REVENUE MEMORANDUM CIRCULAR NO. 81-2025 issued on September 3, 2025 reiterates the criteria and guidelines on the deductibility of ordinary and necessary expenses under Section 34(a)(1)(a) of the National Internal Revenue Code of 1997, as amended.

Section 34 of the Tax Code on deductions from Gross Income clearly provides that in computing taxable income subject to Income Tax, deductions are permitted only for the following:

a. Individuals who are citizens or resident aliens under Section 24(A) of the Tax Code;

b. Non-resident aliens engaged in trade or business in the Philippines under Section 25(A) of the Tax Code;

c. Members of general professional partnerships under Section 26 of the Tax Code;

d. Domestic corporations under Section 27(A) of the Tax Code;

e. Proprietary educational institutions and hospitals under Section 27(B) of the Tax Code;

f. Government-owned and controlled corporations (GOCCs) under Section 27(C) of the Tax Code; and

g. Resident foreign corporations under Section 28(A)(1) of the Tax Code.

In order for a business expense may be allowed as deductions from gross income, the following conditions must be met:

a. The expense must be ordinary and necessary;
b. The expense must be paid or incurred within the taxable year;
c. The expense must have been paid or incurred in carrying on or which are directly attributable to the development, management, operation and/or conduct of the trade, business or exercise of a profession; and
d. The expense must be supported by invoices, records or other pertinent papers.

Taxpayers are allowed to deduct business expenses that are both “ordinary” (common and accepted in the trade and business) and “necessary” (appropriate and helpful for the business) from their gross income to determine their taxable income.

The mere allegation of the taxpayer that an item of expense is ordinary and necessary does not justify its deduction as business expense. The taxpayer must substantially prove by evidence or records (i.e., invoices) that the deductions claimed are allowed under the existing laws, rules and regulations, otherwise, the same will be disallowed.

As settled in various court cases, not all expenses, even if deemed necessary, qualify as ordinary. An expense that is inordinately large cannot be considered as an ordinary expense even if it is necessary. If an expense nearly equaled half of the total claimed expenses, it may be considered as inordinately large and, thus, could not be considered “ordinary,” even if it might be “necessary” for the business’s marketing strategy. Hence, in determining whether a particular expense is ordinary, the size and relative proportion of expenses must be considered. Concomitantly, for an expense to be considered ordinary, they must be ordinary and necessary expenses paid or incurred in carrying on any trade or business, and should meet the further test of reasonableness in amount.

Further, extraordinary and unusual amounts paid to persons (natural or juridical) as compensation for their supposed services, but without any relation to the measure of their actual services, cannot be regarded as ordinary and necessary expenses within the meaning of the law. This posture is in line with the doctrine in the law of taxation that a taxpayer must show that its claimed deduction clearly come within the language of the law since allowances, like exemptions, are matters of legislative grace.” As such, they must be strictly construed against the taxpayer.

Expenditures not directly related to the earnings of the business within the Philippines, such as costs incurred for the remittance of funds to an overseas head office, are not deductible. It is important that the expense is necessary or integral to the income-generating activities of the business. Claims for deductions are a matter of legislative grace and do not turn on mere equitable considerations. The taxpayer in every instance has the burden of justifying the allowance of any deduction claimed.

Section 45 of the Tax Code states that “the deductions provided for in this title shall be taken for the taxable year in which ‘paid or accrued’ or ‘paid or incurred’, dependent upon the method of accounting upon the basis of which the net income is computed, unless in order to clearly reflect the income, the deductions should be taken as of a different period.”

Therefore, the deductible business expenses claimed must be for expenses that are paid or incurred within the taxable year when the corresponding revenue is earned. The term “taxable year” is defined under Sections 22(P) and 52(B) of the Tax Code as either the calendar year or the fiscal year, upon the basis of which the net income is computed. This criterion guarantees that the expense is directly linked to the particular period during which income is generated, which is consistent with the matching principle under the Generally Accepted Accounting Principles.

The expense must be paid or incurred in connection with the development, management, operation, and/or conduct of the trade, business, or profession. This means that there should be a direct link between the expense being deducted and the taxpayer’s business activities.

When a taxpayer incurs expenses related to both active and passive income, determining which expenses qualify as valid deductions under the “ordinary and necessary” provisions requires careful consideration of their direct connection to income-generating activities. Active income typically arises from the direct involvement (active pursuit) in trade, business, or professional activities, while passive income comes from investments like dividends, interest, and royalties. Passive income is already subject to different rates and taxed finally at source, therefore, these incomes are no longer included in the computation of gross income, which determines taxable income. Therefore, it is crucial to segregate the expenses that are directly attributable to active business operations from those related to passive income generation.

In determining whether income is passive or active under the Capital Markets Efficiency Promotion Act and relevant jurisprudence, the key consideration is the level of the taxpayer’s involvement in earning the income. Passive income arises from sources that do not require the taxpayer’s continuous or direct participation, such as interest, royalties, dividends, and capital gains, and is not subject to ValueAdded Tax (VAT). This is affirmed in cases like Commissioner of Internal Revenue v. Bank of Commerce and Republic v. Spouses Bunsay, where such income was taxed separately due to its passive nature. In contrast, in the case of Iconic Beverages, Inc. vs. Commissioner of Internal Revenue, it clarifies that active income results from the taxpayer’s active pursuit of its primary business or trade. A passive income can become active if the taxpayer repeatedly and systematically engages in activities that produce such income, transforming it into a business venture. Likewise, income typically considered active may be treated as passive if it is earned occasionally or without any substantial or recurring effort. Ultimately, classification hinges on whether the income results from habitual, business-driven actions or from merely holding assets and earning returns without substantial participation. Thus, the degree, frequency, and intent of participation in the incomeproducing activity are the main considerations in classifying income as passive or active.

Expenses directly tied to the development, management, operation, or conduct of active trade or business can be deducted as they meet the criteria of being ordinary and necessary. However, expenses related to managing investments that generate passive income, such as fees for financial advice, interest from loan to finance investments, or brokerage services, and other related expenses may not qualify under the same provision, as they do not relate directly to the taxpayer’s active business operations.

Moreover, each income stream, whether subject to regular tax, preferential rates, tax-exempt, or final tax, should have its expenses correctly identified. Furthermore, Section 43 of the Tax Code demands that income be computed annually using a method that clearly reflects the income. Non-compliance with these rules may lead to reclassification of expenses and potential disallowance if they are not directly tied to the development, management, operation and/or business activities, ensuring fairness and transparency in tax reporting.

The taxpayer must substantially prove by evidence or records the deductions claimed under the law, otherwise, the same will be disallowed. The mere allegation of the taxpayer that an item of expense is ordinary and necessary does not justify its deduction. Pieces of evidence, such as official invoices and vouchers, must be presented to substantiate the business expenses.

Expenses solely incurred in relation to tax-exempt income are not deductible for regular Income Tax purposes. Allowing deductions for expenses that produce taxexempt income would effectively give the taxpayer a double benefit – the income is exempt from tax, and the expenses reduce taxable income from other sources. Business expenses related to tax-exempt income do not contribute to the generation of taxable income and therefore do not meet the criteria of being necessary for the conduct of the business in the pursuit of income. Accordingly, if a taxpayer incurs expenses solely to generate tax-exempt income, these expenses cannot be deducted from its regular taxable income.

Income subject to final withholding tax is typically taxed at the source, and the tax withheld is considered the final tax liability on that income. Examples include interest from savings accounts or dividends from stocks, where the financial institution or the payor withholds a flat tax rate. The expenses solely related to generating this income are usually not deductible against other taxable income subject to regular Income Tax. Since this passive income has already been taxed at a final rate, allowing further deductions would distort the taxation principle that final withholding tax is comprehensive and conclusive. Thus, costs related to investment management do not qualify for deductions typically reserved for business operations.

When expenses are directly attributable to income subject to a preferential tax rate due to specific incentives or under special laws, these expenses must be carefully segregated from those subject income. The primary reason for this segregation is to ensure that the expenses directly tied to the preferentially taxed income are not deducted from the regular taxable income, thereby preventing any reduction to regular taxable in the tax base of the regular income. This segregation helps in maintaining the integrity of the tax system and ensures that the benefits of preferential tax rates are not improperly extended to regular income.

For business enterprises registered with Investment Promotion Agencies and whose availing of the five percent (5%) special corporate income tax (SCIT) incentive based on its gross income earned, in lieu of all national and local taxes, under Section 294(B) of the Tax Code, the ‘gross income earned” refers to gross sales/revenues net of sales discounts, returns, allowances, and direct costs related to production of goods/ services. Indirect operating expenses like advertising, representation, entertainment, commissions, clinic and office supplies, as well as freight and handling costs unrelated to production, which did not qualify as direct costs are disallowed as deductions for this purpose. Section 1(b), Rule 2 of the Implementing Rules and Regulations of RA No. 12066 provides for the list of direct costs for purposes of determining the gross income of businesses under the five percent (5%) SCIT incentive.