TAXATION 1 – INCOME TAXATION 2020

Chapter 3

CONCEPT OF INCOME

CONCEPT OF INCOME
One popular definition of income is the amount of wealth accumulated plus savings and the value of
the personal consumption.

The term “income” refers to all earnings derived from service rendered (labor), from capital (business
or investment), or both including gain derived from sale or exchange of personal or real property
either ordinary or capital asset.

The is no single criterion for determining what is income for tax purposes, but it may be helpful to
think that “rule-of-thumb test” to determine income is the increase in net worth.

Return on Capital

Since income is commonly defined as all wealth which flows into a taxpayer’s hand rather than a
mere return of capital (investment), it is, therefore, a return on capital (return on investment).

A sale does not necessarily mean income. To be considered income, the sale must exceed its related
costs. Thus, an income cannot be determined by just receiving cash as a result of sales or collection
of receivable.

Distinctions between Income and Other Terms

Capital Distinguished from Income

Capital denotes the original investment or fund used in order to generate earnings which is called
income. “Capital is a wealth, while income is the service of wealth. The fact is that property is a tree,
income is the fruit; labor is tree, income is the fruit.”

Revenue Distinguished from Income

Revenue pertains to all funds accruing to the treasury of the government derived from tax, donation,
grants and any other source, while income refers to the earnings of individual persons, partnership,
corporation or estate and trust whether or not subject to tax.

Receipts Distinguished from Income

Generally, receipts are considered cash collected over a business period. Receipts may include capital
as well as its earnings, while income refers to the amount after excluding capital invested, cost of
goods sold and other deductions allowed by law.

Nontaxable Income
In order for an income to be classified as nontaxable, it should be excluded by law or treaty from
taxation. Whenever this kind of income is received, it is not required to be included in the
determination of taxable income, neither shall it be included as part of the gross income.

Taxable Income
The term “taxable income” means the pertinent items of gross income specified in the Tax Code less
the deductions, if any and/or personal and additional exemptions authorized by such types of income
by the Tax Code or other special laws.

Taxable income is synonymous to the term “net income”. Net income means gross income less
statutory deductions.

Taxable income is also defined as the amount of income upon which the tax rate prescribed by the
law is applied to obtain the amount of income tax payable.

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Characteristics of Taxable Income
An income to be taxable should have the following characteristics:

1. There must gain or profit.

2. The gain must be realized or received.

Income Constructively Received

An income is considered constructively received whet it is credited to the account of, or segregated
in favor of a person. The person may withdraw the said account credited in his favor anytime without
any substantial limitations or conditions upon which payment or enjoyment is to be made or exercised.

Sources of Income
Source is ascribed to the place wherein the income is earned. It is governed by the situs of taxation.
This classification of income is necessary to determine whether such income is subject to tax or not.

Income may be earned from:

1. Within the Philippines;

2. Without the Philippines; or
3. Partly within and partly without the Philippines.

Income Within comprises earnings from within the Philippine territory (Sec. 42A, NIRC).
Examples are:

a. Compensation for the labor or service derived from the Philippine sources.
b. Interest on bonds, notes, deposits and the like earned in the Philippines;
c. Dividends declared by domestic corporations;
d. Rentals and royalties from property located within the Philippines; and
e. Gains, profits and income from sale of real property as well as from personal property of the
Philippines.

As a rule, incomes earned within the Philippines are taxable.

Income Without refers to earnings coming from outside the Philippines or income derived from
foreign countries (Sec. 42C, NIRC). Examples are:

a. Compensation for labor or service renders by overseas contract workers;

b. Interest on bonds, notes, deposits and the like earned abroad;
c. Dividends declared by nonresident foreign corporation;
d. Rentals and royalties from property located outside the Philippines; and
e. Gains, profits and income from sale of real property as well as from personal property located
outside the Philippines.

In general, income earned outside the Philippines is taxable only when the taxpayer is a resident
Filipino Citizen or Domestic Corporation.

Income Partly Within and Partly Without are earnings from sources partly within and partly
without the Philippines include gains, profits and income from:

a. Transportation or other services rendered partly within and partly outside, and
b. Dividend received by a resident citizen from resident foreign corporation.

In general, when an income is earned partly from within and without, only income within is taxable
in the Philippines, except if the taxpayer is a resident citizen or domestic corporation. A Filipino
citizen or domestic corporation whose income is derived within and without is generally subject to
tax.

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Classifications of Income

Income may be classified as follows:

1. Compensation Income – the gain derived from the labor, especially employment such as
salaries and commissions.
2. Profession or Business Income – the value derived from an exercise of profession, business
or utilization of capital including profit or gain derived from sale or conversion of assets.
3. Passive Income – an income in which the taxpayer merely waits for the amount to come in.
4. Capital Gain – an income derived from the sale of assets not used in trade or business.

All income referred above could be earned by a person at the same taxable year. Capital gains and
passive income are generally subjected to capital gains tax and passive income tax, respectively,
which are final taxes and no longer required to be reported in the Annual Income Tax Return.

Forms and Valuation of Income

Income may be received either in the form of (a) cash, (b) property, (c) service, or (d) a combination
of the three.

Cash as income pertains to money or money substitutes received as compensation or earnings derived
from labor, practice of profession, and conduct of business.

Property as income denotes the right of ownership over a tangible or intangible thing earned as a
result as a result of labor, business or practice of profession.

Service is a form of income based on performance received in payment for the work previously
rendered by one person to another.

In general, taxable income is valued as follows:

1. Cash received for income earned;

2. Fair value of property received as payment for income earned;
3. Fair value (at the date the income was earned) of the share of stocks received as payment of
income earned;
4. Fair value of the service received (in the absence of any stipulated price) as payment of income
earned;
5. Fair value of the promissory notes received as payment of income:
a. Face value of the note, if interest bearing, and
b. Discounted value of the note, if non-interest bearing.

Tax Accounting Periods

Taxes are commonly required to be paid at regular intervals, usually on an annual basis. The dates for
paying taxes are fixed by law to comply with the principle of administrative feasibility. The law
allows the following accounting period for tax purposes:

1. Calendar period. Almost all taxpayers elect to report income covering a “calendar year,”
which covers a period from January 1 to December 31 of the taxable year.
2. Fiscal period. Some taxpayers may opt to report income on a “fiscal year basis’, covering a
period of 12 months which ends on the last day of any calendar month other than December
31.
3. Short period. Income for a period less than 12 months is required to be reported when the
taxpayer dies or when the taxpayer is under jeopardy assessment.

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4. Variable period. A taxpayer is required to file and pay tax within a period that varies
depending on the nature of income earned. This period may be monthly, quarterly, semi-
annually or at specific time per sale or exchange transaction. In other words, variable period
covers taxes paid per transaction basis.

Rules of Accounting Periods and Methods of Accounting

The following rules shall be observed in accordance with Sections 43 to 47 of the NIRC.

1. General Rule

a. The taxable income shall be computed upon the basis of the taxpayer’s annual accounting
period (fiscal or calendar year, as the case may be) in accordance with the method of
accounting regularly employed in keeping the books of such taxpayer.

b. If the method employed does not clearly reflect the income, the computation shall be made
in accordance with such method as in the opinion of the BIR Commissioner clearly reflects
the income.

c. If the Taxpayer’s annual accounting period is other than a fiscal year, or if the taxpayer
has no annual accounting period, or does not keep books, or if the taxpayers is an
individual, the taxable income shall be computed on the basis of the calendar year.

d. In case of death of a taxpayer, there shall be included in computing taxable income for the
taxable period in which falls the date of his death, amounts accrued up to the date of his
death if not otherwise properly includible in respect to such period or prior period.

2. Period for which Deductions and Credits Taken

a. The deductions provided for in his Title shall be taken for the taxable year in which “paid
or accrued,” dependent upon the method of accounting upon the basis of which the net
income is computed, unless in order to clearly reflect the income, the deductions should
be taken as of a different period.

b. In case of death of a taxpayer, there shall be allowed as deduction for the taxable period
in which falls the date of his death, amounts accrued up to the date of his death if not
otherwise properly allowable in respect to such period or a prior period.

3. Change of Accounting Period

a. If a taxpayer, other than an individual, changes his accounting period from fiscal year to
calendar year, from calendar year to fiscal year, or from fiscal year to another, the net
income shall, with the approval of the BIR Commissioner, be computed on the basis of
such new accounting period, subject to the provisions of Section 47 as provided below.

b. Returns for short period resulting from change of accounting period

1. If a taxpayer, other than individual, with the approval of BIR Commissioner, changes
the basis of computing net income from fiscal year to calendar year, a separate final
or adjustment tax return shall be made for the period between the close of the last fiscal
year from which the tax return was made and the following December 31.

2. If the change is from the calendar year to fiscal year, a separate final or adjustment
return shall be made for the period between the close of the last calendar year for which
the tax return was made and the date designated as the close of the fiscal year.

3. If the change is from one fiscal year to another fiscal year, a separate final or adjusted
tax return shall be made for the period between the close of the former fiscal year and
the date designated as the close of the new fiscal year.

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c. Income computed on basis of short period.

Methods of Reporting Income and Expenses

The timing when income was earned is important. In the Philippines, accountants may choose
between the following methods of accounting in reporting income, namely:

1. Cash method – generally reports income upon cash collection and reports expenses upon
payment. If earned from rendering of services, income is to be reported in the year when
collected whether earned and/ or unearned.

2. Accrual method – generally reports income when earned and reports expense when incurred.
If earned from sale of goods, income is to be reported in the year of sale, irrespective of
collection.

3. Special methods
The following are special methods in reporting income:
1. Installment
2. Deferred payment
3. Long-term construction contract classified into:
a. Completed contract method, and
b. Percentage of completion method.
4. Farming, categorized as follows:
a. Cash basis,
b. Accrual basis, and
c. Crop basis.

Installment Method
Under this method, the taxpayer may report income over the several taxable years in which collections
are made based on the terms of payment.
When Installment Method Allowed
1. Installment Sale of Personal Property

a. Regularly sold
b. Casual sale

2. Installment of Real Property

a. Sale of realty (inventory) where the initial payments do not exceed 25% of the selling price.
b. Sale by individuals of real property considered as capital asset, if initial payments do not
exceed 25% of the selling price.

Deferred Payment Method

Where the initial payments on installment sale exceed 25% of the selling price but they may only be
realized in the subsequent year, the taxpayer is allowed to defer reporting income.

In using the deferred payment method, the following rules must be observed:

1. The note evidencing the buyer’s obligation shall be converted to its cash equivalent
(discounted value).
2. Income shall be reported over the years of collections.
3. Previously reported income for current year collections should reduce the current year’s
reportable income.

Income for Long-Term Construction Contracts

Income from long-term construction contracts refer to the earnings derived from construction of
building, bridges, installation and other construction usually covering a period of more than one year.

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The reportable income is calculated by deducting from the contract price the actual cost of
construction.

In recognizing realized revenue for long-term construction contracts, accountants usually follow two
methods – Completed Contract Method, & Percentage of Completion Method.

As the term indicates, the completed contract method requires recognition of revenue only when the
contract is finally completed. On the other hand, the percentage of completion method requires
recognition of income based on the progress of work.

Completed Contract Method.

If the construction project is completed within one year, the 100% completed contract method of
reporting income is applicable.

Percentage of Completion
The percentage of Completion is also used when the contract price is definite and estimates of cost to
complete or the stages of completion can be determined with reasonable accuracy.

For taxation purposes, the percentage of completion method is preferred over the completed contract
method. It spreads the burden of paying tax over the term of the contract.

Gross Income from Farming

Farming business embraces farm in the ordinary accepted sense, and includes stock, dairy, poultry,
fruit and truck farms, also plantations, ranches, and all land used for farming operations.

All individuals, partnerships, or corporations that cultivate, operate, or mange farms for gain or profit
either as owners or tenants are designated farmers. A person cultivating or operating farm for
recreation or pleasure the result of which is a continual loss from year to year is not regarded as a
farmer.

Methods of Computing Gross Income Derived from Farming

There are three methods in computing the gross income derived from farming, namely;

1. Cash basis;
2. Accrual basis; and
3. Crop basis.

Cash basis.
The computation of gross income for this method disregards the presence of inventory.

A farmer reporting on the basis of receipts and disbursements (in which no inventory to determine
profits is used) shall include in his gross income for the taxable year of the following:

a. The amount of cash or the value of merchandise or other property received from the sale of
livestock and products which were raised during the taxable year or prior year;
b. The profits from the sale of any livestock or other items which were purchased; and
c. Gross income from all other sources.

The profits from the sale of livestock or other items that were purchased are to be ascertained by
deducting the cost from the sales price in the year in which the sale occurs.

Accrual Basis.
The computation of gross income for this method considers the presence of inventory.

Crop Basis.
This method is employed by farmers whose crops shall be harvested for more than a year form the
time of planning.

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