Capital Assets (Sec.

39) – include all the property held by the taxpayer (whether or not
connected with his trade or business) but does not include:
 
1. STOCK IN TRADE of the taxpayer or other property of a kind which would properly be
included in the INVENTORY of the taxpayer if on hand at the close of the taxable year,
or
 
2. Property held by the taxpayer primarily FOR SALE to customers in the ordinary course
of his trade or business; or
 
3. Property USED IN TRADE OR BUSINESS, of a character which is subject to the allowance
for depreciation; or
 
4. REAL PROPERTY used in trade or business of the taxpayer
Capital Gains from Dealings in Capital Assets:

1. From sale/exchange of SHARES OF STOCKS of domestic corporation NOT traded in the stock
exchange – 15% of net capital gain

Sale of shares of stocks of domestic corporation traded in the stock exchange (STOCK
TRANSACTION TAX) – 1/6 of 1% of selling price

2. From sale/exchange of REAL PROPERTY located in the Philippines - 6% of selling price or FMV,
whichever is higher

3. From sale/exchange of OTHER capital assets

Capital Gains from Dealings in Capital Assets:
1. From shares of stocks of domestic corporation NOT traded in the stock exchange –
a. Tax rate – Final tax of 5% not over 100,000; 10% in excess of 100,000 (Note that this is the only final tax that is not subject to withholding tax)
 
b. The tax base is the NET CAPITAL GAIN (amount realized from the sale of shares – basis or adjusted basis)
 
• Note that if the total consideration is less than the fair market value of the shares, the transaction is not deemed to be a result of an arms-length
transaction, and the excess (of the fair market value over the total consideration) will be subjected to donor’s tax (transfer for less than adequate
consideration under Sec. 100).

c. The shares of stocks must be issued by a domestic corporation. If issued by foreign corporation, such sale of shares are treated as sale of “”other capital
assets””.
 
d. The shares of stocks must be capital assets. Shares of stocks are capital assets if they are held by taxpayers other than dealers in securities. (Sec.39)
 
 e. Such sale of shares must not be conducted through the stocks exchange (through its facility or the trading system). Such sale is called “over-the counter
transaction” and is done directly between the seller and the buyer.
 
f. If the sale is conducted through the stocks exchange, it will be subject to stock transaction tax (6/10 of 1% based on the selling price – Sec. 127) if it is not
conducted by dealers in securities.
Capital Gains from Dealings in Capital Assets:

2. From sale of real property located in the Philippines –

1. The tax rate is 6% and the tax base is the selling price or the fair market value of the property, whichever is higher.
 
The fair market value is the higher amount between:
a. the zonal value of the BIR (FMV of real properties located in each zone as determined by the CIR in consultation with appraisers
or
b. the FMV in the schedule of values of the provincial and city assessors.

2. The real property sold must be a capital asset. The sale of real property classified as ordinary assets is subject to the creditable
withholding tax based on the GSP or FMV whichever is higher and consequently to the ordinary income tax.

3. The real property must be located in the Philippines.

  a. If real property is not located in the Philippines, the gain realized from the sale will be subjected to ordinary income tax and will
only be taxable to resident citizens and domestic corporations (because they are taxable on income sourced from within and without).

b. If real property located in the Philippines is sold by non-resident foreign corporations – gain on sale of real property located in
the Philippines shall be subject to the final withholding tax of 30% (gross income taxation). If sold by RESIDENT FOREIGN corporations. –
gain on sale real property located in the Philippines shall be subject to the creditable withholding tax, thus ordinary income tax. (or MCIT)

4. If real property is sold by individual taxpayers, except for NRA-NETB, and the buyer is the government or any of its political subdivisions
or agencies or a GOCC, the taxpayer has the following options:
  To have the gain from sale included as part of gross income to be subject to the allowable deductions and/or personal and additional
exemptions, then subject to the schedular tax (Capital gains=Selling price – acquisition price) Capital gains is treated as ordinary income.

5. Domestic corporations do not have the above option.

Capital Gains from Dealings in Capital Assets:

2. From sale of real property located in the Philippines –

6. Under Sec. 24(D)(2) Sale of principal residence by an individual is exempt. Requisites:
a. The proceeds of the sale must be used in acquiring or constructing a new principal residence within 18 months.
b. Availed of once every 10 years
c. Notification within 30 days from date of sale – the CIR have been duly notified by the taxpayer through a prescribed return of his intention to
avail of the exemption.
 
Note: The 6% capital gains tax otherwise due on the presumed capital gains derived from the sale of the principal residence shall be deposited in
cash or manager’s check in interest-bearing account with an authorized agent bank under an ESCROW AGREEMENT between the RDO, the bank and
the seller to the effect that such amount will only be released to the seller upon certification by the RDO that the proceeds of sale has in fact been
utilized within 18 months from the date of the said sale.
 
• Historical cost carried over to new principal residence

Rule for non-full utilization. If there is no full utilization of the proceeds of sale or disposition, the portion of the gain presumed to have been
realized from the sale or disposition shall be subject to capital gains tax. For this purpose, the gross selling price or fair market value at the time of
sale, whichever is higher, shall be multiplied by a fraction which the unutilized amount bears to the gross selling price in order to determine the
taxable portion and the 6% capital gainst tax shall be imposed thereon.

Illustration: 1st principal residence: GSP = 10 million, FMV = 12 million

2nd principal residence: 5 million
 
a. Higher amount between GSP and FMV is 12 million.
b. Unutilized amount is sales proceeds of 10million less 5 million or 5million.
c. Percentage of unutilized amount over the gross selling price is 50%`
d. Capital gains tax will be 6% of 50% of 12 million or 360,000
Capital Gains from Dealings in Capital Assets:

3. From sale of OTHER capital assets

1. They are reported in the ITR together with gains from ordinary assets and from the total the ordinary losses will be deducted (ordinary gain or loss
refers to gain or loss from the sale or exchange of property that is not a capital asset).  

Ordinary Gains
Add: Net Capital Gains
Capital gains
Less: Capital losses
----------------------------
Total Income
Less: Ordinary Losses
-----------------------
Net Income
 
 
2. Limitation of capital losses. Losses from sales or exchanges of capital assets (capital losses) shall be allowed only to the extent of the gains from such
sales or exchanges (capital gains). However, banks or trust companies are not subject to this limitation and they may deduct their capital losses even
if they exceed the capital gains.
 
Example: Mr. X sold his Juan Luna painting and realized therefrom a gain of P1M. He also sold his piano and realized a loss of P1.5M. If he has an ordinary
income of P2M, he cannot deduct his capital loss of P1.5M from his total income of P3M because he is only allowed to deduct P1M (his capital
gain). His taxable income therefore is (3M less 1M).
 
3. Ordinary losses can be deducted from the net capital gains but net capital loss cannot be used as deduction from gross income.

4. Holding period. Under Sec. 39 (B). If a capital asset is held by an individual taxpayer:
– for more than 12 months, only 50% of gain or loss is recognized in computing the net capital gain and
– 100% of gain or loss is recognized if held for not more than 12 months.
 
Illustration:

Ordinary Income 500,000.00

Add: Capital gains
From asset held for more than 12 months 1,000,000.00 50% 500,000.00

From asset held for less than 12 months 1,000,000.00 100% 1,000,000.00 1,500,000.00
Less: Capital losses
Actual capital loss 4,000,000.00

Capital loss limitation 1,500,000.00 (1,500,000.00)

Net Income 500,000.00

Net capital loss carry-over for next taxable year 500,000.00

Excess of actuall capital loss over capital loss limitation 1,000,000.00
Net taxable income which must not be exceeded 500,000.00
Summary of rules for individuals vs. corporation:
Individuals Corporation
1. Holding period - Sec. 39B 1. No holding period
100% of gain or loss is recognized if capital asset has been
held for not more than 12 months
50% of gain or loss if capital asset has been held for more
than 12 months.
Note: Holding period does not apply to sale of shares of stock
and sale of real property.

2. Capital losses are deductible ONLY to the extent of capital 2. Same rule
gains Exception: Banks or trust companies are not subject to
limitation. They may deduct their capital losses even if they
exceed the capital gains.
3. Ordinary losses are deductible from capital gains but net 3. Same rule
capital loss cannot be deducted from ordinary gain or income.

4. Sec. 39D Net Capital Loss Carry-over. - If an individual 4. No carry over

sustains in any taxable year a net capital loss,
a. such loss (in an amount not exceeding the net
income for such year)
b. shall be treated in the succeeding taxable year
c. as a loss from the sale or exchange of a capital
asset held for not more than 12 months. 
(There must be a capital gain)
Capital Gains from Dealings in Capital Assets:

3. From sale of OTHER capital assets

• Net capital loss carry over. Under Sec. 39(D), if any taxpayer, other than a corporation, sustains in any taxable year a net capital loss, such loss (in an
amount not in excess of the net income for such year) shall be treated in the succeeding taxable year as a loss from the sale or exchange of a capital
asset held for not more than twelve (12) months. 

• Note that net capital gains from sale/exchange of capital assets other shares of stocks and real property is included in the gross income of non-
resident alien not engaged in trade or business.
 
• Computation of capital gain or loss. The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom
over the basis or adjusted basis for determining gain, and the loss shall be the excess of the basis or adjusted basis for determining loss over the
amount realized. (Sec. 40).

Gain or loss realized = amount realized from sale or other disposition – basis or adjusted basis
 
The amount realized in this case refers to the actual amount of money received, the fair market value of the property received (other than money),
and liabilities discharged if any less selling costs.

• The adjusted basis refers to the basis at the time of acquisition plus the capital improvements less depreciation, if any. The initial basis refers to the
following:
 
a. If the property was acquired by purchase, the acquisition cost (or the purchase price plus expenses of acquisition)
b. If the property was acquired by inheritance, the fair market value of the property at the time of the death of the decedent (the value for estate tax
purposes). This is referred to as the “stepped-up basis”.
c.   If the property was acquired by gift or donation, the value in the hands of the last preceding owner who did not acquire the property by gift. This is
referred to as the “carry-over basis”. However, if such value is greater than the fair market value of the property at the time of the gift, for the purpose of
determining loss, the fair market value (so that the loss will be smaller).

Example:
Acquisition cost of Donor = 1M, FMV of property at the time of donation= 500k.
– If selling price is 3M, gain = 3M – 1M.
– If selling price is 200K, loss = 200k – 500k
 
Capital Gains Tax
Tax-free exchange transaction.
 
As a general rule, transfer or exchange of property between/among taxpayers resulting to gain are subject to capital gains tax. As
an exception, transfers or exchanges of property for corporate restructuring shall have no income tax consequences. This is
stated under Sec. 40 (c) (2) of the NIRC:
 
(2) Exception. - No gain or loss shall be recognized if in pursuance of a plan of merger or consolidation -
  (a) A corporation, which is a party to a merger or consolidation, exchanges property solely for stock in a corporation, which
is a party to the merger or consolidation; or 

(b) A shareholder exchanges stock in a corporation, which is a party to the merger or consolidation, solely for the stock of
another corporation also a party to the merger or consolidation; or

(c) A security holder of a corporation, which is a party to the merger or consolidation, exchanges his securities in such
corporation, solely for stock or securities in such corporation, a party to the merger or consolidation.

No gain or loss shall also be recognized if property is transferred to a corporation by a person in exchange for stock or unit
of participation in such a corporation of which as a result of such exchange said person, alone or together with others, not
exceeding four (4) persons, gains control of said corporation: Provided, That stocks issued for services shall not be considered as
issued in return for property.

In these transactions, there is only a change in the form of ownership (and no change in substance) of the property transferred.
The rationale for this tax-free exchange is to encourage pooling of resources among corporate businesses. It merely defers the
government’s claim for taxes but may later on be collected when gains are realized by and benefits distributed to the
stockholders as a result of the said transaction.
 
Capital Gains Tax
Tax-free exchange transaction.
 

There are 2 types of tax-free exchanges:

  1. Exchange of property pursuant to a plan of merger or consolidation. This may refer to statutory merger or consolidation or de facto merger.
 
Statutory merger or consolidation happens when there is an approved plan of merger (one the entities to the merger survive as the the merged entity) or
consolidation (results to a creation of a new entity). There is an upstream merger if between parent and subsdiary, the parent survives and the subsdiary is
dissolved and liquidated. Downstream merger is when the subsidiary is the surviving entity.
 
In a de facto merger, similar to a transfer to a controlled corporation, except that at least 80% of the transferor’s assets, including cash are transferred to the
transferee, with the element of permanence and not merely momentary holding. The assets of a corporation are exchanged for the shares of stocks of
another corporation but such transfer may not result to control of the transferee corporation.
 
Example of a de factor merger:
 
1. X corporation exchanges 80% of its assets for the shares of stocks of Y corporation but such transfer does not result in the control of Y
corporation.
 
2. X corporation exchanges 20% of its assets for the shares of stocks of Y corporation resulting to controL.`

It must be undertaken for bona fide business purpose and not solely for the purpose of escaping the burden of taxation. In determining whether a bona
fide business purpose exists, each and every step of the transaction shall be considered and the whole transaction or series of transactions shall be treated
as a single unit (step transaction principle).
 

2. Exchange of property whereby the transferor gains control of the transferee corporation (or the transfer to a controlled corporation)

The transfer should be for the purpose of obtaining control (at least 51% of the OCS). If there was already control prior to the
transfer, it is not a tax-free exchange.
 
Capital Gains Tax
Computation of capital gain or loss.

The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the basis or adjusted basis for
determining gain, and the loss shall be the excess of the basis or adjusted basis for determining loss over the amount realized. (Sec. 40). In formula form:
 
Gain or loss realized = amount realized from sale or other disposition – basis or adjusted basis
 
The amount realized in this case refers to the actual amount of money received, the fair market value of the property received (other than money), and
liabilities discharged if any less selling costs.
 
The adjusted basis refers to the basis at the time of acquisition plus the capital improvements less depreciation, if any. The initial basis refers to the
following:
 
a. If the property was acquired by purchase, the acquisition cost (or the purchase price plus expenses of acquisition)
 
b. If the property was acquired by inheritance, the fair market value of the property at the time of the death of the decedent (the value for estate tax
purposes). This is referred to as the “stepped-up basis”.
 
c. If the property was acquired by gift or donation, the value in the hands of the last preceding owner who did not acquire the property by gift. This is
referred to as the “carry-over basis”. However, if such value is greater than the fair market value of the property at the time of the gift, for the purpose of
determining loss, the fair market value (so that the loss will be smaller).

d. If the property was acquired for less than an adequate consideration, the basis is the amount paid by the transferee for the property.
 
e. If the property was acquired in a transaction where gain or loss is not recognized – SUBSTITUTED BASIS or the basis as defined in Sub. C,5 and B,5; Tax is
imposed on the subsequent sales or exchange.
 
Tax basis: Value of property exchanged
Less: Money received
FMV of property Received
Add: Dividends + Gain on transfer  
Bar Question 2012
 
Mr. Pedro Aguirre, a resident citizen, is working for a larger real estate development company in the country and in 2010, he was promoted to Vice President
of the company. With more responsibilities come higher pay. In 2011, he decided to buy a new car worth P2million and he traded-in his old car with a market
value of P800,000 and paid the difference of P1.2million to the car company. The old car, which was bought 3 years ago by the father of Mr. Pedro Aguirre at a
price of P700,000 was donated by him and registered in the name of his son. The corresponding donor’s tax thereon was duly paid by the father.
 
a. How much is the cost basis of the old car to Mr. Aguirre?

b. What is the nature of the old car – capital asset or ordinary asset?

c. Is Mr. Aguirre liable to pay income tax on the gain from the sale of his old car?

Suggested answers: (UPLC)

 
a. P700,000. The basis of the property in the hands of the donee-son is the carry-over basis, the same basis as if it would be in the hands of the donor-father.
(Sec. 40[B][3]
 
b. The old car is a capital asset. It is a property held by the taxpayer (whether or not connected with his trade, but is not stock in trade or other property of a
kind which would properly be included in the inventory of of the taxpayer, if on hand at the close of the year, or property held primarily for sale to customers
in the ordinary course of his trade or business, or property used in the trade or business of a character subject to depreciation, or real property used in trade
or business of the taxpayer (Sec. 39[A], NIRC).
 
c. Yes, he is liable to income on his capital gain of P100,000 (P800,000 less P700,000) but only 50% of the taxable gain shall be recognized and subject to
income tax, considering that the holding period of the old car is more than one year. (Sec. 39, NIRC).