Tax Notes logo

Troubling Tax Behavior Illustrates Need to Change State Tax Codes

Posted on Jan. 30, 2023
Brian Hamer
Brian Hamer

Brian Hamer is counsel to the Multistate Tax Commission. He was director of the Illinois Department of Revenue from 2003 to January 2015. Before that, he was deputy director of the Chicago DOR and chief assistant corporation counsel at the city’s Department of Law. The views expressed in this article are not necessarily the views of the MTC or its members.

In this installment of Revenue Matters, Hamer argues that recent decisions by Illinois’s Independent Tax Tribunal describe a troubling example of how some multinational taxpayers cross the line circumscribing responsible corporate conduct and show how legislative compromises made in the 1980s continue to threaten state tax bases.

“Taxes are the price that we pay for civilized society.” Compania General de Tabacos v. Collector, 275 U.S. 87, 100 (1927) (O.W. Holmes, J., dissenting).

A decade ago, PepsiCo Inc.,1 a perpetually profitable company with various historic roots in Chicago, rearranged its organizational chart with a view to eliminating its income tax obligations in Illinois and in a dozen other states. The Illinois Department of Revenue challenged PepsiCo’s scheme and assessed taxes for multiple years. Recently, the state’s Independent Tax Tribunal issued two written decisions: the first upholding the tax assessments and the second affirming more than $2 million of penalties.2

These decisions should be required reading for every private sector state tax practitioner and every state tax administrator in the country. Together with the joint stipulation of facts tendered by the parties,3 the decisions describe a troubling example of how some multinational taxpayers cross the line circumscribing responsible corporate conduct. The tribunal’s decisions also show that compromises struck by the federal government, states, and the business community in the 1980s, which altered the way states tax multinationals, are seriously flawed.

PepsiCo and Its Plan to Eliminate State Income Tax

PepsiCo needs no introduction. Through its various subsidiaries, the conglomerate manufactures, markets, and sells a wide variety of snack foods, beverages, and grain-based foods (think Quaker Oats). PepsiCo’s business has particular connections to Chicago. For one, Cracker Jack, now a PepsiCo product, was invented by a Chicago popcorn purveyor and introduced to the public at the Chicago World’s Fair in 1893. And until recently, it was manufactured in the Chicago area. Quaker Oats, before being acquired by PepsiCo in 2001, was for decades based in Chicago, eventually constructing a stunning headquarters building downtown on the Chicago River.

Relevant to the tax story I am about to relate, a subsidiary of PepsiCo named Frito-Lay North America Inc. (FLNA) owns the U.S. rights to PepsiCo’s snack food business, which includes such ubiquitous brands as Lay’s, Doritos, Cheetos, Fritos, Ruffles, and Cracker Jack. FLNA’s management team is located in Texas. According to the joint stipulations of facts, FLNA’s gross sales as reported on federal tax returns during tax years 2010 through 2013 ranged from approximately $8 billion to $8.7 billion per year. These sales were entirely U.S. sales except for about $230 million per year.

PepsiCo’s snack food business, together with its other lines of business, generated substantial income. In 2010 the company reported federal consolidated taxable net income of $1.4 billion. And based on that federal income, it filed an Illinois tax return for that year claiming to owe $5.35 million of state corporate income tax and replacement tax (the latter essentially a surcharge to the state corporate income tax).4

There is one other important set of facts to know before describing PepsiCo’s plan to eliminate state income tax: PepsiCo operated an expatriate program that offered foreign postings to high-performing U.S. employees. Participants in the program worked at various PepsiCo affiliates around the world. Before mid-2010, PepsiCo, as well as two large bottling companies it had recently acquired, used various PepsiCo entities to administer their expatriate programs.

In June 2010 PepsiCo created PepsiCo Global Mobility LLC (PGM) as a Delaware single-member limited liability company under FLNA, which the company elected to treat as a disregarded entity for federal and state income tax purposes. According to testimony provided to the tribunal, the idea of creating PGM was devised in PepsiCo’s tax department.5

Upon its formation, PGM became the designated employer of all PepsiCo expatriate employees but in name only: the various foreign host companies directed, controlled, and supervised the day-to-day services performed by the expatriates. Other than the expatriates, PGM had no employees and maintained no property of any kind. PGM did not identify or approve individuals for assignment under the expatriate program (after all, it had no staff of its own); those functions were performed by employees of other PepsiCo entities. The Pepsi International Support Center, a division of PepsiCo Inc., contracted with an unrelated payroll service to issue paychecks to expatriate employees and to file payroll tax returns. PGM’s books and records were debited to record expatriate compensation expenses and credited to reflect reimbursement of those expenses by the various foreign host companies. PGM did not impose any markup for those charges and earned no profits.

During 2011, 2012, and 2013, a grand total of 151, 165, and 184 employees, respectively, participated in the expatriate program, working at PepsiCo affiliates for up to three to five years.

According to the tribunal hearing record, PepsiCo’s tax department expected that by creating PGM as a division of FLMA and treating all expatriate employees as employees of PGM, PepsiCo would achieve substantial tax savings in 13 states, including Illinois.6 And true to plan, this arrangement proved wildly successful: Based solely on this paper structure, the amount of tax PepsiCo paid to Illinois declined from more than $5 million in 2010 to $0 in 2011, 2012, and 2013. In fact, PepsiCo — which reported approximately $1.4 billion to $1.5 billion of federal net income annually to the IRS in 2011, 2012, and 2013 — reported substantial net operating losses to the state in each of those years.

The theory upon which PepsiCo’s tax department relied to achieve this tax-free result was strikingly simplistic. Similar to statutes in a dozen other states, the Illinois Income Tax Act excludes so-called 80/20 companies from the definition of unitary business group, which in turn reduces the group’s taxable income by the amount of income realized by those 80/20 companies. Section 1501(a)(27)(A) of the act defines 80/20 companies as persons, wherever incorporated or headquartered, “whose business activity outside the United States is 80 percent or more of [their] total business activity.”7 Business activity is measured solely by the amount of a business’s payroll and property.8

The professionals working in PepsiCo’s tax department determined that beginning in 2011, FLNA, whose sales were almost entirely in the United States,9 was an 80/20 company and therefore that its income must be subtracted from PepsiCo’s federal consolidated income for purposes of calculating Illinois tax. This meant that PepsiCo’s substantial federal consolidated income in each of 2011, 2012, and 2013 was converted to loses of $1.3 billion, $1.4 billion, and $800 million, respectively.10

How can this possibly be? According to PepsiCo’s tax department, all the employees of PGM, a disregarded entity under FLNA, were located abroad. Meanwhile, FLNA had relatively few employees because it (1) outsourced the manufacture of its snack food products to Frito-Lay Inc., an entity that was indirectly owned by PepsiCo, and (2) outsourced the distribution and sale of its snack food products to Rolling Frito-Lay Sales LP, another entity that was indirectly owned by PepsiCo. Et voila! Most of FLNA’s workforce worked abroad. In fact, PepsiCo’s tax department calculated that FLNA’s average foreign property and foreign payroll factors equaled 81.72 percent in 2011, 86.54 percent in 2012, and 87.18 percent in 2013, thus satisfying the requirements to be considered an 80/20 company.11

The Tribunal’s Decisions

I will not summarize the tribunal’s compelling legal analysis here. As I expressed above, readers of this article should read the two decisions. Suffice it to say that the decisions, written by the tribunal’s chief administrative law judge, concluded as follows: (1) that PGM lacked economic substance and business purpose; (2) that the expatriates were not true employees of PGM, given that (among other things) PGM exercised no management authority over them and was nothing but a shell corporation; and (3) that PepsiCo’s failure to exercise ordinary care and business prudence removed any justification for the waiver of penalties. The tribunal concluded:

It is astounding that a sophisticated tax department, like PepsiCo’s, would create such an aggressive tax strategy to create a non-operational shell company, [PGM] LLC, whose sole purpose was to make billions of dollars of FLNA’s domestic snack line income, previously recognized for State of Illinois income tax calculations, disappear with a few stokes of a pen.12

Instead, I ask readers to consider two questions: First, when do the actions of a multinational taxpayer cross the line that separates legitimate tax planning from unlawful conduct; and second, does the aggressive tax planning undertaken by PepsiCo and by a long line of other multinationals over the years necessitate a rethinking of state tax codes?

Although I don’t have a precise answer to the first question, I have a few principles to suggest. First, taxpayers should think long and hard before claiming that substantial income can be properly converted to a substantial loss simply by rearranging a corporate organizational chart. Second, responsible citizenship requires that taxpayers do more than play the audit lottery game, waiting for understaffed revenue departments to knock on their door and scrutinize complex legal arrangements. And third, highly profitable corporations, particularly those that have benefited for generations from the communities in which they operate, should consider whether a position that results in zero tax truly reflects their tax obligations.

Regarding the second question, the PepsiCo case illustrates why the answer to the question is most certainly yes.

PepsiCo’s Conduct and Similar Conduct by Others Require a Rethinking of State Tax Codes

In the 1980s, multinational businesses, foreign governments, and eventually federal officials engaged in a campaign to reverse the accelerating trend among states to require worldwide combined reporting. In response to this campaign, and under the threat of broad federal preemption, states changed the way they would source the income of multinationals. This reversal in turn created opportunities for aggressive taxpayers to engage in troubling tax avoidance schemes such as the scheme used by PepsiCo.

Ironically, Illinois was one of the first places where the debate over how multinational corporations should be taxed played out.

In 1981, in Caterpillar Tractor Co. v. Lenchos,13 the Illinois Supreme Court ruled that the state’s Income Tax Act required unitary businesses to file and pay tax on a worldwide combined basis. Almost immediately, multinational businesses (but not Caterpillar, because it benefited from worldwide apportionment) launched an effort to press for legislation reversing the court’s decision. And in short order, both the state Senate and House of Representatives, by large margins, passed a bill that would ban combined reporting, both on a worldwide and a domestic basis. But in a move that surprised many in the Illinois tax world, then-Gov. James R. Thompson, a political moderate, exercised his amendatory veto authority to entirely rewrite the bill, returning to the General Assembly for its consideration an entirely new corporate income tax structure that he argued struck a middle ground. Most significantly, the veto deleted the bill’s language banning combined reporting and replaced it with language requiring domestic combination. The governor’s language included the 80/20 rule that PepsiCo’s tax department eventually relied upon.

In the wake of subsequent events, one sentence of Gov. Thompson’s veto message stands out in particular: “The business structure,” he wrote, “should not be the determining factor in taxation.”14

Gov. Thompson’s action prompted much debate, both within and outside the legislature. Members of the General Assembly seemed most concerned that the rewrite of the original bill exceeded the governor’s amendatory veto authority; transcripts of the floor debates record no discussion about the veto’s 80/20 language. However, some members of a state tax reform commission meeting at that time lodged a warning that seems particularly insightful in light of PepsiCo:

By allowing corporations with foreign subsidiaries to manipulate their books and transfer Illinois profits oversees, the Governor’s method of apportionment allows multi-national corporations to escape tax liability on in-state profits. It is a potentially open-ended loophole.15

In the end, a large majority in each house voted to sustain the governor’s veto, embracing the compromise that apparently both Caterpillar and corporate opponents of combined reporting could live with.16

One year later, a similar story played out on the national level. In June 1983 the U.S. Supreme Court in Container Corp. v. Franchise Tax Board17 upheld the constitutionality of mandatory worldwide combined reporting, which by then had been adopted by a dozen states. Shortly thereafter, in reaction to criticisms of worldwide combination voiced by some U.S. trading partners and multinational corporations, the Reagan administration created a working group to examine state taxation of multinationals and to propose possible changes.18 And the chair of the working group, Treasury Secretary Donald Regan, made it clear that if states did not promptly limit mandatory combination to domestic businesses, the administration would propose federal legislation to achieve that end.

To no great surprise, the members of the working group, which included both business representatives and state officials, failed to agree on a full set of reforms. But because of the forceful insistence of Regan, the working group did agree to restrict mandatory combination to the “water’s edge,”19 and in the following months states that had adopted mandatory worldwide combination reversed course. One area where consensus was not reached was the meaning of water’s edge. Members of the working group who represented states asserted that all U.S. corporations, including 80/20 companies, should be treated as operating within the water’s edge and that exclusion of any domestic companies based on their payroll and property, but not their sales, “undermines the entire rationale for the water’s edge approach.”20 The business representatives, in turn, claimed that 80/20 companies were essentially foreign corporations since the activities of these companies occurred primarily overseas.

The arguments put forth by the state members appear prescient in the aftermath of the PepsiCo litigation before the tribunal. They argued first that exclusion of 80/20 companies from the combined reporting group “creates a significant opportunity for tax avoidance through corporate ‘shellgames.’” For example:

a subsidiary with 100 percent of its sales in the United States could escape water’s edge combination simply because most of its payroll and property is offshore.21

The state members also argued that excluding 80/20 companies from the water’s-edge group “would create a ‘tax planning’ opportunity” because only “in rare circumstances would the IRS audit the transfer prices between ‘80/20’ companies and other U.S. corporations that are members of the same consolidated group.”22

In the end, Secretary Regan agreed to leave the tax treatment of 80/20 companies to resolution at the state level. He apparently concluded that it was sufficient if states abandoned mandatory worldwide combination, even if some states chose not to exclude 80/20 companies from combined reporting groups. Nevertheless, by the time that PepsiCo implemented its plan to eliminate state taxes, there were more than a dozen states that had an 80/20 rule in place, exposing them to the very tax planning strategies that the state members of the working group had predicted.

As of the date of this writing, PepsiCo’s plan to eliminate Illinois income taxation has failed (although the tribunal’s rulings could be reversed on appeal). But the compromises of the 1980s continue to threaten state tax bases, especially given that, as the PepsiCo litigation and other cases involving aggressive state tax planning have revealed, these compromises vastly underestimated the extent to which some multinationals, oblivious to broader community responsibilities, would go to exploit provisions like the 80/20 rule.

Given this history, states should fix their water’s-edge filing rules. One compelling solution is to repeal the 80/20 rule and adopt the carefully crafted description of the water’s-edge group in the Multistate Tax Commission’s model combined reporting statutes.23 Or, as I have previously written, states should consider returning to mandatory worldwide combined reporting.24

In this context, it should be noted that PepsiCo just recently filed a lawsuit challenging the income tax assessments issued by the Illinois DOR that cover tax years 2016 and 2017. This time, the company chose to file its challenge in a downstate circuit court, presumably in pursuit of a more friendly forum to defend its tax scheme. Clearly, states should not assume that some multinational taxpayers will stop engaging in and defending troubling conduct on their own.


1 PepsiCo Inc. is a publicly traded, North Carolina corporation headquartered in Purchase, New York.

2 This case is captioned PepsiCo Inc. v. Illinois Department of Revenue, 16 TT 82 and 17 TT 16. The decisions are titled, respectively, (1) Order on Petitioner’s Motion for Summary Judgment (Order) and (2) Order on Petitioner’s Motion for Summary Judgment for Reasonable Cause Penalty Abatement and Department’s Cross-Motion for Summary Judgment-80/20 Issue Penalties (Penalty Order). They can be found on the tribunal’s website.

3 The joint stipulation of facts also can be found on the tribunal’s website.

4 According to the joint stipulation of facts, an Illinois audit increased the company’s 2010 tax liability to about $6.2 million.

5 Order at 6.

6 Id.

7 35 Ill. Comp. Stat. 5/1501(a)(27)(A).

8 Id.; 35 Ill. Comp. Stat. 5/304. A dozen other states have adopted a similar rule. They are Arizona, Colorado, Connecticut, Indiana, Kentucky, Montana, New Hampshire, New Mexico, North Dakota, Texas, Vermont (which repealed its rule last year), and the District of Columbia.

9 See discussion on page 410 supra.

10 In each of those years, the operating profit of Frito-Lay North American division of PepsiCo, which included FLNA, exceeded $3 billion.

11 For a more in-depth discussion of the 80/20 rule and how it invites abuse, see Bruce J. Fort, “Anatomy of a Domestic Tax Shelter,” Tax Notes State, May 17, 2021, p. 689.

12 Penalty Order at 11.

13 84 Ill. 2d 108 (1981), appeal dismissed sub nom. Chicago Bridge and Iron Co. v. Caterpillar Tractor Co., 463 U.S. 1220 (1983).

14 Legislative Synopsis and Digest, 82d Session of the General Assembly (H.B. 2588), at 1420.

15 State of Illinois, Report of the Tax Reform Commission, at 42-43 (Dec. 1982) (memorandum of dissent).

16 The senator who sponsored the original bill banning combined reporting presented the motion to approve the veto. He said: “I simply move that we do accept this splendid middle ground that the Governor offers in the area of unitary taxation for corporate income tax in the State of Illinois.” Transcript of Proceedings, Illinois, 82d General Assembly, Senate, Dec. 2, 1982, at 30 (remarks of Sen. Grotberg). During the House floor debate on the veto, one legislator noted that the Committee (now Council) On State Taxation had endorsed the compromise proposed by the governor. Id., House of Representatives, Nov. 18, 1982, at 29 (remarks of Rep. Collins).

17 463 U.S. 159 (1983).

18 The working group was called the Worldwide Unitary Taxation Working Group. It was publicly unveiled on September 23, 1983. See “The Final Report of the Worldwide Unitary Taxation Working Group: Chairman’s Report and Supplemental Views” (Aug. 1984) (Working Group Report).

19 In return, members of the working group agreed that the states would receive “increased federal administrative assistance and cooperation . . . to promote full taxpayer disclosure and accountability.” Working Group Report at 9.

20 Id. at 14.

21 Id.

22 Id. at 15.

23 See both the Joyce and Finnigan versions of the Model Statute for Combined Reporting, posted on the MTC website. These model statutes provide that the water’s-edge group includes all members of the unitary group “incorporated in the United States or formed under the laws of any state, the District of Columbia, or any territory or possession of the United States.”

24 Brian Hamer, “States Should Embrace GILTI or Pursue an Alternative Path to Fairness,” State Tax Notes, Feb. 11, 2019, p. 475.


Subject Areas / Tax Topics
Magazine Citation
Tax Notes State, Jan. 30, 2023, p. 409
107 Tax Notes State 409 (Jan. 30, 2023)
Institutional Authors
Multistate Tax Commission
Tax Analysts Document Number
DOC 2023-333
Copy RID