ATO Guidance and High Court Ruling Reshape Royalty Withholding Tax Landscape

Recent developments have significantly reshaped the Australian tax landscape for multinational groups dealing with intellectual property and software-related payments. In quick succession, the Australian Taxation Office (ATO) released draft Practical Compliance Guideline (PCG) 2025/D4, and the High Court handed down its decision in Commissioner of Taxation v PepsiCo Inc [2025] HCA 30 (PepsiCo). Together, these events provide greater clarity—but also introduce new compliance expectations—for cross-border arrangements involving embedded royalties.

ATO’s PCG 2025/D4: A Risk-Based Compliance Framework

Prior to the High Court’s decision in PepsiCo, the ATO issued draft PCG 2025/D4, outlining its compliance approach to cross-border software payments that may attract royalty withholding tax. This guideline complements the ATO’s existing views in TR 2024/D1 and introduces a risk-based framework to help taxpayers assess the likelihood of ATO scrutiny.

The PCG categorises arrangements into risk zones:

  • White Zone: No review required. Applies to arrangements already subject to ATO review, an advance pricing arrangement, or a court/tribunal decision.
  • Green Zone: Low-risk arrangements unlikely to attract compliance action. Includes software that is:
  1. For personal use or internal business use
  2. Widely available and not customised
  3. Embedded in retail products
  4. Resold without rights to offshore intellectual property
  • Other Zones: May be subject to review, particularly where documentation is insufficient or payments are not clearly delineated between software use and IP rights.

Both PCG 2025/D4 and TR 2024/D1 are expected to be reviewed and updated in light of the PepsiCo decision.

High Court Decision in PepsiCo: No Embedded Royalties Found in Contract

In PepsiCo, the Commissioner argued that payments made by Schweppes Australia Pty Ltd (SAPL) to a Singapore-based PepsiCo entity for beverage concentrate included embedded royalties for the use of trademarks and other intellectual property. The Commissioner sought to apply both royalty withholding tax and diverted profits tax (DPT).

The High Court, by a 4:3 majority, rejected both arguments, finding:

  • The payments were solely for the concentration, not for the use of IP.
  • Even if a royalty had been paid or credited, it was not paid to a foreign entity, and therefore no royalty withholding tax would arise.
  • The arrangement did not constitute a scheme with the principal purpose of obtaining tax benefits under the DPT provisions.

This decision reinforces the principle that tax liability must be based on actual contractual obligations and payment flows—not inferred economic benefits.

Key Observations for Multinational Groups

The High Court’s reasoning offers several practical insights for multinational entities (MNEs) with related-party arrangements involving intellectual property and software:

  1. Commercial Practice Matters: The absence of a royalty clause was found to be the market standard. MNEs should consider industry norms when structuring related-party agreements.
  2. Arm’s Length Dealings Are Crucial: The Court acknowledged the existence of arm’s length negotiations between SAPL and the PepsiCo entity. Benchmarking related-party transactions against arm’s-length principles is vital for pricing arrangements that may involve royalties.
  3. Tax Planning ≠ Avoidance: The Court acknowledged that reviewing tax outcomes is common commercial practice. However, this alone does not trigger anti-avoidance provisions:

“But taking tax outcomes into account does not necessarily justify an application of Pt IVA of the ITAA 1936, or, indeed, the imposition of DPT.”

What Now for MNEs?

In light of these developments, multinational groups should consider the following actions:

  • Review Agreements Involving IP: The dissenting judges in PepsiCo acknowledged that embedded royalties can exist. Given the ATO’s unlimited amendment period for withholding tax, historical agreements may be subject to review.
  • Ensure Arm’s Length Pricing: Related-party dealings should reflect commercially accepted standards specific to the relevant market and industry. This is essential for transfer pricing compliance.
  • Strengthen Documentation: Clear contractual terms and robust transfer pricing support are critical. In PepsiCo, the agreement explicitly covered concentrate only. Agreements lacking clarity may be vulnerable to ATO scrutiny.

Updates to PCG 2025/D4 and TR 2024/D1 are anticipated following the PepsiCo decision, which should provide further guidance on the concept of embedded royalties and the application of royalty withholding tax.

Co-authored by Tom Peskett, Senior Manager Tax Consulting, Melbourne