BAMM5: Income Taxation Dr. Noe D. Dasig Jr.

, CPA
NIPSC School of Management Professor
1st Semester, AY 2020-2021

Module 6, Lesson 1
Taxation of Corporations
Introduction
In Modules 1 to 5, you learned about income tax imposed on individuals based on the TRAIN law.
In this module, you will learn about the taxation imposed on corporations. The discussion on taxation on
corporations is divided into two modules. This module deals with normal tax liability and passive income on
corporations. The minimum corporate income tax (MCIT), improperly accumulated earnings tax (IAET) and
gross income tax (GIT) will be discussed in the next module. Let’s begin!

Read the discussion and answer the assessment that follows.

Learning Objective:

1. To provide the knowledge on normal income tax imposed on corporations.

Learning Outcomes:
At the end of this module, you shall be able to:
1. Familiarize the basic tax rules on business income of corporate taxpayers;
2. Identify corporations subject to special tax rate;
3. Enumerate corporations exempt from income tax; and
4. Familiarize the tax rate imposed on certain passive income of corporations.

Discussion

The term “normal income tax” shall mean the income tax rates prescribed under RA 9337. Under
this law, tax rate on corporations shall be at 30% of net income effective Jan 1, 2009 onwards.

Classification of Income Taxpayers (Other than Individuals)

1. Corporations

a. Domestic. Those created or organized under and by virtue of Philippine laws.

1. Domestic corporation, in general
2. Government-owned and - controlled corporations
3. Taxable partnerships
4. Proprietary educational institutions
5. Non-profit hospitals
b. Foreign. Those organized in accordance with laws of their respective countries.
1. Resident. Those engaged in trade or business within the Philippines 2. Non-resident.
Those not engaged in trade or business within the Philippines

2. General Professional Partnership.

3. Estates and Trusts

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References:

Ballada, S. & Ballada, W. (2009) Income Taxation (10th ed.). Philippines: Domdane Publishers

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 End of Module 6, Lesson 1
( #7)

BAMM5: Income Taxation

Module 6, Lesson 1
Assessment

General Instruction: Please write your answer here or in a piece of paper, take a photo and send it to
me via messenger.

Part 1 Identification. Identify the corporate income tax rate imposed on certain corporations.

Tax Rate

1. Proprietary Educational Institutions ___________

2. Philippine Charity Sweepstakes Office (PCSO) ___________

3. Government Service Insurance System (GSIS) ___________

4. Domestic Corporation, in general ___________

5. Regional Operating Headquarters ___________

6. Non-stock and nonprofit educational institution ___________

7. Non-stock, Non-profit Hospital ___________

8. Gross Philippine billings of international shipping operating in the ___________

Philippines 9. Improperly Accumulated Earnings Tax ___________

10. Minimum Corporate Income Tax ___________

Part II. Compute the Tax Due on the following passive income earned by domestic corporation

Passive IncomeTax Due

1. Royalties on invention 1,030,000.00 __________________

2. Interest on BPI bank deposit 9,500.00 __________________

3. Dividends received from Megaworld Corp. 20,000.00 __________________

4. Interest on foreign bank deposit under expanded 15,000.00 __________________ foreign currency
deposit system
5. Capital gain from sale of land with gross selling price of P5,000,000.00 __________________
Part III. True or False Write the word True if the statement is correct and False if the statement is
wrong.

__________1. The 10% tax on the taxable income of a proprietary educational institution is absolute.
__________2. Foreign Corporation is created and organized under the laws of countries other than the
Philippines.

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__________3. Partnership other than a general professional partnership is also taxable on its income as a
general professional partnership.
__________4. A domestic, resident and non-resident foreign corporations may deduct from their business
income, itemized deductions under the Tax Code.
__________5. Domestic corporations are taxable on income from sources within the Philippines only,
__________6. Resident foreign corporation applies to a foreign corporation engaged in trade or business in
the Philippines.
__________7. General professional partnership is exempt from income tax.
__________8. Passive income are not to be included in gross income computation.
__________9. If the gross income from unrelated trade or business exceeds 50% of the total gross income
derived from all sources the entire taxable income of the proprietary educational institutions
is subject to 30% income tax rate.
_________10. Domestic corporation is taxable on all income derived from sources within and outside the
Philippines.
_________11. Every corporation is required to file a final adjustment return covering the total taxable
income of the corporation for the preceding calendar or fiscal year which is required to be
filed and paid on or before April 15 or on or before the 15 th day of the 4th month following
the close of the fiscal year, as the case may be.

Part IV.

1. Give the four (4) government-owned-and-controlled corporations exempt from paying income tax
2. List down at least five (5) corporations exempt from income tax under Section 30 of the Tax Code.

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BAMM5: Income Taxation Dr. Noe D. Dasig Jr., CPA
NIPSC School of Management Professor
1st Semester, AY 2020-2021

Module 7, Lesson 1
Penalty Taxes Imposed on Corporations

Introduction
In Module 6, we discussed the normal tax liability and passive income on corporations. In this
module, you will learn about the two (2) types of penalty taxes imposed on corporations, namely: (1) the
Minimum Corporate Income Tax (MCIT) in Sections 27 (E) and 28 (A) (2) of the NIRC; and (2) the
Improperly Accumulated Earnings Tax (IAET) in Section 29 of the NIRC. Let’s begin!

Read the discussion and answer the assessment that follows.

Learning Objective:
1. To provide basic knowledge on penalty taxes imposed on corporations.

Learning Outcomes:
At the end of this module, you shall be able to:
1. Familiarize the basic principles, compute the MCIT and determine the income tax payable; and
2. Explain the concept, purpose and rules on IEAT;

Discussion

I. Minimum Corporate Income Tax (MCIT)

1. Who are subject?

a) Domestic Corporations, and

b) Resident foreign corporations.

2. Rate and Base - Two percent (2%) of gross income. The taxpayer shall pay whichever is higher
between the MCIT and the regular corporate income tax (RCIT). The present RCIT is 30%.

3. Effectivity. The fourth (4th) taxable year immediately following the year in which such corporation
commenced its business.
The MCIT took effect in 1998. Corporations organized in 1994 or prior years were automatically
subject to MCIT in 1998, four years or more having elapsed from commencement of business. A corporation
organized in 1997 will be subject to MCIT in 2001, the 4th year following the commencement of business. 4.
Carry forward of excess minimum tax - Any excess of the MCIT over the regular corporate income tax
(RCIT) shall be carried forward and credited against regular income tax for the three (3) immediately
succeeding taxable years.
5. Gross income (from sales of goods) - The term “gross income” shall mean gross sales less sales
returns, discounts and allowances, and cost of goods sold. “Cost of goods sold” shall include all
business expenses directly incurred to produce the merchandise to bring them to their present location
and use.

For trading or merchandising concern, “cost of goods sold” shall include the invoice cost of goods
sold, plus import duties, freight in transporting the goods to the place where the goods are actually sold
including insurance while goods are in transit.

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 For manufacturing concern, “cost of goods manufactured and sold” shall include all cost of
production of finished goods, such as raw materials used, direct labor and manufacturing overhead, freight
cost, insurance premiums, and other costs incurred to bring the raw materials to the factory or warehouse.
6. Gross income (from sales of services) - In the case of taxpayers engaged in the sale of services, “gross
income” means gross receipts (actually or constructively received during the taxable year) less sales
returns, allowances, discounts, and cost of services. Provided, that for taxpayers employing the accrual
basis of accounting, the term “gross receipts” shall mean amounts earned as gross income.

“ Cost of services” shall mean all direct costs and expenses necessarily incurred to provide the services
required by the customers and clients including -
a) Salaries and employee benefits of personnel, consultants and specialists directly rendering the
service, and
b) Cost of facilities directly utilized in providing the service such as depreciation or rental of
equipment used and cost of supplies.

Provided, however, that “cost of services” shall not include interest expense except in the case of banks and
other financial institutions.

“Direct costs and expenses” shall pertain only to those costs exclusively and directly incurred in relation to
the revenue realized by the sellers of services. In other words, these refer to costs which are considered
indispensable to the earning of the revenue, such that without such costs, no revenue can be generated. Any
other costs not falling within this definition are not allowed for inclusion to “cost of services” for purposes
of computing the gross income subject to the 2% MCIT.

Illustration 7.1

The records of ABS Corporation, domestic, organized in 2013 and engaged in merchandising, show
the following -

2016 2017 2018

Sales P2,040,000.00 P2,500,000.00 P2,100,200.00

Cost of Sales 430,000.00 310,000.00 510,100.00 Operating Expenses 1,540,200.00
2,100,000.00 1,300,400.00

Compute the Regular Corporate Income Tax (RCIT), the Minimum Corporate Income Tax ( MCIT), and
the income tax payable for 2016, 2017 and 2018.

Solution to Illustration 7.1

Sales P2,04 .00 P2,5 0.00

Cost of Sales (430,000.00)

Gross income 1,610,000.00

Less: Operating expenses (1,540,200.00) )

Taxable income 69,800.00
Rate of Tax x 30% x 30%_
Regular Corporate Income Tax(RCIT) 20,940.00 27,000.00

Gross income P1,610,000.00 P2,190,000.00

Rate of tax x 2% x 2%__
Minimum Corporate Income Tax (MCIT) P32,200.00 P43,800.00

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Tax Due 2016 (RCIT), 2017 (MCIT) P 20,940.00 P43,800.00
Notes:

a) Income tax due for 2016 is the RCIT amounting to P20,940.00 and not the higher MCIT. The ABS
Corporation is not yet subject to the MCIT in 2016 since it is not yet the 4 th taxable year immediately
following the year in which the corporation commenced its business.
b) Income tax due for 2017 is the higher MCIT amounting to P43,800.00. The corporation is subject to
MCIT beginning taxable year 2017, the 4th year following the year it was organized. The excess of
MCIT over the RCIT (P43,800.00 - P27,000.00 = 16,800.00) will be carried over to 2018.

Solution for 2018 (Illustration 7.1)

Sales P2,10 .00

Cost of sales
Gross income
Less: Operating Expenses
Taxable income
Rate of tax x 30% _
Gross income P1,590,100.0 RCIT
0
Rate of tax x 2%___
P86,910.00

MCIT P31,802.00

Tax due (whichever is higher between RCIT & MCIT) 86,910.00 Less:
Excess of MCIT over RCIT in 2017 16,800.00
(Note b - 43,800.00 - 27,000.00) Tax payable in 2018 70,110.00

Illustration 7.2

The records of BS Company, organized in 2007, show the following -

Year RCIT MCIT Excess of MCIT over RCIT

2014 P50,000.00 P120,000.00 P70,000.00

2015 25,000.00 22,000.00 xx
2016 15,000.00 12,000.00 xx
2017 10,000.00 7,000.00 xx
2018 40,000.00 35,000.00 xx

Compute income tax payable each year from 2014 to 2018.

Solution to Illustration 7.2

a) Tax payable 2014 (whichever is higher between RCIT and MCIT, in this case MCIT is higher) is
P120,000.00.

b) Tax due 2015 P25,000.00

(whichever is higher between RCIT (25,000.00) and MCIT (22,000.00), in this case RCIT of 25is higher)
Less: Excess of MCIT over RCIT in 2014

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 (P120,000.00 less P50,000.00) P70,000.00
Excess of MCIT, carried over to 2016 (P45,000.00)
Tax Payable in 2015 None or zero
c) Tax due in 2016 - RCIT, higher P15,000.000
Less: Excess of MCIT over RCIT in 2014 70,000.00
Applied to RCIT in 2015 (25,000.00) 45,000.00
Excess of MCIT, carried over to 2017 (P30,000.00) Tax payable in 2016 None

d) Tax Due in 2017 - RCIT, higher P10,000.0

Less: Excess of MCIT over RCIT in 2014 70,000.00 Applied to RCIT
in 2015 (25,000.00)
Applied to RCIT in 2016 (15,000.00) 30,000.00
Excess of MCIT, but no carry over to 2018 (P20,000.00) Tax payable in 2017 None

e) Tax due in 2018 - (RCIT, higher) P40,000.00

Note: Excess MCIT of P70,000.00 in the year 2014 can be carried over against the RCIT for a period of
three (3) years only. The balance of the excess MCIT in 2017 of P20,000.00 cannot be carried over to 2018.

Illustration 7.3

The records of CSD Company show the following -

Year RCIT MCIT Excess of

MCIT over
RCIT
2013 P5,000.00 P9,500.00 P4,500.00
2014 9,000.00 9,500.00 500.00
2015 8,000.00 9,000.00 1,000.00
2016 6,000.00 8,000.00 2,000.00
2017 15,000.00 10,000.00 xxx

Compute the tax payable from 2013 to 2017.

Solution to Illustration 7.3

‘
a) Tax payable 2013 (MCIT, higher) P9,500.00
b) Tax payable 2014 (MCIT, higher) P9,500.00
c) Tax payable 2015 (MCIT, higher) P9,000.00
d) Tax payable 2016 (MCIT, higher) P8,000.00
P15,000.00
e) Tax due 2017 - (RCIT, higher)
Less: Excess of MCIT over RCIT in
2013(4,500.00) 0
2014(P500.00) 500.00
2015(P1,000.00) 1,000.00
2016 (2,000.00) 2,000.00 (3,500.00)
Tax payable 2017 P11,500.00

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 Note: The excess MCIT in 2013 of P4,500.00 cannot be carried over against the RCIT in 2017.
The excess can be carried over only for a period of 3 years, from 2014 to 2016. Since it was not used or
applied during the said period, its credibility is lost.
7. Domestic Corporations Not Subject to MCIT

The MCIT shall apply only to domestic corporations subject to regular corporate income tax.
Accordingly, the following shall not be subject to MCIT -

a) Domestic corporations operating as proprietary educational institutions subject to tax at ten percent
(10%) on their taxable income;
b) Domestic corporations engaged in hospital operations which are nonprofit subject to tax at ten
percent (10%) on their taxable income;
c) Domestic corporations engage in business as depository banks under expanded foreign currency
deposit system, otherwise known as foreign currency deposit units (FCDUs) on their -
1.Income from foreign currency transactions with non-residents, off-shore banking units in the
Philippines, local commercial banks, including branches of foreign banks, and other
depository banks, and
2.Interest income from foreign currency loans granted to residents of the Philippines under the
expanded foreign currency deposit system, subject to final tax at ten percent (10%) of
such income.
d) Firms that are taxed under special income tax regimes such as those in accordance with the PEZA
law (RA 7916) and the Bases Conversion Development Act (RA No. 7227);
e) Real estate investment trusts (REITs”) shall not be subject to the MCIT as provided under Section
27(E) of the Tax Code.

8. Resident Foreign Corporations Not Subject to MCIT -

The minimum corporate income tax shall apply only to resident foreign corporations which are
subject to the regular income tax. Accordingly, the MCIT shall not apply to the following -
a) Resident foreign corporations engaged in business as “international carrier” subject to tax at two
and one-half percent (2 1/2%) of their “Gross Philippine Billings”
b) Resident foreign corporations engaged in business as Offshore Banking Units (OBUs) on their -
1. Income from foreign currency transactions with non-residents, other offshore banking units,
local commercial banks, including branches of foreign banks, and
2. Interest income from foreign currency loans granted to residents of the Philippines, subject to
final tax at ten percent (10%) of such income
c) Resident foreign corporations engaged in business as regional operating headquarters subject to tax
at ten percent (10%) of their taxable income;
d) Firms that are taxed under special income tax regimes such as those in accordance with the PEZA
law (RA 7916) and the Bases Conversion Development Act (RA No. 7227).

9. Relief from the Minimum Corporate Income Tax

The Secretary of Finance, upon the recommendation of the Commissioner, may suspend imposition
of the MCIT upon submission of proof that the corporation sustained losses on account of a) a prolonged
labor dispute;
b) Because of “force majeure”;
c) Because of legitimate business reverses.

The term “substantial losses from prolonged business dispute” means losses arising from a strike staged by
the employees which lasted more than six (6) months within the taxable period, and which has caused the
temporary shutdown of business operations.

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The term “force majeure” means a cause due to an irresistible force as by an “Act of God” like lightning,
earthquake, storm, flood and the like. The term shall also include armed conflicts like war or insurgency.
The term “legitimate business reverses” shall include substantial losses sustained due to fire, robbery, theft,
embezzlement, or for other economic reasons as determined by the Secretary of Finance.

10. Manner of Filing and Payment

The computation and payment of the MCIT shall likewise apply at the time of filing the quarterly corporate
income tax. Therefore, in the computation of the tax due for the taxable quarter, if the computed quarterly
MCIT is higher than the quarterly RCIT, the tax due for such taxable quarter shall be the quarterly MCIT.

The quarterly MCIT shall be equal to two percent (2%) of the gross income as of the end of the taxable
quarter.

In the payment of said quarter MCIT, excess MCIT from previous taxable year(s) shall not be allowed to be
credited. However, (a) the expanded withholding tax, (b) quarterly income tax payments under the normal
income tax (RCIT) and (c) the MCIT paid in the previous taxable quarter(s) are allowed to be applied against
the quarterly MCIT due.

In the payment of the quarterly RCIT, all items mentioned in the preceding paragraph shall be allowed to be
credited, including the excess MCIT from previous taxable years (subject to the prescriptive period allowed
for its creditability).

Improperly Accumulated Earnings Tax (IAET)

A) Introduction

From 1989 to 1997, dividend income was exempt from income tax. The additional corporate tax of 25%, the
levied for improper accumulation of profits, was also dissolved during the same period.

Beginning 1998, under the new Tax Code, dividend is again made subject to income tax. The old additional
tax on corporations, previously imposed for improper accumulation of profits, was also revived as a
consequence.

B) Concept of the Tax

Dividend is a distribution of corporate earnings or profits. When declared,it becomes subject to income tax in
the hands of stockholders.

In order to compel corporations to distribute or pay dividends to stockholders, the retention or accumulation
of earnings or profits beyond the reasonable needs of the business is made subject to tax.

The rationale is that if corporate earnings and profits were distributed, shareholders would then be liable to
income tax thereon. Whereas, if distributions were not made to them, shareholders would incur no tax with
respect to the undistributed earnings and profits of the corporation.

Thus, the IAET is being imposed in the nature of a penalty to the corporation for the improper accumulation
of its earnings. The tax also acts as a form of deterrent to the avoidance of the tax on dividends upon
shareholders.

The touchstone of the liability is the purpose behind the accumulation of the income rather than the
consequences of the accumulation. Thus, if the failure to pay dividends is due to the use of corporate
earnings and profits for the reasonable needs of the business, such purpose would not generally make the
accumulation or retention of the earnings or profits subject to tax. But if the corporation has accumulated

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income beyond the reasonable needs of the business, the improperly accumulated earnings tax shall be
imposed.
C) Nature of the Tax

This tax is called the Improperly Accumulated Earnings Tax (IAET). The old name was “additional tax for
improper accumulation of profits.”

It applied to domestic corporations classified as closely-held corporations.

The rate of tax is 10% and is based upon the improperly accumulated taxable income of a corporation for
each taxable year.

The IAET is imposed upon corporations which are formed or availed of for the purpose of avoiding the
income tax with respect to its shareholders or stockholders of any other corporation by permitting earnings
and profits to accumulate instead of being divided or distributed.

The IAET is an additional tax to the regular corporate income tax imposed or corporations under Title II of
the Tax Code.

Under the law, a corporation becomes liable to the tax if its profits and earnings are improperly accumulated
or retained, instead of being distributed as dividends to the stockholders. In this sense, the IAET is also
called or regarded as a corporate penalty tax.

D) Purpose of the Tax

The reimposition of the tax on dividends also necessitated the revival of the improperly accumulated
earnings tax.

The tax is intended to discourage corporations from permitting its profits or earnings not needed by the
business to accumulate instead of being distributed to stockholders in the form of dividends. It induces
corporations with accumulated earnings or profits to distribute such earnings or profits every taxable year.

The tax provides as safeguard against the possible abuse in the exercise of corporate powers and prerogatives
regarding the accumulation or retention of disposable corporate income.

E) Background

The taxable income of corporations is subject to the corporate income tax. After payment of the income tax,
the remaining net income, or disposable income of the corporation, is normally expected to be distributed
among the stockholders in the form of dividends.

Dividends in the hands of stockholders is taxable income.

One way of avoiding the taxation of the dividend ( which in effect is a second taxation of corporate net
income) is for corporation to accumulate and retain its profits, and not to distribute them as dividends.

The retention and non-distribution of corporate earnings is an old tax-saving device. This device is usually
resorted to by closely-held corporations or family corporations. In a closely-held corporation, stockholders
generally can readily withdraw corporate funds under the guise of loans, advances, allowances or salaries.
Such withdrawals may be in the nature of a distribution of profits or dividends.

F) Corporations Subject to IAET

The tax is imposed on improperly accumulated taxable income earned starting January 1, 1998 by domestic
corporations ( as defined under the Tax Code) which are classified as closely-held corporations.

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Closely-held Corporations Defined

These are corporations where at least fifty percent (50%) in value of the outstanding capital stock or at least
fifty percent (50%) of the total combined voting power of all classes of stock entitled to vote is owned
directly or indirectly by or for not more than twenty (20) individuals.

Publicly-held Corporations Defined

These are domestic corporations not falling under the aforesaid definition of a closely-held corporation.

Determination of Closely-held Corporation Based on Stock Ownership.

For purposes of determining whether a corporation is a closely-held corporation insofar as such

determination is based on stock ownership, the following rules shall be applied:

1. Stock Not Owned by Individuals - Stock owned directly or indirectly by or for a corporation,
partnership, estate, or trust shall be considered as being owned proportionately by its shareholders,
partners, or beneficiaries.
2. Family and Partnership Ownership - An individual shall be considered as owning the stock owned,
directly or indirectly, by or for his family, or by or for his partner. For purposes of this paragraph, the
“family or an individual” includes his brothers or sisters, spouse, ancestors, and lineal descendants.
3. Option to Acquire Stocks - If any person has an option to acquire stock, such stock shall be considered
as owned by such person. For purposes of this paragraph, an option to acquire such as option and each
one of a series of options shall be considered as an option to acquire such stock.
4. Constructive Ownership as Actual Ownership - Stock constructively owned by reason of the application
of paragraph (1) or (3) hereof shall, for purposes of applying paragraph (1) or (2), be treated as actually
owned by such person; but stock constructively owned by the individual by reason of the application of
paragraph (2) hereof shall not be treated as owned by him for purposed of again applying such
paragraph in order to make another the constructive owner of such stock.

G) Corporations Not Subject to IAET

The Improperly Accumulated Earnings Tax shall not apply to the following corporations:

a. Banks and other non-bank financial intermediaries;

b. Insurance companies;
c. Publicly-held corporations;
d. Taxable partnerships;
e. General professional partnerships;
f. Non-taxable joint ventures;
g. Enterprises duly registered with PEZA under RA 7916, and enterprises registered pursuant to the Bases
Convention and Development Act of 1992 under RA 7227, as well as other enterprises duly registered
under special economic zones declared by law which enjoy payment of special tax rates on their
registered operations or activities in leiu of other taxes, national or local; and
h. Branches of foreign corporations, the same being resident foreign corporations

H) Evidence of Purpose to Avoid Income Tax

1. Prima Facie Evidence - The fact that any corporation is mere holding company or investment
company shall be prima facie evidence of a purpose to avoid the tax upon its shareholders or members.
2. Evidence Determinatice of Purpose - The fact that the earnings or profits or a corporation are
permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to
avoid the tax upon its shareholders or members unless the corporations by the clear preponderance of
evidence shall prove to the contrary.

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The law has created certain prima facie presumptions and evidences of a purpose to avoid the tax upon
shareholders or members. These are:

a) That the corporation is mere holding company; or

b) That the corporation is an investment company; or
c) That the earnings or profits of the corporation are permitted to accumulate beyond the reasonable
needs of the business.

Holding Company Defined

A holding company is a corporation having practically no activities except holding propertym and
collecting the income therefrom or investing therein.

Investment Company Defined

If the activities further include, or consist substantially of, buying and selling stocks, securities, real
estate, or other investment property (whether upon an outright or a marginal basis) so that the income is
derived not only from the investment yield but also from profits upon market fluctuations, the corporation
shall be considered an investment company.

Circumstances Indicative of Purpose to Avoid the Tax

All the other circumstances which might be construed as evidence of the purpose to avoid the tax on
dividends cannot be outlined, but among other things, the following shall be considered:

1. Dealings between the corporation and its shareholders,such as withdrawals by the shareholders as
personal loans;
2. Expenditure of funds by the corporation for the personal benefit of the shareholders;
3. The investment by the corporation of undistributed earnings in assets having no reasonable connection
with the business;
4. Advances in substantial sums made yearly to corporate officers who are the same time the stockholders.

I) Meaning of Reasonable Needs of the Business

The term “reasonable needs of the business” includes the reasonably anticipated needs of the business.

An accumulation of earnings or profits (including undistributed earnings or profits of prior years) is

unreasonable if it is not necessary for the purpose of the business.

In order to determine the “reasonable needs” of the business which will justify an accumulation of earnings,
internal revenue regulations adhere to the so-called “Immediacy Test” under American jurisprudence as
adopted in the Philippines.

Under the “Immediacy Test”, the term “reasonable needs of the business” is construed to mean the
immediate needs of the business, including reasonably anticipated needs. In either case, the corporation
should be able to prove an immediate need for the accumulation of earnings and profits or the direct
correlation of anticipated needs to such accumulation of profits. Otherwise, such accumulation would be
deemed to be not for the reasonable needs of the business.

In a recent case, the taxpayer corporation failed to disclose in its Notes to the Financial Statements the
appropriations made which were significant transactions or information which the stockholders, the
government, and the taxpayer failed to pass the “Immediacy Test” and held that taxpayer liable for the IAET.

In another case, the taxpayer corporation failed to present clear proof to substantiate its claim such as copy of
minutes of the board meeting, a board resolution or a memorandum recommending the accumulation or

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appropriation of such retained earnings for its planned expansion. A mere Secretary’s Certificate without
mentioning a definite planned expansion, as well as self-serving testimonies without supporting evidence of
the planned expansion linked to the accumulation of retained earnings will not suffice. Moreover, the
retained earnings were not even immediately utilized as there was in fact an increase of the same in the
succeeding years. The definiteness of plans coupled with actions taken toward their consummation are
essential to prove the taxpayer’s immediate need for such retained earnings.

1. Proper Accumulation of Profits

The following constitute accumulation of earnings for the reasonable needs of the business:

a. Allowance for the increase in the accumulation of earnings up to 100% of the paid-up capital of the
corporation as of the balance sheet date, inclusive of accumulations taken from other years;
b. Earnings reserved for definite corporate expansion projects or programs requiring considerable
capital expenditures as approved by the Board of DIrectors or equivalent body;
c. Earnings reserved for buildings, plants, or equipment acquisition as approved by the Board of
Directors or equivalent body;
d. Earnings reserved for compliance with any loan covenant or pre-existing obligation obligation
established under legitimate business agreement;
e. Earnings required by law or applicable regulations to be retained by the corporation or in respect of
which there is a legal prohibition against its distribution;
f. In the case of subsidiaries of foreign corporations in the Philippines, all undistributed earnings
intended or reserved for investments within the Philippines as can be proven by corporate records
and/or relevant documentary evidence.

Other Cases:

Undistributed income is properly accumulated in the following cases:

a) If retained for working capital needed by the business;
b) If invested in addition to plant reasonably required by the business; or
c) If, in accordance with contract obligations, placed to the credit of a sinking fund for the purpose of
retiring bonds issued by the corporation.

2. Improper or Unreasonable Accumulation of Profits

In general, an accumulation of earnings or profits is unreasonable or improper if it is not required for the
purposes of the business.

The nature of the investment of earnings or profits is immaterial if they are not in fact needed in the business.
Among other things, the nature of the business, the financial condition of the corporation at the close of the
taxable year, and the use of the undistributed earnings or profits will be considered in determining the
reasonableness of the accumulations.

The business of a corporation is not merely that which it has previously carried on, but includes in general
any line of business which it may undertake. However, a radical change of business when a considerable
surplus has been accumulated may afford evidence of a purpose to avoid the tax upon shareholders or
members.

Instances of Improper Accumulation of Profits

The following are prima facie instances of accumulation of profits beyond the reasonable needs of a business
and indications of a purpose to avoid income tax upon shareholders:

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a. Investment of substantial earnings and profits of the corporation in an unrelated business or in the stock
or securities of an unrelated business;
b. Investment in bonds and other long-term securities;
c. Accumulation of earnings in excess of 100% of paid-up capital, not otherwise intended for the
reasonable needs of the business.

In order to determine whether profits are accumulated for the reasonable needs of the business as to avoid the
imposition of the IAET, the controlling intention of the taxpayer is that which is manifested at the time of
accumulation, not subsequently declared intentions which are merely the product of afterthought. A
speculative and indefinite purpose will not suffice. The mere recognition of a future problem or the
discussion of possible and alternative solutions is not sufficient. Definiteness of plan(s) coupled with
action(s) taken towards its consummation is essential.

J) Tax Base or Basis of the Tax

The rate of the IAET is 10%. It is based upon the improperly accumulated taxable income for each taxable
year.

The term “improperly accumulated taxable income” means the year’s taxable income adjusted by:

First, adding the following:

1. Income exempt from tax;

2. Income excluded from gross income;
3. Income subject to final tax;
4. The amount of net operating loss carry-over (“NOLCO”) deducted; and
5. Accumulated earnings as of the end of the taxable year.

Second, reducing the total thereof by the sum of:

1) Dividends actually or constructively paid/issued from the applicable year’s taxable income;
2) Income tax paid/payable for the taxable year; and
3) Amount that may be retained for the reasonable needs of the business emanating from the covered
year’s taxable income.

The resulting improperly accumulated taxable income shall be multiplied by 10% to get the improperly
accumulated earnings tax.

Illustration No. 7.4

The records of a closely held corporation show the following:

Retained earnings, December 31, 2014 P4,000,000.00

Note: Retention of the profits did not serve any business purpose.

2015

Gross Income P3,000,000.00

Expenses 3,800,000.00 Net income (loss) P800,000.00

2016

Gross income as contractor,

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 Net of WT of 1% P4,950,000.00
Business expense 3,000,000.00
Other income:
Rent, net of WT of 5% 475,000.00

Interest, money market placement, net of WT of 20% 80,000.00

Intercorporate dividend 500,000.00

Additional information:

In the year 2017, dividends were declared and paid, as follows:

Out of 2014 retained earnings P2,000,000.00

Out of 2016 retained earnings 1,500,000.00

In the same year, the Commissioner concluded that the 2016 profits were improperly accumulated, and that
the taxpayer failed to show proof to the contrary.

Required:

1. Compute the regular income tax for 2016.

2. Compute the additional tax on improperly accumulated earnings for 2016.
3. Compute the final tax on dividends.

Solution to Illustration 7.4

1. Regular income tax:

Gross income (P4,950,000.00/99%) P5,000,000.00

Rental income (P475,000.00/95%) 500,000.00 P5,500,000.00
Less: Itemized deductions
Business expenses P3,000,000.00
NOLCO (Net operating loss from 2015) 800,000.00 (3,800,000.00)
Taxable net income P1,700,000.00
Tax rate (2016) x 30%
Tax dueP510,000.00
Less: Tax credits
WT on gross income as contractor
(P5,000,000.00 x 1%) 50,000.00
WT on rental income
(P500,000.00 x 5%) 25,000.00 (75,000.00)
Tax payable P435,000.00

2. Improperly accumulated earnings tax:

Taxable net income (2016 ITR) P1,700,000.00

Add:
Intercorporate dividend P500,000.00
Interest from money market 100,000.00
(80,000/ 80%)
NOLCO, 2015 800,000.00 1,400,000.00

Less:
Dividend paid out of 2016 profits P1,500,000.00

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 Income tax (2016 ITR) 510,000.00
FWT on interest from money market
(P100,000.00 x 20%) 20,000.00 (2,030,000.00)
IAET base P1,070,000.00
IAET rate x 10% IAET payable P107,000.00

Notes:

1. In computing for the regular income tax, the net operating loss is deductible.
2. In computing for the tax on improperly accumulated profits, the net operating loss is not deductible; and
if deducted from income, it has to be added back.
3. Interest on the money market placement is subject to final tax. The gross interest is included in income,
and the tax withheld deducted.
4. The income tax due of P510,000.00 which was deducted includes the total creditable taxes withheld of
P75,000.00 3. Final tax on dividends:

Dividend out of 2014 earnings P2,000,000.00

Rate of tax x 10%
Final tax P200,000.00

Dividend out of 2016 earnings P1,500,000.00

Rate of tax x10%
Final tax P150,000.00
Note:

Once the profit has been subjected to IAET, the same shall no longer be subjected to IAET in later years
even if not declared as dividend.

Notwithstanding the imposition of IAET, profits which have been subjected to IAET, when finally declared
as dividends, shall nevertheless be subject to tax on dividends imposed under the Tax Code except in those
instances where the recipient is not subject thereto.

For purposes of determining the source of earnings or profits declared or distributed from accumulated
income for each taxable year, the dividends shall be deemed to have been paid out of the most recently
accumulated profits or surplus, and shall constitute a part of the annual income of the distributee for the
year in which received pursuant to Section 73(C) of the Tax Code.

Where the dividends or portion of the said dividends declared forms part of the accumulated earnings as of
December 31, 1997, or emanates from the accumulated income of particular year and therefore, is an
exception to the preceding statement, such fact must be supported by a duly executed Board Resolution to
that effect.

Taxable income improperly accumulated prior to the effectivity of Rev. Reg. No. 2-2001, if declared as
dividend and paid/issued within one month from the effectivity hereof will not be subjected to the 10%
improperly accumulated earnings tax.

K) Period For Payment of Dividend/Payment of IAET

The dividends must be declared and paid or issued not later than one (1) year following the taxable year.
Otherwise,the IAET, if any, should be paid within fifteen (15)days thereafter.
Summary

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 Summary Rules of Corporate Penalty Taxes
MCIT IAET
Corporation subject Domestic and resident foreign Domestic corporations which are
corporations which are not classified as closely-held
subject to the regular corporate corporations
income tax rate of 30%
Corporations not subject Domestic and resident foreign 1. Banks and other non-bank
corporations which are not financial intermediaries;
subject to the regular corporate 2. Insurance companies;
3. Publicly-held corporations;
income tax rate of 30%
4. Taxable partnerships;
5. GPPs;
6. Non-taxable JVs;
7. Enterprises registered with
the PESA and other special
economic zones; and
8. RFCs
Tax Base Gross income Improperly accumulated taxable
income
Tax Rate 2% 10%
Effectivity Beginning on the 4th taxable year Starting 1998, the taxpayer shall
following the year of be subject to IAET in any year it
commencement of business, the is found to have improperly
taxpayer shall pay the higher of
accumulated profits
the RCIT or MCIT
References:

Llamado, C. & De Vera, J. (2020). Philippine Income Tax (2020 ed.) Philippines: GIC Enterprises & Co.,
Inc.

End of Module 7, Lesson 1

( #8)
BAMM5: Income Taxation
Module 7, Lesson 1

Assessment

1. The records of DAS Company (domestic) organized in 2006 show the following -

Year RCIT MCIT Excess of MCIT over

RCIT

2011 P25,000.00 P100,000.00 P75,000.00 2012 130,000.00 150,000.00 20,000.00

2013 200,000.00 190,000.00 xx 2014 0.00 300,000.00 300,000.00 2015 10,000.00
50,000.00 40,000.00
2016 15,000.00 60,000.00 45,000.00
2017 8,000.00 40,000.00 32,000.00
2018 1,000.00 50,000.00 49,000.00
2019 180,000.00 100,000.00 xx

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Compute the income tax payable from years 2011 to 2019 (2 points each).

2. The records of XYZ Corporation, domestic, organized in 2015 and engaged in merchandising, show the
following -

Sales P1,00 .00 P1,4 0.00

Cost of Sales 450,000.00 500,000.00
Operating Expenses 250,000.00 800,000.00

Compute the income tax payable in 2019 and 2020 (3 points each).

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