PepsiCo appeal leaves Commissioner with bitter aftertaste

The Full Federal Court earlier this week handed down its globally anticipated PepsiCo appeal decision, finding in favour of PepsiCo, Inc (PepsiCo) and Stokely-Van Camp, Inc (SVC) on both the Commissioner’s royalty withholding tax and diverted profits tax cases.

Late last year, 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 (DPT).  The Full Court (Perram, Colvin and Jackman JJ) on Wednesday disagreed, unanimously allowing PepsiCo’s/SVC’s appeals against the withholding tax assessments and dismissing by majority (Perram and Jackman JJ) the Commissioner of Taxation’s (Commissioner) DPT cross-appeals.

The ATO, who welcomed the first instance decision as confirmation of the DPT’s utility as an effective tool to tackle multinational tax avoidance, has indicated it is considering the Court’s decision (including whether any appeal may be appropriate), but has yet to release a formal statement.

Key takeaways

• Approach to contract interpretation and royalties analysis: The approach adopted by the majority is relevant to how entities should be analysing the form and substance of their arrangements, as well as any alleged ‘embedded royalties’. In particular
  • The majority considered that the application of the royalty withholding tax (RWHT) provisions must begin with the explicit terms of the relevant contracts; in this case, by an orthodox contractual interpretation of the exclusive bottling agreements (EBAs)
  • For both RWHT and DPT purposes, the majority pointed to economic rationality in determining the allocation (and compensation) of benefits and burdens under agreements involving both a transfer of goods and a grant of intellectual property rights
• Consequences of first instance proceedings: The appeal decision was constrained by the evidence led, and the submissions made, at first instance. This has important consequences in interpreting the broader impacts of the decision.  In particular:
  • Valuation evidence: The majority considered both parties’ valuation evidence to be predicated on unsubstantiated assumptions and therefore largely unhelpful. Acknowledging that the valuation of intangibles arises more frequently in a transfer pricing context, they suggested (consistent with KWM’s previous insight article published in December 2023) that Division 815-style evidence (Division 815 containing Australia’s domestic transfer pricing regime) would have assisted in establishing the relationship between the IP rights granted and the concentrate price set under the EBAs
  • Impact of tax treaties: As neither party contended that there was a relevant difference between the treatment of the payments as royalties under Australian and US law, the appeal decision, like the first instance judgment, did not address the overriding application of the US-Australia double taxation treaty
  • Evidence and pre-litigation review: Taxpayers should ensure they prepare the requisite evidence and rebuttal evidence, including of the sort considered by the Full Court in this decision, when documenting similar arrangements, particularly noting that under the DPT regime, a taxpayer is generally restricted in court to relying on evidence provided to the Commissioner during the matter’s audit phase
• Potential impact on ATO’s approach towards royalties and IP rights: Subject to any appeals to the High Court, this judgment will likely impact the ATO’s approach towards characterising payments as “royalties”, outlined most recently in its Draft TR 2024/D1 Income tax: royalties – character of payments in respect of software and intellectual property rights. The broad scope set out in this draft ruling (including the circumstances in which it is appropriate to look beyond the terms of a contract and rather look to arrangements as a whole) appears to be in direct contrast to the majority’s decision, and more aligned with Colvin J’s dissenting reasons
• Special leave: Given the case’s significance, it is likely the Commissioner will seek special leave to appeal to the High Court. In this respect we note:
  • Given all three judges agreed on the issue of constructive receipt (finding that the payments to a related party under the EBAs were not income derived by PepsiCo/SVC) such that no RWHT was payable, special leave on the RWHT arguments may be challenging
  • Insofar as the majority characterised the deficiencies in the Commissioner’s DPT case as principally evidentiary, the High Court could conclude that this case is not a suitable vehicle for Australia’s highest court to test the DPT regime. On the other hand, that this has been the first appellate authority to consider the DPT provisions could support a grant of special leave

Background

In our December 2023 insight article, we considered in detail the background to the matter and the terms of the relevant arrangements and therefore have only summarised this briefly below.

Broadly, during the 2018 and 2019 income years (the Relevant Period):

• under EBAs with PepsiCo and SVC (the PepsiCo Parties), Schweppes Australia Pty Ltd (SAPL) was appointed the sole distributor and “Bottler” in Australia of Pepsi, Mountain Dew and Gatorade;
• Concentrate Manufacturing (Singapore) Pte Ltd (CMSPL) produced concentrate for these beverages according to a formula provided by the PepsiCo Parties;
• CMSPL supplied the concentrate to PepsiCo Beverage Singapore Pty Ltd (PBS);
• under each EBA, PepsiCo/SVC nominated PBS (a non-party to the EBAs) as “Seller”, and PBS supplied concentrate to SAPL as “Bottler” in exchange for payments by SAPL to PBS totalling approximately A$240 million; and
• PBS then paid the money received from SAPL to CMSPL for its own acquisition of the concentrate, less a margin.

In the Federal Court (FCA) before Moshinsky J at first instance, the PepsiCo Parties unsuccessfully challenged the Commissioner’s issue to PepsiCo/SVC of:

• notices of 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.

The PepsiCo Parties subsequently appealed against the trial judge’s RWHT decision, while the Commissioner brought appeals against the trial judge’s DPT decision (predicated on success by PepsiCo and SVC in their appeals).

The Full Court’s decision

The Full Court (FCFCA) unanimously allowed the PepsiCo Parties’ appeals.  As explained below, the majority held that the payments made by the Bottler to the Seller were for concentrate alone and did not include a royalty component for the use of PepsiCo/SVC’s trade marks and other IP associated with the beverages.  While Colvin J dissented on this point, he joined the majority in finding that PepsiCo/SVC did not derive any income as a result of the payment flows described in the factual summary above, with the effect that the RWHT provisions could not apply.

Perram and Jackman JJ also dismissed the Commissioner’s cross-appeal, finding that the PepsiCo Parties did not enter into a scheme conferring on them a tax benefit, namely, that PepsiCo/SVC were not exigible to RWHT in either Australia or the United States.  Colvin J, on the other hand, would have allowed the Commissioner’s DPT appeal.

Royalty withholding tax

The Commissioner’s attempts to bring PepsiCo/SVC to tax under s 128B(2B) failed for two interrelated reasons: there was no ‘royalty’ as required by s 128B(2B)(b) and the payments made to PBS as Seller by SAPL as Bottler did not constitute ‘income derived’ by PepsiCo/SVC within the meaning of s 128(2B)(a).

It was not in dispute that whether the payments were consideration for the right to use the PepsiCo Parties’ IP required “an orthodox exercise in contractual interpretation” of the EBAs (at [12]).  It was also agreed that the ordinary meaning of the language used in the EBAs suggested that the Bottler was required to pay the Seller a price for the concentrate and therefore a price ‘as consideration for’ the sale of that concentrate. 

However, the majority dismissed the Commissioner’s contention that the relevant provisions also included a price component for the Bottler’s contractual entitlement to use the relevant IP.  Most significantly, this was on the basis that the Commissioner’s submission that the Bottler would otherwise have been granted IP right “for nothing” made the “overly simplistic assumption” (at [17] to [18]) that the grant of these rights was of benefit only to the Bottler (when in reality, there were obligations and restrictions placed on the Bottler as well as benefits to PepsiCo’s goodwill arising as a result of the arrangements).  

Notwithstanding that this conclusion meant it was strictly unnecessary to consider the derivation of income issue, the majority also opined on this point.

While a direction by a creditor to a debtor to pay a third party constitutes a payment to the creditor, this is the case only where that debtor owes the creditor an antecedent monetary obligation.  Here, no such monetary obligation arose, as the EBAs made clear that where a related entity was nominated as Seller, it was that related entity and not PepsiCo/SVC that would be selling the concentrate. That the PepsiCo Parties remained contractually bound to the Bottler to ensure that the related entity did, in fact, sell the concentrate, and that the Bottler could sue PepsiCo/SVC directly if the concentrate delivered was not of merchantable quality did not have the effect of making PepsiCo/SVC the vendor of the concentrate:  the parties were explicit that the vendor was to be the nominated related entity.  As the payments did not ‘come home’ to PepsiCo/SVC, the payments made by the Bottler to the Seller could not be income derived by PepsiCo/SVC.

Minority judgment

Colvin J, in dissent, preferred a contextual approach, reasoning that it was difficult to see why the statutory question of whether an amount has been paid ‘as consideration for’ relevant IP should be determined solely by reference to the express terms of the relevant agreement (or resort to extraneous circumstances be limited to resolving contractual ambiguity).  Despite this, because both parties framed the issue as one of proper construction of the EBAs, Colvin J declined to express a concluded view on this issue, and instead confined his decision similarly.

His Honour drew two key propositions from the relevant authorities for determining, as a question of construction, what an amount is paid as consideration for.  He considered it necessary to first determine from the agreement as a whole “the nature of the transaction or dealing that is provided for”, and characterised the consideration as “that which is actuating or moving the whole of that dealing” (at [193]).

Colvin J concluded that the EBAs were properly construed as agreements to bottle, sell and distribute branded products, not simply as agreements for the supply of concentrate, and the prices to be paid were therefore consideration in favour of PepsiCo/SVC (at least in part) for the right conferred by the EBAs to use their “valuable brands” (at [197]).  Interestingly, Colvin J did not engage with the majority’s observations that this exercise would necessarily require a weighing up not only of the benefits to, but also the obligations, burdens and restrictions imposed on, the Bottler.  In any case, his Honour joined the majority in allowing the RWHT appeal: he considered the amounts paid did not constitute income derived by PepsiCo and SVC for substantially the same reasons as Perram and Jackman JJ.

Diverted profits tax

In light of the majority’s finding that the payments did not include a royalty component, the trial judge’s conclusion that DPT could not apply was necessarily in error.  While Moshinsky J gave extensive reasons for why Part IVA would have applied if his primary conclusion that RWHT applied was incorrect, the Full Court’s role was to determine for itself the application of Part IVA based on its own findings on the RWHT issue.    

Perram and Jackman JJ relevantly observed:

• Both the Commissioner’s and PepsiCo’s experts provided opinions expressly premised on an assumption that the concentrate price included a royalty component, which assumption was likewise made by the Commissioner in advancing his DPT case. However, the majority held that there was no evidence before the Court that this assumption was correct
• While both parties’ valuation evidence quantified the value of the IP licence granted under the EBAs, there was no corresponding analysis of the economics of the EBAs and its relationship with the concentrate price establishing that the licence’s value was in fact being recovered through that price

Tax benefit

The scheme alleged by the Commissioner was PepsiCo’s/SVC’s entry into the EBAs on terms whereby no royalty was paid for the use of the PepsiCo IP. 

In support of his contention that by doing so, the PepsiCo Parties obtained a tax benefit, the Commissioner advanced two alternative postulates: namely, that – absent the scheme – the EBAs might reasonably be expected to have either:

• expressed the payments made by the Bottler to be for all of the property provided by (and promises made by) the PepsiCo Parties (rather than for the concentrate alone); or
• provided that the payments made by the Bottler to the Seller included a royalty for the use of the relevant IP.

The majority considered neither counterfactual to be a reasonable alternative to the scheme, on the basis that while the postulates:

• did achieve the same commercial results or consequences as the scheme, namely the payment of the same unspecified amount of money for either the concentrate (the scheme), the concentrate and all of the other property and promises under the EBA (the first postulate), or the concentrate and as a royalty for the right to use the IP (the second postulate): s 177CB(4)(a)(ii);
• they nonetheless departed from the economic and commercial substance of the scheme: s 177CB(4)(a)(i)).

As the scheme did not include as an element that the grant of the IP licence had economic value for the PepsiCo Parties or that the concentrate price included such value, and critically, no evidence was led to support the inclusion of such elements in the scheme, no inference could be drawn that the commercial and economic substance of the scheme was that the concentrate price included a royalty component. 

While the substance of the scheme was therefore that the price agreed for concentrate was for concentrate only, the substance of the first postulate was that the Bottler’s payments for concentrate would also be for the use of the PepsiCo Parties’ IP, while that of the second postulate was that the payments would be for concentrate and the IP rights.

This being the case, it could not be determined that, absent the scheme, PepsiCo/SVC would have sought to recoup the value of the royalty either by expressing the price for concentrate to be for the licence as well (the first postulate) or by specifying a separate royalty whether quantified or not (the second postulate).  Applying the statutory test in s 177CB(3), it was therefore not reasonable to think that, but for the scheme, the taxpayer would have entered into or carried into effect either postulate. 

Furthermore, as the state of the evidence and the terms of the scheme made it impossible to conceive of any reasonable alternative postulate (the only postulates which could bring the payments to RWHT being ones in which the Bottler’s payments for concentrate were in part for the grant of the IP rights), the PepsiCo Parties’ burden of proof was necessarily discharged.

Principal purpose

PepsiCo/SVC having obtained no tax benefit ‘in connection with a scheme’ for the purposes of s 177J(1)(a), they could not have had ‘a principal purpose’ of obtaining a tax benefit and/or of reducing their liability to tax under a foreign law for the purposes of s 177J(1)(b). 

Nonetheless, had the question of tax benefit been determined in the Commissioner’s favour, the majority would have reached the same conclusion as the trial judge: namely, that the requisite purpose under s 177J(1)(b)(i) was established (though they cautioned that Moshinsky J’s characterisation of the EBAs as “contrived” was not called for under s 177J(1)(b) (at [133]), this being a provision concerned solely with objective purpose).

Minority judgment

Following from Colvin J’s opinion for RWHT purposes that the amounts paid by the Bottler consisted of a royalty because they were paid as consideration for the use of the trade marks, Colvin J in dissent considered that it was the mechanism by which a related entity could be nominated as the Seller (and therefore receive the payments under the EBAs) which meant that no royalty income arose that could be made subject to RWHT.

This, therefore, was in his Honour's view the relevant scheme: the EBAs resulted in a tax benefit because, had they not been entered into, a reasonable alternative postulate was entry into EBAs which provided for the royalty to be paid to PepsiCo/SVC as holder of the trade marks. 

On this basis, Colvin J considered PepsiCo/SVC had failed to discharge their burden that there was no reasonable alternative to entering into the scheme.  Concurring with the majority on the question of the PepsiCo Parties’ principal purpose, his Honour would have upheld the Commissioner’s DPT appeal.