In the previous installment of this article, we have distinguished assets that are subject to income tax and assets subject to capital gains tax. It must be emphasized that the distinction is important because capital assets are subject to special rules. The following are the special rules to be remembered in dealing with capital assets
(I) Fixed Income Tax Rate: There is a fixed value for capital gains tax under the law. For sale of house and lot, the rate is fixed at 6%. It is different however for income tax. It is “graduated” in a sense that there is a fixed percentage for a certain range of income. For example, a net taxable income of not more than P 250,000.00 is subject to 0% income tax rate. If the net taxable income is more than P 250,000.00 but not over P 400,000.00, it is subject to income tax rate of 20% in excess of P 250,000.00. This will be further discussed later.
(II) Determination of “Basis”: In order to determine the gain or loss for the purpose of imposing capital gains tax, the “basis” of the capital asset must first be deducted[1]. Generally, for properties acquired through sale, it is the purchase price of the property.[2] If the capital asset however is acquired through inheritance, it is the fair market value of the property.[3] On the other hand, if the property is acquired through donation, it is the “basis” of the property on the hands of the donor, or the fair market value, whichever is lower.
Let me cite an example to clarify. If I bought a house and lot in a remote province for One Million Pesos, but a wealthy developer and politician took interest in developing the province, such that I was able to sell the house and lot for Ten Million ten years after I purchased it, I was able to derive a capital gain of 9 Million Pesos. The Nine Million is derived from subtracting the Ten Million Pesos selling price to the One Million Peso “basis” of the house and lot. If, on the other hand, the conditions around the remote province grew worse, such that I was only able to sell the house and lot for Five Hundred Thousand after Five years, I have a capital loss of Five Hundred Thousand Pesos.
Simple, isn’t it? Dealing with ordinary assets however is much simpler. There is no “basis” to consider to begin with. In other words, if I am on the business of buying and selling house and lots, and I was able to sell one for Ten Million Pesos, the entire Ten Million Pesos shall be subject to income tax, less any ordinary expenses in conducting business, if any.
(III) Division of Capital Loss and Ordinary Loss: Now that we know how to derive capital gains and loss, it must be remembered that losses from dealing with capital assets cannot be used as a deduction in ordinary income tax. In other words, there is a dividing wall between capital loss and ordinary loss. Although we have not yet discussed it at this point, suffice it to say that deductions from ordinary losses are generally allowed in income tax, but deductions from capital losses can only be recognized if there is a capital gain.
Confusing? I bet it is. Allow me to clarify using an example later. Let me first discuss the concept of the holding period.
(IV) Holding Period: The concept of the “holding period” applies only to natural-person taxpayers. In other words, it cannot be availed of by corporations. Under the “holding period” principle, only half (50%) of the loss or gain from the sale of a capital asset held for more than a year shall be considered. If the capital asset has been held on for twelve months or less however, the entire gain or loss shall be taken into account in computing the net capital gain. Since the concept of the “holding period” does not apply to corporations, the entire capital gains or loss shall always be taken into account if the taxpayer is a corporation.
As promised, I shall give you an example. Suppose I am a real estate developer. I own a house and lot in Quezon City which my family personally uses. At the same time, I bought an idle land in a remote municipality in Bulacan, developed it into a subdivision, and sells the houses therein for profit. In the course of my business, I paid my workers Ten Million Pesos in total, and incurred expenses from supplies and materials amounting to Fifty Million Pesos. Heeding my call however, I suddenly decided to sell everything to become a monk. Since the sale was on a “rush”, I sold my family home for only Ten Million Pesos even if I bought it for Twenty Million Pesos six years ago. All the proceeds from the sale of my subdivision house and lots amounted to a total of One Hundred Million Pesos.
How much is my capital loss? Easy. It is the selling price less the “basis” of my family home. Twenty Million less Ten Million is Ten Million Pesos. However, since I had my home for more than a year, only half of which shall be considered in determining my capital loss. Hence, my capital loss is Five Million Pesos. This Five Million Pesos cannot be used as a deduction to my One Hundred Million Pesos profit from the sale of my subdivision land.
Now how much is my ordinary taxable income? It is the proceeds of the sale of the subdivision houses less any ordinary expenses incurred in conducting the business, such as the cost of labor, supplies and materials. The gross sales being at One Hundred Million Pesos while the business expenses reached Sixty Million Pesos, the total taxable income is only Forty Million Pesos. AGAIN, the Five Million Pesos capital loss is separate, and cannot be deducted from the Forty Million Pesos income.
(V) Net Capital Loss Carry-Over: Now what would happen to the capital loss I incurred if I cannot use the same as a deduction from my ordinary income? For natural-person taxpayers, the capital loss may be carried over to the succeeding year provided that it does not exceed the taxable income for the year that it was incurred. This concept of a “Net Capital Loss Carry-Over” however does not apply to corporations; meaning, any capital loss they incur shall forever be lost.
Allow me to illustrate using the example provided above where I incurred a capital loss of Five Million Pesos. Suppose, in my rush to enter the monastery, I realized the following year that I forgot to sell a collectible painting that I lent to my friend. My friend, knowing that I am in the process of liquidating my assets, offered to buy the same for Fifteen Million Pesos, although I only acquired the painting for Three Million Pesos eight years ago. I therefore have a capital gain of Twelve Million Pesos from the sale of the collectible painting. Since I was in possession of the painting for more than a year however, only half of the capital gain shall be taken into consideration for purposes of capital gains tax; in this case only Six Million shall be considered as a capital gain. However, since only a year has passed since I incurred the capital loss of Five Million Pesos, I can deduct the same from my net capital gain of Six Million Pesos in the present year. Only One Million Pesos therefore is subject to capital gains tax.
(VI) Tax-Free Exchange: Since we are limiting the scope of our discussion to the basics of taxation, this concept is already beyond the scope of this Article. Suffice it to say however that capital gain or loss shall not be recognized in transfers of property or shares of stock by a shareholder or corporation in exchange of shares of stock of another corporation in order to merge, consolidate or gain control of another corporation. For example, Disney Inc acquires all the properties of Pixar Inc in exchange of the shares of stock of Disney Inc. Since Pixar does not have any properties anymore, there is, in effect, a merger between Disney Inc and Pixar Inc whereby Disney Inc is the surviving company. The exchange of the properties of Pixar Inc to acquire shares of stock of Disney Inc however is not subject to capital gains tax.
Note that this principle applies as well to individuals, not exceeding five, acquiring control of a corporation through purchasing shares of stock with voting power of at least 51%, in exchange for capital properties. Likewise, such a transaction is exempt from capital gains tax.
Now that we already know the difference between an ordinary asset and a capital asset, as well as the type of transactions subject to capital gains tax, we can now focus on income taxation proper. Stay tuned for our discussion regarding "situs" of taxation on the next installment of this article.
[1] Christian Andrew Labitoria Gallardo is a recent graduate of the Ateneo School of Law with a Juris Doctor degree, and is currently an associate of the Sangalang and Gaerlan, Business Lawyers, a law firm specializing in labor, corporate and business law. You may reach him through a phone call or message (09157042132) or via email (andrew.gallardo@paladinslaw.org)
[1] Section 40, National Internal Revenue Code, as amended.
[2] Revenue Regulations 8-2001.
[3] Id.
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