Regular Income Tax

Inclusion in Gross Income

Module 4 – Part 3
Prepared by Mrs. Nelia I. Tomas, CPA, LPT

INCOME TAXATION Laws. Principles and Applications 2019 OBE Edition by Rex B. Banggawan
Learning Objectives

After completing the lesson, the students will be able to

1. Master the NIRC list of items of gross income subject to regular tax and their
measurement rules
2. Knowledgeable of the boundary between income subject to final tax or capital gains tax
and those subject to regular income tax
3. Understand the link between items of exempt income and income subject to regular
income tax
4. Comprehend the effect of accounting methods and situs rules on the reportable amount
of gross income
5. Knowledgeable of the treatment of creditable withholding tax
6. Understand the treatment of income from pass-through entities
7. Master the rules on recoveries of past deductions
8. Appreciate the essence and purposes of transfer pricing regulation
ITEMS OF GROSS INCOME

The term items of gross income or inclusions in gross income is a broad category pertaining
to all items of income subject to taxation, namely:
1. Gross income subject to final tax
2. Gross income subject to capital gains tax
3. Gross income subject to regular tax
Gross income subject to regular tax

Gross income includes, but is not limited to, the following items:
1. Compensation for services in whatever form paid
2. Gross income from the conduct of trade, business, or exercise of a profession
3. Gains derived from dealings in properties
4. Interest
5. Rents
6. Royalties
7. Dividends
8. Annuities
9. Prizes and winnings
10. Pensions
11. Partners distributive share from the net income of general professional partnership
 Gross income subject to regular tax

Compensation for services in whatever form paid

Compensation income pertains to the types of employee benefits that are subject to regular tax.
The fringe benefits of managerial or supervisory employees are not considered compensation
income and are subject to final tax.

Gross income from the conduct of trade, business, or exercise of a profession

Income from any trade or business, legal or illegal, and whether registered or unregistered.

Gross income from business or profession is determined as follows:

Sales/Revenues/Receipts/Fess P xxx,xxx
Less: Cost of sales or services xxx,xxx
Gross income from operations xxx,xxx
 Gross income subject to regular tax

The following business income shall not be included in gross income subject to income tax:
1. Business income exempt from income tax such as:
a. Gross income from a Barangay Micro-Business Enterprise (BMBE) under RA 9178
b. Gross income from enterprises enjoying tax holiday incentives
2. Business income subject to special tax regime such as:
a. Philippine Economic Zone Authority (PEZA)-registered enterprises subject to 5% gross
income tax
b. Tourism Infrastructure and Enterprise Zone Authority (TIEZA)-registered enterprises
subject to 5% gross income tax
c. Income of self-employed and or individuals (SE/P) who opted to be taxed under the 8%
income tax
3. Business income subject to final tax when not subjected to final tax by the payor
a. Subcontractors of petroleum service contractors subject to 8% final tax
b. Business income of foreign currency deposit units (FCDUs) and offshore banking units
(OBUs) from Philippine residents subject to 10% final tax
Gross income subject to regular tax

Gains derived from dealings in properties

The gains or losses in dealing in ordinary assets are subject to regular income tax. Dealings in capital
assets other than domestic stocks and real properties are also subject to regular income tax.

Interest Income
Interest income other than passive interest income subject to final tax. A taxable interest income must
have been actually an agreement to pay interest. It cannot be imputed. (CIR vs. Filinvest Corporation, GR 163653
and 167689)

Examples of interest income subject to regular income tax:

1. Interest income from lending activities to individuals and corporations by banks finance companies
and other lenders
2. Interest income from bonds and promissory notes
3. Interest income from bank deposits abroad

Interest income exempt from regular income taxation:

1. Interest income earned by landowners in disposing their lands to their tenants pursuant to the
Comprehensive Agrarian Reform Law
2. Imputed interest income (the opportunity cost of money)
Gross income subject to regular tax

Rents
Income arises from leasing properties of any kind. It is a passive income but is not subject to final tax
under the NIRC; hence, it is subject to regular income tax.

Special considerations on rent

1. Obligations of the lessor that are assumed by the lessee are additional rental income to the lessor.
2. Advance rentals are
a. Item of gross income upon receipt if:
i. Unrestricted or
ii. Restricted to be applied in future years or upon the termination of the lease
b. Not an item of gross income if:
i. It constitutes a loan
ii. It is a security deposit to guarantee payment or rent subject to contingency which may or may not
happen.
3. Leasehold improvements made by the lessee on the leased property are recognized by the lessor as
income using the spread-out method or outright method
Gross income subject to regular tax

Royalties
Royalties earned from sources within the Philippines are generally subject to final tax except when they are
active by nature. Active royalty income and royalties earned from sources outside the Philippines are
subject to regular income tax.

Dividends
These pertain to dividends declared by foreign corporations. Dividends declared by domestic corporations
are generally subject to 10% final tax if the recipient is an individual taxpayer and exempt if the recipient is
a domestic or a resident foreign corporation. Cash, property, and scrip dividends from foreign corporations
are items of gross income subject to regular income tax.
Stock dividend
Exempt from income tax, but when the declaration confers to the recipient a different interest or right after
the stock dividend declaration or when stocks dividends are subsequently redeemed such that it amounts
to payment of cash dividend, the fair market value of the stock dividends received is taxable.
Liquidating dividends
Not an income and are considered an amount in exchange for the investment of the investor and are
subject to the rules of dealings in properties.
Gross income subject to regular tax

Annuities
The excess of annuity payments received by the recipient over premium paid is taxable
income in the year of receipt.

Prizes and winnings

Prizes and winnings that are exempted from final tax are not items of gross income subject
to regular income tax.
Exempt prizes and winnings:
1. Prizes received without effort to join a contest
2. Prizes in athletic competitions sanctioned by their respective national sports association
3. Winnings from PCSO or lotto, not exceeding P10,000 in amount
Gross income subject to regular tax

Pensions
These pertain to pensions and retirement benefits that fail to meet the exclusion criteria and
hence subject to regular tax.

Partners distributive share from the net income of general professional partnership
General professional partnerships are not subject to income tax because they are merely
viewed as pass-through entities. The partners are the ones subject to regular tax on their
share in the net income of the general professional partnership.
For this purpose, the net income of the general professional partnership shall include items
of income which are exempted from final tax or capital gains tax to the general professional
partnership.
This rule also applies to other pass-through entities such as:
1. Exempt joint ventures
2. Exempt co-ownership
Illustration 1

A and B practice their profession in a general professional partnership and share profits 60:40. Their firm
reported the following:
Gross receipts P 2,000,000
Less: Professional expenses 1,200,000
Net income from operations P 800,000
Interest from bank deposits 20,000
Distributive net income P 820,000

The share of the partners in the net income of the partnership shall he computed as:
Total distribution to A (60% x P820,000) P 492,000
Total distribution to B (40% x P820,000) 328,000
Distributive net income P 820,000
Gross income subject to regular tax

Business partnership and taxable joint venture or co-ownership

 These entities are subject to corporate income tax.
 The distributive share of a partner, venturer, or co-owner from the net income of these
entities, if organized within the Philippines, is subject to 10% final withholding tax.
 If these entities are organized or constituted abroad, the share from their profit is subject
to regular income tax for taxpayers taxable on global income.
 GENERAL CRITERIA FOR ITEMS OF GROSS INCOME

Items of gross income subject to regular income tax are not limited to the aforementioned NIRC
list. Under the NIRC, the regular income tax has a catch-all provision for all income derived
from whatever sources that are:
1. Not subject to final tax, capital gains tax, and special tax regime, and
2. Not excluded or exempted by law, treaty, or contract from taxation.

OTHER SOURCES OF GROSS INCOME SUBJECT TO REGULAR INCOME TAX

1. Income distributions from taxable estates or trusts
2. Share from the net income of other pass-through entities:
 Exempt joint venture
 Exempt co-ownership
3. Farming income
4. Recovery of past deductions
5. Reimbursement of expenses
6. Cancellation of indebtedness for a consideration
 GENERAL CRITERIA FOR ITEMS OF GROSS INCOME

Income Distribution from taxable estates or trusts income

Any income distribution received by an heir or beneficiary from a taxable estate or trust shall be
included in his gross income subject to regular tax, provided that such income must not have
been subjected to final tax or capital gains tax.

Share from the net income of exempt joint ventures and co-ownerships
The same tax treatment on recognition of share in the net income of a general professional
partnership applies to the share from the net income of exempt joint ventures and co-
ownerships.
 GENERAL CRITERIA FOR ITEMS OF GROSS INCOME

Farming income
Farming operations can be classified as:
1. Raise and sell operation
The proceeds on the sales of livestock or farm products is included in gross income subject
to regular income tax. Animal raising expenses are presented as items of deductions
against gross income.
2. Purchase and sell operation
The gross profit from the sale is included in gross income.
 GENERAL CRITERIA FOR ITEMS OF GROSS INCOME

Recovery of past deductions

When past year deductions from gross income are subsequently recovered by the taxpayer or when accrued
expense previously deducted are subsequently paid at an amount less than the deduction claimed, they
should be analyzed whether or not they resulted in tax benefit to the taxpayer.
Examples of recoveries of past deductions:
1. Recovery of previously claimed bad debt expense
2. Refund of local tax expense
3. Refund of foreign tax previously claimed as deduction
4. Recommissioning of abandoned petroleum service contracts or mining tenements
5. Release of reserve funds of insurance companies
6. Interest expense which were subsequently condoned by the lender
Past deductions that created tax benefit to the taxpayer must be reverted back to gross income in the year of
recovery so that the government will recover the tax lost from the deduction.
Tax benefit of a taxpayer from a deduction:
1. Directly, through reduction of taxable income in the year deduction is made
2. Indirectly, through reduction of future taxable income through carry-over of net operating loss
Illustration 2

Mr. A, a taxpayer, incurred a P90,000 bad debt expense in 2018 out of which P60,000 was recovered in
2020.
2018 2019 2020
Net income before bad debt expense P 70,000 P100,000 P120,000
(Bad debt expense) / Recoveries ( 90,000) -_ 60,000
Net income after bad debt expense (P20,000) P 100,000 P180,000
Less: NOLCO application ( 20,000)
Net Income P 80,000
 GENERAL CRITERIA FOR ITEMS OF GROSS INCOME

Refund of non-deductible expenses

Expenses or payments which are non-deductible against gross income in the computation of taxable net
income will never create tax benefit to the taxpayer. As such, their recovery should not be included in gross
income.

Hence, the refund of the following non-deductible items is not taxable:

1. Philippine income tax
2. Estate or donor's tax
3. Income tax paid or incurred to a foreign country if the taxpayer claimed a credit for such tax in the year it
was paid or incurred.
4. Stock transaction tax in disposing stocks through the Philippine Stock Exchange
5. Special assessment
 GENERAL CRITERIA FOR ITEMS OF GROSS INCOME

Reimbursement of expenses
Expenses of the taxpayer that are reimbursed or paid by the customer or client constitute additional income to
the taxpayer.

Examples:
1. When the lessee pays the ownership costs of the lessor such as real property tax and insurance on the
property, the payment constitutes income to the lessor.
2. When a client reimburses the out-of-pocket expenses of a professional practitioner, the reimbursements
are income to the practitioner.

Cancellation of indebtedness for a consideration

The cancellation of indebtedness may amount to gratuity or payment of income.

The cancellation of debt:

a. In consideration of service or goods - treated as income
b. As an act of gratuity - treated as gift; not as income
c. As capital transaction such as forfeiting the right to receive dividends in exchange of the debt - treated as
dividend income
 SPECIAL CONSIDERATIONS IN REPORTING OF GROSS INCOME

1. Accounting Methods
2. Situs rules
3. Effect of value added tax
4. Creditable withholding tax
5. Power of the CIR to redistribute income and expenses

Accounting Methods
 Cash-basis taxpayers will report their gross receipts or collection as gross income while
accrual basis taxpayers will report their revenue consisting of collected and uncollected
income as gross income.
 Regardless of the accounting methods of the taxpayer, advanced income must be included
in gross income in the period received.
 SPECIAL CONSIDERATIONS IN REPORTING OF GROSS INCOME

Situs rules
 All taxpayers are taxable only on Philippine income except resident citizens and domestic corporations
which are taxable on global income.
 For taxpayers taxable only on Philippine income, only their items of gross income subject to regular tax
from sources within the Philippines are included in gross income.
 For taxpayers taxable on global income, their items of gross income subject to regular tax from sources
within and without the Philippines are included in gross income.

Effects of value added tax

Business taxpayers are required to either register as:
1. VAT taxpayers — if their sales or receipts exceeds P3,000,000 in the last consecutive 12-month period.
The amount of reportable gross income shall not include the output VAT.
2. Non-VAT taxpayers — if their sales or gross receipts is below the VAT threshold or are specifically
designated by the law to pay percentage taxes. The entire amount for the sales of goods or services is
gross income subject to income tax.
 SPECIAL CONSIDERATIONS IN REPORTING OF GROSS INCOME

Creditable withholding tax

Creditable withholding taxes (CWT) deducted by income payors against the gross income of the taxpayer are
not exclusions in gross income. These should be added back to the reportable amount of gross income.
CWTs are tax credits that are deductible against the annual income tax due of the taxpayer.
Illustration 3

Denzo Inc, a non-VAT domestic corporation, reported the following:

Rent income, net of P25,000 CWT P 475,000
Professional fees, net of P40,000 CWT 360,000
Business expenses 500,000

Required: Determine the total reportable gross income and the income tax due and still due under the
regular income tax.
 SPECIAL CONSIDERATIONS IN REPORTING OF GROSS INCOME

Power of the CIR to redistribute income and expenses

In the case of two or more organizations, trades or businesses (whether or not incorporated and
whether or not organized in the Philippines) owned or controlled directly or indirectly by the
same interests, the Commissioner is authorized to distribute, apportion or allocate gross income
or deductions between or among such organization, trade or business, if he determined that
such distribution, apportionment or allocation is necessary in order to prevent evasion of taxes
or clearly to reflect the income of any such organization, trade or business.

The Problem of Unfair Pricing between Associated Enterprises

Examples:
1. A domestic corporation which is subject to 30% corporate tax in the Philippines has a
subsidiary that operates in a tax haven country where no income tax is imposed. The
domestic corporation transfers goods to its foreign subsidiary at a transfer pricing based on
production cost so that no gross income will be recognized in the Philippines while the entire
gross income will be recognized abroad where no tax is imposed.
 SPECIAL CONSIDERATIONS IN REPORTING OF GROSS INCOME

2. A foreign corporation subject to 10% corporate tax in its home country has a branch in the Philippines
which is subject to the 30% corporate income tax herein. The foreign corporation transfers goods at a
pricing method that will allow very minimal profit for the Philippine branch to minimize exposure to higher
income tax.
3. Mr. Wais has a business enjoying a tax holiday under an investment promotion law. Mr. Wais also has a
business that is subject to regular income tax. Mr. Wais orders his taxable business to sell goods and
supplies at cost to his exempt business thereby shifting the profits to the exempt business to save from
income tax.

What are associated enterprises?

Under RR2-2013, two or more enterprises are associated if one participates directly or indirectly in the
management, control, or capital of the other; or if the same persons participate directly or indirectly in the
management, control, or capital of the enterprises. Associated enterprises are also called "related parties."
Examples of associated enterprises:
1. Parent corporation and its subsidiary corporation
2. Sister companies or businesses owned by the same parent corporation
3. All corporations controlled under the same holding company
4. Businesses owned by the same person
 SPECIAL CONSIDERATIONS IN REPORTING OF GROSS INCOME

The transfer pricing guideline

The arm’s length principle
Under RR2-2013, transfer pricing between associated enterprises shall be made under comparable conditions
and circumstances as those entered into between independent parties where market forces drive the terms
and conditions of the transaction rather than being controlled solely by reason of special relationship between
the associated enterprises.
In other words, an uncontrolled pricing method determined by free market forces, also called arm's length
pricing, is preferred.
The failure to comply may expose the taxpayer to a transfer pricing adjustment where the BIR re-computes
the proper income of the associated enterprises.
The arm's length principle shall be applied to:
1. Cross-border transactions between associated enterprises
2. Domestic transactions between associated enterprises
When operations are conducted cross-border, the taxpayer may enter into an “advanced pricing agreement”
with the BIR where a pricing rate is pre-agreed to apply for a period of time.
 SPECIAL CONSIDERATIONS IN REPORTING OF GROSS INCOME
Transfer pricing methods
When the pricing methods between associated enterprises do not reflect arm's length pricing, the BIR will
adjust the controlled transactions to their arm's length values using the most appropriate of the following
method considering the circumstance of the taxpayer:
1. Comparable uncontrolled price (CUP) method - The transaction is valued in reference to the amount
charged in a comparable uncontrolled transaction under comparable circumstances.
2. Resale price method (RPM) - The transaction is valued based on the functions performed by the reselling
party to the product. This is used when products purchased from a related party are resold to an
independent party.
3. Cost plus method (CPM) - The transaction is measured by valuing the function performed by the supplier
of the property or services.
4. Profit split method (PSM) - The profit or loss on the transaction is split based on the division of profits (or
losses) that independent enterprises would have expected to realize from engaging in the transaction or
transactions.
5. Transactional net margin method (TNMM) - This is similar to the cost plus and the resale price methods in
the sense that it uses the margin approach by reference to the operating profit earned in comparable
uncontrolled transactions.
 SPECIAL CONSIDERATIONS IN REPORTING OF GROSS INCOME
Transfer pricing methods
When no comparatives can be derived within the industry of the subject taxpayer, the BIR may consider:
a. Extension of the transfer pricing methods using comparatives derived from another industry segment
b. Use a combination of the transfer pricing methods or other methods

Selection of Transfer Pricing Method

To minimize the risks of transfer pricing adjustments, taxpayers may also consider using the transfer pricing
methods used by the BIR in pricing their transactions with associated enterprises. The taxpayer must support
the propriety of the method adopted through proper documentation.

PERIOD IN WHICH ITEMS OF GROSS INCOME ARE INCLUDED

The amount of all items of gross income shall be included in the gross income for the taxable year in which
received by the taxpayer, unless, under methods of accounting permitted, any such amounts are to be
properly accounted for as of a different period.
Questions to Ponder:
1. Enumerate the NIRC list of items of gross income.
2. What are the broad categories of gross income?
3. Discuss in detail the taxation of interest income. Which is subject to final tax? Which
is subject to regular income tax?
4. Discuss the treatment of gains from dealings in properties. Which gains are subject
to capital gains tax? Which gains are subject to regular income tax?
5. Discuss the taxation of dividends.
6. Discuss the taxation of royalties.
7. Discuss the taxation of prizes and winnings.
8. Compare actual distribution and the share in the net income of the partnership.
Which one is included in the grass income of the partner?
9. Discuss the taxability of recoveries of past deductions.
10. Enumerate examples of pass-through entities. Are they taxable to final tax, capital
gains tax, or regular income tax?
11. Enumerate and discuss the transfer pricing methods.
 Required Readings
1. Chapters 9, pp.276 – 299:

Banggawan, Rex B. 2019. INCOME TAXATION LAWS, PRINCIPLES, AND

APPLICATIONS. Real Excellence Publishing., Pasay Default Barangay, Pasay
City, Philippines.

2. https://www.bir.gov.ph/index.php/tax-information/income-tax.html
 Learning Activities
Chapters 9, pp.300 – 316:

Banggawan, Rex B. 2019. INCOME TAXATION LAWS, PRINCIPLES, AND

APPLICATIONS. Real Excellence Publishing., Pasay Default Barangay, Pasay
City, Philippines.
 Appendix: Course Materials Evaluation
Adopted: BEST PRACTICES AND SAMPLE QUESTIONS FOR COURSE EVALUATION SURVEYS. Retrieved from
https://assessment.provost.wisc.edu/best-practices-and-sample-questions-for-courseevaluation-surveys//.