NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in millions, except share data)

Note 3 Spin-off from and Transactions with Former Affiliates

On the Spin-off Date, we became an independent, publicly owned restaurant company encompassing the combined worldwide operations of KFC, Pizza Hut and Taco Bell (the "Core Business(es)") as well as the Non-core Businesses which were disposed of prior to the Spin-off.

Spin-off and relationship after the Spin-off.At the Spin-off Date, our common shares were distributed to the record date holders of PepsiCo common shares at a ratio of one share for each ten outstanding PepsiCo shares.After the Spin-off, PepsiCo had no ownership in us. Immediately after the Spin-off, however, certain of our shares were held by the PepsiCo pension trust on behalf of PepsiCo employees. We have entered into separation and other related agreements, (the "Separation Agreement") outlined below, governing the Spin-off transaction and our subsequent relationship with PepsiCo. Such agreements provide certain indemnities to the parties, and provide for the allocation of tax and other assets, liabilities and obligations arising from periods prior to the Spin-off. In addition, KFC, Pizza Hut and Taco Bell have each entered into a multi-year agreement with Pepsi-Cola Company, a wholly owned subsidiary of PepsiCo, regarding the purchase of beverage products. We have also signed a multi-year agreement with PFS, a former distribution affiliate, for the distribution of certain products and supplies to U.S. Company units.  Neither contract is for quantities expected to exceed normal usage.

The Separation Agreement provided for, among other things, our assumption of all liabilities relating to the restaurant businesses, inclusive of the Non-core Businesses, and the indemnification of PepsiCo with respect to such liabilities. The Separation Agreement provided that we pay, prior to the Spin-off, $4.5 billion to PepsiCo as repayment of certain amounts due to PepsiCo and as a dividend.  The net investment by and advances from PepsiCo were preliminary determined to be approximately $3.4 billion at the Spin-off Date.  The amount we repaid to PepsiCo in connection with the Spin-off was approximately $2.1 billion and the dividend we paid was approximately $2.4 billion.  PepsiCo contributed to our capital its remaining unpaid advances of approximately $1.3 billion as, provided by the Separation Agreement.  The Agreement also specifies that PepsiCo shall make a final determination regarding the net assets of the restaurants businesses transferred to us at the Spin-off Date.  This determination has been preliminarily completed, but is subject to our agreement.  The accompanying Consolidated Financial Statements reflect our estimates, based on available information, of the net assets that should be transferred. The final approved determination could vary from these estimates.  Any changes are not expected to materially affect future net income.

In addition, a fee will be paid to PepsiCo for all letters of credit, guarantees and contingent liabilities relating to our businesses under which PepsiCo remains liable until such time as they are released, terminated or replaced by a qualified letter of credit covering the full amount of such contingencies under such letters of credit, guarantees and contingent liabilities.  Payments for such fees to PepsiCo during 1997 totaled less than $1 million.  We have indemnified PepsiCo for any costs or losses incurred with respect to such letters of credit, guarantees and contingent liabilities.

In connection with the Spin-off, PepsiCo received a ruling from the Internal Revenue Service (the "IRS") to the effect, among other things, that the Spin-off would qualify as a tax-free reorganization under Sections 355 and 368 of the Internal Revenue Code of 1986, as amended.  Such a ruling, while generally binding upon the IRS, is subject to certain factual representations and assumptions provided by PepsiCo.  The Company has agreed to certain restrictions on its future actions to provided further assurances that the Spin-off will qualify as tax-free.   Restrictions include, among other things, limitations on the liquidation, merger or consolidation with another company, certain issuances and redemptions of our Common Stock, the granting of stock options and the sale, refranchising, distribution or the disposition of assets.  If we fail to abide by such restrictions or obtain waivers from PepsiCo and, as a result, the Spin-off fails to qualify as a tax-free reorganization, we will be obligated to indemnify PepsiCo for any resulting tax liability, which could be substantial.

Until the separation agreements, PepsiCo maintains full control and absolute discretion with regard to any combined or consolidated tax filings for  periods through the Spin-off Date.  PepsiCo also maintains full control and absolute discretion regarding common tax audit issues of such entities.  Although PepsiCo has contractually agreed to, in good faith, use its best efforts to settle all joint interests in any common audit issue on a consistent basis with prior practice, there can be no assurance that determinations so made by PepsiCo would be the same as we would reach, acting on our own behalf.

The separation agreements specify methods for allocation of assets, liabilities and responsibilities with respect to certain existing employee compensation and benefit plans and programs.  Such allocations have been preliminary completed for current and retired employees of the restaurant businesses.  In addition, all vested PepsiCo options held by our employees were not converted to TRICON options.  We have agreed to indemnify PepsiCo as to any employer payroll tax it incurs related to the exercise of such options after the Spin-off.  Certain provisions of the agreements also govern the transfer of employees between the parties during the transition period ending in 1998.  We have also agreed on arrangements between the parties with respect to certain internal software, third-party agreements, telecommunications services and computing services.

Allocations and Determination of Common Costs in Historical Financial Statements.  Prior to the Spin-off, our operations were financed through our operating cash flows, refranchising proceeds and investments by advances from PepsiCo.  These interest allocations were based on PepsiCo's weighted average interest rate applied to the average annual balance of investments by and advances from PepsiCo.

Additionally, our historical financial statements include an allocation of PepsiCo's previously unallocated general and administrative expenses.   These allocations were based on our revenue as a percentage of PepsiCo's total revenue.

The amounts, by year, of the historical allocations described above are as follows:

1997 through
Spin-Off Date

1996 1995
Interest allocated $188 $275 $316
PepsiCo weighted-average interest rate 6.1% 6.2% 6.6%
General and administrative expense allocated $ 37 $ 53 $ 52

We believe that the bases of allocation of interest and general and administrative expenses were reasonable based on the facts available at the date of their allocation.  However, based on current information, such amounts are not indicative of amounts which we would have incurred if we had been an independent, publicly owned entity for all periods presented.  As noted in the accompanying Consolidated Balance Sheet, our capital structure changed as a result of the Distribution to the PepsiCo and bears little relationship to the average net outstanding investments by and advances from PepsiCo as the $4.5 billion in borrowings to fund the dividend and repayments exceed the net aggregate balance owed to PepsiCo at the Spin-off Date.  We will be required to add personnel and incur other costs to perform services previously provided by PepsiCo.  The full cost reflective of our capital structure and our personnel complement will be included in our Consolidated Statement of Operations as incurred.  See Note 16.

For periods prior to the Spin-off, income tax expense was calculated, to the extent possible, as if we had filed separate income tax returns.   As PepsiCo managed its tax position on a consolidated basis, which takes into account the results of all of its businesses, our effective tax rate in the future could vary significantly from our historical effective tax rates.  Our future effective tax rate will be largely dependent on our structure and tax strategies as a separate entity.

Note 4 - Items Affecting Comparability of Net Loss

Certain large charges (credits) are identified below due to either their inherent variability or unusual nature to enhance comparability of periods presented. Facility actions net loss (gain) reflects both our initiative to reduce our percentage ownership of total system units by selling Company restaurants to new and existing franchisees and our committing to close underperforming stores. Impairment charges for restaurants we intend to continue to use in the business are also included in facility actions net loss (gain). Unusual charges are primarily related to the 1997 fourth quarter charge and the 1996 decision to dispose of our Non-core Businesses.

1997
1996
1995
Pre-
Tax
After-
Tax
Pre-
Tax
After-
Tax
Pre-
Tax
After-
Tax
Facility actions net loss (gain)(a) $247 $163 $(37) $(21) $402 $295
Unusual charges(b) 174 159 246 189 --- ---

(a)  Includes $410 million ($300 million after-tax) related to 1997 fourth quarter charges.
(b)  Includes $120 million ($125 million after-tax) related to 1997 fourth quarter charges and an additional $54 million ($34 million after-tax) related to the 1997 disposal of the Non-core Businesses.

1997 Fourth Quarter Charges
U.S. International Worldwide
Store closure costs $141 $ 72 $213
Refranchising losses 77 59 136
Impairment charges
  for stores to be
  used in the business


12
______


49
______
 

61
______

Total facility actions
  net loss
     230      180      410
Impairment of investments
  in unconsolidated affiliates


79

79
Severance and other 18
______
23
______
41
______
Total unusual charges 18
______
102
______
120
______
Total fourth quarter charges $248 $282 $530

The fourth quarter charge of $530 million ($425 million after-tax) represents actions taken to refocus our business.  The charge included (1) underperforming store closures, primarily at Pizza Hut and internationally; (2) restaurants we intend to refranchise whose carrying amounts were reduced to fair market value, less costs to sell; (3) impairment of certain restaurants intended to be used in the business; (4) impairment of certain joint ventures; and (5) related personnel reductions.

Facility Actions Net Loss (Gain)

1997 1997 (Excluding
4th Qtr. Action)
1996 1995
U.S.
Refranchising gains(a) $ (67) $(144) $(134) $(89)
Store closure costs 154 13 45 26
Impairment charges
  for stores to be
  used in the business


59
______


47
______
 

54
______



320
______
Facility actions net loss (gain) 146
______
(84)
______
(35)
______
257
______
International
Refranchising gains(a)(b) (45) (104) (5) (4)
Store closure costs, net 94 22 (5) 12
Impairment charges
  for stores to be
  used in the business


52
______


3
______
 

8
______



137
______
Facility actions net loss (gain) 101
______
(79)
______
(2)
______
145
______
Worldwide
Refranchising gains(a)(b) (112) (248) (139) (93)
Store closure costs 248 35 40 38
Impairment charges
  for stores to be
  used in the business


111
______


50
______
 

62
______



457
______
Facility actions net loss (gain) $ 247
______
$(163)
______
$ (37)
______
$402
______

(a)  Includes initial franchise fees in the U.S. of $39 million, $22 million and $8 million in 1997, 1996 and 1995, respectively, and in International of $2 million in 1997.  See Note 5.
(b)  Includes a tax-free gain of $100 million in 1997 from refranchising our restaurants in New Zealand through an initial public offering.

The impairment charges in 1997 and 1996 resulted from our semi-annual impairment evaluations of each restaurant to be used in the business.We early adopted Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" ("SFAS 121"), as of the beginning of the fourth quarter of 1995. The initial, non-cash charge of $457 million ($324 million after-tax), $120 million of which related to our Non-core Businesses, resulted from our evaluating and measuring impairment of restaurants to be used in the business at the individual restaurant level. Previously, we evaluated and measured impairment if a restaurant concept was incurring operating losses and was expected to incur operating losses in the future.

Unusual Charges

Exclusive of the fourth quarter charge, unusual charges include $54 million in 1997 and $246 million in 1996 resulting from our 1996 decision to dispose of our remaining Non-core Businesses. The 1996 charge represented the reduction of the carrying amounts of the Non-core Businesses to estimated fair market value, less costs to sell.The estimated fair market value was initially determined by using estimated selling prices based upon the opinion of an investment banking firm retained to assist in the selling activity.The 1997 charge adjusted the carrying amount of the Non-core Businesses to their actual selling prices less costs to sell. In accordance with the terms of certain of these transactions and the PepsiCo Separation Agreement, we retained and are holding for disposal certain properties and operating lease liabilities.   No value has been assigned to these properties and all the lease liabilities, net of the expected sublease recoveries, have been fully accrued. The Non-core Businesses contributed $268 million, $394 million and $297 million to revenues in 1997, 1996 and 1995, respectively. Excluding the unusual disposal charges in 1997 and 1996 and the $120 million initial impact of adopting SFAS 121 in 1995, the Non-core Businesses realized income of $10 million ($8 million after-tax) in 1997, and incurred losses of $15 million ($12 million after-tax) and $45 million ($37 million after-tax) in 1996 and 1995, respectively.

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