Unbottling Royalties with PepsiCo
The Pepsi-Cola Cops (1940)
One of the ways multinational corporations consolidate wealth is by manipulating contracts to minimise tax obligations. The complexity of Australian tax law offers ripe opportunities for multinationals and their suite of lawyers and accountants to create sophisticated international schemes that skirt around black-letter law. Shrewd phrasing allows the form of these schemes to obfuscate their true purpose, rendering income untaxable.
The diverted profits tax (‘DPT’) regime within Pt IVA of the Income Tax Assessment Act 1936 (Cth) (‘ITAA’) aims to address this problem. [1] It allows a 40% tax to be imposed on income obtained from a scheme when the ‘principal purpose’ of the scheme was to obtain a tax benefit. [2] However, the regime had never been applied, leading to confusion on how its operative provisions functioned. That is until PepsiCo. Inc v Commissioner of Taxation. [3]
Ultimately, DPT did not apply to PepsiCo as the Commissioner succeeded in their primary argument regarding royalties. [4] Nevertheless, the case illuminates how the ‘principal purpose’ and ‘tax benefit’ tests in Pt IVA function, how the substance of schemes triumphs over legal forms when evaluating whether royalties are paid, and the importance of providing quantitative expert evidence that is derived from accessible data. [5] This judgement does not just clarify novel law – it shows how courts can cut through legal arrangements and reams of data to ascertain the objective purpose behind multinational tax schemes.
Who was involved?
The PepsiCo group is led by a parent entity in the US (‘PepsiCo-US’) that holds a portfolio of intellectual property related to the Pepsi, Mountain Dew, and Gatorade brands. In 2009, PepsiCo-US entered into an ‘exclusive bottling agreement’ (‘EBA’) with Schweppes. [6] This concerned the sale of beverage concentrate used to create PepsiCo products sold in Australia. While the agreement provided that Schweppes could use PepsiCo's intellectual property to fulfil obligations under the EBA, Schweppes did not have to pay PepsiCo-US for this right. Payment was only exchanged for the sale of concentrate. [7] Contractually, PepsiCo-US was not obtaining royalty income as no consideration was being exchanged for the use of intellectual property.
During 2018–2019, PepsiCo-US nominated PepsiCo Beverage Singapore (‘PBS’, a subsidiary of PepsiCo confusingly incorporated in Australia) as a supplier under the EBA which received income from Schweppes. [8] The Commissioner then stated that the payments from Schweppes to PBS were royalties subject to a 5% royalty withholding tax. They also issued a DPT notice, alleging that PepsiCo owed the ATO $28.9 million (calculated as 40% of the ‘royalties’). [9] PepsiCo appealed these determinations in the Federal Court.
Royalty (Withholding Tax)
The legal question the court sought to answer was whether the exclusive bottling agreement involved consideration for the right to use intellectual property, despite this property being technically provided on a free basis. [10]
To determine this question the court first considered the EBA and the terms within it. However, they were also obliged to note the wider commercial context of the EBA and the broader manner by which PepsiCo structured arrangements with its bottlers. [11] In sum, they had to evaluate the substance of EBA and reconcile this with its form. The court held that the payments could be deemed royalties irrespective of their legal form.
The central finding justifying this decision was the fact that the EBA contained an implied licence to use PepsiCo branding, as Schweppes Australia could not fulfil its contractual obligations if could not use PepsiCo intellectual property when labelling, marketing, and distributing products. Indeed, the EBA could be terminated if this did not happen. [12] Additionally, it was found relevant that PepsiCo-US (the ultimate IP holder) was a party to the EBA and historically the PepsiCo concentrate and their brands ‘always [went] together.’ [13] There were no commercial arrangements involving the licensing of the PepsiCo brand without the sale of the concentrate.
Moreover, the global appeal and recognition of the PepsiCo brands indicated it was of high value, and in effect being exchanged in the EBA. [14] Schweppes was held to have gained a specific commercial advantage from being able to use PepsiCo branding.
Royalties
Once it was held the EBA between PepsiCo-US and Schweppes contained a royalty, the court had to determine the quantum of the royalty. While both parties offered expert evidence on this issue, the court preferred the Commissioner’s expert due to his specific experience in valuing royalties. [15] He first analysed the amount of royalties in comparable agreements, determining a royalty rate of 5.88% of net sales was reasonable. [16] The court affirmed this.
A secondary analysis was also performed by collating ‘implied royalty rates’ provided by a third-party aggregator. The second analysis was rejected, as the court could not critically evaluate how implied royalty rates were calculated. [17] Even though implied royalty rates were commonly used in the accounting industry, the Commissioner did not provide the court with the means to verify the assumptions used to calculate these rates. [18] This serves as a stark reminder that courts require utmost clarity on how expert evidence is obtained and clear explanations on how figures are calculated.
The Diverted Profits Tax
For completeness, the court analysed whether income obtained via the scheme could be subject to DPT. To determine this, they had to note whether a tax benefit was obtained and whether this benefit was the ‘principal purpose’ for entering the scheme. [19] To evaluate the former question, the court considered a counterfactual scenario, where Schweppes paid for both PepsiCo's intellectual property and concentrate. [20] The court held that this was a fair scenario given this hypothetical scheme would ultimately cost the same for Schweppes and produce identical commercial benefits; [21] all that had been changed was the wording of the EBA.
Given there was a reasonable chance PepsiCo-US would have paid royalty withholding tax in this counterfactual, it followed a tax benefit accrued to PepsiCo-US. The cCourt then ruled the ‘principal purpose’ test does not require tax avoidance to be the sole or dominant rationale for entering a scheme but merely needs to be a primary factor. [22] This test was satisfied given there was a fundamental disconnect between the legal form and the underlying form of the scheme. [23] The EBA invariably involved the licensing of the PepsiCo brand given it’s high-value and importance to the contract. Despite the scheme only saving PepsiCo-US 2.4 million in tax, a relatively small amount, this did not preclude the incurrence of DPT. [24]
Implications
This decision signals to multinationals that the substance of schemes involving intangibles will be analysed to determine whether royalties ought to be paid. It affirms the ATO's previous guidance and their wide characterisation of ‘embedded royalties’. [25]
Furthermore, given DPT could have applied to PepsiCo, one would expect to see the Commissioner rely upon these provisions more often. This is because the 40% tax penalty it imposes on multinationals far exceeds royalty withholding tax rates within various double tax agreements. Consequently, the Commissioner would have received eight-fold more revenue had they relied upon DPT as their primary argument. The fact that DPT may have applied even though PepsiCo-US only obtained $2.4 million in benefits further expands its potential use.
The old adage about the two inevitabilities in life has been preserved and the opacity invited by corporate entities has been withheld, if only for a little while longer.
[1] Income Tax Assessment Act 1936 (Cth) Pt IVA (‘ITTA’).
[2] (n 1) ITTA s 177J; Diverted Profit Tax Act 2017 (Cth) s 4.
[3] [2023] FCA 1490.
[4] Ibid [8].
[5] Ibid [405]-[466], [237]-[253], [267]-[399].
[6] Ibid [4].
[7] Ibid [6].
[8] Ibid [7].
[9] Ibid [8].
[10] Ibid [223].
[11] Ibid [240]-[241].
[12] Ibid [245].
[13] Ibid [247].
[14] Ibid [248].
[15] Ibid [271]-[272].
[16] Ibid [403].
[17] Ibid [373].
[18] Ibid [367].
[19] (n 1) ITTA s 177J (a)-(b)(i), 177C (bc).
[20] Ibid [428]
[21] Ibid [435]-[439]
[22] Ibid [445]
[23] Ibid [452]; (n 1) ITTA s 177D(2)(a).
[24] PepsiCo, Inc v Commissioner of Taxation [2023] FCA 1490 [464]; (n 1) ITTA s 177J(2)(c).
[25] Australian Taxation Office, Mischaracterisation of activities or payments in connection with intangible assets (TA 2018/2, 20 November 2018).
This article was originally published under the title ‘Unbottling Royalties: Unbottling Royalties: PepsiCo, the ATO, and Diverted Profits’ in The Brief Edition 1, 2024 — Through a Glass, Darkly.