Concept ofIncome

Income Taxation

1st Semester, AY 2016-2017

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What is Income?Revenue Regulations (RR) No. 2-40u Income, in the broad sense, meaning all wealth which

flows into the taxpayer other than as a mere return ofcapital.

u It refers to all earnings derived from services renderedfrom capital or both including gain derived from sale orexchange of personal or real property classified as eitherordinary or capital asset.

u It may also pertain to a taxpayer’s increase in net worth.u Note that the National Internal Revenue Code (NIRC)

does not provide a single definition of “income”.u All items of income from whatever source are taxable

unless a law or treaty exempts the same from taxation.

Case 1 – Group ActivityIncome or not?

u Miss Lugui owns a parcel of land she inherited from herlate grandfather in 20XA amounting to P12,500,000. Theland’s value appreciated by P2,500,000 in 20XB.

u Does the increase in the land’s value constitute income?

Case 1 – Answer

u No. A mere increase in the value of property is notincome but merely an unrealized increase in capital.

Case 2 – Group ActivityIncome or not?

u Mr. A is indebted to Mr. B. Previously, Mr. A renderedcarpeting services to Mr. B. As a result, Mr. B condonedthe obligation of Mr. A to pay him.

u Is there an income on the part of Mr. B?

Case 2 – Answer

u Yes. Condonation of debt in exchange for servicesrendered is income and expense on the part of thecreditor and debtor, respectively.

u Condonation of debt without exchange of services isconsidered a gift subject to donor’s tax.

Case 3 – Group ActivityIncome or not?

u Increase in the book value of a corporation as a result ofrevaluation of assets and liabilities.

u Is there an income?

Case 3 – Answer

u No. Appreciation in the value of property is not even anaccrual of income to the taxpayer prior to the realizationof such appreciation through sale or conversion ofproperty.

Return on Capital

u Since income is commonly defined as all wealth whichflows into a taxpayer’s hand rather than a mere return ofcapital (investment), it is, therefore, a return on capital(return on investment).

Income vs. Capital

► To be considered income, the profit must be in excess ofcapital as a result of an exchange transaction.

► Capital is the original investment used to generateearnings which is called income. In other words, capital iswealth while income is the service of wealth.

Revenue vs. Capital

► Revenue pertains to all funds accruing to the treasury ofthe government derived from tax, donation, grants andany other source.

► Income pertains to the earnings of all taxpayers.

Receipts vs. Income

► Receipts are cash collected over a certain businessperiod. Receipts may also include capital as well asincome.

► Income refers to the amount after excluding capitalinvested, cost of goods sold and other deductionsallowed by law.

Taxable Income vs.Nontaxable Income

► Taxable income refers to those income that are subject totax (whether income tax or any other type of tax) byprovision of the NIRC, as amended.

► Taxable income is synonymous to net income (i.e., grossincome less statutory deductions)

► Nontaxable income refers to income expressly exemptedby law from taxation.

Characteristics of TaxableIncome

► There must be a gain or profit.

► The gain must be realized or received.

► Actual receipt of income

► “As-if” theory of constructive income

► The law or treaty does not exclude the gain from taxation.

Constructive Receipt ofIncome

► An income is considered constructively received when itis credited to the account of, or segregated in favor of aperson.

► This “As If” Theory of Constructive Income is designed toprevent cash basis taxpayers to delay reporting ofincome. It also presumes the existence of income ontransactions supposedly not subject to tax.

Examples of incomeconstructively received

► Interest income credited on savings bank deposit

► Matured interest coupons not yet collected by thetaxpayer

► Dividends applied by the corporation against theindebtedness of a stockholder

► Share in the profit of a partner in a general professionalpartnership, although not yet distributed, is regarded asconstructively received

► Intended payment deposited in court (consignation)

► Services rendered applied by the creditor against thedebtor’s indebtedness

Case 4Taxable income or not?

u On the night of July 4, 2013, A was driving a passengerbus on McKinley Road. One passenger, B, distracted Awhile driving by doing illicit acts. As a result, Aaccidentally hit C, a pedestrian along the road.

u C was rushed to the hospital and incurred expensesamounting to P25,000. C filed a case against A and theCourt awarded C the right to recover damages from A asa result of the latter’s negligence.

u Is the P25,000 damage recovery an income of C?

Case 4Answer

u No. The damage recovery is merely a return of capital(investment) and not a return on capital (income).

Case 5Taxability of Illegal Income

u During the year, Madam Rocha earned P500,000 fromselling smuggled iPhones, P300,000 from selling piratedDVDs and P200,000 from doing inside trading.

u Are those earned by Madam Rocha subject to incometax?

Case 5Answer

u Yes, but only upon discovery by the Bureau of InternalRevenue.

Sources of Income

u Income from sources within the Philippines

u Income from sources outside the Philippines

u Partly within and partly outside the Philippines

Situs of Taxation

u The place or site of taxation

u Factors that determine the situs of taxation:

u Subject matter – persons, property or activity (e.g.,sale)

u Nature of tax – what to impose

u Taxpayer’s citizenship

u Taxpayer’s residence

Situs of TaxationSubject Matter Situs of Taxation

Persons Residence of the taxpayerReal property or tangiblepersonal property

Location of the property

Intangible personal property Generally, domicile of the ownerunless he has acquired a situselsewhere

Income Taxpayer’s residence orcitizenship where income wasearned

Business, occupation orprofession

Place of business

Gratuitous transfer of property Taxpayer’s residence or locationof property

Documents Place where the document issigned

Examples of income fromsources within the Philippines

u Interests (whether from bonds, notes or other interest-bearing obligations)

u Dividends (whether from domestic or foreign corporation)

u Compensation income for services rendered (labor orpersonal)

u Rentals

u Royalties

u Sale of real property

u Sale of personal property

Examples of income from sourcesoutside the Philippines

u Compensation for services rendered by overseascontract workers

u Interest on bonds, notes, deposits and the like earnedabroad

u Dividends received from nonresident foreign corporations

u Rentals and royalties from property located outside thePhilippines

u Gains, profits and income from sale of real property aswell as from personal property located outside thePhilippines

Examples of income from sourcespartly within and outside thePhilippinesu Transportation or other services rendered partly within

and partly outside the Philippines (e.g., transshipmentservices)

u Compensation income received under a “secondment”arrangement (e.g., amounts received abroad and in thePhilippines)

u Dividends received from a domestic corporation andforeign corporation

Classifications of Income

u Capital Gain

u Passive Income

u Compensation Income

u Profession or Business Income

Capital Gain

u An income derived from the sale of assets not used intrade or business.

u Examples are sale of family home and sale of shares ofstocks not traded in the Philippine Stock Exchange(PSE).

Passive Income

u An income in which the taxpayer merely waits for theamount to come in.

u Examples are royalty, interest, prizes, and winnings.

u Generally, passive income is subject to final tax.

Compensation Income

u The gain derived from labor, especially from employmentsuch as salaries and commissions.

u These earnings are subject to the graduated income taxrates (i.e., 5% to 32%).

Profession or BusinessIncomeu The value derived from an exercise of a profession,

business, or utilization of capital including profit or gainderived from sale or conversion of assets.

u Examples are net income from business and gain fromthe sale of assets used in trade or business.

u In case of revenue arising from sales, business income(gross profit) is equal to sales reduced by sales returns,sales discounts, sales allowances and cost of goodssold.

u These earnings are usually subject to the normal tax.u Graduated income tax rates for individualsu 30% income tax for corporations

Normal Tax vs. Final Tax

u Normal tax (ordinary or regular or customary tax) –creditable tax since these are intended to equal or atleast approximate the tax due of the payee on saidincome.

u Final tax – tax on earnings that have been subjected tocomplete withholding tax payment at source (i.e., full andfinal payment).

Forms of Income

CASH PROPERTY SERVICEMoney or

money substituteRight of ownershipover a tangible orintangible property

Based onperformance

received

Valuation of Income

u Cash – Face value

u Property – Fair value

u Shares of stock – Fair value at the date income wasearned

u Services – stipulated price, in the absence of stipulatedprice – fair value of services rendered

u Promissory notes – face value of the note if interestbearing or discounted value of the note if non-interestbearing

Tax Accounting Periods

u Calendar period – ending December 31

u Fiscal period – ending on the last day of any calendarmonth except December 31

u Short period – period less than 12 months (e.g. incomeearned by the estate when the taxpayer dies)

u Variable period – depending on the nature of thetransactions (e.g. per transaction basis in the case ofsale of shares of stock)

Change of Accounting Period

u A taxpayer, other than an individual, needs the approvalof the BIR Commissioner to change in accounting periodfrom fiscal year to calendar year (vice versa), subject tothe provisions of Section 47 of the NIRC, as amended.

u A short period return must be filed as a result of suchchange in reporting period.

Methods of Reporting Incomeand Expensesu Cash method

u Income is reported when cash is receivedu Expense is claimed as deduction when cash is paid

u Accrual methodu Income is reported when earnedu Expense is claimed as deduction when incurredu All-events test

u The right to the income or liability to pay is FIXEDin nature and

u The income or liability is determined withreasonable accuracy

Special Methods of ReportingIncomeu Installment (Selling price <= 25% of the total contract

price)u Deferred payment (Selling price > 25% of the total

contract price)u Long-term construction contracts

u Completed contract methodu Percentage of completion method

u Farmingu Cash basisu Accrual basisu Crop basis

Special Methods of ReportingIncomeu Installment (Selling price <= 25% of the total contract

price)u Deferred payment (Selling price > 25% of the total

contract price)u Long-term construction contracts

u Completed contract methodu Percentage of completion method

u Farmingu Cash basisu Accrual basisu Crop basis

Income from farming -illustration

Assume the following data:Sales:

Palay harvested and sold P100,000Palay purchased and sold 50,000Farm equipment sold 5,000

Cost of palay purchased 45,000Carrying cost of farm equipment sold 4,500Palay inventory, end, at selling price 6,000

Income from farming -solution

Cash Method Accrual MethodHarvested andsold

P100,000 P100,000

Unsold inventoryat year-end

6,000

Gain from palaypurchased andsold

5,000 5,000

Gain from sale offarm equipment

500 500

Gross incomefrom farming

P105,500 P111,500

Difference is the movement in inventory(+) if increase (-) if decrease

Income from farming – cropbasis

Cost of producing apple trees:Year 1 P100,000Year 2 125,000Year 3 125,000Year 4 – Sale P1,000,000Gross income in Year 4:Selling price P1,000,000Less: Year 1 to 3 costs incurred 350,000Gross income P650,000

The entire cost of producing the crop is deductible only fromgross income in the year in which the crop was realized.

What if the taxpayer hasno accounting records?

The “net-worth” methodDiscovering undeclared income

Pro-forma computation:Net worth, ending PxxLess: Net worth, beginning xxIncrease (decrease) in net worth PxxAdd: Nondeductible items xxLess:(1) Nontaxable items xx(2) Personal exemptions (indv only) xxNet taxable income Pxx

Net worth or “equity” = total assets less total liabilities

REVIEW QUESTIONSTRUE OR FALSE

Q1. Unrealized gain on tradingsecurities reported in the profit-and-loss statement is a taxableincome.

A1. FALSE – does not yet arise from a closed andcompleted transaction

Q2. Declared dividends not yetreceived by the stockholders aretaxable income.

A2. TRUE – this is an example of an income constructivelyreceived

Q3. An increase in the value ofproperty is income

A3. FALSE – there is no realization (e.g., sale) of income yet

Q4. All increases in a taxpayer’snet worth are taxable income.

A4. FALSE – not all. E.g., additional investment is not ataxable income since this is a capital

Q5. Properties and labor areparalleled to trees while incomeare fruits

A5. TRUE

Q6. The peso equivalent of aforeign currency as payment forcompensation is considered asthe value of reportable income.

A6. TRUE – the foreign exchange (forex) component is alsoaccounted in computing the taxable income.

Q7. A return of a taxpayer’swealth is considered an income.

A7. FALSE – return of capital is not taxable.

Q8. Most taxpayers elect to reportincome in a fiscal year basis.

A8. FALSE – Calendar year basis (e.g., ending onDecember 31)

Q9. A sale always includes returnon capital.

A9. TRUE – the selling price includes the “cost” of what issold

Q10. Income derived fromunlawful activities are taxableincome.

A10. TRUE – taxable when discovered