Tax Articles

Deductible Costs and Expenses,
No Requirement for Allocation

By Atty. Fulvio D. Dawilan

Recall that in March of 2011, the Department of Finance issued Revenue Regulations No. 04-11 (RR 04-11), which required the allocation of costs and expenses of banks and other financial institutions. This was declared void by the Supreme Court in G.R. Nos. 240163 and 240168-69, December 1, 2021.

Note that banks are generally subject to the regular corporate income tax on the results of operations of the regular banking units. However, the expanded foreign currency deposit units are either exempted from tax or subject to the preferential income tax rate of 10%, depending on the nature and source of income. Similarly, other financial institutions earn income that are subject to the regular corporate income tax, exempt from tax or subject to the final taxes. These tax-exempt income, income taxed at the preferential tax rate, or subject to the final taxes (often referred to as tax-paid income) are not included in the computation of income subject to the regular corporate income tax, obviously because they have different tax treatment. RR 04-11 sought to exclude the costs and expenses allocated to these income as deductions in the computation of the regular corporate income tax, by making allocations. In other words, costs and expenses attributable to the income of foreign currency deposit units and to the tax-exempt and tax-paid income of financial institutions were treated by the regulations as non-deductible in computing regular corporate income tax.

The tax impact of the Court decision for banks and other financial institutions is clear, as they are the subject of RR 04-11 which was declared void. They need not resort to the allocation of their costs and expenses among their different income streams, in determining which costs and expenses are deductible.

What about taxpayers in other industries which are not the subject of RR 04-11 – taxpayers other need not exclude cost and expenses attributable to income exempt from tax or income subjected to final taxes?

Apparently, this had become the practice of tax examiners - to allocate costs and expenses to income subjected to final taxes or exempt from taxes, and exclude such costs and expenses as deductions in the computation of regular income taxes. Examples of these are costs and expenses allocated to income subject to capital gains tax and to investment income subjected to final taxes, on the pretext that costs and expenses are also necessarily incurred to earn these income. Is this correct?

While the Court decision involves taxpayers in the banking and other financial sector, I believe the pronouncements in the decision and reasons mentioned in invalidating the regulations benefit taxpayers in general. Let me further explain one of them.

The Tax Code concedes to the basic rule that all ordinary and necessary expenses paid or incurred in carrying on, or which are directly attributable to the development, management, operation and/or conduct of trade or business shall be allowed as deduction. Citing this provision, the Court noted that common expenses should be deductible in full against the income subject to regular tax. The Court further explained that as the provision of the Tax Code is worded, all expenses are deducted directly and in full without any allocation or attribution between the different income streams. There is no requirement to allocate the common expenses to income subject to final withholding taxes or exempt income. There is no distinction for common expenses among income streams, as these are, after all, common expenses. Thus, there can be no allocation of expenses between different incomes in the same trade or business unit.

Indeed, as the Court explained, the imposition of allocation rules inevitably impairs the right of the taxpayers to claim deductions. The allocation and the consequent non-deduction of portions of expenses is an imposition of additional requirement not provided in the law. To do so would be limiting, modifying and qualifying the otherwise permissible deductions allowed under the Tax Code.

The verdict is clear – an item of cost or expense cannot be excluded as deduction in the computation of the regular income tax, simply on the basis that it is allocated or attributable to income exempt from tax, income subject to final tax, or income subject to preferential tax. In the first place, the law provides no requirement for allocation. Thus, all items of expenses, as long as they comply with all the other requisites for a valid expense, should be allowed as deduction in computing the income subject to the regular corporate income tax. The practice, therefore, of some revenue examiners in excluding portions of costs and expenses as deductions is without basis.

To summarize, the Supreme Court invalidated RR 04-11, the regulations requiring the allocation of costs and expenses incurred by banks and other financial institutions, and effectively allowing only the expenses attributed to income subject to regular income tax as deductions. Banks and other financial institutions should therefore be able to deduct all ordinary costs and expenses, without resorting to allocation. I believe the same rule should apply to any taxpayer. Attributing expenses to exempt income and income subjected to final taxes and excluding them as deduction are without basis.