Income Concept and Determination

INCOME CONCEPT AND DETERMINATION

General Concept of Income

Income, in its broad sense, refers to all wealth that flows into the taxpayer aside from mere capital returns. It encompasses gains and profits, specifically from:

  • Sales of goods or services surpassing production costs.

  • Disposition of property viewed as capital assets.

  • Income acquired through employment or capital investment.

Distinction Between Income and Capital

  • Capital is defined as wealth or funds, while income is the profit or gain derived from the flow of that wealth.

  • A notable analogy: Capital is like a tree, while income is the fruit it bears.

  • For example, if a piece of land is purchased for P300,000 and sold for P500,000, the income derived is P200,000 and the return of capital represents P300,000, denoting the purchase cost for the seller.

Gross Income Concept

Definition of Gross Income

Gross income generally constitutes the total earnings of a business from selling goods or services after deducting the cost of those goods/services but before accounting for selling, administrative, tax, and other expenses. For tax purposes, gross income lacks a strict definition as it may vary in different scenarios, such as for:

  • Income from employment

  • Dividends

  • Royalties

  • Interest

Gross Income Under the National Internal Revenue Code

According to the National Internal Revenue Code, gross income includes:

  1. Compensation for services in all forms, including fees, salaries, and bonuses.

  2. Income derived from trade or business conduct.

  3. Gains from property dealings.

  4. Interest.

  5. Rent.

  6. Royalties.

  7. Dividends.

  8. Annuities.

  9. Prizes and winnings.

  10. Pensions.

  11. Partners’ distributive share from the partnership's net income.

This enumeration comprises both income taxed regularly and those subject to final tax.

Categorization of Gross Income

From the definitions provided, gross income can be further categorized into:

  1. Compensation income

  2. Gross income from business or profession

  3. Passive income

  4. Other sources of income

Compensation and Other Income from Employment

Definition of Compensation Income

Compensation refers to all remuneration provided to an employee for services rendered to an employer within an employer-employee relationship, regardless of how designated. This includes:

  • Salaries, wages, emoluments, honoraria

  • Allowances (e.g., transportation, entertainment)

  • Commissions and fees (including director's fees)

  • Taxable bonuses and pension plans

  • Tips and gratuities

Measuring Compensation Income

  1. Monetary Payments: The received amount in cash is the income measure.

  2. Non-Monetary Payments: The fair market value (FMV) of received stocks, bonds, or property is included as compensation under the following rules:
    a. The FMV is presumed to be the compensation, unless otherwise stated.
    b. For stock given as remuneration, the FMV at the time of rendering the service is used for calculation.
    c. If paid through a promissory note, the FMV at the time of receipt is treated as income, with adjustments made upon note repayment.
    d. Housing or meals provided may be included unless furnished for employer convenience.

Tips and Gratuities

Tips or gratuities paid directly to employees by customers are taxable but not subject to withholding tax. They are not classified as compensation income as they are not employer-paid but are still taxed similarly.

Pensions, Retirement, and Separation Pay

These payments constitute compensation subject to withholding, except for specific exclusions.

Transportation, Representation, and Other Allowances

Such allowances received by public or private employees as additional compensation are subject to withholding tax, unless:

  1. They represent reimbursements for expenses under certain conditions.

  2. Advances that exceed actual expenses which are not returned to the employer.

Note: The Additional Compensation Allowance (ACA) for government employees is exempt from income tax up to P90,000.

Vacation and Sick Leave Allowances

Compensations during vacations or sick leaves are taxable except for monetized time off (10 days or less) received without having taxable implications.

Director’s Fees

Fees paid to corporate directors as compensation income depend on the established employer-employee relationship. Directors not classified as employees for their service to the board do not receive compensation in this category but as professional fees. Such payments are subject to creditable withholding tax based on the annual income received.

Gross Income from Business or Profession

Determination of Gross Income

Gross income from business activities includes:

  • Selling Activity: Revenue minus cost of goods sold.

  • Service Rendering: Receipts minus costs of service provided.

Gains from Property Dealings

Types of Property: Property may yield income as either ordinary or capital assets.

  1. Ordinary Assets: Items held primarily for sale or those subjected to depreciation (e.g., inventory).

    • Examples include finished goods, delivery vehicles, and property utilized in trade.

  2. Capital Assets: Any property held by the taxpayer excluding ordinary assets.

    • Generally, if an asset is not explicitly categorized as an ordinary asset, it shall be classified as a capital asset.

Capital Gain vs. Ordinary Gain

Gains from asset exchanges classify as capital (for capital assets) or ordinary (for ordinary assets).

Interest Income

Interest income relates to compensation received by a lender for lending money. Interest from bank deposits is usually passive income subject to a final tax, while that from other sources may attribute to ordinary business income.

Income from Lease Contracts

Income derived from lease agreements incorporates:

  1. Rent: Reported as income in the year of receipt, irrespective of the accounting method used.

  2. Lessor's Obligations Assumed by Lessee: Such payment by the lessee will add to the lessor's taxable income.

  3. Leasehold Improvements: May either be reported outright or spread-out over the term of the lease, following stipulated methods.

Royalties and Dividend Income

Royalty Income

Royalties are payments made to property owners by others wishing to utilize it for generating revenues, usually expressed as a percentage of revenue.

Dividend Income

Dividends refer to distributions made by a corporation to shareholders derived from profits. Different types include:

  1. Cash Dividends: Taxable when received based on shares held.

  2. Stock Dividends: Uniquely, they are usually not taxable until realized.

  3. Property Dividends: Fair market value of the received property at the time of distribution is taxable.

  4. Liquidating Dividends: Treated as a sale of a capital asset, hence taxable.