Journal Entries and Expenses Under the Optional Standard Deduction for Taxation in the Philippines

Introduction

In the Philippine tax system, the Optional Standard Deduction (OSD) serves as an alternative method for computing allowable deductions from gross income, simplifying tax compliance for eligible taxpayers. Introduced under Republic Act No. 10963, otherwise known as the Tax Reform for Acceleration and Inclusion (TRAIN) Law, which amended the National Internal Revenue Code of 1997 (NIRC), the OSD allows taxpayers to claim a flat deduction equivalent to 40% of their gross sales or gross receipts without the need to itemize and substantiate actual expenses. This mechanism is particularly beneficial for small to medium-sized enterprises and professionals who may find detailed record-keeping burdensome.

However, the adoption of OSD has specific implications for the recording of expenses in accounting journals and the overall tax computation process. While OSD streamlines tax reporting by forgoing itemized deductions, it does not alter the fundamental principles of financial accounting under Philippine Financial Reporting Standards (PFRS) or PFRS for Small and Medium-sized Entities (SMEs). Taxpayers must continue to maintain accurate journal entries for expenses to ensure proper financial reporting, even if these expenses are not deductible for income tax purposes under OSD. This article explores the intricacies of journal entries and expense treatment in the context of OSD, providing a comprehensive overview grounded in Philippine tax law and accounting practices.

Legal Framework

The OSD is governed primarily by Section 34(L) of the NIRC, as amended by the TRAIN Law. This provision states that individual taxpayers engaged in trade, business, or the practice of a profession, as well as domestic and resident foreign corporations, may elect to deduct a standard amount of 40% from their gross sales or gross receipts in lieu of itemizing allowable deductions under Sections 34(A) to (J) and Section 37 of the NIRC. The deduction applies after deducting the cost of sales or cost of services, where applicable, to arrive at gross income.

Revenue Regulations (RR) No. 8-2018, issued by the Bureau of Internal Revenue (BIR), further implements the OSD provisions. It clarifies that OSD is optional and irrevocable for the taxable year once elected. For partnerships, the election is made at the partnership level, and the distributive share of partners is treated accordingly. Non-resident aliens engaged in trade or business in the Philippines are ineligible for OSD, as are estates and trusts in certain cases.

Importantly, the OSD does not extend to value-added tax (VAT) computations, where input VAT credits remain claimable based on actual purchases, regardless of the income tax deduction method chosen. This distinction ensures that OSD affects only income tax liabilities and not other tax obligations.

Eligibility and Election Process

Eligibility for OSD is limited to:

Individual taxpayers (citizens, resident aliens, and non-resident aliens engaged in trade or business) deriving income from business or profession.
Domestic corporations and resident foreign corporations subject to regular corporate income tax.
General professional partnerships (GPPs), where the election binds all partners.

Taxpayers subject to special tax regimes, such as those under the 8% gross income tax option for individuals or the minimum corporate income tax (MCIT), may have restrictions or interactions with OSD. For instance, corporations under MCIT compute tax based on 1% of gross income (as amended by the CREATE Law, Republic Act No. 11534), but OSD can be used if it results in a lower tax base.

The election must be indicated in the taxpayer's first quarterly income tax return (BIR Form 1701Q for individuals or 1702Q for corporations) or, if no quarterly return is required, in the annual income tax return (BIR Form 1701 or 1702). Failure to elect OSD in the initial return defaults the taxpayer to itemized deductions. Once elected, it cannot be revoked mid-year, promoting consistency in tax reporting.

Treatment of Expenses Under OSD

Under OSD, actual business expenses—such as salaries, rent, utilities, depreciation, bad debts, and research and development costs—are not deductible for income tax purposes. Instead, the 40% standard deduction substitutes for all these itemized expenses, eliminating the need for substantiation through official receipts, invoices, or other documentary evidence. This simplifies audits and reduces administrative burdens, as the BIR does not scrutinize expense claims when OSD is availed.

However, this tax treatment does not absolve taxpayers from recording expenses in their books of accounts. The Books of Accounts Rules under Revenue Memorandum Order (RMO) No. 29-2002 require all taxpayers to maintain journals, ledgers, and subsidiary records reflecting actual transactions. Expenses must be recorded on an accrual basis (for businesses with annual gross receipts exceeding P3 million) or cash basis (for smaller entities), in accordance with generally accepted accounting principles (GAAP) in the Philippines.

The divergence between tax and financial reporting creates a book-tax difference. For financial statements, expenses reduce net income, providing a true picture of operational performance. For tax purposes, these expenses are disregarded, and the OSD is applied directly to gross income. This may result in higher taxable income under OSD if actual expenses are less than 40% of gross receipts, or lower if expenses exceed that threshold.

Special considerations apply to certain expenses:

Capital Expenditures: These are not deductible under either method but are capitalized and depreciated over time. Under OSD, depreciation expense is not claimed for tax, but it is still journalized for accounting.
Non-Deductible Expenses: Items like bribes, fines, or personal expenses remain non-deductible and must be properly segregated in journals.
Input VAT: As mentioned, VAT on expenses is creditable against output VAT, requiring separate tracking in subsidiary ledgers.
Withholding Taxes: Expenses subject to expanded withholding tax (e.g., professional fees) must still withhold and remit taxes, with journal entries reflecting the net payment and withheld amount.

Taxpayers must ensure that expenses are arms-length and necessary for the business to avoid BIR adjustments during audits, even under OSD.

Journal Entries for Expenses Under OSD

Journal entries for expenses remain standard and unaffected by the OSD election, as accounting records prioritize financial accuracy over tax optimization. The key principle is that OSD is a tax computation tool, not an accounting methodology. Below are illustrative journal entries for common expenses, assuming a sole proprietorship or corporation using accrual accounting.

1. Recording Operating Expenses (e.g., Rent)

When incurring rent expense:

Debit: Rent Expense – P10,000
Credit: Cash/Accounts Payable – P10,000

This entry reflects the economic outflow, reducing equity or assets in the balance sheet. For tax under OSD, this expense is ignored in the income tax return.

2. Salaries and Wages

For payroll:

Debit: Salaries Expense – P50,000
Debit: Withholding Tax Payable (if applicable) – P5,000
Credit: Cash – P45,000
Credit: Accrued Salaries – P10,000 (if partial accrual)

Withholding taxes are remitted separately via BIR Form 1601C. Under OSD, the salaries expense is not deducted for tax, but the entry ensures compliance with labor laws and financial reporting.

3. Depreciation

For fixed assets:

Debit: Depreciation Expense – P20,000
Credit: Accumulated Depreciation – P20,000

Depreciation follows the straight-line or other methods per PFRS. Tax-wise, no deduction is claimed under OSD, potentially creating a permanent book-tax difference.

4. Bad Debts

If writing off uncollectible receivables:

Debit: Bad Debts Expense – P15,000
Credit: Allowance for Doubtful Accounts – P15,000

Under OSD, bad debts are not deductible, but the entry adjusts the balance sheet for realistic asset valuation.

5. Year-End Adjustments

At year-end, no special OSD-related entries are needed in the journals. However, for tax reconciliation, a memorandum entry or worksheet may note the OSD computation for the income tax return. If there are deferred tax assets/liabilities due to temporary differences (e.g., under PFRS/IAS 12), entries like:

Debit: Deferred Tax Asset – P amount
Credit: Income Tax Expense – P amount

may be recorded, but these are advanced and depend on whether the entity prepares audited financial statements.

In practice, small taxpayers using manual journals or software like QuickBooks must segregate tax-related adjustments in a separate tax workbook, ensuring journals remain "clean" for financial purposes.

Tax Computation Under OSD

The taxable income formula under OSD is:

Gross Sales/Receipts – Cost of Sales/Services = Gross Income
Gross Income × 40% = OSD
Gross Income – OSD = Taxable Income
Taxable Income × Applicable Tax Rate = Income Tax Due

For individuals, rates are graduated (0% to 35%); for corporations, 20% or 25% post-CREATE Law. Quarterly and annual returns reflect this computation, with no attachment of expense schedules required.

If actual expenses exceed 40%, itemized deduction may be preferable; otherwise, OSD yields tax savings.

Advantages and Disadvantages

Advantages of OSD include reduced compliance costs, faster tax filing, and minimized audit risks on expenses. Disadvantages encompass potential over-taxation if expenses are high, inability to carry forward losses from excess expenses, and irrelevance for loss-making years.

For journal entries, OSD simplifies by eliminating the need for tax-specific adjustments, allowing focus on operational accounting.

Conclusion

The Optional Standard Deduction represents a pragmatic approach to taxation in the Philippines, balancing simplicity with revenue protection. While it supplants itemized expenses for tax deduction, it mandates rigorous journal entry practices for expenses to uphold financial integrity. Taxpayers should evaluate their expense ratios annually to decide on OSD, consulting with certified public accountants or tax advisors to align accounting and tax strategies. This framework not only aids in compliance but also supports sustainable business growth within the Philippine legal landscape.