CHAPTER 13 – PRINCIPLES OF DEDUCTIONS

General Principles of Deductions from Gross Income

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

2. Matching Principle

3. The related party rules

o In case of transactions between related parties, gains are taxable, but

losses are not deductible.

4. The withholding rules

o No deduction is allowed unless the withholding tax required by the law or

regulations to be withheld on the income payment (i.e., expense) is withheld and
remitted by the taxpayers to the government.

THE “LOAN” PRINCIPLE

o A deductible business expense is legitimate, ordinary, actual, and

necessary.

Characteristics of a Legitimate Business Expense

1. It is incurred in and for the current taxable period

2. It is not a capital expenditure

3. It pertains to business or profession of the taxpayer

4. It is not contrary to law, public policy, or morals

5. It is adequate substantiated with receipts or other documents.

What is ordinary and necessary expense?

o An expense is necessary if reasonable and essential to the development,

management, operation, or conduct of the trade, business or exercise of
profession of the taxpayer. It is "ordinary" when it is normal in relation to the
business of the taxpayer and the surrounding circumstances. (Atlas vs. CIR) An
expense is al said to be ordinary if it is normally incurred by other taxpayers
under the same line of business.

o A deductible expense must be both ordinary and necessary. An ordinary

business expense may still be disallowed by the BIR if unnecessary or
unnecessarily extravagant or unreasonable taking into consideration the context
of the expense and the nature of the taxpayer's business.
o An extraordinary expense is presumed incurred outside the business of the
taxpayer; hence, it is non-deductible. However, extraordinary expense may be
allowed if its connection and necessity to the business can be demonstrated by
the taxpayer

What is meant by actual expense?

o An expense is actual if it is paid or resulted to an incurrence of an

obligation to the taxpayer. In case of a loss, it must be sustained or realized by
the taxpayer in a dosed and completed transaction.

Meaning of "closed and completed transaction"

o A transaction is said to be closed and completed when no further

transaction emanates from its occurrence. In other words, no right of recourse
for indemnification or reimbursement from other parties exists.

o For example, a fire loss on insured property cannot be said to have been
sustained in a closed and completed transaction because its occurrence gives
rise to another. transaction, the claim for reimbursement. The loss is considered
incurred in a dosed and completed transaction only when final reimbursement is
received from the issuer.

o Furthermore, a loss on lawsuit cannot be said to have been sustained in a

closed and completed transaction until final judgment is rendered without
expectation of further appeal.