SEC 34(B).

INTEREST

INTEREST shall refer to the payment for the use or forbearance or detention of
money, regardless of the name it is called or denominated. It includes the amount paid
for the borrower's use of, money during the term of the loan, as well as for his
detention of money after the due date for its repayment.

REQUISITES FOR DEDUCTIBILITY (REV. REG. NO. 13-2000)

1. There must be indebtedness;

2. There should be an interest expense paid or incurred upon such indebtedness;
3. The indebtedness must be that of the taxpayer;
4. The indebtedness must be connected with the taxpayer's 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;
7. The interest must be legally due;
8. The interest arrangement must not be between related taxpayers;
9. The interest must not be incurred to finance petroleum operations; and
10. 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.
11. The interest is not expressly disallowed by law to be deducted from gross income of
the taxpayer.

RULES ON DEDUCTIBILITY OF INTEREST EXPENSE

General Rule - In general, the amount of interest expense paid or incurred within a
taxable year of indebtedness in connection with the taxpayer's trade business
or exercise of profession, shall be allowed as a deduction from the taxpayer's
gross income.

Limitation - The amount of interest expense paid incurred by a taxpayer in

connection with his trade, business or exercise of a profession from an existing
indebtedness shall be reduced by an amount equal the following percentages of
interest income earned which had been subjected to final withholding
depending on the year when the interest income earned, viz:

41% - beginning January 1, 1998;

39% - beginning January 1, 1998;
38% - beginning January 1, 2000;
 42% - beginning November 1, 2005; and
33% - beginning January 1, 2009 and thereafter.

Aim of Limitation: To discourage so-called back-to-back loans where a taxpayer

secures a loan from a bank, turns around and invests the loan proceeds in
money market placements. By imposing a limit as to the amount of interest expense
that can be deducted from gross income, the previous practice of tax arbitrage was
absolutely nullified.

Tax Arbitrage is a method of borrowing without entering into a debtor/creditor

relationship, often to resolve financing and exchange control problems. In tax
cases, back-to-back loan is used to take advantage of the lower of tax on interest
income and a higher rate of tax on interest expense deduction.

Deductible Interest Expense

Deductible Interest Expense

1. Interest on taxes, such as those paid for deficiency or delinquency, since taxes are
considered indebtedness (provided that the tax is a deductible tax, except in the
case of income tax). However, fines, penalties, and surcharges on account of taxes
are not deductible. The interest on unpaid business tax shall not be subjected
to the limitation on deduction.
2. Interest paid by a corporation on scrip dividends
3. Interest-on deposits paid by authorized banks of the Bangko Sentral ng Pilipinas
to depositors, if it is shown that the tax on such interest was withheld.
4. Interest paid by a corporate taxpayer who is liable on a mortgage upon real property
of which the said corporation is the legal or equitable owner, even though it is not
directly liable for the indebtedness.

NON-DEDUCTIBLE INTEREST EXPENSE

1. An individual taxpayer reporting income on the cash basis incurs an indebtedness

on which an interest is paid in advance through discount or otherwise:

allowed as a deduction in the year the indebtedness is paid

If the indebtedness is payable periodic amortization on, the amount of
interest which corresponds to the amount of the principal amortized or paid
during the year shall be allowed as deduction in such taxable year.

2. Interest paid on indebtedness between related taxpayer

3. If the indebtedness is incurred to finance petroleum exploration
4. Interest on preferred stock, which in reality is dividend
5. Interest on unpaid salaries and bonuses
6. Interest calculated for cost keeping on account of capital or surplus invested in
business which does not represent charges arising under interest-bearing
obligation.
7. Interest paid when there is no stipulation for the payment thereof.

OPTIONAL TREATMENT OF INTEREST EXPENSE

At the option of the taxpayer, interest incurred to acquire property used in trade or
business may be allowed as a deduction or treated as capital expenditure. [Sec
34 (B) (3), NIRC]

Interest expense (tax arbitrage). There are exception and limitations on the
amount of interest expense that can be deducted from income. The taxpayers
allowable deduction for interest expense shall be reduced by an amount equal
to the 33% of the interest income subjected to final tax. Moreover, all interest
incurred or paid to related parties cannot be claimed as deductions to income

Its tax season and business and individuals with taxable year ending December 31 are starting to
work on financial statements and tax returns. One of the areas frequently confused about is the
deductibility of interest expense, on what are the limits, when deductible and when non-deductible.
Lets take a look on what the tax code says about the deductibility of interest expenses.
Section 34 of the National Internal Revenue Code of the Philippines, otherwise known as the Tax
Code of The Philippines set forth the following on the deductibility of interest expense from taxable
gross income:
(B) Interest.-
(1) In General. The amount of interest paid or incurred within a taxable year on indebtedness in connection
with the taxpayers profession, trade or business shall be allowed as deduction from gross income: Provided,
however, That the taxpayers otherwise allowable deduction for interest expense shall be reduced by an
amount equal to the following percentages of the interest income subjected to final tax:
Forty-one percent (41%) beginning January 1, 1998;
Thirty-nine percent (39%) beginning January 1, 1999; and
Thirty-eight percent (38%) beginning January 1, 2000;
(2) Exceptions. No deduction shall be allowed in respect of interest under the succeeding subparagraphs:
(a) If within the taxable year an individual taxpayer reporting income on the cash basis incurs an
indebtedness on which an interest is paid in advance through discount or otherwise: Provided, That such
interest shall be allowed as a deduction in the year the indebtedness is paid: Provided, further, That if the
indebtedness is payable in periodic amortizations, the amount of interest which corresponds to the amount of
the principal amortized or paid during the year shall be allowed as deduction in such taxable year;
(b) If both the taxpayer and the person to whom the payment has been made or is to be made are persons
specified under Section 36 (B); or
(c) If the indebtedness is incurred to finance petroleum exploration.
(3) Optional Treatment of Interest Expense. At the option of the taxpayer, interest incurred to acquire
property used in trade business or exercise of a profession may be allowed as a deduction or treated as a
capital expenditure.
Section 36 (B) of the Tax Code reads as follows:
(B) Losses from Sales or Exchanges of Property. In computing net income, no deductions shall in any case
be allowed in respect of losses from sales or exchanges of property directly or indirectly
(1) Between members of a family. For purposes of this paragraph, the family of an individual shall include
only his brothers and sisters (whether by the whole or half-blood), spouse, ancestors, and lineal descendants;
or
(2) Except in the case of distributions in liquidation, between an individual and corporation more than fifty
percent (50%) in value of the outstanding stock of which is owned, directly or indirectly, by or for such
individual; or
(3) Except in the case of distributions in liquidation, between two corporations more than fifty percent (50%)
in value of the outstanding stock of which is owned, directly or indirectly, by or for the same individual if
either one of such corporations, with respect to the taxable year of the corporation preceding the date of the
sale of exchange was under the law applicable to such taxable year, a personal holding company or a foreign
personal holding company;
(4) Between the grantor and a fiduciary of any trust; or
(5) Between the fiduciary of and the fiduciary of a trust and the fiduciary of another trust if the same person is
a grantor with respect to each trust; or
(6) Between a fiduciary of a trust and beneficiary of such trust.
Based on the above provisions, please see the following examples for you to better understand how
it is to be applied:
1. A company earned interest income from loans to employees amounting to P100,000 and incurred
interest expense on a loan from a bank amounting to P200,000 can deduct the entire interest expense of
P200,000 from its taxable gross income.
2. A company earned interest income from money market placements amounting to P100,000 and
incurred interest expense on a loan from a bank amounting to P200,000. This company can deduct
only P162,000 of the interest income from its taxable gross income. The P200,000 interest expense
is reduced by 38% of P100,000 interest income or P38,000.
3. A company earned interest income from money market placements amounting to P300,000 and
incurred interest expense on a loan from a bank amounting to P100,000. This company is not
allowed to deduct any amount of interest expense from its taxable gross income since the 38% of the
interest income subjected to final tax of P114,000, which will reduce the deductible interest expense,
is higher than the interest expense of P100,000.
4. Mr. X, father of Mr. A, the debtor, lend P1,000,000 for the latters personal business, earning Mr. X
interest income amounting to P50,000 during the current taxable year. Mr. A cannot claim this
interest expense as a deduction against his taxable gross income.
5. ABC Co. purchased a machinery on installment costing P5,000,000 and incurred interest
amounting to P200,000 in financing the purchase. ABC Co. has the option to either claim the interest as
interest expense which is deductible at the time it was paid, or treated as capital expenditure which will
form part of the cost of the machinery and shall be deductible as depreciation expense over the useful
life of the machinery.
6. Mr. A, reporting on a cash basis, borrowed from XYZ Co. P5,000,000 payable in lump sum after 2
years with interest deducted in advance amounting to P700,000. Mr. A can only claim the interest
expense upon payment of the loan.
7. Assuming the same case above, except that the loan is payable semi-annually in
equal installments, Mr. A can claim interest expense corresponding to the amount of principal paid.

Sec. 36. (B) Losses from Sales or Exchanges of Property. - In computing net
income, no deductions shall in any case be allowed in respect of losses from sales or
exchanges of property directly or indirectly -

(1) Between members of a family. For purposes of this paragraph, the family of an
individual shall include only his brothers and sisters (whether by the whole or half-
blood), spouse, ancestors, and lineal descendants; or

(2) Except in the case of distributions in liquidation, between an individual and

corporation more than fifty percent (50%) in value of the outstanding stock of which
is owned, directly or indirectly, by or for such individual; or

(3) Except in the case of distributions in liquidation, between two corporations more
than fifty percent (50%) in value of the outstanding stock of which is owned, directly
or indirectly, by or for the same individual if either one of such corporations, with
respect to the taxable year of the corporation preceding the date of the sale of
exchange was under the law applicable to such taxable year, a personal holding
company or a foreign personal holding company;

(4) Between the grantor and a fiduciary of any trust; or

(5) Between the fiduciary of and the fiduciary of a trust and the fiduciary of another
trust if the same person is a grantor with respect to each trust; or

(6) Between a fiduciary of a trust and beneficiary of such trust.