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Itemized Deductions for Income
Tax Purposes
H07.1 - Regular Income Tax - Itemized
Deductions
Income Taxation (Bicol University)
A. Interest
Requisites: 1. There should be a valid indebtedness. 2. There must be legal liability to pay interest. 3. The indebtedness must have been incurred in connection with the taxpayer's trade, profession, or business. 4. For interest incurred abroad by taxpayers who are subject to income tax only on income earned within the Philippines, the indebtedness must have been actually incurred to provide funds for use in connection with the conduct or operation of trade or business in the Philippines. 5. The deductible amount of interest shall be reduced by an amount equal to 33% of interest income.
Non-deductible interest: 1. Interest paid in advance through discount on indebtedness incurred by an individual taxpayer reporting income under the cash basis. If the discounted liability is payable in installment, the amount of interest which corresponds to the amount of the principal amortized or paid during the year shall be allowed as a deduction in such taxable year. 2. Interest payments with related parties. 3. If the indebtedness is incurred to finance petroleum operations.
Capitalization of interest: At the option of the taxpayer, interest incurred to acquire property used in trade, business, or profession may be allowed as a capital expenditure. The interest expense up to repayment of the debt may be capitalized.
Special Cases: 1. Interest on preferred stock โ these are dividends; hence, not deductible on interest. 2. Interest on scrip dividends โ since there is an evidence of indebtedness, these are deductible interest.
B. Taxes
Generally, taxes paid or accrued within the taxable year in connection with the taxpayer's trade or business or exercise of a profession are deductible from gross income. The deductible tax includes local taxes and some national taxes, but the deductible tax component is the tax proper only. Interest on delinquent taxes is deductible from gross income but as "interest expense," not taxes.
Requisites: 1. Must be paid or accrued within the taxable year. 2. Must be incurred in connection with the taxpayer's trade, professional, or business.
Non-deductible Taxes: 1. Philippine income tax, except fringe benefit tax.
- Estate or donor's tax. 3. Special assessment. 4. Income tax imposed by a foreign country if the taxpayer opted to claim them as a deduction rather than as a tax credit. 5. Stock transaction tax. 6. Value-added tax on business.
Tax Credit for Foreign Income Tax Paid: Taxpayers taxable on world income, such as resident citizens and domestic corporations, have the option to claim the foreign income tax either as a tax credit or a deduction from income. The limit of the tax credit is the lower of the actual amount of foreign tax paid and the amount which reflects the ratio of the gross income from the foreign country to the total world taxable income to the Philippine income tax.
C. Losses
Requisites: 1. The loss must be actually sustained during the taxable year.
- It must not be compensated for by insurance or other forms of indemnity.
- It must be sustained in a close and completed transaction. 4. The loss must be that of the taxpayer. 5. The loss must be reported to the BIR within 45 days from the date of loss or discovery. 6. It must not be claimed as a deduction in the estate tax return for individual income taxpayers.
Deductible losses: 1. Loss incurred in trade, profession, or business. 2. Loss due to fire, storm, shipwreck, or other casualty of property connected with trade, profession, or business. 3. Loss due to theft, robbery, or embezzlement if the property is connected with trade, profession, or business.
Measure of the loss: 1. Total Loss โ book value of the property. 2. Partial Loss โ replacement cost of the damaged portion of the asset or the book value thereof at the time of loss, whichever is lower.
Abandonment Losses: 1. Petroleum operation โ all accumulated exploration and development expenditures pertaining to partially or wholly abandoned contract areas shall be allowed as a deduction, provided notice of abandonment is filed with the Commissioner of Internal Revenue. 2. Producing wells โ the unamortized costs thereof, as well as the undepreciated costs of equipment directly used therein, shall be allowed as a deduction in the year such well, equipment, or facility is abandoned by the contractor.
Special Cases: 1. If there is a pending proceeding in which the loss can be recovered, deduction for the loss is delayed until recovery becomes impossible. 2. Loss of income โ cannot be deducted unless the related income has already been included in gross income. 3. Losses on sale or exchanges of property with related parties โ not deductible.
Net Operating Loss Carry Over (NOLCO): Any excess of allowable deductions over gross income of a business in a taxable year immediately preceding the current taxable year shall be carried over as a deduction from gross income for the next consecutive taxable years immediately following
notifies the Commissioner of Internal Revenue at the beginning of the depreciation period of the rate to be used.
F. Depletion (Cost Depletion)
Depletion is available only for oil and gas wells and mines. Exploration expenditures are those paid or incurred in ascertaining the existence, location, and extent or quality of any deposit of ore or other minerals before the beginning of the development stage of the mine or deposit. Development expenditures are those paid or incurred during the development stage of the mine, which begins when ore or other minerals are shown to exist in commercial quality and quantity and ends upon commencement of actual commercial extraction.
Cost-Depletion Method
Depletion of Oil and Gas Wells or Mines
Depletion should be provided only up to the extent of capital investment in the mine. If intangible development drilling costs are incurred: For non-producing wells and/or mines - deductible in the year incurred. For producing wells and/or mines - at the option of the taxpayer, deduction in full in the year paid or incurred, or capitalized and amortized. Tangible development costs are capitalized and are subject to depreciation. If intangible exploration, drilling and development expenses are claimed as deductions, they should not be added to the adjusted cost basis of the mining property for purposes of computing the cost depletion.
Irrevocable Alternative Deduction: Applicable to Mining
Operation only
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. Limit: the amount of deductible exploration and development cost shall not exceed 25% of taxable income, without the benefit of any tax incentive under existing laws. Once elected, the scheme shall be binding and irrevocable in succeeding taxable years.
Deductibility of Depreciation or Depletion on Mining
Properties
Taxpayers who are taxable on: Units expected recoverable
Capital investment in the mine Unit depletion charge = Depreciable or Depletable Asset / World income
Deductibility based on Location of Asset
If the depreciable or depletable asset is located abroad, the deduction is allowed for world income. If the depreciable or depletable asset is located in the Philippines, the deduction is allowed for Philippine income only.
Charitable and Other Contributions
Requisites
The contribution or gift must be actually paid. The contribution of property must be measured based on acquisition cost. It must be given to an organization specified by law. Net income of the specified institution must not inure to the benefit of any private stockholder or individual. The person making the contribution must be engaged in trade, business or profession.
Classification of Contributions
A. Fully Deductible Contributions
Donation to the government or political subdivisions including fully owned government and controlled corporations to be used exclusively in undertaking priority activities in: Education Health Youth and sport development Human settlements Culture and sports Economic developments Donation to foreign institution or international organization in compliance with agreement or treaties. Donations to accredited domestic non-government organizations for scientific, research, educational, character building, youth and sports development, health, social welfare, cultural, or charitable purposes, or any combination of these purposes. Requisites: The donation must be utilized by the donee institution not later than the 15th day of the third month following the close of the taxable year. The administrative expense must not exceed 30% of the total expenses.
Amortization of Capitalizable Research and Development
Costs
The taxpayer should treat the expenditure as a deferred charge. Amortized over a period of not less than 60 months starting from the month in which the taxpayer first derived benefits from such deferred expense.
Non-deductible Research and Development Expenditures
Expenditure for the acquisition of improvement of a land (in connection with research projects). Any expenditure for the improvement of property to be used in connection with research and development of a kind which is subject to depreciation and depletion. 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 (exploration costs are non-deductible, only development costs).
Expenses, in General
Requisites
It must be ordinary and necessary. It must be paid or incurred during the taxable year. It must be directly attributable to the development, operation, management and/or conduct of the trade, profession or business. It must be reasonable. The amount paid shall be allowed as deduction only if it is shown that the tax required to be deducted and withheld therefrom has been paid to the BIR. It must be supported by official receipts or adequate records.
Compensation
Requisites: 1. Personal services must have been actually rendered. 2. The compensation for such services must be reasonable, including the grossed- up monetary value of fringe benefit furnished to the employee and the applicable final tax remitted to the BIR.
Traveling Expenses
Requisites: 1. Must be incurred while away from home. 2. In pursuant of a trade, profession or business.
Entertainment, Amusement or Recreation Expenses (EAR)
Requisites: 1. It must be directly related to the furtherance of the conduct of trade, profession or business. 2. It must not be contrary to law, morals, good
customs, public policy or public order. 3. It must not have been paid directly or indirectly to an official or employee of the Government or of a foreign government, or to a private individual, corporation, General Professional Partnership or a similar entity, if it constitute bribe, kickback or other similar payments. 4. The official receipts, invoices, bills or statement of accounts should be in the name of the taxpayer claiming the deduction.
Limit of Deductible Amount for EAR
A. Taxpayers deriving income from either sale of properties or sale of services: - Whichever is lower of the following and the actual EAR expense:
- Taxpayers engaged in sale of goods or properties - 1/2 of 1% (or .5%) of net sales. 2. Taxpayers engaged in sale of services (profession, lessors) - 1% of net revenue.
B. Taxpayers deriving income from both sales of properties and sales of services, the deductible amount shall be whichever is lower between the two tests above.
Major Classification of Items Deductions
Cost of sales / cost of services Ordinary allowable itemized deductions Special allowable itemized deductions Net operating loss carry over
Cost of Services
Covers all direct costs and expenses necessary to provide the service required by customers, such as: - Salaries and employee benefits of personnel, consultants and specialists directly rendering the service. - Cost of facilities directly utilized in providing the service such as depreciation or rental of equipment used and cost of supplies. - For banks, the cost of services includes interest expense.
BIR Form 1701 Deduction Classifications
Amortizations Bad debts Charitable and other contributions Depletion Depreciation Entertainment, amusement and recreation Fringe benefits Interest Losses Pension trusts Rental Research and development Salaries, wages and allowances SSS, PhilHealth, HDMF and other contributions
Special Allowable Itemized Deductions
Income Distribution of Taxable Estate and Trust
Transfers to reserve fund and payments to policies and annuity contracts of insurance companies are allowable deductions.
Dividend Distribution of REITs
Dividend distributions of Real Estate Investment Trusts (REITs) are allowable deductions.
Transfers to Reserve Funds of Cooperatives
Transfers to reserve funds of cooperatives are allowable deductions.
Discounts to Senior Citizens and PWDs
Discounts provided to senior citizens and persons with disabilities (PWDs) are allowable deductions.
Deduction Incentives
Additional Compensation Expense for SCs and PWDs
Corporations can deduct additional compensation expenses for hiring senior citizens (SCs) and persons with disabilities (PWDs).
Cost of Facility Improvements for PWDs
Corporations can deduct the cost of facility improvements made to accommodate PWDs.
Additional Training Expense on Jewelry Industry
Corporations can deduct additional training expenses for employees in the jewelry industry.
Additional Contribution Expense on Adopt-a-School
Program
Corporations can deduct additional contributions made to the Adopt-a- School program.
Additional Deductions on Rooming-in and Breastfeeding
Program
Corporations can deduct additional expenses related to rooming-in and breastfeeding programs.
Additional Free Legal Assistance Expense
Corporations can deduct additional expenses for providing free legal assistance.
Additional Productivity Incentive Bonus Expense
Corporations can deduct additional productivity incentive bonuses paid to employees.
Required Disclosures
Corporations must disclose the description, legal basis, and amount of the special deduction claimed.
NET OPERATING LOSS CARRY OVER
(NOLCO)
Measurement
NOLCO and deduction incentives are excluded from the measurement of taxable income.
Requisites
The taxpayer must not be exempt from income tax during the taxable year the NOL was incurred, and there must be no substantial change in ownership of the business enterprise.
ILLUSTRATIONS
Ordinary Allowable Deductions
Interest expense on bank loans can be deducted, offset by net interest income from the temporary deposit of the borrowed amount in the same bank. Deductible interest expenses include interest on borrowings from a sister company, interest paid to preferred shareholders, and interest on tax delinquencies, but not interest on borrowing for machinery currently being depreciated. Deductible taxes and licenses include mayors permit, real property tax, value added tax, documentary stamp tax, donor's tax, fringe benefits
office clerks, depreciation of laptops, and interest expense on bank borrowings are ordinary deductions.
Special Allowable Itemized Deductions
Discounts to Senior Citizens and PWDs
A medicine manufacturer and drug retailer can deduct the discounts provided to senior citizens and PWDs from their net sales.
Salaries to PWD and SC Employees
The company can deduct the salaries paid to PWD and SC employees as special allowable deductions.
Productivity Incentive Bonus
The company can deduct the productivity incentive bonus paid to employees as a special allowable deduction.
Contributions to Adopted Public School
The company can deduct the contributions made to an adopted public school as a special allowable deduction.
REIT Dividend Distribution
A REIT can deduct its dividend distributions as a special allowable deduction, and the final tax on the remaining taxable income is 1%.
Net Operating Loss Carry-Over (NOLCO)
The NOLCO and the taxable income can be computed for a taxpayer who suffered losses in prior years, considering factors such as the sale of the business, BOI registration, and the availability of capital and ordinary losses.
Tax Forms
An individual taxpayer who is purely engaged in business or profession using itemized deduction should use BIR Form 1701.
A mixed-income earner who is using itemized deduction should use BIR Form 1702.
