Royalty-free contracts will attract scrutiny by the ATO

Articles Written by Kathryn Bertram (Partner), Annemarie Wilmore (Partner), Don Spirason (Special Counsel)
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The Federal Court has held in Pepsi Inc v Commissioner of Taxation [2023] FCA 1490  that international arrangements involving the licence of trademarks and other intellectual property (IP) should be subject to royalty withholding tax. Further, if there was no royalty withholding tax, then to the extent that the contract does not expressly identify a separate royalty for IP, the arrangement may be considered to have been entered into for the principal purpose of obtaining a tax benefit under the Diverted Profits Tax (DPT) provisions.

This recent decision of the Federal Court has agreed with the Commissioner of Taxation (Commissioner) that any use of IP may cause a portion of a payment under that contract to be a royalty. This could even arise in the context of fulfilling contractual obligations (such as toll manufacturing arrangements), and in circumstances where the contractual terms do not expressly identify a portion of the consideration as being for the licence (an embedded royalty). This represents a significant shift in conventional views on the topic.

Prior to this case, the conventional application of the royalty withholding tax provisions were in circumstances where the contracts had express terms in relation to the use of IP and also expressly provided for a payment in relation to that right (see for example International Business Machines Corporation and Another v Federal Commissioner of Taxation [2011] FCA 335 (IBM)).

Organisations who use IP as part of their business model should conduct a review of their arrangements as there may be exposure to significant amounts of additional tax, penalties and interest. Arrangements that include the following features will likely require close scrutiny as a result of this decision:

  • contracts which permit another party to use IP (copyright, trademarks, technical knowledge and assistance etc);
  • a single undissected amount of consideration; and
  • payments only expressed to be for other features in the contract (and not for the use of IP).

The Commissioner’s ability to raise adjustments under the withholding tax provisions is not subject to a statute of limitations, and thus this decision could have implications for historical arrangements that have been in place for some time.

This outcome for the Commissioner arises in the context of intense scrutiny by the ATO in relation to IP arrangements and arrangements involving the exploitation of intangible assets. The ATO’s media release states:

'The Pepsi matter is a lead case for our strategy to target arrangements where royalty withholding tax should have been paid. Whilst there may still be more to play out in this matter, it sends strong signals to other businesses that have similar arrangements to review and consider their tax outcomes.’

While the Commissioner was successful in arguing that there was liability to withholding tax (and in the alternative, that the DPT would apply), the Commissioner’s position in relation to quantum of royalty was challenged. The Court did not accept the highest amount contended for by the Commissioner (this itself being a reduction from the initial position). The result is a substantial reduction in the amount to be recouped by the Commissioner compared with his starting position.

Defending these matters will require independent expert evidence from persons appropriately qualified to value IP rights. The case also demonstrates the importance of a brief to the expert which articulates accurately the key IP permissions and their commercial significance, as well as careful scrutiny of the comparable transactions.

Issues in dispute

The case involved a global beverages company, where the world-wide owner of trademarks, designs and other IP was located in the US. The US entity had appointed an independent third party (the bottler) to conduct the bottling and distribution of its products in Australia. Under the terms of the exclusive bottling agreements (EBAs), various permissions were granted to the bottler for the use of trade marks, technical knowledge and assistance and other IP (the licence). The permissions in the EBAs were a fundamental feature, and without the licence, the bottler would not be able to package and sell the beverages under the brand names. The agreement specified that a price should be paid for the supply of concentrate but did not expressly provide for a payment (a royalty) in relation to the licence.

The Commissioner first formed the view that the failure to expressly provide for a royalty for the use of the licence was a scheme to which the DPT applied. Subsequently, the Commissioner issued notices of royalty withholding tax. In the trial, the Commissioner contended that the royalties were to be calculated at about 9 per cent of net sales, consistent with his expert evidence. This submission reflected a downwards revision of the Commissioner’s original calculation of royalty.[1] In contrast, on the assumption that there was a royalty, the taxpayer submitted that the amount of that royalty should have been 2.5 per cent.

Withholding tax

In relation to royalty withholding tax, the Federal Court found that:

  • the payments for the supply of concentrate were, to some extent, consideration for the use of, or the right to use, the relevant trademarks and other intellectual property;
  • the relevant portion of the payments were income derived by the US company for the purposes of section 128B(2B)(a) of the Income Tax Assessment Act 1936 (ITAA 1936); and
  • the relevant portion of the payments were deemed to have been paid by virtue of section 128A(2) of the ITAA 1936.

Amount of royalty and expert evidence

Both parties submitted expert evidence regarding the amount of the royalty. The Federal Court preferred the Commissioner’s expert over the taxpayers’. The Commissioner’s expert had extensive experience in valuing IP rights, including assessing reasonable royalty rates. In contrast, the taxpayers’ expert had considerable experience as a forensic accountant, but only limited experience in valuing IP rights or assessing the royalty rate for the licence of IP. Moshinsky J noted that the Commissioner’s expert had considerably more experience in the area, and expressed himself in a clear and confident manner.

The Commissioner’s expert supported his opinion by a number of different methods. Justice Moshinksy accepted the results of only one of these methods. Broadly, this method involved searching for comparable royalty licences based on data from orthodox and known royalty databases (such as ktMine, RoyaltySource and RoyaltyStat). This method was substantially the same as one of the methods advanced by the taxpayers’ expert.

The result was that the Federal Court found that the value of the royalty should be 5.88 per cent of the net revenue from sales but ought to be adjusted downwards to reflect a finding by Justice Moshinksy that removed one of the agreements from the set of comparable royalties.


This is the first court case to consider the interpretation of the DPT legislation which was introduced in 2017. The Court held that if the DPT provisions apply to a tax benefit consisting of the taxpayer not being liable to pay royalty withholding tax on an amount, DPT at a rate of 40 per cent was payable on the amount of the royalty.

Albeit in light of the conclusion in relation to withholding tax, it was not necessary to consider the DPT, Justice Moshinksy thought it would be appropriate to consider the issue for sake of completeness, and on an assumption that the withholding tax provisions do not apply.

The relevant scheme for the purposes of the DPT was the entry into the EBAs on terms where no royalty was paid for the use of IP. The Commissioner had identified two counterfactuals:

  • the EBAs would or might reasonably have been expected to have expressed the payments to be for all of the property provided by the US entity rather than for the concentrate only; or
  • the EBAs would or might reasonably have been expected to have expressly provided for the payments to include a royalty for the use of, or the right to use the licence (whether or not the amount of royalty was specified).

The taxpayer submitted that the Commissioner’s counterfactuals represented a departure from the substance of the schemes and did not achieve the same commercial results or consequences as the schemes. Justice Moshinksy did not accept these contentions and found that the evidence supported the Commissioner’s first counterfactual as being what might reasonably have been expected to occur.

In relation to tax benefit, Justice Moshinsky was of the view that:

  • it might reasonably be expected that the relevant EBAs would have provided for payments to be made for all of the property provided by US entity (rather than for concentrate only);
  • in considering the substance of the scheme (as required by section 177CB(4)(a)(i)) it is necessary to compare the substance of the counterfactual with the substance of the EBAs. Adopting this approach the substance is the same, namely the payments are for both the concentrate and the licence;
  • in relation to the results or consequences of the scheme (section 177CB(4)(a)(ii)), it was necessary to compare the results or consequences of the counterfactual against those of the EBAs. Again, the results or consequences are the same.

As to whether the scheme was entered into or carried out for the principal purpose of obtaining a tax benefit and to reduce foreign tax liabilities, the noteworthy aspects of Justice Moshinsky's decision include:

  • the consideration of the manner in which the scheme was entered into or carried out. Justice Moshinsky said that the fact that the arrangements and the key aspects of the pricing structure reflected in the EBAs had been in place since the early 1900s, point to some extent, against the presence of a principal purpose. However, they did not take matters very far. There was no detailed or comprehensive evidence as to why in 2009 (when the relevant EBAs the subject of the proceedings was put in place) the group adopted the form of pricing structure in its EBAs. The evidence showed that the pricing model was considerably complex. Overall the structure of the pricing model pointed away from a principal purpose, but only slightly;
  • that there was a disconnect between the form and substance of the scheme. In form, the payments were for concentrate alone, whereas in substance the payments were for both concentrate and the licence. The trademarks were highly valuable, amongst the most valuable brands in the global beverage industry. This strongly supports the Commissioner’s proposition that the requisite purpose did exist;
  • while the amount of royalty withholding tax was not large in the context of the overall payments under the EBAs, the fact that under the scheme no royalty income was received suggested that upon consideration of any change in the financial position of the taxpayer, this tended to point towards the requisite purpose; and
  • similarly, the scheme achieved a reduction in US tax, and for the period prior to 2017, this was substantial (as any royalty that would have been paid in the US would have been subject to tax at 35 per cent.


This case arises in the context of intense scrutiny by the ATO in relation to IP and arrangements involving the exploitation of intangible assets. In recent years, the ATO has received additional powers to raise adjustments such as the DPT (from 2017) with more on the horizon (such as denying deductions for payments in relation to the exploitation of intangible assets in low corporate tax jurisdictions).

Multinational organisations who shares its IP with parties (related or unrelated) in Australia should conduct a review of their arrangements, with view to understanding their risks and putting in place strategies to manage financial exposure.

[1] This amount is not articulated in the decision.

Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).

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