New test, new doubts on royalty withholding tax and diverted profits tax from Pepsi appeal

Angela Wood, Andy Bubb
27 Jun 2024
4 minutes
The Pepsi decision changes the approach for determining if taxpayers are liable to withholding tax in Australia for IP use, particularly where trade marks are involved so multinationals operating in Australia will need to continue reviewing their arrangements to determine their level of risk that royalty withholding tax or the DPT might apply.

Yesterday's Full Federal Court decision in the Pepsi case was a win for Pepsi US, but the Court's findings on royalty withholding tax (RWT) sets a new test which throws some doubt on existing tax arrangements, and thus opens the door to future disputes with the ATO. The Court also found that the diverted profits tax (DPT) did not apply. On both issues the Court overturned the views of Justice Moshinsky at first instance.

Underlying the case was an exclusive bottling agreement (EBA) between Pepsi US and Schweppes Australia:



Royalty withholding tax – a new test

The Full Federal Court concluded that RWT did not apply, for two reasons.

No embedded royalty

The majority concluded that no embedded or implied royalty was part of the price paid by Schweppes Australia for the concentrate. To find such a royalty, a more detailed analysis would have been required to consider all of the benefits and burdens for both of the parties.

The majority rejected the ATO's argument that the concentrate price must include a royalty component as too simplistic. Rather, a broader, more detailed understanding of the IP licence was required. While the IP licence clearly provided benefits to Schweppes Australia, it also imposed restrictions on Schweppes (eg. tight controls by Pepsi US), imposed burdens on Schweppes Australia (eg. testing and inspections), and also provided benefits to Pepsi US (eg. growing its goodwill in Australia). Accordingly, it could not simply be said that part of the concentrate price was a royalty.

This approach sets the new test for whether there is an implied or embedded royalty in the RWT context. At first instance, Justice Moshinsky found that a royalty existed by reference to several factors observed from the parties' dealings and relationship, including the IP's high value and its criticality to the overall business context.

In ascertaining whether part of the payments was consideration for the use of trade marks for the purposes of the Australia / US tax treaty, the majority distinguished the High Court decisions in Dick Smith and Lend Lease, finding that the concentrate prices in the EBA were structurally different to the arrangements in those cases. Because the "central bargain" under the EBA was a distribution arrangement, the concentrate price was not part of what moved the IP licence. This meant that no royalty arose because there was no payment made as consideration for the IP rights.

Justice Colvin dissented, reasoning from the prior High Court decisions that it was necessary to first characterise the nature of the transaction (here, to bottle and distribute the products), with the monetary consideration is what moves the whole of that transaction, part being for IP use.

Not income derived by Pepsi US

Alternatively, the majority also concluded that RWT was not payable because Pepsi US had not derived the royalty income. It reasoned that because Pepsi US made none of the sales, Schweppes Australia never had an obligation to pay an amount to Pepsi US, and having never had a right to receive payment Pepsi US could not make a payment direction in favour of Pepsi Australia. Justice Colvin agreed.

Diverted profits tax

The majority also overturned Justice Moshinsky's conclusion that if RWT did not apply, the DPT would have applied instead.

The DPT issue was considered in the alternative, and therefore requires assumptions about the reasons that RWT did not apply.

At first instance, experts for both parties proceeded on the assumption that the payments included a royalty but no RWT was payable. However, the majority on appeal concluded that this assumption was unsupportable. Although the Commissioner's expert had showed the value of the IP licence, there was no corresponding evidence which showed that this value was recovered through the concentrate price. For the same reasons as discussed above, this would have required broader, more detailed economic analysis. This impacted the two sub-issues in the DPT analysis.

None of the alternative postulates were reasonable

The majority found that neither of the Commissioner's alternative postulates were reasonable alternatives to the actual scheme. The alternatives were for the EBA payments to be expressed as being for all of the property provided, or at least specifically including a royalty for the IP use.

The majority reasoned that:

  • based on the commercial and economic substance of the arrangements, the Commissioner's position that the concentrate payments included a royalty was unsupportable (for the reasons discussed above);
  • the commercial and economic substance of the Commissioner's postulates was different to the actual scheme; and
  • particular regard is required to be given to substance when performing the DPT analysis, so the difference between the substance of the postulates and the scheme indicated that the alternative postulates were not reasonable.

Accordingly, the DPT did not apply.

Principal purpose

The majority then dealt with the principal purpose test in the DPT, on the "highly artificial" assumption that the payments did, as a matter of commercial and economic substance, include a royalty for IP use. On that assumption, it concluded that the purpose test would have been met. The majority mostly agreed with the approach of Justice Moshinsky, although concluding that the manner in which the scheme was carried out was a neutral factor, rather than favouring Pepsi.

What multinationals should be doing now about IP and royalty withholding tax

The ATO might seek special leave to appeal the decision to the High Court. Not many applications are accepted for an appeal hearing, but the lack of a unanimous Full Federal Court judgment might increase the chances of the High Court taking it on.

Until then, this decision will have enormous implications for multinationals' operation in Australia, for various reasons.

  • The ATO will be digesting how this decision impacts its enforcement activities for multinationals. Those in industries with a high degree of IP value such as technology, life sciences and retail will certainly continue to remain in the ATO's sights.
  • Although it has lost this case, the ATO will be determining how widespread the ramifications of this decision are. A lot of evidence was led by Pepsi to defend its position, and other multinationals will need to weigh up whether their own positions for similar arrangements are defensible. Many, many MNEs will debate with the ATO whether this decision is applicable or distinguishable to their facts. The difference between the majority's "central bargain" approach and Justice Colvin's "transaction characterisation" approach in dissent will be highly relevant moving forward.
  • The ATO will also be reassessing which taxpayers it deploys these kinds of arguments against, and whether it also makes arguments based on other legislation tools available to it, including the transfer pricing rules and the general anti-avoidance rule.
  • Questions remain for the ATO's position in its draft software ruling TR 2024/D1, which is about the circumstances in which RWT will apply to software arrangements, relying heavily on Australian copyright law. There are comments in the Pepsi decision about the differences between trade marks and copyright.
  • The Government has two proposed but unenacted measures on this topic, being to extend the general anti-avoidance rule to capture WHT rate reductions and to extend the penalty regime to apply to RWT. Draft legislation is yet to be released. If the Pepsi scenario was previously the poster child for the situation where the new penalty regime might apply, it no longer will be!

We are working with various clients to risk assess their arrangements and would be pleased to discuss how the decision might apply to your business' circumstances.

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