The COVID-19 pandemic is disrupting economies and societies worldwide. We are going through another global recession as business operations stood still for months in most parts of the world. Stock markets are down. Tourism and travel are almost nil. Schools are empty, while hospitals are overcrowded. Medical professionals struggle in saving lives, including their own. Employees are not allowed to go to work and are forced to rely on government subsidies to feed their families.
In the first quarter, the Philippine economy contracted for the first time in more than 21 years. Businesses are incurring losses due to inventory spoilage, production slowdowns, delayed shipments, and reduced mobility, among other reasons.
Since losses are unavoidably incurred, how does a business recoup or report its losses for taxation purposes?
The following are the losses recognized under the Tax Code: a) ordinary loss; b) capital loss; and c) casualty loss.
Ordinary loss pertains to a loss incurred in trade, profession, or business. Generally, ordinary losses are deductible from gross income if the losses are actually sustained during the taxable year when the loss is claimed, and such losses must not be compensated for by insurance.
The temporary closure of businesses during the enhanced community quarantine (ECQ) and the expected slowdown of most business operations even after the lifting of the ECQ may cause some assets to be no longer necessary for operations. Some organizations expect a portion of their manufacturing facilities to be decommissioned. Equipment such as printers or desktop computers may no longer be needed, or office furniture may be considered excess, as most employees continue to work from home. Hence, some companies are forced to conduct a fire sale of assets that are no longer needed in order to earn some much-needed cash.
If such sale or disposal of properties used in trade or business results in a loss, which is the excess of the carrying value over the selling price, such loss from the sale is considered an ordinary loss and is deductible from gross income.
Losses from assets shall be recognized only for taxation purposes when there is a closed and completed transaction. A closed and completed transaction is a taxable event that has been consummated as fixed by identifiable events occurring in a particular year. Thus, there must be an actual sale or disposition of assets before a loss is recognized.
Capital losses arise from the sales or exchange of capital assets. Capital assets refer to property held by the taxpayer but not used in trade or business.
For individual taxpayers, the capital loss shall be recognized in full if the capital assets have been held for not more than 12 months and shall be recognized in 50% if such assets are held for more than 12 months. For both corporations and individuals, however, capital loss to be deducted shall be limited to the extent of the capital gains from such sales or exchanges.
A number of taxpayers, other than dealers of securities, may have an investment in shares of stock that are listed and traded on the Philippine Stock Exchange. As the Philippine Stock Exchange index (PSEi) declines due to the uncertainty caused by this pandemic, some investors contemplate selling their investments in stock. For the sale of stock traded in the stock exchange, a stock transaction tax of 0.6% on the gross selling price shall be imposed. Even if the sale results in a loss, such a loss is not deductible for tax purposes.
For investments in shares in a domestic corporation that is not listed and traded on the stock market, on the other hand, any gain or loss on such a sale is considered capital gain or loss. If the sale results in a capital loss, such a loss shall be deductible only to the extent of capital gains from the same type of transaction during the same period. If the transferor of the shares is an individual, the rule on holding period and capital loss carryover does not apply. The resulting net capital gains shall be subject to 15 percent capital gains tax.
Unfortunately, for some businesses, the effect of losses due to the ECQ is so irreversible that businesses are forced to close, and business owners are left with no recourse but to dissolve the company. If a corporation is forced to close and is liquidated, and the corporation distributes all its assets to its stockholders, any gain derived or any loss sustained by the stockholder from its receipt of liquidating dividends shall be treated as taxable income or deductible loss, as the case may be. The capital gain or loss derived from such a transaction shall be subject to regular income tax rates for individual taxpayers or to the corporate income tax rate for corporations.
Under Revenue Regulations (RR) No. 12-77, the term “casualty” is the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected, or unusual nature. It denotes an accident or some sudden invasion by a hostile agency and excludes progressive deterioration through steadily operating cause.
The Tax Code allows for casualty losses arising from damage to or loss of property used in business as deductions from gross income, provided that the general requirements for deductibility of losses are met, and subject to compliance with certain requirements as outlined in Revenue Memorandum Order No. 31–09, such as a sworn declaration of loss shall be filed within 45 days after the date of the event and proof of the elements of the losses claimed.
Losses from the actual sale of ordinary or capital assets are considered either ordinary or capital losses, respectively. However, can business losses during this COVID-19 crisis be considered casualty losses?
Considering the definition of the word “casualty,” business losses due to the interruption or slowdown of business operations may not be considered casualty losses, as the latter entails complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected, or unusual nature. With this definition, the casualty loss must be due to the destruction of property caused by an event and not mere financial losses due to the inability to operate.
NET OPERATING LOSS CARRYOVER
Although losses due to the government-mandated stoppage of business operations are not considered ordinary or casualty losses per se, the fixed operating expenses incurred during such time may be allowed as a deduction from gross income. Any operating expense in excess of gross income will be considered a net operating loss and shall be carried over as a deduction from gross income for the next three consecutive taxable years immediately following the year of such loss.
To date, there is a proposal from the Department of Finance to allow small businesses to carry over their net operating losses incurred in 2020 over the next five years. Such a proposal, however, requires an amendment to the current Tax Code, which allows only three years of net operating loss carryover. We are hopeful that both houses of Congress are receptive to this proposal and will promptly approve the Tax Code amendment.
We are all grappling during these uncertain times. The downturn has taken each one of us by surprise. No one was prepared for this pandemic. Business losses may be inevitable for many but, for income tax purposes, some of these losses may be claimed as deductions from gross income, provided all the requisites for deductibility are met.
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.
Flourence Kathrine S. Enriquez is a tax manager of Tax Advisory & Compliance division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.