Embedded royalties not just ‘the flavour of the month’: Federal Court scrutinises PepsiCo’s intangibles arrangements

On 30 November 2023, Moshinsky J handed down the Federal Court’s decision in Pepsi Inc v Commissioner of Taxation [2023] FCA 1490 (PepsiCo decision), finding in favour of the Commissioner of Taxation (Commissioner) in a case on the royalty withholding tax provisions. This decision is also the first time a Court has considered the diverted profits tax (DPT) since its introduction in 2017.

Moshinsky J ruled that a component of payments made by an Australian company under exclusive bottling agreements with two US beverage companies were royalties that triggered a withholding tax liability, and in the alternative, were subject to diverted profits tax.

Key takeaways include:

• The decision gives some guidance regarding the ATO’s views on “embedded royalties” that trigger royalty withholding tax, as outlined in the ATO’s Taxpayer Alert TA 2018/2 and other ATO commentary. However, the decision does not expand on the approach to the interpretation of the overriding application of the US-Australia double taxation treaty (US DTA), but rather treats the uniformity of Australia’s domestic provisions and the treaty as a foregone conclusion. Whether this is accurate, especially after considering OECD Commentaries and other sources of technical interpretation, is left for another day.
• The decision emphasises the need for taxpayers to engage appropriately qualified experts in relation to the quantification of royalty rates and will likely lead to increased compliance costs for taxpayers whose cross-border arrangements may require a detailed apportionment exercise.
• In determining whether an entity derived income (and whether income was paid to that entity) for the purposes of the withholding tax regime and whether an entity was beneficially entitled to those amounts under Article 12 of the US DTA, the Court’s conclusion seemed a departure from what appears to be the terms of the arrangement.
• While the ATO has welcomed the decision as confirmation that DPT can be an effective tool to tackle multinational tax avoidance, the decision applies the DPT provisions succinctly, and perhaps lacks the detail that the tax community may have sought, including how DPT differs from the general anti-avoidance rules in Part IVA of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936).

Background

PepsiCo, Inc (PepsiCo) and Stokely-Van Camp, Inc (SVC) are US companies forming part of the PepsiCo Group. In April 2009, both Pepsi (as owner of the Pepsi and Mountain Dew brands) and SVC (as owner of the Gatorade brand) entered into Exclusive Bottling Agreements with Schweppes Australia Pty Ltd (SAPL), an Australian company owned by Asahi Breweries, as “Bottler” (the EBAs).[1]

Under each EBA, PepsiCo or SVC agreed to sell (or cause a related entity to sell) concentrate to SAPL to produce beverages for Australian retail sale.

To enable SAPL to manufacture, bottle and distribute the finished beverages in branded PepsiCo Group packaging, PepsiCo or SVC granted SAPL the right to use the necessary trademarks and other intellectual property (IP) in Australia.

While the EBAs specified the purchase price payable by SAPL for the concentrate, they did not expressly provide for any payment for the right to use the PepsiCo Group’s IP.

During the 2018 and 2019 income years (the Relevant Period):

• Concentrate Manufacturing (Singapore) Pte Ltd (CMSPL) (a Singaporean member of the PepsiCo Group) produced concentrate according to a formula provided by PepsiCo and SVC;
• CMSPL supplied the concentrate to PepsiCo Beverage Singapore Pty Ltd (PBS), an Australian PepsiCo Group entity;
• under each EBA, PepsiCo or SVC nominated PBS as “Seller”, an entity not party to the EBA, and PBS supplied concentrate to SAPL as “Bottler” in exchange for payments totalling approximately A$240 million; and
• PBS transferred the money received from SAPL to CMSPL, less a margin.

The Commissioner issued:

• notices of royalty withholding tax (RWHT) applying s 128B of the ITAA 1936 and Art 12 of the Australia-US tax treaty, imposing around $3.6 million in RWHT; and
• in the alternative, DPT assessments applying Part IVA of the ITAA 1936, imposing around $28.9 million in additional tax for the Relevant Period,

to PepsiCo and SVC (the PepsiCo Parties) for the Relevant Period. In response, the PepsiCo Parties sought declaratory relief with respect to the RWHT notices in proceedings under s 39B of the Judiciary Act 1903 (Cth) and challenged the DPT assessments in proceedings under Pt IVC of the Taxation Administration Act 1953 (Cth). All six proceedings were heard together.

The key issues in dispute

1. The RWHT dispute: whether the payments made by SAPL under the EBAs constituted “royalties” for RWHT purposes – that is:

• whether the payments were, to any extent, consideration for the use of or right to use the items set out in the definition of “royalty” in Art 12(4) of the US DTA and s 6(1) of the ITAA 1936;
• whether the relevant portions of the payments were income derived by and paid (or taken to have been paid) to PepsiCo or SVC for the purposes of s 128B(2B)(a) and (b)(i) of the ITAA 1936 and amounts to which they were beneficially entitled for the purposes of Art 12 of the US DTA; and
• if the answer to both is yes, the amount of the royalties upon which royalty withholding tax is payable.

2. The alternative DPT dispute: if the payments made by SAPL under the EBAs do not constitute “royalties”, whether entry into the relevant EBA on terms whereby no royalty was paid was a scheme to which the DPT provisions applied because:

• PepsiCo/SVC obtained a tax benefit in connection with the scheme; and
• it would be concluded, having regard to the matters in s 177J(2) of the ITAA 1936, that one of the persons who entered into or carried out the scheme or part of it did so for a principal purpose (or for more than one principal purposes that includes the purpose) of enabling PepsiCo/SVC to obtain a tax benefit, or both obtain a tax benefit and reduce their liability to tax under a foreign law.

The Court’s decision

Moshinsky J ruled in favour of the ATO, holding that each of the relevant payments were in part a royalty subject to RWHT (in answer to the Commissioner’s RWHT primary case) and that, even if they did not contain a royalty component, DPT would apply in any event.  

Royalty withholding tax

Section 128B of the ITAA 1936 broadly provides that royalties paid by an Australian resident to a non-resident are subject to RWHT (subject to a number of exceptions and qualifications not presently relevant). Meanwhile, Article 12 of the Australia-US tax treaty prevails over Australia’s domestic RWHT provisions to the extent of any inconsistency.

Both s 6(1) of the ITAA 1936 and Art 12(4) of the Australia-US tax treaty define “royalties” by reference to payments or credits made “as consideration for” the use or right to use certain property or rights, or the supply of certain knowledge or information. It was not in dispute that the IP licensed to SAPL under the EBAs was of a kind which attracted both provisions. However, the PepsiCo parties argued that no amount was payable by SAPL to the PepsiCo parties “as consideration for” the use of any IP, because, inter alia:

• the Commissioner’s case was predicated on an a priori assumption i.e. as SAPL had the right to use the IP under the EBAs with PepsiCo and SVC, the payment to PBS must therefore have included something for that right;
• the objective purpose of the EBAs, as part of a business model dating back to the early 1900s, was to establish a mutually beneficial arrangement to enhance the goodwill in the PepsiCo Group brands sold in Australia; and
• the amounts for which SAPL undertook to purchase concentrate from PBS were unambiguously expressed to be solely for the purchase of concentrate.

Finding that both Art 12(4) and s 6(1) provide that the description given to a payment by the parties to a transaction is not determinative, Moshinsky J approached the task as one of characterisation. Considering the terms of the EBAs in their business and commercial context, he placed particular weight on the following in concluding that SAPL’s payments were, to an extent, “consideration for” the PepsiCo Group’s IP:

• PepsiCo and SVC, as brand owners, rather than PBS, as concentrate producer, were parties to the EBAs;
• as the licence of the IP was the basis for SAPL’s right to package and sell the beverages under the “strong and valuable” Pepsi, Mountain Dew and Gatorade brands, an inference could be drawn that SAPL would not have agreed to make the payments without the licence; and
• under the EBAs, failure by SAPL to perform its payment obligations could result in a termination of the agreement, and therefore also the IP licences further linking the payments with the licences.

Moshinsky J also found that the payments were income “derived by” and constructively “paid to” PepsiCo/SVC, and that PepsiCo/SVC were “beneficially entitled” to those amounts. This finding was based on a conclusion that PepsiCo/SVC were entitled to receive payments under the EBAs for concentrate and had directed those payments to PBS by reason of the nomination of PBS as seller of the concentrate under the EBA. It seems that in making that finding his Honour would have needed to construe an implied term that PepsiCo/SVC had direct recourse to SAPL for payments in respect of the concentrate provided by PBS. This finding is curious (at least for PepsiCo) given that PepsiCo does not appear (based on the clauses referred to in the decision) to have any contractual right to receive the payment for the supply of the concentrate by a nominated third party.

Expert evidence

Each party called one expert witness to quantify what proportion of the amounts paid by SAPL constituted a royalty, on the assumption that (contrary to the PepsiCo Parties’ position) part of those amounts did constitute a royalty. The PepsiCo Parties’ expert (a forensic accountant with minimal experience valuing IP) considered four alternative methods, while the Commissioner’s expert (an IP consultant with extensive experience in valuing IP rights, including assessing reasonable royalty rates) adopted two.

Moshinsky J selected a method proposed by both experts which relied on an analysis of comparable licence agreements to perform a benchmarking exercise. Ultimately, however, Moshinsky J preferred the Commissioner’s expert due to his greater experience and more persuasive rationale for including certain agreements in his set of comparables. On this basis, he adopted his royalty rate of 5.88% of SAPL’s net revenue from sales of the relevant products during the Relevant Period (subject to one minor adjustment), rather than the 2.5% put forward by the PepsiCo Parties’ expert.

The decision highlights the difficulties in obtaining acceptable expert evidence. In choosing the “Relief from Royalty” method of valuation, both experts had to identify comparable agreements. This is a notoriously difficult challenge for integrated and difficult-to-value intellectual property. Perhaps, an economist’s approach to analysing the entire value chain would have given rise to a different result. Under this methodology, would the secret formula and thus the taste of the beverage be characterised as more valuable than the brand, which perhaps could be suggested as a guarantee of the taste? Both PepsiCo and its rivals have launched failed products (the taste of which was not received well) despite being sold under the relevant brand name. While analogies are not always helpful, when one buys a BMW, are the distributor and you paying for the brand or is the brand a guarantee of the engineering know-how and intellectual property underpinning the performance of the vehicle?

Diverted profits tax

Under the DPT regime, broadly, the Commissioner may impose tax at a penalty rate of 40% on significant global entities for schemes carried out for a “principal purpose” of obtaining an Australian tax benefit (or both an Australian tax benefit and the reduction of a foreign tax liability), in circumstances where the taxpayer obtains a tax benefit from the scheme. This “principal purpose” test intentionally lowers the evidentiary hurdle of the “sole and dominant purpose” test contained in the general anti-avoidance rules in Part IVA.

In this case, the alleged scheme was entry into the EBAs on terms whereby no royalty was paid for the use of IP. In determining that each of PepsiCo and SVC obtained a “tax benefit”, Moshinsky J accepted the first of the Commissioner’s two alternative counterfactuals: namely, that absent the scheme, the EBAs might reasonably have been expected to express the payments to SAPL to be for all of the property and promises provided by the PepsiCo Parties (rather than for concentrate only), with the effect that RWHT would have been payable.

Moshinsky J therefore considered this counterfactual to be a reasonable alternative as required by s 177CB(4)(a) of the ITAA 1936 on the basis that, when compared to the EBAs:

• its substance was the same, as under both arrangements, the payments to SAPL were substantively made for both the concentrate and the licence of the IP; and
• the financial and other consequences for the PepsiCo Parties were comparable. While the PepsiCo Parties argued that the counterfactual would introduce complexity into pricing under the franchising business model, which was designed to be “simple”, Moshinsky J considered the evidence to support considerable scope to negotiate the EBAs’ (sometimes complex) pricing terms. Furthermore, he failed to see how a “relatively small textual change” would “open very wide discussions”.

The analysis adopted for quantifying the royalty amount for RWHT purposes was deemed equally applicable for quantifying the “tax benefit” under DPT.

Moshinsky J concluded that one of the principal purposes of each of PepsiCo and SVC in entering into or carrying out the scheme was to obtain a tax benefit (namely avoiding Australian RWHT) and to reduce foreign tax (namely, US income tax).  Among other factors, one element that weighed in favour of the Commissioner’s analysis was the disconnect between the form of the EBAs, which provided that the payments made by SAPL were for the concentrate alone, and their substance, the payments having in fact been made for both the concentrate and the licence of the IP.

Observations and implications

• The finding that the payments were partly a royalty, rather than the alternative of upholding the DPT assessments, resulted in a much lower tax cost to PepsiCo. This was because the treaty rate for royalties is limited to 5% whereas the DPT rate (on the same royalty amount) is 40%.
• This decision marks the latest in a series of hurdles faced by Australian taxpayers that exploit intangibles. It is preceded by around five years of increasingly proactive ATO guidance in this space – including for instance Taxpayer Alert TA 2018/2 relating to embedded royalties and Taxation Ruling TR 2021/D4 relating to royalties and the character of receipts in respect of software – as well as Exposure Drafts released by Treasury in March and June 2023 which proposed to deny deductions for certain payments relating to intangibles connected with low corporate tax jurisdictions.  As we noted in May, the ATO’s increasing focus on intangibles, and in particular the concept of “embedded royalties”, has caused concern internationally, including on the basis that the stance may not align with internationally recognised OECD principles.  Despite these concerns, the PepsiCo decision is an unambiguous sign-post for the ATO to continue its consideration of cross-border intangible arrangements.
• The Court’s acceptance that any rights granted in relation to IP under a contract may render payments made pursuant to that contract a “royalty” is a victory for the ATO’s expansive approach to the characterisation of royalties under Australian law. However, while the decision briefly notes that the provisions in the ITAA 1936 must give way to the US DTA to the extent of any inconsistency, it appears (possibly with the agreement of the parties in this case) to assume the uniformity of Australia’s domestic provisions and the treaty as a foregone conclusion. Whether this is accurate, especially after considering OECD Commentaries and other sources of technical interpretation, is left for another day.
• The Court’s application of the facts to determine who derived income and who income was paid to for the purposes of the RWHT regime / determining beneficial entitlement under Article 12 of the US DTA, seems at odds with the agreed arrangement. A strict reading of Moshinsky’s reasoning would lead to the conclusion that as the whole of the payment made by SAPL under the EBA was income derived by PepsiCo and SVC, intermediate entities in similar arrangements may never derive any income from such arrangements (which does appear to be a strange outcome).
• In light of the PepsiCo decision, taxpayers seeking to both price and risk assess their intangibles-related business arrangements should arm themselves with appropriate expert analysis to pre-empt any challenge on the quantum of a royalty under any relevant arrangement. While Subdivision 815-B issues were not raised by the proceedings, issues relating to the valuation of intangibles arise much more frequently in the context of transfer pricing (TP). It is unclear the extent to which TP principles were considered by the experts (or alternatively, why the parties did not employ experts skilled in TP methodologies and principles) and whether this would have altered the analysis. In particular, if those principles were applied, the question arises whether more profit would be attributed to the concentrate, being a key element provided to the bottler, as opposed to the intellectual property.
• With respect to the DPT analysis, the PepsiCo decision (as the first Australian case to deal with these provisions) was anticipated to provide some much-needed clarity, however it is not immediately apparent that this has been achieved. The DPT rules make two main changes to the ordinary Part IVA purpose test. First, the range of relevant considerations is expanded from the original eight in s 177D(2) to 11. Secondly, the test is satisfied by a principal purpose which may be one of a number of principal purposes, and need not be the dominant purpose.  While the ATO has described the PepsiCo decision as a “landmark” case in relation to DPT, neither of these novel aspects received significant attention and analysis in the decision.
• While official confirmation is unlikely before the expiry of the statutory time limit at the end of this month, PepsiCo Parties may appeal Moshinsky J’s decision to the Full Federal Court. This would provide taxpayers with a second chance for judicial clarification regarding the domestic and international understanding of what constitutes a royalty for RWHT purposes, and the application of the DPT to intangibles arrangements.
• In the interim, considering that the Commissioner’s ability to raise adjustments under the RWHT provisions is not subject to a statute of limitations, it is foreseeable that the PepsiCo decision will have implications for taxpayers’ historical arrangements regardless of how long these have been in place.