PICPA Income Tax Pas Tax2

A Closer Look at ITR Preparation
BIR Form 1702 Annual Income Tax Return for Corporations and Partnerships (July 2008)
Declarations made by a taxpayer in his income tax return are, for all intents and purposes, presumed to be correct having been prepared under pain of being penalized for perjury.
Paseo Realty and Development Corporation vs. Commissioner of Internal Revenue, CTA Case Nos. 4528 and 4913, dated April 30, 1993 and July 29, 1993
Coverage and Presentation

Sales Cost of Sales Other Expenses NOLCO Tax Credits Reconciling Items
Sales
Completeness Correct classification Regular Income Tax Special Tax Exempt
Completeness of Sales
Tie up with Audited Financial Statements
In general, income to be declared in ITR depends on the accounting method consistently employed by the taxpayer in keeping its books, unless a different method is prescribed by the CIR to reflect true income. Revenues declared in ITR should be reconciled with AFS.
Income Tax vs. Books

When on accrual basis, income is reportable when
All the events have occurred that fix the taxpayers right to receive the income; The amount can be determined with reasonable susceptible of accurate estimate and There must be a reasonable expectation that the amount will be paid in due course.
The right to receive the amount must be valid, unconditional and enforceable, i.e., not contingent upon future time.
Income Tax vs. Books

PFRS/Tax differences Fair market value gains on investment, PPE (PAS 39/16/40/38) Lease income (PAS 17) Interest income based on effective interest (PAS 39) Multi-element sales (PAS 2)
Accounting Method is different from Tax Accounting Method Accrual vs. Cash
Income is reported when earned vs. when payment is received
Accrual vs. Installment Method
Income is reported when good is sold vs. when installment payment is received
Accounting Method is different from Tax Accounting Method Accrual vs. Percentage of Completion
Income is reported when service is rendered vs. as a percentage of work performed
Effective Interest vs. Rule 78 Method
Interest income is spread over a straight-line basis vs. declining balance
Specific tax rules prescribed in computing revenues
Computation of revenues for taxpayers with Functional currency AFS For taxpayers using functional currency AFS, monthly revenues in functional currency shall be converted to Phil pesos using the average monthly PDS exchange rate. Total revenue, converted in Phil pesos, shall then be reconciled with the revenues declared in Phil pesos for other tax purposes.
Gross Philippine billings for international air carrier
Refers to gross revenue derived from passage of persons, excess baggage, cargo and/or mail, originating from the Philippines in a continuous and uninterrupted flight Determined by computing the monthly average net fare of all the tax coupons of plane tickets issued for the month per point of final destination, per class of passage and per classification of passenger, and multiplied by the corresponding total number of passengers flown for the month as declared in the flight manifest.
Lease Income If the advance payment is, in fact, pre-paid rental, then such payment is taxable income to the lessor in the year when received. And this is true even though the lessor is on the accrual or the cash method of accounting. (Hyde Park Realty, Inc. v.
Commissioner, 211 F. 2d 462, Cf. Evansville Courier v. Commissioner, 62 F. 2d 232)
Tie up with Audited Financial Statements
Line 17 is Net Sales Gross Sales Less: Discounts/Allowances, Rebates and Returns Details to be presented in Schedule 1
Sales Discounts - a reduction from the full or standard amount of a price or debt.
Trade discounts Volume discounts Term discounts Cash Discounts
Sales Discounts
Nature Discounts vs. Selling Expenses? Discounts vs. Advertising expenses? Discounts vs. product support?
Sales Discounts
Accrual of discounts Actual vs. Estimate Properly documented Credit Memo vs. Customers Invoice
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Classification of Sales
Only one type of Corporate Income Tax Return Distinguish reporting based on tax rate
Regular income tax 35% (30% starting Jan 1, 2009) Special Exempt
Classification of Sales
Distinguish reporting based on tax rate
Regular income tax Special Exempt
Reminder: Do not confuse income tax and VAT rules!
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Special Rate
Educational institutions Hospitals Regional operating headquarters OBUs/FCDUs Corporations covered by special laws PEZA / Subic International carrier 5% 2.5% 10% 10% 10% 10%
Exempt Income
Under the Tax Code
Non-stock, non-profit educational inst. Cemetery company owned and operated exclusively for the benefit of the members
Under special laws

BOI incentives P.D.No. 269 Electric cooperatives
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Cost of Service (Sheds. 2 & 3)
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Cost of Sales Trading and Manufacturing

Finished goods inventory, beginning Add: Purchases/Cost of goods manufactured Equals: Total Goods Available for Sale Less: Finished goods, ending
Equals: Cost of Sales
Cost of Sales
Purchases - Trading
Invoice cost of goods sold Import duties Freight to transport goods to place of sale Insurance while goods are in-transit Total Purchases
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Cost of Sales
Cost of Goods Manufactured Manufacturing Raw Materials Direct Labor Manufacturing Overhead Freight cost Insurance Other costs incurred to bring the materials to the factory or warehouse
Cost of Sales
All direct costs and expenses necessarily incurred to provide the services required by the client including:
Direct Salaries and Benefits Direct Outside services Direct Materials, Supplies Direct Depreciation Direct Rental If a cost or expenditure is incurred both directly to provide a service required by a client, and indirectly for administration, operation, or salespromotion purposes, a ratable portion of such cost or expenditure shall be allowed to form part of the "Cost of Services."
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AFS vs. ITR

Cost of Sales per FS is not automatically the same as Cost of Sales to be reported in ITR
Cost of Goods Sold

Beginning Inventory should tie up with Ending Inventory per ITR last year. Note: Secure copy of LY ITR when preparing the CY ITR
Purchases should tally with amounts per books and per VAT return Note: PFRS adjustments, if any, should be excluded. Ending inventory per ITR is different from amount per books and per Inventory list submitted to BIR.
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Ending Inventory Tax vs. Books

Inventory for TAX: Cost of deductible inventory is the actual cost.
Inventory for AFS: May include impact of certain principles under PAS 2:
Write-downs of Cost to Net Realizable Value Reversals of write-downs previously recognized Implicit interest expense is recognized as part of Purchase Cost
Ending Inventory ITR vs. Inventory List

Inventory list includes goods on hand at the end of the year. Potential Difference between inventory per ITR and Inventory list
Goods in transit
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Cost of Service
Direct costs and expenses" shall only pertain to those costs exclusively and directly incurred in relation to the revenue realized by the sellers of services. These refer to costs which are considered indispensable to the earning of the revenue such that without such costs, no revenue can be generated.
Rev. Memo Circular 24-08
Cost of Service (RMC 4-03)

Banks and non-bank financial intermediaries performing quasi-banking activities Salaries, wages and other employee benefits of personnel directly engaged in any of the said activities Interest expense except interest charged by or paid to the head office on funds considered/classified as assigned capital of the branch PDIC premium payments BSP supervision fee
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Insurance and pension funding companies Salaries, wages and other employee benefits of personnel directly engaged in said activities; Commissions on direct writings/agents of pre-need companies; Claims, losses, maturities and benefits net of reinsurance recoveries; and, Net additions required by law to reserve fund (for insurance companies) and in the case of pre-need companies, contributions to the trust funds to be set up independently as mandated by the SEC.

Finance companies and other financial intermediaries not performing quasi-banking activities
Salaries, wages and other employee benefits of personnel directly doing such functions Interest expense.
Customs, insurance, real estate, immigration and commercial brokers.

Salaries, wages and other employee benefits of personnel directly engaged in brokering activities; and, Commissions paid to its agents who are not employees of the brokerage firm.
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Brokers of securities Salaries, wages and other employee benefits of personnel directly engaged in said activities; Philippine Stock Exchange (PSE) terminal fees; Cost of Service (RMC 4-03) Communication charges related to trading/sales of securities; Research fees such as access to Bloomberg and Reuters stock data; Commissions paid to its agents who are not employees of the brokerage firm; and, Settlement/processing costs of trades, commonly known as "exchange dues."

General engineering and/or building contractors Cost of materials used in construction Salaries, wages and other employee benefits of site laborers and supervisors Health insurance, workers compensation and general liability insurance of site laborers and supervisors Fees and costs paid to sub-contractors Costs of performance bonds on the particular contract Depreciation/amortization, rentals, repairs and maintenance of equipment directly used in the said activities
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Costs of moving equipment and materials to and from the contract site Costs of design and technical assistance Supplies and tools directly used in the said activities

Common carriers or transportation contractors
Salaries, wages and other employee benefits of personnel directly engaged in the operation of the transportation equipment; Toll fees (representing rental for the use of road); Parking fees (for aircraft, sea craft and motor vehicles), Franchise fees (representing rental for the use of road network); Depreciation/amortization, rentals, repairs and maintenance of: Transportation equipment, and
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Common carriers or transportation contractors
Properties, building and improvements exclusively used as parking for aircrafts, sea crafts or motor vehicles; Fuel and lubricants of motor vehicles, aircraft or sea craft directly used in transporting passengers and/or goods/cargoes; Meals provided to passengers; Cost of safety paraphernalia and other supplies for use by passengers (e.g. lifejacket, mask, etc.); and, Annual transportation equipment registration fee.

Hotel, motel, rest/pension/lodging house and resort operators
Salaries, wages and other employee benefits of housekeeping staff, concierge personnel and other hotel/house/resort attendants Depreciation/amortization, rentals, repairs and maintenance of building, properties and facilities, and equipment directly used in the said activities Commissions paid to travel agents for bookings of guests for such establishments In case the operator also serves food and beverage, its direct costs shall include those allowed to food service establishments Supplies (e.g. hotel room/housekeeping, kitchen and laundry)
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Food service establishments
Cost of raw/cooked foods and drinks prepared and served/sold Salaries, wages and other employee benefits of personnel directly engaged in the said activities Depreciation/amortization, rentals, repairs and maintenance of properties, buildings, furniture and fixtures, and equipment directly used in the performance of said activities Cost of cooking oil, condiments and other ingredients used in cooking the food Royalties paid by franchisee.

Lessors of property Depreciation/amortization, rentals, real property taxes/charges, repairs and maintenance, of the properties being leased, Salaries of employees and fees of contractors hired to provide maintenance (repairs, cleaning/maintenance of leased properties) and collection services.
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Telephone and telegraph, electric, gas, and water utilities Salaries, wages and other employee benefits of personnel directly engaged in the said activities Depreciation/amortization, rentals, repairs and maintenance of properties and equipment directly used in the said activities (i.e., water pipes, electric poles, antennas, etc.) Interconnection fee and/or share of foreign telecommunications administration (FA) for the services they perform Fuel and lubricants on vehicles or equipment directly utilized in the said activities Amortization of franchise or development fees Franchise fees Royalties

Radio and/or television broadcasting Fees of talents hired for production/broadcasting; Salaries, wages and other employee benefits of production and broadcasting personnel; Tapes and other production materials & supplies; Satellite charges & wire services; Film rights royalties & dubbing expenses; Set requirements; Rentals for production equipment & facilities; Rentals for locations used exclusively for production/broadcasting; Costumes, props & prizes Depreciation on production and broadcasting equipment
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Other COS items per Tax Rulings

Royalties arising from the technical assistance in the manufacture of transmission and constant velocity joint are rightfully part of the cost of finished goods - BIR RULING [DA-017-05]
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Non-operating and other income

All other items treated as gross income under Section 32 of the NIRC of 1997 that are not subject to final withholding income tax:
Interest income from loans or deposits abroad Commissions Realized foreign exchange gains Net gain from sale of properties/ assets, except real property and stocks in domestic company considered as capital asset
Other Income Tax vs. Books

Gains are recognized only when assets are disposed. Fair Value increases are not taxable. If asset is disposed, for determining gain or loss, the unadjusted carrying value shall be considered as the cost of the property (i.e., cost less depreciation based on cost, without adjustment for revaluation/fair value effects)
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Other Income Tax vs. Books

Financial assets are recorded at contract amount or transaction value. Any gain shall be computed based on the cost recognized for tax purposes, notwithstanding the different recognition under accounting rules.
Allowable Deductions
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For reporting purposes

Exclude expenses classified as cost of goods/services Classify expenses based on their relation to the type of income earned by the Company
Exempt Taxable Special Rate Regular Rate
Report only expenses that comply with requirements for deductibility for tax purposes
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General requisites
1. Ordinary and necessary
2. Paid or incurred during the taxable year 3. Paid or incurred in carrying on, or which are directly attributable to, the development, management, operation and/or conduct of the trade/business 4. Reasonable in amount 5. Substantiated with sufficient evidence 6. Not contrary to law or public policy
Ordinary and necessary

INCLUDES
Salaries, wages, and other forms of compensation for personal services actually rendered, including fringe benefits Travel expenses while away from home in the pursuit of trade/business Rentals and/or other payments for use or possession of property Entertainment, amusement and recreation expenses
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Ordinary vs. Extra-ordinary expenses

Reasonableness - based on the interplay of factors
the type and size of the business; the volume and amount of net earnings; the nature of the expenditure itself; the intention of the taxpayer the general economic conditions
Amount incurred must not be a capital outlay to create "goodwill" for the product and/or the business
Ordinary vs. Extra-ordinary expenses

Unusually large advertising expense should be capitalized. Unreasonableness - P9.5M compared to P4.6 M general and administrative expenses P2.7M "other advertising and promotions expense" and P1.5M for consumer promotion Incurred in order to protect the brand franchise tantamount to acquisition of capital asset, hence, should be amortized
-GR. No. 143672, General Foods, April 24, 2003
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Rules on deductibility of business expense

The accrual of income or expenses is permitted when the all-events test has been met. The allevents test requires:
fixing of a right to income or liability to pay; and the availability of the reasonably accurate determination of such income or liability.
Deduction is taken when the liability for the expense becomes fixed, rather than contingent or estimated, and in which the amount of liability can be determined with reasonable accuracy.
Expenses are deductible in the year the liability is fixed

Even under the accrual method of accounting, fees for professional and security services rendered in a prior year need not be claimed as expense in the year the services were rendered if the amount of service fees cannot yet be ascertained in that year. Such fees can be properly considered deductible expenses in the year when the taxpayers liability to such fees became fixed and certain, that is, in the year when it received the billing statements from the auditors and lawyers who rendered the services.
-CIR v. Isabela Cultural Corp., CA GR SP No. 78426 October 17, 2005
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Substantiated with sufficient evidence

Official receipts or other adequate records showing the amount of the expense the nature of the expense incurred - to ascertain the direct relation of the expense with the trade, business or profession
INCOME TAX
Vs.
VAT
Additional requisites of deductibility

The tax required to be withheld from the amount paid or payable, or taken into consideration in computing gross income or for which depreciation or amortization may be allowed, has been paid to the BIR.
RATE
BASE
TIMING
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Rules on Specific Types of Deductions
Representation expenses
In general: Expenses incurred in entertaining, meeting with a guest or guests Persons or entities with which the taxpayer has direct business relation, such as clients/customers or prospective clients/customers Excludes employees, officers, directors, stockholders At a dining place, place of amusement, country club, theater, concert, play, sporting event, and similar events or places
Note: Does not refer to fixed representation allowances subject to withholding tax on wages under RR 2-98 or FBT under RR 3-98
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Representation Expenses - Limitation
Seller of goods or properties 0.50% of net sales Seller of service 1.0% of net revenue Seller of both goods and services Apportionment formula PENALTY FOR RECLASSIFICATION OF EXPENSE TO AVOID CEILING Any findings of improper reclassification of representation expenses to avoid being subjected to ceiling shall be disallowed in its totality
Excluded from R&E ceiling
Not covered by CAP:

Expenses treated as compensation or fringe benefits Expenses for charitable or fund raising events Expenses for a bonafide business meeting of stockholder, partners or directors Expenses for attending or sponsoring a professional organization meeting Expenses for events organized for promotion, marketing, and advertising including concerts, conference, seminars, workshops, conventions
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Rental expense
The lessee may deduct the amount of rent paid or legally payable during the year.
In BIR Ruling No. 3-00, the income to be reported by the lessor is just the rent actually earned. Conversely, on the part of the lessee, only the rent actually incurred will be allowed as deduction.
Tax deductions for childhood care programs in the workplace Operating costs incurred by employers in supporting workplace-based and related Early Childhood Care and Development (ECCD) programs as deductions Republic Act No. 8980 Condition no user fees charged to employees, whether monetary or non-monetary
BIR Ruling No. 06-2005, July 28, 2005
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Interest Expense
Requirements for deductibility

There must be an indebtedness; There should be an interest expense paid or incurred upon such indebtedness; The indebtedness must be that of the taxpayer, The indebtedness must be connected with the taxpayer's trade, business or exercise of profession; The interest expense must have been paid or incurred during the taxable year;
The interest must have been stipulated in writing;
Interest Expense

The interest payment arrangement must not be between related taxpayers as mandated in Sec. 34(B)(2)(b), in relation to Sec. 36(B), both of the Tax Code of 1997;
The interest must not be incurred to finance petroleum operations; and In case of interest incurred to acquire property used in business, the same was not treated as a capital expenditure.
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Interest Expense - Limitation
Interest expense is reduced by an amount equal to the 33% of the interest income subject to final tax
to address tax arbitrage applies whether or not there was tax arbitrage reduction not to exceed actual interest expense (cannot be a negative value)
Illustration
P1,000,000 loan Taxpayer A P800,000 Working Capital
Bank
P200,000 deposit
Actual Interest Expense (P1,000,000 x 10%) Less: 42% of Interest Income subjected to final tax (P200,000 x 2% x 42%)
P 100,000 P4,000 x 42% - 1,680 P 98,320
Equals:Deductible Interest Expense
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Interest Expense - Not subject to limitation
Interest incurred or paid by the taxpayer on all unpaid business-related taxes shall be fully deductible from gross income. (RR 13-2000)
Interest Expense - Tax vs. Books
Consider impact of new accounting standards on amount of interest per books:

Imputed interest (PAS 39) Interest computed using a rate other than that stated in the written agreement (PAS 39) Interest which are in the nature of payout on redeemable preferred shares entitled to fixed dividend each year (PAS 32) Interest expense incurred on deferred payment of inventory (PAS 2)
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Optional treatment of interest expense
interest incurred to acquire property for use in the business
interest expense
capital expenditure
Taxes
Paid or incurred within the taxable year In connection with trade or business Taxes previously claimed as deduction, when refunded or credited, shall be included as part of gross income in the year of receipt to the extent of the income tax benefit of said deduction.
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Taxes
Deductible
Percentage tax, except VAT Excise Tax DST Local taxes Import duties
Non-deductible
tax Philippine income Income and excess profits taxes imposed by foreign country Estate and gift taxes Taxes assessed against local benefits of a kind tending to increase the value of the property assessed
Losses
Actually sustained and charged off during the taxable year Incurred in trade, or business; of property connected with the trade or business Closed and completed transaction Not compensated for by insurance Casualty loss reported to BIR w/in 45 days
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Losses - Foreign currency loss Deductible only if actually sustained in a closed and completed transaction Mere recognition of loss not yet realized is not deductible
Losses - Inventory
Certification from the BIR of the actual destruction of the obsolete inventories is not necessary but there should be competent documentary evidence to substantiate inventory written off.
- Nidec Copal Philippines Corporation v. CIR, CTA 6577, Sept 5, 2006; - CIR v. Nidec Copal Philippines Corporation, CTA EB 250, October 1, 2007
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Losses Decline in Value of an asset
Deduction for loss of useful value of an asset is allowed even without actual disposal, if due to sudden business changes, the property has been prematurely discarded, or where new legislation directly or indirectly makes the continued profitable use of the property impossible. - Rev. Reg. 2
Losses - NOLCO
NOLCO - Net operating loss of business for any taxable year to be carried over as deduction for the next 3 consecutive taxable years following the year of such loss.
3-year period continues to run even if corporation paid MCIT
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Losses - NOLCO
Has not been claimed as deduction Excludes loss during exempt periods No substantial change in ownership (applied when there is a merger/ business combinations) ITH
75% of outstanding issued shares or paidup capital
Losses - NOLCO
Availed of on first-in, first-out basis Must be properly supported Should be appropriately disclosed in the notes to the Financial Statements
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Losses - NOLCO
Consider impact of new accounting standards on amount of losses per books
Inventory write-downs due to reduction in value of unsold inventory (PAS 2) Losses due to revaluation of property measured based on fair value (PAS 16/36/38/40) Losses on classification of financial assets/liabilities (PAS 39) Losses on classification of property as asset held for sale (PFRS 5)
Bad Debts
Debt is valid and subsisting Ascertained to be worthless or uncollectible Charged off during the taxable year Connected with the trade, business or profession
Specific identification vs. Estimate
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Bad Debts
Establishing worthlessness
Borrowers financial position/condition Collection lawyers certification on legal obstacles to collection All means of collection have been exhausted value of collateral
Bad Debts - Recovery

Bad debt deduction gave tax benefit No tax benefit from bad debt deduction
Recovered bad debt
Tax benefit
Taxable Gross Income
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Depreciation
Depreciation deduction - a reasonable allowance for the exhaustion, wear and tear (including reasonable allowance for obsolescence) of property used in the trade or business.
Depreciation : Tax vs. Books
Consider impact of new accounting standards on amount of depreciation per books:

Change in useful life of assets (PAS 16) Effect on carrying depreciation: value of asset subject to
- Revaluation losses or increments (PAS 16) - Write-downs due to impairment losses (PAS 16) - Estimate of cost of dismantlement, removal or restoration (PAS 16)
Non-recognition of depreciation for assets classified as held for sale (PFRS 5) or de-recognized asset (PAS 16)
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Charitable Contributions Requirements for deductibility

Contribution or gift actually paid or made within the taxable year Recipient Government of the Philippines Accredited domestic corporations or associations organized and operated exclusively for religious, charitable, scientific, youth and sports development, cultural or education purposes or for the rehabilitation of veterans Social welfare institutions Non-government organizations
Charitable Contributions - Substantiation If given to:

Government Certain foreign institutions or international organizations pursuant to agreements, treaties or commitments entered into by the GoP Accredited non-government organizations (NGOs) an NGO duly accredited by the Philippine Council for NGO Certification, Inc.
The amount of any charitable contribution of property other than money shall be based on the acquisition cost of said property
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Charitable Contributions - Substantiation
Individuals 10%
Corporations 5%
of taxable income from trade, business or profession before deduction for charitable contributions
Charitable Contributions - Substantiation Requirements for substantiation

Certificate of Donation issued by donee within 30 days from receipt of donation indicating: actual receipt of donation date of receipt by donee amount of cash donation or acquisition cost if donation is in the form of property. If more than P1 million, the donor should submit copy of notice of donation to BIR after 30 days from receipt of Certificate of Donation Ask for copy Certificate of PCNC Accreditation
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Research and Development Expenses
Taxpayer has the option to

Claim the expense as deduction in the year incurred, or Treat it as deferred expense to be amortized over a period of not less than 5 years (60 mos.) starting from the month when benefits were realized.
If the entity earlier opted to treat such expenditure as deferred asset and claimed the amortization as deduction, it should continue to do so.
R&D: Tax vs. Books
Consider impact of new accounting standards on amount of R&D expenses per books:
Write-off of unamortized research expenditures Research expenditures claimed as expense per books, but capitalized for tax Development expenditures capitalized per books but claimed as expense for tax Revaluation/impairment of capitalized development expenditures
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Pension Cost -
Requirements for deductibility of contributions

Actually paid during the year Contributions paid to a BIR-qualified retirement fund Current service cost full deduction Past services cost - Apportioned in equal parts over 10 consecutive years beginning with the year in which the transfer or payment is made.
Mere accruals of pension cost are not deductible for tax purposes.
Pension Cost If there is no qualified BIR retirement fund, retirement benefits (not the annuity premiums) are deductible in the year paid, regardless when accrued.
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Premium payments to life insurance to fund retirement benefits under RA 7641 The premiums paid by the employer/company for life insurance plans in accordance with R.A. 7641 can be claimed by the employer/company as a deductible business expense under Section 29 (a)(1)(A) [now Section 34(A)(1)(a)]of the Tax Code, as amended.
BIR Ruling No. UN-373-95, October 11, 1995
OSD under RA 9504
(As implemented by Revenue Regulations No. 16-08)
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What is Optional Standard Deduction (OSD) OSD is a fixed percentage of a defined based which a taxpayer can deduct in lieu of the cost of goods sold/cost of sales and/or itemized deductions.
OSD History
Taxpayer/ Law Republic Act 7496 (May 05, 1992) 1/ Republic Act Republic Act 8424 9504 (June 17, (December 11, 2008) 1997)
Individual engaged in business/ practice of profession Corporation
40% of gross receipts
10% of gross 40% of gross income sales/receipts
None
None
40% of gross income
1/ Prior to RA 7496, OSD rate is 10% of gross income of professional/ business-income earner.
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Effectivity of OSD under RA 9504
RA 9504 took effect on July 06, 2008 but for ease in administration, the 40% OSD shall be applied for the period starting July 01, 2008
(RR 16-08)
OSD coverage
1. Individuals a. Resident citizens b. Non-resident citizens c. Resident aliens d. Taxable estates and trusts OSD Basis : 40% of gross sales/receipts
In lieu of: (1) cost of sales and (2) itemized deductions
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OSD coverage
2. Corporations a. Domestic corporations b. Resident foreign corporations
OSD Basis: 40% of gross income In lieu of Itemized deduction
OSD coverage
3. General Professional Partnerships
OSD Basis: GPP: 40% of gross income (same as corporations) Partners: 40% of gross sales/receipts (same as individuals)
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Difference in OSD treatment

Individual P 1,000,000 ________ P1,000,000 Corporation P1,000,000 600,000 _________ P 400,000 400,000 160,000 600,000 240,000
Gross Sales/Receipts Less : Cost of Sales/ Cost of Services Gross Sales/Gross Income
OSD Individual (40% x P1M) Corporation (40% x P400,000) TAXABLE NET INCOME
Determination of OSD for individuals
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OSD coverage/application
1. Pure compensation income Not allowed to claim OSD against compensation income. 2. Business/professional Income May opt to claim OSD by checking the appropriate box in the ITR 3. Mixed Income OSD can be claimed only against business income
OSD base & computation of net income for individuals

BIR Form 1701 (July 2008)
40% OSD should be based on gross sales if individual is on accrual basis and gross receipts if on cash basis. Cost of sales or cost of service are not allowed to be deducted from gross sales/receipts in determining taxable income under OSD
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OSD base & computation of net income for individuals

BIR Form 1701 (July 2008)
Individuals under OSD may still claim personal & additional exemptions and premium payments on health/ hospitalization
10% OSD on gross income vs. 40% OSD on gross sales/receipts

Is 40% OSD on gross sales/revenue under the new law more beneficial than the 10% OSD on gross income (under old law) ? It DEPENDS on your gross profit margin If COGS is high and profit margin is low - OSD IS NOT FAVORABLE If COGS is low and profit margin is high OSD may be more favorable
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Determination of OSD for corporations
OSD for corporations
- Unlike individuals, corporations are allowed to deduct from gross sales/gross receipts, the cost of goods sold/cost of sales to arrive at gross income against which the 40% OSD shall be deducted.
Gross Sales/Receipts Less : Cost of Sales/ Cost of Services Gross Income Less : OSD P400,000) Net Income P1,000,000 600,000 _________ P 400,000 160,000 (40% x _________ P 240,000
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Definition of "gross income" under RR 16-08
For trading/merchandising/manufacturing concern "gross income" means gross sales less sales returns, discounts and allowances and cost of goods sold. For sellers of services - "gross income" means the "gross receipts" less sales returns, allowances, discount and cost of services.
Composition of "gross income"
- All items of gross income under Section 32(a) which are required to be declared in the ITR of taxpayers for taxable year shall form part of gross income (against which the OSD may be deducted). - Passive incomes which have been subjected to a final tax at source shall not form part of the gross income for purposes of 40% OSD.
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Determination of OSD for General Professional Partnerships (GPPs)
OSD for GPPs
GPP - may claim either the itemized deductions or 40% OSD - OSD is based on gross income (like corporations). Partner/s - may still claim either the itemized or OSD from his/her share in the net income of the GPP. - OSD based on gross sales/receipts (like individuals) (i.e., distributive share in net income of GPP which is considered gross income in the hands of the partner)
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Choice of deductions for GPPs/Partner

The GPP and each of the partners are entitled to their own election of deductions. GPP Itemized * Itemized OSD OSD Partner/s Itemized * OSD Itemized OSD
If both GPP and partner/s are claiming itemized deductions, the partner is precluded from claiming expenses already claimed by the GPP.
General rules on availment of OSD
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Election of OSD
- A taxpayer (individual and corporation) must
signify in the return his/its intention to avail of the OSD by checking appropriate box in the ITR forms.
- If choice is not indicated in the ITR, taxpayer shall be considered as having availed of the itemized deductions.
Election of OSD under revised BIR Form 1701 (July 2008) - For individuals in business / practice of profession
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Election of OSD under revised BIR Form 1702 (July 2008) - For corporations & partnerships
Rule on election of OSD under RR 16-08
Once the OSD elected, it is irrevocable for the taxable year for which the return is made.
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Annual filing of ITRs
- Use of hybrid method of claiming deductions (i.e., mix of itemized and OSD on first 3 quarterly ITRs) is not allowed in the final/annual ITR. - Taxpayer should either compute for the itemized deductions or OSD for the whole taxable year in its/his ITR.
Quarterly filing of ITRs for Year 2009 and onwards
- A taxpayer may opt to use either the itemized or OSD
in the filing of its/his quarterly income tax return

Q1 Option 1 Option 2 Option 3 Option 4 Option 5 '' Option Itemized Itemized Itemized OSD OSD " Q2 OSD Itemized OSD Itemized OSD "
Q3 OSD OSD Itemized Itemized Itemized "
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Shifting from itemized deductions to OSD Can a taxpayer who choose itemized deductions amend its/his return to shift to OSD? - RR 16-08 prevents a taxpayer availing of OSD from shifting to itemized. - In case a taxpayer fails to signify his/its intention in the ITR, it/he shall be considered as having availed of the itemized deductions.
Minimum Corporate Income Tax (MCIT)
65
MCIT - Computation
MCIT
Highlights On the 4th taxable year immediately after the corporation commenced business
Year zero = year registered with the BIR
For every taxable quarter At 2% of gross income Whenever the MCIT is greater than the computed RCIT
66
MCIT YEAR REGISTERED WITH THE BIR = YEAR 0 2004 YEAR 0

YEAR REGISTERED WITH BIR 2005 2006 2007 2008 YEAR 1 YEAR 2 YEAR 3 YEAR 4 BEGIN TO COMPUTE FOR MCIT
RCIT VS. MCIT
GROSS SALES/ REVENUES
LESS: DISCOUNTS, RETURNS, ALLWS COST OF SALE GROSS INCOME LESS: ALLOWABLE DEDUCTIONS TAXABLE INCOME MULTIPLY BY: 35% REGULAR CORPORATE INCOME TAX
MULTIPLY BY: 2%
MINIMUM CORPORATE INCOME TAX
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MCIT base
Gross Income All items of gross income (even apart from the core business) realized or earned by the taxpayer during the taxable period which are subject to the normal corporate income tax must be included as part of gross income subject to MCIT Gross income from operations Non-operating and other income Less: Allowable deductions under MCIT rules
68
MCIT Temporary Exemption Taxpayer sustained substantial losses due to

a prolonged labor dispute - strike by employees lasting for more than 6 months resulting to temporary shut down of business force majeure - an irresistible force such as lightning, earthquake, storm, flood, war or insurgency legitimate business reverses - substantial losses due to fire, robbery, theft or embezzlement, or other economic reasons as determined by DOF
Credits Against Tax
Prior years excess credits Excess MCIT credits from prior years Quarterly MCIT Tax payments for the first 3 quarters Creditable Tax Withheld for first 3 Quarters Creditable Tax Withheld for the 4th Quarter Foreign Tax Credits, if Applicable* Tax Paid in Return Previously Filed, if this is an Amended Return
Prior Years ITR
Quarterly ITRs
Foreign ITR Original ITR
69
Carry forward of excess MCIT
Excess MCIT over normal income tax to be carried forward and credited against the normal income tax for 3 immediately succeeding taxable years 2005 2006 2007 RCIT MCIT IT Due less Excess MCIT IT Payable Excess MCIT 120 130 130 100 120 120 300 120 300 30 270
130
10 +
120
20
Creditable Withholding Tax
The creditable taxes withheld are allowed as tax credit against income tax liability in the quarter(s) of the taxable year in which the income (subjected to withholding tax) was earned or received. The fact of withholding is established by a copy of BIR Form 2307 duly issued by the payor (withholding agent) in the name of the payee, showing the amount paid and the amount of tax withheld therefrom.
70
Disposition of Excess Creditable Withholding Taxes
Excess CWT - Disposition
Check the box

Refund / TCC
Carry forward to succeeding years
71
Excess CWT Refund/TCC vs. Carry-over
IRREVOCABLE OPTION
Sec. 76. Final Adjustment Return - . Once the option to carry-over and apply the excess quarterly income tax against income tax due for the taxable quarters of the succeeding taxable years has been made, such option shall be considered irrevocable for that taxable period and no application for cash refund or issuance of a tax credit certificate shall be allowed therefor.
Excess CWT Refund/TCC vs. Carry-over
IRREVOCABLE OPTION Exception: Refund upon dissolution - within the two-year prescription period reckoned from the date of payment of the tax.
- Financial Marketing Services Corporation v. CIR CTA Case No. 6443, September 7, 2005)
72
Supreme Court decision on excess income tax payments - options The option need not be indicated in the ITR. Failure to indicate the option does not bar the taxpayer from making its choice. The option can be determined from the subsequent action of the taxpayer.
Once indicated, the choice becomes irrevocable.

- Philam Asset Management Inc. v. CIR
GR No.56637, December 14, 2005
Applying for refund/TCC
Claim should be filed within the 2-year period prescribed under Sec 230 of the Tax Code Corporate income tax payments for the first three quarters of the taxable year should be deemed to have been paid at the time the final adjusted return is due & payable (15th of the 4th month following the close of the fiscal year). Quarterly payments are only advanced payments.
- CIR v. Philamlife Insurance Co., G.R. No. 105208, May 29, 1995; CIR v. TMX Sales, Inc. GR 83736, Jan 15, 1982
73
Substantiation requirement in applying for refund/TCC Every component of the Total Tax Credits/ Payments reflected in the final adjustment return including the taxpayers excess tax credits from the prior year must be proven or substantiated. Failure to substantiate is a failure to meet the burden of proof required to establish the factual basis of the claim for refund.
- Nissan Motor Philippines, Inc. v. CIR CTA EB No. 139 on CTA Case No. 6622 October 6, 2006
Reconciliation of Net IncomePer Books against Taxable Income
74
Reconciling items
ADD: ADD: LESS:
NON-DEDUCTIBLE EXPENSE CLAIMED IN THE FS (NDE) OTHER TAXABLE INCOME NOT RECOGNIZED IN THE FS (OTI) NON-TAXABLE INCOME RECOGNIZED IN THE FS (NTI)
LESS:
LESS:
INCOME SUBJECTED TO FINAL TAX (ISFT)

SPECIAL DEDUCTIONS NOT RECOGNIZED IN THE FS (DE)
Reconciling Items
Types
Non-PFRS PFRS-related
Substantiation
taxpayers are hereby mandated to maintain books and records that would reflect the reconciling items between FS and ITR figures in such a manner that would facilitate the understanding by the examiners/auditors of the BIR tasked to undertake audit/investigation functions, providing in sufficient detail the computation of the differences and the reasons therefor aimed at bringing into agreement the IFRS and ITR figures.
- Rev. Regulations No. 8-07
75
Non-PFRS Recon Items
Non-deductible Expenses
Expenses which are not ordinary and necessary in trade or business (bribes, kickbacks, and other similar payments) Reduction of interest by 42% of interest income subject to final tax Non-deductible taxes (e.g. Philippine income tax, foreign income tax, donor's tax, special assessment on real property) Non-deductible losses (e.g. losses from wash sale not made by a dealer in stock or securities, excess of capital loss over capital gain) Excess over the limit allowed by law (for representation expense and charitable contribution) Contributions to non-qualified donees
Non-taxable income
Income exempt from tax Income subject to final tax Income from sales recognized this year that will be reported under installment method Lease income arising from advanced rentals reported as income in prior years
76
Deductible expenses
Contributions to BIR-qualified plans Past service cost for retirement benefits Additional deductions allowed under special laws, e.g., Adopt-aschool Program
Taxable Income
Advanced lease payments Income from previously sales in prior years and current year attributable to installments received this year
PFRS Reconciling items

Loans and Receivables
Allowance for doubtful accounts or impairment loss Write-off of receivables previously provided w/ allowance in PY Reversal of PY allowance for doubtful accounts Difference between implicit interest income from the use of effective interest method and nominal interest. Implicit interest income from the use of effective interest method for a non-interest bearing Loan.
NDE/ DTA DE/ (DTA) NTI/ (DTA) NTI/ DTL NTI/ DTL
77

Inventories
Allowance for inventory obsolescence Valuation allowance on the write-down of inventories (NRV is lower than cost) Reversal of PY allowances and write-downs Interest expense on inventories purchased on deferred settlement terms
NDE/ DTA NDE/ DTA NTI/ (DTA) NDE/ DTA
Financial Assets - FVTPL

Unrealized gain on change in fair value Unrealized loss on change in fair value
NTI/ DTL NDE/ DTA

Held to Maturity Investments
Difference between implicit interest income from the use of effective interest method and nominal interest. Impairment loss on HTM investments NDE/NTI DTA/DTL NDE/ DTL
Available for Sale Assets

Impairment loss on AFS assets Recovery of impairment loss on AFS assets Unrealized gain or loss from changes in fair value (charged to equity) NDE/ DTL NTI/ (DTL) NDE/NTI DTA/DTL
78

Investments in Shares of Stock of Associates
Equity share in net income or loss of subsidiaries/ associates Impairment loss on investments in shares of stock of subsidiaries and associates Recovery of impairment loss on investments in shares of stock of subsidiaries and associates NTI/NDE DTL/DTI NDE/ DTA NTI/ (DTA
Non-current Assets Held for Sale

Unrealized gain or loss from change in fair value NTI/NDE DTL/DTA

Property, plant and equipment
Initial estimate of cost of dismantling and removing the item and the cost of restoring the site on which it is located. Cost of testing the PPE net of proceeds from selling any items produced while bringing the asset to intended location and condition. Appraisal surplus Depreciation of revalued amount Impairment loss on PPE Recovery of impairment loss
Depreciation = NDE/ DTA Proceeds = OTI NTI/ DTL NDE/ DTA NDE/ DTA NTI/ (DTA)
79

Intangible Assets
Appraisal surplus Amortization of revalued amount Impairment loss on intangible asset Recovery of impairment loss Expenditures arising from research phase and preoperation, expensed out in FS but subjected to amortization for tax purposes Expenditures arising from development phase capitalized per FS, expensed in ITR NTI/ DTL NDE/ (DTL) NDE/ DTA NTI/ (DTA)
NDE/ DTA DE

Investment property
Appraisal surplus Depreciation of revalued amount Impairment loss Recovery of impairment loss NTI/ DTL NDE/ DTA NDE/ DTA NTI/ DTL
Financial Liabilities FVTPL

Unrealized gain or loss on change in fair value NTI/ NDE
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Financial Liabilities Amortized Cost
Implicit interest income from the use of effective interest method NTI/ DTL
Equity
Dividends on redeemable preferred shares (classified as interest expense) NDE

Leases
Differences on rental expense or income arising from lease with rent-free term and changing rental rates Impairment loss/recovery of impairment loss on leased asset Impairment loss/recovery of impairment loss on lease receivables Initial direct cost capitalized by lessor on leased property accounted for as operating lease Implicit interest income or expense on long-term lease receivable or payable DTA NDE/NTI DTA/ (DTA) NDE/NTI DTA/ (DTA) DE/DTA NTI/ NDE DTL/ DTA
81

Foreign exchange transactions Unrealized foreign exchange gains or losses (P&L) Unrealized foreign exchange gains or losses arising from the translation of the receivables or payables NTI/NDE DTL/ DTA NTI/NDE DTL/ DTA
Employee benefits Accrued compensated absences (i.e., VL and SL) Unamortized past service cost Unfunded current cost Unamortized actuarial gain or loss NDE/ DTA NDE/ DTA NDE/ DTA NTI/NDE DTL/ DTA

Derivatives Unrealized gain or loss from changes in fair value of derivatives NTI/NDE DTL/ DTA
82
TAX IMPLICATIONS OF THE NEW PHILIPPINE ACCOUNTING STANDARDS

Romualdo Murcial Tax Partner, P&A Edward Roguel Tax Partner, P&A
83
New Standards Effective 2005
PAS No. 1 PAS No. 2 PAS No. 10 PAS No. 16 PAS No. 17 PAS No. 19 PAS No. 24 PAS No. 27 PAS No. 29 PAS No. 31
Presentation in Financial Statements Inventories Events after Balance Sheet Date Property, Plant and Equipment Leases Employee Benefits Related Party Transactions Consolidated and Separate Financial Statements Investment in Associates Interest in Joint Ventures
New Standards Effective 2005

PAS No. 32 PAS No. 33 PAS No. 36 PAS No. 38 PAS No. 39 PAS No. 40 PFRS No. 3 PFRS No. 5 Financial Instruments: Presentation and Disclosures
Earnings per Share

Impairment of Assets Intangible Assets Financial Instruments: Recognition and Measurements Investment Property Business Combinations Non-current assets held for sale
84
Accounting standards are relevant to income tax

In general, revenue and expenses are determined based on the accounting method of taxpayer. Audited financial statements are required to be submitted; financial records are reviewed during tax examination Courts refer to accounting standards.
Determination of Income and Expenses (Sec. 43, Tax Code)

Follows the accounting method employed by the taxpayer, unless there are specific tax rules
Exception If accounting method is not reflective of true income, a different method may be used. Implication: A different accounting method may be used for tax reporting than that used for financial reporting.
85
What BIR says about the new accounting standards..

Generally accepted accounting principles (GAAP) and Generally accepted accounting standards (GAAS) approved by the Accounting Standards Council (ASC) may from time to time differ from the provisions of the Tax Code of 1997 and its implementing regulations. In such cases, the provisions of the Tax Code and its implementing rules and regulations shall prevail.
- Rev. Memorandum Circular 22-2004
Implication: If accounting principle is not contrary to tax rules, the taxpayer may adopt them.
What should taxpayers do..

Understand changes brought about by these standards and evaluate if they are contrary to existing tax rules
If not contrary and they will reflect true income, adopt them. If contrary, recognize that they should be reported as reconciling accounts between tax and book income and establish system to capture this information
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Changes under the PFRS/PAS
PAS 2 Inventories
Supersedes SFAS 4 (revised 2000), Inventories
87
Fundamental Principle
Inventories are required to be stated at the lower of: Cost or Net realizable value.
Measurement of Cost
Includes: Cost of purchase Cost of conversion Other costs to bring inventories to present location and condition
Excludes: Abnormal waste Storage costs Unrelated administrative overhead Selling costs Deferred Payment cost Foreign exchange differences
88
Example
Buyer Side Product was invoiced for P100, payable after a year. If cash payment, price will be P90. Purchases Deferred Interest Expense Accounts Payable 90 10 100
How much purchases should be reported for Income Tax? For Withholding Tax? For VAT?
Accounting vs. Tax
Accounting Policy When inventories are purchased with deferred settlement terms, the difference between the purchase price for normal credit terms and the amount paid is recognized as interest expense over the period of financing.
Tax Treatment / Issues Buyer Side: Taxpayer should report as inventory cost the full invoice amount. Implicit interest expense is not deductible. Such interest is not subject to withholding tax. For VAT purposes, purchases to be reported shall be based on invoice amount
89
Example
Seller Side Product was sold for P100, payable after a year. If cash payment, price will be P90. Accounts Receivable Sales Deferred Interest Income 100 90 10
How much sales should be reported for Income Tax? For VAT?
Accounting vs. Tax
Accounting Policy
Tax Treatment / Issues
Seller Side
When inventories are sold Taxpayer should report as sales the full with deferred settlement invoice amount. Implicit interest income on terms, the difference transaction is not taxable. between the sales price for normal credit terms For VAT purposes, sales to be reported and the amount received shall be based on invoice amount. is recognized as interest income over the period of financing.
90
Accounting vs. Tax

Accounting Policy
Foreign exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency should not be included in the cost of inventories purchased. For first year adoption, prior years impact will be reported in the Retained Earnings.

Only realized foreign exchange gains are taxable and realized losses are deductible expenses.
Measurement of Cost Reduction from Cost
Discounts that relate to inventory purchases should be deducted from the cost of inventories.
Trade discounts Settlement discounts If the purchaser does not take advantage of the discount, the additional amount paid should be recorded as a finance charge.
91
EXAMPLE
Purchaser P buys inventory from supplier S on Jan.1. The price is CU1,000 with a 2.5% discount for settlement within 30 days.
Analysis: P records the inventory net of the discount entitlement. The entries on Jan 1 are as follows:
Inventory Current liability 975 975
EXAMPLE
P decides not to take advantage of the discount, and settles at CU1,000.
The ultimate payment of the discount is recorded as a finance cost. The entries on Feb. 28 are as follows:
Finance cost Current liability Current liability Cash 25 25 1,000 1,000
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Measurement of Cost
Contractual rebates (e.g. volume discounts) relating to inventory purchases should be recognized when probable. Once recognized, the rebate should be recorded as a reduction to the cost of the related inventory. To the extent that the inventories have already been sold (or used in production that has been sold) that part of the rebate is recorded in the income statement
Accounting vs. Tax
Accounting Policy Cash discounts and Settlement discounts are recognized when the purchase is booked. Contractual discounts shall be recognized once probable.
Tax Treatment / Issues Only actual discounts are reported as reduction from gross sales. Cash disct. time of purchase Settlement disct. when received Contractual discounts to be recognized only when actually granted to buyer.
93
Measurement of Cost
Cost measurement alternatives (only if result approximates actual costs): Standard costs Retail inventory method Cost formulas Specific identification FIFO or weighted average LIFO is no longer allowed!
Tax Implication
For income tax reporting, LIFO has not been allowed since 1984. (Rev. Reg No. 14-84) Hence, change in accounting method from LIFO to another method as a result of new standard has no tax impact. If taxpayer had been using LIFO for income tax, it should amend prior years tax returns.
94
Fundamental Principle
Inventories are required to be stated at the lower of: Cost or Net realizable value. Net Realizable Value = Estimated selling price Less: Estimated cost of completion Estimated cost to sell
Measurement of Net Realizable Value

Results of comparison of NRV with Costs. Any write-down to NRV expense during the period Any reversal of write-down reduction in inventories recognized as expense during the period
95
Accounting vs. Tax Measurement
Accounting Policy
Inventories should be carried at the lower of Cost, OR Net Realizable value

Cost of deductible inventory is the actual cost. Write-downs of Cost to Net Realizable Value are not valid additions to Cost of Sales. Reversals should not decrease COS.
PAS 16 Property, Plant and Equipment
96
Measurement at Recognition
PPE are initially measured at cost. Components of the cost of PPE: Purchase price, including import duties Directly attributable costs Initial estimate of the costs of dismantling and removing the item and restoring the site
Excludes interest and financing cost to acquire property.
Measurement at Recognition
Directly Attributable Costs: Employee benefits arising directly from construction or acquisition Costs of site preparation Initial delivery and handling costs Installation and assembly costs Costs of testing, after deducting net proceeds from selling any items produced while bringing the asset to that location and condition Professional fees.
97
Accounting vs. Tax Recognition of PPE

Accounting Policy The cost of an item of PPE shall be recognized as an asset if, and only if: (a) it is probable that future economic benefits associated with the item will flow to the entity; and (b) the cost of the item can be measured reliably. Tax Treatment / Issues Taxpayers set their own accounting policies to determine whether an item shall be capitalized or expensed. Factors sometimes considered are the cost of the item and utilization in relation to its business. Can these policies be adopted for tax purposes? Accounting policy should normally apply for tax purposes.
Accounting vs. Tax Cost Element of PPE

Accounting Policy Recognition. Cost shall include initial estimate of the costs of dismantlement or removal or cost of restoration incurred to install an item, Tax Treatment / Issues For tax, cost of dismantlement, removal or restoration will not qualify as part of depreciable cost. For purposes of determining gain or loss when the property is disposed, basis shall be the carrying value of the property less the portion attributable to such type of cost which had been capitalized. Actual dismantling cost shall be deductible in the year it is actually dismantled.
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Accounting vs. Tax Cost Element of PPE (contd)

Accounting Policy Cost shall include initial estimate of the costs of dismantlement or removal or cost of restoration incurred to install an item, Tax Treatment / Issues Withholding tax liability on such purchase, if any, shall be based on actual acquisition cost of PPE. Hence, purchase reported for WTax purposes may be different from amount reported in the financial statements or books. For VAT purposes, capital goods shall be reported at acquisition cost. Hence, purchase reported for VAT purposes may be different from amount reported in the financial statements or the books.
Accounting for Estimated Dismantling and Restoration Costs

Example: (a) Injection Molding Machine Purchase price Installation cost PV Estimated dismantling cost Useful life P 1,500,000 100,000 250,000 5 years
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Accounting for Estimated Dismantling and Restoration Costs (contd.)

Example: Injection Molding Machine
FS Acquisition cost: Purchase price Installation cost PV Est. dismantling cost Total Acquisition Cost Annual Depreciation P 1,500,000 100,000 250,000 P 1,850,000 P 370,000 Tax P 1,500,000 100,000 P 1,600,000 P 320,000
Accounting vs. Tax Directly Attributable Costs of PPE

Accounting Policy Cost of testing whether the asset is functioning properly, after deducting the net proceeds from selling any items produced while bringing the asset to its intended location and condition (i.e., samples produced when testing equipment) may be capitalized as cost of PPE. Tax Treatment / Issues Proceeds from sale of samples when testing equipment are subject to VAT and income tax.
100
Directly Attributable Costs of PPE

Example: Purchase price Cost of machine testing Proceeds from sale of samples Useful life P 5,000,000 250,000 100,000 5 years

Example: FS Acquisition cost: Purchase price Proceeds from sale of samples Cost of testing the machine Total Acquisition Cost Annual Depreciation VAT on sale of samples Tax
P 5,000,000 P 5,000,000 (100,000) 250,000 250,000 P 5,150,000 P 5,250,000 1,030,000 1,050,000 10,000
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Example (contd): Sale of goods Cost of testing Depreciation Net Income (Loss) FS P 1,030,000 (P1,030,000) P Tax 100,000
1,050,000 (P950,000)
NOLCO
= P 950,000
Accounting vs. Tax Cost Element of PPE (contd)

Accounting Policy
Interest and financing charges relating to acquisition of property are not reported as part of the cost of the property but are treated as period expense.

Under existing tax rules, an entity is given the option to treat expenses incurred in connection with the acquisition of property used in trade or business or exercise of a profession either as (1) part of the cost of the property (and thereof be part of the depreciable base) or (2) as expense. Option remains notwithstanding the new accounting rules.
102
Interest Relating to Property Acquisition

In the year of adoption of the standard, in case such interest and other finance charges had been capitalized, the entity is required to write them off in its financial reports and to adjust the related depreciation of the property to exclude the impact of the unamortized portion of the interest. How does this affect the entitys tax reporting? - The write off of the unamortized portion of interest is not deductible. Likewise, the entity may continue to claim the depreciation based on the remaining depreciable value of the property, without adjustment for the interest that had been written off due to the adoption of the standard. Can the entity adopt the new rules for tax purposes if it had previously elected to capitalize these interests? - The Tax Code does not provide explicitly for the conditions when an entity that had previously elected to capitalize such interest may expense it. Notably, however, neither is such practice prohibited.
Accounting vs. Tax PPE at Revalued Amount

Accounting Policy
PPE are carried either at cost or at revalued amounts, less accumulated depreciation and impairment losses.

Depreciation for tax purposes shall be based on cost (without adjustment for revaluation losses or increments). Write-downs due to impairment losses are not deductible. Revaluation increments are not taxable.
103
Confusing BIR Position
The proper allowance for such depreciation of any property used in the trade or business is that amount which should be set aside for the taxable year in accordance with a reasonable consistent plan whereby the aggregate of the amount so set aside, plus the salvage value, will, at the end of the useful life of the property in business, equal the basis of the property. - Revenue Regulations No. 2-40 Company X is allowed to use the appraisal fair market values of their properties used in business and depreciate the same based on the remaining useful life as re-estimated. - BIR Ruling No. 413-04
Componentization of PPE
Previous PAS New PAS
Depreciation Did not clearly set Each part of an item of unit of out this requirement. PPE with a cost that is measure significant in relation to the total cost of the item shall be depreciated separately.
104
Example: Cargo Vessel Engine Frame/body Improvements Equipments Total Cost Useful Life of the vessel
Cost P 15 million 25 million 12 million 8 million P 60 million - 20 years
Life 15 yrs 20 yrs 5 yrs 10 yrs
Example: Cargo Vessel (contd.) Tax Annual depreciation Issues: Basis of allocation of cost of asset components Income tax effect of the adjustment in depreciation expense (adjusted retrospectively) New PAS
P 3,000,000
P 5,450,000
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Accounting vs. Tax Change in Useful Life

Accounting Policy Tax Treatment / Issues
Useful life of an asset may change if expectations differ from previous estimates
BIR needs to be informed of any changes in useful life of PPE.
Accounting vs. Tax De-recognition of PPE

Accounting Policy An asset is de-recognized: Tax Treatment / Issues Gain or loss from de-recognition is not taxable/deductible.
(a) on disposal; or (b) when no future Exception: Deduction for loss of economic benefits are useful value of an asset is allowed expected from its use or under Rev. Reg. 2 if, due to sudden disposal. business changes, the property has The gain or loss arising from the been prematurely discarded, or where de-recognition of an item of new legislation directly or indirectly makes the continued profitable use of PPE shall be included in profit or loss when the item the property impossible. is de-recognized.
106
Accounting vs. Tax End of Depreciation

Accounting Policy Depreciation of an asset ceases the earlier of the date that the asset is classified as held for sale and the date that the asset is de-recognized. Tax Treatment / Issues Taxpayer should cease to claim depreciation when asset is no longer used in trade or business.
Accounting vs. Tax Disposal of Asset

Accounting Policy Gain or loss from disposal shall be the difference between the consideration and the carrying value (cost less accumulated depreciation and impairment loss). An entity cannot classify as part of the line item Revenue a gain it realizes on the disposal of PPE. Tax Treatment / Issues When the PPE is disposed, gain or losses arising from the disposition shall be based on the unadjusted carrying value (i.e., cost less depreciation based on cost)
Notwithstanding the prescribed accounting treatment, gain from the disposal of PPE shall be reported as taxable income for MCIT and local business tax purposes.
107
Basis for Depreciation and Gain/loss on disposal

Accounting Acquisition Cost Installation, assembly expenses Estimated dismantling costs Improvements, additions Impairment losses Revaluation increment Tax
PAS 17 Leases
108
A. Main Changes
Clarifies the definition of interest rate implicit in the lease. Distinguishes between the inception of the lease and the commencement of the lease term. For lease of land and buildings, the land and building elements are considered separately. Provides additional guidance on accounting for initial direct costs incurred in negotiating and arranging a lease
C. Significant Provisions
Classification of Leases (Accounting) 1. 2. Finance Lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset. Operating Lease is a lease other than the finance lease.
109
Definition TAX (RR 19-86)

1. Lease an agreement between the lessor and lessee giving lessee possession and use of a specific property upon payment of rentals over a period of time (CC). 2. Conditional Sale one of the parties obligates himself o transfer ownership of and deliver a determinate thing while the other pays a price certain.(CC) If true character is not ascertained Commissioner makes a determination. Or request for an advance ruling from BIR.
Compelling Persuasive Factors for Conditional sales (RR 19-86)

1. Lessee has option to purchase anytime during obligatory period of lease 2. Lessee acquires automatic ownership of asset upon payment of stated rental 3. Portions of periodic rental payments are credited to purchase price 4. Receipt of payments indicate that payment were made partial or full payment of the asset.
110
Leases for GRT purposes - (RR 09-04)

1. Finance Lease mode of extending credit through a non-cancelable lease under which lessor purchases at the instance of lessee equipment and etc., movable or immovable, in consideration for a periodic payment by lessee of a fixed amount sufficient to amortize at least 70% of purchase price including incidental costs and margin of profit of not less than 2 years and bears all the costs of repairs but with no obligation or option to purchase the leased property at the end of contract. A finance lease is a lease that transfers all the risks and rewards incident to ownership. Title may or may not be eventually transferred (same as accounting) 2. Operating Lease - lease other than a finance lease of a financing company (same as accounting)
Comparisons
PAS 21
Rev Reg No. 19-86
Rev. Reg No. 09-04
A lease is a finance leaseA contract of sale is an A finance lease is a if it transfers agreement where one of lease that transfers all substantially all the risks the contracting parties the risks and rewards and rewards incidental to(seller or vendor) incident to ownership. ownership. obligates himself to Title may or may not transfer ownership of be eventually and to deliver a transferred. determinate thing while the other party (buyer or vendee) obligates himself to pay for said thing a price certain in money or its equivalent.
111
Comparisons
PAS 21
Lessee has option to purchase the asset at a price that is expected to be sufficiently lower than the fair value. At the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.
Rev Reg No. 19-86

The lessee is given the option to purchase the asset at anytime during the obligatory period of the lease, notwithstanding that the option price is equivalent to or higher than the current fair market value of the asset.
Rev. Reg No. 09-04

Consideration of the periodic payment by the lessee of a fixed amount of money sufficient to amortize at least seventy percent (70%) of the purchase price or acquisition cost, including any incidental expenses and a margin of profit
Comparisons
PAS 21 The lease term is for the major part of the economic life of the asset even if title is not transferred
Rev Reg No. 19-86
Rev. Reg No. 09-04 Obligatory period of not less than two (2) years during which the lessee has the right to hold and use the leased property
112
C. Classification of Lease
When is the lease classification made?
Accounting: Inception of the lease - is the earlier of the date of the lease agreement or of a commitment by the parties to the principal provisions of the lease. Tax: Beginning of Contract
D. Accounting for Leases Operating Lease

Lessee - lease payments are recognized as expense for the period on a straight-line basis over the lease term - no assets or obligations are recorded other than security deposits, advance rentals and unamortized balanced of initial direct costs Lessor - lease income are recognized as an income for the period on a straight-line basis over the lease term - report assets in accordance with the nature of the asset (Depreciation policy and subject to impairment)
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Situation - Lease with rent-free period Lease term (inclusive of rent-free period) Annual rent Rent-free period Total rental (P1,000 x 3.5 yrs) Ave. annual rent (P3,500 / 4 yrs) 4 yrs P1,000 6 months P3,500 P875

Situation Lease with rent-free period
Accounting entry upon receipt/payment of rent: Year 1 Lessors Books

Dr. Cash Dr. Receivable Cr. Rent Income P500 375 P875
Lessees Books
Dr. Rent Expense P875 Cr. Cash Cr. Payable P500 375
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Situation Lease with rent-free period Accounting entry upon receipt/payment of rent: Years 2 and 3 Lessors Books
Year 2 One year Dr. Cash P1,000 Cr. Receivable Cr. Rent Income Year 3 One year Dr. Cash P1,000 Cr. Receivable Cr. Rent Income P125 875 P125 875
Lessees Books
Dr. Rent Expense P875 Dr. Payable Cr. Cash 125 P1,000
Dr. Rent Expense P875 Dr. Payable Cr. Cash 125 P1,000
Accounting vs. Tax
Accounting Policy Operating lease: Lessee Lease payments shall be recognized as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the users benefit. In the example: P 875 for 3 yrs.
Tax Treatment / Issues The lessee may deduct the amount of rent paid or legally payable during the year. In BIR Ruling No. 3-00, the income to be reported by the lessor is just the rent actually earned. Conversely, on the part of the lessee, only the rent actually incurred will be allowed as deduction. In the example: Yr.1 500; Yr. 2, 3 P1000
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Accounting vs. Tax
Accounting Policy Operating Lease: Lessor Initial direct costs incurred by lessors in negotiating and arranging an operating lease shall be added to the carrying amount of the leased asset and recognized as expense over the lease term on the same basis as the lease income.
Costs incurred by lessors in negotiating and arranging an operating leases are treated as expense in the period incurred. Costs incurred by lessee which are properly payable by the lessor is deemed received as a rental income of lessor. Example: Real Property Taxes
Accounting vs. Tax
Accounting Policy Operating Lease: Lessor Lease income from operating leases shall be recognized as income on a straight-line basis over the lease term, even if the receipts are not on such a basis.
In BIR Ruling No. 3-00, the income to be reported by the lessor is just the rent actually earned.
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D.
Accounting for Leases Finance Lease
Lessee Finance Lease
Transaction is treated as a purchase of assets. At the commencement of the lease, lessee recognizes assets for the leased property and liabilities for the rentals payable at an amount equal to the lower of: (1) the fair value of the leased property, or the present value of minimum (2) lease payments. The capitalized asset and the related liability are presented in the lessees balance sheet.
D.
Lessee Finance Lease
The capitalized asset is depreciated applying the depreciation policy that used for depreciable assets which are owned. Depreciation period is the shorter of the lease term or the useful life if title does not transfer to the lessee. The asset is also subjected to impairment assessment. Lease payments are apportioned between the finance charge and the reduction of the outstanding liability.
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D.
Situation 4 - Finance Lease with Fixed Annual Rental (direct financing lease type)
Assumptions: Lease term Carrying value Annual rental Implicit interest rate PV of annuity PV 5 years P500 P132 10% 3.791 P500
D.
Lease Liability Balance: Start of lease term End of year 1 End of year 2 P500 418 327.8
End of year 3
End of year 4 End of year 5
228.6
119.5 0
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D.
Interest on Outstanding Liability: Year 1 Year 2 Year 3 Year 4 Year 5 Total Annual deprecation P 50 41.8 32.8 22.9 12.5 P 160 P 100

Situation Finance Leases with Fixed Annual Rental (Direct Financing Lease)
To record the finance lease at commencement date Lessors Books Dr. Lease receivable Cr. Equipment Cr. Unearned interest income P660 500 160 Lessees Books
Dr. Equipment Cr. Lease liability
P500 P500
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D. Accounting for Leases Finance Lease

To record receipt/payment Years 1 to 3
Lessors Books Lessees Books
Year 1
Dr. Cash
P132 P50 132 50
Cr. Lease receivable Dr. Unearned int. income Cr. Interest income
Dr. Lease liability Dr. Interest expense Cr. Cash
P82 50 P132
Year 2
Dr. Cash Cr. Lease receivable Dr. Unearned int. income Cr. Interest income P132 132 P41.8 41.8 Dr. Lease liability Dr. Interest expense Cr. Cash P90.2 41.8 P132
Year 3
Dr. Cash Cr. Lease receivable Dr. Unearned int. income Cr. Interest income
P132 132 P32.8 32.8
Dr. Lease liability Dr. Interest expense Cr. Cash
P99.2 32.8 P132
D. Accounting for Leases Finance Lease
Accounting entry for annual depreciation

Lessors Books Annual Depreciation Lessees Books
Dr. Depreciation exp. No entry Cr. Accum. depreciation
P100 100
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Accounting vs. Tax
Accounting Policy Finance Lease: Lessee- Initial recognition Lessees shall recognize finance leases as assets and liabilities in their balance sheets at amounts equal to the fair value of the leased property, or if lower, the present value of the minimum lease payments each determined at the inception of the lease.
Tax Treatment / Issues If lease is actually a conditional sale-
Lessees recognizes as assets and liabilities. The cost of the asset will be the difference between the total payments and the interest. (in effect PV) (RR 19-86) Hence, the amount at which the asset is recognized in the books may be different from the amount paid.
Accounting vs. Tax
Accounting Policy Finance Lease: Lessee Subsequent Payments A finance lease gives rise to depreciation expense for depreciable assets as well as finance expenses for each accounting period.
Tax Treatment / Issues If lease is actually a conditional sale Deduction for tax purposes shall be the depreciation amount and interest unless interest is capitalized. (Taxpayer has option to expense or capitalize interest). ISSUE: Rule on interest expense deductibility: If the lease contract does not explicitly provide for the interest rate, is the interest expense deductible?
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Accounting vs. Tax
Accounting Policy The discount rate to be used in calculating the present value of the minimum lease payments is the interest rate implicit in the lease, if this is practicable to determine; if not, the lessees incremental borrowing rate shall be used.
Tax Treatment / Issues RR 19-86 allows interest to be computed using either the Annuity or the Sum-of-the-Years method. If taxpayer opts to use the Sum-of-theYears method, the interest rate to be reported for tax purposes is different from that recognized for financial reporting purposes. If it shifts to Annuity Method, then this involves a change in accounting method for which BIR approval is required to be secured.
Accounting vs. Tax
Accounting Policy Finance Lease: Lessee Subsequent Payments
Tax Treatment / Issues If lease is actually a conditional sale-
The depreciation is allocated to Depreciation per books and per tax each accounting period during the may be different if the amounts at period of expected use. which the asset was recognized are different.
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PAS 17: Finance Lease
Accounting Policy Finance Lease: Lessee - Impairment of Assets Determination shall be made whether the leased asset has become impaired, based on IAS 36. Such impairment evaluation may reduce the carrying value of the leased asset. The same will be the basis of subsequent depreciation.
Tax Treatment / Issues If lease is actually a conditional saleDepreciation shall remain the same based on the original carrying cost (no adjustment for impairment loss.)
Accounting vs. Tax

Finance Lease: Lessor Recognition.
Accounting Policy
Lessor shall recognize assets held under a finance lease in their balance sheets and present them as a receivable at an amount equal to the net investment in the lease. Gain from the disposition of the asset shall be the difference between the total lease payments receivable, minus the interest charges, and the carrying value of the asset (net of depreciation and impairment losses.
Tax Treatment / Issues If lease is actually a conditional sale For tax, the lessor shall recognize a gain on the sale of the asset and deferred interest income.
Gain from the disposition of the asset shall be the difference between the total lease payments receivable, minus the interest charges, and the unadjusted carrying value of the asset (net only of depreciation).
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Accounting vs. Tax
Accounting Policy Lessor Recognition. Interest income shall be arrived at using the implicit interest rate.
Tax Treatment / Issues If lease is actually a conditional saleFor tax purposes, interest is computed using either the Sum-of-the-Years or the Annuity method. If taxpayer uses the Sum-of-the-Years method, interest income recognized for tax purposes will be different from that recognized for financial reporting purposes.
E. Sale and Leaseback Transactions

Parties Involved Party A Party B
Vendor
Sale Leaseback
Buyer
Lessor
Lessee
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E.
Sale and Leaseback Transactions
Benefits
(a)The seller-lessee benefits from the higher price because of: - the gain on the sale of the property - the deductibility of the lease payments which are usually larger than the previous depreciation. (b) The buyer-lessor benefits both from the higher rental payments and the larger depreciable base.
Accounting Treatment
Depends on the type of the leaseback same rules on operating lease and finance lease applies.
Accounting vs. Tax

Sale/leaseback transactions
Accounting Policy If the transaction results in a finance lease, any excess of sales proceeds over the carrying amount shall be deferred and amortized over the lease term. If the sales price is below fair market value, any profit or loss shall be recognized immediately except that, if the loss is compensated for by future lease payments at below market price, it shall be deferred and amortized in proportion to the lease payments over the period for which the asset is expected to be used. Tax Treatment / Issues For tax, gain from the sale shall already be taxed. Similar to ordinary sale.
For tax, loss shall be recognized, regardless of the impact of future lease payments. The leaseback shall be taxed depending on whether it will be considered a finance lease or operating lease.
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PAS 19 Employee Benefits Supersedes SFAS 24, Retirement Benefit Costs
SCOPE
Applies to:
Wages and salaries Compensated absences (paid vacation and sick leave) Profit sharing plans Bonuses Medical and life insurance benefits during employment Housing benefits
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SCOPE
Applies to (contd.):
Free or subsidized goods or services given to employees Pension benefits Post employment medical and life insurance benefits Long-service or sabbatical leave, anniversary benefits Deferred compensation programs Termination benefits
BASIC PRINCIPLE
Employee Benefit Cost Recognized
EARNED
Rather than when Paid or Payable
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CLASSIFICATIONS
1. Short-Term Benefits
2. Post Employment Benefits 3. Other Long-term Employee Benefits 4. Termination Benefits
Short-Term Benefits
Includes: All short-term employee benefits Compensated absences Profit sharing and bonus plans
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Short-Term Benefits
Employee Benefits:
Accounting = generally straightforward No actuarial assumptions = undiscounted basis Recognition = expense and liability (accrued expense)
Short-Term Benefits
Compensated Absences
Recognition: If accumulating = when employee render service If non-accumulating = when the absences occur
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Example Accumulating Compensated Absences
A Company has 100 employees who are entitled to 15 days of VL per year. Unused VL can be carried forward for 1 year only. VL is utilized on a LIFO basis. As of December 31, 2005, average unused VL is 5 days per employee. Company expects 90 employees will take 5 days next year and that 10 employees will take 3 days next year. How much is the expense and liability to be recognized as of December 31, 2005?
480 days of VL
Example: Non- Accumulating Compensated Absence

A Company has 100 employees who are entitled to 5 days of SL per year. Unused SL may not be carried forward at the end of the calendar year and employees are not entitled to a cash payment for any unused SL. At December 31, 2005, average unused SL is 3 days per employee. How much is the expense and liability to be recognized as of December 31, 2005?
NONE
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Accounting vs. Tax Short-term benefits

Accounting Policy An entity shall measure the expected cost of accumulating compensated absences as the additional amount that the entity expects to pay as a result of the unused entitlement that has accumulated at the balance sheet date. These include absences due to vacation, sickness and short-term disability, maternity or paternity, etc. Tax Treatment / Issues These benefits can be claimed as deduction in the year the benefit is availed, unless the same is already legally payable.
Rules on Deductibility of Business Expenses

The accrual of income or expenses is permitted when the all-events test has been met. The all-events test requires: 1) fixing of a right to income or liability to pay; and 2) the availability of the reasonably accurate determination of such income or liability. Deduction is taken when the liability for the expense becomes fixed, rather than contingent or estimated, and in which the amount of liability can be determined with reasonable accuracy.
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If the taxpayer is on the accrual basis, for the purposes of determining deductions, it is necessary that there be a definite fixed liability. In order to be accruable in the taxpayer year, a valid obligation upon which the profit (or loss in the case of the deduction) is to be determined must have existed in the year in which the obligation became binding or enforceable. (Same Darby Pilipinas, Inc. vs. CIR, CTA Case No. 4448 dated August 8, 1994)
Accounting vs. Tax
Accounting Policy Accumulating absences may either be vesting (payable in cash upon separation) or non-vesting. If its accumulating, the employee benefits shall be accrued. The obligation arises as employees render service that increases their entitlement to future compensated absences. Non-accumulating compensated absences are not recognized as expense until the time of the absence.
Tax Treatment / Issues Claimed only in the year when availed or utilized, cash conversion is availment, unless already legally payable.
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Short-Term Benefits
Profit-sharing and Bonus Plans
Recognized only when: Company has present legal or constructive obligation Reliable estimate of the obligation can be made
Accounting vs. Tax
Accounting Policy
Profit-sharing and Bonus Plans Deduction to be claimed in (due within 12 months after the end of the year when bonus is paid or the liability is determined. the period in which the employee rendered the related benefits) A liability shall be recognized if the entity has a present legal or constructive obligation to make such payments as a result of past events, and a reliable estimate of the obligation can be made.
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Post-Employee Benefits
Classification: 1. Defined Contribution Plans (DCP) 2. Defined Benefit Plans (DBP)
Defined Contribution Plans:
Companys obligation is limited to the amount contributed to the fund

Risk that benefits will be less or assets are insufficient falls on the employee
Defined Benefit Plans:

Companys obligation is to provide the agreed benefits to current and former employees Risk that benefits will be less or assets are insufficient falls on the Company
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Recognition and measurement:
DCP = expense / accrued liability is the amount of required contribution under the plan. DBP = use of actuarial assumptions to measure the net expense (income) and the retirement benefit obligation (asset).
DBP Amounts Recognized as Net Expense (Income): 1. Current service costs 2. Interest costs 3. Actuarial gains and losses, to the extent recognized 4. Expected return on plan assets 5. Past service costs, to the extend recognized 6. Gains or losses from curtailments or settlements = NET PENSION EXPENSE (INCOME)
135
Accounting vs. Tax
Accounting Policy DCP = expense / accrued liability is the amount of required contribution under the plan. DBP = use of actuarial assumptions to measure the net expense (income) and the retirement benefit obligation (asset).
Tax Treatment / Issues Regardless of whether the retirement benefit is funded through a Defined Contribution or Defined Benefit Plan, only contributions paid during the year to a BIR-qualified trusteed plan are deductible to the following extent: Contributions for present service cost full deductible; Contributions for past service cost 1/10 of the contribution paid.
Termination Benefits
Accounting and recognition:
Amounts payable should be recognized only when: There is a detailed plan of termination before normal retirement date.
There is a detailed plan to offer termination benefits in order to encourage voluntary redundancy.
136
Termination Benefits
Measurement:
At a discount if termination benefits fall due more than 12 months after the BS date Based on the number of employees expected to accept the offer in case of voluntary redundancy
Accounting vs. Tax
Accounting Policy Termination Benefits
Tax Treatment / Issues Deductible only when the legal obligation actually arises, i.e. upon termination of the employees, regardless whether or not actually paid.
137
PAS 39 FINANCIAL INSTRUMENTS : RECOGNITION AND MEASUREMENT
A. Definitions
Financial Instrument Defined

Is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
138
A. Definitions
Financial Asset Defined

Any asset that is: 1. Cash 2. An equity instrument of another entity 3. A contractual right to (liability): Receive cash or another financial asset from another entity; or Exchange financial assets or financial liabilities with another entity under conditions that are potentially favorable to the entity; or
A. Definitions
Cash most basic financial instrument Equity instrument Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities
139
A. Definitions
Other contractual rights to receive (or obligation to deliver) cash or another financial asset Trade accounts receivable and payable Notes receivable and payable Loans receivable and payable Bonds receivable and payable
Example of equity
Company A enters into a contract to deliver 300 of its own common shares to another party in settlement of an obligation regardless of the market value of the common shares. The contract results in the distribution from the residual assets of Company A. It is an equity instrument.
140
Example of liability/asset
Company C borrows money from a bank at a fixed interest rate of 8% per annum. The loan represents a contractual obligation of Company C to deliver cash (principal plus interest payments) to the bank. Therefore it is a financial liability of Company C. It also provides a contractual right for the bank to receive principal and interest payments in the form of cash from Company C. Therefore, it is a financial asset of the bank.
B. Measurement Initial measurement

Financial asset or financial liability is initially recognized at fair value fair value of consideration given (in case of asset) fair value of consideration received (in case of liability)
141
Fair Value
Determining Fair Market Value Quoted market prices Based on recent market transactions Based on similar financial instrument Acceptable valuation technique/methodologies (discounted cash flows or present value)
Example of Present Value
Assumptions: Non-interest bearing notes receivable of P45,000 due in three yearly installments of P15,000. Imputed interest rate is 10%. Face amount of NR Less: Present value of NR (P15000 x 2.4869) Discount on NR P45,000 37,304 P 7,696
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Fair Value
Entry to record notes receivable:

Dr. Notes receivable Dr. Interest expense Cr. Cash 37,304 7,696 45,000
C. Classifications of Financial Assets

Four Classifications for subsequent measurement 1. Financial assets at fair value through profit and loss (FVTPL) At fair value 2. Held-to-maturity (HTM) investments - At amortized cost 3. Loans and receivables At amortized cost 4. Available-for-sale (AFS) financial assets At fair value, changes in FV recognized in equity
143
Subsequent Measurement Financial Assets

Financial Assets Are Subsequently Recognized At Amortized Cost Loans and receivables
Financial assets at fair value through profit and loss (FVPL)
At Fair Value
Held-to-maturity investments Available-for -sale securities
At Cost
Equity instruments w/o quoted market price
Accounting vs. Tax
Accounting Policy Initial Measurement Financial assets or liabilities are recognized at FMV. Financial assets or liabilities with no provision for payment of interest shall be recognized at the date of the inception of the loan at the Present Value of the loan.
Recognized at contract amount or transaction value. Difference between TV and FMV is not recognized as gain or loss unless it is a completed transaction. Effective interest are part of contract value or transaction value.
144
Fair Value
Assumptions: Non-interest bearing notes receivable of P45,000 due in three yearly installments of P15,000. Imputed interest rate is 10%.
Year 1 2 3 Beginning Bal. of NR 37,304 41,034 43,637 PV of Notes 37,304 26,034 13,637 Amortization/ Interest Inc. 3,730 2,603 1,364 7,697 Collections 15,000 15,000 15,000 45,000 Ending Bal. of NR 41,034 43,637 -0-0-
Fair Value
Entry to record notes receivable:

Dr. Notes receivable Dr. Interest expense Cr. Cash 37,304 7,696 45,000
Entry to record first year installment payment:

Dr. Cash Dr. Notes receivable Cr. Cash Cr. Interest income 15,000 3,730 15,000 3,730
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Fair Value
Entry to record second year installment payment:

Entry to record third year installment payment:

Accounting vs. Tax
Accounting Policy
Initial Measurement Interest component is recognized as income or expense.
Effective interest are not taxable or allowed as deduction for tax purposes, unless the same is explicitly provided in the agreement giving rise to the liability (contractual)
146
Accounting vs. Tax
REQUIREMENTS FOR INTEREST DEDUCTIBILITY
1. There must be an indebtedness; 2. There should be an interest expense paid or incurred; 3. The indebtedness must be that of the taxpayer; 4. The indebtedness must be connected with the taxpayers trade, business or exercise of profession; 5. The interest expense must have been paid or incurred during the taxable year; 6. The interest must have been stipulated in writing and must be legally due;
Accounting vs. Tax
REQUIREMENTS FOR INTEREST DEDUCTIBILITY 7. The interest payment arrangement must not be between related taxpayers; 8. The interest must not be incurred to finance petroleum exploration; and 9. In case of interest incurred to acquire property used in trade, business or exercise of profession, the same was not treated as a capital expenditure.
147
Accounting vs. Tax

Tax: Rule on imputation of interest for related party non-interest bearing note or for interest below market notes.
Fil-invest Case: CTA Upheld the imputation CA Did not allow imputation
Computation of Interest
Under PAS 39, interest shall be computed using the Annuity Method. If a different method is being used to compute interest for tax purposes, different shall be reported as reconciling item. If taxpayer wants to adopt the Annuity Method for tax purposes, approval from the BIR must be secured
148
Accounting vs. Tax
Accounting Policy
Subsequent Measurement. Financial assets classified under FV/PL are charged to P&L .
Changes (gain or loss) in FV of asset classified as FVPL are non-taxable or nondeductible for tax purposes. Tax impact arises only when actually incurred or realized on a closed and completed transaction (e.g. financial asset is sold or exchanged).
Accounting vs. Tax
Accounting Policy Subsequent Measurement. Financial assets and liabilities on amortized cost (loans and receivables and held to maturity)
Amortization interest income or interest expense are non-taxable or nondeductible. Interest income/expense for tax are contractual and nominal.
149
Accounting vs. Tax
Accounting Policy
Reclassification of financial assets and liabilities
Gains or losses arising from reclassification shall not be considered for tax purposes.
Accounting vs. Tax
Accounting Policy Gain or loss from disposition of financial asset shall be the difference between the consideration received and the carrying value.
Tax Treatment / Issues When financial assets or liabilities are transferred or sold or disposed, gains or losses arising from the transfer shall be reckoned from the unadjusted carrying value of assets/liabilities (transaction value).
150
Accounting vs. Tax
Accounting Policy
Impairment loss is required to be recognized for a financial asset measured other than at fair value. Impairment is recognized in P&L.
Impairment losses of financial assets are not deductible for tax purposes.
Accounting vs. Tax
Accounting Policy Derivatives are measured at fair values Gains or losses on re-measurement to fair values are included in profit and loss unless the derivatives will qualify as cash flow hedges or hedge of net investment in a foreign operation which is recognized as part of equity
Tax Treatment / Issues Income/losses from derivatives and hedging instruments shall be recognized only when the transaction covered by the instrument has been closed and completed or there is an actual transaction. Difference between TV and Fair values are non-taxable and non-deductible.
151
Accounting vs. Tax
1. Watch out for reconciling items for income tax purposes: Effective interest recognized on PV FMV vs. TV especially upon disposal (determination of taxable gain or loss) Impairment losses Revaluation for FMV Gain or loss on reclassification 2. Actual Transaction Value important for tax determination. Documents should be preserved.
PAS 32 Financial Instruments: Presentation & Disclosures
152
Covers
A. Liability B. Equity C. Compound Financial Instruments D. Interests, Dividends, Losses and Gains
Presentation: Liability vs. Equity

Financial Liability
When issuer is or can be required to deliver either cash or another financial asset to the holder (presence of contractual obligation)
When it represents a residual interest in the net asset of the issuer
Equity Instrument
153
A. Basic Rule: Classification
Accounting
Based on SUBSTANCE
Tax
Based on LEGAL FORM Treated as obligation if covered by PN, Loan agreements and etc. Treated as equity if representing ownership in company. Normally covered by shares of stocks
Accounting
Income: Follows the SUBSTANCE of the FI. (Dividend if Equity and Interest if Liability)
Tax
Income: Follows the LEGAL FORM of FI
154
Financial Liabilities vs. Equity Instruments
Example:
Company A issued on May 5, 2005 preferred shares with 10% dividend per year and are redeemable in May 2010. Accounting: The preferred shares are to be presented in the B/S of Company A as liabilities because they represent contractual obligations of the company to deliver cash at a fixed maturity date. Tax: The preferred shares are treated as equity. Payout is dividend not interest.
Instrument
Common shares Redeemable preferred shares with 50% fixed dividend each year subject to availability of distributable profits Convertible bond which converts into fixed number of shares
Cash Obligation for Principal No
Cash Obligation for Coupon/ Dividends No
Classification
Equity
Yes
Yes
Liability Liability for bond and equity for option Liability
Yes
Yes
Convertible bond which converts into shares to the value of the liability
Yes
Yes
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Compound Instruments
Classification
The issuer of a financial instrument that contains both a liability and an equity element should classify the instrument's component parts separately.
Interest, Dividends, Losses and Gains
Recognition and measurement follows the classification of the related instrument Interest, dividends, gains and losses relating to an instrument classified as financial liability are reported in profit and loss. Distribution to holders of a financial instrument classified as equity are charged directly against equity. Same for Accounting and Tax. HOWEVER, difference may arise if the instrument are classified differently.
156

Instrument
Common shares Redeemable preferred shares with 50% fixed dividend each year subject to availability of distributable profits Convertible bond which converts into fixed number of shares Convertible bond which converts into shares to the value of the liability
Classification For Accounting

Equity
Treatment For Tax

Equity
Payout
Dividends Accounting: Interest Tax: Dividends Accounting: Interest and Dividend Tax: Interest Interest
Liability Liability for bond and equity for option
Equity Liability
Liability
Liability until converted to shares
Tax Treatment: Interest vs. Dividend
Deductibility
Interest Dividend Deductible subject Non-deductible to interest arbitrage Also, subject to rules on interest deductibility - 20% FT if from a bank - 20% FT for foreign loans - Treaty rate -0% if intercorporate -32% if NRFC unless Treaty rate - 15% if Resident payee
Withholding Tax
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F. Tax Treatment: Interest vs. Dividend
Other tax adjustments due to PAS 39 1. Deductibility of the expense 2. Determination of Book Value of Shares 3. Interest Arbitrage 4. Withholding rate applicable 5. Calculation of IAET
PAS 36
Impairment of Assets
158
Significant Provisions
When is an Asset Impaired?
Impairment = Carrying Amount > Recoverable Amount Recoverable amount = Higher of Net Selling Price And Value in Use
PAS 36: Impairment of Assets
Accounting Policy Impairment loss is charged to profit and loss. A reversal of an impairment loss for an asset shall be recognized immediately in profit or loss, unless the asset is carried at revalued amount. Any reversal of an impairment loss of a revalued asset is credited directly to equity under the heading revaluation surplus.
Tax Treatment / Issues Losses recognized due to impairment are not deductible. Gains from reversal of impairment loss are not taxable.
159
Example
Calculation of the Impairment loss at the end of 2005 Carrying amount before impairment loss Recoverable amount (Schedule 1) Impairment loss Carrying amount after impairment loss P121,128 P150,000 121,128 (P 28,872 )
Accounting vs. Tax
Accounting Policy
After recognizing impairment Deductible depreciation shall be loss, the adjusted carrying based on the carrying value before value of assets shall be the adjustments due to impairment. basis of future depreciation and shall be the basis for When the assets are disposed, for recognizing gains or losses purposes of determining gains or losses when the asset is disposed. on sale of assets, the carrying value of the asset (before adjustments due to impairment losses) shall be considered.
160
PAS 38
Intangible Assets
Definition
Intangible asset - An identifiable nonmonetary asset without physical substance. An asset is a resource that is controlled by the enterprise as a result of past events (for example, purchase or self-creation) and from which future economic benefits (inflows of cash or other assets) are expected.
161
Examples of Intangible Assets
computer software patents copyrights motion picture films customer list mortgage servicing rights licenses import quotas franchises customer and supplier relationships marketing rights
Intangibles can be acquired by -
by separate purchase as part of a business combination by a government grant by exchange of assets by self-creation (internal generation)
162
Initial Measurement
1. Separate acquisition purchase price + any directly attributable cost of preparing the asset for its intended use 2. Acquired in a business combination fair value at the acquisition date
Initial Measurement contd.

3. Acquisition by way of government grant at fair value or at a nominal amount plus any expenditure that is directly attributable costs 4. Exchanges of assets fair value unless the exchange (a) lacks commercial substance or (b) neither the fair value of the asset received or given up is reliably measurable. If not at fair value, at the carrying amount of the asset given up.
163
Useful Life of Intangible Asset

Intangible assets are classified as: Finite life: A limited period of benefit to the entity. Indefinite life: No foreseeable limit to the period over which the asset is expected to generate net cash inflows for the entity.
Tax Rules on Amortization of Intangible Assets
An intangible asset acquired through capital outlay is known from experience to be of value in the business for only a limited reasonable certainty, such intangible asset may be the subject of a depreciation allowance provided the facts are fully shown in the return or prior thereto to the satisfaction of the Commissioner of Internal Revenue.
- Sec. 107, Rev. Reg No. 2
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Tax Rules on Amortization of Intangible Assets

Leasehold costs are subject to amortization over the term of the lease.
Organization expenses are subject to amortization and are not deductible in full on the year incurred. Trademarks may be depreciated or amortized over the average remaining useful lives of the trademarks purchased. However, the cost of the different formulae can be amortized over the (a) remaining useful lives of the trademarks purchased, or (b) the expected period within which your client proposes to continue manufacturing the products using the said formulae. BIR Ruling No. 211-88
Amount paid for an agreement not to compete in a trade or business is considered as capital expenditures and is subject to allowances for depreciation ratably spread over the period mentioned in the said agreement but only where the elimination of competition is for a definite and limited term. BIR Ruling No. 206-88 Goodwill is not subject to amortization but can only be deducted for tax purposes when the same business or the assets related to the said goodwill is sold by your client. BIR RULING [UN-207-95]
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Research and Development Costs

1. Research phase expense as incurred 2. Development phase recognize an asset subject to certain criteria
Accounting vs. Tax
Accounting Policy Expenditure on research shall be recognized as an expense when it is incurred.
Tax Treatment / Issues The entity is given the option to treat research expenditures as deferred expenses and claim as deduction ratably distributed over a period of not less than 60 months, beginning with the month in which the taxpayer first realizes benefits from such expenditures. If research expenditures are treated differently for tax and accounting purposes, the account should this be presented as a reconciling item in the Income Tax return.
166
Accounting vs. Tax
Accounting Policy Unamortized research expenditures that had been capitalized in the past should be written off. The resulting loss shall be recognized as expense.
Tax Treatment / Issues If the entity earlier elected to treat such expenditure has a deferred asset and claimed as deduction the related amortization, it should continue to do so. However, it must secure the approval of the BIR Commissioner to change to a different method with respect to the unamortized portion of the research expenditures.
Accounting vs. Tax
Accounting Policy Development expenditures can be capitalized as an intangible asset. Such intangible asset can be carried either at cost, or at revalued amounts, less accumulated amortization and impairment losses.
Tax Treatment / Issues The entity has the option to claim development expenses as deduction in the year incurred, or to treat the same as deferred expenses and claim as deduction the related amortization over a period not less than 60 months.
167
Accounting vs. Tax

Accounting Policy If taxpayer opts to follow the revaluation method, increases in the intangible assets carrying amount shall be credited directly to equity. However, the increase shall be recognized in P&L to the extent that it reverses a revaluation decrease of the same asset previously recognized in P&L. Decreases due to revaluation shall be recognized in P&L. However, the decrease shall be debited directly to equity to the extent of any credit balance in the revaluation surplus in respect of that asset. Tax Treatment / Issues If it chooses to treat Development expenditures as deferred expenses, it can only claim as deduction the amount equivalent to the amortization of the asset. Adjustments in the carrying value of the assets due to revaluation do not impact the determination of the entitys taxable income.
PAS 40 Investment Property
168
Investment property
Is property (land or building) used to earn rentals or for capital appreciation or both rather than for use in the production or supply of goods or for administrative purposes, or sale in the ordinary course of business.
Accounting vs. Tax
Accounting Policy An entity is given the option to choose either (a) a fair value model, under which an investment property is measured at fair value with changes in fair value recognized in profit or loss; (b) a cost model, which requires an investment property to be measured after initial measurement at depreciated cost.
For tax, such losses and gains are not deductible and taxable, respectively. When the assets are disposed, gain or loss shall be determined using the unadjusted carrying value (without adjustment of fair value effects).
169
Tax on Sale of Investment Property
If a property has been re-classified as Investment Property, would the income from the sale or transfer of such property be treated as ordinary income or capital gains? - It depends on the nature of the property. If the property is held for lease, then it is an ordinary asset being used in business and, as such, the gain from the sale shall be treated as ordinary income.
Tax on Sale of Investment Property
If the property is being held for investment purposes, generally, it shall be treated as a capital asset and the gain from disposition thereof shall be a capital gain. Exception: if the property is an ordinary asset if Inventories (personal or real property) Property held primarily for sale to customers in the ordinary course of business Property used in trade or business which are subject to depreciation
170
PFRS 5
Non-Current Assets Held for Sale and Discontinued Operations
Classification
An entity shall classify a non-current asset (or disposal group) as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continuing use.
171
Measurement
The following measurement principles apply:
At the time of classification as held for sale in accordance with applicable IFRSs. After classification as held for sale lower of carrying amount and fair value less cost to sell Impairment: - At time of classification in accordance with applicable IFRSs - After classification Difference between the adjusted carrying amount and fair value less cost to sell.
Measurement
Recognition of Impairment Loss
1. Recognize an impairment loss for any initial or subsequent write-down of the asset to FV less costs to sell. 2. Recognize an impairment gain for any subsequent increase in FV less costs to sell but not in excess of the cumulative impairment loss that has been recognized.
172
Measurement
Depreciation An entity shall not depreciate (or amortize) a non-current asset while it is classified as held for sale or while a part of a disposal group classifies as held for sale
Tax Rule on Depreciation
A depreciation deduction is allowed to cover reasonable allowance for the exhaustion, wear and tear (including reasonable allowance for obsolescence) of property used in the trade or business.
173
Accounting vs. Tax
Accounting Policy An entity shall measure non-current asset held for sale (NCAHS) at lower of its carrying amount and fair value less cost to sell. When sale is expected to occur beyond one year, the entity shall measure the costs to sell at their PV. Any increase in PV of the cost to sell that arises from the passage of time shall be presented in P&L as financing cost.
Tax Treatment / Issues Any gain/loss resulting from remeasurement shall not be taxable/deductible.
Accounting vs. Tax
Accounting Policy An entity shall not depreciate (or amortize) a non-current asset while it is classified as held for sale or while a part of a disposal group classified as held for sale. Impairment losses shall be recognized as expense.
Tax Treatment / Issues Taxpayer shall cease to claim deduction for depreciation for properties held for sale.
Impairment losses are not deductible for tax purposes.
174
Tax on Sale of Properties Held for Sale
When the property is classified as held for sale, does it become a capital asset? - In general, whether depreciation continues or not, an asset previously subject to depreciation does not lose its character as an ordinary asset [Sec. 3(b) of RR 7-03]. However, an ordinary asset shall become a capital asset if it had been idle and not used in business for at least two years. In the case of real property owned by a taxpayer engaged in real estate business shall always be an ordinary asset. (RR 7-03)
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A Closer Look at ITR Preparation

Coverage and Presentation

Income Tax vs. Books

Income Tax vs. Books

Accrual vs. Installment Method

Effective Interest vs. Rule 78 Method

Interest income is spread over a straight-line basis vs. declining balance

Reminder: Do not confuse income tax and VAT rules!

Under special laws

Cost of Service (Sheds. 2 & 3)

Cost of Sales Trading and Manufacturing

Equals: Cost of Sales

AFS vs. ITR

Cost of Goods Sold

Ending Inventory Tax vs. Books

Ending Inventory ITR vs. Inventory List

Cost of Service (RMC 4-03)

Cost of Service (RMC 4-03)

Cost of Service (RMC 4-03)

Customs, insurance, real estate, immigration and commercial brokers.

Cost of Service (RMC 4-03)

Cost of Service (RMC 4-03)

Cost of Service (RMC 4-03)

Cost of Service (RMC 4-03)

Cost of Service (RMC 4-03)

Cost of Service (RMC 4-03)

Cost of Service (RMC 4-03)

Cost of Service (RMC 4-03)

Cost of Service (RMC 4-03)

Cost of Service (RMC 4-03)

Other COS items per Tax Rulings

Non-operating and other income

Other Income Tax vs. Books

Other Income Tax vs. Books

For reporting purposes

Ordinary and necessary

Ordinary vs. Extra-ordinary expenses

Ordinary vs. Extra-ordinary expenses

Rules on deductibility of business expense

Expenses are deductible in the year the liability is fixed

Substantiated with sufficient evidence

Additional requisites of deductibility

Rules on Specific Types of Deductions

Representation Expenses - Limitation

Excluded from R&E ceiling

Not covered by CAP:

Requirements for deductibility

The interest must have been stipulated in writing;

Requirements for deductibility

Interest Expense - Limitation

P 100,000 P4,000 x 42% - 1,680 P 98,320

Equals:Deductible Interest Expense

Interest Expense - Not subject to limitation

Interest Expense - Tax vs. Books

Consider impact of new accounting standards on amount of interest per books:

Optional treatment of interest expense

interest incurred to acquire property for use in the business

Losses Decline in Value of an asset

3-year period continues to run even if corporation paid MCIT

75% of outstanding issued shares or paidup capital