THE CONCEPT OF INCOME

Why is income subject to tax?

Income is regarded as the best measure of taxpayers' ability to pay tax. It is an

excellent object of taxation in the allocation of government costs.

What is income for taxation purposes?

The tax concept of income is simply referred to as "gross income” under the NIRC.

A taxable item of income is referred to as an "item of gross income” or "inclusion in

gross income".

Gross income simply means taxable income in layman's term. Under the NIRC
however, the term "taxable income" refers-to certain items of gross income less
deductions and personal exemptions allowable by law. Technically, gross income
is broader to pertain to any income that can be subjected to income tax.

Gross income is broadly defined as any inflow of wealth to the taxpayer from
whatever source, legal or illegal, that increases net worth. It includes income from
employment, trade, business or exercise of profession, income from properties,
and other sources such as dealings in properties and other regular or casual transactions.

ELEMENTS OF GROSS INCOME

1. It is a return on capital that increases net worth.
2. It is a realized benefit.
3. It is not exempted by law, contract, or treaty.

RETURN ON CAPITAL
Capital means any wealth or property. Gross income is a return on wealth
property that increases the taxpayer's net worth.

Illustration
ABC purchased goods for P300 and sold them for P500. The P500 consideration can be
analyzed as follows:

Selling price (total consideration received) P 500

Cost (value of inventory forgone) 300
Mark-up (gross income) P 200

The return on capital that increases net worth is income subject to income tax.
Return of capital merely maintains net worth, hence, it is not taxable
improvement in net worth indicates an ability to pay tax.
Capital items deemed with infinite value

There are capital items that have infinite value and are incapable of pecuniary
valuation. Anything received as compensation for their loss is deemed a return of
capital.

Examples:
1. Life
2. Health
3. Human reputation

Life
The value of life is immeasurable by money. Under Sec. 32 of the NIRC, the
proceeds of life insurance policies paid to the heirs or beneficiaries upon death of
the insured, whether in a single sum or otherwise, are exempt from income tax.

The proceeds of a life insurance contract collected by an employer as a beneficiary

from the life insurance of an officer or any person directly interested with his
trade are likewise exempt. These proceeds are viewed as advanced recovery of
future loss.

However, the following are taxable return on capital from insurance policies:
a. Any excess amount received over premiums paid by the insured upon
surrender or maturity of the policy (i.e. the insured outlives the policy.)

b. Gain realized by the insured from the assignment or sale of his insurance
policy

c. Interest income from the unpaid balance of the proceeds of the policy

d. Any excess of the proceeds received over the acquisition costs and premium
payments by an assignee of a life insurance policy

Health
Any compensation received in consideration for the loss of health such as
compensation for personal injuries or tortuous acts is deemed a return of capital.

Human Reputation
The value of one's reputation cannot be measured financially. Any indemnity
received as compensation for its impairment is deemed a return of capital exempt
from income tax.

Examples include moral damages received from:

a. Oral defamation or slander
b. Alienation of affection
c. Breach of promise to marry

Recovery of lost capital vs. Recovery of lost profits

The loss of capital results in decrease in net worth while the loss of profits does
not decrease net worth. The recovery of lost capital merely maintains net worth
while the recovery of lost profits increases net worth. Therefore, the recovery of lost
profits is a return on capital.

Taxable recovery of lost profits

The recovery of lost profits through insurance, indemnity contracts, or legal suits
constitutes a taxable return on capital.

The following are taxable recoveries of lost profits:

a. Proceeds of crop or livestock insurance
b. Guarantee payments
c. Indemnity received from patent infringement suit

Illustration 1
Mang Reyes insured his strawberry crop in a P200,000 crop insurance coverage
against calamities. The crop was eventually destroyed by an unusual frost. Mang Reyes
was paid the P200,000 insurance proceeds.

The P200,000 proceeds which is a reimbursement for the lost value of the future harvest,
is an item of gross income. The value of the lost crops is, in effect, realized not through
actual harvest but through the insurance contract.

Illustration 2
Mr. Ramos purchased a franchise. The franchisor guaranteed an annual franchise
income of P100,000 to Mr. Ramos. In the first year of operation, Mr. Ramos 'outlet only
earned P60,000.The franchisor paid the P40,000 difference to Mr. Ramos.

The P40,000 guarantee payment is not a gratuity but a recovery of lost profit for Mr.
Ramos; hence, subject to income tax. Mr. Ramos shall report P100,000 as franchise
income.

Illustration 3
Davao Crocodile Inc. experienced an unusual decline in its income after a competitor
copied its patented invention. Davao Crocodile sued the competitor for patent
infringement and was awarded an indemnity of P3,000,000.

The P3,000,000 indemnity is a compensation for the income not realized by Davao
Crocodile due to the patent infringement. The same is an item of gross income.
The recovery of lost income or profits is not intended to compensate for the loss of
capital. It is as good as realization of income; hence, it is an item of gross income.

The "benefit "concept

The term "benefit" means any form of advantage derived by the taxpayer. There is
benefit when there is an increase in the net worth of the taxpayer. An increase in
net worth occurs when one receives income, donation or inheritance.

The following are not benefits,hence,not taxable:

a. Receipt of a loan-properties increase but obligations also increase resulting
in an offsetting effect in net worth.

b. Discovery of lost properties-under the law, the finder has an obligation to

return the same to the owner.

c. Receipt of money or property to be held in trust for, or to be remitted to

another person.

If the taxpayer is entitled to keep for his account portion of a receipt, only that
portion is a benefit.

Illustration
1. An employee was granted P20,000 transportation advance. He liquidated P18,000
transportation expenses and was allowed by his employer to keep the P2,000
Only the P2,000 retained by the employee is considered income since this was the
extent he was benefited.(RR2-98)
2. A security agency receives P120,000 from clients, P100,000 of which is for the
salaries of security guards. Under RMC 39-2007, only the P20,000 attributable to
the agency is considered income of the agency since it is the extent it is benefited.
The P100,000 pertaining to salaries of security guards is recognized by the agency
as a liability upon receipt.

The "realized "concept

The term realized means earned. It requires that there is a degree of undertaking
or sacrifice from the taxpayer to be entitled of the benefit.

Requisites of a realized benefit:

1. There must be an exchange transaction.
2. The transaction involves another entity.
3. It increases the net worth of the recipient.

Types of Transfers
1. Bilateral transfers or exchanges, such as:
 a. Sale
b. Barter

These are referred to as "onerous transactions".

2. Unilateral transfers, such as:

a. Succession-transfer of property upon death
b. Donation

These are also referred to as "gratuitous transactions".

Under current usage, unilateral transfers are simply referred to as "transfers"

while bilateral transfers are called "exchanges." Benefits derived from onerous
transactions are "earned or realized"; hence, they are subject to income tax.
Benefits derived from gratuitous transactions are not realized because of the
absence of an earning process. Benefits derived from gratuitous transactions are
subject to transfer tax, not income tax.

3. Complex transactions
Complex transactions are partly gratuitous and partly onerous. These are
commonly referred to as "transfers for less than full and adequate consideration".
The gratuitous portion of the transaction is subject to transfer tax while
the benefit from the onerous portion is subject to income tax.

Illustration
A taxpayer sold his car which was previously purchased for P100,000 and with
a current fair value of P180,000 for only P130,000.

The transaction will be analyzed as follows:

Fair value P 180,000

P50,000-Subject to transfer tax
Selling price 130,000
P30,000-Subject to income tax
Cost 100,000

The excess of fair value over selling price is a gratuity or gift whereas the excess of the
selling price over the cost is an item of gross income.

What is meant by another entity?

Every person, natural or juridical, is an entity. Natural persons are living persons
while juridical persons are those created by law such as partnerships and
corporations. An entity may be a taxable entity or an exempt entity. A taxable
item of gross income arises from transactions which involve another natural or
juridical entity.
 Gains or income derived between relatives,corporations,and between a partner
and the partnership are taxable since it is made between separate entities.
Likewise, the income between affiliated companies such as between a holding or
parent company and its subsidiaries and between sister companies are taxable
because each corporation is a separate entity. This applies regardless of the
underlying economic relationship.

However, the sales of a home office to its branch office are not taxable because
they pertain to one and the same taxable entity. Furthermore, the income between
businesses of a proprietor should not be taxed since proprietorship businesses are
taxable upon the same owner. Note that a proprietorship business is not a
juridical entity.

Benefits in the absence of transfers

The increase in wealth of the taxpayer in the form of appreciation or increase in
the value of his properties or decrease in the value of his obligations in the
absence of a sale or barter transaction is not taxable.

These are referred to as unrealized gains or holding gains because they have not
yet materialized in an exchange transaction.

Examples of unrealized gains or holding gains:

a. Increase in value of investments in equity or debt securities
b. Increase in value of real properties held (revaluation increment)
c. Increase in value of foreign currencies held or receivable
d. Decrease in value of foreign currency denominated debt by virtue of favorable
fluctuation in exchange rates
e. Birth of animal offspring, accruals of fruits in an orchard or growth of farm
vegetables
f. Increase in value of land due to the discovery of mineral reserves

Rendering of services
The rendering of services for a consideration is an exchange but does not cause
loss of capital. Hence, the entire consideration received from rendering of services
such as compensation income or service fees is an item of gross income.

Illustration
Mr. Mendoza lists the following possible items of gross income:
Compensation income P 200,000
Winnings from gambling 100,000
Increase in value of investments 50,000
Appreciation in the value of land owned 300,000
Debt of Saladin cancelled by creditors in
consideration for services he rendered to them 150,000
Debt of Saladin cancelled by his creditor out of affection 250,000
Loan received from a bank 400,000
The items of gross income are:
Compensation income P 200,000
Winnings from gambling 100,000
Debt of Mendoza forgiven in consideration
for service rendered to his creditors 150,000

Note:
1. Gains from gambling and the forgiveness of debt in consideration of services or properties
received are realized gains from exchanges.
2. The forgiveness of debt out of affection or mere generosity of the creditor is a gratuitous
transfer subject to transfer tax.
3. The loan received from a bank constitutes a transfer but is not a benefit.

Basis of Exemption of Unrealized Income

Normally, taxpayers will have the ability to pay tax when their income
materializes in an exchange transaction since tax is generally payable in money.

This does not mean, however, that only income realized in cash is subject to tax.
Income realized in non-cash properties are, in effect, received in cash but the
taxpayer used the same to acquire the non-cash property. Income received in non-
cash considerations is taxable at the fair value of the property received. Moreover,
exempting income realized in non-cash considerations would open a wide avenue
for tax evasion since taxpayers can easily divert their income in the form of non-
cash consideration.

Mode of Receipt/Realization Benefits

Taxable items of income may be realized by the taxpayer in two ways:
1. Actual receipt
Actual receipt involves actual physical taking of the income in the form of cash
or property.

2. Constructive receipt
Constructive receipt involves no actual physical taking of the income but the
taxpayer is effectively benefited.

Examples:
a. Offset of debt of the taxpayer in consideration for the sale of goods service
b. Deposit of the income to the taxpayer's checking account
C. Matured detachable interest coupons on coupon bonds not yet encash by the taxpayer
d. Increase in the capital of a partner from the profit of the partnership

Inflow of wealth without increase in net worth

The inflow of wealth to a person that does not increase his net worth is not
income due to the total absence of benefit.

Examples:
a. Receipt of property in trust
b. Borrowing of money under an obligation to return

In law, the proceeds of embezzlement or swindling where money is taken without

an original intention to return are considered as income because of the increase in
net worth of the swindler.

NOT EXEMPTED BY LAW, CONTRACT, OR TREATY

An item of gross income is not exempted by the Constitution, law, contracts treaties from taxation.

The following items of income are exempted by law from taxation; hence, they not
considered items of gross income:
1. Income of qualified employee trust fund
2. Revenues of non-profit, non-stock educational institutions
3. SSS,GSIS,Pag-IBIG,or PhilHealth benefits
4. Salaries and wages of minimum wage earners and qualified senior citizen
5. Regular income of Barangay Micro-business Enterprises (BMBEs)
6. Income of foreign governments and foreign government-owned
controlled corporations
7. Income of international missions and organizations with income tax immunity

TYPES OF INCOME TAXPAYERS

A. Individuals 1. Citizen
a. Resident citizen
b. Non-resident citizen

2. Alien
a. Resident alien
b. Non-resident alien
a. engaged in trade or business
b. not engaged in trade or business
3. Taxable estates and trusts

B. Corporations
1. Domestic corporation
2. Foreign corporation
a. Resident foreign corporation
b. Non-resident foreign corporation

INDIVIDUAL INCOME TAXPAYERS

Citizens Under the Constitution, citizens are:
a. Those who are citizens of the Philippines at the time of adoption of the Constitution on February 2,1987
b. Those whose fathers or mothers are citizens of the Philippines
C. Those born before January 17,1973 of Filipino mothers who elected Filipino citizenship upon reaching the age of majority
d. Those who are naturalized in accordance with the law

Classification of citizens:
A. Resident citizen -A Filipino citizen residing in the Philippines
B. Non-resident citizen includes:
1. A citizen of the Philippines who establishes to the satisfaction of the Commissioner the fact of his physical
presence abroad with a definite intention to reside therein;
2. A citizen of the Philippines who leaves the Philippines during the taxable year to reside abroad, either
as an immigrant or for an employment on a permanent basis;
3. A citizen of the Philippines who works and derives income from abroad and whose employment there at
requires him to be physically present abroad most of the time during the taxable year;
4. A citizen who has been previously considered as non-resident citizen and who arrives in the Philippines
at anytime during the taxable year to reside permanently in the Philippines shall likewise be treated as a
non-resident citizen for the taxable year in which he arrives in the Philippines with respect to his income
derived from sources abroad until the date of his arrival in the Philippines .

Filipinos working in Philippine embassies or Philippine consulate offices are not

considered non-resident citizens.

Alien
A. Resident alien - an individual who is residing in the Philippines but is not a
citizen thereof, such as:
1. An alien who lives in the Philippines without definite intention as to his
stay; or
2. One who comes to the Philippines for a definite purpose which in its
nature would require an extended stay and to that end makes his home
temporarily in the Philippines, although it may be his intention at all times
to return to his domicile abroad;

An alien who has acquired residence in the Philippines retains his status as
such until he abandons the same or actually departs from the Philippines.

B. Non-resident alien -an individual who is not residing in the Philippines and
who is not a citizen thereof
1. Non-resident aliens engaged in business (NRA-ETB)- aliens who stayed
in the Philippines for an aggregate period of more than 180 days during
the year
2. Non-resident aliens not engaged in business (NRA-NETB) - include:
a. Aliens who come to the Philippines for a definite purpose which in its
 nature may be promptly accomplished;
b. Aliens who shall come to the Philippines and stay therein for an
aggregate period of not more than 180 days during the year

THE GENERAL CLASSIFICATION RULE FOR INDIVIDUALS

1. Intention
The intention of the taxpayer regarding the nature of his stay within or
outside the Philippines shall determine his appropriate residency
classification. The taxpayer shall submit to the CIR of the BIR documentary
proofs such as visas, work contracts and other documents indicating such
intention.

Documents purporting short term stay such as tourist visa shall not result in
the reclassification of the taxpayer's normal residency. Documents purporting
a long-term stay such as immigration visa or working visa for an extended
period would result in the automatic reclassification of the taxpayer' residency.

Examples:
a. An alien is normally non-resident. An alien who come to the Philippines with a
tourist visa would still be classified as non-resident alien.
b. A citizen is normally resident. A citizen who would go abroad under a tourist
visa would still be considered a resident citizen
c .An alien who come to the Philippines with an immigration visa would be
reclassified as a resident alien upon his arrival.
d. A citizen who would go abroad with a two-year working visa would be
reclassified as a non-resident citizen upon his departure.
2. Length of stay In default of such documentary proof, the length of stay of the taxpayer is
considered:
a. Citizens staying abroad for a period of at least 183 days are considered
non-resident.
b. Aliens who stayed in the Philippines for more than 1 year as of the end of
the taxable year are considered resident.
C. Aliens who are staying in the Philippines for not more than 1 year but
more than 180 days are deemed non-resident aliens engaged in business.
d. Aliens who stayed in the Philippines for not more than 180 days are
considered non-resident aliens not engaged in trade or business.

Illustration 1
Daniel Mario Aresmendi, a Mexican actor, was contracted by a Philippine television
company to do a project in the Philippines. He arrived in the country on February 29,
2021 and returned to Mexico three weeks later upon completion of the project

Illustration 2 Mamoud Jibril, a Libyan national, arrived in the country on November 4,2021 Mr.
Jibril stayed in the Philippines since then without any working visa or work permit.
Illustration 3 Without any definite intention as to the nature of his stay, Juan Miguel, a Filipino
citizen, left the Philippines and stayed abroad from March 15,2020 to April 1,
2021before returning to the Philippines.

Taxable Estates and Trusts

1. Estate
Estate refers to the properties, rights, and obligations of a deceased person
not extinguished by his death.

Estates under judicial settlement are treated as individual taxpayers. The

estate is taxable on the income of the properties left by the decedent. Estates
under extrajudicial settlement are exempt entities. The income of the
properties of the estate under extrajudicial settlement is taxable to the heirs

2. Trust
A trust is an arrangement whereby one person (grantor or trustor) transfers
(i.e., donates) property to another person (beneficiary), which will be held
under the management of a third party (trustee or fiduciary).

A trust that is irrevocably designated by the grantor is treated in taxation as if

is an individual taxpayer. The income of the property held in trust is taxable
to the trust. Trusts that are designated as revocable by the grantor are not
taxable entities and are not considered as individual taxpayers. The income of
properties held under revocable trusts is taxable to the grantor not toll trust.

When the trust agreement is silent as to revocability of the trust, the trust is
presumed to be revocable.

CORPORATE INCOME TAXPAYERS

The term 'corporation' shall include one person corporations (OPCs) .
partnerships, no matter how created or organized, joint-stock companies, joint
accounts, association, or insurance companies, except general professional
partnerships and a joint venture or consortium formed for the purpose of
undertaking construction projects or engaging in petroleum, coal, geothermal, and
other energy operations pursuant to an operating consortium agreement under
service contract with the government.

Hence, the term corporation includes profit-oriented and non-profit institutions

such as charitable institutions, cooperatives, government agencies and
instrumentalities,associations,leagues,civic or religious and other organizations.

Domestic Corporation
A domestic corporation is a corporation that is organized in accordance with
Philippine laws. It includes one-person corporations (OPC) owned and registered
by resident citizens in the Philippines.

Foreign Corporation
A foreign corporation is one organized under a foreign law.

Types of foreign corporations:

1. Resident foreign corporation (RFC) -a foreign corporation which operates and
conducts business in the Philippines through a permanent establishment
(i.e.a branch).
2.Non-resident foreign corporation (NRFC) - a foreign corporation which does
not operate or conduct business in the Philippines.

Note:
1. A corporation that incorporates in the Philippines is a domestic corporation under the
Incorporation Test even if the same is controlled by foreigners.
2. A foreign corporation that transacts business with residents through a resident branch is
taxable such transactions as a resident foreign corporation through its branch. However,
if its transacts directly to residents outside branch, it is taxable as a non - resident foreign
corporation on the direct transactions.
3. An individual that establishes a one-person corporation (OPC) shall be taxable as a
corporate taxpayer for the business transactions of the OPC but he shall be subject to tax as
an individual for his personal transactions.

Special Corporations
Special corporations are domestic or foreign corporations which are subject to
special tax rules or preferential tax rates.

OTHER CORPORATE TAXPAYERS

1. One-person corporation
A one-person corporation is a corporation with a single stockholder who may
be a natural person, trust or an estate.

Banks and quasi-banks, preneed, trust, insurance, public and publicly-listed

companies, and non-chartered GOCCs may not incorporate as One-person
corporations. A natural person who is licensed to exercise a profession may
not organize as a One Person Corporation for the purpose of exercising such
profession except as otherwise provided under special laws.

2. Partnership

A partnership is a business organization owned by two or more persons who

contribute their industry or resources to a common fund for the purpose of
dividing the profits from the venture.
Types of partnership
a) General professional partnership(GPP)

A GPP is a partnership formed by persons for the sole purpose of

exercising a common profession, no part of the income of which is derived
from engaging in any trade or business.

A GPP is not treated as a corporation and is not a taxable entity. lt is

exempt from income tax, but the partners are taxable in their individual
capacity with respect to their share in the income of the partnership.

b) Business partnership
A business partnership is one formed for profit. It is taxable as a
corporation.

Examples:

a. A partnership between Atty. Mendoza, a lawyer, and Mark Santos, an

accountant, to practice in taxation advisory services would be a business
partnership since the two partners are not in the same profession.

b. A partnership between accountants Khim and Vhinson to venture into

beauty parlor would be a business partnership since the venture is not in
practice of a common profession.

c. A partnership between accountants Juan and Miguel to venture into audit

services would be a general professional partnership.

d. Dentists Wency and Andy partnered to operate a dental clinic. During slacks
season, they are converting their clinic into a beauty saloon. Their partnership
is a business partnership since it is earning income from business.

3. Joint venture
A joint venture is a business undertaking for a particular purpose. It may be
organized as a partnership or a corporation.

Types of joint ventures:

a. Exempt joint ventures
Exempt joint ventures are those formed for the purpose of undertaking
construction projects or engaging in petroleum, coal, geothermal and
other energy operations pursuant to an operating consortium agreement
under a service contract with the Government.

Similar to a GPP, this type of joint venture is not treated as a corporation

and is tax-exempt on its regular income, but their venturers are taxable to
their share in the net income of the joint venture.

b.Taxable joint ventures

All other joint ventures are taxable as corporations.

4. Co-ownership
A co-ownership is joint ownership of a property formed for the purpose of
preserving the same and/or dividing its income.

A co-ownership that is limited to property preservation or income collection

is not a taxable entity and is exempt but the co-owners are taxable on their
share on the income of the co-owned property.

However, a co-ownership that reinvests the income of the co-owned property

to other income-producing properties or ventures will be considered an
unregistered partnership taxable as a corporation.

Taxable on income earned

Individual taxpayers Within Without
Resident citizen TRUE TRUE
Non- resident citizen TRUE
Resident alien TRUE
Non- resident alien TRUE

Corporate taxpayer
Domestic corporation TRUE TRUE
Resident foreign corporation TRUE
Non-resident foreign corporation TRUE
uary 2,1987

reaching the age of majority

r the fact of his physical

eside abroad, either

e employment there at

ives in the Philippines

wise be treated as a
espect to his income