On 13 August 2025, the full bench of the High Court of Australia (High Court) delivered its long-anticipated judgment in Commissioner of Taxation v PepsiCo, Inc.[2025] HCA 30. The High Court, by majority, found that a royalty did not exist where the agreement did not expressly provide for a royalty. Furthermore, the majority also found that the diverted profits tax (DPT) did not apply as there was no tax benefit.

Key highlights

The High Court, by a majority of 4:3, determined that no portion of the payment made was a royalty and royalty withholding tax (RWHT) did not apply. The majority's decision turned upon the contractual arrangements: the language used and the underlying obligations.

The majority concluded that whether payments for beverage concentrate constituted consideration for the right to use intellectual property (IP) turned on the proper construction of the agreements and what the parties had agreed to. In their contractual agreements, the parties had not bargained that the payments were for IP, and the right to use the IP was part of a comprehensive commercial arrangement and was not obtained "for nothing," the court noted. Importantly, the payments were at an arm's-length price.

In this first High Court decision on the application of the DPT, the 4:3 majority found that DPT did not apply as there was no tax benefit; the Commissioner's counterfactuals were found to be not reasonable as they were not commercially or economically equivalent to the scheme in question.

The conclusion on royalty characterization will be seen as a "common sense" outcome by many, bringing welcome clarification to an uncertain area of the law. This is particularly pertinent in light of certain Australian Tax Office (ATO) guidance products (draft Taxation Ruling (TR) 2021/D4 and Practical Compliance Guideline (PCG) 2025/D4) that seek to look beyond the contractual arrangements for the purposes of characterization.

The decision also continues the run of judicial clarifications on the Part IVA general anti-avoidance rules, bringing more welcome guidance on the onus that taxpayer's bear when defending against Part IVA and confirming (again) that merely considering the tax impacts of an arrangement does not, by itself, attract those provisions.

The evident question is whether, given that the PepsiCo case was between unrelated parties, the ATO will seek further strategic litigation to test the extent of the precedence set by the High Court in arrangements involving related parties or instead will seek law reform as the faster avenue to close any perceived gaps.

Relevant facts

PepsiCo and Stokely-Van Camp, Inc. (SvC), related US companies and owners of the Pepsi, Mountain Dew and Gatorade brands, entered into Exclusive Bottling Agreements (EBA) with Schweppes Australia Pty Ltd (SAPL) (a third party).

Under the EBA, PepsiCo/SvC agreed to sell (or cause a related entity to sell) beverage concentrate to SAPL, which SAPL then mixed with other ingredients in accordance with formulas, specifications and other information provided, to produce finished beverages for retail sale in Australia, applying Pepsi branded packaging and under the Pepsi brand name.

Importantly, the EBA provided for SAPL to pay only for the concentrate; there was no express provision for the payment of a royalty for the right to use the relevant IP.

Key issues

The Commissioner of Taxation (Commissioner) contended that PepsiCo/SvC was liable for RWHT under the Income Tax Assessment Act 1936 (Cth) (ITAA 1936), which is subject to Art 12 of the double tax agreement between Australia and the United States (US DTA).

Additionally (and alternatively), the Commissioner issued a DPT assessment to PepsiCo/SvC, imposing a 40% punitive tax on the challenged royalties. The DPT's stated aims are to ensure tax paid reflects the economic substance of a Significant Global Entity's (SGE) Australian activities and to prevent diversion of profits offshore through arrangements with related parties. At first instance, the Federal Court of Australia found in favor of the Commissioner on both points, however the Full Court of the Federal Court overturned that position, finding both points in favor of PepsiCo/SvC. All issues were contested again before the High Court. (For further background, see EY Global Tax Alerts, Australian Full Federal Court reverses finding of embedded royalty in arm's-length contract, dated 3 July 2024, and Australian Federal Court finds embedded royalty in arm's-length contract, dated 21 December 2023.)

Royalty withholding tax

On appeal to the High Court, the majority concluded that the payments SAPL made under the EBAs were not royalties and therefore there was no liability for RWHT.

The High Court found:

• The payments that SAPL made under the EBA were not consideration for the use of, or the right to use, the relevant trademarks and other IP.
• The relevant portions of the payments were not income derived by PepsiCo/SvC for purposes of section 128B(2B)(a) of the ITAA 1936 and were not amounts to which PepsiCo/SvC was beneficially entitled for the purposes of Art 12 of the US DTA.

Royalty characterization

The High Court found that no portion of the payments constituted consideration for various intangible properties listed under Article 12(4)(a)-(b) of the US DTA.

Justices Gordon, Edelman, Steward and Gleeson's key considerations were:

• The right to use the PepsiCo IP was part of a comprehensive commercial arrangement (having arrived at the conclusion that they formed a composite agreement based on the text and structure of the bottling and distribution agreement, marketing agreement and performance agreement), an essential element that obliged SAPL to build PepsiCo/SvC's brands and strengthen the PepsiCo/SvC IP. SAPL was able to leverage PepsiCo/SvC's innovation and marketing capabilities and PepsiCo/SvC received the benefit of SAPL's local investment in bottling and distribution equipment and capabilities.
• PepsiCo/SvC did not give away their IP "for nothing" as the consideration for, or a condition of, SAPL's use of the PepsiCo IP was SAPL's performance of the monetary and nonmonetary undertakings under the composite agreement, including the performance of undertakings or exchange of promises in clause 4 of the PepsiCo EBA, one of which was SAPL's promise to pay agreed unit prices for concentrate.
• Critically, the Commissioner did not contend that the prices were incorrect or inflated to hide a secret royalty. The importance of the arm's-length price paid by SAPL was a key feature throughout the majority judgment.
• The EBA could not be construed as requiring the payment of a royalty in that SAPL's monetary contributions to marketing the beverages did not permanently enhance the value of SAPL's business and the composite agreement provided that SAPL did not have any interest in the PepsiCo IP.
• Certain previous stamp duty decisions did not support the Commissioner's contentions, as neither decision involved looking outside the terms of the arrangements and transactions involved.

Chief Justice Gageler and Justices Jagot and BeechJones dissented, finding the EBA constituted a "single, integrated and indivisible" transaction, from which followed that characterizing the price payable as consideration only for the sale of concentrate purportedly subdivided the indivisible. Hence, in their view, there was an amount that, at least in part, was consideration for the use of the trademarks and was therefore a royalty to that extent.

The derivation point

All the justices held that there was no "payment by direction" in favor of PepsiCo/SvC as there was no antecedent monetary obligation owed by SAPL to PepsiCo/SvC — such a conclusion was not open on the proper construction of the EBA.

As such, the Court concluded that "No monetary obligation was owed by SAPL, or payment made by SAPL, to PepsiCo for or in respect of the concentrate. … Title to the concentrate was never with PepsiCo; title transferred from PBS to SAPL."

Diverted profits tax (DPT)

The majority found that a tax benefit did not arise in connection with the scheme and there was not a principal purpose of obtaining a tax benefit.

In finding that DPT would not have applied, the majority considered that PepsiCo/SvC did not obtain a tax benefit in connection with the relevant scheme as there was no reasonable counterfactual. The Commissioner's alternative postulates misconceived the economic and commercial substance of the scheme and would involve the entry into of a fundamentally different arrangement, the Court concluded.

Furthermore, the Court provided an important clarification regarding the onus of proof upon taxpayers in respect of DPT and Part IVA more generally. The justices held that there is no requirement for a taxpayer to lead evidence of another reasonable alternative postulate to discharge their burden.

The Court clarified however that their conclusion on tax benefit was based on "critical facts, unique to these appeals," which enabled PepsiCo to demonstrate that there were no other reasonable alternative postulates considering that (i) the substance of the scheme indicated that the price paid was only for concentrate, (ii) the scheme was a product of arm's-length dealings between unrelated parties and (iii) the absence of a royalty was market standard.

Notwithstanding their conclusion that no tax benefit arose, the justices considered the question of principal purpose and concluded that obtaining a tax benefit was not a principal purpose of the agreement. In reaching this conclusion, the Court was significantly influenced by the manner in which the scheme was carried out — it was the result of arm's-length negotiations; the price for concentrate was not disproportionately high; and the model conformed with common industry practice.

The justices also observed that "taking tax outcomes into account does not necessarily justify the application of Pt IVA of the ITAA 1936, or, indeed, the imposition of DPT," continuing the chain of court decisions in the last 18 months echoing this sentiment in respect of Part IVA.

Implications of the decision

ATO activity

The issue of characterization has been an area of focus for the ATO and will continue to be, notwithstanding the Court's decision.

Given the unique set of facts in the PepsiCo case — i.e., unrelated parties with arm's-length arrangements and prices — the ATO will likely want to strategically litigate another related-party matter on mischaracterization.

The Court's decision is expected to influence how the ATO approaches finalization of draft TR 2024/D1 and its administration of arrangements involving intangibles. The ATO immediately issued a media release following the judgment, stating it is considering the impact of the decision on TR 2024/D1.

Given the High Court's focus on the terms of the contractual arrangements in determining "consideration" and the broader view of the exchange of promises in commercial arrangements, the current draft view in TR 2024/D1 will likely need substantial revision.

Policy considerations

Given how close the ATO's loss was at the High Court, on a 4:3 basis, the loss may be used as an impetus by the ATO for broader tax law reform considerations.

During the 2022-23 and 2023-24 Federal Budgets, several measures focusing on intangibles were flagged but none have been legislated. Although the earlier policy announcement to deny deductions for intangible payments to low-tax jurisdictions has been shelved, the proposal to impose SGE penalties for mischaracterization of royalty payments is due to start on 1 July 2026. The ATO may seek to lobby government for a broader reform agenda to plug any perceived gaps ahead of those new rules — especially with its publicly stated focus on intangibles and characterization.

Primacy of evidence

Much turned on PepsiCo's ability to demonstrate and evidence the substance of its commercial arrangements. Organizations will need to consider whether, when tested by the ATO as part of review and audit activities, they will be able to do the same.

There may be scenarios in which the legal form, properly characterized, can be found to have a monetary royalty component as part of the bargain between the parties, particularly in arrangements where it cannot be readily proven that the Australian entity provides significant unique nonmonetary benefits in the form of market entry/access, customer relationships or similar. A close assessment of the true nature of the bargain in the context of the legal agreement will be important in evaluating whether, how and to what degree any benefits are provided in consideration for some form of IP.

If the Australian IP user and the foreign IP owner are related parties, a detailed analysis of the legal arrangements and the entirety of the commercial arrangements (including an analysis of the functions, assets and risks) will be vital to establishing the mutual benefits exchanged in such an arrangement.

Next steps

Affected entities with similar facts should consult with a knowledgeable tax advisor for help to:

• Determine whether a royalty exists
• Review applicable arrangements and ensure the evidence and legal structure meets the bar set in the PepsiCo decision
• Assess whether the price of goods, services or underlying arrangements are arm's length
• Prepare for and defend an ATO review or audit on intangibles and mischaracterization