MOVING away from the topsy turvy Trumpian world, let us for the moment, go down under- to Australia. In August 2025, the High Court of Australia (the highest Court of appeals in Australia), gave its first verdict involving the Australian Diverted Profits Act (DPT). The same decision also dealt with the vexed issue of embedded royalty albeit in the context of sale of goods alone. The fact that the revenue won its case before the single judge of the Federal Court but lost before the Full Federal Court by a 2-1 majority before the case was finally decided in favour of the taxpayer but again by a razor-thin majority of 4-3, shows the complexity of the issues involved. The case shows how royalty can still be extracted from source countries without being subjected to any tax thereon and therefore exposes a loophole that has not been adequately considered so far.

We may recall that in the height of Global outrage against MNC tax avoidance, countries were introducing anti- avoidance measures throughout the world and the UK and Australia resorted to legislating their Diverted Profits Provisions starting 2015.The Diverted Profits Tax is a separate and distinct legislation in the UK although the government there is reportedly considering a proposal to repeal the separate legislation and incorporate its essential provisions in the transfer pricing provisions.

The Australian DPT is however contained in Part IV- A of the Income Tax Assessment Act 1936 dealing with the application of the General Anti Avoidance Rules; the principal aim of the DPT provisions being prevention of transfer of Australian profits to offshore associates by significant global entities with annual global revenue of Australian USD 1 billion or more and having Australian turnover of Australian USD 25 million or more. Australian DPT focusses on artificial arrangements and applies a principal purpose test in place of the dominant purpose test of the Australian GAAR that is relatively less demanding for the ATO to apply. A penalty rate of 40% is applied on the diverted profits.

As outlined in a 2015 discussion paper, the Australian tax benefits may be small in the overall scheme of a large MNC and hence reduction of tax liabilities of another jurisdiction is also covered by the Australian legislation.

In this regard, we notice the following provisions of section 177J of the Income Tax Assessment Act 1936:

"Diverted profits tax-- application

Scheme for a purpose including obtaining a tax benefit etc.

 (1)  This Part also applies to a scheme, in relation to a tax benefit (the  DPT tax benefit) if:

 (a)  a taxpayer (a  relevant taxpayer) has obtained, or would but for section   177F obtain, the DPT tax benefit in connection with the scheme, in a year of income; and

 (b)  it would be concluded (having regard to the matters in subsection (2)) that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a principal purpose of, or for more than one principal purpose that includes a purpose of:

 (i)  enabling the relevant taxpayer to obtain a tax benefit, or both to obtain a tax benefit and to reduce one or more of the relevant taxpayer's liabilities to tax under a foreign law, in connection with the scheme; or

 (ii)  enabling the relevant taxpayer and another taxpayer (or other taxpayers) each to obtain a tax benefit, or both to obtain a tax benefit and to reduce one or more of their liabilities to tax under a foreign law, in connection with the scheme;

(…)"

At this stage, we should also note that Section 177CB provides how to determine the amount of a "tax benefit" that was obtained in connection with a scheme. This section gives a framework for comparing the tax outcomes of the scheme against what would have happened if the scheme had not been entered into.

The dense judgement of the High Court is of 98 pages out of which, the minority judgement (that included the Chief Justice) takes 40 pages and the balance 58 pages contain the majority decision.

Facts of the case -

PepsiCo is the owner of a world-wide portfolio of trade marks, designs, and other rights and assets relating to the Pepsi and Mountain Dew brands. Schweppes Australia Pty Ltd (SAPL), is an Australian company owned by Asahi Breweries. It was distributor of Pepsi drinks in Australia. Around 2009, a Restated and Amended Exclusive Bottling Appointment (EBA} was entered into between PepsiCo, the Concentrate Manufacturing Company of Ireland (CMCI) and Schweppes Australia Pty Ltd (SAPL), under which PepsiCo appointed SAPL to bottle, sell and distribute certain beverages- Pepsi, Pepsi Max,Pepsi Light, and Mountain Dew; and CMCI appointed SAPL to bottle, sell and distribute other beverages under the Trade Mark- Seven-UP, in each case as its sole and exclusive licensee within Australia.

Similarly, Stokely-Van Camp, Inc (SVC), another US company of the Pepsi group owning the global brand Gatorade also entered into similar contracts with SAPL.

The contracts provided for the US companies to sell or cause another member of the PepsiCo Group to sell to SAPL the concentrate needed to make the branded drinks. They also provided for the US companies to grant exclusive licences to SAPL to exploit the trademarks and other intellectual property rights to enable SAPL to be the exclusive manufacturer, bottler, packager, seller, and distributor of those branded drinks in Australia.

After the EBA was concluded, PepsiCo and SVC notified SAPL that the seller of the concentrate would be PepsiCo Beverage Singapore Pty Ltd, (PBS) which, despite its name, was actually a PepsiCo Group company in registered in Australia . Thereupon PBS notified SAPL of its bank account details to which the payment was to be made.

In 2018, a group company, Concentrate Manufacturing (Singapore) Pte Ltd (CMSPL) and PBS entered into a concentrate distribution agreement in terms of which CMSPL agreed to sell and PBS agreed to purchase concentrate from CMSPL at a price equal to PBS's sales prices less a distribution discount that was to constitute the sole monetary consideration to PBS for distributing the concentrate. Importantly, distribution price was to be an amount that would be provided by a seller to an unrelated purchaser under similar circumstances.

At the relevant times, SAPL bought concentrate from, and paid, PBS, which in turn transferred almost all the money received from SAPL to CMSPL, retaining only a small margin and recorded the income from the sale of concentrate to SAPL in its Australian income tax returns and financial statements. No payment was made either to PepsiCo or SVC. No provision was made in either EBA for the payment by SAPL to PepsiCo or SVC respectively of a royalty for its use of the PepsiCo Intellectual Property.

SAPL was to follow the US companies' directions in producing the branded drinks, maintain sufficient production capacity to sell and distribute sufficient quantities of the branded drinks throughout Australia, ensure appropriate standards for production of the branded drinks, sell the branded drinks at prevailing competitive market prices, use its reasonable endeavours to maximise the sale of the branded drinks throughout Australia, and enter into advertising and marketing and performance agreements with the US companies under which the parties would promote the marketing and maximisation of sales of the branded drinks in Australia.

It should be noted that PepsiCo and its predecessor company, the Pepsi-Cola Company, have used a franchise model involving the sale of concentrate for their branded drinks to third parties to manufacture, bottle and sell since inception in the early 1900s. The franchise model meant that the PepsiCo Group gained access to the bottler's investment in bottling and distribution equipment and its capabilities, including its distribution network, sales force, leadership, relationships with the trade and local regulatory authorities.

Section 6 of the ITAA, 1936 is called the interpretation section and section 6(1) contains definitions of various terms. The definition of 'royalty' is inclusive and in so far as relevant for the discussion of the present case states as follows:

"Royalty or  royalties includes any amount paid or credited, however described or computed,…, to the extent to which it is paid or credited, as the case may be, as consideration for:

(a)  the use of, or the right to use, any copyright, patent, design or model, plan, secret formula or process, trade mark, or other like property or right; (…)"

In December 2020 and January 2022, the Commissioner issued notices of assessment to both PepsiCo and SVC for the years ended 30 June 2018 and 30 June 2019 on the ground that part of the payments made by SAPL to PBS for the supply of the concentrate was a royalty paid to or derived by PepsiCo or SVC on which withholding tax was payable under s 128B(2B) of the income Tax Assessment Act 1936 or in the alternative there was a diversion of profit that accrued to PepsiCo or SVC for which they were liable to pay Diverted Profits Tax in terms of s 177J in Part IVA of the ITAA 1936.

Three basic questions arose from the Commissioner's action before the courts

The Royalty issues

The Commissioner had argued that the price included a royalty component, as under the EBA PepsiCo granted to SAPL a licence to use its intellectual property, and a payment had to include consideration for the use of the intellectual property, which is royalty as defined in the domestic definition of the term.

Minority view:

As indicated earlier, there was a divergence of opinion amongst the minority and the majority judges both at the Federal Court level as also at the High Court level. Without going into the details, the basic approach of the minority was in effect substance over form. Although in terms of the different agreements, no payment flowed from group companies to PepsiCo, the following observations of the minority is worth noting:

The relevant consideration in the definition of "royalty" in the present case is "any amount paid or credited, however described or computed". (…). An amount may be "computed" by any method of calculation including by the ascribing of objective market value to any description. This means that there is no relevant distinction between the concepts of "money's worth", "the value of a non-monetary consideration", or an "amount paid or credited, however described or computed.

The words "paid or credited", "however described or computed", and "to the extent to which it is paid or credited" in the definition of "royalty" ensure that the definition of "royalty" can extend to:

(1) amounts in fact transferred and amounts not in fact transferred but credited in any way;

(2) such amounts not described as relating to any of the matters specified in the definition;

(3) a formula or description from which such an amount can be "computed"; and

(4) any part of any such amount, all irrespective of the labels or descriptions used by the parties.

The minority held that argument of PepsiCo that a tax Act must take the result of the taxpayer's activities as it finds them and the "relevant transactions were sales of goods for a price", expose the flaw in their case. In objectively construing and characterising an agreement, the court is not bound to accept any label the parties attach to any aspect of their dealings. Nor are the EBAs properly characterised as a sale of goods for a price. While, as PepsiCo and SVC said, a "process of characterisation of a payment must commence with a correct identification of the legal rights and obligations attending the transaction giving rise to the payment", part of that process of characterisation involves identifying if the transaction is single, integrated and indivisible or not, having regard to its text, structure and purpose. If it is, it cannot thereafter be divided into its component parts for the purpose of identifying any royalty component.

Majority view

The Majority considered the different agreements in detail including the anterior arrangements between the different entities and concluded as follows:

The use of a local bottler such as SAPL was mutually beneficial for both PepsiCo and the bottler. SAPL was able to leverage the PepsiCo Group's innovation and marketing capabilities and PepsiCo received the benefit of SAPL's local investment in bottling and distribution equipment and capabilities. Besides, the bottler also helped build the brand of the Beverages. Under the SAPL Bottler, Seller and Distributor Agreement, SAPL was appointed and accepted appointment as the exclusive bottler, seller and distributor of the Beverages as part of a comprehensive arrangement involving an exchange of promises, on an arm's length basis, which included the promise to purchase concentrate at agreed prices which were not disproportionately high, as well as the conferral of intellectual property rights. (Para 147)

The exchange of promises in the SAPL Bottler, Seller and Distributor Agreement between PepsiCo and SAPL was separate from the future agreements that may be, and were, entered into by SAPL for the sale and purchase of concentrate. Indeed, as the PepsiCo EBA contemplated, the future contracts for the purchase of concentrate by SAPL were not with PepsiCo but were with PBS, as the nominated Seller. PBS, which had no need for the PepsiCo Intellectual Property other than to sell the concentrate to SAPL, sold the concentrate to SAPL with a margin of 0.05 per cent. 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 from SAPL for the concentrate as agent or trustee for PepsiCo. The price paid by SAPL to PBS for the concentrate did not move the transfer of the PepsiCo Intellectual Property from PepsiCo to SAPL. (Para 148) Accordingly, the majority did not find a royalty to be paid.

Royalty withholding tax

In Australia there is no withholding tax requirement in respect of payments to residents and consequently WHT in this regard apply uniquely to payments to non-residents.

Section128B(5A) of the Act states: "A person who derives income to which this section applies that consists of a royalty is liable to pay income tax upon that income at the rate declared by the Parliament in respect of income to which this subsection applies."

The question therefore was whether PepsiCo or SVC derived any royalty income. Both the minority and the majority held that there was no such derivation of royalty income by the non-residents. The Commissioner had argued that even if the actual payments were from SAPL to PBS an Australian company, it was at the direction of PepsiCo and hence the WHT should apply.

In this regard, the minority found that PepsiCo and SVC each having nominated PBS as the seller, each was bound to "cause to be sold" by PBS to SAPL the concentrate. However, being obliged to cause to be sold to SAPL the concentrate is not the same as selling to SAPL the concentrate. It is clear from the EBAs that if PepsiCo and SVC nominate a seller other than themselves it is that entity which is the seller. That SAPL promised PepsiCo and SVC, amongst other things, to buy from the seller the concentrate at the agreed prices, and that PepsiCo and SVC could enforce this promise, does not convert the promise into one by which SAPL was bound to make payment to anyone other than PBS as the nominated seller. In that view of the matter, both the minority and the majority held that WHT will not apply.

Applicability of the DPT

In this case, the alternative proposition of the Commissioner was that the royalty (withholding) provision did not apply. Considering the fact that the minority and the majority came to differing conclusions on the royalty question, their conclusion on this aspect obviously differs.

Minority view

As stated by the minority- the provision applies to a "scheme" in relation to a "tax benefit" (a "DPT tax benefit") in a year of income if provisions in respect of a principal purpose component are also satisfied. If the tax benefit and principal purpose requirements are both satisfied, the taxpayer is obliged to pay, for the relevant year of income, tax at a particular rate on the "DPT base amount for that DPT tax benefit.

It was emphasized that the taxpayer bears the onus of proving the assessments are excessive under s 14ZZO(b)(i) of the ITAA. As a result, PepsiCo and SVC accepted that to determine if a taxpayer might reasonably be expected to have been liable to pay withholding tax the taxpayer must prove both that "the Commissioner's postulates are not reasonable ... [and] ... that there is no other reasonable postulate.

The Commissioner asserted that the "scheme" here is the entry into the EBA, which, is an agreement under which each of PepsiCo and SVC granted to SAPL an exclusive licence to use intellectual property rights of substantial value without requiring payment of a royalty for the licence and obtained a tax benefit in connection with a scheme by the EBAs in that they were thereby not liable to pay royalty withholding tax on an amount each might reasonably be expected to have been liable to pay on the amount if the respective schemes had not been entered into or carried out.

The primary judge of the Federal Court had held that "it would be concluded that one of the principal purposes of each of PepsiCo and SVC in entering into or carrying out the relevant scheme was to obtain a tax benefit (namely not being liable to pay Australian royalty withholding tax) and to reduce foreign tax (namely, US tax on their income)", observing that "the terms of the EBAs are contrived, in that payments that are ostensibly for concentrate alone are in substance for both concentrate and the licence of valuable intellectual property.

In this context, the minority held that on their proper construction and characterisation, the EBAs each provide for a single, integrated, and indivisible transaction of which the sale of concentrate by PepsiCo or SVC or their nominated PepsiCo Group member to SAPL forms one inseparable part, from which it follows that the price said to be for the sale of concentrate has within it a component for the transfer of the intellectual property rights (the royalty). Once that is accepted, it also follows that PepsiCo and SVC have not discharged their onus by negativing the reasonable alternative postulate to the schemes that PepsiCo and SVC would be the nominated sellers under the EBAs in circumstances where the price payable by reference to units of concentrate to be sold included a royalty for the use of the intellectual property rights granted by PepsiCo and SVC to SAPL under the EBAs.

The minority observed that it is the commercial and economic substance of the schemes, in which the parties to the EBAs have executed an indivisible transaction involving interlocking promises including the sale of concentrate and the grant of the intellectual property licences along with other promises of value, which drives the outcome. Within that indivisible transaction, there is no doubt that the intellectual property licences are of fundamental importance and substantial value. The evidence exposes that, without them, SAPL would have no interest in buying the concentrate and, indeed, PepsiCo and SVC would not sell SAPL the concentrate to enable it to market the drinks under different brands. The entire object of the EBAs was to enable and to maximise the sale in Australia of the drinks as branded under the globally famous trademarks.

According to the minority, therefore, the primary judge had correctly concluded that, if the royalty withholding tax provisions did not apply, the DPT provisions would apply.

The Majority view

The majority considered the submission of the Commissioner that the majority of the Full Federal Court misidentified the operation of the onus of proof imposed by s 14ZZO of the ITAA in the event that no reasonable alternative to a scheme could be identified on the evidence before the Court. The Commissioner submitted that the majority of the Full Federal Court erred in finding that a taxpayer could discharge the onus by showing that no reasonable postulate existed.That submission should not be accepted, having regard to both the text of s 177CB(3) and authority.

The majority observed that the use of the word "must" in s 177CB(3), namely that "[a] decision that a tax effect might reasonably be expected to have occurred if the scheme had not been entered into or carried out must be based on a postulate that is a reasonable alternative to entering into or carrying out the scheme", mandates that there cannot be a tax benefit if there is no postulate that is a reasonable alternative to a scheme. Put another way, reaching a decision that a "tax effect" in s 177C(1)(bc) might reasonably be expected to have occurred if the scheme had not been entered into or carried out "must" be based and only based on a postulate or postulates that is or are "reasonable". If none exist, no relevant "tax effect" can be demonstrated.

It can be accepted that a taxpayer who merely demonstrates that the postulate relied upon by the Commissioner is unreasonable does not demonstrate that it has not obtained a tax benefit. But it does not follow that the only way a taxpayer can discharge its onus of proof is to lead evidence of another reasonable postulate in which the taxpayer obtains no tax benefit.

it can be accepted that a taxpayer may more usually demonstrate the absence of a tax benefit by identifying, on the evidence, a postulate or counterfactual which shows what it might reasonably be expected to have done, had it not entered into or carried out a relevant scheme. Such a postulate must be a reasonable one, its reasonableness being measured, in accordance with s 177CB(4), by reference to the substance of the scheme, and any result or consequence for that taxpayer achieved by the scheme. Nevertheless, in unusual cases, a taxpayer may demonstrate the absence of a tax benefit by establishing that there is no postulate that is a reasonable alternative to entering into or carrying out the scheme

The majority held that in these appeals, the central question was the economic and commercial substance of the Scheme, as distinct from its legal shape or form. The Commissioner submitted that the economic and commercial substance of the Scheme was that, in return for the making of each payment from SAPL to PBS, SAPL received two valuable benefits - the concentrate and the PepsiCo Intellectual Property. In this respect, the Commissioner submitted that the allocation of the total contract price to concentrate was not the substance of the Scheme but was only a means and form to give it effect.

The majority held the Commissioner's argument as misconceived and held that the true economic and commercial substance of the composite SAPL Bottler, Seller and Distributor Agreement was that SAPL was appointed and accepted appointment as the exclusive bottler, seller and distributor of the Beverages as part of a comprehensive arrangement involving an exchange of promises, on an arm's length basis, which included the promise to purchase concentrate at agreed prices which were not disproportionately high, as well as the conferral of intellectual property rights. That conferral of rights did not take place "for nothing". Under the SAPL Bottler, Seller and Distributor Agreement, other monetary and non-monetary consideration, including the exchange of promises in cl 4 of the PepsiCo EBA, flowed in exchange for the PepsiCo Intellectual Property. In particular, SAPL agreed to build the PepsiCo brands. The PepsiCo Intellectual Property was essential for SAPL to perform that obligation including for the benefit of PepsiCo

In sum, the Commissioner submitted that under the identified alternative postulates SAPL receives the same property (the concentrate and the PepsiCo Intellectual Property) and pays the same amounts as under the PepsiCo EBA. The only difference, it was said, between the PepsiCo EBA and the alternative postulates is a minor textual change in the form of the clauses dealing with payment. In contrast, it was said, the majority below confused the economic substance of the Scheme with the form or mechanism by which the Scheme was implemented. It was also said that the majority ignored the Commissioner's expert who opined that, given that the intellectual property was of value, it was reasonable to expect that appropriate compensation would have been paid for it

In this connection, the majority held that the problem with the Commissioner's position, and the reason that his alternative postulates were not reasonable, is that he misconceived the economic and commercial substance of the Scheme. As the majority of the Full Federal Court rightly observed, for a postulate to be a reasonable alternative it "should correspond to the substance of the scheme". It was not the case that the payments made by SAPL to PBS were consideration for the receipt of two benefits. Rather, as the majority below correctly concluded, "[t]he commercial and economic substance of the [S]cheme was that the price agreed for concentrate was for concentrate". Adjusting the SAPL Bottler, Seller and Distributor Agreement, and the PepsiCo EBA in particular, to provide for some part of that price to be also a royalty involves far more than a simple textual change. It involves the entry into a fundamentally different arrangement.

The majority noted that critical facts, unique to these appeals, enabled PepsiCo to demonstrate that there were no other reasonable alternative postulates and therefore no relevant tax effect. The first is that the substance of the Scheme (as properly construed and characterised) included that the price paid for concentrate was for concentrate and nothing else. The second is that the Scheme was a product of arm's length dealings between unrelated parties.

The majority further observed that the absence of a royalty was market standard, a substantive element of the business model which was adopted by the PepsiCo Group. There was evidence before the primary judge, that PepsiCo (and other beverage competitors) used a "franchise-owned bottling operation" or "FOBO" model. This commenced in the early 1900s when the Pepsi-Cola Company started to sell Pepsi syrup to third party bottling companies within the United States.

The FOBO model requires joint investment by both PepsiCo and the bottler to develop, manufacture, bottle and distribute the beverages and to engage in marketing to promote sales, using both "push" and "pull" strategies. Generally speaking, the franchise bottler makes substantial contributions to the cost of local advertising and marketing and is responsible for "pushing" the brand in the local stores, by addressing the pricing, the display of the product, and its location in stores, as well as trade promotions. In contrast, the PepsiCo Group is responsible for strategies that encourage the consumer to "pull the brand off the shelf". This includes advertising, sponsorship and sampling. The foregoing permits the PepsiCo Group to carry out what it does best, such as the innovation and development of the "brands", which includes the trade marks, the get-up, and the shape of the bottle, leaving the local bottler to focus on the business of bottling, selling and distributing finished beverages. These features of the FOBO model are carefully reflected in the terms of the SAPL Bottler, Seller and Distributor Agreement and benefit both PepsiCo and SAPL.

According to the majority, the most significant features about the manner in which PepsiCo entered into and carried out the Scheme are three-fold. First, 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 FOBO model. It follows that a consideration "of the way in which and method or procedure by which the particular scheme in question was established" and then carried out does not support the conclusion that PepsiCo had a principal purpose of enabling it to obtain a tax benefit.

We have noted how the avoidance of a foreign tax liability may trigger the Australian DPT. In this connection, the majority observed: It should finally be noted that the Commissioner also relied upon a finding below that less tax was paid in the United States by PepsiCo. The relevance of any reduction in foreign tax is mandated by s 177J(1)(b). A saving in tax in the United States was conceded by PepsiCo, but no actual amount of tax saved was determined below, save that the savings before December 2017 were said to appear to be "substantial". It follows that this factor must favour the Commissioner. However, all of the s 177D (2) factors, save for the last, strongly support the conclusion 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 any event, no such tax benefit was ever obtained.

It has been reported that the ATO has accepted the decision. However, as has been pointed out by many commentators, the decision rests on certain unique facts and these have been noted in the majority judgement itself-the long-standing practice and the uncontested arm's length nature of the transaction between unrelated parties. Therefore, related party transactions will likely face greater scrutiny.

That apart, the decision is in respect of sale of products. However, embedded royalty issues also arise in the case of payment for software. Apparently, the Oracle case is also pending adjudication. The ATO is in the process of finalizing its ruling on character of payments in respect of software and intellectual property. The draft ruling TR 2024/D1 is available at: https://www.ato.gov.au/law/view/document?docid=DTR/TR2024D1/NAT/ATO/00001

The final ATO ruling in this regard will therefore be eagerly awaited.