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Overview
In November 2023, the Federal Court (Mohinsky J) handed down its decision in favour of the Australian Taxation Office (“ATO”), vs. PepsiCo, Inc and Stokely-Van Camp, Inc (collectively referred to as “PepsiCo” for the purposes of this article) in relation to Exclusive Bottling Agreements (“EBAs”) entered into by Australian entity Schweppes Australia Pty Ltd (“SAPL”).
The judgments were as follows:
- The court found in favour of the ATO, that PepsiCo was liable to Royalty Withholding Tax (“RWT”) for part of the payments made by SAPL, thereby providing some context to the concept of an “embedded royalty”; and
- The Diverted Profits Tax (“DPT”) provisions were also considered in the alternative (on the premise that PepsiCo was not liable to RWT). Although technically not ruling on this position, the Court indicated it would have found in favour of the ATO that the DPT would have applied where RWT did not apply.
As of 19 January 2024, the decision by Mohinsky J has been appealed by PepsiCo and thus may be subject to further consideration by the Courts.
The Case
The case was a tax dispute between the multinational snack and beverage group, the PepsiCo Group, and the ATO. The PepsiCo Group are the owner of a global portfolio of trademarks, designs and assets such as the Pepsi, Mountain Dew and Gatorade brands (as well as a myriad of other brands).
In 2009, SAPL entered into EBAs in which:
- PepsiCo agreed to sell beverage concentrate to SAPL which was to be mixed by SAPL with other ingredients in accordance with formulas, specifications and other information provided by the PepsiCo Group to produce finished beverages for retail sale in Australia;
- PepsiCo granted SAPL the right to use PepsiCo trademarks and other intellectual property to enable SAPL to manufacture, bottle, sell and distribute finished beverages in branded PepsiCo Group packaging; and
- The EBAs did not expressly provide for the payment of a royalty for the right to use intellectual property.
Key Issues
The key issues under consideration were broadly as follows:
- For RWT purposes - whether the payments made by SAPL under the EBAs were, to any extent, consideration for the use of, or the right to use certain intellectual property in accordance with the items set out in the Australia-US Double Tax Agreement (“DTA”) as well as items set out in paragraphs (a) to (d) of the definition of “royalty” in s 6(1) of the Income Tax Assessment 1936 (“ITAA1936”);
- For DPT purposes - as an alternative should there be no RWT applicable - whether PepsiCo obtained a tax benefit in connection with the scheme and whether the scheme was entered into for a principal purpose of enabling a taxpayer to obtain a tax benefit.
Findings
RWT
Noting that the determination of the issue involved an exercise of "characterisation" (i.e., the “nature” of the payments under the EBAs), the Court considered the terms of the EBAs in their business and commercial context. The Court concluded that the payments were, to some extent, "consideration" for the use of, or the right to use, relevant PepsiCo trademarks and other intellectual property. In other words, the payments made by SAPL were considered to be not only for the purchase of beverage concentrate but rather for the purchase of beverage concentrate and for the use of (or right to use) PepsiCo intellectual property (i.e., an embedded royalty).
The Court noted the following features and terms of the arrangement/EBAs were particularly significant in the determination:
- The EBAs contained a licence by PepsiCo of relevant trademarks and other intellectual property to SAPL (both on an express and implied basis);
- The licence of trademarks and other intellectual property was fundamental to the agreement. Without a licence of the trademarks and other intellectual property, SAPL would not be able to package and sell the beverages under the Pepsi, Mountain Dew and Gatorade brands;
- It may be inferred that SAPL would not have agreed to make the payments under the EBAs without the licence of trademarks and other intellectual property; and
- The payments made by SAPL were linked with the licence of the trademarks and other intellectual property, in the sense that a failure by SAPL to perform payment obligations could result in a termination of the agreement (and therefore the licence).
Under the methodology accepted by the Court, the Court determined that RWT (at a rate of 5% of under the Australia-US DTA) was payable on 5.88% of SAPL's net revenue from sales of licensed products during the relevant years.
DPT
In addition, the Court would have found in favour of the ATO's alternative DPT assessments under Part IVA of the ITAA1936 in relation to the scheme constituted by the EBAs on the basis that the Court found that:
- PepsiCo and SVC obtained a tax benefit from the scheme in not being liable to pay RWT on an amount where they might reasonably be expected to have been liable if the scheme had not been entered into or carried out; and
- It would be concluded that one of the principal purposes of each of PepsiCo and SVC in entering into or carrying out the scheme was to obtain a tax benefit.
We note for completeness that the DPT is imposed at a rate of 40% penalty rate of tax on the “diverted profits”, however, the DPT was not applied given the Court’s conclusion that RWT was payable.
Key Takeaways
The ATO is concerned with arrangements where parties may mischaracterise an amount of payment as not being for the use of intangible assets and thus not recognising a royalty (or embedded royalty), which in turn would lead to a failure to remit RWT.
The PepsiCo Case highlights the ATO’s concerns and litigious approach to certain intangibles arrangements. Further, given that the EBAs did not expressly provide for the payment of a royalty for the right to use intellectual property, the Case clearly demonstrates that the ATO and the Courts may look beyond the “form” of an arrangement and rather consider the “substance” of an arrangement beyond the terms of a contract or agreement.
It is imperative that taxpayers understand the tax outcomes and the nature of their transactions which may contain an “embedded royalty” component in order to discern whether RWT should be remitted. Further, detailed evidence and documentation for the commercial rationale behind intangibles arrangements is critical in obviating any potential challenge from the ATO.
Further, given that the DPT was also considered (and ruled in favour of the ATO) by the Court - albeit as an alternative argument which ultimately was inapplicable - the decision highlights the legal tools at the ATO’s disposal in challenging intangibles arrangements and the Court’s potential views on the application of the DPT. The PepsiCo Case is the first Australian case in which the DPT has been considered by the Courts (albeit in an “alternative” scenario to the consideration of the application of RWT).
Further to the PepsiCo case, the ATO and the Federal Government have palpably focussed their recent attention and resources on intangibles arrangements as evidenced by:
- The new “Intangibles Integrity Measure” which seeks to deny deductions for payments relating to intangibles held in low or no-tax jurisdictions. We note that the legislation for the Intangibles Integrity Measure rules are currently still in draft, however, the rules are set to take effect for payments made on or after 1 July 2023.
- Practical Compliance Guideline 2023/D2: Intangibles Arrangements (currently in draft but to be finalised imminently);
- Taxpayer Alert 2020/1: Non-arm's length arrangements and schemes connected with the development, enhancement, maintenance, protection and exploitation of intangible assets;
- Taxation Ruling 2021/D4: Income tax: royalties - character of receipts in respect of software (currently in draft); and
- Taxpayer Alert 2018/2: Mischaracterisation of activities or payments in connection with intangible assets.
FOR MORE INFORMATION
If you would like to learn more about the topics discussed in this article, please contact your local RSM office.
