Module 9

DEDUCTIONS FROM GROSS INCOME

Allowable Deductions, defined

“Deductions” are the amounts, which the law allows to be deducted from gross
income in order to arrive at net income. On the other hand, “exclusions” are something
received or earned by the taxpayer that do not form part of gross income while
deductions are something spent or paid in earning the gross income. Exclusions pertain
to the computation of gross income, while deductions pertain to the computation of net
income.

Kinds of deductions
1. Itemized deductions
2. Optional standard deduction
3. Special deductions allowed in special cases

ITEMIZED DEDUCTIONS
1. Ordinary and necessary business expenses in general
2. Interest
3. Taxes
4. Losses
5. Bad debts
6. Depreciation
7. Depletion
8. Charitable and other contribution
9. Contributions to pension and trusts
10. Research and development costs

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

Ordinary and necessary trade, business or professional expenses

1. Salaries, wages, and other forms of compensation for personal services
actually rendered, including grossed-up monetary value of fringe benefit
granted by the employer to the employee
2. Travel expenses
3. Rentals
4. Entertainment, amusement, and recreation expense
5. Other necessary business expenses

Requisites for deductibility, in general:

1. Must be ordinary and necessary
2. Paid or incurred during the taxable year
3. Connected with trade, business, or practice of profession
4. Supported by sufficient evidence
 5. Not against the law, morals, public policy, or public order
6. It must have been subjected to withholding tax, if applicable.

Entertainment, amusement, and recreation expense

The amount deductible is whichever is LOWER of the actual expense or the limit
as computed by the formula below:

- For sale of goods or properties

Limit = Net Sales x ½ of 1%

- For sale of services

Limit = Net Revenue x 1%

ILLUSTRATION
CASE A: Niah Corporation is engaged in the sale of goods with net sales of
P3,000,000. The actual entertainment, amusement, and recreation expenses for the
taxable quarter totaled P50,000. For income tax purposes, how much is the deductible
entertainment, amusement, and recreation expenses?

Answer:
Actual 50,000
Limit (P3M x 0.5%) 15,000
Allowed deduction 15,000

CASE B: Niah Corporation is engaged in the sale of goods and services with net
sales and revenues of P8,000,000 and P4,000,000, respectively. The actual
entertainment, amusement, and recreation expenses for the taxable year totaled
P150,000. For income tax purposes, how much is the total deductible entertainment,
amusement, and recreation expenses?

Answer:
Actual – sale of goods (150,000 x 8M/12M) 100,000
Limit (P8M x 0.5%) 40,000
Allowed deduction 40,000

Actual – sale of services (150,000 x 4M/12M) 50,000

Limit (P4M x 1%) 40,000
Allowed deduction 40,000
Total deductible expenses 80,000

Minor or ordinary repairs & maintenance

Kind of Repair Treatment
Repairs that materially add to the value Capitalize
of the property
Repairs that appreciably prolong the life Capitalize
 of the property
Repair that keep the property in its Outright
ordinarily efficient operating condition expense

Interest expense
Requisites for deductibility:
1. There must be an indebtedness
2. The indebtedness must be of the taxpayer
3. The indebtedness is connected with taxpayer’s trade, business, or
practice of profession
4. There must be legal liability to pay interest
5. It must be paid or incurred during the taxable year

If the interest expense arises from loans, the deductible amount shall be:

Interest expense (from loans) xx

Less: interest income subject to final tax multiply by rate xx
Deductible interest expense xx

The rate as stated in the formula is derived from the following:

Effectivity Percentage
January 1, 2009 33%
January 1, 2021 20%

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

ILLUSTRATION
A taxpayer incurred an interest expense of P100,000 and earned P10,000 interest
income on deposits in 2022. The deductible interest expense shall be computed as:

Gross interest expense 100,000

Less: The arbitrage limit (P10,000 x 20%) (2,000)
Deductible interest expense 98,000

*Exception: Interest on tax delinquency or deficiency, provided, the tax is related

to trade, business, or practice of profession shall be 100% deductible.

Optional treatment of interest

Interest related to acquisition of property used in trade, business or profession
may, at the option of the taxpayer, be:
1. claimed as outright expense
2. capitalize and claim depreciation

Nondeductible interest
 1. interest paid to persons classified as related taxpayers under Section 36B of
RA 8424
2. If the indebtedness is incurred to finance petroleum exploration
3. Interest on preferred stock

Taxes
The term “taxes” mean taxes proper and no deductions should be allowed for
amounts representing interest, surcharge, or penalties incident to delinquency.

General rule is taxes paid or incurred within the taxable year in connection with
the taxpayer’s profession, trade or business, shall be allowed as deduction.

The following are exceptions of deductibility of taxes from gross income:

1. Income tax except fringe benefit tax
2. Income tax paid abroad if claimed as tax credit
3. Estate tax
4. Donor’s tax
5. Special assessment
6. Value-added taxes
7. Surcharges or penalties on delinquent taxes

Losses
The following are kinds of losses:
1. Casualty losses
2. Net operating loss carry-over (NOLCO)
3. Capital losses and securities becoming worthless
4. Special losses
a. Losses from wash sales of stock or securities
b. Wagering losses
c. Abandonment losses

Casualty losses
These are the requisites for deductibility of casualty losses:
1. The loss arises from fires, storms, shipwreck or other casualties, or from
robbery, theft or embezzlement
2. The property lost is connected with the trade, business, or profession
3. Actually sustained during the taxable year
4. Not compensated for by insurance or other forms of indemnity
5. Incurred in trade, business or profession
6. Reported with the BIR within 45 days from the time of loss, and
7. Not claimed as deduction for estate tax purposes

Net operating loss carry-over (NOLCO)

“Net Operating Loss” means excess of allowable deduction over gross income of
the business in a taxable year.
 The net operating loss of the business or enterprise for any taxable year shall be
carried over as a deduction from gross income for the next three consecutive taxable
years immediately following the year of such loss.

The following are the requisites for deductibility of NOLCO:

1. At the time of incurring net loss, the taxpayer must not be exempt from
income tax, and
2. There is no substantial change in the ownership of the business or enterprise
in that
a. Not less than 75% in the nominal value of outstanding issued shares, if
the business is in the name of a corporation, is held by or on behalf of the
same persons, or
b. Not less than 75% of the paid up capital of the corporation, if the business
is in the name of a corporation, is held or on behalf of the same persons

To aid taxpayers during the pandemic, the CREATE Law allowed NOLCO
incurred during taxable years 2020 and 2021 to be carried over a period of 5 years. For
taxpayers on a fiscal year basis, NOLCO for fiscal year ending on or before June 30,
2021 and June 30, 2022 will be carried over 5 years. Note that NOLCO incurred after
this two-year period will revert back to the original 3-year period.

NOLCO for Mines other than oil and gas wells

For mines other than oil and gas wells, net operating loss incurred in any of the
first 10 years of operation may be carried over for the next five years.

Losses from wash sales of stock or securities

In case of any loss claimed to have been sustained from any sale or other
disposition of shares of stock or securities shall not be deductible if:
1. The seller is not a dealer of securities
2. Within a period of 30 days before the sale ending 30 days after the sale, the
seller either:
a. Acquired (by purchase or exchange) stock or securities identical to the
stock or securities sold, or
b. Has entered into a contract or option to acquire stock or securities
identical to the stock or securities sold

Wagering losses
Losses from wagering transactions shall be allowed only to the extent of the
gains from such transactions.

Abandonment losses
1. In the event a contract area where petroleum operations are undertaken is
partially or wholly abandoned, all accumulated exploration and development
expenditures pertaining thereto shall be allowed as deduction.
 2. In case a producing well is subsequently abandoned, the unamortized costs
thereof, as well as the undepreciated costs of equipment directly used
therein, shall be allowed as deduction.

If the abandoned well is re-entered and production is resumed or equipment is

restored into service, the effects are:
a. The amount previously claimed as deduction shall be recognized as
income, and
b. Such amount shall also be capitalized and amortized or depreciated, as
the case may be.

Bad debts
Requisites for deductibility:
1. There must be an existing indebtedness due to the taxpayer which must be
valid and legally demandable
2. The same must be connected with the taxpayer’s trade, business, or practice
of profession
3. The same must not be sustained in a transaction between related taxpayers
4. The same must be actually charged off in the books of accounts of the
taxpayer as of the end of the taxable year, and
5. The same must be actually ascertained to be worthless and uncollectible.

Securities becoming worthless

The requisites for deductibility are:
1. Securities are ascertained to be worthless
2. The same is charged off within the taxable year
3. It must be a capital asset

Depreciation
Requisites for deductibility:
1. The property subject to depreciation is used in trade, business or practice of
profession
2. The allowance for depreciation must be sustained by the person who owns or
who has a capital investment in the property
3. The allowance for depreciation must be reasonable
4. The allowance for depreciation should not exceed the cost of the property
5. The schedule of allowance must be attached to the return

Methods of computation in general

1. Straight line method
2. Declining-balance method – rate should not exceed twice the rate in straight
line method
3. Sum of the years digit method
4. Any other method which may be prescribed by the Secretary of Finance upon
recommendation of the Commissioner of BIR
 Depreciation deductible by nonresident aliens engage in trade or business or
resident foreign corporations
In the case of nonresident aliens engaged in trade or business or resident foreign
corporations, depreciation shall be allowed only if the property is located in the
Philippines.

Obsolescence may be deducted in addition to depreciation

Allowance for obsolescence may be deducted in addition to reasonable
allowance for exhaustion, wear and tear.

Charitable contributions

Fully deductible donations

The following charitable contributions shall be fully deductible:
1. Donations to the Government of the Philippines or to any of its agencies or
political subdivisions including fully owned government corporations,
exclusively to be used in undertaking priority activities in:
a. Education
b. Health
c. Youth
d. Sports development
e. Human settlements
f. Science and culture
g. Economic development

2. Donations to foreign institutions or international organizations which are fully

deductible in pursuance of:
a. Agreements
b. Treaties
c. Commitments
d. Special laws

3. Donations to accredited Non-Government Organizations

Non-Government organization in this context means a non-profit domestic
corporation
a. Organized and operated exclusively for:
i. Scientific
ii. Research
iii. Educational
iv. Character building
v. Youth and sports development
vi. Health
vii. Social welfare
viii. Cultural
ix. Charitable purposes, or
x. A combination thereof
 b. No part of the net income of which inures to the benefit of any private
individual
c. Not later than 15th day of the 3rd month after the close of any taxable year
in which contributions are received, makes utilization, unless an extended
period is granted by the Secretary of Finance, upon recommendation of
the Commissioner of Internal Revenue
d. The level of administrative expense of which shall, an annual basis, in no
case to exceed 30% of the total expenses
e. The assets of which, in the event of dissolution, would be distributed to:
i. Another domestic corporation organized for similar purpose or
purposes, or
ii. The state for public purposes, or
iii. Another organization to be used in such manner as in the judgment
of the court shall best accomplish the general purpose for which the
dissolved organization was organized

4. Per special laws, donations made to the following are deductible in full:
a. Integrated Bar of the Philippines (PD 181)
b. International Rice Research Institute (RA 2707)
c. Development Academy of the Philippines (PD 205)
d. The University of the Philippines and other state colleges
e. Cultural Center of the Philippines
f. Artesian Well Fund (RA 1977)
g. Ramon Magsaysay Award Foundation
h. Task Force on Human Settlement
i. Donations to the National Museum, Library and Archives (PD 373)
j. National Commission on Culture
k. Humanitarian Science Foundation
l. National Social Action Council

Donations subject to limit

The following donations, which do not fall under fully deductible donations, shall
be subject to limit:
1. Donations to the Government of the Philippines or any agencies or any
political subdivision thereof exclusively for public purposes
2. Donations to accredited domestic corporations or associations operated
exclusively for:
a. Religious
b. Charitable
c. Scientific
d. Youth and sports development
e. Cultural
f. Educational
g. Rehabilitation of veterans
h. Social welfare institutions, or
 i. Non-government organizations

The allowable deductions from gross income for Charitable contributions is

whichever is lower of the actual charitable contribution or the amount computed using
the following limit:

Taxpayer Rate Base

Corporation 5% Taxable income from trade, business, or
Individual 10% profession before charitable contributions

Valuation in case of donation of non-cash property

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

ILLUSTRATION
CASE A: Corporate Taxpayer
A domestic corporation has the following data on income and expenses:
Sales 10,000,000
Cost of Sales 4,000,000
Operating expenses excluding contributions to the
government and charitable institutions 3,000,000
Contributions to government for priority project in
education 200,000
Contributions to government for public purpose 100,000
Contributions to domestic charitable organization 100,000
Contributions to proprietary educational institutions 200,000
Contributions to a “Party List” candidate 300,000

Required: Determine the taxpayer’s taxable income

Answer:

Sales 10,000,000
Cost of Sales (4,000,000)
Operating expenses excluding contributions to the
government and charitable institutions (3,000,000)
Net income before contributions 3,000,000
Contributions deductible in full:
Contributions to government for priority project in
education (200,000)
Contributions deductible with limit: (to government for
public purpose and domestic charitable institution)
Actual = 200,000
Limit = P3M x 5% = 150,000
Allowed (whichever is lower) (150,000)
 Taxable income 2,650,000

** The contributions to a proprietary educational institution and to a Party List candidate

are nondeductible expenses.

CASE B: Individual Taxpayer

Assume the same data in Case A except that the taxpayer is a resident citizen without
qualified dependents.
Required: Determine the taxpayer’s taxable income.
Sales 10,000,000
Cost of Sales (4,000,000)
Operating expenses excluding contributions to the
government and charitable institutions (3,000,000)
Net income before contributions 3,000,000
Contributions deductible in full:
Contributions to government for priority project in
education (200,000)
Contributions deductible with limit: (to government for
public purpose and domestic charitable institution)
Actual = 200,000
Limit = P3M x 10% = 300,000
Allowed (whichever is lower) (200,000)
Taxable income 2,600,000

Research and development

Condition Action
If not chargeable to capital account Claim as outright expense
If chargeable to capital account but not At the option of the taxpayer:
chargeable to property subject to
depreciation or depletion OPTION 1 – claim as outright expense
OPTION 2 – amortize over 60 months
If chargeable to property subject to Capitalize
depreciation or depletion

Limitations on deduction of research and development

The following research and development expenditures are not deductible:
1. Any expenditure for the acquisition or improvement of land, or for the improvement
of property to be used in connection with research and development of a character
which is subject to depreciation and depletion, and
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 or gas.

Pension trusts
Amount deductible
 Actual contribution to the extent of pension liability xx
Amortization of past service cost xx
Total xx

Pension liability is equal to normal cost. Past service cost is the excess of actual
contributions over the normal cost. It shall be amortized over 10 years.

Optional standard deduction

Optional standard deduction can be claimed in lieu of itemized deductions. The
following may be allowed to claim OSD:
1. Individuals
a. Resident Citizen
b. Nonresident citizen
c. Resident alien
d. Taxable estates and trusts

2. Corporations
a. Domestic corporation
b. Resident foreign corporations

Amount deductible:
Individuals - Gross Sales or Gross Receipts x 40%
Corporations/Partnerships - Gross income x 40%

If the taxpayer has NOLCO, they cannot use NOLCO when the taxpayer avails
the 40% OSD as NOLCO is a result of the taxpayer’s operations and OSD is not.

Nondeductible items
1. Bribes, kickbacks and other similar payments
2. Personal, living or family expenses
3. Any amount paid out for new buildings or for permanent improvements or
betterments made to increase the value of any property or estate
4. Any amount expended in restoring property or in making good the exhaustion
thereof for which an allowance is or has been made
5. 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
6. Interest, losses, and bad debts:
a. Between members of a family. Family of an individual shall include
only his brothers or sisters (whether by the whole or half-blood),
spouse, ancestors, and lineal descendants, or
b. Except in the case of distributions in liquidation, between an individual
and a corporation more than 50% in value of the outstanding stock of
which is owned, directly or indirectly, by or for such individual, or
 c. Except in the case of distributions in liquidation, between an individual
and a corporation more than 50% in value of the outstanding stock of
each of which is owned, directly or indirectly, by or for the same
individual, if either one of such corporation, with respect to the taxable
year of the corporation preceding the date of the sale or exchange was
a personal holding company, or
d. Between the grantor and a fiduciary of the trust, or
e. Between the fiduciary of a trust and fiduciary of another trust if the
same person is the grantor with respect to each trust, or
f. Between a fiduciary of a trust and a beneficiary of such trust

Special deductions

Expenses allowed to proprietary educational institutions:

Cost incurred for the expansion of school facilities may at its option:
1. Capitalize and claim depreciation as deduction, or
2. Claim as outright expense

Special deductions allowed to insurance companies

1. Net additions made within the year to reserve funds, and
2. The sum other than dividends paid within the year on policy and annuity
contracts
Note: Released reserve shall be treated as income for the year of release.

*Additional
Accounting Periods
Kinds
1. Calendar Year – December 31
2. Fiscal Year

Instances when use of calendar year is required

Taxable income shall be computed on the basis of calendar year in the following
cases:
1. If the taxpayer’s annual accounting period is other than a fiscal year
2. If the taxpayer has no annual accounting period
3. If the taxpayer does not keep books of accounts
4. If the taxpayer is an individual (Sec 43, RA 8424)

Short period return

Accounting Period may be less than 12 months may arise when:
1. A corporation is newly organized
2. When a corporation is dissolved
3. When the taxpayer dies
4. When a corporation changes accounting period
Accounting methods
1. Cash method
2. Accrual method
3. Crop basis
4. Percentage of completion
5. Installment method

Reference:

Tabag, E.D., Garcia, E.J. (2019) Income Taxation with Special Topics in Taxation based on
NIRC as amended under RA10963 – Tax Reform for Acceleration and Inclusion Act (TRAIN
Law)

Banggawan, R.B., (2021) Income Taxation Laws Principles and Applications

Bureau of Internal Revenue, https://www.bir.gov.ph/index.php/tax-information/income-tax.html