Basic Taxation Law: Special Topics in Income Taxation
Chapter 8
Special Topics in Income Taxation
A. Determination of Source According to Kinds of Income
Tax Situs of Three Possible Sources of Income
Income from labor (services)
the place where the labor is done;
Income from capital
the place where the capital is employed;
Income from the sale of capital assets
the place where the sale is made.
Settled Case on the Tax Situs of Interest Income
NDC v. Com., 151 SCRA 47
National Development Corporation (NDC) entered into contracts in Tokyo with Japanese building companies for the construction of 12 ocean-going vessels.
Initial payments were in cash and irrevocable letters of credit.
The balance was secured by promissory notes guaranteed by the Republic of the Philippines.
The vessels were completed and delivered to the NDC in Tokyo.
The promissory notes and interest therein were paid by NDC.
Is interest on the promissory notes to be treated income from the Philippines considering that all the elements of the main transaction, i.e., construction and delivery of vessels, were all performed in Japan?
The interest is considered income from the Philippines.
According to Section 36 (now Section 42A[1]) of the NIRC as amended, xxx interest on bonds or other interest bearing obligations of residents, corporate or otherwise, is considered income from the Philippines. The law does not speak of the activity which gave rise to the obligation, but solely of the residence of the obligor.
NDC is undoubtedly a resident of the Philippines. Hence, interest paid even in Tokyo by NDC to the ship builders is considered as income from the Philippines.
11. Gain on sale of transport document - Place of activity that produces income
The source of an income is the property, activity or service that produced the income.
For the income to be considered as coming from the Philippines, it is sufficient that the income is derived from activity within the Philippines.
Commissioner v. BOAC, 149 SCRA 395
The sale of tickets in the Philippines is the activity that produced the income. The tickets exchanged hands here and payments for fares were also made here in the Philippine currency. The flow of wealth proceeded from and occurred within Philippine territory, enjoying the protection accorded by the Philippine government.
In consideration of such protection, the flow of wealth should share the burden of supporting the government. The absence of flight operations to and from the Philippines is not determinative of the source of income or the situs of income taxation.
Admittedly, BOAC was an offline international airline at the time pertinent to this case.
The test of taxability is the “source” and the source of an income is that activity (sale of airline tickets) which produced the income.
Unfortunately, the passage documents were sold in the Philippines and the revenue therefrom was derived from a business activity regularly pursued within the Philippines x x x.
The word “source” conveys one essential idea, that of origin, and the origin of the income herein is the Philippines.
Rev. Regs. No. 15-2002, Implementing Section 28A(3}:
In computing for “Gross Philippine Billings,” there shall be included the total amount of gross revenue derived from passage of persons, excess baggage, cargo and/or mail, originating from the Philippines in a continuous and uninterrupted flight, irrespective of the place of sale or issue and the place of payment of the passage documents.
12. Manufacturing
Produced in whole within and sold within
Income purely within
Produced in whole without and sold without
Income purely without
Produced within and sold without
Income partly within and Income partly without
Produced without and sold within
Income partly within and Income partly without
From the income partly within and partly without, income purely within is derived as follows:
Given Values:
Net Income: P1,000,000
Value of property within the country: P2,000,000
Value of property within and without the country: P5,000,000
Gross sales within the country: P3,000,000
Gross sales within and without the country: P6,000,000
13. Dividend income from:
Domestic corporation
Income within (Phil.)
Foreign corporation
If for the three-year period preceding the declaration of such dividend, the ratio of such corporation's Philippine income to the world (total) income was:
Less than 50%
Entirely without
50% to 85%
Proportionate
More than 85%
Entirely within (Phil.) .
Given Values:
Philippine Gross Income: P3,000,000
Entire Gross Income: P10,000,000
Dividends received within the Philippines: P500,000
B. Capital Transactions
Definition of capital asset.
NIRC (Section 39)
defines capital assets by exclusion.
There is no concrete definition.
The term "capital asset" means property held by the taxpayer (whether or not connected with his trade or business), but does not include the following (these are ordinary assets): SODR
Stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory if on hand at the close of the taxable year (raw materials, work in process, finished goods supplies);
Property held by the taxpayer primarily for sale to customers in the ordinary course of trade or business.
Requisites: SCO
Property must be held primarily for sale.
Property must be held for sale to customers.
A sale by dealer in securities is an ordinary transaction.
Property must be sold in the ordinary course of taxpayer's trade or business.
Trade of business
that which occupies the time, attention, and labor of men for the purpose of livelihood or profit.
"Ordinary course"
indicates significance of the transaction and, therefore, excluded are those sales which are effected by the taxpayer merely incidentally or accidentally to his business.
Hence, isolated transactions would not be in the ordinary course of trade of business .
Property used in trade or business of a character which is subject to the allowance for depreciation.
Depreciable personal properties such as furniture, equipment, and machineries used in trade or business
Real property used in trade or business of the taxpayer.
Properties used or connected with trade or business which are considered capital assets: ASG
Account receivable;
Securities held as Investments;
Goodwill.
Reason: Not included in the four categories of ordinary assets.
Sale of a business to a corporation
Ordinary and capital assets.
Consider the assets involved in the sale.
Sale of partner's interest in a partnership
capital asset.
Reason: Not included in the category of ordinary assets
Car used in trade or business and for personal purpose
One-half of the value
ordinary asset
used in business.
One-half of the value
capital asset
not used in business.
The statutory definition of capital assets is negative in nature.
If the asset is not among the exceptions, it is a capital asset; conversely, assets falling within the exceptions are ordinary assets.
And necessarily, any gain resulting from the sale or exchange of an asset is a capital gain or an ordinary gain depending on the kind of asset involved in the transaction.
However, there is no rigid rule or fixed formula by which it can be determined with finality whether property sold by a taxpayer was held primarily for sale to customers in the ordinary course of his trade or business or whether it was sold as a capital asset.
Although several factors or indices have been recognized as helpful guides in making a determination, none of these is decisive; neither is the presence nor the absence of these factors conclusive.
Each case must in the last analysis rest upon its own peculiar facts and circumstances.
Calasanz v. CIR, 144 SCRA 664:
Extensive improvements like the laying out of streets, construction of concrete gutters and installation of lighting systems and drainage facilities, among others, were undertaken to enhance the value of the lots and make them more attractive to prospective buyers.
34 Am Jur 2d:
Also, a property initially classified as a capital asset may thereafter be treated as an ordinary asset if a combination of the factors indubitably tend to show that the activity was in furtherance of or in the course of the taxpayer's trade or business.
Thus, a sale of inherited real property usually gives a capital gain or loss even though the property has to be subdivided or improved or both to make it saleable.
However, if the inherited property is substantially improved or very actively sold or both it may be treated as held primarily for sale to customers in the ordinary course of the heir's business.
There is authority that a property ceases to be a capital asset if the amount expended to improve it is double its original cost, for the extensive improvement indicates that the seller held the property primarily for sale to customers In the ordinary course of his business.
Construction and interpretation of capital assets
The general rule has been laid down that the codal definition of a capital asset must be narrowly construed while the exclusions from such definitions must be interpreted broadly.
Factors/tests determinative of capital or ordinary asset:
NRV-SE
Nature and character of the taxpayer's title to the property;
Reason, purpose and interest of requisition, as well as its period of duration;
Taxpayer's vocation, extent of activities;
If conducted through a supervision over the agent;
Extent and nature of the taxpayer's efforts to sell.
Jurisprudential criteria in determining the correct boundary between ordinary and capital assets:
IS-IF-TO-ALS
the purpose for which the property was initially acquired;
the purpose for which the property was subsequently held;
the extent to which improvements, if any, were made to the property by the taxpayer;
the frequency, number, and continuity of sales;
the extent and nature of the transactions involved;
the ordinary business of the taxpayer;
the extent of advertising, promotion, or other activities used in soliciting buyers for the sale of the property;
the listing of property with brokers; and
the purpose for which the property was held at the time of sale.
Circumstances showing that the seller was engaged in the real estate business making the lots ordinary assets:
LS-IA–FAS
The parcels of land involved have in totality a substantially large area nearly seven (7) hectares, big enough to be transferred into a subdivision;
They were subdivided into small lots and then sold in installment basis;
Comparatively valuable improvements were introduced in the subdivided lots for the unmistakable purpose of not simply liquidating the estate but of making the lots more saleable to the general public;
The employment of attorney-in-fact for the purpose of developing, managing, administering and selling the lots indicates the existence of owner-realty broker relationship;
The sales were made with frequency and continuity;
Considerable annual sales volume of the seller from the lots;
The seller, by his own tax returns, was not a person who can indubitably be adjudged as a stranger to the real estate business.
Guidelines in determining whether a particular real property Is a capital asset or ordinary asset (Rev. Regs. No. 7-2003)
Taxpayers engaged in the real estate business.
Real property shall be classified with respect to taxpayers engaged in the real estate business as follows: DDLH
Real Estate Dealer.
All real properties acquired by the real estate dealer shall be considered as ordinary assets.
Real Estate Developer.
All real properties acquired by the real estate developer, whether developed or undeveloped as of the time of acquisition, and all real properties which are held by the real estate developer primarily for sale or for lease to customers in the ordinary course of his trade or business or which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year and all real properties used in the trade or business, whether in the form of land, building, or other Improvements shall be considered as ordinary assets.
Real Estate Lessor.
All real properties of the real estate lessor, whether land and/or improvements, which are for lease/rent or being offered for lease/ rent, or otherwise for use or being used In the trade or business shall likewise be considered as ordinary assets.
Taxpayers habitually engaged In the real estate business.
All real properties acquired in the course of trade or business by a taxpayer habitually engaged in the sale of real estate shall be considered as ordinary assets.
Taxpayer not engaged in the real estate business.
In the case of a taxpayer not engaged in the real estate business, real properties, whether land, building, or other improvements, which are used or being used or have been previously used in the trade or business of the taxpayer shall be considered as ordinary assets.
Taxpayer changing business from real estate business to non-real estate business.
In the case of a taxpayer who changed its real estate business to a non-real estate business, or who amended its Articles of Incorporation from a real estate business to a non-real estate business, such as a holding company, manufacturing company, trading company, etc., the change of business or amendment of the primary purpose of the business shall not result in the reclassification of real property held by it from ordinary assets to capital asset.
Taxpayers originally registered to be engaged in the real estate business but failed to subsequently operate.
In the case of subsequent non-operation by taxpayers originally registered to be engaged in the real estate business, all real properties originally acquired by it shall continue to be treated as ordinary assets.
Treatment of abandoned and idle real properties.
Real properties formerly forming part of the stock in trade of a taxpayer engaged in the real estate business, or formerly being used in the trade or business of a taxpayer engaged or not engaged in the real estate business, which were later on abandoned and became idle, shall continue to be treated as ordinary assets.
Treatment of real property subject of involuntary transfer.
In the case of involuntary transfers of properties, including expropriation or foreclosure sale, the involuntariness of such sale shall have no effect on the classification of such real property in the hands of the involuntary seller, either as capital asset or ordinary asset, as the case may be.
Rules on capital gains and losses.
Two conditions must concur: SC
There must be a sale or exchange; and
What is sold or exchanged is a capital asset.
Special Rules on Capital Transactions
Percentage of gain or loss recognized
100%
if the asset was held for not more than 12 months
50%
if the asset was held for more than 12 months
Holding period
It is the length of time the asset was held by the taxpayer.
It covers the period from the date of acquisition of the assets to the date of sale.
In computing the period, the day on which the property was acquired is excluded, the day on which it was disposed of is included.
Loss limitation rule
capital losses are allowed only to the extent of capital gains.
Therefore, capital losses are not deductible from ordinary gains.
Reason: To ensure the matching of costs against revenues consistent with the rule that only business expenses are deductible from gross income.
Capital loss is not a business expense.
Settled rules:
Ordinary loss is deductible from ordinary gain;
Capital loss is deductible from capital gain;
Capital loss is not deductible from ordinary gain;
Ordinary loss is deductible from capital gain.
Net capital gain
excess of capital gain over capital loss.
capital gain — capital loss
Net capital loss
excess of capital loss over capital gain.
capital loss — capital gain
Net Capital Loss (Carry over)
shall be treated in the succeeding taxable year as loss from the sale or exchange of capital asset held for not more than 12 months.
Limitation
not in excess of the taxable (net) income in the preceding year or the lower amount between the net income and the capital loss.
The foregoing rules are not applicable to sale of shares of stock and real property.
Special Capital Transactions
Short Sale.
A transaction in which a speculator sells securities which he does not own in anticipation of a decline in its price.
It represents a debt contracted in goods rather than cash.
Should the price of the securities decline, the seller makes profit.
If the price goes up, he incurs the loss.
Securities becoming worthless.
Requisites: WTLF
Ascertained to be worthless and charged off within the taxable year;
Worthlessness occurred during the taxable year;
Deductible on the last day of the taxable year.
If the loss is due to fluctuation of price in the market, the loss is not deductible until finally disposed of.
Failure to exercise privileges or option to buy or sell property.
A sale of the option itself under allowable covenants would constitute sale or exchange of a capital assets.
In fine, the law considers an option or privilege as the capital asset itself and the failure to exercise the same as transaction.
If the option is not exercised, it is deemed to have been sold or exchanged as of the day the option expires.
Retirement of Bonds.
Amounts received by the holder upon retirement of bonds, debentures, notes or certificates or other evidence of indebtedness issued by any corporation (including those issued by a government or political subdivision thereof) with interest coupons or in registered form, shall be considered as amounts received in exchange therefrom.
Readjustment of interest in a tax-exempt partnership.
Where a partner retires from a tax-exempt partnership, or the partnership is dissolved, the partner realizes gain or suffers a loss determined as follows:
Receipt of liquidating dividend.
If the stock was held as a capital asset, gain or loss is determined as follows:
China Banking Corporation v. CA, 236 SCRA 178:
An equity investment is a capital, not ordinary, asset of the investor the sale or exchange of which results in either a capital gain or a capital loss.
Expenses of Acquisition and Disposition of Capital Assets
Expenses of acquisition (purchase) should be capitalized together with the cost of acquisition;
Expenses of disposition (sale) such as commission and other selllng expenses should be considered as reduction from the selling price.
Exemption of Capital Gain from Income Tax
tax avoidance (both for individual and corporation)
Under the Investment Incentives Act, the capital gain realized from the sale of capital asset shall be exempt from income tax under the following conditions: IR-3,5
Investment in new issues of capital stock of BOI registered enterprise within six months from the date the gains were realized;
Sale and investment of the proceeds should be registered with the BOI and BIR;
Investment must not be disposed of:
3 years — pioneer industry;
5 years — non-pioneer industry
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