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December 21, 2023

Australian Federal Court finds embedded royalty in arm's-length contract

  • The Court found that a royalty was paid, notwithstanding that the contract had not expressly provided for it.
  • Royalty withholding tax was found to be applicable.
  • The Court found that diverted profits tax (DPT) elements were satisfied, but DPT was not applied due to Court's conclusions on royalty withholding tax.
  • The decision is expected to be influential in actions of Commissioner of Taxation going forward.

On 30 November 2023, the Australian Federal Court (Court) delivered a decision in PepsiCo, Inc. v Commissioner of Taxation [2023] FCA 1490 (Pepsi Case), finding that a royalty existed in an agreement between arm's-length parties notwithstanding that the contractual documents did not expressly provide for it. Furthermore, the Court found the Diverted Profits Tax (DPT) provisions to apply in the first judicial consideration of the DPT legislation. This is significant for all agreements in which intellectual property is provided on a "royalty-free" basis.

Executive summary

The Court determined that a portion of the payment made by the Australian entity was a royalty and therefore subject to royalty withholding tax (RWHT). The portion of the payment so determined related to the use of certain intellectual property including trademarks and brands.

The Court reached this conclusion despite the contractual arrangements (i.e., the form) not specifically providing for a payment for the use of the intellectual property.

Both parties provided expert evidence on the royalty rate with the Court favoring the Australian Tax Office's (ATO's) expert. The Court concluded that the royalty rate was 5.88% of net revenue, relying on the expert's method of using license agreements between third parties.

The Court also concluded, in the alternative, that the DPT would have applied as there was a scheme with a principal purpose of avoiding royalty withholding tax.

This is an important judgement reaffirming the ATO's position that the form of the legal arrangements (i.e., the labels in the contract) cannot be determinative of the characterization of payments.

The application of the DPT in the alternative demonstrates the challenges of defending arrangements, some of which may be long standing commercial arrangements.

Relevant facts

PepsiCo, Inc. (PepsiCo), a US company and owner of the Pepsi brand, entered into an Exclusive Bottling Agreement (EBA) with Schweppes Australia Pty Ltd (SAPL) (a third party).

Under the EBA, PepsiCo agreed to sell (or cause a related entity to sell) beverage concentrate to SAPL, which SAPL then mixed with other ingredients in accordance with formulas, specifications and other information provided, to produce finished beverages for retail sale in Australia, applying Pepsi branded packaging and under the Pepsi brand name.

Importantly, the EBA provided for SAPL to pay only for the concentrate; there was no express provision for the payment of a royalty for the right to use the relevant intellectual property.

Key issues

The Commissioner of Taxation (Commissioner) contended that PepsiCo was liable for RWHT under the Income Tax Assessment Act 1936 (Cth) (ITAA 1936), which is subject to Article 12 of the double tax agreement between Australia and the United States (US DTA).

Additionally (and alternatively), the Commissioner issued a DPT assessment to PepsiCo, imposing a 40% punitive tax on the challenged royalties. The DPT's stated aims are to ensure tax paid reflects the economic substance of a Significant Global Entity's Australian activities and to prevent diversion of profits offshore through arrangements with related parties.

RWHT applicable

The Court concluded that the payments made by SAPL under the EBAs were (to an extent) royalties and accordingly, PepsiCo was found to be liable to pay RWHT at the US DTA rate of 5% on those royalties.

The Court reached this conclusion following its findings that:

  • The payments made by SAPL under the EBA were, in part, consideration for the use of, or the right to use, the relevant trademarks and other intellectual property.
  • The relevant portions of the payments were income derived by PepsiCo for the purposes of section 128B(2B)(a) of the ITAA 1936 and amounts to which they were beneficially entitled for the purposes of Article 12 of the US DTA.
  • The relevant portions of the payments were deemed to have been paid by SAPL to PepsiCo by virtue of section 128A(2) of the ITAA 1936.

Each is considered in turn below.

"Consideration for"

The Court found that a portion of the payments was consideration for various intangible properties listed under Article 12(4)(a)-(b) of the US DTA.

Key to the Court's conclusions were:

  • The owner of the intangible property (relevantly PepsiCo) was a party to the EBA; the seller of the concentrates was not.
  • The EBA contained licenses to SAPL to use intangible property.
  • The license of intangible property was fundamental to the EBA as evidenced by various clauses in the EBA, without which SAPL would not have been able to package and sell the branded beverages.
  • Payments made by SAPL were linked with the license of the intangible property, as evidenced by clauses stipulating that failure by SAPL to perform its payment obligations (to concentrate sellers) could result in a termination of the EBA and therefore the licenses.

In summary, the Court looked past the legal form of the arrangement to the substance and found that the payments were (in part) consideration for intangible property. The use of the phrase "to the extent to which" in both Article 12(4) of the US DTA and section 6(1) of the ITAA 1936 necessitates an apportionment exercise where a payment is consideration for more than one thing.

"Income derived," "beneficially entitled" and "paid to"

As a matter of contract law, PepsiCo as a party to the EBA was entitled to receive the payments made by SAPL, and this was the case notwithstanding that another entity was nominated as the seller of the concentrate. The direction for SAPL to pay the seller of the concentrate (rather than PepsiCo directly) did not alter that outcome; being applied as directed, the relevant portion was held to be income derived by PepsiCo.

For the same reasons, the Court found PepsiCo to be beneficially entitled to the relevant payments and to have its royalty income dealt with on their behalf or as they directed. Therefore, the royalty income was deemed to have been paid to PepsiCo under section 128A(2) of the ITAA 1936.

In summary, the Court held that a portion of the payments constituted royalties and RWHT was liable to be withheld and remitted to the ATO.

Determining the royalty amount

Given the payments were characterized as a royalty, it was necessarily to determine what portion of the payment was taken to be a royalty.

Critical to the determination of the appliable rate was the evidence of two expert witnesses: one for the taxpayer and one for the Commissioner, with the Commissioner's being preferred in part due to his greater experience in the relevant field.

It is clear from recent judicial decisions that the choice of expert to consider a particular issue is fraught with difficulties, as is ensuring the right questions, instructions and information are available to them to undertake their task.

Ultimately, the "Relief from Royalty" methodology was preferred (involving an assessment of an appropriate royalty rate based on identifying and considering comparable license agreements) with particular importance placed upon the comparables and benchmarking undertaken.

The Commissioner's analysis involved searching for comparable license agreements and making adjustments for different terms and conditions. The outcome of this analysis was the upper quartile (5.88%) of the range of royalty rates identified by the Commissioner's expert witness under that particular method. The upper quartile was considered appropriate due to the brand's perceived strength and recognition.

The Court found that one comparable agreement was incorrectly characterized as non-exclusive and therefore no adjustment should have been made in calculating the relevant royalty rate. As such, the Court determined the royalty rate should be 5.88% of net revenue on SAPL's sales, subject to a downward adjustment considering the Court's findings on the non-exclusive agreement.

Diverted Profits Tax

The Pepsi Case is the first time that the DPT measures have been considered in the Australian courts. In finding that DPT would have applied (had it otherwise been concluded that there was no RWHT due), the Court considered that PepsiCo obtained a tax benefit in connection with the relevant scheme and that one of PepsiCo's principal purposes in entering into or carrying out the relevant scheme was to obtain a tax benefit (namely not being liable to pay Australian RWHT) and to reduce foreign tax (namely, US tax on their income).

Both the articulation of the scheme and the counterfactual (i.e., alternative scheme) were simple: entry into the relevant EBA on terms whereby no royalty was paid for the use of intellectual property, and the relevant EBA would or might reasonably be expected to have expressed the payments to be made by SAPL to be for all of the property provided by (and promises made by) the PepsiCo Group entities (rather than for concentrate only), respectively. Accordingly, the DPT case turned on one contractual term.

Importantly in the context of withholding tax, the Court's interpretation of the meaning of "tax benefit" in section 177C(1)(g) of the ITAA 1936 carries the consequence that, where a tax benefit arises from a taxpayer not being liable to pay RWHT on an amount, the amount of the tax benefit is the entire royalty amount (not the RWHT). As such, to the extent RWHT applies, it applies at the rate appliable in the relevant DTA (often 5% or 10%) whereas if DPT applies, a rate of 40% is levied.


Affected groups will want to address a variety of issues raised by this decision, including analyzing whether a royalty may be embedded within an arrangement or agreement and what (if any) adjustments ought to be made to reflect a potential royalty following the Pepsi case. Groups will be required to quantify any element that may be considered a royalty, and the value of the royalty, using methodologies acceptable by the Commissioner.

Groups will also want to consider whether to proactively engage with the ATO to deal with potential (or actual) challenges and obtain certainty or how to defend the position adopted by preparing a comprehensive suite of evidence and strategic review/audit assistance.


For additional information with respect to this Alert, please contact the following:

Ernst & Young (Australia), Sydney

Ernst & Young (Australia), Melbourne

Australian Tax Desk, New York

Australian Tax Desk, London

Published by NTD’s Tax Technical Knowledge Services group; Carolyn Wright, legal editor


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