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CHAPTER 17 ITEMIZED DEDUCTIONS

 General rule: Deductions of 1 year cannot be used to reduce the taxable income of a subsequent
year.
 Exception: If it is recognized that there are certain overlapping items of both income and
deduction and these items do not materially distort income, they may be included in the year
taxpayer takes them into accounts.

BUSINESS EXPENSES

1. Ordinary and necessary trade, business, or professional expenses


a. In General – ordinary and necessary expenses paid/incurred during the taxable year directly
attributable to the development, management, operation, and conduct of trade, business,
or exercise of a profession, including:
i. Salaries, wages, other forms of compensation, grossed-up monetary value of fringe
benefits
NOTE: Grossed-up MV of FB – allowed as a deduction if final tax is imposed
ii. Travel expenses in the pursuit of trade, business, or profession
iii. Rentals and/or other payments as a condition for use/possession of property to
which taxpayer has not taken/is not talking title
 Amounts expended for books, furniture, and professional instruments and
equipment, the useful life of which is short, may be deducted.
iv. Entertainment, amusement, and recreation expenses connected to the trade,
business, or profession not to exceed ceilings as the Secretary of Finance may
prescribe
b. Substantiation requirements – no deduction shall be allowed unless taxpayer substantiates
with sufficient evidence (official receipts or other adequate records):
1. Amount of expense being deducted
2. Direct connection/relation of expense being deducted to the development,
management, operation, and conduct of trade, business, or exercise of a profession of
taxpayer
NOTE: Business expenses can be substantiated by evidence other than official receipts
such as vouchers and proper reconciliation.
c. Bribes, kickbacks, and other similar payments – not allowed to be deducted from GI if
payments are made directly or indirectly to an official/employee of the national
government, LGU, GOCC, foreign government, private corporation, GPP, or a similar entity
d. Expenses allowable to non-resident citizens, alien individuals, or FC – expenses deductible
are those paid in carrying on business/trade conducted within the PH
e. Requisites for deduction of business expenses
1. Must be ordinary and necessary
2. Paid/incurred during the taxable year
3. Connected with trade/profession/business
4. Must be reasonable
5. Tax required to be deducted and withheld has been paid to the BIR
f. Ordinary and necessary expense – expense which is merely necessary but not ordinary and
vice versa is not deductible although paid in carrying on a trade/profession/business
 Ordinary expense – normal expense of the business or generally incurred in the
same or similar line of trade/business
 Necessary expense – appropriate and useful/helpful to the
trade/profession/business; is useful when it generates income or prevents losses
 Items included in business expenses are:
1. Management expenses
2. Commissions
3. Labor
4. Supplies
5. Incidental repairs
6. Operating expenses of transportation equipment used in
trade/profession/business
7. Rental for use of business property
8. Advertising and other selling expenses
9. Travelling expenses in the pursuit of a trade/profession/business
10. Insurance premiums against fire, storm, theft, accident, or other similar losses in
the trade/business
g. Compensation for personal services –
Requisites for deduction of compensation:
1. Personal services must have been actually rendered
2. Compensation for such services must be reasonable
3. If corresponding withholding tax has been deducted and remitted to BIR

Reasonableness of compensation

1. Factors considered in determining the reasonableness of compensation are:


a. Work performed by individuals
b. Training & experience
c. Time & energy devoted to the work (current & prior years)
d. Results that have been accomplished
e. Need for unusual ability & skill
f. Past record
g. Adequacy of compensation in prior years where earnings may have been poor
h. Compensation paid for comparable years by a similar business

2. Form or method of fixing compensation is not decisive as to deductibility.


 If contingent compensation is paid pursuant to a free bargain between the
employer and the individual made before services are rendered securing on fair
and advantageous terms the services of the individual – allowed as a deduction
3. Allowance for compensation paid may not exceed what is reasonable.
 Reasonable and true compensation – amount ordinarily paid for like services by
like enterprises in like circumstances (are those existing at the date when
contract for services was made)
Compensation as device for distribution of profits

 Amount paid not in the fact as purchase price of services – not deductible
a. Ostensible salary paid by a corporation may be a distribution of dividend/stock.
– likely to occur in corporations with a few shareholders
 If salaries are in excess of those ordinarily paid for similar services and
correspond to a close relationship to the stockholdings of the
officers/employees – likely paid in distribution of earnings upon stock and thus
are not deductible
b. Ostensible salary part in payment for property – may occur for ex. when a
partnership sells out to a corporation, agreeing to continue in the service of the
corporation – salaries are not merely for services but for the transfer of their
business

Treatment of excessive compensation

 Income tax liability of recipient of compensation but not allowed as a deduction


to the payor will depend on the circumstances of each case.
 In case of excessive payments that correspond to a close relationship to the
stockholdings and are distributions of earnings/profits – excessive payments are
treated as dividends
 If payments constitute payment for property – treated by payor as capital
expenditure and by recipient as part of purchase price

Bonuses to Employees

 If made in good faith, as additional compensation for services rendered, and


when added to stipulated salaries do not exceed a reasonable compensation –
may be deducted
 Donations which do not have the element of compensation or in excess of
reasonable compensation for services – not deductible

Pensions and compensation for injuries

a. Are proper deductions as ordinary and necessary expenses limited to the amount
not compensated for by insurance or otherwise
b. Amount of salary paid in recognition of services rendered of an officer/employee to
his widow or heirs after his death – deductible
 Donations such as coffin or other wake expenses – not deductible
c. Salaries paid to employees who are absent in military, naval, or other service of the
government but who intend to return at conclusion of such service – deductible

2. Expenses allowable to private educational institutions


 May at its option elect either:
a. To deduct expenditures considered as capital outlays of depreciable assets
incurred during the taxable year for expansion of school facilities
b. To deduct allowance for depreciation
3. Travelling expenses – include transportation expenses, and meals and lodging
Requisites for deduction:
a. Travelling exp. must be reasonable and necessary
b. Must be incurred while away from home
 Tax home – refers to the place of work/employment/business
c. Must be incurred in the pursuit of trade/profession/business
 If trip is undertaken for other than business purposes – transportation exp. are
personal exp. & meals and lodging are living exp. – not deductible

Proof of deductibility of expenses on airline carriers

 The amount of expense to be claimed is the actual cost incurred which is the net
amount of ticket fare or airway bill after deducting corresponding fare or freight
adjustments
 If plane tickets are purchased from travel agents – travel expenses shall be
validated on basis of sales invoice/official receipt issued representing cost of
ticket and reasonable margin as payment for the travel agent’s services
4. Entertainment, amusement, and recreational expenses (EAR expenses) – includes
representation expenses and/or depreciation or rental expenses relating to entertainment
facilities
 Representation expenses – incurred in entertaining or meeting with guests at a dining
place, place of amusement, country club, theatre, concert, play, sporting event, and
similar places/events
 Entertainment facilities – yacht, vacation home, condo, or any similar real or personal
property used primarily for entertainment which can be owned or rented by taxpayer
for which he can claim depreciation/rental expense
o Yacht – considered as entertainment facility if use is not restricted to specified
officers/employees – becomes fringe benefit if that’s the case
 Guests – persons/entities with which the taxpayer has direct business relations

Requisites of deductibility:

1. Must be paid/incurred during the taxable year


2. Must be directly connected with the development, management, and operation of or
furtherance of the conduct of the taxpayer’s trade/business/profession
3. Must not be contrary to law, morals, good customs, public policy, or public order
4. Must not constitute a bribe, kickback or other similar payment
5. Must be duly substantiated by adequate proof
6. Appropriate amount of withholding tax should have been withheld therefrom

Exclusions – not considered EAR expenses but may qualify as other items of deductions

1. Compensation/fixed representation allowances subject to WT on wages or fringe benefits


for services under employer-employee relationship
To prove expenses are actually representation expenses and not fringe benefits, taxpayer
should maintain receipts and adequate records that indicate:
a. Amount of expense
b. Date & place of expense
c. Purpose of expense
d. Business relationship of expense
e. Name of persons/company entertained with their contact details
2. Expenses for charitable and fund raising events
3. Expenses for bona fide meetings of stockholders, partners, or directors
4. Expenses for attending/sponsoring an employee to a business league/professional
organizational meeting
5. Expenses for events organized for promotion, marketing, and advertising
6. Other expenses of similar nature

Non-deductible EAR Expenses

a. Expenses incurred for police protection


b. Expenses for political campaigns
c. Expenses to attend funerals of friends
d. Cost of admission tickets to operas

Ceilings on EAR Expenses

a. For taxpayers engaged in sale of goods/properties – ½ of 1% of net sales


 Net sales – gross sales less sales returns/allowances/discounts
b. If engaged in sale of services/exercise of profession/lease of properties – 1% of net revenue
 Net revenue – gross revenue less discounts
c. If derives income from both sale of goods/properties and sale of services – allowable EAR
expenses based on an apportionment formula
Net sales ( for sale of goods )∨Net revenues (for sale of services )
X Actual expense
Total net sales∧net revenues

Audit of EAR Expenses


 Claimed EAR expenses shall be subject to verification and audit by the BIR.
 If taxpayer is found to have shifted EAR expenses to any other expense to avoid being
subjected to the prescribed ceilings – amount shifted shall be disallowed & taxpayer
may face penalties

5. Cost of materials
a. Actual consumption of materials and supplies – should include in expenses charges of
materials and supplies consumed in operation during the year for which the return is made
provided that the cost of such materials & supplies has not been deducted in determining
the net income for previous year
 Can be determined:
1. If taxpayer keeps a record of consumption of materials and supplies
2. If taxpayer takes physical inventories at the beg. and end of the year
b. Total purchases of materials and supplies – if no record of consumption is kept or physical
inventories at the beg. and end of the year are not taken – permissible to deduct total cost
of materials & supplies purchased
6. Repairs
a. Cost of incidental repairs which neither materially add value of the property nor appreciably
prolong its life but keep it in an efficient operating condition – deductible
b. Repairs in nature of replacement that they arrest deterioration and prolong its life – charged
against the depreciation reserves if such account is kept thus non-deductible
7. Rentals and other deductions of lessee – deductible if property rented/leased is used in
trade/business
a. Prepaid rentals – not deductible expenses until the period is used
b. Where leasehold is acquired for business purposes for a specified sum – deductible at an
aliquot part of such sum each year based on the lease term
c. In addition to rent paid/accrued, expenses required to pay to lessor under terms of the lease
contract – deductible
d. Cost borne by lessee in erecting buildings or making permanent improvements on the
ground on which he is a lessee – capital investment thus non-deductible
 To return his capital investment, annual deduction may be made from GI equal the
cost of the improvements divided by the number of remaining years on lease term
(in lieu of deduction for depreciation)
 If remainder of lease term is greater than useful life of building/improvements –
deduction in the form of depreciation
e. Under a finance lease – lessee has right to hold and use leased property with the right to
expense lease rentals paid to lessor
NOTES:
 Obligations of lessor to third persons assumed by lessee constitute additional rent
 Real estate tax paid by lessee is rent income to lessor and expense to lessee –
deductible by the lessor
8. Expenses of farmers
a. Cost of feeding & raising livestock (not including value of farm produce grown upon
the farm or labor of taxpayer) – deductible
b. If farmer is engaged in producing crops which take more than 1 year from the time
of planting to gathering and disposal – expenses deductible may be determined
upon the crop basis and must be deducted in the year GI from crop has been
realized
c. Cost of farm machinery, equipment, and farm buildings – capital investment thus
not deductible
Cost of ordinary tools of short life/small cost – deductible
d. Amounts expended in the development of farms, orchards, and ranches prior to
when productive state is reached - capital investment thus not deductible
e. Amounts expended in purchasing work, breeding, or dairy animals - capital
investment thus not deductible but may be depreciated unless such animals are
inventory
f. Purchase price of transportation equipment - capital investment thus not deductible
g. Cost of gasoline/fuel, repairs, and upkeep of transportation equipment if used
wholly in farming – deductible but if used partly for business purposes and
pleasure/convenience of taxpayer, only portion of cost attributable business
purposes is deductible
h. If operated for recreation/pleasure and not on a commercial basis, and if expenses
incurred are in excess of receipts – entire receipts may be ignored in rendering a
return of income and expenses incurred regarded as personal expenses will not
constitute allowable deductions
9. Miscellaneous expenses
a. Corporate organization costs – may be amortized over the life of corporation. Pre-operating
expenses may be treated as deferred expenses & deducted from GI for not more than 60
mos.
b. Cost of defending a civil suit – deductible irrespective of success of the defense
c. Judgments or other binding judicial adjudication – on account of damages for patent
infringement, personal injuries, etc. – deductible when claim is adjudicated or paid less any
amount compensated by insurance
d. Loss upon a corporation’s sale or retirement of its own bonds
1. If bonds are issued at face value – no gain or loss shall be realized
 If purchased and retired at a price in excess of issuing price/face
value – excess of purchase price over face value is deductible
2. If bonds are issued at a premium – net amount of premium is gain or
income which is prorated or amortized over life of the bond
 If purchased and retired at a price in excess of issuing price/face
value less any amount of premium already returned as income (FV
+ amount of premiums not yet returned as income) - excess of
purchase price over face value less any amount of premium
already returned as income is deductible
3. If bonds are issued at a discount – net amount of discount is deductible
and is amortized over life of the bonds
 If purchased and retired at a price in excess of issuing price/face
value plus any amount of discount already deducted (FV - amount
of discount not yet deducted) - excess of purchase price over face
value plus any amount of discount already deducted is deductible

The Cohan Rule – Approximation of expenses

 Entertainment expenses may be approximated if the exact amount spent therefor cannot be
determined provided there is evidence of the amount of expenses, persons entertained,
necessity of entertaining such persons.
 It is the duty of the BIR to estimate the deduction allowable in computing taxpayer’s taxable
income. If there’s evidence that expenses have been incurred but exact amount cannot be
ascertained due to absence of documentary evidence, bearing heavily against the taxpayer
whose inexactitude is of his own making, a disallowance of 50% of amount claimed as deduction
is valid.

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