Economic Substance Doctrine: The Illusion and the Reality

Roxanne Bland

Roxanne Bland is Tax Notes State’s contributing editor. Before joining Tax Analysts, Bland spent 17 years with the Multistate Tax Commission, where she worked with state revenue agency representatives to draft model legislation pertaining to sales and use taxation and corporate income, analyzed and reported on proposed federal legislative initiatives affecting state taxation, worked with legislative consultants and representatives from other state organizations on international issues affecting states, and assisted member state representatives in federal lobbying efforts. Before that, she was an attorney with the Federation of Tax Administrators for over seven years.

In this installment of The SALT Box, Bland considers the history of the economic substance doctrine in relation to PepsiCo Inc. v. Illinois Department of Revenue and considers when a corporate reorganization is the motivation for subsidiary tax avoidance.

A taxpayer may use any legitimate means to reduce its tax liability. The emphasis, however, is on the term “legitimate.” Eighty-six years ago the U.S. Supreme Court first articulated the economic substance doctrine in Gregory,¹ holding that tax benefits obtained through a transaction shown to lack economic substance or business purpose can be disallowed by the IRS. The taxpayer in Gregory, the sole stockholder of Company 1, wanted to transfer shares of stock of Company 2 held by Company 1 to herself as an individual, but did not want the proceeds to be taxed as a dividend. Following the letter of the law then in effect, she instituted a corporate reorganization by creating Company 3, and caused Company 1 to transfer the stock of Company 2 to Company 3, of which she again was the sole shareholder. Company 3 was then dissolved, its stock liquidated and distributed to the taxpayer. In this way, the proceeds from the liquidation qualified as capital gains instead of a dividend. The tax commissioner disallowed the transaction, arguing that the reorganization should be disregarded, as its sole purpose was to avoid having the proceeds taxed as dividend income. The Court agreed with the commissioner. The tax avoidance strategy used by the taxpayer was carried out within the letter of the law, the Court explained, but as it was constructed with no other purpose than to minimize her tax liability, the strategy lay outside the intent of the law. “To hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose,” the Court said.

Since Gregory was decided in 1935, lower courts have regularly applied the economic substance doctrine to such tax avoidance strategies and have regularly found them wanting. In recent decades, this was especially true of the intangible assets holding company, which corporate taxpayers often used to minimize their state tax liabilities. In its simplest form, a corporate taxpayer creates a Delaware or Nevada subsidiary whose purpose was to hold and manage the parent taxpayer’s intangible assets, generally, its trade and service marks. After transferring ownership of the assets to the holding company, the company then licenses the trade and service marks back to the parent, which pays royalties to the subsidiary for their use. The parent deducts the royalties from its income as a business expense. The royalties paid are then returned to the parent as a dividend; in some instances, the money is returned as a loan, thus allowing the parent to deduct not only the royalty payments, but also interest paid to the subsidiary from its earned income. The subsidiary pays no income tax on its royalty income by virtue of its incorporation in a state where such income is not taxable. Although the stated purpose of the holding company was to protect and manage the parent’s trade and services marks, in many cases, the subsidiary existed only on paper and served as nothing more than a circular conduit through which funds transferred by the parent were of one character (royalties), and then returned to it in a different character (dividends or loans).

Note, however, that the economic substance doctrine does not mean tax avoidance cannot ever be a motivation for a corporate reorganization. It only means that tax avoidance cannot be the sole motivation; that is, its reorganization must have a business purpose beyond tax savings. Thus, determining whether a transaction has economic substance is necessarily fact-intensive, and the facts may support a showing that the reorganization had a valid business purposes besides lowering the parent’s tax liability.

At least one state court found that the taxpayer’s reorganization to create an intangible holding company, which had the hallmarks of a simple tax avoidance scheme, was in fact not the case. In Sherwin-Williams,² the Massachusetts Supreme Court found the taxpayer’s creation of a subsidiary to manage its many trademarks was valid. There were several indicia of a bona fide corporate existence in Sherwin-Williams, including the company’s hiring of an outside firm to value its trademarks and calculate royalty payments at arm’s length, and the subsidiary’s retaining its own counsel, accountant, and outside auditing firm. Perhaps most telling in this case, however, was that the subsidiary did not return royalty payments to Sherwin-Williams as dividends or loans but invested them to its benefit.

From the above, the economic substance doctrine can be summarized as follows: Tax transactions must have an economic reality along with a business purpose, else they are subject to being disregarded in calculating a taxpayer’s tax liability. Put even more succinctly: Substance over form.³

No Pepsi for the New Generation

Of course, holding companies for intangible assets are not the only vehicles that can be used for income tax avoidance. In PepsiCo,⁴ the question was whether a subsidiary should be treated as an 80/20 company, and thus excluded from the taxpayer’s unitary business for purposes of calculating PepsiCo’s apportionment formula to determine its Illinois income. The answer turned on whether a corporate subsidiary of the 80/20 company, by whom PepsiCo’s expatriate employees were employed, had economic substance to justify the 80/20 company’s claim of exclusion from the unitary group based on its payroll factor.

The facts in PepsiCo are complex; thus, only the salient ones will be presented. Like every case involving the issue of economic substance in the income tax area, PepsiCo begins with a corporate reorganization. PepsiCo manufactures, markets, and sells snacks, beverages, and food worldwide. In the United States, these three core businesses lines are run separately, but in its foreign operations, the three lines are combined. After two major acquisitions in 2010, PepsiCo restructured its global operations. Frito-Lay North America Inc. (FLNA), a U.S.-based subsidiary that operates and holds the domestic rights to PepsiCo’s snack food business, was reorganized to encompass PepsiCo’s foreign operations. PepsiCo had what it called an expatriate program, under which the various businesses in the corporate group, acting separately, assigned U.S.-based employees to PepsiCo’s related foreign entities, called host companies. These assignments could be temporary or permanent. Employees sent on temporary assignment were required to sign letters of understanding and agreements that governed the framework of those assignments. As part of the restructuring, the expatriate programs were consolidated and overseen by the human resources function for PepsiCo, which executed all employee transfers.

In the restructuring, PepsiCo created PepsiCo Global Mobility LLC (PGM) a single-member limited liability company owned by FLNA, which, before the reorganization to include PepsiCo’s international operations under its umbrella (and before the creation of PGM), was a member of PepsiCo’s domestic unitary group. Thus, under Illinois’s combined reporting statute, its earnings were subject to state’s corporate income tax. PepsiCo claims that between its international operations being placed under FLNA’s umbrella, and the subsequent creation of FLNA-owned PGM, FLNA had been transformed into an 80/20 company. All U.S.-based employees on temporary assignment were considered employees of PGM. Under the terms of the agreements signed by those employees, they were under the direction, control, and supervision of the foreign host company and not PGM. PGM had no employees other than those on temporary assignment. Thus, the only compensation claimed and reported by PGM was that paid to expatriate employees; its books and records recorded compensation expenses and unspecified income that matched, dollar for dollar, reimbursement of those expenses by foreign host companies, with the result that PGM earned no profits. U.S. income, payroll, and employment taxes were deducted from the expatriate employees’ paychecks, and employees continued to participate in PepsiCo’s employee benefits plans, despite being employees of PGM.

Escaping the Unitary Group

Although the determination of whether a member of a unitary group qualifies as an 80/20 company is usually based on the property and payroll factors, the property factor was not at issue in this case. For the payroll factor, the issue was whether PGM, as a division of FLNA, had economic substance so to qualify FLNA as an 80/20 company, and thus be excluded from PepsiCo’s unitary group; a closely related question is whether PGM should be considered the employer of employees on temporary expatriate assignments. Such a finding would lend much support to the argument that PGM had enough substance to qualify FLNA as an 80/20 company. If FLNA could be excluded from PepsiCo’s unitary group, PepsiCo’s Illinois income tax liability could be greatly reduced.

From the facts, it should be obvious that PGM, at least in terms of a functioning business entity, had no economic substance. It had no employees other than the temporary expatriates; no employees serving in a supervisory capacity, managerial capacity, or any other capacity. Its income and expenses were evenly matched; the books and records recorded income of an unspecified type, which corresponded to the expenses it recorded for expatriate employees. Thus, it made no profit. Indeed, it had no capitalization. Its payroll/benefits function was nonexistent; all payroll/benefit services were handled by PepsiCo employees and a third-party benefits administrator.

It should also be obvious from the facts that PGM’s employment relationship with temporary expatriate employees existed only on paper. The hallmarks of an employer/employee relationship are the right to control, actual control, and the right to discharge. An employment contract may specify these abilities and perhaps more, but the employment contract means nothing if the employer cannot execute the contractual terms. In PGM’s case, there were no managerial or supervisory employees who had authority to control or terminate the expatriate employees. PepsiCo’s human resources group handled such functions for expatriates, but they certainly had no authority to control or terminate expatriate employees. Indeed, day-to-day control over temporary expatriate employees was specifically ceded to the foreign host companies under the agreement signed by the employees. These factors, combined with the reality that PGM was not a functional business, the court said, can only point to the conclusion that the temporary expatriate employees were not employees of PGM. The court disregarded PGM, and because PGM had no economic substance, FLNA therefore could not be an 80/20 company and is properly included as a member of PepsiCo’s unitary group.

Conclusion

Given the long and venerable history of the economic substance doctrine, one wonders why PepsiCo’s tax department would entertain such a scheme to save money on PepsiCo’s tax liabilities, whether in Illinois or any other state. It can only be hoped that this case will serve as a cautionary tale for any other unitary group wanting to play the age-old game of tax avoidance.