Chapter VI

Outline/Overview
Cost and Deductions from Gross Income
Non Deductible Items
Personal Exemptions

A. Return of Capital
B. Deductions from Gross Income
C. Itemized Deductions

1. Business Expenses
2. Interest Expenses
3. Taxes
4. Losses
5. Bad Debts
6. Depreciation
7. Depletion
8. Charitable and other contributions
9. Research and Development
10. Pension Trusts

D. Optional Standard Deductions (OSD)
E. Special Additional Deductions
F. Personal and Additional Exemptions
G. Items not deductible


















A. Return of Capital the cost to acquire the asset
Since income tax is levied only on income, gain or profit. The cost to acquire the asset (return of
capital) should be deducted from the sales proceeds and thus not subject to income tax.

Example:
Sale of real property
Land bought in 1970 at the price of P100,000
Made some improvements on the land costing P200,000 in 1998
Sold the said land for P1M in 2009 which is equal to the Fair market value of BIR

Gross selling price P1,000,000
Less: Cost of Land P100,000
Cost of Improvement 200,000______P 300,000____
Gain from sale (or Gross Income) P 700,000

Sale of goods by a dealer
Dealer of furniture at the beginning of the year has an inventory of P2,000
Bought furniture for P10,000
Sold the furniture for the year at P12,000
At the end of the year it has an inventory left amounting to P4,000

Gross selling price P12,000
Less: Cost of sales
Beg inventory P2,000
Purchases 10,000
End inventory (4,000)________P 8,000______
Gross income P 4,000

Sale of goods by a manufacturer









B. Deductions from Gross Income
Deductions are strictly construed against the taxpayer this means he who claims a deduction
must point to the specific provision in the law authoring it and be able to prove that he is
entitled to it.

Cases:

Western Minolco Corporation v Commisioner tax exemptions are looked upon with disfavor

Commissioner of Customs v Philippine Acetylene Co., 39 SCRA 70 Exemption must be expressly
stated in the law, the taxpayer must atleast be within the purview of the exemption by clear
legislative intent.

Commissioner v Arnoldus Carpentry Shop, L-71122 Mar 25, 1988 If there is an express mention
or if the taxpayers falls within the purview of the exemption by clear intent, the rule on strict
construction will not apply.

BPI v Trinidad, 45 Phil 384 exemption claimed merely on the ground that another person
situated in the same circumstances has not been required to pay or has not paid similar taxes is
unjustifiable and should be ignored.

Types of Deductions
a. The itemized deductions from gross income - Tax Code Section 34 (A) to (J) and (M)
Applicable to all kinds of taxpayers engaged in trade or business or practice of profession
b. Optional Standard Deduction - Tax code Section 34 (L)
Use to be applicable only to individual but now it is available as well to corporation;
c. Special deductions for insurance companies Section 37 and 38
Qualified taxpayer is allowed to deduct 150% of the amount actually paid as deduction
Note: Taxpayers claiming deductions must present and submit adequate receipts or invoices in
support of such deductions; otherwise, the claimed deductions may be disallowed by the BIR.

C. Itemized Deductions Section 34; Section 37 and Section 38; Other itemized deductions could
be granted under general or special laws. Ex PEZA registered enterprises are allowed training
expenses as deductions.








1. Business Expenses
Conditions to be considered deductibility in a business:
Expense must be ordinary and necessary
o Ordinary it connotes a payment which is normal in relation to the business
o Necessary expenditure is appropriate or helpful in the development of the
business or that the same is proper for the purpose of realizing a profit or
minimizing a loss (General Electric v Collector, CTA case 1117, July 14, 1963)
Eg. VisayanCebu Terminal Co v Collector, CTA Case 128, June 29, 1957 and
Hicks v Collector, CTA Case 38, Oct 19, 1955 entertainment expenses has
been allowed as constituted part of the duties assigned to the employee.
Paid within the taxable year claimed as deductions
Directly attributable to the development, management operation and/or conduct of
the trade, business or exercise of profession.
Supported by adequate invoices or receipts
Not contrary to law, publice policy or morals
Tax withheld on the amount paid should have been remitted to the BIR
Examples of business expenses:
Management expenses
Professional fees are deductible in the year the professional services are rendered,
not in the year they are billed, provided that the all events test is present.
Commissions commission payment by a company set up to manage the portfolio
of mutual fund companies, may be amortized over the period to which it relates
under certain conditions
Compensation for personal services it should pass the test of deductibility is
whether they are reasonable compensation and are, in fact payments purely for
service.
Salaries expense needs to be:
o Both ordinary and necessary
o Paid or incurred within the taxable year
o Incurred in carrying on a trade or business
o Must be in fact salaries or other compensation
o Must be for personal services actually rendered
o Must be reasonable in amount

Treatment of excessive compensation the income tax liability of the recipient
in respect of an amount of ostensibly paid to him as compensation will depend
upon the circumstances of each case. It may be found to be distribution of
earnings or profits, the excessive payments will be treated as dividends.
(Aguinaldo Industries Corporation v Collector, CTA Case 1636, June 29, 1968)

Test for determining the reasonableness of a given bonus as compensation
depends upon many factors, one of them being the amount and quality of the
services performed in relation to the business.
Other tests suggested are: payment in good faith, character of the taxpayers
business, the volume and amount of its net earnings, its locality, the type and
extent of the services rendered.
In determining whether the particular salary or compensation payment is
reasonable, the situation must be considered as a whole.
(CM Hoskins & Co., Inc v Commissioner, L-24059, Nov 28, 1969; Pacific Banking
Corp v Commissioner, CTA Case 1667, Oct 29, 1970)

Christmas bonuses are deductible if intended as additional compensation. But
where such bonuses are considered out-and-out gifts, they are gratitude and
are not deductible. (Greenville Textile Supply Co., 1 BTA 1952).

Separation bonuses of directors shall be disallowed where there were no past
services rendered warranting the payment thereof. The recipients were
members of the board of directors (Talisay-Silay Milling Co v Collector, supra).

Compensation for injuries amounts paid for pensions to retired employees or
to their families or others dependent upon them or on account of injuries
received by employees and lump-sum amounts paid or accrued as
compensation for injuries, are proper deductions as ordinary and necessary
expenses.


Advertising Expenses- (Commissioner v General Foods Phil., GR No 143672, Apr 24,
2003) An amount disallowed by BIR was considered as capital expenditure since the
amount was staggering and it was incurred to create or maintain some form of
goodwill for the taxpayers trade or business or for the industry or profession of
which the taxpayer is a member. Therefore, expenses related thereto are not
business expenses but capital expenditures which must be allocated among the
taxable years for which it benefits physical inventories at the end of the taxable year
and consider such inventories prepayments which form part of assets.
Club dues corporations provide for the members of officers to social or athletic
clubs to promote its business such is deductible but subject to the fringe benefits
tax beginning January 1, 1998.

Cost of materials should include in expenses only to the amount that they are
actually consumed and used in operation during the year for which the return is
made.

Travelling expenses include transportation expenses and meals and lodging and its
deductible from gross income. If an individual whose business requires him to travel
receives a salary as full compensation for his services, without reimbursement for
traveling expenses, or is employed on a commission basis with no expense
allowance, his traveling expenses, including the entire amount expended for meals
and lodging, are deductible from gross income.

Expenses of professionals include the cost of supplies used in the practice,
expenses paid in the operation, repair of transportation equipment used in making
professional calls, dues to professional societies, subscriptions to professional
journals, rent, fuel, light, water telephone, hire of office assistants, books, furniture,
professional instruments and equipment


Expenses partly for business purposes expenses shall be apportioned
correspondingly (Jamir v Collector, 4 SCRA 718). Car utilized both for personal and
business needs, it is reasonable to allow as deduction one-half of the drivers salary,
car expenses and depreciation.

Expenses contrary to law or public policy or for immoral purposes shall not be
allowed as deductions. Expenses to obtain contracts with private firms or individuals
are deductible, but those spent for government officials to procure government
contracts are not deductible for being contrary to public policy. (Nava v Collector,
CTA Case No 568, Sept 25, 1961)

Political campaign expenses amounts expended for political campaign purposes or
payments to campaign funds are NOT deductible either as business expense or as
contribution (Felix Montenegro Inc v Commissioner, CTA Case 695, Apr 30, 1969)

Rental leasehold is deductible as business expense. Taxes paid to or for the
landlord are additional rent and constitute a deductible item to the tenant. The cost
borne by lessee in erecting buildings or making permanent improvements on
ground of which he is lessee is held to be a capital investment and not deductible as
a business expense. Only depreciation to the improvements will be considered as
business expense.
Repairs and maintenance these are incidental repairs that does not add to the
value of the property nor prolong its life may be considered deductible business
expenses. But it is prolonged its life, it will be considered as a capital expenditure or
capital investment. Thus, deductible business will be its depreciation. (Visayan
Transportation Co, Inc v Domingo, CTA Case 1119, Sept 30, 1964).
2. Interest Expenses
Requisites for deductibility of Interest Expense:
i. There must be indebtedness. indebtedness is something owned by one who is
unconditionally obligated or bound to pay.
ii. There should be an interest expense paid
iii. Indebtedness must be that of a taxpayer.
iv. Indebtedness must be connected with the taxpayers business or exercise of
profession
v. Interest must be stipulated in writing. In the absence of stipulation in writing
concerning interest, it is not deductible (Limpan Investment Corp v Collector, CTA
Case 1397, Dec 11, 1967)
vi. Interest must be legally due
vii. Interest payment arrangement must not be between related taxpayers
viii. Interest must not be incurred to finance petroleum operations
ix. In case of interest incurred to acquire property used in trade, business or exercise of
profession, the same was not treated as a capital expenditure.
3. Taxes
4. Losses
5. Bad Debts
6. Depreciation
7. Depletion
8. Charitable and other contributions
9. Research and Development
10. Pension Trusts

D. Optional Standard Deductions (OSD)
E. Special Additional Deductions
F. Personal and Additional Exemptions
G. Items not Deductible