Chapter 3 - Introduction to Income Tax

CHAPTER 3
INTRODUCTION TO INCOME TAXATION
Chapter Overview and Objectives
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This chapter discusses the concept of tax income, the situs of income, and the
types of taxpayers.
After this chapter, readers are expected to comprehend and demonstrate
knowledge on the following:
1. The concept of gross income
2. The types of income taxpayers
3. The general rules in income taxation
4. The income tax situs rules

THE CONCEPT OF INCOME

Why is income subject to tax?

Income is regarded as the best measure of taxpayers’ ability to pay tax. It is an
excellent object of taxation in the allocation of government costs.

What is income for taxation purposes?

The tax concept of income is simply referred to as “gross income” under the NIRC.
A taxable item of income is referred to as an “item of gross income” or “inclusion in
gross income”.

Gross income simply means taxable income in layman’s term. Under the NIRC
however, the term “taxable income” refers to certain items of gross income less
deductions and personal exemptions allowable by law. Technically, gross income
is broader to pertain to any income that can be subjected to income tax.
Gross income is broadly defined as any inflow of wealth to the taxpayer from
whatever source, legal or illegal, that increases net worth. It includes income from
employment, trade, business or exercise of profession, income from properties,
and other sources such as dealings in properties and other regular or casual
transactions.

ELEMENTS OF GROSS INCOME

1. It is areturn on capital that increases net worth.
2. Itis arealized benefit.
3. It is not exempted by law, contract, or treaty.

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RETURN ON CAPITAL
Capital means any wealth or property. Gross income is a return on Wealt
property that increases the taxpayer's net worth.
IIJustration
ABC purchased goods for P300 and sold them for P500. The P500 consideration ,
ant
analyzed as follows:
Selling price (total consideration received) P 500 Total return
Cost (value of inventory forgone) 300 Return of capital
Mark-up (gross income) P___200 Return on capital

The return on capital that increases net worth,is income subject to income f
Return of capital merely maintains net worth; hence, it is not taxable
improvement in net worth indicates an ability to pay tax. -

Capital items deemed with infinite value

There are capital items that have infinite value and are incapable of pecup)
valuation. Anything received as compensation for their loss is deemed a returp
capital.
Examples:
1. Life
2. Health
3. Human reputation

Life %
The value of life is immeasurable by money. Under Sec. 32 of the NIRC,
proceeds of life insurance policies paid to the heirs or beneficiaries upon deat!
the insured, whether in a single sum or otherwise, are.exempt from income ta.
The proceeds ofa life insurance contract collected by an employer as a benefic
from the life insurance of an officer or any person directly interested with
trade are likewise exempt. These proceeds are viewed as advanced recover
future loss.

However, the following are taxable return on capital from insurance policies:
a. Any excess amount received over premiums paid by the insured
surrender or maturity of the policy (i.e. the insured outlives the policy.)
b. Gain realized by the insured from the assignment or sale of his insult
policy
c. Interest income from the unpaid balance of the proceeds of the policy
d. Any excess of the proceeds received over the acquisition costs and pre"
payments by an assignee of a life insurance policy

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Health
Any compensation received in consideration for the loss of health such as
compensation for personal injuries or tortuous acts is deemed a return of capital.

Human Reputation
The value of one’s reputation cannot be measured financially. Any indemnity
received as compensation for its impairment is deemed a return of capital exempt
from income tax,

Examples include moral damages received from:

a. Oral defamation or slander
b. Alienation of affection
c. Breach of promise to marry

Recovery of lost capital vs. Recovery of lost profits

The loss of capital results in decrease in net worth while the loss of profits does
not decrease net worth. The recovery of lost capital merely maintains net worth
while the recovery of lost profits increases net worth. Therefore, the recovery of
lost profits is a return on capital.

Taxable recovery of lost profits

The recovery of lost profits through insurance, indemnity contracts, or legal suits
constitutes a taxable return on capital.

The following are taxable recoveries of lost profits:

a. Proceeds of crop or livestock insurance
b. Guarantee payments
c. Indemnity received from patent infringement suit

Illustration 1
Mang Reyes insured his strawberry crop in a P200,000 crop insurance coverage
against calamities. The crop was eventually destroyed by an unusual frost. Mang Reyes
was paid the P200,000 insurance proceeds.
The P200,000 proceeds which is a reimbursement for. the. lost value of the future harvest,
is an item of gross income. The value of the lost crops is, in effect, realized not through
actual harvest but through the insurance contract.

Illustration 2
Mr. Ramos purchased a franchise. The franchisor guaranteed an annual franchise
income of P100,000 to Mr. Ramos. In the first year of operation, Mr. Ramos’outlet only
earned P60,000. The franchisor paid the P40,000 difference to Mr. Ramos.

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Chapter 3 - Introduction to Income Tax

The P40,000 guarantee payment is not a gratuity but a recovery of lost Prof
Ramos; hence, subject to income tax. Mr. Ramos shall report P100,000 as f
income.
Hlustration 3
Davao Crocodile Inc. experienced an unusual decline in its income after a Cor,
copied its patented invention. Davao Crocodile sued the competitor fo
infringement and was awarded an indemnity of P3,000,000.

The P3,000,000 indemnity is a compensation for the income not realized by

Crocodile due to the patent infringement. The same is an item of gross income,

The recovery of lost income or profits is not intended to compensate for the
capital. It is as good as realization of income; hence, it is an item of gross income

REALIZED BENEFIT
What is meant by realized benefit?
The “benefit” concept
The term “benefit” means any form of advantage derived by the taxpayer,
benefit when there is an increase in the net worth of the taxpayer. An ing
net worth occurs when one receives income, donation or inheritance.

The following are not benefits, hence, not taxable:

a. Receipt of a loan - properties increase but obligations also increase r;
in an offsetting effect in net worth. .
b. Discovery of lost properties - under the law, the finder has an oblig:
return the same to the owner.
c. Receipt of money or property to be held in trust for, or to be reni
another person.
If the taxpayer is entitled to keep for his account portion of a receipt, ai
portion is a benefit.
Illustration
1. An employee was granted P20,000 transportation advance. He liquidated
transportation expenses and was allowed by his employer to keep the
Only the P2,000 retained by the employee is considered income since this)
extent he was benefited. (RR2-98)

2. A security agency receives P120,000 from clients, P100,000 of which

salaries of security guards. Under RMC 39-2007, only the P20,000 attribi
the agency is considered income of the agency since it is the extent it isb
The P100,000 pertaining to salaries of security guards is recognized by th
as a liability upon receipt.

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 Chapter3 - Introduction to Income Tax

The “realized” concept

The term realized means earned. It requires that there is a degree of undertaking
or sacrifice from the taxpayer to be entitled of the benefit.
Requisites of a realized benefit:
1. There must be an exchange transaction.
2. The transaction involves another entity.
3. It increases the net worth of the recipient.

Types of Transfers
1. Bilateral transfers or exchanges, such as:
a. Sale
b. Barter
These are referred to as “onerous transactions”.

2. Unilateral transfers, such as:

a. Succession - transfer of property upon death
b. Donation —
These are also referred to as “gratuitous transactions”.

Under current usage, unilateral transfers are simply referred to as “transfers”

while bilateral transfers are called “exchanges.” Benefits derived from onerous
transactions are “earned or realized”; hence, they are subject to income tax.
Benefits derived from gratuitous transactions are not realized because of the
absence of an earning process. Benefits derived from gratuitous transactions are
subject to transfer tax, not income tax.

3. Complex transactions
Complex transactions are partly gratuitous and partly onerous. These are
commonly referred to as “transfers for less than full and adequate consideration’.
The gratuitous portion of the transaction is subject to transfer tax while the
benefit from the onerous portion is subject to income tax.
Illustration
A taxpayer sold his car which was previously purchased for P100,000 and with a
current fair value of P180,000 for only P130,000.

The transaction will be analyzed as follows:

Fair value P 180,000
} P50,000 - Subject to transfer tax
Selling price 130,000

Cost 100,000 P30,000 - Subject to income tax

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The excess of fair value over selling price is a gratuity or gift whereas the EXCos,
selling price over the cost is an item of gross income. "

What is meant by another entity?

Every person, natural or juridical, is an entity. Natural persons are living be
while juridical persons are those created by law such as partnershj
corporations. An entity may be a taxable entity or an exempt entity. 4 t
item of gross income arises from transactions which involve another Naty
juridical entity.

Gains or income derived between relatives, corporations, and between a b

and the partnership are taxable since it is made between separate ¢,
Likewise, the income between affiliated companies such as between a ho},
parent company and its subsidiaries and between sister companies are t,
because each corporation is a separate entity. This applies regardless,
underlying economic relationship.

However, the sales of a home office to its branch office are not taxable },
they pertain to one and the same taxable entity. Furthermore, the income
businesses of a proprietor should not be taxed since proprietorship busines
taxable upon the same owner. Note that a proprietorship business jg
juridical entity. .

Benefits in the absence of transfers

The increase in wealth of the taxpayer in the form of appreciation or inc:
the value of his properties or decrease in the value of his obligations
absence of a sale or barter transaction is not taxable.
These are referred to as unrealized gains or holding gains because they b:
yet materialized in an exchange transaction.
Examples of unrealized gains or holding gains:
a. Increase in value of investments in equity or debt securities
b. Increase in value of real properties held (revaluation increment)
c. Increase in value of foreign currencies held or receivable
d. Decrease in value of foreign currency denominated debt by virtue off:
fluctuation in exchange rates
e. Birth of animal offspring, accruals of fruits in an orchard or growth
vegetables
f. Increase in value of land due to the discovery of mineral reserves
Rendering of services
The rendering of services for a consideration is an exchange but does no!
loss of capital. Hence, the entire consideration received from rendering 0!
such as compensation income or service fees is an item of gross income.

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Illustration
Mr. Mendoza lists the following possible items of gross income:
Compensation income P 200,000
Winnings from gambling 100,000
Increase in value of investments 50,000
Appreciation in the value of land owned 300,000
Debt of Saladin cancelled by creditors in
consideration for services he rendered to them 150,000
Debt of Saladin cancelled by his creditor out of affection 250,000
Loan received from a bank 400,000

The items of gross income are:

Compensation income P 200,000
Winnings from gambling 100,000
Debt of Mendoza forgiven in consideration
for service rendered to his creditors 150,000
. Note: .
1. Gains from gambling and the forgiveness of debt in consideration of services or properties
received are realized gains from exchanges.
2. The forgiveness of debt out of affection or mere generosity of the creditor is a gratuitous |
1

transfer subject to transfer tax,

3. The loan received from a bank constitutes a transfer but is not a benefit.

Basis of Exemption of Unrealized Income

Normally, taxpayers will have the ability to pay tax when their income
materializes in an exchange transaction since tax is generally payable in money.

This does not mean, however, that only income realized in cash is subject to tax. |
Income realized in non-cash properties are, in effect, received in cash but the
taxpayer used the same to acquire the non-cash property. Income received in non-
cash considerations is taxable at the fair value of the property received. Moreover,
exempting income realized in non-cash considerations would open a wide avenue
for tax evasion since taxpayers can easily divert their income in the form of non-
cash consideration:

Mode of Receipt/Realization Benefits

Taxable items of income may be realized by the taxpayer in two ways:
1. Actual receipt
Actual receipt involves actual physical taking of the income in the form of cash
or property.
2. Constructive receipt
Constructive receipt involves no actual physical taking of the income but the
taxpayer is effectively benefited.
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Examples:
a. Offset of debt of the taxpayer in consideration for the sale of goods %
service
b. Deposit of the income to the taxpayer's checking account
c. Matured detachable interest coupons on coupon bonds not yet encasb,,
by the taxpayer
d._ Increase in the capital ofa partner from the profit of the partnership

Inflow of wealth without increase in net worth

The inflow of wealth to a person that does not increase his net worth is ny
income due to the total absence of benefit.
Examples:
a. Receipt of property in trust
b. Borrowing of money under an obligation to return
In law, the proceeds of embezzlement or swindling where money is taken withoy
an original intention to return are considered as income because of the increase;
net worth of the swindler.

NOT EXEMPTED BY LAW, CONTRACT, OR TREATY

An item of gross income is not exempted by the Constitution, law, contracts ¢:
treaties from taxation.

The following items of income are exempted by law from taxation; hence, they ar
not considered items of gross income:
Income of qualified employee trust fund
Revenues of non-profit, non-stock educational institutions
SSS, GSIS, Pag-IBIG, or PhilHealth benefits
Salaries and wages of minimum wage earners and qualified senior citizen
Regular income of Barangay Micro-business Enterprises (BMBEs)
Income of foreign governments and foreign government-owned 2:
controlled corporations
7. Income of international missions and organizations with income tax immutl
Items of gross income that are exempted from taxation are discussed extensivé
under Exclusions in Gross Income in Chapter 8.

TYPES OF INCOME TAXPAYERS

A. Individuals
1. Citizen
a. Resident citizen
b. Non-resident citizen

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2. Alien
a. Resident alien
b. Non-resident alien
a. engaged in trade or business
b. not engaged in trade or business
3. Taxable estates and trusts

B. Corporations
1. Domestic corporation
2. Foreign corporation
a. Resident foreign corporation
b. Non-resident foreign corporation

INDIVIDUAL INCOME TAXPAYERS _

Citizens ering
Under the Constitution, citizens are:
a. Those who are citizens of the Philippines at the time of adoption of the
Constitution on February 2, 1987 a
._ Those whose fathers or mothers are citizens of the Philippines
c. Those born before January 17, 1973 of Filipino mothers who elected Filipino
citizenship upon reaching the age of majority
d. Those who are naturalized in accordance with the law

Classification of citizens:
A. Resident citizen - A Filipino citizen residing in the Philippines
B. Non-resident citizen includes:
1. A citizen of the Philippines who establishes to the satisfaction of the
Commissioner the fact of his physical presence abroad with a definite
intention to reside therein;
2. A citizen of the Philippines who leaves the Philippines during the taxable
year to reside abroad, either as an immigrant or for an employment on a
permanent basis; _ ;
3. A citizen of the Philippines who works and derives income from abroad
and whose employment thereat requires him to be physically present
abroad most of the time during the taxable year;
4. A citizen who has been previously considered as non-resident citizen and
who arrives in the Philippines at anytime during the taxable year to reside
permanently in the Philippines shall likewise be treated as a non-resident
citizen for the taxable year in which he arrives in the Philippines with
respect to his income derived from sources abroad until the date of his
arrival in the Philippines
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Filipinos working in Philippine embassies or Philippine consulate offices are yy,

considered non-resident citizens. .

Alien
A. Resident alien - an individual who is residing in the Philippines but is not;
citizen thereof, such as:
1. An alien who lives in the Philippines without definite intention as to his
stay; or
2. One who comes to the Philippines for a definite purpose which in j,
‘nature would require an extended stay and to that end makes his hom;
temporarily in the Philippines, although it may be his intention at all time
to return to his domicile abroad;

An alien who has acquired residence in the Philippines retains his status z
such until he abandons the same or actually departs from the Philippines.
B. Non-resident alien - an individual who is not residing in the Philippines ani
who is not a citizen thereof uae me
1. Non-resident aliens engaged in business (NRA-ETB)- aliens who stayet!
in the Philippines for an aggregate period of more than 180 days during
the year
2. Non-resident aliens not engaged in business (NRA-NETB) - include:
a. Aliens who come to the Philippines for a definite purpose which init!
nature may be promptly accomplished;
b. Aliens who shall come to the Philippines and stay therein for 2"
aggregate period of not more than 180 days during the year

THE GENERAL CLASSIFICATION RULE FOR INDIVIDUALS

1. Intention
The intention of the taxpayer regarding the nature of his stay within ©
outside the Philippines shall determine his appropriate residen
classification. The taxpayer shall submit to the CIR of the BIR documenta!
proofs such as visas, work contracts and other. documents indicating st!
intention.

Documents purporting short term stay such as tourist visa shall not result!
the reclassification of the taxpayer’s normal residency. Documents purport"
a long-term stay. such as immigration visa or working visa for an extend
period would result in the automatic reclassification of the taxpay®"
residency,

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Examples:
a. An alien is normally non-resident. An alien who come to the Philippines with a
tourist visa would still be classified as non-resident alien.
b. A citizen is normally resident. A citizen who would go abroad under a tourist
visa would still be considered a resident citizen.
c. An alien who come to the Philippines with an immigration visa would be
reclassified as a resident alien upon his arrival.
d. A citizen who would go abroad with a two-year working visa would be
reclassified as a non-resident citizen upon his departure.

2. Length of stay
In default of such documentary proof, the length of stay of the taxpayer is
considered:
a. Citizens staying abroad for a period of at least 183 days are considered
non-resident.
b. Aliens who stayed in the Philippines for more than 1 year as of the end of
the taxable year are considered resident.
c. Aliens who are staying in the Philippines for not more than 1 year but
more than 180 days are deemed non-resident aliens engaged in business.
d. Aliens who stayed in the Philippines for not more than 180 days are
considered non-resident aliens not engaged in trade or business.
Illustration 1
Daniel Mario Aresmendi, a Mexican actor, was contracted by a Philippine television
company to do a project in the Philippines. He arrived in the country on February 29,
2021 and returned to Mexico three weeks later upon completion of the project.
Daniel Mario Aresmendi shall be classified as an NRA-NETB in 2021. His stay is for a
definite purpose which in its nature will be accomplished immediately.

Illustration 2
Mamoud Jibril, a Libyan national, arrived in the country on November 4, 2021 Mr.
Jibril stayed in the Philippines since then without any working visa or work permit.
For the year 2021, Mr. Jibril would be considered an NRA-NETB because he stayed in the
Philippines for less than 180 days as of December 31, 2021. If he is still within the
Philippines until December 31, 2022, he will qualify as a resident alien for 2022.

Illustration 3
Without any definite intention as to the nature of his stay, Juan Miguel, a Filipino
citizen, left the Philippines and stayed abroad from March 15, 2020 to April 1,
2021before returning to the Philippines.
For the year 2020, Juan is a non-resident citizen because he is absent for more than 183
days but he will be classified as resident citizen for the year 2021 because he is absent for
less than 183 days in 2021.
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Taxable Estates and Trusts

1. Estate
Estate refers to the properties, rights, and obligations of a deceased Perso,
not extinguished by his death.
Estates under judicial settlement are treated as individual taxpayers, Thy
estate is taxable on the income of the properties left by the decedent. Estate
under extrajudicial settlement are exempt entities. The income of the
properties of the estate under extrajudicial settlement is taxable to the heirs
2. Trust
A trust is an arrangement whereby one person (grantor or trustor) transfer
(ie. donates) property to another person (beneficiary), which will be hel
under the management of a third party (trustee or fiduciary).

A trust that is irrevocably designated by the grantor is treated in taxation as i

it is an individual taxpayer. The income of the property held in trust is taxabl:
to the trust. Trusts that are designated as revocable by the grantor are no
taxable entities and are not considered as individual taxpayers. The income of
properties held under revocable trusts is taxable to the grantor not to the)
trust.

When the trust agreement is silent as to revocability of Me trust, the trustis

presumed to be revocable.

CORPORATE INCOME TAXPAYERS

The term ‘corporation’ shall include one person. corporations . (OPCS)
partnerships, no matter how created or organized, joint-stock companies, joitt
accounts, association, or insurance companies, except general professiond
partnerships and a joint venture or consortium formed for the purpose o
undertaking construction projects or engaging in petroleum, coal, geothermal, and
other energy operations pursuant to an operating consortium agreement under?
service contract with the government.
Hence, the term corporation includes profit-oriented and non-profit institution
such as charitable institutions, cooperatives, government agencies ant
instrumentalities, associations, leagues, civic or religious and other organizations.

Domestic Corporation
A domestic corporation is a corporation that is organized in accordance with
Philippine laws. It includes one-person corporations (OPC) owned and registereé
by resident citizens in the Philippines.

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Foreign Corporation
A foreign corporation is one organized under a foreign law.

Types of foreign corporations:

1. Resident foreign corporation (RFC) - a foreign corporation which operates and
conducts business in the Philippines through a permanent establishment (i.e.
a branch).
2. Non-resident foreign corporation (NRFC) - a foreign corporation which does
not operate or conduct business in the Philippines
Note:
1. A corporation that incorporates in the Philippines is a domestic corporation under the
Incorporation Test even if the same is controlled by foreigners.
2. A foreign corporation that transacts business with residents through a resident branch is
taxable on such transactions as a resident foreign corporation through its branch. However,
if it transacts directly to residents outside its branch, it is taxable as a non-resident foreign
corporation on the direct transactions.
3. An individual that establishes a one-person corporation (OPC) shall be taxable as a
corporate taxpayer for. the business transactions of the OPC but he shall be subject to tax as
an individual for his personal transactions.

Special Corporations —
Special corporations are domestic or foreign corporations which are subject to
special tax rules or preferential tax rates.

OTHER CORPORATE TAXPAYERS

1. One-person corporation —
A one-person corporation is a corporation with a single stockholder who may
be a natural person, trust or an estate.

Banks and quasi-banks, preneed, trust, insurance, public and publicly-listed

companies, and non-chartered GOCCs may not incorporate as One-person
corporations. A natural person who is licensed to exercise a profession may
not organize as a One Person Corporation for the purpose of exercising such
profession except as otherwise provided under special laws.

2. Partnership
A partnership is a business organization owned by two or more persons who
contribute their industry or resources to a common fund for the purpose of
dividing the profits from the venture.

Types of partnership
a) General professional partnership (GPP)

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A GPP is a partnership formed by persons for the sole PUrPose ,

exercising a common profession, no part of the income of which is deriv,
from engaging in any trade or business.
A GPP is not treated as a corporation and is not a taxable entity, It jy
exempt from income tax, but the partners are taxable in their individy,
capacity with respect to their share in the income of the partnership.
b) Business partnership
A business partnership is one formed for. profit. It is taxable as ;
corporation.
Examples:
a. A partnership between Atty. Mendoza, a lawyer, and Mark Santos, a,
accountant, to practice in taxation advisory services would be a busines,
partnership since the two partners are not in the same profession.
b. A partnership between accountants Khim and Vhinson to venture into 2
beauty parlor would be a business partnership since the venture is not jy
practice of acommon profession.
c. A partnership between accountants Juan and Miguel to venture into audi
services would be a general professional partnership.
d. Dentists Wency and Andy partnered to operate a dental clinic. During slack,
season, they are converting their clinic into a beauty saloon. Their partnership:
is a business partnership since it is earning income from business.

3. Joint venture
A joint venture is a business undertaking for a particular purpose. It may be
organized as a partnership or a corporation.

Types of joint ventures:

a. Exempt joint ventures
Exempt joint ventures are those formed for the purpose of undertaking,
construction projects or engaging in petroleum, coal, geothermal ant}
other energy operations pursuant to an operating consortium agreement:
under a service contract with the Government.

Similar to a GPP, this type of joint venture is not treated as a corporation

and is tax-exempt on its regular income, but their venturers are taxable to!
their share in the net income of the joint venture.

b. Taxable joint ventures

All other joint ventures are taxable as corporations.

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4. Co-ownership
A co-ownership is joint ownership of a property formed for the purpose of
preserving the same and/or dividing its income.

A co-ownership that is limited to property preservation or income collection

is not a taxable entity and is exempt but the co-owners are taxable on their
share on the income of the co-owned property.

However, a co-ownership that reinvests the income of the co-owned property

to other income-producing properties or ventures will be considered an
unregistered partnership taxable as a corporation.

THE GENERAL RULES IN INCOME TAXATION

Taxable on income earned
Individual taxpayers Within Without
Resident citizen v ood
Non-resident citizen v
Resident alien v
Non-resident alien v

Corporate taxpayers
Domestic corporation
NINN

Resident foreign corporation

Non-resident foreign corporation
Note:
1. Consistent with the territoriality rule, all taxpayers, except resident citizens and domestic
corporations, are taxable only on income earned within the Philippines.
2. The NIRC uses the term“without the Philippines” to mean outside the Philippines.

The Residency and Citizenship Rule

Taxpayers who are residents and citizens of the Philippines such as resident
citizen and domestic corporations are taxable on all income from sources within
and without the Philippines. A corporation isa citizen of the country of
incorporation. Thus, a domestic corporation isa citizen of the Philippines.

Basis of the extraterritorial taxation

Resident citizens and domestic corporations derive most of the benefits from the
Philippine government compared to all other classes of taxpayers by virtue of
their proximity to the Philippine government.

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Under our laws, resident citizens and domestic corporations enjoy prefereng;
privileges over aliens. Also, between resident and non-resident citizens, reside,
citizens have full access of the public services of our government because they ate
in the country. The taxation of foreign income of resident citizens and domesti,
corporations properly reflects this difference in benefits consistent with the
Benefit Received Theory.

The extra-territorial tax treatment of resident citizens and domestic corporation,

is also intended as a safety net to the potential loss of tax revenues brought by
situs relocation or the practice of executing or structuring transactions such that
income will be realized abroad to avoid Philippine income taxes.

The issue of international double taxation

The rule on extraterritorial taxation on resident citizens and domesti,
corporations exposes these taxpayers to double taxation. However, the NIR¢
allows a tax credit for taxes paid in foreign countries. In fact, resident citizens and}
domestic corporations pay minimal taxes in the Philippines on their foreign|
income because of the tax credit. woeis

SITUS OF INCOME
The situs of income is the place of taxation of income. It is the jurisdiction that has,
the authority to impose tax upon the income.

Situs of income vs. source of income

Situs of income should be differentiated from the source of income. The latter)
pertains to the activity or property that produces the income.

Situs is important in determining whether or not an income is taxable in the

Philippines. Situs is particularly important to taxpayers taxable only on income
within. However, it is also important to taxpayers taxable on global income for,
purposes of the computation of the foreign tax credit.

INCOME SITUS RULES

Types of income Place of taxation (situs)

1. Interestincome Debtor's residence
2. Royalties Where the intangible is employed
3. Rentincome Location of the property
4, Service income Place where the service is rendered

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Illustration
A taxpayer had the following income:

Interest income from deposits in a foreign bank P 300,000

Interest from domestic bonds 50,000
Royalties from books published in the Philippines 100,000
Rent income from properties abroad (the lease
contracts were executed in the Philippines) 150,000
Professional fees for services rendered in the
Philippines to non-resident clients (paid in US Dollars) 400,000

Applying the situs rules, the following are the situs of the aforementioned income:

Within Without World total

Interest on foreign deposits P - P 300,000 P 300,000
Interest from domestic bonds fh 50,000 50,000
Royalties from books in the Philippines 100,000. 100,000
Rent income on foreign properties 150,000 . 150,000
Professional fees . 400,000 400,000
Total . P550,000 P._450,000 P1,000,000

Resident citizen or domestic corporation taxpayers would be taxable on the world

income while other taxpayers would be taxable only on the income from within
the Philippines.

OTHER INCOME SITUS RULES

A. Gain on sale of properties
1. Personal property
Y Domestic securities- presumed earned within the Philippines
Y Other personal properties - earned in the place where the property is
sold
2. Real property - earned where the property is located

Illustration
A taxpayer had the following income:

Gain on sale of domestic stocks P 200,000

Gain on sale of foreign bonds 100,000
Gain on sale ofa commercial lot in Baguio City 500,000
Gain on sale of car in Ontario, Canada 200,000
Gain on sale of machineries in Mexico, Pampanga 250,000
Interest income on foreign bonds 50,000
Dividends on domestic stocks 150,000
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The following table summarizes the situs of the foregoing income:

Within Without
Gain on sale of domestic stocks P 200,000
Gain on sale of foreign bonds P 100,000
Gain on sale of commercial lot 500,000
Gain on sale of car in Canada 200,000
Gain on the sale of machineries 250,000
Interest on foreign bonds 50,000
Dividends on domestic stocks 150,000
Total P_1,100,000 P__350,000

B. Dividend income from:

1. Domestic corporation - presumed earned within
2. Foreign corporation
a) Resident foreign corporation - depends on the pre-dominance test
The pre-dominance test
If the ratio of the Philippine gross income over the world gross income of
the resident foreign corporation in the three-year period preceding the
year of dividend declaration is:
Y At least 50%, the portion of the dividend corresponding to the
Philippine gross income ratio is earned within
Y Less than 50%, the entire dividends received is earned abroad
b) Non-resident foreign corporation - earned abroad

Illustration
In 2021, Sarah received a P400,000 dividend income from ABC Corporation. ABC
Corporation had the following gross income in 2018 through 2020:
2018 2019 2020 Total
Philippines P 100,000 P 200,000 P 300,000 P 600,000
Abroad 200,000 __ 100,000 100,000 400,000
Total p__300,000 P300,000 Pp400,000 P 1,000,000
If ABC Corporation is a:
1. Domestic corporation - the entire P400,000 is earned within
2. Non-resident foreign corporation - the entire P400,000 is earned abroad
3. Resident foreign corporation - the P400,000 dividend shall be split
Gross Income Ratio = P600,000/P1,000,000 = 60%
Earned within the Philippines (60% x P400,000) =P 240,000
Earned without the Philippines (40% x P400,000) 160,000
Total dividends P___400,000

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Supposing that the ratio is 49%, the entire P400,000 will be deemed earned
outside the Philippines.

c. Merchandising income - earned where the property is sold

IIlustration

Source of gross income Amount

Goods purchased and sold within P= 200,000
Goods purchased within and sold abroad 100,000
Goods purchased abroad and sold within 150,000
Goods purchased and sold abroad 350,000

The income earned within and without shall be:

Within Without
Purchased and sold within P 200,000
Purchased within and sold abroad P 100,000
Purchased abroad and sold within 150,000
Purchased abroad and sold abroad 350,000
Total -P__ 350,000 P_ 450,000

D. Manufacturing income- earned where the goods are manufactured and sold
Operations qQy Remark -
Production | Distribution
Within Within © Total income from production and distribution
is earned within the Philippines
Without Without Total income from production and distribution
is earned without the Philippines
Within Without Production income. is earned © within,
Distribution income is earned without
Without Within Distribution income is earned within,
Production income is earned without

Illustration 1
Island, Inc. manufactures goods and sells them through its branch. Island bills its
branch at established market prices. Island reported the following gross income:

Home office Branch Total

Sales P 4,000,000 P 2,000,000 P 6,000,000
Cost of goods sold 2,400,000 1,200,000 3,600,000
Gross income P_1,600,000 P 800,000 P_2,400,000

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The following shows the situs of the gross income of Island under each of t
following scenario:
Scenario _Home office Branch Within Without
No.1 Philippines =~ Philippines P 2,400,000 P 0
No. 2 Abroad Abroad 0 2,400,000
No.3 Philippines Abroad 1,600,000 800,000
No. 4 Abroad Philippines 800,000 1,600,000
Note:
1. Both production and distribution are conducted by the same taxable entity, Island, Inc.
2. The branch is not a separate taxable entity, but an integral part of Island, Inc.; hence, it
income is taxable to Island Inc.

Illustration 2
Assuming production is conducted by a parent corporation and the distribution ;,
conducted by its subsidiary corporation:
Parent Subsidiary _ Total
Sales P 4,000,000 P 2,000,000. P 6,000,000
Cost of goods sold 2,400,000 1,200,000 3,600,000
Gross income P.1,600,000
P 800,000 P 2,400,000
The gross income recognized by each corporation is taxable to each corporatig,
because each corporation is a separate taxpayer. The situs of taxation shall be the
place of sale without regard to the seller or the supplier.

The following are the situs of income for the parent corporation:
Scenario Parent Subsidiary Within Without
No. 1 Philippines — Philippines P 1,600,000 P oe
No. 2 Abroad Abroad - 1,600,000
No.3 Philippines Abroad 1,600,000
No. 4 Abroad Philippines - 1,600,000

The following are the situs of income for the subsidiary corporation:

Scenario Parent Subsidiary Within Without

No. 1 Philippines Philippines. P 800,000 P -
No. 2 Abroad Abroad : 800,000
No.3 Philippines Abroad - 800,000
No, 4 Abroad Philippines 800,000

Note to readers:
Readers are advised to master the situs rules as this have a significant effect
On your comprehension of advanced tax rules to be introduced in succeeding
chapters,

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