Tax Deductions vs. Tax Credits | Gross Income vs. Net Income vs. Taxable Income | Income Sources | Income | Income Tax | National Internal Revenue Code of 1997 (NIRC), as amended | 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 (R.A. No. 11976), understanding the distinctions among gross income, net income, and taxable income, as well as the differences between tax deductions and tax credits, is crucial for accurate tax reporting and compliance.

Gross Income, Net Income, and Taxable Income

1. Gross Income
   Under Section 32 of the NIRC, gross income encompasses all income from whatever source, whether derived from within or outside the Philippines. This includes (but is not limited to):

   • Compensation for services, including fees, commissions, and similar items.
   • Gross income derived from business or property.
   • Interests, rents, royalties, dividends, annuities.
   • Gains derived from dealings in property.
   • Income from any source, unless explicitly exempt by law.

   The goal of determining gross income is to capture all revenues received by a taxpayer, without yet applying any deductions for expenses or allowable adjustments.

2. Net Income
   Net income is essentially the gross income minus allowable deductions. These deductions are outlined in Section 34 of the NIRC, including but not limited to:

   • Ordinary and necessary expenses incurred in the conduct of trade or business (e.g., salaries, rental expenses, and utilities).
   • Interest expenses (subject to limitations under the law).
   • Taxes (excluding income tax), losses, and bad debts.
   • Depreciation on properties used in business.
   • Charitable contributions (up to a specified limit).

   The result of applying these deductions is the net income, which is a more accurate reflection of the taxpayer's profit or earnings after accounting for necessary expenses.

3. Taxable Income
   Taxable income, as defined in Section 31 of the NIRC, is the amount upon which the income tax is computed. For individuals and corporations, taxable income is derived after all allowable deductions, exemptions, and exclusions have been considered. The significance of taxable income is that it represents the final base on which the income tax rate is applied.

   • Individuals: Taxable income for individuals is subject to a graduated tax rate system under the TRAIN law, which lowered the tax rates for most individual taxpayers to encourage compliance.
   • Corporations: The corporate tax rate under the Corporate Recovery and Tax Incentives for Enterprises (CREATE) Act is applied to corporate taxable income.

Tax Deductions vs. Tax Credits

1. Tax Deductions
   Tax deductions refer to specific expenses or allowable amounts that reduce gross income to arrive at net income. Deductions reduce the income subject to tax, effectively lowering the taxable income amount rather than the tax itself. Notable categories under the NIRC include:

   • Ordinary and Necessary Business Expenses: These are expenses essential to running a business, such as operational expenses, employee salaries, and utility costs.
   • Interest Expenses: These expenses are deductible, provided they meet the limitations set by the NIRC (e.g., the 33% cap rule under Section 34(B) of the NIRC).
   • Depreciation and Amortization: Businesses may deduct depreciation on fixed assets used in the trade or business, calculated over the useful life of the asset.
   • Losses and Bad Debts: Losses sustained in trade or business and debts that are proven uncollectible may be deducted.
   • Charitable Contributions: Within specific limits, contributions to accredited charitable organizations may also be deducted.

   Example: If a business has a gross income of PHP 1,000,000 and deductions totaling PHP 200,000, its net income will be PHP 800,000. The tax rate will then be applied to this net amount.

2. Tax Credits
   Tax credits, on the other hand, directly reduce the tax liability. Unlike deductions, which reduce the income subject to tax, tax credits lower the actual tax due. The NIRC recognizes several types of tax credits, including:

   • Foreign Tax Credits: For residents who pay taxes to foreign governments on foreign-sourced income, the Philippine tax system allows a tax credit for taxes paid abroad to prevent double taxation.
   • Tax Withheld at Source: Taxes withheld on certain income, such as income derived from the Philippines by non-resident aliens, can be credited against the taxpayer’s tax liability.
   • Special Tax Credits: These include incentives provided under special laws, such as the CREATE Act, which may offer tax credits as part of investment promotion schemes.

   Example: If a taxpayer has a computed tax due of PHP 100,000 but has a tax credit of PHP 20,000 (e.g., foreign tax credit or taxes withheld), the taxpayer’s tax liability would be reduced to PHP 80,000.

Practical Implications of Deductions vs. Credits

• Tax Deductions reduce taxable income, lowering the tax base on which the tax rate is applied. For instance, if an individual is in a 20% tax bracket, every PHP 1,000 deduction saves PHP 200 in taxes (PHP 1,000 x 20%).
• Tax Credits, however, provide a one-to-one reduction in tax due. A PHP 1,000 tax credit directly lowers the tax liability by PHP 1,000, which is often more beneficial than a deduction, especially for taxpayers in lower tax brackets.

Regulatory Considerations and Changes under the TRAIN and Ease of Paying Taxes Act

The TRAIN Law introduced reforms that simplified and adjusted income tax brackets for individuals, increased certain allowable deductions, and modified the tax treatment of passive income, among other measures. R.A. No. 11976, the Ease of Paying Taxes Act, further emphasizes the Bureau of Internal Revenue's mandate to simplify and streamline tax compliance, particularly through digital means, in order to reduce the administrative burden on taxpayers.

Understanding these definitions and distinctions between gross, net, and taxable income, and between tax deductions and tax credits, is essential for effective tax planning and compliance under Philippine tax law. The correct application of deductions and credits can significantly reduce the taxpayer's liability while ensuring full adherence to tax regulations.