Republic of the PhilippinesSUPREME COURTManilaFIRST DIVISIONG.R. No. 78133 October 18, 1988MARIANO P. PASCUAL and RENATO P. DRAGON,petitioners,vs.THE COMMISSIONER OF INTERNAL REVENUE and COURT OF TAX APPEALS,respondents.De la Cuesta, De las Alas and Callanta Law Offices for petitioners.The Solicitor General for respondentsGANCAYCO,J.:The distinction between co-ownership and an unregistered partnership or joint venture for income tax purposes is the issue in this petition.On June 22, 1965, petitioners bought two (2) parcels of land from Santiago Bernardino, et al. and on May 28, 1966, they bought another three (3) parcels of land from Juan Roque. The first two parcels of land were sold by petitioners in 1968 toMarenir Development Corporation, while the three parcels of land were sold by petitioners to Erlinda Reyes and Maria Samson on March 19,1970. Petitioners realized a net profit in the sale made in 1968 in the amount of P165,224.70, while they realized a net profit of P60,000.00 in the sale made in 1970. The corresponding capital gains taxes were paid by petitioners in 1973 and 1974 by availing of the tax amnesties granted in the said years.However, in a letter dated March 31, 1979 of then Acting BIR Commissioner Efren I. Plana, petitioners were assessed and required to pay a total amount of P107,101.70 as alleged deficiency corporate income taxes for the years 1968 and 1970.Petitioners protested the said assessment in a letter of June 26, 1979 asserting that they had availed of tax amnesties way back in 1974.In a reply of August 22, 1979, respondent Commissioner informed petitioners that in the years 1968 and 1970, petitioners as co-owners in the real estate transactions formed an unregistered partnership or joint venture taxable as a corporation under Section 20(b) and its income was subject to the taxes prescribed under Section 24, both of the National Internal Revenue Code1that the unregistered partnership was subject to corporate income tax as distinguished from profits derived from the partnership by them which is subject to individual income tax; and that the availment of tax amnesty under P.D. No. 23, as amended, by petitioners relieved petitioners of their individual income tax liabilities but did not relieve them from the tax liability of the unregistered partnership. Hence, the petitioners were required to pay the deficiency income tax assessed.Petitioners filed a petition for review with the respondent Court of Tax Appeals docketed as CTA Case No. 3045. In due course, the respondent court by a majority decision of March 30, 1987,2affirmed the decision and action taken by respondent commissioner with costs against petitioners.It ruled that on the basis of the principle enunciated inEvangelista3an unregistered partnership was in fact formed by petitioners which like a corporation was subject to corporate income tax distinct from that imposed on the partners.In a separate dissenting opinion, Associate Judge Constante Roaquin stated that considering the circumstances of this case, although there might in fact be a co-ownership between the petitioners, there was no adequate basis for the conclusion that they thereby formed an unregistered partnership which made "hem liable for corporate income tax under the Tax Code.Hence, this petition wherein petitioners invoke as basis thereof the following alleged errors of the respondent court:A. IN HOLDING AS PRESUMPTIVELY CORRECT THE DETERMINATION OF THE RESPONDENT COMMISSIONER, TO THE EFFECT THAT PETITIONERS FORMED AN UNREGISTERED PARTNERSHIP SUBJECT TO CORPORATE INCOME TAX, AND THAT THE BURDEN OF OFFERING EVIDENCE IN OPPOSITION THERETO RESTS UPON THE PETITIONERS.B. IN MAKING A FINDING, SOLELY ON THE BASIS OF ISOLATED SALE TRANSACTIONS, THAT AN UNREGISTERED PARTNERSHIP EXISTED THUS IGNORING THE REQUIREMENTS LAID DOWN BY LAW THAT WOULD WARRANT THE PRESUMPTION/CONCLUSION THAT A PARTNERSHIP EXISTS.C. IN FINDING THAT THE INSTANT CASE IS SIMILAR TO THE EVANGELISTA CASE AND THEREFORE SHOULD BE DECIDED ALONGSIDE THE EVANGELISTA CASE.D. IN RULING THAT THE TAX AMNESTY DID NOT RELIEVE THE PETITIONERS FROM PAYMENT OF OTHER TAXES FOR THE PERIOD COVERED BY SUCH AMNESTY. (pp. 12-13, Rollo.)The petition is meritorious.The basis of the subject decision of the respondent court is the ruling of this Court inEvangelista.4In the said case, petitioners borrowed a sum of money from their father which together with their own personal funds they used in buying several real properties. They appointed their brother to manage their properties with full power to lease, collect, rent, issue receipts, etc. They had the real properties rented or leased to various tenants for several years and they gained net profits from the rental income. Thus, the Collector of Internal Revenue demanded the payment of income tax on a corporation, among others, from them.In resolving the issue, this Court held as follows:The issue in this case is whether petitioners are subject to the tax on corporations provided for in section 24 of Commonwealth Act No. 466, otherwise known as the National Internal Revenue Code, as well as to the residence tax for corporations and the real estate dealers' fixed tax. With respect to the tax on corporations, the issue hinges on the meaning of the terms corporation and partnership as used in sections 24 and 84 of said Code, the pertinent parts of which read:Sec. 24.Rate of the tax on corporations.There shall be levied, assessed, collected, and paid annually upon the total net income received in the preceding taxable year from all sources by every corporation organized in, or existing under the laws of the Philippines, no matter how created or organized but not including duly registered general co-partnerships (companies collectives), a tax upon such income equal to the sum of the following: ...Sec. 84(b). The term "corporation" includes partnerships, no matter how created or organized, joint-stock companies, joint accounts (cuentas en participation), associations or insurance companies, but does not include duly registered general co-partnerships (companies colectivas).Article 1767 of the Civil Code of the Philippines provides:By the 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.Pursuant to this article,the essential elements of a partnership are two, namely: (a) an agreement to contribute money, property or industry to a common fund; and (b) intent to divide the profits among the contracting parties. The first element is undoubtedly present in the case at bar, for, admittedly, petitioners have agreed to, and did, contribute money and property to a common fund.Hence, the issue narrows down to their intent in acting as they did. Upon consideration of all the facts and circumstances surrounding the case,we are fully satisfied that their purpose was to engage in real estate transactions for monetary gain and then divide the same among themselves, because:1. Said common fund was not something they found already in existence. It was not a property inherited by them pro indiviso. Theycreated it purposely. What is more they jointly borrowed a substantial portion thereof in order to establish said common fund.2. Theyinvested the same, not merely in one transaction, but in a series of transactions. On February 2, 1943, they bought a lot for P100,000.00. On April 3, 1944, they purchased 21 lots for P18,000.00. This was soon followed, on April 23, 1944, by the acquisition of another real estate for P108,825.00. Five (5) days later (April 28, 1944), they got a fourth lot for P237,234.14.The number of lots (24) acquired and transcations undertaken, as well as the brief interregnum between each, particularly the last three purchases, is strongly indicative of a pattern or common design that was not limited to the conservation and preservation of the aforementioned common fund or even of the property acquired by petitioners in February, 1943. In other words, one cannot but perceive a character of habituality peculiar to business transactions engaged in for purposes of gain.3. The aforesaid lots were not devoted to residential purposes or to other personal uses, of petitioners herein. The properties were leased separately to several persons, who, from 1945 to 1948 inclusive, paid the total sum of P70,068.30 by way of rentals. Seemingly, the lots are still being so let, for petitioners do not even suggest that there has been any change in the utilization thereof.4. Since August, 1945,the properties have been under the management of one person, namely, Simeon Evangelists, with full power to lease, to collect rents, to issue receipts, to bring suits, to sign letters and contracts, and to indorse and deposit notes and checks.Thus, the affairs relative to said properties have been handled as if the same belonged to a corporation or business enterprise operated for profit.5. The foregoing conditions have existed for more than ten (10) years, or, to be exact, over fifteen (15) years, since the first property was acquired, and over twelve (12) years, since Simeon Evangelists became the manager.6. Petitioners have not testified or introduced any evidence, either on their purpose in creating the set up already adverted to, or on the causes for its continued existence. They did not even try to offer an explanation therefor.Although, taken singly, they might not suffice to establish the intent necessary to constitute a partnership,the collective effect of these circumstances is such as to leave no room for doubt on the existence of said intent in petitioners herein. Only one or two of the aforementioned circumstances were present in the cases cited by petitioners herein, and, hence, those cases are not in point.5In the present case, there is no evidence that petitioners entered into an agreement to contribute money, property or industry to a common fund, and that they intended to divide the profits among themselves. Respondent commissioner and/ or his representative just assumed these conditions to be present on the basis of the fact that petitioners purchased certain parcels of land and became co-owners thereof.In Evangelists,there was a series of transactions where petitioners purchased twenty-four (24) lotsshowing that the purpose was not limited to the conservation or preservation of the common fund or even the properties acquired by them.The character of habituality peculiar to business transactions engaged in for the purpose of gain was present.In the instant case, petitioners bought two (2) parcels of land in 1965. They did not sell the same nor make any improvements thereon. In 1966, they bought another three (3) parcels of land from one seller. It was only 1968 when they sold the two (2) parcels of land after which they did not make any additional or new purchase. The remaining three (3) parcels were sold by them in 1970. The transactions were isolated. The character of habituality peculiar to business transactions for the purpose of gain was not present.InEvangelista, the properties were leased out to tenants for several years. The business was under the management of one of the partners. Such condition existed for over fifteen (15) years. None of the circumstances are present in the case at bar. The co-ownership started only in 1965 and ended in 1970.Thus, in the concurring opinion of Mr. Justice Angelo Bautista inEvangelistahe said:I wish however to make the following observation Article 1769 of the new Civil Code lays down the rule for determining when a transaction should be deemed a partnership or a co-ownership. Said article paragraphs 2 and 3, provides;(2) Co-ownership or co-possession does not itself establish a partnership, whether such co-owners or co-possessors do or do not share any profits made by the use of the property;(3) The sharing of gross returns does not of itself establish a partnership, whether or not the persons sharing them have a joint or common right or interest in any property from which the returns are derived;From the above it appears that the fact that those who agree to form a co- ownership share or do not share any profits made by the use of the property held in common does not convert their venture into a partnership. Or the sharing of the gross returns does not of itself establish a partnership whether or not the persons sharing therein have a joint or common right or interest in the property. This only means that, aside from the circumstance of profit, the presence of other elements constituting partnership is necessary, such as the clear intent to form a partnership, the existence of a juridical personality different from that of the individual partners, and the freedom to transfer or assign any interest in the property by one with the consent of the others(Padilla, Civil Code of the Philippines Annotated, Vol. I, 1953 ed., pp. 635-636)It is evident that an isolated transaction whereby two or more persons contribute funds to buy certain real estate for profit in the absence of other circumstances showing a contrary intention cannot be considered a partnership.Persons who contribute property or funds for a common enterprise and agree to share the gross returns of that enterprise in proportion to their contribution, but who severally retain the title to their respective contribution, are not thereby rendered partners. They have no common stock or capital, and no community of interest as principal proprietors in the business itself which the proceeds derived. (Elements of the Law of Partnership by Flord D. Mechem 2nd Ed., section 83, p. 74.)A joint purchase of land, by two, does not constitute a co-partnership in respect thereto; nor does an agreement to share the profits and losses on the sale of land create a partnership; the parties are only tenants in common. (Clark vs. Sideway, 142 U.S. 682,12 Ct. 327, 35 L. Ed., 1157.)Where plaintiff, his brother, and another agreed to become owners of a single tract of realty, holding as tenants in common, and to divide the profits of disposing of it, the brother and the other not being entitled to share in plaintiffs commission, no partnership existed as between the three parties, whatever their relation may have been as to third parties. (Magee vs. Magee 123 N.E. 673, 233 Mass. 341.)In order to constitute a partnership inter sese there must be: (a) An intent to form the same; (b) generally participating in both profits and losses; (c) and such a community of interest, as far as third persons are concerned as enables each party to make contract, manage the business, and dispose of the whole property.-Municipal Paving Co. vs. Herring 150 P. 1067, 50 III 470.)The common ownership of property does not itself create a partnership between the owners, though they may use it for the purpose of making gains; and they may, without becoming partners, agree among themselves as to the management, and use of such property and the application of the proceeds therefrom. (Spurlock vs. Wilson, 142 S.W. 363,160 No. App. 14.)6The sharing of returns does not in itself establish a partnership whether or not the persons sharing therein have a joint or common right or interest in the property. There must be a clear intent to form a partnership, the existence of a juridical personality different from the individual partners, and the freedom of each party to transfer or assign the whole property.In the present case, there is clear evidence of co-ownership between the petitioners. There is no adequate basis to support the proposition that they thereby formed an unregistered partnership. The two isolated transactions whereby they purchased properties and sold the same a few years thereafter did not thereby make them partners. They shared in the gross profits as co- owners and paid their capital gains taxes on their net profits and availed of the tax amnesty thereby. Under the circumstances, they cannot be considered to have formed an unregistered partnership which is thereby liable for corporate income tax, as the respondent commissioner proposes.And even assuming for the sake of argument that such unregistered partnership appears to have been formed, since there is no such existing unregistered partnership with a distinct personality nor with assets that can be held liable for said deficiency corporate income tax, then petitioners can be held individually liable as partners for this unpaid obligation of the partnership p.7However, as petitioners have availed of the benefits of tax amnesty as individual taxpayers in these transactions, they are thereby relieved of any further tax liability arising therefrom.WHEREFROM, the petition is hereby GRANTED and the decision of the respondent Court of Tax Appeals of March 30, 1987 is hereby REVERSED and SET ASIDE and another decision is hereby rendered relieving petitioners of the corporate income tax liability in this case, without pronouncement as to costs.SO ORDERED.Cruz, Grio-Aquino and Medialdea, JJ., concur.Narvasa, J., took no part.

PASCUAL v. Commissioner of Internal Revenue #10 BUSORG G.R. No. 78133 October 18, 1988 GANCAYCO, J.: FACTS: On June 22, 1965, petitioners bought two (2)parcels of land from Santiago Bernardino, et eland on May 28, 1966, they bought another three (3) parcels of land from Juan Roque. The first two parcels of land were sold by petitioners in 1968 to Marenir Development Corporation, while the three parcels of land were sold by petitioners to Erlinda Reyes and Maria Samson on March 19,1970. Petitioner realized a net profit in the sale made in 1968 in the amount of P165, 224.70, while they realized a net profit of P60,000 in the sale made in 1970. The corresponding capital gains taxes were paid by petitioners in 1973 and 1974 .Respondent Commissioner informed petitioners that in the years 1968 and 1970, petitioners as co-owners in the real estate transactions formed an unregistered partnership or joint venture taxable as a corporation under Section 20(b)and its income was subject to the taxes prescribed under Section 24, both of the National Internal Revenue Code; that the unregistered partnership was subject to corporate income tax as distinguished from profits derived from the partnership by them which is subject to individual income tax.

ISSUE:Whether petitioners formed an unregistered partnership subject to corporate income tax(partnership vs. co-ownership)RULING:Article 1769 of the new Civil Code lays down the rule for determining when a transaction should be deemed a partnership or a co-ownership. Said article paragraphs 2 and 3, provides:(2) Co-ownership or co-possession does not itself establish a partnership, whether such co-owners or co-possessors do or do not share any profits made by the use of the property; (3) The sharing of gross returns does not of itself establish a partnership, whether or not the persons sharing them have a joint or common right or interest in any property from which the returns are derived; The sharing of returns does not in itself establish a partnership whether or not the persons sharing therein have a joint or common right or interest in the property. There must be a clear intent to form a partnership, the existence of a juridical personality different from the individual partners, and the freedom of each party to transfer or assign the whole property. In the present case, there is clear evidence of co-ownership between the petitioners. There is no adequate basis to support the proposition that they thereby formed an unregistered partnership. The two isolated transactions whereby they purchased properties and sold the same a few years thereafter did not thereby make them partners. They shared in the gross profits as co- owners and paid their capital gains taxes on their net profits and availed of the tax amnesty thereby. Under the circumstances, they cannot be considered to have formed an unregistered partnership which is thereby liable for corporate income tax, as the respondent commissioner proposes. And even assuming for the sake of argument that such unregistered partnership appears to have been formed, since there is no such existing unregistered partnership with a distinct personality nor with assets that can be held liable for said deficiency corporate income tax, then petitioners can be held individually liable as partners for this unpaid obligation of the partnership

[G.R. No. L-26145. February 20, 1984.]

THE MANILA WINE MERCHANTS, INC.,Petitioner, v. THE COMMISSIONER OF INTERNAL REVENUE,Respondent.

Rafael D. Salcedo forPetitioner.

The Solicitor General forRespondent.

SYLLABUS

1. TAXATION; NATIONAL INTERNAL REVENUE CODE; CORPORATE INCOME TAX; ADDITIONAL TAX ON ACCUMULATED EARNINGS; EXEMPTION THEREFROM. A prerequisite to the imposition of the tax has been that the corporation be formed or availed of for the purpose of avoiding the income tax (or surtax) on its shareholders, or on the shareholders of any other corporation by permitting the earnings and profits of the corporation to accumulate instead of dividing them among or distributing them to the shareholders. If the earnings and profits were distributed, the shareholders would be required to pay an income tax thereon whereas, if the distribution were not made to them, they would incur no tax in respect to the undistributed earnings and profits of the corporation (Mertens, Law on Federal Income Taxation, Vol. 7, Chapter 39, p. 44). The touchstone of liability is the purpose behind the accumulation of the income and not the consequences of the accumulation (Ibid., p. 47). Thus, if the failure to pay dividends is due to some other cause, such as the use of undistributed earnings and profits for the reasonable needs of the business, such purpose does not fall within the interdiction of the statute (Ibid., p. 45).

2. ID.; ID.; ID.; ID.; ID.; WHEN ACCUMULATION CONSIDERED UNREASONABLE. An accumulation of earnings or profits (including undistributed earnings or profits of prior years) is unreasonable if it is not required for the purpose of the business, considering all the circumstances of the case (Sec. 21, Revenue Regulations No. 2).

3. ID.; ID.; ID.; ID.; ID.; "REASONABLE NEEDS OF THE BUSINESS," CONSTRUED. To determine the "reasonable needs" of the business in order to justify an accumulation of earnings, the Courts of the United States have invented the so-called "Immediacy Test" which construed the words "reasonable needs of the business" to mean the immediate needs of the business, and it was generally held that if the corporation did not prove an immediate need for the accumulation of the earnings and profits, the accumulation was not for the reasonable needs of the business, and the penalty tax would apply. American cases likewise hold that investment of the earnings and profits of the corporation in stock or securities of an unrelated business usually indicates an accumulation beyond the reasonable needs of the business. (Helvering v. Chicago Stockyards Co., 318 US 693; Helvering v. National Grocery Co., 304 US 282).

4. REMEDIAL LAW; APPEALS; FACTUAL FINDINGS OF THE COURT OF TAX APPEALS, BINDING. The finding of the Court of Tax Appeals that the purchase of the U.S.A. Treasury bonds were in no way related to petitioners business of importing and selling wines whisky, liquors and distilled spirits, and thus construed as an investment beyond the reasonable needs of the business is binding on Us, the same being factual (Renato Raymundo v. Hon. De Jova, 101 SCRA 495). Furthermore, the wisdom behind thus finding cannot be doubted, The case of J.M. Perry & Co. v. Commissioner of Internal Revenue supports the same.

5. TAXATION; NATIONAL INTERNAL REVENUE CODE; INCOME TAX OF CORPORATIONS; ADDITIONAL TAX ON ACCUMULATED EARNINGS; EXCEPTION THEREFROM; ACCUMULATION OF EARNINGS, MUST BE USED FOR REASONABLE NEEDS OF BUSINESS WITHIN A REASONABLE TIME. The records further reveal that from May 1951 when petitioner purchased the U.S.A. Treasury shares, until 1962 when it finally liquidated the same, it (petitioner) never had the occasion to use the said shares in aiding or financing its importation. This militates against the purpose enunciated earlier by petitioner that the shares were purchased to finance its importation business. To justify an accumulation of earnings and profits for the reasonably anticipated future needs, such accumulation must be used within a reasonable time after the close of the taxable year (Mertens, Ibid., p. 104).

6. ID.; ID.; ID.; ID.; ID.; ID.; INTENTION AT THE TIME OF ACCUMULATION, BASIS OF THE TAX; ACCUMULATION OF PROFITS IN CASE AT BAR, UNREASONABLE. In order to determine whether profits are accumulated for the reasonable needs of the business as to avoid the surtax upon shareholders, the controlling intention of the taxpayer is that which is manifested at the time of accumulation not subsequently declared intentions which are merely the product of afterthought (Basilan Estates, Inc. v. Comm. of Internal Revenue, 21 SCRA 17 citing Jacob Mertens, Jr., The law of Federal Income Taxation, Vol. 7, Cumulative Supplement, p. 213; Smoot and San & Gravel Corp. v. Comm., 241 F 2d 197). A speculative and indefinite purpose will not suffice. The mere recognition of a future problem and the discussion of possible and alternative solutions is not sufficient. Definiteness of plan coupled with action taken towards its consummation are essential (Fuel Carriers, Inc. v. US 202 F supp. 497; Smoot Sand & Gravel Corp. v. Comm., supra). Viewed on the foregoing analysis and tested under the "immediacy doctrine," We are convinced that the Court of Tax Appeals is correct in finding that the investment made by petitioner in the U.S.A. Treasury shares in 1951 was an accumulation of profits in excess of the reasonable needs of petitioners business.chanroblesvirtuallawlibrary

7. ID.; ID.; ID.; ID.; ACCUMULATIONS OF PRIOR YEARS TAKEN INTO ACCOUNT IN DETERMINATION OF LIABILITY THEREFOR. The rule is now settled in Our jurisprudence that undistributed earnings or profits of prior years are taken into consideration in determining unreasonable accumulation for purposes of the 25% surtax. The case of Basilan Estates, Inc. v. Commissioner of Internal Revenue further strengthen this rule in determining unreasonable accumulation for the year concerned.In determining whether accumulations of earnings or profits in a particular year are within the reasonable needs of a corporation, it is necessary to take into account prior accumulations, since accumulations prior to the year involved may have been sufficient to cover the business needs and additional accumulations during the year involved would not reasonably be necessary.

D E C I S I O N

GUERRERO,J.:

In this Petition for Review onCertiorari,Petitioner, the Manila Wine Merchants, Inc., disputes the decision of the Court of Tax Appeals ordering it (petitioner) to pay respondent, the Commissioner of Internal Revenue, the amount of P86,804.38 as 25% surtax plus interest which represents the additional tax due petitioner for improperly accumulating profits or surplus in the taxable year 1957 under Sec. 25 of the National Internal Revenue Code.chanrobles virtualawlibrary chanrobles.com:chanrobles.com.ph

The Court of Tax Appeals made the following finding of facts, to wit:jgc:chanrobles.com.ph

"Petitioner, a domestic corporation organized in 1937, is principally engaged in the importation and sale of whisky, wines, liquors and distilled spirits. Its original subscribed and paid capital was P500,000.00. Its capital of P500,000.00 was reduced to P250,000.00 in 1950 with the approval of the Securities and Exchange Commission but the reduction of the capital was never implemented. On June 21, 1958, petitioners capital was increased to P1,000,000.00 with the approval of the said Commission.

On December 31, 1957, herein respondent caused the examination of herein petitioners book of account and found the latter of having unreasonably accumulated surplus of P428,934.32 for the calendar year 1947 to 1957, in excess of the reasonable needs of the business subject to the 25% surtax imposed by Section 25 of the Tax Code.

On February 26, 1963, the Commissioner of Internal Revenue demanded upon the Manila Wine Merchants, Inc. payment of P126,536.12 as 25% surtax and interest on the latters unreasonable accumulation of profits and surplus for the year 1957, computed as follows:chanrob1es virtual 1aw library

Unreasonable accumulation of surtax P428,934.42

25% surtax due thereon P107,234.00

Add: 1/2% monthly interest from June 20,

1959 to June 20, 1962 19,302.12

TOTAL AMOUNT DUE AND COLLECTIBLE P126,536.12

=========

Respondent contends that petitioner has accumulated earnings beyond the reasonable needs of its business because the average ratio of the cash dividends declared and paid by petitioner from 1947 to 1957 was 40.33% of the total surplus available for distribution at the end of each calendar year. On the other hand, petitioner contends that in 1957, it distributed 100% of its net earnings after income tax and part of the surplus for prior years. Respondent further submits that the accumulated earnings tax should be based on 25% of the total surplus available at the end of each calendar year while petitioner maintains that the 25% surtax is imposed on the total surplus or net income for the year after deducting therefrom the income tax due.

The records show the following analysis of petitioners net income, cash dividends and earned surplus for the years 1946 to 1957: 1

Percentage of

Dividends to

Net Income Total Cash Net Income Balance

After Income Dividends After of Earned

Year Tax Paid Income Tax Surplus

1946 P 613,790.00 P 200,000. 32.58% P 234,104.81

1947 425,719.87 360,000. 84.56% 195,167.10

1948 415,591.83 375,000. 90.23% 272,991.38

1949 335,058.06 200,000. 59.69% 893,113.42

1950 399,698.09 600,000. 150.11% 234,987.07

1951 346,257.26 300,000. 86.64% 281,244.33

1952 196,161.97 200,000. 101.96% 277,406.30

1953 169,714.04 200,000. 117.85% 301,138.84

1954 238,124.85 250,000. 104.99% 289,262.69

1955 312,284.74 200,000. 64.04% 401,548.43

1956 374,240.28 300,000. 80.16% 475,788.71

1957 353,145.71 400,000. 113.27% 428,934.42

P4,179,787.36 P3,585.000. 85.77% P3,785.688.50

========== ========= ======= ==========

Another basis of respondent in assessing petitioner for accumulated earnings tax is its substantial investment of surplus or profits in unrelated business. These investments are itemized as follows:chanrob1es virtual 1aw library

1. Acme Commercial Co., Inc. P 27,501.00

2. Union Insurance Society

of Canton 1,145.76

3. U.S.A. Treasury Bond 347,217.50

4. Wack Wack Golf &

Country Club 1.00

375,865.26

=========

As to the investment of P27,501.00 made by petitioner in the Acme Commercial Co., Inc., Mr. N.R.E. Hawkins, president of the petitioner corporation 2 explained as follows:chanrob1es virtual 1aw library

The first item consists of shares of Acme Commercial Co., Inc. which the Company acquired in 1947 and 1949. In the said years, we thought it prudent to invest in a business which patronizes us. As a supermarket, Acme Commercial Co., Inc. is one of our best customers. The investment has proven to be beneficial to the stockholders of this Company. As an example, the Company received cash dividends in 1961 totalling P16,875.00 which was included in its income tax return for the said year.

As to the investments of petitioner in Union Insurance Society of Canton and Wack Wack Golf Club in the sums of P1,145.76 and P1.00, respectively, the same official of the petitioner-corporation stated that: 3

The second and fourth items are small amounts which we believe would not affect this case substantially. As regards the Union Insurance Society of Canton shares, this was a pre-war investment, when Wise & Co., Inc., Manila Wine Merchants and the said insurance firm were common stockholders of the Wise Bldg. Co.,, Inc. and the three companies were all housed in the same building. Union Insurance invested in Wise Bldg. Co., Inc. but invited Manila Wine Merchants, Inc. to buy a few of its shares.

As to the U.S.A. Treasury Bonds amounting to P347,217.50, Mr. Hawkins explained as follows: 4

With regards to the U.S.A. Treasury Bills in the amount of P347,217.50, in 1950, our balance sheet for the said year shows the Company had deposited in current account in various banks P629,403.64 which was not earning any interest. We decided to utilize part of this money as reserve to finance our importations and to take care of future expansion including acquisition of a lot and the construction of our own office building and bottling plant.

At that time, we believed that a dollar reserve abroad would be useful to the Company in meeting immediate urgent orders of its local customers. In order that the money may earn interest, the Company, on May 31, 1951 purchased US Treasury bills with 90-day maturity and earning approximately 1% interest with the face value of US$175,000.00. US Treasury Bills are easily convertible into cash and for the said reason they may be better classified as cash rather than investments.

The Treasury Bills in question were held as such for many years in view of our expectation that the Central Bank inspite of the controls would allow no-dollar licenses importations. However, since the Central Bank did not relax its policy with respect thereto, we decided sometime in 1957 to hold the bills for a few more years in view of our plan to buy a lot and construct a building of our own. According to the lease agreement over the building formerly occupied by us in Dasmarias St., the lease was to expire sometime in 1957. At that time, the Company was not yet qualified to own real property in the Philippines. We therefore waited until 60% of the stocks of the Company would be owned by Filipino citizens before making definite plans. Then in 1959 when the Company was already more than 60% Filipino owned, we commenced looking for a suitable location and then finally in 1961, we bought the man lot with an old building on Otis St., Paco, our present site, for P665,000.00. Adjoining smaller lots were bought later. After the purchase of the main property, we proceeded with the remodelling of the old building and the construction of additions, which were completed at a cost of P143,896.00 in April, 1962.

In view of the needs of the business of this Company and the purchase of the Otis lots and the construction of the improvements thereon, most of its available funds including the Treasury Bills had been utilized, but inspite of the said expenses the Company consistently declared dividends to its stockholders. The Treasury Bills were liquidated on February 15, 1962.

Respondent found that the accumulated surplus in question were invested to unrelated business which were not considered in the immediate needs of the Company such that the 25% surtax be imposed therefrom."cralaw virtua1aw library

Petitioner appealed to the Court of Tax Appeals.

On the basis of the tabulated figures, supra, the Court of Tax Appeals found that the average percentage of cash dividends distributed was 85.77% for a period of 11 years from 1946 to 1957 and not only 40.33% of the total surplus available for distribution at the end of each calendar year actually distributed by the petitioner to its stockholders, which is indicative of the view that the Manila Wine Merchants, Inc. was not formed for the purpose of preventing the imposition of income tax upon its shareholders. 5

With regards to the alleged substantial investment of surplus or profits in unrelated business, the Court of Tax Appeals held that the investment of petitioner with Acme Commercial Co., Inc., Union Insurance Society of Canton and with the Wack Wack Golf and Country Club are harmless accumulation of surplus and, therefore, not subject to the 25% surtax provided in Section 25 of the Tax Code. 6

As to the U.S.A. Treasury Bonds amounting to P347,217.50, the Court of Tax Appeals ruled that its purchase was in no way related to petitioners business of importing and selling wines, whisky, liquors and distilled spirits. Respondent Court was convinced that the surplus of P347,217.50 which was invested in the U.S.A. Treasury Bonds was availed of by petitioner for the purpose of preventing the imposition of the surtax upon petitioners shareholders by permitting its earnings and profits to accumulate beyond the reasonable needs of business. Hence, the Court of Tax Appeals modified respondents decision by imposing upon petitioner the 25% surtax for 1957 only in the amount of P86,804.38 computed as follows:chanrob1es virtual 1aw library

Unreasonable accumulation

of surplus P347,217.50

25% surtax due thereon P 86,804.38 7

On May 30, 1966, the Court of Tax Appeals denied the motion for reconsideration filed by petitioner on March 30, 1966. Hence, this petition.

Petition assigns the following errors:chanrob1es virtual 1aw libraryI

The Court of Tax Appeals erred in holding that petitioner was availed of for the purpose of preventing the imposition of a surtax on its shareholders.II

The Court of Tax Appeals erred in holding that petitioners purchase of U.S.A. Treasury Bills in 1951 was an investment in unrelated business subject to the 25% surtax in 1957 as surplus profits improperly accumulated in the latter years.III

The Court of Tax Appeals erred in not finding that petitioner did not accumulate its surplus profits improperly in 1957, and in not holding that such surplus profits, including the so-called unrelated investments, were necessary for its reasonable business needs.IV

The Court of Tax Appeals erred in not holding that petitioner had overcome the prima facie presumption provided for in Section 25(c) of the Revenue Code.V

The Court of Tax Appeals erred in finding petition liable for the payment of the surtax of P86,804.38 and in denying petitioners Motion for Reconsideration and/or New Trial.

The issues in this case can be summarized as follows: (1) whether the purchase of the U.S.A. Treasury bonds by petitioner in 1951 can be construed as an investment to an unrelated business and hence, such was availed of by petitioner for the purpose of preventing the imposition of the surtax upon petitioners shareholders by permitting its earnings and profits to accumulate beyond the reasonable needs of the business, and if so, (2) whether the penalty tax of twenty-five percent (25%) can be imposed on such improper accumulation in 1957 despite the fact that the accumulation occurred in 1951.chanrobles virtualawlibrary chanrobles.com:chanrobles.com.ph

The pertinent provision of the National Internal Revenue Code reads as follows:jgc:chanrobles.com.ph

"Sec. 25. Additional tax on corporations improperly accumulating profits or surplus. (a) Imposition of Tax. If any corporation, except banks, insurance companies, or personal holding companies whether domestic or foreign, is formed or availed of for the purpose of preventing the imposition of the tax upon its shareholders or members or the shareholders or members of another corporation, through the medium of permitting its gains and profits to accumulate instead of being divided or distributed, there is levied and assessed against such corporation, for each taxable year, a tax equal to twenty-five per centum of the undistributed portion of its accumulated profits or surplus which shall be in addition to the tax imposed by section twenty-four and shall be computed, collected and paid in the same manner and subject to the same provisions of law, including penalties, as that tax: Provided, that no such tax shall be levied upon any accumulated profits or surplus, if they are invested in any dollar-producing or dollar-saving industry or in the purchase of bonds issued by the Central Bank of the Philippines.xxx

(c) Evidence determinative of purpose. The fact that the earnings of profits of a corporation are permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid the tax upon its shareholders or members unless the corporation, by clear preponderance of evidence, shall prove the contrary." (As amended by Republic Act No. 1823).

As correctly pointed out by the Court of Tax Appeals, inasmuch as the provisions of Section 25 of the National Internal Revenue Code were bodily lifted from Section 102 of the U.S. Internal Revenue Code of 1939, including the regulations issued in connection therewith, it would be proper to resort to applicable cases decided by the American Federal Courts for guidance and enlightenment.chanrobles virtual lawlibrary

A prerequisite to the imposition of the tax has been that the corporation be formed or availed of for the purpose of avoiding the income tax (or surtax) on its shareholders, or on the shareholders of any other corporation by permitting the earnings and profits of the corporation to accumulate instead of dividing them among or distributing them to the shareholders. If the earnings and profits were distributed, the shareholders would be required to pay an income tax thereon whereas, if the distribution were not made to them, they would incur no tax in respect to the undistributed earnings and profits of the corporation. 8 The touchstone of liability is the purpose behind the accumulation of the income and not the consequences of the accumulation. 9 Thus, if the failure to pay dividends is due to some other cause, such as the use of undistributed earnings and profits for the reasonable needs of the business, such purpose does not fall within the interdiction of the statute. 10

An accumulation of earnings or profits (including undistributed earnings or profits of prior years) is unreasonable if it is not required for the purpose of the business, considering all the circumstances of the case. 11

In purchasing the U.S.A. Treasury Bonds, in 1951, petitioner argues that these bonds were so purchased (1) in order to finance their importation; and that a dollar reserve abroad would be useful to the Company in meeting urgent orders of its local customers and (2) to take care of future expansion including the acquisition of a lot and the construction of their office building and bottling plant.

We find no merit in the petition.

To avoid the twenty-five percent (25%) surtax, petitioner has to prove that the purchase of the U.S.A. Treasury Bonds in 1951 with a face value of $175,000.00 was an investment within the reasonable needs of the Corporation.

To determine the "reasonable needs" of the business in order to justify an accumulation of earnings, the Courts of the United States have invented the so-called "Immediacy Test" which construed the words "reasonable needs of the business" to mean the immediate needs of the business, and it was generally held that if the corporation did not prove an immediate need for the accumulation of the earnings and profits, the accumulation was not for the reasonable needs of the business, and the penalty tax would apply. 12 American cases likewise hold that investment of the earnings and profits of the corporation in stock or securities of an unrelated business usually indicates an accumulation beyond the reasonable needs of the business. 13

The finding of the Court of Tax Appeals that the purchase of the U.S.A. Treasury bonds were in no way related to petitioners business of importing and selling wines whisky, liquors and distilled spirits, and thus construed as an investment beyond the reasonable needs of the business 14 is binding on Us, the same being factual. 15 Furthermore, the wisdom behind thus finding cannot be doubted, The case of J.M. Perry & Co. v. Commissioner of Internal Revenue 16 supports the same. In that case, the U.S. Court said the following:jgc:chanrobles.com.ph

"It appears that the taxpayer corporation was engaged in the business of cold storage and wareshousing in Yahima, Washington. It maintained a cold storage plant, divided into four units, having a total capacity of 490,000 boxes of fruits. It presented evidence to the effect that various alterations and repairs to its plant were contemplated in the tax years, . . .

It also appeared that in spite of the fact that the taxpayer contended that it needed to maintain this large cash reserve on hand, it proceeded to make various investments which had no relation to its storage business. In 1934, it purchased mining stock which it sold in 1935 at a profit of US $47,995.29. . . .

All these things may reasonably have appealed to the Board as incompatible with a purpose to strengthen the financial position of the taxpayer and to provide for needed alteration."cralaw virtua1aw library

The records further reveal that from May 1951 when petitioner purchased the U.S.A. Treasury shares, until 1962 when it finally liquidated the same, it (petitioner) never had the occasion to use the said shares in aiding or financing its importation. This militates against the purpose enunciated earlier by petitioner that the shares were purchased to finance its importation business. To justify an accumulation of earnings and profits for the reasonably anticipated future needs, such accumulation must be used within a reasonable time after the close of the taxable year. 17

Petitioner advanced the argument that the U.S.A. Treasury shares were held for a few more years from 1957, in view of a plan to buy a lot and construct a building of their own; that at that time (1957), the Company was not yet qualified to own real property in the Philippines, hence it (petitioner) had to wait until sixty percent (60%) of the stocks of the Company would be owned by Filipino citizens before making definite plans. 18

These arguments of petitioner indicate that it considers the U.S.A. Treasury shares not only for the purpose of aiding or financing its importation but likewise for the purpose of buying a lot and constructing a building thereon in the near future, but conditioned upon the completion of the 60% citizenship requirement of stock ownership of the Company in order to qualify it to purchase and own a lot. The time when the company would be able to establish itself to meet the said requirement and the decision to pursue the same are dependent upon various future contingencies. Whether these contingencies would unfold favorably to the Company and if so, whether the Company would decide later to utilize the U.S.A. Treasury shares according to its plan, remains to be seen. From these assertions of petitioner, We cannot gather anything definite or certain. This, We cannot approve.chanrobles law library

In order to determine whether profits are accumulated for the reasonable needs of the business as to avoid the surtax upon shareholders, the controlling intention of the taxpayer is that which is manifested at the time of accumulation not subsequently declared intentions which are merely the product of afterthought. 19 A speculative and indefinite purpose will not suffice. The mere recognition of a future problem and the discussion of possible and alternative solutions is not sufficient. Definiteness of plan coupled with action taken towards its consummation are essential. 20 The Court of Tax Appeals correctly made the following ruling: 21

"As to the statement of Mr. Hawkins in Exh. "B" regarding the expansion program of the petitioner by purchasing a lot and building of its own, we find no justifiable reason for the retention in 1957 or thereafter of the US Treasury Bonds which were purchased in 1951.xxx

"Moreover, if there was any thought for the purchase of a lot and building for the needs of petitioners business, the corporation may not with impunity permit its earnings to pile up merely because at some future time certain outlays would have to be made. Profits may only be accumulated for the reasonable needs of the business, and implicit in this is further requirement of a reasonable time."cralaw virtua1aw library

Viewed on the foregoing analysis and tested under the "immediacy doctrine," We are convinced that the Court of Tax Appeals is correct in finding that the investment made by petitioner in the U.S.A. Treasury shares in 1951 was an accumulation of profits in excess of the reasonable needs of petitioners business.

Finally, petitioner asserts that the surplus profits allegedly accumulated in the form of U.S.A. Treasury shares in 1951 by it (petitioner) should not be subject to the surtax in 1957. In other words, petitioner claims that the surtax of 25% should be based on the surplus accumulated in 1951 and not in 1957.

This is devoid of merit.

The rule is now settled in Our jurisprudence that undistributed earnings or profits of prior years are taken into consideration in determining unreasonable accumulation for purposes of the 25% surtax. 22 The case of Basilan Estates, Inc. v. Commissioner of Internal Revenue 23 further strengthen this rule, and We quote:jgc:chanrobles.com.ph

"Petitioner questions why the examiner covered the period from 1948-1953 when the taxable year on review was 1953. The surplus of P347,507.01 was taken by the examiner from the balance sheet of the petitioner for 1953. To check the figure arrived at, the examiner traced the accumulation process from 1947 until 1953, and petitioners figure stood out to be correct. There was no error in the process applied, for previous accumulations should be considered in determining unreasonable accumulation for the year concerned.In determining whether accumulations of earnings or profits in a particular year are within the reasonable needs of a corporation, it is necessary to take into account prior accumulations, since accumulations prior to the year involved may have been sufficient to cover the business needs and additional accumulations during the year involved would not reasonably be necessary."chanroblesvirtuallawlibrary

WHEREFORE, IN VIEW OF THE FOREGOING, the decision of the Court of Tax Appeals is AFFIRMED in toto, with costs against petitioner.

SO ORDERED.

Makasiar, Aquino, Concepcion, Jr., Abad Santos, De Castro and Escolin,JJ., concur.

G.R. No. 143672 April 24, 2003

COMMISSIONER OF INTERNAL REVENUE, petitioner,vs.GENERAL FOODS (PHILS.), INC., respondent.

CORONA, J.:

Petitioner Commissioner of Internal Revenue (Commissioner) assails the resolution1 of the Court of Appeals reversing the decision2 of the Court of Tax Appeals which in turn denied the protest filed by respondent General Foods (Phils.), Inc., regarding the assessment made against the latter for deficiency taxes.

The records reveal that, on June 14, 1985, respondent corporation, which is engaged in the manufacture of beverages such as "Tang," "Calumet" and "Kool-Aid," filed its income tax return for the fiscal year ending February 28, 1985. In said tax return, respondent corporation claimed as deduction, among other business expenses, the amount of P9,461,246 for media advertising for "Tang."

On May 31, 1988, the Commissioner disallowed 50% or P4,730,623 of the deduction claimed by respondent corporation. Consequently, respondent corporation was assessed deficiency income taxes in the amount of P2,635, 141.42. The latter filed a motion for reconsideration but the same was denied.

On September 29, 1989, respondent corporation appealed to the Court of Tax Appeals but the appeal was dismissed:

With such a gargantuan expense for the advertisement of a singular product, which even excludes "other advertising and promotions" expenses, we are not prepared to accept that such amount is reasonable "to stimulate the current sale of merchandise" regardless of Petitioners explanation that such expense "does not connote unreasonableness considering the grave economic situation taking place after the Aquino assassination characterized by capital fight, strong deterioration of the purchasing power of the Philippine peso and the slacking demand for consumer products" (Petitioners Memorandum, CTA Records, p. 273). We are not convinced with such an explanation. The staggering expense led us to believe that such expenditure was incurred "to create or maintain some form of good will for the taxpayers trade or business or for the industry or profession of which the taxpayer is a member." The term "good will" can hardly be said to have any precise signification; it is generally used to denote the benefit arising from connection and reputation (Words and Phrases, Vol. 18, p. 556 citing Douhart vs. Loagan, 86 III. App. 294). As held in the case of Welch vs. Helvering, efforts to establish reputation are akin to acquisition of capital assets and, therefore, expenses related thereto are not business expenses but capital expenditures. (Atlas Mining and Development Corp. vs. Commissioner of Internal Revenue, supra). For sure such expenditure was meant not only to generate present sales but more for future and prospective benefits. Hence, "abnormally large expenditures for advertising are usually to be spread over the period of years during which the benefits of the expenditures are received" (Mertens, supra, citing Colonial Ice Cream Co., 7 BTA 154).

WHEREFORE, in all the foregoing, and finding no error in the case appealed from, we hereby RESOLVE to DISMISS the instant petition for lack of merit and ORDER the Petitioner to pay the respondent Commissioner the assessed amount of P2,635,141.42 representing its deficiency income tax liability for the fiscal year ended February 28, 1985."3

Aggrieved, respondent corporation filed a petition for review at the Court of Appeals which rendered a decision reversing and setting aside the decision of the Court of Tax Appeals:

Since it has not been sufficiently established that the item it claimed as a deduction is excessive, the same should be allowed.

WHEREFORE, the petition of petitioner General Foods (Philippines), Inc. is hereby GRANTED. Accordingly, the Decision, dated 8 February 1994 of respondent Court of Tax Appeals is REVERSED and SET ASIDE and the letter, dated 31 May 1988 of respondent Commissioner of Internal Revenue is CANCELLED.

SO ORDERED.4

Thus, the instant petition, wherein the Commissioner presents for the Courts consideration a lone issue: whether or not the subject media advertising expense for "Tang" incurred by respondent corporation was an ordinary and necessary expense fully deductible under the National Internal Revenue Code (NIRC).

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;5 and he who claims an exemption must be able to justify his claim by the clearest grant of organic or statute law. An exemption from the common burden cannot be permitted to exist upon vague implications.6

Deductions for income tax purposes partake of the nature of tax exemptions; hence, if tax exemptions are strictly construed, then deductions must also be strictly construed.

We then proceed to resolve the singular issue in the case at bar. Was the media advertising expense for "Tang" paid or incurred by respondent corporation for the fiscal year ending February 28, 1985 "necessary and ordinary," hence, fully deductible under the NIRC? Or was it a capital expenditure, paid in order to create "goodwill and reputation" for respondent corporation and/or its products, which should have been amortized over a reasonable period?

Section 34 (A) (1), formerly Section 29 (a) (1) (A), of the NIRC provides:

(A) Expenses.-

(1) Ordinary and necessary trade, business or professional expenses.-

(a) In general.- There shall be allowed as deduction from gross income all ordinary and necessary expenses paid or incurred during the taxable year in carrying on, or which are directly attributable to, the development, management, operation and/or conduct of the trade, business or exercise of a profession.

Simply put, to be deductible from gross income, the subject advertising expense must comply with the following requisites: (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.7

The parties are in agreement that the subject advertising expense was paid or incurred within the corresponding taxable year and was incurred in carrying on a trade or business. Hence, it was necessary. However, their views conflict as to whether or not it was ordinary. To be deductible, an advertising expense should not only be necessary but also ordinary. These two requirements must be met.

The Commissioner maintains that the subject advertising expense was not ordinary on the ground that it failed the two conditions set by U.S. jurisprudence: first, "reasonableness" of the amount incurred and second, the amount incurred must not be a capital outlay to create "goodwill" for the product and/or private respondents business. Otherwise, the expense must be considered a capital expenditure to be spread out over a reasonable time.

We agree.

There is yet to be a clear-cut criteria or fixed test for determining the reasonableness of an advertising expense. There being no hard and fast rule on the matter, the right to a deduction depends on a number of factors such as but not limited to: the type and size of business in which the taxpayer is engaged; the volume and amount of its net earnings; the nature of the expenditure itself; the intention of the taxpayer and the general economic conditions. It is the interplay of these, among other factors and properly weighed, that will yield a proper evaluation.

In the case at bar, the P9,461,246 claimed as media advertising expense for "Tang" alone was almost one-half of its total claim for "marketing expenses." Aside from that, respondent-corporation also claimed P2,678,328 as "other advertising and promotions expense" and another P1,548,614, for consumer promotion.

Furthermore, the subject P9,461,246 media advertising expense for "Tang" was almost double the amount of respondent corporations P4,640,636 general and administrative expenses.

We find the subject expense for the advertisement of a single product to be inordinately large. Therefore, even if it is necessary, it cannot be considered an ordinary expense deductible under then Section 29 (a) (1) (A) of the NIRC.

Advertising is generally of two kinds: (1) advertising to stimulate the current sale of merchandise or use of services and (2) advertising designed to stimulate the future sale of merchandise or use of services. The second type involves expenditures incurred, in whole or in part, to create or maintain some form of goodwill for the taxpayers trade or business or for the industry or profession of which the taxpayer is a member. If the expenditures are for the advertising of the first kind, then, except as to the question of the reasonableness of amount, there is no doubt such expenditures are deductible as business expenses. If, however, the expenditures are for advertising of the second kind, then normally they should be spread out over a reasonable period of time.

We agree with the Court of Tax Appeals that the subject advertising expense was of the second kind. Not only was the amount staggering; the respondent corporation itself also admitted, in its letter protest8 to the Commissioner of Internal Revenues assessment, that the subject media expense was incurred in order to protect respondent corporations brand franchise, a critical point during the period under review.

The protection of brand franchise is analogous to the maintenance of goodwill or title to ones property. This is a capital expenditure which should be spread out over a reasonable period of time.9

Respondent corporations venture to protect its brand franchise was tantamount to efforts to establish a reputation. This was akin to the acquisition of capital assets and therefore expenses related thereto were not to be considered as business expenses but as capital expenditures.10

True, it is the taxpayers prerogative to determine the amount of advertising expenses it will incur and where to apply them.11 Said prerogative, however, is subject to certain considerations. The first relates to the extent to which the expenditures are actually capital outlays; this necessitates an inquiry into the nature or purpose of such expenditures.12 The second, which must be applied in harmony with the first, relates to whether the expenditures are ordinary and necessary. Concomitantly, for an expense to be considered ordinary, it must be reasonable in amount. The Court of Tax Appeals ruled that respondent corporation failed to meet the two foregoing limitations.

We find said ruling to be well founded. Respondent corporation incurred the subject advertising expense in order to protect its brand franchise. We consider this as a capital outlay since it created goodwill for its business and/or product. The P9,461,246 media advertising expense for the promotion of a single product, almost one-half of petitioner corporations entire claim for marketing expenses for that year under review, inclusive of other advertising and promotion expenses of P2,678,328 and P1,548,614 for consumer promotion, is doubtlessly unreasonable.

It has been a long standing policy and practice of the Court to respect the conclusions of quasi-judicial agencies such as the Court of Tax Appeals, a highly specialized body specifically created for the purpose of reviewing tax cases. The CTA, by the nature of its functions, is dedicated exclusively to the study and consideration of tax problems. It has necessarily developed an expertise on the subject. We extend due consideration to its opinion unless there is an abuse or improvident exercise of authority.13 Since there is none in the case at bar, the Court adheres to the findings of the CTA.

Accordingly, we find that the Court of Appeals committed reversible error when it declared the subject media advertising expense to be deductible as an ordinary and necessary expense on the ground that "it has not been established that the item being claimed as deduction is excessive." It is not incumbent upon the taxing authority to prove that the amount of items being claimed is unreasonable. The burden of proof to establish the validity of claimed deductions is on the taxpayer.14 In the present case, that burden was not discharged satisfactorily.

WHEREFORE, premises considered, the instant petition is GRANTED. The assailed decision of the Court of Appeals is hereby REVERSED and SET ASIDE. Pursuant to Sections 248 and 249 of the Tax Code, respondent General Foods (Phils.), Inc. is hereby ordered to pay its deficiency income tax in the amount of P2,635,141.42, plus 25% surcharge for late payment and 20% annual interest computed from August 25, 1989, the date of the denial of its protest, until the same is fully paid.

SO ORDERED.

GR No. 143672| April 24, 2003 | J. Corona

Test of ReasonablenessFacts:

Respondent corporation General Foods (Phils), which is engaged in the manufacture of Tang, Calumet and Kool-Aid, filed its income tax return for the fiscal year ending February 1985 and claimed as deduction, among other business expenses, P9,461,246 for media advertising for Tang.The Commissioner disallowed 50% of the deduction claimed and assessed deficiency income taxes of P2,635,141.42 against General Foods, prompting the latter to file an MR which was denied.General Foods later on filed a petition for review at CA, which reversed and set aside an earlier decision by CTA dismissing the companys appeal.

Issue:

W/N the subject media advertising expense for Tang was ordinary and necessary expense fully deductible under the NIRC

Held:

No. Tax exemptions must be construed in stricissimi juris against the taxpayer and liberally in favor of the taxing authority, and he who claims an exemption must be able to justify his claim by the clearest grant of organic or statute law. Deductions for income taxes partake of the nature of tax exemptions; hence, if tax exemptions are strictly construed, then deductions must also be strictly construed.

To be deductible from gross income, the subject advertising expense must comply with the following requisites: (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.

While the subject advertising expense was paid or incurred within the corresponding taxable year and was incurred in carrying on a trade or business, hence necessary, the parties views conflict as to whether or not it was ordinary. To be deductible, an advertising expense should not only be necessary but also ordinary.

The Commissioner maintains that the subject advertising expense was not ordinary on the ground that it failed the two conditions set by U.S. jurisprudence: first, reasonableness of the amount incurred and second, the amount incurred must not be a capital outlay to create goodwill for the product and/or private respondents business. Otherwise, the expense must be considered a capital expenditure to be spread out over a reasonable time.

There is yet to be a clear-cut criteria or fixed test for determining the reasonableness of an advertising expense. There being no hard and fast rule on the matter, the right to a deduction depends on a number of factors such as but not limited to: the type and size of business in which the taxpayer is engaged; the volume and amount of its net earnings; the nature of the expenditure itself; the intention of the taxpayer and the general economic conditions. It is the interplay of these, among other factors and properly weighed, that will yield a proper evaluation.

The Court finds the subject expense for the advertisement of a single product to be inordinately large. Therefore, even if it is necessary, it cannot be considered an ordinary expense deductible under then Section 29 (a) (1) (A) of the NIRC.

Advertising is generally of two kinds: (1) advertising to stimulate the current sale of merchandise or use of services and (2) advertising designed to stimulate the future sale of merchandise or use of services. The second type involves expenditures incurred, in whole or in part, to create or maintain some form of goodwill for the taxpayers trade or business or for the industry or profession of which the taxpayer is a member. If the expenditures are for the advertising of the first kind, then, except as to the question of the reasonableness of amount, there is no doubt such expenditures are deductible as business expenses. If, however, the expenditures are for advertising of the second kind, then normally they should be spread out over a reasonable period of time.

The companys media advertising expense for the promotion of a single product is doubtlessly unreasonable considering it comprises almost one-half of the companys entire claim for marketing expenses for that year under review. Petition granted, judgment reversed and set aside.

G.R. No. 172231 February 12, 2007

COMMISSIONER OF INTERNAL REVENUE, Petitioner,vs.ISABELA CULTURAL CORPORATION, Respondent.

D E C I S I O N

YNARES-SANTIAGO, J.:

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 BIRs disallowance of ICCs 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 ICCs 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

On March 23, 1990, ICC sought a reconsideration of the subject 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 CTAs 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.

SO ORDERED.9

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 determinable at that time, hence, it could be considered as 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 ICCs 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 taxpayers 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 ICCs tax problems for the year 1984. As testified by the Treasurer of ICC, the firm has been its counsel since the 1960s.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 firms 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 BIRs disallowance of ICCs expenses for professional services. The Court of Appeals 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 for the computation of Isabela Cultural Corporations liability under Assessment Notice No. FAS-1-86-90-000680.

SO ORDERED.

G.R. No. 148187 April 16, 2008

PHILEX MINING CORPORATION, petitioner,vs.COMMISSIONER OF INTERNAL REVENUE, respondent.

D E C I S I O N

YNARES-SANTIAGO, J.:

This is a petition for review on certiorari of the June 30, 2000 Decision1 of the Court of Appeals in CA-G.R. SP No. 49385, which affirmed the Decision2 of the Court of Tax Appeals in C.T.A. Case No. 5200. Also assailed is the April 3, 2001 Resolution3 denying the motion for reconsideration.

The facts of the case are as follows:

On April 16, 1971, petitioner Philex Mining Corporation (Philex Mining), entered into an agreement4 with Baguio Gold Mining Company ("Baguio Gold") for the former to manage and operate the latters mining claim, known as the Sto. Nino mine, located in Atok and Tublay, Benguet Province. The parties agreement was denominated as "Power of Attorney" and provided for the following terms:

4. Within three (3) years from date thereof, the PRINCIPAL (Baguio Gold) shall make available to the MANAGERS (Philex Mining) up to ELEVEN MILLION PESOS (P11,000,000.00), in such amounts as from time to time may be required by the MANAGERS within the said 3-year period, for use in the MANAGEMENT of the STO. NINO MINE. The said ELEVEN MILLION PESOS (P11,000,000.00) shall be deemed, for internal audit purposes, as the owners account in the Sto. Nino PROJECT. Any part of any income of the PRINCIPAL from the STO. NINO MINE, which is left with the Sto. Nino PROJECT, shall be added to such owners account.

5. Whenever the MANAGERS shall deem it necessary and convenient in connection with the MANAGEMENT of the STO. NINO MINE, they may transfer their own funds or property to the Sto. Nino PROJECT, in accordance with the following arrangements:

(a) The properties shall be appraised and, together with the cash, shall be carried by the Sto. Nino PROJECT as a special fund to be known as the MANAGERS account.

(b) The total of the MANAGERS account shall not exceed P11,000,000.00, except with prior approval of the PRINCIPAL; provided, however, that if the compensation of the MANAGERS as herein provided cannot be paid in cash from the Sto. Nino PROJECT, the amount not so paid in cash shall be added to the MANAGERS account.

(c) The cash and property shall not thereafter be withdrawn from the Sto. Nino PROJECT until termination of this Agency.

(d) The MANAGERS account shall not accrue interest. Since it is the desire of the PRINCIPAL to extend to the MANAGERS the benefit of subsequent appreciation of property, upon a projected termination of this Agency, the ratio which the MANAGERS account has to the owners account will be determined, and the corresponding proportion of the entire assets of the STO. NINO MINE, excluding the claims, shall be transferred to the MANAGERS, except that such transferred assets shall not include mine development, roads, buildings, and similar property which will be valueless, or of slight value, to the MANAGERS. The MANAGERS can, on the other hand, require at their option that property originally transferred by them to the Sto. Nino PROJECT be re-transferred to them. Until such assets are transferred to the MANAGERS, this Agency shall remain subsisting.

x x x x

12. The compensation of the MANAGER shall be fifty per cent (50%) of the net profit of the Sto. Nino PROJECT before income tax. It is understood that the MANAGERS shall pay income tax on their compensation, while the PRINCIPAL shall pay income tax on the net profit of the Sto. Nino PROJECT after deduction therefrom of the MANAGERS compensation.

x x x x

16. The PRINCIPAL has current pecuniary obligation in favor of the MANAGERS and, in the future, may incur other obligations in favor of the MANAGERS. This Power of Attorney has been executed as security for the payment and satisfaction of all such obligations of the PRINCIPAL in favor of the MANAGERS and as a means to fulfill the same. Therefore, this Agency shall be irrevocable while any obligation of the PRINCIPAL in favor of the MANAGERS is outstanding, inclusive of the MANAGERS account. After all obligations of the PRINCIPAL in favor of the MANAGERS have been paid and satisfied in full, this Agency shall be revocable by the PRINCIPAL upon 36-month notice to the MANAGERS.

17. Notwithstanding any agreement or understanding between the PRINCIPAL and the MANAGERS to the contrary, the MANAGERS may withdraw from this Agency by giving 6-month notice to the PRINCIPAL. The MANAGERS shall not in any manner be held liable to the PRINCIPAL by reason alone of such withdrawal. Paragraph 5(d) hereof shall be operative in case of the MANAGERS withdrawal.

x x x x5

In the course of managing and operating the project, Philex Mining made advances of cash and property in accordance with paragraph 5 of the agreement. However, the mine suffered continuing losses over the years which resulted to petitioners withdrawal as manager of the mine on January 28, 1982 and in the eventual cessation of mine operations on February 20, 1982.6

Thereafter, on September 27, 1982, the parties executed a "Compromise with Dation in Payment"7 wherein Baguio Gold admitted an indebtedness to petitioner in the amount of P179,394,000.00 and agreed to pay the same in three segments by first assigning Baguio Golds tangible assets to petitioner, transferring to the latter Baguio Golds equitable title in its Philodrill assets and finally settling the remaining liability through properties that Baguio Gold may acquire in the future.

On December 31, 1982, the parties executed an "Amendment to Compromise with Dation in Payment"8 where the parties determined that Baguio Golds indebtedness to petitioner actually amounted to P259,137,245.00, which sum included liabilities of Baguio Gold to other creditors that petitioner had assumed as guarantor. These liabilities pertained to long-term loans amounting to US$11,000,000.00 contracted by Baguio Gold from the Bank of America NT & SA and Citibank N.A. This time, Baguio Gold undertook to pay petitioner in two segments by first assigning its tangible assets for P127,838,051.00 and then tran