Income Taxation Dimaampao

BASICAPPf TO INCOME TJ JUSTICE JAPAR B. DI

tsA:Sll,; APPROACH

TO INCOME TAXATION By

JAPAR B. DIMAAMPAO Associate Justice, Court of Appeals Professor of Law, Bar Reviewer

FOURTH EDITION

2011

al3llclo, fv1 VI~

'*

AVI -hi ~rn ek 1

M.

;~iei~~k Sd;~re 856 Nicanor Reyes, Sr. St.

Tel. Nos. 736·05-67 • 735·13-64 1977 c.M. Recto Avenue

Tel. Nos. 735·55·27 • 735.55.34 Manila, Philippines www.rexpublishing.com.ph

CONTENTS Chapter 1 Salient Features of the Present Tax System 1: Individual Income System................................. II. Corporate Income Taxation............................... Ill. Common Features ............................................

1 2 2

Chapter 2 Income and Requisites; Income Tax; Nature and Functions A.

B. C. D. E.

F.

Definitions.......................................................... (1.) Judicial Definitions..................................... (2.) Economist's Definition................................ Income, Capital, Revenue, Receipts; Distinctions................................................. Sources of Income............................................ Income Tax; Basis, Nature, Functions.............. Requisites for Income to be Taxable ......... ....... ( 1 . ) Doctrine of Constructive Receipt of Income............................................ Doctrines on Determination of Taxable Income ( 1.) Claim of Right Doctrine.............................. (2.) Severance test theory................................ (3.) Control test.................................................

4 4 4 5 5 7 8 9

11 11 11 11

Chapter 3 Gross Income A.

General Statutory Definition.............................. xix

12

B.

A. B.

Broad Definition ................................................. Formula: Gross Income; Net Income; Taxable Compensation Income; Income Tax Due; Income Tax Payable .................................. Gross Income Taxation and Net Income Taxation; Distinctions; Advantages and Disadvantages ........................................... Exclusions from Gross Income ......................... Reasons for Exclusion ...................................... Exclusions from Gross Income ......................... (1.) Proceeds of life insurance ......................... (2.) Amount received as return of premium ..... (3.) Gifts, bequests and devises ...................... (4.) Compensation for injuries or sickness ....... (5.) Income exempt under treaty ...................... (6.) Retirement benefits, pensions, gratuities, etc ...................................... (7.) Miscellaneous items ...................................

13

(1.) Other tax implications of condonation

13 14 15 15 15 15 16 17 17 18

E.

F. G.

A.

18 21

Chapter 4 Individual Income Taxation A.

B. C.

Classification of Individual Taxpayers (1.) Resident citizen .......................................... (2.) Non-resident citizen ................................... (3.) Resident alien ............................................ (4.) Non-resident alien ...................................... (5.) Non-resident alien not engaged in trade or business ................................ General Principles; Sources of Income; Tax Base .................................................... Categories of Income ........................................ a. Definition .................................................... b. Basis/Test ................................................... c. Requisites for Taxability ............................. d. Forms of Compensation ............................ xx

25 25 25 27

of indebtedness ......................... Other tax implications of premiums (2.) paid by employer ....................... of the Employer Convenience a.) ............................... Rule De minim is benefits ..................... b.) Special Rules on Fringe Benefits ..................... Doctrine of Cash Equivalent ............................. Allowable Deductions from Gross Compensation Income ............................... (1.) Personal exemptions ................................. (2.) Premium Payments on Health and/or Hospitalization Insurance ........................... Business/Trade/Professional Income Income Covered (1.) Income derived by self-employed from trade or business (trading, manufacturing, merchandising, farming. and others) ........................... Income derived by professionals ............... (2.) (3.) Gross income of farmers include ............... i.) Interest Income ................................. ii.) Rental Income ................................... iii.) Dividend Income ............................... iv.) Passive Investment Income .............. (4.) Other Sources ............................................

30 30 31 32 33 38 38 38 43

44 45 46 46 46 48 50 51

Chapter 5

27

Corporate Income Taxation

27 28 28 29 29 29

A. B.

Definition under the NIRC ................................. Major Groups of Corporation for Income Tax Purposes ............................................. (1.) Domestic Corporations .............................. (2.) Resident Foreign Corporations .................. (3.) Non-resident Foreign Corporations ........... xxi

53 56 56 57 60

C. D. E.

Minimum Corporate Income Tax....................... Improperly Accumulated Earnings Tax............. Other Corporate Tax Rates............................... (1.) Common Tax Rates................................... (2.) Domestic Corporations ............................. , (3.) Resident Foreign Corporations.................. (4.) Non-resident Foreign Corporations........... F. Tax Exempt Corporations Under the NIRC ...... ( 1.) Labor, Agriculture or Horticultural Organization Not Organized Principally for Profit............................. (2.) Mutual Savings Banks and Cooperative Banks.................................................. (3.) Fraternal Beneficiary Society, Order or Association ..... ....... ... ....... .. ..... .... .... (4.) Cemetery Companies................................ (5.) Religious, Charitable, Scientific, Athletic or Cultural Corporations .... ... .... .... ... .. . (6.) Business, Chamber of Commerce, or Board of Trade.................................... (7.) Civic League.............................................. (8.) Non-Stock, Non-Profit Educational Institutions........................................... (9.) Government Educational Institution........... (10.) Mutual Fire Insurance Companies and Like Organizations....................... (11.) Farmers, Fruit Growers' or Like Association.......................................... Tax-Exempt Corporations under Special Laws.......................................

61 69 73 73 73 74 75 77

E.

77 F. 77 78 79 80 80 82 83 85

86

xx ii

H.

90 I.

Allowable Deductions from Gross Income

Basic Principles................................................. The Cohan Rule Principle.................................

G.

85

Chapter 6

A. B.

C. D.

91 91

(1.) Distinctions: Deductions, Exclusions and Personal Exemptions.......................... Kinds of Allowable Deductions ....... ...... ... .. (1.) Itemized Deductions.................................. (2.) Optional Standard Deduction..................... Kinds of Itemized Deductions ... ... ........... ..... ... .. Business Expenses........................................... Interest Expenses............................................. Definition ....... .... .... ... .... ..... ... ...... ...... .......... .. .... . Taxes................................................................. Nature and Scope............................................. Losses............................................................... (1.) Definition.................................................... (2.) Kinds of Losses ........................... .............. (3.) Special Kinds of Losses............................ a.) Wagering losses........................................ b.) Losses due to voluntary removal of building incident to renewal or replacement........................... c.) Loss of useful value of capital asset due to changes in business condition..................................... (4.) Casualty Losses......................................... (5.) Non-deductible Losses.............................. Bad Debts ..... ..... ... ..... ... .. ... .. ... ... ...... ... ..... ... ...... (1.) Definition.................................................... (2.) Requisites for deductibility......................... (3.) Measure of Bad Debts deductible............. Depreciation...................................................... (1.) Definition.................................................... (2.) Requisites for deductibility......................... Depletion........................................................... (1.) Definition.................................................... (2.) Theory and purpose of Depletion allowance............................................ (3.) Who are entitled......................................... Essential factors......................................... xxiii

92 92 92 93 93 93 106 106 110 110 113 113 114 115 115

117

118 122 123 126 126 126 129 131 131 131

134 134 134 134 135

J.

K.

L.

Charitable and Other Contributions ................. . (1.) Kinds ........................................................ .. (2.) Entitled ................................... ., ................. . (3.) Requisites for deductibility ........................ . (4.) Contributions deductible in full ................. .. (5.) Contribution subject to limitation ............... . (6.) Deductible under Special Laws ................ . Research and Development Expenditure ........ . (1.) In General ................................................. . (2.) Limitations on Deduction .......................... . Employer's Contribution to Pension Trust ...... .. (1.) Nature ...................................................... .. (2.) Requisites for Deductibility ....................... . (3.) There is no need of special permit from the BIR to put up a pension plan for the benefit of employees ................... . (4.) Treatment of Income from Pension Plan .. . (5.) Deductible payments to pension trusts .... . Optional Standard Deduction ................... .. Special deductions allowed to Insurance Companies ......................................... . Items not deductible .................................. .

136 136 136 136 137 138 139 139 139 140 140 140 140

141 141 141 141

B.

Settled Case on the Tax Situs of Interest Income ....................................................... Capital Transactions ..........................................

150 153

Chapter 9 Income Tax Rules on Dealings in Property A.

A. B. C. D. E. F.

142 143

Capital Gains from Sale or Other Disposition of Real Property ( 1.) Individual Taxpayers .................................. (2.) Corporate Taxpayers .................................. Gains and Losses from Dealings in Property .......................................... Concept ............................................................. Measure of Income or Loss .............................. Adjusted Basis or Cost of the Property Sold .... Settled Rules on Sale or Exchange .................. Tax-exempt Sales or Exchanges ...................... Gain recognized, loss not recognized Rule ......

164 166 166 166 167 167 169 170 172

Chapter 10 Taxpayers Required to File Income Tax Returns

Chapter 7 A. B.

Estates and Trusts A. B.

C.

Estate ............................................................... . Trust ............. .. ··················································· (1.) Taxable Trust.. ........................................... . (2.) Rules on Taxability ................................... .. Computation of Tax on Estate and Trust.. ...... ..

146 147 147 147 148

C.

Individuals ......................................................... Corporations no matter How created or organized including General Professional Partnerships ............................................... Estates and Trusts Engaged in Trade or Business ................................................

173

175 175

APPENDICES Chapter 8 Special Topics in Income Taxation A.

Determination of Source According to Kind of Income ................................................. .. xx iv

149

Appendix A - Revenue Regulations No. 9-98 .........

176

Appendix B - Revenue Regulations No. 5-99 .........

186

Appendix C - Revenue Regulations No. 13-2000 ..

191

xxv

Appendix D - Revenue Regulations No. 2-2001 ....

197

Appendix E - Revenue Regulations No. 25-2002...

204

Appendix F - Revenue Regulations No. 76-2003...

207

Appendix G - Revenue Regulations No. 12-2007.. Appendix H - 2011 Bar Coverage for Taxation....... Appendix I - Bar Examination Questions on Taxation.................................................

211 220

Chapter 1

259

SALIENT FEATURES OF THE PRESENT INCOME TAX SYSTEM I.

INDIVIDUAL INCOME TAXATION A.

B.

C.

Schedular Tax Treatment

1.

It classifies income.

2.

It provides different tax rules.

3.

It imposes different tax rates.

Net Income Taxation

1.

Resident citizen (RC)

2.

Non-resident citizen (NRC)

3.

Resident alien (RA)

4.

Non-resident alien engaged in trade or business (NRA-ETB)

Gross Income Taxation Non-resident alien not engaged in trade or business (NRA-NETB)

D.

E.

xxvi

Income Tax Situs 1.

Residence

RA,RC

2.

Place

NRA, NRC

3.

Citizenship

RC

Individual taxpayers (compensation earners) except NRA-NETB are entitled to personal exemptions

2

II.

BASIC APPROACH TO INCOME TAXATION

CORPORATE INCOME TAXATION A.

B.

C.

Global Tax Treatment

1.

It generally provides for uniform rules.

2.

It generally imposes uniform tax rate.

3.

It does not generally classify income.

Net Income Taxation

1.

Domestic Corporation (DC)

2.

Resident Foreign Corporation (RFC)

Gross Income Taxation Non-resident Foreign Corporation (NRFC)

D.

Income Tax Situs 1.

Residence

RFC

2.

Place

NRFC

3.

Nationality

DC

Ill. COMMON FEATURES A.

B.

Pay as you File System 1.

Individuals returns

upon filing of their income tax

2.

Corporations - upon filing of their quarterly corporate income tax returns and final adjustment corporate returns

Creditable Withholding Tax System 1.

Withholding agent (source) - withholds the tax and remits the same to the BIR

2.

Tax withheld due

creditable against income tax

CHAPTER 1 SALIENT FEATURES OF THE PRESENT INCOME TAX SYSTEM

C.

3

Final Withholding Tax System 1.

Withholding agent (source) - withholds the tax and remits the same to the BIR

2.

Tax withheld - final settlement of the tax liability on the income covered

CHAPTER2 5 INCOME AND REQUISITES; INCOME TAX; NATURE AND FUNCTIONS

•

it cannot be determined by reckoning cash receipts; other income determining factors: inventories, accounts receivable, property acquisition and accounts payable for expenses incurred.

B.

INCOME, CAPITAL, REVENUE, RECEIPTS; DISTINCTIONS (1995 Bar)

Chapter 2 INCOME AND REQUISITES; INCOME TAX; NATURE AND FUNCTIONS

Capital A.

DEFINITIONS (1969 Bar)

In a broad sense, income means all wealth that flows into the taxpayer other than as a mere return of capital. It includes the forms of income specifically described as gains and profits including gains derived from the sale or other disposition of capital assets.

•

gain derived from capital, or from labor, or from both capital and labor, including the gain derived from the sale or exchange of capital assets (Fisher v. Trinidad, 43 Phil. 973; Eisner v. Macomber, 252 U.S. 189, 40 S. Ct. 189, 64 L. Ed. 521 1920). amount of money coming to a person or corporation within a specified time, whether as payment for services, interest or profit from investment (CONWI v. CTA, 213 SCRA83).

Economist's definition •

money value of the net accretion to one's economic power between two points of time (R.M. Haig, The Federal Income Tax, Columbia University; Anderson, Taxation and the American Economy). 4

Income

Fund

Flow

Wealth

Service of wealth

Tree (property)

Fruit (metaphorical language)

Gross receipt includes receipts which may constitute capital as well as income; therefore, broader in scope. Income connotes a narrower concept limited only to gain derived from labor, capital or property, excluding non-income items such as the capital invested, cost of goods sold or those excluded by law from income taxation.

Judicial definitions •

v.

Revenue refers to all funds or income derived by the government whether from tax or other sources. Revenue is to the government as income is to private persons or corporations. C.

SOURCES OF INCOME •

Property (capital)

•

Labor (service)

•

Sale/Exchange of capital asset and activity

Source of income is any property, activity or service that produced the income (COM v. BOAC, 149 SCRA 395). It may also be in the form of proceeds from sales of transport documents.

6

BASIC APPROACH TO INCOME TAXATION

CHAPTER 2 7 INCOME AND REQUISITES; INCOME TAX; NATURE AND FUNCTIONS

,,,_.-"..,-,,

~!J/Bad debt r~covery-. must be cl_aimed as deduction

Under the Tax Code, however, income derived from whatever source forms part of the taxpayer's income. This includes the following: (1.) Treasure found or punitive damages representing profits lost; (2.) Amount received by mistake (Javier v. CA, 199 SCRA 824; Javier v. Com, CTA Case No. 3393, July 27, 1983).

-

D.

from gross income 1n the preceding year. It assumes that the taxpayer has a net income, not a net loss (2005, 2003 Bar). A!O/ 'f AY.H?t~ 11 ~-" !lei11,;rvi' INCOME TAX; BASIS, NATURE, FUNCTIONS (1.) It is a tax on all yearly profits arising from property, profession, trades or offices or as a tax on a person's income, emoluments, profits and the like.

If a foreign bank erroneously remitted U.S.$1 million instead of U.S.$1,000.00 and it appears subsequently that the recipients spent the difference of U.S. $999,000 on various purchases of property both here and abroad of their own material benefit, the said sum constitutes taxable income.

(2.) It is based on income, either gross or net, realized in one taxable year.

It has been held that if a taxpayer receives earnings under a claim of right without restrictions as to its disposition, he has received income even though it may still be claimed that he is not entitled to retain the money and even though he may still be adjudged liable to restore its equivalent. This is an exception to the rule that income received through mistake is not taxable as its receipt is offset by liability to the party making the excessive payment (North American Consolidated v. Burnet, 286 U.S. 417).

(4.) Functions of income tax:

(3.) Cancellation of the taxpayer's indebtedness. (4.) Payment of usurious interest. (5.) Illegal gains - gambling, theft, embezzlement, extortion, fraud - income to embezzler if forgiven by the owner. (6.) Tax refund - must be claimed as deduction from gross income in the preceding year. It means that the tax must be a deductible one (2005, 2003 Bar).

(3.) Excise tax - it is not levied upon the person or property but upon the right of a person to receive income or profits. a.) to provide large amounts of revenues; b.) to offset regressive sales and consumption taxes; c.) to mitigate the evils arising from the inequalities in the distribution of income and wealth which are considered deterrents to social progress, by a progressive scheme of taxation (Report of the Tax Commission of the Phil., Vol. II; Madrigal v. Rafferty, 38 Phil. 414 ). (5.) The basis of the right of the government to tax income emanates from its partnership in the production of income by providing the protection, resources, incentive and proper climate for such production (Com. v. Lednicky, 11 SCRA 603). This is called the Partnership Theory which has spawned the following principles: a)

Protection theory. It dictates that when the flow of wealth proceeded from, and occurred

8

BASIC APPROACH TO INCOME TAXATION

within, Philippine territory, enjoying the protection accorded by the Philippine government, the same, in consideration of such protection should share the burden of supporting the government [CIR v. BOAC, 149 SCRA 395, 407 (2009 Bar)]. b)

@,

E. Fr'111.iic:11

ri.u:

Theory offavorable business climate. Domestic corporations owe their corporate existence and privilege to do business to the government. They also benefit from the efforts of the government to improve the financial market and to ensure a favorable business climate. It is therefore fair for the government to require them to make a reasonable contribution to the public expenses (CREBA v. Romulo, 614 SCRA 605, 622).

REQUISITES FOR INCOME TO BE TAXABLE (1.) There must be gain or profit, whether in cash or its --· eq(Jivalent. J.~.)

The gain must be realized or received. This implies that not all economic gains constitute taxable income. ~J

Mere increase in the value of property is not income (unrealized increase in capital).

_tl.1

Increases in the taxpayer's net worth are not taxable increases in net worth if they are not the result of the receipt by it of unreported or unexplained taxable income, but are shown to be merely the result of the correction of errors in its entries in its books relating to its indebtedness to certain creditors, which had been erroneously overstated or listed as outstanding when they had in fact been duly paid (Fernan-

CHAPTER 2 9 INCOME AND REQUISITES; INCOME TAX; NATURE AND FUNCTIONS

dez v. Commissioner of Internal Revenue, 29 SCRA 553). c.) But if the increase in the net worth of a taxpayer is the result of the receipt by it of unreported or unexplained taxable income, the correction is taxable income. d J Receipt includes constructive receipt.

-- ·- *1[ill Doctrine of Constructive Receipt of Income - Income which is credited to the account of and §€lt EIP§rt for a J.i:t)(payer and which may be drawn by him at any time is subject to tax for the year during which it was so credited or set apart although not yet then actually received or reduced to his possession. To constitute receipt in such case, the income must be credited to the taxpayer without any substantial limitation or condition upon which payment is to be made. Examples of Constructive Receipt: i.

Matured interest coupons due and demandable (convertible into cash);

ii.

Share in the profits of a partner in a partnership;

iii.

Interest credited on savings bank deposit (Section 53, Revenue Regulations No.2);

iv.

Dividends applied by the corporation against the indebtedness of a stockholder (Section 50, Revenue Regulations No. 2);

v.

Rental payments refused by the lessor when the lessee tendered payment and the latter made a judicial deposit of the

10

CHAPTER 2 11 INCOME AND REQUISITES; INCOME TAX; NATURE AND FUNCTIONS

BASIC APPROACH TO INCOME TAXATION

rental (Limpian Investment Corporation v. Com., 17 SCRA 703). vi.

Amount credited to shareholders of a building and loan association when such credit passes without restriction to the shareholder. The Doctrine of Constructive Receipt is designed to prevent the taxpayer using the cash basis from deferring or postponing the actual receipt of taxable income. Without the rule, the taxpayer can conveniently select the year in which he will report the income. In Filipinas Synthetic Fiber Corporation v. CA [316 SCRA 480, 486], the Supreme Court ruled that it is the right to receive income, and not the actual receipt, that determines when to include the amount in gross income. For taxpayer using the accrual method, the determinative question is, when do the facts present themselves in such a manner that the taxpayer must recognize income? The accrual of income is permitted when the all-events test has been met. This test requires: (1) fixing of a right to income to pay; and (2) the availability of the reasonable accurate determination of such income. [Commissioner of Internal Revenue v. lsabela Cultural Corporation, 515 SCRA 556, 564-565 (2010 Bar)].

@J The gain must not be excluded by law or treaty from taxation. This means that not all income is required to be included in computing the taxable income.

F.

DOCTRINES ON DETERMINATION OF TAXABLE INCOME (1.)it.£\tlaim~~f1"£i@l\ff~{!l©~frlllfta- illegally acquired income

constitutes realized gain (Rutkin v. U.S., 343 U.S. 130). (2001 Bar) (2. )illlil:e\Uil~al!l:!ils&testtl!life1i\l]iY- separation from capital of something which is of exchangeable value (Eisner v. Macomber, 252 U.S. 189). (3. )lk