Interest Expense Limitation

The Bureau of Internal Revenue issued a regulation implementing limitation of interest expense, specifically provides that the limitation shall apply regardless of whether or not a tax arbitrage scheme was entered into by the taxpayer for as long as, during the taxable year, there is an interest expense incurred on one side and an interest income earned on the other side, which interest income had been subjected to final withholding tax.

First things first, we need to know the requisites and rules on the deductibility of interest expense.

In Accordance with the BIR Revenue Regulation 31-2009, the requisites and rules are the following:

REQUISITES FOR DEDUCTIBILITY OF INTEREST EXPENSE (rr 31-09)

1. There must be an indebtedness;
2. There should be an interest expense paid or incurred upon such indebtedness;
3. The indebtedness must be that of the taxpayer’
4. The indebtedness must be connected with the taxpayer’s trade, business or exercise of profession
5. The interest expense must have been paid or incurred during the taxable year;
6. The interest must have been stipulated in writing;
7. The interest must be legally due;
8. The interest payment arrangement must not be between related taxpayers as mandated in Sec. 34(B) (2) (b), in relation to Sec. 36(B), both of the Tax Code of 1997.
9. The interest must not be incurred to finance petroleum operations; and
10. In case of interest incurred to acquire property used in trade, business or exercise of profession, the same was not treated as a capital expenditure.

RULES ON THE DEDUCTIBILITY OF INTEREST EXPENSE

The general rule is that the amount of interest expense paid or incurred within a taxable year on indebtedness in connection with the taxpayer’s trade, business or exercise of profession shall be allowed as deduction from the taxpayer’s gross income. (rr 31-09)

However, the amount of interest expense paid or incurred by a taxpayer in connection with his trade business or exercise of a profession from an existing indebtedness shall be reduced by an amount equal to the following percentage of the interest income earned which has been subjected to final withholding tax depending on the year when the interest income was earned. (rr 31-09)

Based on the regulation, the deductible interest expense is equal to 33% of interest income subjected to final tax, and the remaining portion of the said expense will be non-deductible in income tax computation.

ILLUSTRATION:

Normal Corporate Income Tax Rate                      30%

Less: Final Tax Rate                                                  20%

(NCIT Rate less FT Rate divided by NCIT Rate) 10%/30% NCIT = 33.33%

Interest Income – (Interest income (gross) x 33.33%) = Deductible Interest Expense