Business Taxation 101

BUSINESS TAXATION 101

Christian Andrew Labitoria Gallardo[1]

They say nothing is permanent except death and taxes. Well, nothing scares the people, especially businessmen, more than death and taxes. Since governments and kingdoms have been established however, taxes have always been present to finance wars, diplomatic missions and providing public service in general. Given its pervasive nature therefore, it is necessary in conducting business (or going through life, in general) to know a little about taxes.

There are several types of taxes. In this article however, we shall only deal with taxes commonly encountered in doing business. These are income tax, value-added tax, local tax and documentary stamp tax.

Income Tax

Income tax is a tax on, well, income. It must be noted however that not all gains constitute profit or income for income tax purposes. To determine whether an incidental gain or benefit constitutes profit, one must differentiate between the term “capital” and “income”. This is so because an increase in capital is not taxable, but a flow of income is subject to income tax.

A “capital” refers to any asset used to incur profit. Income, on the other hand, is the flow of wealth from such capital. A common example would be a house in the middle of an abandoned municipality that is being leased out for profit. The house and lot itself is the capital, while the monthly rental is the income derived from putting the house on lease. Say I bought the house and lot in the middle of an abandoned municipality when its value was only Five Hundred Thousand, but I was lucky because ten years after I bought such land, a developer built a hospital, church, school and grocery store nearby, effectively increasing its fair market value to Fifteen Million Pesos. Such increase in the fair market value of the land is not subject to income tax since the house and lot is a capital. Any increase in rent however is subject to income tax.

A more complicated example however involves differentiating between cash dividends and stock dividends. Stocks, as we know it, represents ownership in a company. Through selling stocks, the company acquires the necessary capital to finance its money-making venture. Any increase in the number of stocks due to a declaration of stock dividend therefore is not subject to income tax since stocks represent capital. Contrary to that however, any cash received from a declaration of cash dividend is subject to income tax.

Income Tax vs Capital Gains Tax

It must be noted however that not all house and lots and shares of stocks are to be automatically regarded as “capital” for income tax purposes. If the said properties are actually sold in the regular course of business by real estate developers or stock brokers, the sale of which is subject to income tax. This is because they are no longer “capital”, but are “stocks in trade” ordinarily sold in business. This distinction between a capital asset that is being used for personal purposes and an ordinary asset used for trade or business is very crucial since the sale of the former is subject to a fixed capital gains tax, while the sale of the latter is subject to a graduated income tax

Allow me to clarify by giving a concrete example using the same house and lot in an abandoned municipality. If I live in that house, but suddenly won the lottery and decided to buy a posh house in a gated subdivision, the sale of the old house and lot would give me an income subject to a fixed capital gains tax of 6%. This is not the case however for ordinary assets regularly sold for trade or business. If I am on the business of buying idle lands to develop it into fine subdivisions, selling any house and lots on the same for profit is subject to income tax.

Why is the distinction important? Because capital assets are subject to special rules. Stay tuned and know these special rules by visiting our official website (paladinslaw.org) or our official facebook pages (Business Law Made Easy and Labor Law Made Easy).

[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).