Judgment summary
PepsiCo, Inc and Stokely-Van Camp, Inc (SVC), both United States companies, challenged royalty withholding tax notices and diverted profits tax assessments issued by the Commissioner of Taxation in respect of the years ended 30 June 2018 and 30 June 2019 [1].
PepsiCo and SVC had entered into exclusive bottling agreements (EBAs) with Schweppes Australia Pty Ltd (SAPL), under which SAPL bought concentrate and was granted (expressly or impliedly) a licence to use PepsiCo/SVC trademarks and other intellectual property to manufacture, bottle, sell and distribute finished beverages in Australia [4]-[6]. The EBAs did not expressly provide for payment of a royalty for the intellectual property licence [6].
The Commissioner's primary case was that a portion of the payments made by SAPL constituted royalties attracting withholding tax under s 128B of the ITAA 1936 and Art 12 of the US DTA. The alternative case, arising only if royalty withholding tax did not apply, was that the diverted profits tax provisions in Pt IVA of the ITAA 1936 applied [8].
Justice Moshinsky held that the payments made by SAPL were, to an extent, consideration for the use of the trademarks and other intellectual property, that the relevant portions were income derived by and beneficially owned by PepsiCo/SVC, and that those portions were deemed paid to PepsiCo/SVC under s 128A(2) [18]. Royalty withholding tax at 5% therefore applied [266].
On quantification, the Court preferred the evidence of the Commissioner's expert (Mr Malackowski) under his Method 1 - Part 1 over the PepsiCo parties' expert (Ms Wright), concluding (subject to one adjustment) that the royalty rate was 5.88% of SAPL's net revenue from sales of the relevant products [18(b)], [403]-[404].
Although unnecessary given the royalty withholding tax conclusion, the Court considered the diverted profits tax issue for completeness and found that, had royalty withholding tax not applied, the diverted profits tax provisions would have applied, because each of PepsiCo and SVC obtained a tax benefit and one of the principal purposes of entering into the scheme was to obtain that tax benefit and reduce foreign (US) tax [18(c)], [465]-[466].
Background
PepsiCo owned trademarks and intellectual property relating to Pepsi and Mountain Dew, and SVC owned those relating to Gatorade [3]. On 3 April 2009 PepsiCo and SVC each entered into an EBA with SAPL, an Australian company then owned by Asahi Breweries, covering carbonated soft drinks and non-carbonated beverages respectively [4].
Under the EBAs, concentrate was manufactured by Concentrate Manufacturing (Singapore) Pte Ltd (CMSPL) and supplied to PepsiCo Beverage Singapore Pty Ltd (PBS), an Australian-incorporated PepsiCo Group entity nominated as 'Seller'. PBS on-sold concentrate to SAPL, retaining only a small margin and remitting almost all proceeds to CMSPL [7].
SAPL paid PBS approximately A$[redacted] million during the relevant years for concentrate [7(e)]. The EBAs did not expressly charge a royalty for use of the trademarks and intellectual property, though the SVC EBA contained an express 'royalty-free' licence and the PepsiCo EBA contained an implied licence [57], [91].
Following expert evidence, the Commissioner amended the royalty withholding tax notices and diverted profits tax assessments downward on 6 March 2023 [15]-[17].
Core dispute
The central issues were: (1) whether payments made by SAPL under the EBAs were, to any extent, consideration for the use of, or right to use, trademarks and other intellectual property so as to constitute 'royalties' under s 6(1) of the ITAA 1936 and Art 12 of the US DTA, attracting royalty withholding tax under s 128B [12]; (2) if so, the appropriate amount/rate of any such royalty, contested via competing expert evidence (2.5% per the PepsiCo parties' expert versus 9.0%/8.5% per the Commissioner's expert) [13]; and (3) in the alternative, if no royalty withholding tax applied, whether the diverted profits tax provisions in Pt IVA applied, requiring consideration of whether a 'tax benefit' was obtained and whether a principal purpose of the scheme was to obtain that tax benefit and/or reduce foreign tax liabilities [14].
Court findings
The Court found that although the EBA payments were expressed as being for concentrate only, considering the EBAs in their business and commercial context, the payments were to an extent consideration for the use of, or right to use, the relevant trademarks and other intellectual property [237]-[252]. This followed from features including that PepsiCo/SVC (the trademark owners) were parties to the EBAs, the licences were fundamental to the agreements, and the payment obligations were linked to the continuation of the licences [245].
The Court held that the relevant portions of the payments were income derived by, and beneficially owned by, PepsiCo/SVC because they were entitled to receive the payments under the EBAs and merely directed SAPL to pay their nominee, PBS [253]-[259]. The relevant portions were deemed paid to PepsiCo/SVC under s 128A(2) because they were dealt with 'as [PepsiCo/SVC] directs' [260]-[265].
On quantification, the Court preferred Mr Malackowski's Method 1 - Part 1 (based on comparable third-party licence agreements, using the average of Quartile 3) over Ms Wright's Method 3, save that one agreement (Entenmann's Products, Inc/Coffee Holding Company, Inc) should have been classified as exclusive rather than non-exclusive, requiring a downward revision of the 5.88% figure [399]-[404]. The Court rejected reliance on Malackowski Method 1 - Part 2 (Markables implied royalty rates from enterprise transactions) and Malackowski Method 2 (profit split method) due to unverifiable layered assumptions [373], [394].
On diverted profits tax (considered for completeness), the Court accepted the Commissioner's first counterfactual, that absent the scheme the EBAs would or might reasonably be expected to have expressed the payments as being for all property and promises (not concentrate only), giving rise to a tax benefit [434]-[443]. Weighing the s 177D(2) and s 177J(2) factors, the Court found a disconnect between the form (payments for concentrate only) and substance (payments also for valuable intellectual property) of the scheme, and that reduction of US tax and avoidance of Australian withholding tax were principal purposes [453], [463]-[465].
Outcome
The Court concluded that the payments made by SAPL under the EBAs in the relevant years were, to an extent, 'royalties', and PepsiCo and SVC are liable to pay royalty withholding tax at the rate of 5% on those royalties [266]. The royalty rate was determined to be 5.88% of SAPL's net revenue from sales of the relevant products, subject to a downward revision to account for the reclassification of one comparable licence agreement as exclusive [18(b)], [404].
As the royalty withholding tax conclusion made it unnecessary to decide the diverted profits tax issue, the Court considered that issue for completeness and found that, had the royalty withholding tax provisions not applied, the diverted profits tax provisions would have applied to both PepsiCo and SVC [18(c)], [466].
The Court ordered that, within 14 days, the parties provide any agreed minute of proposed orders giving effect to the reasons, including as to costs, or, failing agreement, file and serve minutes of proposed orders and short submissions within 21 days [467].
Tp method highlighted
Two expert methodologies for quantifying the royalty were considered. Ms Wright's preferred method (Method 3) was a 'relief from royalty' approach, benchmarking against comparable third-party licence agreements sourced from the Royalty Range database, yielding a royalty rate of 2.5% of SAPL's net revenue [299]-[312].
Mr Malackowski used two cumulative methods. Method 1 combined: Part 1, analysis of comparable third-party licence agreements from ktMINE, RoyaltySource and RoyaltyStat databases (with an exclusivity adjustment doubling the rate for four non-exclusive agreements), producing a Quartile 3 average of 5.6% (later revised to 5.88%) [341]-[351], [398]; and Part 2, implied royalty rates derived from Markables data on enterprise-level M&A transactions and purchase price allocations, producing a Quartile 3 average of 10.1% [352]-[373]. Method 2 was a profit-split approach using Markables' Brand/EV ratios applied to a 'grossed-up' EBIT margin (based on Asahi Holdings as a proxy for SAPL), producing 9.9% [377]-[394]. Mr Malackowski averaged Methods 1 and 2 to reach final rates of 9.0% (Pepsi) and 8.5% (Gatorade and Mountain Dew) [395]-[397].
The Court preferred Malackowski Method 1 - Part 1 (essentially the same methodology as Wright Method 3, i.e. comparable licence agreements) over Wright Method 3, and rejected Malackowski Method 1 - Part 2 and Method 2 due to reliance on unverifiable third-party assumptions embedded in Markables data and purchase price allocations [373], [394], [399]-[401]. The Court accepted Mr Malackowski's use of the Quartile 3 average given the strength of the Pepsi, Mountain Dew and Gatorade brands, and his exclusivity adjustments, save for one agreement that should have been treated as exclusive [401]-[404]. This produced a royalty rate of 5.88% of SAPL's net revenue, subject to downward revision for that one matter [404].
Major issues / areas of contention
- Whether payments made by an Australian bottler under exclusive bottling agreements, expressed as being solely for beverage concentrate, were to any extent 'consideration for' the use of trademarks and other intellectual property so as to constitute 'royalties' under s 6(1) of the ITAA 1936 and Art 12 of the US DTA.
- Whether the relevant portions of those payments constituted income derived by, and beneficially owned by, the US parent companies for the purposes of s 128B(2B)(a) of the ITAA 1936 and Art 12 of the US DTA, notwithstanding payment to a nominated related-party seller.
- Whether the relevant portions of the payments were deemed to have been paid to the US parent companies under s 128A(2) of the ITAA 1936.
- The appropriate methodology and rate for quantifying the royalty component of the payments, including the relative merits of a comparable licence agreements approach versus implied royalty rates derived from M&A transaction data and profit-split analysis.
- Whether, if royalty withholding tax did not apply, the diverted profits tax provisions in Pt IVA of the ITAA 1936 applied, requiring identification of an appropriate counterfactual and whether a 'tax benefit' was obtained under s 177C(1)(bc).
- Whether it would be concluded that a principal purpose of entering into or carrying out the scheme was to enable the taxpayers to obtain a tax benefit and/or reduce foreign (US) tax liabilities, having regard to the factors in ss 177D(2) and 177J(2) of the ITAA 1936.