Australia doubles down on a contested software royalty position

A US vendor selling $50 million a year into Australia through a local reseller is paid $45 million under the distribution agreement. If the entire $45 million payment were treated as a royalty and the recipient qualified for an assumed 5% treaty rate, the resulting withholding would be $2.25 million. If that cost were economically borne by the reseller, it would equal three quarters of its stated $3 million profit before considering any contractual gross-up. If the vendor's home country treats the receipt as business profits, it may deny a foreign tax credit for the Australian tax. That is the potential effect of the ATO's September 4, 2026 package, which closes a five-year guidance cycle without moving off a position that departs from the OECD Commentary and that the US Treasury has twice objected to. For modern subscription, download and cloud distribution models, the ATO's proposed pathways to a low-risk position without a recognized royalty are narrow and highly fact-dependent. The harder problem is not reading the treaty. It is that legal, procurement, tax, transfer pricing, accounts payable and treasury each hold part of the facts, and the payment can go out before anyone has put them together.

Executive summary

The Australian Taxation Office released three documents on September 4, 2026: final Taxation Ruling TR 2026/2 on payments under software intermediation arrangements, draft Practical Compliance Guideline PCG 2026/D4 setting out a five-zone compliance-risk framework, and a Decision Impact Statement on the Full Federal Court's decision in Oracle Corporation Australia Pty Ltd v Commissioner of Taxation. The first reaches payments already made. The second signals who is likely to be reviewed. The third confirms the mutual agreement procedure is a real pathway, and that the characterization question itself is still unresolved.

TR 2026/2 keeps the broad, rights-based view the ATO first advanced in draft TR 2021/D4. A payment may be a royalty where performance of the arrangement involves the grant or use of copyright or other intellectual property rights, including rights that are implied rather than expressly identified. It adopts the causal connection requirement from the High Court's decision in Commissioner of Taxation v PepsiCo Inc [2025] HCA 30 and reaches payments made before as well as after September 4, 2026. Royalty withholding tax is imposed under section 128B of the Income Tax Assessment Act 1936, and the obligation to withhold falls on the Australian payer.

For enterprise implementation, draft PCG 2026/D4 may be the more immediately consequential document. Its main test for a recognized royalty depends on cost data from the parent's ledgers. Many subscription arrangements in which no royalty is recognized are likely to fall into amber, the second-highest of its five risk zones, on the draft's own indicators. The guideline is still in draft, and its thresholds may change. The legal question will be argued for years. The operational question, how a group applies one defensible position consistently to every payment it makes under these arrangements, has to be answered now: be decisive about controls and qualified about the law.

How Australia got here

Australia followed the international approach under TR 93/12 until it withdrew that ruling on July 1, 2021. Drafts TR 2021/D4 and TR 2024/D1 followed, and the ATO held its position even after the taxpayer won Commissioner of Taxation v PepsiCo Inc in the High Court in August 2025. Paragraph 14.4 of the OECD Commentary on Article 12 says a distributor's payment to the software owner is not a royalty, whether the software arrives on disc or by download. The ATO accepts that the example may apply to many arrangements, but says it cannot be relied on where a distributor can make software available for download without further action by the software owner, which is how much software is now delivered. The US Treasury has objected twice: the US treats the payment as business profits rather than a royalty, which is why a US credit for the Australian tax may not be available.

The ruling now points at the intermediary

The final ruling narrows its stated scope and widens its practical reach at once. It is not directed at payments by end users, which helps enterprise customers buying for their own use and does nothing for the intermediary, now the express subject of the ruling. Copyright remains at the center of the analysis, and the ATO maintains that the rights attaching to technological protection measures may fall within the "other like property or right" limb of the royalty definition, which puts license keys and passwords in scope on its reading.

The authorization analysis is where most distribution models are caught. On the ATO's view, a distributor can authorize an end user to reproduce software simply by enabling the download and installation, and does not need to hold that right itself. The ruling's Example 3 applies this to an Australian subsidiary distributing its parent's accounting software to customers who cannot use it until the files are copied onto their device and installed. The conclusion does not turn on whether the rights are express or implied, who provides the license key, or where the software is hosted.

For cloud and software-as-a-service, the same logic runs through communication to the public, the copyright owner's right to make a work available to an audience: more than one entity can be responsible, and the local intermediary can be one of them where it contracts with the customer and sets the terms of access.

Five risk zones, and why many reseller models may land in amber

PCG 2026/D4 does not decide the law. It signals where the ATO will spend review resources, sorting arrangements into five zones that run from white (no further risk assessment) and green (low risk) through yellow (less likely to be reviewed) and amber (prioritized for review) to red (a candidate for audit). A zone rating does not decide whether a characterization is correct. In practice, though, the zones are likely to become the benchmark.

An arrangement is amber where the Australian entity sells Australian customers products or services that comprise, or substantially involve, access to or use of software whose IP rights are held by the offshore supplier, and any one of these applies:

• the agreements with the offshore supplier refer to or permit use of that software, however the rights are described, including as limited, restricted or royalty-free;
• Australian customers need the use of, or a license or right to use, that software in order to use the products or services; or
• Australian customers need access to the software and that access is protected by security features such as a key code, password or copy protection.

Those conditions may describe the architecture of many subscription, cloud and software reseller arrangements. Read on their terms, they can reach subscription and cloud arrangements in which the Australian entity has no ability to copy or alter the software at all. An arrangement is also amber where the taxpayer has not self-assessed its zone, or cannot produce evidence explaining the self-assessment it did (paragraph 44). An amber arrangement moves to red where any of these is present:

• the entity makes copies of or modifies the offshore supplier's software in the course of selling to Australian customers, or has the right to do so, or authorizes others to do so;
• a royalty was previously paid under the same or a similar arrangement; or
• the offshore recipient is in a jurisdiction on the ATO's specified list, or has tax concessions, losses that shelter its income, or hybrid status.

There are three ways out of amber. First, a few arrangements reach green with no royalty at all, but the category is narrow: off-the-shelf software bought for the business's own use, firmware built into hardware, and resale of copies with no further copying, customization or related services, sold on physical media or for a one-time fixed price. Second, the group can recognize a royalty, report it, document how it was set and withhold tax on it. That reaches green if the royalty is at least half the total payment or, where the supplier is related, at least 75% of the residual amount explained below. A smaller royalty can still reach yellow. The 75% figure is still draft and will be confirmed after consultation. Third, an operating margin exception moves an amber or red arrangement to yellow if the Australian entity's margin is above 10%, or within 10 percentage points of the global group's margin. These thresholds set review risk; they do not decide the legal answer or the arm's-length price.

The residual amount is the payment less specified offshore supplier costs:

• Included: the offshore supplier's manufacturing, intermediation and distribution costs in relation to sales to the Australian entity, for example infrastructure, sales and marketing, third-party royalty expense and direct labor, plus a 5% mark-up.
• Excluded: royalties the offshore supplier pays to its own related parties, such as a group IP-holding company, amortization of intangibles, stock-based compensation, and any cost not related to sales to the Australian entity.

The formula is simple; the data is the hard part: self-assessing a zone needs the parent's cost data, allocated to Australian sales on a reasonable basis with the working papers kept. The guideline accepts that a cost base built on a reasonable, best-efforts basis may not be precise, which is a more forgiving standard than the exercise first appears to demand.

What it means if you sell through an Australian intermediary

The exposure does not depend on how the vendor describes the relationship. It depends on what the Australian entity does in front of the customer: it signs the contract and sets the terms of access, it hands over the credentials, it gates access behind a license key or password, and it pays a single fee with no royalty carved out. Each is a risk indicator rather than a defense, and many arrangements have all four.

The commercial consequences follow from the economics rather than the law. Withholding is charged on the payment, not on margin, so on a low-margin arrangement it can exceed the intermediary's entire profit. Apportionment is available in principle, on a fair and reasonable basis, but the ruling's own reasoning narrows it: where the IP rights are inseparable in a practical and business sense from everything else the payment buys, the whole payment may be consideration for those rights (TR 2026/2 paragraphs 17, 74 and 75, citing the IBM Corporation case). That is why the withholding base can be the entire payment rather than a slice of it. Intercompany agreements often have a gross-up clause written for service fees, and it may not cover royalty withholding, which leaves open who bears the tax. The exposure also reaches back in time. The ruling applies before and after its date of issue, and reliance on TR 93/12 is preserved only for periods before that ruling was withdrawn on July 1, 2021 (TR 2026/2 paragraphs 37 and 38). An arrangement not revisited since then carries unprotected exposure across the whole window from July 2021 to September 2026.

A worked example

Assume a US software vendor sells subscriptions in Australia through a wholly owned reseller of record. The reseller contracts with customers, bills $50 million a year, provisions the credentials, and pays the parent $45 million, a 90% payout, under an agreement that recognizes no royalty. Local costs are $2 million, so it earns $3 million, a 6% margin. Offshore supplier costs allocable to Australian revenue are $30 million, giving a residual amount of $13.5 million after the mark-up. Assume a 5% treaty rate on royalties, against the 30% domestic rate that applies without treaty relief. The example is illustrative: it assumes treaty eligibility and the stated cost allocation, and does not establish the legal or arm's-length result.

The table calculates withholding at the stated rate (5%, or 30% in the no-treaty row) on the stated payment or royalty amount. It compares the resulting cash amount with the reseller's profit solely to illustrate materiality. Any contractual gross-up would require a separate calculation. On the stated facts, the arrangement appears to meet one or more amber indicators. The 6% local margin is below the 10% threshold, but the alternative comparison with the global group margin cannot be evaluated without the group's actual margin data.

Two points follow. Under the illustrative assumptions, recognizing a royalty the group can support narrows the withholding base from the entire payment to the royalty itself, provided the amount can be defended on transfer pricing grounds. And where the vendor's home jurisdiction treats the payment as business profits rather than a royalty, the tax may become a permanent cash-tax cost if usable foreign tax credit relief is unavailable.

Structure and transfer pricing

The first instinct is to change the structure. Three moves come up, and none of them is clean:

• Contract offshore: leave the Australian company to market and support. This may remove the existing intercompany distribution payment, but it creates a different characterization and operating-model analysis. Local revenue disappears from Australian accounts, invoicing and goods and services tax registration change, and the offshore entity's Australian activity has to be tested against permanent establishment thresholds. The draft guideline cites this very restructure as one the general anti-avoidance rules, including the multinational anti-avoidance law, may catch.
• Split the agreement: the Australian entity sells services and the parent licenses directly. This may contractually isolate the licensed and service elements, although the ATO may still examine the arrangement as a whole and compare the drafting with actual conduct. The authorization analysis may still reach the entity that provisions access, and on the ruling's Example 3 it does not matter who provides the license key or where the software is hosted.
• Convert to cost-plus services: a common defensive answer. A genuine conversion may remove the existing distribution payment. It does not by itself determine the treatment of every related payment or activity. The likely price is the operating model, since pricing authority, customer contracting and revenue recognition typically move offshore.

None of them is a safe harbor. A zone rating does not protect a restructure. Where an arrangement has been reorganized to reduce the withholding charge, the ATO reserves the right to review it regardless of the zone it lands in, and to apply the transfer pricing rules and, where the commercial reason for the change is not evidenced, the anti-avoidance rules. The harder problem is that the compliance grid and transfer pricing pull in opposite directions on the same number. The green zone rewards a larger recognized royalty: the arrangement above needs about $10.1 million to clear 75% of the residual amount. Transfer pricing requires that royalty to be arm's length on its own analysis, and the residual amount in the guideline is a compliance measure, not a benchmark. A group that raises the royalty to reach green has to defend the higher figure on comparables; a group that sets it from comparables, below the threshold, may land in yellow and have the amount reviewed. Documentation prepared for one purpose is unlikely to answer the other.

Then there is the question of who carries the unrelieved tax. If the Australian entity bears it, the tax depresses a margin the group has already benchmarked, which may invite a transfer pricing adjustment on top of the withholding. If it is pushed into a principal company's cost base or absorbed by the parent, the intercompany agreements and cost allocation need to say so before an assessment arrives. Either way, the charge belongs in effective tax rate forecasting, and, where a foreign tax credit is genuinely uncertain, in the tax provision.

From tax analysis to decision orchestration

The sections above describe four separate analyses of the same payment, each usually owned by a different function. Answering one does not answer the others.

The facts that decide each analysis sit in different places: the contract with legal and procurement, the customer terms with sales, the cost data with the parent's finance team, and the payment with accounts payable and treasury. The ATO can be expected to test whether contracts, customer terms, conduct, payment flows and transfer pricing documentation tell one consistent story. That does not happen by memo. It needs one governed workflow, applied to every recurring payment under the arrangement:

• Orchestrate: characterize the payment, apply domestic and treaty rules, quantify the exposure, escalate uncertain cases, route approvals, generate the documentation, and release or hold the payment.
• Monitor: flag changed facts, expired treaty documentation, inconsistent classifications, unsupported overrides and payments that bypass review.
• Evidence: keep the facts, authorities, calculations, approvals, exceptions and final disposition in a reproducible audit trail, which is what a zone self-assessment under paragraph 44 has to rest on.

What to do now

TR 2026/2 is already final and reaches payments made before September 4, 2026, so none of this waits on the consultation. Eight things are worth starting now.

1. Create one record for each Australian arrangement, shared by legal, procurement, tax, transfer pricing, accounts payable and treasury.
2. Self-assess the zone on the draft's own indicators and record the reasoning, keeping the legal characterization separate from the zone assessment. The amber criteria are factual questions, not a judgment call.
3. Establish whether the offshore cost data needed for the residual amount calculation exists in a form that can be allocated to Australian revenue and defended. If it does not, that is a systems problem with a long lead time.
4. Quantify the withholding, gross-up and foreign tax credit exposure, and test the operating margin exception against actual Australian and global group margins, since, outside the narrow green categories, it is the only exit that does not require recognizing a royalty.
5. Read the customer-facing facts against Example 3 and confirm that the agreements, the customer terms, the money and the transfer pricing file all describe the same arrangement. Decide early how you would respond if the ATO challenges the position.
6. Before the next payment, define the escalation criteria, approval owners, payment holds, evidence requirements and permitted overrides.
7. Price any restructuring option against the operating model it costs, and test whether a royalty set to reach the green zone is defensible on comparables.
8. Watch for the final guideline. The 75% threshold may change after consultation, so a self-assessment built on the draft should be rerun once the final version issues.

Until the legal and treaty issues are resolved, the exposure has to be managed payment by payment.

Where TaxRay fits

TaxRay is built for that part of the problem. It is designed to support a governed workflow from transaction intake through characterization, treaty analysis, escalation and approval, with integration into enterprise processes for payment release or hold, and keeps the audit trail a zone self-assessment has to rest on, so the position the tax team has taken is the one applied to every payment. It turns tax advice into an executable, governed and auditable workflow.

In practice, TaxRay's AI agents read distributor, reseller and other intermediary contracts directly to monitor withholding tax exposure under Australian tax law and these latest ATO changes, TR 2026/2, PCG 2026/D4 and the Oracle decision impact statement alike. The platform quantifies the risk in accordance with Australian tax law and ATO guidance across all five risk zones, white, green, yellow, amber and red, rather than a single pass/fail test, and proposes contract language toward a better-supported deal structure, whether that means carving out a defensible royalty, adjusting how access and credentials are granted, or documenting the cost allocation a zone self-assessment depends on.

This article is general commentary on Australian Taxation Office guidance, part of which remains in draft and subject to consultation, and is not tax, legal or accounting advice. No conclusions should be drawn for particular facts without advice on those facts.

Hagit OrenFounder and CEO, TaxRay

Built and ran the global tax function at monday.com through the 2021 IPO, after a decade advising US multinationals on cross‑border structure as a Tax Partner at Herzog Fox & Neeman and Tax Director at Deloitte Israel.

Katie TuckerHead of Tax, TaxRay

Ran the tax department of a listed multinational operating in 17 countries, owning worldwide transfer pricing strategy, ASC 740 and SEC disclosure.