Australian Full Federal Court reverses finding of embedded royalty in arm's-length contract

Executive summary

On 25 June 2024, the Full Court of the Federal Court of Australia delivered a landmark decision in PepsiCo, Inc. v Commissioner of Taxation [2024] FCAFC 86, overturning the first instance decision in the Federal Court. The Full Court, by majority, found that a royalty did not exist in an agreement between arm's-length parties in circumstances where the agreement did not expressly provide for a royalty. Furthermore, the Full Court, also by majority, found the Diverted Profits Tax (DPT) provisions did not apply.

Key highlights

The majority, comprising of Justices Perram and Jackman, determined that no portion of the payment made by the Australian entity was a royalty and therefore royalty withholding tax (RWHT) did not apply. The majority reached this conclusion by giving primacy to the contractual arrangements and concluding that the payment made was for the beverage concentrate.

The majority concluded that the contract was a "distribution arrangement" and the parties were not centrally seeking to achieve a contract for the licensing of intellectual property (IP).

The majority also concluded that the payments were not income derived by PepsiCo, Inc. and Stokely-Van Camp, Inc. (PepsiCo/SvC). The payments were made by the Bottler to the Seller as per the contractual obligations and did not "come home" to PepsiCo/SvC.

Although Justice Colvin found that there was a royalty, he agreed with the majority and found that there was no derivation of income by PepsiCo/SvC and therefore the RWHT did not apply.

The Full Court was split on the application of the DPT, with the majority finding that there was no reasonable alternative to the scheme and therefore the DPT did not apply.

The Full Court found unanimously, however, that there was a principal purpose of obtaining a tax benefit, with the majority basing its conclusion only on "the highly artificial assumption...that the price of concentrate included a royalty."

This is an important judgment that reaffirms the long-standing judicial position of giving primacy to the terms of legal agreements and upholding the form and nature of legal arrangements.

The Commissioner of Taxation will likely lodge a special leave application to appeal to the High Court of Australia.

Relevant facts

PepsiCo/SvC (related US companies) entered into Exclusive Bottling Agreements (EBA) with Schweppes Australia Pty Ltd (SAPL) (a third party).

Under the EBA, PepsiCo/SvC agreed to sell (or cause a related entity to sell) beverage concentrate to SAPL, which SAPL then mixed with other ingredients in accordance with formulas, specifications and other information provided, to produce finished beverages for retail sale in Australia, applying Pepsi branded packaging and under the Pepsi brand name.

Importantly, the EBA provided for SAPL to pay only for the concentrate; there was no express provision for the payment of a royalty for the right to use the relevant IP.

Key issues

The Commissioner of Taxation (Commissioner) contended that PepsiCo/SvC was liable for RWHT under the Income Tax Assessment Act 1936 (Cth) (ITAA 1936), which is subject to Art 12 of the double tax agreement between Australia and the United States (US DTA). At first instance, Justice Moshinsky agreed with the Commissioner.

Additionally (and alternatively), the Commissioner issued a DPT assessment to PepsiCo/SvC, imposing a 40% punitive tax on the challenged royalties. The DPT's stated aims are to ensure tax paid reflects the economic substance of a Significant Global Entity's (SGE) Australian activities and to prevent diversion of profits offshore through arrangements with related parties. At first instance, Justice Moshinsky also agreed with the Commissioner. (For more on the Federal Court decision, see EY Global Tax Alert, Australian Federal Court finds embedded royalty in arm's-length contract, dated 21 December 2023.)

RWHT not applicable

On appeal, the Full Court concluded that the payments made by SAPL under the EBAs were not royalties and therefore there was no liability to RWHT.

The Full Court found:

• The payments made by SAPL under the EBA were not consideration for the use of, or the right to use, the relevant trademarks and other IP.

• The relevant portions of the payments were not income derived by PepsiCo/SvC for the purposes of section 128B(2B)(a) of the ITAA 1936 and were not amounts to which PepsiCo/SvC was beneficially entitled for the purposes of Art 12 of the US DTA. Rather, the nominated concentrate seller (PepsiCo Beverage Singapore Pty Ltd, an Australian resident) was beneficially entitled to the payments on its own account.

"Consideration for"

The Full Court found, by majority, that no portion of the payments were consideration for various intangible properties listed under art 12(4)(a)–(b) of the US DTA.

Justices Perram's and Jackman's key considerations were:

• In approving the IBM decision in 2011 (International Business Machines Corporation v Commissioner of Taxation [2011] FCA 335; 91 IPR 120), the majority held that the plain language of the contract and the legal form is critical to the determination of the character of the payment, and that the exercise is one of "orthodox contractual interpretation."

• Though there is an IP license to SAPL, consideration for the license took the form of PepsiCo/SvC benefitting from having their goodwill sustained and enhanced, and SAPL obtained the benefit of being able to exploit PepsiCo/SvC's goodwill to its own advantage.

• The EBA provides only for a highly restrictive manner of use of the relevant IP by SAPL, namely in selling the beverages, the nature of which was entirely controlled by PepsiCo/SvC. In particular, SAPL could not embark on its own interpretation of the brand strategy. Furthermore, the EBA prescribes rights to inspection, reporting and testing by PepsiCo/SvC.

• This rebuts the Commissioner's contention that PepsiCo/SvC gave away its IP for "nothing" which is, in the majority's view, an "overly simplistic assumption that the grant of the licence right to [SAPL] was only of benefit to [SAPL]" and ignores:
  • The benefits SAPL obtained in being permitted to use the goodwill attaching to the trademarks
  • The restrictions both as to product and marketing imposed on SAPL in its utilization of that goodwill
  • The burdens placed upon SAPL in complying with testing and inspection regimes
  • The benefits PepsiCo/SvC obtained in having SAPL sustain and promote their goodwill in Australia

• Two stamp duty decisions (Chief Commissioner of State Revenue (NSW) v. Dick Smith Electronics Holdings Pty Ltd [2005] HCA 3; 221 CLR 496 and Commissioner of State Revenue (Vic) v. Lend Lease Development Pty Ltd [2014] HCA 51; 254 CLR 142) are not applicable to this scenario as the right to use trademarks and other IP was not the central property disposition or transaction which the EBA contemplated. Rather, it was the concentrate itself.
  • The majority found that "what the parties were centrally seeking to achieve was not a contract for the licencing of trademarks and intellectual property. It was a distribution arrangement of which the licencing of intellectual property was merely a part."

Justice Colvin differed from the majority, finding there was an amount that, at least in part, constituted consideration for the use of the trademarks and therefore was a royalty to that extent.

"Income derived," "beneficially entitled" and "paid to"

Justices Perram and Jackman held that there was no "payment by direction" in favor of PepsiCo/SvC because SAPL had no antecedent monetary obligation to PepsiCo/SvC on the face of the EBA, as PepsiCo/SvC was not the vendor of concentrate (and hence not entitled to payments) when there was a nominated seller. Given that the payments did not "come home" to PepsiCo/SvC, the income was not derived by PepsiCo/SvC. The majority left open the question of whether their answer would have been different had they concluded there was a royalty.

Justice Colvin agreed with the majority on this topic and added that there was no payment "owing" to PepsiCo/SvC once PepsiCo/SvC had nominated a seller of concentrate. This was despite his conclusion that the payment was a royalty. In summary, the Full Court unanimously held that no portion of the payments constituted royalties and RWHT was not liable to be withheld and remitted to the Australian Taxation Office (ATO).

Diverted Profits Tax

In finding that DPT would not have applied, the majority considered that PepsiCo/SvC did not obtain a tax benefit in connection with the relevant scheme as there was no reasonable counterfactual.

While the majority stated that this finding rendered irrelevant the question of whether the "principal purpose" test was met, the majority nevertheless considered that question and concluded that there was a principal purpose to obtain a tax benefit (namely not being liable to pay Australian RWHT) and to reduce foreign tax (namely, US tax on their income). The majority noted this finding was based on the "highly artificial assumption we must make that the price of concentrate included a royalty."

In concluding that there was no tax benefit, the majority stated that the Commissioner's scheme "begs the question of why the concentrate price should be understood as including a royalty." The majority did not agree with the Commissioner's view of the commercial and economic substance of the scheme.

The majority found that the Commissioner's counterfactuals (both of which involved a royalty in the EBA) were not reasonable alternatives to the scheme in question because neither corresponded to the commercial and economic substance of the scheme. The majority also expressed dissatisfaction with the lack of evidence supporting the economics of any royalty component in either counterfactual. In the Court's opinion, therefore, PepsiCo/SvC was able to adequately discharge its burden to prove that both counterfactuals failed to show that the payment for concentrate also included a payment for something else of value.

In a dissenting judgment, Justice Colvin concluded that the second counterfactual was a reasonable alternative (but this was predicated on his decision that the payment for concentrate did include an embedded royalty) and a tax benefit was obtained.

Importantly, in the context of withholding tax, the Full Court upheld Justice Moshinsky's interpretation of the meaning of "tax benefit" in section 177C(1)(g) of the ITAA 1936, which carries the consequence that, where a tax benefit arises from a taxpayer's not being liable to pay RWHT on an amount, the amount of the tax benefit is the entire royalty amount (not the RWHT). As such, to the extent RWHT applies, it applies at the rate applicable in the relevant DTA (often 5% or 10%) whereas if DPT applies, a rate of 40% is levied irrespective of the relevant DTA rate.

Implications for multinationals

The issue of characterization continues to be an area of focus for the ATO. It is expected that the Commissioner will apply for special leave to appeal to the High Court (the Commissioner has until 24 July 2024 to file this application). In the interim, it is too early to determine if the judgment will have an impact on the ATO's compliance approach.

Given the decision of the majority, it may also be that there are certain arrangements where the legal form, properly characterized, can be found to have a royalty component. As such, a close assessment of the true nature of any "quid pro quo" (or bargain) in the context of the legal agreement will be important in evaluating whether any benefits are provided in consideration for some form of IP. As such, it remains important for Australian taxpayers with cross-border licensing or distribution arrangements to review their arrangements in light of the judgment. This will include identification and consideration of steps to mitigate, any risks particularly relating to the substantive withholding tax issue.

Taxpayers will also need to consider and gather a full suite of evidence concerning both qualitative and quantitative aspects in any arrangement involving IP, incidentally or otherwise, along with clear evidence of the commercial and economic substance of the arrangements more broadly. SGEs should also consider undertaking a review of their arrangements to ensure they have sufficient evidence and documentation relevant to mitigating the risks arising from the DPT.

Given the Court's focus on the contractual terms and the central nature of the bargain, the impact on the practical operation of recent developments in the area of intangibles, including Taxpayer Alert TA 2018/2 (Mischaracterisation of Intangibles), Taxation Ruling TR 2024/D1 (Software Royalties), and Practical Compliance Guideline PCG 2024/1 (Intangibles Migration Arrangements), as well as proposed legislation aimed at imposing penalties on the mischaracterization of payments relating to intangible assets, will be eagerly anticipated by taxpayers.

The majority's comments regarding the nature of the agreement reached between the parties and what the parties were centrally seeking to achieve in a contract will be particularly relevant for distribution arrangements and, in the current environment, for software distributors, given the ATO's draft view in TR 2024/D1 (regarding when payments under a software arrangement constitute royalties for the purpose of nonresident royalty withholding tax; see EY Global Tax Alert, Australian Tax Office issues updated draft taxation ruling TR 2024/D1 on software royalties, dated 29 January 2024).