TAXATION LAW COMPENDIUM VOLUME 2

TITLE II: TAX ON INCOME

CHAPTER I
SEC 21. Sources of Revenue - The following taxes, fees and charges are deemed to be national internal revenue taxes:
(a) Income tax;
(b) Estate and donor's taxes;
(c) Value-added tax;
(d) Other percentage taxes;
(e) Excise taxes;
(f) Documentary stamp taxes; and
(g) Such other taxes as are or hereafter may be imposed and collected by the Bureau of Internal Revenue.

Concept of internal revenue

Internal revenue
Monies collected by a government through imposition of levies and taxes on facilities
incomes sales of goods and services transfers of properties and other domestic
transactions as opposed to monies collected from duties imposed on imports and
other international transactions.
External revenue
Income from overseas or tax placed on an item coming into the state.
Example is a custom duty levied against a certain imported product.

It is government revenue from domestic sources; also called inland revenue.

Internal Revenue Taxes of the Philippines

1. Income tax
2. Estate and donor's taxes
3. Value-added tax
4. Other percentage taxes
5. Excise taxes
6. Documentary stamp taxes
7. Such other taxes as are or hereafter may be imposed and collected by BIR

Concept of income
INCOME:
 Flow of services rendered by that capital by that payment of money from it or any other benefit rendered by a fund of capital in relation to such fund through a period
of time.
 Amount of money coming to a person or corporation within a specified time whether as payment for services interest or profit from investment.
 Flow of fruits of one’s labor.
Problems in defining income arise when a taxpayer realizes a benefit or compensation that is not in the form of money.
Ex: fringe benefits (housing education) or de minimis benefits (meal allowance)

Realization of gain need not be in cash derived from sale of an asset. Gain may occur as a result of:
1. Exchange of property
 2. Payment of taxpayer’s indebtedness
3. Relief from a liability
4. Other profit realized from completion of a transaction
Fact that the gain is a portion of the value of property received by the taxpayer does not negate its realization.

Income Capital
Subject to tax Not subject to tax; taxing capital amounts to confiscation of property which violates
due process

All wealth which flows into the taxpayer other than a mere return on capital. Fund or property existing at one distinct point in time
Denotes a flow of wealth during a definite period of time.
Gain derived and severed from capital

Flow Fund
Service of wealth Wealth
Fruit—income Tree—property; labor; capital

Illustrations
1. If taxpayer acquired 10 shares of stock for P100/share and later sells for P100/share proceeds would merely be return of capital and therefore would not be taxable. If
the shares were sold for P150/share the P50 would be taxable.
2. If a creditor collected from his debtor money received is not income. The interest in addition to the principal debt is taxable to the debtor.

Accounting equation
CAPITAL = ASSETS — LIABILITIES
If a taxpayer purchases equipment:
Equipment = P100K

Terms:
 50% downpayment
 5 equal installments

 ASSET is P100000
LIABILITY is P50000
CAPITAL/net worth is P50000
If in the following year taxpayer purchases another equipment worth P50000 payable after 1 year
CAPITAL still P50000 because while there is P50000 increase in assets there is also a corresponding increase of LIABILITY P50000

Any increase in asset or decrease in liability will increase the capital. Increase in capital is presumed income while decrease is presumed loss unless otherwise proven.

NET WORTH METHOD: a taxpayer’s capital (net worth) at the beginning of the year compared to his capital at the end
If his capital increased then he had receipts of money or property
If receipts cannot be accounted for by non-taxable sources receipts are taxable.

An increase in net worth if unreported and not explained by taxpayer comes from income derived from a taxable source. However if increase is not revenue-related then it is
not income.
 Correction of entry in the taxpayer’s books is not taxable. Income Tax Law only imposed tax on income.

Tax on income/partnership theory

Right of a government tot ax income emanates from its partnership in the production of income by providing the protection resources incentive and proper climate for such
production.

Concept of income tax

INCOME TAX: tax levied on income of individuals and/or corporations or other legal entities.
It is an excise tax because it is levied not upon persons property funds or profits but upon right of a person to receive income or profits (natural or juridical).

SEC 32: “all income derived from whatever source:

1. Compensation for services (including fees commissions fringe benefits and similar items)
2. Gross income derived from business
3. Gains derived from dealings in property
4. Interests
5. Rents
6. Royalties
7. Dividends
8. Annuities
9. Prizes and winnings
10. Distributive share of partnership gross income buy incomes any item of income received by taxpayer unless there is a law or treaty exempting it.

Business purpose not required
Despite absence of business purpose following events
are subject to income tax:
1. Recovery of bad debts previously claimed as
deduction which reduced the taxable income
2. Share in hidden treasure
3. Condonation of f a solvent debtor in absence of
donative intent on creditor
4. Damages for loss of profits/opportunities
5. Refund of deductible tax previously claimed as
deduction from gross income
Income tax is assessed on income received from any
property activity or service that produces the income.
Although imposed in come business purpose is not a
requirement in the imposition of taxes.
Taxing authority is morally neutral Requisites of taxable income
Following are subject to income tax: REQUISITES:
1. Collection of usurious interest 1. There must be gain
2. Disposition of amount received by mistake 2. Gain must be realized or received
3. Winnings from illegal gambling 3. Gain must not be excluded by law or treaty
4. Proceeds from illegal sale of body organ from taxation.
5. Money from drug deals
6. Money or property received through mistake
Not all income are subject to income tax.
Government or taxing authority does not distinguish
between illegally sourced and legally sourced income.
Income from illegal source is also taxable.
Purposes of income tax
1. Raise revenues
2. Equalizes tax burden by having each taxpayer pay a similar percentage of income thus offsetting regressive taxes
3. Because income is taxed as it is earned taxpayers have funds to pay
4. Because of upfront payment taxpayers notice the burden less because it does not enter the taxpayer’s coffers anymore

Characteristics of Philippine Income Tax:

1. Direct tax because tax burden is borne by income tax recipient upon whom tax is imposed
2. Progressive because tax rate increases as tax base increases
3. Comprehensive system because it adopts citizenship principle residence principle and source principle
4. Semi-schedular and semi-global
Semi-schedular Semi-global
Income levels are divided into different classifications for determining tax Income is aggregated from all sources and then taxed at a single progressive
rates. rate.

Each income classification represents a different source of income such as: NIRC: taxable income (i.e. gross income – allowable deductions and
1. Business profits exemptions) is subjected to graduated tax rates (if individuals) or corporate
2. Capital gains income tax rate (if corporation) while certain passive incomes and capital
3. Employment income gains are subject to final tax.
4. Entitlements
These are taxed according to the applicable specific provision of tax law.

5. American origin authoritative decision of the official charged should be given construction placed upon revenue law  whose meaning is doubtful by the department
charged with its execution.

Functions of tax law

1. Provide large amount of revenues
2. Offset regressive taxes through progressive taxes
3. Mitigate the evils arising from inequalities in the distribution of income and wealth which are considered deterrents to social progress

Taxable income Accounting income

Based on method of account used by taxpayer it will always differ from accounting
income.

Aimed at collective revenue Attempts to match cost against revenue.

It will not recognize deductions for contingent future losses except in very limited Requires recognition of contingent future losses
situations.

Approved accounting methods

1. Reflecting income
a. All items of gross income and all deductions are treated with reasonable consistency
b. All items of gross income shall be included in the gross income for the taxable year in which they are received by taxpayer and deductions taken accordingly
 unless such amounts are to be properly accounted for as a different period
i. In any case in which it is necessary to use an inventory no accounting as to purchase and sale will correctly reflect income except an accrual method
1. Taxpayer is deemed to have received items of gross income which have been credited or set apart without restriction.
ii. On the other hand appreciation in value of property is not an accrual income prior to the realization of such appreciation through sale or conversion
of property.

Tests/doctrines in determining taxable income

1. FLOW OF WEALTH TEST: there is taxable income so long as gain has been derived by the taxpayer from the event or transaction he has entered into. This is related to
the NET WORTH METHOD.
a. Illustrations
i. A foreign travel agency transmitted funds to a local travel agency for the latter to pay hotel accommodation of tourists that would visit the Philippines.
Funds received by the local travel agency are not taxable because gross receipts subject to tax under NIRC do not include monies or receipts
entrusted to taxpayer which do not belong to them and do not redound to his benefit. It is not necessary that there must be a law or
regulation which would exempt such monies under meaning of gross receipts.

ii. A obtained P1M LOAN from AX BANK with no collateral to secure the same. Loan document provided that debt is payable within 2 years. After 1 year
A migrated abroad.
There is no taxable income because there is still an obligation to pay. When A entered into the contract of loan he bound himself to pay AX
BANK. In case of default AX BANK can run after A’s properties whether here or abroad. There is no increase in A’s networth since amount of
his liability remained despite migrating.

iii. R Corporation (foreign) declared its dividends on record. One stockholder did not pay the tax due on dividends. R CORP shouldered the tax due to BIR.
Stockholder should declare income for tax assumed by R CORP because his tax was his responsibility. His networth increased.

iv. S leased house of L and was required to put a deposit equivalent to 1 month as security. Advance rental would be applied on last month of lease
period and security deposit would answer for damages and/or unpaid utilities at the end of the lease. L used the deposit to make improvements on his
principal residence.
L is not liable for income tax. Although there has been a gain upon the use of deposit there is no increase in L’s wealth. Advance-rental will
be considered income only on the last month of the lease.
Security deposit is earmarked and there is an obligation to return the same at the end of the contract of lease in case there is no damage or
unpaid utility. Thus there is no flow of wealth.
However if there is no obligation to return or it has been forfeited as a consequence of breach it is taxable income.

2. REALIZATION OF INCOME TEST: income is not taxable until it is realized. Mere increase in value does not result in imposition of tax. There is no taxable income until
there is separation from capital of something of exchangeable value thereby supplying the realization or transmutation which would result in the receipt of income.
a. REALIZATION OF INCOME: if there is a taxable event or triggering occurrence that marks the time when income becomes taxable.
i. Examples
1. Disposition of property in question through sale or exchange
2. Receipt of salary

ii. CONDITIONS FOR RECOGNITION OF REVENUE:

1. Earning is complete or virtually complete
 2. Exchange has taken place

iii. Revenue must be earned before it is received.

iv. UNEARNED REVENUE: Amounts in advance are not treated as revenue for the period received but for future period or periods in which they are
earned. Liabilities to transfer goods or render services in the future until the earning process is complete. No exchange has taken place.
v. EXCHANGE/EXCHANGE TRANSACTION: reciprocal transfer between an enterprise and another entity that results in enterprise’s acquiring assets or
services or satisfying liabilities by surrendering other assets or services or incurring other obligations.

vi. Illustration
1. Appreciation of value of house or land is not taxable. To be taxable there must be disposition of ownership and control coupled with actual
or constructive receipt of proceeds in consideration.

b. Recognition of invisible income: although not involving actual or constructive receipt of asset it triggers a tax liability.
i. Illustration
1. If creditor extends a loan but discharges the debtor of legal obligation to repay it is taxable income because debtor has indirectly received a
real and measurable monetary benefit in view of Condonation of debt. Thus there is an accession of wealth.
a. CANCELLATION OF DEBT INCOME: decrease in liability results to increase of capital or networth which is presumed income
2. If donative intent is present discharge indebtedness is considered a gift and subject to donor’s tax. If consideration is other than liberality of
creditor it is subject to income tax. Any gain is considered income.

c. Insolvency exclusion
i. EXCEPTION TO “INCOME FROM DISCHARGE OF INDEBTEDNESS RULE”
ii. INSOLVENCY: when total liabilities exceed fair market value of assets

iii. REASON: there is no accession to income; taxpayer remains insolvent since no assets have been freed.
iv. To the extent the cancellation renders the taxpayer solvent he is deemed to have realized income in the amount by which his assets exceeds his
liabilities immediately after cancellation.

v. Financial Rehabilitation and Insolvency Act (FRIA) 2010: debt discharges in bankruptcy or insolvency proceedings are not taxable income.
vi. Illustrations
1. H borrowed P100K from C. H became insolvent. He then asked his brother E to pay C. E paid C P120K.
H is not subject to tax because he is insolvent. But if the assumption of debt by E makes him insolvent H is liable unless he can prove
that it is a gift which is subject to donor’s tax or he borrowed the amount from E.
C is liable for income tax on the excess of payment amouting to P20000. P100000 is not taxable because it is only a mere return of
capital.

2. B borrowed P200K from K. B became insolvent. A B’s friend gave K P250K to condone the debt of B.
B is not subject to tax because he is insolvent. But if the condonation of his debt makes him solvent he is liable unless he can prove
that it s a gift subject to donor’s tax.
K is not liable for income tax but the gift from A is subject to donor’s tax.

3. F has P50K assets and P100K liabilities therefore insolvent.

Condonation of his debt amounting to P20K will not be taxable because he remains insolvent.
 However if condonation amounts to P70K F will have P20000 taxable income because his liabilities no longer exceed his assets.

d. Revaluation increment
i. REVALUATION INCREMENT: booked by an entity when it elects to revalue premises and other property and equipment through appraisal of repultable
experts and specialists and such revaluation increases the stockholder’s equity of an entity.
1. Difference between assessed value of a real property and actual cost of it does not constitute taxable income unless there has been a sale or
exchange of such property in which gain constitutes taxable income.
2. Excess of appraised value over its net book value is not subject to income tax because there is no realized income on account of the appraisal
of the property.

ii. If taxpayer acquired land for P100K and recorded it in its books revaluation and adjustment of books to P1M after 10 years (pursuant to an appraisal)
will not result to taxable income.

e. DOCTRINE OF CONSTRUCTIVE RECEIPT:

i. Even if income has not actually been reduced to taxpayer’s possession it is deemed to have been received if it is:
1. Credited to the taxpayer’s account
2. Set aside for the taxpayer
3. Made available for the taxpayer’s disposal at any time
4. Directly transferred to a party other than the taxpayer
5. Offsets an obligation of the taxpayer

ii. If and when a taxpayer’s will is the only wall that stands between income and taxpayer’s coffers it will be considered constructively received.
1. Amount credited to taxpayer’s bank account is taxable whether or not he withdraws it.
iii. No constructive receipt if taxpayer is subject to substantial limitations as regards disposition of income received.
iv. Anchored on lifeblood theory and is a deterrent to tax evasion

v. Illustrations
1. ATTY. V engaged in services of DR. A to attend to his family health needs. Cost of medical services amounted to P20000. Instead of paying for
his services ATTY V agreed to appear as counsel in DR A’s malpractice case pending in court.
Both have income which they constructively received. It is not different from where they paid for each other’s services. Income may
be in any form.

2. A issued O a check dated OCT 30 2006 payable on demand. O encashed the check only JAN 3 2007.
O should declare the income on OCT 30 2006 under the principle of Doctrine of Constructive Receipt.

3. Postal service tried to deliver a check to A on DEC 21 2012 but A was not at home to personally receive it.
Such is taxable under 2012 because he must income the amount of the check in his income for that taxable year. A valid check
received or made available before the end of the year is considered income constructively received for that year even if he does not
cash or deposit it to his account until the next year.
However if check was mailed so that it could not possible reach him until after the end of tax year and he could not otherwise get
the funds before the end of the year he should include the amount in his income for the next year.
 f. Power to dispose: equivalent to ownership of it.
i. Exercise of power to procure payment of income to another is the enjoyment hence realization of income by him who exercises it.
ii. Illustration
1. T rendered services for Z. Former instructed the latter to give the service fees to his godson M.
T has taxable income. Despite non-receipt of money or property T’s act of giving the same to M is constructive receipt on his part.
M has no realization of income since gift from his godfather is subject to donor’s tax unless there is service or property given by M in
exchange thereto.

g. Constructive receipt in case of taxes withheld

i. Amount of tax withheld from total payment = income received by earner from source of the payment.
ii. Tax deducted and withheld shall be held as special fund in trust for the government until paid to the collective officer. This does not justify exclusion
from computation of income.
iii. Withholding tax constitutes payment which would extinguish obligation to the government. Taxpayer can only pay money it owns or money it is
authorized to pay.
iv. Withholding tax implies that it comes from income earned. Since amount constitutes income amount is manifested in the taxpayer’s gross receipts.
Because such amount belongs to the taxpayer he can transfer its ownership to the government in payment of his tax liability. Thus amount becomes
from income and forms part of his gross receipts.

v. Illustration
1. When a depository bank withholds the final tax to pay the tax liability of a lending bank there is prior the withholding a constructive receipt
by the lending bank of the amount withheld. From the amount constructively received by lending bank depositary bank deducts the final
withholding tax and remits it to the government for the account of the lending bank. Thus interest income actually received by lending bank
both physically and constructively is net interest + amount withheld = final tax.

h. Realization vs. Recognition

i. RECOGNITION: income recognized and taxed by law.
1. If income is not recognized or is excluded/exempted it is not taxable even if realized.
2. SEC 32 NIRC: enumerates income excluded from gross income and there not taxable.
ii. Unrealized income may be taxable if it is recognized as such.
1. Mere increase in value of property (revaluation increment) without actual realization through sale or other disposition is not taxable in
general because there is no realization.
EXCEPTION: If after appraisal increased value is used as basis for computing depreciation expense.
Difference between original/acquisition cost and appraised value is subject to tax pursuant to economic-benefit principle.

2. Illustration
a. A bought a building for P500K and recorded depreciation based on that amount. After 10 years building was appraised to be P1M. A
used P1M in computing depreciation.
In this case the difference of P500K would be taxable.

3. CLAIM OF RIGHT DOCTRINE: income received without restriction must be reported in the year received even if there is a possibility that it may have to be repaid ina
later year. If it is repaid repayment is deductible in the year of payment.
a. For income to qualify as being received there must be a receipt of cash or property that constitutes income rather than loans or gifts or deposits that are
returnable. Taxpayer needs unlimited control on use or disposition of funds and he must treat income as his own.
 i. An employee who receives a 13th month bonus must report the same as taxable income even if later discovered to be the result of accounting error
and must be returned. Same is true with embezzled funds even if embezzler ma be adjudged to repay the owner + criminal penalty.
1. There is an increase in capital in case of embezzlement since there is an increase in assets without recognition of liability.

ii. Illustration
1. G asked his brother who was based in US to send him $1000. His brother wired him money through local bank. However bank committed an
error in posting the entry instead of $1000 G got $100000. G spent all the money but later got caught.
a. G is subject to tax. Although G had obligation to return the money he had control and complete dominion over the money.
b. Ruling in case of local travel agency which received funds from foreign travel agency to pay hotel accommodation is not application.
IN said case receiver had no control over the amount.

2. R worked as an agent in a big insurance company. His premium collections were inordinately huge. He did not remit the collections but
instead embezzled the money.
a. R is subject to tax because he had complete control over the fund which he used for his benefit.

3. BC CORP won a court case. Decision ordered defendant to pay BC P100K. Defendant filed a notice of appeal but deposited in escrow for BC’s
favor P100000 to prevent interest from accruing and accumulating.
a. BC should not report P100000 as taxable income. Claim of right of doctrine states that income must be reported if use of funds is
unrestricted.

4. Economic-benefit principle (Doctrine or proprietary interest): any economic or financial benefit (such as those conferred by employer to employee as compensation) is
taxable—regardless of form or mode by which that benefit/enrichment is conferred.
i. An employee must report any compensation whether in cash or in kind unless specifically exempted.

ii. Illustration
1. A stock option (right but not an obligation to buy a stock at an agreed price) granted by an employer is not taxable unless exercised by
employee.

b. Prepaid income (such as compensation for future services) is income in the year it is received.
i. However in case of accrual method of accounting recognition of prepaid income is deferred and reported as it is earned (by performing the services)
.
c. Substantial alteration of interest: there is income when there is substantial alteration of interest by taxpayer.
i. Illustration
1. A reclassification of shares that increases the proportionate equity of a stockholder in a corporation is taxable income.

5. Severance theory/test (MACOMBER TEST): income is recognized when there is a separation of a thing which is exchangeable value thereby supplying the realization or
transmutation resulting in the receipt of income.
a. A stock dividend is not taxable because value of equity is the same. Only the shares increased. Taxation comes when stock received as dividend has been sold
or bartered.
b. Connected to:
Realization from labor or capital test Exchangeable value test
Requires that taxable income be derived from labor or capital Requires that it originate from someone other than the taxpayer
 c. It is not necessary to recognition of taxable gain that he should be able to sever the improvement begetting the game from his original capital.
i. If taxpayer received back his land with a new building on it which added an ascertainable amount to its value fact that gain is a portion of value of
property does not negative its realization.

6. ASSIGNMENT OF INCOME DOCTRINE: income generated by performance of services is taxed to the performer while income generated by property is taxed to the
owner of the property. Owner of the tree is taxable for the fruit even if someone else eats it.
a. PURPOSE: Taxation of income is for those who earn or otherwise create the right to receive it and who enjoy the benefit of it when paid.
i. Stockholder remains to be liable for tax on dividends declared by a corporation even if he assigned the same to a tax-exempt entity. However there is
a bona fide transfer of shares of stock prior to declaration of dividends new stockholder is one liable for tax.

b. Illustration
i. A Sr. detached negotiable interest coupons from his corporate bonds and gave the coupons to his son A Jr. Tax due on interest income remained
unpaid. Meanwhile A Jr. became insolvent. BIR discovered non-payment of tax and assessed A Sr. for tax deficiency. A Sr. contended that he was not
liable and A Jr. should be taxed because he was owner of the income.
1. A Sr. is still taxable on interest income because he owned the asset that created the right to the interest income.
2. Under the principle income must be taxed under person who earns it even if another person has a legal right to the wealth represented by
the income.

ii. If taxpayer agrees by contract that a 3rd party is to receive income from him he must income the amount in his income when the 3rd party receives it.
1. Thus if taxpayer and his employer agree that part of his salary is to be paid directly to the taxpayer’s former spouse the taxpayer must
include that amount in his income when his former spouse receives it.

7. ALL-EVENTS TEST
a. Test requires:
i. Fixing of a right to income or liability to pay
ii. Availability of reasonable accurate determination of such income or liability
b. Test does not demand that the amount of income or liability be known absolutely only that a taxpayer has at his disposal the information necessary to
compute the amount with reasonable accuracy.
c. All-events test is satisfied where computation remains uncertain if its basis is unchangeable
d. Test is satisfied where a computation may be unknown but is not as much as unknowable within taxable year
e. Amount of liability does not have to be determined exactly but it must be determined with reasonable accuracy.
i. “REASONABLE ACCURACY”: something less than an exact or completely accurate amount.

f. In case of deductions there is compliance when:

i. All events have occurred which establish the fact of liability
ii. Amount can be determined with reasonable accuracy
iii. Economic performance has occurred with respect to liability

g. Illustrations
i. X a retailer sold product A to Y for P50000. Y paid X upon delivery of product A. Upon testing product A failed to meet agreed specifications. Y sued
X for refund of P50000.
1. Under claim of right doctrine X should report P50000 he received from Y because he has unrestricted claim to the income even if the may be
adjudged later onto the refund. However if Y has not paid X X is not required to report P50000 since his rights to the same have not been
 fixed.
ii. Z CORP bought manufacturing supplies received used and get billed for them in 2011. Even if Z CORP paid billing in 2012 it can deduct the expense in
2011 because the liability was fixed amount was know and economic performance happened in 2011.

Types of Taxable income

1. Compensation Income
a. Income derived from rendering services under an employer-employee relationship.
b. Remuneration for services rendered whether in salary fees or commissions.
c. In addition to wages salaries commissions fees and tips this includes other forms of compensation such as fringe benefits and stock options.

2. Professional Income
a. Income derived from engaging in an endeavor requiring special training and skill as a professional and as a source of livelihood which includes but is not limited
to fees of lawyers accountants doctors engineers and the like.
b. PROFESSIONAL: one engaged in one of learned professions or in an occupation requiring a high level of training and proficiency.

3. Business Income
a. Any income that is realized as a result of business activity. This includes gains or profits derived from rendering services selling merchandise manufacturing
products farming and long-term construction contracts.

4. Passive Income
a. Income earned in an activity in which an individual does not materially participate.
b. Includes income from an interest in a limited partnership; rental income regardless of material participation
c. Also includes but is not limited to interest income royalty income dividend income winnings and prizes
d. ACTIVE INCOME: salaries and wages earnings from a trade or business

5. Capital Gain
a. Profit realized on sale or exchange of capital asset
b. GAIN: difference between cost or the adjusted basis of an asset and net proceeds from sale or exchange of such asset