What are royalties and how do they work for your small business?

Published Friday 5 December 2025

Table of contents

• Types of royalty payments
• How royalties are calculated
• How royalty payments work
• Factors affecting royalty rates
• Tax implications of royalties for business
• Understanding royalty agreements
• How to apply the royalty payment cycle
• Managing royalties with the right tools
• FAQs on royalties

Key takeaways

• Negotiate royalty agreements carefully by defining clear payment structures, usage parameters, and geographic scope to protect both parties and prevent future disputes.

• Track royalty payments systematically using accounting software to maintain accurate records, calculate payments correctly, and ensure compliance with tax obligations.

• Factor international tax implications into royalty arrangements by understanding withholding tax requirements and leveraging double tax agreements to avoid paying tax in multiple jurisdictions.

• Establish transparent reporting cycles where licensees regularly document sales or usage data and provide detailed royalty statements to maintain trust and accuracy in the licensing relationship.

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

Franchise royalties are ongoing payments franchisees make to use a proven business model. This includes access to branding, operational systems, and intellectual property.

Franchising is a common way to grow a business. For example, 93% of McDonald's restaurants operate as franchises.

Payment structure: Most franchise royalties are calculated as a percentage of gross or net revenue. Some agreements use flat monthly fees instead.

Learn more about franchises

Intellectual property royalties

Intellectual property royalties are payments for using protected assets like patents, trademarks, and copyrighted works. For UK tax purposes, the term 'copyright' is broad and includes copyright in any literary work (such as computer programs), dramatic works, musical works, and registered designs.

Common applications:

• Technology: Software patents, manufacturing processes
• Publishing: Book rights, article licensing
• Entertainment: Music rights, film distribution
• Manufacturing: Patented components, production methods

Real-world examples: A tech company pays royalties to license patented software, and recent changes to the UK's original patent box regime mean that claimants must now track this income in greater detail. An author earns royalties when a publisher uses their work.

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.

How royalties are calculated

Royalty calculations depend on the terms you agree to in your licensing contract. While the specifics can vary, most royalties are calculated using one of a few common methods.

• Percentage of revenue: The licensee pays a percentage of the revenue generated from the asset. For example, if a book generates £10,000 in sales and the author's royalty rate is 10%, they receive £1,000.
• Fixed fee per unit: The licensee pays a set amount for each unit sold. For instance, a musician might earn £0.50 for every physical album sold.
• Tiered rates: The royalty rate changes after hitting certain milestones. A software developer might earn a 5% royalty on the first 10,000 units sold, and 7% on all sales after that.

Your royalty agreement should clearly define how payments are calculated, including any deductions for things like returns or marketing costs.

How royalty payments work

The royalty payment process follows a cycle that should be clearly outlined in your agreement. It helps ensure the asset owner (licensor) gets paid correctly and on time by the licensee.

Typically, the process works like this:

1. The licensee tracks the sales or usage of the asset during a specific period, like a month or a quarter.
2. At the end of the period, the licensee prepares a royalty statement. This report shows the total sales or usage and calculates the royalty amount owed.
3. The licensee sends the statement and the payment to the licensor by the agreed-upon date.

Keeping accurate records is essential for both sides to ensure transparency and maintain a good business relationship.

Factors affecting royalty rates

Royalty rates depend on several key factors that determine what licensors can charge:

• Industry standards: Each sector has recognised rate ranges (music typically 8–15%, books 5–15%)
• Asset value: High-value intellectual property commands premium rates
• Negotiating power: Established creators and strong distributors secure better terms
• Exclusivity: Exclusive licensing rights cost 20–50% more than non-exclusive deals
• Market demand: Popular or trending assets can charge significantly higher rates

Learn more about real-world royalty rates

Tax implications of royalties for business

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

How you pay tax on royalties is usually straightforward:

• receiving royalties – you pay tax on royalty income as business revenue, and UK case law says that even lump sums in place of future royalties are taxable as profits of a profession
• paying royalties – you can usually treat royalty payments as tax-deductible business costs

• Paying royalties: Royalty expenses are typically tax-deductible business costs

International tax considerations

International royalty payments involve two key tax considerations:

Withholding tax: Licensees must deduct a percentage of international payments and send it to their local tax authority. In the UK, for example, the law requires the payer to deduct tax at the same time that the payment is made to an overseas recipient.

Double tax agreements: Treaties between countries that reduce or eliminate withholding tax to prevent paying tax twice.

If, for example, your US-based company pays royalties to a UK rights holder, you may have to withhold 30% for the US Internal Revenue Service (IRS). You send only 70% of the payment to the UK-based licensor, with 30% going to the IRS by default.

Licensors therefore often receive international royalty payments with withholding tax already deducted – meaning 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, which allows for double taxation relief to reduce or eliminate 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

Stay compliant with these essential practices:

• Maintain detailed records: Document all payments, dates, and signed agreements
• Consider tax implications: Factor tax costs into rate negotiations and payment terms
• Consult professionals: Work with tax experts for international deals and unfamiliar jurisdictions

Understanding royalty agreements

Royalty agreements are legally binding contracts that govern the licensing relationship. Clear, enforceable terms protect both parties and prevent disputes.

Essential requirements:

• Transparent terms: Both parties must understand their obligations
• Clear consequences: Define what happens if terms aren't met
• Proper documentation: Invest time upfront to create comprehensive agreements

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.

Learn the specific rules in the UK.

How to apply the royalty payment cycle

Here are the basics on how a typical royalty arrangement works in practice – so you're prepared for when you want to buy or sell usage rights to an asset.

1. Establish a royalty agreement

Establishing a royalty agreement creates the legal framework for your licensing relationship. A comprehensive contract protects both parties and ensures clear payment terms.

Core contract elements:

• Asset description: Clearly define what's being licensed
• Usage parameters: Specify how the asset can be used
• Payment structure: Detail royalty rates and payment schedules

Negotiation strategies:

• Include performance clauses: Tie contract terms to revenue thresholds
• Define geographic scope: Specify countries and regions where rights apply
• Set exclusivity terms: Clarify whether others can license the same asset
• Establish duration: Balance stability with flexibility for future negotiations

Learn more about negotiation strategies.

2. Define the payment terms

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

• Percentage of revenue – a fast-food licensee might pay the franchisor 5% of net sales, for example
• Fixed fee per unit – an author could get $5, say, for every copy of an ebook sold
• Usage-based – a band can earn royalties each time a song of theirs is streamed on a music platform

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 – 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 according to the agreed schedule.

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.

Managing royalties with Xero

Whether you're paying or receiving royalties, staying organised is key. Using accounting software can help you automate royalty tracking and payments, so you can focus on running your business.

With the right tools, you can easily track sales, generate reports for royalty statements, create and send invoices, and keep clear records for tax time. This reduces manual work and helps ensure your calculations are accurate.

Xero gives you a clear view of your finances, making it easier to manage royalty payments and stay on top of your numbers.

Try Xero for free today to get started.

FAQs on royalties

Here are answers to some common questions about royalties.

What does a 5% royalty rate mean?

A 5% royalty rate means the recipient earns 5% of the revenue generated from the asset. For example, if a product with a 5% royalty rate generates £2,000 in sales, the royalty payment would be £100 (£2,000 x 0.05).

How often are royalties paid?

The payment schedule is set in the royalty agreement. Common schedules are monthly or quarterly, but they can also be semi-annual or annual. This should be clearly defined in your contract.

Can you negotiate royalty rates?

Yes, royalty rates are almost always negotiable. Factors like the value of the asset, industry standards, market demand, and the negotiating power of each party all play a role in determining the final rate.

What's the difference between royalties and licensing fees?

A royalty is an ongoing payment based on usage or revenue, like a percentage of sales. A licensing fee is often a one-time, upfront payment for the right to use an asset. Some agreements may include both an upfront fee and ongoing royalties.