Legal basis and covered reforms
- The Regulations are issued pursuant to Section 244 of the Tax Code in relation to Section 3 of Republic Act No. 9504, which amends Section 34(L) of the Tax Code of 1997 (as amended).
- The OSD is implemented for purposes of the optional standard deduction allowed to individuals and corporations in computing taxable income.
- The OSD election interacts with the itemized deductions allowed under Section 34 of the Tax Code of 1997 (as amended).
Policy and purpose of the OSD
- The OSD is established as an alternative deduction to itemized deductions for individuals and corporations.
- The Regulations provide rules to determine the amount of OSD and the conditions for using it in tax filings.
- The Regulations include a transition rule for the initial taxable year and period when the 40% OSD applies.
Persons covered and eligible claimants
- The following may claim OSD in lieu of the itemized deductions under Sections 34(A) to (J) and (M) and Section 37 of the Tax Code of 1997 (as amended), and other special laws if applicable:
- Individuals may claim OSD if they are a resident citizen, non-resident citizen, resident alien, or taxable estates and trusts.
- Corporations may claim OSD if they are domestic corporations or resident foreign corporations.
- The Regulations address General Professional Partnerships (GPPs): a GPP itself is not taxed under Title II of the Tax Code, but the partners are taxed on their distributive shares.
- A GPP may claim either the itemized deductions or OSD in computing its net income, and partners report their distributive share as gross income.
OSD for individuals: 40% basis rules
- OSD for individuals is a maximum of 40% of gross sales or gross receipts during the taxable year.
- OSD depends on the individual’s accounting basis:
- If the individual is on the accrual basis, the OSD basis is gross sales for the taxable year.
- If the individual uses the cash basis, the OSD basis is gross receipts for the taxable year.
- The cost of sales (for individuals selling goods) and the cost of services (for individuals selling services) are not allowed to be deducted for purposes of determining the basis of the OSD; the basis is specifically gross sales or gross receipts, not gross income.
- For other individual taxpayers allowed by law to use a different method of accounting (e.g., percentage of completion basis), the basis of the 40% OSD must be determined using that acceptable method of accounting, consistent with gross sales or gross receipts.
- The individual seller of goods uses gross sales as the OSD basis (subject to the accrual/cash basis rule).
- The individual seller of services uses gross receipts as the OSD basis (subject to the accrual/cash basis rule).
OSD for corporations: gross income computation
- OSD for corporate taxpayers subject to tax under Sections 27(A) and 28(A)(1) of the Tax Code (as amended) is not exceeding 40% of their gross income.
- For corporate OSD computation:
- Gross Income means gross sales less sales returns, discounts and allowances and cost of goods sold.
- Gross Sales include only sales contributory to income taxable under Section 27(A) of the Tax Code.
- Cost of goods sold definitions depend on the business type:
- For trading or merchandising concerns, it is invoice cost of goods sold, plus import duties, freight to the place of sale, and insurance while goods are in transit.
- For manufacturing concerns, it includes all costs incurred in producing finished goods such as raw materials, direct labor, manufacturing overhead, freight, insurance premiums, and other costs to bring raw materials to the factory or warehouse; the term may be used interchangeably with cost of goods manufactured and sold.
- For sellers of services:
- Gross Income means gross receipts less sales returns, allowances, discounts and cost of services.
- Cost of services includes all direct costs and expenses necessarily incurred to provide services, including:
- salaries and employee benefits of personnel, consultants, and specialists directly rendering the service; and
- cost of facilities directly utilized (including depreciation or rental of equipment used and cost of supplies).
- Interest expense is excluded from cost of services, except in the case of banks and other financial institutions.
- Gross receipts are amounts actually or constructively received during the taxable year; for accrual-basis service sellers, gross receipts means amounts earned as gross revenue during the taxable year.
- Passive incomes subjected to a final tax at source do not form part of gross income for purposes of computing the 40% optional standard deduction.
- Items required to be declared in the income tax return for the taxable year under Section 32(A) of the Tax Code (as amended) are part of gross income against which the OSD may be deducted to arrive at taxable income.
- For taxpayers using accounting methods other than cash or accrual (e.g., percentage of completion basis), gross income must be determined in accordance with the acceptable method of accounting.
Election, irrevocability, and filing mechanics
- A taxpayer who elects to avail of OSD must signify the election in the tax return, and OSD is used in lieu of itemized deductions.
- If the election to use OSD is not signified in the return, the taxpayer is considered to have availed of the itemized deductions under Section 34.
- The OSD election is irrevocable for the taxable year for which the return is made.
- An individual taxpayer who elected OSD and is entitled to it is not required to submit with the tax return the financial statements otherwise required under the Tax Code.
- An individual taxpayer using OSD must keep records pertaining to gross sales or gross receipts, unless the Commissioner otherwise permits.
- A corporation using OSD must still submit its financial statements when filing its annual income tax return and must keep records pertaining to gross income as defined for OSD purposes.
- In filing quarterly income tax returns, the taxpayer may opt to use either the itemized deduction or OSD.
- In filing the final adjustment income tax return, the taxpayer must choose the deduction method for the entire year’s taxable net income; the taxpayer is not allowed to use a hybrid approach within the same taxable year (itemized for part and OSD for part).
GPP and partner OSD framework
- A GPP is not subject to income tax under Title II of the Tax Code, but partners are liable to pay income tax on their separate and individual capacities for their respective distributive share in the GPP’s net income.
- For computing distributive shares, the GPP net income is computed in the same manner as for a corporation.
- A GPP may claim either itemized deductions or OSD in computing net income, where OSD for the GPP is availed in the amount not exceeding 40% of gross income (consistent with the corporate OSD rule).
- The net income computed by either itemized deductions or OSD in the GPP becomes the distributable net income from which each partner’s share is determined.
- Each partner reports as gross income the distributive share, whether actually or constructively received.
- A GPP and its partners each make their own election of deductions during the taxable year, producing four possible combinations:
- GPP itemized deductions; partner itemized deductions.
- GPP OSD; partner itemized deductions.
- GPP itemized deductions; partner OSD.
- GPP OSD; partner OSD.
- If the GPP claims itemized deductions and a partner also claims itemized deductions, the partner’s deductions must be the ordinary and necessary expenses for the practice of profession that were not yet claimed by the GPP in computing its net income.
Transition rules for initial 2008 implementation
- The 40% maximum OSD for taxable period 2008 is treated as covering only the period beginning the effectivity of Republic Act No. 9504.
- Republic Act No. 9504 became effective on July 6, 2008, and for administrative simplicity, July 1, 2008 is treated as the start of the period when the 40% OSD may be allowed.
- For an individual taxpayer:
- The individual may use either itemized deductions or 40% OSD in the quarterly return covering the third quarter ending September 30, 2008.
- If the individual chooses OSD in the annual return, the OSD rate is:
- 10% of gross income for the period January 2008 to June 30, 2008, computed using gross income determined by deducting cost of sales from gross sales or gross receipts; and
- 40% of gross sales/gross receipts for the period July 1, 2008 to December 31, 2008.
- The individual is not allowed to compute annual net income using a hybrid approach—itemized deductions for part of the year and OSD for another part are not permitted for the entire year.
- For a corporate taxpayer:
- If the corporation opts to use OSD in its annual return for 2008, it may apply the 40% OSD only for the period beginning July 1, 2008, with the deduction method for the earlier period remaining under itemized deductions.
- The corporation applies itemized deductions for the portion before July 1, 2008, and applies 40% OSD for the portion from July 1, 2008 onward.
Repealing and effectivity clauses
- All regulations, rules, orders, or portions inconsistent with the Regulations are amended, modified, or repealed accordingly.
- The Regulations’ effectivity date is July 6, 2008.
Penalties and sanctions
- No penalty, fine, or sanction provision is established within these Regulations for non-compliance.