INCOME TAXATION

IN GENERAL

Income Tax

Income tax has been defined as a tax on all

yearly profits arising from property,

profession, trade or business, or as a tax on

a person’s income, emoluments, profits and

the like.

It is generally regarded as an excise tax. It is

not levied upon persons, property, funds or

profits but upon the right of a person to

receive income or profits.

Purposes of income taxation

1. To provide large amounts of revenues.

2. To offset regressive sales and consumption

taxes.

3. Together with estate tax, to mitigate the

evils arising from the inequalities in the

distribution of income and wealth, which

are considered deterrents to social

progress, by imposing a progressive scheme

of taxation.

Income

Income, in its broad sense, means all wealth

which flows into the taxpayer other than as

a mere return on capital. [Section 36,

Revenue Regulations 2]

Income means accession to wealth, gain or

flow of wealth.

Conwi v. CTA [213 SCRA 83]: Income may

be defined as an amount of money coming

to a person or corporation within a

specified time, whether as payment for

services, interest, or profit from investment.

Commissioner v. BOAC [149 SCRA 395]:

Income means “cash received or its equivalent.” It is the amount of money

coming to a person within a specific time. It

is distinct from capital for, while the latter is

a fund, income is a flow. As used in our

laws, income is flow of wealth. The source

of an income is the property, activity or

service that produces the income. For the

source of income to be considered as

coming from the Philippines, it is sufficient

that income is derived from activity within

the Philippines. IN BOAC’s case, the sale of tickets in the Philippines is the activity that

produces the income.

Fisher v. Trinidad [43 Phil 973]: Stock

dividend is not an income. It merely

evidences the interest of the stockholder in

the increased capital of the corporation. An

income may be defined as the amount of

money coming to a person or corporation

within a specified time, whether as

payment for services, interest, or profit for

investment. A mere advance in the value of

property of a person or corporation in no

sense constitutes the “income” specified in

the revenue law. Such advance constitutes

and can be treated merely as an increase of

capital. An income means cash received or

its equivalent. It does not mean choses in

action or unrealized increments in the value

of the property.

Income v. capital

Capital is a fund or property existing at one

distinct point of time while income denotes

a flow of wealth during a definite period of

time.

The essential difference between capital

and income is that capital is a fund or

property existing at one distinct point of

time; income is a 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. Capital is wealth,

income is the service of wealth. [Madrigal

v. Rafferty, 38 Phil 414]

Capital is the tree while income is the fruit.

SOURCES OF INCOME

What produces income?

The term “source of income” is not a place

but the property, activity or service that

produced the income. In the case of income

derived from labor, it is the place where the

labor is performed; in the case of income

derived from the use of capital, it is the

place where the capital is employed; and in

the case of profits from the sale or

exchange of capital assets, it is the place

where the sale or transaction occurs.

Commissioner v. BOAC: The source of an

income is the property, activity or service

that produces the income. For the source of

income to be considered as coming from

the Philippines, it is sufficient that income is

derived from activity within the Philippines.

IN BOAC’s case, the sale of tickets in the Philippines is the activity that produces the

income. The tickets exchanged hands here

and payments for fares were also made in

Philippine currency. The site of the source

of the income is the Philippines and the

flow of wealth proceeded from and

occurred in Philippine territory, enjoying

the protection accorded by the Philippine

government. Thus, said flow of wealth

should share the burden of supporting the

government.

Sources of income

1. Sources within the Philippines

2. Sources without the Philippines

3. Sources partly within and partly without the

Philippines

TAXABLE INCOME

Taxable income

The term “taxable income” means the

pertinent items of gross income specified in

the NIRC, less the deductions and/or

personal and additional exemptions, if any,

authorized by such types of income by the

NIRC or other special laws.

Requisites for income to be taxable

1. There must be a gain or profit.

2. The gain must be realized or received.

3. The gain must not be excluded by law or

treaty from taxation.

Gain must be realized or received

This implies that not all economic gains

constitute taxable income. Thus, a mere

increase in the value of property is not

income but merely an unrealized increase in

capital.

When is income considered received?

1. actual receipt

2. constructive receipt

Income constructively received

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 so credited

or set apart, although not then actually

reduced to possession.

To constitute receipt in such a case,

the income must be credited to the

taxpayer without any substantial limitation

or restriction as to the time or manner of

payment or condition upon which payment

is to be made. [Section 52, Revenue

Regulations 2]

Limpan Investment Company deemed to

have constructively received rental

payments in 1957 when they were

deposited in court due to its refusal to

receive them. [Limpan v. CIR, 17 SCRA 703]

Examples of constructive receipt

1. Interest coupons which have matured and

are payable, but have not been cashed.

2. Defaulted coupons are income for the year

in which paid.

3. Partner’s distributive share in the profits of a general professional partnership is

regarded as received by the partner,

although not yet distributed.

Are the following items income?

Found treasure - YES

Punitive damages - YES

Damages for breach of promise or

alienation of affection - YES

Worthless debts subsequently collected -

YES

Tax refund – NO (but yes if the tax was

previously allowed as a deduction and

subsequently refunded or credited, as

benefit accrued to the taxpayer; see

discussion on tax as a deductible item)

Non-cash benefits - YES

Income from illegal sources - YES

Psychological benefits of work - NO

Give away prizes – YES

Scholarships/fellowships – YES

Stock dividends - NO

Tests to determine realization of income

1. Severance test

2. Substantial alteration of interest test

3. Flow of wealth test

Severance test

As capital or investment is not income

subject to tax, the gain or profit derived

from the exchange or transaction of said

capital by the taxpayer for his separate use,

benefit and disposal is income subject to

tax.

Substantial alteration of interest test

Income is earned when there is a

substantial alteration of the interest of a

taxpayer, i.e. increase in proportionate

share of a stockholder in a corporation.

Income to be returnable for taxation must

be fully and completely realized. Where

there is no separation of gain or profit, or

separation of increase in value from capital,

there is no income subject to tax.

Thus, stock dividends are not income

subject to tax on the part of the

shareholder for he had the same

proportionate interest in the assets of the

corporation as he had before, and the

stockholder was no richer and the

corporation no poorer after the declaration

of the dividend.

However, if the pre-existing

proportionate interest of the stockholder is

substantially altered, the income is

considered derived to the extent of the

benefit received.

Moreover, if as a result of an exchange of

stocks, the person received something of

value which are essentially and

fundamentally different from what he had

before the exchange, income is realized

within the meaning of the revenue law.

Flow of wealth test

The essential difference between capital

and income is that capital is a fund whereas

income is the flow of wealth coming from

such fund; capital is the tree, income is the

fruit. Income is the flow of wealth other

than as a mere return of capital.

CLASSES OF INCOME

Kinds of taxable income or gain

1. capital gain

2. ordinary gain

a. business income

b. compensation income

c. passive income

d. other income from whatever source

derived i.e. found treasure

Capital gains

Capital gains are gains or income from the

sale or exchange of capital assets. These

include:

1. Income from dealings in shares of

stock of domestic corporation

whether or not through the stock

exchange;

2. Income from dealings in real

property located in the Philippines;

and

3. Income from dealings in other

capital assets other than (a) and (b).

Ordinary gains

Ordinary gains are gains or income from the

sale or exchange of property which are not

capital assets.

Business income

1. Income from trading, merchandising,

manufacturing or mining

2. Income from practice of profession

Note: The term “trade or business” includes the

performance of the functions of a public

office. [Section 22(S), NIRC]

Passive income

1. Passive income from Philippine sources

subject to final tax

2. Passive income from Philippine sources not

subject to final tax

3. Passive income from sources outside the

Philippines

Passive income again

1. Interest income

2. Rentals/Leases

3. Royalties

4. Dividends

5. Annuities and proceeds of life

insurance/other types of insurance

6. Prizes and winnings, awards, and rewards

7. Gifts, bequests, and devises

8. Other types of passive income

APPROACHES IN INCOME RECOGNITION

Approaches in income recognition

1. schedular system

2. global system

Schedular system

The schedular system is one where the

income tax treatment varies and is made to

depend on the kind or category of taxable

income of the taxpayer.

Global system

The global system is one where the tax

treatment views indifferently the tax base

and generally treats in common all

categories of taxable income of the

taxpayer.

Schedular system v. global system

1. Under the schedular treatment, there are

different tax rates, while under the global

treatment, there is a unitary or single tax

rate.

2. Under the schedular treatment, there are

different categories of taxable income,

while under the global treatment, there is

no need for classification as all taxpayers

are subjected to a single rate.

3. The schedular treatment is usually used in

the income taxation of individuals while the

global treatment is usually applied to

corporations.

Approach used in the Philippines

Partly schedular and partly global. The

schedular approach is used in the taxation

of individuals while the global approach is

used in the taxation of corporations.

CLASSES OF INCOME TAXPAYERS

Basis of classification of taxpayers

1. corporations v. individuals

2. nationality

3. residence

Classes of income taxpayers

1. Individuals

a. Resident citizens

b. Non-resident citizens

c. Resident aliens

d. Non-resident aliens

i) engaged in trade or business

in the Philippines, or

ii) not engaged in trade or

business in the Philippines

Note: A non-resident alien individual who shall

come to the Philippines and stay therein for

an aggregate period of more than one

hundred eighty (180) days during any

calendar year shall be deemed a non-

resident alien doing business in the

Philippines. [Section 25(A)(1), NIRC]

2. Corporations

a. Domestic corporations

b. Resident foreign corporations

c. Non-resident foreign corporations

3. Special

a. Proprietary educational institutions

and hospitals that are non-profit

b. Insurance companies

c. General professional partnerships

d. Estates and trusts

Note: Estates and trusts are treated as individual

taxpayers.

Who is a non-resident citizen?

The term “non-resident citizen” means:

1. A citizen of the Philippines who

established to the satisfaction of the

Commissioner the fact of his

physical presence abroad with a

definite intention to reside therein.

2. A citizen of the Philippines who

leaves the Philippines during the

taxable year to reside abroad, either

as an immigrant or for 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. A citizen who has been previously

considered as a non-resident citizen

and who arrives in the Philippines at

any time during the taxable year to

reside permanently in the

Philippines.

Corporation

A corporation, as used in income taxation,

includes partnerships, no matter how

created or organized, joint stock companies,

joint accounts (cuentas en participacion),

and associations or insurance companies.

However, it does not include:

1. a general professional partnership;

and

2. a joint venture or consortium

formed for the purpose of

undertaking construction projects or

engaging in petroleum, coal,

geothermal and other energy

operations pursuant to an operating

or consortium agreement under a

service contract with the

government.

Resident foreign corporation

The term applies to a foreign corporation

engaged in trade or business within the

Philippines.

Non-resident foreign corporation

The term applies to a foreign corporation

not engaged in trade of business in the

Philippines.

GENERAL PROFESSIONAL PARTNERSHIP V. ORDINARY

BUSINESS PARTNERSHIP

General professional partnerships

General professional partnerships are

partnerships formed by persons 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. [Section 22(B), NIRC]

Persons engaging in business as partners in

a general professional partnership shall be

liable for income tax only in their separate

and individual capacities. [Section 26, NIRC]

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. [Section 26, NIRC]

Each partner shall report as gross income

his distributive share, actually or

constructively received, in the net income

of the partnership. [Section 26, NIRC]

Income of a general professional

partnership are deemed constructively

received by the partners. [Section 73(D),

NIRC]

Ordinary business partnership

An ordinary business partnership is

considered as a corporation and is thus

subject to tax as such.

Partners are considered stockholders and,

therefore, profits distributed to them by the

partnership are considered as dividends.

Oña v. Commissioner, 45 SCRA 74 (1972):

Unregistered partnership

Although the CFI already approved the

project of partition of the estate of Julia Buñales

among her surviving spouse, Lorenzo Ona, and her

five children, no attempt was made to divide the

properties left by the decedent. Instead, the

properties remained under the management of

Lorenzo Ona who used said properties in business

by leasing or selling them and investing the income

derived therefrom and the proceeds from the sales

thereof in real property and securities. The said

incomes are recorded in the books of account kept

by Lorenzo Ona where the corresponding shares of

the heirs in the net income for the year are known.

Based on these facts, the Commissioner

ruled that the heirs formed an unregistered

partnership which is thus subject to corporate

income tax. The Court of Tax Appeals and the

Supreme Court affirmed.

For tax purposes, the co-ownership of

inherited properties is automatically converted into

an unregistered partnership the moment the said

common properties and/or the incomes derived

therefrom are used as a common fund with intent

to produce profits for the heirs in proportion to

their respective shares in the inheritance as

determined in a project partition either duly

executed in an extrajudicial settlement or approved

by the court in the corresponding testate or

intestate proceeding.

The reason is simple. From the moment of

such partition, the heirs are entitled already to

their respective definite shares of the estate and

the incomes thereof, for each of them to manage

and dispose of as exclusively his own without the

intervention of the other heirs, and, accordingly, he

becomes liable individually for all taxes in

connection therewith. If after such partition, he

allows his share to be held in common with his co-

heirs under a single management to be used with

the intent of making profit thereby in proportion to

his share, there can be no doubt that, even if no

document or instrument were executed, for the

purpose, for tax purposes, at least, an unregistered

partnership is formed.

For purposes of the tax on corporations, the

NIRC, includes partnerships – except general

professional partnerships – within the purview of

the term “corporation.”

Note: The income derived from inherited

properties may be considered as individual

income of the respective heirs only so long

as the inheritance or estate is not

distributed or, at least, partitioned, but the

moment their respective known shares are

used as part of the common assets of the

heirs to be used in making profits, it is but

proper that the income of such shares be

considered as part of the taxable income of

an unregistered partnership.

Gatchalian v. Collector, 102 Phil 140

Plaintiffs contributed money to buy a

sweepstakes ticket which subsequently won. The

Supreme Court held that they formed an

unregistered partnership. Plaintiffs formed a

partnership of a civil nature since each of them

contributed money to a common fund for the sole

purpose of dividing equally the prize which they

win.

Pascual v. Commissioner

Petitioners bought two parcels of land in

1965, however, they did not sell the same nor

make any improvements thereon. In 1966, they

bought another three parcels of land. It was only in

1968 that they sold the two parcels of land after

which they did not make any additional or new

purchase. The remaining three parcels of land were

sold in 1970. Commissioner assessed them

corporate income taxes on the ground that

petitioners established an unregistered partnership

engaged in real estate transactions.

The Supreme Court ruled that no

unregistered partnership was formed. The sharing

of returns does not itself establish a partnership

whether or not the persons therein have a joint or

common right or interest in the property. There

must be a clear intent to form a partnership, the

existence of which has the juridical personality

different from the individual partners and the

freedom of each party to transfer or assign the

whole property.

In this case, there was no showing of intent

to form a partnership. The transactions were

isolated; therefore, the character of habituality

peculiar to business transactions engaged for the

purpose of gain was not present.

The essential elements of a partnership are:

(1) an agreement to contribute money, property, or

industry to a common fund; and (2) an intent to

divide the profits among the contracting parties.

Unregistered partnership v. co-ownership for tax

purposes

If the activities of co-owners are limited to

the preservation of the property and the

collection of the income therefrom, in

which case, each co-owner is taxed

individually on his distributive share in the

income of the co-ownership.

If the co-owners invest the income in

business for profit, they would be

constituting themselves into a partnership

taxable as a corporation.

Joint venture, how created

A joint venture is created when two

corporations, while registered and

operating separately, were placed under

one sole management which operated the

business affairs of said companies as though

they constituted a single entity thereby

obtaining substantial economy and profits

in the operation.

As stated, a joint venture is not taxed as a

corporation, just like a general professional

partnership.

GENERAL PRINCIPLES OF INCOME TAXATION IN THE

PHILIPPINES

General principles of income taxation in the

Philippines

1. A citizen of the Philippines residing therein

is taxable on all income derived from

sources within and without the Philippines.

2. A non-resident citizen is taxable only on

income derived from sources within the

Philippines.

3. An individual citizen of the Philippines who

is working and deriving income from abroad

as an overseas contract worker is taxable

only on income from sources within the

Philippines. Provided, that a seaman who is

a citizen of the Philippines and who receives

compensation for services rendered abroad

as a member of the complement of a vessel

engaged exclusively in international trade

shall be treated as an overseas contract

worker.

4. An alien individual, whether a resident or

not of the Philippines, is taxable only on

income derived from sources within the

Philippines.

5. A domestic corporation is taxable on all

income derived from sources within and

without the Philippines.

6. A foreign corporation, whether engaged or

not in trade or business in the Philippines, is

taxable only on income derived from

sources within the Philippines.

SOME RULES ON TAXATION OF THE VARIOUS TAXPAYERS

Who are taxed on their global income?

1. Resident citizens

2. Domestic corporations

Who are taxed only on their income from sources

within the Philippines?

1. Non-resident citizen

2. Overseas contract workers

3. Alien individual, whether a resident or not

of the Philippines

4. Foreign corporation, whether engaged or

not in trade or business in the Philippines

Who are taxed based only on their net income?

1. Resident and non-resident citizens

2. Resident alien and non-resident alien

engaged in trade or business in the

Philippines

3. Domestic corporation

4. Resident foreign corporation

Who are taxed based on their gross income?

1. Non-resident alien not engaged in trade or

business in the Philippines

2. Non-resident foreign corporation

TREATMENT OF SOME SPECIAL ITEMS

Forgiveness of indebtedness

The cancellation and forgiveness of

indebtedness may, dependent upon the

circumstances, amount to:

1. a payment of income;

2. a gift; or

3. a capital transaction.

If, for example, an individual performs

services for a creditor who, in consideration

thereof cancels the debt, income to that

amount is realized by the debtor as

compensation for his service.

If, however, a creditor merely desires to

benefit a debtor and without any

consideration thereof cancels the debt, the

amount of the debt is a gift from the

creditor to the debtor and need not be

included in the latter’s gross income.

If a corporation to which a stockholder is

indebted forgives the debt, the transaction

has the effect of payment of a dividend.

[Section 50, Revenue Regulations 2]

Recovery of amounts previously written off

Considered as income

GUIDE QUESTIONS IN DETERMINING TAXABLE INCOME

1. Is there a gain or income?

2. Is the gain or income taxable? Is it excluded

or exempt?

3. What type of income is it: income includible

in the gross income, passive income, capital

gains, income derived from other source?

4. To what class does the taxpayer belong:

individual or corporate, citizen or not or

domestic or foreign, resident or not,

engaged in trade or business or not?

TAX ON INDIVIDUALS

PRELIMINARY POINTS ON TAXATION OF INDIVIDUALS

How taxed?

An individual citizen, both resident and non-

resident, and an individual resident alien

are taxed similarly.

A non-resident alien engaged in trade or

business shall be subject to the same

income tax rates as a citizen and a resident

alien.

Thus, only a non-resident alien who is not

engaged in trade or business is taxed

differently from the other individual

taxpayers.

On what income taxed?

A resident citizen is taxed on all income

from sources within and outside the

Philippines. The tax base is net income.

A non-resident citizen is taxed only on

income from sources within the Philippines.

The tax base is net income.

An alien, whether resident or not, is taxed

only on income from sources within the

Philippines. However, the tax base for a

resident alien and non-resident alien

engaged in trade or business is net income

while the tax base for a non-resident alien

not engaged in trade or business is gross

income.

Types of income taxed

1. Items of income included in the gross

income

2. Passive income

3. Capital gains from sale of shares of stock

not traded in the stock exchange

4. Capital gains from the sale or exchange of

real property

TAX ON INDIVIDUAL CITIZEN (RESIDENT AND NON-RESIDENT)

AND INDIVIDUAL RESIDENT ALIEN

Items of income included in the gross income

A schedular rate of five percent (5%) to

P125,000 + 32% of excess over P500,000.00

by 01 January 2000 is imposed on items of

income of an individual citizen and

individual resident alien which are properly

includible in the gross income.

Rates of tax on certain passive income

1. Interest from any currency bank deposit

and yield or any other monetary benefit

from deposit substitutes and from trust

funds and similar arrangements – 20%

2. Royalties, except on books, as well as other

literary works and musical compositions –

20%

3. Royalties on books, literary works and

musical compositions – 10%

4. Prizes over P10,000.00 – 20%

Note: Prizes less than P10,000.00 are included in

the income tax of the individual subject to

the schedular rate of 5% up to P125,000 +

32% of excess over P500,000.00)