On 4 September 2026, the Australian Taxation Office (ATO) finalised its views in Taxation Ruling TR 2026/2 regarding when a cross-border payment under a software or intellectual property arrangement would constitute a ‘royalty’ and released its draft practical compliance guidelines PCG 2026/D4 for consultation.
The ATO’s views in TR 2026/2 remain essentially unchanged from its drafts (TR 2021/D4 and TR 2024/D1). The ATO has made no effort to retreat from its maximalist position that most Australian distributors of software, and goods which ‘embed’ editable software, will be subject to royalties withholding tax.
Key takeaways
- If you are distributing software via an Australian subsidiary and your IP is held in a foreign jurisdiction, expect an ATO review.
- The ruling has retrospective effect and the ATO will review past income years. The Australian withholding tax regime is not constrained by the usual four-year period of review for large businesses.
- Products which have embedded software can still be caught where the distribution of the product requires the modification of that software for the Australian market, regardless of how minor the modifications may be.
- There are critical and untested legal questions around the meaning of ‘royalties’ and the correctness of the Commissioner’s position legally (both in terms of IP law and tax law).
- While the ATO extensively cites in its ruling the recent PepsiCo High Court decision which concerned embedded royalties in respect of tangible goods, the ruling does not address the inherent tension between the High Court’s findings around the construction of the relevant arrangements in PepsiCo and software distribution arrangements.
- While PCG 2026/D4 has an ‘operating margin exception’ where the ATO will limit the use of its compliance resources, the 10% operating margin threshold is much higher than the 4.1% and 5.4% thresholds for assessing transfer pricing risk in PCG 2019/1.
The royalties saga
In the years since International Business Machines Corporation v Commissioner of Taxation [2011] FCA 335, the software market has changed significantly and the use of local subsidiaries and intermediaries to distribute software electronically has become significantly more common. The Commissioner in 2021, sought to update the ATO’s guidance in respect of these arrangements and withdrew its longstanding view in TR 93/12 and replaced it with TR 2021/D4.
TR 2026/2 is the finalisation of the views expressed by the Commissioner in TR 2021/D4 (which were updated in TR 2024/D1) and follows the decisions in Commissioner of Taxation v PepsiCo Inc [2025] HCA 30 and Oracle Corporation Australia Pty Ltd v Commissioner of Taxation [2025] FCAFC 145. Despite the Commissioner’s losses in the Courts since the original draft ruling in 2021, the Commissioner’s position in TR 2026/2 is no less assertive and will cause concern for most multinational businesses in Australia.
The focus of the ruling
Under Australian law, a payment will only be subject to royalty withholding tax under section 128B of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) where the payment satisfies the definition of ‘royalty’ under the applicable double taxation treaty (if any) and the domestic law definition of royalty in subsection 6(1) of the ITAA 1936.
TR 2026/2 focuses on when a payment under a ’software intermediation arrangement’ will fit the definition of ‘royalty’ under these circumstances. The ruling asserts that a payment will be a royalty where the payment is in consideration for any of the following:
- Grant of a right to use IP.
- Use of any IP right, including any act comprised in the copyright of a work.
- Supply of know-how.
- Supply of assistance to enable the application or enjoyment of IP or knowhow.
- The right to use or the use of any IP right in software embedded in tangible goods.
- Total or partial forbearance in respect of the use or supply of property or rights relating to the above.
The examples provided illustrate the above principles.
In example 1, Ireland Co owns all IP for programs outside of the US. Aus Co contracts with Ireland Co by entering into a Licence Agreement that is specified to be royalty free and:
- Appoints Aus Co as the non-exclusive distributor in Australia.
- Provides Aus Co with “a right to market, promote, distribute, copy (for the purposes of allowing customers to make copies for use) and sell licences for the Programs to end-users”.
- Provides Aus Co with the ability to enter into end-user licence agreements or cloud services agreements with Australian customers.
- Requires Aus Co to pay Ireland Co fees set by reference to a specified operating margin.
TR 2026/2 considers that the payments made in example 1 are royalties, as an objective assessment of the whole arrangement would indicate that the contract requires Aus Co to use copyright rights which are not separate or severable from the other rights and benefits granted. The relevant rights granted which are rights of the copyright owner are:
- The right to reproduce the work (via the right to allow customers to make copies).
- The right to communicate the work by selling and distributing cloud services.
Alternatively, the rights are other property or rights which allow Aus Co to exploit the copyright in the programs by distributing them to end customers.
Example 2 highlights a circumstance where the agreement between an Australian distributor or software intermediator and a foreign IP holder lacks sufficient specificity regarding the rights of each of the parties. In this circumstance, TR 2026/2 considers that where customers pay the distributor to obtain the right to use the software or the right to access cloud services, any payments made by the Australian distributor to the IP holder will be a royalty in its entirety, unless there are independent rights that can be valued, in which case apportionment can be applied.
What TR 2026/2 means
The consequences of the ATO’s views in TR 2026/2 are straightforward. Where there are Australian distributors of software, the ATO expects that the distributor will treat some (if not all) of the payments made offshore as a royalty, which is subject to royalty withholding tax.
This includes where the software is ‘embedded’ in a tangible good if the Australian distributor is allowed ‘copyright’ rights in respect of that software. This will be the case where the Australian distributor is allowed to modify or adapt the software for the Australian market, or Australian consumer. In this situation, the ATO expects that the payment from the Australian distributor will be apportioned to reflect the amount paid for the right to use the copyright right and the amount paid for the tangible good.
The Draft PCG 2026/D4 reflects this maximalist position, as it classifies all royalty free software distribution arrangements as “amber” or “medium to high risk” where a distributor sells products or services that involve access to or use of software held by an offshore supplier unless the Australian operating margin is >10% or within 10 percentage points of the global group’s operating margin.
The 10% operating margin seems completely incongruent with the ATO’s previously stated risk position in PCG 2019/1 for the expected operating margin of ICT distributors. In PCG 2019/1 ATO considers that any Australian ICT distributor with an EBIT margin of above 4.1% (for category 1 distributors) or 5.4% (for category 2 distributors) will be low risk for transfer pricing purposes.
Non-standard treaties
The ruling accepts that there are tax treaties which have material differences from the standard tax treaty definition of royalty including those with the Netherlands, Italy, Singapore, the United States and Mexico. However, to the extent that the elements of the definitions in those treaties are discussed in the ruling, the ruling’s guidance still applies. On this basis, the comments made in paragraph 8 and 9 of TR 2026/2 do not seem to scope out many, if any, arrangements.
For example, in the United States DTA, Article 12(a) states in part that a royalty means “payments or credits of any kind to the extent to which they are consideration for the use of or the right to use” various IP and copyright rights. The phrase “consideration for” is discussed in TR 2026/2 at paragraphs 12 to 15, and paragraph 9 of TR 2026/2 seems to envisage that the guidance provided in respect of the phrase applies to the US DTA in that respect.
The developments (and disputes) in this space will continue to be closely monitored by the G+T Tax team. If you would like to discuss any aspect of the ruling, please get in touch with our team.