Guidelines on the preparation of the annual income tax return

Written by Karen Andrea D. Torres, 29 January 2009

The genius, Albert Einstein, once proclaimed that "the hardest thing in the world to understand is the income tax."

So, could we say that an accountant can be considered a genius too?

Of course, this is an overstatement.

Preparing the annual income tax return (ITR) cannot be more difficult than earning the income itself to be taxed.

To equip taxpayers for the tax season ahead, I have outlined a few pointers to guide them in the preparation of their annual ITR.

First of all, the declared gross income should include all items of income derived from whatever source, including those arising from activities incidental or external to the business’ operations.

For purposes of income tax computation, all income items which, by provisions of law, are exempt from income taxes, and items that have already been subjected to final taxes, should be excluded from the gross income.

Conversely, for items of expenses, four principal criteria must be met before they may be considered income tax deductible, namely:

  • It must be ordinary and necessary.
Expenses are "ordinary and necessary" when they are directly connected with and proximately resulting from carrying on the business. Furthermore, these expenses must be established to be appropriate in and contributing to the development of the taxpayer’s business in the acquisition or pursuit of income or profit;
  • It must be paid or incurred in the taxable year, depending on the method of accounting employed in the books of the taxpayer, i.e., cash or accrual basis accounting.
An expense in considered incurred if it meets the "all-events test." The "all-events test" requires that the liability to pay be fixed, and the amount due be determinable with reasonable accuracy. It is sufficient that the taxpayer has the information necessary to compute the amount of expense with reasonable accuracy and that its basis is unchangeable;
  • The tax required to be deducted and withheld from the expense items must have been paid to the Bureau of Internal Revenue (BIR); and
  • These expenses should be substantiated with sufficient evidence, such as official receipts or other adequate records, indicating the amount of the expense and its direct connection to the conduct of the business.
As a general rule, income and expense recognition for tax purposes will follow financial accounting rules.

Exceptions are those items of income and expenses for which the tax laws have clear provisions regarding their tax treatment.

Some of these exceptions are:

  • Bad debts — A mere allowance in the books is not deductible. The taxpayer should be able to establish with a reasonable degree of certainty the debt cannot be collected: that is, the taxpayer must provide sufficient proof that he has exhausted all efforts to collect the receivables.
  • Depreciation expense — Depreciation of properties should be based on its historical cost. Tax regulations do not confer the taxpayers with the option to follow the revaluation model, as afforded by financial reporting standards. Moreover, it allows taxpayers to recognize impairment only if there is an actual sale or another form of actual disposal.
  • Unrealized gains and losses — Unrealized gains and losses from investments in securities and foreign exchange transactions are not considered taxable or deductible, unless they are actually realized in a close and completed transaction.
  • Interest expense — The amount of interest expense otherwise deductible will be reduced by 42% of the interest income subjected to final tax. Starting last Jan. 1, the interest expense limitation has been reduced to 33%.
  • Entertainment, amusement and recreation expenses — A taxpayer is allowed to claim entertainment, amusement and recreation expenses in the amount equivalent to the actual amount paid or incurred. However, in no case will the deduction exceed half of one percent (0.5%) of net sales for sellers of goods, and one percent (1%) of net revenues for sellers of services.
Unless the taxpayer has suffered from substantial losses on account of a prolonged labor dispute, force majeure or legitimate business reverses, and has secured relief from the Secretary of Finance, the taxpayer should also check if it is subject to the minimum corporate income tax (MCIT). The MCIT is computed at 2% of gross income. The MCIT should be paid if this is higher than the tax due determined under the normal corporate income tax rate.

The taxpayer should also take note that deferred taxes recorded in its books as of Dec. 31, 2008 should be at 30% of the identified temporary differences. This is because deferred taxes should be recorded at the rate effective as of the date it is expected to be reversed, and starting last Jan. 1, corporate income tax rate has been 30%.

Moreover, beginning July 1, 2008, corporate taxpayers may avail of the optional standard deduction (OSD) in an amount not exceeding 40% of its gross income.

So, for taxable year 2008, a corporate taxpayer following the calendar year and availing of the OSD will apply itemized deductions for its first half of operations, and OSD for the latter half.

However, it may choose to apply the itemized deductions for the entire year altogether instead of a hybrid of itemized/OSD approach.

For subsequent taxable years, a hybrid method of deduction for an entire taxable year is prohibited.

Given these guidelines and with reasonable diligence and prudence, the preparation of the annual ITR, or any tax return for that matter, should not be as daunting.

After all, as Franklin D. Roosevelt so aptly put it: taxes are dues that we pay for the privilege of membership in an organized society.