Commissioner’s embedded royalty hunt diverted

The majority of the Full Federal Court has held in PepsiCo, Inc v Commissioner of Taxation [2024] FCAFC 86 that certain international arrangements involving the licence of trademarks and other intellectual property (IP) are not subject to withholding tax and that the Diverted Profits Tax (DPT) does not apply. This decision overturns the earlier decision of Justice Moshinsky at first instance in PepsiCo, Inc v Commissioner of Taxation [2023] FCA 1490. The minority of the Full Federal Court agreed that withholding tax does not apply, but found that the DPT does apply.

The background to the case is set out in our article on the decision of Justice Moshinsky , ‘Royalty-free contracts will attract scrutiny by the ATO’.

Further clarification required concerning “consideration for the use of or right to use” IP

In these matters, there is a heavy focus on discerning the proper construction of the agreements. All of the judges (both Federal Court and Full Federal Court) considered in detail the terms of the agreements and the existing case authorities, with the four evenly split on the issue of whether a component of the payments made by the Australian bottler was properly viewed as consideration for its use or right to use PepsiCo’s IP.

Two of the judges (Justice Moshinsky at first instance and Justice Colvin in the Full Federal Court) found that a component of the payment was such consideration. They appear to have been influenced by the fact that PepsiCo’s IP (including its brands) was considered “strong and valuable” and that it was “commercially unreasonable” that the Australian bottler would have had access to the IP and not have paid for it.

The two judges of the majority in the Full Federal Court (Justices Perram and Jackman) found that the payments were not consideration for the Australian bottler’s use or right to use PepsiCo’s IP. Their Honours disagreed that the IP rights were being granted for nothing. Their Honours noted that the relevant agreements involved an array of rights and obligations and that PepsiCo derived significant benefit from having the Australian bottler distribute products using PepsiCo brands in the Australian market. The Australian bottler was also significantly constrained in terms of what it could do with the PepsiCo IP.

Conventional approach taken to the “derivation” of income analysis

The decision clarifies the circumstances in which royalty income may be “derived” for Australian tax purposes.

All members of the Full Federal Court took a conventional approach to the derivation of income analysis and found that the payment obligations of the Australian bottler were owed to the nominated Australian PepsiCo subsidiary (which supplied the concentrate, issued the relevant invoices and collected payment) and not to PepsiCo.

The approach taken by Justice Moshinsky potentially broadened the concept of derivation and might have caused concern that unexpected outcomes could arise under other common types of contractual arrangements. For example, it is common for a single member of a corporate group to enter into a master supply agreement with a single member of a supplier group to set the pricing and other terms on which goods or services will be supplied by members of the supplier group to members of the corporate group. It would be a concern if all payments made by members of the corporate group were considered to be derived by the single member of the supplier group that was the party to the master supply agreement. The approach taken by the Full Federal Court should allay concerns in this regard.

Consideration of the DPT

The Full Federal Court provides further judicial consideration of the application of the DPT. The Full Federal Court was required to consider the DPT as all three judges found that royalty withholding tax did not apply.

Broadly the DPT applies where:

• there is a scheme;
• the taxpayer obtains a “tax benefit” in connection with that scheme; and
• it would be concluded that the taxpayer or another person entered into the scheme (or part of the scheme) for a principal purpose of obtaining a tax benefit and/or reducing a foreign tax liability. This is an objective test that is determined having regard to certain matters specified in the legislation.

The majority of the Full Federal Court held that the DPT did not apply because PepsiCo did not obtain a “tax benefit”. The majority made several interesting and technical observations about the process for identifying a “tax benefit”.

The majority found, consistent with established authorities on Part IVA, that to identify a relevant “tax benefit” you need to compare the scheme to a postulate that is a reasonable alternative to the scheme. For the purposes of the DPT, in order to determine if a postulate is a reasonable alternative to the scheme, you need to look at the commercial and economic substance of the scheme and compare it to the commercial and economic substance of the postulate. The postulate will only be reasonable where the commercial and economic substance of the postulate and the scheme correspond.

In this case, the majority found that the commercial and economic substance of the scheme was that a price had been agreed for the supply of concentrate only. The scheme articulated by the Commissioner and the evidence led did not provide a basis for the majority to conclude that the price that was agreed in the scheme included a royalty component. On that basis, any alternative postulates that included a royalty component in the price for concentrate were not reasonable as they did not have the same commercial and economic substance as the scheme.

Although the majority found that there was no “tax benefit”, and although not strictly necessary to do so, they offered views about the purpose of those who entered into the scheme and how to go about the task of evaluating the eleven statutory matters through a hypothetical prism (i.e. assuming that there was a tax benefit). The majority agreed with Justice Moshinsky that “a principal purpose” was a purpose which was prominent, leading or main and there could be more than one such purpose. Further, purpose is an objectively determined construct. In evaluating the evidence and the statutory matters, the majority noted that there was a connection between the identification of the tax benefit and the evaluation of the financial and foreign law impact. As such, the majority needed to make “highly artificial” assumptions about the nature of the scheme that were different to their earlier findings.

This renders some of the analysis of the eleven statutory matters counterintuitive (e.g. when comparing the form and substance of the scheme).

Justice Colvin disagreed with the majority’s conclusion in relation to “tax benefit”. His Honour had found that a component of the payments made by the Australian bottler related to its use of PepsiCo’s IP. As such, his Honour’s analysis of the commercial and economic substance of the scheme was different to that of the majority and he identified a “tax benefit” accordingly. Justice Colvin agreed with the majority in relation to “purpose” and found that the DPT applied.

It is difficult to distil the legally binding principles in relation to the interpretation of the purpose test from the four decisions in this case. The comments of three of the judges (Justice Moshinsky at first instance and Justices Perram and Jackman on appeal) are “obiter dicta” (i.e. the judgments were not decided on this basis and so the comments are not binding). The fourth judge (Justice Colvin) does rely on the outcome of the purpose test in his decision (so his Honour’s comments are not “obiter dicta”), but his Honour adopts the reasoning of the majority (which was based on what the majority termed “highly artificial” assumptions).

The taxpayer was fortunate to be able to show, based on the evidence led, that there was no “tax benefit”. The approach taken by the Federal Court to purpose seems to set the bar very low. If the DPT was to apply to a case like this, the result would appear to be quite draconian. The difference in tax rate is much more significant where the “tax benefit” relates to withholding tax. The DPT is imposed at 40 per cent whereas royalty withholding tax can be as low as 5 per cent under some tax treaties. It may also be more difficult for a taxpayer to address issues of double taxation, e.g. Australia has excluded DPT matters from most of the arbitration clauses in its tax treaties.

The Commissioner has the option of seeking special leave to appeal the Full Federal Court’s decision to the High Court.

Action required

In light of the ongoing ambiguity in relation to this area and tight timeframes if faced with a DPT assessment, we continue to recommend that organisations who use IP as part of their business model 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:

• contracts which permit another party to use IP (e.g. copyright, trade marks, technical knowledge and assistance);
• 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).

It will be important for taxpayers to be able to explain the commercial and economic substance of the arrangement, including the role played by the relevant IP. This is likely to be a qualitative and quantitative explanation (the Full Federal Court suggests that evidence of an economic expert may be helpful in this regard).