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

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

3. 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.

4. 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;

5. 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;

6. 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.

7. 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.

8. 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

9. 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%

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

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

12. 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.

13. 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.

14. 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

15. 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.

16. 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.

17. 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.

18. 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.

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

20. END

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

22. 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.

23. 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.

24. 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;

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

26. “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.

27. 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.

28. 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.

29. 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.

30. 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

31. 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 -

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

33. 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

34. 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

35. 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

36. 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

37. 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.

38. 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.

39. 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.

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

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

47. 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.

48. 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.

49. End