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click here for freelancing tutoring sitesGross Income: Income, gain or profit subject to income tax. It includes compensation for personal services, business income, profits and income derived from any source whatever legal or illegal.

Collector vs. HendersonFACTS:

• Sps. Arthur Henderson and Marie Henderson filed their annual income tax with the BIR. Arthur is president of American International Underwriters for the Philippines, Inc., which is a domestic corporation engaged in the business of general non-life insurance, and represents a group of American insurance companies engaged in the business of general non-life insurance.

• The BIR demanded payment for alleged deficiency taxes. In their computation, the BIR included as part of taxable income: 1) Arthur’s allowances for rental, residential expenses, subsistence, water, electricity and telephone expenses 2) entrance fee to the Marikina Gun and Country Club which was paid by his employer for his account and 3) travelling allowance of his wife

• The taxpayers justifications are as follows:

1) as to allowances for rental and utilities, Arthur did not receive money for the allowances. Instead, the apartment is furnished and paid for by his employer-corporation (the mother company of American International), for the employer corporation’s purposes. The spouses had no choice but to live in the expensive apartment, since the company used it to entertain guests, to accommodate officials, and to entertain customers. According to taxpayers, only P 4,800 per year is the reasonable amount that the spouses would be spending on rental if they were not required to live in those apartments. Thus, it is the amount they deem is subject to tax. The excess is to be treated as expense of the company.

2) The entrance fee should not be considered income since it is an expense of his employer, and membership therein is merely incidental to his duties of increasing and sustaining the business of his employer.

3) His wife merely accompanied him to New York on a business trip as his secretary, and at the employer-corporation’s request, for the wife to look at details of the plans of a building that his employer intended to construct. Such must not be considered taxable income.

 

• The Collector of Internal Revenue merely allowed the entrance fee as nontaxable. The rent expense and travel expenses were still held to be taxable. The Court of Tax Appeals ruled in favor of the taxpayers, that such expenses must not be considered part of taxable income. Letters of the wife while in New York concerning the proposed building were presented as evidence.

ISSUE: Whether or not the rental allowances and travel allowances furnished and given by the employer-corporation are part of taxable income?

HELD: NO. Such claims are substantially supported by evidence.

These claims are therefore NOT part of taxable income. No part of the allowances in question redounded to their personal benefit, nor were such amounts retained by them. These bills were paid directly by the employer-corporation to the creditors. The rental expenses and subsistence allowances are to be considered not subject to income tax. Arthur’s high executive position and social standing, demanded and compelled the couple to live in a more spacious and expensive quarters. Such ‘subsistence allowance’ was a SEPARATE account from the account for salaries and wages of employees. The company did not charge rentals as deductible from the salaries of the employees. These expenses are COMPANY EXPENSES, not income by employees which are subject to tax.

CIR vs. CantanedaFACTS:

Efren Castaneda retired from gov’t service as Revenue Attache in the Philippine Embassy, London, England. Upon retirement, he received benefits such as the terminal leave pay. The Commissioner of Internal Revenue withheld P12,557 allegedly representing that it was tax income.

Castaneda filed for a refund, contending that the cash equivalent of his terminal leave is exempt from income tax.

The Solicitor General contends that the terminal leave is based from an employer-employee relationship and that as part of the services rendered by the employee, the terminal leave pay is part of the gross income of the recipient.

CTA -> ruled in favor of Castaneda and ordered the refund.CA -> affirmed decision of CTA. Hence, this petition for review on certiorari.

ISSUE:Whether or not terminal leave pay (on occasion of his compulsory retirement) is subject to income tax.

HELD:

NO. As explained in Borromeo v CSC, the rationale of the court in holding that terminal leave pays are subject to income tax is that:

. . commutation of leave credits, more commonly known as terminal leave, is applied for by an officer or employee who retires, resigns or is separated from the service through no fault of his own. In the exercise of sound personnel policy, the Government encourages unused leaves to be accumulated. The Government recognizes that for most public servants, retirement pay is always less than generous if not meager and scrimpy. A modest nest egg which the senior citizen may look forward to is thus avoided. Terminal leave payments are given not only at the same time but also for the same policy considerations governing retirement benefits.A terminal leave pay is a retirement benefit which is NOT subject to income tax.

*Petition denied.

CIR vs. Filinvest Development Corporation

Filinvest Development Corporation extended advances in favor of its affiliates and supported the same with instructional letters and cash and journal vouchers. The BIR assessed Filinvest for deficiency income tax by imputing an “arm’s length” interest rate on its advances to affiliates. Filinvest disputed this by saying that the CIR lacks the authority to impute theoretical interest and that the rule is that interests cannot be demanded in the absence of a stipulation to the effect.

ISSUE:

Can the CIR impute theoretical interest on the advances made by Filinvest to its affiliates?

HELD:

NO. Despite the seemingly broad power of the CIR to distribute, apportion and allocate gross income under (now) Section 50 of the Tax Code, the same does not include the power to impute theoretical interests even with regard to controlled taxpayers’ transactions. This is true even if the CIR is able to prove that interest expense (on its own loans) was in fact claimed by the lending entity. The term in the definition of gross income that even those income “from whatever source derived” is covered still requires that there must be actual or at least probable receipt or realization of the item of gross income sought to be apportioned, distributed, or allocated. Finally, the rule under the Civil Code that “no interest shall be due unless expressly stipulated in writing” was also applied in this case.

The Court also ruled that the instructional letters, cash and journal vouchers qualify as loan agreements that are subject to DST.

CIR vs. CA, CTA & ANSCOR

Sometime in the 1930s, Don Andres Soriano, a citizen and resident of the United States, formed the corporation “A. Soriano Y Cia”, predecessor of ANSCOR, with a P1,000,000.00 capitalization divided into 10,000 common shares at a par value of P100/share. ANSCOR is wholly owned and controlled by the family of Don Andres, who are all non-resident aliens. In 1937, Don Andres subscribed to 4,963 shares of the 5,000 shares originally issued. The authorized capital stock was increased to P2,500,000.00 divided into 25,000 common shares with the same par value with only 10,000 issued and all subscribed by Don Andres. Don Andres transferred 1,250 shares each to his two sons, Jose and Andres, Jr., as their initial investments in ANSCOR. Both sons are foreigners.Stock dividends were declared on 1947, 1949 and 1963.On December 30, 1964 Don Andres died. As of that date, he has a total shareholdings of 185,154 shares - 50,495 of which are original issues and the balance of 134,659 shares as stock dividend declarations. One-half of that shareholdings were transferred to his wife, Doña Carmen Soriano, as her conjugal share. The other half formed part of his estate.ANSCOR increased its capital stock to P20M and in 1966 to P30M. In the same year, stock dividends worth 46,290 and 46,287 shares were respectively received by the Don Andres estate and Doña Carmen from ANSCOR. Hence, increasing their accumulated shareholdings to 138,867 and 138,864 common shares each.On December 28, 1967, Doña Carmen requested a ruling from the United States Internal Revenue Service (IRS), inquiring if an exchange of common with preferred shares may be considered as a tax avoidance scheme under Section 367 of the 1954 U.S. Revenue Act. By January 2, 1968, ANSCOR reclassified its existing 300,000 common shares into 150,000 common and 150,000 preferred shares. The IRS opined that the exchange is only a recapitalization scheme and not tax avoidance. Consequently, Doña Carmen exchanged her whole 138,864 common shares for 138,860 of the newly reclassified preferred shares. The estate of Don Andres in turn, exchanged 11,140 of its common shares for the remaining 11,140 preferred shares, thus reducing its (the estate) common shares to 127,727.ANSCOR redeemed 28,000 common shares from the Don Andres’ estate. By November 1968, the Board further increased ANSCOR’s capital stock to P75M divided into 150,000 preferred shares and 600,000 common shares. About a year later, ANSCOR again redeemed 80,000 common shares from the Don Andres’ estate further reducing the latter’s common shareholdings to 19,727.In 1973, after examining ANSCOR’s books of account and records, Revenue examiners issued a report proposing that ANSCOR be assessed for deficiency withholding tax-at-source, pursuant to Sections 53 and 54 of the 1939 Revenue Code, for the year 1968 and the second quarter of 1969 based on the transactions of exchange and redemption of stocks.Subsequently, ANSCOR filed a petition for review with the CTA assailing the tax assessments on the redemptions and exchange of stocks.The bone of contention is the interpretation and application of Section 83(b) of the 1939 Revenue Act which provides:Sec. 83. Distribution of dividends or assets by corporations. -(b) Stock dividends - A stock dividend representing the transfer of surplus to capital account shall not be subject to tax. However, if a corporation cancels or redeems stock issued as a dividend at such time and in such manner as to make the distribution and cancellation or redemption, in whole or in part, essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock shall be considered as taxable income to the extent it represents a distribution of earnings or profits accumulated after March first, nineteen hundred and thirteen.” (Italics supplied).Specifically, the issue is whether ANSCOR’s redemption of stocks from its stockholder as well as the exchange of common with preferred shares can be considered as “essentially equivalent to the distribution of taxable dividend,” making the proceeds thereof taxable under the provisions of the above-quoted law.

General RuleSection 83(b) of the 1939 NIRC was taken from Section 115(g)(1) of the U.S. Revenue Code of 1928. It laid down the general rule known as the ‘proportionate test’ wherein stock dividends once issued form part of the capital and, thus, subject to income tax. Specifically, the general rule states that:“A stock dividend representing the transfer of surplus to capital account shall not be subject to tax.”Having been derived from a foreign law, resort to the jurisprudence of its origin may shed light. Under the US Revenue Code, this provision originally referred to “stock dividends” only, without any exception. Stock dividends, strictly speaking, represent capital and do not constitute income to its recipient. So that the mere issuance thereof is not yet subject to income tax as they are nothing but an “enrichment through increase in value of capital investment.” As capital, the stock dividends postpone the realization of profits because the “fund represented by the new stock has been transferred from surplus to capital and no longer available for actual distribution.” Income in tax law is “an amount of money coming to a person within a specified time, whether as payment for services, interest, or profit from investment.” It means cash or its equivalent. It is gain derived and severed from capital, from labor or from both combined - so that to tax a stock dividend would be to tax a capital increase rather than the income. In a loose sense, stock dividends issued by the corporation, are considered unrealized gain, and cannot be subjected to income tax until that gain has been realized. Before the realization, stock dividends are nothing but a representation of an interest in the corporate properties. As capital, it is not yet subject to income tax. It should be noted that capital and income are different. Capital is wealth or fund; whereas income is profit or gain or the flow of wealth. The determining factor for the imposition of income tax is whether any gain or profit was derived from a transaction.

The Exception“However, if a corporation cancels or redeems stock issued as a dividend at such time and in such manner as to make the distribution and cancellation or redemption, in whole or in part, essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock shall be considered as taxable income to the extent it represents a distribution of earnings or profits accumulated after March first, nineteen hundred and thirteen.” (Emphasis supplied).Although redemption and cancellation are generally considered capital transactions, as such, they are not subject to tax. However, it does not necessarily mean that a shareholder may not realize a taxable gain from such transactions. Simply put, depending on the circumstances, the proceeds of redemption of stock dividends are essentially distribution of cash dividends, which when paid becomes the absolute property of the stockholder. Thereafter, the latter becomes the exclusive owner thereof and can exercise the freedom of choice. Having realized gain from that redemption, the income earner cannot escape income tax.As qualified by the phrase “such time and in such manner,” the exception was not intended to characterize as taxable dividend every distribution of earnings arising from the redemption of stock dividends. So that, whether the amount distributed in the redemption should be treated as the equivalent of a “taxable dividend” is a question of fact, which is determinable on “the basis of the particular facts of the transaction in question.” No decisive test can be used to determine the application of the exemption under Section 83(b) The use of the words “such manner” and “essentially equivalent” negative any idea that a weighted formula can resolve a crucial issue - Should the distribution be treated as taxable dividend. On this aspect, American courts developed certain recognized criteria, which includes the following:1) the presence or absence of real business purpose,2) the amount of earnings and profits available for the declaration of a regular dividend and the corporation’s past record with respect to the declaration of dividends,3) the effect of the distribution as compared with the declaration of regular dividend,4) the lapse of time between issuance and redemption,5) the presence of a substantial surplus and a generous supply of cash which invites suspicion as does a meager policy in relation both to current earnings and accumulated surplus.

REDEMPTION AND CANCELLATIONFor the exempting clause of Section 83(b) to apply, it is indispensable that: (a) there is redemption or cancellation; (b) the transaction involves stock dividends and (c) the “time and manner” of the transaction makes it “essentially equivalent to a distribution of taxable dividends.” Of these, the most important is the third.Redemption is repurchase, a reacquisition of stock by a corporation which issued the stock in exchange for property, whether or not the acquired stock is cancelled, retired or held in the treasury. Essentially, the corporation gets back some of its stock, distributes cash or property to the shareholder in payment for the stock, and continues in business as before. The redemption of stock dividends previously issued is used as a veil for the constructive distribution of cash dividends. In the instant case, there is no dispute that ANSCOR redeemed shares of stocks from a stockholder (Don Andres) twice (28,000 and 80,000 common shares). But where did the shares redeemed come from? If its source is the original capital subscriptions upon establishment of the corporation or from initial capital investment in an existing enterprise, its redemption to the concurrent value of acquisition may not invite the application of Sec. 83(b) under the 1939 Tax Code, as it is not income but a mere return of capital. On the contrary, if the redeemed shares are from stock dividend declarations other than as initial capital investment, the proceeds of the redemption is additional wealth, for it is not merely a return of capital but a gain thereon.It is not the stock dividends but the proceeds of its redemption that may be deemed as taxable dividends. Here, it is undisputed that at the time of the last redemption, the original common shares owned by the estate were only 25,247.5. This means that from the total of 108,000 shares redeemed from the estate, the balance of 82,752.5 (108,000 less 25,247.5) must have come from stock dividends. Besides, in the absence of evidence to the contrary, the Tax Code presumes that every distribution of corporate property, in whole or in part, is made out of corporate profits, such as stock dividends. The capital cannot be distributed in the form of redemption of stock dividends without violating the trust fund doctrine - wherein the capital stock, property and other assets of the corporation are regarded as equity in trust for the payment of the corporate creditors. Once capital, it is always capital. That doctrine was intended for the protection of corporate creditorsWith respect to the third requisite, ANSCOR redeemed stock dividends issued just 2 to 3 years earlier. The time alone that lapsed from the issuance to the redemption is not a sufficient indicator to determine taxability. It is a must to consider the factual circumstances as to the manner of both the issuance and the redemption. The “time” element is a factor to show a device to evade tax and the scheme of cancelling or redeeming the same shares is a method usually adopted to accomplish the end sought. Was this transaction used as a “continuing plan,” “device” or “artifice” to evade payment of tax? It is necessary to determine the “net effect” of the transaction between the shareholder-income taxpayer and the acquiring (redeeming) corporation. The “net effect” test is not evidence or testimony to be considered; it is rather an inference to be drawn or a conclusion to be reached. It is also important to know whether the issuance of stock dividends was dictated by legitimate business reasons, the presence of which might negate a tax evasion plan.The issuance of stock dividends and its subsequent redemption must be separate, distinct, and not related, for the redemption to be considered a legitimate tax scheme. Redemption cannot be used as a cloak to distribute corporate earnings. Otherwise, the apparent intention to avoid tax becomes doubtful as the intention to evade becomes manifest.

Depending on each case, the exempting provision of Sec. 83(b) of the 1939 Code may not be applicable if the redeemed shares were issued with bona fide business purpose, which is judged after each and every step of the transaction have been considered and the whole transaction does not amount to a tax evasion scheme.It is the “net effect rather than the motives and plans of the taxpayer or his corporation” that is the fundamental guide in administering Sec. 83(b). This tax provision is aimed at the result. It also applies even if at the time of the issuance of the stock dividend, there was no intention to redeem it as a means of distributing profit or avoiding tax on dividends. The existence of legitimate business purposes in support of the redemption of stock dividends is immaterial in income taxation. It has no relevance in determining “dividend equivalence”. Such purposes may be material only upon the issuance of the stock dividends. The test of taxability under the exempting clause, when it provides “such time and manner” as would make the redemption “essentially equivalent to the distribution of a taxable dividend”, is whether the redemption resulted into a flow of wealth. If no wealth is realized from the redemption, there may not be a dividend equivalence treatment.The three elements in the imposition of income tax are: (1) there must be gain or profit, (2) that the gain or profit is realized or received, actually or constructively,and (3) it is not exempted by law or treaty from income tax. Any business purpose as to why or how the income was earned by the taxpayer is not a requirement. Income tax is assessed on income received from any property, activity or service that produces the income because the Tax Code stands as an indifferent neutral party on the matter of where income comes from.As stated above, the test of taxability under the exempting clause of Section 83(b) is, whether income was realized through the redemption of stock dividends. The redemption converts into money the stock dividends which become a realized profit or gain and consequently, the stockholder’s separate property.Profits derived from the capital invested cannot escape income tax. As realized income, the proceeds of the redeemed stock dividends can be reached by income taxation regardless of the existence of any business purpose for the redemption.A review of the cited American cases shows that the presence or absence of “genuine business purposes” may be material with respect to the issuance or declaration of stock dividends but not on its subsequent redemption. The issuance and the redemption of stocks are two different transactions. Although the existence of legitimate corporate purposes may justify a corporation’s acquisition of its own shares under Section 41 of the Corporation Code, such purposes cannot excuse the stockholder from the effects of taxation arising from the redemption. If the issuance of stock dividends is part of a tax evasion plan and thus, without legitimate business reasons the redemption becomes suspicious which may call for the application of the exempting clause. The substance of the whole transaction, not its form, usually controls the tax consequences.After considering the manner and the circumstances by which the issuance and redemption of stock dividends were made, there is no other conclusion but that the proceeds thereof are essentially considered equivalent to a distribution of taxable dividends. As “taxable dividend” under Section 83(b), it is part of the “entire income” subject to tax under Section 22 in relation to Section 21of the 1939 Code. Moreover, under Section 29(a) of said Code, dividends are included in “gross income”. As income, it is subject to income tax which is required to be withheld at source. The 1997 Tax Code may have altered the situation but it does not change this disposition.

EXCHANGE OF COMMON WITH PREFERRED SHARESExchange is an act of taking or giving one thing for another involving reciprocal transfer and is generally considered as a taxable transaction. The exchange of common stocks with preferred stocks, or preferred for common or a combination of either for both, may not produce a recognized gain or loss, so long as the provisions of Section 83(b) is not applicable. This is true in a trade between two (2) persons as well as a trade between a stockholder and a corporation. In general, this trade must be parts of merger, transfer to controlled corporation, corporate acquisitions or corporate reorganizations. No taxable gain or loss may be recognized on exchange of property, stock or securities related to reorganizations.Both the Tax Court and the Court of Appeals found that ANSCOR reclassified its shares into common and preferred, and that parts of the common shares of the Don Andres estate and all of Doña Carmen’s shares were exchanged for the whole 150, 000 preferred shares. Thereafter, both the Don Andres estate and Doña Carmen remained as corporate subscribers except that their subscriptions now include preferred shares. There was no change in their proportional interest after the exchange. There was no cash flow. Both stocks had the same par value. Under the facts herein, any difference in their market value would be immaterial at the time of exchange because no income is yet realized - it was a mere corporate paper transaction. It would have been different, if the exchange transaction resulted into a flow of wealth, in which case income tax may be imposed.Reclassification of shares does not always bring any substantial alteration in the subscriber’s proportional interest. But the exchange is different - there would be a shifting of the balance of stock features, like priority in dividend declarations or absence of voting rights. Yet neither the reclassification nor exchange per se, yields realize income for tax purposes.

Eisner V. MacomberFacts: Standard Oil Company of California, had surplus and undivided profits amounting to $45,000,000, of which about $20,000,000 had been earned prior to March 1, 1913. In order to readjust the capitalization, the board of directors decided to issue stock dividend of 50 percent of the outstanding stock, and to transfer from surplus account to capital stock account an amount equivalent to such issue.

Macomber,being the owner of 2,200 shares of the old stock, received certificates for 1,100 additional shares, of which 18.07 per cent., or 198.77 shares, par value $19,877, were treated as representing surplus earned between March 1, 1913, and January 1, 1916. She was called upon to pay, and did pay under protest, a tax imposed based upon a supposed income of $ 19,877 because of the new shares.

MACOMBER: Revenue Act of 1916 , in so far as it considers stock dividends as income, violated the Constitution of the United States.

Issue: Whether or not Congress has the power to tax, as income of the stockholder and without apportionment, a stock dividend made lawfully and in good faith against profits accumulated by the corporation.

Held: No, stock dividend is not taxable. Income may be defined as the gain derived from capital, from labor, or from both combined, provided it be understood to include profit gained through a sale or conversion of capital assets and not a gain accruing to capital; not a growth or increment of value in the investment; but a gain, a profit, something of exchangeable value, proceeding from the property, severed from the capital, however invested or employed, and coming in, being 'derived'-that is, received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal- that is income derived from property.

 A 'stock dividend' shows that the company's accumulated profits have been capitalized, instead of distributed to the stockholders or retained as surplus available for distribution in money or in kind should opportunity offer. Far from being a realization of profits of the stockholder, it tends rather to  postpone such realization, in that the fund represented by the new stock has been transferred from surplus to capital, and no longer is available for actual distribution.

 The essential and controlling fact is that the stockholder has received nothing out of the company's assets for his separate use and benefit; on the contrary, every dollar of his original investment, together with whatever accretions and accumulations have resulted from employment of his money and that of the other stockholders in the business of the company, still remains the property of the company, and subject to business risks which may result in wiping out the entire investment. Having regard to the very truth of the matter, to substance and not to form, he has received nothing that answers the definition of income within the meaning of the Sixteenth Amendment.

We are clear that not only does a stock dividend really take nothing from the property of the corporation and add nothing to that of the shareholder, but that the antecedent accumulation of profits evidenced thereby, while indicating that the shareholder is the richer because of an increase of his capital, at the same time shows he has not realized or received any income in the transaction.

BIR RULING NO. 219-93AWARD AS MORAL DAMAGES NOT SUBJ. TO INCOME/WITHHOLDING TAX29 (a) 04-92 19-93Mañacop Law OfficeUnit 102, Mission Garden Condominium59 Sct. Ibardolaza St.Quezon CityAttention: Atty. Jose F . MañacopThis refers to your letter dated August 12, 1992 stating that your client, Mr. Michael Lawrence, was awarded unpaid salaries and commission, plus moral and exemplary damages and attorney's fees in NLRC Case No. 00-11-043031-87, entitled "Michael Lawrence vs. LEP International Phil., Inc."; that said award has already become final and executory, and the respondent is willing to pay the award less the withholding tax thereon; and that it is the belief of your client that the unpaid salaries and commission are subject to withholding tax but the damages which consist of moral and exemplary damages and attorney's fees are not subject to withholding tax to which the respondent disagrees. Based on the foregoing, you now request for a ruling as to whether or not award of damages such as moral, exemplary and attorney's fees or reimbursement of your client's advances to his lawyers, are subject to withholding tax. In reply, I have the honor to inform you that amounts received by a taxpayer as moral damages are not considered taxable income (par. 60, 12 Vol. 1, Mertens Law of Federal Income Taxation). The legal expenses incurred in court proceedings, where the taxpayer was awarded moral damages, are not deductible from gross income, under Section 29(a) of the Tax Code (par. 1130, p. 39001, 1969 U.S. Master Tax Guide). On the other hand, attorney's fees awarded to your client as part of the damages shall not be subject to income tax, the same being merely a reimbursement of his expenses/advances in the course of the hearing of his case. This opinion finds support in the case of Gold Green Mining Corporation vs. Tabios, CIR, CTA Case No. 1497, April 27, 1967 (1988 Ed. Arañas Commentary, p. 190), holding that the so-called "legal fees" are expenses incurred in the carrying on of a trade or business.In view thereof, this Office is of the opinion as it hereby holds that award of damages, such as moral, exemplary and attorney's fees, are not subject to income tax and consequently, to the withholding tax. This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it will be disclosed that the facts are different, then this ruling shall be considered null and void. VICTOR A. DEOFERIO, JR.Deputy Commissioner of Internal Revenue

DEDUCTIONS

ESSO vs. CIR

Facts: In CTA Case No. 1251, Esso Standard Eastern Inc. (Esso) deducted from its gross income for 1959, as part of its ordinary and necessary business expenses, the amount it had spent for drilling and exploration of its petroleum concessions. This claim was disallowed by the Commissioner of Internal Revenue (CIR) on the ground that the expenses should be capitalized and might be written off as a loss only when a "dry hole" should result. Esso then filed an amended return where it asked for the refund of P323,279.00 by reason of its abandonment as dry holes of several of its oil wells. Also claimed as ordinary and necessary expenses in the same return was the amount of P340,822.04, representing margin fees it had paid to the Central Bank on its profit remittances to its New York head office. 

On August 5, 1964, the CIR granted a tax credit of P221,033.00 only, disallowing the claimed deduction for the margin fees paid on the ground that the margin fees paid to the Central Bank could not be considered taxes or allowed as deductible business expenses. 

Esso appealed to the Court of Tax Appeals (CTA) for the refund of the margin fees it had earlier paid contending that the margin fees were deductible from gross income either as a tax or as an ordinary and necessary business expense. However, Esso’s appeal was denied. 

Issues: (1) Whether or not the margin fees are taxes. 

(2) Whether or not the margin fees are necessary and ordinary business expenses. 

Held: (1) No. A tax is levied to provide revenue for government operations, while the proceeds of the margin fee are applied to strengthen our country's international reserves. The margin fee was imposed by the State in the exercise of its police power and not the power of taxation. 

(2) No. Ordinarily, an expense will be considered 'necessary' where the expenditure is appropriate and helpful in the development of the taxpayer's business. It is 'ordinary' when it connotes a payment which is normal in relation to the business of the taxpayer and the surrounding circumstances. Since the margin fees in question were incurred for the remittance of funds to Esso's Head Office in New York, which is a separate and distinct income taxpayer from the branch in the Philippines, for its disposal abroad, it can never be said therefore that the margin fees were appropriate and helpful in the development of Esso's business in the Philippines exclusively or were incurred for purposes proper to the conduct of the affairs of Esso's branch in the Philippines exclusively or for the purpose of realizing a profit or of minimizing a loss in the Philippines exclusively. If at all, the margin fees were incurred for purposes proper to the conduct of the corporate affairs of Esso in New York, but certainly not in the Philippines. 

Zamora vs. CIRFACTS:

Mariano Zamora, owner of the Bay View Hotel and Farmacia Zamora, filed his income tax returns. The CIR found that he failed to file his return of the capital gains derived from the sale of certain real properties and claimed deductions which were not allowable. The collector required him to pay deficiency income tax. On appeal by Zamora, the CTA reduced the amount of deficiency income tax.

Zamora appealed, alleging that the CTA erred in dissallowing P10,478.50, as promotion expenses incurred by his wife for the promotion of the Bay View Hotel and Farmacia Zamora (which is ½ of P20,957.00, supposed business expenses).

Zamora alleged that the CTA erred in disallowing P10,478.50 as promotion expenses incurred by his wife for the promotion of the Bay View Hotel and Farmacia Zamora. He contends that the whole amount of P20,957.00 as promotion expenses, should be allowed and not merely one-half of it, on the ground that, while not all the itemized expenses are supported by receipts, the absence of some supporting receipts has been sufficiently and satisfactorily established.

ISSUE: w/n CTA erred in allowing only one half of the promotion expenses. NO

HELD:Section 30, of the Tax Code, provides that in computing net income, there shall be allowed as deductions all the ordinary and necessary expenses paid or incurred during the taxable year, in carrying on any trade or business. Since promotion expenses constitute one of the deductions in conducting a business, same must satisfy these requirements. Claim for the deduction of promotion expenses or entertainment expenses must also be substantiated or supported by record showing in detail the amount and nature of the expenses incurred.

Considering, as heretofore stated, that the application of Mrs. Zamora for dollar allocation shows that she went abroad on a combined medical and business trip, not all of her expenses came under the category of ordinary and necessary expenses; part thereof constituted her personal expenses. There having been no means by which to ascertain which expense was incurred by her in connection with the business of Mariano Zamora and which was incurred for her personal benefit, the Collector and the CTA in their decisions, considered 50% of the said amount of P20,957.00 as

business expenses and the other 50%, as her personal expenses. We hold that said allocation is very fair to Mariano Zamora, there having been no receipt whatsoever, submitted to explain the alleged business expenses, or proof of the connection which said expenses had to the business or the reasonableness of the said amount of P20,957.00.

In the case of Visayan Cebu Terminal Co., Inc. v. CIR., it was declared that representation expenses fall under the category of business expenses which are allowable deductions from gross income, if they meet the conditions prescribed by law, particularly section 30 (a) [1], of the Tax Code; that to be deductible, said business expenses must be ordinary and necessary expenses paid or incurred in carrying on any trade or business; that those expenses must also meet the further test of reasonableness in amount. They should also be covered by supporting papers; in the absence thereof the amount properly deductible as representation expenses should be determined from available data.

KUENZLE & STREIF, INC. v CIR

FACTS:

Petitioner is a domestic corporation engaged in the importation of textiles, hardware, sundries, chemicals, pharmaceuticals, lumbers, groceries, wines and liquor; in insurance and lumber; and in some exports. When Petitioner filed its Income Tax Return, it deducted from its gross income the following items:

1. salaries, directors' fees and bonuses of its non-resident president and vice-president;

2. bonuses of its resident officers and employees; and

3. interests on earned but unpaid salaries and bonuses of its officers and employees.

The CIR disallowed the deductions and assessed Petitioner for deficiency income taxes. Petitioner requested for re-examination of the assessment. CIR modified the same by allowing as deductible all items comprising directors' fees and salaries of the non-resident president and vice-president, but disallowing the bonuses insofar as they exceed the salaries of the recipients, as well as the interests on earned but unpaid salaries and bonuses.

The CTA modified the assessment and ruled that while the bonuses given to the non-resident officers are reasonable, bonuses given to the resident officers and employees are quite excessive.

ISSUES/RULING:

W/N the CTA erred in ruling that the measure of the reasonableness of the bonuses paid to its non-resident president and vice-president should be applied to the bonuses given to resident officers and employees in determining their deductibility? NO.

It is a general rule that "Bonuses to employees made in good faith and as additional compensation for the services actually rendered by the employees are deductible, provided such payments, when added to the stipulated salaries, do not exceed a reasonable compensation for the services rendered.” The condition precedents to the deduction of bonuses to employees are:

1. the payment of the bonuses is in fact compensation;

2. it must be for personal services actually rendered; and

3. the bonuses, when added to the salaries, are reasonable when measured by the amount and quality of the services performed with relation to the business of the particular taxpayer

There is no fixed test for determining the reasonableness of a given bonus as compensation. However, in determining whether the particular salary or compensation payment is reasonable, the situation must be considered as a whole.

Petitioner contended that it is error to apply the same measure of reasonableness to both resident and non-resident officers because the nature, extent and quality of the services performed by each with relation to the business of the corporation widely differ. Said non-resident officers had rendered the same amount of efficient personal service and contribution to deserve equal treatment in compensation and other emoluments. There is no special reason for granting greater bonuses to such lower ranking officers than those given to the non-resident president and vice president.

W/N the CTA erred in allowing the deduction of the bonuses in excess of the yearly salaries of the employees? NO.

The deductible amount of said bonuses cannot be only equal to their respective yearly salaries considering the post-war policy of the corporation in giving salaries at low levels because of the unsettled conditions resulting from war and the imposition of government controls on imports and exports and on the use of foreign exchange which resulted in the diminution of the amount of business and the consequent loss of profits on the part of the corporation. The payment of bonuses in amounts a little more than the yearly salaries received considering the prevailing circumstances is in our opinion reasonable.

W/N the CTA erred in disallowing the deduction of interests on earned but unpaid salaries and bonuses? NO.

Under the law, in order that interest may be deductible, it must be paid "on indebtedness." It is therefore imperative to show that there is an existing indebtedness which may be subjected to the payment of interest. Here the items involved are unclaimed salaries and bonus participation which cannot constitute indebtedness within the meaning of the law because while they constitute an obligation on the part of the corporation, it is not the latter's fault if they remained unclaimed. Whatever an employee may fail to collect cannot be considered an indebtedness for it is the concern of the employee to collect it in due time. The willingness of the corporation to pay interest thereon cannot be considered a justification to warrant deduction.

C.M. HOSKINS&CO, INC. v CIR

Facts:

Petitioner, a domestic corporation engaged in the real estate business as brokers, managing agents and administrators, filed its income tax return for its fiscal year ending September 30, 1957 showing a net income of P92,540.25 and a tax liability due thereon of P18,508.00, which it paid in due course. Upon verification of its return, CIR, disallowed four items of deduction in petitioner's tax returns and assessed against it an income tax deficiency in the amount of P28,054.00 plus interests. The Court of Tax Appeals upon reviewing the assessment at the taxpayer's petition, upheld respondent's disallowance of the principal item of petitioner's having paid to Mr. C. M. Hoskins, its founder and controlling stockholder the amount of P99,977.91 representing 50% of supervision fees earned by it and set aside respondent's disallowance of three other minor items.

Petitioner questions in this appeal the Tax Court's findings that the disallowed payment to Hoskins was an inordinately large one, which bore a close relationship to the recipient's dominant stockholdings and therefore amounted in law to a distribution of its earnings and profits.

Issue: Whether the 50% supervision fee paid to Hoskin may be deductible for income tax purposes.

Ruling: NO.

Ratio:

Hoskin owns 99.6% of the CM Hoskins & Co. He was also the President and Chairman of the Board. That as chairman of the Board of Directors, he received a salary of P3,750.00 a month, plus a salary bonus of about P40,000.00 a year and an amounting to an annual compensation of P45,000.00 and an annual salary bonus of P40,000.00, plus free use of the company car and receipt of other similar allowances and benefits, the Tax Court correctly ruled that the payment by petitioner to Hoskins of the additional sum of P99,977.91 as his equal or 50% share of the 8% supervision fees received by petitioner as managing agents of the real estate, subdivision projects of Paradise Farms, Inc. and Realty Investments, Inc. was inordinately large and could not be accorded the treatment of ordinary and necessary expenses allowed as deductible items within the purviewof the Tax Code.

The fact that such payment was authorized by a standing resolution of petitioner's board of directors, since "Hoskins had personally conceived and planned the project" cannot change the picture. There could be no question that as Chairman of the board and practically an absolutely controlling stockholder of petitioner, Hoskins wielded tremendous power and influence in the formulation and making of the company's policies and decisions. Even just as board chairman, going by petitioner's own enumeration of the powers of the office, Hoskins, could exercise great power and influence within the corporation, such as directing the policy of the corporation, delegating powers to the president and advising the corporation in determining executive salaries, bonus plans and pensions, dividend policies, etc.

It is a general rule that 'Bonuses to employees made in good faith and as additional compensation for the services actually rendered by the employees are deductible, provided such payments, when added to the stipulated salaries, do not exceed a reasonable compensation for the services rendered. The conditions precedent to the deduction of bonuses to employees are: (1) the payment of the bonuses is in fact compensation; (2) it must be for personal services actually rendered; and (3) the bonuses, when added to the salaries, are 'reasonable when measured by the amount and quality of the services performed with relation to the business of the particular taxpayer.

There is no fixed test for determining the reasonableness of a given bonus as compensation. This depends upon many factors, one of them being the amount and quality of the services performed with relation to the business.' Other tests suggested are: payment must be 'made in good faith'; 'the character of the taxpayer's business, the volume and amount of its net earnings, its locality, the type and extent of the services rendered, the salary policy of the corporation'; 'the size of the particular business'; 'the employees' qualifications and contributions to the business venture'; and 'general economic conditions. However, 'in determining whether the particular salary or compensation payment is reasonable, the situation must be considered as whole. Ordinarily, no single factor is decisive. . . . it is important to keep in mind that it seldom happens that the application of one test can give satisfactory answer, and that ordinarily it is the interplay of several factors, properly weighted for the particular case, which must furnish the final answer."

Petitioner's case fails to pass the test. On the right of the employer as against respondent Commissioner to fix the compensation of its officers and employees, we there held further that while the employer's right may be conceded, the question of the allowance or disallowance thereof as deductible expenses for income tax purposes is subject to determination by CIR. As far as petitioner's contention that as employer it has the right to fix the compensation of its officers and employees and that it was in the exercise of such right that it deemed proper to pay the bonuses in question, all that We need say is this: that right may be conceded, but for income tax purposes the employer cannot legally claim such bonuses as deductible expenses unless they are shown to be reasonable. To hold otherwise would open the gate of rampant tax evasion.

Lastly, We must not lose sight of the fact that the question of allowing or disallowing as deductible expenses the amounts paid to corporate officers by way of bonus is determined by respondent exclusively for income tax purposes. Concededly, he has no authority to fix the amounts to be paid to corporate officers by way of basic salary, bonus or additional remuneration — a matter that lies more or less exclusively within the sound discretion of the corporation itself. But this right of the corporation is, of course, not absolute. It cannot exercise it for the purpose of evading payment of taxes legitimately due to the State."

COMMISSIONER OF INTERNAL REVENUE, petitioner, vs. GENERAL FOODS (PHILS.), INC., respondent.

Petitioner Commissioner of Internal Revenue (Commissioner) assails the resolution[1] of the Court of Appeals reversing the decision[2] of the Court of Tax Appeals which in turn denied the protest filed by respondent General Foods (Phils.), Inc., regarding the assessment made against the latter for deficiency taxes.

The records reveal that, on June 14, 1985, respondent corporation, which is engaged in the manufacture of beverages such as “Tang,” “Calumet” and “Kool-Aid,” filed its income tax return for the fiscal year ending February 28, 1985.  In said tax return, respondent corporation claimed as deduction, among other business expenses, the amount of P9,461,246 for media advertising for “Tang.”

On May 31, 1988, the Commissioner disallowed 50% or P4,730,623 of the deduction claimed by respondent corporation. Consequently, respondent corporation was assessed deficiency income taxes in the amount of P2,635, 141.42.  The latter filed a motion for reconsideration but the same was denied.

On September 29, 1989, respondent corporation  appealed to the Court of Tax Appeals but the appeal was dismissed:

With such a gargantuan expense for the advertisement of a singular product, which even excludes “other advertising and promotions” expenses, we are not prepared to accept that such amount is reasonable “to stimulate the current sale of merchandise” regardless of Petitioner’s explanation that such expense “does not connote unreasonableness considering the grave economic situation taking place after the Aquino assassination characterized by capital fight, strong deterioration of the purchasing power of the Philippine peso and the slacking demand for consumer products”   (Petitioner’s Memorandum, CTA Records, p. 273).  We are not convinced with such an explanation.  The staggering expense led us to believe that such expenditure was incurred “to create or maintain some form of good will for the taxpayer’s trade or business or for the industry or profession of which the taxpayer is a member.”  The term “good will” can hardly be said to have any precise signification;  it is generally used to denote the benefit arising from connection and reputation  (Words and Phrases, Vol. 18, p. 556 citing Douhart vs. Loagan, 86 III. App. 294).   As held in the case of Welch vs. Helvering, efforts to establish reputation are akin to acquisition of capital assets and, therefore, expenses related thereto are not business expenses but capital expenditures.  (Atlas Mining and Development Corp. vs. Commissioner of Internal Revenue, supra).  For sure such expenditure was meant not only to generate present sales but more for future and prospective benefits.  Hence, “abnormally large expenditures for advertising are usually to be spread over the period of years during which the benefits of the expenditures are received”  (Mertens, supra, citing Colonial Ice Cream Co., 7 BTA 154).

WHEREFORE, in all the foregoing, and finding no error in the case appealed from, we hereby RESOLVE to DISMISS the instant petition for lack of merit and ORDER the Petitioner to pay the respondent Commissioner the assessed amount of P2,635,141.42 representing its deficiency income tax liability for the fiscal year ended February 28, 1985.”[3]

Aggrieved, respondent corporation filed a petition for review at the Court of Appeals which rendered a decision reversing and setting aside the decision of the Court of Tax Appeals:

Since it has not been sufficiently established that the item it claimed as a deduction is excessive, the same should be allowed.

WHEREFORE, the petition of petitioner General Foods (Philippines), Inc. is hereby GRANTED.  Accordingly, the Decision, dated 8 February 1994 of respondent Court of Tax Appeals is REVERSED and SET ASIDE and the letter, dated 31 May 1988 of respondent Commissioner of Internal Revenue is CANCELLED.

SO ORDERED.[4]

Thus, the instant petition, wherein the Commissioner presents for the Court’s consideration a lone issue: whether or not the subject media advertising expense for “Tang” incurred by respondent corporation was an ordinary and necessary expense fully deductible under the National Internal Revenue Code (NIRC).

 It is a governing principle in taxation that tax exemptions must be construed in strictissimi juris against the taxpayer and liberally in favor of the taxing authority;[5] and he who claims an exemption must be able to justify his claim by the clearest grant of organic or statute law. An exemption from the common burden cannot be permitted to exist upon vague implications.[6]

Deductions for income tax purposes partake of the nature of tax exemptions; hence, if tax exemptions are strictly construed, then deductions must also be strictly construed.

We then proceed to resolve the singular issue in the case at bar.  Was the media advertising expense for “Tang” paid or incurred by respondent corporation for the fiscal year ending February 28, 1985 “necessary and ordinary,” hence, fully deductible under the NIRC? Or was it a capital expenditure, paid in order to create “goodwill and reputation” for respondent corporation and/or its products, which should have been amortized over a reasonable period?

Section 34 (A) (1), formerly Section 29 (a) (1) (A), of the NIRC provides:

(A) Expenses.-

(1)     Ordinary and necessary trade, business or professional expenses.-

(a)          In general.-  There shall be allowed as deduction from gross income all ordinary and necessary expenses paid or incurred during the taxable year in carrying on, or which are directly attributable to, the development, management, operation and/or conduct of the trade, business or exercise of a profession.

Simply put, to be deductible from gross income, the subject advertising expense must comply with the following requisites: (a) the expense must be ordinary and necessary; (b) it must have been paid or incurred during the taxable year; (c) it must have been paid or incurred in carrying on the trade or business of the taxpayer; and (d) it must be supported by receipts, records or other pertinent papers.[7]

The parties are in agreement that the subject advertising expense was paid or incurred within the corresponding taxable year and was incurred in carrying on a trade or business. Hence, it was necessary. However, their views conflict as to whether or not it was ordinary.  To be deductible, an advertising expense should not only be necessary but also ordinary.  These two requirements must be met.

The Commissioner maintains that the subject advertising expense was not ordinary on the ground that it failed the two conditions set by U.S. jurisprudence: first, “reasonableness” of the amount incurred and second, the amount incurred must not be a capital outlay to create “goodwill” for the product and/or private respondent’s business.   Otherwise, the expense must be considered a capital expenditure to be spread out over a reasonable time.

We agree.

There is yet to be a clear-cut criteria or fixed test for determining the reasonableness of an advertising expense. There being no hard and fast rule on the matter, the right to a deduction depends on a number of factors such as but not limited to: the type and size of business in which the taxpayer is engaged; the volume and amount of its net

earnings; the nature of the expenditure itself; the intention of the taxpayer and the general economic conditions. It is the interplay of these, among other factors and properly weighed, that will yield a proper evaluation.

In the case at bar, the P9,461,246 claimed as media advertising expense for “Tang” alone was almost one-half of its total claim for “marketing expenses.” Aside from that, respondent-corporation also claimed P2,678,328 as “other advertising and promotions expense” and another P1,548,614, for consumer  promotion.

Furthermore, the subject P9,461,246 media  advertising expense for “Tang” was almost double the amount of respondent corporation’s P4,640,636 general and administrative expenses.

We find the subject expense for the advertisement of a single product to be inordinately large. Therefore, even if it is necessary,  it cannot be considered an ordinary expense deductible under then Section 29 (a) (1) (A) of the NIRC.

Advertising is generally of two kinds: (1) advertising to stimulate the current sale of merchandise or use of services and (2) advertising designed to stimulate the future sale of merchandise or use of services. The second type involves expenditures incurred, in whole or in part, to create or maintain some form of goodwill for the taxpayer’s trade or business or for the industry or profession of which the taxpayer is a member.  If the expenditures are for the advertising of the first kind, then, except as to the question of the reasonableness of amount, there is no doubt such expenditures are deductible as business expenses.  If, however, the expenditures are for advertising of the second kind, then normally they should be spread out over a reasonable period of time.

We agree with the Court of Tax Appeals that the subject advertising expense was of the second kind.   Not only was the amount staggering; the respondent corporation itself also admitted, in its letter protest[8] to the Commissioner of Internal Revenue’s assessment, that the subject media expense was incurred in order to protect respondent corporation’s brand franchise, a critical point during the period under review.

The protection of brand franchise is analogous to the maintenance of goodwill or title to one’s property.   This is a capital expenditure which should be spread out over a reasonable period of time.[9]

Respondent corporation’s venture to protect its brand franchise was tantamount to efforts to establish a reputation. This was akin to the acquisition of capital assets and therefore expenses related thereto were not to be considered as business expenses but as capital expenditures.[10]

True, it is the taxpayer’s prerogative to determine the amount of advertising expenses it will incur and where to apply them.[11] Said prerogative, however, is subject to certain considerations.  The first relates to the extent to which the expenditures are actually capital outlays; this necessitates an inquiry into the nature or purpose of such expenditures.[12] The second, which must be applied in harmony with the first, relates to whether the expenditures are ordinary and necessary. Concomitantly, for an expense to be considered ordinary, it must be reasonable in amount.  The Court of Tax Appeals ruled that respondent corporation failed to meet the two foregoing limitations.

We find said ruling to be well founded. Respondent corporation incurred the subject advertising expense in order to protect its brand franchise.  We consider this as a capital outlay since it created goodwill for its business and/or product.  The P9,461,246 media advertising expense for the promotion of a single product, almost one-half of petitioner corporation’s entire claim for marketing expenses for that year under review, inclusive of other advertising and promotion expenses of P2,678,328 and P1,548,614 for consumer  promotion,  is doubtlessly unreasonable.

It has been a long standing policy and practice of the Court to respect the conclusions of quasi-judicial agencies such as the Court of Tax Appeals, a highly specialized body specifically created for the purpose of reviewing tax cases. The CTA, by the nature of its functions, is dedicated exclusively to the study and consideration of tax problems.   It has necessarily developed an expertise on the subject.  We extend due consideration to its opinion unless there is an abuse or improvident exercise of authority.[13] Since there is none in the case at bar, the Court adheres to the findings of the CTA.

Accordingly, we find that the Court of Appeals committed reversible error when it declared the subject media advertising expense to be deductible as an ordinary and necessary expense on the ground that “it has not been established that the item being claimed as deduction is excessive.” It is not incumbent upon the taxing authority to prove that the amount of items being claimed is unreasonable. The burden of proof to establish the validity of claimed deductions is on the taxpayer.[14] In the present case, that burden was not discharged satisfactorily.

WHEREFORE, premises considered, the instant petition is GRANTED. The assailed decision of the Court of Appeals is hereby REVERSED and SET ASIDE.  Pursuant to Sections 248 and 249 of the Tax Code, respondent General Foods (Phils.), Inc. is hereby ordered to pay its deficiency income tax in the amount of P2,635,141.42, plus 25% surcharge for late payment and 20% annual interest computed from August 25, 1989, the date of the denial of its protest, until the same is fully paid. 

SO ORDERED.

CIR v ISABELA CULTURAL CORPORATION

FACTS:ICC was assessed for deficiency income tax [ BIR disallowed expense deductions for professional and security services by 1) auditing services by SGV & Co. 2) legal services Bengzon law office 3) El Tigre Security services] and deficiency expanded withholding tax, when it failed to withhold 1% expanded withholding tax. The CTA cancelled and set aside the assessment notices holding that the claimed deductions for professional and security services were properly claimed in 1986 since it was only in that year when the bills demanding payment were sent to ICC. It also found that the ICC withheld 1% expanded withholding tax for security services. The CA affirmed hence the case at bar.

ISSUE: W/N the aforementioned may be deducted

HELD: for the auditing and legal services NO but for the security services YESThe requisites for deductibility of ordinary and necessary trade, business or professional expenses, like expenses paid for legal and auditing services are: a) the expense must be ordinary and necessary; b) it must have been paid or incurred during the taxable year; c) it must have been paid or incurred in carrying on the trade or business of the taxpayer and d) it must be supported by receipts, records and other pertinent papers. The requisite that it must have been paid or incurred during the taxable year is qualified by Sec. 45 of NIRC which states that “the deduction provide for in this title shall be taken for the taxable year in which ‘paid or incurred’ dependent upon the method of accounting upon the basis of which the net income is computed x x x”.

ICC uses the accrual method. RAM No. 1-2000 provides that under the accrual method, expenses not claimed as deductions in the current year when they are incurred CANNOT be claimed as deduction from income for the succeeding year. The accrual method relies upon the taxpayer’s right to receive amount or its obligation to pay them NOT the actual receipt or payment. Amounts of income accrue where the right to receive them become fixed, where there is created an enforceable liability. Liabilities are accrued when fixed and determinable in amount. The accrual of income and expense is permitted when the ALL-EVENTS TEST has been met. The test requires that: 1) fixing of a right to income or liability to pay and 2) the availability of the reasonable accurate determination of such income or liability. It does not require that the amount be absolutely known only that the taxpayer has information necessary to compute the amount with reasonable accuracy. The test is satisfied where computation remains uncertain if its basis is unchangeable. The amount of liability does not have to be determined exactly, it must be determined with reasonable accuracy. In the case at bar, the expenses for legal services pertain to the years 1984 and 1985. The firm has been retained since 1960. From the nature of the claimed deduction and the span of time during which the firm was retained, ICC can be expected to have reasonably known the retainer fees charged by the firm as well as compensation for its services. Exercising due diligence, they could have inquired into the amount of their obligation. It could have reasonably determined the amount of legal and retainer fees owing to their familiarity with the rates charged. The professional fees of SGV cannot be validly claimed as deductions in 1986. ICC failed to present evidence showing that even with only reasonable accuracy, it cannot determine the professional fees which the company would charge.

CIR v CTA AND SMITH&FRENCH OVERSEAS

Facts:Smith Kline & French Overseas Company is a multinational firm domiciled in Philadelphia, licensed to do business in the Philippines. It is engaged in the importation, manufacture, and sale of pharmaceutical drugs and chemicals.In 1971, it declared a net taxable income of P1.4 M and paid P511k as tax due. It claimed its share of the head office overhead expenses (P501k) as deduction from gross income. In its amended return, it claimed that there was an overpayment of tax (P324k) arising from under-deduction of the overhead expense. This was certified by international independent auditors, the allocation of the overhead expense made on the basis of the percentage of gross income in the Philippines to gross income of the corporation as a whole.In 1974, without waiting for the action of the CIR, Smith filed a petition for review with the CTA. CTA ordered CIR to refund the overpayment or grant Smith a tax credit. CIR appealed to the SC.

Issue: Whether Smith is entitled to a refund – YES

Ratio:The governing law is found in Sec. 37 (b).1 Revenue Regulation No. 2 of the DOF contains a similar provision, with the additional line that “the ratable part is based upon the ratio of gross income from sources within the Philippines to the total gross income” (Sec. 160). Hence, where an expense is clearly related to the production of Philippine-derived income or to Philippine operations, that expense can be deducted from the gross income acquired in the Philippines without resorting to apportionment.However, the overhead expenses incurred by the parent company in connection with finance, administration, and research & development, all of which directly benefit its branches all over the world, fall under a different category. These are items which cannot be definitely allocated or identified with the operations of the Philippine branch. Smith

1Net income from sources in the Philippines. – From the items of gross income specified in subsection (a) of this section there shall be deducted expenses, losses, and other deductions properly apportioned or allocated thereto and a ratable part of any expenses, losses, or other deductions which cannot definitely be allocated to some item or class of gross income. The remainder, if any, shall be included in full as net income from sources within the Philippines.

can claim as its deductible share a ratable part of such expenses based upon the ration of the local branch’s gross income to the total gross income of the corporation worldwide.

CIR’s ContentionThe CIR does not dispute the right of Smith to avail of Sec. 37 (b) of the Tax Code and Sec. 160 of the RR. But he maintains that such right is not absolute and that there exists a contract (service agreement) which Smith has entered into with its home office, prescribing the amount that a branch can deduct as its share of the main office’s overhead expenses. Since the share of the Philippine branch has been fixed, Smith cannot claim more than the said amount.

Smith’s ContentionSmith, on the other hand, submits that the contract between itself and its home office cannot amend tax laws and regulations. The matter of allocated expenses deductible under the law cannot be the subject of an agreement between private parties nor can the CIR acquiesce in such an agreement.SC ruled for Smith Kline and said that its amended return conforms with the law and regulations.

Gutierrez vs. CIRFacts:Lino Gutierrez was primarily engaged in the business of leasing real property for which he paid real estate broker’s privilege tax. The Collector assessed against Gutierrez deficiency income tax amounting to P11,841.

The deficiency tax came about by the disallowance of deductions from gross income representing depreciation expenses Gutierrez allegedly incurred in carrying on his business. The expenses consisted of:

1.       Transportation expenses incurred to attend the funeral of his friends,2.       Procurement and installation of an iron door,3.       Cost of furniture given by the taxpayer in furtherance of a business transaction,4.       Membership fees in organizations established by those engaged in the real estate trade,5.       Car expenses, salary of his driver and car depreciation,6.       Repairing taxpayer’s rental apartments,7.       Litigation expenses,8.       Depreciation of Gutierrez’ residence,9.       Fines and penalties for late payment of taxes,10.   Alms given to in indigent family and a donation consisting of officer’s jewels and aprons to Biak-na-Bato Lodge No. 7.

Issue:Whether or not claims for deduction are proper and allowable.

Held:To be deductible, an expense must be:·         Ordinary and necessary·         Paid or incurred within the taxable year·         Paid or incurred in carrying on a trade or business.

1. Transportation expenses which petitioner incurred to attend the funeral of his friends and the cost of admission tickets to operas - expenses relative to his personal and social activities rather than to his business of leasing real estate.

2. Procurement and installation of an iron door to - purely a personal expense. Personal, living, or family expenses are not deductible.

3. Cost of furniture given by the taxpayer as commission in furtherance of a business transaction - the expenses incurred in attending the National Convention of Filipino Businessmen, luncheon meeting and cruise to Corregidor of the Homeowners' Association were shown to have been made in the pursuit of his business. Commissions given in consideration for bringing about a profitable transaction are part of the cost of the business transaction and are deductible.

4. Membership and activities in connection therewith were solely to enhance his business -Gutierrez was an officer of the Junior Chamber of Commerce which sponsored the National Convention of Filipino Businessmen. He was also the president of the Homeowners' Association, an organization established by those engaged in the real estate trade. Having proved that his, the expenses incurred are deductible as ordinary and necessary business expenses.

5. Car expenses, salary of his driver and car depreciation – 1/3 of the same was disallowed by the Commissioner on the ground that the taxpayer used his car and driver both for personal and business purposes. There is no clear showing, however, that the car was devoted more for the taxpayer's business than for his personal and business needs. According to the evidence, the taxpayer's car was utilized both for personal and business needs. It is reasonable to allow as deduction 1/2 of the driver's salary, car expenses and depreciation.

6. Those used to repair the taxpayer's rental apartments - did not increase the value of such apartments, or prolong their life. They merely kept the apartments in an ordinary operating condition. Hence, the expenses incurred are deductible as necessary expenditures for the maintenance of the taxpayer's business.7. Litigation expenses - defrayed by Gutierrez to collect apartment rentals and to eject delinquent tenants are ordinary and necessary expenses in pursuing his business. It is routinary and necessary for one in the leasing business to collect rentals and to eject tenants who refuse to pay their accounts.

8. Depreciation of Gutierrez' residence - not deductible. A taxpayer may deduct from gross income a reasonable allowance for deterioration of property arising out of its use or employment in business or trade. Gutierrez' residence was not used in his trade or business.

9. Deduction the fines and penalties which he paid for late payment of taxes - while Section 30 allows taxes to be deducted from gross income, it does not specifically allow fines and penalties to be so deducted.

Deductions from gross income are matters of legislative grace; what is not expressly granted by Congress is withheld. Moreover, when acts are condemned, by law and their commission is made punishable by fines or forfeitures, to allow them to be deducted from the wrongdoer's gross income, reduces, and so in part defeats, the prescribed punishment.

10. Alms to an indigent family and various individuals, contributions to Lydia Yamson and G. Trinidad and a donation consisting of officers' jewels and aprons to Biak-na-Bato Lodge No. 7 - not deductible from gross income inasmuch as their recipients have not been shown to be among those specified by law. Contributions are deductible when given to the Government of the Philippines, or any of its political subdivisions for exclusively public purposes, to domestic corporations or associations organized and operated exclusively for religious, charitable, scientific, athletic, cultural or educational purposes, or for the rehabilitation of veterans, or to societies for the prevention of cruelty to children or animals, no part of the net income of which inures to the benefit of any private stockholder or individual.

Gancayco vs. CIR

Petitioner Santiago Gancayco seeks the review of a decision of the Court of Tax Appeals, requiring him to pay P16,860.31, plus surcharge and interest, by way of deficiency income tax for the year 1949.

On May 10, 1950, Gancayco filed his income tax return for the year 1949. Two (2) days later, respondent Collector of Internal Revenue issued the corresponding notice advising him that his income tax liability for that year amounted P9,793.62, which he paid on May 15, 1950. A year later, on May 14, 1951, respondent wrote the communication Exhibit C, notifying Gancayco, inter alia, that, upon investigation, there was still due from him, a efficiency income tax for the year 1949, the sum of P29,554.05. Gancayco sought a reconsideration, which was part granted by respondent, who in a letter dated April 8, 1953 (Exhibit D), informed petitioner that his income tax defendant efficiency for 1949 amounted to P16,860.31. Gancayco urged another reconsideration (Exhibit O), but no action taken on this request, although he had sent several communications calling respondent's attention thereto.

On April 15, 1956, respondent issued a warrant of distraint and levy against the properties of Gancayco for the satisfaction of his deficiency income tax liability, and accordingly, the municipal treasurer of Catanauan, Quezon issued on May 29, 1956, a notice of sale of said property at public auction on June 19, 1956. Upon petition of Gancayco filed on June 16, 1956, the Court of Tax Appeal issued a resolution ordering the cancellation of the sale and directing that the same be readvertised at a future date, in accordance with the procedure established by the National Internal Revenue Code. Subsequently, or on June 22, 1956, Gancayco filed an amended petition praying that said Court:

(a) Issue a writ of preliminary injunction, enjoining the respondents from enforcing the collection of the alleged tax liability due from the petitioner through summary proceeding pending determination of the present case;

(b) After a review of the present case adjudge that the right of the government to enforce collection of any liability due on this account had already prescribed;

(c) That even assuming that prescription had not set in the objections of petitioner to the disallowance of the entertainment, representation and farming expenses be allowed;

In his answer respondent admitted some allegations the amended petition, denied other allegations thereof an set up some special defenses. Thereafter Gancayco received from the municipal treasurer of Catanauan, Quezon, another notice of auction sale of his properties, to take place on August 29, 1956. On motion of Gancayco, the Court of Tax Appeals, by resolution dated August 27, 1956, "cancelled" the aforementioned sale and enjoined respondent and the municipal treasurer of Catanauan, Quezon, from proceeding with the same. After appropriate proceedings, the Court of Tax Appeals rendered, on November 14, 1957, the decision adverted to above.

Gancayco maintains that the right to collect the deficiency income tax in question is barred by the statute of limitations. In this connection, it should be noted, however, that there are two (2) civil remedies for the collection of internal revenue taxes, namely: (a) by distraint of personal property and levy upon real property; and (b) by "judicial

action" (Commonwealth Act 456, section 316). The first may not be availed of except within three (3) years after the "return is due or has been made ..." (Tax Code, section 51 [d] ). After the expiration of said Period, income taxes may not be legally and validly collected by distraint and/or levy (Collector of Internal Revenue v. Avelino, L-9202, November 19, 1956; Collector of Internal Revenue v. Reyes, L-8685, January 31, 1957; Collector of Internal Revenue v. Zulueta, L-8840, February 8, 1957; Sambrano v. Court of Tax Appeals, L-8652, March 30, 1957). Gancayco's income tax return for 1949 was filed on May 10, 1950; so that the warrant of distraint and levy issued on May 15, 1956, long after the expiration of said three-year period, was illegal and void, and so was the attempt to sell his properties in pursuance of said warrant.

The "judicial action" mentioned in the Tax Code may be resorted to within five (5) years from the date the return has been filed, if there has been no assessment, or within five (5) years from the date of the assessment made within the statutory period, or within the period agreed upon, in writing, by the Collector of Internal Revenue and the taxpayer. before the expiration of said five-year period, or within such extension of said stipulated period as may have been agreed upon, in writing, made before the expiration of the period previously situated, except that in the case of a false or fraudulent return with intent to evade tax or of a failure to file a return, the judicial action may be begun at any time within ten (10) years after the discovery of the falsity, fraud or omission (Sections 331 and 332 of the Tax Code). In the case at bar, respondent made three (3) assessments: (a) the original assessment of P9,793.62, made on May 12, 1950; (b) the first deficiency income tax assessment of May 14, 1951, for P29,554.05; and (c) the amended deficiency income tax assessment of April 8, 1953, for P16,860.31.

Gancayco argues that the five-year period for the judicial action should be counted from May 12, 1950, the date of the original assessment, because the income tax for 1949, he says, could have been collected from him since then. Said assessment was, however, not for the deficiency income tax involved in this proceedings, but for P9,793.62, which he paid forthwith. Hence, there never had been any cause for a judicial action against him, and, per force, no statute of limitations to speak of, in connection with said sum of P9,793.62.

Neither could said statute have begun to run from May 14, 1951, the date of the first deficiency income tax assessment or P29,554.05, because the same was, upon Gancayco's request, reconsidered or modified by the assessment made on April 8, 1953, for P16,860.31. Indeed, this last assessment is what Gancayco contested in the amended petition filed by him with the Court of Tax Appeals. The amount involved in such assessment which Gancayco refused to pay and respondent tried to collect by warrant of distraint and/or levy, is the one in issue between the parties. Hence, the five-year period aforementioned should be counted from April 8, 1953, so that the statute of limitations does not bar the present proceedings, instituted on April 12, 1956, if the same is a judicial action, as contemplated in section 316 of the Tax Code, which petitioner denies, upon the ground that

a. "The Court of Tax Appeals does not have original jurisdiction to entertain an action for the collection of the tax due;

b. "The proper party to commence the judicial action to collect the tax due is the government, and

c. "The remedies provided by law for the collection of the tax are exclusive."

Said Section 316 provides:

The civil remedies for the collection of internal revenue taxes, fees, or charges, and any increment thereto resulting from delinquency shall be (a) by distraint of goods, chattels, or effects, and other personal property of whatever character, including stocks and other securities, debts, credits, bank accounts, and interest in and rights to personal property, and by levy upon real property; and (b) by judicial action. Either of these remedies or both simultaneously may be pursued in the discretion of the authorities charged with the collection of such taxes.

No exemption shall be allowed against the internal revenue taxes in any case.

Petitioner contends that the judicial action referred to in this provision is commenced by filing, with a court of first instance, of a complaint for the collection of taxes. This was true at the time of the approval of Commonwealth Act No. 456, on June 15, 1939. However, Republic Act No. 1125 has vested the Court of Tax Appeals, not only with exclusive appellate jurisdiction to review decisions of the Collector (now Commissioner) of Internal Revenue in cases involving disputed assessments, like the one at bar, but, also, with authority to decide "all cases involving disputed assessments of Internal Revenue taxes or customs duties pending determination before the court of first instance" at the time of the approval of said Act, on June 16, 1954 (Section 22, Republic Act No. 1125). Moreover, this jurisdiction to decide all cases involving disputed assessments of internal revenue taxes and customs duties necessarily implies the power to authorize and sanction the collection of the taxes and duties involved in such assessments as may be upheld by the Court of Tax Appeals. At any rate, the same now has the authority formerly vested in courts of first instance to hear and decide cases involving disputed assessments of internal revenue taxes and customs duties. Inasmuch as those cases filed with courts of first instance constituted judicial actions, such is, likewise, the nature of the proceedings before the Court of Tax Appeals, insofar as sections 316 and 332 of the Tax Code are concerned.

The question whether the sum of P16,860.31 is due from Gancayco as deficiency income tax for 1949 hinges on the validity of his claim for deduction of two (2) items, namely: (a) for farming expenses, P27,459.00; and (b) for representation expenses, P8,933.45.

Section 30 of the Tax Code partly reads:

(a) Expenses:

(1) In General — All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; traveling expenses while away from home in the pursuit of a trade or business; and rentals or other payments required to be made as a condition to the continued use or possession, for the purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity. (Emphasis supplied.)

Referring to the item of P27,459, for farming expenses allegedly incurred by Gancayco, the decision appealed from has the following to say:

No evidence has been presented as to the nature of the said "farming expenses" other than the bare statement of petitioner that they were spent for the "development and cultivation of (his) property". No specification has been made as to the actual amount spent for purchase of tools, equipment or materials, or the amount spent for improvement. Respondent claims that the entire amount was spent exclusively for clearing and developing the farm which were necessary to place it in a productive state. It is not, therefore, an ordinary expense but a capitol expenditure. Accordingly, it is not deductible but it may be amortized, in accordance with section 75 of Revenue Regulations No. 2, cited above. See also, section 31 of the Revenue Code which provides that in computing net income, no deduction shall in any case be allowed in respect of any amount paid out for new buildings or for permanent improvements, or betterments made to increase the value of any property or estate. (Emphasis supplied.)

We concur in this view, which is a necessary consequence of section 31 of the Tax Code, pursuant to which:

(a) General Rule — In computing net income no deduction shall in any case be allowed in respect of —

(1) Personal, living, or family expenses;

(2) Any amount paid out for new buildings or for permanent improvements, or betterments made to increase the value of any property or estate;

(3) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made; or

(4) Premiums paid on any life insurance policy covering the life of any officer or employee, or any person financially interested in any trade or business carried on by the taxpayer, individual or corporate, when the taxpayer is directly or indirectly a beneficiary under such policy. (Emphasis supplied.)

Said view is, likewise, in accord with the consensus of the authorities on the subject.

Expenses incident to the acquisition of property follow the same rule as applied to payments made as direct consideration for the property. For example, commission paid in acquiring property are considered as representing part of the cost of the property acquired. The same treatment is to be accorded to amounts expended for maps, abstracts, legal opinions on titles, recording fees and surveys. Other non-deductible expenses include amounts paid in connection with geological explorations, development and subdividing of real estate; clearing and grading; restoration of soil, drilling wells, architects's fees and similar types of expenditures. (4 Merten's Law of Federal Income Taxation, Sec. 25.20, pp. 348-349; see also sec. 75 of the income Regulation of the B.I.R.; Emphasis supplied.)

The cost of farm machinery, equipment and farm building represents a capital investment and is not an allowable deduction as an item of expense. Amounts expended in the development of farms, orchards, and ranches prior to the time when the productive state is reached may be regarded as investments of capital. (Merten's Law of Federal Income Taxation, supra, sec. 25.108, p. 525.)

Expenses for clearing off and grading lots acquired is a capital expenditure, representing part of the cost of the land and was not deductible as an expense. (Liberty Banking Co. v. Heiner 37 F [2d] 703 [8AFTR 100111] [CCA 3rd]; The B.L. Marble Chair Company v. U.S., 15 AFTR 746).

An item of expenditure, in order to be deductible under this section of the statute providing for the deduction of ordinary and necessary business expenses, must fall squarely within the language of the statutory provision. This section is intended primarily, although not always necessarily, to cover expenditures of a recurring nature where the benefit derived from the payment is realized and exhausted within the taxable year. Accordingly, if the result of the expenditure is the acquisition of an asset which has an economically useful life beyond the taxable year, no deduction of such payment may be obtained under the provisions of the statute. In such cases, to the extent that a deduction is allowable, it must be obtained under the provisions of the statute which permit deductions for amortization, depreciation, depletion or loss. (W.B. Harbeson Co. 24 BTA, 542; Clark Thread Co., 28 BTA 1128 aff'd 100 F [2d] 257 [CCA 3rd, 1938]; 4 Merten's Law of Federal Income Taxation, Sec. 25.17, pp. 337-338.)

Gancayco's claim for representation expenses aggregated P31,753.97, of which P22,820.52 was allowed, and P8,933.45 disallowed. Such disallowance is justified by the record, for, apart from the absence of receipts, invoices or vouchers of the expenditures in question, petitioner could not specify the items constituting the same, or when or on whom or on what they were incurred. The case of Cohan v. Commissioner, 39 F (2d) 540, cited by petitioner is not in point, because in that case there was evidence on the amounts spent and the persons entertained and the necessity of entertaining them, although there were no receipts an vouchers of the expenditures involved therein. Such is not the case of petitioner herein.

Being in accordance with the facts and law, the decision of the Court of Tax Appeals is hereby affirmed therefore, with costs against petitioner Santiago Cancayco. It is so ordered.

Padilla, Bautista Angelo, Labrador, Reyes, J.B.L., Barrera and Dizon, JJ., concur.

3M PHILIPPINES v CIR

Facts:3M Philippines, Inc. is a subsidiary of the Minnesota Mining and Manufacturing Company (or "3M-St. Paul") a non-resident foreign corporation with principal office in St. Paul, Minnesota, U.S.A. It is the exclusive importer, manufacturer, wholesaler, and distributor in the Philippines of all products of 3M-St. Paul. To enable it to manufacture, package, promote, market, sell and install the highly specialized products of its parent company, and render the necessary post-sales service and maintenance to its customers, 3M Phils. entered into a "Service Information and Technical Assistance Agreement" and a "Patent and Trademark License Agreement" with the latter under which the 3m Phils. agreed to pay to 3M-St. Paul a technical service fee of 3% and a royalty of 2% of its net sales. Both agreements were submitted to, and approved by, the Central Bank of the Philippines. the petitioner claimed the following deductions as business expenses:(a) royalties and technical service fees of P 3,050,646.00; and(b) pre-operational cost of tape coater of P97,485.08.As to (a), the Commissioner of Internal Revenue allowed a deduction of P797,046.09 only as technical service fee and royalty for locally manufactured products, but disallowed the sum of P2,323,599.02 alleged to have been paid by the petitioner to 3M-St. Paul as technical service fee and royalty on P46,471,998.00 worth of finished products imported by the petitioner from the parent company, on the ground that the fee and royalty should be based only on locally manufactured goods. While as to (b), the CIR only allowed P19,544.77 or one-fifth (1/5) of 3M Phils.capital expenditure of P97,046.09 for its tape coater which was installed in 1973 because such expenditure should be amortized for a period of five (5) years, hence, payment of the disallowed balance of P77,740.38 should be spread over the next four (4) years. The CIR ordered 3M Phil. to pay P840,540 as deficiency income tax on its 1974 return, plus P353,026.80 as 14% interest per annum from February 15, 1975 to February 15, 1976, or a total of P1,193,566.80.3M Phils. protested the CIR’s assessment but it did not answer the protest, instead issuing a warrant of levy. The CTA affirmed the assessment on appeal. Issue:Whether or not 3M Phils is entitled to the deductions due to royalties?Ruling:No. CB Circular No. 393 (Regulations Governing Royalties/Rentals) dated December 7, 1973 was promulgated by the Central Bank as an exchange control regulation to conserve foreign exchange and avoid unnecessary drain on the country's international reserves (69 O.G. No. 51, pp. 11737-38). Section 3-C of the circular provides that royalties shall be paid only on commodities manufactured by the licensee under the royalty agreement:

Section 3. Requirements for Approval and Registration. — The requirements for approval and registration as provided for in Section 2 above include, but are not limited to the following:a. xxx xxx xxx

b. xxx xxx xxxc. The royalty/rental contracts involving manufacturing' royalty, e.g., actual transfers of technological services such as secret formula/processes, technical know how and the like shall not exceed five (5) per cent of the wholesale price of the commodity/ties manufactured under the royalty agreement. For contracts involving 'marketing' services such as the use of foreign brands or trade names or trademarks, the royalty/rental rate shall not exceed two (2) per cent of the wholesale price of the commodity/ties manufactured under the royalty agreement. The producer's or foreign licensor's share in the proceeds from the distribution/exhibition of the films shall not exceed sixty (60) per cent of the net

proceeds (gross proceeds less local expenses) from the exhibition/distribution of the films. ... (Emphasis supplied.) (p. 27, Rollo.)Clearly, no royalty is payable on the wholesale price of finished products imported by the licensee from the licensor. However, petitioner argues that the law applicable to its case is only Section 29(a)(1) of the Tax Code which provides:(a) Expenses. — (1) Business expenses. — (A) In general. — All ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; travelling expenses while away from home in the pursuit of a trade, profession or business, rentals or other payments required to be made as a condition to the continued use or possession, for the purpose of the trade, profession or business, for property to which the taxpayer has not taken or is not taking title or in which he has no equity.Petitioner points out that the Central bank "has no say in the assessment and collection of internal revenue taxes as such power is lodged in the Bureau of Internal Revenue," that the Tax Code "never mentions Circular 393 and there is no law or regulation governing deduction of business expenses that refers to said circular." (p. 9, Petition.)The argument is specious, for, although the Tax Code allows payments of royalty to be deducted from gross income as business expenses, it is CB Circular No. 393 that defines what royalty payments are proper. Hence, improper payments of royalty are not deductible as legitimate business expenses.

Palanca vs. CIRThis is an appeal by the Government from the decision of the Court of Tax Appeals in CTA Case No. 571 ordering the petitioner to refund to the respondent the amount of P20,624.01 representing alleged over-payment of income taxes for the calendar year 1955. The facts are:

Sometime in July, 1950, the late Don Carlos Palanca, Sr. donated in favor of his son, the petitioner, herein shares of stock in La Tondeña, Inc. amounting to 12,500 shares. For failure to file a return on the donation within the statutory period, the petitioner was assessed the sums of P97,691.23, P24,442.81 and P47,868.70 as gift tax, 25% surcharge and interest, respectively, which he paid on June 22, 1955.

On March 1, 1956, the petitioner filed with the Bureau of Internal Revenue his income tax return for the calendar year 1955, claiming, among others, a deduction for interest amounting to P9,706.45 and reporting a taxable income of P65,982.12. On the basis of this return, he was assessed the sum of P21,052.91, as income tax, which he paid, as follows:

Taxes withheld by La Tondeña Inc. from Mr. Palanca's wages P13,172.41

Payment under Income Tax Receipt No. 677395 dated May 11, 1956 3,939.80

Payment under Income Tax Receipt dated August 14, 1956 3,939.80

P21,052.01

Subsequently, on November 10, 1956, the petitioner filed an amended return for the calendar year 1955, claiming therein an additional deduction in the amount of P47,868.70 representing interest paid on the donee's gift tax, thereby reporting a taxable net income of P18,113.42 and a tax due thereon in the sum of P3,167.00. The claim for deduction was based on the provisions of Section 30(b) (1) of the Tax Code, which authorizes the deduction from gross income of interest paid within the taxable year on indebtedness. A claim for the refund of alleged overpaid income taxes for the year 1955 amounting to P17,885.01, which is the difference between the amount of P21,052.01 he paid as income taxes under his original return and of P3,167.00, was filed together with this amended return. In a communication dated June 20, 1957, the respondent (BIR) denied the claim for refund.

On August 27, 1957, the petitioner reiterated his claim for refund, and at the same time requested that the case be elevated to the Appellate Division of the Bureau of Internal Revenue for decision. The reiterated claim was denied on October 14, 1957.

On November 2, 1957, the petitioner requested that the case be referred to the Conference Staff of the Bureau of Internal Revenue for review. Later, on November 6, 1957, he requested the respondent to hold his action on the case in abeyance until after the Court of Tax Appeals renders its division on a similar case. And on November 7, 1957, the respondent denied the claim for the refund of the sum of P17,885.01.

Meanwhile, the Bureau of Internal Revenue considered the transfer of 12,500 shares of stock of La Tondeña Inc. to be

a transfer in contemplation of death pursuant to Section 88(b) of the National Internal Revenue Code. Consequently, the respondent assessed against the petitioner the sum of P191,591.62 as estate and inheritance taxes on the transfer of said 12,500 shares of stock. The amount of P17,002.74 paid on June 22, 1955 by the petitioner as gift tax, including interest and surcharge, under Official Receipt No. 2855 was applied to his estate and inheritance tax liability. On the tax liability of P191,591.62, the petitioner paid the amount of P60,581.80 as interest for delinquency as follows:

1% monthly interest on P76,724.38September 2, 1952 to February 16, 1955

P22,633.69

1% monthly interest on P71,264.77February 16, 1955 to March 31, 1955

1,068.97

1% monthly interest on P114,867.24September 2, 1952 to April 16, 1953

4,287.99

1% monthly interest on P50,832.77 March 31, 1955 to June 22, 1955

1,372.48

1% monthly interest on P119,155.23April 16, 1953 to June 22, 1955

31,218.67

T o t a l P60,581.80

On August 12, 1958, the petitioner once more filed an amended income tax return for the calendar year 1955, claiming, in addition to the interest deduction of P9,076.45 appearing in his original return, a deduction in the amount of P60,581.80, representing interest on the estate and inheritance taxes on the 12,500 shares of stock, thereby reporting a net taxable income for 1955 in the amount of P5,400.32 and an income tax due thereon in the sum of P428.00. Attached to this amended return was a letter of the petitioner, dated August 11, 1958, wherein he requested the refund of P20,624.01 which is the difference between the amounts of P21,052.01 he paid as income tax under his original return and of P428.00.

Without waiting for the respondent's decision on this claim for refund, the petitioner filed his petition for review before this Court on August 13, 1958. On July 24, 1959, the respondent denied the petitioner's request for the refund of the sum of P20,624.01.

The Commissioner of Internal Revenue now seeks the reversal of the Court of Tax Appeal's ruling on the aforementioned petition for review. Specifically, he takes issue with the said court's determination that the amount paid by respondent Palanca for interest on his delinquent estate and inheritance tax is deductible from the gross income for that year under Section 30 (b) (1) of the Revenue Code, and, that said respondent's claim for refund therefor has not prescribed.

On the first point, the Commissioner urges that a tax is not an indebtedness. Citing American cases, he argues that there is a material and fundamental distinction between a "tax" and a "debt." (Meriwether v. Garrett, 102 U.S. 427; Liberty Mutual Ins. Co. v. Johnson Shipyards Corporation, 5 AFTR pp. 5504, 5507; City of Camden v. Allen, 26 N.J. Law, p. 398). He adopts the view that "debts are due to the government in its corporate capacity, while taxes are due to the government in its sovereign capacity. A debt is a sum of money due upon contract express or implied or one which is evidenced by a judgment. Taxes are imposts levied by government for its support or some special purpose which the government has recognized." In view of the distinction, then, the Commissioner submits that the deductibility of "interest on indebtedness" from a person's income tax under Section 30(b) (1) cannot extend to "interest on taxes."

We find for the respondent. While "taxes" and "debts" are distinguishable legal concepts, in certain cases as in the suit at bar, on account of their nature, the distinction becomes inconsequential. This qualification is recognized even in the United States. Thus,

The term "debt" is properly used in a comprehensive sense as embracing not merely money due by contract, but whatever one is bound to render to another, either for contract or the requirements of the law. (Camden vs. Fink Coule

and Coke Co., 61 ALR 584).

Where statutes impose a personal liability for a tax, the tax becomes at least in a broad sense, a debt. (Idem.)

Some American authorities hold that, especially for remedial purposes, Federal taxes are debts. (Tax Commission vs. National Malleable Castings Co., 35 ALR 1448)

In our jurisdiction, the rule is settled that although taxes already due have not, strictly speaking, the same concept as debts, they are, however obligations that may be considered as such. (Sambrano vs. Court of Tax Appeals, G.R. no. L-8652, March 30, 1957). In a more recent case Commissioner of Internal Revenue vs. Prieto, G.R. No. L-13912, September 30, 1960, we explicitly announced that while the distinction between "taxes" and "debts" was recognized in this jurisdiction, the variance in their legal conception does not extend to the interests paid on them, at least insofar as Section 30 (b) (1) of the National Internal Revenue Code is concerned. Thus,

Under the law, for interest to be deductible, it must be shown that there be an indebtedness, that there should be interest upon it, and that what is claimed as an interest deduction should have been paid or accrued within the year. It is here conceded that the interest paid by respondent was in consequence of the late payment of her donor's tax, and the same was paid within the year it is sought to be deducted. The only question to be determined, as stated by the parties, is whether or not such interest was paid upon an indebtedness within the contemplation of Section 30(b) (1) of the Tax Code, the pertinent part of which reads:

Sec. 30. Deductions from gross income — In computing net income there shall be allowed as deductions —

"Interest:

(1) In general. — The amount of interest paid within the taxable year on indebtedness, except on indebtedness incurred or continued to purchase or carry obligations the interest upon which is exempt from taxation as income under this Title.

The term "indebtedness" as used in the Tax Code of the United States containing similar provisions as in the above-quoted section has been defined as the unconditional and legally enforceable obligation for the payment of money. (Federal Taxes Vol. 2, p. 13, 019, Prentice Hall, Inc.; Mertens' Law of Federal Income Taxation, Vol. 4, p. 542.) Within the meaning of that definition, it is apparent that a tax may be considered an indebtedness. . . . (Emphasis supplied)

"It follows that the interest paid by herein respondent for the late payment of her donor's tax is deductible from her gross income under section 30 (b) of the Tax Code above-quoted."

We do not see any element in this case which can justify a departure from or abandonment of the doctrine in the Prieto case above. In both this and the said case, the taxpayer sought the allowance as deductible items from the gross income of the amounts paid by them as interests on delinquent tax liabilities. Of course, what was involved in the cited case was the donor's tax while the present suit pertains to interest paid on the estate and inheritance tax. This difference, however, submits no appreciable consequence to the rationale of this Court's previous determination that interests on taxes should be considered as interests on indebtedness within the meaning of Section 30(b) (1) of the Tax Code. The interpretation we have placed upon the said section was predicated on the congressional intent, not on the nature of the tax for which the interest was paid.

On the issue of prescription: There were actually two claims for refund filed by the herein respondent, Carlos Palanca, Jr., anent the case at bar. The first one was on November 10, 1956, when he filed a claim for refund on the interest paid by him on the donee's gift tax of P17,885.10, as originally demanded by the Bureau of Internal Revenue. The second one was the one filed by him on August 12, 1958, which was a claim for refund on the interest paid by him on the estate and inheritance tax assessed by the same Bureau in the amount of P20,624.01. Actually, this second assessment by the Bureau was for the same transaction as that for which they assessed respondent Palanca the above donee's gift tax. The Bureau, however, on further consideration, decided that the donation of the stocks in question was made in contemplation of death, and hence, should be assessed as an inheritance. Thus the second assessment. The first claim was denied by the petitioner for the first time on June 20, 1957. Thereafter, the said denial was twice reiterated, on October 14, 1957 and November 7, 1957, upon respondent Palanca's plea for the reconsideration of the ruling of June 20, 1957. The second claim was filed with the Court of Tax Appeals on August 13, 1958, or even before the same had been denied by the petitioner. Respondent Palanca's second claim was denied by the latter on July 24, 1959.

The petitioner contends that under Section 11 of Republic Act 1124,1 the herein claimant's claim for refund has prescribed since the same was filed outside the thirty-day period provided for therein. According to the petitioner, the said prescriptive period commenced to run on October 14, 1947 when the denial by the Bureau of Internal Revenue of the respondent Palanca's claim for refund, under his letter of November 10, 1956, became final. Considering that the

case was filed with the Court of Tax Appeals only on August 13, 1958, then it is urged that the same had prescribed.

The petitioner also invokes prescription, at least with respect to the sum of P17,112.21, under Section 306 of the Tax Code.2 He claims that for the calendar year 1955, respondent Palanca paid his income tax as follows:

Taxes withheld by La Tondeña Inc. from Mr. Palanca's wages P13,172.41

Payment under Income Tax Receipt No. 677395 dated May 11, 1956 3,939.89

Payment under Income Tax Receipt No. 742334 dated August 14, 1956 3,939.89

P21,952.01

Therefore, the petitioner contends, the amounts paid by claimant Palanca under his withheld tax and under Receipt No. 677395 dated May 11, 1956 may no longer be refunded since the claim therefor was filed in court only on August 13, 1958, or beyond two years of their payment.

We find the petitioner's contention on prescription untenable.

In the first place, the 30-day period under Section 11 of Republic Act 1125 did not even commence to run in this incident. It should be recalled that while the herein petitioner originally assessed the respondent-claimant for alleged gift tax liabilities, the said assessment was subsequently abandoned and in its lieu, a new one was prepared and served on the respondent-taxpayer. In this new assessment, the petitioner charged the said respondent with an entirely new liability and for a substantially different amount from the first. While initially the petitioner assessed the respondent for donee's gift tax in the amount of P170,002.74, in the subsequent assessment the latter was asked to pay P191,591.62 for delinquent estate and inheritance tax. Considering that it is the interest paid on this latter-assessed estate and inheritance tax that respondent Palanca is claiming refund for, then the thirty-day period under the abovementioned section of Republic Act 1125 should be computed from the receipt of the final denial by the Bureau of Internal Revenue of the said claim. As has earlier been recited, respondent Palanca's claim in this incident was filed with the Court of Tax Appeals even before it had been denied by the herein petitioner or the Bureau of Internal Revenue. The case was filed with the said court on August 13, 1958 while the petitioner denied the claim subject of the said case only on July 24, 1959.

In the second place, the claim at bar refers to the alleged overpayment by respondent Palanca of his 1955 income tax. Inasmuch as the said account was paid by him by installment, then the computation of the two-year prescriptive period, under Section 306 of the National Internal Revenue Code, should be from the date of the last installment. (Antonio Prieto, et al. vs. Collector of Internal Revenue, G.R. No. L-11976, August 29, 1961) Respondent Palanca paid the last installment on his 1955 income tax account on August 14, 1956. His claim for refund of the alleged overpayment on it was filed with the court on August 13, 1958. It was, therefore, still timely instituted.

PAPER INDUSTRIES v CA ( Dec. 1, 1995)

Facts:On various years (1969, 1972 and 1977), Picop obtained loans from foreign creditors in order to finance the

purchase of machinery and equipment needed for its operations. In its 1977 Income Tax Return, Picop claimed interest payments made in 1977, amounting to P42,840,131.00, on these loans as a deduction from its 1977 gross income.

The CIR disallowed this deduction upon the ground that, because the loans had been incurred for the purchase of machinery and equipment, the interest payments on those loans should have been capitalized instead and claimed as a depreciation deduction taking into account the adjusted basis of the machinery and equipment (original acquisition cost plus interest charges) over the useful life of such assets.

Both the CTA and the Court of Appeals sustained the position of Picop and held that the interest deduction claimed by Picop was proper and allowable. In the instant Petition, the CIR insists on its original position.ISSUE:

Whether Picop is entitled to deductions against income of interest payments on loans for the purchase of machinery and equipment.HELD:

YES. Interest payments on loans incurred by a taxpayer (whether BOI-registered or not) are allowed by the NIRC as deductions against the taxpayer's gross income. The basis is 1977 Tax Code Sec. 30 (b).2 Thus, the general 2Sec. 30. Deduction from Gross Income. — The following may be deducted from gross income:

rule is that interest expenses are deductible against gross income and this certainly includes interest paid under loans incurred in connection with the carrying on of the business of the taxpayer.  In the instant case, the CIR does not dispute that the interest payments were made by Picop on loans incurred in connection with the carrying on of the registered operations of Picop, i.e., the financing of the purchase of machinery and equipment actually used in the registered operations of Picop. Neither does the CIR deny that such interest payments were legally due and demandable under the terms of such loans, and in fact paid by Picop during the tax year 1977.

The contention of CIR does not spring of the 1977 Tax Code but from Revenue Regulations 2 Sec. 79. 3 However, the Court said that the term “interest” here should be construed as the so-called "theoretical interest," that is to say, interest "calculated" or computed (and not incurred or paid) for the purpose of determining the "opportunity cost" of investing funds in a given business.Such "theoretical" or imputed interest does not arise from a legally demandable interest-bearing obligation incurred by the taxpayer who however wishes to find out, e.g., whether he would have been better off by lending out his funds and earning interest rather than investing such funds in his business. One thing that Section 79 quoted above makes clear is that interest which does constitute a charge arising under an interest-bearing obligation is an allowable deduction from gross income.Only if sir asks: (For further discussion of CIR’s contention)

It is claimed by the CIR that Section 79 of Revenue Regulations No. 2 was "patterned after" paragraph 1.266-1 (b), entitled "Taxes and Carrying Charges Chargeable to Capital Account and Treated as Capital Items" of the U.S. Income Tax Regulations, which paragraph reads as follows:

(B) Taxes and Carrying Charges. — The items thus chargeable to capital accounts are —

(11) In the case of real property, whether improved or unimproved and whether productive or nonproductive.

(a) Interest on a loan (but not theoretical interest of a taxpayer using his own funds). 

The truncated excerpt of the U.S. Income Tax Regulations quoted by the CIR needs to be related to the relevant provisions of the U.S. Internal Revenue Code, which provisions deal with the general topic of adjusted basis for determining allowable gain or loss on sales or exchanges of property and allowable depreciation and depletion of capital assets of the taxpayer:

Present Rule. The Internal Revenue Code, and the Regulations promulgated thereunder provide that "No deduction shall be allowed for amounts paid or accrued for such taxes and carrying charges as, under regulations prescribed by the Secretary or his delegate, are chargeable to capital account with respect to property, if the taxpayer elects, in accordance with such regulations, to treat such taxes orcharges as so chargeable."

At the same time, under the adjustment of basis provisions which have just been discussed, it is provided that adjustment shall be made for all "expenditures, receipts, losses, or other items" properly chargeable to a capital account, thus including taxes and carrying charges; however, an exception exists, in which event such adjustment to the capital account is not made, with respect to taxes and carrying charges which the taxpayer has not elected to capitalize but for which a deduction instead has been taken. 22 (Emphasis supplied)

The "carrying charges" which may be capitalized under the above quoted provisions of the U.S. Internal Revenue Code include, as the CIR has pointed out, interest on a loan "(but not theoretical interest of a taxpayer using his own funds)." What the CIR failed to point out is that such "carrying charges" may, at the election of the taxpayer, either be (a) capitalized in which case the cost basis of the capital assets, e.g., machinery and equipment, will be adjusted by adding the amount of such interest payments or alternatively, be (b) deducted from gross income of the taxpayer. Should the taxpayer elect to deduct the interest payments against its gross income, the taxpayer cannot at the same time capitalize the interest payments. In other words, the taxpayer is not entitled to both the deduction from gross income and the adjusted (increased) basis for determining gain or loss and the allowable depreciation charge. The U.S. Internal Revenue Code does

xxx xxx xxx(b) Interest:

(1) In general. — The amount of interest paid within the taxable year on indebtedness, except on indebtedness incurred or continued to purchase or carry obligations the interest upon which is exempt from taxation as income under this Title: . . . (Emphasis supplied)

3Sec. 79. Interest on Capital.— Interest calculated for cost-keeping or other purposes on account of capital or surplus invested in the business, which does not represent a charge arising under an interest-bearing obligation, is not allowable deduction from gross income. (Emphases supplied)

not prohibit the deduction of interest on a loan obtained for purchasing machinery and equipment against gross income, unless the taxpayer has also or previously capitalized the same interest payments and thereby adjusted the cost basis of such assets.

CIR vs. LEDNICKY

FACTS:Spouses are both American citizens residing in the Philippines and have derived all their income from Philippine sources for taxable years in question.

On March, 1957, filed their ITR for 1956, reporting gross income of P1,017,287.65 and a net income of P 733,809.44. On March 1959, file an amended claimed deduction of P 205,939.24 paid in 1956 to the United States government as federal income tax of 1956.

ISSUE:Whether a citizen of the United States residing in the Philippines, who derives wholly from sources within the Philippines, may deduct his gross income from the income taxes he has paid to the United States government for the said taxable year?

HELD:An alien resident who derives income wholly from sources within the Philippines may not deduct from gross income the income taxes he paid to his home country for the taxable year. The right to deduct foreign income taxes paid given only where alternative right to tax credit exists.

Section 30 of the NIRC, Gross Income “Par. C (3): Credits against tax per taxes of foreign countries.

If the taxpayer signifies in his return his desire to have the benefits of this paragraph, the tax imposed by this shall be credited with: Paragraph (B), Alien resident of the Philippines; and, Paragraph C (4), Limitation on credit.”

An alien resident not entitled to tax credit for foreign income taxes paid when his income is derived wholly from sources within the Philippines.

Double taxation becomes obnoxious only where the taxpayer is taxed twice for the benefit of the same governmental entity. In the present case, although the taxpayer would have to pay two taxes on the same income but the Philippine government only receives the proceeds of one tax, there is no obnoxious double taxation.

Marcelo Steel Corp vs. Collector

This is a petition to review under section 18, Republic Act No. 1125, a judgement of the Court of Tax Appeals upholding the assessment made by the respondent for income tax due during the years 1952 and 1953 from the petitioner (C.T.A. Case No. 172).

The parties have entered into stipulation of facts which the Court summarized as follows:

The petitioner is a corporation duly organized and existing under and by virtue of the laws of the Philippines, with offices at Malabon, Rizal. It is engaged in three (3) industrial activities, namely, (1) manufacture of wire fence, (2) manufacture of nails, and (3) manufacture of steel bars, rods and other allied steel products. enjoined the benefits of the tax exemption under Republic Act No. 35.

On May 21, 1953, the petitioner filed an income tax return for the year 1952, reflecting a net income of P34,386.58 realized solely from its business of manufacturing wire fence, an activity which is not tax exempt, and on March 31, 1954, it filed its income tax return for the year 1953, showing a net income of P58,329.00 realized from the same sources, i.e., the manufacture of wire fence.

On basis of the said income tax return filed by the petitioner for the year 1952 and 1953 which did not reflect the financial of its tax exempt business activities, the respondent assessed the total sum of P12,750. Accordingly, the petitioner paid the said amount assessed against it on following dates:

Tax Year Date Amount.

1952 May 30, 1953 P3,458.50

1952 August 15, 1953 3,458.50

1952 May 5, 1954 5,833.00

TOTAL .............................. P12,750.00

On October 1, 1954, the petitioner filed amended income tax returns for taxable years 1952 and 1953, showing that bit suffered a net loss of P871,407.37 in 1952, and P10,956.29 in 1953. The said losses were arrived at by consolidating the gross income and expenses and/or deductions of the petitioner in all its business activities, as follows:

For the year 1952

Net Income, taxable industry:

Wire fence P34,386.58.

Net loss,.tax exempt industries:

Nails (P620,722.73)

Steel bars (285,071.22) (905,793.95)

TOTAL NET LOSS (P871,407.37)

For the year 1953

Net income, taxable industry:

Wire fence (P60,950.20)

Steel; bars (102,335.20) (163,285.40)

TOTAL NET LOSS (P104,956.29)

On October 1, 1954, the petitioner, claiming that instead of earning the net income shown in its original income tax returns for 1952 and 1953, it sustained the losses shown in its amended income tax returns for refund of the income taxes for the said years amounting to P12,750.00 which it allegedly paid to the respondent.

After more than ten months of waiting without any action being taken by the respondent on the claim for refund, and in order to protect its right under Section 306 of the National Internal Revenue Code, the petitioner, on August 13, 1955, filed with this Court the instant petition for review.

There are two issues to be resolved in this case, namely, (1) whether or not the petitioner may be allowed to deduct from the profits realized from its taxable business activities, the losses sustained by its tax except industries, and (2) whether or not the action for refund, with regard to the sum of P3,458.50 which was of the Tax Code.

The Court of Tax Appeals held that "petitioner cannot deduct from the profits realized from its taxable industries, the losses sustained by its tax exempt business activities, . . ."

The duration of the petitioner's tax exemption with respect to the manufacture of nails is from 25 June 1949 to 25 June 1953 (Exhibit 7), later adjusted to be from 11 August 1949 to 11 August 1953, and with respect to the manufacture of steel bars, rods and other allied steel product, is from 16 March 1951 to 16 March 1955 (Exhibit 6). The exemption refers to the following internal revenue taxes: the fixed and privilege tax on business, the percentage tax on the sales of manufactured products, in respect to which exemption was granted, the compensating tax on the articles, goods or materials exclusively used in the new and necessary industry, the documentary stamp tax and the income tax with respect to the not income derived from the exempt industry (Exhibits 6 and 7).

The petitioner's theory is that since it is a corporation organized with a single capital that answer for all its financial obligation including those incurred in the tax exempt industries, the gross income derived from both its taxable or non-exempt and tax-exempt industries, and the allowable deductions from said incomes, should be consolidated and its income tax liability should be based on the difference between the consolidated gross incomes and the consolidated allowable deductions. It relies on the provisions of action 24, Commonwealth Act No. 466, as amended, providing that "there shall be levied, assessed, collected, and paid annually upon the total net income received in the preceding taxable year from all sources by every corporation organized in, or existing under the laws of the Philippines." a graduated tax (Emphasis supplied), and of section 30, subsection (d), paragraph (2) of the same Act providing that in computing the net income of a corporation, all losses actually sustained by it and charged off within the taxable year and not compensated for by insurance or otherwise, are allowed as deductions.

Republic Act No. 35, the law under which the petitioner was granted tax exemption for the manufacture of nails and steel bars, rods and other allied steel products, provides:.

SECTION 1. Any person, partnership, company, or corporation who or which shall engage in anew and necessary industry shall, for a period of four years from the date of the organization of such industry, be entitled to exemption from the payment of all internal revenue taxes directly payable by such person, partnership, company, or corporation in respect to said industry.

SEC. 2. The President of the Philippines, shall, upon recommendation of the Secretary of Finance, periodically determine the qualifications that the industries should possess to be entitled to the benefits of this Act.

SEC. 3. This Act shall take effect upon its approval.

(Approved, September 30, 1946.)

The purpose of aim of Republic Act No. 35 is to encourage the establishment or exploitation of new and necessary industries to promote the economic growth of the country. It is a form of subsidy granted by the Government to encourageous staking their capital in an unknown venture. An entrepreneur engaging in a new and necessary industry faces uncertainly and assumes a risk bigger than one engaging in a venture already known and developed. Like a settler in an unexplored land who is just blazing a trial in a virgin forest, he needs all the encouragement and assistance from the Government. He needs capital to buy his implements, to pay his laborers and to sustain him and his family. Comparable to the farmers who had just planted the seeds of fruit bearing trees in his orchard, he does not except an immediate return on his investment. Usually loss is incurred rather than profit made. It is for these reasons that the law grants him tax exemption—to lighten onerous financial burdens and reduce losses. However these may be, Republic Act No. 35 has confined the privilege of tax exemption only to new and necessary industries. It did not intend to grant the tax exemption benefit to an entrepreneur engaged at the same time in a taxable or non-payment industry and a new and necessary industry, by allowing him to deduct his gains or profits derived from the operation of the first from the losses incurred in the operation of the second. Unlike a new and necessary industry, a taxable or non-exempt industry is already a going concern, deriving profits from its operation, and deserving no subsidy from the Government. It is but fair that it be required to give to the Government a share in its profits in the form of taxes.

The fact that the petitioner is a corporate organized with a single capital that answer for all its financial obligations including those incurred in the tax exempt industries is of no moment. The intent of the law is to treat taxable or non-exempt industries as separate and distinct from new and necessary industries which are tax-exempt for purposes of

taxation. Section 7, Executive Order No. 341, series of 1950, issued by the President of the Philippines pursuant to section 2, Republic Act No. 35, provides:

Any industry granted tax exemption under the provisions of Republic Act No. 35 shall report to the Secretary of Finance at the end of every fiscal rear a complete list and a correct valuation of all real and personal property of its industrial plant of factory: shall file a separate income tax return; shall keep separetely the accounting records relative to the industry declared exempt; shall keep such records and submit such sworn statements as may be prescribed from time to time by the Secretary of Finance;1 (Emphasis supplied.)

And when Congress revised the provision of Republic Act No. 35 by enacting onto law Republic Act No. 901 it incorporate similar provisions and provided that "Any industry granted tax exemption under of Republic Act No. 35" shall "file a separate income tax return."2

The petitioner states that it is not liable to pay income tax on its industries of manufacturing nails and steel bars, ros and other allied steel product for the reason that it had incurred loss in their operation and not because it is exempt under the provision of Republic Act No. 35. It argues that by being allowed to deduct its gains derived from the operation of its taxable or non-exempt industry of manufacturing wire fence, from the losses incurred in the operation of its tax-exempt industries of manufacturing nails and steels bars, rod and other allied steel products, it would not receive the benefit of double exemption under Republic Act No. 35 is to lighten the onerous financial burden and reduce the losses of the entrepeneur, yet it is not designed to assure him of a return on his capital invested. As already stated, the law intended to treat to treat taxable or non-excempt industry as separate and distinct from new and necessary industry, which is tax exempt, and did not mean to grant an entrepreneur, engaged at the same time in a taxable or non-exempt industry and a new and necessary industry, the benefit or privilege of deducting his gains or profit derived from the operation of the first from the losses incurred in the operation of the second. Moreover, aside from its exemption from the payment of income tax on its profits derived from the operation of new and necessary industries, the petitioner is exempt from the payment of other internal revenue taxes directly payable by it, such as the fixed and privilege tax on business, the percentage tax on the fixed and privilege tax on business, the percentage tax on the sales of manufactured products, in respect to which exemption is granted, the compensating tax on the articles, goods or material exclusively used in the new and necessary industry, and the documentary stamp tax (Exhibits 6 and 7). These exemption alone are enough to lighten its onerous financial burden and reduce losses.

The petitioner claims that unlike the United States Internal Revenue Code which expressly forbids the deduction of —

Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not only any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this chapter [(Section 24 (a) (5)].

our National Internal Revenue Code does not contain a similar prohibition. When in 1939 Commonwealth Act No. 466, the National Internal Revenue Code, was enacted into law, the idea of granting tax exemption to new and necessary industries in the Philippines had not yet been thought of because there were no new and necessary industries being established or exploited. It was only in 1946, after the last World War, and after the Philippines became sovereign nation, that the establishment or exploitation of new and necessary industries was stimulated. Hence the absence of a similar provision in out National Internal Revenue Code.This absence, however, cannot be capitalized upon by the petitioner in support of its theory. For, as already stated, when Congress enacted Republic Act No. 35 into law, it intended to segregate income derived from the operation of new and necessary industries from that derived from the operation of taxable or non-exempt industries.

For the foregoing reasons, the judgement under review is affirmed, with costs against the petitioner.

Paras, C.J., Bengzon, Bautista Angelo, Labrador, Reyes, J.B.L., Barrera, Gutierrez David, Paredes, and Dizon, JJ., concur.

Plaridel Surety &Ins Co vs. CIR

Petitioner Plaridel Surety & Insurance Co., is a domestic corporation engaged in the bonding business. On November 9, 1950, petitioner, as surety, and Constancio San Jose, as principal, solidarily executed a performance bond in the penal sum of P30,600.00 in favor of the P. L. Galang Machinery Co., Inc., to secure the performance of San Jose's contractual obligation to produce and supply logs to the latter.

To afford itself adequate protection against loss or damage on the performance bond, petitioner required San Jose and one Ramon Cuervo to execute an indemnity agreement obligating themselves, solidarily, to indemnify petitioner for whatever liability it may incur by reason of said performance bond. Accordingly, San Jose constituted a chattel mortgage on logging machineries and other movables in petitioner's favor1 while Ramon Cuervo executed a real estate mortgage.2

San Jose later failed to deliver the logs to Galang Machinery3 and the latter sued on the performance bond. On October 1, 1952, the Court of First Instance adjudged San Jose and petitioner liable; it also directed San Jose and Cuervo to reimburse petitioner for whatever amount it would pay Galang Machinery. The Court of Appeals, on June 17, 1955, affirmed the judgment of the lower court. The same judgment was likewise affirmed by this Court4 on January 11, 1957 except for a slight modification apropos the award of attorney's fees.

On February 19 and March 20, 1957, petitioner effected payment in favor of Galang Machinery in the total sum of P44,490.00 pursuant to the final decision.

In its income tax return for the year 1957, petitioner claimed the said amount of P44,490.00 as deductible loss from its gross income and, accordingly, paid the amount of P136.00 as its income tax for 1957.

The Commissioner of Internal Revenue disallowed the claimed deduction of P44,490.00 and assessed against petitioner the sum of P8,898.00, plus interest, as deficiency income tax for the year 1957. Petitioner filed its protest which was denied. Whereupon, appeal was taken to the Tax Court, petitioner insisting that the P44,490.00 which it paid to Galang Machinery was a deductible loss.

The Tax Court dismissed the appeal, ruling that petitioner was duly compensated for otherwise than by insurance — thru the mortgages in its favor executed by San Jose and Cuervo — and it had not yet exhausted all its available remedies, especially as against Cuervo, to minimize its loss. When its motion to reconsider was denied, petitioner elevated the present appeal.

Of the sum of P44,490.00, the amount of P30,600.00 — which is the principal sum stipulated in the performance bond — is being claimed as loss deduction under Sec. 30 (d) (2) of the Tax Code and P10,000.00 — which is the interest that had accrued on the principal sum — is now being claimed as interest deduction under Sec. 30 (b) (1).

Loss is deductible only in the taxable year it actually happens or is sustained. However, if it is compensable by insurance or otherwise, deduction for the loss suffered is postponed to a subsequent year, which, to be precise, is that year in which it appears that no compensation at all can be had, or that there is a remaining or net loss, i.e., no full compensation.5

There is no question that the year in which the petitioner Insurance Co. effected payment to Galang Machinery pursuant to a final decision occurred in 1957. However, under the same court decision, San Jose and Cuervo were obligated to reimburse petitioner for whatever payments it would make to Galang Machinery. Clearly, petitioner's loss is compensable otherwise (than by insurance).itc-alf It should follow, then, that the loss deduction can not be claimed in 1957.

Now, petitioner's submission is that its case is an exception. Citing Cu Unjieng Sons, Inc. v. Board of Tax Appeals,6 and American cases also, petitioner argues that even if there is a right to compensation by insurance or otherwise, the deduction can be taken in the year of actual loss where the possibility of recovery is remote. The pronouncement, however to this effect in the Cu Unjieng case is not as authoritative as petitioner would have it since it was there found that the taxpayer had no legal right to compensation either by insurance or otherwise.7 And the American cases cited8

are not in point. None of them involved a taxpayer who had, as in the present case, obtained a final judgment against third persons for reimbursement of payments made. In those cases, there was either no legally enforceable right at all or such claimed right was still to be, or being, litigated.

On the other hand, the rule is that loss deduction will be denied if there is a measurable right to compensation for the loss, with ultimate collection reasonably clear. So where there is reasonable ground for reimbursement, the taxpayer must seek his redress and may not secure a loss deduction until he establishes that no recovery may be had.9 In other words, as the Tax Court put it, the taxpayer (petitioner) must exhaust his remedies first to recover or reduce his loss.

It is on record that petitioner had not exhausted its remedies, especially against Ramon Cuervo who was solidarily liable with San Jose for reimbursement to it. Upon being prodded by the Tax Court to go after Cuervo, Hermogenes Dimaguiba, president of petitioner corporation, said that they would10 but no evidence was submitted that anything was really done on the matter. Moreover, petitioner's evidence on remote possibility of recovery is fatally wanting. Its right to reimbursement is not only secured by the mortgages executed by San Jose and Cuervo but also by a final and executory judgment in the civil case itself. Thus, other properties of San Jose and Cuervo were subject to levy and execution. But no writ of execution, satisfied or unsatisfied, was ever submitted. Neither has it been established that Cuervo was insolvent. The only evidence on record on the point is Dimaguiba's testimony that he does not really know if Cuervo has other properties.11 This is not substantial proof of insolvency.itc-alf Thus, it was too premature for petitioner to claim a loss deduction.

But assuming that there was no reasonable expectation of recovery, still no loss deduction can be had. Sec. 30 (d) (2) of the Tax Code requires a charge-off as one of the conditions for loss deduction:

In the case of a corporation, all losses actually sustained and charged-off within the taxable year and not compensated for by insurance or otherwise. (Emphasis supplied)

Mertens12 states only four (4) requisites because the United States Internal Revenue Code of 193913 has no charge-off requirement.itc-alf Sec. 23(f) thereof provides merely:

In the case of a corporation, losses sustained during the taxable year and not compensated for by insurance or otherwise.

Petitioner, who had the burden of proof14 failed to adduce evidence that there was a charge-off in connection with the P44,490.00—or P30,600.00 — which it paid to Galang Machinery.

In connection with the claimed interest deduction of P10,000.00, the Solicitor General correctly points out that this question was never raised before the Tax Court. Petitioner, thru counsel, had admitted before said court 15 and in the memorandum it filed16 that the only issue in the case was whether the entire P44,490.00 paid by it was or was not a deductible loss under Sec. 30 (d) (2) of the Tax Code. Even in petitioner's return, the P44,490.00 was claimed wholly as losses on its bond.17 The alleged interest deduction not having been properly litigated as an issue before the Tax Court, it is now too late to raise and assert it before this Court.

WHEREFORE, the appealed decision is, as it is hereby, affirmed. Costs against petitioner Plaridel Surety & Insurance Co. So ordered.

CIR vs. PRISCILA ESTATE, INC.

REYES, J.B.L., J.:

Review of the decision of the Court of Tax Appeals in its case No. 334 ordering the petitioner, Commissioner of Internal Revenue to refund to the respondent, Priscila Estate, Inc., a domestic corporation engaged in the business of leasing real estate, the sum of P3,045.19, as overpaid income tax for 1950.

The corporation duly filed its income tax returns for the years 1949, 1950 and 1951. On 13 June 1952, however, it amended its income tax returns for 1951 and paid the tax corresponding to the assessment made by the petitioner on the basis of the returns, as amended; and on 13 September 1952, the company claimed a refund of P4,941.00 as overpaid income tax for the year 1950 for having deducted from gross income only the sum of P6,013.85 instead of P39,673.25 as its loss in the sale of a lot and building. Thereupon, the Commissioner of Internal Revenue conducted an investigation of the company's income tax returns for 1949 through 1951 and, thereafter, granted a tax credit of P1,443.00 for 1950 but assessed on 3 November 1953 deficiency income taxes of P3,575.49 for 1949 and P22,166.10 for 1951.

The Priscila Estate, Inc., contested the deficiency assessments and when the Commissioner of Internal Revenue refused to reconsider them, the former brought suit to the tax court which after trial, rendered the decision that, in 1961, the Commissioner elevated to this Supreme Court for review.

The first assignment of error refers to the allowance of a deduction in the 1949 income tax returns of the respondent corporation the amount of P11,237.35 representing the cost of a "barong-barong" (a make-shift building), situated at the corner of Azcarraga Street and Rizal Avenue, Manila, which was demolished on 31 December 1949 and a new one built in its place. The petitioner claims that the value of the demolished building should not be deducted from gross income but added to the cost of the building replacing it because its demolition or removal was to make way for the erection of another in its place. 1äwphï1.ñët

The foregoing argument is erroneous inasmuch as the tax court found that the removal of the "barong-barong", instead of being voluntary, was forced upon the corporation by the city engineer because the structure was a fire hazard; that the rental income of the old building was about P3,730.00 per month, and that the corporation had no funds but had to borrow, in order to construct a new building. All these facts, taken together, belie any intention on the part of the corporation to demolish the old building merely for the purpose of erecting another in its place. Since the demolished building was not compensated for by insurance or otherwise, its loss should be charged off as deduction from gross income. (Sec. 30[2], Internal Revenue Code.)

The second to the fifth assignments of error pertain to depreciation.

Particularly contested by the petitioner is the basis for depreciation of Building Priscila No. 3. This building, with an assessed value of P70,343.00 but with a construction cost of P110,600.00, was acquired by the respondent corporation from the spouses, Carlos Moran Sison and Priscila F. Sison, in exchange for shares of stock. According to the petitioner,

the basis for commuting the depreciation of this building should be limited to the capital invested, which is the assessed value. On the other hand, the respondent based its computation on its construction cost, revaluing the property on this basis by a board resolution in order to "give justice to the Sison spouse Since this revaluation would import an obligation of the corporation to pay the Sison spouses, as vendors, the difference between the assessed value and the revalued construction cost, as provided in resolution Exhibit F-1 (otherwise the revaluation would make no sense), the corporate investment would ultimately be the construction cost which is undisputed), and depreciation logically had to be on that basis. That the revaluation may import additional profit to the vendor spouses is a matter related to their own income tax, and not to that of respondent corporation.

The Collector also questions the rates of depreciation which the tax court applied to the other properties, consisting of store and office building, houses, a garage, library books, furniture and fixtures and transportation equipment.

Depreciation is a question of fact,1 and is "not measured by a theoretical yardstick, but should be determined by a consideration of the actual facts ... ." (Landon vs. CIR of State of Kansas, 260 Fed. 433 [1920]], quoted in Sec. 23.32, Mertens, Federal Income Taxation). The petitioner himself on page 26 of his appeal brief, asserts that "what consist of the depreciable amount (sic) is elusive and is a question of fact."

Since the petitioner does not claim that the tax court, in applying certain rates and basis to arrive at the allowed amounts of depreciation of the various properties, was, arbitrary or had abused its discretion, and since the Supreme Court, before the Revised Rules, limited its review of decisions of the Court of Tax Appeals to questions of law only (Sanchez v. Commissioner of Customs, L-8556, 30 Sept. 1957; Gutierrez v. Court of Tax Appeals, L-9738 & L-9771, 31 May 1957), the findings of the tax court on the depreciation of the several assets should not be disturbed.

In the sixth and last assignment of error, the petitioner argues that the refund to the respondent is barred by the two-year prescriptive period under Section 306 of the Internal Revenue Code because the action for refund was filed on 5 December 1956 while the respondent's 1950 income tax was paid on 15 August 1951. The petitioner's argument would have been tenable but for his failure to plead prescription in a motion to dismiss or as a defense in his answer, said failure is deemed a waiver of the defense of prescription (Sec. 10, Rule 9, Rules of Court).

Finding no reversible error in the decision under review, the same is hereby affirmed. No costs.

China Bank Corp vs. CA

Facts: On 21 August 1974, Galicano Calapatia, Jr., a stockholder of Valley Golf & Country Club, Inc. (VGCCI), pledged his Stock Certificate 1219 to China Banking Corporation (CBC). On 16 September 1974, CBC wrote VGCCI requesting that the pledge agreement be recorded in its books. In a letter dated 27 September 1974, VGCCI replied that the deed of pledge executed by Calapatia in CBC's favor was duly noted in its corporate books. On 3 August 1983, Calapatia obtained a loan of P20,000.00 from CBC, payment of which was secured by the pledge agreement still existing between Calapatia and CBC. Due to Calapatia's failure to pay his obligation, CBC, on 12 April 1985, filed a petition for extrajudicial foreclosure before Notary Public Antonio T. de Vera of Manila, requesting the latter to conduct a public auction sale of the pledged stock. On 14 May 1985, CBC informed VGCCI of the foreclosure proceedings and requested that the pledged stock be transferred to its name and the same be recorded in the corporate books. However, on 15 July 1985, VGCCI wrote CBC expressing its inability to accede to CBC's request in view of Calapatia's unsettled accounts with the club. Despite the foregoing, Notary Public de Vera held a public auction on 17 September 1985 and CBC emerged as the highest bidder at P20,000.00 for the pledged stock. Consequently, CBC was issued the corresponding certificate of sale. 

On 21 November 1985, VGCCI sent Calapatia a notice demanding full payment of his overdue account in the amount of P18,783.24. Said notice was followed by a demand letter dated 12 December 1985 for the same amount and another notice dated 22 November 1986 for P23,483.24. On 4 December 1986, VGCCI caused to be published in the newspaper Daily Express a notice of auction sale of a number of its stock certificates, to be held on 10 December 1986 at 10:00 a.m. Included therein was Calapatia's own share of stock (Stock Certificate 1219). Through a letter dated 15 December 1986, VGCCI informed Calapatia of the termination of his membership due to the sale of his share of stock in the 10 December 1986 auction. On 5 May 1989, CBC advised VGCCI that it is the new owner of Calapatia's Stock Certificate 1219 by virtue of being the highest bidder in the 17 September 1985 auction and requested that a new certificate of stock be issued in its name. On 2 March 1990, VGCCI replied that "for reason of delinquency" Calapatia's stock was sold at the public auction held on 10 December 1986 for P25,000.00. On 9 March 1990, CBC protested the sale by VGCCI of the subject share of stock and thereafter filed a case with the Regional Trial Court of Makati for the nullification of the 10 December 1986 auction and for the issuance of a new stock certificate in its name. On 18 June 1990, the Regional Trial Court of Makati dismissed the complaint for lack of jurisdiction over the subject matter on the theory that it involves an intra-corporate dispute and on 27 August 1990 denied CBC's motion for reconsideration. On 20 September 1990, CBC filed a complaint with the Securities and Exchange Commission (SEC) for the nullification of the sale of Calapatia's stock by VGCCI; the cancellation of any new stock certificate issued pursuant thereto; for the issuance of a new certificate in petitioner's name; and for damages, attorney's fees and costs of litigation. 

On 3 January 1992, SEC Hearing Officer Manuel P. Perea rendered a decision in favor of VGCCI, stating in the main that

considering that the said share is delinquent, VGCCI had valid reason not to transfer the share in the name of CBC in the books of VGCCI until liquidation of delinquency. Consequently, the case was dismissed. On 14 April 1992, Hearing Officer Perea denied CBC's motion for reconsideration. CBC appealed to the SEC en banc and on 4 June 1993, the Commission issued an order reversing the decision of its hearing officer; holding that CBC has a prior right over the pledged share and because of pledgor's failure to pay the principal debt upon maturity, CBC can proceed with the foreclosure of the pledged share; declaring that the auction sale conducted by VGCCI on 10 December 1986 is declared NULL and VOID; and ordering VGCCI to issue another membership certificate in the name of CBC. VGCCI sought reconsideration of the order. However, the SEC denied the same in its resolution dated 7 December 1993. The sudden turn of events sent VGCCI to seek redress from the Court of Appeals. On 15 August 1994, the Court of Appeals rendered its decision nullifying and setting aside the orders of the SEC and its hearing officer on ground of lack of jurisdiction over the subject matter and, consequently, dismissed CBC's original complaint. The Court of Appeals declared that the controversy between CBC and VGCCI is not intra-corporate; nullifying the SEC orders and dismissing CBC’s complaint. CBC moved for reconsideration but the same was denied by the Court of Appeals in its resolution dated 5 October 1994. CBC filed the petition for review on certiorari. 

Issue: Whether CBC is bound by VGCCI's by-laws. 

Held: In order to be bound, the third party must have acquired knowledge of the pertinent by-laws at the time the transaction or agreement between said third party and the shareholder was entered into. Herein, at the time the pledge agreement was executed. VGCCI could have easily informed CBC of its by-laws when it sent notice formally recognizing CBC as pledgee of one of its shares registered in Calapatia's name. CBC's belated notice of said by-laws at the time of foreclosure will not suffice. By-laws signifies the rules and regulations or private laws enacted by the corporation to regulate, govern and control its own actions, affairs and concerns and its stockholders or members and directors and officers with relation thereto and among themselves in their relation to it. In other words, by-laws are the relatively permanent and continuing rules of action adopted by the corporation for its own government and that of the individuals composing it and having the direction, management and control of its affairs, in whole or in part, in the management and control of its affairs and activities. The purpose of a by-law is to regulate the conduct and define the duties of the members towards the corporation and among themselves. They are self-imposed and, although adopted pursuant to statutory authority, have no status as public law. Therefore, it is the generally accepted rule that third persons are not bound by by-laws, except when they have knowledge of the provisions either actually or constructively. For the exception to the general accepted rule that third persons are not bound by by-laws to be applicable and binding upon the pledgee, knowledge of the provisions of the VGCCI By-laws must be acquired at the time the pledge agreement was contracted. Knowledge of said provisions, either actual or constructive, at the time of foreclosure will not affect pledgee's right over the pledged share. Article 2087 of the Civil Code provides that it is also of the essence of these contracts that when the principal obligation becomes due, the things in which the pledge or mortgage consists maybe alienated for the payment to the creditor. Further, VGCCI's contention that CBC is duty-bound to know its by-laws because of Article 2099 of the Civil Code which stipulates that the creditor must take care of the thing pledged with the diligence of a good father of a family, fails to convince. CBC was never informed of Calapatia's unpaid accounts and the restrictive provisions in VGCCI's by-laws. Furthermore, Section 63 of the Corporation Code which provides that "no shares of stock against which the corporation holds any unpaid claim shall be transferable in the books of the corporation" cannot be utilized by VGCCI. The term "unpaid claim" refers to "any unpaid claim arising from unpaid subscription, and not to any indebtedness which a subscriber or stockholder may owe the corporation arising from any other transaction." Herein, the subscription for the share in question has been fully paid as evidenced by the issuance of Membership Certificate 1219. What Calapatia owed the corporation were merely the monthly dues. Hence, Section 63 does not apply.

PAPER INDUSTRIES v CA ( Dec. 1, 1995)

The Paper Industries Corporation of the Philippines ("Picop"), is a Philippine corporation registered with the Board of Investments ("BOI") as a preferredpioneer enterprise with respect to its integrated pulp and paper mill, and as a preferred non-pioneer enterprise with respect to its integrated plywood and veneer mills .

In 1969, 1972 and 1977, Picop obtained loans from foreign creditors in order to finance the purchase of machinery and equipment needed for its operations.

Picop also issued promissory notes of about P230M, on w/c it paid P45M in interest. In its 1977 Income Tax Return, Picop claimed the interest payments on the loans as DEDUCTIONS from its

1977 gross income. The CIR disallowed this deduction upon the ground that, because the loans had been incurred for the purchase

of machinery and equipment, the interest payments on those loans should have been capitalized instead and claimed as a depreciation deduction taking into account the adjusted basis of the machinery and equipment (original acquisition cost plus interest charges) over the useful life of such assets.

I: W/n the interest payments can be deducted from gross income – YES transaction tax R: The 1977 NIRC does not prohibit the deduction of interest on a loan incurred for acquiring machinery and

equipment. Neither does our 1977 NIRC compel the capitalization of interest payments on such a loan.

The 1977 Tax Code is simply silent on a taxpayer's right to elect one or the other tax treatment of such interest payments. Accordingly, the general rule that interest payments on a legally demandable loan are deductible from gross income must be applied.

In this case, the CIR does not dispute that the interest payments were made by Picop on loans incurred in connection with the carrying on of the registered operations of Picop, i.e., the financing of the purchase of machinery and equipment actually used in the registered operations of Picop. Neither does the CIR deny that such interest payments were legally due and demandable under the terms of such loans, and in fact paid by Picop during the tax year 1977.

The CIR has been unable to point to any provision of the 1977 Tax Code or any other Statute that requires the disallowance of the interest payments made by Picop.

THIS PART DI KO SUPER MAGETS: The CIR invokes Section 79 of Revenue Regulations No. 2 w/c provides that Interest calculated for cost-keeping

or other purposes on account of capital or surplus invested in the business, which does not represent a charge arising under an interest-bearing obligation, is not allowable deduction from gross income.

It is claimed by the CIR that Section 79 of Revenue Regulations No. 2 was "patterned after" paragraph 1.266-1 (b), entitled "Taxes and Carrying Charges Chargeable to Capital Account and Treated as Capital Items" of the U.S. Income Tax Regulations, which paragraph reads as follows:

(B) Taxes and Carrying Charges. — The items thus chargeable to capital accounts are —(11) In the case of real property, whether improved or unimproved and whether productive or nonproductive.(a) Interest on a loan (but not theoretical interest of a taxpayer using his own funds). 21

The truncated excerpt of the U.S. Income Tax Regulations quoted by the CIR needs to be related to the relevant provisions of the U.S. Internal Revenue Code, which provisions deal with the general topic of adjusted basis for determining allowable gain or loss on sales or exchanges of property and allowable depreciation and depletion of capital assets of the taxpayer:

Present Rule. The Internal Revenue Code, and the Regulations promulgated thereunder provide that "No deduction shall be allowed for amounts paid or accrued for such taxes and carrying charges as, under regulations prescribed by the Secretary or his delegate, are chargeable to capital account with respect to property, if the taxpayer elects, in accordance with such regulations, to treat such taxes or charges as so chargeable."At the same time, under the adjustment of basis provisions which have just been discussed, it is provided that adjustment shall be made for all "expenditures, receipts, losses, or other items" properly chargeable to a capital account, thus including taxes and carrying charges; however, an exception exists, in which event such adjustment to the capital account is not made, with respect to taxes and carrying charges which the taxpayer has not elected to capitalize but for which a deduction instead has been taken.

The "carrying charges" which may be capitalized under the above quoted provisions of the U.S. Internal Revenue Code include, as the CIR has pointed out, interest on a loan "(but not theoretical interest of a taxpayer using his own funds)." What the CIR failed to point out is that such "carrying charges" may, at the election of the taxpayer, either be (a) capitalized in which case the cost basis of the capital assets, e.g., machinery and equipment, will be adjusted by adding the amount of such interest payments or alternatively, be (b) deducted from gross income of the taxpayer. Should the taxpayer elect to deduct the interest payments against its gross income, the taxpayer cannot at the same time capitalize the interest payments. In other words, the taxpayer is not entitled to both the deduction from gross income and the adjusted (increased) basis for determining gain or loss and the allowable depreciation charge. The U.S. Internal Revenue Code does not prohibit the deduction of interest on a loan obtained for purchasing machinery and equipment against gross income, unless the taxpayer has also or previously capitalized the same interest payments and thereby adjusted the cost basis of such assets.

Collector vs. Goodrich International Rubber Co

Facts:Goodrich claimed for deductions based upon receipts issued, not by entities in which the alleged expenses had been incurred, but by the officers of Goodrich who allegedly paid for them.

The Commissioner disallowed deductions in the amount of P50,455.41 (for the year 1951) for bad debts and P30,188.88 (for year 1952) for representation expenses.

Goodrich appealed from the said assessment to the Court of Tax Appeals (CTA) which allowed the deduction for bad debts but disallowing the alleged representation expenses. CTA amended its decision allowing the deduction of representation expenses.

 The Government appealed to the SC. The alleged bad debts are the following:1. Portillo's Auto Seat Cover                                        630.312. Visayan Rapid Transit                                                 17,810.263. Bataan Auto Seat Cover                                           373.134. Tres Amigos Auto Supply                                         1,370.31

5. P. C. Teodorolawphil                                                  650.006. Ordnance Service, P.A.                                             386.427. Ordnance Service, P.C.                                             796.268. National land Settlement Administration          3,020.769. National Coconut Corporation                               644.7410. Interior Caltex Service Station                             1,505.8711. San Juan Auto Supply                                              4,530.6412. P A C S A                                                                       45.3613. Philippine Naval Patrol                                            14.1814. Surplus Property Commission                             277.6815. Alverez Auto Supply                                                                285.6216. Lion Shoe Store                                                         1,686.9317. Ruiz Highway Transit                                                2,350.0018. Esquire Auto Seat Cover                                        3,536.94T O T A L                                                                               P50,455.41*

Issue:Whether or not these bad debts are properly deducted.

Held:The claim for deduction for debt numbers 1-10 is REJECTED. Goodrich has not established either that the debts are actually worthless or that it had reasonable grounds to believe them to be so.

NIRC permits the deduction of debts “actually ascertained to be worthless within the taxable year” obviously to prevent arbitrary action by the taxpayer, to unduly avoid tax liability.

The requirement of ascertainment of worthlessness require proof of 2 facts:

• 1.       That the taxpayer did in fact ascertain the debt to be worthless• 2.       That he did so, in good faith.

Good faith on the part of the taxpayer is not enough. He must also how that he had reasonably investigated the relevant facts and had drawn a reasonable inference from the information obtained by him. In the case, Goodrich has not adequately made such showing.

The payments made, after being characterized as bad debts, merely stresses the undue haste with which the same had been written off. Goodrich has not proven that said debts were worthless. There was no evidence that the debtors can not pay them.

SC held that the claim for bad debts are allowed but only up to P22,627.35. (those from Debts 11-18)

PHILIPPINE REFINING CO v CA

FACTS:Philippine Refining Corp (PRC) was assessed deficiency tax payments for the year 1985 in the amount of around 1.8M. This figure was computed based on the disallowance of the claim of bad debts by PRC. PRC duly protested the assessment claiming that under the law, bad debts and interest expense are allowable deductions.When the BIR subsequently garnished some of PRC’s properties, the latter considered the protest as being denied and filed an appeal to the CTA which set aside the disallowance of the interest expense and modified the disallowance of the bad debts by allowing 3 accounts to be claimed as deductions. However, 13 supposed “bad debts” were disallowed as the CTA claimed that these were not substantiated and did not satisfy the jurisprudential requirement of “worthlessness of a debt” The CA denied the petition for review.

ISSUE: Whether or not the CA was correct in disallowing the 13 accounts as bad debts.

RULING:YES.Both the CTA and CA relied on the case of Collector vs. Goodrich International, which laid down the requisites for “worthlessness of a debt” to wit:In said case, we held that for debts to be considered as "worthless," and thereby qualify as "bad debts" making them deductible, the taxpayer should show that (1) there is a valid and subsisting debt. (2) the debt must be actually ascertained to be worthless and uncollectible during the taxable year; (3) the debt must be charged off during the taxable year; and (4) the debt must arise from the business or trade of the taxpayer. Additionally, before a debt can be considered worthless, the taxpayer must also show that it is indeed uncollectible even in the future.

Furthermore, there are steps outlined to be undertaken by the taxpayer to prove that he exerted diligent efforts to collect the debts, viz.: (1) sending of statement of accounts; (2) sending of collection letters; (3) giving the account to a lawyer for collection; and (4) filing a collection case in court.PRC only used the testimony of its accountant Ms. Masagana in order to prove that these accounts were bad debts. This was considered by all 3 courts to be self-serving. The SC said that PRC failed to exercise due diligence in order to ascertain that these debts were uncollectible. In fact, PRC did not even show the demand letters they allegedly gave to some of their debtors.

Basilan Estate vs. Commissioner

Doctrine:The income tax law does not authorize the depreciation of an asset beyond its acquisition cost. Hence, a deduction over and above such cost cannot be claimed and allowed. The reason is that deductions from gross income are privileges, not matters of right. They are not created by implication but upon clear expression in the law.

Facts:Basilan Estates, Inc. claimed deductions for the depreciation of its assets on the basis of their acquisition cost. As of January 1, 1950 it changed the depreciable value of said assets by increasing it to conform with the increase in cost for their replacement. Accordingly, from 1950 to 1953 it deducted from gross income the value of depreciation computed on the reappraised value.

CIR disallowed the deductions claimed by petitioner, consequently assessing the latter of deficiency income taxes.

Issue:Whether or not the depreciation shall be determined on the acquisition cost rather than the reappraised value of the assets

Held:Yes. The following tax law provision allows a deduction from gross income for depreciation but limits the recovery to the capital invested in the asset being depreciated:

(1)In general. — A reasonable allowance for deterioration of property arising out of its use or employment in the business or trade, or out of its not being used: Provided, That when the allowance authorized under this subsection shall equal the capital invested by the taxpayer . . . no further allowance shall be made. . . .

The income tax law does not authorize the depreciation of an asset beyond its acquisition cost. Hence, a deduction over and above such cost cannot be claimed and allowed. The reason is that deductions from gross income are privileges, not matters of right. They are not created by implication but upon clear expression in the law [Gutierrez v. Collector of Internal Revenue, L-19537, May 20, 1965].

Depreciation is the gradual diminution in the useful value of tangible property resulting from wear and tear and normal obsolescense. It commences with the acquisition of the property and its owner is not bound to see his property gradually waste, without making provision out of earnings for its replacement.

The recovery, free of income tax, of an amount more than the invested capital in an asset will transgress the underlying purpose of a depreciation allowance. For then what the taxpayer would recover will be, not only the acquisition cost, but also some profit. Recovery in due time thru depreciation of investment made is the philosophy behind depreciation allowance; the idea of profit on the investment made has never been the underlying reason for the allowance of a deduction for depreciation.

Zamora vs. Collector, SUPRA

US vs. Ludley

CERTIORARI TO THE COURT OF CI.AIMS

1. Under the income and excess profits provisions of the Revenue Act of 1916, as amended by Revenue Act of 1917, in determining the existence and amount of profit realized from a sale of oil mining properties -- land, leases, and equipment -- the cost of the property sold is the original cost to the taxpayer (if purchased after March 1, 1913, or its value on that date if acquired earlier for less) diminished by deductions for depreciation and depletion occurring between the dates of purchase (or March 1, 1913) and sale. P. 274 U. S. 300.

2. The depreciation charge permitted as a deduction from the gross income in determining the taxable income of a business for any year represents the reduction, during the year, of the capital assets through wear and tear of the plant used. P. 274 U. S. 300.

3. When a plant is disposed of after years of use, the thing then sold is not the whole thing originally acquired. The amount of the depreciation must be deducted from the original cost of the whole in order to determine the cost of that disposed of in the final sale of properties. P. 274 U. S. 301.

4. This rule applies to mining as well as to mercantile business. P. 274 U. S. 301.

5. The depletion charge permitted as a deduction from the gross income in determining the taxable income of mines for any year represents the reduction in the mineral contents of the reserves from which the product is taken. Because the quantity originally in the reserve is not actually known, the percentage of the whole withdrawn in any year, and hence the appropriate depletion charge, is necessarily a rough estimate. P. 274 U. S. 302.

6. The amounts of depreciation and depletion to be deducted from cost to ascertain gain on a sale of oil properties are equal to the aggregates of depreciation and depletion which the taxpayer was entitled to deduct from gross income in his income tax returns for earlier years; but are not dependent on the amounts which he actually so claimed. P. 274 U. S. 303.

61 Ct.Cls. 126 reversed.

Certiorari (271 U.S. 651) to a judgment of the Court of Claims for an amount exacted as additional income and excess profits taxes.

MR. JUSTICE BRANDEIS delivered the opinion of the Court.

Ludey brought this suit in the Court of Claims to recover an amount exacted as additional taxes for 1917 under the income and excess profits provisions of the Revenue Act of 1916, September 8, 1916, c. 463, Tit. I, 39 Stat. 756-759, as amended by the Revenue Act of 1917, October 3, 1917, c. 63, 40 Stat. 300, 329. The tax was assessed on the alleged gain from a sale in 1917 of oil mining properties which had been owned and operated by him for several years. The Commissioner of Internal Revenue determined that there was a gain on the sale of $26,904.15. Ludey insists that there was a loss of $14,777.33. The amount sued for is the tax assessed on the difference. Whether there was the gain or the loss depends primarily upon whether deductions for depletion and depreciation are to be made from the original cost in determining gain or loss on sale of oil mining properties. The question is one of statutory construction or application. The Court of Claims entered judgment for the plaintiff. 61 Ct.Cls. 126. This Court granted a writ of certiorari. 271 U.S. 651.

The properties consisted, besides mining equipment, in part of oil land held in fee, in part of oil mining leases. The aggregate original cost of the properties was $95,977.33. [Footnote 1] Of this amount, $30,977.33 was the cost of the

Page 274 U. S. 297

equipment used in the business; $65,000 the cost of the oil reserves. The 1917 sale price was $81,200. For the purpose of determining the cost of the properties sold in 1917 the Commissioner deducted from the original cost $10,465.16 on account of depreciation of the equipment through wear and tear, and $32,258.81 on account of depletion of the reserves through the taking out of oil by the plaintiff, after March 1, 1913. There was no dispute of fact concerning the correctness of the estimates upon which these deductions were made. The finding of the depletion was in accordance with the method of computation employed by the Bureau of Internal Revenue, and there was no objection specifically to the method of computation. But Ludey insisted that the amount of depletion, if any, could not be found or stated as a fact, since, in the nature of the case, it was impossible to determine how much oil was recoverable, either when he acquired the properties or when he disposed of them. The finding of the depreciation was, likewise, in accordance with the method of computation employed by the bureau, and there was no objection to the method of computation. But Ludey insisted also in respect to depreciation that the property was, as a matter of law, unchanged in character and quantity throughout the period of operation.

Until 1924, none of the revenue acts provided in terms that, in computing the gain from a sale of any property, a deduction shall be made from the original cost on account of depreciation and depletion during the period of operation. [Footnote 2] But ever since March 1, 1913, the revenue

Page 274 U. S. 298

acts have required that gains from sales made within the tax year shall be included in the taxable income of the year, and that losses on sales may be deducted from gross income. And each of the acts has provided that, in computing the taxable income derived from operating a mine, there may be made a deduction from the gross income for the

depreciation and that some deduction may be made for depletion. The applicable provisions of § 5(a) of the Revenue Act of 1916 concerning deductions to be allowed in computing net income are these:

"Fourth. Losses actually sustained during the year, incurred in his business or trade: . . . Provided, that . . . the . . . value of . . . property [acquired before March 1, 1913] as of March 1, 1913, shall be the basis for determining the amount of such loss. . . ."

"Seventh. A reasonable allowance for the exhaustion, wear and tear of property arising out of its use or employment in the business or trade. . . ."

"Eighth. (a) In the case of oil and gas wells, a reasonable allowance for actual reduction in flow and production; . . . (b) in the case of mines, a reasonable allowance for depletion thereof: . . . Provided, That when the allowances . . . shall equal the capital originally invested . . . , no further allowance shall be made."

Ludey does not deny that Congress has power to require that deductions for depreciation and depletion shall be made from the original cost when determining the cost of oil properties sold. His contention is that, at the time of the sale in question, Congress had not in terms required

Page 274 U. S. 299

the deductions in the case of any property, and that special reasons exist why the acts should be construed as not requiring the deductions in the case of oil wells. He urges that a corporation organized for the purpose of utilizing a wasting property, like an iron mine, is not deemed to have divided a part of its capital merely because it has distributed the net proceeds of its mining operations; that this is true even where the necessary result of the operation is a reduction of the mineral reserve; that, a fortiori, the proceeds of oil mining are to be deemed income, not a partial return of capital, since there is no ownership in oil until it is actually reduced to possession; that a purchase of an oil reserve cannot be likened to the purchase of a certain number of barrels of oil; that an oil reserve is not a reservoir; that Congress allowed the deduction from gross income for depreciation and depletion probably as a reward in an extra-hazardous enterprise in order to encourage new producing properties, and that to allow the deductions would result, in the event of a sale of the property, in taking back the rewards so offered.

The government contends that, in operating the properties, Ludey disposed, in the form of oil, of part of his capital assets; that, in the extraction of the oil, he consumed so much of the equipment as was represented by the depreciation, and disposed of so much of the oil reserves as was represented by the depletion; that the sale of the properties made by him in 1917 was not a sale of all of the property represented by the original cost of $95,977.33, since physical equipment to the amount of the depreciation and oil reserves to the amount of the depletion had been taken from it during the preceding years, and that, for this reason, the cost to plaintiff of the net property sold in 1917 was not $95,977.33, but $53,258.36.

The Court of Claims did not consider whether, ordinarily, deductions for depreciation and for depletion from the

Page 274 U. S. 300

original cost would be proper in determining whether there had been a profit on a sale of property. It held that no deduction from original cost should be made here, because of the nature of oil mining properties. The deduction for depletion was, in its opinion, wrong because oil properties are, in essence, merely the right to extract from controlled land such oil as the owner of the right can find and reduce to possession; because the existence of oil in any parcel of land is dependent upon the movement which the oil makes from time to time under the surface, and because whether there is oil in place which can be reduced to possession, and if so, how much, cannot be definitely determined. It held that, in the case at bar, the right to explore for and take out oil may actually have been more valuable at the time of the sale than at the time of the purchase, and that, for this reason, the removal of the oil by plaintiff during the years of operation cannot be said to have depleted the capital. It held that the depreciation was not deductible, because wear and tear of equipment was an expense or incident of the business.

We are of opinion that the revenue acts should be construed as requiring deductions for both depreciation and depletion when determining the original cost of oil properties sold. Congress, in providing that the basis for determining gain or loss should be the cost or the 1913 value, was not attempting to provide an exclusive formula for the computation. [Footnote 3] The depreciation charge permitted as a deduction from the gross income in determining the taxable income of a business for any year represents the reduction, during the year, of the capital assets through wear and tear of the plant used. The amount of the allowance for depreciation is the sum which should be

Page 274 U. S. 301

set aside for the taxable year, in order that, at the end of the useful life of the plant in the business, the aggregate of the sums set aside will (with the salvage value) suffice to provide an amount equal to the original cost. The theory underlying this allowance for depreciation is that, by using up the plant, a gradual sale is made of it. The depreciation charged is the measure of the cost of the part which has been sold. When the plant is disposed of after years of use, the thing then sold is not the whole thing originally acquired. The amount of the depreciation must be deducted from the original cost of the whole in order to determine the cost of that disposed of in the final sale of properties. [Footnote 4] Any other construction would permit a double deduction for the loss of the same capital assets.

Such being the rule applicable to manufacturing and mercantile businesses, no good reason appears why the business of mining should be treated differently. The reasons urged for refusing to apply the rule specifically to oil mining properties seem to us unsound. If the equipment had been used by its owner on the oil properties owned by another, it would hardly be contended that the depreciation through wear and tear resulting from its use should be ignored in determining, on a sale of the equipment, whether its owner had made a gain or a loss. The fact that the equipment sold is owned by

Page 274 U. S. 302

the person who owned the mining rights, like the fact that it is used in one class of mining, rather than in another, may have an important bearing both upon the price realized on the sale and upon the rate of depreciation which should be allowed, but these facts cannot affect the question whether the part which has been theretofore consumed by use shall be ignored in determining whether a sale of what remains has resulted in a loss or a gain.

The depletion charge permitted as a deduction from the gross income in determining the taxable income of mines for any year represents the reduction in the mineral contents of the reserves from which the product is taken. The reserves are recognized as wasting assets. The depletion effected by operation is likened to the using up of raw material in making the product of a manufacturing establishment. As the cost of the raw material must be deducted from the gross income before the net income can be determined, so the estimated cost of the part of the reserve used up is allowed. The fact that the reserve is hidden from sight presents difficulties in making an estimate of the amount of the deposits. The actual quantity can rarely be measured. It must be approximated. And because the quantity originally the reserve is not actually known, the percentage of the whole withdrawn in any year, and hence the appropriate depletion charge, is necessarily a rough estimate. But Congress concluded, in the light of experience, that it was better to act upon a rough estimate than to ignore the fact of depletion.

The Corporation Tax Law of 1909 had failed to provide for any deduction on account of the depletion of mineral reserves. Stratton's Independence v. Howbert,231 U. S. 339; Von Baumbach v. Sargent Land Co.,242 U. S. 503; United States v. Biwabik Mining Co.,247 U. S. 116; Goldfield Consolidated Mines Co. v. Scott, 247 U.S.

Page 274 U. S. 303

126. The resulting hardship to operators of mines induced Congress to make provision in the Revenue Law of 1913 and all later acts for some deduction on account of depletion in determining the amount of the taxable income from mines. [Footnote 5] It is not lightly to be assumed that Congress intended the fact to be ignored in determining whether there was a loss or a gain on a sale of the mining properties. The proviso limiting the amount of the deduction for depletion to the amount of the capital invested shows that the deduction is to be regarded as a return of capital, not as a special bonus for enterprise and willingness to assume risks. It is argued that, because oil is a fugacious mineral, it cannot be known that the reserve has been diminished by the operation of wells. Perhaps some land may be discovered which, like the widow's cruse, will afford an inexhaustible supply of oil. But the common experience of man has been that oil wells, and the territory in which they are sunk, become exhausted in time. Congress, in providing for the deduction for depletion of oil wells, acted on that experience. Compare Lynch v. Alworth-Stephens Co.,267 U. S. 364. In essence, the deduction for depletion does not differ from the deduction for depreciation.

The Court of Claims erred in holding that no deduction should be made from the original cost on account of depreciation and depletion, but it does not follow that the amount deducted by the Commissioner was the correct one. The aggregate for depreciation and depletion claimed by Ludey in the income tax returns for the years 1913, 1914, 1915, and 1916, and allowed, was only $5,156.

Page 274 U. S. 304

He insists that more cannot be deducted from the original cost in making the return for 1917. The contention is unsound. The amount of the gain on the sale is not dependent on the amount claimed in earlier years. If in any year he has failed to claim, or has been denied, the amount to which he was entitled, rectification of the error must be sought through a review of the action of the bureau for that year. He cannot choose the year in which he will take a reduction. On the other hand, we cannot accept the government's contention that the full amount of depreciation and depletion

sustained, whether allowable by law as a deduction from gross income in past years or not, must be deducted from cost in ascertaining gain or loss. Congress doubtless intended that the deduction to be made from the original cost should be the aggregate amount which the taxpayer was entitled to deduct in the several years.

The findings do not enable us to determine what that aggregate is. The sale included several properties purchased at different times. The deduction allowable in the several years for each of the properties is not found. Under the Act of 1913, the full amount of the depletion was not necessarily deductible. In order that the amount of the gain in 1917 may be determined in the light of such facts, the case is remanded for further proceedings in accordance with this opinion.

Reversed.

ROXAS v CTA

FACTS:

Don Pedro Roxas and Dona Carmen Ayala, Spanish subjects, transmitted to their grandchildren by hereditary succession agricultural lands in Batangas, a residential house and lot in Manila, and shares of stocks in different corporations. To manage the properties, said children, namely, Antonio, Eduardo and Jose Roxas formed a partnership called Roxas y Compania.

On June 1958, the CIR assessed deficiency income taxes against the Roxas Brothers for the years 1953 and 1955. Part of the deficiency income taxes resulted from the disallowance of deductions from gross income of various business expenses and contributions claimed by Roxas. (see expense items below)

The Roxas brothers protested the assessment but inasmuch as said protest was denied, they instituted an appeal in the CTA, which sustained the assessment except the demand for the payment of the fixed tax on dealer of securities and the disallowance of the deductions for contributions to the Philippine Air Force Chapel and Hijas de Jesus' Retiro de Manresa. Not satisfied, Roxas brothers appealed to the SC. The CIR did not appeal.

ISSUES/HELD: W/N the deductions for business expenses and contributions deductible

RATIO: With regard to the disallowed deductions (expenses for tickets to a banquet given in honor of Sergio Osmena and beer given as gifts to various persons, labelled as representation expenses), representation expenses are deductible from gross income as expenditures incurred in carrying on a trade or business under Section 30(a) of the Tax Code provided the taxpayer proves that they are reasonable in amount, ordinary and necessary, and incurred in connection with his business. In the case at bar, the evidence does not show such link between the expenses and the business of Roxas.

The petitioners also claim deductions for contributions to the Pasay City Police, Pasay City Firemen, and Baguio City Police Christmas funds, Manila Police Trust Fund, Philippines Herald's fund for Manila's neediest families and Our Lady of Fatima chapel at Far Eastern University. The contributions to the Christmas funds of the Pasay City Police, Pasay City Firemen and Baguio City Police are not deductible for the reason that the Christmas funds were not spent for public purposes but as Christmas gifts to the families of the members of said entities. Under Section 39(h), a contribution to a government entity is deductible when used exclusively for public purposes . For this reason, the disallowance must be sustained. On the other hand, the contribution to the Manila Police trust fund is an allowable deduction for said trust fund belongs to the Manila Police, a government entity, intended to be used exclusively for its public functions. The contributions to the Philippines Herald's fund for Manila's neediest families were disallowed on the ground that the Philippines Herald is not a corporation or an association contemplated in Section 30 (h) of the Tax Code. It should be noted however that the contributions were not made to the Philippines Herald but to a group of civic spirited citizens organized by the Philippines Herald solely for charitable purposes. There is no question that the members of this group of citizens do not receive profits, for all the funds they raised were for Manila's neediest families. Such a group of citizens may be classified as an association organized exclusively for charitable purposes mentioned in Section 30(h) of the Tax Code.

The contribution to Our Lady of Fatima chapel at the Far Eastern University should also be disallowed on the ground that the said university gives dividends to its stockholders. Located within the premises of the university, the chapel in question has not been shown to belong to the Catholic Church or any religious organization. It belongs to the Far Eastern University, contributions to which are not deductible under Section 30(h) of the Tax Code for the reason that the net income of said university injures to the benefit of its stockholders.

ATLAS CONSOLIDATED MINING v CIR

FACTS:

Atlas is a corporation engaged in the mining industry registered. On August 1962, CIR assessed against Atlas for deficiency income taxes for the years 1957 and 1958. For the year 1957, it was the opinion of the CIR that Atlas is not entitled to exemption from the income tax under RA 909 because same covers only gold mines. For the year 1958, the deficiency income tax covers the disallowance of items claimed by Atlas as deductible from gross income. Atlas protested for reconsideration and cancellation, thus the CIR conducted a reinvestigation of the case.

On October 1962, the Secretary of Finance ruled that the exemption provided in RA 909 embraces all new mines and old mines whether gold or other minerals. Accordingly, the CIR recomputed Atlas deficiency income tax liabilities in the light of said ruling. On June 1964, the CIR issued a revised assessment entirely eliminating the assessment for the year 1957. The assessment for 1958 was reduced from which Atlas appealed to the CTA, assailing the disallowance of the following items claimed as deductible from its gross income for 1958: Transfer agent's fee, Stockholders relation service fee, U.S. stock listing expenses, Suit expenses, and Provision for contingencies. The CTA allowed said items as deduction except those denominated by Atlas as stockholders relation service fee and suit expenses.

Both parties appealed the CTA decision to the SC by way of two (2) separate petitions for review. Atlas appealed only the disallowance of the deduction from gross income of the so-called stockholders relation service fee.

ISSUE/HELD: W/N the ‘annual public relations expense’ (aka stockholders relation service fee) paid to a public relations consultant is a deductible expense from gross income

RATIO: Section 30 (a) (1) of the Tax Code allows a deduction of "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." An item of expenditure, in order to be deductible under this section of the statute, must fall squarely within its language. To be deductible as a business expense, three conditions are imposed, namely: (1) the expense must be ordinary and necessary, (2) it must be paid or incurred within the taxable year, and (3) it must be paid or incurred in carrying in a trade or business. In addition, not only must the taxpayer meet the business test, he must substantially prove by evidence or records the deductions claimed under the law, otherwise, the same will be disallowed. The mere allegation of the taxpayer that an item of expense is ordinary and necessary does not justify its deduction.

The SC has never attempted to define with precision the terms "ordinary and necessary." As a guiding principle, ordinarily, an expense will be considered "necessary" where the expenditure is appropriate and helpful in the development of the taxpayer's business. It is "ordinary" when it connotes a payment which is normal in relation to the business of the taxpayer and the surrounding circumstances. The term "ordinary" does not require that the payments be habitual or normal in the sense that the same taxpayer will have to make them often; the payment may be unique or non-recurring to the particular taxpayer affected.

There is thus no hard and fast rule on the matter. The right to a deduction depends in each case on the particular facts and the relation of the payment to the type of business in which the taxpayer is engaged. The intention of the taxpayer often may be the controlling fact in making the determination. Assuming that the expenditure is ordinary and necessary in the operation of the taxpayer's business, the answer to the question as to whether the expenditure is an allowable deduction as a business expense must be determined from the nature of the expenditure itself, which in turn depends on the extent and permanency of the work accomplished by the expenditure.

It appears that on December 1957, Atlas increased its capital stock. It claimed that its shares of stock were sold in the United States because of the services rendered by the public relations firm. The information about Atlas given out and played up in the mass communication media resulted in full subscription of the additional shares issued by Atlas; consequently, the ‘stockholders relation service fee’, the compensation for services carrying on the selling campaign, was in effect spent for the acquisition of additional capital, ergo, a capital expenditure, and not an ordinary expense. It is not deductible from Atlas gross income in 1958 because expenses relating to recapitalization and reorganization of the corporation, the cost of obtaining stock subscription, promotion expenses, and commission or fees paid for the sale of stock reorganization are capital expenditures. That the expense in question was incurred to create a favorable image of the corporation in order to gain or maintain the public's and its stockholders' patronage, does not make it deductible as business expense. As held in a US case,efforts to establish reputation are akin to acquisition of capital assets and, therefore, expenses related thereto are not business expense but capital expenditures.

Note: The burden of proof that the expenses incurred are ordinary and necessary is on the taxpayer and does not rest upon the Government. To avail of the claimed deduction, it is incumbent upon the taxpayer to adduce substantial evidence to establish a reasonably proximate relation petition between the expenses to the ordinary conduct of the business of the taxpayer. A logical link or nexus between the expense and the taxpayer's business must be established by the taxpayer.

Gancayo vs. CIR, SUPRA