INCOME TAXATION

INCLUSIONS AND EXCLUSIONS FROM BUSINESSAND OTHER SOURCES OF INCOME

UNIT 5

Objectives:
 Compute the taxable income of self-employed individuals or those with mixed income;
 Utilize the new graduated tax table under the TRAIN Law for computing the annual tax due/payable of self-
employed individuals; and
 Develop a sense of stewardship and accountability in recording and reporting taxes truthfully.

Inclusions to Gross Income for the purpose of computing Business, Professional and
Other Sources of Income
1. Gross income derived from the conduct of trade or business, or the exercise of a profession;
2. Gains derived from dealings in Property;
3. Rent;
4. Interest;
5. Royalties;
6. Dividends;
7. Prizes, Awards and Winnings;
8. Annuities

Self-Employed Individuals
There are two kinds of self-employed individuals:
1. Individuals engaged in trade or business
2. Individuals engaged in the practice of a profession

Individuals Engaged in Trade or Business

These are individuals (businessman or entrepreneur) who invests money, property and time to engage in lawful business
(e.g. service, merchandising, and manufacturing) for profit. The following are common businesses they enter into: internet
café; restaurant; hotels; taxis and public utility vehicles; vegetables, fish, meat vendors; barbershops, beauty and funeral
parlors; store and groceries; factory; street and side-walk vendors; junkshop; vulcanizing shops; apartments for rental;
etc.

Individuals Engaged in the Practice of Profession

These individuals are duly licensed by the Professional Regulatory Commission (PRC) and by the boards of their respective
professions (ex. Board Accountancy, Board of Engineering, etc.) to practice his/her profession in the Philippines. Lawyers
are duly licensed by the Supreme Court after passing the BAR examinations.
These professionals earn income from their profession in the form of medical fee, professional fee, retainer’s fee, service
income, and other related fees or revenues.

Business Income
Are income arising from self-employment or practice of profession. The following are the rules for computing taxes of
self-employed and professional taxpayers (SEP) or those with mixed incomes:
A. For purely self-employed and professionals (SEP)
If gross sales/receipts and other non-operating income do not exceed the P3,000,000.00 VAT threshold, the taxpayer
may opt to be taxed at:
 8% of gross sales/receipts and other non-operating income in excess of P250,000.00 in lieu of graduated rates and
 percentage tax; or
 Graduated rates/Personal Income Tax schedule

B. Mixed income earners shall be taxed as follows:

 On their compensation income - Graduated rates/Personal Income Tax schedule
 On their income from the conduct of trade or business or practice of profession:
 If below the VAT threshold - 8% of gross sales/receipts and other non-operating income in lieu of graduated rates
and percentage tax or Graduated rates/Personal Income Tax schedule, at the option of the taxpayer;
 If exceeding the VAT threshold - at Graduated rates/Personal Income Tax schedule.

Computation of Gross Income for SEP

In the case of manufacturing and merchandising business, gross income means Gross Sales, less Cost of Goods Sold
plus any Income from investments and from incidental or outside operations or sources. In the case of service
oriented business, gross income means Gross Receipts, less Cost of Service plus any Income from investments and
from incidental or outside operations or sources.

Gross Sales / Gross Receipts xxx

Less: Cost of Goods Sold / Cost of Service xxx
Gross Profit from Sales / Receipts xxx
Add: Other Income xxx
Total Gross Income xxx

Note: Any income already subjected to Final Tax shall no longer be included in the computation of the gross income
subject to basic tax.

Gains Derived from Dealings in Property

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

Rents
Gross income derived from rent (e.g. personal or real property) are subject to income tax. For tax purposes, the following
are income arising from rentals that must be included as part of the gross income of a taxpayer:
a. Advance rentals received during the taxable year; and
b. Rentals actually earned but not yet collected during the taxable year.

Interests
Gross Income derived from interest refers only to such interest received arising from indebtedness.
Interests from deposits (e.g. Banks) and yield or any other monetary benefit from deposit substitutes and from trust
funds and similar arrangements are subject to 20% final tax which shall NOT form part of the gross income for purposes
of computing income tax.

Royalties
Royalties include earnings derived from:
a. Copyrights
b. Trademarks
c. Patents, and
d. Natural resources under lease
Royalties involves not only the use of property but also its exhaustion (e.g. mineral deposits, mines, etc.).
Dividends
Dividends are distributions made by a corporation out of its earnings or profits and payable to its shareholders whether
in money or in other property.
a. Cash Dividend – is paid to shareholders or members in cash and is taxable with a 10% final tax.
Note: If the dividend is distributed by a Domestic Corporation to a Non-resident alien engaged in trade or business
in the Philippines it is taxable with a 20% final tax.
a. Property Dividend – is paid in property of the corporation such as bonds, securities and stock investments held by
the corporation paying the dividend and is taxable at the same rate as cash dividend.
b. Stock Dividend – It is paid through the company’s `owns stocks, and is not taxable unless it represents a distribution
of earnings or profits

Prizes, Awards, and Winnings

Prizes, awards, and winnings for commercial or non-commercial contests are generally taxable, such payments constitute
gains derived from labor. The following are the rules whether such prizes, awards, or winnings are to be included or
excluded in the gross income of a taxpayer.
a. If the amount of the prize is P10,000.00 or less – to be included in the gross income of the taxpayer subject to
income tax;
b. If the amount of the prize is more than P10,000.00 – a final tax of 20% applies;
c. Philippine Charity Sweepstakes Office (PCSO) winnings and lotto winnings exceeding P10,000.00 are subject to
20% final tax. If the amount of the prize is P10,000.00 or less follow letter A.
d. Prizes and awards granted to athletes in local and international sports competition and tournaments held in the
Philippines or abroad and sanctioned by their National Sports Associations are tax exempt.
e. Prizes and awards in the nature of gifts are tax exempt.

Annuities
These refer to annuity policies sold by insurance companies, which provide installment payments for life, or for a
guaranteed fixed period of time whichever is longer for life or guaranteed fixed period.
a. The portion of each annuity payment that represents return of premium is tax exempt.
b. The portion that represents interest is taxable.

Exclusions to Gross Income for the purpose of computing Business and Other Sources of Income
The following items shall NOT be included in the computation of gross income and are not taxable:
1. Life Insurance. The proceeds of life insurance policies paid to the heirs or beneficiaries upon the death of the insured.
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.

2. Gifts, Bequests (inheritance), and Devises (a property passed on through a will). The value of property acquired
through gift, inheritance, devise are exempted from income tax.
3. Income exempt under Treaty. Income of any kind, to the extent required by any treaty obligation binding upon the
Government of the Philippines are exempted from income tax.
4. Retirement Benefits, Pensions, Gratuities, etc.
a. Retirement benefits received in accordance with a reasonable private benefit plan maintained by the employer.
Provided that the following conditions are present:
 the retiring employee has been in the service of the same employer for at least ten (10) years,
 is not less than fifty (50) years of age at the time of his retirement, and
 the benefits availed of by the employee only once.
b. Any amount received by an employee or by his/her 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 employee.
c. 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, public or private.
d. Benefits due or to become due to any person residing in the Philippines under the laws of the U.S. administered by
the United States Veterans Administration.
5. Miscellaneous Items
a. Income derived from Foreign Government
b. Income derived by the government or its Political subdivisions.
c. Prizes and awards made primarily in recognition of religious, charitable, scientific, educational, artistic, literary, or
civic achievement, provided that the:
 recipient was selected without any action on his part to enter the contest or proceeding;
 recipient is not required to render substantial future services as a condition to receiving the prize or award.
d. Prizes and awards granted to athletes in local and international sports competition and tournaments held in the
Philippines or abroad and sanctioned by their National Sports Associations are tax exempt.
e. Gains from Sale of Bonds, Debentures or other Certificates of Indebtness with a maturity of more than five (5) years.
f. Gains from redemption of shares in Mutual Fund

Allowable Deductions
Deduction are items or amounts which the law allows to be deducted from the Gross Income of a taxpayer in order to
arrive at the Taxable Income.
A taxpayer has the right to deduct all authorized expenses/allowances for the taxable year. As a rule, if he does not deduct
within the taxable year certain expenses, losses, interest taxes, or other charges, he cannot deduct them from the income
of the next or any succeeding year.
The following are the allowable deductions the individual taxpayer may claim:
Deductions from business (i.e. business expenses) and/or professional income of individual taxpayers. An individual
taxpayer may opt for:
1. Itemized Deductions (i.e. actual business expenses) or
2. Claim the 40% Optional Standard Deductions (OSD) from his Gross sales/receipts in lieu of his cost of sales/cost of
service and business expenses.

Classification of Expenses
1. Non-business expenses – This includes personal, family and living expenses of the taxpayer. These are NOT allowed
to be deducted for the purpose of computing the taxable income.
2. Business expenses – are the ordinary and necessary expenses paid or incurred during the taxable year in carrying on
or connected to the operations of the business or trade or in the exercise of profession. This include the following
items: salaries and wages, interest, taxes, losses, bad debts, depreciation, depletion, rent, insurance, charitable
contributions, research and development, other general and administrative expenses.

Itemized Deductions
Business expenses are deemed deductible only if they comply with all the conditions for deductibility, as follows:
1. They are incurred during the taxable year;
2. They are connected to trade, business or profession;
3. They are considered ordinary and necessary business expenses;
4. Not against public order or public policy;
5. Duly substantiated by receipt or supporting documents; and
6. If any, the corresponding withholding taxes must have been paid.

Optional Standard Deduction (OSD)

OSD is a deduction from the gross income in lieu of actual business expenses (cost of sales/service and operating
expenses). OSD is equivalent to forty percent (40%) of Gross Sales/Revenues/Receipts/Fees, while itemized deduction is
a deduction of individually identified expenses. Some features of the OSD are the following:
1. OSD can be claimed by persons engaged in trade or business or in the practice of a profession, except individuals
earning purely compensation income;
2. Individuals who have chosen OSD are not required to submit with their income tax returns any financial statement, but
they should keep the corresponding records pertaining to their gross income.

Computing for OSD:

 40% of gross sales, in the case of merchandising and manufacturing concern
 40% of gross receipts or revenues in the case of service concerned business

Illustrative Problem No.1

The following are the data of Mr. Robert Tomon owning a fruit-stand and an apartment, a married Filipino with one child
during the taxable year of 2019.
Gross Sales from Business 697,234.00
Cost of Sales 266,887.00
Salaries Expense 52,889.00
Utilities Expense (Light & Water) 54,304.00
Depreciation Expense 12,385.00
Rent Expense 24,000.00
Supplies Expense 8,358.00
Other Operating Expenses (P2,089.00 are without receipts/substantiation) 5,589.00
Family Expenses (with receipts/substantiation) 6,230.00
Interest Income from Bank Deposits 2,116.00
Rental Collections (P2,500.00 is an advance rental from the customer) 60,000.00

Compute for the following:

a. Taxable Income & Tax Due for 2019 using Itemized deduction
b. Taxable Income & Tax Due for 2019 using OSD
c. Taxable Income & Tax Due for 2019 using 8% Flat Tax Rate

Answer # 1
a. Taxable Income & Tax Due for 2019 using Itemized deduction Remarks:
Gross Sales from Business P 697,234.00
Rental Income & Collections 60,000.00 (b)
Less: Cost of Sales 266,887.00
Gross Income 490,347.00
Less: Salaries Expense 52,889.00
Utilities Expense (Light & Water) 54,304.00
Depreciation Expense 12,385.00
Rent Expense 24,000.00
Supplies Expense 8,358.00
Other Operating Expenses 3,500.00 (c)
 Taxable Income P 334,911.00
Tax Due P 16,982.00

b. Taxable Income & Tax Due for 2019 using OSD

Gross Sales from Business P 697,234.00
Rental Income & Collections 60,000.00
Gross Sales & Other Income 757,234.00
Less: OSD (757,234.00 X 40%) 302,893.60 (d)
Taxable Income P 454,340.40
Tax Due P 43,585.00

Remarks:
a. Interest from Bank Deposits are already subjected to Final Tax and therefore, should not be included in the
computation of Gross Income.
b. Rent income includes advance rental received and those actually earned but not yet collected.
c. Some operating expenses without receipts and family expenses cannot be deducted as part of deductible expenses.
d. In computing OSD, 40% is multiplied to the total of gross sales and rent income since they are both operation-
related income.

c. Taxable Income & Tax Due for 2019 using 8% Flat Tax Rate
Gross Sales from Business P 697,234.00
Rental Income & Collections 60,000.00
Taxable Income 757,234.00
Tax Due (757,234.00 – 250,000.00) X .08 P 40,579.00

Illustrative Problem No.2

Mr. Danryl Cadenas a lawyer and owns a law firm, married and has two dependents. The following are the data of his law
firm during the taxable year of 2019
Annual Salary (net of mandatory benefits) P 523,576.00
Gross Receipts/ Professional Fees (net of 5% withholding tax) 808,830.00
Cost of Service 224,250.00
Wages Expense 12,235.00
Utilities Expense (Light & Water) 44,137.00
Rent Expense 40,000.00
Supplies Expense 15,300.00
Royalty Income from Copyrights 13,777.00
Cash Dividends 11,058.00
Other Operating Expenses (without receipts/substantiation) 3,222.00
Winnings on Commercial Contest 9,000.00
Withholding tax on compensation 60,894.00
Overpayment of Taxes last year 4,351.00
Income taxes paid during the year 36,675.00

Compute for the following:

a. Taxable Income & Tax Due for 2019 using Itemized deduction
b. Taxable Income & Tax Due for 2019 using OSD
c. Taxable Income & Tax Due for 2019 (for Compensation Income – PIT Schedule and for Business & other sources of
income – 8% Flat Tax Rate)
Answer # 2
a. Taxable Income & Tax Due for 2019 using Itemized deduction Remarks:
Gross Receipts/Professional Fees 851,400.00 (808,830.00 / .95) (a)
Less: Cost of Service 224,250.00
Add: Annual Salary (net of mandatory benefits) 523,576.00
Royalty Income from Copyrights 13,777.00
Winnings on Commercial Contest 9,000.00 (c)
Gross Income 1,173,503.00
Less: Salaries Expense 32,235.00
Utilities Expense (Light & Water) 44,137.00
Rent Expense 40,000.00
Supplies Expense 15,300.00
Taxable Income P 1,041,831.00
Tax Due P 202,549.00
Remarks:
a. All items must be grossed-up (i.e. add back the tax deducted) first in computing the Gross Income, these taxes will
be deducted later in computing the net tax payable.
b. Cash Dividends are already subjected to Final Tax and therefore, should not be included in the computation of
Gross Income.
c. Prizes & Winnings not more than P10,000.00 must be included in computing of Gross Income.
d. Operating Expenses without receipts cannot be deducted as part of deductible expenses.

b. Taxable Income & Tax Due for 2019 using OSD

Gross Receipts/Professional Fees P 851,400.00
Add: Annual Salary (net of mandatory benefits) 523,576.00
Royalty Income from Copyrights 13,777.00
Winnings on Commercial Contest 9,000.00
Gross Receipts & Other Income 1,397,753.00
Less: OSD (851,400.00 X 40%) 340,560.00
Taxable Income P 1,057,193.00
Tax Due P 207,158.00

c. Taxable Income & Tax Due for 2019 using 8% Flat Tax Rate
Annual Salary (net of mandatory benefits) P 523,576.00
Taxable Compensation Income P 523,576.00
Tax Due on Compensation P 60,894.00

Gross Receipts/Professional Fees P 851,400.00

Add: Royalty Income from Copyrights 13,777.00
Winnings on Commercial Contest 9,000.00
Taxable Business & Other sources of Income P 874,177.00
Tax Due on Business & Other sources of Income P 69,934.00 (874,177.00 X .08)
Total Tax Due P 130,828.00 (60,894.00 + 69,934.00)
Net Tax Payable
In order to arrive at the net tax payable, subtract any applicable “tax credits/payments” from the taxpayer’s tax due.
Unlike deductions that reduce taxable income, tax credits/payments are a direct offset (or deduction) to the tax due
itself. These tax credits are the following:
1. Prior years’ excess credits (e.g. overpayment of taxes last year)
2. Income Tax Payments within the year (pertaining to Income tax paid during the first three quarters)
3. Withholding Taxes
a. Withholding Tax on compensation (BIR Form 2316)
b. Expanded Withholding Tax
c. Final Withholding Tax
d. Withholding Tax on Government money payments
4. Foreign Tax Credits
5. Special Tax Credits

Illustrative Problem No.2 (Continuation of B)

Compute the net tax payable of Mr. Orley Monton for the taxable year of 2019 using itemized deductions:
Tax Due (using itemized deductions) P202,549.00
Less: Withholding tax on gross receipts P 42,570.00 (851,400.00 X .05)
Withholding tax on compensation 60,894.00
Overpayment of Taxes last year 4,351.00
Income taxes paid during the year 36,675.00 144,490.00
Net Tax Payable P 58,059.00

Total Amount Payable

The total amount payable is the liability of the individual or entity to the BIR for the relevant taxable period. In order to
arrive at the total amount payable, increase the net tax payable by penalties and interests.
1. A surcharge of twenty five percent (25%) for each of the following violations:
a. Failure to file any return and pay the amount of tax or installment due on or before the due dates;
b. Filing a return with a person or office other than those with whom it is required to be filed;
c. Failure to pay the full or part of the amount of tax shown on the return, or the full amount of tax due for which no
return is required to be filed, on or before the due date;
d. Failure to pay the deficiency tax within the time prescribed for its payment in the notice of Assessment (Delinquency
Surcharge).
2. A surcharge of fifty percent (50%) of the tax or of the deficiency tax, in case any payment has been made on the
basis of such return before the discovery of the falsity or fraud, for each of the following violations:
a. Willful neglect to file the return within the period prescribed by the Code or by rules and regulations; or
b. In case a false or fraudulent return is willfully made.
3. Interest for late payment of twenty percent (20%) per annum from the date the payment is due up to the date of
full payment based on the basic tax.

Illustrative Problem No.3

An income tax return for the calendar year 2018 was due for filing on April 15, 2019, but the taxpayer voluntarily filed
his tax return, without notice from the BIR, only on June 30, 2019, The tax due per return amounts to P100,000.00.
There are no applicable tax credits.
 In this case, the taxpayer shall be liable for delinquency penalties consisting of 25% surcharge, plus 20% interest per
annum computed from the due date of the tax until the date of payment which is computed as follows:
 Income Tax due (per BIR return) P100,000.00
Add: 25% Surcharge (100,000 x 25%) P25,000.00
20% Interest per Annum ((100,000 X 20%) X 75/360) 4.167.00 29,167.00
Total Amount Payable P129,167.00

__________________________________________________ ___END OF NOTES______________________________________________________________

Exercise No. 1
Instruction: Compute what is required in the problem and show your solutions.
Leticia, a resident citizen, married and has one dependent is in the practice of her profession, presented below is her
financial data for the year 2019:
Gross Receipts/ Professional Fees (net of 5% withholding tax) P 661,275.00
Salary (net of mandatory benefits) 325,590.00
Cost of Service 197,890.00
Salaries Expense 44,444.00
Utilities Expense (Light & Water) 41,111.00
Depreciation Expense 11,000.00
Rent Expense 40,000.00
Supplies Expense 8,358.00
Other Operating Expenses (P3,313.00 are without receipts/substantiation) 7,266.00
Family Expenses (with receipts/substantiation) 6,230.00
Income taxes paid during the year 15,990.00
Withholding tax on compensation 15,118.00

Compute for the following:

a. Taxable Income & Due for 2019 using Itemized deduction
b. Taxable Income & Due for 2019 using OSD
c. Taxable Income & Due for 2019 using 8% Flat Tax Rate (for Compensation Income use PIT Schedule and for Business
& other sources of income – 8% Flat Tax Rate)
d. Net Tax Payable for 2019 using Itemized deduction

Exercise No. 2
Instruction: Compute what is required in the problem and show your solutions.
Pacita is a Filipina, married and has two dependents, an employee of the University of the Philippines and has a
merchandising business. The following is her data for the year 2019:
Gross Sales from Business P 690,000.00
Cost of Sales 291,000.00
Salaries Expense 52,777.00
Utilities Expense (Light & Water) 48,999.00
Depreciation Expense 24,500.00
Rent Expense 42,000.00
Income taxes paid during the year 3,785.00
Royalty Income from Copyrights (non-business related) 50,800.00
Cash Dividends 5,800.00
Winnings on Commercial Contest 10,000.00
Overpayment of Taxes last year 3,482.00
Pacita, failed to file her income tax return during April 15, 2019. She filed it on July 31, 2019.
Compute for the following:
a. Taxable Income & Due for 2019 using Itemized deduction
b. Taxable Income & Due for 2019 using OSD
c. Taxable Income & Due for 2019 using 8% Flat Tax Rate
d. Net Tax Payable for 2019 using OSD
e. Total Amount Payable using OSD

Exercise No. 3
Instruction: Compute what is required in the problem and show your solutions.
Jetro Bucton, a resident citizen, married and has three dependents is in the practice of profession, presented below is
his financial data for the year 2019:
Compensation income (net of P34,771.00 withholding tax) P 389,094.00
Net Receipts from the practice of profession (net of 5% withholding tax) 605,000.00
Cost of Service 112,500.00
Advertising Expense 3,500.00
Salaries Expense 35,789.00
Utilities Expense 42,641.00
Rent Expense 30,000.00
Depreciation Expense 8,000.00
Permits and Licenses Expense 4,000.00
Other Expense (with no receipts or substantiation) 2,149.00
Winnings from Commercial contest 9,500.00
Interest from bank deposits 2,049.00
Income taxes paid during the year 8,279.00
Compute for the following:
a. Taxable Income & Due for 2019 using Itemized deduction
b. Taxable Income & Due for 2019 using OSD
c. Taxable Income & Due for 2019 using 8% Flat Tax Rate (for Compensation Income use PIT Schedule and for Business
& other sources of income – 8% Flat Tax Rate)
d. Net Tax Payable for 2019 using 8% Flat Tax Rate
e. Total amount payable using 8% Flat Tax Rate (assume that Mr. Bucton failed to file his income tax return on April 15,
2019, but he voluntarily filed his tax return, without notice from the BIR, only on May 31, 2019)