Deductions from Gross Income

In general, deductions or allowable deductions are business expenses and losses incurred which are allowed by law to be deducted from the gross business income or professional income to arrive at taxable income. Deductions should not be confused with exclusions or tax credit.

A taxpayer has the right to deduct all authorized allowances for the taxable year. 

As a rule, if he does not within any year deduct certain of his expenses, losses, interest, taxes, or other charges, he cannot deduct them from the income of the next of any succeeding year.

Revenue Audit Memorandum Order No. 1-2000, provides that under the accrual method of accounting, expenses not being claimed as deductions by a taxpayer in the current year when they are incurred cannot be claimed as deduction from income for the succeeding year.  Thus, a taxpayer who is authorized to deduct certain expenses and other allowable deductions for the current year but failed to do so cannot deduct the same for the next year. 

Situs of Deductions

The situs of deduction follows the situs of income. Deductions that cannot definitely be allocated shall be apportioned. 

For example, Mr. S, a non-resident alien, who is engaged in business in the Philippines, had the following information in 2020.

	Philippines	Australia
Gross Income	P1,000,000	P4,000,000
Operating Expense (In addition, Mr. S had P200,000 operating expenses which cannot properly be identified whether incurred in the Philippines.)	400,000	2,200,000

How much is the amount of allowable operating expenses for Philippine Income Tax Purposes?

Answer: P440,000

Mr. S is a non-resident alien. He can only deduct operating expenses from within. This means that his total allowable operating expenses consist of P400,000 plus the allocated amount from the P200,000 unidentified operating expenses. 

In that case, we need to determine, first, how much of the P200,000 operating expense is from the Philippines. 

The allocation should be based on the respective gross income from within and without as follows: P1,000,000/5,000,000 x P200,000 = 40,000. Thus, out of P200,000, P40,000 is deemed to be incurred from the Philippines. 

Total allowable operating expenses for Philippine Income Tax Purposes

= 400,000 + 200,000 x (1/5)

= 400,000 + 40,000

= 440,000

The total allowable operating expenses for Philippine Income Tax Purposes would amount to P440,000. 

In computing taxable income defined under Section 31 of the Tax Code, as amended, the taxpayer may opt to use either of the following types of deductions: 

1. Itemized Deductions or 
2. Optional Standard Deduction (OSD).

Itemized Deductions

As to item of deduction, itemized deductions, unlike optional standard deductions, are those enumerated in Section 34 of the NIRC. These are the following:

1. Expenses
2. Interests
3. Taxes
4. Losses
5. Bad debts
6. Depreciation
7. Depletion of oil and gas wells and mines
8. Charitable and other contributions
9. Research and development 
10. Pension trust 

Here is the schedule of Ordinary Allowable Itemized Deductions you can find on BIR Form No. 1701.

A taxpayer can only deduct the actual amount if he avails of itemized deductions. Also, itemized deductions must be substantiated with adequate proof.

Ordinary and Necessary Trade, Business or Professional Expenses

Ordinary means normal and usual in relation to the taxpayer's business and surrounding circumstances; need not be recurring. Capital expenditures are not deductible but can be amortized or a subject of depreciation. 

Necessary means appropriate and helpful in the development of taxpayer's business or are proper for the purpose of realizing a profit or minimizing a loss.

Requisites for Deductibility 

To be deductible, expenses must have the following requisites:

1. It must be an ordinary and necessary trade, business, or professional expenses
2. It must be paid or incurred during the taxable year
3. The tax required to be withheld has been deducted and paid
4. It must be substantiated with official receipts or adequate records
5. Has direct connection or relation to the development, management, operation and/or conduct of the trade, business, or profession of the taxpayer or in the pursuit of trade or business
6. The expense incurred must not be contrary to law, morals, public policy, or public order
7. The amount must be reasonable 
8. The taxpayer must be duly registered before the BIR

The requisites for the deductibility of ordinary and necessary trade, business, or professional expenses, like expenses paid for legal and auditing services, are (a) the expense must be ordinary and necessary; (b) it must have been paid or incurred during the taxable year; (c) it must have been paid or incurred in carrying on the trade or business of the taxpayer; and (d) it must be supported by receipts, records or other pertinent papers.

Substantiation Requirement 

No deduction from gross income shall be allowed unless the taxpayer shall substantiate with sufficient evidence, such as official receipts or other adequate records: 

1. the amount of the expense being deducted, and 
2. the direct connection or relation of the expense being deducted to the development, management, operation, and/or conduct of the trade, business, or profession of the taxpayer. 

When to Accrue Expense

The accrual of income and expense is permitted when the all-events test has been met.  This test requires (1) fixing of a right to income or liability to pay; and (2) the availability of the reasonable accurate determination of such income or liability.

Withholding Requirement

For income payment to be allowed as a deduction, the withholding tax must have been paid [RR No. 12-2013]. No Withholding, No Deduction.

If F Corp. leases its business office in Makati City from J Inc. at a monthly rate of P100,000, then F Corp. should pay J Inc. P95,000 and remit 5% creditable withholding tax amounting to P5,000 to the BIR.

Otherwise, it cannot deduct P100,000 as rent expense.

Kinds of Expenses

Business expenses deductible from gross income include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayer’s trade or business. These include 

1. Compensation expenses
2. Transportation and Travel
3. Cost of materials 
4. Rental
5. Repairs and maintenance 
6. Professional expenses
7. Entertainment expenses 
8. Training expenses 
9. Janitorial and Messengerial Services
10. Security Services
11. Others

Compensation Expense

Salaries, wages, and other forms of compensation for personal services actually rendered, including the grossed-up monetary value of the fringe benefit subjected to fringe benefits tax which tax should have been paid. This also includes SSS, GSIS, Philhealth, HDMF and Other Contributions.

Personal services must be actually rendered and reasonable.

For example, P Corp. paid P5,980,000 to its employees as salaries and fringe benefits. 

How much is the allowable deduction on salary and fringe benefits?

The allowable deduction as compensation expense shall be P7,000,000 (P6,000,000 + P1,000,000).

Rule on Bonus

Bonuses are deductible when: 

1. made in good faith
2. given as additional compensation for personal services actually rendered
3. such payments, when added to the stipulated salaries, do not exceed reasonable compensation for the services rendered

The bonus granted to officers as a share of profit realized from the sale of land is not deductible. In this case, there is no evidence of service actually rendered by the officers which could be the basis of a grant to them. Hence, such a bonus cannot be considered as a selling expense nor can it be deemed reasonable and necessary. Aguinaldo Industries Corporation v. CIR, G.R. No. 29790, 25 February 1982

Types of Employees 

Managerial Employee. A managerial employee is one who is vested with the powers or prerogatives to lay down and execute management policies and/or to hire, transfer, suspend, lay-off, recall, discharge, assign, or discipline employees. 

Supervisory employees. Supervisory employees are those who, in the interest of the employer, effectively recommend such managerial actions if the exercise of such authority is not merely routinary or clerical in nature but requires the use of independent judgment. 

Rank and File Employees. All other employees are considered as rank and file employees.

Transportation and Travel

May be granted by way of:

1. Travel expenses in the pursuit of trade, business, or profession 
2. Expenses for foreign travel in the form of fringe benefits (reported under the compensation expense)

A reasonable allowance for travel expenses, here and abroad, while away from home in the pursuit of trade, business or profession can be claimed as an item of deductions. 

Its characteristics are 

1. Includes transportation expenses and meals and lodging.
2. Expenses must be reasonable and necessary.
3. Must be incurred or paid “while away from home.” Tax home is the principal place of business when referring to “away from home.”
4. Incurred or paid in the conduct of trade or business.

Deductible	Not deductible
Transportation expenses from its office to its customers’ place of business and back	Transportation expenses of an employee from his residence to its office and back. This is considered as personal expense.

Cost of materials

Deductible only to the amount that they are actually consumed and used in operation during the year for which the return is made, provided that their cost has not been deducted in determining the net income for any previous year.

Rental

This refers to earnings derived from leasing real estate as well as personal property. Its requisites for deductibility are 

1. Required as a condition for continued use or possession of property.
2. For purposes of trade business or profession.
3. Taxpayer has not taken or is not taking title to the property or has no equity other than that of lessee, user, or possessor.

Different forms of rental income and rent expenses are treated as follows:

Form	Lessor	Lessee
Rent	Income	Expense (when paid or incurred)
Obligations of the lessor to the third person paid by the lessee	Income	Expense
Advance Rent	Must be reported in full in the year of receipt, regardless of the accounting method used	Expense to be prorated over the period covered regardless of accounting method
Leasehold Improvement	Rent Income from leasehold improvements may be recognized outright or spread out.	Expense (depreciation) over the term of the lease or estimated life whichever is shorter

For example, On June 30, 2020, Y leased an apartment, which he subsequently subleased to another. Total payments and collections for the year amounted to P240,000 representing one-year lease payments and P225,000 representing nine-month lease collections from the sublessee, respectively. How much are the deductible rent expense and the reportable rent income for the year? 

The rent expense shall be P120,000. Rent expenses shall be prorated over the period covered regardless of accounting method.

Hence, rent expense is computed as follows: P240,000/12 x 6 = P120,000. 

Rent income shall be P225,000. Rent income must be reported in full in the year of receipt, regardless of the accounting method used 

Another example, Q signed an 8-year lease contract to occupy a vacant lot for P2,000/month. As a part of the lease agreement, Q constructed a building costing P600,000 completed at the start of the lease contract. The building has an estimated useful life of 10 years. At the end of the lease contract, the landlord will own the building. How much is the allowed deduction on rent?

Monthly rent (P3,000/month x 12 months)	P36,000
Leasehold Improvement P600,000/8 (shorter between lease term and useful life of the building)	75,000
Deductible Rent Expense	P111,000

Repairs and maintenance 

The following are deductible repairs and maintenance:

1. Incidental or ordinary repairs
2. Repairs that neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient working condition.
3. All maintenance expenses on account of non-depreciable vehicles for taxation purposes are disallowed in its entirely.

 

The following are not deductible as repairs and maintenance:

1. Extraordinary repairs/ Capital Expenditures
2. Repairs in the nature of replacement, to the extent that they arrest deterioration and appreciably prolong the life of the property

Entertainment, Recreation, and Amusement Expenses

These are entertainment, amusement and recreation (EAR) expenses incurred or paid during the year that are directly connected to the development, management and operation of the trade, business or profession of the taxpayer.

Any expense incurred for EAR that is contrary to law, morals, public policy, or public order shall in no case be allowed as a deduction. 

Requisites for deductibility

1. Reasonable in amount.
2. Paid or incurred during the taxable period.
3. Directly connected to the development, management, and operation of the trade, business or profession of the taxpayer, or that are directly related to or in furtherance of the conduct thereof.
4. Subject to limitations
5. Not incurred for purposes contrary to law, morals, public policy or public order.
6. Must be substantiated with sufficient evidence such as receipts and/or adequate records. 

Limitations

Entertainment, amusement, and recreation expenses should not exceed 0.5% of net sales for taxpayers engaged in the sale of goods or properties, or 1% of net revenue for taxpayers engaged in the sale of services, including professionals and lessors of properties.

Taxpayer	Rate	Base
Seller of Goods	½%	Net Sales
Seller of Services (including exercise of a profession and use of lease of properties)	1%	Net Revenue

For example, A Corp. reported net revenue of P5,000,000. In paid entertainment and representation expenses amounting to P30,000. How much is deductible EAR expense if it is trading or a service business? 

Business	Limit	Deductible EAR
Trading (Seller of Goods)	½% Limit for Seller of Goods x P5,000,000 reported Net Revenue = P25,000; the EAR should not exceed P25,000 limit	P25,000
Service	1% Limit for Contractor of Services x P5,000,000 reported Net Revenue = P50,000; the EAR should not exceed P30,000 actual payment	30,000

Exclusions from EAR Expenses

1. Expenses which are treated as compensation or fringe benefits for services rendered under an employer-employee relationship
2. Expenses for charitable or fund raising events
3. Expenses for bona fide business meeting of stockholders, partners or directors
4. Expenses for attending or sponsoring an employee to a business league or professional organization meeting
5. Expenses for events organized for promotion marketing and advertising, including concerts, conferences, seminars, workshops, conventions and other similar events; and
6. Other expenses of a similar nature.

Notwithstanding the foregoing, such items of exclusions may, nonetheless, qualify as items of deductions under Section 34 of the Tax Code, subject to conditions for deductibility. 

Expenses Allowable to Private Educational Institutions

In addition to the above, a private educational institution is allowed to treat capital expenditures as outright deductions or depreciation.

In addition to the expenses allowable as deductions under the NIRC, a proprietary educational institution may at its option, elect either:

1. To deduct expenditures otherwise considered as capital outlays or depreciable assets incurred during the taxable year for the expansion of school facilities, or
2. To deduct allowances for depreciation thereof.

Thus, where the expansion expense has been claimed as a deduction, no further claims for yearly depreciation of the school facilities are allowed.

Illustration

P University, a private educational institution, constructed a building with a contract price of P10,000,000. The building has an estimated useful life of 50 years with a salvage value of 10%. How much is the deductible expense under the two options?

If capitalized, the allowed deduction is P180,000 computed as follows. This will be presented as part of the depreciation expense. 

= Cost of building x (1-Salvage Value) / useful life

= 10,000,000 x 90% / 50 Years

= P180,000

If treated as outright expenses, the allowed deduction shall be P10,000,000.

Interests

Interest shall refer to the payment for the use or forbearance or detention of money, regardless of the name it is called or denominated (BIR Ruling No. 196-03 dated 20 June 2003). 

Interests are deductible if it complies with the requirement of under RR No. 13-2000, otherwise, the interest expense shall be treated as nondeductible interest expense: 

1. There is a valid and existing indebtedness.
2. The indebtedness is that of the taxpayer
3. The indebtedness is connected with the taxpayer’s trade, profession, or business.
4. The interest must be legally due.
5. The interest must be stipulated in writing.
6. The taxpayer is liable to pay interest on the indebtedness.
7. The indebtedness must have been paid or accrued during the taxable year.
8. The interest payment arrangement must not be between related taxpayers
9. The interest must not be incurred to finance petroleum operations.
10. In case of interest incurred to acquire property used in trade, business, or exercise of profession, the same was not treated as a capital expenditure.

Deduction for interest expense shall be subject to Tax Arbitrage Rule. 

Tax Arbitrage Rule

The taxpayer's allowable deduction for interest expense shall be reduced by an amount equal to 20% of the interest income subjected to final tax. 

For example, Mr. A obtained a P1 million loan from BDO in connection with his trade or business and paid P200,000 interest for the year. In the same year, his bank deposit realized an interest income of P100,000. How much is allowed a deduction on interest?

a. P167,000

b. P180,000

c. P200,000

d. 100,000

Answer: P180,000

Total Interest Expense	P200,000
Less: Interest Income subjected to Final Tax (P100,000 x 20%); note that in the same year, his bank deposit realized an interest income of P100,000, which is subject to 20% final tax on passive income.	20,000
Amount deductible as interest expense	P180,000

Non-deductible Interest Expense

The following are interest expenses are considered items not deductible from gross income:

1. Interest paid in advance
2. Interest on amortization
3. Interest payments made between related taxpayers.
4. Interest in indebtedness incurred to finance petroleum exploration.
5. Interest treated as capital expenditures

Interest Paid In Advance

No deduction shall be allowed if within the taxable year an individual taxpayer reporting income on cash basis incurs an indebtedness on which an interest is paid in advance through discount or otherwise. 

But the deduction shall be allowed in the year the indebtedness is paid.

Interest on Amortization 

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 deduction in such taxable year 

Interest Treated as Capital Expenditure

At the option of the taxpayer, interest expense on a capital expenditure may be allowed as 

1. A deduction in full in the year when incurred; or
2. Capital expenditure for which the taxpayer may claim only as a deduction the periodic amortization of such expenditure. 

Should the taxpayer elect to deduct interest payments against its gross income, he cannot at the same time capitalize such interest and claim depreciation on the undepreciated cost which includes the interest. [PICOP v. Commissioner, G.R. No. 106949-50 (1995)]

Illustration 

Given the below information, how much is deductible and nondeductible interest expense?

• Interest paid in advance, P20,000
• Interest paid to a brother, P12,000
• Interest paid on delinquency taxes, P8,000
• Interest on borrowings to finance family home, P30,000
• Interest paid to finance petroleum exploration, P100,000

Only P8,000 interest paid on delinquency taxes is deductible. Interest on delinquent taxes, although not deductible as tax, can be deducted as interest expense at its full amount. CIR v. Palanca, G.R. No. L-16626 (1966)

The rest of the items amounting to P162,000 are nondeductible interest expenses. 

Related Taxpayers

The following are related taxpayers:

1. Between members of the family, i.e. brothers and sisters (whether by the whole or half-blood), spouse, ancestor, and lineal descendants; or 
2. Individual and corporation, where individual owns more than 50% of the outstanding stock of the corporation 
3. Between two corporations, either one is a personal holding company of a foreign personal holding company or more than 50% of the outstanding stock of each is owned by or for the same individual
4. Between parties to a trust – Grantor and Fiduciary; or 
5. Fiduciary of a trust and fiduciary of another trust if the same person is a grantor with respect to each trust; or 
6. Fiduciary and Beneficiary 

Taxes

In general, 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 

Such tax must be: 

1. Paid or incurred within the taxable year; 
2. Paid or incurred in connection with the taxpayer‘s trade, profession or business; 
3. Imposed directly on the taxpayer; 
4. Not specifically excluded by law from being deducted from the taxpayer‘s gross income. 

Deductible Taxes

The following taxes are deductible:

1. Import duties;
2. Business tax;
3. Professional/occupation tax;
4. Privilege and excise tax;
5. DST;
6. Motor vehicle registration fees;
7. Real property tax;
8. Electric energy consumption tax; and
9. Interest on delinquent taxes.

Tax Benefit Rule

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

Tax Benefit Rule is a general principle in taxation which states that if a taxpayer deducted an item on his income tax return and enjoyed a tax benefit (reduced his income tax) thereby, and in a subsequent year recovers all or part of that item, he will recognize gross income in the year the deducted item is recovered. The rule has both an inclusionary and an exclusionary component, i.e., the recovery is included in the taxpayer’s gross income to the extent that the taxpayer obtained a tax benefit from the prior year’s deduction, and the recovery is excluded to the extent that the prior year’s deduction did not provide a tax benefit.

The following deductions in NIRC, Sec. 34 makes reference to Tax Benefit Rule:

1. Taxes
2. Abandonment Losses
3. Bad Debts

Treatments of Surcharges/ Interests/Fines for delinquency 

The amount of deductible taxes is limited to the basic tax and shall not include the amount for any surcharge or penalty on delinquent taxes. 

However, interest on delinquent taxes, although not deductible as tax, can be deducted as interest expense at its full amount. CIR v. Palanca, G.R. No. L-16626 (1966)

Income Taxes Paid in Foreign Countries

Resident Citizens and Domestic Corporations are taxable on income derived from sources within and without. The taxes they paid abroad may be claimed either as

1. Tax deductions 
2. Tax credit

Requisites to Avail Tax Credit

1. Must be a resident citizen or domestic corporation 
2. The taxpayer signifies in his return his desire to avail of the tax credit for taxes paid in foreign county 
3. Subject to limitations 

Limitations on Tax Credit

Lower among actual foreign taxes paid, per country limit, and world limit. 

Per Country Limit	Taxable Income per Foreign Country / Worldwide Taxable Income x Phil. Income Tax
World Limit	Total Taxable Income from Foreign Country / Worldwide Taxable Income x Phil. Income Tax

Losses

Losses actually sustained during the taxable year and not compensated for by insurance or other forms of indemnity are allowed to be deductible from gross income. There are two types of losses:

1. Ordinary Losses
2. Capital Losses 

Ordinary Losses

Refer to losses incurred in connection with trade or business or in the exercise of profession or property therewith which are considered deductible in arriving at the taxable income. 

e.g., operating losses, casualty losses, losses due to robbery, theft, or embezzlement 

In case of casualty losses, the taxpayer shall submit a declaration of loss sustained from casualty or from robbery, theft, or embezzlement during the taxable year, not be less than 30 days nor more than 90 days from the date of discovery of casualty, robbery, theft, or embezzlement giving rise to the loss. The loss must not be claimed as a deduction for estate tax purposes in the estate tax return. 

Capital Losses 

Capital loss refers to the excess of cost over the amount realized. Examples of capital losses are 

1. losses on sale or exchange of capital assets, 
2. losses from wash sales of stocks or securities 
3. losses on securities becoming worthless, 
4. losses on retirement of bonds,
5. losses from short sales, and 
6. losses attributable to the failure to exercise the privileges or options to buy or sell property

Securities Becoming Worthless

Worthless securities mean without market value or zero market value. Loss in shrinkage in value of stock through fluctuation in the market is not deductible from gross income.

Illustration 

D Corp. acquired P1,000,000 worth shares of Stocks of B Corp. and P2,000,000 of E Corp.’s. During the year, the value of shares of stocks of E Corp. had decreased to P1,500,000. B Corp. went bankrupt. Accordingly, its shares of stock became worthless. 

How much may D Corp. deduct from its gross income?

D Corp. may deduct P1,000,000 only, with respect to its investment in B Corp. The loss on investment in E Corp. is caused by mere fluctuation in the market, and, hence, not deductible. 

Capital losses are subject to rules on capital gains and losses.

Other Losses 

1. Abandonment losses in petroleum operation and producing well. 
2. Losses due to voluntary removal of building incident to renewal or replacements are deductible from gross income. 
3. Loss of useful value of capital assets due to charges in business conditions is deductible only to the extent of actual loss sustained (after adjustment for improvement, depreciation and salvage value) 
4. Losses from sales or exchanges of property between related taxpayers are not recognized, but the gains are taxable. 
5. Losses of farmers incurred in the operation of farm business are deductible. 

Note that there are certain non-deductible losses.

Net Operating Loss Carry Over 

Net operating loss (NOL) is the excess of allowable deductions over gross income for any taxable year immediately preceding the current taxable year. 

NOL may be carried over as deductions from gross income for the next three consecutive years immediately following the year of such loss. This is known as Net Operating Loss Carry-Over (NOLCO). 

Year	1	2	3	4
Gross Income	P500	600	700	800
Less: Deductions	900	500	500	600
Taxable Income (Net Operating Loss)	(400)	100	200	200
Less: Net Operating Loss Carry Over		(400)	(300)	(100)
Taxable Income (Net Loss)	(400)	(300)	(100)	100

Note that NOLCO is different from Net Capital Loss Carry Over.

Who are entitled

Taxpayers entitled to NOLCO are

1. Individuals engaged in trade or business or in the exercise of his profession (including estates and trusts);
2. Domestic and resident foreign corporations subject to the regular income tax or preferential tax rates. 

When not allowed

It shall not be allowed in the following circumstances:

1. A taxpayer who claims the OSD cannot simultaneously claim deduction of the NOLCO. But the three-year reglementary period shall continue to run. 
2. Net loss incurred during which the taxpayer was exempt from income tax shall be not allowed to deduct NOLCO.
3. There has been substantial change in the ownership of the business or enterprise. 

There is no substantial change in the ownership of the business or enterprise in that not less than 75% in nominal value of outstanding issued shares is held by or on behalf of the same persons; not less than 75% of the paid up capital of the corporation is held by or on behalf of the same persons.

NOLCO from 2020 and 2021 can be carried over for the next 5 years

Pursuant to Section 4 (bbbb) of Bayanihan II and as implemented under RR No. 25-2020, the net operating loss of a business or enterprise incurred for the taxable years 2020 and 2021 can be carried over as a deduction from gross income for the next five (5) consecutive taxable years following the year of such loss. 

Bad debts

Means uncollectible accounts receivable of the taxpayer actually ascertained to be worthless and is charged within the taxable year and must be connected with the exercise of a profession, trade, or business. 

A debt is worthless when after taking reasonable steps to collect it, there is no likelihood of recovery at any time in the future. 

Requisites for deductibility 

Bad debts are deductible if the following requisites are present:

1. Valid and legally demandable debt due to the taxpayer
2. Debt is connected with the taxpayer's trade, business or practice of a profession;
3. Debt was not sustained in a transaction entered into between related parties;
4. Actually ascertained to be worthless and uncollectible as of the end of the taxable year (taxpayer had determined with a reasonable degree of certainty that the claim could not be collected despite the fact that the creditor took reasonable steps to collect); and
5. Actually charged off the books of accounts of the taxpayer as of the end of the taxable year

Special Rule on Write-Off

Banks as creditors – BSP Monetary Board shall ascertain the worthlessness and uncollectibility of the debt and shall approve the writing off 

Receivables from an insurance or surety company (as debtor) may be written off as bad debts only when such company is declared closed due to insolvency or similar reason 

Tax Benefit Rule

Bad debts claimed as deduction in the preceding year(s) but subsequently recovered shall be included as part of the taxpayer‘s gross income in the year of such recovery the extent of the income tax benefit of said deduction. Also called the equitable doctrine of tax benefit. 

Depreciation

Depreciation pertains to an annual reasonable allowance to reduce the wasteful value of the tangible fixed assets resulting from wear and tear and normal obsolescence. 

For intangible assets, the annual allowance to reduce their useful value is called amortization. 

Requisites for deductibility 

To be deductible, the following requisites must be present:

1.  It must be reasonable.
2. It must be charged off during the year.
3. The asset must be used in profession, trade or business.
4. The asset must have a limited useful life.

Start. The depreciation of an asset begins when it is available for use.

Depreciation continues even if the asset becomes idle or is retired from active use, unless the asset is fully depreciated. 

Depreciation is recognized even if the fair value of the asset exceeds its carrying amount, as long as its residual value does not exceed its carrying amount.

End. Depreciation of an asset ceases at the earlier of the date that the asset is derecognized or the date that the asset is reclassified as held for sale.

Depreciation also ceases when an asset previously leased out is transferred to inventory that is held for sale on a routine basis.

Depreciable Vehicle

Only one vehicle for land transport is allowed for the use of an official or employee, the value of which shall not exceed P2,400,000.

No depreciation shall be allowed for yachts, helicopters, airplanes and/or aircrafts, and land vehicles that exceed the threshold amount of P2,400,000, unless the taxpayer’s main line of business is transport operations or lease of transportation equipment and the vehicles purchased are used in the operations.

All maintenance expenses on account of non-depreciable vehicles for taxation purposes are disallowed in their entirety. This is one of the non-deductible expenses.

Charitable and other contributions

Charitable and other contributions may be deductible in full or subject to statutory limitations:

Deductible in Full

Donations to the Government of the Philippines, or to any of its agencies, or political subdivisions, including fully-owned government corporations exclusively to finance, provide for, or to be used in undertaking priority activities in 

1. Education, 
2. Health, 
3. Youth and Sports Development, 
4. Human Settlements, Science, and Culture, and 
5. Economic Development, 

in accordance with a National Priority Plan determined by NEDA (otherwise, subject to statutory limit)

Donations to Certain Foreign Institutions or International Organizations which are fully deductible in compliance with agreements, treaties or commitments entered into by the Government of the Philippines and the foreign institutions or international organizations or in pursuance of special laws

Donations to Accredited Non-government Organizations subject to conditions set forth in RR No. 13-98:

1. NGO means a non-stock non-profit domestic corporation or organization organized and operated exclusively for scientific, research, educational, character-building and youth and sports development, health, social welfare, cultural or charitable purposes, or a combination thereof.
2. No part of the net income of which inures to the benefit of any private individual
3. Directly utilizes contributions for the active conduct of the activities constituting the purpose or function for which it is organized, not later than 15th day of the month following the close of its taxable year in which contributions are received, unless an extended period is granted by the Secretary of Finance, upon recommendation of the CIR
4. Administrative expense, on an annual basis, must not exceed 30% of total expenses for the taxable year
5. Upon dissolution, its assets would be distributed to another accredited NGO organized for a similar purpose or purposes, OR to the State for public purpose, OR would be distributed by a competent court of justice to another accredited NGO to be used in such manner as in the judgment of said court shall best accomplish the general purpose for which the dissolved organization was organized.

Subject to Limit

The following are subject to limit of 10% in case of individual and 5% in case of corporation. The limit is based on the taxpayer's/donor’s income derived from trade, business, or profession computed before the deduction for contributions and donations:

1. Government or any of its agencies or political subdivisions exclusively for public purposes (contributions for non-priority activities)
2. Accredited domestic corporation or associations organized exclusively for Religious, Charitable, Scientific, youth and sports development, cultural, educational purposes, or rehabilitation of veterans, Social welfare institutions, Non-government organizations. No part of the net income of which inures to the benefit of any private stockholder or individual

Illustration 

W Corp. made donations amounting to P500,000 to a religious institution. In 2020, its gross income amounted to P1,000,000 and allowable deductions excluding the donations, P600,000. Compute W’s Taxable Income. 

Gross Income	P1,000,000
Allowable Deductions (excluding charitable contributions)	(600,000)
Income before contributions	400,000
Less: Charitable contributions, Actual P500,000; Limit 400,000 x 5% = P20,000 (since the donor is a corporation, the contribution is subject to 5% limit)	(20,000)
Taxable Income	380,000

Research and Development 

Research and development can be treated as follows:

1. Ordinary and necessary expenses which are not chargeable to capital account 
2. Deferred expenses, which is chargeable to capital account 

Requisites for Deductibility 

As Ordinary and Necessary Expenses

1. Paid or incurred by the taxpayer during the taxable year
2. In connection with his trade, business, or profession and
3. The expenditures so treated shall be allowed as deduction during the taxable year when paid or incurred

As Capital Expenditures

1. Paid or incurred by the taxpayer in connection with his trade, business, or profession
2. Not treated as expenses
3. Chargeable to capital account but not chargeable to property of a character which is subject to depreciation or depletion.

Pension trust 

Contribution to a pension trust may be for the present service cost or past service cost. Present service cost is deductible in full while past service cost should be amortized for a period of ten years. 

Requisites for Deductibility 

In any case, to be deductible, the contributions must comply with the following requisite:

1. There must be a pension or retirement plan established to provide for the payment of reasonable pensions to employees;
2. The pension plan is reasonable and actuarially sound;
3. It must be funded by the employer;
4. The amount contributed must no longer be subject to the employer’s control or disposition; and
5. The payment has not theretofore been allowed before as a deduction.

Illustration 

A Corp. established a pension plan in 2019. It makes a lump sum payment in the amount of P5,000,000 to cover for services of employees before the establishment of the said plan and contribution every year of P200,000 beginning 2019. How much are deductible contributions to pension trust?

Past service cost (P5,000,000/10 years; the company makes a lump sum payment in the amount of P5,000,000 to cover for services of employees before the establishment of the pension plan)	P500,000
Present service cost (this refers to the yearly contribution of P200,000 beginning 2019)	200,000
Total allowed deductions	P700,000

Optional Standards Deduction

In lieu of the itemized deductions, the taxpayer may instead avail of the Optional Standard Deduction (OSD). OSD does not relate to any particular item.

Requisites for Deductibility 

1. The taxpayer must signify his intention to avail OSD, otherwise, he is considered as having availed of the itemized deductions. Such an election is irrevocable for the taxable year.
2. The taxpayer shall keep such records pertaining to his gross sales/receipts or gross income.

Documentation 

OSD does not require documentation. Individual availing OSD is not required to submit with his tax return such financial statements.

Amount Deductible 

For individual taxpayers, OSD is 40% of gross sales or gross receipts except for NRAETB, NRANETB, and earning purely compensation income. The base is gross sales if the individual uses an accrual basis; gross receipts if cash basis. The cost of sales/service is not deducted for the purposes of determining the basis of the OSD.

For corporations, OSD is 40% of gross income except for non-resident foreign corporations. Gross income shall mean gross sales less sales return, discounts, and allowances, and cost of goods sold.

Items not Deductible

The following cannot be deducted from gross income:

1. Personal, living, or family expenses
2. Capital expenditures 
3. Premiums paid on any life insurance policy covering the life of any officer, employee, or any person financially interested in the trade or business carried on by the taxpayer, individual or corporate, when the taxpayer is directly or indirectly a beneficiary under such policy
4. Non-deductible interest
5. Nondeductible taxes
6. Non-deductible losses
7. Non-deductible expenses

Illustration 

Mr. W had the following business expenses and losses in 2020. 

• Salary of employees, P12,000
• Police Protection, P20,000
• Interest expense paid to his father, P10,000
• Gifts made to employees during birthday, P5,000
• Capital loss, P4,000

How much are the nondeductible expenses and losses?

Police Protection	P20,000	Bribes, Kickbacks, and Other Similar Payments are non-deductible.
Interest expense paid to his father	10,000	Interest payments made between related parties are non-deductible.
Gifts made to employees during birthday	5,000	Personal expenses are non-deductible.
Capital loss	4,000	Capital loss can be deducted only to the extent of capital gain.
Total	P39,000

Capital expenditures 

Property, Plant, and Equipment 

Any amount paid out for new buildings or for permanent improvements (capital expenditures), or betterments made to increase the value of any property or estate

Any amount expended in restoring property (major repairs) or in making good the exhaustion thereof for which an allowance for depreciation or depletion is or has been made

Extraordinary Expenses

The media advertising expenses which were found to be inordinately large and thus, not ordinary, and which were incurred in order to protect the taxpayer’s brand franchise which is analogous to the maintenance of goodwill or title to one’s property, are not ordinary and necessary expenses but are capital expenditures, which should be spread out over a reasonable period of time. CIR v. General Foods Phils. Inc, G.R. No. 143672 (2003)

Organization and Pre-operating Expenses

These are considered as capital expenditures and are therefore, not deductible in the year they are paid or incurred. But taxpayers who incur these expenses and subsequently enter the trade or business to which the expenditures relate can elect to amortize these expenditures over a period not less than sixty (60) months. [BIR Ruling 102-97, Sept. 29, 1997]

Premiums paid on any life insurance policy covering the life of any officer, employee, or any person financially interested in the trade or business carried on by the taxpayer, individual or corporate, when the taxpayer is directly or indirectly a beneficiary under such policy

Non-deductible interest

Nondeductible Taxes 

The following taxes are considered items not deductible from gross income.  

1. Philippine income tax, except the fringe benefit tax
2. Income tax imposed by the authority of any foreign country, if the taxpayer claimed credit for such tax in the year it was paid or incurred.
3. Estate and donor’s taxes
4. Special assessments and other taxes assessed against local benefits of a kind tending to increase the value of the property assessed
5. Value Added Tax
6. Fines and penalties due to late payment of tax
7. Final taxes
8. Capital Gains Tax

Refunds of nondeductible taxes are not to be included in the computation of gross income because these are not deductible from gross income in the first place.

Non-deductible Losses

The following losses are considered items not deductible from gross income:

1. Ordinary losses compensated by the insurance or other forms of indemnity 
2. Ordinary Losses already claimed as deduction for estate tax purposes 
3. Losses incurred not in trade, profession, or business
4. Losses from illegal transactions
5. No loss is sustained by the transfer of property by gift or death 
6. NOLCO if during the taxable year the taxpayer is exempt 
7. NOLCO if there has been substantial change in ownership 
8. Wagering losses beyond the wagering gain 
9. Capital losses from sale or exchange in excess of the capital gains 
10. Losses from sales or exchanges of property incurred between related taxpayers
11. Loss on wash sales of stock or securities 
12. Losses incurred in exchange of property pursuant of a plan of merger or consolidation where no gains are recognized either.

Wash Sale

Wash Sale refers to a sale or other disposition of stock or securities where substantially identical securities (substantially the same as those disposed of) are acquired or purchased (or there was an option to acquire, and the acquisition or option should be by purchase or exchange upon which gain or loss is recognized under the income tax law) within a 61-day period, beginning 30 days before the sale and ending 30 days after the sale.

Wagering Losses 

Losses from wagering (gambling) are deductible only to the extent of gains from such transactions. A wager is made when the outcome depends upon chance.

Non-deductible expenses

Deductions from Gross Income / Items not Deductible / Non-deductible Expenses

The following expenses or payments are considered items not deductible from gross income.

Bribes, Kickbacks, and Other Similar Payments. No deduction from gross income shall be allowed by way of ordinary and necessary expenses for any payments made directly or indirectly to the following if the payment constitutes a bribe or kickback:

1. An official or employee of the national government 
2. An official or employee of any local government unit 
3. An official or employee of a GOCC
4. An official or employee or representative of a foreign government 
5. A private corporation 
6. General professional partnership 
7. Similar entity

Political Campaign Expenses. The amount expended for political campaign purposes or payments to campaign funds are NOT deductible either as business expenses or as contribution [CTA Case No. 695, April 30, 1969, citing Mertens] 

All maintenance expenses on account of non-depreciable vehicles for taxation purposes are disallowed in their entirety.