Software royalties back in the spotlight: The ATO’s final position in TR 2026/2 and what it means for taxpayers

The Australian Taxation Office (ATO)’s final software royalty ruling confirms that cross-border software and IP payments remain a priority compliance area. The ATO’s views appear to remain controversial and seemingly extend beyond traditional Organisation for Economic Co-operation and Development (OECD) and international taxation approaches. The practical impact is likely to be broad but may be felt most acutely by taxpayers with US-parented technology groups, offshore IP ownership structures, software distribution models or Software-as-a-Service (SaaS) arrangements.

Taxpayers must revisit distribution, intermediation and SaaS arrangements now to test whether payments contain an unrecognised or “embedded” royalty, whether Australian royalty withholding tax obligations arise, and how their risk position would be assessed under the ATO’s draft compliance framework.

On 4 September 2026, the ATO released two important software royalty products: Taxation Ruling (TR) 2026/2, Income tax: royalties – character of payments in respect of software and intellectual rights, and draft Practical Compliance Guideline (PCG) 2026/D4, Royalty characterisation of payments relating to intermediation or distribution arrangements – ATO compliance approach.

In replacing draft TR 2021/D4 and the historical TR 93/12, TR 2026/2 reflects significant recent judicial developments, including the High Court’s decision in PepsiCo and the Full Federal Court’s decision in Oracle in 2025.

The timing is also notable. While the ATO had already issued its Decision Impact Statement on PepsiCo on 1 May 2026, it released the Oracle Decision Impact Statement on the same day as TR 2026/2 and PCG 2026/D4.

TR 2026/2 and PCG 2026/D4 at a glance

TR 2026/2 confirms the ATO’s final view on when payments under “software intermediation arrangements” may be royalties and therefore subject to Australian royalty withholding tax. The ruling applies with retrospective effect, with limited protection for taxpayers who appropriately relied on TR 93/12 prior to its withdrawal on 1 July 2021.

A software intermediation arrangement is “an agreement, arrangement or scheme under which a software intermediary makes payment or payments directly or indirectly to the owner or licensee of the copyright (or other IP) in software which enables it to be in a position to earn income relating to the use of, or right to use, the software.”

Accompanying TR 2026/2, PCG 2026/D4 sets out the ATO’s proposed compliance approach for cross-border software-related payments. It allows taxpayers to self-assess their royalty characterisation risk using five coloured risk zones, from white through to red, supported by some examples.

The final ATO position puts renewed pressure on taxpayers to review the characterisation of cross-border payments for software or intellectual property. In particular, taxpayers should consider whether their arrangements involve economic substance issues or unrecognised royalties. The ATO’s broad view, which attracted significant concern when released in draft, may affect arrangements that were not previously treated as royalty arrangements, including distribution and SaaS businesses.

Key points from TR 2026/2

The final ruling ends a lengthy period of uncertainty for taxpayers but does not materially retreat from the ATO’s draft position, despite consultation feedback from industry, advisers and the US Treasury.

In substance, the ATO considers that payments made by software distributors (referred to as “software intermediaries” in the ruling) may be royalties where the entity uses, or is granted the right to use, copyright or other IP rights in performing its role. The final ruling also confirms that contractual labels such as “distributor” or “royalty-free” are not determinative.

The ATO has reframed parts of its analysis to reflect PepsiCo. However, given the ATO’s view of that decision and its particular facts, the final ruling continues to adopt a broad interpretation of the key elements of a royalty. Much of that discussion appears in the Explanation rather than the legally binding part of the ruling.

The ATO’s language also indicates that aspects of its analysis remain open to debate, including through phrases such as “we think it is arguable” and “we are of the view”. These issues may ultimately require judicial consideration, particularly given the breadth of the ATO’s position and the complexity of applying royalty principles to modern software arrangements. Notably, the ATO states that it will seek “appropriate opportunities to obtain judicial clarification” in the Oracle Decision Impact Statement.

When a payment is not a royalty

The ruling includes a short discussion of circumstances in which a software-related payment will not be a royalty. Although useful, this part of the ruling is relatively limited.

Examples include:

• Distribution rights only where copies are made by the copyright holder
• Acquisition and resale of existing software copies without copyright rights
• Purchase of tangible goods with embedded software where no IP rights are used or granted
• Services unrelated to any IP rights.

The ruling also expressly states that:

• A distributor acquiring hardware containing embedded software generally does not pay royalties where no copyright rights are granted; and
• Royalties may arise only where the distributor acquires rights such as modification or adaptation rights.

This clarification is helpful, although largely uncontroversial. It is consistent with paragraph 14.4 of the OECD Model Commentary, which the ruling cites: “Thus, in a transaction where a distributor makes payments to acquire and distribute software copies (without the right to reproduce the software), the rights in relation to these acts of distribution should be disregarded in analysing the character of the transaction for tax purposes.”

The ATO expresses that the example in paragraph 14.4 of the OECD Model Commentary “cannot be relied upon where the substance of an arrangement or arrangements differs from the facts in the example, such as arrangements where a distributor can independently make software available to download without further action by a software company”.

When a payment may be a royalty

The characterisation of payments under software intermediation arrangements will depend on the facts and circumstances. The ATO proposes an expansive approach to make an objective assessment by identifying the express and implied terms of the relevant agreements and the conduct of the parties.

The final ruling expands the discussion of several concepts that will be central to the ATO’s royalty analysis, including:

• Authorisation rights
• Communication rights
• SaaS arrangements
• Distributors facilitating customer access.

Particularly notable is the ATO's broad interpretation that a distributor may itself be exploiting copyright where it:

• Authorises downloads
• Authorises reproductions
• Grants access to SaaS products
• Determines the content of the communication
• Facilitates customer access.

Historically, these types of distribution arrangements were treated as generating business profits, not royalties.

The ATO also now states that technological protection measures (TPMs), such as licence keys and activation codes, are within the “genus of intellectual property” and can constitute “other like property or rights”.

In relation to mixed or undissected payments, the ruling confirms two important points:

• There must be a “causal connection” between the consideration and the royalty component. Consideration is now expressly framed as the “purpose, basis or condition” of the payment; and
• “Apportionment” may be required where there is a royalty and non-royalty component to the payment.

While the ruling acknowledges that apportionment should be undertaken on a “fair and reasonable basis”, it does not explain what that means or identify acceptable apportionment methods. Further ATO guidance would be welcomed, particularly given the ATO’s reliance on the principle from the IBM case that, where rights are commercially inseparable and cannot be meaningful severed, the entire payment will be treated as a royalty (as illustrated in Example 1 in the ruling). This lack of guidance may be a significant concern for taxpayers, especially because the “reasonable method of apportionment” scenario included in the draft ruling has been omitted from the final ruling.

The Oracle Decision Impact Statement

The ATO’s Oracle Decision Impact Statement confirms that it will not pursue an appeal of the Oracle Decision to the High Court. The ATO acknowledges that extensive feedback has been provided during the consultation process on TR 2026/2 and there is complexity in applying established principles of royalty characterisation to modern business models. The ATO makes it clear that judicial guidance is still considered desirable and that the ATO intends to pursue future cases to provide clarification on the application of treaty principles to contemporary software arrangements.

Key points from PCG 2026/D4

Rather than providing an interpretative view of the law, the draft PCG sets out how the ATO proposes to assess royalty risk, when it is more likely to apply compliance resources, and what evidence it expects taxpayers to maintain.

The draft PCG also confirms that the ATO has updated its approach following the High Court’s decision in PepsiCo, noting that the economic fundamentals of an arrangement may be relevant in identifying unrecognised royalties.

A formal risk framework

The draft PCG establishes a self-assessment framework under which taxpayers assess the "royalty risk" of cross-border payments to non-residents. The framework contains five risk zones:

• White (further risk assessment not required)
• Green (low risk)
• Yellow (low to medium risk)
• Amber (medium to high risk)
• Red (high risk).

As part of the self-assessment framework, the ATO has introduced a “residual risk assessment calculation” methodology which may be relevant if a taxpayer seeks to fall within the green or yellow zone and a royalty amount is recognised. Under this methodology, the royalty is compared with the residual amount, calculated as the payment received by the offshore supplier less certain of the offshore supplier’s costs including infrastructure costs, sales and marketing costs, third-party royalty expenses and direct labour costs, plus a mark-up of 5 per cent.

Applying this methodology requires the Australian taxpayer to obtain detailed and specific cost information from the related party entity involved in the cross-border arrangement. Given that various costs are explicitly excluded from the calculation and that costs must be appropriately allocated where the offshore supplier sells to multiple entities, the methodology may be challenging to apply in practice and could impose a significant compliance burden.

The ATO states it will concentrate compliance activity on amber and red zone arrangements, while generally not reviewing arrangements falling within the white and green zones, other than to verify the taxpayer's self-assessment. In absence of a risk zone self-assessment, or where such an assessment cannot be evidenced, a taxpayer will automatically fall in the red zone. We expect there will be a requirement to make a disclosure of the risk zone in the Reportable Tax Position schedule.

The ATO expressly warns that restructures which reduce or avoid Australian royalty withholding tax may be reviewed regardless of the outcome under the risk framework. It also flags potential consideration of transfer pricing provisions, the multinational anti-avoidance law and Part IVA.

The draft PCG is proposed to apply to arrangements entered into both before and after its finalisation. This means taxpayers will need to revisit historic positions rather than viewing this solely as a prospective compliance issue.

BDO’s perspective

In our view, TR 2026/2 and PCG 2026/D4 moves the software royalty issue from debate into practical administration, with real technical and interpretative challenges on the horizon. Software distribution and SaaS arrangements should no longer be assumed to sit outside the royalty withholding tax regime merely because they have historically been documented as distribution, access or technology supply arrangements.

For many groups, the greatest challenge will not be identifying the existence of software or intellectual property rights. It will be demonstrating why a particular payment does not have a royalty character and, where necessary, supporting any apportionment methodology adopted (including through transfer pricing). The PCG methodology for assessing whether a royalty amount falls within the green or yellow zone, continues a concerning ATO trend of requiring Australian taxpayers to access detailed information held by offshore related parties.

The ATO’s growing focus on economic substance and commercial outcomes means taxpayers should expect greater scrutiny of arrangements that have historically been documented as straightforward distribution, licensing or technology supply arrangements. Equally, businesses with well-supported positions and robust documentation may gain greater certainty through the framework outlined in the PCG.

What taxpayers should be doing now

The interaction between royalty withholding tax, software distribution models, intellectual property rights, transfer pricing and broader international tax considerations remains complex. As the ATO moves from consultation to administration, taxpayers should review existing (and any proposed new) arrangements now.

The priority should be to identify potential royalty elements, test the robustness of current positions, reassess withholding tax exposure, map arrangements against the PCG risk framework, and assemble evidence before an ATO review or audit begins. Specifically:

• Review existing cross-border software and technology arrangements to identify the rights granted under those arrangements and determine whether any payments (including in prior income years) may contain a royalty component
• Reassess withholding tax exposure in light of the final views expressed in TR 2026/2, taking into account any applicable double tax treaty
• Review any methodologies used to apportion payments between royalty and non-royalty components to ensure they are technically supported and appropriately documented (including through transfer pricing)
• Evaluate where arrangements may fall within the proposed PCG risk framework and identify documentation gaps that may affect your ability to support a lower-risk assessment
• Consider whether historical restructures or operating models could attract increased scrutiny under the ATO’s compliance approach
• Assess whether changes to existing arrangements are warranted, while recognising the ATO’s stated intention to examine changes or restructures which result in a reduction of Australian royalty withholding tax
• If under ATO review or audit, identify whether Mutual Agreement Procedure (MAP) rights may be available and consider initiating MAP at the appropriate time, particularly where double taxation could arise.

Given the ATO's clear intention to continue compliance activity and seek further judicial clarification, taxpayers that act early will be better placed to support their positions, manage potential disputes, reduce compliance risk and respond efficiently to future ATO engagement.

How BDO can help

BDO's tax specialists regularly work with clients in the software and technology industry, and can support you in managing your structure. To discuss the potential implications of the new software PCG and finalisation of the ruling, speak with your local adviser or learn more about our tax services.