The High Court of Australia’s majority decision in PepsiCo is a narrow 4-3 victory for taxpayers and common sense. A third party bottler and distributor’s payment for concentrate was held to be only for that concentrate and not partly a royalty for PepsiCo intellectual property.
But what if the facts were tested against the UK’s new draft transfer pricing rules? Could a similar royalty free licence between third parties be disturbed? We are concerned that the answer could be yes.
Why would the transfer pricing rules be relevant for a commercial transaction?
In PepsiCo, the bottler was a third party. Why would UK transfer pricing rules even be in play?
Currently, s.148 defines “participation” broadly, asking whether one party is “directly or indirectly participating in the management, control, or capital of the other.” This test is narrowed in practice by ss.157–163, which contain objective, computable measures that generally give a clear answer.
However, the proposed new s.148A repeats the test in italics in s.148 and gives HMRC discretion to notify a taxpayer that the participation condition in s.148 is met even if none of the circumstances in ss.157-163 apply.
The judgment highlights PepsiCo’s extensive contractual rights concerning quality control and marketing. Does this mean that PepsiCo was indirectly participating in the management of the Bottler? If so, the logical next step in transfer pricing terms would be to estimate an arm’s length price by identifying a comparable transaction(s). Yet under this approach, the actual commercial arrangements, reached through genuine negotiations, in PepsiCo would effectively be disregarded in favour of less reliable comparables or alternative transfer pricing methods.
HMRC may choose not to exercise this discretion in genuine commercial arrangements, but the drafting suggests they could.
Even if the TP rules apply, could a royalty free licence still be ok?
The PepsiCo arrangement illustrates a familiar situation: a commercial deal that requires the licence of intangibles so that the service provider can actually perform its role. This is common in distribution and contract manufacturing arrangements.
The proposed new TP rules contain a specific instruction at s.151(3) which applies when pricing a transfer or licence of intangibles. It requires an assumption at odds with the PepsiCo facts: “the transfer or grant at arm’s length would be for consideration of a sum of money”.
So, under s.151(3), would the PepsiCo arrangement be displaced? Would we need to hypothesise a standalone price for trademarks and IP rights, ignoring the broader commercial exchange of promises? Could the UK rules actually move taxpayers away from the arm’s length price?
Conclusion
The majority judges can be commended for ultimately looking to the commercial reality of the PepsiCo arrangements. It would be a shame if UK lawmakers were to stand in the way of common sense applying here.
*all legislative references are to TIOPA 2010
