Chapter 3 - Introduction to Income Tax CHAPTER 3 INTRODUCTION TO INCOME TAXATION Chapter Overview and Objectives This chapter discusses the concept of tax income, the situs of income, and the types of taxpayers. After this chapter, readers are expected to comprehend and demonstrate knowledge on the following: 1, The concept of gross income 2. The types of income taxpayers 3. The general rules in income taxation The income tax situs rules THE CONCEPT OF INCOME Why is income subject to tax? Income is regarded as the best measure of taxpayers’ ability to pay tax. It is an excellent object of taxation in the allocation of government costs. What is income for taxation purposes? The tax concept of income is simply referred to as “gross income” under the NIRC. A taxable item of income is referred to as an “item of gross income” or “inclusion in gross income”. Gross income simply means taxable income in layman's term. Under the NIRC however, the term “taxable income” refers to certain items of gross income less deductions and personal exemptions allowable by law. Technically, gross income is broader to pertain to any income that can be subjected to income tax. Gross income is broadly defined as any inflow of wealth to the taxpayer from whatever source, legal or illegal, that increases net worth. It includes income from employment, trade, business or exercise of profession, income from properties, and other sources such as dealings in properties and other regular or casual transactions. ELEMENTS OF GROSS INCOME 1, Itisareturn on capital that increases net worth. 2. Itis a realized benefit. 3. It is not exempted by law, contract, or treaty. 63 Scanned wth G camscannerChapter 3 - Introduction to Income Tax RETURN ON CAPITAL Capital means any wealth or property. Gross income is a return on wealth or property that increases the taxpayer's net worth. Ilustration ABC purchased goods for P300 and sold them for P500. The P500 consideration can be analyzed as follows: Selling price (total consideration received) P 500 Totalreturn Cost (value of inventory forgone) 300 Return of capital Mark-up (gross income) P__200 Return on capital The return on capital that increases net worth is income subject to income tax. Return of capital merely maintains net worth; hence, it is not taxable. An improvement in net worth indicates an ability to pay tax. Capital items deemed with infinite value There are capital items that have infinite value and are incapable of pecuniary valuation. Anything received as compensation for their loss is deemed a return of capital. 3. Human reputation Life The value of life is immeasurable by money. Under Sec. 32 of the NIRC, the proceeds of life insurance policies paid to the heirs or beneficiaries upon death of the insured, whether in a single sum or otherwise, are exempt from income tax. ‘The proceeds of a life insurance contract collected by an employer as a beneficiary from the life insurance of an officer or any person directly interested with his trade are likewise exempt. These proceeds are viewed as advanced recovery of future loss. However, the following are taxable return on capital from insurance policies: a. Any excess amount received over premiums paid by the insured upon surrender or maturity of the policy (i.e. the insured outlives the policy.) b. Sa realized by the insured from the assignment or sale of his insurance policy c. Interest income from the unpaid balance of the proceeds of the policy d. Any excess of the proceeds received over the acquisition costs and premium | payments by an assignee of a life insurance policy | \ | 64 i } Scanned wth G camscannerChapter 3 - Introduction to Income Tax Health Any compensation received in consideration for the loss of health such as compensation for personal injuries or tortuous acts is deemed a return of capital. Human Reputation The value of one’s reputation cannot be measured financially. Any indemnity received as compensation for its impairment is deemed a return of capital exempt from income tax. Examples include moral damages received from: a. Oral defamation or slander b. Alienation of affection c. Breach of promise to marry Recovery of lost capital vs. Recovery of lost profits The loss of capital results in decrease in net worth while the loss of profits does not decrease net worth. The recovery of lost capital merely maintains net worth while the recovery of lost profits increases net worth. Therefore, the recovery of lost profits is a return on capital. Taxable recovery of lost profits The recovery of lost profits through insurance, indemnity contracts, or legal suits constitutes a taxable return on capital. The following are taxable recoveries of lost profits: a. Proceeds of crop or livestock insurance b. Guarantee payments c._ Indemnity received from patent infringement suit Mlustration 1 Mang Reyes insured his strawberry crop in a P200,000 crop insurance coverage against calamities. The crop was eventually destroyed by an unusual frost. Mang Reyes was paid the P200,000 insurance proceeds. The P200,000 proceeds which is a reimbursement for the lost value of the future harvest, isan item of gross income. The value of the lost crops is, in effect, realized not through actual harvest but through the insurance contract. Mlustration 2 Mr. Ramos purchased a franchise. The franchisor guaranteed an annual franchise income of P100,000 to Mr. Ramos. In the first year of operation, Mr. Ramos’outlet only earned P60,000. The franchisor paid the P40,000 difference to Mr. Ramos. 65 ‘Scanned with |CamScannerChapter 3 - Introduction to Income Tax The P40,000 guarantee payment is not a gratuity but a recovery of lost profit for Mr. Ramos; hence, subject to income tax. Mr. Ramos shall report P100,000 as franchise income. Illustration 3 Davao Crocodile Inc. experienced an unusual decline in its income after a competitor copied its patented invention. Davao Crocodile sued the competitor for patent infringement and was awarded an indemnity of P3,000,000. The P3,000,000 indemnity is a compensation for the income not realized by Davao Crocodile due to the patent infringement. The same isan item of gross income. The recovery of lost income or profits is not intended to compensate for the loss of capital. It is as good as realization of income; hence, it is an item of gross income. REALIZED BENEFIT What is meant by realized benefit? The “benefit” concept The term “benefit” means any form of advantage derived by the taxpayer. There is benefit when there is an increase in the net worth of the taxpayer. An increase in net worth occurs when one receives income, donation or inheritance. The following are not benefits, hence, not taxable: a. Receipt of a loan - properties increase but obligations also increase resulting in an offsetting effect in net worth. b. Discovery of lost properties - under the law, the finder has an obligation to return the same to the owner. c. Receipt of money or property to be held in trust for, or to be remitted to, another person. If the taxpayer is entitled to keep for his account portion of a receipt, only that portion isa benefit. Mlustration 1. An employee was granted P20,000 transportation advance. He liquidated P18,000 transportation expenses and was allowed by his employer to keep the P2,000. Only the P2,000 retained by the employee is considered income since this was the extent he was benefited. (RR2-98) 2. A security agency receives P120,000 from clients, P100,000 of which is for the salaries of security guards. Under RMC 39-2007, only the P20,000 attributable to the agency is considered income of the agency since it is the extent it is benefited. ‘The P100,000 pertaining to salaries of security guards is recognized by the agency asa liability upon receipt. 66 Scanned wth G camscannerChapter 3 - Introduction to Income Tax The “realized” concept The term realized means earned. It requires that there is a degree of undertaking or sacrifice from the taxpayer to be entitled of the benefit. Requisites of a realized benefit: 1, There must be an exchange transaction. 2. The transaction involves another entity. 3. Itincreases the net worth of the recipient. Types of Transfers 1. Bilateral transférs or exchanges, such as: a, Sale b. Barter These are referred to as “onerous transactions”. 2. Unilateral transfers, such as: a. Succession - transfef of property upon death b. Donation These are also referred to as “gratuitous transactions". Under current usage, unilateral transfers are simply referred to as “transfers” while bilateral transfers are called “exchanges.” Benefits derived from onerous transactions are “earned or realized”; hence, they are subject to income tax. Benefits derived from gratuitous transactions are not realized because of the absence of an earning process. Benefits derived from gratuitous transactions are subject to transfer tax, not income tax. 3. Complex transactions Complex transactions are partly gratuitous and partly onerous. These are commonly referred to as “transfers for less than full and adequate consideration”. The gratuitous portion of the transaction is subject to transfer tax while the benefit from the onerous portion is subject to income tax. Mlustration: A taxpayer sold his car which was previously purchased for P100,000 and with a current fair value of P180,000 for only P130,000. The transaction will be analyzed as follows: Fair value P 180,000 } 50,000 - Subject to transfer tax Selling price 130,000 } 30,000 - Subject to income tax Cost 100,000 67 ‘Scanned with |CamScannerChapter 3 - Introduction to Income Tax The excess of fair value over selling price is a gratuity or gift whereas the excess of the selling price over the cost is an item of gross income. What is meant by another entity? Every person, natural or juridical, is an entity. Natural persons are living persons while juridical persons are those created by law such as partnerships and corporations. An entity may be a taxable entity or an exempt entity. A taxable item of gross income arises from transactions which involve another natural or juridical entity. Gains or income derived between relatives, corporations, and between a partner and the partnership are taxable since it is made between separate entities, Likewise, the income between affiliated companies such as between a holding or parent company and its subsidiaries and between sister companies are taxable because each corporation is a separate entity. This applies regardless of the underlying economic relationship. However, the sales of a home office to its branch office are not taxable because they pertain to one and the same taxable entity. Furthermore, the income between businesses of a proprietor should not be taxed since proprietorship businesses are taxable upon the same owner. Note that a proprietorship business is not a juridical entity. Benefits in the absence of transfers The increase in wealth of the taxpayer in the form of appreciation or increase in the value of his properties or decrease in the value of his obligations in the absence of a sale or barter transaction is not taxable. These are referred to as unrealized gains or holding gains because they have not yet materialized in an exchange transaction. Examples of unrealized gains or holding gains: a. Increase in value of investments in equity or debt securities b. Increase in value of real properties held (revaluation increment) c. Increase in value of foreign currencies held or receivable d. Decrease in value of foreign currency denominated debt by virtue of favorable fluctuation in exchange rates e. Birth of animal offspring, accruals of fruits in an orchard or growth of farm vegetables f, Increase in value of land due to the discovery of mineral reserves Rendering of services The rendering of services for a consideration is an exchange but does not cause a loss of capital. Hence, the entire consideration received from rendering of services such as compensation income or service fees is an item of gross income. 68 Scanned wth G camscannerChapter 3 - Introduction to Income Tax Mlustration Mr. Mendoza lists the following possible items of gross income: Compensation income P 200,000 Winnings from gambling 100,000 Increase in value of investments 50,000 Appreciation in the value of land owned 300,000 Debt of Saladin cancelled by creditors in consideration for services he rendered to them 150,000 Debt of Saladin cancelled by his creditor out of affection 250,000 Loan received from a bank 400,000 ‘The items of gross income are: Compensation income P 200,000 Winnings from gambling 100,000 Debt of Mendoza forgiven in consideration for service rendered to his creditors 150,000 Note: 1. Gains from gambling and the forgiveness of debt in consideration of services or properties received are realized gains from exchanges. 2. The forgiveness of debt out of affection or mere generosity of the creditor is a gratuitous transfer subject to transfer tax. 3, The loan received from a bank constitutes a transfer but is not a benefit. Basis of Exemption of Unrealized Income Normally, taxpayers will have the ability to pay tax when their income materializes in an exchange transaction since tax is generally payable in money. This does not mean, however, that only income realized in cash is subject to tax. Income realized in non-cash properties are, in effect, received in cash but the taxpayer used the same to acquire the non-cash property. Income received in non- cash considerations is taxable at the fair value of the property received. Moreover, exempting income realized in non-cash considerations would open a wide avenue for tax evasion since taxpayers can easily divert their income in the form of non- cash consideration. Mode of Receipt/Realization Benefits Taxable items of income may be realized by the taxpayer in two ways: 1. Actual receipt Actual receipt involves actual physical taking of the income in the form of cash or property, 2. Constructive receipt Constructive receipt involves no actual physical taking of the income but the taxpayer is effectively benefited. 69 Scanned wth G camscannerChapter 3 - Introduction to Income Tax Examples: a. Offset of debt of the taxpayer in consideration for the sale of goods o, service b. Deposit of the income to the taxpayer’s checking account ¢. Matured detachable interest coupons on coupon bonds not yet encasheq by the taxpayer 4. Increase in the capital of a partner from the profit of the partnership Inflow of wealth without increase in net worth The inflow of wealth to a person that does not increase his net worth is not income due to the total absence of benefit. Examples: a. Receipt of property in trust b. Borrowing of money under an obligation to return In law, the proceeds of embezzlement or swindling where money is taken without an original intention to return are considered as income because of the increase in net worth of the swindler. NOT EXEMPTED BY LAW, CONTRACT, OR TREATY ‘An item of gross income is not exempted by the Constitution, law, contracts or treaties from taxation. The following items of income are exempted by law from taxation; hence, they are not considered items of gross income: 1. Income of qualified employee trust fund 2. Revenues of non-profit, non-stock educational institutions 3. SSS, GSIS, Pag-IBIG, or PhilHealth benefits 4. Salaries and wages of minimum wage earners and qualified senior citizen 5. Regular income of Barangay Micro-business Enterprises (BMBEs) 6. Income of foreign governments and foreign government-owned and controlled corporations 7. Income of international missions and organizations with income tax immunity Items of gross income that are exempted from taxation are discussed extensively under Exclusions in Gross Income in Chapter 8. TYPES OF INCOME TAXPAYERS A. Individuals 1, Citizen a. Resident citizen b. Non-resident citizen 70 Scanned with BcamscannerChapter 3 - Introduction to Income Tax. 2. Allien a. Residentalien b. Non-resident alien a. engaged in trade or business b. not engaged in trade or business 3. Taxable estates and trusts B. Corporations 1. Domestic corporation 2. Foreign corporation a. Resident foreign corporation b. Non-resident foreign corporation INDIVIDUAL INCOME TAXPAYERS Citizens Under the Constitution, citizens are: a. Those who are citizens of the Philippines at the time of adoption of the Constitution on February 2, 1987 b. Those whose fathers or mothers are citizens of the Philippines c. Those born before January 17, 1973 of Filipino mothers who elected Filipino citizenship upon reaching the age of majority d. Those who are naturalized in accordance with the law Classification of citizens: A. Resident citizen - A Filipino citizen residing in the Philippines B. Non-resident citizen includes: 1. A citizen of the Philippines who establishes to the satisfaction of the Commissioner the fact of his physical presence abroad with a definite intention to reside therein; 2. Acitizen of the Philippines who leaves the Philippines during the taxable year to reside abroad, either as an immigrant or for an employment on a permanent basis; 3. A citizen of the Philippines who works and derives income from abroad and whose employment thereat requires him to be physically present abroad most of the time during the taxable year; 4. Acitizen who has been previously considered as non-resident citizen and who arrives in the Philippines at anytime during the taxable year to reside permanently in the Philippines shall likewise be treated as a non-resident citizen for the taxable year in which he arrives in the Philippines with Tespect to his income derived from sources abroad until the date of his arrival in the Philippines 71 Scanned wth G camscanner