Republic of the Philippines

SUPREME COURT
Manila

SECOND DIVISION

G.R. No. 48532 August 31, 1992

HERNANDO B. CONWI, JAIME E. DY-LIACCO, VICENTE D. HERRERA, BENJAMIN T. ILDEFONSO,

ALEXANDER LACSON, JR., ADRIAN O. MICIANO, EDUARDO A. RIALP, LEANDRO G. SANTILLAN, and
JAIME A. SOQUES, petitioners,
vs.
THE HONORABLE COURT OF TAX APPEALS and COMMISSIONER OF INTERNAL REVENUE,
respondents.

G.R. No. 48533 August 31, 1992

ENRIQUE R. ABAD SANTOS, HERNANDO B. CONWI, TEDDY L. DIMAYUGA, JAIME E. DY-LIACCO,

MELQUIADES J. GAMBOA, JR., MANUEL L. GUZMAN, VICENTE D. HERRERA, BENJAMIN T.
ILDEFONSO, ALEXANDER LACSON, JR., ADRIAN O. MICIANO, EDUARDO A. RIALP and JAIME A.
SOQUES, petitioners,
vs.
THE HONORABLE COURT OF TAX APPEALS and COMMISSIONER OF INTERNAL REVENUE,
respondents.

Angara, Abello, Concepcion, Regala & Cruz for petitioners.

NOCON, J.:

Petitioners pray that his Court reverse the Decision of the public respondent Court of Tax Appeals, promulgated
September 26, 19771 denying petitioners' claim for tax refunds, and order the Commissioner of Internal Revenue
to refund to them their income taxes which they claim to have been erroneously or illegally paid or collected.

As summarized by the Solicitor General, the facts of the cases are as follows:

Petitioners are Filipino citizens and employees of Procter and Gamble, Philippine
Manufacturing Corporation, with offices at Sarmiento Building, Ayala Avenue, Makati,
Rizal. Said corporation is a subsidiary of Procter & Gamble, a foreign corporation based
in Cincinnati, Ohio, U.S.A. During the years 1970 and 1971 petitioners were assigned, for
certain periods, to other subsidiaries of Procter & Gamble, outside of the Philippines,
during which petitioners were paid U.S. dollars as compensation for services in their
foreign assignments. (Paragraphs III, Petitions for Review, C.T.A. Cases Nos. 2511 and
2594, Exhs. D, D-1 to D-19). When petitioners in C.T.A. Case No. 2511 filed their income
tax returns for the year 1970, they computed the tax due by applying the dollar-to-peso
conversion on the basis of the floating rate ordained under B.I.R. Ruling No. 70-027 dated
May 14, 1970, as follows:

From January 1 to February 20, 1970 at the conversion rate of P3.90 to

U.S. $1.00;
1
 From February 21 to December 31, 1970 at the conversion rate of P6.25
to U.S. $1.00

Petitioners in C.T.A. Case No. 2594 likewise used the above conversion rate in converting
their dollar income for 1971 to Philippine peso. However, on February 8, 1973 and October
8, 1973, petitioners in said cases filed with the office of the respondent Commissioner,
amended income tax returns for the above-mentioned years, this time using the par value
of the peso as prescribed in Section 48 of Republic Act No. 265 in relation to Section 6 of
Commonwealth Act No. 265 in relation to Section 6 of Commonwealth Act No. 699 as the
basis for converting their respective dollar income into Philippine pesos for purposes of
computing and paying the corresponding income tax due from them. The aforesaid
computation as shown in the amended income tax returns resulted in the alleged
overpayments, refund and/or tax credit. Accordingly, claims for refund of said over-
payments were filed with respondent Commissioner. Without awaiting the resolution of the
Commissioner of the Internal Revenue on their claims, petitioners filed their petitioner for
review in the above-mentioned cases.

Respondent Commissioner filed his Answer to petitioners' petition for review in C.T.A.
Case No. 2511 on July 31, 1973, while his Answer in C.T.A. Case No. 2594 was filed on
August 7, 1974.

Upon joint motion of the parties on the ground that these two cases involve common
question of law and facts, that respondent Court of Tax Appeals heard the cases jointly.
In its decision dated September 26, 1977, the respondent Court of Tax Appeals held that
the proper conversion rate for the purpose of reporting and paying the Philippine income
tax on the dollar earnings of petitioners are the rates prescribed under Revenue
Memorandum Circulars Nos. 7-71 and 41-71. Accordingly, the claim for refund and/or tax
credit of petitioners in the above-entitled cases was denied and the petitions for review
dismissed, with costs against petitioners. Hence, this petition for review on certiorari. 2

Petitioners claim that public respondent Court of Tax Appeals erred in holding:

1. That petitioners' dollar earnings are receipts derived from foreign exchange transactions.

2. That the proper rate of conversion of petitioners' dollar earnings for tax purposes in the prevailing free market
rate of exchange and not the par value of the peso; and

3. That the use of the par value of the peso to convert petitioners' dollar earnings for tax purposes into Philippine
pesos is "unrealistic" and, therefore, the prevailing free market rate should be the rate used.

Respondent Commissioner of Internal Revenue, on the other hand, refutes petitioners' claims as follows:

At the outset, it is submitted that the subject matter of these two cases are Philippine
income tax for the calendar years 1970 (CTA Case No. 2511) and 1971 (CTA Case No.
2594) and, therefore, should be governed by the provisions of the National Internal
Revenue Code and its implementing rules and regulations, and not by the provisions of
Central Bank Circular No. 42 dated May 21, 1953, as contended by petitioners.

Section 21 of the National Internal Revenue Code, before its amendment by Presidential
Decrees Nos. 69 and 323 which took effect on January 1, 1973 and January 1, 1974,
respectively, imposed a tax upon the taxable net income received during each taxable
year from all sources by a citizen of the Philippines, whether residing here or abroad.

2
 Petitioners are citizens of the Philippines temporarily residing abroad by virtue of their
employment. Thus, in their tax returns for the period involved herein, they gave their legal
residence/address as c/o Procter & Gamble PMC, Ayala Ave., Makati, Rizal (Annexes "A"
to "A-8" and Annexes "C" to "C-8", Petition for Review, CTA Nos. 2511 and 2594).

Petitioners being subject to Philippine income tax, their dollar earnings should be
converted into Philippine pesos in computing the income tax due therefrom, in accordance
with the provisions of Revenue Memorandum Circular No. 7-71 dated February 11, 1971
for 1970 income and Revenue Memorandum Circular No. 41-71 dated December 21, 1971
for 1971 income, which reiterated BIR Ruling No. 70-027 dated May 4, 1970, to wit:

For internal revenue tax purposes, the free marker rate of conversion
(Revenue Circulars Nos. 7-71 and 41-71) should be applied in order to
determine the true and correct value in Philippine pesos of the income of
petitioners. 3

After a careful examination of the records, the laws involved and the jurisprudence on the matter, We are inclined
to agree with respondents Court of Tax Appeals and Commissioner of Internal Revenue and thus vote to deny
the petition.

This basically an income tax case. For the proper resolution of these cases income may be defined as an amount
of money coming to a person or corporation within a specified time, whether as payment for services, interest or
profit from investment. Unless otherwise specified, it means cash or its equivalent. 4 Income can also be though
of as flow of the fruits of one's labor. 5

Petitioners are correct as to their claim that their dollar earnings are not receipts derived from foreign exchange
transactions. For a foreign exchange transaction is simply that — a transaction in foreign exchange, foreign
exchange being "the conversion of an amount of money or currency of one country into an equivalent amount of
money or currency of another." 6 When petitioners were assigned to the foreign subsidiaries of Procter &
Gamble, they were earning in their assigned nation's currency and were ALSO spending in said currency. There
was no conversion, therefore, from one currency to another.

Public respondent Court of Tax Appeals did err when it concluded that the dollar incomes of petitioner fell under
Section 2(f)(g) and (m) of C.B. Circular No. 42. 7

The issue now is, what exchange rate should be used to determine the peso equivalent of the foreign earnings
of petitioners for income tax purposes. Petitioners claim that since the dollar earnings do not fall within the
classification of foreign exchange transactions, there occurred no actual inward remittances, and, therefore, they
are not included in the coverage of Central Bank Circular No. 289 which provides for the specific instances when
the par value of the peso shall not be the conversion rate used. They conclude that their earnings should be
converted for income tax purposes using the par value of the Philippine peso.

Respondent Commissioner argues that CB Circular No. 289 speaks of receipts for export products, receipts of
sale of foreign exchange or foreign borrowings and investments but not income tax. He also claims that he had
to use the prevailing free market rate of exchange in these cases because of the need to ascertain the true and
correct amount of income in Philippine peso of dollar earners for Philippine income tax purposes.

A careful reading of said CB Circular No. 289 8 shows that the subject matters involved therein are export
products, invisibles, receipts of foreign exchange, foreign exchange payments, new foreign borrowing and
investments — nothing by way of income tax payments. Thus, petitioners are in error by concluding that since
C.B. Circular No. 289 does not apply to them, the par value of the peso should be the guiding rate used for
income tax purposes.

3
The dollar earnings of petitioners are the fruits of their labors in the foreign subsidiaries of Procter & Gamble. It
was a definite amount of money which came to them within a specified period of time of two yeas as payment
for their services.

Section 21 of the National Internal Revenue Code, amended up to August 4, 1969, states as follows:

Sec. 21. Rates of tax on citizens or residents. — A tax is hereby imposed upon the taxable
net income received during each taxable year from all sources by every individual, whether
a citizen of the Philippines residing therein or abroad or an alien residing in the Philippines,
determined in accordance with the following schedule:

xxx xxx xxx

And in the implementation for the proper enforcement of the National Internal Revenue Code, Section 338 thereof
empowers the Secretary of Finance to "promulgate all needful rules and regulations" to effectively enforce its
provisions. 9

Pursuant to this authority, Revenue Memorandum Circular Nos. 7-71 10 and 41-71 11 were issued to prescribed
a uniform rate of exchange from US dollars to Philippine pesos for INTERNAL REVENUE TAX PURPOSES for
the years 1970 and 1971, respectively. Said revenue circulars were a valid exercise of the authority given to the
Secretary of Finance by the Legislature which enacted the Internal Revenue Code. And these are presumed to
be a valid interpretation of said code until revoked by the Secretary of Finance himself. 12

Petitioners argue that since there were no remittances and acceptances of their salaries and wages in US dollars
into the Philippines, they are exempt from the coverage of such circulars. Petitioners forget that they are citizens
of the Philippines, and their income, within or without, and in these cases wholly without, are subject to income
tax. Sec. 21, NIRC, as amended, does not brook any exemption.

Since petitioners have already paid their 1970 and 1971 income taxes under the uniform rate of exchange
prescribed under the aforestated Revenue Memorandum Circulars, there is no reason for respondent
Commissioner to refund any taxes to petitioner as said Revenue Memorandum Circulars, being of long standing
and not contrary to law, are valid. 13

Although it has become a worn-out cliche, the fact still remains that "taxes are the lifeblood of the government"
and one of the duties of a Filipino citizen is to pay his income tax.

WHEREFORE, the petitioners are denied for lack of merit. The dismissal by the respondent Court of Tax Appeals
of petitioners' claims for tax refunds for the income tax period for 1970 and 1971 is AFFIRMED. Costs against
petitioners.

SO ORDERED.

Narvasa, C.J., Padilla and Regalado, JJ., concur.

Melo, J., took no part.

4
 Republic of the Philippines
SUPREME COURT
Manila

EN BANC

G.R. No. L-65773-74 April 30, 1987

COMMISSIONER OF INTERNAL REVENUE, petitioner,

vs.
BRITISH OVERSEAS AIRWAYS CORPORATION and COURT OF TAX APPEALS, respondents.

Quasha, Asperilla, Ancheta, Peña, Valmonte & Marcos for respondent British Airways.

MELENCIO-HERRERA, J.:

Petitioner Commissioner of Internal Revenue (CIR) seeks a review on certiorari of the joint Decision of the Court
of Tax Appeals (CTA) in CTA Cases Nos. 2373 and 2561, dated 26 January 1983, which set aside petitioner's
assessment of deficiency income taxes against respondent British Overseas Airways Corporation (BOAC) for
the fiscal years 1959 to 1967, 1968-69 to 1970-71, respectively, as well as its Resolution of 18 November, 1983
denying reconsideration.

BOAC is a 100% British Government-owned corporation organized and existing under the laws of the United
Kingdom It is engaged in the international airline business and is a member-signatory of the Interline Air
Transport Association (IATA). As such it operates air transportation service and sells transportation tickets over
the routes of the other airline members. During the periods covered by the disputed assessments, it is admitted
that BOAC had no landing rights for traffic purposes in the Philippines, and was not granted a Certificate of public
convenience and necessity to operate in the Philippines by the Civil Aeronautics Board (CAB), except for a nine-
month period, partly in 1961 and partly in 1962, when it was granted a temporary landing permit by the CAB.
Consequently, it did not carry passengers and/or cargo to or from the Philippines, although during the period
covered by the assessments, it maintained a general sales agent in the Philippines — Wamer Barnes and
Company, Ltd., and later Qantas Airways — which was responsible for selling BOAC tickets covering passengers
and cargoes. 1

G.R. No. 65773 (CTA Case No. 2373, the First Case)

On 7 May 1968, petitioner Commissioner of Internal Revenue (CIR, for brevity) assessed BOAC the aggregate
amount of P2,498,358.56 for deficiency income taxes covering the years 1959 to 1963. This was protested by
BOAC. Subsequent investigation resulted in the issuance of a new assessment, dated 16 January 1970 for the
years 1959 to 1967 in the amount of P858,307.79. BOAC paid this new assessment under protest.

On 7 October 1970, BOAC filed a claim for refund of the amount of P858,307.79, which claim was denied by the
CIR on 16 February 1972. But before said denial, BOAC had already filed a petition for review with the Tax Court
on 27 January 1972, assailing the assessment and praying for the refund of the amount paid.

G.R. No. 65774 (CTA Case No. 2561, the Second Case)

On 17 November 1971, BOAC was assessed deficiency income taxes, interests, and penalty for the fiscal years
1968-1969 to 1970-1971 in the aggregate amount of P549,327.43, and the additional amounts of P1,000.00 and
P1,800.00 as compromise penalties for violation of Section 46 (requiring the filing of corporation returns)
penalized under Section 74 of the National Internal Revenue Code (NIRC).
5
On 25 November 1971, BOAC requested that the assessment be countermanded and set aside. In a letter,
dated 16 February 1972, however, the CIR not only denied the BOAC request for refund in the First Case but
also re-issued in the Second Case the deficiency income tax assessment for P534,132.08 for the years 1969 to
1970-71 plus P1,000.00 as compromise penalty under Section 74 of the Tax Code. BOAC's request for
reconsideration was denied by the CIR on 24 August 1973. This prompted BOAC to file the Second Case before
the Tax Court praying that it be absolved of liability for deficiency income tax for the years 1969 to 1971.

This case was subsequently tried jointly with the First Case.

On 26 January 1983, the Tax Court rendered the assailed joint Decision reversing the CIR. The Tax Court held
that the proceeds of sales of BOAC passage tickets in the Philippines by Warner Barnes and Company, Ltd.,
and later by Qantas Airways, during the period in question, do not constitute BOAC income from Philippine
sources "since no service of carriage of passengers or freight was performed by BOAC within the Philippines"
and, therefore, said income is not subject to Philippine income tax. The CTA position was that income from
transportation is income from services so that the place where services are rendered determines the source.
Thus, in the dispositive portion of its Decision, the Tax Court ordered petitioner to credit BOAC with the sum of
P858,307.79, and to cancel the deficiency income tax assessments against BOAC in the amount of P534,132.08
for the fiscal years 1968-69 to 1970-71.

Hence, this Petition for Review on certiorari of the Decision of the Tax Court.

The Solicitor General, in representation of the CIR, has aptly defined the issues, thus:

1. Whether or not the revenue derived by private respondent British Overseas Airways
Corporation (BOAC) from sales of tickets in the Philippines for air transportation, while having no
landing rights here, constitute income of BOAC from Philippine sources, and, accordingly, taxable.

2. Whether or not during the fiscal years in question BOAC s a resident foreign corporation doing
business in the Philippines or has an office or place of business in the Philippines.

3. In the alternative that private respondent may not be considered a resident foreign corporation
but a non-resident foreign corporation, then it is liable to Philippine income tax at the rate of thirty-
five per cent (35%) of its gross income received from all sources within the Philippines.

Under Section 20 of the 1977 Tax Code:

(h) the term resident foreign corporation engaged in trade or business within the Philippines or
having an office or place of business therein.

(i) The term "non-resident foreign corporation" applies to a foreign corporation not engaged in
trade or business within the Philippines and not having any office or place of business therein

It is our considered opinion that BOAC is a resident foreign corporation. There is no specific criterion as to what
constitutes "doing" or "engaging in" or "transacting" business. Each case must be judged in the light of its peculiar
environmental circumstances. The term implies a continuity of commercial dealings and arrangements, and
contemplates, to that extent, the performance of acts or works or the exercise of some of the functions normally
incident to, and in progressive prosecution of commercial gain or for the purpose and object of the business
organization. 2 "In order that a foreign corporation may be regarded as doing business within a State, there must
be continuity of conduct and intention to establish a continuous business, such as the appointment of a local
agent, and not one of a temporary character. 3

BOAC, during the periods covered by the subject - assessments, maintained a general sales agent in the
Philippines, That general sales agent, from 1959 to 1971, "was engaged in (1) selling and issuing tickets; (2)
6
breaking down the whole trip into series of trips — each trip in the series corresponding to a different airline
company; (3) receiving the fare from the whole trip; and (4) consequently allocating to the various airline
companies on the basis of their participation in the services rendered through the mode of interline settlement
as prescribed by Article VI of the Resolution No. 850 of the IATA Agreement." 4 Those activities were in exercise
of the functions which are normally incident to, and are in progressive pursuit of, the purpose and object of its
organization as an international air carrier. In fact, the regular sale of tickets, its main activity, is the very lifeblood
of the airline business, the generation of sales being the paramount objective. There should be no doubt then
that BOAC was "engaged in" business in the Philippines through a local agent during the period covered by the
assessments. Accordingly, it is a resident foreign corporation subject to tax upon its total net income received in
the preceding taxable year from all sources within the Philippines. 5

Sec. 24. Rates of tax on corporations. — ...

(b) Tax on foreign corporations. — ...

(2) Resident corporations. — A corporation organized, authorized, or existing under the laws of
any foreign country, except a foreign fife insurance company, engaged in trade or business within
the Philippines, shall be taxable as provided in subsection (a) of this section upon the total net
income received in the preceding taxable year from all sources within the Philippines. (Emphasis
supplied)

Next, we address ourselves to the issue of whether or not the revenue from sales of tickets by BOAC in the
Philippines constitutes income from Philippine sources and, accordingly, taxable under our income tax laws.

The Tax Code defines "gross income" thus:

"Gross income" includes gains, profits, and income derived from salaries, wages or compensation
for personal service of whatever kind and in whatever form paid, or from profession, vocations,
trades, business, commerce, sales, or dealings in property, whether real or personal, growing out
of the ownership or use of or interest in such property; also from interests, rents, dividends,
securities, or the transactions of any business carried on for gain or profile, or gains, profits, and
income derived from any source whatever (Sec. 29[3]; Emphasis supplied)

The definition is broad and comprehensive to include proceeds from sales of transport documents. "The words
'income from any source whatever' disclose a legislative policy to include all income not expressly exempted
within the class of taxable income under our laws." Income means "cash received or its equivalent"; it is the
amount of money coming to a person within a specific time ...; it means something distinct from principal or
capital. For, while capital is a fund, income is a flow. As used in our income tax law, "income" refers to the flow
of wealth. 6

The records show that the Philippine gross income of BOAC for the fiscal years 1968-69 to 1970-71 amounted
to P10,428,368 .00. 7

Did such "flow of wealth" come from "sources within the Philippines",

The source of an income is the property, activity or service that produced the income. 8 For the source of income
to be considered as coming from the Philippines, it is sufficient that the income is derived from activity within the
Philippines. In BOAC's case, the sale of tickets in the Philippines is the activity that produces the income. The
tickets exchanged hands here and payments for fares were also made here in Philippine currency. The site of
the source of payments is the Philippines. The flow of wealth proceeded from, and occurred within, Philippine
territory, enjoying the protection accorded by the Philippine government. In consideration of such protection, the
flow of wealth should share the burden of supporting the government.

7
A transportation ticket is not a mere piece of paper. When issued by a common carrier, it constitutes the contract
between the ticket-holder and the carrier. It gives rise to the obligation of the purchaser of the ticket to pay the
fare and the corresponding obligation of the carrier to transport the passenger upon the terms and conditions set
forth thereon. The ordinary ticket issued to members of the traveling public in general embraces within its terms
all the elements to constitute it a valid contract, binding upon the parties entering into the relationship. 9

True, Section 37(a) of the Tax Code, which enumerates items of gross income from sources within the
Philippines, namely: (1) interest, (21) dividends, (3) service, (4) rentals and royalties, (5) sale of real property,
and (6) sale of personal property, does not mention income from the sale of tickets for international
transportation. However, that does not render it less an income from sources within the Philippines. Section 37,
by its language, does not intend the enumeration to be exclusive. It merely directs that the types of income listed
therein be treated as income from sources within the Philippines. A cursory reading of the section will show that
it does not state that it is an all-inclusive enumeration, and that no other kind of income may be so considered. "
10

BOAC, however, would impress upon this Court that income derived from transportation is income for services,
with the result that the place where the services are rendered determines the source; and since BOAC's service
of transportation is performed outside the Philippines, the income derived is from sources without the Philippines
and, therefore, not taxable under our income tax laws. The Tax Court upholds that stand in the joint Decision
under review.

The absence of flight operations to and from the Philippines is not determinative of the source of income or the
site of income taxation. Admittedly, BOAC was an off-line international airline at the time pertinent to this case.
The test of taxability is the "source"; and the source of an income is that activity ... which produced the income.
11 Unquestionably, the passage documentations in these cases were sold in the Philippines and the revenue
therefrom was derived from a activity regularly pursued within the Philippines. business a And even if the BOAC
tickets sold covered the "transport of passengers and cargo to and from foreign cities", 12 it cannot alter the fact
that income from the sale of tickets was derived from the Philippines. The word "source" conveys one essential
idea, that of origin, and the origin of the income herein is the Philippines. 13

It should be pointed out, however, that the assessments upheld herein apply only to the fiscal years covered by
the questioned deficiency income tax assessments in these cases, or, from 1959 to 1967, 1968-69 to 1970-71.
For, pursuant to Presidential Decree No. 69, promulgated on 24 November, 1972, international carriers are now
taxed as follows:

... Provided, however, That international carriers shall pay a tax of 2-½ per cent on their cross
Philippine billings. (Sec. 24[b] [21, Tax Code).

Presidential Decree No. 1355, promulgated on 21 April, 1978, provided a statutory definition of the term "gross
Philippine billings," thus:

... "Gross Philippine billings" includes gross revenue realized from uplifts anywhere in the world
by any international carrier doing business in the Philippines of passage documents sold therein,
whether for passenger, excess baggage or mail provided the cargo or mail originates from the
Philippines. ...

The foregoing provision ensures that international airlines are taxed on their income from Philippine sources.
The 2-½ % tax on gross Philippine billings is an income tax. If it had been intended as an excise or percentage
tax it would have been place under Title V of the Tax Code covering Taxes on Business.

Lastly, we find as untenable the BOAC argument that the dismissal for lack of merit by this Court of the appeal
in JAL vs. Commissioner of Internal Revenue (G.R. No. L-30041) on February 3, 1969, is res judicata to the
present case. The ruling by the Tax Court in that case was to the effect that the mere sale of tickets,

8
unaccompanied by the physical act of carriage of transportation, does not render the taxpayer therein subject to
the common carrier's tax. As elucidated by the Tax Court, however, the common carrier's tax is an excise tax,
being a tax on the activity of transporting, conveying or removing passengers and cargo from one place to
another. It purports to tax the business of transportation. 14 Being an excise tax, the same can be levied by the
State only when the acts, privileges or businesses are done or performed within the jurisdiction of the Philippines.
The subject matter of the case under consideration is income tax, a direct tax on the income of persons and
other entities "of whatever kind and in whatever form derived from any source." Since the two cases treat of a
different subject matter, the decision in one cannot be res judicata to the other.

WHEREFORE, the appealed joint Decision of the Court of Tax Appeals is hereby SET ASIDE. Private
respondent, the British Overseas Airways Corporation (BOAC), is hereby ordered to pay the amount of
P534,132.08 as deficiency income tax for the fiscal years 1968-69 to 1970-71 plus 5% surcharge, and 1%
monthly interest from April 16, 1972 for a period not to exceed three (3) years in accordance with the Tax Code.
The BOAC claim for refund in the amount of P858,307.79 is hereby denied. Without costs.

SO ORDERED.

Paras, Gancayco, Padilla, Bidin, Sarmiento and Cortes, JJ., concur.

Fernan, J., took no part.

9
 Republic of the Philippines
SUPREME COURT
Manila

EN BANC

G.R. No. L-12287 August 7, 1918

VICENTE MADRIGAL and his wife, SUSANA PATERNO, plaintiffs-appellants,

vs.
JAMES J. RAFFERTY, Collector of Internal Revenue, and VENANCIO CONCEPCION, Deputy Collector
of Internal Revenue, defendants-appellees.

Gregorio Araneta for appellants.

Assistant Attorney Round for appellees.

MALCOLM, J.:

This appeal calls for consideration of the Income Tax Law, a law of American origin, with reference to the Civil
Code, a law of Spanish origin.

STATEMENT OF THE CASE.

Vicente Madrigal and Susana Paterno were legally married prior to January 1, 1914. The marriage was
contracted under the provisions of law concerning conjugal partnerships (sociedad de gananciales). On February
25, 1915, Vicente Madrigal filed sworn declaration on the prescribed form with the Collector of Internal Revenue,
showing, as his total net income for the year 1914, the sum of P296,302.73. Subsequently Madrigal submitted
the claim that the said P296,302.73 did not represent his income for the year 1914, but was in fact the income
of the conjugal partnership existing between himself and his wife Susana Paterno, and that in computing and
assessing the additional income tax provided by the Act of Congress of October 3, 1913, the income declared
by Vicente Madrigal should be divided into two equal parts, one-half to be considered the income of Vicente
Madrigal and the other half of Susana Paterno. The general question had in the meantime been submitted to the
Attorney-General of the Philippine Islands who in an opinion dated March 17, 1915, held with the petitioner
Madrigal. The revenue officers being still unsatisfied, the correspondence together with this opinion was
forwarded to Washington for a decision by the United States Treasury Department. The United States
Commissioner of Internal Revenue reversed the opinion of the Attorney-General, and thus decided against the
claim of Madrigal.

After payment under protest, and after the protest of Madrigal had been decided adversely by the Collector of
Internal Revenue, action was begun by Vicente Madrigal and his wife Susana Paterno in the Court of First
Instance of the city of Manila against Collector of Internal Revenue and the Deputy Collector of Internal Revenue
for the recovery of the sum of P3,786.08, alleged to have been wrongfully and illegally collected by the
defendants from the plaintiff, Vicente Madrigal, under the provisions of the Act of Congress known as the Income
Tax Law. The burden of the complaint was that if the income tax for the year 1914 had been correctly and lawfully
computed there would have been due payable by each of the plaintiffs the sum of P2,921.09, which taken
together amounts of a total of P5,842.18 instead of P9,668.21, erroneously and unlawfully collected from the
plaintiff Vicente Madrigal, with the result that plaintiff Madrigal has paid as income tax for the year 1914,
P3,786.08, in excess of the sum lawfully due and payable.

The answer of the defendants, together with an analysis of the tax declaration, the pleadings, and the stipulation,
sets forth the basis of defendants' stand in the following way: The income of Vicente Madrigal and his wife
Susana Paterno of the year 1914 was made up of three items: (1) P362,407.67, the profits made by Vicente
Madrigal in his coal and shipping business; (2) P4,086.50, the profits made by Susana Paterno in her embroidery

10
business; (3) P16,687.80, the profits made by Vicente Madrigal in a pawnshop company. The sum of these three
items is P383,181.97, the gross income of Vicente Madrigal and Susana Paterno for the year 1914. General
deductions were claimed and allowed in the sum of P86,879.24. The resulting net income was P296,302.73. For
the purpose of assessing the normal tax of one per cent on the net income there were allowed as specific
deductions the following: (1) P16,687.80, the tax upon which was to be paid at source, and (2) P8,000, the
specific exemption granted to Vicente Madrigal and Susana Paterno, husband and wife. The remainder,
P271,614.93 was the sum upon which the normal tax of one per cent was assessed. The normal tax thus arrived
at was P2,716.15.

The dispute between the plaintiffs and the defendants concerned the additional tax provided for in the Income
Tax Law. The trial court in an exhausted decision found in favor of defendants, without costs.

ISSUES.

The contentions of plaintiffs and appellants having to do solely with the additional income tax, is that is should
be divided into two equal parts, because of the conjugal partnership existing between them. The learned
argument of counsel is mostly based upon the provisions of the Civil Code establishing the sociedad de
gananciales. The counter contentions of appellees are that the taxes imposed by the Income Tax Law are as
the name implies taxes upon income tax and not upon capital and property; that the fact that Madrigal was a
married man, and his marriage contracted under the provisions governing the conjugal partnership, has no
bearing on income considered as income, and that the distinction must be drawn between the ordinary form of
commercial partnership and the conjugal partnership of spouses resulting from the relation of marriage.

DECISION.

From the point of view of test of faculty in taxation, no less than five answers have been given the course of
history. The final stage has been the selection of income as the norm of taxation. (See Seligman, "The Income
Tax," Introduction.) The Income Tax Law of the United States, extended to the Philippine Islands, is the result of
an effect on the part of the legislators to put into statutory form this canon of taxation and of social reform. The
aim has been to mitigate the evils arising from inequalities of wealth by a progressive scheme of taxation, which
places the burden on those best able to pay. To carry out this idea, public considerations have demanded an
exemption roughly equivalent to the minimum of subsistence. With these exceptions, the income tax is supposed
to reach the earnings of the entire non-governmental property of the country. Such is the background of the
Income Tax Law.

Income as contrasted with capital or property is to be the test. The essential difference between capital and
income is that capital is a fund; income is a flow. A fund of property existing at an instant of time is called capital.
A flow of services rendered by that capital by the payment of money from it or any other benefit rendered by a
fund of capital in relation to such fund through a period of time is called an income. Capital is wealth, while
income is the service of wealth. (See Fisher, "The Nature of Capital and Income.") The Supreme Court of Georgia
expresses the thought in the following figurative language: "The fact is that property is a tree, income is the fruit;
labor is a tree, income the fruit; capital is a tree, income the fruit." (Waring vs. City of Savannah [1878], 60 Ga.,
93.) A tax on income is not a tax on property. "Income," as here used, can be defined as "profits or gains."
(London County Council vs. Attorney-General [1901], A. C., 26; 70 L. J. K. B. N. S., 77; 83 L. T. N. S., 605; 49
Week. Rep., 686; 4 Tax Cas., 265. See further Foster's Income Tax, second edition [1915], Chapter IV; Black
on Income Taxes, second edition [1915], Chapter VIII; Gibbons vs. Mahon [1890], 136 U.S., 549; and Towne vs.
Eisner, decided by the United States Supreme Court, January 7, 1918.)

A regulation of the United States Treasury Department relative to returns by the husband and wife not living
apart, contains the following:

The husband, as the head and legal representative of the household and general custodian of its income, should
make and render the return of the aggregate income of himself and wife, and for the purpose of levying the

11
income tax it is assumed that he can ascertain the total amount of said income. If a wife has a separate estate
managed by herself as her own separate property, and receives an income of more than $3,000, she may make
return of her own income, and if the husband has other net income, making the aggregate of both incomes more
than $4,000, the wife's return should be attached to the return of her husband, or his income should be included
in her return, in order that a deduction of $4,000 may be made from the aggregate of both incomes. The tax in
such case, however, will be imposed only upon so much of the aggregate income of both shall exceed $4,000.
If either husband or wife separately has an income equal to or in excess of $3,000, a return of annual net income
is required under the law, and such return must include the income of both, and in such case the return must be
made even though the combined income of both be less than $4,000. If the aggregate net income of both
exceeds $4,000, an annual return of their combined incomes must be made in the manner stated, although
neither one separately has an income of $3,000 per annum. They are jointly and separately liable for such return
and for the payment of the tax. The single or married status of the person claiming the specific exemption shall
be determined as one of the time of claiming such exemption which return is made, otherwise the status at the
close of the year."

With these general observations relative to the Income Tax Law in force in the Philippine Islands, we turn for a
moment to consider the provisions of the Civil Code dealing with the conjugal partnership. Recently in two
elaborate decisions in which a long line of Spanish authorities were cited, this court in speaking of the conjugal
partnership, decided that "prior to the liquidation the interest of the wife and in case of her death, of her heirs, is
an interest inchoate, a mere expectancy, which constitutes neither a legal nor an equitable estate, and does not
ripen into title until there appears that there are assets in the community as a result of the liquidation and
settlement." (Nable Jose vs. Nable Jose [1916], 15 Off. Gaz., 871; Manuel and Laxamana vs. Losano [1918], 16
Off. Gaz., 1265.)

Susana Paterno, wife of Vicente Madrigal, has an inchoate right in the property of her husband Vicente Madrigal
during the life of the conjugal partnership. She has an interest in the ultimate property rights and in the ultimate
ownership of property acquired as income after such income has become capital. Susana Paterno has no
absolute right to one-half the income of the conjugal partnership. Not being seized of a separate estate, Susana
Paterno cannot make a separate return in order to receive the benefit of the exemption which would arise by
reason of the additional tax. As she has no estate and income, actually and legally vested in her and entirely
distinct from her husband's property, the income cannot properly be considered the separate income of the wife
for the purposes of the additional tax. Moreover, the Income Tax Law does not look on the spouses as individual
partners in an ordinary partnership. The husband and wife are only entitled to the exemption of P8,000
specifically granted by the law. The higher schedules of the additional tax directed at the incomes of the wealthy
may not be partially defeated by reliance on provisions in our Civil Code dealing with the conjugal partnership
and having no application to the Income Tax Law. The aims and purposes of the Income Tax Law must be given
effect.

The point we are discussing has heretofore been considered by the Attorney-General of the Philippine Islands
and the United States Treasury Department. The decision of the latter overruling the opinion of the Attorney-
General is as follows:

TREASURY DEPARTMENT, Washington.

Income Tax.

FRANK MCINTYRE,
Chief, Bureau of Insular Affairs, War Department,
Washington, D. C.

SIR: This office is in receipt of your letter of June 22, 1915, transmitting copy of correspondence "from
the Philippine authorities relative to the method of submission of income tax returns by marred person."

12
You advise that "The Governor-General, in forwarding the papers to the Bureau, advises that the Insular
Auditor has been authorized to suspend action on the warrants in question until an authoritative decision
on the points raised can be secured from the Treasury Department."

From the correspondence it appears that Gregorio Araneta, married and living with his wife, had an
income of an amount sufficient to require the imposition of the net income was properly computed and
then both income and deductions and the specific exemption were divided in half and two returns made,
one return for each half in the names respectively of the husband and wife, so that under the returns as
filed there would be an escape from the additional tax; that Araneta claims the returns are correct on the
ground under the Philippine law his wife is entitled to half of his earnings; that Araneta has dominion over
the income and under the Philippine law, the right to determine its use and disposition; that in this case
the wife has no "separate estate" within the contemplation of the Act of October 3, 1913, levying an
income tax.

It appears further from the correspondence that upon the foregoing explanation, tax was assessed
against the entire net income against Gregorio Araneta; that the tax was paid and an application for
refund made, and that the application for refund was rejected, whereupon the matter was submitted to
the Attorney-General of the Islands who holds that the returns were correctly rendered, and that the
refund should be allowed; and thereupon the question at issue is submitted through the Governor-
General of the Islands and Bureau of Insular Affairs for the advisory opinion of this office.

By paragraph M of the statute, its provisions are extended to the Philippine Islands, to be administered
as in the United States but by the appropriate internal-revenue officers of the Philippine Government.
You are therefore advised that upon the facts as stated, this office holds that for the Federal Income Tax
(Act of October 3, 1913), the entire net income in this case was taxable to Gregorio Araneta, both for the
normal and additional tax, and that the application for refund was properly rejected.

The separate estate of a married woman within the contemplation of the Income Tax Law is that which
belongs to her solely and separate and apart from her husband, and over which her husband has no right
in equity. It may consist of lands or chattels.

The statute and the regulations promulgated in accordance therewith provide that each person of lawful
age (not excused from so doing) having a net income of $3,000 or over for the taxable year shall make
a return showing the facts; that from the net income so shown there shall be deducted $3,000 where the
person making the return is a single person, or married and not living with consort, and $1,000 additional
where the person making the return is married and living with consort; but that where the husband and
wife both make returns (they living together), the amount of deduction from the aggregate of their several
incomes shall not exceed $4,000.

The only occasion for a wife making a return is where she has income from a sole and separate estate
in excess of $3,000, but together they have an income in excess of $4,000, in which the latter event either
the husband or wife may make the return but not both. In all instances the income of husband and wife
whether from separate estates or not, is taken as a whole for the purpose of the normal tax. Where the
wife has income from a separate estate makes return made by her husband, while the incomes are added
together for the purpose of the normal tax they are taken separately for the purpose of the additional tax.
In this case, however, the wife has no separate income within the contemplation of the Income Tax Law.

Respectfully,

DAVID A. GATES.
Acting Commissioner.

13
In connection with the decision above quoted, it is well to recall a few basic ideas. The Income Tax Law was
drafted by the Congress of the United States and has been by the Congress extended to the Philippine Islands.
Being thus a law of American origin and being peculiarly intricate in its provisions, the authoritative decision of
the official who is charged with enforcing it has peculiar force for the Philippines. It has come to be a well-settled
rule that great weight should be given to the construction placed upon a revenue law, whose meaning is doubtful,
by the department charged with its execution. (U.S. vs. Cerecedo Hermanos y Cia. [1907], 209 U.S., 338; In re
Allen [1903], 2 Phil., 630; Government of the Philippine Islands vs. Municipality of Binalonan, and Roman
Catholic Bishop of Nueva Segovia [1915], 32 Phil., 634.) We conclude that the judgment should be as it is hereby
affirmed with costs against appellants. So ordered.

Torres, Johnson, Carson, Street and Fisher, JJ., concur.

14
 135 F.2d 310 (1943)
INTERNATIONAL FREIGHTING CORPORATION, INC.,
v.
COMMISSIONER OF INTERNAL REVENUE.
No. 5.

Circuit Court of Appeals, Second Circuit.

March 6, 1943.

*311 Before L. HAND, CHASE and FRANK, Circuit Judges.

Paul E. Shorb, and Marion P. Wormhoudt, both of Washington, D. C., and David C. Moore, of Wilmington, Del.
(Covington, Burling, Rublee, Acheson & Shorb, of Washington, D. C., of counsel), for petitioner.

Samuel O. Clark, Jr., Asst. Atty. Gen., and Sewall Key and Warren F. Wattles, Sp. Assts. to the Atty. Gen., for
respondent.

During the years 1933 to 1935, inclusive, E. I. duPont deNemours and Company, Inc., owned all of taxpayer's
stock and during the year 1936 it owned two-thirds of taxpayer's stock, the balance being owned by the General
Motors Corporation. During the years 1933 to 1936, inclusive, taxpayer informally adopted the bonus plan of the
duPont Company as its own bonus plan. Class A or class B bonus awards, or both, might be made to employees
under that plan. Class B bonus awards (the only ones here involved) might be granted to those employees who,
by their ability, efficiency and loyalty, had contributed most in a general way to the taxpayer's success, and were
to be made from the portion of taxpayer's profits which its finance committee had set aside in the class B bonus
fund. Only those employees were eligible for class B awards who on January first of the year in which the awards
were made had been in the continuous employ of taxpayer at least two years. Recommendations for bonuses
were to be made by the president or the heads of departments and were to be acted on by the executive
committee or the board of directors. It was not incumbent on the executive committee or the board of directors
to distribute the entire amount available in the fund. The taxpayer reserved the right at any time to discontinue
the awarding of any bonuses.

Bonuses were in the form of common stock of the duPont Company or in the form of cash to be invested in such
stock. Class B bonuses were to be awarded during February of each year "for services rendered *312 during the
preceding year." Annually upon the granting of awards, a "bonus custodian" was to notify each beneficiary of his
bonus award. This bonus custodian, appointed by the executive committee, was to manage all matters relating
to bonus awards. When a class B bonus was awarded or invested in the common stock of duPont Company, a
certificate for one-fourth of the shares, free from all restrictions, was to be delivered to the beneficiary
immediately, and certificates for the balance were to be delivered to the bonus custodian who was to hold them
for release to the beneficiary as follows: One-fourth of the total number of shares after the end of one year; one-
fourth after the end of two years; and one-fourth after the end of three years. The bonus custodian was to open
account with each beneficiary charging, i. e., debiting, him with the total number of shares in his award of
investment, crediting him immediately with the one-fourth thereof then released to him, and crediting him
thereafter each month at the rate of 1/48 of such total number of shares beginning with January of the year in
which the award was made. If, however, the beneficiary left taxpayer's service or was dismissed, the portions of
his stock represented at the time by the debit balance of his account might be sold at the then market value and
the proceeds transferred to the class B bonus fund, but a certificate for the remaining portion of the stock was to
be delivered to the beneficiary. An award in stock was to vest in the beneficiary all the rights of a stockholder in
such stock, subject (1) to the right of the bonus custodian to possession of certificates evidencing the portion of
the stock not immediately released; and (2) the right of the taxpayer, in case the beneficiary left taxpayer's service
or was dismissed, to have that portion of the stock represented at the time by the debit balance of the
beneficiary's account sold at the market value and the proceeds transferred to taxpayer. As to shares not
immediately deliverable to the beneficiary, the bonus custodian was to procure from each beneficiary an
irrevocable power of attorney (1) permitting the sale of the shares in the custody of the custodian at the time the
15
beneficiary ceased to be an employee of the company, (2) providing that the beneficiary would not dispose of
stock in such custody, and (3) providing that stock dividends were to be held by the custodian until release of
the stock upon which it was a stock dividend.

Pursuant to the bonus plan, taxpayer's board of directors made class B bonus awards to certain of its employees
in common stock of the duPont Company as follows: 100 shares in 1934 being awards for 1933; 128 shares in
1935 being awards for 1934; 188 shares in 1936 being awards for 1935. During the calendar year 1936 taxpayer
paid over and distributed to the beneficiaries of its class B bonus award, certificates representing 150 shares of
the common stock of the duPont Company, whose cost to taxpayer at the date of delivery was $16,153.36 and
whose market value was then $24,858.75. Each of the employees receiving those shares in 1936 paid a tax
thereon, computing the market value at the time of delivery as taxable income.

Taxpayer took a deduction of $24,858.75 in its income tax return for 1936 on account of the 150 shares of stock
distributed in that year to its employees. In a notice of deficiency the Commissioner reduced the deduction from
$24,858.75 to $16,153.35, a difference of $8,705.39, determining that, as the bonus was paid in property, "the
basis for calculation of the amount thereof is the cost of such property and not its market value as claimed on
the return." This was the only adjustment which the Commissioner made to taxpayer's return and, as a result,
the Commissioner determined a deficiency in the amount of $2,156.76, in taxpayer's tax liability for the year.
Taxpayer filed a petition with the Tax Court for a redetermination of the deficiency thus determined. By an
amended answer, the Commissioner, in the alternative, alleged that if it were held that taxpayer was entitled to
a deduction in the amount of $24,858.75 on account of the payment of bonus in stock, then taxpayer realized a
taxable profit of $8,705.39 on the disposition of the shares, and taxpayer's net taxable income otherwise
determined should be increased accordingly.

The Tax Court held that taxpayer was entitled to a deduction for compensation paid in the year 1936 in the
amount of $24,858.75. The Tax Court decided for the Commissioner, however, on the defense set forth in the
Commissioner's amended answer, holding that taxpayer realized a gain of $8,705.39 in 1936 by paying the class
B bonus in stock which had cost taxpayer $8,705.39 less than its market value when taxpayer transferred the
stock to its employees. The deficiency resulting from this decision *313 was $2,156.76. From that decision
taxpayer seeks review.

FRANK, Circuit Judge.

1. Up to the time in 1936 when the shares were delivered to the employees, the taxpayer retained such control
of the shares that title had not passed to the employees.[1] We think the Tax Court correctly held that the market
value at the time of delivery was properly deducted by the taxpayer as an ordinary expense of the business
under Revenue Act 1936, § 23(a), 26 U.S.C.A. Int.Rev.Code § 23(a), because that delivery was an additional
reasonable compensation for past services actually rendered. Cf. Lucas v. Ox Fibre Brush Co., 281 U.S. 115,
50 S. Ct. 273, 74 L. Ed. 733.[2] The payment depleted the taxpayer's assets in an amount equal to that market
value fully as much as if taxpayer had, at the time of delivery, first purchased those shares.

2. We turn to the question whether the transaction resulted in taxable gain to taxpayer. We think that the Tax
Court correctly held that it did. The delivery of those shares was not a gift, else (1) it would have been wrongful
as against taxpayer's stockholders, (2) the value of the shares could not have been deducted as an expense
under § 23(a), and (3) the employees as donees would not be obliged to pay, as they must, [3] an income tax on
what they received. It was not a gift precisely because it was "compensation for services actually rendered," i.
e., because the taxpayer received a full quid pro quo. Accordingly, cases holding that one is not liable for an
income tax when he makes a gift of shares are not in point. Nor is General Utilities & Operating Co. v. Helvering,
296 U.S. 200, 56 S. Ct. 185, 80 L. Ed. 154, pertinent. For there the distribution was by way of a dividend to the
taxpayer's own shareholders; in effect they received in altered form what they had theretofore owned collectively;
as no quid pro quo passed to the taxpayer from those distributees, there was no closed taxable transaction; by
the same token, that taxpayer could not have deducted anything from its income on account of that distribution.

16
But, as the delivery of the shares here constituted a disposition for a valid consideration, it resulted in a closed
transaction with a consequent realized gain. It is of no relevance that here the taxpayer had not been legally
obligated to award any shares or pay any additional compensation to the employees; bonus payments by
corporations are recognized as proper even if there was no previous obligation to make them; although then not
obligatory, they are regarded as made for a sufficient consideration.[4] Since the bonuses would be invalid to the
extent that what was delivered to the employees exceeded what the services of the employees were worth, it
follows that the consideration received by the taxpayer from the employees must be deemed to be equal at least
to the value of the shares in 1936. Here then, as there was no gift but a disposition of shares for a valid
consideration equal at least to the market value of the shares when delivered, there was a taxable gain equal to
the difference between the cost of the shares and that market value.

For § 111(a) of the Revenue Act of 1936, 26 U.S.C.A. Int.Rev.Code § 111(a) provides that the gain from "the
sale or other disposition of property" shall be the excess of "the amount realized therefrom" over "the adjusted
basis" provided in § 113(b), and § 113(b) in the light of § 113(a), 26 U.S. C.A.Int.Rev.Code § 113(a) makes the
"basis" the cost of such property. True, § 111(b) provides that "the amount realized" is the sum of "any money
received plus the fair market value of the property (other than money) received." Literally, where there is a
disposition of stock for services, no "property" or "money" is received by the person who thus disposes of the
stock. But, in similar circumstances, it has been held that "money's worth" is received and that such a receipt
comes within § 111(b). See Commissioner v. Mesta, 3 Cir., 123 F.2d 986, 988; cf. Commissioner v. Halliwell, 2
*314 Cir., December 1, 1942, 131 F.2d 642; Kenan v. Commissioner, 2 Cir., 114 F.2d 217.[5]

The taxpayer properly asks us to treat this case "as if there had been no formal bonus plan" and as if taxpayer
"had simply paid outright 150 shares of duPont stock to selected employees as additional compensation." On
that basis, surely there was a taxable gain. For to shift the equation once more, the case supposed is the
equivalent of one in which the taxpayer in the year 1936, without entering into a previous contract fixing the
amount of compensation, had employed a transposition expert for one day and, when he completed his work,
had paid him 5 shares of duPont stock having market value at that time of $500 but which it had bought in a
previous year for $100. There can be no doubt that, from such a transaction, taxpayer would have a taxable
gain. And so here.

The order of the Tax Court is affirmed.

17
 Republic of the Philippines
SUPREME COURT
Manila

EN BANC

G.R. No. 44100 September 22, 1938

WM. H. ANDERSON, plaintiff-appellee,

vs.
JUAN POSADAS, JR., Collector of Internal Revenue, defendant-appellant.

Solicitor-General Hilado for appellant.

Ohnick & Opisso for appellee.

VILLA-REAL, J.:

This is an appeal taken by Juan Posadas, Jr., as Collector of Internal Revenue, from the judgment rendered by
the Court of First Instance of Manila, the dispositive part of which is as follows:

For the foregoing considerations, judgment is rendered:

xxx xxx xxx

4. Approving the deduction of the sum of P42,542.63 representing 100 per cent surcharge on income
tax, disapproved in 1921; .

5. Holding that the amount of P155,000, representing the alleged proceeds of the supposed sale of the
"Goodwill Account", is not subject to income tax, and .

6. Holding that the amount of P125,000, representing an allegedly recovered loss, is not subject to income
tax.

It is ordered that a new assessment of said plaintiff's income tax returns, with reference to these six (6)
items, be made as above-indicated, and upon the termination of said reassessment, the defendant is
ordered to return to the plaintiff any amount in excess of what should be paid under said new assessment,
without interest or costs. It is so ordered.

In support of his appeal, the appellant assigns the following alleged errors as committed by the court a quo in its
judgment in question, to wit:

1. The lower court erred in approving a deduction made in the appellee's income tax return for 1921, in
the amount of P42,542.63, paid as 100 per cent surcharge on the income tax due for 1918 and 1919.

2. The lower court erred in holding that the amount of P125,000, found by the appellant as losses
recovered, is not subject to income tax.

3. The lower court erred in holding that the amount of P155,000, found by the appellant as proceeds from
the sale of good will, is not subject to income tax.

4. The lower court erred in ordering the appellant to make a new income tax assessment against the
appellee and to return to him whatever amount he had paid in excess of the amount that he should pay
under the new assessment.
18
 5. The lower court erred in denying the appellant's motion for new trial on the ground that the decision
was contrary to law and that the evidence was insufficient to justify the same.

The first question to be decided, which is raised in the first assignment of alleged error, is whether or not the
sum of P42,542.63, paid by the appellee Wm. H. Anderson as penalty for fraud committed in his income tax
returns corresponding to the years 1918 and 1919, may be deducted from the income tax return made by him
for the year 1921.

Section 5 of Act No. 2833 of the Philippine Legislature, commonly knows as the Income Tax Law, enumerates
the items that may be deducted in computing the net income of a citizen or resident of the Philippines, but the
amount paid as penalty for fraud is not mentioned aiming them. Section 15 of said provides, among other things,
that "In case a false or fraudulent return or list is willfully made, the Collector of Internal Revenue shall add to the
tax one hundred 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 neglect,
falsity, or fraud, in which case the amount so added shall be collected in the same manner as the tax." Pursuant
to the authority conferred by the Revised Administrative Code and by Act No. 2833, as amended by Act No.
2926, the Department of Finance, under whose jurisdiction the Bureau of Internal Revenue falls, promulgated,
on August 17, 1921, Regulations No. 20, entitled "Income Tax Regulations," section 33 of which, in interpreting
the word "taxes," provides, among other things, as follows: "The word 'taxes' means taxes proper and no
deductions should be allowed for amounts representing interest or penalties incident to delinquency."

Black, in his book "Income Tax Digest," section 355, page 166, states as follows:

FINES AND PENALTIES. — Fines paid because of a violation of law are not deductible even if the
violation is in connection with a trade or business. Items of this type are deemed not to arise from the
ordinary and necessary conduct of business.

It appears, therefore, that in the opinion of the writer Black and of the Department of Finance, fines imposed for
violation of law cannot be considered taxes paid to the Government, which should be deducted from income
subject to the payment of income tax. The tax under consideration is levied on income, while the fine is paid as
penalty for violation of the Internal Revenue Law. The fine, therefore, cannot be considered a tax, inasmuch as
it is not levied on income. In providing that the fine should be added to the tax and collected at the same time
and as a part thereof, the law had for its purpose merely to facilitate the collection of the fine or surcharge.

Furthermore, in the case of Molina vs. Rafferty (38 Phil., 167), this court has laid down the doctrine, cited with
approval in the case of People vs. Hernandez (59 Phil., 272), that "Long continued administrative interpretation
of a tax law, while not conclusive, should be followed unless clearly erroneous." (See also 59 Corpus Juris, 1025,
sec. 609.)

Regulations No. 20, issued by the Department of Finance, were promulgated on August 17, 1921, and published
in volume XX, No. 18, page 323, of the Official Gazette, on February 11, 1922, that is, more than 16 years ago.
The Bureau of Internal Revenue has constantly been enforcing them and no question as to their validity has ever
been raised by anybody. Neither have they been amended by the Legislature which had enacted the law whose
provisions relative to deductions for tax purposes are interpreted by said regulations No. 20. Such silence, under
the rule on interpretation of laws, signifies acquiescene in such construction (59 Corpus Juris, 1037, sec. 613).
While it is true that the above-cited doctrine of this court establishes the exception that the interpretation be not
clearly erroneous, yet it does not appear, for the foregoing reasons, that the interpretation given by the
Department of Finance to the case under consideration in erroneous.

This court, therefore, finds the first assignment of alleged error to be well founded.

19
With respect to the second assignment of alleged error, it is connected that the court a quo erred in holding that
the amount of P125,000, found by the appellant as losses recovered, is not subject to the payment of income
tax.

William H. Anderson had purchased the business of Erlanger & Galinger. In 1915, he incorporated said
partnership under the firm name of Erlanger & Galinger, Inc., with an authorized capital of P600,000, divided into
1,200 shares at the bar value of P500 each. All of said shares were subscribed by the incorporator Anderson,
who paid in cash, on different dates, the total; amount of P70,000. The unpaid balance of P530,000 was entered
in an intermediary account, called underwriting account, which was opened in the corporation in Anderson's
name, in place of his personal account.

On January 1, 1918, there was opened in Anderson's name a good will account, upon the debit side of which
was entered the sum of P300,000. On the same date, the sum of P300,000 was entered upon the credit side of
Anderson's underwriting account, thereby reducing the balance thereof from P530,000 to P230,000.

On said date, January 1, 1918, Anderson sold to Simon Feldstein 200 shares at the rate of 2 to 1, receiving in
payment thereof the sum of P 50,000 with a loss of P50,000.

On January 2d of the same year, Anderson sold 300 more shares to Feldstein at the rate of 3 to 1, and received
in payment thereof the sum of P50,000, having lost P100,000 in the transaction.

In view of said losses, Anderson deducted the sum of P50,000 from the taxable income stated by him in his
return for the year 1918, and the sum of P75,000 from his return for the year 1919, or a total amount of P125,000.
Said deductions were approved by the Bureau of Internal Revenue.

As the Collector of Internal Revenue attempted to collect tax on the P300,000 at which Anderson assessed the
good will of the business' the latter, on December 29, 1923, agreed with the former to eliminate said good will,
which in effect was so done by debiting said sum in his capital account and crediting it in the good will account.
With said elimination, Anderson's debt of P530,000 was restored. To Feldstein's account was debited the sum
of P125,007 which, together with the P100,000 paid by him for the 500 shares which he had bought of Anderson,
to the latter's loss, amounts to P225,007. Said sum of P125,007 was the proportional part of the P300,000 which
correspondent to Feldstein, for the above-stated 500 shares, at the rate of 7/12 for Anderson and 5/12 for
Feldstein.

On January 2, 1924, the sum of P134,169 was debited in Anderson's personal account and that of P95,831 in
Feldstein's capital account, in the same proportion of 7/12 for the former and 5/12 for the latter, that is, the
amount of P230,000, thereby eliminating the underwriting account in said..

It appears, therefore, that with the P100,00 paid by Feldstein on account of the 500 shares bought by him
Anderson, plus the sum of P125,007 debited to Feldstein's account, which is equivalent to 5/12 of the good will
of P300,000, which corresponds to Feldstein for his participation in the share of the corporation, and the above-
stated sum of P95,831, the total amount debited in Simon Feldstein's account is P320,838. This amount exceeds
the sum of P250,000, which represents the value, at the rate of P500 each, of the 500 shares sold to Feldstein
by Anderson. Therefore, as the total of the 500 shares, at the par value of P500 each, has been debited in
Feldstein's account, the loss of P125,000 suffered by Anderson at the hearing, by reason of the sale of said 500
shares, has been recovered, and it is but just that the sum of P125,000, deducted from the profits by reason of
losses suffered temporarily on the capital, be restored thereto.

It is not attempted to consider the sum of P125,000 as profit obtained from the sale of the 500 shares to Feldstein
by Anderson, but as the restoration of a temporarily loss in the same amount, which was deducted from the
income corresponding to the years 1918 and 1919.

The second assignment of alleged error, is likewise well founded.

20
The ruling of the lower court that the amount of P155,000, found by the appellant as proceeds form the sale of
good will, is not subject to income tax, is assigned as third alleged error.

According to Reynolds, a witness for the plaintiff, the good will account of P155,000 was created "because the
conditions of the business deserved the establishment of this item." The phrase "good will" is defined in 28
Corpus Juris, 729, section 1, as follows:

Good will may be defined to be the advantage or benefit which is acquired by an establishment, beyond
the mere value of the capital stock, funds, or property employed therein in consequence of the general
public patronage and encouragement which it receives from constant or habitual customers on account
of its local position or common celebrity or reputation for skill, affluence, punctuality, or from other
accidental circumstances or necessities, or even from accident partialities or prejudices. . . .

According to the above-quoted definition, good will is the reputation of good name of an establishment. If the
good will, that is, the good reputation of the business is acquired in the course of its management and operation,
it does form part of the capital with which it was established. It is an intangible moral profit, susceptible of
valuation in money, acquired by the business by reason of the confidence reposed in it by the public, due to the
efficiency and honesty shown by the manager and personnel thereof in conducting the same on account of the
courtesy accorded its customers, which moral profit, once it is valuated and used, becomes a part of the assets.
The good will of P155,000 created by Anderson has been beneficial not only to him but also to Feldstein in the
proportion of 7/12 for Anderson and 5/12 for Feldstein, which is the proportion of the participation of each in the
shares of the corporation Erlanger & Galinger, Inc., that is, P90,412 for Anderson and P64,588 for Feldstein,
inasmuch as Anderson's personal debt for the balance of the unpaid shares, was dismissed by said sum of
P90,412 and Feldstein's capital account increased by P64,588.

The benefit received by Anderson does not consist merely in the sum of P90,412. He also realized a gain of
P70,838 from the sale of 500 shares to Feldstein. Said benefits, added to gather, make a total of P161,250, that
is, P6,250 more than the sum of P155,000 on which the defendant and appellant Collector of Internal Revenue
is attempting to collect tax from him.

In view of the foregoing considerations, this court is of the opinion and so holds: (1) That the fines paid as penalty
by a taxpayer cannot be deducted from the amount subject to the payment of income tax; (2) that the amount
deducted from the income by reason of temporary partial loss from the capital should, upon the recovery of said
loss, be restored to the profits and pay the corresponding tax, and (3) that the good will created by an incorporator
in the course of the business of a corporation and appraisal to pay the unpaid [price of shares subscribed to by
said incorporator, is a profit and is subject to the payment of income tax.

Wherefore, the appealed judgment is reversed in so far as it (1) approves the deduction of the amount of
P42,542.63, which represents 100 per cent surcharges on income tax; (2) holds that the amount of P125,000,
deducted from the income as loss which was recovered later, is not subject to income tax, and (3) holds that the
amount of P155,00, representing the proceeds of the sale of good will, is not subject to income tax, and the
defendant is absolved from the complaint, with the costs to the plaintiff. So ordered.

Avanceña, C.J., Abad Santos, Imperial, Diaz, Laurel and Concepcion, JJ., concur.

21
 Republic of the Philippines
SUPREME COURT
Manila

EN BANC

G.R. No. L-21570 July 26, 1966

LIMPAN INVESTMENT CORPORATION, petitioner,

vs.
COMMISSIONER OF INTERNAL REVENUE, ET AL., respondents.

Vicente L. San Luis for petitioner.

Office of the Solicitor General A. A. Alafriz, Assistant Solicitor General F. B. Rosete, Solicitor A. B. Afurong and
Atty. V. G. Saldajeno for respondents.

REYES, J.B.L., J.:

Appeal interposed by petitioner Limpan Investment Corporation against a decision of the Court of Tax Appeals,
in its CTA Case No. 699, holding and ordering it (petitioner) to pay respondent Commissioner of Internal Revenue
the sums of P7,338.00 and P30,502.50, representing deficiency income taxes, plus 50% surcharge and 1%
monthly interest from June 30, 1959 to the date of payment, with cost.

The facts of this case are:

Petitioner, a domestic corporation duly registered since June 21, 1955, is engaged in the business of leasing
real properties. It commenced actual business operations on July 1, 1955. Its principal stockholders are the
spouses Isabelo P. Lim and Purificacion Ceñiza de Lim, who own and control ninety-nine per cent (99%) of its
total paid-up capital. Its president and chairman of the board is the same Isabelo P. Lim.1äwphï1.ñët

Its real properties consist of several lots and buildings, mostly situated in Manila and in Pasay City, all of which
were acquired from said Isabelo P. Lim and his mother, Vicente Pantangco Vda. de Lim.

Petitioner corporation duly filed its 1956 and 1957 income tax returns, reporting therein net incomes of P3,287.81
and P11,098.36, respectively, for which it paid the corresponding taxes therefor in the sums of P657.00 and
P2,220.00.

Sometime in 1958 and 1959, the examiners of the Bureau of Internal Revenue conducted an investigation of
petitioner's 1956 and 1957 income tax returns and, in the course thereof, they discovered and ascertained that
petitioner had underdeclared its rental incomes by P20,199.00 and P81,690.00 during these taxable years and
had claimed excessive depreciation of its buildings in the sums of P4,260.00 and P16,336.00 covering the same
period. On the basis of these findings, respondent Commissioner of Internal Revenue issued its letter-
assessment and demand for payment of deficiency income tax and surcharge against petitioner corporation,
computed as follows:

90-AR-C-348-58/56
Net income per audited return P 3,287.81
Add: Unallowable deductions:
Undeclared Rental Receipt

22
 (Sched. A) . . . . . . . . . . . . . . . . . . . . P20,199.00
Excess Depreciation (Sched. B) . . . . . . . . . . . . . . . . . 4,260.00 P24,459.00
Net income per investigation P27,746.00
Tax due thereon P5,549.00
Less: Amount already assessed 657.00
Balance P4,892.00
Add: 50% Surcharge 2,446.00
DEFICIENCY TAX DUE P7,338.00
90-AR-C-1196-58/57
Net income per audited return P11,098.00
Add: Unallowable deductions:
Undeclared Rental Receipt (Sched. A) . . . . . . . . P81,690.00
Excess Depreciation (Sched. B) . . . . . . . . . . . . . . . 16,338.00 P98,028.00
Net income per investigation P109,126.00
Tax due thereon P22,555.00
Less: Amount already assessed 2,220.00
Balance 20,335.00
Add: 50% Surcharge 10,167.50
DEFICIENCY TAX DUE P30,502.50

Petitioner corporation requested respondent Commissioner of Internal Revenue to reconsider the above
assessment but the latter denied said request and reiterated its original assessment and demand, plus 5%
surcharge and the 1% monthly interest from June 30, 1959 to the date of payment; hence, the corporation filed
its petition for review before the Tax Appeals court, questioning the correctness and validity of the above
assessment of respondent Commissioner of Internal Revenue. It disclaimed having received or collected the
amount of P20,199.00, as unreported rental income for 1956, or any part thereof, reasoning out that 'the previous
owners of the leased building has (have) to collect part of the total rentals in 1956 to apply to their payment of
rental in the land in the amount of P21,630.00" (par. 11, petition). It also denied having received or collected the
amount of P81,690.00, as unreported rental income for 1957, or any part thereof, explaining that part of said
amount totalling P31,380.00 was not declared as income in its 1957 tax return because its president, Isabelo P.
Lim, who collected and received P13,500.00 from certain tenants, did not turn the same over to petitioner
corporation in said year but did so only in 1959; that a certain tenant (Go Tong) deposited in court his rentals
amounting to P10,800.00, over which the corporation had no actual or constructive control; and that a sub-tenant
paid P4,200.00 which ought not be declared as rental income.

Petitioner likewise alleged in its petition that the rates of depreciation applied by respondent Commissioner of its
buildings in the above assessment are unfair and inaccurate.

Sole witness for petitioner corporation in the Tax Court was its Secretary-Treasurer, Vicente G. Solis, who
admitted that it had omitted to report the sum of P12,100.00 as rental income in its 1956 tax return and also the

23
sum of P29,350.00 as rental income in its 1957 tax return. However, with respect to the difference between this
omitted income (P12,100.00) and the sum (P20,199.00) found by respondent Commissioner as undeclared in
1956, petitioner corporation, through the same witness (Solis), tried to establish that it did not collect or receive
the same because, in view of the refusal of some tenants to recognize the new owner, Isabelo P. Lim and Vicenta
Pantangco Vda. de Lim, the former owners, on one hand, and the same Isabelo P. Lim, as president of petitioner
corporation, on the other, had verbally agreed in 1956 to turn over to petitioner corporation six per cent (6%) of
the value of all its properties, computed at P21,630.00, in exchange for whatever rentals the Lims may collect
from the tenants. And, with respect to the difference between the admittedly undeclared sum of P29,350.00 and
that found by respondent Commissioner as unreported rental income, (P81,690.00) in 1957, the same witness
Solis also tried to establish that petitioner corporation did not receive or collect the same but that its president,
Isabelo P. Lim, collected part thereof and may have reported the same in his own personal income tax return;
that same Isabelo P. Lim collected P13,500.00, which he turned over to petitioner in 1959 only; that a certain
tenant (Go Tong deposited in court his rentals (P10,800.00), over which the corporation had no actual or
constructive control and which were withdrawn only in 1958; and that a sub-tenant paid P4,200.00 which ought
not be declared as rental income in 1957.

With regard to the depreciation which respondent disallowed and deducted from the returns filed by petitioner,
the same witness tried to establish that some of its buildings are old and out of style; hence, they are entitled to
higher rates of depreciation than those adopted by respondent in his assessment.

Isabelo P. Lim was not presented as witness to corroborate the above testimony of Vicente G. Solis.

On the other hand, Plaridel M. Mingoa, one of the BIR examiners who personally conducted the investigation of
the 1956 and 1957 income tax returns of petitioner corporation, testified for the respondent that he personally
interviewed the tenants of petitioner and found that these tenants had been regularly paying their rentals to the
collectors of either petitioner or its president, Isabelo P. Lim, but these payments were not declared in the
corresponding returns; and that in applying rates of depreciation to petitioner's buildings, he adopted Bulletin "F"
of the U.S. Federal Internal Revenue Service.

On the basis of the evidence, the Tax Court upheld respondent Commissioner's assessment and demand for
deficiency income tax which, as above stated in the beginning of this opinion, petitioner has appealed to this
Court.

Petitioner corporation pursues, the same theory advocated in the court below and assigns the following alleged
errors of the trial court in its brief, to wit:

I. The respondent Court erred in holding that the petitioner had an unreported rental income of
P20,199.00 for the year 1956.

II. The respondent Court erred in holding that the petitioner had an unreported rental income of
P81,690.00 for the year 1957.

III. The respondent Court erred in holding that the depreciation in the amount of P20,598.00 claimed by
petitioner for the years 1956 and 1957 was excessive.

and prays that the appealed decision be reversed.

This appeal is manifestly unmeritorious. Petitioner having admitted, through its own witness (Vicente G. Solis),
that it had undeclared more than one-half (1/2) of the amount (P12,100.00 out of P20,199.00) found by the BIR
examiners as unreported rental income for the year 1956 and more than one-third (1/3) of the amount
(P29,350.00 out of P81,690.00) ascertained by the same examiners as unreported rental income for the year
1957, contrary to its original claim to the revenue authorities, it was incumbent upon it to establish the remainder
of its pretensions by clear and convincing evidence, that in the case is lacking.

24
With respect to the balance, which petitioner denied having unreported in the disputed tax returns, the excuse
that Isabelo P. Lim and Vicenta Pantangco Vda. de Lim retained ownership of the lands and only later transferred
or disposed of the ownership of the buildings existing thereon to petitioner corporation, so as to justify the alleged
verbal agreement whereby they would turn over to petitioner corporation six percent (6%) of the value of its
properties to be applied to the rentals of the land and in exchange for whatever rentals they may collect from the
tenants who refused to recognize the new owner or vendee of the buildings, is not only unusual but
uncorroborated by the alleged transferors, or by any document or unbiased evidence. Hence, the first assigned
error is without merit.

As to the second assigned error, petitioner's denial and explanation of the non-receipt of the remaining
unreported income for 1957 is not substantiated by satisfactory corroboration. As above noted, Isabelo P. Lim
was not presented as witness to confirm accountant Solis nor was his 1957 personal income tax return submitted
in court to establish that the rental income which he allegedly collected and received in 1957 were reported
therein.

The withdrawal in 1958 of the deposits in court pertaining to the 1957 rental income is no sufficient justification
for the non-declaration of said income in 1957, since the deposit was resorted to due to the refusal of petitioner
to accept the same, and was not the fault of its tenants; hence, petitioner is deemed to have constructively
received such rentals in 1957. The payment by the sub-tenant in 1957 should have been reported as rental
income in said year, since it is income just the same regardless of its source.

On the third assigned error, suffice it to state that this Court has already held that "depreciation is a question of
fact and is not measured by theoretical yardstick, but should be determined by a consideration of actual facts",
and the findings of the Tax Court in this respect should not be disturbed when not shown to be arbitrary or in
abuse of discretion (Commissioner of Internal Revenue vs. Priscila Estate, Inc., et al., L-18282, May 29, 1964),
and petitioner has not shown any arbitrariness or abuse of discretion in the part of the Tax Court in finding that
petitioner claimed excessive depreciation in its returns. It appearing that the Tax Court applied rates of
depreciation in accordance with Bulletin "F" of the U.S. Federal Internal Revenue Service, which this Court
pronounced as having strong persuasive effect in this jurisdiction, for having been the result of scientific studies
and observation for a long period in the United States, after whose Income Tax Law ours is patterned (M. Zamora
vs. Collector of internal Revenue & Collector of Internal Revenue vs. M. Zamora; E. Zamora vs. Collector of
Internal Revenue and Collector of Internal Revenue vs. E. Zamora, Nos. L-15280, L-15290, L-15289 and L-
15281, May 31, 1963), the foregoing error is devoid of merit.

Wherefore, the appealed decision should be, as it is hereby, affirmed. With costs against petitioner-appellant,
Limpan Investment Corporation.

Concepcion, C.J., Barrera, Dizon, Regala, Makalintal, Bengzon, J.P., Zaldivar, Sanchez and Castro, JJ., concur.

25
 Republic of the Philippines
SUPREME COURT
Manila

EN BANC

G.R. No. L-21108 November 29, 1966

REPUBLIC OF THE PHILIPPINES, plaintiff-appellant,

vs.
LEONOR DE LA RAMA, ET AL., respondents-appellees.

Office of the Solicitor General for plaintiff-appellant.

Meer, Meer and Meer for respondents-appellees.

ZALDIVAR, J.:

This is an appeal from the decision of the Court of First Instance of Manila, dated December 23, 1961, in its Civil
Case No. 46494, dismissing the complaint of the Republic of the Philippines against the heirs of the late Esteban
de la Rama from the collection of P56,032.50 as deficiency income tax, inclusive of 50% surcharge, for the year
1950.

The estate of the late Esteban de la Rama was the subject of Special Proceedings No. 401 of the Court of First
Instance of Iloilo. The executor-administrator, Eliseo Hervas, filed on March 12, 1951, income tax returns of the
estate corresponding to the taxable year 1950, declaring a net income of P22,796.59, on the basis of which the
amount of P3,919.00 was assessed and was paid by the estate as income tax. The Bureau of Internal Revenue
later claimed that it had found out that there had been received by the estate in 1950 from the De la Rama
Steamship Company, Inc. cash dividends amounting to P86,800.00, which amount was not declared in the
income tax return of the estate for the year 1950. The Bureau of Internal Revenue then, on March 7, 1956, made
an assessment as deficiency income tax against the estate in the sum of P56,032.50 of which amount
P37,355.00 was the deficiency and P18,677.50 was the 50% surcharge.

The Collector of Internal Revenue wrote a letter, dated February 29, 1956, to Mrs. Lourdes de la Rama-Osmeña
informing her of the deficiency income tax and asking payment thereof. On March 13, 1956 the latter's counsel
wrote to the Collector acknowledging receipt of the assessment but contended that Lourdes de la Rama-Osmeña
had no authority to represent the estate, and that the assessment should be sent to Leonor de la Rama who was
pointed to by said counsel as the administratrix of the estate of her late father. On the basis of this information
the Deputy Collector of Internal Revenue, on November 22, 1956, sent a letter to Leonor de la Rama as
administratrix of the estate, asking payment. The tax, as assessed, not having been paid, the Deputy
Commissioner of Internal Revenue, on September 7, 1959, wrote another letter to Mrs. Lourdes de la Rama-
Osmeña demanding, through her, upon the heirs, the payment of the deficiency income tax within the period of
thirty days from receipt thereof. The counsel of Lourdes de la Rama-Osmeña, in a letter dated September 25,
1959, insisted that the letter should be sent to Leonor de la Rama. The Deputy Commissioner of Internal
Revenue wrote to Leonor de la Rama another letter, dated February 11, 1960, demanding, through her as
administratrix, upon the heirs of Esteban de la Rama, the payment of the sum of P56,032.50, as deficiency
income tax including the 50% surcharge, to the City Treasurer of Pasay City within thirty days from receipt
thereof.

The deficiency income tax not having been paid, the Republic of the Philippines filed on March 6, 1961 with the
Court of First Instance of Manila a complaint against the heirs of Esteban de la Rama, seeking to collect from
each heir his/her proportionate share in the income tax liability of the estate. An amended complaint dated August
31, 1961, was admitted by the court.

26
The defendants-appellees, Lourdes de la Rama-Osmeña, Leonor de la Rama, Estefania de la Rama-Pirovano,
Dolores de la Rama-Lopez, Charles Miller, and Aniceta de la Rama-Sian, thru counsel, filed their respective
answers, the gist of their allegations and/or defenses being (1) that no cash dividends of P86,800.00 had been
paid to the estate; (2) that the administration of the estate had been extended by the probate court precisely for
the purpose of collecting said dividends; (3) that Leonor dela Rama had never been administratrix of the estate;
(4) that the executor of the estate, Eliseo Hervas, had never been given notice of the assessment, and
consequently the assessment had never become final; and (5) that the collection of the alleged deficiency income
tax had prescribed. Fausto F. Gonzales, Jr., one of the defendants, not having filed an answer, was declared in
default.

From the evidence introduced at the trial, both oral and documentary, the lower court found that the dividends of
P86,800.00 declared by the De la Rama Steamship Co. in favor of the late Esteban de la Rama were applied to
the obligation of the estate to the company declaring the dividends; that Leonor de la Rama was not the
administratrix of the estate, but it was the late Eliseo Hervas who was the executor-administrator; that the
administration of the estate was extended for the purpose of recovering for the estate said dividends from the
De la Rama Steamship Co., Inc.; and that the question of whether the deceased Esteban de la Rama was a
debtor to the entity known as the Hijos de I. de la Rama, which was also indebted to the De la Rama Steamship
Co., Inc., was not a settled one.

After trial, the lower court rendered its decision, dated December 23, 1961, dismissing the complaint. The
Republic of the Philippines appealed from said decision to the Court of Appeals, but the appeal was later certified
to this Court because only questions of law are involved.

Plaintiff-appellant contends that the trial court erred (1) in holding that there was no basis for the assessment
upon the ground that it was not proved that the income in question was received by the estate of Esteban de la
Rama or by his heirs; (2) in not holding that the income was constructively received by the estate of the late
Esteban de la Rama; (3) in not holding that the heirs and legatees of the late Esteban de la Rama were liable
for the payment of the deficiency income tax; (4) in not holding that the assessment involved in the case had
long become final; (5) in not holding that the service of the notice of assessment on Lourdes de la Rama-Osmeña
and Leonor de la Rama was proper and valid; and (6) in not holding that said court had no jurisdiction to take
cognizance of appellees' defense that the assessment in question was erroneous.

Plaintiff-appellant argues that the deficiency income tax in this case was assessed in the sum of P86,800.00
representing cash dividends declared in ]1950 by the De la Rama Steamship Co., Inc. in favor of the late Esteban
de la Rama and was applied as payment of the latter's account with the former. The application of payment
appears in the books of said creditor company as follows:

Against accounts receivable due from

Esteban de la Rama P25,255.24

Against the account due from Hijos de I.

de la Rama, Inc., of which Don Esteban
de la Rama was the principal owner P61,544.76

Total P86,800.00

The plaintiff-appellant maintains that this crediting of accounts in the books of the company constituted a
constructive receipt by the estate or the heirs of Esteban de la Rama of the dividends, and this dividend was an
income of the estate and was, therefore, taxable.

It is not disputed that the dividends in question were not actually paid either to the estate, or to the heirs, of the
late Esteban de la Rama. The question to be resolved is whether or not the said application of the dividends to
the personal accounts of the deceased Esteban de la Rama constituted constructive payment to, and hence,
27
constructively received by, the estate or the heirs. If the debts to which the dividends were applied really existed,
and were legally demandable and chargeable against the deceased, there was constructive receipt of the
dividends; if there were no such debts, then there was no constructive receipt.

The first debt, as above indicated, had been contested by the executor-administrator of the estate. It does not
even appear that the De la Rama Steamship Co., Inc. had ever filed a claim against the estate in connection
with that indebtedness. The existence and the validity of the debt is, therefore, in dispute, and there was no proof
adduced to show the existence and validity of the debt.

The second debt to which the dividends were partly applied were accounts "due from Hijos de I. de la Rama,
Inc." The alleged debtor here was an entity separate and distinct from the deceased. If that was so, its debts
could not be charged against the deceased, even if the deceased was the principal owner thereof, in the absence
of proof of substitution of debtor. There is no evidence in the instant case that the late Esteban de la Rama
substituted the "Hijos de I. de la Rama" as debtor to the De la Rama Steamship Co., Inc.; nor was there evidence
that the estate of the late Esteban de la Rama owned the "Hijos de I. de la Rama, Inc.," this fact being, as found
by the lower court, not a settled question because the same was denied by the administrator.

Under the National Internal Revenue Code, income tax is assessed on income that has been received. Thus,
Section 21 of the Code requires that the income must be received by an individual before a tax can be levied
thereon.

Sec. 21. Rates of tax on citizens or residents.—There shall be levied, collected, and paid annually upon
the entire net income received in the preceding taxable year from all sources by every individual, a citizen
or resident of the Philippines, . . .

Section 56 also requires receipt of income by an estate before an income tax can be assessed thereon. It
provides:

Sec. 56. Imposition of tax.—(a) Application of tax.—The taxes imposed by this Title upon individuals shall
apply to the income of estates or of any kind of property held in trust, including —

xxx xxx xxx

(3) Income received by estates of deceased persons during the period of administration or settlement of
the estate; . . .

Hence, if income has not been received, no income tax can be assessed thereon. Inasmuch as, the income was
not received either by the estate, or by the heirs, neither the estate nor the heir can be liable for the payment of
income tax therefor.

The trial court, therefore, did not err when it held in its decision that:

After a study of the proofs, the Court is constrained to sustain the position of the defendants on the
fundamental issue that there could have been no correct and real basis for the assessment or that there
is no proof that the income in question had been received; it was not actually delivered unto the Estate
since it was retained by the De la Rama Steamship Co., Inc.; which applied said dividends to certain
accounts receivable due from the deceased allegedly, Exh. A-1; now if truly there had been such
indebtedness owing from the deceased unto said De la Rama Steamship Co., Inc., the Court will agree
with plaintiff that the offsetting of the dividends against such indebtedness amounted to constructive
delivery; but here has not been presented any proof to that effect, i.e., that there was such an
indebtedness due from deceased; on the contrary what the evidence shows is that the former
administrator of the Estate had challenged the validity of said indebtedness, Exh. D, motion of 4 June,
1951; that being the case, there is no clear showing that income in the form of said dividends had really
28
 been received, which is the verb used in Section 21 of the Internal Revenue Code, by the Estate whether
actually or constructively; and the income tax being collected by the Government on income received,
the Government's position is here without a clear basis; the position becomes worse when it be
considered that it is not even the Estate that is being sued but the heirs themselves, who admittedly had
not received any of said dividends themselves; the fiction of transfer of ownership by succession from
the death of the decedent will have to give way to actual fact that the dividends have not been adjudicated
at all to the heirs up to now at least so far as the evidence shows. This being the conclusion of the Court,
there will be no need to discuss the question of whether the action has or has not prescribed.

The factual findings of the trial court, as stated in the above-quoted portion of the decision, are decisive in the
determination of the legal issues in this case.

Appellant cites the case of Herbert v. Commissioner of Internal Revenue, 81 F. (2d) 912 as authority that the
crediting of dividends against accounts constitutes payment and constructive receipt of the dividends. The
citation of authority misses the point in issue. In that case the existence of the indebtedness of Leon S. Herbert
to the corporation that declared the dividends and against which indebtedness the dividends were applied, was
never put in issue, and was admitted. In the instant case, the existence of the obligations has been disputed
and, as the trial court found, has not been proved. It having been shown in the instant case that there was no
basis for the assessment of the income tax, the assessment itself and the sending of notices regarding the
assessment would neither have basis, and so that assessment and the notices produced no legal effect that
would warrant the collection of the tax.

The appellant also contends that the assessment had become final, because the decision of the Collector of
Internal Revenue was sent in a letter dated February 11, 1960 and addressed to the heirs of the late Esteban
de la Rama, through Leonor de la Rama as administratrix of the estate, and was not disputed or contested by
way of appeal within thirty days from receipt thereof to the Court of Tax Appeals. This contention is untenable.
The lower court found that Leonor de la Rama was not the administratrix of the estate of Esteban de la Rama.
The alleged deficiency income tax for 1950 was chargeable against the estate of the deceased Esteban de la
Rama. On December 5, 1955, when the letter of notice for the assessment of the deficiency income tax was first
sent to Leonor de la Rama (See Annex "A" of Answer of defendant Lourdes de la Rama-Osmeña, pp. 16-17,
Record on Appeal, the administration proceedings, in Special Proceedings No. 401 of the Court of First Instance
of Iloilo, were still open with respect to the controverted matter regarding the cash dividends upon which the
deficiency assessment was levied. This is clear from the order dated June 21, 1951 (Exhibit "E") of the Court of
First Instance of Iloilo which in part provides:

El albacea-administrador hace constar, sin embargo, que quedan por cobrar ciertos dividendos
declarados y devengados por las acciones del finado Esteban de la Rama en The De la Rama Steamship
Co., Inc., que los funcionarios de dicha corporacion . . . no han pagado aun . . . y que por tales motivos
habria necesidad de prolongar la administracion, solamente para que esta continue atendiendo con
autorizacion, a tales menesteres.

xxx xxx xxx

Se ordena el cierre de la Administracion; pero se provee, sin embargo, la extension de la misma,

solamente para el proposito de iniciar y proseguir hasta su terminacion una accion contra The De la
Rama Steamship Co., Inc. para el cobro de dividendos declarados por dicha corporacion en Diciembre
31, 1950 sobre las 869 acciones del finado Esteban de la Rama en la misma . . . .

Y finalmente, queda relevado el Administrador Sr. Eliseo Hervas de toda responsibilidad en relacion con
su administracion, excepto en lo que respecta al cobro de dividendos . . . .

The estate was still under the administration of Eliseo Hervas as regards the collection of said dividends. The
administrator was the representative of the estate, whose duty it was to pay and discharge all debts and charges

29
on the estate and to perform all orders of the court by him to be performed (Rule 71, Section 1), and to pay the
taxes and assessments due to the Government or any branch or subdivision thereof (Section 7, Rule 89, Old
Rules of Court). The tax must be collected from the estate of the deceased, and it is the administrator who is
under obligation to pay such claim (Estate of Claude E. Haygood.) (Collector of Internal Revenue v. Haygood,
65 Phil. 520). The notice of assessment, therefore, should have been sent to the administrator. In this case,
notice was first sent to Lourdes de la Rama-Osmeña on February 29, 1956, and later to Leonor de la Rama on
November 27, 1956, neither of whom had authority to represent the estate. As the lower court said in its decision:
"Leonor de la Rama was not the administratrix of the estate of the late Esteban de la Rama and as such the
demand unto her, Exh. Def. 8, p. 112, was not a correct demand before November 27, 1956, because the real
administrator was the late Eliseo Hervas; . . . ." (p. 45, Record on Appeal) The notice was not sent to the taxpayer
for the purpose of giving effect to the assessment, and said notice could not produce any effect. In the case of
Bautista and Corrales Tan v. Collector of Internal Revenue, L-12259, May 27, 1959, this Court had occasion to
state that "the assessment is deemed made when the notice to this effect is released, mailed or sent to the
taxpayer for the purpose of giving effect to said assessment." It appearing that the person liable for the payment
of the tax did not receive the assessment, the assessment could not become final and executory (R. A. 1125,
Section 11).

Plaintiff-appellant also contends that the lower court could not take cognizance of the defense that the
assessment was erroneous, this being a matter that is within the exclusive jurisdiction of the Court of Tax
Appeals. This contention has no merit. According to Republic Act 1125, the Court of Tax Appeals has exclusive
jurisdiction to review by appeal decisions of the Collector of Internal Revenue in cases involving disputed
assessments, and the disputed assessment must be appealed by the person adversely affected by the decision
within thirty days after the receipt of the decision. In the instant case, the person adversely affected should have
been the administrator of the estate, and the notice of the assessment should have been sent to him. The
administrator had not received the notice of assessment, and he could not appeal the assessment to the Court
of Tax Appeals within 30 days from notice. Hence the assessment did not fall within the exclusive jurisdiction of
the Court of Tax Appeals.

IN VIEW OF THE FOREGOING, the decision appealed from should be, as it is hereby, affirmed, without costs.

Concepcion, C.J., Reyes, J.B.L., Barrera, Dizon, Regala, Makalintal, Bengzon, J.P., Sanchez and Castro, JJ.,
concur.

30
 United States Supreme Court

EISNER v. MACOMBER(1920)

No. 318

Argued: April 16, 1919Decided: March 8, 1920

[252 U.S. 189, 190] Mr. Assistant Attorney General Frierson, for plaintiff in error.

[252 U.S. 189, 194] Messrs. Charles E. Hughes and George Welwood Murray, both of New York City, for
defendant in error.

[252 U.S. 189, 199]

Mr. Justice PITNEY delivered the opinion of the Court.

This case presents the question whether, by virtue of the Sixteenth Amendment, Congress has the power to tax,
as income of the stockholder and without apportionment, a stock dividend made lawfully and in good faith against
profits accumulated by the corporation since March 1, 1913.

It arises under the Revenue Act of September 8, 1916 (39 Stat. 756 et seq., c. 463 [Comp. St. 6336a et seq.]),
which, in our opinion ( notwithstanding a contention of the government that will be [252 U.S. 189, 200] noticed),
plainly evinces the purpose of Congress to tax stock dividends as income. 1

The facts, in outline, are as follows:

On January 1, 1916, the Standard Oil Company of California, a corporation of that state, out of an authorized
capital stock of $100,000, 000, had shares of stock outstanding, par value $100 each, amounting in round figures
to $50,000,000. In addition, it had surplus and undivided profits invested in plant, property, and business and
required for the purposes of the corporation, amounting to about $45,000,000, of which about $20,000,000 had
been earned prior to March 1, 1913, the balance thereafter. In January, 1916, in order to readjust the
capitalization, the board of directors decided to issue additional shares sufficient to constitute a stock dividend
of 50 per cent. of the outstanding stock, and to transfer from surplus account to capital stock account an amount
equivalent to such issue. Appropriate resolutions were adopted, an amount equivalent to the par value of the
proposed new stock was transferred accordingly, and the new stock duly issued against it and divided among
the stockholders.

Defendant in error, being the owner of 2,200 shares of the old stock, received certificates for 1,100 additional
[252 U.S. 189, 201] shares, of which 18.07 per cent., or 198.77 shares, par value $19,877, were treated as
representing surplus earned between March 1, 1913, and January 1, 1916. She was called upon to pay, and did
pay under protest, a tax imposed under the Revenue Act of 1916, based upon a supposed income of $ 19,877
because of the new shares; and an appeal to the Commissioner of Internal Revenue having been disallowed,
she brought action against the Collector to recover the tax. In her complaint she alleged the above facts, and
contended that in imposing such a tax the Revenue Act of 1916 violated article 1, 2, cl. 3, and article 1, 9, cl. 4,
of the Constitution of the United States, requiring direct taxes to be apportioned according to population, and
that the stock dividend was not income within the meaning of the Sixteenth Amendment. A general demurrer to
the complaint was overruled upon the authority of Towne v. Eisner, 245 U.S. 418 , 38 Sup. Ct. 158, L. R. A.
1918D, 254; and, defendant having failed to plead further, final judgment went against him. To review it, the
present writ of error is prosecuted.

The case was argued at the last term, and reargued at the present term, both orally and by additional briefs.

31
We are constrained to hold that the judgment of the District Court must be affirmed: First, because the question
at issue is controlled by Towne v. Eisner, supra; secondly, because a re-examination of the question with the
additional light thrown upon it by elaborate arguments, has confirmed the view that the underlying ground of that
decision is sound, that it disposes of the question here presented, and that other fundamental considerations
lead to the same result.

In Towne v. Eisner, the question was whether a stock dividend made in 1914 against surplus earned prior to
January 1, 1913, was taxable against the stockholder under the Act of October 3, 1913 (38 Stat. 114, 166, c. 16
), which provided (section B, p. 167) that net income should include 'dividends,' and also 'gains or profits and
income derived [252 U.S. 189, 202] from any source whatever.' Suit having been brought by a stockholder to
recover the tax assessed against him by reason of the dividend, the District Court sustained a demurrer to the
complaint. 242 Fed. 702. The court treated the construction of the act as inseparable from the interpretation of
the Sixteenth Amendment; and, having referred to Pollock v. Farmers' Loan & Trust Co., 158 U.S. 601 , 15 Sup.
Ct. 912, and quoted the Amendment, proceeded very properly to say (242 Fed. 704):

'It is manifest that the stock dividend in question cannot be reached by the Income Tax Act and could
not, even though Congress expressly declared it to be taxable as income, unless it is in fact income.'

It declined, however, to accede to the contention that in Gibbons v. Mahon, 136 U.S. 549 , 10 Sup. Ct. 1057,
'stock dividends' had received a definition sufficiently clear to be controlling, treated the language of this court in
that case as obiter dictum in respect of the matter then before it (242 Fed. 706), and examined the question as
res nova, with the result stated. When the case came here, after overruling a motion to dismiss made by the
government upon the ground that the only question involved was the construction of the statute and not its
constitutionality, we dealt upon the merits with the question of construction only, but disposed of it upon
consideration of the essential nature of a stock dividend disregarding the fact that the one in question was based
upon surplus earnings that accrued before the Sixteenth Amendment took effect. Not only so, but we rejected
the reasoning of the District Court, saying ( 245 U.S. 426 , 38 Sup. Ct. 159, L. R. A. 1918D, 254):

'Notwithstanding the thoughtful discussion that the case received below we cannot doubt that the dividend
was capital as well for the purposes of the Income Tax Law as for distribution between tenant for life and
remainderman. What was said by this court upon the latter question is equally true for the former. 'A stock
dividend really takes nothing from the property of the corporation, and adds nothing to the [252 U.S. 189,
203] interests of the shareholders. Its property is not diminished, and their interests are not increased.
... The proportional interest of each shareholder remains the same. The only change is in the evidence
which represents that interest, the new shares and the original shares together representing the same
proportional interest that the original shares represented before the issue of the new ones.' Gibbons v.
Mahon, 136 U.S. 549, 559 , 560 S. [10 Sup. Ct. 1057]. In short, the corporation is no poorer and the
stockholder is no richer than they were before. Logan County v. United States, 169 U.S. 255 , 261 [18
Sup. Ct. 361]. If the plaintiff gained any small advantage by the change, it certainly was not an advantage
of $417,450, the sum upon which he was taxed. ... What has happened is that the plaintiff's old certificates
have been split up in effect and have diminished in value to the extent of the value of the new.'

This language aptly answered not only the reasoning of the District Court but the argument of the Solic itor
General in this court, which discussed the essential nature of a stock dividend. And if, for the reasons thus
expressed, such a dividend is not to be regarded as 'income' or 'dividends' within the meaning of the act of 1913,
we are unable to see how it can be brought within the meaning of 'incomes' in the Sixteenth Amendment; it being
very clear that Congress intended in that act to exert its power to the extent permitted by the amendment. In
Towne v. Eisner it was not contended that any construction of the statute could make it narrower than the
constitutional grant; rather the contrary.

The fact that the dividend was charged against profits earned before the act of 1913 took effect, even before the
amendment was adopted, was neither relied upon nor alluded to in our consideration of the merits in that case.
Not only so, but had we considered that a stock dividend constituted income in any true sense, it would have
been held taxable under the act of 1913 notwithstanding it was [252 U.S. 189, 204] based upon profits earned
32
before the amendment. We ruled at the same term, in Lynch v. Hornby, 247 U.S. 339 , 38 Sup. Ct. 543, that a
cash dividend extraordinary in amount, and in Peabody v. Eisner, 247 U.S. 347 , 38 Sup. Ct. 546, that a dividend
paid in stock of another company, were taxable as income although based upon earnings that accrued before
adoption of the amendment. In the former case, concerning 'corporate profits that accumulated before the act
took effect,' we declared ( 247 U.S. 343, 344 , 38 S. Sup. Ct. 543, 545 [62 L. Ed. 1149]):

'Just as we deem the legislative intent manifest to tax the stockholder with respect to such accumulations
only if and when, and to the extent that, his interest in them comes to fruition as income, that is, in
dividends declared, so we can perceive no constitutional obstacle that stands in the way of carrying out
this intent when dividends are declared out of a pre-existing surplus. ... Congress was at liberty under
the amendment to tax as income, without apportionment, everything that became income, in the ordinary
sense of the word, after the adoption of the amendment, including dividends received in the ordinary
course by a stockholder from a corporation, even though they were extraordinary in amount and might
appear upon analysis to be a mere realization in possession of an inchoate and contingent interest that
the stockholder had in a surplus of corporate assets previously existing.'

In Peabody v. Eisner, 247 U.S. 349, 350 , 38 S. Sup. Ct. 546, 547 (62 L. Ed. 1152), we observed that the decision
of the District Court in Towne v. Eisner had been reversed 'only upon the ground that it related to a stock dividend
which in fact took nothing from the property of the corporation and added nothing to the interest of the
shareholder, but merely changed the evidence which represented that interest,' and we distinguished the
Peabody Case from the Towne Case upon the ground that 'the dividend of Baltimore & Ohio shares was not a
stock dividend but a distribution in specie of a portion of the assets of the Union Pacific.'

Therefore Towne v. Eisner cannot be regarded as turning [252 U.S. 189, 205] upon the point that the surplus
accrued to the company before the act took effect and before adoption of the amendment. And what we have
quoted from the opinion in that case cannot be regarded as obiter dictum, it having furnished the entire basis for
the conclusion reached. We adhere to the view then expressed, and might rest the present case there, not
because that case in terms decided the constitutional question, for it did not, but because the conclusion there
reached as to the essential nature of a stock dividend necessarily prevents its being regarded as income in any
true sense.

Nevertheless, in view of the importance of the matter, and the fact that Congress in the Revenue Act of 1916
declared (39 Stat. 757 [Comp. St . 6336b]) that a 'stock dividend shall be considered income, to the amount of
its cash value,' we will deal at length with the constitutional question, incidentally testing the soundness of our
previous conclusion.

The Sixteenth Amendment must be construed in connection with the taxing clauses of the original Constitution
and the effect attributed to them before the amendment was adopted. In Pollock v. Farmers' Loan & Trust Co.,
158 U.S. 601 , 15 Sup. Ct. 912, under the Act of August 27, 1894 (28 Stat. 509, 553, c. 349, 27), it was held that
taxes upon rents and profits of real estate and upon returns from investments of personal property were in effect
direct taxes upon the property from which such income arose, imposed by reason of ownership; and that
Congress could not impose such taxes without apportioning them among the states according to population, as
required by article 1, 2, cl. 3, and section 9, cl. 4, of the original Constitution.

Afterwards, and evidently in recognition of the limitation upon the taxing power of Congress thus determined, the
Sixteenth Amendment was adopted, in words lucidly expressing the object to be accomplished:

'The Congress shall have power to lay and collect taxes on incomes, from whatever source derived,
without apportionment among [252 U.S. 189, 206] the several states, and without regard to any census
or enumeration.'

As repeatedly held, this did not extend the taxing power to new subjects, but merely removed the necessity
which otherwise might exist for an apportionment among the states of taxes laid on income. Brushaber v. Union

33
Pacific R. R. Co., 240 U.S. 1 , 17-19, 36 Sup. Ct. 236, Ann. Cas. 1917B, 713, L. R. A. 1917D, 414; Stanton v.
Baltic Mining Co., 240 U.S. 103 , 112 et seq., 36 Sup. Ct. 278; Peck & Co. v. Lowe, 247 U.S. 165, 172 , 173 S.,
38 Sup. Ct. 432.

A proper regard for its genesis, as well as its very clear language, requires also that this amendment shall not
be extended by loose construction, so as to repeal or modify, except as applied to income, those provisions of
the Constitution that require an apportionment according to population for direct taxes upon property, real and
personal. This limitation still has an appropriate and important function, and is not to be overridden by Congress
or disregarded by the courts.

In order, therefore, that the clauses cited from article 1 of the Constitution may have proper force and effect,
save only as modified by the amendment, and that the latter also may have proper effect, it becomes essential
to distinguish between what is and what is not 'income,' as the term is there used, and to apply the distinction,
as cases arise, according to truth and substance, without regard to form. Congress cannot by any definition it
may adopt conclude the matter, since it cannot by legislation alter the Constitution, from which alone it derives
its power to legislate, and within whose limitations alone that power can be lawfully exercised.

The fundamental relation of 'capital' to 'income' has been much discussed by economists, the former being
likened to the tree or the land, the latter to the fruit or the crop; the former depicted as a reservoir supplied from
springs, the latter as the outlet stream, to be measured by its flow during a period of time. For the present purpose
we require only a clear definition of the term 'income,' [252 U.S. 189, 207] as used in common speech, in order
to determine its meaning in the amendment, and, having formed also a correct judgment as to the nature of a
stock dividend, we shall find it easy to decide the matter at issue.

After examining dictionaries in common use (Bouv. L. D.; Standard Dict.; Webster's Internat. Dict.; Century Dict.),
we find little to add to the succinct definition adopted in two cases arising under the Corporation Tax Act of 1909
(Stratton's Independence v. Howbert, 231 U.S. 399, 415 , 34 S. Sup. Ct. 136, 140 [58 L. Ed. 285]; Doyle v.
Mitchell Bros. Co., 247 U.S. 179, 185 , 38 S. Sup. Ct. 467, 469 [62 L. Ed. 1054]), 'Income may be defined as the
gain derived from capital, from labor, or from both combined,' provided it be understood to include profit gained
through a sale or conversion of capital assets, to which it was applied in the Doyle Case, 247 U.S. 183, 185 , 38
S. Sup. Ct. 467, 469 (62 L. Ed. 1054).

Brief as it is, it indicates the characteristic and distinguishing attribute of income essential for a correct solution
of the present controversy. The government, although basing its argument upon the definition as quoted, placed
chief emphasis upon the word 'gain,' which was extended to include a variety of meanings; while the significance
of the next three words was either overlooked or misconceived. 'Derived-from- capital'; 'the gain-derived-from-
capital,' etc. Here we have the essential matter: not a gain accruing to capital; not a growth or increment of value
in the investment; but a gain, a profit, something of exchangeable value, proceeding from the property, severed
from the capital, however invested or employed, and coming in, being 'derived'-that is, received or drawn by the
recipient (the taxpayer) for his separate use, benefit and disposal- that is income derived from property. Nothing
else answers the description.

The same fundamental conception is clearly set forth in the Sixteenth Amendment-'incomes, from whatever
source derived'-the essential thought being expressed [252 U.S. 189, 208] with a conciseness and lucidity
entirely in harmony with the form and style of the Constitution.

Can a stock dividend, considering its essential character, be brought within the definition? To answer this, regard
must be had to the nature of a corporation and the stockholder's relation to it. We refer, of course, to a corporation
such as the one in the case at bar, organized for profit, and having a capital stock divided into shares to which a
nominal or par value is attributed.

Certainly the interest of the stockholder is a capital interest, and his certificates of stock are but the evidence of
it. They state the number of shares to which he is entitled and indicate their par value and how the stock may be

34
transferred. They show that he or his assignors, immediate or remote, have contributed capital to the enterprise,
that he is entitled to a corresponding interest proportionate to the whole, entitled to have the property and
business of the company devoted during the corporate existence to attainment of the common objects, entitled
to vote at stockholders' meetings, to receive dividends out of the corporation's profits if and when declared, and,
in the event of liquidation, to receive a proportionate share of the net assets, if any, remaining after paying
creditors. Short of liquidation, or until dividend declared, he has no right to withdraw any part of either capital or
profits from the common enterprise; on the contrary, his interest pertains not to any part, divisible or indivisible,
but to the entire assets, business, and affairs of the company. Nor is it the interest of an owner in the assets
themselves, since the corporation has full title, legal and equitable, to the whole. The stockholder has the right
to have the assets employed in the enterprise, with the incidental rights mentioned; but, as stockholder, he has
no right to withdraw, only the right to persist, subject to the risks of the enterprise, and looking only to dividends
for his return. If he desires to dissociate himself [252 U.S. 189, 209] from the company he can do so only by
disposing of his stock.

For bookeeping purposes, the company acknowledges a liability in form to the stockholders equivalent to the
aggregate par value of their stock, evidenced by a 'capital stock account.' If profits have been made and not
divided they create additional bookkeeping liabilities under the head of 'profit and loss,' 'undivided profits,'
'surplus account,' or the like. None of these, however, gives to the stockholders as a body, much less to any one
of them, either a claim against the going concern for any particular sum of money, or a right to any particular
portion of the assets or any share in them unless or until the directors conclude that dividends shall be made
and a part of the company's assets segregated from the common fund for the purpose. The dividend normally is
payable in money, under exceptional circumstances in some other divisible property; and when so paid, then
only (excluding, of course, a possible advantageous sale of his stock or winding-up of the company) does the
stockholder realize a profit or gain which becomes his separate property, and thus derive income from the capital
that he or his predecessor has invested.

In the present case, the corporation had surplus and undivided profits invested in plant, property, and business,
and required for the purposes of the corporation, amounting to about $45,000,000, in addition to outstanding
capital stock of $50,000,000. In this the case is not extraordinary. The profits of a corporation, as they appear
upon the balance sheet at the end of the year, need not be in the form of money on hand in excess of what is
required to meet current liabilities and finance current operations of the company. Often, especially in a growing
business, only a part, sometimes a small part, of the year's profits is in property capable of division; the remainder
having been absorbed in the acquisition of increased plant, [252 U.S. 189, 210] quipment, stock in trade, or
accounts receivable, or in decrease of outstanding liabilities. When only a part is available for dividends, the
balance of the year's profits is carried to the credit of undivided profits, or surplus, or some other account having
like significance. If thereafter the company finds itself in funds beyond current needs it may declare dividends
out of such surplus or undivided profits; otherwise it may go on for years conducting a successful business, but
requiring more and more working capital because of the extension of its operations, and therefore unable to
declare dividends approximating the amount of its profits. Thus the surplus may increase until it equals or even
exceeds the par value of the outstanding capital stock. This may be adjusted upon the books in the mode adopted
in the case at bar-by declaring a 'stock dividend.' This, however, is no more than a book adjustment, in essence
not a dividend but rather the opposite; no part of the assets of the company is separated from the common fund,
nothing distributed except paper certificates that evidence an antecedent increase in the value of the
stockholder's capital interest resulting from an accumulation of profits by the company, but profits so far absorbed
in the business as to render it impracticable to separate them for withdrawal and distribution. In order to make
the adjustment, a charge is made against surplus account with corresponding credit to capital stock account,
equal to the proposed 'dividend'; the new stock is issued against this and the certificates delivered to the existing
stockholders in proportion to their previous holdings. This, however, is merely bookkeeping that does not affect
the aggregate assets of the corporation or its outstanding liabilities; it affects only the form, not the essence, of
the 'liability' acknowledged by the corporation to its own shareholders, and this through a readjustment of
accounts on one side of the balance sheet only, increasing 'capital stock' at the expense of [252 U.S. 189,
211] 'SURPLUS'; IT DOES NOT ALTER THE PRE-EXisting proportionate interest of any stockholder or
increase the intrinsic value of his holding or of the aggregate holdings of the other stockholders as they stood

35
before. The new certificates simply increase the number of the shares, with consequent dilution of the value of
each share.

A 'stock dividend' shows that the company's accumulated profits have been capitalized, instead of distributed to
the stockholders or retained as surplus available for distribution in money or in kind should opportunity offer. Far
from being a realization of profits of the stockholder, it tends rather to postpone such realization, in that the fund
represented by the new stock has been transferred from surplus to capital, and no longer is available for actual
distribution.

The essential and controlling fact is that the stockholder has received nothing out of the company's assets for
his separate use and benefit; on the contrary, every dollar of his original investment, together with whatever
accretions and accumulations have resulted from employment of his money and that of the other stockholders
in the business of the company, still remains the property of the company, and subject to business risks which
may result in wiping out the entire investment. Having regard to the very truth of the matter, to substance and
not to form, he has recived nothing that answers the definition of income within the meaning of the Sixteenth
Amendment.

Being concerned only with the true character and effect of such a dividend when lawfully made, we lay aside the
question whether in a particular case a stock dividend may be authorized by the local law governing the
corporation, or whether the capitalization of profits may be the result of correct judgment and proper business
policy on the part of its management, and a due regard for the interests of the stockholders. And we are
considering the taxability of bona fide stock dividends only. [252 U.S. 189, 212] We are clear that not only does
a stock dividend really take nothing from the property of the corporation and add nothing to that of the
shareholder, but that the antecedent accumulation of profits evidenced thereby, while indicating that the
shareholder is the richer because of an increase of his capital, at the same time shows he has not realized or
received any income in the transaction.

It is said that a stockholder may sell the new shares acquired in the stock dividend; and so he may, if he can find
a buyer. It is equally true that if he does sell, and in doing so realizes a profit, such profit, like any other, is income,
and so far as it may have arisen since the Sixteenth Amendment is taxable by Congress without apportionment.
The same would be true were he to sell some of his original shares at a profit. But if a shareholder sells dividend
stock he necessarily disposes of a part of his capital interest, just as if he should sell a part of his old stock, either
before or after the dividend. What he retains no longer entitles him to the same proportion of future dividends as
before the sale. His part in the control of the company likewise is diminished. Thus, if one holding $60,000 out
of a total $100,000 of the capital stock of a corporation should receive in common with other stockholders a 50
per cent. stock dividend, and should sell his part, he thereby would be reduced from a majority to a minority
stockholder, having six-fifteenths instead of six- tenths of the total stock outstanding. A corresponding and
proportionate decrease in capital interest and in voting power would befall a minority holder should he sell
dividend stock; it being in the nature of things impossible for one to dispose of any part of such an issue without
a proportionate disturbance of the distribution of the entire capital stock, and a like diminution of the seller's
comparative voting power-that 'right preservative of rights' in the control of a corporation. [252 U.S. 189,
213] Yet, without selling, the shareholder, unless possessed of other resources, has not the wherewithal to pay
an income tax upon the dividend stock. Nothing could more clearly show that to tax a stock dividend is to tax a
capital increase, and not income, than this demonstration that in the nature of things it requires conversion of
capital in order to pay the tax.

Throughout the argument of the government, in a variety of forms, runs the fundamental error already mentioned-
a failure to appraise correctly the force of the term 'income' as used in the Sixteenth Amendment, or at least to
give practical effect to it. Thus the government contends that the tax 'is levied on income derived from corporate
earnings,' when in truth the stockholder has 'derived' nothing except paper certificates which, so far as they have
any effect, deny him present participation in such earnings. It contends that the tax may be laid when earnings
'are received by the stockholder,' whereas he has received none; that the profits are 'distributed by means of a
stock dividend,' although a stock dividend distributes no profits; that under the act of 1916 'the tax is on the
stockholder's share in corporate earnings,' when in truth a stockholder has no such share, and receives none in
36
a stock dividend; that 'the profits are segregated from his former capital, and he has a separate certificate
representing his invested profits or gains,' whereas there has been no segregation of profits, nor has he any
separate certificate representing a personal gain, since the certificates, new and old, are alike in what they
represent-a capital interest in the entire concerns of the corporation.

We have no doubt of the power or duty of a court to look through the form of the corporation and determine the
question of the stockholder's right, in order to ascertain whether he has received income taxable by Congress
without apportionment. But, looking through the form, [252 U.S. 189, 214] we cannot disregard the essential
truth disclosed, ignore the substantial difference between corporation and stockholder, treat the entire
organization as unreal, look upon stockholders as partners, when they are not such, treat them as having in
equity a right to a partition of the corporate assets, when they have none, and indulge the fiction that they have
received and realized a share of the profits of the company which in truth they have neither received nor realized.
We must treat the corporation as a substantial entity separate from the stockholder, not only because such is
the practical fact but because it is only by recognizing such separateness that any dividend-even one paid in
money or property-can be regarded as income of the stockholder. Did we regard corporation and stockholders
as altogether identical, there would be no income except as the corporation acquired it; and while this would be
taxable against the corporation as income under appropriate provisions of law, the individual stockholders could
not be separately and additionally taxed with respect to their several shares even when divided, since if there
were entire identity between them and the company they could not be regarded as receiving anything from it,
any more than if one's money were to be removed from one pocket to another.

Conceding that the mere issue of a stock dividend makes the recipient no richer than before, the government
nevertheless contends extent to which the gains accumulated by the extend to which the gains accumulated by
the corporation have made him the richer. There are two insuperable difficulties with this: In the first place, it
would depend upon how long he had held the stock whether the stock dividend indicated the extent to which he
had been enriched by the operations of the company; unless he had held it throughout such operations the
measure would not hold true. Secondly, and more important for present purposes, enrichment through increase
in value [252 U.S. 189, 215] of capital investment is not income in any proper meaning of the term.

The complaint contains averments respecting the market prices of stock such as plaintiff held, based upon sales
before and after the stock dividend, tending to show that the receipt of the additional shares did not substantially
change the market value of her entire holdings. This tends to show that in this instance market quotations
reflected intrinsic values-a thing they do not always do. But we regard the market prices of the securities as an
unsafe criterion in an inquiry such as the present, when the question must be, not what will the thing sell for, but
what is it in truth and in essence.

It is said there is no difference in principle between a simple stock dividend and a case where stockholders use
money received as cash dividends to purchase additional stock contemporaneously issued by the corporation.
But an actual cash dividend, with a real option to the stockholder either to keep the money for his own or to
reinvest it in new shares, would be as far removed as possible from a true stock dividend, such as the one we
have under consideration, where nothing of value is taken from the company's assets and transferred to the
individual ownership of the several stockholders and thereby subjected to their disposal.

The government's reliance upon the supposed analogy between a dividend of the corporation's own shares and
one made by distributing shares owned by it in the stock of another company, calls for no comment beyond the
statement that the latter distributes assets of the company among the shareholders while the former does not,
and for no citation of authority except Peabody v. Eisner, 247 U.S. 347, 349 , 350 S., 38 Sup. Ct. 546.

Two recent decisions, proceeding from courts of high jurisdiction, are cited in support of the position of the
government. [252 U.S. 189, 216] Swan Brewery Co., Ltd. v. Rex, [252 U.S. 189, 1914] A. C. 231, arose under
the Dividend Duties Act of Western Australia, which provided that 'dividend' should include 'every dividend, profit,
advantage, or gain intended to be paid or credited to or distributed among any members or directors of any
company,' except, etc. There was a stock dividend, the new shares being allotted among the shareholders pro
rata; and the question was whether this was a distribution of a dividend within the meaning of the act. The Judicial
37
Committee of the Privy Council sustained the dividend duty upon the ground that, although 'in ordinary language
the new shares would not be called a dividend, nor would the allotment of them be a distribution of a dividend,'
yet, within the meaning of the act, such new shares were an 'advantage' to the recipients. There being no
constitutional restriction upon the action of the lawmaking body, the case presented merely a question of
statutory construction, and manifestly the decision is not a precedent for the guidance of this court when acting
under a duty to test an act of Congress by the limitations of a written Constitution having superior force.

In Tax Commissioner v. Putnam (1917) 227 Mass. 522, 116 N. E. 904, L. R. A. 1917F, 806, it was held that the
Forty-Fourth amendment to the Constitution of Massachusetts, which conferred upon the Legislature full power
to tax incomes, 'must be interpreted as including every item which by any reasonable understanding can fairly
be regarded as income' (227 Mass. 526, 531, 116 N. E. 904, 907 [L. R. A. 1917F, 806]), and that under it a stock
dividend was taxable as income; the court saying (227 Mass. 535, 116 N. E. 911, L. R. A. 1917F, 806):

'In essence the thing which has been done is to distribute a symbol representing an accumulation of
profits, which instead of being paid out in cash is invested in the business, thus augmenting its durable
assets. In this aspect of the case the substance of the transaction is no different from what it would be if
a cash dividend had been declared with the privilege of subscription to an equivalent amount of new
shares.' [252 U.S. 189, 217] We cannot accept this reasoning. Evidently, in order to give a sufficiently
broad sweep to the new taxing provision, it was deemed necessary to take the symbol for the substance,
accumulation for distribution, capital accretion for its opposite; while a case where money is paid into the
hand of the stockholder with an option to buy new shares with it, followed by acceptance of the option,
was regarded as identical in substance with a case where the stockholder receives no money and has
no option. The Massachusetts court was not under an obligation, like the one which binds us, of applying
a constitutional amendment in the light of other constitutional provisions that stand in the way of extending
it by construction.

Upon the second argument, the government, recognizing the force of the decision in Towne v. Eisner, supra,
and virtually abandoning the contention that a stock dividend increases the interest of the stockholder or
otherwise enriches him, insisted as an alternative that by the true construction of the act of 1916 the tax is
imposed, not upon the stock dividend, but rather upon the stockholder's share of the undivided profits previously
accumulated by the corporation; the tax being levied as a matter of convenience at the time such profits become
manifest through the stock dividend. If so construed, would the act be constitutional?

That Congress has power to tax shareholders upon their property interests in the stock of corporations is beyond
question, and that such interests might be valued in view of the condition of the company, including its
accumulated and undivided profits, is equally clear. But that this would be taxation of property because of
ownership, and hence would require apportionment under the provisions of the Constitution, is settled beyond
peradventure by previous decisions of this court.

The government relies upon Collector v. Hubbard (1870) [252 U.S. 189, 218] 12 Wall. 1, (20 L. Ed. 272), which
arose under section 117 of the Act of June 30, 1864 (13 Stat. 223, 282, c. 173), providing that--

'The gains and profits of all companies, whether incorporated or partnership, other than the companies
specified in that section, shall be included in estimating the annual gains, profits, or income of any person,
entitled to the same, whether divided or otherwise.'

The court held an individual taxable upon his proportion of the earnings of a corporation although not declared
as dividends and although invested in assets not in their nature divisible. Conceding that the stockholder for
certain purposes had no title prior to dividend declared, the court nevertheless said (12 Wall. 18):

'Grant all that, still it is true that the owner of a share of stock in a corporation holds the share with all its
incidents, and that among those incidents is the right to receive all future dividends, that is, his
proportional share of all profits not then divided. Profits are incident to the share to which the owner at

38
 once becomes entitled provided he remains a member of the corporation until a dividend is made.
Regarded as an incident to the shares, undivided profits are property of the shareholder, and as such
are the proper subject of sale, gift, or devise. Undivided profits invested in real estate, machinery, or raw
material for the purpose of being manufactured are investments in which the stockholders are interested,
and when such profits are actually appropriated to the payment of the debts of the corporation they serve
to increase the market value of the shares, whether held by the original subscribers or by assignees.'

In so far as this seems to uphold the right of Congress to tax without apportionment a stockholder's interest in
accumulated earnings prior to dividend declared, it must be regarded as overruled by Pollock v. Farmers' Loan
& Trust Co., 158 U.S. 601, 627 , 628 S., 637, 15 Sup. Ct. 912. Conceding Collector v. Hubbard was inconsistent
with the doctrine of that case, because it sustained a direct tax upon property not apportioned [252 U.S. 189,
219] AMONG THE STATES, THE GOVERNMENT NEVERTHEless insists that the sixteenth Amendment
removed this obstacle, so that now the Hubbard Case is authority for the power of Congress to levy a tax on the
stockholder's share in the accumulated profits of the corporation even before division by the declaration of a
dividend of any kind. Manifestly this argument must be rejected, since the amendment applies to income only,
and what is called the stockholder's share in the accumulated profits of the company is capital, not income. As
we have pointed out, a stockholder has no individual share in accumulated profits, nor in any particular part of
the assets of the corporation, prior to dividend declared.

Thus, from every point of view we are brought irresistibly to the conclusion that neither under the Sixteenth
Amendment nor otherwise has Congress power to tax without apportionment a true stock dividend made lawfully
and in good faith, or the accumulated profits behind it, as income of the stockholder. The Revenue Act of 1916,
in so far as it imposes a tax upon the stockholder because of such dividend, contravenes the provisions of article
1, 2, cl. 3, and article 1, 9, cl. 4, of the Constitution, and to this extent is invalid, notwithstanding the Sixteenth
Amendment.

Judgment affirmed.

Mr. Justice HOLMES, dissenting.

I think that Towne v. Eisner, 245 U.S. 418 , 38 Sup. Ct. 158, L. R. A. 1918D, 254, was right in its reasoning and
result and that on sound principles the stock dividend was not income. But it was clearly intimated in that case
that the construction of the statute then before the Court might be different from that of the Constitution. 245 U.S.
425 , 38 Sup. Ct. 158, L. R. A. 1918D, 254. I think that the word 'incomes' in the Sixteenth Amendment should
be read in [252 U.S. 189, 220] 'a sense most obvious to the common understanding at the time of its adoption.'
Bishop v. State, 149 Ind. 223, 230, 48 N. E. 1038, 1040, 39 L. R. A. 278, 63 Am. St. Rep. 270; State v. Butler,
70 Fla. 102, 133, 69 South. 771. For it was for public adoption that it was proposed. McCulloch v. Maryland, 4
Wheat. 316, 407. The known purpose of this Amendment was to get rid of nice questions as to what might be
direct taxes, and I cannot doubt that most people not lawyers would suppose when they voted for it that they put
a question like the present to rest. I am of opinion that the Amendment justifies the tax. See Tax Commissioner
v. Putnam, 227 Mass. 522, 532, 533, 116 N. E. 904, L. R. A. 1917F, 806.

Mr. Justice DAY concurs in this opinion.

Mr. Justice BRANDEIS delivered the following [dissenting] opinion:

Financiers, with the aid of lawyers, devised long ago two different methods by which a corporation can, without
increasing its indebtedness, keep for corporate purposes accumulated profits, and yet, in effect, distribute these
profits among its stockholders. One method is a simple one. The capital stock is increased; the new stock is paid
up with the accumulated profits; and the new shares of paid-up stock are then distributed among the stockholders
pro rata as a dividend. If the stockholder prefers ready money to increasing his holding of the stock in the
company, he sells the new stock received as a dividend. The other method is slightly more complicated.
.arrangements are made for an increase of stock to be offered to stockholders pro rata at par, and, at the same

39
time, for the payment of a cash dividend equal to the amount which the stockholder will be required to pay to
[252 U.S. 189, 221] the company, if he avails himself of the right to subscribe for his pro rata of the new stock.
If the stockholder takes the new stock, as is expected, he may endorse the dividend check received to the
corporation and thus pay for the new stock. In order to ensure that all the new stock so offered will be taken, the
price at which it is offered is fixed far below what it is believed will be its market value. If the stockholder prefers
ready money to an increase of his holdings of stock, he may sell his right to take new stock pro rata, which is
evidenced by an assignable instrument. In that event the purchaser of the rights repays to the corporation, as
the subscription price of the new stock, an amount equal to that which it had paid as a chsh dividend to the
stockholder.

Both of these methods of retaining accumulated profits while in effect distributing them as a dividend had been
in common use in the United States for many years prior to the adoption of the Sixteenth Amendment. They
were recognized equivalents. Whether a particular corporation employed one or the other method was
determined sometimes by requirements of the law under which the corporation was organized; sometimes it was
determined by preferences of the individual officials of the corporation; and sometimes by stock market
conditions. Whichever method was employed the resultant distribution of the new stock was commonly referred
to as a stock dividend. How these two methods have been employed may be illustrated by the action in this
respect (as reported in Moody's Manual, 1918 Industrial, and the Commercial and Financial Chronicle) of some
of the Standard Oil companies, since the disintegration pursuant to the decision of this court in 1911. Standard
Oil Co. v. United States, 221 U.S. 1 , 31 Sup. Ct. 502, 34 L. R. A. (N. S.) 834, Ann. Cas. 1912D, 734.

(a) Standard Oil Co. (of Indiana), an Indiana corporation. It had on December 31, 1911, $1,000,000 capital stock
(all common), and a large surplus. On May 15, [252 U.S. 189, 222] 1912, it increased its capital stock to
$30,000,000, and paid a simple stock dividend of 2,900 per cent. in stock. 2

(b) Standard Oil Co. (of Nebraska), a Nebraska corporation. It had on December 31, 1911, $600,000 capital
stock (all common), and a substantial surplus. On April 15, 1912, it paid a simple stock dividend of 33 1/3 per
cent., increasing the outstanding capital to $800,000. During the calendar year 1912 it paid cash dividends
aggregating 20 per cent., but it earned considerably more, and had at the close of the year again a substantial
surplus. On June 20, 1913, it declared a further stock dividend of 25 per cent., thus increasing the capital to
$1,000,000.3

(c) The Standard Oil Co. (of Kentucky), a Kentucky corporation. It had on December 31, 1913, $1,000,000 capital
stock (all common) and $3,701, 710 surplus. Of this surplus $902,457 had been earned during the calendar year
1913, the net profits of that year having been $1,002,457 and the dividends paid only $100,000 (10 per cent.).
On December 22, 1913, a cash dividend of $200 per share was declared payable on February 14, 1914, to
stockholders of record January 31, 1914, and these stockholders were offered the right to subscribe for an equal
amount of new stock at par and to apply the cash dividend in payment therefor. The outstanding stock was thus
increased to $3,000,000. During the calendar years 1914, 1915, and 1916, quarterly dividends were paid on this
stock at an annual rate of between 15 per cent. and 20 per cent., but the company's surplus increased by
$2,347,614, so that on December 31, 1916, it had a large surplus over its $3,000,000 capital stock. On December
15, 1916, the company issued a circular to the stockholders, saying:

'The company's business for this year has shown a [252 U.S. 189, 223] very good increase in volume
and a proportionate increase in profits, and it is estimated that by January 1, 1917, the company will have
a surplus of over $4,000,000. The board feels justified in stating that if the proposition to increase the
capital stock is acted on favorably, it will be proper in the near future to declare a cash dividend of 100
per cent. and to allow the stockholders the privilege pro rata according to their holdings, to purchase the
new stock at par, the plan being to allow the stockholders, if they desire, to use their cash dividend to
pay for the new stock.'

The increase of stock was voted. The company then paid a cash dividend of 100 per cent., payable May 1, 1917,
again offering to such stockholders the right to subscribe for an equal amount of new stock at par and to apply
the cash dividend in payment therefor.
40
Moody's Manual, describing the transaction with exactness, says first that the stock was increased from
$3,000,000 to $6,000,000, 'a cash dividend of 100 per cent., payable May 1, 1917, being exchanged for one
share of new stock, the equivalent of a 100 per cent. stock dividend.' But later in the report giving, as customary
in the Manual the dividend record of the company, the Manual says: 'A stock dividend of 200 per cent. was paid
February 14, 1914, and one of 100 per cent. on May 1, 1197.' And in reporting specifically the income account
of the company for a series of years ending December 31, covering net profits, dividends paid and surplus for
the year, it gives, as the aggregate of dividends for the year 1917, $ 660,000 (which was the aggregate paid on
the quarterly cash dividend-5 per cent. January and April; 6 per cent. July and October), and adds in a note: 'In
addition a stock dividend of 100 per cent. was paid during the year.' 4 The Wall Street Journal of [252 U.S. 189,
224] May 2, 1917, p. 2, quotes the 1917 'high' price for Standard Oil of Kentucky as '375 ex stock dividend.'

It thus appears that among financiers and investors the distribution of the stock, by whichever method effected,
is called a stock dividend; that the two methods by which accumulated profits are legally retained for corporate
purposes and at the same time distributed as dividends are recognized by them to be equivalents; and that the
financial results to the corporation and to the stockholders of the two methods are substantially the same-unless
a difference results from the application of the federal Income Tax Law.

Mrs. Macomber, a citizen and resident of New York, was, in the year 1916, a stockholder in the Standard Oil
Company (of California), a corporation organized under the laws of California and having its principal place of
business in that state. During that year she received from the company a stock dividend representing profits
earned since March 1, 1913. The dividend was paid by direct issue of the stock to her according to the simple
method described above, pursued also by the Indiana and Nebraska companies. In 1917 she was taxed under
the federal law on the stock dividend so received at its par value of $100 a share, as income received during the
year 1916. Such a stock dividend is income, as distinguished from capital, both under the law of New York and
under the law of California, because in both states every dividend representing profits is deemed to be income,
whether paid in cash or in stock. It had been so held in New York, where the question arose as between life
tenant and remainderman, Lowry v. Farmers' Loan & Trust Co., 172 N. Y. 137, 64 N. E. 796; Matter of Osborne,
209 N. Y. 450, 103 N. E. 723, 823, 50 L. R. A. ( N. S.) 510, Ann.Cas. 1915A, 298; and also, where the question
arose in matters of taxation, People v. Glynn, [252 U.S. 189, 225] 130 App. Div. 332, 114 N. Y. Supp. 460; Id.
198 N. Y. 605, 92 N. E. 1097. It has been so held in California, where the question appears to have arisen only
in controversies between life tenant and remainderman. Estate of Duffill, 183 Pac. 337.

It is conceded that if the stock dividend paid to Mrs. Macomber had been made by the more complicated method
pursued by the Standard Oil Company of Kentucky; that is, issuing rights to take new stock pro rata and paying
to each stockholder simultaneously a dividend in cash sufficient in amount to enable him to pay for this pro rata
of new stock to be purchased-the dividend so paid to him would have been taxable as income, whether he
retained the cash or whether he returned it to the corporation in payment for his pro rata of new stock. But it is
contended that, because the simple method was adopted of having the new stock issued direct to the
stockholders as paid-up stock, the new stock is not to be deemed income, whether she retained it or converted
it into cash by sale. If such a different result can flow merely from the difference in the method pursued, it must
be because Congress is without power to tax as income of the stockholder either the stock received under the
latter method or the proceeds of its sale; for Congress has, by the provisions in the Revenue Act of 1916,
expressly declared its purpose to make stock dividends, by whichever method paid, taxable as income.

The Sixteenth Amendment, proclaimed February 25, 1913, declares:

'The Congress shall have power to lay and collect taxes on incomes, from whatever source derived,
without apportionment among the several states, and without regard to any census or enumeration.'

The Revenue Act of September 8, 1916, c. 463, 2a, 39 Stat. 756, 757, provided:

'That the term 'dividends' as used in this title shall [252 U.S. 189, 226] be held to mean any distribution
made or ordered to be made by a corporation, ... out of its earnings or profits accrued since March first,

41
 nineteen hundred and thirteen, and payable to its shareholders, whether in cash or in stock of the
corporation, ... which stock dividend shall be considered income, to the amount of its cash value.'

Hitherto powers conferred upon Congress by the Constitution have been liberally construed, and have been held
to extend to every means appropriate to attain the end sought. In determining the scope of the power the
substance of the transaction, not its form has been regarded. Martin v. Hunter, 1 Wheat, 304, 326; McCulloch v.
Maryland, 4 Wheat. 316, 407, 415; Brown v. Maryland, 12 Wheat. 419, 446; Craig v. Missouri, 4 Pet. 410, 433;
Jarrolt v. Moberly, 103 U.S. 580, 585 , 587 S.; Legal Tender Case, 110 U.S. 421, 444 , 4 S. Sup. Ct. 122;
Lithograph Co. v. Sarony, 111 U.S. 53, 58 , 4 S. Sup. Ct. 279; United States v. Realty Co., 163 U.S. 427, 440 ,
441 S., 442, 16 Sup. Ct. 1120; South Carolina v. United States, 199 U.S. 437, 448 , 449 S., 26 Sup. Ct. 110, 4
Ann. Cas. 737. Is there anything in the phraseology of the Sixteenth Amendment or in the nature of corporate
dividends which should lead to a departure from these rules of construction and compel this court to hold, that
Congress is powerless to prevent a result so extraordinary as that here contended for by the stockholder?

First. The term 'income,' when applied to the investment of the stockholder in a corporation, had, before the
adoption of the Sixteenth Amendment, been commonly understood to mean the returns from time to time
received by the stockholder from gains or earnings of the corporation. A dividend received by a stockholder from
a corporation may be either in distribution of capital assets or in distribution of profits. Whether it is the one or
the other is in no way affected by the medium in which it is paid, nor by the method or means through which the
particular thing distributed as a dividend was procured. If the [252 U.S. 189, 227] dividend is declared payable
in cash, the money with which to pay it is ordinarily taken from surplus cash in the treasury. But (if there are
profits legally available for distribution and the law under which the company was incorporated so permits) the
company may raise the money by discounting negotiable paper; or by selling bonds, scrip or stock of another
corporation then in the treasury; or by selling its own bonds, scrip or stock then in the treasury; or by selling its
own bonds, scrip or stock issued expressly for that purpose. How the money shall be raised is wholly a matter
of financial management. The manner in which it is raised in no way affects the question whether the dividend
received by the stockholder is income or capital; nor can it conceivably affect the question whether it is taxable
as income.

Likewise whether a dividend declared payable from profits shall be paid in cash or in some other medium is also
wholly a matter of financial management. If some other medium is decided upon, it is also wholly a question of
financial management whether the distribution shall be, for instance, in bonds, scrip or stock of another
corporation or in issues of its own. And if the dividend is paid in its own issues, why should there be a difference
in result dependent upon whether the distribution was made from such securities then in the treasury or from
others to be created and issued by the company expressly for that purpose? So far as the distribution may be
made from its own issues of bonds, or preferred stock created expressly for the purpose, it clearly would make
no difference in the decision of the question whether the dividend was a distribution of profits, that the securities
had to be created expressly for the purpose of distribution. If a dividend paid in securities of that nature represents
a distribution of profits Congress may, of course, tax it as income of the stockholder. Is the result different where
the security distributed is common stock? [252 U.S. 189, 228] Suppose that a corporation having power to buy
and sell its own stock, purchases, in the interval between its regular dividend dates, with moneys derived from
current profits, some of its own common stock as a temporary investment, intending at the time of purchase to
sell it before the next dividend date and to use the proceeds in paying dividends, but later, deeming it inadvisable
either to sell this stock or to raise by borrowing the money necessary to pay the regular dividend in cash, declares
a dividend payable in this stock; can any one doubt that in such a case the dividend in common stock would be
income of the stockholder and constitutionally taxable as such? See Green v. Bissell, 79 Conn. 547, 65 Atl. 1056,
8 L. R. A. (N. S.) 1011, 118 Am. St. Rep. 156, 9 Ann. Cas. 287; Leland v. Hayden, 102 Mass. 542. And would it
not likewise be income of the stockholder subject to taxation if the purpose of the company in buying the stock
so distributed had been from the beginning to take it off the market and distribute it among the stockholders as
a dividend, and the company actually did so? And proceeding a short step further: Suppose that a corporation
decided to capitalize some of its accumulated profits by creating additional common stock and selling the same
to raise working capital, but after the stock has been issued and certificates therefor are delivered to the bankers
for sale, general financial conditions make it undesirable to market the stock and the company concludes that it
is wiser to husband, for working capital, the cash which it had intended to use in paying stockholders a dividend,
42
and, instead, to pay the dividend in the common stock which it had planned to sell; would not the stock so
distributed be a distribution of profits-and hence, when received, be income of the stockholder and taxable as
such? If this be conceded, why should it not be equally income of the stockholder, and taxable as such, if the
common stock created by capitalizing profits, had been originally created for the express purpose of being
distributed [252 U.S. 189, 229] as a dividend to the stockholder who afterwards received it?

Second. It has been said that a dividend payable in bonds or preferred stock created for the purpose of
distributing profits may be income and taxable as such, but that the case is different where the distribution is in
common stock created for that purpose. Various reasons are assigned for making this distinction. One is that
the proportion of the stockholder's ownership to the aggregate number of the shares of the company is not
changed by the distribution. But that is equally true where the dividend is paid in its bonds or in its preferred
stock. Furthermore, neither maintenance nor change in the proportionate ownership of a stockholder in a
corporation has any bearing upon the question here involved. Another reason assigned is that the value of the
old stock held is reduced approximately by the value of the new stock received, so that the stockholder after
receipt of the stock dividend has no more than he had before it was paid. That is equally true whether the dividend
be paid in cash or in other property, for instance, bonds, scrip or preferred stock of the company. The payment
from profits of a large cash dividend, and even a small one, customarily lowers the then market value of stock
because the undivided property represented by each share has been correspondingly reduced. The argument
which appears to be most strongly urged for the stockholders is, that when a stock dividend is made, no portion
of the assets of the company is thereby segregated for the stockholder. But does the issue of new bonds or of
preferred stock created for use as a dividend result in any segregation of assets for the stockholder? In each
case he receives a piece of paper which entitles him to certain rights in the undivided property. Clearly
segregation of assets in a physical sense is not an essential of income. The year's gains of a partner is taxable
as income, although there, likewise, no [252 U.S. 189, 230] segregation of his share in the gains from that of
his partners is had.

The objection that there has been no segregation is presented also in another form. It is argued that until there
is a segregation, the stockholder cannot know whether he has really received gains; since the gains may be
invested in plant or merchandise or other property and perhaps be later lost. But is not this equally true of the
share of a partner in the year's profits of the firm or, indeed, of the profits of the individual who is engaged in
business alone? And is it not true, also, when dividends are paid in cash? The gains of a business, whether
conducted by an individual, by a firm or by a corporation, are ordinarily reinvested in large part. Many a cash
dividend honestly declared as a distribution of profits, proves later to have been paid out of capital, because
errors in forecast prevent correct ascertainment of values. Until a business adventure has been completely
liquidated, it can never be determined with certainty whether there have been profits unless the returns at least
exceeded the capital originally invested. Business men, dealing with the problem practically, fix necessarily
periods and rules for determining whether there have been net profits-that is, income or gains. They protect
themselves from being seriously misled by adopting a system of depreciation charges and reserves. Then, they
act upon their own determination, whether profits have been made. Congress in legislating has wisely adopted
their practices as its own rules of action.

Third. The Government urges that it would have been within the power of Congress to have taxed as income of
the stockholder his pro rata share of undistributed profits earned, even if no stock dividend representing it had
been paid. Strong reasons may be assigned for such a view. See The Collector v. Hubbard, 12 Wall. 1. The
undivided share of a partner in the year's undistributed profits of his firm [252 U.S. 189, 231] is taxable as
income of the partner, although the share in the gain is not evidenced by any action taken by the firm. Why may
not the stockholder's interest in the gains of the company? The law finds no difficulty in disregarding the corporate
fiction whenever that is deemed necessary to attain a just result. Linn Timber Co. v. United States, 236 U.S. 574
, 35 Sup. Ct. 440. See Morawetz on Corporations (2d Ed.) 227- 231; Cook on Corporations (7th Ed.) 663, 664.
The stockholder's interest in the property of the corporation differs, not fundamentally but in form only, from the
interest of a partner in the property of the firm. There is much authority for the proposition that, under our law, a
partnership or joint stock company is just as distinct and palpable an entity in the idea of the law, as distinguished
from the individuals composing it, as is a corporations. 5 No reason appears, why Congress, in legislating under
a grant of power so comprehensive as that authorizing the levy of an income tax, should be limited by the
43
particular view of the relation of the stockholder to the corporation and its property which may, in the absence of
legislation, have been taken by this court. But we have no occasion to decide the question whether Congress
might have taxed to the stockholder his undivided share of the corporation's earnings. For Congress has in this
act limited the income tax to that share of the stockholder in the earnings which is, in effect, distributed by means
of the stock dividend paid. In other words to render the stockholder taxable there must be both earnings made
and a dividend paid. Neither earnings without dividend-nor a dividend without earnings-subjects the [252 U.S.
189, 232] stockholder to taxation under the Revenue Act of 1916.

Fourth. The equivalency of all dividends representing profits, whether paid of all dividends in stock, is so complete
that serious question of the taxability of stock dividends would probably never have been made, if Congress had
undertaken to tax only those dividends which represented profits earned during the year in which the dividend
was paid or in the year preceding. But this court, construing liberally, not only the constitutional grant of power,
but also the revenue act of 1913, held that Congress might tax, and had taxed, to the stockholder dividends
received during the year, although earned by the company long before; and even prior to the adoption of the
Sixteenth Amendment. Lynch v. Hornby, 247 U.S. 339 , 38 Sup. Ct. 543.6 That rule, if indiscriminatingly applied
to all stock dividends representing profits earned, might, in view of corporate practice, have worked considerable
hardship, and have raised serious questions. Many corporations, without legally capitalizing any part of their
profits, had assigned definitely some part or all of the annual balances remaining after paying the usual cash
dividends, to the uses to which permanent capital is ordinarily applied. Some of the corporations doing this,
transferred such balances on their books to 'surplus' account-distinguishing between such permanent 'surplus'
and the 'undivided profits' account. Other corporations, without this formality, had assumed that the annual
accumulating balances carried as undistributed profits were to be treated as capital permanently invested in the
business. And still others, without definite assumption of any kind, had [252 U.S. 189, 233] so used undivided
profits for capital purposes. To have made the revenue law apply retroactively so as to reach such accumulated
profits, if and whenever it should be deemed desirable to capitalize them legally by the issue of additional stock
distributed as a dividend to stockholders, would have worked great injustice. Congress endeavored in the
Revenue Act of 1916 to guard against any serious hardship which might otherwise have arisen from making
taxable stock dividends representing accumulated profits. It did not limit the taxability to stock dividends
representing profits earned within the tax year or in the year preceding; but it did limit taxability to such dividends
representing profits earned since March 1, 1913. Thereby stockholders were given notice that their share also
in undistributed profits accumulating thereafter was at some time to be taxed as income. And Congress sought
by section 3 (Comp. St. 1918, Comp. St. Ann. Supp. 1919, 6336c) to discourage the postponement of distribution
for the illegitimate purpose of evading liability to surtaxes.

Fifth. The decision of this court, that earnings made before the adoption of the Sixteenth Amendment, but paid
out in cash dividend after its adoption, were taxable as income of the stockholder, involved a very liberal
construction of the amendment. To hold now that earnings both made and paid out after the adoption of the
Sixteenth Amendment cannot be taxed as income of the stockholder, if paid in the form of a stock dividend,
involves an exceedingly narrow construction of it. As said by Mr. Chief Justice Marshall in Brown v. Maryland,
12 Wheat. 419, 446 (6 L. Ed. 678):

'To construe the power so as to impair its efficacy, would tend to defeat an object, in the attainment of
which the American public took, and justly took, that strong interest which arose from a full conviction of
its necessity.'

No decision heretofore rendered by this court requires us to hold that Congress, in providing for the taxation of
[252 U.S. 189, 234] stock dividends, exceeded the power conferred upon it by the Sixteenth Amendment. The
two cases mainly relied upon to show that this was beyond the power of Congress are Towne v. Eisner, 245
U.S. 418 , 38 Sup. Ct. 158 L. R. A. 1918D, 254, which involved a question not of constitutional power but of
statutory construction, and Gibbons v. Mahon, 136 U.S. 549 , 10 Sup. Ct. 1057, which involved a question arising
between life tenant and remainderman. So far as concerns Towne v. Eisner we have only to bear in mind what
was there said ( 245 U.S. 425 , 38 Sup. Ct. 159, L. R. A. 1918D, 254): 'But it is not necessarily true that income
means the same thing in the Constitution and the [an] act.' 7 Gibbons v. Mahon is even less an authority for a
narrow construction of the power to tax incomes conferred by the Sixteenth Amendment. In that case the court
44
was required to determine how, in the administration of an estate in the District of Columbia, a stock dividend,
representing profits, received after the decedent's death, should be disposed of as between life tenant and
remainderman. The question was in essence: What shall the intention of the testator be presumed to have been?
On this question there was great diversity of opinion and practice in the courts of English-speaking countries.
Three well-defined rules were then competing for acceptance; two of these involves an arbitrary rule of
distribution, the third equitable apportionment. See Cook on Corporations ( 7th Ed.) 552-558.

1. The so-called English rule, declared in 1799, by Brander v. Brander, 4 Ves. Jr. 800, that a dividend
representing [252 U.S. 189, 235] profits, whether in cash, stock or other property, belongs to the life tenant if it
was a regular or ordinary dividend, and belongs to the remainderman if it was an extraordinary dividend.

2. The so-called Massachusetts rule, declared in 1868 by Minot v. Paine, 99 Mass. 101, 96 Am. Dec. 705, that
a dividend representing profits, whether regular, ordinary or extrordinary, if in cash belongs to the life tenant, and
if in stock belongs to the remainderman.

3. The so-called Pennsylvania rule declared in 1857 by Earp's Appeal, 28 Pa. 368, that where a stock dividend
is paid, the court shall inquire into the circumstances under which the fund had been earned and accumulated
out of which the dividend, whether a regular, an ordinary or an extraordinary one, was paid. If it finds that the
stock dividend was paid out of profits earned since the decedent's death, the stock dividend belongs to the life
tenant; if the court finds that the stock dividend was paid from capital or from profits earned before the decedent's
death, the stock dividend belongs to the remainderman.

This court adopted in Gibbons v. Mahon as the rule of administration for the District of Columbia the so-called
Massachusetts rule, the opinion being delivered in 1890 by Mr. Justice Gray. Since then the same question has
come up for decision in many of the states. The so-called Massachusetts rule, although approved by this court,
has found favor in only a few states. The so-called Pennsylvania rule, on the other hand, has been adopted since
by so many of the states (including New York and California), that it has come to be known as the 'American
rule.' Whether, in view of these facts and the practical results of the operation of the two rules as shown by the
experience of the 30 years which have elapsed since the decision in Gibbons v. Mahon, it might be desirable for
this court to reconsider the question there decided, as [252 U.S. 189, 236] some other courts have done (see
29 Harvard Law Review, 551), we have no occasion to consider in this case. For, as this court there pointed out
( 136 U.S. 560 , 1059 [34 L. Ed. 525]), the question involved was one 'between the owners of successive interests
in particular shares,' and not, as in Bailey v. Railroad Co., 22 Wall. 604, a question 'between the corporation and
the government, and [which] depended upon the terms of a statute carefully framed to prevent corporations from
evading payment of the tax upon their earnings.'

We have, however, not merely argument; we have examples which should convince us that 'there is no inherent,
necessary and immutable reason why stock dividends should always be treated as capital.' Tax Commissioner
v. Putnam, 227 Mass. 522, 533, 116 N. E. 904, L. R. A. 1917F. 806. The Supreme Judical Court of
Massachusetts has steadfastly adhered, despite ever-renewed protest, to the rule that every stock dividend is,
as between life tenant and remainderman, capital and not income. But in construing the Massachusetts Income
Tax Amendment, which is substantially identical with the federal amendment, that court held that the Legislature
was thereby empowered to levy an income tax upon stock dividends representing profits. The courts of England
have, with some relaxation, adhered to their rule that every extraordinary dividend is, as between life tenant and
remainderman, to be deemed capital. But in 1913 the Judicial Committee of the Privy Council held that a stock
dividend representing accumulated profits was taxable like an ordinary cash dividend, Swan Brewery Company,
Limited v. The King, L. R. 1914 A. C. 231. In dismissing the appeal these words of the Chief Justice of the
Supreme Court of Western Australia were quoted (page 236) which show that the facts involved were identical
with those in the case at bar:

'Had the company distributed the 101,450 among the shareholders and had the shareholders repaid such
sums to the company as the price of the 81,160 new SHARES, THE DUTY ON THE 101,450 [252 U.S.
189, 237] WOULD CLEARLY HAVE BEEN PAYable. is not this virtually the effect of what was actually
done? I think it is.'
45
Sixth. If stock dividends representing profits are held exempt from taxation under the Sixteenth Amendment, the
owners of the most successful businesses in America will, as the facts in this case illustrate, be able to escape
taxation on a large part of what is actually their income. So far as their profits are represented by stock received
as dividends they will pay these taxes not upon their income but only upon the income of their income. That such
a result was intended by the people of the United States when adopting the Sixteenth Amendment is
inconceivable. Our sole duty is to ascertain their intent as therein expressed. 8 In terse, comprehensive language
befitting the Constitution, they empowered Congress 'to lay and collect taxes on incomes from whatever source
derived.' They intended to include thereby everything which by reasonable understanding can fairly be regarded
as income. That stock dividends representing profits are so regarded, not only by the plain people, but by
investors and financiers, and by most of the courts of the country, is shown, beyond peradventure, by their acts
and by their utterances. It seems to me clear, therefore, that Congress possesses the power which it exercised
to make dividends representing profits, taxable as income, whether the medium in which the dividend is paid be
cash or stock, and that it may define, as it has done, what dividends representing [252 U.S. 189, 238] profits
shall be deemed income. It surely is not clear that the enactment exceeds the power granted by the Sixteenth
Amendment. And, as this court has so often said, the high prerogative of declaring an act of Congress invalid,
should never be exercised except in a clear case. 9

'It is but a decent respect due to the wisdom, the integrity and the patriotism of the legislative body, by
which any law is passed, to presume in favor of its validity, until its violation of the Constitution is proved
beyond all reasonable doubt.' Ogden v. Saunders, 12 Wheat. 213, 269.

Mr. Justice CLARKE concurs in this opinion.

46
 144 F.2d 110 (1944)
RAYTHEON PRODUCTION CORPORATION
v.
COMMISSIONER OF INTERNAL REVENUE.
No. 3956.

Circuit Court of Appeals, First Circuit.

July 28, 1944.

Writ of Certiorari Denied November 20, 1944.

*111 Edward C. Thayer, of Boston, Mass., for petitioner.

Newton K. Fox, Sp. Asst. to Atty. Gen. (Samuel O. Clark, Jr., Asst. Atty. Gen., and Sewall Key and J. Louis
Monarch, Sp. Assts. to Atty. Gen., on the brief), for respondent.

Before MAGRUDER, MAHONEY, and WOODBURY, Circuit Judges.

Writ of Certiorari Denied November 20, 1944. See 65 S. Ct. 192.

MAHONEY, Circuit Judge.

This case presents the question whether an amount received by the taxpayer in compromise settlement of a suit
for damages under the Federal Anti-Trust Laws, 15 U.S.C.A. § 1 et seq., is a non-taxable return of capital or
income. If the recovery is non-taxable, there is a second question as to whether the Tax Court erred in holding
that there was insufficient evidence to enable it to determine what part of the lump sum payment received by the
taxpayer was properly allocable to compromise of the suit and what part was allocable to payment for certain
patent license rights which were conveyed as a part of the settlement.

Petitioner, Raytheon Production Corporation, came into existence as a result of a series of what both parties as
well as the Tax Court have treated as tax free reorganizations. Since we think such is the proper treatment, we
shall simplify the facts by referring to any one of the original and successor companies as Raytheon. The original
Raytheon Company was a pioneer manufacturer of a rectifying tube which made possible the operation of a
radio receiving set on alternating current instead of on batteries. In 1926 its profits were about $450,000; in 1927
about $150,000; and in 1928, $10,000. The Radio Corporation of America had many patents covering radio
circuits and claimed control over almost all of the practical circuits. Cross-licensing agreements had been made
among several companies including R.C.A., General Electric Company, Westinghouse, and American
Telephone & Telegraph Company. R.C.A. had developed a competitive tube which produced the same type of
rectification as the Raytheon tube. Early in 1927, R.C.A. began to license manufacturers of radio sets and in the
license agreement it incorporated "Clause 9", which provided that the licensee was required to buy its tubes from
R.C.A. In 1928 practically all manufacturers were operating under R.C.A. licenses. As a consequence of this
restriction, Raytheon was left with only replacement sales, which soon disappeared. When Raytheon found it
impossible to market its tubes in the early part of 1929, it obtained a license from R.C.A. to manufacture tubes
under the letters patent on a royalty basis. The license agreement contained a release of all claims of Raytheon
against R.C.A. by reason of the illegal acts of the latter under Clause 9 but by a side agreement such claims
could be asserted if R.C.A. should pay similar claims to others. The petitioner was informed of instances in which
R.C.A. had settled claims against it based on Clause 9. On that ground it considered itself released from the
agreement not to enforce its claim against R.C.A. and consequently, on December 14, 1931, the petitioner
caused its predecessor, Raytheon, to bring suit against R.C.A. in the District Court of Massachusetts alleging
that the plaintiff had by 1926 created and then possessed a large and valuable good will in interstate commerce
in rectifying tubes for radios and had a large and profitable established business therein so that the net profit for
the year 1926 was $454,935; that the business had an established prospect of large increases and that the
business and good will thereof was of a value of exceeding $3,000,000; that by the beginning of 1927 the plaintiff

47
was doing approximately 80% of the business of rectifying tubes of the entire United States; that the defendant
conspired to destroy the business of the plaintiff and others by a monopoly of such business and did suppress
*112 and destroy the existing companies; that the manufacturers of radio sets and others ceased to purchase
tubes from the plaintiffs; that by the end of 1927 the conspiracy had completely destroyed the profitable business
and that by the early part of 1928 the tube business of the plaintiff and its property and good will had been totally
destroyed at a time when it had a present value in excess of $3,000,000, and thereby the plaintiff was injured in
its business and property in a sum in excess of $3,000,000. The action against R.C.A. was referred to an auditor
who found that Clause 9 was not the cause of damage to the plaintiff but that the decline in plaintiff's business
was due to advancement in the radio art and competition. The auditor, however, also found that if it should be
decided that Clause 9 had turned the development of the radio art away from plaintiff's type of tube, then the
damages would be $1,000,000.

In the spring of 1938, after the auditor's report and just prior to the time for the commencement of the trial before
a jury, the Raytheon affiliated companies began negotiations for the settlement of the litigation with R.C.A. In the
meantime a suit brought by R.C.A. against the petitioner for the non-payment of royalties resulted in a judgment
of $410,000 in favor of R.C.A. R.C.A. and the petitioner finally agreed on the payment by R.C.A. of $410,000 in
settlement of the anti trust action. R.C.A. required the inclusion in the settlement of patent license rights and
sublicensing rights to some thirty patents but declined to allocate the amount paid as between the patent license
rights and the amount for the settlement of the suit. The agreement of settlement contained a general release of
any and all possible claims between the parties.

The officers of the Raytheon companies testified that $60,000 of the $410,000 received from R.C.A. was the
maximum worth of the patents, basing their appraisal on the cost of development of the patents and the fact that
few of them were then being used and that no royalties were being derived from them. In its income tax return
the petitioner returned $60,000 of the $410,000 as income from patent licenses and treated the remaining
$350,000 as a realization from a chose in action and not as taxable income. The Commissioner determined that
the $350,000 constituted income on the following ground contained in the statement attached to his notice of
deficiency: "It is the opinion of this office that the amount of $350,000 constitutes income under § 22(a) of the
Revenue Act of 1936. There exists no clear evidence of what the amount was paid for so that an accurate
apportionment can be made as to a specific consideration for patent rights transferred to Radio Corporation of
America and a consideration for damages. The amount of $350,000 has therefore been included in your taxable
income."

The pertinent sections of the statute are set out in the margin.[1]

Adverting to the question of whether *113 that part of the $410,000 which was paid by R.C.A. to Raytheon to
settle the anti trust suit was a return of capital or ordinary income, we must observe that the auditor's report is
immaterial on that issue. Despite the fact that the auditor found that the loss was not caused by Clause 9, it was
open to the jury to come to a different conclusion on the question of liability, and to avoid this R.C.A. settled the
suit by compromise.

Damages recovered in an antitrust action are not necessarily nontaxable as a return of capital. As in other types
of tort damage suits, recoveries which represent a reimbursement for lost profits are income. Swastika Oil & Gas
Co. v. Commissioner, 6 Cir., 1941, 123 F.2d 382, certiorari denied 1943, 317 U.S. 639, 63 S. Ct. 30, 87 L. Ed.
515; H. Liebes & Co. v. Commissioner, 9 Cir., 1937, 90 F.2d 932; Sternberg v. Commissioner, 1935, 32 B.T.A.
1039. The reasoning is that since the profits would be taxable income, the proceeds of litigation which are their
substitute are taxable in like manner.

Damages for violation of the anti-trust acts are treated as ordinary income where they represent compensation
for loss of profits. Commercial Electrical Supply Co. v. Commissioner, 1927, 8 B.T.A. 986; see Park v. Gilligan,
D.C.S.D.Ohio 1921, 293 F. 129, 130.

The test is not whether the action was one in tort or contract but rather the question to be asked is "In lieu of
what were the damages awarded?" Farmers' & Merchants' Bank v. Commissioner, 6 Cir., 1932, 59 F.2d 912;
48
Swastika Oil & Gas Co. v. Commissioner, supra; Central R. Co. of New Jersey v. Commissioner, 3 Cir., 1935,
79 F.2d 697, 101 A.L.R. 1448. See United States v. Safety Car Heating & Lighting Co., 1936, 297 U.S. 88, 98,
56 S. Ct. 353, 80 L. Ed. 500. Plumb, "Income Tax on Gains and Losses in Litigation" (1940) 25 Cornell L. Q.
221. Where the suit is not to recover lost profits but is for injury to good will, the recovery represents a return of
capital and, with certain limitations to be set forth below, is not taxable. Farmers' & Merchants' Bank v.
Commissioner, supra. Plumb, supra, 25 Cornell L. Q. 221, 225. "Care must certainly be taken in such cases to
avoid taxing recoveries for injuries to good will or loss of capital". 1 Paul and Mertens Law of Federal Income
Taxation § 6.48.

Upon examination of Raytheon's declaration in its anti-trust suit we find nothing to indicate that the suit was for
the recovery of lost profits. The allegations were that the illegal conduct of R.C.A. "completely destroyed the
profitable interstate and foreign commerce of the plaintiff and thereby, by the early part of 1928, the said tube
business of the plaintiff and the property good will of the plaintiff therein had been totally destroyed at a time
when it then had a present value in excess of three million dollars and thereby the plaintiff was then injured in its
business and property in a sum in excess of three million dollars." This was not the sort of antitrust suit where
the plaintiff's business still exists and where the injury was merely for loss of profits. The allegations and evidence
as to the amount of profits were necessary in order to establish the value of the good will and business since
that is derived by a capitalization of profits. A somewhat similar idea was expressed in Farmers' & Merchants'
Bank v. Commissioner, supra, *114 59 F.2d at page 913. "Profits were one of the chief indications of the worth
of the business; but the usual earnings before the injury, as compared with those afterward, were only an
evidential factor in determining actual loss and not an independent basis for recovery." Since the suit was to
recover damages for the destruction of the business and good will, the recovery represents a return of capital.
Nor does the fact that the suit ended in a compromise settlement change the nature of the recovery; "the
determining factor is the nature of the basic claim from which the compromised amount was realized." Paul
Selected Studies in Federal Taxation, Second Series, pp. 328-9, footnote 76; Helvering v. Safe Deposit & Trust
Co. of Baltimore, 1941, 316 U.S. 56, 62 S. Ct. 925, 86 L. Ed. 1266, 139 A.L.R. 1513; Lyeth v. Hoey, 1938, 305
U.S. 188, 59 S. Ct. 155, 83 L. Ed. 119, 119 A.L.R. 410; Central R. of New Jersey v. Commissioner, supra;
Farmers' & Merchants' Bank v. Commissioner, supra; Megargel v. Commissioner, 1944, 3 T.C. 238.

But, to say that the recovery represents a return of capital in that it takes the place of the business good will is
not to conclude that it may not contain a taxable benefit. Although the injured party may not be deriving a profit
as a result of the damage suit itself, the conversion thereby of his property into cash is a realization of any gain
made over the cost or other basis of the good will prior to the illegal interference. Thus A buys Blackacre for
$5,000. It appreciates in value to $50,000. B tortiously destroys it by fire. A sues and recovers $50,000 tort
damages from B. Although no gain was derived by A from the suit, his prior gain due to the appreciation in value
of Blackacre is realized when it is turned into cash by the money damages.

Compensation for the loss of Raytheon's good will in excess of its cost is gross income. See Magill Taxable
Income, p. 339. 1 Mertens, Law of Federal Income Taxation, § 5.21, footnote 82. Plumb, supra, 25 Cornell L. Q.
225, 6.

Since we assume with the parties that the petitioner secured the original Raytheon's assets through a series of
tax free reorganizations, petitioner's basis for the good will is the same as that of the original Raytheon. As the
Tax Court pointed out, the record is devoid of evidence as to the amount of that basis and "in the absence of
evidence of the basis of the business and good will of Raytheon, the amount of any nontaxable capital recovery
cannot be ascertained." 1 T.C. 952. Cf. Sterling v. Commissioner, 2 Cir., 1937, 93 F.2d 304.

Where the cost basis that may be assigned to property has been wholly speculative, the gain has been held to
be entirely conjectural and not taxable. In Strother v. Commissioner, 4 Cir., 1932, 55 F.2d 626, affirmed on other
grounds, 1932, 287 U.S. 308, 53 S. Ct. 150, 77 L. Ed. 325, a trespasser had taken coal and then destroyed the
entries so that the amount of coal taken could not be determined. Since there was no way of knowing whether
the recovery was greater than the basis for the coal taken, the gain was purely conjectural and not taxed. Magill
explains the result as follows: "as the amount of coal removed could not be determined until a final disposition
of the property, the computation of gain or loss on the damages must await that disposition." Taxable Income,
49
pp. 339-340. The same explanation may be applied to Farmers' & Merchants' Bank v. Commissioner, supra,
which relied on the Strother case in finding no gain. The recovery in that case had been to compensate for the
injury to good will and business reputation of the plaintiff bank inflicted by defendant reserve banks' wrongful
conduct in collecting checks drawn on the plaintiff bank by employing "agents who would appear daily at the
bank with checks and demand payment thereof in cash in such a manner as to attract unfavorable public
comment". Since the plaintiff bank's business was not destroyed but only injured and since it continued in
business, it would have been difficult to require the taxpayer to prove what part of the basis of its good will should
be attributed to the recovery. In the case at bar, on the contrary, the entire business and good will were destroyed
so that to require the taxpayer to prove the cost of the good will is no more impractical than if the business had
been sold.[2]

Inasmuch as we conclude that the portion of the $410,000 attributable to the suit is taxable income, the second
question as *115 to allocation between this and the ordinary income from patent licenses is not present.

The decision of the Tax Court is affirmed.

50
 Republic of the Philippines
SUPREME COURT
Manila

EN BANC

G.R. No. L-66416 March 21, 1990

COMMISSIONER OF INTERNAL REVENUE, petitioner,

vs.
TOURS SPECIALISTS, INC., and THE COURT OF TAX APPEALS, respondents.

Gadioma Law Offices for private respondent.

GUTIERREZ, JR., J.:

This is a petition to review on certiorari the decision of the Court of Tax Appeals which ruled that the money
entrusted to private respondent Tours Specialists, Inc., earmarked and paid for hotel room charges of tourists,
travelers and/or foreign travel agencies does not form part of its gross receipts subject to the 3% independent
contractor's tax under the National Internal Revenue Code of 1977.

We adopt the findings of facts of the Court of Tax Appeals as follows:

For the years 1974 to 1976, petitioner (Tours Specialists, Inc.) had derived income from its
activities as a travel agency by servicing the needs of foreign tourists and travelers and Filipino
"Balikbayans" during their stay in this country. Some of the services extended to the tourists
consist of booking said tourists and travelers in local hotels for their lodging and board needs;
transporting these foreign tourists from the airport to their respective hotels, and from the latter to
the airport upon their departure from the Philippines, transporting them from their hotels to various
embarkation points for local tours, visits and excursions; securing permits for them to visit places
of interest; and arranging their cultural entertainment, shopping and recreational activities.

In order to ably supply these services to the foreign tourists, petitioner and its correspondent
counterpart tourist agencies abroad have agreed to offer a package fee for the tourists. Although
the fee to be paid by said tourists is quoted by the petitioner, the payments of the hotel room
accommodations, food and other personal expenses of said tourists, as a rule, are paid directly
either by tourists themselves, or by their foreign travel agencies to the local hotels (pp. 77, t.s.n.,
February 2, 1981; Exhs. O & O-1, p. 29, CTA rec.; pp. 2425, t.s.n., ibid) and restaurants or shops,
as the case may be.

It is also the case that some tour agencies abroad request the local tour agencies, such as the
petitioner in the case, that the hotel room charges, in some specific cases, be paid through them.
(Exh. Q, Q-1, p. 29 CTA rec., p. 25, T.s.n., ibid, pp. 5-6, 17-18, t.s.n., Aug. 20, 1981.; See also
Exh. "U", pp. 22-23, t.s.n., Oct. 9, 1981, pp. 3-4, 11., t.s.n., Aug. 10, 1982). By this arrangement,
the foreign tour agency entrusts to the petitioner Tours Specialists, Inc., the fund for hotel room
accommodation, which in turn is paid by petitioner tour agency to the local hotel when billed. The
procedure observed is that the billing hotel sends the bill to the petitioner. The local hotel identifies
the individual tourist, or the particular groups of tourists by code name or group designation and
also the duration of their stay for purposes of payment. Upon receipt of the bill, the petitioner then
pays the local hotel with the funds entrusted to it by the foreign tour correspondent agency.

51
Despite this arrangement, respondent Commissioner of Internal Revenue assessed petitioner for
deficiency 3% contractor's tax as independent contractor by including the entrusted hotel room
charges in its gross receipts from services for the years 1974 to 1976. Consequently, on
December 6, 1979, petitioner received from respondent the 3% deficiency independent
contractor's tax assessment in the amount of P122,946.93 for the years 1974 to 1976, inclusive,
computed as follows:

1974 deficiency percentage tax

per investigation P 3,995.63

15% surcharge for late payment 998.91

—————

P 4,994.54

14% interest computed by quarters

up to 12-28-79 3,953.18 P 8,847.72

1975 deficiency percentage tax

per investigation P 8,427.39

25% surcharge for late payment 2,106.85

—————

P 10,534.24

14% interest computed by quarters

up to 12-28-79 6,808.47 P 17,342.71

1976 deficiency percentage

per investigation P 54,276.42

25% surcharge for late payment 13,569.11

—————

P 67,845.53

14% interest computed by quarters

up to 12-28-79 28,910.97 P 96,756.50

————— —————

52
 Total amount due P 122,946.93
=========

In addition to the deficiency contractor's tax of P122,946.93, petitioner was assessed to pay a
compromise penalty of P500.00.

Subsequently on December 11, 1979, petitioner formally protested the assessment made by
respondent on the ground that the money received and entrusted to it by the tourists, earmarked
to pay hotel room charges, were not considered and have never been considered by it as part of
its taxable gross receipts for purposes of computing and paying its constractor's tax.

During one of the hearings in this case, a witness, Serafina Sazon, Certified Public Accountant
and in charge of the Accounting Department of petitioner, had testified, her credibility not having
been destroyed on cross examination, categorically stated that the amounts entrusted to it by the
foreign tourist agencies intended for payment of hotel room charges, were paid entirely to the
hotel concerned, without any portion thereof being diverted to its own funds. (t.s.n., Feb. 2, 1981,
pp. 7, 25; t.s.n., Aug. 20, 1981, pp. 5-9, 17-18). The testimony of Serafina Sazon was corroborated
by Gerardo Isada, General Manager of petitioner, declaring to the effect that payments of hotel
accommodation are made through petitioner without any increase in the room charged (t.s.n.,
Oct. 9, 1981, pp. 21-25) and that the reason why tourists pay their room charge, or through their
foreign tourists agencies, is the fact that the room charge is exempt from hotel room tax under
P.D. 31. (t.s.n., Ibid., pp. 25-29.) Witness Isada stated, on cross-examination, that if their payment
is made, thru petitioner's tour agency, the hotel cost or charges "is only an act of accomodation
on our (its) part" or that the "agent abroad instead of sending several telexes and saving on bank
charges they take the option to send money to us to be held in trust to be endorsed to the hotel."
(pp. 3-4, t.s.n. Aug. 10, 1982.)

Nevertheless, on June 2, 1980, respondent, without deciding the petitioner's written protest,
caused the issuance of a warrant of distraint and levy. (p. 51, BIR Rec.) And later, respondent
had petitioner's bank deposits garnished. (pp. 49-50, BIR Rec.)

Taking this action of respondent as the adverse and final decision on the disputed assessment,
petitioner appealed to this Court. (Rollo, pp. 40-45)

The petitioner raises the lone issue in this petition as follows:

WHETHER AMOUNTS RECEIVED BY A LOCAL TOURIST AND TRAVEL AGENCY INCLUDED

IN A PACKAGE FEE FROM TOURISTS OR FOREIGN TOUR AGENCIES, INTENDED OR
EARMARKED FOR HOTEL ACCOMMODATIONS FORM PART OF GROSS RECEIPTS
SUBJECT TO 3% CONTRACTOR'S TAX. (Rollo, p. 23)

The petitioner premises the issue raised on the following assumptions:

Firstly, the ruling overlooks the fact that the amounts received, intended for hotel room
accommodations, were received as part of the package fee and, therefore, form part of "gross
receipts" as defined by law.

Secondly, there is no showing and is not established by the evidence. that the amounts received
and "earmarked" are actually what had been paid out as hotel room charges. The mere possibility
that the amounts actually paid could be less than the amounts received is sufficient to destroy the
validity of the ruling. (Rollo, pp. 26-27)

In effect, the petitioner's lone issue is based on alleged error in the findings of facts of the respondent court.
53
The well-settled doctrine is that the findings of facts of the Court of Tax Appeals are binding on this Court and
absent strong reasons for this Court to delve into facts, only questions of law are open for determination. (Nilsen
v. Commissioner of Customs, 89 SCRA 43 [1979]; Balbas v. Domingo, 21 SCRA 444 [1967]; Raymundo v. De
Joya, 101 SCRA 495 [1980]). In the recent case of Sy Po v. Court of Appeals, (164 SCRA 524 [1988]), we ruled
that the factual findings of the Court of Tax Appeals are binding upon this court and can only be disturbed on
appeal if not supported by substantial evidence.

In the instant case, we find no reason to disregard and deviate from the findings of facts of the Court of Tax
Appeals.

As quoted earlier, the Court of Tax Appeals sufficiently explained the services of a local travel agency, like the
herein private respondent, rendered to foreign customers. The respondent differentiated between the package
fee — offered by both the local travel agency and its correspondent counterpart tourist agencies abroad and the
requests made by some tour agencies abroad to local tour agencies wherein the hotel room charges in some
specific cases, would be paid to the local hotels through them. In the latter case, the correspondent court found
as a fact ". . . that the foreign tour agency entrusts to the petitioner Tours Specialists, Inc. the fund for hotel room
accommodation, which in turn is paid by petitioner tour agency to the local hotel when billed." (Rollo, p. 42) The
following procedure is followed: The billing hotel sends the bill to the respondent; the local hotel then identifies
the individual tourist, or the particular group of tourist by code name or group designation plus the duration of
their stay for purposes of payment; upon receipt of the bill the private respondent pays the local hotel with the
funds entrusted to it by the foreign tour correspondent agency.

Moreover, evidence presented by the private respondent shows that the amounts entrusted to it by the foreign
tourist agencies to pay the room charges of foreign tourists in local hotels were not diverted to its funds; this
arrangement was only an act of accommodation on the part of the private respondent. This evidence was not
refuted.

In essence, the petitioner's assertion that the hotel room charges entrusted to the private respondent were part
of the package fee paid by foreign tourists to the respondent is not correct. The evidence is clear to the effect
that the amounts entrusted to the private respondent were exclusively for payment of hotel room charges of
foreign tourists entrusted to it by foreign travel agencies.

As regards the petitioner's second assumption, the respondent court stated:

. . . [C]ontrary to the contention of respondent, the records show, firstly, in the Examiners'
Worksheet (Exh. T, p. 22, BIR Rec.), that from July to December 1976 alone, the following sums
made up the hotel room accommodations:

July 1976 P 102,702.97

Aug. 1976 121,167.19

Sept. 1976 53,209.61

—————

P 282,079.77

=========

Oct. 1976 P 71,134.80

Nov. 1976 409,019.17

54
 Dec. 1976 142,761.55

—————

622,915.51

—————

Grand Total P 904,995.29

=========

It is not true therefore, as stated by respondent, that there is no evidence proving the amounts
earmarked for hotel room charges. Since the BIR examiners could not have manufactured the
above figures representing "advances for hotel room accommodations," these payments must
have certainly been taken from the records of petitioner, such as the invoices, hotel bills, official
receipts and other pertinent documents. (Rollo, pp. 48-49)

The factual findings of the respondent court are supported by substantial evidence, hence binding upon this
Court.

With these clarifications, the issue to be threshed out is as stated by the respondent court, to wit:

. . . [W]hether or not the hotel room charges held in trust for foreign tourists and travelers and/or
correspondent foreign travel agencies and paid to local host hotels form part of the taxable gross
receipts for purposes of the 3% contractor's tax. (Rollo, p. 45)

The petitioner opines that the gross receipts which are subject to the 3% contractor's tax pursuant to Section
191 (Section 205 of the National Internal Revenue Code of 1977) of the Tax Code include the entire gross
receipts of a taxpayer undiminished by any amount. According to the petitioner, this interpretation is in
consonance with B.I.R. Ruling No. 68-027, dated 23 October, 1968 (implementing Section 191 of the Tax Code)
which states that the 3% contractor's tax prescribed by Section 191 of the Tax Code is imposed of the gross
receipts of the contractor, "no deduction whatever being allowed by said law." The petitioner contends that the
only exception to this rule is when there is a law or regulation which would exempt such gross receipts from
being subjected to the 3% contractor's tax citing the case of Commissioner of Internal Revenue v. Manila Jockey
Club, Inc. (108 Phil. 821 [1960]). Thus, the petitioner argues that since there is no law or regulation that money
entrusted, earmarked and paid for hotel room charges should not form part of the gross receipts, then the said
hotel room charges are included in the private respondent's gross receipts for purposes of the 3% contractor's
tax.

In the case of Commissioner of Internal Revenue v. Manila Jockey Club, Inc. (supra), the Commissioner
appealed two decisions of the Court of Tax Appeals disapproving his levy of amusement taxes upon the Manila
Jockey Club, a duly constituted corporation authorized to hold horse races in Manila. The facts of the case show
that the monies sought to be taxed never really belonged to the club. The decision shows that during the period
November 1946 to 1950, the Manila Jockey Club paid amusement tax on its commission but without including
the 5-1/2% which pursuant to Executive Order 320 and Republic Act 309 went to the Board of Races, the owner
of horses and jockeys. Section 260 of the Internal Revenue Code provides that the amusement tax was payable
by the operator on its "gross receipts". The Manila Jockey Club, however, did not consider as part of its "gross
receipts" subject to amusement tax the amounts which it had to deliver to the Board on Races, the horse owners
and the jockeys. This view was fully sustained by three opinions of the Secretary of Justice, to wit:

There is no question that the Manila Jockey, Inc., owns only 7-1/2% of the total bets registered
by the Totalizer. This portion represents its share or commission in the total amount of money it
55
 handles and goes to the funds thereof as its own property which it may legally disburse for its own
purposes. The 5% does not belong to the club. It is merely held in trust for distribution as prizes
to the owners of winning horses. It is destined for no other object than the payment of prizes and
the club cannot otherwise appropriate this portion without incurring liability to the owners of
winning horses. It cannot be considered as an item of expense because the sum used for the
payment of prizes is not taken from the funds of the club but from a certain portion of the total
bets especially earmarked for that purpose.

In view of all the foregoing, I am of the opinion that in the submission of the returns for the
amusement tax of 10% (now it is 20% of the "gross receipts", provided for in Section 260 of the
National Internal Revenue Code), the 5% of the total bets that is set aside for prizes to owners of
winning horses should not be included by the Manila Jockey Club, Inc.

The Collector of the Internal Revenue, however had a different opinion on the matter and demanded payment of
amusement taxes. The Court of Tax Appeals reversed the Collector.

We affirmed the decision of the Court of Tax Appeals and stated:

The Secretary's opinion was correct. The Government could not have meant to tax as gross
receipt of the Manila Jockey Club the 1/2% which it directs same Club to turn over to the Board
on Races. The latter being a Government institution, there would be double taxation, which should
be avoided unless the statute admits of no other interpretation. In the same manner, the
Government could not have intended to consider as gross receipt the portion of the funds which
it directed the Club to give, or knew the Club would give, to winning horses and jockeys —
admittedly 5%. It is true that the law says that out of the total wager funds 12-1/2% shall be set
aside as the "commission" of the race track owner, but the law itself takes official notice, and
actually approves or directs payment of the portion that goes to owners of horses as prizes and
bonuses of jockeys, which portion is admittedly 5% out of that 12-1/2% commission. As it did not
at that time contemplate the application of "gross receipts" revenue principle, the law in making a
distribution of the total wager funds, took no trouble of separating one item from the other; and for
convenience, grouped three items under one common denomination.

Needless to say, gross receipts of the proprietor of the amusement place should not include any
money which although delivered to the amusement place has been especially earmarked by law
or regulation for some person other than the proprietor. (The situation thus differs from one in
which the owner of the amusement place, by a private contract, with its employees or partners,
agrees to reserve for them a portion of the proceeds of the establishment. (See Wong & Lee v.
Coll. 104 Phil. 469; 55 Off. Gaz. [51] 10539; Sy Chuico v. Coll., 107 Phil., 428; 59 Off. Gaz., [6]
896).

In the second case, the facts of the case are:

The Manila Jockey Club holds once a year a so called "special Novato race", wherein only
"novato" horses, (i.e. horses which are running for the first time in an official [of the club] race),
may take part. Owners of these horses must pay to the Club an inscription fee of P1.00, and a
declaration fee of P1.00 per horse. In addition, each of them must contribute to a common fund
(P10.00 per horse). The Club contributes an equal amount P10.00 per horse) to such common
fund, the total amount of which is added to the 5% participation of horse owners already described
herein-above in the first case.

Since the institution of this yearly special novato race in 1950, the Manila Jockey Club never paid
amusement tax on the moneys thus contributed by horse owners (P10.00 each) because it
entertained the belief that in accordance with the three opinions of the Secretary of Justice herein-

56
 above described, such contributions never formed part of its gross receipts. On the inscription fee
of the P1.00 per horse, it paid the tax. It did not on the declaration fee of P1.00 because it was
imposed by the Municipal Ordinance of Manila and was turned over to the City officers.

The Collector of Internal Revenue required the Manila Jockey Club to pay amusement tax on
such contributed fund P10.00 per horse in the special novato race, holding they were part of its
gross receipts. The Manila Jockey Club protested and resorted to the Court of Tax Appeals, where
it obtained favorable judgment on the same grounds sustained by said Court in connection with
the 5% of the total wager funds in the herein-mentioned first case; they were not receipts of the
Club.

We resolved the issue in the following manner:

We think the reasons for upholding the Tax Court's decision in the first case apply to this one.
The ten-peso contribution never belonged to the Club. It was held by it as a trust fund. And then,
after all, when it received the ten-peso contribution, it at the same time contributed ten pesos out
of its own pocket, and thereafter distributed both amounts as prizes to horse owners. It would
seem unreasonable to regard the ten-peso contribution of the horse owners as taxable receipt of
the Club, since the latter, at the same moment it received the contribution necessarily lost ten
pesos too.

As demonstrated in the above-mentioned case, gross receipts subject to tax under the Tax Code do not include
monies or receipts entrusted to the taxpayer which do not belong to them and do not redound to the taxpayer's
benefit; and it is not necessary that there must be a law or regulation which would exempt such monies and
receipts within the meaning of gross receipts under the Tax Code.

Parenthetically, the room charges entrusted by the foreign travel agencies to the private respondent do not form
part of its gross receipts within the definition of the Tax Code. The said receipts never belonged to the private
respondent. The private respondent never benefited from their payment to the local hotels. As stated earlier, this
arrangement was only to accommodate the foreign travel agencies.

Another objection raised by the petitioner is to the respondent court's application of Presidential Decree 31 which
exempts foreign tourists from payment of hotel room tax. Section 1 thereof provides:

Sec. 1. — Foreign tourists and travelers shall be exempt from payment of any and all hotel room
tax for the entire period of their stay in the country.

The petitioner now alleges that P.D. 31 has no relevance to the case. He contends that the tax under Section
191 of the Tax Code is in the nature of an excise tax; that it is a tax on the exercise of the privilege to engage in
business as a contractor and that it is imposed on, and collectible from the person exercising the privilege. He
sums his arguments by stating that "while the burden may be shifted to the person for whom the services are
rendered by the contractor, the latter is not relieved from payment of the tax." (Rollo, p. 28)

The same arguments were submitted by the Commissioner of Internal Revenue in the case of Commissioner of
Internal Revenue v. John Gotamco & Son., Inc. (148 SCRA 36 [1987]), to justify his imposition of the 3%
contractor's tax under Section 191 of the National Internal Revenue Code on the gross receipts John Gotamco
& Sons, Inc., realized from the construction of the World Health Organization (WHO) office building in Manila.
We rejected the petitioner's arguments and ruled:

We agree with the Court of Tax Appeals in rejecting this contention of the petitioner. Said the
respondent court:

57
 "In context, direct taxes are those that are demanded from the very person who, it
is intended or desired, should pay them; while indirect taxes are those that are
demanded in the first instance from one person in the expectation and intention
that he can shift the burden to someone else. (Pollock v. Farmers, L & T Co., 1957
US 429, 15 S. Ct. 673, 39 Law. ed. 759). The contractor's tax is of course payable
by the contractor but in the last analysis it is the owner of the building that shoulders
the burden of the tax because the same is shifted by the contractor to the owner
as a matter of self-preservation. Thus, it is an indirect tax. And it is an indirect tax
on the WHO because, although it is payable by the petitioner, the latter can shift
its burden on the WHO. In the last analysis it is the WHO that will pay the tax
indirectly through the contractor and it certainly cannot be said that 'this tax has no
bearing upon the World Health Organization.'"

Petitioner claims that under the authority of the Philippine Acetylene Company versus
Commissioner of Internal Revenue, et al., (127 Phil. 461) the 3% contractor's tax falls directly on
Gotamco and cannot be shifted to the WHO. The Court of Tax Appeals, however, held that the
said case is not controlling in this case, since the Host Agreement specifically exempts the WHO
from "indirect taxes." We agree. The Philippine Acetylene case involved a tax on sales of goods
which under the law had to be paid by the manufacturer or producer; the fact that the manufacturer
or producer might have added the amount of the tax to the price of the goods did not make the
sales tax "a tax on the purchaser." The Court held that the sales tax must be paid by the
manufacturer or producer even if the sale is made to tax-exempt entities like the National Power
Corporation, an agency of the Philippine Government, and to the Voice of America, an agency of
the United States Government.

The Host Agreement, in specifically exempting the WHO from "indirect taxes," contemplates taxes
which, although not imposed upon or paid by the Organization directly, form part of the price paid
or to be paid by it.

Accordingly, the significance of P.D. 31 is clearly established in determining whether or not hotel room charges
of foreign tourists in local hotels are subject to the 3% contractor's tax. As the respondent court aptly stated:

. . . If the hotel room charges entrusted to petitioner will be subjected to 3% contractor's tax as
what respondent would want to do in this case, that would in effect do indirectly what P.D. 31
would not like hotel room charges of foreign tourists to be subjected to hotel room tax. Although,
respondent may claim that the 3% contractor's tax is imposed upon a different incidence i.e. the
gross receipts of petitioner tourist agency which he asserts includes the hotel room charges
entrusted to it, the effect would be to impose a tax, and though different, it nonetheless imposes
a tax actually on room charges. One way or the other, it would not have the effect of promoting
tourism in the Philippines as that would increase the costs or expenses by the addition of a hotel
room tax in the overall expenses of said tourists. (Rollo, pp. 51-52)

WHEREFORE, the instant petition is DENIED. The decision of the Court of Tax Appeals is AFFIRMED. No
pronouncement as to costs.

SO ORDERED.

Fernan, C.J., Narvasa, Melencio-Herrera, Cruz, Paras, Feliciano, Gancayco, Padilla, Bidin, Sarmiento, Cortes,
Griño-Aquino, Medialdea and Regalado, JJ., concur.

58
 Republic of the Philippines
SUPREME COURT
Manila

SECOND DIVISION

G.R. No. 78953 July 31, 1991

COMMISSIONER OF INTERNAL REVENUE, petitioner,

vs.
MELCHOR J. JAVIER, JR. and THE COURT OF TAX APPEALS, respondents.

Elison G. Natividad for accused-appellant.

SARMIENTO, J.:

Central in this controversy is the issue as to whether or not a taxpayer who merely states as a footnote in his
income tax return that a sum of money that he erroneously received and already spent is the subject of a pending
litigation and there did not declare it as income is liable to pay the 50% penalty for filing a fraudulent return.

This question is the subject of the petition for review before the Court of the portion of the Decision1 dated July
27, 1983 of the Court of Tax Appeals (CTA) in C.T.A. Case No. 3393, entitled, "Melchor J. Javier, Jr. vs. Ruben
B. Ancheta, in his capacity as Commissioner of Internal Revenue," which orders the deletion of the 50%
surcharge from Javier's deficiency income tax assessment on his income for 1977.

The respondent CTA in a Resolution2 dated May 25, 1987, denied the Commissioner's Motion for
Reconsideration3 and Motion for New Trial4 on the deletion of the 50% surcharge assessment or imposition.

The pertinent facts as are accurately stated in the petition of private respondent Javier in the CTA and
incorporated in the assailed decision now under review, read as follows:

xxx xxx xxx

2. That on or about June 3, 1977, Victoria L. Javier, the wife of the petitioner (private respondent
herein), received from the Prudential Bank and Trust Company in Pasay City the amount of
US$999,973.70 remitted by her sister, Mrs. Dolores Ventosa, through some banks in the United
States, among which is Mellon Bank, N.A.

3. That on or about June 29, 1977, Mellon Bank, N.A. filed a complaint with the Court of First
Instance of Rizal (now Regional Trial Court), (docketed as Civil Case No. 26899), against the
petitioner (private respondent herein), his wife and other defendants, claiming that its remittance
of US$1,000,000.00 was a clerical error and should have been US$1,000.00 only, and praying
that the excess amount of US$999,000.00 be returned on the ground that the defendants are
trustees of an implied trust for the benefit of Mellon Bank with the clear, immediate, and continuing
duty to return the said amount from the moment it was received.

4. That on or about November 5, 1977, the City Fiscal of Pasay City filed an Information with the
then Circuit Criminal Court (docketed as CCC-VII-3369-P.C.) charging the petitioner (private
respondent herein) and his wife with the crime of estafa, alleging that they misappropriated,
59
 misapplied, and converted to their own personal use and benefit the amount of US$999,000.00
which they received under an implied trust for the benefit of Mellon Bank and as a result of the
mistake in the remittance by the latter.

5. That on March 15, 1978, the petitioner (private respondent herein) filed his Income Tax Return
for the taxable year 1977 showing a gross income of P53,053.38 and a net income of P48,053.88
and stating in the footnote of the return that "Taxpayer was recipient of some money received
from abroad which he presumed to be a gift but turned out to be an error and is now subject of
litigation."

6. That on or before December 15, 1980, the petitioner (private respondent herein) received a
letter from the acting Commissioner of Internal Revenue dated November 14, 1980, together with
income assessment notices for the years 1976 and 1977, demanding that petitioner (private
respondent herein) pay on or before December 15, 1980 the amount of P1,615.96 and
P9,287,297.51 as deficiency assessments for the years 1976 and 1977 respectively. . . .

7. That on December 15, 1980, the petitioner (private respondent herein) wrote the Bureau of
Internal Revenue that he was paying the deficiency income assessment for the year 1976 but
denying that he had any undeclared income for the year 1977 and requested that the assessment
for 1977 be made to await final court decision on the case filed against him for filing an allegedly
fraudulent return. . . .

8. That on November 11, 1981, the petitioner (private respondent herein) received from Acting
Commissioner of Internal Revenue Romulo Villa a letter dated October 8, 1981 stating in reply to
his December 15, 1980 letter-protest that "the amount of Mellon Bank's erroneous remittance
which you were able to dispose, is definitely taxable." . . .5

The Commissioner also imposed a 50% fraud penalty against Javier.

Disagreeing, Javier filed an appeal6 before the respondent Court of Tax Appeals on December 10, 1981.

The respondent CTA, after the proper proceedings, rendered the challenged decision. We quote the concluding
portion:

We note that in the deficiency income tax assessment under consideration, respondent (petitioner
here) further requested petitioner (private respondent here) to pay 50% surcharge as provided for
in Section 72 of the Tax Code, in addition to the deficiency income tax of P4,888,615.00 and
interest due thereon. Since petitioner (private respondent) filed his income tax return for taxable
year 1977, the 50% surcharge was imposed, in all probability, by respondent (petitioner) because
he considered the return filed false or fraudulent. This additional requirement, to our mind, is much
less called for because petitioner (private respondent), as stated earlier, reflected in as 1977
return as footnote that "Taxpayer was recipient of some money received from abroad which he
presumed to be gift but turned out to be an error and is now subject of litigation."

From this, it can hardly be said that there was actual and intentional fraud, consisting of deception
willfully and deliberately done or resorted to by petitioner (private respondent) in order to induce
the Government to give up some legal right, or the latter, due to a false return, was placed at a
disadvantage so as to prevent its lawful agents from proper assessment of tax liabilities. (Aznar
vs. Court of Tax Appeals, L-20569, August 23, 1974, 56 (sic) SCRA 519), because petitioner
literally "laid his cards on the table" for respondent to examine. Error or mistake of fact or law is
not fraud. (Insular Lumber vs. Collector, L-7100, April 28, 1956.). Besides, Section 29 is not too
plain and simple to understand. Since the question involved in this case is of first impression in

60
 this jurisdiction, under the circumstances, the 50% surcharge imposed in the deficiency
assessment should be deleted.7

The Commissioner of Internal Revenue, not satisfied with the respondent CTA's ruling, elevated the matter to
us, by the present petition, raising the main issue as to:

WHETHER OR NOT PRIVATE RESPONDENT IS LIABLE FOR THE 50% FRAUD PENALTY?8

On the other hand, Javier candidly stated in his Memorandum,9 that he "did not appeal the decision which held
him liable for the basic deficiency income tax (excluding the 50% surcharge for fraud)." However, he submitted
in the same memorandum "that the issue may be raised in the case not for the purpose of correcting or setting
aside the decision which held him liable for deficiency income tax, but only to show that there is no basis for the
imposition of the surcharge." This subsequent disavowal therefore renders moot and academic the posturings
articulated in as Comment10 on the non-taxability of the amount he erroneously received and the bulk of which
he had already disbursed. In any event, an appeal at that time (of the filing of the Comments) would have been
already too late to be seasonable. The petitioner, through the office of the Solicitor General, stresses that:

xxx xxx xxx

The record however is not ambivalent, as the record clearly shows that private respondent is self-
convinced, and so acted, that he is the beneficial owner, and of which reason is liable to tax. Put
another way, the studied insinuation that private respondent may not be the beneficial owner of
the money or income flowing to him as enhanced by the studied claim that the amount is "subject
of litigation" is belied by the record and clearly exposed as a fraudulent ploy, as witness what
transpired upon receipt of the amount.

Here, it will be noted that the excess in the amount erroneously remitted by MELLON BANK for
the amount of private respondent's wife was $999,000.00 after opening a dollar account with
Prudential Bank in the amount of $999,993.70, private respondent and his wife, with haste and
dispatch, within a span of eleven (11) electric days, specifically from June 3 to June 14, 1977,
effected a total massive withdrawal from the said dollar account in the sum of $975,000.00 or
P7,020,000.00. . . .11

In reply, the private respondent argues:

xxx xxx xxx

The petitioner contends that the private respondent committed fraud by not declaring the
"mistaken remittance" in his income tax return and by merely making a footnote thereon which
read: "Taxpayer was the recipient of some money from abroad which he presumed to be a gift
but turned out to be an error and is now subject of litigation." It is respectfully submitted that the
said return was not fraudulent. The footnote was practically an invitation to the petitioner to make
an investigation, and to make the proper assessment.

The rule in fraud cases is that the proof "must be clear and convincing" (Griffiths v. Comm., 50 F
[2d] 782), that is, it must be stronger than the "mere preponderance of evidence" which would be
sufficient to sustain a judgment on the issue of correctness of the deficiency itself apart from the
fraud penalty. (Frank A. Neddas, 40 BTA 672). The following circumstances attendant to the case
at bar show that in filing the questioned return, the private respondent was guided, not by that
"willful and deliberate intent to prevent the Government from making a proper assessment" which
constitute fraud, but by an honest doubt as to whether or not the "mistaken remittance" was
subject to tax.

61
 First, this Honorable Court will take judicial notice of the fact that so-called "million dollar case"
was given very, very wide publicity by media; and only one who is not in his right mind would have
entertained the idea that the BIR would not make an assessment if the amount in question was
indeed subject to the income tax.

Second, as the respondent Court ruled, "the question involved in this case is of first impression
in this jurisdiction" (See p. 15 of Annex "A" of the Petition). Even in the United States, the
authorities are not unanimous in holding that similar receipts are subject to the income tax. It
should be noted that the decision in the Rutkin case is a five-to-four decision; and in the very case
before this Honorable Court, one out of three Judges of the respondent Court was of the opinion
that the amount in question is not taxable. Thus, even without the footnote, the failure to declare
the "mistaken remittance" is not fraudulent.

Third, when the private respondent filed his income tax return on March 15, 1978 he was being
sued by the Mellon Bank for the return of the money, and was being prosecuted by the
Government for estafa committed allegedly by his failure to return the money and by converting
it to his personal benefit. The basic tax amounted to P4,899,377.00 (See p. 6 of the Petition) and
could not have been paid without using part of the mistaken remittance. Thus, it was not
unreasonable for the private respondent to simply state in his income tax return that the amount
received was still under litigation. If he had paid the tax, would that not constitute estafa for using
the funds for his own personal benefit? and would the Government refund it to him if the courts
ordered him to refund the money to the Mellon Bank?12

xxx xxx xxx

Under the then Section 72 of the Tax Code (now Section 248 of the 1988 National Internal Revenue Code), a
taxpayer who files a false return is liable to pay the fraud penalty of 50% of the tax due from him or of the
deficiency tax in case payment has been made on the basis of the return filed before the discovery of the falsity
or fraud.

We are persuaded considerably by the private respondent's contention that there is no fraud in the filing of the
return and agree fully with the Court of Tax Appeals' interpretation of Javier's notation on his income tax return
filed on March 15, 1978 thus: "Taxpayer was the recipient of some money from abroad which he presumed to
be a gift but turned out to be an error and is now subject of litigation that it was an "error or mistake of fact or
law" not constituting fraud, that such notation was practically an invitation for investigation and that Javier had
literally "laid his cards on the table."13

In Aznar v. Court of Tax Appeals,14 fraud in relation to the filing of income tax return was discussed in this
manner:

. . . The fraud contemplated by law is actual and not constructive. It must be intentional fraud,
consisting of deception willfully and deliberately done or resorted to in order to induce another to
give up some legal right. Negligence, whether slight or gross, is not equivalent to the fraud with
intent to evade the tax contemplated by law. It must amount to intentional wrong-doing with the
sole object of avoiding the tax. It necessarily follows that a mere mistake cannot be considered
as fraudulent intent, and if both petitioner and respondent Commissioner of Internal Revenue
committed mistakes in making entries in the returns and in the assessment, respectively, under
the inventory method of determining tax liability, it would be unfair to treat the mistakes of the
petitioner as tainted with fraud and those of the respondent as made in good faith.

Fraud is never imputed and the courts never sustain findings of fraud upon circumstances which, at most, create
only suspicion and the mere understatement of a tax is not itself proof of fraud for the purpose of tax evasion.15

62
 A "fraudulent return" is always an attempt to evade a tax, but a merely "false return" may not be,
Rick v. U.S., App. D.C., 161 F. 2d 897, 898.16

In the case at bar, there was no actual and intentional fraud through willful and deliberate misleading of the
government agency concerned, the Bureau of Internal Revenue, headed by the herein petitioner. The
government was not induced to give up some legal right and place itself at a disadvantage so as to prevent its
lawful agents from proper assessment of tax liabilities because Javier did not conceal anything. Error or mistake
of law is not fraud. The petitioner's zealousness to collect taxes from the unearned windfall to Javier is highly
commendable.1âwphi1 Unfortunately, the imposition of the fraud penalty in this case is not justified by the extant
facts. Javier may be guilty of swindling charges, perhaps even for greed by spending most of the money he
received, but the records lack a clear showing of fraud committed because he did not conceal the fact that he
had received an amount of money although it was a "subject of litigation." As ruled by respondent Court of Tax
Appeals, the 50% surcharge imposed as fraud penalty by the petitioner against the private respondent in the
deficiency assessment should be deleted.

WHEREFORE, the petition is DENIED and the decision appealed from the Court of Tax Appeals is AFFIRMED.
No costs.

SO ORDERED.

Melencio-Herrera, Padilla and Regalado, JJ., concur.

Paras, J., took no part.

63
 Republic of the Philippines
SUPREME COURT
Manila

EN BANC

G.R. No. L-59431 July 25, 1984

ANTERO M. SISON, JR., petitioner,

vs.
RUBEN B. ANCHETA, Acting Commissioner, Bureau of Internal Revenue; ROMULO VILLA, Deputy
Commissioner, Bureau of Internal Revenue; TOMAS TOLEDO Deputy Commissioner, Bureau of
Internal Revenue; MANUEL ALBA, Minister of Budget, FRANCISCO TANTUICO, Chairman,
Commissioner on Audit, and CESAR E. A. VIRATA, Minister of Finance, respondents.

Antero Sison for petitioner and for his own behalf.

The Solicitor General for respondents.

FERNANDO, C.J.:

The success of the challenge posed in this suit for declaratory relief or prohibition proceeding 1 on the validity of
Section I of Batas Pambansa Blg. 135 depends upon a showing of its constitutional infirmity. The assailed
provision further amends Section 21 of the National Internal Revenue Code of 1977, which provides for rates of
tax on citizens or residents on (a) taxable compensation income, (b) taxable net income, (c) royalties, prizes,
and other winnings, (d) interest from bank deposits and yield or any other monetary benefit from deposit
substitutes and from trust fund and similar arrangements, (e) dividends and share of individual partner in the net
profits of taxable partnership, (f) adjusted gross income. 2 Petitioner 3 as taxpayer alleges that by virtue thereof,
"he would be unduly discriminated against by the imposition of higher rates of tax upon his income arising from
the exercise of his profession vis-a-vis those which are imposed upon fixed income or salaried individual
taxpayers. 4 He characterizes the above sction as arbitrary amounting to class legislation, oppressive and
capricious in character 5 For petitioner, therefore, there is a transgression of both the equal protection and due
process clauses 6 of the Constitution as well as of the rule requiring uniformity in taxation. 7

The Court, in a resolution of January 26, 1982, required respondents to file an answer within 10 days from notice.
Such an answer, after two extensions were granted the Office of the Solicitor General, was filed on May 28,
1982. 8 The facts as alleged were admitted but not the allegations which to their mind are "mere arguments,
opinions or conclusions on the part of the petitioner, the truth [for them] being those stated [in their] Special and
Affirmative Defenses." 9 The answer then affirmed: "Batas Pambansa Big. 135 is a valid exercise of the State's
power to tax. The authorities and cases cited while correctly quoted or paraghraph do not support petitioner's
stand." 10 The prayer is for the dismissal of the petition for lack of merit.

This Court finds such a plea more than justified. The petition must be dismissed.

1. It is manifest that the field of state activity has assumed a much wider scope, The reason was so clearly set
forth by retired Chief Justice Makalintal thus: "The areas which used to be left to private enterprise and initiative
and which the government was called upon to enter optionally, and only 'because it was better equipped to
administer for the public welfare than is any private individual or group of individuals,' continue to lose their well-
defined boundaries and to be absorbed within activities that the government must undertake in its sovereign
capacity if it is to meet the increasing social challenges of the times." 11 Hence the need for more revenues. The
power to tax, an inherent prerogative, has to be availed of to assure the performance of vital state functions. It
64
is the source of the bulk of public funds. To praphrase a recent decision, taxes being the lifeblood of the
government, their prompt and certain availability is of the essence. 12

2. The power to tax moreover, to borrow from Justice Malcolm, "is an attribute of sovereignty. It is the strongest
of all the powers of of government." 13 It is, of course, to be admitted that for all its plenitude 'the power to tax is
not unconfined. There are restrictions. The Constitution sets forth such limits . Adversely affecting as it does
properly rights, both the due process and equal protection clauses inay properly be invoked, all petitioner does,
to invalidate in appropriate cases a revenue measure. if it were otherwise, there would -be truth to the 1803
dictum of Chief Justice Marshall that "the power to tax involves the power to destroy." 14 In a separate opinion
in Graves v. New York, 15 Justice Frankfurter, after referring to it as an 1, unfortunate remark characterized it
as "a flourish of rhetoric [attributable to] the intellectual fashion of the times following] a free use of absolutes."
16 This is merely to emphasize that it is riot and there cannot be such a constitutional mandate. Justice
Frankfurter could rightfully conclude: "The web of unreality spun from Marshall's famous dictum was brushed
away by one stroke of Mr. Justice Holmess pen: 'The power to tax is not the power to destroy while this Court
sits." 17 So it is in the Philippines.

3. This Court then is left with no choice. The Constitution as the fundamental law overrides any legislative or
executive, act that runs counter to it. In any case therefore where it can be demonstrated that the challenged
statutory provision — as petitioner here alleges — fails to abide by its command, then this Court must so declare
and adjudge it null. The injury thus is centered on the question of whether the imposition of a higher tax rate on
taxable net income derived from business or profession than on compensation is constitutionally infirm.

4, The difficulty confronting petitioner is thus apparent. He alleges arbitrariness. A mere allegation, as here. does
not suffice. There must be a factual foundation of such unconstitutional taint. Considering that petitioner here
would condemn such a provision as void or its face, he has not made out a case. This is merely to adhere to the
authoritative doctrine that were the due process and equal protection clauses are invoked, considering that they
arc not fixed rules but rather broad standards, there is a need for of such persuasive character as would lead to
such a conclusion. Absent such a showing, the presumption of validity must prevail. 18

5. It is undoubted that the due process clause may be invoked where a taxing statute is so arbitrary that it finds
no support in the Constitution. An obvious example is where it can be shown to amount to the confiscation of
property. That would be a clear abuse of power. It then becomes the duty of this Court to say that such an
arbitrary act amounted to the exercise of an authority not conferred. That properly calls for the application of the
Holmes dictum. It has also been held that where the assailed tax measure is beyond the jurisdiction of the state,
or is not for a public purpose, or, in case of a retroactive statute is so harsh and unreasonable, it is subject to
attack on due process grounds. 19

6. Now for equal protection. The applicable standard to avoid the charge that there is a denial of this constitutional
mandate whether the assailed act is in the exercise of the lice power or the power of eminent domain is to
demonstrated that the governmental act assailed, far from being inspired by the attainment of the common weal
was prompted by the spirit of hostility, or at the very least, discrimination that finds no support in reason. It
suffices then that the laws operate equally and uniformly on all persons under similar circumstances or that all
persons must be treated in the same manner, the conditions not being different, both in the privileges conferred
and the liabilities imposed. Favoritism and undue preference cannot be allowed. For the principle is that equal
protection and security shall be given to every person under circumtances which if not Identical are analogous.
If law be looked upon in terms of burden or charges, those that fall within a class should be treated in the same
fashion, whatever restrictions cast on some in the group equally binding on the rest." 20 That same formulation
applies as well to taxation measures. The equal protection clause is, of course, inspired by the noble concept of
approximating the Ideal of the laws benefits being available to all and the affairs of men being governed by that
serene and impartial uniformity, which is of the very essence of the Idea of law. There is, however, wisdom, as
well as realism in these words of Justice Frankfurter: "The equality at which the 'equal protection' clause aims is
not a disembodied equality. The Fourteenth Amendment enjoins 'the equal protection of the laws,' and laws are
not abstract propositions. They do not relate to abstract units A, B and C, but are expressions of policy arising
out of specific difficulties, address to the attainment of specific ends by the use of specific remedies. The
65
Constitution does not require things which are different in fact or opinion to be treated in law as though they were
the same." 21 Hence the constant reiteration of the view that classification if rational in character is allowable.
As a matter of fact, in a leading case of Lutz V. Araneta, 22 this Court, through Justice J.B.L. Reyes, went so far
as to hold "at any rate, it is inherent in the power to tax that a state be free to select the subjects of taxation, and
it has been repeatedly held that 'inequalities which result from a singling out of one particular class for taxation,
or exemption infringe no constitutional limitation.'" 23

7. Petitioner likewise invoked the kindred concept of uniformity. According to the Constitution: "The rule of
taxation shag be uniform and equitable." 24 This requirement is met according to Justice Laurel in Philippine
Trust Company v. Yatco,25 decided in 1940, when the tax "operates with the same force and effect in every
place where the subject may be found. " 26 He likewise added: "The rule of uniformity does not call for perfect
uniformity or perfect equality, because this is hardly attainable." 27 The problem of classification did not present
itself in that case. It did not arise until nine years later, when the Supreme Court held: "Equality and uniformity in
taxation means that all taxable articles or kinds of property of the same class shall be taxed at the same rate.
The taxing power has the authority to make reasonable and natural classifications for purposes of taxation, ... .
28 As clarified by Justice Tuason, where "the differentiation" complained of "conforms to the practical dictates of
justice and equity" it "is not discriminatory within the meaning of this clause and is therefore uniform." 29 There
is quite a similarity then to the standard of equal protection for all that is required is that the tax "applies equally
to all persons, firms and corporations placed in similar situation."30

8. Further on this point. Apparently, what misled petitioner is his failure to take into consideration the distinction
between a tax rate and a tax base. There is no legal objection to a broader tax base or taxable income by
eliminating all deductible items and at the same time reducing the applicable tax rate. Taxpayers may be
classified into different categories. To repeat, it. is enough that the classification must rest upon substantial
distinctions that make real differences. In the case of the gross income taxation embodied in Batas Pambansa
Blg. 135, the, discernible basis of classification is the susceptibility of the income to the application of generalized
rules removing all deductible items for all taxpayers within the class and fixing a set of reduced tax rates to be
applied to all of them. Taxpayers who are recipients of compensation income are set apart as a class. As there
is practically no overhead expense, these taxpayers are e not entitled to make deductions for income tax
purposes because they are in the same situation more or less. On the other hand, in the case of professionals
in the practice of their calling and businessmen, there is no uniformity in the costs or expenses necessary to
produce their income. It would not be just then to disregard the disparities by giving all of them zero deduction
and indiscriminately impose on all alike the same tax rates on the basis of gross income. There is ample
justification then for the Batasang Pambansa to adopt the gross system of income taxation to compensation
income, while continuing the system of net income taxation as regards professional and business income.

9. Nothing can be clearer, therefore, than that the petition is without merit, considering the (1) lack of factual
foundation to show the arbitrary character of the assailed provision; 31 (2) the force of controlling doctrines on
due process, equal protection, and uniformity in taxation and (3) the reasonableness of the distinction between
compensation and taxable net income of professionals and businessman certainly not a suspect classification,

WHEREFORE, the petition is dismissed. Costs against petitioner.

Makasiar, Concepcion, Jr., Guerero, Melencio-Herrera, Escolin, Relova, Gutierrez, Jr., De la Fuente and
Cuevas, JJ., concur.

Teehankee, J., concurs in the result.

Plana, J., took no part.

66