When you register a business or professional practice with the Bureau of Internal Revenue (BIR), you may choose the 8% option if eligible or use graduated rates. Under graduated rates, you choose how to deduct operating expenses from taxable income.
You can itemize actual expenses and keep supporting receipts, or you can elect the Optional Standard Deduction (OSD). This guide explains how the 40% OSD works, who may use it, how it compares with other tax options, and how to elect it on your tax return.
1. What is the Optional Standard Deduction?
The Optional Standard Deduction is an elective method under Section 34(L) of the National Internal Revenue Code. It allows eligible taxpayers to deduct a fixed 40% of gross sales or gross income instead of listing actual operating expenses.
Under OSD, the BIR treats 40% of your earnings as deductible expenses. You are taxed on the remaining 60%.
You do not need to submit receipts to support the 40% deduction. You also do not need to categorize each expense to calculate it.
2. OSD for individuals and corporations
The calculation depends on whether the taxpayer is an individual or a corporation.
Individuals: sole proprietors and professionals
For individuals, the 40% deduction applies to gross sales.
- OSD deduction:
40% OSD = Gross Sales × 40% - Net taxable income:
Net Taxable Income = Gross Sales - 40% OSD
For example, a freelance consultant with PHP 1,000,000 in gross sales may deduct PHP 400,000 through OSD. Their graduated income tax is then calculated on PHP 600,000.
Corporations: domestic and resident foreign corporations
For corporations, the 40% deduction applies to gross income. Gross income is gross sales minus the Cost of Goods Sold or Cost of Services.
- Formula:
Gross Income = Gross Sales − Cost of Goods Sold - OSD deduction:
40% OSD = Gross Income × 40% - Net taxable income:
Net Taxable Income = Gross Income - 40% OSD
For example, a corporate retail firm with PHP 2,000,000 in sales and PHP 1,200,000 in inventory costs has gross income of PHP 800,000. Its OSD deduction is PHP 320,000, leaving PHP 480,000 subject to corporate income tax.
3. OSD vs. itemized deductions vs. the 8% option
This comparison covers individual taxpayers only. Corporate income-tax rules differ.
| Feature | 40% OSD | Itemized deductions | 8% flat tax option |
|---|---|---|---|
| Income-tax rate | Graduated rates, from 0% to 35% | Graduated rates, from 0% to 35% | Flat 8% rate |
| Deduction amount | 40% of gross | Actual documented costs | PHP 250,000 deduction for purely self-employed |
| Expense receipts | Not required for deductions | Required | Not required |
| Percentage tax under Sec. 116 | 3% of gross sales, if applicable | 3% of gross sales, if applicable | Exempt if validly selected |
| Audited financial statements | Exempt for individuals | Required if sales exceed certain thresholds | Exempt |
| VAT eligibility | Available to VAT and non-VAT taxpayers | Available to VAT and non-VAT taxpayers | Non-VAT only; annual gross sales and non-operating income must not exceed PHP 3 million, subject to other eligibility requirements |
4. Comparison of tax options (high vs. low margin)
Your actual expense ratio affects which option produces the lowest tax.
Scenario A: High-margin professional (purely self-employed)
Juan is a Non-VAT registered freelance developer with PHP 1,500,000 in annual gross sales and PHP 150,000 in actual costs and expenses from his freelance work. Juan initially opted for the 8% income tax option, and thus exempt from the 3% percentage tax on gross sales.
8% flat tax option
- Tax base:
PHP 1,500,000 − PHP 250,000 = PHP 1,250,000 - Tax due:
PHP 1,250,000 × 8% = PHP 100,000 - Percentage Tax: Exempt
- Total tax: PHP 100,000
Graduated rates with itemized deductions
- Documented expenses: PHP 150,000
- Percentage Tax: PHP 45,000
- Total Expenses:
PHP 150,000 + PHP 45,000 = PHP 195,000 - Net taxable income:
PHP 1,500,000 − PHP 195,000 = PHP 1,305,000 - Graduated income tax:
PHP 102,500 + 25% of excess over PHP 800,000 = PHP 228,750 - Total tax: PHP 273,750
Graduated rates with 40% OSD
- OSD deduction: PHP 600,000
- Net taxable income: PHP 900,000
- Graduated income tax:
PHP 102,500 + 25% of excess over PHP 800,000 = PHP 127,500 - Percentage Tax: PHP 45,000
- Total tax: PHP 172,500
For this comparison, the graduated alternatives include 3% percentage tax under Section 116. Juan’s PHP 150,000 in freelance expenses excludes this tax, so the itemized calculation adds PHP 45,000 to deductible expenses.
Under OSD, the deduction remains 40% of Juan’s gross sales. Percentage tax does not increase that deduction, but it is included in the total estimated tax.
For Juan, the 8% option produces the lowest tax, saving PHP 173,750 compared with itemized deductions and PHP 72,500 compared with OSD.
Compare OSD, itemized deductions, and 8% tax using your figures.
Scenario B: High-expense business (purely self-employed)
Juan runs a Non-VAT registered online retail business with PHP 1,500,000 in annual gross sales and PHP 900,000 costs and operating expenses. Juan initially opted for the Graduated - Itemized Deduction income tax option, and is paying 3% percentage tax on gross sales. The percentage tax is already included in the costs and operating expenses.
Graduated rates with itemized deductions
- Documented expenses: PHP 900,000
- Net taxable income: PHP 600,000
- Graduated income tax:
PHP 22,500 + 20% of excess over PHP 400,000 = PHP 62,500 - Percentage Tax: PHP 45,000
- Total tax: PHP 107,500
Graduated rates with 40% OSD
- OSD deduction: PHP 600,000
- Net taxable income: PHP 900,000
- Graduated income tax:
PHP 102,500 + 25% of excess over PHP 800,000 = PHP 127,500 - Percentage Tax: PHP 45,000
- Total tax: PHP 172,500
8% flat tax option
- Tax base:
PHP 1,500,000 − PHP 250,000 = PHP 1,250,000 - Tax due:
PHP 1,250,000 × 8% = PHP 100,000 - Percentage Tax: Exempt
- Total tax: PHP 100,000
The 8% option replaces graduated income tax and percentage tax under Section 116. Actual costs and expenses are not deductible under this option.
The 8% option produces the lowest estimated tax in this hypothetical comparison. Juan has already elected Itemized, so this is not a recommendation to switch methods midyear; the election rules are explained below.
Compare OSD with the other income tax methods before choosing.
5. How and when to elect OSD
The OSD election is made at the beginning of the taxable year, similar to selecting the 8% tax option.
- In the first-quarter Income Tax Return: BIR Form 1701Q for individuals or BIR Form 1702Q for corporations.
- Find the deductions section and select Optional Standard Deduction.
- File the return on or before the first-quarter deadline.
If you do not file the first-quarter return or do not select OSD, the BIR will default you to itemized deductions. Support each deduction with the appropriate records and documents, including compliant invoices where applicable.
It is important to note that once you elect for a tax option, the choice is irrevocable for the taxable year. You cannot voluntarily switch to other options during the year or in the annual filing.
6. What OSD does and does not exempt
OSD reduces the documentation required for expense deductions, but it does not remove all tax responsibilities.
What OSD simplifies
- Expense receipt substantiation: You do not need receipts for business purchases, utilities, rent, or equipment to claim the 40% deduction.
- Audited financial statements: Individuals who elect OSD are exempt from submitting an AFS with their Annual Income Tax Return.
What you must still do
- Maintain books of accounts: Keep the books appropriate to your registered accounting setup. Common examples include the General Journal, General Ledger, Cash Receipts Book, and Cash Disbursements Book; confirm your requirements with your RDO.
- Issue Service Invoices: Issue compliant, serialized Service Invoices for client transactions.
- Keep sales records: Retain records that support your reported sales and collections.
- File percentage tax, if applicable: If you are subject to Section 116, file BIR Form 2551Q and pay 3% percentage tax on gross quarterly sales.
OSD election checklist
- Calculate your operating-expense ratio and compare it with the 40% OSD deduction.
- Choose your tax regime before filing the first quarterly return.
- Open BIR Form 1701Q or Form 1702Q during the first-quarter filing period.
- Select Optional Standard Deduction under the deductions section.
- File the first-quarter return on time to lock in the election.
- Maintain your Cash Receipts Book and issue Service Invoices to support your gross-sales declarations.
Frequently asked questions
Do I need expense receipts to claim the 40% OSD?
No. You do not need receipts to support the fixed 40% deduction or categorize each expense for the calculation. You must still maintain books of accounts, issue Service Invoices, and keep records supporting your reported sales and collections.
Is OSD calculated the same way for individuals and corporations?
No. For sole proprietors and professionals, the 40% deduction applies to gross sales. For domestic and resident foreign corporations, it applies to gross income after subtracting the Cost of Goods Sold or Cost of Services from gross sales.
When do I elect the Optional Standard Deduction?
Select OSD in the first-quarter Income Tax Return: BIR Form 1701Q for individuals or BIR Form 1702Q for corporations. File the return on or before the first-quarter deadline.
Can I switch from OSD to itemized deductions later in the year?
No. Once elected in the first-quarter filing, OSD is irrevocable for that taxable year. You cannot switch during the year or in the annual filing.
What happens if I do not select OSD in my first-quarter return?
The BIR defaults you to itemized deductions. Support each deduction with the appropriate records and documents, including compliant invoices where applicable.