The Australian PepsiCo Case: Withholding Tax on Embedded Royalties—A Canadian Perspective

On November 30, 2023, in the case of PepsiCo Inc. v. Commissioner of Taxation ([2023] FCA 1490), the Federal Court of Australia ruled that a portion of the payments was in fact a royalty for the use of intellectual property (IP) and therefore subject to withholding tax. Are there Mentos in this cola case, or will it fizzle out on appeal? The answer remains unclear, but the court’s decision in this Australian case raises interesting questions from a Canadian tax perspective, which are briefly discussed in this article.

Background

The Australian Tax Office (ATO) has presented PepsiCo as a “lead case for our strategy to target arrangements where royalty withholding tax should have been paid.” The case comes after a 2018 tax alert in which the ATO informed the tax community of its concerns that arrangements between an Australian payer and a non-resident recipient that allocate all consideration to tangible goods may fail to comply with the Australian royalty withholding tax obligations that are associated with consideration for the use of intangible assets.

The PepsiCo case involved payments made by an unrelated third party, Schweppes Australia Pty Ltd., to the designated PepsiCo Group supplier in Australia (payments that were then transferred outside Australia) under exclusive bottling appointment agreements (EBAs). Pursuant to these EBAs, Schweppes Australia purchased beverage concentrate to bottle and distribute beverages under PepsiCo’s brands in the Australian territory. The EBAs also granted Schweppes Australia an exclusive royalty-free licence to use the brands and other IP to manufacture, bottle, sell, and distribute the finished soft drinks.

While the agreements stated that the licence of rights was royalty-free and that compensation was solely for the purchase of concentrate, the ATO argued that a portion of the payments constituted consideration for the licensed IP rights. The ATO’s primary contention was that these alleged embedded royalties should have triggered withholding tax at the treaty rate of 5 percent. In the alternative, the ATO argued that these transactions ought to be subject to Australia’s diverted profits tax (DPT) rules.

Justice Moshinsky of the Federal Court of Australia upheld the ATO’s position with respect to withholding tax. The court also supported the ATO’s alternative argument that the DPT would apply if the embedded royalty argument failed.

The Withholding Tax Issue

The term “royalties” is defined in Australia’s Income Tax Assessment Act 1936 (ITAA) as including “any amount paid or credited, however described or computed . . . to the extent to which it is paid or credited . . . as consideration for the use of, or the right to use,” various IP items. Similarly, article 12(4) of the Australia-US treaty defines “royalties” as “payments or credits of any kind to the extent to which they are consideration for the use of or the right to use” various IP items.

In PepsiCo, the court noted that the two definitions’ use of the phrase “to the extent to which” suggests that a payment can be apportioned if it is consideration for more than one thing. The court proceeded to conclude that

• the payments made by Schweppes Australia under the EBAs were, to some extent, consideration for the use of, or the right to use, the relevant trademarks and other IP;
• the relevant portions of the payments were income derived by PepsiCo for the purposes of Australia’s withholding tax provisions and were amounts to which PepsiCo was beneficially entitled within the meaning of the treaty; and
• the relevant portions of the payments are deemed to have been paid by Schweppes Australia to PepsiCo by virtue of Australia’s withholding tax provisions.

The court opined that the payments may be for the right to use IP, such as trademarks, even if the payments are not called “royalties.”

It is not clear, however, that the issue was merely one of nomenclature in the EBAs. An argument could be made, on the basis of the EBAs and the facts as they are described in the decision, that the amounts were payable only for the purchase of tangible goods. In other words, it appears that the issue was not that the payments were for more than one thing. Rather, the issue was that Schweppes Australia was not paying for licensed rights, because they were granted royalty-free. It is not clear whether expert evidence was introduced on this point. From an economic perspective, however, these two types of transactions have different risk profiles for the parties involved, and it does not automatically follow that the parties intended any royalty or similar payment.

Nevertheless, the fact that the EBAs contained an express, royalty-free licensing of the IP rights to Schweppes Australia was considered by Justice Moshinsky to be of no help in resolving the question of characterization under the applicable Australian tax legislation and the relevant tax treaty provisions. The court, noting the words “of any kind” in the treaty and “however described” in the ITAA, held that the manner in which payments are described by the parties to a transaction is not determinative. The issue in this case was whether the payments made by Schweppes Australia under the EBAs were, to any extent, consideration for the use of, or for the right to use, the relevant trademarks and other IP.

We will have to wait and see how this interpretation plays out on appeal in Australia. This type of analysis would be problematic, however, under Canadian law. It is generally the case in Canada that, in the absence of a sham or the application of an anti-avoidance provision, the taxpayer’s legal arrangements must be respected. Paragraph 212(1)(d) of the ITA imposes withholding tax on rent, royalties, or similar payments, and the language of this provision is broad and expansive. It is doubtful, however, that section 212 could be interpreted as containing anti-avoidance language that would (1) deem an amount to be paid for something other than what the parties agreed to or (2) deem that a royalty or similar payment was paid when the parties agreed that none was payable. If the parties agree to a royalty-free licence, these legal arrangements should generally be respected and (at least in our view) the CRA would not be authorized—in the absence of a sham or the application of an anti-avoidance provision such as GAAR—to recharacterize as a royalty an arm’s-length payment for tangible goods.

The TCC’s decision in Entre Computer Centers Inc. v. R ([1997] 1 CTC 2291) shows that a Canadian court will generally respect the legal arrangements between the parties. In that case, the CRA unsuccessfully tried to apply part XIII withholding tax to amounts that were, as the court found, part of payments that a Canadian distributor had paid to purchase computers for resale. The court stated (at 2303):

The transaction is essentially a sale and the payment of the amount stated on the invoice is the price paid to become owner of the product. The payment does not exhibit any of the characteristics usually found in a payment of rent, royalty or similar payment for the use of or the right to use property. There is simply no link, other than the one established in the deeming provision, between the applicable mark-up and the actual use of or right to use Entré Proprietary Marks. The mark-up is simply dependent upon the volume of products purchased.

A Canadian analysis of the issue would also need to consider case law regarding the definition of “royalties and similar payments” under part XIII. For example, in Hasbro Canada Inc. v. The Queen ([1999] 1 CTC 2512), the TCC concluded that a royalty or similar payment is a payment that is made for the use of property, rights, or information, whereby the payments for such use are contingent upon the extent or duration of use, profits, or sales by the user. In the Australian PepsiCo case, it appears that Schweppes Australia’s payments were calculated on the basis of a price per unit of concentrate under the EBAs, not on the basis of sales made or profits earned by the company. In other words, there does not seem to be an element of contingency based on use, profits, or sales by the IP user.

An analysis of this issue under section 212 of the ITA would include a consideration of, among other things, whether a portion of the payments is made for the use of, or for the right to use, property in Canada. Indeed, on the basis of the reasons advanced by the FCA in Farmparts Distributing Ltd. ([1980] 2 FC 205), the TCC found in Hasbro that the opening words of paragraph 212(1)(d) were broad enough to include any payment made for the use of property in Canada, even though the payment does not qualify, strictly speaking, as “royalties or similar payments.” That said, the EBAs’ explicit statement that the licence of, and thus the right to use, the IP was royalty-free seems to exclude the possibility that any part of the payments was made for such rights.

PepsiCo could also cause unforeseen results for customs purposes. Generally, a royalty paid for the use of IP can qualify under Canadian customs regulations to be excluded from the value for duty. This carve-out arises precisely because the royalty payment is in respect of property and rights that are conceptually different from the cost or value of the tangible imported goods. In other words, if the parties in PepsiCo were using solely the unit prices paid for concentrate for customs compliance, this could be further evidence that the parties thought that their agreement was solely for tangible goods, not for the use of IP. Accordingly, the court’s decision in the case could cause a clear separation between the transaction’s treatment for income tax purposes and its treatment for customs purposes.

It is worth noting, as a final comment on this aspect of the case, that although PepsiCo is not a transfer-pricing case (that is, the issue in the case is not whether Schweppes Australia’s overall payments and distribution margins were arm’s length: Schweppes Australia and PepsiCo are not related parties), the court relied on the arm’s-length principle and transfer-pricing methods for apportionment purposes. The court relied on expert testimony that used the relief-from-royalty method to quantify the amount of the embedded royalty. However, some commentators on the case have noted that this method was, in essence, a slight variation on the comparable uncontrolled price (CUP) method. Again, we will have to wait and see how this plays out on appeal in Australia.

In Canada, however, this aspect of the case would need to be considered in the light of our domestic law and administrative policies. If the CRA were to rely, like the Australian court, on transfer-pricing concepts to apportion an amount for part XIII purposes in a transaction between related parties, consideration would need to be given to (1) section 247 of the ITA, (2) the applicable treaty, (3) Canadian transfer-pricing case law, and (4) interpretive aids such as the OECD’s Transfer Pricing Guidelines and its commentary on its model convention.

In Canada v. Cameco Corporation (2020 FCA 112; leave dismissed 2021 CanLII 10731 (SCC)), the FCA found that it was not possible for the CRA to recharacterize a payment unless the requirements of a specific anti-avoidance provision are met (for example, paragraphs 247(2)(b) and (d) of the ITA). Since the recharacterization rule, as the FCA affirmed in Cameco (at paragraph 77), “only applies if arm’s length persons would not have entered into the particular transaction or series of transactions under any terms and conditions,” it seems unlikely that the CRA could successfully rely on transfer-pricing concepts to recharacterize a part of the payment for tangible goods as being a royalty or like payment. Arm’s-length parties clearly enter into this type of transaction, as PepsiCo demonstrates. That said, this analysis may need to be revisited under amended section 247 of the ITA (as proposed in Bill C-59), in which economic substance becomes the focus of the “non-recognition and replacement” rule, which would replace the recharacterization rule (more on economic substance below).

Similarly, in its Transfer Pricing Memorandum (TPM-06), the CRA acknowledges that although a transaction may need to be unbundled for the purposes of non-resident tax and withholding, it may not be possible or desirable to do so when the properties or services are so closely linked or continuous that they cannot be adequately evaluated on a separate basis. The transfer-pricing policy states that this can be the case “[w]here the synergy or integration between intangible and/or tangible properties is so significant that neither element can be valued separate and apart from the other.” In circumstances like those in PepsiCo, it may not be possible to use the CUP method to reliably apportion the amount of the alleged embedded royalty if the comparables used in the benchmark (for example, licences in the beverage industry) did not also involve related supply agreements for tangible goods (for example, for the supply of concentrate). The decision in Canada v. GlaxoSmithKline Inc. (2012 SCC 52) may also need to be considered. The SCC found that the economically relevant characteristics of the situations being compared may make it necessary to consider other transactions that affect the price under consideration. The court also found that a transaction-by-transaction approach may be ideal, but it is not appropriate in all cases.

The Diverted Profits Tax Issue

Australia introduced the DPT in 2017 as an anti-avoidance measure to help ensure that the tax paid by multinational enterprises “properly reflects the economic substance of their activities in Australia” and to “prevent the diversion of profits offshore through contrived arrangements.”

The DPT features a two-part test: (1) the arrangement must involve a tax benefit, and (2) the scheme must have been undertaken for a principal purpose (or for principal purposes) that includes enabling the taxpayer to obtain the tax benefit. On the first part, the court in PepsiCo found that there was a tax benefit. Had it not been for the arrangements in question, the taxpayer would (in the court’s view) reasonably have been expected to pay withholding tax on the amount of hypothetical royalties. For the second part, the court analyzed eight matters (which are listed in the DPT provision as factors indicative of tax avoidance) to determine whether the requisite purpose was present.

The court found a number of factors indicating that the principal purpose of the scheme was to obtain a tax benefit. The main factor was a discrepancy between form and substance:

453 . . . In form, the payments to be made by [Schweppes Australia] were for the concentrate alone and not for the licence of the trademarks and other intellectual property. However, in substance, the payments to be made by [Schweppes Australia] were for both the concentrate and the licence of the trademarks and other intellectual property. The trademarks licensed under the EBAs were highly valuable; the brands were among the most valuable brands in the global beverage industry. . . . This matter strongly supports the Commissioner’s position that the requisite purpose did exist. [Emphasis added.]

The court reached this conclusion despite PepsiCo’s argument that the ATO’s assumptions represented a departure from the substance of the transactions actually undertaken and would not achieve the same commercial results or consequences as the transacting parties intended. This issue will be interesting to follow at appeals because, from a business and economic perspective (as we mentioned above), valid reasons may exist for parties to agree on a royalty-free licence in the context of broader commercial arrangements. In particular, the existence of a royalty can introduce a different risk profile for the parties, and it may in fact constitute a different transaction. In addition, a buy-sell transaction can be a simpler transaction for arm’s-length parties than one involving a royalty that requires them to share confidential in-market sales or profit-level details.

Although Canada has no DPT as such, GAAR is similar to the DPT in some respects. In Canada, the analysis of an issue like the one treated under the DPT in PepsiCo would likely need to consider the current GAAR rather than the amendments proposed in the 2023 GAAR reform (Bill C-59). The proposed amendments to GAAR explicitly introduce economic substance under the misuse-or-abuse analysis (rather than under the purpose analysis, as the Australian DPT does). If, under the proposed amendments, an avoidance transaction is found to be significantly lacking in economic substance, this determination becomes “an important consideration” that “tends to indicate” that the transaction results in misuse or abuse (albeit without constituting a presumption). This test is not exactly the same as the one applied by the court in PepsiCo, but it does appear to narrow the gap between the threshold for applying the Canadian GAAR and the threshold for applying the Australian DPT.

Conclusion

On January 19, 2024, PepsiCo appealed from the Federal Court of Australia’s decision. For the time being, however, the court’s ruling supports the ATO’s position on both points: that these payments should be characterized as embedded royalties, and that royalty withholding tax should be applied under the Australia-US treaty. The case also sheds some light on the possible use of transfer-pricing principles in quantifying embedded royalties for withholding tax purposes, and on the applicability of the “GAAR-like” Australian DPT in such circumstances.

Sébastien Rheault, Jing Yu Wang, and Julien Tremblay-Gravel
Barsalou Lawson Rheault LLP, Montreal