A sentence is said to be written in an active voice if the subject of the sentence performs the action. Conversely, if the subject of the sentence is the recipient of the action, the sentence is written in passive voice. As such, it is simple to determine if a sentence is written in either active or passive voice by merely identifying if the subject performs or receives the action.
For items of income such as royalties, however, how can one determine if the royalties are active or passive income? Section 27 (A) of the Tax Code provides that gross income, including royalties, shall be subject to a regular corporate income tax rate of 30%. Section 27 (D), on the other hand, provides that certain passive income, which also includes royalties, shall be subject to a final withholding tax rate of 20%. As expressly denoted in the Code, royalties must be in the nature of passive income to be subject to 20% final withholding tax.
The Bureau of Internal Revenue (BIR) has clarified in various rulings that royalty income is considered active income if the same arises from the active pursuit of business, using as basis the primary purpose indicated in the Articles of Incorporation (AOI). But how can you determine if the activity is related to the primary purpose of the business and not merely incidental? What if the primary purpose of the business is to lease out its assets, but its actual income is from franchising? When is an item of royalty subject to the regular corporate income tax rate of 30% or to the final withholding tax rate of 20%?
In a case brought to the Supreme Court (SC), a taxpayer was assessed by the BIR for deficiency income tax on its royalty income earned during taxable year 2010. The taxpayer is a domestic corporation engaged in manufacturing, buying, selling, and dealing alcoholic and non-alcoholic beverages, as stated in its amended AOI. The taxpayer entered into a license agreement with another company (Company A) for the latter’s use of certain domestic intellectual property (IP) rights and received royalty fees. The taxpayer contended that the royalty fees are merely passive income arising from mere ownership of an asset. The generation of such income does not require any active action or material participation from the taxpayer. The taxpayer further reasoned that the act of licensing out certain IP rights is merely incidental to its primary purpose. It also claimed that it did not actively pursue Company A to enter into the said license agreement.
The BIR, however, argued that the taxpayer’s amended AOI revealed that part of the taxpayer’s primary purpose is “to own, purchase, license and/or acquire such trademarks and other intellectual property rights necessary for the furtherance of its business.” Hence, the BIR believed that there is factual basis to conclude that the taxpayer generated its royalty income in active pursuit and performance of its primary purpose. In addition, an analysis of the taxpayer’s financial statements disclosed that it had no other source of income other than the royalty income and a minimal amount of interest income.
The SC, on the other hand, pointed out that the amount of cash inflows from the taxpayer’s operating activities consists only of income from its royalty and interest income, as presented in the Statement of Cash Flows for both taxable years 2010 and 2009. Similarly, the SC observed that the taxpayer’s income tax return did not reflect any cost of sales or services for 2010. Having no amount reflected as cost of sales or services gave the SC sufficient reason to doubt whether the taxpayer’s main line of business actually involves manufacturing, buying, selling, and dealing alcoholic and non-alcoholic beverages, as they claim.
The SC deduced that the taxpayer’s royalty income from licensing its IP rights is income generated in the active pursuit and performance of its primary purpose; thus, it is not considered passive income subject to final withholding tax.
With the SC decision, taxpayers should revisit their agreements involving royalty transactions and determine if the related royalty income is generated in the active pursuit and performance of their primary business. Check whether the activities conducted in generating the royalty income are directly related to the primary purpose, as stated in the AOI. Taxpayers, especially those who mainly earn royalty income, such as franchising businesses, may need to reevaluate if the fees it derived from the grant of use of property, trademarks, and licenses are indeed passive income. These items of income are generally recognized as passive income. It is important to assess each income item and determine if they are derived from the conduct of the primary purpose of the business or merely supplemental.
Anthony Joseph A. Cometa is a senior of the Tax Advisory and Compliance of P&A Grant Thornton. P&A Grant Thornton is one of the leading audit, tax, advisory, and outsourcing services firms in the Philippines.