Tags: Deductibility of Expenses, Passive Income Taxation, RMC No. 81-2025, Supreme Court GR 240163, GR 240168-69, CTA Case No. 10784, Philippine Taxation, Income Tax Deductions, BIR Audit, Final Tax Income, Tax Compliance, CPA Philippines, Tax Law Updates, Business Taxation, NIRC Section 34
One of the most debated tax issues in recent years involves the deductibility of expenses attributable to passive income. The controversy became more pronounced after the issuance of Revenue Memorandum Circular (RMC) No. 81-2025, which revived discussions regarding the treatment of expenses related to income subject to final tax, such as dividends, interest income, royalties, and other forms of passive income.
For taxpayers, accountants, tax practitioners, and business owners, the question appears simple:
"If a taxpayer earns passive income, can expenses related to that income still be claimed as deductible expenses?"
Unfortunately, the answer is not as straightforward as many would hope. While the Bureau of Internal Revenue (BIR) has expressed its position through RMC No. 81-2025, the Supreme Court has previously ruled on a related issue in G.R. Nos. 240163 and 240168-69 dated December 1, 2021. More recently, the Court of Tax Appeals (CTA) also weighed in through CTA Case No. 10784 dated November 4, 2025.
The result is an apparent conflict between administrative interpretation and judicial authority.
This article examines these developments and seeks to answer the most important question:
Which interpretation should taxpayers ultimately follow?
Understanding Passive Income
Before discussing the legal controversy, it is important to understand what passive income means for tax purposes.
Passive income generally refers to earnings that are not generated through the taxpayer's regular trade or business activities. Common examples include:
- Interest income from bank deposits
- Interest income from investments
- Cash dividends
- Royalty income
- Prizes and winnings subject to final tax
- Certain trust fund earnings
Most of these income streams are already subjected to final withholding tax. Since the tax has already been withheld and remitted to the government, they are generally excluded from the computation of regular income tax.
The controversy arises when taxpayers incur expenses while also earning passive income.
The Traditional BIR Position
Historically, the BIR has maintained that expenses attributable to income subject to final tax should not be allowed as deductions against income subject to regular income tax.
The rationale appears logical at first glance.
If the income is not included in the regular taxable income base, then expenses incurred in earning such income should likewise not reduce taxable income subject to regular tax.
This concept is commonly referred to as the matching principle, where expenses should be matched against the income they helped generate.
Under this approach, taxpayers earning both active and passive income would need to allocate expenses between taxable income and passive income streams.
The problem is that the National Internal Revenue Code (NIRC) itself does not expressly require such allocation for common expenses.
The Supreme Court's Landmark Decision
The legal landscape changed significantly when the Supreme Court decided G.R. Nos. 240163 and 240168-69 on December 1, 2021.
The case involved the validity of Revenue Regulations No. 4-2011, which required the allocation of common expenses among various income streams, including income subject to final tax.
The Supreme Court ruled against the BIR.
The Court declared that the regulation exceeded the authority granted by law because Section 34 of the Tax Code does not require taxpayers to allocate common expenses among taxable, exempt, and final-tax income.
The Court emphasized an important constitutional principle:
Administrative agencies may implement the law, but they cannot amend, expand, or restrict what Congress has enacted.
According to the Supreme Court, the BIR cannot create additional requirements for deductibility when the Tax Code itself does not provide them.
This ruling was considered a major victory for taxpayers because it removed a long-standing basis for disallowing portions of common operating expenses.
What the Supreme Court Actually Protected
Many taxpayers interpreted the decision as meaning that all expenses are deductible regardless of passive income.
However, a closer reading suggests that the Court primarily addressed common expenses rather than expenses directly attributable to passive income.
Examples of common expenses include:
- Office rent
- Utilities
- Administrative salaries
- Accounting expenses
- Corporate overhead
- General management costs
These expenses support the overall operations of the business and cannot easily be traced to a specific source of income.
The Supreme Court held that there is no legal basis for forcing taxpayers to allocate such expenses between regular taxable income and passive income.
Enter RMC No. 81-2025
In 2025, the BIR issued RMC No. 81-2025, which again addressed the deductibility of expenses related to passive income.
The Circular reiterated the BIR's position that expenses attributable to passive income should not reduce income subject to regular income tax.
The Circular further stressed that deductions must be directly connected with the taxpayer's trade, business, or profession.
Many practitioners immediately questioned whether the Circular was consistent with the Supreme Court's 2021 ruling.
The answer depends largely on the type of expense involved.
The Critical Distinction: Direct Expenses vs. Common Expenses
The key to reconciling the apparent conflict lies in understanding the distinction between direct expenses and common expenses.
Direct Expenses
Direct expenses can be specifically identified with a passive income activity.
Examples include:
- Investment management fees
- Custodial fees for investment accounts
- Brokerage charges
- Interest on loans used exclusively to acquire investment securities
These expenses have a clear and direct relationship to passive income generation.
The BIR argues that allowing such expenses to reduce regular taxable income would effectively provide a double tax benefit.
Common Expenses
Common expenses support the business as a whole and are not directly attributable to any particular income stream.
Examples include:
- Rent
- Utilities
- Executive salaries
- Administrative expenses
- General accounting expenses
These were the expenses protected by the Supreme Court's ruling.
CTA Case No. 10784 Strengthens the Supreme Court Doctrine
On November 4, 2025, the Court of Tax Appeals issued its decision in CTA Case No. 10784.
Although every case depends on its specific facts, the CTA reportedly recognized the continuing authority of the Supreme Court's 2021 decision.
The CTA emphasized that administrative issuances cannot override judicial interpretations of the Tax Code.
This reinforces a long-standing legal principle:
When a Revenue Memorandum Circular conflicts with a Supreme Court ruling, the Supreme Court ruling prevails.
Why This Issue Matters During BIR Audits
The deductibility issue has enormous practical consequences.
During a tax audit, disallowed expenses directly increase taxable income, resulting in:
- Deficiency income tax
- Interest charges
- Penalties
- Compromise penalties
For large corporations and financial institutions, the amount involved can easily reach millions of pesos.
Consequently, understanding the distinction between direct and common expenses is now essential for tax compliance and tax defense strategies.
Which Authority Ultimately Controls?
In Philippine law, the hierarchy of legal authority is clear.
- Constitution
- Statutes enacted by Congress
- Supreme Court decisions interpreting those statutes
- Administrative regulations and circulars
Because RMC No. 81-2025 is merely an administrative issuance, it cannot override either the Tax Code or Supreme Court jurisprudence.
Therefore, where the Circular appears inconsistent with the Supreme Court's interpretation of Section 34, taxpayers possess strong legal grounds to rely on the Court's ruling.
The Most Defensible Tax Position Today
Based on existing authorities, the most defensible position appears to be the following:
- Common expenses remain fully deductible under the Supreme Court doctrine.
- No mandatory allocation of common expenses exists under Section 34 of the NIRC.
- Expenses directly and exclusively attributable to passive income may still be vulnerable to disallowance.
- Taxpayers should maintain documentation demonstrating whether an expense is direct or common in nature.
This interpretation harmonizes the Supreme Court decision, the CTA ruling, and the BIR's concerns regarding direct passive-income expenses.
Practical Advice for Taxpayers and CPAs
Businesses should carefully review their chart of accounts and identify expenses that may be directly attributable to passive income activities.
Maintaining detailed supporting documentation can help defend deductions during audits.
Companies should also consider preparing internal analyses demonstrating why certain expenses constitute common operating expenses rather than direct passive-income expenses.
Such documentation may prove invaluable during a Letter of Authority examination.
Deductibility of Expenses Related to Passive Income Remains Disputable, and Maybe Disallowed
The controversy surrounding the deductibility of expenses attributable to passive income highlights the ongoing tension between administrative tax enforcement and statutory interpretation.
While RMC No. 81-2025 reflects the BIR's current enforcement position, taxpayers must remember that administrative issuances cannot supersede the Tax Code or Supreme Court jurisprudence.
The Supreme Court's ruling in G.R. Nos. 240163 and 240168-69 remains the controlling authority on the allocation of common expenses. CTA Case No. 10784 further reinforces this principle.
As matters stand today, the strongest legal position is that common expenses remain deductible in full, while expenses directly attributable to passive income continue to be the primary area of dispute.
Until Congress amends Section 34 of the Tax Code or the Supreme Court revisits the issue, taxpayers and practitioners should continue to rely on the prevailing doctrine established by the nation's highest court.
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