Notes For Income Taxation PDF

NOTES FOR INTRODUCTION OF INCOME TAXATION Niño Genesis Rubio, BSA -4 Definition of Income Income: Wealth inflow to taxpayer, excluding return of capital. Implications: o Comprehensive definition. o Distinguish between "return from capital" (income/profit) vs....

NOTES FOR INTRODUCTION OF INCOME TAXATION Niño Genesis Rubio, BSA -4 Definition of Income Income: Wealth inflow to taxpayer, excluding return of capital. Implications: o Comprehensive definition. o Distinguish between "return from capital" (income/profit) vs. "return of capital" (recovery of investment). o "Fruit vs. Tree" analogy: Income is the fruit derived from capital (tree). o Includes profits from labor, capital, sale of assets, etc. o Legal Source Irrelevant: Income is taxable regardless of legality. Tests for Determining Income Accession to Wealth: Person becomes richer or wealthier after the transaction. Realization: Income is only taxable when it is clearly realized (transaction is closed and completed). Control: Complete dominion over the money or rights accrued. (Dominion means sovereignty or control.) Examples of Income Items Compensation: Wages, salaries from employment. Business Profits: Profit from sale of goods or services. Professional Fees: Earnings from professional services. Interest: Income from loans. Other Income: Gains from illegal activities (e.g., kidnapping), sale of fixed assets, rental income, dividends. Valuation of Income Valuation of income refers to the methods used to determine the taxable value of income received by a taxpayer. The valuation varies depending on the form in which the income is received. Here's a breakdown of different scenarios: 1. Cash Received o When income is received in cash, its valuation is straightforward. The amount of cash received is considered the taxable income. 2. Fair Market Value (FMV) of Property Received o If income is received in the form of property (e.g., real estate, equipment), the taxable value is the fair market value (FMV) of that property at the time it is received. o FMV is the price that property would sell for on the open market. Example: If you receive a piece of land worth PHP 1,000,000 as payment for services, your taxable income is PHP 1,000,000. 3. FMV of Shares Received o When income is received in the form of shares of stock (equity), the taxable value is the FMV of the shares on the date the income is considered earned. Example: You perform a service and receive 100 shares of a company as compensation. If each share is worth PHP 500 at the time of receipt, your taxable income is PHP 50,000 (100 shares x PHP 500). 4. FMV of Services Rendered (if no stipulation) o If there is no agreement on the value of the services rendered, the FMV of the service is used to determine the income. This would be the market rate for similar services. Example: A freelance designer does work for a client, and there's no agreed payment. The typical charge for such a service is PHP 10,000. The FMV of the service (PHP 10,000) is treated as income. 5. FMV of Services Received as Payment o When income is received in the form of services instead of cash or property, the FMV of those services is considered taxable income. Example: A lawyer provides legal services and receives accounting services in return. The FMV of the accounting services received is PHP 15,000, which becomes the lawyer's taxable income.  6. FMV of Promissory Notes Received o Interest-Bearing Promissory Notes: If a promissory note (a written promise to pay) bears interest, the face value of the note is considered income. o Non-Interest-Bearing Promissory Notes: For notes that do not bear interest, the taxable income is the discounted value of the note. This means the value at which the note could be sold on the open market, considering the time value of money. Example: o Interest-Bearing Note: You receive a PHP 100,000 promissory note with 5% interest. The taxable income is PHP 100,000. o Non-Interest-Bearing Note: You receive a PHP 100,000 promissory note with no interest due in 3 years. The discounted value (present value) might be PHP 85,000, which is the taxable income. 7. Face Value for Interest-Bearing Notes o If the note is interest-bearing, the face value (the principal amount stated in the note) is considered the amount of income. Key Points to Remember Valuation at FMV: Income is often valued at the FMV, ensuring that the taxpayer is taxed on the economic benefit received. Cash Equivalency: Regardless of the form in which income is received (cash, property, services, or notes), the principle is to assess the equivalent cash value. Legal and Fair Basis: The methods ensure fairness and consistency in determining the taxable income, so taxpayers with similar economic gains are taxed similarly. Situs of Income (Taxable Location) The situs of income refers to the location or place where income is considered to be earned or derived for tax purposes. The situs determines whether income is subject to taxation in a particular jurisdiction. Different types of income have different rules for determining their situs. Here's a breakdown of how the situs of income is determined for various income types: 1. Interest Income Definition: Income earned from lending money, such as loans, bonds, or deposits. Taxable Situs:  o Interest income is treated as income from within the Philippines if the debtor (borrower) or lender is a resident of the Philippines, whether an individual or a corporation. o If the debtor or lender is a non-resident, the income is typically considered foreign- sourced. Example: A Filipino resident lends money to another Filipino resident, and the interest earned is considered Philippine-sourced income. If the lender is a foreign entity, it might be considered foreign-sourced income. 2. Dividends Definition: Income received by shareholders as a distribution of profits from a corporation. Taxable Situs: o Dividends from Domestic Corporations: Always considered income from sources within the Philippines. o Dividends from Foreign Corporations: ▪ Considered Philippine-sourced income if more than 50% of the foreign corporation’s gross income for the three-year period preceding the dividend declaration was derived from sources within the Philippines. ▪ If less than 50% of the gross income of the foreign corporation was derived from the Philippines, then only a portion of the dividend, proportional to the Philippine-sourced income, is considered Philippine-sourced. Example: If a foreign corporation derives 60% of its income from the Philippines, and you receive a PHP 10,000 dividend from that corporation, PHP 6,000 (60% of the dividend) is considered Philippine-sourced income. 3. Services Definition: Income earned from performing services such as consulting, legal services, technical assistance, etc. Taxable Situs: o Income from services is considered sourced within the Philippines if the services are performed within the Philippines, regardless of where the payment is made. o Conversely, if services are performed outside the Philippines, the income is considered foreign-sourced. Example: A consultant performs a project in the Philippines and gets paid PHP 100,000. This income is sourced in the Philippines. If the same consultant performs the project abroad, it would be considered foreign-sourced income. 4. Rentals and Royalties Definition: Income received from allowing others to use your property (rentals) or from the right to use your intangible assets (royalties, such as copyrights, patents, trademarks). Taxable Situs: o Rental or royalty income is considered from sources within the Philippines if the property or interest is located or used in the Philippines. o If the property is located or used outside the Philippines, the income is foreign- sourced. Example: A Filipino resident rents out a condo unit in Manila to a tenant; the rental income is considered Philippine-sourced. However, if they rent out a property in New York, the rental income is foreign-sourced. 5. Sale of Real Property Definition: Income earned from the sale of real estate such as land, buildings, or any immovable property. Taxable Situs: o Income from the sale of real property is considered sourced within the Philippines if the property is located within the Philippines. o If the real property is located outside the Philippines, the income is foreign-sourced. Example: Selling a house in Cebu generates income that is considered Philippine-sourced. Selling a villa in Italy would be foreign-sourced. 6. Sale of Personal Property Definition: Income earned from selling movable properties like vehicles, furniture, or shares of stock. Taxable Situs: o Shares of Stock in a Domestic Corporation: Gains from the sale of shares in a Philippine corporation are considered entirely Philippine-sourced, regardless of where the shares are sold. o Other Personal Property: The situs can be within or outside the Philippines, or partly within and partly outside, depending on the nature of the property and the rules provided in Section 42-E of the Tax Code. Example: Selling shares of a Philippine company listed on the Philippine Stock Exchange is considered Philippine-sourced income. Selling personal jewelry in another country may be considered foreign-sourced. 7. Requisites of Taxable Income in Relation to Situs To be taxable, income must: o Gain or Profit: There must be an economic benefit. o Realization or Receipt: The gain must be realized or received. o Not Excluded by Law: The income must not be excluded by law or international treaties. Key Points to Remember The situs of income is crucial in determining where the income will be taxed. Each type of income has specific rules that define its source based on factors like the location of property, residence status, and location of activities or services. Understanding the situs rules helps taxpayers and businesses comply with tax regulations and avoid double taxation. Requisites for Taxable Income Gain or Profit: Must be present. Realization/Receipt: Income must be realized or received. Legal Inclusion: Not excluded by law or treaty. Accounting Systems: o Accrual: Income is recognized when earned. o Cash Basis: Income is recognized when received. Non-Income Items: Stock dividends, return of capital, unrealized gains, reimbursements. Classification of Income By Source: o Within Philippines: All income earned domestically. o Without Philippines: All income earned abroad. o Mixed: Partly within and without. By Taxability: o Exempt: By constitutional mandate, statute, international treaties. o Taxable: Subject to applicable tax rules. By Type: o Passive Income: Final tax rates (e.g., interest, royalties). o Capital Gains: Gains from the sale of stocks or properties. o Ordinary Income: Regular income taxed at scheduled rates. o Special Income: Special rates apply (e.g., PEZA 5% tax). Types of Taxpayers 1. Individual Taxpayers Individual taxpayers are natural persons subject to income tax. They are classified based on their citizenship and residency status: a. Resident Citizen (RC) Definition: A Filipino citizen residing in the Philippines. Tax Obligation: o Worldwide Income Taxation: Resident citizens are taxed on all income, regardless of whether it is earned within or outside the Philippines. o Example: If a Filipino working in the Philippines also earns rental income from a property in the United States, both incomes are subject to Philippine income tax. b. Non-Resident Citizen (NRC) Definition: A Filipino citizen who: o Establishes residency abroad for at least 183 days during a calendar year, or  o Is a permanent resident of a foreign country or is considered a resident alien in that country, or o Works and resides abroad, such as Overseas Filipino Workers (OFWs). Tax Obligation: o Philippine-Sourced Income Only: Non-resident citizens are taxed only on income derived from sources within the Philippines. o Example: An OFW earning a salary abroad is not taxed on that salary in the Philippines, but any income from a business or property in the Philippines would be taxable. c. Resident Alien (RA) Definition: A foreign national who resides in the Philippines, whether permanently or temporarily. Tax Obligation: o Philippine-Sourced Income Only: Resident aliens are taxed only on income derived from within the Philippines. o Example: A U.S. citizen residing in the Philippines who earns income from a local consulting job would be taxed on that income in the Philippines but not on income earned from U.S. investments. d. Non-Resident Alien (NRA) Non-resident aliens are further classified based on their engagement in trade or business in the Philippines: Non-Resident Alien Engaged in Trade or Business (NRA-ETB) o Definition: A non-resident alien who stays in the Philippines for more than 180 days during a calendar year and engages in any economic activity. o Tax Obligation: ▪ Philippine-Sourced Income Only: Taxed on income from sources within the Philippines. ▪ Tax Rate: Generally subject to the same graduated tax rates as resident citizens and resident aliens. o Example: A foreigner who stays in the Philippines for 200 days and earns income from consulting services is considered NRA-ETB and taxed on that income. Non-Resident Alien Not Engaged in Trade or Business (NRA-not ETB)  o Definition: A non-resident alien who stays in the Philippines for 180 days or less during a calendar year and does not engage in any economic activity. o Tax Obligation: ▪ Philippine-Sourced Income Only: Taxed on income from sources within the Philippines. ▪ Tax Rate: Subject to a flat tax rate of 25% on gross income (without deductions). o Example: A foreign investor who visits the Philippines for a short period (less than 180 days) and earns income from dividends in a Philippine corporation would be taxed as NRA-not ETB. 2. Corporate Taxpayers Corporate taxpayers are juridical entities that are subject to corporate income tax. They are classified based on their incorporation status and operations in the Philippines: a. Domestic Corporation Definition: A corporation created or organized under Philippine laws. Tax Obligation: o Worldwide Income Taxation: Taxed on all income, whether earned within or outside the Philippines. o Example: A corporation registered in the Philippines that has branches in other countries must report and pay taxes on its global income in the Philippines. b. Resident Foreign Corporation Definition: A foreign corporation doing business in the Philippines, typically through a branch, representative office, or other forms of presence. Tax Obligation: o Philippine-Sourced Income Only: Taxed only on income derived from Philippine sources. o Example: A U.S.-based company with a branch in Manila will pay taxes on income generated from its Philippine operations. c. Non-Resident Foreign Corporation Definition: A foreign corporation not engaged in trade or business within the Philippines. Tax Obligation:  o Philippine-Sourced Income Only: Taxed on income earned within the Philippines (usually subject to final withholding tax rates). o Example: A Japanese company receiving royalties from a Philippine company will be taxed on that income in the Philippines. d. Taxable Partnership Definition: A partnership created or organized in the Philippines or under its laws, not exempted by law. Tax Obligation: o Philippine-Sourced Income Only: Taxed on income derived from within the Philippines. o Example: A law firm structured as a partnership in the Philippines will be taxed on its income from legal services. e. Exempt Corporations Definition: Certain corporations that are exempt from income tax by law (e.g., government entities, non-profit organizations). Tax Obligation: o Exempt from Income Tax: They are exempt from paying income tax on income that is related to their exempt purpose. o Example: A charitable organization recognized as tax-exempt does not pay income tax on donations and other income related to its charitable activities. 3. Estates and Trusts Definition: Estates of deceased persons and trusts created by will or agreement. Tax Obligation: o Philippine-Sourced Income Only: Taxed on income derived from sources within the Philippines. o Example: A trust receiving rental income from a property located in the Philippines will be taxed on that income. General Principles in Income Taxation for All Taxpayers Resident Citizens and Domestic Corporations: Taxed on their worldwide income, whether derived from within or outside the Philippines. Non-Residents and Foreign Corporations: Taxed only on income sourced within the Philippines. Tax Rates and Deductions: Vary based on the type of taxpayer and the nature of income earned. Key Points to Remember Residency Status: Determines whether a taxpayer is subject to tax on worldwide income or only on Philippine-sourced income. Type of Income: Different types of income (e.g., compensation, business income, passive income) have different tax implications and rates. Legal Entity: The classification of a taxpayer (individual, corporate, estate, or trust) affects the applicable tax rules and regulations. Engagement in Business: For non-resident aliens and foreign corporations, whether they are engaged in trade or business in the Philippines significantly impacts their tax treatment. Possible Questions That You May Think Of: 1. Q: What is the difference between "income" and "capital"? A: Income is wealth inflow from capital or other sources; capital is the original investment or asset base. 2. Q: Is illegal income subject to tax? A: Yes, all income, whether legal or illegal, is taxable. 3. Q: What determines the situs of income? A: The nature of income (interest, dividends, services, property) and where it is earned or paid. 4. Q: What are passive incomes? A: Income types subjected to final taxes, such as interest, royalties, and dividends. 5. Q: What is the tax treatment for dividends from foreign corporations? A: Treated as income from sources within or outside the Philippines based on the percentage of gross income earned domestically. 6. Q: What is the significance of the "accrual" basis in determining taxable income? A: Income is recognized when earned, not necessarily when received, following the accrual accounting method.