Commissioner orders one last round in PepsiCo

As foreshadowed in our detailed analysis of the decision of the Full Federal Court (Full Court) in PepsiCo, Inc v Commissioner of Taxation [2024] FCAFC 86 (PepsiCo), the Commissioner of Taxation (Commissioner) applied to the High Court for special leave to appeal from the whole of the PepsiCo judgment of the Full Court on 8 August 2024.

The special leave application is significant as it demonstrates the Commissioner’s continued focus on the taxation of intangibles and disagreement with the conclusions drawn by the majority of the Full Court in PepsiCo. In particular, the special leave application highlights the importance to the Commissioner of identifying what constitutes an embedded royalty for tax purposes, the concept of consideration for the use of intangible assets and the application of Australia’s diverted profits tax anti-avoidance provisions.

Summary of key takeaways

• In the High Court special leave application, the Commissioner has ‘honed in’ on the divergent approaches taken by the majority and minority judgments of the Full Court in interpreting and reconciling historical decisions of the High Court in a number of well-known duty cases.
  
  
• The Commissioner has also contended that the majority judgment of the Full Court, and the approach taken to determining the construction of the ‘tax benefit’ criteria of Part IVA of the ITAA 1936, is directly inconsistent with recent decisions of the Full Federal Court in Guardian and RCI.[1]
  
  
• In the view of the Commissioner, a number of high value tax disputes will be impacted by the special leave application and requested resolution of the associated issues, with every anti-avoidance case affected by a High Court determination and resolution of the perceived inconsistencies in relevant Full Federal Court Part IVA authorities – the critical question being whether a taxpayer can discharge its onus where no postulate that is a reasonable alternative to the scheme has been identified.
  
  
• The Australian Taxation Office (ATO) has also deferred the finalisation of Draft Taxation Ruling TR 2024/D1 pending the outcome of any High Court proceedings.

Background

The factual background and issues in dispute as between the Commissioner and PepsiCo were outlined at some length in our previous detailed analysis. Having regard to that analysis, the Commissioner’s grounds of appeal may be summarised as follows:

• The Full Court ought to have found that payments made by Schweppes Australia Pty Ltd (Schweppes) under Exclusive Bottling Agreements (Agreements) entered into with both PepsiCo and Stokely-Van Camp, Inc (SVC), included a royalty paid as consideration for the use or right to use intellectual property licensed to Schweppes.
  
  
• The Full Court ought to have found that such royalty component was income derived by, and was paid to, PepsiCo and SVC, and consequently, was subject to royalty withholding tax.
  
  
• In the alternative, if no royalty withholding tax was payable by PepsiCo or SVC, the Full Court ought to have found that PepsiCo and SVC were liable to diverted profits tax (DPT) in respect of the payments under the Agreements.

Issue 1 – Royalty Withholding Tax

Special leave question 1:

Consideration

As highlighted in detail in our previous analysis, both the majority and minority judgments of the Full Court devoted considerable time and comment in endeavouring to reconcile the apparent contrast in historical decisions of the High Court regarding the determination of the concept of ‘consideration’ in a number of well-known duty cases.[2]

The Commissioner in the special leave application contends that the approach taken by the majority of the Full Court in reconciling this apprehended conflict or tension has “involved error”. In particular, the Commissioner has argued that the reasoning of the majority judgment of the Full Court rested on a misinterpretation of statements in decisions of the High Court as to the meaning of ‘consideration’, leading to the majority “promulgating their own rules” to reconcile those apprehended differences.

In the view of the Commissioner, in order to correctly analyse the definition of a royalty and the requirements of section 6(1) of the ITAA 1936, regard must be had to the whole of the terms of an agreement under which a payment is made, in order to:

• characterise the nature of the commercial dealing effected by the agreement; and
  
  
• reach a conclusion as to what monetary amounts moving from one party to another are consideration for.

This follows the line of reasoning of the minority judgment in the Full Court, which concluded that it would be “commercially unreasonable” for Schweppes to be provided with rights to use intellectual property under the Agreements, without any part of the payments made being attributable to those rights. Further, as also reasoned by the minority judgment, and in the view of the Commissioner, when the High Court authorities are correctly analysed in this way, there is no such conflict regarding the determination of the concept of ‘consideration’ in a revenue context.

Derivation

The Commissioner in the special leave application further contends that, once it is accepted that payments by Schweppes under the Agreements were, in part, a royalty paid as consideration for the licence to it of intellectual property, it follows that these amounts are properly characterised as income derived by PepsiCo and SVC.

In this regard, the Commissioner contends that all three judges of the Full Court erred in their construction of the Agreements, on the basis that:

• PepsiCo Beverage Singapore Pty Ltd (PBS), the seller of concentrate under the Agreements to Schweppes, was not a party to the Agreements;
  
  
• it was therefore PepsiCo and SVC that could sue Schweppes for breach of contract;
  
  
• it was also PepsiCo and SVC that could enforce the performance of Schweppes’ payment obligations under the Agreements, and not PBS; and
  
  
• it was PepsiCo and SVC that granted Schweppes the rights to use PepsiCo Group brands pursuant to an extensive set of contractual provisions.

In the Commissioner's view, it is then readily concluded that PepsiCo and SVC derived royalty income, irrespective of having nominated a related entity (PBS) to whom the royalty amounts were to be transferred under the Agreements.

Issue 2 – Diverted Profits Tax

Special leave question 2:

The Commissioner’s DPT contention in the special leave application relates to the Commissioner’s alternative argument, namely that if no royalty was paid by Schweppes under the Agreements on which royalty withholding tax was payable by PepsiCo and SVC, then PepsiCo and SVC obtained a DPT tax benefit under Part IVA of the ITAA 1936.

As outlined in our previous analysis, the majority judgment of the Full Court placed large emphasis on considering the concepts of ‘scheme’ and the determination of a reasonable alternative postulate for the purposes of Part IVA, within the context of the conclusions drawn from the specific factual and evidentiary circumstances associated with the PepsiCo and SVC arrangements. In particular, the absence of any evidence showing that the value of the intellectual property licences granted to Schweppes under the Agreements was being recovered through the concentrate price, was an important factor to the majority in their reasoning and was noted on a number of occasions.

As contended by the Commissioner, the error made by the majority of the Full Court in relation to this aspect, and in particular the conclusions drawn by the majority in respect of the interpretation of the Agreements entered into by PepsiCo and SVC with Schweppes, and the determination of the consideration payable for the transfer of property under the Agreements, “infected” their reasoning in relation to the alternative DPT arguments.

Importantly, the Commissioner contends that the focus placed by the majority of the Full Court on the Commissioner’s ‘lack of evidence’ resulted in an inverting of the onus of proof required to be discharged by PepsiCo and SVC for the purposes of Part IVA. Rather than demonstrating and “satisfying the Court of what might reasonably be expected to have occurred in the absence of [a] scheme”,[3] the Commissioner contends that in the view of the majority of the Full Court, this onus was characterised and limited to PepsiCo and SVC showing that there was “no postulate which [was] a reasonable alternative to the scheme”.

In the view of the Commissioner, the position taken by the majority of the Full Court in PepsiCo directly contradicts earlier judgements of the Full Federal Court and the approach to onus, as endorsed in RCI and Guardian.

Concluding observations

Specifically in the context of the amendments made to Part IVA in 2013 which saw the introduction of section 177CB of the ITAA 1936, the Commissioner notes in the special leave application that these provisions have not previously been considered by the High Court.

In particular, the Commissioner draws attention to the perceived division between decisions of the Full Federal Court as to whether a taxpayer can discharge its burden in a Part IVA case where they fail to advance any reasonable alternative postulate, noting that more is required under Part IVA than merely showing the Commissioner’s counterfactual was unreasonable, and concluding that the High Court’s “determination of the onus point will affect every anti-avoidance (Part IVA) case”.

Whether Part IVA mandates the identification of an alternative postulate is a fundamental question which has remained unanswered since the amendments to Part IVA in 2013. The heart of the amendments was to ensure that the ‘might reasonably be expected to have’ (‘reconstruction’) limb is based on a postulate that is a reasonable alternative to the scheme, having particular regard to the substance of the scheme and its effect for the taxpayer, but disregarding any potential Australian income tax costs – in effect, eradicating the ‘do nothing’ argument.

However, PespiCo raises the question, what if there is no reasonable alternative to the scheme? Or framed in the circumstances of PepsiCo, how might it reasonably be expected that PepsiCo / SVC and Schweppes would have contracted on a basis that included a royalty payment for the licence of intellectual property, when no part of the actual concentrate price included a royalty for the licence of intellectual property? In our view, the counterfactual must still be ‘reasonable’, so this opens up the possibility that such a counterfactual may not exist. The Commissioner’s alternative postulates address this issue, but also give rise to a significant point of difference as between the majority and minority judgments of the Full Court.

In arriving at a conclusion as to whether an alternative postulate is reasonable, section 177CB(4) of the ITAA 1936 mandates that regard must be had to the substance of the scheme and any non-tax outcomes for the taxpayer. In practice, this requires:

• first, the identification of the financial or other non-tax consequences for the taxpayer that would be accomplished or achieved as an end result of the scheme having been entered into and carried out for the taxpayer; and
  
  
• second, an evaluation of whether the alternative postulate is capable of fulfilling these commercial / non-tax objectives of the transaction.

This is not a simple exercise, with the commercial / non-tax objectives of a scheme gleaned from supporting documentation of the relevant circumstances surrounding the transaction. So, any guidance the High Court may provide on this inquiry is welcomed.

It will be for the High Court to have the final say on these issues should special leave be granted. When coupled with the focus placed by the Commissioner on the inconsistencies of the Full Court in analysing and interpreting the historical High Court authorities regarding the concept of ‘consideration’ in a revenue context, in our view it may be considered ‘more likely than not’ that the Commissioner’s special leave application will be granted by the High Court.

Outside of these specific issues, the ATO has also issued a media release on 9 August 2024 acknowledging that it would defer the finalisation of its Draft Taxation Ruling TR 2024/D1 regarding the characterisation of payments as royalties in respect of software arrangements and intellectual property rights, pending the outcome of any High Court proceedings and any possible consideration by the High Court of related matters in PepsiCo.

As noted in our previous analysis, the landscape regarding the taxation treatment of intellectual property arrangements continues to evolve and remains a focus area of the ATO, and would, in our view, also benefit from further judicial consideration and definitive guidance that may arise from the High Court’s consideration of the issues raised in the PepsiCo special leave application.

^{[1] Commissioner of Taxation v Guardian AIT Pty Ltd ATF Australian Investment Trust (2023) 115 ATR 316 (Guardian) and RCI Pty Ltd v Commissioner of Taxation (2011) 84 ATR 785 (RCI).}

^{[2] Being the decisions of the High Court in Davis Investments Pty Ltd v Commissioner of Stamp Duties (NSW) (1958) 100 CLR 392, Chief Commissioner of State Revenue (NSW) v Dick Smith Electronics Holdings Pty Ltd [2005] HCA 3; 221 CLR 496 and Commissioner of State Revenue (Vic) v Lend Lease Development Pty Ltd [2014] HCA 51; 254 CLR 142.}

^{[3] With the Commissioner specifically referencing the decision of Hespe J of the Full Federal Court in Guardian in this regard.}