The challenges of software distribution payments: a tax perspective

Indonesia’s digital economy is growing rapidly, but uncertainty in tax rules for software distribution continues to create major challenges. Several companies have faced significant tax adjustments, largely due to disputes over how payments are characterized—whether as redistribution income or intellectual property (IP) exploitation.

Globally, both OECD and non-OECD member states generally treat redistribution payments as ordinary business income rather than royalties. Indonesia’s current guidance on software payments may be subject to differing interpretations, potentially affecting tax outcomes and cash flow for software distributors.

Advance pricing agreements (APAs) may provide interim stability by allowing taxpayers and the tax authority to agree in advance on characterization and pricing. However, they are not a permanent fix. For CFOs and business leaders, the priorities are clear: understand how your software transactions are classified, assess whether an APA may mitigate risk, and actively engage in shaping Indonesia’s evolving tax and transfer pricing framework.

Why Indonesia’s software distribution rules pose both tax and transfer pricing challenges

Indonesia’s growing digital economy offers significant opportunities for technology companies expanding their markets and distributing software across borders. At the same time, rising scrutiny from the tax authority makes it essential for businesses to understand how their transactions are characterized. Getting this right can avoid costly disputes, protect cash flow, and support long-term growth.

Beyond the legal definition, characterization directly affects transfer pricing. How a software transaction is defined determines the pricing method applied, the profit level expected in Indonesia, and ultimately how value is allocated across group entities. When the characterization itself is unclear, transfer pricing analyses become inconsistent, leading to disputes on both the nature of income and the margin or return expected.

With rapid digitalization, Indonesia has witnessed a significant increase in cross-border software distribution. As recent Indonesian tax court cases show, disputes in this area are also rising. Some distributors have faced recurring adjustments, sometimes a large share of annual revenue, due to differing interpretations of what constitutes a royalty versus a business profit.

The root issue is the lack of a clear legal distinction between transactions involving the use or right to use intangibles and those intended purely for resale or distribution. This gap leads to practical problems, including incorrect withholding tax, mischaracterization of entities, cash flow disruptions, and double taxation¹.

Amidst the current domestic regulatory framework, which has yet to specifically address certain digital transactions, an important question arises: how prepared is Indonesia to address the tax and transfer pricing complexities of digital transactions? This article aims to clarify how software-related payments should be treated, and whether they are more appropriately considered as conventional royalties or as distribution profits.

Distinguishing redistribution payments from IP exploitation

Software is distinctive because it can take the form of both a digital product and a service, that is, a copyrighted article or a copyright itself. Its applications range from basic interfaces to complex enterprise systems and programs.

The characterization of software payments depends on the purpose and scope of the rights transferred². Where the rights allow reproduction, exploitation, or further development, a payment is considered a royalty. Where rights are limited to redistribution without modification or exploitation, a payment should instead be treated as business income³.

The distinction can be summarized as follows:

From a transfer pricing perspective, this distinction is not just theoretical. A redistribution model typically involves a limited risk distributor earning a routine margin benchmarked under the resale price method. In contrast, where exploitation rights are granted, the analysis shifts to a royalty-based framework, often benchmarked using the comparable uncontrolled transaction method. In practice, when the underlying characterization is uncertain, tax authorities may apply royalty-based markups to distributor-type activities, creating mismatches and excessive adjustments.

This distinction has immediate tax and transfer pricing implications. Royalties are generally subject to withholding tax, while business income is typically taxed under corporate income tax. Divergent classification by the source jurisdiction and the residence jurisdiction may lead to mismatches, creating risks of double taxation.

Mischaracterization may also result in inappropriate application of transfer pricing methodologies. In practice, some software distributors in Indonesia have been asked to benchmark their arrangements against license agreements tied to net sales—an approach that is often impractical and inconsistent with their business reality.

This is where transfer pricing becomes both a tool and a test, ensuring that margins reflect real functions performed in Indonesia, not just labels applied to payments.

Case law insights from Australia, India, and Malaysia

The OECD commentary on the mode tax treaty is clear: payments for the right to use or distribute software, without the right to reproduce, adapt, or otherwise exploit the underlying IP should be treated as business profits not royalties⁴.

Court decisions in Australia, India, and Malaysia spanning both OECD and non-OECD member states reinforce this view.

Australia: Distribution fees treated as business profits

As an OECD member state, Australia has expressly adopted the OECD commentary.

The Australian Tax Office in draft taxation ruling TR 2024/D1 titled Income tax: royalties—character of payments in respect of software and intellectual property rights issued on 17 January 2024 considers that, under paragraph 14.4 of the OECD commentary, payments made by a distribution entity that merely resells software without exploiting the underlying IP should be treated as business income, not royalties⁵. As at the date of publication of this article, TR 2024/D1 has not yet been finalized but generally the final version of a taxation ruling would not be expected to deviate significantly from the draft version.

India: Distribution fees represent ordinary business profits

India, as a non-OECD member state, has also drawn on OECD guidance.

In a 2021 Supreme Court ruling, the court observed that once IP is embedded in a tangible medium (such as books, CDs, or software), the product should be treated as goods subject to sales tax⁶.

This view was held on the grounds that the IP was incorporated into the goods for the purposes of transfer, i.e., what the buyer purchases and pays for is not the disc or CD but the content.

Based on this reasoning, payments received by the licensee to redistribute did not constitute royalties under either the Income-tax Act, 1961 or applicable tax treaties, but instead represented ordinary business income.

Malaysia: Distribution fees not royalties

Malaysia, although not an OECD member state, has shown alignment with OECD interpretations.

In a 2018 decision, the High Court ruled in favor of the taxpayer, holding that software distribution fees constituted business profits under article 8 of the Malaysia-Netherlands tax treaty⁷.

The High Court held that the distribution fee would not fall under the definition of royalties in the treaty, given that the agreement only granted the taxpayer the right to distribute software copies in Malaysia, and there was no element of proprietary rights or know-how being granted or transferred to the taxpayer. Accordingly, the distribution fee paid under the software distribution agreement was not considered a royalty and was not subject to royalty withholding tax.

This position was also reinforced by the Special Commissioners of Income Tax, and by a series of decisions of the Federal Court and Court of Appeals.

The approaches taken by Australia, India, and Malaysia demonstrate broad consensus: software distribution payments that do not involve exploitation of IP should be treated as business income, not royalties. Without clear domestic guidance, there could be potential inconsistency, prolonged disputes, and potential double taxation. Aligning with global standards would not only reduce uncertainty but also strengthen Indonesia’s credibility in handling digital economy transactions.

Using APAs to manage transfer pricing risks in software distribution

As Indonesia works toward clearer rules on the characterization of software payments, taxpayers still require interim solutions to manage recurring disputes. One available mechanism is the APA⁸.

For taxpayers engaged in software distribution arrangements with related parties, an APA offers a structured forum to agree with the Indonesian tax authority the appropriate treatment and pricing of their software distribution transactions. In accordance with PMK-172 of 2023, an APA allows taxpayers to agree on the methodology and pricing policy, including characterization of their transactions for the next five years, as well as rollback for certain years subject to meeting specified conditions. It also promotes transparency and discussion around digital business models that may not fit traditional frameworks.

While APAs can be a practical way to stabilize pricing outcomes, they cannot on their own resolve the more fundamental question of whether a payment is a royalty or a business profit. The characterization must first be agreed upon before the APA can address the pricing of that transaction.

Future outlook and conclusion

While the APA is a useful interim tool, relying on it alone to resolve software distribution disputes is not sustainable. Long-term certainty requires regulatory reform.

For Indonesia to sustain digital growth, attract investment, and advance its OECD accession, the Indonesian tax authority must align its tax and transfer pricing framework with international standards⁹. Such alignment would not only strengthen Indonesia’s standing among G20 economies but also give taxpayers the predictability they need to operate and invest with confidence.

This brings us back to the central question posed at the beginning of this article: is Indonesia ready to support the growth of its digital economy? At present, gaps in clarity create recurring disputes and discourage investment.

The way forward lies in proactive engagement. By working with the tax authority, digital businesses have an opportunity to shape a modern, internationally aligned framework that reflects today’s realities. If exploited correctly, it will reduce disputes, attract investment, and position Indonesia as a competitive hub for digital innovation in the region.

For policymakers, this overlap between tax characterization and transfer pricing highlights a deeper challenge. Indonesia’s TP framework must evolve in tandem with its direct tax rules so that the two speak the same language on digital transactions. Without such alignment, even well-intentioned reforms risk creating parallel interpretations—one from a treaty or withholding tax standpoint and another from a transfer pricing perspective. A harmonized approach would bring consistency, reduce disputes, and support Indonesia’s credibility as it aligns with OECD standards.

For CFOs and business leaders, three immediate steps stand out: review how software payments are currently characterized, evaluate whether an APA can provide interim certainty, and engage in dialogue to help shape Indonesia’s digital tax future.

¹ Under Law Number 7 of 2021 (the Law on the Harmonization of Tax Regulations), the term “royalty” refers to any payment made as compensation for the use of or the right to use various forms of IP or technical rights (this includes copyrights, patents, and know-how, and extends to support services related to these rights). The definition of royalty under Indonesian domestic tax law slightly differs from that in the OECD model tax treaty, which classifies the alienation of IP as a capital gain rather than a royalty.

² The OECD model tax treaty defines royalties as “payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematographic films, any patent, trademark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience.”

³ The primary difference between software royalties and business income lies in the purpose of the acquisition itself. Royalties are paid when the licensee intends to commercially exploit the IP, such as via licensing, without reproduction or modification. Simply using or distributing the software does not qualify as a royalty payment.

⁴ Paragraph 14.4 of article 12 of the OECD commentary, concerning the taxation of royalties, states “Arrangements between a software copyright holder and a distribution intermediary frequently will grant to the distribution intermediary the right to distribute copies of the program. … Thus, in a transaction where a distributor makes payments to acquire and distribute software copies, the rights in relation to these acts of distribution should be disregarded in analysing the character of the transaction for tax purposes. Payments in these types of transactions would be dealt with as business profits in accordance with article 7. This would be the case regardless of whether the copies being distributed are delivered on tangible media or are distributed electronically (without the distributor having the right to reproduce the software), or whether the software is subject to minor customisation for the purposes of its installation.” (emphasis added) (Commentary on Article 12: Concerning the Taxation of Royalties | READ online (oecd-ilibrary.org)

⁵ The Australia Tax Office (ATO)’s Draft Tax Regulations entitled “Income tax: royalties in the character of payments with respect to software and intellectual property rights” (TR 2024/D1 or the Decision) discusses the interpretation of commentaries on paragraph 14.4. As of the time this article was drafted, the finalization of TR 2024/D1 remains on hold but generally the final version would not significantly deviate from the draft version. 2024.03.01ITIcommentonATOdrafttaxationruling(TR2024D1).pdf).

⁶ International Tax Review. (2025). Deep dive: Indian Supreme Court’s ruling on software licensing fees. Retrieved from https://www.internationaltaxreview.com/article/2a68rfy5bw2ycq1ybghlc/deep-dive-indian-supreme-courts-ruling-on-software-licensing-fees

⁷ Orbitax. (2025). Malaysian Court Holds Software-Related Tax Position. Retrieved from https://orbitax.com/news/country/article/Malaysian-Court-Holds-Software-32734

⁸ The technical definition of an APA as per the latest regulation (PMK-172 of 2023) is “[…] a written agreement between the Director General of Taxation and the Taxpayer or the Double Taxation Avoidance Agreement Partner Tax Authority. It pertains to taxpayers within its jurisdiction as specified in Article 18 paragraph (3a) of the Income Tax Law, and aims to agree upon the criteria for Transfer Pricing Determination and/or to pre-approve the arm’s length price or profit.”

⁹ OECD. (2025). Indonesia reaches key milestones in OECD accession process. Retrieved from https://www.oecd.org/en/about/news/press-releases/2025/06/indonesia-reaches-key-milestones-in-oecd-accession-process.html