CIR v. ISABELA CULTURAL CORP

Facts:Isabela Cultural Corporation (ICC), a domestic corporation received an assessment notice for deficiency income tax and expanded withholding tax from BIR. It arose from the disallowance of ICCs claimed expense for professional and security services paid by ICC; as well as the alleged understatement of interest income on the three promissory notes due from Realty Investment Inc. The deficiency expanded withholding tax was allegedly due to the failure of ICC to withhold 1% e-withholding tax on its claimed deduction for security services.

ICC sought a reconsideration of the assessments. Having received a final notice of assessment, it brought the case to CTA, which held that it is unappealable, since the final notice is not a decision. CTAs ruling was reversed by CA, which was sustained by SC, and case was remanded to CTA. CTA rendered a decision in favor of ICC. It ruled that the deductions for professional and security services were properly claimed, it said that even if services were rendered in 1984 or 1985, the amount is not yet determined at that time. Hence it is a proper deduction in 1986. It likewise found that it is the BIR which overstate the interest income, when it applied compounding absent any stipulation.

Petitioner appealed to CA, which affirmed CTA, hence the petition.

Issue:Whether or not the expenses for professional and security services are deductible.

Held:No. One of the requisites for the deductibility of ordinary and necessary expenses is that it must have been paid or incurred during the taxable year. This requisite is dependent on the method of accounting of the taxpayer. In the case at bar, ICC is using the accrual method of accounting. Hence, under this method, an expense is recognized when it is incurred. Under a Revenue Audit Memorandum, when the method of accounting is accrual, expenses not being claimed as deductions by a taxpayer in the current year when they are incurred cannot be claimed in the succeeding year.

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 test does not demand that the amount of income or liability be known absolutely, only that a taxpayer has at its disposal the information necessary to compute the amount with reasonable accuracy.

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. They cannot give as an excuse the delayed billing, since it could have inquired into the amount of their obligation and reasonably determine the amount.

CIR v. GENERAL FOODS

Facts: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 thecurrentsale of merchandise or use of services and (2) advertising designed to stimulate thefuturesale 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.

AGUINALDO INDUSTRIES CORP v. CIR

Facts:Aguinaldo Industries is engaged in the manufacture of fishing nets (a tax exempt industry), which is handled by its Fish Nets Division. It is also engaged in the manufacture of furniture which is operated by its Furniture Division. Each division is provided with separate books of accounts. The income from the Fish Nets Division, miscellaneous income of the Fish Nets Division, and and the income from the Furniture Division are computed individually.

Petitioner acquired a parcel of land in Muntinlupa Rizal as site for its fishing net factory. The transaction was entered in the books of the Fish Nets Division. The company then found another parcel of land in Marikina Heights, which was more suitable. They then sold the Muntinlupa property and the profit derived from the sale was entered in the books of the Fish Nets Division as miscellaneous income to separate it from its tax exempt income.

For 1957, petitioner filed 2 separate ITRs (one for Fish Nets and one for Furniture). After investigation, BIR examiners found that the Fish Nets Div deducted from its gross income PhP 61k as additional remuneration paid to the companys officers. Such amount was taken from the sale of the land and was reported as part of the selling expenses. The examiners recommended that such deduction be disallowed. Petitioner then asserted in its letter that it should be allowed because it was paid as bonus to its officers pursuant to Sec.3 of its by-laws: From the net profits shall be deducted for allowance of the Pres. - 3%, VP - 1%, members of the Board - 10%.

CTA imposed a 5% surcharge and 1% monthly interest for the deficiency assessment. Petitioner then stressed that the profit derived from the sale of the land is not taxable because the Fish Nets Div enjoys tax exemption under RA 901.Issues:Whether the bonus given to the officers of the petitioner upon the sale of its Muntinlupa land is an ordinary and necessary business expense deductible for income tax purposes

Held:YES. These extraordinary and unusual amounts paid by petitioner to these directors in the guise and form of compensation for their supposed services as such, without any relation to the measure of their actual services, cannot be regarded as ordinary and necessary expenses within the meaning of the law. This posture is in line with the doctrine in the law of taxation that the taxpayer must show that its claimed deductions clearly come within the language of the law since allowances, like exemptions, are matters of legislative grace.

Moreover, petitioner cannot now claim that the profit from the sale is tax exempt. At the administrative level, the petitioner implicitly admitted that the profit it derived from the sale of its Muntinlupa land, a capital asset, was a taxable gain which was precisely the reason why for tax purposes the petitioner deducted therefrom the questioned bonus to its corporate officers as a supposed item of expense incurred for the sale of the said land, apart from the P51, 723.72 commission paid by the petitioner to the real estate agent who indeed effected the sale. The BIR therefore had no occasion to pass upon the issue.

To allow a litigant to assume a different posture when he comes before the court and challenge the position he had accepted at the administrative level, would be to sanction a procedure whereby the court which is supposed to review administrative determinations would not review, but determine and decide for the first time, a question not raised at the administrative forum. The requirement of prior exhaustion of administrative remedies gives administrative authorities the prior opportunity to decide controversies within its competence, and in much the same way that, on the judicial level, issues not raised in the lower court cannot be raised for the first time on appeal. Up to the time the questioned decision of the respondent Court was rendered, the petitioner had always implicitly admitted that the disputed capital gain was taxable, although subject to the deduction of the bonus paid to its corporate officers. It was only after the said decision had been rendered and on a motion for reconsideration thereof, that the issue of tax exemption was raised by the petitioner for the first time. It was thus not one of the issues raised by petitioner in his petition and supporting memorandum in the CTA.

ATLAS CONSOLIDATED MINING v. CIR

FACTS:Atlas is a corporation engaged in the mining industry registered. On August 1962, CIR assessed against Atlas for deficiency income taxes for the years 1957 and 1958. For the year 1957, it was the opinion of the CIR that Atlas is not entitled to exemption from the income tax under RA 909 because same covers only gold mines. For the year 1958, the deficiency income tax covers the disallowance of items claimed by Atlas as deductible from gross income. Atlas protested for reconsideration and cancellation, thus the CIR conducted a reinvestigation of the case.

On October 1962, the Secretary of Finance ruled that the exemption provided in RA 909 embraces all new mines and old mines whether gold or other minerals. Accordingly, the CIR recomputed Atlas deficiency income tax liabilities in the light of said ruling. On June 1964, the CIR issued a revised assessment entirely eliminating the assessment for the year 1957. The assessment for 1958 was reduced from which Atlas appealed to the CTA, assailing the disallowance of the following items claimed as deductible from its gross income for 1958: Transfer agent's fee, Stockholders relation service fee, U.S. stock listing expenses, Suit expenses, and Provision for contingencies. The CTA allowed said items as deduction except those denominated by Atlas as stockholders relation service fee and suit expenses.

Both parties appealed the CTA decision to the SC by way of two (2) separate petitions for review. Atlas appealed only the disallowance of the deduction from gross income of the so-called stockholders relation service fee.

ISSUE: WON the annual public relations expense (aka stockholders relation service fee) paid to a public relations consultant is a deductible expense from gross income

RATIO: Section 30 (a) (1) of the Tax Code allows a deduction of "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." An item of expenditure, in order to be deductible under this section of the statute, must fall squarely within its language. To be deductible as a business expense, three conditions are imposed, namely: (1) the expense must be ordinary and necessary, (2) it must be paid or incurred within the taxable year, and (3) it must be paid or incurred in carrying in a trade or business. In addition, not only must the taxpayer meet the business test, he must substantially prove by evidence or records the deductions claimed under the law, otherwise, the same will be disallowed. The mere allegation of the taxpayer that an item of expense is ordinary and necessary does not justify its deduction.

The SC has never attempted to define with precision the terms "ordinary and necessary." As a guiding principle, ordinarily, an expense will be considered "necessary" where the expenditure is appropriate and helpful in the development of the taxpayer's business. It is "ordinary" when it connotes a payment which is normal in relation to the business of the taxpayer and the surrounding circumstances. The term "ordinary" does not require that the payments be habitual or normal in the sense that the same taxpayer will have to make them often; the payment may be unique or non-recurring to the particular taxpayer affected.

There is thus no hard and fast rule on the matter. The right to a deduction depends in each case on the particular facts and the relation of the payment to the type of business in which the taxpayer is engaged. The intention of the taxpayer often may be the controlling fact in making the determination. Assuming that the expenditure is ordinary and necessary in the operation of the taxpayer's business, the answer to the question as to whether the expenditure is an allowable deduction as a business expense must be determined from the nature of the expenditure itself, which in turn depends on the extent and permanency of the work accomplished by the expenditure.

It appears that on December 1957, Atlas increased its capital stock. It claimed that its shares of stock were sold in the United States because of the services rendered by the public relations firm. The information about Atlas given out and played up in the mass communication media resulted in full subscription of the additional shares issued by Atlas; consequently, the stockholders relation service fee, the compensation for services carrying on the selling campaign, was in effect spent for the acquisition of additional capital, ergo, a capital expenditure, and not an ordinary expense. It is not deductible from Atlas gross income in 1958 because expenses relating to recapitalization and reorganization of the corporation, the cost of obtaining stock subscription, promotion expenses, and commission or fees paid for the sale of stock reorganization are capital expenditures. That the expense in question was incurred to create a favorable image of the corporation in order to gain or maintain the publics and its stockholders' patronage, does not make it deductible as business expense. As held in a US case, efforts to establish reputation are akin to acquisition of capital assets and, therefore, expenses related thereto are not business expense but capital expenditures.

Note: The burden of proof that the expenses incurred are ordinary and necessary is on the taxpayer and does not rest upon the Government. To avail of the claimed deduction, it is incumbent upon the taxpayer to adduce substantial evidence to establish a reasonably proximate relation petition between the expenses to the ordinary conduct of the business of the taxpayer. A logical link or nexus between the expense and the taxpayer's business must be established by the taxpayer.

ZAMORA v CIR

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

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

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

ISSUE: WON CTA erred in allowing only one half of the promotion expenses. NO

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

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

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

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

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

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

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

Ruling: NO. Hoskin owns 99.6% of the CM Hoskins & Co. He was also the President and Chairman of the Board. That as chairman of the Board of Directors, he received a salary of P3,750.00 a month, plus a salary bonus of about P40,000.00 a year and an amounting to an annual compensation of P45,000.00 and an annual salary bonus of P40,000.00, plus free use of the company car and receipt of other similar allowances and benefits, the Tax Court correctly ruled that the payment by petitioner to Hoskins of the additional sum of P99,977.91 as his equal or 50% share of the 8% supervision fees received by petitioner as managing agents of the real estate, subdivision projects of Paradise Farms, Inc. and Realty Investments, Inc. was inordinately large and could not be accorded the treatment of ordinary and necessary expenses allowed as deductible items within the purview of the Tax Code.

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

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

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

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

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

CALANOC v. CIR

Kind of tax involved: AMUSEMENT TAX:

FACTS:This case is a petition to review CTA decision which affirmed the assessment ofCIR of amusement tax and surcharge against a boxing and wrestling exhibition held by petitioner Calanoc on 03 Dec 1949 at the Rizal Memorial Stadium.Social Welfare Commission (SCW) issued a solicitation permit, authorizing Calanoc (petitioner) to solicit and receive contributions for the orphans and destitute children of the Child Welfare Workers Club of the SCW. Such solicitation will be done through a boxing and wrestling exhibition at the Rizal Memorial Stadium. Calanoc financedand promoted the exhibition.BEFORE the exhibition took place, Calanoc applied with the Collector ofInternal Revenue (CIR) for exemption from the paymentof the amusement tax, based on Sec 260 of the NIRC. CIR says that such exemption will only be granted if Calanoc complies with the requirements of the law.AFTER the exhibition, CIR investigated the tax case of Calanoc. It was shown that the gross sales amounted to ~26K, expenditures was ~25K, and net profit was only ~ 1K. Other items ofexpenditure included: Police protection, Gifts & Parties & Items for representation. Only the said netprofit was remitted to the SCW forthe said charitable purpose for which the permit was issued. CIR assessed amount against Calanoc. (Around~7K)Sec of Finance authorized the denial of the application for exemption from payment of amusement tax where a) the net proceeds are not substantial OR b) where the expenses are exorbitant.

ISSUE:WON THE ASSESSMENT OF CIR IS VALID. Petitioners argument:Denied having received 1K as stadium fee. Such amount was not included in the receipts; says he cannot be made to pay almost 7 times the amount as amusement tax

HELD:AMUSEMENT TAX IS VALID. You cannot pay for services that are required by law to be performed by government officers. Also,the expenditures are excessive!Evidence showed that while Calanoc did not pay for the stadium fee, said amount was paid by the O-SO Beverages directly to the stadium for advertisement privileges during the exhibition.Since the stadium fee was paid by the concessionaire, Calanoc had no right to include the stadium fee among the items of his expenses. Such amount was unaccounted, and it went into the petitioners pocket.Also, Calanoc cannot justify the other expenses, such as policeprotection and gifts. SC HELD that most of the items of expenditures are either EXORBITANT or were NOT SUPPORTED byreceipts.Payment for police protection given by Calanoc to the police is ILLEGAL since it is a consideration given by the petitioner to the police for the performance by the latter of functions required ofthem to be rendered by law. The expenditures were rather EXCESSIVE, considering that the purpose ofthe law was for a charitable cause.

KUENZLE & STREIF, INC. v CIR

FACTS:Petitioner is a domestic corporation engaged in the importation of textiles, hardware, sundries, chemicals, pharmaceuticals, lumbers, groceries, wines and liquor; in insurance and lumber; and in some exports. When Petitioner filed its Income Tax Return, it deducted from its gross income the following items:1. salaries, directors' fees and bonuses of its non-resident president and vice-president;2. bonuses of its resident officers and employees; and 3. Interests on earned but unpaid salaries and bonuses of its officers and employees. The CIR disallowed the deductions and assessed Petitioner for deficiency income taxes. Petitioner requested for re-examination of the assessment. CIR modified the same by allowing as deductible all items comprising directors' fees and salaries of the non-resident president and vice-president, but disallowing the bonuses insofar as they exceed the salaries of the recipients, as well as the interests on earned but unpaid salaries and bonuses.

The CTA modified the assessment and ruled that while the bonuses given to the non-resident officers are reasonable, bonuses given to the resident officers and employees are quite excessive.

ISSUES:W/N the CTA erred in allowing the deduction of the bonuses in excess of the yearly salaries of the employees?

RULING: NO. The deductible amount of said bonuses cannot be only equalto their respective yearly salaries considering the post-war policy of the corporation in giving salaries at low levels because of the unsettled conditions resulting from war and the imposition of government controls on imports and exports and on the use of foreign exchange which resulted in the diminution of the amount of business and the consequent loss of profits on the part of the corporation. The payment of bonuses in amounts a little more than the yearly salaries received considering the prevailing circumstances is in our opinion reasonable.

Under the law, in order that interest may be deductible, it must be paid "on indebtedness." It is therefore imperative to show that there is anexisting indebtednesswhich may be subjected to the payment of interest. Here the items involved are unclaimed salaries and bonus participation which cannot constitute indebtedness within the meaning of the law because while they constitute an obligation on the part of the corporation, it is not the latter's fault if they remained unclaimed. Whatever an employee may fail to collect cannot be considered an indebtedness for it is the concern of the employee to collect it in due time. The willingness of the corporation to pay interest thereon cannot be considered a justification to warrant deduction.

PAPER INDUSTRIES v CA (Dec. 1, 1995)

Facts:On various years (1969, 1972 and 1977), Picop obtained loans from foreign creditors in order to finance the purchase of machinery and equipment needed for its operations. In its 1977 Income Tax Return, Picop claimed interest payments made in 1977, amounting to P42, 840,131.00, on these loans as a deduction from its 1977 gross income.

The CIR disallowed this deduction upon the ground that, because the loans had been incurred for the purchase of machinery and equipment, the interest payments on those loans should have been capitalized instead and claimed as a depreciation deduction taking into account the adjusted basis of the machinery and equipment (original acquisition cost plus interest charges) over the useful life of such assets.

Both the CTA and the Court of Appeals sustained the position of Picop and held that the interest deduction claimed by Picop was proper and allowable. In the instant Petition, the CIR insists on its original position.

ISSUE:Whether Picop is entitled to deductions against income of interest payments on loans for the purchase of machinery and equipment.

HELD:YES. Interest payments on loans incurred by a taxpayer (whether BOI-registered or not) are allowed by the NIRC as deductions against the taxpayer's gross income. The basis is 1977 Tax Code Sec. 30 (b). Thus, the general rule is that interest expenses are deductible against gross income and this certainly includes interest paid under loans incurred in connection with the carrying on of the business of the taxpayer. In the instant case, the CIR does not dispute that the interest payments were made by Picop on loansincurred in connection with the carrying on of the registered operations of Picop,i.e., the financing of the purchase of machinery and equipment actually used in the registered operations of Picop. Neither does the CIR deny that such interest payments werelegally due and demandableunder the terms of such loans, and in fact paid by Picop during the tax year 1977.

CIR v VDA DE PRIETO

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

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

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

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

RULING:Yes. According to the Supreme Court, although interest payment for delinquent taxes is not deductible as tax under Section 30(c) of the Tax Code and section 80 of the Income Tax Regulations, the taxpayer is not precluded thereby from claiming said interest payment as deduction under section 30(b) of the same Code.

SEC. 30 Deductions from gross income. In computing net income there shall be allowed as deductions (b) Interest:(1)In general. The amount of interest paid within the taxable year on indebtedness, except on indebtedness incurred or continued to purchase or carry obligations the interest upon which is exempt from taxation as income under this Title.

The term "indebtedness" as used in the Tax Code of the United States containing similar provisions as in the above-quoted section has been defined as an unconditional and legally enforceable obligation for the payment of money.

To give to the quoted portion of section 80 of our Income Tax Regulations the meaning that the petitioner gives it would run counter to the provision of section 30(b) of the Tax Code and the construction given to it by courts in the United States. Such effect would thus make the regulation invalid for a "regulation which operates to create a rule out of harmony with the statute, is a mere nullity." As already stated, section 80 implements only section 30(c) of the Tax Code, or the provision allowing deduction of taxes, while herein respondent seeks to be allowed deduction under section 30(b), which provides for deduction of interest on indebtedness.

CIR v. Lednicky,

Facts: The respondents, V.E. Lednicky and Maria Valero Lednicky, are husband and wife, both American citizens residing in the Philippines, and have derived all their income from Philippine sources for the taxable years in question. In compliance with Phil tax law, they filed their income tax return for 1955 and 1956. In 1956, they filed an amended income tax return claiming a tax deduction for federal income taxes which they paid to the United States in the year 1955. In 1959, they likewise claimed a similar tax deduction for the 1956 return. Comm of IR failed to answer the claim for refund, thus they filed a petition with the Tax Court.

Issue:whether a US citizen residing in the Philippines who derives income wholly from sources within the Republic of the Philippines, may deduct from his gross income the income taxes he has paid to the US government for the taxable year on the strength of sec 30 (c-1) of the Phil Internal Revenue Code? Held:

The wording of Sec 30 shows the code's intent that the right to deduct income taxes paid to foreign government from the taxpayer's gross income is given only as an ALTERNATIVE to his right to claim a tax credit for such foreign income taxes under Sec 30 so that unless the alien resident has a right to claim such tax credit if he so chooses, he is precluded from deducting the foreign income taxes from his gross income. The law provides that the deduction shall be allowed if the taxpayer in his return does not signify his desire to have the benefits of tax credits for taxes paid to foreign countries. Thus, the statutes assumes that the taxpayer in question may also signify his desire to claim a tax credit and waive the deduction.

No double credit (i.e, for claiming twice the benefits of his payment of foreign taxes, by deduction from gross income and by tax credit) exists here. This danger cannot exist if the taxpayer cannot claim benefit under either of these headings at his option, so that he must be entitled to a tax credit (respondent here are NOT entitled to tax credit because all their income is derived from Phil sources), or the option to deduct from gross income disappears altogether.

No double taxation exists. Double taxation becomes obnoxious only when the taxpayer is taxed twice for the benefit of the same governmental entity. In the present case, although the taxpayer would have to pay two taxes on the same income but the Philippine government only receives the proceeds of one tax, there is no obnoxious double taxation.

PICOP v. CA

Facts: On various years (1969, 1972 and 1977), Picop obtained loans from foreign creditors in order to finance the purchase of machinery and equipment needed for its operations. In its 1977 Income Tax Return, Picop claimed interest payments made in 1977, amounting to P42, 840,131.00, on these loans as a deduction from its 1977 gross income.The CIR disallowed this deduction upon the ground that, because the loans had been incurred for the purchase of machinery and equipment, the interest payments on those loans should have been capitalized instead and claimed as a depreciation deduction taking into account the adjusted basis of the machinery and equipment (original acquisition cost plus interest charges) over the useful life of such assets.Both the CTA and the Court of Appeals sustained the position of Picop and held that the interest deduction claimed by Picop was proper and allowable. In the instant Petition, the CIR insists on its original position.ISSUE: Whether Picop is entitled to deductions against income of interest payments on loans for the purchase of machinery and equipment.HELD:YES. Interest payments on loans incurred by a taxpayer (whether BOI-registered or not) are allowed by the NIRC as deductions against the taxpayer's gross income. The basis is 1977 Tax Code Sec. 30 (b). Thus, the general rule is that interest expenses are deductible against gross income and this certainly includes interest paid under loans incurred in connection with the carrying on of the business of the taxpayer. In the instant case, the CIR does not dispute that the interest payments were made by Picop on loansincurred in connection with the carrying on of the registered operations of Picop,i.e., the financing of the purchase of machinery and equipment actually used in the registered operations of Picop. Neither does the CIR deny that such interest payments werelegally due and demandableunder the terms of such loans, and in fact paid by Picop during the tax year 1977.The contention of CIR does not spring of the 1977 Tax Code but from Revenue Regulations 2 Sec. 79. However, the Court said that the term interest here should be construed as the so-called "theoretical interest," that is to say, interest "calculated" or computed (and notincurredorpaid) for the purpose of determining the "opportunity cost" of investing funds in a given business. Such "theoretical" or imputed interest doesnot arise from a legally demandable interest-bearing obligation incurred by the taxpayer who however wishes to find out,e.g., whether he would have been better off by lending out his funds and earning interest rather than investing such funds in his business. One thing that Section 79 quoted above makes clear is that interest which does constitute a charge arising under an interest-bearing obligationisan allowable deduction from gross income.It is claimed by the CIR that Section 79 of Revenue Regulations No. 2 was "patterned after" paragraph 1.266-1 (b), entitled "Taxes and Carrying Charges Chargeable to Capital Account and Treated as Capital Items" of the U.S. Income Tax Regulations, which paragraph reads as follows:(B) Taxes and Carrying Charges. The items thus chargeable to capital accounts are (11) In the case of real property, whether improved or unimproved and whether productive or nonproductive. (a) Interest on a loan (but not theoretical interest of a taxpayer using his own funds).The truncated excerpt of the U.S. Income Tax Regulations quoted by the CIR needs to be related to the relevant provisions of the U.S. Internal Revenue Code, which provisions deal with the general topic of adjusted basis for determining allowable gain or loss on sales or exchanges of property and allowable depreciation and depletion of capital assets of the taxpayer:Present Rule. The Internal Revenue Code, and the Regulations promulgated thereunder provide that "No deduction shall be allowed for amounts paidor accruedforsuch taxes andcarrying chargesas, under regulations prescribed by the Secretary or his delegate, are chargeable to capital account with respect to property,if the taxpayer elects, in accordance with such regulations,to treat suchtaxes orcharges as so chargeable."At the same time, under the adjustment of basis provisions which have just been discussed, it is provided that adjustment shall be made for all "expenditures, receipts, losses, or other items" properly chargeable to a capital account, thus including taxes and carrying charges; however,an exception exists,in which event such adjustment to the capital account is not made, with respect to taxes and carrying charges which the taxpayer has not elected to capitalize but for which a deduction instead has been taken.22(Emphasis supplied)The "carrying charges" which may be capitalized under the above quoted provisions of the U.S. Internal Revenue Code include, as the CIR has pointed out, interest on a loan "(but not theoretical interest of a taxpayer using his own funds)." What the CIR failed to point out is thatsuch"carrying charges"may, at the election of the taxpayer,either be (a) capitalizedin which case the cost basis of the capital assets, e.g., machinery and equipment, will be adjusted by adding the amount of such interest paymentsoralternatively, be(b) deducted from gross incomeof the taxpayer. Should the taxpayer elect to deduct the interest payments against its gross income, the taxpayer cannotat the same timecapitalize the interest payments. In other words, the taxpayer isnotentitled toboth the deduction from gross income and the adjusted (increased) basisfor determining gain or loss and the allowable depreciation charge. The U.S. Internal Revenue Codedoes not prohibit the deduction of interest on a loanobtained for purchasing machinery and equipment against gross income,unlessthe taxpayer hasalso or previously capitalized the same interest paymentsand thereby adjusted the cost basis of such assets.

PHILEX MINING v CIR

Facts:

Philex Mining entered into a management agreement with Baguio Gold. The parties' agreement was denominated as "Power of Attorney" which provided among others:a. Funds available for Philex Mining during the management agreement; andb. Compensation to Philex Mining which shall be fifty per cent (50%) of the net profit;

In the course of managing and operating the project, Philex Mining made advances of cash and property in accordance with the agreement. However, the mine suffered continuing losses over the years which resulted to petitioner's withdrawal as manager and cessation of mine operations.

The parties executed a "Compromise with Dation in Payment" wherein Baguio Gold admitted an indebtedness to Philex Mining, which was subsequently amended to include additional obligations. Subsequently, Philex Mining wrote off in its 1982 books of account the remaining outstanding indebtedness of Baguio Gold by charging P112,136,000.00 to allowances and reserves that were set up in 1981 and P2,860,768.00 to the 1982 operations.

In its 1982 annual income tax return, Philex Mining deducted from its gross income the amount of P112, 136,000.00 as "loss on settlement of receivables from Baguio Gold against reserves and allowances." However, BIR disallowed the amount as deduction for bad debt and assessed petitioner a deficiency income tax of P62, 811,161.39.

Issue: Whether the deduction for bad debts was valid?Held:

No. For a deduction for bad debts to be allowed, all requisites must be satisfied, to wit: (a) there was a valid and existing debt; (b) the debt was ascertained to be worthless; and (c) it was charged off within the taxable year when it was determined to be worthless.There was no valid and existing debt. The nature of agreement between Philex Mining and Baguio Gold is that of a partnership or joint venture. Under a contract of partnership, two or more persons bind themselves to contribute money, property, or industry to a common fund, with the intention of dividing the profits among themselves.Perusal of the agreement denominated as the "Power of Attorney" indicates that the parties had intended to create a partnership and establish a common fund for the purpose. They also had a joint interest in the profits of the business as shown by a 50-50 sharing in the income of the mine.Viewed from this light, the advances can be characterized as petitioners investment in a partnership with Baguio Gold for the development and exploitation of the Sto. Nino mine. Since the advanced amount partook of the nature of an investment, it could not be deducted as a bad debt from petitioner's gross income.

PHILIPPINE REFINING CO v CA

FACTS:

Philippine Refining Corp (PRC) was assessed deficiency tax payments for the year 1985 in the amount of around 1.8M. This figure was computed based on the disallowance of the claim of bad debts by PRC. PRC duly protested the assessment claiming that under the law, bad debts and interest expense are allowable deductions.

When the BIR subsequently garnished some of PRCs properties, the latter considered the protest as being denied and filed an appeal to the CTA which set aside the disallowance of the interest expense and modified the disallowance of the bad debts by allowing 3 accounts to be claimed as deductions. However, 13 supposed bad debts were disallowed as the CTA claimed that these were not substantiated and did not satisfy the jurisprudential requirement of worthlessness of a debt The CA denied the petition for review.

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

RULING:

YES. Both the CTA and CA relied on the case of Collector vs. Goodrich International, which laid down the requisites for worthlessness of a debt to wit:

In said case, we held that for debts to be considered as "worthless," and thereby qualify as "bad debts" making them deductible, the taxpayer should show that (1) there is a valid and subsisting debt. (2) The debt must be actually ascertained to be worthless and uncollectible during the taxable year; (3) the debt must be charged off during the taxable year; and (4) the debt must arise from the business or trade of the taxpayer. Additionally, before a debt can be considered worthless, the taxpayer must also show that it is indeed uncollectible even in the future.

Furthermore, there are steps outlined to be undertaken by the taxpayer to prove that he exerted diligent efforts to collect the debts,viz.: (1) sending of statement of accounts; (2) sending of collection letters; (3) giving the account to a lawyer for collection; and (4) filing a collection case in court.

PRC only used the testimony of its accountant Ms. Masagana in order to prove that these accounts were bad debts. This was considered by all 3 courts to be self-serving. The SC said that PRC failed to exercise due diligence in order to ascertain that these debts were uncollectible. In fact, PRC did not even show the demand letters they allegedly gave to some of their debtors.

FERNANDEZ HERMANOS v CIR

Facts:

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

Issue: W/N disallowance is correct

Held: YES

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

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

BASILAN ESTATES, INC. v. CIR

Facts:

Basilan Estates, Inc. claimed deductions for the depreciation of its assets on the basis of their acquisition cost. As of January 1, 1950 it changed the depreciable value of said assets by increasing it to conform to the increase in cost for their replacement. Accordingly, from 1950 to 1953 it deducted from gross income the value of depreciation computed on the reappraised value.CIR disallowed the deductions claimed by petitioner, consequently assessing the latter of deficiency income taxes.

Issue:

Whether or not the depreciation shall be determined on the acquisition cost rather than the reappraised value of the assets

Held:

Yes. The following tax law provision allows a deduction from gross income for depreciation but limits the recovery to the capital invested in the asset being depreciated:(1)In general. A reasonable allowance for deterioration of property arising out of its use or employment in the business or trade, or out of its not being used:Provided, that when the allowance authorized under this subsection shall equal the capital invested by the taxpayer . . . no further allowance shall be made. . . .The income tax law does not authorize the depreciation of an asset beyond its acquisition cost. Hence, a deduction over and above such cost cannot be claimed and allowed. The reason is that deductions from gross income are privileges, not matters of right. They are not created by implication but upon clear expression in the law [Gutierrez v. Collector of Internal Revenue, L-19537, May 20, 1965].Depreciation is the gradual diminution in the useful value of tangible property resulting from wear and tear and normal obsolescence. It commences with the acquisition of the property and its owner is not bound to see his property gradually waste, without making provision out of earnings for its replacement.The recovery, free of income tax, of an amount more than the invested capital in an asset will transgress the underlying purpose of a depreciation allowance. For then what the taxpayer would recover will be, not only the acquisition cost, but also some profit. Recovery in due time thru depreciation of investment made is the philosophy behind depreciation allowance; the idea of profit on the investment made has never been the underlying reason for the allowance of a deduction for depreciation.

LIMPAN INVESTMENT v CIR

FACTS:

BIR assessed deficiency taxes onLimpanCorp, a company that leases real property, for under declaring its rental income for years 1956-57 by around P20K and P81K respectively. Petitioner appeals on the ground that portions of these under declared rents are yet to be collected by the previous owners and turned over or received by the corporation. Petitioner cited that some rents were deposited with the court, such that the corporation does not have actual nor constructive control over them. The sole witness for the petitioner, Solis (Corporate Secretary-Treasurer) admitted to some undeclared rents in 1956 and1957, and that some balances were not collected by the corporation in 1956 because the lessees refused to recognize and pay rent to the new owners and that the corporations president Isabelo Lim collected some rent and reported it in his personal income statement, but did not turn over the rent to the corporation. He also cites lack of actual or constructive control over rents deposited with the court.

ISSUE:

WON the BIR was correct in assessing deficiency taxes againstLimpanCorp. for undeclared rental income

HELD:

Yes. Petitioner admitted that it indeed had undeclared income (although only a part and not the full amount assessed by BIR). Thus, it has become incumbent upon them to prove their excuses by clear and convincing evidence, which it has failed to do.

With regard to 1957 rents deposited with the court, and withdrawn only in 1958, the court viewed the corporation as having constructively received said rents. The non-collection was the petitioners fault since it refused to accept the rent, and not due to non-payment of lessees. Hence, although the corporation did not actually receive the rent, it is deemed to have constructively received them

CONSOLIDATED MINES v. CTA

Facts: The Company, a domestic corporation engaged in mining, had filed its income tax returns for 1951, 1952, 1953 and 1956. In 1957 examiners of the BIR investigated the income tax returns filed by the Company because its auditor, Felipe Ollada, claimed for a refund representing alleged overpayments of income taxes for the year 1951. After the investigation the examiners reported that (A) for the years 1951 to 1954 (1) the Company had not accrued as an expense the share in the company profits of Benguet Consolidated Mines as operator of the Company's mines, although for income tax purposes the Company had reported income and expenses on the accrual basis; (2) depletion and depreciation expenses had been overcharged; and (3) the claims for audit and legal fees and miscellaneous expenses for 1953 and 1954 had not been properly substantiated; and that (B) for the year 1956 (1) the Company had overstated its claim for depletion; and (2) certain claims for miscellaneous expenses were not duly supported by evidence.

In view of said reports the Commissioner of Internal Revenue sent the Company a letter of demand requiring it to pay certain deficiency income taxes for the years 1951 to 1954, inclusive, and for the year 1956. Deficiency income tax assessment notices for said years were also sent to the Company. The Company requested a reconsideration of the assessment, but the Commissioner refused to reconsider, hence the Company appealed to the Court of Tax Appeals. CTA rendered judgment ordering the Company to pay for the deficiency income taxes for the years 1953, 1954 and 1956, respectively.

However, upon motion of the Company, the CTA reconsidered its decision and further reduced the deficiency income tax liabilities of the Company for the years 1953, 1954 and 1956, respectively.Both the Company and the Commissioner appealed to this Court. The Company questions the rate of mine depletion adopted by the Court of Tax Appeals and the disallowance of depreciation charges and certain miscellaneous.

Issue: Whether the Court of Tax Appeals erred with respect to the rate of mine depletion.

Held:

The Tax Code provides that in computing net income there shall be allowed as deduction, in the case of mines, a reasonable allowance for depletion thereof not to exceed the market value in the mine of the product thereof which has been mined and sold during the year for which the return is made [Sec. 30(g) (1) (B)].

The formulafor computing the rate of depletion is:Cost of Mine Property---------------------- = Rate of Depletion per Unit Estimated ore Deposit of Product Mined and sold.

The Commissioner and the Company do not agree as to the figures corresponding to either factor that affects the rate of depletion per unit. They agree, however, that the "cost of the mine property" consists of (1) mine cost; and (2) expenses of development before production. As an income tax concept, depletion is wholly a creation of the statute "solely a matter of legislative grace."

Hence, the taxpayer has the burden of justifying the allowance of any deduction claimed. As in connection with all other tax controversies, the burden of proof to show that a disallowance of depletion by the Commissioner is incorrect or that an allowance made is inadequate is upon the taxpayer, and this is true with respect to the value of the property constituting the basis of the deduction.This burden-of-proof rule has been frequently applied and a value claimed has been disallowed for lack of evidence.The Company's balance sheet for lists the "mine cost" of P2,500,000 as "development cost" and the amount of P1,738,974.37 as "suspense account (mining properties subject to war losses)." The Company claims that its accountant, Mr. Calpo, made these errors, because he was then new at the job. Granting that was what had happened, it does not affect the fact that the, evidence on hand is insufficient to prove the cost of development alleged by the Company. Nor can we rely on the statements of Eligio S. Garcia, who was the Company's treasurer and assistant secretary at the time he testified on August 14, 1959. He admitted that he did not know how the figure P4,238,974.57 was arrived at, explaining: "I only know that it is the figure appearing on the balance sheet as of December 31, 1946 as certified by the Company's auditors; and this we made as the basis of the valuation of the depletable value of the mines."

We, therefore, have to rely on the Commissioner's assertion that the "development cost" was P131, 878.44, broken down as follows: assessment, P34, 092.12; development, P61, 484.63; exploration, P13, 966.62; and diamond drilling, P22, 335.07.

The question as to which figure should properly correspond to "mine cost" is one of fact. The findings of fact of the Tax Court, where reasonably supported by evidence, are conclusive upon the Supreme Court.

3M PHILIPPINES v CIR

Facts:

3M Philippines, Inc. is a subsidiary of the Minnesota Mining and Manufacturing Company (or "3M-St. Paul") a non-resident foreign corporation with principal office in St. Paul, Minnesota, U.S.A. It is the exclusive importer, manufacturer, wholesaler, and distributor in the Philippines of all products of 3M-St. Paul. To enable it to manufacture, package, promote, market, sell and install the highly specialized products of its parent company, and render the necessary post-sales service and maintenance to its customers, 3M Phil entered into a "Service Information and Technical Assistance Agreement" and a "Patent and Trademark License Agreement" with the latter under which the 3m Phils agreed to pay to 3M-St. Paul a technical service fee of 3% and a royalty of 2% of its net sales. Both agreements were submitted to, and approved by, the Central Bank of the Philippines.

The petitioner claimed the following deductions as business expenses:(a) Royalties and technical service fees of P 3,050,646.00; and(b) Pre-operational cost of tape coater of P97, 485.08.

As to (a), the Commissioner of Internal Revenue allowed a deduction of P797, 046.09 only as technical service fee and royalty for locally manufactured products, but disallowed the sum of P2, 323,599.02 alleged to have been paid by the petitioner to 3M-St. Paul as technical service fee and royalty on P46, 471,998.00 worth of finished products imported by the petitioner from the parent company, on the ground that the fee and royalty should be based only on locally manufactured goods. While as to (b), the CIR only allowed P19,544.77 or one-fifth (1/5) of 3M Phils. capital expenditure of P97,046.09 for its tape coater which was installed in 1973 because such expenditure should be amortized for a period of five (5) years, hence, payment of the disallowed balance of P77,740.38 should be spread over the next four (4) years. The CIR ordered 3M Phil. to pay P840, 540 as deficiency income tax on its 1974 return, plus P353,026.80 as 14% interest per annum from February 15, 1975 to February 15, 1976, or a total of P1,193,566.80.3M Phils protested the CIRs assessment but it did not answer the protest, instead issuing a warrant of levy. The CTA affirmed the assessment on appeal.

Issue:Whether or not 3M Phils is entitled to the deductions due to royalties?

Ruling:

No. CB Circular No. 393 (Regulations Governing Royalties/Rentals) dated December 7, 1973 was promulgated by the Central Bank as an exchange control regulation to conserve foreign exchange and avoid unnecessary drain on the country's international reserves (69 O.G. No. 51, pp. 11737-38). Section 3-C of the circular provides that royalties shall be paid only on commodities manufactured by the licensee under the royalty agreement:

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

c. The royalty/rental contracts involving manufacturing' royalty, e.g., actual transfers of technological services such as secret formula/processes, technical know-how and the like shall not exceed five (5) per cent of the wholesale price of the commodity/ties manufactured under the royalty agreement. For contracts involving 'marketing' services such as the use of foreign brands or trade names or trademarks, the royalty/rental rate shall not exceed two (2) per cent of the wholesale price of the commodity/ties manufactured under the royalty agreement. The producer's or foreign licensor's share in the proceeds from the distribution/exhibition of the films shall not exceed sixty (60) per cent of the net proceeds (gross proceeds less local expenses) from the exhibition/distribution of the films. ...

Clearly, no royalty is payable on the wholesale price of finished products imported by the licensee from the licensor. However, petitioner argues that the law applicable to its case is only Section 29(a)(1) of the Tax Code which provides:

(a) Expenses. (1) Business expenses. (A) In general. All ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; travelling expenses while away from home in the pursuit of a trade, profession or business, rentals or other payments required to be made as a condition to the continued use or possession, for the purpose of the trade, profession or business, for property to which the taxpayer has not taken or is not taking title or in which he has no equity.

Petitioner points out that the Central bank "has no say in the assessment and collection of internal revenue taxes as such power is lodged in the Bureau of Internal Revenue," that the Tax Code "never mentions Circular 393 and there is no law or regulation governing deduction of business expenses that refers to said circular."

The argument is specious, for, although the Tax Code allows payments of royalty to be deducted from gross income as business expenses, it is CB Circular No. 393 that defines what royalty payments are proper. Hence, improper payments of royalty are not deductible as legitimate business expenses.

ESSO STANDARD v CIR

FACTS:

ESSO deducted from its gross income, as part of its ordinary and necessary business expenses, the amount it had spent for drilling and exploration of its petroleum concessions. This claim was disallowed by the CIR on the ground that the expenses should be capitalized and might be written off as a loss only when a "dry hole" should result.

ESSO then filed an amended return and claimed as ordinary and necessary expenses margin fees it had paid to the Central Bank on its profit remittances to its New York head office. The CIR disallowed the claimed deduction for the margin fees paid. CIR assessed ESSO a deficiency income tax which arose from the disallowance of the margin fees.

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

ISSUES:1. WON margin fee is a tax and should be deductible from ESSOs gross income. NO2. If margin fees are not taxes, w/n they should nevertheless be considered necessary and ordinary business expenses and therefore still deductible from its gross income. NO.

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

2. NO.To be deductible as a business expense, three conditions are imposed, namely:

(1) The expense must be ordinary and necessary, (2) It must be paid or incurred within the taxable year, and (3) It must be paid or incurred in carrying on a trade or business. In addition, not only must the taxpayer meet the business test, he must substantially prove by evidence or records the deductions claimed under the law, otherwise, the same will be disallowed. The mere allegation of the taxpayer that an item of expense is ordinary and necessary does not justify its deduction.

Ordinarily, an expense will be considered 'necessary' where the expenditure is appropriate and helpful in the development of the taxpayer's business. It is 'ordinary' when it connotes a payment which is normal in relation to the business of the taxpayer and the surrounding circumstances. The term 'ordinary' does not require that the payments be habitual or normal in the sense that the same taxpayer will have to make them often; the payment may be unique or non-recurring to the particular taxpayer affected. There is thus no hard and fast rule on the matter. The right to a deduction depends in each case on the particular facts and the relation of the payment to the type of business in which the taxpayer is engaged. The intention of the taxpayer often may be the controlling fact in making the determination. Assuming that the expenditure is ordinary and necessary in the operation of the taxpayer's business, the answer to the question as to whether the expenditure is an allowable deduction as a business expense must be determined from the nature of the expenditure itself, which in turn depends on the extent and permanency of the work accomplished by the expenditure. Since the margin fees in question were incurred for the remittance of funds to petitioner's Head Office in New York, which is a separate and distinct income taxpayer from the branch in the Philippines, for its disposal abroad, it can never be said therefore that the margin fees were appropriate and helpful in the development of petitioner's business in the Philippines exclusively. ESSO has not shown that the remittance to the head office of part of its profits was made in furtherance of its own trade or business and therefore cannot be claimed as an ordinary and necessary expense paid or incurred in carrying on its own trade or business.