Republic of the Philippines

President Ramon Magsaysay State University

College of Accountancy and Business Administration
(Formerly Ramon Magsaysay Technological University)
Iba, Zambales, Philippines
Tel/Fax No.: (047) 811-1683

College/Department College of Accountancy and Business Administration

Course Code BA Core 3

Course Title Income Taxation

Place of the Course in the Program Major Subject

Semester & Academic Year First Semester AY 2020-2021

CHAPTER 8-INCLUSIONS IN GROSS INCOME

Introduction
This chapter discusses inclusion in gross income subject to the regular income tax.

Intended Learning Outcomes

1. Understanding of the NIRC list of items of gross income subject to regular tax and their measurement rules
2. Analysis of the boundary between income subject to final tax or capital gains tax and those subject to regular
income tax
4. Comprehension of the effect of accounting methods and situs rules on the reportable amount of gross income
5. Knowledge of the treatment of creditable withholding tax
6. Application of the rules on recoveries of past deductions

Discussion

ITEMS OF GROSS INCOME SUBJECT TO REGULAR TAX

Gross income includes, but is not limited to, the following items:
1 .Compensation for services in whatever form paid
2. Gross income from the conduct of trade, business, or exercise of a profession
3. Gains derived from dealings in properties
4. Interest
5. Rents
6. Royalties
7. Dividends
8. Annuities
9. Prizes and winnings
10. Pensions
11.Partner’s distributive share from the net income of general professional partnership

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Compensation for services in whatever form paid
Under current tax rules, the term “compensation income” technically pertains to the types of employee benefit that
are subject to regular tax. The fringe benefits of managerial or supervisory employees are not considered
compensation income and are subject to final tax.

Gross Income from the conduct of trade, business or exercise of a profession

This includes income from any trade or business, legal or illegal, and whether registered or unregistered.

Gross Income from business or profession is determined as follows:

Sales/Revenues/Receipts/Fees P xxx, xxx

Less: Cost of sales or services xxx, xxx
Gross Income from operations P xxx, xxx

Gains from Dealings in properties

Ordinary Gains are included as items of gross income. Ordinary losses are items of deduction against gross income.
The net capital gain from other capital assets after deducting capital losses is also included as an item of gross
income. A net capital loss is not an item of deduction against gross income.

Interest income

Example of income subject to regular income tax:

1. Interest income from lending activities to individuals and corporation by banks, finance companies and
other lenders.
2. Interest income from bonds promissory notes
3. Interest income from banks deposits abroad

Exempt interest income

The following are exempt from regular income taxation:
1. Interest income earned by landowners in disposing their lands to their tenants pursuant to the Comprehensive
Agrarian Reform Law

2. Imputed interest Income

Imputed interest income (the opportunity cost of money) does not constitute an actual income ; hence, it is
exempt from income tax.

The power of the Commissioner to allocate income and deduction does not include the power to impute
“theoretical interest”. (Ibid)

Illustration
Bong Bank has the following income in 2019 :
Interest Income from loans P 3,000,000
Interest income from deposits with other banks 400,000
Interest income from the notes rediscounting 100,000
Interest income from Treasury notes 50,000

Only the interest income from loans and notes rediscounting are items of gross income subject to regular income tax.
The interests on deposits and treasury notes are items of gross income subject to final income tax.

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Rents
Rent income arises from leasing properties of any kind. It is a passive income but is not subject to final tax under the
NIRC; hence, it is subject to regular income tax.

Special considerations on rent

1. Obligations of the lessor that are assumed by the lessee are additional rental income to the lessor.

2. Advance rentals are

a. Item of gross income upon receipt if:
i. Unrestricted or
ii. Restricted to be applied in future years or upon the termination of the lease
b. Not an item of gross income if :
i. it constitute a loan
ii. It is a security deposit to guarantee payment or rent subject to contingency which may or may not happen.
3. Leasehold improvements made by the lesse on the leased property are recognized by the lessor as income using
the spread-out method or outright method.
Illustration
Under the B Corporation’s standard lease contract, lease shall run for a non-preterminable 12-month for a monthly
rental P25,000.The lease shall pay three months rental in advance plus one month security deposit. The rent for the
last two months of lease shall be taken from the advance while the security deposit will be returned if there are no
damage sustained by the property during the lease turn.

Royalties
Royalties earned from sources within the Philippines are generally subject to final income tax except when they are
active by nature. Active royalty income and royalties earned from sources outside the Philippines are subject to
regular income tax.

Illustration 1
Equity is a distributor of a computer program and earns royalties from its licensed users. Computer programs are
specifically tailored to each client and regular continuing maintenance services are provided. During the year,
client-users remitted a total of P500,000 royalty payments.

The entire P500,000 is subject to regular income tax since the royalty is an active income to Equity.

Illustration 2
Mang Kanor has the following royalties:
Royalties from mining properties in the Philippines P 550,000
Royalties from books published in the Philippines 200,000
Royalties from books published abroad 300,000
Royalties from franchise exercised abroad 400,000

Dividends
These pertains to dividends declared by foreign corporations. It should be recalled that dividends declared by
domestic corporations are generally subject to 10% final tax if the recipients is an individual taxpayer and exempt if
the recipient is a domestic or a resident foreign corporation. Cash, property ,and script dividends from foreign
corporation are items of gross income subject to regular income tax.

Illustration
Pasay Corporation, a domestic corporation, received cash dividends from the following corporations:

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Domestic Corporations P 400,000
Resident foreign corporations 200,000
Non-resident foreign corporations 300,000

Annuities
The excess of annuity payments received by the recipient over premium paid is taxable income in the year of
receipt.

Illustration
Andrei purchased an annuity contract for P100,000 which shall pay him P10,000 annually until he dies.

Prizes and winnings

Prizes and winnings that are exempted from the final tax are not items of gross income subject to regular income tax.

Note: Lotto winnings from abroad are items of gross income subject to regular income tax for taxpayers taxable on
global income.

The final taxation of prizes and winnings for corporations is not contemplated in the NIRC. Hence, the taxable
prizes and winnings of corporations are subject to regular income tax.

Illustration
The Province of Zambales held its Dinamulag festival. During the festivities, Mr. Villa, the proprietor of Mr. Sexy
Body Gym, won the P50,000 second prize in the street dancing competition. San Miguel Corporation won the
P600,000 first prize.

Pensions
These pertain to pensions and retirement benefits that fail to meet the exclusion criteria and hence subject to regular
tax.

Partner’s distributable share from the net income of the general professional partnership
It should be recalled that general professional partnership are not subject to income tax (i.e.,, final tax, capital gains
tax or regular income tax). The partners are the ones subject to regular tax on their share in the net income of the
general professional partnership.

Illustration:
Zef and Siegfried practice their profession in a general professional partnership and share profits 60:40.Their firm
reported the following:

Gross receipts P 2,000,000

Less: Professional expenses 1,200,000
Net income from operations P 800,000
Interest from bank deposits 20,000
Distributive net income P 820,000

The share of the partners in the net income of the partnership shall be computed as :
Total distribution to Zef (60% x P820,000) P 492,000
Total distribution to Siegfried (40% x P820,000) 328,000
Distributive net income P 820,000

The partners shall include their respective shares in their gross income subject to regular income tax.

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Note that this rule applies to other entities such as :
1. Exempt joint ventures
2. Exempt co-ownership

Business Partnership and taxable joint venture or co-ownership

These entities are subject to corporate income tax. The distributive share of a partner, venturer, or co-owner from the
net income of these entities, if organized within the Philippines, is subject to 10% final withholding tax.

However, if these entities are organized or constituted abroad, the share from their profit is subject to regular income
tax for taxpayers taxable on global income.

OTHER SOURCES OF GROSS INCOME SUBJECT TO REGULAR INCOME TAX

1. Income distribution from taxable estates or trusts.
2. Share from the net income of other pass-through entities:
a. Exempt joint venture
b. Exempt co-ownership
3. Farming income
4. Recovery of past deductions
5. Reimbursement of expenses
6. Cancellation of indebtedness for a consideration

Income Distribution from taxable estates or trusts

Any income distribution received by an heir or beneficiary from a taxable estate or trust shall be included in his
gross income subject to regular tax, provided that such income must not have been subjected to final tax or capital
gains tax.

Illustrations: Estates
Roman is one of several heir to the business estate of his father which is under judicial settlement. The administrator
distributed the following income for the support of Roman:

Domestic dividends P 22,500

Business Income 70,000

Roman shall include his gross income subject to regular income tax the P70,000 distribution from the business
income. The estate shall prevent the same amount as a deduction against its gross income. The P22,500 dividend
shall not be reported by Roman since this was already subjected to final tax at source.

Illustration : Trusts
Horace received the following income distributions in his capacity as beneficiary to an irrevocable trust designated
by his grandmother:

Net capital gains on sale of domestic stocks P 9,500

Rental income 12,000

Horace shall report only P 12,000 rental income in his gross income subject to regular income tax. The net gain on
the sale of stocks is subject to capital gains tax to the trust.

Share from the net of exempt joint ventures and co-ownership

The same tax treatment on recognition of share in the net income of a general professional partnership applies to the
share from the net income of exempt joint ventures and co-ownerships.

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RECOVERIES OF PAST DEDUCTIONS
When past year deductions from gross income are subsequently recovered by the taxpayer or when accrued expense
previously deducted are subsequently paid at an amount less than the deduction claimed, they should be analyzed
whether or not they resulted in tax benefit to the taxpayer.

Examples of recoveries of past deductions:

1. Recovery of previously claimed bad debt expense
2. Refund of local tax expense
3. Refund of foreign tax previously claimed as deduction
4. Re-commissioning of abandoned petroleum service contracts or mining properties
5. Release of reserve funds of insurance companies
6. Interest expense which were subsequently condoned by the lender

Past deduction that created tax benefit to the taxpayer must be reverted back to gross income in the year of recovery
so that the government will recover the tax lost from deduction.

Tax benefit
There are two ways a taxpayer may benefit from a deduction:
a. Directly, through reduction of taxable income in the year deduction is made
b. Indirectly, through reduction of failure taxable income through carry-over of net operating loss

Note
1. Under our tax laws, the excess of deduction over gross income in a taxable year is carried over as a deduction
against the net income of the next three years of operations. This is called net operating loss carry-over or NOLCO.
Because of this, almost all prior year deductions have tax benefit; hence, their recovery is taxable.
2. NOLCO is partially discussed here because of its relevant to the topic at hand.

Illustration 1 : With Net Income in the year of deduction

A taxpayer incurred P60,000 bad debt expense in 2018 out which P35,000 was recovered in 2020:
2018 2019 2020
Net income before bad debt expense P 100,000 P 80,000 P120,000
(Bad debt expense)/ Recoveries ( 60,000 ) - 35, 000
Net income after bad debt expense P 40,000 P 80,000 P ???

The entire P60,000 deduction in 2018 is a tax benefit to the taxpayer. Hence, the P35,000 recovery from this
deduction is a tax benefit which must be reverted back to grow income in 2020. The taxable net income in 2020
shall be P155,000.

Illustration 2: With operating loss & NOLCO carry-over before recovery

A taxpayer incurred a P90,000 bad debt expense in 2018 out of which P60,000 was recovered in 2020.
2018 2019 2020
Net income before bad debt expense P 70,000 P 100,000 P 120,000
(Bad debt expense)/Recoveries ( 90,000) - 60,000
Net income after bad debt expense (P 20,000) P 100,000 ????
Less: NOLCO application ( 20,000)
Net income P 80,000

The entire P90,000 deduction is a benefit. The taxpayer benefit by the P70,000 reduction in 2018 taxable income
plus the P20,000 carry-over of NOLCO. The P60,000 recovery from the deduction in 2020 is a tax benefit subject to
tax. The reportable net income in 2020 shall be P180,000.

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Illustration 3: with expired NOLCO before recovery
Suppose a taxpayer deducted a P500 interest expense in 2015 but failed to pay for same due to financial difficulty.
The lender condoned the interest in 2019
2015 2016 2017 2018 2019
Income before interest P 100 (P 130) P 80 (P 160) (P 70)
Less: interest ( 500) - - 500
Net income (P 400) (P 130 ) P 80 ( P 160 ) P ???
NOLCO application ( P 80)
Net Income P 0

The interest expense saved the 2015 P100 pre-tax income and the 2017 P80 net income from taxation, note that
NOLCO can be deducted only against net income in the next three years. The P320 remaining NOLCO expired in
2018 without tax benefit. The P500 interest deduction only benefited the taxpayer P180. Hence, only P180 of the
P500 recovery in 2019 shall be reverted back to the 2019 gross income.

ILLUSTRATION 4: With operating loss in the year of recovery

A taxpayer incurred a P90, 000 bad debt expense in 2017 out of which P60,000 was recovered in 2018.
2017 2018
Net income /(loss) before had debts/recovery P 70,000 ( 15,000)
( bad debt expense) Recovery ( 90,000) _______ 45,000
Net income after bad debt expense (P 20,000) P ???

An increase in NOLCO which has not expired before the beginning of the taxable year in which the recovery takes
place shall be treated as tax benefits. Thus, the entire P90,000 is a tax benefits to the taxpayer. Hence, the P45,000
recovered out of it is a tax benefit which must be reverted back to gross income in 2018.

The 2018 net income shall be computed as follows:

Net loss before recovery (P 15, 000)
Add: recovery 45,000
Net income P 30, 000
Less: NOLCO application – 2018 20, 000
Taxable net income P 10,000

ILLUSTRATION 5: Without benefit of NOLCO carry-over

A corporate taxpayer had an exchange in 80% of its shareholder in 2016. Thus, any net operating loss incurred
before 2015 is not allowed to be carried over. A P90, 000 bad debt write-off was made in 2015 out of which P60,000
was recovered in 2017.

2015 2016 2017

Net income before bad debt expense P 70,000 P100, 000 P 120, 000
(bad debt expense)/ recoveries ( 90,000) - 60,000
Net income after bad debt expense (P 20,000) P100,000 ???

The tax benefits of the P90,000 debt expense to the corporation in this case shall be determined using the As-If
Approach.

Assuming the future recovery is known, the 2015 net income should have been:

Net income before bad debt expense P 70,000

Less: bad debt expense if recovery is known (P90,000 – P60,000) 30,000

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Net income if recovery known P 40,000

The tax benefit is the income that escaped taxation in 2015 computed as:

Net income if subsequent recovery is known P 40,000

Less: net income reported in 2015 (recovery is unknown) 0
Tax benefit of the debt expense P 40,000

P40,000 out of the P60,000 recovery in 2017 constitutes tax benefits which must be included in the 2017 gross
income. The net income shall be P160,000.

ILLUSTRATION 6: Taxpayer is exempt in the year of deduction

Kalinga corporation is an exempt BMBE taxpayer in 2015 but became a taxable regular income taxpayer in 2016. It
deducted P120,000 bad debt expense in 2015. In 2016, it recovered P40,000 out of the bad debts.

2015 2016
Net income before bad debt expense P 70,000 P 100,000
(bad debt expense)/Recovery ( 120,000) 40,000
Net income after bad debts expense (P 50,000) P ???

Deduction have no tax benefit to a taxpayer who is exempt from tax. Future recoveries from deductions that made in
the year of exemption are non-taxable. The P40, 000 recovery is not income. The 2016 net income shall be P100,
000.
Refund of non-deductible expenses
Expenses or payments which are not deductible against gross income in the computation of taxable net income will
never create tax benefit to the taxpayer. As such, their recovery should not be included in gross income.

Hence, the refund of the following non-deductible items is not taxable:

1. Philippine income tax
2. Estate or donor’s tax
3. Income tax paid or incurred to a foreign country if the taxpayer claimed a credit for such tax in the year it was
paid or incurred.
4. Stock transaction tax in disposing stocks through the Philippine Stock Exchange
5. Special assessment

REIMBURSEMENT OF EXPENSE
Expenses of the taxpayer that are reimbursed or paid by the customer or client constitute additional income to the
taxpayer.

Examples:
1. When the lessee pays the ownership costs of the lessor such as real property tax and insurance on the property, the
payment constitutes income to the lessor.
2. When a client reimburse the out-of-pocket expenses of a professional practitioner, the reimbursements are income
to the practitioner.

CANCELLATION OF INDEBTEDNESS
The cancellation of indebtedness may amount to gratuity or payment of income.

The cancellation of debt:

a. In consideration of services or goods-treated as income
b. As an act of gratuity-treated gifts; not as income

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c. As capital transactions such as forfeiting the right to receive dividends in exchange of the debt-treated as dividend
income

SPECIAL CONSIDERATIONS IN REPORTING OF GROSS INCOME

1. Accounting methods
2. Situs rules
4. Creditable withholding tax

ACCOUNTING METHOD
The accounting method adopted by the taxpayer has a direct effect on the reportable amount of gross income subject
to regular income tax.
For instance, cash-basis taxpayer will report their gross receipts or collection as gross income while accrual basis
taxpayers will report their revenue consisting of collected and uncollected income in gross income.

It must be recalled also that regardless of the accounting methods of the taxpayer, advanced income must be
included in gross income in the period received.

SITUS RULES
The situs of taxation also affects the extent of income included as items of gross income of the taxpayer. It must be
recalled that all taxpayers are taxable only on Philippine income except resident citizens and domestic corporations
which are taxable on global income.

For taxpayers taxable only on Philippine income, only their items of gross income subject to regular tax from
sources within the Philippines are included in gross income.

For taxpayers taxable on global income, their items of gross income subject to regular tax from sources within and
without the Philippines are included to gross income.

Integrative Illustration 1
Lylia, a finance corporation, lends to various clients:

Interest income from loans to Philippine residents P 400,000

Interest income from loans to non-resident clients 500,000
Interest income from bank deposits in the Philippines 20,000
Interest income from bank deposit abroad 10,000

Required:
Determine the total amount of gross income subject to final tax and the reportable amount of gross income subject to
regular income tax assuming the taxpayer is a:
1. Non-resident foreign corporation
2. Resident foreign corporation
3. Domestic corporation

Solution:
An analysis of the situs of the above income is shown below:
Within Without
Loan interest income P 400,000 P 500,000
Bank interest income 20,000 10,000
Total P 420,000 P 510,000

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The following are the amount subject to final tax and the amount to be reported in gross income subject to regular
income tax:

Subject to

Final tax Regular Tax

1. Non-resident foreign corporation P 420,000 P 0
2. Resident foreign corporation 20,000 400,000
3. Domestic corporation 20,000 910,000

Integrative Illustration 2
A certain taxpayer had the following details of income during the year:

Service fees from Philippine clients P 400,000

Service fees from foreign clients 500,000
Gain on sale of domestic stocks directly to a buyer 150,000
Dividends from domestic corporations 5,000
Interest income on bank deposits abroad 30,000

Required:
Determine the amount of gross income subject to regular income tax, final tax and capital gains tax assuming that
the taxpayer is:

1. an individual
a. Non-resident alien not engaged in trade or business (NRA-NETB)
b. Non-resident alien engaged in trade or business (NRA-ETB), a resident alien (RA) or a non-resident citizen
(NRC)
c. Resident citizen (RC)
2. a corporation
a. Non-resident foreign corporation
b. Resident foreign corporation
c. Domestic corporation

Solution:
An analysis of the situs of the foregoing income as follows:
Within Without
Service fees P 400,000 P 500,000
Gain on sale of domestic stocks 150,000
Domestic dividends 5,000
Interest income from foreign bank - 30,000
Total P 555,000 P 530,000

The following are the amount to be included in gross income subject to final income tax (FIT) ,capital gains
tax(CGT) ,and regular income tax (RIT)

Taxpayers FIT CGT RIT

Individuals
1. NRA-NETB P 405,000 P 150,000 P
2. NRA-ETB, RA, or NRC 5,000 150,000 400,000
3. RC 5,000 150,000 930,000

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Corporations
4. NRFC P 405,000 P 150,000 P
5. RFC - 150,000 400,000
6. DC - 150,000 930,000

Note:
1. NRFC’s and NRA-NETB are subject to final tax on Philippine income.
2. The 5%-10% capital gains tax is the most universal rule in taxation that applies to all taxpayers regardless of
classification.
3.. Inter-corporate dividends are exempt from final tax, except when the recipients is a non-resident foreign
corporation.

CREDITABLE WITHHOLDING TAX

Creditable withholding tax (CTT) deducted by income payors against the gross income of the taxpayer are not
exclusions in gross income. These should be added back to the reportable amount of gross income. CWTs that are
deductible against the annual income tax due of the taxpayer.

Illustration
HANZO Inc., a non-VAT domestic corporation, reported the following:

Rent income, net of 5% or P25, 000 CWT P 475,000

Professional fees, net of 10% or P40, 000 CWT 360,000
Interest income, net of 20% final tax 40,000
Dividends from a domestic corporation 10,000
Business expenses 500,000

Required:
Determine the total reportable gross income and the income tax due and still due under the regular income tax.

The total reportable gross income shall be:

Rent Income (P475K/95% or (475K + P25k) P 500,000

Professional fees (P360K/90% or (P360K + P40K) 400,000
Total gross income P 900,000

Note: The interest income and the dividend income are subject to final tax. They should be included in the item of
gross income subject to regular income tax.

The income tax due and still due shall be determined as:

Total gross income P 900,000

Less: Allowable deductions (business expenses) 500,000
Taxable net income P 400,000
Multiply: Corporate tax rate 30%
Income tax due P 120,000
Less: Creditable withholding tax
-Rent P 25, 000
- Professional fees 40,000 65,000
Income tax still due P 55,000

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The income tax due and still due shall be determined as:

Total gross income P 900,000

Less: allowance deduction (business expense) 500,000
Taxable net income P 400,000
Multiply: corporate tax rate 30%
Income tax due P 120,000
Less: creditable withholding tax
- Rent P25,000
- Professionals fees 40,000 65,000
Income tax still due P 55,000

Note:
1. The CWTs are actually advance to the annual income tax due of corporations and individuals and are
deductible (i.e. creditable) therein, same procedures are applied with individuals except that their income
tax dues are determined by progressive tax rate.
2. The final taxes should not be credited against the annual income tax due.

Activity
1. Calvin, employed, derives the following income during the year:

Gross salaries P400,000

13th month pay and other benefits 40,000
SSS, Philhealth, Pag-ibig Contributions 20,000
Deductions for loan repayments 50,000
Deductions for withholding tax 60,000

Compute the compensation income to be reported in the annual income tax return?__________

2. Cora resigned in 2018 after 12 years of service. She had the following income during the year:

Salary, net of P80,000 withholding tax

P20,000 SSS, P18,000 philhealth P480,000
Separation pay 1,000,000

Compute the gross income subject to regular tax?_________________

3. Mr. Blue, a supervisory employee, received the following income in 2018:

Gross compensation income, before contributions

Of SSS, Philhealth ad HDMF totaling P124,000 P800,000
Fringe benefits 200,000
Gain from redemption of shares in a mutual fund 100,000
Commission income 150,000
Gain on sale of stocks through PSE 400,000

Determine the total income to be reported by Mr. Blue in gross income.____________

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4. Israel Corporation, engaged in the sales of goods, reported the following summarized financial
statements:

Sales P3,500,000
Cost of sales 2,000,000
Gross profit P1,500,000
Commission income on consignment 200,000
Interest income from customers 20,000
Interest income, net of final tax 10,000
Dividend income 50,000
Total income P1,780,000
Admin and Selling Expenses 1,000,000
Net income P780,000

Compute the total gross income subject to regular tax._______________

5. Percy Corp., a domestic Corporation, reported the following income in 2018:

Philippines Abroad
Service fees P400,000 P300,000
Interest income-bank 40,000 70,000
Royalties-franchise 80,000 30,000
Compute the total gross income subject to RIT?_______
6. If Percy Corp. is an RFC, compute the gross income subject to RIT.____________
7. Andy leases a building to a client. During the year, he received the following remittance from the
lessee:
Rental, net of 5% creditable withholding tax P1,900,000
Real property tax of the leased building 50,000
Reimbursement for utilities used by the lessee paid by Andy 200,000

How much will be included in gross income subject to RIT?___________

8. Ms. Villar, a professional practitioner, received the following from his clients:
Advances for future services to be rendered P30,000
Collections for past services rendered 70,000
Reimbursements for client expenses 40,000
Reimbursements for out-of-pocket expenses 10,000

How much will be included in the gross income subject to regular tax?__________
9. Shown below is a compilation of the gain on the sale of real properties:
Real properties classified as Philippines Abroad
Ordinary assets P300,000 P800,000
Capital 400,000 200,000

What is the amount of income to be included in gross income subject to regular tax assuming the
taxpayer is a domestic corporation?______________
10. What is the gain to be included in gross income subject to regular income tax if the taxpayer is a
resident foreign corporation?_________
11. What is the gain to be included in gross income if the taxpayer is a resident alien?___________

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