Australia ended 2023 with a landmark court ruling condemning the beverage giant PepsiCo, Inc. over royalties. Still, the game is at half time since PepsiCo, Inc. may yet appeal the decision.
Background
The Federal Court decision (PepsiCo, Inc. vs Commissioner of Taxation), held that the taxpayer was liable for withholding tax on embedded royalties and opined that if the taxpayer were not liable for royalty withholding tax, Diverted Profits Tax (DPT) would apply. It is precisely this last part that is the big news, as it is the first time that a DPT-related dispute has been decided by an Australian court, opening the door to additional legal measures against aggressive profit-shifting schemes by multinationals.
Assessing the eligibility for royalties and determining the correct amount involves considerations within the established transfer pricing regulations of Australian law and the fundamental principles guiding the distribution of bundled prices.
However, the Commissioner decided to challenge the agreement through the DPT, granting it broad powers and advantages not available under other provisions of the Australian Income Tax Assessment Act. The DPT includes wide-ranging provisions, giving the ATO specific powers that go beyond the typical scope of withholding tax on royalties and the Australian transfer pricing framework.
Diverted Profits Tax (DPT)
The DPT is applicable to income years commencing on or after 1 July 2017, although, it can also be applied to schemes established before that date.
DPT aims to ensure that the tax paid by significant global entities (SGE) properly reflects the economic substance of their activities in Australia, preventing the diversion of profits offshore through contrived arrangements, imposing a distinct 40% penalty rate of tax to be paid upfront (which is a separate tax liability from income tax).
Additionally, encourages SGEs to provide sufficient information to the ATO to allow for the timely resolution of tax disputes.
An entity qualifies as an SGE for an income year if it is either the global parent entity with an annual global income of A$1 billion or a member of a group of entities (consolidated for accounting purposes) where the global parent entity has an annual global income of A$1 billion or more. If global financial statements are not available for the global parent entity, the Commissioner of Taxation has the authority to issue a determination.
The DPT is applicable when, in connection with the scheme:
- the relevant taxpayer obtains a tax benefit;
- one of the principal purposes of a person involved in the scheme is to enable the relevant taxpayer to gain an Australian tax benefit or both an Australian and foreign tax benefit;
- a foreign associate of the relevant taxpayer is engaged in the scheme or is otherwise linked to it;
- none of the exceptions outlined below are applicable.
Taxpayers are not allowed to take part in a 50/50 arrangement if the dispute is connected to a DPT assessment.
The DPT legislation also contains carveouts, i.e. companies where Australian income does not exceed AUD25 million, the diverted profits are taxed elsewhere in the world at a rate which is equal to or greater than 80% of the Australian tax rate (i.e. 30%) and companies who can establish that every group entity involved has “sufficient economic substance”. As you may see, the justification for the last two points is much more complex.
Nonetheless, the DPT will not be applicable if the relevant taxpayer is a managed investment trust, a foreign collection investment vehicle with wide membership, a foreign entity owned by a foreign government, a complying superannuation entity or a foreign pension fund.
DPT Mitigation strategy
The most suitable DPT mitigation strategy is the proactive formulation of a “case theory” against potential DPT risks, with the necessary proof easily available and documented. The reason for this is because the legislation contains provisions preventing the admissibility of evidence in later court proceedings, if that evidence was in the custody and control of the taxpayer and was not provided by the taxpayer to the Commissioner before or during the 12-month review period following a DPT assessment.
The initial step in assessing the DPT risk and outlining the contents of a defence file involves a review to ascertain whether the Commissioner can propose an alternative business model. This alternative business model is called “alternate postulate” and represents a scenario when adopted it would result in a higher payment of Australian tax – note that there could be more than one “alternate postulate“. The additional Australian profits generated under the “alternate postulate” are the diverted profits.
Afterwards, it is critical to assess whether any of the “alternate postulate” model(s) are deemed reasonable. This assessment involves an examination of the commercial factors that make them impossible or improbable. Relevance can be attributed to evidence relating to customary commercial practices in the market, the group’s historical practices and the strategies used in comparable agreements. In addition, evidence relating to the actual valuation of the rights to use the relevant intellectual property in the specific factual context may also be relevant.
The Court Case
The case involves Pepsi (the owner of Pepsi and Mountain Dew) and Stokely-Van Camp (the owner of Gatorade) – both entities operating within the PepsiCo Group – which entered into an arrangement between various entities of the Pepsi Group Australia (Pepsi Australia) and other offshore entities of the Pepsi Group (Pepsi Offshore entities), located in the USA and Singapore.
The litigation focused on two exclusive bottling agreements. The first was between PepsiCo and Schweppes Australia (now known as Asahi Beverages), relating to soft drinks such as Pepsi and Mountain Dew. The second agreement was between Pepsi’s Stokely-Van Camp and Schweppes Australia which related to non-carbonated beverages.
Concentrate Manufacturing (Singapore) Pte Ltd – a Singaporean manufacturer and part of Pepsi – produced concentrate and supplied it to PepsiCo Beverage Singapore (PBS), which was in fact an Australian subsidiary and part of the Pepsi group.
Following this, PBS sold the concentrate to Schweppes Australia, the seller of the local beverage under the bottling agreements with the parent companies. This transaction generated approximately 240 million dollars during the 2018 and 2019 financial years. Schweppes Australia later transferred almost all of this amount to Concentrate Manufacturing (Singapore) Pte Ltd, leaving only a small margin.
The ATO claimed that the payments made by Schweppes Australia to PBS should be characterised as royalties for the use of the intellectual property and the corresponding trademarks related to the beverage concentrate. Therefore, the amounts in question should be subject to withholding tax as royalties in Australia. Alternatively, the ATO argued that the DPT regime should apply to the arrangement.
Federal Court Judge Mark Moshinsky ruled in favor of the ATO, concluding that “One of the principal purposes of [Pepsi and Stokely-Van Camp] in entering into or carrying out the relevant scheme was to obtain a tax benefit (namely not being liable to pay Australian royalty withholding tax) and to reduce foreign tax (namely, US tax on their income)”, since the payments made by Schweppes Australia to PBS constituted “consideration for the use of, or the right to use, the relevant trademarks and other intellectual property“. As a result, the Federal Court ruled that these payments should have been subject to royalty withholding tax. Furthermore, the court agreed with the ATO’s claim that if withholding tax on royalties did not apply, the DPT would have been applicable.
Final remarks
To summarize, we can say that:
- when defining payments made under an agreement, it is crucial to assess the terms in the wider business and commercial context of the arrangement;
- courts have the authority to consolidate transactions involving several parties and agreements, while examining the characteristics of a payment;
- the valuation of an arrangement can be affected by the subjective appreciation of the perceived value of a brand; and
- the assessment of the value of an embedded royalty may in the end depend on the evidence presented by experts.
The ATO is currently involved in similar litigation with The Coca Cola Company, which is fighting 174 million dollars in DPT for the combined years 2018 and 2019 and the success in the Pepsi case will undoubtedly encourage them regarding their current strategy regarding similar settlements.
Nuno Raposo Jacinto
February 2023
[1] Law companion ruling LCR 2018/6
[2] Practical compliance guideline PCG 2018/5
[3] Law administration practice statement 2017/2
[4] Diverted Profits Tax Act 2017 No.21,2017