In late November 2023, the Federal Court found in favour of the ATO, in a case involving embedded royalties in payments made under a soft drink distribution agreement (PepsiCo v FCT [2023] FCA 1490).
Whilst this win to the ATO is now somewhat old news, the case is significant as it is the first time that the Federal Court has heard a dispute involving the application of the Diverted Profits Tax (DPT). This case, the upcoming litigation involving the ATO and Coca Cola and the Commissioner’s recent rulings and guidelines on intangibles (PCG 2024/1 and TR 2024/D1) signals that the ATO and other revenue authorities are increasingly scrutinising arrangements or dealings with intangible assets such as trademarks and intellectual property.
This amplified scrutiny on MNEs is a big red flag to MNEs and their advisors to take extra care when setting up legal agreements and documenting these arrangements not only from a transfer pricing perspective but also from the perspective of the multinational anti-avoidance rules and diverted profits tax. Had PepsiCo’s advisors endured such care when setting up the arrangements, PepsiCo would most likely not have been scrutinised by the ATO in the first place!
To unpack the context of what is at stake we have briefly summarised the PepsiCo decision to pinpoint the risk exposures for MNE’s which will identify practically steps that can be taken to safeguard tax and transfer pricing positions where intangibles are involved.
The PepsiCo case in a nutshell
On 30 November 2023, Moschinsky J of the Federal Court of Australia ruled that payments made to PepsiCo (a US company) pursuant to bottling agreements with their Australian bottler (Schweppes Australia) were subject to royalty withholding tax. His honour further observed that diverted profits tax would have applied in the alternative as PepsiCo had structured the arrangements for the predominant purpose of avoiding royalty withholding tax.
As noted previously the case involved Pepsi US’s exclusive bottling agreement contracts with Schweppes, an unrelated third party owned by Asahi Group Holdings Ltd. Under the contracts, Pepsi US could choose the entity that sold the concentrate to Schweppes – it selected Pepsi AUS – and licensed certain IP to Schweppes such as trademarked labels and know-how (e.g. the soft drink recipe) on a purportedly royalty-free basis.
Schweppes was to pay solely for the concentrate, which was manufactured by Pepsi Singapore and sold to it via Pepsi AUS. Schweppes then distributed the finished drinks to wholesalers in Australia.
The ATO argued that a royalty arose based on the substance of the arrangements, despite the contract saying otherwise and therefore royalty withholding tax (RWHT) applied to the payments made under the bottling agreements. As an alternative the ATO contended that diverted profits tax would have applied to the arrangements as the agreements were structured to obtain a tax benefit being the non-payment of RWHT.
The Court agreed with the ATO that RWHT applied to the payments made under the bottling agreements on the basis of four factual findings:
- The IP licence in the Pepsi-Schweppes agreement was fundamental to the parties’ relationship.
- The PepsiCo party to the agreement was Pepsi US (the IP owner) rather than Pepsi Singapore (the concentrate manufacturer) or Pepsi Australia (the seller).
- PepsiCo always provided an IP licence when selling concentrate.
- The strength of the PepsiCo brand meant that its IP was valuable.
Having found that a royalty arose, the court needed to quantify it. It ultimately accepted that a relief from royalty method was most appropriate, adopting part of the analysis of the ATO’s expert, in arriving at a rate of 5.88% of net revenue.
The withholding tax finding made it unnecessary for the Federal Court to determine whether diverted profits tax applied to the arrangements, but Moschinsky J nevertheless concluded that the tax would have applied if royalty withholding tax had been avoided.
Australia’s diverted profits tax applies to arrangements whose principal purpose is to obtain certain tax benefits, such as avoiding withholding tax. The ATO focused on how the pricing clause was expressed in the Pepsi-Schweppes contract.
The ATO argued that if not for tax reasons, the payment would have been expressed in the contract as being made for all the rights that Schweppes obtained, or at least expressly for the IP – not just for the concentrate.
The court agreed that a contract with the expressed price being for all the property Schweppes obtained would require the payment to be apportioned across the property acquired, including a royalty for IP use. The court then concluded the pricing arrangement had been entered into for the principal purpose of obtaining a diverted profits tax benefit.
A strong factor in the ATO’s favour was the contrast between the legal form of the contract, involving no royalty, and its commercial substance, where the IP use was critical to the parties’ business outcomes.
Scrutiny of MNE’s in IP-intensive industries
The ATO’s success in the PepsiCo case has emblazoned the ATO in scrutinising any mismatch issues between the legal form of contracts involving valuable intangibles and the commercial substance, and it is very likely more compliance activity and DPT assessments will be raised in the coming months.
As noted above, recently Coca Cola (Coke) has filed a matter in the Australian Federal Court disputing DPT assessments issued by the ATO for approximately $174m. It is alleged by the ATO that Coke was involved in a scheme or arrangement involving the shifting of $435m of profit overseas.
Similarly, the ATO’s favourable outcome in the PepsiCo case has coincided with the Commissioner finalising PCG 2024/1 which deals with intangibles migration arrangements and seeks to apply not only the transfer pricing provisions but the general anti-avoidance rules, in particular the DPT to offending high risk arrangements.
Almost at the same time, the ATO released TR2024/d1, this draft ruling considers, when an amount paid under a software distribution arrangement where access to IP is provided, is subject to royalty withholding tax.
These developments and the proposed measures preventing multinationals from claiming Australian tax deductions for payments made for the use of intangible assets to foreign associates in low-tax jurisdictions highlights the tax and transfer pricing risks that MNEs must consider when entering into intangible arrangements (e.g. transfer or licensing arrangements).
Are Treaty benefits eroded with Diverted Profits Tax?
Diverted profits tax is increasingly considered in audits alongside the transfer pricing provisions. Australia’s diverted profits tax is contained within Part IVA of ITAA36 (the general anti-avoidance provisions) which means that the diverted profits tax overrides the tax treaties to the extent of any inconsistency between the treaty provisions and the diverted profits tax rules (see s 4 of the International Tax Agreements Act 1953). Accordingly, no treaty relief is available to taxpayers who are subject to the tax.
Moreover, Australia’s ratification of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) also provides for the modification of Australia’s tax treaties to address multinational tax avoidance. The extent to which the MLI modifies a particular tax treaty varies from jurisdiction to jurisdiction.
Australia has adopted Article 7 of the MLI which provides for a denial of treaty benefits where a scheme or arrangement has been entered into for the principal purpose of accessing the relevant benefit (principal purpose test). In determining whether the principal purpose test applies to deny treaty benefits PSLA 2020/2 notes that the ATO has to have regard to the same factors and circumstances that apply when making a Part IVA determination.
Accordingly, the application of the purpose test in the diverted profits tax rules and Part IVA generally will have an impact on treaty interpretation and application.
How to safeguard intangible arrangements
Considering the PepsiCo decision, taxpayers seeking to both price and risk assess their intangibles-related business arrangements should ally themselves with appropriate expert analysis to pre-empt any challenge on the quantum of a royalty under any relevant arrangement and even more importantly to ensure that the intangibles arrangements are appropriately structured in such a manner that the legal framework matches the commercial substance.
While Subdivision 815-B (the transfer pricing provisions of the Australian Tax Assessment Act 1997 (ITAA 1997)) issues were not raised in the proceedings against PepsiCo, issues relating to the valuation of intangibles arise in the context of transfer pricing and its rulings and guidelines. We are unclear to the extent which TP principles were considered by the experts in the PepsiCo case or why the parties did not employ experts skilled in TP matters and principles. However, it is our opinion with the easy gesture of being retrospective, that if PepsiCo had applied TP principles and employed proper advisors, it is likely that the arrangements would not have been challenged by the ATO, there wouldn’t have been a dispute and DPT wouldn’t have been raised.
The Australian transfer pricing provisions are made so as to best achieve consistency with the relevant transfer pricing guidelines published by the OECD. This is also the case for intangibles and cross-border arrangements for MNE’s. Therefore, involving OECD guideline experts when reviewing intangible arrangements is a great starting point to ensure that the cross-border dealings are fit-for-purpose. That is, when we assist MNE’s with intercompany agreements, we typically start the process with a review of their current arrangements and legal contracts to assess whether these are appropriate. The process would in most cases involve an assessment of the value chain in the context of using the DEMPE model from the OECD Guidelines. Using the DEMPE model will assign which entities in the value chain of the MNE contributes to the Development, Enhancement, Maintenance, Protection, and Exploitation of the valuable intangibles.
This is a complex and technical process involving economic analysis and expert knowledge of tax and transfer pricing laws, however, the points we are making here is the importance of reviewing the current legal agreements and to seek professional assistance. Investing in such assessments and implementing the outcomes of these into robust transfer pricing policies that can be solidified in proper legal contracts, will most likely be more economical over time and will mitigate risks from being challenged by tax authorities, triggering DPT, double taxation, other treaty issues, transfer pricing and tax adjustments and substantial penalties.
Conclusion
PepsiCo’s case serves as a cautionary tale for multinational corporations, highlighting the importance of compliance with tax and transfer pricing laws and regulations. The ATO’s victory underscores the increasing scrutiny on MNEs regarding tax and transfer pricing matters. As tax authorities worldwide intensify their efforts to combat tax avoidance, MNEs must stay abreast of evolving tax and transfer pricing laws and regulations to avoid costly disputes.
Importantly it is essential for multinational groups to be aware of the risks of falsely trusting that its legal agreements or TP documentation to comply with tax or TP requirements does not necessarily need to be the case, if intangibles arrangements are not assessed with an appropriate approach. Which can result in the unfortunate outcome that the taxpayer is not protected from being challenged for anti-avoidance behaviour and exposed to the DPT risk even if the taxpayer’s honest intention was to be compliant with all the tax and TP requirements to mitigate such risks.
