What PepsiCo reveals about IP valuation and expert evidence
Introduction
PepsiCo, Inc v Commissioner of Taxation [2023] FCA 1490 attracted significant attention in the context of royalty withholding tax and the Diverted Profits Tax regime. Although the decision was later overturned on appeal, the judgment remains instructive from an expert evidence and valuation perspective.
In particular, the case provides detailed judicial consideration of issues frequently encountered in intellectual property and broader valuation disputes, including:
selection of comparable agreements
relief from royalty methodologies
implied profit split analyses
reliance on third party valuation data
transparency of expert assumptions, and
the forensic robustness of valuation methodologies under cross-examination.
This article focuses on those quantification and evidentiary insights. Drawing from the Federal Court’s analysis of the competing expert evidence, we outline several practical considerations relevant to lawyers reviewing intellectual property valuation, royalty rate and broader valuation evidence in litigation and advisory contexts.
BACKGROUND
PepsiCo, Inc (PepsiCo), a US resident company, owned the worldwide portfolio of intellectual property associated with the Pepsi and Mountain Dew brands(1). PepsiCo had a bottling agreement with Schweppes Australia Pty Ltd (SAPL) whereby PepsiCo provided SAPL with concentrate and other know-how, as well as granting rights to use the trade marks and other intellectual property, so that SAPL could produce and sell the finished, branded product in Australia.
Whilst SAPL paid PepsiCo for the concentrate, there was no express payment for a royalty associated with the right to use the intellectual property. The ATO contended that PepsiCo is liable for royalty withholding tax, as an element of the payment from SAPL to PepsiCo was consideration for the use of intellectual property as defined in 6(1) of the Income Tax Assessment Act 1936 (Cth). Both sides presented expert evidence on the issue of the amount of the royalties ‘embedded’ in the payments to PepsiCo.
In the alternative, the ATO contended that the more onerous Diverted Profits Tax provisions should apply.
(1) The matter also involved Stokely-Van Camp, Inc, which owns the Gatorade brand
Decisions and methodologies considered
In the Federal Court decision, the Court held that a portion of the payment made by SAPL to PepsiCo was consideration for the use of intellectual property and therefore constituted ‘royalties’ for royalty withholding tax purposes. That meant the question of the diverted profits tax was irrelevant, but the Court addressed the question anyway, ruling that the diverted profits tax provisions would have applied had the royalty withholding tax provisions not applied.
On the issue of the amount of the embedded royalties, the Court considered a number of alternative methodologies presented by the respective experts, including:
analysing SAPL’s business activities and responsibilities under the bottling agreement to identify the extent the payments were for the concentrate versus the intellectual property
a ‘relief from royalty method’, in which a hypothetical royalty rate is estimated, based on analysing rates in comparable licensing agreements
a 25% ‘rule of thumb’ analysis, where it is assumed 25% of the profit (EBIT)(2) from the sale of the product would be paid as a royalty to the licensor
a compilation of third party-calculated implied royalty rates from public company comparable transactions involving the right to use trademarks
an analysis of profit splits implied by the value allocated to brand assets in public company comparable transactions, based on purchase price allocation data.
Both experts presented a ‘relief from royalty’ analysis. In analysing the competing expert evidence, the Court preferred the ATO expert’s assessment of a royalty rate of 5.88%(3), which was applied to SAPL’s sales for the relevant periods, then subject to the 5% royalty withholding tax.
(2) Earnings before interest and tax
(3) Subject to a minor downward adjustment after the Judge ruled one licence agreement should be excluded from the calculation
Insights on embedded royalty quantification from PepsiCo
Drawing from the judgment, we outline seven key considerations for lawyers when reviewing embedded royalty rate assessment reports; whether they have been prepared for tax compliance purposes or litigation.
1. Does the expert have the right expertise?
Ensure the expert quantifying the royalty has the appropriate expertise in valuing intellectual property rights or assessing royalty rates for licensing.
The Judge ultimately preferred the evidence of the ATO’s USA-based expert, who had considerably more experience than PepsiCo’s Australian-based expert in valuing intellectual property rights, including assessing reasonable royalty rates.
Consideration was also given to the persuasiveness of the expert in including or excluding certain licence agreements in their set of comparable agreements.(4)
2. Has the expert considered key attributes of the industry?
Whilst it is not always possible to find an expert with the appropriate expertise and industry experience, consider whether the expert has undertaken sufficient research on the industry to support assumptions made.
PepsiCo’s expert maintained that the Pepsi trademark would have been of no material value to SAPL, given certain restrictions on the use of that trademark. However, under cross-examination the expert was taken to an IBISWorld report that expressed the significance of branding in the soft drink industry in Australia as being the leading point of differentiation.(5)
3. Is the analysis consistent with the instructions and methodology adopted?
Check that the expert's methodology aligns with their instructed assumptions, chosen methodology and the documents they have relied upon.
The Judge placed little weight on an approach put forward that adopted descriptions from bottling agreement in which no payment was made for using intellectual property, given this was inconsistent with the instructed assumptions that a portion of the payments made by SAPL was for the Intellectual property.(6)
4. How comparable are the selected licence agreements in a relief from royalty analysis?
Firstly, when reviewing a relief from royalty analysis, ensure the choice of database and source of data is adequately explained. There is more than one company that collates this royalty data.
Confirm the royalty agreements relied upon by the expert are truly comparable to the subject intellectual property. For example, has the expert considered the relative strength of brands in the comparable agreements, or whether they reflect the same exclusivity arrangements?
A significant portion of the judgment discussed the appropriateness of each expert’s selection of comparable licensing agreements in their respective relief from royalty assessments.
Where there were differences between the comparable agreement and the arrangement between PepsiCo and SAPL, the Judge accepted certain adjustments made by one of the experts in attempting to increase the comparability of selected agreements.(7)
5. Does the expert’s methodology follow recognised professional standards?
Verify with the expert that their methodology aligns with the appropriate professional standards, such as the IVSC International Valuation Standards(8) (IVS).
The IVS outlines two accepted methods that can be used to derive a hypothetical royalty rate: the first based on rates in comparable transactions; the second based on a hypothetical split of profits for using the intangible assets between a willing licensee and willing licensor.(9)
In cross-examination, PepsiCo’s expert was taken to the above section of the IVS on the basis it appeared to support the ATO’s expert’s adoption of a split of profits analysis as an acceptable method.(10)
6. If in a court setting, is the embedded royalty analysis fully transparent?
The fact that a methodology is used in a commercial or compliance context does not necessarily mean it will withstand forensic scrutiny in litigation.
In cross-examination, the ATO’s expert was challenged for adopting the results of subjective analysis conducted by intellectual property platform, Markables.
One of the Judge’s criticisms of this methodology was that it did not rely on analysis conducted by the expert, but rather on analysis conducted by a third party:
“The steps taken by Markables involve making a number of assumptions that are not detailed in the material before the Court and cannot be tested.”(11)
7. Was the underlying valuation data relied upon prepared for another purpose?
Courts may place limited weight on valuation data originally prepared for accounting, tax, transaction or commercial purposes where the underlying assumptions cannot be independently tested in the litigation context.
Consider whether your expert’s methodology relies on third party analyses, accounting allocations or valuation data prepared for a fundamentally different purpose than the question before the Court.
Whilst valuers commonly analyse publicly available data from corporate transactions, litigation requires more than commercial acceptability. The methodology and assumptions adopted must also withstand forensic scrutiny.
One methodology advanced by the ATO’s expert involved an implied profit split analysis derived from purchase price allocation data taken from reported mergers and acquisitions.
The Judge ultimately placed limited reliance on this approach because the underlying purchase price allocations had been prepared by external accountants for the acquiring entities and the assumptions underpinning those allocations were not before the Court. As the Court observed:
“Those figures were prepared for other purposes and were based on a number of assumptions that are not before the Court and cannot be tested.”(12)
(4) PepsiCo, Inc. v Commissioner of Taxation [2023] FCA 1490 – paras. 271 and 400
(5) PepsiCo, Inc. v Commissioner of Taxation [2023] FCA 1490 – paras. 287 to 294
(6) PepsiCo, Inc. v Commissioner of Taxation [2023] FCA 1490 – paras. 278 and 296
(7) PepsiCo, Inc. v Commissioner of Taxation [2023] FCA 1490 – paras. 300 to 320, 344 to 347 and 401
(8) International Valuation Standards Council – International Valuation Standards, effective 31 January 2022
(9) International Valuation Standards Council – International Valuation Standards, effective 31 January 2022 – para. 60.19(b)
(10) PepsiCo, Inc. v Commissioner of Taxation [2023] FCA 1490 – paras. 329 to 330
(11) PepsiCo, Inc. v Commissioner of Taxation [2023] FCA 1490 – paras. 359 to 373
(12) PepsiCo, Inc. v Commissioner of Taxation [2023] FCA 1490 – para. 394
Conclusion
In our view, based on experience preparing embedded royalty reports in both litigation and advisory contexts, applying the considerations above will improve the robustness and credibility of any royalty rate assessment. A report grounded in independent data, transparent assumptions, and clearly articulated reasoning is more likely to be accepted and less vulnerable to challenge. Regardless of the ultimate appellate outcome, the judgment provides a useful illustration of the forensic and evidentiary issues that can arise in intellectual property and royalty valuation disputes, particularly where competing methodologies and comparable agreement analyses are advanced.
Hewlett + Murray is an Australian forensic accounting and valuation firm specialising in expert witness and dispute advisory services. We provide independent expert evidence and financial advisory support in commercial litigation, including economic loss quantification, account of profits, intellectual property disputes, shareholder disputes, post-acquisition disputes and business valuation matters.
Our work combines rigorous financial analysis with clear communication tailored to legal teams, courts and tribunals.
For further information, visit www.hewlettandmurray.com.au