The High Court’s recent decision in favour of Pepsi over the Tax Office has raised questions about the ATO’s aggressive approach to royalty withholding tax.
For years, the ATO has claimed that payments to offshore entities have a royalty embedded in them, if intellectual property (IP) is directly or indirectly involved. These “embedded royalties” are then subjected to royalty withholding tax (RWT).
The Tax Office lost at both the Full Federal Court and the High Court in Pepsi’s Australian arrangements with Schweppes, with the ratio of 6-4 against the ATO, and 10-0 against on one of the ATO arguments.
Following the ruling, the ATO announced it would review its draft ruling on royalties (TR 2024/D1) and related compliance guidance (PCG 2025/D4).
On 13 August 2025, the High Court handed down its judgment in Commissioner of Taxation v PepsiCo Inc & Ors [2025] HCA 30. The case concerned whether payments linked to long-standing bottling arrangements in Australia gave rise to liability for RWT or diverted profits tax (DPT). The majority (Gordon, Edelman, Steward and Gleeson JJ) found that the payments were solely for concentrate, not royalties, and that no DPT liability arose. The minority (Gageler CJ, Jagot and Beech-Jones JJ) would have upheld the Commissioner’s DPT claims but agreed that RWT did not apply.
PepsiCo and its subsidiary Stokely-Van Camp (SVC) held Exclusive Bottling Agreements (EBAs) with Schweppes Australia Pty Ltd (SAPL). Under the EBAs, PepsiCo or SVC supplied concentrate and allowed SAPL to use trademarks and branding, but no separate royalties were charged.
SAPL purchased all concentrate from PepsiCo Beverage Singapore Pty Ltd (PBS), an Australian-incorporated subsidiary. Payments were made only to PBS, which retained a small margin before buying concentrate from another Pepsi entity in Singapore.
The Commissioner argued that the payments to PBS included consideration for PepsiCo/SVC’s trademarks and IP, and therefore contained an embedded royalty. On that basis, PepsiCo and SVC were assessed for RWT. Alternatively, the Commissioner argued that profits were diverted offshore, and DPT should apply through “alternative postulates” where SAPL would otherwise have paid royalties directly.
The Commissioner’s view is that part of the payments SAPL made to PBS represented consideration for the use of, or the right to use, PepsiCo/SVC’s trademarks and other intellectual property. The Commissioner assessed PepsiCo and SVC for RWT under section 128B(2B) of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936), that the EBAs effectively embedded a royalty within the price of the concentrate, meaning that a portion of the payment was “paid or credited” to, or “derived by”, PepsiCo or SVC.
In the alternative, the Commissioner contended that the arrangements effected a diversion of profits to PepsiCo or SVC and that DPT was payable per section 177J of Part IVA of the ITAA 1936. The DPT position relied on “alternative postulates” in which SAPL would have paid a royalty for the intellectual property rights if the arrangement had been structured differently. These alternative postulates were intended to show that PepsiCo and SVC obtained a “tax benefit” by not receiving royalties directly.
The majority of the High Court held that the EBAs made the price payable for concentrate alone, and there was no contractual or economic connection between those payments and the grant of IP rights. They rejected Tax Office claims that IP rights were granted to SAPL for “nothing”.
Even if a royalty could be inferred, the payments were not “paid or credited to” nor “derived by” PepsiCo or SVC, as section 128B(2B) requires. All payments were made to PBS, an Australian company, and neither PepsiCo nor SVC was entitled to them.
The minority took a different view on embedded royalty, concluding that the payments for concentrate implicitly included consideration for the use of intellectual property, that the IP rights were integral to SAPL’s ability to exploit the concentrate and therefore part of the payment should be treated as a royalty derived by PepsiCo/SVC.
The majority found that neither PepsiCo nor SVC obtained a tax benefit in connection with a scheme within the meaning of section 177J of Part IVA. The Commissioner’s alternative postulates - where SAPL would have paid the same total price but split between concentrate and royalties were considered commercially unrealistic.
The minority would have upheld the DPT assessments, accepting that the alternative postulates were reasonable.
The High Court’s majority decision in PepsiCo is likely to prompt greater attention from the Commissioner in reviewing software, licensing or sub-licensing of IP arrangements, and reinforces how commercial contracts should be applied in practice and clarifies how both the courts and the Commissioner are to approach the reasonableness of the transactions undertaken by taxpayers in commercial contexts.
The ATO has said it will review Draft TR 2024/D1, which takes a broad approach to identifying royalties. The High Court’s reasoning confirms that where a payment includes genuine consideration for IP, that part can be a royalty. However, it rejects the idea that an IP licence automatically creates an embedded royalty. Instead, agreements must be properly analysed.
This means some aspects of TR 2024/D1 may be upheld, while others—especially around embedded royalties—may need recalibration.
Although PepsiCo represents a clear win for taxpayers, it does not end the debate. The interaction of TR 2024/D1 and PCG 2025/D4 will shape how future disputes play out, particularly in IP-heavy industries like software, franchising, and branded goods.
The High Court has reinforced that:
RWT cannot apply without clear entitlement of payments to the offshore IP owner.
Embedded royalties are not presumed; contractual terms matter.
DPT counterfactuals must be commercially realistic.
For taxpayers, it is a timely reminder to align commercial arrangements, contracts, and documentation with tax law requirements. For the ATO, the challenge will be recalibrating its administrative positions without losing credibility in future enforcement.
The Tax Advisory team here at Findex can help your organisation navigate the complexities and obligations of royalty withholding tax and diverted profits tax. Get the expert guidance your group will need by contacting us today.
This document contains general information and does not constitute legal or taxation advice. If you need legal or taxation advice, we recommend you speak to a qualified advisor.
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