Tax compliance for year-end expenses

With Christmas just around the corner, company Christmas parties, family reunions, and other gatherings fill our calendars left and right. Even though this year many of these celebrations will be virtual due to the pandemic, we always find a way to make them memorable. The upcoming holiday season also brings the highly anticipated year-end break that every employee looks forward to for much-needed R&R before welcoming the new year.

For accountants, however, the end of the year signals the upcoming busy season, including keeping tabs on the things to be done before the year ends. For instance, they must ensure that expenses up to the last day of the year are well-documented and recognized in the companies’ books in preparation for the finalization of the audited financial statements and the income tax return in the next year. These procedures may involve calling the company’s suppliers to inquire about the amount that would be payable on its year-end purchases even before they receive the actual billing, which normally happens only in the following year.

WHAT DOES THE TAX CODE SAY?
Under Section 34 of the National Internal Revenue Code, otherwise known as the Tax Code, to be considered deductible, a business expense must be ordinary and necessary, and must have been paid or incurred during the taxable year in carrying on the trade or business of the taxpayer; and must be substantiated with sufficient evidence. Additionally, taxes required to be withheld from expenses should have been remitted to the BIR in accordance with the current withholding tax rules.

As mentioned, one of the requirements for deductibility of an expense is its having been paid or incurred during a specific taxable year.

Do bear in mind that during a tax investigation, it is standard procedure for the BIR to request supporting documents for expenses claimed for the year. If such documents indicate that the taxpayer claimed a deduction for goods and services purchased in the prior year, the BIR may potentially disallow such prior period expenses claimed in the current audited year.

WITHHOLDING TAX COMPLIANCE
Another area with potential tax implications is year-end expenses, the issue being whether withholding taxes on accrued expenses were withheld and remitted during the period. This situation often happens when the taxpayer’s withholding tax policy is based on actual payment rather than when it is recorded in its books as an accrued expense.

Under Revenue Regulations No. 2-98, otherwise known as the Withholding Tax Regulations, the obligation to deduct and withhold the tax arises at the time an income is paid or becomes payable, or when it is accrued or recorded as an expense or asset in the payor’s books, whichever comes first.

Notably, the proper timing for withholding taxes on expenses arises not only upon actual payment of such expense. The inclusion of the line, “whichever comes first,” triggers the taxpayer’s obligation to remit withholding taxes to the BIR even upon recording such transactions as an expense or asset (e.g., prepaid expenses) in the books.

While withholding taxes are remitted, albeit belatedly by taxpayers who only withhold upon payment, the imposition of administrative penalties (i.e., 25% surcharge, 12% interest, and compromise penalties) for failure to withhold taxes on time is unavoidable if the late withholding is raised as an issue during a tax audit.

WHAT IF THESE WERE MERE ESTIMATES?
One contention that taxpayers may have against the requirement of withholding upon booking the expense is that, at year-end, they merely estimated the amount for recording purposes. The amounts recorded are still subject to change once billed by the supplier or paid the following year.

This contention may be raised during a tax audit, provided the books reflect the expenses as such. For the book-entry of expenses, taxpayers have the option of recording them as accruals or provisions. But what’s the difference?

Under the accrual method of accounting, the determinative question is, when do the facts present themselves in such a manner that the taxpayer must recognize income or expense? As held in a Supreme Court case (G.R. No. 172231), the accrual of income and expense is permitted when the “all-events test” has been met. This test requires (1) fixing of a right to income or liability to pay; and (2) the availability of reasonably accurate determination of such income or liability.

The all-events test requires that the right to income or liability be fixed and determined with reasonable accuracy. However, the test does not demand that the amount be known absolutely, only that it must be determined with “reasonable accuracy,” which implies something less than an exact or completely accurate amount. Thus, estimates not supported by bills, contracts, or facts to establish the amount of liability with reasonable accuracy may not be deductible yet. They can instead be considered provisions.

A provision is an existing liability of uncertain timing or amount. It is not yet an incurred expense, hence, not deductible for income tax purposes, and the company has no obligation yet to withhold taxes in the year the provision was recognized.

Thus, recording a provision properly may help avoid withholding tax and deduction issues during tax audits. Be that as it may, given the thin line between an accrual and a provision, companies still often record accrued expenses in their books instead of provision accounts. It may be also due to the limitation of adding new accounts into the system or other factors.

I hope the above reminders and explanations will help suppliers empathize and support accountants/finance personnel who request for the amount of their payables at year-end. This will probably help grant their accountant’s wish to spend the holidays with a clear and relaxed mind, optimistically ending 2021 on a high note.