Gross Income_Case Digests

8/11/2019 Gross Income_Case Digests

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Gross 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. Henderson

FACTS:

Sps. Arthur Henderson and Marie Henderson filed their annual income tax with the BIR. Arthur is president of AmericanInternational 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) Arthurs 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) travellingallowance 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 isfurnished and paid for by his employer-corporation (the mother company of American International), for the employe

corporations 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 thereasonable 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-corporationrequest, for the wife to look at details of the plans of a building that his employer intended to construct. Such must not beconsidered taxable income.

The Collector of Internal Revenue merely allowed the entrancefee as nontaxable. The rent expense and travel expenseswere still held to be taxable. The Court of Tax Appeals ruled in favor of the taxpayers, that such expenses must not beconsidered 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 arepart 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 personalbenefit, nor were such amounts retained by them. These bills were paid directly by the employer-corporation to thecreditors. The rental expenses and subsistence allowances are to be considered not subject to income tax. Arthurs high

executive position and social standing, demanded and compelled the couple to live in a more spacious and expensivequarters. 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 govt 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 ofthe 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.


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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 incometax is that:

. . commutation of leave credits, more commonly known as terminal leave, is applied for by an officer or employee whoretires, resigns or is separated from the service through no fault of his own. In the exercise of sound personnel policy, theGovernment encourages unused leaves to be accumulated. The Government recognizes that for most public servantsretirement 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 policyconsiderations 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 instructiona

letters and cash and journal vouchers. The BIR assessed Filinvest for deficiency income tax by imputing an arms lengthinterest rate on its advances to affiliates. Filinvest disputed this by saying that the CIR lacks the authority to imputetheoretical 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) Section50 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 factclaimed 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 toDST.

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 YCia, 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 toP2,500,000.00 divided into 25,000 common shares with the same par value with only 10,000 issued and all subscribed by DonAndres. 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 atotal 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, Doa Carmen Soriano, as her conjugashare. 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 46,287shares were respectively received by the Don Andres estate and Doa Carmen from ANSCOR. Hence, increasing theiraccumulated shareholdings to 138,867 and 138,864 common shares each.On December 28, 1967, Doa Carmen requested a ruling from the United States Internal Revenue Service (IRS), inquiring ifan exchange of common with preferred shares may be considered as a tax avoidance scheme under Section 367 of the


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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, Doa Carmen exchanged her whole 138,864 common shares for 138,860 of the newly reclassified preferredshares. 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

ANSCORs 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 latters common

shareholdings to 19,727.

In 1973, after examining ANSCORs books of account and records, Revenue examiners issued a report proposing tha

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 andexchange 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 taxHowever, 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 taxabledividend, 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 ANSCORs redemption of stocks from its stockholder as well as the exchange of commonwith 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 toincome tax. Specifically, the general rule states that:A stock dividend representing the transfer of surplus to capita

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 Codethis provision originally referred to stock dividends only, without any exception. Stock dividends, strictly speaking, represencapital and do not constitute income to its recipient. So that the mere issuance thereof is not yet subject to income tax asthey 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 totax a capital increase rather than the income. In a loose sense, stock dividends issued by the corporation, are consideredunrealized 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 toincome tax. It should be noted that capital and income are different. Capital is wealth or fund; whereas income is profit orgain 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 taxabledividend, 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 taxHowever, it does not necessarily mean that a shareholder may not realize a taxable gain from such transactions. Simply putdepending 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 theexclusive owner thereof and can exercise the freedom of choice. Having realized gain from that redemption, the incomeearner cannot escape income tax.As qualified by the phrase such time and in such manner, the exception was not intended to characterize as taxabledividend 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 isdeterminable 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 taxabledividend. On this aspect, American courts developed certain recognized criteria, which includes the following:


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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 corporations 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 inrelation both to current earnings and accumulated surplus.

REDEMPTION AND CANCELLATION

For 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 adistribution 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 propertywhether or not the acquired stock is cancelled, retired or held in the treasury. Essentially, the corporation gets back some ofits 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 theinstant case, there is no dispute that ANSCOR redeemed shares of stocks from a stockholder (Don Andres) twice (28,000and 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 theconcurrent 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 initialcapital investment, the proceeds of the redemption is additional wealth, for it is not merely a return of capital but a gainthereon.

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. Thismeans that from the total of 108,000 shares redeemed from the estate, the balance of 82,752.5 (108,000 less 25,247.5) musthave come from stock dividends. Besides, in the absence of evidence to the contrary, the Tax Code presumes that everydistribution of corporate property, in whole or in part, is made out of corporate profits, such as stock dividends. The capita

cannot be distributed in the form of redemption of stock dividends without violating the trust fund doctrine - wherein thecapital stock, property and other assets of the corporation are regarded as equity in trust for the payment of the corporatecreditors. Once capital, it is always capital. That doctrine was intended for the protection of corporate creditors

With respect to the third requisite, ANSCOR redeemed stock dividends issued just 2 to 3 years earlier. The time alone thatlapsed 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 theacquiring (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 dividendswas 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 corporateearnings. 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 havebeen 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 thestock dividend, there was no intention to redeem it as a means of distributing profit or avoiding tax on dividends. Theexistence of legitimate business purposes in support of the redemption of stock dividends is immaterial in income taxation. I

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 ofa taxable dividend, is whether the redemption resulted into aflow 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 asto why or how the income was earned by the taxpayer is not a requirement. Income tax is assessed on income receivedfrom any property, activity or service that produces the income because the Tax Code stands as an indifferent neutralparty 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 realizedprofit or gain and consequently, the stockholders separate property.Profits derived from the capital invested cannotescape 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 materia


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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 acorporations 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 theapplication of the exempting clause. The substance of the whole transaction, not its form, usually controls the taxconsequences.

After considering the manner and the circumstances by which the issuance and redemption of stock dividends weremade, there is no other conclusion but that the proceeds thereof are essentially considered equivalent to a distribution o

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 grossincome. 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 SHARES

Exchange is an act of taking or giving one thing for another involving reciprocal transfer and is generally considered as ataxable transaction. The exchange of common stocks with preferred stocks, or preferred for common or a combination ofeither 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 trademust 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 Doa Carmens shares were exchanged for the whole

150, 000 preferred shares. Thereafter, both the Don Andres estate and Doa Carmen remained as corporate subscribers

except that their subscriptions now include preferred shares. There was no change in their proportional interest after theexchange. There was no cash flow. Both stocks had the same par value. Under the facts herein, any difference in theimarket value would be immaterial at the time of exchange because no income is yet realized - it was a mere corporatepaper 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 subscribers proportional interest. But theexchange 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 accounan 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 18.07per 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 o$ 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 theUnited States.

Issue: Whether or not Congress has the power to tax, as income of the stockholder and without apportionment, a stockdividend 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 bothcombined, 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 exchangeablevalue, 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 thestockholders or retained as surplus available for distribution in money or in kind should opportunity offer. Far from being arealization 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 andaccumulations have resulted from employment of his money and that of the other stockholders in the business of the


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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 thatanswers 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 nothingto that of the shareholder, but that the antecedent accumulation of profits evidenced thereby, while indicating that theshareholder 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. 219-93

AWARD AS MORAL DAMAGES NOT SUBJ. TO INCOME/WITHHOLDING TAX29 (a) 04-92 19-93Maacop Law OfficeUnit 102, Mission Garden Condominium59 Sct. Ibardolaza St.

Quezon CityAttention: Atty. Jose F . MaacopThis 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 unpaidsalaries and commission are subject to withholding tax but the damages which consist of moral and exemplary damagesand 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 consideredtaxable income (par. 60, 12 Vol. 1, Mertens Law of Federal Income Taxation). The legal expenses incurred in courtproceedings, 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 yourclient as part of the damages shall not be subject to income tax, the same being merely a reimbursement of hisexpenses/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. Araas 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 andattorney'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 ordinaryand necessary business expenses, the amount it had spent for drilling and exploration of its petroleum concessions. Thisclaim 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 forthe 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 feespaid on the ground that the margin fees paid to the Central Bank could not be considered taxes or allowed as deductiblebusiness expenses.

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

Essos 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.


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Held:(1) No. A tax is levied to provide revenue for government operations, while the proceeds of the margin fee are applied tostrengthen 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 thebusiness 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 inthe development of Esso's business in the Philippines exclusively or were incurred for purposes proper to the conduct of theaffairs of Esso's branch in the Philippines exclusively or for the purpose of realizing a profit or of minimizing a loss in thePhilippines exclusively. If at all, the margin fees were incurred for purposes proper to the conduct of the corporate affairs oEsso in New York, but certainly not in the Philippines.

Zamora vs. 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 derived from the sale of certain real properties and claimed deductions whichwere not allowable. The collector required him to pay deficiency income tax. On appeal by Zamora, the CTA reduced theamount of deficiency income tax.

Zamora appealed, alleging that the CTA erred in dissallowing P10,478.50, as promotion expenses incurred by his wife for thepromotion of the Bay View Hotel and Farmacia Zamora (which is 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 o

the Bay View Hotel and Farmacia Zamora. He contends that the whole amount of P20,957.00 as promotion expensesshould be allowed and not merely one-half of it, on the ground that, while not all the itemized expenses are supported byreceipts, 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 promotionexpenses 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 indetail 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 ona combined medical and business trip, not all of her expenses came under the category of ordinary and necessaryexpenses; 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 personalbenefit, the Collector and the CTA in their decisions, considered 50% of the said amount of P20,957.00 as business expensesand 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 expenseshad 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 furthe

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 TaxReturn, it deducted from its gross income the following items:


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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 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 ofthe 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-residentpresident 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 actuallyrendered by the employees are deductible, provided such payments, when added to the stipulated salaries, do notexceed a reasonable compensation for the services rendered. The condition precedents to the deduction of bonuses toemployees 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 the particular taxpayer

There is no fixed test for determining thereasonablenessof a given bonus as compensation. However, in determiningwhether 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 officersbecause 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 todeserve equal treatment in compensation and other emoluments. There is no special reason for granting greater bonusesto such lower ranking officers than those given to the non-resident president and vice president.

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

The deductible amount of said bonuses cannot be only equalto their respective yearly salaries considering the post-wa

policy of the corporation in giving salaries at low levels because of the unsettled conditions resulting from war and theimposition of government controls on imports and exports and on the use of foreign exchange which resulted in thediminution 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 opinionreasonable.

W/N the CTA erred in disal lowing 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 showthat 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 becausewhile they constitute an obligation on the part of the corporation, it is not the latter's fault if they remained unclaimedWhatever 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 towarrant deduction.


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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 liabilitydue 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 plusinterests. 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 threeother minor items.

Petitioner questions in this appeal the Tax Court's findings that the disallowed payment to Hoskins was an inordinately largeone, 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 anamounting to an annual compensation of P45,000.00 and an annual salary bonus of P40,000.00, plus free use of thecompany car and receipt of other similar allowances and benefits, the Tax Court correctly ruled that the payment bypetitioner 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, Incwas 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 hadpersonally conceived and planned the project" cannot change the picture. There could be no question that as Chairmanof the board and practically an absolutely controlling stockholder of petitioner, Hoskins wielded tremendous power andinfluence 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 thecorporation, 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 notexceed a reasonable compensation for the services rendered. The conditions precedent to the deduction of bonuses toemployees 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 othe 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 manyfactors, one of them being the amount and quality of the services performed with relation to the business.' Other testssuggested 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 theparticular 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 situationmust 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 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 thecompensation of its officers and employees, we there held further that while the employer's right may be conceded, thequestion 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 officersand employees and that it was in the exercise of such right that it deemed proper to pay the bonuses in question, all thatWe 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 oframpant tax evasion.


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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 vagueimplications.[6]

Deductions for income tax purposes partake of the nature of tax exemptions; hence, if tax exemptions are strictlyconstrued, 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 paidor 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 necessaryexpenses 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 followingrequisites: (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 byreceipts, 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 asto whether or not it was ordinary. To be deductible, an advertising expense should not only be necessary but alsoordinary. 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 respondents 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. Therebeing 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 ofthe expenditure itself; the intention of the taxpayer and the general economic conditions. It is the interplay of these, amongother 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 advertisingand 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 ofrespondent corporations 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 isnecessary, 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 currentsale of merchandise or use of services and

(2) advertising designed to stimulate the future sale of merchandise or use of services. The second type involvesexpenditures incurred, in whole or in part, to create or maintain some form of goodwill for the taxpayers trade or business ofor 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 asbusiness 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 wa


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the amount staggering; the respondent corporation itself also admitted, in its letter protest[8] to the Commissioner of

Internal Revenues assessment, that the subject media expense was incurred in order to protect respondent corporations

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 ones property. This is acapital expenditure which should be spread out over a reasonable period of time.[9]

Respondent corporations 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 asbusiness expenses but as capital expenditures.[10]

True, it is the taxpayers 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 theexpenditures 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 andnecessary. Concomitantly, for an expense to be considered ordinary, it must be reasonable in amount. The Court of TaxAppeals 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/oproduct. The P9,461,246 media advertising expense for the promotion of a single product, almost one-half of petitione

corporations 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 agenciessuch 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 hanecessarily developed an expertise on the subject. We extend due consideration to its opinion unless there is an abuse o

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 mediaadvertising 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 deductionsis 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.), Incis hereby ordered to pay its deficiency income tax in the amount of P2,635,141.42, plus 25% surcharge for late payment and20% 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 expandedwithholding tax, when it failed to withhold 1% expanded withholding tax. The CTA cancelled and set aside the assessmentnotices 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% expandedwithholding 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 incurredduring the taxable year; c) it must have been paid or incurred in carrying on the trade or business of the taxpayer and d) itmust 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 thatthe 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 asdeductions in the current year when they are incurred CANNOT be claimed as deduction from income for the succeeding


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year. The accrual method relies upon the taxpayers right to receive amount or its obligation to pay them NOT the actua

receipt or payment. Amounts of income accrue where the right to receive them become fixed, where there is created anenforceable 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 o

a right to income or liability to pay and 2) the availability of the reasonable accurate determination of such income oliability. It does not require that the amount be absolutely known only that the taxpayer has information necessary tocompute 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 reasonableaccuracy.

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 expectedto have reasonably known the retainer fees charged by the firm as well as compensation for its services. Exercising duediligence, they could have inquired into the amount of their obligation. It could have reasonably determined the amount oflegal 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 thePhilippines. 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 internationaindependent auditors, the allocation of the overhead expense made on the basis of the percentage of gross income in thePhilippines 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 refundYES

Ratio:The governing law is found in Sec. 37 (b).1 Revenue Regulation No. 2 of the DOF contains a similar provision, with theadditional line that the ratable part is based upon the ratio of gross income from sources within the Philippines to the tota

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 toapportionment.

However, the overhead expenses incurred by the parent company in connection with finance, administration, andresearch & development, all of which directly benefit its branches all over the world, fall under a different category. Theseare items which cannot be definitely allocated or identified with the operations of the Philippine branch. Smith can claim

as its deductible share a ratable part of such expenses based upon the ration of the local branchs gross income to the

total gross income of the corporation worldwide.

CIRs Contention

The 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 maintainsthat 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 offices overhead expenses. Sincethe share of the Philippine branch has been fixed, Smith cannot claim more than the said amount.

Smiths Contention

Smith, 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 betweenprivate 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. CIR

1Net income from sources in the Philippines. From the items of gross income specified in subsection (a) of this section there shal

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, shal

be included in full as net income from sources within the Philippines.


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Facts:

Lino Gutierrez was primarily engaged in the business of leasing real property for which he paid real estate brokers privilegetax. 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 expensesGutierrez 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 taxpayers 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 officers 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 inattending 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 theJunior Chamber of Commerce which sponsored the National Convention of Filipino Businessmen. He was also the presidentof 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 depreciation1/3 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 tothe 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 asnecessary 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 andnecessary expenses in pursuing his business. It is routinary and necessary for one in the leasing business to collect rentals andto eject tenants who refuse to pay their accounts.

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


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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 donationconsisting 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 theGovernment of the Philippines, or any of its political subdivisions for exclusively public purposes, to domestic corporations oassociations organized and operated exclusively for religious, charitable, scientific, athletic, cultural or educationa

purposes, or for the rehabilitation of veterans, or to societies for the prevention of cruelty to children or animals, no part othe 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 InternaRevenue 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, notifyingGancayco, 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 April8, 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 severa

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 satisfactionof 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 bereadvertised at a future date, in accordance with the procedure established by the National Internal Revenue CodeSubsequently, 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 liabilitydue 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 onthis account had already prescribed;

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

In his answer respondent admitted some allegations the amended petition, denied other allegations thereof an set upsome 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, byresolution dated August 27, 1956, "cancelled" the aforementioned sale and enjoined respondent and the municipatreasurer 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. Inthis 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 ohas 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 ofInternal Revenue v. Reyes, L-8685, January 31, 1957; Collector of Internal Revenue v. Zulueta, L-8840, February 8, 1957Sambrano 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, wasillegal 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 beenfiled, 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 theexpiration of said five-year period, or within such extension of said stipulated period as may have been agreed upon, inwriting, made before the expiration of the period previously situated, except that in the case of a false or fraudulent return


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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, respondentmade three (3) assessments: (a) the original assessment of P9,793.62, made on May 12, 1950; (b) the first deficiency incometax 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 theoriginal assessment, because the income tax for 1949, he says, could have been collected from him since then. Saidassessment 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 orP29,554.05, because the same was, upon Gancayco's request, reconsidered or modified by the assessment made on Apri

8, 1953, for P16,860.31. Indeed, this last assessment is what Gancayco contested in the amended petition filed by him withthe Court of Tax Appeals. The amount involved in such assessment which Gancayco refused to pay and respondent tried tocollect 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 presentproceedings, 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 fromdelinquency 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 bylevy upon real property; and (b) byjudicial 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 June15, 1939. However, Republic Act No. 1125 has vested the Court of Tax Appeals, not only with exclusive appellate jurisdictionto 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 orcustoms 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 ofinternal revenue taxes and customs duties necessarily implies the power to authorize and sanction the collection of thetaxes 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 ointernal 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 o

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 validityof his claim for deduction of two (2) items, namely: (a) for farming expenses, P27,459.00; and (b) for representationexpenses, P8,933.45.

Section 30 of the Tax Code partly reads:

(a) Expenses:

(1) In GeneralAll 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


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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 thetaxpayer 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 thefollowing to say:

No evidence has been presented as to the nature of the said "farming expenses" other than the bare statement opetitioner 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, iis not deductible but it may be amortized, in accordance with section 75 of Revenue Regulations No. 2, cited above. Seealso, 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 bettermentsmade toincrease 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 RuleIn computing net income no deduction shall in anycase be allowed in respect of

(1) Personal, living, or family expenses;

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

(3) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or hasbeen 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 orindirectly 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 considerationfor the property. For example, commission paid in acquiring property are considered as representing part of the cost of theproperty acquired. The same treatment is to be accorded to amounts expended for maps, abstracts, legal opinions ontitles, recording fees and surveys. Other non-deductible expenses include amounts paid in connection with geologicaexplorations, 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. 75of 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 allowablededuction as an item of expense. Amounts expended in the development of farms, orchards, and ranchesprior 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 clearingoff and grading lots acquired is a capitalexpenditure, representing part of the cost of the land andwas 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 ordinaryand necessary business expenses, must fall squarely within the language of the statutory provision. This section is intendedprimarily, although not always necessarily, to cover expenditures of a recurring nature where the benefit derived from the

payment isrealized and exhausted within the taxable year. Accordingly, if the result of the expenditure is the acquisition oan asset which has an economically useful life beyond the taxable year, no deduction of such payment may be obtainedunder 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. 24BTA, 542; Clark Thread Co., 28 BTA 1128 aff'd 100 F [2d] 257 [CCA 3rd, 1938]; 4 Merten's Law of Federal Income Taxation, Sec25.17, pp. 337-338.)


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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 theexpenditures in question, petitioner could not specify the items constituting the same, or when or on whom or on what theywere 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, althoughthere 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, withcosts 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-residenforeign 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, seland 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 atechnical 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 androyalty 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 thepetitioner from the parent company, on the ground that the fee and royalty should be based only on locally manufacturedgoods. 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 3MPhil. 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?Ruli

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