Active vs. Passive Income | Income from Business | Income Sources | Income | Income Tax | National Internal Revenue Code of 1997 (NIRC), as amended by R.A. No.… | TAXATION LAW

In the context of the National Internal Revenue Code of 1997 (NIRC), as amended by the Tax Reform for Acceleration and Inclusion (TRAIN) Law and the Ease of Paying Taxes Act (Republic Act No. 11976), it is critical to dissect the distinctions between active and passive income within the domain of income from business.

1. Income from Business in the Philippine Tax Code

Income from business generally refers to revenues generated by individuals or entities engaged in business activities. Under the NIRC, as amended by the TRAIN Law, “business income” is typically classified as income generated through the conduct of trade or business, often involving continuous or regular engagement in activities geared towards the sale of goods or services for profit. Business income encompasses both active and passive income, but each type is treated differently for tax purposes.

2. Active vs. Passive Income

The distinction between active and passive income is vital as it influences the tax treatment and reporting requirements for different types of income. Let’s examine each of these in detail:

A. Active Income

Active income from business activities refers to earnings generated through direct engagement in the operations and management of the business. This includes income that requires the taxpayer's substantial involvement in the business activities that produce the revenue.

• Examples of Active Income:

  • Income from Sale of Goods or Services: Revenue generated from the sale of goods, products, or services where the taxpayer actively participates in the business.
  • Income from Professional Services: Earnings from the provision of professional services where the taxpayer (such as an individual practitioner) is personally involved in delivering the service.
  • Income from Contractual Work or Projects: Fees received from completing projects, contractual work, or any income where the taxpayer’s time, effort, and expertise are directly applied.

• Tax Treatment of Active Income:

  • Active business income is typically subject to graduated income tax rates under the NIRC, with tax rates depending on the taxable income and whether the taxpayer is an individual, corporation, or other legal entity.
  • For Individuals (Residents and Citizens): Income tax is imposed on a progressive basis, with rates outlined in the TRAIN Law, ranging up to 35% for income exceeding Php 8 million.
  • For Corporations: Domestic corporations and resident foreign corporations are subject to a corporate income tax of 20% or 25%, depending on gross sales or receipts.

B. Passive Income

Passive income, on the other hand, refers to earnings generated with minimal or no active participation from the taxpayer in the income-generating activity. Passive income is typically derived from investments, rental activities, or other revenue streams that do not require the taxpayer’s direct involvement in operational activities.

• Examples of Passive Income:

  • Interest Income: Interest earned on deposits or investments.
  • Dividends: Earnings from shares of stocks in domestic or foreign corporations.
  • Rental Income: Revenue from leasing real or personal property, subject to certain exceptions where the income might be considered active based on significant involvement.
  • Royalties: Earnings from the use of intellectual property or natural resources, where taxpayer participation is limited.

• Tax Treatment of Passive Income:

  • Passive income is generally subject to final withholding taxes, meaning the income tax is withheld at source and remitted directly to the Bureau of Internal Revenue (BIR). The rates are generally lower than those imposed on active income.
  • Interest and Dividend Income: The final tax rate is typically 20% for interest earned within the Philippines. Dividends paid by domestic corporations to individual citizens and resident aliens are subject to a 10% final withholding tax.
  • Royalties: A 20% final withholding tax is levied on royalties earned within the Philippines.
  • Rental Income: Although rental income may appear to be passive, it can be classified as active if the taxpayer is significantly involved in property management. Passive rental income is taxed at a final tax rate of 5% or 10% under certain conditions.

3. Significance of Active vs. Passive Income Classification

The classification of income as active or passive has significant implications:

• Tax Compliance: Different reporting and tax compliance rules apply based on the income classification. Passive income subjected to final withholding tax does not require further reporting on the taxpayer’s income tax return, as the tax is already deemed paid.
• Deductions and Exemptions: Active income generally qualifies for various deductions and exemptions, which may reduce the overall tax liability. Passive income, being subject to final tax, typically does not allow for deductions.
• Availability of Tax Credits: Taxpayers earning active income from business may be entitled to certain tax credits, depending on the nature and source of their income. Passive income, particularly when earned overseas, may also qualify for foreign tax credits but only if certain requirements are met under the NIRC.

4. Key Amendments under the TRAIN Law and R.A. No. 11976

The TRAIN Law and the Ease of Paying Taxes Act introduced several amendments impacting the treatment of active and passive income:

• TRAIN Law Adjustments: The TRAIN Law modified the income tax structure, adjusted withholding tax rates on passive income, and reduced the corporate income tax rate over a phased period. It also implemented changes to income brackets, affecting both active and passive income earners.
• Ease of Paying Taxes Act: R.A. No. 11976 introduced provisions aimed at streamlining tax compliance and reducing administrative burdens, particularly for small businesses. By simplifying tax filing procedures and extending payment deadlines, it encourages compliance among business operators, especially those with active income.

5. Summary

The NIRC, as amended by the TRAIN Law and R.A. No. 11976, provides clear distinctions between active and passive income from business activities. Understanding these distinctions is critical for compliance and tax planning:

Income Type	Examples	Tax Treatment
Active Income	Sale of goods/services, professional fees, contractual projects	Graduated tax rates for individuals, 20-25% corporate income tax for corporations
Passive Income	Interest, dividends, royalties, rental income	Final withholding taxes, generally 10-20%

Conclusion

Active and passive income classifications are central to the Philippine tax framework, affecting tax rates, compliance obligations, and the overall tax planning strategy for businesses and individual taxpayers alike. Familiarity with the nuances of these classifications allows taxpayers to optimize their tax positions and ensure full compliance with the National Internal Revenue Code, as amended by recent tax reform laws.

Income from Business | Income Sources | Income | Income Tax | National Internal Revenue Code of 1997 (NIRC), as amended by R.A. No.… | TAXATION LAW

Under Philippine law, income derived from business is governed by the National Internal Revenue Code of 1997 (NIRC), as amended by the Tax Reform for Acceleration and Inclusion (TRAIN) Law (Republic Act No. 10963) and more recently, the Ease of Paying Taxes Act (Republic Act No. 11976). This area covers the legal framework and obligations for businesses regarding income tax, the categorization and treatment of income from business, and specific rules impacting the determination, computation, and reporting of business income.

1. Legal Framework for Income Tax on Business Income

The NIRC of 1997, as amended, serves as the primary tax code in the Philippines, outlining the taxation of income derived from all sources within and outside the country, including from business. R.A. No. 10963 (TRAIN Law) introduced reforms aimed at simplifying the tax system, broadening the tax base, and updating tax rates, while R.A. No. 11976 (Ease of Paying Taxes Act) seeks to simplify compliance and administration processes to make tax filing and payment more efficient.

Under these laws, income from business is subject to tax, and the income may be derived by individuals, corporations, and other taxable entities. Taxpayers earning from business activities are classified primarily as (1) individuals engaged in trade or business or practicing a profession, or (2) corporations and other legal entities engaged in trade or business.

2. Sources of Business Income

Business income generally refers to the gross income derived from the conduct of trade or business, including the sale of goods or services. The NIRC distinguishes between various forms of income sources, including:

• Sales of Goods or Properties: This includes revenue from the sale of tangible or intangible properties. Sales income is recognized as gross income, from which allowable deductions may be made to determine taxable income.

• Services Income: Income derived from providing professional, technical, or other forms of services. This includes fees, commissions, and service charges, among others.

• Passive Income: Certain types of income, like interest, dividends, royalties, and rental income, although potentially passive, can also be classified under business income if they arise from or are directly related to the primary business activities of the taxpayer.

3. Taxation of Business Income Under the TRAIN Law

The TRAIN Law introduced significant changes affecting business income taxation, particularly by revising income tax rates and providing alternative taxation mechanisms.

a. Individual Income Tax Rates on Business Income

• Self-employed Individuals and Professionals (SEPs): Individuals earning from business or practicing a profession are subject to graduated tax rates ranging from 0% to 35%, based on net taxable income, with certain tax exemptions on the first Php 250,000 of net taxable income.
• Optional 8% Tax Rate: SEPs may opt to be taxed at an 8% rate on gross sales or receipts in lieu of the graduated rates and percentage tax, provided their gross receipts do not exceed Php 3 million annually. This option simplifies the tax computation by eliminating the need for allowable deductions.

b. Corporate Income Tax Rates on Business Income

• Regular Corporate Income Tax (RCIT): Under the TRAIN Law, the RCIT rate was retained at 30% on the net taxable income for corporations. However, the CREATE (Corporate Recovery and Tax Incentives for Enterprises) Act later reduced this to 25% for domestic and foreign corporations and 20% for domestic corporations with net taxable income not exceeding Php 5 million and total assets not exceeding Php 100 million (excluding land).

• Minimum Corporate Income Tax (MCIT): The TRAIN Law imposes a 1% MCIT on gross income, applied beginning on the fourth taxable year following the year a corporation started business operations. This rate is designed to act as a floor tax, ensuring that all corporations contribute a minimum tax even in years of minimal or no profit.

• Improperly Accumulated Earnings Tax (IAET): A 10% IAET applies to corporations that improperly accumulate earnings beyond reasonable business needs, discouraging corporations from retaining excessive earnings instead of distributing them as dividends.

4. Allowable Deductions on Business Income

Allowable deductions reduce the gross income derived from business activities to arrive at net taxable income. These include:

• Ordinary and Necessary Expenses: Expenses must be both ordinary (common in the industry) and necessary (helpful or appropriate) in carrying on a trade or business.

• Interest Expense: Subject to limitations, interest expense on indebtedness related to business operations may be deducted.

• Bad Debts: Bad debts may be deductible if they are proven to be actual losses.

• Depreciation and Amortization: Depreciation of tangible assets and amortization of certain intangibles used in business may be claimed as deductions.

• Net Operating Loss Carry-Over (NOLCO): NOLCO allows corporations to carry over net operating losses for up to five years following the year of loss, offsetting future profits.

5. Reporting and Compliance

a. Income Tax Returns and Filing Requirements

Businesses are required to file quarterly and annual income tax returns. Corporations file BIR Form 1702, while self-employed individuals and professionals file BIR Form 1701. Taxpayers opting for the 8% income tax rate must still file quarterly but are exempt from percentage tax returns.

b. Books of Accounts and Record-Keeping

Taxpayers must maintain books of accounts and records, such as journals, ledgers, receipts, and invoices, to substantiate business income and deductions. Under the Ease of Paying Taxes Act, digital record-keeping and e-invoicing are encouraged to streamline compliance.

6. Withholding Tax Obligations on Business Income

The NIRC and TRAIN Law require businesses to comply with withholding tax obligations, which include:

• Withholding on Compensation: If the business has employees, it is required to withhold tax on compensation.

• Withholding on Professional Fees and Contractual Services: Businesses must withhold a final or creditable withholding tax on fees paid to contractors and professionals.

• Expanded Withholding Tax: Applicable on certain transactions, including rental payments, payments to suppliers, and other business expenses.

7. Recent Amendments under the Ease of Paying Taxes Act (R.A. No. 11976)

The Ease of Paying Taxes Act introduced several taxpayer-friendly provisions aimed at reducing compliance burdens, particularly for small businesses. Key amendments include:

• Streamlined Taxpayer Registration and Deregistration: Simplifies the process for businesses to register or deregister with the Bureau of Internal Revenue (BIR).

• Simplified Returns and Payment Processes: Reduces documentary requirements for filing and allows electronic submissions, particularly benefiting small businesses and rural taxpayers.

• Updated Filing Thresholds: Adjusts certain thresholds, particularly for small taxpayers, aligning them with inflation and current economic conditions, potentially affecting income tax exemption statuses.

8. Conclusion

Philippine tax law, through the NIRC as amended by the TRAIN Law and the Ease of Paying Taxes Act, imposes a structured approach to taxing income derived from business activities. The framework is designed to balance revenue collection with ease of compliance, particularly in recognition of the needs of small and medium enterprises (SMEs). With ongoing changes and an increasing push toward digital compliance, businesses in the Philippines must remain vigilant in staying compliant with these evolving rules, ensuring proper computation, reporting, and remittance of taxes on business income.