intercompany loans from affiliates totaling $1,515,638,574, while making loans and equity contributions to affiliates that totaled $1,415,237,959.10

301. As part of the Restructuring, Frito-Lay, Metro Bottling, and PepsiCo issued promissory notes to CapCorp, PFAA, and PFAB in exchange for promissory notes previously held by these Netherlands Antilles entities. (Stip. ¶ 17; Ex. 139-P).

302. The total payment that PGI received on the promissory notes from 1997 through 2002 was $1,554,937,676.97. (Stip. ¶¶ 33 and 34; Ex. 139-J).

303. During the years in issue, PGI held large amounts of loans receivables from related parties. (Exs. 75-J, 76-J, and 139-P; Tr. 409).

 

XII. RESPONDENT'S EXPERT WITNESS: JEAN-PAUL R. VAN DEN BERG

 

 

304. Jean-Paul R. van Den Berg ("van Den Berg") is a Dutch tax lawyer, an advocaat, and a member of the Dutch law firm of Stibbe where he has worked since 1998. (Tr. 432; Ex. 140-R at 1).

305. van Den Berg specializes in Dutch domestic and international law with a focus on Dutch corporate taxation. (Ex. 140-R at 1).

306. van Den Berg was hired by Respondent to provide a rebuttal expert report and an addendum to that report in response to issues raised by Sleurink. (Tr. 434-435; Ex. 140-R at 1).

307. van Den Berg was not cross-examined by counsel for Petitioners during the trial of this case. (Tr. 435).

308. van Den Berg testified that Sleurink erred in concluding that the cash flow restrictions set forth in paragraphs 3 and 4 of the 1996/97 Advance Agreements, when considered from a "standalone" perspective, could cause the 1996/97 Advance Agreements to have a profit contingent remuneration. (Ex. 140-R at 2-3).

309. This observation is based on the fact that analyzing the 1996/97 Advance Agreements on a standalone basis, without taking into consideration any of the available information concerning cash flow, is essentially a "fruitless" exercise. (Ex. 140-R at 2-3).

310. In fact, neither Turkenburg nor the Dutch Revenue Service analyzed the 1996 Advance Agreements on a standalone basis. (Ex. 140-R at 3).

311. Rather, the 1996 Advance Agreements were analyzed in connection with the promissory notes held by PGI and PWI. (Ex. 140-R at 3).

312. Based on this review, all parties to the Finance Ruling agreed that PGI would pay Base PR from the funds it received from the Frito-Lay Notes as long as the notes remained outstanding. (Exs. 62-J and 140-R at 3).

313. Under the terms of the Finance Ruling granted to PGI, if Frito-Lay defaulted on its promissory notes or the Frito-Lay Notes were repaid and PGI and PWI did not immediately use these monies to repay the 1996 Advance Agreements, the latter would be reclassified as equity. (Exs. 68-J, 69-J at PEP 0000169, 71-J at PEP 00000225, and 140-R at 3).

314. van Den Berg testified that Sleurink incorrectly translated a number of Dutch words used in the letters exchanged between Turkenburg and Munneke. (Ex. 140-R at 5-8),

315. In commenting on a June 11, 1996 letter from Munneke to Turkenburg, Sleurink erroneously added the phrase "over time" to his translation of the original Dutch. (Exs. 140-R at 5 and 68-J).

316. van Den Berg testified that the words "over time" or any Dutch words with that meaning are not found in the original Dutch letter. (Ex. 140-R at 5-7).

317. Sleurink also mistranslated the Dutch word "uitwerking" as used in the same letter. (Exs. 140-R at 6 and 68-J).

318. In his report, Sleurink translated uitwerking to mean "clearly indicates" and took the position that the word does not express any uncertainty by the writer as to how the document itself was to be interpreted. (Exs. 138-P at 16 and 140-R at 6).

319. van Den Berg properly notes that the word uitwerking means "effect", "result", or "consequence" and posits that based on this proper translation Munneke simply cannot determine the exact consequences of the cash flow restrictions set forth in the 1996 Advance Agreements. (Ex. 140-R at 6).

320. When viewed in the proper context, Munneke advised Turkenburg that even though he cannot determine the consequences or effect of the cash flow restrictions, the parties to the proposed ruling are in agreement that the interest to be paid on the 1996 Advance Agreements is at least equal to the interest to be received on the Frito-Lay receivable and that each time a payment is received by PGI from Frito-Lay a corresponding payment must be made on the 1996 Advance Agreements. (Ex. 140-R at 6-7).

 

XIII. PEPSICO'S OVERSEAS EXPANSION

 

 

A. PepsiCo's Bottling Operations

321. In 1999, PepsiCo spun off its bottling business in a public offering. (Tr. 459-460).

322. As a result of spinning off its bottling business in 1999, PepsiCo no longer directly owned bottling plants and equipment in the United States and overseas, such as in Russia. (Tr. 459-462).

323. Even though it spun off its bottling business in 1999, PepsiCo retained Metro Bottling as a holding company. (Tr. 462-463).

B. Funding Overseas Expansion

324. By the end of 2002, PGI's total capital expenditures to overseas affiliates were $1,415,237,959. This amount included $550,665,460 in loans to those affiliates and $864,572,499 in equity contributions. (Ex. 139-P at Exhibit 4-1).

325. By the end of 2002, PGI had funded over half its total capital expenditures overseas by borrowing $809,201,196 from other PepsiCo overseas affiliates. (Ex. 139-P at Exhibit 4-1, 2, 5, 8, 11, 14, 17).

326. Nearly all of the funds that PGI borrowed during the years in issue originated with PFAB. (Ex. 139-P at Exhibit 4-1, 2, 5, 8, 14, 17).

327. PFAB is a finance entity in the Netherlands Antilles. (Tr. 425-426).

328. When questioned at trial, Bryant had no idea how much funding PFAB provided to PGI from 1996 to 2002. (Tr. 248).

C. ABN-AMRO Credit Facility

329. As previously discussed, during the years at issue, PGI had a credit facility with ABN-AMRO Bank, N.V. ("ABN-AMRO"). (Stip. ¶ 70; Ex. 38-J).

330. The amount of available credit under the ABN-AMRO credit facility varied over time from a low of $20,000,000 to a high of $90,000,000. (Stip. ¶ 71; Ex. 38-J, 39-J and 40-J).

331. The ABN-AMRO credit facility was at all times secured by a Subsidiary Guaranty issued by PepsiCo to ABN-AMRO under which PepsiCo guaranteed the full and prompt payment of all obligations and indebtedness of PGI when due. (Stip. ¶ 72; Ex. 41-J).

 

RESPONDENT'S REQUEST FOR ULTIMATE FINDINGS OF FACT

 

 

1. The payments received by PPR and BFSI from PGI should properly be treated as interest income received on indebtedness for United States federal income tax purposes.

2. No portion of the interest payments received by PPR and consolidated subsidiaries of PepsiCo from PGI constitutes OID on contingent payment debt instruments.

 

POINTS RELIED UPON

 

 

PepsiCo's stated goal was simple enough: offset an interest income receivable in the Netherlands with an interest expense payable, without generating United States interest income. PepsiCo's two-step solution was straightforward: First, craft an intentionally ambiguous related-party instrument (the 1996/97 Advance Agreements) to provide the "wiggle room," as PepsiCo described it, to exploit a contrived difference in the treatment of debt instruments under United States and Dutch tax law. Second, secure a Finance Ruling in the Netherlands to ensure the offset and avoid prohibitive Dutch taxation.

Because the parties to the 1996/97 Advance Agreements were all PepsiCo controlled, step one was easy. Step two, however, proved to be more of a problem. In order to secure the Finance Ruling from the Dutch Revenue Service, PepsiCo and its controlled entities were required to effectively commit themselves to a course of conduct, which, when taken together with all of the surrounding facts and circumstances, demonstrates that the 1996/97 Advance Agreements are debt for United States federal income tax purposes as a matter of law.

It is axiomatic that the substance of a transaction, not its form, governs for tax purposes. This is especially true where, as here, the same people occupy both sides of the bargaining table. Characterization of the advances as either loans or capital contributions is a question that must be answered by reference to all the evidence. The evidence unequivocally shows that the parties intended to create a debt instrument, with a clear expectation of repayment of both principal and Preferred Return divorced from PGI's profitability, and which comported with PepsiCo's economic realities.

Petitioners conceded at trial that they intended to pay Base PR under the 1996/97 Advance Agreements independent of PGI's fortunes as a business enterprise, but contended that there was no "obligation" to do so. Petitioners' contention is factually incorrect: PGI was obligated to pay Base PR each time it received Frito-Lay interest payments under the Finance Ruling, and Frito-Lay had an economic incentive to (and did) make these payments. Moreover, Petitioners' contention is legally irrelevant. As the Third Circuit just reiterated in Merck & Co., Inc. v. United States, 2011 U.S. App. LEXIS 12402, * 17 (3d. Cir. 2011), "formal legal obligations, especially between related parties, are of dubious import in the debt-equity context."

Petitioners urge the Court to ignore economic realities and focus solely upon the purposefully vague definition of "net cash flow" in the 1996/97 Advance Agreements. The overarching doctrine of substance over form as applied in the body of debt-equity case law, however, does not tolerate that result.

 

ARGUMENT

 

 

The Commissioner's determination in this case, as set forth in the statutory notice of deficiency, should be upheld in all respects. The Commissioner's determination should be upheld because the payments received by PPR and BFSI from PGI are interest income received on indebtedness for United States tax purposes under both the substance-over-form doctrine and the traditional factors considered in resolving questions of debt versus equity.

 

I. THE 1996/97 ADVANCE AGREEMENTS ARE DEBT FOR UNITED STATES TAX

 

PURPOSES UNDER THE SUBSTANCE-OVER-FORM DOCTRINE

 

 

The substance of a transaction, not its form, governs for tax purposes. Gregory v. Helvering, 293 U.S. 465 (1935); Commissioner v. Court Holding Co., 324 U.S. 331 (1945); Gilbert v. Commissioner, 262 F.2d 512 (2d Cir. 1959). This is especially true where, as here, the nominal debtor and the nominal creditor are commonly controlled. Laidlaw Transp. v. Commissioner, T.C. Memo 1998-232, 1998 Tax Ct. Memo LEXIS 230 *59 (citing Road Materials, Inc. v. Commissioner, 407 F.2d 1121, 1124 (4th Cir. 1969)). The substance of a transaction is of heightened importance in the related party context because "where the same persons occupy both sides of the bargaining table, the form of a transaction does not necessarily correspond to the intrinsic economic nature of the transaction." Merck, 2011 U.S. App. LEXIS 12402 at * 17 (3d. Cir. 2011) (citing Geftman v. Commissioner, 154 F.3d 61, 75 (3d Cir. 1998) (internal quotation marks omitted)). As a result, transactions between related parties merit extra scrutiny. Merck, 2011 U.S. App. LEXIS 12402 at * 17; see also Calumet Industries Inc. v. Commissioner, 95 T.C. 257, 286 (1990); Malone & Hyde, Inc. v. Commissioner, 49 T.C. 575, 578 (1968).

"The simple expedient of drawing up papers" is not controlling for tax purposes "when the objective economic realities are to the contrary." Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978) (internal quotation marks omitted); Helvering v. Lazarus & Co., 308 U.S. 252, 255 (1939); Commissioner v. Court Holding Co., 324 U.S. 331 (1945) ("In the field of taxation, administrators of the laws, and the courts, are concerned with substance and realities, and formal written documents are not rigidly binding."); see TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006); Gilbert v. Commissioner, 262 F.2d 512 (2d Cir. 1959).11

Accordingly, in debt versus equity cases, courts will look beyond the face of an instrument to ascertain whether there was "a genuine intention to create a debt, with a reasonable expectation of repayment, and if that intention comported with the economic reality of creating a debtor-creditor relationship?" Nestle Holdings, Inc. v. Commissioner, T.C. Memo. 1995-441; 1995 Tax Ct. Memo. LEXIS 439 at *67 (quoting Litton Bus. Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973)); see also A.R. Lantz Co. v. United States, 424 F.2d 1330, 1334 (9th Cir. 1970) ("[I]n resolving a debt-equity question, we must deal with substance and reality and not mere form.") (Internal quotation marks omitted); Fin Hay Realty Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1968); Hambuechen v. Commissioner, 43 T.C. 90, 101 (1964).

Characterization of the advances as either loans or capital contributions is a question that must be answered by reference to all the evidence, with the burden on the taxpayer to establish that the advances were capital contributions. Trans-Atlantic Co. v. Commissioner, 469 F.2d 1189, 1191 (3d Cir. 1972); Berkowitz v. United States, 411 F.2d 818, 820 (5th Cir. 1969); Welch v. Helvering, 290 U.S. 111, 115 (1933); T.C. Rule 142 (a). The intent of the parties to create a debtor-creditor relationship may be evidenced by their subsequent acts and the manner in which the parties treated the instruments. Gregg Co. of Delaware v. Commissioner, 239 F.2d. 498, 501 (2d Cir. 1956); Monon Railroad v. Commissioner, 55 T.C. 345 (1970).

In this case, the evidence establishes that the parties intended to create a debt instrument, with a clear expectation of interest and repayment of principal not based on PGI's profitability, which intention comported with the economic realities imposed upon PepsiCo by the Finance Ruling and the 1996 Global Restructuring.

A. The Substance Of The Payments Of Base PR Under The 1996/97 Advance Agreements Is Different From Their Intentionally Vague Form

Looking to the objective economic realities of the Base PR payments under the 1996/97 Advance Agreements to determine their tax consequences is particularly appropriate here, where PepsiCo itself understood the substance of these payments to be different from their intentionally vague form. For example, at trial Petitioners argued that the "net cash flow" provision created a Base PR payment contingency that mandates that they be treated as returns of equity for United States tax purposes.

Paragraph 3(a) of the both the 1996 Advance Agreements and the 1997 PPR Advance Agreement provide that:

 

[T]he Preferred Return shall be payable only to the extent that the net cash flow of the Company during the preceding year exceeded the sum of (i) the aggregate amount of all accrued but unpaid operating expenses incurred by the Company during such year and (ii) the aggregate amount of all capital expenditures made or approved by the Company during such year, including all capital investments. . . . At the same time, the amount of cash flow for purposes of that sentence shall in no event be less than the aggregate amount of all interest payments and payments of capitalized interest received by the Company from related parties during such year.

 

(Exs. 4-J and 5-J).

In providing that Preferred Return shall be payable as described above, PepsiCo purposely left vague the intended direct link between Frito-Lay payments to PGI and PGI's payments to BFSI or PPR (Exs. 54-J and 62-J).

As defined in the 1996/97 Advance Agreements, "net cash flow" can be interpreted three different ways: (1) net cash flow must equal related party payments less PGI's operating expense and capital expenditures (made or approved) for the year (Petitioners' interpretation based on a narrow reading of these agreements) (Exs. 4-J and 5-J; Tr. 273-276); (2) net cash flow must equal related party payments, unless PGI's operating expenses and capital expenditures (made or approved) for the year exceed the related party payments (Bartley's interpretation in a May 22, 1996 facsimile to Turkenburg) (Ex. 66-J); or (3) net cash flow must equal related party payments, regardless of PGI's operating expenses and capital expenditures (made or approved) for the year (Respondent's interpretation based on the parties understanding for the Dutch Ruling and PepsiCo's subsequent actions). (Exs. 62-J, 68-J, 69-J, and 140-R; Entire Record).

Notwithstanding this ambiguous language, Bartley, the principal drafter of the 1996/97 Advance Agreements, stated in contemporaneous internal correspondence that the payment of Base PR will never be contingent on the profitability of PGI. Specifically, Bartley states that "[u]nder no circumstances will either operating expenses or capital expenditures (no matter what definitional language we use in the AA) prevent the 'flow-thru' payment of interest." (Ex. 62-J). Furthermore, Willem Kuzee, who was responsible for calculating the required spread under the Finance Ruling, never took into account PGI's operating expenses or capital expenditures in calculating the amounts due as Base PR on the 1996/1997 Advance Agreements. (Exs. 78-J and 94-J and 142-R at 121-122). Thus, PepsiCo's contemporaneous internal correspondence and subsequent actions demonstrate that the substance of the 1996/97 Advance Agreements was different from their intentionally vague form, and renders Petitioners' trial argument, regarding payment contingencies based on the potential operating expenses and capital expenditures of PGI, meritless.

B. PepsiCo Intended To Create A Debt

In determining whether an advance is debt, the ultimate question is "was there a genuine intention to create a debt, with a reasonable expectation of repayment, and if that intention comported with the economic reality of creating a debtor-creditor relationship." Nestle, 1995 Tax Ct. Memo LEXIS 439 at *67 (quoting Litton, 61 T.C. at 377). Evidence of the parties' genuine intention to create a debt can take many forms, including the contemporaneous correspondence of the parties to the transaction. Id. at *71. In this case, the parties genuinely intended to create a debt instrument and a debtor-creditor relationship between PGI and KFCIH and PPR under the 1996/97 Advance Agreements.

 

1. PepsiCo's External Correspondence Indicates That PepsiCo Intended To Create A Debt

 

As part of the 1996 Global Restructuring, PepsiCo created the 1996 Advance Agreements to avoid the 35% Dutch corporate income tax that would be imposed on the interest income PGI received from the Frito-Lay Notes. PepsiCo drafted the 1996 Advance Agreements and subsequent 1997 PPR Advance Agreement to be treated as debt for Dutch tax purposes with the Base PR amount being deductible as interest in the Netherlands. As a result of the Finance Ruling PepsiCo obtained, PGI's Dutch corporate income tax was minimized because the interest income PGI received on the Frito-Lay Notes (and subsequent PPR Frito-Lay Notes) was equal to the interest expense PGI paid under the 1996 Advance Agreements (and subsequent 1997 PPR Advance Agreement), less the required taxable spread. (Stip. ¶ 79; Exs. 68-J, 71-J, 72-J and 138-P at 19-20).

Throughout the course of negotiating the Finance Ruling, PepsiCo made numerous factual representations to the Dutch Revenue Service as to how the 1996 Advance Agreements would operate. Those representations, which the Dutch Revenue Service relied on and made conditions of the Finance Ruling, included: (i) that payments of Base PR (and Capitalized Base PR) were not contingent on PGI's profitability; and (ii) that payments of interest and capitalized interest that PGI actually received on the Frito-Lay Notes would be used, each time, for the payment of at least the Base PR, including any Capitalized Base PR amounts, due under the Advance Agreements. (Exs. 68-J, 71-J, 72-J and 140-R at 11). PepsiCo's factual representations to the Dutch Revenue Service evidence that payments of Base PR (and Capitalized Base PR) under the 1996/97 Advance Agreements are payments on indebtedness for United States tax purposes.

The only arm's length bargaining that took place was between PepsiCo and the Dutch Revenue Service in negotiating the Finance Ruling. Throughout the course of these negotiations, PepsiCo committed itself to a course of conduct. Specifically, PepsiCo obligated itself to make payments of Base PR (and Capitalized Base PR) under the 1996/97 Advance Agreements each time it received interest income from Frito-Lay, regardless of PGI's operating expenses or capital expenditures.

On numerous occasions, PepsiCo represented to the Dutch Revenue Service that Base PR payments under the 1996 Advance Agreements were not contingent on the profitability of PGI and all interest payments PGI received under the Frito-Lay Notes would flow through as Base PR under the 1996 Advance Agreements. For example, in PepsiCo's May 9, 1996 Finance Ruling request, Turkenburg repeatedly describes the proposed 1996 Advance Agreements as debt and refers to PGI as a "classic flow-through financing company." Furthermore, Turkenburg specifically states that the interest income PGI receives from the Frito-Lay Notes will not be reinvested and separate financing would be sought for PGI's investments. (Ex. 66-J).

In response to PepsiCo's May 9, 1996 Finance Ruling request, Inspector Munneke of the Dutch Revenue Service granted PepsiCo a conditional approval. That conditional approval confirmed that the 1996 Advance Agreements were debt and that payments of Base PR would be deductible as interest in the Netherlands because these payments were not contingent on the profitability of PGI. (Ex. 68-J). In his June 11, 1996 conditional approval letter (a contemporaneous translation of which was provided to PepsiCo), Munneke stated that

 

The exact application of the cash-flow restriction on the payment of interest can not (sic) be determined by me. Together we have concluded that the interest payable should at least equal the interest received on the loans receivable from Frito Lay. This applies also (or should apply also) to the capitalised base interest in the form of the Capitalised Base PR Amount. This should also always be paid if the corresponding capitalized interest of Frito Lay (New Promissory Note Option) is paid by Frito Lay.

 

(Ex. 68-J at PEP 00000134; Tr. 314-317).

In summarizing his understanding of the financing arrangement, Munneke stated in his June 11th letter that "[a] flow-through of funds form KFCIH is intended." (Ex. 68-J). In closing, Munneke further stated that "[t]he ruling will be valid only if the conditions of the KFCIH advance are in accordance with, or are modified to meet the above described interpretation with respect to the payment of interest and KFCIH accepts the additions included herein." (Ex. 68-J).

In a letter dated June 25, 1996, Turkenburg replied to Munneke's June 11, 1996 conditional approval letter. (Ex. 69-J). In that letter, Turkenburg confirmed that the 1996 Advance Agreements would be treated as debt and the Base PR would be deductible as interest so long as all interest payments PGI received under the Frito-Lay Notes were paid on as Base PR under the 1996 Advance Agreements. (Ex. 69-J). Specifically, Turkenburg stated that "it is decisive that the interest actually received on the loans granted to Fritolay . . . is used each time for payment of, at least, the fixed component of the interest obligations vis-a-vis KFCIH, including the Capitalized Base PR Amount(s)." (Ex. 69-J).

In this same letter, Turkenburg also confirmed that the "net cash flow" provision in the 1996 Advance Agreements would not impair the flow-through of funds. (Ex. 69-J). "In order to clarify this 'flow-through' concept, it is included in the Advance Agreement that the amount of the net cash flow will not be lower than the interest payments and the payments of capitalized interest." (Ex. 69-J) Turkenburg's representation to the Dutch Revenue Service regarding the "net cash flow" provision is entirely consistent with Bartley's understanding mentioned above -- that "[u]nder no circumstances would operating expenses or capital expenditures (no matter what definitional language we use in the AA) prevent the 'flow-thru' payment of interest." (Ex. 62-J). In sum, PepsiCo repeatedly represented to the Dutch Revenue Service that PGI was a back-to-back financing company, that the 1996 Advance Agreements were debt instruments not contingent on the profitability of PGI, and that all payments of interest under the Frito-Lay Notes would immediately flow through as payments of Base PR under the 1996 Advance Agreements.

 

2. PepsiCo's Internal Correspondence Further Indicates That PepsiCo Intended To Create A Debt

 

The factual representations made by PepsiCo to the Dutch Revenue Service are on all fours with its contemporaneous internal communications. PepsiCo's contemporaneous internal communications reveal PepsiCo's intention that all interest payments received by PGI from Frito-Lay would immediately flow through to KFCIH (now BFSI) under the 1996 Advance Agreements (and PPR under the subsequent 1997 PPR Advance Agreement). For example, in a facsimile dated June 20, 1996, from Bartley to Turkenburg, Bartley advised that "[a]s a practical matter we expect all F-L interest payments to flow thru to KFCIH." (Ex. 60-J).

The next day, Turkenburg echoed this understanding in her response to Bartley. In a facsimile dated June 21, 1996, Turkenburg stated that "indeed payments are going to be made as though a back-to-back arrangement existed . . . I have always understood that the financing arrangement odes (sic) not intend to export funds from the US and that you would therefore indeed always use every dollar received from FL towards payment to KFCIH." In fact, Bartley subsequently added handwritten notes to this facsimile where he indicated his agreement with Turkenburg's statements. (Ex. 61-J at LOY 00000180; Tr. 270-271).

Two days later, Bartley reiterated that all interest payments PGI received under the Frito-Lay Notes would flow through as Base PR under the 1996 Advance Agreements. In a facsimile dated June 23, 1996, Bartley stated that "[generally (and with specific reference to paragraph 2 of your fax), all of us [you, me, Bruce, and the inspector] appear to be in agreement. In practice, all interest paid by F-L to PGI/PWI will in turn be paid to KFCIH. The 'flow-thru' results will be proved by actual events. (Any opinion you provide with respect to the AA and the Dutch ruling can and should assume this fact.)" (Ex. 62-J) (emphasis in original). These contemporaneous internal PepsiCo communications further support the conclusion that PGI was merely a back-to-back financing company, the 1996 Advance Agreements (and subsequent 1997 PPR Advance Agreement) were debt instruments not contingent on the profitability of PGI, and that all payments of interest under the Frito-Lay Notes (and subsequent PPR Frito-Lay Notes) would flow through as Base PR under the 1996/97 Advance Agreements.

C. BFSI And PPR Had A Reasonable Expectation Of Principal Repayment

Where a taxpayer has a reasonable expectation that an advance will be repaid, this is indicative of debt. Nestle, 1995 Tax Ct. Memo. LEXIS 439 at * 71-74; Litton, 61 T.C. at 377. If the advance can only be repaid from corporate earnings and is subject to the risks of business, however, this is indicative of equity. Nestle, 1995 Tax Ct. Memo LEXIS 439 at * 71-74. In this case, KFCIH and PPR had more than a reasonable expectation that the 1996/97 Advance Agreements would be repaid.

In addition to actually receiving Base PR each time Frito-Lay made interest payments on its notes (see below), BFSI and PPR as creditors under their respective agreements with PGI had more than a reasonable expectation of repayment of the principal. Frito-Lay, PGI, BFSI and PPR were all wholly owned, either directly or indirectly, by PepsiCo, Inc. at all times relevant to this litigation. (Stip. ¶¶ 5, 140, 207, 208, and 209). In addition, PGI exchanged the 1996 Advance Agreements for Frito-Lay Notes of equal amounts and the 1997 PPR Advance Agreement for PPR Frito-Lay Notes of equal amounts. Therefore, the principal Frito-Lay owes on its notes corresponds to the principal PGI owes under the 1996/97 Advance Agreements. (Stip. ¶¶ 21 and 26).

The 1996/97 Advance Agreements and corresponding Frito-Lay notes are merely intercompany loans between commonly controlled related entities. PepsiCo can terminate these interrelated obligations anytime it considers it beneficial to do so. In fact, on October 19, 1998, an Initial PPR Frito-Lay Note in the principal amount of $214,084,144.00 was repaid in full by Frito-Lay to PGI. (Stip. ¶¶ 28 and 214). On that same day, PGI transferred the exact same amount to PPR in partial satisfaction of the 1997 PPR Advance Agreement. (Stip. ¶¶ 28 and 214).

Further evidence that the 1996/97 Advance Agreements and corresponding Frito-Lay notes are merely intercompany loans, which PepsiCo can manipulate as necessary, can be found by reviewing PepsiCo's conduct after the extension of the Finance Ruling in the Netherlands expired. On August 13, 2007, BFSI and PPR contributed the 1996/97 Advance Agreements to PGI S.a.r.l., PepsiCo's newly organized Luxembourg entity, in exchange for the 2007 Luxembourg Advance Agreements with similar terms, including the same vague definition of "net cash flow." (Stip. ¶¶ 142, 143 and 144; Exs. 84-J and 85-J; Tr. 336). PGI S.a.r.l. continued to forward the interest payments it received from Frito-Lay to BFSI and PPR as Preferred Return under the new 2007 Luxembourg Advance Agreements. (Stip. ¶¶ 31, 33, 34 and 214).

Given the fact that the obligations Frito-Lay owes to PGI are interconnected with the 1996/97 Advance Agreements PGI has with BFSI or PPR and all entities are controlled by PepsiCo, there is clearly a reasonable expectation that the principal owed under these agreements would be repaid whenever PGI receives payment on the Frito-Lay Notes, regardless of PGI's profitability. In addition, such repayments would be consistent with the intent behind the intercompany Finance Ruling PepsiCo received for the 1996/97 Advance Agreements in the Netherlands.

D. The Economic Realities Compelled Frito-Lay To Pay Interest And For PGI To Pay Forward That Interest As Base PR Under The 1996/97 Advance Agreements

The economic realities compelling PGI to make payments of Base PR resulted from the conditions imposed on PepsiCo under the Finance Ruling and the overall tax structure implemented in the Restructuring. If PGI had failed to make payments of Base PR when it received payments from Frito-Lay, then the Finance Ruling would be void. As a result, PGI could be immediately subject to a 35% Dutch corporate income tax on all interest payments PGI received from Frito-Lay without a corresponding interest deduction in the Netherlands.

Under the express terms of the Finance Ruling, PGI was compelled to make payments of Base PR each time it received a payment of interest from Frito-Lay and could not use that interest to fund its Loss-Making Foreign Partnerships. In describing the synchronization between payments in and payments out under the 1996 Advance Agreements, Turkenburg testified that if PGI made equity contributions to their Loss-Making Foreign Partnerships using funds received under the Frito-Lay Notes, PGI would lose the synchronization between the interest income in and the interest expense accruals out and the Base PR would no longer be deductible in the Netherlands. (Tr. 281-283). In fact, as will be illustrated more fully below, PGI never failed to make a payment out of Base PR under the 1996/97 Advance Agreements when it received a payment of interest from Frito-Lay.

PepsiCo also had an economic incentive for Frito-Lay to make timely interest payments to PGI under the Frito-Lay Notes. If Frito-Lay failed to make interest payments when due, additional interest on interest would be required. This would then result in a higher taxable spread to PGI in the Netherlands. As Turkenburg testified, "there was a certain encouragement . . . through the higher interest expense for Frito-Lay to make payments on time" to PGI under the proposed Frito-Lay Notes, since if Frito-Lay did not pay interest on time, PGI's taxable spread in the Netherlands would increase from 1/8 percent to 2 1/8 percent. (Tr. 305-307).

Furthermore, pursuant to the so-called "perpetual clause" in paragraph 6 of the 1996 Advance Agreements and subsequent 1997 PPR Advance Agreement, if Frito-Lay defaulted on its notes to PGI, the initial 40 year term of the 1996/97 Advance Agreements would no longer apply and the instruments would be treated as equity in the Netherlands from that point forward. By treating the 1996/97 Advance Agreements as equity in the Netherlands going forward, PGI would lose subsequent interest deductions for the Base PR and would be prevented from taking a loss for the Frito-Lay default. (Tr. 279-281 and 323-327).

E. Actual Flow Of Funds

During the years at issue and through at least the end of 2009, PGI never failed to make an immediate payment out of Base PR under the 1996/97 Advance Agreements when it received a payment of interest from Frito-Lay under the corresponding Frito-Lay Notes and PPR Frito-Lay Notes.

Specifically, all payments into PGI under the Frito-Lay Notes and all payments out by PGI under the 1996 Advance Agreements (including the 2007 BFSI Luxembourg AA) were made on the same day and the minor differences in amounts are as follows:

 Payment Date     PN Payments In    AA Payments Out   Difference

 

 _____________________________________________________________________

 

 

  9/17/1997          39,072,364       39,072,000           364

 

  3/26/1998         153,491,247      152,408,393     1,082,854

 

  1/21/1999         154,189,638      153,382,088       807,550

 

   2/3/2000         146,222,526      145,419,413       803,113

 

  2/19/2001         169,063,511      168,265,740       797,771

 

   2/5/2002         156,389,875      155,623,247       766,628

 

  1/30/2003          81,446,246       80,674,269       771,977

 

  1/23/2004          69,894,411       69,068,232       826,179

 

  5/11/2005          75,952,332       75,169,892       782,440

 

  6/20/2006         107,419,786      106,591,636       828,150

 

 12/28/2006         141,444,788      140,686,504       758,284

 

  7/14/2008         152,086,891      151,705,232       381,659

 

  1/23/2009         117,669,725      117,340,744       328,981

 

 12/31/2009          70,887,595       70,707,329       180,266

 

 

     TOTALS      $1,635,230,935   $1,626,114,719    $9,116,216

 

 _____________________________________________________________________

 

 

 Payment in Form of Shares in  KFCG II, B.V.

 

 

(Stip. ¶¶ 31 and 33; Ex. 77-J at PEP 00001941).

This chart illustrates that PGI received approximately $1.6 billion in interest payments on the Frito-Lay Notes, and that PGI paid out all but $9 million to KFCIH/BFSI under the 1996 Advance Agreements. This $9 million represented the Dutch withholding tax on outbound Premium PR payments and the required 1/8% taxable spread required by the Finance Ruling. Furthermore, as discussed below, PGI was permitted to make-up any shortfall on the taxable spread within a three year period. Hence, the $9.1 million figure remains subject to adjustment due to the make-up provision.

In addition, all payments into PGI under the PPR Frito-Lay Notes and all payments out by PGI under the 1997 PPR Advance Agreements (including the 2007 PPR Luxembourg AA) were made on the same day and the minor differences in amount, if any, are as follows:

 Payment Date      PN Payments  In    AA Payments Out    Difference

 

 _____________________________________________________________________

 

 

  11/6/1997         42,926,795          42,926,795              0

 

 10/19/1998        323,652,537         323,652,537              0

 

 10/19/1999         91,392,649          91,067,035        325,614

 

 11/16/2000         90,567,602          90,567,602              0

 

 10/19/2001         94,807,820          93,479,092      1,328,728

 

 10/21/2002         93,161,112          92,569,286        591,826

 

 10/23/2003         93,161,112          92,574,905        586,207

 

  5/11/2005         93,161,112          92,608,631        552,481

 

 10/28/2005         91,991,760          91,927,775         63,985

 

 12/29/2005         21,315,517          21,315,517              0

 

 12/28/2006         74,061,149          73,824,095        237,054

 

  7/14/2008         97,748,730          97,569,226        179,504

 

  1/23/2009         95,078,842          94,965,144        113,698

 

 10/19/2009         92,576,436          92,469,502        106,934

 

 

     TOTALS     $1,395,603,173      $1,391,517,142     $4,086,031

 

 _____________________________________________________________________

 

 

 Includes Payoff of FL Note With Principal Amount of $214,084,114

 

 

 Includes $2,546,595.74 payment from Netherlands Antilles Entity

 

 

(Stip. ¶¶ 34 and 214; Ex. 77-J at PEP 00001941).

Similarly, this chart illustrates that PGI received approximately $1.4 billion in interest payments on the Initial PPR Frito-Lay Notes and Additional PPR Frito-Lay Notes, and that PGI paid out all but $4 million to PPR under the 1997 PPR Advance Agreements. This $4 million represents the Dutch withholding tax imposed on the Premium PR payments and the 1/8% taxable spread required by the Finance Ruling.

Furthermore, under the Finance Ruling, PGI was permitted to make-up any shortfall on the taxable spread between the Frito-Lay interest payments and the Base PR under the 1996/97 Advance Agreements within a three year period. As discussed below, PepsiCo did just that to correct a shortfall between the Initial PPR Frito-Lay Notes and the Base PR due on the 1997 PPR Advance Agreement by having Frito-Lay issue the new Additional PPR Frito-Lay Notes with adjusted interest rates.

While the payments of interest and Base PR illustrated in the charts above may facially appear to be significant economic transactions, in reality they were nothing more than PGI's payments in and payments out for Dutch tax purposes, all on the same day.

Further evidencing PepsiCo's intention to make certain that the interest payments into PGI flowed directly out as payments of Base PR under the 1996/97 Advance Agreements is a November 14, 2000 interoffice correspondence. (Ex. 93-J). This document describes a transfer of funds relating to the 1997 Advance Agreement scheduled to take place on November 16, 2000. (Exs. 92-J and 93-J). One of a number of PPR intercompany loan fund transfers discussed in the November 14th interoffice correspondence was PGI's receipt of $90,567,601.67 in interest under the PPR Frito-Lay Notes and PGI's payment of that exact same amount to PPR under the 1997 PPR Advance Agreement, all on November 16, 2000. (Stip. ¶¶ 32 and 34; Exs. 93-J, 142-R at 105-117).

This interoffice correspondence also included "Flow of Funds" charts, one of which illustrated the following would all occur on November 16, 2000: (1) PepsiCo, Inc. was to transfer $144,331,210.61 to Frito-Lay; (2) Frito-Lay was to then transfer $90,567,601.67 of that amount to PGI; (3) PGI was to then transfer that same $90,567,601.67 to PPR; (4) PPR was to then transfer that same $90,567,601.67 to Metro Bottling; and (5) Metro Bottling was to then transfer that same $90,567,601.67 back to PepsiCo, Inc. This chart illustrates that on at least one occasion, PepsiCo, Inc. funded the interest payment of the PPR Frito-Lay Notes to PGI and PGI used those same funds to pay PPR the Base PR under the 1997 PPR Advance Agreement. The chart also establishes that those exact same funds were then returned to PepsiCo, Inc. on the same day. (Stip. ¶¶ 32 and 34; Ex. 77-J at PEP 00001929; 93-J at PEP 00001374-1376 and 142-R at 105-117).

The payments in and out of PGI shown in the charts, coupled with the circular flow of funds illustrated in the November 14th interoffice correspondence further evidence the 1996/97 Advance Agreements' substance. Specifically, the "net cash flow" provision of the 1996/97 Advance Agreements would never prevent the payment of Base PR, and that each time PGI received a payment of interest on the Frito-Lay Notes, PGI would remit it back as Base PR under the 1996/97 Advance Agreements. These payments evidence the economic realities imposed on PepsiCo by the Finance Ruling and the overall tax structure of the Restructuring.

F. The 1996/97 Advance Agreements And Frito-Lay Notes Are Linked

The charts discussed above illustrate the strong link between the payments of Base PR under the 1996/97 Advance Agreements and the payments of interest under the Frito-Lay Notes, the latter of which Petitioners concede were interest payments on a debt instrument for United States tax purposes. PepsiCo consistently represented this much to the Dutch throughout the course of the ruling process. (See Exs. 68-J through 72-J and 140-R). Furthermore, PepsiCo's tax opinion analyzes the 1996 Advance Agreement in comparison to the Frito-Lay Notes, although certain facts are conspicuously absent from the opinion letter (i.e., that all payments of interest under the Frito-Lay Notes were going to flow through as payments of Base PR under the 1996 Advance Agreements). (Ex. 82-J). This linkage between the 1996 Advance Agreements and the Frito-Lay Notes (and the linkage between the 1997 Advance Agreements and the PPR Frito-Lay Notes) is further demonstrated by PepsiCo's subsequent actions.

Specifically, regarding the Frito-Lay Notes and the 1996 Advance Agreements, all eight of the initial Frito-Lay Notes provided that interest on any unpaid principal shall accrue semi-annually at a rate equal to the greater of (i) six-month LIBOR plus 230 basis points or (ii) 7.5% per annum, while the 1996 Advance Agreements provided that the Base PR on the unpaid principal amount shall accrue semi-annually at a six-month LIBOR rate plus 230 basis points minus an adjustment rate. (Exs. 3-J and 4-J).

During 2001, the six-month LIBOR rate dramatically fell and was at 3.9% on July 2, 2001. Therefore, the interest rate on the initial Frito-Lay Notes should have been 7.5%, while the Base PR on the 1996 Advance Agreements should have been 6.2% (3.9% plus 230 basis points) minus an adjustment, creating a significant difference between the accruals/payments on the two instruments. (Stip. ¶¶ 165 and 159; Exs. 3-J and 4-J). Kuzee ignored the falling six-month LIBOR rate and used a 5.69% rate, instead of 3.9%, in calculating the Base PR due under the 1996 Advance Agreements for the second half of 2001. (Stip. ¶ 126; Ex. 78-J at PEP 00003997-3998).

PepsiCo corrected this diverging interest rate problem by amending all eight Frito-Lay Notes on March 1, 2002 and changing the interest as of January 1, 2002, to only a six-month LIBOR plus 230 basis points, which is consistent with the Base PR rate under the 1996 Advance Agreements. (Exs. 3-J and 4-J).

Regarding the PPR Frito-Lay Notes and the 1997 PPR Advance Agreements, it became necessary during the years in issue for PepsiCo to make prospective adjustments to the interest rates of the Initial PPR Frito-Lay Notes to make up for an interest shortfall, as compared to the Base PR on the 1997 PPR Advance Agreement, for the period 1998-2001. (Stip. ¶¶ 132 and 133; Exs. 79-J, 80-J, 81-J and 142-R at 138). Because the required spread under Finance Ruling had not been achieved, Kuzee calculated the interest rate that would be required for renewals of the maturing Initial PPR Frito-Lay Notes, so that PGI would have income in excess of the Base PR to make up for prior-year shortfalls on a prospective basis. (Stip. ¶¶ 131 and 132; Exs. 79-J, 80-J, 81-J and 142-R at 138).

Kuzee proposed a number of options to deal with the shortfall of the required spread between the interest rate under the Initial PPR Frito-Lay Notes and the Base PR under the 1997 PPR Advance Agreement. (Stip. ¶¶ 131, 132 and 133; Exs. 79-J, 80-J, 81-J and 142-R at 138). As a result of one of Kuzee's proposals, the maturities of the remaining four Initial PPR Frito-Lay Notes were subsequently extended through the issuance of three new Additional PPR Frito-Lay Notes with adjusted interest rates. (Stip. ¶¶ 28, 132, 133 and 134; Exs. 7-J, 79-J, 80-J, 81-J and 142-R at 138-154). Despite the fact that Petitioners cannot locate one Additional PPR Frito-Lay Note and apparently all Additional PPR Frito-Lay Notes matured by 2005, Frito-Lay continued to pay interest on these promissory notes until at least 2009. (Stip. ¶ 34).

G. PGI's Payments Under The 1996/97 Advance Agreements Were Not Contingent

At trial, Petitioners argued that while PepsiCo might have intended to use the interest payments PGI received from Frito-Lay to pay Base PR under the 1996/97 Advance Agreements at issue, there was no obligation for PGI to do so. In describing PGI's responsibilities under the 1996/97 Advance Agreements, Petitioners' counsel argued in his opening statement that "an intention to pay a preferred return is not the same as an obligation to pay it." (Tr. 27).

Contrary to Petitioners' trial argument, "[a] formal 'legal obligation' is not an absolute prerequisite for a determination that a transaction is a loan." Merck, 2011 U.S. App. LEXIS 12402 at * 22 (citing Comtel Corp. v. Commissioner, 376 F.2d 791 (2d Cir. 1967), cert. denied, 389 U.S. 929 (1967)). In determining whether an obligation to repay exists, courts look to whether "the transferor's intention was to structure the transaction to ensure repayment of funds as a practical matter, rather than to whether there were literally no conditions on repayment." Id. at * 22-23. As the Third Circuit aptly stated, "[i]t would be simplicity itself for two parties, especially related parties, to draft a contract in which repayment would not occur in the event of some occurrence so unlikely that both parties could be confident that it would never transpire, and thus repayment would occur despite the transfer being 'conditional.'" Id. at * 22-24.

Petitioners have no choice, based on the undisputed record, to concede that PepsiCo intended for PGI to immediately pay Base PR on the 1996/97 Advance Agreements to BFSI and PPR when PGI received interest payments from Frito-Lay. Therefore, Petitioners are left to argue only that the PGI was not "obligated" to make these payments because of the intentionally vague definition of "net cash flow" PepsiCo purposefully included in the 1996/97 Advance Agreements.

Under Petitioners' strained interpretation of the 1996/97 Advance Agreements in a vacuum, "net cash flow" must equal related party payments minus PGI's operating expense and capital expenditures (made or approved) for the year. (Exs. 4-J and 5-J; Tr. 273-276). Therefore, according to Petitioners, PGI was only obligated to pay Preferred Return under the 1996/97 Advance Agreements to the extent the interest payments PGI received from Frito-Lay exceeded PGI's operating expense and capital expenditures (made or approved) for the year. For example, Petitioners argued at trial that PepsiCo planned to make vast investments overseas and that PGI might have needed to fund these investments with the interest payments from Frito-Lay. As stated in Hambuechen, 43 T.C. at 104, however, this Court "will not assume facts in petitioner's favor that are unsupported in the record by competent evidence."

Petitioners' trial arguments not only fly in the face of the record, but are also incompatible with the case law, the actual purposes behind the Restructuring, and the economic realities underlying the creation of the 1996/97 Advance Agreements. In particular, as part of the Restructuring, PepsiCo specifically created the 1996/97 Advance Agreements to avoid an additional 35% Dutch corporate income tax in the Netherlands by providing PGI with an offsetting interest deduction. (Stip. ¶¶ 21 and 79; Exs. 46-J, 64-J, and 146-R; Tr. 124-125 and 157-158).

In this case, PepsiCo's discussions with the Dutch Revenue Service in negotiating the Finance Ruling illustrate that Base PR under the 1996/97 Advance Agreements would be paid whenever PGI received interest payments from Frito-Lay, and regardless of PGI's operating expense and capital expenditures (made or approved) for the year. As discussed during the drafting of the 1996 Advance Agreements, Bartley, PepsiCo's key man in negotiating the Finance Ruling, stated that "[u]nder no circumstances will either operating expenses or capital expenditures (no matter what definitional language we use in the AA) prevent the 'flow-thru' payment of interest." (Ex. 62-J). In addition, Kuzee, when calculating the required spread, never took into account PGI's operating expenses or capital expenses. (Exs. 78-J, 94-J, and 142-R).

As stated above, PepsiCo had a powerful economic incentive to make certain that Frito-Lay made timely interest payments to PGI. If Frito-Lay failed to make interest payments when due, additional interest on interest would accrue. This would result in a higher taxable spread to PGI in the Netherlands. Accordingly, the Finance Ruling and the overall tax structure implemented as part of the Restructuring ensured that all payments of interest PGI received under the Frito-Lay Notes would be paid when due and immediately flow through as Base PR to BFSI and PPR under the 1996/97 Advance Agreements.

Furthermore, Petitioners' trial argument that PGI might have needed to fund overseas investments with the interest payments from Frito-Lay finds absolutely no support in the record. Indeed, this claim was contradicted by PepsiCo's own witnesses' understanding of the Restructuring. Slobbe, the Tax Manager at PepsiCo responsible for the Restructuring, circulated a memo that summarized the Restructuring to certain PepsiCo employees whose responsibilities might be affected. (Ex. 64-J). That memo stated that one of the main objectives of the Restructuring was "to ensure the tax efficient mobilization and recycling of offshore cash in order to avoid trapped and one way cash from the US." (Ex. 64-J). In other words, PepsiCo wanted to recycle and use offshore cash more effectively, and avoid using "one way" cash generated in the United States (e.g. interest payments from Frito-Lay) to fund its overseas expansions. (Exs. 49-J and 64-J; Tr. 245-246).

Bryant, who was responsible for making sure there was sufficient cash available for PepsiCo's operations in international markets, testified as to his understanding of the purposes behind the 1996 Global Restructuring. (Tr. 189-190, 214-215). Bryant contended that one of PepsiCo's main objectives for the Restructuring was "to try and use offshore cash wherever possible to avoid cash coming down from the U.S. prospective" to fund its offshore investments. (Ex. 64-J; Tr. 245-246). He further testified that PepsiCo wanted to limit the amount of cash leaving the United States to fund PepsiCo's offshore investments. (Tr. 233-234). Bryant noted that in some cases, repatriating cash back to the United States can have a tax cost. (Tr. 191). He further testified that "a lot of it [cash] was being generated offshore" and wherever possible PepsiCo tried to recirculate cash that was already offshore to fund its new international operations. (Tr. 190-191). Thus, Petitioners' trial argument is patently inconsistent with one of the main purposes behind the Restructuring: to stop using United States cash to fund overseas investments where repatriation can have a tax cost.

Moreover, Petitioners' trial argument about PGI's potential need to fund its Loss-Making Foreign Partnerships with Frito-Lay interest payments is contradicted by PepsiCo's representations to the Dutch Revenue Service. In PepsiCo's May 9, 1996 Finance Ruling request, Turkenburg represented that PGI/PWI would not use the interest payments PGI received under the Frito-Lay Notes in invest in foreign operations. (Ex. 68-J). If the factual representations made to the Dutch Revenue Service turned out to be incorrect, the Finance Ruling would be deemed void and PGI could immediately be subject to a 35% Dutch corporate income tax on all interest payments received from Frito-Lay.

In addition, Bryant testified that PepsiCo "generally had cash" to fund its new international operations and did not want to borrow money from a bank when "sitting on cash" because there is "obviously a difference between what you can borrow and what you will actually get back on your own cash." (Tr. 192). He further testified that if PGI needed to borrow cash, "where possible, that borrowing would be made from within the [PepsiCo] group," and that if PGI had borrowed from a third party, it would have been "done on a short-term basis" where there was "a requirement for emergency funding." (Tr. 204).

Bryant's opinion that PepsiCo already had the cash at the time of the Restructuring to fund its overseas expansion is corroborated by PepsiCo's 1997 Annual Report. In describing PepsiCo's "Cash Flow" the following statements appear: "One of PepsiCo's most alluring qualities, financially speaking, has always been cash. A powerful cash flow has fueled our growth and driven our stock for 32 years. More cash fuels more success" and "our total free cash flow for the year was more than $7.6 billion." (Ex. 116-J at PEP00004478).

The testimony offered by Petitioners' finance expert, James, also undermines Petitioners' trial argument that PGI might have needed to fund overseas investment with the Frito-Lay interest payments. James analyzed PGI's general ledger and concluded, perhaps unwittingly, that during the years 1997-2002 PGI received intercompany funds from affiliates totaling $1,515,638,574 while making loans and equity contributions to affiliates that totaled $1,415,237,959, which amount included $550,665,460 in loans to affiliates and $864,572,499 in equity contributions. During the years 1997-2002, PGI had funded over half of its total overseas capital expenditures by borrowing $809,201,196 from other PepsiCo overseas affiliates, of which amount $753,494,160 came from PFAB. (Ex. 139-P at Exhibit 4-1, 2, 5, 8, 11, 14, 17).

At trial, James identified PFAB as a "finance entity" in the Netherlands Antilles. Interestingly, Petitioners' counsel did not discuss with Slobbe the fact that PFAB supplied most of the funding for PepsiCo's expanding overseas markets. (Tr. 207-209). Furthermore, on cross-examination, Bryant (the man responsible for making sure there was sufficient cash available to fund PepsiCo's international operations) claimed he had no idea how much funding PFAB had provided to PGI from 1996 to 2002. (Tr. 248).

Based on the foregoing, PGI was able to fund its investments in overseas subsidiaries without using any of the interest paid by Frito-Lay during the years in issue.

The importance Petitioners place on PGI's obtaining the ABN-AMRO credit facility as a possible source of investment funds is also misplaced. The ABN-AMRO credit facility was at all times secured by a Subsidiary Guaranty issued by PepsiCo to ABN-AMRO under which PepsiCo guaranteed the full and prompt payment of all obligations and indebtedness of PGI when due. (Stip. ¶ 172; Ex. 41-J). This is consistent with Petitioners' strategy to borrow on a "short term basis" where there was "a requirement for emergency funding." (Tr. 204).

As a final point, within a year after the Restructuring PepsiCo spun off its restaurant businesses, including those entities located overseas. (Stip. ¶ 23). Furthermore, as a result of spinning off its bottling business in 1999, PepsiCo no longer directly owned bottling plants and equipment in the United States and overseas, such as Russia. (Tr. 459-462). Even though PepsiCo spun off its bottling business, it retained Metro Bottling, which owed interest to PGI under one of the Frito-Lay Notes, as a holding company. (Tr. 462-463).

In sum, Petitioners' claimed contingency that PGI might use the interest payments it received from the Frito-Lay Notes to fund foreign investments has no foundation in fact. Hambuechen, 43 T.C. at 104. From the beginning, PepsiCo intended for PGI to pass through all interest payments received from Frito-Lay to BFSI and PPR under the 1996/97 Advance Agreements, less the required spread in the Netherlands.

H. STATUTORY FACTORS IN DECIDING DEBT VERSUS EQUITY FOR UNITED STATES TAX PURPOSES

In addition, Section 385(b) provides five factors that might be considered among other factors in drafting regulations to determine in a particular factual situation whether a debtor-creditor or a corporation-shareholder relationship exists. Those five factors are as follows:

(1) Whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth and to pay a fixed rate of interest;

(2) Whether there is subordination to or preference over any indebtedness of the corporation;

(3) The ratio of debt to equity of the corporation;

(4) Whether there is a convertibility into the stock of the corporation; and

(5) The relationship between holdings of stock in the corporation and holdings of the interest in question.

Pursuant to Section 385(a), the Service was authorized to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated as stock or indebtedness (or as in part stock and in part indebtedness). To date, no regulations have ever been finalized under Section 385.

I. Use Of The Mixon Factors In Deciding Debt Versus Equity For United States Tax Purposes

 

1. Summary Conclusion

 

In Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972), the Fifth Circuit set forth a list of 13 factors to consider in resolving questions of debt versus equity. Considering the Mixon Factors discussed below, and based upon all of the surrounding facts and circumstances, PGI's payments to BFSI and PPR under the 1996 Advance Agreements and 1997 PPR Advance Agreement, respectively, should properly be treated as interest income received on indebtedness for United States federal income tax purposes.

Numerous appellate courts have identified the factors to be evaluated in resolving questions of debt versus equity. See, e.g., Estate of Mixon, 464 F.2d at 402 (5th Cir. 1972) (13 factors); A.R. Lantz, 424 F.2d at 1333 (11 factors); Fin Hay Realty Co., 398 F.2d at 696 (16 factors); Georgia-Pacific Corp. v. Commissioner, 63 T.C. 790, 796-800 (1975) (13 factors). These factors include: (1) the names given to the certificates evidencing the indebtedness; (2)the presence or absence of a fixed maturity date; (3) the source of payments; (4) the right to enforce payments; (5) the participation in management as a result of the advances; (6) the status of the advances in relation to regular corporate creditors; (7) the intent of the parties; (8) the identity of interest between creditor and stockholder; (9) the "thinness" of capital structure in relation to debt; (10) the ability of corporation to obtain credit from outside sources; (11) the use to which advances were put; (12) the failure of debtor to repay; and (13) the risk involved in making advances. Dixie Dairies Corp. v. Commissioner, 74 T.C. 476, 493-94 (1980).

The identified factors are not equally significant. Estate of Mixon, 464 F.2d at 402. Nor is any one factor determinative or relevant in each case, and weight accorded to each of the Mixon Factors is based upon the case's particular facts and circumstances. Estate of Mixon, 464 F.2d at 402; John Kelly Co. v. Commissioner, 326 U.S. 521, 530 (1946); Slappey Drive Indus. Park v. United States, 561 F.2d 572, 581 (5th Cir. 1977) ("The object of the inquiry is not to count factors, but to evaluate them.") (quoting Tyler v. Tomlinson, 414 F.2d 844, 848 (5th Cir. 1969); Gooding Amusement Co. v. Commissioner, 23 T.C. 408, 418 (1954), aff'd, 236 F.2d 159 (6th Cir. 1956), cert. denied, 352 U.S. 1031 (1957); see Road Materials, Inc. v. Commissioner, 407 F.2d 1121 (4th Cir. 1969); Piedmont Minerals Company v. United States, 429 F.2d 560 (4th Cir. 1970). Courts give less weight to the Mixon factors relating to the form of the transaction when the parties did not deal at arm's length. Laidlaw, 1998 Tax Ct. Memo LEXIS 230 * 62-63. Applying the above-described factors to the facts of this case, shows that all the Advance Agreements at issue are debt for United States tax purposes.

 

2. Name Given to the Instruments

 

Labels cannot change debt to equity, just as labels cannot change equity to debt, and an attempt to characterize a transaction by its moniker "may not be well taken in light of the facts and the circumstances of the case." Estate of Mixon, 464 F.2d at 404. That said, the name "Advance Agreement" connotes an advance of funds. Therefore, this factor nominally supports treating the 1996/97 Advance Agreements as debt.

 

3. Presence or Absence of a Fixed Maturity Date

 

The presence of a fixed maturity date supports debt classification. Estate of Mixon, 464 F.2d at 402. All three 1996/97 Advance Agreements in this case have a fixed maturity date of 40 years, which can be extended for an additional fifteen years. While this maturity date may be lengthy, it does not preclude debt treatment. See Monon, 55 T.C. at 359 (instrument with a term of 50 years considered debt where borrower had established business). Accordingly, the presence of a fixed maturity date supports characterizing the 1996/97 Advance Agreements as debt for U.S. tax purposes.

 

4. Source of Payments

 

Where an issuer has "liquid assets or reasonably anticipated cash-flow from which to repay," the instrument is more likely to be debt. Laidlaw, 1998 Tax Ct. Memo LEXIS 230 at *67. Based on a strained interpretation of the 1996/97 Advance Agreements in a vacuum, Petitioners contend that the interest payments PGI received from Frito-Lay did not ensure corresponding payments of Base PR to BFSI and PPR under the 1996/97 Advance Agreements. As stated above, however, "[a] formal 'legal obligation' is not an absolute prerequisite for a determination that a transaction is a loan." Merck, 2011 U.S. App. LEXIS 12402 at * 22) (citing Comtel Corp. v. Commissioner, 376 F.2d 791 (2d Cir. 1967) cert. denied. 389 U.S. 929 (1967).

All that is required is that the transferor structures the transaction to ensure repayment as a practical matter. Id. at * 22-23.

PGI's repayment of the underlying principal to BFSI and PPR under the 1996/97 Advance Agreements was never in doubt. Given the fact that Frito-Lay's obligations to PGI are interconnected with the 1996/97 Advance Agreements and all entities are controlled by PepsiCo, there is clearly a reasonable expectation that the 1996/97 Advance Agreements will be repaid whenever PGI receives payment on the notes owed by Frito-Lay, regardless of PGI's profitability. In addition, such repayments are consistent with the intent underlying the Finance Ruling PepsiCo received in the Netherlands.

The totality of the evidence clearly demonstrates that regardless of the intentionally vague language PepsiCo used in defining "net cash flow" for Preferred Return purposes, the following course of conduct was anticipated, agreed to for purposes of the Finance Ruling, and ultimately complied with for all the 1996/97 Advance Agreements:

 

(i) All interest paid by Frito-Lay to PGI under its notes would "in turn" be paid by PGI to KFCIH/BFSI and PPR under the 1996/97 Advance Agreements. (See Exs. 60-J through 63-J; 66-J through 69-J).

(ii) Under no circumstances would PGI's operating expenses prevent the "flow-thru" of interest payments from Frito-Lay through PGI to KFCIH/BFSI and PPR. (Ex. 63-J).

(iii) Under no circumstances would PGI's capital expenditures prevent the "flow-thru" of interest payments from Frito-Lay through PGI to KFCIH/BFSI and PPR. (Ex. 63-J).

 

As a practical matter and for economic reasons, PepsiCo was committed to ensuring that Frito-Lay would make timely interest payments and that all payments of interest PGI received under the Frito-Lay Notes would flow through as Base PR under the 1996/97 Advance Agreements. In addition, Petitioners' trial argument that PepsiCo might use the interest payments PGI received under the Frito-Lay Notes to fund foreign operations is wholly without foundation in fact. Therefore, Petitioners' claimed contingencies on PGI's payments of Base PR under the 1996/97 Advance Agreement are without merit.

Thus, this Mixon factor also supports the position that the 1997/97 Advance Agreements are debt, because PGI's ultimate repayment of the underlying principal and the Base PR payments to BFSI and PPR under the 1996/97 Advance Agreements were not contingent on PGI's profitability. See TIFD III-E, 459 F.3d 220 (2d Cir. 2006).12

 

5. Right to Enforce Payment

 

If the holder of an instrument has the right to enforce payment, then the instrument is more likely to be characterized as debt. Estate of Mixon, 464 F.2d at 405-06. The first sentence of Paragraph 6 under all three of the 1996/97 Advance Agreements specifically provides that the holder (BFSI or PPR) may declare unpaid principal or preferred return "immediately due and payable" if PGI either dissolves, becomes insolvent, or declares bankruptcy. (Exs. 4-J and 5-J). While this enforcement remedy does not provide the holder with the right to demand immediate repayment of all outstanding principal and interest in the event PGI misses a single payment of interest, the 1996/97 Advance Agreements do, nonetheless, provide the right to enforce payment. In addition, given the fact that PepsiCo controlled all the entities involved and would be economically disadvantaged if PGI were to default under the 1996/97 Advance Agreements, there was no real possibility that PGI would default on the 1996/97 Advance Agreements.13

Based on the above, this factor supports characterizing the 1996/97 Advance Agreements as debt for United States tax purposes because there was no practical possibility of default on the instruments.

 

6. Management Participation

 

Generally, an increase in, or acquisition of, management responsibilities by the transferor of funds is evidence of an equity relationship. See Stinnett's Pontiac Serv., Inc. v. Commissioner, 730 F.2d 634, 639 (11th Cir. 1984), aff'g. T.C. Memo. 1982-314. Given that all of the transactional parties (PGI, BSFI and PPR) are commonly controlled by PepsiCo, however, this Mixon Factor is also neutral.

 

7. Subordinated to Other Creditors

 

Pursuant to the terms of the 1996/97 Advance Agreements, BFSI and PPR's right to payment of the principal amount and any Preferred Return is nominally subordinate to the rights of all other creditors of PGI. As the Second Circuit has held, however, this fact is not decisive in determining whether a related-party instrument is considered debt. See, e.g., Kraft Foods Co. v. Commissioner, 232 F.2d 125, 126 (2d Cir. 1956) ("Subordination to general creditors is not necessarily indicative of a stock interest. Debt is still debt despite subordination.").

Based on the facts discussed in detail above, the nominal subordination terms set forth in the 1996/97 Advance Agreements serve as nothing more than mere window dressing for Petitioners' equity argument. The practical likelihood of subordination affecting payments to BFSI and PPR is nonexistent because the potential trade creditors Petitioners claim PGI might be liable to involve restaurant and bottling businesses that were spun off by PepsiCo in 1997 and 1999. (Stip. ¶ 23; Tr. 459-460). Thus, this Mixon factor suggests that the 1996/97 Advance Agreements should be characterized as debt for United States tax purposes.

 

8. Intentions of the Parties

 

This is a key inquiry, which incorporates other Mixon Factors. Berthold v. Commissioner, 404 F.2d 119, 122 (6th Cir. 1968); Gregg, 239 F.2d at 498; Monon, 55 T.C. at 345. The issue is whether there was a "genuine intention to create a debt, with a reasonable expectation of repayment, and did that intention comport with the economic reality of creating a debtor/creditor relationship[.]" Litton, 61 T.C. at 377. For purposes of this inquiry, it is appropriate to look at the parties' correspondence, subsequent acts, and the manner in which the parties treat the instruments. Id. at 378; Gregg, 239 F.2d at 501; Monon, 55 T.C. at 357.

Based on the overwhelming evidence discussed above and the economic realities, there is no doubt that PepsiCo intended for PGI to have a debtor-creditor relationship with BFSI and PPR, especially in light of their common control. Thus, this Mixon factor clearly supports treating the 1996/97 Advance Agreements as debt for United States tax purposes.

 

9. Identity of Interest

 

If advances by shareholders are proportionate to their stock ownership, the advances are more likely to be equity. Estate of Mixon, 464 F.2d at 409. Given that all the transactional parties (PGI, KFCIH, BFSI, PPR) are commonly controlled by PepsiCo, this factor is not relevant.

 

10. Inadequate Capitalization

 

Inadequate capitalization suggests that an advance is equity if: (a) the debt to equity ratio was initially high, (b) the parties realized that it would likely go higher, and (c) the recipient of the funds used a substantial part of the funds to buy capital assets and to meet expenses needed to begin operations. Mixon, 464 F.2d at 408.

Petitioners cannot demonstrate that PGI used any of the funds exchanged for the 1996/97 Advance Agreements to buy capital assets or to meet expenses needed to begin operations. Indeed, no funds were actually exchanged under the 1996/97 Advance Agreements. Furthermore, all interest paid by Frito-Lay to PGI under its notes was committed to be paid on by PGI to KFCIH (now BFSI) and PPR. Accordingly, PGI's level of capitalization is of questionable relevance under these facts.

 

11. Ability to Obtain Loans From Third Parties

 

If a corporation can borrow money from third party lenders when it receives an advance of funds, the transfer is more likely to be debt. Estate of Mixon, 464 F.2d at 410. During the years at issue, PGI had a credit facility with ABN-AMRO. (Stip. ¶ 70; Ex. 38-J). The amount of available credit under this credit facility varied over time from a low of $20,000,000 to a high of $90,000,000. The ABN-AMRO credit facility, however, was at all times secured by a Subsidiary Guaranty issued by PepsiCo to ABN-AMRO under which PepsiCo guaranteed the full and prompt payment of all obligations and indebtedness of PGI when due. (Stip. ¶ 72; Ex. 41-J). As Bryant testified, if PGI borrowed from a third party, it would have been done on a "short term basis" where there was "a requirement for emergency funding." (Tr. 204). On balance, this Mixon factor is neutral.

 

12. Use of the Funds

 

Where a corporation uses an advance of funds to acquire capital assets the advance is more likely to be characterized as equity. Estate of Mixon, 464 F.2d at 410; see Laidlaw, 1998 Tax Ct. Memo LEXIS 230 at *90-91 (Taxpayer used advances to expand existing business operations); see also Slappey Drive, 561 F.2d at 583 (Taxpayer used advances to fund initial business operations). In this case, however, because the 1996/97 Advance Agreements were given in exchange for existing Frito-Lay debt there were no funds for PGI to utilize. In addition, PGI did not use the interest payments it received from Frito-Lay to acquire capital assets, expand its existing business operations, or fund its initial business operations. Thus, this Mixon factor supports characterizing the 1996/97 Advance Agreements as debt for United States tax purposes.

 

13. Failure to Repay When Due

 

Payment of principal amounts on the due date indicates that the advances are debt. Estate of Mixon, 464 F.2d at 410. Because principal payments are not yet due under the 1996/97 Advance Agreements, this Mixon Factor is not relevant. PGI did, however, repay $214,084,144 of principal on October 19, 1998, even though principal payments were not yet due.

 

14. Risk Involved in Making Advances

 

If the lender has a reasonable expectation of repayment from the borrower at the time an advance is made, then this suggests the advance is debt. Gilbert v. Commissioner, 248 F.2d 399, 406 (2d Cir. 1957); Nestle, 1995 Tax Ct. Memo. LEXIS 439 at *71-74. Given the fact that all the entities involved under the 1996/97 Advance Agreements are controlled by PepsiCo, there is no doubt that BFSI and PPR will be repaid by PGI under the 1996/97 Advance Agreements. Thus, this Mixon factor suggests that the 1996/97 Advance Agreements are debt for United States tax purposes.

 

II. PETITIONERS' ALTERNATIVE OID ARGUMENT

 

 

Assuming the Court determines that the payments at issue are interest income from indebtedness, Petitioners have raised an alternative OID argument in their petitions. The parties have stipulated the OID issue as follows: "[I]f the Advance Agreements constitute indebtedness, the extent to which payments or accruals thereon constitute interest, taking into the account the application, if any, of Treasury regulations Section 1.1275-4, relating to 'contingent payment debt instruments.'" (Stip. ¶ 146).

In support of their alternative OID argument, Petitioners rely on Treas. Reg. § 1.1275-4(c), which addresses contingent payment debt instruments that are issued for nonpublicly traded property. For this provision to apply, however, it must be determined that the payments due under the 1996/97 Advance Agreements were contingent and, if contingent, pursuant to Treas. Reg. § 1.1275-4(a)(5), that those contingencies were not "remote and incidental" when the 1996/97 Advance Agreements were issued. Under Treas. Reg. § 1.1275-2(h)(2), for purposes of Sections 1271 through 1275 and the regulations thereunder, "[i]f there is a remote likelihood that the contingency will occur, it is assumed that the contingency will not occur."

Petitioners argue that both the obligation to pay principal and the Preferred Return on the 1996/97 Advance Agreements were subject to a number of contingencies. For example, Petitioners argue that the obligation to pay the Preferred Return was limited by the amount of capital investments made or approved by PGI during the relevant period and that the contingency that PGI would make material capital investments was not remote. Petitioners also argue that the uncertainty of the timing for the obligation to repay principal constitutes a contingency. In addition, Petitioners argue that the payments of the Preferred Return on the 1996 Advance Agreements were contingent because the Preferred Return accrued at a rate based on LIBOR.

For the reasons stated above in the discussion to support the treatment of the 1996/97 Advance Agreements as debt for United States federal income tax purposes, PGI's obligation to pay the Preferred Return was not limited both in fact and in substance by the amount of capital investments made or approved by PGI during the relevant period. Therefore, this "limitation" on the obligation to pay the Preferred Return did not result in the obligation to pay the Preferred Return being a contingent payment for purposes of Treas. Reg. § 1.1275-4.

The Dutch Finance Ruling and the overall tax structure implemented as part of the 1996 Global Restructuring ensured that, as a practical matter, all payments of interest PGI received from Frito-Lay would flow thru as Base PR under the 1996/97 Advance Agreements to KFCIH/BFSI and PPR and Frito-Lay would make timely interest payments. In addition, Petitioners' claimed contingency that PGI might have needed to fund overseas investments with the interest payments from Frito-Lay for capital expenditures, instead of paying Base PR, finds absolutely no support in the record. In fact, this claim was contradicted by PepsiCo's own witnesses' (Slobbe and Bryant) understanding of the 1996 Global Restructuring. (Ex. 64-J, Tr. 245-246 and 245-246). Therefore, PGI's payments to KFCIH/BFSI and PPR under the 1996/97 Advance Agreements were anything but contingent at the time the instruments were issued.

This lack of any contingencies is borne out by the fact that from the issuance of the 1996/97 Advance Agreements through 2009, every time PGI received interest income payments under the Frito-Lay and PPR Frito-Lay Notes, PGI "in turn" paid that interest, on the same day, to KFCIH/BFSI or PPR under the instruments. (Stip. ¶¶ 31, 33, 34 and 214; Ex. 77-J) In fact, at no time did Kuzee take into account PGI's operating or capital expenditures in calculating the amounts due as Base PR on the 1996/97 Advance Agreements. (Exs. 78-J and 94-J). In addition, PepsiCo amended the interest rates of the eight Frito-Lay Notes so they would be consistent with the Base PR under the 1996 Advance Agreements and PepsiCo cannot locate the executed second pages for two of those amendments. (Exs. 3-J and 4-J)

Furthermore, in extending the maturities of the Initial PPR Frito-Lay Notes, PepsiCo also caused the interest rates on the Additional PPR Frito-Lay to be revised, so a "shortfall" of the required spread between interest from Frito-Lay and the Base PR under the 1997 PPR Advance Agreement could be corrected. (Stip. ¶¶ 28, 132, 133 and 134; Exs. 7-J, 79-J, 80-J, 81-J and 142-R at 138-154). Despite the fact that Petitioners cannot locate one Additional PPR Frito-Lay Note and apparently all Additional PPR Frito-Lay Notes matured by 2005, Frito-Lay continued to pay interest on these promissory notes until at least 2009. (Stip. ¶ 34).

In addition, even if the limitation on the obligation to pay the Preferred Return were respected as a contingency under the 1996/97 Advance Agreements, for the reasons stated above, Petitioners' alleged payment contingencies under the 1996/97 Advance Agreements are too "remote" under Treas. Reg. § 1.1275-2(h) and, therefore, are ignored for purposes of Treas. Reg. § 1.1275-4. Accordingly, the 1996/97 Advance Agreements would not be contingent payment debt instruments subject to Treas. Reg. § 1.1275-4 solely because of this alleged payment contingency.

In response to Petitioners' argument relating to the repayment of principal, for the reasons stated above in the discussion to support the treatment of the 1996/97 Advance Agreements as debt for United States federal income tax purposes, the obligation to pay principal on the 1996/97 Advance Agreements was not a contingent payment for purposes of Treas. Reg. § 1.1275-4. For example, given the fact that the obligations Frito-Lay owes to PGI are directly interconnected with the 1996/97 Advance Agreements and all entities are controlled by PepsiCo, there is clearly a reasonable expectation that the 1996/97 Advance Agreements would be repaid whenever PGI receives payment on the notes owed by Frito-Lay, regardless of PGI's profitability. In addition, such repayments would be consistent with the intent behind the Finance Ruling PepsiCo received for the 1996 Advance Agreements in the Netherlands.

Furthermore, because the obligation to repay principal was within the total control of PepsiCo, the options to extend the due date of the 1996/97 Advance Agreements should be ignored for purposes of Treas. Reg. § 1.1275-4. Thus, the options to extend the due dates of the 1996/97 Advance Agreements are remote contingencies under Treas. Reg. § 1.1275-2(h) and should be ignored for purposes of Treas. Reg. § 1.1275-4. Regarding the so-called "perpetual clause" in paragraph 6 of the 1996/97 Advance Agreements, if Frito-Lay defaulted on its notes to PGI, the initial 40 year term of these agreements would no longer apply and they would be treated as equity in the Netherlands going forward. (Tr. 279-281 and 323-327). Given the resulting tax consequences in the Netherlands, PepsiCo would never allow Frito-Lay to default on its notes and this potential contingency to repayment is also too remote and should be ignored. Accordingly, the 1996/97 Advance Agreements would not be contingent payment debt instruments subject to Treas. Reg. § 1.1275-4 solely because of these alleged payment contingencies with respect to the repayment of principal.

Petitioners also argue that the 1996 Advance Agreements are contingent payment debt instruments because the Preferred Return on the 1996 Advance Agreements accrued at a rate based on LIBOR. (Ex. 4-J). However, because the other alleged contingencies discussed above are ignored, the 1996 Advance Agreements are variable rate debt instruments subject to Treas. Reg. § 1.1275-5 and not contingent payment debt instruments subject to Treas. Reg. § 1.1275-4. See Treas. Reg. § 1.1275-4(a)(2)(ii). This argument does not even apply to the 1997 PPR Advance Agreement because the Preferred Return on that agreement accrued at a fixed rate, instead of a LIBOR rate. (Ex. 5-J).

Under Treas. Reg. § 1.1275-5(a)(3), one of the requirements for a debt instrument to be a variable rate debt instrument is that the debt instrument must not provide for any stated interest (other than stated interest compounded or paid at least annually). While the 1996 Advance Agreements did not require any annual Preferred Return payments until more than a year after their execution as of September 27, 1996, the first payment of Base PR under this agreement was made within the first year on September 17, 1997 in the form of related party stock. (Stip. ¶ 31; Ex. 4-J). In addition, the 1997 PPR Advance Agreement required an annual Preferred Return payment within the first year after its execution and the first payment of Preferred Return under this agreement was made within that first year. (Stip. ¶ 214; Ex. 5-J). Therefore, this requirement to be a variable rate debt instrument was satisfied.

For the reasons stated above, the 1996/97 Advance Agreements are not contingent payment debt instruments subject to Treas. Reg. § 1.1275-4.

 

CONCLUSION

 

 

It follows that the determination of the Commissioner of Internal Revenue should be sustained.
By: William J. Wilkins

 

Chief Counsel

 

Internal Revenue Service

 

 

Lyle Press

 

Special Trial Attorney (SL)

 

(Manhattan)

 

(Large Business & International)

 

Tax Court Bar No. PL0222

 

33 Maiden Lane

 

New York, NY 10038

 

(917) 421-4633

 

 

Daniel A. Rosen

 

Special Trial Attorney (SL)

 

(Manhattan)

 

(Large Business & International)

 

Tax Court Bar No. RD0473

 

 

Vincent J. Guiliano

 

Senior Counsel (Financial Services)

 

(Large Business & International)

 

Tax Court Bar No. GV0037

 

 

Michael S. Coravos

 

Attorney (Manhattan, Group 1)

 

(Large Business & International)

 

Tax Court Bar No. CM0673

 

Date: July 8, 2011

 

FOOTNOTES

 

 

1 On October 29, 2009, the Court granted Petitioners' Motion for Consolidation.

2 All Section references are to the Internal Revenue Code of 1986, as amended and in effect at the relevant time.

3 The principal ($1,779,662,436) plus the accrued interest ($10,467,257.64) equals the face amount ($1,790,129,693.64) of the KFCIH I Advance Agreement.

4 The principal ($88,984,086.92) plus the accrued interest ($523,368.56) equals the face amount ($89,507,455.48) of the KFCIH II Advance Agreement.

5 SUN, PIE I, and PGI were all Dutch entities. (Ex. 49-J at PEPIRS000236).

6 The 1997 PPR Advance Agreement substitutes the word "period" for the word "year" as any accrued Preferred Return is payable annually on October 19 of each year beginning in 1997. (Ex. 5-J)

7 The amount of Premium PR was reduced by 15% to take into account Dutch withholding tax. (Stip. ¶ 158).

8 The amount of Premium PR was reduced by 15% to take into account Dutch withholding tax. (Stip. ¶ 159).

9 The Dutch Chamber of Commerce is a governmental office responsible for maintaining statutory accounts of Dutch companies. (Ex. 142-R at 57/2-19).

10 $550,665,460 + $864,572,499 = $1,415,237,959.

11 Any appeals of these consolidated cases will be heard by the Court of Appeals for the Second Circuit. I.R.C. § 7482(b).

12 In TIFD III-E (Castle Harbour), as in the instant case, the Government was arguing for debt treatment. Although TIFD III-E dealt with the characterization of a nominal partnership interest, it demonstrates the importance of evaluating economic realities in determining the nature of an investment.

13 Pursuant to the so-called "perpetual clause" in the last sentence of paragraph 6 of the 1996/97 Advance Agreements, if Frito-Lay defaulted on its notes to PGI, the initial 40 year term of the 1996/97 Advance Agreements would no longer apply and the instruments would be treated as equity in the Netherlands from that point forward. By treating the 1996/97 Advance Agreements as equity, PGI would lose subsequent interest deductions for the Base PR and would be prevented from taking a loss for the Frito-Lay default in the Netherlands. (Tr. 279-281 and 323-327).

 

END OF FOOTNOTES
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