Australia: High Court decision in Pepsico case confirms IP Tax boundaries

The landmark 4:3 High Court decision for Pepsico in their case with the ATO is an important outcome for taxation of embedded royalties and application of Australia’s Diverted Profits Tax – although questions remain.

Briefly, Schweppes Australia Pty Ltd (Schweppes) entered into Exclusive Bottling Agreements (EBAs) with both PepsiCo and Stokely-Van Camp, Inc (SVC) for the right to bottle, sell and distribute Pepsico beverages in Australia.

With a focus on taxing overseas companies deriving profits from Australian markets, the ATO argued a two-pronged approach:

• that the consideration paid by Schweppes was for both concentrate and intellectual property (“IP”) rights, subject to royalty withholding tax (RWT), and
• alternately, the contract arrangement was contrived so that the foreign entities obtained tax benefits equal to the avoided royalty payments, liable to diverted profits tax (DPT), under Part IVA. 

After Federal Court of Australia and High Court findings (in favour of the ATO and Pepsico respectively), this High Court Appeal by the ATO found in favour of Pepsico: 

• No RWT applied as there was no embedded royalty and no income derived by Pepsi US for use of IP and other rights under the licensing structure; and
• No DPT applied as the ATO counterfactuals (not having a royalty free license clause) were not reasonable, there was no tax benefit to the foreign entities, and the principal purpose test requirements were not met.

What this means for similar companies:

• This case was not between related parties. For related parties, if a royalty-free arrangement can be shown to be industry standard, this supports TP positions.
• To address ATO counterfactual arguments, taxpayers can demonstrate that what they did was the only reasonable alternative, rather than address the ATO arguments.

The remaining questions:

• There was no royalty, since payments were only for concentrate - and IP use was under separate EBA arrangements. If other companies have sales and IP under the same agreement, would the same outcome have been reached?
• The right to use IP does not necessarily lead to a royalty payment. However, where the royalty does result in a benefit for the foreign entity and it is reflected in the product price – could RWT potentially apply?
• The characterisation of spend in the taxpayer’s business was a key consideration in the Pepsico case – so is broad-based guidance possible?