MODULE 3 -

INCOME TAX

MFA BALILI
Topic Outline
I. Definitions - Sec 22
II. Foundations
A. What is income?
1. Income Defined
2. Gross Income
3. Exclusions from Gross Income
4. Taxable Income
B. Who gets taxed on what?
1. General Principles
2. Source of Income Rules
C. Income Tax Accounting Methods
1. Tax Accounting vs Financial Accounting; Purpose
2. Tax Accounting Methods
(a) Cash Method
(b) Accrual Method
(c) Other Methods Permitted by the Tax Code

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 Topic Outline contd
D. Dealings in Property
1. Capital Asset vs Ordinary Asset
2. General Rule; Determining Gain or Loss
3. Exceptions to General Rule:
(a) 40(c)(2) - Exchanges solely in kind
(b) 40(c)(3) – Exchanges not solely in kind
(c) Assumption of Liabilities

II. Income Tax Rates

A. Individuals
B. Estates and Trusts
C. Corporations

III. Deductions

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Definitions – Sec 22
(A) The term 'person' means an individual, a trust, estate or corporation.
(B) The term 'corporation' shall include partnerships, no matter how created or organized, joint-stock
companies, joint accounts (cuentas en participacion), association, or insurance companies, but
does not include 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 a service contract with the
Government. 'General professional partnerships' are partnerships formed by persons for the sole
purpose of exercising their common profession, no part of the income of which is derived from
engaging in any trade or business.
(C) The term 'domestic', when applied to a corporation, means created or organized in the Philippines or
under its laws.
(D) The term 'foreign', when applied to a corporation, means a corporation which is not domestic
(E) The term 'nonresident citizen' means;
(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.

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Definitions – Sec 22 contd
(2) A citizen of the Philippines who leaves the Philippines during the taxable year to reside abroad,
either as an immigrant or for employment on a permanent basis.
(3) A citizen of the Philippines who works and derives income from abroad and whose employment
thereat requires him to be physically present abroad most of the time during the taxable year.
(4) A citizen who has been previously considered as nonresident citizen and who arrives in the
Philippines at any time during the taxable year to reside permanently in the Philippines shall
likewise be treated as a nonresident 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.
(5) The taxpayer shall submit proof to the Commissioner to show his intention of leaving the
Philippines to reside permanently abroad or to return to and reside in the Philippines as the case
may be for purpose of this Section.
(F) The term 'resident alien' means an individual whose residence is within the Philippines and who is
not a citizen thereof.
(G) The term 'nonresident alien' means an individual whose residence is not within the Philippines and
who is not a citizen thereof.

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Definitions – Sec 22 contd
(H) The term 'resident foreign corporation' applies to a foreign corporation engaged in trade or business
within the Philippines.
(I) The term 'nonresident foreign corporation' applies to a foreign corporation not engaged in trade or
business within the Philippines. (J) The term 'fiduciary' means a guardian, trustee, executor,
administrator, receiver, conservator or any person acting in any fiduciary capacity for any person.
(K) The term 'withholding agent' means any person required to deduct and withhold any tax under the
provisions of Section 57.
(L) The term 'shares of stock' shall include shares of stock of a corporation, warrants and/or options to
purchase shares of stock, as well as units of participation in a partnership (except general
professional partnerships), joint stock companies, joint accounts, joint ventures taxable as
corporations, associations and recreation or amusement clubs (such as golf, polo or similar clubs),
and mutual fund certificates.
(M) The term 'shareholder' shall include holders of a share/s of stock, warrant/s and/or option/s to
purchase shares of stock of a corporation, as well as a holder of a unit of participation in a
partnership (except general professional partnerships) in a joint stock company, a joint account, a
taxable joint venture, a member of an association, recreation or amusement club (such as golf, polo
or similar clubs) and a holder of a mutual fund certificate, a member in an association, joint-stock
company, or insurance company.
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Definitions – Sec 22 contd
(N) The term 'taxpayer' means any person subject to tax imposed by this Title.
(O) The terms 'including' and 'includes', when used in a definition contained in this Title, shall not be
deemed to exclude other things otherwise within the meaning of the term defined.
(P) The term 'taxable year' means the calendar year, or the fiscal year ending during such calendar year,
upon the basis of which the net income is computed under this Title. 'Taxable year' includes, in the
case of a return made for a fractional part of a year under the provisions of this Title or under rules and
regulations prescribed by the Secretary of Finance, upon recommendation of the commissioner, the
period for which such return is made.
(Q) The term 'fiscal year' means an accounting period of twelve (12) months ending on the last day of any
month other than December.
(R) The terms '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 under this Title.
(S) The term 'trade or business' includes the performance of the functions of a public office.
(T) The term 'securities' means shares of stock in a corporation and rights to subscribe for or to receive
such shares. The term includes bonds, debentures, notes or certificates, or other evidence or
indebtedness, issued by any corporation, including those issued by a government or political
subdivision thereof, with interest coupons or in registered form.
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Definitions – Sec 22 contd
(U) The term 'dealer in securities' means a merchant of stocks or securities, whether an individual,
partnership or corporation, with an established place of business, regularly engaged in the purchase of
securities and the resale thereof to customers; that is, one who, as a merchant, buys securities and re-
sells them to customers with a view to the gains and profits that may be derived therefrom.
(V) The term 'bank' means every banking institution, as defined in Section 2 of Republic Act No. 337, [6] as
amended, otherwise known as the "General banking Act." A bank may either be a commercial bank, a
thrift bank, a development bank, a rural bank or specialized government bank.
(W) The term 'non-bank financial intermediary' means a financial intermediary, as defined in Section 2(D)(C)
of Republic Act No. 337, [7] as amended, otherwise known as the "General Banking Act," authorized by
the Bangko Sentral ng Pilipinas (BSP) to perform quasi-banking activities.
(X) The term 'quasi-banking activities' means borrowing funds from twenty (20) or more personal or
corporate lenders at any one time, through the issuance, endorsement, or acceptance of debt
instruments of any kind other than deposits for the borrower's own account, or through the issuance of
certificates of assignment or similar instruments, with recourse, or of repurchase agreements for
purposes of relending or purchasing receivables and other similar obligations: Provided, however, That
commercial, industrial and other non-financial companies, which borrow funds through any of these
means for the limited purpose of financing their own needs or the needs of their agents or dealers, shall
not be considered as performing quasi-banking functions.

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Definitions – Sec 22 contd
(Y) The term 'deposit substitutes' shall mean an alternative from of obtaining funds from the public (the
term 'public' means borrowing from twenty (20) or more individual or corporate lenders at any one time)
other than deposits, through the issuance, endorsement, or acceptance of debt instruments for the
borrowers own account, for the purpose of relending or purchasing of receivables and other obligations,
or financing their own needs or the needs of their agent or dealer. These instruments may include, but
need not be limited to bankers' acceptances, promissory notes, repurchase agreements, including
reverse repurchase agreements entered into by and between the Bangko Sentral ng Pilipinas (BSP) and
any authorized agent bank, certificates of assignment or participation and similar instruments with
recourse: Provided, however, That debt instruments issued for interbank call loans with maturity of not
more than five (5) days to cover deficiency in reserves against deposit liabilities, including those
between or among banks and quasi-banks, shall not be considered as deposit substitute debt
instruments.
(Z) The term 'ordinary income' includes any gain from the sale or exchange of property which is not a capital
asset or property described in Section 39(A)(1). Any gain from the sale or exchange of property which is
treated or considered, under other provisions of this Title, as 'ordinary income' shall be treated as gain
from the sale or exchange of property which is not a capital asset as defined in Section 39(A)(1). The
term 'ordinary loss' includes any loss from the sale or exchange of property which is not a capital asset.
Any loss from the sale or exchange of property which is treated or considered, under other provisions of
this Title, as 'ordinary loss' shall be treated as loss from the sale or exchange of property which is not a
capital asset.
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Definitions – Sec 22 contd
(AA) The term 'rank and file employees' shall mean all employees who are holding neither managerial nor
supervisory position as defined under existing provisions of the Labor Code of the Philippines, as
amended.
(BB) The term 'mutual fund company' shall mean an open-end and close-end investment company as
defined under the Investment Company Act.
(CC) The term 'trade, business or profession' shall not include performance of services by the taxpayer as
an employee.
(DD) The term 'regional or area headquarters' shall mean a branch established in the Philippines by
multinational companies and which headquarters do not earn or derive income from the Philippines and
which act as supervisory, communications and coordinating center for their affiliates, subsidiaries, or
branches in the Asia-Pacific Region and other foreign markets.
(EE) The term 'regional operating headquarters' shall mean a branch established in the Philippines by
multinational companies which are engaged in any of the following services: general administration and
planning; business planning and coordination; sourcing and procurement of raw materials and
components; corporate finance advisory services; marketing control and sales promotion; training and
personnel management; logistic services; research and development services and product
development; technical support and maintenance; data processing and communications; and business
development.
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Definitions – Sec 22 contd
(FF) The term 'long-term deposit or investment certificate' shall refer to certificate of time deposit or
investment in the form of savings, common or individual trust funds, deposit substitutes, investment
management accounts and other investments with a maturity period of not less than five (5) years, the
form of which shall be prescribed by the Bangko Sentral ng Pilipinas (BSP) and issued by banks only
(not by non-bank financial intermediaries and finance companies) to individuals in denominations of
Ten thousand pesos (P10,000) and other denominations as may be prescribed by the BSP.
(GG) The term 'statutory minimum wage' shall refer to the rate fixed by the Regional Tripartite Wage and
Productivity Board, as defined by the Bureau of Labor and Employment Statistics (BLES) of the
Department of Labor and Employment (DOLE)
(HH) The term 'minimum wage earner' shall refer to a worker in the private sector paid the statutory
minimum wage or to an employee in the public sector with compensation income of not more than the
statutory minimum wage in the non-agricultural sector where he/she is assigned.

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 II. Foundations
A. What is income?
1. Income Defined
2. Gross Income
3. Exclusions from Gross Income
4. Taxable Income

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 Income defined
• It is a flow of service rendered by capital by the payment of money from it or
any benefit rendered by a fund of capital in a relation to such fund through
a period of time.

• The Supreme Court of Georgia expresses the thought in the following figurative language:
"The fact is that property is a tree, income is the fruit; labor is a tree, income the fruit;
capital is a tree, income the fruit." xxx A tax on income is not a tax on property. xxx”

• Madrigal vs Rafferty, 38 Phil 414:

“Income as contrasted with capital or property is to be the test. The essential difference
between capital and income is that capital is a fund; income is a flow. A fund of property
existing at an instant of time is called capital. A flow of services rendered by that capital
by the payment of money from it or any other benefit rendered by a fund of capital in
relation to such fund through a period of time is called income. Capital is wealth, while
income is the service of wealth.”

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 Income defined contd
• Eisner v Macomber, 252 US 189 (1920):
• What is or is not "income" within the meaning of the Amendment must be determined in
each case according to truth and substance, without regard to form.
• Income may be defined as the gain derived from capital, from labor, or from both
combined," provided it be understood to include profit gained through a sale or
conversion of capital assets.
• Mere growth or increment of value in a capital investment is not income; income is
essentially a gain or profit, in itself, of exchangeable value, proceeding from capital,
severed from it, and derived or received by the taxpayer for his separate use, benefit, and
disposal.
• The fundamental relation of "capital" to "income" has been much discussed by
economists, the former being likened to the tree or the land, the latter to the fruit or the
crop; the former depicted as a reservoir supplied from springs, the latter as the outlet
stream, to be measured by its flow during a period of time.

MFABALILI 14
 Income defined contd
• Eisner v Macomber contd
• Brief as it is, it indicates the characteristic and distinguishing attribute of income
essential for a correct solution of the present controversy. The government, although
basing its argument upon the definition as quoted, placed chief emphasis upon the word
"gain," which was extended to include a variety of meanings; while the significance of the
next three words was either overlooked or misconceived. "Derived from capital;" "the gain
derived from capital," etc. Here, we have the essential matter: not a gain accruing to
capital; not a growth or increment of value in the investment; but a gain, a profit,
something of exchangeable value, proceeding from the property, severed from the
capital, however invested or employed, and coming in, being "derived" -- that is, received
or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal -- that
is income derived from property. Nothing else answers the description.

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 Gross Income Section 32(A)
• Except when otherwise provided in this Title, gross income means all
income derived from whatever source, including (but not limited to) the
following items:
1) Compensation;
2) Annuities;
3) Rents;
4) Gross income from profession, trade or business;
5) Dividends;
6) Royalties;
7) Interests;
8) Annuities;
9) Prizes and winnings;
10) Gains from dealings in property;
11) Pensions; and
12) Partner’s distributive share in the net income of the general professional
partnership
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 Gross Income contd
• All Inclusive Concept
• “Except when otherwise provided in this Title” --- gross income includes all income from
whatever source derived
• Therefore: The default is income is taxable.
• That is why ---
• Exemptions are strictly construed against the taxpayer.
• We need to be able to point to a specific provision of law or jurisprudence that
exempts the income.

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 Gross Income contd
• Doctrine of Cash Equivalency
• Gross income not limited to cash received
• Includes cash equivalency
• That is why income includes the fair market of value of property received, or
constructively received, as well as cash.
• BUT this doctrine applies only where there would be tax if cash had
been received.

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Gross Income contd
• Gross Income Differs from Gross Receipts

• “Gross receipts” is broader

• Includes receipts which may constitute ---
• Capital
• Income
• Returns of capital which may not be taxed.

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 Gross Income contd
• Concept of Realization of Income

• Inherently necessitated by the definition of income:

• Something of exchangeable value must be separated from capital.
• This supplied the realization or transmutation which results in the receipt of income
 the “Severance test”
• Driven by the principle that a
mere increase in the value of property is not
income, but only an unrealized increase in capital.
• There is no realization through mere bookkeeping.

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Gross Income contd
• Concept of Realization of Income contd
• Practical considerations for the requirement of realization:
(1) A tax on an unrealized increment in value would be awkward from the administrative
point of view.
(2) It would be a hardship ordinarily for the taxpayer who would not have a source from
which the tax could be paid; and
(3) It might result in deductions for losses as yet unrealized.
• Examples ?

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Exclusions from Gross Income Sec 32(B)
• “Except when otherwise provided in this Title”
• The term “exclusions” refers to items that are not included in the determination of
gross income either because:
• they represent return of capital or are not income, gain or profit;
• they are subject to another kind of internal revenue tax; or
• they are income, gain or profit that are expressly exempt from income tax under the
Constitution, tax treaty, Tax Code, or a general or special law.

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 Exclusions from Gross Income contd
• What are these?
1) Proceeds of life insurance – paid to the heirs or beneficiaries upon the death of the
insured. BUT If such amounts are held by the insurer under an agreement to pay
interest thereon, the interest payments included in gross income.
2) Return of insurance premium –amount received by the insured, as a return of
premiums paid by him, either during the term or at the maturity of the term mentioned
in the contract or upon surrender of the contract. BUT the excess over premiums paid
(whether or not in the current year) included in the gross income.
3) Gift, bequest or devise – value of the property received excluded BUT the income from
such property is included in gross income.
4) Compensation for personal injuries or sickness - amounts received, through Accident or
Health Insurance or under Workmen's Compensation Acts, plus the amount of damages
received, whether by suit or agreement, on account of such injuries or sickness.
5) Income exempt under Treaty - Income of any kind, to the extent required by any treaty
obligation binding upon the Government of the Philippines.

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Exclusions from Gross Income contd
6) Retirement benefits, pension, gratuities, etc.
• Those received under R.A. 7641 – The Mandatory Retirement Law (for private firms without
retirement trust fund)
• Those received as a result of involuntary separation – causes beyond the control of the
employee
• Social security benefits, retirement gratuities, pensions etc from foreign government
agencies and other institutions, private or public
• Benefits due to residents who are US veterans
• SSS benefits
• GSIS benefits
• Those received by employees of private employers in accordance with a reasonable private
benefit plan;
• Requisites:
• In the service of the same employer for at least 10 years;
• At least 50 years old;
• Must be availed of only once; and
• Plan approved by the BIR

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Exclusions from Gross Income contd
7) Miscellaneous Items
(a) Passive income derived from investments in the Philippines in loans, stocks, bonds or other
domestic securities, or from interest on deposits in banks in the Philippines by ---
 foreign governments
 financing institutions owned, controlled, or enjoying refinancing from foreign governments
 international or regional financial institutions established by foreign governments
(b) Income derived from any public utility or from the exercise of any essential governmental
function by the Philippine Government or political subdivision thereof
(c) Prizes and awards made primarily in recognition of religious, charitable, scientific, educational,
artistic, literary, or civic achievement but only if:
 The recipient was selected without any action on his part to enter the contest or proceeding;
and
 The recipient is not required to render substantial future services as a condition to receiving
the prize or award.

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Exclusions from Gross Income contd
(d) All prizes and awards granted to athletes in local and international sports competitions and
tournaments whether held in the Philippines or abroad and sanctioned by their national sports
associations.
(e) 13th Month Pay and Other Benefits of public and private entities – BUT total exclusion under this
item not to exceed P30,000
(f) GSIS, SSS, Medicare, Pag-Ibig contributions, and union dues of individuals
(g) Gains from the sale or exchange or retirement of bonds, debentures or other certificate of
indebtedness with a maturity of more than five (5) years.
(h) Gains realized by the investor upon redemption of shares of stock in a mutual fund company as
defined in Section 22(BB)

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Taxable Income defined Sec 31
• The term “taxable income” means the pertinent items of gross income specified in this
Code, less the deductions and/or personal and additional exemptions, if any, authorized for
such types of income by this Code or other special laws.
• As amended by RA 10963 effective January 1, 2018:
The term 'taxable income' means the pertinent items of gross income specified in this
Code, less the deductions and/or personal and additional exemptions, if any,
authorized for such types of income by this Code or other special laws.

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II. Foundations contd

Who gets taxed on what?

1. General Principles
2. Source of Income Rules

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 General Principles Sec 23
• Individuals:
 Resident citizen - taxed on worldwide income
 Nonresident citizen – taxed only on Philippine-source income
 Overseas contract worker – taxed only on Philippine-source income
 Alien, whether resident or nonresident – taxed only on Philippine-source income
• Corporations:
 Domestic corporation – taxed on worldwide income
 Resident foreign corporation – taxed only on Phil-source income
 Nonresident foreign corporation – taxed only on Philippine-source income
• What about Estates and Trusts?

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 Source of Income Rules Sec 42

• Income from sources within the Philippines

• Income from sources without the Philippines
• Income from sources partly within and partly without the Philippines

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 Source of Income Rules contd
1) Income From Sources Within the Phils
• Interest derived from sources within the Philippines, and interest on bonds, notes or
other interest-bearing obligations of residents, corporate or otherwise
• Dividends received ---
 From a domestic corporation; and
 From a foreign corporation.
BUT if less than 50% of the gross income of such foreign corporation for the 3-year period
preceding the declaration of such dividends was derived from sources within the Philippines,
then only so much of such dividends which bears the same ratio as the gross income of the
corporation for such period derived from sources within the Philippines bears to its gross
income from all sources.
• Services — Compensation for labor or personal services performed in the Philippines
• Rentals and royalties from property located in the Philippines or from any interest in
such property, including rentals or royalties for —

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 Source of Income Rules contd
(i) The use of or the right xxx to use in the Philippines any copyright, patent, or other like property
or right;
(ii) The use of, or the right to use in the Philippines any industrial, commercial or scientific
equipment;
(iii) The supply of scientific, technical, industrial or commercial knowledge or information;
(iv) The supply of any assistance that is ancillary xxx and is furnished as a means of enabling the
application or enjoyment of, any property or right mentioned in (i), (ii) or (iii);
(v) The supply of services by a nonresident person or his employee in connection with the use of
property or rights belonging to, or the installation or operation of any brand, machinery or other
apparatus purchased from such nonresident person;
(vi) Technical advice, assistance or services rendered in connection with technical management or
administration of any scientific, industrial or commercial undertaking, venture, project or
scheme;
(vii) The use of or the right to use:
• Motion picture films
• Films or video tapes for use in connection with television
• Tapes for use in connection with radio broadcasting.

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MFABALILI
Source of Income Rules contd
• Sale of Real Property. — Gains, profits and income from the sale of real property located
in the Philippines
• Sale of Personal Property. — Gains, profits and income from the sale of personal
property, as determined in Section 42(E) on Income from Sources Partly Within and
Partly Without the Philippines.
BUT gains from sale of shares of stock of Philippine corporations – always Philippine
source income, regardless of where sold

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Source of Income Rules contd
2) Income from sources without the Phils ---
 Interest
 Dividends
 Service income
 Rentals and Royalties
 Gains from sale of real property

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Source of Income Rules contd
3) Income From Sources PARTLY WITHIN and PARTLY WITHOUT the
Phils
• Gains, profits, income derived from the sale of personal property* ---
• PRODUCED WITHIN and SOLD WITHOUT the Phils, or
• PRODUCED WITHOUT and SOLD WITHIN the Phils
 treated as derived partly from sources within and partly from sources without the
Philippines.
• Gains, profits, income derived from the ----
• PURCHASE of personal property* WITHIN and its SALE WITHOUT the Phils, or
• PURCHASE of personal property* WITHOUT and its SALE WITHIN the Phils
 treated as derived entirely from sources within the country in which sold.
• What determines the place of sale?

* Other than shares of a domestic corporation

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 II. Foundations contd

C. Income Tax Accounting Methods

1. Tax Accounting vs. Financial Accounting; Purpose
2. Tax Accounting Methods
a. Cash Method
b. Accrual Method
c. Others Permitted by Tax Code

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 Income Tax Accounting Methods
• Income Tax Accounting vs. Financial Accounting
• Different purposes, different rules, serve different purposes:
 Financial accounting – to provide useful information to management, shareholders,
creditors and other interested parties as to financial position of a company or a
business
 Tax accounting – to determine when items of income and expenses should be
recognized
• Therefore: they vary on some significant issues, on methods in determining whether and
when income or expenses should be recognized or reported
• BUT are nevertheless interrelated and interdependent.
• Our discussions today limited to Income Tax Accounting.

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 Income Tax Accounting Methods contd
• Purpose: Clear Reflection of Income Sec 43
“No one single method prescribed for all taxpayers. Generally (but not always) methods
that show the consistent use of GAAP are considered to clearly reflect income. A
method of accounting which reflects the consistent application of GAAP in a particular
trade or business in accordance with accepted conditions or practices in that trade or
business is usually regarded as clearly reflecting income, provided all items of gross
income and expenses are treated consistently from year to year.”
• In other words: A taxpayer’s accounting method must clearly reflect income.
• BUT SEE Sec 50 Cf Controlled Taxpayers:
Commissioner has the power to re-allocate income and expenses between and among
controlled taxpayers, if he determines that such re-allocation is necessary to prevent
evasion of taxes or to clearly reflect the income of any of such controlled taxpayers

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 Income Tax Accounting Methods contd
• Sec 43-49:
• Cash Method
• Accrual Method
• Any other method permitted by the Code

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Income Tax Accounting Methods contd
1) Cash Method
• All items that constitute gross income are included in the taxable year in which they
have been ACTUALLY OR CONSTRUCTIVELY RECEIVED.
• Expenses are deductible in the taxable year in which they are PAID.
• BUT cannot be used if inventory is a significant factor in the business
• ACTUAL RECEIPT - Receipt constitutes a transfer of property from one party to another at
the taxpayer’s direction, or for the benefit of the taxpayer; need not be in the form of
cash, can be in the form of property or cash equivalent. If the cash equivalent has a
realizable value and is transferable, it must be recognized as payment for income tax
purposes.
• CONSTRUCTIVE RECEIPT – Amounts are constructively received when (i) credited to the
taxpayer’s account, (ii) set apart for the taxpayer, or (iii) otherwise made available so
that the taxpayer may draw upon it at any time, or draw upon it when notice of intention
to withdraw has been given.

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Income Tax Accounting Methods contd
1) Cash Method contd
• Income which is subject to the taxpayer’s unfettered command and which he is free to
enjoy at his option is taxed to him as income, whether he sees fit to enjoy it or not.
• Constructively received income is taxable when the amount is ascertained and
available to the taxpayer without restriction or subject to his control. Conversely, where
the amount to which the taxpayer is entitled is indefinite, or there is a definite
contingency as to the receipt of that amount, there is no constructive receipt.

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Income Tax Accounting Methods contd
2) Accrual Method
• Generally, all items of income are included in gross income when EARNED, even though
payment may be received in another year. A taxpayer may deduct an expense when
INCURRED, even though payment may be made in another year.
• Income and deductions are not included for a taxable year unless the requirements of the
“ALL-EVENTS TEST” are met.
• Under the “ALL-EVENTS TEST”, income and deductions accrue when---
(a) all the events have occurred which fix the right to receive the income or fix the liability; and
(b) the amount of income or liability is determinable with reasonable certainty.
The “all-events test” does not demand that the amount of income or liability be known
absolutely, only that the taxpayer have at his disposal the information necessary to compute
the amount with reasonable accuracy.
If there is a contingency as to the taxpayer’s right to the income, as distinguished from an
uncertainty as to the time of its receipt, it is taxable in the year when the contingency is
removed. When the taxpayer’s right to the income has not been established, no accrual if
income is required.

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Income Tax Accounting Methods contd
• Examples – Cash vs Accrual Method
• Dividends?
• Deposits?
• Amounts in escrow?
• Success-based fees?
• Prepaid rent?
• Employee stock options?
• Deep in the pocket options?
• Estimated costs to complete development?
• Others?

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Income Tax Accounting Methods contd
3) Other Methods Permitted by Tax Code
• Accounting for Long-term Contracts Sec 48
• Installment Basis Sec 49
• Deferred Payment Sales NOT on the Installment Basis Sec 49

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Income Tax Accounting Methods contd
• Accounting for Long-term Contracts Sec 48
• Percentage of completion method
• Long-term contract – building, installation or construction contracts covering a period
more than one year
• Accounting method – Percentage of completion
• Proof – Certificate of architects or engineers showing %age of completion during the
taxable year

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Income Tax Accounting Methods contd
• Installment Basis Section 49 cf Section 174 Income Tax Regs
• Income is reported based on collection (even if accrual method taxpayer)
• Income is that proportion of the installment payments actually received in that year
which the gross profit realized or to be realized when payment is completed bears to the
total contract price
• When and by whom used?
 Sales of dealers in personal property
• (i) Casual sale or other disposition of personal property (other than 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), for a price exceeding P1,000, or
(ii) sale or other disposition of real property
 if the initial payments in the year of sale do NOT exceed 25% of the selling price.
“Initial payments” - payments received in cash or property other than evidences of
indebtedness of the purchaser during the taxable period in which the sale or other
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disposition is made. 46
Income Tax Accounting Methods contd
• Deferred Payment Sales NOT on the Installment Basis Sec 175 Income
Tax Regs

• Sales of real property in which the payments received in cash or property, other than
evidences of indebtedness of the purchaser, in the year of sale EXCEED 25% of the selling
price
 income is reported like cash sale
 seller recognizes the full gain, and deducts the full cost of the property sold --- even if
he has not yet been paid in full
• What kinds of problems arise from this treatment?

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II. Foundations contd

D. Dealings in Property
1. Capital Asset vs. Ordinary Asset
2. General Rule – Determining Gain or Loss
3. Exceptions to General Rule
a. 40(c)(2) – Exchanges Solely in Kind
b. 40(c)(3) – Exchanges NOT Solely in Kind
c. Assumption of Liabilities

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 Capital Asset vs Ordinary Asset
• Capital asset - property held by the taxpayer (whether or not connected with his trade or
business) OTHER THAN ordinary assets
• Ordinary asset –
(i) 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, or
(ii) property held by the taxpayer primarily for sale to customers in the ordinary course of his
trade or business, or
(iii) property used in the trade or business, of a character which is subject to the allowance
for depreciation; or
(iv) real property used in trade or business of the taxpayer.

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 Capital Asset vs Ordinary Asset contd
Ordinary Asset
Ordinary gains includible in gross
income on ITR subject to normal
income tax
Ordinary losses normally deductible
from gross income
Gain or loss taxable or deductible in full • For individual taxpayers, gain or loss taxable or
regardless of holding period
Ordinary loss may form part of NOLCO
available for carryover
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Capital Asset
Capital gains normally subject to a final tax --- i.e.,taxpayer
need not include gain in gross income in ITR
Capital losses deductible only against capital gains
deductible only up to ---
• 50% if asset held for more than 12 months
• 100% if asset held for not more than 12 months
• Does not apply to gain (loss) from sale of shares of stock
of domestic corporations not listed and traded on the
PSE (see RR 2-82, 6-2008, 6-2013)
• For individual taxpayers, net capital loss carryover to
immediately succeeding year
• Does not apply to gain (loss) from sale of shares of stock
of domestic corporations no listed and traded on the PSE
(see RR 2-82, 6-2008, 6-2013)
50
Capital Asset vs Ordinary Asset contd

• Examples?

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General Rule
• Recognition of Gain Section 40 (C)(1)
• “Except as herein provided, upon the sale or exchange of property, the entire amount of
the gain or loss, as the case may be, shall be recognized.”
• A sale generally occurs when there is a disposition of property for cash, its equivalent,
or the recipient’s promise to pay.
• An exchange ordinarily implies a reciprocal transfer of assets for other than cash, its
equivalent, or the recipient’s promise to pay. An exchange is both a disposition of
property transferred by a taxpayer and an acquisition of property received in return.

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General Rule contd
• To constitute a sale or exchange, a transaction must be a bona fide transaction and not
a mere sham. A transaction will be considered a sham if it lacks economic substance.
• The mere fact that the sale is motivated by tax considerations is not sufficient to
disregard it as long as the transaction has real substance and is not a sham.
• Whether or not a sale took place is to be determined from a consideration of the
SUBSTANCE of the transaction and nt merely its FORM. Book entries, while of some
evidentiary value, are not controlling.
• Immaterial whether sale or exchange is voluntary or involuntary

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General Rule contd
• Determining Gain, Loss
• Remember the General Rule in 40(c)(1)?  “Except as herein provided, upon the
sale or exchange of property, the entire amount of the gain or loss, as the case
may be, shall be recognized.”
• Section 40(A) is the rule in determining amount of gain or loss:
• In a sale or other disposition of property ---
 Gain = the excess of the amount realized over the basis or adjusted basis
for determining gain,
• Loss = the excess of the basis or adjusted basis for determining loss over
the amount realized.
• Where….

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General Rule contd
• Determining Gain, Loss
• Where….
• The amount realized = the sum of money received plus the fair
market value of the property (other than money) received.
• Basis is ---
 if property was purchased = cost
 If property was inherited = FMV at time inherited
 If property was donated = the same basis as the donor or the last person who
acquired the property not by gift. BUT if such basis is greater than the FMV of the
property at the time of the gift, then for purposes of determining loss, basis is
such FMV.
 If property acquired in 40(c)(2) exchanges = transferor’s original or historical
cost

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 Exceptions to General Rule in 40(C)(1)
• Remember General Rule in 40(c)(1)? …
“Except as herein provided, upon the sale or exchange of property, the entire amount of
the gain or loss, as the case may be, shall be recognized.”
• Sections 40(c)(2) & (c)(3) give the exceptions to this General Rule.
 Exchanges solely in kind [Section 40(c)(2)]
 Exchanges not solely in kind [Section 40(c)(3)]
• They are exceptions because either ---
 the entire gain or loss is not recognized, or
 the gain but not the loss is recognized

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 Exceptions to General Rule in 40(C)(1) contd
• Section 40(c)(2) Exchanges - Exchanges SOLELY in kind  Gain or loss is not
recognized:
(1) Merger or consolidation
(2) Transfer to a controlled corporation

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 Exceptions to General Rule in 40(C)(1) contd
• Sec 40(c)(2) exchanges:
(1) Merger or consolidation:
“No gain or loss shall be recognized if in pursuance of a plan of merger or consolidation:
(a) A corporation, which is a party to a merger or consolidation, exchanges property
solely for stock in a corporation, which is a party to the merger or consolidation; or
(b) A shareholder exchanges stock in a corporation, which is a party to the merger or
consolidation, solely for the stock of another corporation also a party to the merger or
consolidation; or
(c) A security holder of a corporation, which is a party to the merger or consolidation,
exchanges his securities in such corporation, solely for stock or securities in another
corporation, a party to the merger or consolidation.”

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 Exceptions to General Rule in 40(C)(1) contd
• Sec 40(c)(2) exchanges:
• "Merger" or "consolidation" when used in this Section means:
(a) the ordinary merger or consolidation – statutory merger, or
(b) the acquisition by one corporation of all or substantially all the properties of another
corporation solely for stock – “de facto” merger
• Requirements:
• Undertaken for a bona fide business purpose
• Not solely for the purpose of escaping the burden of taxation
• Bona fide purpose
In determining whether a bona fide business purpose exists, each and every step of the
transaction shall be considered and the whole transaction or series of transaction shall be treated
as a single unit.
• All or substantially all …
• Generally, 80% of total assets
• The term 'property' shall be taken to include the cash assets of the transferor.

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 Exceptions to General Rule in 40(C)(1) contd
• Sec 40(c)(2) exchanges:
(2)Transfer to a Controlled Corporation
• "No gain or loss shall also be recognized if property is transferred to a corporation by
a person in exchange for stock or unit of participation in such a corporation of which
as a result of such exchange said person, alone or together with others, not
exceeding four (4) persons, gains control of said corporation: Provided, That stocks
issued for services shall not be considered as issued in return for property.”
• “Control” - ownership of stocks in a corporation amounting to at least 51% of the total
voting power of all classes of stocks entitled to vote.
• Number of transferors – not more than 5
• If more than 5, what happens?
• What can be transferred to the transferee-corporation? – Cash?
• Still applies if transferor already in control of transferee-corporation?

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Exceptions to General Rule in 40(C)(1) contd
Section 40(c)(2) Exchanges contd

• Why is the entire amount of the gain or loss not recognized in these like-kind
exchanges? Rationale?

• What happens when the property or shares involved in the exchange are
subsequently sold or exchanged?

• No step-up of basis. Why?

• Distinction between tax-free merger or consolidation and transfer to a controlled

corporation?

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 Exceptions to General Rule in 40(C)(1) contd
Section 40(c)(3) Exchanges – Exchange NOT solely in Kind
• If in a 40(c)(2) exchange, an individual, a shareholder, a security holder or a corporation
receives not only stock or securities, but also money and/or other property 
The gain, if any, is recognized to the extent of the money or FMV of the property
received. The loss, if any, is not recognized.
• The money or property not permitted to be received without recognition of gain  “BOOT”

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Exceptions to General Rule in 40(C)(1) contd
Section 40(c)(3) Exchanges contd
Example 1:
• Ms X transfers property to XCo, which she controls. FMV of property is P500,000; cost basis is
P100,000. She receives from XCo the following:
(1) XCo shares worth P300,000;
(2) cash of P100,000; and
(3) other property with FMV of P100,000.
• Her gain is P400,000, but only P200,000 is recognized.
• Why:

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Exceptions to General Rule in 40(C)(1) contd
Section 40(c)(3) Exchanges contd
Example 1 contd:
1) Amount realized:
(a) XCo shares P300,000
(b) Cash 100,000
(c) Other property 100,000
(d) Total P500,000
2) Less: Basis of property 100,000
3) Gain realized P400,000
Gain recognized P200,000 (which is 1b + 1c, or 3, whichever is less)

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 Exceptions to General Rule in 40(C)(1) contd
Assumption of Liabilities
• General Rule:
Liabilities assumed are NOT to be treated as “money and/or other property” in determining
the amount of realized gain to be recognized, if the transaction would, but for the receipt of
“boot”, qualify as tax-free.
In other words, if the only type of consideration received by the transferor, in addition to the
stocks or securities permitted to be received without recognition of gain, consists of
assumption of liabilities, the transaction if otherwise qualified will still be deemed to be tax-
free.
• Exception:
If the liabilities assumed (+ the amount of liabilities to which the property is subject) subject
exceed the total of the adjusted basis of the property transferred pursuant to the exchange
 excess considered as gain

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