SS2324B-INCOMECONCEPT-02

BSA 1202 F. R. Soriano

INCOME CONCEPT AND DETERMINATION

Income, concept
Income, in its broad sense, means all wealth that flows into the taxpayer other than as a mere return
of capital. It includes the forms of income specifically described as gains and profits, such as those
derived by a business from the sale of goods or services above the cost of production, or gains or profits
derived from the disposition of property regarded as capital assets, or income received from employment
or through investment of capital.

Income distinguished from capital

Capital is wealth or fund, while income is profit or gain from the flow of wealth. (Commissioner of
Internal Revenue vs. Court of Appeals, et. Al., G.R. No. 108657, January 20, 1999) Capital is the tree,
while income is the fruit. (Madrigal vs. Rafferty, 38 Phil 414). Thus, if a parcel of land bought at a cost of
P300,000 is sold for P500,000, the income is P200,000, while the return of capital is P300,000,
representing the cost to the seller.

Gross income, concept

In general, gross income is the amount that a business earns from the sale of goods or services after
deducting the cost of the goods or the service, but before deductions for selling, administrative, tax, and
other expenses. However, for tax purposes, the term “gross income” does not carry a definite and
inflexible meaning under all circumstances, since there are cases where income is considered at gross even
before the cost of goods or services is deducted, such as in the case of income from employment,
dividends, royalties, interests and other types of income.

Gross income under the National Internal Revenue Code

Gross income means all income derived from whatever source, including but not limited to the
following items:

1. Compensation for services in whatever form paid, including, but not limited to fees, salaries,
wages, commissions, and similar items.

2. Gross income derived from the conduct of trade or business or the exercise of a profession.

3. Gains derived from dealings in property.

4. Interests.

5. Rents.

6. Royalties.

7. Dividends.

8. Annuities.

9. Prizes and winnings.

10. Pensions

11. Partner’s distributive share from the net income of the general professional partnership. [Sec. 32
(A)]

Note: The above enumeration includes both income subject to regular tax and final tax.

From the foregoing, gross income may be classified into the following categories:

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1. Compensation income

2. Gross income from business or profession

3. Passive income

4. Other sources of income

COMPENSATION AND OTHER INCOME FROM EMPLOYMENT

Compensation income, defined

In general, the term “compensation” means all remuneration for services performed by an employee
for his employer under an employer-employee relationship.
The name by which the remuneration for services is designated is immaterial. Thus, salaries,
wages, emoluments and honoraria, allowances, (e.g. transportation, representation, entertainment, and the
like) commissions, fees including director’s fees, if the director is, at the same time, an employee of the
employer-corporation; taxable bonuses and fringe benefits, except those subject to the fringe benefits tax
and the allowable “de minimis” benefits; taxable pensions and retirement pay; and other income of a
similar nature, constitute compensation income. (Sec. 2 (a), Revenue Regulation No. 8-2018); tips and
gratuities.

Measure of compensation income

1. If paid in money, the amount of money received is the measurement of the income.

2. If paid in some medium other than money, as for example, stocks, bonds or other forms of
property, the following rules shall be observed:
a. The fair market value of the thing taken in payment is the amount to be included as
compensation. FMV – ARMS’ LENGTH TRANSACTION
b. If the services are rendered at a stipulated price, in the absence of evidence to the contrary,
such price will be presumed to be the fair market value of the remuneration received.
3. If a corporation transfers to its employees its own stock as the remuneration for services rendered
by the employee, the amount of such remuneration is the fair market value of the stock at the time
the services were rendered. [Sec. 2.78.1 (A) (1), Rev. Regs. No. 2-98, as amended]
4. If the service is paid in promissory note, the amount of the remuneration shall be the fair market
value of the note.
A taxpayer receiving a note regarded as good for its face value at maturity, but not bearing
interest, shall treat as income the fair discounted value of the note as of the time of receipt.
However, if the note is paid at maturity, the taxpayer should report as income such portion of the
payment of the note which represents recovery of the discount originally deducted. (Sec. 42, Rev.
Reg. No. 2)
5. If living quarters or meals are provided in the addition to the salary, the value to such person of the
quarters and meals so furnished shall be added to the remuneration paid for the purpose of
determining the amount of compensation.
However, if living quarters or meals are furnished to an employee for the convenience of the
employer, the value thereof need not be included as part of compensation income. [Sec. 2.78.1 (A)
(2), Rev. Regs. No. 2-98, as amended]

Tips and gratuities

Tips or gratuities paid directly to an employee by a customer of the employer which are not
accounted for by the employee to the employer are considered taxable income but not subject to
withholding tax.

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Strictly speaking, tips and gratuities, while they are received in the course of employment, are not
considered as compensation income since they are not paid by the employer. Nonetheless, they shall be
subject to the same tax as compensation income.

Pensions, retirement and separation pay

Pensions, retirement and separation pay constitute compensation income subject to withholding,
except those specifically excluded.

Fixed or Variable Transportation, Representation and Other Allowances

In general, fixed or variable transportation, representation and other allowances which are received
by a public officer or employee or officer or employee of a private entity, in addition to the regular
compensation fixed for his position or office, is compensation subject to withholding tax. However, the
following shall not be subject to income tax and subsequently to withholding tax:

1. Representation and Transportation Allowance (RATA) granted to public officers and

employees under the General Appropriations Act and the Personnel and Economic Relief
Allowance (PERA) which essentially constitute reimbursement for expenses incurred in the
performance of a government personnel’s official duties.

2. Any amount paid specifically, either as advances or reimbursements for travelling, representation
and other bona fide ordinary and necessary expenses incurred or reasonably expected to be
incurred by the employee in the performance of his duties, provided the following conditions
are satisfied:
a. It is for ordinary and necessary travelling and transportation or entertainment expenses paid
or incurred by the employee in the pursuit of the trade, business or profession; and
b. The employee is required to account/liquidate for the foregoing expenses in accordance
with the specific requirements of substantiation for each category of expenses. The
excess of advances over actual expenses shall constitute taxable income if such amount is
not returned to the employer. Reasonable amounts of reimbursements/advances for
travelling and entertainment expenses which are pre-computed on a daily basis and are
paid to an employee while he is on an assignment or duty need not be subject to the
requirement of substantiation and to withholding tax. [Sec. 2.78.1 (A) (6), Rev. Regs. No.
2-98, as amended)

Note: The Additional Compensation Allowance (ACA) granted and paid to all officials and employees of
the National Government Agencies (NGAS) including state universities and colleges, government owned
and/or controlled corporations, government financing institutions and local government units is part of
Other Benefits which is not subject to income tax up to ninety thousand pesos (P90,000.00) (This matter is
to be discussed under Exclusions from Gross Income.)

Vacation and sick leave allowances

Amounts of “vacation allowances or sick leave credits” which are paid to an employee constitute
compensation. Thus, the salary of an employee on vacation or sick leave, which are paid notwithstanding
his absence from work, constitute compensation. However, the monetized value of unutilized vacation
leave credits of ten (10) days or less which were paid to the employee during the year are not subject to
income tax and to withholding tax. [Sec. 2,78.1 (A) (7), Rev. Regs. No. 2-98, as amended]

(Note: The author respectfully submits that vacation allowances given to managerial and supervisory
employees should be treated as fringe benefits subject to fringe benefit tax, while only those given to rank
and file and employees should be treated as taxable compensation income. [See Sec. 33 (B), NIRC on
Fringe Benefits.] As regards monetized sick leave credits, they shall be treated as taxable compensation

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income with respect to private employees, whether managerial/supervisory or rank and file employees, but
exempt with respect to government employees since such benefits are exempt de minimis benefits.

Director’s fees
Fees paid to a member of the board of directors of a corporation are treated as compensation income
subject to withholding tax on compensation if it is established that the director and the corporation have an
employer-employee relationship (RMC 34-2008), such as in the case of the President of a corporation who
is required to be a director under the Revised Corporation Code.

Fees paid to a director who is not an employee of the corporation and whose duties are confined to
the attendance of and participation in the meetings of the board of directors, are not treated as
compensation income but fall under “Professional fees, talent fees, etc. for services rendered by
individuals.” [Sec. 2,57.2 (A) (9), Rev. Regs. No. 2-98, as amended] Such fees, which include per
diems, allowances and any other form of income payment to the director, are subject to 10% creditable
withholding tax if his gross income for the current year does not exceed P720,000.00, or 15% if the
amount exceeds P720,000.00. (Rev. Regs. No. 30-2003) However, the income payment to the director
is not subject to value-added tax or other percentage tax notwithstanding that the fees are treated as
“Professional fees.” (See Rev. Regs. No. 77-08)

GROSS INCOME FROM BUSINESS OR PROFESSION

Determination of gross income from business or profession

Gross income from the conduct of trade or business or the exercise of a profession includes income
from the pursuit of the business activity or the exercise of a profession or calling less direct costs. Thus:

1. Trading or manufacturing

Sales or revenues P xxx

Less: Cost of goods sold xxx
Gross income from business P xxx

2. Sale of service or exercise of profession

Receipts or revenues P xxx

Less: Cost of services xxx
Gross income from service or profession P xxx

GAINS DERIVED FROM DEALINGS IN PROPERTY

Kinds of property
The properties from which gain or income may be derived are either ordinary assets or capital
assets:
1. Ordinary assets
Ordinary assets include the following:
a. Stock in trade of the taxpayer or other property of a kind which would properly be included
in the inventory of the taxpayer if on hand at the close of the taxable year.
Examples: Inventory of raw materials, work in process, finished goods and supplies.

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b. Property held by the taxpayer for sale to customers in the ordinary course of his trade or
business.
Examples: Goods for sale, land for sale by a real estate dealer.
c. Property used in the trade or business, of a character which is subject to allowance for
depreciation.
Examples: Office equipment, delivery truck, machinery, building.
d. Real property used in trade or business.
Example: Land on which the company building stands.

2. Capital assets
The term “capital assets” means property held by the taxpayer (whether or not connected
with trade or business), but does not include any of those enumerated as ordinary assets in No. 1.
The statutory definition of capital assets is negative in nature. If the asset is not among those
enumerated in No. 1, it is a capital asset; conversely, any asset falling within the enumeration is an
ordinary asset.

Capital gain and ordinary gain

Any gain resulting from the sale or exchange of an asset is capital gain or ordinary gain depending
on the kind of asset involved in the transaction. (Calasanz vs. Commissioner of Internal Revenue, G.R.
No. L-26284, October 8, 1986). Thus, there is capital gain if the asset disposed of above the cost was a
capital asset, and there is ordinary gain if the asset disposed of above the cost was an ordinary asset.

INTEREST INCOME

Interest income, concept

Interest income is the compensation received by the lender of money from his borrower for the use
of the same, and generally as a recompense for the debtor’s detention of the debt. Generally, interest
income from a bank deposit is considered as passive income subject to final tax, while interest income
from other sources, such as on trade notes receivable, is ordinary business income subject to regular tax.

RENT INCOME AND OTHER INCOME FROM LEASE CONTRACTS

Income from lease contracts

Income from lease contracts may consist of the following:
1. Rent
If the rent is paid in advance by the lessee without any restriction as to its use by the lessor,
the entire amount shall be reported as income in the year of receipt. This is true whether the lessor
uses the accrual method or cash method of accounting.
Any advance payment made by the lessee which is actually a loan to the lessor, or an option
money for the property, or a security deposit for the faithful performance of certain obligations of
the lessee, is not considered income to the lessor. In the case of security deposit applied by the
lessor to the rental, the same shall be considered taxable rent income to the lessor.

2. Obligations of the lessor which are assumed by the lessee

These are in effect equivalent to additional rent income of the lessor. Examples are real
property taxes, insurance premiums and extraordinary or major repairs on the leased premises,
which are obligations of the lessor, but are paid by the lessee.

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3. Leasehold improvements under an agreement that their ownership shall be turned over to the lessor
at the end of the lease
The leasehold improvements shall be reported by the lessor under any of the following
methods:
a. Outright method
Under this method, the fair market value of the improvements shall be reported in the
year of completion.
b. Spread-out method
Here, the net book value of the improvements upon the termination of the lease shall
be spread out over the remaining term of the lease from the time of the completion of the
improvements. Thus:
Cost of leasehold improvements P xxx
Less: Accumulated depreciation at the
end of the lease xxx
Net book value, end of lease xxx
Divided by remaining term of lease xxx
Income to be reported annually P xxx

If the lease is terminated by the lessor due to causes attributable to the lessee, the lessor
shall report as income the net book value of the leasehold improvements upon cancellation of
the lease less the income already reported. Thus:

Cost of leasehold improvements P xxx

Less: Accumulated depreciation at the
time of cancellation xxx
Net book value upon cancellation xxx
Less: Income already reported xxx
Income to be reported in the year of
cancellation P xxx

ROYALTIES

Royalty income, concept

Royalty refers to the compensation paid to the legal owner of a patent, franchise, copyrighted work,
natural resource or other property by those who wish to make use of it for the purpose of generating
revenues. Royalties are usually expressed as a percentage of the revenues realized from using any of such
property (such as 35% on sales).

DIVIDENDS

Dividend income, concept

Dividend refers to any distribution made by a corporation to its shareholders, whether in money or
in other property, out of its earnings or profits. (Commissioner of Internal Revenue vs. Manning, L-
28398, August 6, 1975, 66 SCRA 26)

Kinds of dividend under the National Internal Revenue Code

1. Cash dividend

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Cash dividend is dividend paid in cash to stockholders on the basis of shares held. When
declared, cash dividend is usually expressed at a specified amount per share (e.g., P1.00 per share).
The measure of the income to be reported is the amount of cash received determined by multiplying
the number of shares by the specified amount per share. They are generally taxable.

2. Stock dividend
Stock dividend is dividend paid in the form of stock of the issuing corporation from its new
or unissued shares. Here, there is a transfer of surplus profits to the capital account. When
declared, stock dividend is expressed at a percentage of shares held (e.g., 20% of 1,000 shares).
Stock dividends are generally not taxable since they represent capital and not considered an income
to the recipient. They are considered as unrealized gain, and cannot be subjected to income tax
until that gain has been realized. (Commissioner of Internal Revenue vs. Court of Appeals, 301
SCRA 152) They are, however, taxable in the following cases:
a. If a corporation cancels or redeems stock issued as a dividend at such time and such manner
as to make the distribution and cancellation or redemption, in whole or in part, essentially
equivalent to the distribution of a taxable dividend, the amount so distributed in redemption
or cancellation of the stock shall be considered as taxable to the extent that it represents a
distribution of earnings or profits. (Sec. 73 (B), NIRC).
b. Where the distribution of the stock dividends results in changes in the proportionate interest
of the stockholder. This occurs when the stock dividend is payable in stock or cash where the
stock dividend received by the stockholders who chose to be paid in stock instead of cash
would be taxable. (See Sec. 252, Rev. Reg. No. 2)

3. Property dividend
Dividend payable in property such as bonds, securities or stock investments held by the
corporation. Treasury shares of the corporation shall be considered as property. The measure of the
income which is subject to tax is the fair market value of the property received at the time of receipt
or distribution. (See Sec. 251, Rev. Reg. No. 2)

4. Liquidating dividend
Dividend representing distribution of all the property or assets of a corporation in complete
liquidation or dissolution where all the assets of the corporation, after deducting its liabilities, are
converted to cash or equivalents. The distribution of dividends in dissolution is considered as a
sale of stock held as capital asset; hence, any resulting capital gain is taxable.

ANNUITIES

Annuity, concept
An aleatory contract which binds the debtor to pay an annual pension or income during the life of
one or more determinate persons in consideration of a capital consisting of money or other property whose
ownership is transferred to him at once with the burden of the income. (Art. 2021, Civil Code of the
Philippines)

PRIZES AND WINNINGS

Prizes and winnings, concept

A prize refers to money or property received in a competition where effort is exerted by the
participants (such as that received in a beauty pageant or art contest). A winning refers to money or
property received in a game of chance (such as that received from lottery or raffle.)

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PENSIONS

Pension, concept

Pension refers to a stated allowance paid to a person or his/her surviving spouse and children for
past services on account of the former’s retirement, old age or disability.

PARTNERS’ DISTRIBUTIVE SHARE FROM THE NET INCOME

OF A GENERAL PROFESSIONAL PARTNERSHIP

Taxation of a partner’s share from the net income of a general professional partnership
A general professional partnership is not subject to income tax. Nonetheless, it is required to file an
annual income tax return for the purpose of furnishing information as to the share that each partner shall
report and include in his personal income tax return.
Each partner shall report as gross income his distributive share, actually or constructively received,
in the net income of the partnership. Such share shall be subject to regular tax.

INCOME FROM OTHER SOURCES

Other items of income

Other items of income include the following:

1. Income from farming

2. Cancelled or forgiven debts

3. Bad debt recoveries

4. Tax refunds

5. Tax informer’s reward

6. Income from illegal sources

GROSS INCOME FROM FARMING

Farm, concept
The term “farm” embraces the farm in the ordinarily accepted sense, and includes stock, dairy,
poultry, fruit, and truck farms, also plantations, ranches, and all lands used for farming operations. (Sec.
45, Rev. Reg. No. 2)

Farmers, concept
Farmers are individuals, partnerships or corporations that cultivate, operate or manage farms for
gain or profit either as owners or tenants. A person cultivating or operating a farm for recreation or
pleasure, the result of which is a continual loss from year to year, is not regarded as a farmer. (Sec. 45,
Rev. Reg. No. 2)

Methods of reporting gross income from farming

1. Cash basis, or receipts and disbursements basis.

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Here, inventory is not considered in determining profits. The gross income shall include the
following:
a. Amount of cash received from the sale of livestock and products raised in the farm.

b. Value of merchandise or other property received from the sale of livestock and products in
raised in the farm.
c. Profits from the sale of livestock or other items which were purchased. In the case of sale of
animals purchased as draft or work animals, or solely for breeding or dairy purposes and not
for resale, the gain shall be computed by deducting the cost and depreciation from the selling
price.

c. Gross income from all other sources. (Sec. 45, Rev. Reg. No. 2)

2. Accrual basis
Here, inventory is considered in determining profits. The gross income is determined by
adding to the inventory value of livestock and products on hand at the end of the year the amount
received from the sale of livestock and farm products, and miscellaneous receipts for hire of teams,
machinery and the like, during the year, and deducting from this sum the inventory value of
livestock and products on hand at the beginning of the year, and the cost of livestock and products
purchased during the year. (Sec. 45, Rev. Reg. No. 2)

3. Crop basis
This method may be used by a farmer engaged in producing crops which take more than one
year from the time of planting to the time of gathering and disposing of the crop. Here, the entire
cost of producing the crop must be taken as a deduction in the year in which the gross income from
the crop is realized. (Sec. 45, Reg. Reg. No. 2)

FORGIVENESS OF INDEBTEDNESS

Taxation of forgiven or cancelled debts

1. If the creditor cancels the indebtedness on account of the services rendered by the debtor, the debt
cancelled is taxable to the debtor as the debt is considered a compensation for such services
rendered.

2. If the creditor without any consideration cancels the debt, the amount of the debt is a gift from the
creditor to the debtor. The debt cancelled is not subject to income tax but may be subject to
donor’s tax.

3. Where the debtor is a stockholder of the corporation which condoned the debt, the condonation is
considered an indirect payment of dividend. Such dividend income may be subject to regular tax or
final tax, or it may be exempt. (See Taxation of Dividends.) (Sec. 50, Rev. Reg. No. 2)

BAD DEBT RECOVERIES

Taxation of bad debt recoveries

If the deduction of the bad debt in a prior year resulted in income tax benefit to the taxpayer, the
bad debt recovered shall be included as part of gross income in the year of recovery to the extent of the tax
benefit of the deduction. Conversely, if the deduction of the bad debt in prior year did not result in
income tax benefit to the taxpayer, the bad debt recovered does not constitute taxable income. [See Sec.
34 (E) (1)] This is known as the “Tax Benefit Rule.” In other words, the bad debt write-off resulted in a

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lower taxable income reported and consequently, a lower tax being paid by the taxpayer, or such bad debt
write-off caused him to sustain a loss such that he did not pay any income tax.

TAX REFUNDS

Taxation of tax refunds

A tax refund is taxable (subject to regular tax) if the tax deduction resulted in income tax benefit to
the taxpayer at the time it was made. Thus, the “Tax Benefit Rule” also applies, just like in the case of
Bad Debt Recoveries. For the tax refund to be taxable, the following requisites must therefore concur:

1. The tax must be an allowable deduction.

a. Taxes that are deductible from gross income include the following:
(1) Percentage taxes, subject to exceptions
(2) Excise taxes
(3) Documentary stamp taxes
(4) Local business taxes
(5) Real property tax on property used in business
(6) Import duties
(7) BIR registration fees
(8) Registration fees of motor vehicles used in business
(9) Professional license fee or occupation tax
(10) Community tax
b. Taxes that are not deductible include the following:
(1) The Philippine income tax
(2) Income taxes imposed by authority of any foreign country, but this deduction shall be
allowed in the case of a taxpayer who does not signify in his return his desire to have
to any extent the benefits relating to credit for taxes of foreign countries.
(3) Estate tax
(4) Donor’s tax
(5) Value-added tax
(6) Surcharge and compromise on tax penalties
(7) Stock transaction tax
(8) Interest on unpaid taxes. (This may be claimed as interest expense but not as a tax
expense.)
(9) Taxes assessed against local benefits of a kind tending to increase the value of the
property assessed. (Special assessments)
(10) Taxes not connected with trade or business or the exercise of a profession.

2. The tax deduction must have resulted in an income tax benefit to the taxpayer.

TAX INFORMER’S REWARD

Amount of tax informer’s reward

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A reward equivalent to 10% of the revenues, surcharges or fees recovered and/or fine or penalty
imposed and collected or P1,000,000.00 per case, whichever is lower, shall be given to a qualified
informer. A cash reward equivalent to 10% of the fair market value of smuggled and confiscated goods
or P1,000,000.00 per case, whichever is lower, shall also be given to persons instrumental in the discovery
and seizure of such smuggled goods. [Sec. 282, (A) and (B), NIRC]

Tax on informer’s reward

The cash rewards of informers shall be subject to income tax, collected as final withholding tax, at
the rate of 10%. (Sec. 282, NIRC)

Persons disqualified to receive informer’s reward

The following are disqualified from availing themselves of the tax informer’s reward:
1. A BIR official or employee or any other incumbent public official or employee.

2. Relative within the sixth civil degree of consanguinity of a BIR official or employee, or other public
officer or employee.

3. Through already retired or otherwise separated from service, BIR officials or employees or other
public officials who acquired the information in the course of performance of their duties during
their incumbency. (Sec. 3, Rev. Regs. No. 16-2010)

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