What happened at the PepsiCo appeal hearing a week ago?
Argument in the Full Federal Court appeal was conducted on 8-10th May.
Many clients have already started work to identify the intellectual property used in their Australian operations which might be affected, and how they evaluate the risk associated with the issue. I would be delighted to assist you to develop your own thinking.
Arguments regarding structure and consideration clause drafting
It is important to understand the aspects of the structure which appear to have attracted the Commissioner’s attention, without wanting to suggest that the characterisations of them he advances are necessarily correct.
The most obvious point is an express grant of rights, between arms length parties, to use intellectual property (principally trade marks) in a manner that would ordinarily mean any payments for the grant would have been a royalty (the “IP rights”).
One exclusive bottling agreement (EBA) simply did not provide for consideration for the grant, the other specifically refers to the grant as “royalty free”. These grants occur in a context of other substantial commercial transactions between the parties and the Commissioner argues some of the consideration otherwise paid should be attributed to the grant of rights.
The risk that the Commissioner might succeed on this point represents a problem for all distributors, even arms length parties such as existed here. And even for payments by Australian companies to local subsidiaries of foreign groups.
In the judgment below, the Court held that 5% of the price paid for concentrate should be seen as attributable to the grant of the right to use trade marks. It did so by finding that the overall “businesss and commercial context” supported such a conclusion. Particularly the fact that SAPL could not have bottled the beverages without the licence, and therefore would not have paid for concentrate without it. And a failure to pay for concentrate as required would have led to cancellation of the licence. This approach seems at odds with what IBM has been seen as standing for, that when consideration is unambiguously expressed to be for an IP right, the payment will be a royalty. Placing significant weight on the express words of the agreements. Moshinsky J said the context of the related agreements was relevant, despite the payments being expressly for concentrate.
Any appeal is limited to issues of law. The taxpayer on appeal focussed on broader arguments about whether a royalty would have been commercially appropriate and also the mechanics of the provisions. The valuations relied on by the Court below were not discussed.
Is it reasonable that a royalty would be charged in such a situation?
Discussion on this point is relevant to both the question of whether it is appropriate to say that the overall business and commercial context indicated part of the payment was for the IP rights, and also (see below) in relation to whether a Diverted Profits Tax (DPT) alternate postulate of a royalty could be “reasonable”. The taxpayer emphasised that this grant of rights was purely to enable the licencee to meet its obligations under the EBA. And that any grant was extremely limited, not permitting exploitation of the trademark in the fullest sense that a licencee would normally have (for instance to apply it to products it made using its own formulations). Any benefit was said to accrue to the licensor’s goodwill because on termination of the bottling agreement there was no ongoing right in relation to the brand. It was no more right to use the brand than any mere distributor would have, although necessarily slightly different because of the context of finishing the goods before their distribution. The terms of the grant itself seemed clear in this regard. These arguments are consistent with the propositions in the OECD commentary in relation to distributors.
A substantial part of the taxpayer’s arguments related to the proposition that, on the face of the agreements, PepsiCo had no legal entitlement to receive any amount and therefore could not have “derived” an amount or “directed” the payment of an amount it was entitled to. Preventing a conclusion that there was a royalty derived by a non resident in a way that triggered withholding.
In argument, the Court questioned what the conclusion might be where an agreement expressly said that a grant was royalty free. Suggesting this might prevent a conclusion that PepsiCo ever had an entitlement to sue for any amount in relation to such a clause. With the consequence that this itself might mean there could be no ability to say there was an entitlement to an amount that was directed to be paid to PBS. Preventing a “payment by direction”. It will be interesting to see if, in the end, the Court comments further on this aspect of the drafting.
The parties particularly focussed on the detail of the process by which sales of concentrate came to be made by PBS. The taxpayer asserted that the consideration the EBA gave PepsiCo (I will not separately refer to the other relevant group member, Stokely-Van Camp) was a promise to purchase concentrate from PepsiCo or its nominee. Not a promise to pay money. It appears from the argument that there was some ambiguity in this construction of the drafting. But it was important in establishing whether it could be said PepsiCo had an entitlement to an amount which it directed be paid to PBS and therefore “derived”. So the fact that SAPL received a grant of IP rights from one group member, and actually bought concentrate under an agreement simply for purchase of concentrate from another may prove to be critical to the question of whether PepsiCo “dereived income”.
The Commissioner has sought to make the absence of explicit purchase and sale documentation relating to concentrate, between PBS and SAPL an issue. Saying it meant the delivery was part of the broader business and commercial context of the EBA. It would seem that the appointment of PBS as seller was not followed by documentation that explicitly ensured each payment to PBS for concentrate was clearly in relation to an express agreement for delivery and payment between PBS and SAPL. The evidence was limited to purchase orders, invoices and bank deposit records. Together with disclosures in official records showing the treatment. The taxpayer also arguing that in any event, the delivery gave rise to a direct obligation to pay the supplier, PBS who clearly had title to the goods. Whether more detailed documentation would have resolved the issue may be clarified in the judgement. In any event the ATO says that decisions in the stamp duty context permit a broader examination of related agreements.
These issues fed into arguments that:
- SAPL did not pay any amount to PBS that was for use of IP rights
- PepsiCo did not have an entitlement to a payment of any amount from SAPL, and therefore could never have income under the arrangement as it operated
- Therefore PepsiCo did not receive a royalty, or direct payment of a royalty it was entitled to , to PBS (which would have been constructive receipt)
- Because there was never a royalty, there could not be a tax benefit which supported the application of the DPT
Diverted Profits Tax
The Commissioner argued that, but for the scheme, the alternate postulates which might reasonably have occurred would be:
PepsiCo would have drafted the EBA with a specified amount of consideration for the grant of IP rights
PepsiCo would have drafted the EBA such that the consideration was for all of the property provided under the EBA, not just the concentrate. So that the group would have separately treated some part of the price paid by SAPL to PBS as a royalty, at least internally.
The taxpayer made much of the fact that the essential structure of the arrangement predated the beginning of withholding tax, and it was difficult to say that a desire to avoid withholding tax lay behind the structure. There was significant evidence, however of variations in the basic structure in different jurisdictions and over time. They also relied heavily on the proposition that the ATO bears the burden of showing that it’s proposed alternate is “reasonable”. And that the ATO alternate involved more complexity and effort for the taxpayer. So it was unreasonable.
Charging a royalty was said to be inconsistent with the substance of the arrangement, where all value in the use of IP accrued to PepsiCo such that SAPL would not pay for the use. The ATO countered saying that their postulate only needed to show same commercial outcome, and that theirs better aligned form and substance. The Court suggested that in the event the ATO’s postulate was reasonable, it was stil not clear how precisely it would have led to an ability to levy withholding tax.