In last week’s article, my colleague discussed the new rules on the treatment of foreign currency transactions for internal revenue tax purposes. That article provided clarifications and guidelines on the use of appropriate forex rates in recording and reporting foreign currency transactions for tax purposes.
Now, let’s do a deep dive into the Bureau of Internal Revenue’s (BIR) recently issued Revenue Memorandum Circular (RMC) No. 19-2024. This RMC provides clarification on the tax treatment of interest expense paid or incurred on indebtedness in connection with the taxpayer’s profession, trade, or business and other related matters. According to BIR, it has been observed that the differences in the treatment of interest expense in the financial statements and tax returns give rise to several issues and concerns for both the BIR and the taxpayers. Hence, the BIR issued the RMC to assist the taxpayers in properly treating the interest expense for tax purposes.
Requirements for deductibility of interest expense
The RMC reiterated that interest expense paid or incurred within a taxable year on indebtedness in connection with the taxpayer's profession, trade, or business shall be allowed as a deduction from gross income when all the requirements of deductibility are satisfied. These requirements include, among others, that the indebtedness must be that of the taxpayer, the interest must have been stipulated in writing, the interest must be legally due, and the interest was not treated as capital expenditure if such interest was incurred in acquiring property used in trade, business, or exercise of profession.
In addition, the RMC stated that the tax must have been withheld on interest to claim such interest as a deduction from gross income. However, with the passage of the Ease of Paying Taxes Act, which became effective on January 22, 2024, this requisite has been repealed.
Capitalizable interest
For tax purposes, only the interest expense directly attributable to the acquisition of any property (e.g., building, car, or machinery) used in trade, business, or exercise of profession (excluding assets intended for sale such as inventories) may be capitalized.
Should the taxpayer elect to capitalize the interest expense incurred to acquire property used in trade, business, or exercise of profession for tax purposes, the following rules and requirements shall be followed:
The BIR provides illustrations and computations in Annex A of the RMC for taxpayers to better appreciate the above rules.
Disclosure in Notes to Financial Statements
For the proper monitoring of interest expenses, the RMC provided that the following may be submitted and/or disclosed in the Notes to Financial Statements of the taxpayer:
With respect to the first requirement (i.e., subsidiary ledger) and last requirement, the RMC did not state when and where the taxpayer would submit the documents. Should the documents be filed annually or during a tax audit? Let’s wait for the BIR’s answer to this.
Prepaid interest or interest expense paid in advance
As a general rule, interest expenses shall be deducted in the year paid or incurred.
Individual taxpayers reporting income on a cash basis who incur an indebtedness on which an interest is paid in advance through discount or otherwise, such interest expense paid in advance shall only be allowed as a deduction in the year when the taxpayer has fully paid the indebtedness. If the indebtedness is payable through periodic amortization, the amount of interest expense that corresponds to the amount of the principal amortized or paid during a certain period shall be allowed as a deduction in such taxable year.
For corporations that prepay the interest at the loan drawdown date, the prepaid interest shall be amortized over the required period. To fully reflect the revenues generated and expenses incurred, the amortized portion shall be deducted from the prepaid interest as the expense for the taxable year within the required period.
Other clarifications
The RMC reiterated the Tax Code provision which states that interest expenses shall not be deductible 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) of the Tax Code, as amended.
Moreover, costs such as service fees and commissions paid to banks and/or lending institutions for borrowing funds shall not be classified as interest expenses but as ordinary and necessary business expenses that are deductible in the year paid or incurred.
Further, the RMC recapped the applicable withholding tax rate on interest expense paid or incurred on debt instruments not within the coverage of deposit substitutes.
Finally, the RMC was issued on February 5, 2024, and took effect immediately.
Takeaway
With the issuance of the RMC, taxpayers are now guided in the proper tax treatment of interest expense; more so, the issues and concerns surrounding the deductibility of interest expense for both BIR and taxpayers during tax audit are expected to lessen.
The efforts put in by the BIR, particularly the BIR Project Management Team for Financial Reporting Standards, to bridge the gaps between financial reporting and tax reporting won’t go unnoticed. Taxpayers, the private sector, and external stakeholders recognized and appreciated the BIR’s drive to boost tax awareness and take the technical concept of taxation to the doors of ordinary taxpayers while communicating through a layman’s point of view, as Commissioner Lumagui said, “Taxation is for everyone. It was not meant to be understood only by a few people.”
Let's Talk Tax is a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.
As published in BusinessWorld, dated 27 February 2024
