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1. Authors receive royalties from book publishers
2. Franchisors (i.e., McDonlads) receive royalties from franchisees (i.e., the owner of a McDonalds location) for use of the company name, as well as the system
3. The holder of a patent receives royalties from those who license the patent for use
4. Musicians receive royalties from their record labels

Obviously, the important point to our discussion is that game developers receive royalties from the game publishers. The basic underlying legal theory is that the owner of the rights can license those rights to someone, generally in return for royalties. This is all pretty elementary level analysis, but there are two additional topics that are important to royalties that aren't as straight forward: royalty structuring and royalty taxation.

Creating a royalty arrangement can actually get fairly complex, as there is generally as much freedom in structuring royalties as there is in general contracting. I'm sure most people think of a royalty in terms of some percent of sales, as was discussed in the case of XBLA. However, there are a lot of other common royalty schemes. Many deals accomplish approximately the same agreement through slightly different means, such as a percentage of gross profits or net revenues or a flat fee per product sold. Others may place incentives on sales thresholds. For example, a bonus may occur if 1,000,000 copies are sold, or the percentage may ratchet up after 100,000 units are sold. There's also a concept called an 'advance against royalties,' whereby a publisher pays an upfront royalty and then the actual amount earned is first used to pay back that amount. Most of these arrangements have no penalty to the creator if the advance isn't repaid based on sales.

In addition to these basic structures, there are some more advanced tweaks to the system that can be added. For a product that is really hot, a licensor may be able to negotiate a 'minimum royalty' which will be paid no matter what sales actually end up being. The minimum may be a one time amount or an annual amount, which may expire after so many years. There may also be deductions from a royalty for returns or bad debts by purchasers or a variety of other cost elements for the producer. This can get complex as a royalty based on 10% of net sales may be worth more than a royalty of 15% with set deductions. Which also means it's possible that under the revised XBLA royalty arrangement, the developer could be better off taking the royalty cut than deductions for the costs of the services they're getting, but without much in the way of actual numbers, it's basically impossible to say.

The other major concern about royalties is taxation. In the US, taxation isn't very complex. Royalties are reported on a 1099-MISC and are treated as ordinary income. Of course, you also have to deal with things on a state-by-state level, and that's often why companies employ so-called 'IP Holding Companies' to control state level taxes. Delaware and Nevada are two of the more popular choices for favorable corporate tax rates.

Things only get more complex worldwide, and so people or companies working with global royalty schemes may attempt to take advantage of different royalty tax rates in other countries. The Netherlands, for example, has tax rates that are very favorable to royalty payments. Related to that, there are also countries with mandated tax withholdings on royalties being paid to foreign individuals or companies. Because of concerns like these, multi-national royalty tax planning can become very complex, and some companies even go as far as to restructure entire corporate arrangements to include greater or lesser percentages of income as royalties in order to maximize tax savings. For that matter, Microsoft may be offering a lot of simplification to XBLA developers on these global tax issues if their games are sold worldwide, but I hesitate to comment without knowing more details.

That pretty much covers the legal basics of royalties in a nutshell. There are a lot of business aspects to figuring royalty payments and amounts from both the developer and publisher standpoints, but I will leave those discussions to the Counting Rupees guys.

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Mark Methenitis is the Editor in Chief of the Law of the Game blog, which discusses legal issues in video games. Mr. Methenitis is also a licensed attorney in the state of Texas with The Vernon Law Group, PLLC and a member of the Texas Bar Assoc., American Bar Assoc., and the International Game Developers Assoc. Opinions expressed in this column are his own. Reach him at: lawofthegame [AAT] gmail [DAWT] com.

The content of this blog article is not legal advice. It only constitutes commentary on legal issues, and is for educational and informational purposes only. Reading this blog, replying to its posts, or any other interaction on this site does not create an attorney-client privilege between you and the author. The opinions expressed on this site are not the opinions of AOL LLC., Weblogs, Inc., Joystiq.com, or The Vernon Law Group, PLLC. As with any legal issue that may confront you in a particular situation, you should always consult a qualified attorney familiar with the laws in your state.