Chapter 5 Income taxation PDF

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Chapter 5 Final Income Taxation This chapter discusses the features of final income taxation, the items of gross income, and class of taxpayer subject the final income tax. Final tax is one of the exemptions to the scope of the regular income tax. An excellent understanding of the items of passive i...

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Chapter 5 Final Income Taxation This chapter discusses the features of final income taxation, the items of gross income, and class of taxpayer subject the final income tax. Final tax is one of the exemptions to the scope of the regular income tax. An excellent understanding of the items of passive income and those taxpayers subject to final tax including their final tax rate is extremely crucial to your mastery of income taxation. FEATURES OF FINAL INCOME TAXATION 1. Final tax 2. Tax withholding at source 3. Territorial imposition 4. Imposed on certain passive income and persons not engage in business in the Philippines The Final Withholding System The final withholding system imposes upon the person making income payments the responsibility to withhold the tax. The text which will be deducted at source is final. The taxpayer receives the income net of tax and there would be no need for him to file an income tax return to report the same. The final withholding system is inherently territorial. It applies only to certain passive income earned from sources within the Philippines. Note that taxation is territorial and we cannot impose tax obligations (filing or withholding) against non-resident subjects of foreign sovereignty. Hence, all items of income earned from sources abroad, passive or active, are subject to tax under the general scope of the income tax. Rationale of Final Income taxation The final withholding tax is built upon taxpayer and government convenience that relieves the taxpayer of the obligation to file an income tax return. This is very convenient for taxpayers who are limited by distance, time and cost to comply. For the government, the final withholding system is the most convenient and effective system in collecting taxes on income where there is high risk of non-compliance or tax evasion. Under the NIRC, tax is imposed on certain passive income and upon non-resident persons not engaged in business in the Philippines. Passive income Items of passive income are earned with very minimal involvement from the taxpayer and are generally irregular in timing and amount. Unlike items of active income, they are not usually specifically monitored by taxpayers. When it's recorded by the taxpayer, their existence can be difficult to predict while the accrued amount may be difficult to determine. Thus, the final withholding tax income is the most favorable scheme in taxing items of passive income. Non-Resident Persons Not Engage In Business in the Philippines

Non-resident persons not engaged in trade or business in the Philippines such as nonresident aliens not engaged in trade or business and nonresident foreign corporation have higher risk of non-compliance. These taxpayers do not have offices or fixed places of business in the Philippines making the compliance very unlikely due to their absence and distance in the Philippines. Also the Philippine government cannot impose upon them the obligation in the return due to territorial consideration. Thus, the law subjects them to final income tax wherein Philippine residence paying them income, passive or active, is obligated to withhold the following final taxes: Non-resident persons not engaged in trade or business General final tax rate NRA-NETB. Non-resident foreign corporation.

25% 30%

PASSIVE INCOME SUBJECT TO FINAL TAX 1. Interest or yield from bank deposits or deposit substitutes 2. Domestic dividends in general 3. Dividend income from a Real Estate Investment Trust 4. Share in the net income of a business partnership, taxable associations, joint ventures, joint accounts, or co-ownership 5. Royalties in general 6. Prizes exceeding P10,000 7. Winnings 8. Informer's tax reward 9. Interest income on tax-free corporate covenant bonds FINAL TAX ON INDIVIDUALS AND CORPORATIONS Unless otherwise indicated, the final tax rates to be discussed in the following sections apply to all taxpayers (individuals and corporations) other than: A. Non-resident aliens not engaged in trade or business (NRA-NETB) B. Non-resident foreign corporation (NRFC) Interest Income or Yield Interest income or yield from local currency bank deposits or deposit institutions are subject to final tax as follows: Source of interest income Short term deposit Long term deposits/investment certificates

Individual 20% Exempt

Corporations 20% 20%

Short term deposits are those made for a period of less than 5 years. Long term deposits or investment certifications refer to certificate all time deposit or investment in the form of savings, individual trust bands, deposit substitutes, investment management accounts, and other investments with a maturity of not less than 5 years, the form of which should be prescribed by the BSP and issued by banks only (not by

non-bank financial institutions or finance companies) in individual in denomination of P10,000 and other denomination as may prescribed by the BSP. Illustration A taxpayer earned the following interest income from various time deposits: 6-month time deposit 2-year time deposit 5-year time deposit Total interest income

P

8,000 12,000 40,000 60,000

Compute the final tax if the taxpayer is an individual and if a corporation. Individual taxpayer: 6-month time deposit 2-year time deposit 5-year time deposit Final withholding tax

P

Corporation: Total interest income

8,000 x 20% 12,000 x 20% 40,000 x 0

P

1,600 2,400 0 4,000

60,000 x 20%

P

12,000

The exemption of individuals in interest income in long term deposits is anchored by the law that long term deposits are usually channeled in the financing of long term projects such as infrastructures, property development and other construction projects which are deeply associated in the development of the country. Note that exemption is limited only in individuals to the inclusion of corporations. . Illustration 2 A resident taxpayer received a P16,000 interest income from bank. Determine the final tax withheld at source. Solution Gross interest income (16,000/80%) Multiply by final tax rates Final tax withheld

P P

20,000 x 20% 4,000

Illustration 3 Banko Negro incurs the following interest in its savings and time deposit accounts from the following deposits:

Deposits Resident individuals Resident and domestic corporations Non-resident aliens not engaged in business

Amount 600,000 800,000 200,000

Non-resident corporations Total accrued interest expense

P

100,000 1,700,000

Compute the total final income tax to be withheld by Banko Negro. Deposits Amount Rate Final tax Resident individuals 600,000 x 20% 120,000 Resident and domestic corporations 800,000 x 20% 160,000 Non-resident aliens not engaged in 200,000 x 25% 50,000 business Non-resident corporations 100,000 x 30% 30,000 Total accrued interest expense P 1,700,000 P 360,000

Tax on pre-termination of long term deposits of individuals If the deposit or investment placement of individual taxpayers is pre-terminated before 5 years, any previously unearned or exempted interest income will be subjected to the following taxes upon pre-termination: Holding period Less than 3 years 3 years to less than 4 years 4 years to less than 5 years 5 years or more

Final tax 20% 12% 5% 0%

Illustration 1 On January 1, 2016, Alice invested P1,000,000 to Baguio Bank’s 5-year time deposit. The deposit pays 10% interest annually. Alice pre-terminated the deposit on July 1, 2019. The final tax on pre-termination will be computed as following: 2016 interest income (1,000,000 x 10%) P 2017 interest income (1,000,000 x 10%) 2018 interest income (1,000,000 x 10%) 2019 accrued interest income (1,000,000 x 10% x 6 months / 12 months) Total interest income Final tax rate applicable to less than 4-year pre-termination Final tax

100,000 100,000 100,000 50,000 350,000 12% 42,000

The net proceeds of the deposit and accrued interest to be released to the depositor upon pre-termination shall be: Principal balance Accrued interest for 2019 Final tax to be withheld

P

1,000,000 50,000 (42,000)

Net proceeds to be released to the depositor

P

1,008,000

Savings or time deposits with cooperatives are not subject to final tax The final tax is limited to banks and shall not be applied with time deposit with time and savings account deposit maintained by members with cooperatives and by primary cooperatives with their federations. (Dumaguete Cathedral Credit Cooperative vs. CIR,GR 152722) Other applications of the final tax on interest 1. Deposit substitute 2. Government securities 3. Money market placement 4. Trust funds 5. Other investments evidenced by certificates prescribed by BSP Deposit substitute means an alternative form of obtaining funds from at least 20 persons at any one time other than deposits through the issuance, endorsements or acceptance of debt instruments for the borrower’s own account for the purpose of relending or purchasing receivables and other obligations or financing their own needs or the needs of their agent or dealer. Foreign currency deposit with foreign currency depositary banks The interest income from foreign currency deposits under the foreign currency deposit system or expanded foreign currency deposit system is by residence is subject to a final tax of 15%. The old law imposed a rate of 7.5% until 2017. Taxpayer Residents Non-residents

Individual 15% exempt

Corporations 15% exempt

Note: 1. Resident taxpayers include resident aliens, resident citizens, domestic corporations and resident foreign corporations. 2. Non-resident taxpayers include non-resident citizens, non-resident aliens, and non-resident foreign corporations 3. It should be emphasized that non-resident aliens not engaged in trade or business (NRA-NETB) and non-resident foreign corporation (NRFC) are also exempted. 4. There is no long term or short term classification of foreign currency deposits.

The reduced final tax rates on interest income on foreign currency deposit and the exemption of non-resident depositors are intended to encourage the deposits of foreign currency in our banks which will be used in the financing of many international trades. Our Philippine peso is not globally accepted currency. The foreign trade will be limited without adequate foreign currency reserves in the banking sectors. Joint accounts on forex deposits If the bank account is jointly in the name of a non-resident and a resident taxpayer, 50% of the interest shall be exempt while the other 50% shall be subject to the 15% final tax. Illustration Mr. Samson is an Overseas Filipino Worker. He deposits all his savings in a savings account under foreign currency deposit unit (FCCU) of a domestic bank during the month, the savings deposit account earned $1,000 interest equivalent to P41,500. Scenario 1: He deposited his savings through the account of his resident wife. The final tax should be computed as follows. Interest income Final tax rate Final tax

P P

41,500 15% 6,225

Scenario 2: He deposited his savings through a joint account of his resident wife. The final tax should be computed as follows: Interest income Portion taxable Taxable interest income Multiply by final tax rate Total tax

P

P

41,500 50% 20,750 15% 3,112.50

Scenario 2: He deposited his savings account through his own account. In this case, the interest income shall be exempt from final tax. Interest income subject to regular tax Interest income from the following sources is subject to regular income tax, not to final tax: 1. Lending activities whether or not in the course of business 2. Investment in bonds 3. Promissory notes 4. Foreign sources whether bank or non-bank 5. Penalty for legal delay or default DIVIDENDS

Dividends means any distribution made by a corporation to its shareholders out of its earnings or profits and payable to its shareholders whether in money or in other property. Types of Dividends 1. Cash dividends – paid in cash 2. Property dividends – paid in non-cash properties including stocks or securities of another corporation 3. Scrip dividends – those paid in notes or evidence of indebtedness of the corporation 4. Stock dividends – paid in the stocks of the corporation 5. Liquidating dividends – distribution of corporate net asset As a rule, dividends are income subject to tax. However, the following are not income for taxation purposes. 1. Stock dividends Stock dividends representing transfer of surplus to capital account shall not be subject to tax. Stock dividends are in the form of increase in corporation value (capital gain) which should be properly taxable when realized through disposal or sale of the stocks investment. The distribution of stocks of another corporation as dividends is a taxable property dividend and not a stock dividend 2. Liquidating dividends Under the NIRC, the receipt of liquidating dividends is not viewed as income but as exchange of properties. When the liquidating dividends exceed the cost of the investments, the excess is taxable capital gain, subject to regular income tax. Any loss is deducted only to the extent of capital gain. Taxability of Stock Dividends Normally, stock dividends are exempt from income tax. Exceptionally, stock dividends are subject to tax at the fair value of the stocks received under the ff. conditions: a. Subsequent cancellation and redemption If a corporation cancels or redeem stocks issued as a dividend at such time and in such manner as to make the distributions and cancellations or redemption in whole or in part equivalent to the distribution of a taxable dividend, the amount so distributed shall be taxable to the extent it represents a distribution of earnings or profit. For instance, a corporation declared a stock dividend, and immediately called the stock dividends for redemption and cancellation. This act is equivalent to declaration of cash dividend.

b. If it leads to substantial alteration in ownership in the corporation Substantial alteration in ownership in a corporation may occur when stock dividends are given in lieu of cash dividends or when the corporation declared an optional stock or cash dividend. Stock dividend vs. stock split Stock dividend is a capitalization of earnings while stock split results in reduction of par value of stock and an increase in the number of shares of shareholders. Assuming a 2for-1 split, a shareholder holding one P50 par value stock will be given two P25 par value stocks. While stock dividend may be taxable under certain conditions, stock split will never be subject to income tax. Dividend Tax Rules Recepients Source of dividends Domestic corporations Foreign corporations

Individuals 10% final tax regular tax

Corporations exempted regular tax

Notes; 1. A NRA-ETB is subject to a 20% final tax on dividend, not to the usual 10% but a NRA-NETB is subject to a 25% final tax. 2. A NRFC is not exempt but is subject to the 30% general final tax rate. However, the imposable dividend tax shall be 15% when the tax sparing rule applies. Illustrative 1 Calhayog Company declared a total of P2,000,000 dividends. P800,000 is due to corporate shareholders while P1,200,000 is due to individual shareholders. The final tax to be withheld by the company shall be: Shareholders Individual shareholders Corporate shareholders Final tax

P

Amount 1,200,000 800,000

Rate x 10% x 0%

P P

Amount 120,000 0 120,000

Illustration 2 Abeclan Company declared a total of P1,000,000 dividends in March 2014. An analysis of the recipient shareholders is as follows. Shareholders Resident aliens and citizens NRAs engaged in trade and business NRAs not engaged in trade or business Total dividends

P

Amount 500,000 100,000 50,000 750,000

`

The total final tax to be withheld by the company shall be: Shareholders Dividends Resident aliens and citizens 500,000 NRAs engaged in trade or business 100,000 NRAs not engaged in trade or business 50,000 Non-resident foreign corporations 100,000 Total 750,000

Rate x 10% x 20% x 25% x 30%

Final tax 50,000 20,000 12,500 30,000 112,500

Historical dividend tax rates The imposable final tax rates vary depending on the source of the dividend declared. Source Earnings before January 1, 1998 Earnings from 1998 Earnings from 1999 Earnings from 2000 and therafter

Final tax exempt 6% 8% 10%

Any distribution made to the shareholders or members of a corporation are deemed to have been made from the most recently accumulated profits and shall constitute a part of the annual income of the distributee for the year which received. Exempt Dividends 1. Inter-corporate dividends 2. Dividends from cooperatives Inter-corporate Dividends Inter-corporate dividends received by a domestic corporation and resident foreign corporation froma domestic corporation are exempted under the NIRC to minimize double taxation. Illustration B Inc. owns 100% of A corp. during he year, A Corp declared P100,000 dividends. B Inc, in turn, declared the same dividends to its shareholders. Double taxation Dividends declared Less: 10% dividends tax Net dividends

P P

A Corp 100,000 10,000 90,000

P

B Inc 90,000 9,000 81,000

This is a form of direct duplicate taxation. To eliminate the impact of double taxation, inter-corporate dividends such as those declared by A Corp to B Inc is exempt from final tax.

The exemption extends to dividends received by business partnerships from domestic corporations since business partnerships are considered corporations under NIRC. However, the exemption does not extend to dividends received by general professional partnerships exempt joint ventures and exempt co-ownership because they are not considered corporations under the NIRC. On the other hand, the exemption of inter-corporate dividend does not apply to the share of a corporation from the net income of a business partnership due to absence of express legal exemptions. Exemption is restricted to dividend declaration only. Dividends from cooperatives Under the RA 9520, the distribution of dividends by an exempt cooperative to its members either representing interest on capital or as patronage refunds shall not be subject to tax. ENTITIES TAXABLE AS CORPORATIONS ARE SUBJECT TO 10% FINAL TAX The 10% final withholding tax also applies to dividends or share in the net income of entities considered corporations under the NIRC and special laws, such as: 1. Real rstae investment trusts 2. Business partnerships 3. Taxable associations 4. Taxable joint ventures, joint accounts or consortia 5. Taxable co-ownerships Real Estate Investment Trust (REIT) A REIT is a publicly listed corporations established principally for the purpose of owning income-generating real estate assets. The following recipients of REIT dividends are exempt from the final tax: a. Non-resident alien individuals or non-resident foreign corporations entitled to claim preferential tax rate pursuant to apllicable tax treaty. b. Domestic corporations or resident foreign corporation c. Overseas Filipino investors – exempt from REIT dividend tax until August 12, 2018 (7 years from the effectivity of RR13-2011which took effect on August 12, 2011)

Business partnership, taxable associations, joint venture, joint associates or coownerships Under sec. 73 of the NIRC, the net income of those entities is deemd constructively received by the partners, members or venturers respectively in the same year the net income is reported. Hence, the 10% final tax applies at the point of determination of the income, not at the point of actual distribution. Share in business partnership net income The share in net income includes the share in the residual p...