Royalties in business: how they work, rates and tax

Published Thursday 19 February 2026

Table of contents

• Business royalties: a definition
• How do royalties work?
• Types of royalty payments
• Common industries that use royalties
• How to calculate royalty rates
• Tax implications of royalties for business
• Understanding royalty agreements
• How to apply the royalty payment cycle
• Simplify royalty payments and business finances with Xero
• FAQs on royalties in business

Key takeaways

• Negotiate clear royalty agreements that specify payment structure, usage rights, territory, duration, and reporting requirements to protect both parties and prevent disputes.
• Track and document all royalty transactions meticulously, including sales data, payment calculations, and signed agreements, as accurate record-keeping is essential for tax compliance and potential audits.
• Research industry-standard royalty rates before negotiations, as rates vary significantly by sector (ranging from 2-5% for patents to 4-12% for franchises) and understanding benchmarks strengthens your negotiating position.
• Consider international tax implications early, including withholding tax requirements and double taxation agreements, and consult a tax professional when dealing with cross-border royalty arrangements.

Business royalties: a definition

Royalties are payments to the owner of an asset for the right to use it. These payments are usually a percentage of revenue earned from the asset, or a fixed fee per unit sold.

The asset owner who receives the royalty is known as the licensor. The licensee pays the licensor for permission to use the asset.

Royalty agreements are common in music, entertainment, software, and pharmaceuticals. Research on rates by industry shows averages can be as high as 9.6%. They typically apply where the product or service is intangible, such as a digital file, patented technology, or brand identity.

How do royalties work?

Royalty payments follow a structured cycle from agreement to payment. The process ensures both parties understand their obligations and receive fair value.

The basic royalty payment process

A typical royalty arrangement follows these steps:

1. Negotiate the agreement: the licensor and licensee agree on terms, including payment structure, usage rights, and duration
2. Use or sell the asset: the licensee uses the licensed asset to generate revenue
3. Track and report: the licensee records sales or usage data and reports to the licensor
4. Calculate payments: royalties are calculated based on the agreed structure
5. Make payments: the licensee pays the licensor on the agreed schedule

Who's involved in royalty payments?

Every royalty arrangement involves at least two parties:

• Licensor: the asset owner who grants usage rights and receives royalty payments
• Licensee: the party who pays for permission to use the asset

Some arrangements also involve intermediaries, such as collection societies in the music industry or licensing agents who manage rights on behalf of creators.

Types of royalty payments

Royalty types vary based on the asset and business model involved. The three most common types for small businesses are:

• Franchise royalties: payments for using an established business model and brand
• Intellectual property royalties: payments for patents, trademarks, and copyrights
• Licensing royalties for creative works: payments for using music, artwork, or other creative content

Here's how each type works.

Franchise royalties

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

The franchise model is popular in fast food. For example, in the US, 95% of McDonald's restaurants are run by franchisees.

Franchisees typically pay royalties in one of two ways:

• Percentage of revenue: a set percentage of gross or net sales
• Flat fees: a fixed amount regardless of revenue

Learn more about franchises.

Intellectual property royalties

Intellectual property royalties are payments for the right to use or sell protected assets. These royalties apply to:

• Patents: protected inventions, processes, or technologies
• Trademarks: protected brand names, logos, or slogans
• Copyrights: protected creative works like books, music, or software

IP royalties are common in tech and manufacturing, where average royalty rates can range from 4.8% for machine tools to 9.6% for software. For example, a tech company might license patented software, or an author might license their work to a publisher and earn royalties on each sale.

Licensing royalties for creative works

Licensing royalties for creative works apply to music, films, artwork, writing, and other creative content. Instead of selling the work outright, creators earn royalties when businesses use their work in a different context.

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

Common industries that use royalties

Royalties aren't limited to entertainment. Many industries use royalty-based models to monetise assets and expand market reach.

Here are the most common:

• Franchising: restaurants, retail chains, and service businesses pay royalties to use established brands and systems
• Technology and software: companies license patents, algorithms, or software to other businesses
• Manufacturing: product designers and inventors earn royalties when manufacturers use their designs or processes
• Publishing: authors, journalists, and content creators earn royalties on books, articles, and digital content
• Entertainment: musicians, filmmakers, and performers earn royalties from streaming, broadcasts, and public performances
• Consumer products: brand owners license their names and logos for use on merchandise and products

If your business creates, owns, or uses intellectual property, royalties may be relevant to your revenue model.

How to calculate royalty rates

Royalty rates are determined through negotiation and influenced by market conditions. There's no single formula, but several factors affect what licensors can charge and what licensees will pay.

Key factors that influence royalty rates:

• Industry standards: industry-specific structures often set expectations. Music and publishing royalties, for example, typically fall within recognised ranges
• Asset value: high-value or unique assets can command higher rates
• Negotiating power: well-known creators often secure better terms, while licensees with strong distribution or marketing reach have leverage too
• Exclusivity: licensees may pay a premium for exclusive rights or non-compete clauses
• Market demand: high demand for an asset allows licensors to negotiate higher rates

Learn more about real-world royalty rates.

Tax implications of royalties for business

Tax treatment of royalties depends on whether you're paying or receiving them. Both licensees and licensors need to account for royalties properly in their tax returns.

Here's the general rule:

• Licensors (receiving royalties): royalty income is typically taxable as ordinary income
• Licensees (paying royalties): royalty payments are usually tax deductible as a business expense

Always consult a tax professional for advice specific to your situation.

International tax considerations

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

When paying international royalties as a licensee, withholding tax requires you to withhold a portion of your royalty payment and send it to your local tax authority. For example, say your US-based company pays royalties to a UK rights holder. You may have to withhold a portion for the IRS. US-sourced royalty payments to nonresidents are generally subject to 30% Federal Tax withholding. You'd send only 70% to the UK-based licensor.

When receiving international royalties as a licensor, you may receive payments with withholding tax already deducted, meaning you could be taxed twice. However, double tax agreements between countries can reduce or eliminate this.

Under the UK–US Double Taxation Convention, royalties received by a UK resident are exempt from tax in the US. This means UK licensors can receive 100% of their royalties before domestic tax applies. To benefit, provide the required paperwork, such as a certificate of residence and Form W-8BEN.

Tips to stay compliant

Follow these tips to stay compliant and maximise your royalty arrangement:

• Keep detailed records: document all royalty payments, dates, and signed agreements
• Consider tax implications early: factor taxes into your rate negotiations 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.

Understanding royalty agreements

Royalty agreements are legally binding contracts that define how royalties are calculated, paid, and enforced. Clear terms protect both parties and prevent disputes.

Whether you're a licensor or licensee, investing time upfront to get the agreement right can save you significant trouble later.

Get legal advice

Both parties should have a lawyer review the contract before signing. Here's what each party should focus on:

• Licensees: ensure the contract is legally compliant and accurately reflects the agreed terms, especially if you're drafting the agreement
• Licensors: review each clause carefully to confirm your rights, payment terms, and protections are clearly outlined

Key elements to include in your agreement

A well-drafted royalty agreement should cover these essential elements:

• Scope of rights granted: specify exactly what the licensee can and cannot do with the asset
• Territory and duration: define where and for how long the rights apply
• Payment structure and schedule: outline the royalty rate, calculation method, and payment frequency
• Reporting requirements: specify how and when the licensee must report sales or usage
• Termination clauses: define conditions under which either party can end the agreement
• Audit rights: give the licensor the right to verify the licensee's records

How to apply the royalty payment cycle

Follow these practical steps to manage a royalty arrangement, from initial agreement to ongoing compliance. Follow these steps whether you're buying or selling usage rights to an asset.

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.

Here are strategies for negotiating a stronger contract:

1. Include a performance-based termination clause: protect yourself from underperforming arrangements by tying termination rights to revenue thresholds
2. Specify territorial and usage rights: define the countries, regions, and domains (such as online or offline) where the rights apply
3. Clarify exclusivity terms: determine whether others can license the same asset, and use exclusivity as a negotiating point for better terms
4. Set the agreement duration: choose longer deals for stability or shorter terms to renegotiate sooner

2. Define the payment terms

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

1. Percentage of revenue: the licensee pays a set percentage of sales. For example, a fast-food franchisee might pay 5% of net sales
2. Fixed fee per unit: the licensee pays a set amount per item sold. For example, an author might receive $5 for every ebook sold
3. Usage-based: the licensor earns royalties each time the asset is used. For example, a band earns royalties each time their song is streamed

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

3. Track your usage or sales

Royalty tracking is the licensee's responsibility. This involves recording how much revenue the asset generates and reporting to the licensor on the schedule set by the contract, typically monthly or quarterly.

Accurate reporting improves trust and strengthens the working relationship between both parties.

4. Calculate your payments

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

Several factors can affect the final amount:

• Minimum guarantees: a set amount the licensor receives regardless of performance
• Advances: upfront payments that are recouped from future royalties
• Deductions: adjustments for returns, refunds, or other agreed expenses
• 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. To document the transaction, the licensee may issue a royalty statement or request that the licensor raise an invoice for the payment amount.

Use one of Xero's free invoice templates.

6. Auditing and compliance

Audit rights give the licensor the ability to review the licensee's records and verify that payments are accurate. Most royalty agreements include this provision, allowing audits on request or at regular intervals.

This protection helps licensors confirm they're receiving the payments they're entitled to and can identify discrepancies early.

Simplify royalty payments and business finances with Xero

Whether you're paying or receiving royalties, you can stay organised and in control with Xero.

With Xero, you can:

• Create and track invoices: send professional invoices and monitor payment status
• Monitor cash flow: see incoming and outgoing royalty payments in real time
• Keep clear records: maintain organised documentation for tax time and audits

Get one month free and simplify your royalty management.

FAQs on royalties in business

Here are answers to common questions about royalties in business.

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 upfront payments for the right to use an asset. Some agreements include both.

What's a typical royalty rate for small businesses?

Royalty rates vary widely by industry. Franchise royalties typically range from 4% to 12% of revenue, while patent royalties often fall between 2% and 5%. Always research industry benchmarks before negotiating.

Do I need a lawyer to create a royalty agreement?

While not legally required, having a lawyer review your royalty agreement is strongly recommended. A poorly drafted contract can lead to disputes, missed payments, or unenforceable terms.

How do I track royalty payments in my accounting software?

Record royalty income as revenue and royalty expenses as operating costs. Use accounting software like Xero to create invoices, track payments, and maintain clear records for tax reporting.

Can royalty-based models work for service businesses?

Yes. Service businesses can earn royalties by licensing proprietary methods, training programmes, or branded systems to other providers. Consulting firms and franchised service businesses commonly use this model.