The proper allocation of costs and expenses for financial institutions
The Regional Trial Court (RTC) of Makati released its decision on the petition of banks seeking the invalidation of Bureau of Internal Revenue (BIR) Revenue Regulations (RR) No. 4-2011, which prescribed the rules for the proper allocation of costs and expenses for banks and financial institutions, for income tax reporting purposes. The RTC ruled that RR No. 4-2011 is unconstitutional, and ordered a permanent injunction on its implementation.
Section 27 of the National Internal Revenue Code (Tax Code) provides that an income tax of 30% is imposed on the taxable income earned by corporations, such as banks. Section 31 defines taxable income as gross income less any deductions authorized by the Tax Code. Meanwhile, Section 34 outlines the deductions allowed for corporations to include ordinary and necessary expenses paid or incurred during the taxable year that are directly attributable to the trade, business or exercise of a profession.
On the matter of the deductibility of expenses of banks, the BIR promulgated RR No. 4-2011 on March 15, 2011. The RR aimed to set the rules on the allocation of cost and expenses between two booking units of a bank: the Regular Banking Unit (RBU) and the Foreign Currency Deposit Unit (FCDU). The allocation was based on the assumption that each booking unit is governed by different income taxation regimes provided by the Tax Code. RR No. 4-2011 further required that subsequent to the allocation of the costs and expenses to the booking units, the costs and expenses should be allocated among income arising from active business operations which are subject to regular income tax, passive activities which are subject to final tax, and other activities producing income which are exempt from income taxes.
To allocate the costs and expenses, RR No. 4-2011 prescribed two methods: (1) By Specific Identification and (2) By Allocation. “By Specific Identification” is used if an expense can be specifically identified with a particular booking unit or taxation regime. “By Allocation” is used if the expense cannot be specifically identified with a particular unit or taxation regime, and allocation must then be based on the percentage share of gross income earned by the booking unit or taxation regime to the total gross income earned.
Considering that costs and expenses are usually allocated to different booking units and taxation regimes, the tax benefits by way of tax deductions enjoyed by the banks from these costs and expenses are significantly decreased. For example, with regard to expenses allocated to FCDU activities which are subject to 10% final tax, no benefit can be derived, as no deduction is allowed to be applied against such activities. For expenses which will be allocated to income subject to final tax, the taxpayer will receive no tax benefit as well, since deductions are not allowed against income subject to final tax. For expenses allocated to income exempt from income taxes, no benefit can be acquired, as income is already exempt from income taxes.
Due to the effect of RR No. 4-2011 on the banking industry, a number of banks filed a petition for Declaratory Relief before the Regional Trial Court on April 6, 2015. The RTC subsequently issued a Temporary Restraining Order (TRO), enjoining the enforcement of RR No. 4-2011, and any issuance of Preliminary Assessment Notice or Final Assessment Notices to enforce the said regulation.
On May 25, 2018, the RTC promulgated its decision declaring RR No. 4-2011 null and void, issued a permanent injunction on its implementation, holding that RR No. 4-2011 was unconstitutional since it was issued beyond the authority of the Secretary of Finance and the Commissioner of Internal Revenue.
The RTC noted that the Supreme Court has consistently ruled that delegation of legislative power to administrative agencies is strictly construed against the said agencies. Regulations issued by the administrative agencies should be in harmony with the provisions of the law, and thus cannot amend or modify any act of Congress. The RTC ruled that the BIR and the Secretary of Finance were not empowered by law to issue RR No. 4-2011, as there is no provision in the Tax Code that requires expenses be allocated. The RTC found that nowhere does Section 27 of the Tax Code provide any basis for the BIR to impose any particular accounting method to allocate expense. Additionally, Section 50 of the Tax Code, which requires that deductions be allocated between or among organizations, is not applicable considering that it only applies to corporations that have two or more separate and distinct organizations, trades or business.
The RTC also ruled that the method of allocation is neither fair nor equitable to similar classes of taxpayers. In effect, RR No. 4-2011 imposed a limitation on the deductibility of ordinary and necessary expenses, which is a taxpayer’s right. The Tax Code only requires that the expense be incurred or paid while carrying out the trade or business of the bank.
Finally, the RTC finds that RR No. 4-2011 violates the equal protection clause, since there is no substantial distinction between banks and other taxpayers, and the singling of banks is not germane to the purpose of the law.
While this is a win for banks, the final outcome is subject to the petition for review on certiorari that the BIR filed with the Supreme Court. Considering that the Supreme Court may reverse or modify the decision of the RTC, banks should take this petition into consideration before relying solely on the decision of the RTC.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.