Taxable Income: Definition and Sources

• Income is legally defined as money received by a person, including payments for services, interest, or investment profits, and gains from capital assets sales.
• For income tax, income means any material gain realized from a closed transaction where economic value is exchanged, including tangible and intangible assets.
• Taxable income includes all wealth flowing to the taxpayer, not just returns of capital.

Income vs. Capital, Receipt, and Revenue

• Capital is a fund; income is the flow from that fund.
• Gross receipt includes both income and capital, making it broader than income.
• Revenue is funds the government gets from taxes, loans, grants, etc., similar to income for individuals.

Sources and Definition of Taxable Income

• Income comes from labor, services, capital use (including land), and profits from selling capital assets.
• Taxable income is gross income items specified in the Tax Code, minus authorized deductions.

Taxability Requirements

• There must be a gain or profit.
• The gain must be realized or received, aligning with revenue recognition principles, but some tax laws need cash method reporting.
• Increases in property value are not income until the property is sold at a higher price than its cost basis.
• The gain must not be excluded by law or treaties.

About Income Tax

• Income tax is levied on income from property or labor and is used to support the government.
• It is a direct tax on persons based on their income, either gross or net, at a basic or final rate.
• It is a national, excise, direct, and general tax.
• Purposes include raising revenue, offsetting regressive taxes, and reducing wealth inequality through progressive taxation.
• Basis in imposing income tax:
  • Payment of taxes is based on benefits received from public services.
  • Taxpayers support the government based on their ability to share the tax burden.
• Factors Affecting the Basis of Income Tax:
  • Nature of income
  • Situs (location) of income sources
  • Types of taxpayer
  • Residence and citizenship of the taxpayer

Basis of Taxability & Types of Tax Payers

• Taxability for individuals depends on citizenship, residence, and income source location.
• For corporations, it depends on whether they are domestic or foreign and if foreign, whether resident or nonresident.
• Income taxpayers include individuals, trusts, estates, and corporations.
• Individual Taxpayers
• Residence and Citizenship:
  • Resident citizen
  • Nonresident citizen
  • Resident alien
  • Nonresident alien engaged or not engaged in trade or business
  • Special alien employees of multinational companies, offshore banking units, and petroleum service contractors.
• Income Received:
  • Individuals earning purely compensation income
  • Self-employed individuals
  • Mixed-income earners
• Corporation Taxpayers
• Domestic:
  • Ordinary or Special
• Foreign:
  • Resident or Nonresident
  • Ordinary or special

Income Tax Coverage (NIRC)

• Resident citizens are taxed on worldwide income.
• Nonresident citizens (including OCWs) are taxed only on Philippine-sourced income.
• Resident or nonresident aliens are taxed only on Philippine-sourced income.
• Domestic corporations are taxed on worldwide income.
• Foreign corporations are taxed only on Philippine-sourced income.

Principles of Income Taxation

• Philippine residents are taxed on all income, worldwide.
• Non-residents are taxed only on income from within the Philippines.
• Overseas Filipino workers are taxed only on income from within the Philippines.
• All foreign income of seamen is excluded from income tax.
• Resident or not, aliens are taxed only on income from within the Philippines.
• Domestic corporations are taxed on all income, worldwide.
• Foreign corporations are taxed only on income from within the Philippines.

Income Taxation Systems

• Global System
  • Tax system treats all taxable income the same way.
  • Taxpayers report all income in one return, taxed under the same rules.
  • Taxes all income except passive incomes and capital gains.
• Schedular System
  • Tax rates vary based on income type.
  • It uses separate returns for each income type, providing different tax treatments.
  • Income from different sources is treated separately.
  • Categorizes income from different sources.
• Based on aggregate income that are not subject to final income tax.
• Taxable corporations adopt a global system that taxes income at 20-25%.
• Individual taxpayers use the schedular tax system.

Income Items

• Items Subject to Income Tax
  • Compensation
  • Business or professional gross income
  • Property gains
  • Interests
  • Rents
  • Royalties
  • Dividends
  • Annuities
  • Prizes and Winnings
  • Pensions
  • Partner's share of professional partnership income

Compensation Income

• Compensation includes all employee remunerations unless excluded by the Tax Code.
• If paid in cash, it is measured at face value.
• If paid in kind, it is measured at the asset's fair market value.
• Services rendered at a stipulated price are based on the agreed price, absent contrary evidence.
• Compensation in stock is measured at the stock's fair market value when services were rendered.
• Payment in discounted notes is equivalent to the discounted value at receipt.
• Payment in non discounted notes is measured at its face value at the time of receipt.
• Debt cancellations in exchange for services are compensation income.
• Creditor condoning debt without service is subject to donor's tax versus income tax.
• Corporate creditor condoning stockholder debt is a taxable dividend.
• Free living quarters are not taxable if for the employer's convenience; otherwise, it’s taxable up to the amount exceeding the employee's reasonable needs
• Convenience of the employer rule- allowances are furnished to the employee for necessary incidents and not taxable.
• Premiums paid by the employer for the employee's family under a life insurance policy is taxable income to the employee.
• Income tax paid by the employer for the employee is taxable income to the employee.
• Compensation income earned partly within and partly without the Philippines is allocated based on service time.

Income within the Philippines = (Days of work in the Philippines / Total days of work) * Total Compensation

• Hidilyn Diaz Illustration
  • Salary cash: P280,000
  • Discounted value of notes: P200,000
  • Honda Civic fair value: P1,800,000
  • Total taxable income: P2,280,000
  • The discount on notes is reported in the year of receipt (2024).
  • Prizes from international sports competitions are tax-exempt.
  • Fair value of items is compensation for endorsing products are taxable.
  • Accounts payable condoned is subject to donor's tax, not income tax.

Income From Trade, Business or Profession

a. Merchandising, Manufacturing, or Mining Business

Gross income = Total sales - Cost of goods sold + peripheral income

b. Long-term Contracts

• Long-term contracts are construction, installation, or building contracts lasting over a year.
• Income can be reported using:
  • Percentage of completion method
  • Output Method of NIRC based on engineering survey output
  • Upon completion of the contract
• Manggagawa Builders Illustration:
• Percentage of completion Method*
  • Determine the percentage of completion via cost-incurred ratio. Percentage of completion = (Cost incurred to date) / (Cost incurred to date - Estimated cost to complete)
  • Multiply the percentage of completion by the contract price.
  • Deduct revenue from prior years to get current year revenue.
  • Determine the costs incurred each year.
  • Deduct incurred costs from revenue recognized each year.
• Completed Contract Method*
• The gross income for the work should report in the year as the construction is completed.

c. Gross Income from Farming

• Farming includes stock, dairy, poultry, fruit, truck farms, plantations, ranches, and all land for farming operations.
• Farmers are those who cultivate, operate, or manage farms for gain or profit.
  • Methods of Reporting Gross Income from Farming: - Cash Basis: - Income is realized upon cash receipt (or equivalents). - Only paid expenses are claimed as deductions. - Used by non-regular bookkeepers. - Accrual Basis: - Income is reported when earned. - Expenses are accounted for when incurred. - Crop Year Basis: - Applicable only for long-term crops. - Expenses are deductible in the year the crop is sold.
• Gains from Dealings in Property include all income derived from the disposition of property for money in case of sale, or for property in case of exchange -Measurement of gain or loss. - Gain or loss is the difference between the selling price and the appropriate basis of the property given up -For property acquired by purchased on or before March 13, 1913, the basis is the cost. -For property acquired through inheritance, the basis is the fair market value as of the date of acquisition. -For property acquired through donation, the basis is the same as it would be in the hands of the donor. -For property acquired for inadequate consideration, the basis is the amount paid by the transfer for the property.
• Interest - refers to the amount of compensation paid for the use of money or forbearance from such use. It includes such interest arising from indebtedness, whether business or non-business, legal or illegal, usurious, or not.
• Rental income refers to the amount of compensation paid for the use or enjoyment of a thing or right.
  • Rental income includes obligations that should have been paid by the lessor to the 3rd party but paid by the lessee.
• Income will only be realized in the event that the lessee violates any provision of the contract.
• The value of permanent leasehold improvements made by a lessee on the leased property that will become the property of the lessor at the end of the lease term:
• Outright method – income from improvements is reported at the time such improvements are completed based on the FMV on such date.
• Spread-out method

Depreciated value = Cost of improvement x Excess useful life over the remaining lease term/ The useful life of the improvement

   - Under the outright method, the calculation for the entire fair value should recognize the increase of the improvement as gross income upon the completion of the improvement in 2023.
   - Under the spread-out method the income from the value is,

Income from the improvement= Depreciated value/ 8 years of remaining lease term = ₱562,500

 - The sharing in earnings derived from the invention, book publication, musical composition, or literary.

dividends comprise any distribution, whether in cash or property, in the ordinary course of business, even though extraordinary in amount, made by a domestic or resident foreign corporation, joint-stock company, partnership, joint account, association, or insurance company to the shareholders or members out of its earnings or profits.

• annuities these refer to annuity policies sold by insurance companies that provide installment payments for life or for a guaranteed fixed period of time, whichever is longer or for life and a guaranteed fixed period. The portion of each annuity payment that represents the return of premium is not taxable while that portion that represents interest is taxable.
• prizes and winnings refers to the amount of money in cash or in kind received by chance or through luck and is generally taxable except if specifically mentioned under exclusion from gross income.
• pension refers to the amount of money received in a lump sum or on a staggered basis in consideration of services rendered. These are given after the individual reaches that age of retirement.
• These are given after the individual reaches that age of retirement. It is taxable to the extent of the amount received except if there is an approved pension plan by the BIR. Partnership Distributive Profits of the Gross income of General Professional Partnership (GPP)

General professional partnerships are partnerships formed by persons for the sole purpose of exercising their common profession, no part of that is derived from the engaging income.A general professional partnership shall not be subject to income tax but the partners in GPP shall be liable for income tax only in their separate and individual capacities.

• Income from other Sources
  1. Illegal gains – refer to gains arising from gambling, betting, and lotteries. Gain from illegal transactions such as extortion or fraud is considered as income subject to tax.
  2. Recovery from damages.
     • Damages are taxable if they represent compensation for loss of income or profit.
     • Recoveries that are to compensate for damage to property are not taxable, as they are treated as a return of capital.
  3. Bad Debts recovery - any amount subsequently received on account of bad debt previously charged off and allowed as a deduction for income tax purposes must be considered taxable income in the year in which it was recovered.
  4. Tax Refunds - all deductible taxes are considered as income when refunded.
• Only item subject to income tax is the payment for lost profits.