tax law review digests

8/12/2019 Tax Law Review Digests

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TAX LAW REVIEW DIGESTSMonteroAlcisso, Arriola, Cajucom, Calalang, Claudio, Escueta, Delos Santos, Dialino, Fajardo, Imperial, Juaquino, Martin, Martinez,

Mendoza, Noel, Pangcog, Plazo Raso, Rosales, Sia, Uy, Venzuela

Q. DEDUCTION

In general

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 withholdingtax, 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 YES

The requisites for deductibility of ordinary and necessary trade, business or professionalexpenses, 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 taxpayers 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


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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 doesnot 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 theirobligation. 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 GENERAL FOODS

AGUINALDO INDUSTRIES v CIR

FACTS:

Aguinaldo Industries Corporation (AIC) is a domestic corporation engaged in themanufacture of fishing nets, a tax-exempt industry and the manufacture of furniture.For accounting purposes, each division is provided with separate books of accounts.Previously, AIC acquired a parcel of land in Muntinlupa, Rizal, as site of the fishing netfactory. Later, it sold the Muntinlupa property. AIC derived profit from this sale which

was entered in the books of the Fish Nets Division as miscellaneous income todistinguish it from its tax-exempt income.

For the year 1957, AIC filed two separate income tax returns for each division. Afterinvestigation, the examiners of the BIR found that the Fish Nets Division deducted fromits gross income for that year the amount of P61,187.48 as additional remuneration paidto the officers of AIC. This amount was taken from the net profit of an isolatedtransaction (sale of Muntinlupa land) not in the course of or carrying on of AIC's trade


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or business, and was reported as part of the selling expenses of the Muntinlupa land.Upon recommendation of the examiner that the said sum of P61,187.48 be disallowed asdeduction from gross income, petitioner asserted in its letter of February 19, 1958, thatsaid amount should be allowed as deduction because it was paid to its officers asallowance or bonus pursuant to its by-laws.

ISSUE/HELD: W/N the bonus given to the officers of the petitioner upon the sale ofits Muntinlupa land is an ordinary and necessary business expense deductible forincome tax purposes - NO

RATIO: Sec. 30 (a) (1) of the Tax Code provides that in computing net income, thereshall be allowed as deductions Expenses, including all the ordinary and necessaryexpenses paid or incurred during the taxable year in carrying on any trade or business,including a reasonable allowance for personal services actually rendered.

The bonus given to the officers of the petitioner as their share of the profit realized fromthe sale of petitioner's Muntinglupa land cannot be deemed a deductible expense for taxpurposes, even if the aforesaid sale could be considered as a transaction for carrying onthe trade or business of the petitioner and the grant of the bonus to the corporateofficers pursuant to petitioner's by-laws could, as an intra-corporate matter, besustained. The records show that the sale was effected through a broker who was paid bypetitioner a commission of P51,723.72 for his services. On the other hand, there isabsolutely no evidence of any service actually rendered by petitioner's officers whichcould be the basis of a grant to them of a bonus out of the profit derived from the sale.This being so, the payment of a bonus to them out of the gain realized from the salecannot be considered as a selling expense; nor can it be deemed reasonable andnecessary so as to make it deductible for tax purposes. The extraordinary and unusualamounts paid by petitioner to these directors in the guise and form of compensation for

their supposed services as such, without any relation to the measure of their actualservices, cannot be regarded as ordinary and necessary expenseswithin the meaningof the law. This is in line with the doctrine in the law of taxation that the taxpayer mustshow that its claimed deductions clearly come within the language of the law sinceallowances, like exemptions, are matters of legislative grace.

ATLAS CONSOLIDATED MINING v CIR

FACTS:

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


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from gross income. Atlas protested for reconsideration and cancellation, thus the CIRconducted a reinvestigation of the case.

On October 1962, the Secretary of Finance ruled that the exemption provided in RA 909embraces 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. OnJune 1964, the CIR issued a revised assessment entirely eliminating the assessment forthe year 1957. The assessment for 1958 was reduced from which Atlas appealed to theCTA, assailing the disallowance of the following items claimed as deductible from itsgross income for 1958: Transfer agent's fee, Stockholders relation service fee, U.S. stocklisting expenses, Suit expenses, and Provision for contingencies. The CTA allowed saiditems as deduction except those denominated by Atlas as stockholders relation servicefee and suit expenses.

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

ISSUE/HELD: W/N the annual public relations expense (aka stockholders relationservice fee) paid to a public relations consultant is a deductible expense from grossincome

RATIO: Section 30 (a) (1) of the Tax Code allows a deduction of "all the ordinary andnecessary expenses paid or incurred during the taxable year in carrying on any trade orbusiness." An item of expenditure, in order to be deductible under this section of thestatute, 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 meetthe business test, he must substantially prove by evidence or records the deductionsclaimed under the law, otherwise, the same will be disallowed. The mere allegation ofthe taxpayer that an item of expense is ordinary and necessary does not justify itsdeduction.

The SC has never attempted to define with precision the terms "ordinary andnecessary." As a guiding principle, ordinarily, an expense will be considered "necessary"where the expenditure is appropriate and helpful in the development of the taxpayer'sbusiness. It is "ordinary" when it connotes a payment which is normal in relation to thebusiness 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 taxpayerwill have to make them often; the payment may be unique or non-recurring to theparticular taxpayer affected.

There is thus no hard and fast rule on the matter. The right to a deduction depends ineach case on the particular facts and the relation of the payment to the type of businessin which the taxpayer is engaged. The intention of the taxpayer often may be thecontrolling fact in making the determination. Assuming that the expenditure is ordinary


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and necessary in the operation of the taxpayer's business, the answer to the question asto whether the expenditure is an allowable deduction as a business expense must bedetermined from the nature of the expenditure itself, which in turn depends on theextent and permanency of the work accomplished by the expenditure.

It appears that on December 1957, Atlas increased its capital stock. It claimed that itsshares of stock were sold in the United States because of the services rendered by thepublic relations firm. The information about Atlas given out and played up in the masscommunication media resulted in full subscription of the additional shares issued byAtlas; consequently, the stockholders relation service fee, the compensation for servicescarrying on the selling campaign, was in effect spent for the acquisition of additionalcapital, ergo, a capital expenditure, and not an ordinary expense. It is not deductiblefrom Atlas gross income in 1958 because expenses relating to recapitalization andreorganization of the corporation, the cost of obtaining stock subscription, promotionexpenses, and commission or fees paid for the sale of stock reorganization are capitalexpenditures. That the expense in question was incurred to create a favorable image ofthe 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 toestablish reputation are akin to acquisition of capital assets and, therefore, expensesrelated thereto are not business expense but capital expenditures.

Note: The burden of proof that the expenses incurred are ordinary and necessary is onthe 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 areasonably proximate relation petition between the expenses to the ordinary conduct ofthe business of the taxpayer. A logical link or nexus between the expense and thetaxpayer's business must be established by the taxpayer.

ROXAS v CTA

FACTS:

Don Pedro Roxas and Dona Carmen Ayala, Spanish subjects, transmitted to theirgrandchildren by hereditary succession agricultural lands in Batangas, a residentialhouse and lot in Manila, and shares of stocks in different corporations. To manage theproperties, said children, namely, Antonio, Eduardo and Jose Roxas formed apartnership called Roxas y Compania.

On June 1958, the CIR assessed deficiency income taxes against the Roxas Brothers forthe years 1953 and 1955. Part of the deficiency income taxes resulted from thedisallowance of deductions from gross income of various business expenses andcontributions 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


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for the payment of the fixed tax on dealer of securities and the disallowance of thedeductions 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 notappeal.

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

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

The petitioners also claim deductions for contributions to the Pasay City Police, PasayCity 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 chapelat Far Eastern University. The contributions to the Christmas funds of the Pasay CityPolice, Pasay City Firemen and Baguio City Police are not deductible for the reason thatthe Christmas funds were not spent for public purposesbut as Christmas gifts to thefamilies of the members of said entities. Under Section 39(h), a contribution to agovernment entity is deductible when used exclusively for public purposes. For thisreason, the disallowance must be sustained. On the other hand, the contribution to theManila Police trust fund is an allowable deduction for said trust fund belongs to theManila Police, a government entity, intended to be used exclusively for its publicfunctions. 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 corporationor an association contemplated in Section 30 (h) of the Tax Code. It should be notedhowever that the contributions were not made to the Philippines Herald but to a groupof civic spirited citizens organized by the Philippines Herald solely for charitablepurposes. There is no question that the members of this group of citizens do not receiveprofits, for all the funds they raised were for Manila's neediest families. Such a group ofcitizens may be classified as an association organized exclusively for charitable purposesmentioned in Section 30(h) of the Tax Code.

The contribution to Our Lady of Fatima chapel at the Far Eastern University should alsobe 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 beenshown to belong to the Catholic Church or any religious organization. It belongs to theFar Eastern University, contributions to which are not deductible under Section 30(h) ofthe Tax Code for the reason that the net income of said university injures to the benefitof its stockholders.


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ZAMORA v CIR

FACTS:

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 derivedfrom the sale of certain real properties and claimed deductions which were notallowable. The collector required him to pay deficiency income tax. On appeal byZamora, the CTA reduced the amount of deficiency income tax.

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

Zamora alleged that the CTA erred in disallowing P10,478.50 as promotion expensesincurred by his wife for the promotion of the Bay View Hotel and Farmacia Zamora. Hecontends that the whole amount of P20,957.00 as promotion expenses, should beallowed and not merely one-half of it, on the ground that, while not all the itemizedexpenses are supported by receipts, the absence of some supporting receipts has beensufficiently 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 beallowed as deductions all the ordinary and necessary expenses paid or incurred duringthe taxable year, in carrying on any trade or business. Since promotion expensesconstitute one of the deductions in conducting a business, same must satisfy these

requirements. Claim for the deduction of promotion expenses or entertainmentexpenses must also be substantiated or supported by record showing in detail theamount and nature of the expenses incurred.

Considering, as heretofore stated, that the application of Mrs. Zamora for dollarallocation shows that she went abroad on a combined medical and business trip, not allof her expenses came under the category of ordinary and necessary expenses; partthereof constituted her personal expenses. There having been no means by which toascertain which expense was incurred by her in connection with the business of MarianoZamora and which was incurred for her personal benefit, the Collector and the CTA intheir 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 toMariano Zamora, there having been no receipt whatsoever, submitted to explain thealleged business expenses, or proof of the connection which said expenses had to thebusiness 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 thatrepresentation expenses fall under the category of business expenses whichare allowable deductions from gross income, if they meet the conditions


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prescribed by law, particularly section 30 (a) [1], of the Tax Code; that to bedeductible, said business expenses must be ordinary and necessaryexpenses paid or incurred in carrying on any trade or business; that thoseexpenses must also meet the further test of reasonableness in amount. Theyshould also be covered by supporting papers; in the absence thereof the

amount properly deductible as representation expenses should bedetermined from available data.

Expenses

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 endingSeptember 30, 1957 showing a net income of P92,540.25 and a tax liability due thereonof 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 anincome tax deficiency in the amount of P28,054.00 plus interests. The Court of TaxAppeals upon reviewing the assessment at the taxpayer's petition, upheld respondent'sdisallowance of the principal item of petitioner's having paid to Mr. C. M. Hoskins, itsfounder and controlling stockholder the amount of P99,977.91 representing 50% ofsupervision 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 paymentto Hoskins was an inordinately large one, which bore a close relationship to therecipient's dominant stockholdings and therefore amounted in law to a distribution ofits earnings and profits.

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

Ruling: NO.

Ratio:

Hoskin owns 99.6% of the CM Hoskins & Co. He was also the President and Chairmanof the Board. That as chairman of the Board of Directors, he received a salary ofP3,750.00 a month, plus a salary bonus of about P40,000.00 a year and an amountingto 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,


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the Tax Court correctly ruled that the payment by petitioner to Hoskins of the additionalsum of P99,977.91 as his equal or 50% share of the 8% supervision fees received bypetitioner as managing agents of the real estate, subdivision projects of Paradise Farms,Inc. and Realty Investments, Inc. was inordinately large and could not beaccorded 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 boardof directors, since "Hoskins had personally conceived and planned the project" cannotchange the picture. There could be no question that as Chairman of the board andpractically an absolutely controlling stockholder of petitioner, Hoskins wieldedtremendous power and influence in the formulation and making of the company'spolicies and decisions. Even just as board chairman, going by petitioner's ownenumeration of the powers of the office, Hoskins, could exercise great power andinfluence within the corporation, such as directing the policy of the corporation,delegating powers to the president and advising the corporation in determiningexecutive salaries, bonus plans and pensions, dividend policies, etc.

It is a general rule that 'Bonuses to employees made in good faith and as additionalcompensation for the services actually rendered by the employees are deductible,provided such payments, when added to the stipulated salaries, do not exceed areasonable compensation for the services rendered. The conditions precedent to thededuction of bonuses to employees are: (1) the payment of the bonuses is in factcompensation; (2) it must be for personal services actually rendered; and (3) thebonuses, when added to the salaries, are 'reasonable when measured by the amount andquality 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 andquality of the services performed with relation to the business.' Other tests suggestedare: payment must be 'made in good faith'; 'the character of the taxpayer's business, thevolume and amount of its net earnings, its locality, the type and extent of the servicesrendered, the salary policy of the corporation'; 'the size of the particular business'; 'theemployees' qualifications and contributions to the business venture'; and 'generaleconomic conditions. However, 'in determining whether the particular salary orcompensation 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 seldomhappens that the application of one test can give satisfactory answer, and that ordinarilyit 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 respondentCommissioner to fix the compensation of its officers and employees, we there heldfurther that while the employer's right may be conceded, the question of the allowanceor disallowance thereof as deductible expenses for income tax purposes is subject todetermination by CIR. As far as petitioner's contention that as employer it has the rightto fix the compensation of its officers and employees and that it was in the exercise of


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such right that it deemed proper to pay the bonuses in question, all that We need say isthis: that right may be conceded, but for income tax purposes the employer cannotlegally claim such bonuses as deductible expenses unless they are shown to bereasonable. 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 asdeductible expenses the amounts paid to corporate officers by way of bonus isdetermined by respondent exclusively for income tax purposes. Concededly, he has noauthority to fix the amounts to be paid to corporate officers by way of basic salary, bonusor additional remuneration a matter that lies more or less exclusively within thesound 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 taxeslegitimately due to the State."

CALANOC v CIR

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 insuranceand lumber; and in some exports. When Petitioner filed its Income Tax Return, itdeducted 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; and3. 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 byallowing as deductible all items comprising directors' fees and salaries of the non-resident president and vice-president, but disallowing the bonuses insofar as theyexceed the salaries of the recipients, as well as the interests on earned but unpaidsalaries 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 employeesare quite excessive.

ISSUES/RULING:

W/N the CTA erred in ruling that the measure of the reasonableness of thebonuses paid to its non-resident president and vice-president should be applied


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to the bonuses given to resident officers and employees in determining theirdeductibility? NO.

It is a general rule that "Bonuses to employees made in good faith and as additionalcompensation for the services actually rendered by the employees are deductible,

provided such payments, when added to the stipulated salaries, do not exceed areasonable compensation for the services rendered. The condition precedents to thededuction of bonuses to employees are:

1. the payment of the bonuses is in fact compensation;2. it must be for personal services actually rendered; and3. 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 theparticular taxpayer

There is no fixed test for determining the reasonablenessof a given bonus ascompensation. However, in determining whether the particular salary or compensationpayment is reasonable, the situation must be considered as a whole.

Petitioner contended that it is error to apply the same measure of reasonableness toboth resident and non-resident officers because the nature, extent and quality of theservices 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 serviceand contribution to deserve equal treatment in compensation and other emoluments.There is no special reason for granting greater bonuses to such lower ranking officersthan 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 theyearly salaries of the employees? NO.

The deductible amount of said bonuses cannot be only equalto their respective yearlysalaries considering the post-war policy of the corporation in giving salaries at low levelsbecause of the unsettled conditions resulting from war and the imposition ofgovernment controls on imports and exports and on the use of foreign exchange whichresulted in the diminution of the amount of business and the consequent loss of profitson the part of the corporation. The payment of bonuses in amounts a little more thanthe yearly salaries received considering the prevailing circumstances is in our opinionreasonable.

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

Under the law, in order that interest may be deductible, it must be paid "onindebtedness." It is therefore imperative to show that there is an existingindebtednesswhich may be subjected to the payment of interest. Here the itemsinvolved are unclaimed salaries and bonus participation which cannot constituteindebtedness within the meaning of the law because while they constitute an obligation


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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 isthe concern of the employee to collect it in due time. The willingness of the corporationto pay interest thereon cannot be considered a justification to warrant deduction.

Interest

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).1Thus, the general rule is that interest expenses are

1Sec. 30. Deduction from Gross Income. The following may be deducted from gross income:

xxx xxx xxx

(b) Interest:

(1) In general. The amount ofinterest paidwithin the taxable year onindebtedness, 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)


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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. 79.2However, 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 incurredorpaid) 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 taxpayerwho 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 CIRs 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 TaxRegulations, which paragraph reads as follows:

(B) Taxes and Carrying Charges. The items thus chargeable to capitalaccounts are

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

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

The truncated excerpt of the U.S. Income Tax Regulations quoted by the CIR needs to berelated to the relevant provisions of the U.S. Internal Revenue Code, which provisionsdeal with the general topic of adjusted basis for determining allowable gain or loss on

2Sec. 79. Interest on Capital.Interest calculated for cost-keeping or other purposeson account of capital or surplus invested

in the business, which does not represent a charge arising under an interest-bearing obligation, is no tallowable deduction from

gross income. (Emphases supplied)


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sales or exchanges of property and allowable depreciation and depletion of capital assetsof the taxpayer:

Present Rule. The Internal Revenue Code, and the Regulationspromulgated thereunder provide that "No deduction shall be allowed for

amounts paid or accruedfor such taxes and carrying charges as, underregulations prescribed by the Secretary or his delegate, are chargeable tocapital account with respect to property, if the taxpayer elects, inaccordance with such regulations, to treat such taxes orcharges as sochargeable."

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

The "carrying charges" which may be capitalized under the above quotedprovisions 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 ownfunds)." What the CIR failed to point out is that such"carrying charges" may, atthe election of the taxpayer, either be (a) capitalized in which case the cost basisof the capital assets, e.g., machinery and equipment, will be adjusted by addingthe amount of such interest payments oralternatively, be (b) deducted fromgross income of the taxpayer. Should the taxpayer elect to deduct the interest

payments against its gross income, the taxpayer cannot at the sametimecapitalize the interest payments. In other words, the taxpayer is notentitledto both the deduction from gross income and the adjusted (increased) basisfordetermining gain or loss and the allowable depreciation charge. The U.S. InternalRevenue Code does not prohibit the deduction of interest on a loan obtained forpurchasing machinery and equipment against gross income, unlessthe taxpayerhas also or previously capitalized the same interest paymentsand therebyadjusted the cost basis of such assets.

CIR v VDA DE PRIETO

FACTS:

On December 4, 1945, the respondent conveyed by way of gifts to her four children,namely, Antonio, Benito, Carmen and Mauro, all surnamed Prieto, real property with atotal assessed value of P892,497.50. After the filing of the gift tax returns on or aboutFebruary 1, 1954, the petitioner Commissioner of Internal Revenue appraised the realproperty donated for gift tax purposes at P1,231,268.00, and assessed the total sum of


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P117,706.50 as donor's gift tax, interest and compromises due thereon. Of the total sumof P117,706.50 paid by respondent on April 29, 1954, the sum of P55,978.65 representsthe total interest on account of deliquency. This sum of P55,978.65 was claimed asdeduction, among others, by respondent in her 1954 income tax return. Petitioner,however, disallowed the claim and as a consequence of such disallowance assessed

respondent for 1954 the total sum of P21,410.38 as deficiency income tax due on theaforesaid P55,978.65, including interest up to March 31, 1957, surcharge andcompromise for the late payment.

Under the law, for interest to be deductible, it must be shown that there be anindebtedness, that there should be interest upon it, and that what is claimed as aninterest deduction should have been paid or accrued within the year. It is here concededthat the interest paid by respondent was in consequence of the late payment of herdonor's tax, and the same was paid within the year it is sought to be declared.

To sustain the proposition that the interest payment in question is not deductible for thepurpose of computing respondent's net income, petitioner relies heavily on section 80 ofRevenue Regulation No. 2 (known as Income Tax Regulation) promulgated by theDepartment of Finance, which provides that "the word `taxes' means taxes proper andno deductions should be allowed for amounts representing interest, surcharge, orpenalties incident to delinquency." The court below, however, held section 80 asinapplicable to the instant case because while it implements sections 30(c) of the TaxCode governing deduction of taxes, the respondent taxpayer seeks to come undersection 30(b) of the same Code providing for deduction of interest on indebtedness.

ISSUE:

Whether or not such interest was paid upon an indebtedness within the contemplation

of section 30 (b) (1) of the Tax Code?

RULING:

Yes. According to the Supreme Court, although interest payment for delinquent taxes isnot deductible as tax under Section 30(c) of the Tax Code and section 80 of the IncomeTax Regulations, the taxpayer is not precluded thereby from claiming said interestpayment as deduction under section 30(b) of the same Code.

SEC. 30Deductions from gross income. In computing net income there shall beallowed as deductions

(b) Interest:

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


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The term "indebtedness" as used in the Tax Code of the United States containingsimilar provisions as in the above-quoted section has been defined as an unconditionaland legally enforceable obligation for the payment of money.

To give to the quoted portion of section 80 of our Income Tax Regulations the meaning

that the petitioner gives it would run counter to the provision of section 30(b) of the TaxCode and the construction given to it by courts in the United States. Such effect wouldthus make the regulation invalid for a "regulation which operates to create a rule out ofharmony with the statute, is a mere nullity." As already stated, section 80 implementsonly section 30(c) of the Tax Code, or the provision allowing deduction of taxes, whileherein respondent seeks to be allowed deduction under section 30(b), which providesfor deduction of interest on indebtedness.

BIR RULING NO 006-00

Taxes

CIR v LEDNICKY

Losses

PAPER INDUSTRIES v CA ( Dec. 1, 1995)

The Paper Industries Corporation of the Philippines ("Picop"), is a Philippinecorporation registered with the Board of Investments ("BOI") as a preferred

pioneer enterprise with respect to its integrated pulp and paper mill, and as apreferred non-pioneerenterprise with respect to its integrated plywood andveneer mills.

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

Picop also issued promissory notes of about P230M, on w/c it paid P45M ininterest.

In its 1977 Income Tax Return, Picop claimed the interest payments on the loansas DEDUCTIONS from its 1977 gross income.

The CIR disallowed this deduction upon the ground that, because the loans hadbeen incurred for the purchase of machinery and equipment, the interest

payments on those loans should have been capitalized instead and claimed as adepreciation deductiontaking into account the adjusted basis of themachinery and equipment (original acquisition cost plus interest charges) overthe useful life of such assets.

I: W/n the interest payments can be deducted from gross income YEStransaction tax

R:


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The 1977 NIRC does not prohibit the deduction of interest on a loan incurred foracquiring machinery and equipment. Neither does our 1977 NIRC compel thecapitalization of interest payments on such a loan.

The 1977 Tax Code is simply silent on a taxpayer's right to elect one or the othertax treatment of such interest payments. Accordingly, the general rule that

interest payments on a legally demandable loan are deductible from gross incomemust 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 registeredoperations of Picop, i.e., the financing of the purchase of machinery andequipment actually used in the registered operations of Picop. Neither does theCIR deny that such interest payments were legally due and demandable underthe 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 anyother Statute that requires the disallowance of the interest payments made byPicop.

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 orsurplus invested in the business, which does not represent a charge arisingunder an interest-bearing obligation, is notallowable deduction from grossincome.

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 ChargesChargeable to Capital Account and Treated as Capital Items" of the U.S. IncomeTax 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 assetsof the taxpayer:

Present Rule. The Internal Revenue Code, and the Regulations

promulgated thereunder provide that "No deduction shall be allowed for

amounts paidor accruedforsuch taxes and carrying charges as, under

regulations prescribed by the Secretary or his delegate, are chargeable to


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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 ownfunds)." 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 oralternatively, 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 notentitled to

both the deduction from gross income and the adjusted (increased) basisfor

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 forpurchasing machinery and equipment against gross income, unlessthe taxpayer

has also or previously capitalized the same interest paymentsand thereby

adjusted the cost basis of such assets.

BIR RULING 30-00

Digest of BIR Ruling No. 030-2000 dated August 10, 2000

INCOME TAX; Tax-free merger under certain condition - Pursuant to Section

40(c)(2)

of the Tax Code, no gain or loss shall be recognized by Blue Circle Philippines, Inc.

(BCPI), Round Royal, Inc. (RRI), SM Investment Corporation (SMIC), Sysmart


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Corporation and CG&E Holdings on the transfer of their Fortune, Zeus and Iligan shares

to Republic, in exchange for ne Republic shares, because they together hold more than

51% of the total voting stock of Republic after the transfer. The transfer through the

facilities of the PSE by the 6th to the last transferor of their Fortune and Zeus shares to

Republic in exchange for new Republic shares will be subject to the of 1% stock

transaction tax based on the gross selling price or gross value in money of the shares

transferred, while the 6th to the last transferor of the Iligan shares will be subject to

capital gains tax (CGT) at the rate of 5%, of the par value of the shares transferred. The

new Republic shares to be issued, being original issuances, are subject to the DST

imposed under Section 175 of the Tax Code at the rate of P2 on each P200, or fractional

part thereof, of the par value of

the new Republic shares issued. The net operating losses of each of Republic, Fortune,

MPCC and Iligan are preserved after the proposed share swap and may be carried over

and claimed as a deduction from their respective gross income, pursuant to Section

34(D)(3) of the Tax Code, because there is no substantial change in the either Republicor Fortune or MPCC or Iligan."

BIR RULING 206-90

This is letter requesting in behalf of Porcelana Mariwasa, Inc. (PMI), a ruling confirming

an opinion that the foreign exchange loss incurred by PMI is a deductible loss in 1990.

It is represented that PMI is a corporation established and organized under Philippine

laws; that it has existing US dollar loans from Noritake Company, Limited (Noritake)and Toyota Tsusho Corporation (Toyota) in the aggregate amounts of US $7,636,679.17

and US $3,054,671.27, respectively, that in 1989, the parties agreed to convert the said

dollar denominated loans into pesos at the exchange rate prevailing on June 30, 1989;

that in December 1989, both agreements were approved by the Central Bank subject to

the submission of a copy each of the signed agreements incorporating the conversion;

thereafter, drafts of the amended agreements were submitted to the Central Bank for

pre-approval; that on January 29, 1990, the Central Bank advised PMI's counsel on their

findings and comments on the said drafts which were considered and incorporated in

the final amended agreements; that in June 1990, the parties submitted to the Central

Bank the signed agreements; that counsel of PMI is of the opinion that in the case of

PMI, the resultant loss on conversion of US dollar denominated loans to peso is more

than a shrinkage in value of money; that the approval by the Central Bank and the

signing by the parties of the agreements covering the said conversion established the

loss, after which, the loss became final and irrevocable, so that recoupment is

reasonably impossible; and that having been fixed and determinable, the loss is no


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longer susceptible to change, hence, it could fairly be stated that such has been

sustained in a closed and completed transaction.

In reply the commissioner informed PMI that the annual increase in value of an asset is

not taxable income because such increase has not yet been realized. The increase in

value i.e., the gain, could only be taxed when a disposition of the property occurredwhich was of such a nature as to constitute a realization of such gain, that is, a severance

of the gain from the original capital invested in the property. The same conclusion

obtains as to losses. The annual decline in the value of property is not normally

allowable as a deduction. Hence, to be allowable the loss must be realized.

When foreign currency acquired in connection with a transaction in the regular course

of business is disposed ordinary gain or loss results from the fluctuation. The loss is

deductible only for the year it is actually sustained. It is sustained during the year in

which the loss occurs as evidenced by the completed transaction and as fixed by

identifiable occurring in that year. No taxation event has as yet been consummated priorto the remittance of the scheduled amortization. Accordingly, PMI's request for

confirmation of opinion was denied considering that foreign exchange losses sustained

as a result of conversion or devaluation of the peso vis-a-vis the foreign currency or US

dollar and vice versa but which remittance of scheduled amortization consisting of

principal and interests payment on a foreign loan had not actually been made are not

deductible from gross income for income tax purposes.

BIR RULING 144-85

(Technically, this ruling has no stated facts. It just said that a request for ruling dated

July 1, 1985 was sent to the BIR for the purpose of clarifying the issue, as herein stated.)

FACTS:

Request to clarify the deductibility of foreign exchange losses incurred by reason of the

devaluation of the peso. The losses arose from matured but unremitted principal

repayments on loans affected by the debt-restructuring program in the Philippines.

ISSUE:

Whether or not foreign exchange losses are deductible for income tax purposes.

HELD: NO.


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The annual increase in value of an asset is NOT TAXABLE INCOME because such

increase has not yet been realized. The increase in value, i.e., the gain, could only be

taxed when a disposition of the property occurred which was of such a nature as to

constitute a realization of such gain, that is, a severance of the gain from the original

capital invested in the property. The aforementioned rule also applies to losses. The

annual decrease in the value of property is not normally allowable as a loss. Hence, to be

allowable the loss must be realized.

When foreign currency acquired in connection with a transaction in the regular course

of business is disposed of, ordinary gain or loss results from the foreign exchange

fluctuations. THE LOSS IS DEDUCTIBLE ONLY FOR THE YEAR IT IS ACTUALLY

SUSTAINED. Thus, there is no taxable event prior to the remittance of the scheduled

amortization.

Accordingly, foreign exchange losses sustained as a result of devaluation of the peso vis-

a-vis the foreign currency e.g., US dollar, but which remittance of scheduled

amortization consisting of principal and interests payments on a foreign loan has not

actually been made are NOT DEDUCTIBLE from gross income for income tax purposes.

NOTE:

To sustain a loss means that the loss has occurred as evidenced by a closed andcompleted transaction and as fixed by identifiable events occurring in that year.

A closed transaction is a taxable event which has been consummated.

Bad debts

PHILEX MINING v CIR

Facts: Philex Mining entered into a management agreement with Baguio Gold. The

parties' agreement was denominated as "Power of Attorney" which provided amongothers:

a. Funds available for Philex Mining during the management agreement; and

b. Compensation to Philex Mining which shall be fifty per cent (50%) of the net

profit;


22/42

In the course of managing and operating the project, Philex Mining made

advances of cash and property in accordance with the agreement. However, the mine

suffered continuing losses over the years which resulted to petitioner's withdrawal as

manager and cessation of mine operations.

The parties executed a "Compromise with Dation in Payment" wherein BaguioGold admitted an indebtedness to Philex Mining, which was subsequently amended to

include additional obligations.

Subsequently, Philex Mining wrote off in its 1982 books of account the remaining

outstanding indebtedness of Baguio Gold by charging P112,136,000.00 to allowances

and reserves that were set up in 1981 and P2,860,768.00 to the 1982 operations.

In its 1982 annual income tax return, Philex Mining deducted from its gross

income the amount of P112,136,000.00 as "loss on settlement of receivables from

Baguio Gold against reserves and allowances." However, BIR disallowed the amount as

deduction for bad debt and assessed petitioner a deficiency income tax of

P62,811,161.39.

Issue: Whether the deduction for bad debts was valid?

Held: No. For a deduction for bad debts to be allowed, all requisites must be satisfied,

to wit: (a) there was a valid and existing debt; (b) the debt was ascertained to be

worthless; and (c) it was charged off within the taxable year when it was determined to

be worthless.

There was no valid and existing debt. The nature of agreement between PhilexMining and Baguio Gold is that of a partnership or joint venture. Under a contract of

partnership, two or more persons bind themselves to contribute money, property, or

industry to a common fund, with the intention of dividing the profits among themselves.

Perusal of the agreement denominated as the "Power of Attorney" indicates that

the parties had intended to create a partnership and establish a common fund for the

purpose. They also had a joint interest in the profits of the business as shown by a 50-

50 sharing in the income of the mine.

Viewed from this light, the advances can be characterized as petitioners

investment in a partnership with Baguio Gold for the development and exploitation ofthe Sto. Nino mine. Since the advanced amount partook of the nature of an investment,

it could not be deducted as a bad debt from petitioner's gross income.

PHILIPPINE REFINING CO v CA


23/42

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 PRCs 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 avalid and subsisting debt. (2) the debt must be actually ascertained to beworthless and uncollectible during the taxable year; (3) the debt must becharged off during the taxable year; and (4) the debt must arise from the

business or trade of the taxpayer. Additionally, before a debt can beconsidered worthless, the taxpayer must also show that it is indeeduncollectible even in the future.

Furthermore, there are steps outlined to be undertaken by the taxpayer to prove that heexerted diligent efforts to collect the debts, viz.: (1) sending of statement ofaccounts; (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 thatthese 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 thesedebts were uncollectible. In fact, PRC did not even show the demand letters theyallegedly gave to some of their debtors.


24/42

FERNANDEZ HERMANOS v CIR

Facts:

Fernandez Hermanos is an investment company. The CIR assessed it for alleged

deficiency income taxes. It claimed as deduction, among others, losses in or bad debts of

Palawan Manganese Mines Inc. which the CIR disallowed and was sustained by the

CTA.

Issue: W/N disallowance is correct

Held: YES

It was shown that Palawan Manganese Mines sought financial help from Fernandez to

resume its mining operations hence a Memorandum of Agreement (MOA) was executed

where Fernandez would give yearly advances to Palawan. But it still continued to suffer

loses and Fernandez realized it could no longer recover the advances hence claimed it as

worthless. Looking at the MOA, Fernandez did not expect to be repaid. The

consideration for the advances was 15% of the net profits. If there were no earnings or

profits there was no obligation to repay. Voluntary advances without expectation of

repayment do not result in deductible losses. Fernandez cannot even sue for recovery as

the obligation to repay will only arise if there was net profits. No bad debt could arisewhere there is no valid and subsisting debt.

Even assuming that there was valid or subsisting debt, the debt was not deductible in

1951 as a worthless debt as Palawan was still in operation in 1951 and 1952 as Fernandez

continued to give advances in those years. It has been held that if the debtor corporation

although losing money or insolvent was still operating at the end of the taxable year, the

debt is not considered worthless and therefore not deductible.

Depreciation

BASILAN ESTATES v CIR

LIMPAN INVESTMENT v CIR


25/42

FACTS:

BIR assessed deficiency taxes on Limpan Corp, a companythat leases real property, forunderdeclaring its rental incomefor years 1956-57 by around P20K and P81K

respectively.Petitioner appeals on the ground that portions of theseunderdeclared rentsare yet to be collected by the previousowners and turned over or received by thecorporation.Petitioner cited that some rents were deposited with the court,such that thecorporation does not have actual nor constructivecontrol over them.The sole witness forthe petitioner, Solis (Corporate Secretary-Treasurer) admitted to some undeclared rentsin 1956 and1957, and that some balances were not collected by thecorporation in 1956because the lessees refused to recognizeand pay rent to the new owners and that thecorpspresidentIsabelo Lim collected some rent and reported it in his personalincomestatement, but did not turn over the rent to thecorporation. He also cites lack of actualor constructive controlover rents deposited with the court.

ISSUE: WON the BIR was correct in assessing deficiency taxesagainst Limpan Corp. forundeclared rental income

HELD:

Yes. Petitioner admitted that it indeed had undeclaredincome (although only a part andnot the full amount assessedby BIR). Thus, it has become incumbent upon them toprovetheir excuses by clear and convincing evidence, which it hasfailed to do.Issue:When is there constructive receipt of rent?With regard to 1957 rents deposited with thecourt, andwithdrawn only in 1958, the court viewed the corporation ashavingconstructively received said rents. The non-collectionwas the petitioners fault since itrefused to refused to acceptthe rent, and not due to non-payment of lessees.

Hence,although the corporation did not actually receive the rent, it isdeemed to haveconstructively received them.

Depletion

CONSOLIDATED MINES v CTA

BIR RULING 19-01

FACTS:

On October 3, 2000, the Philippine Council for NGO Certification (PCNC) sent a request

for ruling to the BIR, mainly to seek an opinion if Conservation International (CI), an

international organization, can be granted a donee institution status. Note that CIs

home office and board members are based abroad, hence, PCNCs evaluation process on

governance cannot be fully executed.

ISSUE:


26/42

Whether or not international organizations with home offices abroad are qualified to be

granted donee institution status.

HELD: NO.

Sec. 34(H)(l) of the NIRC3specifically mentions "accredited domestic corporation or

associations" and "non-government organizations". On the other hand, subparagraph

(2)(c) of the same Section of the Tax Code defines a "non-government organization" to

mean a non-profit domestic corporation.

In implementing Sec. 34(H) of the NIRC, RR 13-984was issued and in relation to the

type of entities that may be accredited, which specifically refers to organizations or

associations created or organized under Philippine laws.

Thus, the BIR opined that a non-stock, non-profit corporation or organization must becreated or organized under Philippine Laws and that an NGO must be a non-profit

domestic corporation, this Office is of the opinion that a foreign corporation, like

Conservation International, whether resident or non-resident, cannot be accredited as

donee institution.

3M PHILIPPINES v CIR

Facts:

3(H) Charitable and Other Contributions.

(l) In General. Contributions or gifts actually paid or made within the taxable year to, or for the use of the Government of the Philippines or

any of its agencies or any political subdivision thereof exclusively for public purposes, or to accredited domestic corporations or associations

organized and operated exclusively for religious, charitable, scientific, youth and sports development, cultural or educational purposes or for

the rehabilitation of veterans, or to social welfare institutions or to non-government organizations, in accordance with rules and regulations

promulgated by the Secretary of Finance, upon recommendation of the Commissioner, no part of the net income of which inures to the benefit

of any private stockholder or individual in an amount not in excess of ten percent (10%) in the case of an individual, and five percent (5%) in the

case of a corporation of the taxpayer's taxable income derived from trade, business or profession as computed without the benefit of this and

the following subparagraphs".

4SEC. 1. Definition of Terms. For purposes of these Regulations, the terms herein enumerated shall have the following meanings:

a) "Non-stock, non-profit corporation or organization" shall refer to a corporation or association/ organization referred to under Section 30

(E) and (G) of the Tax Code created or organized under Philippine laws exclusively for one or more of the following purposes:

xxx xxx xxx

b) "Non-government Organization (NGO)" shall refer to a non-stock, non-profit domestic corporation or organization as defined under

Section 34(H)(2)(c) of the Tax Code organized and operated exclusively . . ."


27/42

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 ordered3M 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 CIRs 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


28/42

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 xxx

c. 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 itscase 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.)


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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.

ESSO STANDARD v CIR

FACTS:

ESSO deducted from its gross income, as part of its ordinary and necessary businessexpenses, the amount it had spent for drilling and exploration of its petroleumconcessions. This claim was disallowed by the CIR on the ground that the expensesshould be capitalized and might be written off as a loss only when a "dry hole" shouldresult.

ESSO then filed an amended return and claimed as ordinary and necessary expensesmargin feesit had paid to the Central Bank on its profit remittances to its New Yorkhead office. The CIR disallowed the claimed deduction for the margin fees paid. CIRassessed ESSO a deficiency income tax which arose from the disallowance of the marginfees.

ESSO paid under protest and claimed for a refund. CIR denied the claims for refund,holding that the margin fees paid to the Central Bank could not be considered taxes orallowed as deductible business expenses.

ISSUES:1. w/n margin fee is a tax and should be deductible from ESSOs gross income. NO2. If margin fees are not taxes, w/n they should nevertheless be considered

necessary and ordinary business expenses and therefore still deductible from itsgross income. NO.

HELD:1. NO. A margin is not a tax but an exaction designed to curb the excessive demands

upon our international reserves. The margin fee was imposed by the State in theexercise of its police power and not the power of taxation.

2. NO.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 on a trade or business.

In addition, not only must the taxpayer meet the business test, he must substantiallyprove by evidence or records the deductions claimed under the law, otherwise, thesame will be disallowed. The mere allegation of the taxpayer that an item of expenseis ordinary and necessary does not justify its deduction.


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Ordinarily, an expense will be considered 'necessary' where the expenditure isappropriate 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 thetaxpayer and the surrounding circumstances. The term 'ordinary' does not requirethat 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 theparticular taxpayer affected. There is thus no hard and fast rule on the matter. Theright to a deduction depends in each case on the particular facts and the relation ofthe payment to the type of business in which the taxpayer is engaged. The intentionof the taxpayer often may be the controlling fact in making the determination.Assuming that the expenditure is ordinary and necessary in the operation of thetaxpayer's business, the answer to the question as to whether the expenditure is anallowable deduction as a business expense must be determined from the nature ofthe expenditure itself, which in turn depends on the extent and permanency of thework accomplished by the expenditure.

Since the margin fees in question were incurred for the remittance of funds topetitioner's Head Office in New York, which is a separate and distinct incometaxpayer from the branch in the Philippines, for its disposal abroad, it can never besaid therefore that the margin fees were appropriate and helpful in the developmentof petitioner's business in the Philippines exclusively. ESSO has not shown that theremittance to the head office of part of its profits was made in furtherance of its owntrade or business and therefore cannot be claimed as an ordinary and necessaryexpense paid or incurred in carrying on its own trade or business.


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R. CAPITAL GAINS and LOSSES

Capital assets

CALASANZ v CIR

Facts: Petitioner Ursula Calasanz inherited from her father de Torres an agriculturalland located in Rizal with an area of 1.6M sqm. In order to liquidate her inheritance,Ursula Calasanz had the land surveyed and subdivided into lots. Improvements, such asgood roads, concrete gutters, drainage and lighting system, were introduced to make thelots saleable. Soon after, the lots were sold to the public at a profit.

In their joint income tax return for the year 1957 filed with the Bureau of InternalRevenue on March 31, 1958, petitioners disclosed a profit of P31,060.06 realized fromthe sale of the subdivided lots, and reported fifty per centum thereof or P15,530.03 astaxable capital gains.

Upon an audit and review of the return thus filed, the Revenue Examiner adjudgedpetitioners engaged in business as real estate dealers, as defined in the NIRC, andrequired them to pay the real estate dealer's tax and assessed a deficiency income tax onprofits derived from the sale of the lots based on the rates for ordinary income.

Tax court upheld the finding of the CIR, hence, the present appeal.

Issues:

a. Whether or not petitioners are real estate dealers liable for real estate dealer's fixedtax. YES

b. Whether the gains realized from the sale of the lots are taxable in full as ordinaryincome or capital gains taxable at capital gain rates. ORDINARY INCOME

Ratio:

The assets of a taxpayer are classified for income tax purposes into ordinary assets andcapital assets. Section 34[a] [1] of the National Internal Revenue Code broadly definescapital assets as follows:

[1] Capital assets.-The term 'capital assets' means property held by thetaxpayer [whether or not connected with his trade or business], but does

not include, stock in trade of the taxpayer or other property of a kindwhich would properly be included, in the inventory of the taxpayer if onhand at the close of the taxable year, or property held by the taxpayerprimarily for sale to customers in the ordinary course of his trade orbusiness, or property used in the trade or business of a character which issubject to the allowance for depreciation provided in subsection [f] ofsection thirty; or real property used in the trade or business of thetaxpayer.


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The statutory definition of capital assets is negative in nature. If the asset is not amongthe exceptions, it is a capital asset; conversely, assets falling within the exceptions areordinary assets. And necessarily, any gain resulting from the sale or exchange of an assetis a capital gain or an ordinary gain depending on the kind of asset involved in the

transaction.

However, there is no rigid rule or fixed formula by which it can be determined withfinality whether property sold by a taxpayer was held primarily for sale to customers inthe ordinary course of his trade or business or whether it was sold as a capitalasset. Although several factors or indices have been recognized as helpful guides inmaking a determination, none of these is decisive; neither is the presence nor theabsence of these factors conclusive. Each case must in the last analysis rest upon its ownpeculiar facts and circumstances.

Also a property initially classified as a capital asset may thereafter be treated as anordinary asset if a combination of the factors indubitably tend to show that the activitywas in furtherance of or in the course of the taxpayer's trade or business. Thus, a sale ofinherited real property usually gives capital gain or loss even though the property has tobe subdivided or improved or both to make it salable. However, if the inherited propertyis substantially improved or very actively sold or both it may be treated as held primarilyfor sale to customers in the ordinary course of the heir's business.

In this case, the subject land is considered as an ordinary asset. Petitioners did not sellthe land in the condition in which they acquired it. While the land was originallydevoted to rice and fruit trees, it was subdivided into small lots and in the processconverted into a residential subdivision and given the name Don Mariano Subdivision.Extensive improvements like the laying out of streets, construction of concrete gutters

and installation of lighting system and drainage facilities, among others, wereundertaken to enhance the value of the lots and make them more attractive toprospective buyers. The audited financial statements submitted together with the taxreturn in question disclosed that a considerable amount was expended to cover the costof improvements. There is authority that a property ceases to be a capital asset if theamount expended to improve it is double its original cost, for the extensiveimprovement indicates that the seller held the property primarily for sale to customersin the ordinary course of his business.

Another distinctive feature of the real estate business discernible from the records is theexistence of contracts receivables, which stood at P395,693.35. The sizable amount of

receivables in comparison with the sales volume of P446,407.00 during the same periodsignifies that the lots were sold on installment basis and suggests the number, continuityand frequency of the sales. Also of significance is the circumstance that the lots wereadvertised for sale to the public and that sales and collection commissions were paidout during the period in question.

Petitioners argument that they are merely liquidating the land must also fail.InEhrman vs. Commissioner, the American court in clear and categorical terms


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rejected the liquidation test in determining whether or not a taxpayer is carrying on atrade or business The court observed that the fact that property is sold for purposes ofliquidation does not foreclose a determination that a "trade or business" is beingconducted by the seller.

One may, of course, liquidate a capital asset. To do so, it is necessary to sell. The salemay be conducted in the most advantageous manner to the seller and he will not losethe benefits of the capital gain provision of the statute unless he enters the real estatebusiness and carries on the sale in the manner in which such a business is ordinarilyconducted. In that event, the liquidation constitutes a business and a sale in theordinary course of such a business and the preferred tax status is lost.

BIR RULING 27-02

Registration with HLURB or HUDCC shall be sufficient for a seller/transferor to beconsidered as habitually engaged in real estate business. If the seller/transferor is notregistered with the HLURB or HUDCC, he/it may prove that he/it is engaged in the realestate business by offering other satisfactory evidence (e.g. consummation during thepreceding year at least 6 taxable real estate transactions regardless of amount). (BIRRuling No. 027-2002 dated July 3, 2002)

Capital assets

CHINA BANKING CORP v CA


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S. DETERMINATION OF GAIN OR LOSS FROM SALE OR TRANSFER OF

PROPERTY

Exchange of property

CIR v RUFINO

FACTS:

The private respondents were the majority stockholders of the defunct EasternTheatrical Co., Inc., (Old Corporation). Ernesto Rufino was the president. The privaterespondents were also the majority and controlling stockholders of another corporation,the Eastern Theatrical Co Inc., (New Corporation). This corporation was engaged in thesame kind of business as the Old Corporation, i.e. operating theaters, opera houses,places of amusement and other related business enterprises. Vicente Rufino was theGeneral Manager.

The Old Corporation held a special meeting of stockholders where a resolution waspassed authorizing the Old Corporation to merge with the New Corporation. Pursuant tothe said resolution, the Old Corporation, represented by Ernesto Rufino as President,and the New Corporation, represented by Vicente Rufino as General Manager, signed aDeed of Assignment providing for the conveyance and transfer of all the business,property assets, goodwill, and liabilities of the Old Corporation to the New Corporationin exchange for the latter's shares of stock to be distributed among the shareholders onthe basis of one stock for each stock held in the Old Corporation. This agreement wasmade retroactive. The aforesaid transfer was eventually made. The resolution and theDeed of Assignment were approved in a resolution by the stockholders of the NewCorporation in their special meeting. The increased capitalization of the New

Corporation was registered and approved by the SEC.

The BIR, after examination, declared that the merger was not undertaken for a bonafidebusiness purpose but merely to avoid liability for the capital gains tax on theexchange of the old for the new shares of stock. Accordingly, deficiency assessmentswere imposed against the private respondents. MR denied. CTA reversed and held thatthere was a valid merger. It declared that no taxable gain was derived by petitionersfrom the exchange of their old stocks solely for stocks of the New Corporation because itwas pursuant to a plan of reorganization. Thus, such exchange is exempt from CGT.

ISSUE/RULING:

W/N the CTA erred in finding that no taxable gain was derived by the privaterespondents from the questioned transaction? NO

There was a valid merger although the actual transfer of the properties subject of theDeed of Assignment was not made on the date of the merger. In the nat

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