Deductions – it is defined as the amounts allowed by law to reduce the gross income to taxable income.

1. Optional standard deduction (OSD) or

2. Itemized deductions

OPTIONAL STANDARD DEDUCTION - is a deduction from gross income allowed to be taken instead of
the itemized deductions. It is an amount not exceeding forty percent (40%) of gross income.

The OSD is a deduction from gross income allowed to be taken in lieu of the itemized deduction. It can
be claimed by any type of taxpayer who are exclusively enumerated below. Excluded also are those
taxpayers who are receiving compensation income.

Who can claim OSD?

Individual taxpayer Corporation and partnership

Gross income from self – employment Gross income from business
1. A resident citizen 1. Domestic corporation
2. A non-resident citizen 2. Resident corporation
3. A resident alien 3. General professional partnership
4. Any other entity on which the rules for
domestic corporations apply (i.e.
partnership other than general
professional partnership, taxable joint
ventures, and taxable co-ownerhip)

Illustrative application of the two taxpayer:

1. Merchandising Business

Individual Corporation
Gross sales 1,200,000 1,200,000
Sales returns 100,000
Sales 50,000 150,000 150,000
discounts
Net sales 1,050,000 1,050,000
Less: Cost of
sales
Inventory, beg 30,000
Purchases 500,000
Purchase 20,000
returns
Purchase 10,000 30,000 470,000
discounts

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Total 500,000
Freight in 15,000
Goods 515,000
available for
sale
Inventory, end 10,000 505,000 505,000
Gross profit 545,000 545,000
from sales
Less: OSD
1,200,000 x 480,000
40%
545,000 x 40% 218,000
Balance 65,000 327,000
Less: Personal 50,000 0
exemption
Taxable income 15,000 327,000

B. Service Business

Individual Corporation
Gross revenues 980,000 980,000
Less: Direct cost of services
Rentals 120,000
Depreciation 20,000
Medical supplies 50,000
Electricity water, and light 150,000
Salaries and 13th month pay 180,000 520,000 520,000
Gross income 460,000 460,000
Less: OSD
980,000 x 40% 392,000
460,000 x 40% 184,000
Basic personal exemption 50,000 0
Taxable income 18,000 276,000

Reminder: A taxpayer that claimed the OSD is not required to submit with the Income Tax Return any
financial statement, but the taxpayer should keep records pertaining to gross income.

Itemized deductions

Itemized Deductions – are expenses and losses related to trade or business. They areL
a. Interest
b. Taxes
c. Losses
d. Bad debts

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 e. Depreciation
f. Depletion
g. Pension trust
h. Charitable and other contributions
i. Research and development
j. Expenses in general

Interest

it must be paid or accrued on the taxpayer’s indebtedness. Indebtedness is a sum of money owned by
one person who is unconditionally bound to pay, and interest is the amount paid for the use of money.

Generally it is 100% deductible but there will be downward adjustments, if the taxpayer has interest
income subject to final tax, the otherwise allowable deduction for interest expense will be reduced by an
amount equal to 33% of interest income subjected to final tax.

But interest paid or accrued on taxes related to business or practice of profession can be deducted in full.

Example:

X Company, a domestic corporation, with interest income on bank deposit of P4,000, had the following
data on interest expense during taxable year:

Interest expense on trade notes payable P 5,000

Interest expense on late payment of business taxes 10,000
The deduction for interest expense would be computed as follows:
Interest expense on trade notes payable P5,000
Less: 33% of P4,000 1, 320 P3,680
Interest expense for late payment of business 10,000
Deduction for interest expense P13,680

Interest on asset acquired

1. As an outright deduction from gross income or

2. As a capital expenditure to form part of the cost of the asset.

Example:

A company borrowed P10,000,000 from a bank to construct a building to be used in business. Interest on
it was deducted in advance by the bank and the amount released to A company was P8,000,000. The
transaction will result in>

Alternative 1. Cost of the building subject to depreciation P8,000,000

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 Prepaid interest 2,000,000

Or

Alternative 2: Cost of the building subject to depreciation P10,000,000

Problem:

A Company is under accrual method of accounting. In in 2010:

Cost of the building constructed P5,000,000

Life of the building 20 years

Interest on bank loan for the next 5 year, used to finance construction

Of building 1,000,000

Deduction in 2010, and in subsequent years, if interest expense is claimed as a deduction for interest?

Deduction in 2010, and in subsequent years, if interest expense is capitalized?

Solution:

a. If interest is claimed as deduction:

Interest expense in 2010 and each of the next four years (P1,000,000/5) P200,000

Depreciation per year (P5,000,000/20 years) 250,000

Total deductions in 2009 and each of the next 4 years P450,000

Deduction beginning the sixth year P250,000

b. If interest is treated as a cost of the asset:

Deduction each year beginning with 2009:

(P6,000,000/20 years) P300,000

TAXES

Taxes paid or accrued in connection with the business are deductible from gross income except:

1. Philippine income tax except for fringe benefit tax.

2. Donor’s tax
3. Special Assessment
4. Income tax imposed by a foreign country.

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 5. Stock transaction tax
6. VAT

Problem:

Philippine income tax P100,000

Real estate tax 32,000
Donor’s tax 10,000
Special assessment 2,000
Value Added Tax 15,000
Stock transaction tax 5,000
Basic and additional community tax 1,700
Percentage tax 6,000
Interest for late payment of tax 2,100
Surcharge for late payment of various business taxes 9,000
Compromise penalty for violations on payment of taxes 4,000
City food and beverage taxes 200

Deduction for taxes?

Solution:

Fringe benefit taxes P32,000

Real estate tax 10,000
Basic and additional community tax 1,700
Percentage taxes 6,000
City food and beverage tax 200
Total P49,900

LOSSES

Losses are those actually sustained during the taxable year and not compensated by insurance or other
form of indemnity.

Requirements:

1. Incurred here in the Philippines.

2. Incurred in trade, business or profession.
3. Of property connected in the proceeding business, the loss was due to fire, storm, shipwreck, or
other casualty, or from robbery theft or embezzlement.

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 4. The taxpayer must submit a declaration of loss, which must not less thatn 30 days nor more than
90 days from the date of the discovery of the casualty. Or robbery or theft or embezzlement;
within 45 days from the discovery of the loss.

Measure of loss:

1. The compensation that reduces the loss may be insurance or any other form of indemnity.
2. In case of partial loss of property used in trade or business or in the practice of profession, the
measure of loss is the Cost to restore the property back to its normal operating condition or
Book value, whichever is lower, reduced by insurance recovery or any form of indemnity.

Problem 1:

Total loss of an asset used in business in a casualty:

Cost of the asset P2,000,000

Accumulated depreciation P1,100,000

Insurance recovery 400,000

Deductible loss?

Solution:

Cost of the asset P2,000,000

Less: Accumulated depreciation 1,100,000
Book value P 900,000
Less: Insurance recovery 400,000
Deductible loss P 500,000

Problem 2:

Partial loss on properties used in business Asset 1 Asset 2

Cost to restore asset to its normal condition P200,000 P100,000

Book value of asset at the time of loss 120,000 180,000

Insurance recovery 80,000 30,000

Deductible loss, Asset 1?

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Deductible loss, Asset 2?

Solution:

Asset 1 Asset 2
Cost to restore the property to its normal condition P200,000 P100,000
Book value of the asset P120,000 P180,000
Whichever is lower P120,000 P100,000
Less; Insurance recovery 80,000 30,000
Deductible loss P 40,000 P70,000

NET OPERATING LOSS

A net operating loss is the excess of allowable deductions over gross income of the business or
enterprise for any taxable year.

NET OPERATING LOSS CARRY-OVER (NOLCO)

A Net operating loss will be carried over as a deduction from gross income for the next three (3)
consecutive years immediately following the year of such loss.

For example:

In pesos 2006 2007 2008 2009 2010

Gross income 500,000 600,000 700,000 500,000 800,000
Less: 900,000 500,000 750,000 420,000 450,000
Deductions
Net loss (400,000) (50,000)
Net income 100,000 80,000 350,000
before NOLCO
Less: NOLCO- 100,000 80,000
2006
2008 50,000
Taxable income 0 0 0 0 300,000

The unused net operating loss of P220,000 of the year 2006 could not be carried over beyond 2009. The
net operating loss of 2008 could be carried ov

Bad Debts, Depreciation, Contributions and Others

BAD DEBTS

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Debts due the taxpayer, connected with trade or business, actually ascertained to be worthless and
charged off within the taxable year.

An account is worthless when it must be ascertained that with a reasonable degree of certainty that the
amount is uncollectible.

Cases:

1. The flight or disappearance of the debtor

2. Insolvency of the debtor
3. The death of the debtor
4. And other situations that may warrant worthlessness of the debt.

If the property is mortgaged, where under a foreclosure of a mortgage, the mortgagee buys the
mortgaged property and credits the indebtedness with the purchase price, the difference between the
purchase price and the indebtedness will not be an allowable deduction for bad debt, for the property
which was a security for the debt stands in place of the debt. The determination of the loss in such a
case is deferred until the disposal of the property.

Problem 1:

The taxpayer had the following journal entry in the books of accounts:

Bad debts 50,000

Accounts receivable 50,000

How much is the deduction for bad debts?

Solution:

Deduction for bad debts P50,000

Problem 2:

A Co., had a receivable of P500,000 from B Co. The indebtedness of B Co. was secured by a mortgage on
the property of B Co. When B Co. could not pay, A Co., foreclosed the on the mortgage and the property
was awarded to A Co., (highest bidder) at public auction for P400,000. The balance cannot be collected
anymore.

How much is the deduction for bad debts of A Co?

Solution: P0.

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Problem 3:

In 2010, A Co. sold the property for P450,000.

How much is the deduction for bad debts of A company?

Solution:

Basis of the receivable uncollected P500,000

Less: Selling price of the property 450,000

Deduction in 2010 P 50,000

DEPRECIATION

A REASONABLE ALLOWANCE for exhaustion, wear and tear (including allowance for obsolescence) of
property used in trade or business.

Depreciable assets

1. Tangible assets
2. Intangible assets (amortization)

Methods of depreciation

1. Straight line method

2. Declining balance method
3. Sum of the years digit method
4. Any other method which may be prescribed by the sec of finance, upon recommendation of BIR.

Problem:

a. H co acquired a machine at a cost of P380,000. Scrap value was placed at P0, and the useful life
was estimated at 25 years. Depreciation was computed on the straight line method. The annual
depreciation would have been computed as follows:

Cost P380,000

Less: Scrap value 0

Depreciable base P380,000

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Annual depreciation (P380,000/25 years) P 15,200

b. If in the preceding example on H Co., after depreciating the asset for twenty years, it was
determined that the life of the asset was not five years but ten years?

Remaining depreciable cost (P380,000-P304,000) P76,000

New annual depreciation charge (P76,000/10 years) P 7,600

DEPLETION

The natural resources are called wasting assets. As the physical units representing such resources are
extracted and sold such assets move towards exhaustion.

Example:

Land containing natural resources was purchased for P100,900,000. It was estimated that the land
after exploration of its natural resource, wii have a value of P900,000. It was estimated that the
natural resources supply was 5,000,000 tons. If withdrawal of resource from the land in 2009 was
500,000 tons, how much was the deduction for the year?

Depletion charge per ton:

Purchase price P100,900,000

Less: Residual value of the land 900,000

Depletion base P100,000,000

Resource supply in tons 5,000,000

Depletion rate per ton (P100,000,000/5,000,000 tons) P20

Depletion for 2009 (500,000 x P20) P 10,2000,000

PENSION TRUSTS

Past service costs- Past services that requires lump sum payment to the pension fund.

Present service costs – for each year after the pension plan was set-up, there should be a payment to
the fund for pension for the services rendered during the year by the employees.

This deduction for pension payments applies only to a pension plan that is funded.

Problem:

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 A pension fund was set up in 2000 for retiring employees. In setting up the fund, P1,000,000 was
deposited as seed money for past service cost. Annual or present service cost is P50,000, beginning
2000.

Deduction in 2000?

Deduction in 2008?

Deduction in 2012?

Solution:

Deduction in 2000:
1/10 of P1,000,000, on past service cost P100,000
Present service cost 50,000
Total P150,000

Deduction in 2008 P150,000

Deduction in 2012 (present service cost) P 50,000

CONTRIBUTIONS AND DONATIONS

1. DEDUCTIBLE IN FULL

a. Donations to the GRP or to any of its agencies or political subdivisions, including fully owned
government corporations, exclusively to finance priority activities in science, education, culture,
health, economic development, human settlement, youth and sports development.
b. Donations to foreign institutions or international organizations, in compliance with agreements,
treaties or commitments entered id into by GRP and the foreign institutions in pursuance of special
laws.
c. Donations to certain accredited non-government organizations (non-profit domestic corporations),
organized and operated exclusively for scientific, educational, cultural, character building and youth
and sports development, charitable, social welfare, health and researches.

2. Deductible subject to limitations

a. The recipient of the contribution or gift is any of:

1. The GRP or any of its agencies, or any political subdivision thereof, for exclusively public
purposes (not included in the priority activities) or
2. Non-government accredited domestic corporations or associations which are:
a. Domestic and
b. Organized and operated exclusively for scientific, educational, cultural, scientific,
educational, cultural, etc.

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 3. The amount should not exceed five percent (5%) of the corporation’s taxable income before
deducting the contribution.

Problem:

N Co had a gross income from business of P1,000,000 and business expenses of P400,000. It made
during the year a contribution that is fully deductible of P10,000 and contribution subject to limitation of
P50,000. The deduction for contribution is P40,000 and the taxable income for the year is P560,000.

Solution:

Gross income from business P1,000,000

Less: Deduction for business expenses 400,000

Taxable income before contributions P 600,000

Less: Contributons subject to limitations:

To L Association P10,000

To M Association 40,000

Total of actual P50,000

5% of P600,000 P30,000

Allowed ( Whichever is lower) 30,000

Taxable income P570,0000

RESEARCH AND DEVELOPMENT COSTS

These expenses are for improvements of processes and formulas, as well as the development of
improved or new product.

Two ways to account for research and development:

1. For acquisition or improvement of property subject to depreciation or depletion .

2. Other research and development costs.
a. As an outright deduction (for the full expenditures), in the year the expense was paid or
incurred.
b. As a deferred expense to be spread and recognized as deduction over a period of not
less than 60 months from the date of acquisition of benefit from the expenditures.
3. Illustration:

Research and development expenditures in 2012:

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For acquisition of land for use as research center P5,000,000
For constructing the research center building, with a useful life of 50 years 3,000,000
Others research and development costs 2,000,000

Benefit from the research expenditure will be received beginning 2013.

Deduction for 2012 if availed of in one lump sum?
Deduction every year/month if the expenditure is recognized as a deferred expense to be spread and
recognized as deduction over a period of not less than 60 months beginning from the first month from
which benefits were received from the expenditure.

Solution:

A. Research and development costs, deduction in one lump sum P2,000,000

B. A deferred expense of P2,000,000, from which there shall be a monthly deduction of P2,000,000
divided by 60 months (cannot be shorter, but can be longer), or P400,000 per year or P33,000
per month.

EXPENSES IN GENERAL

Two kinds of business expenditures; the revenue expenditures and capital expenditures. A revenue
expenditures benefits only one period and it is a deduction from gross income in the year paid and
incurred.

A capital expenditure, usually incurred in the acquisition, betterment or permanent improvement of an

assets benefits more than one accounting period, and it is not deductible from gross income in the year
paid.

An expense must satisfy the following conditions in order to be deductible from gross income:

a. It must be ordinary and necessary;

b. It must be paid or incurred within the taxable year;
c. It must be in carrying on or directly attributable to, the development, management. Operations,
and/or conduct in the trade or business, or the practice of a profession.
d. It must be substantiated by official receipts (OR) and other adequate records.

An expense is considered ordinary, if it is normal in relation to the taxpayer’s business and the
surrounding circumstances. The expense need not be recurring.

Salaries, wages and others.

Compensation payments rendered to the taxpayer are deductible from gross income. A compensation
payment is reasonable, if the same amount shall be paid for similar services by similar enterprises under
similar circumstances. Any excess payments may be treated as distribution of earnings on stock or as a
capitalized expense on the purchase price.

Expenses under lease agreements:

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In addition to the regular rent, the lessee may have other payments, for which deductions may be taken.

a. When a leasehold is acquired for a business purposes for a specified sum, the purchaser may
take a deduction in his return an aliquot part of such sum each year, based on the number of
years the lease will run.
b. Taxes paid by the lessee to or for the lessor and other obligations of the lessor paid by the lessee
under a lease contract constitute additional rent expense for the lessee.
c. The cost of leasehold improvements may be recovered by the lessee over the remaining term of
the lease, or over the life of the improvements whichever period is shorter.

Example 1: R Company is a lessee of the building. Under the terms of the lease contract, it had to make
the following payments:

Monthly rental P50,000

Premium on the fire insurance of the building 10,000
Real estate tax on the land and building 20,000

The deduction of R company for the year is a total of:

Rentals for the year (P50,000 x 12) P600,000

Premium on fire insurance 10,000
Real estate tax 20,000

Total P630,000

Example 2: Santos Company, a lessee, constructed a building on leased land at a cost to him of
P4,000,000. The useful life of the building is 50 years while the remaining term of the lease is 40 years.

How much is the annual deduction for Santos company?

Solution:

The annual deduction for Santos company is P4,000,000 divided by 40 years or P100,000.

Repairs:

Given the following accounting entries:

Entry No. 1 : Repairs P100,000

Cash P100,000

Entry No. 2 : Accumulated depreciation P1,000,000

Cash P1,000,000

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Explanation:

Entry No 1. Records an expenditure which is deductible from gross income. This is just a minor repair
that keeps an asset in its regular operating condition.

Entry No. 2. Records an expenditure that is not deductible form gross income. The entry represents a
major or extraordinary repair, that does not add value to the asset but prolongs its useful life.

Cost of materials and supplies:

Physical inventories to these items must be taken. The expense deductible to this item must be
computed as follows:

Inventories, beginning P300,000

Add: Purchases of materials and supplies during the year 600,000

Total P900,000
Less: Inventories, ending 100,000

Deductible expense for materials and supplies during the year P800,000

Entertainment, amusement and recreation expenses:

Expenses such as this is deductible from gross income if:

a. Directly connected to the development, management, and operations of trade or business of the
taxpayer;
b. Directly related to the furtherance of its trade, or business;

The deduction should not exceed one half percent (1/2%) of net sales (in the case of sale of goods) and
one percent (1%) of net revenues (sale of services).

Any expenses incurred that is contrary to law, morals, public policy or public order will not be allowed as
deduction from gross income.

Expenses of private educational institutions:

An expenditure for expansion of school facilities is a capital expenditure, However, the school may treat
the expenditures in two alternative ways:

1. Deduct the expenditure from its gross income in the year in which it was made; or
2. Capitalize the expenditure, and calim deduction by way of depreciation.

Illustrative example:

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A private educational institution had a gross income of P50,000,000 and expenses of P30,000,000 before
considering an expenditure of P4,000,000 for a building to separately house one of its colleges. The
building has a useful life of 25 years.

Taxable income under alternative treatments for the expenditures?

Solution:
a. When claimed as an outright deduction:

Gross income P50,000,000

Less: Expenses 30,000,000
Net income before expenditure on building 20,000,000

Less; Deduction for expenditure on expansion of school facilities 4,000,000

Taxable income P16,000,000

b. If depreciation is taken on the building:

Gross income P50,000,000

Less: Expenses P30,000,000
Depreciation of new building (P4,000,000/25 years) 160,000 30,160,000

Taxable income P19,840,000

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