LECTURE NOTES

NOTE: AMENDMENTS UNDER THE CREATE LAW, PARTICULARLY ON THE TAX

ARBITRAGE RULE, IS NOT YET INCORPORATED IN THIS NOTE.

TAXATION 1
Atty. Arnel A. dela Rosa, CPA, REB, REA

INCOME TAXATION

DEDUCTIONS FROM GROSS INCOME (CHAPTER VII, NIRC)

Defined

Deductions are items or amounts which the law allows to be deducted from gross income in order
to arrive at net or taxable income.

What is the treatment of return of capital?

Income tax is levied by law only on income; hence, the amount representing return of capital
(e.g. cost of goods sold) should be deducted from the proceeds of sale and should not be subject
to income tax.

Distinguish Exclusions from Deductions

Exclusion (Sec. 32(B)) Deduction (Sec. 34)

Refer to flow of wealth which are not treated Refer to the amounts which the law allows to
as part of the gross income because: a) these be subtracted from the gross income in order
are exempted by law or statute; or b) they do to arrive at the net income.
not come within the definition of income
Pertain to the computation of gross income Pertain to the computation of net income
Something earned by the taxpayer which do Something spent or paid in earning the gross
not form part of the gross income income

Deduction vs. Tax Credits

Deductions are the expenses and other allowable deductions as provided by law which are
incurred for engaging in trade, business or profession, deducted from the gross income to arrive
at the net or taxable income.

Tax Credits are amount of tax previously paid by the taxpayer which later on can be claimed as
tax credit from the tax liability of the taxpayer. It is deducted from the computed tax liability to
arrive at tax still due. (E.g. Creditable Withholding Tax)

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Give the basic principles governing deductions

1. The taxpayer seeking a deduction must point to some specific provision of the statute
authorizing the deduction;
2. He must be able to prove that he is entitled to the deduction authorized or allowed (Atlas
Consolidated Mining v. Commissioner, G.R. No. L-26911, January 21, 1981)

Note: Deductions for income tax purposes partake of the nature of a tax exemption; hence, just
like tax exemptions, deductions must be construed in strictissimi juris against the taxpayer.

May Deductions be created by implication?

No. Deductions have generally been deemed to be a matter of legislative grace. They are allowed
only where there is a clear provision in the statute for the deduction claimed; and where particular
deductions are authorized by the statute, no other may be made. The taxpayer has the burden
of justifying the allowance of any deduction claimed by him.

May the taxpayer deduct lesser amount of deductions or not to deduct at all?

Definitely. For income tax purposes a taxpayer is free to deduct from its gross income a lesser
amount, or not to claim any deduction at all. What is prohibited by the income tax law is to
claim a deduction beyond the amount authorized therein. (CIR V. Phoenix Assurance Co., Ltd.,
G.R. No. L-19727, May 20, 1965)

Basis: Lifeblood doctrine

Who are not allowed to claim deductions?

1. Individuals receiving compensation income;

2. Non-Resident aliens not engaged in trade or business;
3. Aliens (also Filipinos similarly situated) employed in ROHQ, RAHQ, OBU, Petroleum
Contractors;
4. Non-Resident Foreign Corporations;
5. Income subject to Final Withholding Tax

In general, what are the deductions from gross income authorized by the NIRC?

1. Itemized or Actual Deductions – These are the allowable deductions enumerated

under Section 34 of the NIRC.

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 2. Optional Standard Deductions – is a standard deduction in an amount not exceeding
40% of the gross sales/receipt of individuals, other than non-resident aliens, or 40% of
gross income corporations in lieu of the itemized deductions.

Rules on Optional Standard Deduction [Sec. 34(L)]

1. Who are allowed to avail?

a. Individuals except non-resident alien;
b. Domestic and Resident Foreign Corporation
c. General Professional Partnership and its individual partners but may be availed only
once, either the GPP or the partners

2. Rate
a. Individuals – 40% of Gross Sales or Gross Receipts
b. Corporation – 40% of Gross Income as defined in Sec. 32
c. GPP – 40% of ? (the law is silent) but under RR No. 8-2018, its was interpreted to
mean 40% of gross income. See below

3. OSD/Itemized Deduction, how elected. The default deduction is Itemized Deduction;

thus, unless the taxpayer signifies in his return his/its intention to avail of the OSD, he is
deemed to have availed the itemized deduction. Such election of the option, when the
return is made, shall be irrevocable for the taxable year for which the return is made. The
election to claim either the itemized deduction or the OSD for the taxable year must be
signified by checking the appropriate box in the ITR filed for the first quarter of the taxable
year or the initial quarter of the taxable year after the commencement of a new
business/practice of profession. Once the election is made, it must be consistently applied
to all the succeeding quarterly returns and in the final income tax return for the taxable
year.

4. Substantiation requirements. No need to keep records of the expenses. However, the

individual taxpayer shall keep such records pertaining to his gross sales/receipts, while
the corporation, its records pertaining to its gross income as defined under Section 32.

5. Submission of Financial Statement – Individuals who opted OSD, no need to submit FS.

Determination of the OSD for GPPs and Partners of GPPs (RR No. 8-2018)

GPP is not subject to income tax imposed pursuant to Section 26 of the Tax Code, as amended.
However, the partners shall be liable to pay income tax on their separate and individual capacities
for the respective distributive shares 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. Section 26 of the Tax
Code, as amended, likewise provides that – “For purposes of computing the distributive shares
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 under Section 34

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of the Code or in lieu thereof, 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.

xxx

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

What are the itemized deductions under Section 34?

The allowable itemized deductions from gross income are:

1. Expenses
2. Interests on indebtedness
3. Taxes in connection with taxpayer’s business, trade or profession;
4. Losses
5. Bad debts
6. Depreciation
7. Depletion of oil and gas wells and mines
8. Charitable and other contributions
9. Research and Development expenditures
10. Contribution to pension trust

Special deductions
1. Deductions allowed to private proprietary educational institutions and hospitals that are
non-profit [Sec. 34(A)(2)];
2. Deductions allowed to insurance companies (Sec. 37);
3. Deductions allowed to Estates and Trusts (Sec. 61)

What are the items not deductible in computing net income?

1. Personal, living and family expenses (note: Section 35 on Personal Exemptions for
Individual Taxpayer has been repealed by RA 10963, TRAIN Law);
2. Any amount paid out for new building or permanent improvements, or betterment made
to increase the value of any property or estate, except intangible drilling and development
cost in petroleum operations;
3. Any amount expended in restoring property or in making good the exhaustion thereof for
which an allowance is or has been made;

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 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,
individual or corporate, when the taxpayer is directly or indirectly a beneficiary under such
policy.
5. Losses from sale or exchanges of property between related parties;
6. Losses from wash sales of stocks or securities unless the claim is made by a dealer in
stock or securities and with respect to a transaction made in the ordinary course of
business of such dealer;
7. Non-deductible taxes
8. Non-deductible losses;
9. Non-deductible interests

Itemized Deductions

The principle is recognized that when a taxpayer claims a deduction, he must point to some
specific provision of the statute in which that deduction is authorized and must be able to prove
that he is entitled to the deduction which the law allows. As previously adverted to, the law
allowing expenses as deduction from gross income for purposes of the income tax is Section 30
(a) (1) of the National Internal Revenue which allows a deduction of "all the ordinary and
necessary expenses paid or incurred during the taxable year in carrying on any trade or business."
An item of expenditure, in order to be deductible under this section of the statute, must fall
squarely within its language. (Atlas Consolidated Mining v. CIR, G.R. No. L-26911, January
27, 1981)

A. BUSINESS EXPENSES

In general, what are the business expenses that are allowed by law to be deducted
from gross income?

All the ordinary and necessary expenses paid or incurred during the taxable year in carrying
on or which are directly attributable to, the development, management, operation and/or
conduct of the trade, business or exercise of profession [Sec. 34(A)(1)(a), NIRC].

What are the requisites in order that an expense may be deductible for income tax
purposes?

1. The expense must be ordinary and necessary;

Ordinary – when it is common to incur in the trade or business of the taxpayer as

distinguished from capital expenditures. The payments, however, need not be habitual
in the sense that taxpayer will have to make them often.

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 Necessary – if it is appropriate and helpful to the taxpayer’s business or if it is to be
intended to realize a profit or to minimize a loss (Cebu Terminal v. Coll, CTA Case No. 28,
June 29, 1957).

Capital Expenditures – An expenditure that benefits not only the current period but
also future periods. It is not deductible but depreciable, except, if the taxpayer is a non-
profit proprietary educational institution which may elect either to deduct the capital
expense of depreciate it.

Examples of Capital Expenditures:

a. Litigation expenses in defense of a title to mining properties (Atlas Consolidated v.

CIR, supra). These will become part of cost of the property.
b. One-time stock listing expenses as compared to the annual recurring fees paid to
the stock exchange. (Atlas Consolidated v. CIR, supra)
c. Advertising expense designed to stimulate future sales of a merchandise (CIR v.
General Foods, Inc. G.R. No. 143672, April 24, 2003, discussed below)

2. It must be reasonable in amount.

The phrase “ordinary and necessary” implies that the expense must be reasonable. (See
CIR v. General Foods, Inc. supra)

Cases on Requisite Nos. 1 & 2:

Atlas Consolidated Mining v. CIR, supra. [T]he statutory test of deductibility where
it is axiomatic that to be deductible as a business expense, three conditions are imposed,
namely: (1) the expense must be ordinary and necessary, (2) it must be paid or incurred
within the taxable year, and (3) it must be paid or incurred in carrying in a trade or
business. In addition, not only must the taxpayer meet the business test, he must
substantially prove by evidence or records the deductions claimed under the law,
otherwise, the same will be disallowed. The mere allegation of the taxpayer that an item
of expense is ordinary and necessary does not justify its deduction. While it is true that
there is a number of decisions in the United States delving on the interpretation of the
terms "ordinary and necessary" as used in the federal tax laws, no adequate or satisfactory
definition of those terms is possible. Similarly, this Court has never attempted to define
with precision the terms "ordinary and necessary." There are however, certain guiding
principles worthy of serious consideration in the proper adjudication of conflicting claims.
Ordinarily, an expense will be considered "necessary" where the expenditure is
appropriate and helpful in the development of the taxpayer's business. It is "ordinary"
when it connotes a payment which is normal in relation to the business of the taxpayer
and the surrounding circumstances. The term "ordinary" does not require that the
payments be habitual or normal in the sense that the same taxpayer will have to make
them often; the payment may be unique or non-recurring to the particular taxpayer
affected. There is thus no hard and fast rule on the matter. The right to a deduction
depends in each case on the particular facts and the relation of the payment to the type
of business in which the taxpayer is engaged. The intention of the taxpayer often may be
the controlling fact in making the determination. Assuming that the expenditure is

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 ordinary and necessary in the operation of the taxpayer's business, the answer to the
question as to whether the expenditure is an allowable deduction as a business expense
must be determined from the nature of the expenditure itself, which in turn depends on
the extent and permanency of the work accomplished by the expenditure.

Aguinaldo Industries v. CIR, G.R. No. L-29790, February 25, 1982. Facts: Aguinaldo
Industries, in its income tax returns, claimed a deduction from its gross income the
amount of P61,187.48 as additional remuneration paid to the officers of the corporation.
It was found out that this amount was taken from the net profit of an isolated transaction,
i.e. sale of land not in the ordinary course of its business or trade. It appears as well that
the sale was effected thru a broker who earned commission of P51,723.72. Held: The
bonus given to the officers of the petitioner as their share of the profit realized from the
sale of petitioner's Muntinlupa land cannot be deemed a deductible expense for tax
purposes, even if the aforesaid sale could be considered as a transaction for carrying on
the trade or business of the petitioner and the grant of the bonus to the corporate officers
pursuant to petitioner's by-laws could, as an intra-corporate matter, be sustained. The
records show that the sale was effected through a broker who was paid by petitioner a
commission of P51,723.72 for his services. On the other hand, there is absolutely no
evidence of any service actually rendered by petitioner's officers which could be the basis
of a grant to them of a bonus out of the profit derived from the sale. This being so, the
payment of a bonus to them out of the gain realized from the sale cannot be considered
as a selling expense; nor can it be deemed reasonable and necessary so as to make it
deductible for tax purposes.

ESSO v. CIR, G.R. Nos. L-28508-9, July 7, 1989. Facts: In this case, ESSO claimed as
ordinary and necessary expenses the amount of P340,822.04 representing margin fees it
paid to the Central Bank on its profit remittances to its New York head office. Held:
Citing the requirements stated in Atlas Consolidated Mining v CIR, the SC held that ESSO
has not shown that the remittance to the head office of part of its profits was made in the
furtherance of its own trade of business. The petitioner merely presumed that all
corporate expenses are necessary and appropriate in the absence of a showing that they
are illegal or ultra vires. The public respondent is correct when it asserts that "the
paramount rule is that claims for deductions are a matter of legislative grace and do not
turn on mere equitable considerations ... . The taxpayer in every instance has the burden
of justifying the allowance of any deduction claimed." It is clear that ESSO, having
assumed an expense properly attributable to its head office, cannot now claim this as an
ordinary and necessary expense paid or incurred in carrying on its own trade or business.

3. It must have been paid or incurred during the taxable year;

If the taxpayer keeps his/its books on the cash receipts basis, then expenses are
deductible in the year they are paid. If on the accrual basis, then in the year they are
incurred, whether paid or not.

All Events Test. It is applied in recognizing income or liability under accrual method
of accounting. For taxpayer using the accrual method, the determinative question is,
when do the facts present themselves in such a manner that the taxpayer must recognize

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income or expense? The accrual of income and expense is permitted when the all-events
test has been met. This requires: (1) fixing of the right to income or liability to pay; and
(2) the availability of the reasonable accurate determination of such income or liability.

Case: CIR v. Isabela Cultural Corp., G.R. No. 17223, February 12, 2007. Facts:
During the audit of ICC’s books for taxable year 1986, the following BIR disallowed the
following expenses: a) expenses for auditing services for the year 1985; b) expenses for
legal services for the years 1984 and 1985; and c) expenses for security services for 1986.
Moreover, the BIR alleged that ICC understated it’s interest income on the three
promissory notes from Realty Investment Inc. Held: Accounting methods for tax
purposes comprise a set of rules for determining when and how to report income and
deductions. In the instant case, the accounting method used by ICC is the accrual method.
Revenue Audit Memorandum Order No. 1-2000, provides that under the accrual method
of accounting, expenses not being claimed as deductions by a taxpayer in the current year
when they are incurred cannot be claimed as deduction from income for the succeeding
year. Thus, a taxpayer who is authorized to deduct certain expenses and other allowable
deductions for the current year but failed to do so cannot deduct the same for the next
year. The accrual method relies upon the taxpayer’s right to receive amounts or its
obligation to pay them, in opposition to actual receipt or payment, which characterizes
the cash method of accounting. Amounts of income accrue where the right to receive
them become fixed, where there is created an enforceable liability. Similarly, liabilities are
accrued when fixed and determinable in amount, without regard to indeterminacy merely
of time of payment. For a taxpayer using the accrual method, the determinative question
is, when do the facts present themselves in such a manner that the taxpayer must
recognize income or expense? The accrual of income and expense is permitted when the
all-events test has been met. This test requires: (1) fixing of a right to income or liability
to pay; and (2) the availability of the reasonable accurate determination of such income
or liability. The all-events test requires the right to income or liability be fixed, and the
amount of such income or liability be determined with reasonable accuracy. However, the
test does not demand that the amount of income or liability be known absolutely, only
that a taxpayer has at his disposal the information necessary to compute the amount with
reasonable accuracy. The all-events test is satisfied where computation remains uncertain,
if its basis is unchangeable; the test is satisfied where a computation may be unknown,
but is not as much as unknowable, within the taxable year. The amount of liability
does not have to be determined exactly; it must be determined with
"reasonable accuracy." Accordingly, the term "reasonable accuracy" implies
something less than an exact or completely accurate amount. The propriety of
an accrual must be judged by the facts that a taxpayer knew, or could
reasonably be expected to have known, at the closing of its books for the
taxable year. Accrual method of accounting presents largely a question of fact; such
that the taxpayer bears the burden of proof of establishing the accrual of an item of
income or deduction. Corollarily, it is a governing principle in taxation that tax exemptions
must be construed in strictissimi juris against the taxpayer and liberally in favor of the
taxing authority; and one who claims an exemption must be able to justify the same by
the clearest grant of organic or statute law. An exemption from the common burden
cannot be permitted to exist upon vague implications. And since a deduction for income
tax purposes partakes of the nature of a tax exemption, then it must also be strictly
construed. In the instant case, the expenses for professional fees consist of expenses for

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 legal and auditing services. The expenses for legal services pertain to the 1984 and 1985
legal and retainer fees of the law firm Bengzon Zarraga Narciso Cudala Pecson Azcuna &
Bengson, and for reimbursement of the expenses of said firm in connection with ICC’s tax
problems for the year 1984. As testified by the Treasurer of ICC, the firm has been its
counsel since the 1960’s. From the nature of the claimed deductions and the span of time
during which the firm was retained, ICC can be expected to have reasonably known the
retainer fees charged by the firm as well as the compensation for its legal services. The
failure to determine the exact amount of the expense during the taxable year when they
could have been claimed as deductions cannot thus be attributed solely to the delayed
billing of these liabilities by the firm. For one, ICC, in the exercise of due diligence could
have inquired into the amount of their obligation to the firm, especially so that it is using
the accrual method of accounting. For another, it could have reasonably determined the
amount of legal and retainer fees owing to its familiarity with the rates charged by their
long time legal consultant. As previously stated, the accrual method presents largely a
question of fact and that the taxpayer bears the burden of establishing the accrual of an
expense or income. However, ICC failed to discharge this burden. As to when the firm’s
performance of its services in connection with the 1984 tax problems were completed, or
whether ICC exercised reasonable diligence to inquire about the amount of its liability, or
whether it does or does not possess the information necessary to compute the amount of
said liability with reasonable accuracy, are questions of fact which ICC never established.
It simply relied on the defense of delayed billing by the firm and the company, which
under the circumstances, is not sufficient to exempt it from being charged with knowledge
of the reasonable amount of the expenses for legal and auditing services. In the same
vein, the professional fees of SGV & Co. for auditing the financial statements of ICC for
the year 1985 cannot be validly claimed as expense deductions in 1986. This is so because
ICC failed to present evidence showing that even with only "reasonable accuracy," as the
standard to ascertain its liability to SGV & Co. in the year 1985, it cannot determine the
professional fees which said company would charge for its services. ICC thus failed to
discharge the burden of proving that the claimed expense deductions for the professional
services were allowable deductions for the taxable year 1986. Hence, per Revenue Audit
Memorandum Order No. 1-2000, they cannot be validly deducted from its gross income
for the said year and were therefore properly disallowed by the BIR. As to the expenses
for security services, the records show that these expenses were incurred by ICC in
1986 and could therefore be properly claimed as deductions for the said year. Anent the
purported understatement of interest income from the promissory notes of Realty
Investment, Inc., we sustain the findings of the CTA and the Court of Appeals that no
such understatement exists and that only simple interest computation and not a
compounded one should have been applied by the BIR. There is indeed no stipulation
between the latter and ICC on the application of compounded interest. Under Article 1959
of the Civil Code, unless there is a stipulation to the contrary, interest due should not
further earn interest.

4. It must be paid or incurred in carrying on any trade or business or exercise of

profession;

Case: Hospital de San Juan De Dios v. CIR, G.R. No. L-31305, May 10, 1990. Held:
The Supreme Court ruled in the negative. The CTA found that petitioner failed to establish

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 by competent proof that its receipt of interest and dividends constituted the carrying on
of a trade or business so as to warrant the deductibility of the expenses incurred in their
realization. Petitioner could have easily required any of its responsible officials to testify
on this regard but it failed to do so. Under this circumstances and coupled with the fact
that the interest and dividends here in question are merely incidental income to
petitioner’s main activities, which is the operation of its hospital and nursing school, the
conclusion becomes inevitable that petitioner’s activity never go beyond that of a passive
investor, which under existing jurisprudence do not come within the purview of carrying
on any trade or business.

5. It must be substantiated by adequate proof.

Rule: No deduction from gross income shall be allowed x x x unless the taxpayer
substantiate with sufficient evidence, such as official receipts or other adequate records:
(i) the amount of the expense being deducted, and (b) 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.

Exception: Cohan Rule (Cohan v. Commissioner, 39 F. 2d 540, 1930) – In this case,

despite inadequate records, Cohan was allowed was allowed to a deduction based on
close approximation. Generally, the effect of the Cohan decision extends to the
deductibility of business expenses where the taxpayer clearly incurred business expenses,
but kept inadequate records. In order words, this Cohan Rule allows taxpayers to deduct
some of their business-related expenses even if the receipts have been lost or misplaced
so long as they are reasonable and credible.

Best Evidence Obtainable Rule [Sec. 6(B), NIRC]. When a report required by law
as a basis for the assessment of any national internal revenue tax shall not be forthcoming
within the time fixed by laws or rules and regulation or when there is a reason to believe
that any such report is false, incomplete or erroneous, the Commissioner shall assess the
proper tax on the best evidence obtainable.

Cases:

Pilmico-Mauri Foods Corp, G.R. No. 175651, Sept. 14, 2016: Held: To support
deductions for business expense, official receipts and sales invoices must meet the
requirements provided for in Section 238 of the 1977 Tax Code.

Jumbo East Realty v. CIR, CTA Case No. 8380, March 16, 2015. Held: In the absence
of accounting records or other documents necessary for the determination of taxpayer’s
internal revenue tax liability, Section 6(B) of the Tax Code requires that the assessment
of the tax be determined based on the “Best Evidence Obtainable” Under Section
2.4(c) of RMC 23-2000, which prescribes the procedures on the assessment of deficiency
internal revenue taxes based on “Best Evidence Obtainable” under Section 6(B) of the Tax
Code, in case when there is showing that the expenses has been incurred by the taxpayer
but the exact amount of such expenses cannot be ascertained due to absence of
documentary evidence, the BIR can make an estimate of the deduction that may be
allowed in computing the taxpayer’s taxable income, and the disallowance of 50% of the

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 taxpayer’s claimed deduction is valid. In the instant case, while the taxpayer was able to
submit the various official receipts to support the its deductions for operating expenses
and taxes and licenses, the same were denied admission by the CTA for the taxpayer’s
failure to present the original copies for comparison. Hence, considering that the
taxpayer’s claimed deductions were not adequately supported by documentary evidence,
the CTA upheld the disallowance of the operating expenses as well as the taxes and
licenses claimed by the taxpayer. However, since the taxpayer actually incurred the
expenses, the CTA deemed it proper to apply the 50% approximation provided under
Sections 2.3 and 2.4(c) of RMC No. 23-2000. Thus, in computing the taxable income of
the taxpayer, the taxpayer may only deduct 50% of the total amount it claimed for
operating expenses, including taxes and licenses.

Sy Po v. CTA, CIR, G.R. No. 81446, August 18, 1988. Held: The rule on the “best
evidence obtainable” applies when a tax report required by law for the purpose of
assessment is not available or when the tax report is incomplete or fraudulent.

6. If the expense is subject to withholding tax, proof of payment to the BIR must be
shown.

Rule: Any amount paid or payable which is otherwise deductible from or taken into
account in computing gross income or for which depreciation or amortization may be
allowed shall be allowed as a deduction only if it is shown that the tax required to be
deducted and withheld therefrom has been paid to the BIR. [Sec. 34(K])

Instances when a deduction is allowed where no withholding of tax was made

(Revenue Regulation No. 6-2018)
https://www.bir.gov.ph/images/bir_files/internal_communications_1/Full%20Text%20R
R%202018/RR%20No.%206-2018.pdf

a. The payee reported the income and pays the income 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 the
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 the
audit/investigation or reinvestigation/reconsideration;

c. The withholding agent erroneously underwithheld 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.

See: RR Nos. 11-2018 and 14-2018 relative to the list of income payments
subject to withholding taxes.

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https://www.bir.gov.ph/images/bir_files/internal_communications_1/Full%20Text%20R
R%202018/RR%20No.%2011-2018/RR%20No.%2011-2018.pdf
https://www.bir.gov.ph/images/bir_files/internal_communications_1/Full%20Text%20R
R%202018/RR%20No.%2014-2018.pdf

Note: Income payments to registered enterprises availing of income tax holidays are not
subject to creditable withholding tax. (BIR Ruling DA 030-2008, June 23, 2008)

Cases:

a. FEBTC v. CA, CTA, G.R. No. 129130, December 9, 2005. CDB (which later on merged
with FEBTC, the latter being the surviving company) filed its ITR reflecting therein a
negative net income (or net loss). Since there is no tax against which to credit or
offset taxes withheld by CDB, the result was that CDB had excess creditable
withholding tax. Thus, filed for a claim for refund. In denying the claim for refund,
the CA held that the evidence presented by FEBTC consisting of: (1) confirmation
receipts, payment orders, and official receipts issued by the Central Bank and the BIR
with CDB as the payor; (2) Income Tax Returns for 1990 and 1991 with attached
financial statements filed by petitioner with the BIR; and, (3) a list prepared by the
Accounting Department of petitioner purportedly showing the CDB schedule of
creditable withholding tax applied for refund for 1990 and 1991, all failed to clearly
establish that the taxes arising from the sale of its acquired assets sometime in 1990
and 1991 were properly withheld and remitted to the BIR. The CA likewise ruled that
it was incumbent upon petitioner to present BIR Form No. 1743.1 as required under
Revenue Regulation 6-85 to conclusively prove its right to the refund. It held that
petitioner's failure to do so was fatal to its cause.

Held: Petitioner has not sufficiently presented a case for the application of an
exception from the rule.

Firstly, the CA cannot be faulted for not lending credence to petitioner's contention
that it withheld, for its own account, the creditable withholding taxes on the sale of
its acquired assets. In our withholding tax system, possession of the amount that is
used to settle the tax liability is acquired by the payor as the withholding agent of the
government. For this reason, the Tax Code imposes, among others, certain obligations
upon the withholding agent to monitor its compliance with this duty. These include
the filing of the quarterly withholding tax returns, the submission to the payee, in
respect of his or its receipts during the calendar quarter or year, of a written statement
showing the income or other payments made by the withholding agent during such
quarter or year and the amount of the tax deducted and withheld therefrom, and the
filing with the BIR of a reconciliation statement of quarterly payments and a list of
payees and income payments. Codal provisions on withholding tax are mandatory
and must be complied with by the withholding agent. This is significant in that a
taxpayer cannot be compelled to answer for the non-performance by the withholding
agent of its legal duty to withhold unless there is collusion or bad faith. In addition,
the former could not be deemed to have evaded the tax had the withholding agent
performed its duty.

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 On the other hand, it is incumbent upon the payee to reflect in his or its own return
the income upon which any creditable tax is required to be withheld at the source.
Only when there is an excess of the amount of tax so withheld over the tax due on
the payee's return can a refund become possible.

A taxpayer must thus do two things to be able to successfully make a claim for the
tax refund: (a) declare the income payments it received as part of its gross income
and (b) establish the fact of withholding. On this score, the relevant revenue
regulation provides as follows:

Section 10. Claims for tax credit or refund. -- Claims for tax credit or refund
of income tax deducted and withheld on income payments shall be given
due course only when it is shown on the return that the income payment
received was declared as part of the gross income and the fact of
withholding is established by a copy of the statement duly issued by the
payor to the payee (BIR Form No. 1743.1) showing the amount paid and
the amount of tax withheld therefrom.

As mentioned, petitioner relies heavily on the confirmation receipts with the

corresponding official receipts and payment orders to support its case. Standing alone,
however, these documents only establish that CDB withheld certain amounts in 1990
and 1991. It does not follow that the payments reflected in the confirmation receipts
relate to the creditable withholding taxes arising from the sale of the acquired
properties. The claim that CDB had excess creditable withholding taxes can only be
upheld if it were clearly and positively shown that the amounts on the various
confirmation receipts were the amounts withheld by virtue of the sale of the acquired
assets. On this point, the CA correctly pronounced:

The confirmation receipts alone, by themselves, will not suffice to prove

that the taxes reflected in the income tax returns are the same taxes
withheld from CDB's income payments from the sale of its acquired assets.
This is because a cursory examination of the said Confirmation Receipts,
Payment Orders and Official Receipts will show that what are reflected
therein are merely the names of the payors and the amount of tax. The
nature of the tax paid, or at the very least, the income payments from
which the taxes paid were withheld are not reflected therein. If these are
the only entries that are found on these proferred documents, We cannot
begrudge the Respondent Court from nurturing veritable doubts on the
nature and identity of the taxes withheld, when it declared, in part, in its
Decision ( Annex 'A of the Petition ) that, 'It can not well be said that
the amounts paid and remitted to the BIR were for CDB's account and not
for the other possible payees of withholding taxes which CDB may also be
liable to remit as a withholding agent x x x .

Petitioner, apparently aware of the foregoing deficiency, offered into evidence a CDB
Schedule of Creditable Withholding Tax for the period 1990 to 1991 prepared by
petitioner's representative to show that the taxes CDB withheld did, indeed, pertain to the

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taxes accruing on the sale of the acquired assets. The CA, however, found the same to
be 'self-serving and unverifiable and therefore 'barren of evidentiary weight. We accord
this finding on an issue of fact the highest respect and we will not set it aside lightly.

It bears emphasis that questions on whether certain items of evidence should be accorded
probative value or weight, or rejected as feeble or spurious, or whether the proofs on one
side or the other are clear and convincing and adequate to establish a proposition in issue,
are without doubt questions of fact. This is true regardless of whether the body of proofs
presented by a party, weighed and analyzed in relation to contrary evidence submitted by
the adverse party, may be said to be strong, clear and convincing. Whether certain
documents presented by one side should be accorded full faith and credit in the face of
protests as to their spurious character by the other side; whether inconsistencies in the
body of proofs of a party are of such gravity as to justify refusing to give said proofs
weight all these are issues of fact. Questions like these are not reviewable by us. As a
rule, we confine our review of cases decided by the CA only to questions of law raised in
the petition and therein distinctly set forth. We note that without the CDB Schedule, no
evidence links the Confirmation Receipts, Payment Orders and Official Receipts to the
taxes allegedly withheld by CDB on the sale of the acquired assets.

As to the annual income tax returns for 1990 and 1991 presented by petitioner, we must
stress that the mere admission into the records of these returns does not automatically
make their contents or entries undisputed and binding facts. Mere allegations by petitioner
of the figures in its returns are not a sufficient proof of the amount of its refund
entitlement. They do not even constitute evidence adverse to respondent, against whom
these are being presented.

Furthermore, we note that in the proceedings below, respondent Commissioner of Internal

Revenue (CIR) raised the fact that there was a discrepancy in the excess creditable
withholding tax reflected in the returns with the amounts sought to be refunded by
petitioner. Whereas the 1990 and 1991 Income Tax Returns indicated that CDB had excess
creditable withholding tax in the amounts of P535,310 and P357,511, respectively, the
amounts claimed by petitioner as indicated in the CDB Schedule were P512,940.50 for
1990 and P242,774.50 for 1991. The records are bereft of any explanation for such
discrepancy. This further undermines petitioner's contentions, and its reliance on the CDB
Schedule.

Petitioner also asserts that the confusion or difficulty in the implementation of Revenue
Memorandum Circular 7-90 was the reason why CDB took upon itself the task of
withholding the taxes arising from the sale, to ensure accuracy. Assuming this were true,
CDB should have, nevertheless, accomplished the necessary returns to clearly identify the
nature of the payments made and file the same with the BIR. Section 2 of the circular
clearly provides that the amount of withholding tax paid by a corporation to the BIR during
the quarter on sales or exchanges of property and which are creditable against the
corporation's tax liability are evidenced by Confirmation/Official Receipts and covered by
BIR Form Nos. 1743W and 1743-B. On the other hand, Revenue Regulation 6-85 states
that BIR Form No. 1743.1 establishes the fact of withholding. Since no competent
evidence was adduced by petitioner, the failure to offer these returns as evidence of the
amount of petitioner's entitlement during the trial phase of this case is fatal to its

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 cause. For its negligence, petitioner 'cannot be allowed to seek refuge in a liberal
application of the [r]ules. The liberal interpretation and application of rules apply only in
proper cases of demonstrable merit and under justifiable causes and circumstances.

b. Barcelon, Roxas Securities v. CIR, G.R. No. 157064, August 7, 2006. In this case,
petitioner was assessed for deficiency income tax for failure to withhold taxes on
salaries, bonuses, and allowances. The substantive issue, however, was cancelled as
the assessment was already barred by prescription.

7. It must not be against law or public policy.

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.
34(A)(1)(a)(iv)]

No deduction from gross income x x x for any payment made, directly or indirectly, to an
official or employee of the national government, 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 similar entity, if the payment constitutes a bribe or kickback. [Sec.
34(A)(1)(c)].

Specific Ordinary and Necessary Business Expenses that may be Deducted. [Sec.
34(A)(1)(a).

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 Fringe
Benefit Tax thereof has been paid.

Requisites on deductibility of compensation for personal services:

a. The payments are reasonable;

b. They are, in fact, payments for personal services actually rendered (Sec. 70, RR
2-40);
c. If the compensation is a fringe benefits, the Fringe Benefit Tax must have been
paid.

Rules on the deductibility of the bonuses to employees. See C.M. Hoskins v. CIR, G.R.
No. L-24059, November 28, 1969; Kuenzle & Strieff v. CIR, G.R. No. L-18840, May 29,
1969)

a. the payment of the bonuses is in fact compensation;

b. it must be for personal services actually rendered; and

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 c. the bonuses, when added to the salaries, are 'reasonable . . . when measured by
the amount and quality of the services performed with relation to the business of
the particular taxpayer'

Factors to consider in determining reasonableness of a given bonus as compensation

There is no fixed test for determining the reasonableness of a given bonus as

compensation. This depends upon many factors, one of them being 'the amount and
quality of the services performed with relation to the business.' Other tests suggested are:
payment must be 'made in good faith'; 'the character of the taxpayer's business, the
volume and amount of its net earnings, its locality, the type and extent of the services
rendered, the salary policy of the corporation'; 'the size of the particular business'; 'the
employees' qualifications and contributions to the business venture'; and 'general
economic conditions' (4 Mertens, Law of Federal Income Taxation, Secs. 25.44, 25.49,
25.50, 25.51, pp. 407-412). However, 'in determining whether the particular salary or
compensation payment is reasonable, the situation must be considered as whole.
Ordinarily, no single factor is decisive. . . . it is important to keep in mind that it seldom
happens that the application of one test can give satisfactory answer, and that ordinarily
it is the interplay of several factors, properly weighted for the particular case, which must
furnish the final answer. (C.M. Hoskins v. CIR, supra)

b. Reasonable allowance for travel expenses, here or abroad, while away from home in
pursuit of trade, profession or business;

What does the term “travelling expenses” include?

Travelling expenses, as ordinarily understood, include transportation expenses and meals

and lodging incurred while away from home solely in the pursuit of a trade or business.
(Secs. 65, 66, RR 2-40)

Requisites for the allowance of a travelling expense deduction

1. The expense must be reasonable and necessary;

2. They must be incurred or paid “while away from home”;
3. They must be paid or incurred in the conduct of trade or business.

Meaning of “while away from home”

Every taxpayer has the so-called tax “home”. It means his principal place of business,
employment, or post or station where he is employed and not necessarily the place of his
residence. Thus, a taxpayer who operates his business in Manila has his tax-home in
Manila although he may reside elsewhere. However, if he goes, let us say, to Cebu on a
business trip, then he is allowed deductions for his plane fare, meals, and hotel
accommodation because these travelling expenses while away from home. (De Leon)

Distinguish transportation expenses from travelling expenses

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 The ordinary and necessary transportation expenses of the taxpayer incurred in
connection with the pursuit of his business are deductible. They are different from the
transportation expenses included in the term “travelling expenses”. So, a taxpayer
operating his business in Manila is allowed transportation expenses from his office to his
customer’s place of business and back. But his transportation expenses from his residence
to his office and back are not deductible as they are considered personal expenses. (De
Leon)

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 has no equity other than that of a lessee, user, or possessor;

Operating Lease – a lease in which all risks and rewards related to asset ownership
remain with the lessor. The ownership of the asset remains with the lessor for the entire
lease term; thus, the lessee will have to return the asset upon the expiration of the lease
term.

Finance Lease (or Capital Lease) – the risks and rewards related to asset ownership
are transferred to the lessee. The ownership of the property is transferred to the lessee
at the end of the lease term; hence, lessee will not, in general, return the property to the
lessor at the expiration of the lease.

Notes:

1. When a leasehold is acquired for business purpose for a specified sum, the taxpayer
may take as a deduction an aliquot part of such sum each year based on the number
of years the lease has to run. (Sec. 74, RR No. 2-40)

2. Real property taxes on the leased property paid by the tenant to the landlord are
treated as additional rent and hence, constitute a deductible item to the tenant and
taxable income to the landlord, the amount of tax being deductible by the latter. (Ibid)

3. Cost borne by the lessee in erecting a building or making permanent improvements of

the land of which he is the lessee is a capital expenditure and not deductible as a
business expense. In order to return to such taxpayer his capital investment, an
annual deduction may be made from gross income of an amount equal to the cost of
such improvement divided by the number of years remaining of the term of the lease
or life of the building, whichever is shorter in duration.

Annual Deduction = Cost of the building

Lease Term or Useful Life, whichever is shorter

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

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 profession not to exceed such ceilings as the Secretary of Finance may, by

Page 17 of 51
rules and regulations prescribe, upon recommendation of the Commissioner, taking into
account the needs as well as the character of the industry of the taxpayer; Provided, 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.

See: Revenue Regulation No. 10-2002

https://www.lawphil.net/administ/bir/rr/rr10_02.pdf

Who are allowed to claim EAR expense?

1. Individual taxpayers engaged in business, including taxable estate and trusts;
2. Individuals engaged in the practice of profession;
3. Domestic corporations;
4. Resident foreign corporations;
5. General professional partnerships, including its members

What comprises EAR?

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

Representation expenses – 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, and similar events or
places. For purposes of the regulation, representation expense shall not refer to fixed
representation allowances that are subject to withholding tax on wages pursuant to
appropriate revenue regulation.

In the case particularly of a country, golf, sports club, or any other similar club where the
employee or officer of the taxpayer is the registered member and the expenses incurred
thereto are paid for by the taxpayer, there shall be a presumption that such expenses are
fringe benefits subject to fringe benefit tax unless the taxpayer can prove that these are
actually representation expenses. For purposes of proving that said expense is a
representation expense and not fringe benefits, the taxpayer should maintain receipts and
adequate records that indicate the (a) amount of expense; (b) date and place of expense;
(c) purpose of expense; (d) professional or business relationship of expense; (e) name of
person and company entertained with contact details.

Entertainment Facilities – refer to (1) yacht, vacation home or condominium; and (2)
any similar item of real or personal property used by the taxpayer primarily for the
entertainment, amusement or recreation of guests or employees. To be considered
entertainment facility, such yacht, vacation home, or condominium, or item of real or
personal property must be owned or form part of the taxpayer’s trade, business, or
profession, or rented by such taxpayer, for which the taxpayer claims a depreciation or
rental expense. A yacht shall be considered an entertainment facility under this regulation
if its use is in fact not restricted to specified officers or employees or positions in such a
manner as to make the same a fringe benefit for purposes of imposing fringe benefit tax.

Page 18 of 51
Guests – persons or entities with which the taxpayer has direct business relations, such
as but not limited to, clients/customers or prospective clients/customers. The term shall
not include employees, officers, partners, directors, stockholders, or trustees of the
taxpayer.

What are NOT considered EAR expenses?

1. Expenses which are treated as compensation or fringe benefits for services rendered
under an employer-employee relationship, pursuant to RR No. 2-93, 3-98 and
amendments thereto;
2. Expenses for charitable or fund-raising events;
3. Expenses for bona fide business meetings of stockholders, partners, or directors;
4. Expenses for attending or sponsoring an employee to a business league or professional
organization meeting;
5. Expenses for events organized for promotion, marketing and advertising including
concerts, conferences, seminars, workshops, conventions, and other similar events;
6. Other expenses of similar nature.

Notwithstanding the foregoing, such items of exclusions may, nonetheless, qualify as

items of deductions under Section 34 of the Tax Code, subject to conditions for
deductibility stated therein.

What are the REQUSITES for the deductibility of EAR Expenses?

1. It must be paid or incurred during the taxable year;
2. It must be: (i) directly connected to the development, management and operation of
the trade, business or profession of the taxpayer; or (ii) directly related to or in
furtherance of the conduct of his or its trade, business or exercise of 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
national government, or any local government unit, or of any GOCC, or of a foreign
government, or to a private individual, or corporation, or GPP, or a similar entity, if it
constitutes a bribe, kickback or other similar payment;
5. It must be duly substantiated by adequate proof. The official receipts, or invoices, or
bills or statements of accounts should be in the name of the taxpayer claiming the
deduction; and
6. The appropriate amount of withholding tax, if applicable, should have been withheld
therefrom and paid to the BIR.

CEILING ON EAR

1. 0.50% of the net sales (i.e. gross sales less returns/allowances and sales discount)
– for taxpayers engaged in the sale of goods or properties;

2. 1.00% of the net revenue (i.e. gross revenue less discounts) – for taxpayers
engaged in sale of services, including exercise of profession and use or lease of
properties.

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 3. If the taxpayer derives income from both sale of goods/properties and service, the
allowable EAR expense shall in all cases be determined based on apportionment
formula taking into consideration the percentage of the net sales/net revenue
to the total net sales/net revenue but in no case shall exceed the maximum
percentage ceiling provided in the regulation.

Apportionment formula:

Net Sales/Net Revenue x Actual Expense

Total Net Sales and Revenue

Notwithstanding the ceiling imposed on such expense, the claimed expense shall be
subject to verification and audit for purposes of determining its deductibility as well as
compliance with the substantiation requirements. However, if after verification a
taxpayer is found to have shifted the amount of the EAR to any other expense, in
order to avoid being subjected to ceiling herein prescribed, the amount shifted shall be
disallowed in its totality, without prejudice to such penalties as may be imposed by the
Tax Code.

Reporting Requirement.
The taxpayer is required to use in its financial statement and income tax return the
account title “entertainment, amusement and recreation expense”, or in the alternative,
disclose in the notes to financial statement the amount corresponding thereto when
recording expenses paid or incurred of the nature as defined in the revenue regulation
(10-2002). However, such expense should be reported in the taxpayer’s income tax return
as a separate expense item.

e. Other Examples of Business Expenses

Advertising Expense

Case: CIR v. General Foods, Inc. G.R. No. 143672, April 24, 2003. Held: There is
yet to be a clear-cut criteria or fixed test for determining the reasonableness of an
advertising expense. There being no hard and fast rule on the matter, the right to a
deduction depends on a number of factors such as but not limited to: the type and size
of business in which the taxpayer is engaged; the volume and amount of its net earnings;
the nature of the expenditure itself; the intention of the taxpayer and the general
economic conditions. It is the interplay of these, among other factors and properly
weighed, that will yield a proper evaluation. In the case at bar, the P9,461,246 claimed
as media advertising expense for "Tang" alone was almost one-half of its total claim for
"marketing expenses." Aside from that, respondent-corporation also claimed P2,678,328
as "other advertising and promotions expense" and another P1,548,614, for consumer
promotion. Furthermore, the subject P9,461,246 media advertising expense for "Tang"
was almost double the amount of respondent corporation’s P4,640,636 general and
administrative expenses. We find the subject expense for the advertisement of a single
product to be inordinately large. Therefore, even if it is necessary, it cannot be considered

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an ordinary expense deductible under then Section 29 (a) (1) (A) of the NIRC. Advertising
is generally of two kinds: (1) advertising to stimulate the current sale of merchandise or
use of services and (2) advertising designed to stimulate the future sale of merchandise
or use of services. The second type involves expenditures incurred, in whole or in part, to
create or maintain some form of goodwill for the taxpayer’s trade or business or for the
industry or profession of which the taxpayer is a member. If the expenditures are for the
advertising of the first kind, then, except as to the question of the reasonableness of
amount, there is no doubt such expenditures are deductible as business expenses. If,
however, the expenditures are for advertising of the second kind, then normally they
should be spread out over a reasonable period of time. We agree with the Court of Tax
Appeals that the subject advertising expense was of the second kind. Not only was the
amount staggering; the respondent corporation itself also admitted, in its letter protest to
the Commissioner of Internal Revenue’s assessment, that the subject media expense was
incurred in order to protect respondent corporation’s brand franchise, a critical point
during the period under review. The protection of brand franchise is analogous to the
maintenance of goodwill or title to one’s property. This is a capital expenditure which
should be spread out over a reasonable period of time. Respondent corporation’s venture
to protect its brand franchise was tantamount to efforts to establish a reputation. This
was akin to the acquisition of capital assets and therefore expenses related thereto were
not to be considered as business expenses but as capital expenditures. True, it is the
taxpayer’s prerogative to determine the amount of advertising expenses it will incur and
where to apply them. Said prerogative, however, is subject to certain considerations. The
first relates to the extent to which the expenditures are actually capital outlays; this
necessitates an inquiry into the nature or purpose of such expenditures. The second,
which must be applied in harmony with the first, relates to whether the expenditures are
ordinary and necessary. Concomitantly, for an expense to be considered ordinary, it must
be reasonable in amount. The Court of Tax Appeals ruled that respondent corporation
failed to meet the two foregoing limitations. We find said ruling to be well founded.
Respondent corporation incurred the subject advertising expense in order to protect its
brand franchise. We consider this as a capital outlay since it created goodwill for its
business and/or product. The P9,461,246 media advertising expense for the promotion of
a single product, almost one-half of petitioner corporation’s entire claim for marketing
expenses for that year under review, inclusive of other advertising and promotion
expenses of P2,678,328 and P1,548,614 for consumer promotion, is doubtlessly
unreasonable.

Cost of Repairs

Rules:
1. Expenses for repairs are deductible if such repairs are incidental or ordinary, that is,
made to keep the property used in the trade or business of the taxpayer in an ordinarily
efficient operating condition (Sec. 68, RR No. 2-40);

2. Repairs in the nature of replacement to the extent that they arrest deterioration and
prolong the life of the property are capital expenditures (distinguished from
maintenance and incidental repairs) and should be debited against the corresponding
allowance for depreciation (Secs. 68, 120, RR 2-40). Thus, the construction of a

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 hollow block fence with iron grills around the compound of the taxpayer was properly
disallowed because it involved an addition which prolonged the life of the property
and materially increased its value. (Alhambra Cigar v. Coll., 105 Phil. 1337; Comm. V.
Soriano, CTA, G.R. No. L-26893, March 21, 1971)

B. INTEREST [SEC. 34(B), RR NO. 13-2000]

Interest – shall refer to the payment for the use or forbearance or detention of money,
regardless of the name it is called or denominated. It includes the amount paid for the borrower’s
use of money during the term of the loan, as well as for his detention of money after the due
date for its repayment.

Theoretical Interest – it is an interest calculated or computed (and not incurred or paid) for
the purpose of determining the “opportunity cost” of investing funds in a given business. Such
theoretical interest does not arise from a legally demandable interest-bearing obligation incurred
by the taxpayer who wishes to find out, i.e. whether he would have been better off by lending
out his funds and earning interest rather than investing such funds in his business. It is not
deductible as it does not represent a charge arising under an interest-bearing
obligation.

Requisites for deductibility of interest

1. There must be indebtedness;
2. There should be an interest expense paid or incurred upon such indebtedness;
3. The indebtedness must be that of the taxpayer;
4. The indebtedness must be connected with the taxpayer’s trade or business or exercise of
profession;
5. The interest expense must have been paid or incurred during the taxable year;
6. The interest must have been stipulated in writing;
7. The interest must be legally due;
8. The interest arrangement must not be between related taxpayers;
9. In case of interest incurred to acquire property used in trade, business or exercise of
profession, the same was not treated as capital expenditure.
10. The interest must not be incurred to finance petroleum operations;
11. The interest must not expressly disallowed by law to be deducted from gross income of
the taxpayer

Rules on deductibility of interest expense

General Rule: In general, the amount of interest expense paid or incurred within the taxable
year of indebtedness in connection with the taxpayer’s trade, business or exercise of profession,
shall be allowed as a deduction from the gross income.

Limitation: The amount of interest expense paid or incurred by the taxpayer in connection with
his trade, business or exercise of profession shall be reduced by an amount equal to
(beginning 2009 per RA 9337) of interest income earned which had been subjected to
final withholding tax.

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Reason for the Limitation. To discourage the so-called “back-to-back” loans where a taxpayer
secures a loan from a bank, turns around and invests the loan proceeds in money market
placement (which earns interest). By imposing the limit as to the amount of interest expense
that can be deducted from gross income, the previous practice of tax arbitrage was absolutely
nullified.

Tax Arbitrage – in general, this can be defined as the process of exploiting the differences in
the price of an asset by simultaneously buying and selling it. In the Philippine tax landscape, this
pertains to the proceeds of a taxpayer's loan obtained in connection with the operations of his
trade, business or exercise of profession which is afterwards invested, and the interest income
derived from the said investment had been subjected to final withholding tax. It may also mean
as a method of borrowing without entering a debtor/creditor relationship, often to resolve
financing and exchange control problems. In tax cases, back to back loan is used to take
advantage of the lower of tax on interest income and higher rate of tax on interest expense
deduction.

Other Deductible Interest Expense

1. Interest on taxes, such as those paid for deficiency or delinquency, since taxes are
considered. However, fines, penalties, and surcharges on account of taxes are not
deductible. on deduction;
2. Interest paid by a corporation on script dividend;
3. Interest on deposits paid by authorized banks of the BSP to depositors if it is shown that
the tax on such interest was withheld;
4. Interest paid by a corporate taxpayer who is liable under a mortgage upon real property
of which the said corporation is the legal or equitable owner, even though it is not directly
liable for the indebtedness.

Case: CIR v. Palanca, G.R. No. L-16626, October 29, 1966. Held: Interest on delinquent
estate and inheritance tax is deductible from gross income. The rule is settled that although
taxes already due is not, strictly speaking, the same concept as a debt, they are however,
obligations that may be considered as such. In CIR v. Prieto, the Court explicitly announced that
while the distinction between “taxes” and “debts” is recognized in this jurisdiction, the variance
in their legal conception does not extend to the interest paid on them.

Non-Deductible Interest Expense

1. If within the taxable year, an individual taxpayer reporting on a cash basis incurs an
indebtedness on which an interest is paid in advance through discount or otherwise.
Provided, that such interest shall be allowed as a deduction in the year the indebtedness
is paid; Provided further, that if the indebtedness is payable in periodic amortizations, the
amount of interest expense which corresponds to the amount of principal amortized or
paid during the year shall be allowed as a deduction in such taxable year.
2. Interest paid on indebtedness between related parties as defined in Section 36(B), NIRC;
3. If the indebtedness is incurred to finance petroleum exploration;
4. Interest on preferred stock, which in reality is dividend;
5. Interest on unpaid salaries and bonuses;

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 6. Interest calculated for cost keeping on account of capital or surplus invested which does
not represent charges arising under an interest-bearing obligation (theoretical interest);
7. Interest paid when there is no stipulation for the payment thereof.

Optional Treatment of Interest Expense

At the option of the taxpayer, interest incurred to acquire property used in trade, business
may be allowed as a deduction or treated as capital expenditure [Sec. 34(B)(3), NIRC]

C. TAXES [Sec. 34(C)]

TAXES, as used in Sec. 34(C) means taxes proper, and therefore no deductions are allowed for:
a. Interest;
b. Surcharges;
c. Penalties or fines incident to delinquency (Sec. 80, RR No. 2)

Requisites for Deductibility

1. Must be in connection with taxpayer’s business, trade or exercise of profession;
2. Must be imposed by law on, and payable by taxpayer (direct tax; see exceptions below)
3. Paid or incurred during the taxable year.

Taxes NOT Deductible

1. Income taxes provided under Title II of NIRC, including final taxes, e.g. Final Withholding
Taxes on Certain Passive Income, Capital Gains Tax, Fringe Benefit Tax, etc.)
See: Republic v. MERALCO, G.R. No. 141369, November 14, 2002, as previously
discussed)
2. Income taxes imposed by authority of any foreign country [but deduction is allowed if the
taxpayer does not signify his intention of availing Tax Credit for Taxes of Foreign Countries
under Sec. 34(C)(3 and 4)]
3. Estate and donor’s Tax;
4. Special assessments;

Tax Benefit Rule – Taxes allowed as deductions, when 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.

Rule applicable to Non-Resident Alien Engaged in Trade or Business (NRAETB) and

Resident Foreign Corporation (RFC)
Taxes paid or incurred are allowed as deductions only if and to the extent that they are connected
from income within the Philippines.

TAX CREDITS [Sec. 34(C)(3 and 4)]

Defined
Tax credit is the right of an income taxpayer’s right to deduct from the income tax due the amount
of tax he has paid to a foreign country subject to limitations.

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Rationale for Tax Credit
Sometimes instead of merely allowing a deduction from income, the amount of certain foreign
taxes paid by the taxpayer is credited on his income tax. Tax credit is allowed to lessen the
harshness of taxation in case where the same income is subject to a foreign tax and to the
Philippine income tax (De Leon).

Distinguish Tax Deduction and Tax Credit

See CIR v. Central Luzon Drug Store, G.R. No. 159647, April 15, 2005, see digest below)

Who may claim Tax Credit

1. Citizen and Domestic Corporation – in the case of a citizen of the Philippines and of
a domestic corporation, the amount of income taxes paid or incurred during the taxable
year to any foreign country; and
2. Partnerships and Estates – in the case of any such individual who is a member of a
general professional partnership or a beneficiary of an estate or trust, his proportionate
share of such taxes of the GPP or the estate or trust paid or incurred during the taxable
year to a foreign country, if his distributive share of the income of such partnership or
trust is reported for taxation under this Title.

An alien individual and a foreign corporation shall not be allowed the credits
against the tax for taxes of foreign countries allowed under this paragraph (Sec.
34(C)(3), NIRC)

See: CIR v. Lednicky, L-18169, L-18262, L21434, July 31, 1964. Held: Much stress
is laid on the thesis that if the respondent taxpayers are not allowed to deduct the income
taxes they are required to pay to the government of the United States in their return for
Philippine income tax, they would be subjected to double taxation. What respondents fail
to observe is that double taxation becomes obnoxious only where the taxpayer is taxed
twice for the benefit of the same governmental entity (cf. Manila vs. Interisland Gas
Service, 52 Off. Gaz. 6579; Manuf. Life Ins. Co. vs. Meer, 89 Phil. 357). In the present
case, while the taxpayers would have to pay two taxes on the same income, the Philippine
government only receives the proceeds of one tax. As between the Philippines, where the
income was earned and where the taxpayer is domiciled, and the United States, where
that income was not earned and where the taxpayer did not reside, it is indisputable that
justice and equity demand that the tax on the income should accrue to the benefit of the
Philippines. Any relief from the alleged double taxation should come from the United
States, and not from the Philippines, since the former's right to burden the taxpayer is
solely predicated on his citizenship, without contributing to the production of the wealth
that is being taxed. Aside from not conforming to the fundamental doctrine of
income taxation that the right of a government to tax income emanates from
its partnership in the production of income, by providing the protection,
resources, incentive, and proper climate for such production, the interpretation
given by the respondents to the revenue law provision in question operates, in its
application, to place a resident alien with only domestic sources of income in an equal, if
not in a better, position than one who has both domestic and foreign sources of income,
a situation which is manifestly unfair and short of logic. Finally, to allow an alien resident
to deduct from his gross income whatever taxes he pays to his own government amounts

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 to conferring on the latter the power to reduce the tax income of the Philippine
government simply by increasing the tax rates on the alien resident. Every time the rate
of taxation imposed upon an alien resident is increased by his own government, his
deduction from Philippine taxes would correspondingly increase, and the proceeds for the
Philippines diminished, thereby subordinating our own taxes to those levied by a foreign
government. Such a result is incompatible with the status of the Philippines as an
independent and sovereign state.

Limitation on Credit.
The amount of the credit taken under this Section shall be subject to each of the following
limitations:

a. Per Country Limitation. 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.
This is expressed in the following formula:

Taxable Income (TI) from Foreign Country X Phil. Income Tax = Tax Credit Limit
TI from all sources

b. Over All Limitation. 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 his entire taxable income for
the same taxable year.

This is expressed in the following formula:

Taxable Income (TI) from Outside Sources X Phil. Income Tax = Tax Credit Limit
TI from all sources

The allowable tax credit is the “lower amount” between the tax credit limit computed under
(a) and (b).

Adjustments on Payment of Incurred Taxes

If accrued taxes when paid differ from the amounts claimed as credits by the taxpayer, or if any
tax paid is refunded in whole or in part, the taxpayer shall notify the Commissioner, who shall re-
determine the amount of tax due for the year or years affected, and the amount of tax upon such
redetermination, if any, shall be paid by the taxpayer upon notice and demand by the
Commissioner, or the amount of tax overpaid, if any, shall be credited or refunded to the taxpayer.
In the case of such a tax incurred but not paid, the Commissioner as a condition precedent to the
allowance of this credit may require the taxpayer to give a bond with sureties satisfactory to and
to be approved by the Commissioner in such sum as he may require, conditioned upon the
payment by the taxpayer of any amount of tax found due upon any such redetermination. The
bond herein prescribed shall contain such further conditions as the Commissioner may require.

Year in Which Credit Taken

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The credits provided for in Section 34(C)(3) may, at the option of the taxpayer and irrespective
of the method of accounting employed in keeping his books, be taken in the year in which the
taxes of the foreign country were incurred, subject, however, to the conditions prescribed in
Section 34(C)(5). If the taxpayer elects to take such credits in the year in which the taxes of the
foreign country accrued, the credits for all subsequent years shall be taken upon the same basis,
and no portion of any such taxes shall be allowed as a deduction in the same or any succeeding
year.

Proof of Credits
The credits provided in Section 34(C)(3) shall be allowed only if the taxpayer establishes to the
satisfaction of the Commissioner the following:
a. The total amount of income derived from sources without the Philippines;
b. The amount of income derived from each country, the tax paid or incurred to which is
claimed as a credit, such amount to be determined under rules and regulations prescribed
by the Secretary of Finance;
c. All other information necessary for the verification and computation of such credits.

Senior Citizens Discount as Tax Credit

Case: CIR v. Central Luzon Drug Store, G.R. No. 159647, April 15, 2005: Held. The 20
percent discount required by the law to be given to senior citizens is a tax credit, not merely a tax
deduction from the gross income or gross sale of the establishment concerned. A tax credit is
used by a private establishment only after the tax has been computed; a tax deduction, before
the tax is computed. RA 7432 unconditionally grants a tax credit to all covered entities.

The Supreme Court likewise made the following discussions:

Tax Credit versus Tax Deduction

Although the term is not specifically defined in our Tax Code, tax credit generally refers to an
amount that is "subtracted directly from one’s total tax liability." It is an "allowance against the
tax itself” or "a deduction from what is owed by a taxpayer to the government. Examples of tax
credits are withheld taxes, payments of estimated tax, and investment tax credits.

Tax credit should be understood in relation to other tax concepts. One of these is tax deduction -
- defined as a subtraction "from income for tax purposes, or an amount that is "allowed by law
to reduce income prior to [the] application of the tax rate to compute the amount of tax which is
due. An example of a tax deduction is any of the allowable deductions enumerated in Section 34
of the Tax Code.

A tax credit differs from a tax deduction. On the one hand, a tax credit reduces the tax due,
including -- whenever applicable -- the income tax that is determined after applying the
corresponding tax rates to taxable income. A tax deduction, on the other, reduces the income
that is subject to tax in order to arrive at taxable income. To think of the former as the latter is
to avoid, if not entirely confuse, the issue. A tax credit is used only after the tax has been
computed; a tax deduction, before.

Tax Liability Required for Tax Credit

Page 27 of 51
Since a tax credit is used to reduce directly the tax that is due, there ought to be a tax
liability before the tax credit can be applied. Without that liability, any tax credit application will
be useless. There will be no reason for deducting the latter when there is, to begin with, no
existing obligation to the government. However, as will be presented shortly, the existence of a
tax credit or its grant by law is not the same as the availment or use of such credit. While the
grant is mandatory, the availment or use is not.

If a net loss is reported by, and no other taxes are currently due from, a business establishment,
there will obviously be no tax liability against which any tax credit can be applied. For the
establishment to choose the immediate availment of a tax credit will be premature and
impracticable. Nevertheless, the irrefutable fact remains that, under RA 7432, Congress has
granted without conditions a tax credit benefit to all covered establishments.

Although this tax credit benefit is available, it need not be used by losing ventures, since there is
no tax liability that calls for its application. Neither can it be reduced to nil by the quick yet callow
stroke of an administrative pen, simply because no reduction of taxes can instantly be effected.
By its nature, the tax credit may still be deducted from a future, not a present, tax liability,
without which it does not have any use. In the meantime, it need not move. But it breathes.

Prior Tax Payments Not Required for Tax Credit

While a tax liability is essential to the availment or use of any tax credit, prior tax payments are
not. On the contrary, for the existence or grant solely of such credit, neither a tax liability nor a
prior tax payment is needed. The Tax Code is in fact replete with provisions granting or
allowing tax credits, even though no taxes have been previously paid.

[I]t is evident that prior tax payments are not indispensable to the availment of a tax credit. Thus,
the CA correctly held that the availment under RA 7432 did not require prior tax payments by
private establishments concerned.31 However, we do not agree with its finding that the carry-over
of tax credits under the said special law to succeeding taxable periods, and even their application
against internal revenue taxes, did not necessitate the existence of a tax liability.

The examples above show that a tax liability is certainly important in the availment or use, not
the existence or grant, of a tax credit. Regarding this matter, a private establishment reporting
a net loss in its financial statements is no different from another that presents a net income. Both
are entitled to the tax credit provided for under RA 7432, since the law itself accords that
unconditional benefit. However, for the losing establishment to immediately apply such credit,
where no tax is due, will be an improvident usance.

D. LOSSES [Sec. 34(D) and related provisions]

For purpose of deduction from gross income, what does losses comprehend?
The term implies an unintentional parting with something of value. It is used in the income tax
law in a very broad sense to comprehend all losses which are not general or natural to the ordinary
courses of business and are not covered under some other heading such as bad debts, inventory
losses, depreciations, etc.

General Requisites for Deductibility

Page 28 of 51
 1. Actually sustained during the taxable year;
2. Connected with the trade, business or profession;
3. Evidenced by a closed and completed transaction (CIR v. Asturias Sugar Central, G.R.
No. L-15013, August 31, 1961);
4. Not compensated for by insurance or other form of indemnity;
5. Not claimed as a deduction for estate tax purposes
6. Notice of loss must have been filed with the BIR within 45 days from the date of discovery
of the casualty or robbery, theft, or embezzlement

*Close and completed transaction is one which the facts indicate the transaction
sufficiently final to ascertain that a loss has occurred. ( The Coca Cola Exports v. CIR, CTA
Case NO. 5238, December 19, 1997)

What losses may aliens and resident foreign corporation deduct from gross income?
1. Those incurred in the trade or business in the Philippines
2. Losses in transactions entered into for profit in the Philippines.

Categories/Types of Losses
1. Ordinary Losses
2. Capital Losses [Sec. 39]
3. NOLCO (Sec. 34(D)(3)]
4. Casualty Losses
5. Wagering Losses
6. Losses on wash sales of stocks (Sec. 38)
7. Abandonment Losses

Ordinary Losses
These are incurred in the ordinary course of the taxpayer’s trade, business or exercise of
profession.

Includes any loss from the sale or exchange of property which is not a capital asset. [Sec.
22(Z)]

Capital Losses (Sec. 39)

This includes the following:
1. Losses from sale or exchange of capital assets;
2. Losses resulting from securities becoming worthless and which are capital assets;
3. Losses from short sales of property;
4. Losses due to failure to exercise privilege or option to buy or sell property

Meaning of Capital Assets

Capital Assets means property held by the taxpayer (whether or not connected with his
business) but does not include the following:
1. Stock in trade of the taxpayer or other property of a kind which would be included in the
inventory of the taxpayer if at hand at the close of the taxable year;

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 2. Property held by the taxpayer primarily for sale to customers in the ordinary course of his
business;
3. Property used in the trade or business, of a character which is subject to the allowance
for depreciation;
4. Real property used in trade or business of the taxpayer

Limitation on Capital Losses

Losses from sales or exchanges of capital assets shall be allowed only to the extent of the gains
from such sale or exchange.

Net Capital Gains – excess of gains from sale or exchanges of capital assets over the loss
from such sales or exchanges.
➢ Included in the taxable Gross Income

Net Capital Loss - excess of loss from sale or exchanges of capital assets over the gain
from such sales or exchanges.
➢ Not deductible, but may be carried over the next taxable year, subject to condition

Percentage Taken Into Account in Computing Net Capital Gains / Net Capital Loss upon
sale or exchange of Capital Asset (Does not apply to Corporate Taxpayers):

1. 100% if the capital asset has been held for not more than 12 months;
2. 50% if the capital asset has been held for more than 12 months

Exception to the Limitation on Capital Losses

If a bank or trust company incorporated under the laws of the Philippines, a substantial part of
whose business is the receipt of deposits, sells any bond, debenture, note, or certificate or other
evidence of indebtedness issued by any corporation (including by the government or political
subdivision thereof), with interest coupons or in registered form, any loss resulting from such sale
shall not be subjected to the foregoing limitation and shall not be included in the determining the
applicability of such limitation to other losses.

Net Capital Loss Carry-over

If any taxpayer, other than a corporation, sustain in any taxable year a net capital loss, such loss
(in an amount not in excess of the net income for such year) shall be treated in the succeeding
taxable year as a loss from sale or exchange of capital asset held for not more than twelve
months.

Retirement of Bonds
Amounts received by the holder upon the retirement of bonds, debentures, notes or other
certificates or other evidence of indebtedness (including those issued by the government or
political subdivision thereof) with interest coupons or in registered form, shall be considered as
amounts received in exchange therefor.

Capital Gains from Short Sales

Gains or losses from short sales of property shall be considered as gains or losses from sales or
exchange of capital assets;

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 Short sale is a transaction in which the seller sells securities which he does not own and,
therefore, cannot himself supply the securities for delivery, in expectation of the decline in their
price. The seller, in this case, is a mere speculator his purpose being to postpone delivery until
some later date when he hopes to purchase the securities at a price lower than that received on
his sale and thereby make a profit. But should the price of the securities go up, he incurs a loss.

It is not deemed consummated until the delivery of the property to cover the short sale.
If the short sale is made through a broker and the broker borrows property to make delivery, the
short sale is not deemed consummated until the obligation of the seller created by the short sale
is finally discharged by the delivery of property to the broker to replace the property borrowed
by such broker.

Failure to exercise privilege or option to buy or sell property

Gains or losses attributable to the failure to exercise privilege or option to buy or sell property
shall be considered as capital gains or losses.

Securities becoming worthless.

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 stocks during the taxable year, but must be claimed against other capital
gains to the extent provided for under Section 34 of the Tax Code. For the net capital gains tax
to apply, there must be actual disposition of shares of stocks held as capital asset, and the capital
gain and capital loss used as the basis in determining net capital gains, must be derived and
incurred respectively, from a sale, barter, exchange or other disposition of shares of stocks. (RR
No. 6-2008)

Loss resulting from shrinkage in the value of stock

A person possessing stock of a corporation cannot deduct from gross income any amount claimed
as a loss merely on account of shrinkage in value of such stock through the fluctuation of the
market or otherwise. The loss allowable in such case is that actually suffered when the stock is
disposed. (Sec. 99, RR No. 2-40)

Note: We shall discuss how to compute ordinary/capital gains or losses when we take up Section
40

Net Operating Loss Carry Over (NOLCO) [Sec. 34(D)(3); See also RR No. 14-2001 ]
https://www.bir.gov.ph/images/bir_files/old_files/pdf/rr14_01.pdf

Definition of Net Operating Loss

Excess of Allowable Deductions over Gross Income of the Business in a taxable year.

Net Operating Loss Carry Over (NOLCO)

NOL be carried over as a deduction from gross income for the next 3 consecutive years
immediately following the year of such loss.

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For mines other than oil and gas wells, a net operating loss without the benefit of incentives
provided for under EO 226, as amended, incurred in any of the first 10 years of operation may
be carried over for the next 5 years immediately following the year of loss. The entire amount
of the loss shall be carried over to the first of the 5 taxable years, and any portion of such loss
which exceeds the taxable income of such first year shall be deducted in like manner from the
taxable income of the next remaining four (4) years.

Requisites for application of NOLCO

1. The taxpayer was not exempt from income tax in the year of loss of such net operating
loss;
2. The loss was not incurred in a taxable year during the taxpayer was exempt from income
tax;
3. There has been no substantial change in the ownership of the business or enterprise.
There is no substantial change in the ownership of the business when:
a. Not less than 75% in nominal value of the outstanding shares is held by or on
behalf of the same persons; or
b. Not less than 75% of the paid up capital is held by or on behalf of the same person

General Principles and Policies re NOLCO

1. The allowance for deduction of NOLCO shall be limited only to the NOL accumulated
beginning January 1, 1998;
2. In general, NOLCO shall be allowed as a deduction from gross income of the same
taxpayer who sustained and accumulated the NOL regardless of the change in its
ownership. This rule shall also apply in the case of merger where the taxpayer is the
surviving entity;
3. Unless otherwise provided in the regulation, NOLCO of the taxpayer shall not be
transferred or assigned to another person, whether directly or indirectly, such as but not
limited to, the transfer or assignment thereof through merger, consolidation, or any form
of business combination of such taxpayer with another person;
4. NOLCO shall be allowed if there has been no substantial change in the ownership of the
business or enterprise;
5. Unless otherwise provided in the regulation, an individual (including estate and trust)
engaged in trade or business or in the exercise of profession, or a domestic or resident
foreign corporation may be allowed to claim deduction of his/its corresponding NOLCO.
Provided that a taxpayer who claims optional standard deduction shall not simultaneously
claim deduction of the NOLCO; Provided further, that the 3-year reglementary period shall
continue to run notwithstanding the fact that the aforesaid taxpayer who availed of the
OSD during the said period;
6. The 3-year reglementary period on the carry-over of NOL shall continue to run
notwithstanding the fact that the corporation paid its income tax under the MICT
computation;
7. NOLCO shall be availed on a “first-in-first-out” basis;
8. The NOL incurred by a taxpayer in the year in which a substantial change in ownership in
such taxpayer occurs shall not be affected by such change in ownership, notwithstanding
items 3 and 4 above.

Taxpayers/Corporations NOT entitled to claim deduction of NOLCO

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 1. Offshore Banking Unit (OBU) of a foreign banking corporation, and Foreign Currency
Deposit Unit (FCDU) of a domestic or foreign banking corporation, duly authorized as such
by the BSP;
2. An enterprise registered with the Board of Investment (BOI) with respect to BOI-
registered activity enjoying the Income Tax Holiday incentive. Its accumulated NOL
incurred or sustained during the period of such Income Tax Holiday shall not qualify for
purposes of NOLCO;
3. An enterprise registered with the Philippine Economic Zone Authority (PEZA), pursuant to
RA 7916, as amended, with respect to PEZA-registered business activity. Its accumulated
NOL incurred or sustained during the period of such Income Tax Holiday shall not qualify
for purposes of NOLCO;
4. An enterprise registered under RA 7227, otherwise known as the Bases Conversion and
Development Act of 1992, e.g. SBMA-registered enterprise, with respect to its registered
business activity. Its accumulated NOL incurred or sustained during the period of such
Income Tax Holiday shall not qualify for purposes of NOLCO;
5. Foreign corporations engaged in international shipping or air carriage business in the
Philippines; and
6. In general, any person, natural or juridical, enjoying exemption from income tax, pursuant
to the provisions of the Code or any special law, with respect to its operation during the
period for which the aforesaid exemption is applicable. Its accumulated NOL incurred or
sustained during the period of such Income Tax Holiday shall not qualify for purposes of
NOLCO.

Casualty Losses
Losses incurred for properties actually used in the business enterprise that were damaged or lost
due to casualties (shipwrecks, fire, storms, natural calamities).

Requisites for deductibility (RR No. 31-2009)

https://www.bir.gov.ph/images/bir_files/old_files/pdf/47679RMO%2031-2009.pdf

1. A taxpayer engaged in trade or business may be entitled to claim, as business deduction,

casualty losses for properties actually used in the business enterprise that were damaged
and reported as losses in the appropriate declaration filed with the BIR. The loss of asset
not used in the ordinary course of business and/or are personal in nature shall therefore
not be allowed.
2. Properties that shall be reported as casualty losses must have been properly recorded as
part of the taxpayer’s asset in the taxpayer’s accounting records and financial statements
in the year immediately preceding the occurrence of the loss, with the cost of acquisition
clearly established and recorded. Otherwise, the claim for deduction shall not be allowed.
3. The recovery of casualty losses through insurance claims shall be governed by the
guidelines set forth in RR N. 12-77. Moreover, the amount of loss that shall be
compensated by insurance coverage shall not be claimed as a deductible loss;
a. If the insurance proceeds exceed the net book value of the damaged assets, such
excess shall be subjected to the regular income tax, but not to VAT, since the
indemnification is not of actual sale of goods by the insured to the insurer;

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 4. In addition to the policies prescribed in RR No. 12-77 relative to the substantiation of
casualty losses arising from typhoons and other natural disasters, the following guidelines
shall be observed:
a. The deduction of assets as capital (should be casualty?) losses must be recorded
in accounting reports, with the adjustment of the applicable accounts. The
accounting entry to record this action is illustrated as follows:

Debit: Casualty Losses xxxxx

Accumulated Depreciation xxxxx
Credit: Property/Asset Account xxxxx

In the event of a total loss/destruction of properties used in the business

enterprise, the net book value (cost less accumulated depreciation) immediately
preceding the natural disaster shall be used as the basis in claiming casualty losses,
and shall be reduced by the amount of insurance proceeds received.

b. The restoration of the damaged property, or the acquisition of new property to

replace it, must be properly recorded and recognized as either: a) repairs expense;
or b) a capitalized asset.

The appropriate of this property shall be governed by the financial accounting and
tax accounting rules, and must take into account the nature of the transaction, the
value of the amounts involved, and other factors.

Proof of Loss
1. Photographs of the property/ies before the typhoon;
2. Photographs of the property/ies after the typhoon showing the extent of the damage
sustained;
3. Documentary evidence for determining the cost or valuation of the damaged property/ies,
such as, but not limited to: cancelled checks, vouchers, receipts, and other evidence of
loss;
4. Insurance policy, if any;
5. Police report, in case of robbery/theft during the typhoon and/or as a consequence of
looting. Failure to report a theft to the police can be held against the taxpayer. However,
a mere report of an alleged theft or robbery to the police authorities is not considered
conclusive proof of the loss arising therefrom.

Wagering Losses [Sec. 34(D)(6)]

Losses from wagering transactions (losses) are allowed only to the extent of the gains from such
transaction. If there are no gambling winnings, no gambling losses can be claimed as deduction.

Deemed to apply to individuals only.

Losses on Wash Sales on Stocks or Securities (Sec. 38)

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Definition of Wash Sales
Wash sale is a sale or other disposition of stock or securities where substantially identical shares
are acquired or purchased within a period beginning 30 days before the date of such sale or
disposition and ending 30 days after such date, the taxpayer has acquired (by purchase or by
exchange upon which the entire gain or loss was recognized by law), or has entered into a
contract or option so to acquire, substantially identical stock or securities.

Conditions for the existence of wash sale

1. The sale or other disposition of stock or securities resulted at a loss;
2. There was an acquisition or contract or option for acquisition for acquisition of stock or
securities within 30 days before the sale or 30 days after the sale; and
3. The stock or securities sold were substantially the same as those acquired within the 61-
day period.
Note: the acquisition must be by purchase or exchange upon which the entire amount of
gain or loss was recognized by law.

Are losses from wash sale deductible?

No. This is an exception to the rule that losses from sales or exchange of stock or securities are
deductible as losses from sales or exchange of property.

See rules with respect to losses from wash sales of shares of stocks (Revenue Regulation No.
6-2008) https://www.bir.gov.ph/images/bir_files/old_files/pdf/39882rr%20no.%206-2008.pdf

However, when the wash sale is made by a dealer in stock or securities and with respect to a
transaction made in the ordinary course of the business of such dealer, losses from such sale is
deductible.

Are gains from wash sale taxable?

Yes. Section 28 apply only to losses.

What is meant by “substantially identical stock or securities”

It means stock or securities of the same class or which are similar on their important features.
The following are NOT substantially identical:
1. Common stock and preferred stock
2. Voting stock and non-voting stock
3. Stock of X Corporation and Stock of Y Corporation; and
4. Bonds which differ as to interest rates or where one is secured by a mortgage and the
other is not; but not where the only difference is the date of maturity because
“substantially identical” does not mean precise correspondence. (De Leon)

Abandonment Losses (in petroleum operation and producing wells)

Rules [Sec. 34(D)(7)]:

1. In case the contract area where petroleum operations are undertaken is partially or wholly
abandoned, all accumulated explorations and development expenditures related thereto
shall be allowed as a deduction;

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 2. In case the producing well is abandoned, the unamortized cost thereof as well as the
undepreciated cost of equipment directly used therein, shall be allowed in the year the
well, equipment or facility is abandoned.

Other Rules
1. Losses due to voluntary removal of building incident to renewal or replacement –
deductible from gross income. However, if the demolition is in view of erecting a new
building, it will be considered that the taxpayer sustained no deductible loss.

2. Loss of useful value of capital asset due to changes in business conditions – deductible
only to the extent of actual loss sustained (after adjustment for improvements,
depreciation and salvage value).

3. Losses from sale or exchange of property between related parties (Sec. 36(B) – non
deductible

4. Losses from illegel transactions – not deductible

E. BAD DEBTS [SEC. 24(E), RR NO. 5-1999 as amended by RR 25-2002]

https://www.bir.gov.ph/images/bir_files/old_files/pdf/rr99_05.pdf
https://www.bir.gov.ph/images/bir_files/old_files/pdf/1751rr25_02.pdf

Bad Debts – debts due to the taxpayer which are actually ascertained to be worthless and
charged off within the taxable year. Refers to the those debts resulting from the worthlessness
or uncollectibility, in whole or in part, of amounts due the taxpayer by others, arising from money
lent or from uncollectible amounts of income from goods sold or services rendered.

Requisites for Deductibility

1. Existing indebtedness due to the taxpayer which must be valid and legally demandable;
2. Connected with the taxpayer’s trade, business or practice of profession;
3. Must not be sustained in a transaction entered into between related parties [Sec. 36(B)];
4. Actually ascertained to be worthless and uncollectible as of the end of the taxable year;
5. Actually charged off in the books of accounts of the taxpayer as of the end of the taxable
year.

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

In Collector v. Goodyear, G.R. No. L-22265, December 22, 1967, the Supreme Court held that
in ascertaining worthlessness, two facts must be proven:
1. That the taxpayer did in fact ascertain the debt to be worthless, in the year for which
deduction is sought; and
2. That in so doing, he acted in good faith. Good faith does not require that the taxpayer
be an “incorrigible optimist” but on the other hand, he may not be “unduly pessimistic”.

Cases:

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Philippine Refining Company v. CIR, G.R. No. 118794, May 8, 1996 Held: We find that
said accounts have not satisfied the requirements of the "worthlessness of a debt". Mere
testimony of the Financial Accountant of the Petitioner explaining the worthlessness of said
debts is seen by this Court as nothing more than a self-serving exercise which lacks probative
value. There was no iota of documentary evidence (e.g., collection letters sent, report from
investigating fieldmen, letter of referral to their legal department, police report/affidavit that
the owners were bankrupt due to fire that engulfed their stores or that the owner has been
murdered. etc.), to give support to the testimony of an employee of the Petitioner. Mere
allegations cannot prove the worthlessness of such debts in 1985. Hence, the claim for
deduction of these thirteen (13) debts should be rejected. This pronouncement of respondent
Court of Appeals relied on the ruling of this Court in Collector vs. Goodrich International
Rubber Co., which established the rule in determining the "worthlessness of a debt." In said
case, we held that for debts to be considered as "worthless," and thereby qualify as "bad
debts" making them deductible, the taxpayer should show that (1) there is a valid and
subsisting debt. (2) the debt must be actually ascertained to be worthless and uncollectible
during the taxable year; (3) the debt must be charged off during the taxable year; and (4)
the debt must arise from the business or trade of the taxpayer. Additionally, before a debt
can be considered worthless, the taxpayer must also show that it is indeed uncollectible even
in the future. Furthermore, there are steps outlined to be undertaken by the
taxpayer to prove that he exerted diligent efforts to collect the debts, viz.: (1)
sending of statement of accounts; (2) sending of collection letters; (3) giving the
account to a lawyer for collection; and (4) filing a collection case in court. x x x The
contentions of PRC that nobody is in a better position to determine when an obligation
becomes a bad debt than the creditor itself, and that its judgment should not be substituted
by that of respondent court as it is PRC which has the facilities in ascertaining the collectibility
or uncollectibility of these debts, are presumptuous and uncalled for. The Court of Tax Appeals
is a highly specialized body specifically created for the purpose of reviewing tax cases.
Through its expertise, it is undeniably competent to determine the
issue of whether or not the debt is deductible through the evidence presented before it.

Philex Mining v. CIR, G.R. No. 148187, April 16, 2008. Facts: Petitioner deducted from
its gross income the amount of P112,136,000.00 as “loss on settlement of receivables from
Baguio Gold against reserves and allowances”. BIR disallowed such deduction and for which
it assessed petitioner for deficiency income tax. Petitioner protested arguing that the
deduction must be allowed since all the requisites for a bad debt deduction were satisfied;
that the debt arose out of a valid management contract (as embodied in the Special Power of
Attorney) it entered into with Baguio Gold; that the bad debt deduction represents the
advances and payments made by petitioner which, pursuant to the management contract,
formed part of Baguio Gold’s “pecuniary obligations” to the petitioner; that due to Baguio
Gold’s irreversible losses, it became evident that it would not be able to recover the advances
and payments it made in behalf of Baguio Gold; that for a debt to be considered worthless,
petitioner claimed that it was neither required to institute a judicial action for collection against
the debtor nor to sell or dispose of collateral assets in satisfaction of the debt. It is enough
that a taxpayer exerted diligent efforts to enforce collection and exhausted all reasonable
means to collect. BIR denied petitioner’s protest for lack of legal and factual basis. It held
that the alleged debt was not ascertained to be worthless since Baguio Gold remained existing
and had not filed a petition for bankruptcy; and that the deduction did not consist of a valid

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and subsisting debt considering that, under the management contract, petitioner was to be
paid fifty percent (50%) of the project’s net profit. The CTA rejected petitioner’s assertion
that the advances it made for the Sto. Nino mine were in the nature of a loan. It instead
characterized the advances as petitioner’s investment in a partnership with Baguio Gold for
the development and exploitation of the Sto. Nino mine. The CTA held that the "Power of
Attorney" executed by petitioner and Baguio Gold was actually a partnership agreement. Since
the advanced amount partook of the nature of an investment, it could not be deducted as a
bad debt from petitioner’s gross income. The CTA likewise held that the amount paid by
petitioner for the long-term loan obligations of Baguio Gold could not be allowed as a bad
debt deduction. At the time the payments were made, Baguio Gold was not in default since
its loans were not yet due and demandable. What petitioner did was to pre-pay the loans as
evidenced by the notice sent by Bank of America showing that it was merely demanding
payment of the installment and interests due. Moreover, Citibank imposed and collected a
"pre-termination penalty" for the pre-payment. Held: An examination of the "Power of
Attorney" reveals that a partnership or joint venture was indeed intended by the
parties. Under a contract of partnership, two or more persons bind themselves to contribute
money, property, or industry to a common fund, with the intention of dividing the profits
among themselves. While a corporation, like petitioner, cannot generally enter into a contract
of partnership unless authorized by law or its charter, it has been held that it may enter into
a joint venture which is akin to a particular partnership. x x x Perusal of the agreement
denominated as the "Power of Attorney" indicates that the parties had intended
to create a partnership and establish a common fund for the purpose. They also
had a joint interest in the profits of the business as shown by a 50-50 sharing in
the income of the mine. Under the "Power of Attorney", petitioner and Baguio Gold
undertook to contribute money, property and industry to the common fund known as the Sto.
Niño mine. In this regard, we note that there is a substantive equivalence in the respective
contributions of the parties to the development and operation of the mine. Pursuant to
paragraphs 4 and 5 of the agreement, petitioner and Baguio Gold were to contribute equally
to the joint venture assets under their respective accounts. Baguio Gold would
contribute P11M under its owner’s account plus any of its income that is left in the project, in
addition to its actual mining claim. Meanwhile, petitioner’s contribution would consist of
its expertise in the management and operation of mines, as well as the manager’s account
which is comprised of P11M in funds and property and petitioner’s "compensation" as
manager that cannot be paid in cash. x x x The wording of the parties’ agreement as to
petitioner’s contribution to the common fund does not detract from the fact that petitioner
transferred its funds and property to the project as specified in paragraph 5, thus rendering
effective the other stipulations of the contract, particularly paragraph 5(c) which prohibits
petitioner from withdrawing the advances until termination of the parties’ business relations.
As can be seen, petitioner became bound by its contributions once the transfers were made.
The contributions acquired an obligatory nature as soon as petitioner had chosen to exercise
its option under paragraph 5. X X In this case, the totality of the circumstances and
the stipulations in the parties’ agreement indubitably lead to the conclusion that
a partnership was formed between petitioner and Baguio Gold. First, it does not
appear that Baguio Gold was unconditionally obligated to return the advances made by
petitioner under the agreement. Paragraph 5 (d) thereof provides that upon termination of
the parties’ business relations, "the ratio which the MANAGER’S account has to the owner’s
account will be determined, and the corresponding proportion of the entire assets of the STO.
NINO MINE, excluding the claims" shall be transferred to petitioner. As pointed out by the

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 Court of Tax Appeals, petitioner was merely entitled to a proportionate return of the mine’s
assets upon dissolution of the parties’ business relations. There was nothing in the agreement
that would require Baguio Gold to make payments of the advances to petitioner as would be
recognized as an item of obligation or "accounts payable" for Baguio Gold. Thus, the tax
court correctly concluded that the agreement provided for a distribution of assets of the Sto.
Niño mine upon termination, a provision that is more consistent with a partnership than a
creditor-debtor relationship. It should be pointed out that in a contract of loan, a person who
receives a loan or money or any fungible thing acquires ownership thereof and is bound to
pay the creditor an equal amount of the same kind and quality. In this case, however, there
was no stipulation for Baguio Gold to actually repay petitioner the cash and property that it
had advanced, but only the return of an amount pegged at a ratio which the manager’s
account had to the owner’s account. In this connection, we find no contractual basis for the
execution of the two compromise agreements in which Baguio Gold recognized a debt in favor
of petitioner, which supposedly arose from the termination of their business relations over the
Sto. Nino mine. The "Power of Attorney" clearly provides that petitioner would only be entitled
to the return of a proportionate share of the mine assets to be computed at a ratio that the
manager’s account had to the owner’s account. Except to provide a basis for claiming the
advances as a bad debt deduction, there is no reason for Baguio Gold to hold itself liable to
petitioner under the compromise agreements, for any amount over and above the proportion
agreed upon in the "Power of Attorney". Next, the tax court correctly observed that it was
unlikely for a business corporation to lend hundreds of millions of pesos to another corporation
with neither security, or collateral, nor a specific deed evidencing the terms and conditions of
such loans. The parties also did not provide a specific maturity date for the advances to
become due and demandable, and the manner of payment was unclear. All these point to the
inevitable conclusion that the advances were not loans but capital contributions to a
partnership. The strongest indication that petitioner was a partner in the Sto Niño mine is
the fact that it would receive 50% of the net profits as "compensation" under paragraph 12
of the agreement. The entirety of the parties’ contractual stipulations simply leads to no other
conclusion than that petitioner’s "compensation" is actually its share in the income of the joint
venture. X X All told, the lower courts did not err in treating petitioner’s advances
as investments in a partnership known as the Sto. Nino mine. The advances were
not "debts" of Baguio Gold to petitioner inasmuch as the latter was under no
unconditional obligation to return the same to the former under the "Power of
Attorney". As for the amounts that petitioner paid as guarantor to Baguio Gold’s creditors,
we find no reason to depart from the tax court’s factual finding that Baguio Gold’s debts were
not yet due and demandable at the time that petitioner paid the same. Verily, petitioner pre-
paid Baguio Gold’s outstanding loans to its bank creditors and this conclusion is supported by
the evidence on record.

Equitable Doctrine of Tax Benefit/Tax Benefit Rule

This doctrine holds that a recovery of a bad debt previously deducted from gross income
constitutes taxable income if in the year the account was written off, the deduction resulted in a
tax benefit, i.e. in the reduction of taxable income of the taxpayer.

When are bad debts deductible by aliens and resident foreign corporations?

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They are deductible if they have arisen in the course of business or trade within the Philippines
and actually ascertained to be worthless and charged off within the year.

F. DEPRECIATION

Definition
Depreciation is the gradual diminution in the useful value of tangible property used in trade,
profession or business resulting from exhaustion, wear and tear, and obsolescence. The term is
also applied to amortization of the value of intangible assets, the use of which in trade or business
is definitely limited in duration. (Basilan Estate v. Comm., G.R. No. L-22492, September 5,
1967).

Case: Basilan Estate v. Comm., G.R. No. L-22492, September 5, 1967. Facts: Basilan
Estates, Inc. claimed deductions for the depreciation of its assets up to 1949 on the basis of their
acquisition cost. As of January 1, 1950 it changed the depreciable value of said assets by
increasing it to conform with the increase in cost for their replacement. Accordingly, from 1950
to 1953 it deducted from gross income the value of depreciation computed on the reappraised
value. Issue: Whether depreciation shall be determined on the acquisition cost or on the
reappraised value of the assets. Held: 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 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. Precisely, Section 30 (f) (1) which
states: - (1)In general. — A reasonable allowance for deterioration of property arising out of its
use or employment in the business or trade, or out of its not being used: Provided, That when
the allowance authorized under this subsection shall equal the capital invested by the taxpayer .
. . no further allowance shall be made. . . . - allows a deduction from gross income for depreciation
but limits the recovery to the capital invested in the asset being depreciated. The income tax law
does not authorize the depreciation of an asset beyond its acquisition cost. Hence, a deduction
over and above such cost cannot be claimed and allowed. The reason is that deductions from
gross income are privileges, not matters of right. They are not created by implication but upon
clear expression in the law Moreover, the recovery, free of income tax, of an amount more than
the invested capital in an asset will transgress the underlying purpose of a depreciation allowance.
For then what the taxpayer would recover will be, not only the acquisition cost, but also some
profit. Recovery in due time thru depreciation of investment made is the philosophy behind
depreciation allowance; the idea of profit on the investment made has never been the underlying
reason for the allowance of a deduction for depreciation. Accordingly, the claim for depreciation
beyond P36,842.04 or in the amount of P10,500.49 has no justification in the law. The
determination, therefore, of the Commissioner of Internal Revenue disallowing said amount,
affirmed by the Court of Tax Appeals, is sustained.

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Give the necessity of depreciation allowance
The necessity arises from the fact that certain property used in the business gradually approaches
a point where its usefulness is exhausted. By using the property, a gradual sale is made of it;
and the depreciation charged is the measure of the cost which has been sold. When the property
is disposed of after years of use, it is no longer the whole thing originally used.

Requisites for deductibility of depreciation

1. The allowance for depreciation must be reasonable
2. It must be for property used in the trade or business (thus, capital assets or building used
by the taxpayer for his residence are not subject to allowance for depreciation); but see
discussion on EAR regarding entertainment facilities).
3. It must be charged off during the taxable year;
4. A statement on the allowance must be attached to the return

Property Held by One Person for Life with the Remainder to Another Person
The deduction shall be computed as if the life tenant was the absolute owner of the property,
and, as such the expense shall accrue to him (life tenant). (Life tenant – a person who is entitled
to the use of or the income from an asset during his or her lifetime).

Property Held In Trust

Allowable deduction shall be apportioned between the income beneficiaries and the trustees in
accordance with the pertinent provision of the instrument creating the trust or in the absence of
such provision, on the basis of the trust income allowable to each.

How is depreciation measured?

Depreciation Is a question of fact and is not measured by theoretical yardstick but should be
determined by consideration of actual facts. The reasonableness of any claim for depreciation
shall be determined upon the conditions known to exist at the end of the period for which the
return is made (Sec. 109, RR No. 2-40).

Methods of Depreciation [SEC 34(F)(2)]

The term “reasonable allowance” shall include, but not limited to an allowance computed in
accordance with the regulations prescribed by the Department of Finance, under any of the
following methods:
1. Straight-line method
2. Declining balance method using a rate not exceeding twice the rate which would have
been used had the annual allowance been computed under SLM;
3. Sum of years digit method
4. Any other method prescribed by the Dept. of Finance upon the recommendation of the
Commissioner

Straight line method – formula

D= C – SV
L

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 D = Depreciation
C = Acquisition Cost
SV = Salvage Value
L = Estimated Use

Illustration: An asset costing P1,000,000.00 has an estimated useful life of 5 years and
salvage value of P50,000. Compute the depreciation for 2019 if it was acquired on January
1, 2019.

1,000,000 less P50,000 = P190,000

5 years

Note: For years 2 to 5, the taxpayer will report depreciation expense uniformly at
P190,000.00.

Declining Balance Method – Formula

D = R x BV
Where R = 1/L x A
A = not to exceed 200%
BV = C-AD

D = Depreciation
R = Declining Balance Rate
B = Book Value
C = Cost
AD = Accumulated Depreciation

Same illustration but the accelerator is 200%

First Step: Compute the Double Declining Rate (R).

1 / 10 years x 200%
= 20% x 200% = 40%
Note: If depreciation is computed using Straight Line Method, the Depreciation Rate is
20% annually.

Second Step: Compute the Depreciation

A B C D E
Year Rate Book Value Depreciation Accumulated
Depreciation
1 40% 1,000,000.00 400,000.00 400,000.00
2 40% 600,000.00 240,000.00 640,000.00
3 40% 360,000.00 144,000.00 784,000.00
4 40% 216,000.00 86,400.00 870,400.00
5 40% 129,600.00 51,840.00 922,240.00

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Sum of Year’s Digit – Formula

D = R/SYD X (C-SV)
D = Depreciation
R = Remaining Useful Life of the Asset
SYD = Sum of Year’s Digit of the Useful Life of the Asset
C = Cost
SV = Salvage Value

Same Illustration

First Step: Compute the SYD, which is the sum of the remaining useful lives of the asset

Year Remaining Useful Life

1 5
2 4
3 3
4 2
5 1
SYD ➔ 15
Second Step: Compute the Depreciation

A B C D E
Year R SYD C-SV Depreciation
1 5 15 950,000.00 316,666.67
2 4 15 950,000.00 253,333.33
3 3 15 950,000.00 190,000.00
4 2 15 950,000.00 126,666.67
5 1 15 950,000.00 63,333.33
Total ➔ 950,000.00

Agreement as to Useful Life on Which Depreciation is Based

The BIR and the taxpayer may agree in writing on the useful life of the property to be depreciated.
The agreed rate may be modified if justified by facts or circumstances. The change shall not be
effective before the taxable year on which notice in writing by certified mail or registered mail is
served by the party initiating.

Special Types of Depreciation

1. Petroleum Operations
a. Depreciation of all properties directly related to production of petroleum shall be
allowed under straight line method (SL) or declining balance method (DB)
b. May shift from DB to SL
c. Useful life: 10 years or shorter life as allowed by the Commissioner
d. Useful life of property not directly related to production: 5 years under SL method.

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 2. Mining Operations
a. Depreciating on all properties in mining operations other than petroleum
operations at the normal rate if expected life is less than 10 years
b. If expected life is more than 10 years, depreciation shall be any number of years
between 5 years and the expected life.

Depreciation deduction by NRAETB/NRFC

Only when such property is located in the Philippines

Limitation on Deductibility of Depreciation Expense relating to Vehicles (RR No. 12-

2012)
https://www.bir.gov.ph/images/bir_files/old_files/pdf/65716RR%20No%2012-2012.pdf

1. No deduction from gross income for depreciation shall be allowed unless the taxpayer
substantiate the purchase with sufficient evidence, such as official receipt or adequate
records;
2. Only one vehicle for land transport is allowed for the use of an official or employee, the
value of which shall not exceed P2,400,000.00;
3. No depreciation expense shall be allowed for yachts, helicopter, airplane and/or aircrafts,
and land vehicles which exceeds P2,400,000.00, unless the taxpayer’s main line of
business is transport operations or lease of transportation equipment and the vehicle
purchased are used in the said operation
4. All maintenance expense on account of non-depreciable vehicles for taxation purposes are
disallowed in its entirety;

G. DEPLETION [SEC. 34(G)]

Definition
Depletion is the exhaustion of natural resources like mines and oil and gas wells as a result of
production or severance from such mines or wells.

Theory and Purpose of Depletion Allowance

The theory of the allowance for depletion, as I the case that for depreciation, is that, as the
product of the mine is sold, a gradual sale is being made of the taxpayer’s capital interest in the
property. Depletion allowance enables the taxpayer to recover that capital interest free of income
tax, as its cost or on some other basis.

Persons entitled to depletion allowance

Only persons having economic interest in the property are entitled to depletion allowance. To
acquire an economic interest, the taxpayer must have a capital investment in the property and
not a mere economic advantage. The taxpayer must have acquired at least, by investment, any
interest in oil or gas, or mineral in place, and secures, by any form of legal relationship, income

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derived from the extraction of the oil, gas or mineral to which he must look for a return of his
capital.

How shall depletion allowance be completed?

It shall be computed under the cost-depletion method as follows: [Sec. 34(G)(1)]

1. A reasonable allowance for depletion or amortization computed in accordance with the

rules and regulations prescribed by the Secretary of Finance, upon the recommendation
of the CIR;
2. When the allowances shall be equal to the capital invested, no further allowance shall be
granted;
3. After production in commercial quantities has commenced, certain intangible
exploration and development drilling costs:
a. shall be deducted in the year incurred if such expenditures are incurred for non-
producing wells; OR
b. In case incurred for producing wells in the same contract area – options of the
taxpayer:
i. Deducted in full in the year incurred; OR
ii. Capitalized and amortized

Note: Intangible exploration and development drilling costs – refer to any cost
incurred in petroleum operation 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. Said cost shall not pertain to the acquisition of improvement of property of a
character subject to the allowance for depreciation except that the allowance for
depreciation on such property shall be deductible under Section 34(G).

4. 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 basis for purposes of computing allowable cost depletion.

What are the essential facts in determining the amount of cost depletion allowable?
1. The basis of the property (i.e. the pesos amount of the taxpayer’s capital or investment
in the property which he is entitled to recover tax-free during the period he is removing
the mineral in deposit);
2. The estimated total recoverable units in the property;
3. The number of units recovered during the taxable year.

In computing taxable income, may the taxpayer deduct exploration and development
expenditures paid or incurred during the taxable year?

Yes. 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:

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 1. The amount deductible for exploration and development expenditures shall not exceed
25% of the net income from mining operations computed without the benefit of any tax
incentives under existing laws.
2. The actual exploration and development expenditures minus the 25% of the net income
from mining shall be carried forward to the succeeding years until fully deducted.

Notes: a) The election by the taxpayer to deduct the exploration and development expenditures
is irrevocable and shall be binding in succeeding taxable years.
b) This option applies only to the amounts paid or incurred for the exploration and development
of oil and gas.
c) Net income from mining operation = gross income from operations less allowable
deductions which are necessary or related to mining operations.
d) Allowable deductions include mining, milling, and marketing expenses, and depreciation of
properties directly used in the mining operations (but excludes expenditures for the acquisition
or improvement of property of a character which is subject to allowance for depreciation)
c) 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.
d) 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 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.

Is depletion allowance available even if the capital investment has been completely
recovered?
No. Under the cost-depletion method, the allowance shall be limited to the capital investment by
the taxpayer. The ceiling is intended to curb the practice of mining companies of inflating their
gross income so as to have bigger base on which to apply the percentage depletion, if assured
that such gross income could still be reduced substantially for purposes of computing the net
income, thereby avoiding the payment of the proper amount of income tax.

Distinguish Depletion from Depreciation

Both are predicated on the same basic premise of avoiding a tax on capital. However,
depreciation is based upon the concept of the exhaustion of a natural resource whereas
depreciation is based upon the concept of the exhaustion of the property, not otherwise a natural
resource, used in a trade or business or held of the production of income. Thus, depletion and
depreciation are made applicable to different types of assets. And a taxpayer may not deduct
that which the Tax Code allows as a deduction of another. ( Consolidated Mines, Inc. v. CTA,
G.R. No. L-18843, August 29, 1974, in Footnote No. 36)

H. CHARITABLE and OTHER CONTRIBUTION [SEC. 34(H), see also SEC. 101, NIRC;
RR NOS. 13-98; 2-2003]

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RR 13-98:
http://www.usig.org/countryinfo/laws/Philippines/Philippines%20Revenue%20Regulations.pdf
RR: 2-2003: https://lawphil.net/administ/bir/rr/rr02_03.pdf

How are charitable contributions classified?

1. Ordinary – Those which are subject to limitation as to the amount deductible from gross
income; and
2. Special – Those which are deductible in full from gross income

Special (Deductible in Full) Ordinary (Deductible subject to

Limitation)

1. Recipient is: 1. Recipient is:

a. Government of the Philippines; a. Government of the Philippines;
b. Any of its agencies or political b. Any of its agencies or political
subdivisions; or subdivision
c. Any fully-owned government
corporation

For priority activity in: For a non-priority activity in any

a. Education areas mentioned under Donations
b. Health Deductible in Full, but must be
c. Youth and Sports Development exclusively for a public purpose
d. Human settlements
e. Science and Culture
f. Economic Development

2. Recipient is a: 2. Recipient is:

a. Foreign institution; or a. Social welfare institutions;
b. International organization b. Non-government organizations

With an agreement with the Philippine In accordance with the rules and
Government on the full deductibility of regulations promulgated by the
the donation, or in accordance with Secretary of Finance
special law.

3. Recipient is: 3. Recipient is an accredited

a. An accredited non-government domestic corporation or
organization (NGO), fully association organized and operated
organized/operated exclusively exclusively for the following purposes
for the following purposes: a. Religious;
b. Charitable;
i. Scientific; c. Scientific;
ii. Research; d. Youth and Sports Development;
iii. Educational; e. Cultural;
f. Educational; or

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 iv. Character Building and Youth g. Rehabilitation of veterans
and Sports Development;
v. Health;
vi. Social welfare; Subject to the limitation (applicable if
vii. Cultural donation is made to any of the foregoing
viii. Charitable; or recipients):
ix. Combination of (i) to (viii)
a. Individual – 10% of the taxable
And satisfying the following income from trade, business, or
conditions: exercise of profession before the
a. The donation must be utilized not contribution;
later than the 15th day of the 3rd
month following the close of the b. Corporation – 5% of the taxable
taxable year; income from trade, business, or
b. The administrative expense must exercise of profession before the
not exceed 30% of the total contribution;
expenses;
c. Upon dissolution, assets must be
distributed to another non-profit
domestic corporation or to the
State.

Requisites for the deductibility of the Contribution

1. The contribution or gift must be actually paid or made;
2. To the Philippine government or any political subdivision thereof exclusively for
public purpose or to any accredited domestic corporations or associations
mentioned in the Tax Code;
3. It must not exceed 10% in case of individual, and 5% in case of corporation (except in
case when the donation is deductible in full) of the taxpayer’s taxable income derived from
business, trade or exercise of profession and computed without the benefit of the
contribution;
4. It must be evidenced by adequate records or receipts.

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

Substantiation Requirements
See Section 8, RR 13-98

Case: Mariposa Properties Inc. v. CIR, CTA Case No. 6402, 13 February 2007. Held: In
deciding on the BIR’s disallowance of deduction for donations made to private foundation, the
CTA required the donor to prove compliance of both the donor and donee with the requirements
for deductibility of the donations. Hence, for failure of the donor to present proof of the

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foundation’s income tax return and audited financial statements, as well as the annual information
report of the foundation submitted to the BIR as required in the regulations, the deduction was
disallowed. Note: This was affirmed by the CTA En Banc per CTA EB Case NO. 371, April 12,
2008)

I. RESEARCH AND DEVELOPMENT [SEC. 34(I)]

How are Research and Development Expenditures treated taxwise?

Either as:
1. Revenue Expenditures
Requisites:
a. Paid or incurred during the taxable year;
b. Ordinary and necessary expenses in connection with the trade, business or exercise
of profession;
c. Not chargeable to capital account.

2. Deferred Expenses
Requisites:
a. Paid or incurred during the taxable year in connection with the trade, business or
exercise of profession;
b. Not treated as ordinary and necessary expense;
c. Chargeable to capital account but not to property subject to depreciation or depletion.

NOTE: Amount ratably distributed over a period of 60 months beginning with the month
the taxpayer realized benefits from such expenditures.

What are excluded from Research and Development Expenditures?

1. Any expenditures for the acquisition or improvement of land or for the improvement of
the property to be used in connection with research and development subject to
depreciation and depletion;
2. 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 and gas

J. PENSION TRUST CONTRIBUTION [SEC. 34J), SEE ALSO/COMPARE WITH SECS.

32(B)(6) AND 60(B)]

When is deduction for Pension Trust Contribution applicable?

It is applicable only when the employer is establishing or maintaining pension trust to provide
payments of reasonable pensions to his employees.

Requisites for Deductibility

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 1. The employer must have established a pension or retirement plan to provide for the
payment of reasonable pensions to his employees;
2. The pension plan is reasonable and actuarially sound;
3. It must be funded by the employer;
4. The amount contributed must be no longer subject to the control or disposition of the
employer;
5. The payment has not been allowed as a deduction; and
6. The deduction is apportioned in equal parts over a period of 10 consecutive years
beginning with the year in which the transfer or payment is made

Amount that may be deducted

a. Contributions to the trust during the taxable year to cover the pension liability accruing
during the year, allowed as ordinary and necessary expense under Sec. 34(A); and
b. Amount transferred or paid to the trust during the taxable year in excess of such
contribution to cover pension liability to the years prior to the taxable year (past service
cost) or so paid to place the trust in a sound financial basis provided: a) such has not
been allowed as a deduction; and b) the amount is apportioned in equal parts over a
period of 10 consecutive years beginning with the year in which the transfer or payment
is made. This is allowed as a deduction under Sec. 34(J).

Summary of Rules on Retirement Benefit Plan/Pension Trust

1. Exempt from Income Tax – Employees’ trust under Sec. 60(B);

2. Exclusion from Gross Income – amount received by the employee from the fund upon
compliance with certain conditions under Sec. 32(B)(6);
3. Deduction from Gross Income (Sec. 34(J):
a. Amount contributed by the employer during the taxable year into the pension plan
to cover pension liability accruing during the taxable year – considered as
ordinary and necessary expense under Sec. 34(A);
b. 1/10 of the reasonable amount paid by the employer to cover pension liability to
the years prior to the taxable year (past service cost), or so paid to place the trust
in a sound financial basis – deductible under Sec. 34(J).

SPECIAL Provisions Regarding Income and Deductions of Certain Corporations:

1. Expenses Allowable to Private Educational Institutions – In addition to the

expenses allowable under Chapter VII, a Private Educational Institution is allowed, at its
option either to:

a. Deduct expenditures otherwise considered as capital outlays of depreciable assets

incurred during the taxable year for the expansion of school facilities; OR
b. Deduct allowance for depreciation thereof under Section 34(F).

Private/Proprietary Educational Institution is any private school maintained and

administered by private individuals or groups with an issued permit to operate from the
DECS (now DepEd) or the CHED, or TESDA, as the case maybe, in accordance with
existing laws and regulations. [Sec. 27(B)]

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2. Deductions Allowed to Insurance Companies, domestic or foreign doing
business in the Philippines [Sec. 37(A)]:
a. Net additions, if any, required by law to be made within the year to reserve funds;
and
b. Sums other than dividends paid within the year on policy and annuity contracts.

Note: the released reserve shall be treated as income for the year of release.

3. Mutual Companies. Mutual insurance companies (specifically, mutual fire, mutual

employers’ liability and mutual workmen’s compensation and mutual casualty insurance
companies) which require their members to make premium deposits to provide for losses
and expenses, are allowed to deduct from gross income:
a. Any portion of the premium deposit returned to the policy-holders; or
b. Such portion of the premium deposits as are retained for the payment of losses,
expenses, and reinsurance reserves.

4. Mutual Marine Insurance Companies. Mutual marine insurance companies required

to include in their return of gross income the gross premiums collected and
received by them less amount paid for reinsurance, are allowed to deduct from
gross income:
a. Amounts repaid to policy-holders on account of premiums previously paid by them;
and
b. Interest paid upon those amounts between the date of ascertainment and date of
its payment.

5. Assessment Insurance Companies, domestic or foreign:

Assessment insurance companies, whether domestic or foreign, may deduct in a taxable
year the sum actually deposited with the officers of the Government of the Philippines
pursuant to law as additions to guarantee or reserve funds.

6. Deductions allowed to Estate and Trust (Sec. 61) – to be discussed separately.

END

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