DEDUCTIONS

DEDUCTIONS: are the amounts which the laws allow to be deducted from gross income to arrive at taxable income.

Burden of Proof: is with the taxpayer to establish the validity of the deductions claimed. He must point to some specific provisions of the statute in which that
deduction is authorized, and must be able to prove that he is entitled to deduction which the law allows.

Nature: deductions partake of the nature of tax exemptions and as such, they are to be construed strictissimi juris against the taxpayer.

A. OPTIONAL STANDARD DEDUCTION

As discussed under Tax on Individuals, the Optional Standard Deduction (OSD) is 40% of Gross Income and in lieu of the itemized deductions.

OSD for individuals are in all respects similar to the OSD available to an individual earning business income or income from profession, EXCEPT that the basis
of the 40% OSD is the gross income, which is net of the cost of sales or services (similar to MCIT), while for individuals, the basis is gross sales or receipts,
before any such costs.

Likewise, Gross Income for OSD purposes does not include income items which have been already subjected to Final Tax or Capital Gains Tax.

Election of the OSD must be communicated in the 1st quarter return. Meaning, if the corporation used the OSD instead of the itemized deduction in its 1st quarter
return, it cannot later on used the itemized deductions for the Annual Income Tax Return. (RR No. 2-2010)

Applicability: the OSD is available to domestic corporations and resident foreign corporations only.

B. ITEMIZED DEDUCTIONS

General Requirements:
1. Should be ordinary and necessary expenses paid/incurred during the taxable year for the development, management, operation and/or conduct of the
trade, business or profession such as, salaries and other remuneration, travel expenses, rentals, and entertainment, amusement and recreation expenses
directly related to or in furtherance of trade. (Sec. 34[A][1] of the Tax Code);
2. Substantiated by Adequate Proof - documented by official receipts or adequate records which reflect the: (a) amount being deducted and (b) connection
or relation of expense to business/trade. (Sec. [34][A][1][b]);
3. Not contrary to law, morals, public policy or order (e.g., bribes, kickbacks or similar payments) (Sec. 34[A][1][c])
4. The taxes required to be withheld (if applicable) have been properly withheld and remitted on time (Sec. 34[K])

Note that under RR No. 12-2013, amending RR No. 2-98, any deduction which was not subjected to the required withholding tax shall be non-deductible
for income tax purposes, even if the amount of withholding tax is paid during or after an investigation. This rule, however, has been amended by RR No.
6-2018, which reinstated the old rule that a deduction will still be allowed in the following cases:
a. The payee reported the income and pays the tax due thereon and the withholding agent pays the tax including the interest incident to the failure to
withhold the tax, and surcharges, if applicable at the time of the audit/investigation or reinvestigation/reconsideration.
b. The recipient/payee failed to report the income on the due date thereof, but the withholding agent/taxpayer pays the tax, including the interest
incident to the failure to withhold the tax, and surcharges, if applicable at the time of the audit/investigation or reinvestigation/reconsideration.
c. The withholding agent erroneously under-withheld the tax but pays the difference between the correct amount and the amount of tax withheld
including the interest, incident to such error, and surcharges, if applicable, at the time of the audit/investigation or reinvestigation/reconsideration.

Items of deduction representing return of capital such as those pertaining to purchase of raw materials forming part of finished product or purchases of
goods for resale, shall be allowed as deductions upon withholding agent’s payment of the basic withholding tax and penalties incident to non-withholding
or under-withholding.

KINDS OF ITEMIZED DEDUCTIONS AND SPECIFIC RULES:

1. TRAVEL EXPENSES: include transportation expenses and meals and lodging paid by the employer. It also includes laundry and other incidental expenses
that are directly connected with the trip.

Requisites for deductibility:

a. It must be reasonable and necessary;
b. It must be incurred while away from home, here and abroad;
c. It must be paid or incurred in the conduct of trade or business.

The term “away from home” means away from the taxpayer’s employee’s place of employment regardless of where the family residence is maintained.

If an individual is not away from home, expenses related to business may nevertheless be claimed as transportation expenses.

2. RENTAL EXPENSES: a reasonable allowance for rentals and/or other payments which are required as a continued use or possession, for purposes of the
trade, business or profession, or property to which the taxpayer has not taken or is not taking title or in which he has no equity other than that of a lessee,
user or possessor.

3. ENTERTAINMENT, AMUSEMENT AND REPRESENTATION (EAR) EXPENSE:

Requisites for deductibility:

a. It must be directly connected to the development, management and operation of the trade, business or profession of the taxpayer; or directly related
to or in furtherance of the conduct of his or its trade, business or exercise of profession.
b. Not contrary to law, morals, good customs, public policy or public order;
c. It must not have been paid, directly or indirectly, to an official or employee if it constitutes a bribe, kickback, or other similar payment;
d. It must not exceed the prescribed ceiling.
 Ceiling on EAR Expense (RR No. 10-2002)
a. For taxpayers engaged in the sale of goods/properties – 0.50% of net sales (i.e., gross sales less sales returns/allowances and sales discounts)
b. For taxpayers engaged in the sale of services (including exercise of profession and use or lease of properties) – 1% of net revenues (i.e., gross
revenues less discounts)
c. For taxpayers engaged in both sale of goods/ properties and services - apportionment formula as follows:

Net Sales/Net Revenues

x EAR Expense
Total Net Sales and Net Revenues

Bribes, Kickbacks and Similar Payments: if the payment constitutes a bribe or kickback, it shall not be allowed as a deduction from gross income.
However, even if the same is not considered deductible, it shall form part of the recipient’s gross income.

4. INTERESTS (Sec. 34[B]): interest is defined as compensation for the use or forbearance or detention of money, regardless of the name it is called or
denominated. (RR No. 13-2000)

Requisites for Deductibility (Sec. 3 of RR No. 13-2000)

a. An indebtedness exists.
b. The interest has been paid or incurred.
c. The indebtedness must be that of the taxpayer.
d. The indebtedness is connected with the taxpayer’s trade, business or exercise of profession.
e. The interest was paid or incurred during the taxable year.
f. The interest is stipulated in writing.
g. The interest is legally due.
h. The indebtedness is not between related taxpayers*
i. The interest was not incurred to finance petroleum explorations.
j. If incurred on an indebtedness to acquire property, the interest was not treated as a capital expenditure.

*Related taxpayers: refer to the following:

a. between members of the family (brothers and sisters, spouse, ancestors and lineal descendants); or
b. between an individual and a corporation where the former owns, directly or indirectly, more than 50% of the outstanding capital stock of the latter;
c. between two corporations more than 50% in value of the outstanding stock of each 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, a personal holding company or a foreign personal holding company;
d. between the grantor and a fiduciary of any trust;
e. between the fiduciary of a trust and the fiduciary of another trust if the same person is a grantor with respect to each trust;
f. between a fiduciary of a trust and a beneficiary of such trust.

Tax Arbitrage; Limitations on Deductibility (Sec. 34[B][1])

The amount of deductible interest shall be reduced by an amount equal to 33% of interest income earned which had been subjected to final withholding
tax.

Illustration: X corporation earned P100,000 interest income from bank deposits subject to the 20% final tax and incurred P50,000 interest expense from
its loans.

The amount deductible shall be reduced by P33,000 (33% of the P100,000 interest income). Thus, the deductible interest expense shall only be P17,000.

OPTIONAL TREATMENT OF INTEREST EXPENSE (Sec. 34[B][3]

Interest incurred to acquire property used in trade or business may be:

i. Allowed as a deduction: the amount shall be treated as an outright expense;
ii. Treated as a capital expenditure: it shall form part of the acquisition cost of the asset and claimed as a deduction as part of the depreciation.

5. TAXES (Sec. 34[D])

DEDUCTIBLE: Taxes paid or incurred within the taxable year in connection with the taxpayer’s trade or business which are deductible for income tax
purposes, examples of which are:
a. Local business taxes;
b. Real property taxes;
c. License and permit fees;
d. Gross receipts tax for banks and financial institutions;
e. Percentage taxes;
f. Documentary stamp taxes.

VAT is not considered a tax incurred in connection with the taxpayer’s trade or business, since it is a tax on consumption. However, if the input VAT on
purchases is attributable to VAT-exempt sales, it shall form part of the cost or expense to which it is related and may thus be claimed as a deductible
expense for income tax purposes. The same is true with regards the excess of the input VAT attributable to sales to government or directly related thereto
over the standard input VAT.

NON-DEDUCTIBLE (Sec. 34[C][1][a to d]:

a. Philippine income tax
b. Foreign income tax, if taxpayer avails of the foreign tax credit
c. Estate and donor’s tax
d. Taxes assessed against local benefits of a kind that tends to increase the value of the property assessed
Surcharges and penalties arising from assessments: Sec. 80 of RR No. 2-40 states that as a general rule, taxes are deductible with the exception of
those with respect to which the law does not permit deduction. The word "taxes" means taxes, proper and no deduction should be allowed for amounts
representing interest, surcharge, or penalties incident to delinquency.

However, under Sec. 4(C) of RR No. 13-00, interest incurred or paid by the taxpayer on all unpaid business-related taxes shall be fully deductible from
gross income and shall not be subject to the limitation on deduction of interest expense. Thus, such interest expense incurred or paid shall not be diminished
by the percentage of interest income earned which had been subjected to final withholding tax.

▪ The interest on deficiency donor’s tax is deductible. The SC explained that taxes here are considered obligation or indebtedness. And it ruled that we
have to relax the distinction between tax and ordinary obligation in this respect.
▪ Interest on deficiency income tax can also be claimed as deductible interest expense because taxes here are considered ordinary obligations.

Tax Credit: resident citizens and domestic corporations are allowed a credit for taxed paid in foreign countries. Note that this is not allowed for non-
residents and alien individuals, as well as foreign corporations, since they are only taxable in their income from within the Philippines.

Limitations on allowable credit:

1. One foreign country:

Illustration: X Corporation, a domestic corporation, earned a net taxable income of P900,000 in the Philippines and a net taxable income of P600,000 in
Foreign Country Z which was subjected to a P40,000 income tax in Z.

The limit is P180,000, computed as follows:

Income tax liability = P450,000 (P1,500,000 * 30%)

Limit:

Net Income, abroad

x Income tax due = Limit
Net Income, world

Applying the above formula:

P600,000
x P450,000 = P180,000
P1,500,000

The allowable tax credit will be the actual amount paid or the limit, whichever is lower. Since the amount of tax paid in the foreign country (P40,000) is
less, X Corporation may claim the whole amount as tax credit against his Philippine income tax.

2. Two or more foreign countries:

Illustration: X Corporation earned a net taxable income of P300,000 in the Philippines, P200,000 in Foreign Country Y and P100,000 in Foreign Country
Z, where he paid P50,000 and P45,000, respectively. The tax credit limit against the P180,000 Philippine income tax shall be the lower of:

Income tax liability = P180,000 (P600,000 * 30%)

a. Limitation (a), per country:

Country Net Income Limit Paid Allowed

Y P200,000 200,000/600,000 * P50,000 P50,000
180,000 = 60,000

Z 100,000 100,000/600,000 * 45,000 30,000

180,000 = 30,000
PH 300,000
Total 600,000 P80,000

Under limit (a), the limit is computed on a per country basis, using the same formula as that used in a single country limit

b. Limitation (b), total:

Net Income, abroad

(all countries) x Income tax due = Limit
Net Income, world

Applying the above formula:

P300,000
x P180,000 = P90,000
P600,000

The limit computed above (under letter b) is then compared with the total amount paid, which is P95,000, the lower amount of P90,000
would then be limit b.

Limit a (P80,000) and b (P90,000) are then compared, and the limit of tax credit shall be whichever is lower between the two. In this case, the allowable
tax credit shall be the P80,000 computed under limitation (a).
Taxes as credit vis-à-vis as deduction:

TAX DEDUCTION TAX CREDIT

Deduction from gross income to arrive at
taxable income
Includes those taxes which are paid or
incurred in connection with the trade,
business or profession of the taxpayer.
The whole amount paid may be claimed as
deduction even beyond the gross income.
Deduction from tax due to arrive at tax still
payable
The sources of a tax credit include foreign
income tax paid, withholding taxes, prior year’s
excess credits, MCIT carry-over, etc.
The foreign income tax paid to the foreign
country is not always the amount that may be
claimed as tax credit because of the limitations
under the Tax Code.

6. LOSSES (Sec. 34[D])

REQUISITES FOR DEDUCTIBILITY:

a. Actually sustained and charged-off during the taxable year and not compensated for by insurance or other forms of indemnity
b. Incurred in trade, profession or business
c. Of property connected with the trade, business, or profession, if the loss arises from fires, storms, shipwreck or other casualties, or from robbery,
theft, or embezzlement.
d. Sustained in a closed and completed transaction

Insurance: insurance received as compensation for a loss must be subtracted in arriving at the amount of the loss. If the insurance proceeds exceed the
net book value of the damaged assets, such excess shall be subject to the regular income tax, but not to the VAT, since the indemnification is not an actual
sale of goods by the insured company to the insurance company. (RMO No. 31-09)

ILLUSTRATION: ABC Company’s machinery broke down due to floods that inundated its factory. The machinery costs P1,000,000 and at the time of
the flood, it had a carrying amount of P200,000, and a fair market value of P250,000.

How much is deductible loss? P200,000 – the carrying amount of the asset at the time of loss.

If ABC Company received P80,000 as compensation for such loss from insurance, how much is deductible loss? P120,000 – the portion reimbursed by
insurance is not deductible.

If ABC Company received P250,000 from the insurance company, how much is deductible loss? P0. Since the carrying amount (the amount of loss) is
fully compensated by the insurance proceeds. In fact, the excess of P50,000 is subject to regular corporate income tax.

Loss arising from casualty, robbery, theft or embezzlement: shall file a sworn declaration of loss to be filed within 45 days from the date of the event.
Failure to report a theft or robbery to the police can be held against the taxpayer. However, a mere report of an alleged theft or robbery to the police
authorities is not considered as conclusive proof of the loss arising therefrom. (RMO No. 31-09)

Casualty Loss: is one that has occurred in an identifiable event that was sudden, unexpected or unusual. Examples include loss caused by fire, unless
the taxpayer sets the fire, in which case no deduction is available.

The amount deductible shall be based on the following:

a. Total destruction – the net book value immediately preceding the casualty should be used as the basis in claiming losses, to be reduced by an amount
of insurance or compensation received;
b. Partial destruction – the replacement cost to restore the property back to its normal operating condition should be used but in no case shall be
deductible loss be more than the net book value of the property as a whole immediately before the casualty. The excess of the replacement cost over
the book value should be capitalized.

NET OPERATING LOSS CARRY-OVER

a. Net Operating Loss Carry-Over (NOLCO) is an item deductible from Gross Income to arrive at Taxable Income.
b. In a year where there is an operating loss, such operating loss can be carried-over to the next period as a deductible item from gross income.
c. The NOLCO may be carried over as a deduction from gross income for the next 3 consecutive taxable years immediately following the year of such
loss.
d. If the OSD is available, the taxpayer cannot simultaneously claim NOLCO. However, the 3 year period is not interrupted.
e. There must be no substantial change in ownership.
f. A corporation cannot enjoy the benefit of NOLCO for as long as it is subject to MCIT in any taxable year. The running of the three-year period for the
expiry of NOLCO is not interrupted by the fact that such corporation is subject to MCIT in any taxable year during such three-year period (Section 6.5,
Revenue Regulations No. 14-2001).

ILLUSTRATION: For 2016, X Company had gross income amounting to P200,000 and operating expenses amounting to P500,000.

In this case,
• X Company has a Net Operating Loss of P300,000
• This loss can be carried over and claimed as additional deduction in the next three consecutive taxable years, until 2019.
• If X Company avails of the OSD instead in 2017, it cannot claim as a deduction the P300,000 NOLCO. Same is true if in the next three years,
the Company is an MCIT position. Still, the expiration date of the NOLCO to be claimed as deduction remains to be 2019.

The following are not entitled to any deduction for NOLCO:

a. OBUs and FCDUs – for offshore income treated as exempt; and onshore income subject to 10% final tax;
b. Those registered with the BOI or PEZA enjoying Income Tax Holiday (ITH) – for the years covered by the ITH concerning only its registered activities.
c. SBMA registered enterprises
d. Foreign corporations engaged in international shipping or air carriage business in the Philippines;
 e. Any person enjoying exemption from income tax, with respect to its operation during the period for which the exemption is applicable.

Loss from wash sales of shares of stocks or securities: A taxpayer cannot deduct any loss claimed to have been sustained from the sale or other
disposition of stock, if, within a period beginning thirty (30) days before the date of such sale or disposition and ending thirty (30) days after such date
(referred to as the sixty-one (61)-day period), he has acquired (by purchase or by an exchange upon which the entire amount of gain or loss was recognized
by law), or has entered into a contract or option so to acquire, substantially identical stock.

However, this prohibition does not apply in the case of a dealer in stock if the sale or other disposition of stock is made in the ordinary course of the
business of such dealer. (Sec. 6[c.6] of RR No. 6-08)

Substantially identical: means that the stock must be of the same class, or in the case of bonds, the terms thereof must be the same.

Losses from wagering: deductible only to the extent of gains from wagering transactions and cannot be deducted from other gains or income items.
While gains from wagers are taxable in full.

Impairment: reduction in the value of assets through fluctuation of the market prices or otherwise, are not deductible for income tax, unless they are
actually disposed of, destroyed, or sold for less than their actual value.

7. BAD DEBTS (Sec. 34[E]): are those debts or receivables due to the taxpayer which are actually ascertained to be worthless and charged off within
the taxable year.

REQUISITES FOR DEDUCTIBILITY

a. There must be an existing indebtedness due to the taxpayer which must be valid and legally demandable;
b. The same must NOT be sustained in a transaction entered into between related parties enumerated under Section 36(B) of the Tax Code. (see related
parties under Interests)
c. The same must be connected with the taxpayer’s trade, business or practice of profession;
d. The same must be actually charged off the books of accounts of the taxpayer as of the end of the taxable year;
e. The same must be actually ascertained to be worthless and uncollectible as of the end of the taxable year , EXCEPT FOR BANKS where the Bangko
Sentral ng Pilipinas (BSP) shall ascertain the worthlessness and uncollectibility of the bad debts and shall approve the writing-off of said debts.

Currently, under BSP regulations, the BSP must be notified of the decision of the Board of Directors to declare receivables as worthless.

Worthless debts: the determination of whether a debt is worthless must be made by reference to all the pertinent evidence, including the general
financial condition of the debtor and whether the debt is secured by collateral. A receivable is deemed worthless if after taking reasonable steps to
collect the debt, there is no likelihood of recovery at anytime in the future.

It must be noted, however, that a collection suit need not be filed in court, it is sufficient that reasonable efforts were exerted to collect the debt, and
such efforts proved to be insignificant.

Recovery of bad debts previously written off: is taxable only if there was a previous benefit derived therefrom, i.e., it was previously claimed as a
deduction for income tax purposes. If there is no such deduction claimed, then subsequent recovery of a bad debt or uncollectible account is not taxable,
this is otherwise known as the tax benefit rule.

8. DEPRECIATION (Sec. 34[F]): is the gradual diminution in the useful value of the property used in the trade or business resulting from exhaustion, wear
and tear, and normal obsolescence.

REQUISITES FOR DEPRECIATION DEDUCTION

a. must be reasonable;
b. must be for property used or employed in the business, or temporarily not in use;
c. must be charged off during the taxable year

METHODS OF COMPUTING DEPRECIATION

a. Straight-line method
b. Declining-balance method
c. Sum-of-the-years digit method
d. Any other method which may be prescribed by the Secretary of Finance upon recommendation of the BIR

9. DEPLETION OF OIL AND GAS WELLS and MINES (Sec. 34[G]): depletion is the removal, extraction or exhaustion of a natural resource like mines and
gas wells as a result of production or severance from such mines or wells.

A REASONABLE ALLOWANCE FOR DEPLETION SHALL BE ALLOWED AS DEDUCTION:

a. for entities engaged in oil and gas wells or mines
b. under a cost depletion method
c. not permitted if depletion allowance has equaled the invested capital

10. CHARITABLE AND OTHER CONTRIBUTIONS (Sec. 34[H])

REQUISITES FOR DEDUCTIBILITY

a. Evidence or proof submitted to the BIR by showing the Certificate/s of Donation and indicating therein the following:
i. Actual receipt by the accredited non-stock, non-profit corporation/NGO of the donation or contribution and the date of receipt thereof; and
ii. The amount of the charitable donation or contribution, if in cash; if property, whether real or personal, the acquisition cost of the said property.
b. For donation worth over P 50,000, notice to the Revenue District Office is required and Certificate of Donation must be attached.

WHEN FULLY DEDUCTIBLE

Donations to the following shall be allowed FULL deductibility:
 a. Donations to the Philippine Government or to any of its agencies or political subdivisions, including fully-owned government corporations undertaking
priority activities;
b. Donations to foreign institutions or international organizations to whom the Philippine Government has treaties or commitments with or covered by
special laws;
c. Donations to the following:
i. National Museum, Library and Archives (P.D. 373)
ii. Development Academy of the Philippines (P.D. 205)
iii. Intramuros Administration (P.D. 1616)
iv. The Cultural Center of the Philippines
v. International Rice Research Institute
vi. Ministry of Youth & Sports Commission
vii. Museum of Philippine Costumes
viii. University of the Philippines and other state colleges and universities
ix. The Integrated Bar of the Philippines (P.D. 81)

WHEN DEDUCTIBILITY IS LIMITED

Donations to accredited non-stock, non-profit corporations shall be allowed LIMITED deductibility as follows:
a. For individual donor - not in excess of 10% of the donor’s income derived from trade, business or profession computed before the donation; and
b. For corporate donor - not in excess of 5% of the donor’s income derived from trade, business or profession computed before the donation;

Campaign Contributions: under RR No. 7-2011, the campaign contributions may be treated as a deductible item only if the same is declared in the Statement
of Expenditures submitted by the candidate to the COMELEC.

11. RESEARCH AND DEVELOPMENT (Sec. 34[I])

WHEN ALLOWED AS A DEDUCTION

a. if incurred in connection with the trade, business or profession of the taxpayer; and
b. if not charged to capital account

TREATMENT OF R&D AS DEFERRED EXPENSE

At the option of the taxpayer, R&D may be deferred and amortized over a period not less than 60 months if:
a. If paid or incurred in connection with trade, business or profession;
b. if not treated as expense; and
c. if chargeable to capital account not subject to depreciation

12. PENSIONS (Sec. 34[J])

LIMITATIONS ON DEDUCTIONS
Contribution made to a pension trust may be claimed as deduction in the following manner:
a. Amount contributed for the normal service cost – 100% deductible; and
b. Amount contributed for the past service cost – 1/10 of the amount contributed is deductible in year the contribution is made, the remaining balance
will be amortized equally over nine consecutive years

ILLUSTRATION: X Corporation established a pension trust for its employees. For the year 2016, the current service cost as determined by the actuary
amounted to P1M. X Corporation made a total of P1.2M as total contributions for the year.

In this case, the whole P1M will be considered as normal service cost; while the excess of P200,000 will considered for past service cost and shall be
amortized over a period of 10 years, thus, the amount deductible for past service cost is only P20,000 (P200,000/10 years). The total amount deductible
for pension cost is P1,020,000. The remaining P180,000 contributed during the year will be deductible for the succeeding 9 years at the rate of P20,000
annually.

REQUISITES FOR DEDUCTIBILITY OF PAYMENTS TO PENSION TRUSTS

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

13. SENIOR CITIZEN AND PWD DISCOUNT: the 20% discount granted to senior citizen shall not be deducted from the gross sales as are regular discounts,
but forms part of itemized deductions/operating expenses.

ITEMS NOT DEDUCTIBLE (Sec. 36)

a. Personal, living or family expenses

b. Payment for new buildings or for permanent improvement, or betterment made to increase the value of any property or estate (not applicable to intangible
drilling and development costs incurred in petroleum operations);
c. Expenses in restoring property or in making good the exhaustion thereof for which an allowance is or has been made;
d. Premium paid on any life insurance policy covering the life of any officer or employee, or of any person financially interested in any trade or business
carried on by the taxpayer, individual or corporation, when the taxpayer is directly or indirectly a beneficiary under such policy; and
e. Losses from sales or exchanges of property between related parties