PepsiCo Puerto Rico v. Commissioner

Because of a change of law, PepsiCo, Inc. (plaintiff) restructured the capital structure of its global corporate group. As part of this restructuring, PepsiCo sought to issue advance agreements that would be treated as debt for Dutch tax purposes and equity for United States tax purposes. The advances were issued in exchange for notes payable by PepsiCo Global Investments (PGI). PGI, in connection, also held interest-bearing notes issued by Frito-Lay. The proceeds from the advances were used to fund high-risk investments in emerging markets. The advance agreements had a term of 40 years, although they could be extended, and the issuers of the advances had no right to demand repayment if PGI were to default. Moreover, the advance agreements subordinated PGI’s obligations to the advance issuers below those of its other creditors. PepsiCo treated payments on the advances as returns on equity and the interest payments on the Frito-Lay notes as deductible interest expenses. PepsiCo received a tax ruling from the Dutch taxing authorities that the advances would be treated as debt for Dutch purposes. Obtaining this ruling required PepsiCo to represent that, in practice, the interest on the Frito-Lay notes would be used by PGI to pay the returns due on the advances, although PepsiCo refused to characterize this flow-through arrangement as obligatory. In fact, PGI did on occasion deviate from this flow-through structure. The commissioner of the Internal Revenue Service (IRS) (defendant) classified the advance agreements as debt for United States tax purposes. PepsiCo filed a petition in the tax court seeking reevaluation of the IRS’s classification.