Royalties definition: types, rates, and how they work

Published Friday 13 February 2026

Table of contents

• What is a royalty?
• Types of royalty payments
• How royalty payments work
• Factors affecting royalty rates
• Understanding royalty agreements
• Tax implications of royalties for business
• Manage royalty payments with Xero
• FAQs on royalties

Key takeaways

• Establish clear royalty agreements that define payment terms, usage rights, duration, and audit provisions to protect both parties and prevent disputes.
• Choose the appropriate royalty structure based on your situation: percentage of revenue for ongoing income streams, fixed fees per unit for predictable costs, or usage-based payments for variable consumption.
• Track and document all royalty transactions meticulously, including sales data, payment calculations, and reporting schedules to maintain transparency and build trust between licensors and licensees.
• Consider tax implications early in negotiations, especially for international arrangements where withholding taxes and double taxation treaties can significantly affect the actual amounts received or paid.

Key takeaways

• Royalties are payments to asset owners for the right to use their intellectual property, brand, or creative works.
• Common royalty types include franchise royalties, intellectual property royalties, and licensing royalties for creative works.
• Royalty rates depend on factors like industry standards, asset value, exclusivity, and market demand.
• Both licensees and licensors have tax obligations, including potential withholding tax on international payments.
• Strong royalty agreements clearly define payment terms, usage rights, duration, and audit provisions.

Table of contents

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What is a royalty?

A royalty is a payment made to an asset owner for the right to use their property. These payments typically take the form of a percentage of revenue earned from the asset, or a fixed fee per unit sold.

Every royalty arrangement involves two parties:

• Licensor: the asset owner who receives the royalty payment
• Licensee: the party who pays for permission to use the asset

Royalty agreements are common in industries where the product or service is intangible, such as:

• music and entertainment
• publishing
• technology and software
• franchising

Types of royalty payments

Royalty payments fall into three main categories based on the asset being licensed and how it's used. Understanding which type applies to your situation helps you structure agreements and plan for costs.

Here are the three most common types.

Franchise royalties

Franchise royalties are payments franchisees make to franchisors for the right to use an established business model. These payments cover access to branding, intellectual property, and operational systems.

Franchise royalties typically work in one of two ways:

• Percentage of revenue: a set percentage of gross or net sales paid regularly. For franchises, the typical royalty fee varies from 4% to 12% of gross revenue.
• Flat fees: a fixed amount paid regardless of revenue performance

The franchise model is common in fast food. For example, 93% of McDonald's restaurants operate as franchises.

Learn more about franchises

Intellectual property royalties

Intellectual property (IP) royalties are payments for the right to use or sell protected assets. These assets include patents, trademarks, and copyrighted works.

IP royalties are common across several industries:

• Technology and manufacturing: licensing patented software or processes
• Publishing: authors earning royalties from book sales
• Music and film: creators receiving payments for use of their works

For example, a tech company might license patented software from an inventor, or an author might license their manuscript to a publisher in exchange for royalties on each copy sold.

Licensing royalties for creative works

Licensing royalties for creative works are payments for using music, films, artwork, or writing in a new context. Rather than selling the work outright, creators license it for specific uses.

Common licensing scenarios include:

• Advertising: a song licensed for a TV commercial
• Publishing: illustrations licensed for a children's book
• Product design: artwork licensed for merchandise

These arrangements let creators retain ownership while earning ongoing income from their work.

How royalty payments work

When you arrange royalties, the process follows a predictable cycle from agreeing terms to making payment. Understanding each step helps you manage cash flow, maintain accurate records, and build strong working relationships with licensors or licensees.

Here's how a typical royalty arrangement works in practice.

1. Establish a royalty agreement

To arrange royalties, start by negotiating and drafting a formal licence. A strong contract outlines the asset being licensed, how it can be used, and the structure of royalty payments.

Consider these strategies when negotiating:

• 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: Determine whether others can license the same asset, and adjust terms accordingly.
• Set how long the arrangement lasts: Balance stability (longer deals) against flexibility to renegotiate (shorter deals).

2. Define the payment terms

Set out exactly how you'll calculate royalty payments and when you'll pay them. Most royalty structures fall into one of three categories:

• Percentage of revenue: the licensee pays a set percentage of sales (for example, a franchisee paying 5% of net sales)
• Fixed fee per unit: a set amount per item sold (for example, an author receiving $5 per ebook)
• Usage-based: payment each time the asset is used (for example, a musician earning royalties per stream)

If you're the licensor, consider payment timing alongside the amount. How often you receive royalties and how long you wait each month both affect your cash flow.

3. Track your usage or sales

The licensee must track and report royalty-related transactions. This includes recording how much revenue the asset generates and reporting to the licensor on an agreed schedule.

Key tracking responsibilities include:

• Recording revenue: Document sales, usage, or other metrics that determine royalty amounts.
• Reporting regularly: Submit reports monthly, quarterly, or as specified in the contract.
• Providing transparency: Share enough detail so the licensor understands how you calculated the figures.

Accurate reporting builds trust and maintains a strong working relationship between both parties.

4. Calculate your payments

The licensee calculates the royalties they owe based on the payment structure and contract terms you agreed. 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, refunds, or other agreed expenses.
• Escalators: Higher royalty rates triggered after reaching sales or revenue thresholds.

Review your contract carefully to ensure you include all applicable factors in each calculation.

5. Make payments

The licensee pays the royalty according to the agreed schedule. Proper documentation ensures both parties have clear records for accounting and tax purposes.

Payment documentation options include:

• Royalty statement: The licensee issues a statement detailing the calculation and amount paid.
• Invoice request: The licensee asks the licensor to raise an invoice for the payment amount.

Use one of Xero's free invoice templates

6. Auditing and compliance

Most royalty contracts include audit rights that let the licensor review the licensee's records. This ensures payments are accurate and builds confidence in the arrangement.

Audits typically cover:

• Sales and usage records: Verifying the data used to calculate royalties.
• Payment accuracy: Confirming amounts match the agreed terms.
• Contract compliance: Checking that usage stays within licensed scope.

Include clear audit terms in your contract, specifying how often audits can occur and who bears the cost.

Factors affecting royalty rates

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

Key factors that influence royalty rates include:

• Industry standards: Industry-specific structures often set baseline expectations; for example, fast-food franchises may have rates around 5%, while business services franchises charge an average of nearly 12% due to differences in sales volume and margins.
• Asset value: Higher-value assets command higher royalty rates.
• Negotiating power: Well-known creators often secure better terms, while licensees with strong distribution and proven sales records gain bargaining power.
• Exclusivity: Licensees pay premiums for exclusive rights or non-compete clauses.
• Market demand: High-demand assets support higher rates.

Learn more about real-world royalty rates

Understanding royalty agreements

A royalty agreement is a legally binding contract that defines how you license an asset. The terms must be clear, transparent, and enforceable so both parties understand their obligations and what happens if either party doesn't meet the terms.

Whether you're the licensor or licensee, invest time upfront to get the contract right. A well-drafted contract should cover:

• the asset being licensed and permitted uses
• royalty rates and payment schedules
• duration and termination conditions
• audit rights and dispute resolution

Get legal advice

Both parties should ask a lawyer to review the contract before signing. Legal review serves different purposes depending on your role:

• For licensees (typically drafting the agreement): Ensure the contract is legally compliant and accurately reflects the negotiated terms.
• For licensors: Confirm that the contract clearly outlines your rights, payment terms, and protections and that they're enforceable.

Legal fees upfront can prevent costly disputes later.

Tax implications of royalties for business

Royalties are taxable income for licensors and typically tax-deductible costs for licensees. Both parties must account for royalties properly and reflect them in tax returns.

Here's how royalties affect each party:

• Licensors (receiving royalties): Report royalty income on your tax return and pay applicable taxes.
• Licensees (paying royalties): Claim royalty payments as a tax-deductible business expense.

How tax applies varies by jurisdiction, so consult a tax professional for guidance.

International tax considerations

International royalty contracts involve two additional tax factors: withholding tax and double tax treaties. Understanding both helps you avoid unexpected deductions and double taxation.

Withholding tax

Licensees paying royalties internationally must often withhold a portion and send it to their local tax authority. For example, a US-based company paying royalties to a foreign rights holder may need to withhold a portion for the Internal Revenue Service (IRS). In cases where no tax treaty applies, this is a default 30% withholding tax, meaning the licensor receives only 70%.

Double tax agreements

Licensors receiving international payments may face taxation in both countries. Double tax agreements between countries can reduce or eliminate this burden; for example, a treaty between the US and Germany can lower the usual 15% rate on certain royalties to 5% or even 0%.

For example, under the UK-US Double Taxation Convention, UK licensors can receive 100% of royalties (before domestic tax applies) by providing the required paperwork. The treaty sets the withholding tax rate on royalties at 0% for assets like patents, copyrights, and films.

Tips to stay compliant

Here are some tips to help you stay compliant while getting the most out of your royalty arrangement:

• Keep detailed records: Document all royalty payments, dates, and signed agreements.
• Consider tax early: Factor taxes in when you negotiate royalty rates and payment terms.
• Consult a tax professional: Seek expert 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 and in control with Xero. Track every payment, keep clear records, and simplify tax time.

With Xero, you can:

• create and track invoices for royalty payments
• monitor incoming and outgoing cash flow in real time
• keep organised records for tax compliance and audits

Take control of your business finances and get one month free

FAQs on royalties

Here are answers to common questions about royalties in business.

What is the meaning of royalties?

Royalties are payments an asset owner receives in exchange for permission to use their property. You typically calculate these payments as a percentage of revenue or a fixed fee per unit sold.

Who is entitled to royalties?

The licensor (asset owner) is entitled to receive royalties. This includes creators of intellectual property, franchise owners, and anyone who licenses their assets to others for commercial use.

Are royalties considered income?

Yes, royalties count as taxable income for the recipient (licensor). How tax applies varies by jurisdiction, so consult a tax professional for guidance on what you must report.

How are royalty payments calculated?

You typically calculate royalty payments using one of three methods: a percentage of revenue, a fixed fee per unit sold, or a usage-based fee (such as per stream or per download). The royalty contract specifies how to calculate payments.

What's the difference between a royalty and a licence fee?

A licence fee is typically a one-time or upfront payment for the right to use an asset, while royalties are ongoing payments based on usage or sales. Many agreements combine both: an upfront licence fee plus ongoing royalties.