Multinationals in Australia will feel Pepsi tax defeat for years

Angela Wood, Andy Bubb
21 Dec 2023
3 minutes
The Federal Court of Australia’s ruling that PepsiCo’s arrangements with its Australian bottler triggered royalty withholding tax has consequences for MNEs in IP-intensive industries.

Australia’s tax victory over PepsiCo will have major consequences for multinational enterprises that operate in the country. Multinational enterprises (MNEs) should brace for increased scrutiny of embedded royalties that arise from intellectual property use and possible changes to tax treaty interpretation.

The Federal Court of Australia on Nov. 30 ruled in favor of the Australian Taxation Office in its dispute with PepsiCo Inc. The ATO convinced the court that PepsiCo’s business arrangements triggered the federal royalty withholding tax, and diverted profits tax would have applied regardless.

The case, PepsiCo Inc. v. Commissioner of Taxation, was the first time a court had considered Australia’s diverted profits tax since its introduction in 2017.

It involved Pepsi US’s exclusive bottling agreement contracts with Schweppes, an unrelated third party owned by Asahi Group Holdings Ltd. Under the contracts, Pepsi US could choose the entity that sold the concentrate to Schweppes – it selected Pepsi AUS – and licensed certain IP to Schweppes such as trademarked labels on a purportedly royalty-free basis.

Schweppes was to pay solely for the concentrate, which was manufactured by Pepsi Singapore and sold to it via Pepsi AUS. Schweppes then sold the finished drinks to wholesalers in Australia. The ATO successfully argued that a royalty arose based on the substance of the arrangements, despite the contract saying otherwise.

The court reached four factual findings. First, the IP licence in the Pepsi-Schweppes agreement was fundamental to the parties’ relationship. Second, the PepsiCo party to the agreement was Pepsi US (the IP owner) rather than Pepsi Singapore (the concentrate manufacturer) or Pepsi Australia (the seller). Third, PepsiCo always provided an IP licence when selling concentrate. And fourth, the strength of the PepsiCo brand meant that its IP was valuable.

Having found that a royalty arose, the court needed to quantify it. It ultimately accepted that a relief from royalty method was most appropriate, adopting part of the analysis of the ATO’s expert, James Malackowski, in arriving at a rate of 5.88% of net revenue.

The withholding tax finding made it unnecessary for the court to decide the diverted profits tax issue, but it did so anyway, concluding that the tax would have applied if royalty withholding tax had been avoided.

Australia’s diverted profits tax applies to arrangements whose principal purpose is to obtain certain tax benefits, such as avoiding withholding tax. The ATO focused on how the pricing clause was expressed in the Pepsi-Schweppes contract.

The ATO argued that if not for tax reasons, the payment would have been expressed in the contract as being made for all the rights that Schweppes obtained, or at least expressly for the IP – not just for the concentrate.

The court agreed. Justice Mark Moshinsky favored the ATO’s first counterfactual: a contract with the expressed price being for all of the property Schweppes obtained. This approach would require the payment to be apportioned across the property acquired, including a royalty for IP use.

Justice Moshinsky then concluded the pricing arrangement had been entered into for the principal purpose of obtaining a diverted profits tax benefit. He said the strongest factor in the ATO’s favor was the contrast between the legal form of the contract, involving no royalty, and its commercial substance, where the IP use was critical to the parties’ business outcomes.

He added that “the terms of the [agreements] are contrived, in that payments that are ostensibly for concentrate alone are in substance for both concentrate and the licence of valuable intellectual property.”

Scrutiny of embedded royalties

The ATO’s scrutiny of the embedded royalty issue likely will continue. MNEs, particularly those in IP-intensive industries such as life sciences, technology, and retail, will need to review their arrangements to determine if an embedded royalty arises from IP use in Australia.

Under the test applied by Justice Moshinsky, whether a royalty arises will depend on the substance of the arrangements, and can arise even where there is no express licence or where the licence is said to be royalty-free.

The PepsiCo court had the benefit of expert evidence from both parties in concluding that the embedded royalty rate was 5.88% of net revenue. The experts’ analysis was scrutinized closely in the judgment, which provides guidance on what approach may be accepted for MNEs that are calculating their royalties.

Given that there is no statutory limitation period for Australian withholding tax, significant exposure may arise for taxpayers caught in the crosshairs.

The evidence showed that PepsiCo has had royalty-free arrangements for decades, meaning the ATO could theoretically seek to recover an enormous amount of historical withholding tax, even though the case only concerned the fiscal years ending in 2018 and 2019.

Treaty benefits

The ATO has other diverted profits tax cases, including the Coca-Cola Co.'s Federal Court proceedings. Diverted profits tax is increasingly considered in audits alongside the general anti-avoidance rule and the transfer pricing provisions.

Australia’s diverted profits tax is contained within its anti-avoidance provisions, giving it primacy over tax treaties. Accordingly, no treaty relief is available to taxpayers who are subject to the tax.

Also, the diverted profits tax’s purpose test likely will be relevant to treaty interpretation going forward. The principal purpose test is in many of Australia’s tax treaties and denies treaty benefits for arrangements created mainly for that purpose.

The PepsiCo decision applied this test and confirmed that it is a lower bar than the dominant purpose test that applies under Australia’s GAAR.

If PepsiCo chooses to challenge the ruling, it must file an appeal to the full Federal Court within 28 days of the court’s final orders, which haven’t yet been made. A full Federal Court decision before the end of 2025 would seem unlikely.

Copyright 2023 Bloomberg Industry Group, Inc. (800-372-1033) Reproduced with permission.

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