LECTURE NOTES

May 23, 2020

TAXATION 1
Atty. Arnel A. dela Rosa, CPA, REB, REA

INCOME TAXATION

GROSS INCOME [SEC. 32(A)]

State the general statutory definition of gross income?

Section 32 of the NIRC provides for the general statutory definition of Gross Income, to wit:

“Except when otherwise provided in this Title [referring to Title II – Tax on Income], gross
income means all income derived from whatever source, including (but not limited to)
the following items:

(1) Compensation for services in whatever form paid, including, but not limited to fees,
salaries, wages, commissions, and similar items;
(2) Gross Income derived from the conduct of trade or business or the exercise of a
profession;
(3) Gains derived from dealings in property;
(4) Interests;
(5) Rents;
(6) Royalties;
(7) Dividends;
(8) Annuities;
(9) Prizes and winnings;
(10) Pensions; and
(11) Partner’s distributive share from the net income of the general professional
partnership.

What is the concept of “income from whatever source derived”? What does the said
phrase embrace?

The words “income from any source whatever“ disclose a legislative policy to include all income
not expressly exempted within the class of taxable income under our laws. (CIR v. British
Overseas Airways Corp., G.R. No. L-65773-74, April 30, 1987; see also CIR v. Air India, G.R. No.
72443, January 29, 1988)

The phrase embraces all income not expressly exempted within the class of taxable income
under our laws, irrespective of the voluntary or involuntary action of the taxpayer in producing
the gains
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and whether derived from legal or illegal sources. (De Leon citing Gutierrez v. Collector, CTA
Case No. 65, August 31, 1965)

Gross Income vs. Net Income vs. Taxable Income

Gross Income (Sec. 32A) is all income subject to tax. Net Income refers to gross income less
allowable deductions and exemptions. Taxable Income (Sec. 31) is the pertinent items of
gross income specified in the Code, less deductions, if any, authorized for such types of income
by this Code or other special laws.

a. Compensation Income

What Comprises Compensation Income

Compensation income, in general, means all remuneration for services performed by an

employee for his employer under an employer-employee relationship, unless specifically
excluded by the Code.

The name by which the remuneration for services is designated is immaterial. Thus, salaries,
wages, emoluments and honoraria, commissions, allowances (e.g. transportation,
representation, entertainment, and the like); fees including director’s fees, if the director is, at
the same time an employee of the employer/corporation; taxable bonuses and fringe benefits
except those which are subject to the fringe benefit tax under Section 33 of the Code and
allowable “de minimis”
benefits; taxable pensions and retirement pay; and other income of a similar nature constitute
compensation income. (Sec. 2(a), RR 8-2018).

The basis upon which the remuneration is paid is immaterial in determining the whether the
remuneration constitutes compensation. Thus, it may be paid on the basis of piece-of-work, or
a percentage of profits; and may be paid hourly, daily, weekly, monthly or annually.

Remunerations for services constitute compensation even if the employer-employee relationship

no longer exist at the time of payment as the long as the services where rendered at the time
the relationship was in effect .

Employer-Employee Relationship, defined

Employer-Employee Relationship exists when a person for whom services were performed
(employer) has the right to control and direct an individual who performs the services
(employee), not only as to the result of the work to be accomplished but also as to the details,
methods and means by which it is accomplished. An employee is subject to the control of the
employer not only as to what shall be done, but how it shall be done. It is not necessary that
the employer actually exercises the right to direct or control the manner in which the services
are performed. It is sufficient that there exists a right to control the manner of doing the work.
(Sec. 2(e), RR 8-
2018)
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Some rules on inclusion of the corresponding amount of income from compensation
for services rendered.

1. If payment is made in case, the full amount received is subject to tax; 2. If the services
are paid for with something other than money, the fair market value of the thing taken in
payment is the amount to be included as income (Sec. 31, RR 2-40) 3. If the services were
rendered at a stipulated price, the absence of evidence to the contrary, such price shall be
presumed to be the fair market value of the compensation received (Ibid);
4. Compensation paid to an employee of a corporation in its stock is to be treated as if the
corporation sold the stock for the market value and paid the employee in cash (Ibid); 5.
Where living quarters are furnished in addition to cash salary, the rental value of such
quarters should be reported as income (Ibid) [except in case the same is subject to FBT
or furnished for the convenience of the employer.]

Are all Allowances given/furnished to the Employee by the Employer considered

Compensation Income?

General Rule – Yes.

Exceptions: If the allowances are:
1. given for the convenience of the employer (“Convenience of the Employer Rule”; see
BIR Ruling DA 013-2008, January 16, 2008); or
2. by their nature, necessary to employer’s business, trade or profession; or
3. subject to Fringe Benefit Tax; or
4. considered Allowable De Minimis Benefits; or
5. RATA given to government officials and employees under the GAA (BIR Ruling No. 062-
91)

Notes:
a. Any amount paid specifically, either as an advance or reimbursement for travelling,
representation and other bona fide ordinary and necessary expenses incurred or
reasonably expected to be incurred by the employee in the performance of his duties
are not compensation subject to withholding, if:
i. It must be ordinary and in the pursuit of trade, business of profession; ii. Must be
liquidated in accordance with specific requirements of substantiation (Sec. 34,
NIRC). The excess advances over the actual expenses shall constitute taxable
income if not returned to the employer.
iii. If pre-computed on a daily basis, no substantiation requirement is required. (BIR
Ruling DA 013-2008)
b. Representation and Transportation Allowances (RATA) given to government officials and
employees under the General Appropriations Act are deemed reimbursement for
expenses incurred in the performance of the duties of the recipient government officials
and employees and thus are not considered as additional compensation taxable under
the regular individual income tax and subject to withholding tax. (BIR Ruling No. 062-
91).

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Convenience of Employer Rule, concept
Under this rule, fringe benefits and allowances furnished to the employee for and as a necessary
incident to the performance of his duties are not taxable.

Overtime, transportation allowance and duty allowance on night, graveyard shift, outstation or
out of town allowance for carrying on the business of the employer are not subject to fringe
benefit tax for being the convenience of the employer. Moreover, when they are pre-computed
on daily basis and paid while on assignment, they likewise are not subject to income tax and
withholding tax. (BIR Ruling DA 013-2008, January 16, 2008)

Case: Collector v. Hendereson, G.R. No. L-12954, February 28, 1961. Held: The evidence
presented at the hearing of the case substantially supports the findings of the Court of Tax
Appeals. The taxpayers are childless and are the only two in the family. The quarters, therefore,
that they occupied at the Embassy Apartments consisting of a large sala, three bedrooms, dining
room, two bathrooms, kitchen and a large porch, and at the Rosaria Apartments consisting of a
kitchen, sala dining room, two bedrooms and a bathroom, exceeded their personal needs. But
the exigencies of the husband-taxpayer's high executive position, not to mention social standing,
demanded and compelled them to live in a more spacious and pretentious quarters like the ones
they had occupied. Although entertaining and putting up houseguests and guests of the
husband
taxpayer's employer-corporation were not his pre-dominant occupation as president, yet he and
his wife had to entertain and put up houseguests in their apartments. That is why his employer
corporation had to grant him allowances for rental and utilities in addition to his annual basic
salary to take care of those extra expenses for rental and utilities in excess of their personal
needs. Hence, the fact that the taxpayers had to live or did not have to live in the apartments
chosen by the husband-taxpayer's employer-corporation is of no moment, for no part of the
allowances in question redounded to their personal benefit or was retained by them. Their bills
for rental and utilities were paid directly by the employer-corporation to the creditors (Exhibit AA
to DDD, inclusive; pp. 104, 170-193, t.s.n.). Nevertheless, as correctly held by the Court of Tax
Appeals, the taxpayers are entitled only to a ratable value of the allowances in question, and
only the amount of P4,800 annually, the reasonable amount they would have spent for house
rental and utilities such as light, water, telephone, etc., should be the amount subject to tax,
and the excess considered as expenses of the corporation. Likewise, the findings of the Court of
Tax Appeals that the wife-taxpayer had to make the trip to New York at the behest of her
husband's employer-corporation to help in drawing up the plans and specifications of a
proposed building, is also supported by the evidence. The parts of the letters written by the
wife-taxpayer to her husband while in New York and the letter written by the husband-taxpayer
to Mr. C. V. Starr support the said findings (Exhibits U-2, V-1, W-1, X). No part of the allowance
for travelling expenses redounded to the benefit of the taxpayers. Neither was a part thereof
retained by them. The fact that she had herself operated on for tumors while in New York was
but incidental to her stay there and she must have merely taken advantage of her presence in
that city to undergo the operation.

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Are the Fees paid to the Corporation’s Director Compensation?
Yes, if he is likewise an employee of the Corporation (See definition of Compensation Income).

If the Director is not an employee of the Corporation, he is considered as a seller of services,

hence the Director’s Fees is considered as Business Income subject to Income Tax and possibly
Value Added Tax. (See RMC 34-2008, April 15, 2008)

Are Tips/Gratuities/Service Charges (RA No. 11360) considered compensation? Tax

Implication?

Tips and gratuities paid directly to an employee by a customer which are not accounted for by
the employee to the employer are taxable compensation income but not subject to withholding
tax.

Tips and gratuities/services charges which are: a) part of the bill to be paid directly by the
customer to the employer, or b) paid directly to the employee by the customer with an
obligation to account and remit the same to the employer, are taxable compensation income
subject to withholding tax.

What are De Minimis Benefits? Are these considered compensation income? What
are the tax implications? (See relevant provisions of RR No. 2-98, as amended by: RR Nos:
15-2011, 8-2012, 1-2015, 11-2018)

De Minimis Benefits are benefits of relatively small values provided by the employer to the
employee on top of the basic compensation intended for the general welfare of the employees.
Being of relatively small values, the same is not being considered as a taxable compensation and
as such, not subject to income tax and, consequently, withholding tax on compensation.

The following enumerates the updated list of non-taxable de minimis benefits:

1. Monetized unused vacation leave credits of private employees not exceeding ten (10)
days during the year;
2. Monetized value of vacation and sick leave credits paid to government officials and
employees;
3. Medical cash allowance to dependents of employees, not exceeding P1,500 per employee
or P250 per month;
4. Rice subsidy of P2,000 or one (1) sack of 50 kgs. rice per month amounting to not more
than P2,000;
5. Uniform and clothing allowance not exceeding P6,000 per annum;
6. Actual medical assistance, e.g. medical allowance to cover medical and healthcare needs,
annual medical/executive check-up, maternity assistance, and routine consultation, not
exceeding P10,000 per annum;
7. Laundry allowance of not exceeding P300 per month;

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8. Employees achievement awards, e.g. length of service or safety achievement, which must
be in the form of tangible personal property other than cash or gift certificate, with an
 annual monetary value not exceeding P10,000 received by the employee under an
established written plan which does not discriminate in favor of highly paid employees;
9. Gifts made during Christmas and major anniversary celebrations not exceeding P5,000
per annum;
10. Daily meal allowance for overtime work and night/graveyard shift not exceeding 25% of
the basic minimum wage on per region basis;
11. Benefits received by an employee by virtue of a collective bargaining agreement (CBA)
and productivity incentive schemes provided that the total monetary value received from
both CBA and productivity incentive schemes combined do not exceed P10,000 per
employee per taxable year.

Note that all other benefits given by the employers which are not included in the above
enumeration shall not be considered as de-minimis; and hence shall either be subject to income
tax (consequently, to withholding tax on compensation, if given to rank and file employees) OR
fringe benefit tax (if given to managerial or supervisory employees).

Further, any amount or value given to employee above the limits provided above are subject
either to income tax (consequently, to withholding tax on compensation, if given to rank and file
employee) or fringe benefit tax (if given to managerial or supervisory employees).

However, such other benefit or amount paid in excess of the limit, if not subject to Fringe
Benefit Tax, shall be considered in computing the P90,000 exemption on 13 th month pay and
other benefits as provided in Sec. 32(B)(7)(e), NIRC.

b. Business/Professional Income

General Formula in determining gross income from business, trade or exercise of

profession (See. Sec. 27(A), NIRC; Sec. 43, RR 2-40)

Gross Sales/Gross Receipts Pxxxxxx

Less: Sales Returns, Allowances & Discounts Pxxxxxx
Net Sales/Receipts Pxxxxxx
Less: Cost of Sales Pxxxxxx
Gross Profit from Sales Pxxxxxx
Add: Other Income/Gains Pxxxxxx
Gross Income Pxxxxxx
=====

In determining the gross income, subtractions should not be made for depreciation, depletion,
selling expenses, losses, or for items not ordinarily used in computing the cost of good sold.

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How is gross income (and net income) from “long term contracts
determined? It is determined using percentage of completion method. (Sec. 48,

NIRC).

c. Gains Derived from Dealings in Property

What is included in gross income derived from dealings in property?

It includes all income derived from the disposition of property, whether real, personal, or mixed,
for money (sale) or for other property (exchange) or for a combination of both, which result in
gain (or loss) because of the difference between the taxpayer’s investment in what he disposed
of and the value of what he received. The general rule is that the entire amount of gain (or loss,
as the case maybe) arising therefrom is a taxable gain (or a deductible loss).

How is gain (or loss) from sale or exchange of property computed? [Sec. 40 (A),

NIRC] Formula: Amount realized less basis or adjusted basis = gain (loss)

What the meaning of amount realized?

It means the sum of money plus the fair market value of the property [FMV is defined in Section
6(E), i.e. ZV or the FMV as determined by the Assessor)

What is the Basis for determining Gain or Loss from Sale or Disposition of Property?
[Sec. 40(B)]

1. Cost if the property is acquired by purchase on or after March 1, 1913; 2. The Fair Market
Price or Value as of the date of acquisition, if acquired by inheritance; 3. If the property is
acquired by Gift, the same basis as if it would be in the hands of the
donor or last preceding owner by whom it was not acquired by gift, except that if such
basis is greater than the fair market value of the property at the time of the gift, then for
purposes of determining the loss, the basis shall be such fair market value;
4. If the property was acquired for less than an adequate consideration in money or money’s
worth, the basis is the amount paid by the transferee for the property; or 5. The basis as
defined in Section 40(C)(5) if the property is acquired under a tax-free exchanges
transaction under Section 40(C)(2).

Note: We shall discuss this in detail when we take up Section 40.

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 d. Passive Income

Define Passive Income.

Income in which the taxpayer merely waits for the amount to come in. It consists of interest,
dividends, royalties, and rental income.

What is included in income derived from interest?

Interest income is only such interest as arises from indebtedness, i.e. compensation for the loan
or forbearance of money, goods, or credits. Unless exempted by law, interest received by a
taxpayer, whether or not usurious, is taxable.

What is included in income derived from rent/royalty.

Rents may be derived not only from real estate but also from the use of personal property. Like
rents, royalties are payments for the use of property. They include earnings from copyrights,
trademarks, patents, and natural resources under lease.

Buildings/Improvements constructed or introduced by the Lessee.

Buildings constructed or improvements introduced by the lessee pursuant to the lease which
will become the property of the lessor at the expiration or termination of the lease without
compensating the lessee for the value thereof, is taxable income of the lessor.

Lessor may choose the following methods of reporting income.

a) He may report as income at the time when such building or improvement are completed
at fair market value of such building or improvements subject to the lease; or

b) He may spread over the life of the lease the estimated depreciated value of such buildings
or improvements at the termination of the lease and report as income for each year of
the lease an aliquot part thereof. (Sec. 49, RR 2-40).

Illustration:

X leased his lot to Y for 10 years at an annual rent of P120,000.00. Y, pursuant to the
lease contract, erected a building on the lot with a cost of P2,000,000.00 with estimated life of
25 years. The building will become the property of X after the term of the lease. How much is
the rental income to be reported by Y during Year 1 if lease started on January 1, 2019? Assume
the building was completed on the same date.

Pre-termination of the lease, effect.

 Page 8 of 19
If for any other reason than a bona fide purchase from the lessee by the lessor the lease is
terminated, so that the lessor becomes into possession or control of the property prior to the
time originally fixed for the termination of the lease, the lessor receives additional income for
the year in which the lease is so terminated to the extent that the value of such buildings or
improvements when he became entitled to such possession exceeds the amount already
reported as income on account of the erection of such buildings or improvements. No
appreciation in value due to causes other than the premature termination of the lease shall be
included. (Ibid.)

Illustration: In the above example, how much additional income should X report if the lease is
pre-terminated on January 1, 2026?

Destruction of the buildings/improvements prior to the expiration of the lease.

If the buildings or improvements are destroyed prior to the expiration of the lease, the lessor is
entitled to deduct as a loss for the year when such destruction takes place the amount
previously reported as income because of the erection of such buildings or improvement, less
any salvage value of the lease to the extent that such loss was not compensated for by
insurance. (Ibid.)

Illustration. Same problem, however, on January 1, 2022, the building was destroyed. How
much loss is to be recognized by X, if there is a salvage value of P20,000.00 without insurance?
How about if there is an insurance of P500,000?

How is income from Dividends Treated For Income Tax Purposes?

Dividends means any distribution made by a corporation out of its earnings or profits and
payable to its shareholders, whether in money or in other property. [Sec. 73(A), NIRC]

Cash Dividend – taxable to the extent of the cash received.

Property Dividend – taxable to the extent of the fair market value of the property received at the
time of its distribution.

Stock Dividend – general rule, not taxable, except:

a. In case there is a redemption or cancellation of stocks issued as a dividend, the amount
so distributed in redemption or cancellation of the stock shall be taxable to the extent
that it represents a distribution of earnings [Section 73(B), NIRC];
b. In case there is a resulting change in the proportionate interest of the stockholder in the
corporation (applying doctrine of proprietary interest), to the extent of the fair market
value of the new stocks issued;
c. In case the stockholder subsequently sells the stock dividend (severance test), will only
result in taxable gain from sale of capital asset (i.e. not the entire proceeds is taxable)
[Sec. 253, RR 2-40];
Script dividend (i.e. promissory note is given], taxable to the extent of the fair market value
of the script dividend;
 Page 9 of 19
Liquidating Dividend – gain realized or loss sustained by the stockholder, whether individual
or corporation, is taxable income or a deductible loss, as the case maybe [Sec. 73(A), NIRC].

EXCLUSIONS FROM GROSS INCOME [SEC. 32(B)]

Under the 1997 NIRC, “Exclusions” refer to items that are not included in the determination of
gross income either because:
1. They represent return of capital or are not income, gain, or profit; or
2. They are subject to another kind of internal revenue tax;
3. They are income, gain, profit that are expressly exempt from income tax under the
constitution, tax treaty, the Tax Code, or a general or special law.

Who may avail of these Exclusions?

Generally, all taxpayers may avail of the exclusions unless expressly excluded by law.

1. Life Insurance – proceeds of life insurance policies paid to heirs or beneficiaries upon the
death of the insured, whether in a single lumpsum or otherwise, but if such amounts
are held by the insurer under an agreement to pay interest thereon, the interest
payments shall be included in the gross income.

Case: El Oriente Fabrica de Tabacos v. Posadas, G.R. No. 34774, September 21,
1913. Fact: Petitioner insured the life of its Manager, paying the premiums thereon, and
made designated itself as the beneficiary thereof. Manager died, petitioner received the
proceeds of the life insurance policy but did not report the same as part of its gross
income, hence assessed by the CIR. Held: x x x considering the lack of express
legislative intention to tax the proceeds of life insurance policies paid to corporate
beneficiaries on this subject, the clause is inserted “exempt from the provisions of this
law,” we deem it reasonable to hold the proceeds of the life insurance policy in question
as representing an indemnity and not taxable income.

2. Return of Premium – the amount received by the insured, as a return of premiums paid
by him under life insurance, endowment, or annuity contracts, either during the term or
at the maturity of the term mentioned in the contract or upon surrender of the contract.

(Note: If such amounts [when added to the amount already received before the taxable
year under such contract] exceeds the aggregate premiums or considerations paid
[whether or not paid during the taxable year], then the excess shall be included in the
gross income.)

3. Gifts, bequests, and devises – The value of the property acquired by gift, bequest,
devise, or descent: Provided, however, that the income from such property, as well as
gift, bequest, devise, or descent of income from any property, in cases of transfers of
undivided interest, shall be included in the gross income.
 Page 10 of 19
(Note: If the amount received is on account of services rendered, whether constituting
a demandable debt or not, or the use of the opportunity to use a capital, the receipt is
income [Pirovano v. Commissioner, 14 SCRA 832)

4. Compensation for Injuries or Sickness – Amounts received, through Accident or Health

Insurance or under Workmen’s Compensation Act, as compensation for personal injuries
or sickness, plus the amount of any damages received, whether by suit or agreement,
on account of such injuries or sickness.

(Note: The phrase “personal injuries” should be given a restrictive meaning to only refer
to physical injuries. The theory for this is that recoupment on account of such losses is
not income, since it is not derived from capital, from labor or from both combined. And
the fact that the payment of compensation for such loss was voluntary does not change
its exempt status. It was in fact compensation for a loss, which impaired petitioner’s
capital.)

5. Income Exempt under Treaty – Income of any kind, to the extent required by any treaty
obligation binding upon the Government of the Philippines.

6. Retirement Benefits, Pensions, Gratuities, etc. –

a. Retirement benefits received under RA 7641, AND those received by officials and
employees of private firms, whether individual or corporate, in accordance with a
reasonable private benefit plan maintained by the employer; Provided:

i. That the retiring official or employee has been in service of the same employer
for at least 10 years and is not less than 50 years of age at the time of his
retirement;
ii. That the benefits granted under this subparagraph shall be availed of by an
official or employee only once.

Reasonable private benefit plan means a pension, gratuity, stock bonus or

profit-sharing plan maintained by an employer for the benefit of some or all of his
officials or employees, wherein contributions are made by such employer for the
officials or employees, or both, for the purpose of distributing to such officials and
employees the earnings and principal of the fund thus accumulated, and wherein
it is provided that at no time shall any part of the corpus or income of the fund
be used for, or be diverted to, any purpose than for the exclusive benefit of the
said officials and employees.

(Compare this to Section 60(B), NIRC.)

(Notes: Aside from the conditions mentioned above, the plan must likewise be
approved by the BIR pursuant to RR No. 2-98.

In case the conditions set forth above is not met, then the retirement benefits
shall be included in the gross income.)
 Page 11 of 19
Case: Santos v. Servier Philippines, Inc., G.R. No. 166377, November 28,
2008. Facts: Servier was constrained to terminate Santos’ employment
(employee for 8 years) because the latter had not fully recovered mentally and
physically from her illness. As a consequence thereof, Santos was offered, among
others, a retirement plan benefits of P1,063,841. However, of the said amount,
only P701,454.89 was paid to her, the difference was allegedly withheld for tax
purposes. Servier likewise failed to give the other benefits promised to her.
Hence, Santos filed case before the NLRC. Held: For retirement benefits to be
exempt from withholding tax, the taxpayer is burdened to prove the concurrence
of the following: (1) a reasonable private plan is maintained by the employer; (2)
the retiring official or employee has been in the service of the same employer for
at least 10 years; (3) the retiring official or employee is not less than 50 years of
age at the time of retirement; and (4) the benefit had been availed of only once.
Petitioner was qualified for disability retirement. At the time of such retirement,
petitioner was only 41 years of age; and had been in the service for more or less
8 years. As such, the above provision is not applicable for failure to comply with
the age and length of service requirements. Therefore, respondent cannot be
faulted for deducting from petitioner’s total retirement benefits the amount of
P362,386.87, for taxation purposes.

b. Any amount received by an official or employee or by his heirs from the employer as
a consequence of separation of such official or employee from the service of the
employer because of death, sickness or other physical disability, or for any cause
beyond the control of the said official or employee.

(Notes: “for any cause beyond the control of the said official or employee
connotes involuntariness on the part of the said official or employee; separation
must not be asked or initiated by the official or employee. Thus, separation pay
given or paid by the employer will form part of the gross income if the employee
initiates the separation.)

Case: PLDT v. CIR, GR No. 157264, January 31, 2008. (Separation pay due to
redundancy) Held: Proof of receipt by employees of the pay and the remittance
of the withholding tax to the BIR are material to the claim for refund of
erroneously paid withholding tax on separation pay. Also, it must be shown that
employees declared the income and the tax paid to the BIR through withholding.

Case: Re: Request of Atty. Bernardo Zialcita, Admin Matter No. 90-6-015-
SC, October 18, 1990. Issue: The issue here is the tax treatment of the
commutation of his accumulated leave credits (terminal leave pay) of Atty.
Zialcita. Held: 1) Upon his compulsory retirement, he is entitled to the
commutation of his accumulated leave credits to its money value. Within the
purview of Section 28(B)(7)(b) [now Section 32(B)(6)(B)] of the NIRC,
compulsory retirement may be considered as a “cause beyond the control of the
said official or employee”. Consequently, the amount that he received by way of
commutation of his accumulated leave credits as a result of his compulsory
retirement, or his terminal

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 leave pay, falls with the enumerated exclusions from the gross income and is
therefore not subject to tax. 2) The terminal leave pay of Atty. Zialcita may
likewise be viewed as a "retirement gratuity received by government officials and
employees" which is also another exclusion from gross income as provided for in
Section 28(b), 7(f) of the NIRC. A gratuity is that paid to the beneficiary for past
services rendered purely out of generosity of the giver or grantor. (Peralta v.
Auditor General, 100 Phil, 1051 [1957]) It is a mere bounty given by the
government in consideration or in recognition of meritorious services and springs
from the appreciation and graciousness of the government. (Pirovano v. De la
Rama Steamship Co., 96 Phil. 335, 357 [1954]) When a government employee
chooses to go to work rather than absent himself and consume his leave credits,
there is no doubt that the government is thereby benefited by the employee's
uninterrupted and continuous service. It is in cognizance of this fact that laws
were passed entitling retiring government employees, among others, to the
commutation of their accumulated leave credits. That which is given to him after
retirement is out of the Government's generosity and an appreciation for his
having continued working when he could very well have gone on vacation.
Section 286 of Revised Administrative Code, as amended by RA 1081, provides
that "whenever any officer, employee or laborer of the Government of the
Philippines shall voluntarily resign or be separated from the service through no
fault of his own, he shallbe entitled to the commutation of all accumulated
vacation and/or sick leave
to his credit: xxx." (Underlining supplied) Executive Order No. 1077, mentioned
above, later amended Section 286 by removing the limitation on the number of
leave days that may be accumulated and explicitly allowing retiring government
employees to commute their accumulated leaves. The commutation of
accumulated leave credits may thus be considered a retirement gratuity, within
the import of Section 28(b), 7(f) of the NIRC, since it is given only upon
retirement and in consideration of the retiree's meritorious services. It is clear
that the law expresses the government's appreciation for many years of service
already rendered and the clear intention to reward faithful and often underpaid
workers after the official relationship had been terminated.

c. The provisions of any existing law to the contrary notwithstanding, social security
benefits, retirement gratuities, pensions and other similar benefits received by
resident or non-resident citizens of the Philippines or aliens who come to reside
permanently in the Philippines from foreign government agencies and other
institutions, private or public.

d. Payments of benefits due or to become due to any person residing in the Philippines
under the laws of United States administered by the United States Veterans
Administration.

e. Benefits received from or enjoyed under the Social Security System in accordance
with the provisions of RA 8282;
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f. Benefits received from the GSIS under RA No. 8291, including retirement gratuity
received by government officials and employees.

7. Miscellaneous Items –

a. Income Derived by Foreign Government – Income derived from investments in the

Philippines in loans, stocks, bonds, or other domestic securities, or from interest
on deposits in banks in the Philippines by (i) foreign governments, (ii) financing
institutions owned, controlled, or enjoying refinancing from foreign governments;
and (iii) international or regional financial institutions established by foreign
governments.

b. Income Derived by the Government or its Political Subdivisions – Income derived

from any public utility or from the exercise of any essential governmental
functions accruing to the government of the Philippines or to any political
subdivision.

c. Prizes and Awards. – Prizes and awards made primarily in recognition of religious,
charitable, educational, artistic, literary, or civic achievement but only if:

i. The recipient was selected without any action on his part to enter the contest
or proceedings; and
ii. The recipient is not required to render substantial future services as a condition
to receiving the prize or award.

(Note: if the conditions are not met, such as when the taxpayer nominated
himself to the award, the prize/award is part of the gross income)

d. Prizes and Awards in Sports Competition – All prizes and awards granted to athletes
in local and international sports competitions and tournaments whether held in
the Philippines or abroad and sanctioned by their national sports association.

(Note: If the conditions are not met, such as when the competition is not
sanctioned by the national sports association, the prize or awards are part of the
gross income)

e. 13th Month Pay and Other Benefits – Gross benefits received by officials and
employees of public and private entities; Provided, however, That the total
exclusion under this subparagraph shall not exceed ninety thousand (P90,000.00)
which shall cover:

i. Benefits received by officials and employees of the national and local

government pursuant to RA NO. 6686;
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ii. Benefits received by employees pursuant to PD NO. 851, as amended by
Memorandum Order No. 28, dated August 13, 1986;

iii. Benefits received by officials and employees not covered by PD No. 851, as
amended by Memorandum Order No. 28, dated August 13, 1986; and

iv. Other benefits such as productivity incentives and Christmas Bonus

(Note: The amount in excess is part of the gross income of the employee or
official)

f. GSIS, SSS, Medicate and other Contributions – GSIS, SSS, Medicare and Pag-Ibig
contributions and union dues of individuals.
g. Gains from the Sale of Bonds, Debentures, and other Certificate of Indebtedness –
Gains realized from the sale or exchange or retirement of bonds, debentures or
other certificate of indebtedness with a maturity of five (5) years.

(Note: If the maturity is less than 5 years, the gain is included in the gross income)

h. Gains from Redemption of Shares in Mutual Fund. Gains realized by the investor upon
redemption of shares of stocks in a mutual fund company as defined in Section
22(BB) of this Code.

DEDUCTIONS FROM GROSS INCOME

Defined

Deductions are items or amounts which the law allows to be deducted from gross income in
order to arrive at net or taxable income.

What is the treatment of return of capital?

Income tax is levied by law only on income; hence, the amount representing return of capital
(e.g. cost of goods sold) should be deducted from the proceeds of sale and should not be
subject to income tax.

Distinguish Exclusions from Deductions

Exclusion (Sec. 32(B)) Deduction (Sec. 34)

Refer to flow of wealth which are not Refer to the amounts which the law allows
treated as part of the gross income to be subtracted from the gross income in
because: a) these order to arrive at the net income.
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are exempted by law or statute; or b) they

do not come within the definition of income

Pertain to the computation of gross income Pertain to the computation of net income

Something earned by the taxpayer which do Something spent or paid in earning the
not form part of the gross income gross income

Deduction vs. Tax Credits

Deductions are the expenses and other allowable deductions as provided by law which are
incurred for engaging in trade, business or profession, deducted from the gross income to arrive
at the net or taxable income.

Tax Credits are amount of tax previously paid by the taxpayer which later on can be claimed as
tax credit from the tax liability of the taxpayer. It is deducted from the computed tax liability to
arrive at tax still due. (E.g. Creditable Withholding Tax)

Give the basic principles governing deductions

1. The taxpayer seeking a deduction must point to some specific provision of the statute
authorizing the deduction;
2. He must be able to prove that he is entitled to the deduction authorized or allowed (Atlas
Consolidated Mining v. Commissioner, G.R. No. L-26911, January 21, 1981)

Note: Deductions for income tax purposes partake of the nature of a tax exemption; hence, just
like tax exemptions, deductions must be construed in strictissimi juris against the taxpayer.

May Deductions be created by implication?

No. Deductions have generally been deemed to be a matter of legislative grace. They are
allowed only where there is a clear provision in the statute for the deduction claimed; and
where particular deductions are authorized by the statute, no other may be made. The taxpayer
has the burden of justifying the allowance of any deduction claimed by him.

May the taxpayer deduct lesser amount of deductions or not to deduct at all?

Definitely. For income tax purposes a taxpayer is free to deduct from its gross income a lesser
amount, or not to claim any deduction at all. What is prohibited by the income tax law is to
claim a deduction beyond the amount authorized therein. (CIR V. Phoenix Assurance Co., Ltd.,
G.R. No. L-19727, May 20, 1965)
Basis: Lifeblood doctrine

Who are not allowed to claim deductions?

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1. Individuals receiving compensation income;
2. Non-Resident aliens not engaged in trade or business;
3. Aliens (also Filipinos similarly situated) employed in ROHQ, RAHQ, OBU, Petroleum
Contractors;
4. Non-Resident Foreign Corporations;
5. Income subject to Final Withholding Tax

In general, what are the deductions from gross income authorized by the NIRC?

1. Itemized or Actual Deductions – These are the allowable deductions enumerated

under Section 34 of the NIRC.

2. Optional Standard Deductions – is a standard deduction in an amount not exceeding

40% of the gross sales/receipt of individuals, other than non-resident aliens, or 40% of
gross income corporations in lieu of the itemized deductions.

What are the itemized deductions under Section 34?

The allowable itemized deductions from gross income are:

1. Expenses
2. Interests on indebtedness
3. Taxes in connection with taxpayer’s business, trade or profession;
4. Losses
5. Bad debts
6. Depreciation
7. Depletion of oil and gas wells and mines
8. Charitable and other contributions
9. Research and Development expenditures
10. Contribution to pension trust

Special deductions
1. Deductions allowed to private proprietary educational institutions and hospitals that are
non-profit [Sec. 34(A)(2)];
2. Deductions allowed to insurance companies (Sec. 37);
3. Deductions allowed to Estates and Trusts (Sec. 61)

What are the items not deductible in computing net income?

1. Personal, living and family expenses (note: Section 35 on Personal Exemptions for
 Individual Taxpayer has been repealed by RA 10963, TRAIN Law);
2. Any amount paid out for new building or permanent improvements, or betterment made
to increase the value of any property or estate, except intangible drilling and
development cost in petroleum operations;

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3. Any amount expended in restoring property or in making good the exhaustion thereof for
which an allowance is or has been made;
4. Premiums paid on any life insurance policy covering the life of any officer or employee, or
of any person financially interested in any trade or business carried on by the taxpayer,
individual or corporate, when the taxpayer is directly or indirectly a beneficiary under
such policy.
5. Losses from sale or exchanges of property between related parties;
6. Losses from wash sales of stocks or securities unless the claim is made by a dealer in
stock or securities and with respect to a transaction made in the ordinary course of
business of such dealer;
7. Non-deductible taxes
8. Non-deductible losses;
9. Non-deductible interests

Rules on Optional Standard Deduction [Sec. 34(L)]

1. Who are allowed to avail?

a. Individuals except non-resident alien;
b. Domestic and Resident Foreign Corporation
c. General Professional Partnership and its individual partners but may be availed only
once, either the GPP or the partners

2. Rate
a. Individuals – 40% of Gross Sales or Gross Receipts
b. Corporation – 40% of Gross Income as defined in Sec. 32
c. GPP – 40% of ? (the law is silent) but under RR No. 8-2018, its was interpreted to
mean 40% of gross income. See below

3. OSD/Itemized Deduction, how elected. The default deduction is Itemized Deduction;

thus, unless the taxpayer signifies in his return his/its intention to avail of the OSD, he is
deemed to have availed the itemized deduction. Such election of the option, when the
return is made, shall be irrevocable for the taxable year for which the return is made.
The election to claim either the itemized deduction or the OSD for the taxable year must
be signified by checking the appropriate box in the ITR filed for the first quarter of the
taxable year or the initial quarter of the taxable year after the commencement of a new
business/practice of profession. Once the election is made, it must be consistently
applied to all the succeeding quarterly returns and in the final income tax return for the
taxable year.

4. Substantiation requirements. No need to keep records of the expenses. However, the

individual taxpayer shall keep such records pertaining to his gross sales/receipts, while
the corporation, its records pertaining to its gross income as defined under Section 32.
 5. Submission of Financial Statement – Individuals who opted OSD, no need to submit FS.

Determination of the OSD for GPPs and Partners of GPPs (RR No. 8-2011)

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GPP is not subject to income tax imposed pursuant to Section 26 of the Tax Code, as amended.
However, the partners shall be liable to pay income tax on their separate and individual
capacities for the respective distributive shares in the net income of the GPP.

The GPP is not a taxable entity for income tax purposes since it is only acting as a “pass
through” entity where its income is ultimately taxed to the partners comprising it. Section 26 of
the Tax Code, as amended, likewise provides that – “For purposes of computing the distributive
shares of the partners, the net income of the GPP shall be computed in the same manner as a
corporation.” As such, a GPP may claim either the itemized deductions allowed under Section 34
of the Code or in lieu thereof, it can opt to avail of the OSD allowed to corporations in claiming
the deductions in an amount not exceeding forty percent (40%) of its gross income.

xxx

The distributable net income of the partnership may be determined by claiming either itemized
deductions or OSD. The share in the net income of the partnership, actually or constructively
received, shall be reported as taxable income of each partner. The partners comprising the GPP
can no longer claim further deduction from their distributive share in the net income of the GPP
and are not allowed to avail of the 8% income tax rate option since their distributive share from
the GPP is already net of cost and expenses.

If the partners also derive other income from trade, business or practice of profession apart and
distinct from the share in the net income of the GPP, the deduction can be claimed from the
other income would either be the itemized deductions or OSD.

To be continued
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