CHAPTER 3

Introduction to Income Taxation

The Concept of Income

Why is Income Subject to Tax?
 Income is regarded as the best measure of taxpayers' ability to pay tax. It is an
excellent object of taxation in the allocation of government costs.

What is Income for Taxation Purposes?

 The tax concept of income is simply referred to as “Gross Income" under the
NIRC. A taxable item of income is referred to as an "item of gross income" or
"inclusion in gross income".
 Gross income simply means taxable income in layman's term. Under the NIRC,
however, the term "taxable income" refers to certain items of gross income
less deductions and personal exemptions allowable by law. Technically, gross
income is broader to pertain to any income that can be subjected to income tax.
 Gross income is broadly defined as any inflow of wealth to the taxpayer from
whatever source, legal or illegal, that increases net worth. It includes income
from employment, trade, business or exercise of profession, income from
properties, and other sources such as dealings in properties and other regular or
casual transactions.

Elements of Gross Income

1. It is a return on capital that increases net worth.
2. It is a realized benefit.
3. It is not exempted by law, contract, or treaty.

Return on Capital
 Capital means any wealth or property. Gross income is a return on wealth or
property that increases the taxpayer's net worth.
Illustration
1. ABC purchased goods for P300 and sold them for P500. The P500
consideration can be analyzed as follows:
Selling Price (total consideration received) P500 Total return
Cost (value of inventory forgone) 300 Return of capital
Mark-Up (gross income) P200 Return on capital
 The Return on Capital that increases net worth is income subject to income tax.
 Return of Capital merely maintains net worth; hence, it is not taxable of
improvement in net worth indicates an ability to pay tax.
Capital Items Deemed with Infinite Value
 There are capital items that have infinite value and are incapable of pecuniary
valuation. Anything received as compensation for their loss is deemed a return
of capital.
Examples:
1. Life
2. Health
3. Human Reputation
Life
 The value of life is immeasurable by money. Under Sec. 32 of the NIRC, the
proceeds of life insurance policies paid to the heirs or beneficiaries upon
death of the insured, whether in a single sum or otherwise, are exempt from
income tax.
 The proceeds of a life insurance contract collected by an employer as a
beneficiary from the life insurance of an officer or any person directly interested
with the trade are likewise exempt. These proceeds are viewed as advanced
recover for future loss.
 However, the following are taxable return on capital from insurance policies:
1. Any excess amount received over premiums paid by the insured upon
surrender or maturity of the policy (i.e. the insured outlives the policy.)
2. Gain realized by the insured from the assignment or sale of his
insurance policy.
3. Interest income from the unpaid balance of the proceeds of the policy.
4. Any excess of the proceeds received over the acquisition costs and
premium payments by an assignee of a life insurance policy.
Health
 Any compensation received in consideration for the loss of health such as
compensation for personal injuries or tortuous acts is deemed a return of
capital.
Human Reputation
 The value of one's reputation cannot be measured financially. Any indemnity
received as compensation for its impairment is deemed a return of capital
exempt from income tax.
Examples include moral damages received from:
1. Oral defamation or slander
2. Alienation of affection
 3. Breach of promise to marry

Recovery of Lost Capital vs. Recovery of Lost Profits

 The loss of capital results in decrease in net worth while the loss of profits
does not decrease net worth. The recovery of lost capital merely maintains net
worth while the recovery of lost profits increases net worth. Therefore, the
recovery of lost profits is a return on capital.
Taxable Recovery of Lost Profits
 The recovery of lost profits through insurance, indemnity contracts, or legal suits
constitutes a taxable return on capital.
The following are taxable recoveries of lost profits:
1. Proceeds of crop or livestock insurance
2. Guarantee payments
3. Indemnity received from patent infringement suit
Illustration 1
2. Mang Reyes insured his strawberry crop in a P200,000 crop insurance coverage
against calamities. The crop was eventually destroyed by an unusual frost. Mang
Reyes was paid the P200,000 insurance proceeds.
 The P200,000 proceeds which is a reimbursement for the lost value of
the future harvest, is an item of gross income. The value of the lost
crops is, in effect, realized not through actual harvest but through the
insurance contract.
Illustration 2
3. Mr. Ramos purchased a franchise. The franchisor guaranteed an annual
franchise income of P100,000 to Mr. Ramos. In the first year of operation, Mr.
Ramos' outlet only earned P60,000. The franchisor paid the P40,000 difference
to Mr. Ramos.
 The P40,000 guarantee payment is not a gratuity but a recovery of lost
profit for Mr. Ramos; hence, subject to income tax. Mr. Ramos shall
report P100,000 as franchise income.
Illustration 3
4. Davao Crocodile Inc. experienced an unusual decline in its income after a
company copied its patented invention. Davao Crocodile sued the competitor for
patent infringement and was awarded an indemnity of P3,000,000.
 The P3,000,000 indemnity is a compensation for the income not realized
by Davao Crocodile due to the patent infringement. The same is an item
of gross income.
  The recovery of lost income or profits is not intended to compensate for
the lost capital. It is as good as realization of income; hence, it is an item
of gross income.

Realized Benefit
What is Meant by Realized Benefit?
 The benefit means any form of advantage derived by the taxpayer. There is
benefit when there is an increase in the net worth of the taxpayer.
 An increase of net worth occurs when one receives income, donation or
inheritance.
 The following are not benefits, hence, not taxable:
1. Receipt of a Loan – properties increase but obligations also increase
resulting in an
offsetting effect in net worth.
2. Discovery of Lost Properties – under the law, the finder has an
obligation to return
the same to the owner.
3. Receipt of Money or Property to be Held in Trust for, or to be remitted
to another person.
 If the taxpayer is entitled to keep for his account portion of a receipt, only the
portion is a benefit.

Illustration
1. An employee was granted P20,000 transportation advance. He
liquidated 18,000 transportation expenses and was allowed by his
employer to keep the 2,000. Only the P2,000 retained by the employee is
considered income since this was the extent he was benefited. (RR2-98)
2. A security agency receives P120,000 from clients, P100,000 of which is
for the salaries of security guards. Under RMC 39-2007, only the P20,000
attributable to the agency is considered income of the agency since it is
the extent it is benefitted. The P100,000 pertaining to salaries of security
guards is recognized by the agency as a liability upon receipt.

The Realized Concept

 The term realized means earned. It requires that there is a degree of
undertaking or sacrifice from the taxpayer to be entitled of the benefit.
Requisites of a Realized Benefit
 1. There must be an exchange transaction
2. The transaction involves another entity
3. It increases the net worth of the recipient

Types of Transfers
1. Bilateral Transfers or Exchanges, such as:
a. Sale
b. Barter
 These are referred to as “onerous transactions”

2. Unilateral Transfers, such as:

a. Succession – transfer of property upon death.
b. Donation
 These are also referred to as “gratuitous transactions”
 under current usage, unilateral transfers are simply referred to as
“transfers” while bilateral transfers are called “exchanges”.
 Benefits derived from onerous transactions are “earned or realized”,
hence, they are subject to income tax. Benefits derived from
gratuitous transactions are not realized because of the absence of an
earning process. Benefits derived from gratuitous transactions are subject
to transfer tax, not income tax.
3. Complex Transactions
 are partly gratuitous and partly onerous. These are commonly referred to
as “transfers for less than full and adequate consideration”. The
gratuitous portion of the transaction is subject to transfer tax while the
benefit from the onerous portion is subject to income tax.
Illustration
 A taxpayer sold his car which was previously purchased for P100,000 and
with a current fair value of P180,000 for only P130,000.
The transaction will be analyzed as follows:
Fair Value Price P 180,000 P50,000 – Subject to Transfer
Selling Price 130,000 Tax
P30,000 – Subject to Income Tax
Cost 100,000
 The Excess of Fair Value over Selling Price is a gratuity or gift whereas
the Excess of Selling Price over the Cost is an item of gross income.

What is Meant by Another Entity?

  Every person, natural or juridical, is an entity. Natural persons are living person
while juridical persons are those created by law such as partnerships or
corporations.
 Gains or income derived between relatives, corporations, and between a
partners and the partnership are taxable since it is made between separate
entities. Likewise, the income between affiliated companies such as between a
holding parent company and its subsidiaries and between sister companies are
taxable because each corporation is a separate entity. This applies regardless of
any underlying economic relationship.
 However, the sales of a home office to its branch office are not taxable because
they pertain to one and the same taxable entity. Furthermore, the income
between the businesses of a proprietor should not be taxed since proprietorship
businesses are taxable upon the same owner. Note that a proprietorship is not
a juridical entity.

Benefits in the Absence of Transfers

 The increase in wealth of the taxpayer in the form of appreciation or increase in
the value of his properties or decrease in the value of his obligations in the
absence of a sale or barter transaction is not taxable.
 These are referred to as unrealized gains or holding gains because they have
not yet materialized in an exchange transaction.

Examples of Unrealized Gains or Holding Gains:

1. Increase in value of investments in equity or debt securities.
2. Increase in value of real properties held (revaluation increment).
3. Increase in value of foreign currencies held or receivable.
4. Decrease in value of foreign currency denominated debt by virtue of
favorable fluctuation in exchange rates.
5. Birth of animal offspring, accruals of fruits in an orchard or growth of farm
vegetables.
6. Increase in value of land due to the discovery of mineral reserves.

Rendering of Services
 The rendering of services for a consideration is an exchange but does not cause
loss of capital. Hence, the entire consideration received from rendering of
services such as compensation income or service fees is an item of gross
income.
Illustration:
 Mendoza lists the following possible items of gross income
 Compensation Income 200,000
Winnings from Gambling 100,000
Increase in Value of Investments 50,000
Appreciation in the Value of Land Owned 300,000
Debt of Saladin cancelled by creditors in consideration 150,000
for services he rendered to them
Debt of Saladin cancelled by his creditor out of affection 250,000
Loan Received from a Bank 400,000

The items of Gross Income are:

 Compensation Income 200,000
 Winnings from Gambling 100,000
 Debt of Saladin cancelled by creditors in 150,000
consideration for services he rendered to them
Note:
1. Gains from gambling and the forgiveness of debt in consideration of services
received are realized gains from exchanges.
2. The forgiveness of debt out of affection or mere generosity of the creditor is a
gratuitous transfer subject to transfer tax.
3. The loan received from a bank constitutes a transfer but is not a benefit.

Basis of Exemption of Unrealized Income

 Normally, taxpayers will have the ability to pay tax when their income
materializes in an exchange transaction since tax is generally payable in money.
 This does not mean, however, that only income realized in cash is subject to
tax. Income realized in non-cash properties are, in effect, received in cash but
the taxpayer used the same to acquire the non-cash property.
 Income received in non-cash considerations is taxable at the fair value of the
property received. Moreover, exempting income realized in non-cash
considerations would open a wide avenue for tax evasion since taxpayers can
easily divert their income in the form of non-cash consideration.

Mode of Receipt / Realization Benefits

 Taxable items of income may be realized by the taxpayer in two ways:
1. Actual Receipt – involves actual physical taking of the income in the form
of cash or
property.
2. Constructive Receipt – involves no actual physical taking of the income
but the
 taxpayer is effectively benefited.
Examples:
a. Offset of debt of the taxpayer in consideration for the sale of
goods or service.
b. Deposit of the income to the taxpayer's checking account.
c. Matured detachable interest coupons on coupon bonds not yet
encashed by the taxpayer.
d. Increase in the capital of a partner from the profit of the
partnership.

The Inflow of Wealth without Increase in Net Worth

 The inflow of wealth to a person that does not increase his net worth is not
income due to the total absence of benefit.
Examples:
a. Receipt of property in trust
b. Borrowing of money under an obligation to return
 In law, the proceeds of embezzlement or swindling where money is taken
without an original intention to return are considered as income because of the
increase net worth of the swindler.

Not Exempted By Law, Contract, or Treaty

 An item of gross income is not exempted by the Constitution, law, contracts, or
treaties from taxation.
 The following items of income are exempted by law from taxation; hence,
they are not considered items of gross income:
1. Income of qualified employee trust fund.
2. Revenues of non-profit, non-stock educational institutions.
3. SSS, GSIS, Pag-IBIG, or PhilHealth benefits.
4. Salaries and wages of minimum wage earners and qualified senior
citizens.
5. Regular income of Barangay Micro-business Enterprises (BMBEs).
6. Income of foreign governments and foreign government-owned and
controlled corporations.
7. Income of international missions and organizations with income tax
immunity.
 Items of gross income that are exempted from taxation are discussed extensively
under Exclusions in Gross Income in Chapter 8.
 B. Dividend Income from:
1. Domestic Corporation – presumed earned within.
2. Foreign Corporation
a. Resident Foreign Corporation – depends on the pre-dominance
test.
Pre-Dominance Test
 If the ratio of the Philippine gross income over the world
gross income of the resident foreign corporation in the three-
year period for preceding year of dividend declaration is:
 At least 50%, the portion of the dividend
corresponding to the Philippine gross income ratio is
earned within.
 Less than 50%, the entire dividends received is
earned abroad.
b. Non-Resident Foreign Corporation – earned abroad.
Illustration
 In 2021, Sarah received a P400,000 dividend income from ABC
Corporation. The Corporation had the following gross income in 2018
through 2020:
2018 2019 2020 Total
Philippines P 100,000 P 200,000 P 300,000 P 600,000
Abroad 200,000 100,000 100,000 400,000
Total P 300,000 P 300,000 P 400,000 P 1,000,000
If ABC Corporation is a:
1. Domestic Corporation – the entire P400,000 is earned within.
2. Non-Resident Foreign Corporation – the entire P400,000 is earned abroad.
3. Resident Foreign Corporation – the P400,000 dividend shall be split.
Gross Income Ratio = P600,000/P1,000,000 = 60%
Earned Within the Philippines (60% x P400,000) P 240,000
Earned Without the Philippines (40% x P400,000) 160,000
Supposing that the ratio is 49%, the entire P400,000 will be deemed earned outside the
Philippines.

C. Merchandising Income – earned where the property is sold.

 Illustration
Source of Gross Income Amount
Goods purchased and sold within P 200,000
Goods purchased within and sold abroad 100,000
Goads purchased abroad and sold within 150,000
Goods purchased and sold abroad 350,000

The income earned within and without shall be:

Source of Gross Income Within Without
Goods purchased and sold within P 200,000
Goods purchased within and sold P 100,000
abroad
Goads purchased abroad and sold 150,000
within
Goods purchased and sold abroad _________ 350,000
Total P 350,000 P 450,000
D. Manufacturing Income – earned where the goods are manufactured and sold

Operations Remark
Production Distribution
Within Within  Total income from production and distribution is
earned within the Philippines
Without Without  Total income from production and distribution is
earned without the Philippines
Within Without  Production income is earned within, Distribution
income is earned without
Without Within  Distribution income is earned within, Production
income is earned without

Illustration 1
 Island, Inc. manufactures goods and sells them through its branch. Island bills its
branch at established market prices. Island reported the following gross income:
Home Office Branch Total
Sales P 4,000,000 P 2,000,000 6,000,000
Cost of Goods (2,400,000) (1,200,000) (3,600,000)
Sold
Gross Income P 1,600,000 P 800,000 P 2,400,000
The following shows the situs of the gross income of Island under each of the following
scenario:

Scenario Home Office Branch Within Without

No.1 Philippines Philippines P 2,400,000 P0
No.2 Abroad Abroad 0 2,400,000
No.3 Philippines Abroad 1,600,000 800,000
No.4 Abroad Philippines 800,000 1,600,000
Note:
1. Both the production and distribution are conducted by the same taxable entity,
Island Inc.
2. The branch is not a separate taxable entity, but an integral part of Island Inc.,
hence income is taxable to Island Inc.

Illustration 2
 Assuming production is conducted by a parent corporation and the distribution is
conducted by its subsidiary corporation:
Parent Subsidiary Total
Sales P 4,000,000 P 2,000,000 6,000,000
Cost of Goods (2,400,000) (1,200,000) (3,600,000)
Sold
Gross Income P 1,600,000 P 800,000 P 2,400,000

 The gross income recognized by each corporation is taxable to each corporation

because each corporation is a separate taxpayer. The situs of taxation shall be
the place of sale without regard to the seller or the supplier.

The following are the situs of income for the parent corporation:
Scenario Parent Subsidiary Within Without
No.1 Philippines Philippines P 1,600,000 P-
No.2 Abroad Abroad - 1,600,000
No.3 Philippines Abroad 1,600,000 -
No.4 Abroad Philippines - 1,600,000

The following are the situs of income for the subsidiary corporation:
Scenario Parent Subsidiary Within Without
No.1 Philippines Philippines P 800,000 P-
No.2 Abroad Abroad - 800,000
No.3 Philippines Abroad - 800,000
No.4 Abroad Philippines 800,000 -