Royalties: What they are, how payments work in business

Published Friday 16 January 2026

Table of contents

• What are royalties?
• Types of royalty payments
• Factors affecting royalty rates
• Understanding royalty agreements
• How royalty payments work in practice
• Tax implications of royalties for business
• Streamline your royalty management with Xero
• FAQs on royalties in business

Key takeaways

• Negotiate comprehensive royalty agreements that clearly define payment structures, usage rights, geographic scope, and termination clauses to protect your interests and prevent costly disputes.
• Implement systematic tracking and reporting processes to accurately monitor sales or usage data, calculate payments according to agreed terms, and maintain detailed records for tax compliance and auditing purposes.
• Factor international tax implications into your royalty arrangements, including withholding taxes and double taxation treaties, and seek professional advice to optimize cross-border licensing agreements.
• Utilize accounting software to automate royalty invoicing, payment tracking, and financial reporting, which streamlines administrative tasks and ensures accurate documentation for tax purposes.

What are royalties?

Royalties are payments made to asset owners for the right to use their property. These payments typically take two forms: a percentage of revenue or a fixed fee per unit sold.

The licensor owns the asset and receives royalty payments. The licensee pays the licensor for permission to use the asset. This arrangement is common in industries like music, technology, and franchising where intangible assets drive business value.

Royalty agreements are most common in industries with intangible assets:

• Music and entertainment: Digital files, streaming rights, and performance licenses
• Publishing: Books, articles, and written content
• Technology: Patents, software, and proprietary systems
• Franchising: Brand identity, business models, and operational systems

Types of royalty payments

Royalties come in different forms, depending on the nature of the asset and the business model. Here are three common types.

Franchise royalties

Franchisees pay royalties to the franchisor for the right to use their business model and its elements, like branding, intellectual property, and operational systems.

The franchise business model is popular in fast food, and 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 in our guide.

Intellectual property royalties

Licensees pay intellectual property royalties for the right to use or sell protected assets like patents, trademarks, and copyrighted works. They’re commonly seen in tech and manufacturing, while copyright royalties are particularly common in the publishing, music, and film industries, with specific tax rules often applying. For example, Canadian tax law requires withholding tax on payments to non-residents for the use of a motion picture film or videotape for television.

Examples include a tech company licensing patented software or an author licensing their work to a publisher and earning royalties in return.

Licensing royalties for creative works

These royalties apply to music, films, artwork, writing, and other creative mediums. Instead of selling the work directly, businesses pay licensing fees to use these works in a different context – often in advertising, entertainment, or product design – such as a song licensed for a TV ad or a publisher licensing illustrations for a children’s book.

Factors affecting royalty rates

Royalty rates depend on specific market and contractual factors that determine an asset’s value:

• Industry standards: Established rate ranges within specific sectors
• Asset value: High-value assets command higher royalty rates
• Negotiating power: Well-known creators and strong distributors secure better terms
• Exclusivity: Exclusive rights typically cost more than shared licensing
• Market demand: Popular or anticipated assets generate premium rates

Learn more about real-world royalty rates.

Understanding royalty agreements

Royalty agreements are legally binding contracts. This means its terms must be clear, transparent, and enforceable so both parties understand what they’re agreeing to, and what happens if the terms aren’t met.

Strong royalty agreements protect both parties and prevent costly disputes. Proper preparation saves time and money throughout the licensing relationship.

• For licensors: Ensure your rights, payment terms, and protections are clearly outlined and enforceable.
• For licensees: Verify the contract accurately reflects your intended use and complies with applicable laws.

Get legal advice

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

• For the licensee, who is likely drafting the agreement, the contract needs to be legally compliant, and accurately reflect the terms of the specific arrangement.
• For the licensor, it’s more about understanding each clause fully and ensuring your rights, payments, and protections are clearly outlined.

How royalty payments work in practice

The royalty payment cycle establishes a systematic process for licensing assets and managing ongoing payments. Understanding each step helps you negotiate better terms and avoid common pitfalls.

This process applies whether you’re licensing your assets to others or acquiring rights to use someone else’s property.

1. Establish a royalty agreement

A royalty arrangement starts with the licensor and licensee negotiating and drafting a formal licensing agreement. A strong contract should outline the asset being licensed, how it can be used, and the structure of the royalty payments.

Contract negotiation strategies help you secure favorable terms and protect your interests:

• Include performance-based termination clauses: Protect yourself from underperforming arrangements by setting clear revenue expectations
• Define geographic and usage scope: Specify exactly where and how the rights apply to avoid future disputes
• Negotiate exclusivity terms: Exclusive rights cost more but prevent competitors from accessing the same assets
• Set appropriate contract duration: Balance stability with flexibility to renegotiate as markets change

2. Define the payment terms

Payment structure selection determines how much you’ll pay or receive and when those payments occur. Choose the structure that best aligns with your business model and cash flow needs.

Three main royalty structures:

• Percentage of revenue: A fixed percentage of sales (example: 5% of net sales for franchisees)
• Fixed fee per unit: A set amount per item sold (example: $5 per ebook copy)
• Usage-based payments: Fees tied to actual usage (example: per-stream payments for music)

If you’re the licensor, look beyond the payment amount. Think about how often you’ll receive the royalties and how long you’ll have to wait each month, both of which would affect your cash flow.

3. Track your usage or sales

The licensee is responsible for royalty reporting and tracking. They record how much revenue the asset generates (so the licensor understands where the numbers come from) and report to the licensor on a schedule set by the contract, such as monthly or quarterly.

Reporting sales in this way improves accuracy and trust, which is an essential part of a strong working relationship between the parties.

4. Calculate your payments

Next, the licensee calculates what royalty revenues are owed to the licensor based on the payment structure and the agreed terms.

Several factors can affect the final amount:

• Minimum guarantees: A set amount the licensor is paid regardless of performance
• Advances: Payments made upfront and recouped on future royalties
• Deductions: Adjustments for returns and refunds
• Escalators: Higher royalty rates that apply after reaching certain sales or revenue thresholds

5. Make payments

Finally, the licensee makes the payment to the licensor according to the agreed schedule. For international payments, any tax withheld must also be remitted to the proper authorities; in Canada, non-resident tax deductions must be received by the Canada Revenue Agency (CRA) on or before 15 of the following month.

The licensee may issue a royalty statement or request that the licensor raises an invoice for the payment amount to document the transaction.

Use one of Xero’s free invoice templates.

6. Auditing and compliance

Most royalty agreements give the licensor the right to audit the licensee’s records (on request, or every so often) to make sure payments are correct.

This is an extra layer of protection that gives the licensor comfort they’re receiving the payments they agreed.

Tax implications of royalties for business

Both licensees and licensors should account for royalties properly and reflect them in their tax returns.

Tax treatment differs depending on your role in the royalty arrangement:

• Receiving royalties: You must pay tax on royalty income as business revenue. For example, the Canada Revenue Agency clarifies that even payments from programs like the Public Lending Rights (PLR) for authors are considered taxable as business income.
• Paying royalties: Royalty payments are typically tax-deductible business expenses

International tax considerations

International royalty agreements involve additional tax considerations that can significantly impact your payments and obligations.

Two key factors affect cross-border royalty arrangements:

• Withholding tax: The licensee’s country automatically deducts tax from royalty payments before sending them to the licensor. In Canada, for instance, non-residents must pay a 25% tax on these amounts, although this rate can be reduced or eliminated by a bilateral tax treaty.
• Double tax agreements: Treaties between countries that reduce or eliminate withholding tax to prevent paying tax in both jurisdictions.

Withholding tax process:

1. Automatic deduction: Licensees withhold a percentage of each royalty payment
2. Tax remittance: The withheld amount goes directly to the licensee’s tax authority
3. Reduced payment: Licensors receive only the remaining percentage

Example: A US company paying UK royalties must withhold 30% for the IRS by default. The UK licensor receives 70% of the agreed payment, with 30% going to US tax authorities.

Licensors therefore often receive international royalty payments with withholding tax already deducted, which means they’re taxed twice. But they can avoid this if they live in a country that has made a double tax agreement, such as the UK–US Double Taxation Convention, that reduces or eliminates withholding tax.

Under the UK–US agreement, UK licensors can get 100% of the royalties (before domestic tax is applied). So if you’re the UK rights holder in this situation, just provide the paperwork (such as a certificate of residence and a Form W-8BEN), to avoid being taxed in both jurisdictions.

Tips to stay compliant

Compliance strategies help you maximize your royalty arrangement while avoiding tax issues:

• Maintain detailed records: Document all royalty payments, dates, and signed agreements to avoid significant penalties. Failing to deduct the required non-resident tax in Canada, for instance, can result in a penalty of 10% of the amount, which can increase to 20% for repeat failures.
• Consider tax implications: Factor tax costs into royalty rate negotiations and payment terms
• Seek professional advice: Consult tax professionals for cross-border licensing or unfamiliar jurisdictions

Learn more about withholding tax and other tax deductions, and see extra information on how royalties are taxed.

Streamline your royalty management with Xero

Streamlined royalty management reduces administrative burden and ensures accurate financial tracking. Xero’s integrated platform handles the complexities of royalty accounting automatically.

Key capabilities:

• Automated invoice creation: Generate and track royalty invoices with customizable templates
• Payment monitoring: Track incoming and outgoing royalty payments in real-time
• Tax-ready records: Maintain organized documentation for compliance and reporting
• Integrated reporting: Access comprehensive financial insights across all royalty arrangements

Ready to simplify your royalty management? Try Xero for free and see how Xero streamlines your business finances.

FAQs on royalties in business

Here are answers to some common questions about royalties.

What does a 5% royalty mean?

A 5% royalty means you, as the licensee, must pay 5% of your revenue to the asset’s owner (the licensor). For example, if you have a 5% royalty agreement and earn $100,000 in sales, you would pay $5,000 in royalties to the franchisor.

Who gets paid royalties?

The owner of the asset, known as the licensor, gets paid royalties. This could be an individual, like an author or musician, or a company, like a franchisor or patent holder. In some cases, royalties are split between multiple owners or creators based on their contribution or agreement.

Can royalty rates change over time?

Yes, royalty rates can change. Some agreements include ‘escalator’ clauses, where the rate increases after reaching certain sales or revenue milestones. Rates can also be renegotiated when a licensing agreement is renewed, especially if the asset’s market value has changed.