Income realization principle
By Gladys Jane Dela Cruz on March 9,2023
FOR income taxes to be due, there must be a realized income. Thus, it is critical to determine what is income and when it is realized for tax purposes.
Income is the inflow of wealth. As early as 1922, the Supreme Court defined income as the gain derived from capital, from labor or from both combined, and includes profit gained through a sale or conversion of capital assets (Fisher v Trinidad, GR 17518, Oct. 30, 1922). Further, in the case of Commissioner of Internal Revenue v Japan Air Lines Inc., income is defined as cash received or its equivalent, or the amount of money coming to a person within a specific time. It means something distinct from principal or capital. (GR 60714, Oct. 4, 1991).
Revenue Regulations 2-40 defines income as all wealth that flows into the taxpayer other than as a mere return of capital. It includes the forms of income specifically described as gains and profits, including gains derived from the sale or other disposition of capital assets.
It is well-settled that income is not subject to tax until it is earned. One of the tests in determining whether income is earned for tax purposes is the Realization Principle. Under this principle, income is generally recognized when both of the following conditions are met: first, the earning process is complete or virtually complete, and second, an exchange has taken place. This principle requires that income must be earned before it is recorded in the books of the taxpayer (Manila Mandarin Hotels Inc. v The Commissioner of Internal Revenue, CTA Case 5046, March 24, 1997). Once recognized as earned, the income is deemed taxable.
The US Supreme Court case of Eisner v Macomber (252 US 189, March 8, 1920) stated the Realization Principle in this way: the income is not deemed “realized” until the fruit has been plucked from the tree.
In the said case, the so-called Severance Test was also conceptualized, which states that there is no taxable income until there is a separation from capital of something of exchangeable value, thereby supplying the realization or conversion which would result in the receipt of income. The essence of the test is that in order for income to be taxed, it is to be severed or separated from the property from which it is derived. From then on, the Realization Principle and the Severance Test then were being used interchangeably.
As to the first criterion, the Realization Principle requires that the income should be realized out of a closed and completed transaction. The US Supreme Court considered “capital” as being separate from “income” such that a tree is separate from its fruit. The Realization Principle requires the presence of a “taxable event” which triggers a transfer of ownership of property. In other words, the taxable event being pertained to is the income-producing event, not the “capital.”
The above requirement is exemplified by changes in fair value of investment in shares of stock. If the value of the investment increased, a taxpayer who holds the same will recognize in its books an “unrealized gain from changes in fair value.” If the same taxpayer was able to sell the investment in an even higher amount, only then will the taxpayer recognize a “realized gain from sale.” This transaction is the closed and completed transaction from which an income should be recognized, and this is the taxable event contemplated above.
Meanwhile, as to the second criterion, the Realization Principle requires that there should be an exchange of economic value for economic value.
The second criterion can be best illustrated by a donation transaction. If A gives a million pesos to B out of pure liberality, the million pesos is not income subject to tax as far as B is concerned because the donated amount has economic value, whereas pure liberality has none. While the said transaction is subject to donor’s tax, strictly speaking, it is not an income subject to income tax because what is taxed in a donation transaction is the gratuitous transfer of property.
Hence, it is important to distinguish the two concepts: “income” and “capital.” The Supreme Court made the distinctions: first, capital is a fund, while income is a flow; second, capital is a fund of property existing at an instant in time, while income is a flow of services rendered by that capital by the payment of money from it or any other benefit rendered by a fund of capital in relation to such fund through a period of time; third, capital is wealth, while income is the service of wealth; and lastly, capital is the tree, while income is the fruit; labor is a tree, income is the fruit; property is a tree, income is the fruit (Madrigal v Rafferty, GR 12287, Aug. 7, 1918).
As a final note, it is stressed that income does not only refer to the money a taxpayer received but includes anything of value, whether tangible or intangible. If the material gain is not yet realized by the taxpayer, there is no income to speak of (Antam Consolidated Inc. v Commissioner of Internal Revenue, CTA Case 4580, Aug. 20, 2004). If there is no income to speak of, then there is no income to be subject to tax.
Gladys Jane M. de la Cruz is an associate of Mata-Perez, Tamayo and Francisco.