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Tax Alert

Criteria and Guidelines on the Deductibility of Ordinary and Necessary Trade, Business or Professional Expenses

04 Sep 2025 11 min read

(Revenue Memorandum Circular No. 81-2025 issued on September 3, 2025)

This Tax Alert is issued to inform taxpayers of the reiteration of the criteria and guidelines on the deductibility of ordinary and necessary expenses under Section 34(A)(1)(a) of the Tax Code. 

Pursuant to Section 34(A)(1)(a) of the Tax Code, ordinary and necessary expenses paid or incurred during the taxable year in carrying on or which are directly attributable to, the development, management, operation and/or conduct of the trade, business or exercise of a profession, shall be allowed as deduction from gross income.

I. Persons Entitled to Deduction

a. Individuals – citizens, resident alien, non-resident alien engaged in trade or business in the Philippines, members of general professional partnerships

b. Corporations/institutions – domestic corporations, resident foreign corporations, proprietary educational institutions and hospitals, and Government-owned and controlled corporations (GOCCs)

II. Criteria for Deductibility 

a. Ordinary and Necessary Expenses

The expense must be both ordinary and necessary to the trade, business or practice of profession. 

Ordinary Expense

An “ordinary expense” is one that is normal, usual and customary in the type of business conducted by the taxpayer. It does not need to be habitual or recurring but should be common in the context of the business. The term “ordinary” denotes that the expense must be typical and usual in relation to the business activities. 

The expenses must meet the further test of reasonableness in amount. An expense that is inordinately large (nearly equaled half of the total claimed expenses) cannot be considered as an ordinary expense even if it is necessary. The size and relative proportion of expenses must be considered.

Extraordinary and unusual amounts paid to persons (natural or juridical) as compensation for their supposed services, but without any relation to the measure of their actual services, cannot be regarded as ordinary and necessary expenses within the meaning of the law. This posture is in line with the doctrine in the law of taxation that a taxpayer must show that its claimed deduction clearly come within the language of the law since allowances, like exemptions, are matters of legislative grace. 

Necessary Expense

A “necessary expense” is one that is appropriate and helpful for the development of the taxpayer’s business. This implies that the expense should be directly connected and proximately resulting from carrying on the business and must contribute to the generation of income or profit or minimizing a loss.

Expenditures not directly related to the earnings of the business within the Philippines, such as costs incurred for remittance of funds to an overseas head office, are not deductible.

b. Paid or Incurred Within the Taxable Year

Pursuant to Section 45 of the Tax Code, the deductions shall be taken for the taxable year (either calendar year or fiscal year) in which 'paid or accrued' or 'paid or incurred', dependent upon the method of accounting upon the basis of which the net income is computed, unless in order to clearly reflect the income, the deductions should be taken as of a different period.

Therefore, the deductible business expenses claimed must be for expenses that are paid or incurred within the taxable year when the corresponding revenue is earned.

c. Direct Attribution to Trade, Business or Profession 

There should be a direct link between the expense being deducted and the taxpayer’s business activities. 

“Directly attributable" means the expenses must have a clear and direct connection to the development, management, operation, and/or conduct of the trade, business, or profession, ensuring they are essential for maintaining and generating business income. 

Active Income vs. Passive Income

When a taxpayer incurs expenses related to both active and passive income, determining which expenses qualify as valid deductions under the "ordinary and necessary" provisions requires careful consideration of their direct connection to income-generating activities. 

Active income typically arises from direct involvement (active pursuit) in trade, business, or professional activities, while passive income comes from investments like dividends, interest, and royalties. A passive income can become active if the taxpayer repeatedly and systematically engages in activities that produce such income, transforming it into a business venture. Likewise, income typically considered active may be treated as passive if it is earned occasionally or without any substantial or recurring effort. Ultimately, classification hinges on whether the income results from habitual business-driven actions or from merely holding assets and earning returns without substantial participation. 

Expenses related to managing investments that generate passive income, such as fees for financial advice, interest from loan to finance investments, or brokerage services, and other related expenses may not qualify as deduction, as they do not relate directly to the taxpayer's active business operations.

Each income stream, whether subject to regular tax, preferential rates, tax-exempt, or final tax, should have its expenses correctly identified.

Expenses Pertaining to Tax-Exempt Income 

Expenses solely incurred in relation to tax-exempt income are not deductible for regular income tax purposes. Business expenses related to tax-exempt income do not contribute to the generation of taxable income and therefore do not meet the criteria of being necessary for the conduct of the business in the pursuit of income.

Expenses Pertaining to Income Subject to Final Withholding Tax

The expenses solely related to generating income subject to final withholding tax are usually not deductible against other taxable income subject to regular income tax. Since this passive income has already been taxed at a final rate, allowing further deductions would distort the taxation principle that final withholding tax is comprehensive and conclusive. Thus, costs related to investment management do not qualify for deductions typically reserved for business operations.

Expenses Pertaining to Income Subject to Preferential Tax Rate

Expenses which are directly attributable to income subject to a preferential tax rate due to specific incentives or under special laws, are not deductible from the regular taxable income.

For business enterprises registered with Investment Promotion Agencies and whose availing of the five percent (5%) special corporate income tax (SCIT) incentive based on its gross income earned, in lieu of all national and local taxes, under Section 294(B) of the Tax Code, the “gross income earned” refers to gross sales/revenues net of sales discounts, returns, allowances, and direct costs related to production of goods/services. Indirect operating expenses like advertising, representation, entertainment, commissions, clinic and office supplies, as well as freight and handling costs unrelated to production which did not qualify as direct costs are disallowed as deductions for this purpose. Section 1(b), Rule 2 of Implementing Rules and Regulations of RA No. 12066 provides for list direct costs for purposes determining gross income businesses under five percent (5%) SCIT incentive.

d. Substantiation

The taxpayer must substantially prove by evidence or records the deductions claimed under the law, otherwise, the same will be disallowed. Pieces of evidence, such as official invoices and vouchers, must be presented to substantiate the business expenses.

All revenue issuances and BIR rulings inconsistent with the provisions of this circular are considered amended, modified or revoked accordingly.

The circular takes effect immediately.

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