Landmark PepsiCo Decision On Australian Royalty Withholding And Diverted Profits Tax

1. Summary

The High Court of Australia has delivered its eagerly awaited decision in Commissioner of Taxation v PepsiCo Inc [2025] HCA 30, dismissing the Australian Commissioner of Taxation's (Commissioner)appeals by a 4-3 majority representing a significant victory for multinational taxpayers.

The case provides important guidance on issues of consideration in determining the character of payments and the interpretation of the Australian diverted profits tax (DPT).

The majority found that payments made by Schweppes Australia Pty Ltd (SAPL) to PepsiCo Beverage Singapore Pty Ltd (PBS) – despite its name, an Australian resident company – were for beverage concentrate only and did not include embedded royalty components, consistent with the express terms of the contracts. Consideration for the provision of the intellectual property (IP) was, the majority held, the performance of the obligations of SAPL in bottling, selling and distributing the products.

While the minority concluded that the payments made under the exclusive bottling agreements (EBAs) were, to some extent, for the grant of the licence to use the intellectual property, both the minority and majority concluded that PespiCo, Inc (PepsiCo)had not derived any amount of the payments made by SAPL. Accordingly, no amount of the payment could be subject to Australian royalty withholding tax.

Critically, and in comments relevant to the application of the general anti-avoidance rules in Part IVA of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) and not just DPT, the majority also found that the Commissioner's alternative postulates under the DPT provisions were not "reasonable alternatives" within the meaning of section 177CB(3), so that no 'tax benefit' could arise for DPT purposes. In any event, the majority also concluded that "the principal purpose of PepsiCo in entering into the arrangements was not to obtain the tax benefit identified by the Commissioner".

However, how much comfort can be taken in relation to analogous arrangements between related parties within a multinational group is unclear given:

• the numerous obligations imposed on SAPL in relation to its bottling and distribution activities as well as the intellectual property;
• the importance the majority placed on the fact that the terms of the relevant contracts were products of arm's length dealings between unrelated parties; and
• the Commissioner had accepted, as a factual matter, that the price for concentrate was not disproportionately high – to that end, it is an open question whether this concession will be made in future cases.

With the ATO flagging that revised guidance on the character of payments made for software arrangements is imminent and the Government set to introduce new penalties for significant global entities which mischaracterise or undervalue royalty payments, the Australian tax landscape remains challenging.

2. Background: The bottler model under scrutiny

PepsiCo and Stokely-Van Camp, Inc (SVC), had EBAs with an unrelated Australian bottling company, SAPL. Under this agreement, PepsiCo or SVC agreed to sell, or cause a related entity to sell, beverage concentrate to SAPL for bottling and sale, and which the parties agreed contained an implied licence for SAPL to use the Pepsi, and an express licence in respect of the Mountain Dew and Gatorade trade marks. However, no royalties were paid under the agreement, and therefore, no withholding tax was paid in Australia.

The only relevant payments made were for the purchase of concentrate. During the 2017-18 and 2018-19 years (the Relevant Years):

• Concentrate Manufacturing (Singapore) Pte Ltd (CMSPL), a Singaporean entity and a member of the PepsiCo Group, produced concentrate according to a recipe or formula provided by PepsiCo and SVC;
• CMSPL supplied the concentrate to PBS, an Australian entity also a member of the PepsiCo Group;
• PBS supplied concentrate to SAPL and invoiced SAPL for the concentrate that had been supplied and SAPL paid PBS for the concentrate; and
• PBS transferred the money received from SAPL to CMSPL (we assume as a concentrate purchase price, retaining only a small margin). The Commissioner did not allege that the transactions for the sale of concentrate by PBS to SAPL were a sham or that PBS received any part of the payments for the concentrate as agent or trustee for PepsiCo.

The Commissioner issued royalty withholding tax notices under section 128B of the ITAA 1936 to PepsiCo and SVC requiring both entities to pay approximately $3.6 million in royalty withholding tax on money paid by SAPL to PBS.

In the alternative, the Commissioner issued DPT assessments pursuant to Part IVA of the ITAA 1936 imposing a tax liability of $28.9 million on PepsiCo and SVC.

For more background on the lower court decisions, see here, here and here.

3. The three key questions before the High Court

The case turned on three critical questions that had divided the lower courts:

• Question 1: Did SAPL pay a royalty within the meaning of section 6(1) of the ITAA 1936?
• Question 2: If so, did PepsiCo and SVC derive income from those royalty payments under section 128B(2B) of the ITAA 1936?
• Question 3: If no royalty withholding tax was payable, were PepsiCo and SVC liable for DPT?

The Court's findings on each of these matters is summarised below.

4. Question 1: The royalty characterisation divide

The majority's approach

The majority (Gordon, Edelman, Steward and Gleeson JJ) found that no amount of the payment by SAPL was relevantly referable to the right to use intellectual property.

Rather the payment was solely attributable to the purchase of concentrate. In particular, stating:

The majority considered that decisions of the High Court in the stamp duty cases of Dick Smith and Lend Lease that were referred to by the Commissioner were either irrelevant or promoted the taxpayer's arguments.

Ultimately, the majority concluded that:

The minority's integrated transaction approach

The minority (Gageler CJ, Jagot and Beech-Jones JJ) found that the payments were to an extent a royalty because the payments in part moved the grant of the intellectual property licences. That is, the arrangement was to be considered holistically as an exchange of promises relating to the sale of the concentrate needed to make the branded beverages, and the IP rights needed to sell the beverages in Australia.

The minority characterised the arrangements as a "single, integrated and indivisible transaction" and, following the approach in Lend Lease, attempting to separate concentrate payments from the intellectual property licensing involved "purportedly subdivid[ing] the indivisible." The minority criticised the Full Court majority for engaging in "a process of subdivision in which the payment (said to be for concentrate) attached to the concentrate and the other exchanges of value attached to other aspects of the agreement."

The minority considered that, in objectively construing and characterising an agreement, the court is not bound to accept the labels attached by the parties to their dealings.

The approach promoted by the minority could lead to further complexity in practice had it prevailed. For example, under a share sale agreement a seller receives a payment for the sale of shares, typically backed by an extensive warranty and indemnity regime, together with among other things undertakings on future conduct. Adopting the minority's approach may require bifurcating the sale price as consideration for both the shares being sold and also for these various undertakings. Further taking the minority's position to its logical conclusion would mean that some part of the provision of the concentrate by PBS was consideration for SAPL to undertake its obligations in relation to distribution and marketing. Presumably that would be a taxable receipt for SAPL. Thankfully, such analysis should not be necessary, at least for arm's length transactions.

Key legal principles emerging from the split

In applying the "consideration for" test in section 6(1), the majority's approach means that courts should:

• respect genuine commercial arrangements with arm's length pricing;
• focus on actual contractual obligations and consideration flows; and
• consider the broader commercial context including mutual benefits.

Ultimately the majority found that contractual obligations, including to pay money, can be separately allocated to promises made by the other party, whether the supply of goods or the licence of intellectual property rights, provided that allocation is consistent with the intention of the parties when objectively ascertained.

Importantly, whether or not consideration can be allocated to specific contractual obligations will turn on the specific arrangements, relationships and agreements between the parties.

5. Question 2: The derivation question - rare consensus

Both the majority and minority agreed that PepsiCo and SVC did not derive income from the concentrate payments, following the Full Court's reasoning.

Under the EBAs, PepsiCo (and SVC) agreed to, "sell or cause to be sold by one of its subsidiaries... to SAPL and SAPL agreed to buy only from the Seller all units of concentrate required for the manufacture of the Beverage by SAPL" (emphasis added). Contrary to the submissions made by the Commissioner, the majority found that this was not a 'sale clause' rather a promise to enter into future agreements for the sale and purchase of concentrate.

A key finding, therefore, was that there was no antecedent monetary obligation owed by SAPL to PepsiCo or SVC. Once PBS was nominated as the seller under the EBAs, PBS became the actual contracting party for concentrate sales. As the minority explained, "[b]eing obliged to cause to be sold to SAPL the concentrate is not the same as selling to SAPL the concentrate."

The Court found that PBS held title and risk in the concentrate, invoiced SAPL directly, and received payments into its own bank account. Neither PepsiCo nor SVC ever held title to the concentrate or had direct contractual relationships with SAPL for concentrate purchases.

This consensus represents an important limitation on the Commissioner's ability to invoke section 128A(2) "payment by direction" provisions without establishing genuine antecedent obligations. It is also an important outcome from the perspective of SAPL (or taxpayers in analogous circumstances to SAPL) as it should limit the circumstances in which the Commissioner could potentially assert an obligation to withhold under the constructive payment rules in circumstances where payments are made to Australian residents.

For completeness, the Court noted that the Commissioner did not allege any relationship of agency between PepsiCo/SVC and PBS, or that payments were held by SAPL on trust for each of PepsiCo/SVC, which may have otherwise had a bearing on this issue.

6. Question 3: The DPT divide and 2013 amendments

The majority: no tax benefit and no principal purpose

The majority found no DPT liability arose, providing the first substantive High Court guidance on the 2013 amendments to Part IVA which are relevant to identifying a 'tax benefit' for DPT purposes and Part IVA more generally.

Determining whether a DPT liability arises requires a consideration of:

1. was a 'tax benefit' obtained, whether based on plausible counterfactuals or actual events leaving aside the actual scheme; and
2. was the 'purpose' test satisfied?

Tax benefit

In order for there to be a tax benefit (based on counterfactuals), section 177CB(3) requires that the counterfactual analysis be based on "a reasonable alternative to entering into or carrying out the scheme." The majority emphasised that the word "must" in section 177CB(3) is mandatory - there cannot be a tax benefit if no reasonable alternative postulate exists:

In discussing the onus of proving a tax benefit had not been obtained, the majority rejected the Commissioner's argument that PepsiCo had to prove a reasonable counterfactual in which it did not pay royalty withholding tax. The Commissioner argued it was not enough for PepsiCo to show the Commissioner's counterfactuals were unreasonable. While demonstrating the Commissioner's counterfactual is unreasonable does not itself prove no tax benefit was obtained, the majority concluded that the absence of a tax benefit can be shown by establishing that no reasonable alternatives exist.

The majority found the Commissioner's alternative postulates were not reasonable because they "involve[d] the entry into a fundamentally different arrangement" that did not conform to the "economic substance" of the SAPL/PBS/PepsiCo agreements. The majority approved of the comments by the majority in the Full Federal Court that for a postulate to be a reasonable alternative it "should correspond to the substance of the scheme":

Critical to this analysis was:

• the 'franchise-owned bottling operation' (or FOBO) model was used by PepsiCo since the early 1900s supported finding that alternative arrangements were not reasonable;
• the substance of the scheme was that "the price agreed for concentrate was for concentrate and nothing else"; and
• the arrangements were "the product of arm's length dealings between unrelated parties".

Accordingly, the majority found the alternative postulates proposed by the Commissioner failed to correspond to the substance of the scheme. The majority also accepted PepsiCo was able to demonstrate there were no other reasonable counterfactuals. Therefore, no tax benefit could arise.

Purpose

Although not necessary as to the result, the majority also concluded that that the principal purpose of PepsiCo in entering into and carrying out the Scheme was not to obtain the tax benefit identified by the Commissioner. In particular, the following factors in section 177D supported that conclusion:

• unlike the finding of the judge at first instance, the majority concluded that the manner in which the scheme was entered into strongly pointed to a conclusion that PepsiCo did not enter into the transactions to obtain a tax benefit:

Relatedly, the majority made clear that, "[i]t would be unthinkable to suppose that that sophisticated commercial operators did not take tax outcomes into consideration in negotiating the form of a transaction" and that, "taking tax outcomes into account does not necessarily justify an application of Pt IVA of the ITAA 1936, or, indeed, the imposition of DPT." The majority also referred to comments in Hart on choosing to lease rather than buy premises as illustrating that reality;

• the form and substance aligned (in accordance with the earlier conclusion that none of the payment related to a royalty);
• in respect of the result that would be achieved but for Part IVA the majority accepted PepsiCo's submission that the royalty withholding tax said to have been avoided represented about one per cent of the total payments made by SAPL: "this is a negligible sum for such large commercial enterprises. That fact militates strongly against the presence of the required principal purpose; and
• the parties were acting at arm's length and the Collis case had no relevance.

The only factor that the majority held supported the Commissioner was an unquantified US tax saving, regard to which is required by section 177J(1)(b).

The minority's embedded royalty approach

The minority found DPT was payable, accepting Colvin J's reasoning from the Full Federal Court. Having found that royalty payments were embedded in concentrate prices but not paid to PepsiCo/SVC, they concluded there was a tax benefit under section 177C(1)(bc).

The minority accepted that the postulate that "the EBAs would have provided for the royalty to be paid to PepsiCo or SVC as relevant, being the holders of the rights to the intellectual property" was a reasonable alternative under section 177CB(3). They found this "accords with the commercial and economic essence of the schemes" because the only change would be that PepsiCo/SVC would be the seller rather than PBS.

The minority also found the requisite principal purpose under section 177J(1)(b), considering multiple factors including:

• the disconnect between form and substance of the EBAs (in accordance with their earlier conclusion that there was an embedded royalty);
• the change in financial position from avoiding withholding tax;
• the reduction in US tax achieved by the arrangements; and
• the lack of detailed evidence explaining why the pricing structure was adopted.

Key legal principles emerging from the split

The majority's approach to section 177CB(3) establishes several important principles:

• The word "must" means no tax benefit can exist under section 177CB(3) without reasonable alternative postulates. This is not merely an evidentiary burden but a substantive legal requirement.
• Under section 177CB(4), reasonable alternatives must "correspond to the substance of the scheme." Alternatives should "generally accord with the scheme, in its commercial and economic substance or essence."
• Established business models carry weight in the reasonableness analysis. Long-standing commercial practices are less likely to be characterised as contrived or artificial.
• Similarly, arm's length negotiations and contract terms are more likely to sustain review.
• Given that the 2013 amendments to the concept of tax benefit for Part IVA purposes were introduced, in part, to prevent the application of Part IVA being thwarted by a 'do nothing' counterfactual, i.e. an assertion that absent the scheme the taxpayer would not have entered into any alternative transaction, this aspect of the decision may suggest the legislative change did not have its intended effect. However, it is worth recalling that the particular perceived mischief which led to the changes was the acceptance of an argument that a taxpayer would not have entered into an alternative scheme because of the tax consequences of the alternative scheme. Here, the conclusion was based on the alternative not corresponding to the substance of the scheme actually undertaken and was based on "[c]ritical facts, unique to these appeals".
• Importantly, the minority did not disagree with the assertion that a taxpayer may discharge their onus of proof by proving that there is no reasonable alternative postulate, instead stating that on their view "it is unnecessary to resolve that aspect of the dispute".
• Counterfactuals that involve "fundamentally different arrangements" rather than mere variations in legal form are not reasonable. In this regard, while the minority were of the view that a finding that an actual scheme not including a royalty payment would require any alternative postulate to similarly not include a royalty payment, it is difficult to conceive of a case where a taxpayer obtained rights to use or exploit IP without providing "consideration" on the minority's broad view, and yet a reasonable alternative scheme would involve the provision of consideration for the same IP. Accordingly, there are real questions whether DPT can apply to effectively deem an 'embedded royalty' where none is disclosed on the face of a transaction. This will be an important point for the ATO to address in its updated guidance.

7. Limitations of the PepsiCo reasoning

Importantly, several features of PepsiCo's arrangements may limit the decision's broader application:

• The mutual benefits flowing from brand-building activities were critical to the majority's analysis. IP licensing arrangements without similarly substantive reciprocal benefits or obligations may be distinguishable.
• Arm's length parties: The decision involved unrelated parties dealing at arm's length. Related party arrangements will face different analysis under both transfer pricing rules and Part IVA.
• Established business models: The majority emphasised that PepsiCo followed "a pre-existing and entirely commercial way of doing business." Novel structures may not benefit from similar reasoning.

It is notable that PepsiCo was not a treaty case – while DPT and Part IVA stand outside Australia's Double Tax Treaties, it would be important to consider how the case on royalties would be determined if treaty principles were engaged.

Going forward it will be important to ensure multinational arrangements which cater for the use of IP rights clearly reflects the commercial rationale for the arrangement structures adopted, particularly if rights to use intellectual property are not express or are bundled with other activities.

8. ATO response and future developments

Review of ATO guidance

The ATO has indicated that finalisation of draft guidance on the application of the royalty tax provisions to software arrangements in Draft Taxation Ruling 2024/D1 was delayed pending the decision in PepsiCo

Some aspects of the draft ruling may need to be revised in light of the majority's reasoning. For example, the ATO's stated position that undissected amounts which are only partially for the use of IP may be considered a royalty in their entirety (because the IP rights are inseparable, from a practical and business point of view, from the other things for which the consideration is paid), are inconsistent with the majority's views.

The ATO will also need to revisit the recently released draft Practical Compliance Guideline on "Factors to consider when determining the amount of your inbound, cross-border related party financing arrangement" (PCG 2025/D2).

Legislative developments

The Government's 2024 Budget announcement of new penalties for significant global entities that "mischaracterise or undervalue royalty payments" remains on foot. This suggests the Government sees ongoing compliance risks in this area despite the PepsiCo outcome.

The new penalty regime will likely focus on:

• arrangements that artificially inflate non-royalty payments to avoid withholding tax;
• undervaluation of intellectual property licensing components; and
• mischaracterisation of bundled arrangements.

Long-term implications

The narrow 4-3 split and the majority's focus on the facts in this decision provides a roadmap for future Commissioner challenges, particularly in cases involving:

• related party arrangements;
• non-monetary benefits and obligations do not flow both ways; and
• less established business models.

9. Conclusion: taxpayer victory with limitations

The High Court's decision represents a significant victory for multinational taxpayers, affirming that genuine arm's length commercial arrangements should be respected for tax purposes. The majority's emphasis on commercial substance, arm's length dealing and established business models provides important protection for well-structured arrangements.

The decision's reasoning may prove most protective for taxpayers with:

• long-established, commercially-driven business models;
• clear arm's length pricing for actual goods/services;
• genuine reciprocal benefits between parties; and
• robust commercial documentation.

Taxpayers in different circumstances should not assume they benefit equally from the PepsiCo reasoning.

With the ATO finalising its guidance on the royalty withholdings tax treatment of software arrangements and new penalty regimes on the horizon, the tax landscape remains challenging. While PepsiCo provides important judicial support for respecting commercial arrangements, it is unlikely to mark the end of scrutiny in this area.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.