Australia: PepsiCo's Royalty Withholding and Diverted Profits Tax Decision Overturned

In a significant decision on June 26, 2024, the Full Federal Court of Australia (FFC) reversed a previous ruling that had implications for PepsiCo's Royalty Withholding Tax (RWT) and Diverted Profits Tax (DPT) liabilities. The case, PepsiCo, Inc. v Commissioner of Taxation [2024] FCAFC 86, revolved around payments made by Schweppes Australia Pty Ltd (SAPL) to PepsiCo Bottling Singapore Pty Ltd (PBS) under Exclusive Bottling Agreements (EBAs) for the purchase of beverage concentrate.

BACKGROUND AND KEY ISSUES

SAPL, as the sole distributor and bottler in Australia for Pepsi, Mountain Dew, and Gatorade, purchased concentrate from PBS, an Australian subsidiary of PepsiCo. The EBAs also included rights for SAPL to use associated trademarks and intellectual property. However, there was no explicit provision for royalty payments for these rights.

The Australian Taxation Office (ATO) contended that these payments were royalties, making PepsiCo liable for RWT under section 128B of the Income Tax Assessment Act 1936 (ITAA 1936). Additionally, the ATO assessed PepsiCo for DPT, a 40% penalty tax aimed at profits transferred offshore through related party transactions.

FEDERAL COURT RULING

Initially, the Federal Court sided with the ATO, ruling that a portion of SAPL's payments were indeed for the use of trademarks and intellectual property, thus constituting royalties. Consequently, PepsiCo was deemed liable for RWT. Furthermore, the court held that even if RWT did not apply, PepsiCo would still be liable for DPT, as the transactions aimed at obtaining tax benefits.

FULL FEDERAL COURT'S REVERSAL

On appeal, the FFC unanimously overturned the Federal Court's decision. The majority of the FFC judges (Justices Perram and Jackman) concluded that the payments were solely for the beverage concentrate and did not include any royalty component. They emphasized the primacy of the contractual arrangements, noting that the EBAs were essentially distribution agreements and not contracts for licensing intellectual property.

Additionally, the FFC found that the payments were not income derived by PepsiCo or Stokely-Van Camp, Inc. (SVC) since they were made to PBS, an Australian entity, which retained the payments after a minor profit margin before forwarding them to the concentrate producer in Singapore. Thus, there was no basis for RWT liability.

DIVERTED PROFITS TAX

Regarding the DPT, the majority of the FFC judges concluded that there was no reasonable alternative to the actual scheme carried out by the parties, thereby ruling out the application of DPT. They dismissed the ATO's arguments that the EBAs should have included royalty payments as unrealistic.

IMPLICATIONS OF THE DECISION

This decision could impact other Australian entities with similar arrangements, where payments under agreements with foreign entities do not explicitly include royalties. The ATO may need to reconsider its stance on "embedded royalties," particularly in light of draft taxation ruling TR 2024/D1 concerning software and intellectual property rights.

Furthermore, the ruling could affect the Federal Government's plans, announced in the 2024-25 Federal Budget, to introduce penalties for significant global entities (SGEs) that mischaracterize or undervalue royalty payments. These penalties, set to commence on July 1, 2026, might need re-evaluation based on the FFC's findings.

FUTURE PROSPECTS

Given the significance of the FFC's decision, it is anticipated that the Commissioner of Taxation will seek special leave to appeal to the High Court of Australia. Until then, the implications of this ruling will continue to influence the legal landscape concerning international tax arrangements and compliance for multinational entities operating in Australia.

SOURCES/RECOMMENDED READ:

• PepsiCo, Inc v Commissioner of Taxation [2024] FCAFC 86 (fedcourt.gov.au)
• PepsiCo wins in Full Federal Court - BDO
• Australian Full Federal Court reverses finding of embedded royalty in arm's-length contract | EY - Global