Most common issues on deductions

Taxpayers, whether corporate or individual, whether subject to income tax or exempt, are not immune from being audited by the tax authorities.

While some taxpayers have seldom experienced receiving a Letter of Authority (LOA) from the BIR (define BIR), which notifies commencement of an audit, others may have received LOAs almost every year.

This article will be focusing on some of the common issues that may lead to disallowance of deductions claimed in the Income Tax Return (ITR).

The most common reason for disallowance is non-withholding. The first thing that the BIR would do is to compare expenses claimed in the ITR against the expenses that were subjected to withholding tax per withholding tax returns. If the expenses claimed in the ITR is greater than withholding tax returns (which is usually the case), the BIR will disallow as expenses the noted discrepancies.

Now, how would the taxpayer typically address this issue? By preparing a reconciliation schedule and submitting supporting documents to justify the discrepancies. Some of the reasons why certain expenses are not subject to withholding tax are as follows:

1. It is exempt from withholding tax as it is not listed among the income payments subject to withholding tax or is specifically exempt from withholding. RR (define RR) 2-98 provides a list of income payments subject to withholding tax. If the expenses are not included in the list, the same are not subject to withholding tax.

2. The payment is not in the nature of income payment but mere reimbursement of cost. A classic example of this would be payment made to an Advertising Agency. An advertising agency collects from the advertiser its commission and the media cost. Whenever the advertiser pays to the advertising agency, it typically only withholds two percent on its income payment which represents the commission of the advertising agency while payment for the media cost is not subjected to withholding tax being a mere reimbursement and not an income of the advertising agency.

Taxpayers may ask, what about expenses that have been accrued at the end of the year? Most taxpayers only withhold once payment is made and do not withhold taxes upon accrual. However, RR 2-99, as amended by RR 6-2001, specifically states that the obligation of the payor to deduct and withhold the tax arises at the time an income payment is paid or becomes payable, or the income payment is accrued or recorded as an expense or asset, whichever is applicable in the payor’s books and whichever comes first. Thus, whenever accrual is made and the accrued expense is claimed as a deduction in the ITR, the taxpayer should already withhold the appropriate taxes.

However, one of the main concerns of a taxpayer in complying with withholding on accruals is that in some cases, the amounts are just estimates and therefore the accrued expense may be higher than the actual expense and this can only be determined in the subsequent calendar or fiscal year. A taxpayer may therefore ask, “Is there an alternative means of escaping the requirement of withholding on accrued expense?” While accrued expenses may have been recorded in the Audited Financial Statements of a taxpayer, if the same have not been claimed as an expense in the ITR of the taxpayer, then, theoretically, no withholding is due as there is no expense to speak of which can be used as basis for withholding.

Another reason that the BIR may raise is with respect to substantiation requirements. Generally, expenses must be supported by adequate invoices or receipts. Some expenses are disallowed because the invoice or receipt is not issued in the name of the taxpayer claiming the expense, while some are disallowed for failure to prove that they are entitled to claim such expense. 

Relevant to lack of substantiation requirements are two expenses which in most cases, once claimed as a deduction in the ITR, would usually be disallowed during audit. These are bad debts and inventory losses.

As to bad debts expense, the BIR would only allow the said expense when the taxpayer is able to prove worthlessness of the accounts or that reasonable steps were taken to collect the debt. Some of the documents that may be presented to substantiate the claim are demand letters and the legal counsel’s certification as to the impossibility of collecting said receivable, among others. However, receivables in small amounts, the collection of which through court action may be more costly to the taxpayer, may be written-off as bad debts without conclusive evidence that the taxpayer’s receivable has become worthless.

With respect to Inventory losses or write-off, the BIR would normally look for a BIR Certification of the actual destruction of the obsolete inventories and failure to present it may lead to disallowance of the expense. In the consolidated case of CIR vs. NIDEC Copal Philippines Corp. and NIDEC Copal Philippines Corp. vs. CIR (CTA Case no. 6577, CTA EB Nos. 250 & 255, dated 1 October 2007), the CTA ruled that a certification from the BIR of the actual destruction of the claimed obsolete inventories is not necessary in order that the cost thereof may be written-off and claimed as deduction. The taxpayer, however, should present competent documentary evidence to establish that the amount claimed as losses actually pertained to destroyed obsolete inventories. Thus, while the Certification is not required, it would be prudent on the part of the taxpayer to comply with the notice and witness requirement to prove that the amount claimed as expense actually pertains to the destroyed inventories.

To sum it all up, taxpayers should be aware and comply with the requirements before they claim the expense as a deduction so that should an audit occur, the taxpayer is ready to face any question, finding or assessment of the BIR. With proper reconciliation and supporting documents, assessments are not difficult to rebut.

(Jean P. Del Rosario is a Senior Manager  for Tax & Corporate Services of Manabat Sanagustin & Co., CPAs, a member firm of KPMG network of independent member firms affiliated with 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. The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of Manabat Sanagustin & Co., CPAs.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]).