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Illinois decides 80/20 company inclusion question

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The Illinois Independent Tax Tribunal recently decided that a company that qualified as an 80/20 company under the statutory requirements could not be excluded from the Illinois unitary group.1 In doing so, the Tribunal held that a single member limited liability company (SMLLC) owned by the company lacked economic substance and should not be considered in the analysis. In the opinion, the Tribunal determined the payroll costs and calculation of excluded 80/20 companies for ultimate inclusion in the Illinois unitary group. According to the Tribunal, an SMLLC must have economic substance for inclusion in the analysis and only the true employer of expatriate employees may include them in the 80/20 calculation.

Background The taxpayer, PepsiCo, manufactures, markets, and sells a variety snacks, beverages, and foods in approximately 200 countries around the world. The largest operations take place in North America and the United Kingdom. PepsiCo’s operations are divided into three principal business lines: (i) beverages (e.g., Pepsi and Gatorade), (ii) the snack-food business (e.g., Frito-Lay potato chips), and (iii) the grain-based foods business (e.g., Quaker Oats cereal). While domestic employees are divided across the three business lines, foreign employees serve all three lines.

Frito-Lay North America, Inc. (FLNA) operates PepsiCo’s domestic snack food business. Following a 2010 global restructuring, Frito-Lay, Inc. (FLI) became a direct and wholly owned subsidiary of FLNA. FLI performed some of the daily operations of the snack food line, while FLNA continued to employ the “general management.” FLNA’s gross sales during the 2011-2013 tax years subject to audit approximated $8.6 billion per year. All sales, with the exception of approximately $230 million of foreign sales from the United States shipped abroad, were sales within the United States.

During the tax years at issue, PepsiCo offered global job postings through its Expatriate Program. Under this program, employees took assignments throughout the world with PepsiCo’s related foreign business entities. Most expatriates were designated to work for the snack-foods business exclusively or partially (as opposed to other business lines). In June 2010, PepsiCo formed PepsiCo Global Mobility LLC (PGM) as an SMLLC owned by FLNA. PepsiCo elected to treat this new entity as disregarded for federal and state income tax purposes. All expatriates were listed as employees of PGM.

PGM reported payroll consisting only of expatriate employees assigned to work for and under the direction and control of Foreign Host Companies. There were no transactions reported other than offsetting compensation expense and “other income” resulting from reimbursement of the payroll expense. PGM reported no other employees, did not report ownership of any tangible or real property, and did not maintain an office. All decisions regarding assignment of these employees were made by PepsiCo Corporate Group’s management. Upon assignment, PGM ceded control over the expatriates to the Foreign Host Companies.

Following an audit, the Illinois Department of Revenue issued notices of deficiency for the 2011-2013 tax years that disallowed PepsiCo’s treatment of FLNA as an excluded 80/20 company. The Department added FLNA’s income, approximately $2.5 billion each year, to PepsiCo’s unitary group’s income. PepsiCo filed two petitions with the Tribunal that were consolidated and only concerned the FLNA 80/20 issue for the 2011-2013 tax years. PepsiCo filed a motion for summary judgment with the Tribunal.

Unitary group inclusion (80/20 Rule) In general, Illinois follows the rule that all unitary members of the business group must be included in the unitary group.2 However, Illinois allows an exemption for water’s edge filers that can demonstrate that more than 80% of their business activities fall outside the United States (commonly known as the 80/20 rule). To qualify, the member must calculate a ratio of its domestic to worldwide property and payroll factors.3 If these calculations reflect that less than 20% of the member’s business activity is conducted within the United States, the exemption is available for that member and that member’s income and apportionment factors are excluded from the overall income of the unitary business group for Illinois income tax purposes.4

PepsiCo argued that the 80/20 statute provides a “straight-forward mechanical” test that should not be further analyzed beyond the calculation itself. Said another way, once the payroll and property ratios are calculated, the analysis required to determine whether such company meets the 80/20 rule is complete. According to PepsiCo, since PGM was the true employer of the foreign employees, PGM’s employees were required to be included in determining whether FLNA met the 80/20 exclusion. Moreover, PepsiCo contended that PGM was critical to the success of PepsiCo as a whole, and that in any event, economic substance is not applicable to an analysis of the 80/20 exclusion. In response, the Department argued additional examination was necessary in this instance as the exclusion of FLNA via PGM resulted in a “gross distortion of income attributable to Illinois business activities.”

The Tribunal agreed with PepsiCo’s assertion that the 80/20 statute mandates straightforward mathematical calculations. However, the Tribunal rejected the notion that the Department must accept the calculations of the taxpayer5 as the Department is normally afforded the opportunity to properly review a tax return6 and a “taxpayer has the burden of proving clearly it is entitled to an exemption.”7

Substance over form Over time, judicial anti-abuse doctrines have developed to “prevent taxpayers from subverting the legislative purpose of the tax code.”8 The concept of “substance over form” has been the primary anti-abuse doctrine since its inception in 1935.9 As explained by the Tribunal, substance over form “determines the taxability of transactions and that legal transactions or entities which have neither real economic substance and business purpose are disregarded for tax purposes.” Congress further clarified this concept in 2010 by enacting Internal Revenue Code (IRC) Section 7701(o), providing that economic substance of the transaction is met “only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected.”10

PepsiCo argued the Department could not look beyond the mechanical test, and that applying the substance over form doctrine would go against legislative intent as found in Summa Holdings.11 While the Tribunal acknowledged there is nothing wrong with attempting to lower tax obligations, and a transaction can even have tax reduction as a primary goal, it determined that transactions must provide economic substance. As explained by the Tribunal, “[i]n enacting the 80/20 test, the Illinois legislature did not intend to a create a tax-avoidance vehicle that lacked economic substance to incentivize companies to conduct certain business operations by creating tax-savings advantages.” In fact, the Tribunal determined that the use of the term “business activity” in the 80/20 statute refers to a consideration of the true substance of a taxpayer’s business operations.

During the time in question, PGM had no assets, capitalization, management or supervisory employees, or offices. It conducted no business that could potentially create any profit. The Tribunal found that PGM was a shell corporation to be disregarded for having no economic substance or valid business purpose. Furthermore, the Tribunal concluded PGM existed only on paper to avoid certain states’ income taxes and did not exert control over the expatriates. Ultimately, the employees could not be considered employees of PGM or FLNA. Since the transaction did not meet the substance over form doctrine, the Tribunal denied PepsiCo’s motion for summary judgment and upheld the Department’s assessment.

Commentary This decision, as it stands, provides further guidance to taxpayers regarding how the Department is interpreting 80/20 exclusion positions. The most interesting part of this determination is that the Tribunal accepted the Department’s ability to go beyond the simple mechanical calculation in analyzing the validity of the 80/20 exclusion, and instead applied “substance over form” concepts.

This decision should be compared to International Business Machines Corp. v. Illinois Department of Revenue, in which the Tribunal also ruled on an 80/20 company determination.12 The Tribunal addressed the IBM case during the 80/20 company portion of its PepsiCo opinion, but did not specifically mention IBM during its substance over form analysis. The Tribunal did not apply the doctrine of substance over form in IBM. As explained by the Tribunal in IBM, “[w]hether or not the ‘substance over form’ doctrine is even applicable or relevant in the present case is a question best left for another day as it cannot be answered on the undeveloped record before the Tribunal.” Apparently, the Tribunal determined that the record was sufficiently developed in PepsiCo and the substance over form doctrine was applicable and relevant. The PepsiCo decision was the “another day” anticipated by the Tribunal in IBM.

While the PepsiCo case is likely to be appealed, this is a significant change in the 80/20 analysis. It should be noted that bills were introduced in the Illinois General Assembly during the last legislative session to revise the definition of an 80/20 company to include only a foreign incorporated company and not a domestic incorporated company.13

The Department likely selected this case and pursued it based on the level of materiality because the income added to the Illinois base for PepsiCo exceeded $2.5 billion for each of the years in question. Based on PepsiCo’s analysis, as noted in the Tribunal’s decision, this transaction would have resulted in savings of approximately $14 million per year in state income taxes across appropriate states. Query whether the matter would have reached the Tribunal if the tax effect of the transaction was substantially lower.

While the Tribunal stated there is no issue with taxpayers attempting to lower their income tax liability, transactions with no economic reality that violate the anti-abuse doctrines set forth in federal and Illinois case law, as well as IRC Sec. 7701(o), will not be respected. Ultimately, the Tribunal went against the mechanical straightforwardness of the 80/20 rule. In doing so, the Department arguably is taking the analysis beyond that written by the legislature. To the extent that the taxpayer relied on the statutory test solely, it met the mechanics of the 80/20 test. However, the taxpayer could have taken steps to mitigate the substance test relied upon by the Tribunal. For instance, the salaries of the employees paid by PGM were reimbursed dollar for dollar by the foreign host companies. If the employees were actual employees of PGM, and PGM exercised direction, control, and supervision of the employees, this may have provided enough substance to escape scrutiny from the Department.



1 PepsiCo Inc. and Affiliates v. Illinois Department of Revenue, Illinois Independent Tax Tribunal, Nos. 16 TT 82 and 17 TT 16, April 13, 2021.
2 35 ILL. COMP. STAT. 5/1501(a)(27)(A).
3 Ill. ADMIN. CODE tit. 86 § 100.9700(c)(2)(A).
4 35 ILL. COMP. STAT. 5/1501(a)(27).
5 International Business Machines Corp. v. Illinois Department of Revenue, Illinois Independent Tax Tribunal, No. 14 TT 229, June 30, 2015.
6 35 ILL. COMP. STAT. 5/1401.
7 Quoting International Business Machines, Illinois Independent Tax Tribunal, No. 14 TT 229, which cites United Air Lines, Inc. v. Johnson, 419 N.E.2d 899, 904 (Ill. 1981).
8 Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1353 (Fed. Cir. 2006).
9 Gregory v. Helvering, 293 U.S. 465 (1935).
10 IRC § 7701(o)(2)(A).
11 Summa Holdings, Inc. v. Commissioner, 848 F.3d 779 (6th Cir. 2017).
12 Illinois Independent Tax Tribunal, No. 14 TT 229, June 30, 2015.
13 H.B. 2085, introduced Feb. 5, 2019; S.B. 1115, introduced Feb. 5, 2019. Both bills died upon adjournment.



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