DEDUCTIONS (Secs.

34 and 36A)
Computation of Taxable Income: Sales: Less: Cost of Sales Gross Income: Less: Deductions Taxable Income Cost of Sales XXX XXX XXX XXX XXX

1. For a trading or merchandising concern, "cost of goods" sold shall include

the invoice cost of the goods sold, plus import duties, freight in transporting the goods to the place where the goods are actually sold, including insurance while the goods are in transit. 2. For a manufacturing concern, "cost of goods manufactured and sold" shall include all costs of production of finished goods, such as raw materials used, direct labor and manufacturing overhead, freight cost, insurance premiums and other costs incurred to bring the raw materials to the factory or warehouse. 3. In the case of taxpayers engaged in the sale of service, 'gross income' means gross receipts less sales returns, allowances and discounts. "Cost of services" shall mean all direct costs and expenses necessarily incurred to provide the services required by the customers and clients including (A) salaries and employee benefits of personnel, consultants and specialists directly rendering the service and (B) cost of facilities directly utilized in providing the service such as depreciation or rental of equipment used and cost of supplies: Provided, however, That in the case of banks, "cost of services" shall include interest expense. Note: Definitions taken from Secs. 27(A) GIT and 27(E) MCIT.

A. Expenses 1. Requisites for Deductibility: a. The expense must be ordinary and necessary; b. It must be paid or incurred within the taxable year; c. It must be paid or incurred in carrying in a trade or business. d. In addition, not only must the taxpayer meet the business test, he
must substantially prove by evidence or records the deductions claimed under the law, otherwise, the same will be disallowed. The mere allegation of the taxpayer that an item of expense is ordinary and necessary does not justify its deduction. Ordinary and Necessary Similarly, this Court has never attempted to define with precision the terms "ordinary and necessary." There are however, certain guiding principles worthy of serious consideration in the proper adjudication of conflicting claims. Ordinarily, an expense will be considered "necessary" where the expenditure is appropriate and helpful in the development of the taxpayer's business. It is "ordinary" when it connotes a payment

which is normal in relation to the business of the taxpayer and the surrounding circumstances. The term "ordinary" does not require that the payments be habitual or normal in the sense that the same taxpayer will have to make them often; the payment may be unique or non-recurring to the particular taxpayer affected. There is thus no hard and fast rule on the matter. The right to a deduction depends in each case on the particular facts and the relation of the payment to the type of business in which the taxpayer is engaged. The intention of the taxpayer often may be the controlling fact in making the determination. Assuming that the expenditure is ordinary and necessary in the operation of the taxpayer's business, the answer to the question as to whether the expenditure is an allowable deduction as a business expense must be determined from the nature of the expenditure itself, which in turn depends on the extent and permanency of the work accomplished by the expenditure.

In Atlas Consolidated Mining vs. CIR, the issues were, whether the following are deductible as business expenses: 1. Services rendered by a public relations firm P.K. Macker & Co. labelled as stockholders relation service fee in an effort to sell Atlas additional capital stock is an allowable deduction as business expense? Atlas Contention: It was aimed at creating a favorable image and goodwill to gain or maintain their patronage. SC: Not deductible. Not an ordinary expense, because expenses relating to recapitalization and reorganization of the corporation, the cost of obtaining stock subscription, promotion expenses and commission or fees paid for the sale of stock organization are capital expenditures. That the expense in question was incurred to create a favorable image of the corporation in order to gain or maintain the public's and its stockholders' patronage, does not make it deductible as business expense. As held in the case of Welch vs. Helvering, efforts to establish reputation are akin to acquisition of capital assets and, therefore, expenses related thereto are not business expense but capital expenditures. 2. Agent Transfers Fees in relation to Atlas shares of stock (stock listing fee). CIRs Contention: Said fees were incurred not for the production of income but for the acquisition of capital. It should be disallowed in view of the definition that an expense is deemed to be incurred in trade or business if it was incurred for the production of income, or in the expectation of producing income for the business. SC: Deductible. We find the Chesapeake decision controlling with the facts and circumstances of the instant case. In Dome Mines, Ltd. case, the stock listing fee was disallowed as a deduction not only because the expenditure did not meet the statutory test but also because the same was paid only once, and the benefit acquired thereby continued indefinitely, whereas, in the Chesapeake Corporation case, fee paid to the stock exchange was annual and recurring. In the instant case, We deal with the stock listing fee paid annually to a stock exchange for the privilege of having its stock listed. It must be noted that the Court of Tax Appeals rejected the Dome Mines case, because it involves a payment made only once, hence, it was held therein that the single payment made to the stock exchange was a capital expenditure, as distinguished from the instant case, where payments

were made annually. For this reason, We hold that said listing fee is an ordinary and necessary business expense. 3. Attorney's fees and litigation expenses in the defense of title to the Toledo Mining properties purchased by Atlas from Mindanao Lode Mines Inc. SC: Not Deductible. In line with the decision of the U.S. Tax Court in the case of Safety Tube Corp. vs. Commissioner of Internal Revenue, it is well settled that litigation expenses incurred in defense or protection of title are capital in nature and not deductible. Likewise, it was ruled by the U.S. Tax Court that expenditures in defense of title of property constitute a part of the cost of the property and are not deductible as expense. Note: Attorneys Fees are generally deductible as business expense. Paid or incurred within the Taxable Year The expense must be claimed in the proper taxable period. Otherwise, it will be disallowed. (See Isabela Cultural Corporation Case) SEC. 45. Period for which Deductions and Credits Taken. - The deductions provided for in this Title shall be taken for the taxable year in which "paid or accrued" or "paid or incurred", dependent upon the method of accounting the basis of which the net income is computed, unless in order to clearly reflect the income, the deductions should be taken as of a different period. In the case of the death of a taxpayer, there shall be allowed as deductions for the taxable period in which falls the date of his death, amounts accrued up to the date of his death if not otherwise properly allowable in respect of such period or a prior period. Accrual Accounting vs. Cash Accounting. Generally, Accrual Accounting is used. o The accrual method relies upon the taxpayer's right to receive amounts or its obligation to pay them, in opposition to actual receipt or payment, which characterizes the cash method of accounting. Amounts of income accrue where the right to receive them become fixed, where there is created an enforceable liability. Similarly, liabilities are accrued when fixed and determinable in amount, without regard to indeterminacy merely of time of payment. o For a taxpayer using the accrual method, apply the all-events test. The accrual of income and expense is permitted when the all-events test has been met. This test requires: (1) fixing of a right to income or liability to pay; and (2) the availability of the reasonable accurate determination of such income or liability. The all-events test requires the right to income or liability be fixed, and the amount of such income or liability be determined with reasonable accuracy. However, the test does not demand that the amount of income or liability be known absolutely, only that a taxpayer has at his disposal the information necessary to compute the amount with reasonable accuracy. The all-events test is satisfied where computation remains uncertain, if its basis is unchangeable; the test is satisfied where a computation may be unknown, but is not as much as

unknowable, within the taxable year. The amount of liability does not have to be determined exactly; it must be determined with "reasonable accuracy." Accordingly, the term "reasonable accuracy" implies something less than an exact or completely accurate amount. In the case of Isabela Cultural Corporation vs. CIR, the issue was, whether or not a taxpayer under the accrual accounting method, may claim as deduction, auditing and legal expenses for the year 1984 and 1985 but paid only in 1986? Contention of ICC: The bills demanding payment were only sent in 1986. Thus, in 1984 and 1985, it could not declare the same as deduction for the said years as the amount thereof could not be determined at that time. SC: No. In the instant case, the expenses for professional fees consist of expenses for legal and auditing services. The expenses for legal services pertain to the 1984 and 1985 legal and retainer fees of the law firm Bengzon Zarraga Narciso Cudala Pecson Azcuna & Bengson, and for reimbursement of the expenses of said firm in connection with ICC's tax problems for the year 1984. As testified by the Treasurer of ICC, the firm has been its counsel since the 1960's. From the nature of the claimed deductions and the span of time during which the firm was retained, ICC can be expected to have reasonably known the retainer fees charged by the firm as well as the compensation for its legal services. The failure to determine the exact amount of the expense during the taxable year when they could have been claimed as deductions cannot thus be attributed solely to the delayed billing of these liabilities by the firm. For one, ICC, in the exercise of due diligence could have inquired into the amount of their obligation to the firm, especially so that it is using the accrual method of accounting. For another, it could have reasonably determined the amount of legal and retainer fees owing to its familiarity with the rates charged by their long time legal consultant. Substantiation Requirements No deduction from gross income shall be allowed under Subsection (A) hereof unless the taxpayer shall substantiate with sufficient evidence, such as official receipts or other adequate records: (i) the amount of the expense being deducted, and (ii) the direct connection or relation of the expense being deducted to the development, management, operation and/or conduct of the trade, business or profession of the taxpayer. Salaries, Wages and Other Forms of Compensation Deductible as business expenses; Including: a. A reasonable allowance for salaries, wages, and other forms of compensation for personal services actually rendered, including the grossed-up monetary value of fringe benefit furnished or granted by the employer to the employee: Provided, That the final tax imposed under Section 33 hereof has been paid;

Thus, for income tax purposes in relation to the FBT, the grossed-up monetary value of the fringe benefit is deductible, meaning the following items are deductible: i. Monetary Value of the Fringe Benefit; and, ii. The Fringe Benefits Tax.

b. Bonuses to employees - Bonuses to employees will constitute allowable deductions from gross income when such payments are made in good faith and as additional compensation for the services actually rendered by the employees, provided such payment, when added to the stipulated salaries, do not exceed a reasonable compensation for the service rendered. It is immaterial whether such bonuses are paid in cash or in kind or partly in cash and partly in kind. Donations made to employees and others, which do not have in them the element of compensation or are in excess of reasonable compensation for services, are not deductible from gross income. [Sec. 72, RR No. 2-40] In the case of Kuenzle & Streiff vs. CIR, the Supreme Court held that bonuses paid to officers and staff members of the corporation, despite it incurring losses, were considered not reasonable and disallowed for income tax purposes. The condition precedents to the deduction of bonuses to employees are: (1) the payment of the bonuses is in fact compensation; (2) it must be for personal services actually rendered; and (3) bonuses, when added to the salaries, are `reasonable ... when measured by the amount and quality of the services performed with relation to the business of the particular taxpayer'. Travelling and Transportation Expenses A reasonable allowance for travel expenses, here and abroad, while away from home in the pursuit of trade, business or profession. Travelling expenses as ordinarily understood, include transportation expenses and meals and lodging. If the trip is undertaken for other than business purposes, the transportation expenses are personal expenses, and the meals and lodging are living expenses, and therefore, not deductible. If the trip is solely on business, the reasonable and necessary travelling expenses, including transportation expenses, meals and lodging, become business instead of personal expenses. Claim for the deductions referred to herein must be substantiated, when required by the Commissioner of Internal Revenue by record showing in detail the amount and nature of the expenses incurred. [Sec. 66 RR No. 2-40]

Cost of Materials Taxpayers carrying materials and supplies on hand should include in expenses the charges for materials and supplies only to the amount that they are actually consumed and used in operation during the year for which the return is made, provided that the cost of such materials and supplies has not been deducted in determining the net income for any previous year. If a taxpayer carries incidental materials or supplies on hand for which no record of consumption is kept or of which physical inventories at the beginning and end of the year are not taken, it will be permissible for the taxpayer to include in his expenses and deduct from gross income the total cost of such supplies and materials as were purchased during the year for which the return is made, provided the net income is clearly reflected by this method. [Sec. 76 RR No. 2-40]

Rentals and / or other payments for use or possession of property A reasonable allowance for rentals and/or other payments which are required as a condition for the continued use or possession, for purposes of the trade, business or profession, of 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. Where a leasehold is acquired for business purposes for a specified sum, the purchaser may take as a deduction in his return an aliquot part of such sum each year, based on the number of years the lease has to run. Taxes paid by a tenant to or for a landlord for business property are additional rent and constitute a deductible item to the tenant and taxable income to the landlord, the amount of the tax being deductible by the latter. The cost borne by a lessee in erecting buildings or making permanent improvements on ground of which he is lessee is held to be a capital investment and not deductible as a business expense. In order to return to such taxpayer his investment of capital, an annual deduction may be made from gross income of an amount equal to the cost of such improvements divided by the number of years remaining of the term of lease, and such deduction shall be in lieu of a deduction for depreciation. If the remainder of the term of lease is greater than the probable life of the buildings erected, or of the improvements made, this deduction shall take the form of an allowance for depreciation. [Sec. 74 RR No. 2-40]

Repairs and Maintenance The cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted as expense, provided the plant or property account is not increased by the amount of such expenditure. Repairs in the nature

of replacement, to the extent that they arrest deterioration and appreciably prolong the life of the property should be charged against the depreciation reserves if such account is kept. [Sec. 74 RR No. 2-40]

INTEREST EXPENSE 1. Requisites for Deductibility: a. There must be an indebtedness; b. There should be an interest expense paid or incurred upon such indebtedness; c. The indebtedness must be that of the taxpayer, d. The indebtedness must be connected with the taxpayer's trade, business or exercise of profession; e. The interest expense must have been paid or incurred during the taxable year; f. The interest must have been stipulated in writing; g. The interest must be legally due; h. The interest payment arrangement must not be between related taxpayers as mandated in Sec. 34(B)(2)(b), in relation to Sec. 36(B), both of the Tax Code of 1997; i. j. The interest must not be incurred to finance petroleum operations; and In case of interest incurred to acquire property used in trade, business or exercise of profession, the same was not treated as a capital expenditure.

2. Rules:

General Rule. In general, the amount of interest expense paid or incurred within a taxable year on indebtedness in connection with the taxpayer's trade, business or exercise of profession shall be allowed as a deduction from the taxpayer's gross income.

Limitation. the taxpayer's otherwise allowable deduction for interest expense shall be reduced by forty-two percent (42%) of the interest income subjected to final tax: Provided, That effective January 1, 2009, the percentage shall be thirty-three percent (33%).

This limitation shall apply regardless of whether or not a tax arbitrage scheme was entered into by the taxpayer or regardless of the date when the interest bearing loan and the date when the investment was made for as long as, during the taxable year, there is an interest expense incurred on one side and an interest income earned on the other side, which interest income had been subjected to final withholding tax. This rule shall be observed irrespective of the currency the loan was contracted and/or in whatever currency the investments or deposits were made. Tax Arbitrage Scheme An investment strategy that attempts to profit by exploiting the price differences between tax rates or systems.

Interest on Unpaid Taxes. The limitation provided for above notwithstanding, 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 heretofore mentioned. 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.

Optional treatment of interest expense on capital expenditure. At the option of the taxpayer, interest expense on a capital expenditure incurred to acquire property used in trade, business or exercise of a profession may be allowed as a deduction in full in the year when incurred, the provisions of Sec. 36 (A)(2) and (3) of the Tax Code of 1997 to the contrary notwithstanding, or may be treated as a capital expenditure for which the taxpayer may claim only as a deduction the periodic amortization of such expenditure.

3. Non-deductible Interest Expense:

A. If within the taxable year, an individual taxpayer reporting income on the cash basis incurs an indebtedness on which an interest is paid in advance through discount or otherwise: Provided, That such interest shall be allowed as a deduction in the year the indebtedness is paid: Provided, further, That if the indebtedness is payable in periodic amortization, the amount of interest which corresponds to the amount of the principal amortized or paid during the year shall be allowed as deduction in such taxable year. Illustration: Mr. Cruz, a self-employed individual, consistently employs the cash-basis accounting method in keeping his books of accounts. Assuming that on January 1, 1998, he contracted a loan of P1,000,000 from XYZ Bank

for use in his business operations. Terms: Payable in two (2) years at 15% interest per annum, payable in advance. On January 1, 1998, he received from the bank the proceeds of his loan in the sum of P700,000, net of interest paid in advance in the amount of P300,000. In general, the interest expense shall be taken for the taxable year in which "paid or incurred" or "paid or accrued" depending upon the method of accounting upon the basis of which the net income is computed, unless in order to clearly reflect the income, the deduction should be taken as of a different period. Thus, a self-employed individual is allowed to deduct from his gross income the entire amount of interest expense actually paid during the taxable year. However, if the interest expense is paid in advance and the accounting method used by the self-employed individual is the cash-basis accounting method, such interest expense paid in advance shall only be allowed as deduction in the year when he has fully paid his liability. So that if the said debtor has fully paid his loan as of the end of the taxable year 1999, his interest expense paid in advance on January 1, 1998 in the amount of P300,000 shall only be allowed as deduction from his gross income in the taxable year 1999. On the other hand, even if the interest expense is paid in advance but the indebtedness is payable in periodic amortization, the amount of interest expense which corresponds to the amount of the principal amortized or paid during the respective years 1998 and 1999 shall be allowed as deduction in such respective taxable years. B. If both the taxpayer and the person to whom the payment has been made or is to be made are persons specified under Sec. 36(B) of the Tax Code of 1997, viz:

1. Between members of a family. For purposes of this paragraph, the family of an individual shall include only his brothers and sisters (whether by the whole or half-blood), spouse, ancestors and lineal descendants; or 2. Between an individual and a corporation more than fifty percent (50%) in value of the outstanding stock of which is owned, directly and indirectly, by or for such individual; or 3. Between two corporations more than fifty percent (50%) in value of the outstanding stock of each of which is owned, directly or indirectly, by or for the same individual; or 4. Between the grantor and a fiduciary of any trust; or 5. Between the fiduciary of a trust and the fiduciary of another trust if the same person is a grantor with respect to each trust; or 6. Between a fiduciary of a trust and a beneficiary of such trust.

TAXES General Rule - Taxes paid or incurred within the taxable year in connection with the taxpayer's profession, trade or business, shall be allowed as deduction Non-deductible Taxes: The income tax under Title II of the NIRC except FBT which is deductible; Allowable Foreign Income Tax if not claimed as a tax credit; Estate and donor's taxes; and Taxes assessed against local benefits of a kind tending to increase the value of the property assessed. So-called taxes, more properly assessments, paid for local benefits, such as street, sidewalk, and other like improvements, imposed because of and measured by some benefit inuring directly to the property against which the assessment is levied, do not constitute an allowable deduction from gross income. A tax is considered assessed against local benefits when the property subject to the tax is limited to the property benefited. Special assessments are not deductible, even though an incidental benefit may inure to the public welfare. The taxes deductible are those levied for the general public welfare, by the proper taxing authorities at a like rate against all property in the territory over which such authorities have jurisdiction. When assessments are made for the purpose of maintenance or repair of local benefits, the taxpayer may deduct assessments paid as an expense incurred in business, if the payment of such assessments is necessary to the conduct of his business. When the assessments are made for the purpose of constructing local benefits, the payments by the taxpayer are in the nature of capital expenditures and are not deductible. Special Rules on Interest / Surcharge and Fines for delinquency: The word "taxes" means taxes proper and no deductions should be allowed for amounts representing interest, surcharge, or penalties incident to delinquency. [Sec. 80 RR No. 2-40] However, in CIR vs. Vda de. Prieto, the Supreme Court held that: although interest payment for delinquent taxes is not deductible as tax under Section 30(c) of the Tax Code [Now Sec. 34 (C)] and section 80 of the Income Tax Regulations, the taxpayer is not precluded thereby from claiming said interest payment as deduction under section 30(b) [as interest expense now Sec. 34(B)] of the same Code. LOSSES Requisites: 1. Losses must be actually sustained during the taxable year; 2. Not compensated for by insurance or other forms of indemnity shall be allowed as deductions: 3. Must be incurred in trade, profession or business;

4. Related to 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; 5. Such loss has not been claimed as a deduction for estate tax purposes. Note: In the case of a nonresident alien individual or foreign corporation, the losses deductible shall be those actually sustained during the year incurred in business, trade or exercise of a profession conducted within the Philippines, when such losses are not compensated for by insurance or other forms of indemnity. Capital Losses: Deductible only to the extent of the capital gains. Securities becoming worthless: Considered as a loss from the sale or exchange, on the last day of such taxable year, of capital assets. Thus, deductible only to the extent of capital gains. Losses on Wash Sales: