No royalty withholding tax or diverted profits tax payable for PepsiCo

PepsiCo has successfully appealed to the Full Federal Court (FFC), which has held that payments made by the Australian bottler of Pepsi and other beverages, were not subject to Royalty Withholding Tax (the first issue) and was also not subject to Diverted Profits Tax (the second issue).

On 26 June 2024, in PepsiCo, Inc v Commissioner of Taxation [2024] FCAFC 86, the FFC reversed the Federal Court single judge decision by unanimously deciding on the first issue that payments made by the Australian bottler, Schweppes Australia Pty Ltd (Schweppes), to the seller of beverage concentrate, PepsiCo Bottling Singapore Pty Ltd (PBS) (an Australian company) were not subject to Royalty Withholding Tax.

On the second issue, two out of the three FFC judges concluded that if the payments were not royalties, the diverted profits (DPT) tax would not apply in these circumstances. This is the first occasion that the operation of the Diverted Profits Tax provisions in s177J of Part IVA ITAA 1936 has been judicially considered. The DPT applies to significant global entities (those with annual global income of $1b or more) operating in Australia where, based on information available to the Commissioner, it is reasonable to conclude that, under a scheme to obtain tax benefits, profits have been artificially diverted from Australia. Generally, DPT imposes a 40 per cent penalty tax on profits transferred offshore through related party transactions.

Background facts  

Schweppes was the sole distributor and bottler in Australia of beverages: Pepsi, Mountain Dew and Gatorade. It purchased concentrate to make the beverages from PBS, an Australian subsidiary of the PepsiCo group. 

The payments were made under two ‘Exclusive Bottling Agreements’ (EBAs) that determined the price at which the beverage concentrates were to be purchased. The EBAs also included a grant, by two US members of the PepsiCo group (PepsiCo, Inc and Stokely-Van Camp, Inc (SVC)) to Schweppes, for the right to use the trademarks and other intellectual property associated with each beverage. Although PepsiCo and SVC were parties to their respective EBAs, neither EBA made any provision for the payment by Schweppes of a royalty for its use of the intellectual property. Under the EBAs, the payments for supply of the concentrate were made by the Schweppes to PBS, an Australian subsidiary of Pepsi Co, which on paid it (less a small profit margin) to the producer of the concentrate in Singapore (another subsidiary of PepsiCo). There was no indication that the producer on paid any of the payment to PepsiCo, Inc or SVC, the owners of the trademarks and other intellectual property.

Federal Court Decision

In the first instance, the Federal Court held that the payments by Schweppes were, to some extent, consideration for the right to use the trademarks and other intellectual property, and thus ‘royalties’ for the purposes of s128B of the ITAA 1936 and the US Double Tax Convention. Although the payment from Schweppes was to an Australian subsidiary of PepsiCo, the Federal Court held the payments were attributable to the royalties for use of trademarks and other intellectual property. It was also held that the payments were also income derived by PepsiCo Inc and SVC and taken to be paid to them because they were parties to the EBAs. Accordingly, PepsiCo, Inc and SVC were liable to pay Royalty Withholding Tax (RWT) in respect of the part of the payment by Schweppes characterised as ‘royalties’ (i.e. RWT was payable on 5.88 per cent of Schweppes Australia's net revenue from sales of licensed products during the relevant years).

The Federal Court also held that if PepsiCo and SVC were not liable to pay RWT, they would have been liable to pay DPT on the basis they had entered into a scheme with the ‘principal purpose’ of obtaining tax benefits (including the non-payment of RWT) for the purposes of s177J. 

Full Federal Court Decision  

Royalty Withholding Tax

The Majority of the FFC, two of three judges, concluded that the payments made by Schweppes to the Seller were for concentrate alone and did not include any component that was a royalty for the use of PepsiCo/SVC’s intellectual property. The payments were in no part made in ‘consideration for’ the use of that intellectual property and they did not therefore include a ‘royalty’ within the definition of that term in s6(1) of the ITAA 1936. Further, all three of the FFC court judges concluded that even if the payments were attributable to ‘a royalty’, the payments were received by the Seller (the Australian subsidiary of PepsiCo) on its own account and they cannot be said to have been paid to PepsiCo/SVC. Therefore, they were not income derived by PepsiCo/SVC for the purposes of s128B(2B). Hence, the FFC unanimously held that PepsiCo/SVC were not liable to pay Royalty Withholding Tax on the payments made by Schweppes to the Seller.

Diverted Profits Tax

By a majority, the Court concluded that PepsiCo and SVC were not liable to pay DPT. In coming to this conclusion, the majority judges considered but rejected the two alternative postulates (below) put forward by the Commissioner, as not being ‘reasonable alternatives’: 

• The EBA would or might reasonably be expected to have expressed the payments to be made by Schweppes to be for all of the property provided by (and promises made by) the PepsiCo Group entities (rather than for concentrate only); or 
• The EBA might reasonably be expected to have expressly provided for the payments to be made by Schweppes to include a royalty for the use of, or the right to use, the relevant trademarks and other intellectual property (whether or not the amount of the royalty was specified).

Further the majority FFC considered that the only postulates which could bring the payments to tax were ones in which the payments for concentrate could be seen as being made in part for the grant of the rights to use PepsiCo and SVC's intellectual property. However, based on the Court’s findings, they determined there was no postulate which was a reasonable alternative to the scheme actually carried out. Therefore, PepsiCo and SVC did not obtain a tax benefit "in connection with a scheme" for the purposes of s177J. 

On this point the minority judge disagreed with the majority decision, finding that PepsiCo and SVC would have been subject to DPT. The minority judge taking the view that the EBAs resulted in a tax benefit because, if the EBAs had not been entered into, a reasonable postulate was that the EBAs would have provided for the royalty to be paid to PepsiCo or SVC as the holder of the rights to the trademark. This view being consistent with the second of the reasonable alternatives advanced by the Commissioner. 

Impact and implications of FFC decision in PepsiCo 

The result of the FFC decision may have some implications for other Australian entities that have entered into agreements with foreign entities to use intellectual property where the agreements do not provide for the payment for the use of the intellectual property. It may also have implications for the Australian Taxation Office (ATO) in finalising its views in draft taxation ruling TR 2024/D1 on the character of payments in respect of software and intellectual property rights. Many of the comments in TR 2024/D1 are reliant on the ATO finding that there are embedded royalties in agreements that do not provide for payments for the use of copyright or other intellectual property. The FFC decision discounted this concept of embedded royalties, therefore the ATO may have to reconsider its position in TR 2024/D1.

As part of the 2024-25 Federal Budget, the Federal Government have announced its intention to introduce penalties for SGEs that are found to have mischaracterised or undervalued royalty payments to which royalty withholding tax would otherwise apply. This new additional penalty will apply from 1 July 2026. The PepsiCo decision will likely impact how the Government drafts its proposed penalty provision.

Due to the significance of both Federal and FFC decisions, it is anticipated the Commissioner will request special leave to appeal to the High Court. Therefore, it may not be all over just yet. 

Should you have any questions regarding how this Full Court decision may impact your organisation, please contact your BDO tax adviser for further guidance and visit our tax services page to see how we can help.