When do royalties become ordinary income?
By: Atty. Euney Marie Mata-Perez on May 1,2025
ROYALTIES are generally considered passive income. Thus, royalties earned by an individual citizen or domestic corporation are generally subject to a 20-percent final withholding tax. The rate is reduced to 10 percent if it is earned on books, literary works, and musical compositions.
Our National Internal Revenue Code (Tax Code) enumerates royalties in the list of passive income which a taxpayer may earn, together with interest, dividends, prizes and winnings. (Tax Code, Sec. 2 [b]). However, it also includes royalties as gross income, which can be subject to ordinary income tax.
There have been instances when royalties may be considered ordinary income, as a result of which the recipient is required to report the amounts received as part of gross income in calculating net taxable income subject to regular income tax.
Generally, ordinary income is generated in the pursuit and performance of the corporation’s primary purpose and ordinary course of business. On the other hand, passive income is a type of income that is acquired with little or no labor to earn or maintain. It is generally derived from work that one does not personally do, or directly participate in. Thus, clear examples of passive income are interest income, dividends, rental income, and royalties.
However, it has been held that, if the earning of the “passive income” is the corporation’s main purpose, the income may be considered as ordinary income.
Based on the above, royalties are therefore not automatically considered passive income. There must be a determination of whether the income is generated in the active pursuit and performance of the corporation’s primary purpose. Thus, in the case of Iconic Beverages Inc. v. Commissioner of Internal Revenue (CTA EB Case Nos. 1563 & 1564, Sept. 18, 2018), the taxpayers argued that the royalty income they received should be taxed as passive income because it was incidental to the ownership of an asset. They argued that they did not even pursue the licensee to enter into a license agreement and that the licensing out of the intellectual property rights was only incidental to their primary purpose, which is to manufacture, buy, sell, and deal in alcoholic and non-alcoholic beverages.
The Court of Tax Appeals, however, disagreed and held that the taxpayer’s royalty income was ordinary business income. They considered that the taxpayer’s 2009 and 2010 audited financial statements showed that the royalty income was its main source of income. Also, the CTA took note that the taxpayer’s primary purpose included the power “to own, purchase, license and/or acquire such trademarks and other intellectual property rights necessary for the furtherance of its business.”
The Bureau of Internal Revenue took a similar view in BIR Ruling 323-19 wherein Goldilocks Bakeshop, Inc. (GBI) was determined to have included franchising as a primary business purpose and was thus liable for regular corporate income tax on their income derived from its franchising business.
In this ruling, GBI requested confirmation on whether their royalty income from licensing and franchising activities is considered ordinary income, therefore subject to the 30-percent regular corporate income tax. In GBI’s Amended Articles of Incorporation, its primary purpose included the ability to carry on business “either by wholesale, retail or franchising; to establish, operate and maintain restaurants, refreshment parlors or other food outlets; to serve, arrange, cater food, drinks refreshments and other food or commodities” and “to offer such services to the public, and to do and perform such other acts and things necessary or incidental to the accomplishment of the foregoing corporate business and objects insofar as may be allowed by applicable laws and rules and regulations, including, without limitation, to invest, own or hold interest in similar businesses.”
The BIR held that to be subject to the 20-percent final withholding tax, the royalties must be in the nature of passive income as defined by the Tax Code. Since the income derived by GBI from its licensing and franchising activities is income generated in the active pursuit and performance of its primary purpose, the same is clearly not passive income subject to the 20 percent final tax. Stated differently, the BIR held that the royalty fees received by GBI were in the nature of ordinary business income because the aforesaid income was derived or generated from activities that were in accordance with the firm’s primary purpose, which is to operate and franchise Goldilocks Bakeshop stores.
It should be pointed out that under the Tax Code, royalties are considered the fees for the use of or the right or privilege to use in the Philippines any copyright, patent, design or model, plan, secret formula or process, goodwill, trademark, trade brand or other like property or right. However, it is also defined to include fees for the supply of scientific, technical, industrial or commercial knowledge or information as well as the supply of any ancillary and subsidiary assistance. It also includes fees for technical advice, assistance or services rendered in connection with technical management or administration of any scientific, industrial or commercial undertaking, venture, project or scheme.
Based on the above, before the regular income tax rates may apply to royalty income, it is necessary to determine whether the royalty income is indeed passive income or ordinary income.
Euney Marie J. Mata-Perez is a CPA-lawyer and the managing partner of Mata-Perez, Tamayo & Francisco (MTF Counsel). She is a corporate, M&A and tax lawyer who has been ranked as one of the top 100 lawyers of the Philippines by Asia Business Law Journal and is also the chairman of the tax committee of the Management Association of the Philippines. She acknowledges the contribution of Atty. Donn Marie Isabelle M. Balina in this article, which is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. If you have any question or comment, you can email the author at info@mtfcounsel.com or visit the MTF website at www.mtfcounsel.com.