Income Taxation

I. Definition of Income Tax

It may be defined as (1) a tax on all yearly profits arising property, profession, trades or offices or (2) a
tax on a person's income, emolument, profits and the like. It may also be defined as a tax on income,
whether gross or net, realized in one taxable year.
II. Nature of Income Tax
Income tax is:
1. National Because it is collected by the BIR.
2. Excise It is a tax on the exercise of a profession or privilege; It is a tax on the right to earn
something.
3. Direct Impact and incidence of taxation is upon the taxpayer. It cannot be shifted to another,
thus it is also personal.
4. General Levied of all kinds of income. Note that income tax is source blind. In other words,
increase of income derived from illegal acts are still subject to income tax.
III. Purpose of Income Tax
The purpose of income tax maybe divided into two:
1. Fiscal purpose: To provide large amounts of revenue for the government
2. Non-fiscal purpose: To offset regressive sales and consumption of taxes; To mitigate the evils
arising in the unequal distribution of income and wealth.
IV. Definition of Terms
Income All wealth which flows into the taxpayer other than as a mere return of capital; includes the
forms of income specifically described as gains and profits, including derived from the sale or other
disposition of capital assets.
Simply, income means an accession to wealth, gain or flow of wealth.
Capital A fund or property existing at one point of time (while income denotes a flow of wealth
during a definite period of time). Capital is wealth, income is the flow of wealth. Capital should not be
subject to income tax.
Case Law: Madrigal vs. Rafferty
GR No. L-12287
Income as contrasted with capital or property is to be the test. The essential difference between
capital and income is that capital is a fund; income is a flow. A fund of property existing at an instant
of time is called capital. A flow of services rendered by that capital by the payment of money from it
or any other benefit rendered by a fund of capital in relation to such fund through a period of time is
called an income. Capital is wealth, while income is the service of wealth. (See Fisher, "The Nature of
Capital and Income.") The Supreme Court of Georgia expresses the thought in the following figurative
language: "The fact is that property is a tree, income is the fruit; labor is a tree, income the fruit;
capital is a tree, income the fruit." (Waring vs. City of Savannah [1878], 60 Ga., 93.) A tax on income is
not a tax on property. "Income," as here used, can be defined as "profits or gains."

Gain Transaction resulting in increase of wealth capable of pecuniary estimation

Gross income Income, in its broad sense, less income which is by statutory provision or otherwise
excluded from the tax imposed by law. This includes but not limited to the enumeration under Section
32a.
Gross income taxation A system of taxation where the income is taxed at gross. The taxpayers under
this system are not entitled to any deductions.
Net income taxation A system of taxation where the income is taxed at net. The taxpayer may claim
allowable deductions.
Passive income It refers to those items of gross income earned by the taxpayer without his active or
direct participation in the earning process.
Taxable income Pertinent items of income as specified in the Tax Code less the deductions and/or
personal and additional exemptions, if any, authorized for such types of income by the Code or other
special laws. It is the amount of income that is taxed.
V. Taxable Individuals
1. A Resident Citizen is taxable on all income derived from sources within and without (outside)
the Philippines.
2. A Nonresident Citizen is taxable only on incomes derived from sources within the Philippines.
3. An Overseas Contract Worker (OCW or OFW) is taxable only on income from sources within the
Philippines.
4. An Alien Individual, whether resident or not of the Philippines, is taxable only on income
derived from sources within the Philippines.
5. A Domestic Corporation is taxable on all income derived from sources within or without the
Philippines.
6. A Foreign Corporation whether engaged or not in trade or business in the Philippines, is
taxable only on income derived from sources within the Philippines.
VI. Criteria to Determine if Income is Taxable
The criteria to determine if income is taxable:
1. There is gain or profit;
2. The gain or profit is realized or received;
3. Such gain or profit is not exempt under any law or treaty;
A. There is gain or profit
Notes:
Condition based from closed and completed transaction
Determined if under employer-employee or practice of profession
Concept of accrual and deferral in accounting will not matter because:
Rendered the service: Taxable
Not rendered the service but received compensation: Taxable

B. The gain or profit is realized or received (Either actually or constructively)

Actually
Physical possession regardless whether there was service rendered or not
Constructively
The disposition is under your control although not yet received
Constructive Receipt Concept
Income which is credited to the account of or set apart for a taxpayer and which may be
drawn upon by him at any time is subject to tax for the year during which so credited or set
apart, although not then actually reduced to possession. The income must be credited to
the taxpayer without any substantial limitation or restriction as to the time or manner of
payment or condition upon which payment is to be made.
VII. Test of Income
The following are test for income:
1. Flow of Wealth Test
2. Realization Test
3. Economic-benefit Principle
4. Net Effect Test
5. Claim of Right Doctrine
A. Flow of Wealth Test
There is gain in a particular transaction. If there is gain, there is flow of wealth.
B. Realization Test
No taxable income until there is separation from capital of something of exchangeable value, thereby
supplying the realization or transmutation which would result in the receipt of income.
C. Economic-benefit Principle
Flow of wealth is taxable only when the taxpayer is economically benefited.
D. Net Effect Test
The substance of the whole transaction will be taken into consideration.
E. Claim of Right Doctrine
The service is already rendered or already parted ways with the consideration (goods were delivered)
then the claim of right accrues, which means that the ownership or control of the property/income
can already be claimed due to the fulfillment of the obligation.
VIII. Kinds of Taxable Income or Gain
A. Capital Gains
Gains or income from sale or exchange of capital assets. It can be realized in relation to capital asset.
Capital AssetsThe term 'capital assets' means property held by the taxpayer (whether or not
connected with his trade or business), but does not include stock in trade of the taxpayer or other
property of a kind which would properly be included in the inventory of the taxpayer if on hand at the
close of the taxable year or property held by the taxpayer primarily for sale to customers in the

ordinary course of his trade or business, or property used in the trade or business, of a character
which is subject to the allowance for depreciation provided in Subsection (F) of Section 34; or real
property used in trade or business of the taxpayer.
Capital gains includes:
1. Income from dealings in shares of stocks of domestic corporation whether or not through the
stock exchange;
Sale of shares of stocks
Listed and traded in the stock exchange
Exempt form Capital Gains Tax but subject to Stock Transaction Tax
Not listed or not traded in the Local Stock Exchange
Subject to Capital Gains Tax
2. Income from dealings in real property located in the Philippines;
Capital asset not used in trade or business and not primarily held for sale.
Sale of real property is located abroad?
Determine the owner of the real property. If owned by a resident citizen or domestic
corporation, it is taxable (worldwide). They will form part of the ordinary income.
3. Income from dealings in capital assets other than (a) and (b).
B. Ordinary Gains
Gains or income from the sale or exchange or property which are not capital assets.
Business income derived from business; merchandising, manufacturing, exercise of
profession;
Compensation income Presupposes employee-employer relationship
Passive income Received without any act from the taxpayer
Other income derived from whatever source
IX. Gross Income
Inclusions
A. Compensation
Notes:
This includes all renumeration for services performed by an employee for his employer under
an employer-employee relationship.
Wages and salaries, insofar as taxation is concerned, are just the same.
The renumeration referred here does not include:
For agricultural labor paid entirely in products of the farm where the labor is performed, or
For domestic service in a private home, or
For casual labor not in the course of the employer's trade or business, or
For services by a citizen or resident of the Philippines for a foreign government or an
international organization.
This includes the cash value all renumeration paid in any medium other than cash (like stocks
and other forms of properties)
B. Business Income
Notes

How computed?
Manufacturing, Merchandising and/or Mining Business: Gross Income = Total Sales less
Cost of Goods Sold plus other income from other investment
Service enterprises: Gross Income = Total receipts less Direct Cost

C. Gains derived from dealings in property

C.1. Shares of stock of a domestic corporation
Capital assets if not a dealer in securities
A dealer in securities (those engaged in the buying and selling of stocks), the shares of
stocks are considered as ordinary asset so subject to ordinary income tax rates
Listed and traded in local stock exchange
Subject to Stock Transactions Tax
Not listed or listed but not traded in local stock exchange
Subject to Capital Gains Tax
C.2. Real Property
If located in the Philippines
Subject to income tax if the seller is a real estate dealer
Subject to capital asset if the seller is not a real estate dealer
Note that if the sale is an involuntary sale, taxes should be counted from the date the
right to redeem the property has expired and it is based on the bid price, FMV or zonal
value, whichever is higher
If located outside the Philippines
Subject to graduated income tax for resident or normal corporate income tax (NCIT) for
corporation
C.3. Other Capital Asset
Subject to the graduated income tax for individuals or NCIT for corporations
Notes:
Capital losses can be offset only against and to the extent of the capital. Capital loss is different from
ordinary loss. Capital gain is different from ordinary gain.
Situs of Income
1. Compensation Income Place where the service is rendered
2. Merchandising Business Income Place where the business is undertaken
3. Manufacturing Business Income
Goods manufactured and sold within the Philippines Income derived purely within
Goods manufactured and sold outside the Philippines Income derived purely outside
Goods manufactured within the Philippines and sold outside the Philippines Income
partly within and partly without
Good manufactured outside the Philippines and sold within the Philippines Income partly
within and partly without
4. Income from Sale or Exchange of Property Personal property: Place of Sale; Real Property:
Place or location of real property

5.
6.
7.
8.

Interest Income Residence of the debtor/borrower

Rent Income Place where the property
Royalties Place where the intangible property is used
Dividends Received from domestic corporation: Income purely within; Received from foreign
corporation outside the income of the foreign corporation in the Philippines during the last
preceding 3 taxable years, following rules shall apply to wit:
1. The income is purely within if the income derived from the Philippines is more the 85%;
2. It is purely without the proportion of its Philippines income to the total income is less than
50%;
3. There should be an allocation if it is 50% but not more than 85%
9. Annuities Place where the contract was made
10. Prizes and Winnings:
If on account of services rendered: place where the services were rendered;
If not on account of service rendered: place where the same is given
11. Pension Place where this may be given on account of services rendered
12. Professional income of professional partners Place where the exercise of profession is
undertaken
Exclusion
Exclusions from Gross Income. - The following items shall not be included in gross income and shall
be exempt from taxation under this Title:
1. Life Insurance. - The proceeds of life insurance policies paid to the heirs or beneficiaries upon
the death of the insured, whether in a single sum or otherwise, but if such amounts are held
by the insurer under an agreement to pay interest thereon, the interest payments shall be
included in gross income.
Exceptions (Instances where it is subject to tax):
If insurer and insured agreed that the amount of the proceeds shall be withheld by the
insurer with the obligation to pay interest in the same, the interest will be subject to tax;
If there is transfer of the insurance policy
2. Amount Received by Insured as Return of Premium. - The amount received by the insured, as
a return of premiums paid by him under life insurance, endowment, or annuity contracts,
either during the term or at the maturity of the term mentioned in the contract or upon
surrender of the contract.
3. Gifts, Bequests, and Devises. - The value of property acquired by gift, bequest, devise, or
descent: Provided, however, That income from such property, as well as gift, bequest, devise or
descent of income from any property, in cases of transfers of divided interest, shall be included
in gross income.
4. Compensation for Injuries or Sickness. - amounts received, through Accident or Health
Insurance or under Workmen's Compensation Acts, as compensation for personal injuries or
sickness, plus the amounts of any damages received, whether by suit or agreement, on
account of such injuries or sickness.
5. Income Exempt under Treaty. - Income of any kind, to the extent required by any treaty
obligation binding upon the Government of the Philippines.
6. Retirement Benefits, Pensions, Gratuities, etc. Retirement benefits received under Republic Act No. 7641 and those received by officials
and employees of private firms, whether individual or corporate, in accordance with a

reasonable private benefit plan maintained by the employer: Provided, That the retiring
official or employee has been in the service of the same employer for at least ten (10)
years and is not less than fifty (50) years of age at the time of his retirement: Provided,
further, That the benefits granted under this subparagraph shall be availed of by an official
or employee only once. For purposes of this Subsection, the term 'reasonable private
benefit plan' means a pension, gratuity, stock bonus or profit-sharing plan maintained by
an employer for the benefit of some or all of his officials or employees, wherein
contributions are made by such employer for the officials or employees, or both, for the
purpose of distributing to such officials and employees the earnings and principal of the
fund thus accumulated, and wherein its is provided in said plan that at no time shall any
part of the corpus or income of the fund be used for, or be diverted to, any purpose other
than for the exclusive benefit of the said officials and employees.
Any amount received by an official or employee or by his heirs from the employer as a
consequence of separation of such official or employee from the service of the employer
because of death sickness or other physical disability or for any cause beyond the control
of the said official or employee.
The provisions of any existing law to the contrary notwithstanding, social security benefits,
retirement gratuities, pensions and other similar benefits received by resident or
nonresident citizens of the Philippines or aliens who come to reside permanently in the
Philippines from foreign government agencies and other institutions, private or public.
Payments of benefits due or to become due to any person residing in the Philippines under
the laws of the United States administered by the United States Veterans Administration.
Benefits received from or enjoyed under the Social Security System in accordance with the
provisions of Republic Act No. 8282.
Benefits received from the GSIS under Republic Act No. 8291, including retirement gratuity
received by government officials and employees.
7. Miscellaneous Items. Income Derived by Foreign Government. - Income derived from investments in the
Philippines in loans, stocks, bonds or other domestic securities, or from interest on
deposits in banks in the Philippines by (i) foreign governments, (ii) financing institutions
owned, controlled, or enjoying refinancing from foreign governments, and (iii) international
or regional financial institutions established by foreign governments.
Income Derived by the Government or its Political Subdivisions. - Income derived from any
public utility or from the exercise of any essential governmental function accruing to the
Government of the Philippines or to any political subdivision thereof.
Prizes and Awards. - Prizes and awards made primarily in recognition of religious,
charitable, scientific, educational, artistic, literary, or civic achievement but only if:
The recipient was selected without any action on his part to enter the contest or
proceeding; and
The recipient is not required to render substantial future services as a condition to
receiving the prize or award.
Prizes and Awards in sports Competition. - All prizes and awards granted to athletes in local
and international sports competitions and tournaments whether held in the Philippines or
abroad and sanctioned by their national sports associations.
13th Month Pay and Other Benefits. - Gross benefits received by officials and employees of

public and private entities: Provided, however, That the total exclusion under this
subparagraph shall not exceed eighty-two thousand pesos (P82,000) which shall cover:
Benefits received by officials and employees of the national and local government
pursuant to Republic Act No. 6686;
Benefits received by employees pursuant to Presidential Decree No. 851, as amended
by Memorandum Order No. 28, dated August 13, 1986;
Benefits received by officials and employees not covered by Presidential decree No.
851, as amended by Memorandum Order No. 28, dated August 13, 1986; and
Other benefits such as productivity incentives and Christmas bonus: Provided, That
every three (3) years after the effectivity of this Act, the President of the Philippines
shall adjust the amount herein stated to its present value using the Consumer Price
Index (CPI), as published by the National Statistics Office.
GSIS, SSS, Medicare and Other Contributions. - GSIS, SSS, Medicare and Pag-Ibig
contributions, and union dues of individuals.
Gains from the Sale of Bonds, Debentures or other Certificate of Indebtedness. - Gains
realized from the same or exchange or retirement of bonds, debentures or other certificate
of indebtedness with a maturity of more than five (5) years.
Gains from Redemption of Shares in Mutual Fund. - Gains realized by the investor upon
redemption of shares of stock in a mutual fund company as defined in Section 22 (BB) of
this Code.

X. Allowable Deductions
A. Basic Principles Governing Deductions
1. The taxpayer seeking deductions must point to some specific provisions of the statute
authorizing the deduction, and
2. He must be able to prove that he is entitled to the deduction authorized or allowed
3. Doubtful provisions pertaining to deductions are strictly construed against the taxpayer and
liberally construed against the government
4. You must be able to follow statutory requirements
B. Kinds of Allowable Deductions
1. Personal and additional deductions or exemptions
Equivalent to 50,000 regardless of civil status
Does not apply to corporate taxpayers
Additional deductions/exemptions pertaining to children
25,000 per child
Up to 4th child
2. Itemized deductions
3. Optional Standard Deduction of forty percent (40%) of gross income
XI. Non-deductible Items
1. Personal living or family expense
2. Amount paid for new buildings or permanent improvements, or betterment to increase the
value of any property or estate
3. Any amount expended in restoring property or in making good the exhaustion thereof for
which an allowance is or has been made

4. Premium paid on any life insurance policy covering the life of any officer or employee or of any
person financially interested in any trade or business carried on by the taxpayer, individual or
corporate, when the taxpayer is directly or indirectly a beneficiary under such policies
5. Losses from sale or exchanges of property directly or indirectly:
Between members of a family;
Except in case of distributions in liquidation, between an individual and a corporation
more than 50% in value of the outstanding stock of each of which is owned directly by or
for such individual;
Except in case of distributions in liquidation, between two corporation more than 50% in
value of the outstanding stock each of which is owned, directly or indirectly, by or for same
individual, if either one of such corporation is a personal holding company; or
Between the grantor and a fiduciary of any trust;
Between fiduciary of a trust and the fiduciary of another trust, if the same person is a
grantor with respect to each trust; or
Between a fiduciary of a trust and a beneficiary of such trust.