PepsiCo had devised hybrid securities, which were treated as debt in the Netherlands and equity in the United States. Hence, the payments were treated as tax deductible interest expenses in the Netherlands but as tax free dividend income on equity in the US.
The IRS held that the payments received from PepsiCo in the Netherlands should also be characterised as taxable interest payments for federal income tax purposes and issued an assessment for FY 1998 to 2002.
PepsiCo brought the assessment before the US Tax Court.
Based on a 13 factors-analysis the Court concluded that the payments made to PepsiCo were best characterised as nontaxable returns on capital investment and set aside the assessment.
Factors considered were: (1) names or labels given to the instruments; (2) presence or absence of a fixed maturity date; (3) source of payments; (4) right to enforce 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) “thinness” 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.
“And, perhaps most convincingly, the “independent creditor test” underscores that a commercial bank or third party lender would not have engaged in transactions of comparable risk.”
“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.”
“We hold that the advance agreements are more appropriately characterized as equity for Federal income tax purposes.”US vs PepsiCo Sep 2012 US Tax Court Opinion, T-C-Memo 2012-269