LESSON 2

INCOME CONCEPTS AND EXCLUSIONS

Learning Objectives:

At the end of the chapter, the student should be able to:

➢ Know the legal concept of income.
➢ Explain the bases and nature of income.
➢ Know the different kind of income in taxation.
➢ Know the exclusions from gross income.

Sec. 32 of National Internal Revenue Code (NIRC) states that Gross income means all income derived
from whatever source, including the following:
1. Compensation for services in whatever form paid
2. Income derived from the conduct of trade or business or the exercise of a profession
3. Gains derived from dealings in property
4. Interest
5. Rents
6. Royalties
7. Dividends
8. Annuities
9. Prizes and winnings
10. Pensions
11. Partner’s distributive shape from the net income of the general professional partnership

GENERAL CLASSIFICATION OF INCOME

For taxation purposes, the income of a taxpayer may be broadly classified as taxable income and
non-taxable income.
Taxable income refers to the earnings of a taxpayer subject to the basic or normal income tax, rates
ranging from 20% to 35% for the taxable year 2018-2022 and 15% to 35% for the taxable year 2023
onwards, on the amount in excess of ₱250,000.00, or to final tax.
Non-taxable income refers to earning of the taxpayers that are excluded from gross
income as provided in the NIRC, as amended, and other tax laws. Non-taxable income should never be
included in the computation of the gross taxable income.

INCOME

Taxable Non-taxable

1. Compensation 1. Life insurance proceeds

2. Business income 2. Return of premium
3. Gains from property 3. Gifts, bequest, devices
4. Passive income 4. Compensation for injuries
5. Other taxable income 5. Retirement benefits
6. Other non-taxable income 14
CLASSIFICATION OF TAXABLE INCOME

The Tax Code does not expressly classify taxable income. However, to facilitate discussion, the
following broad classification is made:
1. Compensation income
2. Business income from exercise of profession
3. Gains from dealings in property
4. Passive income
5. Other taxable income

COMPENSATION INCOME

Compensation income means all remuneration for services performed by an employee for his/her
employer under the employer-employee relationship, unless clearly excluded by the Tax Code.

Composition of Gross Compensation Income

The following are included as part of gross compensation income;
1. Salaries, wages or frees
2. Commission
3. Honoraria
4. Allowances
5. Thirteenth month pay and other benefits
6. Holiday pay, overtime pay, night shift differential pay, and hazard/emergency pay
7. Separation pay
8. Retirement pay
9. Sick leave pay/vacation leave pay
10. Fringe benefits

Salaries, Wages or Fees

Salaries are generally an earning paid on regular interval; wages are paid on an hourly or daily
basis; and fees implies payment to an individual who is of authority like director’s fees, legal fees,
account’s fees or fees for conduct of religious ceremony (e.g., marriage, baptismal or masses.

Commission

Payment made based on certain percentage of output like salesman commission or underwriter’s
commission. Commission is taxable even if the employee receiving the compensation is a minimum wage
earner.

Honoraria

Honoraria are earnings derived from services usually undertaken by an individual who rendered
his/her expertise in a particular field. An example is the honoraria given to a special lecturer.

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Allowances
An allowance may either be fixed or variable. Allowance may be fixed when it is attached to the
position or office, and variable when it changes consequently as influenced by certain factors such as
number of visitors, distance of travels, or frequencies of seminar.

The most common types of allowances received by an employee are:

1. Cost of living allowance (COLA).
2. Representation and traveling allowance (RATA).
3. Personnel economic relief allowance (PERA).

Thirteenth Month Pay and Other Benefits

The thirteenth (13th) month pay of an employee is tantamount to one-month basic salary of
officials and employees of the government, national or local, including government-owned or controlled
corporations, and/or private offices, it is received after the 12th month pay.
The 13th month pay is equals to the total basic salary during the year divided by 12 months.
Other benefits include Christmas bonus, productivity incentive bonus, performance-based bonus,
loyalty award, gifts in cash or in kind, and other benefits of similar nature actually received by officials and
employees of both government and private offices.
The 13th month pay shall cover benefits paid or accrued during the year, provided that the total
amount shall not exceed ₱90,000.
Otherwise stated, any amount in excess of ₱90,000 is taxable. Thus, 13th month pay, cash gift, and
bonus not exceeding ₱90,000 is neither taxable nor subject to withholding tax.

Holiday, Overtime, Night Shift Differential, and Hazard/Emergency Pay

Hazard pay refers to the amount paid by the employer to employees who were actually assigned
to work to danger or strife-torn areas, disease-infested places, or in distressed or isolated stations and
camps, which expose them to great danger of contagion or peril to life. Holiday pay, overtime pay, night
shift differential pay, and hazard pay is generally taxable.

Separation Pay

Separation pay may be taxable or non-taxable. It is taxable if the separation is voluntarily made
by the employee. Separation pay is not taxable on account of:
1. Sickness
2. Disability
3. Death
4. Reorganization of the company
5. Bankruptcy of the company

Retirement Pay

As a general rule, retirement pay is taxable. The exceptions are the following:
1. Retirement pay from SSS or GSIS
2. Retirement pay from employer, provided the following requirements are compiled:
a. The retirement plan of the company has been approved by the BIR Commissioner.
b. The retiree should have been connected with the company for 10 years.

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 c. The retiree should be at least 50 years old.
d. The retiree availed the retirement for the first time.
e. The retirement plan is fair and equitable to all employees, regardless of position.

Sick Leave and Vacation Leave

The salary of an employee on vacation or sick leave, which is paid to him/her notwithstanding
his/her absence from work, constitutes taxable compensation income.

Fringe Benefits

Fringe benefits means any good, service or other benefit granted in cash or in kind by an employer
to an individual employee in addition to his/her basic salary.

Fringe benefits may be subject to final or basic tax. The guidelines are:
1. If the recipient of the fringe benefit is a rank-and-file employee, the amount is subject to basic tax;
hence, it becomes part of gross compensation income.
2. If the recipient is occupying supervisory or managerial position, the fringe benefit is subject to final
tax.

BUSINESS/PROFESSIONAL INCOME

Business income represents gain or profit derived from the investment of money, goods, services or
its equivalent.
Professional income refers to the earnings of individuals who exercise their profession to the public.
For example, a physician that provides medical services in his/her clinic, a certified public accountant who
offers accounting bookkeeping, tax consultancy and auditing services, and a lawyer who provides legal
services are all professionals with income obtained from the exercise of their profession.
Gross income derived from doing business shall be equivalent to gross sales less sales returns,
discounts and allowances, and cost of goods sold.
In the case of taxpayers engaged in the sale of services, gross income means gross receipts sales
returns, discounts, allowances and cost of services
Cost of services shall mean all direct costs and expenses necessarily incurred to provide the services
required by the customers and clients.
Cost of goods sold shall include all business expenses directly incurred to produce the
merchandise to bring them to their present location and use.
For trading or merchandising concerns, cost of goods sold shall include the invoice cost of the
goods sold, plus import duties, freight in transporting goods to the place where the goods are actually
sold, including insurance while the goods are in transit.
For manufacturing concerns, cost of goods manufactured and sold shall include all costs of production of finished goods,
such as raw materials used, direct labor and manufacturing overhead, freight cost, insurance premiums, and other costs
incurred to bring raw materials to the factory or warehouse.

OTHER TAXABLE INCOME

Income earned that cannot be classified as compensation, business income, earnings from
dealings f properties or passive income shall be classified under this category
Other income includes the following:
1. Interest income
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 2. Rent income
3. Dividend income
4. Annuities
5. Prizes and winnings
6. Pensions

INTERST INCOME

Interest income on bank deposit in the Philippines is subject to final tax 20%. However, interest
income on bank deposit earned outside the Philippines shall be part of the gross taxable income subject
to basic tax.
Interest income other than those subject to final tax is included as part of the gross income subject
to basic normal tax. Unless exempted by law, interest received by a taxpayer is taxable. Interest includes
those arising from indebtedness, whether business or non-business.

RENT INCOME

Rent income arises from leasing out of property, either real or personal. The amount of taxable
rent income shall be the sum of the following:
1. Current rent lease payment
2. Advance rent payment or security deposit without restriction
3. Payment of the lessee to third parties like interest, taxes, and loans insurance premium in
behalf of the lessor
4. Uncollected rent income earned already (accruals) at the end of the period
5. Income from leasehold improvements

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 Advanced rent or security deposit without restriction shall be reported as income in the period
actually received, regardless if the taxpayer uses an accrual or cash basis of accounting.

Income from Leasehold Improvements

Leasehold improvements are additions, improvements, major renovation or complete new

structure to the existing property to improve the present condition, appearance or working capacity.

Method of Computing Income from Leasehold Improvements

1. Outright method. The basis of tax using the outright method is the fair market value of the
improvement on the date such improvement has been completed notwithstanding the effective
date of the contract. No income on leasehold improvement shall be recognized, therefore, unless
the improvement has been completed notwithstanding the consummation of lease contract.
2. Spread-out Method. The amount of income that shall be recognized under the spread-outmethod
shall be the allocated portion pertaining to each period or term realized. The allocated portion
pertaining to each period is equal to the book value of the improvement at the end of the lease
term of the leaser.

DIVIDEND INCOME

This is an income earned by a taxpayer from the distribution of earnings or profits of a

corporation. The dividends are payable in money or in property. The dividends that are not subject to final
tax or not expressly exempted from taxation shall be included in the gross income of individual or
corporate taxpayers.

Basic Guidelines on Dividends

To facilitate easy understanding of dividends, the following categories are suggested:

1. Dividend received from a domestic corporation. A domestic corporation subject to tax declares
and distributes dividends, and the recipient of dividends is:
a. A domestic or resident corporation. The dividend is tax-exempt.
b. A resident foreign corporation. The dividend received is exempt from tax.
c. A non-resident foreign corporation. Generally, the dividend is subject to a final tax rate of 30%
effective January 1, 2009. However, under the rule f reciprocity, it is subject to a final tax of
15%.
d. A resident citizen, non-resident citizen, or resident alien. The dividend is subject to 10% final
tax.
e. A non-resident alien engaged in business or trade in the Philippines. The dividend earned is
subject to final tax of 20%.
f. A non-resident alien not engaged in business or trade in the Philippines. The dividend is subject
to 25% final tax.

The dividend income from a domestic corporation deemed 100% from within the
Philippines.

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 2. Dividend earned from a resident foreign corporation. The following tax procedures may be
followed.
a. Dividend received by individual taxpayers from resident foreign corporation shall be included
in the computation of gross taxable income subject to the scheduler income tax rate.
b. Dividends received by corporate entity subject to tax from resident foreign corporation are
included in computing gross taxable income subject to 30% tax rate effective January 1, 2009.
c. Resident foreign corporation is taxable on its income from within the Philippines. In case the
gross income of a resident foreign corporation derived from the Philippines for three-year
period preceding the declaration of dividend is:
• Less than 50% of the total gross income (within and without) – the dividend is
deemed earned from outside the Philippines. The dividend shall not be included
as part of the gross taxable income.
• More than 50% but not more than 85% of the total gross income (within and
without) – the dividend income is deemed earned partly within and partlyoutside
the Philippines. The dividends shall be prorated, and the amount realized from
within the Philippines shall be included in computing gross taxableincome.
• More than 85% of the total gross income (within and without) – the dividend is
deemed earned from within the Philippines; hence, the total amount of dividend
is included in the computation of gross taxable income.
d. In case the problem is silent, dividend income earned is deemed 100% earned from within
the Philippines.

3. Dividend earned from a non-resident foreign corporation. The following guidelines may be
observed if dividends are declared and distributed by a non-resident foreign corporation:
a. In case the recipient is an individual taxpayer, the amount of dividends shall be included
in computing gross taxable income subject to the scheduler income tax rate.
b. If the recipient is a domestic corporate entity, the inter-corporate dividends shall be
included in the computation of gross taxable income subject to 30% income tax rate
effective January 1, 2009.

ANNUITIES

Annuity refers to the installment amount paid for life insurance coverage returned by an
insurance company. The annuity received that represents interest is taxable, and shall be included in the
gross taxable income, while the amounts that represent return of premium are not taxable.

PRIZES AND WINNINGS

The guidelines to be observed are:

1. Prizes, winnings, and awards shall be included in the computation of gross income if:
a. Received by an individual taxpayer from Philippines sources, and the amount of prizes
or winnings is ₱10,000 or less;
b. Received by an individual taxpayer from foreign sources regardless of the amount; and
c. Received by corporations from Philippines or foreign sources regardless of the amount.
2. Prizes, winnings, and awards received by an individual taxpayer from Philippines sources are
subject to 20% final tax.
3. The following prizes, winnings, ad awards are tax-exempt; hence, they are to be excluded from
gross taxable income, whether the taxpayer is an individual or corporate entity:

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 a. Prizes or awards to athletes in national and international sports competition held in the
Philippines and abroad and governed by recognized sports associations
b. Prizes and awards in recognition of religious, charitable, educational, scientific, artistic or
literary performance or achievement, provided the recipient was selected without action
on his/her part, and he/she is not required to render substantial future service in view of
the award

PENSIONS

Amount of money received in lump sum or on staggered basis in consideration of services rendered.
Pensions are being given after the individual reaches the age of retirement. It is taxable to the extent of
the amount received except if there is as approved pension plan by the Bureau of Internal Revenue.

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