Employees can sometimes find themselves in the position of having to pay for business-related expenses out of their own pockets. Such transactions can include transportation expenses and office supplies, for which they would later seek reimbursement from their employers.
Regardless of how business practices change, there remain firm rules in place that will affect how taxpayers or employers approach these “business-related expenses” in terms of deductibility. Some of the most common Bureau of Internal Revenue (BIR) audit findings have to do with expenses which were not subjected to expanded withholding taxes (EWT) and expenses that were improperly substantiated, leading to the disallowance of a Value-Added Tax (VAT) claim. Hence, the following questions arise:
1) What happens during BIR Audits? and
2) How should employers treat such expenses moving forward?
WHAT HAPPENS DURING BIR AUDITS?
BIR-driven Tax Assessments typically start with the issuance of a Letter of Authority (LoA), in which the assigned examiner compares the expenses reported on the taxpayer’s books, such as the audited financial statements or the taxpayer’s trial balance, against the expenses claimed in the tax returns. Any resulting difference could lead to a deficiency tax if caused by a non-deductible expense or unaccounted income.
One of the most common findings by the BIR are expenses that were not subjected to EWT pertaining to employee reimbursements. As a result, a deficiency in EWT remittance plus penalties and interest will be exacted by the BIR on the taxpayer, with such expenses possibly disallowed as deductions from gross income in the income tax return (ITR).
HOW SHOULD EMPLOYERS TREAT SUCH BUSINESS-RELATED EXPENSES?
In order to appropriately identify how taxpayers can resolve such issues, let us look into the regulations related to the withholding of employee-reimbursed business expenses. Section 2.78.1 6(b) of Revenue Regulations (RR) No. 2-98 as amended, states that any amount paid specifically, either as an advance or an item to be reimbursed for travel, representation, and other bonafide ordinary and necessary expenses incurred or reasonably expected to be incurred by the employee in the performance of his duties are not compensation subject to withholding, if the following conditions are satisfied:
(i) It is for ordinary and necessary traveling and representation or entertainment expenses paid for or incurred by the employee in the pursuit of the trade, business or profession; and
(ii) The employee is required to account/ liquidate the foregoing expenses in accordance with the specific requirements of substantiation for each category of expenses pursuant to Sec. 34 of the Tax Code. The excess of actual expenses over advances made shall constitute taxable income if such amount is not returned to the employer. Reasonable amounts of reimbursements/ advances for traveling and entertainment expenses which are pre-computed on a daily basis and are paid to an employee while he is on an assignment or duty need not be subjected to the requirement of substantiation and to withholding on compensation.
Now that we are enlightened as to what will form part of the employees’ taxable income, let us move forward as to the effect of such reimbursements to the employers.
SUBSTANTIATION AND WITHHOLDING REQUIREMENTS
Accordingly, for taxpayers to legitimately claim such ordinary and necessary expenses, Section 34 of the National Internal Revenue Code (NIRC) as amended, specifies that to claim a deduction from gross income, the taxpayer must substantiate with sufficient evidence, such as official receipts or other adequate records, (i) the amount of the expense being deducted, and (ii) the direct connection or relation of the expense being deducted to the development, management, operation, and/ or conduct of the trade, business or profession of the taxpayer.
Furthermore, Revenue Memorandum Circular (RMC) No. 72-2004 clarified that taxpayers classified as top 20,000 corporations (TTC)/as large taxpayers (LT) should subject payments made to their regular suppliers which were shouldered by their employees/agents to an EWT of 1% on purchase of goods or 2% on purchase of services. The RMC further clarified that the sales invoices/official receipts should be in the name of the persons whom they represent and that the corresponding certificate of taxes withheld at source (BIR Form No. 2307) is issued. There is another option for taxpayers to eliminate the complexity of the administrative task of compliance, one of which is for taxpayers to issue a company credit card to employees, since no withholding is required for transactions paid with company-issued credit cards.
Moreover, should the taxpayer/employer fail to subject such employee reimbursements to EWT, it would not only give rise to various tax penalties but, as a significant effect, a possible disallowance of such expenses against gross income. Nevertheless, as a remedy should the BIR raise a non-withholding or under-withholding issue resulting in the disallowance of the expense, Revenue Regulations (RR) No. 6-2018 reinstated the provisions for deductibility as stated in RR No. 14-2002. In the said RR, any income payment that is otherwise deductible under the Tax Code will now be allowed where no withholding was made, as long as the withholding agent pays the tax (or the difference between the correct amount and the amount of tax withheld, in the case of an erroneous under-withholding), including the interest and surcharges incident to non-withholding (or under withholding), at the time of audit/investigation or reinvestigation/reconsideration. In a Court of Tax Appeal decision, the Court held that the audit/investigation or reinvestigation/reconsideration had been concluded when the Final Decision on Disputed Assessment (FDDA) was issued. It is prudent, therefore, to settle the deficiency withholding tax at least before the issuance of the FDDA to be able to claim the related expense.
In addition, with the consideration of audit findings related to VAT, taxpayers should also keep in mind the appropriate invoicing requirements as part of the substantiation requisites since improper supporting documents and improper invoicing requirements could as well result to audit findings related to VAT. Commonly, such findings pertain to 1) failure to support purchase of services with an official receipt and as well failure to support purchase of goods transactions with a sales invoice, 2) failure to separately indicate the input VAT in the receipt, and 3) failure to properly indicate the required taxpayer’s information such as the registered name, taxpayers identification number (TIN), the registered business address, and the business style or trade name of the taxpayer in the Sales Invoice (SI) or Official Receipt (OR).
Due to the complex nature of the substantiation and invoicing requirements, companies could issue a policy regarding employee reimbursements, denying reimbursement if employees fail to meet the substantiation and invoicing requirements.
Finally, due to the growing complexity of day-to-day business transactions and as businesses move towards globalization, it is time that the BIR issues guidelines to ease the process of withholding taxes on employee reimbursements. Until then, taxpayers staying updated with and informed of the tax rules won’t be sufficient to keep up with the evolution of business and tax practices. Taxpayers should as well become proactive in conducting their internal tax compliance audits in order to revisit internal tax policies and align with the ever-changing landscape of Philippine taxation. As stated by the Greek philosopher Heraclitus, the only constant thing in life is change.
Let’s Talk Tax is a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.
Cydnie C. Hieras is a senior in charge of the Tax Advisory & Compliance Practice Area of P&A Grant Thornton. P&A Grant Thornton is one of the leading audits, tax, advisory, and outsourcing firms in the Philippines, with 29 Partners and more than 1000 staff members.
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