PepsiCo Australia Victory Highlights Need for Careful Contracts

PepsiCo Inc.’s August win on the application of royalty withholding tax and diverted profits tax sets a precedent in clarifying how Australian courts approach the characterization of payments under complex cross-border arrangements.

The High Court of Australia’s 4-3 decision, which involved PepsiCo’s Australia beverage distribution arrangements, shows the importance of carefully structured contracts, accurate valuation of intangibles, and comprehensive documentation to ensure payment allocations reflect commercial reality and withstand regulatory challenge.

For royalty withholding tax to be payable, the commissioner of taxation needed to establish that payment arrangements included a royalty component, and that payments received for the royalty constituted “income derived” by PepsiCo. The court rejected both of those arguments and held that, consequently, the diverted profits tax didn’t apply to the bottling arrangements.

The case provides important guidance on how payments under integrated commercial arrangements should be characterized, particularly where intellectual property rights are intertwined with the supply of goods or services.

The court emphasized that assessing whether a payment is truly paid “as consideration for” the grant of IP rights, rather than for a commercial arrangement as a whole, is the correct test to characterize consideration as “royalty.” Such assessment should consider the actual realities of both parties finding the real deal.

This is a welcome clarification against the backdrop of Australian Taxation Office guidance on royalties and payments in connection with software and IP rights. It also reinforces that Australia’s anti-avoidance and transfer pricing rules must be interpreted in line with economic reality.

Court Decision

In reaching its conclusion, the court majority relied on proper construction of the agreements linking Schweppes, PepsiCo, and SVC. Determining whether the payments made by Schweppes constituted a royalty meant assessing whether those payments were made “in consideration for” the use of the PepsiCo IP.

The court highlighted that bundled arrangements, such as exclusive bottling or distribution agreements, often involve interdependent promises. The payments linked to agreements involving IP use would be treated only as royalties if, when viewed in the context of the parties’ overall commercial arrangements, they directly link to the grant of those IP rights.

Any consideration for other obligations relating to quality, marketing, exclusivity, supply of goods, services, or alternative benefits can’t automatically be recharacterized as royalty payments.

The court also recognized that IP consideration sometimes can take the form of non-monetary commitments, including the licensee’s performance of contractual obligations. In such cases, the contractual structure and transaction pricing support a product-based characterization.

In this context, the court noted that payments made by Schweppes to PBS for concentrate were solely for goods supplied and represented an arm’s length, fair price. Because the price wasn’t excessive or disproportionate, no part of it could be recharacterized as a royalty for using PepsiCo’s intellectual property.

The court unanimously held that Schweppes’ payments to PepsiCo’s subsidiaries weren’t income derived by PepsiCo because receiving PepsiCo entities had no pre-existing obligations to pay amounts received to PepsiCo itself.

The derivation argument that worked in favor of PepsiCo may not exist in other traditional arrangements—such as in software and other industries, where it might be difficult to separate the vendor of the goods in question with the IP owner.

Transfer Pricing Lessons

For transfer pricing purposes, the decision underscores that taxpayers must show that related-party prices reflect arm’s-length outcomes and that the allocation of value between tangible and intangible contributions is defensible.

It reinforces that transfer pricing analyses must go beyond contract wording and reflect the economic substance of bundled supplies. Even when agreements are framed as simple product sales, tax authorities and courts may recharacterize part of the consideration as a payment for intangibles, if the commercial reality shows that brand use, trademarks, or marketing rights are embedded in the transaction.

The court noted that the exclusive bottling agreements were “single, integrated and indivisible” transactions, involving interlocking promises: the sale of concentrate, the grant of IP licenses, and various obligations regarding quality, marketing, and performance.

Therefore, the consideration must be attributed to all elements of the transaction, including the grant of IP rights, even if not separately identified or labelled as a royalty.

The decision also highlights the need for valuations to reflect a company’s best estimate of economic reality and the need to assess whether distinct components of intra-group transactions should and can be segregated and priced separately.

Where goods are sold together with embedded rights to use intangibles, arm’s length benchmarks must support an allocation of consideration. This raises challenges for multinational enterprises because separating the value of tangible products from intangible contributions is inherently complex and often lacks clear comparables.

The decision suggests that failure to perform this assessment may expose groups to adjustments and withholding tax liabilities.

Impact on Companies

The court’s approach in this decision parallels OECD guidance on intangibles, which stresses accurate delineation of transactions and appropriate recognition of brand-related returns. For multinationals, this could mean that exclusive distribution or licensing arrangements will be scrutinized under transfer pricing rules and under withholding tax provisions.

The decision has wider relevance across industries. It provides some comfort to companies in consumer goods and franchise distribution model that including brand use within supply agreements won’t by itself be treated as a royalty.

However, technology and digital services providers should be more cautious, as payments for software, software as a service, or other digital IP are far more likely to be considered royalties. The ATO has indicated, through draft guidance on royalties and payments in connection with software and IP rights, that it intends to keep a close eye on such arrangements.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Rezan Ökten is a partner and head of transfer pricing at Dentons’ Amsterdam office.

Sue Williamson is a tax partner in Dentons’ Melbourne office.

Ritu Bharadwaj is an associate in Dentons’ Amsterdam office and member of the transfer pricing practice.

Jesse Loudovaris of Dentons contributed to this article.

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