Is a Franchise Fee a Royalty or Ordinary Income? BIR Withholding Rules for Franchisors and Franchisees

A franchise fee paid to a domestic franchisor is, by default, treated as a royalty and subject to a 20% final withholding tax under Revenue Regulations No. 2-98 — but where franchising is the franchisor’s own core business, the BIR has instead classified the fee as active business income subject to a much lower 2% expanded withholding tax. Getting this classification wrong means a franchisee either over-withholds (starving the franchisor of cash it’s entitled to) or under-withholds (exposing itself to a deficiency assessment), so the distinction is worth understanding before a franchise agreement’s first fee payment goes out.

What’s the default rule for royalty payments? #

Royalties derived from sources within the Philippines and paid to a domestic corporation or resident individual are generally subject to a 20% final withholding tax, and a franchise fee — payment for the right to use a franchisor’s brand, trademarks, proprietary systems, and business methods — fits the ordinary definition of a royalty on its face. This is the baseline rule under RR No. 2-98’s withholding framework, the same regulation this site’s other withholding guides rely on for professional fees, rentals, and contractor payments. As tax practitioner summaries of the regulation’s royalty provision describe the rate:

Royalties derived from sources within the Philippines are subject to a final withholding tax of twenty percent (20%), whether paid to a citizen, resident alien individual, or a domestic corporation.

Under this default treatment, the franchisee withholds 20% of the gross franchise fee, remits it to the BIR as a final tax, and the franchisor has no further income tax obligation on that specific payment — the 20% closes out the transaction.

When does the BIR treat a franchise fee as active income instead? #

Where a company’s primary business is franchising itself — not merely licensing out a brand it built for some other purpose — the BIR has ruled that the resulting fee income is active business income rather than passive royalty income, because the franchisor is systematically operating a franchising business rather than passively collecting royalties on intellectual property incidental to some other trade. This distinction was applied concretely in BIR Ruling No. OT-179-2022, involving Max’s Group, Inc. and its subsidiaries. The ruling addressed franchise and royalty fees the group earned from its franchisees, and reached two connected conclusions:

• The franchise/royalty fees were earned from the franchisor’s primary business activity, and so were treated as active income subject to the regular corporate income tax rate, rather than the passive-income 20% final withholding tax that would apply to a true royalty.
• Correspondingly, franchisees — at least those classified among the BIR’s top withholding agents — were confirmed to withhold 2% expanded (creditable) withholding tax on the franchise fees paid to the franchisor, rather than 20% final tax.

The practical takeaway isn’t that every franchise fee automatically gets the lower 2% rate — a ruling issued to one taxpayer binds that taxpayer’s own facts, not the industry generally. The takeaway is that the classification genuinely turns on substance: is the franchisor primarily in the business of franchising (active income, 2% creditable withholding), or is it licensing a mark more incidentally to its main business (passive royalty, 20% final withholding)? A franchisee should confirm which category its own franchisor falls into rather than assume one rate by default.

Comparing the two withholding paths #

Worked example #

A mid-sized food franchise operator (the franchisor) charges each of its 40 franchisees a monthly royalty/franchise fee of 5% of gross sales. One franchisee posts ₱2,000,000 in monthly gross sales, generating a ₱100,000 franchise fee due to the franchisor.

• If treated as a passive royalty (default rule): the franchisee withholds 20% — ₱20,000 — as final tax, remits it, and the franchisor receives ₱80,000 net with no further income tax due on that fee.
• If the franchisor has confirmed its franchise fees are active business income (consistent with the classification applied in BIR Ruling No. OT-179-2022): the franchisee instead withholds 2% — ₱2,000 — as creditable tax, issues BIR Form 2307 for that amount, and the franchisor reports the full ₱100,000 in its own income tax return, crediting the ₱2,000 withheld against its total tax due for the period.

The cash-flow difference for the franchisor is significant — ₱80,000 net immediately under the final-tax route versus ₱98,000 net immediately under the creditable route (with the balance trued up through the franchisor’s own annual return either way) — which is exactly why getting the classification right, in writing, before the first payment matters to both sides of a franchise relationship.

Frequently asked questions #

What withholding tax rate applies to a franchise fee paid to a domestic franchisor? #

It depends on how the fee is classified. Royalties paid to a domestic corporation are generally subject to a 20% final withholding tax under Revenue Regulations No. 2-98. But where franchising is the franchisor’s own primary trade or business, the BIR has treated franchise fees as active business income rather than passive royalties, subjecting them instead to a 2% expanded (creditable) withholding tax.

Why does it matter whether a franchise fee is “active” or “passive” income? #

The classification determines both the withholding rate and whether the tax withheld is final or creditable. A passive royalty is subject to a 20% final withholding tax, closing out the franchisor’s tax liability on that specific payment. Active business income is instead subject to a lower 2% creditable withholding tax, with the franchisor reporting the full fee in its regular income tax return and crediting the 2% withheld against its total tax due.

Is a franchisee required to issue BIR Form 2307 on franchise fee payments? #

Yes, when the fee is subject to expanded (creditable) withholding tax rather than final withholding tax. A franchisee withholding under the 2% creditable rate issues BIR Form 2307 to the franchisor as proof of the tax withheld, which the franchisor then credits against its income tax due — the same mechanism used for any other creditable withholding tax.

Does this analysis change for a foreign (non-resident) franchisor? #

Yes. Royalties and business fees paid to a non-resident foreign corporation are generally subject to a final withholding tax of 25% on the gross amount, or a lower rate under an applicable tax treaty, rather than the domestic 20% royalty rate or the 2% creditable rate discussed here, which apply to domestic or resident payees.

Can a franchisee simply decide which withholding rate to apply? #

No. The classification should follow the substance of the arrangement and the franchisor’s own business — whether the franchise fee is passive royalty income or active income from the franchisor’s regular trade. A specific BIR ruling addressing a particular franchisor’s structure only binds that taxpayer; a franchisee unsure how its own franchisor’s fee should be classified should confirm the position with its own tax adviser rather than assume either rate applies by default.

Summary #

A franchise fee defaults to royalty treatment — 20% final withholding tax under RR No. 2-98 — but the BIR has recognized, in a ruling involving a well-known Philippine food franchise, that a franchise fee earned from the franchisor’s own core franchising business is active income subject instead to a 2% creditable withholding tax, evidenced by BIR Form 2307 rather than a final-tax certificate. A franchisee should confirm which classification its franchisor actually falls under rather than defaulting to either rate by assumption. For the general mechanics of issuing a creditable withholding certificate, see How to Claim Creditable Withholding Tax Credit Using BIR Form 2307, and for how royalty withholding compares with other passive-income certificates, see Withholding Tax on Interest, Royalties, and Dividends.