The US Tax Court has held that advance agreements executed between related parties were appropriately characterised as equity for US Federal income tax purposes. PepsiCo Puerto Rico, Inc. v. Commissioner of Internal Revenue; PepsiCo, Inc. and Affiliates v. Commissioner of Internal Revenue, T.C. Memo. 2012-269 (Docket Nos. 13676-09, 13677-09, 20th September 2012).
The case involved a US parent corporation (PepsiCo) and its group of affiliated corporations that included Netherlands Antilles companies. The Netherland Antilles companies held promissory notes issued by the group’s US affiliated corporations (Frito-Lay, Metro Bottling, and PepsiCo) and held interests in foreign entities that were treated as partnerships for US Federal income tax purposes (foreign partnerships).
The deficits of the foreign partnerships reduced the earnings and profits of the Netherland Antilles companies, which in turn reduced the amount of the interest income from the notes that would otherwise have flowed-through to PepsiCo as subpart F income. To avoid the adverse consequences that would result from the pending termination of the extension of the US-Netherlands treaty to the Netherlands Antilles, and also to benefit from the favourable tax treatments of the US-Netherlands DTAA and Dutch corporate income tax, PepsiCo transferred the ownership of some of the foreign partnerships from the Netherland Antilles companies to newly-formed Dutch companies (PWI and PGI).
During this global restructuring, Frito-Lay, Metro Bottling, and PepsiCo issued new promissory notes to replace the existing promissory notes and the new promissory notes were ultimately contributed to PWI and PGI. In exchange for the contributed promissory notes, PWI and PGI issued advance agreements to the group’s US affiliates (BFSI and PPR). The advance agreements had terms of 40 years, which could be unilaterally extended by PWI and PGI for an additional 15 years.
The advance agreements, however, would be rendered perpetual if a related party defaulted on any loan receivables held by PGI or PWI. A preferred return unconditionally accrued on any unpaid principal amounts of the advance agreements. The preferred return included a base rate determined by reference to LIBOR plus a premium rate. However, PWI and PGI were required to make any payments of the accrued preferred return only to the extent their net cash flow exceeded the sum of accrued but unpaid operating expenses and capital expenditures made or approved by them, but in no event could the cash-flow amount be less than the interest received from the affiliated companies.
PWI and PGI were allowed to make payments on the advance agreements in full or in part at any time. In addition, the rights of the creditors of PWI and PGI were superior to the holders of the advance agreements. The group treated payments of preferred return on the advance agreements as distributions on equity on its US Federal income tax returns. Interest payments on the promissory notes were deducted by Frito-Lay, Metro Bottling, and PepsiCo u/s. 163 of the US Internal Revenue Code (IRC) and were also exempt from US withholding tax pursuant to the US-Netherlands tax treaty.
The issue of the case was whether the advance agreements were appropriately characterised as equity for US Federal income tax purposes. The US Internal Revenue Service (IRS) asserted that the advance agreements and the promissory notes were merely intercompany loans between commonly controlled related companies. The US Tax Court stated that, while the substance of a transaction governs for tax purposes, the form of a transaction often informs its substance.
The US Tax Court further stated that, although the greater scrutiny should be afforded to relatedparty transactions, disregarding the taxpayers’ international corporate structure based solely on the entities’ interrelatedness is, without more, unjustified. The US Tax Court noted that the focus of a debt-versus-equity inquiry is whether there was intent to create a debt with a reasonable expectation of payment and, if so, whether that intent comports with the economic reality of creating a debtor-creditor relationship.
The US Tax Court then applied 13 factors that it has articulated for the debt-versus-equity inquiry. After analysing those factors, the US Tax Court concluded that the advance agreements exhibited more qualitative and quantitative indicia of equity than debt. The US Tax Court determined that the advance agreements were appropriately characterised as equity for US Federal income tax purposes. 10. Netherlands Supreme Court: burden of proof regarding transfer of legal seat on taxpayer On 30th November 2012, the Supreme Court of the Netherlands (Hoge Raad der Nederlanden) gave its decision in case No. 11/05198 as to whether or not, in the context of the transfer of the legal seat of a company, the burden of proof (of the transfer) rests on the taxpayer. For the facts, legal background and issues of the case, as well as the opinion of the Advocate General (AG), the Taxpayer presented the Supreme Court with two arguments:
• Firstly, the Taxpayer appealed against the finding of the Court of Appeal (Gerechtshof) of Arnhem that it (the Taxpayer) had not shown that the place of effective management had, since 1st July 2001, been transferred to the Netherlands Antilles. The Court dismissed this appeal on the grounds that it is a reasonable finding of facts, which can as such not be considered by the Supreme Court.
• Secondly, the Taxpayer essentially argued that the burden of proof regarding its (Netherlands Antilles) residence status only extends to the year in which the transfer takes place, i.e. to 2001. The AG had concluded that the shift in the burden of proof to the Taxpayer applies for a period of 1 year after the transfer of the place of effective management has been “made plausible”.
• The Court noted, as the Court of Appeal had, that the aim of article 35b(7) of the Tax Regulation for the Kingdom of the Netherlands, as deduced from parliamentary and legislative documentation, is to combat tax avoidance which may arise from the nominal (paper) transfer of the legal seat of a company. This article provides for a shift in the burden of proof to the taxpayer in certain situations where there is a transfer of the legal seat.
• On this point, the Supreme Court agreed with the Court of Appeal, and decided that the burden of proof is shifted to the taxpayer until that taxpayer can make plausible the transfer of the place of effective management.
• This second argument, the Court noted, was somewhat academic as the first hurdle, namely proving that the place of effective management had indeed been transferred, had not been taken by the taxpayer.
[Acknowledgement/Source: We have compiled the above summary of decisions from the Tax News Service of IBFD for the period 18-09-2012 to 17-12-2012.]
