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 4,_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. It is a return on capital that increases net worth. 2. Itisa realized benefit. 3. Itis not exempted by law, contract, or treaty. 63(Chapter 3 Introduction to income Tax RETURN ON CAPITAL Capital means any wealth or property. Gross income is a retum on weahy property that increases the taxpayer's net worth. « Mlustration {ABC purchased goods for P300 and sold them for PSOO. The PSOO consideration cay analyzed as follows: be Selling price (total consideration receved) P_ 500 Total return Cost (value of inventory forgone) 100 Return of capital Maricup (gross income) E200 Return on capital ‘The return on capital that Increases net worth is income subject to income tx Return of capital merely maintains net worth; hence, it is not taxable. 44 improvement in net worth indicates an ability to pay tax. Capital items deemed with infinite value There are capital tems that have infinite value and are incapable of pecuniay valuation, Anything received as compensation for thei los is deemed a return capital Examples: 1 Life 2. Health 3. Human reputation Life ‘The value of life is immeasurable by money. Under Sec. 32 of the NIRC, te proceeds of ance policies paid to the heirs or beneficiaries upon death {he insured, whether ina single sum or otherwise, are exempt from income tax ‘The proceeds of 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 o ture’ However, the following are taxable return on capital from insurance policies: 2 Any excess amount received over premiums paid by the insured upon surrender or maturity ofthe policy (te. the insured outlives the policy.) Gain cealzed by the insured from the assignment or sale of his insuratet Interest income from the unpaid balance of the proceeds of the policy Any excess of the proceeds raceived over the acquisition costs and prem? payments by an assignee ofa life insurance policy, ae Chapter 3- Invoduction to Income Tax. Health ‘Any compensation received in consi ‘compensation for personal injuries orto \deration for the loss of health such as stuous acts is deemed a return of capital Human Reputation ‘The vaiue 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: 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 not decrease net worth. Th while the recovery of lost pt lost profits is a return on capi Taxable recovery of lost profits ‘The recovery of lost profits through insurance, indemnity contracts, or legal sults constitutes a taxable return on capita. “The following are taxable recoveries of lost profits 18. Proceeds of crop or livestock insurance Guarantee payments c_ Indemnity received from patent infringement suit, Mlustration 1 Mang Tomas insured his strawberry crop in a P200,000 crop insurance coverage ageinst calamities. The crop was eventually destroyed by an unusual frost, Mang ‘Tomas was paid the P200,000 insurance proceeds. ‘The P200,000 proceeds whichis a reimbursement for the lost value ofthe future harvest, isan item of gross income. The value of the lost crops is, in effect, realized not through ‘ctual harvest but through the insurance contract. Mlustration 2 Mr. Santiago purchased a franchise. The franchisor Jncome of P100,000 to Mr, Santiago. in the first year of operation, Mr. Santiago's outlet ‘only earned P60,000. The franchisor paid the P40,000 difference to Mr. Santiago anteed an annual franchise 6Chapter 3 - Introduction to Income Tax i ee ec ee ee Th De 2 ee rata Mlustration 3 Mindoro Ine. experienced an unusual decline in its income after a competitor coping its patented invention. Mindoro sued the competitor for patent infringement and wee awarded an indemnity of 3,000,000. ‘The P3,000,000 indemnity is a compensation forthe income not realized by Mindor dy to che patent infringement. The sare isan item of gross income. ‘The recovery of lost income or profits is not intended to compensate for the isso capital It's as good a: realization of income; hence, it isan 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. Thereis 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 taxabl ‘a Receipt of a loan - properties increase but obligations also increase resulting in an offsetting effect in networth b. Discovery of lost properties - under the law, the finder has an obligation to return the same to the owner © Receipt of money or property to be held in trust for, or to be remitted t, another person If the taxpayer is entitled to keep for his account portion of a receipt, only that portion is a benefit. Mlustration 1. An employee was granted ?20,000 transportation advance. He liquidated 10,000 fransportaion expenses and was alowed by his erployer to keep the P2008 was Only the 2,000 retained by the employee is considered income since t ‘extent he was benefited. (222-96) 2. A security agency receives P120,000 from clients, salaries of security guards, Under RMC 39-2007, 0 the agency is considered inceme of the agency since ‘The P100,000 pertaining to salaries of security guards ls recognized asallabilty upon receipt. 66 Chapter 3- Introduction to income Tax ures that there is a degree of undertaking, dof the benefit. Types of Transfers 1, Bilateral transfers or exchanges, such as: a. Sale b, Barter ‘These are referred toas “onerous transactions". 2. Unilateral transfers, such as: ‘a. Succession - transfer of property upon death b. Donation ‘These are also referred to as “gratuitous transactions”. transactions are 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 1s subject to mcome tax. Mlustration Taxpayer sold his car which was previously purchased for P100.000 and with a ‘current fair value of P180,000 for only P130.060. “The transaction will be analyzed as follows. rasan > 180m roost nen Fanon sictoncme 7Chapter 3 - Introduction to Income Tax “The excess of fae value over selling price isa gratuity or gift whereas the selling price over the cost is an item of gross income. MOSS of, What is meantby another entity? Every person, natural or juridical isan entity. Natural persons ae living pe ‘a persons are those created by law such as partnershipy at corstons An entity may be a taxable ently oF an exempt entity. A taxa seert gross income arises from transactions which involve another natu) juridical en a Gains or income derived between relatives, corporations, and between rare wash partnership are taxable since it is made between separate eatne ikeunse the income between affliated companies such as between a holding parent company and is subsidiaries and between sister companies are tae Eecause each corporation is a separate entity. This apples regardless of ty underlying economic relationship. However, the sales of a home office to its branch office are not taxable because one and the same taxable entity. Furthermore, the income betwer they perta ‘businesses of a proprietor should not be taxed since proprietorship businesses ae taxable upon the same owner. Note that a proprietorship business is not: Juridical entity. Benefits in the absence of transfers ‘The increase in wealth of the taxpayer in the form of appreciation or increaseit the value properties or decrease in the value of his obligations in th absence of a sale or barter transaction is not taxable. ‘These are referred to as unreolized gains or holding gains because they have ta sn exchange transaction, yet materialized ins oF holding gains investrients in equity or debt securities of real properties held (revaluation increment) held or receivable ign currency denominated debt by virtue of favorsbe fluctuation n exchange rates ¢. Birth of animal offspring, accruals of fruts in an orchard or growth of fm vegetables Increase in value of land due to the discovery of mineral reserves Rendering of services ‘The rendering of services for 1 consideration is an exchange but does not cause? Joss of capital Hence, the entice consideration received from rendering of seme such as compensation income or service fes is an item of gross income 68 Chapter 3- Introduction to Income Tax s the following possible items of gross income: P 200,000 100,000 50,000 300,000 150,000 250,000 400,000 3 out of affection. P 200,000 100,000 Saladin forgiven in consideration srnce rendered tohis creditors 150,000 ees “fection or mere generosty ofthe creditor i a gratuitous a ansferbut snot a benefit iption of Unrealized Income hhave the ability to pay tax when their income mnsaction since tax is generally payable in money. ized in cash is subject to tax operti . received in cash but the the non-cash property. Income received in non. the fair value ofthe property received. Moreover, .sh considerations would open a wide avenue ly divert their income in the form of non- taxpayer cash considerations is taxable for tax evasion since taxpayers can easil cash consideration. Mode of Receipt/Realtzation Benefits ‘Taxable items of income niay be realized by the taxpayer in two ways: 1. Actual recelpt ‘Actual receipt wn ‘or property: 2 Constructive receipt Constructive receipt involves no actual physical taking of the income but the taxpayer is afectively benefited. wolves actual physical aking of the income in the form of cash csChapter 3 - Introduction to income Tax Examples: Offset of debt of the taxpayer in consideration for the sale of goods service b. Deposit ofthe income to the taxpayer's checking account Matured detachable interest coupons on coupon bonds not yet encasy by the taxpayer Increase in the capital ofa parter from the profit ofthe partnership Inflow of wealth without increase Ia net worth at does not increase his net worth 1s ny absence of benefit. income due to the to 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 withog tention to return are considered as income because of the increase 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 treaties from taxation, sms of income are exempted by law from taxation; hence, they are es and wages of minimum wage earners and qualified senior citizen Regular income of Barangay Micro-business Enterprises (BMBEs) Income of foreign governments and foreign government-owned asd controlled corporations 7. Income of international missions and organizations with income tax immunity ems of gross income that are exempted from taxation are discussed extensively under Exclusions in Gross Income in Chapter 8. ‘TYPES OF INCOME TAXPAYERS. 7” chapter 3- Introduction to Income Tax 2. Alien 3, Resident alien b. Non-restdentalien a engaged in trade or business b. notengaged in trade or business 3. Taxoble 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 Phi mon February 2. 1987 se fathers or mothers are citizens ofthe Philippines ‘Those born before January 17, 1973 of Filipino mothers who elected Filipino citizenship upon reaching the age of majority . ‘Those who are naturalized im accordance with the law pines at the time of adoption of the b. (Classification of citizens: ines who establishes to the sa his physical presence abroad -s who leaves the Philippines during the taxable F for an employment on a perman ‘A citizen of the Philippines who works and derives income from abroad. land whose employment thereat requires him to be physically present me during the taxable year: taxable year in which be arrives yme derived from sources abroad until the n‘chapter 3-Invoducton to neome Ta Jes or Philippine consulate off nas working in Priipine embassies oF PRIKPP! 8g ved non-resident citizens: Alten ‘A. Resident alfen- 29 ize thereat, suchas “an alien who lives nthe sayior snes to the Phibppines fora definite PUTDOSE which sed stay and to that end makes his hot ual who is residing in the Philippines but i ae ines without definite intention a5 9 ar et he sbandons the same or actually departs from the Philippines “ who is not residing in the Philippines ang B. Non-resident alten - an individual who is nota citizen thereof 1. Non-resident allens engaged in business (NRA-ETB)- aliens who stayeg nike Philippines for an aggregate period of more than 180 days during the year 2. Nonresident aliens not engaged in business (NRA-NETB) - include: se eanens who come to the Philippines for a definite purpose which in ity nature may be promptly accomplis by. Allens who shall come to the Philippines and stay therein for n agregate period of not more than 180 days during the year ‘THE GENERAL CLASSIFICATION RULE FOR INDIVIDUALS 1. Intention ‘The intention of the taxpayer regarding the nature of his stay within or outside the Philippines shall determine his appropriate residency lassification. The taxpayer shall submit to the CIR of the BIR docurmentary proofs such as visas, work contracts and other documents indicating such intention Documents purporting short term stay such as tourist visa shall not result in ‘the reclassification of the taxpayer's normal residency. Documents purporting 4 long term stay such as immigration visa or working visa for an extended period would result in the automatic reclassification of the taxpayer's residency n chapter 3 - Introduction to Income Tax the Philippines with a is normally non-resident. An alien who co jffed as non-residen igo abroad under a tourist ines with an immigration visa would De who Feclasifed asa resident alien upon his ari Jretizen who would go abroad with a two- A Aisetfied asa non-resident citizen upon his departure. year working visa would be 4 ength of 2 Length of ch documentary proot the length of stay ofthe taxpayers oreitysens staying abroad for a period of at least 183 days are considered non-resident. bb, Aliens who stayed in the Philippines for more than 1 year 1e taxable year are considered resident, Viens who are staying in the Philippines for not more than 1 year but vore than 10 days are deemed non-resident aliens engaged in business. 4. Aliens who stayed in the Philippines for not more than 180 days are considered non-resident aliens not engaged in trade or business. as of the end of or ‘Aresmendi, a Mexican actor, was contracted by a Philippine television ca pany to do-a project in the Philippines. He arrived in the country on February 29, Jord and returned to Mexico three weeks later upon completion of the project. I be classified as an NRA-NETB in 2019. His stay is for @ nature will be accomplished immediately. Luiz Mario Aresmen definite purpose which Libyan national, arrived in the country on November 4, 2019. Mr. spines since then without any working visa or work permit. would be considered an NRA-NETB because he stayed in the in 180 days as of December 31, 2019. If he is still within the jecember 34, 2020, he wil qualify as a resident alien for 2020. tion as to the nature of his stay, Juan Masipag, a Filipino ‘and stayed abroad from March 15, 2019 to April 1, 2020 {sa non-resident citizen because he is absent for more than 183 ified as resident citizen for the year 2020 because he is absent for B‘Chapter 9 Introduction to Income Tax ‘Taxable Estates and Trusts 1 state saat exw the proper rhs, and OBEBLONS Of & decease py otentingshed by hs death _. iy | setement are treated as indvidvaltaxpa cont of the properties It bythe decedent fT thier extrjuceal ts f properties ofthe estate under extrajudicial Settlement i taxable tothe vente Estates under 2 whereby one person (97antor or trustor) isan arrangement ane person (grantor or trustor) trang a gery co anather person (beneficiary), which will we seh fa third party (trustee or fiduciary). sruthare weve designated by the grt i tented in ation a ye mea fe propery held n rats ea ian na ger ie cesgated we revo bythe grantor ath Be Ta Tt contre arin payers The acre at ne de ovcble ust abe tothe grantor nox el es ‘When he es arene slant 8 to reocablyof Uh ust. the ru preruned bers ‘CORPORATE INCOME TAXPAYERS ‘The term ‘corporation’ shail include partnerships, no matter how created or organized, tack com it accounts, association, or insurance ‘companies, except general professional partnerships and a joint venture or consortium formed for the purpose of undertaking construction projects or engaging in petroleum, coal, geothermal, and other energy operations pursuant ts fan operating consortium agreement under a service contract with the ‘government. Hence, the term corpor:tion includes profit-oriented and non-prof such ‘as charitable institutions, cooperatives, government instrumentalites associations, leagues, civic or religious and other organizations. Domestic Corporati A domestic corporation is a corporation that is organized in accordance with Philippine laws. Foreign Corporation A foreign corporation is one organized under a foreign law. % chapter 3 - Introduction to Income Tax “ctkcam cepts eae ere crn cxorton wich operes snd poacts business in the Philppines through a permanent establishment (Ie. a branch). ‘2. Non-resident foreign corporation (NRC) - a foreign corporation which does fot operate or conduct business in the Philippines Note: 14 corporation that ine Incorporation T ‘orporation on dhe dret transactions Spectal Corporations ‘Special corporations are domestic or foreign corporations which are subject to special tax rules or preferential tax rates. OTHER CORPORATE TAXPAYERS 4, Partnership A partnership is a business organization owned by two or more persons who try oF resources to a common fund for the purpose of dividing the profits from the venture. ‘Types of partnership 4). General professional partnership (GPP) AGPP isa partnership formed for the exercise of a common profession. All partners must belong to the same profession. not treated as a corporation and is not a entity. fom income tax, but the partners are taxable in their individual ‘with respect to their share in the income of the partnership. +b) Business partnership A business partnership is one formed for profit. It is taxable as a ‘corporation. Examples: A partnership between Andrix, lawyer, and Mark, an accountant, to practice in taxation advisory services would be a business partnership since the two the same profession, fen accountants Zeus and Darrell to venture into a beauty be a business partnership since the venture is notin practic of ‘2 common profession. 78to income Tax ease Ange a ‘Chapter 3 introduction verry 2, Joint venture “Ayoint venture is a business ‘organized as a partnership oF @COrPOF s undertaking for a particular purpose, jy ration. 7 RY by ype ofl ventures: a Brempt ole ventares romp ain ventures are tose formed for the PATPOsE of und Bet ners oF en4s68 In PETOIAM: COal geothermal St rarer meng eperations pursvant to a8 Operating CONSOTtIUM agree Gndera service contract with the Government. etme treated as a co ed as 8 Corporati, Similar to a GPP, this type of jint venture i Venturers are taxable and is tax-exempt on its regular in their share in the net income ofthe j 1b Taxable joint ventures ‘Alother joint ventures are taxable as corporations. 3. Co-owmership ‘A co-ownershp is joint owmership of a property formed for the purpose of preserving the sameand/or dwviding its income. ‘A-co-ownership that is limited to property preservation or income collection fs not a taxable entity and is exempt but the co-owners are taxable on ther ‘share on the income of the co-owned property However, aco-ownership that reinvests the income of the co-owned propery to other income:producmg properties or ventures will be considered an “unregistered partnership taxable as a corporation. “THE GENERAL RULES IN INCOME TAXATION ‘Taxable on income camned Individual taxpayers ‘Wichin Without 7 [Resident citizen chapter 3- ltroducton to Income Tax 7 dent orig corporal z — sors, cet resent cstens ond dome otal rue ll taxp ns 3 iy on income earned vain te 3 TPR es the term widow the Pipes teen out he PIPINES ‘the Residency and Citizenship Rule rs who are residents and citizens of es such as resident ‘Taxpayer TiNton and domestic corporations are taxable or yme from sources within and fe Philippines. A corporation jen_of the country of ippines. incorporation. Thus,a domestic corporation is a pasts of the extraterritortal taxation Resident citizens and domestic corporations rnment compared to all other classes of tax (othe Philippine government. ident citizens and dom: ‘enjoy preferential 5. Also, between resident and non itizens, resident ‘government because they are tuzens and domestic consistent with the derive most of the benefits from the cpayers by virtue of cess of the public services of our ountry. The taxation of foreign income of Gorporavions. properly reflects this difference in be ‘Benofie Received Theory. ins and domestic corporations of tax revenues brought by turing transactions such that ion or the practice of exe fe realized abroad to avoid Philippine income taxes double taxation ‘rial taxation on resident citizens and domestic ation, Hower NIRC ras and foreign ‘The Issue of intern The rule on ext corporations exposes income because of the tax credit ‘SITUS OF INCOME “The situs of income isthe place of taxation of income. Itis the jurisdiction that has the authority to impose tax upon the income. n‘Chapter 3- neduction to income Tax Situs of tcome rs sure fn Situs of income should be aifferer Dm pertains tothe acity oF property that produces 1d from the source of income, he income. The tay, an ancoMe 15 taxahy ning whether oF le oy imporant to taxpayers taxable ony op Ue important to taxpayers taxable on global ggg 4 of he foreign ax credit fe 4 Serve income Place where the service is rendered iosraton ‘A anpayer had the folowing income P 300.000 50,000 Royalies trom books published nthe Philppines 100,000 150,000 US Dollars) 400,000, ‘poling the situs rules he following are the situs ofthe aforementioned income Within without _Word sta P P 300.000 300,006 50,000 ped 100,000 ioe 150,000 150,000 Rosauowe b 450009 ELogo.e Resident citizen or domestic corporation taxpayers would be tax on the word te Pag ng tte UzEayers would be taxable oly on the income from witha ‘Chapler 3 - Introduction to Income Tax OTHER INCOME SITUS RULES ‘A. Galn on sale of properties 1. Personal property - ¥ Domestic securities - presumed earned within the Philippines | Y Other personal properties - earned in the place where the property sold 2. Real property - earned where the property is located Ilustration ‘taxpayer had the following income: P 200,000 100,000 500,000 200,000 ‘ofmachineries in Mexico, Pampanga 250,000 income on foreign bonds 50.000 Dividends on domestic stocks 150,000 ‘The following table summarizes the situs of the foregoing income: Within _ _Without Gain onsale of domestic stocks 200,000 Gain on sale of 100.000 Gain on sale 500,000 Gain on sale of car in Canak 200,000 ‘on the sale of machineries 250,000 on foreign bonds 50,000 lends on domestic stocks 50.004 Rat0v09 B 350.000 B. Dividend income from: 1. Domestic corporation - presumed earned within 2. Foreign corporation 4) Resident foreign corporation - depends on the pre-dominance test income over the world gross income of in the three-year period preceding the “At least 50%, the portion of the dividend corresponding to the Philippine gross income ratio is earned within, ¥ Less than 50%, the entire dividends received is earned abroad ) Non resident foreign corporation - earned abroad 8