Tax Articles

Under the Tax Code, for the purpose of determining the taxable income subject to tax, there shall be allowed as deduction from gross income all the ordinary and necessary expenses paid or incurred in the development, management, operation and/or conduct of the trade, business or exercise of a profession of a taxpayer such as reasonable allowance for salaries and wages and other forms of compensation for personal services, reasonable allowance for travel expenses, reasonable allowance for entertainment and recreation expenses, and reasonable allowance for rentals and other payments which are required for the continued use or possession of the trade, business or profession of the taxpayer.

In Revenue Memorandum Circular 81-2025, the Bureau of Internal Revenue (BIR), citing existing court decisions, laid down the conditions for the deductibility of business expenses from gross income, as follows: 1) the expense   must be ordinary   and necessary; 2) the expense   must be paid or incurred within the taxable   year; 3) the expense   must   have been 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 a profession;   and 4) the expense   must be supported   by invoices,   records or other pertinent   papers.

Therefore, for an expense to be deductible, the same should be ordinary and necessary. And it must be reasonable, among other requirements. Except for a few items, there has been no exact formula under the Tax Code on what constitutes ordinary and necessary as well as what is considered reasonable as the operational needs of a particular business are heavily dependent upon the circumstances and the nature of the trade, business, or profession of the taxpayer.

So, what constitutes an ordinary expense? As defined in the circular, an "ordinary   expense" is one that is normal, usual   and customary   in the type of business   conducted   by the taxpayer.   It does not need to be habitual or recurring but should   be common in the context of the business. Further, the expense must be typical and usual in relation to the business activities.

Citing existing court decisions on the matter, the circular further clarified that in determining whether a particular   expense is ordinary, the size and relative proportion of expenses must be considered and should meet the further test of reasonableness in amount. Thus, an expense that is inordinately large cannot be considered as an ordinary expense even if it is necessary. And if an expense nearly equaled half of the total claimed expenses, it may be considered as inordinately large and, thus, could not be considered "ordinary," even if it might be "necessary" for the taxpayer’s marketing strategy.

On the other hand, a "necessary expense" is one that is appropriate and helpful for the development of the taxpayer's business. The expense should be directly connected and proximately resulting from carrying on the business and must contribute to the generation of income or profit or minimizing a loss. Thus, expenditures not directly related to the earnings of the business within the Philippines are not deductible. The expense must be necessary or integral to the income-generating activities of the business.

So, therefore, a luxury service vehicle may not be ordinary and necessary for a certain type of business, say a construction company, but may be ordinary and necessary for another type of business, say, a travel agency catering to high-end tourists. So also, bribes, kickbacks, and other similar payments may be necessary to accomplish a business purpose, but the same is not ordinary. So, it cannot be claimed as deduction for tax purposes even if the same was actually incurred in carrying out the taxpayer’s business. Incidentally, by express provisions of the Tax Code, no deduction from gross income shall be allowed for any payment made, directly or indirectly, to an official or employee of the national government, any local government unit, government-owned or controlled corporation, representative of a foreign government, or to a private corporation, general professional partnership, or a similar entity, if the payment constitutes a bribe or kickback.

I hope the provisions of the circular would be implemented with caution and in accordance with the spirit of the cited court decisions. The decisions are anchored on the specific facts surrounding the case and therefore should only serve as mere guidelines and will not serve as absolute formula in the determination of what is considered ordinary and necessary as the need of a particular business is necessarily different from the need of the others.