TAX LAW REVIEW DIGESTS Montero

Alcisso, Arriola, Cajucom, Calalang, Claudio, Escueta, Delos Santos, Dialino, Fajardo, Imperial, Juaquino, Martin, Martinez,
Mendoza, Noel, Pangcog, Plazo Raso, Rosales, Sia, Uy, Venzuela

Q. DEDUCTION

In general
CIR v ISABELA CULTURAL CORPORATION

FACTS:
ICC was assessed for deficiency income tax [ BIR disallowed expense deductions for
professional and security services by 1) auditing services by SGV & Co. 2) legal services
Bengzon law office 3) El Tigre Security services] and deficiency expanded withholding
tax, when it failed to withhold 1% expanded withholding tax. The CTA cancelled and set
aside the assessment notices holding that the claimed deductions for professional and
security services were properly claimed in 1986 since it was only in that year when the
bills demanding payment were sent to ICC. It also found that the ICC withheld 1%
expanded withholding tax for security services. The CA affirmed hence the case at bar.
ISSUE: W/N the aforementioned may be deducted
HELD: for the auditing and legal services NO but for the security services YES
The requisites for deductibility of ordinary and necessary trade, business or professional
expenses, like expenses paid for legal and auditing services are: a) the expense must be
ordinary and necessary; b) it must have been paid or incurred during the taxable year; c)
it must have been paid or incurred in carrying on the trade or business of the taxpayer
and d) it must be supported by receipts, records and other pertinent papers.
The requisite that it must have been paid or incurred during the taxable year is qualified
by Sec. 45 of NIRC which states that the deduction provide for in this title shall be
taken for the taxable year in which paid or incurred dependent upon the method of
accounting upon the basis of which the net income is computed x x x.

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


CIR v GENERAL FOODS

AGUINALDO INDUSTRIES v CIR

FACTS:
Aguinaldo Industries Corporation (AIC) is a domestic corporation engaged in the
manufacture of fishing nets, a tax-exempt industry and the manufacture of furniture.
For accounting purposes, each division is provided with separate books of accounts.
Previously, AIC acquired a parcel of land in Muntinlupa, Rizal, as site of the fishing net
factory. Later, it sold the Muntinlupa property. AIC derived profit from this sale which
was entered in the books of the Fish Nets Division as miscellaneous income to
distinguish it from its tax-exempt income.
For the year 1957, AIC filed two separate income tax returns for each division. After
investigation, the examiners of the BIR found that the Fish Nets Division deducted from
its gross income for that year the amount of P61,187.48 as additional remuneration paid
to the officers of AIC. This amount was taken from the net profit of an isolated
transaction (sale of Muntinlupa land) not in the course of or carrying on of AIC's trade
or business, and was reported as part of the selling expenses of the Muntinlupa land.
Upon recommendation of the examiner that the said sum of P61,187.48 be disallowed as
deduction from gross income, petitioner asserted in its letter of February 19, 1958, that
said amount should be allowed as deduction because it was paid to its officers as
allowance or bonus pursuant to its by-laws.
ISSUE/HELD: W/N the bonus given to the officers of the petitioner upon the sale of
its Muntinlupa land is an ordinary and necessary business expense deductible for
income tax purposes - NO
RATIO: Sec. 30 (a) (1) of the Tax Code provides that in computing net income, there
shall be allowed as deductions Expenses, including all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or business,
including a reasonable allowance for personal services actually rendered.
The bonus given to the officers of the petitioner as their share of the profit realized from
the sale of petitioner's Muntinglupa land cannot be deemed a deductible expense for tax
purposes, even if the aforesaid sale could be considered as a transaction for carrying on
the trade or business of the petitioner and the grant of the bonus to the corporate
officers pursuant to petitioner's by-laws could, as an intra-corporate matter, be
sustained. The records show that the sale was effected through a broker who was paid by
petitioner a commission of P51,723.72 for his services. On the other hand, there is
absolutely no evidence of any service actually rendered by petitioner's officers which
could be the basis of a grant to them of a bonus out of the profit derived from the sale.
This being so, the payment of a bonus to them out of the gain realized from the sale
cannot be considered as a selling expense; nor can it be deemed reasonable and
necessary so as to make it deductible for tax purposes. The extraordinary and unusual
amounts paid by petitioner to these directors in the guise and form of compensation for
their supposed services as such, without any relation to the measure of their actual
services, cannot be regarded as ordinary and necessary expenses within the meaning
of the law. This is in line with the doctrine in the law of taxation that the taxpayer must
show that its claimed deductions clearly come within the language of the law since
allowances, like exemptions, are matters of legislative grace.


ATLAS CONSOLIDATED MINING v CIR

FACTS:
Atlas is a corporation engaged in the mining industry registered. On August 1962, CIR
assessed against Atlas for deficiency income taxes for the years 1957 and 1958. For the
year 1957, it was the opinion of the CIR that Atlas is not entitled to exemption from the
income tax under RA 909 because same covers only gold mines. For the year 1958, the
deficiency income tax covers the disallowance of items claimed by Atlas as deductible
from gross income. Atlas protested for reconsideration and cancellation, thus the CIR
conducted a reinvestigation of the case.
On October 1962, the Secretary of Finance ruled that the exemption provided in RA 909
embraces all new mines and old mines whether gold or other minerals. Accordingly, the
CIR recomputed Atlas deficiency income tax liabilities in the light of said ruling. On
June 1964, the CIR issued a revised assessment entirely eliminating the assessment for
the year 1957. The assessment for 1958 was reduced from which Atlas appealed to the
CTA, assailing the disallowance of the following items claimed as deductible from its
gross income for 1958: Transfer agent's fee, Stockholders relation service fee, U.S. stock
listing expenses, Suit expenses, and Provision for contingencies. The CTA allowed said
items as deduction except those denominated by Atlas as stockholders relation service
fee and suit expenses.
Both parties appealed the CTA decision to the SC by way of two (2) separate petitions for
review. Atlas appealed only the disallowance of the deduction from gross income of the
so-called stockholders relation service fee.
ISSUE/HELD: W/N the annual public relations expense (aka stockholders relation
service fee) paid to a public relations consultant is a deductible expense from gross
income
RATIO: Section 30 (a) (1) of the Tax Code allows a deduction of "all the ordinary and
necessary expenses paid or incurred during the taxable year in carrying on any trade or
business." An item of expenditure, in order to be deductible under this section of the
statute, must fall squarely within its language. To be deductible as a business expense,
three conditions are imposed, namely: (1) the expense must be ordinary and necessary,
(2) it must be paid or incurred within the taxable year, and (3) it must be paid or
incurred in carrying in a trade or business. In addition, not only must the taxpayer meet
the business test, he must substantially prove by evidence or records the deductions
claimed under the law, otherwise, the same will be disallowed. The mere allegation of
the taxpayer that an item of expense is ordinary and necessary does not justify its
deduction.
The SC has never attempted to define with precision the terms "ordinary and
necessary." As a guiding principle, ordinarily, an expense will be considered "necessary"
where the expenditure is appropriate and helpful in the development of the taxpayer's
business. It is "ordinary" when it connotes a payment which is normal in relation to the
business of the taxpayer and the surrounding circumstances. The term "ordinary" does
not require that the payments be habitual or normal in the sense that the same taxpayer
will have to make them often; the payment may be unique or non-recurring to the
particular taxpayer affected.
There is thus no hard and fast rule on the matter. The right to a deduction depends in
each case on the particular facts and the relation of the payment to the type of business
in which the taxpayer is engaged. The intention of the taxpayer often may be the
controlling fact in making the determination. Assuming that the expenditure is ordinary
and necessary in the operation of the taxpayer's business, the answer to the question as
to whether the expenditure is an allowable deduction as a business expense must be
determined from the nature of the expenditure itself, which in turn depends on the
extent and permanency of the work accomplished by the expenditure.
It appears that on December 1957, Atlas increased its capital stock. It claimed that its
shares of stock were sold in the United States because of the services rendered by the
public relations firm. The information about Atlas given out and played up in the mass
communication media resulted in full subscription of the additional shares issued by
Atlas; consequently, the stockholders relation service fee, the compensation for services
carrying on the selling campaign, was in effect spent for the acquisition of additional
capital, ergo, a capital expenditure, and not an ordinary expense. It is not deductible
from Atlas gross income in 1958 because expenses relating to recapitalization and
reorganization of the corporation, the cost of obtaining stock subscription, promotion
expenses, and commission or fees paid for the sale of stock reorganization are capital
expenditures. That the expense in question was incurred to create a favorable image of
the corporation in order to gain or maintain the public's and its stockholders' patronage,
does not make it deductible as business expense. As held in a US case, efforts to
establish reputation are akin to acquisition of capital assets and, therefore, expenses
related thereto are not business expense but capital expenditures.
Note: The burden of proof that the expenses incurred are ordinary and necessary is on
the taxpayer and does not rest upon the Government. To avail of the claimed deduction,
it is incumbent upon the taxpayer to adduce substantial evidence to establish a
reasonably proximate relation petition between the expenses to the ordinary conduct of
the business of the taxpayer. A logical link or nexus between the expense and the
taxpayer's business must be established by the taxpayer.

ROXAS v CTA

FACTS:
Don Pedro Roxas and Dona Carmen Ayala, Spanish subjects, transmitted to their
grandchildren by hereditary succession agricultural lands in Batangas, a residential
house and lot in Manila, and shares of stocks in different corporations. To manage the
properties, said children, namely, Antonio, Eduardo and Jose Roxas formed a
partnership called Roxas y Compania.
On June 1958, the CIR assessed deficiency income taxes against the Roxas Brothers for
the years 1953 and 1955. Part of the deficiency income taxes resulted from the
disallowance of deductions from gross income of various business expenses and
contributions claimed by Roxas. (see expense items below)
The Roxas brothers protested the assessment but inasmuch as said protest was denied,
they instituted an appeal in the CTA, which sustained the assessment except the demand
for the payment of the fixed tax on dealer of securities and the disallowance of the
deductions for contributions to the Philippine Air Force Chapel and Hijas de Jesus'
Retiro de Manresa. Not satisfied, Roxas brothers appealed to the SC. The CIR did not
appeal.
ISSUES/HELD: W/N the deductions for business expenses and contributions
deductible
RATIO: With regard to the disallowed deductions (expenses for tickets to a banquet
given in honor of Sergio Osmena and beer given as gifts to various persons, labelled as
representation expenses), representation expenses are deductible from gross income as
expenditures incurred in carrying on a trade or business under Section 30(a) of the Tax
Code provided the taxpayer proves that they are reasonable in amount, ordinary and
necessary, and incurred in connection with his business. In the case at bar, the evidence
does not show such link between the expenses and the business of Roxas.
The petitioners also claim deductions for contributions to the Pasay City Police, Pasay
City Firemen, and Baguio City Police Christmas funds, Manila Police Trust Fund,
Philippines Herald's fund for Manila's neediest families and Our Lady of Fatima chapel
at Far Eastern University. The contributions to the Christmas funds of the Pasay City
Police, Pasay City Firemen and Baguio City Police are not deductible for the reason that
the Christmas funds were not spent for public purposes but as Christmas gifts to the
families of the members of said entities. Under Section 39(h), a contribution to a
government entity is deductible when used exclusively for public purposes. For this
reason, the disallowance must be sustained. On the other hand, the contribution to the
Manila Police trust fund is an allowable deduction for said trust fund belongs to the
Manila Police, a government entity, intended to be used exclusively for its public
functions. The contributions to the Philippines Herald's fund for Manila's neediest
families were disallowed on the ground that the Philippines Herald is not a corporation
or an association contemplated in Section 30 (h) of the Tax Code. It should be noted
however that the contributions were not made to the Philippines Herald but to a group
of civic spirited citizens organized by the Philippines Herald solely for charitable
purposes. There is no question that the members of this group of citizens do not receive
profits, for all the funds they raised were for Manila's neediest families. Such a group of
citizens may be classified as an association organized exclusively for charitable purposes
mentioned in Section 30(h) of the Tax Code.
The contribution to Our Lady of Fatima chapel at the Far Eastern University should also
be disallowed on the ground that the said university gives dividends to its stockholders.
Located within the premises of the university, the chapel in question has not been
shown to belong to the Catholic Church or any religious organization. It belongs to the
Far Eastern University, contributions to which are not deductible under Section 30(h) of
the Tax Code for the reason that the net income of said university injures to the benefit
of its stockholders.


ZAMORA v CIR

FACTS:

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

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

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

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

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

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

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




Expenses

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

Facts:

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

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

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

Ruling: NO.

Ratio:

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

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

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

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

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

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


CALANOC v CIR

KUENZLE & STREIF, INC. v CIR
FACTS:
Petitioner is a domestic corporation engaged in the importation of textiles, hardware,
sundries, chemicals, pharmaceuticals, lumbers, groceries, wines and liquor; in insurance
and lumber; and in some exports. When Petitioner filed its Income Tax Return, it
deducted from its gross income the following items:
1. salaries, directors' fees and bonuses of its non-resident president and vice-
president;
2. bonuses of its resident officers and employees; and
3. interests on earned but unpaid salaries and bonuses of its officers and employees.
The CIR disallowed the deductions and assessed Petitioner for deficiency income taxes.
Petitioner requested for re-examination of the assessment. CIR modified the same by
allowing as deductible all items comprising directors' fees and salaries of the non-
resident president and vice-president, but disallowing the bonuses insofar as they
exceed the salaries of the recipients, as well as the interests on earned but unpaid
salaries and bonuses.
The CTA modified the assessment and ruled that while the bonuses given to the non-
resident officers are reasonable, bonuses given to the resident officers and employees
are quite excessive.
ISSUES/RULING:
W/N the CTA erred in ruling that the measure of the reasonableness of the
bonuses paid to its non-resident president and vice-president should be applied
to the bonuses given to resident officers and employees in determining their
deductibility? NO.
It is a general rule that "Bonuses to employees made in good faith and as additional
compensation for the services actually rendered by the employees are deductible,
provided such payments, when added to the stipulated salaries, do not exceed a
reasonable compensation for the services rendered. The condition precedents to the
deduction of bonuses to employees are:
1. the payment of the bonuses is in fact compensation;
2. it must be for personal services actually rendered; and
3. the bonuses, when added to the salaries, are reasonable when measured by the
amount and quality of the services performed with relation to the business of the
particular taxpayer
There is no fixed test for determining the reasonableness of a given bonus as
compensation. However, in determining whether the particular salary or compensation
payment is reasonable, the situation must be considered as a whole.
Petitioner contended that it is error to apply the same measure of reasonableness to
both resident and non-resident officers because the nature, extent and quality of the
services performed by each with relation to the business of the corporation widely differ.
Said non-resident officers had rendered the same amount of efficient personal service
and contribution to deserve equal treatment in compensation and other emoluments.
There is no special reason for granting greater bonuses to such lower ranking officers
than those given to the non-resident president and vice president.
W/N the CTA erred in allowing the deduction of the bonuses in excess of the
yearly salaries of the employees? NO.
The deductible amount of said bonuses cannot be only equal to their respective yearly
salaries considering the post-war policy of the corporation in giving salaries at low levels
because of the unsettled conditions resulting from war and the imposition of
government controls on imports and exports and on the use of foreign exchange which
resulted in the diminution of the amount of business and the consequent loss of profits
on the part of the corporation. The payment of bonuses in amounts a little more than
the yearly salaries received considering the prevailing circumstances is in our opinion
reasonable.
W/N the CTA erred in disallowing the deduction of interests on earned but
unpaid salaries and bonuses? NO.
Under the law, in order that interest may be deductible, it must be paid "on
indebtedness." It is therefore imperative to show that there is an existing
indebtedness which may be subjected to the payment of interest. Here the items
involved are unclaimed salaries and bonus participation which cannot constitute
indebtedness within the meaning of the law because while they constitute an obligation
on the part of the corporation, it is not the latter's fault if they remained unclaimed.
Whatever an employee may fail to collect cannot be considered an indebtedness for it is
the concern of the employee to collect it in due time. The willingness of the corporation
to pay interest thereon cannot be considered a justification to warrant deduction.
Interest

PAPER INDUSTRIES v CA ( Dec. 1, 1995)

Facts:
On various years (1969, 1972 and 1977), Picop obtained loans from foreign
creditors in order to finance the purchase of machinery and equipment needed for its
operations. In its 1977 Income Tax Return, Picop claimed interest payments made in
1977, amounting to P42,840,131.00, on these loans as a deduction from its 1977 gross
income.
The CIR disallowed this deduction upon the ground that, because the loans had
been incurred for the purchase of machinery and equipment, the interest payments on
those loans should have been capitalized instead and claimed as a depreciation
deduction taking into account the adjusted basis of the machinery and equipment
(original acquisition cost plus interest charges) over the useful life of such assets.
Both the CTA and the Court of Appeals sustained the position of Picop and held
that the interest deduction claimed by Picop was proper and allowable. In the instant
Petition, the CIR insists on its original position.
ISSUE:
Whether Picop is entitled to deductions against income of interest payments on
loans for the purchase of machinery and equipment.
HELD:
YES. Interest payments on loans incurred by a taxpayer (whether BOI-registered
or not) are allowed by the NIRC as deductions against the taxpayer's gross income. The
basis is 1977 Tax Code Sec. 30 (b).
1
Thus, the general rule is that interest expenses are

1
Sec. 30. Deduction from Gross Income. The following may be deducted from gross income:
xxx xxx xxx
(b) Interest:
(1) In general. The amount of interest paid within the taxable year on indebtedness, except on
indebtedness incurred or continued to purchase or carry obligations the interest upon which is exempt
from taxation as income under this Title: . . . (Emphasis supplied)

deductible against gross income and this certainly includes interest paid under loans
incurred in connection with the carrying on of the business of the taxpayer. In the
instant case, the CIR does not dispute that the interest payments were made by Picop on
loans incurred in connection with the carrying on of the registered operations of
Picop, i.e., the financing of the purchase of machinery and equipment actually used in
the registered operations of Picop. Neither does the CIR deny that such interest
payments were legally due and demandable under the terms of such loans, and in fact
paid by Picop during the tax year 1977.
The contention of CIR does not spring of the 1977 Tax Code but from Revenue
Regulations 2 Sec. 79.
2
However, the Court said that the term interest here should be
construed as the so-called "theoretical interest," that is to say, interest "calculated"
or computed (and not incurred or paid) for the purpose of determining the
"opportunity cost" of investing funds in a given business. Such "theoretical"
or imputed interest does not arise from a legally demandable interest-
bearing obligation incurred by the taxpayer who however wishes to find out, e.g.,
whether he would have been better off by lending out his funds and earning interest
rather than investing such funds in his business. One thing that Section 79 quoted above
makes clear is that interest which does constitute a charge arising under an interest-
bearing obligation is an allowable deduction from gross income.
Only if sir asks: (For further discussion of CIRs contention)
It is claimed by the CIR that Section 79 of Revenue Regulations No. 2 was
"patterned after" paragraph 1.266-1 (b), entitled "Taxes and Carrying Charges
Chargeable to Capital Account and Treated as Capital Items" of the U.S. Income Tax
Regulations, which paragraph reads as follows:
(B) Taxes and Carrying Charges. The items thus chargeable to capital
accounts are
(11) In the case of real property, whether improved or unimproved and
whether productive or nonproductive.
(a) Interest on a loan (but not theoretical interest of a taxpayer using his
own funds).
The truncated excerpt of the U.S. Income Tax Regulations quoted by the CIR needs to be
related to the relevant provisions of the U.S. Internal Revenue Code, which provisions
deal with the general topic of adjusted basis for determining allowable gain or loss on

2
Sec. 79. Interest on Capital. Interest calculated for cost-keeping or other purposes on account of capital or surplus invested
in the business, which does not represent a charge arising under an interest-bearing obligation, is not allowable deduction from
gross income. (Emphases supplied)
sales or exchanges of property and allowable depreciation and depletion of capital assets
of the taxpayer:
Present Rule. The Internal Revenue Code, and the Regulations
promulgated thereunder provide that "No deduction shall be allowed for
amounts paid or accrued for such taxes and carrying charges as, under
regulations prescribed by the Secretary or his delegate, are chargeable to
capital account with respect to property, if the taxpayer elects, in
accordance with such regulations, to treat such taxes orcharges as so
chargeable."
At the same time, under the adjustment of basis provisions which have
just been discussed, it is provided that adjustment shall be made for all
"expenditures, receipts, losses, or other items" properly chargeable to a
capital account, thus including taxes and carrying charges; however, an
exception exists, in which event such adjustment to the capital account is
not made, with respect to taxes and carrying charges which the taxpayer
has not elected to capitalize but for which a deduction instead has been
taken.
22
(Emphasis supplied)
The "carrying charges" which may be capitalized under the above quoted
provisions of the U.S. Internal Revenue Code include, as the CIR has pointed out,
interest on a loan "(but not theoretical interest of a taxpayer using his own
funds)." What the CIR failed to point out is that such "carrying charges" may, at
the election of the taxpayer, either be (a) capitalized in which case the cost basis
of the capital assets, e.g., machinery and equipment, will be adjusted by adding
the amount of such interest payments or alternatively, be (b) deducted from
gross income of the taxpayer. Should the taxpayer elect to deduct the interest
payments against its gross income, the taxpayer cannot at the same
time capitalize the interest payments. In other words, the taxpayer is not entitled
to both the deduction from gross income and the adjusted (increased) basis for
determining gain or loss and the allowable depreciation charge. The U.S. Internal
Revenue Code does not prohibit the deduction of interest on a loan obtained for
purchasing machinery and equipment against gross income, unless the taxpayer
has also or previously capitalized the same interest payments and thereby
adjusted the cost basis of such assets.

CIR v VDA DE PRIETO

FACTS:
On December 4, 1945, the respondent conveyed by way of gifts to her four children,
namely, Antonio, Benito, Carmen and Mauro, all surnamed Prieto, real property with a
total assessed value of P892,497.50. After the filing of the gift tax returns on or about
February 1, 1954, the petitioner Commissioner of Internal Revenue appraised the real
property donated for gift tax purposes at P1,231,268.00, and assessed the total sum of
P117,706.50 as donor's gift tax, interest and compromises due thereon. Of the total sum
of P117,706.50 paid by respondent on April 29, 1954, the sum of P55,978.65 represents
the total interest on account of deliquency. This sum of P55,978.65 was claimed as
deduction, among others, by respondent in her 1954 income tax return. Petitioner,
however, disallowed the claim and as a consequence of such disallowance assessed
respondent for 1954 the total sum of P21,410.38 as deficiency income tax due on the
aforesaid P55,978.65, including interest up to March 31, 1957, surcharge and
compromise for the late payment.

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

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

ISSUE:

Whether or not such interest was paid upon an indebtedness within the contemplation
of section 30 (b) (1) of the Tax Code?

RULING:

Yes. According to the Supreme Court, although interest payment for delinquent taxes is
not deductible as tax under Section 30(c) of the Tax Code and section 80 of the Income
Tax Regulations, the taxpayer is not precluded thereby from claiming said interest
payment as deduction under section 30(b) of the same Code.
SEC. 30 Deductions from gross income. In computing net income there shall be
allowed as deductions
(b) Interest:
(1) In general. The amount of interest paid within the taxable year on
indebtedness, except on indebtedness incurred or continued to purchase or carry
obligations the interest upon which is exempt from taxation as income under this
Title.
The term "indebtedness" as used in the Tax Code of the United States containing
similar provisions as in the above-quoted section has been defined as an unconditional
and legally enforceable obligation for the payment of money.
To give to the quoted portion of section 80 of our Income Tax Regulations the meaning
that the petitioner gives it would run counter to the provision of section 30(b) of the Tax
Code and the construction given to it by courts in the United States. Such effect would
thus make the regulation invalid for a "regulation which operates to create a rule out of
harmony with the statute, is a mere nullity." As already stated, section 80 implements
only section 30(c) of the Tax Code, or the provision allowing deduction of taxes, while
herein respondent seeks to be allowed deduction under section 30(b), which provides
for deduction of interest on indebtedness.

BIR RULING NO 006-00

Taxes

CIR v LEDNICKY

Losses

PAPER INDUSTRIES v CA ( Dec. 1, 1995)

The Paper Industries Corporation of the Philippines ("Picop"), is a Philippine
corporation registered with the Board of Investments ("BOI") as a preferred
pioneer enterprise with respect to its integrated pulp and paper mill, and as a
preferred non-pioneer enterprise with respect to its integrated plywood and
veneer mills.
In 1969, 1972 and 1977, Picop obtained loans from foreign creditors in order to
finance the purchase of machinery and equipment needed for its operations.
Picop also issued promissory notes of about P230M, on w/c it paid P45M in
interest.
In its 1977 Income Tax Return, Picop claimed the interest payments on the loans
as DEDUCTIONS from its 1977 gross income.
The CIR disallowed this deduction upon the ground that, because the loans had
been incurred for the purchase of machinery and equipment, the interest
payments on those loans should have been capitalized instead and claimed as a
depreciation deduction taking into account the adjusted basis of the
machinery and equipment (original acquisition cost plus interest charges) over
the useful life of such assets.
I: W/n the interest payments can be deducted from gross income YES
transaction tax
R:
The 1977 NIRC does not prohibit the deduction of interest on a loan incurred for
acquiring machinery and equipment. Neither does our 1977 NIRC compel the
capitalization of interest payments on such a loan.
The 1977 Tax Code is simply silent on a taxpayer's right to elect one or the other
tax treatment of such interest payments. Accordingly, the general rule that
interest payments on a legally demandable loan are deductible from gross income
must be applied.
In this case, the CIR does not dispute that the interest payments were made by
Picop on loans incurred in connection with the carrying on of the registered
operations of Picop, i.e., the financing of the purchase of machinery and
equipment actually used in the registered operations of Picop. Neither does the
CIR deny that such interest payments were legally due and demandable under
the terms of such loans, and in fact paid by Picop during the tax year 1977.
The CIR has been unable to point to any provision of the 1977 Tax Code or any
other Statute that requires the disallowance of the interest payments made by
Picop.
THIS PART DI KO SUPER MAGETS:
The CIR invokes Section 79 of Revenue Regulations No. 2 w/c provides that
Interest calculated for cost-keeping or other purposes on account of capital or
surplus invested in the business, which does not represent a charge arising
under an interest-bearing obligation, is not allowable deduction from gross
income.
It is claimed by the CIR that Section 79 of Revenue Regulations No. 2 was
"patterned after" paragraph 1.266-1 (b), entitled "Taxes and Carrying Charges
Chargeable to Capital Account and Treated as Capital Items" of the U.S. Income
Tax Regulations, which paragraph reads as follows:
(B) Taxes and Carrying Charges. The items thus chargeable to capital
accounts are
(11) In the case of real property, whether improved or unimproved and
whether productive or nonproductive.
(a) Interest on a loan (but not theoretical interest of a taxpayer using his
own funds).
21

The truncated excerpt of the U.S. Income Tax Regulations quoted by the CIR needs to be
related to the relevant provisions of the U.S. Internal Revenue Code, which provisions
deal with the general topic of adjusted basis for determining allowable gain or loss on
sales or exchanges of property and allowable depreciation and depletion of capital assets
of the taxpayer:
Present Rule. The Internal Revenue Code, and the Regulations
promulgated thereunder provide that "No deduction shall be allowed for
amounts paid or accrued for such taxes and carrying charges as, under
regulations prescribed by the Secretary or his delegate, are chargeable to
capital account with respect to property, if the taxpayer elects, in
accordance with such regulations, to treat such taxes or charges as so
chargeable."
At the same time, under the adjustment of basis provisions which have
just been discussed, it is provided that adjustment shall be made for all
"expenditures, receipts, losses, or other items" properly chargeable to a
capital account, thus including taxes and carrying charges; however, an
exception exists, in which event such adjustment to the capital account is
not made, with respect to taxes and carrying charges which the taxpayer
has not elected to capitalize but for which a deduction instead has been
taken.
The "carrying charges" which may be capitalized under the above quoted
provisions of the U.S. Internal Revenue Code include, as the CIR has pointed out,
interest on a loan "(but not theoretical interest of a taxpayer using his own
funds)." What the CIR failed to point out is that such "carrying charges" may, at
the election of the taxpayer, either be (a) capitalized in which case the cost basis
of the capital assets, e.g., machinery and equipment, will be adjusted by adding
the amount of such interest payments or alternatively, be (b) deducted from
gross income of the taxpayer. Should the taxpayer elect to deduct the interest
payments against its gross income, the taxpayer cannot at the same time
capitalize the interest payments. In other words, the taxpayer is not entitled to
both the deduction from gross income and the adjusted (increased) basis for
determining gain or loss and the allowable depreciation charge. The U.S. Internal
Revenue Code does not prohibit the deduction of interest on a loan obtained for
purchasing machinery and equipment against gross income, unless the taxpayer
has also or previously capitalized the same interest payments and thereby
adjusted the cost basis of such assets.

BIR RULING 30-00


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

INCOME TAX; Tax-free merger under certain condition - Pursuant to Section
40(c)(2)
of the Tax Code, no gain or loss shall be recognized by Blue Circle Philippines, Inc.
(BCPI), Round Royal, Inc. (RRI), SM Investment Corporation (SMIC), Sysmart
Corporation and CG&E Holdings on the transfer of their Fortune, Zeus and Iligan shares
to Republic, in exchange for ne Republic shares, because they together hold more than
51% of the total voting stock of Republic after the transfer. The transfer through the
facilities of the PSE by the 6th to the last transferor of their Fortune and Zeus shares to
Republic in exchange for new Republic shares will be subject to the of 1% stock
transaction tax based on the gross selling price or gross value in money of the shares
transferred, while the 6th to the last transferor of the Iligan shares will be subject to
capital gains tax (CGT) at the rate of 5%, of the par value of the shares transferred. The
new Republic shares to be issued, being original issuances, are subject to the DST
imposed under Section 175 of the Tax Code at the rate of P2 on each P200, or fractional
part thereof, of the par value of
the new Republic shares issued. The net operating losses of each of Republic, Fortune,
MPCC and Iligan are preserved after the proposed share swap and may be carried over
and claimed as a deduction from their respective gross income, pursuant to Section
34(D)(3) of the Tax Code, because there is no substantial change in the either Republic
or Fortune or MPCC or Iligan."


BIR RULING 206-90

This is letter requesting in behalf of Porcelana Mariwasa, Inc. (PMI), a ruling confirming
an opinion that the foreign exchange loss incurred by PMI is a deductible loss in 1990.
It is represented that PMI is a corporation established and organized under Philippine
laws; that it has existing US dollar loans from Noritake Company, Limited (Noritake)
and Toyota Tsusho Corporation (Toyota) in the aggregate amounts of US $7,636,679.17
and US $3,054,671.27, respectively, that in 1989, the parties agreed to convert the said
dollar denominated loans into pesos at the exchange rate prevailing on June 30, 1989;
that in December 1989, both agreements were approved by the Central Bank subject to
the submission of a copy each of the signed agreements incorporating the conversion;
thereafter, drafts of the amended agreements were submitted to the Central Bank for
pre-approval; that on January 29, 1990, the Central Bank advised PMI's counsel on their
findings and comments on the said drafts which were considered and incorporated in
the final amended agreements; that in June 1990, the parties submitted to the Central
Bank the signed agreements; that counsel of PMI is of the opinion that in the case of
PMI, the resultant loss on conversion of US dollar denominated loans to peso is more
than a shrinkage in value of money; that the approval by the Central Bank and the
signing by the parties of the agreements covering the said conversion established the
loss, after which, the loss became final and irrevocable, so that recoupment is
reasonably impossible; and that having been fixed and determinable, the loss is no
longer susceptible to change, hence, it could fairly be stated that such has been
sustained in a closed and completed transaction.
In reply the commissioner informed PMI that the annual increase in value of an asset is
not taxable income because such increase has not yet been realized. The increase in
value i.e., the gain, could only be taxed when a disposition of the property occurred
which was of such a nature as to constitute a realization of such gain, that is, a severance
of the gain from the original capital invested in the property. The same conclusion
obtains as to losses. The annual decline in the value of property is not normally
allowable as a deduction. Hence, to be allowable the loss must be realized.
When foreign currency acquired in connection with a transaction in the regular course
of business is disposed ordinary gain or loss results from the fluctuation. The loss is
deductible only for the year it is actually sustained. It is sustained during the year in
which the loss occurs as evidenced by the completed transaction and as fixed by
identifiable occurring in that year. No taxation event has as yet been consummated prior
to the remittance of the scheduled amortization. Accordingly, PMI's request for
confirmation of opinion was denied considering that foreign exchange losses sustained
as a result of conversion or devaluation of the peso vis-a-vis the foreign currency or US
dollar and vice versa but which remittance of scheduled amortization consisting of
principal and interests payment on a foreign loan had not actually been made are not
deductible from gross income for income tax purposes.
BIR RULING 144-85

(Technically, this ruling has no stated facts. It just said that a request for ruling dated
July 1, 1985 was sent to the BIR for the purpose of clarifying the issue, as herein stated.)

FACTS:
Request to clarify the deductibility of foreign exchange losses incurred by reason of the
devaluation of the peso. The losses arose from matured but unremitted principal
repayments on loans affected by the debt-restructuring program in the Philippines.

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

HELD: NO.
The annual increase in value of an asset is NOT TAXABLE INCOME because such
increase has not yet been realized. The increase in value, i.e., the gain, could only be
taxed when a disposition of the property occurred which was of such a nature as to
constitute a realization of such gain, that is, a severance of the gain from the original
capital invested in the property. The aforementioned rule also applies to losses. The
annual decrease in the value of property is not normally allowable as a loss. Hence, to be
allowable the loss must be realized.

When foreign currency acquired in connection with a transaction in the regular course
of business is disposed of, ordinary gain or loss results from the foreign exchange
fluctuations. THE LOSS IS DEDUCTIBLE ONLY FOR THE YEAR IT IS ACTUALLY
SUSTAINED. Thus, there is no taxable event prior to the remittance of the scheduled
amortization.

Accordingly, foreign exchange losses sustained as a result of devaluation of the peso vis-
a-vis the foreign currency e.g., US dollar, but which remittance of scheduled
amortization consisting of principal and interests payments on a foreign loan has not
actually been made are NOT DEDUCTIBLE from gross income for income tax purposes.

NOTE:
To sustain a loss means that the loss has occurred as evidenced by a closed and
completed transaction and as fixed by identifiable events occurring in that year.
A closed transaction is a taxable event which has been consummated.


Bad debts

PHILEX MINING v CIR

Facts: Philex Mining entered into a management agreement with Baguio Gold. The
parties' agreement was denominated as "Power of Attorney" which provided among
others:
a. Funds available for Philex Mining during the management agreement; and
b. Compensation to Philex Mining which shall be fifty per cent (50%) of the net
profit;
In the course of managing and operating the project, Philex Mining made
advances of cash and property in accordance with the agreement. However, the mine
suffered continuing losses over the years which resulted to petitioner's withdrawal as
manager and cessation of mine operations.
The parties executed a "Compromise with Dation in Payment" wherein Baguio
Gold admitted an indebtedness to Philex Mining, which was subsequently amended to
include additional obligations.
Subsequently, Philex Mining wrote off in its 1982 books of account the remaining
outstanding indebtedness of Baguio Gold by charging P112,136,000.00 to allowances
and reserves that were set up in 1981 and P2,860,768.00 to the 1982 operations.
In its 1982 annual income tax return, Philex Mining deducted from its gross
income the amount of P112,136,000.00 as "loss on settlement of receivables from
Baguio Gold against reserves and allowances." However, BIR disallowed the amount as
deduction for bad debt and assessed petitioner a deficiency income tax of
P62,811,161.39.
Issue: Whether the deduction for bad debts was valid?
Held: No. For a deduction for bad debts to be allowed, all requisites must be satisfied,
to wit: (a) there was a valid and existing debt; (b) the debt was ascertained to be
worthless; and (c) it was charged off within the taxable year when it was determined to
be worthless.
There was no valid and existing debt. The nature of agreement between Philex
Mining and Baguio Gold is that of a partnership or joint venture. Under a contract of
partnership, two or more persons bind themselves to contribute money, property, or
industry to a common fund, with the intention of dividing the profits among themselves.
Perusal of the agreement denominated as the "Power of Attorney" indicates that
the parties had intended to create a partnership and establish a common fund for the
purpose. They also had a joint interest in the profits of the business as shown by a 50-
50 sharing in the income of the mine.
Viewed from this light, the advances can be characterized as petitioners
investment in a partnership with Baguio Gold for the development and exploitation of
the Sto. Nino mine. Since the advanced amount partook of the nature of an investment,
it could not be deducted as a bad debt from petitioner's gross income.


PHILIPPINE REFINING CO v CA

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

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

RULING:YES.
Both the CTA and CA relied on the case of Collector vs. Goodrich International, which
laid down the requisites for worthlessness of a debt to wit:
In said case, we held that for debts to be considered as "worthless," and thereby qualify
as "bad debts" making them deductible, the taxpayer should show that (1) there is a
valid and subsisting debt. (2) the debt must be actually ascertained to be
worthless and uncollectible during the taxable year; (3) the debt must be
charged off during the taxable year; and (4) the debt must arise from the
business or trade of the taxpayer. Additionally, before a debt can be
considered worthless, the taxpayer must also show that it is indeed
uncollectible even in the future.
Furthermore, there are steps outlined to be undertaken by the taxpayer to prove that he
exerted diligent efforts to collect the debts, viz.: (1) sending of statement of
accounts; (2) sending of collection letters; (3) giving the account to a lawyer
for collection; and (4) filing a collection case in court.
PRC only used the testimony of its accountant Ms. Masagana in order to prove that
these accounts were bad debts. This was considered by all 3 courts to be self-serving.
The SC said that PRC failed to exercise due diligence in order to ascertain that these
debts were uncollectible. In fact, PRC did not even show the demand letters they
allegedly gave to some of their debtors.

FERNANDEZ HERMANOS v CIR

Facts:
Fernandez Hermanos is an investment company. The CIR assessed it for alleged
deficiency income taxes. It claimed as deduction, among others, losses in or bad debts of
Palawan Manganese Mines Inc. which the CIR disallowed and was sustained by the
CTA.

Issue: W/N disallowance is correct

Held: YES
It was shown that Palawan Manganese Mines sought financial help from Fernandez to
resume its mining operations hence a Memorandum of Agreement (MOA) was executed
where Fernandez would give yearly advances to Palawan. But it still continued to suffer
loses and Fernandez realized it could no longer recover the advances hence claimed it as
worthless. Looking at the MOA, Fernandez did not expect to be repaid. The
consideration for the advances was 15% of the net profits. If there were no earnings or
profits there was no obligation to repay. Voluntary advances without expectation of
repayment do not result in deductible losses. Fernandez cannot even sue for recovery as
the obligation to repay will only arise if there was net profits. No bad debt could arise
where there is no valid and subsisting debt.

Even assuming that there was valid or subsisting debt, the debt was not deductible in
1951 as a worthless debt as Palawan was still in operation in 1951 and 1952 as Fernandez
continued to give advances in those years. It has been held that if the debtor corporation
although losing money or insolvent was still operating at the end of the taxable year, the
debt is not considered worthless and therefore not deductible.


Depreciation

BASILAN ESTATES v CIR

LIMPAN INVESTMENT v CIR

FACTS:

BIR assessed deficiency taxes on Limpan Corp, a companythat leases real property, for
underdeclaring its rental incomefor years 1956-57 by around P20K and P81K
respectively.Petitioner appeals on the ground that portions of theseunderdeclared rents
are yet to be collected by the previousowners and turned over or received by the
corporation.Petitioner cited that some rents were deposited with the court,such that the
corporation does not have actual nor constructivecontrol over them.The sole witness for
the petitioner, Solis (Corporate Secretary-Treasurer) admitted to some undeclared rents
in 1956 and1957, and that some balances were not collected by thecorporation in 1956
because the lessees refused to recognizeand pay rent to the new owners and that the
corps presidentIsabelo Lim collected some rent and reported it in his personalincome
statement, but did not turn over the rent to thecorporation. He also cites lack of actual
or constructive controlover rents deposited with the court.

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

HELD:

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

Depletion

CONSOLIDATED MINES v CTA

BIR RULING 19-01

FACTS:
On October 3, 2000, the Philippine Council for NGO Certification (PCNC) sent a request
for ruling to the BIR, mainly to seek an opinion if Conservation International (CI), an
international organization, can be granted a donee institution status. Note that CIs
home office and board members are based abroad, hence, PCNCs evaluation process on
governance cannot be fully executed.
ISSUE:
Whether or not international organizations with home offices abroad are qualified to be
granted donee institution status.
HELD: NO.
Sec. 34(H)(l) of the NIRC
3
specifically mentions "accredited domestic corporation or
associations" and "non-government organizations". On the other hand, subparagraph
(2)(c) of the same Section of the Tax Code defines a "non-government organization" to
mean a non-profit domestic corporation.
In implementing Sec. 34(H) of the NIRC, RR 13-98
4
was issued and in relation to the
type of entities that may be accredited, which specifically refers to organizations or
associations created or organized under Philippine laws.

Thus, the BIR opined that a non-stock, non-profit corporation or organization must be
created or organized under Philippine Laws and that an NGO must be a non-profit
domestic corporation, this Office is of the opinion that a foreign corporation, like
Conservation International, whether resident or non-resident, cannot be accredited as
donee institution.


3M PHILIPPINES v CIR

Facts:

3
(H) Charitable and Other Contributions.
(l) In General. Contributions or gifts actually paid or made within the taxable year to, or for the use of the Government of the Philippines or
any of its agencies or any political subdivision thereof exclusively for public purposes, or to accredited domestic corporations or associations
organized and operated exclusively for religious, charitable, scientific, youth and sports development, cultural or educational purposes or for
the rehabilitation of veterans, or to social welfare institutions or to non-government organizations, in accordance with rules and regulations
promulgated by the Secretary of Finance, upon recommendation of the Commissioner, no part of the net income of which inures to the benefit
of any private stockholder or individual in an amount not in excess of ten percent (10%) in the case of an individual, and five percent (5%) in the
case of a corporation of the taxpayer's taxable income derived from trade, business or profession as computed without the benefit of this and
the following subparagraphs".
4
SEC. 1. Definition of Terms. For purposes of these Regulations, the terms herein enumerated shall have the following meanings:
a) "Non-stock, non-profit corporation or organization" shall refer to a corporation or association/ organization referred to under Section 30
(E) and (G) of the Tax Code created or organized under Philippine laws exclusively for one or more of the following purposes:
xxx xxx xxx
b) "Non-government Organization (NGO)" shall refer to a non-stock, non-profit domestic corporation or organization as defined under
Section 34(H)(2)(c) of the Tax Code organized and operated exclusively . . ."

3M Philippines, Inc. is a subsidiary of the Minnesota Mining and Manufacturing
Company (or "3M-St. Paul") a non-resident foreign corporation with principal office in
St. Paul, Minnesota, U.S.A. It is the exclusive importer, manufacturer, wholesaler, and
distributor in the Philippines of all products of 3M-St. Paul. To enable it to manufacture,
package, promote, market, sell and install the highly specialized products of its parent
company, and render the necessary post-sales service and maintenance to its customers,
3M Phils. entered into a "Service Information and Technical Assistance Agreement" and
a "Patent and Trademark License Agreement" with the latter under which the 3m Phils.
agreed to pay to 3M-St. Paul a technical service fee of 3% and a royalty of 2% of its net
sales. Both agreements were submitted to, and approved by, the Central Bank of the
Philippines. the petitioner claimed the following deductions as business expenses:
(a) royalties and technical service fees of P 3,050,646.00; and
(b) pre-operational cost of tape coater of P97,485.08.
As to (a), the Commissioner of Internal Revenue allowed a deduction of P797,046.09
only as technical service fee and royalty for locally manufactured products, but
disallowed the sum of P2,323,599.02 alleged to have been paid by the petitioner to 3M-
St. Paul as technical service fee and royalty on P46,471,998.00 worth of finished
products imported by the petitioner from the parent company, on the ground that the
fee and royalty should be based only on locally manufactured goods. While as to (b), the
CIR only allowed P19,544.77 or one-fifth (1/5) of 3M Phils.capital expenditure of
P97,046.09 for its tape coater which was installed in 1973 because such expenditure
should be amortized for a period of five (5) years, hence, payment of the disallowed
balance of P77,740.38 should be spread over the next four (4) years. The CIR ordered
3M Phil. to pay P840,540 as deficiency income tax on its 1974 return, plus P353,026.80
as 14% interest per annum from February 15, 1975 to February 15, 1976, or a total of
P1,193,566.80.
3M Phils. protested the CIRs assessment but it did not answer the protest, instead
issuing a warrant of levy. The CTA affirmed the assessment on appeal.
Issue:
Whether or not 3M Phils is entitled to the deductions due to royalties?
Ruling:
No. CB Circular No. 393 (Regulations Governing Royalties/Rentals) dated December 7,
1973 was promulgated by the Central Bank as an exchange control regulation to
conserve foreign exchange and avoid unnecessary drain on the country's international
reserves (69 O.G. No. 51, pp. 11737-38). Section 3-C of the circular provides that
royalties shall be paid only on commodities manufactured by the licensee under the
royalty agreement:

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

b. xxx xxx xxx
c. The royalty/rental contracts involving manufacturing' royalty, e.g., actual transfers of
technological services such as secret formula/processes, technical know how and the
like shall not exceed five (5) per cent of the wholesale price of the commodity/ties
manufactured under the royalty agreement. For contracts involving 'marketing' services
such as the use of foreign brands or trade names or trademarks, the royalty/rental rate
shall not exceed two (2) per cent of the wholesale price of the commodity/ties
manufactured under the royalty agreement. The producer's or foreign licensor's share in
the proceeds from the distribution/exhibition of the films shall not exceed sixty (60) per
cent of the net proceeds (gross proceeds less local expenses) from the
exhibition/distribution of the films. ... (Emphasis supplied.) (p. 27, Rollo.)
Clearly, no royalty is payable on the wholesale price of finished products imported by
the licensee from the licensor. However, petitioner argues that the law applicable to its
case is only Section 29(a)(1) of the Tax Code which provides:
(a) Expenses. (1) Business expenses. (A) In general. All ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or business,
including a reasonable allowance for salaries or other compensation for personal
services actually rendered; travelling expenses while away from home in the pursuit of a
trade, profession or business, rentals or other payments required to be made as a
condition to the continued use or possession, for the purpose of the trade, profession or
business, for property to which the taxpayer has not taken or is not taking title or in
which he has no equity.
Petitioner points out that the Central bank "has no say in the assessment and collection
of internal revenue taxes as such power is lodged in the Bureau of Internal Revenue,"
that the Tax Code "never mentions Circular 393 and there is no law or regulation
governing deduction of business expenses that refers to said circular." (p. 9, Petition.)
The argument is specious, for, although the Tax Code allows payments of royalty to be
deducted from gross income as business expenses, it is CB Circular No. 393 that defines
what royalty payments are proper. Hence, improper payments of royalty are not
deductible as legitimate business expenses.

ESSO STANDARD v CIR

FACTS:

ESSO deducted from its gross income, as part of its ordinary and necessary business
expenses, the amount it had spent for drilling and exploration of its petroleum
concessions. This claim was disallowed by the 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 and claimed as ordinary and necessary expenses
margin fees it had paid to the Central Bank on its profit remittances to its New York
head office. The CIR disallowed the claimed deduction for the margin fees paid. CIR
assessed ESSO a deficiency income tax which arose from the disallowance of the margin
fees.

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

ISSUES:
1. w/n margin fee is a tax and should be deductible from ESSOs gross income. NO
2. If margin fees are not taxes, w/n they should nevertheless be considered
necessary and ordinary business expenses and therefore still deductible from its
gross income. NO.

HELD:
1. NO. A margin is not a tax but an exaction designed to curb the excessive demands
upon our international reserves. The margin fee was imposed by the State in the
exercise of its police power and not the power of taxation.

2. NO.
To be deductible as a business expense, three conditions are imposed, namely:
(1) the expense must be ordinary and necessary,
(2) it must be paid or incurred within the taxable year, and
(3) it must be paid or incurred in carrying on a trade or business.
In addition, not only must the taxpayer meet the business test, he must substantially
prove by evidence or records the deductions claimed under the law, otherwise, the
same will be disallowed. The mere allegation of the taxpayer that an item of expense
is ordinary and necessary does not justify its deduction.

Ordinarily, an expense will be considered 'necessary' where the expenditure is
appropriate and helpful in the development of the taxpayer's business. It is 'ordinary'
when it connotes a payment which is normal in relation to the business of the
taxpayer and the surrounding circumstances. The term 'ordinary' does not require
that the payments be habitual or normal in the sense that the same taxpayer will
have to make them often; the payment may be unique or non-recurring to the
particular taxpayer affected. There is thus no hard and fast rule on the matter. The
right to a deduction depends in each case on the particular facts and the relation of
the payment to the type of business in which the taxpayer is engaged. The intention
of the taxpayer often may be the controlling fact in making the determination.
Assuming that the expenditure is ordinary and necessary in the operation of the
taxpayer's business, the answer to the question as to whether the expenditure is an
allowable deduction as a business expense must be determined from the nature of
the expenditure itself, which in turn depends on the extent and permanency of the
work accomplished by the expenditure.

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

R. CAPITAL GAINS and LOSSES
Capital assets
CALASANZ v CIR

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

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

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

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

Issues:

a. Whether or not petitioners are real estate dealers liable for real estate dealer's fixed
tax. YES
b. Whether the gains realized from the sale of the lots are taxable in full as ordinary
income or capital gains taxable at capital gain rates. ORDINARY INCOME

Ratio:

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

[1] Capital assets.-The term 'capital assets' means property held by the
taxpayer [whether or not connected with his trade or business], but does
not include, stock in trade of the taxpayer or other property of a kind
which would properly be included, in the inventory of the taxpayer if on
hand at the close of the taxable year, or property held by the taxpayer
primarily for sale to customers in the ordinary course of his trade or
business, or property used in the trade or business of a character which is
subject to the allowance for depreciation provided in subsection [f] of
section thirty; or real property used in the trade or business of the
taxpayer.

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

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


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


In this case, the subject land is considered as an ordinary asset. Petitioners did not sell
the land in the condition in which they acquired it. While the land was originally
devoted to rice and fruit trees, it was subdivided into small lots and in the process
converted into a residential subdivision and given the name Don Mariano Subdivision.
Extensive improvements like the laying out of streets, construction of concrete gutters
and installation of lighting system and drainage facilities, among others, were
undertaken to enhance the value of the lots and make them more attractive to
prospective buyers. The audited financial statements submitted together with the tax
return in question disclosed that a considerable amount was expended to cover the cost
of improvements. There is authority that a property ceases to be a capital asset if the
amount expended to improve it is double its original cost, for the extensive
improvement indicates that the seller held the property primarily for sale to customers
in the ordinary course of his business.

Another distinctive feature of the real estate business discernible from the records is the
existence of contracts receivables, which stood at P395,693.35. The sizable amount of
receivables in comparison with the sales volume of P446,407.00 during the same period
signifies that the lots were sold on installment basis and suggests the number, continuity
and frequency of the sales. Also of significance is the circumstance that the lots were
advertised for sale to the public and that sales and collection commissions were paid
out during the period in question.

Petitioners argument that they are merely liquidating the land must also fail.
In Ehrman vs. Commissioner,

the American court in clear and categorical terms
rejected the liquidation test in determining whether or not a taxpayer is carrying on a
trade or business The court observed that the fact that property is sold for purposes of
liquidation does not foreclose a determination that a "trade or business" is being
conducted by the seller.

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


BIR RULING 27-02

Registration with HLURB or HUDCC shall be sufficient for a seller/transferor to be
considered as habitually engaged in real estate business. If the seller/transferor is not
registered with the HLURB or HUDCC, he/it may prove that he/it is engaged in the real
estate business by offering other satisfactory evidence (e.g. consummation during the
preceding year at least 6 taxable real estate transactions regardless of amount). (BIR
Ruling No. 027-2002 dated July 3, 2002)

Capital assets

CHINA BANKING CORP v CA
S. DETERMINATION OF GAIN OR LOSS FROM SALE OR TRANSFER OF
PROPERTY
Exchange of property
CIR v RUFINO
FACTS:
The private respondents were the majority stockholders of the defunct Eastern
Theatrical Co., Inc., (Old Corporation). Ernesto Rufino was the president. The private
respondents were also the majority and controlling stockholders of another corporation,
the Eastern Theatrical Co Inc., (New Corporation). This corporation was engaged in the
same kind of business as the Old Corporation, i.e. operating theaters, opera houses,
places of amusement and other related business enterprises. Vicente Rufino was the
General Manager.
The Old Corporation held a special meeting of stockholders where a resolution was
passed authorizing the Old Corporation to merge with the New Corporation. Pursuant to
the said resolution, the Old Corporation, represented by Ernesto Rufino as President,
and the New Corporation, represented by Vicente Rufino as General Manager, signed a
Deed of Assignment providing for the conveyance and transfer of all the business,
property assets, goodwill, and liabilities of the Old Corporation to the New Corporation
in exchange for the latter's shares of stock to be distributed among the shareholders on
the basis of one stock for each stock held in the Old Corporation. This agreement was
made retroactive. The aforesaid transfer was eventually made. The resolution and the
Deed of Assignment were approved in a resolution by the stockholders of the New
Corporation in their special meeting. The increased capitalization of the New
Corporation was registered and approved by the SEC.
The BIR, after examination, declared that the merger was not undertaken for a bona
fide business purpose but merely to avoid liability for the capital gains tax on the
exchange of the old for the new shares of stock. Accordingly, deficiency assessments
were imposed against the private respondents. MR denied. CTA reversed and held that
there was a valid merger. It declared that no taxable gain was derived by petitioners
from the exchange of their old stocks solely for stocks of the New Corporation because it
was pursuant to a plan of reorganization. Thus, such exchange is exempt from CGT.
ISSUE/RULING:
W/N the CTA erred in finding that no taxable gain was derived by the private
respondents from the questioned transaction? NO
There was a valid merger although the actual transfer of the properties subject of the
Deed of Assignment was not made on the date of the merger. In the nature of things,
this was not possible. Obviously, it was necessary for the Old Corporation to surrender
its net assets first to the New Corporation before the latter could issue its own stock to
the shareholders of the Old Corporation because the New Corporation had to increase
its capitalization for this purpose. This required the adoption of the resolution for the
registration of such issuance with the SEC and its approval. All these took place after the
date of the merger but they were deemed part and parcel of, and indispensable to the
validity and enforceability of, the Deed of Assignment.
There is no impediment to the exchange of property for stock between the two
corporations being considered to have been effected on the date of the merger. That, in
fact, was the intention, and the reason why the Deed of Assignment was made
retroactive which provided in effect that all transactions set forth in the merger
agreement shall be deemed to be taking place simultaneously when the Deed of
Assignment became operative.
The basic consideration, of course, is the purpose of the merger, as this would determine
whether the exchange of properties involved therein shall be subject or not to the capital
gains tax. The criterion laid down by the law is that the merger" must be undertaken for
a bona fide business purpose and not solely for the purpose of escaping the burden of
taxation."
Here, the purpose of the merger was to continue the business of the Old Corporation,
whose corporate life was about to expire, through the New Corporation to which all the
assets and obligations of the former had been transferred. What argues strongly, indeed,
for the New Corporation is that it was not dissolved after the merger agreement. On the
contrary, it continued to operate the places of amusement originally owned by the Old
Corporation and continues to do so today after taking over the business of the Old
Corporation 27 years ago.
What is also worth noting is that, as in the case of the Old Corporation when it was
dissolved, there has been no distribution of the assets of the New Corporation since then
and up to now, as far as the record discloses. To date, the private respondents have not
derived any benefit from the merger of the Old Corporation and the New Corporation
almost 3 decades earlier that will make them subject to the capital gains tax under
Section 35. They are no more liable now than they were when the merger took effect, as
the merger, being genuine, exempted them under the law from such tax.
By this decision, the government is, of course, not left entirely without recourse, at least
in the future. The fact is that the merger had merely deferred the claim for taxes, which
may be asserted by the government later, when gains are realized and benefits are
distributed among the stockholders as a result of the merger. In other words, the
corresponding taxes are not forever foreclosed or forfeited but may at the proper time
and without prejudice to the government still be imposed.


BIR RULING 274-87

GREGORY v HELVERING

Facts:
Petitioner was the owner of all the stock of United Mortgage Corporation(UMC).
That corporation held among its assets 1,000 shares of the Monitor Securities
Corporation(MSC). Petitioner wanted these shares transferred to her at a profit and
with the minimum income tax liability. In order to achieve this purpose, Petitioner
made it appear that she was making a reorganization (in conforme with Revenue Act
of 1928
5
). Under this law, a reorganization would effect a direct transfer of a
corporations share by way of dividend at a lower taxable transaction.
In order to have an appearance of a reorganization, she(Petitioner) organized
Averill Corporation (AC). Three (3) days later, UMC transferred the 1,000 shares of
MSC to AC. Then these shares were all transferred to Petitioner. Subsequently, AC was
dissolved with no other transaction being made other the transfer of the shares.
Petitioner then sold the shares and declared a lower taxable liability. The Board
contended that the so-called reorganization should be considered ineffective since it
was just a scheme to have a lower tax liability.
ISSUE:
Whether the reorganization is valid which would result to a lower tax liability.
HELD:
NO. It is contended that since every element required by the foregoing
subdivision (B) (refer to footnote) is to be found in what was done, a statutory
reorganization was effected, and that the motive of the taxpayer thereby to escape
payment of a tax will not alter the result or make unlawful what the statute allows.
The Court said, although the legal right of a taxpayer to decrease the amount of
what otherwise would be his taxes, or altogether avoid them, by means which the law
permits, cannot be doubted, the question for determination is whether what
was done, apart from the tax motive, was the thing which the statute
intended.

5
"Sec. 112. (g) Distribution of Stock on Reorganization. If there is distributed, in pursuance of a plan of reorganization, to a
shareholder in a corporation a party to the reorganization, stock or securities in such corporation or in another corporation a party to the
reorganization, without the surrender by such shareholder of stock or securities in such a corporation, no gain to the distributee from the
receipt of such stock of securities shall be recognized. . . ."
"(i) Definition of Reorganization. -- As used in this section . . ."
"(1) The term 'reorganization' means . . . (B) a transfer by a corporation of all or a part of its assets to another corporation if immediately
after the transfer the transferor or its stockholders or both are in control of the corporation to which the assets are transferred. . . ."

When subdivision (B) speaks of a transfer of assets by one corporation to
another, it means a transfer made "in pursuance of a plan of reorganization of corporate
business, and not a transfer of assets by one corporation to another in pursuance of a
plan having no relation to the business of either, as plainly is the case here.
Simply an operation having no business or corporate purpose -- a mere device
which put on the form of a corporate reorganization as a disguise for concealing its real
character, and the sole object and accomplishment of which was the consummation of a
preconceived plan, not to reorganize a business or any part of a business, but to transfer
a parcel of corporate shares to the petitioner. The rule which excludes from
consideration the motive of tax avoidance is not pertinent to the situation, because the
transaction, upon its face, lies outside the plain intent of the statute. (kasi wala nga
talagang business purpose but to circumvent the law).
T. SITUS OF TAXATION
Gross income from sources within the Phils
CIR v MARUBENI CORPORATION
CIR v BOAC
CIR v CTA AND SMITH&FRENCH OVERSEAS

Facts:
Smith Kline & French Overseas Company is a multinational firm domiciled in
Philadelphia, licensed to do business in the Philippines. It is engaged in the
importation, manufacture, and sale of pharmaceutical drugs and chemicals.
In 1971, it declared a net taxable income of P1.4 M and paid P511k as tax due. It claimed
its share of the head office overhead expenses (P501k) as deduction from gross income.
In its amended return, it claimed that there was an overpayment of tax (P324k) arising
from under-deduction of the overhead expense. This was certified by international
independent auditors, the allocation of the overhead expense made on the basis of the
percentage of gross income in the Philippines to gross income of the corporation as a
whole.
In 1974, without waiting for the action of the CIR, Smith filed a petition for review with
the CTA. CTA ordered CIR to refund the overpayment or grant Smith a tax credit. CIR
appealed to the SC.
Issue: Whether Smith is entitled to a refund YES
Ratio:
The governing law is found in Sec. 37 (b).
6
Revenue Regulation No. 2 of the DOF
contains a similar provision, with the additional line that the ratable part is based upon
the ratio of gross income from sources within the Philippines to the total gross income
(Sec. 160). Hence, where an expense is clearly related to the production of Philippine-
derived income or to Philippine operations, that expense can be deducted from the gross
income acquired in the Philippines without resorting to apportionment.
However, the overhead expenses incurred by the parent company in connection with
finance, administration, and research & development, all of which directly benefit its

6
Net income from sources in the Philippines. From the items of gross income specified in subsection (a) of this
section there shall be deducted expenses, losses, and other deductions properly apportioned or allocated thereto
and a ratable part of any expenses, losses, or other deductions which cannot definitely be allocated to some item
or class of gross income. The remainder, if any, shall be included in full as net income from sources within the
Philippines.
branches all over the world, fall under a different category. These are items which
cannot be definitely allocated or identified with the operations of the Philippine branch.
Smith 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 maintains that such right is not absolute and that there exists
a contract (service agreement) which Smith has entered into with its home office,
prescribing the amount that a branch can deduct as its share of the main offices
overhead expenses. Since the 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 between private parties nor can the
CIR acquiesce in such an agreement.
SC ruled for Smith Kline and said that its amended return conforms with the law and
regulations.

PHIL GUARANTY CO v CIR

Facts: The Philippine Guaranty Co., Inc., a domestic insurance company, entered into
reinsurance contracts, on various dates, with foreign insurance companies not doing
business in the Philippines.
The reinsurance contracts made the commencement of the reinsurers' liability
simultaneous with that of Philippine Guaranty Co., Inc. under the original insurance.
Philippine Guaranty Co., Inc. was required to keep a register in Manila where the risks
ceded to the foreign reinsurers where entered, and entry therein was binding upon the
reinsurers. A proportionate amount of taxes on insurance premiums not recovered from
the original assured were to be paid for by the foreign reinsurers. The foreign reinsurers
further agreed, in consideration for managing or administering their affairs in the
Philippines, to compensate the Philippine Guaranty Co., Inc., in an amount equal to 5%
of the reinsurance premiums. Conflicts and/or differences between the parties under the
reinsurance contracts were to be arbitrated in Manila. Philippine Guaranty Co., Inc. and
Swiss Reinsurance Company stipulated that their contract shall be construed by the laws
of the Philippines.
Pursuant to the aforesaid reinsurance contracts, Philippine Guaranty Co., Inc. ceded
premiuns to the foreign reinsurers. Said premiums were excluded by Philippine
Guaranty Co., Inc. from its gross income when it file its income tax returns for 1953 and
1954. Furthermore, it did not withhold or pay tax on them. Consequently, the
Commissioner of Internal Revenue assessed against Philippine Guaranty Co., Inc.
withholding tax on the ceded reinsurance premiums.
Issue: Whether the reinsurance premiums ceded to foreign reinsurers not doing
business in the Philippines are subject to withholding tax?
Held: The reinsurance premiums are subject to withholding tax. The reinsurance
contracts, however, show that the transactions or activities that constituted the
undertaking to reinsure Philippine Guaranty Co., Inc. against loses arising from the
original insurances in the Philippines were performed in the Philippines. The liability of
the foreign reinsurers commenced simultaneously with the liability of Philippine
Guaranty Co., Inc. under the original insurances. Philippine Guaranty Co., Inc. kept in
Manila a register of the risks ceded to the foreign reinsurers. Entries made in such
register bound the foreign resinsurers, localizing in the Philippines the actual cession of
the risks and premiums and assumption of the reinsurance undertaking by the foreign
reinsurers. Taxes on premiums imposed by Section 259 of the Tax Code for the privilege
of doing insurance business in the Philippines were payable by the foreign reinsurers
when the same were not recoverable from the original assured. The foreign reinsurers
paid Philippine Guaranty Co., Inc. an amount equivalent to 5% of the ceded premiums,
in consideration for administration and management by the latter of the affairs of the
former in the Philippines in regard to their reinsurance activities here. Disputes and
differences between the parties were subject to arbitration in the City of Manila. All the
reinsurance contracts, except that with Swiss Reinsurance Company, were signed by
Philippine Guaranty Co., Inc. in the Philippines and later signed by the foreign
reinsurers abroad. Although the contract between Philippine Guaranty Co., Inc. and
Swiss Reinsurance Company was signed by both parties in Switzerland, the same
specifically provided that its provision shall be construed according to the laws of the
Philippines, thereby manifesting a clear intention of the parties to subject themselves to
Philippine law.
Section 24 of the Tax Code subjects foreign corporations to tax on their income from
sources within the Philippines. The word "sources" has been interpreted as the activity,
property or service giving rise to the income.
1
The reinsurance premiums were income
created from the undertaking of the foreign reinsurance companies to reinsure
Philippine Guaranty Co., Inc., against liability for loss under original insurances. Such
undertaking, as explained above, took place in the Philippines. These insurance
premiums, therefore, came from sources within the Philippines and, hence, are subject
to corporate income tax.
The foreign insurers' place of business should not be confused with their place of
activity. Business should not be continuity and progression of transactions while activity
may consist of only a single transaction. An activity may occur outside the place of
business. Section 24 of the Tax Code does not require a foreign corporation to engage in
business in the Philippines in subjecting its income to tax. It suffices that the activity
creating the income is performed or done in the Philippines. What is controlling,
therefore, is not the place of business but the place of activity that created an income.


HOWDEN & CO v CIR
PHILIPPINE AMERICAN LIFE INSURANCE CO v CTA
Howden Vs CIR
(taxation from Sources in the Philippines)

FACTS:

Commonwealth Insurance Co. (CIC), a domestic corporation, entered into reinsurance
contracts with 32 British companies not engaged in business in thePhilippines
represented by herein Plaintiff. CIC remitted to Plaintiff reinsurance premiums and, on
behalf of Plaintiff, paid income tax on the premiums. Plaintiff filed a claim for a refund
of the paid tax, stating that it was exempted from withholding tax reinsurance
premiums received from domestic insurance companies by foreign insurance companies
not authorized to do business in the Philippines. Plaintiffs stated that since Sec. 53 and
54 were substantially re-enacted by RA 1065, 1291 and 2343,
said rulings should be given the force of law under the principle of legislative approval
by re-enactment.

ISSUE:
W/N the tax should be withheld.

HELD:

No. The principle of legislative enactment states that where a statute is susceptible of
the meaning placed upon it by a ruling of the government agency charged with its
enforcement and the legislature thereafter re-enacts the provisions without substantial
changes, such action is confirmatory to an extent that the ruling carries out the
legislative purpose. This principle is not applicable for heaforementioned sections were
never re-enacted. Only the tax rate was amended. The administrative rulings invoked by
the CIR were only contained in unpublished letters. It cannot be assumed that the
legislature knew of these rulings. Finally, the premiums remitted were to indemnify CIC
against liability. This took place within the
Philippines, thus subject to income tax