Australia PepsiCo Case Raises Royalty Questions for South Africa

The Australian case, PepsiCo, Inc. v Commissioner of Taxation, [2023] FCA 1980, centered on whether a payment made for concentrate sold by PepsiCo to its Australian-appointed bottler constituted, in part, a royalty.

In South African tax law, it is necessary to know when a payment constitutes a royalty mainly because of the need to impose withholding tax on amounts paid by way of royalty to nonresidents, where the royalty is of a South African source. The provisions pertaining to royalty withholding tax are contained in part IV:A of the South African Income Tax Act. South Africa imposes a royalty withholding tax at a rate of 15% on South African sourced royalties paid for the benefit of a foreign person.

Definitions

The term “royalty” is defined in section 49A of the South African Income Tax Act as any amount that is received or accrued in respect of the use, right of use, or permission to use any intellectual property as defined in section 23I of the act; the imparting of or the undertaking to impart any scientific, technical, industrial, or commercial knowledge or information; or the rendering of or the undertaking to render any assistance or service connected with the application or use of such knowledge or information.

Section 23I defines “intellectual property” as:

a) patent as defined in the Patents Act, including any application for a patent in terms of the Patents Act
b) design as defined in the Designs Act
c) trademark as defined in the Trade Marks Act
d) copyright as defined in the Copyright Act
e) patent, design, trade mark or copyright defined or described in any similar law to that in (a), (b), (c), or (d) of a country other than South Africa
f) property or right of a similar nature to that in (a), (b), (c), (d), or (e)
g) knowledge connected to the use of such patent, design, trademark, copyright, property, or right

PepsiCo Case Facts

These definitions should be considered against the PepsiCo case. In Australia, a local company, Schweppes Australia Pty Ltd (SAPL), entered into exclusive bottling agreements with PepsiCo (or PepsiCo group entities) under which:

• SAPL would purchase beverage concentrate from the PepsiCo group and then manufacture, bottle, sell, and distribute branded beverages such as Pepsi, Mountain Dew, and Gatorade in Australia.
• The exclusive bottling agreements included the grant of rights to use trademarks and other IP owned by PepsiCo/Stokely-Van Camp. The local bottler, being SAPL, had the right to use that IP in Australia under the arrangement.
• Crucially, the EBAs did not expressly provide for the payment of a separate royalty for the right to use the IP.
• The arrangement provided for the purchase of the concentrate at a price, but no explicit royalty component.

The Australian Commissioner for Taxes argued that part of the payments made under the exclusive bottling agreements by SAPL to the group entities must constitute a royalty—that is, payment for the use of or right to use intangible property—under the relevant Australian tax law (in particular, section 6(1) of the Income Tax Assessment Act 1936).

If part of the payment constituted a royalty, then withholding tax should apply under section 128B(5A) of the Income Tax Assessment Act 1936 (and under the Australia–US Double Tax Agreement) on amounts paid to nonresidents.

The Australian Commissioner for Taxes also postulated an alternative argument through the application of the Australian diverted profits tax as an anti-avoidance provision. This legislation is designed to ensure that large multinational companies—those with annual global turnover above AU$1 billion ($701 million)—pay an appropriate amount of tax based on their activities conducted in Australia, discouraging them from shifting profits out of Australia through artificial or contrived arrangements. A penalty tax rate of 40% is imposed on the amount of the diverted profits.

The case went on appeal and was heard in various Australian courts. The High Court ultimately found against the Australian Commissioner for Taxes. It upheld the findings of the Federal Court stating that, based on the construct of the agreements concluded between SAPL and each of PepsiCo and Stokely-Van Camp, the payments made by SAPL were for concentrate only and did not include any component that was a royalty for the use of intellectual property.

The High Court also held that the diverted profits tax law did not apply, because the scheme was an arrangement between unrelated parties concluded at arm’s length, and because it was market practice in the beverage industry not to apply a royalty (that is, to license the IP for no consideration) and that this was a substantive element of the business model that PepsiCo and other beverage competitors adopted.

South Africa Impact

This case raises a question for South Africa: Could the South African Revenue Service argue that, where a contract expressly states that a right of use of IP is granted but for no consideration, that other payments made under that agreement are in part made for the use of IP—and are therefore a royalty that is subject to withholding tax (if paid to a foreign party)?

There are likely only two possible avenues in tax law that would allow scope for SARS to challenge the position adopted by the taxpayer: the substance-over-form doctrine or the general anti-avoidance rule (GAAR).

Under the substance-over-form doctrine, SARS must demonstrate that the contractual arrangements concluded between the parties do not match the true or real arrangement—that is, the arrangement is simulated or a sham. It is worth noting that in terms of section 102 of the Tax Administration Act 28 of 2011, the burden of proof lies with the taxpayer to show:

• that an amount, transaction, event, or item is exempt or otherwise not taxable
• that an amount or item is deductible or may be set off
• the rate of tax applicable to a transaction, event, item, or class of taxpayer
• that an amount qualifies as a reduction of tax payable
• that a valuation is correct
• whether a decision that is subject to objection and appeal under a tax act is incorrect

SARS only has the burden to prove the facts on which it based the imposition of an understatement penalty under Chapter 16, or whether an estimate under section 95 is reasonable. However, in a case where SARS wants to allege that the parties have concluded a simulated or sham transaction, the onus would arguably be on SARS to prove this.

As in the case of the Australian court’s findings, we imagine that it would be extremely difficult for SARS to prove that an arrangement is a sham where the agreements are clear (regarding what is made available and what the charges are under the agreement), the parties act at all times in accordance with the terms of the agreements, and the manner in which the agreements are structured is common in the industry.

Of course, the position would have to be assessed per taxpayer. Key to this is ensuring that formal contracts are put in place and that these contracts are a true representation of the agreement between the parties.

Taxpayers should review their contractual arrangements against their current practices to ensure they are aligned, especially in respect of long-standing relationships, where the practice may have changed over time without the parties necessarily thinking to update or amend old agreements. They also should assess whether distinct components of arrangements can, and should, be segregated and priced separately.

On the question of GAAR’s possible application, SARS has extremely wide powers whereby it can, inter alia, recharacterize any gross income, receipt, or accrual of a capital nature or expenditure. This means that if SARS were to successfully argue that the GAAR applies, it could treat a portion of the payments made under the contract as a royalty.

To do this, SARS must prove that the arrangement is an impermissible one—an arrangement whose sole or main purpose was to obtain a tax benefit, through means or in a manner which would not normally be employed for bona fide business purposes. Alternatively, SARS could prove the arrangement lacks commercial substance, in whole or in part (taking into account the provisions of section 80C of the South African Income Tax Act).

In addition, the GAAR applies if the arrangement created rights or obligations that would not normally be created between persons dealing at arm’s length, or if it would result in the misuse or abuse of the provisions of the South African Income Tax Act (including the provisions of the GAAR).

Coming back to the PepsiCo case, it is interesting to note that the High Court focused on the fact that the arrangements were concluded between unrelated parties and that the arrangements were common in the industry. These are likely similar inquiries that would help mitigate application of South Africa’s GAAR.

But before discussion of the “normality” and “commerciality” of the arrangement arises, it may be worth comparing the increased cost of import duties with the withholding tax lost to see if a tax benefit even materializes. One caution to this is that in certain instances, a royalty charged under a supply/distribution agreement must be included in the customs value of the goods.

The fact that the PepsiCo case parties were unrelated was a principal argument supporting the High Court’s findings that the arrangement was not subject to the diverted profits rules. In cases where the supply/distribution agreements are between group companies, it will likely prove more difficult to demonstrate the “commerciality” or the “normality” of not charging a royalty. Intra-group arrangements should therefore be a key focus area.

Outlook

Taxpayers should ready themselves by ensuring that their cross-border supply or distribution agreements (especially long-standing ones) match their practices and are a true reflection of what the parties agreed commercially.

Where services are rendered (for example, IP is licensed) for no consideration, the agreement should expressly record this so that the language in the agreements matches the parties’ intent.

Taxpayers should also document why they view their approach as commercially justifiable and—better yet—as a common practice in the industry, especially in the context of intra-group arrangements.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Esther Geldenhuys is a partner in Bowmans’ tax practice in Johannesburg and specializes in international tax and exchange control for outbound and inbound investments, with a focus on African investments.

Robyn Berger is a tax executive in Bowmans’ corporate department and member of the firm’s tax practice in Johannesburg.

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