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Deducting bad debt expense

Deducting bad debt expense

by Deo D. Saludario

Mandated to ensure effective tax administration, the Bureau of Internal Revenue (BIR) is stepping up its implementation of the tax rules and regulations in order to meet the demands and challenges of realizing its target revenue collection.

One of the focus of the tax authorities is the correctness of the availment of tax exemptions.

Deduction for income tax purposes, by its nature, is equated to exemption, hence construed strictly against the taxpayer. An item of expense should not be based merely on the assertion of the taxpayer but should be supported by convincing evidence to pass the test of deductibility.
And sometimes, the nature of the transaction may be deduced from the actual facts and not from what the parties stipulate in the contract.

This strict construction of deductibility of expenses was once again demonstrated in a recent case decided by the Supreme Court. The case involved two companies whereby the owner of a mining claim entered into an agreement with the project manager to manage and operate the said mining claim. The project owner was to provide funds for the management of the mining project, while the designated project manager could also transfer its own funds or property to the project when deemed necessary for the management of the project.

The manager then made advances of cash and property to the project in accordance with the agreement. As consideration thereof, the manager was to be entitled to 50% of the net profits of the project as a form of compensation.

Due, however, to continuing losses of the project that eventually resulted in cessation of the mining operations, the manager withdrew. Thereafter, payments were made by the project owner on the advances of the manager.

The remaining outstanding indebtedness was written off by the project manager as a loss on the settlement of a receivable from the project owner. Accordingly, this loss was claimed as deduction.

This was later on disallowed by the BIR upon examination.

The disallowance was sustained by the Court of Tax Appeals and the Court of Appeals and affirmed by the Supreme Court (SC).

The decision of the High Tribunal was premised on the requisites prescribed by law for bad debt expenses to be legally deductible for income tax purposes, to wit:

    • there must be an existing indebtedness due to the taxpayer, which must be valid and legally demandable;
    • the debt must be ascertained to be worthless; and
    • the debt was actually charged off within the taxable year when it was determined to be worthless.

In the instant case, the SC sustained the findings that there was no valid and existing indebtedness between the parties. The advances made by the manager were not made in the nature of a loan but were considered as an investment to the project.

The totality of the events that transpired revealed the intention to create a partnership or a joint venture between the parties rather than a management agreement. The parties, in fact, contributed funds and industry to the project with the intention of sharing the profits 50-50, albeit it may have been designated as "compensation" in the agreement.

Considering that the advances made were not loans but in fact investments to the project, the Supreme Court disallowed the bad debt expense as deduction and ordered the project manager to pay the corresponding deficiency taxes. The Court took note of the fact that the manager shares in the net profit of the project, which is a characteristic of an investment. This negates the claim that the payment was in the nature of compensation as the manager receives nothing in case of a loss.

This decision of the Supreme Court further intensifies the position of the tax authorities to implement strictly the requirements prescribed for tax deductible expenses. It is therefore incumbent upon the taxpayers to comply with these requirements and provide relevant and conv incing supporting documents for every deduction claimed. Taxpayers can always raise legal and factual arguments to contest tax assessment cases. However, these arguments must always be supported by documents that complement the defenses thus maintained.

More often that not, even a carefully documented transaction fails to consider the tax impact of the intended transaction. These tax implications should always be included in the planning, drafting and execution of contracts as a misguided assertion will only bite us at the end.

(The author is a tax manager at Punongbayan & Araullo, a member firm within Grant Thornton International Ltd. For comments and inquiries, please e-mail the author or call 886-5511.)