Royalties – understanding additional forms of income

In the professional world, there are different types of compensation, including salaries, fees, commissions, bonuses and royalties. As with a bonus or commission how high a royalty rate is depends on the success of a respective company. But what exactly is meant by a royalty?

Who receives royalties?

There are two main groups of professionals who receive royalties. The first includes musicians, authors and artists who are often paid exclusively in royalties or in addition to extra income streams.

The second group includes individuals working in companies. For many employees in senior positions, royalties are commonplace. An example is members of a corporation’s management board, who often receive regular bonuses related to their performance in the company.

These royalties are generally contingent on the performance of the company and are designed to encourage strong performance from senior members of staff.

What are royalties?

In the corporate world, royalties refer to additional revenue directly linked to the success of the business. From a tax perspective, royalties count as income and are taxed according to income tax law. Whether an employee is entitled to royalties is usually specified in their employment contract.

Royalties refer to a bonus whereby the recipient receives a certain portion of the profit as additional income. There is no binding right to a royalty, however, once it has been guaranteed in the employment contract it cannot be suspended.

Royalties vs commission

Royalties and commission are not the same. The commission is paid in relation to the performance of an employee (for example, a successful business deal or their sales performance). Royalties, on the other hand, are payments made to owners of intellectual property in exchange for usage or licensing rights of that property over a specified period of time.

Profit royalties vs revenue royalties

In most cases, royalties are calculated as a percentage of revenue - revenue being net sales, i.e. sales after the deduction of taxes and other items defined in a license.

Where the licensor prefers a simpler relationship with licensees in certain countries or industry segments, royalties are specified in amounts per item/unit. Importantly, it may be less adversarial to ask for manufacturing or shipping reports from licensees (that may include competitors) than request financial disclosure of sales reports.

Royalty payment size and frequency

The rate and frequency at which royalties are paid must be stipulated in the contract. There are no fixed rules.

Guaranteed royalties

Guaranteed royalties differ to this arrangement somewhat. While royalties are usually based on revenue, guaranteed royalties will be distributed irrespective of how well an invention performs. Even if the company has made little or no profit, the agreed royalty still has to be paid.

Discretionary royalties

Discretionary royalties work a little differently. This amount is not tied to a contractually agreed percentage but awarded by the employer or supervisory board at its own discretion. The employer has discretion over the rate, but it is generally considered prudent for the amount to be in reasonable relation to the success of the company for tax purposes.

The discretionary bonus is stated in the employment contract and the criteria is used to determine the size of the pay-out specified in the bonus scheme.

Royalties in relation to tax

Royalties are treated as taxable income. Most royalties are not paid until January of the following tax year, but this may vary from company to company.

Even where a payment relates to the previous financial year, the funds are generally not received by an employee until the following financial year.

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