Episode Transcript
[00:00:00] Speaker A: Foreign.
[00:00:06] Speaker B: Hi, everybody. Welcome to the latest installment of Alvarez and Marcel's podcast series. My name is Jade Thompson. I'm an international tax managing director at Alvarez and Marcel. I head up the international tax practice here in Australia and I'm joined by my colleague Shaz Panwa, who heads up the transfer pricing practice here in Australia.
We're here today to talk about the recent High court decision in PepsiCo. There's been a lot of noise, a lot of discussion. It was a very narrow wind for PepsiCo with a 6, 5 victory when you take into consideration the full federal court, but it as well as the High Court, but it was a landmark case on both royalty withholding tax and the diverted profits tax here in Australia.
In fact, the first time we've had any judicial consideration of the diverted profits tax in Australia. So everyone was very excited to kind of see the judgment come down on this one. But perhaps. Shaz, do you want to maybe kick it off with a bit of an overview of what the key facts were in this case?
[00:01:12] Speaker A: Sure. Thanks, Jade. So here we had PepsiCo and Circle Van Camp. They are the owners of the Pepsi brands and Mountain Dew brands globally. They entered into an exclusive bottling arrangement with Schweppes Australia. So a completely independent third party entity where Schweff's Australia was going to take concentrate, bottle it and distribute it within Australia.
So PepsiCo and SVC granted them some rights to use an IP. And as part of this exclusive bottling agreement, they were able to nominate a supplier of concentrate for Schreps Australia.
The concentrate was manufactured by a entity in Singapore and that entity in Singapore, which was a member of the Pepsi SVC group, had a subsidiary in Australia where the Singaporean Ent the sold concentrate into the Australian entity, which was PBS Pepsi Brands Singapore, an Australian entity, and Schweppes Australia acquired the concentrate from pbs. So there was a domestic acquisition and a domestic payment for concentrate trips. Australia would then take their concentrate, bottle it up and then distribute it in Australia utilizing the Pepsi and Mountain Dew brands.
So that's sort of the background facts.
Next we'll just have a very quick overview of the provisions that we're going to cover. So the royalty provisions were probably the main argument that the Commission had. So the Commission's argument was that there was a embedded royalty into this payment and part of the payment that was made to PBS was in relation to a royalty. So quick overview of the royalty provisions. There has to be a right provided which is consistent with the definition of royalty. There has to be consideration Paid in relation to that right. That income has to be derived by and beneficially entitled to be derived by a cross border entity. The amount has to be paid to it and there has to be a quantum or an amount of that payment. For the royalty withholding tax provisions to apply through the sort of courts. We had the first instance judgment in the Federal court finding in favor of the Commissioner and we had in the full, in the Federal Court appeal we had a 2 to 1 victory in favor of the taxpayers and in the High Court similarly we had a 4 to 3 victory for the taxpayers on the issue of royalty with tolling tax on the diverted profits tax. It's a unique element of Australian tax. Australia and UK are the only ones with this particular type of provision. It's an anti avoidance provision, sits outside the treaty, applies to significant global entities and applies where you have a tax benefit which can be an Australian or foreign tax benefit, you have a principal purpose and not a sole dominant, a principal purpose of obtaining that benefit. There is a foreign associate which is part of the scheme and none of the exceptions apply. So none of the exceptions were relevant for these particular matters.
But the DPT again sits outside of treaty is a 40% tax rate that is applied on the benefit. So it's a punitive provision which is above the 30% Australian corporate tax rate.
So what are some of the observations and insights Jay, that we sort of came from this case? For me, probably the top three were the importance of the consideration of the contractual arrangements and the true substance of those arrangements. So that the holistic sort of assessment of what's been contractually provided and received by both parties, very different approaches by the majority and minority.
But again it goes to for me the importance of really accurately being able to construct your agreements and understand what is the true substance of what those agreements are. That's the first thing.
The second for me was that arms and dealings really mattered in this case. So this was a case where you had two independent entities, third parties entering through this arrangement. It was a long standing arrangement that they had.
And I think the High Court in particular found or you know, full Federal court and High Court found it really challenging to say we're going to challenge this existing third party arrangement and we're going to try to reconstruct or we're going to try to challenge some of these commercial arrangements that these two parties have entered into in order to find in favor of the taxpayer. Is that something that they're going to have a particular problem with when it's related party to be seen. But it's one of those key factors in this case that really distinguish it from other cases that the ATO might run in the future.
And probably most important for me, all of the judges throughout the court or throughout the proceedings. So from the first sentence all the way to the majority and minority of the High Court, all of them found that valuable IP was provided.
However, just because valuable IP is provided and a payment was made somewhere does not mean that that payment was consideration for that ip. So just you, you have the provision of IP coming across does not mean that the payment was in, was in consideration of it. What was found here by the majority was that there was, there were rights and obligations provided to and from Schweff's Australia to Pepsi and those rights and obligations, that sort of exchange of rights and obligations was what the consideration was for the provision yp so not the payment made for the concentrate, that was a separate transaction but IP was granted and there was this mutual exchange of rights and obligations and that was what the consideration was for it.
[00:06:55] Speaker B: Yeah, and I think perhaps just to add to that, Shaz as well, I guess from a diverted profits tax part for a counterfactual perspective, one of the key observations coming out of this was that the High Court made it very clear that constructing a valid counterfactual requires more than just a hypothetical tax saving comparison. And I think reading the judgment here, PepsiCo's ability to show that there were no other reasonable commercial arrangements was critical. But what was really interesting was the way in which the majority were very quick to note that PepsiCo had critical facts. It was the decision, the decision was unique to those facts. They had long standing commercial arrangements, et cetera. So whilst there was a helpful kind of commentary on DPT and Part 4A counterfactuals, you can see that it was very much confined to those critical facts.
The other point I guess I would make is around principal and dominant purpose tests. Obviously the majority found that there was no tax benefit in this particular case, so technically probably didn't need to go through the principal purpose argument, but they did anyway went through all 11 factors. And I think what the judgment provided was important guidance on the application of the principal purpose test in part 4A. And it confirmed that taxpayers can consider the impact of tax in an ordinary commercial sense, providing that the arrangement reflects genuine commercial intent. So again, it comes back to that commercial element in terms of kind of where to from here. There was a lot that was riding on the outcome of the PepsiCo case.
So there was, you Know, obviously we are waiting now to see the ATO's PepsiCo Decision Impact Statement that has not yet been released, but it will come.
There's also, you know, the draft software distribution royalty ruling TR 20042024 D1, which everybody is waiting to see the outcomes of.
We also had PCG 2025 D4 which is yet to be finalized. It did provide very vanilla, very green zone type examples. So it'll be interesting to see whether or not that is updated to include additional schedules for maybe more examples in the grey. We'll wait to see. And then obviously there's all the ongoing compliance around reportable tax position schedules, new C by C short form, and also PCG 20241 involving intangible migrations. But Shaz, there's also another area that people need to consider and that's really around the transfer pricing reconstruction rules. What do you want to say about that?
[00:09:41] Speaker A: Correct. I mean that's one of the sort of unknowns is how would the TP reconstruction provisions have applied if this were a related party scenario? Obviously we have third parties. Yes. So those provisions weren't going to apply, but complete potential game changer from the ATO's perspective in terms of how they might look to attack this in the future.
A lot of other insights, sort of takeaways going forward. I mean, you know, let's, let's talk about if we were taxpayers, you know, what's first things that we'd be doing. For me, really looking at what are my, you know, what's documented on paper, right. The, the court placed such an emphasis from a withholding tax perspective on what is documented. What do legal agreements say? Right. So first thing I'm doing is having a look. Do my legal agreements make it clear that, you know, whether or not there's IP being provided? Does it make it clear what the consideration is for? Is there this mutual exchange of rights and obligation or is it just a payment that's going through? You know, all of these factors will have a huge saying based on the sort of court's decision in terms of whether or not royalty withholding tax might apply in their sort of circumstances. The other thing I'd be doing is considering what I'm doing right now, in fact, considering how's the next case going to change because there's no real precedent until the second case is heard because people learn from the first one and the approaches from both parties are going to be different.
So for me there's two key things there. Right. One is obviously if it's a related party, I think the courts are going to be far more willing to be to challenge legal agreement or existing arrangements because they don't have that, you know, presumption of commerciality necessarily behind those arrangements. So will they be willing to challenge a legal agreement if a related party? I think it's far more likely that they'll do that.
They put a lot of respect on the fact that there was third party arrangements in the PepsiCo decision. The second is, you know, what new evidence is the Commission going to run and what new defence will taxpayers have to consider in response to that? So one of the things that was really clear for the court is that didn't that payment for the concentrate? The court was very clear, the majority was very clear in the High Court that there was no evidence put forward by the Commissioner that would warrant that economically, commercially, would warrant having to bifurcate that concentrate payment into IP and into sort of concentrate or the tangible element of the concentrate. I think in future the Commission is going to look to run, you know, channel profit arguments or look to, you know, bring forward, put forward evidence that there is a discrepancy between the cost of manufacture of a particular item. In this case it would be the concentrate and the price charged. So if there's a significant delta between the cost of manufacture and what's being charged, that might be sufficient evidence, particularly in related party context, for the court to say, well, here's now a reason or here's a basis for which I can now bifurcate this payment, which wasn't there in the PepsiCare. So a lot to consider, Jade. It's a huge decision, one that we're having a lot of conversations on and I don't think this is the end because for me, this is a rare case where it's a win for both the taxpayer and possibly the Commissioner. There's certainly a lot there, I'm sure you'll agree, a lot there for the Commissioner in terms of how he will use this to justify sort of future audits, future sort of litigation as well, from his end.
[00:13:12] Speaker B: Yeah. And I think just maybe. One final comment from me, Shaz. You know, I echo the comments that you've made, particularly in relation to related party transactions.
I think the embedded royalty in the withholding tax risk exists across industries, whether arrangements involve tangible or intangible goods and services. So I think we can't just be looking at particular, particular types of payments. I think there's an inherent risk there that people need to be assessing what their existing arrangements look like and you absolutely nailed it. Reconsideration of legal arrangements, clarifying rights and obligations.
Commercial substance. Like, you know, what is your commercial substance? What support do you have for that? The valuation of the rights.
But also, you know, for me, there's also a piece around M and A as well. You know, whether you're looking at pre and post deal transactions and then just making sure that you've got defence ready, contemporaneous evidence to support the arrangements that you've got in place. So I think they're the key things for me in terms of what I think taxpayers should be, should be thinking about post Pepsi.
I think that's all we've got time for, Shaz. So thank you.
Look forward to the next installment of the podcast series.
[00:14:26] Speaker A: Thanks, Jade.
