THE CONCEPT OF INCOME

Handout No. 1-03 A.G. DULAY

A. DEFINITION OF INCOME
1. Broad Sense
Income means all wealth, which flows into the taxpayers hands other than as a
mere return of capital (meaning that income is a return on capital).

Return OF capital vs Return ON capital:

Return OF capital = return of investment

Return ON capital = profit

2. Judicial Definition
Income is the gain derived from labor, or from capital, or from both labor and
capital, including the gain derived from the sale or exchange of capital asset.

Rule-of-thumb test:
~ Income is the increase in net worth. (NET WORTH METHOD)

Net worth, ending P xx

Less: Net worth, beginning xx
Increase (decrease) in net worth P xx
Add: Non-deductible items xx
Total P xx
Less: Non-taxable items P xx
Personal exemptions* (for individuals) xx xx
Net Taxable Income P xx

*Corporations are not entitled to personal exemptions.

What is Net Worth?

Net worth = Total Assets - Total Liabilities

B. INCOME VS OTHER TERMS

INCOME CAPITAL
A flow of wealth during a definite period A fund or property existing at one distinct time
Service of wealth Wealth

INCOME REVENUE
Refers to money or gain received, coming to a Refers to all funds or income derived by the
person (natural or juridical), during a given period government, whether from tax or any other source
of time
To a person (natural or juridical) To the government

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THE CONCEPT OF INCOME
Handout No. 1-03 A.G. DULAY

INCOME RECEIPTS
Specific Broader in scope
The amount after excluding capital invested, cost of Have reference to all wealth that flows into the
goods sold and other deductions allowed by law taxpayer, which includes returns of capital

C. TYPES OF INCOME
1. Taxable Income
Refers to 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 laws.

2. Non-taxable Income
Refers to the income which is neither included as part of gross income nor required
to be included in the determination of taxable income. To be classified as such, it
should be excluded by law or treaty from taxation.

D. CHARACTERISTICS OF A TAXABLE INCOME

1. There must be a gain.
2. The gain must be realized or received (actual or constructive receipt).

Examples of constructive receipt of income:

a. Interest credited on savings bank deposit;
b. Matured interest coupons not yet collected by the taxpayer;
c. Dividends applied by the corporation against the indebtedness of a stockholder;
d. Share in the profit of a partner in a general professional partnership (GPP),
although not yet distributed; or
e. Intended payment deposited in court (consignation).

Remember: Taxation uses cash basis of accounting.

3. The gain must not be excluded by law from taxation.

E. CLASSIFICATION OF INCOME AS TO SOURCE

1. Income purely within;
2. Income purely without;
3. Income partly within and partly without.

F. SOURCES AND TAXABILITY OF INCOME

Remember: The source of income is attributed to the place where it is earned, hence
the situs of taxation.

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THE CONCEPT OF INCOME
Handout No. 1-03 A.G. DULAY

Source of Income
(Taxable or Not?)
Type of Taxpayer
Within &
Within Without
Without
Individual Income Taxpayer
Resident Citizen Y Y Y
Non-resident citizen Y N N
Resident Alien Y N N
Non-resident alien Y N N

Corporate Income Taxpayer

Domestic Corporation Y Y Y
Foreign Corporation Y N N

1. Income from sources WITHIN the Philippines

a. Interests derived from sources within the Philippines, and interests on bonds, notes
or other interest-bearing obligations of residents, corporate or otherwise;

b. Dividends received from (1) domestic corporation and (2) foreign corporation,
UNLESS <50% of its gross income for the 3-year period ending with the close of its
taxable year preceding the declaration of such dividends (or for such part of the
period as the corporation has been in existence) was derived from sources within
the Philippines;

c. Compensation for labor or personal services performed in the Philippines;

Note: When the personal service or labor is performed partly within and partly
without the Philippines and no accurate allocation can be made, the
following formula shall apply:

# of days labor was performed in the Philippines

Income within = x Total compensation received
Total # of days labor was performed

d. Rentals and Royalties from property located in the Philippines or from any interest
in such property; and

e. Gains, profits and income from the sale of real and personal property located in the
Philippines.

Remember R2IDS!!

Rule: If income is derived within the Philippines, such income is taxable within.

2. Income from sources WITHOUT the Philippines

a. Interests other than those derived from sources within the Philippines;

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THE CONCEPT OF INCOME
Handout No. 1-03 A.G. DULAY

b. Dividends other than those derived from sources within the Philippines (e.g.
dividends received from a non-resident foreign corporation);

c. Compensation for labor or personal services performed without the Philippines;

d. Rentals and Royalties from property located without the Philippines or from any
interest in such property including rentals or royalties for the use of or for the
privilege of using without the Philippines, patents, copyrights, secret processes and
formulas, goodwill, trademarks, trade brands, franchises and other like properties;
and

e. Gains, profits and income from the sale of real and personal property located
without the Philippines.

Remember R2IDS (without)!!

Rule: Income earned without the Philippines is taxable only when the taxpayer is a
Resident Citizen or a Domestic Corporation.

3. Income partly from sources WITHIN & partly from sources WITHOUT the Philippines
a. Income from transportation and other services rendered partly within and partly
without the Philippines;

b. Income from the sale of personal property produced in whole or in part by the
taxpayer within and sold without the Philippines; and

c. Income from sale of property produced, in whole or in part by the taxpayer without
and sold within the Philippines.

G. CLASSIFICATION OF INCOME
1. Compensation Income
refers to the gain derived from labor, especially employment (earned from
employer-employee relationship), such as salaries and commissions

2. Profession or Business Income

refers to 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
refers to an income in which the taxpayer merely waits for the amount to come in
(subject to final tax)

4. Capital Gain
refers to an income derived from sale of assets not used in trade or business

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Notes:
a. All the above-mentioned income could be earned by a person at the same taxable year.

b. Normal Tax vs Final Tax

Subject to final tax ----- No need to report as part of taxable income in

the annual Income Tax Return (ITR)

Not subject to final tax ----- Should be reported as part of taxable income
subject to the normal tax in the annual ITR

H. VALUATION OF INCOME
Income may be received in any of the following forms:
1. Cash;
2. Property;
3. Service; or
4. A combination of the three

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.

I. TAX ACCOUNTING PERIODS

1. Calendar period or Calendar Year (CY)
covers a 12-month period starts in January 1 and ends in December 31 of a given
taxable year

2. Fiscal period or Fiscal Year (FY)

covers a 12-month period which starts on the first day of any month other than
January and ends on the last day of any month other than December

3. Short period
covers a period less than 12 months

4. Variable period
maybe monthly, quarterly, semi-annually or at specific time per sale or exchange
transaction depending on the nature of income earned (per transaction basis)

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Rule: The taxable income shall be computed upon the basis of the taxpayers regular
annual accounting period (calendar or fiscal year, as the case may be), EXCEPT on
the following situations:

a. the method employed does not clearly reflect the income

use the method given by the BIR Commissioner

b. the taxpayer has no annual accounting period

use the calendar year method

c. the taxpayer does not keep books

use the calendar year method

d. the taxpayer is an individual

use the calendar year method

Notes:
a. Under Section 34 (A) (1) (a) of the Tax Code, all the ordinary and necessary expenses
paid or incurred1 during the taxable year in carrying on or which are directly
attributable to the development, management, operation and/or conduct of the trade,
business or exercise of a profession shall be allowed as deductions from taxable
income.

1
Section 171 (a) of Revenue Regulations (RR) No. 2: The terms paid or incurred and
paid or accrued will be construed according to the method of accounting upon the
basis of which the net income is computed by the taxpayer. The deductions and credits
must be taken for the taxable year in which paid or accrued or paid or incurred,
unless in order to clearly reflect the income such deductions or credits should be taken
as of a different period.

b. In case of a death of a taxpayer, the deduction allowed includes amounts accruing up to

the date of his death.

c. Change in accounting period ---- needs the approval of the BIR Commissioner

d. Types of short period tax returns resulting from a change in accounting period:
1. from FY to CY ---- a separate final or adjustment tax return shall be made for the
period between the close of the last FY from which the tax return was made and
following December 31.

2. from CY to FY ---- a separate final or adjustment tax return shall be made for the
period between the close of the last CY from which the tax return was made and
the date designated as the close of the FY.

3. from one FY to another FY ---- a separate final or adjustment tax return shall be
made for the period between the close of the former FY from which the tax return
was made and the date designated as the close of the new FY.

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THE CONCEPT OF INCOME
Handout No. 1-03 A.G. DULAY

J. METHOD OF REPORTING INCOME AND EXPENSES

1. Cash Method vs Accrual Method

ACCRUAL BASIS CASH BASIS

Revenue is recognized when it is EARNED Revenue is recognized when cash is

regardless of collection COLLECTED
(Realization of Revenue Principle)

Expense is recognized when it is Expense is recognized when cash is PAID

INCURRED regardless of payment
(Recognition of Expense Principle)

2. Special Methods
a. Installment Method
applies when collections extends over relatively long periods of time and there
is a strong possibility that full collection will not be made.

Relevant formulas:
1. To determine the reportable income:
Installment collection Gross Profit
Reportable Income = x
received Contract Price

2. To determine the selling price:

Cash received P xx
FMV of the property received xx
Installment obligations of the buyer
(evidenced of indebtedness) xx
Mortgage assumed by the buyer xx
Selling Price P xx

3. To determine the contract price:

Selling Price P xx
Add: Excess of mortgage over cost xx
Total P xx
Less: Mortgage assumed by the buyer xx
Contract Price P xx

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4. To determine the initial payments:

Downpayment P xx
Installments received in the year of sale xx
Total P xx
Add: Excess of mortgage over cost xx
Initial payments P xx

5. To determine the annual (equal) installment payments:

Selling Price P xx
Less: Initial payments P xx
Mortgage assumed by the buyer xx xx
Balance P xx
Divided by remaining years of payment xx
Annual installment payment after year of sale P xx

6. To determine the installment tax due:

Installment payment received
Installment tax due = x Total Tax Due
Contract Price

When to Use?
1. Installment sale of personal property
a. Personal property is regularly sold on an installment basis by a dealer
b. Casual sale of personal property on installment basis with the following
conditions:
selling price (SP) > P1,000;
initial payments 25% of SP (otherwise will be considered as cash
sales); and
the property sold is not an inventory

2. Installment sale of real property

a. Sale of inventory where the initial payments 25% of SP (sale is subject
to normal tax)
b. Sale by individuals of real property considered as capital asset, if initial
payments 25% of SP (sale is subject to capital gains tax)

b. Deferred Payment Method

applies where the initial payments on installment > 25% of SP but may only be
realized in the subsequent year.

Rules:
1. The note evidencing the buyers obligation shall be converted to its cash
equivalent.
2. Income shall be reported over the years of collection.

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3. Previously reported income for current year collections should reduce the
current years reportable income.

c. Long-term construction contract classified into:

c1. Completed contract method
o applies when the construction project is completed within one year

c2. Percentage-of-completion method

applies when the construction project is to be completed for more than one
year

d. Farming, categorized as:

d1. Cash Basis
disregards the presence of inventory; reports income on the basis of
receipts and disbursements

d2. Accrual Basis

considers the presence of inventory; the ending inventory is added as part
of gross income while the beginning inventory is deducted to compute the
gross income

d3. Crop Basis

applies when the crops shall be harvested for more than a year from the
time of planting

Sources:
1. The 1997 National Internal Revenue Code
2. Various BIR Regulations
3. Income Taxation by Valencia and Roxas 6th edition
4. Review Notes from various Review Centers

To live is not enough. We have to take part in what is good and do or best
-Pablo Casals

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