Course Code and Title : BACR 5 – INCOME TAXATION (BSBA)

Lesson Number : 3

Topics : Income Tax Concepts

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LEARNING OBJECTIVES

At the end of this lesson, the student should be able to:

1. Explain the concepts for gross income;

2. Identify and differentiate the different classifications of income taxpayers;

3. Differentiate the treatment of recovery of loss capital and loss profits;

4. Explain the general rules in income taxation;

5. Explain the concepts of realized benefit and identify the modes where income is
realized; and

6. Identify the situs of income taxes.

PRE-ASSESSMENT:

Try to answer the following questions.

1. When is a foreigner considered a resident of the Philippines?
2. Are compensations from vehicular accidents taxable?
3. Name a type of permanent difference as discussed in your BAFACR4X class?
4. Do you think a dead person is still liable to pay income tax?
5. When can you say you are a Filipino citizen?

LESSON PRESENTATION:
CONCEPT OF INCOME

One popular definition of income is the amount of wealth accumulated plus savings and the
value of the personal consumption.

The term 'income' refers to all earnings derived from service rendered (labor), from capital
(business or investment), or both including gain derived from sale or exchange of personal or
real property classified as either ordinary or capital asset.

There is no single criterion for determining income for tax purposes, but it may be helpful to
remember that the "rule-of-thumb test” to determine income is the increase in net worth.
W hy 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.

W hat 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 a return on capital that increases net worth.
2. It is a realized benefit.
3. It is not exempted by law, contract, or treaty.
Increase in Net Worth
The following must be considered if a transaction would result to an increase in net worth.

R eturn on Capital vs. Return of Capital

Capital means any wealth or property. Gross income is a return on wealth or property that
increases the taxpayer's net worth. The return on capital that increases net worth is income
subject to income tax. Return of capital merely maintains net worth; hence, it is not taxable. An
improvement in net worth indicates an ability to pay tax.

Illustration 3.1.
Miss Dina B. Nalican invested P10,000 in the stocks of a mining company. On December 29,
2020, she received P2,500 dividends from the company. Twenty percent of the dividend
received was considered liquidating dividends.

Only P500 of the receipt is taxable as this is the return on capital. Since the P2,000 received was
liquidating dividend, this clearly suggest a return of capital.

C apital items deemed with infinite value

There are capital items that have infinite value and are incapable of pecuniary valuation.
Anything received as compensation for their loss is deemed a return of capital.

Life
The value of life is immeasurable by money. Under Sec. 32 of the NIRC, the proceeds of
life insurance policies paid to the heirs or beneficiaries upon death of the insured, whether
in a single sum or otherwise, are exempt from income tax.

The proceeds of a life insurance contract collected by an employer as a beneficiary from the
life insurance of an officer or any person directly interested with his trade are likewise exempt.
These proceeds are viewed as advanced recovery of future loss.

However, the following are taxable return on capital from insurance policies:

a. Any excess amount received over premiums paid by the insured upon 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 insurance 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 premium
payments by an assignee of a life insurance policy
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.

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

Illustration 3.2.
Mang Tomas insured his strawberry crop in a P200,000 crop insurance coverage against
calamities. The crop was eventually destroyed by an unusual frost. Mang Tomas 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.

Realized Benefit
The following must be met for the income to have a realized benefit.

R ealized
The term realized means earned. It requires that there be a degree of undertaking or sacrifice
from the taxpayer to be entitled of the benefit. For a benefit to be realized, there must be an
exchange transaction and the transaction involves another entity.

Exchange Transaction
Bilateral transfers such as sale and barter are onerous transactions and gains from these
transactions are more likely taxable as income. For unilateral transfers such as donations and
succession, these gratuitous transfers do not involve an earning process. Complex transactions
like transfers for less than full and adequate consideration are taxable under income tax and
transfer tax.
 Illustration 3.3.
A seller sold a piece of jewelry for P140,000 when its fair market value was P200,000. The cost
of the jewelry was P90,000.

The difference of the sale price and cost of P50,000 is subject to income tax while the excess of the fair
market value and the sale price of P60,000 is deemed a donation subject to donor’s tax.

Involvement of Another Entity

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

Gains or income derived between relatives, corporations, and between a partner and the
partnership are taxable since it is made between separate entities. Likewise, the income between
affiliated companies such as between a holding or parent company and its subsidiaries and
between sister companies are taxable because each corporation is a separate entity. This applies
regardless of the underlying economic relationship.

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

B enefit
The term "benefit" means any form of advantage derived by the taxpayer. There is benefit when
there is an increase in the net worth of the taxpayer. An increase in net worth occurs when one
receives income, donation or inheritance.

The following are not benefit, hence, not taxable:

a. Receipt of a loan - properties increase but obligations also increase resulting in

an offsetting effect in net worth
b. Discovery of lost properties - under the law, the finder has an obligation to return
the same to the owner
c. Receipt of money or property to be held in trust for, or to be remitted to, another person
If the taxpayer is entitled to keep for his account portion of a receipt, only that portion
is a benefit.
 Illustration 3.4.
An employee was granted P20,000 transportation advance. He liquidated P18,000
transportation expenses and was allowed by his employer to keep the P2,000.

Only the P2,000 retained by the employee is considered income since this was the extent he was
benefited.

Tax Treatment of Increase in the Value of Property

The increase in wealth of the taxpayer in the form of appreciation or increase in the value of his
properties or decrease in the value of his obligations in the absence of a sale or barter
transaction is not taxable. A mere increase in the value of property is not income, but merely
and unrealized increase in capital.

These are referred to as unrealized gains or holding gains because they have not 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 of favorable
fluctuation in exchange rates
e. Birth of animal offspring, accruals of fruits in an orchard or growth of farm 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 not cause a loss of capital.
Hence, the entire consideration received from rendering of services such as compensation
income or service fees is an item of gross income.

Illustration 3.5.
Mr. Nash E. Mulan wants you to evaluate whether he is liable to tax on the following:
Income from employment P 250,000
Prizes from jueteng 5,000
Fair Value increase of trading investments 25,000
Cancelled debt for services he rendered 50,000
Cancelled debt out of affection 10,000
Receipt of cash, in trust for his nephew 40,000

There is no realization of benefits for the fair value increase of the trading investments. The
cancelled
debt out of affection constitutes gratuity and is not subject to income tax. The cash receipt which
was in trust does not increase his net worth.
Not Exempted by Law, Contract, or Treaty
An item of gross income is not exempted by the Constitution, law, contracts or treaties from
taxation.

The following items of income are exempted by law from taxation; hence, they are not
considered items of gross income:

1. Income of qualified employee trust fund

2. Revenues of non-profit non-stock educational institutions
3. SSS, GSIS, Pag-Ibig, or PhilHealth benefits
4. Salaries and wages of minimum wage earners and qualified senior citizen
5. Regular income of Barangay Micro-business Enterprises (BMBEs)
6. Income of foreign governments and foreign government-owned and
controlled corporations
7. Income of international missions and organizations with income tax immunity

CLASSIFICATIONS OF TAXPAYERS
One of the determinants in the imposition and assessment of taxes is the classification of the
taxpayer, thus, one should consider the nationality and residence of individual taxpayers in
computing for their taxes.

General Classification Rule

In classifying individual taxpayers based on residency, one ought to consider the intention of an
individual’s stay within the Philippines or abroad. The taxpayer shall submit documentary
proofs such as visas, work contracts and other documents indicating such intention.

Individual Taxpayers
R esident Citizen (RC)
A Filipino citizen residing in the Philippines

Definition of a Citizen under the Constitution

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
b. Those whose father or mother 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
N on-Resident Citizen (NRC)
The following are considered as non-resident citizens:

a. A citizen of the Philippines who establishes to the satisfaction of the BIR

Commissioner the fact of his physical presence abroad with a definite intention to
reside therein
b. A citizen of the Philippines who leaves the country during the taxable year to
reside abroad, either as an immigrant or for an employment on a permanent basis
c. 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;
d. A citizen who has been previously considered as non-resident citizen and who arrives
in the Philippines at any time during the taxable year to reside permanently in the
Philippines shall likewise be treated as 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
e. In the absence of information on taxpayer’s intent, citizens staying abroad for a
period of a t least 183 days are considered non-resident citizens.

Filipinos working in Philippine embassies or Philippine Consulate Offices are not

considered non-resident citizens.

R esident Alien (RA)

A resident alien is someone who is residing in the Philippines but is not a citizen.

a. An alien who lives in the Philippines without definite intention as to his stay
b. One who comes to the Philippines for a definite purpose which in its nature would
require an extended stay and to that end makes his home temporarily in the
Philippines, although it may be his intention at all times to return to his domicile abroad
c. In the absence of information on intention, aliens who stayed in the Philippines for more
t han 1 year as of the end of the taxable year are considered resident aliens.

An alien who has acquired residence in the Philippines retains his status as such until he
abandons the same or actually departs from the Philippines.

N on-Resident Alien Engaged in Trade or Business (NRA-ETB)

An individual who is not residing on the Philippines and is not a resident thereof, intends to
conduct trade, business or exercise of his profession.
 In the absence of information as to taxpayer’s intent, aliens who stayed in the Philippines for
an aggregate period of more than 180 days during the year are presumed to be engaged in
trade or business.

N on-Resident Alien not Engaged in Trade or Business (NRA-NETB)

An individual who is not residing on the Philippines and is not a resident thereof, not intending
to conduct trade, business or exercise of his profession. Aliens who come to the Philippines for a
definite purpose which in its nature may be promptly accomplished shall not be considered to
be engaged in trade or business.

O ther Individual Taxpayers

The tax treatments for these taxpayers will be discussed in Module 7.

Estate
This refers to the properties, rights and obligations of a deceased person not extinguished by
death. Estates under judicial settlement are treated as individual taxpayers. Estates under
extrajudicial settlement are exempt entities. The income of properties of the estate under
extrajudicial settlement is taxable to the heirs.

Trust
A trust is an arrangement whereby one person called the grantor or trustor transfers property
to another person called the beneficiary, which will be held under the management of a third
party called the trustee or fiduciary.

Corporate Taxpayers
D omestic Corporation (DC)
A corporation formed and authorized to conduct trade and business under the Philippine law.

R esident Foreign Corporation (RFC)

A corporation organized, authorized, or existing under the laws of any foreign country but is
authorized to engage in trade or business in the Philippines through a permanent
establishment.

N on-Resident Foreign Corporation (NRFC)

A corporation organized, authorized, or existing under the laws of any foreign country and is
not authorized to engage in trade or business in the Philippines.

O ther Corporate Taxpayers

The tax treatments for these taxpayers will be discussed in Module 7.
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.

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

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

Taxability
The income earned by a taxpayer may be taxed depending on the situs or place where it was
earned. Following is a table summarizing taxability of a taxpayer’s income based on its situs.

Income Income
Classification earned earned Rate of Tax
Within Without
RC ✓ ✓
NRC ✓ X
Generally, progressive tax on the net income
RA ✓ X
NRA-ETB ✓ X
NRA-NETB ✓ X Generally, 25% final tax on the gross income
DC ✓ ✓
Generally, 30% ad valorem tax on net income
RFC ✓ X
NRFC ✓ X Generally, 30% final tax on the gross income
Depends on the
Estates and Trusts Generally, progressive tax on the net income
decedent or trustor
Illustration 3.6.
Mrs. Dina A. Moon, a tax practitioner, derives the following income during the taxable year (all in
Philippine pesos).

Nature Within Without

Income from Employment 180,000 -
Consultancy Fees 270,000 140,000
Rental Income 40,000 70,000
Interest Income 50,000 10,000
Determine the amount subject to income tax if she is:
Resident Citizen
She will be taxable on her worldwide income totaling P760,000.
Resident Alien
She will only be taxable on her income within totaling P540,000.

SITUS OF INCOME
The situs of income is the place of taxation. It is the jurisdiction that has the authority to
impose tax upon the income. It is to be noted that it is different from source of income
as the latter pertains to the activity or property that produces the same. The following
are the specific income situs rules:

Interest Income Debtor’s Residence

Royalties Where the intangible is employed
Rent Income Location of the property
Service Income Place where the service is performed
Basic Rules
Merchandising
Earned where the property is sold
Income
Manufacturing Earned where the goods are manufactured and sold
Income ~ separated if the places of such are not the same
Illustration 3.7.
Jack E. Shang obtained the following income during the taxable year.
 Collected interest income of P15,000 from a resident Indonesian when they were
in vacation in Macau
 Earned P60,000 from rentals of commercial spaces in Tokyo, Japan
 Earned P280,000 compensation expense from a domestic employer
 Received P25,000 royalties from musical compositions copyrighted in the Philippines
 Earned P145,000 from professional services rendered in the Philippines to
non- resident clients
 Earned a gain of P80,000 on merchandise purchased abroad but sold locally
 Transferred goods manufactured at a cost of P80,000 to a foreign branch for
P100,000 and was subsequently sold by the branch at P150,000

The interest income is earned within as the debtor resides in the Philippines. The rentals are earned
abroad as the property is located outside the country. The compensation expense is earned within as the
service is performed and the employer is located domestically. The royalties are earned within as this
was registered in the country. Though the recipient of the professional services are non-residents, the
services are rendered within making the income earned within. The gain on merchandising is earned
within as the place of sale is the Philippines. The excess of P20,000 on the transfer of goods to the
foreign branch is a manufacturing income earned within, whereas, the gain of P50,000 is a gain earned
abroad.

Domestic Securities Presumed earned within the Philippines

Gains on sale Other Personal
Earned in the place where the property is sold
of property Properties
Real Properties Earned where the property is located

Illustration 3.8.
Paul E. Goss obtained the following income:
 Gain on sale of foreign stocks sold in Makati– P200,000
 Gain on sale of domestic bonds sold in Phuket– P50,000
 Gain on sale of agricultural lot in Ilocos – P180,000
 Gain on sale of jewelries in Calamba – P75,000

All are earned within except for the gain on sale of stocks.
 From Domestic
Presumed earned within the Philippines
Corporation
Predominance Test:
Compare the Philippine Gross Income with the
World Gross Income in the preceding three-year
p eriod
Dividend From Resident
~ If at least 50%, the portion of the dividend
Income Foreign Corporation
corresponding to the Philippine gross income is
earned within
~ Less than 50%, the entire dividends received is
earned abroad
From Non-Resident
Presumed earned abroad
Foreign Corporation

Illustration 3.9.
Rosa Noble received P120,000 dividends from Tulips Corporation which had the following
gross income in the following years.

Situs 2016 2017 2018 2019

Philippines 100,000 100,000 200,000 300,000
Abroad 1 50,000 2 00,000 1 00,000 1 00,000
Total 250,000 300,000 300,000 400,000

Determine where the dividend is earned under the following independent scenarios:
a. Tulips is a domestic corporation
The total amount of P120,000 dividend received is earned within.
b. Tulips is a non-resident foreign corporation
The total amount of P120,000 dividend received is earned abroad.
c. Tulips is a resident foreign corporation and the dividend is received in 2020
The gross income ratio for 2017-2019 is 60%. Prorated to the dividend received, only P72,000
is earned within and the P48,000 is earned abroad.
d. Tulips is a resident foreign corporation and the dividend is received in 2019
The gross income ratio is 47%, therefore, the whole P120,000 is earned without.
 GENERALIZATION:
This module discusses the concept of gross income, the types of income taxpayers, the
general rules in income taxation and the income tax situs rules.

APPLICATION:
Problem 3.1 HENSON CASE
Henson sued an unscrupulous person for derogatory remarks which he considered
to have besmirched his reputation. The court awarded Henson an indemnity of
P1,000,000 inclusive of P200,000 reimbursement for Attorney's fees and P100,000
exemplary damages.

Compute Henson's total return on capital.

Problem 3.2 DENVER CASE

Denver is a supervisory employee of Atlantis Corporation. He had the following items of
gross income during the year:
• Denver was paid P800,000 salaries.
• Denver's P100,000 personal loan was paid by Atlantis Corporation as reward for
his excellent performance.
• Denver's P50,000 advances to the company was paid by Atlantis' chief
executive officer as a gift.
• Denver is entitled to excess representation and travel allowances. He
received P150,000 of which only P120,000 was actually disbursed.

Compute Denver’s total income subject to income tax.

Problem 3.3 TC COMPANY

TC Company manufactures wooden furniture for the local and export market. It has a
distribution outlet abroad which handles foreign sales. It bills all customers, including the
foreign outlet, 70% above manufacturing costs. The foreign outlet bills its customers 100%
above TC Company's billing price. TC Company reports P3,400,000 in total sales inclusive of
sales to the foreign outlet. The foreign outlet reports P2,720,000 total sales to customers.

Compute the manufacturing income respectively earned within and earned without
the Philippines.
 ACTIVITY / EVALUATION:

TRUE OR FALSE:

Determine whether the following statements are true or false. Write the answer on
the blank space provided for:

1. Dividends received from a foreign corporation may be earned within

the Philippines.
2. A citizen may be both a resident and non-resident in a taxable year.
3. There must be another party involved in an exchange transaction for a
benefit to be realized.
4. The situs of the gains on sale of domestic stocks is the place where the
sale occurred.
5. In classifying individual taxpayers, the intention is evaluated first before
applying rules on length of stays.

MULTIPLE CHOICE
Choose the best answer from the choices provided.
1. Which of the following is there a benefit realized?
a. Receipt of proceeds of an approved bank loan
b. Receipt of a car from a deed of donation
c. Discovery of lost properties
d. Discovery of hidden treasures in a lot owned
e. None of the above

2. Which of the following is taxable on their income earned abroad?

a. Resident Alien
b. Resident Citizen
c. Non-Resident Alien
d. Non-Resident Citizen

3. When are holding gains subject to income tax?

a. Never subject to income tax
 b. Once the value is determined
c. Once the asset is sold
d. Every yearend

4. Which of the following is subject to income tax?

I. Return on Capital
II. Return of Capital
III. Recovery of Lost Capital
IV. Recovery of Lost Profits
a. I and III
b. I and IV
c. II and III
d. II and IV

5. Dividends from this corporation is subject to the pre-dominance test.

a. Domestic Corporation
b. Resident Foreign Corporation
c. Non-Resident Foreign Corporation
d. Special Corporation
REINFORCEMENT:

TAXPAYER CLASSIFICATION
Determine the classification of each of the following taxpayers.
1. Liza Sober, a Filipino actress, visited Canada for 3 days to promote her
movie "Darna"
2. Melania, a Russian beauty queen, stayed for in the Philippines for 181 days
3. Valak Caudian, an Ilongga dancer, left the Philippines on March 15
for Tokyo, Japan to be an entertainer
4. Lala Pitan, a Cebuana, is employed in the Philippines in the
regional headquarters of McBonalds, a multinational company
5. Kim Chi, a Chinese, stayed in the Philippines for more than one year
6. Paul Lickett, an British citizen, has a business in the Philippines. He has
staying in the Philippines since April 17 of the previous year
7. Coolie Tan, a Filipino citizen, works as a chef in a Chinese restaurant
in Binondo
8. Sam Vanda, a Scottish, lives in the Philippines after being naturalized
9. Michael Angan, a Filipino, maintained his residence in Australia to live a
life with his wife

10. Moira dela Sobre, a Filipino citizen, has been residing abroad for 90 days as
an Overseas Filipino Worker
11. Jason Nonoa, an American citizen, left for South Korea on March 17 for a 50-
day vacation. After his vacation, he immediately boarded to the Philippines.
He stayed in the Philippines for 2 weeks for the finalization of some business
deals
12. Stephen Agila, a Filipino Pharmacist, went to a 183-day backpacker
adventure with his friends in Iraq.
13. Lina Vaughn, a German, works as a Secretary for the German Ambassador to
the Philippines in the British Embassy
14. Dina Natuto, a Filipino CPA, went abroad for a vacation on September 5. She
fell in love with the country she visited so she decided to stay there for good.
15. Lone Lee, a Singaporean tourist, finding the beauty of the Philippines, stayed
therein for 180 days.
16. Lee Gon Na, a Korean Superstar, visited the Philippines for one week to
promote a major clothing line.
 REFERENCES:

 Income Taxation with Special Topics and Properly Filled BIR Forms, 2020
Edition - Enrico D. Tabag, CPA, MBA & Earl Jimson R. Garcia, CPA, MBA

 Reviewer in Taxation Updated TRAIN-Book 1 2018 Edition- Asser S.

Tamayo, CPA, MBA

 Income Taxation-Laws, Principles and Applications- Rex B. Banggawan,

CPA, MBA

 National Internal Revenue Code of 1997

 Bureau of Internal Revenue Regulations

 Bureau of Internal Revenue Memorandum Circulars

 Supreme Court Jurisprudence on Tax Cases

REFERENCES

 Reviewer in Taxation Updated TRAIN-Book 1 2018 Edition- Asser

S. Tamayo, CPA, MBA
 Income Taxation-Laws, Principles and Applications- Rex B.
Banggawan, CPA, MBA
 Income Taxation with Special Topics in Taxation- Enrico D. Tabag,
CPA, MBA & Earl Jimson R. Garcia, CPA, MBA
 National Internal Revenue Code of 1997
 Bureau of Internal Revenue Regulations