Interest expense is a common cost incurred by businesses in the course of securing financing for operations, expansion, or other corporate activities. In the Philippines, the tax treatment of interest expense on corporate borrowings is governed by the National Internal Revenue Code (NIRC) and various regulations issued by the Bureau of Internal Revenue (BIR).
Proper classification and deduction of interest expenses can significantly impact a company’s taxable income. Therefore, this blog will guide you through key aspects such as the definition and capitalization conditions under PAS 23, tax implications as explained in RMC No. 19-2024, and considerations for intercompany loans.
Additionally, we will also explore how interest expense on corporate borrowings is treated for tax purposes in the Philippines, the limitations imposed by tax laws, and the compliance requirements businesses must follow.
Hence, it is fair to say that by exploring these sections, businesses and individuals will gain a clearer understanding of how to manage borrowing costs to ensure compliance and optimize their financial benefits.
What is Borrowing Costs Under PAS 23 in The Philippines?
Borrowing Costs under PAS 23 (Philippine Accounting Standard 23) refer to the interest and other costs incurred by an entity in connection with the borrowing of funds. These costs include interest on loans, amortization of discounts or premiums on borrowings, and finance charges related to leases.
PAS 23 provides guidance on how to account for these costs, specifically addressing when they should be capitalized as part of the cost of an asset and when they should be expensed.
Under PAS 23, borrowing costs that are directly attributable to the acquisition, construction, or production of a qualifying asset must be capitalized. A qualifying asset takes a substantial period to get ready for its intended use or sale.
Borrowing costs that are not directly attributable to the acquisition of a qualifying asset are recognized as an expense in the period in which they are incurred.
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Conditions Under Which Borrowing Costs Are Capitalized
Borrowing costs can be capitalized under PAS 23 when they are directly attributable to the acquisition, construction, or production of a qualifying asset. This process ensures that the cost of financing a long-term project is included in the value of the asset.
Below are the specific conditions under which borrowing costs are capitalized:
1. Qualifying Asset
Borrowing costs are capitalized if they relate to a qualifying asset which are assets that require a substantial period to get ready for its intended use or sale, such as buildings, plants, or infrastructure projects.
2. Direct Attribution
The borrowing costs must be directly attributable to the acquisition, construction, or production of the qualifying asset. This means the costs incurred should be specifically for the purpose of financing that particular asset.
3. Commencement of Capitalization
Capitalization of borrowing costs starts when three criteria are met:
- Expenditures for the asset are being incurred.
- Borrowing costs are being incurred.
- Activities necessary to prepare the asset for its intended use or sale are in progress.
4. Suspension of Capitalization
Capitalization of borrowing costs is temporarily suspended during periods in which active development of the asset is interrupted.
5. Cessation of Capitalization
Capitalization of borrowing costs ceases when substantially all the activities necessary to prepare the asset for its intended use or sale are complete, even if the asset is not yet in use.
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Key Features of RMC No. 19-2024 in The Philippines
Revenue Memorandum Circular (RMC) No. 19-2024, issued by the Philippine Bureau of Internal Revenue (BIR) on February 5, 2024, clarifies the tax treatment of interest expenses incurred in connection with a taxpayer’s profession, trade, or business.
Here, take a closer look at its crucial features:
1. Deductibility of Interest Expenses
Interest expenses are deductible from gross income when the following conditions are met:
- The indebtedness is that of the taxpayer.
- The interest is stipulated in writing.
- The interest is legally due.
- The interest payment arrangement is not between related taxpayers.
- The interest is not incurred to finance petroleum operations.
- The interest was not treated as a capital expenditure if incurred in acquiring property used in trade, business, or exercise of profession.
- The interest shall be reduced by an amount equivalent to 20% of interest income subjected to final tax.
Previously, taxpayers were required to withhold tax on interest to claim it as a deduction. However, with the passage of the Ease of Paying Taxes Act, effective January 22, 2024, this requirement has been repealed.
2. Capitalization of Interest Expenses
Taxpayers may opt to capitalize interest expenses directly attributable to the acquisition of property used in trade, business, or exercise of profession.
The option to capitalize is irrevocable per specific asset and must be applied consistently across all related loans. The capitalized interest is then depreciated or amortized based on the asset's useful life.
3. Prepaid Interest or Interest Expense Paid in Advance
For individual taxpayers reporting income on a cash basis, interest expenses paid in advance are deductible in the year the indebtedness is fully paid.
If the indebtedness is payable in periodic amortizations, the interest expense corresponding to the principal amortized or paid during the year is deductible in that taxable year.
4. Interest Expense on Indebtedness Between Related Parties
Interest expenses are not deductible if the payment arrangement is between related taxpayers, as defined under Section 36(B) of the National Internal Revenue Code of 1997, as amended.
5. Required Disclosures in Financial Statements
Taxpayers should disclose the following in the Notes to Financial Statements:
- A subsidiary ledger detailing the interest expense capitalized or expensed.
- Disclosure of principal payments made and interest expenses paid or incurred.
- Documents justifying the capitalization of interest, such as board resolutions, loan documents, and certifications from financial institutions
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Key Conditions Required To Capitalize Interest Expenses For Tax Purposes in The Philippines
In the Philippines, the option to capitalize interest expenses on corporate borrowings is not automatic. Under Philippine tax law, specifically Revenue Memorandum Circular (RMC) No. 19-2024, interest expenses directly attributable to the acquisition of property used in trade, business, or the exercise of a profession may be capitalized.
This means that instead of being deducted as an expense in the year incurred, the interest is added to the property's acquisition cost and depreciated over its useful life.
Here, take a closer look at the key conditions under which interest rates are capitalized for tax purposes in the Philippines:
1. Direct Attribution
Only interest expenses directly related to the acquisition of qualifying assets (e.g., buildings, vehicles, machinery) can be capitalized.
2. Irrevocable Election
The choice to capitalize interest expense is irrevocable for each specific asset.
3. Proportional Capitalization
If a loan is used to acquire multiple properties, the interest expense must be proportionately capitalized across those properties.
4. Depreciation
Capitalized interest is subject to depreciation based on the asset's useful life, commencing when the asset is ready for its intended use.
Do you want to understand how you can claim interest rates as tax deductions in the Philippines? Check out this detailed video to learn more. This video discusses how interest expense can be claimed as a tax deduction under the 1997 National Internal Revenue Code (NIRC) in the Philippines.
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Full Deduction as an Outright Expense With Interest Arbitrage Rule
Understanding when interest expenses can be fully deducted as an outright expense requires clarity on certain tax rules and scenarios. In the context of Philippine taxation, businesses generally aim to maximize the deduction of expenses, including interest expenses, to reduce their taxable income.
Here's how deductions work under different circumstances:
1. Interest Expense Deduction
Interest expenses incurred by businesses in the course of trade or business can be fully deducted from gross income, provided that they meet specific conditions under the tax code. These include being legally due, directly related to the taxpayer's trade or business, and not between related parties.
2. Non-Capitalized Interest
Interest expenses that are not capitalized as part of the cost of an asset (for long-term projects or asset acquisition) can be deducted as outright expenses in the year they are incurred.
What Role Does The Interest Arbitrage Rule Play?
The Interest Arbitrage Rule comes into play when taxpayers attempt to fully deduct interest expenses from taxable income while simultaneously earning interest income subject to lower tax rates or final withholding tax. This practice is carefully regulated to prevent tax avoidance.
The purpose of the Interest Arbitrage Rule is to prevent businesses from benefiting from both low-taxed interest income and fully deductible interest expenses, which would create a tax advantage through arbitrage. This ensures a more balanced tax system where income and expenses are treated equitably.
Example
If a corporation incurs PHP 100k in interest expenses and earns PHP 50k in interest income subject to final tax, typically at a 20% withholding tax rate, the corporation can deduct only 80% of PHP 50k from the total interest expenses.
This results in a reduced deduction of PHP 90k (PHP 100k - [20% of PHP 50k]).
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Tax Treatment of Interest and Non-Interest Borrowing Costs
In assessing the tax treatment of interest and non-interest borrowing costs for corporations in the Philippines, it's essential to differentiate between interest expenses and other related costs.
Interest expenses refer to the actual interest paid on borrowed funds, which can be a crucial aspect of a company's operational expenses. Non-interest borrowing costs, such as service fees and commissions paid to banks or lending institutions, aren't classified as interest.
Instead, they're considered ordinary and necessary business expenses. This classification allows these non-interest costs to be deductible in the year they are paid or incurred, provided they relate directly to the taxpayer’s trade, business, or profession.
When borrowing funds from non-resident foreign corporations, interest paid on these loans is subject to a final withholding tax rate of 20%. However, this rate may be lower if there's a relevant tax treaty in place.
For example, the Philippines-Singapore tax treaty applies a reduced withholding tax rate of 15% on interest income for Singaporean residents, showcasing the importance of considering international agreements.
It's important to note that entertainment and similar expenses are subject to a capped deduction limit based on sales or revenue, which can influence the treatment of borrowing costs within certain corporate expense strategies.
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Potential Challenges of Borrowing From Related Parties
Interest expenses on corporate borrowings in the Philippines are generally deductible from gross income, provided they meet certain conditions outlined by the Bureau of Internal Revenue (BIR), including those specified in Revenue Memorandum Circular (RMC) No. 19-2024.
To qualify for a deduction, the interest expense must be legally due, not capitalized, and the borrowing must not involve related parties, among other criteria. However, borrowing from related parties presents several challenges when it comes to the deductibility of interest expenses.
Here, take a closer look at the potential challenges of borrowing from related parties:
1. Non-Deductibility of Interest Expense:
Interest expenses on loans between related parties are not deductible for tax purposes under Section 36(B) of the National Internal Revenue Code (NIRC) of 1997, as amended.
This is because such transactions are often scrutinized for potential tax avoidance schemes, where the true nature of the transaction may be questioned.
2. Transfer Pricing Issues
Related-party transactions, including borrowings, are subject to transfer pricing regulations. The BIR closely monitors whether interest rates charged in these transactions reflect market conditions, often referred to as the arm’s length principle.
If the interest rate is deemed too high or too low compared to the market, the BIR may adjust the taxable income, disallowing excessive deductions or adding imputed income.
3. Documentation Requirements
Loans between related parties require comprehensive documentation to prove that the transaction is legitimate and in line with market rates.
Lack of proper documentation, such as loan agreements or evidence of repayment terms, may lead to the disallowance of the interest deduction by the BIR.
4. Thin Capitalization Rule
The Philippines does not have explicit thin capitalization rules, but borrowing excessively from related parties instead of obtaining equity financing may trigger scrutiny under transfer pricing or other anti-avoidance provisions.
Thin capitalization refers to a situation where a company is financed with disproportionately high levels of debt compared to equity.
5. Withholding Tax Obligations
Interest payments to related parties, especially if they are foreign entities, may attract withholding tax obligations. Failure to correctly apply withholding tax rates or meet compliance requirements could result in penalties, which may offset the benefits of the borrowing.
Conclusion
In conclusion, understanding the tax implications of interest expenses on corporate borrowings in the Philippines is crucial for maintaining compliance with tax regulations.
Compliance is essential not just to avoid legal repercussions but also to sustain a positive corporate reputation. Non-compliance risks include damaging your company's public image and losing the trust of investors.
Therefore, it is critical for companies to ensure they gather and maintain comprehensive documentation related to their borrowing and interest expenses. This documentation can include written agreements, payment records, and proof of withheld taxes, which are necessary to justify claims for interest expense deductions.
Moreover, accurate compliance impacts a company’s financial reporting. When interest expenses are reported accurately, it enhances transparency and presents a true view of a company's financial statements and tax liabilities.
Frequently Asked Questions (FAQs)
1. Is interest expense tax-deductible in the Philippines?
Yes, interest expense is tax-deductible in the Philippines, provided it meets certain conditions under the National Internal Revenue Code, and the expenses must be incurred in the course of trade, business, or exercise of a profession.
The deduction is subject to the Interest Arbitrage Rule, which reduces the deductible portion by 20% of interest income subject to final tax.
2. Is interest paid on corporate debt tax-deductible in the Philippines?
Yes, interest paid on corporate debt is generally tax-deductible in the Philippines. However, the Interest Arbitrage Rule reduces the deductible amount by 20% of any interest income subjected to final tax.
Additionally, interest payments to related parties are not deductible, and proper documentation is essential to support the deduction.
3. How much interest expense is deductible for corporations in the Philippines?
In the Philippines, corporations can generally deduct the full amount of interest expenses incurred in the course of trade or business. However, the Interest Arbitrage Rule reduces this deductible amount by 20% of any interest income that is subject to final tax.
Additionally, interest expenses incurred on loans between related parties are not deductible for income tax purposes.
4. What expenses are non-deductible in the Philippines?
In the Philippines, non-deductible expenses include personal or living expenses, capital expenditures, bribes or illegal payments, fines and penalties for legal violations, and expenses related to tax-exempt income.
Additionally, interest on loans between related parties, excessive salaries, and expenses without proper documentation are not tax-deductible. These rules ensure that only legitimate business expenses reduce taxable income.
