An update on the Pepsi embedded royalty tax litigation in Australia

On 8-10 May 2024, the appeal in the dispute between Pepsi and the Australian Commissioner of Taxation was heard by three judges in the Full Federal Court.

The trial decision in November 2023 found that Pepsi was liable to royalty withholding tax (RWT), or alternatively that Australia’s diverted profits tax (DPT) would apply. Both issues were in play in the appeal.

The case involves the sale of concentrate by Pepsi to Schweppes Australia (an unconnected entity), with Pepsi IP also licensed so that Schweppes Australia could finish the drinks, label them, and sell them to wholesalers. A contract was entered into between Pepsi US and Schweppes Australia, with Pepsi US appointing Pepsi AUS as the seller of the concentrate to Schweppes Australia. The contract specified that the price was to be calculated based on the amount of concentrate purchased by Schweppes Australia, with a price per unit, and with the IP being licensed to Schweppes Australia on a royalty-free basis.

Interestingly, there was no focus in the appeal on how the embedded royalty rate (5.88%) was calculated at first instance. Although the dispute has not been argued on transfer pricing grounds, the royalty rate (and therefore the royalty which is subject to withholding tax) was determined by using a TP-style analysis. At first instance, the Court favoured part of the evidence of the ATO’s expert, being to look at comparable agreements between independent licensors and bottlers, adjusting for region, exclusivity (or not) and brand strength in particular.

The key arguments in the appeal are:

• Whether “consideration” for WHT is construed broadly or narrowly. Pepsi argues that no consideration was paid for the use of IP, with the payment only occurring under the concentrate transaction between Schweppes AUS and Pepsi AUS, not the broader Exclusive Bottling Agreement. The ATO argues that a broader analysis is required, and that the IP and concentrate come as a package deal, requiring apportionment of the price between them. The relevance of case law in other tax contexts in which consideration is relevant (e.g. duty) was heavily considered.
• Whether a payment obligation arose to Pepsi US, triggering WHT. Pepsi argues that nothing in the agreements caused Schweppes AUS to have a payment obligation to Pepsi US, with the payment obligations only being owed to Pepsi AUS for concentrate. In contrast, the ATO argues that because a portion of the payments was for IP use, a liability necessarily arises in favour of Pepsi US because it is the IP owner.
• Does Pepsi win on DPT if the ATO counterfactuals are unreasonable? Pepsi argues that the 2013 amendments to tax benefit in section 177CB of Part IVA mean that if it can show the ATO counterfactuals to be unreasonable, it wins the DPT case. It argues that the ATO counterfactuals are unreasonable because they are more complex than the scheme and introduce commercial risk from renegotiations, given that the royalty-free pricing mechanism was already entrenched between the parties and in the cola industry.
• Weighing the DPT purpose factors. The parties emphasise different purpose factors. Pepsi relies heavily on the manner factor, pointing to a long history of royalty-free agreements. The ATO relies most on the substance / form factor, pointing to the valuable IP which Pepsi says it did not pay for.

Pepsi needs to win on both the RWT and DPT issues for tax to not apply. Under the RWT argument, its liability is around AU$2 million, being the 5% treaty rate for RWT multiplied by the implied royalty amount of AU$37 million (being 5.88% of Schweppes Australia’s net sales of AU$630 million). Under the DPT, a 40% tax rate would apply to the implied royalty amount, having no regard to the 5% withholding tax rate under the Australia / US treaty, resulting in a liability of approximately AU$16 million.

The case is important for a few reasons:

• Taxation of embedded royalties in Australia. The agreement between the unrelated parties had said that the IP was licensed on a royalty-free basis, but the court disagreed, concluding that a broader test applies which looks at the character of the payments in the business context of the relevant agreement. The question remains as to what arrangements might be captured for other taxpayers. Multinationals which use IP in Australia need to review their arrangements – not just their agreements. Those in the technology, life sciences and retail sectors should pay attention, and need to consider the overlay of Australian IP law concerning trademarks, copyright and patents in particular. Many organisations are doing this work now.
• The case is the first application of Australia’s DPT. The DPT applies at a 40%, which is above the corporate tax rate (30%) to include a penalty component. Taxpayers generally get no tax treaty relief for DPT, which is a separate tax to Australia’s income tax, so the consequences of having the DPT apply are particularly onerous. The DPT involves a principal purpose test, with 11 statutory factors to consider, so the factual inquiry which is required can be intensive.
• WHT has no time limit. Unlike the typical four-year period of review for large corporates, there is no statutory time limit for withholding tax in Australia. This means that the potential exposure of taxpayers with a withholding tax risk is much greater than for other taxes.

The Full Federal Court’s decision is expected in late 2024 or early 2025. Taxpayers will be hoping for a favourable outcome. In the meantime, the ATO’s review of multinationals’ positions involving the use of IP will continue, and multinationals will need to be across the potential implications of the Pepsi decision in advance of it landing.

Andy Bubb, Special Counsel –Tax Disputes, Clayton Utz