Interest Expense Deductibility Rules

Legal basis and implementing scope

The Regulations are promulgated pursuant to Section 244 of the Tax Code of 1997, which authorizes the issuance of implementing rules.
The Regulations implement Section 34(B) of the Tax Code of 1997, focusing on the deductibility requirements and limitations for interest expense.
The Regulations apply “in general” to interest expense deductions of taxpayers engaged in trade or business or the practice of profession.

Defined terms

“Interest” means payment for the use, or forbearance, or detention of money, regardless of its name or denomination.
“Interest” includes amounts paid for the borrower’s use of money during the term of the loan and amounts for detention of money after the due date for repayment.
“Taxpayer” means a person, whether natural or juridical, engaged in trade, business, or in the exercise of profession, except one earning compensation income arising from personal services rendered under an employer-employee relationship.

Deductibility requisites for interest expense

Deductibility is subject to limitations, but the following are requisites for interest expense to be deductible:
An interest expense deduction requires indebtedness.
The taxpayer must have interest expense paid or incurred on the indebtedness.
The indebtedness must be the taxpayer’s.
The indebtedness must be connected with the taxpayer’s trade, business or exercise of profession.
The interest expense must be paid or incurred during the taxable year.
The interest expense must be stipulated in writing.
The interest must be legally due.
The interest arrangement must not be between related taxpayers as mandated in Section 34(B)(2)(b), in relation to Section 36(B), of the Tax Code of 1997.
The interest must not be incurred to finance petroleum operations.
If the interest is incurred to acquire property used in trade, business, or profession, it must not be treated as a capital expenditure (for purposes of the general deductibility framework).

General rule and proportional limitation

The Regulations provide that, in general, interest expense paid or incurred within a taxable year on indebtedness connected with the taxpayer’s trade, business, or profession is allowed as a deduction from gross income.
The Regulations impose a limitation for interest expense from existing indebtedness, requiring a reduction of the deductible interest expense by a percentage of certain interest income.
For this limitation, the reduction equals 41% beginning January 1, 1998; 39% beginning January 1, 1999; and 38% beginning January 1, 2000 and thereafter of the interest income earned that had been subjected to final withholding tax.
This limitation applies regardless of whether a tax arbitrage scheme was entered into and regardless of the date when the interest-bearing loan and the date when the investment was made, as long as during the taxable year there is:
- interest expense incurred on one side; and
- interest income earned on the other side, with such interest income subjected to final withholding tax.
The limitation applies irrespective of the currency the loan was contracted and the currency of the investments or deposits.

Special rule: interest on unpaid business taxes

Interest incurred or paid by the taxpayer on all unpaid business-related taxes is fully deductible from gross income.
Such interest expense is not subject to the percentage limitation based on interest income subjected to final withholding tax.

Mandatory nondeductible cases

No interest expense is allowed as a deduction from gross income in any of the following cases:
Advanced/discouned interest by a cash-basis individual
- No deduction is allowed in the taxable year where, within the taxable year, an individual taxpayer reporting income on the cash basis incurs an indebtedness on which interest is paid in advance through discount or otherwise.
- The interest paid in advance is allowed as a deduction in the year the indebtedness is paid.
- If the indebtedness is payable in periodic amortization, the deduction is allowed for the portion of interest corresponding to the principal amortized or paid during the year.
Interest paid/earned between related persons/cases under Section 36(B)
- No deduction is allowed where both the taxpayer and the person to whom payment has been made or is to be made are persons specified under Section 36(B) of the Tax Code of 1997, including the following relationships:
  - Between members of a family, where the family of an individual includes only:
    - brothers and sisters (whether by whole or half-blood), spouse, ancestors, and lineal descendants;
  - Between an individual and a corporation more than 50% in value of outstanding stock of which is owned, directly and indirectly, by or for such individual;
  - Between two corporations more than 50% in value of the outstanding stock of each of which is owned, directly and indirectly, by or for the same individual;
  - Between the grantor and a fiduciary of any trust;
  - Between the fiduciary of a trust and the fiduciary of another trust if the same person is a grantor with respect to each trust;
  - Between a fiduciary of a trust and a beneficiary of such trust.
Petroleum exploration financing in the Philippines (service contractor operations)
- No deduction is allowed where the indebtedness on which the interest expense is paid is incurred to finance petroleum exploration in the Philippines.
- The nondeductible interest pertains to interest or other consideration paid or incurred by a Service Contractor engaged in discovery and production of indigenous petroleum in the Philippines for financing its petroleum operations pursuant to Section 23 of P.D. No. 8, as amended by P.D. No. 87, titled “The Oil Exploration and Development Act of 1972.”

Optional treatment: interest related to capital expenditure

The Regulations allow the taxpayer to choose treatment for interest expense on a capital expenditure incurred to acquire property used in trade, business, or exercise of a profession.
At the taxpayer’s option, the interest expense may be allowed as a full deduction in the year incurred, notwithstanding Section 36(A)(2) and (3) of the Tax Code of 1997.
At the taxpayer’s option, the interest expense may be treated as a capital expenditure, in which case the taxpayer may claim only the periodic amortization of such expenditure as deduction.

Repeals and effect on inconsistent issuances

The Regulations repeal, amend, or modify any prior revenue regulation, revenue issuance, or ruling inconsistent with these Regulations under the Repealing Clause.
The Regulations contain an Effectivity Clause stating they take effect immediately.