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11 September 2026 Australian Taxation Office finalizes software royalties ruling and expands compliance approach
On 4 September 2026, the Australian Taxation Office (ATO) released three significant publications relevant to cross-border software and intellectual property arrangements and royalties:
The ATO has finalized TR 2026/2, substantially maintaining its view that payments under software arrangements may be royalties if the arrangement involves the grant or use of copyright or other intellectual property (IP) rights. While the final ruling incorporates the requirement for a causal connection between the payment and the relevant IP rights from the High Court's PepsiCo decision, the ATO will consider a broad range of evidence including contracts, conduct, pricing and valuations. (For more on the PepsiCo ruling, see EY Global Tax Alert, Australian Taxation Office releases Decision Impact Statement on High Court PepsiCo decision, dated 20 March 2026.) The ATO continues to rely on Australian copyright concepts, including reproduction, communication and authorization. Cloud and software as a service (SaaS) arrangements therefore remain in scope even if the Australian entity does not own, host or supply the software. Draft PCG 2026/D4 has been released for consultation with submissions closing on 2 October 2026. The draft PCG introduces five risk zones, demarcated by the colors white, green, yellow, amber and red. Many subscription-based software distribution arrangements in which no royalty is recognized may fall within the amber zone. The PCG introduces an operating margin exception, quantitative thresholds for recognized royalties and a residual amount calculation based on the payment, less specified offshore supplier costs. This will create significant documentation and information requirements. The Oracle ATO DIS confirms the importance of the MAP as a dispute resolution pathway but does not determine whether the underlying software payments constitute royalties. Taxpayers will now need to reassess their arrangements, preliminary PCG risk zone and supporting evidence. TR 2026/2 finalizes draft TR 2024/D1 and is the culmination of the ATO's software royalties guidance process that commenced with draft TR 2021/D4. Although the final ruling has been updated to reflect the High Court's recent PepsiCo decision and a number of matters raised during consultation, the ATO has not materially retreated from its central technical position. The final ruling continues to take a broad, rights-based approach to royalty characterization. In particular, the ATO maintains that payments under software intermediation arrangements may constitute royalties if the performance of the arrangement involves the grant or use of copyright or other IP rights. This can include rights that are implied rather than expressly identified in the relevant agreements. The changes refine and clarify the ATO's reasoning but do not materially narrow its substantive position. The High Court's decision is now expressly incorporated in statutory law. The final ruling adopts the requirement for a causal connection between the payment and the relevant IP rights, but the ATO continues to consider contracts, implied terms, conduct, pricing, valuations and the broader exchange of undertakings. The scope of the final ruling is more clearly focused on software intermediaries. Specifically, the final ruling replaces the broader expression "software arrangement" with "software intermediation arrangement" and confirms that it is not directed to payments made by end-users. The authorization analysis is more qualified but remains broad. The ATO acknowledges the limited authority on authorization outside the copyright infringement context, while maintaining that distributors may authorize reproduction or communication. A new authorization example has been added. Example 3 concludes that an Australian distributor employs a right protected by copyright by providing customers with the means to download and install software, thereby authorizing reproduction. The former apportionment scenario has been removed. The ruling continues to recognize fair and reasonable apportionment but directs taxpayers to the PCG for the ATO's compliance approach to the quantum of a recognized royalty. The ruling applies to cross-border payments under a software intermediation arrangement. This is an arrangement under which a software intermediary makes payments directly or indirectly to an owner or licensee of IP in software, enabling the intermediary to earn income relating to the use of, or right to use, that software.
The final ruling also confirms that payments will not be royalties if they are solely for specified non-royalty matters. These include the acquisition and distribution of software copies without the use of, or right to use, IP, certain outright assignments, qualifying tangible goods with embedded software and services unrelated to IP. The requirement that the payment be solely for the non-royalty matter is important. If the arrangement also involves relevant IP rights, the ATO may contend that the payment is wholly or partly a royalty. The ruling now expressly reflects the High Court's reasoning that there must be a causal connection between the payment and the use of, or right to use, the relevant IP. The inquiry is directed to the objective purpose, basis or condition of the payment and what the parties have agreed as properly construed. This is a meaningful change in the articulation of the ATO's position. The contractual arrangements and the commercial bargain cannot simply be displaced by a general inquiry into economic substance. The ATO may consider express and implied contractual terms, conduct, pricing and valuation evidence, monetary and nonmonetary undertakings, the relationship between the parties, the commercial purpose of the arrangement and the manner in which the rights are used. Accordingly, the ATO does not regard the High Court as requiring characterization to be determined solely from the payment clause or the labels adopted in the contract. Nor does it accept that describing rights as "royalty-free" prevents the associated payment from being characterized as a royalty. The ATO continues to rely heavily on Australian copyright law when determining whether a software intermediary uses, or receives the right to use, copyright. Potentially relevant copyright rights include reproduction, publication, communication to the public, adaptation and authorization. The ATO also maintains that technological protection measures may constitute "other like property or rights" within the royalty definition. The discussion of authorization in the final ruling is more qualified than in the draft. The ATO acknowledges that the leading authorities largely concern copyright infringement and that it is not clear how the courts would apply those principles outside the infringement context. It also accepts that determining whether authorization has occurred requires close attention to the taxpayer's actual involvement.
Relevant rights may exist expressly or by implication. For SaaS and cloud arrangements, the ATO also continues to consider that more than one entity may be responsible for communicating software to the public. A local intermediary may be responsible if it enters into the customer agreement and determines the software, features or terms of access, even if the software is hosted and supplied from offshore. While the ruling includes greater acknowledgement of the factual inquiry required, its practical reach remains broad. Arrangements under which the Australian entity contracts with customers, issues credentials, controls access or administers end-user terms are areas of particular ATO focus. The ruling introduces a new example involving an Australian subsidiary that distributes software owned by its foreign parent. The Australian distributor provides customers with the credentials or instructions needed to download and install the software. The ATO concludes that, by agreeing to supply the software and enabling the download and installation, the Australian distributor authorizes customers to reproduce the software files. The ATO considers that this authorization is a use of copyright and that the agreement gives the Australian distributor the right to grant that authorization. According to the ATO, the conclusion is not affected by whether the relevant rights are express or implied, who provides the license key, which entity enters into the end-user license agreement, or how the software is hosted or supplied. The ruling also addresses technological protection measures used to control access to software or prevent unauthorized acts, including access controls and copy-protection mechanisms. The ATO considers that the statutory rights associated with these measures may constitute "other like property or rights" within the royalty definition, even though the relevant remedies are distinct from copyright infringement. This may be relevant if access to software is controlled through license keys, passwords, authentication tools or other technical restrictions. The ruling confirms that if a payment is consideration for several things, it may be apportioned on a fair and reasonable basis. However, the ATO continues to distinguish between:
The ruling removes the third scenario in draft TR 2024/D1, which had illustrated a reasonable method of apportionment. The ATO instead points taxpayers to PCG 2026/D4, which contains its compliance approach to assessing the quantum of a recognized royalty. The ATO accepts that the Organisation for Economic Co-operation and Development (OECD) Commentary is an important interpretative aid if the wording of a tax treaty is ambiguous, but maintains that the treaty text has primacy. The ATO reads the OECD example concerning the mere distribution of software copies narrowly. It considers the example does not apply if the distributor makes software available for download or uses or receives other IP rights. Accordingly, whether a payment is a royalty will depend on the particular treaty and how Australian copyright law applies to the arrangement. TR 2026/2 applies to payments made both before and after 4 September 2026. The ATO states that the ruling does not represent a change of view and reflects how it has applied the law as a longstanding practice. Former TR 93/12 may continue to apply to periods before its withdrawal on 1 July 2021 if it was appropriately relied upon. However, the ATO has not provided guidance for demonstrating appropriate reliance, and states that the position will depend on the facts and circumstances. Draft PCG 2026/D4 replaces the more limited draft PCG 2025/D4. The earlier draft largely identified arrangements that would not attract ATO compliance attention. The revised PCG introduces a complete risk framework covering white, green, yellow, amber and red zones, together with quantitative thresholds for recognized royalties and a residual amount calculation. The PCG must be read with TR 2026/2 and does not determine whether a payment is legally a royalty. Instead, the risk zones indicate the likelihood that the ATO will priorities compliance resources to review an arrangement. A red-zone rating does not create a presumption of non-compliance, while a green or yellow rating does not establish that the taxpayer's legal characterization is correct.
A recognized royalty that does not meet these thresholds may instead fall within the yellow zone, provided the royalty is reported, substantiated and subject to withholding tax. The 75% threshold for the yellow zone remains subject to consultation. An arrangement that would otherwise fall within the amber or red zone may be classified in the yellow zone if the Australian entity's operating margin either: This is a compliance-risk exception only and does not determine whether the payment is a royalty under the law. An arrangement may be amber if the Australian entity sells products or services involving access to offshore software and:
These criteria may capture many SaaS and subscription distribution models, even if the Australian entity cannot copy or modify the software and describes its payment as being for distribution rights.
Red-zone arrangements are the ATO's highest priority for review and may require detailed offshore supplier cost information. The outcome of the calculation affects the risk zone if a royalty is recognized. Broadly, a royalty that is at least 75% of this residual amount may qualify for the green zone; a lower recognized royalty may fall within the yellow zone, provided the other requirements are satisfied. Relevant costs generally include infrastructure, distribution, sales and marketing, third-party royalties and direct labor, plus a 5% mark-up. Related-party royalties, intangible amortization and stock-based compensation are excluded. Although this is a compliance-risk calculation rather than the legal test for a royalty, it is likely to create substantial offshore information and allocation requirements. The ATO may review an arrangement regardless of its risk zone if it has been restructured to reduce or avoid royalty withholding tax. Transfer pricing and anti-avoidance provisions may also be considered, particularly if commercial substance or rationale is not adequately evidenced. The recent Federal Court decision in Oracle concerned whether court proceedings should be stayed while the competent authorities of Australia and Ireland pursued the MAP under the Australia-Ireland tax treaty. At first instance, the Commissioner successfully opposed the stay, relying on the broader significance of the substantive royalty dispute and the potential for domestic litigation to resolve it more efficiently. The Full Federal Court concluded that, on the evidence before it, the stay should have been granted. The ATO accepts that conclusion in the DIS but emphasizes that the decision was fact-specific. The ATO also maintains that it may seek to suspend a MAP if domestic proceedings are underway, subject to judicial oversight of the exercise of that power. Importantly, neither the Full Court decision nor the DIS determines whether the underlying software payments were royalties. The substantive characterization dispute remains unresolved. The decision nevertheless confirms that the MAP is a genuine and potentially valuable dispute resolution pathway. Taxpayers should consider MAPs, domestic objections and litigation together at an early stage, particularly where the ATO's royalty characterization gives rise to double taxation or a material risk that foreign tax credits will not be available. The final ruling and expanded PCG provide the ATO with a more structured basis for identifying and prioritizing software royalty risks. Taxpayers should expect increased focus on amber- and red-zone arrangements, including detailed requests for contracts, pricing and valuation evidence, offshore supplier costs and the basis for any PCG self-assessment. Taxpayers should refresh earlier analysis against the final ruling's treatment of the High Court decision, express and implied IP rights, the new PCG risk zones, the operating margin exception and the residual amount calculation. As the ruling applies before and after 4 September 2026, historical payments and any reliance on former TR 93/12 should also be considered and documented. Agreements remain the starting point, but the ATO will also consider conduct, pricing, valuation evidence and the broader commercial arrangement. Contracts, customer terms, actual activities, payment flows and transfer pricing documentation should therefore tell a consistent story. If a royalty is recognized or apportioned, taxpayers will need evidence supporting the methodology, offshore costs and Australian allocations. If no royalty is recognized, taxpayers should be able to explain why the payment is not causally connected to IP rights. The PCG risk zones and residual amount calculation do not determine the law. However, they are likely to become important benchmarks in ATO reviews. Taxpayers adopting a position outside the lower-risk zones should expect to explain both their legal position and why the ATO's risk framework produces an inappropriate outcome. Restructures that reduce or avoid royalty withholding tax may attract review regardless of the PCG zone. For situations in which the ATO position may produce double taxation, taxpayers should consider MAPs, objections and litigation strategy early, including the interaction between those pathways.
Document ID: 2026-1937 | ||||||||||||||||||
