PepsiCo, Inc v Commissioner of Taxation [2024] FCAFC 86 – Another twist in the embedded royalties tale

Summary

As expected, the Commissioner of Taxation (Commissioner) has now applied for special leave to appeal to the High Court of Australia in respect of the recent decision of the Full Federal Court (FFC) in PepsiCo, Inc v Commissioner of Taxation [2024] FCAFC 86 [1].

The Full Federal Court decision found in favour of PepsiCo, Inc (PepsiCo), with the majority finding that there was no embedded royalty to which royalty withholding tax could apply, and that the diverted profits tax provisions (DPT) in Part IVA of the Income Tax Assessment Act 1936 (Cth) (Part IVA) had no application, overturning the decision of the lower court in PepsiCo, Inc v Commissioner of Taxation [2023] FCA 1490. A&M’s analysis of the first instance decision can be found here.

Whether the High Court will agree to hear the appeal remains to be seen. However, the outcome of the Commissioner’s application for special leave (and any resulting appeal) should bring much welcome clarity to a complex area of the law. For now, the FFC decision represents a win for multinationals on embedded royalties and indicates that a holistic and substance-based approach should be adopted when characterising payments under distribution and other cross-border agreements. At the same time the actual form of the arrangements should be respected unless there is evidence to disregard them. As the first case to consider the DPT provisions in Part IVA, the case also provides important commentary on these provisions as well as the formulation of alternate postulates under Part IVA more generally (an issue which has been considered in several recent and high profile Part IVA cases).

In Brief

At the centre of the case were the exclusive bottling agreements (EBAs) entered into between PepsiCo, its subsidiary Stokely-Van Camp (SVC) and Schweppes Australia Pty Ltd (the Bottler). The Commissioner had taken the position that a portion of the payments made by the Bottler to purchase concentrate from a PepsiCo-nominated related entity (being SVC) should have been subject to royalty withholding tax, on the basis that the payments included an embedded royalty component for the use of PepsiCo’s valuable trademarks and intellectual property.

Whilst the Federal Court initially found in favour of the Commissioner, in a split 2-1 decision the majority of the Full Court rejected the Commissioner’s arguments on appeal, finding that the concentrate payments did not include any royalty element, and that the DPT provisions in Part IVA did not apply.

This represents an important win for PepsiCo and for multinationals operating in Australia. Subject to the Commissioner’s success on appeal, the decision also provides valuable judicial guidance for other multinational enterprises engaging in similar licensing and distribution arrangements in Australia (particularly those with valuable intellectual property utilised by local subsidiaries or third parties).

Case Background and Timeline

The Exclusive Bottling Agreements

The EBAs between PepsiCo/SVC and the Bottler were agreements governing the Bottler’s appointment as the exclusive distributor of PepsiCo’s branded beverages in Australia. Key aspects of the EBAs included:

• PepsiCo appointed the Bottler as the sole and exclusive licensee to bottle, sell and distribute its beverages, including Pepsi, Mountain Dew, and Gatorade;
• PepsiCo (impliedly) and SVC (expressly) granted the Bottler a licence to use their trademarks and other intellectual property;
• The EBAs specified the prices the Bottler would pay per unit of concentrate required to manufacture the beverages; and
• PepsiCo/SVC nominated an Australian entity, PepsiCo Beverage Singapore Pty Ltd as “Seller”, who supplied concentrate to the Bottler in exchange for payments by the Bottler to the Seller.

Importantly, the EBAs did not provide for any separate royalty payment by the Bottler for the use of the trademarks and intellectual property.

The Commissioner’s Position

The Commissioner had issued assessments seeking to impose royalty withholding tax on the basis that a portion of the concentrate payments should have been characterised as royalties. The Commissioner argued that the EBAs, properly construed, showed the payments were partly consideration for the use of PepsiCo’s valuable intellectual property.

Alternatively, the Commissioner asserted that the payments would be subject to the DPT provisions, a measure introduced into Part IVA of the Income Tax Assessment Act 1936 (Cth) in 2017, as PepsiCo/SVC had the principal purpose of avoiding royalty withholding tax and reducing its foreign tax liabilities. This would have resulted in PepsiCo being liable for diverted profits tax at a punitive 40% rate [2].

The Full Federal Court’s Reasoning

In rejecting the Commissioner’s arguments, a majority of the Full Court emphasised that the definition of “royalty” in the tax law focuses on whether an amount is paid “as consideration for” the use of intellectual property, rather than how the amount is described or calculated.

Embedded Royalty Argument

Applying principles of contractual interpretation, the Court found that the prices specified in the EBAs did not include any element for the license to use trademarks or other intellectual property but were payments for the beverage concentrate itself. In reaching this conclusion, the Court noted that the EBAs were not merely agreements for the supply of concentrate, but rather comprehensive arrangements governing the Bottler’s appointment as the exclusive distributor of PepsiCo’s branded beverages.

Importantly, the Court acknowledged that the trademarks and intellectual property licensed to the Bottler had significant commercial value. However, it ultimately determined that the concentrate prices, as specified in the EBAs and as paid to the PepsiCo-nominated Seller, were not paid “as consideration for” the use of trademarks or other intellectual property rights, but that these rights were granted as part of a wider commercial arrangement which generated benefits both for Pepsi-Co/SVC (broadly, having its product distributed and goodwill retained) and the Bottler as distributor (broadly, its rights to distribute the beverages and revenue generated from these activities). In addition, all three justices found that the payments could not be subject to royalty withholding tax as PepsiCo/SVC had not derived any income, with income instead being derived by the Seller – an Australian entity nominated by PepsiCo/SVC.

Diverted Profits Tax Argument

The majority of the Full Federal Court also rejected the Commissioner’s alternative case under the DPT provisions in Part IVA. The Commissioner put forward two alternative postulates [3], neither of which were considered by the majority to reflect the true “commercial and economic substance” of the transaction. Satisfised that neither of the Commissioner’s alternative postulates were reasonable (and further that there were no other reasonable alternative postulates), the majority held that no tax benefit was achieved by PepsiCo/SVC, and consequently the DPT could not apply.

A&M’s Key Observations

This case and the Commissioner’s application for special leave represents another chapter in the saga of embedded royalties, which the Commissioner has sought a position on for many years and adds further complexity to the already challenging issue of royalty withholding tax for multinational corporations operating in Australia, and the application of the DPT. In particular:

• The Full Federal Court judgment indicates that provided the commercial substance of the arrangement is genuinely a payment for the supply of goods or services (including, as in this case, as part of a broader commercial arrangement and as described in the legal agreements), these payments can be distinguished from royalties for the use of intellectual property, even where the intellectual property is valuable and essential to the business model or broader commercial arrangement. In assessing what the payments were “consideration for”, the majority of the Full Federal Court undertook an extensive analysis not only of the rights granted to the Bottler, but the benefits to PepsiCo/SVC of the arrangement and concluded that the rights to use the valuable intellectual property rights were granted as part of a broader and mutually beneficial commercial arrangement.
• The Commissioner’s grounds of appeal to the High Court unsurprisingly indicate that the Commissioner still considers that the payments under the EBAs included an embedded royalty component, with the Commissioner arguing that neither the label given to a payment nor the way in which it is calculated should be determinative of what the payment is “consideration for”. In this respect, any appeal to the High Court is likely to involve the Commissioner running similar arguments to those run at first instance (with success) and on appeal (with less success, with the Commissioner explicitly referencing in the grounds for appeal the reasoning of Full Federal Court dissenting justice Colvin J, who considered that the EBAs were for “much more” than the supply of concentrate – and therefore that the payments must have also been for more than just the concentrate).
• Contrary to the conclusion of all three justices of the Full Federal Court (who unanimously considered that any embedded royalty payments did not “come home” to PepsiCo/SVC) the Commissioner’s grounds of appeal argue that due to PepsiCo/SVC’s nomination of the Seller, the embedded royalties were derived by, paid to and dealt with on behalf of PepsiCo/SVC (and were therefore capable of attracting royalty withholding tax). The outcome of any appeal on this ground will have relevance far beyond cross-border intellectual property and distribution agreements, and is likely to be relevant to the “derivation” question in the context of nominations, payment directions and trust and agency relationships more generally;
• The Full Federal Court decision indicates that in identifying alternate postulates under the DPT and more broadly under Part IVA, regard must be had to the “commercial and economic substance” of the overall transaction and what it achieves, rather than just the technical contractual wording. The Commissioner’s grounds of appeal on the DPT issue argue that it is the taxpayer who bears the burden of proof in demonstrating not only that the Commissioner’s alternate postulate is not reasonable, but in satisfying the Court of a postulate that is reasonable (and that PepsiCo failed to do this). The question of what is a reasonable alternate postulate is a consistent theme across other recent decisions, including a string of recent Part IVA defeats for the Commissioner. For example, in the recent Ierna [4] case, the Commissioner contended that a restructure and subsequent capital reduction was a scheme aimed at avoiding tax and proposed an alternative postulate which the Federal Court rejected as “just not reasonable” – with Part IVA therefore having no application. Our insights on the Ierna case can be found here. Similarly, in the recent Mylan [5] case, Button J ultimately found that the Commissioner’s primary alternate postulate did not represent a prediction of the events which might reasonably have taken place, with the Court presenting and applying its own alternative postulate (but ultimately finding no dominant purpose). Our insights on the Mylan case can be found here.
• Ultimately, whilst not enlivened in the PepsiCo case, this case shows the DPT provisions remain available for use by the Commissioner (particularly given the dissenting justice Colvin J concluded that the DPT applied, and all three justices of the Full Federal Court agreed that the “principal purpose” test in the DPT provisions was satisfied). Multinationals must be cognisant in ensuring that their cross-border arrangements have a sound commercial rationale, particularly given the emphasis placed by the courts on economic and commercial substance of transactions rather than just their legal form.
• Regardless of the outcome of the Commissioner’s special leave application, we expect the Commissioner to continue scrutinising intangible arrangements, looking for any evidence that the pricing of goods or services may include an embedded royalty component. In announcing the special leave application, the Commissioner also indicated that the finalisation of the recently released draft ruling TR 2024/D1 – Income tax: royalties – character of payments in respect of software and intellectual property rights will be deferred until after the outcome of the High Court decision (which is not surprising as the Commissioner’s detailed analysis and position regarding embedded royalties in that draft ruling stand somewhat in contradiction to the positions set out in the Full Federal Court decision). Our insights on the draft ruling can be found here.
• Careful regard to commercial considerations, appropriate pricing and documentation will remain key to managing the risk of challenge on similar arrangements. This will be even more relevant to “significant global entities” with the introduction of new penalties for the mischaracterisation or undervaluing of royalty payments which would otherwise be subject to royalty withholding tax, as announced in the 2024/2025 Federal Budget (albeit with limited details – see our summary of this measure in our budget update here). This raises the stakes for multinationals, with the split decision in this case and the Commissioner’s special leave application resulting in yet another chapter in the embedded royalties saga. Hopefully, the outcome of the special leave application will bring much needed clarity and certainty to an area of the law replete with complexity.

[1]. ATO seeks special leave to appeal to High Court in the PepsiCo Inc v Commissioner of Taxation case: https://www.ato.gov.au/media-centre/ato-seeks-special-leave-to-appeal-to-high-court-in-the-pepsico-inc-v-commissioner-of-taxation-case.

[2]. Broadly speaking, the objective of Part IVA is to target schemes where the dominant purpose is to obtain a tax benefit, whereas DPT specifically targets multinational corporations diverting profits from Australia to low-tax jurisdictions.

[3]. The two alternative postulates put forward by the Commissioner were: (1) the relevant EBA would have expressed the payments to be for all of the property provided (and promises made by) the PepsiCo entities – rather than for concentrate only; or (2) the relevant EBA would or might reasonably be expected to have expressly provided for the payments to include a royalty for the use of, or the right to use, the relevant trademarks and other intellectual property (whether or not the amount of the royalty was specified).

[4]. Ierna v Commissioner of Taxation [2024] FCA 592.

[5]. Mylan Australia Holding Pty Ltd v Commissioner of Taxation (No 2) [2024] FCA 253.

https://www.alvarezandmarsal.com/insights/pepsico-inc-v-commissioner-taxation-2024-fcafc-86-another-chapter-embedded-royalties-saga