Every year, the January to April period marks the busy season for auditors and accountants alike. This is due to mandatory compliance requirements such as business permit renewal, audit of financial statements, and filing of the annual income tax return (ITR).
For taxpayers following the taxable year ending Dec. 31, the impending April 15 deadline for the filing and payment of the annual ITR is roughly two months away. Considering this, here are some guidelines on relevant corporate income tax (CIT) matters:
RECONCILIATION OF ACCOUNTING INCOME AND TAXABLE INCOME
In determining the income tax due or overpayment, we must first understand that certain income and expense items may differ in recognition between our books (“accounting income”) vs. our ITR (“taxable income”). These differences are classified as either “permanent differences” or “temporary differences.”
Permanent differences are those arising from income or expense, which are considered under accounting income, but would never be considered under taxable income, and vice versa. On the other hand, temporary differences are those arising from income or expense on which the period or timing of recognition under accounting income is different from that of taxable income.
Below are some common reconciling items between the accounting income and taxable income:
1. Permanent differences
a. Income subjected to final withholding tax. Some passive income (e.g., interest income, dividend income) which have been subjected to final withholding tax shall no longer form part of the taxable income for income tax purposes.
b. Non-deductible interest expense. Interest expense shall be reduced by 33% of interest income subjected to final withholding tax. On the other hand, interest expense incurred on loans between related parties under Section 36(b) of the Tax Code, as amended, is not deductible for income tax purposes.
c. Unsupported bad debts expense. Under Revenue Regulations (RR) No. 25-2002, for taxpayers to validly claim bad debts or receivables written off: (1) there must be an existing valid and legally demandable indebtedness, (2) the same must be connected with the taxpayer’s business, (3) it must not be a transaction entered into between related parties, (4) it must be actually charged off the books as of end of the taxable year, and (5) it must be ascertained to be worthless and uncollectible as of the end of the year.
Further, as mentioned in a 1996 Supreme Court (SC) decision, the following steps are outlined to be undertaken by the taxpayer to prove that he exerted diligent efforts to collect the debts: (1) sending of statement of accounts, (2) sending of collection letters, (3) giving the account to a lawyer for collection, and (3) filing a collection case in court.
Should the abovementioned not be complied with, the bad debts or receivables written off shall not be deductible for income tax purposes.
d. Excess of entertainment, amusement, and recreation (EAR) expenses over the limit. Pursuant to RR No. 10-2002, EAR expenses are only deductible up to 0.5% and 1% of net sales for those engaged in sale of goods and services, respectively.
For taxpayers engaged in both sale of goods and services, the actual EAR expenses shall first be apportioned between the percentage of sales of goods and services. After allocating the actual EAR expenses, the EAR expenses limit shall be considered separately for the sale of goods and services.
Any excess of the actual EAR expenses over the limit shall not be deductible for income tax purposes.
e. Interests and penalties paid to the government for income tax purposes. Interests incurred for late or non-payment of taxes are deductible, while surcharges and compromise penalties are not deductible.
2. Temporary differences
a. Unrealized foreign exchange gains and losses. For income tax purposes, foreign exchange gains and losses arising only from closed and completed transactions (e.g., collection of receivables, settlement of loans) should be considered as deductible expenses.
b. Differences in recognition of lease expenses. For accounting purposes, under the Philippine Financial Reporting Standards (PFRS) 16, except for those classified as low-value assets or short-term leases, lessees shall recognize a right-of-use asset (ROUA) and a lease liability. The ROUA is amortized periodically, while the lease liability is recorded at present value and an interest expense is recognized periodically.
On the other hand, for income tax purposes, the deductible lease should be the amount actually paid or payable during the period based on the lease contract.
c. Amortization of the excess of pension trust contributions over normal cost. For income tax purposes, pension contributions in excess of the normal costs, which represent the pension liability applicable to such a year, as determined in accordance with the pension plan, shall be allowed as a deduction through amortization for 10 years.
GENERAL REQUISITES FOR DEDUCTIBILITY OF EXPENSES
Under existing regulations, in general, all ordinary and necessary expenses, or those which are directly related to the conduct of trade or business of the taxpayer, are allowed as deductions for income tax purposes. To validly claim these expenses, the taxpayer shall substantiate the same with sufficient evidence such as official receipts or other adequate records: (1) the amount being deducted, and (2) the direct relation of the expense to the taxpayer’s business.
Moreover, to avoid disallowance of expenses and imposition of penalties in case of BIR assessment, taxpayers must ensure that deductions claimed in the ITR have been subjected to the applicable withholding tax.
ACCRUAL OF INCOME OR EXPENSES
Guidelines for taxpayers using the accrual method were provided in a 2007 SC decision. For income tax purposes, accrual of income and expense is permitted when the all-events test has been met. This test requires (1) the fixing of a right to income or liability to pay, and (2) the availability of the reasonable accurate determination of such income or liability.
The all-events test does not demand that the amount of income or liability be known absolutely, only that a taxpayer has at his disposal the information necessary to compute the amount with reasonable accuracy.
On the other hand, “provision” of income and expense is subject to a contingency (i.e., conditions or happening of a future event), and hence should not yet be reported for income tax purposes.
It is important to differentiate accruals from provisions for the proper timing of recognition of income and expenses in the ITR. If left unchecked, the improper timing or recognition in the ITR may lead to additional taxes and penalties when assessed by the BIR.
CHANGE IN THE INCOME TAX RATE FROM CREATE
As mentioned in last week’s article, once the Corporate Recovery and Tax Incentives for Enterprises (CREATE) Bill is signed into law, the CIT rate will be reduced to 25% for domestic and resident foreign corporations. Furthermore, domestic corporations with net taxable income not exceeding P5,000,000 and with total assets not exceeding P100 million shall be subject to a lower CIT rate of 20%.
Under the bill, the effectivity period of the above retroacts to July 1, 2020. For purposes of computation of CIT due, the income and expenses of the taxpayer shall be deemed to have been earned and spent equally for each month for the fiscal year. Hence, the income and expenses shall be prorated depending on the number of months within the fiscal year of the taxpayer.
Due to the ever-changing tax laws and regulations, it is often a daunting task for us taxpayers to keep up. Nonetheless, we hope that the changes brought about by the current and future tax reforms will help ease our burden, especially during these trying times.
Let’s Talk Tax is a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.
Ajeth A. Calabano is a senior-in charge of the Tax Advisory & Compliance division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.