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LEARNING OUTCOMES
At the end of this module, you are expected to:

1. Explain the importance of considering taxes in terms of decision-making;

2. Explain the goals of tax planning;
3. Identify and differentiate the general tax planning strategies;
4. Explain the different tax law concepts and principles;

Pre-Activity
Please review the topics discussed in your BAINCTAX class.

TAX PLANNING
Reducing taxes is beneficial, but why should managers learn the basics of tax planning? It may
seem obvious at first glance, especially to the owner-manager or corporate entrepreneur. But this
is an important question, which can be answered differently at different times, in different
organizations, and for operations in different countries.

Managers need to learn about taxes because optimizing a venture’s total tax burden is important
to its success, and managers are the main decision makers in an organization. Knowing the
fundamentals of taxation and how to apply them allows managers to make better decisions and
thus be more effective in their jobs.

Managers who are able to identify tax issues can also make more effective use of tax consultants,
because these managers can recognize a problem when it arises and advise consultants of the
tradeoffs involved. Taxes impact success because operational decisions are generally based on
the risk-adjusted net present value of expected after-tax cash flows. In addition, income taxes,
payroll (e.g., Social Security), business (e.g., value-added, goods and services, or gross receipts),
and property taxes often add up to one of the largest expense items of an organization.
Furthermore, tax payments typically have a high legal priority claim on an organization’s cash
flow. That is, not only can taxes be a big expense, but they must also be paid, and paid quickly.

Publicly traded companies can be especially sensitive to tax expense. This is because earnings
(which usually have a major impact on stock prices) must be reported on an after-tax basis.
Indeed, not only must earnings be reduced by taxes paid in the current year, but earnings must
also be reduced by any expected future income taxes generated by such earnings. Because senior
managers’ compensation is often tied to earnings via stock prices (e.g., through stock options),
key decision makers in multinational organizations often have a high personal stake in
optimizing taxes.
COST-BENEFIT CONSIDERATION
All in all, there are many factors that combine to motivate managers of organizations to seek to
reduce taxes, provided the cost of doing so is not too high. This is because tax planning requires
making changes, and doing so is not cost free, nor are the rewards certain.

First, the details of taxation are hideously complex. Second, the cost of complying with tax rules
(e.g., preparing tax returns and providing details requested by tax auditors) can be significant.
Not only can it be costly to figure out how much to pay but also who to pay and when to pay.

Such costs can be particularly high for cross-border activities, which can involve a multitude of
different tax jurisdictions imposing different taxes. In addition, similar taxes are often imposed
by different jurisdictions using similar but different basic definitions. This raises the specter of
multiple taxation (e.g., the same income effectively being taxed at rates exceeding 100%),
although governments typically try to avoid this situation through tax treaties and special
adjustments, such as the foreign tax credit.

GOALS OF TAX PLANNING

Most people think that minimizing taxes should be the goal of tax planning. This is shortsighted,
because taxes are only one factor, albeit a major one, in the mix of costs and other factors that
generate the amounts most often taxed: profits and wealth. Put simply, one can avoid many taxes
by neither earning a living nor owning property, but most people do not aspire to a life of poverty,
however tax free it is. Furthermore, strategies that reduce taxes are rarely cost free. If nothing else,
when focusing on saving taxes, managers are not focusing on increasing sales, improving product
quality, or producing goods and services more efficiently. The SAVANT framework recognizes
this by striving toward optimizing taxes rather than minimizing them. The goal is to balance the
benefits against the risks and costs.

Tax strategies are also risky: Changing operations to save taxes (e.g., by operating through
multiple corporations) often results in an increase in long-term administrative costs and generates
uncertain returns because tax laws can change (and, as the Comprehensive Tax Reform Program
of the government have demonstrated in the Philippines, change can occur dramatically, rapidly,
and unpredictably), and tax rules themselves are all too often obscure at best.

In cross-border transactions, the interactions of multiple taxes imposed by different jurisdictions

also must be appreciated. Also, tax-savings strategies can be intrusive. Why is it, for example,
that profitable businesses in the National Capital Region do not all move to identified less
developed areas (LDAs) should they want to avail incentives under preferential taxes? One
reason is that it is costly to move. Another is that nontax factors dominate the decision: Many
business owners may simply want to live in a specific area. Yet another reason is that skilled
labor, qualified subcontractors, and competitive suppliers may be plentiful in a particular area.

GENERAL TAX PLANNING STRATEGIES

Thus, even though total elimination of taxes is not a goal, people and organizations often invest
significant amounts of time and resources in implementing tax-reducing strategies. The ultimate
goal is to reduce taxes while not excessively intruding on the organization’s overall operations.

SAVANT also illustrates that tax strategies are usually based on taking advantage of either the
time value of money (e.g., paying taxes later) or differences in tax rates (i.e., tax-rate arbitrage).
As already noted, tax arbitrage is typically behind artificial transfer pricing schemes, that is, using
accounting entries to shift profits to jurisdictions that impose the lowest net taxes (i.e., the lowest
tax costs relative to the benefits received by operating in a particular jurisdiction).

Types
Tax savings strategies usually fall into one of four types.

Creation involves plans that take advantage of tax subsidies, such as

Creation
moving an operation to a jurisdiction that imposes lower taxes.
Conversion entails changing operations so that more tax-favored
Conversion
categories of income or assets are produced.
Timing involves techniques that move amounts being taxed (also called
Timing
the tax base) to more favorable tax-accounting periods.
Splitting techniques entail spreading the tax base among two or more
Splitting
taxpayers to take advantage of differing tax rates.

GOALS OF AN IDEAL TAXING SYSTEM

The basic objective of taxation is to raise revenues to finance governments. Governments also
attempt to achieve other objectives in designing and implementing tax systems. These objectives
are frequently complicated by the dynamics of political, economic, and social forces. Since the
writings of eighteenth-century economist Adam Smith, people designing tax systems have often
considered the criteria he identified: equality, certainty, convenience, and economy.

Equality
Equality means that taxpayers should bear a fair level of tax relative to their economic positions
(e.g., income, for income taxes). Equality can be defined in terms of horizontal and vertical equity.
Horizontal equity means that two similarly situated taxpayers are taxed the same. Vertical equity
means that when taxpayers are in different economic positions, the taxpayer with the greatest
ability to pay incurs the most taxes.

Most income taxes are progressive. That is, higher tax rates apply when there are higher levels of
the amount being taxed. For income taxes, this amount—called the tax base—is taxable income.
However, consumption-related taxes (such as VAT) are rarely progressive (and are often
considered regressive) because there is typically only one tax rate. These are usually paid to states
and localities by consumers of tangible goods. Because poor people spend much more of their
incomes on consumption than do rich people, they pay proportionately more of their incomes on
sales and use taxes.

Certainty
Certainty means that a taxpayer knows when, how, and how much tax is paid. In the Philippines,
it is most likely that those who are employed generally know that their income taxes are withheld
by their employers every payroll period. For those self-employed taxpayers, it may be
generalized that only those which are operating for a period of time may be knowledgeable on
taxes. Others may not even give distinguishment on income tax and business tax. More so for the
taxes on one-time transactions (ONETT), generally, taxpayers end up incurring large amounts of
penalties due to delay in filing and payment.

Convenience
Convenience means that the taxes should be levied at the time it is most likely to be convenient
for the taxpayer to make the payment. This generally occurs as they receive income because this
is when they are most likely to have the ability to pay. Another aspect of convenience is method
of collection. Income taxes in the Philippines are privately determined by individuals and
businesses and are self-assessed. In contrast, import, property, and other taxes are calculated and
assessed either by governments or (for sales, use, and value-adding taxes) by vendors.

Economy
Economy means that a tax should have minimum compliance and administrative costs. That is,
it should require a minimum of time and effort for the taxpayer to calculate and pay the tax.
Administrative costs are expenses incurred by the government to collect the tax. Compliance and
administrative costs are highest for income taxes, because of their complexity.

TAX RATES AND STRUCTURES

Taxes are computed by multiplying the tax rate by the tax base, that is, tax rate × tax base = tax.
The tax base is the amount that is subject to tax. For income taxes, the tax base is taxable income,
defined roughly as income less allowable expenses. For property taxes, the tax base is some
measure of the value of the property. Consumption taxes, such as VAT and percentage tax, are
most often based on the sales price of the merchandise sold. For payroll taxes, a common tax base
is compensation.

For most taxes there are three types of tax rates: marginal, average, and effective rates.

The marginal rate is the tax rate that will be paid on the next dollar of tax
Marginal base (i.e., the rate on the next dollar of income for income taxes, or the rate
of tax that will be saved on the next dollar of deduction).
The average rate is usually computed by dividing the total tax by the total
Average
tax base.
The effective rate is usually computed by dividing the total tax by the total
Effective
financial accounting income.

Illustration 9.1 TAX RATES

Assume the following financial figures of a purely self-employed as of December 30, 2020, gross
of any kind of income tax.
Gross Income
Gross Profit from Sales Activity 4,960,000
Interest Income from Peso Deposits 25,000
Gain on Sale of Long-Term Bonds 15,000 5,000,000
Operating Expenses
Deductible Expenses 2,990,000
Non-Deductible Expenses 260,000 3,250,000
Net Income before Income Taxes 1,750,000
Suppose an order was received on December 31, 2020 which would generate a gross profit of
P50,000.
Let us first compute the taxable income as of December 31, 2020.
Gross Profit from Sales Activity 4,960,000
Deductible Expenses 2,990,000
Taxable Income 1,970,000

In computing for the marginal rate, it is to be considered that the taxable income of P1,970,000
is taxed at 30%. The P50,000 gross profit would increase the taxable income at P2,020,000 which
would now fall on the next bracket at 32%. In this case the marginal rate would be the current
marginal rate of 30% on the first P30,000 and 32% for the next P20,000.
Let us now assume that the order received was not fulfilled during the year, therefore, not
earned. In computing for the average rate, we now need to obtain all the income subject to tax
and divide it to the total of their corresponding income taxes.
Total Income Taxes
Regular Income Tax (basing on the tax table) 481,000
Final Tax on Peso Deposit (25,000 x 20%) 5,000 486,000
Divide by: Total Income Subject to Tax
Taxable Income under Regular Tax 1,970,000
Income under Final Tax 25,000 1,995,000
Average Rate 24.36%

In computing for the effective rate, we use the financial accounting income in lieu of the
taxable income. As such, we are now considering both permanent and temporary differences.
Total Income Taxes 486,000
Divide by: Financial Accounting Income 1,750,000
Taxable Income 24.67%

Tax rate structures can be thought of as being proportional, progressive, or regressive. With a
proportional (or flat) tax rate, the average rate remains the same as the tax base increases. Other
than the income tax, most taxes are proportional. For example, local government charges a 1%
real property tax on the assessed value of property owned. Whether the corporation owns
P100,000 or P100 million worth of property, the rate is still 1% (i.e., it is proportional.)

With a progressive tax rate structure, the average rate increases as the tax base increases. Most
income tax systems are progressive. Common example is the income tax on individual taxpayers.

A regressive structure is one where the average rate decreases when the base increases. Many
people consider consumption taxes as regressive. This is because if the total consumption tax paid
by a taxpayer is divided by income, the average rate decreases by income.

Illustration 9.2 CONSUMPTION TAX AS REGRESSIVE TAX

Jack and Dina are best friends who are both widowed. Their spouses left them to take care of
the three children of each family. Both families consumed P10,000 worth of groceries, net of
VAT, for each month. Jack earns P60,000 per month while Dina earns P48,000.
Essentially, the consumers are the economic taxpayers of the value added tax.
Purchases 10,000
VAT Rate 12%
Value Added Tax 1,200
Let us try to compute for the average rate for each of the families.
Jack Dina
Value Added Tax 1,200 1,200
Monthly Earnings 60,000 48,000
Average Rate 2% 2.5%
As can be inferred, the average rate is higher for those who have less income, reflecting the
characteristic of a regressive tax.

SOURCES OF TAX LAWS

With the exercise of the power of taxation, tax laws provide guidance on its scope. The following
are the common sources of tax statutes.

Constitution of the Philippines

The term Constitution refers to that body of rules and maxims in accordance with which the
powers of sovereignty are habitually exercised. A constitutional provision regarding taxation is
primarily intended to limit and regulate the exercise of taxation power. The State can exercise the
power to tax even if the Constitution is completely silent about taxation.

Statutes
Statutes are laws enacted and established by the will of the legislative department of the
government. The present tax statutes of the Philippines are embodied in the Republic Act No.
8424, which is now the prevailing NIRC effective January 1, 1998, which was amended by various
republic acts and revenue regulations.

Judicial Decisions
These refer to the decisions for application made concerning tax issues by the proper courts
exercising judicial authority of competent jurisdiction. These courts may be the Supreme Court
and the Court of Tax Appeals. Their decisions on tax laws comprise the greater portion of tax
jurisprudence. They form part of the legal system of the Philippines.

Executive Orders
Executive orders are regulations issued by the President or some administrative authority under
his direction for the purpose of interpreting, implementing, or giving administrative effect to a
provision of the Constitution or of some law or treaty.

Tax Treaties and Conventions

These refer to the treaties or international agreements with foreign countries regarding tax
enforcement and exemptions. They have the force and effect of law.
IMPORTANT PRINCIPLES AND CONCEPTS IN TAX LAW
This multifaceted system of tax rules may seem bewildering at first. However, most tax systems
have developed around fundamental concepts that do not change much and thus provide a deep
structure to tax rules. For example, a number of principles and concepts guide how tax laws are
structured in the Philippines. While they cannot be used to provide guidance on all tax rules, they
generally explain why many tax laws are structured the way they are throughout the world.

Ability-to-Pay Principle
Under the ability-to-pay principle, the tax is based on what a taxpayer can afford to pay. One
concept that results from this is that taxpayers are generally taxed on their net incomes.

Entity Principle
Under the entity principle, an entity (such as a corporation) and its owners (for a corporation, its
shareholders) are separate legal entities. As such, the operations, record keeping, and taxable
incomes of the entity and its owners (or affiliates) are separate.

Pay-as-You-Go Concept
Related to the ability-to-pay concept is the pay-as-you-go concept. Taxpayers must pay part of
their estimated annual tax liability throughout the year, or else they will be assessed penalties
and interest. For individuals, the most common example is income tax withholding. In the
Philippines, for example, employers withhold minimum amount of income taxes from each
employee’s paycheck and then remit the withholding to the government. Another example
would be the quarterly returns for income tax on businesses and the monthly remittance of the
value-added tax.

All-Inclusive Income Principle

This principle basically means that if some simple tests are met, then receipt of some economic
benefit will be taxed as recognized income, unless there is a tax law specifically exempting it from
taxation. The tests are (each test must be met if an item is to be considered as income):

 Does it seem like income?

 Is there a transaction with another entity?
 Is there an increase in wealth?

Related to this principle would be the following.

Realization For income to be recognized, there must be a measurable transaction with

Principle another entity. Therefore, accretion in wealth cannot generate income.
Increase-in- The increase-in-wealth test means that unless there is a change in net
Wealth Test wealth, no income will be recognized.
 Recovery of Under recovery of capital, a taxpayer does not usually recognize income
Capital on the sale of an asset until the taxpayer’s capital is first recovered.
Under claim of right, income is recognized once the taxpayer has a legal
Claim of Right
right to the income.
Constructive Under constructive receipt, income is recognized when it is available for
Receipt the taxpayer’s use, even if the taxpayer does not collect the income.

Legislative Grace
Closely related to the income concepts already described is the concept of legislative grace. Here
income that would normally be taxed under the preceding rules is either exempt from tax or
subject to a lower tax rate due to special rules. Some examples would be the holding period rule
for capital gains of individual taxpayers, exemption of inter-company dividends from final tax,
and exemption of some fringe benefits of employees.

The legislative grace concept applies to deductions as well (deductions are expenses that can be
used to reduce taxable income). Usually, no deduction is allowed under our tax laws unless it is
specifically authorized by the law. For businesses and sole proprietors, the usual types of
expenses are generally allowed for tax purposes. However, other deductions for individuals exist
purely by legislative grace. For example, as already noted, there is a fixed standard deduction.

Business Purpose Concept

Business purpose is closely related to legislative grace as it relates to deductions. Here business
expenses are deductible only if they have a business purpose, that is, the expenditure is made for
some business or economic purpose, and not for tax-avoidance purposes. The test is applied to a
bona fide trade or business, or to expenses for the production of income.

Accounting Methods
As noted, some general rules apply when a taxpaying entity wants to choose among cash, accrual,
or hybrid (part cash, part accrual) methods of accounting.

Tax-Benefit Rule
Under the tax-benefit rule, if a taxpayer receives a refund of an item for which it previously took
a tax deduction (and received a tax benefit), the refund becomes taxable income in the year of
receipt.

Substance over Form

Under the doctrine of substance over form, even when the form of a transaction complies with a
favorable tax treatment, if the substance of the transaction is the intent to avoid taxes, the form
will be ignored and the transaction recast to reflect its real intent.

References:
Karayan, J.E. & Swenson, C. (2007). Strategic Business Tax Planning. New Jersey: John Wiley & Sons, Inc.
Self-Check!
Basing on your readings, answer the following questions.
1. What is tax planning and what are its goals?
2. How do the four types of tax planning strategies differ from one another?
3. What are the goals of an ideal taxing system?
4. What are the tax rates and structures used for tax planning?
5. What are the sources of tax laws in the Philippines?
6. Explain the different principles and concepts employed in tax laws.

Exercise 9.1 TRUE OR FALSE

Determine whether the following statements are true or false.
1. The primary purpose of most taxes is to raise revenue to finance governments.
2. Though taxes impose significant costs, it merely cannot change one’s behavior.
3. Tax planning can affect decision making in even the most commonplace of settings.
4. Income tax typically is tax based on gross income for each calendar year.
5. Taxes are one of the most important aspects in structuring a transaction.
6. Taxes may be a dominant or minor factor in every decision to be made.
7. One way to measure how well a firm is managing its taxes is to look at its nominal
income tax rate.
8. Estate taxes help provide additional horizontal equity in the tax system beyond that
provided by the income tax.
9. In certain instances, there may be more than one marginal rate.
10. The concept of certainty is similar to that of the fiscal adequacy principle.
11. The basis for computing the average tax rate is the financial accounting income.
12. Tax laws arise from all three branches of the government.
13. The primary goal of tax planning of minimization of taxes.
14. Managers need to learn about taxes because optimizing a venture’s total tax burden is
important to its success, and managers are the main decision makers in an organization.
15. Tax planning is free, thus, always economical to be exercised.

Exercise 9.2 TAX CONCEPTS AND PRINCIPLES

Identify the tax concepts and principles best illustrated by the following situations.
1. An idea was brought up by a tax advisory regarding a measure where a client may save
taxes but would require higher cost of compliance.
2. X and Y corporations each have sales revenues of P500,000. Expenses for the two
corporations are P100,000 and P300,000, respectively. Corporation X will pay more
taxes, because it has greater net income and cash flows, and thus can afford to pay more.
3. An entrepreneur forms a corporation that develops and sells the entrepreneur’s
software products. During the year, the corporation has P200,000 in revenue and
P50,000 in expenses. The entrepreneur also has a salary of P100,000. The corporation
will file a corporate tax return showing P50,000 in taxable income, and the entrepreneur
will file an individual tax return showing P100,000 of income.
4. A corporation pays its entire P250,000 in net income to the entrepreneur as a salary for
being president of the corporation. Suppose that a reasonable salary for a president of
a small software company is P100,000. The effect of the salary is to reduce the
corporation’s taxable income to zero, so that it does not have to pay any taxes. While
salaries in such closely held corporations are deductible in general, in this case the arm’s
length test is not met. As a result, only P100,000 (i.e., the reasonable portion) of the
salary will be deductible by the corporation. The remaining P150,000 will be considered
a dividend.
5. An individual sells the shares in his company to a larger firm. He sells the company for
P10 million. His tax basis in the shares—what he put into the company in return for
shares—is P1 million. After subtracting his basis (pursuant to the concept of recovery
of capital), his capital gain is P9 million. The capital gain will be halved for the
computation of taxable income.
6. A corporation owns two assets that have gone up in value. It owns common stock in
another corporation, which it originally purchased for P100,000 and is now worth
P500,000. It also owns raw land worth P1 million, which it originally purchased for
P200,000. It sells the stock for its fair market value, but not the land. Income is
recognized only on the stock; there has been no realization on the land.
7. A corporation pays a consulting firm P100,000 for consulting services in one year.
Because this is a normal business expense, the corporation takes a tax deduction for
P100,000. Early the next year, the consulting firm realizes it has made a billing mistake
and refunds P20,000 of the fees. The P20,000 is taxable income to the corporation in
second year because it received a tax benefit in the prior year.
8. A corporation expects to owe P200,000 in taxes at the end of the year. It is required to
prepay P50,000 every three months or else be subject to penalties and interest.
9. An entrepreneur owns 100% of the stock of her corporation. She has the corporation
buy an aircraft to facilitate any out-of-town business trips she might make. The
entrepreneur, who also happens to enjoy flying as a hobby, rarely makes out-of-town
business trips. Since the plane will not really help the business, and there is a tax-
 avoidance motive (the plane would generate tax-depreciation deductions), there is no
business purpose to the aircraft. Accordingly, any expenses related to the aircraft,
including depreciation, are nondeductible.
10. A corporation borrows P5 million from a bank, issues P1 million in common stock, and
floats a bond issue for which it receives P10 million. Although each of these transactions
involves cash inflows and transactions with other entities, there is no change in net
wealth. This because for each of the three cash inflows, there is an offsetting increase in
liabilities (or equity) payable.
11. An entrepreneur is the sole stockholder of his corporation. The corporation never pays
dividends to the entrepreneur, and, instead, each year it pays out 100% of the
corporation’s net income as a salary to the entrepreneur (who also serves as company’s
chief executive officer). Tax authorities may tax at least part of the salary as if it were a
dividend.
12. X Corporation has net income from the sales of widgets of P15,000. Y Corporation has
net income of P15,000 from the performance of services. Both pay a tax of P2,250.

Problem 9.1 TAX RATES

Jack E. Pagarop, a self-employed individual reported the following Income Statement for the
taxable year, gross of any type of income tax.
Note
Net Sales
Gross Sales 8,745,000
Less: Sales Discounts [1] 85,000
Less: Sales Returns 175,000 8,485,000
Less: Cost of Sales 4,750,000
Gross Profit 3,735,000
Other Income
Gain on sale of domestic shares [2] 35,000
Interest income on bank deposits 15,000
Gain on sale of land [3] 450,000
Gain on redemption of share in a mutual fund 30,000 530,000
Gross Income 4,265,000
Less: Operating Expenses
Depreciation Expense [4] 480,000
Salaries and Wages [5] 680,000
Fringe Benefit Expense [6] 65,000
 Entertainment and Amusement Expense 45,000
Interest Expense 35,000
Pension Trust Expense [7] 110,000
Other Deductible Expenses 1,750,000 3,165,000
Net Income before Income Taxes 1,100,000

Following are the relevant notes:

 Note 1 - P15,000 of this amount is given as discounts to senior citizens and disabled
persons.
 Note 2 - The shares were sold directly to the buyer at P100,000.
 Note 3 - The land which was classified as a capital asset had a carrying amount of
P1,400,000 and fair market value of P2,000,000.
 Note 4 - Included in this amount is the annual depreciation of a vehicle which had was
acquired on July 1 of the current year at P2,500,000 and has a useful life of 10 years.
 Note 5 - Included in this amount is P25,000 salary of senior citizen employees and
P15,000 salary of a disabled person employee.
 Note 6 - Half of this amount is the monetary value of what is subject to Fringe Benefit
Tax.
 Note 7 - P25,000 of this amount is applicable to past service costs.
Compute the following:
Jack uses Itemized Jack uses Optional
Deductions Standard Deduction
Marginal Tax Rate should Jack have
additional taxable income of P150,000
Average Tax Rate
Effective Tax Rate

Problem 9.2 TAX STRUCTURES

The three siblings of Amon Family have the following income and paid the following taxes.
Jack Dina Pal
Monthly Income 60,000 80,000 120,000
Tax A 2,625 3,500 5,250
Tax B 360 320 240
Tax C 4,000 6,500 12,500
Determine which of the following taxes is progressive, proportional and regressive.
Problem 9.3 EFFECTIVE TAX RATE
Two corporate taxpayers have the following financial figures for a particular year.
Corp. A Corp. B
Taxable Income 5,600,000 8,900,000
Permanent Difference due to being subject to 10% final tax 30,000 80,000
Permanent Difference due to Income exemption 210,000 250,000
Taxable Temporary Difference 120,000 190,000
Deductible Temporary Difference 190,000 90,000
Which of the two corporations is better in managing its taxes for the year?