On 9 August 2024, the Commissioner announced he had sought special leave to appeal to the High Court. The Commissioner also announced that he will defer finalisation of his draft ruling on software royalties (TR 2024/D1) pending the outcome of the High Court proceedings.
On 26 June 2024, the Full Federal Court comprising Perram, Colvin and Jackman JJ handed down its much-anticipated decision in PepsiCo, Inc v Commissioner of Taxation [2024] FCAFC 86 (PepsiCo Decision ).
In a joint decision, Justices Perram and Jackman held that neither PepsiCo nor its related entity, Stokely-Van Camp (SVC), were liable for royalty withholding tax (RWT) or diverted profits tax (DPT).
Justice Colvin, in a dissenting judgment, agreed that there was no liability for RWT but thought DPT would apply.
The PepsiCo Decision is the first time that DPT has been considered and, given the split nature of the decision, it is unsurprising that the Commissioner has now sought special leave to appeal to the High Court.
Background
Schweppes Australia Pty Ltd (Schweppes) entered into exclusive bottling agreements (EBAs) with PepsiCo and SVC to bottle, sell and distribute beverages including Pepsi, Mountain Dew and Gatorade.
The EBA with SVC provided expressly for ‘an exclusively royalty-free licence’ to use its intellectual property (IP). The EBA with PepsiCo contained no terms relating to IP but it was uncontroversial that this licence was implied by law.
The EBAs also contained a specified price for concentrates required for the manufacture of the relevant beverages. The concentrate itself would be supplied by PepsiCo, SVC or a nominated seller.
An Australian subsidiary of PepsiCo was ultimately nominated as the seller of the concentrate (the Seller). The Seller supplied the concentrate and invoiced Schweppes consistently under the pricing terms of the EBAs, with Schweppes paying the Seller as per the invoice. The EBAs did not contain any express payment for the use of IP.
The Federal Commissioner of Taxation (Commissioner) argued for two alternative outcomes:
- that the payments for concentrate contained an embedded royalty component that would be subject to RWT; or
- should RWT not apply, DPT would.
The Federal Court at first instance
At first instance, Moshinsky J found in favour of the Commissioner on RWT, holding that Schweppes paid PepsiCo and SVC to use their IP via a royalty embedded in the price paid for concentrate.
His Honour continued that had he found RWT did not apply, he would have found that PepsiCo and SVC were liable to DPT.
You can read our case summary of the first instance decision here.
The Full Federal Court
The Full Federal Court provided a resounding win for the taxpayers, finding unanimously that Moshinsky J was incorrect in deciding RWT applied and, by majority (Perram and Jackman JJ), also incorrect that DPT would have applied if RWT did not.
Royalty withholding tax issue
For RWT to apply the Commissioner had to show that:
- embedded in the price stipulated as only being for concentrate under the EBAs was actually an amount for the licence to use IP; and
- that this embedded royalty was income derived by PepsiCo or SVC.
The Commissioner failed to convince the majority of either point.
Was there an embedded royalty?
The majority used “an orthodox exercise in contractual interpretation” to find that the price for concentrate contained in the EBAs did “not include a component for the licence to use trade marks and other intellectual property”.
Consideration then turned to the High Court cases of Davis, Dick Smith and Lend Lease and submissions put forward by the Commissioner that consideration for a transfer of property could be something different to that which the parties had agreed it to be. The majority decided Dick Smith and Lend Lease did not apply in the circumstances. Instead, Davis governed the EBAs which meant they operated as agreed by the parties, being that payments made by Schweppes to the Seller did not contain a royalty component for the use of IP.
Conversely, Colvin J found that on the proper construction of the EBAs “[the price for concentrate] was, in part, consideration for the use of the trade marks and was therefore a royalty to that extent”.
The majority also rejected the Commissioner’s arguments that the IP was given away for nothing. They found Schweppes “obtained the benefit of being able to exploit PepsiCo/SVC’s goodwill to its own advantage” although under several restrictions and obligations, whilst in return PepsiCo and SVC had Schweppes “sustain and promote their goodwill in Australia” by distributing the trademarked beverages.
Was the embedded royalty income derived by PepsiCo or SVC?
Despite the split decision on whether there was an embedded royalty, their Honours unanimously held that RWT could not apply because even if an embedded royalty did exist, the payments to the Seller did not “come home” as income derived by PepsiCo or SVC.
The Commissioner did not argue payments received by the Seller from Schweppes gave “rise to some species of agency or trust” in favour of PepsiCo or SVC. Although the majority pointedly “draw no firm conclusions”, they acknowledged that if he had made those arguments the outcome may have been different. This is something the Commissioner may now try to run in future RWT cases where payments are directed to related party recipients.
Diverted profits tax issue
To enliven DPT, the Commissioner had to prove PepsiCo and SVC:
- were parties to a scheme;
- obtained a tax benefit in relation to that scheme; and
- effected the scheme for a principal purpose of obtaining that tax benefit.
The Commissioner failed on point two and therefore PepsiCo and SVC were not liable for DPT.
It was uncontroversial that a scheme existed, being that PepsiCo and SVC allowed Schweppes to use their IP without paying a royalty. However, the majority held that the required tax benefit was not present (Colvin J in dissent) because there was no reasonable alternative postulate to the scheme. Despite this, Perram, Jackman and Colvin JJ all agreed that if there was a tax benefit, PepsiCo and SVC would have implemented the scheme for a principal purpose of obtaining that tax benefit.
Tax benefit issue
It was argued that the tax benefit obtained by PepsiCo and SVC under the scheme was that they were not liable for RWT.
To deny the existence of that tax benefit, PepsiCo and SVC bore the onus of showing that there was no reasonable alternative to the scheme under which they would have attracted RWT.
The Commissioner argued two alternative postulates that he thought were reasonable. The first, that the payments made by Schweppes could have been for both the concentrate and the use of IP and, second, that the EBAs could have expressly provided for a payment to use IP. Beyond this, PepsiCo and SVC still also had to prove no other reasonable alternative existed.
In deciding whether an alternative postulate is reasonable a court is bound to consider the substance of the scheme and any result for the taxpayer achieved by the scheme compared to the alternative postulates. The majority decided that analysing “substance” meant the commercial and economic substance.
Although the majority decided that the results of the scheme and the postulates achieved the same outcome, “the commercial and economic substance of the scheme was that the price agreed for concentrate was for concentrate” and neither alternative postulate provided by the Commissioner nor any other alternative matched the substance of the scheme.
As such, the majority found there was no tax benefit obtained under the scheme and DPT could not apply. Justice Colvin’s dissenting view was that the Commissioner’s second alternative postulate was a reasonable alternative to the scheme and so a tax benefit existed.
Principal purpose issue
Despite the findings by the majority that DPT could not apply as there was no tax benefit, they still considered whether the relevant principal purpose was present had there been a tax benefit.
The Court was bound to consider eleven factors to decide if the relevant principal purpose existed. The first eight factors are those appearing in s 177D(2), which are regularly used for Australia’s general anti-avoidance rule in Part IVA. The remaining three are contained in s 177J(2) and focus on non-tax benefits of the scheme, foreign laws and the amount of the benefit.
After considering the 11 factors, the Court unanimously held that a principal purpose of obtaining a tax benefit would have existed if that tax benefit was present.
Where to now?
Given the split nature of the decision, the strong dissent by Colvin J, and the concessions by Perram and Jackman JJ that DPT would apply if an embedded royalty was present in the EBAs, it is unsurprising that the Commissioner has sought leave to appeal this case to the High Court.
In the meantime, the ATO likely will continue to scrutinize arrangements involving large multinationals, with a range of other weapons in its arsenal such as Australia’s transfer pricing framework and general anti-avoidance rules.
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