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 government2. Levied at progressive rates, regarded as the best measure of

ability to pay3. Necessary to offset the regressive sales and consumption

taxes4. 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 loss2. The rule of taxation may not be equitable and uniform if the

gross income were the basis of the tax3. 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 person’s 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. Progressive2. Global system for corporations and schedular for individuals3. 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 baseb. 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%

tax rate=total taxliabilitytax base (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 services2. Gross income derived from the conduct of trade, business

or exercise of profession3. Gains derived from dealings in property4. Interests5. Rents6. Royalties7. Dividends8. Annuities9. Prizes and winnings10. Pensions11. Partner’s 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 law2. Realized out of a closed and completed transaction3. 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 propertyb. Incomes subject to the schedular rate

1. Compensation income earned by an individual or2. The income of an individual from trade, business or

exercise of a profession, or3. 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 NIRC2. 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 taxpayer’s

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 usedi. 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. Individuasii. Estates and trusts

iii. General professional partnerships2. 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 yearb. 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 forb. As of a different period (Sec. 44, NIRC)

Inclusions in gross income in case of deceased taxpayer

1. In computing taxable incomea. For the taxable period

b. In which falls the date of his death2. Amounts accrued

a. Up to the date of his deathb. If not otherwise properly includible. (Sec. 44)

Period for which deductions and credit taken

1. The deductions alloweda. Shall be taken for the taxable yearb. In which ‘paid or accrued’ or ‘paid or incurred’

2. Dependent upon the method of accountinga. 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 year2. 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 partnershipsiii. 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; and2. 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: TotalGross ProfitTotalSelling Price

× Installment received for the Year=Income for the Year subject ¿ incometax

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 lessor’s property, sufficient in total to amortize the capital outlay of the lessor and to provide for lessor’s 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 user’s benefit.

Realization principle for recognizing income

Realized out of a closed and completed transaction