I believe it works in the digital domain, which means it will degrade quality. I run my AppleTV's via their optical out to an external DAC. My (possibly wrong) understanding is that if something at the source decreases volume through the source's digital output, it is doing it digitally.
Having said that, when using the AppleTv's volume control for modest volume attenuation, I don't hear any significant sound quality degredation. That said, I only use the AppleTV's volume control in my second system, which is not the final word on resolution.
Having said that, when using the AppleTv's volume control for modest volume attenuation, I don't hear any significant sound quality degredation. That said, I only use the AppleTV's volume control in my second system, which is not the final word on resolution.