What are royalties? Definition, types and payment terms

Published Tuesday 21 April 2026

Table of contents

• What are business royalties?
• Types of royalty payments
• How to apply the royalty payment cycle
• Factors affecting royalty rates
• Understanding royalty agreements
• Tax implications of royalties for business
• FAQs on royalties

Key takeaways

• Recognize that royalties are ongoing payments based on usage or sales, making them a reliable source of income for asset owners while giving licensees access to valuable intellectual property without buying it outright.
• Structure your royalty agreement carefully by defining the asset, usage rights, payment terms, territory, and duration upfront, as renegotiating after signing is only possible if both parties agree or the contract includes a review clause.
• Track and document all royalty payments accurately, whether you are the licensor or licensee, since royalties are taxable income for the licensor and typically tax-deductible for the licensee, with additional withholding obligations applying to payments made to foreign residents.
• Get a lawyer to review any royalty agreement before signing, as these contracts are legally binding, financially significant, and can have long-term consequences for both parties if terms are unclear or incomplete.

What are business royalties?

Royalties are payments made to asset owners for the right to use their property, typically intellectual property. As the High Court of Australia has described the essence of a royalty in ATO Interpretive Decision IT 2660, they're usually calculated as a percentage of revenue or a fixed fee per unit sold. Royalties provide ongoing income for licensors while giving licensees access to valuable assets without full ownership.

Key elements of royalty payments include:

• Payment structure: a percentage of revenue or fixed fee per unit
• Licensor: the asset owner who receives royalty payments
• Licensee: the party who pays to use the asset
• Common assets: patents, trademarks, copyrights, and franchise systems

Royalty agreements are most common in industries dealing with intangible assets (where a business will self-assess the effective life for tax purposes, as outlined in the Treasury's intangible asset depreciation guidance), including:

• Technology: software patents and proprietary systems
• Publishing: books, articles, and written content
• Entertainment: music, films, and digital media
• Franchising: brand identities and business models

Types of royalty payments

Royalties come in different forms depending on the nature of the asset and business model. Understanding which type applies to your situation helps you structure agreements correctly.

Franchise royalties

Franchise royalties are payments franchisees make to franchisors for the right to use their business model, branding, intellectual property, and operational systems. The franchise model is popular in fast food; 93% of McDonald's restaurants are franchised, for example.

Franchisees usually pay royalties as a percentage of their gross or net revenue, although some agreements use flat fees.

Learn more about franchises.

Intellectual property royalties

Intellectual property royalties are payments licensees make for the right to use or sell protected assets like patents, trademarks, and copyrighted works. They're common in tech and manufacturing, while copyright royalties appear frequently in publishing, music, and film.

Examples include:

• a tech company licensing patented software
• an author licensing their work to a publisher

Licensing royalties for creative works

Licensing royalties for creative works apply to music, films, artwork, writing, and other creative mediums. Instead of selling the work outright, creators earn royalties when businesses pay to use these works in advertising, entertainment, or product design.

Examples include:

• a song licensed for a TV advertisement
• illustrations licensed for a children's book

How to apply the royalty payment cycle

The royalty payment cycle guides you through establishing and managing ongoing licensing relationships, ensuring accurate payments, that you communicate clearly, and that you comply with legal requirements throughout the agreement.

1. Establish a royalty agreement

Establish a royalty agreement by negotiating terms and creating comprehensive documentation. A well-drafted agreement protects both parties and prevents disputes.

Essential agreement elements:

• Asset definition: clearly identify what's being licensed
• Usage rights: specify how the asset can be used
• Payment structure: define rates, timing, and calculation methods
• Territory and duration: set geographical and time limitations

Practical ways to negotiate a stronger contract:

• Include a performance-based termination clause: This lets you end the arrangement if the asset doesn't meet agreed targets, protecting you if revenue falls short.
• Define territorial rights clearly: Specify the countries, regions, and channels (online or offline) covered by the licence.
• Address exclusivity upfront: If the licensee wants exclusive rights, the licensor can negotiate better terms.
• Set the contract duration strategically: Longer deals provide stability, while shorter ones let licensors renegotiate terms sooner.

Learn more negotiation strategies.

2. Define the payment terms

Payment terms establish how royalties will be calculated and collected. Clear terms prevent misunderstandings and ensure predictable cash flow.

Common royalty structures:

• Percentage of revenue: A fast-food franchisee pays 5% of net sales.
• Fixed fee per unit: An author earns $5 for every ebook sold.
• Usage-based: A band receives payment each time their song is streamed.

If you're the licensor, look beyond the payment amount. Consider how often you'll receive royalties and how long you'll wait each payment cycle, as both affect your cash flow.

3. Track your usage or sales

Tracking usage or sales is the licensee's responsibility. Accurate tracking builds trust and ensures correct payments.

The licensee records how much revenue the asset generates and reports to the licensor on a schedule set by the contract, typically monthly or quarterly. This transparency helps both parties understand where the numbers come from.

4. Calculate your payments

Calculating payments involves applying the agreed payment structure to tracked usage or sales data. The licensee calculates what's owed based on the contract terms.

Several factors can affect the final amount:

• Minimum guarantees: a fixed amount paid to the licensor regardless of performance
• Advances: upfront payments later recouped from future royalties
• Deductions: adjustments for returns and refunds
• Escalators: higher royalty rates that apply after sales reach an agreed threshold

5. Make payments

Making payments happens according to the agreed schedule. The licensee may issue a royalty statement or ask the licensor to raise an invoice (see accounts receivable) so the transaction is documented. You can use one of Xero's free invoice templates.

6. Auditing and compliance

Auditing and compliance provisions give the licensor the right to audit the licensee's records, either on request or at set intervals. This ensures payments are correct and reassures the licensor that they're receiving what was agreed.

Factors affecting royalty rates

Royalty rates depend on market conditions and contractual factors that determine an asset's commercial value. Several key factors influence the rates you can negotiate:

• Industry standards: established rate ranges within specific sectors
• Asset value: higher-value assets may command stronger economic terms
• Negotiating power: strong brands or proven sales records improve terms
• Exclusivity: exclusive licences often command stronger financial terms than non-exclusive licences
• Market demand: popular or anticipated assets can charge higher rates

Understanding royalty agreements

Royalty agreements are legally binding contracts that require you to prepare carefully to protect both parties. Australia has tax treaties with over 40 countries (see ATO guidance on withholding from royalties paid to foreign residents). If a conflict arises between domestic tax law and a double tax agreement, the agreement's definition will override local law, as explained in ATO Interpretive Decision IT 2660.

Get legal advice

Both parties should ask a lawyer to review the contract before signing.

• Licensees (who typically draft the agreement) need to ensure the contract is legally compliant and accurately reflects the agreed terms.
• Licensors need to understand each clause fully and confirm their rights, payments, and protections are clearly outlined.

Tax implications of royalties for business

Tax treatment of royalties affects licensors and licensees differently based on their role in the agreement, particularly when paying foreign residents without a tax treaty, where the withholding rate will be 30% (see ATO guidance on withholding from royalties).

For licensors (receiving royalties):

• Income tax: royalties are typically taxable income
• Reporting: declare payments on your tax return and maintain detailed records
• Deductions: claim expenses directly related to creating or maintaining the licensed asset

For licensees (paying royalties):

• Business expenses: royalty payments are usually tax deductible as business expenses
• Withholding obligations: you may need to withhold tax when paying foreign residents
• Record keeping: maintain contracts and payment records for tax purposes

Consider consulting a tax professional to understand your specific obligations based on your industry, the type of royalty, and whether international payments are involved.

FAQs on royalties

Here are answers to common questions about royalties and royalty agreements.

What's the difference between royalties and licensing fees?

Royalties are ongoing payments based on usage or sales, while licensing fees are typically one-time or periodic fixed payments for the right to use an asset. Royalties align the licensor's income with the licensee's success.

How do I determine a fair royalty rate?

Research industry standards for your asset type, consider the asset's value and market demand, evaluate your negotiating position, and factor in whether you're offering exclusive or non-exclusive rights. Professional valuation may help for high-value assets.

Can I negotiate royalty terms after signing an agreement?

You can only renegotiate if both parties agree or if the contract includes review clauses. This is why it's important to include renegotiation provisions or contract review dates when you first draft the agreement.

What happens if a licensee doesn't pay royalties on time?

Your royalty agreement should specify remedies for late payment, which may include interest charges, penalties, or termination rights. You may need to audit their records or take legal action to recover unpaid royalties.

Do I need a lawyer for every royalty agreement?

While not legally required, professional legal advice is strongly recommended for royalty agreements. These contracts are complex and have long-term financial implications, so having a lawyer review the terms protects your interests.