PepsiCo Full Federal Court Decision

Introduction/Overview

In a critical decision on 26 June, 2024, the Full Federal Court held firstly, that payments made under two Exclusive Bottling Agreements (EBAs) were not subject to Royalty Withholding Tax and secondly (by majority), that Diverted Profits Tax would not apply – Colvin J (in minority) holding that Diverted Profits tax should apply.

The three Federal Court Judges comprising the Full Federal Court considered the Appeal from the decision of Moshinsky J of the Federal Court on 30 November, 2023 where he held that certain portions of payments related to the sale of beverage concentrate were royalties and thus subject to Royalty Withholding Tax, or in the alternative, that Diverted Profits Tax would apply – see our International Tax Alert/Insight of December, 2023 attached.

By way of background, under the two Exclusive Bottling Agreements involving PepsiCo, Inc. (PepsiCo) and Stokely-Van Camp, Inc (SVC), two US resident companies, Schweppes Australia Pty Ltd (SAPL), an Australian resident company, was provided with beverage concentrate to produce finished beverages for retail sale in Australia, as well as, an express or implied license of trademarks and other intellectual property (including brands) covering both carbonated soft drinks (eg. Pepsi and Mountain Dew) and non-carbonated beverages (eg. Gatorade).  The beverage concentrate was effectively sold as a ‘kit’ which contained liquids, powders and other ingredients for blending and resale.

 

Key Observations

The approach of the three Federal Court Judges (including Perram & Jackman in the majority) to the two key taxation issues ie. Royalty Withholding Tax and Diverted Profits Tax, varies significantly from that of the Trial Judge, Moshinsky J and, amongst other matters, focused intensely on a detailed contractual interpretation of the EBAs, the central rights sought and obtained by the parties, reference to significant stamp duty case precedent (and other transfers of property/rights), ‘commercial and economic substance’ and a simplistic approach to contractual arrangements and reasonable alternative postulates.

Given the divergence in views on and approaches to the critical tax and related issues (including the key concepts of ‘royalties’, ‘tax benefit’ and ‘principal purpose’) of the four Federal Court Judges that have now opined on the PepsiCo scenario, and the critically important precedent of this case, particularly relating to DPT, we would expect the ATO to seek leave to appeal to the High Court of Australia on this important Full Federal Court decision.

Several key sectors with highly valuable IP including, the Consumer Goods/Retail, Pharmaceuticals/Medical/Life Sciences and the broader Technology Sectors, are closely monitoring and are likely to be impacted by the PepsiCo decision. There will also likely be ongoing implications for the characterisation and tax treatment of certain receipts from the distribution and licencing of software which is the subject of close scrutiny including, following the release of the ATO’s draft ruling TR2024/D1 in January, 2024.

Finally, the PepsiCo Full Federal Court decision and any further appeals will likely impact on the proposed penalty provision applicable to mischaracterised or undervalued royalty payments, to which royalty withholding tax would apply, as announced in the May, 2024 Federal Budget and applicable from 1 July, 2026.

 

Majority Judges: Perram & Jackman JJ

Royalties & Royalty Withholding Tax

Perram and Jackman JJ held firstly, that the payments made under the EBAs by SAPL(ie. the  Bottler) to the Seller (ie. PepsiCo Bottling Singapore Pty Ltd – “PBS”) were for beverage concentrate alone and did not include any component that was a royalty for the use of PepsiCo/SVC’s intellectual property, including trademarks.  Further and secondly, they held that the payments cannot be said to have been paid to PepsiCo/SVC, but rather were received by SAPL on its own account.

Referring to various stamp duty cases as precedent, the majority Judges said that to determine whether the payments made by SAPL under the EBAs were in part paid as consideration for the right to use trademarks and other intellectual property (and thus would effectively be royalties), attention is to be confined to the terms of the contractual documents ie., the EBAs, purchase orders, invoices and related documents.  The nature of the payments could not be altered merely because of the nomination of Seller arrangement.  This approach relying on the relevant agreements was supported by International Business Machines Corporation v Commission of Taxation (2011) FCA335.

While the majority Judges recognised the licence to SAPL for using the trademarks and other intellectual property, they emphasised that these licence rights should be viewed as not only of benefit to SAPL, and more particularly also of benefit to PepsiCo/SVC; eg. the right to take advantage of the goodwill attaching to these trademarks belonging to PepsiCo/SVC.

Importantly, the majority Judges distinguished these licensing rights from those like the grant of a right to do the acts comprised in the copyright or the grant of a right to make products under a patent.

In this context, the majority Judges rejected the Commissioner’s submission that some element of the concentrate price should be seen as embedding some value for the license of trademarks and other intellectual property.  Further, the majority Judges stated that the Commissioner did not submit, and that they have no need to consider, that the price charged for the concentrate was disproportionately high.

In concluding on this point, the majority Judges said that the price paid for concentrate was not part of what moved the right of SAPL to use the trademarks and other intellectual property; ie this was not the central property disposition or transaction that SAPL contemplated.  Rather, the central bargain under the EBAs was the establishment of the exclusive arrangement to distribute PepsiCo/SV’s beverages in Australia; while noting that the right to use trademarks and intellectual property was a necessary element in the transaction.

Accordingly, in the majority Judges’ view, the payments made by SAPL to the Seller did not include an element that was a royalty for use of the trademarks ie. since the payments were not in consideration for the right to use the trademarks.  This conclusion was underscored by the fact that the EBA provided the licence was to be royalty free, at least under the SVC/EBA.

Given that there was no portion of the payments under the EBAs that could be considered a royalty for taxation purposes, it was unnecessary in principle for the majority Judges to consider whether the amounts received by the Seller from SAPL were properly regarded as income derived by PepsiCo/SVC.  In any event, the majority Judges held that, unless there was an antecedent monetary obligation effectively owed by the Bottler to PepsiCo/SVC, the payments could not be regarded as being income derived by PepsiCo/SVC; for example, as where there might be a pre-existing debtor/creditor relationship.

Further, the majority Judges held that the relevant payments did not ‘come home’ to PepsiCo/SVC in these circumstances.

Accordingly, as no portion of the payments under the EBAs were royalties and the payments were not income derived by PepsiCo/SVC, there was no liability for Royalty Withholding Tax in Australia.

Diverted Profits Tax (DPT)

In the context of the potential application of DPT, the Commissioner had put forward two alternative postulates firstly, that the relevant EBA would or might reasonably be expected to have expressed the payments to be made by SAPL to be for all of the property provided (ie. including the right to use trademarks and other IP) rather than for the beverage concentrate only.

Secondly, the relevant EBA might reasonably be expected to have expressly provided for the payments by SAPL to include a royalty for the use of or the right to use the relevant trademarks and other IP.

Although the majority Judges, based on the ‘commercial and economic substances’, thought that the relevant taxpayers could be considered in principle, to be securing a ‘tax benefit’ based on the requisite purpose (‘principal purpose’) in Section 177 J, they believed that both of the Commissioner’s postulates were not ‘reasonable alternatives’ and that there were no other reasonable alternative postulates and thus the Commissioner’s arguments on Diverted Profits Tax failed.  This conclusion was reached after a detailed analysis of the relevant indicators (in sections 177/D(2) and 177J(2)) to the requisite purpose and the alternative postulates involving a potential royalty component.  More analysis regarding the conclusions on ‘principal purpose’ are warranted in particular factual circumstances.

 

Minority Judge: Colvin J.

Royalties and Royalty Withholding Tax

Colvin J. importantly characterised the EBAs as appointing SAPL as having the right to bottle, distribute and sell branded beverages. Further, he highlighted that the trademarks were known to the parties to be strong and valuable. Thus, if the amounts paid under the EBAs were for concentrate alone, then the right to distribute the branded products without any monetary consideration attributable to the licence to use the valuable brands of PepsiCo/SVC, would be a commercially unreasonable view of the terms of the EBAs considered as a whole.

Accordingly, a part of the consideration paid under the EBAs was for the use of trademarks and therefore a royalty to that extent.

However, the nomination of the Seller under the EBAs meant that the amounts paid were not owed to or otherwise derived by PepsiCo/SVC. Thus, no royalty withholding tax was applicable in these circumstances.

Diverted Profits Tax (DPT)

Given Colvin J.’s views on the royalty issue above and that he believed that a reasonable alternative postulate would be that the EBAs would have provided for the royalty to be paid to PepsiCo/SVC, a ‘tax benefit’ resulted and in his view the ‘principal purpose’ of entering into the scheme to achieve the tax benefit was established in these circumstances.

Accordingly, Colvin J. was of the view that DPT would apply in these circumstances.