NATURE OF DEDUCTONS

In general, deductions or allowable deductions are business

expenses and losses incurred which the law allows to reduce gross
business income to arrive at net income subject to tax.
Deductions are strictly construed against the taxpayer. They are not
presumed but allowable only by reason of specific provisions of law
and not under any general equitable or Constitutional concept.
The taxpayer seeking a deduction must be able to prove that he is
entitled to the deduction which the law allows. Adequate records
should be kept to support deductions, except when the law
dispenses the records, documents or receipts to support the
deductions.
The purpose of deductions from gross income is to provide the
taxpayer a just and reasonable taxable amount as the basis of
income tax. It is because many taxpayers spend adequate
expenditures in order to obtain a legitimate income.
Mandatory Withholding of Taxes. BIR issued RR No. 12-
2013 amending Sec. 2.85.5 of RR. No. 2-98 as amended,
relative to the requirements for deductibility of certain income
payments.
The salient features of Revenue Regulations No. 12-2013 are:
1. No deduction shall be allowed on income payments if it is
shown that the applicable withholding taxes required by
the rules had not been withheld.
2. No deduction will also be allowed if during tax assessment
on deficiency withholding taxes for alleged failure to
withhold the taxpayer paid the withholding taxes.
Note: In effect Revenue Regulations No.12-2013 makes it
mandatory for taxpayers to withhold on expenses required to
be withheld for purposes of expense deduction for income tax
purposes in the Philippines.
Revenue vs. Capital Expenditures
There are two major classifications of business expenditures: (a)
Revenue Expenditures, and (b) Capital Expenditures.
Revenue expenditures are ordinary recurring expenditures that
provide benefits to the current accounting period. They are usually
called “period cost” because they are related to a particular period
of time of business operation.
They are charged to expense as incurred, and are deductible from
gross income if they satisfy the conditions as prescribed by the Tax
Code.
Examples of revenue expenditures are:
1. Salary expense;
2. Supplies expense;
3. Repairs and maintenance such as painting, lubricating,
cleaning expenditures; and
4. Other recurring expenditures that benefit only current operation
and do not improve or extend the life of the asset used in
business.
Capital expenditures are nonrecurring
expenditures related to the acquisition of
depreciable assets to be used in the business, but
not for sale, having a useful life of several years.
They provide current and future benefits in
business operations.
The cost incurred(or paid) for acquiring such asset
is capitalized and not immediately expensed. They
are gradually expended from period to period in
the form of depreciation or amortization within their
estimated useful life.
Expenditures After Acquisition
Costs after the acquisition of plant assets shall be capitalized
when any of the following conditions are met:
1. Increase in useful life. There is an increase in the economic
life of the asset if its new useful life exceeds its original life
after the expenditures. For instance, if the asset’s original
useful life is 5 years; it becomes 9 years after the
expenditures.
2. Increase in capacity. There is an increase in the units
produced from the utilization of the asset after the
expenditures. For instance, if the normal production per
period is 10,000 units, it becomes 15,000 after the
expenditures.
3. Increase in efficiency. The asset provide better quality of
services or products after the expenditures.
If neither of the conditions is met, the expenditures are intended only to sustain
the ordinary level and quality of services to be provided by the plant assets.
Thus, expenditures should be designated as revenue expenditures and
recorded as repairs expense during the year incurrence.

Summary Application
Deductibility of Expenditures
As to Usage Deductibility from business income
Year 1 Year 2 Year 3
Personal use -0- -0- -0-

Business use: Capital expenditures allocated

as depreciation or amortization. xxx xxx xxx

Revenue expenditures
Year 1 xxx
Year 2 xxx
Year 3 xxx
Situs of Expenses
The place of business becomes the basis if
business expenses are deductible for Philippine
income tax purposes.
As a rule, business expenses are deductible only
if they are incurred in relation to the business
income taxable in the Philippines, (except when
the taxpayer is a resident Filipino or a domestic
corporation). If a business expense could not be
traced whether incurred within or not, such
expense shall be allocated based on the gross
income within and without.
Illustration
Mr. Dacu Chan, a nonresident alien engaged in
business in the Philippines, presented the
following incomes and expenses during the
taxable year:
Philippines Foreign
Gross income P 10,000,000 P 30,000,000
Operating expenses 1,000,000 5,000,000

In addition, Mr. Smith presented P600,000

mixed operating expenses both Philippines and
foreign operations.
 The total amount of operating expenses for Philippine income
tax purposes would be
Operating expenses-Philippines P 1,000,000
Add: Allocated share on mixed expenses
-Philippines(P600,00x ¼) 500,000
Total amount of operating expenses-Philippines P 1,500,000
Note: The mixed expenses is allocated based on the gross income.
Summary Application
Situs of Deductible Expenses
Income Taxpayers
Situs of Expenses: RC/DC NRC/Aliens/FC
Incurred:
Within Deductible Deductible
Without Deductible Not Deductible
Partly within and Deductible Partly Deductible
without
RC-Resident Citizens NRC-Nonresident Citizens
DC-Domestic Corporations FC-Foreign Corporations
 ITEMS NOT DEDUCTIBLE FROM GROSS INCOME
As a general rule in computing net income, no deductions shall in any case be allowed
with respect to:
1. Personal, living or family expenses(Sec. 36(A),NIRC).
2. Any amount paid out for new buildings or for permanent improvements, or
betterments made to increase the value of any property or estate.
3. Any amount expended in restoring property for which an
4. 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, when the taxpayer is directly or indirectly a beneficiary under such
policy.
5. Transactions between related taxpayers resulting to losses from sales or exchanges
of property, interest expense or bad debts.
6. Bribes, kickbacks and other similar payments. Payment for police protection is
illegal.
7. 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.
8. The amount spent for political campaign funds and donations to political parties or
candidates are NOT deductible either as business or contribution expenses from
gross income.
Tax Laws versus GAAP
For taxation purposes, whenever there is a
conflict between Tax laws and GAAP, the former
prevails over the latter.
Comparative Presentation
Tax Code GAAP
Sales P xxx Sales
Less: Cost of Sales xxx Less: Cost of sales
Business Income P xxx Gross Profit
Less: Allowable itemized deductions xxx Less: Operating
expenses
Income before personal exemptions P xxx Net income before tax
Less: Personal exemptions xxx
Net taxable income P xxx
Illustration
Mr. Maginoo reports the following sales and expenses during a
taxable year:
Sales P500,000 Estimated uncollectibles P5,000
Cost of sales 200,000 Miscellaneous expense
Salary expense 50,000 (without receipts) 2,000
Rent expense 24,000 Depreciation 6,000
The comparative computation would be
Tax Code GAAP
Sales P500,000 Sales P500,000
Cost of sales ( 200,000) Cost of sales ( 200,000)
Business income P300,000 Gross Profit P300,000
Itemized allowable Operating expenses:
deductions:
Salary expense (P 50,000) Salary expense (P 50,000)
Rent expense ( 24,000) Rent expense ( 24,000)
Depreciation expense ( 6,000) Depreciation expense ( 6,000)
Estimated uncollectibles ( 5,000)
Miscellaneous expense ( 2,000)
Total itemized deductions (P 80,000) Total operating expense (P 87,000)
Taxable income P220,000 Net income P213,000
Less: Personal exemption 50,000
Net taxable income P170,000 Net income before tax P213,000
Notes:
1. Observe that there are expenses that are allowed as deduction under GAAP
but disallowed under Tax Code. The gross profit under GAAP is the business
income under the Tax Code and the operating expenses under GAAP are the
itemized deductions under the Tax Code.
2. Determination of the Net Taxable Income:
Employed Taxpayer. For individual taxpayer, the deductions of items specified in
Section 34 of NIRC are not allowed with respect to compensation income arising
from personal services rendered under an employer-employee relationship.
Items allowed to reduce the compensation income for individual taxpayer are
 Allowance for personal exemptions, and
 Premium payments of health and/or hospitalization insurance (PPHHI) not
exceeding P2,400 in a year.
The PPHHI is deductible only if the total family income does not exceed P250,000
in a year.
Employed and Self-employed. The deductions allowed by law under Section 34 of
NIRC are allowed to reduce only the gross business income of an individual
taxpayer.
The format to compute the net taxable income of employed and at the sa time self-
employed taxpayer is
Compensation income P xxx
Less: Personal Exemptions xxx
Compensation income after personal exemption P xxx
Add: Gross income from business P xxx
Less: Allowable itemized deductions xxx
Net business income xxx
Net taxable income P xxx
Corporation. The deductions allowed by law under Section 34 of NIRC
are allowed to reduce gross income of the corporation. There are no
deductions allowed of personal exemption and PPHHI for corporations.
The format to compute the net taxable income of corporation as defined
by Tax Code would be

Gross income P xxx

Less: Allowable itemized deductions xxx
Net taxable income P xxx
Classifications of Deductions
from Gross Income
Deductions from gross income are classified as follows:
1. Optional standard deduction (OSD);
2. Regular allowable itemized deduction; and
3. Special allowable itemized deduction.
Unless the taxpayer signifies in his return his intention to elect
the OSD, he shall be considered as having availed himself of
the allowable itemized deductions.
The Tax Code provides that once a taxpayer elected a
deduction(optional or itemized) in his income tax return, such
election is irrevocable for the taxable year in which the return
is made.

Quarterly OSD or Itemized Deductions. The BIR recently

changed the rules with its issuance of RR 02-10, and
Revenue Memorandum Circular(RMC) No. 16-10.
Optional Standard
Deduction(OSD)
In lieu of allowable itemized deductions, the OSD may be
deducted from the gross income as follows:
If the taxpayer is
1. An individual other than a nonresident alien, the OSD is
40% of his gross sales or gross receipts.
If an individual opted to use OSD, he is no longer allowed to
deduct cost of sales or cost of services.
The Tax Law (R.A. 9504) is specific as to the basis of OSD
which states that for individuals, the basis of the 40% OSD
shall be the “gross sales” or “gross receipts” and not the
“gross income.”
An individual who opts to avail of this deduction need not
submit the Account Information form/ Financial Statements.
2. A corporation, the OSD is 40% of its gross income.
OSD Illustration-Individual vs.
Corporation
Section 5 of Revenue Regulations No. 16-2008 provides the
following examples in determining the basis of the 40% OSD for
individuals and corporations.
Assume the following data of a taxpayer:
Gross sales P1,000,000
Cost of goods sold 800,000
How much is the OSD if the taxpayer is a/an (1) individual, or (2) a
corporation?
The OSD of the taxpayer would be
If Individual If Corporation
Gross sales P1,000,000 P1,000,000
Less: Cost of goods sold _________ 800,000
Basis of OSD P1,000,000 P 200,000
Multiplied by OSD rate 40% 40%
OSD amount P 400,000 P 80,000
If the taxpayer opts to use OSD in lieu of the
itemized deduction allowed under Section 34 of
the Code as amended, his/its net taxable income
shall be as follows:
If Individual If Corporation
Gross sales P1,000,000 P1,000,000
Less: Cost of goods sold __________ 800,000
Sales/Gross income P1,000,000 P 200,000
Less: OSD amount 400,000 80,000
Net income P 600,000 P 120,000

Query: Are other items of gross income not subjected to final taxes
excluded from gross income for corporate OSD purposes?
Answer: No other items of income not subjected to final taxes are included
in the gross income in determining corporate OSD. Consider the following
provisions of Revenue Regulations No. 16-2008.
“Passive incomes which have been subjected to final tax at source shall
NOT form part of the gross income for purposes of computing the forty
percent (40%) optional standard deduction.”
It could be inferred that only those that have been subjected to final taxes are
precluded to be part of gross income for corporate OSD purposes. Accordingly,
other items of income that were not subjected to final taxes are NOT precluded as
part of the gross income in computing the 40% corporate OSD.
With foregoing, the gross income basis of 40% corporate OSD should include other
taxable income not subjected to final tax.
Notes:
1. Section 2 of Revenue Regulations No.16-2008 provides that the following may
be allowed to claim OSD in lieu of itemized deductions under Sections 34 (A)
to (J) and (M), Section 37, other special law, if applicable:
Individuals:
a. Resident citizen
b. Nonresident citizen
c. Resident alien
d. Taxable estates and trusts
Corporations:
a. Domestic corporations
b. Resident foreign corporations

2. An individual who is entitled to and claimed for the OSD shall not be required
to submit with his tax return the supporting financial statements.
3. If an individual employs the accrual basis of accounting for his income
and deductions, the OSD shall be based on the gross sales during the
taxable year. If he/she employs cash basis, the OSD shall be based
on his gross receipts during the year.
4. Allowances are considered to derive the basis of sales in computing
OSD. This rule is supported by the tax principle that the lower amount
of deduction will be allowed for income tax purposes.
5. Components of Gross Income for purposes of Corporate OSD
“Gross income derived from business shall be equivalent to gross sales
less sales returns, discounts and allowances and cost of goods sold. Gross
sales shall include only sales contributory to income taxable under Sec.
27(A) of the Tax Code.”
“Cost of goods sold shall include all business expenses directly incurred
to produce the merchandise to bring them to their present location and
use.”
6. If a taxpayer elects to offset his losses against his profit from capital
asset transactions, he may no longer claim the OSD under Sec. 34 (L)
of NIRC because this section provides that the OSD shall be in lieu of
the itemized allowed deductions under Sec.34 which evidently include
losses from sales or exchanges of capital assets.
Regular Allowable Itemized
Deductions
Itemized deductions are allowed deductible ordinary and
necessary business expenses paid or incurred during the taxable
year. As a rule, these deductions require supporting documents to
justify the reduction from gross income.
Notes:
1. Compensation income is not allowed to be reduced by OSD or
itemized deductions.
2. Each spouse may either use OSD or itemized deductions.
3. If any income of the husband and wife could not be definitely
identified as income exclusively earned or realized by either of
the spouses, the same shall be divided equally between the
spouses for the purpose of determining their respective taxable
income.
4. In the case of an individual entitled to claim the OSD,
“allowable deductions” shall mean the aforesaid OSD plus
deduction of premium payments on health and/or
hospitalization insurance, if applicable, as provided under
Section 34(M) of the Tax Code.
Income Subject to Regular
Allowable Itemized Deductions
The following items of income are granted with itemized
deductions:
1. Business/ professional income derived within and outside the
Philippines by a resident citizen;
2. Business/ professional income derived within the Philippines
by a nonresident citizen; a resident alien; and a nonresident
alien;
3. Business/ professional income of a general co-partnership;
4. Business income derived within and outside the Philippines
by a domestic corporation;
5. Business income of proprietary educational institution and
nonprofit hospitals;
6. Business income of proprietary government-owned or
controlled corporation; and
7. Business income within the Philippines earned by a foreign
corporation.
Composition of Regular Allowable
Itemized Deductions
Section 34 A to J of the NIRC lists the following as the
composition of itemized deductions:
1. General business expenses;
2. Interest;
3. Taxes;
4. Losses;
5. Bad debts;
6. Depreciation;
7. Depletion of oil and gas wells and mines;
8. Charitable and other contribution;
9. Research and development;
10. Pension trust; and
11. Premium payments on health and/or hospitalization
insurance. (For individual taxpayers only)