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The decision provides clarity around royalty withholding tax as well as diverted profits tax.
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The ATO’s loss to PepsiCo in the Full Federal Court
05 July 2024
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Broadly, the case involved an agreement that provided for an Australian ‘bottling’ company (SAPL) to make payments to a US company (PepsiCo) or its Australian nominee for the acquisition of beverage concentrate.
SAPL was to mix the concentrate with other ingredients in accordance with formulas and specifications provided from PepsiCo so that SAPL could then produce finished beverages for sale in Australia.
Under the arrangement, PepsiCo granted an explicit and/or implicit right to use trademarks and other intellectual property (IP) associated with the beverages (such as bottle and can designs), yet the relevant agreement did not provide for the payment of any royalty for the right to use any IP.
Issue
The primary issue before the court was whether payments made by SAPL to PepsiCo’s Australian nominee for the ‘concentrate’ in fact included a (deemed embedded) royalty component for the licence to use the trademarks and IP that was taken to be paid to PepsiCo. If so, royalty withholding tax would be payable on that royalty component.
The secondary issue was if royalty tax did not apply, did the diverted profits tax (DPT) apply on the basis that PepsiCo entered into schemes for the principal purpose of obtaining tax benefits (being the lack of royalty withholding tax in Australia or the US)? The DPT only applies to significant global entities (SGEs) (entities with turnover of $1 billion or more), whereas the primary issue has a much broader application.
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First instance – the Federal Court
At first instance, the Federal Court agreed with the ATO and held that when considered in its business and commercial context, the (deemed) payment to PepsiCo was to be characterised as a royalty because:
- PepsiCo was a party to the agreement and owned the relevant IP.
- The agreement contained an express and implied licence of the IP to SAPL.
- The licence was fundamental to the agreement.
- Given the strength and value of the Pepsi brand, it would be very surprising if PepsiCo would be prepared to license the IP for nothing.
After considering the expert evidence of each party, the court held that the appropriate royalty rate embedded within each payment was 5.88 per cent of SAPL’s net revenue amount.
Given the finding, there was no need for the trial judge to consider the DPT, but his Honour indicated that DPT would have applied had the Commissioner lost on the primary question of withholding tax.
The Full Federal Court
By majority, the Full Court held that the payments from SAPL to PepsiCo’s appointed Australian subsidiary did not attract royalty withholding tax because the payments were for ‘concentrate alone and did not include any component which was a royalty for the use of [PepsiCo’s] IP’. In ascertaining whether any part of the payments were in ‘consideration for’ the use of IP, attention is ‘confined to the terms of the contractual documents’.
The majority considered that to ‘see the trademark [and IP] licence as simply a contractual grant of a right solely for the benefit of the grantee’ (thereby justifying the inference that the payments must have included an embedded royalty component) is to ‘misunderstand the nature of the rights involved’.
The majority found that the lack of a royalty was understandable because under the arrangement.
- PepsiCo benefited by virtue of ‘having their goodwill sustained and enhanced’ by SAPL.
- SAPL faced significant restrictions and burdens - for example, unlike a copyright or patent licence, it was not permitted to use the trademarks for any purpose it liked, and so it could not sell its cola under the Pepsi brand.
- SAPL was bound to use the trademarks only for the purpose of distributing PepsiCo’s particular beverages.
In other words, the Full Court did not accept that to find otherwise meant that PepsiCo was giving away its valuable brand for nothing.
Additionally, all three members of the Full Court held that even if the payments were a royalty, the payments were not made to – and so were not derived by – the US entity, PepsiCo. Rather, the payments were made to – and so derived by – PepsiCo’s Australian subsidiary ‘on its own account’.
While drawing no firm conclusion, the majority observed that had they found that the payments by SAPL did include an embedded royalty component, it is possible that the royalty would have been taken to have been paid to PepsiCo (US) possibly based on an agency or trust relationship between PepsiCo and its Australian subsidiary.
Despite this conclusion, the majority accepted that there may be cases where it is apparent that a price set under a contract for the transfer of property does, on a proper construction of the contract, include an embedded royalty component. Such cases will present a ‘conventional exercise in contractual interpretation and will turn on the language used by the parties.’ However, this was not relevant in this case because here the licences were not given for nil value but rather for the benefits enjoyed by PepsiCo and the restrictions and burdens imposed on SAPL outlined above.
In reaching its conclusion, the Court grappled with reconciling the application of certain High Court cases, which may open the door to an appeal.
Although only relevant to SGEs, the Full Court also held that the DPT did not apply because PepsiCo did not obtain a tax benefit since there was no reasonable alternative to the scheme the parties entered into that would have resulted in an enhanced tax liability. That is, if the scheme by which the transaction was implemented had not been entered into, it was not the case that the taxpayer might have reasonably been expected to have been liable to pay royalty withholding tax.
Takeaway
We will need to watch this space to see whether the ATO will seek special leave to appeal to the High Court and/or whether it updates its draft ruling TR 2024/D1 to reflect the Full Court’s decision.
It should also be noted that standard ‘white labelling’ arrangements may be distinguishable from this case on the basis that the licensees under such arrangements are permitted to use the grantor’s IP to sell their own marketed products, which would typically be expected to include a royalty component.
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