What are royalties in business? Types, tax and payments

Published Friday 20 February 2026

Table of contents

• What are royalties?
• How do royalties work?
• Types of royalty payments
• Factors affecting royalty rates
• Understanding royalty agreements
• Setting up royalty payments
• Tax implications of royalties for business
• Manage royalty payments with Xero
• FAQs on royalties in business

Key takeaways

• Negotiate royalty agreements carefully by including performance-based termination clauses, defining geographic and usage scope clearly, and specifying exclusivity terms to protect your interests whether you're paying or receiving royalties.
• Choose the right payment structure for your situation by selecting between percentage of revenue (like 5% of gross sales), fixed fee per unit, or usage-based payments depending on your business model and cash flow needs.
• Maintain detailed records of all royalty transactions and consult tax professionals for compliance, as royalties you receive count as taxable income while royalties you pay are typically tax-deductible business expenses.
• Include audit provisions in your royalty agreements to verify payment accuracy, with clauses requiring the licensee to reimburse audit costs if significant payment discrepancies are discovered.

What are royalties?

Royalties are payments made to an asset owner for the right to use that asset. The owner who receives payment is called the licensor, while the party paying for usage rights is the licensee.

These payments typically take one of two forms:

• Percentage of revenue: A share of earnings generated from the asset
• Fixed fee per unit: A set amount for each unit sold or used

Royalty agreements are common in industries like music, publishing, and technology where products are intangible rather than physical. The global franchise market was valued at over $121 billion in 2023 and is projected to more than double by 2032.

How do royalties work?

Royalty payments flow from the licensee (the party using the asset) to the licensor (the asset owner) based on terms set in a licensing agreement. The agreement specifies how much is owed, when payments are due, and how usage is tracked.

Here's a simple example: a franchisee agrees to pay 5% of gross revenue to the franchisor. If the franchisee earns $100,000 in sales, they owe $5,000 in royalties.

The basic process works like this:

1. Agreement: Both parties negotiate and sign a licensing contract
2. Usage: The licensee uses the asset to generate revenue
3. Tracking: The licensee records sales or usage data
4. Payment: The licensee calculates and pays royalties on the agreed schedule

Payment schedules vary by agreement. Some royalties are paid monthly, others quarterly or annually.

Types of royalty payments

Royalty payments fall into three main categories: franchise royalties, intellectual property royalties, and licensing royalties for creative works. The type you'll encounter depends on the asset involved and your business model.

Franchise royalties

Franchise royalties are payments franchisees make to use a franchisor's business model, branding, and operational systems.

Most franchisees pay a percentage of revenue. In the quick-service restaurant sector, for instance, these fees typically range from 4% to 8% of gross sales. So, a franchisee earning $100,000 in sales at a 5% royalty rate would pay $5,000 to the franchisor. Some agreements use flat fees instead.

The franchise model is common in fast food: 93% of McDonald's restaurants are franchised.

Learn more about franchises

Intellectual property royalties

Intellectual property royalties are payments for the right to use or sell protected assets like patents, trademarks, and copyrighted works.

These royalties appear across several industries:

• Tech and manufacturing: Companies license patented software or technology
• Publishing: Authors earn royalties when publishers sell their books
• Music and film: Creators receive payments when their work is used or distributed

Licensing royalties for creative works

Licensing royalties for creative works apply when businesses pay to use music, films, artwork, or writing in a new context rather than purchasing the work outright.

Common examples include:

• Advertising: A song licensed for a TV commercial
• Publishing: Illustrations licensed for a children's book
• Product design: Artwork licensed for merchandise

Factors affecting royalty rates

Royalty rates vary based on commercial, contractual, and market factors. Understanding these helps you negotiate fair terms whether you're paying or receiving royalties.

Key factors that influence rates:

• Industry standards: Music and publishing royalties often fall within recognised ranges, with patent licensing rates, for example, ranging from 0.1% to 25% of net sales depending on the industry.
• Asset value: High-value or proven assets can command higher royalty rates
• Negotiating power: Well-known creators often secure better terms, while licensees with strong distribution reach have bargaining power too
• Exclusivity: Licensees typically pay a premium for exclusive rights or non-compete clauses
• Market demand: Highly anticipated assets attract higher rates

Learn more about real-world royalty rates

Understanding royalty agreements

Royalty agreements are legally binding contracts that define how royalties are paid, when, and under what conditions. The terms must be clear, transparent, and enforceable so both parties understand their obligations and what happens if terms aren't met.

Whether you're paying or receiving royalties, invest time upfront to get the agreement right.

Get legal advice

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

• Licensees drafting agreements: Ensure the contract is legally compliant and accurately reflects the specific arrangement
• Licensors reviewing agreements: Understand each clause fully and confirm your rights, payments, and protections are clearly outlined

Setting up royalty payments

Setting up a royalty arrangement involves several key steps, from negotiating the agreement to making payments. Here's how the process typically works.

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 royalty payments.

Negotiation strategies for a stronger contract:

• Include a performance-based termination clause: Protect yourself if the asset doesn't generate expected revenue
• Specify geographic and usage scope: Define the countries, regions, and domains (online or offline) where rights apply
• Clarify exclusivity terms: If the licensee wants exclusive rights, the licensor can negotiate better rates
• Set the contract duration: Longer deals offer stability, while shorter terms let licensors renegotiate sooner

2. Define the payment terms

Set out exactly how royalty payments will work. Royalty structures typically fall into one of three categories:

• Percentage of revenue: The licensee pays a share of earnings, such as 5% of net sales
• Fixed fee per unit: The licensor receives a set amount per sale, such as $5 per ebook
• Usage-based: The licensor earns payment each time the asset is used, such as per stream on a music platform

If you're the licensor, look beyond the payment amount. Consider payment frequency and timing, as both affect your cash flow.

3. Track your usage or sales

Tracking and reporting is the licensee's responsibility. They record how much revenue the asset generates and report to the licensor on a schedule set by the contract, typically monthly or quarterly.

Clear reporting improves accuracy and trust between both parties.

4. Calculate your payments

The licensee calculates royalties owed based on the payment structure and agreed terms.

Several factors can affect the final amount:

• Minimum guarantees: A set amount paid to the licensor regardless of performance
• Advances: Upfront payments recouped from future royalties
• Deductions: Adjustments for returns and refunds
• Escalators: Higher royalty rates that apply after reaching certain sales thresholds

5. Make payments

The licensee makes payment according to the agreed schedule. They may issue a royalty statement or request that the licensor send an invoice to document the transaction.

Use one of Xero's free invoice templates

6. Auditing and compliance

Auditing rights are typically included in royalty agreements, allowing the licensor to review the licensee's records to verify accuracy. To provide an extra layer of protection, many agreements also require the licensee to reimburse the licensor for audit costs if significant payment variances are found.

Tax implications of royalties for business

Royalties are taxable income for licensors who receive them and typically tax-deductible expenses for licensees who pay them. The IRS reinforces this by categorising payments for assets like copyright, software, broadcasting, and endorsements as income, which must be properly accounted for on tax returns.

International tax considerations

International royalty payments involve two additional tax considerations: withholding tax and double tax agreements.

Withholding tax for licensees: When paying royalties to an overseas licensor, you may need to withhold a portion for your local tax authority. For example, a US company paying royalties to a UK rights holder may withhold 30% for the IRS, sending only 70% to the licensor.

Double taxation for licensors: Without a tax treaty, both countries can tax licensors. Double tax agreements between countries can reduce or eliminate this. Under the UK–US Double Taxation Convention, UK licensors can receive 100% of royalties by providing the right paperwork, such as a certificate of residence and Form W-8BEN.

Tips to stay compliant

Here are some tips to stay compliant while getting the most from your royalty arrangement:

• Keep detailed records: Document all royalty payments, dates, and signed agreements
• Consider tax implications: Factor taxes into your negotiations on rates and payment terms
• Consult a tax professional: Get advice when licensing across borders or dealing with unfamiliar tax jurisdictions

Learn more about withholding tax and other tax deductions.

Manage royalty payments with Xero

Whether you're paying or receiving royalties, you can stay organised with Xero. Create and track invoices, monitor incoming and outgoing payments, and keep clear records for tax time: all in one place.

Get one month free and simplify your royalty management with Xero.

FAQs on royalties in business

Here are answers to some common questions about royalties in business.

What's the difference between royalties and licensing fees?

A licensing fee is typically a one-time or upfront payment for usage rights, while royalties are ongoing payments based on sales, revenue, or usage over time. Some agreements include both.

What does a 5% royalty rate mean in practice?

A 5% royalty rate means the licensee pays 5% of their revenue to the licensor. For example, if you earn $50,000 in sales from a licensed product, you'd pay $2,500 in royalties.

Are royalty payments tax-deductible?

Yes, royalties you pay as a business expense are typically tax-deductible. Royalties you receive are considered taxable income. Consult a tax professional for guidance on your specific situation.

How often are royalties typically paid?

Payment frequency depends on the agreement. Common schedules include monthly, quarterly, or annually. The contract should specify when payments are due and how they're calculated.

Can I negotiate royalty rates?

Yes, royalty rates are negotiable. Factors like asset value, exclusivity, market demand, and each party's negotiating power all influence the final terms.