Module 5

Introduction to Income Tax

This lesson discusses the Concept of tax Income, the situs of income, and the types of taxpayers.

After this lesson, readers are expected to comprehend and demonstrate knowledge on the
following:

1. The concept of gross income

2. The types of income taxpayers

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 a return on capital that increases net worth.

2. It is a realized benefit.
3. It is not exempted by law, contract, or treaty.

RETURN ON CAPITAL
Capital means any wealth or property. Gross Income is a return on wealth or property that
increases the taxpayer’s net worth.
Illustration.
ABC purchased goods for P300 and sold them for P500. The P500 consideration can be 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 tax. Return of
capital merely maintains net worth; hence, it is not taxable. An 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 pecuniary valuation.
Anything received as compensation for their loss is deemed a return of capital.
Examples:
1. Life
2. Health
3. Human reputation

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
assignment 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.

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 ofcrop or livestock insurance
b. Guarantee payments
c. Indemnity received from patent infringement suit

Illustration 1

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

Illustration 2

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

The P40,000 guarantee payment is not gratuity but a recovery of lost profit for Mr. Santiago;
hence, subject to income tax. Mr. Santiago shall report P100,000 as franchise income
Illustration 3

Mindoro Inc. experienced an unusual decline in its income after a competitor copied its patented
invention. Mindoro sued the competitor for patent infringement and was awarded an indemnity
of P3,000,000.

The P3,000,000 indemnity is a compensation for the income not realized by Mindoro 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 loss of 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. 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 benefits, hence, not taxable:

a. Receipt of a loan - properties increase but obligations also increase resulting in an offsetting
effect in networth.
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

1. 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 that P2,000
retained by the employee is considered income since this was the extent he was benefited. (RR-
98)

2. A security agency was granted P120,000 from c1ients, P100,000 of which is for the salaries os
security guards. Under RMC 39-2007 only the P20,000 attributable to the agency is considered
income of the agency since it is the extent it is benefited. The P100,000 pertaining to salaries of
security guards is recognized by the agency as a liability upon receipt.

The “realized” concept

The term realized mean earned. It requires that there is a degree of undertaking or sacrifices
from the taxpayer to be entitled of the benefit.
Requisites of 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 transaction”.

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 as “transfers” while bilateral
transfers are called “exchanges.” Benefits derived from onerous transactions are “earned or
realize”; 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
P30,000- Subject to income tax
Cost 100,000

The excess of fair value over selling price is a gratuity or gift whereas the excess of the 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 persons 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.

Benefits in the absence of transfers

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.

These are referred to as unrealized gains or holding gains because they have not yet materialized
in an exchange transaction.

Example of unrealized gains or holding gains:

a. Increase in value of investment 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 an e animal offspring, accruals of fruits in an orchard or growth of farm vegetable.
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 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

Mr. Saladin lists the following possible items of gross income:

Compensation in income P 200,000

Winning from gambling 100,000
Increase in value of investment 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 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 Saladin forgiven in consideration
For service rendered to his creditor 150,000

Note:
1. Gains from gambling and the forgiveness of debt in consideration of service 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 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 consideration would
open a wide avenue for tax evasion since taxpayer 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- involves actual physical taking of the income in the form of cash or property.

2. Constructive receipt- involves no actual physical taking of the income but the taxpayer is
effectively benefited.

Examples:
a. Offset of debt of the taxpayer in consideration for the sale of goods or service.
b. Deposit of the income to the taxpayer’s checking account.
c. Matured detachable interest coupons on coupon bonds not yet encashed by the taxpayer
d. increase in the capital of a 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 not income due to the
total absence of benefit.

Examples:
a. Receipt of property trust
b. Borrowing of money under an obligation to return

In law, the proceeds of embezzlement or swindling where money is taken without an original
intention to return are considered as income because of the increase in 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 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 Microbusiness 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

TYPES OF INCOME TAXPAYERS

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

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
Under the Constitution, citizens are:
a. Those who are citizens of the Philippines at the same time of adoption of the Constitution on
February 2, 1987
b. 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 presents 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.

Filipinos working in the Philippine embassies or Philippine consulate offices are not considered
non-resident citizen.

Alien
A. Resident alien- an individual who is residing in the Philippines but is not a citizen thereof
such as:
1. An alien who lives in the Philippines without definite intention as to his sta; or
2. 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;
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.
B. Non-resident alien- an individual who is not residing in the Philippines and who is not a
citizen thereof
1. Non-resident aliens engaged in business (NRA-ETB) aliens who stayed 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 in its nature may be promptly
accomplished;
b. Aliens who shall come to the Philippines and stay therein for an aggregate period of not more
than 180 days during the year