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.
