High Court clarifies royalty withholding and diverted profits tax, in landmark PepsiCo case

Key points

• The High Court found payments for concentrate were not royalties paid to PepsiCo
• Payments were for concentrate only, not for intellectual property use.
• Diverted Profits Tax did not apply, as no reasonable alternative arrangement existed.
• In doing so, the High Court accepted a “do nothing” scenario (that the taxpayer would never have entered into an alternative transaction)

The High Court of Australia ruled 4-3 in favour of PepsiCo in a long-running dispute over royalty withholding tax (RWHT) and diverted profits tax (DPT). The case, which scrutinised complex licensing and payment arrangements with the PepsiCo Group, offers critical insights not just for multinational businesses operating in Australia, but for anti-avoidance provisions in general.

Background

Schweppes Australia Pty Ltd (SAPL) entered into Exclusive Bottling Agreements (EBAs) with both Stokely-Van Camp Inc (SVC) and PepsiCo Inc (PepsiCo), to manufacture and sell beverages in the Australian market. Under the agreements, PepsiCo agreed to sell, or cause one of its subsidiaries to sell, beverage concentrate to SAPL to be used to produce the beverages in Australia. Payments were made to an Australian subsidiary, PepsiCo Beverage Singapore Pty Ltd (PBS), for the beverage concentrate, but no separate royalties were paid for the use of PepsiCo’s intellectual property (IP).

The Commissioner of Taxation (Commissioner) argued that a portion of the payments for concentrate were, in effect, for the IP rights and therefore constituted a royalty that was subject to RWHT. In the alternative, the Commissioner argued that the arrangements were structured to avoid tax in a way that would be subject to DPT.

Royalty withholding tax

The High Court unanimously dismissed the Commissioner’s appeal, confirming that no RWHT applied. While the Court was divided on whether a portion of the payments made under the EBAs could be considered to be for the use of IP (an embedded royalty), both the majority and minority agreed that the payments were nevertheless not income “derived by” or “paid to” PepsiCo or SVC as required under section 128B of the Income Tax Assessment Act 1936 (Cth) (ITAA36).

Was there an embedded royalty payment?

A key issue was whether the payments for beverage concentrate were partly made “in consideration for” the use of the PepsiCo IP for the purposes of the definition of royalty in subsection 6(1) of the ITAA36. The majority determined that while the EBAs did grant SAPL a licence to use PepsiCo’s IP, including trademarks and product IP, the majority found that the payments were solely for the supply of the concentrate.

In reaching this conclusion, the majority emphasised the proper construction of the agreements and contemporaneous evidence, such as invoices and the absence of any royalty pricing mechanism. Additionally, it was conceded that the prices for the concentrate were an arm’s length price that was not incorrect, inflated or otherwise disproportionately high. The Commissioner’s argument that the IP was used without compensation (and therefore some of the sale price for the concentrate must have included payment for IP) was rejected; the majority found that PepsiCo received valuable non-monetary consideration through SAPL’s other performance obligations under the agreement.

Was a payment derived by PepsiCo?

Even if the payments could be characterised as royalties, it was concluded that they were not “paid or credited to” or “derived by” PepsiCo or SVC as required under section 128B of the ITAA 1936. The payments were made to PBS, an Australian subsidiary, and there was no evidence of a prior monetary obligation or direction that would attribute those payments to the US-based IP owners (PepsiCo). Rather, the umbrella agreement included a requirement that PepsiCo cause the concentrate to be sold to SAPL, through either itself or a subsidiary. The Court found that this affected a sale between PBS and SAPL, not PepsiCo and SAPL. As such, there was no payment by direction resulting from PepsiCo nominating PBS as the seller under the umbrella agreement.

Diverted profits tax

The High Court rejected the argument that, in the absence of RWHT, PepsiCo and SVC should be liable under the DPT provisions in Part IVA of the ITAA36.

Central to the majority’s decision was the requirement to identify a “DPT tax benefit” – being a scheme with the principal purpose of enabling a taxpayer (that is a significant global entity) to obtain a tax benefit (which includes that the taxpayer is not liable to pay RWHT). In ascertaining that a tax benefit exists, a comparison must be made between the taxpayer’s actual outcome with a reasonable alternative (known as the alternate postulate).

If DPT was found to have applied, PepsiCo and SVC would be taxed on 40% of the amount of the royalty, despite the RHWT rate being 5% under the relevant tax treaty.

Was there a reasonable alternative where PepsiCo would have paid RWHT?

The Court found no reasonable alternative to the existing arrangements, and therefore no tax benefit could be identified.

The majority pointed to what it saw as the three most significant features of the scheme: (1) it was the product of an arm’s length negotiation between experienced and large commercial enterprises (2) under the scheme, the price payable for concentrate was not disproportionately high and paid to an Australian resident taxpayer, and (3) it followed broadly a pre-existing and entirely commercial way of doing business.

The majority rejected the argument that PepsiCo could satisfy its burden of proof simply by demonstrating that each of the Commissioner’s proposed alternatives was unreasonable. However, they clarified that this did not mean the taxpayer must always point to a specific alternative in which no tax benefit would arise – although this was the most common method. Instead, the majority accepted that, although uncommon, a taxpayer may establish the absence of a tax benefit by showing that no reasonable alternative to the existing arrangement existed. PepsiCo was able to prove that there was no reasonable alternative in which they would have done anything other than enter into the EBAs.

The Court ultimately held that no tax benefit was identified because the Commissioner had failed to establish a reasonable alternate postulate. On the facts, the Commissioner’s counterfactuals were not grounded in commercial reality; the evidence indicated that PepsiCo would not have implemented the arrangements in a materially different way.

Was the principal purpose of the scheme to derive a tax benefit?

The majority, while not required to rule on the issue, provided some insight into the application of the principal purpose test, noting that it would be “unthinkable” for “sophisticated commercial operators” not to take tax outcomes into account when negotiating the form of a transaction, but that does not necessarily justify an application of Part IVA or DPT.

Part IVA

Arguably, the most interesting aspect of the majority’s judgment lies not in its treatment of RWHT or DPT, but in its broader implications for the application of Part IVA.

The High Court decision offers valuable guidance as to how the Court’s should consider the application of Part IVA. By accepting that a “do nothing” scenario (that the taxpayer would never have entered into an alternative transaction) could, in some cases, be a valid and defensible outcome, the decision appears to challenge the intent behind 2013 amendments to Part IVA. These amendments were designed to limit the availability of such scenarios as a legitimate counterfactual.

In recent years, the ATO has increasingly taken Part IVA cases to the Courts, with mixed levels of success. With this decision, the High Court has reinforced that anti-avoidance provisions aren’t the catch-all that the ATO has often approached it. Just because an arrangement is effective at reducing tax does not automatically bring it within the scope of Part IVA. The High Court has made it clear that the Commissioner must establish a tax benefit by reference to a reasonable and commercially realistic alternative, not simply rely on hypothetical reconstructions that lack substance.

Impact on other ATO guidance materials

The Commissioner has yet to finalise Draft Ruling TR 2024/D1, which addresses the characterisation of payments for software and intellectual property rights in the context of royalties. The ATO has confirmed it is reviewing the impact of the PepsiCo decision on this draft, but has yet to provide any timelines for its completion. Given the majority’s comments, it is likely that the Commissioner will need to revisit certain positions, particularly those concerning “undissected amounts.”

Additionally, the ATO released Draft PCG 2025/D4 earlier this year, outlining its risk framework for such payments. The decision may prompt further refinement of this guidance.

What are the next steps?

While the High Court’s decision provides clarity on key principles, the determination of whether a payment constitutes a royalty ultimately hinges on the contractual terms and obligations between the parties. The majority emphasised that the facts in PepsiCo were “unique” and a lot was made of the fact that the arrangement was at arm’s length. Different conclusions may be reached on different arrangements, particularly where the legal arrangements do not provide for the flow of other benefits in lieu of specific consideration.

The question now is whether the ATO will seek legislative reform to directly address the issues raised in this case. PepsiCo may have prevailed before the High Court, but with a narrow majority and a split in the Full Federal Court, the decision highlights the complexity and evolving nature of Australia’s anti-avoidance provisions.