The High Court of Australia has handed PepsiCo Inc. a significant victory in a closely watched cross-border tax case. In a 4–3 decision, the court dismissed the Australian Taxation Office’s (ATO) appeal over alleged “embedded royalties” under a contract between a PepsiCo Singapore affiliate and an Australian bottler, reinforcing the importance of contractual clarity in international supply arrangements and the respect for third-party negotiated agreements.

Case summary

The dispute centered on payments made by Schweppes Australia (SAPL) to PepsiCo Beverage Singapore (PBS) for the supply of soda concentrate.  Note that PBS is Singapore incorporated but an Australian tax resident.  The ATO argued that these payments included embedded royalties for the use of PepsiCo’s trademarks and other intellectual property, triggering royalty withholding tax. As an alternative, the ATO sought to apply the diverted profits tax (DPT), claiming PepsiCo obtained an inappropriate tax benefit through its structuring of the arrangement.

The High Court rejected both arguments (albeit by a narrow 4-3 margin). The ATO appeal was from an equally narrow 2-1 ruling by the Full Federal Court in favor of PepsiCo, which was itself an appeal from a single judge Federal Court that held for the ATO.

The High Court majority held that SAPL’s payments to PBS were solely for soda concentrate and not for the use of IP assets and therefore did not constitute royalties.  Further, because PBS was an Australian tax resident, even if there was a royalty component such was not paid or credited to, nor derived by, nonresident licensors in the US or otherwise.  Similarly, as a result, the ATO’s attempts to apply the DPT were not valid because PepsiCo obtained no improper or artificial tax benefit.

Of significant importance, the High Court emphasized that the arrangement was a comprehensive commercial bargain between arm’s-length parties, with a fixed price that expressly included royalty-free use of PepsiCo’s trademarks and intellectual property.

Impacts on multinationals

While many tout this as a victory for multinational taxpayers, the narrowness of the win should be considered; Texas A&M University School of Law professor William Byrnes who is an international tax and transfer pricing expert indicated, “It’s a close decision – this is truly a tax risk management concern going forward.”

While emphasizing the importance of careful contract drafting (particularly with respect to IP rights and pricing) and associated documentation, how far this decision will go in defending related party transactions remains unclear.  The ATO has greater leeway under such provisions in a related party context, however, attention to detail in the drafting of intercompany supply arrangements with Australian affiliates and the associated terms and conditions surrounding IP assets and pricing are crucial in mitigating potential assessments and protracted litigation.

Conclusion

The decision in the PepsiCo case narrows the scope for the ATO to assert that bundled payments conceal royalties, particularly where contracts are clearly drafted and negotiated on arm’s-length terms.

While highly fact-specific, the case sets an important precedent for multinational businesses in structuring supply and licensing arrangements, especially those involving intellectual property, and underscores the need for businesses to monitor and continuously assess cross-border business policies related to bundled goods and IP arrangements.

Key takeaways

Multinationals with applicable fact patterns should:

• Identify controlled buy-sell arrangements (particularly in Australia as well other jurisdictions) where a claim of an embedded royalty could arise under the positions taken by the ATO.
• Review the terms and conditions of intercompany legal agreements to consider if relevant terms reasonably and affirmatively address considerations of the use of relevant intangible properties among the parties.
• Reassess whether the current pricing for the controlled sale of goods continues to meet the arm’s length standard and underpinning principles.
• Review and assess transfer pricing documentation reports for content and the functional circumstances stated in support of the arm’s length position.

For personalized guidance, connect with our international tax services team here.

 

Our International Tax Services Team

 

Scott Montopoli

Director, International Tax Services

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Tyler LeFevre

Senior Manager, International Tax Services

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Jonathan Voll

Director, Transfer Pricing Services

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