Embedded royalties?

The High Court of Australia has granted the Australian Taxation Office (ATO) leave to appeal from an important decision of the Federal Court of Australia, in relation to whether payments made under a bottling agreement are subject to royalty withholding tax.

Ordinarily, royalties payable by an Australian company to an offshore licensor are subject to withholding tax.  An Australian licensee is required to remit a percentage of each royalty payment to the ATO.  The offshore licensor may in turn be entitled to a credit for the tax withheld in their own jurisdiction, under the double tax treaties.

Schweppes bottles and sells beverages under various well-known brands, including Pepsi, Mountain Dew and Gatorade, under a series of exclusive bottling agreements (EBAs).  Each EBA included a licence to Schweppes to use the relevant trade marks, and required Schweppes to use concentrate purchased from a member of the PepsiCo group.  However, the EBAs did not specify that any royalty was payable for use of the licensed trade marks – the only amounts payable were for the concentrate used to make the beverages.

The ATO argued that the payments for the concentrate in fact included an amount referable to the licensed trade marks – i.e. the payments were for both the concentrate and the right to use the trade marks, so that a proportion of the payments was subject to withholding tax.  PepsiCo argued that the payments were entirely for the concentrate, and that no part of the payment should be attributed to the trade mark licence.

At first instance, the Federal Court agreed with the ATO.  On appeal, the Full Court agreed with PepsiCo.  The Full Court’s reasoning is not easy to follow.  The Court put considerable weight on that fact that PepsiCo benefitted from Schweppes using its trade marks, through sustaining and generating goodwill in the marks.  The Court also stressed that Schweppes was not free to use the trade marks for any purpose it liked, but was subject to restrictions (such as the requirement to use the concentrate).

However, the Full Court overlooked the fact that quality control is an essential element of trade mark licensing, and that one common form of quality control is for the licensor to specify the use of particular ingredients or consumables.  In fact, if Schweppes were to use PepsiCo’s marks without restriction, it would not be an “authorised user” of the marks and PepsiCo’s rights in its marks would potentially be at risk (e.g. for non-use).

It is, frankly, commercially unrealistic to suggest that Schweppes was simply purchasing concentrate, and that no aspect of the purchase price was attributable to Schweppes’ right to use PepsiCo’s marks.  Would Schweppes have paid the same price for PepsiCo’s concentrate if it were only able to resell the concentrate as a distributor, or if it had the right to use the concentrate to bottle beverages but could not supply them under PepsiCo’s marks?   That seems highly unlikely.  The right to sell beverages under PepsiCo’s marks is obviously a significant source of value to Schweppes, and an essential aspect of each EBA.   The Full Court’s approach fails to recognise that the EBAs are in substance trade mark licences, not distribution agreements.

The High Court’s decision is awaited with interest!  The Full Court’s decision can be found here.