It’s tax season and business and individuals with taxable year ending December 31 are starting to work on financial statements and tax returns. One of the areas frequently confused about is the deductibility of interest expense, on what are the limits, when deductible and when non-deductible.
Let’s take a look on what the tax code says about the deductibility of interest expenses.
Section 34 of the National Internal Revenue Code of the Philippines, otherwise known as the Tax Code of The Philippines set forth the following on the deductibility of interest expense from taxable gross income:
(1) In General. – The amount of interest paid or incurred within a taxable year on indebtedness in connection with the taxpayer’s profession, trade or business shall be allowed as deduction from gross income: Provided, however, That the taxpayer’s otherwise allowable deduction for interest expense shall be reduced by an amount equal to the following percentages of the interest income subjected to final tax:
Forty-one percent (41%) beginning January 1, 1998;
Thirty-nine percent (39%) beginning January 1, 1999; and
Thirty-eight percent (38%) beginning January 1, 2000;
(2) Exceptions. – No deduction shall be allowed in respect of interest under the succeeding subparagraphs:
(a) If within the taxable year an individual taxpayer reporting income on the cash basis incurs an indebtedness on which an interest is paid in advance through discount or otherwise: Provided, That such interest shall be allowed as a deduction in the year the indebtedness is paid: Provided, further, That if the indebtedness is payable in periodic amortizations, the amount of interest which corresponds to the amount of the principal amortized or paid during the year shall be allowed as deduction in such taxable year;
(b) If both the taxpayer and the person to whom the payment has been made or is to be made are persons specified under Section 36 (B); or
(c) If the indebtedness is incurred to finance petroleum exploration.
(3) Optional Treatment of Interest Expense. – At the option of the taxpayer, interest incurred to acquire property used in trade business or exercise of a profession may be allowed as a deduction or treated as a capital expenditure.
Section 36 (B) of the Tax Code reads as follows:
(B) Losses from Sales or Exchanges of Property. – In computing net income, no deductions shall in any case be allowed in respect of losses from sales or exchanges of property directly or indirectly –
(1) Between members of a family. For purposes of this paragraph, the family of an individual shall include only his brothers and sisters (whether by the whole or half-blood), spouse, ancestors, and lineal descendants; or
(2) Except in the case of distributions in liquidation, between an individual and corporation more than fifty percent (50%) in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual; or
(3) Except in the case of distributions in liquidation, between two corporations more than fifty percent (50%) in value of the outstanding stock of which is owned, directly or indirectly, by or for the same individual if either one of such corporations, with respect to the taxable year of the corporation preceding the date of the sale of exchange was under the law applicable to such taxable year, a personal holding company or a foreign personal holding company;
(4) Between the grantor and a fiduciary of any trust; or
(5) Between the fiduciary of and the fiduciary of a trust and the fiduciary of another trust if the same person is a grantor with respect to each trust; or
(6) Between a fiduciary of a trust and beneficiary of such trust.
Based on the above provisions, please see the following examples for you to better understand how it is to be applied:
1. A company earned interest income from loans to employees amounting to P100,000 and incurred interest expense on a loan from a bank amounting to P200,000 can deduct the entire interest expense of P200,000 from its taxable gross income.
2. A company earned interest income from money market placements amounting to P100,000 and incurred interest expense on a loan from a bank amounting to P200,000. This company can deduct only P162,000 of the interest income from its taxable gross income. The P200,000 interest expense is reduced by 38% of P100,000 interest income or P38,000.
3. A company earned interest income from money market placements amounting to P300,000 and incurred interest expense on a loan from a bank amounting to P100,000. This company is not allowed to deduct any amount of interest expense from its taxable gross income since the 38% of the interest income subjected to final tax of P114,000, which will reduce the deductible interest expense, is higher than the interest expense of P100,000.
4. Mr. X, father of Mr. A, the debtor, lend P1,000,000 for the latter’s personal business, earning Mr. X interest income amounting to P50,000 during the current taxable year. Mr. A cannot claim this interest expense as a deduction against his taxable gross income.
5. ABC Co. purchased a machinery on installment costing P5,000,000 and incurred interest amounting to P200,000 in financing the purchase. ABC Co. has the option to either claim the interest as interest expense which is deductible at the time it was paid, or treated as capital expenditure which will form part of the cost of the machinery and shall be deductible as depreciation expense over the useful life of the machinery.
6. Mr. A, reporting on a cash basis, borrowed from XYZ Co. P5,000,000 payable in lump sum after 2 years with interest deducted in advance amounting to P700,000. Mr. A can only claim the interest expense upon payment of the loan.
7. Assuming the same case above, except that the loan is payable semi-annually in equal installments, Mr. A can claim interest expense corresponding to the amount of principal paid.
Let’s discuss your thoughts! 😉
Hi Sir, what if the interest expense is from discounting the security deposit since the security deposit is under a long term contract and present value of it is necessary. Is it considered permanent difference in computing taxable income? Since security deposit is to be refunded and will not apply to as part of payment of the tenants once they fall due? Thank you.
Yes, it is a permanent difference.
hello sir, in case number 6, is the deductible interest 700,000 pesos or will it still be reduced by 38%? and in case number 7, what if the installments were not made in equal payments can the interest be deductible? Thank you in advance
First question – yes, it shall be reduced by 38% of interest income subject to final tax. Second question – yes deductible, for the interest that correspond to the principal paid in that installment, even if not equal.
In case 2 and 3,
What if the interest expense is not incurred on a loan from a bank (e.g. from purchase of high value paraphernalia)? Is there still a need to reduced the deductible interest expense?
Yes, as long as you have interest income subjected to final tax.
thanks for the immediate response. by the way, is this based on what bir regulation or ruling? glad if you can provide the related ruling
with your answer that would mean that the amount that will be added back in the income tax computation as non deductible tax expense is net of interest portion…right? thus, the interest portion should be recorded as interest expense and not as taxes and licenses…
Hi Dru, yes, true, tax deficiency assessments recorded as expenses shall be added back and the interest portion of it shall be claimed as interest, not taxes and licenses. With regards to the regulation supporting it, can’t recall the exact regulation, i remembered reading it before. Will post it if ever it come to my attention again. 🙂 Thanks for dropping by.
how about the interest portion in the tax assessment is it deductible or not?
Hi Dru, glad you dropped by… Yes, it is deductible for tax purposes as “interest”. The compromise and surcharges on the other hand are not. 🙂