CONTINUATION OF PRINCIPLES OF DEDUCTIONS

REGULAR ALLOWABLE ITEMIZED DEDUCTIONS

Itemized Deductions From Gross Income

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

If not directly connected with the selling of goods or rendering of services, these items of expenses
are classified as “Regular allowable itemized deductions”.

1. INTEREST EXPENSE
Requisites on the deductibility of interest (RR13-2000):
1. There must be a valid indebtedness.
2. The indebtedness must be that of the taxpayer.
3. The indebtedness must be connected with the taxpayer‘s trade, business or exercise of profession.
4. Interest expense must have been paid or incurred during the taxable year.
5. Interest must have been stipulated in writing.
6. Interest must be legally due.
7. Interest payments must not be between related taxpayers.
8. Interest must not be incurred to finance petroleum operations.
9. In case of interest incurred in the acquisition of property, used in trade, business or profession, the
same is not treated as a capital expenditure.
10. The interest is not expressly disallowed by law to be deducted from gross income of the taxpayer.

Deductible amount of interest expense

The deductible amount of interest expense is the gross interest expense reduced by the following
percentage of the interest income:
 Effectivity Percentage
January 1, 1998 41%
January 1, 1999 39%
January 1, 2000 38%
November 1, 2005 42%
January 1, 2009 33%

This percentage is referred to as the arbitrage limit or the arbitrage cap.

Illustration
A taxpayer incurred an interest expense of P100,000 and earned P10,000 interest income during the
year.

The deductible interest expense shall be computed as:

Gross interest expense P100,000
Less: Arbitrage limit (P10,000 x 33%) ( 3,300)
Deductible interest expense P 96,700

Rationale of the arbitrage limit

The limit is intended to recover the tax savings of taxpayers who take advantage of higher regular tax
savings created from interest expense deduction and a lower final tax on deposit interest income.

Illustration: The Interest Arbitrage Scheme

A corporation taxpayer which is subject to 30% regular corporate income tax borrowed P1,000,000
from a bank which charges 6% interest and invested the same proceeds to a 6% time deposit in the
same bank.

The following table summarizes the effect of the interest arbitrage within a year:
Bank loan P1,000,000
Interest expense 60,000

Bank deposits 1,000,000

Interest income 60,000
Without an interest expense deduction limit, the financial effect of this scheme can be analysed as
follows:

Net interest income 60,000 x (100%-20% final tax) P 48,000

Payment of interest expense to the bank ( 60,000)
Tax savings from interest expense (60,000x30%) 18,000
Financial tax savings from the arbitrage P 6,000

This will motivate taxpayers to enter into unnecessary loan-and-deposit transactions to save from total
income tax.

Determination of the Arbitrage Limit

To eliminate the arbitrage savings, a deduction cap was set which was mathematically computed as:
(Corporate income tax rate – final tax on interest income)
Corporate Income Tax Rate

Optional treatment of interest expense

Interest incurred in financing, the acquisition of property used in trade or business, may, at the option
of the taxpayer, be claimed as:
1. an outright deduction from gross income or
2. a capital expenditure claimable through depreciation

2. TAXES
Taxes paid or incurred within the taxable year in connection with the taxpayer’s trade, business or
exercise of profession shall be allowed as deduction except:
1. Philippine income taxes except fringe benefit tax
a. Final income tax
b. Capital gains tax
c. Regular income tax
2. Foreign income tax, if claimed as tax credit
3. Estate tax and donor’s tax
4. Special assessment

Other non-deductible taxes

1. Business taxes, in particular the Value Added Tax (VAT)
2. Surcharges or penalties on delinquent taxes
Examples of deductible taxes:
1. Percentage tax
2. Excise tax
3. Documentary stamp tax
4. Occupational tax
5. License tax
6. Fringe Benefit tax
7. Local taxes except special assessment
8. Community tax
9. Municipal tax
10. Foreign income tax if not claimed as tax credit
Only basic tax is deductible
Only the basic tax is allowable as deduction. Tax surcharges for late payments are avoidable and
unnecessary expenses; hence, they are non-deductible. Moreover, allowing these as deduction will
relax policy on tax collection. Nevertheless, interest for late payment of tax was held deductible by
the Supreme Court but as interest expense rather than as tax expense.

Foreign Income Tax

Income taxes paid in a foreign country can either be claimed as:
1. Deduction
2. Tax credit

Illustration 1: One foreign country

A domestic corporation reported the following result of operations:
Taxable income from the Philippines P1,800,000
Taxable income from Japan 1,200,000
Quarterly estimated income tax paid in the Philippines 200,000
Income tax paid in Japan 300,000

Deduction approach
The taxable income and income tax liability will simply be computed as follows:
Taxable income from the Philippines P 1,800,000
Taxable income from Japan 1,200,000
Total P 3,000,000
Less: Foreign income tax expense 300,000
Taxable income- world P 2,700,000
Multiply by: Corporate tax rate 30%
 Corporate income tax due P 810,000
Less: Philippines quarterly estimated tax payments 200,000
Income Tax Payable P 610,000

Note: Under the deduction approach, the foreign taxes paid are deducted but will not be
claimed as tax credit.

Tax Credit Approach

Taxable income from the Philippines P1,800,000
Taxable income from Japan 1,200,000
Taxable income- world P3,000,000
Multiply by: Corporate tax rate 30%
Corporate world income tax due P 900,000
Less: Tax credit
Philippine income tax credit P200,000
Foreign tax credit * 300,000 500,000
Income tax payable P 400,000

Note: Under the tax credit approach, the foreign taxes paid are not deducted against gross income but
are credited against the income tax due on world taxable income.

Determination of Foreign Tax Credit: One foreign country*

The foreign tax credit shall be the lower of the actual foreign income tax paid and the following limit:
Foreign taxable income X Philippine income tax due
World taxable income
Hence,
Actual foreign income tax paid P300,000
Limit: (1,200,000/3,000,000) x P900,000) P360,000

Foreign tax credit- LOWER P300,000

Illustration 2: More than one foreign country
A domestic corporation had the following data on its Philippine and foreign operations:
Taxable income in the Philippines P1,800,000
Taxable income from Japan 1,200,000
Taxable income from Taiwan 1,000,000
Taxable income- World Income P4,000,000
Multiply by: 30%
Corporate income tax due P1,200,000
Less: Tax credit
Philippine Income Tax Credit P300,000
Foreign tax credit* 560,000 860,000
Income tax still due P 340,000

Determination of Foreign Tax Credit: With multiple foreign countries*

The final foreign tax credit shall be the lower of the total of the tax credit allowable per country and
the world income tax credit limit computed as follows:
Total foreign taxable income x Philippine income tax due
World taxable income

Per country tax credit:

Japan:
Actual amount paid P400,000
Country limit: (P1.2M/4M x P1.2M) 360,000
Lower amount P360,000

Taiwan
Actual amount paid P200,000
Country limit: (P1.0M/4M x P1.2 M) 300,000
Lower amount P200,000

Japan allowable tax credit P360,000

Taiwan allowable tax credit 200,000
Total tax credit allowable per country P560,000
World tax credit limit:
[(1.2M + 1.0M)/4.0M x P1.2M tax due] 660,000
Foreign income tax credit (LOWER) P560,000
Who can claim tax credit or deduction for foreign taxes paid?
Consistent with the matching rule, only taxpayers taxable on world income such as domestic
corporations and resident citizens can claim deduction or tax credit for foreign income taxes paid.

Tax treatment of refunds or credit of taxes

The refund or credit of deductible taxes must be reverted back to gross income to the extent of their
tax benefit. Incidentally, the refund of non-deductible taxes is exempt from income tax.

3. LOSSES
Losses actually sustained during the taxable year and not compensated by insurance or other
indemnity shall be allowed as deductions.

Types of losses
1. Ordinary loss
2. Capital loss

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

4. BAD DEBTS
Bad debts refer to debts due to the taxpayer which were actually ascertained to be worthless and were
charged off within the taxable year. The accounting bad debt expense called “estimated bad debt
expense” is not deductible in taxation because it is a mere estimate rather than an actual loss. The
deductible bad debt expense pertains to the write-off of uncollectible receivables after having been
actually ascertained to be worthless.

Subsequent recovery of bad debts

Under the NIRC, the recovery of bad debts previously allowed as a deduction in the preceding years
shall be included as part of the gross income in the year of recovery to the extent of the income tax
benefit of said deduction.

Subsequent change in accounting methods

Bad debts expense sustained by the taxpayer under the cash basis of accounting should not be
deducted even if the taxpayer subsequently changed its accounting method to the accrual basis of
accounting. What cannot be done directly cannot be done indirectly.

5. DEPRECIATION
There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion and
wear and tear of property used in the trade or business.

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

Stages of wasting activities:

1. Exploration period – involves ascertaining the existence, location, extent or quality of any deposit
or mineral.
2. Development period – commences when deposits of ore or minerals are shown to exist in sufficient
commercial quantity.
3. Commercial production – stage of actual extraction, processing and sale.

Common rules for both mining and oil operations

Taxpayers engaged in wasting assets shall classify their expenditures into:
1. Costs of acquisition or improvement of tangible properties
2. Intangible exploration, drilling and development costs

Treatment of tangible development costs

Tangible development costs include the acquisition or improvement of tangible property which are of
a character subject to the allowance for depreciation. This may include construction of mine-plant
roads, buildings, processing plants and installation of heavy equipment on-site.

Tangible exploration and development drilling costs are capitalized and deducted through allowance
for depreciation subject to the following rules:
1. Petroleum operations
Properties directly used in petroleum operations
The NIRC prescribes either the straight line method or declining-balance method at the option of the
taxpayer for properties directly related to the production of petroleum. A shift from the straight line
method to declining balance method is allowed. The useful life shall be 10 years or such shorter life as
may be permitted by the CIR.

Properties not used directly in petroleum operations

The NIRC prescribed the straight line method on the basis of an estimated useful life of 5 years.

2. Mining Operations
If the expected life of the property used in mining is 10 years or less, the taxpayer can use the normal
rate of depreciation. If the expected life is more than 10 years, the property can be depreciated over
any number of years between 5 years and 10 years. (Sec. 34(E)(5), NIRC)

Intangible exploration and development costs

Intangible costs in petroleum operations include any incidental and necessary costs of drilling wells or
preparing wells for petroleum production and which have no salvage value.

Intangible costs in mining operations include the costs of diamond drilling, tunnelling, and other
improvements of a nature that is not subject to allowance for depreciation.

Tax treatment of intangible exploration and development costs

A. Before commercial production — capitalized as cost of the wasting asset
B. After commencement of commercial production, if incurred with:
1. Non-producing wells or mines, deducted in the period paid or incurred
2. Producing wells or mines, at the option of the taxpayer, either:
a. Capitalized and amortized using the cost-depletion method
b. Deducted in the year paid or incurred

7. CHARITABLE AND OTHER CONTRIBUTIONS

Contributions or gifts made to the government or non-government organizations (NGOs) may be
deducted against gross income.

Donations that fail any of the requisites are non-deductible. Those that meet the requisites are either:
a. Fully deductible
b. Partially deductible (deductible subject to limit)
Classification of contributions
A. Fully deductible contributions (Mnemonics: PTA)
1. Donations to the government or political subdivisions including fully owned government and
controlled corporations to be used exclusively in undertaking priority activities as determined by the
National Economic Development Authority (NEDA) in:
a. Education d. Human settlements
b. Health e. Culture and sports
c. Youth and sports development f. Economic developments

2. Donation to foreign institution or international organization in pursuance of, or in compliance with

agreements, treaties or special laws.
Note that this is an exception to the rule that the donee institution must be a domestic organization.

3. Donations to accredited domestic non-government organizations.

Pursuant to E0 671, the NGO must be an accredited donee institution with certifications issued by the
following designated accrediting entities:
a. Department of Social Welfare and Development - for charitable and or social welfare organizations,
foundations and associations
b. Department of Science and Technology - for research and other scientific activities
c. Philippine Sports Commission - for sports development
d. National Council for Culture and Arts - for cultural activities
e. Commission on Higher Education — for educational activities

Requisites for deductibility of contributions to accredited NGOS

1. The NGO must be organized and operated exclusively for the above purposes, and no income
inures to the benefit of any private individuals.
2. The non-profit organization makes utilization of the contribution not later than the 15th day of the
third month after the close of its taxable period.
3. The administrative expenses of the NGO do not exceed 30% of its total expenses.
4. Members of the Board of Trustees must not receive remunerations.
5. In the event of liquidation, the asset of the NGO will be distributed to nonprofit domestic
corporation organized for similar purpose.
6. The amount of contribution of property other than money must be valued at acquisition cost.

B. Contributions subject to limit

1, Donations to the Government of the Philippines or political subdivisions exclusively for public
purposes not in accordance with priority activities
2. Donation to non-accredited non-government organizations or to domestic corporations organized
exclusively for the following purposes:
a. Religious e. Cultural
b. Charitable f. Educational
c. Scientific g. Rehabilitation of veterans
d. Youth and sports development h. Social welfare

Limit of deduction for contributions:

Based on the taxable income derived from trade, business or profession before the deduction of any
contributions
1. 10% for individuals
2. 5% for corporations

Illustration 1
Mr. Sagyaya, a practicing accountant, had the following income and the year:
Professional fees P 1,100,000
Donations to government priority activities 100,000
Donations pursuant to treaties 30,000
Donations to accredited charitable institutions 50,000
Donations to the government for public purpose 80,000
Donations to non-accredited charitable institutions 60,000
Donations to a foreign charitable institution 40,000
Donations to street beggars 50,000
Other deductible business expenses 600,000
The deductible contribution expense shall be computed as follows
Fully deductible contributions:
To government priority activities P 100.000
To accredited charitable institutions 50,000
To treaty-covered entities 30,000 P180,000

Partially deductible contributions:

To government non-priority activities P 80,000
To non-accredited charitable institutions 60,000
Total contributions subject to limit P140,000
Deduction limit P 50,000
Deductible contributions with limit (LOWER) 50,000
Total deductible contribution expense P230,000
The deduction limit for partially deductible contributions is computed as follow.
Professional fees P100,000
Less: Other deductions before contribution 600,000
Net income before contributions P500,000
Multiply by: individual limit percentage 10%
Deduction limit P 50,000

Note:
1. The donation to a foreign institution is not deductible unless in accordance with treaties.
2. The donation to beggars is not made to a domestic organization; hence, it is not deductible.
3. Contributions to non-qualified donee institutions are not deductible against gross income and are
subject to donor’s tax. )

9. RESEARCH AND DEVELOPMENT (R&D) COSTS

Research activities are geared towards discovery of new knowledge. Development activities are
geared towards determining application of research knowledge which could provide income and
benefits for the business.

Tax Treatment of R&D Costs

1. Research and Development Costs related to capital accounts such as property used in business are
capitalized as part of the cost of the property and deducted through depreciation expense.
2. Research and development costs not related to capital accounts are treated as follows at the option
of the taxpayer:
a. Outright expense or
b. Deferred expense amortized over a period not less than 60 months beginning from the
month the taxpayer realize benefits from the R&D expenditures

10. EXPENSES IN GENERAL

Other legal, ordinary, actual and necessary expenses of business can be claimed by the taxpayers as
long as there are substantiated with official receipts or other pertinent records.

Examples of other deductible expenses

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