LESSON 3 (3 Hours)

FUNDAMENTALS OF INCOME TAXATION

INCOME – all wealth, which flows into the taxpayer other than as a mere return of capital and includes
gains

WHY IS INCOME TAXED? Income is the best measure of a taxpayer’s ability to pay.

BASIC DEFINITIONS;
1. GROSS INCOME- refers to what is income for taxation purposes
2. TAXABLE INCOME- as the pertinent items of gross income that are subject to tax after allowable
deductions
3. TAX BASE- the value of a certain goods or property for taxation purposes

CHARACTERISTICS OF GROSS INCOME

1. RETURN ON CAPITAL- resulted to an increase in net worth at the moment of its generation
2. REALIZED BENEFIT- by the taxpayer (realization means actual or constructive receipt of in cash)
Example of constructive receipt of income
1. Credit to an account owned by the taxpayer
2. Declaration of a share of the profits of a General Professional Partnership
3. Offsetting debt with right to receive dividends
4. Cancellation of debt in payment of service

Which do not constitute gross income?

1. Receipt representing returns of capital.
A. Proceeds of life insurance policy (upon death of the insured)
B. Proceeds received by the insured (still living) representing the premiums paid
2. Unrealized income
A. Appreciation of value of properties
B. Unrealized gain on investments
3. Those exempted by the Constitution, statutes, treaties or contract with taxpayer.
A. Receipt of non-profit institutions from their main activities
B. Contributions to GSIS, SSS, Philhealth, PAG-IBIG
C. Retirement and separation benefits under certain circumstances
D. Tax holiday for entities registered pursuant to the Omnibus Investment Code
E. Income of foreign government or corporations owned or controlled by them.

Tax Concept of Income = Gross Income = Taxable Income

 Gross income is broadly defined as any inflow of wealth to the taxpayer that increases net
worth from whatever source, legal or illegal.
 Elements of Gross Income:
o Return on Capital (Ability to Pay)
 Anything received as compensation for the loss of capital items deemed with
infinite value is considered a return of capital. (Life, Health, Human Reputation).
 For life, any gain realized, interest income or excess amount of proceeds are
taxable.

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  The recovery of lost profits through insurance, indemnity contracts or legal suite
constitutes a taxable return on capital.
o Realized Benefit (Benefit Received)
 Requisites:
 There must be an exchange transaction
 The transaction involves another entity
 It increases net worth of the recipient
 Benefits in the absence of transfers / Holding Gains, not taxable
 Actual Receipt / Constructive Receipt
 Income received in non-cash considerations is taxable at the fair value of the
property received.
o Not exempted by law, contract or treaty.
 Exclusions on Gross Income
Note: Entire Consideration received for Rendering of Services is an item of gross income.

TAXATION OF GROSS INCOME

A. PASSIVE INCOME
1. CAPITAL GAINS TAXATION- few final tax is imposed on certain gains on dealings on
properties.
A. Final tax on net gain on sale of domestic stocks directly to buyer (withheld at source)
B. Final tax on gains on sale of real property located in the Philippines classified as capital
asset.
2. OTHER WITHHELD FINAL TAX- these are groups of passive income that are subject to
withholding by the income payor.
A. Interest on deposits with banks
B. Prizes
C. Dividends received from domestic corporation
D. Winnings
E. Royalties

B. REGULAR (ACTIVE) INCOME TAX- applies to all items of gross income that are generated by
the taxpayer in the ordinary course of business or those items of passive income that are subject to
withholding by the income payor.
A. Progressive tax (0-35% schedular tax rates)- applicable to individual and taxable trusts
and estates.
B. Final Tax (30%)- applicable to corporations

Examples of active income:

1. Compensation income
2. Professional income
3. Business income
4. Those items of income that are excluded from capital gains tax
A. Gain on sale of properties located abroad
B. Gain on sale of properties located in the Philippines by non-residents
C. Gain on sale of other non-domestic stocks and non-real property capital assets
5. Those items of income that are excluded from other final taxes
A. Interest income on notes receivable (not deposit)

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 B. Prizes where taxpayer has no intention or active effort to compete (Nobel Prize, Cash
awards to “Most Outstanding Cagayano/Isabela”
C. Dividends from foreign corporations
6. Others
A. Certain tax benefits (i.e. items id deductions claimed in the past that are subsequently
recovered)
B. Obligations waived by the creditors in consideration of service

Classes of Individual Taxpayer and Their Situs

1. Resident Citizen (RC) – taxable globally (within and outside)

2. Non-resident Citizen (NRC) – taxable for incomes derived within the Philippines only
a. Who establishes to the satisfaction of the CIR the fact of their physical presence abroad
with a definite intention to reside therein;
b. Who leaves the Philippines during the taxable year to reside abroad, either as an
immigrant or for employment on a permanent basis;
c. Who stays outside the Philippines for more than 183 days
d. A citizen who has been previously considered as non-resident citizen and who arrives in
the Philippines shall likewise be treated as a nonresident citizen for the taxable year in
which he arrives in the Philippines with respect to his income derived from sources abroad
until the date of his arrival in the Philippines.
e. Overseas Contract Workers (OCWs). They are Filipino citizens employed in foreign
countries who are physically present in a foreign country as a consequence of their
employment thereat. To be considered as an OCW or OFW, he or she must be duly
registered as such with the Philippine Overseas Employment Administration
(POEA) with a valid Overseas Employment Certificate (OEC).

3. Resident Alien (RA) – taxable for incomes derived within the Philippines only
a. We generally consider as residents those whose length of assignments are indefinite or
exceeding two (2) years (BIR Rulings Nos. 051-81 and 052-81).

4. Non-resident Alien Engaged in Trade or Business (NRAETB) – taxable for incomes

derived within the Philippines only.
a. The term trade or business shall not include performance of services by the taxpayer as an
employee.
b. A nonresident alien individual who shall come in the Philippines and stay herein for an
aggregate period of more than 180 days during any calendar year shall be deemed as
doing business in the Philippines

5. Non-resident Alien Not Engaged in Trade or Business (NRANETB) – taxable for

incomes derived within the Philippines only

Corporate Income Taxpayers

1. Domestic Corporation – organized in accordance with Philippine Laws, Taxable Within and
Without
2. Foreign Corporation – organized in a Foreign Law

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 a. Resident Foreign Corporation – operates and conducts business in the Philippines through
a permanent establishment, taxable for income within
b. Non-Resident Foreign Corporation – does not operate or conduct business in the
Philippines, taxable for income within

Other Corporate Taxpayers

1. Partnership
a. General Professional Partnership – for the exercise of a common profession. GPP is not
treated as a corporation and is not a taxable entity but the partners are taxable with
respect to their share in net income of the partnership.
b. Business Partnership – taxable as a corporation
2. Joint Venture
a. Under a service contract with the Government - is not treated as a corporation and is not
a taxable entity but the venturers are taxable with respect to their share in net income of
the partnership.
b. All other JV are taxable as a corporation.
3. Co-Ownership
a. Property Preservation or Income Collection – not taxable, but the co-owners are taxable
with respect to their share in net income of the co-owned property
b. If the income of the co-owned property is to reinvested – considered as an unregistered
partnership, taxable as a corporation.

Income Tax Schemes

 Item of Gross Income taxable at either, Final Tax, Capital Gains Tax, and Regular Income Tax.

SITUS OF INCOME
A. Interest- debtor’s residence
B. Dividends
1. By a domestic corporation- within the Philippines
2. By a foreign corporation- apply income dominance test
Basis:
World gross income for the three-year period ending the current taxable year
preceding the declaration of such dividends.
A. If Philippine gross income is less than 50% of the basis, the whole dividend is
considered earned outside the Philippines.
B. If Philippine gross income is more than 50% of the basis, the ratio of Philippine
gross income over the basis multiplied by the dividend is considered earned within the
Philippines.
C. Service- place of performance of the service
D. Rent- location of the property
E. Royalties- place where the intangible is used
F. Gain on sale
A. Real Property- location of the property
B. Domestic shares of stock- within the Philippines always
C. Personal property- place of sale
G. Mining- location of mine
H. Farming- location of farm
I. Merchandising- place of sale

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 J. Manufacturing- place of production and place of sale (Sec. 42 (E), NIRC as amended)
PLACE OF PRODUCTION PLACE OF SALE INCOME IS EARNED
1. Within Within Within
2. Within Abroad Within and Abroad
3. Abroad Within Within and Abroad
4. Abroad Abroad Abroad
Allocation methods:
1. With factory or production price: the value as transfer price of the factory to the selling
segment is deemed the selling price of the commodity transferred.
2. Without factory or production price0 the portion deemed earned within the Philippines is:
(Property value, Philippines / Property Value, World) * 50% of income P xxx
(Gross sales, Philippines / Gross sales, World) * 50% of income xxx
Manufacturing income earned from the Philippines P xxx

TAX ACCOUNTING PERIODS:

Gross income accumulates over a period of time. Income taxation would require adoption of an
accounting period wherein to measure the income. The NIRC provides that “taxable income shall be
computed upon the basis of the taxpayer’s annual accounting period in accordance with the methods
of accounting regularly employed in keeping the books of such taxpayer.”

There are two types of accounting periods:

1. CALENDAR YEAR- the 12-month period ending December 31 and is applicable to: (1) Individuals,
(2) Taxpayers who do not keep books, (3) taxpayers with accounting periods other than the fiscal year,
and (4) taxpayers with no annual accounting period.
2. FISCAL PERIOD- any 12-month period ending the last day of any month other than December 31.
This is not available to Non-corporate taxpayers.

Normally, accounting period are uniformly 12-months, however, short accounting period may arise in
the following cases:
1. Death of a taxpayer
2. Dissolution of a business
3. Newly organized business
4. Changes in accounting periods- for non-corporate taxpayers
5. Termination of the accounting period of the taxpayer

TAX PAYMENTS:
Tax shall be paid on the 15th day of the month following the close of the taxpayer’s taxable year.

TAX ACCOUNTING METHODS:

So as the reporting of income would be consistent, tax accounting methods should be applied such as
the following:

A. PRINCIPAL METHODS
1. CASH BASIS METHOD- income is recorded in the year it is actually or constructively received,
expenses are generally reported in the year it is paid
2. ACCRUAL METHOD- income is reported in the year it is earned and expenses are deductible
in the year it is incurred

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 3. HYBRID METHOD- combination of both the Cash Basis and Accrual Basis

B. DEFERRED PAYMENT SALES

1. INSTALLMENT METHOD- applicable in the following three cases only:
a) Sale of personal property by a dealer
b) Casual sale of real property where:
i. Selling price is over P 1,000.00
ii. Initial payment do not exceed 25% of the selling price.
iii. Property is of a kind which would be included in the taxpayer’s inventory if on hand at the
close of the taxable year
c) Sale of real property where initial payment do not exceed 25% of the selling price
Initial payment- refers to payments which the seller receives upon the execution of the
instruments of sale and those scheduled to be received in the year of sale or disposition. It simply
means “total first year payments” but do not include receipts of evidence of indebtedness of
the buyer such as notes.

2. DEFERRED PAYMENT BASIS- applicable when a buyer has issued evidence of obligation (notes).
The notes shall be valued at its market value at the date of receipt. The difference between the fair
value and the face value is reported as interest income in future taxable period. This is an alternative
to delaying tax payments when the installment method is not available.

C. LONG-TERM CONSTRUCTION CONTRACTS

a) PERCENTAGE OF COMPLETION- this is applicable only to long-term construction contracts
covering a period in excess of one year. (Architect or engineer’s certification is required)
b) COMPLETED CONTRACT BASIS- gross income is recognized upon completion of
construction contract

D. FARMING INCOME
CROP YEAR BASIS- applicable only to farmers engaged in the production of crops which takes
more than a year from the time of planting to the process of gathering and disposal. Expenses paid or
incurred are deductible in the year the gross income from the sale of the crops is realized.

E. LEASEHOLD IMPROVEMENT
a) OUTRIGHT METHOD- the value of the leasehold improvement attributable to the lessor is
reported in taxable income at the time of the completion of the leasehold
b) SPREAD OUT METHOD- the value of the leasehold improvement attributable to the lessor is
reported in taxable income over the lease term

REMINDERS ON TAX ACCOUNTING METHODS

1. Absence of accounting method or use of one that do not clearly reflect income
The computation shall be made in accordance with such method as in the opinion of the
Commissioner clearly reflects the income
2. Consolidation of gross income from two or more methods
If a taxpayer adopted the cash basis and accrual basis in accounting for income earned on a
separate trade or business, he may opt to combine the two income determined from the respective
methods as a consolidated income for tax purposes.
3. Change of tax method

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 - Prior BIR approval is required
- If the taxpayer changes its accounting methods from accrual to installment method, he should
include in future periods the collection of receivables in future gross income
4. Expenditure benefiting future periods- shall be deferred and allocated to those periods
expected to be benefited by the expenditure
5. Advanced receipt of gross income-taxable in the year of receipt

GENERAL RULE IN INCOME TAXATION

TYPE OF TAXPAYERS INCOME TAXABLE IN THE PHILIPPINES
Earned in the Philippines Earned Abroad
1. INDIVIDUALS
A. Citizens
1. Resident / /
2. Non-Resident /
B. Aliens
1. Resident /
2. Non-resident
a. In business /
b. Not in Business /
C. Estates and Trusts Same rule with Individuals
[Link]
A. DOMESTIC / /
B. FOREIGN CORPORATION
1. Resident /
2. Non-Resident /

TAX COMPLIANCE
The Philippines follows the “SELF ASSESSMENT METHOD” wherein taxpayers determine their gross
income, prepare their income tax returns and pay the tax accordingly. The return filed is presumed
correct unless proven otherwise by the government. However, in cases of failure to file a return, the
CIR shall file a return from the best available information and such return thus file is presumed to be
correct. The taxpayer has the burden of proof in this case. The same rule applies when tax authorities
has reasons to believe that the tax return of the taxpayer is grossly misstated.

Income tax return is required for items of gross income that are subject to:
1. Regular Income Tax (quarterly and annual consolidated return)
2. Capital Gains Tax (per transaction and an annual consolidated return)

Who shall file the income tax returns?

1. Every Filipino Citizen-resident
2. Every Non-resident Filipino Citizen who has income from sources within the Philippines
3. Every resident alien on income from sources within the Philippines, and
4. Every non-resident alien engaged in trade or business or in the exercise of profession in the
Philippines, on income from sources within the Philippines

Who are not required to file an individual return for income tax?

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 1. An individual whose gross income do not exceed his total personal and additional exemptions,
except those engaged in business or profession
2. An individual with respect to pure compensation income, derived from sources in the
Philippines, the income tax on which has been correctly withheld, except those with
con-current employment
3. An individual whose income has been subjected to final tax
4. An individual who is exempt from filing income tax returns in pursuant to other provisions of the
Tax Code and other laws

Where to file Income Tax Returns?

1. Authorized Agent Banks
2. Revenue District Officer
3. Collection Agent
4. Duly authorized Treasurer of the city or municipality in which the taxpayer has his legal
residence or principal place of business in the Philippines, or
5. Office of the Commissioner of Internal Revenue if the taxpayer has no legal residence of place
of business in the Philippines

PAYMENT OF INCOME TAX

1. Outright Method 2. Installments (for individual taxpayers only)

The NETWORTH METHOD

The networth method serves as a test of the existence of income when not specifically disposed
Possible Gross Income= Personal Expenditures + Change in Networth*

* The Change in Networth is computed as follows:

Assets,end - Liabilites, end = Networth,end

Less: Assets,beg - Liabilites, beg = Networth,beg
Change in Networth

The possible gross income is generally taxable except when it:

1. Is excluded by law, contract, treaty, public policy from taxation
2. Results from additional investment
3. Is not income for income tax purposes (I.e. does not meet the three characteristics of gross income)

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TEACHER’S INSIGHT

Students are advised to master the situs rules as this have a significant
effect on your comprehension of advanced tax rules to be introduces in our
succeeding discussions.

Also, students are advised to master the coverage of both final income tax
and capital gains tax. A thorough understanding of these exceptional tax
treatments is very essential to your mastery of income taxation.

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