ACCO 2033

INCOME TAXATION

COMPILED BY:
Huwag nlng po send sa ibng sec..
 Introduction

This introductory Taxation course is primarily concerned with income taxation. The
objective is to develop a working knowledge of the basic principles and rules of the income as
these apply to individuals, partnerships and corporations. It covers an overview of the national
tax system, and the income taxation of employees and unincorporated businesses and
incorporated businesses. It provides the students with knowledge of the capital gains tax, final
tax on certain passive income, and the year-end tax. Including the minimum corporate income
tax, the normal tax, and the improperly accumulated profits tax of corporations and withholding
taxes.

Taxation may be defined as a State power, a legislative power and a mode of

government cost distribution. As a state power, taxation is an inherent power of the state to
enforce proportional distribution from its subjects for public purpose. As a process, taxation is a
process of laying taxes by the legislature of the state to enforce proportional contributions from
its subjects for public purposes. As a mode of cost distribution, taxation is a mode by which the
State allocates its costs or burden to its subjects who are benefited by its spending.

Every government provides a vast array of public services including defense, public
order and safety, health, education, and social protection among others. A system of
government is indispensable to every society. Without it, other people will not relish the benefits
of a civilized and orderly society. However, a government cannot exist without a system of
funding. The governments necessity for funding is the theory of taxation. The government
provides benefit to the people in the form of public service and the people provide the funds that
finance the government. The mutuality of support between the people and the government is
referred to as the basis of taxation.

A government has its basic needs and rights which co-exist with its creation. It has rights
to sustenance, protection, and properties. The government sustains itself by the power of
taxation, secures itself and the well-being of its people by police power and secures its own
properties to carry out its public services by the power of eminent domain. The rights, dubbed
as powers, are natural, inseparable, and inherent to every government.

The inherent powers of the State is comprised of three optimum powers namely:
Taxation power which enforces proportional contribution from its subjects to sustain self; police
power which enact laws to protect the well-being of the people; eminent domain which provides
the State to take private property for public use after paying just compensation. Taxation is a
complex subject matter that needs in depth comprehension and analysis, characteristics
students must possess. The knowledge derived from learnings in this subject will benefit
individuals and organizations in the proper imposition and payment of tax which provides future
benefit to the state and its people.

ii
 Table of Contents
CHAPTER I 1

INCOME TAXATION 1

Objectives 1

Taxation Definition 1

The Theory of Taxation 1

The Basis of Taxation 2

Receipts of benefits is conclusively presumed 2

Theories of Cost Allocation 2

Aspects of the Ability to Pay theory 3

The Lifeblood Doctrine 3

Implication of the Lifeblood Doctrine 3

Inherent Powers of the State 4

Inherent Powers of the State 4

Comparison of the three powers of the State 4

Similarities of the three powers of the State 5

Scope of Taxation Power 5

Limitations of Taxation Power 5

Inherent Limitation of Taxation 6

Exception to the Territoriality Principle 6

Constitutional Limitations of Taxations 9

Aspects of Due Process 9

Stages of the Exercise of Taxation Power 13

Situs of Taxation 14

Other Fundamental Doctrines in Taxation 15

Vague Tax Laws 16

iii
 Double Taxation 17

Types of Double Taxation 17

Escapes from Taxation 18

Categories of Escapes from Taxation 18

Forms of Shifting 19

Self-Text Exercises 20

CHAPTER II 21

TAXES, TAX LAWS AND TAX ADMINISTRATION 21

Objectives 21

Taxation Law 21

Sources of Taxation Laws 21

Types of Administrative Issuances 22

Tax 24

Classification of Taxes 24

Distinction of Taxes with Similar Items 26

Tax System 27

Types of Tax System According to Imposition 27

Types of Tax System According to Impact 27

Tax Collection Systems 28

Principles of a Sound Tax System 28

Tax Administration 29

Powers of the Bureau of Internal Revenue 30

Powers of the Commissioners of Internal Revenue 30

Non-delegated power of the CIR 32

Taxpayer Classification for Purposes of Tax Administration 33

Automatic Classification of Taxpayers as Large Taxpayers 34

Self-Test Exercises 35

iv
CHAPTER III 36

INTRODUCTION TO INCOME TAXATION 36

Objectives 36

The Concept of Income 36

Elements of Gross Income 36

Return on Capital 37

Capital Items Deemed with Definite Value 37

Recovery of Lost Capital vs. Recovery of Lost Profits 38

Types of Transfers 40

Complex Transactions 40

Benefits in the Absence of Transfers 41

Mode of Receipt/ Realization Benefits 42

Inflow of Wealth Without Increase in Net Worth 43

Types of Income Taxpayers 43

The General Rules in Income Taxation 49

Basis of the Extraterritorial Taxation 49

The Issue of International Double Taxation 50

Other Income Situs Rules 51

Self-Test Exercises 55

CHAPTER IV 57

INCOME TAX SCHEMES, ACCOUNTING PERIODS, ACCOUNTING METHODS AND

REPORTING 57

Objectives 57

Income Taxation Schemes 57

Mutually exclusive coverage 57

Classification of Items of Gross Income 57

Accounting Period 59

v
 Types of accounting periods 59

Instances of Short Accounting Period 60

Accounting Methods 61

The Percentage of Completion Method for Construction Contracts 70

Income Tax Reporting 73

Types of income tax-related returns filed to the government 73

Self-Test Exercises 79

CHAPTER V 81

FINAL INCOME TAXATION 81

Objectives 81

Taxability of Stock Dividends 88

Entities Taxable As Corporations Are Subject To 10% Final Tax 91

Fringe Benefits Tax 99

Self-Test Exercises 100

CHAPTER VI 102

CAPITAL GAINS TAXATION 102

Objectives 102

Classification of Taxpayer's Properties 102

Asset Classification Is Relative 102

Asset Classification Rules 103

Types of Gains on Dealings in Properties 104

Sale, Exchange and Other Disposition Of Domestic Stocks Directly To Buyer 104

Issue of Stocks Including Treasury Stocks 105

Tax on Sale, Exchange and other Dispositions of Domestic Stock 107

Capital Gains Tax Compliance 112

Special Tax Rules In Capital Gain Or Loss Measurement 115

Tax Free Exchanges 119

vi
 Tax Issue: Sale Of Stocks Dividend-On To A Corporate Buyer 124

Sale, Exchange And Other Disposition Of Real Property Classified As Capital Asset
Located In The Philippines 125

BIR Tax Clearance 126

Exceptions To The 6% Capital Gains Tax 127

Capital Gains Tax Exemption Under Special Laws 130

Payment of The 6% Capital Gains Tax In Installment 131

Documentary Stamp Tax On The Sale Of Capital Assets 133

Self-Test Exercises 133

CHAPTER VII 135

INTRODUCTION TO REGULAR INCOME TAX 135

Objectives 135

The Regular Income Tax Model 135

Characteristics of the Regular Income Tax 135

Types of Gross Income Subject to Regular Income Tax 138

Taxable Income of Individual Taxpayers 146

Types of Regular Income Tax 149

Self-Test Exercises 153

CHAPTER VIII 155

REGULAR INCOME TAX: EXCLUSIONS FROM GROSS INCOME 155

Objectives 155

Exclusions from Gross Income 155

Exclusion from Gross Income 156

Other Exempt Income Under the NIRC and Special Laws 165

Self-Test Exercises 169

CHAPTER IX 170

REGULAR INCOME TAX: INCLUSIONS FROM GROSS INCOME 170

vii
 Objectives 170

Items of Gross Income 170

Accounting Method 184

Transfer Pricing Methods 189

Self-Test Exercises 192

CHAPTER X 194

COMPENSATION INCOME 194

Objectives 194

Employer-Employee Relationship 194

Elements of Employer and Employee Relationship Under Case Law 194

Types of Employees As To Function 195

Types of Employees As To Taxability 195

Requirements to Filipinos Employed by RHQs and ROHOs 196

Non-Taxable or Exempt Compensation 198

De Minimis Benefits 199

Gross Taxable Compensation Income 205

Supplementary Compensation 207

13th Month Pay And Other Benefits 210

Other Fringe Benefits 211

Tax Treatment of Gross Taxable Compensation Income 219

Procedural Computation of The Withholding Tax On Compensation 225

Benefits Not Subject To Withholding Tax On Compensation Under Rr2-98, As Amended.

227

Self-Test Exercises 229

CHAPTER XI 230

FRINGE BENEFIT TAX 230

Objectives 230

viii
 Fringe Benefits 230

General Categories of Fringe Benefits Subject To Final Tax 231

The Fringe Benefit Tax 234

Characteristics of The Fringe Benefit Tax 234

Rules on Valuation of Fringe Benefits 236

Special Guidelines on Monetary Value Determination 236

Motor Vehicles of Any Kind 239

Interest on Loan at Less than Market Rate 242

Educational Assistance To The Employee or His Dependents 244

Fringe Benefit Tax Rates 245

Accounting Entries 247

Self-Test Exercises 249

CHAPTER XII 251

PRINCIPLES OF DEDUCTIONS 251

Objectives 251

Deductions From Gross Income 251

Special Considerations With Deductions 258

Effect of Accounting Method On Deductions 263

Mode of Claiming Deductions From Gross Income 273

Self-Test Exercises 273

ix
 Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
College of Business Administration

Course Title : INCOME TAXATION

Course Code : ACCO 2033
Course Credit : 3 UNITS
Course Description : This introductory Taxation course is primarily concerned with income taxation. The objective is to
develop a working knowledge of the basic principles and rules of the income as these apply to individuals, partnerships and
corporations. It covers an overview of the national tax system, and the income taxation of employees and unincorporated businesses
and incorporated businesses. It provides the students with knowledge of the capital gains tax, final tax on certain passive income,
and the year-end tax. Including the minimum corporate income tax, the normal tax, and the improperly accumulated profits tax of
corporations and withholding taxes.
Course Objectives : Upon the successful completion of this course, the students will develop the issues related to income
taxation (personal or corporate), in accordance with the legislative provisions. It also aims to introduce students to the methodology
of estimating and calculating accounting information and tax liability. They will be able to as well distinguish sources of income,
deductible and non-deductible expenses, and apply the tax code provisions.

Semester and Academic Year: 1st SEMESTER / AY 2019-2020

COURSE PLAN
Wee Topic Leaning Outcomes Methodology Resources Assessment
k
Identify the concept of taxation, its
elements and its necessity for every
Banggawan, R.
government
(2015) Income
Checking of Self-
Taation. Laws,
Introduction to Assimilate the theories of government test exercises,
1 Lecture Principles, and
Taxation cost allocation inherent power of the assignments and
Applications. Real
state other activities
Excellence
Publishing.
Comprehend the limitations and stages
of taxation power
2-3 Taxes, Tax Laws, Enumerate the types of taxation laws Lecture Banggawan, R. Checking of Self-

x
 (2015) Income
Distinguish tax laws, revenue
Taation. Laws,
regulations and rulings test exercises,
and Tax Principles, and
assignments and
Administration Applications. Real
Understand tax, its elements and other activities
Excellence
classifications, and how it is
Publishing.
administered
Comprehend the concept of gross
income and distinguish the types of Banggawan, R.
income taxpayers (2015) Income
Checking of Self-
Taation. Laws,
Introduction to test exercises,
4 Identify the general rules income Lecture Principles, and
Income Taxation assignments and
taxation Applications. Real
other activities
Excellence
Familiarize self with the income tax Publishing.
situs rules
Identify the types of taxation schemes
and their scope
Banggawan, R.
Familiarize self with the concept of (2015) Income
Tax Schemes, Checking of Self-
accounting period and its types Taation. Laws,
Periods and test exercises,
5-6 Lecture Principles, and
Methods of assignments and
Comprehend the concept of Applications. Real
reporting other activities
accounting methods and their Excellence
accounting procedures, types of tax Publishing.
returns, their deadline and place of
filing
7 Final Income Understand and appreciate the Lecture Banggawan, R. Checking of Self-
Taxation features and scope of final tax. (2015) Income test exercises,
Taation. Laws, assignments and
Discuss the concept of certain passive Principles, and other activities
income subject to final tax and their Applications. Real
corresponding final tax rates. Excellence
Publishing.
Comprehend the general final tax rates
on certain non-residents and their

xi
 exceptions.
Identify and distinguish ordinary asset
and capital asset and recite the asset
classification rules Banggawan, R.
(2015) Income
Checking of Self-
Master the procedural computations of Taation. Laws,
Capital Gains test exercises,
8-9 the 5&10% capital gains tax and the Lecture Principles, and
Taxation assignments and
6% capital gains tax Applications. Real
other activities
Excellence
Master the rules on wash sales and Publishing.
tax-free exchanges and the exceptions
to the 6% capital gains tax
Midterm Examination
Assimilate the scope of regular income
and its tax model, inclusion and
Banggawan, R.
exclusions from gross income
(2015) Income
Checking of Self-
Introduction to Taation. Laws,
Understand the concept of deduction test exercises,
11-12 Regular Income Lecture Principles, and
and personal exemption assignments and
Taxation Applications. Real
other activities
Excellence
Familiarize self with the computation of
Publishing.
the regular tax for individuals and
corporations
Enumerate the list of exclusions from
Banggawan, R.
gross income
(2015) Income
Regular Income Checking of Self-
Taation. Laws,
Taxation – Comprehend exclusion conditions or test exercises,
13-14 Lecture Principles, and
Exclusions in limitations of certain items of income assignments and
Applications. Real
Gross income other activities
Excellence
Enumerate the list of entities exempt
Publishing.
under the NIRC and special laws
15 Regular Income Familiarize self with the NIRC list of Lecture Banggawan, R. Checking of Self-
Taxation – items of gross income subject to (2015) Income test exercises,
Inclusions in Gross regular income tax and their Taation. Laws, assignments and
income measurement rules. Principles, and other activities
Applications. Real

xii
 Understand the treatment of creditable
withholding tax.
Excellence
Publishing.
Appreciate the essence and purpose of
transfer pricing regulation
Understand the classifications of
employees and the tax treatment of
their compensation income and fringe
Banggawan, R.
benefits
(2015) Income
Checking of Self-
Taation. Laws,
Compensation Assimilate the condition for exemption test exercises,
16 Lecture Principles, and
Income of employee benefits under treaty or assignments and
Applications. Real
international agreement other activities
Excellence
Publishing.
Comprehend the fringe benefits
subject to regular tax and fringe
benefits subject to fringe benefits tax
Understand the scope of the final
Banggawan, R.
fringe benefit tax and its characteristics
(2015) Income
Checking of Self-
Taation. Laws,
Fringe Benefits Understand the procedures of fringe test exercises,
17 Lecture Principles, and
Taxation benefit tax computation assignments and
Applications. Real
other activities
Excellence
Master the procedures for the
Publishing.
computation of the fringe benefit tax
Distinguish business expense from a
personal expense Banggawan, R.
(2015) Income
Checking of Self-
Comprehend the concept of an Taation. Laws,
Principles of test exercises,
18 expense and a capital expenditure Principles, and
Deductions assignments and
Applications. Real
other activities
Understand the general principles of Excellence
deductions and tax reporting of Publishing.
deductions
FINAL EXAMINATION

xiii
COURSE GRADING SYSTEM
Class Standing 70%
 Quizzes
 Assignments
 Case Analysis
 Activities
Midterm / Final Examinations 30%
100%
Midterm Grade + Final Term Grade = FINAL GRADE
2
Enhanced by: Received by: Noted by:

Fernando F. Estingor, MSIT Jenny Q. Estingor, MEM Fernando F. Estingor, MSIT

Instructor Academic Head Campus Director

xiv
 CHAPTER I

INCOME TAXATION

Objectives
After the completion of this module, you should be able to comprehend and demonstrate
the mastery of the following:
 Concept of taxation and its necessity for every government
 Theories of government cost allocation inherent power of the state
 Limitations of taxation power
 Stages of taxation
 Concepts of tax amnesty and condonation

Taxation Definition
Taxation may be defined as a State power, a legislative power and a mode of
government cost distribution.
1. As a state power – Taxation is an inherent power of the state to enforce proportional
distribution from its subjects for public purpose.
2. As a process – Taxation is a process of laying taxes by the legislature of the state to
enforce proportional contributions from its subjects for public purposes.
3. As a mode of cost distribution - Taxation is a mode by which the State allocates its costs
or burden to its subjects who are benefited by its spending.

The Theory of Taxation

G
mb
u
P
tlic
rn
e
v
o s
p
x
a
T

Every government provides a vast array of public services including defense, public
order and safety, health, education, and social protection among others. A system of
government is indispensable to every society. Without it, other people will not relish the benefits

1
of a civilized and orderly society. However, a government cannot exist without a system of
funding. The governments necessity for funding is the theory of taxation.

The Basis of Taxation

The government provides benefit to the people in the form of public service and the
people provide the funds that finance the government. The mutuality of support between the
people and the government is referred to as the basis of taxation.

Receipts of benefits is conclusively presumed

Every citizen and resident of the State directly or indirectly benefit from the public
services rendered by the government. These benefits can be in the form of daily free usage of
public infrastructures, access to public health or educational services, the protection and
security of person and property, or simply the comfort of living in a civilized and peaceful society
which is maintained by the government.
While most public services are received indirectly, their realization by every citizen and
resident is undeniable. In taxation, the receipt of these benefits by the people is conclusively
presumed. Thus, taxpayers cannot avoid payment of taxes under the defense of absence of
benefit received. The direct receipt or actual availment of government services is not a
precondition to taxation.

Theories of Cost Allocation

Taxation is a mode of allocating government costs or burden to the people. In
distributing the costs or burden, the government regards the following general considerations in
the exercise of its taxation power:
1. Benefit perceived theory
The benefit perceived theory presupposes that the more benefit one receives from the
government, the more taxes he should pay.
2. Ability to pay theory
The ability to pay theory presupposes that taxation should also consider the taxpayers
ability to pay. Taxpayers should be required to contribute based on their relative capacity to
sacrifice for the support of the government. In short, those who have more should be taxed
more even if they benefit less from the government. Those who have less shall contribute less
even if they receive more of the benefits from the government.

2
Aspects of the Ability to Pay theory
1. Vertical equity
Vertical equity proposes that the extent of one’s ability to pay is directly proportional to
the level of his tax base. For example, A has P200,000 income while B has P400,000. In taxing
income, the government should tax B more than A because B has greater income; hence,
greater capacity to contribute.
2. Horizontal equity
Horizontal equity requires consideration of the circumstance of the taxpayer. For
example, both A and B have P300,000 income. A is single without a child but B is married with
four children. In taxing income, the government should tax A more than B because A has
greater capacity to contribute since he has no dependents to support. B has less capacity to
contribute considering the support requirements of his dependents. Vertical equity is a gross
receipt while horizontal equity is a net concept.

The Lifeblood Doctrine

Taxes are essential and indispensable to the continued subsistence of the government.
Without taxes, the government would be paralyzed for lack of motive power to activate or
operate it. Taxes are the lifeblood of the government and their prompt and certain availability
are imperious need. Upon taxation depends the government’s ability to serve the people for
whose benefit taxes are collected.

Implication of the Lifeblood Doctrine

1. Tax is imposed even in the absence of a constitutional grant.
2. Claims for tax exemption are construed against taxpayers.
3. The government reserves the right to choose the objects of taxation.
4. The court are not allowed to interfere with the collection of taxes.
5. In income taxation:
a. Income received in advance is taxable upon receipt.
b. Deduction for capital expenditure and prepayments is not allowed as it effectively
defers the collection of income tax.
c. A lower amount of deduction is preferred when a claimable expense is subject to
limit.
d. A higher tax base is preferred when tax objects has multiple tax bases.

3
Inherent Powers of the State
A government has its basic needs and rights which co-exist with its creation. It has rights
to sustenance, protection, and properties. The government sustains itself by the power of
taxation, secures itself and the well-being of its people by police power and secures its own
properties to carry out its public services by the power of eminent domain. The rights, dubbed
as powers, are natural, inseparable, and inherent to every government.
No government can sustain of effectively operate without these powers. Therefore, the
exercise if these powers by the government is presumed, understood, and acknowledged by the
people from the very moment they establish their government. These powers are naturally
exercisable by the government even in the absence of an express grant of power in the
Constitution.

Inherent Powers of the State

1. Taxation power – the power of the State to enforce proportional contribution from its
subjects to sustain self.
2. Police power – the general power of the State to enact laws to protect the well-being of the
people.
3. Eminent domain – the power of the State to take private property for public use after
paying just compensation.

Comparison of the three powers of the State

Point of
Taxation Police power Eminent domain
difference
Exercising Government and
Government Government
authority private utilities
For the support of the To protect the general
Purpose For public use
government welfare of the people
Persons Community or class of Community or class of Owner of the
affected individuals individuals property
No amount imposed
Limited (imposition is
Amount of Unlimited (tax is based (the government
limited to cover cost of
imposition on government needs) pays just
regulation)
compensation)
Importance Most important Most superior Important
Relationship Inferior to the Non- Superior to the Non- Superior to the Non-
with the Impairment Clause of Impairment Clause of Impairment Clause of
Constitution the Constitution the Constitution the Constitution
Constitutional and Public interest and due Public purpose and
Limitation
inherent limitations process just compensation

4
Similarities of the three powers of the State
1. They are all necessary attributes of sovereignty.
2. They are all inherent of the State.
3. They are all legislative in nature.
4. They are all ways in which the State interferes with private rights and properties.
5. They all exist independently with the Constitution and are exercisable by the government
even without Constitutional grant. However, the Constitution may impose conditions or limits
of their exercise.
6. They all presuppose an equivalent form of compensation received by the persons affected
by the exercise of power.
7. The exercise of these powers by the local government units may be limited by the national
legislature.

Scope of Taxation Power

The scope of taxation is widely regarded as comprehensive, plenary, unlimited and
supreme. However, despite the unlimited nature of taxation, it is not unlimited. Taxation has its
own inherent limitations and limitations imposed by the Constitution.

Limitations of Taxation Power

A. Inherent Limitations
1. Territoriality of taxation
2. International comity
3. Public purpose
4. Exemption of the government
5. Non-delegation of the taxing power
B. Constitutional Limitations
1. Due process of law
2. Equal protection of the law
3. Uniformity rule in taxation
4. Progressive system of taxation
5. Non-imprisonment for non-payment of debt or poll tax
6. Non-impairment of obligation and contract
7. Free worship rule

5
8. Exemption of religious or charitable entities, non-profit cemeteries, churches and mosque
from property taxes.
9. Non-appropriation of public funds or property for the benefit of any church, sect or system of
religion
10. Exemption from taxes of the revenues and assets of non-profit, non-stock educational
institutions
11. Concurrence of majority of all members of Congress for the passage of a law granting tax
exemption
12. Non-diversification of tax collections
13. Non-delegation of the power of taxation
14. Non-impairment of the jurisdiction of the Supreme Court to review tax cases
15. The requirement that appropriations, revenue of tariff bills shall originate exclusively in the
House of Representatives
16. The delegation of taxing power to local government units

Inherent Limitation of Taxation

Territoriality of Taxation
Public services are normally provided within the boundaries of the State. Thus, tax can
be imposed only within the territories of the State. There is no basis in taxing foreign subjects
abroad since they do not derive benefits from our government. Furthermore, extraterritorial
taxation will amount to encroachment of foreign sovereignty.

Exception to the Territoriality Principle

1. In income taxation, resident citizens and domestic corporations are taxable on income
derived within and outside the Philippines.
2. In transfer taxation, residents or citizens such as resident citizen, non-resident citizen and
resident alien are taxable on transfers of properties located within or outside the Philippines.

International comity
International comity pertains to mutual courtesy or reciprocity between states. It is a
basic principle of international law that all states are equally sovereign. Each state observes co-
equal sovereignty by not taxing on transfers of properties located within or outside the
Philippines. Consistent with this, embassies or consular offices in the Philippines of foreign

6
governments including international organizations and their non-Filipino staffs are not subject to
Philippine taxation. Under the NIRC, the income of foreign government and foreign government-
owned and controlled corporations are not subject to income tax. When a state enters into
treaties with other states, it is bound to honor the agreements as a matter of mutual courtesy
and in case its treaty agreements with other states conflicts with its local tax laws, treaty
agreements are given primacy.

Public purpose
Tax is extended for the common good. Taxation must be exercised absolutely for public
purpose. It cannot be exercised to further any private interest.

Exemption of the government

The taxation power is broad. The government can exercise the power upon the anything
including itself. However, the government normally does not tax itself as this will not raise
additional funds but will only impute additional costs. Under the NIRC, government properties
and income from essential public functions are not subject to taxation. However, income of the
government from its properties and activities conducted for profit including income from
government-owned and controlled corporations are subject to tax.

Non-delegation of taxing power

The legislative taxing power is vested exclusively in Congress and is non-delegable in
pursuant to the doctrine of separation of the branches of the government to ensure a system of
checks and balances. The power of lawmaking, including taxation, is delegated by the people to
the legislature. So as not to spoil the purpose of delegation. It is held that what has been
delegated cannot be further delegated.

Exceptions to the rule of non-delegation

1. Under the Constitution, local government units can exercise the power to tax to enable them
to exercise their fiscal autonomy.
2. Under the Tariff and Customs Code, the President is empowered to fix the number of tariffs
to be flexible to trade conditions.
3. Other cases thar requires expedient and effective administration and implementation of
assessment and collection of taxes.

7
Constitutional Limitations of Taxations
Observance of due process of law
No one should be deprived of his life, liberty, property without due process of law. Tax
laws should neither be harsh nor oppressive.

Aspects of Due Process

1. Substantive due process
Tax must be imposed only for public purpose, collected only under authority of a valid
law and by the taxing power having jurisdiction. An assessment without legal basis violates the
requirement of due process.
2. Procedural due process
There should be no arbitrariness in assessment and collection of taxes and the
government shall observe the taxpayers right to notice and hearing. The law established
procedures which must be adhered to in making assessments and in enforcing collections.
Under the NIRC, assessments shall be made within three years from the due date of
filing of the return or from the date of actual filing, whichever is later. Collection shall be made
within five years from the date of assessment. The failure of the government to observe these
rules violates the requirement of due process.

Equal Protection of Law

No person shall be denied the equal protection of the law. Taxpayers should be treated
equally both in terms of rights conferred and the obligations imposed. This rule applies where
taxpayers are under the same circumstances and conditions. This requirement would mean the
Congress cannot exempt sellers of balot while subjecting sellers of penoy to tax since they are
essentially the same goods.

Uniformity rule in Taxation

The rule of taxation shall be uniform and equitable. Taxpayers under dissimilar
circumstances should not be taxed the same. Taxpayers should be classified according to
commonality in attributes and the tax classification to be adopted should be based on
substantial distinction. Each class is taxed differently but taxpayers falling under the same class
are taxed the same. Hence, uniformity is relative equality.

8
Progressive system of Taxation
Congress shall evolve a progressive system of taxation. Under the progressive system,
tax rates increase as the tax base increase. The Constitution favors progressive tax as it is
consistent with the taxpayer’s ability to pay. Moreover, the progressive system aids in an
equitable distribution of wealth to society by taxing the rich more than the poor.

Non-imprisonment for non-payment of debt or poll tax

As a policy, no one shall be imprisoned by virtue of his poverty and no one shall be
imprisoned for more inability to pay debt. However, the Constitutional guarantee applies. Only
when the debt is acquired by the debtor in good faith. Debt acquired in bad faith constitutes
estafa, a criminal offense punishable by imprisonment.

Is non-payment of tax equivalent to non-payment of debt?

Tax arises from Law and is a demand of sovereignty. It is distinguished from debt which
arises from private contracts. Non-payment of tax compromises public interest while the non-
payment of debt compromises private interest. The non-payment of tax is like crime. The
Constitutional guarantee on non-imprisonment for non-payment of debt does not extend to non-
payment of tax, except poll tax.

Poll, personal, community or residential tax.

a. Basic community tax
b. Additional community tax
The Constitutional guarantee of non-imprisonment for non-payment of poll tax applies
only to the basic community tax. Non-payment of the additional community tax is an act of tax
evasion punishable by imprisonment.

Non-impairment of obligation and contract

The State should set an example of good faith among its constituents. It should not set
aside its obligations from contracts by the exercise of its taxation power. Tax exemptions
granted under contract should be honored and should not be cancelled by unilateral
government action.

Free Worship Rule

9
 The Philippine government adopts free exercise of religion and do not subject its
exercise to taxation. Consequently, the properties and revenues od religious institutions such as
tithes or offerings are not subject to tax. This exemption, however, does not extend to income
from properties or activities of religious institutions that are proprietary or commercial in nature.

Exemption of religious. Charitable or educational entities, non-profit cemeteries,

churches and mosques, lands buildings and improvements from property taxes.
The Constitutional exemption from property tax applies for properties, directly and
exclusively, used for charitable, religious and educational purpose.
In observing this Constitutional limitation, the Philippines follows the doctrine of use
wherein only properties devoted for religious, charitable or educational activities are exempt
from real property tax.
Under the doctrine of ownership, the properties of religious, charitable or educational
entities whether used in their primary operations are exempt from real property tax. This,
however, is not applied in the Philippines.

Non-appropriation of public funds or property for the benefit of any church, sect or
system of religion
The constitutional limitation is intended to highlight the separation of religion and the
State. To support the freedom of religion, the government should not favor any system of
religion by appropriating public funds or property in support thereof. It should be noted,
however, that compensation to priests, imam or religious ministers working with the military,
penal institutions, orphanages or leprosarium is not considered religious appropriation.

Exemption from taxes of the revenues and assets of non-profit, non-stock educational
institutions including grants, endowments, donations or contributions for educational
purposes.
The Constitution recognizes the necessity of education in state building by granting tax
exemption on revenues and assets of non-profit educational institutions. This exemption,
however, applies only on revenues and assets that are, directly and exclusively devoted for
educational purposes. Consistent with this constitutional recognition of education is necessity,
the National Internal Revenue Code (NIRC) also exempts government educational institutions
from income tax and subjects’ private educational institutions to a minimal 10% income tax.

10
Concurrence of most of all members of Congress for the passage of a law granting tax
exemption
Tax exemption law counters against lifeblood doctrine as it deprives the government of
revenues. Hence, the grant of tax exemption must proceed only upon a valid basis. As a safety
net, the Constitution requires the vote of most of all members of Congress in the grant of tax
exemption. In the approval of exemption law, an absolute majority or most of all members of the
Congress, and not relative majority or quorum majority is required. However, in the withdrawal
of tax exemption, only a relative majority is required.

Non-diversification of tax collections

Tax collections should be used only for public purpose. It should never be diversified or
used for private purpose.

Non-delegation of power of taxation

The principle of checks and balances in a republican state require that taxation power as
part of lawmaking to be vested exclusively in Congress.
However, delegation may be made on matters involving the expedient and effective
administration and implementations of assessment and collection of taxes. Also, certain aspects
of the taxing process that are non-legislative in character are delegated.
Hence, implementing administrative agencies such as Department of Finance and the
BIR issues revenue regulations, rulings, orders, or circulars to interpret and clarify the
application of law. But even so, their functions are merely intended to interpret or clarify the
proper application of the law and are not allowed to introduce new legislations within their quasi-
legislative authority.

Non-impairment of the jurisdiction of the Supreme Court to review tax cases

Notwithstanding the existence of the Court of Tax Appeals, which is a special court, all
cases involving taxes can be raised to and be finally decided by the Supreme Court of the
Philippines.

Appropriations, revenue or tariff bills shall originate exclusively in the House of

Representatives, but the Senate may propose or concur with amendments
Laws that add income to the national treasury and those that allows spending therein
must originate from the House of Representatives while Senate may concur with amendments.

11
The origination of a bill by Congress does not necessarily mean that the House Bill must
become the final law. It was held constitutional by the Supreme Court when Senate changed the
entire house version of tax bill.

Each local government unit shall exercise the power to create its own sources of revenue
and shall have a just share in the national taxes
This is a constitutional recognition of the local autonomy of local governments and an
express delegation of taxing power.

Stages of the Exercise of Taxation Power

1. Levy or imposition
This process involves the enactment of a tax law by Congress and is called impact of
taxation. It is also referred to as the legislative act in taxation. Congress is imposed of two
bodies: the House of Representatives, and the Senate.
As mandated by the Constitution, a tax bill must originate from the House of
Representatives. Each may, however, have their own versions of a proposed law and is
approved by both bodies but tax bills cannot originate exclusively from the Senate.

Matters of legislative discretion in the exercise of taxation

a. Determining the object of taxation
b. Setting the tax rate or amount to be collected
c. Determining the purpose for the levy, which must be public use
d. Kind of tax to be imposed
e. Apportionment of the tax between the national and local government
f. Situs of taxation
g. Method of collection

2. Assessment and collection

The tax law is implemented by the administrative branch of the government.
Implementation involves assessment or the determination of the tax liabilities of taxpayers and
collection. This stage is referred to as incidence of taxation or the administrative act of taxation.

12
Situs of Taxation
Situs is the place of taxation. It is the tax jurisdiction that has the power to levy taxes
upon the tax object. Situs rules serve as frames of reference in gauging whether the tax object
is within or outside the tax jurisdiction of the taxing authority.

Examples of Situs rules

1. Business tax situs – businesses are subject to tax in the place where business is conducted.
Illustration
A taxpayer is involved in car dealership abroad and restaurant operation in the
Philippines. The restaurant business will be subject to business tax in the Philippines since the
business is conducted herein but the car dealing business is exempt because the business is
conducted abroad.
2. Income tax situs on services – service fees are subject to tax where they are rendered.
Illustration
A foreign corporation leases a residential space to a non-resident Filipino citizen abroad.
The rent income will be exempt from Philippine taxation as the leasing service is rendered
abroad.
3. Income tax situs on sale of goods – the gain on sale is subject to tax in the place of sale.
Illustration
While in China, a non-resident OFW citizen agreed with a Chinese friend to sell his
diamond necklace to the latter. They stipulated that the delivery of the item and the payment will
be made a week later in the Philippines. The sale was consummated as agreed. The contract of
sale is consensual and is perfected by the meeting of the minds of the contracting parties. The
perfection of the contract of sale is in China. The situs of taxation is China. The gain on the sale
of the necklace will be taxable abroad and exempt in the Philippines.
4. Property tax situs – properties are taxable in their location.
Illustration
An overseas Filipino worker has a residential lot in the Philippines. He will still pay real
property tax despite his absence in the Philippines because his property is located therein.
5. Personal tax situs – persons are taxable in their place of residence.
Illustration
Ahmed Lofti is a Sudanese studying medicine in the Philippines. Ahmed will pay
personal tax in the Philippines even if he is an alien because he is residing in the Philippines.

13
Other Fundamental Doctrines in Taxation
1. Marshall Doctrine – The power to tax involves the power to destroy. Taxation power can be
used as an instrument of police power. It can be used to discourage or prohibit undesirable
activities or occupation. As such, taxation power carries with it the power to destroy.
However, the taxation power does not include the power to destroy if it’s used solely for the
purpose of raising revenue.
2. Holme’s Doctrine – Taxation power is not the power to destroy while the court sits.
Taxation power may be used to build or encourage beneficial activities or industries by the
grant of tax incentives. While the Marshall Doctrine and the Holme’s Doctrine appear to
contradict each other, both are employed in practice. A good manifestation of the Marshall
Doctrine is the imposition of excessive tax on cigarettes while the applications of the
Holme’s Doctrine include the creation of Ecozones with tax holidays and provision of
incentives such as E. O. 226 and the BMBE Law.
3. Prospectivity of tax laws – tax laws are generally prospective in operation. An ex post
facto law or law that retroacts is prohibited by the Constitution. Exceptionally, income tax
laws may operate retrospectively if so, intended by Congress under certain justifiable
conditions. For example, Congress can levy tax on income earned during periods of foreign
occupation even after the war.
4. Non-compensation or set-off – taxes are not subject to automatic set-off or compensation.
The taxpayer cannot delay payment of tax to wait for the resolution of a lawsuit involving his
pending claim against the government. Tax is not a debt; hence it is not subject to set-off.
This rule is important to allow the government sufficient period to evaluate the validity of the
claim.
Exceptions:
a. Where the taxpayers claim has already become due and demandable such as when the
government already recognized the same and an appropriation for refund was made.
b. Cases of obvious overpayment of taxes
c. Local taxes
5. Non-assignment of taxes – tax obligations cannot be assigned or transferred to another
entity by contract. Contracts executed by the taxpayer to such effect shall not prejudice the
right of the government to collect.
6. Imprescriptibility in taxation – as a rule, taxes do not prescribe unless the law itself
provides for prescription. Under the NIRC, tax prescribes if not collected within 5 years from

14
 the date of its assessment. In the absence of assessment, tax prescribes if not collected by
judicial action within 3 years from the date the return is required to be filed. However, taxes
due from taxpayers who did not file a return or those who filed fraudulent returns do not
prescribe.
7. Doctrine of estoppel – under the doctrine of estoppel, any misinterpretation made by one
party toward another who relied therein in good faith will be held true and binding against
that person who made the misinterpretation. The government is not subject to estoppel. The
error of any government employee does not bind the government. It is held that the neglect
or omission of government officials entrusted with the collection of taxes should not be
allowed to bring harm or detriment to the interest of the people. Also, erroneous applications
of the law by public officers do not block the subsequent correct application of the same.
8. Judicial non-interference – generally, courts are not allowed to issue injunction against the
government’s pursuit to collect tax as this would unnecessarily defers tax collection. This
rule is anchored on the Lifeblood Doctrine.
9. Strict Construction of Tax Laws – when the law clearly provides for taxation, taxation is
the general rule unless there is a clear exemption. Hence the maxim, taxation is the rule,
exemption is the exception. When the language of the law is clear and categorical, there is
no room for interpretation. There is only for application. However, when taxation laws are
vague, the doctrine of strict legal construction is observed.

Vague Tax Laws

Vague tax laws are construed against the government and in favor of the taxpayers. A
vague tax law means no tax law. Obligation arising from law is not presumed. The Constitutional
requirement of due process requires laws to be sufficiently clear and expressed in their
provisions.

Vague Exemption Laws

Vague tax exemption laws are construed against the taxpayer and in favor of the
government. A vague tax exemption law means no exemption law. The claim for redemption is
construed strictly against the taxpayer in accordance with the lifeblood doctrine. The right of
taxation is inherent to the State. It is a prerogative essential to the perpetuity of the government.
He who claims exemption for the common burden, must justify his claim by the clearest grant of
organic or statute law. When the exemption is claimed, it must be shown indubitably to exist. At
the outset, every presumption is against it. A well-founded doubt is fatal to the claim; it is only

15
when the terms of the concession are too explicit to admit fairly of any other construction that
the preposition can be supported.
Tax exemption cannot arise from vague inference. Tax exemption must be clear and
unequivocal. A taxpayer claiming a tax exemption must point to a specific provision of law
conferring on the taxpayer, in clear and plain terms, exemption from a common burden. Any
doubt whether a tax exemption to exist is resolved against the taxpayer.

Double Taxation
Double taxation occurs when the same taxpayer is taxed twice by the same tax
jurisdiction for the same thing.

Elements of Double Taxation

1. Primary element: Same object
2. Secondary element:
a. Same type of tax
b. Same purpose of tax
c. Same taxing jurisdiction
d. Same tax period

Types of Double Taxation

1. Direct double taxation – this occurs when all the element of double taxation exists for both
impositions.
Example:
a. An income tax of 10% on monthly sales and a 2% income tax on the annual sales (total
of monthly sales)
b. A 5% tax on bank reserve deficiency and another 1% penalty per day because of such
reserve deficiency.
2. Indirect double taxation – this occurs when at least one of the secondary elements of
double taxation is not common for both impositions.
Example:
a. The national government levies business tax on the sales or gross receipts of business
while the local government levies business tax upon the same sales or receipts.
b. The national government collects income tax from a taxpayer on his income while the
local government collects community tax upon the same income.

16
 c. The Philippine government taxes foreign incomes of domestic corporations and resident
citizen while a foreign government also taxes the same income (international double
taxation).
Nothing in our law expressly prohibits double taxation. In fact, indirect double taxation is
prevalent in practice. However, direct double taxation is discouraged because it is oppressive
and burdensome to taxpayers. It is also believed to counter against the rule of equal protection
and uniformity in the Constitution.

How can double taxation be minimized?

The impact of double taxation can be minimized by any one or a combination of the
following:
a. Provision of tax exemption
b. Allowing foreign tax credit (deduction for taxes paid abroad)
c. Allowing reciprocal tax treatment between the home country and a foreign country
d. Entering into treaties or bilateral agreements

Escapes from Taxation

Escapes from taxation are the means available to the taxpayer to limit or even avoid the
impact of taxation.

Categories of Escapes from Taxation

A. Those that result to loss of government revenue
1. Tax evasion – also known as tax dodging, refers to any act or trick that tends to illegally
reduce or avoid the payment of tax. In income taxation, this can be perpetrated by due
understatement of income, overstatement of expenses or non-declaration of income.
2. Tax avoidance – also known as tax minimization, refers to any act or trick that reduces or
totally escapes taxes by any illegally permissible means. This may be done by selecting tax
options allowed by the law which minimizes tax liability or by careful tax planning to reduce
tax exposure.
3. Tax exemption – also known as tax holiday, refers to the immunity, privilege or freedom
from being subject to a tax which other are subject to. Tax exemptions may be granted by
the Constitution, law or contract. All forms of tax exemptions can be revoked by Congress
except those granted by the Constitution and those granted under contracts.

17
B. Those that do not result to loss of government revenue
1. Shifting – the process of transferring tax burden to other taxpayers.

Forms of Shifting
a. Forward – shifting of tax which follows the normal flow of distribution (i.e. from manufacturer
to wholesalers, retailers to consumers). Forward shifting is common with essential
commodities and services such as food and fuel.
b. Backward – the reverse of forward shifting. Backward shifting is common with non-essential
commodities where buyers have considerable market power and commodities with
numerous substitute products.
c. Onward – any tax shifting in the distribution channel that exhibits forward or backward.
Shifting is common with business taxes where taxes imposed on business revenue can
be shifted or passed on to customers.
2. Capitalization – occurs when the value of assets adjusts to accommodate increases in
taxes. For instance, the value of a mining property will correspondingly decrease when
mining output is subjected to higher taxes. This is a form of backward shifting of tax.
3. Transformation – occurs when wastes or losses are eliminated by the taxpayer to form
savings to compensate for the tax imposition or increase in taxes.

Tax Amnesty
Amnesty is a general pardon granted by the government for erring taxpayers to give
them the chance to reform and to enable them a fresh start to be a part of a society with a clean
slate. It is an absolute forgiveness or waiver by the government on its right to collect and is
retrospective in application.

Tax Condonation
Tax condonation is forgiveness of the tax obligation of a certain taxpayer under certain
justifiable grounds. This is also referred to as tax remission. Because they deprive the
government of revenues, tax exemption, tax refund, tax amnesty, and tax condonation are
construed against the taxpayer and in favor of the government.

Tax Amnesty vs. Tax Condonation

Amnesty covers both civil and criminal liabilities, but condonation covers only civil
liabilities of the taxpayers. Amnesty operates retrospectively by forgiving past violations.

18
Condonation apples prospectively to any unpaid balance of the tax; hence the portion already
paid by the taxpayer will not be refunded. Amnesty is also conditional upon the taxpayer paying
the government a portion of the tax whereas condonation requires no payment.

Self-Text Exercises
Discussion Questions
1. Define taxation.
2. Distinguish the theory and the basis of taxation.
3. What are the theories of government cost allocation? Explain each.
4. Differentiate vertical and horizontal equity.
5. Discuss the Lifeblood Doctrine.
6. Enumerate and explain the inherent powers of the State.
7. Distinguish the three powers of the State and enumerate their similarities.
8. Describe the scope and power of taxation.
9. Distinguish substantive and procedural due process.
10. Distinguish the concept of equality and the concept of uniformity in taxation.
Exercise Drill: In the space provided for, indicate whether the statement relates to a
Constitutional limitation (C), or inherent limitation (I). If not a limitation to the taxing power,
indicate (N).
1. Non-imprisonment for non-payment of tax or debt
2. Non-delegation of the taxing power
3. Taxes must be for public use
4. Exemption of the property of religious institutions from income tax
5. Exemption of the revenues and assets of non-profit non-stock educational
institution
6. Territoriality of taxation
7. Non-appropriation for religious purpose
8. The requirement of absolute majority in the passage of tax exemption law
9. Non-assignment of taxes
10. Imprisonment for non-payment of poll tax.

19
 CHAPTER II

TAXES, TAX LAWS AND TAX ADMINISTRATION

Objectives
After the completion of this module, you should be able to comprehend and demonstrate
the knowledge of the following:
 Types of taxation laws
 Distinction of tax laws, revenue regulations and rulings
 Tax, its elements and classifications
 Distinction of tax with similar items
 How tax is administered

Taxation Law
Taxation law refers to any law that arises from the exercise of the taxation power of the
State.
Types of Taxation Laws
1. Tax laws – laws that provide for the assessment and collection of taxes.
Examples:
a. The National Internal Revenue Code (NIRC)
b. The Tariff and Customs Code
c. The Local Tax Code
d. The Real Property Tax Code
2. Tax exemption laws – laws that grant immunity from taxation.
Examples:
a. The Minimum Wage Law
b. The Omnibus Investment Code of 1987 (E. O. 226)
c. Barangay Micro Business Enterprise Law
d. Cooperative Development Act

Sources of Taxation Laws

1. Constitution
2. Statutes and Presidential Decrees
3. Judicial Decisions or case laws
4. Executive orders and Batas Pambansa

20
5. Administrative issuances
6. Local ordinances
7. Tax Treaties and conventions with foreign countries
8. Revenue regulations

Types of Administrative Issuances

1. Revenue regulations
2. Revenue memorandum orders
3. Revenue memorandum rulings
4. Revenue memorandum circulars
5. Revenue bulletins
6. BIR rulings
Revenue regulations are issuances signed by the Secretary of Finance, upon
recommendation of the Commissioner of Internal Revenue (CIR) that specify, prescribe or
define rules and regulations for the effective enforcement of the provisions of the National
Internal Revenue Code (NIRC) and related statutes. Revenue regulations are formal
pronouncement intended to clarify or explain the tax law and carry into effect its general
provisions by providing details of administration and procedure. Revenue regulation has the
force and effect of a law but is not intended to expand or limit the application of law; otherwise, it
is void.
Revenue Memorandum Orders (RMO) are issuances that provide directives or
instructions; prescribe guideline; and outline processes, operations, activities, workflows,
methods and procedures necessary in the implementation of stated policies, goals, objectives,
plans and programs of the Bureau in all areas of operations, except auditing.
Revenue Memorandum Rulings (RMM) are rulings, opinions and interpretations of the
CIR with respect to the provisions of the Tax Code and other tax laws, as applied to a specific
set of facts, with or without established precedents, and which the CIR may issue from time to
time for the purpose of providing taxpayers guidance on the tax consequences in specific
situations. BIR rulings, therefore, cannot contravene duly issued RMRs; otherwise, the rulings
are null and void ab initio.
Revenue Memorandum Circulars (RMC) are issuances that publish pertinent and
applicable portions, as well as amplifications, of laws, rules, regulations, and precedents issued
by BIR and other agencies / offices.

21
 Revenue Bulletin (RB) refers to periodic issuances, notices and official announcements
of the Commissioner of Internal Revenue that consolidate the Bureau of Internal Revenues
position on certain specific issues of law or administration in relation to the provisions of the Tax
Code, relevant tax laws and other issuances for the guidance of the public.
BIR Rulings are official position of the Bureau to queries raised by taxpayers and other
stakeholders relative to clarification and interpretation of tax laws. Rulings are merely advisory
or sort of an information service to the taxpayer such that none of them are binding except to
the addressee and may be reversed by the BIR at any time.

Types of Rulings
1. Value Added Tax (VAT) rulings
2. International Tax Affairs Division (ITAD) rulings
3. BIR rulings
4. Delegated Authority (DA) rulings

Generally Accepted Accounting Principles (GAAP) vs. Tax Laws

Generally accepted accounting principles or GAAP are not laws but are mere
conventions of financial reporting. They are benchmark for the fair and relevant valuation and
recognition of income, expense, assets, liabilities and equity of a reporting entity for general
purpose financial reporting. GAAP accounting reports are intended to meet the common needs
of a vast number of users of the public. Tax laws including rules, regulations and rulings
prescribe the criteria for tax reporting, a special form of financial reporting which is intended to
meet specific needs of tax authorities.
Taxpayers normally follow GAAP in recording transactions in their books. However, in
preparation and filing of tax returns, taxpayers are mandated to follow the tax law in cases of
conflict with GAAP.

Nature of Philippine Tax Laws

Philippine tax laws are civil and not political in nature. They are effective even during
periods of enemy occupation. They are laws of the occupied territory and not by the occupying
enemy. Tax payments made during occupations of foreign enemies are valid. Our internal
revenue laws are not penal in nature because they do not define crime. Their penalty provisions
are merely intended to secure taxpayers’ compliance.

22
Tax
Tax is an enforced proportional contribution levied by the lawmaking body of the State to
raise revenue for public purpose.

Elements of Valid Tax

1. Tax must be levied by the taxing power having jurisdiction over the subject of taxation.
2. Tax must not violate constitutional and inherent limitations.
3. Tax must be uniform and equitable.
4. Tax must be for public purpose.
5. Tax must be proportional in character.
6. Tax is generally payable in money.

Classification of Taxes
A. As to purpose
1. Fiscal or revenue tax – s tax imposed for general purpose
2. Regulatory – a tax imposed to regulate business, conduct, acts or transactions
3. Sumptuary - tax levied to achieve some social or economic objectives
B. As to subject matter
1. Personal, poll or capitation – a tax on persons who are residents of a territory
2. Property tax – a tax on properties, real or personal
3. Excise or privilege tax – a tax imposed upon the performance of an act, enjoyment or
privilege or engaging in an occupation
C. As to incidence
1. Direct tax – when both the impact and incidence of taxation rest upon the same
taxpayer, the tax is said to be direct. The tax is collected from the person who is
intended to pay the same. The statutory taxpayer is the economic taxpayer.
2. Indirect tax – when the tax is paid by any person other than the one who is intended to
pay the same, the tax is called to be indirect. This occurs in the case of business taxes
where the statutory taxpayer is not the economic taxpayer. The statutory taxpayer is the
person named by the law to pay the tax. An economic taxpayer is the one that pays the
tax.
D. As to amount
1. Specific tax – a tax of fixed amount imposed on a per unit basis such as per kilo, liter or
meter, etc.

23
 2. Ad valorem – a tax of a fixed proportion imposed upon the value of the tax object
E. As to rate
1. Proportional tax – a tax of flat or fixed percentage is applied to the tax base. The use of
proportional tax rates emphasizes equality as it subjects all taxpayers with the same rate
without regard to their ability to pay.
2. Progressive or graduated tax – tax rates increases as the tax base increases. The use of
progressive tax rates results in in more equitable taxes as it tends to lessen the gap
between the rich and the poor.
3. Regressive tax – tax rate decreases as the tax base increases. Regressive tax is anti-
poor and unconstitutional. It directly violates the Constitutional guarantee of progressive
taxation.
4. Mixed tax – a tax with a tax rate which is a combination of any of the above rates.
F. As to imposing authority
1. National tax – tax imposed by the national government
Examples:
a. Income tax – tax on annual income, gains or profits
b. Estate tax – tax on gratuitous transfer of properties by a decedent upon death
c. Donors tax – tax on gratuitous transfer of properties by a living donor
d. Value Added Tax – consumption tax collected by VAT business taxpayers
e. Other percentage tax – consumption tax collected by non-VAT business taxpayers.
f. Excise tax – tax on sin products and non-essential commodities such as alcohol,
cigarettes, and metallic minerals. This should be differentiated with the privilege tax
which is also called excise tax.
g. Documentary stamp tax – a tax on documents, instruments, loan agreements and
papers evidencing the acceptance, assignment, sale or transfer of an obligation, right
or property incident thereto.
2. Local tax – tax imposed by the municipal or local government
Examples:
a. Real property tax
b. Professional tax
c. Business taxes, fees and charges
d. Community tax
e. Tax on banks and other financial institutions

24
Distinction of Taxes with Similar Items

Tax vs. revenue

Tax refers to the amount imposed by the government for public purpose. Revenue refers
to all income collections of the government which includes taxes, tariff, licenses, toll, penalties,
and others. The amount imposed is tax, but the amount collected is revenue.

Tax vs. license fee

Tax has a broader subject than license. Tax emanates from taxation power and is
imposed upon any objects such as persons, properties, or privileges to raise revenue. License
fee emanates from police power and is imposed to regulate the exercise of a privilege such as
the commencement of a business or a profession. Taxes are imposed after the commencement
of a business or profession whereas license fee is imposed before engagement in those
activities. In other words, tax is post-activity imposition whereas license fee is a pre-activity
imposition.

Tax vs. poll

Tax is a levy of government; hence, it is a demand of sovereignty. Toll is a charge for the
use of others property; hence, it is a demand of ownership. The amount of tax depends upon
the needs of the government, but the amount of toll is dependent upon the value of the property
leased. Both the government and private entities impose toll, but private entities cannot impose
taxes.

Tax vs. debt

Tax arises from law while debt arises from private contracts. Non-payment of tax leads
to imprisonment but non-payment of debt does not lead to imprisonment. Debt can be subject
to set-off, but tax is not. Debt can be paid in kind by dacion en pago, but tax is generally payable
in money. Tax draws interest only when the taxpayer is delinquent. Debt draws interest when it
is so stipulated by the contracting parties or when the debtor incurs a legal delay.

Tax vs. Special assessment

Tax is an amount imposed upon persons, properties, or privileges. Special assessment
is levied by the government to lands adjacent to a public improvement. It is imposed in land only
and is intended to compensate for a part of the cost of improvement. The basis of special

25
assessment is the benefit in terms of the appreciation in land value cause by the public
improvement. On the other hand, tax is levied without expectation of a direct proximate benefit.
Unlike taxes, special assessment attaches to the land. It will not become a personal obligation
of the landowner. Therefore, non-payment of special assessment will not result into
imprisonment of the owner unlike non-payment of taxes.

Taxes vs. tariff

Tax is broader than tariff. Tax is an amount imposed upon persons, privilege,
transactions or properties. Tariff is the amount imposed on imported or exported commodities.

Tax vs. penalty

Tax is an amount imposed for the support of the government. Penalty is amount
imposed to discourage an act. Penalty may be imposed by law by both the government and
private individuals. It may arise both from law and contract whereas tax arises from law.

Tax System
The tax system refers to the methods or schemes of imposing, assessing, and collecting
taxes. It includes all the tax laws and regulations, the means of their enforcement and the
government offices, bureaus and withholding agents which are part of the machineries of the
government in tax collection. The Philippine tax system is divided into two: the national tax
system and the local tax system.

Types of Tax System According to Imposition

1. Progressive – employed in the taxation of individual income and transfers of properties by
individuals
2. Proportional – employed in taxation of corporate income and business
3. Regressive – not employed in the Philippines

Types of Tax System According to Impact

1. Progressive tax system – is one that emphasizes direct taxes. A direct tax cannot be shifted.
Hence, it encourages economic efficiency as it leaves no other resort to taxpayers than to
be efficient. This type of tax system impacts more upon the rich.
2. Regressive tax system – is one that emphasizes indirect taxes. Indirect taxes are shifted by
businesses to consumers; hence, the impact of taxation rests upon the bottom end of the
society. In effect, a regressive tax system is anti-poor. It is widely believed that despite the

26
 Constitutional guarantee of a progressive taxation, the Philippine has a dominantly
regressive tax system due to the prevalence of business taxes.

Tax Collection Systems

1. Withholding systems – under this collection system, the payor of the income withholds or
deducts the tax on the income before releasing the same to the payee and remits the same
to the government. The following are the withholding taxes collected under this system:
a. Withholding tax on compensation – a tax withheld by the employer from payments of
compensation income to employees
b. Expanded withholding tax – a withholding tax prescribed on certain income payments
and is creditable against the income tax due of the payee for the taxable quarter or year
in which the income was earned.
c. Final withholding tax – a kind of withholding tax which is prescribed on certain income
payments and is not creditable against any income tax due of the payee for the taxable
year.
d. Withholding tax on government payments – the tax withheld by the national government
agencies and instrumentalities including government-owned and controlled corporations
on their payment to taxpayers, suppliers or payees.
2. Voluntary compliance system – under this collection system, the taxpayer himself
determines his income, reports the same through income tax returns and pays the tax to the
government. This system is also referred to as the self-assessment method. A portion of the
tax due payable herein may have been withheld under the withholding system such as:
a. Withholding tax on compensation by compensation earners
b. Expanded withholding tax by taxpayer engaged in business or exercise of profession
The taxes withheld are treated as tax credit (deduction) against the tax due of the
taxpayer in the income tax return. The taxpayer shall pay any balance still due after such
credit or claim refund or tax credit for excess tax withheld.
3. Assessment or enforcement system – under this collection system, the government
identifies the non-compliant taxpayers, assesses their tax dues and penalties and enforces
collection by coercive means such as summary proceeding or judicial proceeding when
necessary.

27
Principles of a Sound Tax System
According to Adam Smith, governments should adhere to certain principles or canons to
evolve a sound tax system:
1. Fiscal adequacy
2. Theoretical justice
3. Administrative feasibility
Fiscal adequacy
Fiscal adequacy requires that the sources of the government funds must be sufficient to
cover government expenditures. The government must not incur a deficit. A budget deficit
paralyzes the government’s ability to deliver the essential public services to the people. Hence,
taxes should increase in response to increase in government spending.

Theoretical justice
Theoretical justice or equity suggests that taxation should consider the taxpayers ability
to pay. It also suggests that the exercise of taxation should not be oppressive, unjust or
confiscatory.

Administrative feasibility
Administrative feasibility suggests that the tax laws should be capable of efficient and
effective administration to encourage compliance. Government should make it easy for the
taxpayer to comply by avoiding administrative bottlenecks and reducing compliance costs. The
applications of the principle of administrative feasibility in our current tax system include:
1. E-filing and e-payment of taxes
2. Substituted filing system for employees
3. Final withholding tax on non-resident aliens or corporations
4. Accreditation of authorized agent banks in the filing and payment of taxes

Tax Administration
Tax administration refers to the management of the tax system. Tax administration of the
national tax system in the Philippines is entrusted to the Bureau of Internal Revenue which is
under the supervision and administration of the Department of Finance.
Chief Officials of the Bureau of Internal Revenue
1. 1 Commissioner
2. 4 Deputy Commissioners, each to be designated to the following:

28
 a. Operations group
b. Legal Enforcement group
c. Information Systems group
d. Resource Management group

Powers of the Bureau of Internal Revenue

1. Assessment and collection of taxes
2. Enforcement of all forfeitures, penalties, and fines and judgments in all cases decided in its
favor by the courts
3. Giving effects to and administering the supervisory and police powers conferred to it by the
NIRC and other laws
4. Assignment of internal revenue officers and other employees to other duties
5. Provision and distribution to proper officials of forms, receipts and certificates, stamps, etc.
6. Issuance of receipts and clearances
7. Submission of annual report, pertinent information to Congress and reports to the
Congressional Oversight Committee in matters of taxation

Powers of the Commissioners of Internal Revenue

1. To interpret the provisions of the NIRC, subject to review by the Secretary of Finance
2. To decide tax cases, subject to the exclusive appellate jurisdiction of the Court of Tax
Appeals, such as:
a. Disputed assessments
b. Refunds of internal revenue taxes, fees or other charges
c. Penalties imposed
d. Other NIRC and special law matters administered by the BIR
3. To obtain information and to summon, examine and take testimony of persons to effect tax
collection
Purpose: For the CIR to ascertain:
a. The correctness of any tax return or in making a return when none has been made by
the taxpayer
b. The tax liability of any person for any internal revenue tax or in correcting any such
liability
c. Tax compliance of the taxpayer
Authorized acts

29
 a. To examine any book, paper, record or other data relevant to such inquiry
b. To obtain on a regular basis any information from any person other than the person
whose internal revenue tax liability is subject to audit
c. To summon the person liable for tax or required to file a return, his employees or any
person having possession and custody of his books of accounts and accounting records
to produce such books, papers, records or other data and to give testimony
d. To take testimony of the person concerned, under oath, as may be relevant or material
to the inquiry
e. To cause revenue officer and employees to make canvass of any revenue district
4. To make assessment and prescribe additional requirement for tax administration and
enforcement
5. To examine tax returns and determine tax due thereon
The CIR or his duly authorized representatives may authorize the examination of any
taxpayer and the assessment of the correct amount of tax. Failure to file a return shall not
prevent the CIR from authorizing the examination. Tax or deficiency assessments are due upon
notice and demand by the CIR or his representatives. Returns, statements or declarations shall
not be withdrawn but may be modified, changed, and amended by the taxpayer within three
years from the date of filing, except when a notice for audit or investigation has been served
upon the taxpayer.
When a return shall not be forthcoming within the prescribed deadline or when there is a
reason to believe that the return is false, incomplete or erroneous the CIR shall assess the
proper tax on the basis of best evidence available. In case a person fails to file a required return
or other documents at the time prescribed by law or willfully files a false or fraudulent return or
other documents, the CIR shall make or amend the return from his own knowledge and from
such information obtained from testimony. The return shall be presumed prima facie correct and
sufficient for all legal purposes.
6. To conduct inventory taking or surveillance
7. To prescribe presumptive gross sales and receipts for a taxpayer when:
a. The taxpayer failed to issue receipts
b. The CIR believes that the books or other records of the taxpayer do not correctly
reflect the declaration of return
The presumptive gross sales or receipt shall be derived from the performance of similar
business under similar circumstances adjusted for other relevant information.
8. To terminate tax period when the taxpayer is:
a. Retiring from business
b. Intending to leave the Philippines
c. Intending to remove, hide or conceal his property

30
 d. Intending to perform any act tending to obstruct the proceedings for the collection of
tax or render the same ineffective
The termination of the taxable period shall be communicated through a notice to the
taxpayer together with a request for immediate payment. Taxes shall be due and payable
immediately.
9. To prescribe real property values
The CIR is authorized to divide the Philippines into zones and prescribe real property
values after consultation with competent appraisers. The values prescribed are referred to as
zonal value.
For the purposes of internal revenue taxes, fair value of real property shall mean
whichever is higher of:
a. Zonal value prescribed by the Commissioner
b. Assessed value per the Provincial and City Assessors Office
For the purposes of local taxes, fair value of real property pertains to the assessed
value.
10. To compromise tax liabilities of taxpayers
11. To inquire into bank deposits, only under the following instances:
a. Determination of the gross estate of decedent
b. To substantiate the taxpayer’s claim of financial incapacity to pay tax in an
application for tax compromise
In cases of financial incapacity, inquiry can proceed only if the taxpayer waives his
privilege under the Bank Deposit Secrecy Act.
12. To accredit and register tax agents
The denial by the CIR of application for accreditation is appealable to the Department of
Finance. The failure of the Secretary of Finance to act on the appeal within 60 days is deemed
an approval.
13. To refund or credit internal revenue taxes
14. To abate or cancel tax liabilities in certain cases
15. To prescribe additional procedures or documentary requirements
16. To delegate his powers to any subordinate officer with rank equivalent to a division chief of
an office

Non-delegated power of the CIR

The following power of the Commissioner shall not be delegated:

31
1. The power to recommend the promulgation of rules and regulations to the Secretary of
Finance
2. The power to issue rulings of first impression or to revise, revoke or modify any existing
rulings of the Bureau.
3. The power to compromise or abate any tax liability
Exceptionally, the Regional Evaluation Boards may compromise tax liabilities under the
following:
a. Assessments are issued by the regional offices involving basic deficiency tax of
P500,000 or less
b. Minor criminal violations discovered by regional and district officials
Composition of the Regional Evaluation Board
a. Regional Director as Chairman
b. Assistant Regional Director
c. Heads of the Legal, Assessment and Collection Division
d. Revenue District Officer having jurisdiction over the taxpayer
4. The power to assign and reassign internal revenue officers to establishments where articles
subject to excise tax are produced or kept.

Rules in assignments of revenue officers to other duties

1. Revenue officers assigned to an establishment where excisable articles are kept shall in no
case stay therefore more than 2 years.
2. Revenue officers assigned to perform assessment and collection function shall not remain in
the same assignment for more than 3 years.
3. Assignment of internal revenue officers and employees of the Bureau to special duties shall
not exceed 1 year.

Agents and Deputies for Collection of National Internal Revenue Taxes

The following are constituted agents for the collection of internal revenue taxes:
1. The Commissioner of Customs and his subordinates with respect to collection of national
internal revenue taxes on imported goods.
2. The head of appropriate government offices and his subordinates with respect to the
collection of energy tax.

32
3. Banks duly accredited by the Commissioner with respect to receipts of payments of internal
revenue taxes authorized to be made thru banks. These are referred to as authorized
government depositary banks (AGDB).

Taxpayer Classification for Purposes of Tax Administration

For purposes of effective and efficient tax administration, taxpayers are classified into
large and non-large. Large taxpayers are under the supervision of the Large Taxpayers Service
(LTS) of the BIR. Non-large taxpayers are under the supervision of the respective Revenue
District Offices (RDOs) where the business, trade or profession of the taxpayer is situated. The
following are the criteria for determining large taxpayers:
a. As to payment
 Value Added Tax – at least P200,000 per quarter for the preceding year
 Excise Tax – at least P1,000,000 tax paid for the preceding year
 Income Tax – at least P1,000,000 annual income tax paid for the preceding year
 Withholding tax – at least P1,000,000 annual withholding tax payments or remittances from
all types of withholding taxes
 Percentage tax – at least P200,000 percentage tax paid or payable per quarter for the
preceding year
 Documentary stamp tax – at least P1,000,000 aggregate amount per year
b. As to financial conditions and results of operations
1. Gross receipts or sales – P1,000,000,000 total annual gross sales or receipts
2. Net worth – P300,000,000 total net worth at the close of each calendar of fiscal year
3. Gross purchases – P800,000,000 total annual purchases for the preceding year
4. Top corporate taxpayer listed and published by the Securities and Exchange Commission

Automatic Classification of Taxpayers as Large Taxpayers

The following taxpayers shall be automatically classified as large taxpayers upon notice
in writing by the CIR.
1. All branches of taxpayers under the Large Taxpayers Service
2. Subsidiaries, affiliates and entities of conglomerates or group of companies of a large
taxpayer
3. Surviving company in case of merger or consolidation of a large taxpayer
4. A corporation that absorbs the operation or business in case of spin-off of any large
taxpayer

33
5. Corporation with an authorized capitalization of at least P300,000,000 registered with the
SEC
6. Multinational enterprises with an authorized capitalization or assigned capital of at least
P300,000,000
7. Publicly listed corporations
8. Universal, commercial and foreign banks (the regular business unit and foreign currency
deposit unit shall be considered one taxpayer for purposes of classifying them as large
taxpayer)
9. Corporate taxpayers with at least P100,000,000 authorized capital in banking insurance,
telecommunication, utilities, petroleum, tobacco, and alcohol industries
10. Corporate taxpayers engaged in the production of metallic minerals

Self-Test Exercises
Discussion Questions
1. Distinguish tax law from tax exemption law.

2. Discuss the nature of Philippine tax law.

3. Define tax and identify its elements.

4. Compare tax with revenue, license, toll, debt, special assessment, tariff and penalty.

5. What is a tax system? What are its types?

6. Enumerate the principles of a sound tax system? Explain each.

7. Enumerate the powers of the BIR.

8. Enumerate the non-delegated powers of the CIR.

9. Enumerate the sources of tax laws.

10. Distinguish tax laws, revenues and rulings.

Exercise Drill: Identify the type of tax that is described by the following:
1. Tax on residents of a country
2. Tax upon performance of an act or enjoyment of a privilege
3. Tax for general purpose
4. Tax collected upon persons who are not the statutory taxpayers
5. Tax that is imposed based on the value of the tax
6. Tax that decrease in rates as the amount or value of the tax object
increases
7. Tax imposed by the national government

34
8. Tax on sin products or non-essential commodities
9. Tax on gratuitous transfer of property upon death
10. Consumption tax collected by non-VAT business

35
 CHAPTER III

INTRODUCTION TO INCOME TAXATION

Objectives
After the completion of this module, you should be able to comprehend and demonstrate
the knowledge of the following:
 The concept of gross income
 The types of income taxpayers
 The general rules income taxation
 The income tax situs rules

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 fewer personal exemptions
allowable by law. Technically, gross income is broader too pertain to any income that can be
subjected to income tax. Gross income is broadly defined as any inflow of wealth to the
taxpayer that increases net worth from whatever source, legal or illegal. It includes income from
employment, trade/business, exercise of profession, income from properties, and other
resources such as dealing 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 retained 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 taxpayers net worth.

36
Illustration:
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 foregone) 300 Return of capital
Mark-up (gross income) P200 Return on capital
The return of capital that increases net worth is income subject to income tax. Return
of capital merely maintains net worth hence, not taxable. An improvement in net worth indicates
an ability to pay tax.

Capital Items Deemed with Definite Value

There are capital items that have definite value and are incapable of pecuniary valuation.
Anything received as compensation for their loss is deemed a return of capital. Examples:
 Life
 Health
 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 or sum or otherwise, are exempt from income tax. The proceeds of life insurance contract
collected by an employer as a beneficiary from the life insurance of an officer or any person
directly interested with his trade are likewise exempt.
These proceeds are viewed as advanced recovery of 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 the 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 insurance policy
3. Interest income from the unpaid balance of the proceeds of the policy
4. Any excess of the proceeds received over acquisition costs and premium payments by
assignee of a life insurance policy
a. An assignee s a purchaser of life insurance contract. He is taxable on gains realized
on the proceeds of the insurance upon the death of the insured.
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.

37
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:
a. Oral defamation or slander
b. Alienation of affection
c. 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 of capital.

Taxable recovery of lost profits

The recovery of lost profits through insurance, indemnity or contracts or legal suit
constitutes a taxable return on capital. The following are taxable recoveries of lost profits:
a. Proceeds of crop or livestock insurance
b. Guarantee payments
c. Indemnity received from patent infringement suit
Illustration 1
Mang Tomas insured his strawberry farm crop in a P200,000 crop insurance coverage
against calamities. The crop was eventually destroyed in an unusual frost. Mang Tomas 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
Mr. Santiago purchased a franchise. The franchisor guaranteed an annual franchise
income of P100,000 to Mr. Santiago. In the first year of the operation, Mr. Santiago’s outlet only
earned P60,000. The franchisor paid the P40,000 difference to Mr. Santiago. The P40,000
guarantee payment is not a gratuity but a recovery of lost profit for Mr. Santiago; hence, subject
to income tax. Mr. Santiago shall report P100,000 as franchise income.

Illustration 3

38
 Mindoro, Inc. experienced an unusual decline in its income after a competitor copied its
patented invention. Mindoro 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 Mindoro 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 loss of capital. It is as
good as realization of income; hence, its is an item of gross income.

Realized Benefit
The term 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 in net worth occurs
when one receives income, donation or inheritance. The following are not benefits, hence, not
taxable:
a. Receipt of a loan – properties increase but obligations also increase resulting in an
offsetting effect in net worth.
b. Discovery of lost properties – under the law, the finder has an obligation to return the
same to the owner.
c. 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 the receipt, only that portion is
a benefit.
Illustration 1
An employee was granted P20,000 transportation advance. He liquidated P18,000
transportation expenses and was allowed by his employer to keep the P2,000. Only the P2,000
retained by the employee is considered income since this was the extent he was benefited.
Illustration 2
A security agency receives P120,000 from clients, P100,000 of these 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 benefited. 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, meaning, there is a degree of understanding or
sacrifice from the taxpayer to be entitled of the benefit.

39
Requisites of realize 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 sale and barter
2. Unilateral transfers such as succession – transfer of property upon death and donation.
These are also referred to as gratuitous transactions.
Under current usage, unilateral transfers are simply referred to as transfers while
bilateral transfers ae called exchanges. Benefits derived from onerous transactions are earned
and realized, hence, subject to income tax. Benefits derived from gratuitous transactions are not
realized because of the absence of an earning process. Benefits from gratuitous transactions
are subject to transfer tax, not income tax.

Complex Transactions
Complex transactions are partly gratuitous and partly onerous. These transactions 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:
Fair value P180,000
P50,000 – subject to transfer tax
Selling price 130,000
Cost 100,000 P30,000 – subject to income tax

The excess value over selling price is a gratuity whereas the excess of the 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 persons while
juridical persons are those created by law such as partnership and corporations. An entity may
be a taxable entity or an exempt entity. A taxable item of gross income arises from transactions

40
which involves another natural or juridical entity. Gains or income derived between relatives,
corporations and between a partner and the partnership are taxable since its is made between
separate entities. Likewise, the income between affiliated companies such as between a holding
or parent company and its subsidiaries and between sister companies are taxable because
each corporation is a separate entity. This applies regardless of the 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 businesses of a
proprietor should not be taxed since proprietorship businesses are taxable upon the same
owner. Note that a proprietorship business 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. They are referred to as unrealized gains or holding gains
because they have not yet materialized in an exchanged transaction. Examples of unrealized
gains or holding gains:
a. Increase in value of investments in equity or debt securities
b. Increase in value of real properties held
c. Increase in value of foreign currencies held or receivable
d. Decrease in value of foreign currency denominated debt by virtue of favorable
fluctuation in exchange rates.
e. Birth of animal offspring, accruals of fruits in an orchard or growth of farm vegetables
f. Increase in value of land due to discovery of mineral reserves

Rendering of services
The rendering of services for a consideration is an exchange but do not cause a 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.

41
Illustration
Mr. Saladin lists the following possible items of gross income:
Compensation income P200,000
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 for services he 150,000
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 P200,000
Winnings from gambling 100,000
Debt of Saladin forgiven in consideration for the services rendered to 150,000
his creditors
Notes:
1. Gains from gambling and forgiveness of debt in consideration of services or properties
received are realized gains from exchanges.
2. The forgiveness of debt out of affection or mere generosity of a creditor is a gratuitous
transfer subject to transfer tax.
3. The loan received from a bank constitutes a transfer but not a benefit.

Basis of Exemption of Unrealized Income

Normally, taxpayers will have the ability to pay tax when his income materializes in
exchange of 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.

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 – involves no actual physical taking of the income but the taxpayer is
effectively benefited.
Examples:
a. Offset of debt to the taxpayer in consideration for the sale of goods or service

42
b. Deposit of the income to the taxpayers 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

Inflow of Wealth Without Increase in Net Worth

The inflows of wealth to a person that do 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 in net worth to the
swindler.

Not Exempted by Law, Contract, or Treaty

An item of gross income is not exempted by the Constitution, law contracts or treaty from
taxation. The following items of income are exempted by law from taxation, hence, not
considered items of gross income:
1. Income of qualified employee trust fund
2. Revenues of non-profit non-stock educational institution
3. PCSO or lotto winnings
4. SSS, GSIS, Pag-IBIG or PhilHealth benefits
5. Salaries and wages of minimum wage earners and qualifying senior citizen
6. Regular income of Barangay Micro-business Enterprise (BMBEs)
7. Income of foreign governments and foreign government-owned and controlled corporations
8. Income of international missions and organizations with income tax immunity

Types of Income Taxpayers

A. Individuals
1. Citizens
a. Resident citizen
b. Non-resident citizen
2. Alien
a. Resident alien

43
 b. Non-resident alien
3. Taxable estates and trusts
B. Corporations
1. Domestic corporations
2. Foreign corporations
a. Resident foreign corporations
b. Non-resident foreign corporations

Individual Income Taxpayers

 Citizens
Under the Constitution, citizens are:
a. Those who are citizens of the Philippines at the time of adoption of the Constitution on
February 2, 1987
b. Those whose fathers or mothers are citizens of the Philippines
c. Those born before January 17, 1973 of Filipino mothers who elected Filipino citizenship
upon reaching the age of majority
d. Those who are naturalized in accordance with the law

Classifications of Citizens:
A. Resident citizen – a Filipino citizen residing in the Philippines
B. Non-resident citizen includes:
a. A citizen of the Philippines who establishes to the satisfaction of the Commissioner
the fact of his physical presence abroad with a definite intention to reside therein;
b. A citizen of the Philippines who leaves the Philippines during the taxable year to
reside abroad, either as an immigrant or for an employment on a permanent basis;
c. A citizen of the Philippines who works and derives income from abroad and whose
employment thereat requires him to be physically present abroad most of the time
during the taxable year;
d. A citizen who has been previously considered as non-resident citizen and who
arrives in the Philippines at any time during the taxable year to reside permanently in
the Philippines shall likewise be treated as non-resident citizen for the taxable year in
which he arrives in the Philippines with respect to his income derived from sources
abroad until the date of his arrival in the Philippines.

44
 Filipinos working in Philippine embassies or Philippine consulate offices are not
considered non-resident citizens.
 Alien
A. Resident alien – an individual who is residing in the Philippines but is not a citizen thereof,
such as:
a. An alien who lives in the Philippines without definite intention as to his stay;
b. One who comes to the Philippines for a definite purpose which in its nature would
require an extended stay and to that end makes his home temporarily in the
Philippines, although it may be his intention at all times to return to his domicile
abroad;
Alien who has acquired residence in the Philippines retains his status as such until he
abandons the same or departs from the Philippines.
B. Non-resident alien – individuals who is not residing in the Philippines and who is not a
citizen thereof
a. Non-resident aliens engaged in business (NRA-ETB) – aliens who stayed in the
Philippines for an aggregate period of more than 180 days during the year.
b. Non-resident aliens not engaged in business (NRA-NETB) – includes:
i. Aliens who comes to the Philippines for a definite purpose which in its nature
may be promptly accomplished.
ii. Aliens who shall come to the Philippines and stay therein for an aggregate
period of not more than 180 days during the year.

The General Classification Rule for Individuals

1. Intention – the intention of the taxpayer regarding the nature of his stay within or outside
the Philippines shall determine his appropriate residency classification. The taxpayer shall
submit to the Commissioner documentary proofs such as visas, work contracts, and other
documents indicating such intentions.
2. Length of stay – in default of such documentary proof, the length of stay of the taxpayer is
to be considered:
a. Citizens staying abroad for a period of at least 183 days are considered non-
resident.
b. Aliens who stayed in the Philippines for more than 1 year as of the end of the taxable
year is considered resident.

45
 c. Aliens who are staying in the Philippines for not more than one year, but more than
183 days are deemed non-resident aliens engaged in business.
d. Aliens who stayed in the Philippines for not more than 180 days are considered non-
resident aliens not engaged in trade or business.
Illustration 1
Luiz Mario Aresmendi, a Mexican actor is contracted by a Philippine television company
to do a project in the Philippines. He arrived in the country on February 29, 2014 and returned to
Mexico three weeks later upon completion of the project. Luiz Mario Aresmendi is a non-
resident alien not engaged in trade or business in 2014. His stay is for a definite purpose which
in its nature will be accomplished immediately.
Illustration 2
Mamoud Jibril, a Libyan national, arrived in the country on November 4, 2013. Mr. Jibril
stayed in the Philippines since then without any working visa or working permit. For the year
2013, Mr. Jibril will be considered non-resident alien not engaged in trade or business because
he stayed in the Philippines for less than 180 days as of December 31, 2013. If he is still within
the Philippines until December 31, 2014, he will qualify as a resident alien for 2014.
Illustration 3
Without any definite intention as to the nature to stay, Juan Masipag, a Filipino citizen,
left the Philippines and stayed abroad from March 15, 2013 to April 1, 2014 before returning to
the Philippines. For the year 2013, Juan will be classified as non-resident citizen because he is
absent for more than 183 days, but he will be classified as resident citizen for the year 2014
because he is absent for less than 183 days in 2014.

Taxable Estates and Trusts

1. Estate – refers to the properties, rights and obligations of a deceased person not
extinguished by his death. Estates under judicial settlement are treated as individual
taxpayers. The estate is taxable on the income of the properties left by the decedent.
Estates under extrajudicial settlement is taxable to the heirs.
2. Trust – is an arrangement whereby one-person (grantor or trustor) transfers property to
another person (beneficiary), which will be held under the management of a third party
(trustee or fiduciary). A trust is irrevocably designated by the grantor is treated in taxation as
if its an individual taxpayer. The income of the property held in trust is taxable to the trust.
Trusts that are designated as revocable by the grantor are not taxable entities and are not
considered as individual taxpayers. The income of properties held under revocable trusts is

46
 taxable to the grantor not to the trust. When trusts agreement is silent as to revocability of
the trust, the trust is presumed to be revocable.

Corporate Income Taxpayers

The term corporation shall include partnerships, no matter how created or organized,
joint-stock companies, joint accounts, association, or insurance companies, except general
professional partnerships and a joint venture or consortium formed for the purpose of
undertaking construction projects or engaging in petroleum, coal, geothermal and other energy
operations pursuant to an operating consortium agreement under a service contract with the
Government. Hence, the term corporation includes profit-oriented and non-profit institutions
such as charitable institutions, cooperatives, government agencies and instrumentalities,
associations, leagues, civic or religious and other organizations.

Domestic Corporations
A domestic corporation is a corporation that is organized in accordance with Philippines.

Foreign Corporations
A foreign corporation is one organized in a foreign law. Types of Foreign Corporations
1. Resident foreign corporation (RFC) – a foreign corporation which operates and conducts
business in the Philippines through permanent establishment. (i.e. branch)
2. Non-resident foreign corporation (NFRC) – a foreign corporation which does not operate
conduct business in the Philippines.
Note:
1. A corporation that incorporates in the Philippines is a domestic corporation under the
Incorporation Test even the same is controlled by foreigners.
2. A foreign corporation that transacts business with residents through a resident branch is
taxable on such transactions as a resident foreign corporation through its branch.
However, if it transacts directly to residents outside its branch, it is taxable as non-
resident foreign corporation on the direct transactions.

Special Corporations
Special corporations are domestic or foreign corporations which are subject to special
tax rules or preferential tax rates.

47
Other Corporate Taxpayers
1. Partnership – a partnership is a business organization owned by two or more persons who
contribute their industry or resources to a common fund for the purpose of dividing profits
from the venture.
a. General Professional Partnership (GPP) – is a partnership formed for the exercise
of a common profession. All partners must belong to the profession. A GGP is not
treated as a corporation and is not a taxable entity; hence exempt on its regular
income, but the partners are taxable in their individual capacity with respect to their
share in the income of the partnership.
b. Business Partnership – is one formed for profit. It is taxable as a corporation.
2. Joint Venture – is a business undertaking for a particular purpose. It may be organized as a
partnership or a corporation.
a. Exempt Joint Ventures – are those formed for the purpose of undertaking
construction projects or engaging in petroleum, coal, geothermal and other energy
operations, pursuant to an operating consortium agreement under a service contract
with the government. Like GPP, this type of joint venture is not treated as a
corporation and is tax exempt on its regular income, but their ventures are taxable to
their share in the net income of the joint venture.
b. Taxable Joint Ventures – all other joint ventures are taxable as a corporation.
3. Co-ownership – is a joint ownership of a property formed for the purpose of preserving the
same and or dividing its income. A co-ownership that is limited to property preservation or
income collection is not a taxable entity and is exempt, but the co-owners are taxable to
their share on the income of the co-owned property. However, a co-ownership that reinvests
the income of the co-owned property to other income producing properties or ventures will
be considered an unregistered partnership taxable as corporation.

48
The General Rules in Income Taxation
Taxable on income earned
Individual taxpayers Within Without
Resident citizen  
Non-resident citizen 
Resident alien 
Non-resident alien 
Corporate taxpayers
Domestic corporation  
Resident foreign corporation 
Non-resident foreign corporation 

Note:
1. Consistent with territoriality rule, all taxpayers are taxable only on income earned within the
Philippines, except resident citizens and domestic corporations.
2. The NIRC used the term without the Philippines to mean outside the Philippines.

The Residency and Citizenship Rule

Taxpayers who are residents and citizens of the Philippines such as resident citizen and
domestic corporations are taxable on all income from sources within and without the Philippines.
A corporation is a citizen of the country of incorporation. Thus, a domestic corporation is a
citizen of the Philippines.

Basis of the Extraterritorial Taxation

Resident citizen and domestic corporations derive most of the benefits from the
Philippine government compared to all other classes of taxpayers by virtue of their proximity to
the Philippine government. Under our laws, resident citizens and domestic corporations enjoy
preferential privileges than aliens. Also, between resident and non-resident citizens, resident
citizens unarguably enjoy much of the public services and privileges because they are in the
country. The taxation of foreign income of resident citizens and domestic corporations properly
reflected this difference in benefits consistent with the Benefit Received Theory.
The extra-territorial tax treatment of resident citizens and domestic corporations is also
intended as a safety net to the potential loss of tax revenues brought by situs relocation or the
practice of executing or structuring transactions such that income will be realized abroad to
avoid Philippine income taxes.

49
The Issue of International Double Taxation
The rule on extraterritorial taxation on resident citizens and domestic corporations
expose these taxpayers to double taxation. However, the NIRC allows a tax credit for taxes paid
in foreign countries. In fact, resident citizens and domestic corporations pay minimal taxes in the
Philippines on their foreign income because of the tax credit.

Situs of Income
The situs of income is the place of taxation of income. It is the jurisdiction that has the
authority to impose tax upon the income.

Situs Income Vs. Source of Income

Situs income should be differentiated with the source of income. The latter pertains to
the activity or property that produces income. Situs is important in determining whether an
income is taxable in the Philippines. Situs is particularly important to taxpayers taxable only on
income within. However, it is also important to taxpayers taxable on global income for purposes
of the computation of the foreign tax credit.

Income Situs Rules

Types of income Place of taxation (situs)
1. Interest income Debtors residence
2. Royalties Where the intangible is employed
3. Rent income Location of the property
4. Service income Place where the service is rendered

Illustration
A taxpayer had the following income:
Interest income from deposits in a foreign bank P300,000
Interest from domestic bonds 50,000
Royalties from books published in the Philippines 100,000
Rent income from properties abroad (the lease contracts were executed in the 150,000
Philippines)
Professional fees for services rendered in the Philippines for non-resident clients 400,000
(paid in dollar)

Applying the situs rules, the following are the situs of the income:
Within Without
Interest income from deposits in a foreign bank P300,000
Interest from domestic bonds P 50,000
Royalties from books published in the Philippines 100,000
Rent income from properties abroad (the lease contracts were 150,000

50
executed in the Philippines)
Professional fees for services rendered in the Philippines for non- 400,000
resident clients (paid in dollar)
P550,000 P450,000

Other Income Situs Rules

A. Gain on sale of properties
a. Personal properties
i. Domestic securities – presumed earned within the Philippines
ii. Other personal properties – earned in the place where the property is sold
a. Real property – earned where the property is located
Illustration
A taxpayer had the following income:
Gain on sale of domestic products P200,000
Gain on sale of foreign bonds 100,000
Gain on sale of a commercial lot in Baguio City 500,000
Gain on sale of car in Ontario, Canada 200,000
Gain on sale of machineries in Mexico, Pampanga 250,000
Interest income of foreign bonds 50,000
Dividends of domestic stocks 150,000

51
 The following table summarizes the situs of the foregoing income:
Within Without
Gain on sale of domestic products P200,000
Gain on sale of foreign bonds P 100,000
Gain on sale of a commercial lot in Baguio City 500,000
Gain on sale of car in Ontario, Canada 200,000
Gain on sale of machineries in Mexico, Pampanga 250,000
Interest income of foreign bonds 50,000
Dividends of domestic stocks 150,000
P1,100,000 P350,000
B. Dividend income from:
a. Domestic corporation – presumed earned within
b. Foreign corporation
i. Resident foreign corporation – depends on the predominance test

The predominance tests

If the ratio of the Philippine gross income over the world gross income of the resident
foreign corporation in a three-year period preceding the year of dividend declaration is:
 At least 50% the portion of the dividend corresponding to the Philippines gross income
ratio is earned within
 Less than 50%, the entire dividend received is earned abroad
ii. Non-resident foreign corporation – earned abroad
Illustration
In 2014, Sarah received a P400,000 dividend income from ABC Corporation. ABC
Corporation had the following gross income in 2011 through 2013:
2011 2012 2013 Total
Philippines P100,000 P200,000 P300,000 P600,000
Abroad 200,000 100,000 100,000 400,000
Total P300,000 P300,000 P400,000 P1,000,000

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 divided shall be split
Gross Income Ratio = P600,000/P1,000,000 = 60%
Earned within the Philippines (60%xP400,000) P240,000
Earned without the Philippines (40%xP400,000) 160,000
Total dividends P400,000

52
 Supposing that the ratio is 40% 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 P200,000
Goods purchased within and sold abroad 100,000
Goods purchased abroad and sold within 150,000
Goods purchased and sold abroad 350,000

The income earned within and without shall be:

Purchased and sold within P200,000
Purchased within and sold abroad P 100,000
Purchased abroad and sold within 150,000
Purchased and sold abroad 350,000
Total P350,000 P450,000

D. Manufacturing income – earned where the goods are manufactured and sold
Operations Remarks
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
Butuan, Inc. manufactures goods and sells them through its branch. Butuan bills its
branch at established market prices. Butuan reported the following gross income:
Home Office Branch Total
Sales P4,000,000 P2,000,000 P6,000,000
Cost of goods sold 2,400,000 1,200,000 3,600,000
Gross income P1,600,000 P800,000 P2,400,000
The following shows the situs of the gross income of Butuan under each of the following
scenario:
Scenario Home Office Branch Within Without
No. 1 Philippines Philippines P2,400,000 P
No. 2 Abroad Abroad P2,400,000
No. 3 Philippines Abroad P1,600,000 P800,000
No. 4 Abroad Philippines P800,000 P1,600,000
Note:

53
 Both production and distribution are conducted by the same taxable entry, Butuan, Inc.
the branch is not a separate taxable identity, but it is an integral part of Butuan, Inc.; hence, its
income is taxable to Butuan, Inc.
Illustration 2
Assuming production is conducted by a parent corporation and the distribution is
conducted by its subsidiary corporation:
Parent Subsidiary Total
Sales P4,000,000 P2,000,000 P6,000,000
Cost of goods sold 2,400,000 1,200,000 3,600,000
Gross income P1,600,000 P800,000 P2,400,000

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 from the parent
corporation:
Scenario Parent Subsidiary Within Without
No. 1 Philippines Philippines P1,600,000 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 P800,000 P
No. 2 Abroad Abroad 800,000
No. 3 Philippines Abroad 800,000
No. 4 Abroad Philippines 800,000

Self-Test Exercises
Discussion Questions
1. Enumerate the characteristics of gross income.
2. What are capital items considered with infinite value? Enumerate.
3. When is income considered realized?
4. Distinguish exchange from transfer.
5. What is complex transaction? How it is taxed?
6. What is holding gain? Why its is exempt from taxation?
7. Compare actual receipt with constructive receipt.
8. Enumerate and explain the classifications of corporate taxpayers.
9. Discuss the taxability of each class of taxpayers.

54
10. Explain situs. Differentiate situs with source of income.

Exercise Drill: Tax concept of income. Check the appropriate box whether the following are
exempt or taxable.
1. Item Taxable Exempt
2. Indemnity for moral damages
3. Compensation income
4. Amount received by the insured more than insurance
premiums paid
5. Gain on sale of goods by the home office to its branch
6. Gain on sale of goods and services between relatives
7. Appreciation in the value of land
8. Birth of animal offspring
9. Cancellation of debt out of gratuity of the creditor
10. Receipt of bank loan
11. Salaries of minimum wage earner

55
 CHAPTER IV

INCOME TAX SCHEMES, ACCOUNTING PERIODS, ACCOUNTING METHODS AND

REPORTING

Objectives
After the completion of this module, you should be able to comprehend and demonstrate
the knowledge of the following:
 Types of taxation schemes and their scope
 Concept of accounting period and its types
 Concept of accounting methods and their accounting procedures
 Types of tax returns, their deadline and place of filing

Income Taxation Schemes

There are three income taxation schemes under the NIRC:
1. Final income taxation
2. Capital gains taxation
3. Regular income taxation
An item of gross income is taxable to either of these tax schemes.

Items of gross income

Taxable in
either

Final income Capital gains Regular income

taxation taxation taxation

Mutually exclusive coverage

The tax schemes are mutually exclusive. An item of gross income that is subject to tax in
one scheme will not be taxed to the other schemes. Similarly, items of income that are
exempted in one scheme are not taxable to other schemes.

Classification of Items of Gross Income

Because of the different tax schemes, items of gross income can be classified as
follows:

56
1. Gross income subject to final tax
2. Gross income subject to capital gains tax
3. Gross income subject to regular tax

Final Income Taxation

Final income taxation is characterized by final taxes. Final taxes are withheld at source.
Consequently, the income received by the taxpayer under this system is net of tax. The tax
withheld at source is final and there would be no need to file an income tax return to report the
income to the government. Final taxation is applicable only to certain passive income. Not all
passive income is subject to final taxation.

Passive Income Vs. Active Income

Passive income is earned with very minimal or even without active involvement from the
taxpayer in the earning process. Examples:
1. Interest from banks
2. Dividends from domestic corporations
3. Royalties
Active or regular income arises from transactions requiring considerable degree of effort
or undertaking from the taxpayer. It is the direct opposite of passive income. Examples:
1. Compensation income
2. Business income
3. Professional income

Capital Gains Taxation

A capital gains tax is imposed on the capital gain on the sale, exchange and other
disposition of certain capital assets. Also, not all capital gains are subject to capital gains tax.
Most of them are subject to regular income tax.

Capital assets vs. ordinary assets

Capital assets include all other assets other than ordinary asset. Ordinary assets are
assets directly used in the business, trade or profession of the taxpayer such as inventory,
supplies and items of property, plant and equipment.

Capital gains vs. ordinary gains

57
 Capital gains arise from the sale, exchange and other disposition of capital assets.
Ordinary gains arise from the sale, exchange and other disposition of ordinary assets. The
NIRC identifies capital gains tax as a final tax but they are not actually final tax like those
imposed under final income taxation. The taxpayer still files a capital gains tax return to report
the gain to the government and pay the corresponding tax. Capital gains taxation applies only to
two types of capital assets: domestic stocks and real property.

Regular Income Taxation

The regular income taxation is the general rule in income taxation and covers all other
income such as:
1. Active income
2. Gains from dealings in properties
a. Dealings in ordinary assets
b. Dealings in other capital asset not subject to capital gains tax
3. Other income, active passive, not subject to final tax.
Items of gross income from these sources are measured using an accounting method,
accumulated over an accounting period and reported through an income tax return.

Accounting Period
Accounting period is the length of time over which income is measured and reported.

Types of accounting periods

1. Regular accounting period – 12 months in length
a. Calendar
b. Fiscal
2. Short accounting period – less than 12 months

Calendar Year
The calendar accounting period starts from January 1 and ends December 31. This
accounting period is available to both corporate taxpayers and individual taxpayers. Under the
NIRC, the calendar year shall be used when the:
1. Taxpayers annual accounting period is other than a fiscal year
2. Taxpayer has no accounting period
3. Taxpayer does not keep books

58
 4. Taxpayer is an individual

Fiscal year
A fiscal accounting period is any 12-month period that ends on any day other than
December 31. The fiscal accounting period is available only to corporate income taxpayers.

Deadline of Filing the Income Tax Return

Under the NIRC, the return is due for filing on the fifteenth day of the fourth month
following close of the taxable year of the taxpayer. The regular tax due is payable upon filing of
the income tax return.
Illustration: Due date of the annual income return
Taxpayers under the calendar year must file their annual income tax return for the
current period not later than April 15 of the following year. A corporate taxpayer within a fiscal
year ending June 30, 2014 must file its annual income tax return not later than October 15,
2014.

Instances of Short Accounting Period

1. Newly commenced business – the accounting period covers the date of the start of the
business until the designated year-end of the business.
Illustration
Palawan, Inc. started business operation on June 30, 2014 and opted to use the
calendar year accounting period. Palawan should file its first income tax return covering June 30
to December 31, 2014 for the year 2014. The return must be filed on or before April 15, 2015.
2. Dissolution of business – the accounting period covers the start of the current year to the
date of dissolution of the business.
Illustration
Tawi-Tawi, Inc. is on the fiscal year accounting period ending every March 31. It ceased
business operations on August 15, 2014. Tawi-Tawi should file its last income tax return
covering April 1 to August 15, 2014. Under the old NIRC, dissolving corporation shall file their
return within 30 days from the cessation of activities or 30 days from the approval of merger by
the Securities and Exchange Commission in the case of merger. Hence, the return shall be files
on or before September 15, 2014. For individuals, the return shall be due on or before April 15,
2015. There is no requirement for early filing under the NIRC.

59
3. Change of accounting period by corporate taxpayers – the accounting period covers the
start of the previous accounting period up to the designated year-end of the new accounting
period. Notice that BIR approval is required in changing an accounting period. It is not
automatic.
Illustration 1
Effective February 2014, Sulu Corporation changed its calendar accounting period to a
fiscal year ending every June 30. Sulu shall file an adjustment return covering the income from
January 1 to June 30, 2014 on or before October 15, 2014.
Illustration 2
Effective August 2014, Zamboanga company changed its fiscal year accounting period
ending every June 30 to the calendar year. Zamboanga Company should file an adjustment
return covering July 1 to December 31, 2014 on or before April 15, 2015.
4. Death of the taxpayer – the accounting period covers the start of the calendar year until the
death of the taxpayer.
Illustration
Mr. Jacob died on November 2, 2014. The heirs of Mr. Jacob or his estate administrators
or executors shall file his last income tax return covering his income from January 1 to
November 2, 2014. There is no requirement for early filing in case of death of taxpayers. Hence,
the income tax return shall be filed on or before the usual deadline, April 15, 2015.
5. Termination of the accounting period of the taxpayer by the Commissioner of Internal
revenue – the accounting period covers the start of the current year until the date of the
termination of the accounting period.
Illustration
The accounting period of a taxpayer under the calendar year basis was terminated by
the CIR on August 2, 2014. The taxpayer must file an income tax return covering January 1 to
August 2, 2014. The income tax return and the tax shall be due and payable immediately.

Accounting Methods
Accounting methods are accounting techniques used to measure income.

Types of Accounting Methods

1. The general methods
a. Accrual basis
b. Cash basis

60
 2. Installment and deferred payment method
3. Percentage of completion method
4. Outright and spread-out method
5. Crop year basis
General Methods for Income from Sale of goods or service
Accrual basis
Under the accrual basis of accounting, income is recognized when earned regardless of
when received. Expense is recognized when incurred regardless of when paid. Income is said
to have accrued when the right to receive is established or when an enforceable right to secure
payment is created against the counterparty.
Cash basis
Under the cash basis of accounting, income is recognized when received and expense
is recognized when paid.

Tax and accounting concepts of accrual basis and cash basis distinguished
The financial accounting concept of accrual basis and cash basis are similar with the tax
counterparts, except only for the following tax rules:
1. Advanced income is taxable upon receipt. Income received in advanced is taxable upon
receipt in pursuant to the lifeblood doctrine and the ability to pay theory.
2. Prepaid expense in non-deductible. Prepaid expense is advanced payment for expenses of
future taxable periods. These are not deductible against gross income in the year paid. They
are deducted against income in the future period they are used in the business, trade, or
profession of the taxpayer. Normally, the expensing of prepayments does not properly
reflect the income of the taxpayer, it also contradicts the lifeblood doctrine as it effectively
defers the recognition of income.
3. Special tax accounting requirement must be followed. There are cases where the tax law
itself provides for specific accounting treatment of an income or expense. As such, the
specified method should be observed even if it departs with the basis regularly employed by
the taxpayer in keeping his books.
The tax accrual basis income is determined as:
Cash income PXXX,XXX
Accrued (uncollected) income XXX,XXX
Advanced income XXX,XXX
Gross income PXXX,XXX
The tax accrual expense is determined as:
Cash expenses PXXX,XXX

61
Accrued (unpaid) expense XXX,XXX
Amortization of prepayments and depreciation of capital expenditures XXX,XXX
Deductions PXXX,XXX
The tax cash basis income is determined as:
Cash income PXXX,XXX
Advanced income XXX,XXX
Gross income PXXX,XXX

The tax cash basis expense is determined as:

Cash expenses PXXX,XXX
Amortization of prepayments and depreciation of capital expenditures XXX,XXX
Deductions PXXX,XXX

Illustration
A taxpayer providing services reported the following in 2013 and 2014:
2013 2014
Collection from services rendered P500,000 P800,000
Accrued income from services rendered 500,000 400,000
Collection from accrued income in 2013 470,000
Collection of services not yet rendered 300,000 200,000
Payment of expenses of current period 400,000 600,000
Accrued expenses 100,000 150,000
Payment of accrued expenses of 2013 100,000
Payment for next year expenses 200,000 300,000

Tax Accrual Basis

2013 2014
Cash income P500,000 P800,000
Accrued income 500,000 400,000
Collection for future services – advances 300,000 200,000
Total gross income P1,300,000 P1,400,000
Less: deductions
Cash expenses 400,000 600,000
Accrued expense 100,000 150,000
Amortization of 2013 prepaid expense 200,000
Total deductions P500,000 P950,000
Net income P800,000 450,000

Points to consider in converting GAAP Accrual Basis to Tax Accrual Basis

1. In accounting accrual basis, income is recognized when earned even if not yet received.
Advanced income is inherently not included in the net income. For the purposes of taxation,
advanced income is taxable. Hence, it must be added to accrual basis gross income.
2. In accounting, expense is recognized when accrued even if not yet paid. Prepaid expenses
are inherently not deducted. Hence, no adjustment for prepayments is necessary under
accrual basis.
Tax Cash Basis

62
 2013 2014
Collection from services rendered P500,000 P*1,270,000
Collection for future services – advances 300,000 200,000
Total gross income P800,000 P1,470,000
Less: deductions
Payment of expenses P400,000 P**700,000
Amortization of 2013 payments 200,000
Total deductions P400,000 P900,000
Net income P400,000 P570,000
Note: P800,000 + P470,000 = P1,270,000*; P600,000 + 100,000 = P700,000**

Points to consider in converting GAAP cash basis to Tax cash basis

1. Under the accounting cash basis, income is recognized when received not when it is
earned. Advanced income is inherently recognized as income. Hence, no adjustment is
necessary on income.
2. Under accounting cash basis, expense is deducted when paid including prepaid expenses.
Hence, the deducted prepaid expenses must be reversed for purposes of taxation.

Seller of goods
The gross income of taxpayers selling goods is determined as follows:
Sales PXXX,XXX
Less: XXX,XXX
Gross income PXXX,XXX
The cost of sales is computed using the inventory method:
Beginning inventory PXXX,XXX
Add: purchases XXX,XXX
Total goods available for sale PXXX,XXX
Less: ending inventory XXX,XXX
Cost of goods sold PXXX,XXX
The expensing of the purchase cost of goods does not properly and fairly reflect the
income of the taxpayer particularly when there are significant fluctuations in inventory levels
between accounting periods. This could expose the taxpayer to risk of BIR assessment. The
use of the accrual method is suggested but of course subject to practical and cost
considerations.

Hybrid basis
The hybrid basis is a combination of accrual basis, cash basis of other methods of
accounting. It is used when the taxpayer has several businesses which employ different
accounting methods.
Illustration

63
 Mr. Roxas has two proprietorship businesses: a service business which uses cash basis
and a trading business which uses accrual basis. The gross income as determined by cash
basis in the service business and the gross income as determined by the accrual basis in the
trading business are simply combined. There is no requirement to measure the income of
different businesses under a single accounting method.

Sale of goods with extended payment terms

The sale of goods with extended payment terms may be reported using the accrual
basis, installment method or deferred payment method.
Installment method
Under the installment method, gross income is recognized and reported in proportion to
the collection from the installment sales.
Installment method is available to the following taxpayers:
1. Dealers of personal property, on the sale of properties they regularly sell
2. Dealers of real properties, only if their initial payment do not exceed 25% of the selling price
3. Casual sale of non-dealers on property, real or personal, when their selling price exceeds
P1,000 and their initial payment do not exceed 25% of the selling price
Initial payment
Initial payment means total payments by the buyer, in cash or property, in the taxable
year the sale was made. The term initial payment is broader than down payment. It also
includes the installment payments in the year of sale.

Selling price
Selling price means the entire amount for which the buyer is obligated to the seller. It is
computed as:
Cash received and or receivable PXXX,XXX
Fair market value of property received or receivable XXX,XXX
Mortgage of any indebtedness assumed by the buyer XXX,XXX
Selling price PXXX,XXX

Contract price
The contract price is the amount receivable in cash or other property from the buyer. It is
usually the selling price in the absence of an agreement whereby the debtor assumes
indebtedness on the property.

64
Comprehensive illustration
Canlubang Company, a car dealer, sold a machine with a tax basis of P1,200,000 on
installment on January 3, 2014. Canlubang received a P200,000 cash down payment and a
P1,800,000 promissory note for the balance payable in six installments of P300,000 every July
3 and January 3 thereafter. The selling price and gross profit on the sale is computed as:
Cash down payment P200,000
Notes receivable P1,800,000
Selling price P2,000,000
Less: tax basis of machine sold (1,200,000)
Gross profit P800,000

Accrual basis
Under the accrual basis, the entire P800,000 gross profit shall be reported as gross
income in 2014, the year of sale.

Installment basis
Canlubang cannot readily use the installment method because it is a dealer of cars
rather than a dealer of machineries. The sale of properties which the seller is not a dealer is
referred to as casual sale. Hence, the ratio of initial payment shall be tested first. The initial
payment of Canlubang can be computed as:
Cash down payment (January 3, 2014) P200,000
First installment (July 3, 2014) 300,000
Initial Payment P500,000
Ratio of initial payment (P500,000/P2,000,000) 25%
Canlubang can use the installment method. The contract price or the amount due shall
be determined next. Since there is no mortgage assumed by the buyer, the selling price is the
contract price. The gross profit will be reported in gross income throughout the installment
period by the formula: (collection/contract price)x gross profit. Canlubang shall recognize the
following gross income:
At the date of the sale: (P200.000/P2,000,000 x P800,000) P80,000
Upon every installment: (P300,000/P2,000,000 x P800,000) P120,000
If Canlubang is a dealer in machinery, it can avail of the installment method even if the
ratio of its initial payment over selling price exceeds 25% so long as the selling price on the
installment sale exceeds P1,000.

With indebtedness assumed by the buyer

The application of the installment method will slightly vary when the buyer assumes
indebtedness in the property sold. In this case, the selling price is no longer the contract price.

65
The contract price is the residual amount after deducting the mortgage from the selling price.
Thus;
Selling price PXXX,XXX
Less: mortgage assumed by buyer XXX,XXX
Contract price PXXX,XXX
Illustration
On January 3, 2014, Tagaytay, Inc., a real property dealer, sold a lot costing P1,400,000
for P2,000,000. The lot was encumbered by a P1,000,000 mortgage which was assumed by the
buyer. The buyer paid P200,000 down payment. The balance is due over four installments of
P200,000 every July 3 and January 3 thereafter. The gross profit can be computed as:
Selling price P2,000,000
Less: tax basis of lot sold 1,400,000
Gross profit P600,000
Note that dealers of properties are subject to limitation on the use of installment method.
The ratio of initial payment shall be determined first.
January 3, 2014 cash down payment P200,000
June 3, 2014 installment 200,000
Initial payment P400,000
Ratio of initial payment (P400,000/P2,000,000) 20%

Tagaytay is qualified to use the installment method. The contract price should be
determined next.
Selling price P2,000,000
Less: mortgage assumed by the buyer 1,000,000
Gross profit P1,000,000

Alternatively, the contract price can be computed directly as:

Cash down payment P200,000
Collectible balance (P200,000 x 4 installments) 800,000
Contract price P1,000,000

Tagaytay shall recognize the following gross income:

At the date of sale: (P200,000/P1,000,000 x P600,000) P120,000
Upon every installment: (P200,000/P1,000,000 x P600,000) P120,000

Indebtedness assumed exceeds tax basis of property sold

When the indebtedness assumed by the buyer exceeds the tax basis of the property
sold, the excess is an indirect receipt realized by the seller. This is an indirect down payment
which must be added as part of the contract price and the initial payment. Note also that under

66
this condition, all collection from the contract including the excess mortgage is a collection of
income. The contract price shall be computed as:
Selling price PXXX,XXX
Less: mortgage assumed by buyer XXX,XXX
Cash collectible XXX,XXX
Add: excess indebtedness – constructive receipt XXX,XXX
Contract price PXXX,XXX

The initial payment shall be computed as:

Down payment PXXX,XXX
Installment in the year of sale XXX,XXX
Excess of mortgage over tax basis XXX,XXX
Initial payment PXXX,XXX
Illustration
On July 1, 2014, a taxpayer made a casual sale of property with a tax basis of
P1,300,000 for P2,000,000. The property was subject to a P1,500,000 mortgage which was
agreed to be assumed by the buyer. The buyer paid a P100,000 down payment with the
balance due on two installments of P200,000 on December 31, 2014 and July 1, 2015. The
gross profit on the sale is determined as:
Selling price P2,000,000
Less: tax basis of property sold 1,300,000
Gross profit P700,000

The initial payment shall be determined first:

Down payment P100,000
December 31, 2014 installment 200,000
Excess of mortgage over tax basis (P1,500,000-P1,300,000) 200,000
Initial payment P500,000
Ratio of initial payment (P500,000/P2,000,000) 25%

The contract price shall be computed as:

Selling price P2,000,000
Less: mortgage assumed by buyer 1,500,000
Cash collectible P500,000
Excess mortgage (P1,500,000-P1,300,000) 200,000
Contract price P700,000
Note that the gross profit on the sale is the same as the contract price. Hence, any
collection from the contract including the excess of mortgage shall be recognized as gross
income upon collection. Canlubang shall recognize the following gross income:
At the date of sale: (P200,000 down payment + P100,000 excess) P300,000
Upon receipt of first installment-12/31/14 P200,000
Upon receipt of second installment-7/1/15 P200,000
Total gross profit on the contract P700,000

67
Deferred payment method
The deferred payment method is a variant of the accrual basis and is used in reporting
income when a non-interest-bearing note is received as consideration in a sale. Under the
deferred payment method, the gross income is computed based on the present value
(discounted value) of a note receivable from the contract. The discount interest on the note is
amortized (i.e. spread) as interest income over the installment term.
Illustration
On December 31, 2013, a taxpayer sold an office building costing P1,400,000 for
P2,000,000. The buyer made P1,000,000 down payment and the balance, evidenced by a note,
is due in 2 annual installments of P500,000 every December 31 starting December 31, 2014.
Note that installment method cannot be allowed since the ratio of initial payment is already 50%
(P1,000,000/P2,000,000). Assume the note is non-interest bearing but can be discounted at a
local bank for P900,000. Under the deferred payment method, the reportable gross income for
each year shall be:
2013 2014 2015
Cash down payment P1,000,000
Present value of the note 900,000
Selling price P1,900,000
Less: tax basis of the property 1,400,000
Gross income P500,000
Interest income (P1,000,000-P900,000) P50,000 P50,000
Note:
1. The difference between the face value and the present value of the note, known as
discount, will not be recognized in gross income at the date of sale but will be deferred and
recognized as interest income.
2. The discount is amortized as interest income upon every collection on the balance of the
note as follows: P500,000 installment/P1,000,000 total note balance x P100,000 discount
In the case of interest-bearing notes, the use of the deferred payment method will bear
the same result as the accrual basis of accounting.

The Percentage of Completion Method for Construction Contracts

Under the percentage of completion method, the estimated gross income from
construction is reported based on the percentage of completion of the construction project.
There are several methods of estimating project completion in practice, but the output method
based on engineering survey is prescribed by the NIRC.
Illustration

68
 In 2013, Cagayan Construction Company accepted a P5,000,000 fixed price
construction contract. The following shows the details of its construction activities:
2013 2014
Constructions expenses P3,000,000 P1,200,000
Engineers estimate of completion 70% 100%
The reportable gross income on construction will simply computed as:
2013 2014
Contract price P5,000,000 P5,000,000
Multiply by: % of completion 70% 100%
Construction revenue P3,500,000 P5,000,000
Less: construction revenue in prior year P3,500,000
Construction revenue this year P3,500,000 P1,500,000
Less: expenses during the year 300,000 1,200,000
Construction gross income P500,000 P300,000

Income from leasehold improvement

Leasehold improvements are tangible improvements made by the lessee to the property
of the lessor. Improvements will benefit the lessor when their useful life extends beyond the
lease term. This benefit is referred to as income from leasehold improvement. Under Revenue
Regulations No. 2, the income from leasehold improvement can be reported using either of the
following method at the option of the taxpayer:
1. Outright method – the lessor may report as income at the time when such buildings or
improvements are completed the fair market value of such buildings or improvements
subject to the lease.
2. Spread out method – the lessor may spread over the life of the lease the estimated
depreciated value of such buildings or improvements at the termination of the lease and
report as income for each year of the lease an aliquot part thereof. The depreciated value of
the leasehold improvement is computed as:
Excess useful life over lease term
Cost of improvement x
Useful life of the improvement

69
Illustration
In January 1, 2014, Anderson leased a vacant lot to Greg under a 20-year lease
contract. Greg immediately constructed a building on the lot at a total cost of P4,500,000. The
building has useful life of 30 years.

Outright method
Under the plain wordings of the Sec. 49 of the Revenue Regulations No. 2, Anderson
shall recognize the entire P4,500,000 fair value of the improvement as gross income upon
completion of the improvement in 2014. This is not an income in its totality, but this is the
amount referred by the regulation.

Spread-out method
The depreciated value of the property at the termination of the lease is the value of the
years of usage of lessor. This can be computed by splitting the value of the improvement as
follows:
User Years of usage Allocation Cost
Lessee 20 20/30 x P450,000 P3,000,000
Lessor 10 10/30 x P4,500,000 1,500,000
Total 30 P4,500,000
The P 1,500,000 depreciated value of the improvement at the termination of the lease is
an income from leasehold improvement by the lessor. Under the spread-out method, Anderson
shall spread the P 1,500,000 income over 20 periods or recognize an annual income P 75,000
from the leasehold improvement from 2014 to 2033.

Farming Income
Farming income is commonly recognized using the cash basis or accrual basis.
However, long-term crops or those that takes more than one year to harvest may be accounted
for under the crop year basis.

Crop year basis

Under the crop year basis, farming income is recognized as the difference between the
proceeds of harvest and expenses of the crop harvested. The expenses of each crop are
accumulated and deducted upon the harvest of the crop.
Illustration
Juan de la Cruz, a farmer, plants a certain crop that takes more than a year to harvest.
Juan had the following data on his farming operations:
2013 2014 2015
Proceeds of harvest P 750,000 P1,000,000

70
1st cropping expenses 400,000 200,000
2nd cropping expenses 500,000 300,000

The reportable farming income using crop year method would be:
2013 2014 2015
Proceeds of harvest P 750,000 P1,000,000
Less: cropping expenses
Incurred last year 400,000 500,000
Incurred this year 200,000 300,000
Farming gross income P150,000 P200,000
Crop year basis is an accounting method and is not an accounting period.

Use of different accounting methods

Taxpayers with more than one type of businesses using different accounting methods
can consolidate the income reported using the different methods. There is no need to restate
the income to a common accounting method. However, the methods applied to each business
should be applied consistently from period to period.

Change in Accounting Methods and Accounting Periods

Under the NIRC, the change in accounting methods by any taxpayer and the change in
accounting period by corporate taxpayers require prior BIR notice.

Income Tax Reporting

The Self-Assessment Method

In preparing their tax return, taxpayers declare their income, expense and personally
determine the tax due thereon. The government relies on the good faith of taxpayers in the
preparation of their tax return but employs detective techniques to ascertain non-compliance or
under-compliance.

Types of income tax-related returns filed to the government

1. Income tax returns
2. Withholding tax returns
3. Information returns

Types of income tax return

1. Capital gains tax return
2. Regular income tax return

71
The Withholding System
Aside from the income tax return, the government also requires taxpayers to withhold
(i.e. deduct) taxes on their income payments (i.e. expenses). These withheld taxes are called
"withholding tax". These are not tax to the taxpayer but to the recipient of the income payments.
The taxpayer must deduct the withholding tax on his income payments, file withholding tax
return and remit the withheld tax to the government. Non-compliance to the withholding tax rules
shall expose the taxpayer to penalties and fines aside from the disallowance of the expense as
deductions against income.

Types of withholding tax

a. Final withholding tax
b. Creditable withholding tax
Final withholding taxes are the full taxes upon the income of the recipient. The recipient
will not pay additional taxes upon the income subjected to final withholding taxes. Creditable
withholding taxes are advance taxes. The recipient of the income payments must report the
income in his income tax return and claim the creditable withholding tax withheld as tax credit
against his tax due.

Information Returns
Certain taxpayers are also required to file information returns to the government. These
information returns do not involve any payment or withholding of tax but are essential to the
government in its tax mapping efforts and in its evaluation of tax compliance. Non-filing of
required information returns is also subject to penalties, fines and or imprisonment.

Where to File Income Tax Return?

Manual Filing System
The traditional manual system of filing income tax return is by paper documents where
taxpayer’s fill-up BIR forms to report income, expenses or any declaration required to be filed
with the BIR. The income tax return shall be filed to the following, in descending order of priority,
within the revenue district office where the taxpayer is registered or required to register:
1. An authorized agent banks
2. Revenue Collection Officer
3. Duly authorized city or municipal Treasurer

72
Electronic Filing and Payment System (eFPS)
The eFPS is a paperless tax filing system developed and maintained by the BIR.
Taxpayers file tax returns including attachments in electronic format and pay the tax through the
internet.

Taxpayers mandated to use the eFPS

1. Large taxpayers duly notified by the BIR
2. Top 20,000 private corporations duly notified by the BIR
3. Top 5,000 individual taxpayers duly notified by the BIR
4. Taxpayers who wishes to enter contracts with government offices Corporations with paid-up
capital of P10,000,000
5. PEZA-registered entities and those located within Special Economic Zones
6. Government offices, in so far as remittance of withheld VAT and business tax is concerned
7. Taxpayers included in the Taxpayer Account Management Program (TAMP)
8. Accredited importers, including prospective importers required to secure the Importers
Clearance Certificate (ICC) and Custom brokers Clearance Certificate (BCC)
In case of unavailability of the eFPS during maintenance or instances of technical errors,
eFPS enrolled taxpayers may file manually.

Grouping of Taxpayers under EFPS:

1. Group A
a. Banking institutions
b. Insurance and pension funding
c. Non-bank financial intermediation
d. Activities auxiliary to financial intermediation
e. Construction
f. Water transport
g. Hotels and restaurants
h. Land transport
2. Group B
a. Manufacture and repair of furniture
b. Manufacture of basic metals
c. Manufacture of chemicals and chemical products

73
 d. Manufacture of coke, refined petroleum and fuel products
e. Manufacture of electrical machinery and apparatus NEC
f. Manufacture of fabricated metal products
g. Manufacture of foods, products and beverages
h. Manufacture of machineries and equipment NEC
i. Manufacture of medical, precision, optical instruments
j. Manufacture of motor vehicles, trailers and semi-trailers
k. Manufacture of office, accounting and computing machineries
l. Manufacture of other non-metallic mineral products
m. Manufacture of other transport equipment
n. Manufacture of other wearing apparel
o. Manufacture of papers and paper products
p. Manufacture of radio, TV and communication equipment and apparatus
q. Manufacture of rubber and plastic products
r. Manufacture of textiles
s. Manufacture of tobacco products
t. Manufacture of wood and wood products
u. Manufacturing N.E.C.
v. Metallic ore mining
w. Non-metallic mining and quarrying
3. Group C
Retail sale
a. Wholesale trade and commission trade
b. Sale, maintenance, repair of motor vehicle, sale of automotive fuel
c. Collection, purification and distribution of water
d. Computer and related activities
e. Real estate activities
4. Group D
a. Air transport
b. Electricity, gas, steam, and hot water supply
c. Postal and telecommunications
d. Publishing, printing and reproduction of recorded media
e. Recreational, cultural and sporting activities
f. Recycling

74
 g. Renting of goods and equipment
h. Supporting and auxiliary transport activities
Group E
a. Activities of membership organizations Inc.
b. Health and social work
c. Private educational services
d. Public administration and defense compulsory social security
e. Public educational services
f. Research and development
g. Agricultural, hunting, and forestry
h. Farming of animals
i. Fishing
j. Other service activities
k. Miscellaneous business activities
l. Unclassified activities

Payment of Income Taxes

The capital gains tax and regular income tax is paid as the taxpayer files his return.
Installment payment of income tax is allowed on certain conditions. Taxpayers under the EFPS
system shall e-pay their tax online through internet banking service. The account of the taxpayer
will be auto debited for taxes to be paid.

Penalties for Late Filing or Payment And Non-Withholding Or Non-Remittance Of

Withheld Tax
The late filing and payment of taxes is subject to the following additional charges:
1. Surcharge —
a. 25% of the basic tax for failure to file or pay deficiency tax on time
b. 50% for willful neglect to file and pay taxes
The non-filing is considered 'willful neglect' if the BIR discovered the non-filing first. This
is the case when the taxpayer received a notice from the BIR to file return. If the taxpayer filed a
return before the receipt of such notice, the same is considered simple neglect subject to the
25% surcharge.
2. Interest— 20% per annum

75
3. Compromise penalty — compromise penalty is an amount paid in lieu of criminal
prosecution over a tax violation.
Illustration 1: Late filing and payment of tax
An individual taxpayer filed his 2014 income tax return with a computed tax due of
P100,000 on July 15, 2015. The total amount to be paid by the taxpayer including penalties
shall be:
Tax due P100,000
Plus: Penalties
Surcharge (PIOO,OOO x 25%) 25,000
Interest (P 100,000 x 20% x 90 days/360 days) 5,000
Compromise* 15,000
Total tax due P145.000
Note:
1. The deadline of the 2014 income tax return is April 15, 2015. April 15, 2015 to July 15, 2015
is a 90-day delay.
2. Interest is computed from the basic tax due before surcharge.
3. The compromise penalty is taken from the table of compromise penalties for failure to file
and or pay internal revenue tax at the time or times required by law, as follows:*
If the amount of tax unpaid
Exceeds But not exceed Compromise is
P10,000 P20,000 5,000
20,000 50,000 10,000
50,000 100,000 15,000
100,000 500,000 20,000
Illustration 2: Non-withholding and non-remittance of withholding tax
On March 1, 2015, the taxpayer paid rental expenses to a lessor but failed to withhold
the P25,000 creditable withholding tax on the rental expense which should have been remitted
to the government on April 1, 2015. The taxpayer discovered the oversight on April 1, 2016 and
wished to settle the same. The total amount to be paid by the taxpayer on April 1,2016 shall be:
Withholding tax due P25,000
Plus: penalties
Surcharge (P25,OOO x 25%) 6,250
Interest (P25,000 x 20% x 360 days/360 days) 5,000
Compromise* 10.000
Total tax due P46,250
Note: The compromise penalty is taken from the table of compromise penalties for failure to
withhold or remit withheld tax at the time or times of required compromise by law, penalties as
follows:*
If the amount of tax unpaid
Exceeds But not exceed Compromise is
P0 P5,000 P1,000

76
 5,000 P15,000 3,000
15,000 20,000 5,000
20,000 50,000 10,000
50,000 500,000 15,000
Penalties for Non-Filing Or Late Filing Of Information Return
For each failure to file a separate information return, statement or list, or keep any
record, or supply any information required by the Code or by the Commissioner on the date
prescribe therefor, unless it is shown that such failure is due to reasonable cause not to willful
neglect, shall be subject to a penalty off P1,000 for each such failure. Provided that the amount
imposed for all such failure during a calendar year shall not exceed P 25,000.00

Self-Test Exercises
Discussion Questions
1. What are the three income taxation schemes? Briefly discuss the scope of each.
2. Discuss the nature of final income taxation.
3. What are ordinary assets? Compare them with capital assets.
4. What capital gains are subject to capital gains taxation?
5. What are the special features of regular income taxation?
6. Enumerate the instances wherein short accounting period will arise.
7. What are the tax accounting methods in reporting income? Briefly explain each.
8. What are the two types of income tax return?

77
 Exercise Drill: True or False
1. There are two types of gross income for taxation purposes.
2. The three tax schemes are mutually exclusive in coverage.
3. Final tax generally covers passive income.
4. Regular income tax generally covers active income and capital gains.
5. Ordinary gains arise from the sale, exchange and other disposition of
any assets.
6. Regular accounting records are calendar and fiscal.
7. There are only three types of assets for purposes of taxation.
8. Accrual basis and cash basis are the most common accounting
methods used in practice.
9. All taxpayers can change their accounting period when there is
change their business but, in all cases, the BIR must be notified.
10. Individuals file their income tax returns on or before April 15 of the
following calendar year.

78
 CHAPTER V

FINAL INCOME TAXATION

Objectives
After the completion of this module, you should be able to comprehend and demonstrate
the knowledge of the following:
 Understanding and appreciation of the features and scope of final tax.
 Mastery of those certain passive income subject to final tax and their corresponding final tax
rates.
 Mastery of the general final tax rates on certain non-residents and their exceptions.
 Knowledge of the other applications of the final income tax scheme
Features of Final Income Taxation
1. Final tax
2. Tax withholding at source
3. Territorial imposition
The Final withholding system
The final withholding system imposes upon the person making income payments the
responsibility to withhold the tax. The tax which will be deducted at source is final. The taxpayer
receives the income net of tax and there would be no need for him to file an income tax return to
report the same. The final withholding system is inherently territorial. It applies only to certain
passive income earned from sources within the Philippines. The Philippine government cannot
compel non-resident subjects of foreign countries to withhold the tax as this would amount to
infringement of foreign sovereignty. Hence, all items of income earned from sources abroad,
passive or active, are subject to tax under the general scope of the regular income tax.
Rationale of Final Income Taxation
The final withholding tax is built upon taxpayer and government convenience. It relieves
the taxpayer of the obligation to file income tax return. This is very convenient for taxpayers who
are limited to comply by distance, time and cost. For the government, the final withholding
system is the most convenient and effective system in collecting taxes on income where there is
high risk of non-compliance or tax evasion. Under the NIRC, final income tax is imposed on
certain passive income and to nonresident persons not engaged in business in the Philippines.
Passive income
Items of passive income are earned with very minimal involvement from the taxpayer
and are generally irregular in timing and amount. They are usually not specifically monitored by

79
taxpayers unlike items of active income. When not recorded by the taxpayer, their existence can
be difficult to predict while their actual amount may be difficult to determine. Thus, the final
withholding at source became the most favored scheme in taxing items of passive income.
Non-resident persons not engaged in business in the Philippines
Non-resident persons, not engaged in trade or business in the Philippines, such as non-
resident aliens not engaged in trade or business (NRA-NETBs) and non-resident foreign
corporations (NRFCs), have high risk of non-compliance. These taxpayers usually do not have
principal offices or fixed place of business in the Philippines. Their distance and absence from
the Philippines make it very unlikely for tax compliance to be expected. Thus, the law subjects
them to final income tax. Philippine residents shall withhold the following final tax from their
gross income, active or passive, from all sources within the Philippines:
Non-resident person not engaged in trade or General final tax rate
business
Non-resident alien not engaged in trade or business 25%
Non-resident foreign corporation 30%
Passive Income Subject to Final Tax
1. Interest or yield from bank deposits or deposit substitutes
2. Domestic dividends, in general
3. Dividend income from a Real Estate Investment Trust
4. Share in the net income of a business partnership, taxable associations, joint ventures, joint
accounts or co-ownership
5. Royalties, in general
6. Prizes exceeding P 10,000
7. Winnings
8. Informer's tax reward
9. Interest income on tax-free corporate covenant bonds
Final Tax on Individuals And Corporations
Unless otherwise indicated, the final tax rates to be discussed in the following sections
apply to all taxpayers (individuals and corporations) other than:
a. Non-resident alien not engaged in trade or business (NRA-NETB), and
b. Non-resident foreign corporation (NRFC).
Interest Income or Yield
Interest income or yield from local currency bank deposits or deposit substitutes are
subject to final tax as follows:
Recipient
Source of interest income Individuals Corporations

80
 Short term deposits 20% 20%
Lon -term deposits investment certificates Exempt* 20%
Note: *Exemption does not include NRA-NETB
Short term deposits are those made for a period of Jess than five years. Long-term
deposits or investment certificates refer to certificate or time deposit or investment in the form of
savings, common or individual trust funds, deposit substitutes, investment management
accounts and other investments with a maturity of not less than five years, the form of which
shall be prescribed by the BSP and issued by banks only (not by nonbank financial
intermediaries or finance companies) to individuals in denominations of P10,000 and other
denominations as may be p:escribed by the BSP. (RMC 18-2011)
Illustration 1
A taxpayer earned the following interest income from various time deposits:
6-month time deposit P8,000
2-year time deposit 12,000
5-year time deposit 40,000
Total interest income P60,000
Required: Compute the final tax if the taxpayer is an individual and if a corporation.
Solution:
Individual taxpayers
6 months’ time deposit P8,000 x 20% P1,600
2-year time deposit 12,000 x 20% 2,400
5-year time deposit 40,000 x 0% 0
Final withholding tax 4,000
Corporate taxpayers 60,000 x 20% P12,000
The exemption of individuals on interest income on long-term deposits is anchored to the
fact that long-term deposits are usually channeled to the financing of long-term projects such as
infrastructures, property developments and other construction projects which are deemed
essential to the development of the country. Note that exemption is limited only to individuals to
the exclusion of corporations.
Illustration 2
A resident taxpayer received a P 16,000 interest income from a bank. Determine the
final tax withheld at source.
Solution:
Gross interest income (P16,000/80%) P20,000
Multiply by final tax rates 20%
Final tax withheld P4,000
Illustration 3
Banko Negro incurs the following interest in its savings and time deposit accounts from
the following depositors:

81
 Depositors Amount
Resident individuals P600,000
Resident and domestic corporations 800,000
Non-resident aliens not engaged in business 200,000
Non-resident corporations 100,000
Total accrued interest expense P1,700,000
Required: Compute the total final income tax to be withheld by Banko Negro.
Solution:
Depositors Amount Rate Final tax
Resident individuals P600,000 X 20% P120,000
Resident and domestic corporations 800,000 X20% 160,000
Non-resident aliens not engaged in business 200,000 X25% 50,000
Non-resident corporations 100,000 X30% 30,000
Total accrued interest expense P1,700,000 P360,000
Tax on pre-termination of long-term deposits of individuals
If the deposit or investment placement of individual taxpayers is pre-terminated before 5
years, any previously untaxed or exempted interest income will be subjected to the following
final taxes upon pre-termination:
Holding period Final Tax
Less than 3 years 20%
3 years to less than 4 years 12%
4 years to less than 5 years 5%
5 years or more 0%
Illustration 1
On January 1, 2011, Alice invested P 1,000,000 in Baguio Bank's 5-year time deposit.
The deposit pays 10% interest annually. Alice pre-terminated the deposit on July 1, 2014. The
final tax on pre-termination will be computed as:
2011 interest income (P1,000,000x10%) P100,000
2012 interest income (P1,000,000x10%) 100,000
2013 interest income (P1,000,000x10%) 100,000
2014 accrued interest income (P1,000,000x10%x6 months/12 months) 50,000
Total interest income P350,000
Final tax rate applicable to less than 4-year pre-termination 12%
Final tax P42,000
The net proceeds of the deposit and accrued interest to be released to the depositor
upon pre-termination shall be:
Principal balance P 1,000,000
Accrued interest for 2014 50,000
Final tax to be withheld (42,000)
Net proceeds to be released to the depositor P1,008,000
Savings or time deposits with cooperatives are not subject to final tax

82
 The final tax is limited to banks and shall not be applied with time and savings account
deposit maintained by members with cooperatives and by primary cooperatives with their
federations. (Dumaguete Cathedral Credit Cooperative vs. CIR, G.R. 182722)
Other applications of the final tax on interest
1. Deposit substitute
2. Government securities
3. Money market placements
4. Trusts funds
5. Other investments evidenced by certificates prescribed by the Bangko Sentral ng Pilipinas
(BSP)
Deposit substitute means an alternative form of obtaining funds from at least 20 persons
at any one time other than deposits, through the issuance, endorsement, or acceptance of debt
instruments for the borrowers own account, for the purpose of relending or purchasing of
receivables and other obligations, or financing their own needs or the needs of their agent or
dealer. Government debt instruments and securities including Treasury bonds, Treasury bills,
and treasury notes shall be considered as deposit substitute irrespective of the number of
lender at origination if such debt instruments and securities are to be traded or exchanged in the
secondary market.
Foreign currency deposit with foreign currency depositary banks
The interest income from foreign currency deposits under the foreign currency deposit
system or expanded foreign currency deposit system by residents are subject to a final tax of 7
½ %.
Taxpayer Individuals Corporations
Residents 7.5% 7.5%
Non-residents Exempt Exempt
Note:
1. Resident taxpayers include resident citizen, resident alien, domestic corporations and
resident foreign corporations.
2. Non-residents taxpayers include non-resident citizens, non-resident aliens and nonresident
foreign corporations.
3. It should be emphasized that NRA-NETBs and NRFCs are also exempt.
4. There is no long-term or short-term classification of foreign currency deposits.
The reduced final tax rates on interest income on foreign currency deposit and the
exemption of non-resident depositors is intended to encourage the deposit of foreign currencies
in our banks which will be used in the financing of our international trades. Our Philippine Peso

83
is not a globally accepted currency. Our foreign trade will be limited without adequate foreign
currency reserves in our banking sector.
Joint accounts on forex deposits
If the bank account is jointly in the name of the non-resident and a resident taxpayer,
50% of the interest shall be exempt while the other 50% shall be subject to the 7.5% final tax.
(RR10-98)
Illustration
Mr. Siman is an Overseas Filipino Worker. He deposits all his savings in a savings
account under the foreign currency deposit unit (FCDU) of a domestic bank. During the month,
the savings deposit account earned $1,000 interest equivalent to P41,500.
Scenario 1: Mr. Siman deposited his savings through the account of his resident wife.
The final tax shall be P3,112.50, computed as:
Interest income P41,500
Final tax rate 7.5%
Final tax P3,112.50
Scenario 2: Mr. Siman deposited his savings through a joint account with his resident
wife. The final tax shall be P 1,556.25, computed as:
Interest income P41,500
Portion taxable 50%
Taxable interest income P20,750
Multiply by: final tax rate 7.5%
Final tax P1,556.25
Scenario 3: Mr. Siman deposited his savings account through his own account.
In this case, the interest income shall be exempt from final tax.

Interest income subject to regular tax

Interest income from the following sources is subject to regular income tax, not to final
tax:
1. Lending activities, whether during business
2. Investments in bonds
3. Promissory notes
4. Foreign sources, whether bank or non-bank
5. Penalty for legal delay or default

Dividends

84
 "Dividends" means any distribution made by a corporation to its shareholders out of its
earnings or profits and payable to its shareholders, whether in money or in other property. (Sec.
73, NIRC)

Types of Dividends:
1. Cash dividends - paid in cash
2. Property dividends - paid in non-cash properties including stocks or securities of
another corporation
3. Scrip dividends - those paid in notes or evidence of indebtedness of the corporation
4. Stock dividends - paid in the stocks of the corporation
5. Liquidating dividends - distribution of corporate net asset
As a rule, dividends are income subject to tax. However, the following are not income for
taxation purposes:
1. Stock dividends
Stock dividend representing transfer of surplus to capital account shall not be subject to
tax. Stock dividends are in the form of increase in corporate value (i.e. capital gain) which
should be properly taxable when realized through disposal or sale of the stock’s investment.
The distribution of stocks of another corporation as dividend is a taxable property dividend and
not a stock dividend.
2. Liquidating dividends
Under the NIRC, the receipt of liquidating dividends is not viewed as income but as
exchange of properties. When the liquidating dividends exceed the cost of the investments, the
excess is a taxable capital gain, subject to regular income tax. Any loss is deductible only to the
extent of capital gain.

Taxability of Stock Dividends

Normally, stock dividends are exempt from income tax. Exceptionally, stock dividends
are subject to tax at the fair value of the stocks received under the following conditions:
a. Subsequent cancellation and redemption
If a corporation cancels or redeems stock issued as a dividend at such time and in such
manner as to make the distribution and cancellation or redemption, in whole or in part,
equivalent to the distribution of a taxable dividend, the amount so distributed shall be taxable to
the extent it represents a distribution of earnings or profit. For instance, a corporation declared

85
stock dividends and immediately called the stock dividends for redemption and cancelation. This
act is equivalent to declaration of cash dividends.
b. If it leads to substantial alteration in ownership in the corporation
Substantial alteration in ownership in a corporation may occur when stock dividends are
given in lieu of cash dividends or when the corporation declared an optional stock or cash
dividend.

Stock dividend vs. Stock split

Stock dividend is a capitalization of earnings while stock split results in reduction in the
par value of stock and an increase in the number of shares of shareholders. Assuming a 2-for-l
split, a shareholder holding one P50-par value stock will be given two P 25-par value stocks.
While stock dividend may be taxable under certain conditions, stock split will never be subject to
income tax.
Dividend Tax Rules
Recipient of dividends
Source of dividends Individuals Corporations
Domestic corporation 10% final tax (1) Exempt (2)
Foreign corporation Regular tax Regular tax
Note:
1. A NRA-ETB is subject to a 20% final tax on dividend, not to the usual 10%; but an
NRANETB is subject to a 25% final tax.
2. A NRFC is not exempt but is subject to the 30% general final tax rate. However, the
imposable dividend tax shall be 15% when the tax sparing rule applies. This will be
discussed later.
Illustrative 1
Calbayog Company declared a total of P 2,000,000 dividends. P800,000 is due to
corporate shareholders while P 1,200,000 is due to individual shareholders. The final tax to be
withheld by Calbayog Company Shall be:
Shareholders Amount Rate Amount
Individual shareholders P 1,200,000 x 10% P120,000
Corporate shareholders 800,000 x 0% 0
Final tax P120,000
Illustrative 2
Aborian Company declared a total of P 1,000,000 dividends in March 2014. An analysis
of the recipient shareholders is as follows:
Shareholders Amount
Resident aliens and citizens P500,000

86
NRAs engaged in trade or business 100,000
NRAs not engaged in trade or business 50,000
Non-resident corporations 100,000
Total dividends P750,000

The total final tax to be withheld by Aborian Company shall be:

Shareholders Dividends Rate Final Tax Shareholders
Resident aliens and citizens P 500,000 x 10% P50,000
NRAs engaged in trade or business 100,000 X20% 20,000
NRAs-NETBs 50,000 x 25% 12,500
NRFCs 100,000 X 30% 30,000
Total P750,000 P 112,500

87
Historical dividend tax rates
The imposable final tax rates vary depending on the source of the dividends declared:
Source Final tax
Earnings before January 1, 1998 Exempt
Earnings from 1998 6%
Earnings from 1999 8%
Earnings from 2000 and thereafter 10%
Any distribution made to the shareholders or members of a corporation shall be deemed
to have been made from the most recently accumulated profits or surplus, and shall constitute a
part of the annual income of the distribute for the year in which received. (Sec. 73(C), NIRC)

Exempt Dividends
1. Inter-corporate dividends
2. Dividends from cooperatives

Inter-corporate dividends
Inter-corporate dividends received by a domestic corporation and resident foreign
corporation from a domestic corporation are exempted under the NIRC to minimize double
taxation.
Illustration
B, Inc. owns 100% of A Corp. During the year, A Corp. declared P 100,000 dividends to
B, Inc. B, Inc., in turn, declared the same dividends to its shareholders. The following table
illustrates the double taxation:
A Corp B, Inc.
Dividends declared P100,000 90,000
Less: 10% dividends 10,000 9,000
tax
Net dividends P90,000 P81,000

This is a form of direct duplicate taxation. To eliminate the impact of double taxation,
inter-corporate dividends such as those declared by A Corp. to B, Inc. is exempted from final
tax. When the dividend finally falls to an individual shareholder, the 10% final tax applies. This
exemption extends to dividends received by business partnerships from domestic corporations
since business partnerships are considered corporations under the NIRC.
However, the exemption does not extend to dividends received by general professional
partnership, exempt joint ventures and exempt co-ownership because they are not considered
corporations under the NIRC. On the other hand, the exemption of inter-corporate dividend does

88
not apply to the share of a corporation from the net income of a business partnership due to
absence of express legal exemption. Exemption is restricted to dividend declaration only.

Dividend from cooperatives

Under RA 9520, the distribution of dividends by an exempt cooperative to its members
either representing interest on capital or as patronage refunds shall not be subject to tax.

Entities Taxable As Corporations Are Subject To 10% Final Tax

The 10% final withholding tax also applies to dividends or share in the net income of
entities considered corporations under the NIRC and special laws, such as:
1. Real Estate Investment Trusts
2. Business partnership
3. Taxable associations
4. Taxable joint venture, joint accounts or consortium
5. Taxable co-ownership

Real Estate Investment Trust or REIT

A REIT is a publicly listed corporation established principally for the purpose of owning
income-generating real estate assets. The following recipients of REIT dividends are exempt to
the final tax:
a. Non-resident alien individual or non-resident foreign corporations entitled to claim
preferential tax rate in pursuant to applicable tax treaty.
b. Domestic corporation or resident foreign corporation
c. Overseas Filipino investors - exempt from REIT dividend tax until August 12, 2018 (7 years
from the effectivity of RR13-2011 which took effect on August 12, 2011)

Business partnership, taxable associations, joint venture, joint accounts or co-ownership

Under Sec. 73 of the NIRC, the net income of these entities is deemed constructively
received by the partners, members or venturers, respectively, in the same year the net income
is reported. Hence, the 10% final tax applies at the point of determination of the income - not at
the point of actual distribution.

Share in business partnership net income

89
 The "share in net income" includes not only the share in the residual profit but also
provisions for salary, interest and bonus to a partner. However, if the provisions for salaries,
interests and bonuses are expensed as such in the book of the partnership, they are subject to
regular tax to the receiving partner, not to final tax. In this case, only the share in the residual
income after such provisions is subject to final tax.
Illustration
The partnership profit distribution of partners Andy and Mar based on their agreed profit
distribution scheme is as follows:
Andy Mar
Salaries to industrial partner P40,000 P
Interest to capitalist partner 12,000
Bonus to industrial partner 25,000
Residual profit sharing 8,000 24,000
Profit sharing P73,000 P36,000
Assuming the salaries, interest and bonus are not expense in the book, the 10% final tax
shall be:
Profit sharing P73,000 P36,000
Multiply by: Final tax rate 10% 10%
Final tax P7,300 P3,600
Note: A partner, member or venture who is an NRA-ETB, NRA-NETB or NRFC shall be
subject to 20%, 25% and 30% final tax rate, respectively.

The Improperly Accumulated Earnings Tax

Domestic corporations cannot avoid the dividends tax by simply not declaring dividends.
Corporations which accumulate earnings beyond the reasonable needs of business will be
imposed the 10% Improperly Accumulated Earnings Tax - a penalty tax.
Royalties
Passive royalty income received from sources within the Philippines is subject to the
following final tax rates:
Recipient
Source of passive royalties Individuals Corporations
Books, literary works and musical compositions 10% final tax 20% final tax
Other sources 20% final tax 20% final tax
Note:
1. Under the regulations, the 10% preferential royalty final tax on books and literary works
pertain to printed literatures. Royalties on books sold on e-copies or CDs such as e-books
are subject to the 20% final tax.

90
2. Royalties on cinematographic films and similar works paid to NRA-ETBs, NRA-NETBs or
NRFCs is subject to a final tax of 25%*.

Passive vs. Active royalties

Royalties of a passive nature such as royalties of claim owners or land owners of mining
properties, royalties of inventors from companies that manufacture and sell their invention and
royalty from licensing agreements that transfers the use of trademark or technology are subject
to 20% final tax. When royalties accrue from an undertaking where the taxpayer has active
involvement, it is an active income subject to the regular income tax.
Illustration
E-Soft, Inc. develops application programs for establishments. These programs were
individually tailored to meet specific requirements of the establishments and require upgrades,
occasional troubleshooting and adjustments for problems. The developer receives 1% of the
sales of the establishment as royalty. E-Soft also developed a utility program and assigned it to
an e-marketer which sells the utility program through the internet.
E-Soft receives 30% royalty on each copy of the program sold. The royalties from
application programs are active income subject to regular income tax. The royalty from the utility
programs is passive income subject to final withholding tax but if the e-marketer is not resident
in the Philippines, the passive income from abroad shall be subject to regular tax. Royalties,
active or passive, earned from sources abroad are subject to regular income tax.

Prizes
The taxation of prizes varies. Prizes may be exempt from income tax or subject to either
final tax or regular income tax.
Exempt prizes
1. Prizes received by a recipient without effort on his part to join a contest. Examples include
prizes from such awards as Nobel Prize, Most Outstanding Citizen, Most Benevolent Citizen
of the Year and similar awards.
2. Prizes from sports competitions that are sanctioned by their respective national sport
organization

Requisite of exemption
1. The recipient was selected without any action on his part to enter the contest

91
2. The recipient is not required to render substantial future services as a condition to receiving
the price or reward

Taxable prizes
For individual income taxpayers, taxable prizes are subject to either final tax or regular
tax depending on the amount of the prize. There may be events or competitions where
corporations earn prizes. However, there is no final tax imposition on corporate prizes under the
NIRC. Hence, the same must be subject to regular income tax.
Table summary of rules Recipient
Amount of taxable prize Individuals Corporations
Prize exceeding P10,000 20% final tax Regular tax
Prize not exceeding P10,000 Regular tax Regular tax
Recall also that final taxation do not apply on foreign passive income; hence, prizes from
foreign sources are subject to the regular income tax.

Winnings
For individual income taxpayers, winnings received from sources within the Philippines
are generally subject to 20% final tax except for the following exempt winnings:
1. Philippine Charity Sweepstakes Office (PCS()) winnings
2. Lotto winnings
Like prizes, there is no final tax imposed on corporate winnings under the NIRC.
Winnings that are not subjected to final tax by the payor should be reported as part of the
regular income. Also, winnings from foreign sources are subject to regular income tax.
Table summary of rules Recipient
Types of winnings Individuals Corporations
PCSO or lotto winnings Exempt Exempt
Other winnings in general 20% final tax Regular tax
Note: The exemption on PCS() or lotto winnings also extends to NRA-NETBs and NRFCs.

92
Tax Informer's Reward
Cash reward may be given to any person instrumental in the discovery of violations of
the National Internal Revenue Code or discovery and seizure of smuggled goods. Tax
informer's reward is subject to 10% final tax.

Requisites of Tax Informer's Reward:

1. Definite sworn information which is not yet in the possession of the BIR.
2. The information furnished lead to the discovery of fraud upon internal revenue laws or
provisions thereof.
3. Enforcement results in recovery of revenues, surcharges and fees and/or conviction of the
guilty party or imposition of any fine or penalty
4. The informer must not be a:
a. BIR official or employee
b. Other public official or employee
c. relative within the 6th degree of consanguinity of those officials or employee in a. and

Amount of Cash Reward - whichever is the lower of the following per case:
1. 10% of revenues, surcharges or fees recovered and or fine or penalty imposed and
collected or
2. P1,000,000
The amount of cash reward is subject to 10% final withholding tax which shall be
withheld by the government.
Illustration
Ms. Kirsten provided information to the BIR leading to the recovery of PI 2,000,000
unpaid taxes. The cash reward shall be computed as:
10% cash reward (P12,000,000x10%) P1,2000,0000
Cash reward limit 1,000,000
Cash reward (whichever is lower) P 1,000,000
Less: 10% final withholding tax 100,000
Net amount to be released to the tax informer P900,000

Tax-Free Corporate Covenant Bonds

Interest income of non-resident aliens, citizen or resident of the Philippines on bonds,
mortgages, deeds of trust, or other similar obligations of domestic or resident foreign
corporation with tax-free or tax-reduction provision where the obligor shoulders in whole or in
part any tax on the interest shall be subject to a final withholding tax of 30%.

93
 Recipient
Individuals Corporations
Tax on interest income on tax-free corporate 30% final tax Regular income tax
covenant bonds
Note:
1. The final tax applies to all individuals, regardless of classification.
2. There is no similar final tax provision for corporate recipient of "tax-free" interest; hence, the
regular income tax shall apply.

Exceptions To The General Final Tax On Non-Resident Persons Not Engaged In Trade Or
Business In The Philippines
NM-NETB NRFC
General Final Tax Rate 25% 30%
Exceptions:
Capital gain on sale of domestic stocks 5%-10% Capital gains 5%-10% Capital
directly to buyer tax gains tax
Rentals on cinematographic films and
25% of rentals 25% of rentals
similar works
Rentals of vessels 25% of rentals 4.5% of rentals
Rentals of aircrafts, machineries and other
25% of rentals 7.5% of rentals
equipment
Special aliens (special employees) 15% of gross income N/A
from employer
Lotto and PCSO winnings Exempt Exempt
Interest income under the foreign currency
Exempt Exempt
deposit system
Interest on foreign loans N/A 20%
15% if tax sparing
Dividend income 25%
rule is applicable
Tax on corporate bonds 30% 30%

94
Capital gains tax
As a rule, NRA-ETBs and NRFCs do not file income tax returns. Exceptionally,
NRANETBs and NRFCs are required to file income tax return to report their gain from dealings
in domestic stocks directly to buyer. Ownership to the stocks shall not be transferred to the
assignee without the required return and tax clearance (Certificate Authorizing Registration or
CAR) from the BIR that the tax on the transfer has been paid.

Special aliens
Special aliens are NRA-NETBs employed by regional or area headquarters and regional
operating headquarters of multinational companies, offshore banking units or petroleum service
contractors or subcontractors. Special aliens are subject to a final tax of 15% on gross income
from their employers.
Illustration: NRA-NETBs
In 2014, Mr. Tih Wong, an NRA-NETB, is a consultant to Raha Humabon Manufacturing
Company (RHMC), a domestic manufacturer. RHMC also pays Mr. Wong royalty for using his
invention. During the year, Mr. Wong purchased shares of RHMC and sold them directly to a
buyer.
Royalties from invention P300,000
Professional fees 1,000,000
Gain on sale of domestic stocks directly to buyer 40,000
Required: Compute the total final tax withheld at source.
Solution:
Royalties from invention P 300,000
Professional fees 1,000,000
Total gross income P1,300,000
Multiply by: final tax on NRA-NETB 25%
Total final withholding tax P325,000
Note:
1. The final tax applies on gross income, whether active or passive. The same rule applies with
NRFC except that the final tax rate is 30%.
2. Mr. Wong shall file a capital gains tax return for the gain on the sale of domestic stocks.

95
The Tax Sparing Rule
NRFCs shall be subject to a 15% final tax on dividend income instead of the 30%
general final tax if the country of domicile of the NRFC credits against the tax due of such NRFC
taxes presumed to have been paid by such NRFC from the Philippines equivalent to 15% of the
dividends.
In applying the tax sparing rule, the Supreme Court ruled that the NIRC does not require
that the foreign law of the non-resident corporation must give a deemed paid tax credit for
dividend equivalent to the percentage points waived by the Philippines pointing that the NIRC
merely require the country of the NRFC to a deemed paid tax equivalent to that waived by the
Philippines. (CIR vs. Procter & Gamble Philippines Manufacturing Corporation and the CTA
(G.R. 66836))
Thus, the requirement of the tax sparing rule is deemed satisfied if the country to which the
NRFC is domiciled imposes no tax on dividends from foreign sources. (BIR Ruling Nos. 104-
2012, March 22, 2012)

Illustration: The Tax Sparing Rule with NRFCs

An NRFC is due to receive a dividend of P 1,000,000 from a domestic corporation. The
final tax to be imposed by the Philippines which shall be withheld by the domestic corporation
shall be 15%, not 30%, if the country of domicile of the NRFC also reduce its income tax upon
the P 1,000,000 dividend by at least 15%, the dividend tax percentage waived by the Philippines
computed as 30% general final tax rate - 15% imposable final tax. If the country of the NRFC do
not reduce its tax on the dividend by at least 15%, the Philippines imposes the 30% final tax.

Other Applications Of Final Income Tax

1. Compensation income of Filipinos qualified as special aliens
2. Fringe benefits of managerial or supervisory employees
3. Income payments of residents other than depositary banks under the expanded foreign
currency deposit system (EFCDS) to offshore banking units (OBUs) and expanded foreign
currency deposit units (EFCDUs)
4. Income payments to oil exploration service contractors or sub-contractors

Filipino Employees Qualified As Special Aliens

Filipino employees occupying the same position as those held by special aliens subject
to 15% final tax may opt to be taxed at the same 15% final tax.

96
Fringe Benefits Tax
Fringe benefits include all remunerations under an employer-employee relationship that
do not form part of compensation income. The fringe benefits of managerial and supervisory
employees are subject to a final fringe benefits tax.

Interest And Other Income Payments To Depositary Banks Under The Expanded Foreign
Currency Deposit System
Residents, other than depositary banks under the expanded foreign currency deposit
system, shall withhold 10% final tax on income payments such as interest income on loans from
offshore banking units (OBUs) and expanded foreign currency deposit units (FCDUs).

Income Payments To Sub-Contractors Of Petroleum Service Contractors

Under PD 1354, every subcontractor, whether domestic or foreign, entering into a
contract with a service contractor engaged in petroleum operations in the Philippines shall be
liable to a final income tax equivalent to eight percent (8%) of its gross income derived from
such contract , such tax to be in lieu of any and all taxes, whether national or local.
Provided, however, that any income received from all other sources within and without
the Philippines in the case of domestic subcontractors and within the Philippines in the case of
foreign subcontractors shall be subject to the regular income tax under the NIRC. The term
"gross income" means all income earned or received because of the contract entered by the
subcontractor with a service contractor engaged in petroleum operations in the Philippines
under Presidential Decree No. 87.
Note that the 8% final tax applies only to subcontractors, whether individuals or
corporations, resident or non-resident. Petroleum service contractors are subject to the regular
income tax. Persons or entities contracted by a petroleum service contractor to locally supply
goods and materials that are required by and in, or that are inherently necessary or incidental
to, its exploration and development of petroleum mineral resources and are entitled to the
preferential 8% final tax on their gross income derived from such contracts. (BIR Ruling No.
024-2001, June 13, 2001)

Final Withholding Tax Return

97
 The final withholding tax return (BIR Form 1601 -F), Monthly Remittance Return of Final
Income Taxes Withheld, shall be filed in triplicate by every withholding agent or payor who is
either an individual or corporation.
Deadline and place for manual filing
The return shall be filed, and the tax shall be paid or before the 10th day of the month
following the month in which withholding was made with:
a. The authorized agent bank of the revenue district office having jurisdiction over the
withholding agent's place of business
b. In places where there are no authorized agent banks, to the revenue collection officer
c. The authorized city or municipality treasurer within the revenue district where the withholding
agent's place of business is located

Deadline for eFPS filing

In accordance with the schedule set forth in RR No. 26-2002, the deadline for efiling of
returns is as follows:
Group A - Fifteen (15) days following end of the month
Group B - Fourteen (14) days following end of the month
Group C - Thirteen (13) days following end of the month
Group D - Twelve (12) days following end of the month
Group E — Eleven (11) days following end of the month
Note: Please check the groupings of taxpayers under eFPS in Chapter 4.

Penalties for Late Filing or Remittance of Final Income Taxes Withheld

The same penalties for non-withholding on income payments discussed under Chapter 4
apply for non-withholding or non-remittance of final taxes.
Entities Exempt From Final Income Tax
1. Foreign governments and foreign government-owned and controlled corporations
2. International missions or organization with tax immunity
3. Qualified employee trust fund
4. A qualified employee trust fund is exempt from any income tax imposed under the NIRC.
A comprehensive summary of final tax rates is presented in the Appendix 1 of the book
for your convenience.

98
Self-Test Exercises
Discussion Questions
1. What are the features of final income taxation?
2. Explain withholding at source.
3. Enumerate the passive income subject to final tax and their corresponding tax rates.
4. What are the two types of taxpayers who are subject to final tax rates on all income from
within the Philippines? What are the general tax rates applicable to each.
5. Enumerate the requisites of the tax informers reward.

Exercise Drill: True or False

1. The tax sparing rule is applicable to resident and non-resident
foreign corporations.
2. Royalties, active or passive, is subject to regular income tax.
3. All foreigners are exempt on final tax on foreign currency
deposits.
4. The share in the net income of the business partnership is
subject to creditable withholding tax, not to final tax.
5. Stock dividends are always exempt from final tax.
6. Dividends from resident corporations are subject to 10%
dividends tax.
7. Interest income on government securities are subject to final
tax.
8. Items of passive income from abroad are subject to final tax.
9. Corporations are exempt on inter-corporate dividends.
10. Generally, interest income from non-bank sources is subject
to regular income tax.

99
 CHAPTER VI

CAPITAL GAINS TAXATION

Objectives
After the completion of this module, you should be able to comprehend and demonstrate
the knowledge of the following:
 Identify and distinguish ordinary asset and capital asset
 Recite the asset classification rules
 Master the procedural computations of the 5&10% capital gains tax and the 6% capital
gains tax
 Master the rules on wash sales and tax-free exchanges
 Master the exceptions to the 6% capital gains tax

Classification of Taxpayer's Properties

1. Ordinary assets - assets used in business, such as:
a. Stock in trade of a taxpayer or other real 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
b. Real property held by the taxpayer primarily for sale to customers in the ordinary
course of his trade or business
c. Real property used in trade or business (i.e., buildings and/or improvements) of a
character which is subject to the allowance for depreciation
d. Real property used in trade or business of the taxpayer
2. Capital assets - any assets other than ordinary assets

Asset Classification Is Relative

The classification of assets or properties as ordinary asset or capital asset depends
upon the nature of the taxpayer’s business.
Example:
1. A domestic stock is an ordinary asset for a dealer in securities but is a capital asset to a
non-security dealer. A "dealer in securities" is a merchant of stocks or securities with a
registered place of business, regularly engaged in the purchase of securities and their re-
sale to customers.

100
2. A vacant and unused lot is an ordinary asset to a taxpayer engaged in the real estate
business such as realty dealer, realty developer or lessor but is a capital asset to those not
engaged in the real estate business.
Interestingly, the revenue regulations classify real and other properties acquired (ROPA)
by banks as ordinary assets even if banks are not actually engaged in the realty business. This
is an apparent recognition to the fact that ROPA are normally acquired and sold by banks in
their normal course of business. However, ROPA in the form of domestic stocks held by banks
are capital asset. Under RR6-2008, "stocks classified as capital assets" means all stocks and
securities held by taxpayers other than dealers in securities.

Asset Classification Rules

1. A property purchased for future use in business is an ordinary asset even though this
purpose is later thwarted by circumstances beyond the taxpayer's control.
2. Discontinuance of the active use of the property does not change its character previously
established as a business property.
3. Real properties used, being used or have been previously used, in trade of the taxpayer
shall be considered ordinary asset.
4. A depreciable asset is an ordinary asset even if it is fully depreciated or there is a failure to
take depreciation during the period of ownership.
5. Real properties used by an exempt corporation in its exempt operations are considered
capital assets.
6. For taxpayers not engaged in the real estate business, ordinary assets are automatically
converted to capital asset upon showing proof that the same have not been used in
business for more than 2 years prior to the consummation of the taxable transaction
involving such property.
7. The classification of property transferred by sale, barter or exchange, inheritance, donation
or declaration of property dividends shall depend on whether the acquirer uses it in
business.
8. For real properties subject of involuntary transfer such as expropriation and foreclosure sale,
the involuntariness of such sale shall have no effect on the classification of such real
property.
All the personal assets of taxpayers not engaged in business are capital assets while the
business assets of taxpayers engaged in business may either be ordinary asset or capital asset
by applying the foregoing rules.

101
Types of Gains on Dealings in Properties
1. Ordinary gain - arises from the sale, exchange and other disposition, including pacto de
retro sales and other conditional sales, of ordinary assets
2. Capital gain - arises from the sale, exchange and other disposition, including pacto de retro
sales and other conditional sales, of capital assets

Taxation of Gains on Dealings in Properties

Types of gains Regular income tax
Ordinary gains General rule: Regular income tax
Capital gains Exception rule: Capital gains tax

Capital Gains Subject to Capital Gains Tax

There are only two types of capital gains subject to capital gains tax:
1. Capital gains on the sale of domestic stocks sold directly to buyer
2. Capital gains on the sale of real properties not used in business

Scope of Capital Gains Taxation

Gains on dealings in capital assets Tax rates
Gain on the sale, exchange, and other disposition of domestic 5% and 10% capital gains
stocks directly to the buyer tax
Sale, exchange, and other disposition of real property in the 6% capital gains tax
Philippines
Gains from other capital assets Regular income tax

Sale, Exchange and Other Disposition Of Domestic Stocks Directly To Buyer

Meaning of "Domestic Stocks"
Domestic stocks are evidence of ownership or rights to ownership in a domestic
corporation, regardless of its features, such as:
 Preferred stocks (participative, cumulative, etc.)
 Common stocks
 Stock rights
 Stock options
 Stock warrants
 Unit of participation in any association, recreation or amusement club (golf, polo or similar
clubs)

102
 The capital gains tax covers not only sales of domestic stocks for cash, but also
exchange of domestic stocks in kind and other disposition, such as:
1. Foreclosure of property in settlement of debt
2. Pacto de retro sales - sale with buy back agreement
3. Conditional sales - sales which will be perfected upon completion of certain specified
conditions
4. Voluntary buy-back of shares by the issuing corporation - redemption of shares which may
be re-issued and not intended for cancellation
The term "other disposition" does not include:
1. Issuance of stocks by a corporation
2. Exchange of stocks for services
3. Redemption of shares in a mutual fund
4. Worthlessness of stocks
5. Redemption of stocks for cancellation by the issuing corporations
6. Gratuitous transfer of stocks

Issue of Stocks Including Treasury Stocks

The issue of stocks to stockholders by a corporation is a financing transaction rather
than a sale transaction. The excess of fair value received over the par value of shares issued is
an additional capital to the corporation. Stocks acquired by the corporation from its
shareholders, treasury shares, cannot be considered assets or investments in accounting
sense.
The excess of the consideration received in the re-issuance of treasury stocks, called
treasury share premium, is an additional capital and is not income. Under US tax rules, treasury
shares can be considered as investments if the corporation trades on its shares as it would in
the shares of other corporations. As such, the treasury share premium is viewed as a capital
gain. Under the NIRC and RR6-2008, however, there is no express provision taxing treasury
share premium. Hence, treasury share premium should not be subjected to capital gains tax.

Exchange of Stocks for Services

Similarly, the exchange or issue of stocks for services cannot be considered as
exchanged for property. No gain or loss can be imputed as it involves payment of expense in
kind.

103
Redemption of Shares in A Mutual Fund
Gains from redemption of shares in a mutual fund are exempted by the NIRC from
income taxation.

Worthlessness of Stocks
The value of stocks becoming worthless is considered a capital loss subject to the rules
of regular income tax. This will be discussed in Chapter 12.

Redemption of Stocks by the Issuing Corporation

Under RR6-2008, any gain or loss on the mandatory redemption of stocks by the issuing
corporation for the purpose of stock cancellation shall be subject to the rules of regular income
tax under Dealings in Properties in Chapter 12. It should be noted therefore that the gain by the
investor on redemption of redeemable preferred shares shall be subject to regular income tax.
Note, however, that this does not include the voluntary buy-back of the shares by the issuing
corporation to be held in treasury which may later be re-issued. The gain or loss realized by the
investor on voluntary buy-back of shares by the issuing corporation is taxable under capital
gains taxation.

Gratuitous Transfer of Stocks

The gratuitous transfer of stocks either by way of donation inter-vivos or donation mortis
causa is subject to transfer tax, not to income tax.

Modes of Disposing Domestic Stocks

Shares of stocks may be sold, exchanged or disposed:
a. Through the Philippine Stock Exchange (PSE) or
b. Directly to buyer

Tax on Sale of Domestic Stocks through The PSE

The sale of domestic stocks classified as capital assets through the PSE is not subject to
capital gains tax. It is subject to a stock transaction tax of h of 1% of the selling price.
Illustration 1: Non-dealer in stocks
Mr. San Juan, not a dealer in stocks, sold the following stock investments through the
Philippine Stock Exchange:

104
 Date Stock code Selling price Cost Gain (loss)
4/5/2014 AC P4,000,000 P3,700,000 P300,000
4/5/2014 SMB 3,000,000 3,200,000 (200,000)
Total P7,000,000 P6,900,000 P100,000
The stock transaction tax shall be computed as:
Total selling prices of stocks through the PSE P 7,000,000
Multiply by: Transaction tax rate 0.5%
Transaction tax P35,000
Note:
1. The stock transaction tax applies on the selling price regardless of the existence of a gain or
loss on the sale transaction.
2. The P65,000 net capital gains, after deduction of the P35,000 transaction tax, is exempt
from income tax. It will no longer be subject to capital gains tax or to regular income tax.
Illustration 2: Dealer in stocks
Assume the same data in the previous illustration, except that Mr. San Juan is a dealer
in stocks. Mr. San Juan shall not be subject to the stock transaction tax but the P300,000 gain is
an ordinary gain reportable as item of gross income subject to regular income tax. The
P100,000 loss is also an ordinary loss reportable as item of deduction against gross income
under the regular income tax.

Tax on Sale, Exchange and other Dispositions of Domestic Stock

Directly to Buyer
The net gain on the sale, exchange and other disposition of domestic stocks directly to
buyer is subject to a two-tiered capital gains tax:
Tax rate
Net gain up to P100,000 5%
Excess net gain above P100,000 10%
The net gain is determined as:
Selling price PXXX,XXX
Less:
Basis of shares disposed PXXX,XXX
Selling expense XXX,XXX
Documentary stamp tax on the sale XXX,XXX XXX,XXX
Net capital gain (loss) PXXX,XXX
Selling price shall mean:
1. In case of cash sale, the total consideration received per deed of sale
2. If total consideration is paid partly in money and partly in property, the sum of money and
fair value of consideration received
3. In case of exchanges, the fair value of the property received

105
Illustration
Cool sold his stocks receiving in exchange a building with a tax basis of P2,000,000 but
with a fair value of plus goods worth P 100,000 and P400,000 cash.
Fair value of building received P2,500,000
Fair value of goods received 100,000
Cash 400,000
Total consideration or selling price P3,000,000
Basis of the stocks shall mean:
 If acquired by purchase - the cost of the property which will be determined by the following
methods in descending order of priority:
o Specific identification - if the shares can be specifically identified v'/ Moving average
method - if books of accounts is maintained by the seller where transaction of every
particular stock is recorded
o First-in, first out method - if the stocks cannot be specifically identified If acquired by
devise, bequest or inheritance - fair value at the time of death of the decedent
 If acquired by gift - the lower of the fair market value at the time of gift and the basis in the
hands of the donor or the last preceding owner by whom it was not acquired by gift
 If acquired for inadequate consideration - the amount paid by the transferee for the property
 If acquired under tax-free exchanges, the substituted basis of the stocks
Illustration 1: Cost of acquisition
Mrs. La Carlota purchased 1,000 shares of Bacolod Corporation for P100,000 and paid
broker's commission of P 1,000. The stocks were subject to a chattel mortgage of P10,000
which Mrs. La Carlota assumed.
The cost or basis of the stocks shall be:
Cash paid P100,000
Obligations assumed on the property purchased P10,000
Direct acquisition cost P1,000
Total cost (tax basis) P111,000
Illustration 2: Costing procedures
Mr. Alcantara had the following purchases and sales of shares of the stocks of El
Dorado Corporation:
Date Transaction Shares Price Cost
January 1 Purchase 10,000 P10.00 P100,000
March 1 Purchase 5,000 11.03 55,150
March 23 Purchase 20,000 12.00 240,000
April 4 Sale 25,000 15.00
The cost of the shares sold shall be determined as follows:

106
 Assuming Mr. Alcantara identified that the shares sold shares were those bought on
March 1 and March 23, the applicable method is specific identification method. Under specific
identification, the actual cost of the shares sold, and the remaining stocks shall be:
March 1 purchase 5,000 shares P55,150
March 23 purchase 20,000 shares 240,000
Cost of 25,000 shares sold P295,150
Cost of remaining 10,000 stocks P100,000
Assuming Mr. Alcantara cannot identify the shares sold but retains detailed records of
purchase and sale in the stocks of El Dorado, the applicable method is the moving average
method. Under the moving average method, the cost of the shares sold, and the remaining
shares shall be computed as follows:
Date Transaction Shares Unit cost Cost
January 1 Purchase 10,000 P10.00 P100,000
March 1 Purchase 5,000 P11.03 55,150
March 23 Purchase 20,000 12.00 240,000
35,000 P11.29 P395,150
Less: Cost of shares sold 25,000 P11.29 (P282,250)
Quantity and cost of ending shares 10,000 P11.29 P112,900
Note:
1. Average unit cost =P395,150/35,000 = PI 1.29
2. Under the moving average method, the average unit cost of the stocks is determined after
every purchase.
3. The cost of ending shares can be computed as 10,000 x P11.29.
Assuming Mr. Alcantara cannot identify the stocks sold and do not maintain detailed
record of transaction in the shares of El Dorado, the applicable method is the First-in, first-out
method. The cost of the shares sold shall be presumed from the cost of the first 25,000 shares
bought:
Date Transaction Shares Unit cost Cost
January 1 Purchase 10,000 P10.00 P100,000
March 1 Purchase 5,000 P11.03 55,150
March 23 Purchase 20,000 12.00 240,000
35,000 P395,150
Less: Cost of shares sold 25,000 P11.29 (P282,250)
January 1 10,000 P10.00 P100,000
March 1 5,000 P11.03 55,150
March 23 20,000 12.00 120,000
25,000 (P275,150)
Quantity and cost of ending shares 10,000 P12.00 P120,000
Note:
1. The 10,000 and 5,000 shares from January 1 and March 1, respectively, are deemed first
sold. The other 10,000 shares sold are deemed coming from the last purchase on March 23.

107
2. The cost of the 10,000 shares in the last purchase is computed as 10,000/20,000 x
P240,000 = P120,000.
Illustration 3: Acquisition by gratuitous title
On March 2013, Mrs. Lipa received by gratuitous acquisition shares of stocks of Taal
Corporation from her father, Don Bosco. Don Bosco acquired the same shares by donation in
June 1999 from his mother, Doha Karena, who bought the shares for P400,000 on April 1996.
The shares have fair value of P 700,000 on June 1999 and on March 2013.
Assuming the shares was acquired by Mrs. Lipa from her father by way of:
1. Donation: Assuming the shares were donated by Don Bosco to Mrs. Lipa on March 2013 -
the basis of the shares to Mrs. Lipa shall be whichever is lower of:
a. P400,000, the basis in the hand of the last preceding owner (Doha Karena) who did
not acquire the property by gift, and
b. P2,500,000, the fair value at the date of donation. Hence, P400,()00.
2. Inheritance: Assuming the shares were inherited by Mrs. Lipa when Don Bosco died on
March 2013 - the basis of the shares to Mrs. Lipa shall be P 2,500,000, the fair value at the
date of death of Don Bosco.
3. Purchase for an inadequate consideration: Assuming the shares were bought by Mrs. Lipa
from Don Bosco for only P 1,200,000 - the basis of the shares to Mrs. Lipa shall be P
1,200,000, the actual price paid for.
The computation of adjusted basis on tax-free exchanges will be discussed under tax-
free exchanges in this chapter.

Stocks sold below its fair value

The excess of the fair value over the selling price is subject to donor's tax.
Illustration
Mr. Navotas sold his investment in domestic stocks directly to buyer for P500,000. The
shares have a fair value of P650,000 and P 300,000 tax basis and expenses at the date of sale.
Fair value P650,000
P150,000 gratuity subject to
transfer tax
Selling price 500,000
Less: cost and expenses
P200,000 subject to capital gains
300,000
tax
The rules on the determination on fair value of stocks and transfer taxation will be
discussed in Business and Transfer Taxation by the same author.

108
Scope Of The Two-Tiered Capital Gains Tax
The two-tiered capital gains tax applies for all class of taxpayers, individuals or
corporations, regardless of the place of sale, the identity of the buyer and the length of time the
domestic stocks were held by the taxpayer. Even NRA-NETBs and NRFCs are required to file
the capital gains tax return. Due to this, it is regarded as the most universal rule in income
taxation.
The transfer by a nonresident alien or a foreign corporation to anyone of any share of
stock issued by a domestic corporation shall not be effected in its book unless the transferor has
filed with the Commissioner a bond conditioned upon the future payment by him of any income
tax that may be due on the gains derived from such transfer, or the Commissioner has certified
that the taxes, if any, due on the gain realized from such sale or transfer have been paid. It shall
be the duty of the transferor and the corporation the shares of which are sold or transferred, to
advise the transferee of this requirement.

109
Capital Gains Tax Compliance
1. Transactional capital gains tax
2. Annual capital gains tax

Transactional Capital Gains Tax

The capital gains or losses are required to be reported after each sale, exchange and
other dispositions through the capital gains tax return, BIR Form 1707.
Illustration: Computation of Capital Gains Tax
Cherry disposed her investments in domestic stocks costing P100,000 directly to buyer.
She paid on the sale P2,000 and P500 broker's commission and documentary stamp tax
expense, respectively. Compute the capital gains tax under each of the following conditions:
Selling price P180,000
Less: cost and expense
Purchase cost P100,000
Commission expense 2,000
Documentary stamp tax expense 500 102,500
Capital gain P77,500
First P100,000 of gain P77,500
Multiply by applicable rate 5%
Capital gains tax due P3,875
Selling price 240,000
Selling price P240,000
Less: cost and expenses 102,500
Capital gain P137,500
First P100,000 gain at 5% P100,000 P5,000
Excess gain at 10% 37,500 3,750
Capital gains tax due P8,750

Deadline of the transactional capital gains tax return

The capital gains tax return (BIR Form 1707) shall be filed within 30 days after each
sale, exchange and other disposition of stocks. If the tax is qualified for payment under the
installment method, the tax is due within 30 days after each installment.

110
Annualized Capital Gains Tax
The tax on capital gains on the sale, exchange and other disposition of domestic stocks
directly to buyer is based on the annual net capital gains. The annual net capital gain or loss is
computed as transactional capital gains less transactional capital losses. The transactional
capital gains taxes paid during the year are deducted as tax credit against the annual capital
gains tax due. The excess of the annual capital gains tax due over the sum of the transactional
capital gains taxes paid during the year is a capital gains tax payable. The excess of the sum of
transactional capital gains tax over the annual capital gains tax due is a capital gains tax
refundable.
Illustration
Allison, Inc. disposed several equity securities directly to buyer during its fiscal year
ending June 30, 2014:
Selling Cost and Capital gain Capital
Date Equity securities
price expense (loss) gains tax
1/12 Preferred stock P210,000 P100,000 P110,000 P6,000
3/18 Common stocks 80,000 90,000 (10,000)
5/14 Stock rights 160,000 70,000 90,000 4,500
6/17 Stock options 80,000 100,000 (20,000)
Total P170,000 P10,500
The final capital gains tax payable (refundable) shall be:
Annual net capital gain P170,000
Less: first P100,000 net gain 100,000 5% P5,000
Excess net capital gain P70,000 10% 7,000
Annual capital gains tax due P12,000
Less: total transactional capital gains taxes paid 10,500
Capital gains tax payable (refundable) P1,500

Deadline of annual capital gains tax return

The annual capital gains tax return, BIR Form 1707-A, shall be filed on or before the 15 th
day of the fourth month following the close of the taxable year of the taxpayer.
Illustration
In the immediately preceding illustration, the P 1,500 net capital gains tax payable is due
on or before October 15, 2014, the 15 th day of the fourth month following the fiscal year-end,
June 30, 2014. For individual taxpayers, the P 1,500 capital gains tax shall be payable on or
before April 15, 2015 since individuals are allowed only the calendar year accounting period.
Installment Payment Of The 5%-10% Capital Gains Tax
When domestic stock is sold in installment, the capital gains tax may also be paid in
installment if:

111
a. Selling price exceeds P 1,000 and
b. Initial payment does not exceed 25% of the selling price
Illustrative Case: Basic
On November 1, 2014, Mr. Batanes made a sale of domestic stocks costing P700,000
directly to buyer for P 1,000,000. The buyer agreed to pay in P 100,000 monthly installments
starting November 30. The capital gains tax shall be:
Selling price P1,000,000
Less: cost of shares sold 700,000
Net capital gain P300,000
Less: first P100,000 100,000 X 5% P5,000
Excess gain P200,000 X 10% 20,000
Net capital gains tax due P25,000
Illustration 1: No mortgage on the shares sold
Initial payment:
First installment (November 30) P100,000
Second installment (December 31) 100,000
Total initial payment P200,000
Ratio of initial payment (P200,000/P1,000,000) 20%
The taxpayer is qualified to pay capital gains tax in installment. Under the installment
method, the tax will be paid based on the pattern of collection of the contract price. The contract
price is the total sum of money collectible from the contract. It is normally the selling price in the
absence of any indebtedness on the shares sold. Under the installment method, the capital
gains tax payable every installment shall be computed as: Collection / Contract price x Capital
gains tax. The capital gains tax payable for every installment shall be P2,500, computed as x
P25,000. Note that the selling price is used to measure the initial payment ratio, but the contract
price is used in determining the capital gains tax in installment.
Illustration 2: With mortgage on stocks but not more than cost
Assume the stocks were previously mortgaged for P600,000 which the buyer assumed.
The P400,000 balance is payable in monthly installment of P 100,000 starting November 30,
2014. The gain and the capital gains tax shall be the same as P300,000 and P25,000,
respectively. The contract price or total sum collectible on the sale shall be:
Selling price P1,000,000
Less: mortgage assumed 600,000
Contract price P400,000
The capital gains tax payable every installment shall be P6,250, computed as x
P100,000/P400,000 x P25,000.
Illustration 3: With excess mortgage over cost
Assume instead that the stock was subject to P750,000 mortgage which the buyer
assumed. The P250,000 balance is payable in monthly installments of P50,000 starting

112
November 30, 2014. The gain and the capital gains tax shall be the same as P 300,000 and
P25,000, respectively. The excess of mortgage over the basis of the stocks is an indirect down
payment - a form of constructive receipt. The contract price shall be computed as:
Selling price P1,000,000
Less: mortgage assumed 750,000
Cash collectible P250,000
Constructive receipt (P750,000 mortgage-P700,000 basis) 50,000
Contract price P300,000
The initial payment shall be computed as:
Indirect down payment (constructive receipt) P50,000
First installment (November 31) 50,000
Second installment (December 31) 50,000
Total initial payment P150,000
Ratio of initial payment (P150,000/P1,000,000) 15%
The taxpayer is qualified to pay capital gains tax in installment. The capital gains tax
shall be as follows:
For the sale P50,000/P300,000 X P25,000 P4,166.67
For every installment P50,000/P300,000 X P25,000 P4,166.67

Special Tax Rules In Capital Gain Or Loss Measurement

1. Wash sales of stocks
2. Tax free exchanges
a. Exchange of stocks in pursuant to a merger or consolidation
b. Transfer of stocks resulting in corporate control
Wash Sales Rule
Wash sale of securities is deemed to occur when within 30 days before and 30 days
after the sale (also referred to as the 61-day period), the taxpayer acquired or entered into a
contract or option to acquire substantially identical securities. Capital losses on wash sales by
non-dealers in securities are not deductible against capital gains.

Day of losing sale

30 days 30 days
"Securities" for purposes of the 61-day rule include stocks and bonds. The wash sales
rule has significance on the recognition of reportable capital losses on domestic stocks sold
directly to buyer. To this rule, "substantially identical" mean that stocks of the same class with
the same features. A common stock is not substantially identical with a preferred stock. A
participating and a non-participating preferred stock are not substantially identical.
Illustration 1: Acquisition of identical shares before a losing sale
In 2014, Mr. Toledo had the following transactions in the shares of Talisay, Inc., a
domestic corporation:
Date Transaction Shares Price Cost

113
 January 5 Purchase 10,000 P4.00 P40,000
March 1 Purchase 10,000 4.10 41,000
March 18 Sale* 10,000 3.80
*those purchased January 5, 2014
The capital gain or loss on March 18, 2014 shall be computed as:
Selling price P38,000
Less: cost of shares sold 40,000
Capital loss P2,000
In pursuant to the wash sales rule, the P2,000 capital loss on the sale shall not be
deductible in the computation of the annual net capital gains in 2014 since the shares sold were
fully replaced within the 61-day period. There is full replacement or full cover-up when the
quantity of the shares acquired in the 61-day period is at least equal to the quantity of the
shares sold. In this case, the loss is deferred and is added to the tax basis of the replacement
shares. The adjusted basis of the replacement shares acquired on March 1, 2014 shall
be:
Purchase price P41,000
Add: deferred loss on March 18 wash sales 2,000
Basis of replacement shares P43,000
What if the replacement shares are less than the shares sold? Assume that the shares
bought on March 1, 2014 were only 8,000 shares for P32,800. Only the portion covered with
replacement shares shall be disallowed. The portion without replacement cover is a deductible
realized loss. Thus, the capital loss shall be split as follows:
Deferred loss (8,000 shares/ 10,000 shares x P2,000) P1,600
Deductible loss (2,000 shares/ 10,000 shares x P2,000 400
Capital loss P2,000
The adjusted basis of the replacement shares acquired on March 1, 2014 shall be:
Purchase price P32,800
Add: deferred loss on March 18 wash sales 1,600
Basis of 8,000 replacement shares P34,400
What if the 10,000 shares bought on March 1, 2014 were the same shares sold at a loss
on March 18, 2014? Note that wash sales involve the sale of shares at a loss, but the same
shares were effectively re-acquired before or after the sale by a covering acquisition. In this
case, the P2,000 capital loss is not a wash sales loss since there is no acquisition of
replacement shares within the 61-day period. Hence, the capital loss is deductible against
capital gains.
Illustration 2: Acquisition of identical shares after a losing sale
In, 2014, Mr. Balangkayan had the following transactions in the stocks of Sta. Rita
Corporation, a domestic corporation:
Date Transaction Shares Price Cost

114
 January 4 Purchase 10,000 P20.00 P200,000
February 28 Sale 10,000 18.00 180,000
March 4 Purchase 12,000 16.00 192,000

The capital gains or capital loss shall be computed as:

Selling price P180,000
Less: cost of shares sold 200,000
Capital loss (P20,000)

Since there is a full replacement cover (i.e. 12,000 shares) within the 61-day period (i.e.
March 4, 2014), the capital loss shall be deferred and included as part of the cost of the
replacement shares. The basis of the replacement shares purchased in March 4 shall be:
Purchase price P192,000
Add: deferred loss on wash sales 20,000
Basis of 12,000 replacement shares P212,000

What if replacement shares are less than the shares sold? Assume instead that only
7,000 shares were bought on March 4 for PI 10,000. In this case, the capital loss shall be split
as follows:
Deferred loss (7,000 shares/ 10,000 shares x P20,000) P14,000
Deductible loss (3,000 shares/ 10,000 shares x P20,000 6,000
Capital loss P20,000
The adjusted basis of the replacement shares acquired on March 4, 2014:
Purchase price P110,000
Add: deferred loss on wash sales 14,000
Basis of 7,000 replacement shares P124,000
Illustration 3: Acquisition of identical shares before and after a losing sale
In 2014, Mr. Iriga had the following transactions in the shares of Naga Corporation, a
domestic corporation:
Date Transaction Shares Price/share Value
January 4 Purchase 15,000 P20.00 P300,000
February 15 Purchase 5,000 21.00 105,000
February 28 Sale* 12,000 18.00 216,000
March 4 Purchase 3,000 16.00 48,000
April 1 Purchase 7,000 14.00 98,000
The shares sold on February 28 were the shares bought on January 4, 2014. The capital
loss is P24,000, computed as (P18/share selling price - P20/share cost) x 12,000 shares sold.
There were 12,000 shares sold at a loss while there were a total of 8,000 replacement shares in
the 61-day period: 5,000 shares acquired on February 15 (i.e. before the sale) and 3,000 shares
acquired on March 4 (i.e. after the sale). Since this is a partial replacement, the capital loss shall
be split as follows:

115
Deferred loss (8,000 shares/ 12,000 shares x P24,000) P16,000
Deductible loss (4,000 shares/ 12,000 shares x P24,000 8,000
Capital loss P24,000
The adjusted basis of the replacement shares acquired on February 15, 2014 shall be:
Purchase price P105,000
Add: deferred loss (5,000/8,000 shares x P16,000) 10,000
Basis of 5,000 replacement shares on February 15 P115,000
The adjusted basis of the replacement shares acquired on March 4, 2014 shall be:
Purchase price P48,000
Add: deferred loss (3,000/8,000 shares x P16,000) 6,000
Basis of 3,000 replacement shares on March 4 P54,000

116
Illustration 4: No replacement shares in the 61-day period
On January 18, 2014, Mr. Mulanay bought 10,000 shares of Gen. Luna Corporation for
P100,000. On February 6, 2014, he sold the same shares for P95,000. On March 28, 2014, he
bought 5,000 shares for P55,000. Note that the March 28 acquisition is beyond the 61-day
period. Since there is no acquisition of replacement shares within the 61-day period, the P5,000
is not a wash sales loss but a deductible realized loss against capital gain from the sale of
domestic stocks directly to buyer. The basis of the shares bought on March 28, 2014 shall be
P55,000.

Rationale of the wash sales rule

The wash sales rule is intended to prevent taxpayers from feigning temporary losses
which could enable them to manipulate their reportable taxable net gain. Hence, the prohibition
against the claim of wash sales is not an absolute rule but is a form of deferral of loss. The wash
sales rule is not applicable to dealers in securities as it is a normal way of business for them to
buy and sell stocks and realize gains or incur losses within short periods of time.

Tax Free Exchanges

Merger or Consolidation
Stockholders of a domestic corporation may exchange their stocks for the stock of
another corporation in pursuant to a plan of merger or consolidation. The gains or losses on
share-for-share swaps in pursuant to a plan of merger or consolidation will not be recognized for
taxation purposes. In a share-swap in pursuant to a plan of merger or consolidation, the
shareholders of the acquired corporation will be integrated in the acquiring corporation. The
shares of the acquired corporations will be called in for replacement with the shares of the
acquiring corporation. In effect, the transaction merely involves a replacement of shares of
stocks of the shareholders of the absorbed corporation with them being simply integrated as
shareholders of the acquiring corporation.
Illustration
Mr. Santiago was required to surrender his Carranglan, Inc. shares in exchange for
Baler shares with total fair value of P 1,200,000 in pursuant to the merger of Carranglan, Inc.
and Baler, Inc. The Carranglan shares were previously purchased by Mr. Santiago for
P1,000,000.
Fair value of Baler shares received (selling price) P1,200,000
Less: Cost of Carranglan shares exchanged 1,000,000
Indicated gain P200,000

117
 The P200,000 indicated gain is not taxable as the exchange involves stocks for stocks.
Similarly, an indicated loss shall not likewise be recognized. The P 1,000,000 tax basis of the
Carranglan shares given shall be carried over as the substituted basis of the Baler shares
received.

Initial Acquisition of control

No gain or loss shall also be recognized if property is transferred to a corporation by a
person in exchange for the stock or unit of participation in such a corporation of which as a
result of such exchange, said person, alone or together with others not exceeding four, gains
control of said corporation. "Control" shall mean ownership of stocks in a corporation
possessing at least 51% of the total voting power of all classes of stocks entitled to vote. This
rule may be relevant only to the capital gains tax or the recognition of capital gains when stocks
are exchanged in the acquisition of corporate control.
Illustration
Mr. Gapan exchanged his shares in Cabanatuan Corporation costing P2,000,000 in
exchange for the shares of Dingalan Corporation with a fair value of P 1,800,000. The transfer
resulted in Mr. Gapan acquiring 51% ownership (corporate control) in Dingalan Corporation.
Total consideration received or selling price P1,800,000
Less: Cost of Cabanatuan stocks exchanged 2,000.000
Indicated loss (P200,000)
The P200,000 indicated loss shall not be recognized. Any indicated gain shall not also
be recognized. The law views initial acquisition of corporate control by not more than 5 persons
as an investing transaction rather than an income generating transaction. The tax basis of the
Dingalan shares received shall be P2,000,000, the same as the tax basis of the Gapan shares
exchanged.

Exchange not solely for stocks

In tax-free exchanges, if stocks are exchanged not solely for stocks but with other
consideration such as cash and other properties, the gains but not losses are recognized up to
the extent of cash and other properties received.
Illustration 1: Cash and property received exceed indicated gain
Assume that in pursuant to the plan of merger between Carranglan, Inc. and Baler, Inc.,
Mr. Santiago was required to surrender his Carranglan, Inc. shares costing P1,000,000 in
exchange for Baler shares with total fair value of P900,000 plus P100,000 cash and P200,000
worth of goods.

118
Total consideration received or selling price (P900,000+P100,000+P200,000) P1,200,000
Less: Cost of stocks exchanged 1,000.000
Indicated loss P200,000
The amount of cash and other properties received is considered realization of gains to
the extent of the indicated gain. The excess amount of cash and other properties received is a
return of capital. Hence,
Realized return on capital (to the extent of the indicated gain) P200,000
Return of capital (more than the indicated gain) 100,000
Total cash and other properties received P300,000
The P200,000 gain shall be reported as a capital gain. The substituted basis of the Baler
shares received in the exchange shall be:
Basis of the Carranglan shares exchanged P1,000,000
Add: Basis of other properties exchanged 0
Less: Return of capital 100.000
Basis of the Baler shares received P900,000
Illustration 2: Indicated gain exceeds cash and other properties received
Assume that in pursuant to the plan of merger between Carranglan, Inc. and Baler, Inc.,
Mr. Santiago was required to surrender bis Carranglan, Inc. shares costing P 1,000,000 in
exchange for Baler shares with 'total fair value of P 1,050,000 plus P150,000 cash.
Total consideration received or selling price (P1,050,000+P150,000) P1,200,000
Less: Cost of stocks exchanged 1,000.000
Indicated gain P200,000
The indicated gain is recognized to the extent the cash and or other properties received.
The indicated gain is considered as:
Realized gain (up to the value of cash and other properties received) P150,000
Unrealized return of capital (more than value of cash and other properties 50,000
received)
Total indicated gain P200,000
The substituted tax basis of the Baler shares received shall be:
Basis of the Carranglan shares exchanged P1,000,000
Add: Basis of other properties exchanged 0
Less: Return of capital 0
Basis of the Baler shares received P1,000,000

Regulatory Formula on Tax Substituted Basis

The regulations gave the following formula in computing the tax basis of properties
arising from the tax-free exchanges:
Tax basis of old shares exchanged PXXX,XXX
Add: Gain recognized on the transfer XXX,XXX
Less: Cash or other properties received XXX,XXX
Tax basis of new shares received PXXX,XXX

119
 If we will apply this formula with the two previous illustrations, we will come up with
essentially the same tax bases as computed.

Minimum public float requirement of publicly listed corporations

Listed corporations are mandatorily required to maintain a minimum public ownership
under Philippine Stock Exchange (PSE) regulations. The minimum public ownership is the
higher of:
1. the 10% of issued and outstanding shares, and
2. the minimum public ownership required by the Securities and Exchange Commission or the
Philippine Stock Exchange
Non-compliance to the minimum public ownership shall result in the de-listing of the
stocks of the corporation in the PSE. Under RR16-2012, the sale of listed stocks which fall
below their minimum public ownership requirement will be subject to the 5%-10% capital gains
tax and not to the 1/2 of 1% stock transaction tax.

Comprehensive Illustrations:
Illustration 1: Sale by a security dealer
Benjie, a security dealer, sold various domestic stocks for P 1,200,000, net of selling
expenses. These stocks were acquired at a cost of P800,000. The capital gains tax is nil
because domestic stocks are ordinary assets to a security dealer. The P400,000 net gain is an
ordinary gain subject to regular income tax.
Illustration 2: Sale of domestic bonds
Carlo, not a security dealer, sold domestic bonds directly to buyer at a net gain Of
P200,000. Carlo is not a dealer of domestic bonds. The capital gains tax is nil. The gain on the
sale of domestic bonds is a capital gain subject to regular income tax.
Illustration 3: Exchange of stocks for other securities
Debbie, an NRA-NETB, exchanged her domestic stocks costing P300,000 for bonds
with fair value P400,000. The P100,000 capital gain is subject to capital gains tax since it is not
a share-for-share swap in pursuant to a plan of merger or consolidation. The same rule applies
for share-for-share swap not in pursuant to a plan of merger or consolidation. Non-resident
persons not engaged in business in the Philippines such as NRA-NETBs and NRFCs are
subject to the capital gains tax and are required to file capital gains tax return.
Illustration 4: Issuance of stocks

120
 HKG, Inc., a domestic corporation, issued 10,000 PIO-par ordinary shares in exchange
for a vacant lot owned by KIT, Inc. The vacant lot has a fair value of P500,000. Compute the
capital gains tax. The transaction involves issue by HKG, Inc. of its own shares of stocks. These
stocks do not represent investment in the shares of another corporation. The share premium of
P300,000, [P500,000 - (10,000 x P10)], is part of HKG's corporate capital, not an income.
Hence, not subject to capital gains tax.
Illustration 5: Sale of stocks ex-dividend
Ms. Pearl bought 10,000 shares of Zuma, a domestic corporation, at PIO/shares. On
February 14, 2014, Zuma declared a dividend of P2/share with record date of March 20, 2014
and payment date of April 20, 2014. On April 2, 2014, Ms. Pearl sold all the shares for P15 per
share directly to a buyer. The selling expenses were P 5,000. The shareholders' right to
dividend accrues at the date of declaration. The stocks may pass through different hands
anytime. However, those who are registered as shareholders of the corporation at record date
shall receive the dividends. Between the date of record and the date of payment, stocks are
said to be selling ex dividend. The seller receives the dividends. The price of the stocks on
those dates includes only the selling price of the stocks. Thus, the capital gain shall be normally
computed as:
Total selling price (P15 x 10,000) P150,000
Less: Cost of stocks and expenses (P10) 105,000
Capital gains P45,000
In this case, the dividends to b.f received by Ms. Pearl shall be subject to the 10%final
tax to be withheld by Zuma Corporation:
Illustration 6: Sale of stocks dividend-on
Ms. Pearl owns 10,000 PIO-par value shares of Zuma, a domestic corporation. On
February 14, 2014, Zuma declared a dividend of P2/share with record date of March 20, 2014
and payment date of April 20, 2014. On February 18, 2014, Ms. Pearl sold all the shares for P15
per share directly to Mr. Lover. The selling expenses were P 4,000. Between the date of
declaration and the date of record, stocks are said to be selling dividend-on, meaning, the buyer
shall receive the dividends. The selling price of stocks on these dates includes both the price of
the stocks and the dividends on the stocks. Thus, the capital gains of Ms. Pearl on the
disposition of the stock’s dividend-on shall be determined as follows:
Total selling price (P15 x 10,000) P150,000
Less: Cost and expenses (P10 x P10,000 + P4,000) 104,000
Net dividends receivables (P2 x P10,000 x 90%) 18,000
Capital gains P28,000

121
 It should be noted that the dividends to be received by Pearl is net of the 10% final
withholding tax on dividends of individual taxpayers.

Tax Issue: Sale Of Stocks Dividend-On To A Corporate Buyer

Dividends may escape taxation when stocks are sold dividend-on by individual
taxpayers to a corporate buyer between the date of declaration and the date of record. At the
date of record, the corporate buyer will be listed as shareholder in the corporate books and will
not be subjected to the 10% dividend tax. Assuming the same data under Illustration 6, the
capital gain shall be computed as:
Total selling price (P15 x 10,000) P150,000
Less: Cost and expenses (P10 x P10,000 + P4,000) 104,000
Net dividends receivables (P2 x P10,000 x 100%) 20,000
Capital gains P26,000
Note that the individual seller effectively realizes the entire dividend income under the
cloak of the dividend exemption of the corporate buyer who will be registered as shareholder at
the date of record.

How should the dividend on the stocks sold be taxed?

Under the NIRC, all income not expressly exempted or not subjected to final tax or
capital gains tax must be included in gross income subject to regular income tax. Hence, the
individual seller shall exceptionally report the P 10,000 domestic dividend in gross income
subject to regular income tax.

Persons not liable to the 5%-10% capital gains tax

1. Dealers in securities
2. Investors in shares of stock in a mutual fund company in connection with gains realized
upon redemption of stock in the mutual company
3. All other persons, whether natural or juridical, who are specifically exempt from national
revenue taxes under existing investment incentives and other special laws
Examples:
a. Foreign governments and foreign government-owned and controlled corporations
b. Qualified employee trust funds

122
Sale, Exchange And Other Disposition Of Real Property Classified As Capital Asset
Located In The Philippines
The sale, exchange and other disposition of real property capital assets in the
Philippines is subject to a tax of 6% of the selling price or the fair value, whichever is higher.
Under the NIRC, the fair value of real property is whichever is higher of the:
a. Zonal value - value prescribed by the Commissioner of Internal Revenue for real properties
for purposes of enforcement of internal revenue laws, and
b. Assessed value - value prescribed by the City or Municipal Assessor's Office for purposes
of the real property tax
Zonal value exists only for land but assessed value is prescribed separately for land and
improvements. For lands, the capital gains tax is 6% of whichever is the highest of the selling
price (bid price in the case of foreclosure sales), zonal value or assessed value. Note that
independent appraisal valuation, the fair value commonly used in external financial reporting, is
not used in the computation of the capital gains tax.
Illustration 1
Terry sold a parcel of land for P5,000,000. The land has an appraisal value of
P8,000,000 and zonal value of P6,000,000, assessed value of and was previously purchased by
Terry for P4,000,000. The highest of the selling price, zonal value and assessed value is the
zonal value. Hence, the capital gains tax would be computed x 6%; hence, P360,000. It should
be emphasized the independent appraisal value is not used.
Illustration 2
Anjo sold his residential house and lot for P5,000,000. Anjo purchased the lot when it
was worth P 1,000,000 and constructed on it the house at a total cost of P2,500,000. The lot
had a zonal value of P4,000,000 and assessed value of P2,500,000. The house had an
assessed fair value of P2,000,000.
Selling price P5,000,000
Fair value of land (P4,000,000 or P2,500,000 w/e is higher) 4,000,000
Assessed fair value of improvement 2,000,000
Fair market value (higher) P6,000,000
The capital gains tax shall be computed be 6% x or P360,000.
Illustration 3
A real property dealer sold a condo unit costing P1,200,000 to a client for P1,500,000.
The unit has a total assessed value of P900,000 and zonal value of land and assessed value on
improvements of P 1,000,000 at the date of sale. The capital gains tax is nil. The condo unit is
an ordinary asset to a realty dealer, lessor or developer. The actual gain (P1,500,000 -
P1,200,000) is an ordinary gain subject to regular income tax.

123
BIR Tax Clearance
No registration of any document transferring real property shall be effected by the
Register of Deeds unless the Commissioner or his duly authorized representative has certified
that such transfer has been reported, and the capital gains or creditable withholding tax, if any,
has been paid. (Sec 58(E), NIRC) The certificate for purposes is referred to as the "Certificate
Authorizing Registration (CAR)".

Nature of The 6% Capital Gains Tax

a. Presumption of capital gains – the 6% capital gains tax applies even if the sale transaction
resulted to a loss. Gain is always presumed to exist. The basis of taxation is the selling price
or fair value whichever is higher, not the actual gain.
b. Non-consideration to the involuntariness of the sale – the capital gains tax applies even if
the sale is involuntary or is forced by circumstances such as in the' case of expropriation
sale, foreclosure sale, dispositions by judicial order and other forms of forced disposition. It
also applies to conditional sales and pacto de retro sales.

Scope And Applicability Of The 6% Capital Gains Tax

Taxpayers
Location of property
Individuals Corporations
Domestic corporation
Within the Philippines All individuals
only
Outside the Philippines Not applicable Not applicable
The 6% capital gains tax is universal to all individual taxpayers. For corporations, it
applies only to domestic corporations. Interestingly, the NIRC did not impose final capital gains
tax on foreign corporations. However, in cases where foreign corporations realize gains from the
sale of real property classified as capital assets, the capital gain shall be subject to the regular
income tax. Under the NIRC, the sale of real property located abroad is not covered by the
capital gains tax. Hence, the actual gains on the sale, exchange and other dispositions of
properties abroad are subject to the regular income tax but only for taxpayers taxable on global
income (i.e. resident citizen and domestic corporations).

Exceptions To The 6% Capital Gains Tax

Under the NIRC, there are only two exceptions to the 6% capital gains tax:
1. Alternative taxation rule
2. Exemption rules
a. Exemption under the NIRC

124
 b. Exemption under special laws

Alternative Taxation
An individual seller of real property capital assets has the option to be taxed at either:
a. 6% capital gains tax or
b. the regular income tax
It should be noted that this is permissible only when:
1. the seller is an individual taxpayer, and
2. the buyer is the government, its instrumentalities or agencies, including government owned
and controlled corporations
Illustration
Gretchen sold to the government a vacant lot for P800,000. The lot was purchased for
P200,000 in 1980 and had an assessed value of P400,000 and zonal value of P500,000 at the
date of sale. Gretchen may opt to be subject to tax at 6% of or report the P600,000 actual
capital gain in her annual regular income tax return.

Basis of Alternative Taxation

The alternative taxation is intended to ease the burden of government expropriation
where taxpayers may incur losses on the forced expropriation sale and are still required to pay
tax.
Illustration
An individual taxpayer bought a house and lot near a highway at a cost of P 2,000,000.
After several years, the government invoked its power of eminent domain to buy the property for
the expansion of the highway. Assuming the property has a fair value of P for purposes of the
expropriation, the taxpayer would be forced to incur loss (P1.8M-P2.0M) and pay the 6% capital
gains tax. This would be too oppressive to the taxpayer. With the alternative regular income tax
option, the taxpayer would be given the benefit of deduction of the P200,000 loss without being
imposed the 6% capital gains tax.

Exemption To The 6% Capital Gains Tax Under The NIRC

The sale, exchange and other disposition of principal residence for the reacquisition of a
new principal residence by individual taxpayers is exempt from the 6% capital gains tax.

Requisite of exemption:

125
 1. The seller must be a citizen or resident alien
2. The sale involves the principal residence of the seller-taxpayer
3. The proceeds of the sale are utilized in acquiring a new principal residence
4. The BIR is duly notified by the taxpayer of his intention to avail of the tax exemption
within 30 days of the sale through a prescribed return (BIR Form 1706) and "Sworn
declaration of intent"
5. The reacquisition of the new residence must be within 18 months from the date of sale
6. The capital gain is held in escrow in favor of the government
7. The exemption can only be availed once in every 10 years
8. The historical cost or adjusted basis of the principal residence sold shall be carried over
to the new principal residence built or acquired

Meaning o/ "Principal Residence"

Principal residence means the house and lot which is the primary domicile of the
taxpayer. If the taxpayer has multiple residences, his principal residence is deemed that one
shown in his latest tax declaration.
Illustration
Helen sold her principal residence with a fair market value of P6,000,000 for Helen
purchased the residence for P3,000,000 several years ago. The capital gains tax is 6% of or
P360,000. Helen should indicate her intention to apply for exemption in the capital gains tax
return to I'd,' filed and submit a "Sworn declaration of intent". She will be required to deposit the
capital gains tax in an escrow account in favor of the government.

Full utilization of proceeds is exempt

Assuming Helen acquires a new principal residence for P5,200,000 within 18 months,
the P360,000 capital gains tax in escrow will be released to her. If Helen does not acquire a new
principal residence within 18 months, the capital gains tax in escrow will be taken by the
government.

Basis of new residence with full utilization

If the proceed is fully utilized, the tax basis of the new residence shall be the basis of the
old residence plus additional cost incurred by the taxpayer in acquiring the new residence. The
additional cost is the excess of the purchase price of the new residence over the selling price of
the old residence. Thus, the tax basis of the new residence shall be:

126
Basis of old residence P3,000,000
Add: additional out-of-pocket costs (P5,200,000 – P5,000,000) 200,000
Basis of new residence P3,200,000
Tax basis has no relevance for real property capital assets because the actual gain on
the sale is irrelevant to capital gains taxation. However, when the real property capital assets
subsequently qualify as ordinary assets such as when they are later employed in business, the
tax basis of the property becomes necessary for gain or loss measurement. That's why the
basis of the new property needs to be monitored.

Partial utilization of proceeds is partially exempt

Assume Helen uses only P4,500,000 out of the P5,000,000 proceeds in acquiring her
new residence. The portion representing the unused proceeds shall be subject to tax. The
capital gains tax held in escrow account including any accrued interest shall be allocated as
follows:
To Helen P324,000 (P4,500,000/P5,000,000 x P360,000)
To the government 36,000 (P500,000/P5,000,000 x P360,000)
Total amount in escrow P360,000
Note: Any interest which might have accrued on the escrow fund shall be released to the
taxpayer. The government is entitled to the amount of the unpaid tax only.

127
Tax basis of the new residence with less than full utilization
If the proceeds are not fully utilized, the tax basis of the new residence shall be
accordingly reduced as follows:
Tax basis of old residence x utilized proceeds / total proceeds
Thus, the tax basis of the new principal residence shall be computed as: P3,000,000 x
P4,500,000 / P5,000,000 = P 2,700,000.
Another illustration
Alberto sold his residential lot with fair value of P 1,000,000 for P 2,000,000. He
purchased a new residence for P 1,500,000 within 18 months. Alberto will be required to pay
P120,000 x 6%) capital gains tax whether he utilized the proceeds to acquire a new residence.
The same shall be the rule assuming Alberto sold his principal residence to acquire a residential
lot. Note that the exemption rule envisages a sale of principal residence for the acquisition of a
new principal residence.

Capital Gains Tax Exemption Under Special Laws

1. Sale of land in pursuant to the Comprehensive Agrarian Reform Program
2. Sale of socialized housing units by the National Housing Authority

Sale of land under the Comprehensive Agrarian Reform Program

The sale of agricultural lands by landowners in pursuant to the Comprehensive Agrarian
Reform Program of the government shall be exempt from capital gains tax. Similarly, interest
income on the selling price that may have been agreed by the landowner and the tenant-buyer
shall be exempt from income tax.

Sale of socialized housing units by the National Housing Authority

The sale of socialized housing units for the underprivileged and homeless citizens by the
National Housing Authority (NHA) in pursuant to the Urban Development and Housing Act of
1992 is exempt from the capital gains tax. This exemption is limited to socialized housing units
only. The BIR ruled that the sale of the NHA of commercial lots which is not part of the
socialized housing project for the poor and homeless is subject to capital gains tax or regular tax
and documentary stamp tax. To qualify for exemption, the socialized housing units of the NHA
must comply with price ceilings set by the NIRC and other special laws.

128
Payment of The 6% Capital Gains Tax In Installment
The capital gains tax may be paid in installment if, under the payment terms, the initial
payment does not exceed 25% of the selling price. The "initial payment" refers to the collections
in the year the sale is made.
Illustration 1: Without mortgage
On December 1, 2013, Ms. Batanes sold for P4,000,000 an unused lot with a cost and
fair value of P2,000,000 and P5,000,000, respectively. The buyer agreed to pay P500,000
monthly installments starting December 31, 2013.
Capital gains tax = P5,000,000 x 6% P300,000
Initial payment (December installment) P500,000
Ratio of initial payment = P500,000/P4,000,000 12.50%
The installment sale qualifies to the ratio ceiling; hence, the capital gains tax can be paid
in installment. The capital gains tax payable every installment shall be P37,500, computed as x
P300,000.
Illustration 2: With mortgage not more than cost
Assume that the lot in the previous illustration is mortgaged for P 1,000,000 which the
buyer assumed, and the buyer agreed to pay the P3,000,000 balance in P300,000 monthly
installments December 31, 2013.
Capital gains tax = P5,000,000 x 6% P300,000
Initial payment (December installment) P300,000
Ratio of initial payment (P300,000/P4,000,000) 7.5%
The contract price shall be computed as: Selling price
Selling price P4,000,000
Less: Mortgage assumed by buyer 1,000,000
Contract price P3,000,000
The capital gains tax payable every installment shall be P50,000, computed as
P300,000/P3,000,000 x P300,000 capital gains tax.
Illustration 3: With mortgage more than cost
Assume further that the lot is mortgaged for P2,500,000 which the buyer assumed, and
the buyer agreed to pay the P 1,500,000 balance in P300,000 monthly installments starting
December 31, 2013. It should be recalled that the excess of the mortgage over the tax basis of
the property is an indirect down payment which must be included in the initial payment and
contract price.
Capital gains tax = P 5,000,000 x 6% P 300,000
The contract price shall be computed as follows:
Selling price P4,000,000
Less: mortgaged assumed 2,500,000

129
Cash collectible P1,500,000
Add: constructive down payment – excess mortgage 500,000
(P2,500,000 mortgage – P2,000,000 cost)
Contract price P2,000,000
The initial payment shall be computed as:
Constructive down payment (excess mortgage) P500,000
December 31 installment 300,000
Initial payment P800,000
Ratio of initial payment = P800,000 / P4,000,000 20%
The installment plan qualifies to the ratio ceiling, hence, the capital gains tax can be paid
in installment. Under the installment method, the capital gains tax payable shall be:
For the sale P500,000/P2,000,000 x P300,000 P75,000
For every installment P300,000/P2,000,000 x P300,000 P45,000
Illustration 4: Initial payment exceeds 25% of selling price
Assume that the initial payment on the sale of Ms. Batanes exceeds 25% of the selling
price. The sale would be taxed as if it is a cash sale. The capital gains tax shall be paid in lump
upon filing of the capital gains tax return. This applies without regard to whether any mortgage
on the property exceeds the cost of the property disposed of.

Deadline for payment of the capital gains tax

The 6% capital gains tax will be filed through BIR Form 1706 and is due within 30 days
from the date of sale or exchange. For foreclosure sale, it is due within 30 days from the
expiration of the applicable statutory redemption period. When the tax on the sale is qualified for
installment payment, it is due 30 days upon receipt of every installment

Statutory redemption period on foreclosure sale

Foreclosed properties are subject to a right of redemption by individual mortgagor within
one year counted not from the date of sale but from the time of registration of the sale in the
Office of the Registry of Deeds. (Santos vs. Register of Deeds of Manila) For juridical persons,
redemption must be made before the registration of the certificate of foreclosure sale with the
applicable Register of Deeds or within 3 months from foreclosure, whichever is earlier.

Documentary Stamp Tax On The Sale Of Capital Assets

Documentary stamp tax on the sale, exchange, and other dispositions of domestic
stocks directly to buyer
The sale of domestic stocks is subject to a documentary stamp tax of P0.75 for every
P200 of the par value of the stocks sold. (RA 9243)

130
Illustration
A taxpayer sold domestic stocks with total par value of P800,000 for P1,000,000. The
stocks have fair value of P 1,250,000 and was acquired for P 1,000,000 six months ago. The
documentary stamp tax shall be P 3,000 computed as P0.75/P200 x P800,000.

Documentary Stamp Tax on the Sale of Real Properties

The sale of real property capital asset is subject to a documentary stamp tax on the
gross selling price or fair market value, whichever is higher. The documentary stamp tax is P15
for every P 1,000 and fractional parts of the tax basis thereof. However, if the government is a
party to the sale, the basis shall be the consideration paid.
Illustration
A taxpayer disposed a real property capital asset which was acquired for P 2,000,000 10
years ago for P4,000,000. The property has a zonal value of P5,000,000 and declared real
property value per real property tax declaration of P 3,000,000. The documentary stamp tax
shall be computed from the fair value since it is higher than the selling price. Hence, the
documentary stamp tax shall be P75,000, computed as P15/P1,000 x P5,000,000.

Penalties For Late/Non-Filing Or Non-Payment Of Capital Gains Tax

The late filing and payment of capital gains tax at the time or times required by law
subject to the same penalties discussed in Chapter 4.

Self-Test Exercises
Discussion Questions
1. What are ordinary assets and capital assets? Discuss.
2. Enumerate the two types of capital assets subject to capital gains tax?
3. What are the transactions considered as other disposition of domestic stocks?
4. Discuss the rules on tax basis of stocks acquired by purchase, inheritance, donation, for
an inadequate consideration and under a tax-free exchange.
5. Enumerate the methods in costing stocks in order of priority.
6. Discuss the compliance requirements of the two-tiered capital gains tax.
7. Explain the concept of wash sale.
8. Enumerate and discuss the tax-free exchanges.
9. What are the criteria of alternative taxation to the 6% capital gains tax?
10. Discuss the nature of the 6% capital gains tax.

131
 Exercise Drills: True of False
1. Assets shall cease their classification to be ordinary assets when they are
discontinued from active use.
2. A vacant and unused lot is an ordinary asset to a real estate developer.
3. Real and other properties acquired are ordinary assets to banks even if
they are not engaged in the realty business.
4. Capital assets become ordinary assets when used in the business.
5. An ordinary asset becomes a capital asset when it gets fully depreciated.
6. The real properties used by exempt corporations in their exempt
operations are capital assets.
7. Dealers in realties are subject to the 6% capital gains tax.
8. Donated assets become ordinary assets when the done employs the
same in business.
9. The sale of real property capital assets may be subject to regular income
tax.
10. The excess premium on the re-issuance of treasury stock is subject to
capital gains tax.

132
 CHAPTER VII

INTRODUCTION TO REGULAR INCOME TAX

Objectives
After the completion of this module, you should be able to comprehend and demonstrate
the knowledge of the following:
 The scope of regular income and its tax model
 The concept of inclusion and exclusions from gross income
 The concept of deduction and personal exemption
 Measurement of gross income from employment and business and the treatment of
other income
 The computation of the regular tax for individuals and corporations

The Regular Income Tax Model

Gross income PXXX,XXX
Less: allowable deductions XXX,XXX
Personal exemptions XXX,XXX
Taxable income PXXX,XXX

Characteristics of the Regular Income Tax

1. General in coverage
2. A net income tax
3. An annual tax
4. Creditable withholding tax

General coverage
The regular income tax applies to all items of income except those that are subject to
final tax, capital gains tax and special tax regimes.

Net income taxation

The regular tax is an imposition on residual profits or gains after deductions for
expenses and personal exemptions allowable by law.

133
Annual tax
The regular income tax applies on yearly profits or gains. The gross income and
expenses of the taxpayer are measured using the accounting methods adopted by the taxpayer
and are reported to the government over the accounting period selected by the taxpayer.

Creditable withholding taxes

Most items of regular income are subject to creditable withholding tax (CWT). The CWT
is withheld at source by customers or clients but is not a final tax.
It is an advance tax deductible against the annual income tax due of the taxpayer.

Final Withholding Tax vs. Creditable Withholding Tax (CWT)

Similarities:
1. In both cases, the income payor withholds a fraction of the income and remits the same to
the government.
2. By collecting now cash is available, both serve to avoid or minimize cash flow problem to the
taxpayer and collection problems to the government.

Differences:
Final withholding tax Creditable withholding tax
Income tax withheld Full Only a portion
Certain passive income and active
Coverage Certain passive income
income
Income payor for the CWT and the
Who remits the actual tax Income payor
taxpayer for the balance
Necessity of an annual
Not required Required
consolidated return

Gross Income
For purposes of the regular income tax, gross income constitutes all items of income that
are neither excluded in gross income nor subjected to final tax or capital gains tax.

Exclusions from Gross Income

These pertain to items of income that are excluded, hence, exempt from income
taxation.

Excluded income vs. Exempt income

134
 Excluded income is also exempt income. Both are not included in gross income but differ
only as to source. Excluded income traces their origin from the NIRC but exempt income traces
their origin from either the NIRC or special laws.

Allowable Deductions
Allowable deductions, or simply "deductions", are expenses in the conduct of business
or exercise of profession. Deductions can be claimed itemized wherein the taxpayer support
every item of deduction or standardized through the Optional Standard Deductions wherein the
deduction is simply presumed as a percentage of gross sales, gross receipts or gross income.
The book sub-divided the vast topic of deductions as follows:
1. Principles of deductions - Chapter 13
2. Regular allowable itemized deductions - Chapter 13-A
3. Special allowable itemized deductions & Net Operating Loss Carry-Over Chapter 13-B
4. The Standard Optional Deductions (OSD) - Chapter 13-C

Personal Exemptions
Ideally, income taxation should not apply to the basic subsistence and support of
individual taxpayers because imposing tax on these would be tantamount to killing the goose
that lays the golden egg. The amount exempted by law in lieu of the personal, living and family
expenses of an individual taxpayer is referred to as personal exemption.

Allowable Deduction vs. Personal exemption

1. Allowable deductions pertain to costs or expenses of earning items of gross income while
personal exemptions are deductions in lieu of the personal, family and cost of living
expenses of individual taxpayers.
2. Personal exemption is applicable only to individual taxpayers. Corporations cannot claim
personal exemptions. However, both corporations and individuals can claim deductions.
3. Allowable deductions are generally deductible by corporations. For individual taxpayer, only
self-employed individuals or those engaged in business or exercise of a profession can
claim deductions. No deduction can individuals who are purely employed while exemption
can individuals whether purely employed or self-employed.
4. Allowable deductions are deductible only from gross income from business or exercise of a
profession. Personal exemption is deductible against all types of gross income subject to
regular income tax.

135
5. Allowable deductions are considered in the determination of net income from business or
profession whereas personal exemption is considered in the computation of taxable income.

Types of Gross Income Subject to Regular Income Tax

1. Compensation income
2. Business or professional income
3. Other income - non-business income and non-compensation income, such as:
a. gains from dealings in properties
b. other active or passive income, not subject to final tax

The Regular Tax Model In Expanded Form

Business or
Employment Others Total
profession
Gross income XXX XXX XXX
Less:
Deductions (XXX)
Personal exemptions (XXX)
Taxable income XXX + XXX + XXX = XXX

Compensation Income
In taxation, the term "compensation income" generally comprises all remunerations
under an employer-employee relationship, such as the regular pay of employees every payroll
period and other benefits or incentives other than the basic pay which are commonly known as
fringe benefits.
Classification of employee remunerations
Rank and file employees Managerial and supervisory employees
Regular pay Compensation income Compensation income
Fringe benefits Compensation income Fringe benefit
Compensation income is subject to regular income tax. The fringe benefits of rank and
file employees are included as part of compensation income and are subject to regular income
tax while the fringe benefits of managerial or supervisory employees are excluded in
compensation income and are subject to a special final tax, called fringe benefit tax.
Tax Reporting of Compensation Income
Compensation income is presented in the income tax return as:
Gross compensation income PXXX,XXX
Less: Non-taxable compensation XXX,XXX
Gross taxable compensational income PXXX,XXX
Less: personal exemption XXX,XXX
Net taxable compensation income PXXX,XXX

136
 Non-taxable compensation includes items of compensation income that are exempted
by law, contracts or treaty from income taxation. The detailed tax rules on compensation income
will be discussed in Chapter 10.

Business Income
Business income arises from habitual engagement in any commercial activity involving
regular sales of goods or services by an individual or a corporation. The income from business,
legal or illegal, registered or unregistered is taxable.
The business gross income from the sale of goods is computed as:
Sales PXXX,XXX
Less: Cost of goods sold (cost of sales) XXX,XXX
Gross income PXXX,XXX

Cost of sales
Cost of sales pertains to the acquisition cost of the goods sold or the manufacturing
costs of the goods sold.

Cost of sale of a trading business

The cost of goods sold may be determined by the specific identification using perpetual
inventory system with the aid of Point-of-sale (POS) machines or by the periodic inventory
system using the following formula:
Beginning inventory PXXX,XXX
Purchases, net of returns and allowances XXX,XXX
Freight in XXX,XXX
Total goods available for sale PXXX,XXX
Less: ending inventory XXX,XXX
Cost of goods sold PXXX,XXX
Under the periodic system, the cost of goods sold is determined through bar codes of
the goods sold or by stock cards indicating the costs of the goods sold. Under the periodic
system, the cost of goods sold is established by counting the inventories. The cost of missing
items at every reporting date is considered sold. For purposes of costing, the freight costs of the
goods purchased are allocated to all units purchased.

Cost of sales of a manufacturing business

The cost of goods sold of a manufacturing business is computed in almost the same way
with those of a trading business.
Illustration

137
 A taxpayer had the following data during the year:
Gross sales P4,000,000
Sales discounts 100,000
Sales returns 200,000
Beginning inventory 600,000
Purchases 2,500,000
Purchase returns and allowances 150,000
Freight in 200,000
Ending inventory 800,000
The cost of sale shall be computed as:
Beginning inventory 600,000
Net purchases (P2,500,000-P150,000) 2,350,000
Freight in 200,000
Total goods available for sale P3,150,000
Less: ending inventory 800,000
Cost of sales P2,350,000
The business gross income shall be computed as follows:
Sales (P4,000,000-P100,000-P200,000) P3,700,000
Less: cost of sales 2,350,000
Gross income P1,350,000

138
Professional Income
The gross income from exercise of a profession or business gross income from the sales
of services is measured as:
Revenues or gross receipts XXX,XXX
Less: Cost of services XXX,XXX
Gross income PXXX,XXX
Service providers using the accrual basis shall report their revenues while those using
the cash basis shall report their gross receipts or collections.

Cost of services
Cost of services cost labor, of services materials pertains and overhead to all direct
costs. cost The of cost rendering of services they should services be such distinguished as cost
of with the costs of administration and marketing of the business. These two are separately
presented under the deduction category "Regular allowable itemized deductions".
Illustration
A practicing auditor had the following income and expenses during the year:
Billing for services rendered and out of pocket costs P4,500,000
Salaries of audit staffs 1,400,000
Salaries of administrative employees 200,000
Transportation expenses to and from clients 12,000
Supplies used on various engagements 250,000
Supplies and general utilities 120,000
Depreciation of office equipment 80,000
Depreciation of laptops issued to audit staffs 50,000
Insurance expense on office properties 20,000
Rent expenses allocable to workspaces 400,000
Rent expenses allocable to administrative offices 50,000
Bad debt expense on non-paying clients 100,000
The cost of services shall include only those directly incurred or related gross revenue
from the rendition of services such as:
Salaries of audit staffs P1,400,000
Transportation expenses to and from clients 12,000
Rental expense on staff workspaces 400,000
Supplies used on various engagements 250,000
Depreciation of laptops 50,000
Total cost of services P2,112,000
The gross income shall be computed as:
Revenue (P4,000,000 + P500,000) P4,500,000
Less: cost of services 2,112,000
Gross income P2,388,000

Tax Reporting of Business or Professional Income

139
Tax Reporting by Individual Taxpayers
Net Sales/Revenues/Receipts/Fees PXXX,XXX
Add: Other taxable income from operation not subject to final tax XXX,XXX
Total sales/revenues/receipts/fees PXXX,XXX
Less: Cost of sales or services XXX,XXX
Gross Income from business/profession PXXX,XXX
Add: Non-operating income XXX,XXX
Total Gross income PXXX,XXX
Less: Allowable deductions XXX,XXX
Net income PXXX,XXX

Sales, revenues, receipts and fees distinguished

"Revenue" is a general term which pertains to the gross inflow of benefits (total return)
arising from the primary operations of the business. The term "sale" pertains to revenue from
the sale of goods while "fees" to revenue from the sale of service. The term "receipt" pertains
to cash collection from the sale of goods or services. The term "sale" or "fees" or simply
"revenue" is commonly used to denote the income of taxpayers using the accrual basis while
the term "receipts" is used to denote the income of taxpayers using the cash basis.

Revenue vs. gross income

Revenue is a gross concept pertaining to the total return in a transaction which
includes the return of capital and the return on capital. Gross income is a net concept
pertaining to the return on capital in a transaction. Gross income is net of the cost of sales or
cost of services.

Other taxable income from operations

"Other taxable income from operations" includes revenues or receipts from incidental or
secondary operations aside from the primary operations.
Examples:
1. A school has tuition fees as primary revenue but its income from bookstore' canteen or
student dormitories constitutes other operating revenues.
2. A manufacturing firm has its gross income from sale of finished goods as its primary
revenue but its income from scrap sales constitutes other operating revenues.
3. A private hospital has patient service fees as its primary revenue but may have room
rental and sale of medicines at its other operating revenues.
4. A dormitory has boarding fees as its primary revenue but may have laundry fees and
canteen income as other operating revenue.

140
 5. A retail store has its sales of merchandise as its primary revenue but may earn
consignment commission income as other operating revenues.
6. A bus transport company has the receipts from passengers and baggage as primary
revenue but may earn income from bus stop restaurants and comfort rooms as other
operating revenues.
Non-operating income
Non-operating income includes all other items of gross income, such as:
1. Gains from dealings in properties
Gains are net of the cost of the property sold. They are gross income items rather than
revenue. Hence, they are excluded under the "Sale/ Revenues/ Receipts/ Fees" of individual
taxpayers and are included under "Non-operating income". Dealings in properties pertain to the
sale, exchange and other disposition of properties by the taxpayer. The rules on gains in dealing
in properties not covered by the capital gains tax will be discussed in Chapter 12 under regular
income taxation.
2. Income distribution from a general professional partnership, taxable trust or estate or
from an exempt joint venture
Income distributions from these entities are not revenue but items of gross income,
hence, included as part of the non-operating income of individuals.
3. Casual active income
This includes active income from isolated or one-time transactions such as causal
carpentry income of a person not engaged in carpentry business. Any expense on casual
transactions is set-off with the casual income. The net gain or income is a non-operating
income.
4. Passive income not subject to final tax
This includes passive income not connected with the business of the taxpayer and is not
subjected to final tax such as interest on advances to employees and dividends from foreign
corporations. Like casual income, these do not arise from the regular business operations,
hence, classified as non-operating income.
Illustration
An individual taxpayer who is using the accrual basis in his manufacturing business
reported the following results of operations in the preceding year:
Sales, net of returns and discounts P4,000,000
Cost of sales 1,800,000
Dividend income, net of final tax 36,000
Business expenses 1,600,000

141
Gain on sale of old equipment 100,000
Sale of scrap metals 200,000
Interest income on employee advances 45,000
Gain on sale of domestic stocks directly to buyer 10,000
The business income of the individual will be presented in the income tax return as:
Net Sales/Revenues/Receipts/Fees P4,000,000
Add: Other taxable income from operations - Scrap sales 200,000
Total Sales/ Revenues/Receipts/Fees P4,200,000
Less: Cost of sales or services 1,800,000
Gross Income from Business/Profession P2,400,000
Add: Non-operating income
Gain on sale of equipment P100,000
Interest income on employee advances 45,000 145,000
Total Gross Income P2,545,000
Less: Allowable deductions (Business expenses) 1,600,000
Net income P945,000
Note: Income items subject to final tax like the dividends and capital gains on the stocks
are excluded in the computation of the gross income subject to regular income tax.

Reporting by Corporate Taxpayers

Net Sales/Revenues/Receipts/Fees PXXX,XXX
Less: Cost of sales or services XXX,XXX
Gross income from operations PXXX,XXX
Add: Other taxable income not subject to final tax XXX,XXX
Total gross income PXXX,XXX
Less: Allowable deductions XXX,XXX
Net income PXXX,XXX
Note: For corporate taxpayers, revenues or receipts from secondary or incidental
operations will be included under the classification "Sales/Revenues/Receipts/Fees".

Other taxable income not subject to final tax

This category includes other items of gross income whether arising from the operations
of the corporation such as gains from dealings in properties, income distribution from an exempt
joint venture and other passive income not subject to final tax.
Illustration
Assuming the same data in the previous illustration except that the taxpayer is a
corporation, the business income shall be reported as follows:
Net Sales / Revenues / Receipts / Fees (P4,000,000 + P4,200,000
P200,000)
Less: Cost of sales or services 1,800,000
Gross Income from Business/Profession P2,400,000
Add: Non-operating income
Gain on sale of equipment P100,000

142
Interest income on employee advances 45,000 145,000
Total Gross Income P2,545,000
Less: Allowable deductions (Business expenses) 1,600,000
Net income P945,000
The difference in presentation between individuals and corporations is necessitated by
the Optional Standard Deduction (OSD). The basis of the OSD for individual taxpayers is the
total revenues or receipts from operations while the basis of the OSD for corporations is on total
gross income subject to regular income tax whether they arise from the regular business
operations.

Separate Bookkeeping for Business and Professional Practice

Individual taxpayers engaged in business or exercise of a profession must maintain a
separate record of their transactions from business or professional transactions. The personal
transactions of the individual taxpayer must not be mixed with the transactions of the business
or professional practice. This is important in the tax treatment of expenses. The personal
expense of the taxpayer cannot be deducted against the gross income of the business. The
allowable personal exemption fixed by law for individual taxpayers is in lieu of all the actual
personal, family and cost of living expenses of the taxpayer.

Determination of Taxable Income

The taxable income shall be computed upon the basis of the taxpayer's annual
accounting period in accordance with the method of accounting regularly employed in keeping
the books of such taxpayer, but if no such method of accounting has been so employed, or if the
method employed does not clearly reflect the income, the computation shall be made in
accordance with such method as in the opinion of the Commissioner clearly reflects the income.

Taxable Income of Corporate Taxpayers

The taxable income of corporate taxpayers is simply the net income from business
because corporations cannot claim personal exemptions.

Taxable Income of Individual Taxpayers

The computation of the taxable income of an individual taxpayer depends on whether he
or she is a:
1. Pure compensation income earner
2. Pure business income or pure professional income earner

143
3. Mixed income earner

Pure compensation income earner

The taxable income of a pure compensation income earner is computed as:
Gross taxable compensation income PXXX,XXX
Less: Personal exemptions XXX,XXX
Taxable compensation income PXXX,XXX
Individuals deriving pure compensation income from one employer and without other
income outside his employment may avail of the substituted filing system where the employer
withholds the total income tax on compensation of the employee income. The employee need
not file an income tax return provided that the employer withheld the correct amount of tax.

Treatment of Other Income of a Pure Compensation Earner

The other income is simply added to the taxable compensation income, as follows:
Gross taxable compensation income PXXX,XXX
Less: Personal exemption XXX,XXX
Taxable compensation income PXXX,XXX
Add: Other income XXX,XXX
Taxable income PXXX,XXX
Note: Employed individuals with other income outside employment are required to file the
annual income tax return for pure compensation earner (BIR Form 1700).

Pure business or professional income earner

The taxable income of a pure business or professional income earner is the net income
from business or profession less the personal exemption:
Net income from business or profession PXXX,XXX
Less: Personal exemptions XXX,XXX
Taxable business income PXXX,XXX

Treatment of Other Income of A Pure Business or Professional Income Earner

The other income of individuals is integrated to the business or professional net income
through the category "non-operating income".

Mixed Income Earner

The taxable income of an individual taxpayers deriving income from both employment
and self-employment in business or exercise of a profession shall be determined as:
Taxable compensation income PXXX,XXX
Net income from business or profession XXX,XXX

144
Total taxable income PXXX,XXX
Note: Self-employed individuals, estates and trusts, and mixed income earners shall file BIR
Form 1701.
A negative taxable compensation income is deductible to net business or professional
income in consonance to the rule that personal exemption is deductible against all types of
income subject to regular tax. However, a net operating loss on business or professional
practice is not deductible against taxable compensation income. A net operating loss can be
carried over as an item of deduction (Net Operating Loss Carry-Over or NOLCO) against any
net income in the succeeding three years.

145
Illustration: Individual income taxpayer
Case 1 Case 2 Case 3 Case 4
Compensation income P4,000,000 P100,000 P400,000
Gross business income P400,000 400,000 200,000
Deductions 280,000 280,000 280,000
Other gross income 20,000 20,000 20,000 20,000
Personal exemption 125,000 125,000 125,000 125,000
Taxable income shall be determined in each of the above case as follows:
Case 1: A compensation earner with other gross income
Compensation income P400,000
Less: Personal exemption 125,000
Taxable compensation income P275,000
Add: Other gross income 20,000
Taxable income P295,000
Case 2: A business income earner with other gross income
Gross business income P400,000
Add: Other gross income 20,000
Total gross income P420,000
Less: allowable deduction 280,000
Net income P140,000
Less: personal exemption 125,000
Taxable income P15,000
Case 3: A mixed income earner - negative taxable compensation income
Gross taxable compensation income P100,000
Less: personal exemption 125,000
Taxable compensation income (P25,000)
Gross business income P400,000
Other gross income 20,000
Total gross income P420,000
Less: deductions 280,000 140,000
Taxable income P115,000
Note: A negative taxable compensation income is deductible against business or professional
net income.

Case 4: Mixed income earner - with business/professional net loss

Gross taxable compensation income P100,000
Less: personal exemption 125,000
Taxable compensation income (P25,000)
Gross business income P200,000
Other gross income 20,000
Total gross income P220,000
Less: deductions 280,000
Net loss (NOLCO) (P60,000)
Taxable income P275,000
Note: A net operating loss from business or profession is not deductible against taxable
compensation income.

146
Types of Regular Income Tax
1. Individual income tax
2. Corporate income tax
Individual Income Tax
The individual income tax or progressive income tax is determined about a tax table of
progressive tax rates.
The Income Tax Table for Individual Taxpayers
Over But not over Basic tax Plus Of excess over
P0.00 P10,000 P0 5% P0
10,000 30,000 500 10% 10,000
30,000 70,000 2,500 15% 30,000
70,000 140,000 8,500 20% 70,000
140,000 250,000 22,500 25% 140,000
250,000 500,000 50,000 30% 250,000
500,000 125,000 32% 500,000
Note: Examinees are not required to memorize this tax table for Board Exam purposes.

Scope of the Progressive Tax

The progressive tax covers all individuals, including taxable estates and trusts, except
those subject to final income tax:
a. NRA - NETB - subject to 25% final tax on gross income
b. Special aliens or special employees - subject to 15% final tax on gross income from
employment
Illustration 1: Income Tax Computation
A resident citizen with a personal exemption of P50,000 has a compensation income of
P150,000 within the Philippines and P 100,000 from abroad. The taxable income of the resident
citizen shall be computed as:
Gross compensation income (P150,000 + P100,000) P250,000
Less: personal exemption P50,000
Taxable compensation income P200,000
The income tax due shall be computed as follows:
Tax due
Taxable compensation income P200,000
Less: lower limit of the income bracket where the taxable income 140,000 P22,500
qualifies
Excess P60,000
Multiply by: bracket marginal rate 25% 15,000
Total income tax due P37,500

Over But not over Basic tax Plus Of excess over

147
 70,000 140,000 8,500 20% 70,000
140,000 250,000 22,500 25% 140,000
250,000 500,000 50,000 30% 250,000
Note: Recall that a resident citizen is taxable on global income.
Illustration 2: Income Tax Computation
A resident alien with a P 100,000 personal exemption has a business net income of P
750,000 in the Philippines and P250,000 from abroad.
The taxable income of the resident alien shall be computed as:
Business net income P750,000
Less: Personal exemption 100,000
Taxable net income P650,000
The income tax due shall be computed as follows:
Tax due
Taxable compensation income P650,000
Less: lower limit of the income bracket where the taxable income 500,000 P125,000
qualifies
Excess P150,000
Multiply by: bracket marginal rate 32% 48,000
Total income tax due P173,000

Over But not over Basic tax Plus Of excess over

140,000 250,000 22,500 25% 140,000
250,000 500,000 50,000 30% 250,000
500,000 125,000 32% 500,000
Note: Recall that a resident alien is taxable only on Philippine income.

Special Alien Employees

These pertain to employees that are subject to a 15% final tax on gross compensation
income. These will be discussed in detail under Chapter 10.

Corporate Income Tax

The corporate income tax, commonly referred to as the regular corporate income tax
(RCIT), is a proportional or flat tax at a rate of 30% on taxable income. The RCIT applies to any
corporations other than those:
 Subject to final tax, such as non-resident foreign corporation and FCDU interest income
not subjected to final tax
 Special corporations or those subject to special tax regimes, such as PEZA and TIEZA-
registered enterprises
 Exempt corporations on their exempt income
Illustration

148
 A corporation has a net income of P 1,200,000 in the Philippines and P800,000 from
abroad. Assuming the corporation is a domestic corporation, the income tax due shall be
computed as:
Taxable income (world) P2,000,000
Multiply by: Tax rate 30%
Income tax due P600,000
Assuming the corporation is a resident foreign corporation, the income tax due shall be
computed as:
Taxable income (Philippines) P1,800,000
Multiply by: Tax rate 30%
Income tax due P360,000
Note:
1. Recall that a domestic corporation is taxable on global income while are resident foreign
corporation is taxable on Philippine income.
2. Under RR2-2014, corporations file their annual income tax return using:
a. BIR Form 1702-RT for corporations subject only to regular income tax
b. BIR Form 1702-EX for exempt corporations under the NIRC and special laws with no
other taxable income
c. BIR Form 1702-MX for corporations with income subject to multiple income tax rates
or with income subject to special or preferential rate

Special Corporations
These are corporations that are subject to a preferential (i.e. lower) rate at less than the
30% regular corporate income tax or are subject to special tax rules. The taxation of these
corporations is discussed in detail in Chapter 15-A. These corporations file BIR Form 1702-MX.

Exempt Corporations
It should be noted that exempt corporations are required report their results of
operations through BIR Form 1702-EX even if they do not have taxable income. They are
mandated to use the Itemized deductions in their income tax return. The rule is apparently
intended to assist the BIR in monitoring compliance to the creditable withholding tax by exempt
corporations. Exempt corporations with gross income subject to the regular corporate income
tax shall file BIR Form 1702-RT for such income.

Rules in Rounding of Centavos in The Income Tax Return

149
 The requirement for entering centavos in the latest version of the income tax return
(June 2013 version) has been eliminated. If the number of centavos is 49 or less, the centavos
are dropped down. If the amount is 50 centavos or more, it is rounded up to the next Peso.
Hence, an amount for P 100.49 shall be entered in the income tax return as P100. An amount of
P100.50 shall be rounded to P101.00.

150
Deadline of Filing The Income Tax Return
The annual income tax return is due for filing on the 15th day of the fourth month
following the taxable year of the taxpayer. The income tax due shall be paid upon filing.

Quarterly Filing of Income Tax Return

Corporations and individuals engaged in business and those engaged practice of a
profession are required to file three quarterly returns aside from the annual consolidated income
tax return. Individual taxpayers engaged in business or practice of profession shall file their
quarterly income tax return using BIR Form 1701Q. Corporations shall file their quarterly income
tax return using BIR Form 1702Q. Taxpayers make estimated quarterly tax payments. These
quarterly tax payments are claimed as tax credit (deductions) to the annual consolidated income
tax due of the taxpayer.

Deadline of Quarterly Income Tax Returns

Taxpayers
Income tax returns Individuals Corporations
1st quarter April 15, same year 60 days end of 1st quarter
2nd quarter August 15, same year 60 days end of 2nd quarter
3rd quarter September 15, same year 60 days end of 3rd quarter

Self-Test Exercises
Discussion Questions
1. Discuss the scope of the regular income tax especially on passive income and capital
gains.
2. Enumerate the characteristics of the regular income tax.
3. What is exclusion in gross income?
4. Distinguish allowable deductions from personal exemption.
5. How is cost of goods sold determined?
6. What are included in the cost of services?
7. Distinguish other taxable income from operations and non-operating income.
8. Distinguish revenue from sales, fees and receipt.
9. What are the deadlines of the quarterly regular income tax for individuals and
corporations?
10. What is the treatment of negative taxable compensation income and negative business
income?

151
 Exercise Drill: True or False
1. All taxpayers are subject to final tax.
2. All taxpayers are subject to regular income tax.
3. There are two types of regular income tax: proportional income tax for
corporations and progressive income tax for individuals.
4. Taxable income is synonymous with net income.
5. For all taxpayers, taxable income means the pertinent items of gross income
not subject to capital gains tax and final tax less allowable deductions and
personal exemption.
6. NRA-NETBs and NRFCs are also subject to regular income tax.
7. The basic pay of both rank and file employees and managerial or supervisory
employees is considered compensation income and is subject to regular
income tax.
8. Items of gross income subject to final tax and capital gains tax are excluded in
gross income subject to regular income tax.
9. Employed taxpayers can claim expenses from their employment as
deductions against their compensation income.
10. The personal exemption allowable to individual taxpayers is in lieu of their
personal and business expenses.

152
 CHAPTER VIII

REGULAR INCOME TAX: EXCLUSIONS FROM GROSS INCOME

Objectives
After the completion of this module, you should be able to comprehend and demonstrate
the knowledge of the following:
 Mastery of the list of exclusions from gross income
 Comprehension of exclusion conditions or limitations of certain items of income
 Knowledge on the list of entities exempt under the NIRC and special laws

Exclusions from Gross Income

Exclusions in gross income are income which will not be subject to income tax. They are
not included in gross income subject to regular tax, capital gains tax or final tax. Under Sec.
32(B) of the NIRC, the following items shall not be included in gross income and shall be
exempt from taxation:
a. Proceeds of life insurance policy
b. Amount received by the insured as a return of premium
c. Gift, bequest, devise or descent
d. Compensation for injuries or sickness
e. Income exempts under treaty
f. Retirement benefits, pensions, gratuities, etc.
g. Miscellaneous items
1. Income in the Philippines of foreign government or foreign government owned and
controlled corporations
2. Income of the government and its political subdivisions
3. Prizes and awards in recognition of religious, charitable, scientific, educational,
artistic, literary or civic achievements
4. Prizes and awards in athletic sports competitions
5. Contributions to GSIS, SSS, PhilHealth, Pag-lbig and Union dues
6. 13th month pay and other benefits not exceeding P82,000
7. Gains from sale of bonds, debentures or certificates of indebtedness with maturity of
more than 5 years
8. Gains from redemption of shares in mutual fund

153
Exclusion from Gross Income
A. Proceeds of a Life Insurance policy - 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. Life is regarded as a capital Item With
infinite value. Hence, the proceeds of life insurance are a return of capital.
B. Amount received by the insured as a 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. The amount received by the insured as a return of premium
on any insurance contract is a return of capital; hence, excluded from gross income.
Illustration 1: Life insurance contracts
Alberto is insured in a P 1,000,000 life insurance policy with annual premium payments
of P20,000 up to 10 years. If Alberto outlives the policy after the 10 th year, he will be paid a
P500,000 maturity value.
Scenario 1
Alberto died on the 8th year of coverage and his heirs collected the proceeds. The entire
insurance proceeds of P1,000,000 is not taxable.
Scenario 2
Upon the death of Alberto, the insurance company negotiated for an extension of the
payment of the proceeds wherein the insurance company shall pay P1,050,000 on the extended
payment. The P1,000,000 proceeds will not be taxed upon collection but the P50,000 excess
representing interest is a taxable item of gross income.
Scenario 3
Alberto outlived the policy and collected the maturity value of P500,000. The total
proceeds shall be analyzed as:
Total proceeds P500,000
Return of premium (P20,000 x 10 years) 200.000
Return on capital (item of gross income) P300,000
Scenario 4
After 6 years of payment, Alberto assigned the policy to Glino who paid him P130,000
then Glino continued the premium payments for two more years after which Alberto died. Glino
collected the P1,000,000 insurance proceeds. The assignment or sale of the policy by Alberto to
Glino for P130,000 resulted into P120,000 (P20,000 x 6) return of premiums and P10,000

154
taxable return on capital. The receipt of the insurance proceeds by Glino resulted in P170,000
return of capital [P130,000 + (P20,000 x 2)] and P830,000 taxable return on capital. There is
loss of life in this scenario, but it does not pertain to the purchaser of the life insurance policy.
Hence, the excess must be taxable to the heirs.
Illustration 2: Life insurance of company officers
Alberto is insured by his employer corporation for P 1,000,000 with the employer
corporation as the beneficiary. Alberto subsequently died and the corporation collected the
P1,000,000 life insurance proceeds. It is interesting to note that the entire proceeds under this
insurance arrangement are held within the purview of the NIRC exemption; hence, not taxable.

Property insurance contracts

The proceeds of property insurance contracts more than the tax basis of the property
lost or destroyed is a taxable return on capital.

Illustration: Property insurance

Aztec Company secured a fire insurance covering the entire P2,000,000 fair value of its
office building. The building was completely destroyed by fire when the depreciated cost (tax
basis) of the building was P 1,800,000. Aztec recovered the P2,000,000 insurance proceeds.
The total proceeds shall be analyzed as:
Total proceeds P2,000,000
Less: Basis of property destroyed (return of capital) 1,800,000
Return on capital (item of gross income) P200,000

C. Gifts, Bequests, and Devises or Descent - 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.
Illustration
Mark received a restaurant business as a gift on April 1, 2010. On that date, the
restaurant has total properties amounting to P400,000 including P50,000 cash income earned
since January 1, 2010. The restaurant posted additional P 150,000 cash income from April 1 to
December 31, 2010.
The transfer of business properties worth P400,000 to Mark is a gratuity subject to
transfer tax, not income tax. However, the P 50,000 donated income shall be included in gross
income, but in the income tax return of the donor. The P 150,000 income of the donated

155
property after the perfection of the donation is included as item of gross income in the tax return
of Mark, the donee.

Gift distinguished from exchange

The transferor's intention or motive must be evaluated in determining whether a transfer
is a gift or an exchange. Gifts are characterized by pure liberality or disinterested generosity and
are given without any consideration. An exchange always involves a consideration.

Employment Gratuities
Gratuities given under an employer-employee relationship are normally treated in
exchange for services rendered by employees. Hence, they are subject to income tax. The
transfer of properties by the employer to managerial or supervisory employees is generally
subject to fringe benefit tax. Christmas or major anniversary gifts granted by the employer to
employees are de minimis benefit subject to income tax.

D. Compensation for injuries and 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
Illustration 1
Andrew was hit by a jeepney. He spent 3 months in the hospital and paid P 100,000 for
hospitalization expenses. He sued the jeepney driver and was awarded by the court a total
indemnity of P340,000 divided as follows: P200,000 indemnity for his pain, anguish and
sufferings, P40,000 for his lost salaries and P100,000 as reimbursement for his hospital bills.
The indemnity and the reimbursement for hospitalization expenses are non-taxable
returns of capital. Note that health is a capital item with infinite value. However, the 40,000
reimbursement for lost salary is a recovery of lost profit hence, an item of gross income.
Illustration 2
Mr. Pogi was driving his brand new P1,200,000-car when a truck bump it resulting to the
total wreckage of his car. Luckily, he managed to escape the incident unharmed. He received a
P1,300,000 indemnity from the incident. The P100,000 excess indemnity is an item of gross
income. Note that the law pertains to personal physical injury rather than injury to rights or
property.

156
E. Income exempt under treaty – Income items that are excluded by international agreement
to which the Philippine government is a signatory are excluded from income tax. It must be
recalled that treaty agreements override provisions of our revenue tax laws in case of
conflict under the exemption doctrine of international comity.
F. Retirement Benefits, Pensions, Gratuities and others benefits
1. Retirement benefit under R.A. 7641 and those received by officials and employees of private
firms in accordance with a reasonable private benefit plan maintained by the employer
Requisites of exemption:
a. The employer maintains a reasonable private benefit plan.
b. The retiring official or employee has been in the services of the same employer for at
least ten (10) years.
c. The retiring employee is at least fifty (50) years of age at the time of retirement.
d. This is the first time availment of retirement benefit exemption.
A 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 it 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.
To be exempt, the retirement benefit plan must be a "trusteed" plan where the fund is
held under the management of a trustee free from both employer and employee control. The 10-
year service period requirement pertains to cumulative years of employment with the same
employer. It does not need to be continuous years of employment. A requirement for continuous
employment would be prejudicial to working women.
Illustration 1
Angel was employed in 1990 when she was 25 years old. In 2010, she availed of the
early retirement program of her employer. Angel satisfied the 10-year cumulative employment
requirement, but she is only 45 years old (i.e. 25 + {2010-1990}) at the time of her retirement.
The retirement benefit is taxable. It is an inclusion in gross income as compensation income.
Illustration 2
Assume that Angel joined another employer and worked therein for 7 more years after
which she retired from her employment. Although Angel is 50 years old by then, she is only 7

157
years under the employ of her second employer. The second retirement benefit is also taxable
as compensation income since she failed the residency requirement.
Illustration 3
Assume instead that Angel was 30 years old when she joined her first employer and
worked therein for 20 years after which she retired at 50. She immediately joined another
employer and retired after 10 years of service when she was 60 years old. The first retirement
benefit from the first employer is exempt since Angel is 50 years old and had rendered at least
10 years of service (i.e. 20 years). The second retirement benefit from the second employer is
taxable even she met the residency and age requirement since retirement benefit exemption
can be availed only once in a lifetime.

2. Separation or Termination
Requisite of exemption:
 The separation or termination must be due to job-threatening sickness, death or other
physical disability; and
 The same must be due to any cause beyond the control of the employee or official such as:
a. Redundancy
b. Retrenchment
c. Closure of employer's business
d. Employee lay-off
e. Downsizing of employer's business
f. Sickness or death of the employee
The phrase "beyond the control of the employee" connotes involuntariness on the part of
the employee. In other words, the separation must not be of his own making. Abandonment of
office such as the registration and subsequent appointment to another office is considered as a
voluntary separation and does not fall within the purview of the phrase "for any cause beyond
the control of such official or employee". (BIR Ruling 054-2001)
The exemption of termination or separation benefits does not extend to:
 Backwages or illegal deductions repaid by the employer upon termination (BIR Ruling 003-
2004)
 Terminal leave pay or the commutation of accumulated unused leave credits. (BIR Ruling
No. 199-2011)

158
 To avail for tax exemption, the employee or his heirs shall request for a ruling or
certificate of exemption (CTE) from the BIR. The request for a CTE and other required
documents shall be filed to the RDO where the employer is registered.
Illustration 1
Yvonne is an employee of Goldfish Company which closed its business during the year.
Yvonne's last paycheck shows the following detail:
Unpaid salary in the last two months P30,000
Current month salary 15,000
Separation pay 100,000
Total pay P145,000
The current month salary and the P30,000 backwages are subject to income tax. The
P100,000 separation pay is an exclusion from gross income; hence, not taxable.
Illustration 2
Henson's employer was downsizing its business operations. Henson was identified
among others to be laid off. To avoid implications of inefficiencies on his part, Henson filed a
resignation letter to the company and received a separation pay of P 120,000. The separation
pay is taxable as compensation income since the underlying reason of the severance of the
employment (i.e. resignation) is within the control of the employee. If Henson got terminated
without resigning, the separation pay would be exempt.
Illustration 3
Mr. Swabe was diagnosed to have a sexually transmitted disease (STD). Due to this, his
employer decided to terminate his services but granted him P1,000,000 separation pay. The
separation pay is taxable as STD do not normally render the employee incapable of working.

3. Social Security Benefits, Retirement Gratuities, and Other similar benefits from
foreign government agencies and other institutions, private or public received by
resident or non-resident citizens or aliens who come to settle permanently in the Philippines
Illustration
John was an OFW employed by Microsoft Corporation in the USA. John retired and
returned to permanently settle in the Philippines. He is paid a $2,000 monthly pension from
Microsoft pension fund and another $800 monthly benefit from the US social security benefit.
Both the pension and the social security benefits are exempt. Note that these benefits were
earned abroad when the taxpayer is a non-resident. Under situs rule, the foreign income of non-
residents is not taxable in the Philippines. This holds true even if the taxpayer subsequently
receives the income as a resident of the Philippines.

159
4. United States Veterans Administration (USVA) - administered benefits under the laws of
the United States received by any person residing in the Philippines.
Illustration
Mr. Jackson is a retired US serviceman from the Iraqui war. He married a beautiful
Filipina and settled in the Philippines. He is receiving a $1,000 monthly benefit from the USVA.
The USVA benefit is excluded in gross income. The same rule applies to [JSVA benefits for
beneficiaries of Filipino veterans who fought under the American flag in World War Il.

5. Social Security Systems(SSS) benefits under RA 8282

6. GSIS benefits under RA 8291 including retirement gratuity received by government officials
and employees

G. Miscellaneous items
1. Income derived on investments in the Philippines in loans, stocks, bonds, or other
domestic securities, or from interest on deposits in banks in the Philippines by:
a. Foreign governments
b. Financing institutions owned, controlled, or enjoying refinancing from foreign
government
c. International or regional financial institutions established by foreign governments
These are exempt under the exemption doctrine of international comity.
2. Income derived by the government and its political subdivisions from:
a. Any public utility or
b. Exercise of essential government function

Government agencies and instrumentalities

The general rule with government agencies and instrumentalities is exemption because
of their public service nature. However, taxation applies when they engage in income-producing
activities which are proprietary or commercial in nature. This exemption does not extend to
government-owned and controlled corporations (GOCCs). GOCCs are generally taxable as
regular corporations because their operations are proprietary in nature.
3. Prizes and Awards made primarily in recognition of religious, charitable, scientific,
educational, artistic, literary, or civic achievements but only if:

160
a. The recipient was selected without any action on his part to enter the contest or proceeding;
and
b. The recipient is not required to render substantial future services as a condition to receiving
the prize or award
Prizes of this kind partakes the nature of a unilateral transfer and hence, exempt from
income tax but is not also subject to transfer tax. If the recipient exerted effort for the grant of
the prize such as joining a contest or is required to render service for its grant, the price would
be construed as received in an exchange; hence, taxable as income.
Examples of exempt prizes:
 Nobel prize winning
 Gawad ng Sining Award
 CNN Hero of the Year
 Most Outstanding Citizen

4. Prizes and Awards in Sports Competitions granted to athletes:

 In local or international competitions and tournaments
 Whether held in the Philippines or abroad; and
 Sanctioned by their national sports associations

5. Contributions for GSIS, SSS, PhilHealth, Pag-lbig and Union dues of individuals
This pertains to the employee share in the premium contributions to GSIS, SSS,
PhilHealth, Pag-lbig and union dues. The portion of the salary thus contributed is exempt from
income tax.
Under RMC No. 21-2011, the exclusion pertains only to the mandatory or compulsory
monthly contributions. Voluntary contributions to Pag-lbig Il, GSIS or SSS in excess of the
mandatory monthly contribution are taxable. Note that Pag-Ibig is now called the Home
Development Mutual Fund or HDMF.

Illustration
An employee has a gross compensation income of P400,000 during 2014. His employer
deducted P5,000 SSS, P4,000 PhilHealth, P3,000 HDMF, P2,000 union dues and P80,000
creditable withholding tax.
Thus, the gross income subject to regular tax shall be computed as:
Gross compensation income P400,000

161
Less: Excluded compensation income or contributions
Contributions to SSS P5,000
Contributions to PhilHealth 4,000
Contributions to HDMF 3,000
Union dues 2,000 14,000
Gross taxable compensation income P386,000
Note: The creditable withholding tax is not an exclusion in gross income but a tax credit which is
deductible against the income tax due of the taxpayer.
The employer's share in SSS, GSIS, PhilHealth and HDMF contributions is not exclusion
from gross income but an item of deduction against gross income.

6. 13th Month Pay and Other Benefits received by officials and employees of public or
private entities not exceeding P82,000

7. Gains from sale of bonds, debentures or other certificate of indebtedness with a

maturity of more than 5 years.
This exemption is grounded upon the same assumption that long-term indebtedness is
diverted to the financing of long-term projects which is viewed as beneficial to the development
of the country. The term "gain", however, does not include "interest". (Nippon Life Insurance
Company of the Philippines vs. CIR, CTA Case No. 6142)
Illustration
On September 1, 2014, an individual taxpayer sold a 6-year term bond investment for P
1,100,000. These bonds bear 8% interest payable every December 31 and were previously
acquired at P 1,000,000 face value on January 1, 2014. The gain on sale will be computed as:
Selling price P1,100,000
Less: Cost of bonds sold 1,000,000
Interest accrued (P1,000,000 x 8% x 9 mos./ 12 mos.) 60,000
Gain on sale P40,000
The gain from the sale of the long-term bonds is exempt because the bonds have
maturity period of more than 5 years. However, the accrued interest income is an item of gross
income subject to regular income tax.
8. Gains realized from redemption of shares in mutual fund company by the investor
The term 'mutual fund company' shall mean an open-end and close-end investment
company as defined under the Investment Company Act. Mutual funds pool the money invested
by different investors and invest the money to earn investment income which shall add up to the
net assets of the fund.

162
 A participating investor must purchase participation shares from the fund at their Net
Asset Value (NAV). Upon redemption of his participation shares, the investor gains or losses by
his proportionate share in the increase or decrease in the Net Asset Value of the fund.
Illustration
A taxpayer bought 10,000 shares from Golden Dragon Mutual Fund at PI 20 NAV per
share. The taxpayer redeemed his shares when the NAV per share was P 180. The P600,000
gain, computed as [(P180 - P120) x 10,000], on redemption is excluded from gross income,
hence, exempt from taxation. The exemption is apparently intended to mitigate double taxation.
Most of the items of income of mutual funds are subject to final tax at source. The
subsequent distribution of these to the investors at redemption should no longer be subject to
income tax. On the other hand, the exemption may have been intended to promote the growth
of mutual funds which are widely regarded as key participants in providing liquidity in most
financial markets.

Other Exempt Income Under the NIRC and Special Laws

1. Minimum wage and certain benefits of Minimum wage earners
2. Income of Barangay Micro-Business Enterprises Act (RA 9178)
3. Income of cooperatives (RA 9520)
4. Income of non-stock, non-profit entities
5. Income of qualified employee trust fund

Minimum Wage Earners

A minimum wage earner is an individual recipient of a minimum wage as fixed by the
Regional Tripartite Productivity Wage and Productivity Board of the Department of Labor and
Employment. A minimum wage earner is exempt from income tax on the minimum wage
including holiday pay, overtime pay, night shift differential pay, and hazard pay.

Barangay Micro-Business Enterprise (BMBE)

A BMBE is a business entity or enterprise engaged in the production, processing or
manufacturing of products or commodities, including agro-processing, trading and services,
whose total assets including those arising from loans but exclusive of the land on which the
particular business entity's office, plant and equipment are situated, do not exceed P3,000,000.
The term "service" excludes those rendered by licensed professionals and partnership
and corporations engaged in consultancy, advisory and similar services which are essentially

163
carried out through licensed professionals. A BMBE shall include any individual owning such
business entity or enterprise, partnership, cooperative, corporation, association or other entity
incorporated and/organized and existing under Philippine laws; and registered with the office of
the treasurer of a city or municipality.
To qualify as BMBE, an enterprise must not be a branch, or a subsidiary of a large-scale
enterprise and its policies and modus operandi must not be determined by a large-scale
enterprise such as in the case of franchises. To avail of the benefits and privileges of a BMBE,
an applicant must secure a certificate of authority to operate and be registered as a BMBE from
the Office of the Treasurer or city or municipality that has jurisdiction.

Tax Exemption on Income from Operations

Aside from other incentives afforded by the law, the income of BMBE from their
operation is exempt, hence, excluded in gross income subject to regular income tax. BMBEs file
an Annual Information Return in lieu of the income tax return. However, their non-operating,
passive and capital gains are subject to the appropriate type of income tax.
Illustration
Jane has a bakery with total assets of P4,000,000, inclusive of a lot with book value of
P1,200,000.
Gross income from sales of bread P 300,000
Interest on promissory notes of retail stores clients 12,000
Royalties on sale of recipe books 36,000
Dividend income from domestic stocks 10,000
Note that Jane's total asset is P 2,800,000, excluding the lot. Hence, Jane's business
qualifies as a BMBE. If Jane obtained a certificate of authority to operate as BMBE, the
following items of operating income are exempt from income tax:
Gross income from sales of bread P300,000
Other operating income:
Interest income from client promissory notes 12,000
Total exempt income P312,000
Assuming Jane's bakery is not registered as a BMBE, the P312,000 total operational
income will be subject to the regular income tax. Either way, the royalty income and dividend
income are exclusion in gross income subject to regular tax but are inclusion in gross income
subject to final tax.
Another illustration
Chris Santana has an accounting and auditing firm with total assets of P2,500,000. He
derived a total operating income of P 1,000,000 in 2014. The entire P1,000,000 is taxable since
Mr. Santana is a professional service provider not qualified to be a BMBE.

164
Revocation of BMBE Tax Exemptions
The income tax exemption of a BMBE may be revoked for any of the reasons:
1. Transfer of place of business
2. Value of assets exceeds P3,000,000
3. Voluntary surrender of the Certificate of Authority
4. Death of the registered individual owner; violation or non-compliance with the provisions of
RA 9178
5. Merger or consolidation with an entity which is not eligible to be a BMBE
6. Sale or transfer of the BMBE, if a sole proprietorship without prejudice to the transferee
applying for registration
7. Submission of fake or falsified documents
8. Retirement from business, or cessation/suspension of operations for one year
9. Making false or omitting required declarations or statements

Cooperatives
Cooperatives that transact business purely with members are exempt from all taxes and
fees. Cooperatives that transact business with non-members are likewise exempt from all taxes
and fees if their accumulated reserve and undivided savings do not exceed P10M. Otherwise,
the amount of surplus allocated for interest on capitals is subject to regular tax. However, the
income of any cooperatives from non-related sources is fully taxable to regular tax.

Non-Stock and Non-profit Entities

Non-stock entities that are not organized for profit are exempt from income tax on their
income from operations. However, their income from unrelated sources is taxable.

165
Qualified Employee's Trust Fund
An employee's trust fund which forms part of a pension, stock bonus or profit-sharing
plan of an employer for the benefit of some or all his employees is exempt from any income tax
under the NIRC.
Conditions for exemptions of employee trust funds
a. Contributions are made to the trust by such employer, or employees, or both for the
purpose of distributing to such employees the earnings and principal of the fund
accumulated by the trust in accordance with such plan.
b. The asset of the fund shall not be diverted for other purposes other than the exclusive
benefit of the employees.

Qualification of Exemption of Exempt Entities

Tax incentive or exemption is highly disfavored in law. It is not automatic. Taxpayers with
exemptions or tax incentives under any existing laws or contracts must establish their
entitlement by filing required documents with the BIR. BMBEs need to secure a Certificate of
Authority. Cooperatives need to secure a certificate of Tax Exemption / Ruling (CTE). Once
exemption is established, it only operates prospectively.

Income Subject to Final Tax or Capital Gains Tax

Items of income that are subject to final income tax or capital gains tax are not items of
gross income subject to regular income tax. Also, income items that are exempted in the
coverage of final tax or capital gains tax are not taxable to the regular income tax.

Exclusions Vs. Deductions

Exclusions from gross income are not included in the amount of reportable gross income
in the income tax return. The amount of deductions is initially included in the amount of gross
income but is separately presented as deduction against gross income in the income tax return.

Note to readers
Exclusion in gross income represents one of the exceptions to the general scope of the
regular income tax. Readers are advised to master or, at least, familiarize the list and their
respective exclusion criteria before proceeding to the next chapters of the book. This is
important in assisting readers in mastering the regular income tax.

166
Self-Test Exercises
Discussion Questions
1. Enumerate the exclusion from gross income.
2. What capital items are considered with infinite value?
3. Enumerate the exclusion conditions of retirement benefits.
4. Discuss the exclusion condition of termination benefit.
5. Discuss the rules on taxation and prizes.
6. Enumerate the exclusions from gross compensation income in the determination of gross
taxable compensation income.
7. Who is a minimum wage earner?
8. Enumerate the benefits of minimum wage earners exempt from income tax.
9. What is BMBE?
10. What are the exemption conditions of an employee trust fund?
Exercise Drills: True or False
1. The amount received more than the premium paid in insurance contract
constitutes an item of gross income.
2. Donated income is included in the gross income of the donee.
3. The proceeds of life insurance received by the heirs of the insured upon
his death is excluded in the gross income.
4. Compensation for injuries and sickness constitutes profit, hence, an
inclusion in gross income.
5. An employee can secure retirement benefit exemption only once in a
lifetime.
6. It is sufficient that the employee rendered more than 10 years of service
for his retirement benefit to be exempt.
7. An employee must have rendered more than 10 years of service before
claiming exemption for his termination benefits.
8. It is a must that the employer maintains a reasonable pension benefit
plan for the retirement benefit to be exempt.
9. The income of the Philippine government form essential public functions
is exempt from income tax.
10. Prizes paid to corporations are inclusion in gross income subject to final
tax.

167
 CHAPTER IX

REGULAR INCOME TAX: INCLUSIONS FROM GROSS INCOME

Objectives
After the completion of this module, you should be able to comprehend and demonstrate
the knowledge of the following:
 Mastery of the NIRC list of items of gross income subject to regular income tax and their
measurement rules.
 knowledge on the link between items of exempt income and income subject to regular
income tax.
 Knowledge of the treatment of creditable withholding tax.
 Mastery of rules on recoveries of past deductions
 Appreciation of the essence and purpose of transfer pricing regulation

Items of Gross Income

The term "items of gross income or inclusions in gross income" is a broad category
pertaining to all items of income subject to taxation, namely:
1. Gross income subject to final tax
2. Gross income subject to capital gains tax
3. Gross income subject to regular tax

Items of Gross Income Subject to Regular Tax

Gross income includes, but is not limited, to the following items:
1. Compensation for services in whatever form paid
2. Gross income from the conduct of trade, business or exercise of a profession
3. Gains derived from dealings in properties
4. Interest
5. Rents
6. Royalties
7. Dividends
8. Annuities
9. Prizes and winnings
10. Pensions
11. Partner's distributive share from the net income of general professional partnership
Compensation For Services In Whatever Form Paid

168
 Under current tax rules, the term "compensation income" technically pertains to the
types of employee benefits that are subject to regular tax. The fringe benefits of managerial or
supervisory employees are not considered compensation income and are subject to final tax. To
minimize the complexity of this section, compensation income is separately discussed in the
next chapter.

Gross Income From The Conduct Of Trade, Business Or Exercise Of A Profession

This includes income from any trade or business, legal or illegal, and whether registered
or unregistered. Gross income from business or profession is determined as:
Sales/Revenues/Receipts/Fees PXXX,XXX
Less: Cost of sales or services XXX,XXX
Gross income from operations PXXX,XXX
The following business income shall not be included in gross income subject to regular
income tax:
1. Business income exempt from income tax, such as:
a. Gross income from a Barangay Micro-Business Enterprise (BMBE) under RA 9178
b. Gross income from enterprises enjoying tax holiday incentives under EO 226 which
have not yet graduated to their income tax holiday incentives
2. Business income subject to special tax regime, such as:
a. Philippine Economic Zone Authority (PEZA)-registered enterprises subject to 5%
gross income tax
b. Tourism Infrastructure and Enterprise Zone Authority (TIEZA)-registered enterprises
subject to 5% gross income tax
3. Business income subject to final tax, when not subjected to final tax by the payor
a. Subcontractors of petroleum service contractors subject to 8% final tax
b. Business income of foreign currency deposit units (FCDUs) and offshore banking
units (OBUs) from Philippine residents subject to 10% final tax
Taxpayers with multiple type of business income shall report their gross income subject
to regular tax under the column "Regular" in the computation of tax per regime in the Annual
Income Tax Return. Gross income subject to special rate and those exempts are separately
presented under the columns "Total Special" and "Total Exempt", respectively.

169
Gains From Dealings In Properties
The gains or losses in dealing in ordinary assets are subject to regular income tax.
Dealings in capital assets other than domestic stocks and real properties are also
subject to regular income tax. Ordinary gains are included as items of gross income. Ordinary
losses are items of deductions against gross income. The net capital gain from other capital
assets after deducting capital losses is also included as item of gross income. A net capital loss
is not an item of deduction against gross income. Also, to avoid complicating this section, the
detailed tax rules on measurement and recognition of gains from dealings in properties will be
discussed extensively in

Interest Income
This particularly refers to interest income other than passive interest income Subject to
final tax. A taxable interest income must have been actually paid out of an agreement to pay
interest. It cannot be imputed. (CIR vs. Filinvest Development Corporation, GR 163653 and
167689)
Examples of interest income subject to regular income tax:
1. Interest income from lending activities to individuals and corporations by banks, finance
companies and other lender
2. Interest income from bonds and promissory notes
3. Interest income from bank deposits abroad

Exempt Interest Income

The following are exempt from regular income taxation:
1. Interest income earned by the landowners in disposing their lands to their tenants in
pursuant to the Comprehensive Agrarian Reform Law.
2. Imputed interest income - Imputed interest income, the opportunity cost of money, does
not constitute an actual income; hence, exempt from income tax.
The power of the Commissioner to allocate income and deduction does not include the
power to impute "theoretical interest". (lbid)
Illustration
Sapphire Bank has the following income in 2014:
Interest income from loans P3,000,000
Interest income from deposits with other banks 400,000
Interest income from notes rediscounting 100,000
Interest income from Treasury notes 50,000

170
 Only the interest income from loans and notes rediscounting are items of gross income
subject to regular income tax. The interest on deposits and treasury notes are items of gross
income subject to final income tax.

Rents
Rent income arises from leasing properties of any kind. It is a passive income but is not
subject to final tax under the NIRC; hence, subject to regular income tax.

Special considerations on rent

1. Obligations of the lessor that are assumed by the lessee are additional rental income to the
lessor.
2. Advance rentals are
a. Item of gross income upon receipt if:
i. Unrestricted or
ii. Restricted to be applied in future years or upon the termination of the lease
b. Not an item of gross income if:
i. It constitutes a loan
ii. It is a security deposit to guarantee payment or rent subject to contingency
which may or may not happen
3. Leasehold improvements made by the lessee on the leased property are recognized by the
lessor as income using the spread-out method or outright method discussed in Chapter 4.
Illustration
Under the lba Leasing Corporation's standard lease contract, lease shall run for a non-
preterminable 12-month period at monthly rental of P25,000. The lessee shall pay three-month
rent in advance plus one-month security deposit. The rent for the last two months of the lease
shall be taken from the advance while the security deposits will be return if there are no
damages sustained by the property during the lease term.
The entire P75,000 rental payments for the current month and the advanced rental for
the last two months is an item of income subject to regular tax. The P25,000 security deposit is
not an income.

171
Royalties
Royalties earned from sources within the Philippines are generally subject to final
income tax, except when they are active by nature. Active royalty income and royalties earned
from sources outside the Philippines are subject to regular income tax. Recall also that royalties
earned by resident foreign corporations are subject to regular income tax.
Illustration 1
Forres softwares is a distributor of a computer program and earns royalties from its
licensed users. Computer programs are specifically tailored to each client and regular
continuing maintenance services are provided. During the year, client-users total of P500,000
royalty payments.
The entire P500,000 is subject to regular income tax since the royalty is an active
income to Forressoftwares.
Illustration 2
Mang Damian has the following royalties:
Royalties from mining properties in the Philippines P 550,000
Royalties from books published in the Philippines 200,000
Royalties from books published abroad 300,000
Royalties from franchise exercised abroad 400,000
The royalties from mining properties and from books in the Philippines is subject to final
tax. The royalties from sources abroad aggregating P700,000 are items of gross income subject
to regular income tax. Remember that the final withholding tax inherently do not apply to foreign
income.

Dividends
This pertains to dividends declared by foreign corporations. It should be recalled that
dividends declared by domestic corporations are generally subject to 10% final tax if the
recipient is an individual taxpayer and exempt if the recipient is a domestic or a resident foreign
corporation. Cash, property and script dividends from foreign corporations are items of gross
income subject to regular income tax.

Stock dividend
It should be recalled that stock dividend is exempt from income tax but when the
declaration confers to the recipient a different interest or right after the stock dividend
declaration or when stocks dividends are subsequently redeemed such that it amounts to
payment of cash dividend, the fair market value of the stock dividends received is taxable.

172
Liquidating dividends
Liquidating dividend is not income. The liquidating dividend is considered as amount in
exchange for the investment of the investor and is subject to the rue of dealings in properties in
Chapter 12.
Illustration
Caloocan Corporation, a domestic corporation, received cash dividends from following
corporations:
Domestic corporations P400,000
Resident foreign corporations 200,000
Non-resident foreign corporations 300,000
The P400,000 inter-corporate dividends declared by a domestic corporation is exempted
from final tax. Therefore, it is not an item of gross income subject to regular income tax. The
P500,000 total dividends from the resident and non-resident foreign corporations are items of
regular income subject to regular income tax and shall be reported as follows:
Scenario 1: Assuming Caloocan Corporation is a domestic corporation, the P500,000 total
dividends from foreign corporations shall be included in gross income because domestic
corporation are taxable on world income.
Scenario 2: Assuming Caloocan Corporation is a resident foreign corporation, only a portion of
the P200,000 dividends from the resident foreign corporation determined as earned within by
the Pre-dominance test discussed in Chapter 3 shall be included in gross income. Note that the
situs of dividends from the non-resident foreign corporation is abroad.

Annuities
The excess of annuity payments received by the recipient over premium paid is taxable
income in the year of receipt.
Illustration
Andrew purchased an annuity contract for P100,000 which shall pay him P10,000
annually until he dies. The receipt of the first 10 annual annuity payments is a return of capital.
Any further receipt from year 11 and onward is an item of gross income subject to regular
income tax.

173
Prizes and Winnings
Prizes and winnings that are exempted from final tax are not items of gross income
subject to regular income tax.

Exempt prizes and winnings:

1. Prizes received without effort to join a contest
2. Prizes in athletic competition sanctioned by their respective national sports association
3. Winnings from PCSO or lotto
The following table summarizes the rules of taxable prizes and winnings to individual
taxpayers:
Earned from sources
Within Abroad
Prizes:
P10,000 and below Regular tax Regular tax
More than P10,000 Final tax Regular tax
Winnings, other than PCSO and lotto Final tax Regular tax
Note: PCSO and lotto winnings are exempt from any income tax. However, lotto winnings from
abroad are items of gross income subject to regular tax for taxpayers taxable on global income.
The final taxation of prizes and winnings for corporations is not contemplated in the
NIRC. Hence, the taxable prizes and winnings of corporations are subject to regular income tax.
Illustration
The City of Baguio held its Panagbenga flower festival. During the festivities, Mr. Erorita,
the proprietor of Mr. Sexy Body Gym, won the P500,000 second prize in the flower float
competition. John Hay Management Corporation won the P600,000 first prize. The City of
Baguio shall withhold 20% final tax on the winnings of Mr. Erorita. The prize of John Hay
Management Corporation shall not be subjected to a 20% final tax but to creditable withholding
tax. John Hay shall include the prize in its gross income subject to regular income tax.

Pensions
This pertains to pensions and retirement benefits that fail to meet the exclusion criteria
and hence subject to regular tax.

174
Partner's Distributable Share From The Net Income Of The General Professional
Partnership
It should be recalled that general professional partnerships are not subject to regular
income tax as they are merely viewed as pass-through entities. These entities do not pay tax on
their regular income. The partners are the ones subject to regular tax on their share in the net
income of the general professional partnership. Pass-through entities; however, are subject to
final tax and capital gains tax. The computation of the partners share in the net income from the
partnership shall not include the income from items subjected to capital gains tax and final tax.
Illustration
Zef and Siegfried practice their profession in a general professional partnership and
share profits 60:40. Their firm reported the following:
Gross receipts P2,000,000
Less: Professional expenses 1,200,000
Net income from operations P800,000
Interest from bank deposits, net of final tax 20,000
Distributive net income P820,000
Total distribution to Zef (60% x P820,000) P492,000
To distribution to Siegfried (40% x P820,000) 328,000
Total distributive net income as accounted for P820,000

Determination Of The Partner's Distributive Share In Net Income

The NIRC clearly point to the partner's distributive share in the net income of the general
professional partnership. This is technically different with the partners actual distribution.
The net income pertains to items of regular income less allowable deductions while the
actual distribution includes the partner's share on all other items of gross income such as those
subject to final tax or capital gains tax including exempt income. Items of gross income
subjected to final tax and capital gains tax to the general professional partnership should no
longer be included as item of gross income subject to regular income tax when distributed to the
partners. When received directly, these items of income are not included in the partners gross
income subject to regular tax.
The same rule shall be observed when these items of income are coursed through a
pass-through entity. What cannot be done directly cannot be done indirectly. Hence, the amount
of the partners' distributive share in net income which will be included in gross income of the
partners shall be computed as:
Professional gross income of Zef (60% x P800,000) P480,000
Professional gross income of Darrel (40% x P800,000) 320,000
Total distributive income subject to regular tax P800,000
Note that this rule applies to other pass-through entities such as:

175
1. Exempt joint ventures
2. Exempt co-ownership

Business Partnership And Taxable Joint Venture Or Co-Ownership

These entities are subject to corporate income tax. The distributive share of a partner,
venturer or co-owner from the net income of these entities, if organized within the Philippines, is
subject to 10% final withholding tax. However, if these entities are organized or constituted
abroad, the share from their profit is subject to regular income tax for taxpayers taxable on
global income. It should be recalled again that the final income taxation is territorial and does
not apply to foreign income.

General Criteria On Gross Income

Items of gross income subject to regular income tax are not limited the NIRC list. Under
the NIRC, the regular income tax has a catch-all provision for all income derived from whatever
sources that are:
1. not subject to final tax, capital gains tax and special tax regime, and
2. not excluded or exempted by law, treaty, or contract from taxation

Other Sources Of Gross Income Subject To Regular Income Tax

1. Income distributions from taxable estates or trusts
2. Share from the net income of other pass-through entities
3. Exempt joint venture
4. Exempt co-ownership
5. Farming income
6. Recovery of past deduction
7. Reimbursement of expenses
8. Cancellation of indebtedness for a consideration

176
Income Distribution From a Taxable Estates Or Trusts
Any income distribution received by an heir or beneficiary from a taxable estate or trust
shall be included in his gross income subject to regular tax, provided that such income must not
have been subjected to final tax or capital gains tax.
Illustration: Estates
Roman is one of several heirs to the business estate of his father which is under judicial
settlement. The administrator distributed the following income for the support of Roman:
Domestic dividends P22,500
Business income 70,000
Roman shall include in his gross income subject to regular income tax the P70,000
distribution from business income the estate shall present the same amount as a deduction
against its gross income. The P22,500 dividend shall not be reported by Roman since this is
already subjected to final tax at source.
Illustration: Trusts
Horace received the following income distributions in his capacity as beneficiary to an
irrevocable trust designated by his grandmother:
Net capital gains on sale of domestic stocks P9,500
Rental income 12,000
Horace shall report only the P12,000 rental income in his gross income subject to
regular income tax. The net gain on the sale of stocks is subject to capital gains tax to the trust.

Share From The Net Income Of Exempt Joint Ventures And Co-Ownership
The same tax treatment on recognition of share in the net income of a general
professional partnership applies to the share from the net income of exempt joint ventures and
co-ownership.

Farming income
Farming operations can be classified as:
1. Raise and sell operation – the proceeds on the sales of livestock or farm products is
included in gross income subject to regular income tax. Animal raising expenses are
presented as items of deductions against gross income.
2. Purchase and sell operation – the gross profit from the sale (sales less cost of purchase)
is included in gross income.
Taxpayers may follow accrual or cash basis in accounting for inventories of livestock or
farm products. The crop year basis discussed in Chapter 4 may be used for recognizing income

177
for long-term crops. It should be recalled that the proceeds of crop or livestock insurance
constitute a taxable item of gross income because they are recovery of lost profits.

Recoveries of Past Deductions

When past year deductions from gross income are subsequently recovered by the
taxpayer or when accrued expense previously deducted are subsequently paid at an amount
less than the deduction claimed, they should be analyzed whether or not they resulted in tax
benefit to the taxpayer. Past deductions that created tax benefit to the taxpayer must be
reverted to gross income in the year of recovery. Past deductions that did not create tax benefit
need not be reverted to gross income because the government will not lose any tax.
A past deduction is said to have created a tax benefit to the taxpayer if it reduced
taxable income in the year it is deducted. This is the case if the taxpayer had positive net
income before the deduction was made. The amount of tax benefit is the amount of net income
saved (i.e. erased) by the deduction from taxation.

Examples of taxable recovery of past deductions:

1. Recovery of previously claimed bad debt expense
2. Refund of local tax expense
3. Refund of foreign tax previously claimed as deduction
4. Re-commissioning of abandoned petroleum service contracts or mining properties
5. Release of reserve funds of insurance companies
Illustration 1
Let us assume that a taxpayer had the following bad debt expense (accounts written off)
and subsequent recoveries of accounts written off:
2015 2014
Net income before bad debt expense P100,0000 P100,0000
(Bad debt expense)/Recoveries (60,000) 35,000
Net income after bad debt expense P40,000 P???
Required: How much of the P35,000 recovery of in 2015 has tax benefit and thus be
reverted to gross income?

178
Solution:
The As-if Approach
This can best be determined by the As-If Approach. Re-compute the net income in the
year of deduction by adjusting the deduction assuming the subsequent recovery is known.
Under this assumption, the net income should have been:
Net income before bad debt expense P100,000
Less: Bad debt expense (P60,000 - P35,000) 25,000
Net income if recovery known P75,000
The tax benefit is the income that escaped taxation in 2014 computed as:
Net income if subsequent recovery is known P75,000
Net income as reported (recovery unknown) 40,000
Tax benefit of the write-off P35,000
Hence, P35,000 of the recovery should be reverted as item of gross income in 2015.
The net income in 2015 shall be:
Net income before recovery P100,000
Other taxable income (bad debt recovery) 35,000
Net income P135,000
Illustration 2
Supposing a taxpayer had the following data:
2015 2014
Net income before bad debt expense P100,0000 P100,0000
(Bad debt expense)/Recoveries (120,000) 100,000
Net income after bad debt expense P20,000 P???
Required: How much of the P100,000 recovery in 2015 has tax benefit? The 2014 net
income assuming the recovery is known would have been:
Net income before bad debt expense P100,000
Less: Bad debt expense (P120,000- P100,000) 20,000
Tax benefit of the write-off P 80,000
Note that a negative net income or a net operating loss is as good as zero income
Thus, the tax benefit should be analyzed as follows:
Net income subsequent recovery is unknown P80,000
Net income as reported 0
Tax benefit of the write-off P 80,000
The P80,000 should be reverted as item of gross income in 2015.
Illustration 3
Supposing further that a taxpayer had the following data:
2015 2014
Net income before bad debt expense P70,0000 P100,0000
(Bad debt expense)/Recoveries (120,000) 40,000
Net income after bad debt expense P50,000 P???
Required: How much of the P40,000 recovery in 2015 has tax benefit? The 2014 net
income assuming the recovery is known would have been:

179
Net income before bad debt expense P70,000
Less: Bad debt expense (P120,000- P40,000) 80,000
Net income if subsequent recovery is unknown P 80,000
A negative net income means no income is taxed. The tax benefit shall be analyzed as
follows:
Net income if subsequent recovery is known P0
Net income as reported 0
Tax benefit of the write-off P0
None of the recovery shall be included in the gross income of 2015.

Additional Points For Consideration

1. Once a portion of the past deduction is determined to be taxable using the as-f approach, all
subsequent recoveries from the same deduction is an item of gross income subject to
regular income tax.
2. Net loss in the period of deduction – If the net operating loss in the period the deduction was
made exceeds the amount of the deduction, all recoveries from the deduction is non-taxable
since there can be no tax benefit under such condition.
3. Net income in the period of deduction – If the net income in the period the deduction was
made exceeds the amount of the deduction, all recoveries from the deduction are taxable
and must he have reverted to gross income. The entire amount or deduction under this ion
has income tax benefit.
These rules apply to other recoveries of past deductions.

180
Refund of Non-Deductible Expenses
Non-deductible taxes will never create tax benefit to the taxpayer. As such, the refund
should not be included in gross income. Hence, the refund of the following non-deductible items
is not taxable:
1. Philippine income tax
2. Estate or donor's tax
3. Income tax paid or incurred to a foreign country, if the taxpayer claimed a credit for such
tax in the year it was paid or incurred.
4. Stock transaction tax in disposing stocks through the Philippine Stock Exchange
5. Special assessment

Reimbursements of Expenses
Expenses of the taxpayer that are reimbursed or paid by the customer or client
constitute additional income to the taxpayer.
Examples:
1. When the lessee pays the ownership costs of the lessor such as real property tax and
insurance on the property, the payment constitutes income to the lessor.
2. When a client reimburses the out-of-pocket expenses of a professional practitioner, the
reimbursements are income to the practitioner.

Cancellation of Indebtedness
The cancellation of indebtedness may amount to gratuity or payment of income:
The cancellation of debt:
a. In consideration of service or goods - treated as income
b. As an act of gratuity - treated as gift; not as income
c. As capital transaction such as forfeiting the right to receive dividend in exchange of the debt-
treated as dividend income

Special Considerations in Reporting Of Gross Income

1. Accounting methods
2. Situs rules
3. Creditable withholding tax
4. Power of the CIR to redistribute income and expenses

181
Accounting Method
The accounting method adopted by the taxpayer has direct effect on the reportable
amount of gross income subject to regular income tax. For instance, a cash-basis taxpayer will
report his gross receipts or collection as gross income while an accrual basis taxpayer will
report his revenue consisting of collected and uncollected income as gross income. It must be
recalled also that regardless of the accounting methods of the taxpayer, advanced income must
be included in gross income in the period received.

Situs Rules
The situs of taxation also affects the extent of income included as items of gross income
of the taxpayer. It must be recalled that all taxpayers are taxable only on Philippine income
except resident citizen and domestic corporations which are taxable on global income. For
taxpayers taxable only on Philippine income, only their items of gross income subject to regular
tax from sources within the Philippines is included in gross income. For taxpayers taxable on
global income, their items of gross income subject to regular tax from sources within and without
the Philippines are included in gross income.

Integrative Illustration 1
Nomisma, a finance corporation, lends to various clients:
Interest income from loans to Philippine residents P400,000
Interest income from loans to non-resident clients 500,000
Interest income from bank deposits in the Philippines 20,000
Interest income from bank deposits abroad 10,000
Required: Determine the total amount of gross income subject to final tax and the
reportable amount of gross income subject to regular income tax assuming the taxpayer is:
1. Non-resident foreign corporation
2. Resident foreign corporation
3. Domestic corporation
Solution:
An analysis of the situs of the above income is shown below:
Within Without
Loan interest income P400,000 P500,000
Bank interest income 20,000 10,000
Total P420,000 P510,000
The following are the amounts subject to final tax and the amounts to be reported in
gross income subject to regular income tax:
Subject to

182
 Regular tax Final tax
Non-resident foreign corporation P420,000
Resident foreign corporation 20,000 400,000
Domestic corporation 20,000 910,000
Note:
1. Non-resident foreign corporations are subject to final income tax on gross income within.
Philippine residents shall withhold 30% final tax on their gross income.
2. The interest income from banks in the Philippines is an item of gross income subject to 20%
final tax. The gross income subject to regular income tax of resident foreign corporations
includes only those earned from sources within.
3. Income from sources abroad, passive or active, are subject to regular income tax for
taxpayers subject to tax on global income. The gross income of domestic corporations
includes items of gross income subject to regular tax from sources within and outside the
Philippines. Thus, P400K + P500K + P10K.

Integrative Illustration 2
A certain taxpayer had the following details of income during the year:
Service fees from Philippine clients P400,000
Service fees from foreign clients 500,000
Gain on sale of domestic stocks directly to buyer 150,000
Dividends from domestic corporations 5,000
Interest income on bank deposits abroad 30,000
Required: Determine the amount of gross income subject to regular income tax, final tax
and capital gains tax if the taxpayers:
1. an individual
a. Non-resident alien not engaged in trade or business (NRA-NETB)
b. Non-resident alien engaged in trade or business (NRA-ETB), a resident alien (RA) or
a non-resident citizen (NRC)
c. Resident citizen (RC)
2. a corporation
a. Non-resident foreign corporation
b. Resident foreign corporation
c. Domestic corporation
Solution:
An analysis of the situs of the foregoing income is as follows:
Within Without
Service fees P400,000 P500,000
Gain on sale of domestic stocks 150,000

183
Domestic dividends 5,000
Interest income from foreign bank 30,000
Total P555,000 P530,000
The following are the amounts to be reported in gross income subject to final income tax
(FIT), capital gains tax (CGT) and regular income tax (RIT):
Taxpayers FIT CGT RIT
Individuals P405,000 P150,000 P
1. NRA-NETB 5,000 150,000 400,000
2. NRA-ETB, RA or NRC 5,000 150,000 930,000
3. RC
Corporations P P150,000 P-
4. NRFC - 150,000 400,000
5. RFC - 150,000 930,000
6. DC
Note:
1. NRFCs and NRA-NETBs are subject to final tax on Philippine income.
2. The 5%-10% capital gains tax is the most universal rule in taxation that applies to all
taxpayers regardless of classification.
3. Inter-corporate dividend is exempt from final tax, except when the recipient is a non-
resident foreign corporation.

Creditable Withholding Tax

Creditable withholding taxes (CWT) deducted by income payors against the gross
Income of the taxpayer are not exclusions in gross income. These should be added back to the
reportable amount of gross income. CWTs are tax credits that are deductible against the annual
income tax due of the taxpayer.

184
Illustration
Denzo Inc., a domestic corporation, reported the following:
Rent income, net of 5% or P25,000 CWT P 475,000
Professional fees, net of 10% or P40,000 CWT 360,000
Interest income, net of 20% final tax 40,000
Dividends from a domestic corporation 10,000
Business expenses 500,000
Required: Determine the total reportable gross income and the income tax due and still
due under the regular income tax.
The total reportable gross income shall be:
Rent income [P475K/95% or (P475K + P25K)] P 500,000
Professional fees [P360K/90% or (P360K+ P40K)]| 400,000
Total gross income P 900,000
Note: The interest income and the dividend income are subject to final tax. They should
not be included in the item of gross income subject to regular income tax.
The income tax due and still due shall be determined as:
Total gross income P900,000
Less: Allowable deductions (business expenses) 500.000
Taxable net income P400,000
Multiply: Corporate tax rate 30%
Income tax due P 120,000
Less: Creditable withholding tax
Rent P25,000
Professional fees 40,000 65,000
Income tax still due P55,000
Note:
1. The CWTs are advances to the annual income tax due of corporations and individuals and
are deductible (i.e. creditable) thereto. Same procedures are applied with individuals except
that their income tax dues are determined by progressive tax rates.
2. The final taxes should not be credited against the annual income tax due.

Power of The CIR To Redistribute Income And Deductions

In the case of two or more organizations, trades or businesses (whether or not
incorporated and whether or not organized in the Philippines) owned or controlled directly or
indirectly by the same interests, the Commissioner is authorized to distribute, apportion or
allocate gross income or deductions between or among such organization, trade or business, if
he determined that such distribution, apportionment or allocation is necessary in order to
prevent evasion of taxes or clearly to reflect the income of any such organization, trade or
business. (Sec. 50, NIRC)

185
The Problem of Unfair Pricing between Associated Enterprises
There is a risk that the pricing of the transfer of goods and services between associated
enterprises will be controlled in such a way to further the interests of the associated enterprises
as a whole in disregard of their social responsibility on taxes.
Examples:
1. A domestic corporation which is subject to 30% corporate tax in the Philippines has a
subsidiary that operates in a tax haven country where no income tax is imposed. The
domestic corporation transfers goods to its foreign subsidiary at a transfer pricing based on
production cost so that no gross income will be recognized in the Philippines while the entire
gross income will be recognized abroad where no tax is imposed.
2. A foreign corporation subject to 10% corporate tax in its home country has a branch in the
Philippines which is subject to the 30% corporate income tax herein. The foreign corporation
transfers goods at a pricing method that will allow very minimal profit for the Philippine
branch to minimize exposure from higher income tax.
3. Mr. Wais has business enjoying tax holiday under an investment promotion law. Mr. Wais
also has a business that is subject to regular income tax. Mr. Wais orders his taxable
business to sell goods and supplies at cost to his exempt business thereby shifting the
profits to the exempt business to save from income tax.

The Transfer Pricing Guideline

Those enumerated scenarios are just few of the problems in taxation brought by unfair
pricing practices. To limit these unfair practices and to properly reflect the income of associated
enterprises, the BIR and the Department of Finance promulgated Revenue Regulations No. 2
series of 2013 (RR2-2013) on transfer pricing.

What are associated enterprises?

Under RR2-2013, two or more enterprises are associated if one participates directly or
indirectly in the management, control, or capital of the other; or if the same persons participate
directly or indirectly in the management, control, or capital of the enterprises. Associated
enterprises are also called "related parties".
Examples of associated enterprises:
1. Parent corporation and its subsidiary corporation
2. Sister companies or businesses owned by the same parent corporation
3. All corporations controlled under the same holding company

186
 4. Businesses owned by the same person

The arm's length principle

Under RR2, 2013, transfer pricing between associated enterprises shall be made under
comparable conditions and circumstance as those entered into between independent parties
where market forces drive the terms and conditions of the transaction rather than being
controlled solely by reason of special relationship between the associated enterprises.
In other words, an uncontrolled pricing method determined by free market forces, also
called arm's length pricing is preferred. The failure to comply may expose the taxpayer to a
transfer pricing adjustment where the BlR re-computes the roper income of the associated
enterprises. The arm's length principle shall be applied to:
1. Cross-border transaction between associated enterprises
2. Domestic transaction between associated enterprises
When operations are conducted cross-border, the taxpayer may enter an "advanced
pricing agreement' with the BIR where a pricing rate is pre-agreed to apply for a period.
Although this is not a mandatory requirement, this may serve as a safety net for the taxpayer to
avoid the risk of transfer pricing examination and adjustment and the inconvenience it may
possibly cause.

Transfer Pricing Methods

When the pricing methods between associated enterprises do not reflect arm's length
pricing, the BIR will adjust the controlled transactions to their arm's length values using of the
following methods:
1. Comparable uncontrolled price (CUP) method – The transaction is valued about the
amount charged in a comparable uncontrolled transaction in comparable circumstances.
2. Resale price method (RPM) – The transaction is valued based on the functions performed
by the reselling party to the product. This is used when products purchased from a related
party is resold t0 an independent party.
3. Cost plus method (CPM) – The transaction is measured by valuing the function performed
by the supplier of the property or services.
4. Profit split method (PSM) – The profit or loss on the transaction is split based on the
division of profits (or losses) that independent enterprises would have expected to realize
from engaging in the transaction or transactions.

187
 a. Residual profit split approach – profit is first allocated to provide a basic return
appropriate for the type of transaction the participant is engaged, the residual profit
after such allocation is further allocated among the parties based on an analysis of
how the residual would have been divided between independent parties
b. Contribution profit split approach – the combined profits from controlled
transactions are divided between associated enterprises in a single stag based upon
the parties' relative contribution to the profit or the relative value of the functions
performed by each of the associated enterprises participants in the controlled
transactions
5. Transactional net margin method (TNMM) – Similar to the cost plus and resale price
methods in the Sense that it uses the margin approach by reference the operating profit
earned in comparable uncontrolled transaction.
The methods to be employed shall be dependent on whatever is the most relevant to the
circumstance of the taxpayer.
Illustration 1: With an Advanced Pricing Agreement
The Crosby Manufacturing Corporation usually bills its foreign branch at cost; however, it
entered into an advanced pricing agreement (APA) with the BIR which fixed its cross-border
pricing to its foreign branch at 150% of cost.
Crosby compiled the following costs and sales during the year:
Philippines Branch
Sales through the branch (intra-company sales):
Sales P7,000,000 P12,000,000
Less: cost of sales 7,000,000 7,000,000
Gross income P5,000,000
Sales to un-associated domestic enterprises:
Sales P3,000,000
Less: cost of sales 1,200,000
Gross income P1,800,000
Total gross income P5,300,000
Applying the APA, the gross income earned from within and outside the Philippines shall
be computed as:
Philippines Branch Total
Sales through the branch (intra-company sales):
Sales *P10,500,000 P12,000,000 P12,000,000
Less: cost of sales 7,000,000 10,500,000 7,000,000
Gross income P3,500,000 P1,500,000 P5,000,000

Philippines Branch Total

Sales to un-associated domestic enterprises:

188
Sales P3,000,000 P0 P3,000,000
Less: cost of sales 1,200,000 0 1,200,000
Gross income P1,800,000 0 P1,800,000
Total gross income P5,300,000 P1,500,000 P6,800,000
Note:
1. The total income on the P12,000,000 sales is split into Philippine gross income and foreign
gross income using the APA rate. The Philippine sales shall be measured as: P7,000,000
cost of goods transferred and sold x 150% = P10,500,000. The amount determined as
Philippines sales shall be the deemed cost of sales of the foreign branch.
2. The transfer pricing rule does not apply to transactions with unrelated parties.
Scenario 1: Crosby Is A Domestic Corporation
Crosby shall report P6,800,000 gross income since Crosby Is taxable on global income.
Note that transfer pricing rule is only important in the measurement of the proper income from
foreign sources for purposes of the computation of the foreign tax credit.
Scenario 2: Crosby Is A Domestic Corporation and The Foreign Operation Is Not A
Branch But A Foreign Subsidiary Incorporated Abroad
Crosby shall report P5,300,000 gross income. The income of the foreign subsidiary is
not taxable in the Philippines as it is a non-resident foreign corporation. Note the importance of
the transfer pricing rule in measuring the fair and proper amount of the reportable gross income
from within. The profits on the sales of Crosby to the foreign affiliates could have escaped
taxation without this rule. The same procedures in this scenario will be applied if Crosby is a
resident foreign corporation.
Illustration 2: Without an Advanced Pricing Agreement
Hot Corporation, a foreign corporation, sells cosmetics products in the Philippines
through its branch. The Philippine branch filed an income tax return reflecting the following
gross income:
Sales P4,000,000
Less: cost of sales 3,500,000
Gross income P500,000
Scenario 1: The BIR determined that Hot Corporation is billing its branch at 200% of cost.
Meanwhile, other competitors of Hot Corporation which offer similar product lines are
billing their Philippine independent distributors at an average of 150% of cost.
The gross income of the Hot Corporation for purposes of Philippine income tax shall be
restated by re-measuring the cost of goods sold as follows:
Cost of sales at 200% billing rate (i.e. 200% x Cost) P3,500,000
Cost to the selling party (P3,500,000/200%) 1,750,000
Cost at arm' length price (150% x P1,750,000) 2,625,000

189
 Thus, the gross income of Hot Corporation shall be restated to:
Sales P4,000,000
Less: cost of sales 2,625,000
Gross income P1,375,000
Note: Hot Corporation will be given an assessment by the BIR for the incremental tax plus
penalties that may be due from this restatement.
Scenario 2: Hot Corporation Bills Its Branch At Establish Market Prices
Since the transfer price of Hot Corporation reflects arm's length pricing, no transfer
pricing adjustment shall be made.
Period In Which Items Of Gross Income Are Included
The amount of all items of gross income shall be included in the gross income for the
taxable year in which received by the taxpayer, unless, under methods of accounting permitted,
any such amounts are to be properly accounted for as of a different period.

Self-Test Exercises
Discussion Questions
1. Enumerate the NIRC list of items of gross income.
2. What are the broad categories of gross income?
3. Discuss in detail the taxation of interest income. Which is subject to final tax? Which is
subject to regular tax?
4. Discuss the treatment of gains from dealings in properties. Which gains is subject to
capital gains tax? Which gains is subject to regular income tax?
5. Discuss the taxation of dividends.
6. Discuss the taxation of royalties.
7. Discuss the taxation of prizes and winnings.
8. Compare actual distribution and the share in the net income of the partnership. Which
one is included in the gross income of the partner?
9. Discuss the taxability of recoveries of past deductions.
10. Enumerate examples of pass-through entities. Are they taxable to final tax, capital gains
tax or regular income tax?

Exercise Drill: True or False

1. Items of gross income subject to regular income tax and capital gains
tax are reportable to the government.
2. Rent is a passive income but it is not subject to final tax.
3. Gains form dealings in ordinary assets are subject to regular income

190
 tax.
4. Gains from dealings in capital assets are generally subject to the
regular income tax.
5. The reportable gross income from business or the exercise of a
profession is net of the cost of goods sold or cost of services.
6. The share in the business partnership is subject to final tax but the
share in a general professional partnership is subject to regular income
tax.
7. The interest income from bonds issued by bank is subject to final tax.
8. Items of passive royalty income are subject to final income tax while
items of active royalty income are subject to regular income tax.
9. Compensation income is an inclusion in gross income subject to regular
tax, except compensation income of special aliens.
10. The gross income from operations enjoying tax holiday are included in
gross income subject to regular tax but are presented as deductions in
the income tax return.

191
 CHAPTER X

COMPENSATION INCOME

Objectives
After the completion of this module, you should be able to comprehend and demonstrate
the knowledge of the following:
 Knowledge of the classifications of employees and the tax treatment of their
compensation income and fringe benefits
 Mastery of the list of employee benefits exempted under the NIRC and special laws and
the de minimis list
 Knowledge of the condition for exemption of employee benefits under treaty or
international agreement
 Mastery of the composition of "13th month pay and other benefits" for rank and file
employees and managerial or supervisory employees
 Comprehension of the fringe benefits subject to regular tax and fringe benefits subject to
fringe benefits tax

Employer-Employee Relationship
Employer refers to person for whom an individual performs any service, of whatever
nature, as employee of such person. An employer is the person who has control over the
payment of the employee the remuneration. But if such person is a non-resident not engaged in
trade or business in the Philippines, the employer is deemed the person paying remuneration in
their behalf.
Employee refers to any individual who is a recipient of wages and includes officer,
employee or elected official of the Government of the Philippines or any political subdivisions,
agency or instrumentality thereof. The term also includes an officer of a corporation.

Elements of Employer and Employee Relationship Under Case Law

1. Selection and engagement of employees – there is a screening process for
employees to hire.
2. Payment of wages – the employer usually fixes and controls the payment of wages.
3. Power of dismissal - employer has power to retrench or terminate employees when
incurring heavy losses or other reasonable basis.

192
 4. Power of control – the employer has power to control the employee on the means and
methods by which the work is accomplished.
An arrangement which do not manifest all the elements is not an employer- employee
relationship but an independent contract for the provision of services.
The following are not considered employees:
1. Consultants
2. Directors without management function
3. Talents and artists on TV shows or radio broadcasts (Sonza vs. ABS-CBN
Broadcasting Corporation, G.R. No. 138051)
The income or fees of these individuals are not compensation income but are business
or professional income.

Types of Employees As To Function

1. Managerial employees – those who are given powers or prerogatives to lay down and
execute managerial policies and/or to hire, transfer, suspend, lay- off, recall, discharge,
assign or discipline employees.
2. Supervisory employees – those who effectively recommend such managerial actions if the
exercise of such authority is not merely routinary or clerical in nature but requires the use of
independent judgment.
3. Rank and file employees – those who hold neither managerial nor supervisory functions.

Types of Employees As To Taxability

1. Minimum wage earners – an employee who is a recipient of minimum wage and is exempt
from income taxation
2. Special employees – special aliens subject to the 15% final income tax on compensation
income
3. Regular employees – an employee subject to the regular progressive income tax

Minimum Wage Earner

A minimum wage earner refer to a worker in the private sector who is paid the minimum
wage, or to an employee in the public sector with compensation income of not more than the
statutory minimum wage (i.e. those with salary grade 1 to 3) in the non-agricultural sector where
he or she is assigned. The statutory minimum wage refers to rate fixed by the Regional
Tripartite Wage and Productivity Board of the Department of Labor and Employment or

193
P5,000/month or P60,000/year, whichever is higher. To be considered as minimum wage
earner, the employee must not have other income aside from minimum wage and exempt
benefits. A recipient of a minimum wage but with other taxable income is a regular employee.

Special Alien
Special aliens refer to aliens holding managerial or technical position in a:
a. Regional or area headquarters (RHQ) or Regional operating headquarters (ROHQ) of
multinational companies.
b. Offshore banking units
c. Petroleum service contractors/subcontractors
An RHQ or an ROHQ is branch of a multinational company or foreign firm or entity
engaged in international trade, with affiliates, subsidiaries or branch offices in the foreign
markets, and is governed by Book Ill of Executive Order No. 226, as amended by RA 8756.
An offshore banking unit is a division of a foreign bank which is authorized to
transact banking transactions in foreign currencies in the Philippines.
A petroleum service contractor is an awardee of a petroleum service contract under
Oil Exploration and Development Act of 1972 either alone or in consortium with others.
Taxation of Special Aliens
Special aliens are subject to 15% tax on gross income received such as salaries, wages,
annuities, compensation, remuneration and other emoluments such as honoraria and
allowances, except those subject to fringe benefit tax.

Optional Final Income Tax To Filipino Employees

Filipinos who are occupying the same positions as those held by special aliens may opt
to be taxed at 15% final income tax on gross income or the regular income tax. Hence, the term
"special alien" includes qualifying Filipino employees who opted to be taxed at 15% of gross
income.

Requirements to Filipinos Employed by RHQs and ROHOs

To qualify as special alien employee, Filipinos occupying managerial or technical
position in RHQs or ROHQS must meet all the following:
1. Position and function test – the Filipino employee must be occupying and exercising a
managerial or supervisory position

194
2. Compensation threshold test – the Filipino employee must have a gross annual taxable
income of at least P975,000
3. Exclusivity test – the Filipino employee is not consultant or contractual personnel, and is
solely employed by the RHQ or ROHQ

Special Alien Is Not a General Classification

It must be noted that the "special alien" classification is not a general classification but a
special category that exists only in tax law for purposes of taxing compensation income. For
purposes of taxation of other income, special aliens are classified according to the appropriate
general classification.
Illustration 1
Mr. Kuonoman is a non-resident Japanese expert hired as a technical employee of
FilDrill, a petroleum service contractor developing the Malampaya Service Contract No. 32. Mr.
Kuonoman shall be considered a special alien with respect of his compensation income from
FilDrill. He shall be considered a non-resident alien on all other items of income from the
Philippines.
Illustration 2
Mr. Camacho, a resident Filipino, is hired as operations manager of the offshore banking
unit of Eurobank in the Philippines. Mr. Camacho opted to the 15% preferential income tax. Mr.
Camacho shall be considered a special alien with respect to his compensation income from the
OBU. He shall be classified as resident citizen for all other items of income he may derive
outside the OBU.
Illustration 3
Mr. Escala, a resident Filipino, occupies a managerial position in the ROHQ of
Cosmetics International. He derived an annual income of P1,100,000 inclusive of P300,000
annual part-time income from outside employment. Mr. Escala shall be treated as a regular
employee subject to the regular tax since he failed both the compensation threshold test and the
exclusivity test. Note that he has concurrent employment and that he only derives an annual
income of P800,00 0 (P1,100,000 - P300,000) from the ROHQ.
The Tax Model On Compensation Income
Gross compensation income P XXX,XXX
Less: Non-taxable compensation XXX,XXX
Gross taxable compensation income P XXX,XXX

195
Gross Compensation Income
Gross compensation income generally includes all remunerations received under an
employer-employee relationship.

Non-Taxable or Exempt Compensation

A. Benefits excluded and/or exempted under the NIRC and special laws
B. Benefits exempt under treaty or international agreements
C. Benefits necessary to the trade, business or conduct of profession of the employer
D. Benefits for the convenience or advantage of the employer

Exempt Benefits Under The NIRC, As Amended, And Special Laws

1. Remunerations received as incidents of employment
a. Exempt retirement benefits under RA 7641, including exempt retirement gratuities to
government officials and employees
b. Exempt termination benefits
c. Benefits from the United States Veterans Administration
d. Social security, retirement gratuities, pensions and similar benefits from foreign
government agencies and other institutions, private or public
e. Benefits from SSS, under the SSS Act of 1954, as amended
f. Benefits from GSIS under the GSIS Act of 1937, as amended
2. Employee mandatory contributions to GSIS, SSS, PhilHealth, HDMF and Union dues
3. Certain benefits of minimum wage earners
4. De minimis benefits
5. 13th month pay and other benefits not exceeding P82,000

Exempt Benefits of Minimum Wage Earners

1. Basic minimum wage
2. Holiday pay
3. Overtime pay
4. Night shift differential pay
5. Hazard pay
To be exempt from regular income tax, a minimum wage earner must not have
other items of taxable income aside from these employee benefits.

196
De Minimis Benefits
De minimis benefits are facilities or privileges such as entertainment, medical services,
or courtesy discounts on purchases that are of relatively small value and are furnished by the
employer merely as a means of promoting the health, goodwill, contentment or efficiency of his
employees. De minimis benefits are petty fringe benefits exempt from income tax.
As originally conceived, other petty fringe benefits which fall within the purview of de
minimis even it not part or the de minimis list are normally treated as de minimis and are also
exempt from income tax. However, the BIR and the Department of Finance changed the rule
under RR5-2011 wherein the term "de minimis benefits was restricted to mean only the
following:
1. Monetized unused vacation eave credits of private employees - not exceeding 10 days
during the year
2. Monetized unused vacation and sick leave credits paid to government officials and
employees
3. Medical cash allowance to dependents of employees not exceeding P750 per employee per
semester, or P125 per month
4. Rice subsidy - P1,500 or 1 sack of 50-kg rice per month amounting to not more than P1,500.
5. Uniform and clothing allowance not exceeding P5.000 per annum (RR8- 2012)
6. Actual Medical Assistance, e.g. medical allowance to cover medical and healthcare needs,
annual medical/executive check-up, maternity assistance, and routine consultations not
exceeding P10,000 per annum
7. Laundry allowance not exceeding P300 per month
8. Employee achievement award, e.g. for length of service or safety achievement, which must
be in the form of tangible property other than cash or gift certificates, with an annual
monetary value not exceeding P10,000 received by the employee under an established
written plan which does not discriminate in favor of highly paid employees.
9. Gifts given during Christmas and major anniversary celebrations not exceeding P5,000 per
employee per annum (i.e. Christmas gift and anniversary gifts)
10. Daily meal allowance for overtime work and night or graveyard shift not exceeding 25% of
the basic minimum wage on a per region basis (i.e. overtime meal)
11. Benefits received by an employee by virtue of a collective bargaining agreement (CBA) and
productivity incentive schemes provided that the total annual monetary value received from
both CBA and productivity incentive schemes combined do not exceed P10,000 per
employee per taxable year. (RA 10653, effective January 1, 2015 under RR3-2015)

197
Taxable De Minimis Benefits
1. Excess de minimis over their limits
2. Other benefits of relatively small value that are not included in the list of de minimis benefits

Treatment of Taxable De Minimis Benefits

a. For rank and file employees- treated as other compensation income under the category
"13th month pay and other benefits
b. For managerial and supervisory employees fringe benefit subject to final fringe benefit tax
(RR5-2011 as clarified by RMC20-2011)

Determination of Excess De Minimis Benefits

Illustration 1: De Minimis Limits
Alexander, a private employee who is paid a P600 daily rate, receives the following
benefits during the year 2015:
Monetized unused vacation leave credits 9 days
Monetized unused sick leave credits 9 days
Medical assistance b P 7,000
Rice subsidy (P2,000 per month) 24,000
Clothing allowance 8,000
Laundry allowance 6,000
Required: Determine the taxable amount of de-minimis benefits.
Solution:
Actual Limit Excess
Monetized unused VL P5,400 P6,000 P0
Monetized unused SL 5,400 5,400
Medical assistance 7,000 10,000
Rice subsidy 24,000 18,000 6,000
Clothing allowance 8,000 5,000 3,000
Laundry allowance 6,000 3,600 2,400
Taxable de minimis as "other benefits" P16,800
Note: Private employees
1. The actual value of the monetized unused VL was computed as P600 x 9 while the limit was
P600 x 10.
2. The 10-day rule applies only to vacation leave. Monetization of sick leave of private
employees is taxable. (BIR Ruling No. 227-2013, June 20, 2013).
3. The rice subsidy and laundry allowance were likewise annualized by multiplying their
monthly limit by 12. The de-minimis benefits within the limits are exempt from income tax.
Illustration 2
Giovanni, a government rank and file employee, received the following benefits:

198
Monetized unused vacation leave credits (10 days) P6,000
Monetized unused sick leave credits (15 days) 9,000
Uniform allowance 5,000
Laundry allowance 4,800
Required: Determine the amount to be included in other benefits.
Solution:
Actual Limit Excess
Monetized unused vacation leave credits (10 days) Exempt P6,000 0
Monetized unused sick leave credits (15 days) Exempt 9,000 0
Uniform allowance 5,000 5,000 0
Laundry allowance 3,600 4,800 1,200
Taxable de minimis as "other benefits" P1,200
Note: It is clear under RR5-2011 that the vacation leave and sick leave of government
employees are not subject to the 10-day limit rule.
Illustration 3
Professor Radvic was one of the Hall of Fame awardees of Youbee University. He was
granted P25,000 cash as loyalty award for his 30 years of service. He was also given P10,000
Christmas gift and an additional P10,000 gift during the institution's Founding Day Anniversary.
Besides, he was also given free lunch meals with a total value of P15,000 during the same year.
Required: Compute the total taxable de-minimis benefits as other benefits.
Solution:
Actual Limit Excess
Loyalty or service award P25,000 P0 P25,000
Christmas and anniversary gift 20,000 5,000 15,000
Meals 15,000 0 15,000
Total taxable de minimis as "other benefits" P55,000
Note:
1. The limit on loyalty or service award applies only if it is given in kind.
2. Only meal for overtime or graveyard shift is considered de minimis. Other meal benefits are
no longer considered de minimis.
Note that in all three illustrations, if the employee is a managerial or supervisory
employee, the entire excess de minimis shall be considered as other fringe
benefits subject to fringe benefits tax.

Commutation of Accumulated Leave Credits

The terminal leave pay or the commutation of unused leave credits due to involuntary
separation from employment or the employee is now treated as ae minimis benefits subject to
the 10-day leave credit limit and is no longer exempt as part of exempt termination benefits.

199
13th Month Pay And Other Benefits Not In Excess Of P82,000
The composition of "13th month pay and other benefits" will be discussed later under
taxable benefits.

B. Benefits Exempt Under Treaty or International Agreements

Employee benefits of non-Filipino nationals and or non-permanent residents of the
Philippines from foreign governments, embassies or diplomatic missions and international
organizations in the Philippines are exempt from income tax.

Exemption from withholding tax does not mean income tax exemption
Foreign government embassies, diplomatic missions and international organizations are
immune from income tax including the obligation to withhold income tax by virtue of international
comity as embodied in several international agreements to which the Philippines is a signatory.
However, this exemption from the obligation to withhold tax does not mean income tax
exemption to their Filipino employees. In fact, most of the international agreements to which the
Philippine is a signatory limit exemption only to non-Filipino nationals and/or non-residents of
the Philippines. Filipino employees of foreign governments, international missions and
organizations are taxable as a rule, except only to employees of the following organizations:
1. United Nations (UN)
2. Specialized Agencies of the United Nations
3. Australian Agency for International Development (AUSAID)
4. Food and Agriculture Organization (FAO)
5. World Health Organization (WHO)
6. United Nations Development Programme (UNDP)
7. International Organization for Migration (1OM)
8. International Seabed Authority (ISA)
These organizations have exemption provision that extends even to their Filipino
employees. Other aid agencies or international organization may have tax free
provision in their articles of agreement on Filipino employees.

Confirmation of Tax Exemptions

The exemption of Filipino employees is not automatic. Filipinos claiming exemptions
under the terms of international agreements or under provisions of special laws granting
privileges to international organizations shall file an application for confirmation of tax exemption

200
with the BIR'S International Tax Affairs Division (ITAD). The confirmation shall serve as proof of
exemption. Without the confirmation certificate, the employee is taxable.

Employees of Philippine embassies or consulate offices

It should be recalled that employees working on Philippine embassies or Philippine
consulate offices are not considered non-resident citizens and are therefore subject to
Philippine income tax.
Summary of rules
Foreign embassy, missions Philippine embassy
or organization or consulate office
In the Philippines
-Filipino citizens Taxable* N/A
-Aliens Exempt N/A
Abroad
-Filipino citizens Exempt Taxable
-Aliens Exempt Exempt
*Taxpayer must prove if there is an exemption grant under contract or special law.

Benefits Required By The Nature of, or Necessary To The Trade, Busines or Conduct of
Profession of The Employer
Benefits or allowances furnished by the employer to the employees to enable them to
execute their duties appropriately and effectively as required by their employment are exempt
from income tax. This is referred to as "necessity of the employer rule."
Examples:
1. Necessary traveling, transportation, representation or entertainment expenses that are
subject to an accounting or liquidation in accordance with specific requirements of
substantiation of expense.
2. Allowances which essentially constitute reimbursement to government personnel for
expenses they incurred in the performance of their official duties, such as:
a. Representation and Transportation Allowance (RATA) of public officers and
employees under the General Appropriation Act
b. Personnel Economic Relief Allowance (PERA) (RR10-2008)
3. Reasonable amounts of reimbursements or advances to employees for travelling and
representation which are pre-computed daily, and which are paid to any employee while on
assignment or duty.

201
 These amounts given to the employee are not income but are expenses of the trade,
business or profession of the employer that are incurred or paid through the employee. These
are not benefits since they are mere advances or replenishments of what are supposed to be
direct cash outflows from the employer, hence, not considered as compensation income.

Benefits for The Convenience or Advantage, of The Employer

Benefits or allowances which are intended for the furtherance of the interest of the
employer's business or to ensure its smooth operations are likewise exempt from income tax.
This is referred to as the "convenience of the employer rule”.
Examples:
1. Work-related mobile phone allowance and transportation allowance, particularly to
employees of call centers which are operated on a 24-hour basis where employees are
required to be available always for assignment and consultation (BIR Ruling DA-233-07)
2. Outstation allowance for employees who will be out from office site at least 8 hours to visit
lotto franchise holders for repairs and/or inspection of equipment leased by the employer
(BIR Ruling No. 013-02)
3. Grant of housing privilege to employees working at distant or remote facilities even if the
dwelling is distanced from the facility in compliance to labor safety standards (BIR Ruling
No. 055-99)
4. Car incentives to medical doctors on-call who are required to report on duty anytime
5. Scholarship grant to employee under contract to remain in service for a specified period
upon completion of the study
6. Housing privilege of military officials of the AFP located inside or near the military camps
These types of employer spending are regarded as business expenses and are not
considered as employee reward because they are not intended for the free personal
consumption or disposal of the employees but as implements of the employer's business to
ensure the employer's convenience. However, if the expense is unreasonably excessive making
it depart from the nature of a reasonable business expense, such as when it is deliberately
granted to include a benefit for the employee, the portion of the expense representing provision
or privilege to the employee is considered a taxable fringe benefit. These types of expense are
regarded as "hybrid expenses" because they are partially business expense and partially
employee benefits.

202
Gross Taxable Compensation Income
Classification of gross taxable compensation income
1. Regular compensation – the fixed remunerations received by the employee every payroll
period
2. Supplemental compensation – other performance-based pays to employees with or
without regard to the payroll period
3. 13th month pay and other benefit – a residual category which generally includes incentive
pays and all other taxable employee benefits
The amount of 13th month pay and other benefit not exceeding P82,000 is an as an
exclusion from gross income. The amount more than P82,000 is considered as supplemental
compensation.
Illustration
An employee received P400,000 regular compensation, P100,000 supplemental
compensation and P90,000 13th month pay and other benefits. The gross taxable
compensation income shall be computed as:
Regular compensation P400,000
Supplemental compensation 100,000
13th month pay and other benefits (P90,000 - P82,000) 8,000
Gross taxable compensation income P508,000

Regular Compensation Income

The regular compensation includes fixed remunerations due to be received by an
employee every period, such as:
1. Basic salary
2. Fixed allowances, such as cost of living allowance, fixed housing allowance, representation,
transportation and other allowances paid to an employee every payroll period

Fixed allowances
Allowances which are fixed in amounts and regularly received as part of the basic
monthly, bi-weekly, weekly or daily salaries or wages are part of regular compensation. This
apply even if portion of the allowances are used in the employer's business.

Exception rule on the taxability of allowances:

a. If it is an ordinary and necessary travelling, representation or entertainment expense of
employee in the pursuit of his trade, business or profession

203
 b. The expense is subject to accounting or liquidation
c. Any excess advances are returned to the employer
Hence, variable and liquidated allowances are not subject to tax. However,
amounts of allowances that are retained by the employee for himself shall be considered
compensation.

Paid vacation and sick leave allowances

The paid absences of an employee applied against his vacation or sick leave credits
which are normally received as part of the regular salary is part of the regular compensation.

Non-Compensation Items
1. Fees – Retainer fees of consultants, talents and directors who have no management
function in the business are professional income not compensation income of the recipient.
2. Commissions to non-employees such as independent sales agent are business income to
the sales agent.
3. Tips and gratuities – tips and gratuities paid directly to an employee by customers of the
employer which are not accounted for by the employee to the employer are not considered
as compensation income but are to be reported as "other income" in the income tax return of
the employee.

Valuation of compensation paid in kind

Compensation in kind is taxable at the fair value of the consideration received. If
received in shares, the fair value of the shares at the date services were provided is used.
Illustration 1
The following pertains to an employee in 2015:
Gross salaries P400,000
Cost of living allowance 36,000
Fixed monthly transportation allowance (P2Kx 12) 24,000
Deduction for withholding tax on compensation 10,000
Deduction for employee share in SSS, PHIC and HDMF 32,000
The gross taxable compensation income shall be computed as:
Gross salaries P400,000
Cost of living allowance 36,000
Fixed monthly transportation allowance 24,000
Gross compensation income P460,000
Less: Non-taxable compensation 32,000
Gross taxable compensation income P428,000
Illustration 2

204
 An employee who was terminated during 2015 due to business closure of the employer
received the following:
Unpaid 2015 salaries P200,000
Unpaid 2014 salaries 20,000
Reimbursement for transportation expenses 10,000
Termination pay 100,000
The gross taxable compensation shall be computed as:
Gross compensation income (P200K + P20K+ P100K) P 320,000 P320,000
Less: Non-taxable compensation 100,000
Gross taxable compensation income P220,000
Note:
1. Reimbursement for transportation expense is not an income to the employee.
2. The termination pay is included in gross compensation income but is also deducted as non-
taxable compensation because the reason of termination is beyond the employee's control.

Supplementary Compensation
Supplementary or additional Compensation includes performance-based remunerations
to an employee in addition to the regular compensation with or without regard to the payroll
period. The following are the additional compensation under current tax rules:
1. Overtime pay
2. Hazard pay
3. Night shift differential pay
4. Holiday pay
5. Commissions
6. Fees, including director's fees (if director is an employee)
7. Emoluments and honoraria
8. Taxable retirement and separation pay
9. Value of living quarters or meals
10. Gains on exercise of stock options (BIR Ruling 119-2012)
11. Profit sharing and taxable bonuses

Overtime, holiday, hazard, and night differential pay

These constitute additional compensation, except when derived by a minimum wage
earner.

Commissions, emoluments, and honoraria

205
 Commission is an incentive intended to stimulate sales. It may be given as a profit
sharing or performance bonus. Emolument pertains to any pay in general while honoraria are
additional payment for attending to special tasks or assignments.

Living quarters or meals

If an employee receives in addition to salary for services rendered, living quarters or
meals, the value to the employee of such living quarters or meals is included compensation
income. However, when the same was furnished to an employee for convenience of the
employer or out of necessity of the employer's business, the value thereof is not compensation
income but a business expense.

Stock option plans

Under various stock option plans, employees are given the privilege to buy shares at an
agreed exercise price after meeting stipulated vesting conditions. The option will have value
when the stock of the employer increases in value above the exercise price at exercise date.
The value of the option is the discount at exercise date. In the past, stock options were not
taxed at exercise date under the view that the discount becomes realized only when the stocks
are disposed. Under current tax rules, the discount (i.e. market price - exercise price) at
exercise date is viewed as compensation in kind. The gain from the exercise of stock options
constitutes a taxable compensation income unless they qualify as fringe benefits subject to final
tax. (RMC88-2012)
Illustration
Mr. Anthony met the vesting condition of his employer's stock option plan where he is
entitled to buy 10,000 of his employer's share at a strike price of P100. Mr. Anthony exercised
the option when the share of his employer is selling P150/share. The discount of P500,000,
computed as [(P150-P100) x 10,000], shall be reported and treated as additional compensation
income of Mr. Anthony.

Treatment of the subsequent sale of the shares

If the employer is a:
1. Domestic corporation, and the sale of the stocks is made:
a. through the PSE, the sale is subject to a transaction tax 1/2 of 1% of the gross
selling price.
b. directly to buyer, the net gain on the sale is subject to the 5%-10% capital gains tax.

206
2. Foreign corporation, the net gain on the sale is a capital gains subject to the regular income
tax.

Profit sharing or taxable bonus

Profit sharing is a reward for churning the busines to post a profit. It is a compensation
for controlling all the factors that influence profit such as marketing and sales, productivity, and
administrative factors. It is a reward which can be enjoyed by individual employees such as
salesmen, division heads, key officers or by all employees collectively. Bonuses are
supplemental or additional compensation. However, if they are linked solely upon productivity
under the productivity incentive plan of the employer pursuant to RA 6971, they should be
considered as de minimis benefits.

Productivity incentive bonus

The Productivity Incentive Act of 1990 (RA 6971) encourages private employers to set-
up productivity incentive programs. A productivity incentive is linked to improvements in
productivity usually in terms of cost savings through waste reduction, efficient labor utilization or
increase volume of production. Under the NIRC, productivity incentive bonus is considered as
part of "other benefits. Under "13th month pay and other benefits. Under the revision of RA
10653, productivity incentive is now a de minimis benefit.

Productivity incentive distinguished with profit sharing bonus

Productivity incentive is anchored on improvements in the factors of production and is
usually enjoyed collectively by employees due to the inherent difficulty of tracing productivity to
individual performance. It is based upon cost savings hence, payable even if the business
poses a loss. Profit sharing is payable only
when the business posts a profit.

13th Month Pay And Other Benefits

"13th Month Pay and Other Benefits" includes:
1. 13th month pay
2. Other benefits
a. Christmas bonus of private employees
b. Cash gifts, other than Christmas or anniversary gifts, of private employees (RR2-98,
as amended by RR5-2011)

207
 c. Additional compensation allowance (ACA) of government personnel (RR8-2000)
d. 14th month, 15th month, etc.
e. Other fringe benefits of rank and file employees

13th month pay

a. The 13th month pay of government employees consists of a Christmas bonus equivalent
to one-month salary plus a P5,000 cash gift. (RA6686 as amended by RA 8441)
b. The 13th month pay of private employees is equivalent to one-month salary. (PD 851)

Christmas bonus and Christmas gift

The Christmas bonus of government employees is their 13th month pay. In private
companies, the term "Christmas bonus" may pertain to the 13th month pay, a separate incentive
pays or to a profit sharing. Christmas bonus of private employees which is a non-performance-
based incentive pay is part of other benefits. Christmas bonus profit sharing should be treated
as additional compensation income, not as other benefits". The nature of the Christmas bonus
of private employees shall determine its tax classification.
The Christmas gift of government employees is specifically designated as part of "13th
month pay and other benefit" under Sec. 32 (B) (7)(e) (i) of the NIRC. RR5- 2011 includes
Christmas gift in list of de minimis benefit. But since revenue regulations cannot amend the law
they implement, RR5-2011 should be interpreted to apply only to Christmas gifts of private
employees.
Hence,
Government Private
employees employees
13th month pay and other
Christmas bonus 13th month pay and other benefits
benefits
13th month pay and other
Christmas gift De minimis
benefits

Bonus vs. Gift

Bonus is performance-based and is non-discretionary to the employer while a gift is a
gratuity and is discretionary upon the employer.

208
Other Fringe Benefits
Other fringe benefits include all other taxable fringe benefits not specifically included in
compensation income as regular, supplementary or 13th month pay and other benefits under
current tax rules, such as:
1. Employee personal expenses shouldered by the employer
2. Taxable de minimis benefits, such as:
a. Excess de minimis over their limits
b. Benefits not included in the de minimis list

Employee personal expenses

Employee personal expenses such as, but not limited to, rental of residence, grocery,
association or club membership dues, travel or vacation expense or tuition fees, when assumed
or paid by the employer, constitute fringe benefits to the employee. This fact holds true even if
the expense is receipted in the name of the employer.

209
Taxable de minimis benefits
All other benefits of relatively small value which are not included in the list of de minimis
benefits shall not be considered as de minimis but as ordinary fringe benefits. Corollary to this
rule, excess de minimis benefits should be considered as taxable ordinary fringe benefits.

Tax Treatment of Other Fringe Benefits

a. For rank and file employees treated as compensation income as part or other benefits"
under "13th month pay and other benefits
b. For managerial or supervisory employee treated as fringe benefit subject to fringe benefit
tax
It must be emphasized that the "other fringe benefits" of managerial or supervisory
employee is excluded in their "13th month pay and other benefits".
Illustration 1
The employer pays for the tuition fee of the employee in addition to his regular
compensation. The tuition fee paid is a fringe benefit which will be treated as follows:
1. As a compensation income as part of "other benefit" under"13m month pay and other
benefit" if the employee is a rank and file employee
2. As a fringe benefit subject to fringe benefit tax if the employee is a managerial or
supervisory employee
3. As an exempt fringe benefit, regardless of the type of employee, if the same was given by
the employer for his convenience or business necessity such as when the employee is
required to study to acquire an expertise for the future use of the employer's business.
Illustration 2
An employee receives a monthly rice allowance of P2,000 a month which is P500 more
than the P1,500 a month de minimis limit for rice allowance. The P500 monthly excess
constitute a taxable de minimis benefit taxable as compensation as part of "other benefits" for a
rank and file employee. It is a fringe benefit subject to final fringe benefit tax for a managerial or
supervisory employee.

Tax Treatment of 13th Month Pay and Other Benefits

RR2-98 provides that 13th month pay, and other benefits are exempt from withholding
on compensation provided they do not exceed P82,000. It follows, therefore, that the excess
above P82,000 is subject to the withholding tax on compensation. RR3-98, the revenue
regulation implementing the fringe benefit tax, also provides that it does not cover benefits

210
forming part of compensation income subject to the withholding tax on compensation. Hence,
the excess of "13th month pay and other benefits" over P82,000 should be treated as
compensation income subject to regular income tax.
Illustration 1
A government rank and file employee received the following benefits aside from the
basic pay in 2015:
Christmas bonus P50,000
Cash gift 5,000
Additional compensation allowance 36,000
Personnel Economic Relief Allowance (P2,000/month) 24,000
Monetized value of vacation leave and sick leave (18 days) 9,000
Uniform and clothing allowance 5,000
Required: Determine the taxable "13th month pay and other benefits”
Solution:
Christmas bonus (13th month pay of gov't employees) P50,000
Cash gift 5,000
Additional compensation allowance 36,000
Total 13th month pay and other benefits P91,000
Less: Exclusion Threshold 82,000
Taxable 13th month pay and other benefits P9,000
Note on government employees:
1. Personnel Economic Relief Allowance is not subject to income tax and withholding tax
(Under RR8-2000, as affirmed by RR10-2008)
2. The P5,000 Christmas gift of government employees is designated by the NIRC to be part
of "13th month pay and other benefits"; hence, not a de minimis benefit.
3. Under RR5-2011, the monetization of vacation leave and sick leave credits of government
official is an exempt de minimis without regard to the number of days.
Illustration 2
A private rank and file employee working on a remote tower station of No-Signal
Telecom received the following benefit during 2014:
13th month pay P67,000
Performance bonus 15,000
Christmas gift 22,000
Danger exposure allowance (hazard pay) 6,000
Housing privilege 38,000
Uniform and clothing allowance 7,000
Laundry allowance 6,000
The housing privilege pertains to the annual value of the employees living quarter
furnished by the employer for staying on-site.
Required: Compute the excess 13th month pay and other benefits.

211
Solution:
De minimis Limit Other Benefits
Christmas gift P22,000 P5,000 P17,000
Uniform and clothing allowance 7,000 5,000 2,000
Laundry allowance 6,000 3,600 2,400
Excess de minimis benefits (other fringe P21,400
benefits)
13th month pay 67,000
Total 13th month pay and other benefits 2P0 P89,400
Less: Exclusion threshold 82,000
Taxable 13th month pay and other benefits P7,400
Note: Private employees
1. Performance bonus is a supplemental or additional compensation.
2. The laundry allowance limit is computed as P300 x 12 = P3,600.
3. Christmas gift is a de minimis benefit for private employees under RR5-2011.
4. The housing privilege is exempt under the convenience of the employer rule.
5. The "13th month pay and other benefits" of rank and file employees includes "other fringe
benefits"
Illustration 3
A managerial employee received the following benefits in 2015:
13th month pay P75,000
Rental expense on condominium unit 18,000
Salary of personal bodyguard 12,000
Profit sharing 12,000
Rice allowance 21,600
Clothing allowance 6,000
Night shift differential pay 11,000
Productivity incentive bonus 8,000
Required: Determine the taxable "13th month pay and other benefits", additional
compensation and the fringe benefit subject to fringe benefit tax.
Solution:
De minimis Limit Other Benefits
Rice allowance P21,600 P18,000 P3,600
Clothing allowance 6,000 5,000 1,000
Excess de minimis P4,600
Other fringe benefits
Rent of residence paid by employer 18,000
Salary of personal bodyguard 12,000
Total fringe benefit subject to fringe benefit P34,600
tax
Profit sharing P12,000
Night shift differential pay 11,000
Total supplemental compensation P23,000
13th month pay P75,000

212
Productivity incentive bonus 8,000
Total 13th month pay and other benefits P83,000
Less: exclusion threshold 82,000
Taxable 13th month pay and other benefits P1,000

Integrative Illustrations: Compensation Income

Integrative Illustration 1
A government rank and file employee had the following summary of his compensation
and benefits in 2015:
Gross compensation income P324,000
Less: Employee payroll deductions
Employee contribution to GSIS, PHIC, HDMF 32,000
Employee deduction for withholding tax 34,000 66,000
Net regular payroll P258,000
Representation and Transportation Allowance 18,000
Personnel Economic Relief Allowance 24,000
Christmas bonus 27,000
Uniform allowance 5,000
Christmas gift 5,000
Honoraria 15,000
Total compensation P 352,000
The gross taxable compensation income shall be computed as follows:
De Non- Other Taxable
minimis taxable benefits benefits
Regular and supplementary compensation
Regular compensation P32,000 P292,000
Supplemental compensation
Honoraria 15,000
RATA 18,000
PERA 24,000
Total P74,000 P0 P307,000
13th month pay and other benefits
Christmas bonus P27,000
Christmas gift 5,000
Excess de minimis
Uniform allowance P5,000 P5,000 0
Total P5,000 P79,000 P32,000
Exclusion threshold (up to P82,000) 32,000 -32,000
Total P111,000 P0
Taxable excess 13th month pay and other 0
benefits
Gross taxable compensation income P307,000
Note:
1. The taxable regular compensation income is computed as (P324,000- P32,000)
2. The excess of P82,000 over the actual 13th month pay, and other benefits is non-deductible
to other items of compensation income. (RR3-2015)

213
Presentation in the Income Tax Return of the employee:
Gross compensation income (i.e. P352K + P66K) P418,000
Less: Non-taxable income 111.000
Gross taxable compensation income P307,000

214
Integrative Illustration 2
A private employee derived the following remunerations and benefits in 2015:
Basic compensation, net of P24,000 SSS, PHIC, PhilHealth, HDME, union P246,000
dues and P30,000 withholding tax
Overtime pay 21,000
Productivity incentive 20,000
Vacation expenses of the employee paid by employer 24,000
Cost of living allowance (COLA) 12,000
Pre-computed daily transportation allowance 16,000
Rice subsidy (12 cavans worth P2,100 each) 25,200
13th month pay 25,000
Monetized unused leave credit (10 VL and 8 SL) 18,000
Uniform allowance 4,000
Total compensation income P411,200
The non-taxable compensation income and the gross taxable compensation income
shall be computed as follows:
For a rank and file employee:
De Non- Other Taxable
minimis taxable benefits benefits
Regular and supplementary compensation
Regular compensation P24,000 P276,000
Supplemental compensation
Overtime pay 21,000
COLA 12,000
Pre-computed daily transportation 16,000 0 0
Total P40,000 P0 P309,000
13th month pay and other benefits
13th month pay P25,000
Other benefits
Productivity incentive 20,000
Vacation expense paid by employer P24,000
Excess de minimis benefits:
Rice subsidy P25,200 18,000 7,200
Monetized VL 10,000 10,000
Monetized SL 8,000 0 8,000
Uniform allowance 4,000 4,000 0
Total P47,200 P72,000 P84,200 P309,000
Exclusion threshold 82,000 -82,000
Total non-taxable benefits P154,000 P2,200
Taxable 13th month pay and other benefits -2,200 2,200
Gross taxable compensation income P311,200
Note:
1. The P276,000 basic compensation is computed as P246,000+P30,000. Note that the
withholding tax is not an exclusion from gross income.
2. The rice subsidy limit is computed as P1,500 x 12. The limit of the monetized unused VL is
computed as P18,000 x 10/18 and P18,000 x 8/18 for the SL.

215
3. The vacation expense shouldered by the employer is a fringe benefit forming part of
compensation income of a rank and file employee under “other benefits”

Presentation in the Income Tax Return of the employee:

Gross compensation income* P465,200
Less: Non-taxable income 154,000
Gross taxable compensation income P311,200
*P411,200 net pay + (P24,000 + P30,000) payroll deductions

For a managerial or supervisory employee:

De Non- Other Taxable
minimis taxable benefits benefits
Regular and supplementary compensation
Regular compensation P24,000 P276,000
Supplemental compensation
Overtime pay 21,000
COLA 12,000
Pre-computed daily transportation 16,000 0
Total P40,000 P0 P309,000
13th month pay and other benefits
13th month pay P25,000
Productivity incentive 20,000
Total P45,000
Exclusion threshold (up to P82,000) 45,000 -45,000
Total P85,000 P0
Excess 13th month pay and other benefit 0
Gross taxable compensation income P309,000
Other fringe benefit:
Vacation expense paid by employer P24,000
Excess de minimis benefits:
Rice subsidy P25,200 18,000 7,200
Monetized VL 10,000 10,000
Monetized SL 8,000 0 8,000
Uniform allowance 4,000 4,000 0
Total P47,200 P32,000 P15,200
Total non-taxable benefits P117,000
Taxable 13th month pay and other benefits -15,200 15,200
Gross taxable compensation income P39,200
The gross compensation income is computed as:
Gross compensation income P465,200
Less: fringe benefit subject to final tax 39,200
Gross taxable compensation income P426,000
Presentation in the Income Tax Return of the employee:
Gross compensation income P426,000
Less: Non-taxable income 117,000
Gross taxable compensation income P309,000

216
Tax Treatment of Gross Taxable Compensation Income
The ultimate taxation of gross taxable compensation income will depend upon the type
of employee involved. The following table summarizes the rules:
Types of employee Income tax treatment
Regular employee Progressive tax
Special employee 15% final tax
Minimum wage earner Exempt

217
Illustration
An employee, with a total personal exemption of P75,000, received the following
remunerations and benefits during the year:
Gross salaries P300,000
Supplemental compensation 80,000
13th and 14th month pay 87,000
Other fringe benefits 34,000
Required: Compute the gross taxable compensation income and the income tax due if
the employee is a:
1. Regular employee
a. Rank and file employee
b. Managerial or supervisory employee
2. Special alien employee
Solution: Regular Rank And File Employee
Gross salaries P300,000
Supplemental compensation 80,000
13th month pay and other benefits P 87,000
Other fringe benefits 34,000
13th month pay and other benefit P121,000
Less: Exclusion threshold 82,000 39,000
Gross taxable compensation income P 419,000
Less: Personal exemption 75,000
Taxable income P344,000
The income tax due shall be computed from the income tax table as follows:
Tax due
Taxable income P344,0000
Less: Lower limit of applicable bracket 250,000 P 50,000
Excess P 94,000
Multiply by: incremental tax rate 30% 28,200
Income tax due P 78,200

Over But not over Basic tax Plus Of excess over

140,000 250,000 22,500 25% 140,000
250,000 500,000 50,000 30% 250,000
Solution: Managerial/Supervisory Employee And Special alien
The gross compensation income shall be computed as follows:
Gross salaries P 300,000
Supplemental compensation 80,000
13th month and other benefits P 87,000
Less: Exemption threshold 82,000 5,000
Gross taxable compensation income P385,000

Tax due of regular employees

218
 For regular managerial or supervisory employee, the income tax due shall be
determined based on taxable income as follows:
Gross taxable compensation income P385,000
Less: Personal exemption 75,000
Taxable income P310,000
Using the individual tax table, the income tax due shall be P 68,000.

Tax due of special alien employees

For a special alien employee, the income tax due shall be computed as:
Gross taxable compensation income P385,000
Multiply by final tax 15%
Final tax on compensation P57,7500
Note: There shall be no deduction for personal exemption as the 15% final tax is imposed on
gross income.

Tax on the fringe benefits:

The fringe benefit tax of special alien is subject to 15% final tax while 32% to regular
managerial or supervisory employees. The final tax is computed from the grossed-up monetary
value of the fringe benefit as follows:
Special alien (P34,000/85%) x 15%) P6,000
Regular managerial employee (P34,000/68%) x 32%) P16,000
The detailed rules on fringe benefit taxation will be discussed in the following chapter. It
is merely shown here for you to obtain preliminary understanding.

219
Taxability of Minimum Wage Earners (MWE)
Under RR10-2008, a minimum wage earner loses the special privilege of tax exemption
for the year when he or she derives other income, such as:

Taxable income from employment

This may include taxable allowances, commissions, honoraria, fringe benefits. other
benefits more than P82,000 and other taxable income other than the SMW, holiday pay,
overtime pay, hazard pay, and night shift differential pay. In other words, this pertains to fixed
allowances, and non-exempt supplemental compensation to MWEs. The receipt of 13th month
pay and other benefit will not automatically disqualify a MWE unless the same exceeds
P82,000.

Taxable income outside employment

This may include income from conduct of trade, business or practice of profession,
except those subject to final tax and other income subject to regular income tax. In the first case
of disqualification, the employee shall be subject to withholding tax on compensation like other
regular employees. In the second case of disqualification, however, the employee is exempt
from withholding tax but he or she must file an annual income tax return. (RR10-2008)
Illustration 1
John, a company guard employed in Region II with a regional minimum wage of
P300/day or P7,800/month, received the following compensation in 2014:
Basic pay (P7,800 x 12) P93,600
13th month pay 7,800
Overtime pay 12,000
Night shift differential pay 9,300
Hazard pay 6,400
Total compensation P129,100
The entire compensation is exempt from income tax and to the withholding tax on
compensation.
Illustration 2
Supposed John received the following benefits in 2014:
Basic pay P93,600
Monthly fixed transportation allowance (P500/month) 6,000
13th month pay 7,800
Overtime pay 9,000
Night shift differential pay 6,300
Hazard pay 6,400
Total compensation P 129,100

220
 The entire compensation income will be subject to income tax. John's employer must
deduct withholding tax on the compensation. If John is not covered by the substituted filing of
tax return, he shall file an income tax return covering his entire income in 2014.
Illustration 3
Mary earns a minimum wage of P90,000 plus P2,000 interest from deposits from her
savings account and P2,000 dividends from her stock investments. Mary is still a minimum
wage earner. Only those other income subject to regular tax disqualifies a taxpayer from
exemption as a minimum wage earner. Note that the dividend income and deposit interest are
subject to final tax. 1t must be emphasized that the exemption of a minimum wage earner
relates only to income subject to regular income tax.
Illustration 4
Assume Mary derives a minimum wage of P90,000 but earns P30,000 income from
operating a "sari-sari" store. Although a recipient of minimum wage, Mary is not a minimum
wage earner as contemplated by the law. Despite this, Mary's compensation income shall not
be subject to withholding tax on compensation. This rule applies even if the employer has
knowledge of Mary's other income outside employment.
However, Mary must file an annual income tax return covering her P90,000 minimum
wage and P30,000 other income and shall pay any tax thereon. The exemption from the
withholding tax on compensation is merely a relief from the withholding tax deduction on every
payroll period but it does not mean tax exemption.

Rules of change in Status as a Minimum Wage Earner during a year

1. When an employee become a minimum wage earner during the year, he shall be subject to
income tax only on compensation earned before becoming a minimum wage earner
Illustration 1
Anthony had a basic pay of P400/day when the minimum wage was P382/day. He is
also receiving overtime pay and the year-end 13th month pay. On July 1, 2014, the Regional
Wages and Productivity Board increase the minimum wage by P22/day to P404/day. Anthony's
employer increased his salary to the minimum P404/day. Anthony shall be taxed on his income
from January 1 to June 30 because he is not yet a minimum wage earner. The employer shall
regularly deduct the withholding tax compensation from his salary but shall stop withholding by
June 30. Anthony's compensation starting July 1 including overtime pay and year-end 13th
month pay shall be tax exempt.

221
 If the exact amount of income taxes had been withheld by the employer for the January
1 to June 30 compensation, Anthony need not file an income tax return. Otherwise, Anthony
shall file an adjustment return reflecting his compensation from January 1 to June 30 and shall
pay the tax still due or claim for refund in case of excess withholding.
This rule may also apply in cases of:
a. Transfer to an employer paying salary at the minimum wage
b. Transfer of employment to a region with higher minimum wage
2. When an employee ceases to be a minimum wage earner during the year due to increase in
salary, only the income for the rest of the year is taxable
Illustration 2
Andrea is a minimum wage earner. She was promoted and was given a salary raise
above the minimum wage starting August 1, 2014. Andrea shall be exempt from income tax
from January 1 to July 31 because she is a minimum wage earner. Effective August 1, 2014,
Andrea shall be subject to tax. The employer shall start deducting the withholding tax on
compensation from Andrea's salaries effective the same date. If the employer properly withheld
the income tax for the period August 1 to December 31, Andrea need not file an income tax
return. Otherwise, she shall file an adjustment return reflecting her compensation from the same
period and shall pay the tax still due or claim for refund in case of excess withholding.
This rule applies in cases of:
a. Transfer to an employer paying salary above the minimum wage
b. Transfer of employment to a region with lower statutory minimum wage
3. When an employee ceases to be a minimum wage earner during the year by disqualification
(i.e. earning taxable income)
Illustration 3
Mr. Jones is a minimum wage earner. During November 2015, he received a one- time
commission of P500. His entire compensation income in 2015 including the minimum wage
shall be subject to income tax. It should be emphasized again that an employee with other
taxable income is not a minimum wage earner even though he or she is a recipient of a
minimum wage.
The employer shall withhold income tax for the salaries of Mr. Jones for the entire year.
In all the three illustrations, if the personal exemption of the employee exceeds their reportable
compensation income, there is no need to file income tax return.

222
Treatment of Cost of Living Allowance of MWEs
Under RMO23-2011, COLA which forms part of the new wage rates prescribed to be the
statutory minimum wage should be treated as part of the minimum wage and shall not be
treated as a separate or other benefit.

The Withholding Tax on Compensation

The withholding tax on compensation is a method of collecting the income tax at source
upon receipt of the income. It applies to all employed individuals whether citizens or aliens. The
employer is constituted as the withholding agent. Reproduced herein is the withholding tax table
for semi-monthly compensation:
Semi- 1 2 3 4 5 6 7 8
monthly
Exemption 0.00 0.00 20.83 104.17 354.17 937.50 2,083.33 5,208.33
Status +0% +5% +10% +15% +20% +25% +30% +32%
over over over over over over over over
Table for employees without qualified dependent children
Z 0.0 1 0 417 1,250 2,917 5,833 10,417 20,833
S/ME 50.0 1 2,083 2,500 3,333 5,000 7,917 12,500 22,917
Table for single / married employee with qualified dependent child(ren)
ME1/S1 75.0 1 3,125 3,542 4,375 6,042 8,958 13,542 23,958
ME2/S2 100.0 1 4,167 4,583 5,417 7,083 10,000 14,583 25,000
ME3/S3 125.0 1 5,208 5,625 6,458 8,125 11,042 15,625 26,042
ME4/S4 150.0 1 6,250 6,667 7,500 9,167 12,083 16,667 27,083
Note:
1. "Z stands for zero-exemption. This is used when employer is not constituted as the primary
withholding agent for an employee with multiple employments.
2. "S/M" stands for single or married employee without dependents. "ME1/S1" stands for
married or single employee with 1 dependent child. "ME2/S2" stands for married or single
employee with 2 dependent children, and so forth.
3. Numbers 1 to 8 are income brackets where the employee income could qualify.

Procedural Computation of The Withholding Tax On Compensation

1. The tax status of the employee (i.e. S/ME, ME1/S1, etc.) is first determined. This row is the
starting point.
2. The regular compensation is traced starting from the status row across the column (i.e. 1 to
8) to determine the maximum amount of income it exceeds. This maximum amount and the
column marginal tax rate are flagged.

223
3. The maximum amount is deducted against the regular compensation. The basic tax for this
maximum amount is located just below the pertinent column line number.
4. Supplemental or additional compensation are added to the excess. The resultant total is
subjected to the column marginal tax rate.
5. The withholding tax due is the sum of the taxes determined in procedures 3 and 4.
For purposes of the withholding tax, 13th month pay and other benefits are excluded
from withholding until they exceed P82,000. The excess of 13th month pay over P82,000 is
treated as supplemental or additional compensation.
Illustration 1
An unmarried employee without qualified dependent is paid semi-monthly. He had the
following income for the first two weeks of December 2015:
Regular compensation P14,000
Supplemental compensation 4,000
13th month pay and other benefits 11,500
The employee is single without a dependent, hence, the status is "S/ME". From the
"S/ME" status row on the semi-monthly withholding tax table, the P14,000 regular
compensation shall be traced across the columns to determine the maximum income it
exceeded. The maximum income exceeded is P12,500 under Column No. 7. The withholding
tax on compensation shall be computed as follows:
Regular compensation income P4,000
Less: Compensation level at Column No. 7 12,500
Excess P1,500
Add: Supplementary compensation 4,000
Total P5,500
Tax on first P12,500 income 2,083.33
Marginal tax on excess (P5,500 x 30%) 1,650.00
Withholding tax for the first half of December 2015 P3,733.33
Note:
1. The "13th month pay and other benefits" is exempt as it is within the P82,000 threshold.
2. The employer shall deduct the withholding tax on compensation from the employee's semi-
monthly pay.
Illustration 2
A married individual with three qualified dependent children is paid semimonthly. He
received a regular compensation income of P12,000 and a supplemental compensation income
of P3,000 on the second half of June 2015. The status of the employee is "ME3/$3". Tracing
from the "ME3/$3" row, the maximum income exceeded is P11,042 under Column No. 6. The
withholding tax on compensation shall be computed as:
Regular compensation income P12,000

224
Less: Compensation level at Column No. 6 11,042
Excess P958
Add: Supplementary compensation P3,000
Total P3,958
Tax on first P11,042 income P937.50
Marginal tax on excess (P3,958 x 25%) 989.50
Withholding tax for the second half of June 2015 P 1,927.00
The procedures discussed herein are applicable for daily, weekly and monthly payroll
periods. Separate withholding tax tables are available for each type of payroll periods. Refer to
the Appendix of the book for the withholding tax tables.

Benefits Not Subject To Withholding Tax On Compensation Under Rr2-98, As Amended.

1. Remunerations received as incidents of employment
2. Remuneration paid for agricultural labor and paid entirely in products of the farm where the
labor is performed
3. Remuneration for domestic services – note that the minimum wage for domestic workers or
"kasambahay" prescribed under Sec. 24, Art. IV of RA 10361 or the Domestic Workers Act
or Batas Kasambahay of 2013 ranges from P1,500 to P2,500 a month too low compared to
the tax exempt minimum wage for commercial, industrial or agricultural workers.
4. Remuneration for casual labor not during an employer's trade or business- treated as other
income
5. Compensation for services by a citizen or resident of the Philippines for a foreign
government or an international organization. Under RMC 31-2013, these are not
compensation income subject to withholding but they are still taxable compensation income,
hence, must be reported by the employee.
6. Damages paid by the employer to employees
7. Proceeds of life insurance
8. Amounts received by an insured employee as a return of premium
9. Compensation for injuries or sickness
10. Income exempts under treaty
11. 13th month pay and other benefits not exceeding P82,000
12. GSIS, SSS, PhilHealth and other contributions
13. Compensation income, including overtime pay, holiday pay, night shift differential pay, and
hazard pay of Minimum Wage Earners
14. Compensation income of employees in the public sector if the same does not exceed those
of minimum wage earners in the non-agricultural sector

225
 These listed benefits are not considered compensation income; hence, exempt from the
withholding tax on compensation.

Deadline of Filing And Remittance Of The Withholding Tax On Compensation

Employers shall file the BIR Form 1601-C (Monthly Remittance Return of Income Taxes
Withheld on Compensation) on or before the 10th day of the following month the withholding
was made except for taxes withheld for December which shall be filed/paid on or before January
15 of the succeeding year. Employers are also required to file BIR Form 1604-CF (Annual
Information Return of Income Taxes Withheld on Compensation and Final Withholding Taxes)
on or before January 31 of the following calendar year in which the compensation income
payments and passive income payments was made.

Penalties for Non-compliance

Employers are subject to the same penalties discussed in Chapter 4 for non-
compliance of withholding tax requirements.

Treatment of Withholding Tax On Compensation

To the employee, the withholding tax on compensation is a tax credit which is deductible
against his consolidated or annual income tax due. If the employee has other items of income
that are subject to regular income tax such as income from business or profession, income from
other employment or casual income, he must file a consolidated income tax return to include
such items of income for the entire taxable year. The withholding tax on compensation is
credited against the total tax due in the consolidated income tax return. If an employee has no
other sources of income subject to regular tax aside from his compensation, he may apply for
substituted filing of tax return.
Substituted Filing of Tax Return
Under the substituted filing system, the employer files the income tax return of the
employee. If the amount of tax is correctly withheld by the employer, the employee no longer
needs to file an annual income tax return.

Self-Test Exercises
Discussion Questions
1. Enumerate and explain the elements of employer-employee relationship.
2. What are the types of employees as to function? Enumerate and explain.

226
 3. What are the types of employees as to taxability? Distinguish each.
4. Who are minimum wage earners? Enumerate their exempt benefits.
5. Who is a special alien?
6. Enumerate and explain the tests for Filipinos to qualify as special alien.
7. Demonstrate the tax model in compensation income.
8. What are the classifications of compensation income? Discuss each.
9. Enumerate the general classes of non-taxable benefits.
10. Enumerate the list of de minimis benefits and their respective threshold.

Exercise Drill: True or False

1. A regular employee is subject to the regular income tax.
2. A consultant is not an employee.
3. A manager has the power to lay down and execute policies.
4. A rank and file employee recommends managerial actions.
5. A special employee may include Filipino citizens.
6. Filipinos employed by international missions are generally exempt.
7. Filipinos working in Philippine embassies are exempt from taxation.
8. A minimum wage earner is exempt from income tax.
9. A special alien is exempt from income tax.
10. Benefits for the advantage of the employee are exempt from income
tax.

227
 CHAPTER XI

FRINGE BENEFIT TAX

Objectives
After the completion of this module, you should be able to comprehend and demonstrate
the knowledge of the following:
 Understanding of the scope of the final fringe benefit tax
 Knowledge of the characteristics of fringe benefits tax
 Understanding of the procedures of fringe benefit tax computation
 Comprehension of the general rules on monetary value
 Mastery of the procedures for the computation of the fringe benefit tax

Fringe Benefits
Under labor laws, fringe benefits pertain to all other benefits or incentives of employees
other than the basic pay. The basic pay is the fixed regular salary or wages of employees every
payroll period. Under the NIRC, the term "fringe benefit" was defined to pertain to goods,
services or other benefits furnished by the employer to the employees.

Tax classification of fringe benefits

Under current tax rules, however, items of fringe benefits in the strict sense are
scattered to the three classes of gross taxable compensation income while some
are exempt from income tax:
For example:
a. Fringe benefits that are fixed every payroll period are considered regular compensation.
For example: Fix transportation allowance
b. Fringe benefits that are variable and performance-based are considered supplemental
compensation. For example: commission, profit sharing and overtime pay
c. Fringe benefits in the form of incentives are considered 13th month pay and other
benefits
d. Fringe benefits furnished for the employer's convenience or necessity are exempt from
income tax

Other Fringe Benefits

228
 As mentioned in the previous chapter, other fringe benefits not included or classifiable as
item of compensation income and which are not exempted under the law are treated as follows:
1. For rank and file employees included as "other benefits" under "13th month pay and other
benefits"
2. For managerial and supervisory employees- excluded in compensation income and are
subjected to final fringe benefit tax

Scope of The Fringe Benefit Tax

The fringe benefit tax covers only the taxable fringe benefits of managerial and
supervisory employees. For purposes of the fringe benefit tax, RR3-98 clarifies that taxable
fringe benefits exclude those items considered as compensation income. Hence, an excellent
understanding of the items of compensation income is very important in highlighting the bounds
between compensation income and the fringe benefits subject to fringe benefit tax.

General Categories of Fringe Benefits Subject To Final Tax

1. Management perquisite benefits
2. Employee personal expenses shouldered by the employer
3. Taxable de minimis benefits
a. Excess de minimis over their limits
b. Benefits not included in the de minimis list

Management Perquisite Benefits

Perquisite benefits, also called "management perks" are highly privileged incentives
given only to a special group of employees. These benefits are non- performance based and
are given as incentives to management employees. Perquisite benefits are not considered as
compensation income but as fringe benefit subject to fringe benefit tax. practice, the boundary
between fringe benefits subject to final tax and compensation income subject to regular tax
sometimes overlapped. Basing on past rulings, however, the BIR seemed to consistently
maintain the view that performance-based benefits are compensation income while benefits
incentive or perks are fringe benefits.
As a safety net, it is therefore best recommended for taxpayers to secure BIR rulings on
the proper treatment of income in their compensation plans to avoid inconvenience.

Employee Personal Expenses

229
 When the expense partake the nature of an employee personal expense or expenditure
and in default of a proximate or direct business necessity but is nevertheless paid or assumed
by the employer, it is deemed fringe benefit in its entirety even if the expense is receipted in the
name of the employer.
Illustration
Mr. Lakewood, a managerial expatriate employee, was granted by his employer with a
P30,000 monthly housing allowance in addition to his regular salary. The actual monthly rent of
Mr. Lakewood's residence is P25,000. The P25,000 personal expense assumed by the
employer constitute a taxable fringe benefit subject to fringe benefit tax. The monthly fixed
P5,000 excess is additional compensation. (BIR Ruling No. 512-2011)

Hybrid expenses
When the employer incurs expenses, which is purported partly for business and partly
for employee's incentive, only 50%% of the expense representing the employee incentive is
subject to the fringe benefit tax. The following are hybrid expenses under RR3-1998:
1. Housing benefits in the form of rental accommodation – when an employer leases a
residential unit for the use of the employee and the business, the rental expense is deemed
half business expense and half fringe benefit to the employee.
2. Allowing an employee free use of business property – when the employer allows its
employee to use business properties, the rental value or depreciation value of the business
property over the period of usage is deemed half business expense and half fringe benefit to
the employee.
Illustration 1
The University of Caceres pays for the P50,000 monthly rental of the residential unit of
its President. The amount of taxable fringe benefits shall be P25,000, computed as 50% x
P50,000.
Illustration 2
A manufacturer and distributor of consumer products all over the Philippines leases cars
and other vehicles for the use of its employees. The company requires employees to share at
least 40% of the monthly rental deductible through their payroll while the company books the
60% as rent expense. The BIR opined that only 10% of the monthly rental is taxable as fringe
benefit since employees shouldered 40% of their 50% counterpart. (BIR Ruling No. 009-2000)

Exempt fringe benefits

230
 The following fringe benefits are exempt to the fringe benefit tax:
1. Fringe benefit which are authorized and exempted from tax under special laws. Examples:
Employer's contribution to SSS, PhilHealth, HDMF or group insurance
2. Benefits required by the nature of, or necessary to the trade, business or profession of the
employer
3. Benefit given for the convenience or advantage of the employer
4. Contributions of the employer for the benefit of the employee to retirement, insurance and
hospitalization benefit plans
5. Benefit given to rank and file employees, whether granted under a collective bargaining
agreement. The taxable fringe benefits of rank and file employees are exempt from fringe
benefit tax but are subject to regular income tax as part of compensation income.
6. De minimis benefits not more than their legal limits

"Necessity or convenience of the employer" rule

If an expense is necessitated by nature of the trade, business or profession of the
employer, or is furnished principally for the employer's convenience or advantage, it is an
ordinary business expense. The personal advantage of the employee is merely incidental to the
expense. These fringe benefits are not viewed as taxable fringe benefits under the NIRC.
Examples of exempt benefits under this rule:
1. Scholarship program for an employee t0 study and acquire competence for future use
of the business
2. Car incentives to medical doctors so they will be available on duty anytime
3. Free transportation services to employees working at distant facilities
4. Mobile phone allowance to corporate secretaries who are required to handle off- duty
client inquiries
5. Sleeping quarters to field engineers and staffs working on remote facilities.
6. Helicopters assigned to fishing employees for locating schools of fish offshore to mining
engineers for mineral exploration purposes
7. Personal aircraft to a chief executive officer managing business affiliates and
subsidiaries spread across different countries
8. Car incentive to a travelling company salesman
9. Sleeping quarters near the camp furnished to military personnel so they will be
available on duty at any time of insurgency

231
 10. Housing units for an employee and his family near the employer's place of business to
ensure the employee's availability anytime when the employer needs him

The Fringe Benefit Tax

The fringe benefit tax is a final tax imposed on the fringe benefit furnished, granted or
paid by the employer to the employee, except rank and file employees, whether Such employer
is an individual, professional partnership or corporation, regardless of whether the corporation is
taxable or not, or the government and its instrumentalities. For the purposes of the fringe benefit
tax, "fringe benefit" means any good, service or other benefits furnished or granted in cash or in
kind by the employer to individual employee(except rank and file employee) such as, but not
limited to, the following:
1. Housing benefits
2. Expense account
3. Vehicles of any kind
4. Household personnel, such as maid, driver or others
5. Interest, for the difference between the market rate (12%) and the actual interest granted
6. Membership fees, dues and other expenses borne by the employer for the employee in
social and athletic clubs or other similar organizations reign travel
7. Expense for)
8. Holiday and vacation expenses
9. Educational assistance to the employee or his dependents
10. Life or health and other non-life insurance premiums or similar accounts more than what the
law allows

Characteristics of The Fringe Benefit Tax

Final tax
The fringe benefit tax is a final tax which is withheld by the employer at source. Thus, the
employee need not report the fringe benefits in his income tax return.

Tax upon managerial or supervisory employee

The fringe benefit tax is not a tax to the employer. It is a tax upon the fringe benefit
realized by the managerial or supervisory employee. It is a tax to the employee; hence, it
applies regardless of the identity of the employer. Therefore, it applies even if the employer is a
sole proprietor, partnership, corporation, whether taxable or exempt, or the government.

232
Paid by the employer
As a final tax, the tax is withheld at source and will be remitted by the employer to the
government.

Grossed-up tax
The monetary value or the amount of fringe benefit realized or taken home by the
employee is effectively net of the final tax which is to be withheld at source. Hence, the
monetary value is first grossed-up by the complement percentage of the applicable fringe
benefit tax rate before the fringe benefit tax rate is applied.

Due quarterly
The fringe benefit tax is due for remittance quarterly based on the accounting period
(fiscal or calendar) selected by the employer. The monetary value of each taxable fringe benefit
is determined and reported quarterly through BIR Form 1603.
The quarterly fringe benefit tax is due as follows:
Manual filing EFPS filing
On or before the 10th day of the month On or before the 15th day of the month
following the quarter in which withholding was following the quarter in which withholding was
made made

Procedures In Computing The Fringe Benefit Tax

1. Determine the monetary value.
Monetary Value
Monetary value refers to the taxable amount of benefits taken home or realized by the
managerial or supervisory employee. The monetary value is presumed net of the final tax.
2. Determine the gross-up rate and fringe benefit tax rate applicable for the taxpayer.
The gross up rate is the complement of the fringe benefit tax rate. If the fringe benefit tax
rate is 32%, the gross-up rate is (100% less 32%) or 68%. If the fringe benefit tax rate is 25%,
the gross-up rate is 75%.
3. Determine the grossed-up monetary value by dividing the monetary value be the gross-up
rate.
4. Determine the fringe benefit tax by multiplying the fringe benefit tax rate to the grossed-up
monetary value.

233
Rules on Valuation of Fringe Benefits
1. When benefit is given in cash or paid for in cash, the monetary value is the amount paid for
in cash.
Note: The only exception here is when the employer pays for the rent of the residence of the
employee. Monetary value is 50% of the rental payment.
2. When benefit is given in kind, the monetary value is the fair value of the thing given unless
its book value is higher. Book value is the cost less any provision for depreciation for
depreciable properties. Simply stated, the monetary value is the fair value, or the book value
of the thing given, whichever is higher. When ownership over the property is transferred to
the employee, the monetary value is the entire fair value of the property even if the property
is partially used in the business of the employer.
3. When the benefit is given in the form of free use of the employer's property, the monetary
value is 50% of the rental value of the property. If the property has no rental value, the
depreciation value is used.
For purposes of the depreciation value, the presumptive useful lives of the property are:
a. 20 years for real properties. Hence, the depreciation value is computed as 1/20 or 5% of the
value of the property.
b. 5 years for movable properties. Hence, the depreciation value is computed as 1/5 or 20% of
the value of the property.
Since the fringe benefit tax is paid quarterly, the valuation and reporting of monetary
value is also done quarterly. In case of use of employer properties, the reporting of monetary
value ceases from the month the free use is discontinued.
Illustration: Determination of depreciation value
A partnership transferred the use of a property with a fair value of P2,000,000 to its
supervisor. The annual depreciation value shall be:
1. If the property is an immovable such as residential unit, the annual depreciation value shall
be P100,000, computed as P2,000,000 x 5%.
2. If the property is movable such as car or other motor vehicles, the annual depreciation value
shall be P400,000, computed as P2,000,000 x 20%.
In quarterly reporting for the fringe benefit tax, the quarterly monetary value is
determined by dividing the annual value by 4.

Special Guidelines on Monetary Value Determination

Taxable Housing Benefits

234
1. Employer leases a residential property for the use of his employee and the said property is
the usual residence of the employee.
Monetary value = 50% of the benefit
Illustration
A sole proprietorship business leases a residential house and lot for the use of his
business manager for P20,000/month. The monetary value shall be:
Quarterly value = (P20,000 x 3 months) = P 60,000
Quarterly monetary value = P 60,000 x 50% = P 30,000
2. Employer owns a residential property and assigns the same for the use of his employee as
his usual place of residence, the annual value of the benefit is 5%of whichever is higher of
the zonal or assessed value of the land and improvement.
Monetary value = 50% of the annual value of the benefit
Illustration
Chamberly, Inc. allowed one of its unused realty investment costing P3,500,000 with
zonal value of P4,000,000 and assessed value of P3,000,000 to be used by its vice president.
The monetary value shall be determined as:
Annual depreciation value = P4,000,000 x 5% P200,000
Quarterly value = P200,000/4 quarters P50,000
Quarterly monetary value = P50,000 x 50% P25,000
3. The employer purchases a residential property on installment basis and allows his employee
to use the same as his usual place of residence, the annual value is 5% or 1/20 of the
acquisition cost, exclusive of interest. This is the same with No. 2 except that the basis is the
purchase price of the property.
Monetary value = 509% of the annual value of the benefit
Illustration
Cotabato Corporation purchased a residential property for the use of its production
manager. The property is payable over 11 annual installments of P200,000 including interests
but have cash price of P2,000,000. For accounting purposes, Cotabato Corporation opted to
capitalize the interest and recorded the P2,200,000 contract price as acquisition cost of the
property. The monetary value shall be determined as:
Annual depreciation value = P2,000,000 x 5% P 100,000
Quarterly value = P100,000/4 quarters P 25,000
Quarterly monetary value = P25,000 x 50% P 12.500
Note: The purchase price is the cost net of interest
4. Purchase by the employer of residential property and transfer of ownership in the name of
the employee, the value of the benefit is whichever is higher of the acquisition cost or zonal
value

235
 Monetary value = 100% of the value of the benefit
Illustration
A non-profit corporation bought a residential dwelling for P5,000,000 and transferred
ownership to its president. The property has P3,000,000 zonal value. Since there is transfer of
ownership, the monetary value is the entire P5,000,000, the higher of book value(i.e. cost in this
case) and zonal value.
5. Purchase by employer of property and transfer of title to employee for less than adequate
consideration, the value is [(fair market value or zonal value, whichever is higher) less
consideration paid by employee
Monetary value = 100% of the value of the benefit
Illustration
Denzy, a professional practitioner, transferred his residential property in the name of his
managerial employee for P2,000,000. The property has fair value per tax declaration of
P3,400,000 and P5,000,000 zonal value. Since there is a transfer of ownership (i.e. title), the
monetary value is P3,000,000, computed as P5,000,000 fair value less the P2,000,000
consideration paid.
Exempt housing privileges:
1. Military officials of the Armed Forces of the Philippines (AFP), Philippine Air Force (PAF),
Philippine Army, Philippine Navy on their quarters which are within or accessible from the
military camp so they can be readily available on call to meet the exigencies of their military
service.
2. Housing unit situated or adjacent to the premises of a business or factory (within a
maximum of 50 meters) from the perimeter of the business premises. The 50-meter rule
may be relaxed when upon the basis of health or safety requirements such as in the case of
chemical manufacturing, the housing needs to be located at a farther location.
3. Temporary housing for an employee in a housing unit for 3 months or less (i.e. not
exceeding one quarter)
Expense Account
Expense incurred by an employee, but which are paid by his employer or incurred and
paid by employee but reimbursed or advanced by the employer are taxable fringe benefits. The
monetary value is the amount paid by the employer.

Properly documented employer expense

236
 When the expense is receipted for and in the name of the employer and the expenditure
do not partake the nature of a personal expense attributable to the employee, it is not a taxable
fringe benefit. It is a business expense. Personal expenses of the employee such as groceries
for the personal consumption of the employee and or his family, if paid or reimbursed by the
employer, are taxable fringe benefits whether receipted in the name of the employer. Fixed and
regular RATA are treated as part of regular compensation income and are subjected to
creditable withholding taxes not to fringe benefit tax.
Illustration
Denver Corporation paid for the following expenses which were liquidated by its
managerial employee
Water and electricity bill at manager's home P15,000
Meals and groceries at manager's home 18,000
Bill on business telephone 2,000
Bill on personal phone 1,000
Transportation - office to and from clients 12,000
Transportation - office to and from manager's home 10,000
Foods and beverages for visiting business clients 8,000
The monetary value of fringe benefits shall be computed as:
Water and electricity bill at director's home P15,000
Meals and groceries at director's home 18,000
Bill on personal phone 1,000
Transportation - office to home 10,000
Total monetary value P44,000
Note: Business telephone bill, office to client transportation and food and beverages for client
visitors are business expenses - not fringe benefits to the manager.

Motor Vehicles of Any Kind

1. Purchase by employer of motor vehicle in the name of the employee regardless of whether
the same is used partially in the business of the employer
Monetary value = 100% of the cost of the motor vehicle
Note that the monetary value shall be reported in the quarter of purchase.
2. Cash benefit to employee for the purchase of vehicle, even if the vehicle is partly used in the
business of the employer. Monetary value = 100% of the cash benefit, except when the
amount is subjected to withholding tax on compensation. Car benefits that are paid in cash
and are subjected to withholding tax on Compensation are subject to regular tax not to
fringe benefit tax. If subject to fringe benefit tax, the monetary value shall be reported in the
quarter of payment.

237
3. Purchase of car on installment basis by the employer with ownership placed in the name of
the employee even if the car is used partly for the employer's business, the benefit is the
acquisition cost divided by 5 years.
Monetary value = (1/5) or 20% of the acquisition cost
Illustration
An employer purchased a car for P1,000,000 payable in four installments plus 10%
interest on the outstanding unpaid balance of the car. The entire acquisition cost shall be
recognized as monetary value since there is transfer of ownership, but the regulation requires
amortization over 5 years. Hence, the employer shall recognize P1,000,000/5 or P200,000
monetary value annually until five years. For every quarter, the employer shall report
P200,000/4 or P50,000 monetary value until the cost is fully reported over 5 years.
4. Employer shoulders a portion and is placed in the name of the employee, even if partially
used in business.
Monetary value = the portion shouldered by the employee
Illustration
An employer assisted its managerial employee to purchase a brand-new car for
P4,000,000. 60% of the value is deductible against future salaries of the managerial employee.
The monetary value shall be P1,600,000 computed as P4,000,000 x 40% representing the
portion shouldered by the employer. This will be reported in the quarter the employer's share is
paid.
5. Fleet of motor vehicles owned for the use of the business and the employees, the value of
benefit is the cost of all motor vehicles not used for sales, freight, delivery service and other
non-personal uses divided by 5 years.
Monetary value = 50% of the value of benefit
It should be noted that the cost of motor vehicles not used in business is amortized over
5 years. There being no transfer of title, 50% of the benefit is recognizable as monetary value.
The quarterly recognition of monetary value continues until the free usage is terminated.
It must be noted that because of the inherent difficulty of tracing the realization of the
fringe benefits to a particular employee considering the collective enjoyment of the benefit by
the employees (managerial, supervisory or possibly including rank and file alike), the regulations
simply subjected it to the final fringe benefit tax.
6. Fleet of motor vehicles leased for the use of the business and the employee, the value of
the benefits is the rental payments for motor vehicles not normally used for sales, freight,
delivery, service and other non-personal use.

238
 Monetary value = 50% of the value of the benefit
7. Aircrafts including helicopters are deemed solely for business use; hence, not subject to
fringe benefit tax.
8. Yacht whether owned and maintained or leased by the employer are presumed not for
business use; hence, taxable fringe benefit. If owned or maintained, the value of the benefit
is measured as the depreciation value over 20 years
Illustration
Assume a corporation acquired a P10,000,000 yacht for the use of its executives. The
monetary value shall be determined as:
Annual depreciation value = P10,000,000/20 P500,000
Quarterly monetary value = P500,000/4 P125,000
Yacht is considered immovable by it is fixed and cannot be removed on water. Hence,
the 20-year presumptive useful life for real properties is used. If this is leased, the entire rental
payment is the monetary value. Note that the 50% rule is not applied by the regulation.
Supposing the yacht is purchased and transferred in the name of the executive, the monetary
value shall be the entire P10,000,000.
Note on aircraft and yacht
The high cost of ownership of aircrafts makes it inherently prohibitive or impractical to be
for personal use. Thus, aircrafts are deemed by the regulations as solely for business use;
hence, exempt from fringe benefit tax. Yachts, though pricey on the other hand, generally lack
any sensible business purpose aside from being for personal pleasure; hence, its depreciation
value is subject to fringe benefit tax in full.
Exceptionally, if the yacht is used solely for the entertainment of guests or prospective
clients, it is not be subject to the fringe benefit tax. In this case, the depreciation of the yacht
qualifies as "entertainment, amusement and recreation expense".
Household Expenses
Employee expenses borne by the employer for household personnel, salaries of
household help, personal driver of the employee, and other personal expenses such as
homeowners association dues, garbage dues, electricity, and water are taxable fringe benefit.
The monetary value is the amount paid.
Illustration
Henesy Corporation granted the following benefits to a managerial employee:
Salary of household personnel P12,000/month
Salary of personal driver 10,000/month
Homeowner’s association dues 4,000/year
The quarterly monetary value of the benefit shall be determined as:

239
Salary of household personnel P12,000 x3 P36,000
Salary of personal driver P10,000 x3 30,000
Homeowner’s association dues* P4,000/4 1,000
P 67,000
Note: A year is composed of 4 quarters.

Interest on Loan at Less than Market Rate

The interest forgone by the employer representing the difference between 12% and the
actual interest charged is a taxable fringe benefit.
Illustration
Europa Cooperative lent its chief executive officer P1,000,000 at a minimal 3% annual
interest rate. The monetary value shall be computed as:
Annual monetary value = (12%-3%) x P1,000,000 P90,000
Quarterly monetary values = P 90,000/4 P22,500

Membership fees, dues and other expenses borne by the employer for his employees, in
social and athletic clubs or other similar organizations constitute taxable fringe benefit. The
monetary value is the amount paid.

Expenses for Foreign Travel

Reasonable business expenses for foreign travel for attending business meetings and
conventions are exempt.
 In land travel expenses: Food, beverage and local transportation, except lodging costs,
amounting to an average of $300 or less per day - exempt
 Lodging costs exempt
 Economy and business class airplane ticket – exempt
 First class ticket - 30% of ticket cost is presumed fringe benefit

240
Substantiation Requirement
The above rules apply if the expenses were supported by documentations proving actual
occurrences or the meeting or convention; otherwise, it shall be subject to fringe benefit tax.
 Business meetings – must be supported by official communication from business
associates abroad indicating purpose of the meeting
 Business conventions – must be supported by official invitation or communication from the
host organization or entity abroad
Expenses for the family members of employee shouldered by the employer are taxable
fringe benefit in full.
Illustration
MIG, Inc. allowed its VP Finance, Mr. Lasuna, to attend a convention abroad with the
privilege to bring his wife. The expenses of the foreign travel were:
Mr. Lasuna Mrs. Lasuna Total
First class plane ticket P70,000 P70,000 P140,000
Lodging cost 60,000 60,000 120,000
Foods & local transportation* 50,000 50,000 100,000
P180,000 P180,000 P360,000
The applicable exchange rate is P40:$1 - P40 x $250 x 5 days each to Mr. and Mrs.
Lasuna. The monetary value shall be determined as:
Items Remarks Amount
First class plane ticket
Mr. Lasuna P70,000 x 30% P21,000
Mrs. Lasuna P70,000 x 100% 70,000
Lodging cost
Mr. Lasuna Exempt 0
Mrs. Lasuna Fully taxable 60,000
Foods & local transportation*
Mr. Lasuna Exempt – below limit 0
Mrs. Lasuna Fully taxable 50,000
Total monetary value P201,000

241
Holiday And Vacation Expense
Holiday and vacation expenses are taxable fringe benefit if shouldered by the employer.
The monetary value is the amount paid or shouldered by the employer.

Educational Assistance To The Employee or His Dependents

Educational assistance to the employee is generally taxable, except when it is incurred
for the convenience or furtherance of the employer s business, such as:
1. the education or study is directly connected with the employer's trade, business or
profession; and
2. there is a written contract (i.e. employee bond) that the employee is under obligation to
remain at the employ of the employer for a period for time they mutually agreed
Educational assistance granted to dependents of the employee is generally taxable,
except, when the assistance was provided through a competitive scheme under a scholarship
program of the company.
Illustration
Cleopatra Marketing, a distributor of cosmetics products, provides educational
assistance to the following employee under an employment bond:
Position Field of study Amount per semester
VP for Management Doctor in Business P50,000
Administration
VP for Marketing Master’s in marketing 35,000
management
Operations manager B.S. Cosmetology 25,000
Accounting supervisor B.S. Criminology 24,000
Accounting staff B.S. Accountancy 20,000
Only the tuition fee of the accounting supervisor is subject to fringe benefit tax and shall
be reported in the quarters it is paid. Even if covered by an employee bond, his field of study is
neither related to the nature of his job nor to the employer's business. The fringe benefit of all
the other employees will neither be subject to the fringe benefit tax nor the regular income tax
under the "convenience of the employer" rule.

Life or health insurance and other non-life insurance premiums or similar amounts more
than what the law allows
These are taxable fringe benefits, except the following insurance or premium
contributions allowed or required by law:
1. Contributions of the employer for the benefit of the employee, in pursuant to the provisions
of existing law such as contributions to SSS, GSIS, PhilHealth and HDMF

242
2. Cost of premium for group insurance df employees
Illustration
Queensdale Company made the following insurance premium payments during a
calendar quarter:
 P30,000 premium for the life insurance of the Chief Executive Officer (CE0) with
Queensdale Company as the beneficiary of the policy
 P20,000 premium for the life insurance of the Company Chief Operating Officer (COO) with
his wife as the beneficiary
 P15,000 insurance premium of the personal car of the company manager
 P40,000 premium for group insurance of employees
 P80,000 premium share in SSS, PhilHealth and Pag-Ibig dues of employees
 P10,000 fire insurance premium for the company building
The quarterly monetary value of fringe benefit shall be computed as:
Life insurance premium of CO0 where his wife is the beneficiary P20,000
Car insurance of company manager 15,000
Quarterly monetary value P35,000
Note:
1. The insurance premium on the life of the CEO where the company itself is the beneficiary is
not a fringe benefit to the executive employee but a business expense.
2. Group insurance premiums and those required by special laws are not taxable.
3. The premium for fire insurance on company building is a business expense.

Fringe Benefit Tax Rates

The fringe benefit tax rates are as follows:
Type of employee
Residents or Special
Year Non-resident aliens
citizens* Aliens
1998 34% 15% 25%
1999 33% 15% 25%
2000 and thereafter 32% 15% 25%
*Includes resident citizens, non-resident citizens and resident aliens

Grossed-Up Monetary Value

The basis of the fringe benefit tax is the grossed-up monetary value of the fringe benefit.
The grossed-up monetary value is the monetary value of benefits divided by the appropriate
grossed-up rate for the employee. The grossed-up monetary value is inclusive of the fringe
benefit tax. The following are the grossed-up rate:

243
 Type of employee
Residents or Special
Year Non-resident aliens
citizens* Aliens
1998 66% 85% 75%
1999 67% 85% 75%
2000 and thereafter 68% 85% 75%
Illustration
Assume an employer grants fringe benefits with monetary value of P54,400 to a resident
citizen managerial employee. The grossed-up monetary value is computed as P54,400/68% = P
80.000. If the employee is a special alien, the grossed-up monetary value shall be computed as
P54,400/85% = P64.000.
Illustrations: Fringe Benefit Tax Computations
Illustration 1: Citizens or Residents
In the last quarter of 2014, Alexander, a Filipino supervisory employee, was given
P13,600 worth of groceries for personal use.
Monetary value P13,600
Grossed-up monetary value P13,000/68% 20,000
Fringe benefit tax P20,000x 32% P6,400
Alternatively, the fringe benefit tax can be directly computed as P13,600 x 32%/68%.
Illustration 2: Special Alien
An offshore banking unit (OBU) reimbursed the following personal expenses of its
managerial employee during a calendar quarter:
Golf club membership dues - 100% in the name of P10,000
the employer
Groceries - 50% in the name of the employer 36,000
Homeowners association dues 5,000
Total 51,000
Monetary value 51,000
Grossed-up monetary value P51,000/85% P 60,000
Fringe benefit tax P60,000 x 15% P9,000.00
Note:
1. The fringe benefit tax can be computed directly as P60,000 x15%/85%.
2. Personal expenses are taxable fringe benefits in full even if they are receipted, in full or in
part, in the name of the employer.
Illustration 3: Non-resident alien
On January 2014, Cyberspace Company purchased a P3,000,000 car and designated it
for the personal use its non-resident alien executive.
Monetary value (P3,000,000/5) x 50% P300,000
Quarterly value (P300,000/4) P75,000
Quarterly grossed-up monetary value (P75,000/75%) P100,000
Quarterly fringe benefit tax (P100,000 x 25%) P25,000

244
Note:
1. The fringe benefit tax continues to be payable for as long as the employee uses the property
for personal use and or business use.
2. The quarterly fringe benefit tax can be directly computed as P75,000 x 25%/75%.

Accounting Entries
Accounting entries shall be classified as follows:
1. Taxable benefits paid for in cash or in kind
2. Taxable benefits which do not involve payment of cash or transfer of property
3. Exempt benefits paid for in cash or in kind
4. Exempt benefits which do not involve payment of cash or transfer of property

Benefits Paid For In Cash Or In Kind

Taxpayers shall record fringe benefits paid for in cash or in kind in their books as follows:
Fringe benefit expense (monetary value) xxx
Fringe benefit tax expense xxx
Cash/Tax basis of property given xxx
Fringe benefit tax payable xxx
Illustration 1: Rental Accommodation
Plato Corporation paid P54,400 for the rental of a housing unit for the use of its
president.
Fringe benefit expense (monetary value) P54,400
Fringe benefit tax expense 12,800
Cash P54,400
Fringe benefit tax payable 12,800
Fringe benefit tax = [(P54,400 x 50%)/68%] x 32%
Illustration 2: Transfer of Ownership Over Properties
Aristotle Company transferred ownership over a newly acquired investment property
Costing P1,428,000 as residence of its supervisory employee. The property has a zonal value of
P1,700,000.
Fringe benefit expense (monetary value) P1,428,000
Fringe benefit tax expense (P1.7Mx32%/68%) 800,000
Investment property P1,428,000
Fringe benefit tax payable 800,000

Benefits which do not involve payment of cash or properties

Taxpayers shall record fringe benefits without outflow of cash or properties in
their books as follows:

245
Fringe benefit expense (monetary value) xxx
Fringe benefit tax payable xxx
Illustration 1: Free Usage of Assets
Homer Realty, Inc. designated a unit of its condominium property for the use of its vice
president for finance as his family residence. The rental value of the unit for the past calendar
quarter would have been P340,000.
Fringe benefit expense P80,000
Investment property P80,000
Fringe benefit tax = [(P340,000 x 50%)/68%]x32%
Note that the employer is not allowed to claim fringe benefit expense. A deductible
expense needs to be an actual outflow or depletion of resources. Anyway, the employer can
claim depreciation expense if the property is an ordinary asset. In case of capital asset where
no depreciation is allowable, fringe benefit tax rules shall not inappropriately allow the claim of
deduction.
Illustration 2: Interest Free Loans
Petro drill, an oil exploration company, granted a P1,000,000 interest free loan to its
managerial employee considered a special alien.
Fringe benefit expense P21,176
Investment property P21,176
Fringe benefit tax = [(P1,000,000 x 12%])/85%)x15%
Note also that the interest expense is not recognized as a fringe benefit expense
because it is not an expense involving actual payment or transfer of properties.
Exempt benefits paid for in cash or in kind
The taxpayer shall record exempt fringe benefits paid in cash or in kind as follows:
Fringe benefit expense (monetary value) xxx
Cash/Property given xxx
Illustration: Exempt Transfer
An employer paid P120,000 for the tuition fee of its supervisor who is taking
advancement course in furtherance of the employer's business.
Fringe benefit expense P120,000
Cash P120,000

Exempt benefits which do not involved payment of cash or transfer of property

No entry is required.

Tax Treatment of the Total Fringe Benefit Expense

The total fringe benefit expense including the fringe benefit tax expense is a deductible
expense to the employer against his gross income in the computation of his taxable income. It

246
must be noted that a deductible fringe benefit expense exists only when the benefit is paid in
cash or in kind.

Self-Test Exercises
Discussion Questions
1. Enumerate the components of taxable compensation income.
2. Discuss the general categories of fringe benefits.
3. Discuss the two-tax treatment of fringe benefits.
4. What types of employee benefits are subject to the fringe benefit taxes?
5. Discuss the 50% rule on hybrid expense.
6. What are the two exceptions to the 50% rule.
7. Enumerate the fringe benefits exempt from the fringe benefits tax.
8. Enumerate and discuss the characteristics of fringe benefit tax.
9. Enumerate the procedures in computing the fringe benefit tax.
10. Discuss the general rules on monetary value.

Exercise Drill: True or False

1. Fringe benefits are always subject to fringe benefit tax.
2. The tax base of the fringe benefit tax is the grossed-up monetary value of
the fringe benefit.
3. The taxable fringe benefit subject to the fringe benefit tax is the excess of
the de minimis benefits over P82,000.
4. Managerial or supervisory employees are subject to fringe benefit tax.
5. Rank and file employees may be subject to fringe benefit tax.
6. The fringe benefit tax is a creditable withholding tax presumed to have
been withheld at source by the employer from fringe benefits of
supervisory or managerial employees.
7. The personal expenses of employees shouldered by the employer are
fringe benefits.
8. Half of the benefits that are necessary to the trade of the employer’s
business are subject to fringe benefit tax.
9. Benefits provided by the employer for his convenience is exempt from
fringe benefit tax.
10. Benefits in the form of properties transferred in the name of the employee
are subject to fringe benefit tax in full.

247
 CHAPTER XII

PRINCIPLES OF DEDUCTIONS

Objectives
After the completion of this module, you should be able to comprehend and demonstrate
the knowledge of the following:
 Distinction of business expense from a personal expense
 Concept of an expense and a capital expenditure
 Mastery of the different depreciation methods and the special considerations on
deductions
 General principles of deductions
 Tax reporting of deductions

Deductions From Gross Income

Deductions from gross income pertain to business expenses incurred by a taxpayer
engaged in business or engaged in the practice of profession.

What is a business?
Business means habitual engagement in a commercial activity involving the regular sale
of goods and services to customers or clients. In taxation, the term "business" is generally used
to include the exercise of a profession. Self-employment is a busines, but employment is not a
business.

Business Expense vs. Personal Expense

Business expenses are costs of doing trade, business or practice of profession such as
employee salaries, office utilities, supplies and rent, taxes, losses, bad debts, depreciation on
business properties, research and development and the like. Personal expenses include the
living and family expenses of individual taxpayers such as family food, personal recreation and
transportation, medication, home rentals and utilities, tuition fees of dependents and other
similar expenses. The separation of the business expenses and the personal expenses of an
individual income taxpayer is important because only business expenses are deductible. The
personal exemption allowed by law is in lieu of all personal expenses of individual taxpayers.
Hence, personal expenses are non-deductible

248
Allocation of common expenses
Expenses that are intended for both the business and for personal use of the taxpayer
are allocated between the two. Only those that pertain to the business are deductible.
Illustration 1
A taxpayer borrowed money from a bank and used 60% of the proceeds to finance the
construction of his house and the remaining 40% as working capital for his business. He later
paid P10,000 in interest. Only 60% of the interest expense (P6,000) shall be considered
personal expense while the P4,000 is considered business expense.
Illustration 2
A taxpayer engaged in trading business is renting a two-story warehouse for P40,000 a
month. He used the lower floor to store merchandise and the upper floor as his residence. In
this case, half of the rent pertaining to the lower floor is a business expense while the other half
of the rent is a personal expense.

Business Expense vs. Business Capital Expenditure

Business expenses benefit only the current accounting period. They are costs of
generating income or gains for the current period. Hence, they are deductible against gross
income in the current period.

Examples of expenses:
1. Salaries and wages expense
2. Utilities expense such as electricity, telephone, internet, gas and water
3. Selling expenses, such as delivery and commission expense
4. Rent
5. Local taxes and permits
Capital expenditures are expenses that benefit future accounting periods. They are
initially recorded as assets upon acquisition then later deducted against future gross income
when used in the trade, business or profession of the taxpayer. The advanced deduction of
capital expenditures is not warranted as it contradicts the Lifeblood Doctrine.
Examples of capital expenditures:
1. Items of property, plant and equipment
2. Inventory
3. Investments
4. Prepayments

249
5. Acquisition of intangible assets such as patent or franchise, including costs of defending the
same in court
6. Expenses to promote business goodwill
7. Rentals on capital lease or finance lease that transfers ownership
Property, plant and equipment pertain to all types of properties used or reserved for use
in the business of the taxpayer such as:
1. Land - used currently or intended to be used in the business
2. Depreciable properties
a. Land improvements such as fences, benches and roads
b. Building
c. Building improvements such as installed escalator or elevator
d. Machineries and equipment
e. Furniture and fixtures
f. Leasehold improvements
Depreciable properties pertain to those that decrease in value through normal
wear and tear by usage or through obsolescence by the passage of time.
Inventory includes merchandise intended for sale. It may also include tools and supplies
used by the taxpayer in his business. Investments are assets purchased which are intended to
earn from appreciation in value or for accrual of income such as dividends and interest.
Examples of investments:
a. Lands held for appreciation in value
b. Stocks, bonds and other securities of another corporation

Acquisition of Intangible Properties

The acquisition of intangible assets such as patent and franchise constitute capital
expenditure that must be amortized (deducted) over the period they are expected to be used.

Expenses To Promote Business Goodwill

Expenses incurred to create or maintain some form of goodwill for the taxpayer's trade
or business or for the industry or profession of which the taxpayer is a member are non-
deductible. The term goodwill is used generally to denote the benefit arising from connection
and reputation in business.
Efforts to establish reputation are akin to acquisition of capital assets and, therefore,
expenses related thereto are not business expenses but capital expenditures. (Atlas Mining and

250
Development Corp. vs. Commissioner of Internal Revenue) These expenditures are expected to
benefit future periods; hence, should be amortized over the period of years during which the
benefits of the expenditures are realized.

Rental Payments on Finance Lease That Transfers Ownership

Rentals on a finance lease or capital lease that transfers ownership at the end of the
lease term, commonly known as rent-to-Own arrangement are not considered expense. The
rentals constitute acquisition cost of the leased property that should be initially capitalized. The
capitalized cost shall be depreciated throughout the useful life of the property.

Rules on Deducting Capital Expenditures

1. Non-depreciable asset
The cost of assets that do not depreciate by usage or by passage of time such as land is
deducted against the selling price when sold.
2. Depreciable properties
The "depreciable cost" or the acquisition cost, net of expected salvage value, is
allocated as deduction over the useful life the property. The useful life of the property is the
length of time it is expected to be serviceable or its legal life, if applicable, whichever is lower.
Note that the law requires maximum usage life on certain items of properties such as vessels or
aircrafts after which they must be de-commissioned from use.

Useful Life and Depreciation Rate

Under Sec. 34(F)(3) of the NIRC, the taxpayer and the CIR may enter into a written
agreement on the estimated useful life and rate of depreciation of any property. Such
agreement shall be binding on both the taxpayer and the Government in the absence of facts
and circumstances not taken into consideration during the adoption of the agreement. Any
change in the agreed rate and useful life shall be applied prospectively starting on the taxable
period when notice by certified mail or registered mail is rendered by the initiating party to the
other party.

Depreciation methods
The taxpayer may choose from the following methods:
a. Straight line method
b. Sum-of-the-years-digit method

251
c. Declining balance method (150% or 200%)
d. Other methods which may be prescribed by the Secretary of Finance upon
recommendation of the Commissioner

Straight line method

The depreciable cost is simply spread equally over the useful life. The annual
depreciation expense is computed as:
Acquisition cost - salvage value) / useful life in years
Alternatively, the straight-line depreciation rate may be computed as a fraction of one
over the useful life in years. The depreciation rate is multiplied to the depreciable cost of the
property to arrive at the depreciation expense.
Illustration
On January 1, 2014, a taxpayer acquired P6,000,000 building with P1,000,000
salvage value at the end of its 5-year expected useful life. The annual straight-line rate is 1/5 or
20%. The annual depreciation expense shall be P1,000,000, computed as P5,000,000 x 20% or
P5,000,000/5.

Sum-of-the -years-digit method

The depreciation charge is computed as a fraction of the remaining useful life over the
total of the annual remaining useful life of the asset.
Illustration
A taxpayer bought a machine for P120,000 and is expected to be sold P20,000 net of
selling expense after its 4-year estimated useful life. The depreciable cost is P100,000,
computed as (P120,000 - P20,000). The divisor is first determined as the sum of the annual
remaining useful life. Hence, 4 +3 +2 + 1 10. For simplicity, this arithmetic series is computed
using the following formula: n x (n + 1)/2, where "n" is the useful life of the asset. Hence, 4 x
(4+1)/2 equals 10. The depreciation expense for each period is computed based on the
depreciable amount as follows:
Depreciation expense Book value at year-end
First year: 4/10 x P100,000 P 40,000 P 80,000
Second year: 3/10 x P100,000 P 30,000 P 50,000
Third year: 2/10 x P100,000 P 20,000 P 30,000
Fourth year: 1/10 x P100,000 P 10,000 P 20,000
The "book value" or carrying value is the acquisition cost less periodic depreciation.
Book value is referred to as adjusted tax basis in taxation. The same shall equal the salvage
value at the end of the useful life of the machine.

252
Declining Balance Method
A declining rate not exceeding double of the straight-line rate is applied to the book
value of the property. For every period, depreciation expense is computed by multiplying the
depreciation rate to the declining book value of the property. The salvage value is initially
ignored in computing depreciation expense but is considered in the terminal year of the
property. The 150% declining balance and the double declining balance are more common in
practice. Under the 150% declining rate and double declining rate the depreciation rate is
determined by multiplying the straight-line rate by 150% and 200%, respectively.
Illustration
In January 2, 2014, a taxpayer purchased an equipment for P500,000 which is estimated
to last for 5 years with P50,000 salvage value. The taxpayer uses the double declining balance
method of depreciation. The depreciation rate is computed by multiplying the straight-line rate
1/5, by 200%; hence, 40%. The periodic depreciation expense and adjusted tax basis is
computed as:
Depreciation expense Year-end adjusted tax basis
2014: 40% x P500,000 P 200,000 P 300,000
2015: 40% x P300,000 P 120,000 P 180,000
2016: 40% x P180,000 P 72,000 P 108,000
2017: 40% x P108,000 P 43,200 P 64,800
2018: (P64,800- P50,000) P 14,800 P 50,000
Note: The provision for depreciation expense in the terminal year shall not result in a tax basis
less than the residual value. Hence, the depreciation expense is merely an adjustment of the
remaining book value to the salvage value.

Disposal of Properties Before Full Depreciation

If the property is disposed before it gets fully depreciated, its book value is deducted
against the selling price of the sale. If the property is destroyed, its book value is recognized as
an ordinary loss.
3. Intangible assets
Amortizable intangible assets or those that lose their value over time should be
expensed over their legal life or expected usage life, whichever is lower. Intangible assets that
do not lose their value such as franchise of public utility vehicles shall not be amortized.
4. Inventory
For goods inventory and supplies, their costs are deducted when sold or used in the
business using the inventory method or the specific identification method with the aid of a Point-
of-Sale (POS) machine.

253
Illustration: The Inventory method
California Corporation had the following data pertaining to its inventory:
Gross purchases P2,500,000
In-transit freight and insurance 50,000
Purchase returns and discounts 100,000
The beginning and ending inventories during the year were P250,000 and P340,000,
respectively. The cost of goods sold shall be computed as:
Beginning inventory P250,000
Add: Net purchases
Gross purchases P2,500,000
Add: freight in and insurance 50,000
Less: purchase returns and discounts 100,000 2,450,000
Total goods available for sale P2,700,000
Less: Ending inventory 340,000
Cost of goods sold/cost of sales P2,360,000
Cost of goods sold shall include the purchase price or cost to produce the merchandise
and all expenses directly incurred in bringing them to their present location and use. The same
computational procedure is employed with supplies and tools, but the resultant figure is referred
to as "supplies expense. The inventory method is applicable to taxpayer using either cash basis
or accrual basis. Note that the expensing of purchase cost of inventory or supplies normally do
not properly reflect the income of the taxpayer, unless the fluctuation in inventory levels is
immaterial. This may expose the taxpayer to risk of income re-computation and assessment by
the CIR.

Presentation in the Income Tax Return

The cost of goods sold is deducted outright from gross sales in the measurement of the
gross income from operations.
5. Prepaid expenses
Prepayments are deducted in the future period as they expire or as they are used in the
business or profession of the taxpayer. The advanced deduction of prepayments, if material in
amount, will cause significant distortion in income; hence, not allowed.
Illustration
In 2012, Zefra, Inc. paid P300,000 3-year advanced rental for the lease of a building to
commence 2013 through 2015. To close the lease contract, Zefra also paid the lessor a lease
bonus of P30,000. The P30,000 lease bonus is not an expense but a prepayment that should be
amortized together with the P300,000 prepaid rentals. These should be amortized a P110,000
annual rent expense from 2013 to 2015.

254
Immaterial Capital Expenditures
The acquisition of items of property, plant and equipment, inventories or prepayments of
expenses which are relatively immaterial in amount may be deducted outright as expense upon
acquisition as this will not materially distort net income. Moreover, the inventory method may
likewise be impractical to use for such items.

Special Considerations With Deductions

1. Property repairs and improvements
2. Property acquisition-related costs
3. Securities issue costs
4. Manufacturing expenses
5. Effects of accounting methods

Property Repairs And Improvements

Repairs that significantly increase the value or prolong the useful life of properties are
capital expenditures. These are capitalized to the adjusted tax basis of the property and are
included in the subsequent annual provision for depreciation. Repairs that merely restore the
value or functionality of the property without causing increase in fair value or useful life of the
property shall be deducted as outright expense. If the fair value of the property increases due to
repairs, improvements additions, the actual cost of the repairs, improvements or additions
should be capitalized not to exceed the appreciation in fair value. If the fair value of the property
is not determinable, the excess of the actual repair cost over the tax basis of the property is
presumed a capitalizable increase in fair value. Improvements and additions to properties
normally increase the value or useful of life of properties; hence, capitalized and depreciated.
Illustration
The building of BCorp with a carrying value of P1,000,000 was partially dilapidated
through long usage. A repair of P500,000 was made on the property.
Case 1: No increase in property value or useful life
The P500,000 repair is deductible as "repair expense". The tax basis of the property
remains at P1,000,000.
Case 2: Property fair value increased to P1,800,000 after the repair
The entire P500,000 repair is capitalizable since it is less than the P800,000
appreciation in fair value. The adjusted tax basis of the property for purposes of future provision
of depreciation expense shall be P1,500,000.

255
Case 3: Property fair value increased to P1,400,000 after the repair
The P500,000 repair cost shall be capitalized only to the extent of the P400,000 increase
in fair value. The excess P100,000 repair cost is expensed. The adjusted basis of the property
for future depreciation shall be P1,400,0000.
Case 4: P1,200,000 repair cost was made to restore the property; fair value after repair is
unknown
P1,000,000 is deductible as repairs expense while the excess P200,000 is a
capitalizable improvement. The adjusted tax basis of the property shall be P1,200,000. The
same principles apply in case of repairs of properties due to partial destruction by fire, storm
and other calamities; except that, the deductible repair cost is presented as a "loss".
Case 5: No increase in fair value but with increase in useful life
The P500,000 will be capitalized. The adjusted basis for future depreciation shall be
P1,500,000.

Replacements of old or destroyed properties

The tax basis of the old property is deductible as a loss but the cost of the as
replacement property is capitalized subject to future provisions for depreciation.
Illustration
The office building of Andrix Corporation with a carrying value of P4,000,000 was
destroyed by an earthquake. The same was replaced with a new building total cost of
P8,000,000. The P4,000,000 is deductible as loss while the P8,000,000 is capitalized as the tax
basis of the new building subject to future provision for depreciation.

Cost of Demolishing Old Building

When land was acquired with an old building in it but was not intended to be used by the
buyer, the entire amount paid is assigned only to the land. The costs of demolishing the old
building, net of any salvage scrap, are treated as additional cost of acquisition of the land. The
cost of razing or removing an old building to give way for the erection of another in its place is
not a deductible expense but capitalized as part of the cost of the replacement building.
(Priscilla Estate vs. CTA)
Illustration
Determined to be insufficient for business use, the 2-storey building of Benguet
Corporation was decided to be replaced by a 9-storey building. The 2-storey building with a
P1,500,000 carrying value was razed at a cost of P600,000. A 9-storey building was constructed

256
in its place for P12,000,000. The P1,500,000 carrying value of the old building shall be deducted
as a loss. The cost of the 9-storey building shall be P12,600,000, inclusive of the demolition cost
of the old building.

Asset Acquisition-Related Costs

All costs directly related to the acquisition of an item of property, plant and equipment
such as in transit insurance, title guarantee insurance, freight, finder's fee or commissions,
import duties, and other taxes (excluding VAT for a VAT taxpayer) are capitalized as part of the
cost of the property subject to depreciation.
Expenses incurred which are directly related to the acquisition of goods such as
transportation, broker's commissions and insurance in transit including those incurred in
bringing the goods for sale such as consignment freight-out are capitalized to the cost of the
goods and are expensed through cost of goods sold when sold. Cost of financing asset
acquisition (i.e. interest expense) may, at the option of the taxpayer, be expensed outright or
capitalized and depreciated.

Security Issue Costs

Expenses of issuing equity or debt securities (i.e. stock or bonds) such as cost of
registering shares of stock to the Securities and Exchange Commission (SEC), cost of printing
bond or stock certificates, or brokers commission on selling stocks or bonds, are not deductible
expense against gross income. They are deducted against the proceeds of such securities.

Manufacturing Expenses
Plant or factory expenses such as cost of raw materials and supplies used, labor, and
other overheads like plant utilities, maintenance and security, supplies and depreciation are
capitalized as part of the cost of the goods being processed and are expensed through cost of
sales when sold.
The cost of goods sold of a manufacturing firm is computed as:
Raw materials, beginning PXXX,XXX
Add: Net purchases XXX,XXX
Raw materials available for use PXXX,XXX
Less: Raw materials, ending XXX,XXX
Raw materials used PXXX,XXX
Direct labor (direct workers' salaries) XXX,XXX
Factory overhead (all other plant costs) XXX,XXX
Total manufacturing costs PXXX,XXX
Add: Cost of work in-process, beginning XXX,XXX

257
Total cost of goods placed into process PXXX,XXX
Less: Costs of work in-process, ending [Link]
Cost of goods manufactured (finished) PXXX,XXX
Add: Cost of finished goods, beginning XXX,XXX
Total cost of goods available for sale PXXX,XXX
Less: Cost of finished goods, end XXX,XXX
Cost of goods sold PXXXXXX
Illustration
A manufacturing firm had the following data in March:
March 1 March 31
Finished goods (undelivered work orders) P 150,000 P 110,000
Work-in-process (unfinished work orders) 380,000 250,000
Raw materials 30,000 45,000
The following costs and expenses were incurred during March:
Total raw materials purchases 140,000
Factory supplies used 30,000
Factory salaries and wages 600,000
Factory utilities expenses (gas, water and electricity) 70,000
Machinery repair and maintenance 20,000
Plant depreciation 100,000
Office utilities 80,000
Office building depreciation 50,000
Administrative salaries 120,000
Sales salaries 50,000
Commission expenses 20,000

Non-Manufacturing Costs - Administrative And Selling Expenses

Non-manufacturing expenses commonly classified as administrative expenses and
selling expenses in financial accounting should be expensed as incurred or paid depending on
the accounting method adopted by the taxpayer:
Administrative expenses:
Office utilities P 80,000
Office building depreciation 50,000
Administrative salaries 120.000
Total deductible administrative expenses P 250,000
Selling expenses:
Sales salaries P 50,000
Commission expenses 20.000
Total deductible selling expenses P 70.0000

Manufacturing costs
Manufacturing expenses should not be expensed outright but are capitalized to inventory
then expensed through cost of goods sold.
Cost of goods sold:
Raw materials, beginning P30,000

258
Raw materials purchased 140,000
Less: raw materials, ending 45,000
Raw materials used P 125,000
Conversion costs:
Factory labor P 600,000
Factory supplies 30,000
Factory utilities expense 70,000
Machinery repair & maintenance 20,000
Plant depreciation expense 100,000 820,0000
Total manufacturing costs P 945,000
Add: In-process work, beginning 380,000
Total manufacturing costs placed to process P1,325,000
Less: In-process work, ending 250,000
Cost of goods finished, this period P1,075,000
Add: Finished goods, beginning 150,000
Total goods available for sale P1,225,000
Less: Finished goods, ending 110,000
P1,115.000
Like trading firms, the cost of goods sold of manufacturing firms is deducted against
sales in determining the reportable gross income from operations.

Effect of Accounting Method On Deductions

The methods adopted by the taxpayer in accounting for expense have a significant
bearing on the deductible expense. It must be recalled that under the cash basis, expenses are
deductible when paid regardless of when they accrue while under the accrual basis, expenses
are deductible when they accrue regardless of when they are paid. However, prepayments and
capital expenditures cannot be deducted outright.
Under the cash basis, deductions shall be composed of the following:
Cash expenses (paid) P XXX,XXX
Amortization of prepayments XXX,XXX
Depreciation of properties XXX,XXX
Cash basis deductions P XXX,XXX
Under the accrual basis, deductions shall be composed of the following:
Accrued expenses (paid or unpaid) P XXX,XXX
Amortization of prepayments XXX,XXX
Depreciation of properties XXX,XXX
Accrual basis deductions P XXX,XXX
Illustration
Xhelsy Corporation had the following items of expense and expenditures in 2015:
Purchase of equipment (paid in cash) P200,000
Freight on purchase of equipment (paid in cash) 20,000
2015 salaries expenses paid this period (cash expense) 50,000
Supplies bought in 2014, half is used in 2015 16,000
Depreciation expense on property 24,000

259
2015 expenses, not paid this period (accrued expense) 12,000
2016 expenses, paid this period (prepaid expense) 18,000
Required: Determine the total deductions under:
1. Cash basis of accounting
2. Accrual basis of accounting
Solution:
Cash Basis Deductions
Salaries expense (cash expense) P 50,000
Supplies expense (P16,000 x 1/2) 8,000
Depreciation expense 24.000
Total deductible expenses P 82,000
Note:
1. Accrued expenses are not deductible under cash basis.
2. Capital expenditures and prepaid expenses cannot be deducted in the current period but in
the future period they relate.

Accrual Basis Deductions

Salaries expense (cash expense) P 50,000
Supplies expense 8,000
Depreciation expense 24,000
Accrued expense 12,000
Total deductible expenses P 94,000
Note:
1. Note that the accrued expenses are also deductible.
2. Prepayments and capital expenditure items such as the cost of equipment, the acquisition
related freight costs and the prepaid expense are excluded.

General Principles of Deductions From Gross Income

1. Expenses must be legitimate, ordinary, actual and necessary (LOAN)
2. The Matching Principle - only business expenses which contribute to, or are incurred in
connection with, the generation of income, gain or profits subject to regular income tax are
deductible.
3. The Related Party Rule - in case of transactions between related parties, gains are taxable,
but losses are not deductible. Also, in pursuant to the transfer pricing rule, non-arm’s length
expenses incurred between associated enterprises may be restated to their arm length fair
values to reflect the correct income of each of the associated enterprises.

260
4. The Withholding Rule - no deduction is allowed unless the creditable withholding tax
required by the law or regulations to be withheld on the income payment (i.e. expense) is
withheld by the taxpayer.

The "Loan" Principle

A deductible business expense is legitimate, ordinary, actual and necessary.

Characteristics of a legitimate business expense:

1. It is incurred in and for the current taxable period
2. It is not a capital expenditure
3. It pertains to the business or profession of the taxpayer
4. It is not contrary to law, public policy or morals. Examples: Bribes, kickbacks to government
officials, payment to police officers for protection (Calanoc vs. CIR), and revolutionary taxes
to rebels are held no deductible illegal payments.
5. It is adequately substantiated with receipts or other documents
Illustration
A taxpayer compiled the following payments:
Salaries of employees P 400,000
Maintenance repair of office building 100,000
Renovation cost of an old building 200,000
Purchase of new equipment 150,000
Bribes to government officials to win business deals 200,000
Dividend distributions to shareholders 400,000
Only salaries and maintenance are deductible. The renovation cost and purchase of
equipment are capital expenditures claimable through depreciation. Bribe is a non-deductible
illegal payment. The dividend is not an expense but a distribution of corporate profit.

What is an ordinary and necessary expense?

An expense is necessary if reasonable and essential to the development, management,
operation or conduct of the trade, business or exercise of profession of the taxpayer. It is
"ordinary" when it is a payment which is normal in relation to the business of the taxpayer and
the surrounding circumstances. (Atlas vs. CIR) An expense is also said to be ordinary if it is
normally incurred by other taxpayers under the same line of business. A deductible expense
must be both ordinary and necessary.
An ordinary business expense may still be disallowed by the BIR if unnecessary or
unnecessarily extravagant or unreasonable talking into consideration the context of the expense

261
and the nature of the taxpayer's business. An extraordinary expense is presumed incurred
outside the business of the taxpayer; hence, non-deductible. However, extraordinary expense
may be allowed if its connection and necessity to the business can be demonstrated by the
taxpayer.

Factors in assessing reasonableness

There is no fixed test or clear-cut criteria in determining reasonableness of an expense.
In CIR vs. General Foods (Phils), Inc., it was held that reasonableness will be judged on the
interplay of many factors such as, but not limited to the following:
1. Type and size of business in which the taxpayer is engaged;
2. Volume and amount of its net earnings;
3. Nature of the expenditure itself;
4. Intention of the taxpayer; and
5. General economic conditions.
The burden of proof of establishing the validity and reasonableness of an expense rests
upon the taxpayer and not upon the taxing authority.

What is meant by actual expense?

An expense is actual if it is paid or resulted to an incurrence of an obligation to the
taxpayer.
In case of a loss, it must be sustained or realized by the taxpayer in a closed and
completed transaction.

Meaning of "closed and completed transaction"

A transaction is said to be closed and completed when no further transaction emanates
from its occurrence. In other words, no right of recourse for indemnification or reimbursement
from other parties exists. For example, a fire loss on insured property cannot be said to have
been sustained in a closed and completed transaction because its occurrence gives rise to
another transaction - the claim for reimbursement.
The loss is considered incurred in a closed and completed transaction only when final
reimbursement is received from the insurer. Furthermore, a loss on lawsuit cannot be said to
have been sustained in a closed and completed transaction until final judgment is rendered
without expectation of further appeal.

262
Examples of non-deductible expense under this rule:
1. Decrease in value of properties or investments, such as:
a. Decrease in value of securities such as stocks or bonds
b. Decrease in value of foreign currencies or foreign currency denominated receivables
c. Decrease in value of machineries, equipment and building brought by obsolescence
2. Estimated future losses, such as:
a. Estimated loss on bad debts or uncollectible receivables
b. Estimated loss on lawsuit not yet confirmed by a final judgment
3. Loss on properties covered with insurance or indemnity contracts
These losses are merely temporary and may reverse until they become sustained upon
final settlement by the insurer.

The Matching Principle

It is a well-established rule in income taxation that only business expenses that are
incurred for the generation of items of gross income subject to regular tax deductible. This is a
pervasive criterion that is consistently observed by the NIRC including revenue regulations and
BIR rulings. Let us refer to this rule as "Matching Principle." Business expenses incurred to
generate items of gross income that are either exempt or excluded from taxation, subject to final
tax or capital gains tax or to a special tax regime must not be matched or deducted against
gross income subject to regular tax.

Examples of non-deductible expenses under this rule:

1. Expense on exempt income
a. Expenses incurred to finance the acquisition of a tax-exempt security
b. Premiums paid for the life insurance of an officer where the taxpayer-business itself is
the beneficiary. The proceeds from such insurance arrangement is tax exempt, hence,
the premium expense is not deductible. However, if the beneficiary is other than the
employer, the same shall be deductible as fringe benefit expense.
c. Expense on EFCDU or OBU from foreign currency operation. Expanded foreign
currency deposit units (EFCDU) or Offshore Banking Units (OBUs) are exempt from
regular income tax on their income from foreign currency transactions in the Philippines.
Hence, OBU and EFCDU expenses from exempt operations cannot be deducted against
their items of gross income subject to regular income tax.

263
 d. Expenses of non-profit organizations, government agencies, and cooperatives from their
exempt operations cannot be deducted within their gross income subject to regular tax.
2. Expenses on income subject to a special tax regime
a. Expenses of new enterprises registered with the Tourism Infrastructure and Enterprise
Zone Authority (TIEZA). Under RA 9593, newly registered enterprises of the TIEZA is
subject to a 5% gross income tax in lieu of all other national and local taxes, license fees
imposts, assessments, except real estate taxes and such fees as may be imposed by
the TIEZA.
b. Expenses of enterprises registered with the Philippine Economic Zone Authority. Under
RA 7916, registered enterprises in special economic zones (ECOZONES) are subject to
5% gross income tax on their registered operations in lieu of all taxes, national or local,
except real property taxes on land.
The expenses of these businesses in connection with their operations subject to the 5%
gross income tax are non-deductible against their gross income subject too
regular income tax.
3. Business expenses of taxpayers subject to final income tax, such as:
a. Non-resident alien, not engaged in trade or business
b. Non-resident foreign corporations
These taxpayers are not subject to regular income tax; hence, they cannot claim
deductions of whatever nature.
4. Expenses and taxes on income subject to final tax or capital gains tax
a. Selling expenses of domestic stocks directly to buyer
b. Selling expenses of real properties classified as capital assets
c. Expenses of petroleum service subcontractors in supplying goods and services to
petroleum service operators
In pursuant to PD 1354, the gross income derived by subcontractors with petroleum
service contractors is subject to 8% final tax in lieu of all taxes national or local.
5. Foreign business expenses of taxpayers taxable only on Philippine income, such as:
a. Resident alien and non-resident alien engaged in trade or business in the Philippines
b. Resident foreign corporations
The foreign income of these taxpayers is not included in gross income for Philippine
taxation purposes. Hence, their foreign expenses shall not be deductible, unless the same are
incurred in connection with their Philippine business.
6. Loss of income not yet recognized in gross income

264
 a. Write-off of receivable under the cash basis of accounting
b. Destruction of unharvested farm fruits or vegetables
c. Death of animal offspring
The Related Party Rule
Gains realized between related parties are taxable, but losses are non- deductible. The
rule is intended as a control measure since related party transactions can be easily tailored in a
way to evade taxes. This rule is particularly relevant in the claim of losses, bad debts and
interest expense.
Who are related parties?
1. Members of a family
2. Except in cases of distribution in liquidation, the direct or indirect controlling individual of
a corporation
3. Except in cases of distribution in liquidation, corporations under direct or indirect
common control by or for the same individual
4. Grantor and fiduciary of any trust
5. Fiduciary of a trust and the beneficiary of such trust
6. Fiduciaries of trusts with the same grantor
Members of a family includes brothers and sisters (whether half-blood or full blood)
spouse, lineal ascendants and descendants.
Control means ownership of more than 1 of the voting stocks of a corporation.
Illustration 1: Corporations

Mr. Lanao owns 60% of Misamis Corporation and 30% of Basilan Company. Misamis
owns 70% of Compostela Company and 80% of Surigao Company. Compostela owns 55% of
Cotabato, Inc. Surigao Company also owns 40% of Davao Company.
Note:

265
1. The related parties are indicated in bold font. Transactions between any of these taxpayers,
either inter-company or involving Mr. Lanao, the ultimate controlling individual, are
transactions between related parties.
2. There being absence of control, Basilan and Davao are not related between themselves and
to the group of affiliated corporations.
3. In liquidation, all shareholders, related or unrelated, may realize actual losses on their
investments. Hence, liquidation losses incurred from a related party are deductible.
Illustration 2: Trusts
Mr. Sarangani designated three trusts under management of different trustees. Trust 1 is
in favor of Agus as beneficiary while Trust 2 and Trust 3 are in favor of Cami as beneficiary. The
trusts are irrevocably designated, except Trust No.3.

Note:
1. The fiduciaries of all the trusts are related to Mr. Sarangani.
2. The fiduciaries of Trust 2 and Trust 3 are related because the trust they managed are for the
same beneficiary.
3. Agus is related to the fiduciary of Trust 1 but not to those fiduciaries of Trust 2 and Trust 3.
4. Cami is related to the fiduciaries of Trust 2 and Trust 3 but is not related to the fiduciary or
Trust 1.
5. Agus, Canmi and Mr. Sarangani are not related, except when they are members of a family.

Transfer Pricing Regulation

Transactions between associated enterprises must be made at arms' length. Pursuant to
RR2-2013, the BIR may restate the price of a non-arm's length expense between associated or
related enterprises to their arm's length fair value comparable to those entered by independent
enterprises. The amount determined as arm's length value shall be the deductible amount for
purposes of income tax.

266
The Withholding Rule
The business or professional practice must withhold (pre-deduct) any required final
taxes or creditable withholding taxes upon his income payments (i.e. expenses) and remit the
same to the government. Non-withholding shall render the expense non-deductible.
List of expenses subject to withholding taxes:
a. Compensation expense - BIR Form 1601-C
b. Fringe benefits expense BIR Form 1601-F
c. Passive expenses (i.e. passive income to payees subject to final tax) BIR Form 1601-F
d. Expenses subject to the expanded withholding taxes - BIR Form 1604-E
Please refer to Appendix 3 of the book for the list of income payments that are subject to
the expanded withholding taxes.
The business or professional practice must release to the recipient of the income
payments (i.e. payee) copies of evidence of the withholding:
a. BIR Form 2306 (Certificate official tax withheld at source) or
b. BIR Form 2307 (Certificate of creditable tax withheld at source)
BIR Form 2307 shall be treated by the payee as his tax credit against his total regular
income tax due. In cases where no withholding is made, no deduction will be allowed
notwithstanding the payment of the withholding tax by the taxpayer at the time of the audit
investigation or reinvestigation/reconsideration. For income payments exempt from creditable
withholding tax such as salaries payments to minimum wage earners, the taxpayer must have to
comply with certain documentary requirements required by the BIR for the expense to be
deductible.

Since tax withholding is made only when expense is paid, does this mean that expenses
are deductible only when paid?
The NIRC recognized both the accrual basis and the withholding rule. The withholding
rule should not be interpreted to eliminate the use of the accrual basis on expenses. Some
practitioners are into the belief that the withholding rule applies only to the income payments
covered by the expanded withholding tax. While this may be true, there would be no problem if
deduction for accrued expense is allowed in the period of accrual but the same must be
reverted to gross income if the taxpayer tailed to withhold upon payment. This treatment
reconciles these two rules without causing drastic changes to both.

Period For Which Deductions And Credits Are Taken

267
 The deductions shall be taken for the taxable year paid or accrued depending upon the
method of accounting employed by the taxpayer, unless to clearly reflect the income, the
deductions should be taken as of a different period. (Sec. 45, NIRC)

Non-Deductible Expenses
The NIRC lists the following non-deductible expenses:
1. Personal, living or family expenses
2. Amount paid out for new buildings or for permanent, or betterments made to increase the
value of any property or estate
3. Any amount expended in restoring property or in making good the exhaustion thereof
4. Premiums paid on any life insurance policy covering the life of any officer or employee, or
any person financially interested in any trade or business carried on by the taxpayer,
individually or corporate, when the taxpayer is directly or indirectly a beneficiary under such
policy

Tax Reporting Classification Of Deductions

1. Cost of sales or cost of services
2. Regular allowable itemized deductions
3. Special allowable itemized deductions
4. Net Operating Loss Carry Over (NOLCO)
5. Cost of sales or cost of services is deducted outright against sales, revenues, receipts or
fees of individual taxpayers in the measurement of gross income from operations.
Regular allowable itemized deductions pertain to all necessary and ordinary expenses
paid or incurred during the taxable year including directly attributable costs in carrying on the
development, management, operation and/or conduct or the trade, business or exercise of
profession. It must be noted that expenses that are directly related to the rendering services or
in the acquisition of goods are excluded in the regular allowable itemized deductions and are
included in "cost of sales" or "cost of services as the case may be. Expenses which are not
directly related to the acquisition of goods or provision of services are included in regular
allowable itemized deductions. These include administrative expenses and selling expenses.
Special allowable itemized deductions are additional deductions as provided under the NIRC or
special laws. Special allowable deductions can be categorized into two types:
1. Actual compliance expense
2. Deduction incentives

268
 Compliance expenses are actual payments or transfers of funds. Deduction incentives
are not actual expenses but are merely allowed by law to encourage taxpayer to support
government programs. Net Operating Loss Carry-Over (NOLCO) pertains to the excess of
deductions over gross income during a taxable year which is allowed by the law to be deducted
against the net income of the following three years.

Mode of Claiming Deductions From Gross Income

1. Itemized deductions
2. Optional standard deductions
Itemized Deductions
Under the itemized deductions, the taxpayer lists every item of business expense he
claims as deduction. Deductions are strictly construed against the taxpayer. The taxpayer has to
point to the provision of the law authorizing the deduction, substantiates his claim by supporting
the deduction with official receipts, payment vouchers, cancelled checks or other adequate
records and documentations, and complies with any withholding tax requirements on expenses.
Deductions claimed must also comply with any applicable deduction ceilings set by law.
Optional Standard Deductions
The optional standard deduction is in lieu of the itemized deductions, regular or special,
including NOLCO. The deduction is merely presumed as a fixed percentage of gross income for
corporations and gross sales or gross receipts for individuals.

Self-Test Exercises
Discussion Questions
1. Distinguish a business expense and a personal expense.
2. Distinguish an expense from a capital expenditure.
3. Discuss how depreciable and non-depreciable assets are expensed.
4. Explain the inventory method for inventory and supplies.
5. Enumerate the common depreciation methods used in practice. Distinguish how
depreciation is computed under each method.
6. Distinguish how is intangible assets expensed.
7. Illustrate the computation of the cost of goods manufactured and sold.
8. Discuss how repairs and asset-related acquisition costs are accounted for.
9. How does accrual expense and cash basis expense differ?
10. Enumerate and discuss the four general principles of deductions.

269
 Exercise Drill: True or False
1. Capital expenditures are deductible against future income.
2. Personal expenses are deductible from gross income.
3. Losses on properties not used in business may be deducted but only
to the extent of capital gains.
4. Expenses intended for the business and the personal use of the
taxpayer must be allocated between the two. Only a portion pertaining
to the business is deductible.
5. The expenses of defending a patient is a business expense
deductible in the current period.
6. Supplies and inventories are expensed using the inventory method.
7. The cost of investments and land are deductible against their
proceeds in the year of sale.
8. The entire cost of depreciable properties is deductible against the
proceeds in the year of sale.
9. The depreciation of a property revaluation gain is deductible.
10. Prepaid expenses are deductible upon payment consistent to the rule
that advanced incomes are taxable upon receipt.

References:

 Banggawan, R. (2015) Income Taation. Laws, Principles, and Applications. Real Excellence
Publishing.

270