Where Royalty Agreements Arise

A note on statutory royalties. Royalties payable to the State under the Mines and Minerals (Development and Regulation) Act, 1957 and comparable resource legislation are fixed by statute and notification, not by negotiation. This page concerns contractual royalties for intellectual property and content, which operate on entirely different principles.

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Royalty Structures

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Defining the Royalty Base

This is the clause to draft first and negotiate hardest.

Choose the reference figure

• Gross sales — the invoiced value, before any deduction. Simple, and correspondingly resisted by licensees
• Net sales — gross less defined deductions. The usual commercial landing point, and the definition that must be exhaustive
• Net selling price — per-unit variant of the same concept
• Ex-factory value — where the licensee also distributes, removing distribution margin from the base
• Net receipts — actual amounts received, which shifts collection risk to the licensor

Deductions: state them exhaustively

Ordinarily permitted, if drafted:

• GST and other indirect taxes, where separately stated on the invoice
• Trade discounts and volume rebates actually allowed and taken
• Returns, credits and rejections, adjusted in the period in which they occur
• Freight, insurance and packing where separately invoiced and not marked up
• Documented bad debts, with a claw-back if subsequently recovered

Ordinarily not permitted:

• Marketing, advertising and promotional expenditure
• Distribution, warehousing and administrative overheads
• Commissions and incentives paid to the licensee’s own personnel
• Cash discounts for early payment, unless expressly agreed

Then address the items that generate disputes

Free goods, samples and promotional units. Royalty-free up to a stated percentage of volume, and royalty-bearing beyond it — otherwise “promotional” volume expands remarkably.

Bundled and combination products. Where the licensed IP is one element of a larger product, the base must be apportioned. Options include royalty on the standalone value of the licensed component, a reduced rate on the whole product, or a fixed per-unit sum. Left undefined, this becomes the single most expensive dispute in technology licensing.

Related-party and inter-company sales. Deemed to be at the price at which comparable goods are sold to an independent third party, so that the base cannot be shrunk by routing sales through an affiliate at cost.

Captive consumption and internal use. Valued at a stated basis, or excluded expressly.

Sub-licence income. Decide clearly between a royalty on the sub-licensee’s sales and a percentage of what the licensee receives from the sub-licensee. These produce very different outcomes and both are commonly used.

Exports and multiple currencies. State the currency of account, the conversion source and the conversion date.

Royalty stacking. Where the licensee must also pay third-party licensors on the same product, an anti-stacking clause may permit a reduction — commonly allowing the licensee to deduct a proportion of third-party royalties, subject to a floor below which your rate cannot fall.

Most favoured licensee. If granted, define the comparison carefully — a bare “no less favourable terms” clause is unworkable, because terms travel in packages and cannot be compared line by line.

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Accrual, Payment and Set-Off

Accrual trigger. Specify precisely: on despatch, on invoice, or on receipt of payment from the customer. The difference matters enormously in a business with long receivable cycles, and the choice determines who carries collection risk.

Payment period and deadline. Monthly or quarterly, with payment within a stated number of days of period end, accompanied by the royalty statement.

Interest on late payment, at a stated rate.

Set-off. Ordinarily excluded for the licensee, so that disputes on other matters do not become a self-help deduction from royalty.

Withholding and gross-up. State expressly whether amounts are payable net of withholding tax or whether the payer must gross up. This single sentence can move the economics by ten to twenty per cent in a cross-border arrangement and is frequently left ambiguous.

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Reporting and Audit

A royalty right that cannot be verified is an estimate.

Royalty statements should specify the format, the level of detail — SKU-level, territory-level, channel-level — the reconciliation to reported turnover, and certification by the licensee’s finance function.

Record retention for a defined period beyond the term, covering books, invoices, despatch records, and GST and statutory filings.

Audit rights should state:

• Frequency — commonly once per financial year, with a right to audit more often where a discrepancy has been found
• Notice period and the scope of access, including the licensee’s manufacturing and distribution records
• Appointment of an independent chartered accountant or firm, with a confidentiality undertaking
• The right to reconcile reported sales against GST returns and audited financial statements
• Cost allocation — the licensor bears the cost unless the audit reveals an underpayment exceeding a stated threshold, commonly three to five per cent, in which case the licensee pays
• Interest on underpaid amounts, and immediate payment of the shortfall
• A right to terminate for material or repeated underreporting

Where the licensee is a manufacturer, add rights over production records, batch data and despatch documentation, since sales value can be understated but units produced are harder to conceal.

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Minimums and Performance

A minimum guaranteed royalty is the mechanism that converts an exclusive licence into an obligation to perform. Without one, an exclusive or sole licensee can hold a territory or category indefinitely while doing nothing, and the licensor has no remedy.

Structure the minimum with:

• A per-period figure, escalating over the term
• Whether it is recoupable against running royalty in the same period, across periods, or not at all
• Consequences of shortfall — payment of the difference, conversion of exclusivity to non-exclusive, reduction of territory or categories, or termination
• Performance milestones in addition — first commercial launch by a date, minimum sales volumes, minimum outlets opened, minimum marketing spend

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Term, Termination and What Happens to Royalty Afterwards

• Accrued royalty survives termination — say so expressly
• Sell-off period — royalty continues to be payable on inventory sold during the run-off, at the same rate, with quantities certified and a hard cut-off
• Final statement and audit right surviving termination for a stated period
• Post-expiry royalty on expired rights. Where the royalty is tied to a patent, Section 141 of the Patents Act, 1970 gives either party the right to determine the contract on three months’ notice once the patent, or all the patents by which the article or process was protected, ceases to be in force. Where the arrangement is a hybrid licence covering patents and know-how, and the parties intend payments to continue after patent expiry, this must be structured deliberately — with the know-how component identified and separately valued — rather than left to run on by default
• Survival of confidentiality, audit, indemnity and dispute resolution

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The Tax Architecture

GST

Licensing of intellectual property is a supply of service. The applicable rate, classification and place of supply must be determined for the arrangement. Where the recipient is outside India and the conditions are satisfied, the supply may qualify as an export of service and be zero-rated. Where an Indian licensee pays a foreign licensor, the reverse charge position must be considered. Whether royalty is quoted inclusive or exclusive of GST should be stated in the agreement.

Withholding tax

To claim treaty benefit, the non-resident must furnish a Tax Residency Certificate, Form 10F, and ordinarily a no permanent establishment declaration. The remitter must complete Form 15CA and Form 15CB compliance. The definition of royalty is set out in Explanation 2 to Section 9(1)(vi) and is materially wider than the definition in many treaties, which is why the treaty position must be examined rather than assumed.

Software payments. The Supreme Court in Engineering Analysis Centre of Excellence Pvt. Ltd. v. CIT held that amounts paid by Indian end-users and distributors to non-resident suppliers for the resale or use of shrink-wrapped or off-the-shelf computer software are not royalty under the applicable treaties, and accordingly do not attract withholding under Section 195. The characterisation of any particular software arrangement still turns on its terms, and the analysis should be done at the drafting stage.

Transfer pricing

Where royalty is paid between associated enterprises, Sections 92 to 92F require the transaction to be at arm’s length. Both charging no royalty and charging a rate that cannot be supported attract scrutiny, and brand and technology royalty — along with associated advertising, marketing and promotion expenditure — is among the most heavily litigated areas of Indian transfer pricing. Contemporaneous benchmarking, a documented commercial rationale and evidence of benefit received should be prepared when the agreement is put in place, not after an assessment notice.

Reliefs worth claiming

• Section 115BBF — concessional rate of tax on royalty income in respect of a patent developed and registered in India by an eligible resident patentee, subject to the prescribed conditions and election
• Section 80RRB — deduction for a resident individual patentee in respect of royalty income from a patent registered under the Patents Act, 1970, up to the prescribed limit
• Section 80QQB — deduction for a resident individual author in respect of royalty income from books, up to the prescribed limit

Rates, thresholds and limits change with each Finance Act. Confirm the position in force before structuring.

Foreign exchange

Payment of royalty and lump-sum fees to a foreign licensor is permitted under the automatic route as a current account transaction, subject to the conditions in force. The position for the specific arrangement should be confirmed rather than assumed, and the withholding and treaty analysis should be settled before signing rather than at the point of remittance.

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Copyright Societies, Statutory Licences and Royalty in Music

Content royalty in India carries a further regulatory layer:

• Section 33 of the Copyright Act, 1957 provides that the business of issuing or granting licences in respect of works may be carried on only through a registered copyright society. Commercial users — venues, broadcasters, event organisers, retail and hospitality — require licences covering the musical work, the associated literary work and the sound recording
• Following the Copyright (Amendment) Act, 2012, authors of literary and musical works incorporated in cinematograph films and sound recordings retain the right to receive royalties for utilisation other than in the film or in a cinema hall, and that right cannot be assigned except to their legal heirs or to a copyright society. Music and film royalty agreements must be drafted consistently with this
• Section 31D provides for a statutory licence for broadcasting of literary and musical works and sound recordings, with royalties determined by the prescribed authority

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Competition Law

Section 3(5) of the Competition Act, 2002 preserves the right to impose reasonable conditions necessary to protect intellectual property rights, so ordinary field, territory and quality restrictions attached to a royalty arrangement are generally acceptable. The exemption is not unlimited. Tie-ins, exclusive supply obligations, refusal to deal and resale price maintenance are assessed under Section 3(4), and abuse of a dominant position under Section 4 is not exempt at all — which is the context in which excessive or discriminatory royalty demands by a dominant licensor have been examined. Royalty for standard essential patents on fair, reasonable and non-discriminatory terms has been a live area of litigation before the Delhi High Court, and licensors and implementers in standards-based industries should take advice specific to that framework.

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Drafting Checklist

• Parties, and the schedule of licensed rights with registration numbers and status
• Grant — exclusive, sole or non-exclusive; field; territory; channels; term
• Royalty rate, and any tiering or escalation
• Royalty base, with an exhaustive deductions list
• Treatment of free goods, bundles, combination products, related-party sales, captive use and sub-licence income
• Anti-stacking provision with a floor, and any most favoured licensee term
• Minimum guaranteed royalty, recoupment and shortfall consequences
• Performance milestones and marketing commitments
• Accrual trigger, payment period, deadline, currency and conversion
• Withholding and gross-up position; GST inclusive or exclusive
• Interest on late payment; exclusion of set-off
• Reporting format and certification; record retention
• Audit rights, threshold-based cost allocation, and remedies for underreporting
• IP ownership, goodwill accrual and prohibition on registration by the licensee
• Renewal and maintenance responsibility for the licensed rights, with a step-in right
• Enforcement — notification, control, costs and recovery sharing
• Warranties, indemnity, insurance and liability caps
• Confidentiality
• Termination, sell-off, accrued royalty survival, and the post-expiry position
• Assignment, sub-licensing and change of control
• Governing law, jurisdiction and dispute resolution, with an expert determination mechanism for accounting disputes

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Where Royalty Agreements Go Wrong

1. “Net sales” left undefined, or defined by reference to the licensee’s own accounting policy
2. Deductions listed non-exhaustively, with “and such other deductions as are customary”
3. No minimum guaranteed royalty in an exclusive licence
4. Free goods and samples unlimited and royalty-free
5. Combination and bundled products with no apportionment mechanism
6. Sub-licence income treatment unstated
7. Related-party sales valued at transfer price, shrinking the base
8. Audit rights with no independent auditor, no access to records and no cost-shifting threshold
9. Accrual trigger unspecified, so the licensee accounts on receipt while the licensor expected despatch
10. Withholding and gross-up ambiguous, producing a dispute at the first remittance
11. Treaty benefit claimed without a TRC, Form 10F and no-PE declaration in place
12. Intra-group royalty set without benchmarking, creating transfer pricing exposure
13. Anti-stacking with no floor, allowing the rate to be reduced to nothing
14. Accrued royalty not expressly surviving termination
15. Post-patent-expiry royalty left to run without addressing Section 141 or separating the know-how component
16. Section 115BBF, 80RRB and 80QQB reliefs never considered
17. Music and film royalty drafted inconsistently with the 2012 amendment provisions on authors’ royalties

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How Delhi Legal Company Handles Royalty Agreements

• Structuring — lump sum, running, per-unit, tiered, milestone or hybrid, chosen against the commercial reality and the reporting the licensee can actually produce
• Royalty base engineering — exhaustive net sales definitions, deduction lists, apportionment for combination products, related-party pricing rules and sub-licence income treatment
• Minimums and performance — guaranteed royalties, recoupment mechanics, milestones and graduated consequences short of outright termination
• Audit architecture — reporting formats, record retention, independent auditor rights, threshold-based cost allocation and reconciliation to GST and statutory filings
• Tax structuring alongside the drafting — GST classification and place of supply, Section 194J and Section 195 withholding, treaty analysis with TRC, Form 10F and no-PE documentation, gross-up allocation, and Section 115BBF, 80RRB and 80QQB reliefs where available
• Transfer pricing support for intra-group brand and technology royalty, coordinated with your tax advisers
• Regulatory review — Competition Act screening, copyright society and Section 31D position for content and music, and FEMA for cross-border remittance
• Disputes — royalty audits, underreporting claims, base interpretation disputes, termination and recovery of accrued royalty

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Frequently Asked Questions (FAQs)

1. What is a royalty agreement?

A. It is a contract under which one party pays another for the use of an asset — most commonly intellectual property or content — usually as a percentage of sales or a per-unit amount, over the period of use. It may be a standalone agreement or the payment architecture within a broader licence or franchise agreement.

2. What is the difference between a licence and a royalty agreement?

A. The licence is the permission to use the right; the royalty provisions are the payment mechanism. In most cases they sit in one document. A royalty agreement drafted separately usually arises where the permission already exists and only the commercial terms are being recorded or revised.

3. What royalty rate is normal?

A. There is no standard rate. It varies enormously by sector, by the strength and remaining life of the right, by exclusivity, by territory, and by what else the licensor is providing — know-how, training, marketing support or supply. What matters far more than the rate is the base to which it is applied, because the same rate on differently drafted bases produces very different money.

4. What is the royalty base?

A. The figure to which the royalty rate is applied — commonly net sales, but also gross sales, ex-factory value, net selling price or net receipts. It is the most important definition in the agreement and should be drafted exhaustively rather than by reference to what is customary.

5. What deductions are usually allowed in calculating net sales?

A. Typically GST and other indirect taxes where separately stated on the invoice, trade discounts and rebates actually allowed, returns and credits, freight, insurance and packing where separately invoiced and not marked up, and documented bad debts. Marketing costs, distribution and administrative overheads are ordinarily not deductible unless expressly agreed.

6. How should free goods and samples be treated?

A. Define a permitted royalty-free allowance as a percentage of volume, with royalty payable on anything beyond it. Without a cap, promotional volume has a tendency to expand and the base shrinks correspondingly.

7. Our product contains the licensed technology plus a lot else. How is royalty calculated?

A. Through an apportionment mechanism, agreed in advance. Common approaches are royalty on the standalone value of the licensed component, a reduced rate applied to the whole product, or a fixed sum per unit. Leaving combination products undefined is the most expensive omission in technology licensing.

8. What is a minimum guaranteed royalty and do I need one?

A. It is a floor payable regardless of actual sales. In any exclusive or sole licence it is essential, because without it the licensee can hold the territory or category and do nothing while preventing you from appointing anyone else. The agreement should state whether it is recoupable against running royalty and what happens on shortfall.

9. How is sub-licence income treated?

A. Choose expressly between a royalty on the sub-licensee’s sales and a percentage of what the licensee actually receives from the sub-licensee. Both are used, they produce very different results, and the agreement should also state whether sub-licensing is permitted at all and on what terms.

10. What is royalty stacking?

A. It arises where the licensee must pay several licensors on the same product, so the aggregate royalty burden becomes commercially unviable. An anti-stacking clause permits a reduction in your rate to reflect third-party royalties — and it should always be subject to a floor, below which your rate cannot fall.

11. When does royalty become payable?

A. Whenever the agreement says. The accrual trigger should be specified precisely — on despatch, on invoice, or on receipt of payment from the customer. This determines who carries collection risk and can materially change cash flow in a business with long receivable cycles.

12. What audit rights should a licensor have?

A. The right to appoint an independent chartered accountant, on reasonable notice, at a defined frequency, with access to books, invoices, despatch and production records, and the ability to reconcile against GST returns and audited financials — together with cost-shifting where an underpayment above a stated threshold is found, interest on the shortfall, and a right to terminate for material underreporting.

13. How long should the licensee retain records?

A. For the term and for a defined period afterwards, long enough to cover the final audit right. The retention obligation should survive termination expressly, or the records will be gone by the time the final audit is conducted.

14. Does royalty attract GST?

A. Yes. Licensing of intellectual property is a supply of service and attracts GST, with the rate, classification and place of supply to be determined for the arrangement. Exports of service may be zero-rated where the conditions are satisfied, and payments to foreign licensors raise reverse charge considerations. The agreement should state whether royalty is quoted inclusive or exclusive of GST.

15. What TDS applies to royalty payments?

A. Domestic royalty attracts withholding under Section 194J. Royalty paid to a non-resident attracts withholding under Section 195 at the rate prescribed by Section 115A, plus surcharge and cess, subject to the beneficial rate under an applicable tax treaty. Rates change with each Finance Act and should be confirmed before payment.

16. Who bears the withholding tax?

A. Whoever the agreement says, and it must say. If the agreement provides for payment net of tax, Section 195A requires the amount to be grossed up for withholding purposes, which increases the payer’s cost significantly. Ambiguity here is a common source of dispute at the first remittance.

17. What is needed to claim a lower treaty rate?

A. The non-resident recipient must furnish a Tax Residency Certificate, Form 10F and ordinarily a declaration of no permanent establishment in India. The remitter must complete Form 15CA and Form 15CB compliance. Because the domestic definition of royalty in Explanation 2 to Section 9(1)(vi) is wider than most treaty definitions, the treaty position must be examined rather than assumed.

18. Is payment for software a royalty?

A. Not necessarily. The Supreme Court in Engineering Analysis Centre of Excellence Pvt. Ltd. v. CIT held that amounts paid by Indian end-users and distributors to non-resident suppliers for resale or use of shrink-wrapped or off-the-shelf software are not royalty under the applicable treaties, so no withholding arises under Section 195. The characterisation of any particular arrangement depends on its terms, and should be analysed at the drafting stage.

19. We pay royalty to our parent company. Is that a problem?

A. It requires care. Royalty between associated enterprises must be at arm’s length under the transfer pricing provisions, and brand and technology royalty is among the most litigated issues in Indian transfer pricing. Both charging nothing and charging an unsupportable rate attract scrutiny. Benchmarking and evidence of benefit received should be documented when the arrangement is put in place.

20. Are there tax reliefs on royalty income?

A. Yes, and they are frequently missed. Section 115BBF provides a concessional rate on royalty from a patent developed and registered in India by an eligible resident patentee. Section 80RRB provides a deduction for a resident individual patentee on royalty from a patent registered under the Patents Act, 1970. Section 80QQB provides a deduction for a resident individual author on royalty from books. Limits and conditions should be confirmed against the current law.

21. Can royalty continue after the patent expires?

A. It requires deliberate structuring. Section 141 of the Patents Act, 1970 gives either party the right to determine the contract on three months’ notice once the patent, or all the patents protecting the article or process, ceases to be in force. Where the arrangement covers both patents and know-how and payments are intended to continue, the know-how component should be identified and valued separately rather than allowing patent royalty to run on by default.

22. What happens to royalty when the agreement is terminated?

A. Accrued royalty should survive termination expressly, royalty should continue to be payable on any inventory sold during an agreed sell-off period, a final statement should be required, and the audit right should survive for a stated period. If these are not said, they are frequently argued about.

23. Do we need a copyright society licence to use music commercially?

A. Yes. Section 33 of the Copyright Act, 1957 provides that the business of issuing licences in respect of works may be carried on only through a registered copyright society, and commercial use of music requires licences covering the musical work, the associated literary work and the sound recording.

24. Can authors and composers assign away their royalty rights?

A. Not entirely. Following the Copyright (Amendment) Act, 2012, authors of literary and musical works incorporated in cinematograph films and sound recordings retain the right to receive royalties for utilisation other than in the film or in a cinema hall, and that right cannot be assigned except to their legal heirs or to a copyright society. Agreements must be drafted consistently with this.

25. Can a licensor charge whatever royalty it likes?

A. Ordinarily yes, subject to contract. However Section 3(5) of the Competition Act, 2002 protects only reasonable conditions necessary to protect intellectual property, and abuse of a dominant position under Section 4 is not exempt at all. Excessive or discriminatory royalty demands by a dominant licensor, and royalty for standard essential patents, are areas where specific advice should be taken.

26. What does Delhi Legal Company charge for royalty agreement work?

A. It depends on whether the engagement is drafting, negotiation, a review of an agreement you have been offered, or a royalty audit and recovery matter. We quote in writing, and we handle the commercial drafting and the GST, withholding and transfer pricing structuring together rather than leaving the tax position to be discovered after signing.