Decision Alert: Federal Court finds PepsiCo liable for royalty withholding tax and potential diverted profits tax

By Ryan Leslie, Geraldine Chan and Graeme Cooper

Overview

The Federal Court has ruled in favour of the Commissioner of Taxation (Commissioner) against PepsiCo, Inc (PepsiCo) in PepsiCo, Inc v Commissioner of Taxation [2023] FCA 1490 (30 November 2023). The case concerned PepsiCo’s “royalty-free” agreements with Schweppes Australia Pty Ltd (SAPL).

The Federal Court ruled that PepsiCo was liable for royalty withholding tax (at a 5% rate) in relation to portions of payments made under exclusive botting agreements (EBAs) which were held to be royalties and, in the alternative, diverted profits tax (DPT) would apply at a rate of 40%, i.e. if the payments were not royalties.

This decision was the first time the DPT provisions were considered by a Court. PepsiCo have now appealed the decision. In order to achieve a successful outcome, PepsiCo needs to succeed on both the royalty issue and the DPT issue. If PepsiCo succeeds on the royalty issue but doesn’t also succeed on the DPT issue on appeal, this would increase the tax bill 8-fold.

Key takeaways

• Scrutiny of “royalty-free” arrangements: the case further emphasises the ATO’s ongoing focus on cross-border intangible arrangements where royalty withholding tax has not been paid, including where licences are granted and no express royalty is payable. Multinational entities operating in Australia under similar arrangements may face increased scrutiny. The ATO has also released a draft taxation ruling TR 2024/D1 Income tax: royalties – character of payments in respect of software and intellectual property rights, which reflects its current draft views on when payments made in respect of software and intellectual property rights will be a royalty. Those views continue to differ from those expressed in the now withdrawn ruling TR 93/12.
• A broader approach to characterisation of “royalties”?: previous case law in IBM and Task Technology had emphasised that in determining whether payments made are characterised as royalties, Australian courts have interpreted the rights and obligations under the relevant agreement,’ as the agreement will determine whether the payments are for the right or use of, relevantly, software. However, the decision of the Federal Court indicates that in considering whether a payment constitutes a “royalty”, it is necessary to consider the characterisation of the relevant payments and the terms of the relevant agreements in their “business and commercial context”. The Court drew support from section 6(1) of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) which defined royalty regardless of how the payments are described and that Article 12(4) referred to payments “of any kind”.
• Payments from an Australian resident entity to another Australian resident entity may give rise to royalty withholding tax: the Federal Court found that the payments made by SAPL were “income derived by” and “paid at the direction of” PepsiCo since the EBA obliged SAPL to buy concentrate from PepsiCo or a subsidiary nominated by PepsiCo. Such a broad reading of the EBA would appear to impose a withholding obligation on SAPL (despite SAPL paying an Australian entity and not being pursued for failure to withhold penalties based on the facts described in the case).
• DPT: the Federal Court’s decision sheds some light on the application of the DPT provisions. It confirms that the “principal purpose test” within the DPT provisions is a lower bar compared to the “dominant purpose test” within the general anti-avoidance provisions. The Federal Court confirmed that the meaning of “principal purpose” is “a purpose that is a prominent, leading or main purpose”, of which there can be more than one but need not be the dominant purpose.

Background

PepsiCo and Stokely-Van Camp, Inc (SVC), had EBAs with an independent Australian bottling company, Schweppes Australia Pty Ltd (SAPL). Under this agreement, PepsiCo or SVC agreed to sell, or cause a related entity to sell, beverage concentrate to SAPL for bottling and sale, and granted SAPL the right to use the Pepsi and Mountain Dew trademarks. However, no royalties were paid under the agreement, and therefore, no withholding tax was paid in Australia. The only relevant payments made were for the purchase of concentrate. During the 2017-18 and 2018-19 years (the Relevant Years):

• Concentrate Manufacturing (Singapore) Pte Ltd (CMSPL), a Singaporean entity and a member of the PepsiCo Group, produced concentrate according to a recipe or formula provided by PepsiCo and SVC;
• CMSPL supplied the concentrate to PepsiCo Beverage Singapore Pty Ltd (PBS), an Australian entity also a member of the PepsiCo Group;
• PBS supplied concentrate to SAPL and invoiced SAPL for the concentrate that had been supplied and SAPL paid PBS for the concentrate; and
• PBS transferred the money received from SAPL to CMSPL (we assume as a concentrate purchase price – the ATO did not seem to assert that any portion of this payment was a royalty), retaining only a small margin.

It is interesting to note that the terms of the EBAs were changed in 2020, and the payment and pricing terms were removed from the EBAs and instead moved to a separate Concentrate Sale Agreement. Such a change may have led to a different tax outcome for Pepsico and SVC, however this was not considered by the Federal Court as the change to the terms of the EBAs occurred after the Relevant Years.

The Commissioner issued royalty withholding tax notices under section 128B of the ITAA 1936 to PepsiCo and SVC requiring both entities to pay approximately $3.6 million in royalty withholding tax on money paid by SAPL to PBS.

In the alternative, the Commissioner issued DPT assessments pursuant to Part IVA of the ITAA 1936 imposing a tax liability of $28.9 million on PepsiCo and SVC.

Decision

Royalty withholding tax

The Federal Court held that royalty withholding tax was payable because:

• a portion of the payments made by SAPL to PBS were “consideration for” the use of, or the right to use, the relevant trademarks and other intellectual property which were provided under the EBAs, in the circumstances of this case. As such, the payments satisfied the definition of “royalty” in Article 12(1) of the US DTA and section 6(1) of the ITAA 1936. Although PBS was not a party to the EBAs, the Federal Court held that payments made by SAPL and PBS were linked to the license of PepsiCo’s trademarks and intellectual property (that is, without PepsiCo’s trademarks and IP: (a) SAPL would not have been able to package and sell the beverages under PepsiCo’s and SVC’s brands and if so, it could be inferred that SAPL may not have agreed to make the payments, and (b) a failure by SAPL to perform its payment obligations could result in a termination of the agreement and therefore the licence). The Federal Court’s consideration of the treaty was on a ‘textual’ basis and did not consider extrinsic materials that may have assisted in interpreting it;
• the circumstances in which a royalty will be found to be payable extend beyond the terms of the agreement, and may include the business and commercial context in which the agreement was struck. In the circumstances, his Honour considered that it was appropriate to look beyond the description of the payments in the agreement between the parties. His Honour concluded that “the licence of the trademarks and other intellectual property was fundamental to the agreement” and that “the payments…were linked with the licence of the trademarks and other intellectual property”;
• the relevant portions of the payments were income derived by PepsiCo or SVC for the purposes of section 128B(2B)(a) of the ITAA 1936 and amounts to which they were beneficially entitled for the purposes of Article 12 of the US DTA. As PBS was nominated as the seller of the concentrate under the EBAs, the Federal Court held that this constituted a direction to pay PBS rather than PepsiCo/SVC. The payments therefore “came home” to PepsiCo/SVC by being applied as they directed; and
• for the same reasons above, the relevant portions of the payments were therefore deemed to have been paid by SAPL to PepsiCo or SVC by virtue of section 128A(2) of the ITAA 1936. The payments were “dealt with on behalf of PepsiCo/SVC” or dealt with “as PepsiCo/SVC directs” as the Federal Court concluded that PepsiCo and SVC were entitled to receive the payments made by SAPL under the EBAs and had nominated PBS as the seller of the concentrate under the EBAs, and thereby directed SAPL to pay PBS.

The conclusion that the payments were “income derived by” entities other than the entities which sold the concentrate seems to rely on a very broad interpretation of the relevant concepts.

DPT

The Federal Court held that if the royalty withholding tax provisions did not apply, the DPT provisions would apply.

The alleged scheme was entry into the EBAs on terms whereby no royalty was paid for the use of intellectual property. In determining that each of PepsiCo and SVC obtained a “tax benefit”, The Federal Court accepted the Commissioner’s counterfactual that absent the scheme, the EBAs might reasonably have been expected to express the payments to SAPL to be for all of the property provided by PepsiCo rather than for concentrate only. Consequently, PepsiCo/SVC might reasonably be expected to have been liable to pay royalty withholding tax on a portion of the payments.

The Federal Court ruled that:

• each of PepsiCo and SVC obtained a tax benefit in connection with the relevant scheme; and
• having regard to the matters in section 177J(2) of the ITAA 1936, it would be concluded that PepsiCo and SVC in entering into or carrying out the relevant scheme had a principal purpose to obtain a tax benefit (not being liable to pay Australian royalty withholding tax) and to reduce foreign tax (US tax on their income). Relevantly, the Federal Court considered that one of the factors indicating the presence of the requisite principal purpose was the disconnect between the form and substance of the EBAs. In form, the payments to be made by SAPL were for the concentrate alone and not for the licence of the trademarks and other intellectual property. However, in substance, the payments to be made by SAPL were for both the concentrate and the licence of the trademarks and other intellectual property.

Although PepsiCo was unsuccessful in arguing that the royalty withholding tax provisions did not apply to the arrangement, the tax liability for PepsiCo and SVC would have been significantly higher if the royalty withholding tax provisions did not apply and the DPT applied instead (5% of the royalty amount under the royalty withholding tax provisions compared to 40% of the royalty amount under the DPT provisions).

In view of PepsiCo’s decision to appeal the decision, we expect that a superior court’s view on the issues will be instructive on both the royalty and DPT issues, though it of course remains possible a settlement is reached before an appeal is heard given the downside risk if the royalty withholding tax aspects of the appeal succeed and the DPT aspects do not.