By: Jackie Lou Chua
WHEN operating a company, capitalization and working funds are needed for it to run properly and efficiently. One way of getting this necessary funding is through borrowings. Normally, a company will borrow from banks or any financial institution that is willing to lend, provided certain qualifications or collaterals are offered. This route, however, may take a while to get approved.
As an alternative, a company can opt to borrow from related parties that are willing to lend under more convenient circumstances, that is, without requiring collaterals or qualifications guaranteeing the company's ability to pay. These lenders instead rely on the related party relationship as assurance that the company will pay them back.
The question now is: Can interest expense be claimed as a deduction from gross income, and what are the requirements for the same to be considered deductible?
Based on the recent issuance of Revenue Memorandum Circular (RMC) 19-2024, under Section III. A1, interest paid or incurred within a taxable year on indebtedness in connection with the taxpayer's profession, trade, or business shall be allowed as a deduction from gross income, subject to certain limitations, when the following requisites, provided in Section 34(B)(2) of the National Internal Revenue Code (NIRC) of 1997, as amended, and as implemented by Revenue Regulation (RR) 13-2000 and Section 7(B) of RR 5-2-21, are met:
In addition, the taxpayer must have withheld the appropriate tax to claim the interest expense as deduction from gross income. Further, the same RMC also provides that interest expense paid on intercompany loans will not be deductible from gross income if both the taxpayer and the person to whom the payment has been made are persons specified under Section 36(B) of the NIRC of 1997, as amended.
Section 36(B) reads as follows: "(B) Losses from Sales or Exchanges of Property. – In computing net income, no deductions shall in any case be allowed in respect of losses from sales or exchanges of property directly or indirectly... (1) Between members of a family. For purposes of this paragraph, the family of an individual shall include only his brothers and sisters (whether by the whole or half-blood), spouse, ancestors, and lineal descendants...."
Based also on RR 19-2020, in determining whether a person or entity is a related party, the following will apply: A person or a close member of that person's family is related to a reporting entity if that person has control or joint control of the reporting entity, has significant influence over the reporting entity or is a member of the key management personnel of the reporting entity or of a parent of the reporting entity.
An entity is related to a reporting entity if any of the following conditions apply:
In all cases, the substance of relationships between entities shall be taken into account and not merely the legal form.
With the above clarifications, borrowings from a related party will not be considered deductible for purposes of income tax calculation even if all other requisites are met and even if corresponding withholding taxes are remitted to the tax office.
Although it is easier to borrow from a related party, it comes at a price: not being able to deduct the corresponding interest expense for purposes of income tax calculation. Hence, taxpayers should carefully consider their options when the need to borrow arises. For all its requirements and scrutiny, perhaps borrowing from banks and other financial institutions is the smarter move compared to knocking on the door of a related party.
As published in The Manila Times on 4 March 2024. The author is a Senior Manager with the Tax & Corporate Services division of Deloitte Philippines.