Ch. 13: Principles of Deductions

Question 1

Explain what deductions from gross income are?

Answer 1

pertain to business expenses incurred by a taxpayer engaged in business or engaged in the practice of profession

Question 2

What is a business

Answer 2

means a habitual engagement in a commercial activity involving the regular sale of goods and services to customers or clients.

Question 3

In taxation, business means what?

Answer 3

the term business is generally used to include the exercise of a profession.

Question 4

Is self-employment considered a business?

Answer 4

Yes, but normal employment is not a business

Question 5

Differentiate Business expense to Personal Expenses

Answer 5

Business expense are costs of doing trade, business or practice of profession such as employee salaries, office utilities, supplies and rent, taxes, losses, bad debts, depreciation on business properties, research and development and the like.

Personal expenses include the living and family expenses of individual taxpayers such as family food, personal recreation and transportation, medication, home rentals and utilities, tuition fees of dependents, and other similar expenses.

Question 6

How do we treat common expenses? (Common meaning intended for both business and personal use)

Answer 6

Expenses that are intended for both the business and for personal use of the taxpayer are allocated between the two. Only those that pertain to the business are deductible.

Question 7

Differentiate Business Expense to Business Capital Expenditure

Answer 7

Business expenses benefit only the current accounting period. Capital expenditures are expenses that benefit future accounting periods.

Question 8

What is a business expense?

Answer 8

These are costs of generating income or gains for the current period. Hence, these are deductible against gross income in the current period.

Question 9

What is a business capital expenditure?

Answer 9

These are initially recorded as assets upon acquisition then later deducted against future gross income when used in the trade, business or profession of the taxpayer. The advanced deduction of capital expenditures is not warranted as it contradicts the Lifeblood Doctrine.

Question 10

Property, plant, and equipment pertain to

Answer 10

all types of properties used or reserved for use in the business of the taxpayer

Question 11

Depreciable properties pertain to

Answer 11

those that decrease in value through normal wear and tear by usage or through obsolescence by passage of time

Question 12

Inventory includes

Answer 12

merchandise intended for sale. It may also include tools and supplies used by the taxpayer in his business

Question 13

Investments are

Answer 13

assets purchased which are intended to earn from appreciation in value or for accrual of income such as dividends and interest

Question 14

How do we treat a intangible property?

Answer 14

The acquisition of intangible assets such as patents and franchises constitutes capital expenditure that must be amortized (deducted) over the period they are expected to be used

Question 15

How are expenses incurred to promote business goodwill treated?

Answer 15

Expenses incurred to create or maintain some form of goodwill for the taxpayer’s trade or business or for the industry or profession of which the taxpayer is a member are non-deductible. These expenditures are expected to benefit future periods; hence, they should be amortized over the period of years during which the benefits of the expenditures are realized

Question 16

How are rental payments on finance lease that transfers ownership treated?

Answer 16

Rentals on a finance lease or capital lease that transfers ownership at the end of lease term, commonly known as “rent-to-own” arrangements are not considered expense. The rentals constitute acquisition cost of the leased property that should be initially capitalized. The capitalized cost shall be depreciated throughout the useful life of the property. For all other finance leases under the GAAP, the rental payments can be considered as expenses for tax purposes

Question 17

What are the rules on deducting capital expenditures of a non-depreciable asset?

Answer 17

The cost of assets that do not depreciate by usage or by passage of time such as land is deducted against the selling price when sold

Question 18

What are the rules on deducting capital expenditures on depreciable properties?

Answer 18

The “depreciable cost” or the acquisition cost, net of expected salvage value, is allocated as deduction over the useful life of the property.

Question 19

What is the useful life of a depreciable property?

Answer 19

The useful life of the property is the length of time it is expected to be serviceable or its legal life. If applicable, whichever is lower.

Question 20

The taxpayer and CIR may enter into a written agreement on the estimated useful life and rate of depreciation of any property. Any change in the agreed rate and useful life shall be applied?

Answer 20

prospectively starting on the taxable period when notice by certified mail or registered mail is rendered by the initiating party to the other party.

Question 21

How do we treat immaterial capital expenditures?

Answer 21

The acquisition of items of PPE, inventories or prepayments of expenses which are relatively immaterial in amount may be deducted outright as expense upon acquisition as this will not materially distort net income. Moreover, the inventory method may likewise be impractical to use for such items.

Question 22

Items of special considerations with deductions

Answer 22

1. Property repairs and improvements
2. Property acquisition-related costs
3. Securities issue costs
4. Manufacturing expenses
5. Effects of accounting methods
6. Effects of value added tax

Question 23

When are expenses related to property repairs and improvements capitalized?

Answer 23

Repairs that significantly increase the value or prolong the useful life of properties are capital expenditures. These are capitalized to the adjusted tax basis of the property and are included in the subsequent annual provision for depreciation.

Question 24

When are expenses related to property repairs and improvements outright expensed?

Answer 24

Repairs that merely restore the value or functionality of the property without causing increase in fair value or useful life of the property shall be deducted as outright expense

Question 25

What happens to the actual cost of the repairs, improvements, additions if the fair value of the property increases

Answer 25

The actual cost of repairs, improvements, additions should be capitalized not to exceed the appreciation in fair value.

Question 26

What happens to the actual cost of the repairs, improvements, additions if the fair value of the property is undeterminable?

Answer 26

The excess of the actual repair cost over the tax basis of the property is presumed a capitalizable increase in fair value

Question 27

How are replacement of old or destroyed properties treated?

Answer 27

The tax basis of the old property is deductible as a loss, but the cost of the replacement property is capitalized subject to future provisions for depreciation

Question 28

How are the cost of demolishing old buildings?

Answer 28

When land was acquired with an old building in it but was not intended to be used by the buyer, the entire amount paid is assigned only to the land.

The costs of demolishing the old building, net of any salvage scrap, are treated as additional cost of the acquisition of the land, and is capitalized as part of the cost of the replacement building

Question 29

How are asset acquisition-related costs treated?

Answer 29

All costs directly related to acquisition of n item of PPE, such as in-transit insurance, title guarantee insurance, freight, finder’s fee or commissions, import duties, and other taxes are capitalized as part of the cost of the property subject to depreciation

Question 30

How are the cost of financing asset acquisition treated?

Answer 30

It may, at the option of the taxpayer, be expensed outright or capitalized and depreciated

Question 31

How are security issue costs treated?

Answer 31

Expenses of issuing equity or debt securities, are not deductible expense against gross income. They are deducted against the proceeds of such securities.

Question 32

How are manufacturing expenses treated?

Answer 32

Plant or factory expenses such as cost of raw materials and supplies used, labor, and other overhead like utilities, maintenance and security, supplies and depreciation are capitalized as part of the cost of the goods being processed and are expensed through cost of goods sold

Question 33

What is the effect of accounting methods on deductions?

Answer 33

The methods adopted by the taxpayer in accounting for expense have a significant bearing on the deductible expense. It must be recalled that under cash basis, expenses are deductible when paid regardless of when they accrue while under the accrual basis, expenses are deductible when they accrue regardless of when they are paid. However, prepayments and capital expenditures cannot be deducted outright.

Question 34

What is the effect of VAT on Deductions

Answer 34

When purchases of goods and services are made from VAT suppliers, taxpayers will pay the VAT passed-on by the supplier. To the seller’s perspective, this is called output VAT. But to the buyer, this is called input VAT

Question 35

What is the treatment for input VAT

Answer 35

a. For VAT taxpayer, the input VAT is claimable as tax credit against output VAT; hence, it is not claimable as deduction
b. For non-VAT taxpayer, the input VAT is part of costs of the purchase or expense of the taxpayer; hence, it is claimable as deduction

Question 36

What are the general principles of deductions from gross income?

Answer 36

1. Expenses must be legitimate, ordinary, actual, and necessary (LOAN)
2. The Matching Principle
3. The Related Party Rule
4. The Withholding Rule

Question 37

What is the Loan Principle?

Answer 37

A deductible business expense is legitimate, ordinary, actual and necessary

Question 38

What are the characteristics of a legitimate business expense?

Answer 38

1. It is incurred in and for the current taxable period
2. It is not a capital expenditure
3. It pertains to the business or profession of the taxpayer
4. It is not contrary to law, public policy, or morals
5. It is adequately substantiated with receipts or other documents

Question 39

A deductible expense must be both?

Answer 39

ordinary and necessary

Question 40

An expense is necessary if

Answer 40

reasonable and essential to the development, management, operation, or conduct of trade, business, profession of the taxpayer.

Question 41

An expense is ordinary when

Answer 41

it is normal in relation to the business of the taxpayer and the surrounding circumstances. An expense is also said to be ordinary if it is incurred by other taxpayers under the same line of business.

Question 42

What is meant by actual expense?

Answer 42

An expense is actual if it is paid or resulted to an incurrence of an obligation of the taxpayer. In case of a loss, it must be sustained or realized by the taxpayer in a “closed and completed transaction”

Question 43

What is meant by “closed and completed transaction”

Answer 43

A transaction is said to be closed and completed when no further transaction emanates from its reoccurrence. In other words, no right of recourse for indemnification or reimbursement from other parties exists.

Question 44

What is meant by the matching principle rule

Answer 44

It is well-established rule in income taxation that only business expenses that are incurred for the generation of items of gross income subject to regular tax are deductible. This is a pervasive criterion that is consistently observed by the NIRC, revenue regulations, and BIR rulings.

Question 45

What is the related party rule?

Answer 45

“Gains realized between related parties are taxable, but losses are non-deductible”
The rule is intended as a control measure due to the fact that related party transactions can be easily tailored in a way to evade taxes. This rule is particularly relevant to the claim of losses, bad debts, and interest expenses

Question 46

Who are the related parties?

Answer 46

1. Members of a family
2. Except in cases of distribution in liquidation, the direct or indirect controlling individual of a corporation
3. Except in cases of distribution in liquidation, corporations under direct or indirect common control by or for the same individual
4. Grantor and fiduciary of any trust
5. Fiduciaries of trust with the same grantor
   6 . Fiduciary of a trust and the beneficiary of such trust

Question 47

Members of a family includes

Answer 47

brothers and sisters (whether half-blood or full-blood), spouse, lineal ascendants and descendants

Question 48

Control means

Answer 48

ownership of more than 1/2 of the voting stocks of a corporation

Question 49

What is the withholding rule?

Answer 49

Payors of income are required to withhold income taxes on their payments. he failure to comply with this requirement shall result in the disallowance of the expense as deduction. The rule is “no withholding, no deduction.”

Question 50

When is the timing of withholding of tax?

Answer 50

Per RR12-2001, the obligation of the payor to deduct and withhold tax from the income payment arises upon the occurrence of any of the following, whichever comes first:
a. Payment
b. when the income payment becomes due or payable
c. recording of the income payment as expense or asset in the books

Question 51

How is late payment of withholding taxes treated?

Answer 51

Under the new rules, expenses will still be deductible even if the withholding tax, surcharge including interest of such late withholding is paid at the time of audit investigation or reinvestigation. This is a reversal of the previous rule that no deduction is allowed even if the withholding tax and penalties is subsequently paid.

Question 52

When is the period for which deductions and credits are taken?

Answer 52

The deductions shall be taken for the taxable year paid or accrued depending upon the method of accounting employed by the taxpayer, unless in order to clearly reflect the income, the deductions should be taken as of a different period.

Question 53

What are the tax reporting classification of deductions

Answer 53

1. Cost of sales or cost of services
2. Ordinary allowable itemized deductions
3. Special allowable itemized deductions
4. Net Operating Loss Carry Over (NOLCO)

Question 54

Explain the cost of sales or cost of services deductions

Answer 54

These are deducted outright against sales, revenues, receipts, or fees of individual taxpayers in the measurement of gross income from operations

Question 55

Explain ordinary allowable itemized deductions

Answer 55

also referred to as regular allowable itemized deductions, pertain to all necessary and ordinary expenses paid on incurred during the taxable year including directly attributable costs in carrying on the development, management, operation and/or conduct of tade, business, or exercise of profession

Question 56

Explain special allowable itemized deductions

Answer 56

are other deductions under the NIRC, or special laws that are not arising from normal business operations

Question 57

Special allowable deductions may be categorized into two types, what is it?

Answer 57

1. Deduction incentives - bonus deductions for taxpayers
2. Special deductions - those mandated by the NIRC special laws to be treated as deduction against gross income

Question 58

Explain the Net Operating Loss Carry-Over

Answer 58

pertains to the excess of expense deduction over gross income during the taxable year which is allowed by the law to be deducted against the net income of the following three years.

Question 59

What are the mode of claiming deductions from gross income

Answer 59

1. Itemized deduction
2. Optional Standard Deduction

Question 60

Explain itemized deductions

Answer 60

Under itemized deductions, taxpayers list every item of business expense they claim as deductions. The taxpayer has to point to the provision of the law authorizing the deduction, substantiate his claim by supporting the deduction with official receipts, payment vouchers, cancelled checks or other adequate records and documentations, and comply with any withholding tax requirements on expenses. Deductions claimed must also comply with any applicable deductions ceiling set by law

Question 61

Explain optional standard deduction

Answer 61

The optional standard deduction is in lieu of the itemized deductions, regular or special, including NOLCO. The deduction is merely presumed as a fixed percentage of gross income for corporations and gross sales or gross receipts for individuals.