Chapter 3 - Notes from Income Taxation PDF

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CHAPTER 3INTRODUCTION TO INCOME TAXATIONWhy is income subject to tax? Income is regarded as the best measure of taxpayer’s ability to pay tax.  It is an excellent object of taxation in the allocation of government costsINCOME FOR TAXATION PURPOSES“GROSS INCOME” – taxable income in layman’s term. T...

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CHAPTER 3 INTRODUCTION TO INCOME TAXATION Why is income subject to tax?  

Income is regarded as the best measure of taxpayer’s ability to pay tax. It is an excellent object of taxation in the allocation of government costs

INCOME FOR TAXATION PURPOSES “GROSS INCOME” – taxable income in layman’s term. Tax concept of income under NIRC Taxable income in NIRC refers to certain items of gross income less deductions and personal exemptions allowable by law Taxable item of income – “item of gross income” or “inclusion in gross income” GROSS INCOME – any inflow of wealth to the taxpayer (legal or illegal) that increases net worth. Ex. income for employment, trade, business/exercise of profession, income from properties ELEMENTS OF GROSS INCOME 1. RETURN ON CAPITAL THAT INCREASES NET WORTH

Taxable return on capital from insurance policies  Excess amount received over premiums paid by the insured upon surrender or maturity of the policy  Gain realized by the insured from the assignment or sale of his insurance policy  Interest income from the unpaid balance of the proceeds of the policy  Any excess of the proceeds received over the acquisition costs and premium payments by an assignee of a life insurance policy 

Health – 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 – any indemnity received as compensation for its impairment is deemed a return of capital exempt from income tax Ex. moral damages from oral defamation or slander, alienation of affection, breach of promise to marry.

Recovery of lost capital vs. Recovery of lost profit

CAPITAL – any wealth or property. Gross income is a return or wealth or property

Loss of Capital Recover of Lost Capital

Ex. purchased goods at 300, sold for 500

Los of Profits

SP Cost Mark-up

Recover of Lost Profits

500 Total Return (300) Return OF Capital 200 Return ON Capital

RETURN ON CAPITAL – increases net worth. Subject to income tax RETURN OF CAPITAL – merely maintains net worth, not taxable. *Improvement in net worth indicates ability to pay tax Capital Items with INFINITE VALUE  Life – proceeds from life insurance policies paid to heirs/beneficiaries upon death of insured, proceeds of life insurance contract collected by an employer as beneficiary from the life insurance of an officer are exempt from income tax. (viewed as advance recovery of future loss)

Decrease in net worth Merely maintains net worth DO NOT decrease net worth Return on capital

Taxable recovery of lost profits - recovery of lost profits through insurance, indemnity contracts, or legal suits (taxable return on capital) Taxable recoveries of lost profits a) proceeds of crop or livestock insurance b) guarantee payments c) indemnity received from patent infringement suit 2. REALIZED BENEFIT “BENEFIT CONCEPT” – benefit means advantage derived by taxpayer. There is benefit when net

worth of taxpayer is increased (increase when receives income, donation, or inheritance) NOT BENEFITS (NOT taxable) a) Receipt of a Loan – properties and obligation increase (off set) b) Discovery of lost properties – finder has an obligation to return to owner c) Receipt of money property – to be held in trust for or to be remitted to another person *if taxpayer is entitled to keep for his account portion of a receipt, only that portion is a benefit. “REALIZED CONCEPT” – realized means earned. Requires a degree of undertaking/sacrifice from the taxpayer to be entitled of the benefit. Requisites of a realized benefit 1. there must be an exchange of transaction 2. transaction involves another entity 3. increases the net worth of the recipient TYPES OF TRANSFERS 1. Bilateral Transfers or Exchanges – onerous transactions; benefits are “earned or realized” thus subject to income tax a. Sale b. Barter 2. Unilateral Transfers or Transfers – gratuitous transactions; benefits are NOT realized because of the absence of an earning process. Subject to TRANSFER TAX, NOT income tax a. Succession – transfer of property upon death b. Donation 3. Complex Transactions – partly gratuitous and partly onerous; “transfers for less than full and adequate consideration”. Gratuitous portion subject to TRANSFER TAX, while Onerous portion is subject to INCOME TAX. Ex. excess of FV over selling price is gratuity, excess of SP over cost is item of gross income. NOTES: - sales of a home office to its branch office are NOT taxable as they pertain to one and the same taxable entity. - income between businesses of proprietor should NOT be taxed since proprietorship business are taxable upon the same owner.

BENEFITS IN THE ABSENCE OF TRANSFERS - increase in wealth through appreciation or decrease in obligation in the absence of a sale or barter transaction is NOT TAXABLE. Referred to as UNREALIZED GAINS OR HOLDING GAINS as they have NOT yet materialized in an exchange transaction. Examples 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 – considered an exchange but does NOT cause a loss of capital. Hence, entire consideration received (compensation income, services fee) is an item of gross income. Ex. debt cancelled in consideration for services rendered. This is considered realized gains from exchanges thus an item of gross income. BASIS OF INCOME

EXEMPTION

OF

UNREALIZED

- income received in NON-cash consideration is taxable at the FV of property received. MODE OF RECEIPT/REALIZATION BENEFITS taxable income may be realized by taxpayer in: 1. Actual Receipt – actual physical taking of income in form of cash or property 2. Constructive Receipt – NO actual physical taking of income, but the taxpayer is effectively benefited (ex. offset of debt, deposit of income in checking account) Inflow of wealth without increase in net worth - inflow that does NOT increase net worth is income due to total absence of benefit Examples: receipt of property in trust, borrowing money under an obligation to return (LOAN)

*proceeds of embezzlement or swindling where money is taken without original intention to return is considered income because of the increase in net worth of the swindler.

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3. NOT EXEMPTED BY LAW, CONTRACT, OR TREATY

Classification of Citizens

- item of gross income is NOT exempted by the Constitution, law, contracts of treaties from taxation. Following items are exempted by LAW from taxation (NOT considered items of gross income): 1. Income of qualified employee trust fund 2. Revenues on non-profit, non-stock educational institutions (ex. AdDU) 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 enterprise (BMBEs) 6. Income of foreign governments and foreign Government owned controlled corporations (GOCC) 7. Income form 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 i. Engaged in trade or business ii. NOT engaged in trade or business 3. Taxable estates and trust B. CORPORATIONS 1. Domestic Corporation 2. Foreign Corporation a. Resident foreign Corporation b. Non-Resident Foreign Corporation INDIVIDUAL INCOME TAXPAYERS



Citizens of PH at time of adoption Constitution on Feb. 2, 1987 Father and mother are citizen of PH

A. Resident Citizen – filipino citizen residing in PH B. Non-resident Citizen  Citizen of PH with physical presence abroad with a definite intention to reside therein  Leaves PH during taxable year to reside abroad (immigrant or employment on permanent basis)  Citizen of PH who works and derives income from abroad and whose employment threat requires him to be physically present abroad most of the time during the taxable year  Citizen previously considered as NONresident citizen who arrives in the PH at anytime during the taxable year to reside permanently in PH shall be treated as NON-resident citizen for the taxable year in which he arrives in the PH with respect to his income derived from sources abroad until the date of his arrival in the PH *Filipinos working in PH embassies or PH consulate offices are NOT considered non-resident citizens. Alien 1. Resident Alien – residing in the PH but is NOT citizen  Lives in the PH without definite intention as to his intention  Comes to PH for a definite purpose which in its nature would require an extended stay and to that end makes his home temporarily in the PH although intention at all times is to return to his domicile abroad *if acquired residence in PH retains his status as such until he abandons the same or actually departs from the PH

Citizens 



Born before Jan. 17, 1973 of Filipino Mothers who elected Filipino citizenship upon reaching the age of majority Naturalized in accordance with the law

of 2. Non-Resident Alien – NOT residing in PH retains his status as such until he abandons the same or actually departs from PH

a. Non-Resident Aliens Engaged in Business (NRA-ETB) – aliens who stayed in PH for an aggregate period of MORE THAN 180 days during the year b. Non-Resident Aliens NOT Engaged in Business (NRA-NETB) i. Comes to PH for a definite purpose which in its nature may be promptly accomplished ii. Comes to PH and stay therein for aggregated period for NOT more than 180 days during the year

THE GENERAL CLASSIFICATION RULE FOR INDIVIDUALS 1. Intention – the intention shall determine his appropriate residential classification. Taxpayers submit to the CIR of the BIR documentary proofs (visas, work contracts, etc.) indicating intention. Documents with short term stay (tourist visa) shall NOT result in reclassification of normal residency. If long-term stay documents (immigration visa, working visa) for an extended period would result to automatic reclassification of residency 2. Length of Stay – in default of such documentary proof, the length of stay is considered: a. Citizens staying abroad for a period of at least 183 days are considered nonresident. b. Aliens who stayed in PH for more than 1 year as of the end of taxable year are considered resident c. Aliens who are staying in PH for not more than 1 year, but more than 180 days are deemed non-resident aliens engaged in business d. Aliens who stayed in PH for NOT more than 180 days are considered nonresident aliens NOT engaged in trade or business TAXABLE ESTATES AND TRUSTS 1. ESTATE - Refers to properties, rights, and obligation of deceased person NOT extinguished by his death.

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Estates under judicial settlement are treated as individual taxpayers. Estate is taxable on income of properties left. - Estates under extrajudicial settlement are exempt entities. Income under these properties is taxable to the heirs 2. TRUST - An arrangement where one person (grantor/trustor) transfers (donates) property to another person (beneficiary), which will be held under the management of a third party (trustee/fiduciary) - Trust irrevocably designated by the grantor is treated as if it’s an individual taxpayer - Income of property held in trust is taxable to the trust - Trust designated as revocable by grantor are NOT taxable entities and NOT considered as individual taxpayers. Income is taxable to the grantor - When trust agreement is silent as to revocability, presumed to be revocable CORPORATE INCOME TAXPAYERS Term ‘corporation’ includes OPC (One Person Corporation), partnerships, joint-stock companies, joint accounts, associations, insurance companies (EXCEPT: general professional partnerships, joint venture in consortium formed for undertaking construction project or engaging petroleum, coal, geothermal and other energy operations pursuant to an operating consortium agreement under service contract with the govt). hence, corporation includes profit-oriented and non-profit institution (charitable institutions, cooperatives, government agencies and instrumentalities, associations, leagues, civic or religious and other organizations. DOMESTIC CORPORATION – organized in accordance with PH laws. Includes OPC owned and registered by resident citizens in PH. Still a domestic corporation if controlled by foreigners but incorporated in PH FOREIGN CORPORATION – organized under foreign law TYPES OF FOREIGN CORPORATION 1. RESIDENT FOREIGN CORPORATION (RFC) – operates and conducts business in PH through permanent establishment (ex. branch). taxable on transaction through branch

2. NONRESIDENT FOREIGN CORPORATION – does NOT operate or conduct business in PH. Transacts directly to residents outside its branch, taxable on the direct transactions. SPECIAL CORPORATIONS – domestic or foreign corporation subject to special tax rules or preferential tax rates. OTHER CORPOARATE TAXPAYERS 1. One Person Corporation (OPC) – single stockholder (can be natural, trust, or estate). Banks etc. and practice for procession cannot incorporate as OPC. 2. Partnership a. General Professional Partnership (GPP) – sole purpose of exercising profession (NO part of income can be derived from trade or business). NOT treated as corporation and is NOT a taxable entity. Exempt from income tax but partners are taxable individually with respect to share in income of the partnership. (ex. practice in same professions – both accountants) b. Business Partnership – formed for profit. Taxable as corporation. (ex. practice of two different profession – atty and accountant) 3. Joint Venture a. Exempt Joint Ventures – for purpose of undertaking construction projects or engaging petroleum, coal, geothermal and other energy operations. NOT treated as corporation thus tax-exempt on regular income, but venturers are taxable on share on net income of JV b. Taxable Joint Ventures – other than JV (residual) 4. Co-Ownership - joint ownership of property formed for preserving the same and/or dividing its income. - If limited to property preservation or income collection, NOT taxable entity but co-owners are taxable on their share on income of co-owned property. - If reinvests income of co-owned property to other income producing properties/ventures, it will be considered an unregistered partnership taxable as corporation

THE GENERAL RULES IN INCOME TAXATION INDIVIDUAL TAXPAYERS

Taxable On Income Earned WITHI WITHOUT N (outside PH) / / / / /

Resident Citizen Non-Resident Citizen Resident Alien Non-Resident Alien CORPORATE TAXPAYERS Domestic Corporation / / Resident Foreign / Corporation Non-Resident Foreign / Corporation Note: “territoriality rule” – ALL taxpayers (except resident citizens and domestic corporations) are taxable only on income earned within the PH THE RESIDENCY AND CITIZENSHIP RULE Resident Citizens of PH and Domestic Corporations – taxable on ALL income from sources WITHIN and WITHOUT *corporation is a citizen of the country where it incorporated. BASIS OF THE EXTRATERRITORIAL TAXATION Resident citizens and domestic corporation have full access on benefits from government. The taxation on their foreign income properly reflects this difference in benefits consistent with the Benefit Received Theory. The extraterritorial treatment is intended as a safety net to the potential loss of tax revenues brought by situs relocation or practice of executing or structuring transaction transactions such that income will be realized abroad to avoid PH income taxes. ISSUE OF INTERNATIONAL DOUBLE TAXATION Rule on extraterritorial taxation exposes resident citizens and domestic corporation to DOUBLE TAXATION. However, NIRC allows a tax credit for

taxes paid in foreign countries. They also pay minimal taxes in PH on their foreign income because of tax credit. SITUS OF INCOME – place of taxation of income. It is the jurisdiction that has the authority to impose tax upon the income. Determines whether or not an income is taxable in the PH. Particularly important to taxpayers taxable only on income WITHIN but also important on global income for computation of foreign tax credit. SOURCE OF INCOME – pertains to activity/property that produces the income (different with SITUS OF INCOME)

 Less than 50%, the entire dividends are earned abroad NOTE: If ratio is less than 50% then the gross income from abroad will be deemed earned outside the PH, thus dividends will NOT be split to Within/Without PH (Refer to page 80) C. Merchandising Income – earned where the property is sold D. Manufacturing Income – earned where the goods are manufactured and sold OPERATIONS PRODUCTION

DISTRIBUTION

REMARK

Within

Within

Without

Without

Within

Without

Without

Within

INCOME SITUS RULES Types of Income 1. Interest Income 2. Royalties 3. Rent Income 4. Service Income

Place of Taxation (situs) Debtor’s Residence Where the intangible is employed Location of Property Place where service is rendered

OTHER INCOME SITUS RULES A. Gain on Sale of Properties a. Personal Property – i. Domestic Securities – presumed earned within PH ii. Other Personal Properties – earned where property is sold b. Real Property – earned where the property is located B. Dividend Income a. Domestic Corporation – presumed earned within b. Foreign Corporation i. Resident Foreign Corporation – depends on predominance test ii. Non-Resident Foreign Corporation – earned abroad *PRE-DOMINANCE TEST – if ratio of PH gross income over world gross income of the resident foreign corporation in the three-year period preceding the year of dividend declaration is:  At least 50% the portion of the dividend corresponding to the PH gross income ratio is earned within

Total Income from production and distribution earned WITHIN the PH Total Income from the production and distribution is earned WITHOUT the PH Production Income is earned within, Distribution Income is earned WITHOUT Distribution Income is earned within, Production Income is earned WITHOUT

NOTE: page 82  Home Office and Branch – NOT separate  Parent and Subsidiary - Separate...