Module 1 - Introduction to Taxation PDF

Tax 301 – Income Tax Prepared by: Mark Paul I. Ramos, CPA, MBA MODULE 1 INTRODUCTION TO TAXATION INTRODUCTION...

Tax 301 – Income Tax Prepared by: Mark Paul I. Ramos, CPA, MBA MODULE 1 INTRODUCTION TO TAXATION INTRODUCTION This chapter discusses the fundamental principles of taxation. After this chapter, readers must be able to comprehend and demonstrate mastery of the following: 1. Concept of taxation and its necessity for every government 2. Lifeblood doctrine and its implication to taxation 3. Theories of government cost allocation 4. Inherent power of the State 5. Scope of the taxation power 6. Limitations of the taxation power 7. Stages of taxation 8. Concept of situs in taxation 9. Fundamental principles surrounding taxation 10. Various escapes from taxation 11. Concept of tax amnesty and condonation INTENDED LEARNING OUTCOMES ILO 1 – Demonstrate an extensive knowledge on the background, nature, scope, and characteristics of taxation ILO 2 – Understand the principles of taxation, its theory, scope, and limitations of taxation ILO 3 – Understand the escapes from taxation, amnesty and condonation What is Taxation? Taxation may be defined as a State power, a legislative process, and a mode of government cost distribution. 1. As a state power Taxation is an inherent power of the State to enforce a proportional contribution from its subjects for public purpose. 2. As a process Taxation is a process of levying taxes by the legislature of the State to enforce proportional contributions from its subjects for public purpose. 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 Every government provides a vast array of public services including defense, public order and safety, health, education, and social protection among others. 1 | Page  Tax 301 – Income Tax Prepared by: Mark Paul I. Ramos, CPA, MBA A system of government is indispensable to every society. Without it, the people will not relish the benefits of a civilized and orderly society. However, a government cannot exist without a system of funding. The government's necessity for funding is the theory of taxation. The Basis of Taxation The government provides benefits to the people in the form of public services, and the people provide the funds that finance the government. This mutuality support between the people and the government is referred to as the basis of taxation. This mutuality is illustrated as follows: Receipt of benefits is conclusively presumed Every citizen and resident of the State directly or indirectly benefits 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 received theory 2. Ability to pay theory Benefit received theory The benefit received theory presupposes that the more benefit one receives from the government, the more taxes he should pay. Ability to pay theory The ability to pay theory presupposes that taxation should also consider the taxpayer's ability to pay. Taxpayers should be required to contribute based on their relative capacity to sacrifice for the support of the government. 2 | Page  Tax 301 – Income Tax Prepared by: Mark Paul I. Ramos, CPA, MBA 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. 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, a greater capacity to contribute. 2. Horizontal equity Horizontal equity requires consideration of the particular circumstance of the taxpayer. For example, Businessmen A and B both have P300,000 income. A incurred P200,000 in business expenses while B incurred only P50,000 business expenses. The government should tax B more than A because he has lesser expenses and thus greater capacity to contribute taxes. Vertical equity is a gross concept 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. (CIR vs. Algue) Taxes are the lifeblood of the government, and their prompt and certain availability are an imperious need. Upon taxation depends on the government's ability to serve the people for whose benefit taxes are collected. (Vera vs. Fernandez) Implication of the lifeblood doctrine in taxation: 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 courts 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 expenditures 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 the tax object has multiple tax bases INHERENT POWERS OF THE STATE 3 | Page  Tax 301 – Income Tax Prepared by: Mark Paul I. Ramos, CPA, MBA 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. These rights, dubbed as "powers" are natural, inseparable, and inherent to every government. No government can sustain or effectively operate without these powers. Therefore, the exercise of 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. The Inherent Powers of the State 1. Taxation power is the power of the State to enforce proportional contribution from its subjects to sustain itself. 2. Police power is the general power of the State to enact laws to protect the so well-being of the people. 3. Eminent domain is 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 Difference Taxation Police Power Eminent Domain Exercising authority Government Government Government and private entities Purpose For the support of To protect the For public use the government general welfare of the people Persons affected Community or class Community or class Owner of the of individuals of individuals property Amount of Unlimited Limited No amount imposed. imposition (Tax is based on (Imposition is limited (The government government needs) to cover cost of pays just regulation) compensation) Importance Most important Most superior Important Relationship with the Inferior to the Superior to the Superior to the Constitution “Non-impairment “Non-impairment “Non-impairment Clause” of the Clause” of the Clause” of the Constitution Constitution Constitution Limitation Constitutional and Public interest and Public purpose and inherent limitations due process just compensation Similarities of the three powers of the State 1. They are all necessary attributes of sovereignty. 2. They are all inherent to the state. 3. They are all legislative in nature. 4. They are all ways in which the State interferes with private rights and properties. 4 | Page  Tax 301 – Income Tax Prepared by: Mark Paul I. Ramos, CPA, MBA 5. They all exist independently of the Constitution and are exercisable by the government even without a constitutional grant. However, the Constitution may impose conditions or limits for their exercise. 6. They all presuppose an equivalent form of compensation received by the persons affected by the exercise of the power. 7. The exercise of this powers by the local government units may be limited by the national legislature. SCOPE OF THE TAXATION POWER The power of taxation is the most absolute of all the powers of the government. a. Comprehensive – covers all (persons, businesses, professions, right and privileges) b. Unlimited – In the absence of limitations provided by the law or the constitution, the power to tax is unlimited and comprehensive. Its force is so searching to the extent that the courts scarcely venture to declare that it is subject to any restrictions. c. Plenary – it is complete; BIR may avail of certain remedies to ensure collection of taxes. d. Supreme – in so far as the selection of the subject of taxation THE LIMITATIONS OF THE 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 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 a 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 5 | Page  Tax 301 – Income Tax Prepared by: Mark Paul I. Ramos, CPA, MBA 14. Non-impairment of the jurisdiction of the Supreme Court to review tax cases 15. The requirement that appropriations, revenue, or tariff bills shall originate exclusively in the House of Representatives 16. The delegation of taxing power to local government units ESSENTIAL ELEMENTS OF TAX 1. It is an enforced contribution. 2. It is generally payable in money. 3. It is proportionate in character. 4. It is levied on persons, property or rights. 5. It is levied by the law-making body of the state. 6. It is levied for public purpose. ASPECTS OF TAXATION 1. Levying or imposition of tax 2. Assessment and collection of tax 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 composed of two bodies: 1. The House of Representatives, and 2. The Senate As mandated by the Constitution, tax bills must originate from the House of Representatives. Each may, however, have their own versions of a proposed law which is approved by both bodies, but tax bills cannot originate exclusively from the Senate. Matters of legislative discretion in the exercise of taxation 1. Determining the object of taxation 2. Setting the tax rate or amount to be collected 3. Determining the purpose for the levy which must be public use 4. Kind of tax to be imposed 5. Apportionment of the tax between the national and local government 6. Situs of taxation 7. Method of collection 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. SITUS OF TAXATION 6 | Page  Tax 301 – Income Tax Prepared by: Mark Paul I. Ramos, CPA, MBA 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 the 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 herein. 5. Personal tax situs: Persons are taxable in their place of residence. Illustration 7 | Page  Tax 301 – Income Tax Prepared by: Mark Paul I. Ramos, CPA, MBA 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. 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 is used solely for the purpose of raising revenue (Roxas vs. CTA). 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 actually employed in practice. A good manifestation of the Marshall Doctrine is the imposition of excessive tax on cigarettes while applications of the Holme's Doctrine include the creation of Ecozones with tax holidays and provision of incentives, such as the Omnibus Investment Code (E.O. 226) and the Barangay Micro-Business Enterprise (BMBE) Law. 3. Prospectivity of tax laws Tax laws are generally prospective in operation. An ex post facto law or a 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. (See Philex Mining Corporation vs. CIR, G.R. 125704) Exceptions: a. Where the taxpayer's 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 8 | Page  Tax 301 – Income Tax Prepared by: Mark Paul I. Ramos, CPA, MBA 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 Prescription is the lapsing of a right due to the passage of time. When one sleep on his right over an unreasonable period of time, he is presumed to be waiving his right. The government's right to collect taxes does not prescribe unless the law itself provides for such prescription. Under the NIRC, tax prescribes if not collected within 5 years from the date of its assessment. In the absence of an 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 misrepresentation made by one party toward another who relied therein in good faith will be held true and binding against that person who made the misrepresentation. 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 defer 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 room 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. 9 | Page  Tax 301 – Income Tax Prepared by: Mark Paul I. Ramos, CPA, MBA 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 exemption 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 from the common burden must justify his claim by the clearest grant of organic or statute law. (Iloilo, et al. vs. Smart Communications, Inc., G.R. No. 167260, February 27, 2009) When 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 when the terms of the concession are too explicit to admit fairly of any other construction that the proposition can be supported. (Ibid) 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 exists is resolved against the taxpayer. (see Digital Telecommunications, Inc. vs. City Government of Batangas, et al) 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 elements: 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. Examples: 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 as a consequence 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. 10 | Page  Tax 301 – Income Tax Prepared by: Mark Paul I. Ramos, CPA, MBA Examples: 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. c. The Philippine government taxes foreign income of domestic corporations and resident citizens 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 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 - only one tax law is allowed to apply to the tax object while the other tax law exempts the same tax object b. Allowing foreign tax credit - both tax laws of the domestic country and a foreign country tax the tax object, but the tax payments made in the foreign tax law are deductible against the tax due of the domestic tax law c. Allowing reciprocal tax treatment - provisions in tax laws imposing a reduced tax rates or even exemption if the country of the foreign taxpayer also gives the same treatment to Filipino non-residents therein d. Entering into treaties or bilateral agreements - countries may stipulate for a lower tax rates for their residents if they engage in transactions that are taxable by both of them. 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. Examples: a. This can be achieved by gross understatement of income, non-declaration of income, overstatement of expenses or tax credit. b. Misrepresenting the nature or amount of transaction to take advantage of lower taxes. 11 | Page  Tax 301 – Income Tax Prepared by: Mark Paul I. Ramos, CPA, MBA 2. Tax avoidance, also known as tax minimization, refers to any act or trick that reduces or totally escapes taxes by any legally permissible means. Examples: a. Selection and execution of transaction that would expose taxpayer to lower taxes. b. Maximizing tax options, tax carry-overs or tax credits c. Careful tax planning 3. Tax exemption, also known as tax holiday, refers to the immunity, privilege or freedom from being subject to a tax which others 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. B. Those that do not result to loss of government revenue 1. Shifting - This is the process of transferring tax burden to other taxpayers. Forms of shifting a. Forward shifting - This is the 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 shifting - This is 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 shifting - This refers to any tax shifting in the distribution channel that exhibits forward shifting or backward shifting. Shifting is common with business taxes where taxes imposed on business revenue can be shifted or passed-on to customers. 2. Capitalization - This pertains to the adjustment of the value of an asset caused by changes in tax rates. 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 - This pertains to the elimination of wastes or losses 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 a chance to reform and enable them to have a fresh start to be part of a society with a 12 | Page  Tax 301 – Income Tax Prepared by: Mark Paul I. Ramos, CPA, MBA 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 taxpayer. Amnesty operates retrospectively by forgiving past violations. Condonation applies 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. 13 | Page  Tax 301 – Income Tax Prepared by: Mark Paul I. Ramos, CPA, MBA MODULE EXERCISES True or False 1. There should be direct receipt of benefit before one could be compelled to pay taxes. 2. Eminent domain involves confiscation of prohibited commodities to protect the well-being of the people. 3. Horizontal equity requires consideration of the circumstance of the taxpayer. 4. Taxes are the lifeblood of the government. 5. Taxation is a mode of apportionment of government costs to the people. 6. The exercise of taxation power requires Constitutional grant. 7. Taxation is inherent in sovereignty. 8. Police power is the most superior power of the government. Its exercise needs to be sanctioned by the Constitution. 9. All inherent powers presuppose an equivalent form of compensation. 10. The reciprocal duty of support between the government and the people underscores the basis of taxation. 11. The scope of taxation is regarded as comprehensive, plenary, unlimited, and supreme. 12. The Constitutional exemption of religious, charitable, and non-profit cemeteries, churches, and mosques refers to income tax and real property tax. 13. Taxpayers under the same circumstance should be taxed differently. 14. Taxation is subject to inherent and Constitutional limitations, 15. International comity connotes courtesy between nations. 16. Collection of taxes in the absence of a law is violative of the Constitutional requirement for due process. 17. No one shall be imprisoned for non-payment of tax. 18. The lifeblood doctrine requires the government to override its obligations and contracts when necessary. 19. 2/3 of all members of Congress is required to pass a tax exemption law. 20. The government should tax itself. 14 | Page  Tax 301 – Income Tax Prepared by: Mark Paul I. Ramos, CPA, MBA Reference: Tabag, E.D., Garcia, E.J.R., (2024 Edition), Income taxation Banggawan, R. B. (2023-2024 Edition), Income Taxation Laws, Principles and Applications Bureau of Internal Revenue, https://www.bir.gov.ph/index.php/tax-information/income-tax.html 15 | Page