Taxation of royalties: Distinction between active and passive income

TAX LAW FOR BUSINESS

- Fulvio D. Dawilan

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 percent (10 percent 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.