PepsiCo has filed a notice of appeal to the Full Federal Court in relation to the recent landmark decision where the Court found PepsiCo owed the ATO approximately AUD 3.6m in royalty withholding tax for the 2018 and 2019 financial years.
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This case, concerning the characterisation of payments in connection to intellectual property (IP) in the context of a ‘distribution’ arrangement, presented a clear warning to all Australian taxpayers performing distribution activities on behalf of offshore affiliates – that they can expect heightened focus from the ATO on embedded royalties arising from IP use.

PepsiCo and embedded royalties

In a decision handed down on 30 November 2023, Mohinsky J found that a component of the payments ‘taken to be’ received by PepsiCo and its subsidiary Stokely-Van Camp (SVC) in the US from Schweppes Australia Pty Ltd (SAPL) for concentrate should have been characterised as royalties.

The US entities were therefore found to owe the Australian Taxation Office (ATO) approximately AUD 3.6m in royalty withholding tax for the 2018 and 2019 financial years. If the royalty withholding tax provisions were deemed not to apply, the Court found that the Diverted Profits Tax (DPT) provisions would have applied in the alternate. In what was the first DPT case in Australia since its introduction in 2017, this outcome would have resulted in PepsiCo owing the ATO approximately 28.9 million in DPT for the 2018 and 2019 financial years.  

The facts 

PepsiCo. Inc as the brand owner for carbonated soft drinks such as Pepsi and Mountain Dew, and SVC as the brand owner for non-carbonated soft drinks such as Gatorade, entered into Exclusive Bottling Agreements (EBAs) with SAPL (an Australian third party). The EBAs enabled SAPL to manufacture finished beverages by mixing concentrate with other ingredients using confidential formulas and specifications provided by PepsiCo Group. In addition, the EBAs authorised SAPL to bottle and package the beverages in PepsiCo-branded packaging prior to sale. 

The concentrate needed by SAPL to perform its manufacturing activities was produced by Concentrate Manufacturing (Singapore) Pty Ltd (CMPL) in Singapore. The concentrate was sold by CMPL to a nominated seller, namely PepsiCo Beverage Singapore Pty Ltd (PBS) in Australia, who on-sold the concentrate to SAPL. Over the course of 2018 and 2019, SAPL made AUD 240m in payments to PBS for the concentrate, which PBS returned to CMPL, after retaining a small margin.   

Per the terms of the EBAs, while the pricing for the concentrate was explicit, the rights to use trademarks were implied or expressly described as ‘royalty-free’ and no price was attached to use of these rights.

Key findings

  • The Court agreed with The Commissioner’s argument that royalties were ‘embedded’ within the payments made by SAPL for the concentrate, as SAPL would not have been able to manufacture, package, and sell the beverages without consideration for the use of, or the right to use, the relevant trademarks and other IP (i.e. formulas, specifications, branding etc).
  • It was considered inconceivable that PepsiCo was willing to license its brand to a third party for no compensation, particularly given the global strength of its brand which increased its value. This contention was supported by evidence that similar agreements for the sale of PepsiCo concentrate involved a licence of the brand.
  • To quantify what proportion of the payments made by SAPL constituted a royalty, a royalty rate of 5.88 per cent was adopted in relation to SAPL’s net revenue from sales of the relevant products. In this regard and with respect to the liabilities of PepsiCo and SVC for royalty withholding tax, this totalled approximately AUD 3.6m (PepsiCo: $3,023,148; SVC: $601,413).
  • As required under the US-Australia Double Tax Agreement and withholding tax provisions, despite payments being made from SAPL to PBS, the Court found that the payments were income ‘derived by’ and deemed to have been ‘paid to’ PepsiCo and SVC. Similarly, it was also concluded that PepsiCo and SVC were ‘beneficially entitled’ to those amounts. This was on the basis that PepsiCo and SVC were the parties to the respective EBAs and were entitled to receive payment for the concentrate. It was concluded that the nomination of PBS as seller merely constituted a direction of payment for SAPL to pay PBS rather than PepsiCo/SVC (and therefore the income ‘came home’ and was derived by PepsiCo and SVC).
  • The Court contended that, had the royalty withholding tax provisions not applied, the diverted profits tax provisions (40 per cent penalty tax rate) would have instead been relevant as PepsiCo and SVC contrived the arrangement in question to obtain a tax benefit, and one of the principal purposes for entering into the scheme was to obtain a tax benefit.

Recommendations for impacted taxpayers

All taxpayers performing distribution activities should be mindful of this outcome, and:

  • Consider how the ATO’s guidance regarding embedded royalties in Taxpayer Alert TA 2018/2, may apply to their existing arrangements;
  • Conduct a review of intercompany transactions and associated legal agreements, to consider whether there are express or implied rights to use IP and if the legal and economic substance of the transactions align (and if these have been priced appropriately); and
  • Maintain evidence of the commerciality of IP arrangements.

What does this all mean?

Even though the decision is being appealed, this landmark outcome recognises the ATO’s targeted focus on multinational tax avoidance and in this case, the setup of corporate arrangements to avoid withholding tax payments.

In fact, the ATO are presently involved in a similar tax dispute with The Coca-Cola Company and Coca-Cola Amatil (its Australian subsidiary), issuing The Coca-Cola Company with a $173.8m penalty notice for 2018 and 2019. In that case, the ATO also noted Coca-Cola Amatil did not pay The Coca-Cola Company for the use of IP, thereby avoiding royalty withholding tax liabilities and resulting in diverted profit benefits.

Both PepsiCo and the ongoing Coca-Cola dispute illustrate that while the legal form of an intercompany agreement is important, the ATO (and Federal Court in the case of PepsiCo) will look beyond the terms to the commercial substance of the arrangements in determining whether a royalty exists. 

Australian taxpayers with distribution arrangements should expect heightened scrutiny on embedded royalties arising from IP exploitation. In addition, certain taxpayers may be open to significant exposure given there is no statutory limitation period for Australian withholding tax or the DPT.

Grant Thornton contacts

If you wish to discuss the above or the broader implications of this ruling further, please reach out to the contacts below or a member of the Grant Thornton tax team.  

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