Illinois Pepsi Tax Decision Shows 80/20 Rule Is a Policy Relic

The Sangamon County Circuit Court’s recent decision in PepsiCo Inc. v. Illinois Dept. of Revenue—which held that PepsiCo improperly excluded an affiliate from its water’s-edge combined return—suggests that there are limits to the courts’ willingness to condone tax-motivated corporate restructurings that rely on changes to accounting practices but have little or no economic substance to them.

The case also highlights the need for states to reconsider their statutes exempting “80/20” companies from combination. These statutes invite underreporting of in-state profits by allowing income to be shifted to genuine foreign operating companies and paper ones alike.

Illinois is one of 14 states to exclude US corporations with at least 80% overseas property and payroll factors from the combined return. The carveout came into being as states moved away from worldwide combined reporting in the 1980s. It was justified as an accounting convenience for multinational enterprises, allowing them to conduct foreign operations through US subsidiaries without state tax complications. That historic justification seems increasingly tenuous in this age of sophisticated accounting software.

PepsiCo affiliate PepsiCo Global Mobility LLC, or PGM, was established to meet the letter of the 80/20 laws even though its only business activity was holding the rights to PepsiCo’s entire domestic snack foods business through a disregarded entity, Frito-Lay North America Inc.

The key to the plan was to establish PGM as the employer of record for scores of PepsiCo’s overseas employees. The plan’s downfall was that it was all too obvious that those employees had nothing to do with the domestic snack foods business.

The Sangamon County Circuit Court concluded that PGM “was created to operate and was, in fact, operating as a ‘shell’ company for purposes of tax benefits for Frito-Lay.”

Because it was a shell company, PGM lacked the ability to control the activities of its nominal employees and so couldn’t be considered their employer under common law standards. PepsiCo failed to rebut the state’s prima facie case that the creation of PGM—and the agreements that purported to place PepsiCo’s overseas employees on PGM’s books—lacked economic substance. The circuit court’s decision follows a similar conclusion reached by the Illinois Independent Tax Tribunal in 2021, concerning the 2011–2013 tax years.

The PepsiCo litigation is the latest example of the potential for abuse arising from the 80/20 exclusion. Minnesota eliminated its 80/20 carveout in 2013, following the determination of the state’s highest court that a single employee’s presence in the Cayman Islands was sufficient to allow a bank to avoid tax on its profits derived from loans to Minnesota customers.

Some state tax practitioners took the holding in HMN Financial Inc. v. Commissioner and similar cases to signal that the federal economic substance doctrine had no place in state tax determinations. The PepsiCo decision comes as a welcome reaffirmation of the basic principle that substance controls over form in state as well as federal tax matters.

The mechanism by which 80/20 companies can be used to shift profits away from the states’ taxing jurisdiction is easily explained. The federal tax code is designed to function on what is essentially a water’s-edge combined reporting basis under its consolidated filing rules. The tax code permits property transfers between members of the consolidated group without recognition of gain, because the entire domestic group is essentially treated as a single taxpayer.

Transfers of property to actual foreign affiliates, meanwhile, trigger a tax liability measured by the transferee’s expected profits from that property. Because the 80/20 companies are regarded as domestic companies for federal tax calculations, no gain is recognized when a related party transfers intangible property to them, defeating the logic of the federal system.

The dual nature of these entities sets the stage for transferring unlimited amounts of intangible property—and the profits commensurate with that property—to an entity that the states have chosen not to tax. Similarly, 80/20 companies can be used to report global intangible low-taxed income and other federal income amounts that would otherwise be included in the state tax base.

The PepsiCo case—and a similar case in Wisconsin involving the transfer of Skechers USA Inc.’s intellectual property to a holding company—may signal a refreshing willingness by state tax administrators to contest the economic substance of state-tax-motivated transactions.

The 2010 federal codification of the economic substance doctrine in Section 7701(o) of the tax code has buoyed the states’ efforts. That provision places the burden of proof on a taxpayer to demonstrate that a transaction changed the taxpayer’s economic position apart from tax savings, and had a substantial non-tax business purpose. It should provide a solid analytical foundation for courts to evaluate whether the tax effects of similar tax-motivated transactions should be disregarded.

Many state tax minimization plans are similarly vulnerable to challenge under the economic substance doctrine. They tend to rely on transactions between members of the same federal consolidated group that occur mostly on paper and so would rarely be capable of changing the group’s economic position in a meaningful way.

Somewhat ironically, the absence of a legitimate policy justification for the state’s 80/20 exclusion may have contributed to PepsiCo’s inability to demonstrate the economic substance of its arrangement. It would be difficult to show how moving PepsiCo’s domestic snack food business to a purported foreign operating company would increase the company’s profitability—or even that it had reduced compliance burdens.

It doesn’t appear that PepsiCo tried to prove either claim. Had there been a substantial purpose to the 80/20 carveout, the taxpayer may have succeeded in showing how its restructuring would advance that purpose.

Not all transactions between taxpayers and their 80/20 cousins are susceptible to challenge under the economic substance doctrine, nor should they be. Instead, state legislatures must acknowledge that the policy reasons that might have supported the carveout in the 1980s no longer apply—and consider eliminating this relic of what we affectionately call the “tainted eighties.”

The case is PepsiCo Inc. v. Illinois Department of Revenue, Ill. Cir. Ct., No. 2022TX000155, decided 1/9/25.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Bruce Fort is senior counsel at the Multistate Tax Commission. The views expressed herein are those of the author and do not necessarily represent the views of the Multistate Tax Commission or its members.

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