PepsiCo and Oracle cases: reassessing royalties in Australian tax

Australia has had an interesting few weeks in regard to royalty.

Royal visitors aside, the decision of the Federal Court in Oracle Corporation Australia Pty Ltd v Commissioner of Taxation (Stay Application) [2024] FCA 1262 (Oracle Stay Application), which was handed down on 31 October 2024, at its heart concerned the question of what a royalty is, under Australia’s various double taxation agreements.

In addition, as foreshadowed in our previous analysis of the Commissioner of Taxation’s (Commissioner’s) High Court special leave application in relation to the Full Federal Court (Full Court) decision in PepsiCo, Inc v Commissioner of Taxation [2024] FCAFC 86 (PepsiCo), the Full Bench of the High Court on 7 November 2024 granted the Commissioner’s special leave application in full. The hearing dates and ultimate judgment of the High Court are now eagerly awaited.

These two decisions highlight the significant and ongoing focus on the taxation treatment of intangible arrangements and the enormous uncertainty that continues to face affected taxpayers. Any judicial guidance is still likely to take some time, however.

Summary of key takeaways from the Oracle Stay Application and PepsiCo case

• In granting the Commissioner’s special leave application in PepsiCo, taxpayers may anticipate some guidance from the High Court regarding the fundamental aspect of determining what a payment is ‘consideration for’ in the context of Australia’s royalty withholding tax provisions. This is together with clarifying the approach towards the determination of the ‘tax benefit’ criteria construction in Part IVA, and specifically whether a taxpayer can discharge its onus where no postulate that is a reasonable alternative to the scheme has been identified.
  
  
• In not granting a stay of the current Federal Court proceedings associated with the dispute between Oracle and the Commissioner, the Federal Court has elevated the question as to what constitutes a royalty for the purposes of Australia’s double taxation agreements to one of utmost and primary importance. This seeks to resolve the large number of royalty withholding tax audits and disputes currently on foot between the Commissioner and taxpayers, particularly those taxpayers with cross-border software distribution arrangements.
  
  
• The outcomes of the High Court’s consideration of issues in PepsiCo – and the Federal Court’s consideration of issues in the Oracle dispute (and subject to any appellate court’s consideration of those issues) – will have direct implications for the position currently adopted by the Commissioner in Draft Taxation Ruling TR 2024/D1 Income tax: royalties – character of payments in respect of software and intellectual property rights.

PepsiCo

Background

The factual background and issues in dispute between the Commissioner and PepsiCo have been articulated in our initial analysis of the Full Court decision. In endeavouring to draw some conclusions from the High Court’s granting of the special leave application, we contrast the positions taken and contentions made by the Commissioner^[1] (who sought leave to appeal) and PepsiCo^[2] in their most recent special leave submissions.

Ground 1 – Royalty Withholding Tax

The Commissioner, in his special leave application, contended that 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. Further, the royalty was paid as consideration for the use or right to use intellectual property licensed to Schweppes.

PepsiCo’s special leave submission started with the proposition – uncontroversial – that the question as to whether royalty withholding tax might be payable would ‘be determined on the facts of a given case’.

PepsiCo added to this general proposition by specific reference to the majority of the Full Court findings, submitting that ‘the majority’s construction of the [Agreements] was an archetypal exercise in consideration of contractual terms in their commercial context’ (at [27]). The submission also reiterated a conclusion of the majority of the Full Court that the Agreements were not intellectual property licensing agreements, but rather were ‘distribution arrangements of which the licensing of the intellectual property was merely a part’ (at [7]).

PepsiCo also submitted that the present dispute was an ‘inappropriate vehicle’ in which to revisit the line of High Court stamp duty cases that were a large focus of the decision of the Full Court and the Commissioner’s special leave application, for reasons including:

• those cases were concerned with a substantively different statutory regime to the withholding tax provisions of the Australian income tax legislation; and
  
  
• no monetary amounts were received by PepsiCo or SVC, in contrast to the stamp duty cases, each of which involved the receipt of monetary amounts by the relevant vendor.

The Commissioner’s reply noted that the issue in question did not concern principles of contractual interpretation, but rather raised an important question regarding the correct approach to determining what a payment is ‘consideration for’. In the Commissioner’s view, the majority’s determination ‘gives an imprimatur to arrangements’ which, like the Agreements, were in part a licence to use highly valuable intellectual property, and in part conferred other rights. This is notwithstanding that they involved a single payment described in the contract to be entirely for those other rights (at [3]). As noted by the Commissioner, his concern is that ‘multinationals can “contract out” of paying tax in Australia on valuable intellectual property licenced for use in Australia’ (at [2]).

The Commissioner also concluded that, as both the Federal Court and the Full Court considered that the line of stamp duty authority guided the proper construction of the term ‘consideration for’ in respect of the meaning of a ‘royalty’ (albeit approaching that question differently), the conflict was ‘ripe for resolution in this case’ (at [8]).

Ground 2 – Derivation

The Commissioner, in his special leave application, further contended that 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.

PepsiCo noted in its submission that every member of the Full Court concluded that Schweppes, as the bottler, owed no monetary obligation to PepsiCo or SVC, with all agreeing that PepsiCo derived no income from the sale of concentrate by PepsiCo Beverage Singapore Pty Ltd (PBS) to Schweppes (at [13]).

Accordingly, the Commissioner’s case of ‘payment by direction’ of amounts to PepsiCo and SVC was contradicted by the evidence and lacked legal foundation. It could not be concluded that PepsiCo or SVC had derived income that consisted of a royalty, on the basis that no royalty was paid as consideration for the licence of intellectual property because no amounts were paid to them at all. Further, PepsiCo submitted that the ‘fundamental difficulty’ with the Commissioner’s case – namely, that there was no antecedent monetary obligation owed by Schweppes to PepsiCo or SVC – could not be overcome, including by way of application of the High Court stamp duty cases (at [8], [9] and [15]).

The Commissioner’s reply refocussed on the contention made regarding the ‘consideration’ analysis in the special leave application. Namely, that in the Commissioner’s view, once it is accepted that the payments were in part consideration for the use of PepsiCo’s and SVC’s intellectual property, it is ‘hardly a stretch’ to conclude that the direction for Schweppes to pay amounts under the Agreements to PBS, resulted in a payment by Schweppes to, and the derivation of income by, PepsiCo and SVC (at [12]). The Commissioner reinforced this technical position by highlighting that, in the Commissioner’s view, a more fulsome analysis of the facts and evidence set out at first instance, ‘comfortably satisfies the principles of derivation of income by way of a payment by direction’ (at [11]).

Ground 3 – Diverted Profits Tax

In the alternative, the Commissioner, in his special leave application, also contended that 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.

In our previous analysis of the Commissioner’s High Court special leave application, we highlighted the main contention of the Commissioner regarding the alternative DPT argument. In addition, we identified key observations regarding whether or not Part IVA mandates the identification of an alternative postulate, and how to determine whether an alternative postulate is ‘reasonable’.

The Commissioner’s primary contention relates to, in the Commissioner’s view, the erroneous conclusions drawn by the majority of the Full Court regarding the interpretation of the Agreements PepsiCo and SVC entered into with Schweppes. That is, the determination of the consideration payable for the transfer of property under the Agreements, ultimately resulted in an inverting of the onus of proof required to be discharged by PepsiCo and SVC for the purposes of Part IVA, and directly contradicted earlier judgements of the Full Federal Court in Guardian and RCI.^[3]

PepsiCo’s special leave submission directly rejected the Commissioner’s contention. PepsiCo submitted that, contrary to the Commissioner’s contentions, the majority of the Full Court placed express reliance on the decisions in Guardian and RCI. Further, the majority’s consideration of the evidence before it, in relation to the elements and commercial and economic substance of the scheme, was inconsistent with the reversal of the onus of proof, as suggested by the Commissioner (at [10] and [22]).

PepsiCo submitted that, in the Full Court, PepsiCo and SVC had established that there was no postulate that was a reasonable alternative to entering into or carrying out the scheme, including those relied upon by the Commissioner. PepsiCo also submitted that the circumstance that no reasonable postulate could be identified in the present case arose because of the particular way in which the Commissioner pleaded the scheme, and that ultimately the majority of the Full Court rejected the Commissioner’s alternative postulates on the evidence before it (at [18], [20] and [23]).

PepsiCo also noted that, when considering the High Court decision in Commissioner of Taxation v Peabody [1994] HCA 43; 181 CLR 359 (Peabody), it was unremarkable that, if a taxpayer is able to show that there is no such postulate, the conclusion must be drawn that no tax benefit was obtained (at [8]).

Further, PepsiCo contended that the ‘reasonable alternative’ principle is formalised in section 177CB(3), which is a provision not confined to the operation of the DPT provisions. Accordingly, for this reason, together with the proposition that any principle emerging from further judicial consideration of Part IVA would be linked to the application of the withholding tax provisions in the context of the peculiar facts of the PepsiCo dispute, PepsiCo contended that this makes the current case an inappropriate vehicle in which to seek the intervention of the High Court (at [8], [17] and [27]).

The Commissioner’s reply reasserted the proposition from the Commissioner’s special leave application that the reasons of the majority in the Full Court were inconsistent with the previous decisions in Guardian and RCI. The reply also stated that there remained a divergence in Full Federal Court authority as to whether a taxpayer must satisfy the court as to what might reasonably be expected to have occurred instead of the relevant scheme (at [13]).

The Commissioner’s reply also submitted that this question is not answered by Peabody, and nor does section 177CB(3) address the consequence, for the purposes of discharging the relevant onus, of a taxpayer failing to establish any such reasonable alternative postulate (at [4]).

Observations in PepsiCo

In an indication of the importance and complexity of the issues raised in PepsiCo, the Commissioner’s special leave application was considered by the Full Bench of the High Court, with special leave granted from the whole of the judgment of the Full Court.

Notably, the Commissioner’s granting of the special leave application does not indicate success or failure one way or another for either the Commissioner or PepsiCo.

Rather, it is difficult to escape the conclusion that the perceived – and argued – disparity in views as between the Commissioner and PepsiCo, particularly in respect of the line of ostensibly settled High Court stamp duty authority, and the correct interpretation of fundamental principles emanating from recent Part IVA case law, is rather difficult to resolve, and was simply too hard for the High Court to ignore. This is particularly the case in the context of the Part IVA contentions and submissions made by both the Commissioner and PepsiCo. These now also appear to include a divergence of opinion regarding the interpretation and application of the High Court’s decision in Peabody, and the statutory directive contained within section 177CB(3).

Perhaps as posited in the Commissioner’s special leave reply (at [6]):

‘The operation of the taxpayer’s onus in a scheme case impacts all Part IVA litigation, and it is not “hyperbole” to suggest that this includes the extant disputes referred to in the Commissioner’s affidavit evidence … All of the taxpayers in those matters need to know what they need to prove in order to resolve their disputes, as does the Commissioner, and so too does the Federal Court in the range of Part IVA and DPT cases presently before it.’

Considering the above, the outcome of the High Court’s ultimate decision in PepsiCo will be eagerly anticipated by taxpayers.

Oracle

As noted above, the Oracle dispute is, at its heart, concerned with the question of what a royalty is, under Australia’s various double taxation agreements. More specifically, and considering the judgment of Perram J of the Federal Court, the Oracle dispute may be summarised as follows (at [3] and [4]):

• Oracle Corporation Australia Pty Ltd (Oracle Australia) purchased enterprise software and hardware from Oracle Capac Services Unlimited Company (Oracle Ireland) and distributed these products in Australia.
  
  
• The supply by Oracle Ireland to Oracle Australia is governed by complex contractual arrangements under which Oracle Australia made sublicence fee payments to Oracle Ireland.
  
  
• One bundle of rights which Oracle Australia obtained from Oracle Ireland related to Oracle Australia’s use of computer programs in which Oracle Ireland owned the copyright.
  
  
• The sublicence fee payments were made in the income years ending 31 May 2013 to 31 May 2018.
  
  
• If the sublicence fee payments are found to be ‘royalties’ within the meaning of the Australia / Ireland double taxation agreement (DTA), then Oracle Ireland will be liable to pay withholding tax.

The Commissioner, following multiple audits of the Oracle companies, concluded that royalty withholding tax in the amount of approximately A$253 million was payable in relation to payments made by Oracle Australia to Oracle Ireland relating to the income years ending 31 May 2013 to 31 May 2018.

The Commissioner issued notices of non-resident royalty withholding tax to Oracle Ireland, which gave rise to Oracle Ireland lodging requests for a mutual agreement procedure (MAP) under the DTA. The Commissioner also issued penalty notices for failure to withhold to Oracle Australia, in addition to making decisions not to remit those penalties. This gave rise to Oracle Australia objecting against the penalty notices and non-remission decisions, which were, in turn, disallowed by the Commissioner.

Being subject to a 60-day time limit in which to appeal the Commissioner’s disallowance of its objections, Oracle Australia filed proceedings in the Federal Court in order to preserve its domestic Australian rights of appeal. At the same time, a temporary stay of Federal Court proceedings was sought, in order to permit the MAP procedures to progress to finality (at [9] to [14]).

In a comprehensive judgment, Perram J of the Federal Court undertook a detailed analysis of the principles governing the interpretation of Australia’s network of double taxation agreements, including under the Vienna Convention on the Law of Treaties. This was specifically in the context of the Federal Court’s power to make orders granting a temporary stay in proceedings under section 23 of the Federal Court of Australia Act 1976 (Cth).

In another indication of the importance and complexity of the issues raised in the Oracle Stay Proceedings, Perram J identified and analysed a number of factors that tended to both the granting and the non-granting of the stay, noting (at [59]):

“ … As I have explained, the terms of the DTA provide a powerful reason why the stay should be granted and, as I will explain, there is also a powerful reason why a stay should not be granted. In that context, the question of who bears the [onus of demonstrating that the stay should be allowed or refused] on the application is not especially helpful. Both sides have established good and understandable reasons for their positions. The substantial question is which of those good reasons is to prevail.”

The ‘powerful reason’ referred to by Perram J may be taken to be a reference to his Honour’s comments at [62] to [67] where, inter alia:

• according to the ATO, there are currently approximately fifteen other entities whose distribution of software or related arrangements requires consideration of the definition of ‘royalty’ for Australian tax purposes;
  
  
• the Commissioner submitted that a judicial determination by the Federal Court (or more likely, any appellate court) would provide guidance both to him and other taxpayers about the operation of the ‘royalty tax’;
  
  
• the Commissioner’s approach to what constitutes a royalty for the purpose of double taxation treaties has created friction and “strong concerns” with the United States, giving rise to the US Treasury Department writing to the Australian Treasury regarding the non-conformity of the Commissioner’s position with OECD Model Commentaries;^[4]
  
  
• the dispute with the United States is potentially emblematic of a larger dispute between Australia and other members of the OECD about how royalties are to be approached in the case of software distribution arrangements;
  
  
• in the context of fifteen other taxpayers whose circumstances seem to raise similar concerns, it would be useful to have a judicial determination of whether arrangements such as those present in the Oracle dispute do or do not involve a royalty under the various double taxation treaties which exist; and
  
  
• the existence of a final appellate conclusion on whether distribution arrangements such as the present involve royalties will assist in the conduct of other MAP cases.

Ultimately, while acknowledging (at [82], emphasis added):

“The Court’s decision of whether to stay the proceedings is discretionary. The terms of the treaties show that, generally speaking, in a case where a taxpayer has been forced to commence domestic proceedings to meet a time limit, proceedings should be stayed to permit the mutual agreement procedure (including any arbitration) to proceed if that is what the taxpayer wishes. It is the taxpayer which, generally speaking, gets to choose whether to pursue domestic proceedings or to enliven the mutual agreement procedure between the competent authorities. Denying a stay in such cases would effectively result in the competent authority being able to force the taxpayer to abandon one process. Because this is not what the treaties contemplate, this is a powerful consideration favouring the grant of the stay sought.”

Perram J determined that (at [83], emphasis added):

“However, the question of what a royalty is under the various double taxation agreements and how it is to be applied to 15 different taxpayers is a question which subtends the position of the taxpayers in this case, as does the dispute with the United States. This larger consideration speaks powerfully to the need for there to be a final appellate judicial determination of the issue. Such a determination will provide guidance to the various competent authorities, to the other taxpayers, to arbitrators and to any other trading partners with whom the Commonwealth is presently in dispute about the nature of a royalty. This consideration strongly suggests that one case should proceed to final appellate determination for the guidance of all.”

And stated (at [85] and [86]):

“Were it not for the position of the 15 other taxpayers and the dispute with the United States, I would grant the stay sought. The balance of the other discretionary matters are outweighed by my impression of how these treaties are generally to operate in circumstances such as the present.

However, the need for a judicial determination of the royalties question for the benefit of others persuades me that a stay should not be granted for public interest reasons.”

Observations in Oracle

Perram J’s concluding comment (at [88]) acknowledged that refusing the stay ‘has a significant impact on [the Oracle companies] and on the administration of the tax system’. It was therefore also appropriate to grant them leave to appeal to test the correctness of the decision.

This is particularly significant given certain other acknowledgements made by Perram J throughout his reasoning, including that the OECD’s commentary concerning MAP:

• “shows that generally, where domestic proceedings are commenced, a competent authority in the position of the ATO should seek to suspend the domestic proceedings” (at [39]); and
  
  
• “the choice of redress is normally that of the taxpayer and in most cases it is the domestic recourse provisions such as appeals or court proceedings that are held in abeyance in favour of the less formal and bilateral nature of [MAP]” (at [40]).

Perram J also noted that:

• “the intention of the drafters of the DTA was for the taxpayer – not the competent authority – to choose whether to proceed by a [MAP] or domestic proceedings” (at [46]); and
  
  
• in circumstances where “a domestic time limit forces a taxpayer’s hand”, then the taxpayer should not be forced to choose between remedies, and absent any public interest considerations, in “such cases the competent authority should not oppose the grant of a stay sought by the taxpayer of their own domestic proceedings” (at [54]).

Notably, the decision was ultimately made by Perram J in favour of the Commissioner to not grant a stay of the Federal Court proceedings associated with the Oracle dispute. This was based on the weighting given to the significant and exceptional circumstances associated with the fifteen other taxpayers with similar issues to those faced by the Oracle companies, and the nature of the dispute between the United States and Australian Treasury Departments.

In absence of any appeal, the Commissioner may benefit from an outcome that contrasts with generally accepted and settled OECD principles. The Australian Treasury and the Commissioner have adopted a position and an approach that, in the opinion of the United States Treasury, also contrasts with generally accepted and settled OECD guidance materials and commentary.

As a side observation – simultaneously noting that nothing turns on this particular fact – Perram J also formed part of the majority of the Full Court in PepsiCo, for which special leave, as noted above, has now been granted by the High Court.

What is of relevance in the current circumstances are Perram J’s additional comments in the Oracle Stay Proceedings (at [65]) that “I accept that any decision by this or an appellate court will provide guidance to the Commissioner about his draft ruling”.

We noted in our previous analysis of the Commissioner’s High Court special leave application in PepsiCo that the ATO has deferred finalisation of TR 2024/D1, pending the outcome of those proceedings. Given the above comments of Perram J in the Oracle Stay Proceedings, and particularly considering the nature of the United States Treasury correspondence, taxpayers may anticipate possible further communication from the ATO that any finalisation of TR 2024/D1 will be further deferred pending the outcome of all proceedings – in particular any appellate proceedings regarding the substantive technical royalty question – in the Oracle dispute. Importantly however, such a course would be unlikely to prevent the ATO from continuing to conduct related reviews and audits of multinational enterprises.

When coupled with Perram J’s earlier acknowledgement of the Commissioner’s submission (at [62]) that “a judicial determination by this Court (or, more likely, any appellate court) will provide guidance both to him and other taxpayers about the operation of the royalty tax”, it also seems as though there will likely be a detailed process of hearing, decision, and appeal at multiple stages of the Oracle dispute, before resolution.

These comments also have implications for the amount of interest that may be accruing in connection with the Oracle dispute, depending on any payment arrangements entered into between the Oracle companies and the Commissioner. While the Full Court’s judgment quantifies the amount of royalty withholding tax in question, it only makes passing reference to the Commissioner advising Oracle Ireland that a ‘general interest charge’ applied.

Given that the current rate of the general interest charge is 11.38%, that the general interest charge would also likely apply to any unpaid component of the penalty for failure to withhold issued to Oracle Australia, and that Exposure Draft legislation regarding the proposed non-deductibility of the general interest charge (and shortfall interest charge) is currently the subject of a Treasury consultation process, the ultimate impost to the Oracle companies will be significant.

As the first relevant income year in the Oracle dispute is the income year ending 31 May 2013, it also remains to be seen just how long, in terms of years, it will take for the Oracle dispute from beginning to end, and indeed the broader confusion and complexity regarding the taxation treatment of intellectual property licensing arrangements, cross-border distribution arrangements more broadly, royalty issues and embedded royalties in particular, and associated royalty withholding tax implications, to be resolved.

^{[1]  The Commissioner as the Applicant filed a further submission on 6 September 2024 by way of a reply to the submissions filed by PepsiCo on 30 August 2024.}

^{[2]  PepsiCo as the Respondent filed two submissions on 30 August 2024 by way of a response to the application for special leave filed by the Commissioner on 8 August 2024.}

^{[3]  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).}

^{[4]  More specifically, the Commissioner’s approach to software distribution and position on royalties in relation to software distribution arrangements was initially the subject of Draft Taxation Ruling TR 2021/D4 Income tax: royalties – character of receipts in respect of software, which was revised and replaced by Draft Taxation Ruling TR 2024/D1 Income tax: royalties – character of payments in respect of software and intellectual property rights (TR 2024/D1).}