i. Tax Deductions vs. Tax Credits

Distinguish: exclusions, deductions, and tax credits

Exclusion: not included in the computation of gross income; an amount may be excluded because it is not income in the first place or because the law excludes it from income taxation.

Deduction: these are included in the gross income but are later deducted to compute the net income or taxable income.

Tax Credit: an amount allowed by law to be applied directly against the taxpayer’s tax liability, such as creditable tax withheld or a statutory tax credit.

General Rule

To be deductible as a business expense:

• The expense must be ordinary and necessary;
• It must be paid or incurred within the taxable year;
• It must be paid or incurred in carrying on a trade or business; (business test) and
• It must be substantially proven by evidence or records (Esso Standard Eastern, Inc. v. CIR, G.R. No. L-28508-9)¹

Note: Under RA 11976 (Ease of Paying Taxes Act), amending NIRC Sec. 34(K), an otherwise deductible expense is not disallowed solely because the payor failed to withhold or remit the applicable withholding tax; the payor remains liable for any withholding-tax violation.

The “all events test” is used to determine when an accrual of income or expense is permitted for claiming deductions. It requires:

• Fixing of a right to income or liability to pay; and
• The availability of the reasonable accurate determination of such income or liability.

Under this test, the amount of deduction need not be determined exactly as long as the same may be determined with reasonable accuracy. The term “reasonable accuracy” clearly implies something less than an exact or completely accurate amount. (CIR v. Isabela Cultural Corporation, G.R. No. 172231, 12 February 2007)²

Bad Debts

Bad debts are debts due to the taxpayer actually ascertained to be worthless and charged off during the year may be claimed as a deduction.

Requisites for deductibility:

• There must be an existing indebtedness due to the taxpayer which must be valid and legally demandable;
• It must be connected with the taxpayer’s trade, business or practice of profession;
• It must not be sustained in a transaction entered into between related parties;
• It must actually be charged off in the books of accounts of the taxpayer as of the end of the taxable year;
• It must actually be ascertained to be worthless and uncollectible as of the end of the taxable year (Rev. Regs. 05-99³, as amended by Rev. Regs. 25-02⁴)
• The bad debt must not be one contracted with a related party

A related party for tax purposes includes individuals and entities with significant control or influence over each other, often defined by familial, ownership, or management relationships.

Bad debts arising from transactions between related parties are NOT deductible.

• Between members of a family (includes only brothers & sisters, spouse, ancestors, & lineal descendants)
• Between an individual & a corporation, more than 50% in value of outstanding stock is owned by such individual (except in case of distributions in liquidation)
• Between 2 corporations more than 50% in value of outstanding stock owned by same individual, if either one is a personal holding company or a foreign holding company during the taxable year preceding the date of sale/exchange
• Between grantor & fiduciary of any trust
• Between fiduciary of a trust & the fiduciary of another if same person is a grantor to each trust
• Between fiduciary & a beneficiary of a trust

Effects of recovery of bad debts

Tax Benefit Rule - Recovery of bad debts previously allowed as deduction in the preceding years shall be included as part of gross income in the year of recovery to the extent of the income tax benefit of such deduction. (Rev. Regs. 05-99, Sec. 4)⁵

Example. A taxpayer incurred P50,000 bad debt expense in 2018 out of which P20,000 was recovered in 2020. If the 2018 deduction produced an income-tax benefit of at least P20,000, the P20,000 will be reverted back to gross income in 2020. Thus, taxable income shall be P150,000. Otherwise, include the recovery in gross income only to the extent of the income-tax benefit from the 2018 deduction.

Ascertainment of worthlessness

(Collector of Internal Revenue v. Goodrich International Rubber Co, G.R. No. L-22265, 22 December 1967)⁶:

Taxpayer did in fact ascertain the debt to be worthless in the year for which the deduction was sought. Worthlessness is not determined by an inflexible formula or slide rule calculation but upon the exercise of sound business judgment.

The determination of worthlessness must depend upon the particular facts and circumstances of the case. It must be uncollectible even in the future.

That in so doing, he acted in good faith. Good faith does not require that the taxpayer be an incorrigible optimist but on the other hand, he may not be unduly pessimistic.

Requisites for deductibility

• Must be ordinary and necessary.
• Must have been paid or incurred during the taxable year.
• Must have been paid or incurred in carrying on the trade or business of the taxpayer.
• Must be supported by receipts, records or other pertinent papers. (CIR v. General Foods, G.R. No. 143672, 24 April 2003)⁷

Expenses to be deductible:

• Amount must be reasonable
• It must be substantiated
• It is not contrary to law, public policy or morals

Applicable withholding and remittance obligations must still be complied with, but payment of tax required to be withheld is no longer a requisite for deductibility under NIRC Sec. 34(K), as amended by RA 11976.

Substantiation requirements

Sufficient evidence (i.e. official receipts, financial statements or other adequate records) to substantiate:

• Amount of expense deducted; and
• Direct connection/relation of the expense to the development, management operation and/or conduct of the trade, business or profession of the taxpayer.

Classification of Expenses:

• Ordinary expense – normal or usual in relation to the taxpayer’s business and the surrounding circumstances.
• Necessary expense – appropriate and helpful to the taxpayer’s trade, business, or profession; it need not recur daily.

Note: While illegal income will form part of the income of the taxpayer, expenses which constitute bribe, kickback, and other similar payment, being against law and public policy are not deductible from gross income.

• Business expense – an expenditure related to the business; it is currently deductible only if it meets the statutory requirements and is properly deductible for that taxable year under the taxpayer’s accounting method.
• Capital expense – an expenditure that creates or improves a capital asset; it is generally capitalized rather than immediately deducted. Its cost may be recovered through depreciation if the asset is depreciable, or otherwise under the applicable rules, including upon disposition.
• Private educational institutions - in addition to the expenses ordinarily allowed as deductions, a private educational institution has the option to either (Sec. 34 (A)(2)⁸):
• Deduct outright those otherwise considered as capital outlays of depreciable assets for the expansion of school facilities; or
• Capitalize asset & deduct allowance for depreciation

Advertising expense

There is yet to be a clear-cut criterion or a fixed test for determining the reasonableness of an advertising expense. There being no hard and fast rule, the right to a deduction depends on a number of factors such as but not limited to: the type and size of business in which the taxpayer is engaged; the volume and amount of its net earnings; the nature of the expenditure itself; the intention of the taxpayer; and the general economic conditions. (CIR v. General Foods)⁹

Salaries, wages & other forms of compensation for personal services actually rendered (including grossed-up monetary value of fringe benefit); but the final tax should have been paid

Must be reasonable. Must be for the personal services actually rendered.

Travel expenses, here and abroad, in pursuit of trade, business/profession

Travel expenses include transportation expenses, meals and lodging incurred solely on business. Travel expenses attributable to personal purposes are not deductible; substantiated expenses attributable to the trade, business, or profession may be deducted if they otherwise meet the statutory requirements. (Rev. Regs. 02-40, Sec. 66)¹⁰

Cost of materials

Taxpayers should include in expenses the charges for materials and supplies only to the amount that they are actually consumed and used in operation during the year for which the return is made, provided that the cost of such materials and supplies has not been deducted in determining the net income for any previous year. (Rev. Regs. 02-40, Sec. 67)¹¹

If the materials or supplies are used directly or indirectly in the production of the product, the related cost shall form part of the cost of the product and will be deductible as such when the product is sold.

Rentals and/or other payments as lessee, user or possessor

On accrual basis, rent is deductible as expense when liability is incurred during the period of use.

On cash basis, rent is deductible when incurred and paid.

An advance payment is not deductible expense on the part of the lessee until the same is used for the relevant period, although the lessor may be required to report the amount when received.

Expenses under lease agreements

Lessor

All ordinary and necessary expenses paid or incurred during the taxable year which are attributable to earning the lease income are deductible.

Lessee

The lessee may deduct qualifying rental expenses attributable to its trade or business, subject to the applicable timing and substantiation rules. Advance rent is apportioned over the relevant lease periods; a refundable deposit is not deductible as rent when paid. (NIRC, Sec. 34(A)(1); Rev. Regs. 19-86, Sec. 3)

If the payments are so arranged as to constitute advance rentals, the same shall be duly apportioned over the lease term. In computing the term of the lease, all options to renew shall be taken into consideration if there is a reasonable expectation that such options will be exercised. (Rev. Regs. 19-86, Sec. 3)¹²

Repairs and maintenance

Incidental (minor) repairs are deductible from gross income. They do not materially add to the value of the property nor appreciably prolong its life but keep it in an ordinarily efficient operating condition.

Major repairs (replacement) are not deductible from gross income. They prolong the life of the asset and thus should be capitalized.

Expenses for professionals

Amounts expended for books, furniture, and professional instruments and equipment, the useful life of which is short, may be deducted.

However, amounts expended for books, furniture, and professional instruments and equipment of a permanent character are not allowable as deductions.

Entertainment, amusement & recreation expenses directly connected to the development, management & operation & conduct of trade, business/ profession

Subject to a limit of:

• For taxpayers engaged in sale of goods/properties – one half of one percent (0.50%) of net sales (gross sales less sales returns/allowances/discounts)
• For taxpayers engaged in sale of services, exercise of profession – one percent (1%) of net revenues (gross revenue less discounts)
• Engaged in both sale of goods/properties and services – determined based on apportionment formula taking into consideration net sales/revenue to total net sales/revenue, in which case shall not exceed maximum ceiling prescribed above. (Rev. Regs. 10-02, Sec. 5)¹³

Requisites for deductibility:

• Must be paid or incurred during the taxable year
• Must be directly connected to the development, management and operation of trade, or business, profession of the taxpayer
• Not contrary to law, morals, good customs, public policy or public order
• Must not have been paid, directly or indirectly, to any person as a bribe, kickback or other similar payment;
• Must be duly substantiated by adequate proof; and
• Appropriate amount of withholding tax, if applicable, should have been withheld and paid to the BIR. (Rev. Regs. 10-02)¹⁴

Training expenses

Ordinary and necessary expenses for education and training actually incurred by the taxpayer during the taxable year may be deductible.

Incentive Scheme –

An additional deduction from taxable income of one-half of the value of labor training expenses incurred for developing or upgrading the productivity and efficiency of unskilled labor or for management development programs shall be granted to the taxpayer, provided:

• Such training program is approved by the National Manpower and Youth Council; and
• Such deduction shall not exceed 10 percent of direct labor wage (Sec. 10, IRR of the Labor Code, Book II, Rule III¹⁵)

Allowable training expenses

The training expenses shall be in the form of personal services, traveling expenses, equipment, training tools, training supplies and materials, and a reasonable amount for contingencies. (Sec. 8, IRR of the Labor Code, Book II, Rule III)¹⁶

Non-applicability of incentive scheme

Training programs undertaken by training institutions and/or associations operating for profit shall not qualify under this incentive scheme. (Sec. 10, IRR of the Labor Code, Book II, Rule III)¹⁷

Losses

i. Requisites for deductibility of ordinary loss:

• Must be of the taxpayer;
• Actually sustained during the taxable year;
• Not compensated for by insurance or other forms of indemnity;
• Incurred in trade, business or profession OR property connected with trade, business or profession lost through fires, storm, shipwreck, other casualties, robbery, theft or embezzlement;
• Evidenced by a completed transaction;
• Not claimed as a deduction for estate tax purposes; and
• For a casualty, robbery, theft, or embezzlement loss, a declaration of loss must be filed with the BIR within 45 days after discovery of the loss.

The taxpayer’s failure to record in his books the alleged loss proves that the loss had not been suffered, hence, not deductible. (City Lumber, Inc. v. Domingo, G.R. No. L-18611, 30 January 1964)¹⁸

Note: A declaration of loss should be filed with the BIR within 45 days after discovery of the casualty, robbery, theft, or embezzlement loss. Failure to submit the declaration within the prescribed time will result in the disallowance of the loss. However, the mere filing of the declaration of loss does not automatically entitle the taxpayer to deduct the alleged loss from gross income. (Rev. Regs. 12-77¹⁹, as amended by Rev. Regs. 10-79)

The amount of loss deductible is limited to the difference between the value of the property immediately preceding the loss and its value immediately thereafter but shall not exceed an amount equal of the cost or other adjusted basis of the property, or depreciated cost reduced by any insurance or other compensation received.

Losses are deductible only by the person sustaining them. They are purely personal and cannot be used as deductions by another.

In Tambunting Pawnshop v. CIR²⁰, the Supreme Court disallowed claims for deductions due to losses for failure to substantiate the losses. As to the auction sale, the taxpayer merely relied on entries made in its books. As to the losses due to fire, the taxpayer failed to submit a Sworn Declaration of Loss, which is required 45 days from the discovery of the loss.

Other types of losses

(a) Capital losses – deductions allowed only to the extent of the gains from pertinent sales or exchanges of capital assets

• Losses from sale or exchange of capital assets
• Losses resulting from securities becoming worthless and which are capital assets
• Losses from short sales of property
• Losses due to failure to exercise privilege or option to buy or sell property

(b) Securities becoming worthless

Loss resulting from securities becoming worthless shall be considered loss from the sale or exchange of capital asset.

Such loss shall be computed on the last day of the taxable year.

General Rule: securities becoming worthless are deductible

Exception: In the case of banks or trust companies incorporated under the laws of the Philippines, a substantial part of whose business is the receipt of deposits, the loss is not treated as a loss from the sale or exchange of a capital asset; its deductibility is governed by the applicable rules for ordinary losses. (NIRC, Sec. 34(D)(4); Rev. Regs. 05-99, Sec. 5)²¹

Losses from wash sales of stock or securities

Wash sale is a sale or other disposition of stock or securities at a loss, where, during the period beginning 30 days before the sale and ending 30 days after the sale, the taxpayer acquires or enters into a contract or option to acquire substantially identical stock or securities.

General rule: not deductible

Exception: unless claim is made by a dealer in stock/securities and made in ordinary course of business

Wagering losses

Allowed only to the extent of the gains from wagering transactions

Net operating loss carry-over (NOLCO)

Net operating loss refers to the excess of allowable deductions over gross income of the business for any taxable year, which has not been previously offset as deduction from gross income. Generally, the net operating loss of a business shall be carried over as a deduction from gross income for the next 3 consecutive taxable years immediately following the year of such loss. Net operating losses incurred in taxable years 2020 and 2021 may instead be carried over for the next 5 consecutive taxable years (NIRC, Sec. 34(D)(3), as amended by RA 11494, Sec. 4(bbbb)).

The 3-year period shall continue to run notwithstanding that the corporation paid its taxes under MCIT, or that the individual availed of the Optional Standard Deduction.

For mines, other than oil & gas wells, if loss is incurred in any of the first 10 years of operation, it may be carried over for the next 5 years.

Requirements:

• The taxpayer was not exempt from income tax in the year of such net operating loss;
• The loss was not incurred in a taxable year during which the taxpayer was exempt from income tax, and
• There has been no substantial change in the ownership of the business or enterprise.

A merged with B, with A as the surviving corporation. A cannot claim B’s prior losses as deductions (PICOP v. CA, G.R. No. 106949-50 & 106984-85)²².

There is no substantial change in the ownership of the business when:

• Not less than 75% in nominal value of outstanding issued shares, or not less than 75% of the paid-up capital, is held by or on behalf of the same persons (NIRC, Sec. 34(D)(3)).

Note: No actual change in ownership occurs:

• in case the transfer involves change from direct ownership to indirect ownership, or
• merger of the subsidiary into the parent company.

If several corporations enter an agreement to integrate their respective businesses, can each of the corporations continue to carry-over their respective net operating losses?

IF the separate corporations are not dissolved but are merely integrated for a legitimate business purpose, then the NOLCO of each separate corporation is preserved after the proposed share swap. This is because there is no substantial change in the ownership of the business. (BIR Ruling No. 30-00).

Taxes

The term “taxes” refers to national and local taxes

Deductible Taxes – All taxes, national or local, paid or incurred during the taxable year in connection with the taxpayer’s profession, trade or business, are deductible from gross income.

Requisites for deductibility:

• It must be paid or incurred within the taxable year;
• It must be paid or incurred in connection with the taxpayer’s trade, profession or business;
• It must be imposed directly on the taxpayer; and
• It must not be specifically excluded by law from being deducted from the taxpayer’s gross income

Examples:

• Percentage tax
• Excise tax
• Documentary stamp tax
• Occupational tax
• License tax
• Fringe benefit tax
• Local taxes except special assesment
• Community tax
• Municipal tax (Banggawan)

Non-Deductible Taxes:

• Philippine income tax
• Final income tax
• Capital gains tax
• Regular income tax
• Income taxes imposed by authority of any foreign country except when the taxpayer does not signify in his return his desire to claim it as tax credit;
• Estate and donor’s taxes
• Special assessments, i.e., taxes assessed against local benefits of a kind tending to increase the value of the property assessed
• VAT

Treatments of surcharges/ interests/ fines for delinquency

Interest on taxes - incurred or paid by a taxpayer on all unpaid business-related taxes; deductible from gross income as interest expense, subject to applicable requirements and the 20% interest-income offset. (NIRC, Sec. 34(B)(1), as amended by RA No. 11534)²³

Surcharges – non-deductible (Rev. Regs. 02-40, Sec. 80)

Penalties or fines incident to delinquency – nondeductible (Rev. Regs. 02-40, Sec. 80)

Treatment of Special Assessments

General rule: Special assessments are not deductible, even though an incidental benefit may inure to the public welfare.

Exception: When assessments are made for the purpose of maintenance or repair of local benefits, the taxpayer may deduct assessments paid as an expense incurred in business, if the payment of such assessments is necessary to the conduct of his business. (Rev. Regs. 02- 40, Section 83)²⁶

Tax Credit v. Deduction

Tax deduction is treated as a tax-deductible expense that is subtracted from the gross income and results in a lower taxable income. It is an amount that is allowed by law to reduce the income prior to the application of the tax rate to compute the amount of tax which is due. Being a tax deduction, the discount does not reduce taxes owed on a peso for peso basis but merely offers a fractional reductions in taxes owed. On the other hand, a tax credit is a peso-for-peso deduction from a taxpayer’s tax liability due to the government. (Carlos Superdrug Corp v. Department of Social Welfare and Development, G.R. No. 166494, 29 June 2007)²⁷

Taxes, when refunded or credited, shall be included as part of gross income in the year of receipt to the extent of income tax benefit of said deduction (tax benefit rule).

For NRA-ETB and RFC, taxes paid or incurred are allowed as deductions only if and to the extent that they are connected from income within the Philippines. (Rev. Regs. 02-40, Sec. 80)²⁸

Exception to the rule that only such persons on whom the tax is imposed by law can claim deduction thereof

• Taxes of shareholder upon his interest as such and paid by the corporation without reimbursement from him can be claimed by the corporation as deduction.

Exception to the exception - A corporation paying the tax for the holder of its bonds or other obligations containing a tax-free covenant clause cannot claim deduction for such taxes paid by it pursuant to such covenant.

Foreign tax credit – subject to statutory limitations, an eligible taxpayer may credit qualifying foreign income taxes against Philippine income tax under NIRC, Sec. 34(C). The tax-sparing rule concerns a reduced Philippine tax rate on certain dividends paid to a nonresident foreign corporation when the statutory conditions are met under NIRC, Sec. 28(B)(5)(b).

Who can claim taxes as allowable deductions

• Citizen
• Domestic Corporation
• Member of GPP
• Beneficiary of an estate or trust

Who cannot claim taxes as allowable deductions

• Nonresident alien individuals not engaged in trade or business in the Philippines
• Nonresident foreign corporations

Substantiation Requirements for Tax Credit

The tax credit shall be allowed only if the taxpayer establishes to the satisfaction of the CIR the following:

• The total amount of income derived from sources without the Philippines;
• The amount of income derived from each country, the tax paid or incurred to which is claimed as a credit under said paragraph, such amount to be determined under rules and regulations prescribed by the Secretary of Finance; and
• All other information necessary for the verification and computation of such credits

What amount may be taken as tax credit:

The amount of tax credit allowed is equivalent to the tax paid or incurred to a foreign country during the taxable year but not to exceed the following limits:

Per country limitation – The credit for tax paid or incurred to any one foreign country shall not exceed the Philippine income tax multiplied by the taxable income from sources within that country divided by the entire taxable income. (NIRC, Sec. 34(C)(4))

Global limitation – The total credit for foreign taxes shall not exceed the Philippine income tax multiplied by the taxable income from sources outside the Philippines divided by the entire taxable income. (NIRC, Sec. 34(C)(4))

Note: Allowable tax credit shall be the LOWER of the actual tax paid to the foreign country, per country limitation and global limitation.

When credit for taxes may be taken:

The credit for taxes provided by Section 34(C)(3) to (7) of the NIRC²⁹ may ordinarily be taken either in the return for the year in which the taxes accrued or on which the taxes were paid, dependent upon whether the accounts of the taxpayer are kept and his returns filed upon the accrual basis or upon cash receipts and disbursements basis.

Example:

Depreciation

Refers to the gradual diminution in the service or useful value of tangible property due from exhaustion, wear and tear and normal obsolescence; also applies to amortization of intangible assets, the use of which in trade or business is of limited duration.

Requisites for deductibility:

• The allowance for depreciation must be reasonable;
• It must be for property used for employment in trade or business or out of its not being used temporarily during the year;
• The allowance must be charged off; and
• Schedule on the allowance must be attached to the return

Requisites for deductibility on depreciation of land vehicles capitalized by the taxpayer:

• The taxpayer must substantiate the purchase of vehicle with sufficient evidence;
• Only one vehicle for land transport is allowed for the use of an official or employee, the value of which should not exceed P2.4 million;
• No depreciation shall be allowed for yachts, helicopters, airplanes and/or aircrafts, and land vehicles which exceed the above threshold amount, unless the taxpayer’s main line of business is transport operations or lease of transportation equipment and the vehicles purchased are used in said operations;
• All maintenance expenses on account of non-depreciable vehicles for taxation purposes are disallowed in their entirety; and
• The input taxes on the purchase of non-depreciable vehicles and all input taxes on maintenance expenses incurred thereon are likewise disallowed for taxation purposes. (Rev. Regs. 12-12, Sec. 3³⁰, as clarified by RMC No. 02-13³¹)

Note: Depreciation is deductible by NRA-ETB or NRC only when such property is located in the Philippines.

The BIR and the taxpayer may agree in writing on the useful life of the property to be depreciated. The agreed rate may be modified if justified by facts or circumstances. The change shall not be effective before the taxable year on which notice in writing by registered mail is served by the party initiating.

Interest

The requisites for the deductibility of interest expense are as follows:

• There must be an indebtedness;
• An interest expense must be paid or incurred upon such indebtedness;
• The indebtedness must be that of the taxpayer;
• The indebtedness must be connected with the taxpayer’s trade, business, or exercise of profession;
• The interest expense must have been paid or incurred during the taxable year;
• The interest must arise from an enforceable obligation, whether by written agreement or by operation of law, and satisfy the other applicable requirements for deduction (NIRC, Sec. 34(B); Commissioner of Internal Revenue v. Palanca, G.R. No. L-16626, October 29, 1966);
• The interest must be legally due;
• The interest payment arrangement must not be between related taxpayers;
• The interest must not have been incurred to finance petroleum operations;
• Interest incurred to acquire property used in trade, business, or the exercise of a profession may be deducted if otherwise allowable, unless the taxpayer elects to treat it as a capital expenditure (NIRC, Sec. 34(B)(3)); and
• The interest is not expressly disallowed by law from being deducted from the taxpayer’s gross income (Rev. Regs. No. 13-00)³².

General Rule on Deduction of Interest Expense

The amount of interest expense paid or incurred within a taxable year of indebtedness in connection with the taxpayer’s trade, business, or exercise of profession shall be allowed as a deduction from the taxpayer’s gross income.

Limitation on Deduction of Interest Expense

A taxpayer’s otherwise allowable deduction for interest expense shall be reduced by 20% of the interest income subjected to final tax. (Sec. 34 (B)(1))³³

Example: Year 2012

Interest expense                                                                                          P 2,000

Interest income                                                                                                1,500

Historical example (2012, when the reduction was 33%): Deductible interest expense [P2,000- (1,500 x 33%)]                 P 1,505 For a taxable year governed by the current 20% rule, the same figures yield P 1,700 (NIRC, Sec. 34(B)(1), as amended by RA 11534).

The objective of the limitation is to discourage tax arbitrage on back-to-back loans, the proceeds of which are invested in income earning interest that is subject to 20% final tax.

Tax Arbitrage - a method of borrowing without entering into a debtor/creditor relationship, often to resolve financing and exchange control problems; in tax cases, back-to-back loan is used to take advantage of the lower rate of tax on interest income and a higher rate of tax on interest expense deduction.

Deductible Interest Expense

Interest on taxes (discussed in the succeeding page), such as those paid for deficiency or delinquency, since taxes are considered indebtedness (even if the underlying tax is not deductible, subject to the applicable requirements of Sec. 34(B) of the NIRC); however, fines, penalties, and surcharges on account of taxes are not deductible; interest on unpaid business tax shall not be subjected to the 20% interest-arbitrage reduction under Sec. 34(B)(1) of the NIRC, as amended by RA 11534.

Interest paid by a corporation on scrip dividends. (Rev. Regs. 02-40, Sec. 78)³⁴

Interest on deposits paid by authorized banks of the BSP to depositors, if it is shown that the tax on such interest was withheld.

Interest paid by a corporate taxpayer which is liable on a mortgage upon real property of which the said corporation is the legal or equitable owner, even though it is not directly liable for the indebtedness. (Rev. Regs. 02-40, Sec. 78)

Non-deductible interest expense

No deduction shall be allowed in respect to the ff:

• If within the taxable year an individual taxpayer reporting income on the cash basis incurs an indebtedness on which an interest is paid in advance through discount or otherwise. Provided, that such interest shall be allowed as a deduction in the year that the indebtedness is paid. Provided, further, that if the indebtedness is payable in periodic amortizations, the amount of interest which corresponds to the amount of the principal amortized or paid during the year shall be allowed as a deduction in such taxable year;
• If both the taxpayer and the person to whom the payment has been made or is to be made are:
• Between members of a family (includes only brothers & sisters, spouse, ancestors, & lineal descendants);
• Between an individual & a corporation, more than 50% in value of outstanding stock is owned by such individual (except in case of distributions in liquidation);
• Between 2 corporations more than 50% in value of outstanding stock owned by the same individual, if either one is a personal holding company or a foreign holding company during the taxable year preceding the date of sale/exchange (except in case of distributions in liquidation);
• Between grantor & fiduciary of any trust;
• Between fiduciary of a trust & the fiduciary of another if same person is a grantor to each trust;
• Between fiduciary & a beneficiary of a trust (Sec. 34(B)(2))³⁵
• If the indebtedness is incurred to finance petroleum exploration;
• Interest on preferred stock which in reality is dividend
• Interest on unpaid salaries or bonuses is not automatically nondeductible. Determine whether it is interest on an indebtedness and whether it satisfies Sec. 34(B), including its applicable limitations.
• Interest calculated for cost keeping on account of capital or surplus invested in business which does not represent charges arising under interest-bearing obligation
• Interest paid when there is no stipulation for the payment thereof

Interest subject to special rules ( Sec. 34(B))³⁶

• Interest paid in advance
• Interest periodically amortized
• Interest incurred to acquire property used in trade or business
• Reduction of interest expense/interest arbitrage

Optional Treatment of Interest Expense

At the option of the taxpayer, interest incurred to acquire property used in trade or business or exercise of profession may be allowed as (Sec. 34 (B)(3)³⁷):

• Expense (outright deduction) or
• Capital expenditure (capitalized as part of the property's cost and recovered under the applicable depreciation, amortization, or basis rules)

Depletion

Depletion expense is a provision for the periodic return of capital investments in wasting assets such as minerals, gas, and oil.

A reasonable allowance for depletion or amortization computed in accordance with the cost-depletion method shall be granted. Provided, That when the allowance for depletion shall equal the capital invested no further allowance shall be granted: Provided, further, That after production in commercial quantities has commenced, certain intangible exploration and development drilling costs: (a) shall be deductible in the year incurred if such expenditures are incurred for non-producing wells, or (b) shall be deductible in full in the year paid or incurred or at the election of the taxpayer, may be capitalized and amortized if such expenditures incurred are for producing wells in the same contract area. Mining exploration and development expenditures are governed separately by Sec. 34(G)(2). (Sec. 34(G))³⁸

Charitable & Other Contributions

Requisites for Deductibility (contributions subject to limitations):

• Contributions or gifts must be actually paid or made within the taxable year;
• To or for the use of the government or its agencies or any political subdivision, exclusively for public purpose; or
• To domestic corporations or associations organized and operated exclusively for:
• Religious
• Charitable
• Scientific
• Youth & sports development
• Cultural or educational purposes
• Rehabilitation of veterans
• Social welfare institutions
• NGOs

Contributions to accredited NGOs are addressed separately under the rule on contributions deductible in full (NIRC, Sec. 34(H)(2)(c)).

No part of the recipient organization’s net income may inure to the benefit of any private stockholder or individual. For contributions subject to limitation, the donor’s deduction is subject to the following limits (NIRC, Sec. 34(H)(1)):

• For individual: not more than 10% of taxable income before deducting the charitable contributions.
• For corporation: not more than 5% of taxable income before deducting the charitable contributions.

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Valuation

The amount of any charitable contribution of property other than money shall be based on the acquisition cost of said property.

Contributions subject to limitations

(see requisites for deductibility)

Contributions deductible in full

• Donations to the government – to finance, to provide for, or to be used in undertaking priority activities in education, health, youth & sports development, human settlements science & culture & in economic development according to National Priority Plan determined by NEDA

If not in accordance with annual priority plan, donation is subject to 10% / 5% limitation

• Donations to certain foreign institutions or international organizations – in compliance with agreements, treaties, or commitments entered into by Philippine government and foreign institutions/international organizations or in pursuance to special laws
• Donations to accredited NGOs – Organized & operated exclusively for scientific, educational, character-building & youth & sports development, health, social welfare, cultural or charitable purposes or combination thereof (no part of net income inures to the benefit of any private individual)

Must be utilized not later than the 15th day of the 3rd month after the close of the taxable year, directly for the active conduct of activities constituting the purpose of the organization, unless period is extended.

The level of administrative expense must conform with the rules and regulations prescribed by the Secretary of Finance but should not be greater than 30% of total expenses.

Upon dissolution, assets would be distributed to another nonprofit domestic corporation organized for similar purpose or to the state for public purpose or to another organization to be used in the same purpose as the dissolved corporation.

Pension Trusts (Past Service Cost)

Pension Trust Contributions – a deduction applicable only to the employer on account of his contributions to a private pension plan for the benefit of his employees; purely business in character.

Normal Cost – the contributions during the taxable year to cover the pension liability accruing during such taxable year; allowed as a deduction under Sec. 34(A)(1) of the NIRC³⁹ as “expenses in general.”

Past Service Cost – amount in excess of the above contribution (covering pension liability pertaining to old employees which accrued during the years previous to the establishment of the pension trust); allowed as deduction only if all of the requisites below concur.

Requisites for deductibility of past service cost:

• The employer must have established a pension or retirement plan to provide for the payment of reasonable pensions to his employees;
• The pension plan is reasonable and actuarially sound;
• The pension plan must be funded by the employer;
• The pension plan must be funded by the employer;
• The payment has not yet been allowed as a deduction; and
• The deduction is apportioned in equal parts over a period of 10 consecutive years beginning with the year in which the transfer of payment is made.

Nothing precludes the employer from making property contributions (other than monetary contributions) to the pension plan for as long as no part of the corpus or income of the fund shall be used for, or be diverted to, any purpose other than for the exclusive benefit of the employees. The transfer of property to the pension plan is neither a sale nor a donation. (BIR Ruling No. DA-486-04)⁴⁰

Summary rules on retirement benefits plan/pension trust:

• Exempt from income tax– employees’ trust under Sec. 60(B) of the NIRC⁴¹
• Exclusion from gross income – amount received by the employee from the fund upon compliance with certain conditions under Sec. 32(B)(6) of the NIRC⁴²
• Deduction from gross income
• If Normal Cost: as an expense under Section 34(A) of the NIRC⁴³.
• If Past Service Cost: as a pension trust under Sec. 34(J) of the NIRC⁴⁴

(3) DEDUCTIONS UNDER SPECIAL LAWS

RA 10028⁴⁵: expenses incurred by a private health and nonhealth facility to comply with the Breast Milk Act is deductible up to TWICE of the actual amount incurred (RMC No. 47-10⁴⁶)

RA 8502⁴⁷: additional deduction of 50% of expenses incurred in training schemes in the jewelry industry approved by the appropriate agency (RMC No. 33-04⁴⁸)

RA 8525⁴⁹: additional deduction equivalent to 50% of expenses incurred in joining the Adopt-a-School program (Rev. Regs. 10-03aa⁵⁰)

RA 9999⁵¹: for free legal assistance, taxpayers can deduct the amount that could have been collected from the client, or up to 10% of gross income derived from the actual performance of legal services, whichever is LOWER

RA 7277⁵²: private entities that employ disabled persons are entitled to an additional deduction equivalent to 25% of the total amount paid as salaries and wages to disabled persons; private entities that improved or modify their physical facilities in order to provide reasonable accommodation for disabled persons shall also be entitled to an additional deduction from their net taxable income, equivalent to 50% of the direct costs of the improvements or modifications.

The following are individual taxpayers who are mandated to use only the itemized deductions:

• Those exempt under the NIRC⁵³ and other special laws, with no other taxable income (e.g. Barangay Micro Business Enterprise [BMBE]);
• Those with income subject to special/preferential tax rates; and
• Those with income partially subject to income tax rate under Sec. 24 of the NIRC⁵⁴ and partially subject to special/preferential tax rates. (Rev. Regs. 02-14, Sec. 5⁵⁵)

Personal and Additional Exemptions

[Repealed by RA 10963⁵⁶ or TRAIN]

Items Not Deductible

Deductibility is determined under the applicable deduction provisions of the NIRC; failure to withhold and remit tax is not, by itself, a ground to disallow an otherwise allowable expense deduction.

In computing net income, no deduction shall in any case be allowed in respect to the ff (Sec. 36)⁵⁷:

• Personal, living or family expenses;
• Amounts paid out for new buildings or for permanent improvements, or betterments made to increase the value of any property or estate (not applicable to intangible drilling and development costs incurred in petroleum operation);
• Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made;
• Premiums paid on any life insurance policy covering the life of any officer or employee, or any person financially interested in trade or business carried on by the taxpayer, individual or corporate, when the taxpayer is directly or indirectly a beneficiary under such policy;
• Losses from sales or exchanges of property indirectly or directly
• Between members of a family. For purposes of this paragraph, the family of an individual shall include only his brothers and sisters (whether by the whole or half-blood), spouse, ancestors, and lineal descendants; or
• Except in the case of distributions in liquidation, between an individual and corporation more than fifty percent (50%) in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual; or
• Except in the case of distributions in liquidation, between two corporations more than fifty percent (50%) in value of the outstanding stock of which is owned, directly or indirectly, by or for the same individual if either one of such corporations, with respect to the taxable year of the corporation preceding the date of the sale or exchange was under the law applicable to such taxable year, a personal holding company or a foreign personal holding company;
• Between grantor & fiduciary of any trust;
• Between the fiduciary of a trust and the fiduciary of another trust, if the same person is a grantor with respect to each trust; or
• Between a fiduciary of a trust and beneficiary of such trust.
• Non-deductible interest, such as:
• Interest on preferred stock, which in reality is dividend;
• Interest on unpaid salaries and bonuses;
• Interest calculated for cost keeping;
• Interest paid where parties did not agree in writing to pay interest;
• Interest paid on indebtedness between related persons specified in Sec. 36(B) of the NIRC, subject to the applicable statutory rules (Sec. 34(B));
• Interest paid in advance by a cash-basis taxpayer is not deductible until the indebtedness is paid, subject to Sec. 34(B)(2)(a) of the NIRC;
• Interest expense, bad debts, and losses from sales of property between related parties;
• Non-deductible taxes, such as:
• Income tax provided under the NIRC;
• Income taxes imposed by foreign authority, except when the taxpayer did not signify in his return that he will avail of the tax credit;
• Estate tax and donor’s taxes;
• Special assessments – taxes levied against any local upgrades which potentially benefit/increase the value of the property assessed;
• Stock Transaction Tax
• Final Taxes
• Presumed Capital Gains Tax
• VAT
• Losses from wash sales of stock or securities are generally nondeductible, except when claimed by a dealer in stock or securities for a transaction made in the ordinary course of the dealer’s business (Sec. 38(A))⁵⁸

(ii) Itemized deductions

Pertains to the items in Sec. 34 of the NIRC⁵⁹ as discussed under Deductions from Gross Income

When itemized deductions is mandatory

The following are corporations, partnerships and other non-individuals that are ineligible to elect the optional standard deduction (OSD); those with taxable income compute it using itemized deductions:

• Those exempt under the NIRC (i.e., exempt corporations under Sec. 30⁶⁰ and GOCCs expressly excepted from income tax under Sec. 27(C)⁶¹ and other special laws), with no other taxable income, need not claim deductions;
• Those with income subject to special/preferential tax rates; and
• Those with income partially subject to income tax rate under Secs. 27(A)⁶² and 28(A)(1) of the NIRC and partially subject to special/preferential tax rates. (Rev. Regs. 02-14, Sec. 5)⁶³

Excess MCIT Carry-over

Excess of MCIT over the RCIT shall be carried forward and credited against RCIT tax due in the immediately succeeding three (3) years.

Rules for MCIT carry-over

• Excess MCIT can be used as tax credit against RCIT if RCIT is greater than MCIT. Excess MCIT cannot be deducted against MCIT tax due.
• Unused MCIT at the end of the 3-year period shall expire and will no longer be used.

(ii) Itemized deductions

Pertains to the items in Sec. 34 of the NIRC⁶⁴ as discussed under Deductions from Gross Income

When itemized deductions is mandatory

The following are corporations, partnerships and other non-individuals that are not eligible to elect the optional standard deduction (OSD); those with no taxable income need not claim deductions:

• Those exempt under the NIRC (i.e., exempt corporations under Sec. 30⁶⁵ and GOCCs expressly excepted from income tax under Sec. 27(C)⁶⁶ and other special laws, with no other taxable income;
• Those with income subject to special/preferential tax rates; and
• Those with income partially subject to income tax rate under Secs. 27(A)⁶⁷ and 28(A)(1) of the NIRC⁶⁸ and partially subject to special/preferential tax rates. (Rev. Regs. 02-14, Sec. 5)⁶⁹