Understanding the Difference Between 8% Deduction, OSD and Itemized Deductions in Taxation

Overview

Navigating the complexities of taxation is crucial for shaping your financial strategy and managing your tax liability effectively. As a new business owner without the resources to hire an accountant, I need to personally handle and oversee the filing and monitoring of my income and taxes, especially with my first tax filing approaching. In this blog, we’ll explore the differences between the 8% deduction, Optional Standard Deduction (OSD), and itemized deductions, helping you make informed decisions for your tax filings.

Disclosure: This article does not constitute tax or legal advice, as I am not a tax professional or expert. The definitions outlined here are based solely on my personal experience regarding researching the internet for tax information for my business purposes. It is therefore still advisable to seek guidance from your own accountant for advice tailored to your business’s specific needs.

Before we define each type of tax deduction, let’s first clarify some common terms used in the realm of taxation by BIR:

Glossary

Gross Income – refers to the total amount of money earned by an individual or business before any deductions or taxes are taken out. This includes wages, salaries, bonuses, tips, rental income, interest, dividends, and any other earnings from various sources.
Income Tax – is a tax on the annual earnings generated from property, professions, trades, or offices. It encompasses a person’s income, salaries, profits, and similar earnings.
Percentage Tax – is a business tax applied to individuals or entities that sell or lease goods, properties, or services during the course of trade or business, whose gross annual sales or receipts do not exceed P550,000 and who are not VAT-registered.
Withholding Tax – is the tax withheld from individuals receiving purely compensation income.
Taxable Income – this is the income that is subjected for computation of your tax once deductions are taken out.
BMBE (Barangay Micro Business Enterprise) – any business involved in production, processing, or manufacturing of products, including agro-processing, as well as trading and services, with total assets not exceeding P3 million. These assets include those acquired through loans but exclude the land on which the plant and equipment are situated. Once you are a BMBE, you are exempted from income tax, but still liable to other internal revenue tax.
VAT – to qualify for VAT registration, your annual sales must be P3,000,000 and above thus your tax is 12% of VAT payable (output tax – input tax). The output tax is computed from gross sales, while input tax is computed from expenses.
Non-VAT – to qualify for Non-VAT registration, your annual sales must be less than P3,000,000 thus your tax will be 3% of gross sales.

Annual Withholding Tax Table

The table below is the latest tax table used to calculate annual income tax based on a person’s taxable income. We will use this table for our sample annual tax computations for each method.

Now let’s start defining each tax deductions:

The 8% Tax Rate Deduction

The 8% deduction is a simplified tax method offered in some jurisdictions, particularly in the Philippines, for individuals and small businesses. Here’s what you need to know:

Applicability: This method is available to self-employed individuals and professionals who earn income purely from their practice or business. Compensation income earners are not qualified to avail this as well BMBE. Under the 8% tax rate deduction, you are exempt from paying the percentage tax. As a BMBE, you are exempt from paying income tax. Therefore, if you attempt to avail both, you would be claiming a double tax exemption, which is illegal under the law.
Income Tax: Taxpayers can choose to pay a flat 8% tax on their gross sales or receipts that exceed PHP 250,000 in annual income. This PHP 250,000 exemption applies only to sole proprietors. However, if you become a mixed-income earner (both a business owner and an employee), this exemption will no longer apply, as your employer is already factoring this PHP 250,000 deduction into your salary tax computation.
Percentage Tax: Under 8% deduction, you are NOT required to pay percentage tax.
Simplicity: The main advantage is simplicity. By opting for the 8% flat rate, taxpayers bypass the need to compute for graduated income tax rates and potentially complex itemized deductions.
No Further Deductions: Under this method, taxpayers forego any further deductions or personal exemptions.
Documentation: Does not requires Financial Statement therefore there is no need to keep Receipts/Invoices.

Example: If your gross income is PHP 1,000,000, you can elect to pay a flat 8% tax on PHP 750,000 (after the initial PHP 250,000 exemption), resulting in an Income Tax of PHP 60,000. Your percentage tax is 0 (zero). Therefore your total Tax to pay is PHP 60,000.

Optional Standard Deduction (OSD)

The Optional Standard Deduction (OSD) is another simplified method but differs significantly from the 8% deduction:

Applicability: Available to both individuals and corporations. This is ideal for businesses with low operating expenses since you may not gain too much advantage from keeping itemized deductions. BMBE cannot avail this because once you’re a BMBE-certified, you’ll have to itemize every single expense. This is so the government can tell if you can still continue your status as BMBE on succeeding years. But itemizing your expenses is not a feature of OSD but rather the Itemized Deduction option only.
Income Tax: Taxpayers can deduct a fixed percentage of their gross income. For individuals, the OSD is 40% of gross receipts. For corporations, it’s also 40% of gross income. Therefore you can declare up to 40% of your gross sales/receipts as business expenses, of which the remaining 60% will then be taxable.
Percentage Tax: 3% of your Gross Sales
Documentation: This method is beneficial for those who do not want to maintain detailed records of their expenses, as it allows for a straightforward computation. Similar to 8% deduction, OSD does not requires Financial Statement however in some instances, taxpayer is still required to keep records of actual business expenses as a requirement for BIR examination purposes.
No Other Deductions: Similar to the 8% deduction, opting for OSD means you cannot claim any other itemized deductions.
Income Loss: In case you incur losses during the taxable year, you are STILL required to pay income tax.
Accountant: You are no longer required to hire a CPA and submit an Account Information Return (AIF) or financial statements otherwise required under the Tax Code.

Example: If your gross income is PHP 1,000,000, you can deduct 40% (PHP 400,000) as OSD, resulting in a taxable income of PHP 600,000. According to the annual tax table, this amount falls into the 3rd row. Therefore, your income tax is calculated as PHP 22,500 plus 20% of (600,000 – 400,000), which equals PHP 62,500. Additionally, your percentage tax is 3% of PHP 1,000,000, which amounts to PHP 30,000. Consequently, your total tax liability is the sum of the income tax and the percentage tax (PHP 62,500 + PHP 30,000), totaling PHP 92,500.

Itemized Deductions

Itemized deductions involve listing and deducting actual business expenses incurred during the taxable year. In return, this method can potentially offer more significant savings than what you can apply for with the OSD (40%) [Especially if you have huge direct cost and operating expenses (e.g. employee salaries, rental and utilities)]

Applicability: Available to both individuals and corporations. As a registered BMBE, you are automatically required to use the Itemized Deduction Method.
Flexibility: Taxpayers can deduct a wide range of expenses, including operating costs, salaries, rent, utilities, and other allowable expenses.
Income Tax: Your taxable income is when you deduct all your valid and recorded expenses from your gross income.
Percentage Tax: 3% of your Gross Sales
Documentation: By the name itself, Itemized, you need to list and declare all your valid deductible expenses thus it requires meticulous record keeping. This detailed records and receipts are necessary to substantiate the deductions claimed. Should your annual sales or receipts exceed P3,000,000, you will be required to have a Certified Public Accountant (CPA) audit your accounting records, translating to more resources spent on managing your books. Hiring an accountant can also be too expensive depending on how big your business transactions are. Aside from its tedious work, you need to keep all official receipts and other proof of expenses (required to be stored up to 10 years). If your gross sales are less than P3,000,000, you are required to prepare a Financial Statement. If your gross sales exceed this amount, you must prepare an Audited Financial Statement.
Potential Savings: If your actual business expenses are high, itemizing could reduce your taxable income significantly more than the OSD or 8% methods.
Income Loss: In case you incur losses during the taxable year, you WON’T be required to pay income tax.

Example: If your gross income is PHP 1,000,000 and your documented expenses total PHP 700,000, you can deduct these expenses, leaving you with a taxable income of PHP 300,000. According to the annual tax table, this amount falls into the 2nd row. Therefore, your income tax is calculated as 15% of (300,000 – 250,000), which equals PHP 7,500. Additionally, your percentage tax is 3% of PHP 1,000,000, which amounts to PHP 30,000. Consequently, your total tax liability is the sum of the income tax and the percentage tax (PHP 7,500 + PHP 30,000), totaling PHP 37,500.

To summarize and compare the total tax amounts for each method, I have compiled and presented the results in the table below:

The table above indicates that the Itemized Deduction method results in the lowest tax payable, while the OSD deduction method results in the highest tax amount. However, this is true only for the specific sample values of gross income and expenses provided. The outcome can vary based on factors such as your annual gross sales, valid expenses (with invoices), and your taxpayer category. To help you better understand these computations and explore different scenarios based on your input values, I have attached an Excel-format Tax Calculator tool in this blog. This tool assists non-VAT taxpayers in determining the most suitable tax method for their situation.

Choosing the Right Method

The best deduction method depends on your individual circumstances of your business. Here are some factors to consider:

Income Level: If your income is relatively low, the simplicity of the 8% deduction might be beneficial. For higher incomes with significant expenses, itemizing may yield better savings.
Record-Keeping: If maintaining detailed records is challenging (like in Itemized), OSD offers a simpler alternative without the need for documentation.
Expense Structure: Analyze your typical expenses. If your actual expenses are minimal, the 8% or OSD might be more advantageous. Conversely, if your expenses are substantial, itemizing could lower your tax liability significantly. The general rule is that if your expenses is greater than 40% of your income, Itemized is the more tax efficient choice. But if your expenses is equal to or less than 40% of your income, OSD is the more tax efficient choice

To assist you better in determining the best method for your tax situation, here is a free Tax Rate Selection Tool specifically designed for non-VAT taxpayers. This tool also accommodates mixed-income earners, allowing you to include your annual salary in the computation of your total annual tax payable.

Reminders:

You can use only one scheme for the entire taxable year (covering all 4 quarters). For example, if you choose OSD in the first quarter, you must continue using OSD for the remaining quarters of that taxable year. You can only change the scheme in the following year.
If you are a non-resident alien engaged in trade or business in the Philippines, you may only opt for the itemized deduction scheme.
Ensure that your expenses are included in the BIR’s list of deductible expenses. These include charitable contributions, advertising, and research and development.
Determine that the expenses meet the criteria set by the Bureau, such as that these should be business-related, have supporting documents, be legal, have withholding taxes paid, and the amount being deducted must be reasonable.

Final Thought

Understanding the differences between the 8% deduction, Optional Standard Deduction, and Itemized deductions is crucial for effective tax planning. Each method has its advantages and potential drawbacks, and the optimal choice will depend on your income, expenses, and record-keeping capabilities. Consulting with a tax professional can provide personalized advice and ensure you select the most beneficial deduction method for your situation. Wishing you the best of luck in your business endeavors!

If you want to know more about the updated BIR Withholding Tax, you can visit their official site here.

See other related tax topics in the Philippines below:

How To Add Tax Information For Google AdSense(Philippines) In Singapore

Guide To Paying Your Real Property Tax In The Philippines

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