Embedded Royalties for Sales of Pepsi Concentrate in Australia

This is a guest post by Harold McClure, a New York City-based independent economist with 26 years of transfer pricing and valuation experience. (One of several that he has written for us.) Here he looks in detail at a case currently ongoing in Australia, Pepsi, in the light of a 2020 case involving Coca-Cola. 

Pepsi’s Singapore affiliate sells concentrate to an Australian third party bottler, which is a similar business structure to how Coca Cola’s Irish affiliate sells concentrate to third party European bottlers. The Australian Tax Office (ATO) has imposed withholding taxes on what it deems to be the embedded royalties implicit in this third party transaction. Andy Bubb and Paul Sutton discussed the legal issues involved during a recent LCN Legal podcast entitled “Ongoing TP Litigation in Australia". Andy said:

 "The Schweppes Australia entity makes payments to Pepsi in Singapore for use of certain IP and other concentrate that it acquires to be able to bottle the concentrate and sell it in Australia. And the ATO’s concern is with what those payments that are being made to Pepsi Singapore are payments for, and specifically whether there's a payment being made for any IP and therefore a royalty being paid."

If the ATO prevails, then the economic question is how much of the third party price for concentrates represents royalties versus compensation for the cost incurred by the Singapore affiliate, and the profits that this affiliate should receive.

This note frames this economic issue in terms of the discussions surrounding The Coca-Cola Company & Subsidiaries v IRC (No. 31183-15), 2020. The following table assumes that 500 million bottles of Pepsi were sold in 2018 with a retail price equal to 1.6 Australian dollars, which translates into U.S. $1.20 at the exchange rate of one Australian dollar = $0.75. Let’s also assume that the wholesale price paid to the Australian third party bottler was $1 per bottle. If the Pepsi financial facts resemble those for Coca Cola, the price of concentrate = $0.20 per bottle. Our hypothetical income statement also assumes that total operating costs including production, sales, and marketing incurred by Pepsi Singapore = 55% of concentrate sales, so consolidated profits = 45% of concentrate sales.

Hypothetical Pepsi Singapore Income Statement Under Alternative Royalty Rates (US$)

Coca Cola Ireland paid its parent corporation royalties nearly 15% of concentrate sales, which is equivalent to 3% of the wholesale price paid to the third party bottler. This policy left Coca Cola Ireland with income = 30% of concentrate sales. Our illustration assumes a similar transfer pricing policy for Pepsi Singapore.

The IRS in Coca-Cola asserted that this royalty rate should be increased to 40% of concentrate sales or 8% of the wholesale price, by arguing that the routine return for Coca Ireland should be only 5% of concentrate sales or 1% of the wholesale price. The representatives for Coca Cola assumed a similar level of routine returns but objected to the premise of the IRS application of the Comparable Profits Method (CPM) that the arm’s length royalty should represent 100% of residual profits.

The representatives of Coca Cola tried to assert that the Irish licensee owned the marketing intangibles while the U.S. parent owned the product intangibles. The tax court rejected this position asserting that the parent owned both the product and marketing intangibles. Even if the U.S. parent owned all of the valuable intangibles, the Irish licensee would deserve a share of residual profits if it bore significant commercial risk by licensing valuable intangible assets owned by another entity. Sound financial economics would assert an intermediate royalty rate by considering the role of risks assumed by the licensee such as franchisees of McDonalds, which is what I described in my discussions of the Coca Cola litigation. For example, my November 23, 2020 MNE Tax post entitled “US IRS prevails in Coca-Cola transfer pricing dispute over intercompany royalties” noted:

"Assume a McDonald’s franchisee pays McDonald’s royalties equal to 5 percent of sales for the use of intangibles, including product, process, and marketing intangibles. These franchisees are also required to contribute mandatory advertising fees but do not retain ownership of the McDonald’s intangible assets.  In addition to the valuable intangible assets licensed from McDonald’s, the franchisee must contribute the land and building as well as the equipment. Consider a franchisee with four stores where expected sales equal $10 million, operating costs equal $8 million, and the value of tangible assets equal $12 million. Consolidated profits before royalties equal 20 percent of sales. If we assume a 10 percent cost of capital, routine profits represent 12 percent of sales with residual profits equal to 8 percent of sales. While an application of CPM would argue for an 8 percent royalty rate, McDonald’s charges a royalty rate of only 5 percent to third-party licensees because these licensees utilize a valuable intangible asset owned by McDonald’s. Market rates in the fast-food restaurant are consistent with the proposition that arm’s length royalty rates should be between 60 and 75 percent of residual profits."

If the business structure for Pepsi Singapore was similar to the business structure for Coca Cola Ireland, then the same tensions between the questionable application of CPM versus application of a Residual Profit Split approach applies to the evaluation of the appropriate royalty rate in this Australian litigation.