28.2 Individual Income Tax: Deductions, Passive Income, and Capital Gains

Individual Income Tax: Deductions, Passive Income, and Capital Gains

This section continues individual taxation with the computation of taxable income for self-employed individuals under graduated rates, the final taxes on passive income as revised by CMEPA from July 1, 2025, capital gains taxes on unlisted shares and real property held as a capital asset, and annual and quarterly filing requirements.

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1. Allowable Deductions for Self-Employed Individuals under Graduated Rates

When a self-employed individual does not elect the 8% optional tax, they must choose between Itemized Deductions and the Optional Standard Deduction (OSD).

Itemized Deductions under Section 34

To be deductible, business expenses must be ordinary, necessary, directly attributable to the business or profession, reasonable in amount, substantiated with official invoices or receipts, and subjected to withholding tax where applicable.

1. Ordinary and Necessary Expenses (Section 34(A)): Salaries, rent, utilities, office supplies, repairs, and travel expenses.
2. Interest Expense (Section 34(B)): Interest paid or accrued within the taxable year on business indebtedness. Tax Arbitrage Rule: Under Section 34(B)(1), deductible interest expense must be reduced by 20% of the interest income subjected to final tax earned by the taxpayer. The CREATE Act (RA 11534) lowered this reduction from 33% to 20%, effective July 1, 2020, to match the lower corporate income tax rates.
3. Taxes (Section 34(C)): Deductible taxes include local business taxes, mayor's permit fees, real property taxes on business assets, and community taxes. Non-Deductible Taxes: Philippine income tax, estate tax, donor's tax, foreign income taxes claimed as tax credits, and value-added tax (for VAT-registered taxpayers).
4. Losses (Section 34(D)): Losses actually sustained during the year not compensated by insurance. Net Operating Loss Carry-Over (NOLCO): Any net operating loss incurred in a taxable year can be carried over as an itemized deduction for the next three (3) consecutive taxable years immediately following the loss year.
5. Bad Debts (Section 34(E)): Debts arising from trade, business, or profession that become completely worthless and are charged off within the year.
6. Depreciation (Section 34(F)): Reasonable allowance for exhaustion, wear, and tear of property used in trade or business.
7. PERA contributions (Section 34(M), added by CMEPA): Private employers that contribute to employees' Personal Equity and Retirement Accounts at least equal to the employees' own contributions get an additional deduction of 50% of the employer's actual contributions.
8. Charitable Contributions (Section 34(H)): Deductible up to a statutory ceiling of 10% of taxable income derived from trade, business, or profession before charitable contributions (for individuals). Contributions to priority government projects or accredited non-government organizations (NGOs) meeting statutory standards may qualify for 100% full deduction.

Optional Standard Deduction (OSD) under Section 34(L)

• Rate for Individual Taxpayers: 40% of Gross Sales or Gross Receipts (for individuals, cost of sales is not deducted before applying the 40% rate; for corporations, OSD is 40% of gross income).
• Key Features:
  • No requirement to substantiate individual expense items with supplier receipts or invoices.
  • No requirement to submit audited financial statements.
  • Irrevocable for the taxable year in which the election is made.

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2. Passive Income Taxation for Individual Taxpayers

Certain passive income streams derived from sources within the Philippines are subject to final withholding taxes (FWT). The tax is withheld at source, and the income is not included in the taxpayer's annual graduated income tax return.

Passive Income Tax Schedule (after CMEPA, effective July 1, 2025)

Key exam points:

• CMEPA made the rate on bank interest uniform at 20% regardless of currency, removed the exemption for individuals' long-term deposits, and raised the rate on residents' FCDU interest from 15% to 20%. Interest on foreign currency deposits of nonresidents remains exempt.
• Under the CMEPA transitory rule, financial instruments issued or transacted before July 1, 2025 keep the tax treatment in force when they were issued for their remaining term.
• PCSO and Lotto winnings of PHP 10,000 or less remain exempt; larger winnings are subject to 20% final tax.

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3. Capital Gains Taxation on Specific Dealings in Property

Capital assets are all properties held by a taxpayer, whether or not connected with trade or business, that do not fall under ordinary asset definitions (stock in trade, inventory, depreciable property, and business real property). Two specific capital asset transactions are subject to specialized final capital gains taxes:

1. Sale of Shares Not Traded Through a Stock Exchange (Section 24(B)(3) after CMEPA)

• Tax Base: Net Capital Gain (Selling Price less Cost and incidental selling expenses).
• Tax Rate: Flat 15% final tax on net capital gains, first set by TRAIN (replacing the old 5%/10% tiers). Since CMEPA (July 1, 2025), the 15% tax covers shares of domestic or foreign corporations that are not sold through a local or foreign stock exchange.
• Contrast with Listed Shares: Sales of listed shares traded through a local stock exchange (and of domestic shares traded through a foreign stock exchange) are subject to the Stock Transaction Tax (STT) under Section 127 at 1/10 of 1% (0.1%) of the gross selling price since July 1, 2025 (0.6% before CMEPA), in lieu of capital gains tax. Dealers in securities report such gains as ordinary income.

2. Sale of Real Property Classified as Capital Asset Located in the Philippines (Section 24(B)(4) after CMEPA, formerly Section 24(D))

• Tax Base: The Gross Selling Price (GSP) or the Current Fair Market Value (FMV), whichever is higher.
  • The current FMV is the higher of the Zonal Value determined by the CIR or the Fair Market Value in the Schedule of Values established by the Provincial/City Assessor.
• Tax Rate: Flat 6% Final Capital Gains Tax.
• Presumed Capital Gains: The 6% tax applies regardless of whether the seller realized an actual gain or sustained a severe financial loss on the sale.

Statutory Exemption for Sale of Principal Residence

A natural person seller is exempt from the 6% capital gains tax on the sale of their principal residence if five conditions are satisfied:

1. The proceeds are fully utilized in acquiring or constructing a new principal residence within eighteen (18) calendar months from the date of disposition;
2. The historical cost or adjusted basis of the real property sold is carried over to the new principal residence;
3. The BIR is formally notified within thirty (30) days from the date of sale through prescribed forms;
4. The tax exemption can be availed of only once every ten (10) years; and
5. The 6% capital gains tax is deposited in an escrow account with an authorized agent bank; if the proceeds are fully utilized within 18 months, the escrow amount is released back to the seller. If proceeds are partially utilized, the 6% tax is assessed proportionally on the unutilized amount.

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4. Income Tax Compliance and Statutory Return Filing

Individual taxpayers must file periodic tax declarations and annual returns using prescribed BIR forms: