Tax deductions

Endgame: SC rolls back restriction on bank tax deductions

As we awaited the results of the recently concluded 2022 National Elections, the Supreme Court (SC) issued its ruling signifying a victory for Banks and Other Financial Institutions (AIFs).

On May 10, the SC issued its decision enacted on December 1, 2021 on the motion for certiorari by the Department of Finance (DoF) and the Bureau of Internal Revenue (BIR) seeking the setting aside of an order of the Regional Trial Court (RTC) Makati City Branch 57 which declared Tax By-law No. 4-2011 null and void.

The SC rescinded the 2011 income regulations issued by the BIR which effectively limited the income tax deductions of banks and OFIs in calculating their taxable income.

Banks derive their income from the operations of their Regular Banking Units (RBU) or Foreign Currency Depository Units (FCDU), Extended Foreign Currency Depository Units (E/FCDU) or Offshore Banking Units (OBU).

The Bank’s taxable income is subject to various tax rates. Taxable income from the operation of RBUs ​​is subject to ordinary corporation tax (RCIT) at 25%/20%. However, banks’ taxable income from E/FCDUs with respect to foreign exchange transactions with non-residents, OBUs in the Philippines and local commercial banks, including branches of foreign banks authorized to deal with E/ FCDU are exempt from income tax. Interest income from foreign currency loans extended by these depository banks under the expanded system to residents other than offshore units in the Philippines or other depository banks under the expanded system is subject to a final tax of 10%.

However, under RA 11534 or CREATE, the taxation of OBU income has been modified and subject to the RCIT of 25%.

In 2011, the Bureau of Internal Revenue (BIR) issued Revenue Regulations (RR) No. 4-2011 prescribing rules for the proper apportionment of costs and expenses of income from banks and financial institutions for income tax reporting. income, considering that the taxable income of banks may be subject to different tax rates.

The RR provides that a bank may only deduct costs and expenses attributable to the operations of its RBU to arrive at the taxable income of the RBU subject to ordinary income tax. Any cost or expense related to or incurred for the operations of its FCDU/EFCDU or OBU is not allowed as a deduction from the taxable income of the RBU.

When calculating the deductible amount of RBU operations, the costs and expenses must be allocated between the RBU and the E/FCDU or OBU using the prescribed methods:

1. By specific identification: used for expenses that can be specifically identified with a particular booking unit or tax regime

2. By assignment: used for expenses that cannot be specifically identified to a particular unit or tax regime. Allocation should be based on the percentage share of gross revenue earned by the booking unit or tax system relative to total gross revenue earned.

Based on revenue regulations, banks had no choice but to identify their own method of allocating expenses that cannot be specifically identified to a particular unit. The BIR has ruled that attribution can only be based on the gross revenue share percentage.

The RR was intended to establish rules that banks may only deduct costs and expenses attributable to the operations of its RBUs ​​to arrive at the RBU’s taxable income subject to ordinary income tax.

Since costs and expenses are generally allocated to various units of accounting and tax regimes, the tax benefits resulting from the deductions enjoyed by banks on these costs and expenses are significantly reduced.

Take, for example, expenses allocated to the activities of the FCDU which are subject to the final tax of 10%. No benefit can be derived from this as no deductions can be applied to these activities. No tax benefit will be received by taxpayers for expenses which will be set off against income subject to final tax since deductions are not authorized on income subject to final tax. On the other hand, for expenses allocated to income exempt from income tax, no advantage can be acquired, as the income is already exempt from income tax.

Due to the issuance of the RR, several banks filed for declaratory relief before the RTC. The RTC ruled in favor of the banks and the case went to the SC. Upon reviewing the case, the SC emphasized that a motion for certiorari or a restraining order, not a declaratory judgment, is the proper remedy to challenge the validity or constitutionality of executive decisions. In addition, the Court of Tax Appeals, not the RTC, has jurisdiction to rule on the constitutionality and validity of Commissioner of Internal Revenue (CIR) tax issuances.

However, the SC, noting that the validity of RR 4-2011 has considerable ramifications among banks and OFIs, decided to treat the request as a request for certiorari.

The SC ruled that RR 4-2011 is void because the CIR went beyond and even seriously abused its authority by issuing such a regulation. In addition, the issuance of the RR was found to contain substantive and procedural irregularities.

She pointed out that, in her previous rulings, she has consistently ruled that the delegation of legislative power to administrative agencies is strictly construed against the agencies. Administrative agencies may not amend or modify any act of Congress and shall only issue regulations consistent with the provisions of the law.

In the publication of RR 4-2011, the SEC noted that the BIR expanded or modified the law when it reduced the income tax deductions of the responding banks and when it sanctioned the method of accounting that the banks should use, without any basis. This comes down to tax law, a power held only by Congress.

The law does not empower the BIR and the Secretary of Finance to issue a regulation such as RR No. 4-2011. The Tax Code allows taxpayers to determine for themselves the accounting method that is most applicable to them. The CIR can only prescribe an accounting method if (a) the taxpayer has not used an accounting method, or (b) the accounting method used does not clearly reflect the taxpayer’s income. Such circumstances are not present in the present case. The SC ruled that the CIR can only challenge the correctness of the accounting policy through an investigation or audit assessment. The CIR can then issue a finding if the accounting method has distorted the taxable income of the taxpayer. Without such a finding, the CIR cannot simply substitute for its own judgment and impose an accounting method to be used.

Even Article 50 of the Tax Code, which provides for the allocation of deductions between or among organizations, is not applicable since it only applies to companies having at least two separate and distinct organizations, trades or businesses. .

SC also noted that RR 4-2011 imposes an additional requirement for the deductibility of expenses which is not provided for in the Tax Code. It was also issued without notice or a hearing, rendering it ineffective.

Ultimately, the SC decided that the Commissioner of Internal Revenue, in the case of RR No. 4-2011, had exceeded his powers.

While this recent SC decision for Banks signifies a major victory in this protracted battle, the war is far from over. As long as uncertainties remain, driven by the imperfect interactions between tax authorities and taxpayers, and given the complexity of the tax landscape, the possibility of a reversal or modification of the decision of the SC division is possible. But until then, victory is ours.

Let’s Talk Tax is a weekly column from P&A Grant Thornton that aims to keep the public informed of various tax developments. This article is not intended to be a substitute for competent professional advice.

Vinces Paul C. Leorna is senior in charge of the Tax Advisory & Compliance division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.

[email protected]