The Federal Court has held in Pepsi Inc v Commissioner of Taxation  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  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:
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.
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. 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.
In relation to royalty withholding tax, the Federal Court found that:
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 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:
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:
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.
 This amount is not articulated in the decision.
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