CIR, Petitioner, vs.
ISABELA CULTURAL On March 23, 1990, ICC sought a reconsideration of the subject
CORPORATION, Respondent
Petitioner Commissioner of Internal Revenue (CIR) assails the
September 30, 2005 Decision1 of the Court of Appeals in CA-G.R.
SP No. 78426 affirming the February 26, 2003 Decision2 of the
Court of Tax Appeals (CTA) in CTA Case No. 5211, which
cancelled and set aside the Assessment Notices for deficiency
income tax and expanded withholding tax issued by the Bureau of
Internal Revenue (BIR) against respondent Isabela Cultural
Corporation (ICC).
The facts show that on February 23, 1990, ICC, a domestic
corporation, received from the BIR Assessment Notice No. FAS-
1-86-90-000680 for deficiency income tax in the amount of
P333,196.86, and Assessment Notice No. FAS-1-86-90-000681
for deficiency expanded withholding tax in the amount of
P4,897.79, inclusive of surcharges and interest, both for the
taxable year 1986.
The deficiency income tax of P333,196.86, arose from:
(1) The BIR’s disallowance of ICC’s claimed expense
deductions for professional and security services billed to
and paid by ICC in 1986, to wit:
(a) Expenses for the auditing services of SGV &
Co.,3 for the year ending December 31, 1985;4
(b) Expenses for the legal services [inclusive of
retainer fees] of the law firm Bengzon Zarraga
Narciso Cudala Pecson Azcuna & Bengson for
the years 1984 and 1985.5
(c) Expense for security services of El Tigre
Security & Investigation Agency for the months
of April and May 1986.6
(2) The alleged understatement of ICC’s interest income
on the three promissory notes due from Realty
Investment, Inc.
The deficiency expanded withholding tax of P4,897.79 (inclusive
of interest and surcharge) was allegedly due to the failure of ICC
to withhold 1% expanded withholding tax on its claimed
P244,890.00 deduction for security services.7
determinable at that time, hence, it could be considered as
assessments. On February 9, 1995, however, it received a final
notice before seizure demanding payment of the amounts stated
in the said notices. Hence, it brought the case to the CTA which
held that the petition is premature because the final notice of
assessment cannot be considered as a final decision appealable
to the tax court. This was reversed by the Court of Appeals
holding that a demand letter of the BIR reiterating the payment of
deficiency tax, amounts to a final decision on the protested
assessment and may therefore be questioned before the CTA.
This conclusion was sustained by this Court on July 1, 2001, in
G.R. No. 135210.8 The case was thus remanded to the CTA for
further proceedings.
On February 26, 2003, the CTA rendered a decision canceling
and setting aside the assessment notices issued against ICC. It
held that the claimed deductions for professional and security
services were properly claimed by ICC in 1986 because it was
only in the said year when the bills demanding payment were sent
to ICC. Hence, even if some of these professional services were
rendered to ICC in 1984 or 1985, it could not declare the same as
deduction for the said years as the amount thereof could not be
determined at that time.
The CTA also held that ICC did not understate its interest income
on the subject promissory notes. It found that it was the BIR which
made an overstatement of said income when it compounded the
interest income receivable by ICC from the promissory notes of
Realty Investment, Inc., despite the absence of a stipulation in the
contract providing for a compounded interest; nor of a
circumstance, like delay in payment or breach of contract, that
would justify the application of compounded interest.
Likewise, the CTA found that ICC in fact withheld 1% expanded
withholding tax on its claimed deduction for security services as
shown by the various payment orders and confirmation receipts it
presented as evidence. The dispositive portion of the CTA’s
Decision, reads:
WHEREFORE, in view of all the foregoing, Assessment Notice
No. FAS-1-86-90-000680 for deficiency income tax in the amount
of P333,196.86, and Assessment Notice No. FAS-1-86-90-
000681 for deficiency expanded withholding tax in the amount of
P4,897.79, inclusive of surcharges and interest, both for the
taxable year 1986, are hereby CANCELLED and SET ASIDE.
Petitioner filed a petition for review with the Court of Appeals,
which affirmed the CTA decision,10 holding that although the
professional services (legal and auditing services) were rendered
to ICC in 1984 and 1985, the cost of the services was not yet
deductible expenses only in 1986 when ICC received the billing
statements for said services. It further ruled that ICC did not
understate its interest income from the promissory notes of Realty
Investment, Inc., and that ICC properly withheld and remitted
taxes on the payments for security services for the taxable year
1986.
Hence, petitioner, through the Office of the Solicitor General, filed
the instant petition contending that since ICC is using the accrual
method of accounting, the expenses for the professional services
that accrued in 1984 and 1985, should have been declared as
deductions from income during the said years and the failure of
ICC to do so bars it from claiming said expenses as deduction for
the taxable year 1986. As to the alleged deficiency interest
income and failure to withhold expanded withholding tax
assessment, petitioner invoked the presumption that the
assessment notices issued by the BIR are valid.
The issue for resolution is whether the Court of Appeals correctly:
(1) sustained the deduction of the expenses for professional and
security services from ICC’s gross income; and (2) held that ICC
did not understate its interest income from the promissory notes of
Realty Investment, Inc; and that ICC withheld the required 1%
withholding tax from the deductions for security services.
The requisites for the 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 or other pertinent papers.11
The requisite that it must have been paid or incurred during the
taxable year is further qualified by Section 45 of the National
Internal Revenue Code (NIRC) which states that: "[t]he deduction
provided for in this Title shall be taken for the taxable year in
which ‘paid or accrued’ or ‘paid or incurred’, dependent upon the
method of accounting upon the basis of which the net income is
computed x x x".
Accounting methods for tax purposes comprise a set of rules for
determining when and how to report income and deductions.12 In
the instant case, the accounting method used by ICC is the
accrual method.
Revenue Audit Memorandum Order No. 1-2000, provides that
under the accrual method of accounting, expenses not being
claimed as deductions by a taxpayer in the current year when
they are incurred cannot be claimed as deduction from income for
the succeeding year. Thus, a taxpayer who is authorized to
deduct certain expenses and other allowable deductions for the
current year but failed to do so cannot deduct the same for the
next year.13
The accrual method relies upon the taxpayer’s right to receive
amounts or its obligation to pay them, in opposition to actual
receipt or payment, which characterizes the cash method of
accounting. Amounts of income accrue where the right to receive
them become fixed, where there is created an enforceable
liability. Similarly, liabilities are accrued when fixed and
determinable in amount, without regard to indeterminacy merely
of time of payment.14
For a taxpayer using the accrual method, the determinative
question is, when do the facts present themselves in such a
manner that the taxpayer must recognize income or expense?
The accrual of income and expense is permitted when the all-
events test has been met. This test requires: (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.
The all-events test requires the right to income or liability be fixed,
and the amount of such income or liability be determined with
reasonable accuracy. However, the test does not demand that the
amount of income or liability be known absolutely, only that a
taxpayer has at his disposal the information necessary to compute
the amount with reasonable accuracy. The all-events test is
satisfied where computation remains uncertain, if its basis is
unchangeable; the test is satisfied where a computation may be
unknown, but is not as much as unknowable, within the taxable
year. The amount of liability does not have to be determined
exactly; it must be determined with "reasonable accuracy."
Accordingly, the term "reasonable accuracy" implies
something less than an exact or completely accurate
amount.[15]
The propriety of an accrual must be judged by the facts that a
taxpayer knew, or could reasonably be expected to have
known, at the closing of its books for the taxable
year.[16] Accrual method of accounting presents largely a
question of fact; such that the taxpayer bears the burden of proof
of establishing the accrual of an item of income or deduction.17
Corollarily, it is a governing principle in taxation that tax
exemptions must be construed in strictissimi juris against the
taxpayer and liberally in favor of the taxing authority; and one who
claims an exemption must be able to justify the same by the
clearest grant of organic or statute law. An exemption from the
common burden cannot be permitted to exist upon vague
implications. And since a deduction for income tax purposes
partakes of the nature of a tax exemption, then it must also be
strictly construed.18
In the instant case, the expenses for professional fees consist of
expenses for legal and auditing services. The expenses for legal
services pertain to the 1984 and 1985 legal and retainer fees of
the law firm Bengzon Zarraga Narciso Cudala Pecson Azcuna &
Bengson, and for reimbursement of the expenses of said firm in
connection with ICC’s tax problems for the year 1984. As testified
by the Treasurer of ICC, the firm has been its counsel since the
1960’s.19 From the nature of the claimed deductions 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 the compensation for its legal services. The failure to
determine the exact amount of the expense during the taxable
year when they could have been claimed as deductions cannot
thus be attributed solely to the delayed billing of these liabilities by
the firm. For one, ICC, in the exercise of due diligence could have
inquired into the amount of their obligation to the firm, especially
so that it is using the accrual method of accounting. For another, it
could have reasonably determined the amount of legal and
retainer fees owing to its familiarity with the rates charged by their
long time legal consultant.
As previously stated, the accrual method presents largely a
question of fact and that the taxpayer bears the burden of
establishing the accrual of an expense or income. However, ICC
failed to discharge this burden. As to when the firm’s performance
of its services in connection with the 1984 tax problems were
completed, or whether ICC exercised reasonable diligence to
inquire about the amount of its liability, or whether it does or does
not possess the information necessary to compute the amount of
said liability with reasonable accuracy, are questions of fact which
ICC never established. It simply relied on the defense of delayed
billing by the firm and the company, which under the
circumstances, is not sufficient to exempt it from being charged
with knowledge of the reasonable amount of the expenses for
legal and auditing services.
In the same vein, the professional fees of SGV & Co. for auditing
the financial statements of ICC for the year 1985 cannot be validly
claimed as expense deductions in 1986. This is so because ICC
failed to present evidence showing that even with only
"reasonable accuracy," as the standard to ascertain its liability to
SGV & Co. in the year 1985, it cannot determine the professional
fees which said company would charge for its services.
ICC thus failed to discharge the burden of proving that the
claimed expense deductions for the professional services were
allowable deductions for the taxable year 1986. Hence, per
Revenue Audit Memorandum Order No. 1-2000, they cannot be
validly deducted from its gross income for the said year and were
therefore properly disallowed by the BIR.
As to the expenses for security services, the records show that
these expenses were incurred by ICC in 198620 and could
therefore be properly claimed as deductions for the said year.
Anent the purported understatement of interest income from the
promissory notes of Realty Investment, Inc., we sustain the
findings of the CTA and the Court of Appeals that no such
understatement exists and that only simple interest computation
and not a compounded one should have been applied by the BIR.
There is indeed no stipulation between the latter and ICC on the
application of compounded interest.21 Under Article 1959 of the
Civil Code, unless there is a stipulation to the contrary, interest
due should not further earn interest.
Likewise, the findings of the CTA and the Court of Appeals that
ICC truly withheld the required withholding tax from its claimed
deductions for security services and remitted the same to the BIR
is supported by payment order and confirmation receipts. 22 Hence,
the Assessment Notice for deficiency expanded withholding tax
was properly cancelled and set aside.
In sum, Assessment Notice No. FAS-1-86-90-000680 in the
amount of P333,196.86 for deficiency income tax should be
cancelled and set aside but only insofar as the claimed
deductions of ICC for security services. Said Assessment is valid
as to the BIR’s disallowance of ICC’s expenses for professional
services. The Court of Appeal’s cancellation of Assessment
Notice No. FAS-1-86-90-000681 in the amount of P4,897.79 for
deficiency expanded withholding tax, is sustained.
WHEREFORE, the petition is PARTIALLY GRANTED. The
September 30, 2005 Decision of the Court of Appeals in CA-G.R.
SP No. 78426, is AFFIRMED with the MODIFICATION that
Assessment Notice No. FAS-1-86-90-000680, which disallowed
the expense deduction of Isabela Cultural Corporation for
professional and security services, is declared valid only insofar
as the expenses for the professional fees of SGV & Co. and of the
law firm, Bengzon Zarraga Narciso Cudala Pecson Azcuna &
Bengson, are concerned. The decision is affirmed in all other
respects. The case is remanded to the BIR.
C. M. HOSKINS & CO., INC., petitioner, vs. CIR
We uphold in this taxpayer's appeal the Tax Court's ruling that
payment by the taxpayer to its controlling stockholder of 50% of
its supervision fees or the amount of P99,977.91 is not a
deductible ordinary and necessary expense and should be treated
as a distribution of earnings and profits of the taxpayer.
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, respondent Commissioner of Internal
Revenue, 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. The Tax Court therefore
determined petitioner's tax deficiency to be in the amount of
P27,145.00 and on November 8, 1964 rendered judgment against
it, as follows:
WHEREFORE, premises considered, the decision of the
respondent is hereby modified. Petitioner is ordered to
pay to the latter or his representative the sum of
P27,145.00, representing deficiency income tax for the
year 1957, plus interest at 1/2% per month from June 20,
1959 to be computed in accordance with the provisions of
Section 51(d) of the National Internal Revenue Code. If
the deficiency tax is not paid within thirty (30) days from
the date this decision becomes final, petitioner is also
ordered to pay surcharge and interest as provided for in
Section 51 (e) of the Tax Code, without costs.
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.
We find no merit in petitioner's appeal.
As found by the Tax Court, "petitioner was founded by Mr. C. M.
Hoskins in 1937, with a capital stock of 1,000 shares at a par
value of P1.00 each share; that of these 1,000 shares, Mr. C. M.
Hoskins owns 996 shares (the other 4 shares being held by the
other four officers of the corporation), which constitute exactly
99.6% of the total authorized capital stock (p. 92, t.s.n.); that
during the first four years of its existence, Mr. C. M. Hoskins was
the President, but during the taxable period in question, that is,
from October 1, 1956 to September 30, 1957, he was the
chairman of the Board of Directors and salesman-broker for the
company (p. 93, t.s.n.); 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 (p. 94, t.s.n.); that he was also a
stockholder and officer of the Paradise Farms, Inc. and Realty
Investments, Inc., from which petitioner derived a large portion of
its income in the form of supervision fees and commissions
earned on sales of lots (pp. 97-99, t.s.n.; Financial Statements,
attached to Exhibit '1', p. 11, BIR rec.); that as chairman of the
Board of Directors of petitioner, his duties were: "To act as a
salesman; as a director, preside over meetings and to get all of
the real estate business I could for the company by negotiating
sales, purchases, making appraisals, raising funds to finance real
estate operations where that was necessary' (p. 96, t.s.n.); that he
was familiar with the contract entered into by the petitioner with
the Paradise Farms, Inc. and the Realty Investments, Inc. by the
terms of which petitioner was 'to program the development,
arrange financing, plan the proposed subdivision as outlined in
the prospectus of Paradise Farms, Inc., arrange contract for road
constructions, with the provision of water supply to all of the lots
and in general to serve as managing agents for the Paradise
Farms, Inc. and subsequently for the Realty Investment, Inc." (pp.
96-97. t.s.n.)
Considering that in addition to being Chairman of the board of
directors of petitioner corporation, which bears his name, Hoskins,
who owned 99.6% of its total authorized capital stock while the
four other officers-stockholders of the firm owned a total of four-
tenths of 1%, or one-tenth of 1% each, with their respective
nominal shareholdings of one share each was also salesman-
broker for his company, receiving a 50% share of the sales
commissions earned by petitioner, besides his monthly salary of
P3,750.00 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 Section 30 (a) (i) of the Tax Code.
If such payment of P99,977.91 were to be allowed as a deductible
item, then Hoskins would receive on these three items alone
(salary, bonus and supervision fee) a total of P184,977.91, which
would be double the petitioner's reported net income for the year
of P92,540.25. As correctly observed by respondent. If
independently, a one-time P100,000.00-fee to plan and lay down
the rules for supervision of a subdivision project were to be paid to
an experienced realtor such as Hoskins, its fairness and
deductibility by the taxpayer could be conceded; but here 50% of
the supervision fee of petitioner was being paid by it to Hoskins
every year since 1955 up to 1963 and for as long as its contract
with the subdivision owner subsisted, regardless of whether
services were actually rendered by Hoskins, since his services to
petitioner included such planning and supervision and were
already handsomely paid for by petitioner.
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,
holding 99.6% of its stock, 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.1
Petitioner's invoking of its policy since its incorporation of sharing
equally sales commissions with its salesmen, in accordance with
its board resolution of June 18, 1946, is equally untenable.
Petitioner's Sales Regulations provide:
Compensation of Salesmen
8. Schedule I — In the case of sales to prospects
discovered and worked by a salesman, even though the
closing is done by or with the help of the Sales Manager
or other members of the staff, the salesmen get one-half
(1/2) of the total commission received by the Company,
but not exceeding five percent (5%). In the case of
subdivisions, when the office commission covers general
supervision, the 1/2-rule does not apply, the salesman's
share being stipulated in the case of each subdivision. In
most cases the salesman's share is 4%. (Exh. "N-1").2
It will be readily seen therefrom that when the petitioner's
commission covers general supervision, it is provided that the 1/2
rule of equal sharing of the sales commissions does not apply and
that the salesman's share is stipulated in the case of each
subdivision. Furthermore, what is involved here is not Hoskins'
salesman's share in the petitioner's 12% sales commission, which
he presumably collected also from petitioner without respondent's
questioning it, but a 50% share besides in petitioner's planning
and supervision fee of 8% of the gross sales, as mentioned
above. This is evident from petitioner's board's resolution of July
14, 1953 (Exhibit 7), wherein it is recited that in addition to
petitioner's sales commission of 12% of gross sales, the
subdivision owners were paying to petitioner 8% of gross sales as
supervision fee, and a collection fee of 5% of gross collections, or
total fees of 25% of gross sales.
The case before us is similar to previous cases of disallowances
as deductible items of officers' extra fees, bonuses and
commissions, upheld by this Court as not being within the purview
of ordinary and necessary expenses and not passing the test of
reasonable compensation.3 In Kuenzle & Streiff, Inc. vs.
Commissioner of Internal Revenue decided by this Court on May
29, 1969,4 we reaffirmed the test of reasonableness, enunciated in
the earlier 1967 case involving the same parties, that: "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' (4 Mertens Law of
Federal Income Taxation, Sec. 25.50, p. 410). 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' (Idem., Sec. 25, 44, p. 395).
"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' (4 Mertens, Law of
Federal Income Taxation, Secs. 25.44, 25.49, 25.50, 25.51, pp.
407-412). 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 respondent
Commissioner of Internal Revenue. Thus: "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."
Finally, it should be noted that we have here a case practically of
a sole proprietorship of C. M. Hoskins, who however chose to
incorporate his business with himself holding virtually absolute
control thereof with 99.6% of its stock with four other nominal
shareholders holding one share each. Having chosen to use the
corporate form with its legal advantages of a separate corporate
personality as distinguished from his individual personality, the
corporation so created, i.e., petitioner, is bound to comport itself in
accordance with corporate norms and comply with its corporate
obligations. Specifically, it is bound to pay the income tax imposed
by law on corporations and may not legally be permitted, by way
of corporate resolutions authorizing payment of inordinately large
commissions and fees to its controlling stockholder, to dilute and
diminish its corresponding corporate tax liability.
ACCORDINGLY, the decision appealed from is hereby affirmed.