The High Court of Australia has handed down its much-anticipated decision in Commissioner of Taxation v PepsiCo, which considered the application of royalty withholding tax and the diverted profits tax (DPT) to certain beverage distribution arrangements in Australia.
By a 4-3 majority, the court dismissed the Commissioner of Taxation’s (the Commissioner’s) appeal and found in favour of the taxpayer, PepsiCo, holding that neither royalty withholding tax nor the DPT applied to the distribution arrangements.
This decision, on August 13, will have a significant impact on the tax treatment of distribution arrangements in Australia. It will be important to monitor how the Australian Tax Office (ATO) responds to the ruling, particularly in relation to draft taxation ruling, TR 2024/D1, regarding software distribution arrangements.
Key findings
Payments were for concentrate, not royalties
The majority (Justices Gordon, Edelman, Steward, and Gleeson) held that:
Under agreements between Schweppes Australia Pty Ltd (SAPL) and PepsiCo entities, payments made by SAPL were solely for concentrate and did not include consideration for the right to use trademarks or other intellectual property (IP); and
These payments, therefore, did not constitute a royalty.
The majority placed significant weight on the contractual terms of the legal agreements, and upon the “proper construction of the agreements”, along with contemporaneous evidence, such as invoices sent to SAPL. Notably, the Commissioner did not allege that the concentrate prices were inflated to mask a royalty payment.
Although the IP licence was an important part of the arrangements, the court rejected the Commissioner’s view that PepsiCo was not compensated for the IP if no royalty was paid. Instead, the court accepted that the consideration for the IP was “the performance of the monetary and non-monetary undertakings by SAPL” under the agreements, which were of real value to PepsiCo – even if they were not royalties.
Payments were not ‘paid or credited’ to, or ‘derived by’, PepsiCo
The High Court unanimously held that royalty withholding tax was not payable in any case because the payments from SAPL under the distribution arrangements were neither “paid or credited” to nor “derived by” PepsiCo or Stokely-Van Camp, Inc. (SVC), a US-based PepsiCo subsidiary that owned certain IP and was a party to the relevant distribution arrangements.
The Commissioner argued that SAPL had an “antecedent monetary obligation to PepsiCo”. All seven judges rejected this and held that the payments were received by PepsiCo Beverage Singapore (PBS) on its own account. This was further supported by the fact that any payment default would give rise to an action for debt only by PBS, the contracting party, and not PepsiCo itself.
No tax benefit for DPT purposes
The majority found that neither PepsiCo nor SVC obtained a tax benefit in connection with a scheme for DPT purposes.
The Commissioner’s alternative postulates were rejected as unreasonable because their commercial and economic substance did not align with the actual arrangements. The majority of the court accepted PepsiCo’s evidence that there were no other reasonable alternate postulates to the current arrangement, on the basis that:
Payments were for concentrate only;
The arrangement was arm’s length between unrelated parties; and
The absence of a royalty was consistent with market practice for this business model, adopted by the PepsiCo group since the early 1900s.
Key takeaways
This decision reinforces the position that cases involving royalty withholding tax and the DPT will always depend heavily on their specific facts and contractual arrangements.
For businesses in the food and beverage industry, or other sectors involving the distribution of tangible goods, the outcome of this case provides some reassurance that granting IP rights (e.g., trademarks) for the purpose of local distribution in Australia will not necessarily give rise to a royalty subject to withholding tax.
However, businesses in the tech sector, particularly those operating under software-as-a-service (SaaS) or software distribution models, should be cautious in applying this decision to their arrangements. A critical aspect of the PepsiCo case was that the distributor’s payments were for a physical product (i.e., the concentrate) rather than intangible software or digital services. As such, the reasoning may not directly apply to software-based business models.
The judgment also sets the stage for the ATO to finalise TR 2024/D1. It will be important to monitor how the ATO addresses royalty withholding tax in the context of software and SaaS arrangements in light of the High Court’s findings.
