Deductibility of Interest Expense from the Gross Income of a Taxpayer RR 13-2000 dated Nov. 20, 2002 Deductibility of Interest Expense from the Gross Income of a Taxpayer

Coverage Corporation Individual engaged in trade, business or in the practice of profession

Definition 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 the detention of money after the due date for its repayment.

Requisites for its Deductibility There must be an indebtedness; There should be an interest expense paid or incurred upon such indebtedness; The indebtedness must be that of the taxpayer; The indebtedness must be connected with the taxpayer’s trade, business or exercise of profession;

Requisites for its Deductibility The interest expense must have been paid or incurred during the taxable year; The interest must have been stipulated in writing; The interest must be legally due; The interest payment arrangement must not be between related taxpayers;

Requisites for its Deductibility The interest must not be incurred to finance petroleum operations; In case of interest incurred to acquire property used in business or exercise of profession, the same was not treated as a capital expenditure.

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

Rules on its Deductibility Limitation The interest expense paid or incurred shall be reduced by an amount equal to the following percentages of the interest income: 41% - Jan. 1, 1998 39% - Jan. 1, 1999 38% - beg. Jan. 1, 2000 & thereafter

Why such rate? Tax rate of 34% less 20% FWT=14% 41% for 1998 Tax rate of 34% less 20% FWT=14% 14% / 34% = 41% 39% for 1999 Tax rate of 33% less 20% FWT=13% 13% / 33% = 39% 38% for 2000 & thereafter Tax rate of 32% less 20% FWT=12% 12% / 34% = 38%

Illustration Final WT 36,000 Interest expense 150,000 Given data for 2003: Interest income P 180,000 Final WT 36,000 Interest expense 150,000 Net Income before interest expense 1,000,000 How much is the deductible interest expense?

Illustration (continued…) Answer Net income before interest expense P1,000,000 Less: Interest expense 150,000 Less: 38% of interest income (P180,000 x 38%) 68,400 Deductible interest expense P 81,600 Taxable Income P 918,400 ========= Tax due P 293,888

Rules on its Deductibility Interest on Unpaid Taxes Interest incurred on unpaid business-related taxes shall be fully deductible from gross income and shall not be subject to the limitation.

Cases where interest is not deductible Those reporting on cash basis - not allowed if interest is paid paid in advance or otherwise, but allowed as deduction on the year of indebtedness; - in case of periodic amortization, only the amount corresponds to the principal amortized shall be allowed.

Illustration Mr. Cruz, a self-employed individual, consistently employs the cash basis accounting method in keeping his books of accounts. Assume the following data: - Loan of P1M was contracted on 1/1/2003 - @ 15% interest p.a. payable in 2 years - interest of P300,000 payable in advance - net proceeds - P700,000

Analysis If interest was paid in advance using the cash basis accounting method – the interest of P300,000 is deductible in the year the loan is fully paid. If interest is paid in advance and the indebtedness is payable in periodic amortization – interest corresponding to the principal amortized is allowed in such respective year.

Cases where Interest is not Deductible If both parties are persons specified under Sec. 36(B) of the Tax Code: a) Between members of a family b) Between an individual and a corporation more than 50% in the value of the O/S is owned by or for such individual.

Cases where Interest is not Deductible c) Between two corporations with more 50% in value of O/S is owned by the same individual. d) Between the grantor and a fiduciary of any trust. e) Between the fiduciary of a trust and the fiduciary of another trust if the same person is a grantor with respect to each trust.

Cases where Interest is not Deductible f) Between a fiduciary of a trust and a beneficiary of such trust. If the interest expense is incurred to finance petroleum exploration in the Philippines.

Optional treatment of interest expense on capital expenditure At the option of the taxpayer: - as interest expense - as capital expenditure subject to periodic amortization.

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Requirements for Deductibility of Bad Debts RR No. 25-2002 dated Nov. 19/02 (amending RR 5-99) Requirements for Deductibility of Bad Debts from Gross Income

Definition Shall refer to those debts resulting from the worthlessness or uncollectibility, in whole or in part, of amounts due to the taxpayer by others, arising from money or from uncollectible amounts of income from goods sold or services rendered.

Requisites of Deductibility There must be an existing indebtedness due to the taxpayer which must be valid and legally demandable; The same must be connected with the taxpayer’s trade, business or practice of profession.

Requisites of Deductibility Must not be sustained in a transaction entered into between related parties enumerated under Sec. 36(B) of the Tax Code of 1997; Must be actually charged off from the books of accounts of the taxpayer as of the end of the taxable year;

Requisites of Deductibility Must be actually ascertained to be worthless and uncollectible as of the end of taxable year.

“Actually ascertained to be worthless” defined: Debt is not worthless simply because it is of doubtful value or difficult to collect; It is determined by exercise of sound business judgment; The worthlessness in a given case must depend upon the particular facts and the circumstances of the case.

In the case of Banks: Without prejudice to the determination of the CIR whether or not bad debts are worthless and uncollectible, the taxpayer shall submit a BSP/MB written approval of the writing off of the indebtedness.

In case of insurance/ surety company In no case may a receivable be written-off from the taxpayer’s books unless the company has been declared closed due to insolvency or any similar reason.

Tax Benefit Rule The recovery of bad debts previously allowed as deduction in the preceding year/s shall be included as part of the taxpayer’s gross income in the year of such recovery to the extent of the income tax benefit.

Tax treatment on the Recovery of Bad Debts Illustration Case 1 Case 2 Case 3 Year of deduction (2001) Net Income(loss) b4 BD Less: BD written off 150,000 100,000 (50,000) Net Income (loss) - (200,000) Extent of Income tax benefit

Tax treatment on the Recovery of Bad Debts Case 1 Case 2 Case 3 Year of recovery Amount received as recovery of bad debts 150,000 Amount to be included in the gross income in the year of receipt (equal to the extent of Income tax benefit) 100,000 -

Entertainment, Amusement and Recreational Expenses RR No. 10-2002 Effective Sept. 1/02 Ceilings on Entertainment, Amusement and Recreational Expenses

Coverage Individuals engaged in business, including taxable estates and trusts Individuals engaged in the practice of profession Domestic corporations Resident foreign corporations GPP, including its members

Definition Expenses incurred in connection with the conduct of trade, business or exercise of profession In entertaining, providing amusement and recreation to or meeting with a guest/s At a dining place, place of amusement, country club, theater, concert, play, sporting event, and similar events or places

Exception It does not refer to fixed representation allowances that are subject to withholding tax on wages (RR 2-98) or FBT (RR 3-98). In the case of clubs (ex. Country sports, golf, and similar clubs) where a) officer is registered member, and b) expenses are paid by company: Presumption : Fringe Benefit

Except Receipt and adequate records showing * Amount of expenses * Date and place of expenses * Purpose of expense * Professional or business relationship of expense * Name of person and company entertained with contact details

Entertainment, Amusement, and Recreation Expenses Includes representation expenses/ or depreciation or rental expense relating to entertainment facilities: * Yacht * Vacation Home * Condominium * Any similar item of real or personal property for the entertainment, amusement or recreation of guest.

Entertainment Facilities Conditions * The property must be owned or formed part of taxpayer’s trade, business or profession for which taxpayer claims depreciation expense or * The property must be rented by the taxpayer for which he claims rental expense.

Guests Persons or entities with which the taxpayer has direct business relations, such as clients/customers or prospective clients/customers Not included are employees, officers, partners, directors, stockholders, or trustees of the taxpayer.

Exclusions Expenses treated as compensation or fringe benefit Expenses for charitable or fund raising events Expenses for a bonafide business meeting of stockholders, partners or directors

Exclusions Expenses for attending or sponsoring a professional organization meeting Expenses of events organized for promotion, marketing and advertising including concerts, conference, seminars, workshops, conventions or similar events Other expenses of similar nature

Requisites for Deductibility It must be paid or incurred during the taxable year It must be directly connected to the development, management and operation of trade, business or profession It must be directly related to or in furtherance of the conduct of his or its trade, business or exercise of a profession

Requisites for Deductibility It must be duly substantiated with adequate proof The appropriate amount of withholding tax should have been withheld and paid, if required Not contrary to law, morals, customs, public policy and public order

Ceiling on R&E Actual expenses but should not exceed: Seller of goods or properties * 0.50% of net sales Seller of services (including exercise of profession and use or lease of properties) * 1.0% of net revenue

Ceiling on R&E Net Sales or revenue x Actual For seller of both goods and services apportionment formula should be used: Net Sales or revenue x Actual Total net sales and net revenue expenses

Verification/Substantiation Notwithstanding the ceilings imposed, the R & E shall be subject to verification to determine its deductibility and compliance with substantiation.

Effect of Reclassification Any findings of improper reclassification of representation expenses to other expense to avoid being subjected to ceiling shall be disallowed in its totality.

Reporting Requirement Taxpayers are required to use the account title “Entertainment, Amusement and Recreation Expense” both in the financial statements and income tax return In the alternative, disclose in the notes to F/S the amount but should be reported as a separate item in the ITR.

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