Republic of the Philippines

President Ramon Magsaysay State University

College of Accountancy and Business Administration
(Formerly Ramon Magsaysay Technological University)
Iba, Zambales, Philippines
Tel/Fax No.: (047) 811-1683

College/Department College of Accountancy and Business Administration

Course Code BA Core 3

Course Title Income Taxation

Place of the Course in the Program Major Subject

Semester & Academic Year First Semester AY 2020-2021

CHAPTER 12-REGULAR ALLOWABLE ITEMIZED DEDUCTIONS

Introduction
Chapter Overview and Objectives
This chapter discusses the rules of regular itemized allowable deductions under the NIRC.

Intended Learning Outcomes

After this chapter, readers are expected to demonstrate:
1. Knowledge of the application of the principles of deductions on each item of deduction
2. Mastery of the deduction conditions, rules, and computational procedures of each item of deduction from gross
income.
3. Application of the procedures in computing foreign tax credits.

Discussion
ITEMIZED DEDUCTIONS FROM GROSS INCOME

1. Interest expense
2. Taxes
3. Losses
4. Bad debts
5. Depreciation
6. Depletion
7. Charitable and other contributions
8. Contributions to pension and trust
9. Research and development and costs
10. Other ordinary and necessary trade, business, or professional expenses

If not directly connected with the selling of goods or rendering of services, these items of expenses are classified as
“Regular allowable itemized deductions.”

INTEREST EXPENSE

173
Requisite on the deductibility of interest (RR13-2000):
1. There must be a valid indebtedness.
2. The indebtedness must be that of the taxpayer.
3. The indebtedness must be connected with the taxpayer’s trade, business or exercise of profession.
4. Interest expense must have been paid or incurred during the taxable year.
5. Interest must have been stipulated in writing.
6. Interest must be legally due.
7. Interest payments must not be between related taxpayers.
8. Interest must not be incurred to finance petroleum operations.
9. In case of interest incurred in the acquisition of property, used in trade, business or profession, the same is not
treated as a capital expenditure.
10. The interest is not expressly disallowed by law to be deduction from gross income of the taxpayer.

Deductible amount of interest expense

The deductible amount of interest expense is the gross interest expense reduced by the
following percentage of the interest income:

Effectivity Percentage
January 1, 1998 41%
January 1, 1999 39%
January 1, 2000 38%
November 1, 2005 42%
January 1, 2009 33%

This percentage is referred to as the arbitrage limit or the arbitrage cap.

Illustration
A taxpayer incurred an interest expense of P100, 000 and earned P10, 000 interest income
during the year.

The deductible interest expense shall be ______________ 10k x 33% = 3,300

100k – 3,300= 96,700

Rationale of the arbitrage limit

The limit is intended to recover the tax savings of taxpayers who take advantage of higher
regular tax savings created from interest expense deduction and a lower final tax on deposit
interest income.

Illustration: The Interest Arbitrate Scheme

A corporate taxpayer which is subject to 30% regular corporate income tax barrowed
P1,000,000 from a bank which charges 6% interest and invested the same proceeds to a 6%
time deposit in the same bank.

The following table summarizes the effect of the interest arbitrage within a year:

174
Bank loan P1,000,000
Interest expense 60,000

Bank Deposits 1,000,000

Interest Income 60,000

Without an interest expense deduction limit, the financial effect of this scheme can be analyzed
as follows:

Net interest income P 60,000 x (100%-20% final tax) P 48,000

Payment of interest expense to the bank ( 60,000)
Tax savings from interest expense (P60,000 x 30%) 18,000
Financial tax savings from the arbitrage P 6,000 pag inaapply yung limit
mawawala yung 6k tax savings is

This will motivate taxpayers to enter into unnecessary loan-and-deposit transactions to save
from total income tax:

Determination of the Arbitrage Limit

To eliminate the arbitrage savings, a deduction cap was set which was mathematically
computed as:

(Corporate income tax rate – final tax on interest income)

Corporate income tax rate

Illustration 2
A taxpayer had the following interest expense and interest income in 2015:

Interest expense on bank loan P 100,000

Interest income from time deposit, gross 10,000 x 33% 3,300 = 96,700
Interest income from promissory notes 40,000

The deductible expense shall be ___96,700_____________________

It must be emphasized also that the basis of the arbitrage limit is the interest income subject to
final tax because no arbitrage will arise from interest income not subject to final tax.

Illustration 3
Assume a taxpayer paid P200,000 interest expense on a business loan in 2015 and received net
interest income from a deposit of P40,000.

The deductible interest expense shall be 40k/80%=50,000 x 33% =16,500

200k – 16,500 = 183,500

175
Examples of non-deductible interest
1. Interest on personal loans
2. Interest incurred with a related party
3. Discount or pre-deducted interest applicable to future periods for individual taxpayers
4. Interest expense incurred to finance petroleum operations
5. Interest on redeemable preferred shares
6. Imputed interest

TAXES
Taxes paid or incurred within the taxable year in connection with the taxpayer’s trade, business, or exercise of
profession shall be allowed as deduction except:
1. Philippines income taxes except fringe benefit tax
a. Final income tax
b. Capital gain tax
c. Regular income tax
2. Foreign income tax, if claimed as tax credit
3. Estate tax and donor’s tax
4. Special assessment

Other non-deductible taxes

1. Business taxes, in the particular the Value added tax (VAT)
2. Surcharges or penalties on delinquent taxes

For the buyer, business taxes form part of the cost of purchases; hence, deductible through cost of sales or other
expense categories but not as tax expense.

Examples of deductible taxes:

1. Percentage tax
2. Excise tax
3. Documentary stamp tax
4. Occupational tax
5. License tax
6. Fringe benefit tax
7. Local taxes except special assessment
8. Community tax
9. Municipal tax
10. Foreign income tax if not claimed as tax credit

Only basic tax is deductible

Only the basic tax of a deductible tax is allowable as deduction. Tax surcharges for late payments are avoidable and
unnecessary expenses; hence, they are non-deductible. Moreover, allowing these as deduction will relax policy on
tax collection. Nevertheless, interest for late payment of tax was held deductible by the Supreme Court but as
interest expense rather than as tax expense.

FOREIGN INCOME TAX

Income taxes paid in a foreign country can either be claimed as:
1. Deduction
2. Tax credit

176
Illustration 1: One foreign country
A domestic corporation reported the following result of operations:

Taxable income from the Philippines P 1,800,000

Taxable income from Japan 1,200,000
Quarterly estimated income tax paid in the Philippines 200,000
Income tax paid in Japan 300,000

Deduction Approach
The taxable income and income tax liability will simply be computed as follows:

Taxable income from the Philippines P 1,800,000

Taxable income from Japan 1,200,000
Total P 3,000,000
Less: Foreign income tax expense 300,000
Taxable income – world P 2,700,000
Multiply by: Corporate tax rate 30%
Corporate income tax due P 810,000
Less: Philippines quarterly estimated tax payments 200,000
Income tax payable P 610,000

Note: Under the deduction approach, the foreign taxes paid are deducted but will not be claimed as tax credit.

Tax Credit Approach

Taxable income from the Philippines P 1,800,000
Taxable income from Japan 1,200,000
Taxable income – world 3,000,000
Multiply by: Corporate tax rate 30%
Corporate world income tax due P 900,000
Less: Tax credit
Philippine income tax credit P 200,000
Foreign tax credit* 300,000 500,000
Income tax payable P 400,000

Note: Under the tax credit approach, the foreign taxes paid are not deducted against gross income but are credited
against the income tax due on world taxable income.

Determination of Foreign Tax credit: One foreign country*

The foreign tax credit shall be the lower of the actual foreign income tax paid and the following limit:

Foreign taxable income

X Philippines income tax due

World taxable income

Hence,

Actual foreign income tax paid P 300,000

Limit: (1,200,000/3,000,000 x P900,000) P 360,000

Foreign tax credit – LOWER P 300,000

177
Illustration 2: More than one foreign country
A domestic corporation had the following data on its Philippine and foreign operation:

Taxable income in the Philippines P 1,800,000

Taxable income from Japan 1,200,000/4M X 1,200,000= 360,000
Taxable income from Taiwan 1,000,000
Quarterly income tax paid in the Philippines 300,000
Income tax paid in Japan 400,000
Income tax paid in Taiwan 200,000

Tax Credit Approach

Taxable in the Philippines P 1,800,000
Taxable income from Japan 1,200,000
Taxable income from Taiwan 1,000,000
Taxable income – world P 4,000,000
Multiply by: 30%
Corporate income tax due P 1,200,000
Less: Tax credit
Philippine income tax credit P 300,000
Foreign tax credit* 560,000 860,000
Income tax still due P 340,000

Determination of Foreign tax credit: With multiple foreign countries*

The final foreign tax credit shall be the lower of the total of the tax credit allowable per country and the world
income tax credit limit computed as follows:
Total foreign taxable income
X Philippine income tax due

World taxable income

Per country tax credit:

Japan:
Actual amount paid P 400,000
Country limit: (P1.2M/ 4M x P1.2M) 360,000
Lower amount P 360,000

Taiwan:
Actual amount paid P 200,000
Country limit: (P1.0M/ 4M x P1.2M) 300,000
Lower amount P 200,000

Japan allowable tax credit P 360,000

Taiwan allowable tax credit 200,000
Total tax credit allowable per country P 560,000
World tax credit limit:
[(1.2M+1.0M)/ 4M x P1.2M tax due)] 660,000

Foreign income tax credit (LOWER) P 560,000

Who can claim tax credit or deduction for foreign taxes paid?

178
Consistent with the matching rule, only taxpayers taxable on world income such as domestic corporations and
resident citizens can claim deduction or tax credit for foreign income taxes paid.

Tax treatment of refunds or credit of taxes

The refund or credit of deductible taxes must be reverted back to gross income to the extent of their tax benefit.
Incidentally, the refund of non-deductible taxes is exempt from income tax.

LOSSES
Losses actually sustained during the taxable year and not compensated by insurance or other indemnity shall be
allowed as deductions.

Requisites for the deduction of losses

1. It must be incurred in trade, profession or business of the taxpayer. (The loss must be a business loss, not a
personal loss.)
2. It must pertain to property connected with the trade, business or profession, if the loss arises from fires, storms,
shipwrecks, or other casualties, or from robbery, theft, or embezzlement.
(The loss must be an ordinary loss.)
3. The loss must not be compensated by insurance or indemnity contract. (The loss must be actually sustained, not
temporary.)
4. A declaration of loss must have been filed by the taxpayer within 45 days from the date of discovery of the
casualty or robbery, theft or embezzlement giving rise to the loss.
5. The loss must not have been claimed as a deduction for estate tax purpose in the estate tax return. (Doubled
deduction is not allowed.)

Type of losses
1. Ordinary loss
2. Capital loss

Losses from ordinary assets are deemed normal to the taxpayer’s trade, business or profession; hence, these are
deductible in full. Losses on capital assets are deemed by law unnecessary expense; hence, these are deductible only
up to the extent of capital gains.

Illustration
A taxpayer engaged in farming incurred the following losses:

Loss on destruction of residence by a storm P 1,200,000

Loss on sale of old farm equipment 50,000
Loss on assignment of receivables to a bank 40,000
Purchase cost of a bull lost during a storm 30,000
Value of animal offspring killed by Black Leg disease 20,000

The following are deductible losses:

Loss on sale of old farm equipment 50,000

Purchase cost of a bull lost during a storm 30,000
Total deductible loss 80,000

Examples of deductible ordinary losses

a. Loss on disposal or destruction of any ordinary asset
b. Loss due to voluntary removal of building incident to renewal or replacement

179
c. Permanent or irreversible loss in value of assets due to changes in business conditions, only to the extent
actually realized
d. Abandonment loss

Rules on restoration or replacement of destroyed properties

1. Total destruction of properties
If the restoration involves total replacement of the previous property, the tax basis of the old property shall be
claimed as a loss while the entire replacement cost is capitalized as cost of the replacement property subject to
allowance for depreciation.
2. Partial destruction of properties
If the restoration involves partial replacement of the previous property, the restoration cost shall be expensed up to
the extent of the tax basis of the property immediately before the casualty. Any excess is capitalized subject to
allowance for depreciation.

Illustration: Total and partial destruction

An uninsured building had a book value of P1,000,000 when a fire broke out. It was later restored at a total cost of
P1,200,000.

Total loss
Assuming that the building was totally destroyed, the P1,000,000 tax basis is deductible as fire loss while
P1,200,000 replacement cost is capitalized as cost of the new building.

Partial loss
Assuming that the building was partially destroyed, the restoration cost of P1,000,000 shall be expensed as fire loss
while the excess P200,000 restoration cost shall be capitalized as part of the cost of the building.

Loss of value of assets

The loss of value of assets, as a rule, is not deductible due to their temporary and reversible nature. However,
impairment losses that became actually sustained can be deducted.

Illustration 1
Fast Corporation maintains a fleet of high speed passenger jets. These jets had been eight years in service and have
an aggregate book value of P200,000,000. Due to the increasing incidence of aircraft accident, Congress passed a
law shortening the service life of high-speed passenger jets to five years. This resulted in mandatory retirement of
the jets. The jets have current fair value totaling P90,000,000.

In this case, the P110,000,000 impairment loss is deductible, but only upon disposal of the passenger jets when it
becomes actually sustained.

Illustration 2
DC Company uses a certain preservative in its food products. DC Company had P600,000 of the preservative in
stocks. Congress passed a law prohibiting the use of the substance and required their submission to authorities for
immediate destruction.

The P600,000 total impairment in value will be deductible upon confiscation or submission of the preservatives to
authorities.

Loss on Insured Property

Abandonment losses

Losses from wagering transactions or passive activities

180
BAD DEBTS
Bad debts refer to debts due to the taxpayer which were actually ascertained to be worthless and were charged off
within the taxable year.

Requisites of claim for deduction of bad debt:

1. The debt must have been ascertained to be worthless.
2. It must be charged off within the taxable year.
3. It must be connected with the taxpayer’s profession, trade or business (i.e., uncollectible personal credits are
non-deductible).
4. The taxpayer must be under the accrual basis of accounting.
5. It must not be incurred from a related party.

Illustration
Mr. Ali Gator, a lending investor, loaned a corporation P1,000,000. After three taxable period, the corporation
became bankrupt. The entire principal and accrued interest of P240,00 became totally worthless.

If Mr. Gator is under the accrual basis, he can deduct the P1,240,000 consisting of P1,000,000 loss of capital plus
P240,000 loss of income as bad debt expense. If Mr. Gator is under the cash basis, he can, nevertheless, deduct the
P1,000,000 as bad debts expense but not the P240,000 receivable.

Securities becoming worthless

For domestic banks and trust companies a substantial part of whose business is the receipts of deposits, securities
becoming worthless are bad debt expense and not capital loss. However, the term securities specifically covers only
bonds, debentures, notes, certificates, or other evidence of indebtedness with interest coupons or in registered form.

Illustration

ABC Corporation, an accrual basis taxpayer, estimates additional probable uncollectible accounts of P700,000 aside
from the following accounts which were ascertained to be worthless and were written off during the year:

Receivable from sale of goods to a bankrupt client P 200,000

Investment in a subsidiary liquidated at a loss 1,500,000 CAPITAL LOSS OR CAPITAL ASSET
Receivable from sale of services to the subsidiary 100,000 ALLOWED AS A DEDUCTION
Advances to the president set off against his salaries 500,000 COMPENSATION EXPENSE NOT BAD
DEBT EXPENSE

The following write-offs are deductible as bad debt expenses:

Receivable from a bankrupt client P 200,000

Receivable from a liquidated subsidiary 100,000
Bad debt expense P 300,000

Examples of capital losses not deductible as bad debts

1. Bad debts from personal receivables
2. Securities becoming worthless of taxpayers other than domestic banks and trust companies a substantial part of
whose business is the receipts of deposits
3. Loss on capital investments in partnerships, joint ventures, or corporations

181
Subsequent recovery of bad debts

Subsequent change in accounting methods

Bad debt expense sustained by the taxpayer under the cash basis of accounting should not be deducted even if the
taxpayer subsequently change its accounting method to the accrual basis of accounting. What cannot be done
directly cannot be done indirectly.

DEPRECIATION

Depreciation methods
1. Straight-line method
2. Declining-balance method
3. Sum-of-the-year-digit method
4. Any other method which may be prescribed by the Secretary of Finance upon recommendation of the CIR

These methods were discussed in the preceding chapter.

Special Rules on Depreciation

1. Life tenancy to a property
2. Properties held in trust

Illustration
Don Pedro set up an irrevocable trust by transferring a commercial building in favor of his
daughters, Ana and Karena. Don Pedro designated 10% of the rent income of the building to be
given to Ana for her studies while 20% shall be given to Karena for her family support. The
building earned P2,000,000 rentals and reported P400,000 depreciation expense in 2014.

The gross income and the depreciation expense shall be split among the trust and the
beneficiaries based on the provision of the trust as follows: 10% to Ana, 20% to Karena and 70%
to the trust.

Hence,
Ana Karena Trust Total __
Gross income P 200,000 P 400,000 P1,400,000 P2,000, 000
Depreciation expense 40,000 80,000 280,000 400,000

3. Revaluation on properties REVALUATION EXPENSE NOT DEDUCTIBLE

4. Rules on depreciation of passenger vehicles

AMORTIZATION OF INTANGIBLE ASSETS

The same concepts discussed herein are also applicable to the exhaustion of intangible assets with definite useful life
such as patents, royalties, and franchises. The depreciation of intangible assets is referred to as “amortization
expense.” However, intangible assets that do not lose their value throughout time should not be amortized.

Optional Expensing of Capital Expenditure

182
Under the NIRC, private educational institutions are granted the option to treat capital expenditure as an outright
expense or as a deduction through allowance for depreciation.

DEPLETION
Depletion expense is a provision for the periodic return of capital investments is wasting assets such as minerals,
gas, and oil.

Common rules for both mining and oil operations

Taxpayers engaged in wasting assets shall classify their expenditures into:
1. Costs of acquisition or improvement of tangible properties.
2. Intangible exploration, drilling and development cost.

Treatment of tangible development cost

Tangible development costs include the acquisition or improvement of tangible property which are of a character
subject to the allowance for depreciation. This may include construction of mine-plant roads, buildings, processing
plants and installation of heavy equipment on-site.

Tangible exploration and development drilling cost are capitalized and deducted through allowance for depreciation
subject to the following rules:

1. Petroleum operations
Properties directly used in petroleum operations
The NIRC prescribes either the straight line method or declining-balance method at the option of the taxpayer for
properties directly related to the production of petroleum. A shift from the straight line method to declining balance
method is allowed. The useful life shall be 10 years or such shorter life as may be permitted by CIR.

Properties not used directly in petroleum operations

The NIRC prescribe the straight line method on the basis of an estimated useful life of 5 years.

2. Mining Operations
If the expected life of the property used in mining 10 years or less, the taxpayer can use the normal rate of
depreciation. If the expected life is more than 10 years, the property can be depreciated over any number of years
between 5 years and 10 years. (Sec. 34(E)(5),NICR)

Intangible exploration and development costs

Intagible costs in petroleum opreations include any incidental and necessary costs of drilling wells or preparing
wells for petroleum production and which have no salvage value.

Intangible costs in petroleum operations include any incidental and necessary costs of diamond drilling, tunneling,
and other improvements of a nature that is not subject to allowance for depreciation.

Tax treatment of Intangible exploration and development costs

A. Before commercial production – capitalized cost as cost of the wasting asset
B. After commencement of commercial production, if incurred with:
1.Non-producing wells or mines, deducted in the period paid or incurred
2. Producing wells mines, at the option of the taxpayer, either:
i. Capitalized and amortized using the cost-depletion method or
ii. Deducted in the year paid or incurred

CHARITABLE AND OTHER CONTRIBUTIONS

183
Contributions or gifts made to the government or non-government organizations (NGOs) may be deducted against
gross income.

Requisites of claim for deduction on contributions:

1. The done institution must be a domestic institution.
2. No income of the done institution must inure to the benefit of any private stockholder or individual.
3. The contribution must be valued at the tax basis of the property donated.
4. The taxpayer must be engaged in trade or business.
5. The done must issue a Certificate of Donation (BIR Form 2322) which includes a donor’s statement of values.

Donations that fail any of the requisites are non-deductible. Those that meets the requisites are either:
a. Fully deductible
b. Partially deductible (deductible subject to limit)

Classification of contributions

A. Fully deductible contributions (Mnemonics: PTA)

1. Donations to the government or political subdivisions including fully owned government and controlled
corporations to be used exclusively in undertaking priority activities as determined by the National
Economic Development Authority (NEDA) in:
a Education d. Human settlements
b Health e. Culture and sports
c Youth and sports development f. Economic development

2. Donation to foreign institution or international organization in pursuance of or in compliance with

agreements, treaties or special laws

Note that this is an exception to the rule that the done institution must be a domestic organization.

3. Donations to accredited domestic non-government organizations.

Pursuant to EO 671, the NGO must be an accredited done institution with certifications issued by the following
designated accrediting entities:
a. Department of Social Welfare and Development – for charitable and or social welfare
organizations, foundations and associations
b. Department of Science and Technology – for research and other scientific activities.
c. Philippines Sports Commission – for sports development.
d. National Council for Culture and Arts – for cultural activities
e. Commission on Higher Education – for educational activities

The accreditation by the Philippine Council for NGO Certificate, Inc (PCNC) is no longer regarded for this purpose.

The accredited done institution shall issue to the donor a certificate of donation in such form prescribed by the BIR.
For donations exceeding of donation in such form prescribed by the BIR. For donations exceeding P1,000,000 in
value, the donor is required to notify the Revenue District Officer (RDO) with jurisdiction to his place of place
business within 30 days from the receipt of the certificate of donation.

Requisites for full deductibility of contributions to accredited NGOs

1. The NGO must be organized and operated exclusively for the above purposes, and no income inures to
the benefit of any private individuals.

184
 2. The non-profit organization makes utilization of the contribution not later than the 15th day of the third
month after the close of its taxable period.
3. The administrative expenses of the NGO do not exceed 30% of its total expenses.
4. Members of the Board of Trustees must not receive remunerations.
5. In the event of liquidation, the asset of the NGO will be distributed to another nonprofit domestic
corporation of property other than money must be valued at acquisition cost.

B. Contributions subject to limit

1. Donations to the Government of the Philippines or political subdivisions exclusively for public purpose not
in accordance with priority activities.

2. Donation to non-accredited non-government organizations or to domestic corporations organized

exclusively for following purpose:
a. Religious e. Culture
b. Charitable f. Educational
c. Scientific g. Rehabilitations of veterans
d. Youth and sports development h. Social welfare

Limit of deduction for contribution:

Based on the taxable income derived from trade, business or profession (i.e., net income) before the deduction of
any contributions
1. 10% for individuals
2. 5% for corporations

Illustration 1
Mr. Kaneki, a practicing accountant, had the following income and donations during the year:

Professional fees P 1,100,000

Donations to government priority activities 100,000
Donations pursuant to treaties 30,000
Donations to accredited charitable institutions 50,000
Donations to the government for public purpose 80,000
Donations to non-accredited charitable institutions 60,000
Donations to a foreign charitable institution 40,000
Donations to street beggars 50,000
Other deductible business expenses 600,000

The deductible contributions expense shall be computed as follows:

Fully deductible contributions:

To government priority activities P 100,000
To accredited charitable instructions 50,000
To treaty-covered entities 30,000
P 180,000
Partially deductible contributions:
To government non-priority activities P 80,000
To non-accredited charitable institutions 60,000
Total contributions subject to limit P 140,000
Deduction limit P 50,000
Deductible contributions with limit (LOWER) 50,000
Total deductible contribution expense P 230,000

185
The deduction limit partially deductible contributions is computed as follows:

Professional fees P1,100,000

Less: Other deductions before contribution expense 600,000
Net income before contributions P 500,000
Multiply by: Individual limit percentage 10%
Deduction limit P 50,000

Illustration 2
Mr. Bohol, both employed and self-employed, reported the following during the year.
Gross compensation income P 400,000
Gross income from business 900,000
Fully deductible contributions 100,000
Contributions deductible with limit 40,000
Non-deductible business expenses 20,000
Other deductible business expenses 300,000

The contribution deduction limit__________________________

The deductible contribution ________________________

Illustration 3
Batangas Corporation reported the following during s year:

Gross income from business P 900,000

Fully deductible contributions 100,000
Deductible contributions with limit 40,000
Non- deductible contributions 20,000
Other deductible expenses 300,000

The deduction limit is ______________________

The deductible contribution shall be_____________________

RESEARCH AND DEVELOPMENT (R&D) COSTS

Research activities are geared towards discovery of new knowledge. Development activities are geared towards
determining application of research knowledge which could provide income and benefits for business.

Tax Treatment of R&D Costs

1. Research and development costs related to capital accounts such as property used in business are capitalized as
part of the property and deducted through depreciation expense.

2. Research and development cost not related to capital accounts are treated as follows at the option of the
taxpayer:
a. Outright expense or
b. Deferred expense amortized over a period not less than 60 months beginning from the month the taxpayer
realize benefits from the R&D expenditures

186
EXPENSES, IN GENERAL
Other legal, ordinary, actual and necessary expenses of business can de claimed by the taxpayers as long as these are
substantiated with official receipts or other pertinent records.

Examples of other deductible expenses:

1. Salaries and allowances
2. Fringe benefits
3. SSS,GSIS, PhilHealth, HDMF, and other contributions
4. Commissions
5. Outside services
6. Advertising
7. Rental
8. Insurance
9. Royalties
10. Repairs and maintenance
11. Entertainment, amusement, and recreation expenses
12. Transportation and travel
13. Fuel and oil
14. Communication, light and water
15. Supplies
16. Miscellaneous expenses

Entertainment, Amusement, and Recreation (EAR) Expense

EAR expense includes representation expense and/ or depreciation or rental expense relating to entertainment
facilities.

Representation expense shall refer to expenses incurred by a taxpayer in connection with the conduct of his trade,
business, or exercise of profession in entertaining, providing amusement and recreation to, or meeting with, a guest
or guests at a dining place, place of amusement, country club, theater, concert, play, sporting, event or other similar
places.

Representation expense excludes fixed allowances considered as regular compensation of employees which are
subject to the creditable withholding tax.

Entertainment facilities refer to a yacht, vacation home or condominium, and any similar item of real property used
by the taxpayer primarily for the entertainment, amusement, or recreation of guests or employees.

A yacht shall be considered an entertainment facility if its use is in fact not restricted to specified officers or
employee position in such manner as to make the same a fringe benefit subject to fringe benefit tax.

Requisites of deductibility of EAR Expense

1. It must be paid or incurred during the taxable year.
2. It must be directly connected to the development, management, and operation of the trade, business, or
profession of the taxpayer or directly related to or in furtherance of the conduct of his or his or this trade,
business, or exercise of a profession
3. It must not be contrary to law, morals, good customs, public policy, or public order.
4. It must not have been paid, directly or indirectly, to an official or employee of the government or
government-owned and controlled corporation or of a foreign government, private individual, corporation,
general professional partnership or similar entity if it constitutes a bribe, kickback, or other similar
payments
5. It must have been duly substantiated with adequate proof. The official receipt, invoices, bills or statements
of accounts should be in the same of the taxpayer claiming the deduction.

187
 6. The appropriate amount of withholding tax should have been withheld therefrom and paid to the BIR.

Ceiling on Deduction
• For taxpayers engaged in the sales of goods or properties- 0.5%of net sales
• For taxpayers engaged in the sales of services - 1% of net revenues

“Net sales” is computed as gross sales less sales returns, allowances and sales discounts. “Net revenue” is gross
revenue less discounts,

• For taxpayers engaged in the sales of both goods or properties and services, the allowable EAR shall in all
cases be determined based on following apportionment formula::

Net sales/Net revenue ____

X Actual EAR
Total net sales and net revenue

In no case shall the deductible EAR exceed the maximum percentage ceiling for the sales of goods and sales of
services.

Illustration 1
Mr. Luis, a seller of goods, had a net sales of P200,000 and expenses for entertainment, amusement and recreation
of P1,400 in 2019.

The deductible EAR shall be the lower of P1,400 and P1,000, computed as (0.5% x P200,000); hence, P1,000.

Illustration 2
Mr. Trent is a service provider with a net revenue of P300,000. He incurred P2,500 in entertainment, amusement and
recreation during the year.

The deductible EAR shall be the lower of P2,500 and P3,000, computed as (1%x P300,000); hence, P2,500.

Illustration 3
Mrs. Pelonia is engaged in both sales of goods and sales of services. She incurred a total; P9,000 entertainment,
amusement, and recreation expenses in 2015. She reported P300,000 in net sales and P700,000 in net revenues.

The deductible EAR shall be computed as follows:

Allocation* Ceiling*_ Amount Deductible

Sales of goods P 300,000 P 2,700 P 1,500 P 1,500
Sales of services 700,000 6,300 7,000 6,300
Total P 1,000,000 P 9,000 P 8,500 P 7,000

Note:
*P300k/P1,000k x P9,000= P 2,700; P700k/P1,000k x P9,000= P6,300
**P300,000 x .5%= P1,500; P700 x 1%= P7,000

Activity
1. A taxpayer under the cash basis had the following expenditures:
Acquisition of office equipment at the middle of the year (5 year useful life) P200,000
Payment of employee salaries 40,000

188
 Payment for office utilities expenses 60,000

How much is claimable as deductible business expense for the year?____________

2. The following relates to a taxpayer’s warehouse:

Cost P2,000,000
Accumulated depreciation 600,000
Residual value 200,000
Current fair market value 2,500,000
Remaining useful life 12 years

Compute the deductible depreciation expense._________________

3. The following relates to a taxpayer:

Interest expense P400,000

Interest income-time deposit 100,000
Compute the deductible interest expense.________________

4. The following relates to a taxpayer:

Interest expense P400,000
Interest income-promissory notes 100,000
Compute the deductible interest expense.___________

5. The taxpayer has the following losses:

Net operating loss carry over-last year P200,000
Net capital loss-current 80,000
Net capital loss-last year 70,000
Ordinary loss 50,000
Taxable income before losses 400,000
Compute the total deductible losses in the current year._____________

6. An individual income taxpayer reported the following:

Capital loss-current year P50,000
Capital gain-current year 200,000
Net capital loss-last year 70,000

Compute the total capital loss deductible against capital gain in the current year.___________

7. Supposed the income taxpayer in the preceding problem is a corporation, compute the deductible
capital loss against capital gain.______________
Page 494

8. Mr. B made contributions to the following in 2018:

Street beggars P50,000
Barrio fiestas 60,000
Various cancer patients 40,000
Takusa, an accredited non-profit organization 100,000

Compute the deductible contribution expense.__________

189
9. Friend Company declared a property dividend with book value of P1,000,000, fair value of
P1,200,000. The total dividends withheld on the dividends were P60,000. Compute the total deductible
expense._______________
10. A taxpayer with net sales of P2,000,000 and cost of sales of P1,800,000 incurred P15,000 for
entertainment, amusement and recreation expenses (EAR). Compute the allowable deduction for EAR
expenses.____________

190