Lesson 10

Deductions from Gross Income: Itemized Deductions

Items of Deduction
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 deduction in such taxable year.
Note: If the borrower is a corporation, pre-deducted interest
could be claimed as deduction in the year of granting of the
loan.
2. Interest payments with related parties
3. If 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
Note: the capitalization of borrowing cost under PAS 23 is not
followed for taxation purposes. The interest expense up to
repayment of the debt may be capitalized.
 Special Cases:
1. Interest on preferred stock – these are dividends; hence, not
deductible on interest
2. Interest on scrip dividends – since there is 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; however, the
deductible tax component is the proper tax only. Interest on
delinquent taxes is deductible from gross income but as “interest
expense” not taxes.
Note: no deduction is allowed for surcharges or penalties on
delinquent taxes. Interest in tax delinquency is deductible as
interest expense.
 Requisites:
B. must be paid or accrued within the taxable year
C. must be incurred in connection with the taxpayer’s trade,
professional or business
 Non-deductible Taxes:
1. Philippine income tax, except fringe benefit tax
2. Estate or donor’s tax
3. Special assessment
4. Income tax imposed by a foreign country if the taxpayer opted to
claim them as deduction rather than as tax credit
5. Stock transaction tax
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Lesson 10
Deductions from Gross Income: Itemized Deductions
6. Value-added tax on business

 Tax Credit for Foreign Income Tax Paid

Can be claimed only by those taxable on world income such as
resident citizen and domestic corporations
 Taxpayers have the option to claim the foreign income tax either
as:
1. tax credit or
2. deduction from income
 Limit of Tax Credit:
a. 1st Limitation: Per Country Evaluation - whichever is lower of
the actual amount of foreign tax paid and the amount which
reflects the ratio which the gross income from the foreign
country bears with the total world taxable income to the
Philippine income tax
For instance, the amount creditable or deductible for tax paid
per foreign country is:

b. 2nd Limitation: Total Foreign Country Evaluation: whichever is

lower of the aggregate lower values of the per-country evaluation
and the amount which reflects the ratio of the taxable income
from all foreign countries bears with the total world taxable
income to the Philippine tax.

 Rules on Income Taxes Paid:

 Refund of taxes: The refund of a deductible tax is taxable if it

created a tax benefit in the year it is deducted
C. Losses
1. Ordinary Loss
Requisites:
a. loss must be actually sustained during the taxable year
b. not compensated for by insurance or other forms of indemnity
c. it must be sustained in a close and completed transaction
d. the loss must be that of the taxpayer
e. the loss must be reported to the BIR within 45 days from the
date of loss or discovery
f. not claimed as a deduction in the estate tax return for
individual income taxpayer only*
Note: *In estate taxation, losses incurred during the settlement of
the estate such as theft of property or results of calamity may be
claimed as deduction in determining the net taxable estate.
Deductible losses:
a. loss incurred in trade, profession or business
b. loss due to fire, storm, shipwreck or other casualty of
property connected with trade, profession or business
c. loss due to theft, robbery, or embezzlement if the property is
connected with trade, profession or business
Measure of the loss:
1. Total Loss – book value of the property
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Lesson 10
Deductions from Gross Income: Itemized Deductions
2. Partial Loss – replacement cost of the damaged portion of the
asset or the book value thereof at the time of loss, whichever
is lower.
Note: The asset must be written-off before a loss can be claimed
as a deduction.
Abandonment Losses
1. Petroleum operation – all accumulated exploration and
development expenditures pertaining to partially or wholly
abandoned of contract area shall be allowed as a deduction,
provided notice of abandonment shall be filed with the
Commissioner of Internal Revenue
2. Producing wells – 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
Note: if the abandoned well is re-entered and production is
resumed, or if such equipment is restored into use, the same cost
claimed as deduction shall be reverted back into gross income
subject to the income tax benefit rule
Special Cases:
1. If there is a pending proceeding in which the loss can be
recovered, deduction for the loss is delayed until the
recovery becomes impossible. Pending the resolution of the
proceeding, the transaction is not yet complete; hence, the
loss is not yet sustained.
2. Loss of income – cannot be deducted unless the related income
has already been included in gross income (For example:
worthless receivable is not deductible under cash basis of
reporting income).
3. Losses on sale or exchanges of property with related parties –
not deductible.
Net Operating Loss Carry Over (NOLCO)
o 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 the year of such loss provided there is no
substantial change in the ownership of the business.
2. Capital Loss
o Capital losses are deductible only to the extent of capital
gains. But a net capital loss carry-over can be deducted in
the following year it arose for non-corporate taxpayers.
(Please check handouts in Dealings in Properties.)
D. Bad Debts
Requisites:
1. There must be valid and subsisting debt due to the taxpayer.
2. it must be connected with the taxpayer’s trade, profession or
business
3. the debt is actually ascertained to be worthless
4. it must be charged-off within the taxable years
Recovery of bad debts
a. Taxpayers under cash basis – Taxable but subject to Income Tax
Benefit Rule
b. Taxpayers under accrual basis – Always taxable
Non-deductible bad debts:
1. Those incurred under cash basis of reporting gross income
2. Those sustained in a transaction entered into by related parties
3. For taxpayers not taxable on world income, those that represents
loss of foreign income.

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Lesson 10
Deductions from Gross Income: Itemized Deductions
 The rules on bad debts may be applicable to debt securities
becoming worthless for dealers in securities only such as domestic
banks and trusts companies whose major part of business are dealing
with securities. For other taxpayers where such security is a
capital asset, the rules on capital loss apply and are deductible
subject to limit.
Special Cases with Bad Debts:
o Receivables assigned without recourse – only the difference of
amount paid and amount recovered is allowed as deduction.
E. Depreciation
Requisites:
1. the property must be used in trade, profession or business
2. the property must have a limited useful life
3. the provision must be charged off during the taxable year
4. the provision must be reasonable
Special Option with depreciation:
1. For a proprietary or private educational institution only
2. May either choose to:
a. charged off as capital outlays of depreciable asset in the
year of acquisition; or
b. deduct allowance for depreciation
Basis of Depreciation - The fair market value at the time of
acquisition
a. The taxpayer and the Commissioner of Internal Revenue shall agree
in writing about the useful life and rate of depreciation. Such
agreement shall be binding upon the taxpayer and the National
Government in the absence of circumstances not taken into
consideration during the adoption of the agreement.
b. Any change in the agreed rate and useful life shall operate
prospectively.
c. In default of such agreement, the adoption of the taxpayer of
useful life and depreciation rate for depreciable assets without
the objection of the Commissioner or his duly authorized
representative shall be considered binding.
Methods of Depreciation
1. Straight line
2. Declining balance
3. Sum of the years
4. Other methods which may be prescribed by the Secretary of Finance
upon recommendation of the Commissioner of Internal Revenue
Petroleum Operation:
o The taxpayer may choose either declining-balance method or
straight-line method at the option of the contractor.
o Useful life of depreciable asset:
 used in or related to the production of petroleum – 10
years or shorter as may be permitted by the Commissioner
of Internal Revenue
 not used in or not related to the production of petroleum
– 5 years under straight line method
Mining Operations:
o For all properties used in mining operations, other than
petroleum operation:
 10 year useful life or less – At normal rate of
depreciation
 More than 10 years useful life – depreciated over any
number of years between 5 and the expected life. Provided
the taxpayer notifies the CIR at the beginning of the
deprecation period of the rate to be used.
F. Depletion (Cost Depletion) – available only for oil and gas wells and
mines.
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Lesson 10
Deductions from Gross Income: Itemized Deductions
 Exploration Expenditure – expenditures paid or incurred in
ascertaining the existence, location and extent, or quality of any
deposit or ore or other minerals before the beginning of the
development stage of the mine or deposit.
 Development Expenditure – paid or incurred during the development
stage of the mine. The development stage begins when ore or other
minerals are shown to exist in commercial quality and quantity and
end upon commencement of actual commercial extraction.
Method to Use: Cost-Depletion Method
 Depletion should be provided only up to the extent of capital
investment in the mine only.

Oil and Gas Wells or Mines: Treatment of Intangible Exploration and

Development Drilling Costs
 Provided that production in commercial quantities has commenced,
if intangible development drilling cost are incurred for:
i. Non-producing wells and or mines – deductible in the year
incurred
ii. Producing wells and or mines – at the option of the
taxpayer, deduction in full in the year paid or incurred, or
capitalized and amortized
Note: 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:

G. Charitable and Other Contributions

Requisites:
1. the contribution or gift must be actually paid
2. the contribution of property must be measured based on
acquisition cost
3. it must be given to an organization specified by law
4. net income of the specified institution must not inure to the
benefit of any private stockholder or individual
5. the person making the contribution must be engaged in trade,
business or profession
Note: if the taxpayer is not engaged in trade, business or
profession, the rules on Donor’s taxation applies. Similar gifts
are usually exempt under donor’s taxation provided that not more
than 30% of the donation is used for administrative purposes by
such done non-profit entity.
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Lesson 10
Deductions from Gross Income: Itemized Deductions
Classification of contributions
1. Fully deductible contributions
a. Donation to the government or political subdivisions
including fully owned government and controlled corporations
to be used exclusively in undertaking priority activities
in:
i. Education
ii. Health
iii. Youth and sport development
iv. Human settlements
v. Culture and sports
vi. Economic developments
Provided, donation to the government that is not in
accordance with priority activities are subject to limit.
b. Donation to foreign institutions or international
organizations in compliance with agreement or treaties.
c. Donations to accredited domestic non-government
organizations. These include organizations 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
x. Any combination of the listed purposes
Requisites:
a. 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
b. the administrative expense must not exceed 30% of the total
expenses
c. Upon dissolution, assets must be distributed to another non-
profit domestic corporation of to the Government
 If these conditions are not complied with, the donation
is subject to limit
2. Contributions subject to limit
a. Donations to the Government of the Philippines or political
subdivisions exclusively for public purposes (nonpriority
activities)
b. Donations to non-government organizations or to domestic
corporations organized exclusively for the following
purposes:
i. Religious
ii. Charitable
iii. Scientific
iv. Youth and sports development
v. Cultural
vi. Educational
vii. Rehabilitation of veterans
viii. Social welfare
Limit of deduction:
o Based on the taxable income derived from business or
profession prior to the deduction of contributions (either
fully deductible or subject to limit)
 10% for Individual
 5% for Corporations
Deductible Contribution subject to limit
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Lesson 10
Deductions from Gross Income: Itemized Deductions
o The deductible contribution subject to limit shall be
whichever is lower of the actual contribution with the limit
as set forth herein.
H. Contribution to Pension Trust
B. Current Service Cost – actually computed value of services rendered
by a plan employee during the year
C. Past Service Cost – value of services rendered by employees in the
past that partially satisfy vesting conditions
Rules for Pension Expense:
1. Payments to the trust to cover pension liability accruing during
the year (current service cost) are fully deductible expense for
the taxable year.
2. Payment to the trust in excess of the current period costs is
attributed to past service cost up to the balance of unfunded
past service cost. Funding of past service cost is amortized
over a period of 10 years starting from the year in which the
contribution was made.
Actuarially, costs that accrue during the current year include the
value of services rendered currently (current service cost and
interest cost).
Note: Deductions claimed for non-vesting employees should be
reversed to gross income.
I. Research and Development Cost
Requisites:
1. It must be paid or incurred during the taxable year
2. it must be connected with the trade, profession or business of
the taxpayer
3. it is not chargeable to capital accounts (capitalizable
expenditure)
Amortization of Capitalizable Research and Development Costs that are
not chargeable to a property of a kind that is subject to depreciation
or depletion:
1. The taxpayer should treat the expenditure as a deferred charge
2. 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:
1. expenditure for the acquisition of the improvement of land (in
connection with research projects)
2. 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; and (these items are
capitalized then charged off to depreciation)
3. 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)
J. Expenses, in general
Requisites:
1. it must be ordinary and necessary
2. it must be paid or incurred during the taxable year
3. it must be directly attributable to the development, operation,
management and or conduct of the trade, profession or business
4. it must be reasonable
5. 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
6. it must be supported by official receipts or adequate records
A. Compensation
Requisites:
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Lesson 10
Deductions from Gross Income: Itemized Deductions
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
B. Traveling Expenses
Requisites:
1. must be incurred while away from home
2. in pursuant of a trade, profession or business
C. 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 (local or national,
including government-owned and controlled corporations) or to
a private individual, corporation, General Professional
Partnership or a similar entity, if it constitutes 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:
1. Taxpayers deriving income from either sale of properties or sale
of services:
o Whichever is lower of the following and the actual EAR
expense
 Taxpayers engaged in sale of goods or properties – ½ of
1% (or .5%) of net sales (i.e.: sales less sales
returns, allowances and discounts)
 Taxpayers engaged in sale of services (profession,
lessors) – 1% of net revenue (i.e.: gross revenue less
discounts)
2. Taxpayers deriving income from both sales of properties and sales
of services, the deductible amount shall be whichever is lower
between the two tests below:
o 1st Limit Test:
 Note: The tentative deductible amounts are first
determined using rules 1 and 2 above for each
respective class of business (service or sales).
 The final deductible amounts shall be whichever is
lower of the respective tentative deductible amount and
the respective amounts which the total sales or revenue
bears to the total sales and revenue bears to the
actual entertainment, amusement or recreation expenses.
o 2nd Limit Test:

Major Classification of Items Deductions

1. Cost of sales / cost of services
 Cost of services –covers all direct costs and expenses necessary
to provide the service required by customers such as:
a. Salaries and employee benefits of personnel, consultants and
specialists directly rendering the service
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Lesson 10
Deductions from Gross Income: Itemized Deductions
b. Cost of facilities directly utilized in providing the
service such as depreciation or rental of equipment used and
cost of supplies
 The cost of services of banks includes interest expense.
2. Ordinary allowable itemized deductions
3. Special allowable itemized deductions
4. Net operating loss carry over

BIR Form 1701 Deduction classifications

1. Amortizations
2. Bad debts
3. Charitable and other contributions
4. Depletion
5. Depreciation
6. Entertainment, amusement and recreation
7. Fringe benefits
8. Interest
9. Losses
10. Pension trusts
11. Rental
12. Research and development
13. Salaries, wages and allowances
14. SSS, PhilHealth, HDMF and other contributions
15. Taxes and licenses
16. Transportation and travel
17. Others (janitorial, professional, security, etc.)

BIR Form 1702 Deduction classifications

1. Advertising and promotions
2. Amortizations
3. Bad debts
4. Charitable contributions
5. Commissions
6. Communications, light and water
7. Depletion
8. Director’s fees
9. Fringe benefits
10. Fuel and oil
11. Insurance
12. Interest
13. Janitorial and messengerial services
14. Losses
15. Managerial and consultancy fees
16. Miscellaneous
17. Office supplies
18. Other services
19. Professional fees
20. Rental
21. Repairs and maintenance – labor and or materials
22. Repairs and maintenance – materials/supplies
23. Representation and entertainment
24. Research and development
25. Royalties
26. Salaries and allowances
27. Security services
28. SSS, GSIS, PhilHealth, HDMF and other contributions
29. Taxes and licenses
30. Tolling fees
31. Training and seminars
32. Transportation and travels
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Lesson 10
Deductions from Gross Income: Itemized Deductions
33. Others

Special Allowable Itemized Deductions

o There are two types of special allowable itemized deductions:
1. Special expense under the NIRC and special laws – with outflows
2. Deduction incentives under special laws – no outflows

Special Expenses
1. Income distribution of taxable estate and trust
2. Transfers to reserve funds and payments to policies and annuity
contracts of insurance companies
3. Dividend distribution of REITs
4. Transfers to reserve funds of cooperatives
5. Discounts to senior citizens and PWDs

Deduction incentives
1. Additional compensation expense for SCs and PWDs
2. Cost of facility improvements for PWDs
3. Additional training expense on jewelry industry
4. Additional contribution expense on Adopt-a-School program
5. Additional deductions on rooming-in and breastfeeding program
6. Additional free legal assistance expense
7. Additional productivity incentive bonus expense

Required disclosures:
1. Description of the special deduction
2. Legal basis
3. Amount

Net Operating Loss Carry Over (NOLCO)

o Measurement: Exclude NOLCO and deduction incentives
o Requisites:
1. Taxpayers must not be exempt from income tax during the taxable
year the NOL was incurred.
2. There must be no substantial change in ownership of the business
enterprise

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