MODULE 4: Principles of Income Taxation

Meaning of Income

Income refers to the wealth or gain that flows into a taxpayer, other than a mere return of capital. It may come from:

• Capital or investments.

• Labor or services rendered.

• A combination of capital and labor.

• Profits earned from selling or dealing with property.

In simple terms, income is an increase in wealth resulting from an activity or transaction, rather than simply getting back what you originally invested.

Capital vs. Income

Case: Madrigal v. Rafferty, G.R. No. L-12287, August 7, 1918

The case explains the distinction between capital and income.

Capital	Income
The fund or property used to produce wealth.	The gain or benefit produced by that capital.
Wealth existing at a particular point in time.	The flow or return generated over a period of time.
The source of wealth.	The product of that source.
Example: A tree.	Example: The fruit produced by the tree.

Return of Capital vs. Return on Capital

When selling an asset, the amount received must be separated into:

• Return of Capital: The amount that recovers the original investment or cost.

• Return on Capital: The additional amount earned from the investment, which represents income.

Example 1: Sale with a gain

Mr. A purchased land for ₱500,000 and later sold it for ₱1,200,000.

Particulars	Amount
Selling price	₱1,200,000
Return of capital	₱500,000
Return on capital (gain)	₱700,000

The first ₱500,000 simply recovers the original investment. The remaining ₱700,000 is the gain.

Realized vs. Unrealized Income

Not every increase in the value of an asset is automatically taxable.

• Realized income: A gain that has already been obtained through a completed transaction, such as selling property for more than its cost.

• Unrealized income: A gain that exists only because an asset increased in market value but has not yet been sold or disposed of.

Example: You purchased land for ₱10 million, and its market value later increased to ₱15 million.

• Current value: ₱15 million

• Original cost: ₱10 million

• Unrealized gain: ₱5 million

The ₱5 million increase is generally not yet taxable income because you have not sold the land or actually realized the gain.

Meaning of Income Tax

Income tax is a tax imposed on a person's income, earnings, profits, or gains from property, employment, profession, trade, or business.

axpayer's income - less deductions allowed by law, depending on the applicable tax treatment.

Functions of Income Tax

1. Revenue generation: Provides the government with funds for public services and government operations.

2. Offsetting regressive taxes: Helps balance the effects of sales and consumption taxes, which may affect lower-income individuals more heavily.

3. Reducing income inequality: Helps address unequal distribution of income and wealth by imposing taxes based on a taxpayer's ability to pay.

Nature and Purpose of Income Tax

• Excise or privilege tax: It is imposed on the privilege of earning income or engaging in activities that generate taxable income.

• Self-assessing or self-computed: Taxpayers generally determine, report, and pay their own tax liabilities through their tax returns.

• Primarily for revenue: Its main purpose is to generate funds for the government.

Requisites for Taxability of Income

For an amount to be considered taxable income, three requisites must generally be present:

1. There must be a gain or profit.

There must be an actual economic gain, not merely the recovery of the original investment.

• Sale of land for more than its purchase price = gain.

• Sale of a truck below its book value = loss, not income.
  
  

2. The gain must be received or realized.

The taxpayer must have obtained the gain, either through actual receipt or constructive receipt.

Actual Receipt: The taxpayer physically receives the money or payment.

3. The gain must not be excluded or exempt by law or treaty.

Even if an amount is received and represents a gain, it will not be taxable if a specific provision of law or an applicable tax treaty excludes or exempts it.

Example: Certain qualifying benefits, such as SSS and GSIS benefits, are excluded from taxable income under applicable rules.

Cash Basis vs. Accrual Method of Accounting

These accounting methods determine when income is recognized for tax purposes.

Cash Basis	Accrual Method
Income is recognized when actually or constructively received.	Income is recognized when earned, even if payment has not yet been received.
Focuses on when the taxpayer receives control of the money.	Focuses on when the right to receive income is established.
Example: Customer pays on December 29, so income is recognized in that year.	Example: Services are completed and income is earned in December, but payment arrives in January.

Remember: Cash basis focuses on receipt; accrual focuses on earning.

Refund of Tax Overpayment

If a taxpayer pays more than the required tax, the taxpayer may generally apply for a tax refund or tax credit, subject to the applicable legal requirements.

According to the general rule discussed in the lecture:

• The claim must be filed within two years from the date of payment.

• The right to claim may prescribe after the applicable period.

• Refunds are generally granted without interest, subject to the governing law.

Types of Taxable Income

For purposes of Philippine income taxation, income is generally classified according to how it is taxed.

1. Regular Income

Regular income is generally subject to the regular income tax system. It is usually combined with other income belonging to the same regular tax category before applying the applicable tax rates.

Examples include:

• Compensation income.

• Income from business.

• Income from the practice of a profession.

• Rental income.

• Other income not specifically subject to final tax.

2. Passive Income Subject to Final Tax

Certain types of passive income are taxed separately at fixed rates through final withholding tax.

Examples from the lecture:

Type of Income	Illustrative Final Tax Rate
Interest from peso bank deposits	20%
Dividends from domestic corporations	10%
Royalties from books	10%

The applicable rate depends on the specific type of income and taxpayer.

How final withholding tax works:

1. The taxpayer earns passive income.

2. The income payer or withholding agent deducts the applicable tax.

3. The withholding agent remits the tax to the BIR.

4. The taxpayer receives the remaining amount after withholding.

The income payer is responsible for properly withholding and remitting the tax. Failure to do so may result in deficiency taxes, surcharges, interest, and compromise penalties.

Income Tax Systems in the Philippines: Global System

1. Global System

The global system combines different categories of income subject to regular income tax and applies one set of applicable tax rates to the total taxable income.

In simple terms, income belonging to the regular income tax category is added together before computing the tax.

Example:

Type of Income	Amount
Net compensation income	₱600,000
Net business/professional income	₱1,000,000
Non-operating income subject to regular tax	₱400,000
Total taxable income	₱2,000,000

Using the individual graduated income tax rates, the tax due is:

₱402,500

Income Tax Systems in the Philippines: Schedular System

Schedular System

The schedular system treats different categories of income separately. Each category may have its own tax rate and tax computation.

Example:

An individual earns the following passive income:

Type of Income	Tax Base	Rate	Final Tax
Royalties from books	₱200,000	10%	₱20,000
Dividends from domestic corporation	₱100,000	10%	₱10,000
Interest from peso bank deposit	₱5,000	20%	₱1,000
Total	₱305,000		₱31,000

Instead of combining all three amounts and applying graduated rates, each income category is taxed separately.

 Income Tax Systems in the Philippines: Semi-Global / Semi-Schedular System

Semi-Global / Semi-Schedular System

The Philippines uses both systems simultaneously:

Income Classification	Tax Treatment	System
Income subject to regular income tax	Combined with other regular taxable income	Global
Income subject to final tax	Computed separately using its applicable rate	Schedular
Excluded or exempt income	Not included in taxable income, subject to applicable rules	Tax-exempt

Example:

A taxpayer earns:

• Compensation income: ₱1,000,000

• Bank deposit interest: ₱1,000

• Gain from the sale of a personal asset: ₱700,000

The bank deposit interest is separately subject to the applicable final tax. The other income must be classified according to the specific rules governing the transaction before determining whether it belongs in the regular tax computation or another tax category.

Important: Not all income is automatically combined. The first step is identifying the applicable tax treatment.

Income Tax Systems in the Philippines: Exclusions from Taxable Income

Exclusions from Taxable Income

Some income is excluded from taxation under the Tax Code or other applicable laws.

Examples discussed in the slides include:

• Certain SSS and GSIS benefits.

• Qualifying retirement benefits.

• 13th month pay and other benefits up to the combined ₱90,000 exclusion limit, subject to applicable rules.

Memory aid:

• Global = Combine.

• Schedular = Separate.

• Exempt = Excluded.

General Principles of Philippine Income Taxation

The general principles determine which income the Philippines can tax, depending on the taxpayer's citizenship, residence, and the source of income.

1. Factors Determining Income Tax Situs

Situs of income taxation refers to the place or jurisdiction where income is considered taxable.

Three factors determine the scope of a taxpayer's Philippine income tax liability:

• Citizenship: Whether the taxpayer is a Filipino citizen or an alien.

• Residence: Whether the taxpayer resides in the Philippines or abroad.

• Source of income: Whether the income was earned within or outside the Philippines.

Memory aid: CITUS = Citizenship, Residence, Source.

2. General Rules on Taxability

Taxpayer	Income Within the Philippines	Income Outside the Philippines
Resident Citizen	Taxable	Taxable
Non-Resident Citizen	Taxable	Not taxable
Overseas Contract Worker (OCW/OFW)	Taxable	Not taxable
Resident Alien	Taxable	Not taxable
Non-Resident Alien	Taxable	Not taxable
Domestic Corporation	Taxable	Taxable
Foreign Corporation	Taxable	Not taxable

Main takeaway: Resident citizens and domestic corporations are generally taxed on worldwide income. Other taxpayers are generally taxed only on Philippine-sourced income.

Classification of Taxpayers: 1) Individual Taxpayers

Individuals are classified according to their citizenship and residence.

A. Resident Citizen (RC)

A Filipino citizen who resides in the Philippines.

• Taxable on income earned both within and outside the Philippines.

• Generally subject to graduated income tax rates of 0%–35% on taxable income.
  
  

B. Non-Resident Citizen (NRC)

A Filipino citizen who resides abroad under circumstances recognized by the Tax Code.

This includes Filipinos who:

• Establish a definite intention to reside permanently abroad.

• Leave the Philippines as immigrants.

• Work abroad as permanent employees.

• Stay and work outside the Philippines for at least 183 days during the taxable year, subject to the applicable statutory requirements.

Tax treatment:

• Taxable only on Philippine-sourced income.

• Foreign-sourced income is generally not taxable in the Philippines.

• Philippine-sourced income remains taxable under the applicable rules.

C. Overseas Contract Workers (OCWs) / Overseas Filipino Workers (OFWs)

An OFW is a Filipino worker employed abroad who meets the applicable registration and documentation requirements.

According to the lecture:

• The worker must be duly registered with the Department of Migrant Workers (DMW), formerly POEA.

• The worker must have the required overseas employment documentation, such as a valid Overseas Employment Certificate (OEC).

• Seafarers must also have the required seafarer documentation, including the applicable MARINA-issued Seaman's Book.

Tax treatment:

• Taxable only on income from Philippine sources.

• Foreign-sourced employment income is generally not subject to Philippine income tax.

D. Resident Alien (RA)

A foreign citizen who resides in the Philippines and is not merely a transient or sojourner.

• Taxable only on Philippine-sourced income.

• Generally subject to graduated income tax rates of 0%–35% on taxable income.

E. Non-Resident Alien (NRA)

A foreign citizen who does not reside in the Philippines.

There are two classifications:

1. Non-Resident Alien Engaged in Trade or Business (NRAETB)

• Generally refers to an alien who stays in the Philippines for more than 180 days during the calendar year.

• Taxable only on Philippine-sourced income.

• Generally subject to graduated income tax rates of 0%–35% on taxable net income.

2. Non-Resident Alien Not Engaged in Trade or Business (NRANETB)

• Generally refers to an alien who stays in the Philippines for 180 days or less during the calendar year.

• Also includes certain aliens whose purpose of stay can be promptly accomplished.

• Taxable on Philippine-sourced income.

• Generally subject to a flat 25% final tax on gross income, subject to applicable exceptions.

Classification of Taxpayers: 2) Philippine Citizenship (Jus Sanguinis)

The Philippines follows the principle of Jus Sanguinis, meaning citizenship is determined by blood or parentage, rather than the place of birth.

• A child with at least one Filipino parent is generally considered a Filipino citizen, regardless of where the child was born.

• A person born in another country may still be a Filipino citizen if the citizenship requirements are met.

• Naturalized citizens are generally treated as citizens for income tax purposes.

Remember: Jus Sanguinis = Citizenship by blood, not by birthplace.

Classification of Taxpayers: 3)  Individual Income Tax Rates

The following graduated rates apply to individual taxpayers subject to the regular income tax system, effective 2023 onwards under the TRAIN Law amendments.

Taxable Income	Income Tax Due
Not over ₱250,000	0%
Over ₱250,000 to ₱400,000	15% of excess over ₱250,000
Over ₱400,000 to ₱800,000	₱22,500 + 20% of excess over ₱400,000
Over ₱800,000 to ₱2,000,000	₱102,500 + 25% of excess over ₱800,000
Over ₱2,000,000 to ₱8,000,000	₱402,500 + 30% of excess over ₱2,000,000
Over ₱8,000,000	₱2,202,500 + 35% of excess over ₱8,000,000

Important: The tax rate applies only to the portion specified by the bracket formula, not to the entire taxable income.

Classification of Taxpayers: 4) Corporate Taxpayers

A. Domestic Corporation

A corporation incorporated or organized under Philippine laws.

• Taxable on income from within and outside the Philippines.

• Generally subject to 25% regular corporate income tax.

• May qualify for the reduced 20% rate if it meets both statutory conditions.

Requirements for the 20% rate:

1. Net taxable income does not exceed ₱5 million.

2. Total assets do not exceed ₱100 million, excluding land on which the office, plant, and equipment are situated.

Both requirements must be satisfied.

B. Resident Foreign Corporation (RFC)

A foreign corporation that is engaged in trade or business in the Philippines, such as through a Philippine branch.

• Taxable only on Philippine-sourced income.

• Generally subject to 25% regular corporate income tax on net taxable income.

C. Non-Resident Foreign Corporation (NRFC)

A foreign corporation that is not engaged in trade or business in the Philippines.

• Taxable only on Philippine-sourced income.

• Generally subject to 25% final tax on gross income, subject to applicable exceptions and treaty provisions.

CALCULATION OF TAX: Gross Income vs. Net Income

Gross Income	Net Income
Income before deducting allowable expenses.	Income after deducting allowable expenses.
Generally, sales less cost of sales/services plus other income.	Gross income less allowable deductions.

Formula:

GrossIncome=Sales-CostofSales+OtherIncome

NetIncome=GrossIncome-Deductions

CALCULATION OF TAX: Corporate Income Tax Rates

Corporation	Tax Rate
Domestic Corporation (general)	25%
Qualified Domestic Corporation	20%
Resident Foreign Corporation	25%
Non-Resident Foreign Corporation	25% final tax

Classification of Taxpayers: 5) Special Aliens

The slides also discuss certain foreign employees, including employees of Regional Operating Headquarters (ROHQs), Offshore Banking Units (OBUs), and petroleum service contractors.

These employees were previously associated with a preferential 15% tax rate. The lecture notes explain that they are now generally subject to the applicable regular income tax rates instead.

Classification of Taxpayers: 6) Corporations Under the Tax Code

Under the Revised Corporation Code, a corporation is an artificial being created by operation of law, having the right of succession and powers, attributes, and properties expressly authorized by law.

For taxation, the Tax Code's definition of a corporation is broader and may include:

• One Person Corporations (OPCs).

• Partnerships, except those specifically excluded.

• Joint-stock companies.

• Joint accounts.

• Associations.

• Joint ventures.

One Person Corporation (OPC)

An OPC is a corporation with only one stockholder, who may be a natural person, trust, or estate.

A licensed professional generally cannot organize an OPC solely to exercise their licensed profession, subject to applicable laws.

Entities Excluded from the Tax Code Definition of Corporation

Examples include:

• General Professional Partnerships (GPPs).

• Qualified construction joint ventures.

• Qualified energy consortium joint ventures under service contracts.

Classification of Taxpayers: 7) Branch vs. Subsidiary

 Branch vs. Subsidiary

This distinction is important when determining whether a foreign corporation is resident or non-resident.

Branch	Subsidiary
An extension of the foreign parent corporation.	A separate corporation established under the laws of the country where it is incorporated.
Does not have a separate corporate identity from its parent.	Has its own separate legal personality.
Generally classified as a Resident Foreign Corporation when doing business in the Philippines.	If incorporated in the Philippines, generally classified as a Domestic Corporation.

Memory aid: A branch is part of the parent company; a subsidiary is a separate corporation.

Classification of Taxpayers: 8) Special Corporations (Proprietary Educational Institutions and Private Non-Profit Hospitals)

Certain proprietary educational institutions and private non-profit hospitals may qualify for special corporate income tax treatment.

According to the PowerPoint:

Period	Tax Rate
July 1, 2020 – June 30, 2023	1%
July 1, 2023 onwards	10%

Predominance Test

If the gross income from unrelated trade, business, or other activities exceeds 50% of the institution's total gross income, the regular corporate income tax rates of 20% or 25% apply.

Example: A school earns:

• ₱4 million from educational activities.

• ₱6 million from unrelated commercial activities.

Unrelated income makes up 60% of total gross income. Since it exceeds 50%, the school is subject to the applicable regular corporate tax rate.

Classification of Taxpayers: 9) Government-Owned and Controlled Corporations (GOCCs)

Government-Owned and Controlled Corporations (GOCCs)

GOCCs are generally subject to income tax, unless specifically exempted by law.

The PowerPoint identifies the following exceptions:

• Government Service Insurance System (GSIS).

• Social Security System (SSS).

• Philippine Health Insurance Corporation (PhilHealth).

• Local Water Districts.

Tax-Exempt Corporations

The Tax Code identifies certain organizations that may qualify for income tax exemption.

Examples from the slides include:

1. Labor, agricultural, or horticultural organizations.

2. Mutual savings banks and cooperative banks without capital stock.

3. Fraternal beneficiary societies.

4. Cemetery companies.

5. Non-stock corporations organized for religious, charitable, scientific, or similar purposes.

6. Business leagues and chambers of commerce.

7. Civic leagues and organizations operated exclusively for social welfare.

8. Non-stock, non-profit educational institutions.

9. Government educational institutions.

10. Mutual insurance companies and certain mutual organizations.

11. Farmers' or other producers' marketing cooperatives.

Important exception:

Even if an organization is generally exempt, its income from profit-making activities or properties may still be taxable.

Classification of Taxpayers: 10) Partnerships

A. Meaning of Partnership

Under the Civil Code, a partnership is a contract where two or more persons agree to contribute money, property, or industry to a common fund, with the intention of dividing the profits among themselves.

In simpler terms, people combine resources or skills to operate an undertaking and share its profits.

B. Partnership vs. Co-Ownership

Case: Evangelista v. Commissioner of Internal Revenue, G.R. No. L-9996, October 15, 1957

This case explains that a group of individuals who contribute resources and manage property together for profit may be considered a taxable partnership, even if they do not formally call themselves partners.

Case: Tan v. Del Rosario, G.R. No. 109289, October 3, 1994

The case discusses the distinction between co-ownership and a taxable partnership.

Co-Ownership	Partnership
People jointly own property.	People contribute resources or services to a common fund.
Ownership alone does not automatically create a partnership.	There is an intention to carry on an undertaking and divide profits.
May exist without conducting business.	Generally involves an income-generating business or activity.

C. Kinds of Partnerships

There are two main types discussed in the lecture:

1. General Professional Partnership (GPP)

2. Business or Taxable Partnership

D. General Professional Partnership (GPP)

A GPP is formed by individuals who exercise a common profession and join together to practice it.

Examples include:

• Lawyers practicing together.

• Accountants operating a professional partnership.

• Doctors practicing through a professional partnership.

Tax treatment:

• The GPP itself is generally exempt from income tax.

• It must file an information return, such as BIR Form 1702-EX.

• Each partner reports their distributive share of the partnership's income as their own income.

• The partner pays the applicable individual income tax.

• The distributive share is subject to applicable creditable withholding tax (CWT).

Why is the GPP exempt?

The income is passed on to the individual partners for taxation. The partnership is not treated like an ordinary corporation for this purpose.

E. Business Partnership

A business partnership is generally treated as a corporation for income tax purposes.

Tax treatment:

• The partnership is subject to corporate income tax at 20% or 25%, depending on its qualifications.

• The remaining income may be distributed to the partners.

• The partners' distributive shares are generally subject to final tax as dividends, using the applicable rate for each partner's classification.

Partner Classification	Illustrative Final Tax Rate
Resident Citizen	10%
Non-Resident Citizen	10%
Resident Alien	10%
NRA Engaged in Trade or Business	20%
NRA Not Engaged in Trade or Business	25%

Estates and Income Tax

An estate refers to the property, assets, and obligations left behind by a deceased person.

For income tax purposes, the important question is who receives or controls the income-producing property during the settlement of the estate?

According to the PowerPoint:

Type of Settlement	Who Is Taxable on the Income?
Judicial settlement	Estate
Extrajudicial settlement	Heirs

Trusts and Income Tax

A trust is an arrangement where one person or entity holds and manages property for the benefit of another person.

The tax treatment depends on whether the trust is revocable or irrevocable.

A. Irrevocable Trust

An irrevocable trust is generally one that cannot simply be cancelled or taken back by the person who created it.

Tax treatment:

• The trust is generally taxable on its income.

• Income distributed to beneficiaries is generally deductible by the trust, subject to applicable rules.

• The beneficiaries report the income distributed to them as taxable income.

B. Revocable Trust

A revocable trust is one that the trustor can generally cancel, change, or take back.

Tax treatment:

• The income is generally taxable to the trustor.

• The trustor remains responsible for reporting the income because they retain the power to revoke the arrangement.

Irrevocable Trust	Revocable Trust
Generally taxable to the trust.	Generally taxable to the trustor.
Beneficiaries may be taxed on income distributed to them.	Trustor remains responsible for the income tax.
Trustor generally gives up the power to revoke the trust.	Trustor retains the power to revoke or modify it.