PepsiCo victory: the High Court provides welcome guidance on “embedded royalties” and the DPT

In a landmark decision, last week, the High Court of Australia by a 4:3 majority dismissed the Commissioner of Taxation’s appeal from a decision of the Full Federal Court of Australia in Commissioner of Taxation v PepsiCo Inc [2025] HCA 30 and related proceedings. 

The case concerned international agreements between entities in the US (PepsiCo, Inc and Stokely-Van Camp, Inc^[1]) and an unrelated party in Australia (Schweppes Australia Pty Ltd, SAPL) for the bottling, sale and distribution of beverages in Australia. The agreements provided for the sale of flavour concentrate necessary for the manufacture of the beverages. An Australian PepsiCo group company, PepsiCo Beverage Singapore Pty Ltd (PBS) was nominated to supply the concentrate to SAPL. In addition, SAPL used the intellectual property (IP) associated with the beverages (trade marks, brand names, know-how, etc.) to fulfill its obligations under the agreements. No royalty was paid for this use.

Broadly, there were four questions considered by the High Court:

1. whether the payments made included an amount paid “as consideration for” IP, within the definition of “royalty” in s 6(1) of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936);

2. if so, then whether the royalty component of the payments was “paid to” and hence income “derived” by PepsiCo under s 128B(2B) of the ITAA 1936, such that withholding tax was payable under s 128B(5A);

3. if there was no liability to withholding tax, whether under the Diverted Profits Tax (DPT) rules, PepsiCo obtained a “tax benefit” in connection with a scheme; and

4. whether the DPT applied (ss 177J and 177P of the ITAA 1936) on the basis that the scheme was entered into or carried out for the principal purpose of enabling PepsiCo to obtain the tax benefit identified by the Commissioner.

Set out below are our key observations and takeaways from the case followed by a high-level summary of the judgment of the High Court majority.

Key observations and takeaways

The Commissioner of Taxation (Commissioner) has for some time had an intensive focus on the Australian taxation consequences of international arrangements involving the use of intangibles. In particular, the Commissioner has sought to identify potential “embedded royalties” (to which royalty withholding tax may apply) in payments under ordinary commercial arrangements in various contexts. The Commissioner has also been prepared to use all the tools available to him, including the DPT, to challenge any perceived underpayment of tax. The DPT is a heavy-handed anti-avoidance measure. It has several unique features, including the requirement to pay 40 per cent of the tax benefit (in the PepsiCo scenario the amount of the royalty) up front, and a fast-tracked dispute process. A taxpayer faced with a DPT assessment will need to exert significant effort to gather evidence, including potentially evidence that demonstrates that the relevant arrangements have economic substance and accord with commercial and third-party dealings. 

The Commissioner’s approach to “embedded royalties” is a difficult issue. Except in more egregious cases, the parties to the arrangement under review may not have contemplated the existence of a royalty. In this context, it can be very difficult to interpret the available facts and evidence through the prism of the legal tests for royalty withholding tax (or the DPT). The PepsiCo case demonstrates that reasonable minds can differ as to the interpretation and effect of contractual arrangements regarding the use of IP. PepsiCo can take comfort from the fact that the High Court majority found for the taxpayer on all four of the questions noted above. However, from a broader perspective, a total of 11 judges (across the Federal Court and the High Court) considered the case. On two of the key legal tests considered (i.e. questions one and three above), only six of the 11 (a bare majority) found for the taxpayer. On the other two key legal tests the judges found resoundingly for the taxpayer (10 to one) on question 2, whereas a majority (seven to four) found for the Commissioner on question 4 (albeit that two of the seven judges based their analysis and conclusions on question 4 on “highly artificial” assumptions regarding the nature of the scheme, different to their earlier findings). 

The decision is a great outcome for PepsiCo and clarifies the tax treatment of their particular arrangements (and potentially those of other taxpayers with taxable facts similar to those of PepsiCo). However, the issue of “embedded royalties” continues to be a minefield for taxpayers more broadly. It is unlikely that the PepsiCo case will dissuade the Commissioner from maintaining his focus on vigorously testing whether arrangements for the use of intangible assets give rise to appropriate revenue returns to Australia. We anticipate that the Commissioner will study the High Court’s judgments carefully and attempt to understand how similar or different other taxpayer arrangements are from the taxable facts in the PepsiCo case. The implications and broader considerations arising from this case include:

• Royalty-free arrangements and royalty withholding tax: It is necessary to consider carefully the terms of the arrangement agreed between the parties to determine whether there is a nexus between any payments under those arrangements and the conferral of IP rights. Factual elements that were helpful for the taxpayer in the PepsiCo case included that:
  • the contracts for the sale of concentrate were separate from the broader arrangements for the bottling, sale and distribution of branded products (under which the relevant IP rights were granted);
  • the amounts of the relevant payments were found to be arm’s length, a fair price and not disproportionately high;
  • the arrangements were between independent third parties; and
  • the relevant payments (for the concentrate) were not made (and were not legally required to be made) to the IP owner.

In future cases, the Commissioner may attempt to distinguish the PepsiCo case on its facts and seek out taxpayers with taxable facts that do not have these features. The Commissioner may also take lessons from how he ran the case (e.g. regarding the evidence adduced and the payments that he focused on). 

• DPT and the taxpayer’s onus of proof: Taxpayers should reflect upon whether the economic substance of their arrangements is adequately and expressly explained in their contractual arrangements and other contextual evidence. There is a direct correlation between the characterisation of the substance of the arrangements for the purposes of determining if there is a tax benefit and the form and substance matter in s 177D(2) of the purpose analysis. Taxpayers require extensive evidence to discharge their onus of proof. The case confirms that there are ways in which taxpayers can show that there was no tax benefit. These include that there was no reasonable alternative to the actual arrangement. However, this argument may only be available in “unusual” cases. In the PepsiCo case, the taxpayer’s argument in this regard was “enabled” by the fact that the substance of the arrangements included that the price paid for concentrate was for concentrate and nothing else, the arrangements were at arm’s length, between unrelated parties and the absence of a royalty was market standard.
• ATO guidance and alerts: the broad approach to interpretation of the contractual arrangements and royalty withholding tax obligations taken by the Commissioner in running this case has also been reflected in Draft TR 2024/D1, Income tax: royalties – character of payments in respect of software and intellectual property rights. A similar approach has been adopted in Taxpayer Alert TA 2018/2 Mischaracterisation of activities or payments in connection with intangible assets. We expect the ATO to update its interpretive approach and alerts to reflect the findings of the High Court. This does not necessarily mean that the ATO will change its conclusions, but it may seek to explain why the findings of the High Court do not impact its interpretive approach.
• Possible legislative reform: The Commissioner is known to run cases with a view to clarifying the law, and in some cases where the Commissioner has been unsuccessful, Treasury has introduced legislation to remedy the perceived gap. It is too early to know whether this will be a consequence of the PepsiCo case; although it appears a definite possibility that taxpayers and their advisers need to be alive to. In our view, ”knee jerk” law change based on the outcome in the PepsiCo case is unwarranted and would be unhelpful and ought to be strongly resisted. Australia’s tax administrators and policy makers should keep in mind that the High Court majority described the critical facts in the PepsiCo case as “unusual” and “unique”. Further, Australia’s anti-avoidance provisions are already broad and uncertain (and have significant consequences where they apply). Rather than seeking to expand the statutory provisions, it may be more constructive to reflect on whether the PepsiCo case was in fact an appropriate case in which to seek to apply the DPT. 

Summary of decision of High Court majority

Royalty withholding tax

The Commissioner contended that the payments from SAPL to PBS for the concentrate were in part “consideration for” SAPL having the right to use PepsiCo’s IP. However, the majority of the High Court (Gordon, Edelman, Steward and Gleeson JJ) found that the payments were for concentrate and did not include a component which was a royalty. It found that whether a payment is for the use of IP will depend on the basis, purpose or condition for the conferral of the use of the IP and this depends on what the parties have agreed. On the construction of all the promises and obligations of the arrangements between the parties in this case, the majority concluded that there was no causal connection between the promise to pay the contractual price for the concentrate and the right to use the IP. In fact, the contract for the sale of the concentrate (and associated payment) was separate from the broader bottling arrangements under which the IP rights were granted.

Importantly, the Court also noted that the Commissioner did not contend that the price paid for the concentrate was incorrect, not arm’s-length or fair or had been inflated to hide a secret royalty.

The Court unanimously dismissed the Commissioner’s contention that PepsiCo “derived” income from the payment of a royalty. In that regard, there was no monetary obligation, antecedent or otherwise, to pay the IP owner (i.e. PepsiCo, in respect of the concentrate and such a construction did not accurately reflect the actual terms of the agreements.

DPT

Broadly, for the DPT provisions to apply, it is necessary for the Commissioner to identify a scheme, a tax benefit and that a person or persons entered into or carried out the scheme for the principal purpose of enabling the taxpayer to obtain the tax benefit or obtain the tax benefit and reduce a foreign tax liability in connection with the scheme. The Commissioner’s identified scheme was entering into the arrangements on terms where SAPL bought concentrate and was licensed to use the IP but paid no royalty for the use of that IP. According to the Commissioner, had the scheme not been entered into or carried out, a reasonable alternative was that the contracts would have either:

• expressed the payments to be for all of the property provided by and promises made by PepsiCo; or
• expressly provided for the payments to include a royalty for the licensed IP.

Tax benefit 

The majority confirmed, consistent with orthodox approaches to Part IVA analysis, that whether there is a tax benefit is to be established as an objective fact, and that the inquiry involves a comparison between the scheme and the alternative postulate.

Importantly, the majority clarified that there cannot be a tax benefit if there is no reasonable alternative to the scheme. In discharging its onus, a taxpayer does not need to prove the existence of a reasonable alternative postulate in which it was not liable to pay tax. The majority acknowledged that in “unusual” cases a taxpayer may establish that there is no tax benefit by demonstrating that there is no postulate that is a reasonable alternative to the scheme (measured by reference to the substance of the scheme and any result or consequence for the taxpayer achieved by the scheme). In clarifying this area of contention that has emerged in recent Part IVA cases, the majority endorsed the Full Federal Court decision in RCI Pty Ltd v Federal Commissioner of Taxation,^[2] noting that the question posed by s 177C(1)(bc) of the ITAA 1936 is whether the taxpayer would have, or might reasonably be expected to have, been liable to pay tax if the scheme identified by the Commissioner had not been entered into or carried out. This is a question to be resolved objectively on all of the evidence, including inferences available based on the evidence as well as the apparent logic of events.

It was observed by the majority that a correct understanding of the economic substance of the contractual arrangements is important in considering the application of the DPT provisions. The Commissioner submitted that the economic and commercial substance of the scheme was that in return for each payment SAPL received two benefits: the concentrate and the PepsiCo IP. The Commissioner, by submitting that the allocation of the total contract price to concentrate was not the substance of the scheme, had misconceived and oversimplified the contractual arrangements between the parties. On this basis, the Commissioner’s alternative postulates were not considered to be reasonable as they did not reflect the true economic and commercial substance of the scheme. 

The majority found that PepsiCo was able to demonstrate that there were no other reasonable alternatives to the scheme because there was no way that the commercial substance of the scheme could be satisfied and an amount be allocated to a royalty at the same time. The conclusion that the taxpayer did not obtain a tax benefit was enabled by three critical facts, “unique” to the appeals:

• the substance of the scheme (properly construed and characterised) included that the price paid for concentrate was for concentrate and nothing else;
• the scheme was a product of arm’s length dealings between unrelated parties; and
• the absence of a royalty was a market standard, and a substantive element of the business model adopted by the PepsiCo group (PepsiCo’s longstanding “franchise-owned bottling operation” (FOBO model)).

Purpose

While not strictly necessary for the majority to consider the question of purpose given the conclusion it reached in relation to tax benefit, the majority nonetheless helpfully made some observations about a number of the factors relevant to ascertaining purpose that are found in s 177D(2).

The majority endorsed an observation of the primary judge, stating that it would be unthinkable that sophisticated commercial operators did not take tax outcomes into consideration in negotiating transactions. Consistent with a long line of previous cases, the majority confirmed that taking tax outcomes into account does not necessarily justify the application of Part IVA or the imposition of the DPT.

The majority said that the manner in which the scheme was entered into or carried out pointed away from the requisite purpose, for reasons which included that the scheme was a product of arm’s length negotiations, produced a price for concentrate that was not disproportionately high, was paid to an Australian resident taxpayer and followed broadly a pre-existing and entirely commercial way of doing business (i.e. the FOBO model). Further, the Commissioner’s position in relation to form and substance was flawed because it misstated the true economic and commercial substance of the scheme. As to the other factors, the majority noted that all, with the exception of the last factor (i.e. a reduction in foreign tax), “strongly support” the conclusion that the principal purpose of PepsiCo in entering into and carrying out the scheme was not to obtain the tax benefit identified by the Commissioner. 

^{[1] For simplicity, we only refer to PepsiCo in this article, but the analysis and outcomes for the arrangements with Stokely-Van Camp, Inc were the same. 
[2] (2011) 84 ATR 785}