INCOME TAXATION - DEDUCTIONS

LECTURE NOTES ON

DEDUCTIONS
Deductions from GROSS INCOME

 It pertains to business expenses incurred by a taxpayer engaged in business or engaged in the practice of
profession.
 Business expenses are cost of doing trade, business or practice of profession such as employee salaries, office
utilities, supplies, rent and taxes.
 Only business expenses are deductible

BUSINESS EXPENSE BUSINESS CAPITAL EXPENDITURE

 It only benefits the current accounting
period and deductible against gross
income in the current period.
Examples:
- Salaries and wages expenses
- Utilities expense
- Selling expense
- Rent
- Local taxes and permits
 It benefits the future accounting period
and initially recorded as assets then later
deductible against future gross income.
Examples:
- Items of PPE
- Invetory
- Investments
- Prepayments
- Acquisition of intangible assets
- Expenses to promote business goodwill
- Rentals on capital lease or finance lease that
transfer ownership

Rules on Deducting Capital Expenditures

1. Non-depreciable asset – deducted against the selling price when sold. (Do not depreciate by usage or by passage
of time)
2. Depreciable properties – deduction over useful life of the property. (The acquisition cost)

Note: The useful life and depreciation rate can be agreed by written agreement between taxpayer and the CIR
under Sec. 34 (F) (3) of the NIRC. In the absence of facts and circumstance, the agreement shall be binding on
both the taxpayer and Government.

Choices for Depreciation Method

a. Straight line method  Depreciable cost = acquisition cost – net

 (Acquisition cost – salvage value) / of selling expense
useful life in years (First year depreciation = (n/y) x
depreciable cost, where n is number of
current years and y is the divisor which
is the sum of the annual remaining
useful life

b. Sum of the years digit method c. Declining balance method (150% or

200%)
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 Depreciation rate x declining book value d. Other methods which may be prescribed
of the property by the Secretary of Finance upon
recommendation of the Commissioner
of Internal Revenue

3. Intangible assets – expense over their legal life or expected life whichever is lower.
4. Inventory – deducted when sold or used in the business using inventory method or specific identification method
with the aid of a Point-of-Sale (POS) machine.

Presentation in the Income Tax Return

The cost of goods sold is deducted outright from gross sales in the measurement of the gross income from
operations.

5. Prepaid Expenses – deducted in the future period when expired or used in the business or profession of the
taxpayer

Immaterial Capital Expenditures

Property, plant and equipment, Deducted outright

inventories or prepayments of as EXPENSE
expenses that were acquired in an
IMMATERIAL AMOUNT

SPECIAL CONSIDERATIONS WITH DEDUCTIONS

1. Property repairs and improvements – repairs that significantly increase the value or prolong the useful life of
properties are capital expenditures.
 If merely restore without increasing the value – deducted as outright expense
 If improves and increases the value – the cost should be capitalized not to exceed the appreciation in fair
value
 If the value cannot be determined, the excess of actual repair cost over tax basis of the property as the
capitalizable increase in fair value.
 Tax basis of old property is deductible as a loss
 Cost of replacement of old or destroyed property is capitalized subject to future provisions for
depreciation
 Cost of demolishing the old building is an additional cost of acquisition of land
 Cost of razing or removing an old building to give way for erection of another in its place is not
deductible expense but capitalized as part of cost of the replacement building.
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ILLUSTRATIONS

Situations Capitalizable Expense Tax basis

No increase in property Deductible as repair Remains the same
value or useful life expense
Property fair value Repair is Carrying value plus
increase to more than capitablizable repair cost
the repair cost

Property fair value Repair cost is Excess of repair cost Carrying value plus the
increase to less than the capitalized over the increase in excess value
repair cost value is expensed

Repair cost is more Excess in repair The remaining repair Repair Cost
than the carrying value; cost over carrying cost same as carrying
fair value after repair is value is value is expense
unknown capitalizable

No Increase in fair Repair cost is Repair cost plus carrying

value but with increase capitalized value
in useful life

2. Property acquisition-related costs

 All cost directly related to the acquisition of an item of PPE such as freight and import duties are
capitalized as a part of the cost of the property subject to depreciation
 Expenses incurred directly related to the acquisition of goods such as transportation and in bringing the
goods for sale such as consignment freight out are capitalized to the cost of the goods and are expense
through cost of goods sold when sold
 Cost of financing asset acquisition such as interest expense may, at the option of taxpayer, be expensed
outright or capitalized and depreciated.

3. Securities issue costs

 Cost of registering shares of stock to the SEC and cost of printing bonds or stock certificates are deducted
against the proceeds of such securities

4. Manufacturing expenses
 Cost of raw materials and supply used, labor and other overhead cost like maintenance and depreciation
are capitalized as part of the cost of goods being processed and are expense through cost of sales when
sold
 Cost of goods sold of manufacturing firms is deducted against sales in determining the reportable gross
income from operations

5. Effects of accounting methods

 Under cash basis, expenses are deductible when paid regardless of when they accrue
Cash Expenses (paid) + Amortization of Prepayments + Declaration of
properties = Cash basis deductions
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 Under accrual basis, expenses are deductible when they accrue regardless of when they are paid
Accrued expenses (paid or unpaid) + Amortization of prepayments +
Depreciation of properties = Accrual basis deductions

 Prepayments and Capital expenditures cannot be deducted outright

6. Effects of value added tax – If purchases goods are made from VAT suppliers, taxpayers will pay the VAT
passed-on by the supplier.
 Output VAT – from seller’s perspective
 Input VAT – from buyer’s perspective
 As VAT Taxpayer, the input VAT is claimable as tax credit against output VAT and not claimable as
deduction
 As non-VAT Taxpayer, the input VAT is part of costs of the purchase or expense of the taxpayer and
claimable as deduction

GENERAL PRINCIPLES OF DEDUCTIONS FROM GROSS INCOME

1. Expenses must be legitimate, ordinary, actual and necessary (loan)

2. The matching principle – only business related expenses and profits subject to regular income are deductible
3. The Related Party Rule – transactions between related parties are taxable but losses are not deductible
4. The Withholding Rule – no deduction is allowed unless the withholding tax required by the law

Other Information

 Necessary expense – reasonable and essential to the management or business or exercise of profession of taxpayer
 Ordinary expense – normal in relation to the business of the taxpayer
 Deductible expense – must be both ordinary and necessary
 Extraordinary expense – incurred outside the business of the taxpayer and non-deductible

Examples of non-deduction expense under LOAN rule:

1. Decrease in value of properties or investments such as decrease in value of:

o Securities
o Foreign currencies or foreign currency- denominated receivables
o Machineries, equipment and building brought by obsolescence and impairment

2. Estimated future losses on:

 Bad debts
 Lawsuit not yet confirmed by a final judgment
 Warranty expense
3. Loss on properties covered by insurance or indemnity contracts
Examples of non-deductible expenses under The Matching Principle:

1. Expenses on exempt income 4. Expenses and taxes on income subject to final tax or
2. Expenses on income subject to a special tax regime capital gains tax
3. Business expenses of taxpayers subject to final 5. Foreign business expenses of taxpayers taxable only
income tax on the Philippine income
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6. Loss of income not yet recognized in gross income

Summary of Expanded withholding tax rates:

A. Payments to suppliers of goods, in general 1%

B. Payments to suppliers of servicers in general 1%
Except:
1. Rentals of properties or films and toll fees to refineries 5%
2. Professional services to:
a) Individual professionals, brokers, agents, entertainers 5% or 10%
b) Corporations 10% or 15%
c) General professional partnerships 0%
3. Embalmers by funeral companies 1%
4. Additional payments to government personnel from importers, shipping
and airline companies or their agents for overtime services 15%
C. Income distribution by
1. Estates and trusts to heirs or beneficiaries 15%
2. General professional partnership to partners 10%
D. Payments made by credit card companies .5% or 1%

 Sworn declaration must be submitted by professionals indicated that his gross receipts do not exceed
3M in a year and it will be basis for the withholding agent to deduct 5% and if he fails to submit, he
shall be deducted 10% withholding tax.

 Sworn declaration must be submitted by corporate taxpayer indicated that his gross incomes do not
exceed 720k in a year and shall be deducted by 10% but if they fails to submit, 15% withholding tax
shall be deducted.

Copies of evidence release to the payee of the income payments

1. Certificate of final tax withheld at source (BIR For income exempt:

FORM 2306)
3. Certificate income payment not subject to
2. Certificate of creditable tax withheld at source
withholding tax (BIR FORM 2304)
(BIRD FORM 2307)

EXAMPLES:

Expanded withholding tax – non-VAT supplier

1. Abby is due to pay 30,000 monthly rental expense to non-VAT lessor

 Withheld tax is 1,500 (30k x 5%)
 Abby shall pay 28,500 to the lessor (30k-1,500)
 Remit the withheld tax to government through an authorized government depository bank

Expanded withholding tax – VAT Supplier

1. Melissa Magno Realty Corporation (MMRC) a VAT taxpayer, is about to pay 996,000 commission to Mr.
Galante, a VAT-registered realty broker
 MMRC shall deduct 10% withholding tax on the gross income of Mr. Galante
 INCOME TAXATION - DEDUCTIONS

 Gross amount due 996,000

Less: Output VAT (996,000 x 12/112 106,714
Commission income 889,286
Multiply by: Withholding rate 10%
Withholding tax 88,929
 889,286 as commission expense, 88,929 as input VAT (tax credit)

Timing of withholding

 The obligation of the payor to deduct and withhold tax from the income payment arises upon the occurrence of
any of the following, whichever comes first:

a. Payment c. Recording of the income payment as

b. When the income payment becomes due or expense or asset in the books
payable

Penalties for non-withholding or late remittance of withholding tax

 Late remittance of withholding tax is subject to the same penalties for late filing or late payments of tax

Examples:

1. On March 8, 2021, the taxpayer paid 570,000 net rental to a lessor but failed to remit 30,000 withholding tax to
the government. The taxpayer filed BIR Form 0619-E on June 29, 2021.
Amount to be paid by the taxpayer on June 29, 2021 shall be:
 Withholding tax due 30,000
Plus: Penalties
Surcharge (30,000 x 25%) 7,500
Interest (30,000 x 12% x 80/365) 789
Compromise* 10,000
Total tax due 48,289
 Deadline of tax was April 10, 2021 (10th day of the following month)
 April 10, 2021 to June 29, 2021 is 80 days
 The compromise penalty is taken from the table of compromise penalties for failure to withhold or remit.

If the amount not withheld or remitted

Exceeds But not exceed Compromise
is
… … …
15,000 20,000 5,000
20,000 50,000 10,000
50,000 500,000 15,000

NON-DEDUCTIBLE EXPENSES

1. Personal, living or family expenses

2. Amount paid out for new buildings or betterments made to increase the value of any property or state
3. Any amount expended in restoring property
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4. Premiums paid on any life insurance policy covering life of any personally interested in business carried by
taxpayer

TAX REPORTING CLASSIFICATIONS DEDUCTIONS

1. Cost of sales or cost of services – deducted outright against sales, revenues, receipts or fees of individual tax
payers in gross income from operations
2. Regular allowable itemized deductions – for all necessary and ordinary expenses pair or incurred during the
taxable year in carrying on the business operations
3. Special allowable itemized deductions – additional deductions categorize by (1) actual compliance expense, (2)
Deduction incentives
4. Net Operating Loss Carry Over (NOLCO) – excess of expense deduction over gross income during taxable year
and be deducted against the net income of the following 3 years. (Not an expense)

MODE OF CLAIMING DEDUCTIONS FROM GROSS INCOME

1. Itemized deductions – with list of every item of business expense claim by taxpayers as deductions, deductions
are strictly construed against taxpayer
2. Optional standard deductions – deduction is merely presumed as fixed percentage of gross income for
corporations and gross sales or receipts for individuals

REGULAR ALLOWABLE ITEMIZED DEDUCTIONS

Itemized deductions from GROSS INCOME:

1. Interest Expense 7. Charitable and other contributions

2. Taxes 8. Contributions to pension and trusts
3. Losses 9. Research and development costs
4. Bad debts 10. Other ordinary and necessary trade, business or
5. Depreciation professional expense
6. Depletion

Those are not connected with selling of goods or renderings services are classified as Regular allowable itemized
deductions.

INTEREST EXPENSE

Requisites on the deductibility of interest (RR13-2000)

1. Indebtedness must be:

o Valid
o By taxpayer
o Connected with the taxpayer’s trade, business or exercise of profession
2. Interest must be:
o Expense have been paid or incurred during the taxable year
o Stipulated in writing
o Legally due
o Not be between taxpayers
o Not incurred to finance petroleum operations
 INCOME TAXATION - DEDUCTIONS
o Not expressly disallowed by law to be deducted from gross income of the taxpayer
3. If interest incurred by acquisition of property used in business, same is not treated as capital expenditure

Deductible amount of interest expense

 It is the gross interest expense reduced by the arbitrage limit or percentage of the interest income subject to
final tax – 20% (effective as of January 1, 2021)

Formula:
Deductible interest expense is computed as:

Gross interest expense xxx

Less: the arbitrage limit (interest income x 20%) xxx

Deductible interest expense xxx

Determination of the Arbitrage limit

To eliminate the arbitrage savings, a deduction cap was set and it was computed as:

(Corporate income tax rate – final tax on interest income)

Corporate income tax rate
o Arbitrage limit is (25-20)/25 or 20%
o Net interest income must be grossed up first by percentage of final tax (100%-20%) before computing the
arbitrage
ARBITRAGE LIMIT under CREAT transition

If the change in corporate tax is The arbitrage limit must change

From To From To
30% 25% 33% 20%
30% 20% 33% 0%

Optional treatment of interest expense 2. Interest from scrip dividends

 Outright deduction from gross

income
Non-deductible interest
 Capital expenditure claimable
through depreciation 1. Interest on personal loans
2. Interest incurred with related parte
Other deductible interest expense
3. Interest expense incurred to finance petroleum
1. Interest from tax delinquency operations
4. Interest on redeemable preferred shares

TAXES

Other non-deductible taxes

 INCOME TAXATION - DEDUCTIONS
1. Business taxes, in particular the Value added tax (VAT)
2. Surcharges or penalties on delinquent taxes

Deductible taxes

1. Percentage tax 7. Local taxes except special assessment

2. Excise tax 8. Community tax
3. Documentary stamp tax 9. Municipal tax
4. Occupational tax 10. Foreign income tax if not claimed as tax credit
5. License tax
6. Fringe benefit tax

 Only basic tax of a deductible tax is allowable as deductions

 For foreign income taxes paid, only taxpayers taxable on world income such as domestic corporations and RC
can claim deduction or tax credit

LOSSES

 Sustained during taxable year and not compensated by insurance or other indemnity shall be allowed as
deductions

REQUISITES for the Deduction of losses

1. Must be a business loss, not personal loss

2. Must be an ordinary loss
3. Must be actually sustained, not temporary
4. Declaration of loss must be filed by the taxpayer within 45 days from the date of discovery of casualty
5. Double deduction is not allowed

Type of losses

1. Ordinary loss – deductible in full

2. Capital loss – expense, deductible only up to the extent of capital gains

Examples of deductible ordinary losses

a. Loss on disposal or destruction of any ordinary asset

b. Loss due to voluntary removal of building incident to renewal or replacement
c. Permanent or irreversible loss in value of assets due to changes in business conditions, only to the extent actually
realized
d. Abandonment loss

BAD DEBTS

 Debt due which considered worthless

REQUISITES of claim for Deduction of Bad debt
1. Must have been ascertained to be worthless
2. Must be charged off within the taxable year
3. Must be connected to the taxpayer’s profession
or business
4. Must be under the accrual basis of accounting
5. Must not be incurred from related party
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Not deductible as bad debts 2. Securities becoming worthless of taxpayer
3. Loss on capital investment in partnerships, joint
1. Bad debts from personal receivables
ventures or corporations

DEPRECIATION

 Gradual exhaustion in the value of tangible business properties through usage or by the passage of time

SPECIAL RULES on Depreciation

1. Life tenancy to a property
2. Properties held in trust
3. Revaluation on properties
4. Rules on depreciation of passenger
vehicles
Deduction shall computed as if the life tenant was
the absolute owner
Deduction shall be apportioned between income
beneficiaries and trustees
Revaluation surplus and impairment losses is not
deductible
 With official receipt or identification
numbers
 To be use directly to business
 Shall not exceed 2.4M for land
 No depreciation for a water and air
vehicles and land which exceeded the
threshold unless transport operation
businesses

CHARITBLE AND OTHER CONTRIBUTIONS

 Gift or contributions made to government or NGO’s can be deducted against cross income

REQUISITES of claim for deduction on contributions

1. Must a domestic institution

2. No income must inure to the benefit of any private stockholder or individual
3. Contribution is tax basis of the property donated
4. Taxpayer must be engaged in trade or business
5. Issue Certificate of Donation (BIR Form 2322)
6. File Notice of Donation when donation is at least 50,000

Note: Donations that fail any requisites are non-deductible

Those meet the requisites are: Limited of deduction for contributions (taxable
income derived from business)
a. Fully deductible or
b. Partially deductible a. 10% for individuals
b. 5% for corporations

CONTRIBUTIONS TO PENSION TRUST

 INCOME TAXATION - DEDUCTIONS
 Defined contribution plan – deductible expense of the employer is the amount of contributions
 Defined benefit plan – employer guarantees the amount benefits to the employees

REQUISITES for deductibility of pension expense

1. Employer must have established a pension fund

2. Sound and reasonable actuarial assumptions
3. Fund must be funded by employer
4. Fund assets must be independent
5. Deductible in full if current services contribution
6. Amortized over a period of 10 years if past service contribution

RESEARCH AND DEVELOPMENT (R&D COSTS)

 Activities geared towards discovery of new knowledge

 R&D cost is part of the cost of the property related to capital accounts used in business and deducted through
depreciation expense
 If not related to capital accounts – outright expense or deferred expense

Examples of other deductible expenses:

1. Salaries and allowances 9. Royalties

2. Fringe benefits 10. Repairs and maintenance
3. SSS, GSIS, Phil Health, HDMF, and other 11. Entertainment, amusement, and recreation
contributions expenses
4. Commissions 12. Transportation and travel
5. Outside services 13. Fuel and oil
6. Advertising 14. Communication, light, and water
7. Rental 15. Supplies
8. Insurance 16. Miscellaneous expenses

SPECIAL ALLOWABLE ITEMIZED DEDUCTIONS AND NOLCO

 Items of deductions which may or may not partake of the nature of expense but allowed by the NIRC or by
special laws as deductions

Special Allowable Deductions

A. Special expenses under the NIRC and special laws

1. Income distribution (taxable estate or trust)

2. Transfer to reserve fund and payments (insurance companies)
3. Dividend distribution of a Real Estate Investment Trust (REIT)
4. Transfer to reserves funds of taxable cooperatives
5. Senior Citizen Discounts
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6. PWD Discounts
7. Additional expenses on apprenticeship agreement

B. Deduction incentives under the NIRC and special laws

1. Cost of facilities improvements for PWD

2. Additional for:

 Compensation expense for  Contribution expense

senior citizen employees  Deductions for compliance to
 Compensation expense for rooming-in and breastfeeding
PWD  Free legal assistance
 Training expense  Productivity incentive bonus
 Labor training expense expense

Treatment of NOCLO

 Net operating loss carry-over – treated as separate item of deduction in the next 3 consecutive
taxable years.

Rules in Carry-Over of NOLCO

1. Claimable in a FIFO (first-in first out) fashion

2. Claimed only up to the net income of the business in the next 3 years, prior year – cannot be deducted against
subsequent year net operating loss
3. If remains unused at the end of 3 year prescriptive period will expire

 NOLCO is not allowed as deduction when there is substantial change in the ownership of the business
 It is not a transferrable right, privilege or interest
 NOLCO for individual taxpayers – measured by separating compensation income from business/profession
income

REQUISITES for deductibility of NOLCO:

1. Taxpayer –must not exempt from income tax when the NOLCO incurred during taxable year
2. No substantial change in the ownership of the business

OPTIONAL STANDARD DEDUCTION (OSD)

 Is in lieu of the itemized deduction allowable under the NIRC and special laws
INCOME TAXATION - DEDUCTIONS
 Allowable deduction is the percentage of Gross sales or receipt for individuals and Gross income for corporations
 NRA-ETB and taxpayers mandated to use itemized deductions are cannot use OSD

Percentage of OSD

1. Individual taxpayers – 40% of total sales/revenue/receipts/fees

2. Corporate taxpayers – 40% of gross income

EXAMPLE: The income statement of a retailer goods under accrual basis of accounting is shown below:

Sales, net of returns, allowances and discounts 2,000,000

Less: Cost of sales 900,000
Gross Income 1,100,000
Less: Operating expenses
Administrative expenses 250,000
Selling expenses 320,000 570,000
Net Income 530,000

Answer: The OSD of the taxpayer shall be computed as follows

If the taxpayer is
Individual Corporation
Sales, net of returns, 2,000,0000 2,000,000
allowances and discounts
Less: Cost of sales - 900,000
Total sales/Gross Income 2,000,000 1,100,000
Multiply by: OST rate 40% 40%
Optional Standard 800,000 440,000
deductions

Rules on Determination of OSD for Rules on Determination of OSD for

INDIVIDUAL TAXPAYES CORPORATE TAXPAYERS

 Gross sales – only sales  Gross income – (Gross sales or

contributory to income Gross receipts less sales return,
 Gross receipts – actually discounts and allowances and
received during taxable year cost of sales)

 All gross income are subject to the regular income tax (operations or non-operating sources
Corporate OSD is computed as follows:

Net sales/Revenues/Receipt/Fees xxx,xxx

Less: Cost of sales or services xxx,xxx
Gross Income from operations xxx,xxx
Add: other taxable income not subject to final tax xxx,xxx
Total Gross Income P xxx,xxx
Multiply by: OSD percentage 40%
Optional Standard Deduction P xxx,xxx