Income taxation chapter 5 notes PDF

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CHAPTER 5 FINAL INCOME TAXATIONFEATURES OF FINAL INCOME TAXATION Final tax Tax withholding at source Territorial imposition Imposed on certain passive income and persons not engaged in business in the Philippines The Final withholding system The final withholding system imposes upon the person maki...

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(NRA-NETBs) and non-resident foreign corporations (NRFCs), have high risk of non-compliance. These taxpayers do not have offices or fixed places of business in the Philippines making tax compliance very unlikely due to their absence and distance in the Philippines. Also, the Philippine government cannot impose upon them the obligation to file return due to territorial consideration. Thus, the law subjects them to final income tax final wherein Philippine residents paying them income, passive or active, are obligated to withhold the following final tax:

CHAPTER 5 FINAL 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 engaged in business in the Philippines

The Final withholding system 

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The final withholding system imposes upon the person making income payments the responsibility to withhold the tax. The tax 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 obligation (filing or withholding) against nonresident 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 regular income tax.

Rationale of Final Income Taxation 

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The final withholding tax is built upon taxpayer and government convenience relieves the taxpayer of the obligation to file an income tax return. This 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, final income tax is imposed on certain passive income and upon non-resident persons not engaged in business in the Philippines.

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Non-resident person not engaged in trade or business. Non-resident alien not engage in trade or business Non-resident foreign corporation

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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 not recorded by the taxpayer, their existence can be difficult to predict while their actual amount may be difficult to determine. Thus, the final withholding at source is the most favored scheme in taxing items of passive income. Non-resident persons not engaged 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

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 association, 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 

Passive income 

General final tax rate

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 alien not engaged in trade or business (NRA-NETB), and b. Non-resident foreign corporation (NRFC).

INTEREST INCOME OR YIELD 

Interest income or yield from local currency bank deposits or deposit substitutes are subject to final tax as follows:

Source of interest income Short term deposits Long-term deposits/investment certificates

Recipient Individuals Corporations 20% 20% Exempt* 20%

Note: *Exemption does not include NRA-NETB  Short term deposits are those made for a period of less than five years.  Long-term deposits or investment certificates refer

to certificate of time deposit or investment in the

form of savings, common or individual trust funds, deposit substitutes, investment management accounts, and other investments with a maturity of not less than five years, the form of which shall be prescribed by the BSP and issued by banks only (not by non-bank financial intermediaries or finance companies) to individuals in denominations of P10,000 and other denominations as may be prescribed by the BSP. (RMC 18-2011) Illustration 1 A taxpayer earned the following interest income from various time deposits: 6-month time deposit P 8,000 2-year time deposit 12,000 5-Year time deposit 40.000 Total interest income P 60,000 Required: Compute the final tax if the taxpayer is an individual and if a corporation. Solution: Individual taxpayers 6-month time deposit P 8,000 x 20% P 1,600 2-year time deposit 12,000 x 20% 2,400 5-year time deposit 40,000 x 0% 0 Final withholding tax P 4,000 Corporate taxpayers P 60,000 x 20% P 12.000  The exemption of individuals on interest income on long-term deposits is anchored on the fact that longterm deposits are usually channeled to the financing of long-term projects such as infrastructures, property developments, and other construction projects which are deemed essential to the development of the country.  Note that exemption is limited only to individuals to the exclusion of corporations. Illustration 2 A resident taxpayer received a P16,000 interest income from a bank. Determine the final tax withheld at source. Solution: Gross interest income (P16,000/80%) P 20,000 Multiply by: final tax rates 20% Final tax withheld P 4,000 Illustration 3 Banko Negro incurs the following interest in its savings and time deposit accounts from the following depositors: Depositors Amount Resident individuals P 600 000 Resident and domestic corporations 800 000 Non-resident aliens not engaged in business 200 000 Non-resident corporations 100 000 Total accrued interest expense P 1 700 000

Required: Compute the total final income tax to be withheld by Banko Negro.

Solution: Depositors Amount Rate Final Tax Resident individuals P 600,000 x 20% P120,000 Resident/domestic corporations 800,000 x 20% 160,000 NRA-NETB 200,000 x 25% 50,000 NRFCs 100 000 x 30% 30,000 Total accrued interest expense P1 700 000 360,000

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 untaxed or exempted interest income will be subjected to the following final taxes upon pretermination:

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 in 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 follows: 2016 interest income (P1,000,000 x 10%) P 100,00 2017 interest income (P1,000,000 x 10%) 100,00 2018 interest income (P1,000,000 x 10%) 100,00 2019 accrued interest income (P1,000,000 x 10% x 6 months/12 months) 50,000 Total interest income P 350,000 Final tax rate applicable to less than 4-year pre-termination 12% Final tax P 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 Net proceeds to be released to the depositor

P 1,000,000 50,000 ( 42,000) 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 and savings account deposit maintained by members with cooperatives and by primary cooperatives with their federations. (Dumaguete Cathedral Credit Cooperative vs. CIR, G.R. 182722)

Other applications of the final tax on interest 1. Deposit substitute 2. Government securities 3. Money market placements

4. Trust Funds

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5. Other investment evidenced by certificates prescribed by the Bangko Sentral ng Pilipinas (BSP) Deposit substitute means an alternative form of obtaining funds from at persons at any one time other than deposits through the Issuance, endorse ' acceptance of debt Instruments for the borrowers own account, for the purpose of relending or purchasing of receivables and other obligations, or financing their own needs or the needs of their agent or dealer. Government debt instruments and securities including Treasury bonds, Treasury bills and treasury notes shall be considered as deposit substitute irrespective of number of lenders at origination if such debt instruments and securities are to traded or exchanged in the secondary market.

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 by residents subject to a final tax of 15%.  The old law imposed a rate of 7.5% unti12017. Taxpayers Individuals Corporations Residents 15% 15% Non-residents Exempt Exempt Note: 1. Resident taxpayers include resident citizens, resident aliens, domestic corporations and resident foreign corporations. 2. Non-residents taxpayers include non-resident citizens, non-resident aliens and non- foreign resident corporations 3. It should be emphasized that NRA-NETBs and NRFCs are also exempt 4. There is no long-term or short-term classification of foreign c exempt current, deposits.  The reduced final tax rates on interest income on foreign currency deposit and the exemption of nonresident depositors are intended to encourage the deposit of foreign currencies in our banks which will be used in the financing of our international trades.  Our Philippine peso is not a globally accepted currency.  Our foreign trade will be limited without adequate foreign currency reserves in our banking sector 

Joint accounts on forex deposits 

If the bank account is jointly in the name of a non-resident taxpayer, 50% of the interest shall be exempt while the other 50% shall be subject to the 15% final tax.

Illustration Mr. Siman is an Overseas Filipino Worker. He deposits all his savings in a savings account under the foreign currency deposit unit (FCDU) of a domestic bank. During the month, the savings deposit account earned $1,000 interest equivalent to P41,500. Scenario 1: Mr. Siman deposited his savings through the account of his resident wife. The final tax shall be computed as follows: Interest income P 41,500.00 Final tax rate 15% Final tax P 6,225.00 Scenario 2: Mr. Siman deposited his savings through a joint account with his resident wife. The final tax shall be computed as follows: Interest income P 41,500.00 Portion taxable 50% Taxable interest income P 20,750.00 Multiply by: final tax rate 15% Final tax P 3,112.50 Scenario 3: Mr. Siman 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. Investments 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. (Sec. 73, NIRC) 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 corporation 4. Stock dividends - paid in the stocks of the corporation 5. Liquidating dividends - distribution of corporate net asset As a rule, dividends are incomes subject to tax. However, the following are tax 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 corporate value (i.e. 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 a taxable capital gain, subject to regular income tax.  Any loss is deductible 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 following conditions: a. Subsequent cancellation and redemption If a corporation cancels or redeems stock issued as a dividend at such time and in such manner as to make the distribution and cancellation 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 stock dividends and immediately called the stock dividends for redemption and cancellation. This act is equivalent to declaration of cash dividends. 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 as capitalization of earnings  Stock split results in reduction in the par value of stock and increase in the number of shares of shareholders.  Assuming a 2-for-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 Source of dividends Domestic corporation Foreign corporation

Recipient of dividends Individuals Corporation s 10% final tax Exempt Regular tax Regular tax

Note: 1. A NRA-ETB is subject to a 20% final tax on dividend, not to the usual 10%; but an 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. This will be discussed later. Illustrative 1 Calbayog 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 Calbayog Company shall be: Shareholders Amount Rate Amount Individual shareholders P 1,200,000 x 10% P 120,000 Corporate shareholders 800,000 x 0% 0 Final tax P 120,000

Illustrative 2 Aborian Company declared a total of P1,000,000 dividends in March 2014. An analysis of the recipient shareholders is as follows: Shareholders Amount Resident aliens and citizens P 500,000 NRAs engaged in trade or business 100,000 NRAs not engaged in trade/business 50,000 Non-resident corporations 100,000 Total dividends P 750,000 The total final tax withheld by Aborian Company shall be: Shareholders Dividends Rate Final Tax Resident aliens and citizens P500 000 x 10% P50 000 NRAs engaged in trade or business 100 000 x 20% 20 000 NRAs – NETBs 50 000 x 25% 12 500 NRFCs 100 000 x 30% 30 000 Total P750 000 P112 500

Historical dividend tax rates The imposable final tax rates vary depending on the source of the declared: Source Final tax Earnings before January 1, 1998 Exempt Earnings from 19911 6% Earnings from 1999 8% Earnings from 2000 and thereafter 10% Any distribution made to the shareholders or members of a corporation shall deemed to have been made from the most recently accumulated profits or surplus. and shall constitute a part of the annual income of the distribute

for the year which received. (Sec, 73(0, NIRC)

5. 5. Taxable co-ownerships

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 from a domestic corporation are exempted under the NIRC to minimize double taxation. Illustration B, Inc. owns 100% of A Corp. During the year. A Corp. declared P100 000 dividend to B, Inc.B, in turn declared the same dividends to its shareholders. The following table illustrates the double taxation: A Corp. B. Inc Dividends declared P 100 000 90 000 Less: 10% dividends tax 10 000 9 000 Net dividends P 90 000 81 000  This is 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 exempted from final tax.  When the dividend finally falls to an individual shareholder, the 10% final tax applies.  This exemption extends to dividends received by business partnerships from domestic corporations since business partnerships are considered corporations under the NIRC.  However, the exemption does not extend to dividends received by general professional partnership, exempt joint ventures and exempt coownership 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 exemption.  Exemption is restricted to dividend declaration only.

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Dividends from cooperatives 

Under 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 Estate Investment Trusts 2. Business partnerships 3. Taxable associations 4. Taxable joint ventures, joint accounts or

Real Estate Investment Trust or REIT A REIT is a publicly listed corporation established principally for the purpose of owning incomegenerating 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 applicable tax treaty. b. Domestic corporations or resident foreign corporations c. Overseas Filipino investors - exempt from REIT dividend tax until August 12, 2018 (7 years from the effectivity of RR13-2011 which took effect on August 12, 2011) 

Business partnership, taxable associations, joint venture, joint accounts or co-ownerships Under Sec. 73 of the NIRC, the net income of these entities is deem 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 t...