How does Royalty Works & Tax Implications

How does Royalty Works & Tax Implications

Understanding Royalties

Royalties are payments to owners of property for use of that property. Royalties often deal with payments for the right to use intellectual property (IP), such as copyrights, patents, and trademarks. The payment includes royalty for the use of intangible assets, such as copyrights, trademarks, or franchise model agreements. Royalties are typically agreed upon as a percentage of gross or net revenues derived from the use of an asset or a fixed price per unit sold of an item of such, but there are also other modes and metrics of compensation

An example of royalties would be payments received by musicians when their original songs are played on the radio or television, used in movies, performed at concerts, bars, and restaurants, or consumed via streaming services.

KEY TAKEAWAYS

  • A royalty is an amount paid by a third party to an owner of a product or patent for the use of that product or patent.
  • The terms of royalty payments are laid out in a licensing agreement.
  • The royalty rate or the amount of the royalty is typically a percentage based on factors such as the exclusivity of rights, technology, and the available alternatives.
  • Royalty agreements should benefit both the licensor (the person receiving the royalty) and the licensee (the person paying the royalty).
  • Investments in royalties can provide a steady income and are considered less risky than traditional stocks.

Types of Royalties

Common types of royalties include:

  • Performance royalties for the use of copyrighted music
  • Royalties for the use of online images and artworks, such as stock photography
  • Book royalties that publishers pay to a book's author
  • Patent royalties paid to the owner of a patented invention by a third party who makes and sells the invention
  • Franchise royalties paid to the owner of a business' name and assets
  • Mineral rights paid when natural resources are extracted from a person's land by a utility company
  • Royalties paid to celebrities who use their name to promote a fashion line


How Royalties Work


Royalty fees and payment amounts can be set in a variety of ways. For example, in a franchise situation, fees can be set as a fixed or variable percentage of gross sales. In many cases, there is a minimum royalty. Some common forms of royalty payments include:
  • Royalties for specific products (like a book, a piece of music, a patented product, or a concert) are generally based on the number of units sold.1
  • Royalties for oil, gas, and mineral properties may be based on either revenue or on units, such as barrels of oil or tons of coal.
  • A variable percentage is often used for newly created IP. In this case, the royalty percentage might be small in the beginning as sales are low. Then, as the sales increase, the royalty percentage might increase to a maximum amount.


Terms of Royalty Agreements

While royalty contracts can vary in terms, most require payment of a percentage of the revenue earned while using the property in question. The license agreement must specify the length of the agreement, the product that is given in exchange for the royalty payment, the amount of the royalty payment, and any geographic limitations for use of the product. Note whether the property is being licensed for one-time or perpetual use. 

This agreement should also indicate when payments will be made, how records should be kept, and whether an advance payment (sometimes called an earn-out) is required. A common example is with an author contract; he or she receives an advance from the publisher and after royalty amounts exceed that advance, the author will begin receiving royalty payments.


Tax Implications of Royalty Payments

Like other forms of payment in a business, royalties are taxable income and also a business expense.

If you receive royalties from someone for use of your property, you must claim these payments as business income, usually on Schedule E (Form 1040 or Form 1040-SR). Royalties from copyrights, patents, and oil, gas, and mineral properties are taxable as ordinary income. In general, any royalties you receive are considered as income in the year when you receive them.

If you are paying royalties or licensing fees, these payments are legitimate business expenses. If the payments are for the purchase of property, the property becomes an asset on your business balance sheet, and the payments might need to be amortized. If you pay more than $10 in royalties in a year, you must give the payee a 1099-MISC form to show the total of your payments for the year. 

If you sell your royalty interest, it will likely be considered a capital gain and thus subject to capital gains tax. 

Deduction for Royalty Income of Authors

Authors write books and give it to publishers. Publishers publish them and earn profit on selling those. They pay an agreed  percentage of profit or sales made to the authors as a reward or compensation for writing books. This reward or compensation is called Royalty.

While the Income tax department charges tax on this income under “Profit and Gains of Business or Profession” or “Other Sources” head of Income ,it also provides a deduction on the same that can be claimed by the authors to save tax. This deduction is covered under 80QQB of the Income Tax Act,1961.

Amounts Included in Royalty Income

  • Any Income earned by an author for practicing his profession
  • Any Income earned as a lump sum payment for assignment (or grant) of any of his interests in the copyright of any book based on literary, artistic or scientific in nature or of royalty or copyright fees for author’s book
  • Any Income received as advance payment of royalties/ copyright fees (amount which is non- refundable)

Amount of Deduction

Deduction available will be lower of the following:

  • Rs. 3 lakhs or
  • The amount of royalty income received

Conditions to avail the benefit of Sec 80QQB

a. Following are certain conditions to be satisfied for income earned in India and outside India

i)  Individual claiming the deduction must be a resident in India or resident but not ordinarily resident in India.

ii) Individual must have authored or co-authored a book that falls under the category of literary, artistic or scientific work.

iii) Individual must file his income tax return to claim the deduction.

iv) If an Individual has not received a lump sum amount , 15% of the value of the books sold during the year (before allowing any expenses) should be ignored.

v)  Individual must obtain FORM 10CCD  from the person responsible for making the payment.

b.  Additional requirement for Income Earned outside India

Individual is allowed deduction on income earned outside India when the income is brought to India in convertible foreign exchange within 6 months from the end of the year or within the period allotted by RBI or other competent authority for this purpose. Individual must obtain a certificate in FORM 10H.

Conclusion

A royalty agreement specifies the terms and conditions of grant of right to use under the agreement. The agreement also mentions the consideration for the right to use and the duration. From a tax perspective, royalty agreements should be on an arms-length basis. The taxation, however, depends on the law of each country.



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Posted by Ramesh Kumar Gupta

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