Five years of consultation, one uncompromising view

After a consultation cycle stretching back to the withdrawal of TR 93/12 in 2021 and running through two prior drafts (TR 2021/D4 and TR 2024/D1), the Commissioner has now issued Taxation Ruling TR 2026/2 "Income tax: royalties — character of payments in respect of software and intellectual property rights", finalising the January 2024 draft and, before it, TR 2021/D4 and TR 93/12. The Ruling applies both before and after its date of issue (4 September 2026), with only limited grandfathering for taxpayers who "appropriately relied upon" TR 93/12 before its withdrawal on 1 July 2021.

The finalisation ends a lengthy period of uncertainty for taxpayers making cross-border software-related payments. Certainty, however, has come at a cost. The ATO has held the line on the expansive characterisation position it advanced in the earlier drafts — and, in several respects, contrary to feedback provided in consultation, has broadened it. For most multinationals that grant distribution rights into Australia, and especially for software developers with Australian intermediaries, the finalised position will be a significant concern.

What the Ruling says

The Ruling addresses when a payment under a "software intermediation arrangement" is subject to royalty withholding tax under section 128B of the ITAA 1936 because it is a royalty within the definition in subsection 6(1). Where a treaty applies, the treaty will only trigger a withholding tax obligation to the extent it is also covered by the domestic tax law definition of ‘royalty’. The ruling is said to focus on payments to residents of jurisdictions whose treaty with Australia contains the "standard tax treaty definition" of royalty. Relevantly, the ATO acknowledge the definition of royalty or royalties has some material differences from the standard tax treaty definitions in the US and Singapore treaties, both of which are common jurisdictions through which software distribution can occur. Where a payment is a royalty under that treaty definition, the ATO's position is that it will also be a royalty under the domestic definition.

At the heart of the Ruling is the proposition that a payment is a royalty where it is consideration for the grant of a right to use IP (whether or not exercised); the use of any IP right (including the doing of any act comprised in copyright, and including the exclusive right to authorise a person to do such an act); the supply of know-how; ancillary and subsidiary assistance; the right to use or use of IP embedded in tangible goods; or total or partial forbearance in respect of any of those things.

Two examples in the binding section illustrate the outcomes.

Example 1 deals with a scenario whereby an Irish Entity owns all IP in programs outside the US. It enters into a non-exclusive distribution agreement with an Australian entity, permitting it to enter into end-use licenses or cloud service agreements with end-users and receive payment. The distribution agreement includes the right "to market, promote, distribute, copy (for the limited purpose of permitting end-users to make copies for their internal use) and sell licences for the Programs to end-users". Critically, the actual software is made available, either physically or virtually, by Irish Co.

The ATO consider this type of arrangement results in a royalty as (a) the right to permit end users to make copies is the exercise of a right of the copyright holder; (b) although the communication of the software originates from Ireland, the Australian entity is not precluded from being an entity responsible for determining the content of its communication. Therefore, it is said:

The rights to authorise reproduction, to communicate the Programs, and to grant access are acts comprised in copyright, and therefore use of a copyright right, as they facilitate the use of copyright in a computer program by the end-user.

Alternatively, the ATO says there are other like property or rights ’ within paragraph (a) of the standard tax treaty definition of ‘royalty’, being valuable rights which entitle OBA to exploit the copyright in Programs by distributing use of the Programs to end-users.

In Example 2 titled 'an agreement lacking specificity regarding the parties' rights and obligations', the end-user enters into a standard contract with AusCo for the purchase of the relevant products. Following this the offshore parent grants a limited IP licence directly to the end-user and Foreign Co then grants the customer with access through a foreign server it controls. The Australian distributor's payment is nonetheless considered by the ATO to be a royalty, because customers pay it for rights to use the software, and the distributor also obtains use of trademarks, brand and designs, technical and commercial know-how, ancillary services and access to software protected by access control technological protection measures (ACTPMs).

Broader in reach — even than the draft

Although presented as a clarifying exercise, several changes in the final Ruling widen its practical reach.

Terminology. The draft's "software arrangement" and "distributor" have been replaced by "software intermediation arrangement" and "software intermediary". The new formulations sit more loosely against traditional distribution concepts, and it is not difficult to see them being applied by the ATO to structures that participants would not naturally describe as "distribution" at all. The Compendium confirms that whether an arrangement is a "software intermediation arrangement" must be considered on a case-by-case basis, and that neither embedded-software fact patterns nor corporate-group membership alter the analysis.

Consideration. Reflecting the ATO's view of the High Court's decision in PepsiCo, "consideration" is now expressly framed as the "purpose, basis or condition" of the payment, requiring a causal connection between the consideration and something within the royalty definition. The Compendium notes that the ATO has abandoned the draft's reliance on GST authorities. The change of authority is significant: it moves the enquiry firmly onto an objective, purpose-focused test in which the contractual labels chosen by the parties matter little.

Apportionment. The Ruling continues to acknowledge that where an amount is consideration for several things, apportionment on a fair and reasonable basis may be required. But it provides almost no guidance on methodology. Worse, it retains the draft's IBM-inspired reasoning that where the IP rights granted are inseparable, from a practical and business point of view, from the other rights granted, the entire payment will be a royalty, and the Compendium confirms the ATO's view that "commonly" in software intermediation arrangements the IP rights are neither separate nor severable from the other rights granted, so that the entirety of the consideration is characterised as a royalty. The draft's Scenario 3 (which was the only apportionment worked example, and dealt with a distributor granted rights to distribute physical copies and online access) has not been retained — with taxpayers instead directed to draft PCG 2026/D4 for compliance guidance. Taxpayers who expected the final Ruling to open up a workable apportionment pathway will find it does the opposite.

Technological protection measures. The Ruling now devotes a discrete section to TPMs. The ATO takes the position that the causes of action in the Copyright Act in relation to the circumvention of TPMs reflects a domestic recognition that TPM use and control are within the genus of IP, so use of, or the right to use, a TPM falls within the standard treaty definition of 'royalties'. Ordinary features of online software delivery — account creation gates, payment-before-access controls, licence keys and activation codes — are, in the ATO's view, capable of constituting ACTPMs, and a distributor's role in issuing licence keys or restricting customer access may indicate use of copyright rights (including authorisation) as well.

Copyright analysis. The copyright discussion has been rewritten to incorporate recent authority — including the High Court's 2023 decision in Real Estate Tool Box v Campaigntrack [2023] HCA 38 and the Federal Court in Take-Two Interactive Software v Anderson (No 2) [2024] FCA 1459 on the meaning of "act comprised in the copyright", and Hytera Communications v Motorola Solutions [2024] FCAFC 168 on the substantiality test for adaptation. The right to publish, previously absent from the draft's list, is now expressly included among the exclusive rights relevant to software intermediation arrangements.

Commercial rental arrangements. In one useful narrowing, the ATO has removed the draft's "commercial rental arrangement" analysis, now considering it "less likely" that a commercial rental arrangement will be found in these arrangements.

Tension with the US/Australia treaty and OECD position

Perhaps the most consequential feature of the Ruling is that the ATO's characterisation is at odds with the mainstream international position, including the position of a key treaty partner. The US Treasury has, both formally and in commentary on the earlier draft, indicated that under the US/Australia treaty and by reference to paragraph 14.4 of the Commentary on Article 12 of the OECD Model, payments by a distribution intermediary that do not carry a right to reproduce, adapt or otherwise exploit the copyright in the software should be treated as business profits under Article 7, not royalties.

The ATO acknowledges paragraph 14.4 but says it "cannot be relied upon where the substance of an agreement or arrangement 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", and that its relevance depends on the domestic copyright law of the country from which the payment is made. In the Compendium the ATO reaffirms that view, stating that the facts assumed in paragraph 14.4 "are usually not present in modern software intermediation arrangements".

The practical consequence is straightforward. Payments that the US regards as business profits will, on the ATO view, be subject to Australian royalty withholding tax — with no matching US foreign tax credit and, therefore, a real risk of double taxation. It is close to inevitable that impacted multinationals will invoke the mutual agreement procedure (MAP) under the relevant treaty to seek relief. It is difficult to see the US acceding to the Australian position.

An unusual invitation to litigate

The ATO is unusually candid in the Compendium about its appetite to test its position in Court. In response to concerns about the copyright analysis, the ATO expressly states that it is "willing to test our position in the courts". On the alignment concern raised in respect of the US position and MAP, the ATO offers that:

"clarification of law via the Australian court processes is an option available to obtain certainty on the correctness of our view. One benefit may be ascertaining the correct application of Australian law before any mutual agreement procedure."

That approach mirrors what has been seen in the Oracle proceedings, where the Commissioner resisted the taxpayer's ability to access treaty relief in order to secure domestic judicial guidance on the underlying characterisation issue. It is an approach that raises real questions of persuasiveness in a bilateral context. It is difficult to see why a competent authority — in particular, the US competent authority, where the US Treasury's written objections to the ATO's position have been public since the draft — would treat a favourable Federal Court or even High Court decision as compelling for MAP purposes. Australia's willingness to litigate does not solve the double taxation exposure; it more likely than not simply displaces it into a longer, more expensive dispute cycle.

What multinationals should be doing now

Impacted groups should be considering, as a matter of priority:

• Mapping cross-border payments made by Australian intermediaries against the new tests, including for prior periods now covered by retrospective application.
• Reviewing contractual documentation — including whether legacy characterisations of payments as "royalty-free", "distribution fees" or "resale margins" will withstand the ATO's objective purpose-based enquiry, which now expressly draws on PepsiCo.
• Assessing exposure to a full-royalty rather than apportioned outcome, given the ATO's stated view that in most software intermediation arrangements the IP rights granted will be inseparable from other rights.
• Considering MAP and, where relevant, competent authority engagement early — particularly for US-parented groups given the US Treasury's stated position.
• Modelling gross-up risk under existing distribution contracts, and reviewing whether Australian withholding costs will be borne locally or passed back to the IP owner.
• Reviewing TPM and cloud/SaaS delivery architectures in light of the expanded ACTPM commentary.
• Considering restructuring — noting the ATO's caution in the Compendium that the application of general anti-avoidance provisions to unseen arrangements is beyond the scope of the Ruling.