Fizz, Tax, and Legal Facts: Unpacking PepsiCo v Commissioner of Taxation

This case has already gone through the Full Federal Court, who decided in favour of PepsiCo in June of 2024, overturning the Federal Court’s earlier decision which had ruled in favour of the Commissioner. Now, with the most recent update in November that the High Court has granted the Commissioner special leave to appeal, there’s a chance we’ll see some further clarity – or a shake-up – in how these payments are regulated under Australia’s tax law.

For professionals advising multinational corporations, this case is a big deal. It brings into question how cross-border arrangements are structured and scrutinised, and it underscores the need to balance legal precision with commercial realities. Whether you’re in tax law, corporate advisory, or simply interested in global business, there’s a lot to unpack here.

• In this case, PepsiCo and Stokely-Van Camp, both belonging to the PepsiCo Group, entered into Exclusive Bottling Agreements (EBAs) with Schweppes Australia Pty Ltd (Schweppes). The EBAs provided that PepsiCo and SVC (or a seller they nominated) agreed to sell concentrate to Schweppes for PepsiCo branded beverages, as well as the exclusive license to use PepsiCo’s trademarks and other intellectual property necessary to bottle, distribute and sell PepsiCo branded beverages in Australia (namely, the popular beverages Pepsi, Mountain Dew and Gatorade). Notably, the EBAs did not specify any separate royalty payments for the use of this intellectual property. Payments were then made by Schweppes to PepsiCo Bottling Singapore Pty Ltd (the Seller nominated by PepsiCo), who then passed those payments (minus a small margin) along to the Singapore-based producer of the concentrate, which was also another subsidiary of PepsiCo. The Commissioner of Taxation (Commissioner) argued that part of Schweppe’s payments should be classified as royalty payments for the use of PepsiCo’s trademarks and IP, and therefore should be subject to Royalty Withholding Tax (RWT) under the ITAA. Further, the Commissioner argued that if PepsiCo and SVC were not liable to pay RWT, then they should be subject to Diverted Profits Tax (DPT) under the ITAA, which applies to multinational corporations whose profits have been diverted offshore to avoid Australian tax, arguing that they had structured the EBAs for the principal purpose of avoiding tax.At first instance, the Federal Court held that part of the payments Schweppes made for the concentrate constituted royalties under the ITAA and as a result, PepsiCo and SVC were liable for RWT on a portion of the sales. The Court also found that, if RWT was not applicable, the arrangement was for the principal purpose of obtaining a tax benefit, and as such PepsiCo and SVC would have been liable for DPT. However on appeal, the Full Federal Court (FFC) overturned the decision. It unanimously ruled that the payments from Schweppes to the Seller were not subject to RWT. Additionally, a majority of the FFC held that if the payments were not royalties, the DPT would not apply. Most recently at the time of writing, in November 2024, the High Court granted the Commissioner special leave to appeal the FFC’s decision.

Oracle Corporation Australia Pty Ltd v Commissioner of Taxation (Stay Application) [2024] FCA 1262

• Oracle Australia purchased software and hardware from Oracle Ireland under complex contractual arrangements, making sublicence fee payments for rights including the use of copyrighted programs. The key issue was whether these payments constituted ‘royalties’ under the Australia-Ireland double taxation agreement, which would trigger a withholding tax obligation. The Federal Court declined to stay proceedings, citing the need for a judicial determination on the definition of ‘royalty’ due to its implications for multiple taxpayers and international tax relations, particularly the dispute between the United States and Australian Treasury.

• PepsiCo may prompt distributors to review their distribution agreements to determine who bears the cost of withholding tax, potentially leading to a reevaluation of cost allocation between distributors and offshore sellers. This decision could pose practical challenges for anyone involved in cross-border trade, particularly in terms of passing on additional costs to the original seller.
• International treaties exist to prevent companies from paying tax twice on profits through a network of withholding tax agreements between countries.
• The concept of a royalty in tax is defined as a payment for the use of intellectual property. IP lawyers may not understand this concept as it is a tax concept rather than an IP law concept. Courts have determined that giving someone permission to do something restricted by IP law qualifies as a use of the relevant intellectual property.
• Australia has General Anti-Avoidance provisions, found in Part IVA of the ITAA, allowing the Commissioner to set aside transactions done to avoid tax and reinstate the correct ones. This provision grants the commission significant power, including the DPT, with this being the first case involving the DPT rules in Australia.
• The DPT targets the behaviour of large multinational corporations, imposing penalties and restrictions on access to dispute resolution processes. It includes a 40% penalty, a one-year waiting period before accessing courts or arbitrators, and an evidentiary sanction preventing the introduction of evidence not produced during the waiting period in court proceedings.
• The system involves determining the answer under domestic law and then assessing if it is influenced by a treaty. Despite some variations in definitions, the consideration for trademark use remains crucial in both contexts, indicating similarities rather than major distinctions in this particular matter.
• The Oracle decision acknowledges a broad range of international commentary beyond traditional sources, including new OECD directives on Base Erosion and Profit Shifting. International tax lawyers face the challenge of sifting through this growing body of commentary to determine its relevance to interpreting treaties like the US-Australia treaty, which may continue to evolve in meaning even after execution.
• Australia is facing a tension between participating in an OECD process that influences international laws and asserting its own domestic position, which may lead to inconsistency. It is important to consider how this balance can significantly impact the interpretation and application of laws.

• Several important rulings involving the ATO, including the PepsiCo and Oracle decisions, have demonstrated the importance of bundling up commercial arrangements and viewing them as a whole to determine consideration. It is essential to gather all relevant documents and interpret them collectively to understand the totality of the agreements involved.
• The Commissioner emphasises that these cases should provide guidance to many taxpayers, but small factual differences can greatly affect the outcome. This suggests that there may be limitations to the applicability of such guidance.
• Parties are recognising the broader risks in agreements and are taking commercial steps to manage them, particularly in terms of recovery against the other party. This has led to a renewed focus on traditional risk management approaches and addressing issues around passing risk back and forth in contractual terms.
• Consolidating all relevant documents, considering intellectual property, engaging in the process, and reflecting on pricing and terms can help assess tax risks and determine risk management strategies.
• To progress your career development, it is important to consider the type of work and clients you have access to in your role to ensure you are working with a suitable level of complexity. Additionally, focus on topics that interest you in a multidisciplinary sense.

Today on the show we’re talking about PepsiCo, Inc v the Commissioner of Taxation. Now, this PepsiCo case has been going on for a while and if you haven’t heard about it, well, it’s been sparking significant interest this year in the tax law community and for good reason. At its core, it’s a dispute about how Australia taxes payments between multinational corporations and their Australian subsidiaries.

Now, this case has already gone through the Full Federal Court, who decided in favour of PepsiCo in June 2024, overturning the Federal Court’s earlier decision, which had ruled in favour of the Commissioner. Now, with the most recent update in November, the High Court has granted the Commissioner special leave to appeal to the High Court.

So, there’s a chance that we’ll see some further clarity, or maybe even a shake up, in how these payments are regulated under Australia’s tax legislation. Now, for professionals advising multinational corporations, this case is a big deal. It brings into question how cross border arrangements are structured and scrutinised, and it underscores the need to balance legal precision with commercial reality.

If you’re in tax law, corporate advisory, or you’re just interested in global business practice, there’s a lot to unpack. Now to guide us through the intricacies of this case and its broader implications, we’re joined by the Principal of McNab Tax Lawyers, Paul McNab. With years of experience in navigating the complexities of cross border tax transactions, Paul’s here to share his insights on what this case could mean for multinational corporations and the lawyers who advise them.

Paul, thank you so much for joining us today on Hearsay.

So this decision has a potential application across a huge range of tangible goods companies. That’s the first observation.  Second observation, though, is that there are now a significant number of business models, especially in the hardware, software, IT services markets, where we’re not dealing with trademarks – although they may be there as well – but we were dealing with services or products that involve other intellectual properties, such as copyrights and patents. So what we see here. Yes, there’s an argument about whether or not part of the payment for goods is royalty, but there’s also an underlying argument about what is a royalty?  What use has to be made of intellectual property before it gives a rise to royalty? So the Commissioner has come out and said, for instance, that a major ruling on royalties in the software sector has been delayed pending the final judgment in PepsiCo.

TIP: So what are the Diverted Profit Tax, or DPT provisions in the Income Tax Assessment Act? Well, these provisions ensure that significant global entities, or SGEs, pay taxes reflecting their economic activities in Australia. It’s supposed to prevent profit diversion to offshore arrangements, and it’s supposed to promote timely resolution of tax disputes by encouraging SGEs to provide comprehensive information to the ATO. The Diverted Profit Tax provisions apply to SGEs – defined as entities with a global income of a billion dollars Australian or more – either as Australian headquartered entities or local operations of foreign multinationals. Interestingly, if no global financial statements exist to base that one billion dollars of income on… Well, the Commissioner of Taxation can determine an entity’s SGE status based on reasonable belief. The DPT targets schemes designed to provide Australian tax benefits through arrangements with foreign associates, but exceptions include meeting the 25 million income threshold, sufficient foreign tax, or economic substance tests.

The Commissioner of Taxation applies an alternative postulate test in a DPT assessment – a bit like the general anti avoidance provisions – to determine the tax benefit gained from a particular arrangement. The test requires identifying a reasonable alternative postulate; a hypothetical arrangement that could have achieved substantially the same non tax results as the actual arrangement. This alternative has to align with the commercial and economic substance of the original arrangement, assuming that tax considerations were irrelevant. The use of the alternative postulate is meant to ensure that the arrangement is assessed on its commercial merits, focusing on whether it reflects genuine economic activity or constitutes tax avoidance. Similar to the UK’s relevant alternative provision test, the test examines whether under comparable commercial circumstances, an equivalent transaction might have occurred, potentially involving different parties or terms. If such a reasonable alternative would not have provided a tax benefit, then no DPT assessment applies. DPT assessments, once made, are subject to internal ATO review and some administrative guidance has been provided by the ATO that clarified DPT laws and their risk assessment frameworks  – and we’ll leave a link to that guidance material in the show notes. 

In the PepsiCo case, the Commissioner argued that under the alternative postulate test, if PepsiCo had not been motivated by tax considerations, they would’ve structured the payments differently by splitting them into distinct components. One part for the use of the trademarks and another for the use of the concentrate. This argument was meant to show that the actual payment structure, i.e. a single concentrate price, obscured what was an implicit royalty to use the trademarks, which could have triggered the DPT. However, the Full Federal Court rejected this, finding that the Commissioner’s alternative postulate did not reflect the commercial and economic substance of the actual arrangement.

The Court emphasised that the alternative postulates were inconsistent with the realities of the transaction, especially because the concentrate price could not be reasonably construed as including a separate royalty component. This inconsistency rendered the postulates unreasonable under the DPT framework, and as a result, the DPT didn’t apply. 

The DPT though is a provision designed to leverage the behaviour of multinationals. So the DPT part really only applies to large groups and it has a couple of particular provisions in it and the main ones that concern groups are; it says that the Commissioner is entitled when he applies the provision to assess you plus a 40% penalty, and to do two things. Firstly, make you wait for a year before you can access the courts, so it slows up your access to an arbitrator. And secondly, any evidence you don’t produce during the year can’t later be introduced in any subsequent court proceedings. So there’s an evidentiary sanction, a cash flow up front, and a delay in access to other dispute resolution processes.  So DPT is a pretty powerful provision for the Commissioner.

TIP: The Australian DPT provisions are modelled on the UK DPT provisions, but they exhibit important differences reflecting distinct tax systems. Both regimes address profit shifting by multinational enterprises, but have unique thresholds, applications, and interactions with their existing rules. The UK DPT provisions, introduced in 2015, have two limbs; the diverted profits charge, and the avoided permanent establishment charge. The latter parallels Australia’s multinational anti avoidance law, which commenced just a little bit later in 2016. The Australian DPT, which commenced in 2017, shares some conceptual similarities but incorporates a higher corporate tax rate and different tests, impacting its practical application. For instance, the UK’s effective tax mismatch outcome primarily affects tax haven transactions, while Australia’s higher tax rate creates broader challenges in proving sufficient foreign taxes are paid, even in jurisdictions that aren’t traditionally considered a tax haven, like the United States. Both DPTs interact with transfer pricing rules, but differ in their integration. The UK DPT allows recharacterisation of entire arrangements, analysing the consolidated arrangement rather than individual entities and transactions. Australia’s DPT operates independently, but lacks some clarity on its application alongside transfer pricing rules.  Also, while the UK DPT applies much more broadly to all transactions involving all corporate entities except for small to medium enterprises, Australia’s DPT only targets those significant global entities. Those are entities with a global income exceeding a billion dollars.

So just to go backwards to the precise rules of the DPT, though, essentially the Commissioner has an alternate postulate. He says, “if you weren’t motivated by tax, you would have actually done this instead.”

TIP: So as I just mentioned, we actually discussed the General Anti-Avoidance Rules in Part IVA of the ITAA in another recent Hearsay episode with Sydney tax lawyer, Matthew Leighton-Daly. If you’re interested, that episode is number 137, it’s out right now, and it’s called ‘Getting Down to Brass Tax (see what we did there?): Understanding asset protection versus tax avoidance.’

It’s interesting, though, when you have a look at the decisions of the Federal Court in Pepsi, at first instance, the Court said, “look, it’s not necessary to explore the DPT as a ratio, because we found that there was a payment of an amount that was royalty. So there’s no need to invoke an avoidance rule.”

TIP: Paul just mentioned the Oracle decision. That case centred on defining royalties under Australia’s double taxation agreements with implications for withholding tax. The issue in that case were sub-licence fees paid by Oracle Corporation Australia Pty Ltd, as you can tell from the name, an Australian subsidiary of Oracle, to Oracle Ireland for rights related to software distribution spanning from 2013 to 2018. The ATO deemed these payments to be royalties under the Australia Ireland double taxation agreement and issued a tax liability of 253 million dollars alongside some penalties for non compliance to Oracle. Oracle sought a stay of the Australian proceedings to allow resolution through the double taxation agreement mutual agreement procedure but the Federal Court led by Justice Perram denied the request for a stay. Justice Perham emphasised the public interest in achieving judicial clarity on the treatment of royalties, given there were 15 similar taxpayer cases and some tensions with the United States over Australia’s non alignment with OECD guidelines. While the mutual agreement procedures generally allowed taxpayers to pause domestic proceedings, broader public interest justified rejecting that stay.

 The Court also recognised the taxpayers preference for the mutual agreement procedure – that is, Oracle’s preference for that procedure – that Justice Perham prioritised a definitive judicial resolution to guide Australian tax practices and global disputes. As Paul mentioned, Justice Perham’s analysis in the Oracle case had regard to the relationship between domestic tax enforcement and international treaty obligations.

In his judgement, Justice Perham drew from international treaties like the Vienna Convention on the Law of Treaties, and treaty mechanisms – he considered the definition of royalties and its implications for domestic tax liabilities and compliance with international frameworks. The Australian Tax Office’s stance on royalties has drawn criticism from the United States for deviating from the OECD model commentary, and the Oracle case really underscores that tension between Australia’s sovereignty and unilateral interpretation of its obligations and its reliance on international consensus within the OECD. By deferring to OECD models while pursuing this unilateral interpretation of how they’re applied, we get this tension between Australia and its global neighbours and treaty partners, highlighting the delicate balance required in global tax cooperation and enforcement. 

In both cases, the commission has made much of the fact that these cases give guidance to a large number of taxpayers. But as you say, in the end, very small factual differences will have a significant impact. So I think there is a limit on the validity of that proposition.

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