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Proposed ceiling on representation
Oct 23, 2001

Currently being exposed for comments from the trade organizations whose members will be affected by its promulgation is a draft revenue regulation on the deductibility of entertainment, amusement and recreation expenses from a business enterprise’s gross income. For the most part, the proposed regulation is a reiteration of what is written in the statute, which in turn incorporates decisional doctrines fashioned by tax litigation since the income tax became part of our law in 1939. Its most significant and newest feature, however, is a proposed ceiling on amount that may be deducted. As it stands, the ceiling sought to be imposed is likely to make a businessman hit the roof.

The imposition of a ceiling on how much of expenses claimed to have been incurred in entertainment, amusement and recreation is a power only recently granted to the Secretary of Finance when Congress passed the so-called Tax Reform Act of 1997. It was generally conceded then, and up to now, that the privilege of claiming these deductions against gross income is among the most abused. This abuse results in the depriving the government much needed revenues. Therefore, the reasoning went, the government, since the ability to claim deductions is a matter of legislative grace, should be able, in the exercise of judicious judgment, should be able to prescribe limits to its exercise.

Actually, prescinding from the likelihood of abuse, the rationale for deduction of entertainment, amusement and recreation expenses from gross income contains an internal weakness. Entertainment, amusement and recreation expenses are essentially for the enjoyment by individuals; only incidentally are they connected to the generation of income. Thus, a person goes to the theatre to watch the opera; only incidentally will watching the opera increase one’s sales, e.g. when the person you are watching it with is your trading partner who is in love with Pavarotti. Since the entire expense for opera tickets is, at best, partly for pleasure and partly for business, there is a theoretical necessity to allocate and limit the deduction from gross income only to that portion that is connected with the business. Of course, the taxpayer can claim he hates Pavarotti and extremely suffers through the performance. But that only underscores the difficulty of characterizing for tax purposes the nature of entertainment, amusement and recreation expenses.

The standard way of resolving such difficulties, known in tax literature as the Cohan rule, after the US case laying down the principle as a doctrine, dates back to biblical times. The decision is left to Solomon who shows his wisdom (really, lack thereof), by simply wanting to split it in half. That is the tack that the proposed regulation has taken.

Section 1 lists down the requisites for deductibility. Except for the last item, the enumeration in Section 1 restates the law, particularly Section 34(A)(1)(a)(iv), 34(A)(1)(b), 34(A)(1)(c) and 34(K): the expense must be incurred during the taxable year, directly connected to his business, not illegal, not a bribe or kickback, duly substantiated, and subjected, if the law requires, to withholding. The last item requires that the amount claimed should not exceed the ceiling prescribed in Section 2, which in turn, Solomonically resolves our theological problems practically by fixing the ceiling at one-half of the amount of the qualified expenses.

The wisdom of Solomon, in this case, is, to my mind, an unreliable guide in two respects.

First, the 50-50 solution is obviously plucked out of thin air, without no obvious relation to concrete circumstances. One can see, for instance, why 50-50 is a correct allocation if the taxpayer were to bring a client to restaurant for a business lunch and both of them chose to take the same businessman’s meal. But, if the client, taking advantage of the taxpayers’ "hospitality", chose to eat escargot and the taxpayer, nervous about reaching his credit card limit, ate only a dish of clams, then the 50-50 solution breaks apart. Likewise, if the client brought his assistant along, then it should be 1/3 non-deductible (for what the taxpayer ate) and 2/3 (for what the client and his assistant ate).

The second inadequacy of the 50-50 solution is that the limit is imposed on the specific expense items claimed. The rationale, seems to be, that for each and every entertainment, amusement and recreation expense, there is a personal component that should be disallowed, and that personal component is 50 percent. That is not true at all. Not in all cases, anyway. A taxpayer who is a vegetarian may have, in the course of business, to take his client to a business lunch to a steak house. In such a case, cost of the lunch for the two of them should be considered all business. Moreover, if the taxpayer is a corporation, one cannot reasonably speak of a personal component of the lunch expense.

The more logical basis, to my mind, for a ceiling is a studied percentage, fixed according to industry standards and in conformity with best practice, based on the gross income of the taxpayer, whether individual or corporate. The norm should be, what the law itself provides, namely "all the ordinary and necessary expenses…directly attributable to the development, management, operation and/or conduct of the trade, business, or exercise of a profession". In some sectors, costs for the entertainment of clients are as standard as giving bulk discounts. Just as there is a limit (imposed by the exigencies of the business no doubt) to the total discounts that a taxpayer can give without ruining his business, there is also a limit to the total amount of entertainment, amusement and recreation expense a taxpayer should be willing to spend without turning himself into a charitable institution.

A percentage of the gross income is the more relevant measure of the reasonable impact of a taxpayers’ total entertainment, amusement and recreation expenses on the production of that income. After all, those items are allowed to be deducted on the theory that they contribute to the production of income. Therefore, the ratio of those expenses to the income produced is the better ceiling. Of course, that ceiling should be different from one general type of service to another (e.g. a taxpayer who is in the embalming business cannot reasonably maintain that he needs to spend 80 percent of his income in business lunches) depending on the special circumstances, nature and character of the industry, trade, business, or profession of the taxpayer.

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