On 3 April, the High Court of Australia reserved its decision in an appeal by the Commissioner of Taxation against the decision of the Full Federal Court in the PepsiCo case. This followed two days of oral argument.
The case is significant for several reasons. Firstly, it is one of only a handful of cases involving large foreign multinationals to have reached the courts after more than a decade of governments of both persuasions, and the Australian Taxation Office, talking tough about foreign multinationals paying their “fair share” of tax.
Secondly, it will be the first opportunity the High Court has had to consider the operation of the general anti-avoidance rule, in Part IVA of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936), since it was amended in 2013 to address weaknesses exposed by the Federal Court, and again in 2017, to modify its operation with respect to schemes by “significant global entities” to divert profits away from Australia.
Clearly, the High Court’s decision will have implications for other foreign multinationals doing business in Australia under similar contracting arrangements, particularly software manufacturers and distributors. But that is not the focus of this article.
The focus of this article, published in two parts, is on what the case may say about the efficacy of the 2013 remedial amendments and, therefore, the capacity of Part IVA to counteract tax avoidance. This is Part 1.
The PepsiCo case
The primary issue in the appeal is whether any part of the consideration paid by Schweppes Australia Pty Ltd to bottle, sell and distribute PepsiCo branded beverages in Australia was consideration for the use by Schweppes of the PepsiCo group’s intellectual property. Put simply, was it a royalty?
To the extent it was a royalty, and it was derived by foreign members of the PepsiCo group, the foreign entities will be liable to royalty withholding tax under section 128B(5A) of the ITAA 1936.
The primary issue depends on how the High Court characterises a complex series of interlocking multi-partite contractual arrangements under which payments made by Schweppes for the supply of PepsiCo’s concentrate were isolated from the contracts under which Schweppes acquired the rights to use PepsiCo’s valuable intellectual property.
The High Court will have to decide whether the payments were for the concentrate only, or for both the concentrate and the intellectual property rights. If the latter, a subsidiary question then arises as to whether the foreign members of the PepsiCo group constructively derived the payments.
Should the High Court find against the Commissioner of Taxation on the royalty question, it will have to decide, in the alternative, whether the contractual arrangements were contrived, objectively, for the principal purpose of the foreign members of the PepsiCo group avoiding withholding tax, or withholding tax and USA taxes, on what was, in substance, a royalty.
If the arrangements were so contrived, and those foreign entities obtained tax benefits equal to the amount of the royalty avoided, they will be liable to diverted profits tax (DPT) under the 2017 modifications to Part IVA.
Although the Commissioner of Taxation initially succeeded in the Federal Court, on both grounds, he failed when PepsiCo appealed to the Full Federal Court. There, all three judges found against him on the royalty issue and two of the three judges (the plurality) found against him on Part IVA.
What Part IVA issues does PepsiCo raise?
Part IVA empowers the Commissioner of Taxation to cancel a “tax benefit” obtained in connection with a scheme if a participant in the scheme had a sole or dominant purpose of a taxpayer obtaining a “tax benefit”. Or, in the case of the Diverted Profits Tax, a principal purpose of a relevant taxpayer obtaining a “tax benefit”, or both a “tax benefit” and a reduction in foreign tax liabilities.
A “tax benefit” is identified by comparing the tax effect of the actual scheme with the tax effect of an “alternative postulate” which has materially the same substance and effect as the actual scheme.
In PepsiCo, the Commissioner of Taxation advanced two possible “alternative postulates”, both of which involved Schweppes paying royalties to foreign members of the PepsiCo group. Both postulates were rejected by the plurality. The plurality (contrary to the trial judge below, and the dissenting judge), took the view that, in legal form, and as a matter of commercial and economic substance, Schweppes’ payments were solely for the concentrate. Accordingly, they concluded that the Commissioner’s postulates were not “reasonable alternatives” to the actual arrangements, and the foreign entities had not therefore obtained any “tax benefits”.
Given the plurality’s characterisation of the dealings between the PepsiCo group and Schweppes, their conclusion is not surprising. As explained in Part II of this article, Part IVA is predicated on the idea that tax is avoided when an arrangement is implemented in a contrived form to avoid tax that would otherwise be due if a taxpayer had achieved the same economic substance, and effect, by more conventional legal means. If there is no dissonance between the substance and form of an arrangement, there is no mischief for Part IVA to correct.
What is surprising, however, is the way the plurality characterised the process by which “alternative postulates” are identified as evidence-based exercises in prediction (see [95]—[97]). This was a feature of the pre 2013 Federal Court reasoning which the remedial amendments were intended to displace.
As explained in Part II, if an “alternative postulate” is a prediction, and not merely an alternative legal form by which the substance and effect of a scheme could have been achieved, the internal logic of Part IVA will be frustrated.
What insights are we likely to get from the High Court?
Should the High Court consider Part IVA, it will have to decide if there is any dissonance between the substance and form of PepsiCo’s contractual arrangements. This could be illuminating. The distinction between substance and form is central to the operation of Part IVA. The High Court will also have to construe the 2013 remedial amendments. As explored in Part II, the efficacy of Part IVA depends on the amendments operating harmoniously with the other provisions in the statutory scheme.
Disclaimer: Kate Roff contributed to the design of the 2013 remedial amendments in her then position as a Principal Advisor in the Commonwealth Treasury. The views and opinions presented in this article are solely those of the author and are based on the author’s own understanding of the statutory provisions.
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