Tax Articles

Taxation of Royalties: Distinction Between Active and Passive Income

By Atty. Fulvio D. Dawilan

Fulvio D. Dawilan Managing Partner   +632 8403 2001 loc.310 This email address is being protected from spambots. You need JavaScript enabled to view it. View Profile

The taxation of royalties had not changed, even with the amendments introduced by the Capital Markets Efficiency Promotion Act (CMEPA). Yet to some, there is confusion. To provide clarity, let me revisit the rules affecting the taxation of royalties.

For income taxation purposes, royalties may either be treated as active income or passive income – and these are taxed differently. Royalties earned as active income are subject to the regular income taxes while royalties earned as passive income attract 20% (10% on books and other literary works) final withholding taxes. Because of this difference, a determination as to whether a royalty income is passive or active is necessary for the correct tax treatment to be applied.

So when should a royalty be treated as active income and when should it be treated as passive income? Even before the enactment of the CMEPA, the distinction was already clear – based on clarifications made by the tax bureau in a number of issuances (rulings) and in the explanations made in some Court decisions. While there was no specific definition of passive income in our tax law, through these pronouncements, we’ve learned that - if the income is generated in the active pursuit and performance of the taxpayer’s primary purposes, the same is not passive income.

So when is an income considered to have been earned in the active pursuit of the taxpayer’s business and when it is not? Typically, this can be determined from the purposes for which the taxpayer was organized and the business that it is actually pursuing. In one case, for example, the taxpayer’s financial statements indicated that royalty was the main source of income of the taxpayer. It was also in line with the taxpayer’s primary purposes, which includes owning, purchasing, licensing and/or acquiring trademarks. On these bases, the taxpayer’s royalty income was deemed to have been generated in the active pursuit and performance of its primary purposes. The Tax Court also noted that the act of licensing out taxpayer’s intellectual property rights cannot be said to be an incidental transaction considering that the financial statements clearly show that the main source of income is royalty. The determination of whether or not the royalty income is passive income is directly related to whether the income is generated in the active pursuit and performance of the taxpayer’s primary purpose.

The enactment of CMEPA had not changed this rule. It only made it clearer. While CMEPA added sub-provisions for individuals and corporations, specifically dealing with the taxation of royalties earned as passive income, that was only to separate it from other types of passive income and emphasize the taxation of royalties earned as such. And to be clear what constitutes passive income, for the first time, the Tax Code defined the term “passive income” as – referring to any income that is earned from sources that do not require a taxpayer’s active pursuit and performance of trade or business and is not subject to value-added tax. Nonetheless, this is not new as it simply mirrors the earlier pronouncements by our tax authority and by the Courts.

Interestingly, the recently issued Revenue Memorandum Circular No. 81-2025 also clarified that a passive income can become active if the taxpayer repeatedly and systematically engages in activities that produce such income, transforming it into business venture. Likewise, income typically considered active may be treated as passive if it is earned occasionally or without any substantial or recurring effort. Based on the same circular, classification hinges on whether the income results from habitual, business-driven actions or from merely holding assets and earning returns without substantial participation. The degree, frequency and intent of participation in the income-producing activity are the main considerations in classifying income as passive or active.

These parameters in determining the classification of royalty income or income payment is important to both the incomer payor and income earner – to the payor because the classification determines the withholding tax obligation and to the income earner because the classification determines whether it is liable to pay the regular income taxes or simply leaves the responsibility to the payor to remit the taxes through the final taxes withheld. Hence, there is a need for both parties to determine and agree on the proper classification.

Not Covered. These rules apply only to income derived from sources within the country. Royalty income derived from sources outside the Philippines, even if earned by residents and taxed in the country, do not require distinction for purposes of imposing the proper income tax.

Neither do they affect all types of taxpayers. The rule covers only the income derived by citizens, resident aliens, non-resident aliens engaged in trade or business in the Philippines, domestic corporations and resident foreign corporations. Royalty income earned by non-resident aliens not engaged in trade or business in the Philippines and non-resident foreign corporations are not governed by these rules. These types of taxpayers are subject to the 25% final withholding tax on their royalty income earned from Philippine sources. But if the income earner is a resident of a country of which the Philippines has an existing tax treaty, a lower tax rate as defined in the applicable tax treaty may apply. For these taxpayers, same rule applies without distinction as to whether the royalty income is considered active or passive.

As a last note, the new Tax Code definition of passive income includes the phrase “not subject to value-added tax”. With this specific qualification, I submit that once an income is classified as passive income, no VAT should attach – not even the rule on incidental transaction should apply.