- Pepsico, Inc. (hereinafter “Pepsico”) restructured to create a single member limited liability company, PepsiCo Global Mobility, LLC (“PGM”), which was a disregarded entity owned by Pepsico’s Frito-Lay North America (“Frito-Lay”)
- PGM was the putative employer of Pepsico’s expatriate workforce, which meant that Frito-Lay and the disregarded PGM had greater than 80 percent of its property and payroll outside of the United States.
- So-called 80/20 companies are usually excluded from the Illinois unitary group, but the Appellate Court of Illinois found that there was no employer-employee relationship between the expatriates and PGM; therefore, Frito-Lay failed the 80/20 test.
Background
Illinois is a water’s edge unitary combined reporting state, which means that related, domestic companies have to file on a combined basis. 80/20 companies - that is, those companies that have greater than 80 percent of their property and payroll outside the United States - are excluded from the unitary group.
Forvis Mazars Insight: The 80/20 concept is found in multiple states beyond Illinois that use water’s edge combined reporting, though the rules may vary slightly from state to state in practice.
The Pepsico Restructuring
Pepsico is a multinational food and beverage business headquartered in Purchase, New York. Its subsidiary, Frito-Lay is headquartered in Texas. Pepsico’s tax department created PGM, a Delaware limited liability company, as a part of a global restructuring. PGM was formed in part to consolidate the three separate expatriate programs that Pepsico had prior to the restructuring.
PGM entered into secondment agreements with the foreign subsidiaries of Pepsico that were going to utilize the services of the expatriates in question. It also entered into a letter of understanding (“LOU”) with each expatriate. PepsiCo Corporate Group (“PCG”) human resources personnel executed the LOUs on behalf of PGM. After the restructuring, all expatriates were reported as a part of PGM’s payroll for accounting purposes; the upshot was that FLNA (the owner of the disregarded PGM) had greater than 80% of its payroll outside of the United States as a result of the restructuring. Pepsico excluded FLNA from its Illinois water’s edge combined report as a result, generating significant tax savings from FLNA’s exclusion as well as deferred tax assets (as the remaining members of the Pepsico water’s edge group operated at a loss).
The Illinois Department of Revenue Audit
Upon audit, the Illinois Department of Revenue (the “Department”) determined that FLNA’s income was improperly excluded from the Illinois’ water’s edge unitary group. The basis for the conclusion was the auditor’s assertion that if the PGM/FLNA payroll was properly assigned by business unit based upon the unit that benefited from the expatriate employees, FLNA would not meet the definition of an 80/20 company.
Appeal to the Independent Tax Appeals Tribunal
Pepsico appealed the Department’s findings to the Illinois Independent Tax Appeals Tribunal (the “Tribunal”). The main thrust of its motion for summary judgment was that the expatriates were properly assigned as employees to PGM/FLNA and should be considered as such by the Department. The Department, in opposition, claimed that PGM had no economic substance, and was a legal shell that merely existed as an employer for compensation and payroll reporting purposes. The Tribunal found in favor of the Department, concluding that PGM lacked economic substance and solely existed for the tax benefits it created. Notably, it labelled PGM a shell corporation without assets, capitalization or supervisory employees, that merely existed to “…list expatriates as employees.” Therefore, the employees in question were not properly employees of PGM, but rather the foreign affiliates; as a result, FLNA/PGM did not meet the definition of an 80/20 company. Pepsico appealed the decision of the Tribunal to the Appellate Court of Illinois.
Forvis Mazars Insight: While a full discussion of the economic substance doctrine is beyond the scope of this alert, it is one of the foundational equitable tax doctrines taxpayers should be cognizant of when undertaking any restructuring that has state tax impacts. The economic substance doctrine generally asks if the taxpayer’s restructuring or transaction has resulted in any meaningful economic impact. In the instant case, the question was if the 80/20 company actually had foreign property and payroll in substance rather than simply on paper.
The Appellate Decision
The appellate decision initially dispensed with some procedural issues that arose in the course of the appeal. Pepsico argued that the Tribunal should not have considered the Department’s brief as a cross-motion for summary judgment and that the Tribunal did not apply the correct legal standard in evaluating the Department’s brief. It summarily dismissed these procedural claims. Further, it concluded that the appropriate standard to apply in Illinois when reviewing a decision such as this where there is a mixed question of law and fact (more particularly, how to apply the law to a specified set of facts) is to respect the decision unless it is clearly erroneous.
As to the merits, the appellate court began its discussion with an overview of the nexus standards applicable to the instant case as well as a brief discourse on the unitary business principle. It noted that under Illinois’ water’s edge combined reporting system, companies with 80% of their property and payroll outside the United States are excluded from the combined group.
Turning to the expatriate employees at issue, the court sought to determine if an employer-employee relationship existed between these employees and PGM. It used common law principles to make this determination. The court determined that PGM was not the expatriates’ employer. The foreign affiliates directed and controlled the activities of the expatriates, according to the court, and not PGM. The court noted the following factors in reaching this conclusion: annual performance ratings were done by a manager employed by one of the foreign host affiliates; the foreign companies bore the cost of salaries, benefits, insurance, and work facilities; and the foreign affiliates had the right to terminate the expatriate employees.
The court did not lend much credence to Pepsico’s argument that it had the right to control the expatriates vis-à-vis the secondment agreements with the foreign affiliates, concluding that these agreements did not result in an employer employee relationship between the expatriates and PGM. It noted that PGM had no control over compensation for the expatriates, and that PGM was 100% reimbursed for any payments and benefits it made to the seconded employees. Additionally, annual reviews and compensation adjustments were approved by a corporate compensation team at PCG, not at PGM. PGM, according to the court, had minimal control over the employees in question; control largely rested with the foreign affiliates and PCG. Given that the court found that PGM was not the employer, FLNA failed to meet the definition of an 80/20 company and should have been included in the Illinois filings.
The court likewise denied Pepsico’s request for an abatement of penalties. In order to qualify for an abatement of penalties under the reasonable cause standard, Pepsico could have shown it relied upon the advice of a competent and independent professional which was reasonable under the circumstances. The only witness it put on at the Tribunal in this regard was the Vice President of State and Local Tax at Pepsico. The court noted that Pepsico did not produce any opinion or advice from an outside advisor, nor could it produce any written evidence (such as a memo or other document) generated by the presumptively sophisticated tax department as to FLNA’s viability as an 80/20 company. The appellate court therefore denied to abate the penalties.
Forvis Mazars Insight: The appellate court veered from relying directly on the economic substance principles relied upon by the Tribunal, instead relying on the nature of the relationship between PGM and the expatriates to find that PGM was not their employer. The Illinois Supreme Court has yet to make a ruling directly addressing the economic substance doctrine.
In Hartney Fuel Oil Co. v. Hamer, the Illinois Supreme Court ruled on how local sales taxes are sourced, specifically in the context of businesses that strategically located their sales order acceptance offices in low-tax areas. Hartney, a fuel oil retailer, had located its sales office in the Village of Mark, Illinois, a location with no local sales taxes, to avoid paying higher local rates in other areas like Forest View and Cook County. The Illinois Department of Revenue challenged this, arguing that the company's sales should be sourced to its primary location in Forest View, based on where customers made their purchases, not where the sales order was accepted. The Department also raised the notion of economic substance, but the court held in favor of the taxpayer in that it followed the published regulations, albeit invalid ones.
How Forvis Mazars Can Help
Restructurings often have significant state and local tax impacts. Forvis Mazars can work with your internal tax department and inside or outside counsel to consider these impacts and work with these resources to make sure that you understand the state and local tax implications of the concomitant change in operations as the result of a restructuring.