What the ATO’s finalised software royalties ruling & draft guidance means for businesses
11/09/2026
The Australian Taxation Office (ATO) recently issued TR 2026/2, which sets out its view on when payments relating to software and intellectual property rights may constitute royalties for Australian tax purposes. At the same time, the ATO released draft PCG 2026/D4, which provides a practical compliance framework to help taxpayers assess the ATO's likely level of scrutiny for software intermediation and distribution arrangements.
While the ruling sets out the ATO's interpretation of the law, the draft Practical Compliance Guideline is arguably the more important document for many taxpayers because it provides a roadmap for understanding how the ATO intends to allocate its compliance resources. In simple terms, taxpayers can self-assess their arrangements into a risk zone ranging from white (lowest compliance risk) to red (highest compliance risk).
For CFOs, financial controllers, and technology businesses, the key question is often not whether software payments exist, but whether the ATO might consider part of those payments to be royalties that should be subject to royalty withholding tax. The new framework is intended to provide greater certainty around that issue.
Why has the ATO released this guidance?
The framework follows the High Court's decision in PepsiCo and reflects the ATO's view that economic substance and examining the totality of the arrangement may be relevant in identifying an embedded royalty, even where no royalty is expressly stated in the contract.
The guidance currently applies to software intermediation and distribution arrangements, with further schedules expected for other industries and transaction types.
Understanding the risk zones
| Zone | Arrangements falling within the zone |
|---|---|
| White | Limited arrangements that the ATO considers unlikely to present royalty withholding tax concerns (e.g. under settlement agreement, advanced pricing agreement, or previously looked at by the ATO or a court or tribunal). Taxpayers that satisfy the white zone criteria generally do not need to undertake a detailed royalty risk assessment under the framework. |
| Green | Low-risk arrangements, including software acquired for the taxpayer’s own internal business use or straightforward acquisition and resale of software copies without rights to copy, modify, or adapt the software. Also includes arrangements where a royalty is recognised, can be substantiated, is reported for Australian tax purposes, and royalty withholding tax is paid, and either: • the royalty is at least 75% of the residual amount • the royalty amount is equal to or greater than 50% of the undissected payment. If the royalty amount is less than 50% of the undissected payment, then the arrangement falls into the yellow zone. The residual amount is, broadly, the payment to the offshore supplier less the offshore supplier’s costs, with adjustments where relevant. |
| Yellow | Low to medium-risk arrangements, generally where a royalty has been recognised, substantiated and reported, royalty withholding tax has been paid, and the taxpayer can support the methodology adopted, but the royalty amount falls below the green zone thresholds. Arrangements where no royalty is recognised may also fall within the yellow zone if they do not exhibit higher-risk Amber or red zone characteristics. An operating margin exception may also allow an otherwise amber or red zone arrangement to fall into the yellow zone where the offshore supplier’s operating margin exceeds 10% or is within 10 percentage points of the global group’s operating margin. The guidance does not define ‘operating margin’. |
| Amber | Medium to high-risk arrangements, generally where an Australian business sells products or services that substantially involve software owned by an offshore supplier and the contractual arrangements suggest that rights associated with that software are being used in Australia. This may include agreements referring to software rights or arrangements where Australian customers require access to software controlled by an offshore entity. The amber zone may also apply where taxpayers have not undertaken a self-assessment or cannot explain their risk rating. An example based on Example 8 of the draft PCG is discussed later in this article. |
| Red | Highest-risk arrangements, including arrangements where the Australian entity has rights to copy or modify software, similar arrangements previously involved royalty payments that are no longer being made, payments are made to entities in certain low-tax or preferential tax jurisdictions, or other indicators suggest that the arrangement may have been designed to reduce Australian tax outcomes. |
Particular focus on restructures
The draft guidance includes a clear ATO warning on restructures.
The ATO may review changes to contractual or operating structures that reduce or eliminate Australian royalty withholding tax, even where the arrangement otherwise falls within a lower-risk zone. Transfer pricing, MAAL, DPT, and Part IVA may also be relevant.
Multinational groups undertaking software licensing or distribution restructures should therefore consider royalty withholding tax alongside transfer pricing.
Amber Zone example
A foreign software provider licenses ERP software to AU Software Co, an Australian related-party distributor, for supply to Australian customers. The agreement with the software owner grants AU Software Co the exclusive right to market and distribute the ERP software to Australian customers. However, it does not grant AU Software Co the right to make copies of, or modify, the ERP software. AU Software Co enters into customer contracts and receives payments from those customers, while the offshore supplier owns the software and provides the underlying platform and support. AU Software Co does not recognise any part of its payment to the offshore supplier as a royalty for Australian tax purposes.
On the facts in Example 8, the ATO would treat the arrangement as falling within the amber zone. The key risk indicators are that the Australian distributor is selling software-related products or services to Australian customers, the software and associated intellectual property are held offshore, and no Australian royalty has been recognised or subjected to royalty withholding tax.
The example illustrates that, where the relevant software rights and economic value sit offshore but Australian customer-facing activities are carried on locally, the ATO may expect taxpayers to undertake and document a more detailed royalty risk assessment.
By contrast, the risk assessment changes to the red zone where AU Software Co is also granted rights to make copies of, or modify, the ERP software. A red zone outcome may also arise where the software owner is located in a specified jurisdiction, or, generally speaking, is otherwise shielded from tax on the relevant income.
How SW can help
Businesses with cross-border software, SaaS, platform or technology distribution arrangements should review their existing arrangements against the framework. Even where no royalty has historically been recognised, the ATO expects taxpayers to be able to explain and support that position.
SW can assist in the following assessment:
- assessing where your arrangement is likely to sit within the ATO’s risk framework
- whether the undissected payments contain a royalty component
- whether sufficient documentation exists to support your position
- identifying whether practical steps are available to mitigate the relevant royalty withholding tax risk.
The release of TR 2026/2 and PCG 2026/D4 signals that software royalty arrangements will remain an area of significant ATO focus. Early assessment of risk positions and supporting documentation may help reduce the likelihood of future disputes and compliance costs.
