PepsiCo Prevails – But Is This the Last Sip in the Royalty Saga?

The High Court of Australia has handed down its decision in relation to Commissioner of Taxation v PepsiCo, Inc in favour of PepsiCo, Inc. 

The Court clarified that payments for embedded intellectual property within product pricing do not necessarily constitute royalties under Australian tax law.  

Central to the case was whether PepsiCo, Inc derived royalty income through its bottling arrangements with Schweppes Australia Pty Ltd (SAPL). The court found that payments made by SAPL did not include an embedded royalty, and as such PepsiCo, Inc did not derive royalty income that would have been subject to royalty withholding tax. 

It also offers valuable guidance on how the Diverted Profits Tax should be interpreted and applied, with broader implications for other anti-avoidance provisions in the tax law, including the general anti-avoidance rules set out in Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936). 

Whilst this decision provides some comfort for taxpayers involved in the distribution of tangible goods, the broader implications for taxpayers involved in related party distribution arrangements or distribution arrangements involving other products and/or services (e.g., software) remains to be seen. 

The essential features of the arrangement are diagrammatically presented below:

• A critical fact was that SAPL (a third party) did not pay a royalty (nor was it required to) for the use of or right to use the intellectual property of PepsiCo, Inc and Stokely-Van Camp, Inc (collectively PepsiCo). That is, SAPL were allowed to use the trademarks, designs and other rights (the IP) of PepsiCo without making a specific payment for the right to use that IP.  
• The only payments made by SAPL were for the purchase of beverage concentrate to PepsiCo Beverage Singapore Pty Ltd (PBS), an Australian resident company. 

Issues before the court 

The Commissioner’s main arguments before the courts can be reduced to the following three main points:

1. (the Embedded Royalty Question) Part of the purchase of the concentrate was a payment for the use of, or right to use, the IP of PepsiCo (i.e., there was an embedded royalty component to the purchase of the concentrate).
2. (The Derivation Question) Payments received by PBS which included a royalty component, were at the direction of PepsiCo, and were therefore deemed to be paid to PepsiCo and subject to royalty withholding tax, notwithstanding that the actual recipient was an Australian resident company.

(Alternatively)

(The Diverted Profits Tax Question) If PepsiCo was not subject to royalty withholding tax then PepsiCo has intentionally structured the arrangement with SAPL to obtain a tax benefit (i.e., not being subject to royalty withholding tax). 

The Decision

Summarised below are the respective findings of the Federal Court, the Full Federal Court and the High Court of Australia: 

Overview of the Arrangement 

1. PepsiCo are the owners of a portfolio of trademarks, designs and other rights (relating to the Pepsi, Mountain Dew and Gatorade brands).  
2. In 2009, SAPL, an unrelated third-party of PepsiCo, signed exclusive bottling agreements (EBA) with PepsiCo. Under the EBAs:
   1. PepsiCo agreed to supply (or arrange supply of) beverage concentrate to SAPL.
   2. SAPL would mix the concentrate with other ingredients using PepsiCo’s formulas to make finished drinks for sale in Australia.
   3. SAPL would pay for the concentrate, but the agreement didn’t specifically mention any payment for using PepsiCo’s intellectual property (like its formulas or brand).
3. As per the diagram above, Concentrate Manufacturing (Singapore) Pte Ltd (CMSPL), produced the concentrate and then supplied it to PepsiCo Beverage Singapore Pty Ltd (PBS) (itself an Australian resident company, despite its name). Both CMSPL and PBS are members of the PepsiCo Group.
4. PBS supplied the concentrate SAPL and invoiced SAPL for the concentrate. For the 2018 and 2019 income years, this amounted to ~A$240 million. Importantly, SAPL did not make any payments specifically for a royalty or a licence to use the intellectual property of PepsiCo. 

The Commissioner’s Argument(s)

The Commissioner’s primary argument  was that PepsiCo is subject to royalty withholding tax on a portion of the payments made for concentrate. The Commissioner’s primary argument was broken down as follows: 

1. The payments made by SAPL under the EBAs were, to an extent, “consideration for” the use of, or the right to use, the items set out in paras (a) to (d) of the definition of “royalty” in s 6(1) of the ITAA 1936 and paras (4)(a) and (b) of Article12 of the US – Australia Double Tax Agreement (DTA).
2. That royalty income was “derived” by and deemed to have been received PepsiCo and accordingly a withholding tax obligation applied to PepsiCo under section 128B(2B) of ITAA 1936. 
   The Commissioner’s alternative argument was that the diverted profits tax (DPT) provisions in Part IVA of the ITAA 1936 applied. 

Round 1 - Federal Court Decision

In November 2023, the Federal Court (Mohinsky J) handed down its decision in favour of the Commissioner. Put simply, it was the Court’s view that the EBAs contained a right to use the IP of PepsiCo (i.e., the relevant trademarks and other intellectual property) to SAPL and that IP was fundamental to the operation of the agreement. 

The court further found that, despite SAPL not making any royalty payments directly to PepsiCo, a royalty was deemed to have been constructively paid  (in other words, the royalty component had been paid to PBS at the direction of PepsiCo) and that PepsiCo was beneficially entitled to that royalty income . Therefore, the Court found that a royalty was “derived by” PepsiCo.

Whilst the court did not specifically rule on the application of DPT, the Court found that had the royalty withholding tax provisions not applied, the DPT (40 percent penalty tax rate) would have instead applied pursuant to Part IVA of the ITAA 1936. This is on the basis that the key requirements of the DPT would have been met, namely: 
(a)    A scheme has been entered into 
(b)    A tax benefit has been derived; and 
(c)    And the scheme was entered with a principle purpose of obtaining a tax benefit. 

PepsiCo appealed the decision. 

Round 2 - PepsiCo’s Appeal (Full Federal Court) 

In June 2024, the Full Federal Court of Australia handed down its decision on the appeal. Colvin J summarised the two main issues before the Court that needed to be considered as follows:

1. Whether, upon the proper construction of the EBAs (and in the manner in which they were performed), the agreed price was not payable in consideration for the concentrate alone but was payable as to part as a royalty.
2. Whether amounts paid to the related party supplier of the concentrate under the terms of the EBAs constituted income derived by PepsiCo and SVC even though not received by them.

(1)    The Embedded Royalty Question 

Majority Decision

Perram and Jackman JJ (in the majority judgement) preferred a strict and legalistic approach to their consideration of whether a payment was being made for the right to use the intellectual property of PepsiCo. 

They focused on the terms of the EBA actually entered into and stated that; 

“… to determine whether the payments made by [SAPL] to [PBS] were in part paid as consideration for the right to use the trade-marks and other intellectual property, attention is to be confined to the terms of the contractual documents which, in this case, include at least the EBAs.” 

The majority also affirmed the decision of Bennet J in International Business Machines Corporation v Commissioner of Taxation [2011] FCA 335, which provided:

“… the question of whether payments are consideration for the right to use intellectual property rights, and therefore a ‘royalty’, for the purpose of s 128B of the ITAA 1936 is determined by the construction of the relevant agreement”.

The majority judgement also considered the Commissioner’s view that without an embedded royalty being a component of the concentrate, PepsiCo were in effect giving away the right to use their intellectual property for nothing. In this regard, the Court (in the majority) provided that; 

“a complete view of the licence granted by [PepsiCo] to the Bottler is one which acknowledges: (a) the benefits obtained by the Bottler in being permitted to use the goodwill attaching to the trade marks; (b) the restrictions both as to product and marketing imposed on the Bottler in its utilisation of that goodwill; (c) the burdens placed uponthe Bottler in complying with testing and inspection regimes; and (d) the benefits obtained by [PepsiCo] in having the Bottler sustain and promote their goodwill in Australia. Once that is appreciated, the Commissioner’s submission that [PepsiCo] were giving away the right to use the trade marks for nothing unless some element of the concentrate price was seen as embedding some value for it, must be rejected”. 

Therefore, it was the view of the court (in the majority) that there was no payment for the use of the IP held by PepsiCo and there was a commercially sound rationale for the absence of a royalty payment in the EBAs. 

Minority Decision 

Colvin J, in the minority , did not favour this view, but rather took the view that the EBAs were not an agreement to supply concentrate, but rather an agreement whereby PepsiCo appointed SAPL to bottle and distribute the branded beverages of PepsiCo. Colvin J took the view that; 

“the trade marks are known to the parties to be strong and valuable. That is to say they have considerable existing goodwill. If the amount that is required to be paid under the EBAs is for the concentrate alone then the right to distribute the branded products is being afforded without any part of the monetary consideration being attributable to the licence to use the valuable brands of PepsiCo. That is a commercially unreasonable view of the terms of the EBAs considered as a whole”. 

(2)    The Derivation Question 

All three judges of the court ultimately concluded that the payments made by SAPL to PBS for the concentrate was not income that was derived by PepsiCo for the purposes of section 128B of the ITAA 1936. The key reason to the rejection of the derivation requirement was that there was no “antecedent monetary obligation owed by [SAPL] to PepsiCo…Since there was no antecedent monetary obligation, it is not possible that by paying [PBS], [SAPL] was paying [PepsiCo]” . In other words, there was no requirement under the EBA for a royalty payment to be paid to PepsiCo, meaning it could not reasonably be said that the payment to PBS was at PepsiCo’s direction (and therefore deemed to have been ‘paid’ to PepsiCo for royalty withholding tax purposes).

(3)    The Diverted Profits Tax Question

It was concluded (again, in the majority with Colvin J dissenting), that the DPT did not apply as PepsiCo did not obtain a tax benefit "in connection with a scheme" and as such the requirements of the DPT were not met. 

The main requirement of the DPT that was discussed, was whether a tax benefit had been derived. In order to establish that a tax benefit had been derived, it would need to be established that a reasonable alternative to the “scheme” (referred to as a “reasonable alternative postulate”) existed and if that alternative scheme had been entered into, a higher amount of tax would be paid. 

The Full Federal Court (majority) found that the scheme had been entered into and carried out for the principal purpose of obtaining the tax benefit (i.e., they agreed with the primary judgement), but nonetheless held that PepsiCo had discharged its onus of demonstrating that it had not obtained any tax benefit. Critical to the reasoning of the majority was that the commercial and economic substance of the scheme was "that the price agreed for concentrate was for concentrate" (i.e., not an embedded royalty). Both of the reasonable alternative postulates put forward by the Commissioner envisaged that part of the payment made by SAPL to PBS was a royalty. As the majority found that no embedded royalty existed, these alternatives were not considered reasonable. 

Decision

The Full Federal Court, found that PepsiCo’s appeal should be allowed and the notices of assessment for royalty withholding tax should be set aside. Colvin J, would have allowed the appeal by the Commissioner in respect of the DPT. 

The Commissioner sought special leave to apply to the High Court of Australia which was granted. 

Round 3 - High Court Decision 

The High Court of Australia handed down its decision on 13 August 2025. To put it simply, the High Court majority (four to three) found in favour of PepsiCo. 

(1)    The Embedded Royalty Question 

In the majority judgment, Gordan, Edelman, Steward and Gleeson JJ, found that: 

1. The majority of the Full Federal Court were correct to conclude that the payments made by SAPL to PBS were for concentrate and did not include any component which was a "royalty" for the use of the PepsiCo’s Intellectual Property ; and
2. The payments made by SAPL to PBS were not brought to tax under section 128B of the ITAA 1936  because there was no "royalty" and the payments made by SAPL to PBS was not income derived by or paid to PepsiCo. 

Key to their decision was that in order for there to have been a royalty payment there must be a “causal connection between the making of a promise to pay or confer some other benefit and the receipt of a right to use the intellectual property”. As the EBAs did not require a payment to be made for the use of the IP of PepsiCo, there is no demonstrable causal connection between the requirement of SAPL to make a payment the receipt of any of PepsiCo’s IP. This follows the strict approach adopted by the majority decision in the Full Federal Court.

In the minority judgement, Gageler CJ, Jagot and Beech Jones JJ, disagreed with the majority and found that; 

“The Commissioner therefore is correct to have submitted that... that the EBAs ultimately secured the right to distribute the famous beverages of which the use of intellectual property was a necessary element required a conclusion that part of the payments made by SAPL was for the use of [PepsiCo] intellectual property". 

(2)    The Derivation Question 

With respect to the requirements of section 128B, both the majority and the minority agreed that the payment by SAPL to PBS was for the sale and supply of the concentrate and no part of that payment was consideration for the use of PepsiCo’s IP. Therefore, the Court found unanimously that no royalty income had been paid to or derived by PBS for royalty withholding tax purposes. 

(3)    The Diverted Profits Tax Question

With regards to the DPT issue, the minority judgement found that a scheme had been entered into, that a tax benefit had been derived from the arrangement, and that this scheme was entered into with ‘a’ principal purpose of obtaining a tax benefit. 

In the majority decision, their honours found that the “principal purpose test” had not been satisfied and therefore no tax benefit had been derived. In arriving at this decision their honours found that: 

“…the Scheme was the product of an arm's length negotiation between experienced and large commercial enterprises. Second, the Scheme produced a price payable for concentrate that was not disproportionately high and which was paid to an Australian resident taxpayer. Third, the Scheme followed broadly a pre-existing and entirely commercial way of doing business: namely the [franchise-owned bottling operation] model.”

As such, the Commissioner’s appeals were dismissed with costs.

 Key takeaways

There are in our view a number of key takeaways from the High Court’s decision, including:

• Questions regarding the broad precedential value of the decision, noting the unique facts of the case, including that the scheme was the product of arm’s length dealings between unrelated parties. It will be interesting to see the pending Decision Impact Statement to be issued by the Commissioner, as well as what revisions will be made to TR 2024/D1 and PCG 2025/D4 (the latter being just a week young). Whilst there may well be direct implications for the forthcoming Coca-Cola proceedings in the Federal Court, broader implications should be expected to arise from the judicial determination of the royalties question in the Oracle appeal.
• Taxpayers have now received coherent guidance from an apex court on the application of subsection 177CB(3) of the ITAA 1936 (i.e., the DPT). Specifically, and despite the Commissioner’s submissions to the contrary, the majority held that in certain cases a taxpayer may demonstrate the absence of a tax benefit by establishing the absence of a reasonable alternative postulate.
• The likelihood that seeking to infer a different substance and consequent tax effect to complex third party commercial agreements will lead to the need for a very detailed analysis of the legal agreements and relevant facts. The four-three decision in the High Court (and overall six-five outcome from the eleven judges who decided these questions throughout the court processes) shows how finely balanced and difficult to predict the outcomes can be.
• PepsiCo’s success lay in part to its ability to evidence that the substance was in line with market expectations and there was a sound commercial rational for entering into the arrangement. When applying the same principles to a related party transaction, wherein the Commissioner has the ability to reconstruct the transaction, the Commissioner’s approach regarding substance over form and commercial realism would become even more consequential. For related party transactions involving a similar ‘bundling’ of products and IP, aside from being able to establish that the arrangement has been structured in a commercially sound manner, the parties will require a body of evidence that demonstrates that third-parties do enter into similar arrangements or the end outcome may not be the same.
• Some welcome judicial clarity on the relevant meaning of ‘consideration for’, which appears to depart from the position espoused by the Commissioner in TR 2024/D1. Specifically, the majority’s rejected the Commissioner’s contention that ‘consideration’ does not have its technical meaning in contract law and incorporates a wider notion than consideration in a contractual sense, finding that seminal stamp duty case law (viz. Dick Smith and Lend Lease, the former cited in TR 2024/D1) did not support such construction.  

For further information

Please contact one of the authors to this Tax Insight, or your local RSM Advisor, if you would like to discuss the potential impact of this decision on your organisation.