The Supreme Court, time and again, has held that banking institutions are imbued with public interest. Banking is also one of the most regulated industries, if not the most. Under Philippine tax laws and regulations, a bank operating in the Philippines has two separate units, the Regular Banking Unit (RBU) and Foreign Currency Deposit Unit (FCDU), with separate books of account and separate registrations with the Bureau of Internal Revenue (BIR).

Income derived from the RBU is generally subject to the Regular Corporate Income Tax (RCIT) of (now) 25%. In contrast, income from the FCDU is categorized into the following:

1. Offshore income — or those derived from non-residents (including FCDUs of other banks) which is treated as exempt from tax;
2. Onshore income — or interest income derived from residents which is subject to 10% Final Withholding Tax (FWT); and
3. Others — for those not classified as Onshore or Offshore, which is also subject to the RCIT.

On March 15, 2011, the Department of Finance (DoF) issued Revenue Regulations (RR) No. 4-2011 providing for the rules on the allocation of costs and expenses among income earnings of banks and other financial institutions. Put simply, this RR required that costs and expenses must be allocated between the RBU and FCDU of a bank, where only the costs and expenses that may be attributed to the operations of the RBU will be deductible in computing the income tax liability. The method of allocation to be utilized by the taxpayer is as follows:

1. Specific Identification — where the costs and expenses specifically identified as pertaining to the RBU or the FCDU are declared as costs or expenses of that unit; and
2. By allocation — where common expenses that cannot be specifically identified for a particular unit shall be allocated based on the percentage of gross income earnings of a unit over the total gross income of both units, including those which may be exempt from tax and those subjected to FWT.

The RR prescribed the same method of allocation for other financial institutions that have regular income, “tax-paid” income (or those subject to FWT), and those that are exempt; or in the case of a bank, an intra-RBU or intra-FCDU allocation.

Essentially, the RR limited the deductibility of ordinary and necessary expenses to gross income or revenue which may be subject to RCIT, and expenses that are then allocated to FCDUs or other types of income would no longer be deductible. The RR effectively provided a different treatment for the expenses of banks and other financial institutions which cannot be found in the Tax Code nor applied to other taxpayers which also derive tax-paid income and income exempt from tax.

On Dec. 1, 2021, the Supreme Court, in the case of Department of Finance vs Asia United Bank, et al. (G.R. Nos. 240163 and 240168-69), held that the above-mentioned RR is void and invalid.

According to the Court, the RR not merely provided an interpretation, but effectively modified the Tax Code it seeks to implement. The Court said “taxpayers are allowed to adopt their accounting methods and periods, the Commissioner of Internal Revenue (CIR) may only prescribe an accounting method if any of the following conditions exist: (a) no accounting method has been employed by the taxpayer; or (b) while an accounting method has been employed, it does not clearly reflect the income of the taxpayer.”

The Court found that none of these conditions were present and held that the RR’s allocation rules essentially prescribed a uniform accounting method on banks in determining their deductions and taxable income and curtailed their right to adopt their own accounting methods.

The Court went further to explain that “while the CIR is empowered to distribute, apportion, or allocate gross income or deductions under Section 50 of the Tax Code, the same is applicable only if they determine that such distribution, apportionment, or allocation: (a) is necessary in order to prevent evasion of taxes; or (b) clearly to reflect the income of organizations, trades, or businesses.” Neither one of these conditions was present in the taxpayer’s case. Moreover, this power of the Commissioner to allocate expenses applies only to allocations between two or more organizations, trades or businesses. The two units of the bank (despite having separate certificates of registration and books of account as per BIR rules) are part of a single bank or financial institution. Thus, Section 50 cannot be invoked as the statutory basis for RR No. 4-2011.

Moreover, the Court held that the prescribed allocation limited the taxpayers’ right to claim deductions under Section 34 of the Tax Code by requiring the aforesaid allocation of costs and expenses of banks with respect to its RBU and FCDU operations and as to its “tax paid income” and “tax-exempt income” activities. The allocation method, thus, effectively imposed an additional requirement for deductibility of expenses which is not provided under the Tax Code.

The Court concluded that common expenses of the banks and other financial institutions should be deductible in full against their income subject to regular tax. As currently worded, all expenses are deducted directly and in full without any allocation or attribution between the different income streams. There is no requirement to allocate the common expenses to such taxpayers’ income subject to FWT or exempt income. There is no distinction for common expenses among income streams, as these are, after all, common expenses. Thus, there can be no allocation of expenses between different incomes in the same trade or business unit.

This decision of the Court provides uniformity of treatment of the expenses across taxpayers who are also earning tax-paid income and income exempt from tax and does not treat the banking industry and other financial institutions to a separate set of rules applicable only to them.

As was held by the SC in the same case, the implementing rules and regulations of a law cannot extend the law or expand its coverage, as the power to amend or repeal a statute is vested in the legislature.

The views or opinions expressed in this article are solely those of the author and do not necessarily represent those of Isla Lipana & Co. The content is for general information purposes only, and should not be used as a substitute for specific advice.

Cesar Nickolai Soriano, Jr. is a senior manager at the Tax Services department of Isla Lipana & Co., the Philippine member firm of the PwC network.

cesar.nickolai.soriano@pwc.com