Finals Reviewer Tax 1

FINALS REVIEWER TAXATION 1 – Prof. Othelo Carag

Passive income 



Passive income is income derived not from direct or active practice of trade, industry or profession. It is “passive” because it is income that originates from an existing asset or investment (or an offshoot of an asset) and it is earned without active participation on the part of the taxpayer. Rather than being subject to the graduated income tax (in case of individuals) or the regular corporate income tax (RCIT, in case of corporations), certain passive income are subject to final tax. (Refer to 24.B for individuals and 27.D for corporations)

What are considered as passive income? 1. Interest income (see page 1) 2. Dividend income (see page 2) 3. Royalty income 4. Rental income 5. Annuities/proceeds from life insurance/other types of insurance 6. Prizes and awards 7. Pensions/retirement benefits 8. Income from whatever source

Coverage: Passive income (p. 18 of course outline) onwards Prepared by C. Gomez

Interest income Rules on Interest income Source General rule Exceptions

Residence of debtor, source within the Phils. Included in gross income 1. If exempt from tax 2.

Subject to final tax at preferential rate

Interest income subject to final tax Type Interest on any currency bank deposit Yield or any other monetary benefit from deposit substitutes, trust funds, and similar arrangements Interest income received from a depositary bank under the FCD system Interest income from long-term deposits or investment

Individual (24.B.1) NRA-ETB RA

RC

NRC

20%

20%

20%

20%

20%

20%

20%

20%

7½%

Exempt

7½%

Exempt

Holding period > 5 years 4 to < 5 years 3 to < 4 years < 3 years

Final tax Exempt 5% 12% 20%

Corporation NRA-NETB

DC (27.D.1)

RFC (28.A.7)

Part of gross income

20%

20%

Part of gross income

Part of gross income

20%

20%

Part of gross income

7½%

7½%

Exempt

Exempt 25% 25% 25%

20%

Interest income subject to final tax of certain corporations Creditor (interest income derived by)

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Exempt

Not subject to final tax. Included as part of gross income.

Interest on foreign loans

Depository banks under the expanded FCD system (28.A.7.b) Offshore banking units (28.A.4)

NRFC

Debtor Residents

Non-resident

10%

Exempt

10%

Exempt

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FINALS REVIEWER TAXATION 1 – Prof. Othelo Carag

Coverage: Passive income (p. 18 of course outline) onwards Prepared by C. Gomez

Dividend income Rules on Dividend income Source General rule Exceptions

Royalty income Mamalateo: Royalty is valuable property than can be developed and sold on a regular basis for a consideration.

Residence of corporation paying dividends Included in gross income 1. If exempt from tax 2. Subject to final tax at preferential rate Total amount received subject to income tax FMV of property received subject to income tax General rule: not taxable Exception: gain resulting from a change in interest subject to income tax Not taxable (return of capital) Any distribution made by a corporation to its shareholders, whether in money or other property, out of its earnings or profits is subject to income tax. (CIR v Manning 66 SCRA 14)

Cash dividend Property dividend Stock dividend

Liquidating dividend Disguised dividend

Dividend income subject to final tax Payor Recipient>> Domestic corporation Joint stock company Insurance or mutual fund company Regional operating headquarters of multinational company Business partnership

RC

Individual (24.B.2) NRA-ETB NRC RA

Corporation NRA-NETB

DC (27.D.4)

RFC (28.A.7.d)

Exempt

Exempt

Exempt

Exempt

Exempt

Exempt

(25.A.2)

10%

10%

10%

20%

10%

10%

10%

20% Part of gross income

10%

10%

10%

20%

10%

10%

10%

20%

Exempt

Exempt

10%

10%

10%

20%

Exempt

Exempt

NRFC (28.B.5.b)*

15% if there is tax sparing credit, or simply part of gross income

Rules on Royalty income Source General rule Exceptions

Location of the property or interest in the property Included in gross income (active business income) Subject to final tax at preferential rate (royalty received from another for the use of taxpayer’s intellectual property—passive income)

Royalty income subject to final tax The following table applies if the royalties are received from sources within the Philippines. Type of Royalty

Individual (24.B.1) NRA-ETB RA

Corporation

(25.A.2)

DC (27.D.1)

RFC (28.A.7.d)

20% 10%

20% 10%

20% 20%

20% 20%

10%

10%

10%

20%

20%

10%

10%

10%

20%

20%

Recipient>>

RC

NRC

Royalties, in general Royalties on books Royalties on literary works Royalties on musical compositions

20% 10%

20% 10%

10% 10%

NRA-NETB

Part of gross income

Part of gross income

If, however, a resident citizen or a domestic corporation receives royalties from sources without the Philippines (foreign corporations), they are taxable using the graduated income st tax table (in case of individuals) or RCIT (in case of corporations). Source: Mamalateo 1 edition, p. 135.

Taxable intercorporate dividends – dividends received by NRFC These dividends are subject to final tax of 15% if: 1. Paying corporation is a domestic corporation 2. Receiving corporation is an NRFC 3. Country in which NRFC is domiciled allows credit against the tax due from the NRFC tax deemed paid equivalent to 15% (Difference between RCIT of 30% and final tax of 15%) *If dividends received by NRFC do not qualify as enumerated above, included as part of gross income, taxable at a fixed rate of 35%.

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NRFC (28.B.5.b)*

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FINALS REVIEWER TAXATION 1 – Prof. Othelo Carag

Coverage: Passive income (p. 18 of course outline) onwards Prepared by C. Gomez

Rental income

Prizes & Awards

Rules on Rental income Source General rule

Rules on Prizes and awards General rule Exceptions

Location of the property or interest in the property Included in gross income

Special issues on Rental income Tax treatment of leasehold improvements by lessee – taxable income if the ownership of such improvements will transfer to the lessor at the end of the lease term. Taxable based on the fair market value of such improvements either as a one-time charge or on a staggered basis. Tax treatment of advance rental/long-term lease – if prepaid, considered as taxable income when received.

Annuities/Proceeds from life insurance

Included in gross income If subject to final tax

Prizes and awards subject to final tax Type of Prize/award Recipient>>

RC

NRC

Prizes in general Prizes amounting to P10k or less Winnings in general Winnings from PCSO

20%

20%

Individual (24.B.1) NRA-ETB RA 20%

Corporation NRA-NETB

(25.A.2)

DC (27.D.1)

RFC (28.A.7.d)

20%

20%

20%

20%

20%

20%

20%

20%

20%

Part of gross income 20%

20%

20%

20%

Part of gross income

Rules on Annuities/proceeds from insurance General rule The proceeds of life insurance policies paid to heirs or beneficiaries upon the death of the insured should be treated as indemnity and not as gain or income. (32.B.1 and 32.B.2) Exceptions 1. If such amounts are held by the insurer under an agreement to pay interest thereon, such interest payments shall be included in gross income. 2. Subject to estate tax if proceeds are from a life insurance and: a. Decedent is the policy owner and the beneficiary is the estate b. Decedent is the policy owner and the beneficiary is any other person, but such designation is revocable Summary table Excluded from gross income Excluded from gross estate Included in gross estate (taxable – estate tax)

All proceeds from life insurance 1. Decedent is not the policy holder 2. Designation of beneficiary is irrevocable 1. Decedent is policy holder and beneficiary is the estate, whether or not irrevocable 2. Decedent is the policy holder and beneficiary is anybody, but such designation is revocable

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NRFC (28.B.5.b)*

Part of gross income

FINALS REVIEWER TAXATION 1 – Prof. Othelo Carag

Coverage: Passive income (p. 18 of course outline) onwards Prepared by C. Gomez from sources within the Philippines so long as the services were performed in the Philippines, regardless of: 1. Residence of the payor 2. Place where the contract was executed 3. Place of payment

Situs/Sources of Income

Other rules pertaining to income from services: 1. Rendered partly in the Philippines and partly outside, formula as follows:

Situs vs. Source Source of income – not a place but an activity or property from which income is derived; That activity which produced the income; conveys one essential idea, that of origin (Commissioner vs. BOAC 149 SCRA 395) Situs of income – location of taxing authority or place where the source of income should be taxed Classification of income as to source (Sec. 42) 1. Income from sources within the Philippines 2. Income from sources outside the Philippines 3. Income partly from sources within and partly outside the Philippines

2.

General rule The place of the contract is not a sole criterion that exclusively determines situs. Place of activity, not place of business, is controlling. Rules on Sources of Income Type of income Interest

Dividends

Within the Philippines (Sec 42.A) Interest on bonds, notes, or other interest-bearing obligations of residents, corporate or otherwise (42.A.1) Hence, interest income is to be considered to be derived from Philippine sources if the debtor, whether an individual or a juridical person and whatever debt instrument, is a resident of the Philippines Amount received as dividends from a: 1. Domestic corporation 2. Foreign corporation, if at least 50% of the gross income of such corporation for the 3-year period ending with the close of the taxable year preceding the declaration of such dividends was derived from sources within the Philippines; dividend from source within the Philippines shall be computed only in the same proportion with the gross income derived from sources within the Philippines. (42.A.2) Computation as follows:

Services

Compensation for labor or personal services performed in the Philippines (42.A.3) Hence, income from services shall be considered to have been derived

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Rentals and royalties Sale of property Real Personal

International shipping line – Gross Philippine billings or all revenues originating from the Philippines up to final destination, regardless of the place of sale or payment of tickets 3. International air carrier – Gross Philippine billings or all revenues originating from the Philippines in a continuous and uninterrupted flight, irrespective of the place of sale or payment of the ticket a. Flight originating from the Philippines, but transshipment takes place at any port outside involving another carrier – Only income from such leg flown from the Philippines to such other port shall be considered derived from the Philippines b. Ticket sold by foreign carrier through an agent in the Philippines – The sale of tickets in the Philippines is the activity that produces income. Hence, such sales, although pertaining to travel between countries other than the Philippines, is considered income derived from sources within the Philippines (Commissioner vs. BOAC) 4. Turnkey contracts – income from such services are to be considered within the Philippines if the services for design, fabrication, engineering, and manufacture, not merely assembly and installation, were rendered in the Philippines. (Commissioner vs. Marubeni) Rentals and royalties from property located in the Philippines. (42.A.4) Gains, profits, and income from the sale of real property located in the Philippines. (42.A.5) General rule Income derived from country where such personal property was sold. Place of sale is determine by when or where the title passes from the buyer to the seller. Exceptions 1. Sale of shares of stock of a domestic corporation – income derived from such sale shall always be considered as from sources within the Philippines, regardless where such shares were actually sold. 2. Produced in whole or in part by the taxpayer within the Philippines and sold outside 3. Produced in whole or in part by the taxpayer outside the Philippines and sold within Page 4 of 10

FINALS REVIEWER TAXATION 1 – Prof. Othelo Carag Computation of taxable income from sources within the Philippines Deductions General rule, as to deductions

Exceptions

Items of deductions to be allowable must be effectively connected with the business or trade conducted exclusively within the Philippines and fully substantiated by all the information necessary for its calculation. (42.B.1) Interest expense will only be deductible if the funds obtained from the loan to which such interest is related to were for use in connection with the conduct or operation of trade or business in the Philippines.

Formula

*If deductions can be directly attributed to gross income derived from sources either within the Philippines or outside, the portion to be deducted as pertaining to Philippine sources is to be computed as follows:

Coverage: Passive income (p. 18 of course outline) onwards Prepared by C. Gomez

Exclusions from Gross Income What is gross income (32.A) All income derived from whatever source, including (but not limited to) the following items: 1. Compensation for services in whatever form paid, including, but not limited to, fees, salaries, wages, commissions, and similar items; 2. Gross income derived from the conduct of trade or business or the exercise of a profession 3. Gains derived from the dealings in property 4. Interests 5. Rents 6. Royalties 7. Dividends 8. Annuities 9. Prizes and winnings 10. Pensions 11. Partner’s distributive share from the net income of a general professional partnership

Exclusions An item may not be taxable for any of the following reasons: 1. The item of receipt does not fall within the meaning of income for income tax purposes (e.g. return of capital) 2. A provision of law exempts it from income tax a. Under the Constitution b. Under the Tax Code c. Under special laws Exclusions under the Constitution All assets and revenues of a non-stock, non-profit private educational institution used directly, actually, and exclusively for private educational purposes shall be exempt from taxation. Exclusions under the Tax Code (32.B) Item of income excluded Proceeds from life insurance

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Remarks Proceeds are excluded from the gross income of the beneficiary, but may be subject to estate tax if: 1. Decedent is policy holder and beneficiary is the estate, whether or not irrevocable 2. Decedent is the policy holder and beneficiary is anybody, but such Page 5 of 10

FINALS REVIEWER TAXATION 1 – Prof. Othelo Carag

Coverage: Passive income (p. 18 of course outline) onwards Prepared by C. Gomez designation is revocable

Amount received by insured as return of premium

Gifts, bequests, and devises

Compensation for injuries or sickness

Income exempt under treaty Retirement benefits, pensions, gratuities, etc. Retirement benefits under RA 7641

Amount received by an employee or his heirs as a consequence of separation from employment

Interest paid by the insurer in connection with the proceeds are included in gross income. (32.B.1) These are considered returns of capital or the premiums paid. If the aggregate amounts received exceed the premiums paid, the excess shall be included in gross income. (32.B.2) These are not subject to income tax, but to estate or donor’s tax. Income derived from such property shall, however, be subject to income tax. Any amount received as an indemnity (proceeds of insurance, damages recovered, etc.) is excluded from gross income.

Reasonable private benefit plan Pension, gratuity, stock, bonus, or profitsharing plan maintained by an employer for the benefit of some or all of his officials or employees, where in contributions are made by such employer or the employees or both for the purpose of distributing such earnings and principal thus accumulated to the employees. Requisites a. Employee has been in the continuous service of the same employer for at least 10 years b. Employee is not less than 50 years of age c. Benefits shall be availed of only once Requisites a. Employee is separated from the service of the employer due to death, sickness, or other physical disability or for cause beyond his control b. The employer pays benefits to the official or employee or his heirs as a consequence of his separation

gratuities, pensions, and other similar benefits Payments of benefits in relation to US Veterans administration SSS benefits GSIS benefits Miscellaneous items Income derived by foreign government

Income derived by the Government or its political subdivision Prizes and awards – religious, charitable, scientific, artistic, literary

Prizes and awards in Sports Commission

th

13 month pay and other benefits GSIS, SSS, Medicare, and other contributions Gains from the sale of bonds, debentures, or other certificates of indebtedness Gains from redemption of shares in mutual fund.

Income of: 1. Foreign governments 2. Financing institutions owned and controlled or enjoying refinancing from foreign governments 3. International or regional financial institutions established by foreign governments, received from their investments in the Philippines The government cannot logically tax itself. Requisites a. Recipient was selected without any action on his part to enter the contest or proceeding b. The recipient was not required to render substantial future services as a condition to receiving the prize Prizes from PCSO and lotto winnings shall be exempt from tax (24.B.1) 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 the Philippine Olympic Committee. Only up to the extent of P30,000.

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FINALS REVIEWER TAXATION 1 – Prof. Othelo Carag

Coverage: Passive income (p. 18 of course outline) onwards Prepared by C. Gomez

Exclusions under special laws 1. PAGCOR (PD 1869) 2. Gain arising from the transfer of agricultural land (CARP) 3. Interest on bonds paid by the NPC to its foreign bondholders (RA 6975) 4. BSP (RA 7459) 5. PEZA-registered enterprises (PEZA law) 6. Special-purpose vehicles (RA 9182) 7. BOI-registered entities (Omnibus investments act)

Costs, Deduction, & Personal Exemptions

Exempt Corporations

1. 2.

See discussion under tax on corporations.

Deductible costs Cost of goods sold Cost of services

Deductions, in general General rules 1. Strictly construed against taxpayers claiming it 2. Must be paid or incurred in connection with the taxpayer’s trade, business, or profession 3. Must be supported by adequate receipts or invoices (except for OSD) Deductions from gross income per taxpayer Individuals 1. Citizens 2. Resident aliens 3. Nonresident aliens engaged in trade or business With gross compensation With gross income from income only business or practice of a profession 1. Optional Standard Deduction (OSD) 2. Itemized deductions 1. Premium payments on 3. Premium payments on health and/or health and/or hospitalization hospitalization insurance insurance 2. Personal exemptions 3. Personal exemptions

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Corporations 1. Domestic corporations 2. Resident foreign corporations 3. Taxable partnerships 4. Estates and trusts

1.

OSD

2.

Itemized deductions

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FINALS REVIEWER TAXATION 1 – Prof. Othelo Carag

Coverage: Passive income (p. 18 of course outline) onwards Prepared by C. Gomez

Itemized Deductions Deduction Business expenses

Interest

2.

Remarks Requisites for deductibility 1. Must be ordinary and necessary 2. Paid or incurred within the taxable year 3. Incurred in carrying on, or directly attributable to, the development, management, operation and/or conduct of the trade or business, or the exercise of a profession 4. Substantiated by official receipts and other adequate records Examples of business expenses 1. Salaries, wages, and other forms of compensation for personal services, including grossed up monetary value of fringe benefits, the FBT for which has been duly paid. 2. Traveling/transportation expenses – incurred while away from home 3. Cost of materials 4. Rent 5. Repairs and maintenance – incurred to keep the property used in the trade or business in an ordinarily efficient operating condition. 6. Expenses under lease agreements 7. Professional fees 8. Entertainment expenses Ceiling a. Merchandising/manufacturing entity – 0.5% of net sales b. Service entity – 1% of net revenues 9. Political campaign expenses 10. Training expenses Requisites for deductibility 1. There must be an indebtedness 2. Indebtedness must be that of the taxpayer 3. Interest must be legally due and stipulated in writing 4. Interest expense must be paid or incurred within the taxable year 5. Indebtedness must be connected with the taxpayer’s trade, business, or exercise of profession Non-deductible interest expense 1. Interest incurred abroad by non-resident parent lending institution 2. Interest on preferred stocks 3. Interest on loans between related parties 4. Interest paid on earned but unpaid salary 5. Interest on indebtedness incurred to finance petroleum operations 6. Interest on indebtedness for purely personal reasons Other issues regarding interest expense 1. Interest paid in advance – interest shall be deductible in the year

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the principal indebtedness is paid Reduction of interest expense – formula

3.

Taxes

Interest expense incurred to acquire property for use in trade/business/profession – may be, at the option of the taxpayer, be included in the cost of such asset or property Requisites for deductibility 1. Taxes are imposed by law upon the taxpayer 2. Paid or accrued within the taxable year in connection 3. In connection with the taxpayer’s trade, business, or profession 4. Not expressly prohibited by law to be deductible

1. 2. 3. 4. 5. Losses

Deductible Taxes Import duties Business taxes License taxes Privilege taxes Documentary stamps tax

1. 2. 3.

Non-deductible Taxes Income tax, whether Philippine or foreign Estate and donor’s taxes Special assessments or levies on real property Final tax

4. Requisites for deductibility 1. Must be actually sustained and charged off within the taxable year 2. Incurred in trade, business, or profession 3. Must be evidenced by a closed or completed transaction 4. Must not be compensated for by insurance or other form of indemnity Types of losses 1. Ordinary losses 2. Capital losses 3. Special kinds of losses Net operating loss carry over (NOLCO) The net operating loss, which had not been previously offset as deduction from gross income, shall be carried oever as a deduction from gross income for the next 3 consecutive taxable years immediately following the year of such loss.

What is Net Operating Loss? Excess of allowable deductions over gross income of the business or enterprise for any taxable year When net operating loss not deductible Page 8 of 10

FINALS REVIEWER TAXATION 1 – Prof. Othelo Carag 1.

2.

Any net loss incurred in a taxable year during which the taxpayer was exempt from income tax shall not be allowed as a deduction (Net operating loss during income tax holiday) There is substantial change in the ownership of the enterprise. When there is substantial change – If, as a result of a business combination, the stockholders of the transferor or the transferor, gains control of the enterprise claiming the NOLCO as a deduction such that they acquire: a. Less than 75% of the outstanding shares or paid-in capital of the transferee enterprise b. Less than 75% interest in the business of the transferee

Coverage: Passive income (p. 18 of course outline) onwards Prepared by C. Gomez 3. 4. 5.

Depreciation

Sample application of NOLCO

Depletion Pension trust Charitable and other contributions

Must not be between related parties Must be actually charged-off the books of accounts of the taxpayer as of the end of the taxable year Must be worthless and uncollectible (write-off)

Recovery of accounts previously written-off – Tax Benefit Rule Subsequent recovery of previously written-off accounts are to be included in the gross income of the taxable year in which these were received only to the extent the taxpayer was benefited when it claimed the write-off as a deduction. Requisites for deductibility 1. Must be reasonable 2. Must be for property arising out of its use or employment in the business or trade 3. Must be charged-off during the taxable year Payments to employees’ pension trust (reasonable pension plan) Requisites for deductibility 1. Must actually paid or made to the Philippine government or any political subdivision thereof exclusively for public purposes 2. Must be made within the taxable year 3. Must not exceed 10% (individual) or 5% (corporation) of the taxpayer’s taxable income before charitable contributions

Research and development

Bad debts

Entitlement to NOLCO Entitled Not entitled 1. Any individual engaged in 1. OBUs trade or business or in the 2. FCDUs practice of a profession 3. BOI-registered entity 2. Domestic corporations 4. PEZA, SBMA, CSEZ(including private registered enterprises educational institutions) 5. Entity already enjoying 3. Resident foreign income tax holiday (ITH) corporations (including regional operating headquarters Requisites of deductibility 1. There must be an existing indebtedness which must be valid and legally demandable 2. Must be connected with the taxpayer’s trade, business or profession

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FINALS REVIEWER TAXATION 1 – Prof. Othelo Carag

Coverage: Passive income (p. 18 of course outline) onwards Prepared by C. Gomez

Optional Standard Deduction (OSD) What is OSD? It is the standard deduction availed of, equal to 40% of gross income (gross profit), in lieu of itemized deductions. Who may avail of OSD? Individuals 1. Resident citizen 2. Non-resident citizen 3. Resident alien 4. Estate and trusts

1. 2.

Corporations Domestic corporations Resident foreign corporations

Unless the taxpayer signifies his intention to elect the OSD, he shall be considered as having availed himself of the itemized deductions. Such election when made in the return shall be irrevocable for the taxable year for which the return was made.

Personal and Additional Exemptions Basic personal exemptions Additional exemptions

P50,000 for each taxpayer, whether single, married, or head of the family P25,000 for each dependent, not exceeding 4 dependents A person is a dependent if: 1. He is not more than 21 years of age, unless incapacitated or incapable of self-support 2. Unmarried 3. Not gainfully employed 4. Living with the taxpayer 5. Chiefly dependent on the support provided by the taxpayer

Who may avail of Personal exemptions Individual Basic RC Yes NRC Yes RA Yes NRA-ETB Yes, subject to reciprocity, whichever is LOWER between P50,000 and amount allowed by foreign country NRA-NETB No

Additional Yes Yes Yes No

No

Status at the end of the year rule In case a taxpayer changes his status during the year, his status shall remain the same as prior to the change until the end of the taxable year.

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