Module No.

11 – Principles of Deductions

Learning Outcome/s:
Familiarize and understand the general principles of deductions, the tax reporting of deductions, and the
modes of claiming deductions from gross income

Core Values/Biblical Principles:

The fear of the Lord is the beginning of wisdom, and the knowledge of the Holy One is insight. –
Proverbs 9:10 (ESV)

Introduction:
Deductions from gross income pertain to business expenses incurred by a taxpayer engaged in business
or engaged in the practice of profession.

Body:
Business expenses vs. Personal expenses
Business expenses – costs of doing trade, business, or practice of profession.
Personal expenses – include the living and family expenses of individual taxpayers.

The separation of the business expenses and the personal expenses of an individual income taxpayer is
important because only business expenses are deductible.

Business expenses vs. Business capital expenditures

Business expenses – benefit only the current accounting period.
Capital expenditures – benefit future accounting periods. They are initially recorded as assets upon
acquisition then later deducted against future gross income when used in the trade, business, or
profession.

Rules on deducting capital expenditures

1. Non-depreciable asset – cost is deducted against the selling price when sold.
2. Depreciable assets – the depreciable cost or acquisition costs (net of expected salvage value) is
allocated as deduction over the useful life of the property.

Depreciation methods
a. Straight line method – depreciable cost is spread equally over the useful life.

Illustration
On January 1, a taxpayer acquired a Php 6,000,000 building with Php 1,000,000 salvage
value at the end of its 5-year expected useful life.

Annual depreciation expense = (6,000,000 – 1,000,000) / 5 = Php 1,000,000

b. Sum-of-the-years-digit method – depreciation expense is computed as a fraction of the

remaining useful life over the total of the annual remaining useful life of the asset.

Illustration
A taxpayer bought a machine for Php 120,000. The machine is expected to be sold Php
20,000 net of selling expense after its 4-year estimated useful life.

Depreciable cost = 120,000 – 20,000 = Php 100,000

Divisor = N x (N + 1) = 4 x (4 + 1) = 10
2 2
 Depreciation expense Book value at year-end
st
1 year: 100,000 x 4/10 Php 40,000 Php 80,000
2nd year: 100,000 x 3/10 30,000 50,000
3rd year: 100,000 x 2/10 20,000 30,000
4th year: 100,000 x 1/10 10,000 20,000

c. Declining balance method (150% or 200%) – depreciation expense is computed by

multiplying the depreciation rate to the declining book value of the property. The salvage
value is initially ignored in computing depreciation expense but is considered in the terminal
year of the property.

Illustration
In January 1, a taxpayer purchased an equipment for Php 500,000 which is estimated to last
5 years with Php 50,000 salvage value.

Depreciation rate = 2/5 = 40%

Depreciation expense Book value at year-end
1st year: 500,000 x 40% Php 200,000 Php 300,000
2nd year: 300,000 x 40% 120,000 180,000
3rd year: 180,000 x 40% 72,000 108,000
4th year: 108,000 x 40% 43,200 64,800
5th year: 64,800 – 50,000 14,800 50,000

d. Other methods which may be prescribed by the Secretary of Finance upon recommendation
of the Commissioner of Internal Revenue

3. Intangible assets – amortizable intangible assets or those that lose their value over time should
be expensed over their legal life or expected usage life whichever is lower.

4. Inventory – costs are deducted when sold or used in the business using the inventory method or
the specific identification method with the aid of a point-of-sale (POS) machine.

Illustration
California Corporation had the following data pertaining to its inventory:
Gross purchases Php 2,500,000
In-transit freight and insurance 50,000
Purchase returns and discounts 100,000

The beginning and ending inventories during the year were Php 250,000 and Php 340,000,
respectively.

Beginning inventory Php 250,00

Add: Net purchases
Gross purchases Php 2,500,000
Add: Freight-in and insurance 50,000
Less: Purchase returns and discounts 100,000 2,450,000
Total goods available for sale Php 2,700,000
Less: Ending inventory 340,000
Cost of goods sold/Cost of sales Php 2,360,000

5. Prepaid expenses – deducted in the future period as they expire or as they are used in the
business or profession of the taxpayer.
 Illustration
In 2012, Zefra Inc. paid Php 300,000 as a three-year advanced rental for the lease of a building
to commence 2013 through 2015. To close the lease contract, Zefra also paid the lessor a lease
bonus of Php 30,000.

The Php 30,000 lease bonus is not an expense, but a prepayment that should be amortized
together with the Php 300,000 prepaid rentals. These should be amortized as Php 110,000
annual rent expense from 2013 to 2015.

Manufacturing expenses
Raw materials, beginning Php xxx
Add: Net purchases xxx
Raw materials available for use Php xxx
Less: Raw materials, ending xxx
Raw materials used Php xxx
Direct labor xxx
Factory overhead xxx
Total manufacturing costs Php xxx
Add: Cost of work in process, beginning xxx
Total cost of goods placed into process Php xxx
Less: Cost of work in process, ending xxx
Cost of goods manufactured Php xxx
Add: Cost of finished goods, beginning xxx
Total cost of goods available for sale Php xxx
Less: Cost of finished goods, ending xxx
Cost of goods sold Php xxx

Effect of value added tax on deductions

When purchases of goods or services are made from VAT suppliers, taxpayers will pay the VAT passed-
on by the supplier. To the seller’s perspective, this is called output VAT. To the buyer, it is called input
VAT.

Treatment of input VAT:

a. VAT taxpayer – input VAT is claimable as tax credit against output VAT hence, it is not claimable
as deduction.
b. Non-VAT taxpayer – input VAT is part of the costs of purchase or expense of the taxpayer hence,
it is claimable as deduction.

General principles of deductions from gross income

1. Expense must be legitimate, ordinary, actual, and necessary (LOAN)
2. Matching principle – only business expenses which contribute to or are incurred in connection
with the generation of income, gain, or profits subject to regular income tax are deductible.

Business expenses incurred to generate items of gross income that are either exempt or
excluded from taxation, subject to final tax or capital gains tax or to a special tax regime, must
not be matched or deducted against gross income subject to regular tax.

3. Related party rule – gains are taxable, but losses are not deductible. Further, transactions
between associated enterprises must be made at arm’s length.

Who are related parties?

a. Members of a family
b. Except in cases of distribution in liquidation, the direct or indirect controlling individual of a
corporation
 c. Except in cases of distribution in liquidation, corporations under direct or indirect common
control by or for the same individual
d. Grantor and fiduciary of any trust
e. Fiduciaries of trusts with the same grantor
f. Fiduciary of a trust and the beneficiary of such trust

4. Withholding rule – no deduction is allowed unless the withholding tax required by the law or
regulations to be withheld on the income payment is withheld and remitted by the taxpayer to
the government.

Types of withholding taxes

Types Expense type BIR form Deadline
Withholding tax on Compensation 1601-C On or before the 10th
compensation expense day of the month
Final withholding tax Certain passive 0619-F following the month
income and fringe in which withholding
benefits was made. For eFPS
Expanded Other income 0619-E filers, their
withholding tax payments which are respective group
subject to regular tax deadlines apply.
to the recipient

Tax reporting classification of deductions

1. Cost of sales or cost of services – deducted outright against sales, revenues, receipts, or fees of
individual taxpayers in the measurement of gross income from operations.
2. Regular allowable itemized deductions – pertain to all necessary and ordinary expenses paid or
incurred during the taxable year.
3. Special allowable itemized deductions – additional deductions as provided under the NIRC or
special laws. Special allowable deductions can be categorized into two types: actual compliance
expense and deduction incentives.
4. Net operating loss carry-over (NOLCO) – excess of expense deduction over gross income during
a taxable year which is allowed by the law to be deducted against the net income of the
following three years.

Mode of claiming deductions from gross income

1. Itemized deductions – taxpayer lists every item of business expense he claims as deductions.
Deductions are strictly construed against the taxpayer.
2. Optional standard deductions – in lieu of the itemized deductions, regular or special, including
NOLCO. The deduction is merely presumed as a fixed percentage of gross income for
corporations and gross sales or receipts for individuals.

Summary:
The government is strict in allowing the taxpayers to claim expenses as deductions since these will lower
the taxable income. Hence, mastery of the principles of deductions and the proper classification of the
expenses are necessary.

References:
Income Taxation, Rex Banggawan 2019 Edition