Australia’s PepsiCo case. What does it mean for New Zealand?

By David Watkins, Liam O'Brien, Bart de Gouw & Melanie Meyer

The Full Federal Court of Australia (FFCA) has decided (by 2-1 majority) in favour of the taxpayer in the PepsiCo case (PepsiCo, Inc v. Commissioner of Taxation [2024] FCAFC 86), overturning the November 2023 first instance decision which upheld the Commissioner of Taxation’s position.

This is a significant case in Australia given the Australian Taxation Office (ATO) focus on intangible arrangements and in as much as it provided the most authoritative judicial analysis to date of both the diverted profits tax (DPT) and 2012 amendments to the Australian general anti-avoidance rules (GAAR) following an earlier series of court decisions on Part IVA that went against the Commissioner.

Case background

The case relates to an exclusive bottling agreement (EBA) involving PepsiCo, Inc (PepsiCo) being a US tax resident in connection with the Pepsi and Mountain Dew beverages, and a separate EBA involving Stokely-Van Camp Inc (SVC) in connection with Gatorade. SVC was also a US tax resident and a member of the PepsiCo group. In this article, references to PepsiCo should be read as also including SVC unless otherwise stated.

In summary, the facts are set out below:

• Parties to the EBA were PepsiCo, another PepsiCo group entity and Schweppes Australia Pty Limited (SAPL);

• SAPL was the sole distributor and bottler of the Pepsi and Mountain Dew beverages in Australia;

• PepsiCo undertook that it or its nominee would sell concentrate to SAPL. In the relevant years, being years ending 30 June 2018 and 2019, PepsiCo Bottling Singapore Pty Ltd (Seller) was the seller of the concentrate to SAPL. The price paid by SAPL to the Seller was agreed per the terms of the EBA. SAPL made a payment (EBA payment) to Seller for the concentrate; and

• PepsiCo granted SAPL a right to use the relevant trademarks and other intellectual property, such as bottle and can design. SVC granted an express license. No amount was expressed to be payable by SAPL for the use of the trademarks and other intellectual property.

Commissioner’s position

The Commissioner imposed tax on PepsiCo with respect to a portion of the EBA payment as follows:

• Royalty withholding tax (RWHT) pursuant to section 128B, Income Tax Assessment Act 1936 (ITAA 36); and

• In the alternative, pursuant to the DPT.
  

2023 decision

In the 2023 judgment, the court upheld the Commissioner’s position in respect of the RWHT argument and indicated that if it had not upheld the RWHT argument, it would have upheld the Commissioner’s DPT position.

2024 FFCA decision

On 26 June 2024, the FFCA overturned this decision with a 2-1 majority finding in favour of PepsiCo that neither RWHT nor DPT applied to the EBA payment. There were two sub-issues for both matters.

Was there a royalty?

There was no express payment for the use of the trademarks identified in the EBA. The majority held “The ordinary meaning of the language used by the parties therefore suggests that what was to be paid by the Bottler [SAPL] to PepsiCo/SVC...was a price being paid for the concentrate and therefore ‘as consideration for’ the sale of the concentrate” [13].

Following a discussion of relevant authorities, the majority concluded “It follows that the consideration for the purchase of the concentrate was the price the parties stipulated for it in the EBAs. As such, the payments made by the Bottler [SAPL] to the Seller did not include an element which was a royalty for the use of the trade marks (since the payments were not in consideration for the right to use the trade marks)” [37].

Was there any income derived by PepsiCo?

Although not necessary given the above conclusion, the majority addressed the question of whether moneys had been paid to and derived by PepsiCo. The majority rejected the Commissioner’s submission that there had been a direction to pay given to SAPL to pay the amount to Seller: “there can be no payment by direction unless there is an antecedent monetary obligation owed by the Bottler [SAPL] to PepsiCo” [40]. The majority concluded that there was no amount of income which had been derived or which had come home to PepsiCo.

Did DPT apply?

The DPT sits within the Australian GAAR provisions in Part IVA, ITAA 36.
The majority examined the scheme and concluded that the “commercial and economic substance of the scheme was that the price agreed for concentrate was for concentrate” [82], and for nothing else. The majority rejected the Commissioner’s proposed counterfactuals and held that the counterfactuals did not correspond with the substance of the scheme [86 and 87]. The majority thus held that “neither postulate is a reasonable alternative to the scheme” [99]. In the absence of a reasonable postulate, there could be no tax benefit. As a result, the DPT could not be applied.

The minority took a dissenting view that a DPT could be applied if there was a requisite principal purpose.

A full analysis of this decision can be found in this Deloitte Australia tax@hand article.

Implications of the decision – Deloitte Australia comments

This is a significant case given the Australian Taxation Office (ATO) focus on intangible arrangements. This case provides the most authoritative judicial analysis to date of both the DPT and the 2012 amendments to the Australian GAAR following an earlier series of court decisions on Part IVA that went against the Commissioner.

The ATO has not yet announced whether it intends to seek special leave to appeal to the High Court. If leave is sought, the High Court has a discretion as to whether to allow leave. It is public knowledge that another similar case is subject to dispute and may be heard by the courts in due course.

The facts associated with the EBA and the beverage distribution model are likely bespoke to that industry and so it is not clear what wider consequences can be drawn from this decision. However, the issue of embedded royalties is broadly relevant to a wide range of companies and manufacturers.

The ATO has been expressing concerns about royalties, intellectual property matters, and so-called “embedded royalties” over recent years. The ATO is also adopting a position that goes beyond the global consensus with respect to the application of the royalty provisions to software distribution arrangements. Intangibles will remain a key area of focus and likely dispute.

The Australian government has recently announced that Part IVA will be expanded, in particular to deal with cases that also include a foreign tax advantage. More recently, it has also been proposed that a penalty will be introduced from 1 July 2026 “to [large group] taxpayers …that are found to have mischaracterized or undervalued royalty payments, to which royalty withholding tax would otherwise apply.”

All of these developments create uncertainty for taxpayers. At this stage, however it seems that the following observations can be made:

• The Full Federal Court decision rejects a number of key ATO arguments in relation to royalty related matters.

• In particular, the court rejected that a royalty or an embedded royalty could be extracted out of a commercial arrangement that did not expressly provide for payment of a royalty, and this is the case even where it was clear that there was a grant of a right to use a trademark.

• The court provided the most authoritative analysis of the DPT to date, although it did not consider the relevant exceptions to the DPT (sufficient foreign tax and sufficient economic substance).

• Importantly, the court considered for the first time in detail the operation of section 177CB in Part IVA.

• On a majority basis, the fallback argument of the DPT was not successful. This principally turned upon the interpretation of section 177CB and the extent of “correspondence” that is required as between the substance of the scheme vs. the substance of an asserted counterfactual. The court (majority and minority) adopted a relatively strict application of section 177CB. The application of section 177B in this case was effectively determined by the position taken on the primary argument as to whether there was, in substance, a royalty under the actual arrangements (issue 1).

• Section 177CB is relevant to all applications of Part IVA: the multinational anti-avoidance law, the DPT, and the general operation of Part IVA.

• The transfer pricing provisions in Division 815 were not raised or considered in this case, so it is not clear at this stage whether the “arm’s length conditions” analysis would affect the outcome.
  

What does this mean for New Zealand? Deloitte New Zealand comments

New Zealand groups with Australian subsidiaries (or broader business relationships with third parties in Australia) should monitor the progress of the ATO’s possible appeal and/or any ATO interpretive decisions that may be released on the back of the FFCA’s decision and be aware of the potential impacts on existing arrangements. Those companies operating in the technology industry should also keep a close eye on whether the ATO’s position in Taxation Ruling TR 2024/D1 (when use of copyright under a software arrangement is subject to royalty withholding tax) is impacted.

Although Inland Revenue has not made any public statements, we understand that they are monitoring developments in this area closely. In addition to potentially impacting New Zealand groups with Australian arrangements, the current activity in Australia may also have implications for how Inland Revenue treats similar payments made by New Zealand companies.