Pepsico, Inc. and Affiliates, Petitioner

F p SEC T.C. Memo. 2012-269 UNITED STATES TAX COURT PEPSICO PUERTO RICO, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent PEPSICO, INC. AND AFFILIATES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket Nos. 13676-09, 13677-09.

Filed September 20, 2012.

Mario J. Verdolini Jr., D. Scott Wise, Leslie J. Altus, Craig A. Phillips, and Ethan R. Goldman, for petitioners.

Lyle B. Press, Daniel A. Rosen, Vincent J. Guiliano, and Michael S.

Coravos, for respondent.

SERVED Sep 20 2012

MEMORANDUM FINDINGS OF FACT AND OPINION

GOEKE, Judge: Respondent determined income tax deficiencies with respect to PepsiCo, In . PepsiCo), and Affiliates for taxable years ended December 26, 1998, December 25, 1999, December 30, 2000, December 29, 2001, and December 28, 20(2, of $53,683,731, $48,488,863, $20,497,493, $26,653,075, and $46,694,856, respectively. Respondent separately determined deficiencies for PepsiCo Puerto Rico, Iná. (PPR), for taxable years ended November 30, 1998, 1999, 2000, 2001, and 2002, of $38,348,937, $31,873,463, $31,698,661, $32,717,683, and $32,399,250, respectively. These cases were consolidated for trial, briefing, and opinion. The parties submit two issues for decision:

(1) whether Ldvance agreements issued by PepsiCo's Netherlands subsidiaries to certain PepsiCo domestic subsidiaries and PPR are more appropriately characterized as debt than as equity; and, (2) if the advance agreements are characterized as debt, whether, and to what extent payments on the advance agreements constitute original issue discount, relating to contingent payment debt instruments under section 1.1275- 4(c), Income Tax Regs.¹ iUnless otherwise indicated, all section references are to the Internal Revenue Code (Code) in effect for the years in issue, and all Rule references are to (continued...)

' We hold that the advance agreements are appropriately characterized as equity for Federal income tax purposes. Accordingly, we need not consider the remainmg issue.

I. Petitioners

FINDINGS OF FACT

PepsiCo is incorporated under the laws of North Carolina. At the time of petition, the principal office of PepsiCo was in Purchase, New York. At all times during the years at issue, PepsiCo was the common parent of a group of affiliated corporations pursuant to section 1504.2 PepsiCo, together with its consolidated affiliates, is a leading global beverage, snack, and food company. It manufáctures and markets carbonated and noncarbonated beverages and a variety of snack foods. PepsiCo also owned and operated an international restaurant business, which was spun off in 1997.

PPR is incorporated under the laws of Delaware. At the time of petition, PPR's principal office was in Purchase,'New York. PPR was a wholly owned subsidiary of PepsiCo that elected the benefits of sections 936 and 30A for all the (...continued) the Tax Court Rules of Practice and Procedure.

Pepsico filed a consolidated return for U.S. Federal income tax purposes for each of the tax ýears in issue.

tax years in issue. PPR directly owned and operated concentrate and snack food manufacturing facilities and performed snack food distribution functions.

Effective December 1, 2006, PPR's section 936 status expired. As of that date, PPR was a member of PepsiCo's consolidated group, which filed its return on a consolidated basis.

II. The Pre-1996 Structure In 1996 PepsiCo's direct subsidiary, PepsiCo Capital Corp. N.V.

(CapCorp), held stock in two separate subsidiaries: PepsiCo Finance (Antilles A) N.V..(PFAA) and PepsiCo Finance (Antilles B) (PFAB). ÇapCorp, PFAA, and PFAB (collectively, PepsiCo companies) were all corporations organized under the law of the Netherlands Antilles, each with single classes of equity outstanding, and all were treated as controlled foreign corporations for U.S. Federal income tax purposes. The PepsiC³ companies each held interests in foreign entities that were treated as partnerships fo U.S. Federal income tax purposes (foreign partnerships).3 The forei n partnerships öperated in areas in which PepsiCo was developing its brand,and a market for its products; many were generating losses.

3The foreign pa nerships included Pepsi-Cola Trading Sp.zo.o (Poland), PepsiCola GmbH (Germäny), Pepsi-Cola France Snc, KFC France Snc, Spizza 30 Snc (France), Pepsi-C la CR S.R.O. (Czech Republic), PepsiCo Restaurants Sca (Spain), Pepsi-Cola SP_ S.R.O. (Slovakia), SVE Trading & Manufacturing Limited (Hungary), PepsiCo Investments Ltd. (China), and PepsiCo Poland.

.

The PepsiCo companies each held promissory notes (pre-1996 notes) issued before 1996 by Frito-Lay, Inc. (Frito-Lay), incorporated under the laws of Delaware; Pepsi-Cola Metropolitan Bottling Co., Inc. (Metro Bottling), incorporated under the laws of New Jersey; or PepsiCo.⁴ The notes were traceable to indebtedness that was originally incurred in the 1980s to finance various business acquisitions and investments. As a result of a "large capital ruling" (LCR) procured from the Netherlands Antilles taxing authority in-1989, any interestipayments received by the PepsiCo comþanies were subject toe de minimis taxation in the Netherlands Antilles.

Payments of interest on the pre-1996 notes were also exempt from U.S.

withholding tax under the income tax treaty between the United States and the Netherlands then in effect (Dutch tax treaty), the interest article of which extended 4Frito-Lay and Metro Bottling were, at all relevant times, wholly owned (directly or indirectly) by PepsiCo.

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.

The one pre-1996 note issued by PepsiCo was held by CapCorp in the principal amount of $118,393,106.86. Petitioners have not found this note.

(cid:16)042 to residents of the Netherlands Antilles for those years.⁵ Furthermore, deficits of the foreign partnershil s reduced the earnings and profits of the PepsiCo companies, thereby reduçing the amount of interest then includable by PepsiCo as "subpart F" income under sections 951.and 952.

Interest due on the pre-1996 notes was also deductible for U.S. Federal income tax purposes by Frito-Lay, PepsiCo, and Metro Bottling pursuant to section 163.

III. Global Restructuring

By the mid-199 s PepsiCo recognized certain business opportunities were materializing in both e and existing international markets in which its primary competitor, Coca-Cola, was not the dominant soft-drink.brand. PepsiCo perceived, in particular, a more level and competitive mternational business landscape in Eastern urope following the fall of the Berlin Wall in 1989. .

o Contemporaneously, once-dormant Asian markets began to appear more receptive to a greater Western business presence. PepsiCo also understood that billions of dollars in capital mves mønts would be necessary for the company to successfully establish its brand in ese areas.

5See Conventioi³ with Respect to Taxes on Income and Certain Other Taxes, U.S.-Neth.: Apr. 29, 1 48, 62 Stat:1757. The Dutch tax treaty was extended to the Netherlands Antilles in 1955.

In October 1995, as PepsiCo began to consider a large-scale investment in these emerging markets, the United States and the Netherlands signed a protocol which amended article VIII of the Dutch tax treaty, terminating its extension to residents of the Netherlands Antilles.⁶ As a result, any interest payments made by Frito-Lay, PepsiCo, or Metro Bottling to the PepsiCo companies pursuant to the pre-1996 notes would become subject to U.S. withholding tax as of September 28, 1996.

PepsiCo, recognizing the unique confluence of both tax and business factors, endeavored to undertake a global restructuring of their international operations. A main function of the restructuring, aside from the aforementioned considerations, was for PepsiCo to organize its international holdings to allow for a more effective use of overseas earnings and to avoid using cash from the United States to fund its overseas expansion.⁷ 6PrOtOCOl Amending Article VIII of the 1948 Convention with Respect to Taxes on Income and Certain Other Taxes as Applicable to the Netherlands Antilles, U.S.-Neth., Oct. 10, 1995, Tax Treaties (CCH) para. 6205.

In implementmg its new international business model, PepsiCo decided to reconfigure its existing overseas structure by transferring.ownership of some of the foreign partnershi s from various Netherlands Antilles holding companies to Netherlands holding c nipanies, where the Dutch tax treaty remained in effect.

The Netherlands, unli e he Netherlands Antilles, had cultivated an extensive treaty network with the countries in which.the foreign partnerships were organized. This treaty network reduced or eliminated withholding taxes on dividends paid to Netherlands holding companies. The Netherlands corporate income tax laws also xempted distributions of profits to Netherlands holding companies from Dute e rporate income tax. PepsiCo,was cognizant that this favorable tax environment would allow it to mobilize its cash more efficiently than had been possible wit the initial Netherlands Antilles holding company structure.

As a prelimin step in PepsiCo's reorganization, on July 24, 1996, the PepsiCo companies e h contributed their interests in some of the Foreign Partnerships to Senrab Limited (Senrab) and Bramshaw Limited (Bramshaw), both Irish corporations. Senrap and Bramshaw subsequently formed PepsiCo Worldwide Investments (PWI) and PensiCo Global Investments (PGI), respectively, both beloter vennotschaps or private limited liability companies organized under Dutch law.⁸ Thereafter, Senrab and Bramshaw contributed their interestá in the Foreign Partnerships to PWI and PGI'.9 Following the formation of the new entities under Netherlands law; Frito- Lay, PepsiCo, and Metro Bottling issued six new notes (PepsiCo Frito-Lay notes), on September 1, 1996, to the PepsiCo companies in exchange for the six pre-1996 notes, plus accrued interest. All of the PepsiCo Frito-Lay notes provided that Interest shall accrue on any unpaid Principal Amount at a rate set initially 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 * * * plus 230 basis points or (ii) 7.5% per annum. * * * Accrued interest shall be payable on each December 31 (or the first business day following), annually in arrears, beginning in 1997. * * * [Emphasis supplied.] , The PepsiCo Frito-Lay notes had initial maturities of 15 years, with an issuer option to extend the maturity for an additional 25 years. To the extent that the borrower failed to pay accrued interest when required, all of the PepsiCo Frito-Lay 8PGI and PWI were initially formed as separate subsidiaries to enable the Foreign Partnerships to continue their status as partnerships for U.S. Federal income tax purposes; however, on September 2, 1997, PepsiCo caused PWI to merge into PGI. Thereafter, PepsiCo filed "check the box" elections to treat the Foreign Partnerships as "disregarded entities" for U.S. Federal income tax purposes.

9Before 1996 PepsiCo was engaged in beverage, restaurant, and snack food operations in China through various operating companies. formed PepsiCo Investments (China) Ltd. (PICL) to serve as a holding company for the operating companies.

In 1997 PICL was transferred to PGI.

In 1994 PepsiCo notes provided that the that the lender had the right to: (1) the immediate payment of all unpaid principal and accrued interest; or (2) the immediate execution of a new fi -ÿear note (baby note) for the full amount of the accrued or unpaid interest. The aby notes would thereafter accrue.interest according to a separate rate calculation.

CapCorp and PFA contributed their PepsiCo Frito-Lay notes to PFAA.

PFAA thereafter transferred all the PepsiCo Frito-Lay notes to its indirect subsidiary, Kentucky Fried Chicken International Holdings, Inc. (KFCIH), a Delaware corporation.

IV. The 1996 Advance Agreements On September 27, 1996, KFCIH contributed a portion of the PepsiCo Frito- Lay notes having an aggr gate principal amount of $1,779,662,436 and $10,467,257:64 of accrued interest to PGI in exchange for an advance agreement (KFCIH I advance agreement)1° having a face amount of $1,790,129,693.64. On the same day, KFCIH eor3tributed the remaining PepsiCo Frito-Lay notes, having an aggregate principal mount of $88,984,086.92 and $523,368.56 of accrued interest, to PWI in exc ange for an advance agreement (KFCIH II advance 1°The advance agreements are discussed further infra.

agreement, and together with the KFCIH I advance agreement, 1996 advance agreements) having a face amount of $89,507,455.48.

On October 2, 1997, PepsiCo engaged in the public spinoff of its restaurant business, which included KFCIH." As part of the spinoff, KFCIH transferred the 1996 advance agreements to Beverages, Foods & Service Industries, Inc. (BFSI), a Delaware corporation and indirect subsidiary of PepsiCo, which continued to hold the 1996 advance agreements throughout the years at issue.

V. The 1997 Advance Agreement On May 29, 1997, PGI issued an advance agreement (1997 advance agreement, and together with the 1996 advance agreement, advance agreements) to PPR in exchange for separate Frito-Lay notes (initial PPR Frito-Lay notes) then held by PPR. The initial PPR Frito-Lay notes had been issued in 1994, 1995, and 1996 and had initial terms of three to five years. As of the exchange date, the aggregate principal amount of the initial PPR Frito-Lay notes equaled $1,378,292,737.95, the face amount of the 1997 advance agreement. In 1998 one of the initial PPR Frito-Lay notes in the principal amount of $214,084,144 was paid in full. The maturities of the remaining.initial PPR Frito-Lay notes were "From 1997 through 2002, PGI acquired interests in several PepsiCo subsidiaries. It also disposed of a number of subsidiaries during the same period.

subsequently extended through thë issuance of new Frito-Lay notes (additional PPR Frito-Lay notes, and collectively with the initial Frito-Lay notes and the PepsiCo Frito L y notes, Frito-Lay notes).

VI. Development of the Advance Agreements PepsiCo sought to effect the global reorganization in a manner that would preserve the tax attrib tes of the Netherlands Antilles holding company structure before the protocol to he Dutch tax treaty. Accordingly, PepsiCo sought to create instruments, the adva e agreements, which would be classified, partially, as debt in the Netherlands and tréated as equity in the United States. It was contemplated that the tax treatment of these instruments would preserve the foreign tax benefits achieved by the LCR in the prior Netherlands Antilles structure by reducing PGI's Dutch corporate taxable income from accrued interest from the Frito-Lay notes by the amount of interest xpense pursuant to the advance agreements. From a U.S.

tax perspective, petiti ners anticipated that payments to the U.S. entities pursuant to the advance agreements would be treated as distributions on equity. With ° The initial PPA Frito-Lay notes and the additional'PPR Frito-Lay notes each had fixed interest rates ranging from 7.35% to 10%.

One of the additioijal Frito-Lay notes was issued to extend the maturities of two initial Frito-Lay nutep issued on October 19, 1995 and 1996, in principal amounts of $41,523,243.83 and $97,685,350.12, respectively. Petitioners have not found this additional F ito-Lay note.

earnings and profits of PGI predicted to be drastically reduced or eliminated by the foreign partnerships' losses in the foreseeable future, it appeared unlikely that petitioners would be subject to "subpart F" income or dividend treatment on distributions." In an effort to secure the desired Dutch treatment of the advance agreements, PepsiCo began the interdependent processes of drafting the instruments and negotiating with the Dutch Revenue Service to procure a tax ruling."

In 1996 the tax ruling process in the Netherlands was generally centralized and formalized on the basis of published model rulings.¹⁵ Taxpayers could also "Under subpt. F (secs. 951 through 965), a U.S. shareholder of a controlled foreign corporation generally mu(cid:0)541tinclude in gross income a pro rata share of the corporation's subpt. F income in each year; however, the subpt. F income of a controlled foreign corporation in a taxable year cannot exceed its earnings and profits in the same year. See sec. 952(c)(1)(A).

"In 1995 the Dutch Under-Minister of Finance described tax rulings as:

[A]n 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. [Resolution of the Under- Minister of Finance of 6 July 1995, No. DGO95/2714, V-N 1995, p. 2453.]

"The Dutch tax ruling process was described in petitioners' Dutch tax expert's report, discussed further infra. Respondent does not contest these general findings, and we produce this discussion here to place petitioners' negotiations (continued...)

obtain "tailor madÉ" rulings for nonstandard transactions; however, the .

model rulings typicall provided a framework for ruling negotiations.

In the standard ruling for "in ra-group financing activities", the Dutch Revenue Service provided that if a "Du h financing company" agreed to report as net taxable profit per 12 months a percent ge (spread) of the total amount of funds borrowed and thereafter 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". The initial, acceptable spre d for a tax ruling was 1/8% of the total amount of funds borrowed and subseg ntly lent; the spread decreased as the total amount of funds I borrowed and lent increased (varying from 1/8% to 1/16%). The procurement of a tax ruling was further co ditioned upon eliminating any currency or creditor risk for the pertinent Dute entity.

.

Koen Slobbe, a PepsiCo employee and tax manager within PepsiCo's tax department in Richmond, UK, was tasked with the preparation and circulation of the preliminary 1996 a vance agreements. On January 29, 1996, Mr. Slobbe sent the first draft to various PepsiCo employees including Matthew Bartley, then a member of PepsiCo's international tax group in Purchase, New York, and "(...continued) with the Dutch Revente Service in proper context.

Anthony Bryant, then PepsiCo's vice president of tax and treasury for Europe, the Middle East, and Africa.¹⁶ The following day, Mr. Bartley forwarded the draft to Mariëtte Turkenburg, a partner in the Rotterdam office of the Dutch tax advising firm of Loyens & Volkmaars, N.V. (Loyens), which had previously been engaged to represent PepsiCo, PGI, and PWI for the purpose of procuring the Dutch tax ruling.

The preliminary draft was a working model and consisted of several possible provisions that PepsiCo management could adopt or discard. The primary provision of the draft provided for the accrual of a "preferred return" which would be payable annually, or alternatively, only if certain conditions were met. Specifically, the alternate provision provided that The Preferred Return shall be payable only to the extent that the net cash flow of the * * * [new Netherlands company] exceeded the sum of (i) the amount of all operating expenses incurred by the * * * [new Netherlands company] during such year and, (ii) the amount of all expenditures made by the [new Netherlands company] during such year * * *.

To the extent that the accrued preferred return was not paid "as a result of the restrictions" noted supra, the amount of the accrued but unpaid preferred return would be capitalized into a "separate and segregated amount". This separate

amount would correspondingly be payable at maturity, but only if "aggregate net cash flow ' for the period of nonpayment exceeded the aggregate sum of all operating e penses incurred and capital expenditures made by the new Netherlands company uring the same period. Nonetheless, the draft made clear that the new Netherl s company was allowed to pay any such amounts, including the principal amount, at any point.

The preliminary draft also specified that the principal amount was payable at some undetermined ipoint in 2011; however, the new Netherlands company was !

given the unrestricted p ion to extend the payment to February 1, 2021.

Furthermore, the draft xplicitly stated that any "obligation" to pay the principal amount or "preferred r turn" would be subordinated to all indebtedness of the new Netherlands company Following her review of the preliminary draft, Ms.

Turkenburg had reservatiöns as to whether it met the criteria for creating a debt instrument under Dutch law.

During the same period the preliminary drafts were circulated, Ms.

Turkenburg, on behalf of PepsiCo, PGI, and PWI, began a dialogue with Timo Munneke, a tax inspec or employed with the Dutch Revenue Service, with the intention of eventually securing the Dutch tax ruling.

In the course of negotiations, Ms. Turk:nburé, consistently sent unofficial translations of her correspondence with Inspector Munneke to Mr. Slobbe and other employees of PepsiCo for review.

Following a meeting on March 8, 1996, Ms. Turkenburg wrote a memorandum to Inspector Munneke describing their prior discussion and the contemplated structure of the 1996 advance agreement. Referring to the relationship between the relevant Frito-Lay notes and the proposed 1996 advance agreement as well as to the effect of the "net cash flow" provision on preferred return payments, Ms. Turkenburg noted:

[T]he conditions of the loans to Fritolay will not be identical to the conditions based on which PGI/PWI will borrow. Apart from a long term, which will, however, match the Fritolay-loans, the incoming loans will be subordinated and the payment of interest will be contingent on the cash-flow position of PGI/PWI. These conditions entail that the interest on the * * * [advance agreements] will have two components: a base interest, which will, after deduction of the required spread, match the interest on the Fritolay-loans, i.e. a libor market rate with a regular risk surcharge, and a premium that constitutes compensation for particularly the subordination.

Ms. Turkenburg also emphasized that the interest received by PGI/PWI would be used at their discretion to finance PepsiCo investments in emerging markets:

We discussed the reason for the subordination [is] that [it] in fact allows PGI/PWI to reinvest the revenues, if desired, in the participations and to consolidate the financing and the holding activities. PGI/PWI will acquire a portfolio of participations that particularly operate in new markets, as a result of which expansion investments are to be expected. It is noted that the participations will be funded with equity.

At trial, Ms. Turkenbürg clarified that the final sentence in the excerpt, supra, was drafted to indicate thal PÒI/PWI would use Frito-Lay note interest to make capital contributions to foreign subsidiaries.

On April 24, 1996 Mr. Bartley sent Ms. Turkenburg two new draft versions of the 1996 advance agreement labeled "mtaadbv" and "mtaudbv", respectively.

The mtaadbv version mo ified the "net cash flow" definition to include "all interest payments received by the Company from related parties during such year."

In a cover letter acco pa ying the drafts, Mr. Bartley emphasized that the '_'net cash flow" definition in t e mtaadbv version "is intended to provide the link between Frito-Lay int re t payments made to PGI and * * * payments to KFCIH.

This link is intentional y non-specific, to avoid giving the IRS any hook on which to hang a straight look thru argument." While expressing acceptance of the "net cash flow" definition provided in mtaadbv, Mr. Bartley noted that PepsiCo would "prefer to use mtaudby, hich creates no express link between the * * * [Frito- Lay] loans and the * * * [1996 advance agreement].?

"The mtaudbv ver ion did not specifically define "net cash flow" but simply indicated that it wöuld not include "any equity contributions, loans, or other capital investmerÅts received by the Company.

- -19 - In a May 7, 1996, facsimile, Mr. Bartley provided Ms. Turkenburg with a subsequent draft of the 1996 advance agreement which included a further refinement of the definition of "net cash flow". The revised version provided that "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 received by the Company from related parties during such year." Two days later, Ms.

Turkenburg formally submitted PepsiCo's tax ruling request to the Dutch Revenue Service.

In the letter representing Pepsico's formal request, Ms. Turkenburg reiterated that The actual payment of the base interest and premium is dependent on 'Cash flow' is defined in the agreement. the cash-flow of PGI/PWI. Contrary to our previous discussions, it is not the intention that this income is reinvested in the participations. The cash-flow definition in the agreement underlines this. Separate financing will be sought for such additional investments.

In further describing the "cash flow" limitation, the request noted that "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)."

On June 11, 1996, Inspector Munneke sent Ms. Turkenburg a letter approving the tax ruling. The ruling was, however, conditioned on the 1996 advance agreement's operating in conformity with Inspector Munneke'(cid:0)541 interpretation of its terms:

The exact appli ation of the cash-flow restriction on the payment of interest can not be determined by me. Together we have concluded that the interest payable should at least equal to the interest received on the loans rec ivable from Frito Lay. This applies also (or should apply also) to t e uapitalised base interest in the form of the Capitalised Base R Amount. This should also always be paid if the corresponding capitalised interest of Frito Lay * * * is paid by Frito Lay.

* * * * These activities ha e as [a] main characteristic the flow-through. A flow-through of funds * * * [from] KFCIH is intended.

Following Inspector Munneke's letter, Mr Bartley sent Ms.

Turkenburg a facsimile, dated June 20, 1996, in which he indicated that payments of interest and bapitalized interest were not technically required pursuant to the terms f the 1996 advance agreement draft, but "As a practical matter we ex ect all * * * [Frito-Lay] interest payments to flow thru to KFCIH." Ms. Tu kenburg responded to Mr. Bartley, on June 21, 1996, with a facsimile wl ich revealed that Inspector Munneke's understanding of the p offered 1996 advance agreement draft was unacceptable:

In his letter * * * [Inspector Munneke] clearly states that he is still not convinced that the cash-flow definition would have the flow-through result that he is looking for. The definition as it is worded would not give that result unless parties are very careful to monitor the situation so that the actual facts, in fact the net cash-flow, expenses and capital expenditures are such that in actual fact a flow-through results. For obvious US reasons we can not accommodate him. * * * [T]he 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 * * * [does] not intend to export funds from the US and that you would therefore indeed always use every dollar received from * * * [Frito-Lay] towards payment to KFCIH.

Two days later, on June 23, 1996, Mr. Bartley sent Ms. Turkenburg another facsimile clarifying that PGI/PWI would make preferred return payments to KFCIH, notwithstanding the terms of the 1996 advance agreements:

1. Generally * * * all of us [you, me, Bruce, and the inspector] appear to be in agreement. In practice, aH 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 * * * [1996 advance agreements] and the Dutch ruling can and should assume this fact.)

* * * * * *.

3. Under no circumstances will either operating expenses or capital expenditures (no matter what definitional language we use in the * * * [1996 advance agreements]) prevent the "flow-thru" payment of interest. Reiterate point 1 above.

.

4. As you npte, the difficulty from a US tax perspective is that direct express likäge between * * * [Frito-Lay] payment and PGI/PWI paym nt (and/or any requirement that cash received from * * * [Frito-Lay] be paid to KFCIH) would create significant risk that the * * * [1996 d ance agreement] will be treated as debt rather than equity. If the tehns of the * * * [1996 advance agreement] either assure or requir be paid on to KFCIH, the IRS has a strong argument that the * * * [1996 advance agreement] is nothing more than a linked (back-to- back) debt instrumënt.

tliat any payment from * * * [Frito-Lay] will or must * * * We need to be able to argue compellingly that the test - will not necessarily assure or require interest payments from related parties to be paiËon to KFCIH under the * * * [1996 advance agreement].

[EiÅphasis supplied.¹⁸] Ms. Turkenburg, on June 25, 1996, sent Inspector Munneke a followup letter in response to his conditionäl approval of June 11, 1996. Ms. Turkenburg drafted her letter to clarify an sümmarize the continued discourse between the parties.

She proffered:

As long as the funds obtained from KFCIH are onlent to Fritolay In that respect, it is * * * the loan fr m KFCIH qualifies as debt. decisive that the interest actually received on the loans granted to Fritolay, and/or the capitalized interest paid by means of redemption of the New Pro issory Notes (also referred to in our consultation as "baby notes"), i used each time for the payment of, at least, the fixed component of th interest obligations vis-à-vis KFCIH, including the Capitalized BasÊ PR Amount(s). For Dutch tax purposes, this fixed component qualifies as an interest payment not contingent on profit, 18The phrase "[you, me, Bruce, and the inspector]" in the first line of the quoted passage, see supra p. 21, refers to Ms. Turkenburg, Mr. Bartley, Mr. Meyer, and Inspector lÝIunneke, respectively.

nor accruing to the shareholder as such, and is deductible for Dutch corporate income tax purposes."

Furthermore, Ms. Turkenburg noted: "In order to clarify this 'flow-through' concept, it is included in the * * * [1996 advance agreement] that the amount of the net cash flow will not be lower than the [Frito-Lay] interest payments and the payments of capitalized interest."

On July 1, 1996, Mr. Bartley, responding to a separate Inspector Munneke request that PWI/PGI avoid "debtor's risk", faxed Ms. Turkenburg a revised draft of a 1996 advance agreement that added a provision addressing the term of the agreement in the event a related party default on loan obligations.¹⁹ The addition read:

[T]o the extent the Company holds loan receivables from related parties and such related parties default with respect to required payments under such loans (and fail to cure the payment defaults within any applicable cure periods), the term of this Advance Agreement, * * * shall no longer apply.

The effect of this provision was that if Frito-Lay defaulted on its notes to PGI, the 40-year term of the 1996 advance agreements would no longer apply and the 1996 advance agreements would thereafter, for Dutch corporate income tax purposes, be 19The parties' discussion of "debtor's risk" concerned the possible scenario where PGI would suffer a Dutch tax loss on the Frito-Lay notes while remaining obligated to pay the principal amounts on the advance agreements.

treated as equity.²⁰ Following her receipt of the revised 1996 Advanced Agreement, Ms. Turkent urg forwarded a copy to Inspector Munneke the following day.

Inspector Munneke responded to Ms. Turkenburg by facsimile, on July 31, 1996,23 and confirmed, on the totality of the representations made by Ms.

Turkenburg, that PGI I would be allowed to report a taxable spread of 1/8%.22 VII. The Final Advance Agreements The final terms of the 1996 advance agreements and, thereafter, the 1997 advance agreement, inco orated many of the initial provisions submitted by Mr.

Slobbe in the preliminary draft; however, as a result of PepsiCo's correspondence wih Inspector Munneke, arious provisions were tailored to address the Dutch Revenue Service's co cerns.

20Similarly, in a u y 30, 1996, facsimile to Inspector Munneke, Ms.

Turkenburg emphasiz synchronization the qu lification of the funding switches to equity."

this point and reiterated that upon a "violation of * * * 2iThe facsimile was originally sent by.Inspector Munneke on July 23, 1996, and was resent following his receipt of Ms. Turkenburg's July 30, 1996, facsimile.

22On November 24 2000, Ms. Turkenburg, on behalf of PepsiCo, sent a letter to Inspector Munneke requesting a four-year extension of the Dutch tax ruling. Four months later, on March 29, 2001, the Dutch Revenue Service approved a five-year e te sion of the Dutch tax ruling until December 31, 2005, and noted that no additional extensions would be allowed.

The advance agreements provided for payments of principal amounts after initial terms of 40 years." PWI and PGI had unrestricted options (initial options) to renew the advance agreements for a period of 10 years. If the initial options were exercised, the entities could exercise a separate option delaying payment of principal for an additional 5 years. The advance agreements would become perpetual, however, to the extent of any uncured defaults on loan receivables held by PWI or PGI from related parties.

A preferred return accrued on any unpaid principal amounts pursuant to the advance agreements and consisted of two components: "base preferred return" (base pr) and "premium preferred return" (premium pr). Under the terms of the 1996 advance agreements, base pr accrued semiannually at six-month LIBOR (London Interbank Offering Rate) plus 230 basis points, minus an "adjustment "The advance agreements explicitly provided that the instruments would be "governed by and construed in accordance with the laws of the State of Delaware."

rate".24 Premium r on the 1996 advance agreements accrued semiannually at a rate equal to .1/2 of the 6-month LIBOR rate.

24The adjustment r te was the weighted average of 1/8%, 3/32%, and 1/16%. The weightin of each depended upon the extent to .which the principal amount and capitalized b se pr of the advance agreements exceeded 1 billion Dutch guilders and, agai1í, upon the extent to which the principal amount and the capitalized base pr exceeded 3 billion Dutch guilders. The principal amount and the capitalized base pr were converted into Dutch guilders on each date the rate was set.

"The accrual pr vision specifically prescribed that * * * Th P eferred Return shalÍ accrue semi-annually at a rate 2.(a) equal to the su of (i) the applicable LIBOR-based rate (the "Base PR") plus (ii) ea h of the applicable deferral and subordination premiums (in the aggregate, the "Premium PR"). The applicable LIBOR-based r e hall be determined initially on the date hereof and shall be re-set s mt-annually (on each subsequent January 1 and July 1). The applica le LIBOR-based rate shall equal six-month LIBOR as of the relevan re-set date * * * plus 230 basis points minus an adjustment rate * * * . Each of the applicable deferral and subordination premiums shall be determined with reference to six- month LIBOR as defined above. The applicable deferral premium shall equal six-n(cid:16)041oi(cid:0)541thLIBOR multiplied by a factor of 0.05. The applicable subor ir(cid:16)041ationpremium shall equal six-month LIBOR multiplied by a factor of 0.45. not available for the relevant re-set date, * * * [PGI/PWI] and the Holder shall agree upon an appropriate variable interest rate standard to be used to calèulate the Preferred Return.

In the event six-month LIBOR * * * is Conversely, the 1997 advance agreement provided that base pr accrued semiannually at a rate of 7.951% minus an "adjustment rate"2s with premium pr accruing at a rate of approximately 3.98%."

While preferred return unconditionally accrued pursuant to the advance agreements, the instruments required PGI/PWI to the make payments of the accrued preferred return only under certain specified circumstances:

3.(a) Any accrued Preferred Return (including accrued Base PR and accrued Premium PR) shall be payable annually on * * * [specific days of each year] beginning in 1997 and on the date the Principal 26The "adjustment rate" of the 1997 advance agreement was defined similarly to the "adjustment rate" found in the 1996 advance agreements. See supra note 24.

.

, "The provision specifically prescribed that * * * The Preferred return shall accrue semi-annually at a rate 2.(a) equal to the sum of (i) the applicable FIXED rate (the "Base PR") plus (ii) each of the applicable deferral and subordination premiums (in the aggregate, the "Premium PR"). The applicable FIXED rate shall be determined initially on the date set forth herein and then re- computed on November 23, 2000. The applicable FIXED rate shall be equal to 7.951% minus an adjustment rate * * * . Each of the applicable deferral and subordination premiums shall be determined with reference to the FIXED rate as defined above. The applicable deferral premium shall equal the FIXED rate multiplied by a factor of 0.05. The applicable subordination premium shall equal the FIXED rate multiplied by a factor of 0.45. defined above cannot be determined for whatever reason, * * * [PGI] and the Holder shall agree upon an appropriate fixed interest rate standard to be used to calculate the Preferred Return.

In the event the FIXED rate as Amount i paid in full;.provided:however, that the Preferred Return shall be payable only to the extent that the net cash flow of the Company durin the preceding year exceeded the sum of (I) the f all accrued but unpaid operating expenses aggregate amount o pany during such year and (ii) the aggregate incurred by the amount of all capital expenditures made or approved by the Company during such year, including all capital investments (whether in the form of equity con ributions, loans, or other capital investments) made or approved by the Company during such year. For purposes of the preceding s determined wit principles. At t e hame 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 ompany from related parties during such year.

tënce, the net cash flow of the Company shall be reference to generally accepted accounting To the extent any accrued preferred return was not paid when due, as contemplated in Mr. Slobbe's.preliminary draft, that amount would be capitalized into "capitalized base preferred return" (capitalized base pr) and "capitalized premium preferred return ' (capitalized premium pr) amounts, respectively.²⁸ Similar to the payment of preferred return, the separate payment of capitalized base pr was required annùally, but only to the extent that the "aggregate net cash flow" for the period duri g which the amount remained unpaid exceeded the sum of (i) the aggregate amount of all accrued but unpaid operating expenses "incurred'' by the compa during such period and (ii) the aggregate amount of all 28Preferred return accrued on both capitalized base pr and capitalized premium pr amounts.

capital expenditures made or approved by the company, including all capital investments made or approved during the same period. Payment of capitalized premium pr was payable only when the principal amount of its corresponding advance agreement was paid in full, but was subject to the same "aggregate net cash flow" restrictions for the period of nonpayment.

In both circumstances, net cashflow would, in no event, be less than the aggregate amount of all interest payments and payments of capitalized interest received from related parties during the same period.

Notwithstanding the aforementioned provisions, the advance agreements allowed PGI/PWI to pay unpaid principal amount, accrued but unpaid preferred return, any unpaid capitalized base pr amount, and any unpaid capitalized premium pr amount, in full or in part at any time. The obligation to pay any such amounts was also subordinate to "all the indebtedness of * * * [PWI/PGI], without limitation." Similarly, the rights of all creditors of PGI/PWI to receive payments from PGI/PWI were "superior and prior to" the rights of the holders of the advance agreements to receive any required payments.

Subject to the conditions and the subordination provision noted supra, the holders of the advance agreements could declare as immediately due any unpaid principal amount, accrued but unpaid preferred return, unpaid capitalized base pr return, and unpLid capitalized premium pr, upon the occurrence of any of - 30 -- the following:

6. * * * (a) dissolution or termination of the legal existence of * * * [PWI/PGI] (except in the case of a merger or similar successor-in- interest transaction); (b) insolvency of * * * [PWI/PGI] (other than technical insolv n y); or (c) receivership or appointment of a liquidator or adrhinistrator for * * * [PWI/PGI] or over all or a substantial portion of its assets under any law relating to bankruptcy, insolvency, or r or anization.

VIII. ABN-AMRO C dit Facility

During the years at issue, PGI maintained a credit facility with ABN-AMRO Bank, N.V. (ABN-AMRO). The amount of available credit under the credit facility varied over time om a low of $20 million to a high of $90 million. The credit facility was, at all times, secured by a subsidiary guaranty issued by PepsiCo to ABN-AMRO. PGI drew as much as $60 million from the credit facility from 1997 through 1999; however, as a general matter, PGI preferred to borrow cash from PepsiCo affiliates rather than from third-party lending institutions because of the higher costs of external borrowing.

IX. PGI's Related Party

Indebtedness and Capital Investments During the year a issue, PGI had outstanding indebtedness to related parties that ranged from approximately $437 million to more than $937 million.

In the same period PGI made advances in the form of loans and equity investments in affiliates of approximately $1.415 billion.

Concerning PGI's varied equity holdings, three such investments bear noting: (1) Pepsi-Cola France, a French société en nom collectif (SNC) engaged in the distribution and sale of all Pepsi beverages in France; (2) Spizza 30, SNC, which owned and operated Pizza Hut restaurants in France; and (3) PepsiCo Restaurants International (PRI), a Spanish Sociedad Comanditaria por Acciones (SCA), which owned and operated Pizza Hut restaurants in Spain.²⁹ The three operating entities had aggregate liabilities of more than $180 million and $157 million in 1996 and 1997, respectively.

X. 2001 LIBOR Concern As noted supra, each of the PepsiCo Frito-Lay:notes (exchanged by KFCIH for the 1996 advance agreements) provided that interest on unpaid principal would accrue semiannually at a rate equal to the greater of (i) six-month LIBOR plus 230 basis points or (ii) 7.5% per annum.

In contrast, the 1996 advance agreements provided that the base pr would accrue semiannually on the same dates at six-month LIBOR plus 230 basis points minus an adjustment rate. During 29After the public spinoff of PepsiCo's global restaurant business on October 2, 1997, PGI no longer held direct or indirect interests in, among other entities, Spizza 30, Snc, and PepsiCo Restaurants International Sca.

2001, the six-month LIBOR rate fell dramatically to 3.9% on July 2, 2001.

Therefore, the interest ra e on the Frito-Lay notes should have been 7.5%, while accrual of base pr on the 1996 advance agreements should have been 6.2% (3.9% plus 230 basis points) minus an adjustment, creating a significant imbalance between the payment f i terest on the Frito-Lay notes.and the accrual of base pr on the 1996 advance agreements. However, in calculating base pr due under the 196 advance agreements or the second;half of 2001, PGI's corporate accountant, Willem Kuzee, used a 5. 9% rate, instead of 3.9% as required by the instruments.

PepsiCo corrected this interest rate problem by thereafter amending the PepsiCo Frito-Lay notes on March 1, 2002. The amendments changed the interest rates on the notes to six-nhonth LIBOR plus 230 basis points to be consistent with the base pr rate provided in the 1996 advance agreements.

XI. 2007 Luxembourg Advance Agreements .

On August 13, 2 0 , BFSI and PPR contributed the advance agreements to a newly organized Lux nibourg S.a.r.l. (PGI S.a.r.l.), in exchange for new advance agreements with simil terms (Luxembourg advance agreements).3° As part of the transaction, PGI filed an IRS Form 8832, Entity.Classification Election, electing to 3°The transaction was intended to be treated as a reorganization under sec.

368(a)(1)(F).

be treated as a "disregarded entity" for U.S. Federal income tax purposes. As a result, BFSI and PPR thereafter treated the Luxembourg advance agreements as continuations of the advance agreements for U.S. Federal income tax purposes.

XII. Payments of Preferred

Return on the Advance Agreements The timing and amounts of all payments of principal and preferred returns paid by PGI on the 1996 advance agreements before 2010 are set forth in the following table:"

Payment date Principal Base PR Premium PR (net of Dutch withholding tax) Total payment Sept. 17, 1997 Mar. 26, 1998 Jan.²¹,1999 Feb.³,2000 Feb.¹⁹,2001 Feb. 5, 20021 Jan. 30, 2003 Jan. 23, 2004 May 11, 2005 June²⁰,2006 Dec. 28, 2006 $39,072,000.00 $39,072,000.00 151,071,461.99 $1,336,931.20 152,408,393.19 152,385,058.00 997,030.00 153,382,088.00 144,427,861.00 991,552.00 145,419,413.00 167,280,781.38 984,958.46 168,265,739.84 154,676,738.83 946,508.00 155,623,246.83 79,721,156.30 953,112.27 80,674,268.57 68,071,108.51 1,015,123.39 69,086,231.90 74,040,445.38 1,129,446.95 75,169,892.33 105,437,379.00 1,154,256.65 106,591,635.65 139,556,631.66 1,129,872.77 140,686,504.43 All such payments were made in cash with the exception of the payment made on September 17, 1997, which was made in kind with shares of a PGI subsidiary as part of the spinoff of PepsiCo's global restaurant business.

.

July 14, .

2008 Jan. 23, 2009 Dec. 31, 2009 .

150,631,714.23 1,073,518.06 " 151,705,232.29 117,070,104.32 270,639.77 117,340,744.09 70,282,049.84 . 425,278.75 70,707,328.59 'Unpaid preferred e million as of the end of the attributable to premium pr The remaining $79,721,156.30 of accrued base pr was paid on January 30, 2003.

rn on the 1996 advance agreements was approximately $386 psiCo years at issue, approximately $306 million of which was The timing and ámount of all payments of principal and preferred return paid by PGI on the 1997 advance agreement before 2010 are set forth in the following table:

Payment date Principal Base PRI Nov. 6, 1997 Oct. 19, 1998 $214,08 144.00 Premium PR (net of Dutch withholding t_a_x_f Total payment $42,926,795.08 323,652,537.00 Oct. 19, 1999 Nov. 16, 2000 Oct. 19, 2001 Oct. 21, 20023 Oct. 23, 2003 May 11, 2005 Oct. 28, 2005 Dec. 29, 2005 Dec. 28, 2006 -0 -0 -0 -0 -0 -0 -0 $90,665,018.85 $402,015.78 91,067,034.63 90,567,601.67 91,838,594.93 91,838,594.93 91,838, 94.93 91,838,594.93 91,838,594.93 21,315,517.00 73,470,875.95 -0- .

90,567,601.67 1,640,497.10 93,479,092.03 730,690.71 92,569,285.64 736,311.40 92,574,906.34 770,035.59 92,608,630.52 89,180.29 91,927,775.22 21,315,517.00 353,219.25 73,824,095.20 "All such paym nt were made in cash.

July 14, 2008 Jan. 23, 2009 Oct. 19, 2009 97,059,506.36 509,719.94 97,569,226.30 94,695,035.97 270,107.80 94,965,143.77 92,202,410.11 267,091.84 92,469,501.95 iThe parties did not specify the amount of base pr paid by PGI on November 6, 1997, or October 19, 1998, nor could we determine those amounts from the record.

3Unpaid preferred return on the 1997 advance agreement issued to PPR was approximately $287 million as of the end of the PPR years at issue, approximately $266 million of which was attributable to premium pr. The remaining accrued base pr was paid on October 23, 2003.

XIII. Payments on the Frito-Lay Notes

The timing and amounts of interest payments received by PGI on the PepsiCo Frito-Lay notes before 2010 are set forth in the following table:"

Payment date Frito-Lay notes PepsiCo notes Metro Bottling notes Total payments Sept. 17, 1997 $39,072,364.00 $39,072,364.00 Mar. 26, 1998 131,786,523.59 $13,568,655.59 $8,136,067.81 153,491,246.99 Jan. 21, 1999 136,808,012.00 10,866,082.00 6,515,544.00 154,189,638.00 Feb. 3, 2000 129,741,117.00 10,303,313.00 6,178,096.00 146,222,526.00 Feb. 19, 2001 150,007,590.65 11,912,763.30 7,143,157.43 169,063,511.38 Feb. 5, 2002 138,762,364.06 11,019,796.63 6,607,714.78 156,389,875.47 Jan. 30, 2003 72,266,067.86 5,738,966.66 3,441,211.86 81,446,246.38 Jan. 23, 2004 62,010,962.88 4,928,318.44 2,955,129.18 69,894,410.50 May 11, 2005 67,391,279.14 5,351,921.66 3,209,131.08 75,952,331.88 June 20, 2006 95,314,551.77 7,567,558.44 4,537,676.10 107,419,786.31 "All such payments were made in cash.

Dec. 28, 2006 125, 01 899.77 9,966,658.48 5,976,229.76 141,444,788.02 July 14, 2008 134,944 482.97 10,716,535.60 6,425,872.72 152,086,891.29 Jan. 23, 2009 104, 06 633.02 . 8,291,390.46 4,971,701.85 117,669,725.33 Dec. 31, 2009 62, 88 657.08 4,994,265.16 2,994,672.35 70,887,594.59 The timing and amount of all payments of príncipal and interest received by PGI on the initial PPR Frito Lay notes and the additional PPR Frito-Lay notes before 2010 are set forth in th f Ilowing table:34 Payment ate Nov. 6, 1 97 Oct. 19, 1 9 Oct. 19, 1 9 Nov. 16, 0Q⁰ Oct. 19, 2 01 Oct. 21, 2 02 Oct. 23, 2003 May 11, 200 Oct. 28, 2005 Dec. 29, 2 05 Dec. 28, 2 06 July 14, 2008 Total payment $42,926,795.08 323,652,537.04 91,392,649.22 90,567,601.67 94,807,820.45 93,161,112.05 93,161,112.05 93,161,112.05 91,991,759.88 18,768,921.26 74,061,148.76 97,748,730.30 34All such payments were made in cash.

.

Jan. 23, 2009 Oct. 19, 2009 95,078,841.77 92,576,435.95 IThis includes repayment of a note with a principal amount of $214,084,114 that matured on December 9, 1997.

XIV. Summary of the Payments PGI paid out nearly all of the amounts received under the Frito-Lay notes from 1997 through 2009. With respect to the 1996 advance agreements, PGI received $1,635,230,935 in interest payments from the PepsiCo Frito-Lay notes during those years and paid out base pr and premium pr³⁵ totaling $1,626,114,719.

Each preferred return payment was remitted on the same date that interest due on the PepsiCo Frito-Lay notes was remitted to PGI.

With respect to the 1997 advance agreement, PGI received $1,395,603,173 in interest payments from the initial PPR Frito-Lay notes and the additional PPR Frito Lay notes from 1997 through 2009 and paid out base pr and premium pr³⁶ totaling $1,391,517,142. Each preferred return payment was made on the same day that interest due on the initial PPR Frito-Lay notes and the additional PPR Frito Lay notes was paid to PGI.

35The amount of premium pr was reduced by 15% to take into account Dutch withholding tax.

36See s_u_p_ a note 35.

XV. U.S. Taxes

Following the Global Restructuring Petitioners treated the payments of preferred return on all the advance agreements as distribut ns on equity on its U.S. Federal income tax retµrns. All interest due on the Frit -Lay notes was claimed as a deduction by Frito-Lay, PepsiCo, and Metro Bo tling under section 163. Payments of interest on the Frito- Lay notes to PGI/PWI we e also exempt from U.S. withholding tax pursuant to the Dutch tax treaty.

During the years at issue, interest on the Frito-Lay notes was included as subpart F income on PepsiCo's consolidated U.S. Federal income tax returns to the extent of PGI's earnings and profits in the following amounts:

Year enced Dec. 26, 1998 Dec. 25, 1999 Dec. 30, 2000 Dec. 29, 001 Dec. 28, 2002 Subpart F inclusion $6,879,805 86,036,586 .

103,136,493 PPR did not report any subpart F income during the years at issue.

In subsequent taxable years, petitioners' aggregate subpart F inclusions with respect to interest incorr e on the Frito-Lay notes were as follows:

Year ended Subpart F inclusion Dec. 27, 2003 Dec. 25, 2004 Dec. 31, 2005 Dec. 30, 2006 Dec. 29, 2007 Dec. 27, 2008 Dec. 26, 2009 $23,072,249 38,865,815 109,004,397 202,082,564 197,987,655 207,605,843 165,959,993 XVI. Expert Reports At trial, petitioners submitted expert reports prepared by Paul Sleurink, a Dutch tax law specialist, and Christopher James, an American professor of finance.

Respondent submitted a rebuttal expert report prepared by a Dutch tax lawyer, Jean-Paul R. van Den Berg, which scrutinized certain aspects of Mr. Sleurink's report.

A. Petitioners'Experts 1. Paul Sleurink Mr. Sleurink was engaged as an expert witness to testify to the debt characterization of the advance agreements for Dutch corporate income tax purposes, as well as the basis for claiming a deduction for the base pr whether paid and/or accrued and the basis for treating payments of the premium pr as dividends when paid. As a su plementary inquiry, Mr. Sleurink was asked to construe the terms of the Dutch tax ruling negotiated by Inspector Munneke and Ms.

Turkenburg.

Mr. Sleurink prefacéd his analysis by noting that noncontingent amounts payable on an instrument that is debt for Dutch corporate income tax purposes are deductible on an accrual basis unless payments of such amounts are "highly uncertain". Similarly, contingent payments are deductible on an accrual basis unless the likelihood of pa ment is "remote".38 Contrary to accrual for U.S.

Federal income tax law, in determining whether an item has accrued for Dutch tax purposes it is not relevant hether all events have occurred to fix the liability and the amount of the paympn . See sec. 1.451-1(a), Income Tax Regs.

Concerning the ro er tax characterization of financial instruments, Mr.

Sleurink submitted that, subject to three narrowly drawn exceptions (the only relevant exception at present is the "participating loan exception"), such instruments are treated as ebt for Dutch corporate income tax purposes if they are considered debt for Dutch ivil law purposes. The decisive consideration under 37As discussed su r , Mr. Sleurink also summarized the Dutch tax ruling process in the 1980s an 1990s.

38Mr. Sleurink di ot explain when payments were "highly uncertain" and when they were "remote".

Dutch civil law for debt characterization is whether a borrower has an obligation to repay advances at the end of a stated term, or upon its bankruptcy or liquidation.

As clarified by the Dutch Supreme Court in a 1998 case,39 the "participating loan exception" is invoked, and an advance recharacterized as equity, when three conditions are met: (1) the interest is profit dependent; (2) the loan is subordinated to the interests of all senior creditors; and (3) the loan has no fixed repayment date and needs to be repaid only in the event of a bankruptcy, liquidation, or moratorium.

After establishing this Dutch tax law background, Mr. Sleurink endeavored to determine whether, according to such principles, the advance agreements would be treated as debt or as equity for Dutch tax purposes. Mr. Sleurink noted that the advance agreements obligated PGI/PWI to repay principal after a maximum of 55 years (without accounting for the subsequent condition that could render the 39While the Dutch Supreme Court case was decided after the advance agreements were issued, Mr. Sleurink asserted that "various acknowledged legal scholars interpreting prior Supreme Court decisions confirmed and anticipated the Supreme Court's 1998 view. * * * [I]n practice, both the Dutch Revenue Service and the Courts give considerable weight to views of acknowledged legal scholars." Furthermore, the decision of the Court of Appeals of Amsterdam which precipitated the Dutch Supreme Court's decision was publicly available in printed form before the 1996 advance agreements were issued. The Court of Appeals' decision, as with the later Supreme Court case, discussed the three key requirements noted supra.

instruments perpetual), or upon their bankruptcy or liquidation. This, Mr.

Sleurink reasoned, qualifi d the advance agreements as debt for Dutch civil law purposes. Nonetheless Mr. Sleurink recognized that the possibility of a perpetual term for the advance a re ments, as well as the "net cash flow" conditions, left the instruments susceptibl to equity characterization under the "participating loan exception". While adn itting that he was ùnable to render a definitive conclusion regarding the classifica ioh of the advance agreements for Dutch tax purposes, Mr.

Sleurink opined that thë instruments would not be reclassified as equity. Key to his conclusion were that: (1) at issuance, notwithstanding conditions which would provide otherwise, the instruments did not have a perpetual term;4° and (2) preferred return was based on a floating LIBÖR rate or a fixed rate and could be deferred in the event of insufficient PGI/PWI net cashflows (as opposed to profit).41 4°Mr. Sleurink noted that some Dutch caselaw during the mid-1990s might have suggested that an in trument's 50-year term was so extended that it evinced equity-like characteris ic ; however, he qualified that statement by asserting that it "was not the prevailing view of the courts at that time".

41Mr. Sleurink distilnguished profit from cashflow as follows:

An impor a observation * * * is that case law as well as * * * [the Dutch Co o ate Income Tax Act] clearly looked (and still do) at what is referred to as "profit destination" (winstbestemming), i.e. the bottom lin profit available for use, once determined, for distribution or o remam within the company as an addition to profit (continued...)

Mr. Sleurink was also influenced by the fact that preferred return payable was "further removed from profit" of the borrower by the advance agreement provision dictating that net cashflow would never be less than "interest or capitised [sic] amounts received from related parties during such year, reduced by capital expenditures made or approved."

Regarding the Dutch tax ruling, Mr. Sleurink analyzed the entirety of Ms.

Turkenburg's correspondence with Inspector Munneke and determined that the terms of the ruling dictated that (i) the principal lent to PGI/PWI under the Advance Agreements constituted debt for Dutch corporate income tax purposes and the interest expense (Base Preferred Return) paid or accrued would be deductible if and to the extent PGI/PWI would realise [sic] at least the minimal taxable spread as referred to in (iii) below:

(ii) the Premium PR and Capitalised [sic] Premium PR amount should be considered a dividend. The dividend would not be recognized until the actual date of payment of the Premium PR; (...continued) given that the instrument would be reclassified as equity and payments thereon as distributions of profits, i.e. dividends paid to shareholders. By contrast, linking a payment of interest to sufficiently high cash-flows with the borrower, or for example value shifts of certain assets owned by the borrower, would fall in the category of "profit determination" (winstbepaling), i.e. amounts taken into account ("above the line") in calculating bottom line profits.

(iii) a taxable spre d of 1/8% (of the total amount of funds borrowed) reported by PGI and PWI will be considered "at arms length" as (I) the financial position of PGI and PWI will not deteriorate if the eceivables on Frito-Lay, Inc. prove irrecoverable (because the Ad equity) and (ii) P I and PWI will not report a tax loss in the case of losses on the ree ivables.

ce Agreements become perpetual and are treated as 2. Christopher J es Christopher James was hired by petitioners for the sole purpose of determining whether "a b nk or other lender would have issued a loan to PGI in similar amounts and unde any reasonably similar terms to those of the Advance Agreements." In formula ing his opinion, Mr. James performed a systematic analysis of PGI's ability to repay the advance agreements. His methodology was consistent with the approach taken by commercial lenders in deciding whether to engage in similar investm nts and focused on factors such as use of the loan proceeds, loan amount, source and timing of repayment, and collateral.

After examining PGI's financial records⁴² and considering the terms of the advance agreements, he concluded:

It is unlikely that a bank or other lender would be willing to lend the amounts associated with the Advance Agreements without sufficient safeguards in place to protect its right to repayment, such as a reasonably short term to maturity, senior status vis-a-vis other creditors and/or collateral, loan covenants and acceleration rights upon certain defaults or other credit events. absence of these safeguards from the terms of the Advance Agreements would lead a bank to decline to issue a loan in the amount of the Advance Agreements to any company. Moreover, PGI presented additional risk because it was a holding company for a number of PepsiCo's ventures.in emerging markets. PepsiCo expected that it would be necessary to make substantial capital investments and expenditures in these markets for years to come.

In my opinion, the Mr. James also used specialized databases, containing loan data collected from commercial lenders, in an attempt to find debt instruments that were both issued contemporaneously with and shared similar characteristics with the advance 42In the course of his analysis, Mr. James determined that PGI made total aggregate equity investments in and loans to affiliates of approximately $1.4 billion during the years at issue ($864,572,499 in equity investments; $550,665,460 in loans). PGI also had outstanding indebtedness to affiliates in amounts as high as $980 million during the same period.

In evaluating the capitalization of PGI, Mr. James noted that if the 1996 advance agreements were classified as debt, PGI's debt-to-equity ratio in 1996 would have been 14.1. If the 1997 advance agreement was further classified as debt, PGI's debt-to-equity ratio would have been 26.2 to 1 in 1997.

agreements. Mr. J es reported that his review of over 400,000 commercial loans and "corporate deb issuances" in such databases did not reveal any debt instruments that would b "reasonably similar" to the advance agreements.

B. Respondent's Expert Jean-Paul R. van Den Berg Mr. van Den Berg enerally faults Mr. Sleurink's report for focusing on the terms of the advance agre ments in a "standalone" manner without considering their connection with the Frito-Lay notes. He also submitted that Mr. Sleurink's interpretation of certai correspondence between Inspector Munneke and Ms.

Turkenburg is flawed ecause.of Mr. Sleurink's mistranslation of several Dutch words in the document .4 In particular, in the June 11, 1996, letter from Inspector Munneke to Ms. Turke b rg, Mr. van Den Berg scrutinized Mr. Sleurink's reliance on the following passage in which Mr. Sleurink added the phrase "over time", which was not i el ded in the unofficial translations provided by Loyens:

"Together we have concluded that,.over time, the interest payable should at least be equal to the interest eceivable on the loans receivable from Frito-Lay."

(Emphasis added.) Mr. van Den Berg proffers that without the erroneous addition 43Mr. Sleurink egamined the origihal versions of letters and facsimiles between petitioners and the Dutch Revenue Service, which were written in Dutch; however, both petition rs nd respondent during the course of litigation generally relied upon the unoffici!al translations provided by Loyens.

.

of the phrase "over time", it becomes clear, especially when viewed in conjunction with the entire document and in the light of subsequent correspondence, that [E]ach time an actual payment of interest is received on the loan to Frito-Lay, a corresponding payment would need to be made on the Advance Agreements and each time an actual payment of accrued interest is made by Frito-Lay * * * a corresponding actual payment of Capitalized Base PR Amount needs to be made.

OPINION

The principal issue in these cases concerns the appropriate characterization of the advance agreements for Federal income tax purposes. Respondent generally asserts that the substance of the transactions, revealed primarily through petitioners' dialogue with the Dutch Revenue Service during negotiations to .

secure a Dutch tax ruling, evidence petitioners' clear intentions in structuring the advance agreements and, concomitantly, underscore that the instruments manifest a creditor-debtor arrangement. Petitioners dispute that characterization, insisting that the form of the advance agreements comports with their substance and that when correspondence between petitioners and the Dutch Revenue Service is considered in the light of relevant testimony adduced at trial, it leads to the unequivocal conclusion that the advance agreements are legitimate equity L instruments for Ée eral income tax purposes. We find petitioners' argument to be more persuasive.

I. Burden of Proof

The taxpayer bears the burden of proving by a preponderance of the evidence that the Commissioner's determinations are incorrect. Rule 142(a); Welch v. Helvering, 2 0 .S. 111, 115 (1933).

In general, the burden of proof with regard to factual a ers rests with the taxpayer. Under section 7491(a), if the taxpayer produces credible evidence with respect to any factual issue relevant to ascertaining the tax ay r's liability for tax and meets other requirements, the burden of proof shifts from the taxpayer to the Commissioner as to that factual issue. As we decide thes cases on the preponderance of the evidence, we need not decide upon which y the burden rests.

.

II. Substance Over Form

Respondent asks th s Court to disregard the objective form of the advance agreements and exami e t e substance of the transactions in discerning their proper characterization for Federal income tax purposes. It is axiomatic that the substance of a transaction governs for tax purposes. See Commissioner v. Court Holding Co.,.324 U.S. 33 , 334 (1945) ("The incidence of taxation depends upon the substance of a transact on."); Gregory v. Helvering, 293 U.S. 465 (1935); Hardman v. United States, 827 F.2d 1409, 1411 (9th Cir. 1987) ("Substance, not form, controls the characterization of a taxable transaction.

Courts will not tolerate the use of mere formalisms solely to alter tax liabilities."

(Citations omitted.)); Calumet Indus., Inc. v. Commissioner, 95 T.C. 257, 288 (1990) ("the substance of the transaction is controlling, not the form in which it is cast or described."). This principle is equally applicable in debt-versus-equity inquiries. See Gilbert v. Commissioner, 262 F.2d 512, 514 (2d Cir. 1957) ("[T]he determination [of] whether the funds advanced are to be regarded as a 'capital contribution' or 'loan' must be made in the light of all the facts of the particular case.").

While cognizant that the substance-over-form doctrine permeates tax law jurisprudence, we believe it prudent to emphasize that the form of a transaction often informs its substance. See e.g., Hewlett Packard Co. v. Commissioner, T.C.

Memo. 2012-135 (dismissing the labels afforded to transactional instruments, but examining their terms to discern the true substance of the economic arrangement).

An analysis focused myopically on the "substance" of a transaction, but devoid of any consideration of the obligations engendered by the terms of the governing instruments, would typically result in deficient, or wholly flawed, determinations 44 An admonition rendered by the Court of Appeals for the Fifth Circuit appears particularly prescient in this regard:

guard against oversimplification, for a glib at substance rather than form is determinative of tax We must generalization consequences not nly would be of little assistance in deciding - troublesome tax cases, but also would be incorrect. The fact--at least the tax world fa --is that in numerous situations the form by which a transaction is effected does influence and may indeed decisively control the tax conÊequences. This generalization does, however, reflect the fact tl at icourts will, and do, look beyond the superficial formalities of a t arËsaction to determine the proper tax treatment. [Blueberry Land Co. v. Commissioner, 361 F.2d 93, 101 (5th Cir. 1966), afg 42 T.C. .1137 (1964); fn. ref. omitted.]

Mindful that we mûst be circumspect in avoiding an unjustified extension of the substance-over-form doctrine, we note that respondent's argument is, in substantial part, predic te upon the substantive integration of PepsiCo and its affiliates because they ar all related parties under the common control. of PepsiCo.⁴⁵ Respondent asserts that removing the ostensible constructs separating 44Perhaps in no ther context is the form of a transaction more significant than in international fina cial arrangements where two separate tax regimes both endeavor to apply their respective tax laws to transactions considering, primarily, the objective terms of the governing instruments.

45For instance, in his posttrial brief respondent in part submits:

The 1996/97 Advance Agreements and corresponding Frito- Lay notes are merely intercompany loans between commonly controlled related eritities. PepsiCo can terminate these interrelated (continued...)

the legally distinct entities and disregarding many of the "intentionally vague" terms of the advance agreements illuminates the debt-like nature of the instruments.

Indeed, courts have recognized that transactional forms between related parties are susceptible of manipulation and, accordingly, warrant a more thorough and discerning examination for tax characterization purposes. See United States v. Uneco, Inc. (In re Uneco, Inc.), 532 F.2d 1204, 1207 (8th Cir.

1976) ("Advances between a parent corporation and a subsidiary or other affiliate are subject to particular scrutiny 'because the control element suggests the opportunity to contrive a fictional * * * [arrangement].'" (quoting Cuyuna Realty Co. v. United States, 382 F.2d 298 (Ct. Cl. 1967))); see also Kraft Foods Co. v.

Commissioner, 232 F.2d 118, 123-124 (2d Cir. 1956), rev'g 21 T.C. 513 (1954).

45(...continued) obligations anytime it considers it beneficial to do so. * * * * * * * * * * 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.

However, notwi hstanding the greater scrutiny afforded to related-party transactions, we believ that disregarding petitioners' international corporate structure based solely on he entities' interrelatedness is, without more, unjustified.

See, e.g., C.M. Gooch Lumber Sales Co. v. Commissioner, 49 T.C. 649, 656 (1968) ("[W]e recognize at, although the affiliation which existed between petitioner and * * * [re at d entities] is not an insuperable barrier to petitioner's position, it does 'invite close scrutiny.'") (citing Kraft Foods Co. v.

Commissioner, 232 F.2d t 123), remanded pursuant to stipulation of the parties, 406 F.2d 290 (6th Cir. 19 9); see also Malone & Hyde, Inc. v. Commissioner, 49 .

T.C. 575, 578 (1968) (ree gnizing a "close scrutiny" standard, but finding it "unwarranted to apply eg listic and mechanical tests, in the area of parent- subsidiary relationship , without regard to the realities of the business world and the manner in which transactions are handled in the normal and ordinary course of doing business"). If we were to find otherwise, we would risk minimizing, or perhaps eviscerating, t e legal distinctions between corporate branches and subsidiaries.

In accord with this reasoning, the Court of Appeals for the Second Circuit, the court to whicl appeal in these cases would lie, has indicated that there is a marked difference between a more critical examination of transactions between related parties an the substantive integration of related entities [I]t is one thing to say that transactions between affiliates should be carefully scrutinized and sham transactions disregarded, and quite a different thing to say that a genuine transaction affecting legal relations should be disregarded for tax purposes merely because it is a transaction between affiliated corporations. We think that to strike down a genuine transaction because of the parent-subsidiary relation would violate the scheme of the statute and depart from the rules of law heretofore governing intercompany transactions.

* * * [A]Il legitimate and genuine corporation-stockholder arrangements have legal--and hence economic--significance, and must be respected in so far as the rights of third parties, including the tax collector, are concerned.

[Kraft Foods Co. v. Commissioner, 232 F.2d at 124; fn. ref.

omitted.]

In sum, we approach our consideration of the characterization of the advance agreements acknowledging that the various PepsiCo entities' relatedness may factor into our inquiry, but without a preconception that such relatedness alone allows us to blur the legally significant lines separating such entities.

III. Debt-Versus-Equity Factors A "singular defined set of standards" capable of being uniformly applied in debt-versus-equity inquiries remains elusive. See Segel v. Commissioner, 89 T.C.

816, 826-828 (1987).46 In differentiating between loans and capital investments, 46Sec. 385(b) sets forth five factors that may be included in any regulations prescribed by the Secretary to determine the character, for Federal income tax purposes, of an investment in a corporation. Those factors are:

(continued...)

"It is not always any to tell which are which, for securities can take many forms, and it is hazardou to try to find moulds into which all arrangements can certainly be poured." je el Tea Co., Inc. v. United States, 90 F.2d 451, 453 (2d Cir. 1937).

.

Notwithstanding th difficulty in distinguishing between debt instruments and equity instruments t e focus of a debt-versus-equity inquiry generally narrows to whether there was an intent to create a debt with a reasonable expectation of repayment and, if so, whether that intent comports with the economic reality of creating a debtor-creditor relationship. Fin Hay Realty Co. v.

United States, 398 F.2d 694, 697 (3d Cir. 1968); Litton Bus. Sys., Inc. v.

Commissioner, 61 T.C. 367, 377 (1973). The-key to this determination is 46(...cOnlinued) (1) whether here is a written unconditional promise to pay on demand or on a spe ified 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 inte est, (2) wheth r 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 convertibility into the stock of the corporation, and (5) the relationship between holdings of stock in the corporation and 1 01 ings of the interest in question.

primarily the taxpayer's actual intent, evinced by the particular circumstances of the transfer. A. R. Lantz Co. v. United States, 424 F.2d 1330, 1333 (9th Cir. 1970); see also United States v. Uneco, Inc. (In re Uneco, Inc.), 532 F.2d at 1209 (in resolving debt-equity questions, both objective and subjective evidence of a taxpayer's intent are considered and given weight in the light of the particular circumstances of a case).47 Various Courts of Appeals have identified and considered certain factors in resolving debt-versus-equity inquiries.⁴⁸ See, e.g., United States v. Uneco, Inc. (In re Uneco, Inc.), 532 F.2d at 1208 (10 factors); Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972) (13 factors); Fin Hay Realty Co. v. United States, 398 F.2d at 697 (16 factors).49 This Court has articulated a list of 13 47This is a factual issue, to be decided upon all the facts and circumstances in each case. See Estate of Chism v. Commissioner, 322 F.2d 956, 960 (9th Cir. 1963), af['g T.C. Memo. 1962-6.

48In a typical debt-versus-equity case, the Commissioner argues for equity characterization whereas the taxpayers endeavor to secure debt characterization. In the present circumstances the roles are reversed. "This different twist to the usual fact pattern, however, does not require us to apply different legal principles." Segel v. Commissioner, 89 T.C. 816, 826 (1987) (citing Ragland Inv. Co. v. Commissioner, 52 T.C. 867, 875 (1969)). See aenerally Hewlett Packard Co. v. Commissioner, T.C. Memo. 2012-135.

49The Court of Appeals for the Second Circuit, the court to which appeal in these cases would lie, has not explicitly adopted a specific factor test; however, the (continued...)

factors germane to uch an analysis: (1) names or labels given to the instruments; (2) presence or absence of a fixed maturity date; (3) source of payments; (4) right to enf rce payments; (5) participation in management as a result of the advances; (6 status of the advances,in relation to regular corporate creditors; (7) intent of the parties; (8) identity of interest between creditor and stockholder; (9)"thinnes " of capital structure in relation to debt; (10) ability of the corporation to obtain credit from outside sources; (11) use to which advances were put; (12) failure of debtor to repay; and (13) risk involved in making advances. Dixie Dairies Corp. v. Commissioner, 74 T.C. 476, 493 (1980).5° "The various factors which have been identified * * * are only aids in answering the ultimate question whether the investment, analyzed in terms of its economic reality, constitutes risk capital entirely subject to the fortunes of the corporate venture or represents a strict debtor-creditor relationship." Fin Hay Realty Co. v. United States, 398 F.2d at 697.

49(...continued) court has implied that a thorough inquiry would include factors designated by IRS Notice 94-47, 1994-1 C.B. 357 (eight factors), supplemented with additional, pertinent factors generally considered by other courts. See TIFD III-E, Inc. v. United States, 459 F.3d 220, 239-240 (2d Cir. 2006).

soThe factors ideriti ed in Notice 94-47, supra, are subsumed within the - more discerning inqui espoused in Dixie Dairies Corp.

We address each of the factors, as applied to the advance agreements, in turn.

.

1. The Names or Labels Given to the Instruments The issuance of a stock certificate indicates an equity contribution, whereas the issuance of a bond, debenture, or note indicates a bona fide indebtedness.

Hardman v. United States, 827 F.2d at 1412.51 The advance agreements, at least superficially, evince neither a debt nor an equity instrument. Accordingly, we find that this factor is neutral.

2. Presence or Absence of a Fixed Maturity Date⁵² "The presence of a fixed maturity date indicates a fixed obligation to repay, a characteristic of a debt obligation. The absence of the same on the other hand would indicate that repayment was in some way tied to the fortunes of the business, indicative of an equity advance." Estate of Mixon, 464 F.2d at 404; see Anchor Nat'l Life Ins. Co. v. Commissioner, 93 T.C. 382, 405 (1989). "[I]n the 51The form and the labels used for the transaction may signify little when the parties to the transaction are related. Calumet Indus., Inc. v. Commissioner, 95 T.C. 257, 286 (1990); see also Fin Hay Realty Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1968).

52Preferred stock may be structured to have a maturity date. See Miele v. Commissioner, 56 T.C. 556, 566 (1971), aff'd without published opinion, 474 F.2d 1338 (3d Cir. 1973).

absence of * * * [a arovision that the holder may unconditionally demand his advance at a fixed me] the security cannot be a debt." Jewel Tea Co. Inc. v.

United States, 90 F.2d at 53; see also Monon R.R. v. Commissioner, 55 T.C. 345, 359 (1970) ("[A] definite maturity date on which the principal falls due for payment, without reser ion or condition, * * * is a fundamental characteristic of a debt.").

The advance agreements have terms of 40 years which can be unilaterally extended by their hold rs an additional 15 years; however, to the extent a related party defaults on any 1 an receivables held by PGI/PWI, such terms are voided, rendering the instrume ts perpetual. Petitioners aver that the extended "maturity dates" of the advance agr ements, when viewed in isolation, effectively subject the holders' investments t the busmess risks of PWI/PGI. The uncertainty of PWI/PGI's financial condition at such future "maturity dates", petitioners reason, makes speculative any e ayment of principal, thereby exhibiting the capital nature of the investme . Alternatively, petitioners submit that the real possibility of default by a related pa y on a loan receivable held by PGI/PWI, which would eliminate any set term f the investment, ensures that the advance agreements lack an unconditional, fixed epayment date, serving to further divorce the qualities of the advance agreements fr m those of a typical debt instrument.

Respondent counters that the "maturity dates" of the advance agreements remain fixed and not so far removed from the issuance of the instruments as to restrict this Court from finding that such terms are consistent with those of a general credit-debtor arrangement. Respondent relies primarily on Monon R.R. v.

Commissioner, 55 T.C. 345, to demonstrate that this Court has accepted as debt certain instruments with terms of similar duration as those provided in the advance agreements. Furthermore, respondent dismisses as unrealistic the possibility that the terms of the advance agreements would become perpetual presuming that petitioners, through their control of all involved entities, would "never cause Frito- Lay, Metro Bottling, or PepsiCo, Inc. to default on their notes".

Instead, respondent submits that the "perpetual clause" was added to the advance agreements solely to "placate" the Dutch Revenue Service's concern that a Frito- Lay default would result in a Dutch tax loss. Accordingly, it remains respondent's position that the "perpetual clause is meaningless".

In Monon R.R. v. Commissioner, 55 T.C. at 349-350, the taxpayer issued unsecured, 50-year, 6% income debentures to shareholders in exchange for shares of a certain class of stock.

Interest on the debentures, while accruing annually, was mandatorily payable only to the extent of "available net income".

Id. at 352.

Nonetheless, the taxpayer could, at the discretion of its board of directors, pay any unpaid accrued iriterest, even if then not required to be paid. EL at 353."

The taxpayer consistently represented to its shareholders, the Interstate Commerce Commission, and the ev York Stock Exchange that the debentures were an "obligation" of the corpo ation.

Id. at 349-354.54 Furthermore, notwithstanding "In Monon R.R., hen discussing the debtlike nature of the interest payments, this Court nÅte :

Although the int rest is payable out of the * * * [taxpayer's] available net income, and is thus liable to fluctuate according to the vicissitudes of the * * * [taxpay r's] business fortunes, the amount of interest required to be paid in any year may be ascertained according to an established·form la, and such formula for payment leaves nothing to the discretion of th corporate directors. The fact that the directors have the discretion o make payments to the debenture holders in - addition to the ii terest which is required to be paid under the formula does not affect tl e character of the obligation. The basic provision . for the payment f erest was automatic rather than dependent upon the directors. That he amount of interest paid out depends upon profits and is no always the same fixed percentage of principle does not transform th debentures into equity certificates under these circumstances. (1970); citation mitted.]

[M non R.R. v. Commissioner, 55 T.C. 345, 360-361 an those at issue in Monon. We find this assertion s fully described in the quoted excerpt , the directors in Respondent proffers th the interest provisions of the advance agreements exhibit more debtlike qualities entirely unpersuasive. Monon were given no cliseretion to eliminate mandatory interest payments; rather, they were permitted to make additional, nonmandatory payments if desired. Petitioners, however, can completely eliminate interest payment by the expedient of simply approving ca ital investments or expenditures in a given year.

54In an inducemeut to participate in the exchange, the taxpayer advertised (continued...)

the fact that the instrument's payment obligations were subordinated to other general creditors, in the event of a taxpayer default, the shareholders were afforded a mechanism by which they could assert creditor remedies and declare "the principal of all outstanding debentures to be due and payable immediately." Id. at 352-353. The taxpayer also established a noncumulative sinking fund for the debentures' retirement.

Id. at 353. At the close of the year in which the exchanges took place, the taxpayer's debt-to-equity ratio, including the debentures as debt instruments, was 1.08 to 1.

Id. at 360.

In holding that the debentures were debt for Federal income tax purposes, we cited many of the aforementioned characteristics as evincing the instruments' debtlike nature.

Id. at 356-362. We also specifically found that the unconditional 50 year term of the debentures was consistent with such holding.

Id. at 359.

Nonetheless, we qualified our finding by signaling that instruments with definite terms of similar duration might appropriately be subject to future scrutiny:

Although 50 years might under some circumstances be considered as a long time for the principal of a debt to be outstanding, we must take into consideration the substantial nature of the * * * [taxpayer's] business, and the fact that it had been in corporate existence since 54(...continued) that the debentures were "a debt obligation of the Corporation, a promise to pay a sum certain at a definite maturity date". Monon R.R. v. Commissioner, 55 T.C. at 351.

1897, or 61 ears prior to the issuance of the debentures. Therefore, we thin that a 50-year term in the present case is not unreasonable. * * [Monon R.R. v. Commissioner, 55 T.C. at 359.]

Following our d cision in the Monon R.R., the Commissioner endeavored to limit the effect of the case by explicitly cautioning taxpayers against relying on the Opinion to justify debt treatment for long-term instruments:

.

[I]n the case of dn instrument having a term of less than 50 years, Monon Railroad g nerally does not provide support for treating an instrument as debt for federal income tax purposes if the instrument contains significant equity characteristics not present in that case. The reasonableness of an instrument's term (including that of any relending obligatiop or similar arrangement) is determined based on all the facts and circumstances, including the issuer's ability to satisfy the instrument. maturity that is reasonable in one set of circumstances may be unreasonable in another if sufficient equity characteristics are resent.

[Notice 94-47, 1994-1 C.B. 357.]

In the light of express language of the Opinion and the Commissioner's subsequent notice, we are unconvinced that the holding of Monon R.R. gives credence to respondent s assertion that a 50-year term supports the advance agreements' debt chara terization; rather, we believe that the precedential scope of our holding in that case w s delimited to the peculiar circumstances therein and that the facts at present are sufficiently distinguishable.- In particular, the advance agreements do not bear many of the same debtlike indicia as the debentures at issue in Monon R.R.55 In contrast to those debentures, the advance agreements neither afford their holders traditional creditor remedies upon default nor provide nondiscretionary interest payments (discussed supra). Furthermore, petitioners never established a reserve or sinking fund to ensure repayment of principal and PGI/PWI's debt-to-equity ratio, including the advance agreements as debt, hovered at fiscally unsustainable levels (discussed infra).

We also find, in the present circumstances, that issuing a 50-year debt instrument would not reflect the economic reality of petitioners' international business structure.⁵⁶ Respondent, in accord with his overall litigation strategy, asserts that the entirety of petitioners' business operations should be considered in determining both the "reasonableness" of the advance agreements' terms, see Monon R.R. v. Commissioner, 55 T.C. at 359, and similarly, the likelihood of repayment of principal at maturity; however, respondent fails to consider the import of petitioners' stated intention to keep separate their domestic and "For purposes of this section, we examine the term of the advance agreements without referring to the possibility that a default by a related party on a loan receivable held by PGI/PWI would render the instruments perpetual. This characteristic, alone, wholly differentiates the advance agreements from the debentures in Monon R.R.

56We discuss further, infra, that no reasonable commercial investor would have issued a loan to PGI "in similar amounts and under any reasonably similar terms to those of the Advance Agreements."

international cashflows. As testified by Mr. Bryant, petitioners endeavored to create a more self-sustaining international business component and to avoid using domestic cash "wherever possible" in their global expansion. Petitioners' uncontested reluctance to use domestic moneys in this regard accentuates the uncertainty of repayment of the principal amounts of the advance agreements at maturity. While there as hope that the new and expansive international investments in unpenetrated markets would prove lucrative in the future, there was no assurance of success.

Indeed, petitioners foresaw immediate, substantial losses associated with costs ir development of the Pepsi brand in such markets. The extended maturity date of the advance agreements effectively subjected the principal amounts of the i istruments.to an uncertain international economic climate for an inordinate period." In these circumstances, we cannot conclude that a 50-year term was "reasonable."58 .

"The recent economic instability experienced in many foreign corridors underscores the precarious nature of similar large international investments.

58See United Stat s 1966)(holding that a 20- investment); see also C distant due date sugges s equity because it exposes an investment to greater risk of an issuer's business and creates uncertainty regarding both the timing and certainty of repayment.'').

. Snyder Brothers Co., 367 F.2d 980, 984-985 (5tli Cir. ar term on an instrument was indicative of an equity 200932049 (Mar. 10, 2009) ("Generally, the use of a (cid:16)042 Respondent further errs in dismissing the legitimate possibility that a related party would default on loan receivables held by PGI/PWI, thereby voiding the term of the advance agreements. The uncontested testimony of petitioners' finance expert, Mr. James, revealed that PGI made loans to affiliates of approximately $550 million during the years at issue.⁵⁹ Repayment of those loans was subject to the success of petitioners' speculative new investments in unestablished foreign markets. Given both the magnitude of the loans and the financially precarious nature of the foreign investments, PGI could not be certain that its foreign affiliates would be able to fulfill all their payment obligations.

Respondent chooses not to address these separate loan receivables and instead refers this Court only to the purported link between payment of interest on the Frito-Lay notes, which he asserts is the only loan receivable of significance, and payment of base pr on the advance agreements. By doing so, respondent demonstrates his indifference to the real legal obligations created by the advance agreements, one of the main defects in his substance-over-form argument. While the purpose of inserting the perpetual clause in the advance agreements might have been to assuage certain unrelated concerns of the Dutch Revenue Service, the clause engendered real obligations between the parties. With the legitimate 59This amOunt does not include loan receivables contributed to PGI.

possibility that a related party default would render the advance agreements' terms perpetual, we cannot conclude that PGI/PWI had "an unqualified obligation to pay a sum certain at rpasonable close fixed maturity date". Gilbert v.

Commissioner, 248 F. d 99, 402 (2d Cir. 1957), rev'g and remanding T.C.

Memo. 1956-137; see als Boris I. Bittker & James S. Eustice, Federal Income Taxation of Corporations and Shareholders, para. 4.03[2][b], at 4-25 (7th ed.

2006) ("a fixed or asce ainable maturity date is virtually essential to debt classification ".)

In accord with our discussion supra, we find that this factor weighs heavily in favor of treating the advance agreements as capital investments.

3. Source of Payments6° A taxpayer willipg to condition the repayment of an advance on the financial well-being of the receiving company acts "'as a classic capital investor hoping to make a profit, not as a creditor expecting to be repaid regardless of the company's success or f il re.'" Calumet Indus., Inc. v. Commissioner, 95 T.C. at 287-288 (quoting In re Larson, 862 F.2d 112, 117s(7th Cir. 1988)); see also Estate of Mixon, 464 F.2d at 405 ("[I]f repayment is possible only out of corporate 60"This factor is soniewhat anomalous because most loans are repaid out of earnings." Laidlaw Transp., Inc. v. Commissioner,-T.C. Memo. 1998-232 (citing Estate of Mixon v. United States, 464 F.2d 394, 405 n.¹⁵ (5th Cir. 1972)).

earnings, the transaction has the appearance of a contribution of equity capital but if repayment is not dependent upon earnings, the transaction reflects a loan to the coi.poration." (citing Harlan v. United States, 409 F.2d 904, 909 (5th Cir. 1969))).

In considering-this factor, we are again tasked with discerning whether certain discrete terms of the advance agreements reflect the transaction's substance, or, alternatively, whether the instruments serve as a mere contrivance produced solely to secure desired tax treatment.

The provisions of the advance agreements were meticulously structured to ensure that annual payments of base pr remained, effectively, discretionary. PGI was required to make payments only to the extent "net cash flow" (which, at minimum, included payments of interest or capitalized interest from related parties) exceeded "accrued but unpaid operating expenses incurred" and "capital expenditures made or approved" by PGI during the applicable year. Petitioners contend that this clear language ties annual payment of base pr to PGI's speculative investments in new markets and, furthermore, subjects the effectuation of the payments to the unfettered judgment of PGI.

Indeed, petitioners submit that by merely approving capital expenditures, regardless of whether such expenditures actually materialized, PGI could indefinitely defer "mandatory" payment of base pr. Respondent, however, avers that petitioners' dialogue with the Dutch Revenue - 68.- Service effectively obligated PGI to make payments of base pr and that actual events demonstr e that such payments were never in doubt.

In effect, respondent proffers th ments of base pr would occur under all circumstances, irrespective of the suc ss of PGI's foreign business ventures.

When viewed e toto, the catalogue of correspondence between petitioners and.the Dutch Revenu SÅrvice depicts the difficulties petitioners experienced in attempting to reconcile th ir stated desire to retain discretion regarding actual payment of base pr wit tl e Dutch Revenue Service's continued insistence that each payment of interest n the Frito Lay Notes be used, apart from a taxable spread, to annually fund such payments. As reflected in Ms. Turkenburg's March 8, 1996, memorandum o, nspector Munneke, petitioners' original understanding was that the advance a re ments "allow[ed] PGI/PWI.to reinvest revenues, if desired, in the particip tions". Petitioners believed that-permitting interest on the Frito-Lay notes to fund PGI's investments in new'markets would functionally sever any perceived rel ionship between the Frito-Lay notes and the advance agreements. Mr. Bartley, member of PepsiCo's international tax group, reiterated petitioners' p s tion in an April 24, 19963 letter to Ms. Turkenburg, expressing reservations that connection with the Frito-Lay notes might subject the advance agreement tc IRS scrutiny and noting that he preferred a draft [*69} version of the advance agreements which contained no express or implicit link to the Frito-Lay notes.

Nonetheless, as petitioners' dialogue with the Dutch Revenue Service progressed, it became increasingly clear that in order to secure the desired tax .

ruling, the Dutch Revenue Service needed to be assured that interest received from the Frito-Lay notes would be (apart from the taxable spread) in pari passu with payments of base pr on the advance agreements. Accordingly, in their first formal tax ruling request, petitioners disavowed their prior stated "intention" of using interest on the Frito-Lay notes for investments in new markets; instead, they recognized that "Separate financing * * * [would] be sought for such additional investments." Inspector Munneke's June 11, 1996, conditional approval letter reaffirmed and emphasized the Dutch Revenue Service's position that "interest payable should at least be equal to the interest received on the loans receivable from Frito Lay." A subsequent facsimile from Mr. Bartley to Ms. Turkenburg further exhibited petitioners' intention that as a "practical matter" all the parties expected the Frito-Lay interest payments to "flow thru to KFCIH".

However, notwithstanding petitioners' and the Dutch Revenue Service's mutual understanding that base pr would be paid annually, petitioners remained unwilling to establish a definitive link with the Frito-Lay notes in the provisions of . - 70 - the advance agre ments. The absence of such a connection in the governing agreements greatly co cerned Inspector Munneke and he.was, correspondingly, apprehensive in appro in the tax ruling.

In an illuminative facsimile to Mr.

Bartley,.Ms. Turkenburg noted that Inspector Munneke remained unconvinced that the "net cash flow'' d finition in the advance agreement, as.drafted, would provide the "flow-thro gh result" that the Dutch Revenue Service sought.

Nonetheless, Ms. Turk nburg stressed that "for obvious US reasons" petitioners could not "accommodate' the wishes of the Dutch Revenue Service. Rather, Ms.

Turkenburg asserted that the ultimate test is going to be the actual events as they are going to occur in the ure, i.e. that indeed payments are going to be made as though a back-to-back rr ngement existed." Mr. Bartley, in a responding facsimile, concurred w th iMs. Turkenburg's analysis that the "flow-thru" result would be "proved by actu 1 events" confirming again that, "In practice, all interest paid by * * * [Frito-La ] o PGI/PWI will in turn be paid to KFCIH."

Furthermore, Mr. Bartley mphasized that, irrespective of the language inserted in the instruments, "under n circumstances" would·operating expenses or capital expenditures vary this res it. Eventually, on the basis of continued representations and assurances to the Dutch Revenue Service reflecting this understanding, Inspectqr l Aunneke approved the tax ruling.

An objective interpretation of petitioners' extended dialogue with the Dutch Revenue Service, supplemented by communications between petitioners' employees and their Dutch tax counsel, invariably leads to the conclusion that petitioners internally committed themselves to a distinct course of conduct; for at least the period the Dutch tax ruling remained valid, petitioners assured the Dutch Revenue Service that each payment of interest on the Frito-Lay notes would, in turn, be used to fund payments of base pr on the advance agreements.

Indeed, petitioners do not dispute that PGI paid nearly all of the amounts received under the Frito-Lay notes to the holders of the advance agreements from 1997 to 2009.

Petitioners, instead, argue that there was no legal compulsion to make such payments and that the aforementioned communications merely evince a preliminary understanding that interest on the Frito-Lay notes would fund the base pr payments if separate financing for PGI's global investments could be secured.⁶¹ 61Petitioners prOffer that the adherence to the payment schedule implicitly outlined in the Dutch tax ruling was effectively subject to the contingency of PGI's securing sufficient additional financing for their foreign operations. Citing the testimony of Anthony Bryant, who indicated that he was uncertain as to whether the stream of funding from the Frito Lay Notes would be needed in the context of the global expansion, petitioners submit that it was distinctly possible, as of the issuance of the advance agreements, that PGI might use Frito-Lay interest payments to fund anticipated capital investments.

We believe that both business exigencies and unforeseen funding shortfalls (continued...)

In support of this position, petitioners cite the portion of Ms. Turkenburg's testimony denying that petitioners' negotiations with the Dutch Revenue Service functionally committed or obligated petitioners to make such payments:

Q: * * * Was there an agreement to an effective obligation to pay?

A: No. We convinced * * * [Inspector Munneke] that the - - actual events would - - well, what we explained to him, to address his, his well, to give him a ertain comfort, is we explained to him how the company would op rate, I discussed before, that it would seek funding from other sources for the equity investments.

Q: I see. And woul d you describe the understandmg with the inspector as a su stantive commitment to pay through the interest received on the promissory notes as base preferred return?

A: No, because the e was no obligation.

Petitioners' attempt to discredit respondent's argument is, nonetheless, deficient.

The absence of an expres obligation to make a payment,does not, for purposes of 61(...COntinued) e Dutch Revenue Service in their formal request for a could have conceivably necessitated the diversion of the Frito-Lay funding stream to PGI's capital investme ts. Indeed, the conditionality of the payment of base pr is one of the defining e u y features of the advance agreements. Nonetheless, petitioners represented to tax ruling that "it is not th intention that * * * [the Frito-Lay interest] is reinvested in the participa ions". Mr. Bartley's later facsimiles similarly indicate that all parties recogniz d the "flow thru" nature of the transaction. Accordingly, it appears that in an effort to secure the tax ruling, petitioners internally committed themselves to making süch payments (albeit with no guaranty), notwithstanding the fact that separate financing for their new foreign investments was not yet identified.

this debt-versus-equity factor, diminish the importance of a taxpayer's effective, internal commitment to make annual payments on a financial instrument from a reasonably certain⁶² stream of revenue. Accordingly, we are unpersuaded that petitioners have effectively minimized the significance of their stated "intentions" clearly articulated in their correspondence with the Dutch Revenue Service.

Petitioners alternatively contend that, notwithstanding their representations to the Dutch Revenue Service, they were free to deviate from the conditions of the tax ruling and remain in a position to claim that payments of base pr were interest for Dutch income tax purposes. Petitioners' argument presupposes that the freedom to vary from the conditions set forth in the tax ruling renders uncertain the "flow-through" of Frito-Lay interest and, accordingly, subjects payment of base pr to the success or failure of PGI's investments. Respondent again counters that the Dutch Revenue Service's affirmation of the tax ruling served to economically compel petitioners to comport with their prior representations.

Otherwise, respondent asserts, the advance agreements would be treated as equity 62Ms. Turkenburg testified that there was a "certain encouragement * * * for Frito-Lay to make payments on time." If Frito-Lay deferred payment, they would have to capitalize such payment in a separate "baby note" with a corresponding "two percent surcharge". This "surcharge" would thereafter increase PGI's taxable spread.

[*74 ]in the Netherlands, Jeffectively negating petitioners' attempt to properly claim an interest deduåtic n for Dutch tax purposes.

Mr. Sleurink, pe itioners' Dutch tax law expert, testified that PGI was not bound by Dutch law to a t in the manner contemplated in the tax ruling. Rather, Mr. Sleurink asserted that any departure from the intended course of conduct would simply entitle t e IDutch Revenue Service to reexamine the transaction.

In a posited scenario where in erest on the Frito-Lay notes was used in PGI's foreign investments, Mr. Sleurink submitted that base pr on the advance agreements would still be characterized as an interest expense pursuant to Dutch tax law and would, accordingly, be deductible on an accrual basis.⁶³ Respondent's Dutch tax law expert, while faulti g Mr. Sleurink's narrow analysis of the advance agreements on a "stand Icne basis", generally agreed with the statement in Sleurink's report that " here existed * * * strong arguments for the view that the Advance Agreements c u d not be reclassified as equity" based on the provisions of the instruments.

It also appears that, in actuality,.petitioners did deviate from the conditions of the tax ruling. The arties stipulated that all payments of base pr were made in 63Ms. Turkenbur t stified that under similar circumstances, only the future deduction of capitalized base pr would be affected.

cash with the exception of a payment made on September 17, 1997, on the 1996 advance agreement, which was made in kind with shares of a PGI subsidiary as part ofthe spinoff of PepsiCo's global restaurant business. Clearly then, interest on the Frito-Lay notes was not always used "in turn" for payments of base pr. While no evidence was submitted by either party as to PGI's use of the corresponding Frito-Lay interest payment in September 1997, it appears likely that the payment was used in the context of petitioners' global expansion. Contrary to respondent's contention, this deviation did not void the tax ruling and subject petitioners to a 35% Dutch corporate income tax on all subsequent interest payments received from Frito-Lay. Petitioners were allowed to report their Dutch tax items for the remainder of the years at issue in a manner consistent with that contemplated in the Dutch tax ruling. It appears this reporting convention continued even after the expiration of the five-year extension of the Dutch tax ruling on December 31, 2005.

Nevertheless, despite the in-kind distribution, we cannot dismiss the connection between payment of interest on the Frito-Lay notes and payment of base pr on the advance agreements.⁶⁴ Each payment on the advance agreements 64Respondent also alleges that the payment of principal on the Frito-Lay riotes was linked to payment of principal on the Advance Agreements. of this contention he refers us to an October 19, 1998, repayment of one of the In support (continued...)

was made on the same date that interest due on the Frito-Lay notes was paid to PGI, and in substan ially similar amounts.⁶⁵ Furthermore, petitioners' intercompany memos n representations to the Dutch Revenue Service uniformly expressed the intended "flow-through" nature of the Frito-Lay interest payments.

In sum, it appears clear t at payments of base pr, at least during the taxable years at issue, were largely link d to interest received on the Frito-Lay notes.⁶⁶ 64(...COntinued) initial PPR Frito-Lay notes in the principal amount of $214,084,144 which corresponded to a payment, in the exact same amount and on the same day, by PGI to PPR in partial satisfaction of the 1997 advance agreement. Respondent further notes that the aggregate principal amounts of the Frito-Lay notes equal the aggregate principal amou ts of the Advance Agreements (referred to by petitioners and the Duteh fevenue Service as "synchronization"). Nonetheless, given the lengthier ter principal of no other Frito Lay Note has been paid, we believe it premature to conclude that the paym n of principal on one instrument would necessitate the payment of principal on t e other.

s of the Advance Agreements and the fact that the 65Respondent als submits a "flow of funds" chart which purports to illustrate that "on at lea t ne occasion, PepsiCo * * * provided the funds for Frito-Lay to make its interest payments to PGI and those same funds were then returned through PPR ek to PepsiCo on the same day."

66PetitiOners Cite h ·March 2002 amendments to the PepsiCo Frito-Lay notes to further demons r e the connection between the instruments.

Accordingly, we find that this factor emphasizes a debt characteristic of the advance agreements.⁶⁷ 4. Right To Enforce Payments A defmite obligation to repay an advance, including interest thereon, suggests a loan obligation. See Laidlaw Transp., Inc. v. Commissioner, T.C.

Memo. 1998-232; see also Notice 94-47, supra. If a financial instrument does not provide its holder with any means to ensure payment of interest, it "is a strong indication of a stockholding, rather than a creditor debtor relationship. The right to enforce the payment of interest is one of the requisites of a genuine indebtedness." Gokey Props., Inc. v Commissioner, 34 T.C. 829, 835 (1960), aff'd, 290 F.2d 870 (2d Cir. 1961);68 see also Kraft Foods Co. v. Commissioner, 232 F.2d at 122 (suggesting that an "unconditional obligation" to pay interest and principal are "necessary features of instruments of indebtedness").

67The significance of this factor, however, is tempered to an extent given both the long terms of the advance agreements and the limited time the Dutch tax ruling remained effective.

68"The classic debt is an unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor's income or lack thereof." Gilbert v. Commissioner, 248 F.2d 399, 402 (2d Cir. 1957).

Respondent coneec es that there is no mechanism which provides the holders of the advance agreements with the right to demand immediate repayment of all outstanding principal and interest in the event PGI defaults on payment of base pr.⁶⁹ Cf. Hewlett Packard Co. v. Commissioner< T.C. Memo. 2012-135 (finding that articles of i orporation and other various agreements pertaining to an investment in a foreign corporation afforded the taxpayer an apparatus to enforce creditor rights).

onetheless, respondent again reasons: "given the fact that PepsiCo controlled a 1 the entities involved and would be economically disadvantaged if PGI were to default under the 1996/97 Advance Agreements, there was no real possibil ty that PGI would default on the 1996/97 Advance Agreements." We find respondent's position untenable. Suggesting that the success of petitioners' nuperous speculative investments in foreign subsidiaries was absolute and that detitioners could therefore ensure the timely payment of , intercompany obligations; based solely on the subsidiaries' inter-relatedness, finds no basis in fact or law, as noted supra.

69The advance ag eements are "governed by and construed in accordance with the laws of the State af Delaware." Respondent has not argued that Delaware law would provide the olders of the advance agreements a remedy if PGI defaulted on "mandatory" base pr payments.

Petitioners' finance expert, Mr. James, testified that PGI held notes evincing outstanding indebtedness of its affiliates in amounts as high as $550 million during the years at issue. Many of these affiliates were funded to help foster the development of the PepsiCo brand in then-uncultivated foreign markets, in effect subjecting repayment of PGI's advances to the business risks of these entities.

Regulatory hazards and currency exposure served as possible impediments to full and timely repayment of such advances as well. Upon default of any one of these intercompany receivables, the terms of.the advance agreements became void, rendering the advance agreements equity for Dutch tax purposes. At that point, any ostensible tax "compulsion" for PGI to pay annual base pr would evanesce. In such a circumstance, it appears probable that PGI would be reluctant to follow.its, payment intentions on the advance agreements; however, the holders of the advance agreements would have no means to compel such payments.

A corollary argument advanced by respondent, citing Merck & Co. v.

United States, 652 F.3d 475 (3d Cir. 2011), is that the absence of a formal obligation, on the part of PGI, to make annual preferred return payments is mitigated by the fact that petitioners intended to, and were, in fact, internally committed to make such payments.

In Merck & Co., 612 F.3d at 476-477, Schering-Plough, a New Jersey corporation, sought to epatriate significant cash reserves held in foreign subsidiaries without addi ional tax cost.

In a strategy designed by Merrill Lynch, Schering-Plough transferred the "receive leg" of a 20-year interest rate swap to its foreign subsidiary in e e ange for a lump sum of money.

Id. at 478-479. The transaction was intended to allow Schering-Plough to characterize the transaction as a sale, in effect allo i g the corporation to spread its tax recognition of the lump-sum payment over the term of the swap pursuant to then-valid Notice 89-21, 1989-1 C.B. 651.

Id. n affirming the lower court's holding that the transaction was, in substance, a disguised loan, the Court of Appeals dismissed the taxpayer's contention that the absen e of an express, unconditional obligation to repay principal precluded reclia acterization of the sale.

Id. at 482. Rather, the court stated:

[A] formal 'legal obligation' is not an absolute prerequisite for a determination that a transaction is a loan. * * * In the face of[the tax code's general insistence on the controlling effect o economic reality rather than form, it is more appropriate t at, in determining whether there was an 'obligation' to reþay, the court look to whether the transferor's intention was to str cture the transaction to ensure repayment of funds as a practical matter, rather than to whether there were literally no condi io s on repayment. It would be for 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 483.]

Setting aside the fact that Merck & Co. concerned, in large part, the sale- versus-loan dichotomy rather than the debt-versus-equity question at issue, we believe that the facts of the case are clearly distinguishable from those at hand.

The Scherling-Plough transaction "had certain objective indicia of loans" not apparent in the advance agreements such as an unconditional "fixed maturity date" and "periodic interest payments". See id. at 482. Further, the main contention in Merck & Co. concerned the repayment of principal, which was contingent on payments based on a floating interest rate.

Id. at 482-483. Scherling-Plough submitted that if interest rates fell to a certain level, the payments would not be sufficient to repay the advances.

Id. Nonetheless, based on testimony of Scherling-Plough representatives adduced at trial evidencing that the parties always expected the recovery of principal, as well as the economic reality that interest rates were almost certain not to fall to a level subjecting repayment to uncertainty, it was clear to the Court of Appeals that repayment was "unconditional".

Id. at 483-484.

In contrast, the long and perhaps perpetual terms of the advance agreements rendered repayment of principal speculative, as noted _ supra, and paynients of base pr, while clearly expected by petitioners during the period the Dutch tax ruling remained effective, were subject to the business realities and uncertaint es of petitioners' global expansion throughout the long term of the investment Therefore, we are not convinced that full repayment of principal and interest on t e advance agreements was "effectively if not explicitly, unconditional." S_eee ià at 484.7° Respondent's f na contention is that the advance agreements provide other legitimate creditor safegu rds, referring us to a provision which allows holders to declare unpaid principal nd preferred return "immediately due and payable" upon dissolution, insolvency, o receivership of PGI. What respondent fails to appreciate,'however, is that any such payment remained subject to "net cash flow" restrictions and, more importantly, would remain subordinate to all indebtedness of PGI and the rights of all creditors. This subordination is both meaningful and significant in the light öf PGI's $980 million in outstanding indebtedness to affiliates during the ye rs at issue. PGI was also exposed to the liabilities of several of its subsidiaries ^or two of the years at issue, in amounts over $150 7°Indeed, the court in Merck & Co., Inc. v. United States, 652 F.3d 475, 483 (3d Cir. 2011), qualified its holding by noting that "under many, perhaps most, circumstances, repaym nt might be sufficiently conditional to prevent characterization of a transaction as a loan."

million, the possible claims of.which were senior to those of the advance agreements holders, discussed further infra.

We have previously held that a provision in a financial instrument affording holders certain rights in the event of liquidation, but nonetheless subordinating those rights to general creditors, "lends no support to the contention that the * * * [instrument] in question represents an obligation of debt rather than merely a preferred stock obligation." Mullin Bldg. Corp. v. Commissioner, 9 T.C. 350, 354 (1947), aff'd, 167 F.2d 1001 (3d Cir. 1948). We believe the same logic equally applies here.

In sum, we find that the absence of any legitimate creditor safeguards afforded to the holders of the advance agreements is a significant factor evidencing the equity.nature of the investment. See Tyler v. Tomlinson, 414 F.2d 844, 849 (5th Cir. 1969) (finding that notes which contained "no enforcement provisions, no specific maturity dates, and no sinking fund from which payments of interest and principal might be made" were more appropriately characterized as equity instruments).

5. Participation in Management as a Result of the Advances The right of the entity advancing funds to participate in the management of the receiving entity's business demonstrates that the advance may not have been bona fide debt and instead was intended as an equity investment. Am.

Offshore, Inc. v. Commissioner, 97 T.C. 579, 603 (1991). The parties did not substantively address this factor as PepsiCo commonly controlled PGI and PWI before the issuance of the advance agreements. Accordingly, this factor is neutral.

6. Status of the Advances in Relation to Regular Corporate Creditors Whether an advanc is subordinated to obligations to other creditors bears on whether the taxpayer a vancing the funds was acting as a creditor or an investor. Estate of Mixon, 464 F.2d at 406. Taking a subordinate position to other creditors may sugge t an equity investment. See CMA Consol., Inc. v.

Commissioner, T.C. Mem . 2005-16.

The advance agree ents, by their own terms, unequivocally subordinate any obligation of PGI to pay unpaid principal or accrued, but unpaid, preferred return to all indebtedness of PGI and the rights of all;creditors. Nonetheless, respondent submits that this featur is not dispositive of equity characterization. See Kraft Food Co. v. Commissioner, 232 F.2d at 126 ("subordination to general creditors is not necessarily indicati e f a stock interest. Debt is still debt despite subordination."); see al o ommissioner v. O.P.P. Holding Corp., 76 F.2d 11, 12 (2d Cir. 1935) ("We do not think it fatal to thedebenture holder's status as a creditor that his claim is subordinated to those of general creditors. The fact that ultimately he must be paid a definite sum at a fixed time marks his relationship to the corporation as that of creditor rather than shareholder.").

Furthermore, respondent proffers that, irrespective of the subordination provision, the "practical likelihood" of it affecting payments is "nonexistent".

Respondent is correct in asserting that the advance agreements' subordination, in itself, is not determinative of equity treatment; however, the same principle applies equally to every factor in our analysis. See Welch v.

Commissioner, 204 F.3d 1228, 1230 (9th Cir. 2000), a_ff'g T.C. Memo. 1998-121; see also John Kelley Co. v. Commissioner, 326 U.S. 521, 530 (1946) ("There is no one characteristic, not even exclusion from management, which can be said to be decisive in the determination of whether the obligations are risk investments * * * or debts."). Nonetheless, it is widely recognized, even by the Commissioner, that the legitimate subordination of a financial instrument remains a relevant determinant in a debt-versus-equity inquiry. See eg, sec. 385(b)(2); TIFD III-E, Inc., 459 F.3d at 237; Roth Steel Tube Co. v. Commissioner, 800 F.2d 625, 631- 632 (6th Cir. 1986), aff'g T.C. Memo. 1985-58; Pritired 1, LLC v. United States, 816 F. Supp. 2d 693, 734-735 (S.D. Iowa 2011); Notice 94-47, supra.

During the years at issue, PGI had outstanding indebtedness to affiliates in amounts as high as $9 0 million." All such indebtedness ranked superior to any rights engendered in t e advance agreements. Respondent, consistent with his general attempt to inte ra:e petitioners' entire corporate structure, dismisses as irrelevant such related party indebtedness; he contends that the likelihood that PepsiCo would allow G¹ or any of its subsidíaries default on their obligations was "effectively nil".

s discussed supra, respondent's position finds no basis in fact or law. Responderit l·as submitted no evidence that PepsiCo was under any obligation to ensure PGI's or other foreign affiliates' "inter-company" obligations.

Instead, the eventual satisfaction of such obligations was dependent upon the success of PGI's investments in foreign-markets.

PGI's credit fadili1y with ABN-AMRO Bank, N.V., which was secured by a subsidiary guaranty i sued by PepsiCo, is not considered in this analysis. See TIFD III-E, Inc., 459 F. d at 237 (finding that Dutch banks' investment, although generally subordinated o ::reditors', was secured by a guaranty from the taxpayer's "far more solvent parent", rendering subordination a mere "fiction").

"PGI's investments in foreign subsidiaries subjected such advances to creditor-debtor, bankruptcy, and general business law in various jurisdictions. Without the benefit of any evidence to the contrary, we believe a default on such obligations both plausi$le. and, perhaps, beneficial for business purposes in certain circumstances.

PGI, during 1996 and 1997, also had substantial exposure to the liabilities of several of its foreign investments." In particular, as a member of Pepsi-Cola France Snc and Spizza 30 Snc, PGI remained directly liable to creditors, following a period of notice and demand against the individual entities, for claims against the businesses pursuant to applicable French statutes. Similarly, under Spanish law, PGI had unlimited liability for the debts and obligations of PRI, a Spanish operating entity. The three foreign businesses, collectively, had aggregate liabilities of more than $180 million and $157 million in 1996 and 1997, respectively; the rights of those creditors were senior to those of the advance agreement holders under the express terms of the governing instruments. While PGI's interests in Spizza 30 Snc and PRI terminated in the 1997 spinoff, this subsequent reorganization was not contemplated when the advance agreements were issued and does not diminish the significance of PGI's liabilities in 1996 and 1997. Further, PGI was not limited in investing in other ventures in the future which might expose it to further liability.

In determining foreign law, we are free to consider "any relevant material or source, including testimony, whether or not submitted by a party or otherwise admissible. The Court's determination shall be treated as a ruling on a question of law." Rule 146; see also Angerhofer v. Commissioner, 87 T.C. 814, 819 (1986). Petitioners submitted relevant foreign statutes and secondary sources concerning French and Spanish law. Respondent, while questioning the materiality of such law in these cases, does not contest the validity of the proffered sources.

We find both real and meaningful the subordination provision in the advance agreements; tl7is factor demonstrates an equity characteristic of the instruments.

7.

Intent of the Parties .

As noted sup_rra, th inquiry of a court in resolving the debt-equity issue is primarily directed at asce aining the intent of the parties". A.R. Lantz Co., 424 F.2d at 1333 (citing Ta v. Commissioner, 314 F.2d 620 (9th Cir. 1963), aff'g in part, rev'g in part T.C. Memo. 1961-230): "The intent of the parties, in turn, may be reflected by their subsequent acts; the manner in which the parties treat the instruments is relevant in 'letermining their character." Monon R.R. v.

Commissioner, 55 T.C. at 357.

Petitioners, engãgin in legitimate tax planning, designed the advance agreements with an expèct tion that the instruments would be characterized as equity for U.S. Federal inc me tax purposes and as debt under Dutch tax law. The negotiations with the Dutch Revenue Service underscore petitioners' efforts to secure this hybrid dynaiuic. While eventually assuring the Dutch Revenue Service that base pr payments wpu d be madé annually, irrespective of provisions in the advance agreements whi!ch might provide otherwise, petitioners were uncompromising in thei(refusal to insert terms in the instruments engendering an obligation for PGI to make such payments. Petitioners' vigilance preserved what amounts to base pr payment discretion, a material feature in the light of both the differing terms of the advance agreements and the Frito-Lay notes, and the limited period the Dutch tax ruling remained effective (described further supra).

See Universal Castings Corp. v. Commissioner, 37 T.C. 107, 115 (1961) (indicating that issuer discretion on payments reflects an equity investment), aff'd, 303 F.2d 620 (7th Cir. 1962). Undoubtedly, petitioners' internal commitment to make annual base pr payments that were functionally linked to Frito-Lay Note interest payments evinces a debtlike characteristic of the instruments. Nonetheless, by retaining judgment on whether to make such future payments, petitioners were free to deviate from their representations to the Dutch Revenue Service without the specter of legal consequence. The benefit of added financial maneuverability was desired and sought by petitioners and illuminates a significant equity aspect of the investment.

Similarly, petitioners' actions during the taxable years at issue do not subvert or vítiate their clear intentions to create a legitimate hybrid instrument."

"Transactions are often purposefully structured to produce favorable tax consequences, and such planning, alone, does not compel the disallowance of the transaction's tax effects. See Frank Lyon Co. v. United States, 435 U.S. 561, 580 (1978); see also ASA Investerings P'ship v. Commissioner, 201 F.3d 505, 513 (continued...)

While PGI made ännual preferred return payments, including base pr, the advance agreements expressly permitted such payments. PGI also made an "in- kind" base pr payment to IlFCIH in 1997, apparently in direct contravention of the Dutch tax ruling. Such de iation, according to respòndent's general contentions, should have immediately invalidated the tax ruling, rendering the instruments equity for Dutch tax purposes. Nonetheless, petitioners continued their tax reporting in the manner contemplated in that ruling without adverse effect.

The long, and possi ly perpetual, terms of the advance agreements also demonstrate that petitioners did not intend to create an instrument with traditional debt characteristics and attendant obligations according to Federal income tax law.

As noted supra, the repayment of the principal of petitioners' advance to PGI was effectively subject to PGI's speculative investments in undeveloped foreign markets. It remained uncertain at issuance whether funds would be available for repayment at the extend d maturity dates. The realistic possibility that a related party might default on a receivable held by PGI, causing the advance agreements to "(...continued) (D.C. Cir. 2000) ("It is un formly recognized that taxpayers are entitled to structure their transactiëns in such a way as to minimize tax."), aff'g T.C. Memo. 1998-305; Ewing v. CoÊissioner, 91 T.C. 396, 420 (1988) ("we are cognizant of the fact that tax planninlg is an economic reality in the business world and the effect of tax laws on a tra saction is routinely considered"), aff'd without published opinion, 940 F.2d 1534 (9th Cir. 1991).

I become perpetual instruments, further dissipated any reasonable expectation of repayment of principal.

In sum, we fmd that petitioners' intentions comport with the substance of the transaction. They did not intend to create a "definite obligation, repayable in any event." See Hewlett Packard Co. v. Commissioner, T.C. Memo. 2012-135. As a result, this factor demonstrates the equity nature of the instruments.

8.

Identity of Interest Between Creditor and Stockholder If advances are made by stockholders in proportion to their respective stock ownership, an equity capital contribution is indicated. Estate of Mixon, 464 F.2d at 409; Monon R.R. v. Commissioner, 55 T.C. at 358.

Petitioners did not address this factor and respondent, noting that all transactional parties are commonly controlled by PepsiCo, contends that it is not relevant. We agree that the factor does not aid in our inquiry.

9. "Thinness" of Capital Structure in Relation to Debt The purpose of examining the debt-to-equity ratio in characterizing an advance is to determine whether a corporation is so thinly capitalized that repayment would be unlikely. CMA Consol., Inc. v. Commissioner, T.C. Memo.

2005-16.

In such a circumstance, the advance would be indicative of venture capital rather than a loan. Bauer v. Commissioner, 748 F.2d 1365, 1369 (9th Cir.

1984); see also H bert Enters., Inc. v. Commissioner, 125 T.C. 72, 96-97 (2005), aff'd in part, vacated in part and remanded on other grounds, 230 Fed.

Appx. 526 (6th Cir. 20Q⁷).

Petitioners' finan e expert, Mr. James, testified that if the advance agreements are treated as ebt for U.S. Federal income tax purposes, PGI's debt- "Respondent relies on Fifth Circuit precedent which recognizes that thin capitalization is "very strong evidence" of a capital investment where: (1) the itially high; (2) the parties understood that it would debt-to-equity ratio was i bstantial portions of these funds were used for the likely go higher; and (3) purchase of capital assets nd for meeting expenses needed to commence operations. _S_ee Estate of ixon, 464 F.2d at 408 (citing United States v. Henderson, 375 F.2d 36, 40 (5th Cir. 1967)). Respondent contends that petitioners cannot satis y his standard; he submits that, in particular, petitioners have not conclusively denionstrated that PGI used advances to purchase capital assets or to meet expenses needed to commence operations.

However, neithe tFis Court nor the Court of Appeals for the Second Circuit has embraced this more nuanced test for thin capitalization in a debt-versus-equity analysis. See, e.g., Nassan Lens Co. v. Commissioner, 308 F.2d 39, 47 (2d Cir. 1962), remanding 35 T.C. 268 (1960); Kraft Foods Co. v. Commissioner, 232 F.2d at 127; Hubert Enters., Inc. v. Commissioner, 125 T.C. 72, 96 (2005); Anchor Nat'l Life Ins. Co. v. ConÅnissioner, 93 T.C. 382, 401 n.¹⁶ (1989); Recklitis v. Commissioner, 91 T.C. 8 4, 903-905 (1988). stated that the isolated de t-to-equity ratio is of "great importance in determining whether an ambiguous ins rument is a debt or an equity interest." Kraft Foods Co. v. Commissioner, 232 F.2 at 127. Moreover, the other elements in the Fifth Circuit standard are subs approach the "thin capital zation" factor without addressing the additional Fifth Circuit elements.

ed within our larger inquiry. Accordingly, we Indeed, the Second Circuit has to-equity ratio would have been 14.1 to 1 in 1996 and 26.2 to 1 in 1997.

In his expert report, Mr. James noted:

In some industries, such as banking, it is common to see debt-to-equity ratios that exceed 14 to 1. However, a bank, unlike PGI, is required to maintain significant diversification in its assets by type, industry, geography, maturity and overall risk. PGI's assets, by contrast, primarily consisted of equity investments in and loans to businesses in emerging markets and * * * [Frito-Lay notes]. In my experience, it is highly unlikely that any institution would have extended a loan of similar size to the Advance Agreements if the borrower's overall leverage were at these levels, particularly given the duration of the Advance Agreements and the expected business plans for PGI's subsidiaries. It is also unlikely that given this level of leverage that debt could be issued in a capital market transaction.

Respondent has not contested this section of Mr. James' analysis.

Given PGI's untenable debt-to-equity ratio according to industry standards, we find that this factor supports the advance agreements' equity characterization.

See Recklitis v. Commissioner, 91 T.C. 874, 904 (1988) (suggesting the importance of "capitalization averages" in the relevant business when analyzing the alleged thin capitalization of a corporation).

10. Ability of Corporation To Obtain Credit From Outside Sources "[T]he touchstone of economic reality is whether an outside lender would have made the payments in the same form and on the same terms." Segel v.

Commissioner, 89 T.C. at 828 (citing Scriptomatic, Inc. v. United States, 555 F.2d 364, 367 (3d Cir. 1977)); see Calumet Indus.

Inc. v. Commissioner, 95 T.C.

at 287; see also Fin Ha Realty Co. v. United States, 398 F.2d at 697 ("Under an objective test of econon ic reality it is useful to compare the form which a similar transaction would have taken had it been between the corporation and an outside lender, and if the * * * [related party's] advance is far more speculative that what an outsider would make, it is obviously a loan in name only.").76 Petitioners' finance xpert, Mr. James, asserts that "no third party lending institution or lender in the capital markets would have loaned funds in the amount of the advance agreements to PGI under any reasonably similar financial terms."

Mr. James derived his cónclusion from what he perceived were several atypical or unattractive (from an leñd r's standpoint) aspects of the advance agreements, including: (1) the long an perhaps perpetual terms; (2) the subordination of repayment in the light of P3I's anticipated significant investments in foreign markets; (3) the lack of hcceleration rights on default and, similarly, the distinct 76Respondent, misconstruing relevant legal precedent, initially submitted that the ABN-AMRO crec it facility evidences that outside lenders were willing to advance funds to PGI, ren:lering this factor neutral. However, the focus of the law "is not simply on the abili y of a corporation to obtain the funds from outside sources; rather, the focÔs is whether an outside lender would have lent the funds on the same or similar terns." Segel v. Commissioner, 89.T.C. at 832 (emphasis supplied) (citing Scrip on atic, Inc. v. United States, 555 F.2d 364, 368 (3d Cir. 1977), and Fin Hay Realt Co. v. United States, 398 F.2d at 697).

possibility of deferral of repayment; and (4) the preferred return payment restrictions.

Respondent does not substantively address whether an independent creditor would have advanced funds to PGI in the "same or similar" terms as the advance agreements; rather, he summarily dismisses Mr. James' conclusions as irrelevant insisting that the expert analysis irreparably suffers from a narrow focus on the terms of the advance agreements and, concomitantly, a failure to perceive the actualities of the transaction. We have previously expressed the limitations of this argument in our discussions concerning other debt-versus-equity factors; respondent's failure to adequately appreciate the legal significance of the terms of the advance agreements serves as a ubiquitous, acute flaw in his substance-over- form argument.

The factors influencing Mr. James' conclusion have also been discussed further supra and need not be addressed in greater detail.

In the light of our previous discussions, supplemented by the unrebutted expert opinion of Mr. James, we find that the terms of the advance agreements could not have been replicated, in any reasonably similar manner, by independent debt financing. Consequently, this factor highlights the equity characteristics of the instruments.

11. Use to Which dvances Were Put Where a corporation uses an advance of funds to acquire capital assets, the advance is more likely to e characterized as equity. Estate of Mixon, 464 F.2d at 410. Use of advances to eet the daily operating needs of the corporation, rather than to purchase capital as ets, is indicative of bona fide indebtedness. Stinnett's Pontiac Serv., Inc. v. Comnissioner, 730 F.2d 634, 640 (11th Cir. 1984), a_fff'g T.C.

Memo. 1982-314; Raymor d v. United States, 511 F.2d 185, 191 (6th Cir. 1975); Estate of Mixon, 464 F.2d at 410.

PGI issued the advance agreements in exchange for Frito-Lay Notes. With the exception of a September 1997 payment, which was made in kind with shares of a PGI subsidiary as part of the spinoff of PepsiCo's global restaurant business, every interest payment on -he Frito-Lay notes was used to make preferred return payments on the advance agreements. As noted supm, while no evidence was submitted by either party as to PGI's use of the corresponding Frito-Lay interest payment in September 1997, it appears likely that the payment was used in the context of petitioners' global expansion. Notwithstanding this deviation, PGI was internally committed to use Frito Lay interest to fund preferred return payments on the advance agreements for the period the Dutch tax ruling remained effective.

Without a greater connection between Frito Lay interest payments and PGI's capital investments for the years at issue, we find that this factor demonstrates the debtlike character of the advance agreements.

12. Failure of Debtor To Repay The repayment of an advance may support its characterization as bona fide indebtedness. Estate of Mixon, 464 F.2d at 4.10. The advance agreements mature, if at all, in future years; however, petitioners did repay $214,084,144 of principal on the 1997 advance agreement in 1998. Nonetheless, it is premature to rely on this factor as tending to demonstrate either the equity or the debtlike features of the advance agreements. Accordingly, as recognized by respondent, this factor is neutral.

13. Risk Involved in Making Advances A significant consideration in our inquiry is "whether the funds were advanced with reasonable expectations of repayment regardless of the success of the venture or were placed at the risk of the business". Gilbert v. Commissioner, 248 F.2d at 406. Many of the general debt-versus-equity factors "may bear on the degree of the risk" associated with a financial instrument at issue.

Id. In essence, this factor represents another means by which to ascertain the intentions of the parties.

As noted supra, several factors evince the uncertainty of repayment of principal on the advanc agreements.

In particular, the long and conditional maturity dates of the ad a ce agreements, considered in the light of PGI's investments in foreign markets, subject repayment to the success of such ventures.

The overall subordination of those payments similarly diminished any reasonable return of KFCIH's or PPR's investment. KFCIH and PPR were also not afforded legitimate creditor remedies to ensure repayment of principal or base pr.. And, perhaps most convincingly, the "independent creditor test" underscores that a commercial bank or thi d party lender would not have engaged in transactions of comparable risk.

While we previo sl recognized the link between Frito-Lay interest payments and payments o base pr on the advance agreements, that link was tenuously conditioned upo PGI's maintaining the "flow-through" nature of the payments even after the D tch tax ruling expired. This "flow-through", while expected, was not assured.

Indeed, PGI's "in kind" distribution in 1997 evidences petitioners' willingness to vary their conduct from the express terms of the Dutch tax ruling during the years at issue. Further, petitioners never expressed an intention to abide by the pLyment convention for the extended period following the expiration of the tax ruling. We also noted that although the principal of the Frito-Lay notes equaled the principal of the advance agreements, the maturity dates of the respective instruments were not congruent. Therefore, when the Frito- Lay notes matured, PGI was not compelled to make corresponding payments of principal on the advance agreements.

In accord with our prior discussion, we find that this factor illuminates the equity characteristics of the advance agreements.

14. Debt-Versus-Equity Conclusion The determination of debt or equity is no mere counting of factors. Bauer v.

Commissioner, 748 F.2d at 1368. However, after consideration of all the facts and circumstances, we believe that the advance agreements exhibited more qualitative and quantitative indicia of equity than debt.

IV. Conclusion

We hold that the advance agreements are more appropriately characterized as equity for Federal income tax purposes.

In reaching our holdings herein, we have considered all arguments made, and, to the extent not mentioned above, we conclude they are moot, irrelevant, or without merit.

To reflect the fore oing, Decisions will be entered under Rule 155.

2. The parties did not specify the amount of premium pr paid by PGI on November 6, 1997, or October 19, 1998, nor could we determine those amounts from the record.
7. PepsiCo expected that cash generated by its North American businesses would fund the company's dividends and share purchases.
16. Mr. Slobbe also sent the drafts to certain KPMG LLP employees who were responsible for the PepsiCo accounts during that period.