ii. Realization and Recognition

ii. Realization of income

Test of Realization: Under the Realization Principle, revenue is generally recognized when both of the following conditions are met:

• The earning is complete or virtually complete; and
• An exchange has taken place.

This principle requires that revenues must generally be earned before they are recognized; payment may be received in advance. For financial-accounting purposes, amounts received in advance may be carried as unearned revenue, that is, liabilities to transfer goods or render services in the future — until the earning process is complete. For income-tax purposes, recognition depends on the taxpayer’s accounting method and applicable tax rules; an advance receipt is not necessarily deferred until earned. (Manila Mandarin Hotels v. Commissioner, CTA Case No. 5046)¹

Actual v. Constructive Receipt

• Actual Receipt occurs when there is a physical transfer of the money consideration or its equivalent to a person.
• Constructive Receipt occurs when the money consideration or its equivalent, is placed at the control of the person who rendered the service without restrictions by the payor.

Examples:

• Deposits in banks which are made available to the seller of service without restrictions;
• Issuance by the payor of a notice to offset any debt or obligation and acceptance thereof by the seller as payment for services rendered; and
• Transfer of amounts retained by the payor for the account of the seller. (Rev. Regs.16-05, Sec. 4.108-4)²

iii. Recognition of income

Receipt of income for purposes of taxation may be actual or constructive. (CIR v. BPI, G.R. No. 147375)³

The law thus recognizes “income” as taxable even in the absence of actual/physical receipt. In fact, Sec. 4(e) of RR No. 12-80⁴ (on final tax) provides that income could be recognized by the taxpayer either at the time of its actual receipt or its accrual, depending on the accounting method used by the taxpayer. The NIRC, in turn, recognizes certain principal accounting methods in recognizing income or revenue. (Vitug and Acosta)

When Income is Taxable

Tests in Determining whether Income is Earned for Tax Purposes

i. Realization test

While not new in Philippine jurisprudence, courts have not fully adopted the doctrine. (See discussion on “Tests of Realization”)

ii. Claim of right doctrine or doctrine of ownership, command or control

The “Claim-of-Right” Doctrine provides that if a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income even though one may claim he is not entitled to the money. Should it later appear that the taxpayer was not entitled to keep the money, the taxpayer would be entitled to a deduction in the year of repayment. (BIR Ruling No. DA- (C-168)519-08⁵ citing the US case of North American Oil Consolidated v. Burnet⁶)

iii. Economic benefit test or doctrine of proprietary interest

The Economic Benefit Theory provides that a material or economic benefit may constitute taxable income when it falls within taxable gross income and is recognized under applicable law; not every benefit or unrealized increase in property value is taxable. (NIRC, Secs. 32 and 40(A); BIR Ruling No. 123-97)⁷

As a general rule, in this jurisdiction, mere increase in the value of property without actual realization, either through sale or other disposition, is not taxable, the only exception being that even without sale or other disposition, if by reason of appraisal, the cost basis of property is increased and the resultant basis is used as the new tax base for purposes of computing the allowable depreciation expense, the net difference between the original cost basis and new basis due to appraisal is taxable under the economic-benefit principle. (BIR Ruling No. 029-98)⁸

iv. Severance test

Under the Severance Theory Test, income is recognized when there is a separation of something which is of exchangeable value. (Eisner v. Macomber, 252 U.S. 189 [1920])⁹

The annual increase in value of an asset is not taxable income because such increase has not yet been realized. The increase in value i.e., the gain, could only be taxed when a disposition of the property occurred which was of such a nature as to constitute a realization of such gain, that is, a severance of the gain from the original capital invested in the property. The same conclusion obtains as to losses. The annual decline in the value of property is not normally allowable as a deduction. Hence, to be allowable, the loss must be realized. (BIR Ruling No. 206-90¹⁰ citing Surre Warren, Federal Income Taxation)

Tax-Free Exchanges

Tax-free exchanges refer to those instances enumerated in Section 40(C)(2) of the NIRC¹¹ in which gain or loss is not recognized on qualifying exchanges, subject to its conditions. This nonrecognition is not a permanent income tax exemption; Documentary Stamp Tax and Value-added Tax treatment must be determined separately under the provisions governing those taxes.

In general, there are two kinds of tax-free exchange: (1) transfer to a controlled corporation; and, (2) merger or consolidation.

Transfer to a controlled corporation

No gain or loss shall be recognized if property is transferred to a corporation by a person in exchange for stock or unit of participation in such corporation of which as a result of such exchange said person, alone or together with others, not exceeding four persons, gains control of said corporation.

Merger or Consolidation

No gain or loss shall be recognized if in pursuance of a plan of merger or consolidation ---

• a corporation, which is a party to a merger or consolidation, exchanges property solely for stock in a corporation, which is a party to the merger or consolidation; or
• a shareholder exchanges stock in a corporation, which is a party to the merger or consolidation, solely for the stock of another corporation also a party to the merger or consolidation; or
• a security holder of a corporation, which is a party to the merger or consolidation, exchanges his securities in such corporation, solely for stock or securities in another corporation, a party to the merger or consolidation.