Deductibility of business expenses

“A life without love is like a year without summer”, so says a Swedish proverb. 

In this summer of 2008, opportunity presents itself once more to celebrate life and love in its entire splendor.  Alas, we can even simply embrace its warm presence (at times literally reaching up to 35 degrees Centigrade) or spend it in style frolicking in some beautiful beach or a vacation spot.  And hopefully, as we take a break from school or work and seek for a change of pace or scenery, we start feeling renewed and reborn.

But whatever course we choose to take, the pragmatic in us would still keep tab of the cost to foot this summer break.  For the corporate taxpayer, while it incurs cost to provide for some sort of a summer break to its employees, will it at the same time enjoy a tax break?  In other words, may such be considered a business expense and, thus, be treated an allowable deduction against gross income? 

To put this in the proper perspective, at the outset it may be well to remind that deductions are construed strictly against the claimant.  He who claims a deduction must point to the specific provision of the statute authorizing it, and he must prove that he is entitled to it.

When we speak of business expenses as an allowable deduction from gross income, generally we refer to ordinary and necessary expenses paid or incurred during the taxable year in carrying on or which are directly attributable to, the development, management, operation and/or conduct of the trade, business or exercise of a profession. Among the items included in business expenses are reasonable allowances for:

(1) salaries, wages, and other forms of compensation for personal services actually rendered including the grossed up monetary value of fringe benefit furnished or granted by the employer to the employee;

(2) travel expenses, here and abroad while away from home in the pursuit of trade, business or profession;

(3) rentals and/or other payments which are required as a condition for the continued use or possession, for purposes of the trade, business or profession, of property to which the taxpayer has not taken or is not taking title or in which he has no equity other than that of a lessee, user or possessor;

(4) entertainment, amusement and recreation expenses during the taxable year, that are directly connected to the development, management and operation of the trade, business or profession of the taxpayer, or that are directly related to or in furtherance of the conduct of his trade, business or exercise of a profession not to exceed such ceilings by the prescribed rules and regulations, taking into account the needs as well as the special circumstances, nature and character of the industry, trade, business or profession of the taxpayer.

Based on the above, to properly claim the expense as a deduction from ordinary gross income, the following requirements must be satisfied:

(1) The expense must be ordinary and necessary;

(2) It must be paid or incurred within the taxable year;

(3) It must be paid or incurred in carrying on or which are directly attributable to the development, management, operation and/or conduct of the trade, business or exercise of profession (business test rule);

(4) It must be supported by adequate invoices or receipts (substantiation rule);

(5) It is not contrary to law, public policy or morals; and

(6) The tax required to be withheld on the expense paid or payable is shown to have been remitted to the BIR.

When do we say that an expense is “ordinary and necessary”?  In one case, the Supreme Court said that while it has never attempted to define with precision the terms “ordinary and necessary”, there are certain guiding principles worthy of serious consideration in the proper adjudication of conflicting claims.  An expense is considered “ordinary” when it connotes a payment which is normal in relation to the business of taxpayer and the surrounding circumstances.  This does not require that the payments be habitual or normal in the sense that the same taxpayer will have to make them often; the payment may be unique or non-recurring to the particular taxpayer affected.  It is “necessary” where the expenditure is appropriate and helpful in the development of the taxpayer’s business.

The Supreme Court went on to explain further that there is no hard and fast rule on the right to a deduction.  It depends in each case on the particular facts and the relation of the payment to the type of business in which the taxpayer is engaged.  The intention of the taxpayer often may be the controlling fact in making the determination.  Whether an expense is ordinary and necessary and thus, allowable deduction as a business expense must be determined from the nature of the expenditure itself, which in turn depends on the extent and permanency of the work accomplished by the expenditure.

As applied, the BIR in one ruling said expenses considered as ordinary and necessary covers only those expenses which are directly connected with and proximately resulting from carrying on the business and must be shown to be appropriate in the development, management, operation and/or conduct of the taxpayer’s business for the acquisition or pursuit of income or profit.

Moreover for an expense to be deductible it must also comply with substantiation requirements in the form of sufficient evidence like an official receipt or other adequate records bearing the amount of the expense to be deducted and the direct connection or relation of the expense being deducted to the development, management, operation and/or conduct if the trade, business or profession of the taxpayer.

Lastly, the claimant of the business expense has the obligation to keep and preserve the original of the receipt or invoice in his place of business for a period of three (3) years from the close of the taxable year in which such invoice or receipt was issued.

Given that, how’d you like summer with a dash of tax so far?  Not a likely combination one might say.  But then again, trying new things makes life and even summer interesting.  And so in the heat of the summer fun and as our brains fry under the summer sun, all the while wondering if that Swedish proverb would ever make sense in the reverse and read instead as, “A year without summer is like a life without love”?  May be so!  In any case, who wants to be reflective, we’re on a B-R-E-A-K here . . . bring in more of that refreshing mango shake please!

(Alma L. Barcelo  is a Director  for Tax and Corporate Services of Manabat Sanagustin & Co., CPAs, a member firm of KPMG International, a Swiss Cooperative. This article is for general information only and is not intended to be, nor is it a substitute for, informed professional advice. While due care was exercised to ensure the quality of the information contained in this article, readers should carefully evaluate its accuracy, completeness and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances. For comments or inquiries, please email [email protected] or [email protected])