The ATO has finalised Taxation Ruling Income tax: royalties – character of payments in respect of software and intellectual property rights (TR 2026/2), its binding ruling on when payments under ‘software intermediation arrangements’ are royalties subject to withholding tax. The ruling is only binding as against the Commissioner of Taxation (Commissioner) and is relevant to the assessment of penalties, however, it is also informative of the ATO’s views in respect of the application of the law to the arrangements it covers. It replaces the 2024 draft ruling (TR 2024/D1) and applies both before and after its date of issue. Simultaneously, the ATO has released its Draft Practical Compliance Guideline: Royalty characterisation of payments relating to intermediation or distribution arrangements — ATO compliance approach (PCG 2026/D4).
What this means for you
The finalisation of TR 2026/2 and the release of PCG 2026/D4 represent a significant moment for businesses with cross-border software distribution arrangements. The key practical implications are as follows:
- Review existing arrangements. Australian software intermediaries (let’s call them distributors) should review existing software distribution agreements and assess royalty withholding tax exposure against the finalised ruling.
- Self-assess under the PCG. Businesses should determine their risk zone under the PCG 2026/D4 framework and ensure appropriate documentation supports their self-assessment. The five-tier framework provides a structure for this purpose.
- Engage IP counsel. The ruling makes it clear that detailed analysis of Australian copyright law is central to payment characterisation. Tax advisers should work alongside IP specialists to properly analyse the copyright implications of software distribution arrangements.
- Assess tax gross-up exposure. Businesses with tax gross-up provisions in distribution agreements should assess the potential financial impact if payments are recharacterised as royalties.
- Consider PepsiCo implications. The PepsiCo, Inc v Commissioner of Taxation [2025] HCA 28 (PepsiCo) decision reinforces the importance of well-documented commercial arrangements and arm’s length pricing. Businesses should ensure their documented arrangements are consistent with the economic fundamentals.
- Monitor the PCG consultation. PCG 2026/D4 is still in draft. Comments are invited and businesses should consider making submissions, particularly on the operation of the risk zones and the quantitative thresholds.
Background
This alert summarises the latest update on the ATO’s approach to royalties in the context of software distribution arrangements, referred to by the ATO as ‘software intermediation arrangements’. It builds on our earlier analyses of the 2024 draft ruling, the decision in PepsiCo and the ATO’s practical compliance guidance.
On 4 September 2026, the ATO released TR 2026/2 which replaced draft ruling TR 2024/D1, which itself replaced TR 2021/D4, and the long-standing TR 93/12 (dating from 1993).
The finalisation of TR 2024/D1 was deferred pending the High Court’s decision in PepsiCo, handed down on 13 August 2025 (see our alert on the High Court decision here). The ATO subsequently released its Decision Impact Statement on 19 March 2026, signalling its approach to the decision and confirming that TR 2024/D1 would be reviewed in light of the High Court’s reasoning.
Alongside TR 2026/2, the ATO has released PCG 2026/D4, a new draft practical compliance guideline that replaces the earlier PCG 2025/D4 (issued 6 August 2025). PCG 2026/D4 provides a five-tier risk assessment framework for ‘software intermediation arrangements’.
The release of these instruments forms part of a broader suite of ATO activity in the intangibles and cross-border payments space over the past five years. This includes the intangibles-related measures in the Multinational Tax Integrity Package under the October 2022/23 Budget, which introduced revised exposure draft legislation denying deductions for payments relating to intangible assets connected with low-tax jurisdictions (which was ultimately not pursued), and the proposed penalty for significant global entities who mischaracterise or undervalue royalty payments that was announced in the May 2024/25 Budget (see our earlier alerts here and here).
TR 2026/2 at a glance
- The core positions from the 2024 draft are largely retained — the final ruling is an incremental update, not a fundamental rethink of the ATO’s position. Consistent with the 2024 draft, the ATO considers that a broad range of payments for access to software under distribution arrangements could be characterised as royalties.
- The ruling now takes into account the High Court’s landmark decision in PepsiCo, particularly in respect of when a payment is consideration ‘for’ the use of an IP right (see the section 'PepsiCo and its influence on TR 2026/2' below).
- PCG 2026/D4 provides a risk-zone self-assessment framework (white, green, yellow, amber, red) for software intermediation arrangements — a significant expansion from the earlier PCG 2025/D4.
- The concept of ‘simple use’ remains absent. Instead, end-user payments falling in the green zone under PCG 2026/D4 will be categorised as low risk.
- TR 2026/2 was also accompanied by the issuance of a Compendium (TR 2026/2EC), which acknowledged the many submissions and concerns raised by industry. Although these were addressed for transparency, they have largely not affected the key positions of concern raised during consultation.
Key takeaways
TR 2026/2
- Applies retrospectively. The final ruling is binding as against the Commissioner and applies both before and after its date of issue, despite significant industry lobbying for prospective-only application. However, it remains to be seen whether a court would, in assessing penalties, take into account a ruling which did not exist at the time of the relevant transactions. Further, the mere fact that a public ruling has issued does not necessarily mean that “alternative treatments to that suggested by the public ruling cannot be reasonably arguable” (MT 2008/2, at [46]). Note that the previous TR 93/12 may still be applied to arrangements covered by TR 2026/2 prior to 1 July 2021 (when TR 93/12 was withdrawn).
- Core positions retained, with refinements. Despite substantial drafting changes, the final ruling retains many of the core principles and conclusions contained in the 2024 draft. Key changes are primarily refinements (including updating terminology such as ‘software intermediary’ and ‘software intermediation arrangement’ to reflect the focus of the ruling on intermediaries, not end-users), incorporation of reasoning from PepsiCo, and removal of some elements such as the commercial rental arrangement discussion.
- Tax risks remain. The ATO takes the view that payments under software distribution arrangements such as SaaS, electronic download and distribution of tangible goods with embedded software could be characterised as a royalty, even where those arrangements would not typically be considered to involve an exercise of copyright by the distributor.
- IP law analysis is central. As raised in our earlier alert, ‘a proper payment analysis requires consideration of Australian copyright law and/or other intellectual property laws that may apply to relevant software arrangements’. The final ruling is clear that analysis of IP rights is central to the characterisation question. Businesses should engage IP counsel alongside tax advisers when considering their distribution arrangements.
- Narrow OECD Commentary interpretation maintained. Despite significant pushback from submitters and the US Treasury, the ATO maintains a narrow reading of paragraph 14.4 of the OECD Commentary on Article 12. The ATO’s position is that the example in paragraph 14.4 depends on the specific facts of an arrangement and the application of relevant domestic copyright law and cannot be relied upon where the substance of an arrangement differs.
- ‘Simple use’ still absent. The ATO confirms in the Compendium that it has not reintroduced the concept of ‘simple use’ because it considers the term irrelevant to the characterisation question. The ATO notes that ‘simple use’ is not found in the royalty definition or copyright law and was used in TR 93/12 in relation to end-users (not intermediaries). Instead, end-user payments in the green zone under PCG 2026/D4, which includes certain payments relating to ‘private or domestic use’, will be categorised as low risk. This represents a practical concession, even if the conceptual framework has not shifted.
PCG 2026/D4
- Full-spectrum risk framework. PCG 2026/D4 is a significant expansion from the earlier PCG 2025/D4 — moving from a ‘low-risk only’ framework (white/green zones) to a comprehensive five-tier risk assessment covering white, green, yellow, amber and red zones. This gives taxpayers a framework for self-assessment, though it is likely that many businesses currently making cross-border supplies will find themselves in the red and amber zones.
- New quantitative tools. The PCG includes a new residual risk assessment calculation and an operating margin exception, providing benchmarks against which to assess risk.
- Green zone safe harbours. The PCG provides green zone safe harbours for own-use software, simple distribution of physical media, and embedded software in tangible goods.
Outline of TR 2026/2 — what the final ruling says
Summary: when a payment IS and is NOT a royalty
The following table summarises the ATO’s final position (at paragraphs [16] and [18]):
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A PAYMENT IS A ROYALTY IF IT IS CONSIDERATION FOR:
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A PAYMENT IS NOT A ROYALTY IF IT IS:
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(a) the grant of a right to use IP, regardless of whether that right is exercised |
(a) consideration for, and only for, the grant of a right to distribute copies made by the copyright holder, and not for the use of, or right to use, any IP rights |
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(b) the use of any IP right |
(b) consideration wholly for the assignment of all rights relating to the copyright in software |
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(c) the supply of know-how |
(c) a payment wholly for acquisition of tangible goods with embedded software, provided the distributor does not use and is not granted the right to use any IP in the embedded software |
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(d) the supply of assistance furnished as a means of enabling the application or enjoyment of any of the above |
(d) a payment wholly for acquisition of physical media on which software is stored, provided the distributor does not use and is not granted the right to use any IP in the software stored on that media |
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(e) the right to use, or use of, any IP right in software that is embedded in tangible goods |
(e) consideration wholly for the provision of services unrelated to any IP right or knowledge or information |
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(f) total or partial forbearance in respect of the use or supply of any property or right referred to above |
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The Explanation, which is not part of the binding ruling, provides the following details on how the ATO’s view was reached.
Part 1: Royalties — the five key components
The ATO’s Explanation analyses the royalty definition by reference to five key elements:
- ‘However described or computed’ — the label given to a payment is not determinative. The substance of the arrangement, not its form, governs the characterisation.
- ‘Consideration’ — takes a broader meaning under the royalty definition than the narrow technical contract law concept. It means the ‘purpose, basis or condition’ of the payment (paragraphs [63]–[65] of the ruling, citing PepsiCo at [160]).
- ‘For’ — connotes a ‘causal connection’ between the payment and the IP right (paragraph [67], citing PepsiCo at [161]). The terms of any agreement, including implied terms, are the starting point (paragraph [68], citing PepsiCo at [141]). The objective purpose is determined by all circumstances, including the commercial purpose and the relationship between the parties (paragraph [69], citing PepsiCo at [174]). This incorporates the principle in International Business Machines Corporation v Commissioner of Taxation [2011] FCA 335 that the characterisation is a question of fact. Close analysis of the quid pro quo in commercial arrangements will be critical to ensure that a payment is actually being made in exchange ‘for’ a grant of copyright.
- ‘To the extent’ — permits apportionment where a payment is partly a royalty and partly something else. This is relevant where arrangements bundle IP rights with other elements. The former Scenario 3 under TR 2024/D1, which supported discussion of a payment being a royalty ‘to the extent’ it was consideration for one or more of the acts in the definition of royalty, has not been retained. The ATO has instead deferred practical apportionment guidance to PCG 2026/D4. The ATO’s view, expressed in the Compendium, is that software intermediation arrangements commonly grant IP rights that are neither separate nor severable from other rights, such that the arrangement cannot be performed without exercising IP rights. This may be an area of contention going forward.
- ‘Use’ — the ‘use’ of an IP right covers all forms of use of the right or property short of an outright sale of the right.
Part 2: Copyright — exclusive rights in software
Following this, the Explanation analyses certain relevant exclusive copyright rights in detail:
- Reproduction right — the right to reproduce the work in a material form. The ruling considers when copying of software in the distribution chain constitutes reproduction.
- Communication to the public — this is particularly relevant for SaaS and cloud-based software delivery. The ruling considers when making software available online constitutes communication to the public. Contentiously, the ruling now asserts that ‘access to or enjoyment of the function of the software by the end-user is a consequence of the software being made available online’ (at paragraph [109]). This is a wide reading of the communication right, particularly in the context of software, and is likely to be controversial.
- Adaptation — the right to make an adaptation of a literary work (which includes computer programs).
- Authorisation — this has received expanded treatment in the final ruling, including a new Example 3. The ATO asserts that authorisation is an exclusive right of the copyright owner (at paragraph [115]) but acknowledges that leading cases on authorisation concern infringement actions and that it is ‘not clear’ how courts would apply those principles in a non-infringement context (at paragraph [117]). The ATO maintains that ‘a person may authorise an act without themselves having the right to do the act being authorised’ (at paragraph [124], citing Example 1). We expect this is intended to capture scenarios where a person holds themselves out as a rightsholder but does not actually hold the copyright. Again, this reading of the authorisation right is likely to be controversial.
- Publication right — the list of exclusive copyright rights now includes the right to publish (subparagraph 31(1)(a)(ii) of the Copyright Act), following a submission that this right had been inexplicably omitted from the draft. While this is unlikely to be a primary focus in most software arrangements, it broadens the range of copyright rights that may be relevant.
Notably, the discussion of commercial rental arrangements has been removed. The ATO now accepts that it is ‘less likely’ that a commercial rental arrangement will be found in the kinds of software intermediation arrangements contemplated by the ruling.
Part 3: Non-copyright IP rights
In addition, the ATO has expanded its discussion of technological protection measures (TPMs). Control of access through TPMs was mentioned in the draft ruling as a factor indicating the exercise of an IP right. In the final ruling, the ATO takes the position that the statutory causes of action in the Copyright Act relating to the circumvention of TPMs ‘reflect a recognition by the Australian domestic legal system that the use and control of TPMs, are within the genus of IP’ and that, accordingly, the use of (or right to use) TPMs falls within the standard tax treaty definition of ‘royalties’ (paragraph [144]). This extension is controversial. Stakeholders in the consultation process challenged the characterisation of TPMs as giving rise to a separate IP right, and argued that the TPM provisions in the Copyright Act are directed at preventing piracy and unauthorised access rather than creating a separate monopoly ‘right of access’ to copyright works.
Various controls which restrict the initial access to or activation of software, including the use of licence keys, activation codes, user account requirements or pay walls, may constitute access control TPMs. The practical consequence of the ATO’s expanded view is that, where a distributor issues licence keys or otherwise manages end user access, the ATO may treat this as indicative of the distributor’s use of IP rights, including the authorisation of acts comprised in copyright.
Part 4: Embedded software
The treatment of embedded software in tangible goods is largely unchanged from the draft ruling. Uncontroversially, where a distributor acquires tangible goods with embedded software and does not use or receive the right to use any IP in the software, the payment is not a royalty. On the other hand, a payment for software is a royalty to the extent that it is consideration for the use of, or the right to use, any IP right in the embedded software. In the context of an embedded royalty, this may prove an illusory distinction if the use of the intellectual property is limited to inputting data and receiving results.
PepsiCo and its influence on TR 2026/2
The High Court’s decision in PepsiCo was the most significant Australian tax case on royalties in decades. Despite the ATO’s view that its future application would be limited due to its unique facts, the decision has had a direct and pervasive influence on the final ruling.
The decision
The High Court, by a 4:3 majority (Gordon, Edelman, Steward and Gleeson JJ; Gageler CJ, Jagot and Beech-Jones JJ dissenting), held that payments by a bottler to a seller for concentrate were not ‘consideration for’ the use of IP rights. Instead, the payments were for concentrate alone. The IP licence was part of a comprehensive commercial arrangement with separate non-monetary consideration.
Unanimously, the Court also held that the payments were not ‘paid to’ or ‘derived by’ the relevant taxpayers, meaning no withholding tax was payable in any event.
The Decision Impact Statement (19 March 2026)
The ATO’s Decision Impact Statement made clear its views that:
- The concept of ‘embedded royalties’ survives PepsiCo — the ATO will continue to examine the economic fundamentals of arrangements involving IP.
- ‘Consideration’ is not to be given a narrow technical contract law meaning — the broader purposive interpretation applies.
- The ATO will seek to understand and test the economic fundamentals of arrangements, including by seeking evidence on the values of IP rights being supplied.
- The unique facts of PepsiCo (arm’s length dealing, market standard model, fair price for concentrate) limit its broader applicability.
Incorporation in TR 2026/2
The ATO refers to the PepsiCo decision in the final ruling and interprets the decision in several key ways:
- Broadened meaning of ‘consideration’ — the ‘purpose, basis or condition’ of the payment.
- Causal connection — the payment must be ‘for’ the IP right in a causal sense.
- Importance of the totality of the bargain — form is not determinative; the agreement as a whole (including the substance and economic reality of the arrangement) must be considered.
- Implied terms — the terms of the agreement, including implied terms, are the starting point in characterisation.
- Relevance of valuation evidence — the pricing and value of what is supplied and whether the parties are dealing at arm’s length.
The ruling also cites Oracle Corporation Australia Pty Ltd v Commissioner of Taxation [2025] FCAFC 145, which reinforces that the characterisation of a payment as a royalty is ultimately a question of fact.
Practical takeaway: the ATO will seek to understand and test the substance and economic reality of arrangements involving IP in future cases, including by seeking evidence on the values of IP rights being supplied. Businesses should ensure that their commercial arrangements are well-documented and that pricing reflects genuine arm’s length bargaining.
PCG 2026/D4 — new draft practical compliance guidance
Overview
PCG 2026/D4, released on 4 September 2026, replaces the earlier PCG 2025/D4 (issued 6 August 2025). It outlines the ATO’s compliance approach to identifying whether cross-border payments relating to software are royalties subject to withholding tax.
Notably, the PCG expressly excludes content streaming. There is no similar exclusion in TR 2026/2.
Key structural change and new features
PCG 2025/D4 covered only white and green (low-risk) zones. PCG 2026/D4 is a comprehensive five-tier framework covering white, green, yellow, amber and red zones. This is a significant expansion that provides a full-spectrum compliance framework for the first time.
The framework now includes a residual risk assessment calculation to enable taxpayers to self-assess a ‘residual amount’, taking into account offshore supplier costs where that supplier is a related party, as well as an operating margin exception that may result in an arrangement falling into a lower risk zone.
Risk zones
Expanded examples
PCG 2026/D4 includes 9 examples (up from 4 in PCG 2025/D4), including new green zone examples (downloadable/cloud software, smartphones with embedded software, video game simple distribution), and new amber and red zone examples. The expanded example set provides significantly more practical guidance for taxpayers.
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