Tests to determine realization of income

1.

Severance test

2.

Substantial alteration of interest test

3.

Flow of wealth test

Severance test

As capital or investment is not income subject to tax, the gain or profit derived from the exchange or transaction of said capital by the taxpayer for his separate use, benefit and disposal is income subject to tax.

Substantial alteration of interest test

Income is earned when there is a substantial alteration of the interest of a taxpayer, i.e. increase in proportionate share of a stockholder in a corporation.

Income to be returnable for taxation must be fully and completely realized. Where there is no separation of gain or profit, or separation of increase in value from capital, there is no income subject to tax.

Thus, stock dividends are not income subject to tax on the part of the shareholder for he had the same proportionate interest in the assets of the corporation as he had before, and the stockholder was no richer and the corporation no poorer after the declaration of the dividend.

However, if the pre-existing proportionate interest of the stockholder is substantially altered, the income is considered derived to the extent of the benefit received.

Moreover, if as a result of an exchange of stocks, the person received something of value which are essentially and fundamentally different from what he had before the exchange, income is realized within the meaning of the revenue law.

Flow of wealth test

The essential difference between capital and income is that capital is a fund whereas income is the flow of wealth coming from such fund; capital is the tree, income is the fruit. Income is the flow of wealth other than as a mere return of capital.

Claim of right doctrine or doctrine of ownership, command or control- In this case, Javier is not liable for fraud penalty because the income he received is not yet a taxable gain since it is still under litigation.

FACTS:

1977: Victoria Javier, wife of Javier-respondent, received $999k from Prudential Bank remitted by her sister Dolores through Mellon Bank in US. Around 3 weeks after, Mellon Bank filed a complaint with CFI Rizal against Javier claiming that its remittance of $1M was a clerical error and should have been $1k only and praying that the excess be returned on the ground that the Javiers are just trustees of an implied trust for the benefit of Mellon Bank. CFI charged Javier with estafa alleging that they misappropriated and converted it to their own personal use. A year after, Javier filed his Income Tax Return for 1977 and stating in the footnote that the taxpayer was recipient of some money received abroad which he presumed to be a gift but turned out to be an error and is now subject of litigation The Commissioner of Internal Revenue wrote a letter to Javier demanding him to pay taxes for the deficiency, due to the remittance. Javier replied to the Commissioner and said that he will pay the deficiency but denied that he had any undeclared income for 1977 and requested that the assessment of 1977 be made to await final court decision on the case filed against him for filing an allegedly fraudulent return. Commissioner replied that the amount of Mellon Banks erroneous remittance which you were able to dispose is definitely taxable and the Commissioner imposed a 50% fraud penalty on Javier.

ISSUE: Whether or not Javier is liable for the 50% penalty.

HELD: No.

The court held that there was no actual and intentional fraud through willful and deliberate misleading of the BIR in the case. Javier even noted that the taxpayer was recipient of some money received abroad which he presumed to be a gift but turned out to be an error and is now subject of litigation (the ff are not expressly written in the case, in fact the doctrine I just found it elsewhere but this is relevant to the topic rather than the issue in the case) o Claim of right doctrine- a taxable gain is conditioned upon the presence of a claim of right to the alleged gain and the absence of a definite and unconditional obligation to return or repay. o In this case, the remittance was not a taxable gain, since it is still under litigation and there is a chance that Javier might have the obligation to return it. It will only become taxable once the case has been settled because by then whatever amount that will be rewarded, Javier has a claim of right over it.

North American Oil Consolidated v. Burnet, (1932), was a landmark decision by the United States Supreme Court that established the claim of right doctrine. Facts This case involved the North American Oil Consolidate company which operated several properties in 1916. One of the properties was a section of oil land, and the United States held the legal title to the property. In 1915, the United States government filed a suit to remove North American Oil from the property, and on February 2, 1916, the court appointed a receiver to operate the property and hold the income derived from the property while ensued. In 1917, North American Oil was paid the 1916 profits which were acquired during the receivership by order of the District Court. The government appealed, but it was not until 1920 that the Circuit Court of Appeals affirmed the District Courts decision. Finally, in 1922, a further appeal to the U.S. Supreme Court was dismissed by stipulation. In 1918, North American Oil filed an amended tax return including the profits from the receivership in its 1916 taxable income. The IRS filed a deficiency, claiming that the income North American Oil gained from receivership should have been taxed in 1917 when they achieved control of it. The Board of Tax Appeals found that the money was taxable to the receiver in 1916. On appeal, the Circuit Court of Appeals held that the profits were taxable to the company as income in 1917. North American Oil appealed on the basis that the income was taxable either in 1916 when it was earned, or 1922 when the final decision regarding the land was made, and was granted a writ of certiorari. Issue Whether the profits paid to North American Oil in 1917 were taxable income for that particular year? Analysis The Commissioner of the Internal Revenue Service (IRS) argued that the 1916 profits should be included in the 1917 taxable year. North American Oil had not entered the profit as income in 1916 but did include it in an amended return for 1916 in 1918. The United States Supreme Court affirmed the Circuit Court of Appeals. The Court analyzed the facts and arrived at three main conclusions:

1. The 1916 profits received by the receiver in 1916 were not income to the receiver. 2. The 1916 profits were not taxable to North American Oil as income in 1916 because it did not know, at that 3.
point, whether it would ever actually receive the money. North American Oil had no accession to wealth, or control of the income at that point. Through 1916, it was uncertain who was entitled to the profits. The 1916 profits were not income in the year 1922when the final judgment was entered and the litigation was finally terminated.[6] North American Oil had a right to the 1916 profits in 1917, by order of the District Court. The Court held, If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent. It was in 1917 that the profits became entitled to them, and they achieved access to and control of the gains. If the 1922 decision had ruled in favor of the government, North American Oil would have been entitled to a deduction in the amount of those lost profits.

Impact This case is significant for all taxpaying individuals, even in todays world, because the court articulated a claim of right doctrine. This doctrine generally states that when a taxpayer receives income for which they have a claim of right it is then included as income in that year, when that claim of right is established. Later, if it turns out that the taxpayer must return the income, then the taxpayer will generally be entitled to take a deduction for the returned amount.

B. Recoupment The doctrine of equitable recoupment allows a taxpayer whose claim for refund has prescribed to offset tax liabilities with his claim of overpayment. A doctrine applicable in limited circumstances to a taxpayer who erroneously paid a tax and is later properly assessed a tax arising from the same taxable event. The doctrine allows the taxpayer to offset the tax properly assessed by the tax erroneously paid, even if the statute of limitations would otherwise prevent the taxpayer from recovering the earlier overpayment through a claim for refund. A setoff which is time-barred may not be asserted by a private litigant in an affirmative monetary suit by the government. However, a defendant may reduce the government's recovery by the assertion of a claim under the equitable doctrine of recoupment. See Bull v. United States, 295 U.S. 247, 258-63 (1935). Recoupment requires that the defendant's claim arise out of the same transaction as that sued upon by the United States. See Rothensies v. Electric Storage Battery Co., 329 U.S. 296 (1946). See also Frederick v. United States, supra. Ball vs. US 295 US 247 Facts:

Archibald H. Bull died February . He had been a member of a partnership engaged in the business of ship-brokers. The agreement of association provided that in the event a partner died the survivors should continue the business for one year subsequent to his death, and his estate should 'receive the same interests, or participate in the losses to the same extent,' as the deceased partner would, if living, 'based on the usual method of ascertaining what the said profits or losses would be . ... Or the estate of the deceased partner shall have the option of withdrawing his interest from the firm within thirty days after the probate of will ... and all adjustments of profits or losses shall be made as of the date of such withdrawal.' The estate's representative did not exercise the option to withdraw in thirty days, and the business was conducted. When plaintiff filed an income tax return for the periodfor the estate of the decedent, which return did not include, as income, the amount of $200,117.09 received as the share of the profits earned by the partnership during the period for which the return was filed. The Commissioner determined that the sum should have returned by the executor as income to the estate and notified the plaintiff to pay for the deficiency. The Board sustained the Commissioner's action in including the item of $200,117.99 without any reduction on account of the value of the decedent's interest in the partnership at the date of death The executor filed a claim for refund of this amount, setting forth that the $200,117.99, by reason of which the additional tax was assessed and paid, was corpus; that it was so originally determined by the Commissioner and the estate tax assessed thereon was paid by the executor; and that the subsequent assessment of an income tax against the estate for the receipt of the same sum was erroneous. Held: We are of opinion that the petitioner was entitled to have credited against the deficiency of income tax the amount of his overpayment of estate tax with interest, and that he should have

been given judgment accordingly. The judgment must be reversed, and the cause remanded for further proceedings in conformity with this opinion. The petitioner acquiesced and paid the tax assessed in full in August, 1921. He had no reason to assume the Commissioner would adjudge the $212,718.79 income and taxable as such. . We concur in the view of the Court of Claims that the amount received from the partnership as profits earned prior to Bull's death was income earned by him in his lifetime and taxable to him as such; and that it was also corpus of his estate and as such to be included in his gross estate for computation of estate tax. We also agree that the sums paid his estate as profits earned after his death were not corpus but income received by his executor, and to be reckoned in computing income tax for the years 1920 and 1921. Where the effect of the contract is that the deceased partner's estate shall leave his interest in the business and the surviving partners shall acquire it by payments to the estate, the transaction is a sale, and payments made to the estate are for the account of the survivors. It results that the surviving partners are taxable upon firm profits and the estate is not. Here, however, the survivors have purchased nothing belonging to the decedent, who had made no investment in the business and owned no tangible property connected with it. The portion of the profits paid his estate was therefore income and not corpus; and this is so whether we consider the executor a member of the old firm for the remainder [295 U.S. 247, 255] of the year, or hold that the estate became a partner in a new association formed upon the decedent's demise.
Collector vs. UST 104 Phil 1062 Doctrine of Equitable Recoupment It provides that a claim for a refund barred by a prescription maybe allowed to offset unsettled tax liabilities should be pertinent only to taxes arising from the same transaction in which overpayment is made and where underpayment is due. SC held that doctrine was rejected, saying that it was not convinced of the wisdom and proprietary thereof, that it may work temptation to the collecting agency and the taxpayer to delay and neglect their respective pursuits of legal action within the period set by law.