ll.

INCOME TAXATION
Income Tax is a tax on a person's income, emoluments, profits arising from property, practice of
profession, conduct of trade or business or on the pertinent items of gross income specified in
the Tax Code of 1997 (Tax Code), as amended, less the deductions and/or personal and
additional exemptions, if any, authorized for such types of income, by the Tax Code, as
amended, or other special laws.
Person means an individual, a trust, estate or a corporation (Sec. 22[A] of the Tax Code)

A. lncome Tax Systems

1. Global Tax System - Where the taxpayer is required to lump up all items of income
earned during taxable period and pay under a single set of income tax rate on these different
items of income.
2. Schedular Tax Systems - where there are different tax treatments of different types
of income so that a separate tax return is required to be filed for each type of income and the
tax is computed on a per return or per schedule basis.
3. Semi-Schedular or Semi-Global Tax System - whre the tax system is either (a)
global (e.g. taxpayer with compensation income not subject to final withholding tax or business
or professional income or mixed income - compensation and business or professional income)
or (b) schedular (e.g. taxpayer with compensation, capital gains, passive income, or other
income subject ti final withholding tax) or (c) Bith global and schedular may be applied
depending on the nature of the income realized by the taxpayer during the year.
B. Characteristics and Features of the Philippine lncome Tax System
The Philippine tax system is a combination of the global and schedular systems of taxation.
Domestic and resident taxpayers are taxed on a worldwide income. Non-resident taxpayers are
taxed on Philippine-source income. While a corporation is levied at a flat rate, individuals are
taxed at progressive rates.
C. Definition of lncome
Fisher vs. Trinidad, GR No. 17518 dated October 30, 7922

FACTS: Philippine American Drug Company was a corporation duly organized and existing under the
laws of the Philippine Islands, doing business in the City of Manila. Fisher was a stockholder in said
corporation. Said corporation, as result of the business for that year, declared a "stock dividend" and that
the proportionate share of said stock divided of Fisher was P24,800. Said the stock dividend for that
amount was issued to Fisher. For this reason, Trinidad demanded payment of income tax for the stock
dividend received by Fisher. Fisher paid under protest the sum of P889.91 as income tax on said stock
dividend. Fisher filed an action for the recovery of P889.91. Trinidad demurred to the petition upon the
ground that it did not state facts sufficient to constitute cause of action. The demurrer was sustained and
Fisher appealed.

ISSUE: Whether or not the stock dividend was an income and therefore taxable.

HELD: Income is defined as the amount of money coming to a person or corporation within a specified
time whether as payment for services, interest, or profit from

investment. A stockholder who receives a stock dividend has received nothing but a representation of his
increased interest in the capital of the corporation. We believe that the Legislature when it provided
income tax, intended only to tax the income of corporations or firms as that used in its common
acceptation; that is money received for services, interest or profit from investments
1. When is income taxable?
i. Realization Test Unless income is deemed realized, then there is no taxable income.
Revenue is generally recognized when both conditions are met: a. The earning process is
complete or virtually complete; and b. An exchange has taken place. (Manila Mandarin Hotels,
Inc. v. CIR)
1. Sec. 38 of RR No. 2-40 dated February 10, 1940
SECTION 38. Bases of computation. Approved standard methods of accounting will be
ordinarily regarded as clearly reflecting income. A method of accounting will not, however, be
regarded as clearly reflecting income unless all items of gross income and all deductions are
treated with reasonable consistency. All items of gross income shall be included in the gross
income for the taxable year in which they are received by the taxpayer and deductions taken
accordingly, unless in order clearly to reflect income such amounts are to be properly
accounted for as of a different period. For instance, in any case in which it is necessary to
use an inventory, no accounting in regard to purchases and sales will correctly reflect income
except an accrual method. A taxpayer is deemed to have received items of gross income
which have been credited to or set apart for him without restriction. On the other hand,
appreciation in value of property is not even an accrual of income to a taxpayer prior to the
realization of such appreciation through sale or conversion of the property. (For methods of
accounting and determination of accounting period, see Sections 166 to 169 of these
regulations.) (Section 29(a) of the Code)

Manila Mandarin Hotels, lnc. vs. ClR, CTA Case No. 5046 dated March 24, 1997
Manila Mandarin Hotels, lnc. vs. ClR
Under the realization principle, revenue is generally recognized when both of the following
conditions are met: (a) the earning process is complete or virtually complete, and (b ) an
exchange has taken place. This principle requires that revenue must be earned before it is
recorded. Thus, the amounts received in advance are not treated as revenue of the period in
which they are received but as revenue of the future period or periods in which they are earned.
These amounts are carried as unearned revenue, that is, liabilities to transfer goods or future
until the earning render services in the process is complete.

BIR Ruling No.049-98 dated February 10, 1998

Case 1
"On October 1, 1997, Mr. A (lessor) leased his lot to X company (lessee) for a period of ten
years at a monthly rent of P1,000.00. The written lease contract requires lessee X to make an
advance rental payment equivalent two years rentals. X Company paid a lump sum of
P24,000.00 corresponding to and credited as rentals for the first 24 months of the lease. Both
the lessor and lessee are on calendar year tax cycle."
Questions
(a) "Is Mr. A (lessor) required to declare the entire P24,000 as his taxable income during the
year it was received (1997) or can he declare only such portion as will correspond to the rental
income during the taxable year, i.e. P3,000 for 1997; P12,000 for 1998; and P9,000.00 for
1999?"
(b) "Is X company (lessee) entitled to claim as its deductible expenses in its income tax
return for 1997 the entire P24,000.00 advance rental it paid to lessor A; or is it allowed to deduct
only P3,000.00 as rental expense in 1997, the P12,000.00 in 1998 and finally the P9,000.00 in
1999? Obviously there was a pre-payment of rentals up to September 1999."
(c) "What is the tax treatment (income tax) on the part of the lessor and on the lessee if we
vary the above facts such that the advance rental payment is stipulated to be applied or
credited as rentals for the last two years of the lease contract, that is, as rentals for October 1,
2006 to September 30, 2007?"
Answer-
In reply, please be informed that in BIR Ruling No. 69-011 dated October 3, 1969, this Office
citing US precedents, held that if the advance payment is, in fact, prepaid rental, then such
payment is taxable to the lessor in the year when received, even though the lessor is on the
accrual or cash method of accounting. On the part of the lessee, such prepaid rental is to be
treated as capital expenditure and he cannot deduct in the year of payment the full amount of
the prepaid rent as business expense but must spread them over the entire remaining term of
the lease.
Accordingly, and in line with the said BIR ruling which is still being enforced by this Office to
date, Mr. A (lessor) is required to declare the entire amount of P24,000.00 as his taxable income
for the year 1997 when he received the same. On the other hand, X company (lessee) cannot
deduct the entire amount of P24,000.00 as deductible expense in its income tax return for the
year 1997 but must amortize the same over the entire period of the lease.
For the same reason, the advance rental payment is reportable as income in the year of receipt
even if there is a stipulation that same is to be applied or credited as rentals for the last two
years of the contract, i.e., for October 1, 2006 to September 30, 2007.

Case II
"On September 1, 1997, Mr. B (lessor) leased an office unit to ABC company (lessee) for a
period of three (3) years at a monthly rent of P5,000.00. Bills for electricity, telephone and water
shall be paid by Lessee ABC Company. The written lease contract requires that lessee ABC
Company to make SECURITY DEPOSIT in cash in the amount of FIFTEEN THOUSAND
PESOS. This cash security deposit will be held by the lessor Mr. B, to answer for whatever
unpaid rentals, unpaid electrical, telephone and water bills, and damages to the leased
premises, and the balance to be refunded without interest to lessee ABC Company at the end of
the lease contract. ABC Company deposited the required security deposit of P15,000.00."
Questions
(d) "For income tax purposes, is said security deposit of P15,000.00 to be declared as
income on the part of Lessor B and correspondingly as deductible expense on the part of lessee
ABC Company in the taxable year 1997? (Note: It is possible that the entire security deposit will
be refunded to lessee ABC Company at the end of the period of lease). For income tax
purposes, does it matter if the security deposit is mixed with the funds of lessor Mr. B, that is, he
can use it for business purposes but always subject to the purpose for which it was provided in
the contract of lease."
(c) "Is BIR Ruling No. 69-011 dated March 3, 1969 still valid and applicable? Or has the
same been rescinded or amended?"
In reply, please be informed that a security deposit is an advanced payment received by the
Lessor from the Lessee, as security for the lessee's performance of his obligations under the
lease. It is not income to the Lessor when received, as the lessor is required to return this
deposit at the end of the lease period upon fulfillment of all the obligations of the lessee. In this
respect, a security deposit is somewhat analogous to a loan and the lessor has no income and
the lessee no deduction when the deposit is made with the lessor, and the lessor has no
deduction and the lessee no income when it is repaid. This rule applies even when the lessor
has the right to commingle and use the security deposit for his own purposes without interest
during the term of the lease . . . ." (Morten's, Chapter 12 pp. 165-166)
And in BIR Ruling No. 144-88 dated April 18, 1988, this Office ruled as follows:
"In reply, please be informed that if the advance payment made pursuant to a Lease Contract is
in the nature of a security deposit for the faithful performance of certain obligation of the lessee,
the lessor realizes no taxable income in the year the advance payment is received. However, if
the advance payment is a security deposit and the conditions which make the security deposit
the property of the lessor occur; then the lessor realizes a taxable income to the extent of the
security deposit and the lessee is entitled to a deduction to that same extent. (Estate of George
E. Baker, 13 BTA 562 in BIR Ruling No. 011-69 dated October 3, 1969)". In short, the answer to
the question of whether or not the amount of P15,000.00 will be declared as income on the part
of Lessor B and correspondingly deductible expense on the part of lessee ABC will depend on
the nature of said security deposit.
ii. Claim of Right Doctrine A taxable gain is conditioned upon the presence of a claim of right
to the alleged gain and the absence of a definite unconditional obligation to return or repay.
BIR Ruling No. (C-168) 51948 dated December 12, 2008
FACTS: LHC entered into an agreement ("Turnkey Contract") with Transfield Philippines, Inc. (the
"Contractor"). Under the Turnkey Contract, if the Contractor fails to comply with the target completion
date, LHC may consider it in breach, in which case the Contractor shall be liable to LHC for liquidated
damages payable without need of demand.

Due to the delay in the completion of the Project, LHC considered the Contractor liable for breach of
contract. Thus, LHC collected the liquidated damages and reported the amount of liquidated damages
received as part of its taxable income in its income tax returns("ITR") for the years 2000 and 2001,
respectively.

The Contractor protested the claim for liquidated damages. Thus LHC and the Contractor elevated their
claims and counter-claims arising from the delay in the completion of the Project to an Arbitration Tribunal
operating under the Rules of the International Chamber of Commerce sitting in Singapore and later
inAustralia. The Arbitration Tribunal rendered a Final Arbitration Award (the "Arbitral Award") in favor of the
Contractor. Meanwhile, LHC protested the award. Thus, when the Contractor filed before the local courts
a petition applying for confirmation or recognition and enforcement of the Arbitral Award, LHC opposed
and moved for dismissal. LHCmoved for dismissal not only on the grounds sanctioned by the Revised
Rules of Court, but also on a claim that the Arbitral Award that the Contractor sought to enforce is null and
void, having been rendered contrary to public policy. The Court of Appeals found that the enforcement
and recognition of the Arbitral Award would be contrary to Philippine laws and public policies and thus, it
ordered that the Arbitral Award be vacated.

LHC and the Contractor decided in 2008 to enter into an out-of-court settlement (the "Settlement") to
avoid a drawn out legal battle and avoid further litigation expenses. As part of the Settlement, LHC agreed
to return part of the liquidated damages amounting to US$14 million.

ISSUE: Is the return or repayment by LHC in 2008 of the liquidated damages in the amount of US$14.0
million, which was part of the sum previously reported as gross income of LHC in the years 2000 and
2001, an allowable deduction from LHC's gross income for tax purposes in the year 2008, the year of
return or repayment?

HELD: The payment by LHC of the sum of US$14.0 million to the Contractor, which sum LHC previously
reported as part of its taxable income, is an allowable deduction from the gross income of LHC in 2008,
whether such payment is viewed as a return of previously reported income or as a settlement payment
under an out-of-court compromise. Generally, the tax treatment of the return of previously-recognized
income is dependent on the tax treatment of the income previously reported. If the taxpayer received an
income and reported the same as part of taxable gross income, but later on was made to return the said
income, the taxpayer is allowed a deduction for the amount returned against the gross income. The
deduction must be made at the time of the return. This treatment follows the rationale behind allowing
sales return as a deduction from gross sales not only for income tax but also for value-added tax("VAT")
purposes.

In Maurice P. O'Meara v. Commissioner of Internal Revenue, the Tax Court of the United States ruled,
citing the Commissioner's own ruling, held that a taxpayer, having properly reported royalties from
property as income received in cash in 1937, and being required by an adverse court decree to make
restitution, was entitled in a deduction for the amount repaid in cash in 1941 to the extent of the net
royalties previously reported as taxable income notwithstanding that the inclusion of royalty income in
earlier year created no tax burden.
This ruling followed the doctrine laid down in North American Oil Consolidated v. Burnet, 5(5) where the
US Supreme Court enunciated the so-called "claim-of-right" doctrine. This doctrine provides that if a
taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has
received income even though one may claim he is not entitled to the money. Should it later appear that
the taxpayer was not entitled to keep the money, the taxpayer would be entitled to a deduction in the year
of repayment.

Manila Electric Company vs. ClR, CTA Case No.7242 dated December 6, 2010 (also read
dissent of Justice Castaneda)
iii. All events test - The accrual of income and expense is permitted when the all-events test
has been met. This test requires: (1) fixing of a right to income or liability to pay; and (2) the
availability of the reasonable accurate determination of such income or liability. The all-events
test requires the right to income or liability be fixed, and the amount of such income or liability
be determined with reasonable accuracy. However, the test does not demand that the amount of
income or liability be known absolutely, only that a taxpayer has at his disposal the information
necessary to compute the amount with reasonable accuracy. If the taxpayer is on the accrual
method, he can deduct the expense upon accrual thereof. An item that is reasonably
ascertained as to amount and acknowledged to be due has accrued; actual payment is not
essential to constitute expense.
CIR vs. lsabela Cuftural Corporotion, GR No. 172231 dated February 72, 2007
D. Accounting Periods and Methods - correlate with recognition of income and expense
L. Sec. 43-50 of the NIRC 2. Change in Accounting Period E. lndividual lncome Taxation 1.
JulY 26 1999 2. RR No. 1440 dated November 20, t999