Income taxation

Basic concepts
Definition
a tax on the yearly profits arising from property, profession,
trade and office
a national tax imposed on the net or the gross income
realized in a taxable year
a tax based on income, gross or not
As contrasted from
Amusement tax - tax collected from the proprietor, lessee or
operator of duly designated places or activities for pleasurable
diversion or entertainment.
Percentage tax a tax imposed on a fixed ratio between the gross
sales or receipts and the burden imposed upon the tax payer.
VAT a tax which is imposed only on the increase in the worth,
merit or importance of goods, properties or services, on the total
value of the goods or services being sold or rendered.
Nature of income tax it is an excise tax and not tax on property.
The theory that tax on income is legally or economically a tax on its
source is no longer tenable.
Income tax vs property tax
Incidence: IT falls on the earner, it is the earner who pays
the tax; PT falls on the property itself, it Is the owner of
the property who pays the tax
Measurement standard: IT by the amount of income
received on a period; PT by the value of the property at a
particular date
Frequency of taxation: IT only once; PT governmental
protection extended to the property
Functions or purposes of income tax
1. Dependable source of revenue to the government
2. Levied at progressive rates, regarded as the best measure of
ability to pay
3. Necessary to offset the regressive sales and consumption
taxes
4. Most effective means of removing inequalities in the
distribution of wealth
Income tax systems global and schedular
Global
system employed where the tax system views indifferently
the tax base and generally treats in common all categories
of taxable income of the individual.
system which taxes all categories of income except certain
passive incomes and capital gains
taxation for corporations

Schedular
system employed where the income tax treatment varies
and is made to depend on the kind or category of taxable
income of the taxpayer
a system which itemizes the different income and provides
for varied percentages of taxes, to be applied thereto
taxation for individuals
Semi-schedular or semi-global tax system used in the Philippines
Schedular vs Global
S there are different tax rates; G there is unitary or
single tax rate
S there are different categories of taxable income; G
there is no need for classification as all the taxpayers are
subjected to single rate
S usually used in income taxation of individuals; G
corporations
Gross income taxation the tax base is the total gross income of an
individual during the taxable year without any deductions allowed.
Kinds of gross income taxation
1. Pure gross income taxation this type occurs where the tax
base is the total gross income of an individual during the
taxable year.
2. Adjusted or modified gross income taxation this is where
the tax base is reduced by some items of deduction not
subject to the usual defects of discretion and manipulation.
3. Third kind where no deductions are allowed but the
applicable rates are reduced to compensate for the non-
allowance (Sec. 27 NIRC corporations has the option to be
taxed at 15% gross income).
System of gross compensation income considered valid
Reason: taxpayers may be classified into different
categories. It is enough that the classification must rest
upon substantial distinctions that ake real differences.
Advantages of gross income taxation
1. The procedure for the computation is simple;
2. Less discretion will be allowed to the tax examiners;
3. Examination and investigation of tax returns can be made
faster;
4. If accepted with an effective withholding tax system would
provide more returns with the government.
Disadvantages of gross income taxation
1. A tax payer may derive gross income but suffers net loss
2. The rule of taxation may not be equitable and uniform if the
gross income were the basis of the tax
3. If gross were the basis, it may serve as a disincentive to
further employment.
Kinds of income tax
1. Presumptive income tax a scale of income tax is imposed
in relation to a group of persons actual expenditure and the
presumed income.
2. Composite tax a tax consisting of a series of separate
quasi-personal taxes, assessed on the particular source of
income with a superimposed personal tax on the income as
a whole.
3. Unitary income tax incomes are arranged according to
source. The separate items are added together and the rate
applied to the resulting total income.
Tax system
Basic features
1. Progressive
2. Global system for corporations and schedular for individuals
3. Uses gross compensation system
Kinds of tax rates
1. Flat or proportional the tax liability increases at the same
rate as the increase in the tax base.
2. Graduated tax rate a tax rate where the rate changes with
the tax base.
a. Progressive tax rate increases with the tax base
b. Regressive rates decreases as the tax base
increases
Tax bracket the different divisions of the base. Ex over P10,000
but not over P30,000
Marginal rate the rate applicable to the highest tax bracket within
which the taxpayer is taxable. Ex 5%, 10% etc.
Marginal rate bracket the highest bracket by the tax base of a
particular taxpayer. Ex for income over P140,000 but not over
P250,000 = the marginal rate bracket is P250,000
Importance of knowing the marginal rate in order to
determine the effect of increasing or decreasing income
subject to tax. It is useful as a tool for analysis in the tax
planning.
Effective rate the average tax rate is determined by dividing total
tax liability by the tax base. Ex the effective rate for P500,000 is
P125,000 divided by P5000,000 = 25%



(Sec 24 NIRC)
Top marginal rate the highest rate applicable 32%
Concepts of income
Definition all wealth which flows into the taxpayer other than as a
mere return of capital.
Includes the forms of income specifically described as gains
and profits, including gains derived from the sale or other
disposition of capital asset.
Income as the fruit of capital or labor severed from the tree.
Gain derived and severed from capital, from labor or from
both combined.
Income vs Capital
Income: Profit or gain from the flow of wealth, fruit; Capital
wealth or fund, tree
Gross receipts includes money or its equivalent actually or
constructively received in consideration of services rendered or
articles sold, exchanged or leased, whether actual or constructive.
Gross revenues covers money or its equivalent actually or
constructively received, including the value of services rendered as
article sold, exchanged or leased, the payment of which is yet to be
received.
Gross income means all income derived from whatever source,
including the following items:
1. Compensation for services
2. Gross income derived from the conduct of trade, business
or exercise of profession
3. Gains derived from dealings in property
4. Interests
5. Rents
6. Royalties
7. Dividends
8. Annuities
9. Prizes and winnings
10. Pensions
11. Partners distributive share from the net income of the
general professional partnership
Income for financial accounting vs income for tax purposes
Financial accounting increases in economic benefits; tax
purposes constitutive of gross income as defined under
the NIRC.
Financial accounting encompasses both revenue and gains
whether exempt from taxation or not; tax purposes does
not include certain items that are exempt from taxation.
Conceptual definition of income
1. Any material gain, not excluded by law
2. Realized out of a closed and completed transaction
3. Where there is an exchange of economic value for
economic value
To be used only for determining which items to be
considered as income
Not to be used in answering objective type questions
Material gain income does not only refer to the money a taxpayer
receives but includes anything of value, whether tangible or
intangible.
Annual compensation of an employee of a brand new car
part of income
Security advances/deposits paid by lessee to a lessor not
considered as income; lessor did not earn any profit.
Not added by law an income may have the other elements of the
conceptual definition but the law may specifically exclude it.
Kinds of income according to tax rates: subject tofinal tax, reduced
rate
a. Income subject to final tax (Sec. 24, NIRC)
1. Certain passive income
Interests, royalties, prizes and other winnings
Cash and/or property dividends
2. Capital gains from sale of shares of stock not traded in
the stock market
3. Capital gains from sales of real property
b. Incomes subject to the schedular rate
1. Compensation income earned by an individual or
2. The income of an individual from trade, business or
exercise of a profession, or
3. The income earned by estates or trusts
The schedular tax rate, which is progressive in character, is
applied to the taxable income.
c. Incomes subject to reduced rate also known as normal
rate, or the MCIT, whichever is higher.
Taxable income
Definition: Means the
1. Pertinent items of gross income specified in the NIRC
2. Less the deductions and/or personal and additional
exemptions, if any, authorized for such types of income by
the NIRC and other special laws.
Determinants of taxable income taxable income shall be
computed on the basis of taxpayers
1. Annual accounting period (fiscal year or calendar year, as
the case may be)
2. In accordance with the method of accounting regularly
employed in keeping the books of such taxpayer.
Annual accounting period
Taxable period the calendar year, or the fiscal year ending during
such calendar year, upon the basis of which the net income is
computed for income tax purposes.
General rule: taxable period always 12 months, whether calendar or
fiscal year.
Exceptions: instances when a taxpayer may have a taxable
period of less than 12 months
a. When a corporation is newly organized and
commenced operations on any day within the year;
b. When a corporation changes its accounting period;
c. When a corporation is dissolved;
d. When the Commissioner of Internal Revenue, by
authority, terminates the taxable period of a
taxpayer pursuant to Section 6 of the Tax Code;
e. In case of final return of the decedent and such
period ends at the time of his death.
Kinds of accounting period
1. Calendar year 12 consecutive months starting on January
1 and ending on December 31
Instances when calendar year shall be used
i. When the taxpayer is an individual
ii. When the taxpayer does not keep books of
account
iii. When the taxpayer has no annual
accounting period
iv. When the taxpayer is an estate or a trust.
Taxpayers who are required to use only the
calendar year taxpayers other than corporations
are required to use only the calendar year. These
are
i. Individuas
ii. Estates and trusts
iii. General professional partnerships
2. Fiscal year means an accounting period of 12 months
ending on the last day of any month other than December.
Could start at any month and end 12 months later.
Usually July 1 to June 30
Accounting period of a corporation a corporation may employ
either calendar year or fiscal year.
Period within which items of gross income are included
1. The amount of all items of gross income shall be included:
a. In the gross income for the taxable year
b. In which received by the taxpayer
2. Unless, under methods of accounting permitted under the
NIRC
a. Any such amounts are to be properly accounted for
b. As of a different period (Sec. 44, NIRC)
Inclusions in gross income in case of deceased taxpayer
1. In computing taxable income
a. For the taxable period
b. In which falls the date of his death
2. Amounts accrued
a. Up to the date of his death
b. If not otherwise properly includible. (Sec. 44)
Period for which deductions and credit taken
1. The deductions allowed
a. Shall be taken for the taxable year
b. In which paid or accrued or paid or incurred
2. Dependent upon the method of accounting
a. Upon the basis of which the net income is
computed,
3. Unless in order to clearly reflect the income
a. The deductions should be taken as of a different
period. (Sec. 45)
Paid or incurred and paid or accrued shall be construed
according to the method of accounting upon the basis of which the
net income is computed for purposes of income taxation. (Sec.22)
Change of accounting period if a taxpayer, other than an
individual, his accounting period
1. From fiscal year to calendar year
2. From calendar year to fiscal year,
3. From one fiscal year to another
the approval of the CIR
only a corporation may change its accounting periods.
Accounting methods
Principal methods Cash and Accrual
1. Cash method income should be construed as income for
tax purposes only upon actual or constructive receipt of the
cash payment or property.
Under this method, the income earned by the
taxpayer is not included in gross income until
received, and expenses are not deducted until paid
within the taxable year.
Tax payers who use this method generally, the
taxpayers who use the cash method are those
whose transactions are not numerous:
i. Individuals engaged in business and practice
of profession
ii. Professional partnerships
iii. Professional service organizations
2. Accrual method this is a method of accounting for income
in the period it is earned, regardless of whether it has been
received or not.
Net income is measured by the excess of income
earned during the period over the expenses
incurred.
Expenses not claimed as deductions in the current
year when they are incurred cannot be claimed as
deduction for the next year.
Requisites to determine when to include amount in
gross income it is the right to receive income, and
not the actual receipt, that determines when to
include the amount in gross income. The following
are the requisites:
1. That the right to receive the income must be
valid, unconditional and enforceable, i.e. not
contingent in the future;
2. The amount must be reasonably susceptible of
accurate estimate;
3. There must be a reasonable expectation that
the amount will be paid in due course.
1. Recognition of income and expenses under the
accrual method the accrual of income and
expense is permitted when the all-events test
has been met.
2. All events test :
1. Fixing of a right to income or liability to
pay; and
2. The availability of the reasonable
accurate determination of such income
or liability
o It is satisfied where computation remains
uncertain, if its basis is unchangeable. The
amount of liability does not have to be
determined exactly, it must be determined with
reasonable accuracy.
3. Taxpayers that use the accrual method this is
being used by taxpayers whose nature of business
uses inventories since this method will correctly
reflect income by matching purchase and expenses
against sales.
Gross income from construction contracts
Construction contract a contract specifically negotiated
for the construction of an asset or a combination of assets
that are closely interrelated or interdependent in terms of
their design, technology and function or purpose.
Long-term contract means building, installation or
construction contracts covering a period in excess of 1
year. Kinds:
1. Fixed price contract a construction contract in
which the contractor agrees to fix contract price, or a
fixed rate per unit of output, which in some cases
subject to cost escalation clause.
2. Cost plus contract a construction contract in which
the contractor is reimbursed costs, plus a percentage
of these costs or a fixed fee.
Completion of contract basis gross income is to be reported in the
taxable year in which the contract is fully completed and accepted
by the contractor.
All expenditures are deducted from gross income during the
life of the contract.
Not recognized for tax purposes.
Percentage of completion basis contracts revenue is recognized as
revenue in the accounting period in which the work is performed.
Contract costs are usually recognized as an expense in the income
statement. However, any expected excess of total contract costs
over total contract revenue for the contract is recognized as an
expense immediately.
Installment basis for income recognition
Installment basis it is considered appropriate when
collections extend over relatively long periods of time and
there is a strong possibility that full collection will not be
made.
Formula:




Income from lease lease is an agreement whereby the lessor
conveys to lessee in return for payment or series of payments the
right to use an asset for an agreed duration.
Classification of leases
1. for civil law purpose 1) lease of things, 2) lease of
work/service
2. for financial accounting purposes Finance lease and
Operating lease
Finance lease or full payout lease is a contract involving payment
over an obligatory period of specified rental amounts for the use of
a lessors property, sufficient in total to amortize the capital outlay
of the lessor and to provide for lessors borrowing costs and profits.
Considered as conditional sale
Installments method of income recognition shall be used.
If there is reasonable certainty that the lessee will obtain
ownership by the end of the lease term, the period of
expected use is the useful life of the asset.
Lessee - The asset subject of the lease is initially recognized
as assets and liabilities in the balance sheet.
Lessors shall recognize assets under the finance lease in their
balance sheets and present them as receivable at an amount
equal to the net investment in the lease.
Methods for income recognition where ownership of improvements
constructed by the lessees is transferred to the lessor after the
lease period
1. Lessor reports as income the fair market value of the
improvements at the time of completion of
construction.
2. Lessor spreads over the life of the lease the estimated
depreciated value of improvements at the termination
of the lease and report as income for each year of the
lease an aliquot part thereof.
Operating lease is a lease other than a finance lease
Truly a lease of things whereby one of the parties binds
himself to give to another the enjoyment or use of a thing,
for a certain price, and for a period which may be definite or
indefinite.
Lease Package that type of finance lease which has 2 or more
lessors, particularly if the size of the lease facility is substantial
relative to the exposure limits of a lessor.
Rental for income tax purposes the amount paid for lease of
property is rental income to the owner of the property.
Any additional amount paid, directly or indirectly, by the
lessee in consideration for the lease is considered rental.
Taxes paid by the lessee on leased property are part o
rental income of the landlord.
Tax treatment where a corporation leases its property in
consideration of dividends or interest in lieu of rentals. such
payments shall be considered rental payments and shall be
returned by the lessor corporation as income.
Equipment leasing is not installment sales, because
1. Agreements were all prepared in the form of lease contracts
which spelled out its equipment being leased, the lease period
and rentals.
2. The lease agreement included extraordinary terms such as
option to acquire the lease equipment by paying the stipulated
loss value, requiring the lessee to pay the insurance premium
on the leased equipment.
Treatment of operating leases by the lessor lessors shall present
assets subject to operating leases in their balance sheets according
to the nature of the assets.
Treatment of operating leases by the lessee lease payments under
an operating lease shall be recognized as an expense on a straight-
line basis over the lease term unless another systematic basis is
more representatives of the time pattern of the users benefit.
Realization principle for recognizing income
Realized out of a closed and completed transaction