Franchise Royalty Tax in the Philippines: What Franchisees and Franchisors Should Know

Franchise royalties in the Philippines are treated as income from services, and the tax consequences depend on whether the franchisor is a VAT-registered service provider. Under the Tax Code, income from services rendered in the Philippines is generally subject to value-added tax (VAT), while the franchisee may also have withholding obligations. The royalty is not a passive dividend or interest payment — it is compensation for the continuous use of a brand, system, and support services, which is why it is analyzed as service income.

This article explains the general tax treatment of franchise royalties, how VAT applies to service income, and what both parties should confirm before signing a franchise agreement.

How Franchise Royalties Are Characterized for Tax Purposes

A franchise royalty is the periodic fee a franchisee pays the franchisor for the right to use the franchisor's trademark, business system, and operational know-how. In Philippine tax practice, this is generally characterized as income from services rather than as a sale of goods or a passive investment return.

The distinction matters because the Tax Code treats service income differently from certain passive incomes. Under the VAT system, a sale of services is a taxable transaction, and the seller of the service — the franchisor — is the one liable for the VAT, although the tax is typically passed on to the franchisee as part of the billing.

Revenue Memorandum Circular No. 28-2003, which addresses VAT on financial institutions, confirms the general principle that VAT applies to fees and compensation received for performing services. While that circular specifically discusses trust departments and financial intermediaries, it illustrates the broader rule: the VAT attaches to the fee or compensation for the service, not to the underlying asset or fund.

VAT on Royalty Payments

If the franchisor is VAT-registered, the royalty it receives is generally subject to VAT. The franchisor must issue a VAT invoice or official receipt reflecting the output tax separately.

RMC No. 28-2003 states that a billing statement or statement of account cannot serve as an official receipt, because an official receipt is issued only upon receipt of the monetary consideration. This principle is relevant to franchise arrangements: the franchisor should issue the proper BIR-registered receipt upon collection of the royalty, not merely a monthly statement of account.

The same circular emphasizes that VAT-registered persons cannot forego the issuance of VAT invoices or receipts, and that failure to issue them can result in suspension of business operations and other sanctions. Franchisors should therefore ensure that every royalty collection is properly documented.

For the franchisee, the VAT passed on by a VAT-registered franchisor may be claimed as input tax if the franchisee is also VAT-registered and the transaction is supported by a valid VAT invoice or official receipt. The input tax must be recorded in the books as a separate item from the account where it was sourced.

Withholding Tax on Royalties

Philippine tax rules generally require the franchisee to withhold a portion of the royalty payment and remit it to the Bureau of Internal Revenue. This is a separate obligation from VAT. The withholding tax is not an additional cost to the franchisee if it is properly withheld and remitted — it is an advance payment of the franchisor's income tax.

The specific withholding rate depends on the franchisor's classification and the applicable revenue regulations. Because rates and thresholds can change, the franchise agreement should clearly state who bears the withholding tax and how the gross-up, if any, will be computed.

Timing of VAT on Royalty Income

Under the VAT system, the tax is generally imposed on gross receipts, whether actually or constructively received. RMC No. 28-2003 explains that "gross receipts" is generally determined on a cash basis, so that if income is received actually or constructively, it is already subject to VAT. Constructive receipt occurs when the payment is placed at the control of the person who rendered the service without restrictions by the payor.

For franchisors, this means the VAT on royalty income arises when the royalty is received or made available, not merely when it is earned or invoiced. Accrual of income in the books without actual or constructive receipt is not yet a VAT taxable event, according to the same circular.

What the Franchise Agreement Should Address

A well-drafted franchise agreement should specify the royalty rate, the payment schedule, and whether the royalty is inclusive or exclusive of VAT. It should also state which party is responsible for withholding tax and whether the franchisee must gross up the payment if withholding applies.

The agreement should also require the franchisor to issue a BIR-registered VAT invoice or official receipt for each royalty payment. This protects the franchisee's ability to claim input VAT and ensures compliance with the documentation requirements under the Tax Code.

Frequently asked questions

Is franchise royalty subject to VAT in the Philippines?

Yes, if the franchisor is VAT-registered. Royalty is treated as income from services, and the sale of services is generally subject to VAT. The franchisor issues a VAT invoice or official receipt and passes the VAT on to the franchisee.

Does the franchisee need to withhold tax on royalty payments?

Yes, in most cases. The franchisee generally acts as a withholding agent and must withhold the applicable percentage tax on the royalty and remit it to the BIR. The specific rate depends on the franchisor's classification and the applicable regulations.

When is the VAT on royalty considered received?

Under the cash basis rule described in RMC No. 28-2003, VAT is imposed on income actually or constructively received. Constructive receipt happens when the payment is placed at the control of the franchisor without restrictions by the franchisee.

Practical takeaways

• Franchise royalties are generally treated as income from services, making them subject to VAT if the franchisor is VAT-registered.
• The franchisor must issue a BIR-registered VAT invoice or official receipt for each royalty collection; a billing statement alone is not sufficient.
• The franchisee typically has a withholding tax obligation on royalty payments and should remit the withheld amount to the BIR.
• VAT on royalty income arises upon actual or constructive receipt, not merely upon accrual or invoicing.
• The franchise agreement should clearly allocate VAT and withholding tax responsibilities and require proper BIR documentation.

Primary sources

The rules discussed above are drawn from the following primary sources. Where the firm's library holds the document as a PDF it is embedded here in full; the rest are cited by title.

RMC No. 28-2003 — Clarifies certain issues on the imposition of Value-Added Tax on banks, non-bank financial intermediaries, finance companies and other financial intermediaries not performing quasi-banking functions Digest | Full TextOpen in Law LibraryDownload PDF

• REPUBLIC ACT NO. 11232 - AN ACT PROVIDING FOR THE REVISED CORPORATION CODE OF THE PHILIPPINES

• REPUBLIC ACT NO. 590 - AN ACT TO AMEND CERTAIN SECTIONS OF COMMONWEALTH ACT NUMBERED FOUR HUNDRED AND SIXTY-SIX, AS AMENDED, OTHERWISE KNOWN AS THE NATIONAL INTERNAL REVENUE CODE, AND TO ADD TO TITLE II THEREOF A SUPPLEMENT PROVIDING FOR THE WITHHOLDING OF THE INCOME TAX ON WAGES, AND FOR OTHER PURPOSES.

This article is general information and not legal advice. For your specific situation, consult a lawyer or ask ASG Legal AI.