Subject: Taxation

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 NAVOTAS POLYTECHNIC COLLEGE
Bachelor of Science in Business Administration
Taxation
Atty. Christian Wilfred D. Morales, CPA1

Module 5: Allowable Deductions

Intended Learning Outcomes (ILO)

At the end of this topic, the student must have understood deductions from gross
income in general as enumerated, identified the limitations, valuation and
requisites in all kinds of deductions, enumerate list of items not deductibles,
classify those allowable deductions.

Lecture Proper and Discussion

The tax base of a normal or net income tax (individual) and a regular corporate
income tax (corporation) is the taxable income, thus the formula;

Gross Income xxx

Allowable Deductions (xx)
Taxable Income xxx
Applicable Tax Rate (xx)
Income Tax Due xx

The provision of allowable deduction2 is applicable only to normal or net income

tax because these is the only income tax that allow deductions in the
determination of income tax liability.

Nature of Deductions

Deductions are items allowed by the Tax Code or special law to be subtracted
from the gross income in order to arrive at the taxable income, which is the tax
base of the normal or net income tax. Deductions for income tax purposes
partake the nature of tax exemption; hence, strictly construed against the
taxpayer.3 Deductions from gross income are matters of legislative grace.

Tax Deduction v. Tax Credits

1
Member of the Integrated Bar of the Philippines, Member of the Philippine Institute of Certified
Public Accountant, former Associate of Maceda, Valencia and Co., Maceda Valencia & Co. (MVCo.),
a member firm of Nexia International, former Senior Financial Specialist of Financial Management
Division (FMD), former Senior Internal Control Officer and Head of Financial Audit Section (FAS) of
Internal Audit Services, National Irrigation Adminstration (NIA), former Professor of Law and
Accounting at College of Business Administration, City of Malabon University (CMU), Attorney II at
BIR Legal Division, Law Practitioner
2
Sec. 34 of the NIRC
3
CIR v. General Foods, G.R. No. 143672, April 24, 2003

Page 2 of 33
Tax credit is an amount deducted from a taxpayer’s total tax liability to arrive at
the tax due while a tax deduction reduces the taxpayer’s taxable income upon
which a tax liability is based. A credit differs from deduction in that the former is
deducted from tax while the latter is deducted from income before the tax is
computed. Tax credit is a direct deduction from the tax payable to the
government.4 Thus, the formula:

Gross Income xxx

Allowable Deductions (xx)
Taxable Income xxx
Applicable Tax Rate (xx)
Income Tax Due xx
Tax Credit (xx)
Income Tax Payable xxx

Tax Deduction v. Tax Exclusions

Exclusions are items not included or excluded in determining the gross income.
Tax deductions are items considered in determining the taxable income.
Exclusions are income items earned by the taxpayer which do not form part of
gross income while tax deductions are something paid in earning gross income.

Exclusions are not included in the gross income either because they are exempted
from tax by law, treaty, subject to final tax or a mere return of capital. In contrast,
tax deductions are items allowed by the law to be deducted from gross income in
order to arrive at the taxable income.

Kinds of Deductions

Deductions may be classified into Itemized Deductions or Optional Standard

Deduction (OSD). There are however special provisions5 regarding deductions of
insurance companies under the Tax Code.

ITEMIZED DEDUCTIONS

Expenses

Ordinary and Necessary Trade, Business or Professional Expenses

Ordinary and necessary expenses in the conduct of trade or business or exercise of

profession is allowed as deduction from gross income. An expense is “ordinary”
when it connotes a payment which is normal in relation to the business of the
taxpayer and surrounding circumstances. An expense is “necessary” when the
expenditure is appropriate or helpful in the development of taxpayer’s business or
that the same is proper for the purpose of realizing a profit or minimizing loss.

4
CIR v. Central Luzon Drug Corporation, G.R. No. 15961., June 12, 2008
5
Sec. 37 of the NIRC

Page 3 of 33
Ordinary and necessary expense includes the following:

(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 has been paid;

(b) A reasonable allowance for travel expenses, here and abroad, while away from
home in the pursuit of trade, business or profession;

(c) 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;

(d) A reasonable allowance for entertainment, amusement and recreation

expenses during the taxable year, that are directly connected to the development,
management and operation of the trade, business or profession of the taxpayer, or
that are directly related to or in furtherance of the conduct of his or its trade,
business or exercise of a and that any expense incurred for entertainment,
amusement or recreation that is contrary to law, morals public policy or public
order shall in no case be allowed as a deduction.

The following limits are set as deduction from gross income for Entertainment,
Amusement, and Recreation (EAR) expenses: (1) For taxpayers engaged in sale
of goods or properties, the EAR expense allowed is the actual amount paid or
one-half percent (1/2%) of the net sales, which ever is lower, and (2) For
taxpayers engaged in sale of services, the EAR expense allowed is the actual
amount paid or one percent (1) of the net sales, whichever is lower.

If the taxpayer is deriving from both the sale of goods and services, the allowable
EAR shall be apportioned by the following formula:

Net Sales / Net Revenue

Limit EAR= x Actual EAR
Total Net Sales and Net Revenue

Sample 1: Goodhouse Industries, Inc. is engaged in the sale of goods and services
with net sales and net revenue of P3,000,000.00 and P2,000,000.00, respectively.
The actual entertainment, amusement and recreational expense for the year
totaled to P30,000. Determine the amount of allowable EAR deduction.

Page 4 of 33
 Sale of Goods 3,000,000.00
Sale of Services 2,000,000.00
Gross Income 5,000,000.00

Sale of Goods
Actual (P30,000 x 3/5) 18,000.00
Limit (P3,000,000 x 1/2%) 15,000.00
Lower 15,000.00

Sale of Services
Actual (P30,000 x 2/5) 12,000.00
Limit (P2,000,000 x 1%) 20,000.00
Lower 12,000.00

Amount Deductible as EAR 27,000.00

(e) An additional deduction from taxable income of one-half (1/2) of the value of
labor training expenses incurred for skills development of enterprise-based
trainees enrolled in public senior high schools, public higher education
institutions, or public technical and vocational institutions and duly covered by
an apprenticeship agreement under Labor Code of the Philippines shall be
granted to enterprises provided that the additional deduction for enterprise-based
training of students from public educational institutions, the enterprise shall
secure proper certification from the DepEd, TESDA, or CHED and such
deduction shall not exceed ten percent (10%) of direct labor wage.6

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.7

No deduction from gross income shall be allowed for any payment made, directly
or indirectly, to an official or employee of the national government, or to an
official or employee of any local government unit, or to an official or employee of
a government-owned or -controlled corporation, or to an official or employee or
representative of a foreign government, or to a private corporation, general
professional partnership, or a similar entity, if the payment constitutes a bribe or
kickback.8

Expenses Allowable to Private Educational Institutions

For capital expenditures, a Private Educational Institution (PEI) may, at its

option, elect to either: (1) Capitalize and claim depreciation as deduction; or (2)
Claim as outright expense.

6
Sec. 34(A)(1)(a)(v) of the NIRC
7
Sec. 34(A)(1)(b) of the NIRC
8
Sec. 34(A)(1)(c) of the NIRC

Page 5 of 33
Sample 2: Goodhouse House Industries Inc., a domestic manufacturing
corporation, had gross sales of P100,000,000 for fiscal year ending June 30, 2021
and incurred cost of sales of P17,500,000, with the following details: Materials in
the amount of P30,000,000, Labor in the amount of P20,000,000, Overhead in
the amount of P10,000,000, Salaries in the amount of P7,000,000, Taxes in the
amount of P300,000, Depreciation Expense in the amount of P3,500,000,
Professional Fees in the amount of P200,000, Advertising Expense in the amount
of P3,000,000, Training Expense in the amount of P3,000,000 and Office
Supplies in the amount of P500,000. Determine the additional training expense to
be claimed as deduction and the taxable net income of Goodhouse.

Gross Sales 100,000,000.00

Less: Cost of Sale
Direct Materials 30,000,000.00
Direct Labor 20,000,000.00
Manufacturing Overhead 10,000,000.00 60,000,000.00
Gross Income 40,000,000.00
Less: Expenses
Salaries 7,000,000.00
Taxes 300,000.00
Depreciation 3,500,000.00
Professional Fees 200,000.00
Advertising Expenses 3,000,000.00
Training Expenses 3,000,000.00
Office Supplies 500,000.00
Additional Training Expense 1,500,000.00 19,000,000.00
Net Taxable Income 21,000,000.00

Additional Training Expense:

Actual Value of Training 3,000,000.00
Rate 50%
Additional Training Expense: 1,500,000.00

The amount of P1,500,000 can be claimed as additional training expenses since it

did not exceed the ten percent (10%) of the Direct Labor Wage which is
P2,000,000 (10% x P20,000,000). If the Direct Labor Wage is only P10,000,000,
the additional training expense that can be allowed is only P1,000,000 (10% x
P10,000,000).

Interest

Interest refers to payment for the use or forbearance of detention of money

regardless of the name it is called or dominated. It includes the amount paid for

Page 6 of 33
the detention of the money after the due date for its repayment.9 In fine, the
interest is the fee paid for the use of someone else money.

For an interest expense to be deductible, the following requisites must be met:

(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 must not be incurred to finance petroleum operation; and

(i) The interest payment arrangement must not be between related taxpayers.

Tax Arbitrage Rule

The amount of interest paid or incurred within a taxable year on indebtedness in

connection with the taxpayer's profession, trade or business shall be allowed as
deduction from gross income.

The interest expense that may be deducted shall be reduced if the taxpayer has
derived certain interest income which had been subjected to final withholding tax.
The taxpayer’s allowable deduction for interest expense shall be reduced by
twenty percent (20%) of the interest income subjected to final tax.

The rationale behind the tax arbitrage rule is to limit the practice of profiting from
the different tax treatment of interest income and interest expense.10

Sample 3: Nem has the following data for 2021 taxable year: Interest paid on
business loan in the amount of P100,000, Interest paid on loan to finance
personal car in the amount of P500,000, Interest expense on delinquency
business-related taxes in the amount of P50,000 and Interest income at BDO
West Avenue Branch in the amount of P24,000, net of final tax. Determine the
deductible interest expense.

9
Sec. 2, Revenue Regulation 13-2000
10
Sec. 34(B)(1)

Page 7 of 33
 Interest Paid on Loan 100,000.00
Interest Reduction
Interest Income, net of Final tax 24,000.00
Final Tax Rate (100% - 20%) 80%
Interest Income, Gross of Final tax 30,000.00
Tax Arbitrage Rate 20% (6,000.00)
Interest on Taxes 50,000.00
Allowable Deduction 144,000.00

Interest expense arising from unpaid taxes or tax assessment or interest on

deficiency or delinquency tax, provided that the tax is related to the profession or
business of the taxpayer, shall not be covered by limitation.

Micro, Small and Medium Enterprises (MSME)

Domestic corporations with net taxable income not exceeding Five Million Pesos
(P5,000,000.00) and total assets not exceeding One Hundred Million Pesos
(P100,000,000), excluding the land on which the particular business entity’s
office, plant and equipment are situated, the deduction is zero percent (0%) since
there is no difference in the income tax rate on taxable income (20%) with the tax
rate applied on the interest income subjected to final tax (20%). Thus, there is no
interest arbitrage. The allowable interest expense shall be the same with the actual
interest incurred.

Sample 4: For the year 2021, Goodhouse Industries incurred interest expense of
P500,000 on its bank loan. For the year, its gross assets amounted to
P50,000,000, exclusive of cost of the land of P7,100,000. It registered a gross
income of P10,000,000 and incurred operating expense of P6,000,000 inclusive of
P500,000 interest expense. It had interest income earned for the same year
amounting to P150,000. Determine the allowable deduction for interest expense.

The allowable interest deduction is P500,000. The deduction is zero percent (0%)
since there is no difference in the income tax rate on taxable income (20%) with
the tax rate applied on the interest income subjected to final tax (20%). Thus,
there is no interest arbitrage. The allowable interest expense shall be the same
with the actual interest incurred.

Exceptions to Interest Expense as Deduction

No deduction shall be allowed in respect of interest under the succeeding

subparagraphs:

(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. However, such interest shall be allowed as a deduction in
the year the indebtedness is paid;

Page 8 of 33
(b) If the indebtedness is payable in periodic amortizations, 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;

(b) If both the taxpayer and the person to whom the payment has been made or is
to be made is between members of a family (brothers, sisters, spouse, ascendants
and descendants); or

(c) If the indebtedness is incurred to finance petroleum exploration.11

Optional Treatment of Interest Expense

At the option of the taxpayer, interest incurred to acquire property used in trade
business or exercise of a profession may be allowed as a deduction or treated as a
capital expenditure.12

Taxes

Taxes paid contemplates either as a deduction or a tax credit. This section refers
to tax paid as a deduction. This can be illustrated in the following formula:

Gross Income xxx

Allowable Deductions (includes Taxes) (xx)
Taxable Income xxx
Applicable Tax Rate (xx)
Income Tax Due xx
Tax Credit (xx)
Income Tax Payable xxx

Taxes paid or incurred within the taxable year in connection with the taxpayer's
profession, trade or business, shall be allowed as deduction, except:

(a) The income tax provided for under this Code;

(b) Income taxes imposed by authority of any foreign country; but this deduction
shall be allowed in the case of a taxpayer who does not signify in his return his
desire to have to any extent the tax benefit rule (relating to credits for taxes of
foreign countries);

(c) Estate and donor's taxes; and

(d) Taxes assessed against local benefits of a kind tending to increase the value of
the property assessed.

Requisites of Deductibility of Taxes

11
Sec. 34(B)(2) of NIRC
12
Sec. 34(B)(3) of NIRC

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Taxes may be deducted in the gross income when the following requisites are
present:

(a) Taxes must be paid or incurred within the taxable year;

(b) Taxes must be paid or incurred in connection with the taxpayer’s trade,
business, or profession;

(c) It must be imposed directly on the taxpayer; and

(d) It must not be specifically excluded by law from being deducted from the
taxpayer’s gross income.

Tax Benefit Rule

Under the Tax Benefit Rule, an amount that is previously claimed as a deduction
when recovered or refunded is included in the gross income in the year of receipt.
As applied in taxes, taxes allowed as deduction that were subsequently refunded
or credited shall be included as part of the gross income in the year of receipt to
the extent of the income tax benefit of said deduction.

Limitations of Tax as Deduction

In the case of a nonresident alien individual engaged in trade or business in the

Philippines and a resident foreign corporation, the deductions for taxes shall be
allowed only if and to the extent that they are connected with income from
sources within the Philippines.13

Sample 5: During 2021, Goodhouse Industries Inc. claimed a tax deduction in

the amount of P100,000. The following year, the P100,000 claimed deduction
was refunded to the company. Determine the amount to be included in the gross
income in the year of refund.

Amount Claimed as Tax Deduction 100,000.00

Tax Rate 30%
Tax Benefit Arising from Deduction 30,000.00

Goodhouse obtained only a tax benefit of P30,000 from the amount claimed as
deduction, meaning, the income tax has been reduced by P30,000. Thus, when a
refund of the tax has been made, only the P30,000 shall be included in the gross
income in the year of refund.

Tax as Tax Credit

Tax credit refers to an amount of taxes paid by a taxpayer in a foreign country

that is allowed to be deducted in the said taxpayer’s tax liability in the

13
Sec. 32(C)(2) of the NIRC

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Philippines. The right to credit foreign taxes paid is only available to a resident
citizen, domestic corporation, partner in a General Professional Partnership and
beneficiaries of estate and trust.

Those who may avail tax credits are those taxable on income from sources within
and outside the Philippines while those who are not entitled are those taxable
only from sources within the Philippines.

The amount of tax credit to be claimed shall be subject to each of the following
limitations;

(a) Limitation 1: The amount of the credit in respect to the tax paid or incurred to
any country shall not exceed the same proportion of the tax against which such
credit is taken, which the taxpayer's taxable income from sources within such
country under this Title bears to his entire taxable income for the same taxable
year; and

(b) The total amount of the credit shall not exceed the same proportion of the tax
against which such credit is taken, which the taxpayer's taxable income from
sources without the Philippines taxable under this Title bears to his entire taxable
income for the same taxable year.

These limitations are better expressed in the following formula:

Limit 1:

Taxable Income from Foregin Country

Tax Credit = x Philippine Income Tax
Taxable Income - All Sources

Limit 2:

Taxable Income from Sources Outside PH

Tax Credit = x Philippine Income Tax
Taxable Income - All Sources

The allowable tax credit is the lower between the actual tax credit, the limitation
1 and limitation 2.

Losses

Losses actually sustained during the taxable year and not compensated for by
insurance or other forms of indemnity shall be allowed as deductions if incurred
in trade, profession or business or involves 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.14

14
Sec. 32(D)(1) of the NIRC

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No loss shall be allowed as a deduction if at the time of the filing of the return,
such loss has been claimed as a deduction for estate tax purposes in the estate tax
return.

Requisites for Deductibility

For a loss to be claim as additional deduction, the following requisites must be

established by the taxpayer:

(a) The loss must be that of taxpayer;

(b) There must be an actual loss suffered in a closed and completed transaction;

(c) The loss must be connected to the taxpayer’s trade, business, or profession;

(d) The loss must not be compensated by insurance or otherwise;

(e) The loss must be actually sustained and charge-off during the taxable year;

(f) In case of casualty loss, the declaration must have been filed within forty-five
(45) days from the occurrence of the casualty loss15; and

(g) The loss must not have been claimed for estate tax purposes.

Sample 6: On January 6, 2021, Malen purchased for P500,000 an automobile

which will be exclusively used for her business. She deducted an annual
depreciation on the basis of five (5) years useful life with no estimated scrap
value. Three years later, the vehicle was partially damaged in an accidental
collision with another vehicle. Malen received insurance proceeds of P70,000.
The cost of repairs amounted to P100,000. Determine the deductible loss.

Acquisiton Cost 500,000.00

Less: Accumulated Depreciation (P100,000x3) 300,000.00
Book Value 200,000.00
Cost to Restore 100,000.00
Lower of Cost to Restore and Book Value 100,000.00
Less: Proceeds from Insurance (70,000.00)
Deductible Loss 30,000.00

In case of partial loss, deductible loss is determined by the lower between the cost
to restore and the book value less any insurance proceeds. On the other hand, if
the loss is total in character, the deductible loss is determined by the book value
less any proceeds from insurance.

Kinds of Losses

15
Revenue Regulation 12-77, as amended

Page 12 of 33
(a) Casualty Losses

(b) Net Operating Loss Carry Over (NOLCO)

(c) Capital Losses and Worthless Securities

(d) Special Losses

(i) Losses from Wash Sales

(ii) Wagering Losses

(iii) Abandonment Losses

Net Operating Loss Carry Over (NOLCO)

Net Operating Loss means the excess of allowable deduction over the gross
income in a taxable year. The net operating loss of a business for any taxable year
shall be carried over as a deduction from gross income for three (3) consecutive
taxable years. However, the NOLCO of a business for taxable years 2020 to 2021
shall be carried over as a deduction from gross income for five (5) consecutive
years following the year of loss.

The NOLCO shall be carried for three (3) years or five (5) years, as the case may
be, provided that:

(a) The taxpayer was not exempt from income tax in the year of such net
operating loss; and

(b) There has been no substantial change in the ownership of the business of
enterprise.

There is no substantial change when not less than seventy-five percent (75%) in
nominal value of outstanding issued shares, if the business is in name of a
corporation, is held by or on behalf of the same person, or not less than seventy-
five percent (75%) of the paid-up capital of the corporation, if the business is in
the name of a corporation, is held by or on behalf of the same person.

NOLCO for mines other than gas and oil well incurred in any of the first ten (10)
years operation may be carried over for the next five (5) years.

The running the three-year, or five-year period, as the case maybe, on the carry-
over shall continue to run even if such corporation paid the Minimum Corporate
Income Tax.

NOLCO, in general, can be claimed by all taxpayers subject to normal or net

income tax or at preferential tax rate can avail or claim. However, taxpayers who
are subject to gross income tax, subject to final income tax, exempt from income
tax or enjoying income tax holiday.

Page 13 of 33
Sample 7: Goodhouse Industries, Inc., a domestic corporation, has provided you
the following data: 2021 Sales – P17,000,000, 2022 Sales – P23,000,000, 2021
Cost of Sales – P10,500,000, 2022 Cost of Sales – P14,250,000, 2021 Operating
Expenses – P6,750,000, and 2022 Operating Expense – P4,800,000.00. Determine
the taxable income for 2022.

2021 2022
Sales 17,000,000.00 23,000,000.00
Cost of Sales (10,500,000.00) (14,250,000.00)
Gross Income 6,500,000.00 8,750,000.00
Operating Expense (6,750,000.00) (4,800,000.00)
NOLCO (250,000.00)
Taxable Net Income (Loss) (250,000.00) 3,700,000.00

Capital Losses

Capital losses are allowed as deduction subject to certain conditions. Capital

losses as deduction will be discussed thoroughly later in the course.

Securities Becoming Worthless

If securities become worthless during the taxable year and are capital assets, the
loss resulting therefrom shall, for purposes of this Title, be considered as a loss
from the sale or exchange, on the last day of such taxable year, of capital assets.16

The term 'securities' means shares of stock in a corporation and rights to subscribe
for or to receive such shares. The term includes bonds, debentures, notes or
certificates, or other evidence or indebtedness, issued by any corporation,
including those issued by a government or political subdivision thereof, with
interest coupons or in registered form.17

Losses from shares of stock, held as capital asset, which have become worthless
during the taxable year shall be treated as capital loss as of the end of the year.
However, this loss is not deductible against the capital gains realized from the
sale, barter, exchange or other forms of disposition of shares of stock during the
taxable year, but must be claimed against other capital gains. For 15% Capital
Gains Tax on Sale of Securities not thru the Stock Exchange, net Capital Gains
Tax to apply, there must be an actual disposition of shares of stock held as capital
asset, and the capital gain and capital loss used as the basis in determining net
capital gain, must be derived and incurred respectively, from a sale, barter,
exchange or other disposition of shares of stock.18

16
Sec. 34(D)(4)(b) of the NIRC
17
Sec. 22(T) of the NIRC
18
Revenue Regulation No, 6-2008

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In case of any loss claimed to have been sustained from any sale or other
disposition of shares of stock or securities shall not be deductible if:

(a) the seller is not a dealer in securities; and

(b) within a period of thirty (30) days before the sale and ending thirty (30) days
after the sale, the seller shall either acquired stock or securities identical to the
stock or securities sold or has entered into a contract or option to acquire stock or
securities identical to stock or securities sold.

Sample 8: On December 1, 2021, Nem purchased 100 shares of common stock of

Goodhouse Industries Inc. for P10,000. On December 15, 2021, she purchased
100 additional shares for P9,000. On January 2, 2022, she sold the 100 shares
purchased on December 1, 2021 for P9,000. Determine the deductible loss.

Selling Price 9,000.00

Cost 10,000.00
Indicated Loss (1,000.00)

*No Deductible Loss

The indicated loss is not a deductible loss for determination of taxable income
because within a period of thirty (30) days before the sale and ending thirty (30)
days after the sale the seller acquired stock. December 15, 2021 to January 2,
2021 is within the thirty (30) day period. Hence, a non-deductible loss.

Wagering Losses

Wagering loss or gambling loss shall be allowed only to the extent of gain from
such transaction.19

Abandonment Losses

In the event a contract area where petroleum operations are undertaken is

partially or wholly abandoned, all accumulated exploration and development
expenditures pertaining thereto shall be allowed as a deduction: Provided, that
accumulated expenditures incurred in that area prior to January 1, 1979 shall be
allowed as a deduction only from any income derived from the same contract
area. In all cases, notices of abandonment shall be filed with the Commissioner.20

In case a producing well is subsequently abandoned, the un-amortized costs

thereof, as well as the un-depreciated costs of equipment directly used therein,
shall be allowed as a deduction in the year such well, equipment or facility is
abandoned by the contractor: Provided, That if such abandoned well is re-entered
and production is resumed, or if such equipment or facility is restored into

19
Sec. 35(D)(6) of the NIRC
20
Sec. 35(D)(7)(a) of the NIRC

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service, the said costs shall be included as part of gross income in the year of
resumption or restoration and shall be amortized or depreciated, as the case may
be.21

Bad Debts

Bad debts are debts due to the taxpayer arising from or connected with the trade,
business or profession actually ascertained to be worthless and charged off within
the taxable year.22

For a bad debts to be claimed as deduction, the following circumstances must be

present:

(a) there must be an existing indebtedness due to the taxpayer which must be due
and legally demandable;

(b) the same must be connected with the taxpayer’s trade, business or practice of
profession;

(c) the same must be not be sustained in a transaction entered into between
related parties.

(d) the same must be actually charged off the book of accounts of the taxpayer as
of the end of the taxable year; and

(e) the same must be actually ascertained to be worthless and uncollectible as of

the end of the taxable year.

Before a taxpayer may charge off and deduct a debt he must ascertain and deduct
a debt, he must ascertain and be able to demonstrate with reasonable degree of
uncertainty the uncollectibility of the debt.

Furthermore, there are steps outlines to be undertaken by the taxpayer to prove

exertion of diligent efforts to collect debt, vis: (1) sending of statement of
accounts; (2) sending of collection letters; (3) giving the account to a lawyer for
collection; and (4) filing of a collection case in court.

Hence, a mere testimony of the financial accountant explaining the worthlessness

of the debt is not sufficient to establish the worthlessness of the debt.23

Thus, where the surrounding circumstances indicate that a debt is worthless and
uncollectible and that legal action to enforce payment would in all probability not
result in the satisfaction of execution of judgment, a showing of those facts will be
sufficient evidence of the worthlessness of the debt for the purpose of deduction.24

21
Sec. 35(D)(7)(b) of the NIRC
22
Sec. 35(E)(1) of the NIRC
23
CIR v. Goodrich International Rubber Co., 21 SCRA 1336, December 22, 1967
24
Revenue Regulation No. 5-99, as amended by Revenue Regulations No. 25-2002

Page 16 of 33
However, a mere establishment of provision for bad debts will not suffice for a
claim of deduction based on bad debts. There must be an actual write-off of the
account.

Tax Benefit Rule

The recovery of bad debts previously allowed as 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 deductions. If the taxpayer did not receive any
income tax benefit from the bad debt written off, the bad debt recovery is not to
be included in the gross income of the year of recovery.

Sample 9: Goodhouse Industries, Inc. charged off a bad debt amounting to

P100,000 against its gross income of Php 500,000 in 2019. On the following year,
the company recovered the bad debts of P100,000. Determine the tax benefits to
be included in the gross income.

Gross Income 500,000.00

Less: Bad Debts Written-off (100,000.00)
Taxable Income 400,000.00

2020
Bad Debts Written Off 100,000.00
Corporate Tax Rate 30%
Tax Benefit to be Included in the Gross Income 30,000.00

Securities Becoming Worthless

If securities are ascertained to be worthless and charged off within the taxable
year and are capital assets, the loss resulting therefrom shall, in the case of a
taxpayer other than a bank or trust company incorporated under the laws of the
Philippines a substantial part of whose business is the receipt of deposits, for the
purpose of this Title, be considered as a loss from the sale or exchange, on the last
day of such taxable year, of capital assets.25

Depreciation

Depreciation is the gradual diminution in the useful value of tangible property

resulting from wear and tear and normal obsolescence. The term is also applied to
amortization of the value of intangible assets, the use of which in the trade or
business is definitely limited in duration.

Depreciation commences with the acquisition of the property and its owner is not
bound to see his property gradually waste, without making provision out of
earnings for its replacement. It is entitled to see that from earnings the value of

25
Sec. 35(E)(2) of the NIRC

Page 17 of 33
the property invested is kept unimpaired, so that at the end of any given term of
years, the original investment remains as it was in the beginning. It is not only the
right of a company to make such a provision, but it is its duty to its bond and
stockholders, and, in the case of a public service corporation, at least, its plain
duty to the public. Accordingly, the law permits the taxpayer to recover gradually
his capital investment in wasting assets free from income tax.26

For a depreciation to be deductible, the following circumstances must be present:

(a) the allowance for depreciation must be reasonable;

(b) it must be property arising out of its use or employment in the business or
trade, or out of its not being used temporarily during the year;

(c) it must be charged off during the taxable year;

(d) A statement on the allowance must be attached to the return; and

(e) the property must have a limited useful life.

Reasonableness of Depreciation

The term “reasonable allowance” for purposes of depreciation is usually

determined based on the conditions existing on the taxpayer and on the property.

To determine the reasonable allowance for depreciation, the following methods

may be used:

(a) Straight Line Method, a method of calculating depreciation and amortization,

the process of expensing an asset over a longer period of time than when it was
purchased. It is calculated by dividing the difference between an asset's cost and
its expected salvage value by the number of years it is expected to be used.

(b) Declining Balance Method, a method which is an accelerated depreciation

system of recording larger depreciation expenses during the earlier years of an
asset's useful life and recording smaller depreciation expenses during the asset's
later years.

(c) Sum-of-the-Years-Digit-Method, a form of accelerated depreciation that is

based on the assumption that the productivity of the asset decreases with the
passage of time. Under this method, a fraction is computed by dividing the
remaining useful life of the asset on a particular date by the sum of the year's
digits.

(d) Any other method which may be recommended by the Secretary of Finance
upon the recommendation of the Commissioner of Internal Revenue.

26
Basilan Estate v. CIR, G.R. No. L-22492, September 5, 1967

Page 18 of 33
Depreciation of Properties Used in Petroleum and Mining Operations

An allowance for depreciation of all properties directly related to production if

petroleum initially placed in service in a taxable year shall be allowed under the
straight-line or double declining method. However, if the service contractor
initially elects the declining-balance method, it may at any subsequent date, shift
to the straight-line method.

The useful life of properties related to petroleum used in or related to production

of petroleum shall be ten (10) years of such shorter life as may be permitted by the
Commissioner of Internal Revenue. Properties not used directly in the production
of petroleum shall be depreciated under the straight-line method on the basis of
an estimated useful life of five (5) years.

With respect to properties used in mining operations, the allowance for

depreciation shall be computed as follows:

(a) at the normal rate of depreciation if the expected life is ten (10) years or less;
or

(b) depreciation over any number of years between five (5) years and the expected
life if the latter is more than ten (10) years, and the depreciation thereon allowed
as deduction from taxable income provided that the contractor notifies the
Commissioner of Internal Revenue at the beginning of the depreciation period
which depreciation rate allowed.

Depreciation Deductible by Nonresident Aliens Engaged in Trade or Business or Resident

Foreign Corporations

In the case of a nonresident alien individual engaged in trade or business or

resident foreign corporation, a reasonable allowance for the deterioration of
property arising out of its use or employment or its non-use in the business trade
or profession shall be permitted only when such property is located in the
Philippines.

Depletion of Oil and Gas Wells and Mines

In the case of oil and gas wells or mines, a reasonable allowance for depletion or
amortization computed in accordance with the cost-depletion method shall be
granted under rules and regulations to be prescribed by the Secretary of finance,
upon recommendation of the Commissioner. Provided, That when the allowance
for depletion shall equal the capital invested no further allowance shall be
granted: Provided, further, That after production in commercial quantities has
commenced, certain intangible exploration and development drilling costs:

(a) shall be deductible in the year incurred if such expenditures are incurred for
non-producing wells and/or mines; or

Page 19 of 33
(b) shall be deductible in full in the year paid or incurred or at the election of the
taxpayer, may be capitalized and amortized if such expenditures incurred are for
producing wells and/or mines in the same contract area.

“Intangible costs in petroleum operations” refers to any cost incurred in

petroleum operations which in itself has no salvage value and which is incidental
to and necessary for the drilling of wells and preparation of wells for the
production of petroleum: Provided, That said costs shall not pertain to the
acquisition or improvement of property of a character subject to the allowance for
depreciation except that the allowances for depreciation on such property shall be
deductible under this Subsection.

Any intangible exploration, drilling and development expenses allowed as a

deduction in computing taxable income during the year shall not be taken into
consideration in computing the adjusted cost basis for the purpose of computing
allowable cost depletion.

Election to Deduct Exploration and Development Expenditures

In computing taxable income from mining operations, the taxpayer may at his
option, deduct exploration and development expenditures accumulated as cost or
adjusted basis for cost depletion as of date of prospecting, as well as exploration
and development expenditures paid or incurred during the taxable year: Provided,
That the amount deductible for exploration and development expenditures shall
not exceed twenty-five percent (25%) of the net income from mining operations
computed without the benefit of any tax incentives under existing laws. The
actual exploration and development expenditures minus twenty-five percent
(25%) of the net income from mining shall be carried forward to the succeeding
years until fully deducted.

The election by the taxpayer to deduct the exploration and development

expenditures is irrevocable and shall be binding in succeeding taxable years.

“Net income from mining operations” shall mean gross income from operations
less 'allowable deductions' which are necessary or related to mining operations.
'Allowable deductions' shall include mining, milling and marketing expenses, and
depreciation of properties directly used in the mining operations. This paragraph
shall not apply to expenditures for the acquisition or improvement of property of
a character which is subject to the allowance for depreciation.

In no case shall this paragraph apply with respect to amounts paid or incurred for
the exploration and development of oil and gas.

The term “exploration expenditures” means expenditures paid or incurred for the
purpose of ascertaining the existence, location, extent or quality of any deposit of
ore or other mineral, and paid or incurred before the beginning of the
development stage of the mine or deposit.

Page 20 of 33
The term “development expenditures” means expenditures paid or incurred
during the development stage of the mine or other natural deposits. The
development stage of a mine or other natural deposit shall begin at the time when
deposits of ore or other minerals are shown to exist in sufficient commercial
quantity and quality and shall end upon commencement of actual commercial
extraction.

Depletion of Oil and Gas Wells and Mines Deductible by a Nonresident Alien individual or
Foreign Corporation

In the case of a nonresident alien individual engaged in trade or business in the

Philippines or a resident foreign corporation, allowance for depletion of oil and
gas wells or mines shall be authorized only in respect to oil and gas wells or mines
located within the Philippines.

Charitable and Other Contributions

Charitable and other contributions are allowed as deduction even though these
are not business-related expenses. In essence, these are contributions which are
actually based on the liberality and beneficence of the giver, also called the donor.
As such, the donor is entitled to claim this as a deduction because he is the one
who incurred the expense.

Apparent to these contributions is that an individual is not listed as one of those

qualified receivers, also called the donee or beneficiaries. This means that
donation to an individual is not allowed to be claimed as a charitable contribution
deduction. Simply, to qualify as a charitable and other contributions as deduction
the donee must be one of those enumerated hereunder.

Charitable and other contributions may be deductible in full or partial subject to

limitations under the rules.

Charitable and Other Contributions Deductible in Full

The following contributions, regardless of the amount, may be claimed in full as

deduction from gross income of the donor;

(a) Donations to the Government

Donations to the Government of the Philippines or to any of its agencies or

political subdivisions, including fully-owned government corporations,
exclusively to finance, to provide for, or to be used in undertaking priority
activities in education, health, youth and sports development, human settlements,
science and culture, and in economic development according to a National
Priority Plan determined by the National Economic and Development Authority
(NEDA), in consultation with appropriate government agencies, including its
regional development councils and private philanthropic persons and institutions.

Page 21 of 33
Any donation which is made to the Government or to any of its agencies or
political subdivisions not in accordance with the said annual priority may be
claimed as deduction subject to limitations, as discussed below.

(b) Donations to Certain Foreign Institutions or International Organizations

Donations to foreign institutions or international organizations which are fully

deductible in pursuance of or in compliance with agreements, treaties, or
commitments entered into by the Government of the Philippines and the foreign
institutions or international organizations or in pursuance of special laws.

(c) Donations to Accredited Nongovernment Organizations

Donations to accredited nongovernment organizations may also be deducted in

full. The term “nongovernment organization” means a non-profit domestic
corporation:

(i) Organized and operated exclusively for scientific, research, educational,

character-building and youth and sports development, health, social
welfare, cultural or charitable purposes, or a combination thereof, no part
of the net income of which inures to the benefit of any private individual;

(ii) Which, not later than the 15th day of the third month after the close of
the accredited nongovernment organizations taxable year in which
contributions are received, makes utilization directly for the active conduct
of the activities constituting the purpose or function for which it is
organized and operated, unless an extended period is granted by the
Secretary of Finance in accordance with the rules and regulations to be
promulgated, upon recommendation of the Commissioner;

(iii) The level of administrative expense of which shall, on an annual basis,

conform with the rules and regulations to be prescribed by the Secretary of
Finance, upon recommendation of the Commissioner, but in no case to
exceed thirty percent (30%) of the total expenses; and

(iv) The assets of which, in the event of dissolution, would be distributed

to another non-profit domestic corporation organized for similar purpose
or purposes, or to the state for public purpose, or would be distributed by a
court to another organization to be used in such manner as in the
judgment of said court shall best accomplish the general purpose for which
the dissolved organization was organized.

Charitable and Other Contributions Subject to Limitations

Contributions or gifts are actually paid or made within the taxable year:

(a) Contributions or gifts actually paid or made within the taxable year to, or for
the use of the Government of the Philippines or any of its agencies or any
political subdivision thereof exclusively for public purposes; or

Page 22 of 33
(b) To accredited domestic corporation or associations organized and operated
exclusively for religious, charitable, scientific, youth and sports development,
cultural or educational purposes or for the rehabilitation of veterans, or to social
welfare institutions, or to non-government organizations, no part of the net
income of which inures to the benefit of any private stockholder or individual in
an amount not in excess of ten percent (10%) in the case of an individual, and five
percent (5%) in the case of a corporation, of the taxpayer's taxable income derived
from trade, business or profession as computed without the benefit of this
charitable and other contributions.

Unlike other deductions, Charitable and Other Contributions Subject to

Limitations is not deductible directly from the gross income but deducted from
the net income before the charitable and other contributions before arriving at the
taxable income. Thus, the following formula:

Gross Income xxx

Allowable Deductions (excluding Charitable and Other Contributions) (xx)
Net Income before Charitable and Other Contributions xxx
Less: Charitable and Other Contributions (xx)
Taxable Income xxx

The limitation of ten percent (10%) for individual and five percent (5%) for
corporation are based on the net income before charitable and other
contributions.

Sample 10: Nem has a gross income of P1,000,000.00 and other deductions of
P400,000, excluding charitable contributions. She donated cash amounting to
P500,000 to the government but not in pursuant to a national development
priority program. Determine the taxable income of Nem.

Gross Income 1,000,000.00

Less: Deductions excl. Contributions (400,000.00)
Net Income Before Contributions 600,000.00
Less: Contributions (10%) (60,000.00)
Taxable Income 540,000.00

The excess charitable contributions over the 10% limit is not deductible since the
contribution was not made pursuant to a national development priority program.

Sample 11: Goodhouse Industries, Inc. has a gross income of P1,000,000.00 and
other deductions of P400,000, excluding charitable contributions. The company
donated cash amounting to P500,000 to the government but not in pursuant to a
national development priority program. Determine the taxable income of
Goodhouse.

Page 23 of 33
 Gross Income 1,000,000.00
Less: Deductions excl. Contributions (400,000.00)
Net Income Before Contributions 600,000.00
Less: Contributions (5%) (30,000.00)
Taxable Income 570,000.00

Valuation

The amount of any charitable contribution of property other than money shall be
based on the acquisition cost of said property.

Research and Development.

A taxpayer may treat research or development expenditures which are paid or

incurred by him during the taxable year in connection with his trade, business or
profession as ordinary and necessary expenses which are not chargeable to capital
account. The expenditures so treated shall be allowed as deduction during the
taxable year when paid or incurred.27

At the election of the taxpayer, the following research and development

expenditures may be treated as deferred expenses:

(a) Paid or incurred by the taxpayer in connection with his trade, business or
profession;

(b) Not treated as expenses; and

(c) Chargeable to capital account but not chargeable to property of a character

which is subject to depreciation or depletion.

In computing taxable income, such deferred expenses shall be allowed as

deduction ratably distributed over a period of not less than sixty (60) months as
may be elected by the taxpayer.

The method so elected, and the period selected by the taxpayer, shall be adhered
to in computing taxable income for the taxable year for which the election is
made and for all subsequent taxable years a change to a different method is
authorized with respect to a part or all of such expenditures. The election shall
not apply to any expenditure paid or incurred during any taxable year for which
the taxpayer makes the election.28

The deduction for research and development is subject to the following

limitations;

27
Sec. 35(I)(1) of the NIRC
28
Sec. 35(I)(2) of the NIRC

Page 24 of 33
(a) Any expenditure for the acquisition or improvement of land, or for the
improvement of property to be used in connection with research and development
of a character which is subject to depreciation and depletion; and

(b) Any expenditure paid or incurred for the purpose of ascertaining the existence,
location, extent, or quality of any deposit of ore or other mineral, including oil or
gas.29

Pension and Trusts

An employer establishing or maintaining a pension trust to provide for the

payment of reasonable pensions to his employees shall be allowed as a deduction
(in addition to the contributions to such trust during the taxable year to cover the
pension liability accruing during the year, allowed as a deduction) a reasonable
amount transferred or paid into such trust during the taxable year in excess of
such contributions, but only if such amount:

(a) has not theretofore been allowed as a deduction, and

(b) is apportioned in equal parts over a period of ten (10) consecutive years
beginning with the year in which the transfer or payment is made.

Additional Requirements for Deductibility of Certain Payments

For a taxpayer engaged in trade or business or exercise of a profession, it is not

sufficient that the deduction claimed is properly substantiated by receipts. As an
additional requirement, it must also be established by sufficient evidence that the
required tax to be deducted has been withheld and paid to the BIR.

This requirement of refers to the creditable withholding taxes on certain income

payments. Creditable withholding tax system is a tool adopted by the BIR for the
effective collection of taxes because it encourages voluntary compliance of
payment of taxes, collection of taxes, and provides regular source of inflow to the
government by providing revenues through out the year.

An important person in the creditable withholding tax system is the withholding

agent who is the payor of income which has the duty to withhold and remit the
tax to the BIR. The tax withheld and remitted by the withholding agent serves as
a tax credit on the income tax liability of the income payee or recipient. The
recipient of the income or the income payee computes the income tax still due
based on the following formula:

29
Sec. 35(I)(3) of the NIRC

Page 25 of 33
 Gross Income xxx
Allowable Deductions (xx)
Taxable Income xxx
Schedular Tax Rate (xx)
Income Tax Due xxx
Less: Creditable Withholding Tax (xx)
Income Tax Still Payable xxx

Any income payments which is otherwise deductible under the Tax Code shall be
allowed as deduction from the taxpayer’s gross income only if its shown that the
income tax required to be withheld has been paid.

As an exemption, deduction may be allowed in the following circumstances

where no withholding tax has been made:

(a) The payee reported the income and pays the tax due thereon and the
withholding agent pays the tax, including the interest incident to the failure to
withhold the tax, and surcharges, if applicable, at the time of audit/investigation
or reinvestigation/reconsideration;

(b) The recipient/payee failed to report the income on the due date thereof, but
the withholding agent/taxpayer pays the tax, including the interest incident to the
failure to withhold the tax, and surcharges, if applicable, at the time of
audit/investigation or reinvestigation/reconsideration; and

(c) The withholding agent erroneously under withheld the tax but pays the
difference between the correct amount and the amount of tax withheld, including
the interest incident to such error and surcharges, if applicable, at the time of
audit/investigation or reinvestigation/reconsideration.

Items of deduction representing return of capital, such as those pertaining to

purchases of raw materials forming part of finished product purchases of goods
for resale, shall be allowed as deduction upon withholding agent’s payment of the
basic withholding tax and penalties incident to non-withholding or under
withholding.

OPTIONAL STANDARD DEDUCTION (OSD)

In lieu of the deductions allowed, an individual, other than a nonresident alien,

may elect a standard deduction in an amount not exceeding forty percent (40%)
of his gross sales or gross receipts, as the case maybe. The benefit derived from
availing the OSD is that the taxpayer does not need to substantiate or present
proof in order to avail deductions. However, availing OSD does not relieve the
taxpayer to withhold and remit tax to the BIR.

Availment of OSD

Page 26 of 33
All individual taxpayers, except non-resident alien engaged in trade or business
and non-resident alien engaged in trade or business, and all corporation, except
non-resident foreign corporation, may avail of the OSD.

However, the following taxpayers are mandatorily required to use itemized

deductions:

(a) Corporations, partnership and other non-individuals who are exempt under
the Tax Code and other special laws, with no other taxable income;

(b) Corporations, partnership and other non-individuals with income subject to

special/preferential tax rates; and

(c) Corporations, partnership and other non-individuals with income subject to

regular corporate income tax and also with income subject to special/preferential
tax rates.

Juridical entities whose taxable base is the gross revenue or receipts are not
entitled to the itemized deductions nor to the Optional Standard Deduction
(OSD).

(d) Individual taxpayers who are exempt under the Tax Code, as amended, and
other special laws with no other taxable income (e.g. Barangay Micro Business
Enterprise);

(e) Individual taxpayers who are subject to special/preferential tax rates; and

(f) Individual taxpayers who are subject to Normal Income, and also with income
subject to special/preferential tax rates.

Rate and Base of OSD

For individual taxpayers, OSD is forty percent (40%) of gross sales or gross
receipts. For corporation, OSD is forty percent (40%) based of gross income.
Thus:

Individual Corporate
Gross Sales 1,500,000.00 1,500,000.00
Less: Cost of Sale - (700,000.00)
Gross Income 1,500,000.00 800,000.00
OSD Rate 40% 40%
OSD Amount 600,000.00 320,000.00

Gross Sales 1,500,000.00 1,500,000.00

Less: Cost of Sale - (700,000.00)
Gross Income 1,500,000.00 800,000.00
Less: OSD (600,000.00) (320,000.00)
OSD Amount 900,000.00 480,000.00

Page 27 of 33
OSD for Individuals

The OSD allowed to individual taxpayers shall be a maximum of forty percent

(40%) of gross sales or gross receipts during the taxable year. If the individual is
on the accrual basis of accounting for his income and deductions, the OSD shall
be based on the gross sales during the taxable year. On the other hand, if the
individual employs the cash basis of accounting for his income and deductions,
the OSD shall be based on his gross receipts during the taxable year.

It should be emphasized that the “cost of sales” in case of individual seller of

goods, or the “cost of services” in the case of individual seller of services, are not
allowed to be deducted for purposes of determining the basis of the OSD, the
basis of the 40% OSD shall be the “gross sales” or “gross receipts” and not the
“gross income”.

For other individual taxpayers allowed by law to report their income and
deductions under a different method of accounting (e.g., percentage of
completion basis, etc.) other than cash and accrual method of accounting, the
“gross sales” or “gross receipts” shall be determined in accordance with said
acceptable method of accounting.30

OSD for Corporations

In the case of corporate taxpayers, the OSD allowed shall be in an amount not
exceeding 40 % of their gross income.

“Gross Income” shall mean the gross sales less sales returns, discounts and
allowances and cost of goods sold. “Gross sales” shall include only sales
contributory to income taxable. “Cost of goods sold” shall include the purchase
price or cost to produce the merchandise and all expenses directly incurred in
bringing them to their present location and use.

For trading or merchandising concern, “cost of goods sold” means the invoice
cost of 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.

For manufacturing concern, “cost of goods sold” means all costs incurred in the
production of the 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. The term may be
used interchangeably with “cost of goods manufactured and sold”.

In the case of sellers of services, the term “gross income” means the “gross
receipts” less sales returns, allowances, discounts and cost of services. “Cost of
services” means all direct costs and expenses necessarily incurred to provide the

30
Revenue Regulation No. 16-2008

Page 28 of 33
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.

However, “cost of services” shall not include interest expense except in the case
of banks and other financial institutions. The term “gross receipts” as used herein
means amounts actually or constructively received during the taxable year.
However, for taxpayers engaged as sellers of services but employing the accrual
basis of accounting for their income, the term “gross receipts” shall mean
amounts earned as gross revenue during the taxable year.

The items of gross income, as amended, which are required to be declared in the
income tax return of the taxpayer for the taxable year are part of the gross income
against which the OSD may be deducted in arriving at taxable income.

Passive incomes which have been subjected to a final tax at source shall not form
part of the gross income for purposes of computing the forty percent (40%)
optional standard deduction.31

Rules in Availing OSD

A taxpayer who elected to avail of the OSD shall signify in his/its return such
intention, otherwise he/it shall be considered as having availed himself of the
itemized deductions.

Once the election to avail the OSD is signified in the return, it shall be irrevocable
for the taxable year for which the return is made. This means that a taxpayer who
initially filed a return availing OSD is precluded from amending said return in
order to shift to the itemized deductions.

An individual taxpayer who is entitled to and claimed the OSD shall not be
required to submit with his tax return such financial statements otherwise
required under the Code. However, the said individual shall keep such records
pertaining to his gross sales or gross receipts.

In the case of a corporation, however, said corporation is still required to submit

its financial statements when it files its annual income tax return and to keep such
records pertaining to its gross income.

In the filing of the quarterly income tax returns, the taxpayer may opt to use
either the itemized deduction or OSD. However, in filing the final adjustment
income tax return, the taxpayer must make a choice as to what method of
deduction it or he shall employ for the purpose of determining its/his taxable
net income for the entire year. The taxpayer is, thus, not allowed to use a hybrid
method of claiming its/his deduction for one taxable year.

31
Id.

Page 29 of 33
OSD for GPP and Partners of GPP

A General Professional Partnership (GPP) may avail of the OSD only once,
either by the GPP or the partners comprising the partnership. Thus, a GPP and a
partner cannot both avail OSD at the same time or during the same taxable year.
GPP is not subject to income tax. However, the partners shall be liable to pay
income tax on their separate and individual capacities for their respective
distributive share in the net income of the GPP.

The GPP is not a taxable entity for income tax purposes since it is only acting as a
“pass- through” entity where its income is ultimately taxed to the partners
comprising it. For purposes of computing the distributive share of the partners,
the net income of the GPP shall be computed in the same manner as a
corporation.” As such, a GPP may claim either the itemized deductions allowed
or it can opt to avail of the OSD allowed to corporations in claiming the
deductions in an amount not exceeding Forty Percent (40 %) of its gross income.

The distributable net income of the partnership may be determined by claiming

either itemized deductions or OSD. The share in the net income of the
partnership, actually or constructively received, shall be reported as taxable
income of each partner.

The partners comprising the GPP can no longer claim further deduction from
their distributive share in the net income of the GPP and are not allowed to avail
of the 8% Income Tax rate option since their distributive share from the GPP is
already net of cost and expenses.

If the partner also derives other income from trade, business or practice of
profession apart and distinct from the share in the net income of the GPP, the
deduction that can be claimed from the other income would either be the
itemized deductions or OSD.32

Sample 12: Nem is a partner of N&A, a general professional partnership, and

owns twenty-five percent (25%) interest. The gross receipts of the partnership
amounted to P10,000,000.00 and the recorded cost of service and operating
expenses were P2,750,000.00 and P1,500,000.00, respectively. The partnership
opted to choose OSD. Determine Nem’s share in the distributive profit.
Gross Receipts 10,000,000.00
Less: Cost of Service (2,750,000.00)
Gross Income 7,250,000.00
OSD Rate 40%
OSD Amount 2,900,000.00

Gross Sales 10,000,000.00

Less: Cost of Sale (2,750,000.00)
Gross Income 7,250,000.00
Less: OSD (2,900,000.00)
Net Income of Partnership 4,350,000.00
Nem's Interest 25%
Share in the Distributive Profit 1,087,500.00

32
Id.

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There is no income tax liability for the partnership since it is a GPP. Individual
partner is not allowed to claim further deduction from distributive share since this
is already net of cost and expenses. Taxpayer is not allowed to avail eight percent
(8%) income tax rate option for the same reason.

ITEMS NOT DEDUCTIBLE

The items enumerated hereunder are not deductible from the gross income
because they are either not related to the conduct of trade, business or profession,
or because of the proximity of relations between parties which the law presumes
irregularity.

In computing net income, no deduction shall in any case be allowed in respect to:

(a) Personal, living or family expenses;

(b) Any amount paid out for new buildings or for permanent improvements, or
betterments made to increase the value of any property or estate;

This Subsection shall not apply to intangible drilling and development costs
incurred in petroleum operations which are deductible.

Additional exception to this is with regards to Private Educational Institutions

(PEI) which the law grants the PEI an option to either deduct expenditures which
are considered as capital outlays of depreciable assets incurred during the taxable
year for the expansion of school facilities or to deduct the allowance for
depreciation.

(c) Any amount expended in restoring property or in making good the exhaustion
thereof for which an allowance is or has been made; or

(d) Premiums paid on any life insurance policy covering the life of any officer or
employee, or of any person financially interested in any trade or business carried
on by the taxpayer, individual or corporate, when the taxpayer is directly or
indirectly a beneficiary under such policy.

If the designated beneficiary is the estate of the employee or executor, or

administrator, the insurance premium maybe claimed as an ordinary and
necessary expenses.

Losses from Sales or Exchanges of Property

In computing net income, no deductions shall in any case be allowed in respect of

losses from sales or exchanges of property directly or indirectly:

(a) 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

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(b) Except in the case of distributions in liquidation, between an individual and
corporation more than fifty percent (50%) in value of the outstanding stock of
which is owned, directly or indirectly, by or for such individual; or

(c) Except in the case of distributions in liquidation, between two corporations

more than fifty percent (50%) in value of the outstanding stock of which is
owned, directly or indirectly, by or for the same individual if either one of such
corporations, with respect to the taxable year of the corporation preceding the
date of the sale of exchange was under the law applicable to such taxable year, a
personal holding company or a foreign personal holding company;

(d Between the grantor and a fiduciary of any trust; or

(e) Between the fiduciary of and the fiduciary of a trust and the fiduciary of
another trust if the same person is a grantor with respect to each trust; or

(f) Between a fiduciary of a trust and beneficiary of such trust.

Prizes and Awards to Local and International Sports Tournaments and

Competitions

R.A. 754933 provides that all prizes and awards granted to athletes in local and
international sports tournaments and competitions held in the Philippines or
abroad and sanctioned by their respective national sports associations shall be
exempt from income tax and that such prizes and awards given to said athletes
shall be deductible in full from the gross income of the donor.

-o0o-

Suggested Teaching Activities (TAs)

Refer to our Google Classroom for the Suggested Teaching Activities

Assessment Tasks / Output (ATOs)

Refer to our Google Classroom for the Assessment Task/Output

Readings and Other References

1. Taxation Law, Volume 1, Raegan L. Capuno (2020)

2. Taxation Law, Volume 2, Raegan L. Capuno (2020)
3. CPA Reviewer in Taxation, Enrico D. Tabag (2021)
4. CPA Reviewer in Taxation, Omar Erasmo G. Ampongan (2021)
5. Republic Act No. 8424 or the Tax Reform Act of 1997

33
An Act Exempting All Prizes And Awards Gained From Local And International Sports
Tournaments And Competitions From The Payment Of Income And Other Forms Of Taxes And For
Other Purposes

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6. Republic Act No. 10963 or the Tax Reform for Acceleration and Inclusion
Law
7. Republic Act No. 11534 or the Corporate Recovery and Tax Incentives for
Enterprises (CREATE) Act
8. Republic Act No. 11469 or the The Bayanihan to Heal as One Act
9. Republic Act No. 11494 or the The Bayanihan to Recover as One Act
10. RR No. 8-2018 - Implements the amended provisions on Income Tax
pursuant to RA No. 10963 (TRAIN Law)
11. RR No. 2-2021 - Amends certain provisions of RR No. 2-98, as amended,
to implement the amendments introduced by RA No. 11534 (Corporate
Recovery and Tax Incentives for Enterprises Act or CREATE Act) to the
NIRC of 1997, as amended, relative to the Final Tax on certain passive
income
12. RR No. 3-2021 - Prescribes the Rules and Regulations to implement
Section 3 of RA No. 11534 (Corporate Recovery and Tax Incentives for
Enterprises Act or CREATE Act), amending Section 20 of the NIRC of
1997
13. RR No. 5-2021 - Implements the new Income Tax rates on the regular
income of corporations, on certain passive incomes, including additional
allowable deductions from Gross Income of persons engaged in business
or practice of profession pursuant to RA No. 11534 (Corporate Recovery
and Tax Incentives for Enterprises Act or CREATE Act), which further
amended the NIRC of 1997.

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