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Income Taxation

Introduction and Basic


Principles
Income Tax
- tax on all yearly profits arising from
property, profession, trade or
business, or a tax on persons income,
emoluments, profits and the like.
(Fisher vs. Trinidad, GR L-19030, Oct. 20,
1922)
Nature of Income Tax
An income tax is generally an excise tax
and not a tax on property. It is levied
upon the privilege of receiving income
or profit.
(Republic of the Philippines vs. Manila Electric
Company, November 15, 2002)
Basis of Taxing Income:
State Partnership Theory
The basis of government in taxing
income emanates from the States
partnership in the production of income
by providing protection, resources,
incentives and proper climate for such
production. (CIR v. Lednicky, G.R. Nos. L-18169, L-
18262 and L-21434, July 31, 1964).
General Principles of Income Taxation
TAXPAYER TAXABLE INCOME
Resident citizen All income derived from sources within and
without the Philippines
Non-resident citizen Taxable only on income derived from sources
within the Philippines
Alien (whether resident or Taxable only on income derived from sources
non-resident) within the Philippines
Domestic Corporation Taxable on all income derived from sources
within and outside the Philippines
Foreign Corporation Taxable only on income derived from sources
within the Philippines.
In short
only RESIDENT CITIZENS (RC) AND
DOMESTIC CORPORATIONS (DC) are
taxable on their WORLDWIDE income;
and
other types of individual and corporate
taxpayers (i.e. non-resident citizen, non-
resident alien, foreign corporation) are
taxable only on income derived from
sources WITHIN the Philippines.
INCOME
refers to all wealth which flows into the
taxpayer other than a mere return of
capital
includes the forms of income
specifically described as gains and
profits, including gains derived from the
sale or disposition of capital assets.
INCOME
Flow of service rendered by capital by
payment of money from it or any
benefit rendered by a fund of capital in
relation to such fund through a period of
time (Madrigal v. Rafferty, GR 12287, Aug.
8, 1918).
INCOME
Take Note:
Mere advance in the value of the
property or of a corporation in no sense
constitutes the income specified by law.
Such advance constitutes and can be
treated merely as an increase in capital.
What is the nature of income?
Income is that flow of services rendered by that
capital by the payment of money from it or any
other benefit rendered by a fund of capital in
relation to such fund through a period of time;
Income is the fruit of capital or labor severed
from the tree.
(Madrigal v. Rafferty, GR 12287, Aug. 8, 1918)
Distinctions between Capital
and Income (1995 Bar Question)
CAPITAL INCOME
Constitutes the Any wealth which flows into the
investment which is the taxpayer other than a mere return of
source of the income capital
It is the wealth which is the is the service of wealth; the fruit of
source of income capital
Fund Flow
Not subject to tax Subject to tax
Examples:
a) LOANS RECEIVABLE
Receipt of payment of :
principal- mere return of capital
interest paid on such loans- return on capital

b) SALE OF MERCHANDISE
Receipt of payment:
representing Cost of Sales mere return of
capital
representing the profit (mark-up) - return on
capital
When is income taxable?
Elements of Taxable Income:
1. There is income, gain or profit (existence of
income);
2. The income, gain, or profit is not exempt or
excluded from income tax; and
3. The income, gain or profit is received or
realized during the taxable year (realization
of income).
When is income considered
received for income tax purposes?
1. If actually or physically received by
the taxpayer (actual receipt); or
2. If constructively received by the
taxpayer (constructive receipt)
Principle of Constructive Receipt
for Tax Purposes
Income which is credited to the account of or
set apart for a taxpayer and which may be
drawn upon by him at any time is subject to tax
for the year during which they are so credited or
set apart, although not then actually reduced
to possession. (refer to Sec. 52, RR No. 2-40)
When is income realized?
Conditions:
1. The earning process is complete
or virtually complete; and
2. An exchange has taken place
1989 Bar Question:
In 2000, ABC Corporation had a capital stock of 1,000
shares without par value. At the time of its incorporation,
the value of each no-par value share was P10. In 2011, due
to its profitable operations, the corporation earned a
surplus of P200,000.00. The Corporations Board of
Directors increased the stated value of each share by
P190, making each share worth P200. The BIR, for income
tax purposes assessed each stockholder for the P190
increase. Is the BIR correct?
Answer:
No. The stockholders have not physically or
constructively received any income subject to tax. There
was no change in the proportion of their ownership in
the corporation considering that the shares of stock are
without par value. Furthermore, there was no realization
of the income through the change in stated value. When
the stockholder disposes of the shares, then the same
would be subject to capital gains taxes.
Tests for Income Determination:
1. Realization/ Severance Test
There is no taxable income until there is a
separation from capital of something of
exchangeable value.
Income is not deemed realized until the
fruit has been plucked from the tree.
(Eisner v. Macomber, 252 US 426)
Tests for Income Determination:
2. Claim of Right Doctrine
a taxable gain is conditioned upon the
presence of a claim of right to the
alleged gain and the absence of definite
unconditional obligation to return or
repay. (Doctrine of Ownership,
Command, or Control)
Tests for Income Determination:
3. All Events Test
for income or expense to accrue, this
test requires the fixing of a right to
income or liability to pay, and the
availability of the reasonable accurate
determination of such income or
liability. (CIR v. Isabela Cultural Corp., G.R. No.
172231, February 12, 2007)
Taxable Periods:
1. Calendar Period or CalendarYear
an accounting period which starts from January 1 and
ends on December 31.
2. Fiscal Period or FiscalYear
an accounting period of 12 months ending on the last
day of any month other than December 31.
3. Short Period
an accounting period wherein income shall be
computed on the basis of a period less than 12
months..
What is the general rule in
computing the taxpayers taxable
income?
The taxable income shall be
computed upon the basis of the
taxpayers annual accounting period,
that is, fiscal year or calendar year, as
the case may be.
Can an individual taxpayer compute
his income on the basis of fiscal year?
No. Individual taxpayers cannot use
the fiscal period. They are required to
use the calendar year (RR 2-40). This
would include Estates and Trusts and
General Professional Partnerships.
Is a corporation required to use only
the calendar year?
No. Corporations may, with the
approval of the CIR, file their returns
and compute their income on the basis
of a fiscal year (see Section 43, Tax
Code).
When is taxable income computed
on the basis of calendar year?
1. Taxpayers accounting period is other than fiscal
year
2. Taxpayer has no annual accounting period
3. Taxpayer does not keep books
4. Taxpayer is an individual
5. Taxpayer is a general professional partnership
6. Taxpayer is an estate or a trust
When is taxable income computed
on the basis of a short period?
1. Taxpayer, other than an individual, changes his
accounting period from fiscal to calendar year or from
calendar year to fiscal year or from one fiscal year to
another (Section 46, Tax Code)
2. Taxpayer dies
3. Corporation is newly-organized
4. Corporation is dissolved
5. Tax period is terminated by the CIR by authority of law
(Section 6 (D), Tax Code
METHODS OF ACCOUNTING
Accounting Method Recognition of Income and Expense
CASH METHOD All items of income received during the year shall be
accounted for in such taxable year
Only expenses actually paid shall be claimed as
deductions during the year
Dependent on inflow or outflow of cash
Gains and profits are included in gross income when
earned whether received or not,
Expenses are allowed as deductions in the period
ACCRUAL METHOD they are incurred, although not yet paid.
It is the right to receive and not the actual receipt
that determines the inclusion of the amount in the
gross income
METHODS OF ACCOUNTING
Installment Method
appropriate when collections of the proceeds of
sales and incomes extend over relatively long
periods of time and there is strong possibility
that full collection will not be paid

Seller recognizes the gross profit on sale in


proportion to the cash collected during the year.
METHODS OF ACCOUNTING
Percentage of Completion
applicable in the case of a building, installation, or
construction contract covering a period in excess of one
year

gross income derived from such contract may be


reported upon the basis of percentage of completion
What are the different kinds of income tax
systems?
1. Global Tax System
taxpayer is required to lump up all items of income
earned during a taxable period
pay under a single set of income tax rates on these
different types of income
2. Schedular Tax System
different tax treatments for different types of income
separate tax return is required to be filed for each type
of income
tax is computed on per return or per schedule basis.
What are the different kinds of income tax
systems?
3. Semi-Global or Semi-Schedular Tax System
tax system which is either (a) global or (b) schedular or
(c) both global and schedular may be applied
depending on the nature of the income realized by the
taxpayer during the year.

Note: The Philippines has adopted the semi-schedular or


semi-global tax system.
What are the features of the Philippine Income
Tax systems?
1. It is a direct tax
tax burden is borne by the income recipient upon
whom the tax is imposed
2. It is a progressive tax
tax rate increases as the tax base increases
3. It is comprehensive
adopts citizenship principle, resident principle and the
source principle in imposing income tax.
Types of Taxable Income
1. Compensation Income - derived from rendering
of services under an employer-employee
relationship

2. Professional Income - fees derived from


engaging in an endeavour requiring special
training as professional as a means of livelihood
Types of Taxable Income
3. Business Income - gain or profits derived from
rendering services, selling merchandise, manufacturing
products, farming and long-term contracts.
4. Passive Income -income in which the taxpayer merely
waits for the amount to come in such as Dividend
income, interest income, royalty income, winnings and
prizes, etc.
5. Capital Gain -gain derived from dealings in capital
assets
COMPENSATION INCOME
DEFINITION OF COMPENSATION FOR
INCOME TAX PURPOSES
All remuneration for services performed by an
employee for his employer under an employer-
employee relationship unless specifically excluded by
the Tax Code. This includes the cash value of all
remuneration paid in any medium other than cash.
(Section 78, NIRC, Section 2.78.3, RR No. 2-98).
DEFINITION OF COMPENSATION FOR
INCOME TAX PURPOSES
NOTE:
The name by which the remuneration for services is
designated is immaterial.
The basis upon which the remuneration is paid is
immaterial.
TEST TO DETERMINE WHETHER AN INCOME
IS COMPENSATION OR NOT
The test is whether such income is received by
virtue of an employer-employee relationship.
Q: If the compensation is paid after separation,
will it still form part of compensation income?
Yes. Remuneration for services constitutes
compensation even if the employer-employee
relationship no longer exists at the time when
payment is made between the person in whose
employ the services had been performed and the
individual who performed them (Section 2.78.1(A)
RR No. 2-98]
Q: Are living allowances treated as compensation
income?
A: Generally, living allowances should be treated as
income of the recipient. However, if any amount
thereof is paid directly by the employer and paid for
the convenience of the latter, the excess of what
the recipient employee would have ordinarily
incurred for his own subsistence is not taxable
income but a business expense of the employer.
This exemplifies the employers convenience rule
(COLLECTOR VS. HENDERSON [1 SCRA 649])
BACKWAGES, ALLOWANCES AND BENEFITS
AWARDED IN LABOR DISPUTE
Backwages, allowances and benefits awarded in a labor
dispute constitute remuneration for services that would have
been performed by the employee in the year when actually
received or during the period of his dismissal from the service
which was subsequently ruled to be illegal.
The employee should report as income and pay the
corresponding income taxes by allocating or spreading his
backwages, allowances and benefits thru the years from this
separation up to the final decision of the court awarding the
backwages.
ITEMS NOT INCLUDED IN
COMPENSATION INCOME

1. For agricultural labor paid entirely in products of the


farm where the labor is performed;
2. For domestic service in a private home;
3. For casual labor not in the course of the employers
trade or business;
4. For services by a citizen or resident of the Philippines
for a foreign government or an international
organization.
STATUTORY MINIMUM WAGE
Compensation income falling within the meaning of
"statutory minimum wage" (SMW) under R.A. No. 9504 shall
be exempt from income tax and withholding tax.
Holiday pay, overtime pay, night shift differential pay, and
hazard pay earned by Minimum Wage Earner (MWE) shall
likewise be covered by the above exemption, provided that
an employee who receives/earns additional compensation in
EXCESS of the allowable statutory amount of P30,000 shall
NOT enjoy the privilege of being a MWE and, therefore,
his/her entire earnings are not exempt from income tax and
withholding tax.
PROFESSIONAL INCOME
DEFINITION OF PROFESSIONAL INCOME
Professional income refers to fees received by a professional
from the practice of his profession provided that there is NO
employer-employee relationship between him and his clients.
It includes the fees derived from engaging in an endeavor
requiring special training as a professional as a means of
livelihood, which includes, but is not limited to, the fees of
CPAs, doctors, lawyers, engineers and the like (RR No. 2-98)
Q: Distinguish professional income from
compensation income.
The existence or absence of an employer-employee
relationship determines whether the income shall
be treated as compensation income or professional
income. If there is an employer-employee
relationship, then it is considered compensation
income. Otherwise, it is considered professional
income.
INCOME FROM BUSINESS
DEFINITION OF BUSINESS INCOME
Business income refers to gross income derived from
the sale of goods, properties or services. It may come
from the conduct of trade or business or the exercise of
a profession or gains from dealings in property.
ENGAGED IN TRADE OR BUSINESS
There is no specific criterion as to what constitutes "doing" or
"engaging in" or "transacting" business. Each case must be judged
in the light of its peculiar environmental circumstances.

The term implies continuity of commercial dealings and


arrangements and contemplates, to that extent, the performance
of acts or works or the exercise of some of the functions normally
incident to, and in progressive prosecution of, commercial gain or
for the purpose and object of the business organization.
(Commissioner vs British Overseas Airways Corporation)
INCOME FROM DEALINGS IN
PROPERTY
What gains from dealings in property are
included in the gross income?
Only gains derived from the sale or exchange of property
considered as ordinary assets.
Q: What is the importance of knowing if an
asset/income is capital or ordinary
The tax treatment will vary depend on the nature of
the asset. For example, if real property is a capital
asset, the gain from the sale thereof shall be subject to
the final capital gains tax of 6%. If it is an ordinary
asset, any gain from the sale thereof shall form part of
the ordinary income which shall be subject either to
graduated income tax rates (if an individual) or
corporate income tax (if a corporation).
Passive Income
Refers to income derived from any activity on
which the taxpayer has no active participation
or involvement.
Passive incomes subject to final tax under
the NIRC (Section 24 (B))

1. Interests;
2. Cash and/or property dividends;
3. Royalties; and
4. Prizes and awards.
What is meant by income subject to final
tax? (2001 Bar)
Income subject to final tax refers to income wherein the tax
due is fully collected through the withholding tax system.
The payor of the income withholds the tax and remits it to
the government as a final settlement of the income tax due
on said income.
The recipient is no longer required to include the item of
income subjected to final tax as part of his gross income in
his income tax return.
Interest income
It is the amount of compensation paid for the
use of money or forbearance from such use.
1. Interest on currency bank deposits, yield or
other monetary benefits from deposit
substitutes, trust funds & similar arrangements.

RECIPIENTS TAX RATE


RC/NRC/RA/NRA-ETB 20% final tax
NRA-NETB 25% final tax
2. Interest income under the Expanded
Foreign Currency Deposit System

RECIPIENTS TAX RATE


RC/RA 7.5% final tax
NRC/NRA-ETB/NRA-NETB EXEMPT
NOTE:
Under Revenue Regulations No. 14-2012, if a bank
account that is jointly in the name of a non-
resident citizen such as an overseas contract
worker or a Filipino seaman and his/her spouse or
dependent who is a resident in the Philippines, 50%
of the interest income from such bank deposit shall
be treated as exempt while the other 50% shall be
subject to a FWT of 7.5%.
3. Interest income from long-term deposit
or investment
RECIPIENTS TAX RATE
RC/NRC/RA/NRA-ETB Deposit held for:
1. Less than 3 years 20%
2.3 years to less than 4 years
12%
3. 4 years to less than 5 years
5%
4.5 years or more - EXEMPT
NRA-NETB 25% final tax
Dividend income

Any distribution made by corporation to its


shareholders out of its earnings or profits and
payable to its shareholders, whether in money or
other property (NIRC, Sec. 73 (A).
Cash and/or property dividends may come
from:
A domestic corporation or from a joint stock company,
insurance or mutual fund companies and regional operating
headquarters of multinational companies;
Share of an individual in the distributable net income after
tax of a partnership (except a GPP) of which he is a partner;
Share of an individual in the net income after tax of an
association, a joint account, or a joint venture or consortium
taxable as a corporation of which he is a member or co-
venturer.
Tax on cash and/or property dividends shall apply only on
income earned on or after January 1, 1998 subject to the
following rates:
a. 6% beginning January 1, 1998;
b. 8% beginning January 1, 1999; and
c. 10% beginning January 1, 2000.
Tax rates of dividend income
RECIPIENTS TAX RATE
RC/NRC/RA 10% final tax
NRA-ETB 20% final tax
NRA-NETB 25% final tax
NOTE: Cash and/or property dividends
from a foreign corporation

If the recipient is a resident citizen, it shall be subject


to the normal graduated tax rates.
If the recipient is a non-resident citizen or a resident
alien, it shall be subjected to the graduated rates for
dividend earned from sources within the Philippines.
Royalty income

It is the payment for the use and exhaustion


of property such as earnings from copyrights,
patents, trademarks, formulas and natural
resources under lease.
Tax rates of other royalties (e.g. patents
and franchises)
RECIPIENTS TAX RATE
RC/NRC/RA/NRA-ETB 20% final tax
NRA-NETB 25% final tax
Tax rates of royalties on books, literary
works and musical composition

RECIPIENTS TAX RATE


RC/NRC/RA/NRA-ETB 10% final tax
NRA-NETB 25% final tax
Prizes and winnings

Refers to the amount of money in cash or in kind


received by chance or through luck and are
generally taxable except those mentioned under
Section 32 (B) of the NIRC.
Tax rates on prizes (exceeding
P10,000.00) and winnings
RECIPIENTS TAX RATES
RC/RA/NRC/NRA-ETB 20% final tax
NRA-NETB 25% final tax
NOTE: Lotto winnings and winnings
from the Philippine Charity
Sweepstakes are tax-exempt.
Income Taxation for General
Professional Partnership
SECTION 26

A general professional partnership as such shall not be


subject to the income tax imposed under this Chapter.
Persons engaging in business as partners in a general
professional partnership shall be liable for income tax
only in their separate and individual capacities.
For purposes of computing the distributive share of
the partners, the net income of the partnership shall
be computed in the same manner as a corporation.

Each partner shall report as gross income his


distributive share, actually or constructively received,
in the income of the partnership.
What is General Professional Partnership?

- a partnership formed by professionals for the sole purpose


of exercising their common profession, no part of the
income of which is derived from engaging in any trade or
business.
General Professional Partnership are NOT
subject to income tax

- but they are required to file returns of their income


for the purpose of furnishing information as to the
share in the gains or profits which each partner shall
include in his individual return
The distributive shares of individual partners in the
net profit of a GPP is taxable in the hands of the
partners
It is the individual partners who shall be subject to
income tax, and consequently, to withholding tax, in
their separate and individual capacities
Since the taxable income is in the hands of the
partner, the individual partner may still claim
deductions apart from the expenses claimed by the
GPP.
ILLUSTRATION:
A and B formed a General Professional
Partnership under the style of A, B and
Associates engaged in the practice of
architectural design. Their profit and loss
sharing ratios are : A, 70% and B, 30%.

During the year, the partnership made a


net income of P100, 000.
Question No. 1:
Is the partnership subject to income tax? Why?
Answer:
No. Under the Tax Code, a general
professional partnership is exempt from
income tax.
Question No. 2:
Is the partnership required to file an income
tax return?
Answer:
Yes. Even if a general professional partnership is exempt
from income tax, it is required under the Tax Code to file an
ITR because it serves as a check on the partners share in the
net income of the partnership as reported by them in their
individual ITR and as a basis in the examination by the BIR to
determine the correctness of such share as declared by the
partners.
Question No. 3:
How much should be reported by the partners in
their individual ITR assuming no profits were
distributed to them?

Answer:
Their respective shares in the net income of P100, 000.
To A: 70%of P100, 000= P70, 000
To B, 30% of P100, 000 = P30, 000
Question No. 4:
How much should the partners report in their individual
ITR assuming A received P5,000 and B P5,000 as partial
distribution of their shares in the net income of the
partnership of P100, 000?

Answer:
The answer is the same in 3rd because the partners in a
general professional partnership are required to declare
in their ITR their respective shares whether distributed
or not in the net income of the partnership.