Chapter 13 -A

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 osts

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"

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 exerise 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 incureed to finnce petroleum operations.

9. In case of interest incurred in the acquisitio of property, used in trade, busiess 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 subject to final tax:

Effectivity Percentage

January 1, 2009 33%

January 1, 2021 20%

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

Illustration

A taxpayer incurred an interest expense of P100,000 and earned P10,000 interest income on deposits in
2022.

The deductible interest expense shall be computed as:

Gross interest expense P 100,000

Less: The arbitrage limit (P10,000 x 20%) 2,000

Deductible interest expense P 98, 000

RATIONALE OF THE ARBITRAGE LIMIT

The imit is intended to recover the 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 Sheme

A corporate taxpayer which is subject to 25% 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 P 1, 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 analyzed as
follows:

Net interest income P60,000 x (100%-20% final tax) P 48, 000

Payment of interest expense to the bank ( 60, 000 )

Tax savings on interest expense (P60,000 x 25%) 15, 000

Financial tax savings from the arbitrage P 3, 000

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

Determinationof the Arbitrage Limit

To eliminate the abitrage savings, a deduction cap was set which was mathematically coputed as:

(Corporate income tax rate- final tax on interest income)

Corporate income tax rate

Effect of the Arbitrage Limit

Under current corporate income tax rate, the arbitrage limit is (25-20)