Mt.

Morris vs Commissioner
The Commissioner determined a deficiency in the petitioner's income and excess profits tax for 1950 in
the amount of $3,150.13. The only issue for decision is whether the amount of $8,224 spent by the
petitioner in 1950 to construct a drainage system was deductible either as an ordinary and necessary
business expense or as a loss, as contended by the petitioner, or whether it was a nondepreciable
capital expenditure, as determined by the Commissioner. An alternative issue raised by the petitioner
that the cost of the drainage system should be amortized over a period of at least 5 years was expressly
abandoned by it at the hearing.

FINDINGS OF FACT.
The petitioner is an Ohio corporation with its principal offices in Cleveland, Ohio. It filed an original and
an amended Federal income and excess profits tax return for the calendar year 1950 with the collector
of internal revenue for the eighteenth district of Ohio.

In 1947 petitioner purchased 13 acres of farm land located on the outskirts of Flint, Michigan, upon
which it proceeded to construct a drive-in or outdoor theatre. Prior to its purchase by the petitioner the
land on which the theatre was built was farm land and contained vegetation. The slope of the land was
such that the natural drainage of water was from the southerly line to the northerly boundary of the
property and thence onto the adjacent land, owned by David and Mary D. Nickola, which was used both
for farming and as a trailer park. The petitioner's land sloped sharply from south to north and also
sloped from the east downward towards the west so that most of the drainage from the petitioner's
property was onto the southwest corner of the Nickolas' land. The topography of the land purchased by
petitioner was well known to petitioner at the time it was purchased and developed. The petitioner did
not change the general slope of its land in constructing the drive-in theatre, but it removed the covering
vegetation from the land, slightly increased the grade, and built aisles or ramps which were covered
with gravel and were somewhat raised so that the passengers in the automobiles would be able to view
the picture on the large outdoor screen.

As a result of petitioner's construction on and use of this land rain water falling upon it drained with an
increased flow into and upon the adjacent property of the Nickolas. This result should reasonably have
been anticipated by petitioner at the time when the construction work was done.

The Nickolas complained to the petitioner at various times after petitioner began the construction of the
theatre that the work resulted in an acceleration and concentration of the flow of water which drained
from the petitioner's property onto the Nickolas' land causing damage to their crops and roadways. On
or about October 11, 1948, the Nickolas filed a suit against the petitioner in the Circuit Court for the
County of Genesee, State of Michigan, asking for an award for damages done to their property by the
accelerated and concentrated drainage of the water and for a permanent injunction restraining the
defendant from permitting such drainage to continue. Following the filing of an answer by the petitioner
and of a reply thereto by the Nickolas, the suit was settled by an agreement dated June 27, 1950. This
agreement provided for the construction by the petitioner of a drainage system to carry water from its
northern boundary across the Nickolas' property and thence to a public drain. The cost of maintaining
the system was to be shared by the petitioner and the Nickolas, and the latter granted the petitioner
and its successors an easement across their land for the purpose of constructing and maintaining the
drainage system. The construction of the drain was completed in October 1950 under the supervision of
engineers employed by the petitioner and the Nickolas at a cost to the petitioner of $8,224, which
amount was paid by it in November 1950. The performance by the petitioner on its part of the
agreement to construct the drainage system and to maintain the portion for which it was responsible
constituted a full release of the Nickolas' claims against it. The petitioner chose to settle the dispute by
constructing the drainage system because it did not wish to risk the possibility that continued litigation
might result in a permanent injunction against its use of the drive-in theatre and because it wished to
eliminate the cause of the friction between it and the adjacent landowners, who were in a position to
seriously interfere with the petitioner's use of its property for outdoor theatre purposes. A settlement
based on a monetary payment for past damages, the petitioner believed, would not remove the threat
of claims for future damages.

On its 1950 income and excess profits tax return the petitioner claimed a deduction of $822.40 for
depreciation of the drainage system for the period July 1, 1950, to December 31, 1950. The
Commissioner disallowed without itemization $5,514.60 of a total depreciation expense deduction of
$19,326.41 claimed by the petitioner. In its petition the petitioner asserted that the entire amount spent
to construct the drainage system was fully deductible in 1950 as an ordinary and necessary business
expense incurred in the settlement of a lawsuit, or, in the alternative, as a loss, and claimed a refund of
part of the $10,591.56 of income and excess profits tax paid by it for that year.

The drainage system was a permanent improvement to the petitioner's property, and the cost thereof
constituted a capital expenditure.

The stipulation of facts and the exhibits annexed thereto are incorporated herein by this reference.

OPINION.
KERN, Judge:

When petitioner purchased, in 1947, the land which it intended to use for a drive-in theatre, its
president was thoroughly familiar with the topography of this land which was such that when the
covering vegetation was removed and graveled ramps were constructed and used by its patrons, the
flow of natural precipitation on the lands of abutting property owners would be materially accelerated.
Some provision should have been made to solve this drainage problem in order to avoid annoyance and
harrassment to its neighbors. If petitioner had included in its original construction plans an expenditure
for a proper drainage system no one could doubt that such an expenditure would have been capital in
nature.

Within a year after petitioner had finished its inadequate construction of the drive-in theatre, the need
of a proper drainage system was forcibly called to its attention by one of the neighboring property
owners, and under the threat of a lawsuit filed approximately a year after the theatre was constructed,
the drainage system was built by petitioner who now seeks to deduct its cost as an ordinary and
necessary business expense, or as a loss.

We agree with respondent that the cost to petitioner of acquiring and constructing a drainage system in
connection with its drive-in theatre was a capital expenditure.

Here was no sudden catastrophic loss caused by a "physical fault" undetected by the taxpayer in spite of
due precautions taken by it at the time of its original construction work as in American Bemberg
Corporation, 10 T.C. 361; no unforeseeable external factor as in Midland Empire Packing Co., 14 T.C.
635; and no change in the cultivation of farm property caused by improvements in technique and made
many years after the property in question was put to productive use as in J. H. Collingwood, 20 T.C. 937.
In the instant case it was obvious at the time when the drive-in theatre was constructed, that a drainage
system would be required to properly dispose of the natural precipitation normally to be expected, and
that until this was accomplished, petitioner's capital investment was incomplete. In addition, it should
be emphasized that here there was no mere restoration or rearrangement of the original capital asset,
but there was the acquisition and construction of a capital asset which petitioner had not previously
had, namely, a new drainage system.

That this drainage system was acquired and constructed and that payments therefore were made in
compromise of a lawsuit is not determinative of whether such payments were ordinary and necessary
business expenses or capital expenditures. "The decisive test is still the character of the transaction
which gives rise to the payment." Hales-Mullaly v. Commissioner, 131 F.2d 509, 511, 512.

In our opinion the character of the transaction in the instant case indicates that the transaction was a
capital expenditure.

Reviewed by the Court.

Decision will be entered for the respondent.

Midland Empire v CIR

ARUNDELL

Petitioner, a meat-packing corporation, by lining the walls and floor of its basement with concrete,
sought to protect it from the seepage of oil spilled on the ground by a neighboring refinery. The oil
nuisance threatened continued operation of the packing plant. The purpose of the expenditure for the
concrete liner was not to prepare the plant for operation on a changed or larger scale, nor to make it
suitable for new or additional uses, but only to permit petitioner to continue the use of the plant, and
particularly the basement, in normal operation. Held, the expenditure for lining the basement walls and
floor was essentially a repair and as such is deductible as an ordinary and necessary business expense
under section 23(a) of the Internal Revenue Code. James R. Felt, Esq., for the petitioner. Wilford H.
Payne, Esq., for the respondent.

This case involves deficiencies in declared value excess profits tax in the amount of $321.34 and excess
profits tax in the amount of $4,092.72 for the taxable year ended November 30, 1943. The issue
presented for decision is whether or not the sum of $4,868.81 expended by the petitioner in oilproofing
the basement of its meat-packing plant during the taxable year 1943 is deductible as an ordinary and
necessary business expense under section 23(a) of the Internal Revenue Code, or, in the alternative, as a
loss sustained during the year and not compensated for by insurance or otherwise under section 23(f) of
the Internal Revenue Code.

The case has been submitted on a partial stipulation of facts, documentary evidence, and oral
testimony.

FINDINGS OF FACT.
The petitioner, herein sometimes referred to as Midland, is a Montana corporation and the owner of a
meat-packing plant which is located adjacent to the city of Billings, Yellowstone County, State of
Montana. Its returns for the period here involved were filed with the collector of internal revenue for
the district of Montana. Its books of account and its tax returns were, during the taxable year and at all
other times, kept on the accrual basis of accounting. Petitioner's returns were based on a fiscal year
ending November 30.

The basement rooms of petitioner's plant were used by it in its business for the curing of hams and
bacon and for the storage of meat and hides. These rooms have been used for such purposes since the
plant was constructed in about 1917. The original walls and floors, which were of concrete, were not
sealed against water. There had been seepage for many years and this condition became worse around
1943. At certain seasons of the year, when the water in the Yellowstone River was high, the
underground water caused increased seepage in the plant. Such water did not interfere with petitioner's
use of the basement rooms. They were satisfactory for their purpose until 1943.

The Yale Oil Corporation, sometimes referred to herein as Yale, was the owner of an oil-refining plant
and storage area located some 300 yards upgrade from petitioner's meat-packing plant. The oil plant
was constructed some years after petitioner had been in business in its present location. Yale expanded
its plant and storage from year to year and oil escaping from the plant and storage facilities was carried
to the ground surround the the plant of petitioner. In 1943 petitioner found that oil was seeping into its
water wells and into water which came through the concrete walls of the basement of its packing plant.
The water would soon drain out through the sump, leaving a thick scum of oil on the basement floor.
Such oil gave off a strong odor, which permeated the air of the entire plant. The oil in the basement and
fumes therefrom created a fire hazard. The Federal meat inspectors advised petitioner to oilproof the
basement and discontinue the use of the water wells or shut down the plant.

As soon as petitioner discovered that oil had begun to seep into its water wells and into the basement of
its plant, its officers conferred with the officers of the Yale Oil Corporation and informed Yale that they
intended to hold it liable for all damage caused by the oil which had saturated the ground around its
packing plant. They informed the officials of Yale that they believed this condition constituted a legal
nuisance, which condition they expected would continue to exist for future years, and that they were
discontinuing the use of their water wells. The officials of Yale were also informed that the Federal
inspectors were requiring petitioner to oilproof the basement.

A. F. Lamey, attorney at law in Billings, Montana, handled nearly all of the negotiations for the
settlement of the claims made by Midland against the Yale Oil Corporation for damages resulting from
the oil escaping from Yale's refineries to the premises of the packing company. He represented the Yale
Corporation and the Maryland Casualty Co., which carried liability insurance with respect to Yale. Early
in 1943 he went to the packing plant to inspect the basement and observed the situation as found
above. He talked with Chris Shaffer, of the petitioner corporation, and informed him that Yale was not
assuming any responsibility and that it was petitioner's duty to take whatever steps were necessary to
minimize damages. Prior to that time, petitioner suggested piece-meal settlements, which Yale declined
to consider because they felt it would be to their disadvantage to assume responsibility for any damages
without a complete release. Lamey wrote to the Maryland Casualty Co., Yale's insurer, in a letter dated
March 31, 1943, with reference to this situation, in part as follows:

Past experience indicates that little can be done through a conference with Mr. Shaffer, who is in charge
of the plant. His demands are always exorbitant and he has never been willing to make any proposition
for a complete and final settlement. He seems to have the idea that the Yale should make monthly
payments on the water account, pay damages on hides each year as they are injured, etc. If we ever
began making payments on that basis there would be no end to our difficulties. We therefore suggested
to the Yale that we do nothing. We feel that we would have a better opportunity to dispose of this claim
if the Packing Company obtained the services of a lawyer who could advise them with reference to their
rights, and the limits of the Yale's responsibilities.

On June 10, 1943, Lamey again wrote to the Maryland Casualty Co. with respect to the matter of Yale's
liability to Midland:

Since our letter of the 5th, we have held two conferences with representatives of the Midland Empire
Packing Company. The claimant has employed M. J. Lamb of this city as attorney. At the conference,
Mr. Frank Jacoby, a contractor, has also been present. It is our understanding that he has some interest
in the packing plant. However, we know him very well. He is a competent and honest contractor.

Frank Jacoby was a construction contractor, who also did repair and improvement work at various times
for petitioner corporation. He owned one-third of the capital stock of the petitioner throughout the
period here involved and later became vice president of the corporation. Jacoby talked with the officers
of Yale about the nature of the oil-sealing work to be done on petitioner's plant in order to insure that
the work was done to the satisfaction of Yale, inasmuch as petitioner was looking for reimbursement for
that amount from Yale. Midland decided to proceed with the work in the basement and Yale agreed that
it should be done and that in any litigation or in any settlement that ensued it would accept the
testimony of Jacoby as to the reasonableness of the cost of the work done. They also agreed to
acknowledge the bills for such work as an element of damages if a settlement was later effected. The
Yale officials refused to do the repair work themselves.

The president of Midland continued to refuse to give a complete release covering future damage. The
letter of June 10, 1943, recited some of the items claimed by petitioner corporation, including several
references to the repairs in petitioner's basement.

With respect to the delay in giving the petitioner a definite answer to the settlement of its liability, the
letter stated:

It is rather difficult for the officers of the packing company to understand why we cannot give an
immediate definite answer, in view of the fact that the offices of the Yale Petroleum Company are
located in Billings. They have no knowledge that there is insurance coverage. We mention this so that
you will understand the importance of making some decision with reference to a basis of settlement as
soon as possible.

Finally, regarding the legal basis of Yale's liability to the petitioner for the damages caused by the oil,
Lamey wrote to the insurance company that it was his opinion that Midland would have little difficulty
in establishing liability on the part of the Yale Oil Corporation. He also noted that the item of damage
claimed by the packing company could be considered as evidence of damages. The letter then stated
that, while the amount needed to settle the claim might be large and the Yale Co. would not be able to
get a release for future damages, when the basement repairs were completed there should be little
future damage. He recommended that the claim be settled and concluded with a statement that it was
to Yale's advantage that Midland was proceeding with repairs to the basement.
The original walls and floor of petitioner's plant were of concrete construction. For the purpose of
preventing oil from entering its basement, petitioner added concrete lining to the walls from the floor
to a height of about four feet, and also added concrete to the floor of the basement. Since the walls and
floor had been thickened, petitioner now had less space in which to operate. Petitioner had this work
done by independent contractors, supervised by Jacoby, in the fiscal year ended November 30, 1943, at
a cost of $4,868.81. Petitioner paid for this work during that year.

The oilproofing work was effective in sealing out the oil. While it has served the purposes for which it
was intended down to the present time, it did not increase the useful life of the building or make the
building more valuable for any purpose than it had been before the oil had come into the basement. The
primary object of the oilproofing operation was to prevent the seepage of oil into the basement so that
the petitioner could use the basement as before in preparing and packing meet for commercial
consumption.

After the oilproofing was completed and prior to the close of the petitioner's taxable year ended
November 30, 1943, negotiations for settlement were again conducted between representatives of
petitioner and the Yale Oil Corporation, at which time Yale offered to pay petitioner in cash the sum of
approximately $7,500 in satisfaction of all claims asserted by Midland against Yale, provided Midland
would execute a general release to Yale. Because Midland was unwilling and refused to give such
release for the payment offered, no amount was in fact paid to petitioner by Yale in that year. Petitioner
continued to maintain that it was entitled to a much larger amount for the general damage done to the
plant by this nuisance. Negotiations had reached this point in the fiscal year ended November 30, 1943.

The petitioner thereafter filed suit against Yale, on April 22, 1944, in a cause of action sounding in tort
and on November 30, 1944, joined as a defendant in such action Yale's successor, the Carter Oil Co.,
which had acquired the properties of Yale Oil Corporation. This action was to recover damages for the
nuisance created by the oil seepage. In those proceedings the defendants demurred to the joinder of
parties in the petitioner's complaint. On appeal, the Montana Supreme Court sustained the demurrer.

Petitioner subsequently settled its cause of action against Yale for $11,659.49 and gave Yale a complete
release of all liability. This release was dated October 23, 1946. The recovery of the cost of the
waterproofing only was reported in its excess profits and income tax returns for the year ended
November 30, 1946.

The petitioner is still making claim upon the Carter Oil Co. and is endeavoring to settle that claim
without suit.

Midland charted the $4,868.81 to repair expense on its regular books and deducted that amount on its
tax returns as an ordinary and necessary business expense for the fiscal year 1943. The Commissioner,
in his notice of deficiency, determined that the cost of oilproofing was not deductible, either as an
ordinary and necessary expense or as a loss in 1943.

OPINION.
ARUNDELL, Judge:
The issue in this case is whether an expenditure for a concrete lining in petitioner's basement to oilproof
it against an oil nuisance created by a neighboring refinery is deductible as an ordinary and necessary
expense under section 23(a) of the Internal Revenue Code, on the theory it was an expenditure for a
repair, or, in the alternative, whether the expenditure may be treated as the measure of the loss
sustained during the taxable year and not compensated for by insurance or otherwise within the
meaning of section 23(f) of the Internal Revenue Code.

The respondent has contended, in part, that the expenditure is for a capital improvement and should be
recovered through depreciation charges and is, therefore, not deductible as an ordinary and necessary
business expense or as a loss.

It is none too easy to determine on which side of the line certain expenditures fall so that they may be
accorded their proper treatment for tax purposes. Treasury Regulations 111, from which we quote in
the margin, is helpful in distinguishing between an expenditure to be classed as a repair and one to be
treated as a capital outlay. In Illinois Merchants Trust Co., Executor, 4 B.T.A. 103, at page 106, we
discussed this subject in some detail and in our opinion said:

SEC. 29.23(a)-4. REPAIRS.— The cost of incidental repairs which neither materially add to the value of
the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition,
may be deducted as expense, provided the plant or property account is not increased by the amount of
such expenditures. Repairs in the nature of replacements, to the extent that they arrest deterioration
and appreciably prolong the life of the property, should be charged against the depreciation reserve if
such account is kept. (See sections 29.23(l)-1 to 29.23(l)-10, inclusive.)

It will be noted that the first sentence of the article (now Regulations 111, sec. 29.23(a)-4) relates to
repairs, while the second sentence deals in effect with replacements. In determining whether an
expenditure is a capital one or is chargeable against operating income, it is necessary to bear in mind
that purpose for which the expenditure was made. To repair is to restore to a sound state or to mend,
while a replacement connotes a substitution. A repair is an expenditure for the purpose of keeping the
property in an ordinarily efficient operating condition. It does not add to the value of the property nor
does it appreciably prolong its life. It merely keeps the property in an operating condition over its
probable useful life for the uses for which it was acquired. Expenditures for that purpose are
distinguishable from those for replacements, alterations, improvements, or additions which prolong the
life of the property, increase its value, or make it adaptable to a different use. The one is a maintenance
charge, while the others are additions to capital investment which should not be applied against current
earnings.

It will be seen from our findings of fact that for some 25 years prior to the taxable year petitioner had
used the basement rooms of its plant as a place for the curing of hams and bacon and for the storage of
meat and hides. The basement had been entirely satisfactory for this purpose over the entire period in
spite of the fact that there was some seepage of water into the rooms from time to time. In the taxable
year it was found that not only water, but oil, was seeping through the concrete walls of the basement
of the packing plant and, while the water would soon drain out, the oil would not, and there was left on
the basement floor a thick scum of oil which gave off a strong odor that permeated the air of the entire
plant, and the fumes from the oil created a fire hazard. It appears that the oil which came from a nearby
refinery had also gotten into the water wells which served to furnish water for petitioner's plant, and as
a result of this whole condition the Federal meat inspectors advised petitioner that it must discontinue
the use of the water from the wells and oilproof the basement, or else shut down its plant.

To meet this situation, petitioner during the taxable year undertook steps to oilproof the basement by
adding a concrete lining to the walls from the floor to a height of about four feet and also added
concrete to the floor of the basement. It is the cost of this work which it seeks to deduct as a repair. The
basement was not enlarged by this work, nor did the oilproofing serve to make it more desirable for the
purpose for which it had been used through the years prior to the time that the oil nuisance had
occurred. The evidence is that the expenditure did not add to the value or prolong the expected life of
the property over what they were before the event occurred which made the repairs necessary. It is
true that after the work was done the seepage of water, as well as oil, was stopped, but, as already
stated, the presence of the water had never been found objectionable. The repairs merely served to
keep the property in an operating condition over its probable useful life for the purpose for which it was
used.

While it is conceded on brief that the expenditure was ‘necessary,‘ respondent contends that the
encroachment of the oil nuisance on petitioner's property was not an ‘ordinary‘ expense in petitioner's
particular business. But the fact that petitioner had not theretofore been called upon to make a similar
expenditure to prevent damage and disaster to its property does not remove that expense from the
classification of ‘ordinary‘ for, as stated in Welch v. Helvering, 290 U.S. 111, ‘ordinary in this context
does not mean that the payments must be habitual or normal in the sense that the same taxpayer will
have to make them often. * * * the expense is an ordinary one because we know from experience that
payments for such a purpose, whether the amount is large or small, are the common and accepted
means of defense against attack. Cf. Kornhauser v. United States, 276 U.S. 145. The situation is unique in
the life of the individual affected, but not in the life of the group, the community, of which he is a part.‘
Steps to protect a business building from the seepage of oil from a nearby refinery, which had been
erected long subsequent to the time petitioner started to operate its plant, would seem to us to be a
normal thing to do, and in certain sections of the country it must be a common experience to protect
one's property from the seepage of oil. Expenditures to accomplish this result are likewise normal.

In American Bemberg Corporation, 10 T.C. 361, we allowed as deductions, on the ground that they were
ordinary and necessary expenses, extensive expenditures made to prevent disaster, although the repairs
were of a type which had never been needed before and were unlikely to recur. In that case the
taxpayer, to stop cave-ins of soil which were threatening destruction of its manufacturing plant, hired an
engineering firm which drilled to the bedrock and injected grout to fill the cavities were practicable, and
made incidental replacements and repairs, including tightening of the fluid carriers. In two successive
years the taxpayer expended $734,316.76 and $199,154.33, respectively, for such drilling and grouting
and $153,474.20 and $79,687.29, respectively, for capital replacements. We found that the cost (other
than replacement) of this program did not make good the depreciation previously allowed, and stated in
our opinion:

In connection with the purpose of the work, the Proctor program was intended to avert a plant-wide
disaster and avoid forced abandonment of the plant. The purpose was not to improve, better, extend, or
increase the original plant, nor to prolong its original useful life. Its continued operation was
endangered; the purpose of the expenditures was to enable petitioner to continue the plant in
operation not on any new or better scale, but on the same scale and, so far as possible, as efficiently as
it had operated before. The purpose was not to rebuild or replace the plant in whole or in part, but to
keep the same plant as it was and where it was.

The petitioner here made the repairs in question in order that it might continue to operate its plant. Not
only was there danger of fire from the oil and fumes, but the presence of the oil led the Federal meat
inspectors to declare the basement an unsuitable place for the purpose for which it had been used for a
quarter of a century. After the expenditures were made, the plant did not operate on a changed or
larger scale, nor was it thereafter suitable for new or additional uses. The expenditure served only to
permit petitioner to continue the use of the plant, and particularly the basement for its normal
operations.

In our opinion, the expenditure of $4,868.81 for lining the basement walls and floor was essentially a
repair and, as such, it is deductible as an ordinary and necessary business expense. This holding makes
unnecessary a consideration of petitioner's alternative contention that the expenditure is deductible as
a business loss, nor need we heed the respondent's argument that any loss suffered was compensated
for by ‘insurance or otherwise.‘

Decision will be entered under Rule 50.

INDOPCO, INC. v. CIR(1992)

No. 90-1278
Argued: November 12, 1991Decided: February 26, 1992
On its 1978 federal income tax return, petitioner corporation claimed a deduction for certain investment
banking fees and expenses that it incurred during a friendly acquisition in which it was transformed from
a publicly held, freestanding corporation into a wholly owned subsidiary. After respondent
Commissioner disallowed the claim, petitioner sought reconsideration in the Tax Court, adding to its
claim deductions for legal fees and other acquisition-related expenses. The Tax Court ruled that,
because long-term benefits accrued to petitioner from the acquisition, the expenditures were capital in
nature, and not deductible under 162(a) of the Internal Revenue Code as "ordinary and necessary"
business expenses. The Court of Appeals affirmed, rejecting petitioner's argument that, because the
expenses did not "create or enhance . . . a separate and distinct additional asset," see Commissioner v.
Lincoln Savings & Loan Assn., 403 U.S. 345, 354 , they could not be capitalized under 263 of the Code.

Held:

Petitioner's expenses do not qualify for deduction under 162(a). Deductions are exceptions to the norm
of capitalization, and are allowed only if there is clear provision for them in the Code and the taxpayer
has met the burden of showing a right to the deduction. Commissioner v. Lincoln Savings & Loan Assn.,
supra, holds simply that the creation of a separate and distinct asset may be a sufficient condition for
classification as a capital expenditure, not that it is a prerequisite to such classification. Nor does Lincoln
Savings prohibit reliance on future benefit as means of distinguishing an ordinary business expense from
a capital expenditure. Although the presence of an incidental future benefit may not warrant
capitalization, a taxpayer's realization of benefits beyond the year in which the expenditure is incurred is
important in determining whether the appropriate tax treatment is immediate deduction or
capitalization. The record in the instant case amply supports the lower court's findings that the
transaction produced significant benefits to petitioner extending beyond the tax year in question. Pp.
83-90.

918 F.2d 426 (CA3 1990) affirmed.

BLACKMUN, J., delivered the opinion for a unanimous Court. [503 U.S. 79, 80]
Richard J. Hiegel argued the cause for petitioner. With him on the briefs were Geoffrey R. S. Brown, Rory
O. Millson, and Richard H. Walker.

Kent L. Jones argued the cause for respondent. With him on the brief were Solicitor General Starr,
Assistant Attorney General Peterson, Deputy Solicitor General Wallace, Gelbert S. Rothenberg, and
Bruce R. Ellisen. *

[ Footnote * ] Timothy J. McCormally and Mary L. Fahey filed a brief for the Tax Executives Institute, Inc.,
as amicus curiae urging reversal.

JUSTICE BLACKMUN delivered the opinion of the Court.

In this case, we must decide whether certain professional expenses incurred by a target corporation in
the course of a friendly takeover are deductible by that corporation as "ordinary and necessary"
business expenses under 162(a) of the Internal Revenue Code.
I
Most of the relevant facts are stipulated. See App. 12, 149. Petitioner INDOPCO, Inc., formerly named
National Starch and Chemical Corporation and hereinafter referred to as National Starch, is a Delaware
corporation that manufactures and sells adhesives, starches, and specialty chemical products. In
October, 1977, representatives of Unilever United States, Inc., also a Delaware corporation (Unilever), 1
expressed interest in acquiring National Starch, which was one of its suppliers, through a friendly
transaction. National Starch at the time had outstanding over 6,563,000 common shares held by
approximately 3700 shareholders. The stock was listed on the New York Stock Exchange. Frank and Anna
Greenwall were the corporation's largest shareholders, and owned approximately 14.5% of the
common. The Greenwalls, getting along in years and concerned about [503 U.S. 79, 81] their estate
plans, indicated that they would transfer their shares to Unilever only if a transaction tax-free for them
could be arranged.

Lawyers representing both sides devised a "reverse subsidiary cash merger" that they felt would satisfy
the Greenwalls' concerns. Two new entities would be created - National Starch and Chemical Holding
Corp. (Holding), a subsidiary of Unilever, and NSC Merger, Inc., a subsidiary of Holding that would have
only a transitory existence. In an exchange specifically designed to be tax-free under 351 of the Internal
Revenue Code, 26 U.S.C. 351, Holding would exchange one share of its nonvoting preferred stock for
each share of National Starch common that it received from National Starch shareholders. Any National
Starch common that was not so exchanged would be converted into cash in a merger of NSC Merger,
Inc., into National Starch.

In November 1977, National Starch's directors were formally advised of Unilever's interest and the
proposed transaction. At that time, Debevoise, Plimpton, Lyons & Gates, National Starch's counsel, told
the directors that, under Delaware law, they had a fiduciary duty to ensure that the proposed
transaction would be fair to the shareholders. National Starch thereupon engaged the investment
banking firm of Morgan Stanley & Co., Inc., to evaluate its shares, to render a fairness opinion, and
generally to assist in the event of the emergence of a hostile tender offer.

Although Unilever originally had suggested a price between $65 and $70 per share, negotiations
resulted in a final offer of $73.50 per share, a figure Morgan Stanley found to be fair. Following approval
by National Starch's board and the issuance of a favorable private ruling from the Internal Revenue
Service that the transaction would be tax-free under 351 for those National Starch shareholders who
exchanged [503 U.S. 79, 82] their stock for Holding preferred, the transaction was consummated in
August, 1978. 2

Morgan Stanley charged National Starch a fee of $2,200,000, along with $7,586 for out-of-pocket
expenses and $18,000 for legal fees. The Debevoise firm charged National Starch $490,000, along with
$15,069 for out-of-pocket expenses. National Starch also incurred expenses aggregating $150,962 for
miscellaneous items - such as accounting, printing, proxy solicitation, and Securities and Exchange
Commission fees - in connection with the transaction. No issue is raised as to the propriety or
reasonableness of these charges.

On its federal income tax return for its short taxable year ended August 15, 1978, National Starch
claimed a deduction for the $2,225,586 paid to Morgan Stanley, but did not deduct the $505,069 paid to
Debevoise or the other expenses. Upon audit, the Commissioner of Internal Revenue disallowed the
claimed deduction and issued a notice of deficiency. Petitioner sought redetermination in the United
States Tax Court, asserting, however, not only the right to deduct the investment banking fees and
expenses but, as well, the legal and miscellaneous expenses incurred.

The Tax Court, in an unreviewed decision, ruled that the expenditures were capital in nature, and
therefore not deductible under 162(a) in the 1978 return as "ordinary and necessary expenses."
National Starch and Chemical Corp. v. Commissioner, 93 T.C. 67 (1989). The court based its holding
primarily on the long-term benefits that accrued to National Starch from the Unilever acquisition. Id., at
75. The United States Court of Appeals for the Third Circuit affirmed, upholding the Tax Court's findings
that "both Unilever's enormous resources and the possibility of synergy arising from the transaction
served the long-term betterment [503 U.S. 79, 83] of National Starch." National Starch and Chemical
Corp. v. Commissioner, 918 F.2d 426, 432-433 (1990). In so doing, the Court of Appeals rejected
National Starch's contention that, because the disputed expenses did not "create or enhance . . . a
separate and distinct additional asset," see Commissioner v. Lincoln Savings Loan Assn., 403 U.S. 345,
354 (1971), they could not be capitalized, and therefore were deductible under 162(a). 918 F.2d, at 428-
431. We granted certiorari to resolve a perceived conflict on the issue among the Courts of Appeals. 3
500 U.S. 914 (1991).

II
Section 162(a) of the Internal Revenue Code allows the deduction of "all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or business." 26 U.S.C. 162(a).
In contrast, 263 of the Code allows no deduction for a capital expenditure - an "amount paid out for new
buildings or for permanent improvements or betterments made to increase the value of any property or
estate." 26 U.S.C. 263(a)(1). The primary effect of characterizing a payment as either a business expense
or a capital expenditure concerns the timing of the taxpayer's cost recovery: while business expenses
are currently deductible, a capital expenditure usually is amortized and depreciated [503 U.S. 79, 84]
over the life of the relevant asset, or, where no specific asset or useful life can be ascertained, is
deducted upon dissolution of the enterprise. See 26 U.S.C. 167(a) and 336(a); Treas.Reg. 1.167(a), 26
CFR 1.167(a) (1991). Through provisions such as these, the Code endeavors to match expenses with the
revenues of the taxable period to which they are properly attributable, thereby resulting in a more
accurate calculation of net income for tax purposes. See, e.g., Commissioner v. Idaho Power Co., 418
U.S. 1, 16 (1974); Ellis Banking Corp. v. Commissioner, 688 F.2d 1376, 1379 (CA11 1982), cert. denied,
463 U.S. 1207 (1983).
In exploring the relationship between deductions and capital expenditures, this Court has noted the
"familiar rule" that "an income tax deduction is a matter of legislative grace, and that the burden of
clearly showing the right to the claimed deduction is on the taxpayer." Interstate Transit Lines v.
Commissioner, 319 U.S. 590, 593 (1943); Deputy v. Du Pont, 308 U.S. 488, 493 (1940); New Colonial Ice
Co. v. Helvering, 292 U.S. 435, 440 (1934). The notion that deductions are exceptions to the norm of
capitalization finds support in various aspects of the Code. Deductions are specifically enumerated, and
thus are subject to disallowance in favor of capitalization. See 161 and 261. Nondeductible capital
expenditures, by contrast, are not exhaustively enumerated in the Code; rather than providing a
"complete list of nondeductible expenditures," Lincoln Savings, 403 U.S., at 358 , 263 serves as a general
means of distinguishing capital expenditures from current expenses. See Commissioner v. Idaho Power
Co., 418 U.S., at 16 . For these reasons, deductions are strictly construed and allowed only "as there is a
clear provision therefor." New Colonial Ice Co. v. Helvering, 292 U.S., at 440 ; Deputy v. Du Pont, 308
U.S., at 493 . 4 [503 U.S. 79, 85]

The Court also has examined the interrelationship between the Code's business expense and capital
expenditure provisions. 5 In so doing, it has had occasion to parse 162(a) and explore certain of its
requirements. For example, in Lincoln Savings, we determined that, to qualify for deduction under
162(a), "an item must (1) be "paid or incurred during the taxable year," (2) be for "carrying on any trade
or business," (3) be an "expense," (4) be a "necessary" expense, and (5) be an "ordinary" expense." 403
U.S., at 352 . See also Commissioner v. Tellier, 383 U.S. 687, 689 (1966) (the term "necessary" imposes
"only the minimal requirement that the expense be `appropriate and helpful' for `the development of
the [taxpayer's] business,'" quoting Welch v. Helvering, 290 U.S. 111, 113 (1933)); Deputy v. Du Pont,
308 U.S. 488, 495 (1940) (to qualify as "ordinary," the expense must relate to a transaction "of common
or frequent occurrence in [503 U.S. 79, 86] the type of business involved"). The Court has recognized,
however, that the "decisive distinctions" between current expenses and capital expenditures "are those
of degree, and not of kind," Welch v. Helvering, 290 U.S., at 114 , and that, because each case "turns on
its special facts," Deputy v. Du Pont, 308 U.S., at 496 , the cases sometimes appear difficult to
harmonize. See Welch v. Helvering, 290 U.S., at 116 .

National Starch contends that the decision in Lincoln Savings changed these familiar backdrops and
announced an exclusive test for identifying capital expenditures, a test in which "creation or
enhancement of an asset" is a prerequisite to capitalization, and deductibility under 162(a) is the rule,
rather than the exception. Brief for Petitioner 16. We do not agree, for we conclude that National Starch
has overread Lincoln Savings.

In Lincoln Savings, we were asked to decide whether certain premiums, required by federal statute to be
paid by a savings and loan association to the Federal Savings and Loan Insurance Corporation (FSLIC),
were ordinary and necessary expenses under 162(a), as Lincoln Savings argued and the Court of Appeals
had held, or capital expenditures under 263, as the Commissioner contended. We found that the
"additional" premiums, the purpose of which was to provide FSLIC with a secondary reserve fund in
which each insured institution retained a pro rata interest recoverable in certain situations, "serv[e] to
create or enhance for Lincoln what is essentially a separate and distinct additional asset." 403 U.S., at
354 . "[A]s an inevitable consequence," we concluded, "the payment is capital in nature, and not an
expense, let alone an ordinary expense, deductible under 162(a)." Ibid.

Lincoln Savings stands for the simple proposition that a taxpayer's expenditure that "serves to create or
enhance . . . a separate and distinct" asset should be capitalized under 263. It by no means follows,
however, that only expenditures that create or enhance separate and distinct assets are [503 U.S. 79,
87] to be capitalized under 263. We had no occasion in Lincoln Savings to consider the tax treatment of
expenditures that, unlike the additional premiums at issue there, did not create or enhance a specific
asset, and thus the case cannot be read to preclude capitalization in other circumstances. In short,
Lincoln Savings holds that the creation of a separate and distinct asset well may be a sufficient, but not a
necessary, condition to classification as a capital expenditure. See General Bancshares Corp. v.
Commissioner, 326 F.2d 712, 716 (CA8) (although expenditures may not "resul[t] in the acquisition or
increase of a corporate asset, . . . these expenditures are not, because of that fact, deductible as
ordinary and necessary business expenses"), cert. denied, 379 U.S. 832 (1964).

Nor does our statement in Lincoln Savings, 403 U.S., at 354 , that "the presence of an ensuing benefit
that may have some future aspect is not controlling" prohibit reliance on future benefit as a means of
distinguishing an ordinary business expense from a capital expenditure. 6 Although the mere presence
of an incidental future benefit - "some future aspect" - may not warrant capitalization, a taxpayer's
realization of benefits beyond the year in which the expenditure is incurred is undeniably important in
determining whether the appropriate tax treatment is immediate deduction or capitalization. See
United States v. Mississippi Chemical Corp., 405 U.S. 298, 310 (1972) (expense that "is of value in more
than one taxable year" is a nondeductible capital expenditure); Central Texas Savings & Loan Assn. v.
United States, 731 F.2d 1181, 1183 (CA5 1984) ("While the period of the benefits may not be controlling
in all cases, it nonetheless [503 U.S. 79, 88] remains a prominent, if not predominant, characteristic of a
capital item."). Indeed, the text of the Code's capitalization provision, 263(a)(1), which refers to
"permanent improvements or betterments," itself envisions an inquiry into the duration and extent of
the benefits realized by the taxpayer.

III
In applying the foregoing principles to the specific expenditures at issue in this case, we conclude that
National Starch has not demonstrated that the investment banking, legal, and other costs it incurred in
connection with Unilever's acquisition of its shares are deductible as ordinary and necessary business
expenses under 162(a).

Although petitioner attempts to dismiss the benefits that accrued to National Starch from the Unilever
acquisition as "entirely speculative" or "merely incidental," Brief for Petitioner 39-40, the Tax Court's
and the Court of Appeals' findings that the transaction produced significant benefits to National Starch
that extended beyond the tax year in question are amply supported by the record. For example, in
commenting on the merger with Unilever, National Starch's 1978 "Progress Report" observed that the
company would "benefit greatly from the availability of Unilever's enormous resources, especially in the
area of basic technology." App. 43. See also id., at 46 (Unilever "provides new opportunities and
resources"). Morgan Stanley's report to the National Starch board concerning the fairness to
shareholders of a possible business combination with Unilever noted that National Starch management
"feels that some synergy may exist with the Unilever organization given a) the nature of the Unilever
chemical, paper, plastics and packaging operations . . . and b) the strong consumer products orientation
of Unilever United States, Inc." Id., at 77-78.

In addition to these anticipated resource-related benefits, National Starch obtained benefits through its
transformation from a publicly held, freestanding corporation into a wholly [503 U.S. 79, 89] owned
subsidiary of Unilever. The Court of Appeals noted that National Starch management viewed the
transaction as "swapping approximately 3500 shareholders for one." 918 F.2d, at 427; see also App. 223.
Following Unilever's acquisition of National Starch's outstanding shares, National Starch was no longer
subject to what even it terms the "substantial" shareholder-relations expenses a publicly traded
corporation incurs, including reporting and disclosure obligations, proxy battles, and derivative suits.
Brief for Petitioner 24. The acquisition also allowed National Starch, in the interests of administrative
convenience and simplicity, to eliminate previously authorized but unissued shares of preferred and to
reduce the total number of authorized shares of common from 8,000,000 to 1,000. See 93 T.C., at 74.

Courts long have recognized that expenses such as these, "incurred for the purpose of changing the
corporate structure for the benefit of future operations are not ordinary and necessary business
expenses." General Bancshares Corp. v. Commissioner, 326 F.2d, at 715 (quoting Farmers Union Corp. v.
Commissioner, 300 F.2d 197, 200 (CA9), cert. denied, 371 U.S. 861 (1962)). See also B. Bittker & J.
Eustice, Federal Income Taxation of Corporations and Shareholders, pp. 5-33 to 5-36 (5th ed. 1987)
(describing "well-established rule" that expenses incurred in reorganizing or restructuring corporate
entity are not deductible under 162(a)). Deductions for professional expenses thus have been
disallowed in a wide variety of cases concerning changes in corporate structure. 7 Although support for
these decisions can be [503 U.S. 79, 90] found in the specific terms of 162(a), which require that
deductible expenses be "ordinary and necessary" and incurred "in carrying on any trade or business," 8
courts more frequently have characterized an expenditure as capital in nature because "the purpose for
which the expenditure is made has to do with the corporation's operations and betterment, sometimes
with a continuing capital asset, for the duration of its existence or for the indefinite future or for a time
somewhat longer than the current taxable year." General Bancshares Corp. v. Commissioner, 326 F.2d,
at 715. See also Mills Estate, Inc. v. Commissioner, 206 F.2d 244, 246 (CA2 1953). The rationale behind
these decisions applies equally to the professional charges at issue in this case.

IV
The expenses that National Starch incurred in Unilever's friendly takeover do not qualify for deduction
as "ordinary and necessary" business expenses under 162(a). The fact that the expenditures do not
create or enhance a separate and distinct additional asset is not controlling; the acquisition-related
expenses bear the indicia of capital expenditures, and are to be treated as such.

The judgment of the Court of Appeals is affirmed.

It is so ordered.

CIR vs General Foods

Petitioner Commissioner of Internal Revenue (Commissioner) assails the resolution[1 of the Court of
Appeals reversing the decision[2 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.[3cräläwvirtualibräry

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.[4cräläwvirtualibräry

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.[6cräläwvirtualibräry
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.[7cräläwvirtualibräry

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
protest[8 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.[9cräläwvirtualibräry

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.[10cräläwvirtualibräry

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.

U.S. Supreme Court

Welch v. Helvering, 290 U.S. 111 (1933)
Welch v. Helvering

No. 33

Argued October 19, 1933

Decided November 6, 1933

290 U.S. 111

CERTIORARI TO THE CIRCUIT COURT OF APPEALS

FOR THE EIGHTH CIRCUIT

Syllabus
1. What are "ordinary and necessary expenses" in carrying on a business, within the meaning of
provisions of Revenue Acts allowing deductions of such expenses in computing net income, must be
determined by conduct and forms of speech prevailing in the business world. P. 290 U. S. 113.

2. The Court cannot say, in the absence of proof and as a matter of judicial knowledge, that payments
on the debts of a corporation, made by its former officer after its discharge in bankruptcy and for the
purpose of strengthening his own business standing and credit were ordinary and necessary expenses of
his business. P. 290 U. S. 115.

Page 290 U. S. 112

3. A finding by the Commissioner of Internal Revenue that such payments are not ordinary and
necessary expenses of a taxpayer, and hence not deductible under the revenue acts and regulations in
computing his net income, is presumptively correct. P. 290 U. S. 115.

63 F.2d 976 affirmed.

Certiorari, 289 U.S. 720, to review a judgment of the Circuit Court of Appeals which affirmed the action
of the Board of Tax Appeals, 25 B.T.A. 117, disallowing certain deductions in an income tax return.

MR. JUSTICE CARDOZO delivered the opinion of the Court.

The question to be determined is whether payments by a taxpayer, who is in business as a commission

agent, are allowable deductions in the computation of his income if made to the creditors of a bankrupt
corporation in an endeavor to strengthen his own standing and credit.

In 1922, petitioner was the secretary of the E. L. Welch Company, a Minnesota corporation, engaged in
the grain business. The company was adjudged an involuntary bankrupt, and had a discharge from its
debts. Thereafter the petitioner made a contract with the Kellogg Company to purchase grain for it on a
commission. In order to reestablish his relations with customers whom he had known when acting for
the Welch Company and to solidify his credit and standing, he decided to pay the debts of the Welch
business so far as he was able. In fulfillment of that resolve, he made payments of substantial amounts
during five successive years. In 1924, the commissions

Page 290 U. S. 113

were $18,028.20, the payments $3,975.97; in 1925, the commissions $31,377.07, the payments
$11,968.20; in 1926, the commissions $20,925.25, the payments $12,815.72; in 1927, the commissions
$22,119.61, the payments $7,379.72, and in 1928, the commissions $26,177.56, the payments
$11,068.25. The Commissioner ruled that these payments were not deductible from income as ordinary
and necessary expenses, but were rather in the nature of capital expenditures, an outlay for the
development of reputation and goodwill. The Board of Tax Appeals sustained the action of the
Commissioner (25 B.T.A. 117), and the Court of Appeals for the Eighth Circuit affirmed. 63 F.2d 976. The
case is here on certiorari.

"In computing net income, there shall be allowed as deductions . . . all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or business."
Revenue Act of 1924, c. 234, 43 Stat. 253, 269, § 214, 26 U.S.C. § 955; Revenue Act of 1926, c. 27, 44
Stat. 9, 26, § 214, 26 U.S.C.App. § 955; Revenue Act of 1928, c. 852, 45 Stat. 791, 799, § 23(a); cf.
Treasury Regulations 65, Arts. 101, 292, under the Revenue Act of 1924, and similar regulations under
the acts of 1926 and 1928.

We may assume that the payments to creditors of the Welch Company were necessary for the
development of the petitioner's business, at least in the sense that they were appropriate and helpful.
McCulloch v. Maryland, 4 Wheat. 316. He certainly thought they were, and we should be slow to
override his judgment. But the problem is not solved when the payments are characterized as
necessary. Many necessary payments are charges upon capital. There is need to determine whether
they are both necessary and ordinary. Now, what is ordinary, though there must always be a strain of
constancy within it, is nonetheless a variable affected by time and place

Page 290 U. S. 114

and circumstance. "Ordinary" in this context does not mean that the payments must be habitual or
normal in the sense that the same taxpayer will have to make them often. A lawsuit affecting the safety
of a business may happen once in a lifetime. The counsel fees may be so heavy that repetition is
unlikely. Nonetheless, the expense is an ordinary one because we know from experience that payments
for such a purpose, whether the amount is large or small, are the common and accepted means of
defense against attack. Cf. Kornhauser v. United States, 276 U. S. 145. The situation is unique in the life
of the individual affected, but not in the life of the group, the community, of which he is a part. At such
times, there are norms of conduct that help to stabilize our judgment, and make it certain and objective.
The instance is not erratic, but is brought within a known type.

The line of demarcation is now visible between the case that is here and the one supposed for
illustration. We try to classify this act as ordinary or the opposite, and the norms of conduct fail us. No
longer can we have recourse to any fund of business experience, to any known business practice. Men
do at times pay the debts of others without legal obligation or the lighter obligation imposed by the
usages of trade or by neighborly amenities, but they do not do so ordinarily, not even though the result
might be to heighten their reputation for generosity and opulence. Indeed, if language is to be read in its
natural and common meaning (Old Colony R. Co. v. Commissioner, 284 U. S. 552, 284 U. S. 560;
Woolford Realty Co. v. Rose, 286 U. S. 319, 286 U. S. 327), we should have to say that payment in such
circumstances, instead of being ordinary, is in a high degree extraordinary. There is nothing ordinary in
the stimulus evoking it, and none in the response. Here, indeed, as so often in other branches of the law,
the decisive distinctions are those of degree, and not of kind.

Page 290 U. S. 115

One struggles in vain for any verbal formula that will supply a ready touchstone. The standard set up by
the statute is not a rule of law; it is rather a way of life. Life in all its fullness must supply the answer to
the riddle.

The Commissioner of Internal Revenue resorted to that standard in assessing the petitioner's income,
and found that the payments in controversy came closer to capital outlays than to ordinary and
necessary expenses in the operation of a business. His ruling has the support of a presumption of
correctness, and the petitioner has the burden of proving it to be wrong. Wickwire v. Reinecke, 275 U. S.
101; Jones v. Commissioner, 38 F.2d 550, 552. Unless we can say from facts within our knowledge that
these are ordinary and necessary expenses according to the ways of conduct and the forms of speech
prevailing in the business world, the tax must be confirmed. But nothing told us by this record or within
the sphere of our judicial notice permits us to give that extension to what is ordinary and necessary.
Indeed, to do so would open the door to many bizarre analogies. One man has a family name that is
clouded by thefts committed by an ancestor. To add to this own standing he repays the stolen money,
wiping off, it may be, his income for the year. The payments figure in his tax return as ordinary
expenses. Another man conceives the notion that he will be able to practice his vocation with greater
ease and profit if he has an opportunity to enrich his culture. Forthwith the price of his education
becomes an expense of the business, reducing the income subject to taxation. There is little difference
between these expenses and those in controversy here. Reputation and learning are akin to capital
assets, like the goodwill of an old partnership. Cf. Colony Coal & Coke Corp. v. Commissioner, 52 F.2d
923. For many, they are the only tools with which to hew a pathway

Page 290 U. S. 116

to success. The money spent in acquiring them is well and wisely spent. It is not an ordinary expense of
the operation of a business.

Many cases in the federal courts deal with phases of the problem presented in the case at bar. To
attempt to harmonize them would be a futile task. They involve the appreciation of particular situations
at times with border-line conclusions. Typical illustrations are cited in the margin. *

The decree should be

Affirmed.

* Ordinary expenses: Commissioner v. People's Pittsburgh Trust Co., 60 F.2d 187, expenses incurred in
the defense of a criminal charge growing out of the business of the taxpayer; American Rolling Mill Co. v.
Commissioner, 41 F.2d 314, contributions to a civic improvement fund by a corporation employing half
of the wage earning population of the city, the payments being made, not for charity, but to add to the
skill and productivity of the workmen (cf. the decisions collated in 30 Columbia Law Review 1211, 1212,
and the distinctions there drawn); Corning Glass Works v. Lucas, 59 App.D.C. 168, 37 F.2d 798, donations
to a hospital by a corporation whose employees with their dependents made up two-thirds of the
population of the city; Harris & Co. v. Lucas, 48 F.2d 187, payments of debts discharged in bankruptcy,
but subject to be revived by force of a new promise. Cf. Lucas v. Ox Fibre Brush Co., 281 U. S. 115, where
additional compensation, reasonable in amount, was allowed to the officers of a corporation for services
previously rendered.

Not ordinary expenses: Hubinger v. Commissioner, 36 F.2d 724, payments by the taxpayer for the repair
of fire damage, such payments being distinguished from those for wear and tear; Lloyd v. Commissioner,
55 F.2d 842, counsel fees incurred by the taxpayer, the president of a corporation, in prosecuting a
slander suit to protect his reputation and that of his business; One Hundred Five West Fifty-Fifth Street
v. Commissioner, 42 F.2d 849, and Blackwell Oil & Gas Co. v. Commissioner, 60 F.2d 257, gratuitous
payments to stockholders in settlement of disputes between them, or to assume the expense of a
lawsuit in which they had been made defendants; White v. Commissioner, 61 F.2d 726, payments in
settlement of a lawsuit against a member of a partnership, the effect being to enable him to devote his
undivided efforts to the partnership business and also to protect its credit.
G.R. No. L-26911 January 27, 1981

ATLAS CONSOLIDATED MINING & DEVELOPMENT CORPORATION,

Petitioner, vs. COMMISSIONER OF INTERNAL REVENUE, Respondent.

G.R. No. L-26924 January 27, 1981

COMMISSIONER OF INTERNAL REVENUE, Petitioner, vs. ATLAS

CONSOLIDATED MINING & DEVELOPMENT CORPORATION and COURT OF
TAX APPEALS, Respondents.
DE CASTRO, J.:

These are two (2) petitions for review from the decision of the Court of Tax Appeals of October 25, 1966
in CTA Case No. 1312 entitled "Atlas Consolidated Mining and Development Corporation vs.
Commissioner of Internal Revenue." One (L-26911) was filed by the Atlas Consolidated Mining &
Development Corporation, and in the other L-26924), the Commissioner of Internal Revenue is the
petitioner.chanroblesvirtualawlibrary chanrobles virtual law library

This tax case (CTA No. 1312) arose from the 1957 and 1958 deficiency income tax assessments made by
the Commissioner of Internal Revenue, hereinafter referred to as Commissioner, where the Atlas
Consolidated Mining and Development Corporation, hereinafter referred to as Atlas, was assessed
P546,295.16 for 1957 and P215,493.96 for 1958 deficiency income taxes.chanroblesvirtualawlibrary
chanrobles virtual law library

Atlas is a corporation engaged in the mining industry registered under the laws of the Philippines. On
August 20, 1962, the Commissioner assessed against Atlas the sum of P546,295.16 and P215,493.96 or a
total of P761,789.12 as deficiency income taxes for the years 1957 and 1958. For the year 1957, it was
the opinion of the Commissioner that Atlas is not entitled to exemption from the income tax under
Section 4 of Republic Act 909 1 because same covers only gold mines, the provision of which reads:
chanrobles virtual law library

New mines, and old mines which resume operation, when certified to as such by the Secretary of
Agriculture and Natural Resources upon the recommendation of the Director of Mines, shall be exempt
from the payment of income tax during the first three (3) years of actual commercial production.
Provided that, any such mine and/or mines making a complete return of its capital investment at any
time within the said period, shall pay income tax from that year.

For the year 1958, the assessment of deficiency income tax of P761,789.12 covers the disallowance of
items claimed by Atlas as deductible from gross income.chanroblesvirtualawlibrary chanrobles virtual
law library
On October 9, 1962, Atlas protested the assessment asking for its reconsideration and cancellation. 2
Acting on the protest, the Commissioner conducted a reinvestigation of the
case.chanroblesvirtualawlibrary chanrobles virtual law library

On October 25, 1962, the Secretary of Finance ruled that the exemption provided in Republic Act 909
embraces all new mines and old mines whether gold or other minerals. 3 Accordingly, the Commissioner
recomputed Atlas deficiency income tax liabilities in the light of the ruling of the Secretary of Finance.
On June 9, 1964, the Commissioner issued a revised assessment entirely eliminating the assessment of
P546,295.16 for the year 1957. The assessment for 1958 was reduced from P215,493.96 to P39,646.82
from which Atlas appealed to the Court of Tax Appeals, assailing the disallowance of the following items
claimed as deductible from its gross income for 1958: chanrobles virtual law library

Transfer agent's fee.........................................................P59,477.42chanrobles virtual law library

Stockholders relation service fee....................................25,523.14 chanrobles virtual law library

U.S. stock listing expenses..................................................8,326.70 chanrobles virtual law library

Suit expenses..........................................................................6,666.65 chanrobles virtual law library

Provision for contingencies..................................... .........60,000.00

Total....................................................................P159,993.91

After hearing, the Court of Tax Appeals rendered a decision on October 25, 1966 allowing the above
mentioned disallowed items, except the items denominated by Atlas as stockholders relation service fee
and suit expenses. 4 Pertinent portions of the decision of the Court of Tax Appeals read as follows:
chanrobles virtual law library

Under the facts, circumstances and applicable law in this case, the unallowable deduction from
petitioner's gross income in 1958 amounted to P32,189.79.chanroblesvirtualawlibrary chanrobles virtual
law library

Stockholders relation service fee.................................... P25,523.14 chanrobles virtual law library

Suit and litigation expenses................................................ 6,666.65

Total................................................................................... P32,189.79 chanrobles virtual law library

As the exemption of petitioner from the payment of corporate income tax under Section 4, Republic Act
909, was good only up to the Ist quarter of 1958 ending on March 31 of the same year, only three-fourth
(3/4) of the net taxable income of petitioner is subject to income tax, computed as follows: chanrobles
virtual law library

1958 chanrobles virtual law library

Total net income for 1958.................................P1,968,898.27 chanrobles virtual law library

Net income corresponding tochanrobles virtual law library

taxable period April 1 tochanrobles virtual law library

Dec. 31, 1958, 3/4 ofchanrobles virtual law library

P1,968,898.27..........................................................1,476,673.70 chanrobles virtual law library

Add: 3/4 of promotion fees chanrobles virtual law library

of P25,523.14..............................................................P19,142.35 chanrobles virtual law library

Litigation chanrobles virtual law library

expenses.........................................................................6, 666.65

Net income per decision..........................................11, 02,4 2.70 chanrobles virtual law library

Tax due thereon.........................................................412,695.00 chanrobles virtual law library

Less: Amount already assessed .............................405,468.00

DEFICIENCY INCOME TAX DUE............................P7,227.00 chanrobles virtual law library

Add: 1/2 % monthly interestchanrobles virtual law library

from 6-20-59 to 6-20-62 (18%)....................................P1,300.89 chanrobles virtual law library

TOTAL AMOUNT DUE & COLLECTIBLE............P8,526.22

From the Court of Tax Appeals' decision of October 25, 1966, both parties appealed to this Court by way
of two (2) separate petitions for review docketed as G. R. No. L-26911 (Atlas, petitioner) and G. R. No. L-
29924 (Commissioner, petitioner).chanroblesvirtualawlibrary chanrobles virtual law library

G. R. No. L-26911-Atlas appealed only that portion of the Court of Tax Appeals' decision disallowing the
deduction from gross income of the so-called stockholders relation service fee amounting to P25,523.14,
making a lone assignment of error that - chanrobles virtual law library

THE COURT OF TAX APPEALS ERRED IN ITS CONCLUSION THAT THE EXPENSE IN THE AMOUNT OF
P25,523.14 PAID BY PETITIONER IN 1958 AS ANNUAL PUBLIC RELATIONS EXPENSES WAS INCURRED FOR
ACQUISITION OF ADDITIONAL CAPITAL, THE SAME NOT BEING SUPPORTED BY THE EVIDENCE.

It is the contention of Atlas that the amount of P25,523.14 paid in 1958 as annual public relations
expenses is a deductible expense from gross income under Section 30 (a) (1) of the National Internal
Revenue Code. Atlas claimed that it was paid for services of a public relations firm, P.K Macker & Co., a
reputable public relations consultant in New York City, U.S.A., hence, an ordinary and necessary business
expense in order to compete with other corporations also interested in the investment market in the
United States. 5 It is the stand of Atlas that information given out to the public in general and to the
stockholder in particular by the P.K MacKer & Co. concerning the operation of the Atlas was aimed at
creating a favorable image and goodwill to gain or maintain their patronage.chanroblesvirtualawlibrary
chanrobles virtual law library

The decisive question, therefore, in this particular appeal taken by Atlas to this Court is whether or not
the expenses paid for the services rendered by a public relations firm P.K MacKer & Co. labelled as
stockholders relation service fee is an allowable deduction as business expense under Section 30 (a) (1)
of the National Internal Revenue Code.chanroblesvirtualawlibrary chanrobles virtual law library

The principle is recognized that when a taxpayer claims a deduction, he must point to some specific
provision of the statute in which that deduction is authorized and must be able to prove that he is
entitled to the deduction which the law allows. As previously adverted to, the law allowing expenses as
deduction from gross income for purposes of the income tax is Section 30 (a) (1) of the National Internal
Revenue which 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.chanroblesvirtualawlibrary
chanrobles virtual law library

We come, then, to the statutory test of deductibility where it is axiomatic that 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. 6 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. 7 chanrobles virtual law library

While it is true that there is a number of decisions in the United States delving on the interpretation of
the terms "ordinary and necessary" as used in the federal tax laws, no adequate or satisfactory
definition of those terms is possible. Similarly, this Court has never attempted to define with precision
the terms "ordinary and necessary." There are however, certain guiding principles worthy of serious
consideration in the proper adjudication of conflicting claims. Ordinarily, an expense will be considered
"necessary" where the expenditure is appropriate and helpful in the development of the taxpayer's
business. 8 It is "ordinary" when it connotes a payment which is normal in relation to the business of the
taxpayer and the surrounding circumstances. 9 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. 10 chanrobles virtual law library

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.
11 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. 12 chanrobles virtual law library

It appears that on December 27, 1957, Atlas increased its capital stock from P15,000,000 to
P18,325,000. 13 It was claimed by Atlas that its shares of stock worth P3,325,000 were sold in the
United States because of the services rendered by the public relations firm, P. K. Macker & Company.
The Court of Tax Appeals ruled that 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 questioned item, stockholders relation service fee, was in effect spent for the
acquisition of additional capital, ergo, a capital expenditure.chanroblesvirtualawlibrary chanrobles
virtual law library

We sustain the ruling of the tax court that the expenditure of P25,523.14 paid to P.K. Macker & Co. as
compensation for services carrying on the selling campaign in an effort to sell Atlas' additional capital
stock of P3,325,000 is not an ordinary expense in line with the decision of U.S. Board of Tax Appeals in
the case of Harrisburg Hospital Inc. vs. Commissioner of Internal Revenue. 14 Accordingly, as found by
the Court of Tax Appeals, the said expense is not deductible from Atlas gross income in 1958 because
expenses relating to recapitalization and reorganization of the corporation (Missouri-Kansas Pipe Line
vs. Commissioner of Internal Revenue, 148 F. (2d), 460; Skenandos Rayon Corp. vs. Commissioner of
Internal Revenue, 122 F. (2d) 268, Cert. denied 314 U.S. 6961), the cost of obtaining stock subscription
(Simons Co., 8 BTA 631), promotion expenses (Beneficial Industrial Loan Corp. vs. Handy, 92 F. (2d) 74),
and commission or fees paid for the sale of stock reorganization (Protective Finance Corp., 23 BTA 308)
are capital expenditures.chanroblesvirtualawlibrary chanrobles virtual law library

That the expense in question was incurred to create a favorable image of the corporation in order to
gain or maintain the public's and its stockholders' patronage, does not make it deductible as business
expense. As held in the case of Welch vs. Helvering, 15 efforts to establish reputation are akin to
acquisition of capital assets and, therefore, expenses related thereto are not business expense but
capital expenditures.chanroblesvirtualawlibrary chanrobles virtual law library

We do not agree with the contention of Atlas that the conclusion of the Court of Tax Appeals in holding
that the expense of P25,523.14 was incurred for acquisition of additional capital is not supported by the
evidence. The burden of proof that the expenses incurred are ordinary and necessary is on the taxpayer
16 and does not rest upon the Government. To avail of the claimed deduction under Section 30(a) (1) of
the National Internal Revenue Code, 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.chanroblesvirtualawlibrary chanrobles virtual law library

G. R. No. L-26924-In his petition for review, the Commissioner of Internal Revenue assigned as errors the
following: chanrobles virtual law library

I chanrobles virtual law library

THE COURT OF TAX APPEALS ERRED IN ALLOWING THE DEDUCTION FROM GROSS INCOME OF THE SO-
CALLED TRANSFER AGENT'S FEES ALLEGEDLY PAID BY RESPONDENT;

IIchanrobles virtual law library

THE COURT OF TAX APPEALS ERRED IN ALLOWING THE DEDUCTION FROM GROSS INCOME OF LISTING
EXPENSES ALLEGEDLY INCURRED BY RESPONDENT;

IIIchanrobles virtual law library

THE COURT OF TAX APPEALS ERRED IN HOLDING THAT THE AMOUNT OF P60,000 REPRESENTED BY
RESPONDENT AS "PROVISION FOR CONTINGENCIES" WAS ADDED BACK BY RESPONDENT TO ITS GROSS
INCOME IN COMPUTING THE INCOME TAX DUE FROM IT FOR 1958;

IVchanrobles virtual law library

THE COURT OF TAX APPEALS ERRED IN DISALLOWING ONLY THE AMOUNT OF P6,666.65 AS SUIT
EXPENSES, THE CORRECT AMOUNT THAT SHOULD HAVE BEEN DISALLOWED BEING P17,499.98.

It is well to note that only in the Court of Tax Appeals did the Commissioner raise for the first time (in his
memorandum) the question of whether or not the business expenses deducted from Atlas gross income
in 1958 may be allowed in the absence of proof of payments. 17 Before this Court, the Commissioner
reiterated the same as ground against deductibility when he claimed that the Court of Tax Appeals erred
in allowing the deduction of transfer agent's fee and stock listing fee from gross income in the absence
of proof of payment thereof.chanroblesvirtualawlibrary chanrobles virtual law library

The Commissioner contended that under Section 30 (a) (1) of the National Internal Revenue Code, it is a
requirement for an expense to be deductible from gross income that it must have been "paid or
incurred during the year" for which it is claimed; that in the absence of convincing and satisfactory
evidence of payment, the deduction from gross income for the year 1958 income tax return cannot be
sustained; and that the best evidence to prove payment, if at all any has been made, would be the
vouchers or receipts issued therefor which ATLAS failed to present.chanroblesvirtualawlibrary
chanrobles virtual law library

Atlas admitted that it failed to adduce evidence of payment of the deduction claimed in its 1958 income
tax return, but explains the failure with the allegation that the Commissioner did not raise that question
of fact in his pleadings, or even in the report of the investigating examiner and/or letters of demand and
assessment notices of ATLAS which gave rise to its appeal to the Court of Tax Appeal. 18It was
emphasized by Atlas that it went to trial and finally submitted this case for decision on the assumption
that inasmuch as the fact of payment was never raised as a vital issue by the Commissioner in his
answer to the petition for review in the Court of Tax Appeal, the issues is limited only to pure question
of law-whether or not the expenses deducted by petitioner from its gross income for 1958 are
sanctioned by Section 30 (a) (1) of the National Internal Revenue Code.chanroblesvirtualawlibrary
chanrobles virtual law library

On this issue of whether or not the Commissioner can raise the fact of payment for the first time on
appeal in its memorandum in the Court of Tax Appeal, we fully agree with the ruling of the tax court that
the Commissioner on appeal cannot be allowed to adopt a theory distinct and different from that he has
previously pursued, as shown by the BIR records and the answer to the amended petition for review. 19
As this Court said in the case of Commissioner of Customs vs. Valencia 20 such change in the nature of
the case may not be made on appeal, specially when the purpose of the latter is to seek a review of the
action taken by an administrative body, forming part of a coordinate branch of the Government, such as
the Executive department. In the case at bar, the Court of Tax Appeal found that the fact of payment of
the claimed deduction from gross income was never controverted by the Commissioner even during the
initial stages of routinary administrative scrutiny conducted by BIR examiners. 21 Specifically, in his
answer to the amended petition for review in the Court of Tax Appeal, the Commissioner did not deny
the fact of payment, merely contesting the legitimacy of the deduction on the ground that same was not
ordinary and necessary business expenses. 22chanrobles virtual law library
As consistently ruled by this Court, the findings of facts by the Court of Tax Appeal will not be reviewed
in the absence of showing of gross error or abuse. 23 We, therefore, hold that it was too late for the
Commissioner to raise the issue of fact of payment for the first time in his memorandum in the Court of
Tax Appeals and in this instant appeal to the Supreme Court. If raised earlier, the matter ought to have
been seriously delved into by the Court of Tax Appeals. On this ground, we are of the opinion that under
all the attendant circumstances of the case, substantial justice would be served if the Commissioner be
held as precluded from now attempting to raise an issue to disallow deduction of the item in question at
this stage. Failure to assert a question within a reasonable time warrants a presumption that the party
entitled to assert it either has abandoned or declined to assert it.chanroblesvirtualawlibrary chanrobles
virtual law library

On the second assignment of error, aside from alleging lack of proof of payment of the expense
deducted, the Commissioner contended that such expense should be disallowed for not being ordinary
and necessary and not incurred in trade or business, as required under Section 30 (a) (1) of the National
Internal Revenue Code. He asserted that said fees were therefore incurred not for the production of
income but for the acquisition petition of capital in view of the definition that an expense is deemed to
be incurred in trade or business if it was incurred for the production of income, or in the expectation of
producing income for the business. In support of his contention, the Commissioner cited the ruling in
Dome Mines, Ltd vs. Commisioner of Internal Revenue 24 involving the same issue as in the case at bar
where the U.S. Board of Tax Appeal ruled that expenses for listing capital stock in the stock exchange are
not ordinary and necessary expenses incurred in carrying on the taxpayer's business which was gold
mining and selling, which business is strikingly similar to Atlas.chanroblesvirtualawlibrary chanrobles
virtual law library

On the other hand, the Court of Tax Appeal relied on the ruling in the case of Chesapeake Corporation of
Virginia vs. Commissioner of Internal Revenue 25where the Tax Court allowed the deduction of stock
exchange fee in dispute, which is an annually recurring cost for the annual maintenance of the
listing.chanroblesvirtualawlibrary chanrobles virtual law library

We find the Chesapeake decision controlling with the facts and circumstances of the instant case. In
Dome Mines, Ltd case the stock listing fee was disallowed as a deduction not only because the
expenditure did not meet the statutory test but also because the same was paid only once, and the
benefit acquired thereby continued indefinitely, whereas, in the Chesapeake Corporation case, fee paid
to the stock exchange was annual and recurring. In the instant case, we deal with the stock listing fee
paid annually to a stock exchange for the privilege of having its stock listed. It must be noted that the
Court of Tax Appeal rejected the Dome Mines case because it involves a payment made only once,
hence, it was held therein that the single payment made to the stock exchange was a capital
expenditure, as distinguished from the instant case, where payments were made annually. For this
reason, we hold that said listing fee is an ordinary and necessary business expense chanrobles virtual
law library

On the third assignment of error, the Commissioner con- tended that the Court of Tax Appeal erred
when it held that the amount of P60,000 as "provisions for contingencies" was in effect added back to
Atlas income.chanroblesvirtualawlibrary chanrobles virtual law library

On this issue, this Court has consistently ruled in several cases adverted to earlier, that in the absence of
grave abuse of discretion or error on the part of the tax court its findings of facts may not be disturbed
by the Supreme Court. 26 It is not within the province of this Court to resolve whether or not the
P60,000 representing "provision for contingencies" was in fact added to or deducted from the taxable
income. As ruled by the Court of Tax Appeals, the said amount was in effect added to Atlas taxable
income. 27 The same being factual in nature and supported by substantial evidence, such findings
should not be disturbed in this appeal.chanroblesvirtualawlibrarychanrobles virtual law library

Finally, in its fourth assignment of error, the Commissioner contended that the CTA erred in disallowing
only the amount of P6,666.65 as suit expenses instead of P17,499.98.chanroblesvirtualawlibrary
chanrobles virtual law library

It appears that petitioner deducted from its 1958 gross income the amount of P23,333.30 as attorney's
fees and litigation expenses in the defense of title to the Toledo Mining properties purchased by Atlas
from Mindanao Lode Mines Inc. in Civil Case No. 30566 of the Court of First Instance of Manila for
annulment of the sale of said mining properties. On the ground that the litigation expense was a capital
expenditure under Section 121 of the Revenue Regulation No. 2, the investigating revenue examiner
recommended the disallowance of P13,333.30. The Commissioner, however, reduced this amount of
P6,666.65 which latter amount was affirmed by the respondent Court of Tax Appeals on
appeal.chanroblesvirtualawlibrary chanrobles virtual law library

There is no question that, as held by the Court of Tax Ap- peals, the litigation expenses under
consideration were incurred in defense of Atlas title to its mining properties. In line with the decision of
the U.S. Tax Court in the case of Safety Tube Corp. vs. Commissioner of Internal Revenue, 28 it is well
settled that litigation expenses incurred in defense or protection of title are capital in nature and not
deductible. Likewise, it was ruled by the U.S. Tax Court that expenditures in defense of title of property
constitute a part of the cost of the property, and are not deductible as expense. 29 chanrobles virtual
law library

Surprisingly, however, the investigating revenue examiner recommended a partial disallowance of

P13,333.30 instead of the entire amount of P23,333.30, which, upon review, was further reduced by the
Commissioner of Internal Revenue. Whether it was due to mistake, negligence or omission of the
officials concerned, the arithmetical error committed herein should not prejudice the Government. This
Court will pass upon this particular question since there is a clear error committed by officials concerned
in the computation of the deductible amount. As held in the case of Vera vs. Fernandez, 30 this Court
emphatically said that taxes are the lifeblood of the Government and their prompt and certain
availability are imperious need. Upon taxation depends the Government's ability to serve the people for
whose benefit taxes are collected. To safeguard such interest, neglect or omission of government
officials entrusted with the collection of taxes should not be allowed to bring harm or detriment to the
people, in the same manner as private persons may be made to suffer individually on account of his own
negligence, the presumption being that they take good care of their personal affair. This should not hold
true to government officials with respect to matters not of their own personal concern. This is the
philosophy behind the government's exception, as a general rule, from the operation of the principle of
estoppel. 31chanrobles virtual law library

WHEREFORE, judgment appealed from is hereby affirmed with modification that the amount of
P17,499.98 (3/4 of P23,333.00) representing suit expenses be disallowed as deduction instead of
P6,666.65 only. With this amount as part of the net income, the corresponding income tax shall be paid
thereon, with interest of 6% per annum from June 20, 1959 to June 20,1962.chanroblesvirtualawlibrary
chanrobles virtual law library
SO ORDERED.

Makasiar, Fernandez, Guerrero and Melencio-Herrera, ,JJ., concur.chanroblesvirtualawlibrary

chanrobles virtual law library

Teehankee, J., (Chairman), took no part.

[G.R. No. L-24059. November 28, 1969.]

C. M. HOSKINS & CO., INC., Petitioner, v. COMMISSIONER OF INTERNAL

REVENUE, Respondent.

Ross, Salcedo, Del Rosario, Bito & Misa for Petitioner.

Solicitor General Arturo A. Alafriz, Assistant Solicitor General Felicisimo R.

Rosete and Special Attorney Michaelina R. Balasbas for Respondent.

SYLLABUS

1. TAXATION; INCOME TAX; DEDUCTIONS FROM NET INCOME; ORDINARY AND NECESSARY EXPENSES;
INORDINATELY LARGE COMMISSIONS AND FEES PAID TO CONTROLLING STOCKHOLDER ARE
DISALLOWED AS DEDUCTIBLE EXPENSES; CASE AT BAR. — Considering that in addition to being
Chairman of the board of directors of petitioner corporation, which bears his name, Hoskins,
who owned 99.6% of its total authorized capital stock while the four other officers-stockholders
of the firm owned a total of four-tenths of 1%, or one-tenth of 1% each, with their respective
nominal shareholdings of one share each, was also salesman/broker for his company, receiving a
50% share of the sales commissions earned by petitioner, besides his monthly salary of
P3,750.00 amounting to an annual compensation of P45,000.00 and an annual salary bonus of
P40,000.00, plus free use of the company car and receipt of other similar allowances and
benefits, the Tax Court correctly ruled that the payment by petitioner to Hoskins of the
additional sum of P99,977.91 as his equal or 50% share of the 8% supervision fees received by
petitioner as managing agents of the real estate, subdivision projects of Paradise Farms, Inc. and
Realty Investments, Inc. was inordinately large and could not be accorded the treatment of
ordinary and necessary expenses allowed as deductible items within the purview of Section
30(a)(i) of the Tax Code.

2. ID.; ID.; ID.; BONUSES AS DEDUCTIBLE EXPENSE. — 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.
3. ID.; ID.; ID.; ID.; NECESSARY CONDITIONS FOR SUCH DEDUCTION. — The condition precedents to the
deduction of bonuses to employees are: (1) the payment of the bonuses is in fact compensation;
(2) it must be for personal services actually rendered; and (3) the bonuses, when added to the
salaries, are reasonable . . . when measured by the amount and quality of the services
performed with relation to the business of the particular taxpayer.

4. ID.; ID.; ID.; ID.; REASONABLENESS THEREOF TO BE SHOWN. — 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.

5. ID.; ID.; CORPORATE TAX LIABILITY OF CORPORATION OF SOLE PROPRIETORSHIP. — Petitioner

corporation, a sole proprietorship of C.M. Hoskins who virtually holds 99.6% of the stocks of said
corporation is duty bound to pay the income tax imposed on corporations and may not legally
be permitted, by way of corporate resolution authorizing payment of inordinately large
commissions and fees to its controlling stockholder, to dilute and diminish its corresponding
corporate tax liability.

DECISION

TEEHANKEE, J.:

We uphold in this taxpayer’s appeal the Tax Court’s ruling that payment by the taxpayer to its
controlling stockholder of 50% of its supervision fees or the amount of P99,977.91 is not a
deductible ordinary and necessary expense and should be treated as a distribution of earnings
and profits of the taxpayer.

Petitioner, a domestic corporation engaged in the real estate business as brokers, managing agents and
administrators, filed its income tax return for its fiscal year ending September 30, 1957 showing
a net income of P92,540.25 and a tax liability due thereon of P18,508.00, which it paid in due
course. Upon verification of its return, respondent Commissioner of Internal Revenue,
disallowed four items of deduction in petitioner’s tax returns and assessed against it an income
tax deficiency in the amount of P28,054.00 plus interests. The Court of Tax Appeals upon
reviewing the assessment at the taxpayer’s petition, upheld respondent’s disallowance of the
principal item of petitioner’s having paid to Mr. C. M. Hoskins, its founder and controlling
stockholder the amount of P99,977.91 representing 50% of supervision fees earned by it and set
aside respondent’s disallowance of three other minor items. The Tax Court therefore
determined petitioner’s tax deficiency to be in the amount of P27,145.00 and on November 8,
1964 rendered judgment against it, as follows:jgc:chanrobles.com.ph

"WHEREFORE, premises considered, the decision of the respondent is hereby modified. Petitioner is
ordered to pay to the latter or his representative the sum of P27,145.00, representing deficiency
income tax for the year 1957, plus interest at 1/2% per month from June 20, 1959 to be
 computed in accordance with the provisions of Section 51(d) of the National Internal Revenue
Code. If the deficiency tax is not paid within thirty (30) days from the date this decision becomes
final, petitioner is also ordered to pay surcharge and interest as provided for in Section 51(e) of
the Tax Code, without costs."cralaw virtua1aw library

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

We find no merit in petitioner’s appeal.

As found by the Tax Court, "petitioner was founded by Mr. C. M. Hoskins in 1937, with a capital stock of
1,000 shares at a par value of P1.00 each share; that of these 1,000 shares, Mr. C. M. Hoskins
owns 996 shares (the other 4 shares being held by the other four officers of the corporation),
which constitute exactly 99.6% of the total authorized capital stock (p. 92, t.s.n.); that during the
first four years of its existence, Mr. C. M. Hoskins was the President, but during the taxable
period in question, that is, from October 1, 1956 to September 30, 1957, he was the chairman of
the Board of Directors and salesman-broker for the company (p. 93, t.s.n.); that as chairman of
the Board of Directors, he received a salary of P3,750.00 a month, plus a salary bonus of about
P40,000 00 a year (p. 94, t.s.n.); that he was also a stockholder and officer of the Paradise
Farms, Inc. and Realty Investments, Inc., from which petitioner derived a large portion of its
income in the form of supervision fees and commissions earned on sales of lots (pp. 97-99,
t.s.n.; Financial Statements, attached to Exhibit ‘1’, p. 11, BIR rec.); that as chairman of the
Board of Directors of petitioner, his duties were: "To act as a salesman; as a director, preside
over meetings and to get all of the real estate business I could for the company by negotiating
sales, purchases, making appraisals, raising funds to finance real estate operations where that
was necessary’ (p. 96, t.s.n.); that he was familiar with the contract entered into by the
petitioner with the Paradise Farms, Inc. and the Realty Investments. Inc. by the terms of which
petitioner was ‘to program the development, arrange financing, plan the proposed subdivision
as outlined in the prospectus of Paradise Farms, Inc., arrange contract for road constructions,
with the provision of water supply to all of the lots and in general to serve as managing agents
for the Paradise Farms, Inc. and subsequently for the Realty Investment, Inc." (pp. 96-97, t.s.n.).

Considering that in addition to being Chairman of the board of directors of petitioner corporation, which
bears his name, Hoskins, who owned 99.6% of its total authorized capital stock while the four
other officers-stockholders of the firm owned a total of four-tenths of 1%, or one tenth of 1%
each, with their respective nominal shareholdings of one share each, was also salesman-broker
for his company, receiving a 50% share of the sales commissions earned by petitioner, besides
his monthly salary of P3,750.00 amounting to an annual compensation of P45,000.00 and an
annual salary bonus of P40,000.00, plus free use of the company car and receipt of other similar
allowances and benefits, the Tax Court correctly ruled that the payment by petitioner to Hoskins
of the additional sum of P99,977.91 as his equal or 50% share of the 8% supervision fees
received by petitioner as managing agents of the real estate, subdivision projects of Paradise
Farms, Inc. and Realty Investments, Inc. was inordinately large and could not be accorded the
treatment of ordinary and necessary expenses allowed as deductible items within the purview
of Section 30 (a) (i) of the Tax Code.
If such payment of P99,977.91 were to be allowed as a deductible item, then Hoskins would receive on
these three items alone (salary, bonus and supervision fee) a total of P184,977.91, which would
be double the petitioner’s reported net income for the year of P92,540.25. As correctly
observed by respondent, if independently, a one-time P100,000.00-fee to plan and lay down the
rules for supervision of a subdivision project were to be paid to an experienced realtor such as
Hoskins, its fairness and deductibility by the taxpayer could be conceded; but here 50% of the
supervision fee of petitioner was being paid by it to Hoskins every year since 1955 up to 1963
and for as long as its contract with the subdivision owner subsisted, regardless of whether
services were actually rendered by Hoskins, since his services to petitioner included such
planning and supervision and were already handsomely paid for by petitioner.

The fact that such payment was authorized by a standing resolution of petitioner’s board of directors,
since "Hoskins had personally conceived and planned the project" cannot change the picture.
There could be no question that as Chairman of the board and practically an absolutely
controlling stockholder of petitioner, holding 99.6% of its stock, Hoskins wielded tremendous
power and influence in the formulation and making of the company’s policies and decisions.
Even just as board chairman, going by petitioner’s own enumeration of the powers of the office,
Hoskins could exercise great power and influence within the corporation, such as directing the
policy of the corporation, delegating powers to the president and advising the corporation in
determining executive salaries, bonus plans and pensions, dividend policies, etc. 1

Petitioner’s invoking of its policy since its incorporation of sharing equally sales commissions with its
salesmen, in accordance with its board resolution of June 18, 1946, is equally untenable.
Petitioner’s Sales Regulations provide:jgc:chanrobles.com.ph

"Compensation of Salesmen

"8. Schedule I — In the case of sales to prospects discovered and worked by a salesman, even though
the closing is done by or with the help of the Sales Manager or other members of the staff, the
salesmen get one-half (1/2) of the total commission received by the Company, but not
exceeding five percent (5%). In the case of subdivisions, when the office commission covers
general supervision, the 1/2-rule does not apply, the salesman’s share being stipulated in the
case of each subdivision. In most cases the salesman’s share is 4%. (Exh.’N-1’)." 2

It will be readily seen therefrom that when the petitioner’s commission covers general supervision, it is
provided that the 1/2 rule of equal sharing of the sales commissions does not apply and that the
salesman’s share is stipulated in the case of each subdivision. Furthermore, what is involved
here is not Hoskins’ salesman’s share in the petitioner’s 12% sales commission, which he
presumably collected also from petitioner without respondent’s questioning it, but a 50% share
besides in petitioner’s planning and supervision fee of 8% of the gross sales, as mentioned
above. This is evident from petitioner’s board’s resolution of July 14, 1953 (Exhibit 7), wherein it
is recited that in addition to petitioner’s sales commission of 12% of gross sales, the subdivision
owners were paying to petitioner 8% of gross sales as supervision fee, and a collection fee of 5%
of gross collections, or total fees of 25% of gross sales.

The case before us is similar to previous cases of disallowances as deductible items of officers’ extra
fees, bonuses and commissions, upheld by this Court as not being within the purview of ordinary
and necessary expenses and not passing the test of reasonable compensation. 3 In Kuenzle &
 Streiff, Inc. v. Commissioner of Internal Revenue decided by this Court on May 29, 1969, 4 we
reaffirmed the test of reasonableness, enunciated in the earlier 1967 case involving the same
parties, that: "It is a general rule that ‘Bonuses to employees made in good faith and as
additional compensation for the services actually rendered by the employees are deductible,
provided such payments, when added to the stipulated salaries, do not exceed a reasonable
compensation for the services rendered’ (4 Mertens, Law of Federal Income Taxation, Sec.
25.50, p. 410). The conditions precedent to the deduction of bonuses to employees are: (1) the
payment of the bonuses is in fact compensation; (2) it must be for personal services actually
rendered; and (3) the bonuses, when added to the salaries, are ‘reasonable . . . when measured
by the amount and quality of the services performed with relation to the business of the
particular taxpayer’ (Idem., Sec. 25, 44, p. 395).

"There is no fixed test for determining the reasonableness of a given bonus as compensation. This
depends upon many factors, one of them being ‘the amount and quality of the services
performed with relation to the business.’ Other tests suggested are: payment must be ‘made in
good faith’; ‘the character of the taxpayer’s business, the volume and amount of its net
earnings, its locality, the type and extent of the services rendered, the salary policy of the
corporation’; ‘the size of the particular business’; ‘the employees’ qualifications and
contributions to the business venture’; and ‘general economic conditions’ (4 Mertens, Law of
Federal Income Taxation, Secs. 25.44, 25.49, 25.50, 25.51, pp. 407-412). However, ‘in
determining whether the particular salary or compensation payment is reasonable, the situation
must be considered as a 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."cralaw virtua1aw library

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

"Lastly, We must not lose sight of the fact that the question of allowing or disallowing as deductible
expenses the amounts paid to corporate officers by way of bonus is determined by respondent
exclusively for income tax purposes. Concededly, he has no authority to fix the amounts to be
paid to corporate officers by way of basic salary, bonus or additional remuneration — a matter
that lies more or less exclusively within the sound discretion of the corporation itself. But this
right of the corporation is, of course, not absolute. It cannot exercise it for the purpose of
evading payment of taxes legitimately due to the State."cralaw virtua1aw library

Finally, it should be noted that we have here a case practically of a sole proprietorship of C. M. Hoskins,
who however chose to incorporate his business with himself holding virtually absolute control
thereof with 99.6% of its stock with four other nominal shareholders holding one share each.
 Having chosen to use the corporate form with its legal advantages of a separate corporate
personality as distinguished from his individual personality, the corporation so created, i.e.,
Petitioner, is bound to comport itself in accordance with corporate norms and comply with its
corporate obligations. Specifically, it is bound to pay the income tax imposed by law on
corporations and may not legally be permitted, by way of corporate resolutions authorizing
payment of inordinately large commissions and fees to its controlling stockholder, to dilute and
diminish its corresponding corporate tax liability.

ACCORDINGLY, the decision appealed from is hereby affirmed, with costs in both instances against
petitioner.

Concepcion, C.J., Reyes, J.B.L., Dizon, Makalintal, Zaldivar, Sanchez, Castro, Fernando and Barredo, JJ.,
concur

[G.R. Nos. L-12010 & L-12113. October 20, 1959.]

KUENZLE & STREIFF, INC., Petitioner, v. THE COLLECTOR OF INTERNAL

REVENUE, Respondents.

Angel S. Gamboa for Petitioner.

Solicitor General Ambrosio Padilla, Assistant Solicitor General José P.

Alejandro and Special Attorney Librada del Rosario-Natividad for
Respondent.

SYLLABUS

1. TAXATION; DEDUCTIONS; BONUSES TO EMPLOYEES WHEN DEDUCTIBLE. — 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" (Mertens, Law of Federal
Income Taxation, Sec. 25-50, p. 410).

2. ID.; ID.; ID.; CONDITION PRECEDENTS. — The condition precedents to the deduction of bonuses to
employees are: (1) the payment of the bonuses is in fact compensation; (2) it must be for
personal services actually rendered; and (3) the bonuses, when added to the salaries, are
"reasonable . . . when measured by the amount and quality of the services performed with
relation to the business of the particular taxpayer" (Idem, Sec. 25.44, p. 395).

3. ID.; ID.; ID.; NO FIXED TEST TO DETERMINE REASONABLENESS OF PAYMENT OF BONUSES. — There is
no fixed test for determining the reasonableness of a given bonus as compensation. This
depends upon many factors, one of them being "the amount and quality of the services
 performed with relation to the business." Other tests suggested are: payment must be "made in
good faith" ; "the character of the taxpayer’s business, the volume and amount of its net
earnings, its locality, the type and extent of the services rendered, the salary policy of the
corporation" ; "the size of the particular business" ; "the employees’ qualifications and
contributions to the business venture" ; and "general economic conditions" (4 Mertens, Law of
Federal Income Taxation, Sec. 25-44, 25-49, 25-50, 25-57, pp. 407-412). However, "in
determining whether the particular salary or compensation payment is reasonable, the situation
must be considered as a 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" (Idem.) .

4. WORDS AND PHRASES; INDEBTEDNESS. — The term indebtedness is restricted to its usual import
which "is the amount which one has contracted to pay for the use of borrowed money."

DECISION

BAUTISTA ANGELO, J.:

This is a petition for review of a decision of the Court of Tax Appeals, as later modified, declaring
petitioner liable for the total sum of P33,187.00 as deficiency income tax due for the years 1950,
1951 and 1952.

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. In the income tax returns for the years 1950, 1951 and 1952 it filed with
respondent, petitioner deducted from its gross income certain items representing salaries,
directors’ fees and bonuses of its non-resident president and vice-president; bonuses of some of
its resident officers and employees; and interests on earned but unpaid salaries and bonuses of
its officers and employees. The income tax computed in accordance with these returns was duly
paid by petitioner.

On July 2, 1953, after disallowing the deductions of the items representing directors’ fees, salaries and
bonuses of petitioner’s non-resident president and vice president; the bonus participation of
certain resident officers and employees; and the interests on earned but unpaid salaries and
bonuses, respondent assessed and demanded from petitioner the payment of deficiency income
taxes in the sums of P26,370.00, P53,865.00 and P44,112.00 for the years 1950, 1951 and 1952,
respectively. Petitioner requested for the re-examination of this assessment, and on June 8,
1955, respondent 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. Hence, for the years 1950, 1951 and 1952, respondent made a new
assessment and demanded from petitioner as deficiency income taxes the amounts of
P10,147.00, P26,783.00 and P20,481.00, respectively. Petitioner having taken the case on
 appeal to the Court of Tax Appeals, the latter modified the assessment of respondent as stated
in the early part of this decision.

From this decision both parties have appealed, petitioner from that portion which holds that the
measure of the reasonableness of the bonuses paid to its non-resident president and vice
president should be applied to the bonuses given to resident officers and employees in
determining their deductibility and so only so much of said bonuses as applied to the latter
should be allowed as deduction, and respondent from that portion of the decision which allows
the deduction of so much of the bonuses which is in excess of the yearly salaries paid to the
respective recipients thereof.

The law involved here is Section 30 (a) (1) and (b) (1) of the National Internal Revenue Code, the
pertinent provisions of which we quote:jgc:chanrobles.com.ph

"SEC. 30. Deductions from gross income. — In computing net income there shall be allowed as
deductions —

(a) Expenses:chanrob1es virtual 1aw library

(1) In general. — All the ordinary and necessary expenses paid or incurred during the taxable year in
carrying on any trade or business, including a reasonable allowance for salaries or other
compensation for personal services actually rendered; . . .

(b) Interest:chanrob1es virtual 1aw library

(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."cralaw virtua1aw library

It would appear that all ordinary and necessary expenses paid or incurred in carrying on a trade or
business, including a reasonable allowance for salaries or other compensation for personal
services actually rendered, may be allowed as deductions in computing the taxable income
during the year. It likewise appears that the amount of interests paid within the taxable year on
any indebtedness may also be deducted from the gross income. Here it is admitted that the
bonuses paid to the officers and employees of petitioner, whether resident or non-resident,
were paid to them as additional compensation for personal services actually rendered and as
such can be considered as ordinary and necessary expenses incurred in the business within the
meaning of the law, the only question in dispute being how much of said bonuses may be
considered reasonable in order that it may be allowed as deduction.

It should be noted that petitioner gave to its non-resident president and vice president for the years
1950 and 1951 bonuses equal to 133-1/2% of their annual salaries and bonuses equal to 125
2/3% for the year 1952, whereas with regard to its resident officers and employees it gave them
much more on the alleged reason that they deserved them because of their valuable
contribution to the business of the corporation which has made it possible for it to realize huge
profits during the aforesaid years. And the Court of Tax Appeals ruled that while the bonuses
given to the non-resident officers are reasonable considering their yearly salaries and the
services actually rendered by them, the bonuses given to the resident officers and employees
 are, however, quite excessive, the court saying on this point that "there is no special reason for
granting greater bonuses to such lower ranking officers than those given to Messrs. Kuenzle and
Streiff." Petitioner now disputes this ruling insofar as the resident officers and employees are
concerned contending that the same is not in accordance with the usual pattern to be followed
in determining the reasonableness of a given compensation because it ignores the nature,
extent and quality of the services actually rendered by its resident officers and employees.

It is a general rule that "Bonuses to employees made in good faith and as additional compensation for
the services actually rendered by the employees are deductible, provided such payments, when
added to the stipulated salaries, do not exceed a reasonable compensation for the services
rendered" (4 Mertens, Law of Federal Income Taxation, Sec. 25.50, p. 410). The condition
precedents to the deduction of bonuses to employees are: (1) the payment of the bonuses is in
fact compensation; (2) it must be for personal services actually rendered; and (3) the bonuses,
when added to the salaries, are "reasonable . . . when measured by the amount and quality of
the services performed with relation to the business of the particular taxpayer" (Idem, Sec.
25.44, p. 395). Here it is admitted that the bonuses are in fact compensation and were paid for
services actually rendered. The only question is whether the payment of said bonuses is
reasonable.

There is no fixed test for determining the reasonableness of a given bonus as compensation. This
depends upon many factors, one of them being "the amount and quality of the services
performed with relation to the business." Other tests suggested are: payment must be "made in
good faith" ; "the character of the taxpayer’s business, the volume and amount of its net
earnings, its locality, the type and extent of the services rendered, the salary policy of the
corporation" ; "the size of the particular business" ; "the employees’ qualifications and
contributions to the business venture" ; and ‘general economic conditions" (4 Mertens, Law of
Federal Income Taxation, Sec. 25.44, 25.49, 25.50, 25.51, pp. 407-412). However, "in
determining whether the particular salary or compensation payment is reasonable, the situation
must be considered as a 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" (Idem.) .

Considering the different tests formulated above, was the trial court justified in holding that the
reasonableness of the amount of bonuses given to resident officers and employees should
follow the same pattern for determining the reasonableness of the amount of bonuses given to
non-resident officers?

Petitioner contends that it is error to apply the same measure of reasonableness to both resident and
non-resident officers because the nature, extent and quality of the services performed by each
with relation to the business of the corporation widely differ, as can be plainly seen by
considering the factors already mentioned above, to wit, the character, size and volume of the
business of the taxpayer, the profits made, the volume and amount of its earnings, the salary
policy of the taxpayer, the amount and quality of the services performed, the employee’s
qualifications and contributions to the business venture, and the general economic conditions
prevailing in the place of business. And elaborating on these factors in connection with the
business of petitioner, its counsel made a detailed exposition of the facts and figures showing in
a nutshell that through the efficient management, personal effort and valuable contribution
 rendered by the resident officers and employees, the corporation realized huge profits during
the years 1950, 1951 and 1952, which entitle them to the bonuses that were given to them for
those years, especially having in mind the after-liberation policy of the corporation of giving
salaries at low levels because of the unsettled conditions that prevailed after the war and the
imposition of controls on exports and imports and on the uses of foreign exchange without
prejudice of making up later for that shortcoming by giving them additional compensation in the
form of bonuses if the financial situation of the corporation would warrant. As the General
Manager Jung testified, the payments of bonuses were strictly based on the amount of work
performed, the nature of responsibility, the years of service, and the cost of living.

While it may be admitted that the resident officers and employees had performed their duty well and
rendered efficient service and for that reason were given greater compensation than the non-
resident officers, it does not necessarily follow that they should be given greater amount of
additional compensation in the form of bonuses than what was given to the non-resident
officers. The reason for this is that, in the opinion of the management itself of the corporation,
said non-resident officers had rendered the same amount of efficient personal service and
contribution to deserve equal treatment in compensation and other emoluments with the
particularity that their liberation yearly salaries had been much smaller.

Thus, according to counsel for petitioner, the following is the contribution made by said non-resident
officers of the corporation: "A.P. Kuenzle and H.A. Streiff, had dedicated abroad, especially in
New York City, New York, U.S.A. and Zurich, Switzerland, their full time and attention to the
services of Kuenzle & Streiff, Inc.; engaging themselves exclusively in the purchases abroad of
the merchandise for the supply of the import business of the Kuenzle & Streiff, Inc., taking care
of its orders of the importation of the merchandise and also of their shipments to the said
Company, making contacts and effecting transactions with the suppliers abroad, and directing,
controlling and supervising the business operations and affairs of the company by directives. . . .
They have been the policy- makers for the company. All decisions to be made by the company
on important matters and anything and everything outside of the routinary have always been
first determined by them and made only upon their instructions which had been strictly adhered
to by the management of the Company. A. P. Kuenzle and H. A. Streiff have been the president
and vice president, respectively, of the company for many years before 1950, 1951 and 1952
and during these particular years up to the present." Indeed, the trial court was justified in
expressing the view that "there is no special reason for granting greater bonuses to such lower
ranking officers than those given to Messrs. Kuenzle and Streiff." We concur in this observation.

The contention of respondent that the trial court erred also in allowing as deduction bonuses in excess
of the yearly salaries of their respective recipients predicated upon his own decision that the
deductible amount of said bonuses should be only equal to their respective yearly salaries
cannot also be sustained. This claim cannot be justified considering the factors we have already
mentioned that play in the determination of the reasonableness of the bonuses or additional
compensation that may be given to an officer or an employee which, if properly considered,
warrant the payment of the bonuses in question to the extent allowed by the trial court. This is
specially so 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.

As regards the amount of interests disallowed, we also find the ruling of the trial court justified. There is
no dispute that these items accrued on unclaimed salaries and bonus participation of
shareholders and employees. Under the law, in order that interest may be deductible, it must be
paid "on indebtedness" (Section 30, (b) (1) of the National Internal Revenue Code). It is
therefore imperative to show that there is an existing indebtedness which may be subjected to
the payment of interest. Here the items involved are unclaimed salaries and bonus participation
which in our opinion 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. It is a well-settled rule that the term indebtedness is restricted to its
usual import which "is the amount which one has contracted to pay for the use of borrowed
money." 1 Since the corporation had at all times sufficient funds to pay the salaries of its
employees, 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.

Wherefore, the decision appealed from is affirmed, without pronouncement as to costs.

Paras, C.J. Bengzon, Padilla, Montemayor, Labrador, Concepcion, Endencia, Barrera and Gutierrez David,
JJ., concur.

G.R. No. 172231 February 12, 2007

COMMISSIONER OF INTERNAL REVENUE, Petitioner,

vs.
ISABELA CULTURAL CORPORATION, Respondent.

DECISION
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 BIR’s disallowance of ICC’s claimed expense deductions for professional and security services
billed to and paid by ICC in 1986, to wit:

(a) Expenses for the auditing services of SGV & Co.,3 for the year ending December 31, 1985;4

(b) Expenses for the legal services [inclusive of retainer fees] of the law firm Bengzon Zarraga Narciso
Cudala Pecson Azcuna & Bengson for the years 1984 and 1985.5

(c) Expense for security services of El Tigre Security & Investigation Agency for the months of April and
May 1986.6

(2) The alleged understatement of ICC’s interest income on the three promissory notes due from Realty
Investment, Inc.

The deficiency expanded withholding tax of P4,897.79 (inclusive of interest and surcharge) was allegedly
due to the failure of ICC to withhold 1% expanded withholding tax on its claimed P244,890.00 deduction
for security services.7

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 CTA’s Decision, reads:

WHEREFORE, in view of all the foregoing, Assessment Notice No. FAS-1-86-90-000680 for deficiency
income tax in the amount of P333,196.86, and Assessment Notice No. FAS-1-86-90-000681 for
deficiency expanded withholding tax in the amount of P4,897.79, inclusive of surcharges and interest,
both for the taxable year 1986, are hereby CANCELLED and SET ASIDE.

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 ICC’s gross income; and (2) held that ICC did not
understate its interest income from the promissory notes of Realty Investment, Inc; and that ICC
withheld the required 1% withholding tax from the deductions for security services.

The requisites for the deductibility of ordinary and necessary trade, business, or professional expenses,
like expenses paid for legal and auditing services, are: (a) the expense must be ordinary and necessary;
(b) it must have been paid or incurred during the taxable year; (c) it must have been paid or incurred in
carrying on the trade or business of the taxpayer; and (d) it must be supported by receipts, records or
other pertinent papers.11

The requisite that it must have been paid or incurred during the taxable year is further qualified by
Section 45 of the National Internal Revenue Code (NIRC) which states that: "[t]he deduction provided for
in this Title shall be taken for the taxable year in which ‘paid or accrued’ or ‘paid or incurred’, dependent
upon the method of accounting upon the basis of which the net income is computed x x x".

Accounting methods for tax purposes comprise a set of rules for determining when and how to report
income and deductions.12 In the instant case, the accounting method used by ICC is the accrual method.

Revenue Audit Memorandum Order No. 1-2000, provides that under the accrual method of accounting,
expenses not being claimed as deductions by a taxpayer in the current year when they are incurred
cannot be claimed as deduction from income for the succeeding year. Thus, a taxpayer who is
authorized to deduct certain expenses and other allowable deductions for the current year but failed to
do so cannot deduct the same for the next year.13

The accrual method relies upon the taxpayer’s right to receive amounts or its obligation to pay them, in
opposition to actual receipt or payment, which characterizes the cash method of accounting. Amounts
of income accrue where the right to receive them become fixed, where there is created an enforceable
liability. Similarly, liabilities are accrued when fixed and determinable in amount, without regard to
indeterminacy merely of time of payment.14

For a taxpayer using the accrual method, the determinative question is, when do the facts present
themselves in such a manner that the taxpayer must recognize income or expense? The accrual of
income and expense is permitted when the all-events test has been met. This test requires: (1) fixing of
a right to income or liability to pay; and (2) the availability of the reasonable accurate determination of
such income or liability.

The all-events test requires the right to income or liability be fixed, and the amount of such income or
liability be determined with reasonable accuracy. However, the test does not demand that the amount
of income or liability be known absolutely, only that a taxpayer has at his disposal the information
necessary to compute the amount with reasonable accuracy. The all-events test is satisfied where
computation remains uncertain, if its basis is unchangeable; the test is satisfied where a computation
may be unknown, but is not as much as unknowable, within the taxable year. The amount of liability
does not have to be determined exactly; it must be determined with "reasonable accuracy." Accordingly,
the term "reasonable accuracy" implies something less than an exact or completely accurate
amount.[15]

The propriety of an accrual must be judged by the facts that a taxpayer knew, or could reasonably be
expected to have known, at the closing of its books for the taxable year.[16] Accrual method of
accounting presents largely a question of fact; such that the taxpayer bears the burden of proof of
establishing the accrual of an item of income or deduction.17

Corollarily, it is a governing principle in taxation that tax exemptions must be construed in strictissimi
juris against the taxpayer and liberally in favor of the taxing authority; and one who claims an exemption
must be able to justify the same by the clearest grant of organic or statute law. An exemption from the
common burden cannot be permitted to exist upon vague implications. And since a deduction for
income tax purposes partakes of the nature of a tax exemption, then it must also be strictly
construed.18

In the instant case, the expenses for professional fees consist of expenses for legal and auditing services.
The expenses for legal services pertain to the 1984 and 1985 legal and retainer fees of the law firm
Bengzon Zarraga Narciso Cudala Pecson Azcuna & Bengson, and for reimbursement of the expenses of
said firm in connection with ICC’s tax problems for the year 1984. As testified by the Treasurer of ICC,
the firm has been its counsel since the 1960’s.19 From the nature of the claimed deductions and the
span of time during which the firm was retained, ICC can be expected to have reasonably known the
retainer fees charged by the firm as well as the compensation for its legal services. The failure to
determine the exact amount of the expense during the taxable year when they could have been claimed
as deductions cannot thus be attributed solely to the delayed billing of these liabilities by the firm. For
one, ICC, in the exercise of due diligence could have inquired into the amount of their obligation to the
firm, especially so that it is using the accrual method of accounting. For another, it could have
reasonably determined the amount of legal and retainer fees owing to its familiarity with the rates
charged by their long time legal consultant.

As previously stated, the accrual method presents largely a question of fact and that the taxpayer bears
the burden of establishing the accrual of an expense or income. However, ICC failed to discharge this
burden. As to when the firm’s performance of its services in connection with the 1984 tax problems
were completed, or whether ICC exercised reasonable diligence to inquire about the amount of its
liability, or whether it does or does not possess the information necessary to compute the amount of
said liability with reasonable accuracy, are questions of fact which ICC never established. It simply relied
on the defense of delayed billing by the firm and the company, which under the circumstances, is not
sufficient to exempt it from being charged with knowledge of the reasonable amount of the expenses
for legal and auditing services.

In the same vein, the professional fees of SGV & Co. for auditing the financial statements of ICC for the
year 1985 cannot be validly claimed as expense deductions in 1986. This is so because ICC failed to
present evidence showing that even with only "reasonable accuracy," as the standard to ascertain its
liability to SGV & Co. in the year 1985, it cannot determine the professional fees which said company
would charge for its services.

ICC thus failed to discharge the burden of proving that the claimed expense deductions for the
professional services were allowable deductions for the taxable year 1986. Hence, per Revenue Audit
Memorandum Order No. 1-2000, they cannot be validly deducted from its gross income for the said year
and were therefore properly disallowed by the BIR.

As to the expenses for security services, the records show that these expenses were incurred by ICC in
198620 and could therefore be properly claimed as deductions for the said year.

Anent the purported understatement of interest income from the promissory notes of Realty
Investment, Inc., we sustain the findings of the CTA and the Court of Appeals that no such
understatement exists and that only simple interest computation and not a compounded one should
have been applied by the BIR. There is indeed no stipulation between the latter and ICC on the
application of compounded interest.21 Under Article 1959 of the Civil Code, unless there is a stipulation
to the contrary, interest due should not further earn interest.

Likewise, the findings of the CTA and the Court of Appeals that ICC truly withheld the required
withholding tax from its claimed deductions for security services and remitted the same to the BIR is
supported by payment order and confirmation receipts.22 Hence, the Assessment Notice for deficiency
expanded withholding tax was properly cancelled and set aside.

In sum, Assessment Notice No. FAS-1-86-90-000680 in the amount of P333,196.86 for deficiency income
tax should be cancelled and set aside but only insofar as the claimed deductions of ICC for security
services. Said Assessment is valid as to the BIR’s disallowance of ICC’s expenses for professional services.
The Court of Appeal’s cancellation of Assessment Notice No. FAS-1-86-90-000681 in the amount of
P4,897.79 for deficiency expanded withholding tax, is sustained.

WHEREFORE, the petition is PARTIALLY GRANTED. The September 30, 2005 Decision of the Court of
Appeals in CA-G.R. SP No. 78426, is AFFIRMED with the MODIFICATION that Assessment Notice No. FAS-
1-86-90-000680, which disallowed the expense deduction of Isabela Cultural Corporation for
professional and security services, is declared valid only insofar as the expenses for the professional fees
of SGV & Co. and of the law firm, Bengzon Zarraga Narciso Cudala Pecson Azcuna & Bengson, are
concerned. The decision is affirmed in all other respects.

The case is remanded to the BIR for the computation of Isabela Cultural Corporation’s liability under
Assessment Notice No. FAS-1-86-90-000680.
SO ORDERED.

G.R. Nos. 106949-50 December 1, 1995

PAPER INDUSTRIES CORPORATION OF THE PHILIPPINES (PICOP), petitioner,

vs.
COURT OF APPEALS, COMMISSIONER OF INTERNAL REVENUE and COURT
OF TAX APPEALS, respondents.

G.R. Nos. 106984-85 December 1, 1995

COMMISSIONER INTERNAL REVENUE, petitioner,

vs.
PAPER INDUSTRIES CORPORATION OF THE PHILIPPINES, THE COURT OF
APPEALS and THE COURT OF TAX APPEALS, respondents.

FELICIANO, J.:

The Paper Industries Corporation of the Philippines ("Picop"), which is petitioner in G.R. Nos. 106949-50
and private respondent in G.R. Nos. 106984-85, is a Philippine corporation registered with the Board of
Investments ("BOI") as a preferred pioneer enterprise with respect to its integrated pulp and paper mill,
and as a preferred non-pioneer enterprise with respect to its integrated plywood and veneer mills.

On 21 April 1983, Picop received from the Commissioner of Internal Revenue ("CIR") two (2) letters of
assessment and demand both dated 31 March 1983: (a) one for deficiency transaction tax and for
documentary and science stamp tax; and (b) the other for deficiency income tax for 1977, for an
aggregate amount of P88,763,255.00. These assessments were computed as follows:

Transaction Tax

Interest payments on

money market

borrowings P 45,771,849.00
———————

35% Transaction tax due

thereon 16,020,147.00
Add: 25% surcharge 4,005,036.75

——————

T o t a l P 20,025,183.75

Add:

14% int. fr.

1-20-78 to

7-31-80 P 7,093,302.57

20% int, fr.

8-1-80 to

3-31-83 10,675,523.58

——————

17,768,826.15

——————

P 37,794,009.90

Documentary and Science Stamps Tax

Total face value of

debentures P100,000,000.00

Documentary Stamps

Tax Due

(P0.30 x P100,000.000 )

( P200 ) P 150,000.00

Science Stamps Tax Due

(P0.30 x P100,000,000 )

( P200 ) P 150,000.00
——————

T o t a l P 300,000.00

Add: Compromise for

non-affixture 300.00

——————

300,300.00

——————

TOTAL AMOUNT DUE AND COLLECTIBLE P 38,094,309.90

===========

Deficiency Income Tax for 1977

Net income per return P 258,166.00

Add: Unallowable deductions

1) Disallowed deductions

availed of under

R.A. No. 5186 P 44,332,980.00

2) Capitalized interest

expenses on funds

used for acquisition

of machinery & other

equipment 42,840,131.00

3) Unexplained financial

guarantee expense 1,237,421.00

4) Understatement

of sales 2,391,644.00
5) Overstatement of

cost of sales 604,018.00

——————

P91,406,194.00

Net income per investigation P91,664,360.00

Income tax due thereon 34,734,559.00

Less: Tax already assessed per return 80,358.00

——————

Deficiency P34,654,201.00

Add:

14% int. fr.

4-15-78 to

7-31-81 P 11,128,503.56

20% int. fr.

8-1-80 to

4-15-81 4,886,242.34

——————

P16,014,745.90

——————

TOTAL AMOUNT DUE AND COLLECTIBLE P 50,668,946.90 1

===========

On 26 April 1983, Picop protested the assessment of deficiency transaction tax and documentary and
science stamp taxes. Picop also protested on 21 May 1983 the deficiency income tax assessment for
1977. These protests were not formally acted upon by respondent CIR. On 26 September 1984, the CIR
issued a warrant of distraint on personal property and a warrant of levy on real property against Picop,
to enforce collection of the contested assessments; in effect, the CIR denied Picop's protests.
Thereupon, Picop went before the Court of Tax Appeals ("CTA") appealing the assessments. After trial,
the CTA rendered a decision dated 15 August 1989, modifying the findings of the CIR and holding Picop
liable for the reduced aggregate amount of P20,133,762.33, which was itemized in the dispositive
portion of the decision as follows:

35% Transaction Tax P 16,020,113.20

Documentary & Science

Stamp Tax 300,300.00

Deficiency Income Tax Due 3,813,349.33

——————

TOTAL AMOUNT DUE AND PAYABLE P 20,133,762.53 2

===========

Picop and the CIR both went to the Supreme Court on separate Petitions for Review of the above
decision of the CTA. In two (2) Resolutions dated 7 February 1990 and 19 February 1990, respectively,
the Court referred the two (2) Petitions to the Court of Appeals. The Court of Appeals consolidated the
two (2) cases and rendered a decision, dated 31 August 1992, which further reduced the liability of
Picop to P6,338,354.70. The dispositive portion of the Court of Appeals decision reads as follows:

WHEREFORE, the appeal of the Commissioner of Internal Revenue is denied for lack of merit. The
judgment against PICOP is modified, as follows:

1. PICOP is declared liable for the 35% transaction tax in the amount of P3,578,543.51;

2. PICOP is absolved from the payment of documentary and science stamp tax of P300,000.00 and the
compromise penalty of P300.00;

3. PICOP shall pay 20% interest per annum on the deficiency income tax of P1,481,579.15, for a period
of three (3) years from 21 May 1983, or in the total amount of P888,947.49, and a surcharge of 10% on
the latter amount, or P88,984.75.

No pronouncement as to costs.

SO ORDERED.

Picop and the CIR once more filed separate Petitions for Review before the Supreme Court. These cases
were consolidated and, on 23 August 1993, the Court resolved to give due course to both Petitions in
G.R. Nos. 106949-50 and 106984-85 and required the parties to file their Memoranda.

Picop now maintains that it is not liable at all to pay any of the assessments or any part thereof. It assails
the propriety of the thirty-five percent (35%) deficiency transaction tax which the Court of Appeals held
due from it in the amount of P3,578,543.51. Picop also questions the imposition by the Court of Appeals
of the deficiency income tax of P1,481,579.15, resulting from disallowance of certain claimed financial
guarantee expenses and claimed year-end adjustments of sales and cost of sales figures by Picop's
external auditors. 3

The CIR, upon the other hand, insists that the Court of Appeals erred in finding Picop not liable for
surcharge and interest on unpaid transaction tax and for documentary and science stamp taxes and in
allowing Picop to claim as deductible expenses:

(a) the net operating losses of another corporation (i.e., Rustan Pulp and Paper Mills, Inc.); and

(b) interest payments on loans for the purchase of machinery and equipment.

The CIR also claims that Picop should be held liable for interest at fourteen percent (14%) per annum
from 15 April 1978 for three (3) years, and interest at twenty percent (20%) per annum for a maximum
of three (3) years; and for a surcharge of ten percent (10%), on Picop's deficiency income tax. Finally, the
CIR contends that Picop is liable for the corporate development tax equivalent to five percent (5%) of its
correct 1977 net income.

The issues which we must here address may be sorted out and grouped in the following manner:

I. Whether Picop is liable for:

(1) the thirty-five percent (35%) transaction tax;

(2) interest and surcharge on unpaid transaction tax; and

(3) documentary and science stamp taxes;

II. Whether Picop is entitled to deductions against income of:

(1) interest payments on loans for the purchase of machinery and equipment;

(2) net operating losses incurred by the Rustan Pulp and Paper Mills, Inc.; and

(3) certain claimed financial guarantee expenses; and

III. (1) Whether Picop had understated its sales and overstated its cost of sales for 1977; and

(2) Whether Picop is liable for the corporate development tax of five percent (5%) of its net income for
1977.

We will consider these issues in the foregoing sequence.

I.

(1) Whether Picop is liable

for the thirty-five percent
(35%) transaction tax.
With the authorization of the Securities and Exchange Commission, Picop issued commercial paper
consisting of serially numbered promissory notes with the total face value of P229,864,000.00 and a
maturity period of one (1) year, i.e., from 24 December 1977 to 23 December 1978. These promissory
notes were purchased by various commercial banks and financial institutions. On these promissory
notes, Picop paid interest in the aggregate amount of P45,771,849.00. In respect of these interest
payments, the CIR required Picop to pay the thirty-five percent (35%) transaction tax.

The CIR based this assessment on Presidential Decree No. 1154 dated 3 June 1977, which reads in part
as follows:

Sec. 1. The National Internal Revenue Code, as amended, is hereby further amended by adding a new
section thereto to read as follows:

Sec. 195-C. Tax on certain interest. — There shall be levied, assessed, collected and paid on every
commercial paper issued in the primary market as principal instrument, a transaction tax equivalent to
thirty-five percent (35%) based on the gross amount of interest thereto as defined hereunder, which
shall be paid by the borrower/issuer: Provided, however, that in the case of a long-term commercial
paper whose maturity exceeds more than one year, the borrower shall pay the tax based on the amount
of interest corresponding to one year, and thereafter shall pay the tax upon accrual or actual payment
(whichever is earlier) of the untaxed portion of the interest which corresponds to a period not exceeding
one year.

The transaction tax imposed in this section shall be a final tax to be paid by the borrower and shall be
allowed as a deductible item for purposes of computing the borrower's taxable income.

For purposes of this tax —

(a) "Commercial paper" shall be defined as an instrument evidencing indebtedness of any person or
entity, including banks and non-banks performing quasi-banking functions, which is issued, endorsed,
sold, transferred or in any manner conveyed to another person or entity, either with or without
recourse and irrespective of maturity. Principally, commercial papers are promissory notes and/or
similar instruments issued in the primary market and shall not include repurchase agreements,
certificates of assignments, certificates of participations, and such other debt instruments issued in the
secondary market.

(b) The term "interest" shall mean the difference between what the principal borrower received and the
amount it paid upon maturity of the commercial paper which shall, in no case, be lower than the
interest rate prevailing at the time of the issuance or renewal of the commercial paper. Interest shall be
deemed synonymous with discount and shall include all fees, commissions, premiums and other
payments which form integral parts of the charges imposed as a consequence of the use of money.

In all cases, where no interest rate is stated or if the rate stated is lower than the prevailing interest rate
at the time of the issuance or renewal of commercial paper, the Commissioner of Internal Revenue,
upon consultation with the Monetary Board of the Central Bank of the Philippines, shall adjust the
interest rate in accordance herewith, and assess the tax on the basis thereof.
The tax herein imposed shall be remitted by the borrower to the Commissioner of Internal Revenue or
his Collection Agent in the municipality where such borrower has its principal place of business within
five (5) working days from the issuance of the commercial paper. In the case of long term commercial
paper, the tax upon the untaxed portion of the interest which corresponds to a period not exceeding
one year shall be paid upon accrual payment, whichever is earlier. (Emphasis supplied)

Both the CTA and the Court of Appeals sustained the assessment of transaction tax.

In the instant Petition, Picop reiterates its claim that it is exempt from the payment of the transaction
tax by virtue of its tax exemption under R.A. No. 5186, as amended, known as the Investment Incentives
Act, which in the form it existed in 1977-1978, read in relevant part as follows:

Sec. 8. Incentives to a Pioneer Enterprise. In addition to the incentives provided in the preceding section,
pioneer enterprises shall be granted the following incentive benefits:

(a) Tax Exemption. Exemption from all taxes under the National Internal Revenue Code, except income
tax, from the date the area of investment is included in the Investment Priorities Plan to the following
extent:

(1) One hundred per cent (100%) for the first five years;

(2) Seventy-five per cent (75%) for the sixth through the eighth years;

(3) Fifty per cent (50%) for the ninth and tenth years;

(4) Twenty per cent (20%) for the eleventh and twelfth years; and

(5) Ten per cent (10%) for the thirteenth through the fifteenth year.

xxx xxx xxx 4

We agree with the CTA and the Court of Appeals that Picop's tax exemption under R.A. No. 5186, as
amended, does not include exemption from the thirty-five percent (35%) transaction tax. In the first
place, the thirty-five percent (35%) transaction tax 5 is an income tax, that is, it is a tax on the interest
income of the lenders or creditors. In Western Minolco Corporation v. Commissioner of Internal
Revenue, 6 the petitioner corporation borrowed funds from several financial institutions from June 1977
to October 1977 and paid the corresponding thirty-five (35%) transaction tax thereon in the amount of
P1,317,801.03, pursuant to Section 210 (b) of the 1977 Tax Code. Western Minolco applied for refund of
that amount alleging it was exempt from the thirty-five (35%) transaction tax by reason of Section 79-A
of C.A. No. 137, as amended, which granted new mines and old mines resuming operation "five (5) years
complete tax exemptions, except income tax, from the time of its actual bonafide orders for equipment
for commercial production." In denying the claim for refund, this Court held:

The petitioner's contentions deserve scant consideration. The 35% transaction tax is imposed on interest
income from commercial papers issued in the primary money market. Being a tax on interest, it is a tax
on income.

As correctly ruled by the respondent Court of Tax Appeals:

Accordingly, we need not and do not think it necessary to discuss further the nature of the transaction
tax more than to say that the incipient scheme in the issuance of Letter of Instructions No. 340 on
November 24, 1975 (O.G. Dec. 15, 1975), i.e., to achieve operational simplicity and effective
administration in capturing the interest-income "windfall" from money market operations as a new
source of revenue, has lost none of its animating principle in parturition of amendatory Presidential
Decree No. 1154, now Section 210 (b) of the Tax Code. The tax thus imposed is actually a tax on interest
earnings of the lenders or placers who are actually the taxpayers in whose income is imposed. Thus "the
borrower withholds the tax of 35% from the interest he would have to pay the lender so that he
(borrower) can pay the 35% of the interest to the Government." (Citation omitted) . . . . Suffice it to
state that the broad consensus of fiscal and monetary authorities is that "even if nominally, the
borrower is made to pay the tax, actually, the tax is on the interest earning of the immediate and all
prior lenders/placers of the money. . . ." (Rollo, pp. 36-37)

The 35% transaction tax is an income tax on interest earnings to the lenders or placers. The latter are
actually the taxpayers. Therefore, the tax cannot be a tax imposed upon the petitioner. In other words,
the petitioner who borrowed funds from several financial institutions by issuing commercial papers
merely withheld the 35% transaction tax before paying to the financial institutions the interests earned
by them and later remitted the same to the respondent Commissioner of Internal Revenue. The tax
could have been collected by a different procedure but the statute chose this method. Whatever
collecting procedure is adopted does not change the nature of the tax.

xxx xxx xxx 7

(Emphasis supplied)

Much the same issue was passed upon in Marinduque Mining Industrial Corporation v. Commissioner of
Internal Revenue 8 and resolved in the same way:

It is very obvious that the transaction tax, which is a tax on interest derived from commercial paper
issued in the money market, is not a tax contemplated in the above-quoted legal provisions. The
petitioner admits that it is subject to income tax. Its tax exemption should be strictly construed.

We hold that petitioner's claim for refund was justifiably denied. The transaction tax, although
nominally categorized as a business tax, is in reality a withholding tax as positively stated in LOI No. 340.
The petitioner could have shifted the tax to the lenders or recipients of the interest. It did not choose to
do so. It cannot be heard now to complain about the tax. LOI No. 340 is an extraneous or extrinsic aid to
the construction of section 210 (b).

xxx xxx xxx 9

(Emphasis supplied)

It is thus clear that the transaction tax is an income tax and as such, in any event, falls outside the scope
of the tax exemption granted to registered pioneer enterprises by Section 8 of R.A. No. 5186, as
amended. Picop was the withholding agent, obliged to withhold thirty-five percent (35%) of the interest
payable to its lenders and to remit the amounts so withheld to the Bureau of Internal Revenue ("BIR").
As a withholding agent, Picop is made personally liable for the thirty-five percent (35%) transaction tax
10 and if it did not actually withhold thirty-five percent (35%) of the interest monies it had paid to its
lenders, Picop had only itself to blame.

Picop claims that it had relied on a ruling, dated 6 October 1977, issued by the CIR, which held that Picop
was not liable for the thirty-five (35%) transaction tax in respect of debenture bonds issued by Picop.
Prior to the issuance of the promissory notes involved in the instant case, Picop had also issued
debenture bonds P100,000,000.00 in aggregate face value. The managing underwriter of this debenture
bond issue, Bancom Development Corporation, requested a formal ruling from the Bureau of Internal
Revenue on the liability of Picop for the thirty-five percent (35%) transaction tax in respect of such
bonds. The ruling rendered by the then Acting Commissioner of Internal Revenue, Efren I. Plana, stated
in relevant part:

It is represented that PICOP will be offering to the public primary bonds in the aggregate principal sum
of one hundred million pesos (P100,000,000.00); that the bonds will be issued as debentures in
denominations of one thousand pesos (P1,000.00) or multiples, to mature in ten (10) years at 14%
interest per annum payable semi-annually; that the bonds are convertible into common stock of the
issuer at the option of the bond holder at an agreed conversion price; that the issue will be covered by a
"Trust Indenture" with a duly authorized trust corporation as required by the Securities and Exchange
Commission, which trustee will act for and in behalf of the debenture bond holders as beneficiaries; that
once issued, the bonds cannot be preterminated by the holder and cannot be redeemed by the issuer
until after eight (8) years from date of issue; that the debenture bonds will be subordinated to present
and future debts of PICOP; and that said bonds are intended to be listed in the stock exchanges, which
will place them alongside listed equity issues.

In reply, I have the honor to inform you that although the bonds hereinabove described are commercial
papers which will be issued in the primary market, however, it is clear from the abovestated facts that
said bonds will not be issued as money market instruments. Such being the case, and considering that
the purposes of Presidential Decree No. 1154, as can be gleaned from Letter of Instruction No. 340,
dated November 21, 1975, are (a) to regulate money market transactions and (b) to ensure the
collection of the tax on interest derived from money market transactions by imposing a withholding tax
thereon, said bonds do not come within the purview of the "commercial papers" intended to be
subjected to the 35% transaction tax prescribed in Presidential Decree No. 1154, as implemented by
Revenue Regulations No. 7-77. (See Section 2 of said Regulation) Accordingly, PICOP is not subject to
35% transaction tax on its issues of the aforesaid bonds. However, those investing in said bonds should
be made aware of the fact that the transaction tax is not being imposed on the issuer of said bonds by
printing or stamping thereon, in bold letters, the following statement: "ISSUER NOT SUBJECT TO
TRANSACTION TAX UNDER P.D. 1154. BONDHOLDER SHOULD DECLARE INTEREST EARNING FOR INCOME
TAX." 11 (Emphases supplied)

In the above quoted ruling, the CIR basically held that Picop's debenture bonds did not constitute
"commercial papers" within the meaning of P.D. No. 1154, and that, as such, those bonds were not
subject to the thirty-five percent (35%) transaction tax imposed by P.D. No. 1154.

The above ruling, however, is not applicable in respect of the promissory notes which are the subject
matter of the instant case. It must be noted that the debenture bonds which were the subject matter of
Commissioner Plana's ruling were long-term bonds maturing in ten (10) years and which could not be
pre-terminated and could not be redeemed by Picop until after eight (8) years from date of issue; the
bonds were moreover subordinated to present and future debts of Picop and convertible into common
stock of Picop at the option of the bondholder. In contrast, the promissory notes involved in the instant
case are short-term instruments bearing a one-year maturity period. These promissory notes constitute
the very archtype of money market instruments. For money market instruments are precisely, by
custom and usage of the financial markets, short-term instruments with a tenor of one (1) year or less.
12 Assuming, therefore, (without passing upon) the correctness of the 6 October 1977 BIR ruling, Picop's
short-term promissory notes must be distinguished, and treated differently, from Picop's long-term
debenture bonds.

We conclude that Picop was properly held liable for the thirty-five percent (35%) transaction tax due in
respect of interest payments on its money market borrowings.

At the same time, we agree with the Court of Appeals that the transaction tax may be levied only in
respect of the interest earnings of Picop's money market lenders accruing after P.D. No. 1154 went into
effect, and not in respect of all the 1977 interest earnings of such lenders. The Court of Appeals pointed
out that:

PICOP, however contends that even if the tax has to be paid, it should be imposed only for the interests
earned after 20 September 1977 when PD 1154 creating the tax became effective. We find merit in this
contention. It appears that the tax was levied on interest earnings from January to October, 1977.
However, as found by the lower court, PD 1154 was published in the Official Gazette only on 5
September 1977, and became effective only fifteen (15) days after the publication, or on 20 September
1977, no other effectivity date having been provided by the PD. Based on the Worksheet prepared by
the Commissioner's office, the interests earned from 20 September to October 1977 was
P10,224,410.03. Thirty-five (35%) per cent of this is P3,578,543.51 which is all PICOP should pay as
transaction tax. 13 (Emphasis supplied)

P.D. No. 1154 is not, in other words, to be given retroactive effect by imposing the thirty-five percent
(35%) transaction tax in respect of interest earnings which accrued before the effectivity date of P.D. No.
1154, there being nothing in the statute to suggest that the legislative authority intended to bring about
such retroactive imposition of the tax.

(2) Whether Picop is liable

for interest and surcharge
on unpaid transaction tax.

With respect to the transaction tax due, the CIR prays that Picop be held liable for a twenty-five percent
(25%) surcharge and for interest at the rate of fourteen percent (14%) per annum from the date
prescribed for its payment. In so praying, the CIR relies upon Section 10 of Revenue Regulation 7-77
dated 3 June 1977, 14 issued by the Secretary of Finance. This Section reads:

Sec. 10. Penalties. — Where the amount shown by the taxpayer to be due on its return or part of such
payment is not paid on or before the date prescribed for its payment, the amount of the tax shall be
increased by twenty-five (25%) per centum, the increment to be a part of the tax and the entire amount
shall be subject to interest at the rate of fourteen (14%) per centum per annum from the date
prescribed for its payment.

In the case of willful neglect to file the return within the period prescribed herein or in case a false or
fraudulent return is willfully made, there shall be added to the tax or to the deficiency tax in case any
payment has been made on the basis of such return before the discovery of the falsity or fraud, a
surcharge of fifty (50%) per centum of its amount. The amount so added to any tax shall be collected at
the same time and in the same manner and as part of the tax unless the tax has been paid before the
discovery of the falsity or fraud, in which case the amount so added shall be collected in the same
manner as the tax.

In addition to the above administrative penalties, the criminal and civil penalties as provided for under
Section 337 of the Tax Code of 1977 shall be imposed for violation of any provision of Presidential
Decree No. 1154. 15 (Emphases supplied)

The 1977 Tax Code itself, in Section 326 in relation to Section 4 of the same Code, invoked by the
Secretary of Finance in issuing Revenue Regulation 7-77, set out, in comprehensive terms, the rule-
making authority of the Secretary of Finance:

Sec. 326. Authority of Secretary of Finance to Promulgate Rules and Regulations. — The Secretary of
Finance, upon recommendation of the Commissioner of Internal Revenue, shall promulgate all needful
rules and regulations for the effective enforcement of the provisions of this Code. (Emphasis supplied)

Section 4 of the same Code contains a list of subjects or areas to be dealt with by the Secretary of
Finance through the medium of an exercise of his quasi-legislative or rule-making authority. This list,
however, while it purports to be open-ended, does not include the imposition of administrative or civil
penalties such as the payment of amounts additional to the tax due. Thus, in order that it may be held to
be legally effective in respect of Picop in the present case, Section 10 of Revenue Regulation 7-77 must
embody or rest upon some provision in the Tax Code itself which imposes surcharge and penalty
interest for failure to make a transaction tax payment when due.

P.D. No. 1154 did not itself impose, nor did it expressly authorize the imposition of, a surcharge and
penalty interest in case of failure to pay the thirty-five percent (35%) transaction tax when due. Neither
did Section 210 (b) of the 1977 Tax Code which re-enacted Section 195-C inserted into the Tax Code by
P.D. No. 1154.

The CIR, both in its petition before the Court of Appeals and its Petition in the instant case, points to
Section 51 (e) of the 1977 Tax Code as its source of authority for assessing a surcharge and penalty
interest in respect of the thirty-five percent (35%) transaction tax due from Picop. This Section needs to
be quoted in extenso:

Sec. 51. Payment and Assessment of Income Tax. —

(c) Definition of deficiency. — As used in this Chapter in respect of a tax imposed by this Title, the term
"deficiency" means:

(1) The amount by which the tax imposed by this Title exceeds the amount shown as the tax by the
taxpayer upon his return; but the amount so shown on the return shall first be increased by the
amounts previously assessed (or collected without assessment) as a deficiency, and decreased by the
amount previously abated, credited, returned, or otherwise in respect of such tax; . . .

xxx xxx xxx

(e) Additions to the tax in case of non-payment. —

(1) Tax shown on the return. — Where the amount determined by the taxpayer as the tax imposed by
this Title or any installment thereof, or any part of such amount or installment is not paid on or before
the date prescribed for its payment, there shall be collected as a part of the tax, interest upon such
unpaid amount at the rate of fourteen per centum per annum from the date prescribed for its payment
until it is paid: Provided, That the maximum amount that may be collected as interest on deficiency shall
in no case exceed the amount corresponding to a period of three years, the present provisions regarding
prescription to the contrary notwithstanding.

(2) Deficiency. — Where a deficiency, or any interest assessed in connection therewith under paragraph
(d) of this section, or any addition to the taxes provided for in Section seventy-two of this Code is not
paid in full within thirty days from the date of notice and demand from the Commissioner of Internal
Revenue, there shall be collected upon the unpaid amount as part of the tax, interest at the rate of
fourteen per centum per annum from the date of such notice and demand until it is paid: Provided, That
the maximum amount that may be collected as interest on deficiency shall in no case exceed the
amount corresponding to a period of three years, the present provisions regarding prescription to the
contrary notwithstanding.

(3) Surcharge. — If any amount of tax included in the notice and demand from the Commissioner of
Internal Revenue is not paid in full within thirty days after such notice and demand, there shall be
collected in addition to the interest prescribed herein and in paragraph (d) above and as part of the tax a
surcharge of five per centum of the amount of tax unpaid. (Emphases supplied)

Section 72 of the 1977 Tax Code referred to in Section 51 (e) (2) above, provides:

Sec. 72. Surcharges for failure to render returns and for rendering false and fraudulent returns. — In
case of willful neglect to file the return or list required by this Title within the time prescribed by law, or
in case a false or fraudulent return or list is wilfully made, the Commissioner of Internal Revenue shall
add to the tax or to the deficiency tax, in case any payment has been made on the basis of such return
before the discovery of the falsity or fraud, as surcharge of fifty per centum of the amount of such tax or
deficiency tax. In case of any failure to make and file a return or list within the time prescribed by law or
by the Commissioner or other Internal Revenue Officer, not due to willful neglect, the Commissioner of
Internal Revenue shall add to the tax twenty-five per centum of its amount, except that, when a return
is voluntarily and without notice from the Commissioner or other officer filed after such time, and it is
shown that the failure to file it was due to a reasonable cause, no such addition shall be made to the tax.
The amount so added to any tax shall be collected at the same time, in the same manner and as part of
the tax unless the tax has been paid before the discovery of the neglect, falsity, or fraud, in which case
the amount so added shall be collected in the same manner as the tax. (Emphases supplied)

It will be seen that Section 51 (c) (1) and (e) (1) and (3), of the 1977 Tax Code, authorize the imposition
of surcharge and interest only in respect of a "tax imposed by this Title," that is to say, Title II on
"Income Tax." It will also be seen that Section 72 of the 1977 Tax Code imposes a surcharge only in case
of failure to file a return or list "required by this Title," that is, Title II on "Income Tax." The thirty-five
percent (35%) transaction tax is, however, imposed in the 1977 Tax Code by Section 210 (b) thereof
which Section is embraced in Title V on "Taxes on Business" of that Code. Thus, while the thirty-five
percent (35%) transaction tax is in truth a tax imposed on interest income earned by lenders or creditors
purchasing commercial paper on the money market, the relevant provisions, i.e., Section 210 (b), were
not inserted in Title II of the 1977 Tax Code. The end result is that the thirty-five percent (35%)
transaction tax is not one of the taxes in respect of which Section 51 (e) authorized the imposition of
surcharge and interest and Section 72 the imposition of a fraud surcharge.

It is not without reluctance that we reach the above conclusion on the basis of what may well have been
an inadvertent error in legislative draftsmanship, a type of error common enough during the period of
Martial Law in our country. Nevertheless, we are compelled to adopt this conclusion. We consider that
the authority to impose what the present Tax Code calls (in Section 248) civil penalties consisting of
additions to the tax due, must be expressly given in the enabling statute, in language too clear to be
mistaken. The grant of that authority is not lightly to be assumed to have been made to administrative
officials, even to one as highly placed as the Secretary of Finance.

The state of the present law tends to reinforce our conclusion that Section 51 (c) and (e) of the 1977 Tax
Code did not authorize the imposition of a surcharge and penalty interest for failure to pay the thirty-
five percent (35%) transaction tax imposed under Section 210 (b) of the same Code. The corresponding
provision in the current Tax Code very clearly embraces failure to pay all taxes imposed in the Tax Code,
without any regard to the Title of the Code where provisions imposing particular taxes are textually
located. Section 247 (a) of the NIRC, as amended, reads:

Title X

Statutory Offenses and Penalties

Chapter I

Additions to the Tax

Sec. 247. General Provisions. — (a) The additions to the tax or deficiency tax prescribed in this Chapter
shall apply to all taxes, fees and charges imposed in this Code. The amount so added to the tax shall be
collected at the same time, in the same manner and as part of the tax. . . .

Sec. 248. Civil Penalties. — (a) There shall be imposed, in addition to the tax required to be paid, penalty
equivalent to twenty-five percent (25%) of the amount due, in the following cases:

xxx xxx xxx

(3) failure to pay the tax within the time prescribed for its payment; or

xxx xxx xxx

(c) the penalties imposed hereunder shall form part of the tax and the entire amount shall be subject to
the interest prescribed in Section 249.

Sec. 249. Interest. — (a) In General. — There shall be assessed and collected on any unpaid amount of
tax, interest at the rate of twenty percent (20%) per annum or such higher rate as may be prescribed by
regulations, from the date prescribed for payment until the amount is fully paid. . . . (Emphases
supplied)
In other words, Section 247 (a) of the current NIRC supplies what did not exist back in 1977 when Picop's
liability for the thirty-five percent (35%) transaction tax became fixed. We do not believe we can fill that
legislative lacuna by judicial fiat. There is nothing to suggest that Section 247 (a) of the present Tax
Code, which was inserted in 1985, was intended to be given retroactive application by the legislative
authority. 16

(3) Whether Picop is Liable

for Documentary and
Science Stamp Taxes.

As noted earlier, Picop issued sometime in 1977 long-term subordinated convertible debenture bonds
with an aggregate face value of P100,000,000.00. Picop stated, and this was not disputed by the CIR,
that the proceeds of the debenture bonds were in fact utilized to finance the BOI-registered operations
of Picop. The CIR assessed documentary and science stamp taxes, amounting to P300,000.00, on the
issuance of Picop's debenture bonds. It is claimed by Picop that its tax exemption — "exemption from all
taxes under the National Internal Revenue Code, except income tax" on a declining basis over a certain
period of time — includes exemption from the documentary and science stamp taxes imposed under
the NIRC.

The CIR, upon the other hand, stresses that the tax exemption under the Investment Incentives Act may
be granted or recognized only to the extent that the claimant Picop was engaged in registered
operations, i.e., operations forming part of its integrated pulp and paper project. 17 The borrowing of
funds from the public, in the submission of the CIR, was not an activity included in Picop's registered
operations. The CTA adopted the view of the CIR and held that "the issuance of convertible debenture
bonds [was] not synonymous [with] the manufactur[ing] operations of an integrated pulp and paper
mill." 18

The Court of Appeals took a less rigid view of the ambit of the tax exemption granted to registered
pioneer enterprises. Said the Court of Appeals:

. . . PICOP's explanation that the debenture bonds were issued to finance its registered operation is
logical and is unrebutted. We are aware that tax exemptions must be applied strictly against the
beneficiary in order to deter their abuse. It would indeed be altogether a different matter if there is a
showing that the issuance of the debenture bonds had no bearing whatsoever on the registered
operations PICOP and that they were issued in connection with a totally different business undertaking
of PICOP other than its registered operation. There is, however, a dearth of evidence in this regard. It
cannot be denied that PICOP needed funds for its operations. One of the means it used to raise said
funds was to issue debenture bonds. Since the money raised thereby was to be used in its registered
operation, PICOP should enjoy the incentives granted to it by R.A. 5186, one of which is the exemption
from payment of all taxes under the National Internal Revenue Code, except income taxes, otherwise
the purpose of the incentives would be defeated. Documentary and science stamp taxes on debenture
bonds are certainly not income taxes. 19 (Emphasis supplied)

Tax exemptions are, to be sure, to be "strictly construed," that is, they are not to be extended beyond
the ordinary and reasonable intendment of the language actually used by the legislative authority in
granting the exemption. The issuance of debenture bonds is certainly conceptually distinct from pulping
and paper manufacturing operations. But no one contends that issuance of bonds was a principal or
regular business activity of Picop; only banks or other financial institutions are in the regular business of
raising money by issuing bonds or other instruments to the general public. We consider that the actual
dedication of the proceeds of the bonds to the carrying out of Picop's registered operations constituted
a sufficient nexus with such registered operations so as to exempt Picop from stamp taxes ordinarily
imposed upon or in connection with issuance of such bonds. We agree, therefore, with the Court of
Appeals on this matter that the CTA and the CIR had erred in rejecting Picop's claim for exemption from
stamp taxes.

It remains only to note that after commencement of the present litigation before the CTA, the BIR took
the position that the tax exemption granted by R.A. No. 5186, as amended, does include exemption
from documentary stamp taxes on transactions entered into by BOI-registered enterprises. BIR Ruling
No. 088, dated 28 April 1989, for instance, held that a registered preferred pioneer enterprise engaged
in the manufacture of integrated circuits, magnetic heads, printed circuit boards, etc., is exempt from
the payment of documentary stamp taxes. The Commissioner said:

You now request a ruling that as a preferred pioneer enterprise, you are exempt from the payment of
Documentary Stamp Tax (DST).

In reply, please be informed that your request is hereby granted. Pursuant to Section 46 (a) of
Presidential Decree No. 1789, pioneer enterprises registered with the BOI are exempt from all taxes
under the National Internal Revenue Code, except from all taxes under the National Internal Revenue
Code, except income tax, from the date the area of investment is included in the Investment Priorities
Plan to the following extent:

xxx xxx xxx

Accordingly, your company is exempt from the payment of documentary stamp tax to the extent of the
percentage aforestated on transactions connected with the registered business activity. (BIR Ruling No.
111-81) However, if said transactions conducted by you require the execution of a taxable document
with other parties, said parties who are not exempt shall be the one directly liable for the tax. (Sec. 173,
Tax Code, as amended; BIR Ruling No. 236-87) In other words, said parties shall be liable to the same
percentage corresponding to your tax exemption. (Emphasis supplied)

Similarly, in BIR Ruling No. 013, dated 6 February 1989, the Commissioner held that a registered pioneer
enterprise producing polyester filament yarn was entitled to exemption "from the documentary stamp
tax on [its] sale of real property in Makati up to December 31, 1989." It appears clear to the Court that
the CIR, administratively at least, no longer insists on the position it originally took in the instant case
before the CTA.

II

(1) Whether Picop is entitled

to deduct against current
income interest payments
on loans for the purchase
of machinery and equipment.

In 1969, 1972 and 1977, Picop obtained loans from foreign creditors in order to finance the purchase of
machinery and equipment needed for its operations. 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.

We begin by noting that 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. Section 30 of the 1977
Tax Code provided as follows:

Sec. 30. Deduction from Gross Income. — The following may be deducted from gross income:

(a) Expenses:

xxx xxx xxx

(b) Interest:

(1) In general. — The amount of interest paid within the taxable year on indebtedness, except on
indebtedness incurred or continued to purchase or carry obligations the interest upon which is exempt
from taxation as income under this Title: . . . (Emphasis supplied)

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. 20 In the instant case, the CIR does not dispute that the interest payments were made by
Picop on loans incurred in connection with the carrying on of the registered operations of Picop, i.e., the
financing of the purchase of machinery and equipment actually used in the registered operations of
Picop. Neither does the CIR deny that such interest payments were legally due and demandable under
the terms of such loans, and in fact paid by Picop during the tax year 1977.

The CIR has been unable to point to any provision of the 1977 Tax Code or any other Statute that
requires the disallowance of the interest payments made by Picop. The CIR invokes Section 79 of
Revenue Regulations No. 2 as amended which reads as follows:

Sec. 79. Interest on Capital. — Interest calculated for cost-keeping or other purposes on account of
capital or surplus invested in the business, which does not represent a charge arising under an interest-
bearing obligation, is not allowable deduction from gross income. (Emphases supplied)

We read the above provision of Revenue Regulations No. 2 as referring to so called "theoretical
interest," that is to say, interest "calculated" or computed (and not incurred or paid) for the purpose of
determining the "opportunity cost" of investing funds in a given business. Such "theoretical" or imputed
interest does not arise from a legally demandable interest-bearing obligation incurred by the taxpayer
who however wishes to find out, e.g., whether he would have been better off by lending out his funds
and earning interest rather than investing such funds in his business. One thing that Section 79 quoted
above makes clear is that interest which does constitute a charge arising under an interest-bearing
obligation is an allowable deduction from gross income.

It is claimed by the CIR that Section 79 of Revenue Regulations No. 2 was "patterned after" paragraph
1.266-1 (b), entitled "Taxes and Carrying Charges Chargeable to Capital Account and Treated as Capital
Items" of the U.S. Income Tax Regulations, which paragraph reads as follows:

(B) Taxes and Carrying Charges. — The items thus chargeable to capital accounts are —

(11) In the case of real property, whether improved or unimproved and whether productive or
nonproductive.

(a) Interest on a loan (but not theoretical interest of a taxpayer using his own funds). 21

The truncated excerpt of the U.S. Income Tax Regulations quoted by the CIR needs to be related to the
relevant provisions of the U.S. Internal Revenue Code, which provisions deal with the general topic of
adjusted basis for determining allowable gain or loss on sales or exchanges of property and allowable
depreciation and depletion of capital assets of the taxpayer:

Present Rule. The Internal Revenue Code, and the Regulations promulgated thereunder provide that
"No deduction shall be allowed for amounts paid or accrued for such taxes and carrying charges as,
under regulations prescribed by the Secretary or his delegate, are chargeable to capital account with
respect to property, if the taxpayer elects, in accordance with such regulations, to treat such taxes or
charges as so chargeable."

At the same time, under the adjustment of basis provisions which have just been discussed, it is
provided that adjustment shall be made for all "expenditures, receipts, losses, or other items" properly
chargeable to a capital account, thus including taxes and carrying charges; however, an exception exists,
in which event such adjustment to the capital account is not made, with respect to taxes and carrying
charges which the taxpayer has not elected to capitalize but for which a deduction instead has been
taken. 22 (Emphasis supplied)

The "carrying charges" which may be capitalized under the above quoted provisions of the U.S. Internal
Revenue Code include, as the CIR has pointed out, interest on a loan "(but not theoretical interest of a
taxpayer using his own funds)." What the CIR failed to point out is that such "carrying charges" may, at
the election of the taxpayer, either be (a) capitalized in which case the cost basis of the capital assets,
e.g., machinery and equipment, will be adjusted by adding the amount of such interest payments or
alternatively, be (b) deducted from gross income of the taxpayer. Should the taxpayer elect to deduct
the interest payments against its gross income, the taxpayer cannot at the same time capitalize the
interest payments. In other words, the taxpayer is not entitled to both the deduction from gross income
and the adjusted (increased) basis for determining gain or loss and the allowable depreciation charge.
The U.S. Internal Revenue Code does not prohibit the deduction of interest on a loan obtained for
purchasing machinery and equipment against gross income, unless the taxpayer has also or previously
capitalized the same interest payments and thereby adjusted the cost basis of such assets.
We have already noted that our 1977 NIRC does not prohibit the deduction of interest on a loan
incurred for acquiring machinery and equipment. Neither does our 1977 NIRC compel the capitalization
of interest payments on such a loan. The 1977 Tax Code is simply silent on a taxpayer's right to elect one
or the other tax treatment of such interest payments. Accordingly, the general rule that interest
payments on a legally demandable loan are deductible from gross income must be applied.

The CIR argues finally that to allow Picop to deduct its interest payments against its gross income would
be to encourage fraudulent claims to double deductions from gross income:

[t]o allow a deduction of incidental expense/cost incurred in the purchase of fixed asset in the year it
was incurred would invite tax evasion through fraudulent application of double deductions from gross
income. 23 (Emphases supplied)

The Court is not persuaded. So far as the records of the instant cases show, Picop has not claimed to be
entitled to double deduction of its 1977 interest payments. The CIR has neither alleged nor proved that
Picop had previously adjusted its cost basis for the machinery and equipment purchased with the loan
proceeds by capitalizing the interest payments here involved. The Court will not assume that the CIR
would be unable or unwilling to disallow "a double deduction" should Picop, having deducted its interest
cost from its gross income, also attempt subsequently to adjust upward the cost basis of the machinery
and equipment purchased and claim, e.g., increased deductions for depreciation.

We conclude that the CTA and the Court of Appeals did not err in allowing the deductions of Picop's
1977 interest payments on its loans for capital equipment against its gross income for 1977.

(2) Whether Picop is entitled

to deduct against current
income net operating losses
incurred by Rustan Pulp
and Paper Mills, Inc.

On 18 January 1977, Picop entered into a merger agreement with the Rustan Pulp and Paper Mills, Inc.
("RPPM") and Rustan Manufacturing Corporation ("RMC"). Under this agreement, the rights, properties,
privileges, powers and franchises of RPPM and RMC were to be transferred, assigned and conveyed to
Picop as the surviving corporation. The entire subscribed and outstanding capital stock of RPPM and
RMC would be exchanged for 2,891,476 fully paid up Class "A" common stock of Picop (with a par value
of P10.00) and 149,848 shares of preferred stock of Picop (with a par value of P10.00), to be issued by
Picop, the result being that Picop would wholly own both RPPM and RMC while the stockholders of
RPPM and RMC would join the ranks of Picop's shareholders. In addition, Picop paid off the obligations
of RPPM to the Development Bank of the Philippines ("DBP") in the amount of P68,240,340.00, by
issuing 6,824,034 shares of preferred stock (with a par value of P10.00) to the DBP. The merger
agreement was approved in 1977 by the creditors and stockholders of Picop, RPPM and RMC and by the
Securities and Exchange Commission. Thereupon, on 30 November 1977, apparently the effective date
of merger, RPPM and RMC were dissolved. The Board of Investments approved the merger agreement
on 12 January 1978.

It appears that RPPM and RMC were, like Picop, BOI-registered companies. Immediately before merger
effective date, RPPM had over preceding years accumulated losses in the total amount of
P81,159,904.00. In its 1977 Income Tax Return, Picop claimed P44,196,106.00 of RPPM's accumulated
losses as a deduction against Picop's 1977 gross income. 24

Upon the other hand, even before the effective date of merger, on 30 August 1977, Picop sold all the
outstanding shares of RMC stock to San Miguel Corporation for the sum of P38,900,000.00, and
reported a gain of P9,294,849.00 from this transaction. 25

In claiming such deduction, Picop relies on section 7 (c) of R.A. No. 5186 which provides as follows:

Sec. 7. Incentives to Registered Enterprise. — A registered enterprise, to the extent engaged in a

preferred area of investment, shall be granted the following incentive benefits:

xxx xxx xxx

(c) Net Operating Loss Carry-over. — A net operating loss incurred in any of the first ten years of
operations may be carried over as a deduction from taxable income for the six years immediately
following the year of such loss. The entire amount of the loss shall be carried over to the first of the six
taxable years following the loss, and any portion of such loss which exceeds the taxable income of such
first year shall be deducted in like manner from the taxable income of the next remaining five years. The
net operating loss shall be computed in accordance with the provisions of the National Internal Revenue
Code, any provision of this Act to the contrary notwithstanding, except that income not taxable either in
whole or in part under this or other laws shall be included in gross income. (Emphasis supplied)

Picop had secured a letter-opinion from the BOI dated 21 February 1977 — that is, after the date of the
agreement of merger but before the merger became effective — relating to the deductibility of the
previous losses of RPPM under Section 7 (c) of R.A. No. 5186 as amended. The pertinent portions of this
BOI opinion, signed by BOI Governor Cesar Lanuza, read as follows:

2) PICOP will not be allowed to carry over the losses of Rustan prior to the legal dissolution of the latter
because at that time the two (2) companies still had separate legal personalities;

3) After BOI approval of the merger, PICOP can no longer apply for the registration of the registered
capacity of Rustan because with the approved merger, such registered capacity of Rustan transferred to
PICOP will have the same registration date as that of Rustan. In this case, the previous losses of Rustan
may be carried over by PICOP, because with the merger, PICOP assumes all the rights and obligations of
Rustan subject, however, to the period prescribed for carrying over of such
losses. 26 (Emphasis supplied)

Curiously enough, Picop did not also seek a ruling on this matter, clearly a matter of tax law, from the
Bureau of Internal Revenue. Picop chose to rely solely on the BOI letter-opinion.

The CIR disallowed all the deductions claimed on the basis of RPPM's losses, apparently on two (2)
grounds. Firstly, the previous losses were incurred by "another taxpayer," RPPM, and not by Picop in
connection with Picop's own registered operations. The CIR took the view that Picop, RPPM and RMC
were merged into one (1) corporate personality only on 12 January 1978, upon approval of the merger
agreement by the BOI. Thus, during the taxable year 1977, Picop on the one hand and RPPM and RMC
on the other, still had their separate juridical personalities. Secondly, the CIR alleged that these losses
had been incurred by RPPM "from the borrowing of funds" and not from carrying out of RPPM's
registered operations. We focus on the first ground. 27

The CTA upheld the deduction claimed by Picop; its reasoning, however, is less than crystal clear,
especially in respect of its view of what the U.S. tax law was on this matter. In any event, the CTA
apparently fell back on the BOI opinion of 21 February 1977 referred to above. The CTA said:

Respondent further averred that the incentives granted under Section 7 of R.A. No. 5186 shall be
available only to the extent in which they are engaged in registered operations, citing Section 1 of Rule
IX of the Basic Rules and Regulations to Implement the Intent and Provisions of the Investment
Incentives Act, R.A. No. 5186.

We disagree with respondent. The purpose of the merger was to rationalize the container board
industry and not to take advantage of the net losses incurred by RPPMI prior to the stock swap. Thus,
when stock of a corporation is purchased in order to take advantage of the corporation's net operating
loss incurred in years prior to the purchase, the corporation thereafter entering into a trade or business
different from that in which it was previously engaged, the net operating loss carry-over may be entirely
lost. [IRC (1954), Sec. 382(a), Vol. 5, Mertens, Law of Federal Income Taxation, Chap. 29.11a, p. 103]. 28
Furthermore, once the BOI approved the merger agreement, the registered capacity of Rustan shall be
transferred to PICOP, and the previous losses of Rustan may be carried over by PICOP by operation of
law. [BOI ruling dated February 21, 1977 (Exh. J-1)] It is clear therefrom, that the deduction availed of
under Section 7(c) of R.A. No. 5186 was only proper." (pp. 38-43, Rollo of SP No. 20070) 29 (Emphasis
supplied)

In respect of the above underscored portion of the CTA decision, we must note that the CTA in fact
overlooked the statement made by petitioner's counsel before the CTA that:

Among the attractions of the merger to Picop was the accumulated net operating loss carry-over of RMC
that it might possibly use to relieve it (Picop) from its income taxes, under Section 7 (c) of R.A. 5186. Said
section provides:

xxx xxx xxx

With this benefit in mind, Picop addressed three (3) questions to the BOI in a letter dated November 25,
1976. The BOI replied on February 21, 1977 directly answering the three (3) queries. 30 (Emphasis
supplied)

The size of RPPM's accumulated losses as of the date of the merger — more than P81,000,000.00 —
must have constituted a powerful attraction indeed for Picop.

The Court of Appeals followed the result reached by the CTA. The Court of Appeals, much like the CTA,
concluded that since RPPM was dissolved on 30 November 1977, its accumulated losses were
appropriately carried over by Picop in the latter's 1977 Income Tax Return "because by that time RPPMI
and Picop were no longer separate and different taxpayers." 31

After prolonged consideration and analysis of this matter, the Court is unable to agree with the CTA and
Court of Appeals on the deductibility of RPPM's accumulated losses against Picop's 1977 gross income.
It is important to note at the outset that in our jurisdiction, the ordinary rule — that is, the rule
applicable in respect of corporations not registered with the BOI as a preferred pioneer enterprise — is
that net operating losses cannot be carried over. Under our Tax Code, both in 1977 and at present,
losses may be deducted from gross income only if such losses were actually sustained in the same year
that they are deducted or charged off. Section 30 of the 1977 Tax Code provides:

Sec. 30. Deductions from Gross Income. — In computing net income, there shall be allowed as
deduction —

xxx xxx xxx

(d) Losses:

(1) By Individuals. — In the case of an individual, losses actually sustained during the taxable year and
not compensated for by an insurance or otherwise —

(A) If incurred in trade or business;

xxx xxx xxx

(2) By Corporations. — In a case of a corporation, all losses actually sustained and charged off within the
taxable year and not compensated for by insurance or otherwise.

(3) By Non-resident Aliens or Foreign Corporations. — In the case of a non-resident alien individual or a
foreign corporation, the losses deductible are those actually sustained during the year incurred in
business or trade conducted within the Philippines, . . . 32 (Emphasis supplied)

Section 76 of the Philippine Income Tax Regulations (Revenue Regulation No. 2, as amended) is even
more explicit and detailed:

Sec. 76. When charges are deductible. — Each year's return, so far as practicable, both as to gross
income and deductions therefrom should be complete in itself, and taxpayers are expected to make
every reasonable effort to ascertain the facts necessary to make a correct return. The expenses,
liabilities, or deficit of one year cannot be used to reduce the income of a subsequent year. A taxpayer
has the right to deduct all authorized allowances and it follows that if he does not within any year
deduct certain of his expenses, losses, interests, taxes, or other charges,
he can not deduct them from the income of the next or any succeeding year. . . .

xxx xxx xxx

. . . . If subsequent to its occurrence, however, a taxpayer first ascertains the amount of a loss sustained
during a prior taxable year which has not been deducted from gross income, he may render an amended
return for such preceding taxable year including such amount of loss in the deduction from gross income
and may in proper cases file a claim for refund of the excess paid by reason of the failure to deduct such
loss in the original return. A loss from theft or embezzlement occurring in one year and discovered in
another is ordinarily deductible for the year in which sustained. (Emphases supplied)
It is thus clear that under our law, and outside the special realm of BOI-registered enterprises, there is
no such thing as a carry-over of net operating loss. To the contrary, losses must be deducted against
current income in the taxable year when such losses were incurred. Moreover, such losses may be
charged off only against income earned in the same taxable year when the losses were incurred.

Thus it is that R.A. No. 5186 introduced the carry-over of net operating losses as a very special incentive
to be granted only to registered pioneer enterprises and only with respect to their registered
operations. The statutory purpose here may be seen to be the encouragement of the establishment and
continued operation of pioneer industries by allowing the registered enterprise to accumulate its
operating losses which may be expected during the early years of the enterprise and to permit the
enterprise to offset such losses against income earned by it in later years after successful establishment
and regular operations. To promote its economic development goals, the Republic foregoes or defers
taxing the income of the pioneer enterprise until after that enterprise has recovered or offset its earlier
losses. We consider that the statutory purpose can be served only if the accumulated operating losses
are carried over and charged off against income subsequently earned and accumulated by the same
enterprise engaged in the same registered operations.

In the instant case, to allow the deduction claimed by Picop would be to permit one corporation or
enterprise, Picop, to benefit from the operating losses accumulated by another corporation or
enterprise, RPPM. RPPM far from benefiting from the tax incentive granted by the BOI statute, in fact
gave up the struggle and went out of existence and its former stockholders joined the much larger group
of Picop's stockholders. To grant Picop's claimed deduction would be to permit Picop to shelter its
otherwise taxable income (an objective which Picop had from the very beginning) which had not been
earned by the registered enterprise which had suffered the accumulated losses. In effect, to grant
Picop's claimed deduction would be to permit Picop to purchase a tax deduction and RPPM to peddle its
accumulated operating losses. Under the CTA and Court of Appeals decisions, Picop would benefit by
immunizing P44,196,106.00 of its income from taxation thereof although Picop had not run the risks and
incurred the losses which had been encountered and suffered by RPPM. Conversely, the income that
would be shielded from taxation is not income that was, after much effort, eventually generated by the
same registered operations which earlier had sustained losses. We consider and so hold that there is
nothing in Section 7 (c) of R.A. No. 5186 which either requires or permits such a result. Indeed, that
result makes non-sense of the legislative purpose which may be seen clearly to be projected by Section
7 (c), R.A. No. 5186.

The CTA and the Court of Appeals allowed the offsetting of RPPM's accumulated operating losses
against Picop's 1977 gross income, basically because towards the end of the taxable year 1977, upon the
arrival of the effective date of merger, only one (1) corporation, Picop, remained. The losses suffered by
RPPM's registered operations and the gross income generated by Picop's own registered operations
now came under one and the same corporate roof. We consider that this circumstance relates much
more to form than to substance. We do not believe that that single purely technical factor is enough to
authorize and justify the deduction claimed by Picop. Picop's claim for deduction is not only bereft of
statutory basis; it does violence to the legislative intent which animates the tax incentive granted by
Section 7 (c) of R.A. No. 5186. In granting the extraordinary privilege and incentive of a net operating
loss carry-over to BOI-registered pioneer enterprises, the legislature could not have intended to require
the Republic to forego tax revenues in order to benefit a corporation which had run no risks and
suffered no losses, but had merely purchased another's losses.
Both the CTA and the Court of Appeals appeared much impressed not only with corporate technicalities
but also with the U.S. tax law on this matter. It should suffice, however, simply to note that in U.S. tax
law, the availability to companies generally of operating loss carry-overs and of operating loss carry-
backs is expressly provided and regulated in great detail by statute. 33 In our jurisdiction, save for
Section 7 (c) of R.A. No. 5186, no statute recognizes or permits loss carry-overs and loss carry-backs.
Indeed, as already noted, our tax law expressly rejects the very notion of loss carry-overs and carry-
backs.

We conclude that the deduction claimed by Picop in the amount of P44,196,106.00 in its 1977 Income
Tax Return must be disallowed.

(3) Whether Picop is entitled

to deduct against current
income certain claimed
financial guarantee expenses.

In its Income Tax Return for 1977, Picop also claimed a deduction in the amount of P1,237,421.00 as
financial guarantee expenses.

This deduction is said to relate to chattel and real estate mortgages required from Picop by the
Philippine National Bank ("PNB") and DBP as guarantors of loans incurred by Picop from foreign
creditors. According to Picop, the claimed deduction represents registration fees and other expenses
incidental to registration of mortgages in favor of DBP and PNB.

In support of this claimed deduction, Picop allegedly showed its own vouchers to BIR Examiners to prove
disbursements to the Register of Deeds of Tandag, Surigao del Sur, of particular amounts. In the
proceedings before the CTA, however, Picop did not submit in evidence such vouchers and instead
presented one of its employees to testify that the amount claimed had been disbursed for the
registration of chattel and real estate mortgages.

The CIR disallowed this claimed deduction upon the ground of insufficiency of evidence. This
disallowance was sustained by the CTA and the Court of Appeals. The CTA said:

No records are available to support the abovementioned expenses. The vouchers merely showed that
the amounts were paid to the Register of Deeds and simply cash account. Without the supporting
papers such as the invoices or official receipts of the Register of Deeds, these vouchers standing alone
cannot prove that the payments made were for the accrued expenses in question. The best evidence of
payment is the official receipts issued by the Register of Deeds. The testimony of petitioner's witness
that the official receipts and cash vouchers were shown to the Bureau of Internal Revenue will not
suffice if no records could be presented in court for proper marking and identification. 34 Emphasis
supplied)

The Court of Appeals added:

The mere testimony of a witness for PICOP and the cash vouchers do not suffice to establish its claim
that registration fees were paid to the Register of Deeds for the registration of real estate and chattel
mortgages in favor of Development Bank of the Philippines and the Philippine National Bank as
guarantors of PICOP's loans. The witness could very well have been merely repeating what he was
instructed to say regardless of the truth, while the cash vouchers, which we do not find on file, are not
said to provide the necessary details regarding the nature and purpose of the expenses reflected
therein. PICOP should have presented, through the guarantors, its owner's copy of the registered titles
with the lien inscribed thereon as well as an official receipt from the Register of Deeds evidencing
payment of the registration fee. 35 (Emphasis supplied)

We must support the CTA and the Court of Appeals in their foregoing rulings. A taxpayer has the burden
of proving entitlement to a claimed deduction. 36 In the instant case, even Picop's own vouchers were
not submitted in evidence and the BIR Examiners denied that such vouchers and other documents had
been exhibited to them. Moreover, cash vouchers can only confirm the fact of disbursement but not
necessarily the purpose thereof. 37 The best evidence that Picop should have presented to support its
claimed deduction were the invoices and official receipts issued by the Register of Deeds. Picop not only
failed to present such documents; it also failed to explain the loss thereof, assuming they had existed
before. 38 Under the best evidence rule, 39 therefore, the testimony of Picop's employee was
inadmissible and was in any case entitled to very little, if any, credence.

We consider that entitlement to Picop's claimed deduction of P1,237,421.00 was not adequately shown
and that such deduction must be disallowed.

III

(1) Whether Picop had understated

its sales and overstated its
cost of sales for 1977.

In its assessment for deficiency income tax for 1977, the CIR claimed that Picop had understated its sales
by P2,391,644.00 and, upon the other hand, overstated its cost of sales by P604,018.00. Thereupon, the
CIR added back both sums to Picop's net income figure per its own return.

The 1977 Income Tax Return of Picop set forth the following figures:

Sales (per Picop's Income Tax Return):

Paper P 537,656,719.00

Timber P 263,158,132.00

———————

Total Sales P 800,814,851.00

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

Upon the other hand, Picop's Books of Accounts reflected higher sales figures:

Sales (per Picop's Books of Accounts):

Paper P 537,656,719.00
Timber P 265,549,776.00

———————

Total Sales P 803,206,495.00

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

The above figures thus show a discrepancy between the sales figures reflected in Picop's Books of
Accounts and the sales figures reported in its 1977 Income Tax Return, amounting to: P2,391,644.00.

The CIR also contended that Picop's cost of sales set out in its 1977 Income Tax Return, when compared
with the cost figures in its Books of Accounts, was overstated:

Cost of Sales
(per Income Tax Return) P607,246,084.00
Cost of Sales
(per Books of Accounts) P606,642,066.00

———————

Discrepancy P 604,018.00
============

Picop did not deny the existence of the above noted discrepancies. In the proceedings before the CTA,
Picop presented one of its officials to explain the foregoing discrepancies. That explanation is perhaps
best presented in Picop's own words as set forth in its Memorandum before this Court:

. . . that the adjustment discussed in the testimony of the witness, represent the best and most objective
method of determining in pesos the amount of the correct and actual export sales during the year. It
was this correct and actual export sales and costs of sales that were reflected in the income tax return
and in the audited financial statements. These corrections did not result in realization of income and
should not give rise to any deficiency tax.

xxx xxx xxx

What are the facts of this case on this matter? Why were adjustments necessary at the year-end?

Because of PICOP's procedure of recording its export sales (reckoned in U.S. dollars) on the basis of a
fixed rate, day to day and month to month, regardless of the actual exchange rate and without waiting
when the actual proceeds are received. In other words, PICOP recorded its export sales at a pre-
determined fixed exchange rate. That pre-determined rate was decided upon at the beginning of the
year and continued to be used throughout the year.

At the end of the year, the external auditors made an examination. In that examination, the auditors
determined with accuracy the actual dollar proceeds of the export sales received. What exchange rate
was used by the auditors to convert these actual dollar proceeds into Philippine pesos? They used the
average of the differences between (a) the recorded fixed exchange rate and (b) the exchange rate at
the time the proceeds were actually received. It was this rate at time of receipt of the proceeds that
determined the amount of pesos credited by the Central Bank (through the agent banks) in favor of
PICOP. These accumulated differences were averaged by the external auditors and this was what was
used at the year-end for income tax and other government-report purposes. (T.s.n., Oct. 17/85, pp. 20-
25) 40

The above explanation, unfortunately, at least to the mind of the Court, raises more questions than it
resolves. Firstly, the explanation assumes that all of Picop's sales were export sales for which U.S. dollars
(or other foreign exchange) were received. It also assumes that the expenses summed up as "cost of
sales" were all dollar expenses and that no peso expenses had been incurred. Picop's explanation
further assumes that a substantial part of Picop's dollar proceeds for its export sales were not actually
surrendered to the domestic banking system and seasonably converted into pesos; had all such dollar
proceeds been converted into pesos, then the peso figures could have been simply added up to reflect
the actual peso value of Picop's export sales. Picop offered no evidence in respect of these assumptions,
no explanation why and how a "pre-determined fixed exchange rate" was chosen at the beginning of the
year and maintained throughout. Perhaps more importantly, Picop was unable to explain why its Books
of Accounts did not pick up the same adjustments that Picop's External Auditors were alleged to have
made for purposes of Picop's Income Tax Return. Picop attempted to explain away the failure of its
Books of Accounts to reflect the same adjustments (no correcting entries, apparently) simply by quoting
a passage from a case where this Court refused to ascribe much probative value to the Books of
Accounts of a corporate taxpayer in a tax case. 41 What appears to have eluded Picop, however, is that
its Books of Accounts, which are kept by its own employees and are prepared under its control and
supervision, reflect what may be deemed to be admissions against interest in the instant case. For
Picop's Books of Accounts precisely show higher sales figures and lower cost of sales figures than Picop's
Income Tax Return.

It is insisted by Picop that its Auditors' adjustments simply present the "best and most objective"
method of reflecting in pesos the "correct and ACTUAL export sales" 42 and that the adjustments or
"corrections" "did not result in realization of [additional] income and should not give rise to any
deficiency tax." The correctness of this contention is not self-evident. So far as the record of this case
shows, Picop did not submit in evidence the aggregate amount of its U.S. dollar proceeds of its export
sales; neither did it show the Philippine pesos it had actually received or been credited for such U.S.
dollar proceeds. It is clear to this Court that the testimonial evidence submitted by Picop fell far short of
demonstrating the correctness of its explanation.

Upon the other hand, the CIR has made out at least a prima facie case that Picop had understated its
sales and overstated its cost of sales as set out in its Income Tax Return. For the CIR has a right to
assume that Picop's Books of Accounts speak the truth in this case since, as already noted, they embody
what must appear to be admissions against Picop's own interest.

Accordingly, we must affirm the findings of the Court of Appeals and the CTA.

(2) Whether Picop is liable for

the corporate development
tax of five percent (5%)
of its income for 1977.
The five percent (5%) corporate development tax is an additional corporate income tax imposed in
Section 24 (e) of the 1977 Tax Code which reads in relevant part as follows:

(e) Corporate development tax. — In addition to the tax imposed in subsection (a) of this section, an
additional tax in an amount equivalent to 5 per cent of the same taxable net income shall be paid by a
domestic or a resident foreign corporation; Provided, That this additional tax shall be imposed only if the
net income exceeds 10 per cent of the net worth, in case of a domestic corporation, or net assets in the
Philippines in case of a resident foreign corporation: . . . .

The additional corporate income tax imposed in this subsection shall be collected and paid at the same
time and in the same manner as the tax imposed in subsection (a) of this section.

Since this five percent (5%) corporate development tax is an income tax, Picop is not exempted from it
under the provisions of Section 8 (a) of R.A. No. 5186.

For purposes of determining whether the net income of a corporation exceeds ten percent (10%) of its
net worth, the term "net worth" means the stockholders' equity represented by the excess of the total
assets over liabilities as reflected in the corporation's balance sheet provided such balance sheet has
been prepared in accordance with generally accepted accounting principles employed in keeping the
books of the corporation. 43

The adjusted net income of Picop for 1977, as will be seen below, is P48,687,355.00. Its net worth figure
or total stockholders' equity as reflected in its Audited Financial Statements for 1977 is P464,749,528.00.
Since its adjusted net income for 1977 thus exceeded ten percent (10%) of its net worth, Picop must be
held liable for the five percent (5%) corporate development tax in the amount of P2,434,367.75.

Recapitulating, we hold:

(1) Picop is liable for the thirty-five percent (35%) transaction tax in the amount of P3,578,543.51.

(2) Picop is not liable for interest and surcharge on unpaid transaction tax.

(3) Picop is exempt from payment of documentary and science stamp taxes in the amount of
P300,000.00 and the compromise penalty of P300.00.

(4) Picop is entitled to its claimed deduction of P42,840,131.00 for interest payments on loans for,
among other things, the purchase of machinery and equipment.

(5) Picop's claimed deduction in the amount of P44,196,106.00 for the operating losses previously
incurred by RPPM, is disallowed for lack of merit.

(6) Picop's claimed deduction for certain financial guarantee expenses in the amount P1,237,421.00 is
disallowed for failure adequately to prove such expenses.

(7) Picop has understated its sales by P2,391,644.00 and overstated its cost of sales by P604,018.00, for
1977.
(8) Picop is liable for the corporate development tax of five percent (5%) of its adjusted net income for
1977 in the amount of P2,434,367.75.

Considering conclusions nos. 4, 5, 6, 7 and 8, the Court is compelled to hold Picop liable for deficiency
income tax for the year 1977 computed as follows:

Deficiency Income Tax

Net Income Per Return P 258,166.00

Add:

Unallowable Deductions

(1) Deduction of net

operating losses
incurred by RPPM P 44,196,106.00

(2) Unexplained financial

guarantee expenses P 1,237,421.00

(3) Understatement of
Sales P 2,391,644.00

(4) Overstatement of
Cost of Sales P 604,018.00

——————

Total P 48,429,189.00

——————

Net Income as Adjusted P 48,687,355.00

===========

Income Tax Due Thereon 44 P 17,030,574.00

Less:

Tax Already Assessed per

Return 80,358.00

——————

Deficiency Income Tax P 16,560,216.00

Add:

Five percent (5%) Corporate

Development Tax P 2,434,367.00

Total Deficiency Income Tax P 18,994,583.00

===========

Add:

Five percent (5%) surcharge 45 P 949,729.15

——————

Total Deficiency Income Tax

with surcharge P 19,944,312.15

Add:

Fourteen percent (14%)

interest from 15 April

1978 to 14 April 1981 46 P 8,376,610.80

Fourteen percent (14%)

interest from 21 April

1983 to 20 April 1986 47 P 11,894,787.00

——————

Total Deficiency Income Tax

Due and Payable P 40,215,709.00

===========

WHEREFORE, for all the foregoing, the Decision of the Court of Appeals is hereby MODIFIED and Picop is
hereby ORDERED to pay the CIR the aggregate amount of P43,794,252.51 itemized as follows:

(1) Thirty-five percent (35%)

transaction tax P 3,578,543.51

(2) Total Deficiency Income

Tax Due 40,215,709.00

———————

Aggregate Amount Due and Payable P 43,794,252.51

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

No pronouncement as to costs.

SO ORDERED.

Narvasa, C.J., Regalado, Davide, Jr., Romero, Bellosillo, Melo, Puno, Kapunan, Mendoza, Francisco,
Hermosisima, Jr. and Panganiban, JJ., concur.

Padilla, J., took no part.

G.R. No. L-13912 September 30, 1960

THE COMMISSIONER OF INTERNAL REVENUE, petitioner,

vs.
CONSUELO L. VDA. DE PRIETO, respondent.

Office of the Solicitor General Edilberto Barot, Solicitor F.R. Rosete and
Special Atty. B. Gatdula, Jr. for petitioner.
Formilleza and Latorre for respondent.
GUTIERREZ DAVID, J.:

This is an appeal from a decision of the Court of tax Appeals reversing the decision of the Commissioner
of Internal Revenue which held herein respondent Consuelo L. Vda. de Prieto liable for the payment of
the sum of P21,410.38 as deficiency income tax, plus penalties and monthly interest.

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

Under the law, for interest to be deductible, it must be shown that there be an indebtedness, that there
should be interest upon it, and that what is claimed as an interest deduction should have been paid or
accrued within the year. It is here conceded that the interest paid by respondent was in consequence of
the late payment of her donor's tax, and the same was paid within the year it is sought to be declared.
The only question to be determined, as stated by the parties, is whether or not such interest was paid
upon an indebtedness within the contemplation of section 30 (b) (1) of the Tax Code, the pertinent part
of which reads:

SEC. 30 Deductions from gross income. — In computing net income there shall be allowed as deductions
—

xxx xxx xxx

(b) Interest:

(1) In general. — The amount of interest paid within the taxable year on indebtedness, except on
indebtedness incurred or continued to purchase or carry obligations the interest upon which is exempt
from taxation as income under this Title.

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.1awphîl.nèt (Federal Taxes Vol. 2, p. 13,019, Prentice-Hall, Inc.; Merten's Law of
Federal Income Taxation, Vol. 4, p. 542.) Within the meaning of that definition, it is apparent that a tax
may be considered an indebtedness. As stated by this Court in the case of Santiago Sambrano vs. Court
of Tax Appeals and Collector of Internal Revenue (101 Phil., 1; 53 Off. Gaz., 4839) —

Although taxes already due have not, strictly speaking, the same concept as debts, they are, however,
obligations that may be considered as such.

The term "debt" is properly used in a comprehensive sense as embracing not merely money due by
contract but whatever one is bound to render to another, either for contract, or the requirement of the
law. (Camben vs. Fink Coule and Coke Co. 61 LRA 584)

Where statute imposes a personal liability for a tax, the tax becomes, at least in a board sense, a debt.
(Idem).

A tax is a debt for which a creditor's bill may be brought in a proper case. (State vs. Georgia Co., 19 LRA
485).

It follows that the interest paid by herein respondent for the late payment of her donor's tax is
deductible from her gross income under section 30(b) of the Tax Code above quoted.

The above conclusion finds support in the established jurisprudence in the United States after whose
laws our Income Tax Law has been patterned. Thus, under sec. 23(b) of the Internal Revenue Code of
1939, as amended 1 , which contains similarly worded provisions as sec. 30(b) of our Tax Code, the
uniform ruling is that interest on taxes is interest on indebtedness and is deductible. (U.S. vs. Jaffray,
306 U.S. 276. See also Lustig vs. U.S., 138 F. Supp. 870; Commissioner of Internal Revenue vs. Bryer, 151
F. 2d 267, 34 AFTR 151; Penrose vs. U.S. 18 F. Supp. 413, 18 AFTR 1289; Max Thomas Davis, et al. vs.
Commissioner of Internal Revenue, 46 U.S. Boared of Tax Appeals Reports, p. 663, citing U.S. vs. Jaffray,
6 Tax Court of United States Reports, p. 255; Armour vs. Commissioner of Internal Revenue, 6 Tax Court
of the United States Reports, p. 359; The Koppers Coal Co. vs. Commissioner of Internal Revenue, 7 Tax
Court of United States Reports, p. 1209; Toy vs. Commissioner of Internal Revenue; Lucas vs. Comm., 34
U.S. Board of Tax Appeals Reports, 877; Evens and Howard Fire Brick Co. vs. Commissioner of Internal
Revenue, 3 Tax Court of United States Reports, p. 62). The rule applies even though the tax is
nondeductible. (Federal Taxes, Vol. 2, Prentice Hall, sec. 163, 13,022; see also Merten's Law of Federal
Income Taxation, Vol. 5, pp. 23-24.)

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. We find the lower court's ruling to be correct.
Contrary to petitioner's belief, the portion of section 80 of Revenue Regulation No. 2 under
consideration has been part and parcel of the development to the law on deduction of taxes in the
United States. (See Capital Bldg. and Loan Assn. vs. Comm., 23 BTA 848. Thus, Mertens in his treatise
says: "Penalties are to be distinguished from taxes and they are not deductible under the heading of
taxs." . . . Interest on state taxes is not deductible as taxes." (Vol. 5, Law on Federal Income Taxation, pp.
22-23, sec. 27.06, citing cases.) This notwithstanding, courts in that jurisdiction, however, have
invariably held that interest on deficiency taxes are deductible, not as taxes, but as interest. (U.S. vs.
Jaffray, et al., supra; see also Mertens, sec. 26.09, Vol. 4, p. 552, and cases cited therein.) Section 80 of
Revenue Regulation No. 2, therefore, merely incorporated the established application of the tax
deduction statute in the United States, where deduction of "taxes" has always been limited to taxes
proper and has never included interest on delinquent taxes, penalties and surcharges.

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." (Lynch vs. Tilden Produce Co., 265 U.S. 315; Miller vs. U.S., 294 U.S. 435.) 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.

In conclusion, we are of the opinion and so hold that 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.
In view of the foregoing, the decision sought to be reviewed is affirmed, without pronouncement as to
costs.

Bengzon, Bautista Angelo, Labrador, Barrera, Paredes, and Dizon, JJ., concur.
Paras, C. J., Concepcion, and Reyes, J.B.L., JJ., concur in the result.

Revenue Regulation No. 13-2000 (DIGEST)

Issued December 29, 2000 implements the provisions of Section 34(B) of the Tax Code of 1997 relative
to the requirements for the deductibility of interest expense from the gross income of a corporation or
an individual engaged in trade, business or in the practice of profession.

In general, subject to certain limitations, the following are the requisites for the deductibility of interest
expense from gross income: a) there must be an indebtedness; b) there should be an interest expense
paid or incurred upon such indebtedness; c) the indebtedness must be that of the taxpayer; d) the
indebtedness must be connected with the taxpayer's trade, business or exercise of profession; e) the
interest expense must have been paid or incurred during the taxable year; f) the interest must have
been stipulated in writing; g) the interest must be legally due; h) the interest payment arrangement
must not be between related taxpayers; i) the interest must not be incurred to finance petroleum
operations; and j) in case of interest incurred to acquire property used in trade, business or exercise of
profession, the same was not treated as a capital expenditure