G.R. No.
179579               February 1, 2012 the subject matter of the case, because respondent was
COMMISSIONER OF CUSTOMS and the DISTRICT
COLLECTOR OF THE PORT OF SUBIC, Petitioners,
vs.
HYPERMIX FEEDS CORPORATION, Respondent.
DECISION
SERENO, J.:
Before us is a Petition for Review under Rule
45,1 assailing the Decision2 and the Resolution3 of the
Court of Appeals (CA), which nullified the Customs
Memorandum Order (CMO) No. 27-20034 on the tariff
classification of wheat issued by petitioner
Commissioner of Customs.
The antecedent facts are as follows:
On 7 November 2003, petitioner Commissioner of
Customs issued CMO 27-2003. Under the
Memorandum, for tariff purposes, wheat was classified
according to the following: (1) importer or consignee; (2)
country of origin; and (3) port of discharge.5 The
regulation provided an exclusive list of corporations,
ports of discharge, commodity descriptions and countries
of origin. Depending on these factors, wheat would be
classified either as food grade or feed grade. The
corresponding tariff for food grade wheat was 3%, for
feed grade, 7%.
CMO 27-2003 further provided for the proper procedure
for protest or Valuation and Classification Review
Committee (VCRC) cases. Under this procedure, the
release of the articles that were the subject of protest
required the importer to post a cash bond to cover the
tariff differential.6
A month after the issuance of CMO 27-2003, on 19
December 2003, respondent filed a Petition for
Declaratory Relief7 with the Regional Trial Court (RTC) of
Las Piñas City. It anticipated the implementation of the
regulation on its imported and perishable Chinese milling
wheat in transit from China.8 Respondent contended that
CMO 27-2003 was issued without following the mandate
of the Revised Administrative Code on public
participation, prior notice, and publication or registration
with the University of the Philippines Law Center.
Respondent also alleged that the regulation summarily
adjudged it to be a feed grade supplier without the
benefit of prior assessment and examination; thus,
despite having imported food grade wheat, it would be
subjected to the 7% tariff upon the arrival of the
shipment, forcing them to pay 133% more than was
proper.
Furthermore, respondent claimed that the equal
protection clause of the Constitution was violated when
the regulation treated non-flour millers differently from
flour millers for no reason at all.
Lastly, respondent asserted that the retroactive
application of the regulation was confiscatory in nature.
On 19 January 2004, the RTC issued a Temporary
Restraining Order (TRO) effective for twenty (20) days
from notice.9
Petitioners thereafter filed a Motion to Dismiss.10 They
alleged that: (1) the RTC did not have jurisdiction over
asking for a judicial determination of the classification of
wheat; (2) an action for declaratory relief was improper;
(3) CMO 27-2003 was an internal administrative rule and
not legislative in nature; and (4) the claims of respondent
were speculative and premature, because the Bureau of
Customs (BOC) had yet to examine respondent’s
products. They likewise opposed the application for a
writ of preliminary injunction on the ground that they had
not inflicted any injury through the issuance of the
regulation; and that the action would be contrary to the
rule that administrative issuances are assumed valid
until declared otherwise.
On 28 February 2005, the parties agreed that the
matters raised in the application for preliminary injunction
and the Motion to Dismiss would just be resolved
together in the main case. Thus, on 10 March 2005, the
RTC rendered its Decision11 without having to resolve the
application for preliminary injunction and the Motion to
Dismiss.
The trial court ruled in favor of respondent, to wit:
WHEREFORE, in view of the foregoing, the Petition is
GRANTED and the subject Customs Memorandum
Order 27-2003 is declared INVALID and OF NO FORCE
AND EFFECT. Respondents Commissioner of Customs,
the District Collector of Subic or anyone acting in their
behalf are to immediately cease and desist from
enforcing the said Customs Memorandum Order 27-
2003.
SO ORDERED.12
The RTC held that it had jurisdiction over the subject
matter, given that the issue raised by respondent
concerned the quasi-legislative powers of petitioners. It
likewise stated that a petition for declaratory relief was
the proper remedy, and that respondent was the proper
party to file it. The court considered that respondent was
a regular importer, and that the latter would be subjected
to the application of the regulation in future transactions.
With regard to the validity of the regulation, the trial court
found that petitioners had not followed the basic
requirements of hearing and publication in the issuance
of CMO 27-2003. It likewise held that petitioners had
"substituted the quasi-judicial determination of the
commodity by a quasi-legislative
predetermination."13 The lower court pointed out that a
classification based on importers and ports of discharge
were violative of the due process rights of respondent.
Dissatisfied with the Decision of the lower court,
petitioners appealed to the CA, raising the same
allegations in defense of CMO 27-2003.14 The appellate
court, however, dismissed the appeal. It held that, since
the regulation affected substantial rights of petitioners
and other importers, petitioners should have observed
the requirements of notice, hearing and publication.
Hence, this Petition.
Petitioners raise the following issues for the
consideration of this Court:
I. THE COURT OF APPEALS DECIDED A
QUESTION OF SUBSTANCE WHICH IS NOT
IN ACCORD WITH THE LAW AND
PREVAILING JURISPRUDENCE.
 II. THE COURT OF APPEALS GRAVELY
ERRED IN DECLARING THAT THE TRIAL
COURT HAS JURISDICTION OVER THE
CASE.
The Petition has no merit.
We shall first discuss the propriety of an action for
declaratory relief.
Rule 63, Section 1 provides:
Who may file petition. – Any person interested under a
deed, will, contract or other written instrument, or whose
rights are affected by a statute, executive order or
regulation, ordinance, or any other governmental
regulation may, before breach or violation thereof, bring
an action in the appropriate Regional Trial Court to
determine any question of construction or validity arising,
and for a declaration of his rights or duties, thereunder.
The requirements of an action for declaratory relief are
as follows: (1) there must be a justiciable controversy;
(2) the controversy must be between persons whose
interests are adverse; (3) the party seeking declaratory
relief must have a legal interest in the controversy; and
(4) the issue involved must be ripe for judicial
determination.15 We find that the Petition filed by
respondent before the lower court meets these
requirements.
First, the subject of the controversy is the
constitutionality of CMO 27-2003 issued by petitioner
Commissioner of Customs. In Smart Communications v.
NTC,16 we held:
The determination of whether a specific rule or set of
rules issued by an administrative agency contravenes
the law or the constitution is within the jurisdiction of the
regular courts. Indeed, the Constitution vests the power
of judicial review or the power to declare a law, treaty,
international or executive agreement, presidential
decree, order, instruction, ordinance, or regulation in the
courts, including the regional trial courts. This is within
the scope of judicial power, which includes the authority
of the courts to determine in an appropriate action the
validity of the acts of the political departments. Judicial
power includes the duty of the courts of justice to settle
actual controversies involving rights which are legally
demandable and enforceable, and to determine whether
or not there has been a grave abuse of discretion
amounting to lack or excess of jurisdiction on the part of
any branch or instrumentality of the Government.
(Emphasis supplied)
Meanwhile, in Misamis Oriental Association of Coco
Traders, Inc. v. Department of Finance Secretary,17 we
said:
xxx [A] legislative rule is in the nature of subordinate
legislation, designed to implement a primary legislation
by providing the details thereof. xxx
In addition such rule must be published. On the other
hand, interpretative rules are designed to provide
guidelines to the law which the administrative agency is
in charge of enforcing.
Accordingly, in considering a legislative rule a court is
free to make three inquiries: (i) whether the rule is within
the delegated authority of the administrative
agency; (ii)  whether it is reasonable; and (iii) whether it
was issued pursuant to proper procedure. But the court
is not free to substitute its judgment as to the desirability
or wisdom of the rule for the legislative body, by its
delegation of administrative judgment, has committed
those questions to administrative judgments and not to
judicial judgments. In the case of an interpretative rule,
the inquiry is not into the validity but into the correctness
or propriety of the rule. As a matter of power a court,
when confronted with an interpretative rule, is free
to (i) give the force of law to the rule; (ii) go to the
opposite extreme and substitute its judgment; or (iii) give
some intermediate degree of authoritative weight to the
interpretative rule. (Emphasis supplied)
Second, the controversy is between two parties that
have adverse interests. Petitioners are summarily
imposing a tariff rate that respondent is refusing to pay.
Third, it is clear that respondent has a legal and
substantive interest in the implementation of CMO 27-
2003. Respondent has adequately shown that, as a
regular importer of wheat, on 14 August 2003, it has
actually made shipments of wheat from China to Subic.
The shipment was set to arrive in December 2003. Upon
its arrival, it would be subjected to the conditions of CMO
27-2003. The regulation calls for the imposition of
different tariff rates, depending on the factors
enumerated therein. Thus, respondent alleged that it
would be made to pay the 7% tariff applied to feed grade
wheat, instead of the 3% tariff on food grade wheat. In
addition, respondent would have to go through the
procedure under CMO 27-2003, which would
undoubtedly toll its time and resources. The lower court
correctly pointed out as follows:
xxx As noted above, the fact that petitioner is precisely
into the business of importing wheat, each and every
importation will be subjected to constant disputes which
will result into (sic) delays in the delivery, setting aside of
funds as cash bond required in the CMO as well as the
resulting expenses thereof. It is easy to see that
business uncertainty will be a constant occurrence for
petitioner. That the sums involved are not minimal is
shown by the discussions during the hearings conducted
as well as in the pleadings filed. It may be that the
petitioner can later on get a refund but such has been
foreclosed because the Collector of Customs and the
Commissioner of Customs are bound by their own CMO.
Petitioner cannot get its refund with the said agency. We
believe and so find that Petitioner has presented such a
stake in the outcome of this controversy as to vest it with
standing to file this petition.18 (Emphasis supplied)
Finally, the issue raised by respondent is ripe for judicial
determination, because litigation is inevitable19 for the
simple and uncontroverted reason that respondent is not
included in the enumeration of flour millers classified as
food grade wheat importers. Thus, as the trial court
stated, it would have to file a protest case each time it
imports food grade wheat and be subjected to the 7%
tariff.
It is therefore clear that a petition for declaratory relief is
the right remedy given the circumstances of the case.
Considering that the questioned regulation would affect
the substantive rights of respondent as explained above,
it therefore follows that petitioners should have applied
the pertinent provisions of Book VII, Chapter 2 of the
Revised Administrative Code, to wit:
Section 3. Filing. – (1) Every agency shall file with the
University of the Philippines Law Center three (3)
certified copies of every rule adopted by it. Rules in force
on the date of effectivity of this Code which are not filed
within three (3) months from that date shall not thereafter
be the bases of any sanction against any party of
persons.
x x x           x x x          x x x
Section 9. Public Participation. - (1) If not otherwise
required by law, an agency shall, as far as practicable,
publish or circulate notices of proposed rules and afford
interested parties the opportunity to submit their views
prior to the adoption of any rule.
(2) In the fixing of rates, no rule or final order
shall be valid unless the proposed rates shall
have been published in a newspaper of general
circulation at least two (2) weeks before the first
hearing thereon.
(3) In case of opposition, the rules on contested
cases shall be observed.
When an administrative rule is merely interpretative in
nature, its applicability needs nothing further than its
bare issuance, for it gives no real consequence more
than what the law itself has already prescribed. When,
on the other hand, the administrative rule goes beyond
merely providing for the means that can facilitate or
render least cumbersome the implementation of the law
but substantially increases the burden of those
governed, it behooves the agency to accord at least to
those directly affected a chance to be heard, and
thereafter to be duly informed, before that new issuance
is given the force and effect of law.20
Likewise, in Tañada v. Tuvera,21 we held:
The clear object of the above-quoted provision is to give
the general public adequate notice of the various laws
which are to regulate their actions and conduct as
citizens. Without such notice and publication, there
would be no basis for the application of the maxim
"ignorantia legis non excusat." It would be the height of
injustice to punish or otherwise burden a citizen for the
transgression of a law of which he had no notice
whatsoever, not even a constructive one.
Perhaps at no time since the establishment of the
Philippine Republic has the publication of laws taken so
vital significance that at this time when the people have
bestowed upon the President a power heretofore
enjoyed solely by the legislature. While the people are
kept abreast by the mass media of the debates and
deliberations in the Batasan Pambansa – and for the
diligent ones, ready access to the legislative records –
no such publicity accompanies the law-making process
of the President. Thus, without publication, the people
have no means of knowing what presidential decrees
have actually been promulgated, much less a definite
way of informing themselves of the specific contents and
texts of such decrees. (Emphasis supplied)
Because petitioners failed to follow the requirements
enumerated by the Revised Administrative Code, the
assailed regulation must be struck down.
Going now to the content of CMO 27-3003, we likewise
hold that it is unconstitutional for being violative of the
equal protection clause of the Constitution.
The equal protection clause means that no person or
class of persons shall be deprived of the same protection
of laws enjoyed by other persons or other classes in the
same place in like circumstances. Thus, the guarantee of
the equal protection of laws is not violated if there is a
reasonable classification. For a classification to be
reasonable, it must be shown that (1) it rests on
substantial distinctions; (2) it is germane to the purpose
of the law; (3) it is not limited to existing conditions only;
and (4) it applies equally to all members of the same
class.22
Unfortunately, CMO 27-2003 does not meet these
requirements. We do not see how the quality of wheat is
affected by who imports it, where it is discharged, or
which country it came from.
Thus, on the one hand, even if other millers excluded
from CMO 27-2003 have imported food grade wheat, the
product would still be declared as feed grade wheat, a
classification subjecting them to 7% tariff. On the other
hand, even if the importers listed under CMO 27-2003
have imported feed grade wheat, they would only be
made to pay 3% tariff, thus depriving the state of the
taxes due. The regulation, therefore, does not become
disadvantageous to respondent only, but even to the
state.
It is also not clear how the regulation intends to "monitor
more closely wheat importations and thus prevent their
misclassification." A careful study of CMO 27-2003
shows that it not only fails to achieve this end, but results
in the opposite. The application of the regulation
forecloses the possibility that other corporations that are
excluded from the list import food grade wheat; at the
same time, it creates an assumption that those who
meet the criteria do not import feed grade wheat. In the
first case, importers are unnecessarily burdened to prove
the classification of their wheat imports; while in the
second, the state carries that burden.
Petitioner Commissioner of Customs also went beyond
his powers when the regulation limited the customs
officer’s duties mandated by Section 1403 of the Tariff
and Customs Law, as amended. The law provides:
Section 1403. – Duties of Customs Officer Tasked to
Examine, Classify, and Appraise Imported Articles. –
The customs officer tasked to examine, classify, and
appraise imported articles shall determine whether the
packages designated for examination and their contents
are in accordance with the declaration in the entry,
invoice and other pertinent documents and shall make
return in such a manner as to indicate whether the
articles have been truly and correctly declared in the
entry as regard their quantity, measurement, weight, and
tariff classification and not imported contrary to law. He
shall submit samples to the laboratory for analysis when
feasible to do so and when such analysis is necessary
for the proper classification, appraisal, and/or admission
into the Philippines of imported articles.
Likewise, the customs officer shall determine the unit of
quantity in which they are usually bought and sold, and
appraise the imported articles in accordance with
Section 201 of this Code.
Failure on the part of the customs officer to comply with
his duties shall subject him to the penalties prescribed
under Section 3604 of this Code.1âwphi1
The provision mandates that the customs officer must
first assess and determine the classification of the
imported article before tariff may be imposed.
Unfortunately, CMO 23-2007 has already classified the
article even before the customs officer had the chance to
examine it. In effect, petitioner Commissioner of
Customs diminished the powers granted by the Tariff
and Customs Code with regard to wheat importation
when it no longer required the customs officer’s prior
examination and assessment of the proper classification
of the wheat.

It is well-settled that rules and regulations, which are the

product of a delegated power to create new and
additional legal provisions that have the effect of law,
should be within the scope of the statutory authority
granted by the legislature to the administrative agency. It
is required that the regulation be germane to the objects
and purposes of the law; and that it be not in
contradiction to, but in conformity with, the standards
prescribed by law.23

In summary, petitioners violated respondent’s right to

due process in the issuance of CMO 27-2003 when they
failed to observe the requirements under the Revised
Administrative Code. Petitioners likewise violated
respondent’s right to equal protection of laws when they
provided for an unreasonable classification in the
application of the regulation. Finally, petitioner
Commissioner of Customs went beyond his powers of
delegated authority when the regulation limited the
powers of the customs officer to examine and assess
imported articles.

WHEREFORE, in view of the foregoing, the Petition is

DENIED.

SO ORDERED.
FIRST DIVISION
[ G.R. No. 197980, December 01, 2016 ]
DEUTSCHE KNOWLEDGE SERVICES PTE LTD.,
PETITIONER, VS. COMMISSIONER OF INTERNAL
REVENUE, RESPONDENT.
DECISION
LEONARDO-DE CASTRO, J.:
This is an appeal from the Decision[1] dated July 22,
2011 of the Court of Tax Appeals (CTA) En Banc in CTA
E.B. Case No. 596, entitled "Deutsche Knowledge
Services Pte Ltd. v. Commissioner of Internal
Revenue." The aforementioned judgment affirmed with
modification the Resolution dated October 28, 2009 as
well as the Resolution dated February 8, 2010 of the
CTA (Former Second Division) in CTA Case No. 7921.
Both resolutions disposed of the petition for review and
the subsequent motion for reconsideration filed by
petitioner Deutsche Knowledge Services Pte. Ltd. before
the CTA's former Second Division with regard to the
alleged inaction of respondent Commissioner of Internal
Revenue on the former's application for tax credit/refund
of alleged excess and unutilized input Value-Added Tax
(VAT).
The factual and procedural antecedents of this case
were narrated in the July 22, 2011 Decision of the
CTA En Banc  in this wise:
Petitioner avers that on March 31, 2009, it filed an
application for Tax Credit/Refund of its allegedly excess
and unutilized input VAT for the 1st quarter of the
calendar year 2007 in the amount of P12,549,446.30
with respondent Commissioner of Internal Revenue
(empowered to act upon and approve claims for refund
or tax credit as provided by law) through its BIR
Revenue District No. 47.
Citing inaction on the part of respondent, petitioner on
April 17, 2009 filed a Petition for Review or [s]eventeen
(17) days after petitioner filed an application for tax
credit/refund with respondent based on Section 112 and
229 of the National Internal Revenue Code of 1997, as
amended.
However, on June 8, 2009, instead of an Answer
respondent filed a Motion to Dismiss on ground of
prescription. Citing the case of Commissioner of Internal
Revenue v. Mirant Pagbilao Corporation (Mirant Case),
respondent alleged that the Petition for Review was filed
out of time on the ground of having been filed beyond
the two-year prescriptive period.
A day after or on June 9, 2009, respondent filed an
Answer again citing the same grounds in the Motion to
Dismiss in her Special and Affirmative defenses.
After hearing and the filing of Comment/Opposition on
the Motion to Dismiss, the former Second Division of this
Court resolved to grant said motion on October 28, 2009.
Petitioner filed a motion for reconsideration thereon on
November 16, 2009.
However, in an Order dated January 11, 2010, the case
was ordered to be transferred to the Third Division of this
Court pursuant to CTA Administrative Circular No. 01-
2010, "Implementing the Fully Expanded Membership in
the Court of Tax Appeals".
Notwithstanding, on February 8, 2010, the former
Second Division of this Court promulgated a Resolution
which denied petitioner's Motion for Reconsideration.[2]
Petitioner then filed a petition for review with the CTA En
Banc. However, the said tribunal merely affirmed with
modification the assailed resolutions and dismissed
petitioner's suit for having been prematurely filed prior to
the expiration of the 120-day period granted to
respondent to resolve the tax claim. The dispositive
portion of the assailed July 22, 2011 Decision of the
CTA En Banc  reads:
WHEREFORE, premises considered, the Resolution of
the former Second Division of this Court in CTA Case
No. 7921, dated October 28, 2009 and its Resolution,
dated February 8, 2010, are hereby AFFIRMED with
MODIFICATION. Accordingly, CTA Case No. 7921 is
hereby DISMISSED for having been prematurely filed
pursuant to the case of Commissioner of Internal
Revenue v. Aichi Forging Company of Asia, Inc. No
pronouncement as to costs.[3]
Hence, petitioner resorted to the present appeal, by way
of a petition for review under Rule 45, wherein it cited the
following errors allegedly committed by the CTA En
Banc:
ASSIGNMENT OF ERRORS
THE CTA EN BANC  DECISION IS NOT IN ACCORD
WITH LAW AND WITH THE RELEVANT DECISIONS
OF THE SUPREME COURT, AND CONSTITUTE A
DEPARTURE FROM THE ACCEPTED AND USUAL
COURSE OF JUDICIAL PROCEEDINGS AS TO CALL
FOR AN EXERCISE OF THE POWER OF THIS
HONORABLE COURT'S SUPERVISION, AS
FOLLOWS:
A.
THE CTA EN BANC  COMMITTED REVERSIBLE
ERROR IN AFFIRMING THAT THE CTA'S FORMER
SECOND DIVISION COULD STILL RESOLVE
PETITIONER'S MOTION FOR RECONSIDERATION
AFTER IT HAD LOST JURISDICTION OVER THE
CASE UPON ITS TRANSFER TO THE THIRD
DIVISION.
B.
THE CTA EN BANC  COMMITTED REVERSIBLE
ERROR IN NOT FINDING THAT THE CTA'S FORMER
SECOND DIVISION SHOULD HAVE ORDERED THE
PRE-TRIAL CONFERENCE TO PROCEED:
B.1 THE CTA'S FORMER SECOND DIVISION FAILED
TO ADDRESS VITAL SUFFICIENT TO RENDER
RESPONDENT'S MOTION TO DISMISS MOOT AND
ACADEMIC.
B.2 RESPONDENT DEFIED THE CTA'S FORMER
SECOND DIVISION'S ORDER. THE SECOND
DIVISION INTENDED TO HEAR THE CASE IN ITS
ENTIRETY WHEN IT ORDERED RESPONDENT TO
FILE AN ANSWER INSTEAD OF A MOTION TO
DISMISS, IN LINE WITH THE INTEGRATED BAR OF
THE PHILIPPINES-OFFICE OF THE COURT
ADMINISTRATOR MEMORANDUM ON POLICY
GUIDELINES DATED MARCH 12, 2002 ("IBP-COA
MEMORANDUM").
B.3 RESPONDENT LOST HER RIGHT TO ASSAIL
THE FORMER SECOND DIVISION'S JURISDICTION
WHEN SHE SOUGHT RELIEF FROM THE COURT BY
FILING A MOTION FOR EXTENSION OF TIME TO
FILE ANSWER.
B.4 THE ISSUES OF THE CASE HAVE BEEN JOINED
UPON RESPONDENT'S FILING OF THE ANSWER,
AND THUS, PRE-TRIAL AND TRIAL SHOULD HAVE
PROCEEDED AS A MATTER OF PROCEDURE; AND
C.
THE CTA EN BANC  ERRED IN NOT FINDING THAT
PETITIONER'S JUDICIAL CLAIM FOR REFUND WAS
TIMELY FILED IN ACCORDANCE WITH SECTION
112(C), TAX CODE IN RELATION TO THE TWO-YEAR
PRESCRIPTIVE PERIOD PROVIDED UNDER
SECTION 229, TAX CODE. THE LETTER AND THE
INTENT [OF THE] LAW AS WELL AS EXISTING
JURISPRUDENCE ALL POINT TO THE PRIMORDIAL
SIGNIFICANCE OF THE TWO-YEAR PRESCRIPTIVE
PERIOD:
C.1 THE TWO-YEAR PRESCRIPTIVE PERIOD FOR
THE FILING OF CLAIMS FOR REFUND SHOULD BE
RECKONED FROM THE DATE OF FILING OF THE
QUARTERLY VAT RETURN AS SETTLED IN ATLAS.
C.2 THE CTA EN BANC  ERRED IN FINDING
THAT AICHI PREVAILS OVER AND/OR
OVERTURNED THE DOCTRINE IN ATLAS, WHICH
UPHELD THE PRIMACY OF THE TWO-YEAR PERIOD
UNDER SECTION 229, 1997 TAX CODE. THE LAW
AND JURISPRUDENCE HAVE LONG ESTABLISHED
THE DOCTRINE THAT THE TAXPAYER IS DUTY-
BOUND TO OBSERVE THE TWO-YEAR PERIOD
UNDER SECTION 229, 1997 TAX CODE WHEN
FILING ITS CLAIM FOR REFUND OF EXCESS AND
UNUTILIZED VAT.
C.3 THE CTA EN BANC  ERRED IN NOT HOLDING
THAT RESPONDENT IS PRECLUDED FROM
QUESTIONING THE JURISDICTION OF THE CTA-
DIVISION BASED ON HER PRONOUNCEMENTS
RECOGNIZING THAT THE 120-DAY PERIOD IS NOT
JURISDICTIONAL VIS-A-VIS HER FAlLURE TO
RAISE THE ISSUE OF PREMATURITY IN HER
ANSWER AND IN HER MOTION TO DISMISS.
C.4 THE CTA EN BANC  ERRED IN FINDING
THAT AICHI CAN BE APPLIED INVARIABLY TO
TAXPAYERS WHO, IN GOOD FAITH, FILED AND
LITIGATED THEIR CLAIMS FOR REFUND OF INPUT
VAT RELYING UPON ESTABLISHED
DECLARATIONS AND PRONOUNCEMENTS OF THIS
HONORABLE COURT AND THE CTA.
ASSUMING AICHI IS MADE TO APPLY, THE
PROSPECTIVE APPLICATION THEREOF IS
LEGALLY AND EQUITABLY IMPERATIVE.[4]
In deciding the substantive aspect of petitioner's suit
before it, the CTA En Banc ratiocinated that:
[T]he substance of petitioner's argument is the alleged
applicability of the Decision of the Supreme Court in the
case of Atlas Consolidated Mining and Development
Corporation v. Commissioner of Internal Revenue
(Atlas Case) promulgated on June 8, 2007 and the non-
applicability of the case of Commissioner of Internal
Revenue v. Mirant Pagbilao Corporation (Mirant Case),
promulgated on September 12, 2008.
In applying the Mirant  Case in relation to Section 112,
the former Second Division held that the administrative
claim was filed on time while the Petition for Review
before this Court's Division was filed out of time or
beyond the two-year prescriptive period, the close of the
taxable first quarter of the calendar year 2007 or March
31, 2007 as the reckoning period, it appearing that the
application for tax credit/refund was filed with the
respondent on March 31, 2009 and the petition for
review was filed on April 17, 2009.
However, in the case of Commissioner of Internal
Revenue v. Aichi Forging Company of Asia,
Inc.,  reiterating the "Mirant Case", the Supreme Court
categorically ruled that unutilized input VAT must be
claimed within two years after the close of the taxable
quarter when the sales were made and that the 120-day
period is crucial in filing an appeal with this Court. The
pertinent portion of which reads as follows:
"The pivotal question of when to reckon the running of
the two-year prescriptive period, however, has already
been resolved in Commissioner of Internal Revenu v.
Mirant Pagbilao Corporation, where we ruled that
Section 112(A) of the NIRC is the applicable provision in
determining the start of the two-year period for claiming
a refund/credit of unutilized input VAT, and Sections
204(C) and 229 of the NIRC are inapplicable as "both
provisions apply only to instances of erroneous payment
or illegal collection of internal revenue taxes." x x x.
x x x x
In view of the foregoing, we find that the CTA En
Banc  erroneously applied Sections 114(A) and 229 of
the NIRC in computing the two-year prescriptive period
for claiming refund/credit of unuti1ized input VAT. To be
clear, Section 112 of the NIRC is the pertinent provision
for the refund/credit of input VAT. Thus, the two-year
period should be reckoned from the close of the taxable
quarter when the sales were made.
x x x x
Section 112(D) of the NIRC clearly provides that the CIR
has "120 days, from the date of the submission of the
complete documents in support of the application [for tax
refund/credit]," within which to grant or deny the claim. In
case of full or partial denial by the CIR, the taxpayer's
recourse is to file an appeal before the CTA within 30
days from receipt of the decision of the CIR. However, if
after the 120-day period the CIR fails to act on the
application for tax refund/credit, the remedy of the
taxpayer is to appeal the inaction of the CIR to CTA
within 30 days.
In this case, the administrative and the judicial claims
were simultaneously filed on September 30, 2004.
Obviously, respondent did not wait for the decision of the
CIR or the lapse of the 120-day period. For this reason,
we find the filing of the judicial claim with the CTA
premature.
Respondent's assertion that the non-observance of the
120-day period is not fatal to the filing of a judicial claim
as long as both the administrative and the judicial claims
are filed within the two-year prescriptive period has no
legal basis.
There is nothing in Section 112 of the NIRC to support
respondent's view. Subsection (A) of the said provision
states that "any VAT-registered person, whose sales are
zero-rated or effectively zero-rated may, within two
years after the close of the taxable quarter when the
sales were made, apply for the issuance of a tax
credit certificate or refund of creditable input tax due
or paid attributable to such sales." The phrase "within
two (2) years x x x apply for the issuance of a tax credit
certificate or refund" refers to applications for
refund/credit filed with the CIR and not to appeals made
to the CT A. This is apparent in the first paragraph of
subsection (D) of the same provision, which states that
the CIR has "120 days from the submission of complete
documents in support of the application filed in
accordance with Subsections (A) and (B)" within which
to decide on the claim.
In fact, applying the two-year period to judicial claims
would render nugatory Section 112(D) of the NIRC,
which already provides for a specific period within which
a taxpayer should appeal the decision or inaction of the
CIR. The second paragraph of Section 112(D) of the
NIRC envisions two scenarios: (1) when a decision is
issued by the CIR before the lapse of the 120-day
period; and (2) when no decision is made after the 120-
day period. In both instances, the taxpayer has 30 days
within which to file an appeal with the CTA. As we see it
then, the 120-day period is crucial in filing an appeal with
the CTA.
With regard to Commissioner of Internal Revenue v.
Victorias Milling, Co., Inc. relied upon by respondent, we
find the same inapplicable as the tax provision involved
in that case is Section 306, now Section 229 of the
NIRC. And as already discussed, Section 229 does not
apply to refunds/credits of input VAT, such as the instant
case.
In fine, the premature filing of respondent's claim for
refund/credit of input VAT before the CTA warrants a
dismissal inasmuch as no jurisdiction was acquired by
the CTA."
In the instant case, the administrative claim or
application for tax credit/refund of its allegedly excess
and unutilized input VAT for the first quarter of taxable
year 2007 was filed on March 31, 2009 or within the two-
year prescriptive period. Respondent had 120 days or
until July 29, 2009 to determine the validity of the claim.
However, petitioner filed an appeal by way of a petition
for review on April 17, 2009 or 17 days after the filing of
the administrative claim. Apparently, petitioner did not
wait for the decision of the CIR or the lapse of the 120-
day period and this is in clear contravention of Section
112(D) [now Section 112(C)] of the 1997 NIRC, as
amended, and of the doctrine laid down in the Aichi
case.
Accordingly, we find the filing of an appeal by way of a
petition for review before this Court's former Second
Division is strikingly similar with that of the facts in
the Aichi  Case. In both cases, the taxpayer (petitioner in
the instant case) did not wait for the decision of the CIR
or the lapse of the 120-day period before the filing of an
appeal by way of a petition for review before this Court.
Pertinently, our disquisitions in the case of Marubeni
Philippines Corporation v. Commissioner of Internal
Revenue  of the applicability of Section 112 of the 1997
NIRC and Aichi Case in the instant case are hereby
adopted, as follows:
"A careful analysis of the above-mentioned cases Atlas,
Mirant  and Aichi clearly shows that the Atlas Case was
an interpretation by the Supreme Court of the 1977
NIRC, prior to its amendment by R.A. 7716; while
the Mirant  and Aichi cases was an interpretation of the
1997 NIRC or the application and interpretation of the
amendatory provisions of the Tax Reform Act of 1997.
Significantly, it is emphasized that the premise of the
Supreme Court's ruling in the Atlas  Case was anchored
on the need to harmonize the provisions on Refund or
Tax Credits of Input Tax under Section 106 (now Section
112) with the two-year prescriptive period for instituting a
suit or proceeding for the Recovery of Tax Erroneously
or Illegaly paid under Section 230 (now Section 229) of
the Tax Code of 1977, as amended, citing the cases
of ACCRA Investments Corporation v. Court of Appeals
and Commissioner of Internal Revenue v. TMX Sales,
Inc.  x x x.
It was the advent of R.A. No. 7716 and R.A. 8424 when
the legislature specifically provided for a judicial recourse
with the Court of Tax Appeals in claiming unutilized input
VAT refund/credit under Section 106(D) of the NIRC of
1977 (now Section 112 of the NIRC of 1997) within
which the period of thirty (30) days reckoned from the
receipt of the decision of the CIR denying the claim or
after the expiration of a given period (now 120 days).
Accordingly, petitioner cannot blindly invoke the doctrine
enunciated in Atlas case in the instant case. As
discussed above, the need to harmonize the provisions
of Section 106 and Section 230 of the Tax Code of 1977
is no longer necessary nor applicable due to the clear
legislative intent embodied in the provisions of R.A. No.
7716 and R.A. 8424, which delineated specific
amendatory provision for the prescriptive period in
claiming [administrative] and judicial claims for unutilized
input VAT refund/credit."
In fine, we find that the Aichi  Case is the prevailing
doctrine in so far as the mandatory observance of the
120-30 day period under Section 112 of the NIRC of
1997 before filing an appeal with the Court of Tax
Appeals and that the Atlas Case and Section 229 of the
1997 NIRC are not applicable in the instant case.[5]
From the foregoing, it is apparent that the assailed July
22, 2011 ruling of the CTA En Banc, in dismissing
petitioner's appeal before it, relied on Section 112(C)[6] of
the 1997 National Internal Revenue Code (NIRC) as well
as the doctrine laid down by the First Division of this
Court in Commissioner of Internal Revenue v. Aichi
Forging Company of Asia, Inc.[7] (Aichi case) which
states that the 120-day period is crucial in filing an
appeal with the CTA. The CTA En Banc was correct in
so ruling since, at the time the assailed July 22, 2011
ruling was promulgated, the Aichi case was still the
controlling jurisprudence on the matter.
However, subsequent to the Aichi ruling and during the
pendency of the case at bar, the Supreme Court En
Banc  resolved the consolidated cases involved
in Commissioner of Internal Revenue v. San Roque
Power Corporation[8] (San Roque case) and stated that a
judicial claim for refund of input VAT which was filed with
the CTA before the lapse of the 120-day period under
Section 112 of the NIRC is considered to have been
timely made, if such filing occurred after the issuance of
the Bureau of Internal Revenue (BIR) Ruling No. DA-
489-03 dated December 10, 2003 but before the
adoption of the Aichi doctrine which was promulgated on
October 6, 2010.
In San Roque, we recognized that prior to BIR Ruling
No. DA-489- 03, which expressly stated that the
"taxpayer-claimant need not wait for the lapse of the
120-day period before it could seek judicial relief with the
CTA by way of Petition for Review," the Commissioner of
Internal Revenue (CIR) was correct in considering the
120-day period as mandatory and jurisdictional before a
judicial claim can be filed. Nevertheless, we cited two
exceptions to this rule: (1) if the CIR, through a specific
ruling, misleads a particular taxpayer to prematurely file
a judicial claim with the CTA - that specific ruling is
applicable only to such particular taxpayer; and (2) if the
CIR, through a general interpretative rule issued under
Section 4 of the NIRC, misleads all taxpayers into filing
prematurely judicial claims with the CTA - in these
cases, the CIR cannot later on be allowed to question
the CTA's assumption of jurisdiction over such claim
since equitable estoppel has set in as expressly
authorized under Section 246 of the NIRC.[9]
Pursuant to the CIR's power to interpret tax laws under
Section 4[10] of the NIRC, the CIR issued BIR Ruling No.
DA-489-03 which we considered in San Roque  as a
general interpretative rule that may be relied upon by
taxpayers from the time the rule was issued up to its
reversal by the CIR or by this Court, thus, providing a
valid claim for equitable estoppel under Section 246 of
the NIRC, to wit:
quarter of the calendar year 2007 in the amount of
P12,549,446.30 with respondent on March 31, 2009.
Subsequently, petitioner filed its judicial claim on the
same matter through a petition for review with the CTA
on April 17, 2009. It is undisputed that the
aforementioned date of filing falls within the period
following the issuance of BIR Ruling No. DA-489-03 on
December 10, 2003 but before the promulgation of
the Aichi  case on October 6, 2010. In accordance with
the doctrine laid down in San Roque, we rule that
petitioner's judicial claim had been timely filed and
should be given due course and consideration by the
CTA.
In light of the foregoing, we find it unnecessary to pass
upon the other issues raised in the petition.

SEC. 246. Non-Retroactivity of Rulings. - Any WHEREFORE, the petition is GRANTED. The Decision

revocation, modification or reversal of any of the rules dated July 22, 2011 of the Court of Tax Appeals En
and regulations promulgated in accordance with the Banc  in CTA EB Case No. 596 is REVERSED and SET
preceding Sections or any of the rulings or circulars ASIDE. The Court of Tax Appeals is
promulgated by the Commissioner shall not be given hereby ORDERED to proceed with the hearing and
retroactive application if the revocation, modification resolution of CTA Case No. 7921.
or reversal will be prejudicial to the taxpayers, except
in the following cases: SO ORDERED.

(a) Where the taxpayer deliberately misstates or omits

material facts from his return or any document required
of him by the Bureau of Internal Revenue;

(b) Where the facts subsequently gathered by the

Bureau of Internal Revenue are materially different from
the facts on which the ruling is based; or

(c) Where the taxpayer acted in bad faith. (Emphases

supplied.)

We likewise held that Section 246 of the NIRC is not

limited to a reversal only by the CIR because the same
expressly states "[a]ny revocation, modification or
reversal" without specifying who made the revocation,
modification or reversal; hence, a reversal by this Court
is covered under the said tax provision.[11]

Thus, we elaborated in San Roque  that a reversal of a

BIR regulation or ruling cannot adversely prejudice a
taxpayer who in good faith relied on the BIR regulation or
ruling prior to its reversal and that taxpayers should not
be prejudiced by an erroneous interpretation by the CIR,
particularly on a difficult question of law. We quote the
relevant portion of San Roque  here:

Taxpayers should not be prejudiced by an erroneous

interpretation by the Commissioner, particularly on a
difficult question of law. The abandonment of
the Atlas doctrine by Mirant  and Aichi is proof that the
reckoning of the prescriptive periods for input VAT tax
refund or credit is a difficult question of law. The
abandonment of the Atlas doctrine did not result
in Atlas,  or other taxpayers similarly situated, being
made to return the tax refund or credit they received or
could have received under Atlas  prior to its
abandonment. This Court is
applying Mirant and Atlas prospectively. Absent fraud,
bad faith or misrepresentation, the reversal by this Court
of a general interpretative rule issued by the
Commissioner, like the reversal of a specific BIR ruling
under Section 246, should also apply prospectively. x x
x.[12]

In the present case, the records indicate that petitioner

filed its administrative claim for tax credit/refund of its
allegedly excess and unutilized input VAT for the 1st
G.R. No. L-17518             October 30, 1922
FREDERICK C. FISHER, plaintiff-appellant,
vs.
WENCESLAO TRINIDAD, Collector of Internal
Revenue, defendant-appellee.
JOHNSON, J.:
The only question presented by this appeal is: Are the
"stock dividends" in the present case "income" and
taxable as such under the provisions of section 25 of Act
No. 2833? While the appellant presents other important
questions, under the view which we have taken of the
facts and the law applicable to the present case, we
deem it unnecessary to discuss them now.
The defendant demurred to the petition in the lower
court. The facts are therefore admitted. They are simple
and may be stated as follows:
That during the year 1919 the Philippine American Drug
Company was a corporation duly organized and existing
under the laws of the Philippine Islands, doing business
in the City of Manila; that he appellant was a stockholder
in said corporation; that said corporation, as result of the
business for that year, declared a "stock dividend"; that
the proportionate share of said stock divided of the
appellant was P24,800; that the stock dividend for that
amount was issued to the appellant; that thereafter, in
the month of March, 1920, the appellant, upon demand
of the appellee, paid under protest, and voluntarily, unto
the appellee the sum of P889.91 as income tax on said
stock dividend. For the recovery of that sum (P889.91)
the present action was instituted. The defendant
demurred to the petition upon the ground that it did not
state facts sufficient to constitute cause of action. The
demurrer was sustained and the plaintiff appealed.
To sustain his appeal the appellant cites and relies on
some decisions of the Supreme Court of the United
States as will as the decisions of the supreme court of
some of the states of the Union, in which the questions
before us, based upon similar statutes, was discussed.
Among the most important decisions may be mentioned
the following: Towne vs. Eisner, 245 U.S., 418; Doyle vs.
Mitchell Bors. Co., 247 U.S., 179; Eisner vs. Macomber,
252 U.S., 189; Dekoven vs Alsop, 205 Ill., 309; 63
L.R.A., 587; Kaufman vs. Charlottesville Woolen Mills,
93 Va., 673.
In each of said cases an effort was made to collect an
"income tax" upon "stock dividends" and in each case it
was held that "stock dividends" were capital and not an
"income" and therefore not subject to the "income tax"
law.
The appellee admits the doctrine established in the case
of Eisner vs. Macomber (252 U.S., 189) that a "stock
dividend" is not "income" but argues that said Act No.
2833, in imposing the tax on the stock dividend, does not
violate the provisions of the Jones Law. The appellee
further argues that the statute of the United States
providing for tax upon stock dividends is different from
the statute of the Philippine Islands, and therefore the
decision of the Supreme Court of the United States
should not be followed in interpreting the statute in force
here.
For the purpose of ascertaining the difference in the said
statutes ( (United States and Philippine Islands),
providing for an income tax in the United States as well
as that in the Philippine Islands, the two statutes are
here quoted for the purpose of determining the
difference, if any, in the language of the two statutes.
Chapter 463 of an Act of Congress of September 8,
1916, in its title 1 provides for the collection of an
"income tax." Section 2 of said Act attempts to define
what is an income. The definition follows:
That the term "dividends" as used in this title
shall be held to mean any distribution made or
ordered to made by a corporation, . . . which
stock dividend shall be considered income, to
the amount of its cash value.
Act No. 2833 of the Philippine Legislature is an Act
establishing "an income tax." Section 25 of said Act
attempts to define the application of the income tax. The
definition follows:
The term "dividends" as used in this Law shall
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,
nineteen hundred and thirteen, and payable to
its shareholders, whether in cash or in stock of
the corporation, . . . . Stock dividend shall be
considered income, to the amount of the
earnings or profits distributed.
It will be noted from a reading of the provisions of the
two laws above quoted that the writer of the law of the
Philippine Islands must have had before him the statute
of the United States. No important argument can be
based upon the slight different in the wording of the two
sections.
It is further argued by the appellee that there are no
constitutional limitations upon the power of the Philippine
Legislature such as exist in the United States, and in
support of that contention, he cites a number of
decisions. There is no question that the Philippine
Legislature may provide for the payment of an income
tax, but it cannot, under the guise of an income tax,
collect a tax on property which is not an "income." The
Philippine Legislature can not impose a tax upon
"property" under a law which provides for a tax upon
"income" only. The Philippine Legislature has no power
to provide a tax upon "automobiles" only, and under that
law collect a tax upon a carreton or bull cart.
Constitutional limitations, that is to say, a statute
expressly adopted for one purpose cannot, without
amendment, be applied to another purpose which is
entirely distinct and different. A statute providing for an
income tax cannot be construed to cover property which
is not, in fact income. The Legislature cannot, by a
statutory declaration, change the real nature of a tax
which it imposes. A law which imposes an important tax
on rice only cannot be construed to an impose an
importation tax on corn.
It is true that the statute in question provides for an
income tax and contains a further provision that "stock
dividends" shall be considered income and are therefore
subject to income tax provided for in said law. If "stock
dividends" are not "income" then the law permits a tax
upon something not within the purpose and intent of the
law.
It becomes necessary in this connection to ascertain
what is an "income in order that we may be able to
determine whether "stock dividends" are "income" in the
sense that the word is used in the statute. Perhaps it
would be more logical to determine first what are "stock
dividends" in order that we may more clearly understand
their relation to "income." Generally speaking, stock
dividends represent undistributed increase in the capital
of corporations or firms, joint stock companies, etc., etc.,
for a particular period. They are used to show the
increased interest or proportional shares in the capital of
each stockholder. In other words, the inventory of the
property of the corporation, etc., for particular period
shows an increase in its capital, so that the stock
theretofore issued does not show the real value of the
stockholder's interest, and additional stock is issued
showing the increase in the actual capital, or property, or
assets of the corporation, etc.
To illustrate: A and B form a corporation with an
authorized capital of P10,000 for the purpose of opening
and conducting a drug store, with assets of the value of
P2,000, and each contributes P1,000. Their entire assets
are invested in drugs and put upon the shelves in their
place of business. They commence business without a
cent in the treasury. Every dollar contributed is invested.
Shares of stock to the amount of P1,000 are issued to
each of the incorporators, which represent the actual
investment and entire assets of the corporation.
Business for the first year is good. Merchandise is sold,
and purchased, to meet the demands of the growing
trade. At the end of the first year an inventory of the
assets of the corporation is made, and it is then
ascertained that the assets or capital of the corporation
on hand amount to P4,000, with no debts, and still not a
cent in the treasury. All of the receipts during the year
have been reinvested in the business. Neither of the
stockholders have withdrawn a penny from the business
during the year. Every peso received for the sale of
merchandise was immediately used in the purchase of
new stock — new supplies. At the close of the year there
is not a centavo in the treasury, with which either A or B
could buy a cup of coffee or a pair of shoes for his
family. At the beginning of the year they were P2,000,
and at the end of the year they were P4,000, and neither
of the stockholders have received a centavo from the
business during the year. At the close of the year, when
it is discovered that the assets are P4,000 and not
P2,000, instead of selling the extra merchandise on hand
and thereby reducing the business to its original capital,
they agree among themselves to increase the capital
they agree among themselves to increase the capital
issued and for that purpose issue additional stock in the
form of "stock dividends" or additional stock of P1,000
each, which represents the actual increase of the shares
of interest in the business. At the beginning of the year
each stockholder held one-half interest in the capital. At
the close of the year, and after the issue of the said
stock dividends, they each still have one-half interest in
the business. The capital of the corporation increased
during the year, but has either of them received an
income? It is not denied, for the purpose of ordinary
taxation, that the taxable property of the corporation at
the beginning of the year was P2,000, that at the close of
the year it was P4,000, and that the tax rolls should be
changed in accordance with the changed conditions in
the business. In other words, the ordinary tax should be
increased by P2,000.
Another illustration: C and D organized a corporation for
agricultural purposes with an authorized capital stock of
P20,000 each contributing P5,000. With that capital they
purchased a farm and, with it, one hundred head of
cattle. Every peso contributed is invested. There is no
money in the treasury. Much time and labor was
expanded during the year by the stockholders on the
farm in the way of improvements. Neither received a
centavo during the year from the farm or the cattle. At
the beginning of the year the assets of the corporation,
including the farm and the cattle, were P10,000, and at
the close of the year and inventory of the property of the
corporation is made and it is then found that they have
the same farm with its improvements and two hundred
head of cattle by natural increase. At the end of the year
it is also discovered that, by reason of business
changes, the farm and the cattle both have increased in
value, and that the value of the corporate property is now
P20,000 instead of P10,000 as it was at the beginning of
the year. The incorporators instead of reducing the
property to its original capital, by selling off a part of its,
issue to themselves "stock dividends" to represent the
proportional value or interest of each of the stockholders
in the increased capital at the close of the year. There is
still not a centavo in the treasury and neither has
withdrawn a peso from the business during the year. No
part of the farm or cattle has been sold and not a single
peso was received out of the rents or profits of the
capital of the corporation by the stockholders.
Another illustration: A, an individual farmer, buys a farm
with one hundred head of cattle for the sum of P10,000.
At the end of the first year, by reason of business
conditions and the increase of the value of both real
estate and personal property, it is discovered that the
value of the farm and the cattle is P20,000. A, during the
year, has received nothing from the farm or the cattle.
His books at the beginning of the year show that he had
property of the value of P10,000. His books at the close
of the year show that he has property of the value of
P20,000. A is not a corporation. The assets of his
business are not shown therefore by certificates of stock.
His books, however, show that the value of his property
has increased during the year by P10,000, under any
theory of business or law, be regarded as an "income"
upon which the farmer can be required to pay an income
tax? Is there any difference in law in the condition of A in
this illustration and the condition of A and B in the
immediately preceding illustration? Can the increase of
the value of the property in either case be regarded as
an "income" and be subjected to the payment of the
income tax under the law?
Each of the foregoing illustrations, it is asserted, is
analogous to the case before us and, in view of that fact,
let us ascertain how lexicographers and the courts have
defined an "income." The New Standard Dictionary,
edition of 1915, defines an income as "the amount of
money  coming to a person or corporation within a
specified time whether as payment or corporation within
a specified time whether as payment for services,
interest, or profit from investment." Webster's
International Dictionary defines an income as "the
receipt, salary; especially, the annual receipts of a
private person or a corporation from property." Bouvier,
in his law dictionary, says that an "income" in the federal
constitution and income tax act, is used in its common or
ordinary meaning and not in its technical, or economic
sense. (146 Northwestern Reporter, 812) Mr. Black, in
his law dictionary, says "An income is the return in
money  from one's business, labor, or capital invested;
gains, profit or private revenue." "An income tax is a tax
on the yearly profits arising from property , professions,
trades, and offices."
The Supreme Court of the United States, in the case o
Gray vs. Darlington (82 U.S., 653), said in speaking of
income that mere advance in value in no sense
constitutes the "income" specified in the revenue law as
"income" of the owner for the year in which the sale of
the property was made. Such advance constitutes and
can be treated merely as an increase of capital. (In
re Graham's Estate, 198 Pa., 216; Appeal of Braun, 105
Pa., 414.)
Mr. Justice Hughes, later Associate Justice of the
Supreme Court of the United States and now Secretary
of State of the United States, in his argument before the
Supreme Court of the United States in the case of
Towne vs. Eisner, supra, defined an "income" in an
income tax law, unless it is otherwise specified, to mean
cash or its equivalent. It does not mean choses in action
or unrealized increments in the value of the property,
and cites in support of the definition, the definition given
by the Supreme Court in the case of Gray vs.
Darlington, supra.
In the case of Towne vs. Eisner, supra, Mr. Justice
Holmes, speaking for the court, said: "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. . . . 'A stock
dividend really takes nothing from the property of the
corporation, and adds nothing to the interests of the
shareholders. Its property is not diminished and their
interest are not increased. . . . The proportional interest
of each shareholder remains the same. . . .' In short, the
corporation is no poorer and the stockholder is no richer
then they were before." (Gibbons vs. Mahon, 136 U.S.,
549, 559, 560; Logan County vs. U.S., 169 U.S., 255,
261).
In the case of Doyle vs. Mitchell Bros. Co. (247 U.S.,
179, Mr. Justice Pitney, speaking for the court, said that
the act employs the term "income" in its natural and
obvious sense, as importing something distinct from
principal or capital and conveying the idea of gain or
increase arising from corporate activity.
Mr. Justice Pitney, in the case of Eisner vs. Macomber
(252 U.S., 189), again speaking for the court said: "An
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."
For bookkeeping purposes, when stock dividends are
declared, the corporation or 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 by the
corporation during a particular period and not divided,
they create additional bookkeeping liabilities under the
head of "profit and loss," "undivided profits," "surplus
account," etc., 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 or
corporation, for any particular sum of money, or a right to
any particular portion of the asset, or any shares sells or
until the directors conclude that dividends shall be made
a part of the company's assets segregated from the
common fund for that purpose. The dividend normally is
payable in money and when so paid, then only does the
stockholder realize a profit or gain, which becomes his
separate property, and thus derive an income from the
capital that he has invested. Until that, is done
the increased assets belong to the corporation and not
to the individual stockholders.
When a corporation or company issues "stock dividends"
it 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 said realization, in that the
fund represented by the new stock has been transferred
from surplus to assets, 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
resulting 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 of the
entire investment. Having regard to the very truth of the
matter, to substance and not to form, the stockholder by
virtue of the stock dividend has in fact received nothing
that answers the definition of an "income." (Eisner vs.
Macomber, 252 U.S., 189, 209, 211.)
The stockholder who receives a stock dividend has
received nothing but a representation of his increased
interest in the capital of the corporation. There has been
no separation or segregation of his interest. All the
property or capital of the corporation still belongs to the
corporation. There has been no separation of the interest
of the stockholder from the general capital of the
corporation. The stockholder, by virtue of the stock
dividend, has no separate or individual control over the
interest represented thereby, further than he had before
the stock dividend was issued. He cannot use it for the
reason that it is still the property of the corporation and
not the property of the individual holder of stock
dividend. A certificate of stock represented by the stock
dividend is simply a statement of his proportional interest
or participation in the capital of the corporation. For
bookkeeping purposes, a corporation, by issuing stock
dividend, acknowledges a liability in form to the
stockholders, evidenced by a capital stock account. The
receipt of a stock dividend in no way increases the
money received of a stockholder nor his cash account at
the close of the year. It simply shows that there has been
an increase in the amount of the capital of the
corporation during the particular period, which may be
due to an increased business or to a natural increase of
the value of the capital due to business, economic, or
other reasons. We believe that the Legislature, when it
provided for an "income tax," intended to tax only the
"income" of corporations, firms or individuals, as that
term is generally used in its common acceptation; that is
that the income means money received, coming to a
person or corporation for services, interest, or profit from
investments. We do not believe that the Legislature
intended that a mere increase in the value of the capital
or assets of a corporation, firm, or individual, should be
taxed as "income." Such property can be reached under
the ordinary from of taxation.
Mr. Justice Pitney, in the case of the Einer vs.
Macomber, supra, said in discussing the difference
between "capital" and "income": "That 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." It may be argued that a stockholder
might sell the stock dividend which he had acquired. If
he does, then he has received, in fact, an income and
such income, like any other profit which he realizes from
the business, is an income and he may be taxed
thereon.
There is a clear distinction between an extraordinary
cash dividend, no matter when earned, and stock
dividends declared, as in the present case. The one is a
disbursement to the stockholder of accumulated
earnings, and the corporation at once parts irrevocably
with all interest thereon. The other involves no
disbursement by the corporation. It parts with nothing to
the stockholder. The latter receives, not an actual
dividend, but certificate of stock which simply evidences
his interest in the entire capital, including such as by
investment of accumulated profits has been added to the
original capital. They are not income to him, but
represent additions to the source of his income, namely,
his invested capital. (DeKoven vs. Alsop, 205, Ill., 309;
63 L.R.A. 587). Such a person is in the same position, so
far as his income is concerned, as the owner of young
domestic animal, one year old at the beginning of the
year, which is worth P50 and, which, at the end of the
year, and by reason of its growth, is worth P100. The
value of his property has increased, but has had an
income during the year? It is true that he had taxable
property at the beginning of the year of the value of P50,
and the same taxable property at another period, of the
value of P100, but he has had no income in the common
acceptation of that word. The increase in the value of the
property should be taken account of on the tax duplicate
for the purposes of ordinary taxation, but not as income
for he has had none.
The question whether stock dividends are income, or
capital, or assets has frequently come before the courts
in another form — in cases of inheritance. A is a
stockholder in a large corporation. He dies leaving a will
by the terms of which he give to B during his lifetime the
"income" from said stock, with a further provision that C
shall, at B's death, become the owner of his share in the
corporation. During B's life the corporation issues a stock
dividend. Does the stock dividend belong to B as an
income, or does it finally belong to C as a part of his
share in the capital or assets of the corporation, which
had been left to him as a remainder by A? While there
has been some difference of opinion on that question,
we believe that a great weight of authorities hold that the
stock dividend is capital or assets belonging to C and not
an income belonging to B. In the case of D'Ooge vs.
Leeds (176 Mass., 558, 560) it was held that stock
dividends in such cases were regarded as capital and
not as income  (Gibbons vs. Mahon, 136 U.S., 549.)
In the case of Gibbson vs. Mahon, supra, Mr. Justice
Gray said: "The distinction between the title of a
corporation, and the interest of its members or
stockholders in the property of the corporation, is familiar
and well settled. The ownership of that property is in the
corporation, and not in the holders of shares of its stock.
The interest of each stockholder consists in the right to a
proportionate part of the profits whenever dividends are
declared by the corporation, during its existence, under
its charter, and to a like proportion of the property
remaining, upon the termination or dissolution of the
corporation, after payment of its debts." (Minot vs. Paine,
99 Mass., 101; Greeff vs. Equitable Life Assurance
Society, 160 N. Y., 19.) In the case of Dekoven vs. Alsop
(205 Ill ,309, 63 L. R. A. 587) Mr. Justice Wilkin said: "A
dividend is defined as a corporate profit set aside,
declared, and ordered by the directors to be paid to the
stockholders on demand or at a fixed time. Until the
dividend is declared, these corporate profits belong to
the corporation, not to the stockholders, and are liable
for corporate indebtedness.
There is a clear distinction between an extraordinary
cash dividend, no matter when earned, and stock
dividends declared. The one is a disbursement to the
stockholders of accumulated earning, and the
corporation at once parts irrevocably with all interest
thereon. The other involves no disbursement by the
corporation. It parts with nothing to the stockholders. The
latter receives, not an actual dividend, but certificates of
stock which evidence in a new proportion his interest in
the entire capital. When a cash becomes the absolute
property of the stockholders and cannot be reached by
the creditors of the corporation in the absence of fraud. A
stock dividend however, still being the property of the
corporation and not the stockholder, it may be reached
by an execution against the corporation, and sold as a
part of the property of the corporation. In such a case, if
all the property of the corporation is sold, then the
stockholder certainly could not be charged with having
received an income by virtue of the issuance of the stock
dividend. Until the dividend is declared and paid, the
corporate profits still belong to the corporation, not to the
stockholders, and are liable for corporate indebtedness.
The rule is well established that cash dividend, whether
large or small, are regarded as "income" and all stock
dividends, as capital or assets (Cook on Corporation,
Chapter 32, secs. 534, 536; Davis vs. Jackson, 152
Mass., 58; Mills vs. Britton, 64 Conn., 4; 5 Am., and Eng.
Encycl. of Law, 2d ed., p. 738.)
If the ownership of the property represented by a stock
dividend is still in the corporation and to in the holder of
such stock, then it is difficult to understand how it can be
regarded as income to the stockholder and not as a part
of the capital or assets of the corporation. (Gibbsons vs.
Mahon, supra.) the stockholder has received nothing but
a representation of an interest in the property of the
corporation and, as a matter of fact, he may never
receive anything, depending upon the final outcome of
the business of the corporation. The entire assets of the
corporation may be consumed by mismanagement, or
eaten up by debts and obligations, in which case the
holder of the stock dividend will never have received an
income from his investment in the corporation. A
corporation may be solvent and prosperous today and
issue stock dividends in representation of its increased
assets, and tomorrow be absolutely insolvent by reason
of changes in business conditions, and in such a case
the stockholder would have received nothing from his
investment. In such a case, if the holder of the stock
dividend is required to pay an income tax on the same,
the result would be that he has paid a tax upon an
income which he never received. Such a conclusion is
absolutely contradictory to the idea of an income. An
income subject to taxation under the law must be an
actual income and not a promised or prospective
income.
The appelle argues that there is nothing in section 25 of
Act No 2833 which contravenes the provisions of the
Jones Law. That may be admitted. He further argues
that the Act of Congress (U.S. Revenue Act of 1918)
expressly authorized the Philippine Legislatures to
provide for an income tax. That fact may also be
admitted. But a careful reading of that Act will show that,
while it permitted a tax upon income, the same provided
that income shall include gains, profits, and income
derived from salaries, wages, or compensation for
personal services, as well as from interest, rent,
dividends, securities, etc. The appellee emphasizes the
"income from dividends." Of course, income received as
dividends is taxable as an income but an income from
"dividends" is a very different thing from receipt of a
"stock dividend." One is an actual receipt of profits; the
other is a receipt of a representation of the increased
value of the assets of corporation.
In all of the foregoing argument we have not overlooked
the decisions of a few of the courts in different parts of
the world, which have reached a different conclusion
from the one which we have arrived at in the present SIRJMADAM/GENTLEMEN:
case. Inasmuch, however, as appeals may be taken
from this court to the Supreme Court of the United The bearer(s) hereof RO’s Irene Goze & Rosario Padilla
States, we feel bound to follow the same doctrine to be Supervise by GH Catalina_Leny Barrion of the
announced by that court. Special Team created pursuant to RSO 770-99 is/are
authorized to examine your books of accounts and other
Having reached the conclusion, supported by the great accounting records for a11 internal revenue taxes for the
weight of the authority, that "stock dividends" are not period from example year, 1998 to ______, 19___. He
"income," the same cannot be taxes under that provision is/[t]hey are provided with the necessary identification
of Act No. 2833 which provides for a tax upon income. card(s) which shall be presented to you upon request.
Under the guise of an income tax, property which is not
an income cannot be taxed. When the assets of a It is requested that all facilities be extended to the
corporation have increased so as to justify the issuance Revenue Officer(s) in order to expedite the examination.
of a stock dividend, the increase of the assets should be
taken account of the Government in the ordinary tax You will be duly informed of the results of the
duplicates for the purposes of assessment and collection examination upon approval of the report submitted by
of an additional tax. For all of the foregoing reasons, we the aforementioned Revenue Officer(s).7
are of the opinion, and so decide, that the judgment of
the lower court should be revoked, and without any
finding as to costs, it is so ordered. After the conduct of an examination pursuant to the LOA,
the BIR issued a Preliminary Assessment Notice
(PAN)8 which cited Lancaster for:
G.R. No. 183408
1) overstatement of its purchases for the fiscal year April
COMMISSIONER OF INTERNAL REVENUE, Petitioner 1998 to March1999;  and 2) noncompliance with the
vs. generally accepted accountingprinciple of proper
LANCASTER PHILIPPINES, INC., Respondent matching of cost and revenue.9 More concretely, the BIR
disallowed the purchases of tobacco from farmers
DECISION covered by Purchase Invoice Vouchers (PIVs) for the
months of February and March 1998 as deductions
MARTIRES, J.: against income for the fiscal year April 1998 to March
1999. The computation of Lancaster's tax deficiency,
This is a Petition for Review on Certiorari1 under Rule 45 with the details of discrepancies, is reproduced below:
of the Rules of Court seeking to reverse and set aside
the 30 April 2008 Decision2 and 24 June 2008 INCOME TAX:
Resolution3 of the Court of Tax Appeals (CTA) En Banc
in CTA EB No. 352. Taxable Income per ITR -0-
Add: Adjustments-Disallowed
The assailed decision and resolution affirmed the 12 11,496,770.18
purchases
September 2007 Decision4 and 12 December 2007
Resolution5 of the CTA First Division (CTA Division) in Adjusted Taxable Income
₱11,496,770.18
CTA Case No. 6753. per Investigation
INCOME TAX DUE-Basic
THE FACTS
April 1 - December 31, 1998
The facts6 are undisputed. (9/12x ₱l1,496,770.18 x
34%) ₱2,913,676.4
Petitioner Commissioner of Internal Revenue (CIR) is January 1 - March 31, 1999
authorized by law, among others, to investigate or (3/12x ₱l1,496,770.18 x
examine and, if necessary, issue assessments for 33%) 948,483.54
deficiency taxes.
Income tax still due per
₱3,880,159.94
On the other hand, respondent Lancaster Philippines, investigation
Inc. (Lancaster) is a domestic corporation established in
Interest (6/15/99 to 10115/02) .66 2,560,905.56
1963 and is engaged in the production, processing, and
marketing of tobacco. Compromise Penalty 25,000
TOTAL DEFlCIENCY INCOME
In 1999, the Bureau of Internal Revenue (BIR) issued ₱6,466,065.50
TAX
Letter of Authority (LOA) No. 00012289 authorizing its
revenue officers to examine Lancaster's books of
accounts and other accounting records for all internal DETAILS OF DISCREPANCIES
revenue taxes due from taxable year 1998 to an Assessment No. LTAID II-98-00007
unspecified date. The LOA reads:
A. INCOME TAX (₱3,880,159.94) - Taxpayer's fiscal
SEPT. 30 1999 year covers April 1998 to March 1999. Verification of the
books of accounts and pertinent documents disclosed
LETTER OF AUTHORITY that there was an overstatement of purchases for the
year. Purchase Invoice Vouchers (PIVs) for February
LANCASTER PHILS. INC. and March 1998 purchases amounting to ₱ll,496,770.18
11th Flr. Metro Bank Plaza were included as part of purchases for taxable year 1998
Makati City in violation of Section 45 of the National Internal
Revenue Code in relation to Section 43 of the same and
Revenue Regulations No. 2 which states that the Crop-
Basis method of reporting income may be used by a
farmer engaged in producing crops which take more
than one (1) year from the time of planting to the time of
gathering and disposing of crop, in such a case, the
entire cost of producing the crop must be taken as
deduction in the year in which the gross income from the
crop is realized and that the taxable income should be
computed upon the basis of the taxpayer's annual
accounting period, (fiscal or calendar year, as the case
may be) in accordance with the method of accounting
regularly employed in keeping with the books of the
taxpayer. Furthermore, it did not comply with the
generally accepted principle of proper matching of cost
and revenue.10
Lancaster replied11 to the PAN contending, among other
things, that for the past decades, it has used an
entire 'tobacco-cropping season' to determine its total
purchases covering a one-year period from 1 October up
to 30 September of the followingyear (as against its
fiscal year which is from 1 April up to 31 March of the
followingyear); that it has been adopting the 6~month
timing difference to conform to the matching concept (of
cost and revenue); and that this has long been installed
as part of the company's system and consistently
applied in its accounting books.12
Invoking the same provisions of the law cited in the
assessment, i.e., Sections 4313 and 4514 of the National
Internal Revenue Code (NJRC), in conjunction with
Section 4515 of Revenue Regulation No. 2, as amended,
Lancaster argued that the February and March 1998
purchases should not have been disallowed. It
maintained that the situation of farmers engaged in
producing tobacco, like Lancaster, is unique in that the
costs, i.e., purchases, are taken as of a different period
and posted in the year in which the gross income from
the crop is realized. Lancaster concluded that it correctly
posted the subject purchases in the fiscal year ending
March 1999 as it was only in this year that the gross
income from the crop was realized.
Subsequently on 6 November 2002, Lancaster received
from the BIR a final assessment
notice (FAN),16 captioned Formal Letter of Demand
andAudit Result/Assessment .Notice LTAID II IT-98-
00007, dated 11 October2002, which assessed
Lancaster's deficiency income tax amounting to Pl
l,496,770.18, as a consequence of the disallowance of
purchases claimed for the taxable year ending199931.
March 1999.
Lancaster duly protested17 the FAN. There being no
action taken by the Commissioner on its protest,
Lancaster filed on 21 August 2003 a petition for
review18 before the CTA Division.
The Proceedings before the CTA
In its petition before the CTA Division, Lancaster
essentially reiterated its arguments in the protest against
the assessment, maintaining that the tobacco purchases
in February and March 1998 are deductible in its fiscal
year ending 31 March 1999.
The issues19 raised by the parties for the resolution of
the CTA Division were:
I
WHETHER OR NOT PETITIONER COMPLIED WITH
THE GENERALLY ACCEPTED ACCOUNTING
PRINCIPLE OF PROPER MATCHING OF COST AND
REVENUE;
II
WHETHER OR NOT THE DEFICIENCY TAX
ASSESSMENT AGAINST PETITIONER FOR THE
TAXABLE YEAR 1998 IN THE AGGREGATE AMOUNT
OF ₱6,466,065.50 SHOULD BE CANCEILED AND
WITHDRAWN BY RESPONDENT.
After trial, the CTA Division granted the petition of
Lancaster, disposing as follows;
IN VIEW OF THE FOREGOING, the subject Petition for
Review is hereby GRANTED. Accordingly, respondent is
ORDERED to CANCEL and WITHDRAW the deficiency
income tax assessment issued against petitioner under
Formal l;etter of Demand and Audit Result/Assessment
Notice No. L TAID II IT-98-00007 dated October 11,
2002, in the amount of ₱6,466,065.50, covering the
fiscal year from April l, 1998 to March 31, 1999.20
The CIR move21 but failed to obtain reconsideration of
the CTA Division ruling.22
Aggrieved, the CIR sought recourse23 from the CTA En
Banc to seek a reversal of the decision and the
resolution of the CTA Division.
However, the CTA En Banc found no reversible error in
the CTA Division's ruling, thus, it affirmed the
cancellation of the assessment against Lancaster. The
dispositive portion of the decision of the CTA En Banc
states:
WHEREFORE, premises considered, the present
Petition for Review is hereby DENIED DUE COURSE,
and, accordingly DISMISSED for lack of merit.24
The CTA En Banc likewise denied25 the motion for
reconsideration from its Decision.
Hence, this petition.
The CIR assigns the following errors as committed by
the CTA En Banc:
I.
THE COURT OF TAX APPEALS EN BANC ERRED IN
HOLDING THAT PETITIONER'S REVENUE OFFICERS
EXCEEDED THEIR AUTHORITY TO INVESTIGATE
THE PERJOD NOT COVERED BY THEIR LETTER OF
AUTHORITY.
II.
THE COURT OF TAX APPEALS EN BANC ERRED IN
ORDERING PETITIONER TO CANCEL AND
WITHDRAW THE DEFICIENCY ASSESSMENT
ISSUED AGAINST RESPONDENT.26
THE COURT'S RULING
We deny the petition.
The CTA En Banc did not err when it ruled
that the BIR revenue officers had
exceeded their authority.
To support its first assignment of error, the CIR argues
that the revenue officers did not exceed their authority
when, upon examination (of the Lancaster's books of
accounts and other accounting records), they verified
that Lancaster made purchases for February and March
of 1998, which purchases were not declared in the
latter's fiscal year from 1 April 1997 to 31 March 1998.
Additionally, the CIR posits that Lancaster did not raise
the issue on the scope of authority of the revenue
examiners at any stage of the proceedings before the
CTA and, consequently, the CTA had no jurisdiction to
rule on said issue.
On both counts, the CIR is mistaken.
A. The Jurisdiction of the CTA
Preliminarily, we shall take up the CTA's jurisdiction to
rule on the issue of the scope of authority of the revenue
officers to conduct the examination of Lancaster's books
of accounts and accounting records.
The law vesting unto the CTA its jurisdiction is Section 7
of Republic Act No. 1125 (R.A. No. 1125),27 which in part
provides:
Section 7. Jurisdiction. - The Court of Tax Appeals shall
exercise exclusive appellate jurisdiction to review by
appeal, as herein provided:
(1) Decisions of the Collector of Internal Revenue in
cases involving disputed assessments, refunds of
internal revenue taxes, fees or other charges, penalties
imposed in relation thereto, or other matters arising
under the National Internal Revenue Code or other law
or part of law administered by the Bureau of Internal
Revenue; x x x. (emphasis supplied)
Under the aforecited provision, the jurisdiction of the
CTA is not limited only to cases which involve decisions
or inactions of the CIR on matters relating to
assessments or :refunds but also includes other cases
arising from the NIRC o:r related laws administered by
the BIR. 28 Thus, for instance, we had once held that the
question of whether or not to impose a deficiency tax
assessment comes within the purview of the
words "othermatters arising under the National Internal
Revenue Code."[[29]
The jurisdiction of the CTA on such other matters arising
under theNIRC  was retained under the amendments
introduced by R.A No. 9282.30Under R.A. No. 9282,
Section 7 now reads:
Sec. 7. Jurisdiction. - The CTA shall exercise:
a. Exclusive appellate jurisdiction to review by appeal, as
herein provided:
1. Decisions of the Commissioner of Internal Revenue in
cases involving disputed assessments, refunds of
internal revenue taxes, fees or other charges, penalties
in relation thereto, or other matters arising under the
National Internal Revenue or other laws administered by
the Bureau of Internal Revenue;
2. Inaction by the Commissioner of Internal Revenue in
cases involving disputed assessments, refunds of
internal revenue taxes, fees or other charges, penalties
in relation thereto, or other matters arising under the
National Internal Revenue Code or other laws
administered by the Bureau of Internal Revenue, where
the National Internal Revenue Code provides a specific
period of action. in which case the inaction shall be
deemed a denial; x x x." (emphasis supplied)
Is the question on the authority of revenue officers to
examine the books and records of any person
cognizable by the CTA?
It must be stressed that the assessment of inten1al
revenue taxes is one of the duties of the BIR. Section 2
of the NIRC states:
Sec. 2. Powers and Duties oftheBureau of Internal
Revenue. - The Bureau of Internal Revenue shall be
under the supervision and control of the Department of
Fin[:l.11ce and its powers: and duties shall comprehend
the assessment and collection of all national internal
revenue taxes, fees, andcharges, and the enforcement
of all forfeitures, penalties, and fines connected
therewith, including the execution of judgments in all
cases decided in its favor by the Court of Tax Appeals
and the ordinary courts.
The Bureau shall give effect to and administer the
supervisory and police powers conferred to it by this
Code or other laws. (emphasis supplied)
In connection therewith, the CIR may authorize the
examination of any taxpayer and correspondingly make
an assessment whenever necessary.31 Thus, to give
more teeth to such power of the CIR, to make an
assessment, the NIRC authorizes the CIR to examine
any book, paper, record, or data of any person. 32 The
powers granted by law to the CIR are intended, among
other things, to determine the liability of any person for
any national internal revenue tax.
It is pursuant to such pertinent provisions of the NIRC
conferring the powers to the CIR that the petitioner (CIR)
had, in this case, authorized its revenue officers to
conduct an examination of the books of account and
accounting records of Lancaster, and eventually issue a
deficiency assessment against it.
From the foregoing, it is clear that the issue on whether
the revenue officers who had conducted the examination
on Lancaster exceeded their authority pursuant to LOA
No. 00012289 may be considered as covered by the
terms "other matters" under Section 7 of R.A. No. 1125
or its amendment, R.A. No. 9282. The authority to make
an examination or assessment, being a matter provided
for by the NIRC, is well within the exclusive and
appellate jurisdiction of the CTA.
On whether the CTA can resolve an issue which was not
raised by the parties, we rule in the affirmative.
Under Section 1, Rule 14 of A.M. No. 05-11-07-CTA, or
the Revised Rules of the Court of Tax Appeals,33 the CT
A is not bound by the issues specifically raised by the
parties but may also rule upon related issues necessary
to achieve an orderly disposition of the case. The text of
the provision reads:
SECTION 1. Rendition of judgment. - x xx
In deciding the case, the Court may not limit itself to the
issues stipulated by the parties but may also rule upon
related issues necessary to achieve an orderly
disposition of the case.
The above section is clearly worded. On the basis
thereof, the CTA Division was, therefore, well within its
authority to consider in its decision the question on the
scope of authority of the revenue officers who were
named in the LOA even though the parties had not
raised the same in their pleadings or memoranda. The
CTA En Banc was likewise correct in sustaining the CTA
Division's view concerning such matter.
B. The Scope of the Authority
of the Examining Officers
In the assailed decision of the CTA Division, the trial
court observed that LOA No. 00012289 authorized the
BIR officers to examine the books of account of
Lancaster for the taxable year 1998 only or, since
Lancaster adopted a fiscal year (FY), for the
period 1April1997 to 31March1998. However, the
deficiency income tax assessment which the BIR
eventually issued against Lancaster was based on the
disallowance of expenses reported in FY 1999, or for the
period 1 April 1998 to 31March1999. The CTA
concluded that the revenue examiners had exceeded
their authority when they issued the assessment against
Lancaster and, consequently, declared such assessment
to be without force and effect.
We agree.
The audit process normally commences with the
issuance by the CIR of a Letter of Authority. The LOA
gives notice to the taxpayer that it is under investigation
for possible deficiency tax assessment; at the same time
it authorizes or empowers a designated revenue officer
to examine, verify, and scrutinize a taxpayer's books and
records, in relation to internal revenue tax liabilities for
a particular period.34
In this case, a perusal of LOA No. 00012289 indeed
shows that the period of examination is the taxable year
1998. For better clarity, the pertinent portion of the LOA
is again reproduced, thus:
The bearer(s) hereof x x x is/are authorized to examine
your books of accounts and other accounting records for
all internal revenue taxes for the period from taxable
year, 1998 to __, 19_. x x x." (emphasis supplied)
Even though the date after the words "taxable year 1998
to" is unstated, it is not at all difficult to discern that the
period of examination is the whole taxable year 1998.
This means that the examination of Lancaster must
cover the FY period from 1April1997 to 31March1998. It
could not have contemplated a longer period. The
examination for the full taxable year 1998 only is
consistent with the guideline in Revenue Memorandum
Order (RMO) No. 43-90, dated 20 September 1990, that
the LOA shall cover a taxable period not exceeding
one taxable year.35 In other words, absent any other
valid cause, the LOA issued in this case is valid in all
respects.
Nonetheless, a valid LOA does not necessarily clothe
validity to an assessment issued on it, as when the
revenue officers designated in the LOA act in excess or
outside of the authority granted them under said LOA.
Recently in CIR v. De La Salle University, Inc. 36 we
accorded validity to the LOA authorizing the examination
of DLSU for "Fiscal Year Ending 2003and Unverified
Prior Years" and correspondingly held the assessment
fortaxable year 2003 as valid because this taxable period
is specified in the LOA. However, we declared void the
assessments for taxable years 2001 and 2002 for having
been unspecified on separate LOAs as required under
RMO No. 43-90.
Likewise, in the earlier case of CIR v. Sony, Phils.,
Inc.,37 we affirmed the cancellation of a deficiency VAT
assessment because, while the LOA covered "the
period 1997and unverified prior years, " the said
deficiency was arrived at based on the records of a later
year, from January to March 1998, or using the fiscal
year which ended on 31March1998. We explainedthat
the CIR knew which period should be covered by the
investigation and that if the CIR wanted or intended the
investigation to include the year 1998, it would have
done so by including it in the LOA or by issuing another
LOA.38
The present case is no different from Sony in that the
subject LOA specified that the examination should be for
the taxable year 1998 only but the subsequent
assessment issued against Lancaster involved
disallowed expenses covering the next fiscal year, or the
period ending 31 March 1999. This much is clear from
the notice of assessment, the relevant portion of which
we again restate as follows:
1âwphi1
INCOME TAX:
Taxable Income per ITR -0-
Add: Adjustments-Disallowed
11,496, 770.18
purchases
Adjusted Taxable Income per ₱l
Investigation 1,496,770.18
INCOME TAX DUE-Basic
April 1 -December 31, 1998
(9/12xPl1,496,770.18 x 34%) ₱2,913,676.4
January 1-March 31, 1999
(3/12xPl1,496,770.18 x 33%) 948,483.54
Income tax still due per investigation ₱3,880,159.94
Interest (6/15/99 to 10/15/02) .66 2,560,905.56
Compromise Penalty 25,000
TOTAL DEFICIENCY INCOME TAX ₱6,466,065.50
(emphasis supplied)
The taxable year covered by the assessment being
outside of the period specified in the LOA in this case,
the assessment issued against Lancaster is, therefore,
void.
This point alone would have sufficed to invalidate the
subject deficiency income tax assessment, thus,
obviating any further necessity to resolve the issue on
whether Lancaster erroneously claimed the February
and March 1998 expenses as deductions against income
for FY 1999.
But, as the CTA did, we shall discuss the issue on the
disallowance for the proper guidance not only of the
parties, but the bench and the bar as well.
II.
The CTA En Banc correctly sustained the
order cancelling and withdrawing
the deficiency tax assessment.
To recall, the assessment against Lancaster for
deficiency income tax stemmed from the disallowance of
its February and March 1998 purchases which Lancaster
posted in its fiscal year ending on 31 March 1999 (FY
1999) instead of the fiscal year ending on
31March1998 (FY 1998).
On the one hand, the BIR insists that the purchases in
question should have been reported in FY 1998 in order
to conform to the generally accepted accounting
principle of proper matching of cost and revenue. Thus,
when
Lancaster reported the said purchases in FY 1999, this
resulted in overstatement of expenses warranting their
disallowance and, by consequence, resulting in the
deficiency in the payment of its income tax for FY 1999.
Upon the other hand, Lancaster justifies the inclusion of
the February and March 1998 purchases in its FY 1999
considering that they coincided with its crop year
covering the period of October 1997 to September 1998.
Consistent with Revenue Audit Memorandum (RAM) No.
2-95,39 Lancaster argues that its purchases in February
and March 1998 were properly posted in FY 1999, or the
year in which its gross income from the crop was
realized. Lancaster concludes that by doing so, it had
complied with the matching concept that was also relied
upon by the BIR in its assessment.
The issue essentially boils down to the proper timing
when Lancaster should recognize its purchases in
computing its taxable income. Such issue directly
correlates to the fact that Lancaster's 'crop year  ' does
not exactly coincide with its fiscal year for tax purposes.
Noticeably, the records of this case are rife with terms
and concepts in accounting. As a science,
accounting 40 pervades many aspects of financial
planning, forecasting, and decision making in business.
Its reach, however, has also permeated tax practice.
To put it into perspective, although the foundations of
accounting were built principally to analyze finances and
assist businesses, many of its principles have since
been adopted for purposes of taxation.41 In our
jurisdiction, the concepts in business accounting,
including certain generally accepted accounting
principles (GAAP), embedded in the NIRC comprise the
rules on tax accounting.
To be clear, the principles under financial or business
accounting, in theory and application, are not necessarily
interchangeable with those in tax accounting. Thus,
although closely related, tax and business accounting
had invariably produced concepts that at some point
diverge in understanding or usage. For instance, two of
such important concepts are taxable income and
business income (or accounting income). Much of the
difference can be attributed to the distinct purposes or
objectives that the concepts of tax and business
accounting are aimed at. Chief Justice Querube
Makalintal made an apt observation on the nature of
such difference. In Consolidated Mines, Inc. v. CTA, 42he
noted:
While taxable income is based on the method of
accounting used by the taxpayer, it will almost always
differ from accounting income. This is so because of a
fundamental difference in the ends the two concepts
serve. Accounting attempts to match cost against
revenue.  Tax law is aimed at collecting revenue.  It is
quick to treat an item as income, slow to recognize
deductions or losses. Thus, the tax law will not recognize
deductions for contingent future losses except in very
limited situations. Good accounting, on the other hand,
requires their recognition. Once this fundamental
difference in approach is accepted, income tax
accounting methods can be understood more
easily.43 (emphasis supplied)
While there may be differences between tax and
accounting,44 it cannot be said that the two mutually
exclude each other. As already made clear, tax laws
borrowed concepts that had origins from accounting. In
truth, tax cannot do away with accounting. It relies upon
approved accounting methods and practices to
effectively carry out its objective of collecting the proper
amount of taxes from the taxpayers. Thus, an important
mechanism established in many tax systems is the
requirement for taxpayers to make a return of their true
income.45 Maintaining accounting books and records,
among other important considerations, would in turn
assist the taxpayers in complying with their obligation to
file their income tax returns. At the same time, such
books and records provide vital information and possible
bases for the government, after appropriate audit, to
make an assessment for deficiency tax whenever so
warranted under the circumstances.
The NIRC, just like the tax laws in other jurisdictions,
recognizes the important facility provided by generally
accepted accounting principles and methods to the
primary aim of tax laws to collect the correct amount of
taxes. The NIRC even devoted a whole chapter on
accounting periods and methods of accounting, some
relevant provisions of which we cite here for more
emphasis:
CHAPTER VIII
ACCOUNTING PERIODS AND METHODS OF
ACCOUNTING
Sec. 43. General Rule.  - The taxable income shall be
computed upon the basis of the taxpayer's annual
accounting period (fiscal year or calendar year, as the
case may be) in accordance with the method of
accounting regularly employed in keeping the books of
such taxpayer; but if no such method of accounting has
been so employed, or if the method employed does not
clearly reflect the income, the computation shall be made
in accordance with such method as in the opinion of the
Commissioner clearly reflects the income.
If the taxpayer's annual accounting period is other than a
fiscal year, as defined in Section 22(Q), or if the taxpayer
has no annual accounting period, or does not keep
books, or if the taxpayer is an individual, the taxable
income shall be computed on the basis of the calendar
year.
Sec. 44. Period in which Items of Gross Income
Included.  - The amount of all items of gross income
shall be included in the gross income for the taxable year
in which received by the taxpayer, unless, under
methods of accounting permitted under Section 43, any
such amounts are to be properly accounted for as of a
different period.
In the case of the death of a taxpayer, there shall be
included in computing taxable income for the taxable
period in which falls the date of his death, amounts
accrued up to the date of his death if not otherwise
properly includible in respect of such period or a prior
period.
Sec. 45. Period/or which Deductions and Credits
Taken. - The deductions provided for in this Title shall be
taken for the taxable year in which 'paid or
accrued'  or 'paid or incurred,' dependent upon the
method of accounting upon the basis of which the net
income is computed, unless in order to clearly reflect the
income, the deductions should be taken as of a different
period. In the case of the death of a taxpayer, there shall
be allowed as deductions for the taxable period in which
falls the date of his death, amounts accrued up to the
date of his death if not otherwise properly allowable in
respect of such period or a prior period.
Sec. 46. Change of Accounting Period. - If a taxpayer,
other than an individual, changes his accounting period
from fiscal year to calendar year, from calendar year to
fiscal year, or from one fiscal year to another, the net
income shall, with the approval of the Commissioner, be
computed on the basis of such new accounting period,
subject to the provisions of Section 47.
xxxx
Sec. 48. Accounting for Long-term Contracts.  -
Income from long-term contracts shall be repo1ied for
tax purposes in the manner as provided in this Section.
As used herein, the term 'long-term contracts'  means
building, installation or construction contracts covering a
period in excess of one (1) year.
Persons whose gross income is derived in whole or in
part from such contracts shall report such income upon
the basis of percentage of completion.1âwphi1
The return should be accompanied by a return certificate
of architects or engineers showing the percentage of
completion during the taxable year of the entire work
performed under contract.
There should be deducted from such gross income all
expenditures made during the taxable year on account of
the contract, account being taken of the material and
supplies on hand at the beginning and end of the taxable
period for use in connection with the work under the
contract but not yet so applied.
If upon completion of a contract, it is found that the
taxable net income arising thereunder has not been
clearly reflected for any year or years, the Commissioner
may permit or require an amended return.
Sec. 49. Installment Basis. -
(A) Sales of Dealers in Personal Property. - Under
rules and regulations prescribed by the Secretary of
Finance, upon recommendation of the Commissioner, a
person who regularly sells or otherwise disposes of
personal property on the installment plan may return as
income therefrom in any taxable year that proportion of
the installment payments actually received in that year,
which the gross profit realized or to be realized when
payment is completed, bears to the total contract price.
(B) Sales of Realty and Casual Sales of Personality.  -
In the case (1) of a casual sale or other casual
disposition of personal property (other than property of a
kind which would properly be included in the inventory of
the taxpayer if on hand at the close of the taxable year),
for a price exceeding One thousand pesos (₱1,000), or
(2) of a sale or other disposition of real prope1iy, if in
either case the initial payments do not exceed twenty-
five percent (25%) of the selling price, the income may,
under the rules and regulations prescribed by the
Secretary of Finance, upon recommendation of the
Commissioner, be returned on the basis and in the
manner above prescribed in this Section.
As used in this Section, the term 'initial
payments' means the payments received in cash or
property other than evidences of indebtedness of the
purchaser during the taxable period in which the sale or
other disposition is made.
(C) Sales of Real Property Considered as Capital Asset
by Individuals.  - An individual who sells or disposes of
real property, considered as capital asset, and is
otherwise qualified to report the gain therefrom under
Subsection (B) may pay the capital gains tax in
installments under rules and regulations to be
promulgated by the Secretary of Finance, upon
recommendation of the Commissioner.
(D) Change from Accrual to Installment Basis.  - If a
taxpayer entitled to the benefits of Subsection (A) elects
for any taxable year to report his taxable income on the
installment basis, then in computing his income for the
year of change or any subsequent year, amounts
actually received during any such year on account of
sales or other dispositions of property made in any prior
year shall not be excluded." (emphasis in the original)
We now proceed to the matter respecting the accounting
method employed by Lancaster.
An accounting method is a "set of rules for determining
when and how to report income and deductions."46 The
provisions under Chapter VIII, Title II of the NIRC cited
above enumerate the methods of accounting that the law
expressly recognizes, to wit:
(1) Cash basis method;47
(2) Accrual method;48
(3) Installment method;49
(4) Percentage of completion method;50 and
(5) Other accounting methods.
Any of the foregoing methods may be employed by any
taxpayer so long as it reflects its income properly and
such method is used regularly. The peculiarities of the
business or occupation engaged in by a taxpayer would
largely determine how it would report incomes and
expenses in its accounting books or records. The NIRC
does not prescribe a uniform, or even specific, method of
accounting.
Too, other methods approved by the CIR, even when not
expressly mentioned in the NIRC, may be adopted if
such method would enable the taxpayer to properly
reflect its income. Section 43 of the NIRC authorizes the
CIR to allow the use of a method of accounting that in its
opinion would clearly reflect the income of the taxpayer.
An example of such method not expressly mentioned in
the NIRC, but duly approved by the CIR, is the 'crop
method of accounting' authorized under RAM No. 2-
95. The pertinent provision reads:
II. Accounting Methods
xxxx
F. Crop Year Basis is a method applicable only to
farmers engaged in the production of crops which take
more than a year from the time of planting to the process
of gathering and disposal. Expenses paid or incurred are
deductible in the year the gross income from the sale of
the crops are realized.
The crop method recognizes that the harvesting and
selling of crops do not fall within the same year that they
are planted or grown. This method is especially relevant
to farmers, or those engaged in the business of
producing crops who, pursuant to RAM No. 2-95, would
then be able to compute their taxable income on the
basis of their crop year. On when to recognize expenses
as deductions against income, the governing rule is
found in the second sentence of Subsection F cited
above. The rule enjoins the recognition of the expense
(or the deduction of the cost) of crop production in the
year that the crops are sold (when income is realized).
In the present case, we find it wholly justifiable for
Lancaster, as a business engaged in the production and
marketing of tobacco, to adopt the crop method of
accounting. A taxpayer is authorized to employ what it
finds suitable for its purpose so long as it consistently
does so, and in this case, Lancaster does appear to
have utilized the method regularly for many decades
already. Considering that the crop year of Lancaster
starts from October up to September of the following
year, it follows that all of its expenses in the crop
production made within the crop year starting from
October 1997 to September 1998, including the
February and March 1998 purchases covered by
purchase invoice vouchers, are rightfully deductible for
income tax purposes in the year when the gross income
from the crops are realized. Pertinently, nothing from the
pleadings or memoranda of the parties, or even from
their testimonies before the CT A, would support a
finding that the gross income from the crops (to which
the subject expenses refer) was actually realized by the
end of March 1998, or the closing of Lancaster's fiscal
year for 1998. Instead, the records show that the
February and March 1998 purchases were recorded by
Lancaster as advances and later taken up
as purchases  by the close of the crop year in September
1998, or as stated very clearly above, within the fiscal
year 1999.51On this point, we quote with approval the
ruling of the CT A En Banc, thus:
Considering that [Lancaster] is engaged in the
production oftobacco, it applied the crop year basis in
determining its total purchases for each fiscal year.
Thus, [Lancaster's] total cost for the production of its
crops, which includes its purchases, must be taken as a
deduction in the year in which the gross income is
realized. Thus, We agree with the following ratiocination
of the First Division:
Evident from the foregoing, the crop year basis is one
unusual method of accounting wherein the entire cost of
producing the crops (including purchases) must be taken
as a deduction in the year in which the gross income
from the crop is realized. Since the petitioner's crop year
starts in October and ends in September of the following
year, the same does not coincide with petitioner's fiscal
year which starts in April and ends in March of the
following year. However, the law and regulations
consider this peculiar situation and allow the costs to be
taken up at the time the gross income from the crop is
realized, as in the instant case.
[Lancaster's] fiscal period is from April 1, 1998 to March
31, 1999. On the other hand, its crop year is from
October 1, 1997 to September 1, 1998. Accordingly, in
applying the crop year method, all the purchases made
by the respondent for October 1, 1997 to September 1,
1998 should be deducted from the fiscal year ending
March 31, 1999, since it is the time when the gross
income from the crops is realized.52
The matching principle
Both petitioner CIR and respondent Lancaster, it must be
noted, rely upon the concept of matching cost against
revenue to buttress their respective theories. Also, both
parties cite RAM 2-95 in referencing the crop method of
accounting.
We are tasked to determine which view is legally sound.
In essence, the matching concept, which is one of the
generally accepted accounting principles, directs that the
expenses are to be reported in the same period that
related revenues are earned. It attempts to match
revenue with expenses that helped earn it.
The CIR posits that Lancaster should not have
recognized in FY 1999 the purchases for February and
March 1998.53 Apparent from the reasoning of the CIR is
that such expenses ought to have been deducted in FY
1998, when they were supposed to be paid or incurred
by Lancaster. In other words, the CIR is of the view that
the subject purchases match with revenues in 1998, not
in 1999
A reading of RAM No. 2-95, however, clearly evinces
that it conforms with the concept that the
expenses paid  or incurred  be deducted in the year in
which gross income from the sale of the crops
is realized. Put in another way, the expenses are
matched with the related incomes which are eventually
earned. Nothing from the provision is it strictly required
that for the expense to be deductible, the income to
which such expense is related to be realized in the same
year that it is paid or incurred.  As noted by the
CTA,54 the crop method is an unusual method of
accounting, unlike other recognized accounting methods
that, by mandate of Sec. 45 of the NIRC, strictly require
expenses be taken in the same taxable year when the
income is 'paid  or incurred, ' or 'paid or accrued, '
depending upon the method of accounting employed by
the taxpayer.
Even if we were to accept the notion that applying the
1998 purchases as deductions in the fiscal year 1998
conforms with the generally accepted principle of
matching cost against revenue, the same would still not
lend any comfort to the CIR. Revenue Memorandum
Circular (RMC)  No. 22-04, entitled "Supplement to
Revenue Memorandum Circular No. 44-2002 on
Accounting Methods to be Used by Taxpayers for
Internal Revenue Tax Purposes"55dated 12 April 2004,
commands that where there is conflict between the
provisions of the Tax Code (NIRC), including its
implementing rules and regulations, on accounting
methods and the generally accepted accounting
principles, the former shall prevail. The relevant portion
of RMC 22-04 reads:
II. Provisions of the Tax Code Shall Prevail.
All returns required to be filed by the Tax Code shall be
prepared always in conformity with the provisions of the
Tax Code, and the rules and regulations implementing
said Tax Code. Taxability of income and deductibility of
expenses shall be determined strictly in accordance with
the provisions of the Tax Code and the rules and
regulations issued implementing said Tax Code. In case
of difference between the provisions of the Tax Code
and the rules and regulations implementing the Tax
Code, on one hand, and the general(v accepted
accounting principles (GAAP) and the generally
accepted accounting standards (GAAS), on the other
hand, the provisions of the Tax Code and the rules and
regulations issued implementing said Tax Code shall
prevail. (italics supplied)

RAM No. 2-95 is clear-cut on the rule on when to

recognize deductions for taxpayers using the crop
method of accounting. The rule prevails over any GAAP,
including the matching concept as applied in financial or
business accounting.

In sum, and considering the foregoing premises, we find

no cogent reason to overturn the assailed decision and
resolution of the CT A. As the CTA decreed, Assessment
Notice LTAID II IT-98-00007, dated 11 October 2002, in
the amount of ₱6,466,065.50 for deficiency income tax
should be cancelled and set aside. The assessment is
void for being issued without valid authority.
Furthermore, there is no legal justification for the
disallowance of Lancaster's expenses for the purchase
of tobacco in February and March 1998.

WHEREFORE, the petition is DENIED. The assailed 30

April 2008 Decision and 24 June 2008 Resolution of the
Court of Tax Appeals En Banc are AFFIRMED. No cost

SO ORDERED.
G.R. No. 139786             September 27, 2006
COMMISSIONER OF INTERNAL REVENUE, petitioner,
vs.
CITYTRUST INVESTMENT PHILS., INC., respondent.
x---------------------------------------------x
G.R. No. 140857             September 27, 2006
ASIANBANK CORPORATION, petitioner,
vs.
COMMISSIONER OF INTERNAL
REVENUE, respondent.
DECISION
SANDOVAL-GUTIERREZ, J.:
Does the twenty percent (20%) final withholding tax
(FWT) on a bank's passive income1  form part of the
taxable gross receipts for the purpose of computing the
five percent (5%) gross receipts tax (GRT)? This is the
central issue in the present two (2) consolidated petitions
for review.
In G.R. No. 139786, petitioner Commissioner of Internal
Revenue (Commissioner) assails the Court of Appeals
Decision dated August 17, 1999 in CA-G.R. SP No.
527072 affirming the Court of Tax Appeals (CTA)
Decision3 ordering the refund or issuance of tax credit
certificate in favor of respondent Citytrust Investment
Philippines., Inc. (Citytrust). In G.R. No. 140857,
petitioner Asianbank Corporation (Asianbank) challenges
the Court of Appeals Decision dated November 22, 1999
in CA-G.R. SP No. 512484 reversing the CTA
Decision5 ordering a tax refund in its (Asianbank's) favor.
A brief review of the taxation laws provides an adequate
backdrop for our subsequent narration of facts.
Under Section 27(D), formerly Section 24(e)(1) of the
National Internal Revenue Code of 1997 (Tax Code), the
earnings of banks from passive income are subject to a
20% FWT,6 thus:
(D) Rates of Tax on Certain Passive Incomes –
(1) Interest from Deposits and Yield or any other
Monetary Benefit from Deposit Substitutes and from
Trust Funds and Similar Arrangements, and Royalties. –
A final tax at the rate of twenty percent (20%) is
hereby imposed upon the amount of interest on
currency bank deposit and yield or any other monetary
benefit from deposit substitutes and from trust funds and
similar arrangements received by domestic corporation
and royalties, derived from sources within the
Philippines: x x x
Apart from the 20% FWT, banks are also subject to the
5% GRT on their gross receipts, which includes their
passive income. Section 121 (formerly Section 119) of
the Tax Code reads:
SEC. 121. Tax on banks and Non-bank financial
intermediaries. – There shall be collected a tax
on gross receipts derived from sources within the
Philippines by all banks and non-bank financial
intermediaries in accordance with the following schedule:
(a) On interest, commissions and discounts from
lending activities as well as income from financial
leasing, on the basis of remaining maturities of
instruments from which such receipts are derived:
Short-term maturity (not in excess of two [2]
years) 5%
Medium-term maturity (over two [2] years but not
exceeding four [4] years) 3%
Long-term maturity –
      (1) Over four (4) years but not exceeding seven
(7) years 1%
      (2) Over seven (7) years 0%
(b) On dividends 0%
(c) On royalties, rentals of property, real or
personal, profits from exchange and all other items
treated as gross income under Section 32 of this
Code 5%
Provided, however, That in case the maturity period
referred to in paragraph (a) is shortened thru
pretermination, then the maturity period shall be
reckoned to end as of the date of pretermination for
purposes of classifying the transaction as short, medium
or long-term and the correct rate of tax shall be applied
accordingly.
Nothing in this Code shall preclude the Commissioner
from imposing the same tax herein provided on persons
performing similar banking activities.
I - G.R. No. 139786
Citytrust, respondent, is a domestic corporation engaged
in quasi-banking activities. In 1994, Citytrust reported the
amount of P110,788,542.30 as its total gross receipts
and paid the amount of P5,539,427.11 corresponding to
its 5% GRT.
Meanwhile, on January 30, 1996, the CTA, in Asian
Bank Corporation v. Commissioner of Internal
Revenue7 (ASIAN BANK case), ruled that the basis in
computing the 5% GRT is the gross receipts minus the
20% FWT. In other words, the 20% FWT on a bank's
passive income does not form part of the taxable gross
receipts.
On July 19, 1996, Citytrust, inspired by the above-
mentioned CTA ruling, filed with the Commissioner a
written claim for the tax refund or credit in the amount of
P326,007.01. It alleged that its reported total gross
receipts included the 20% FWT on its passive income
amounting to P32,600,701.25. Thus, it sought to be
reimbursed of the 5% GRT it paid on the portion of 20%
FWT or the amount of P326,007.01.
On the same date, Citytrust filed a petition for review
with the CTA, which eventually granted its claim.8
On appeal by the Commissioner, the Court of Appeals
affirmed the CTA Decision, citing as main
bases Commissioner of Internal Revenue v. Tours
Specialist Inc.9 and Commissioner of Internal Revenue
v. Manila Jockey Club,10 holding that monies or receipts
that do not redound to the benefit of the taxpayer are not
part of its gross receipts, thus:
Patently, as expostulated by our Supreme
Court, monies or receipts that do not redound to the
benefit of the taxpayer are not part of its gross
receipts for the purpose of computing its taxable
gross receipts. In Manila Jockey Club, a portion of the
wager fund and the ten-peso contribution,
although actually received by the Club, was not
considered as part of its gross receipts for the purpose of
imposing the amusement tax. Similarly, in Tours
Specialists, the room or hotel charges actually
received by them from the foreign travel agency was,
likewise, not included in its gross receipts for the
imposition of the 3% contractor's tax. In both cases, the
fees, bets or hotel charges, as the case may be, were
actually received and held in trust by the taxpayers. On
the other hand, the 20% final tax on the
Respondent's passive income was already deducted
and withheld by various withholding agents. Hence,
the actual or the exact amount received by the
Respondent, as its passive income in the year 1994,
was less the 20% final tax already withheld by
various withholding agents. The various withholding
agents at source were required under section 50 (a),
of the National Internal Revenue Code of 1986, to
withhold the 20% final tax on certain passive income
x x x.
Moreover, under Section 51 (g) of the said Code, all
taxes withheld pursuant to the provisions of this
Code and its implementing regulations are
considered trust funds and shall be maintained in a
separate account and not commingled with any
other funds of the withholding agent.
Accordingly, the 20% final tax withheld against the
Respondent's passive income was already remitted
to the Bureau of Internal Revenue, for the
corresponding year that the same was actually
withheld and considered final withholding taxes
under Section 50 of the same Code. Indubitably, to
include the same to the Respondent's gross receipts
for the year 1994 would be to tax twice the passive
income derived by Respondent for the said year,
which would constitute double taxation anathema to
our taxation laws.
II - G.R. No. 140857
Asianbank, petitioner, is a domestic corporation also
engaged in banking business. For the taxable quarters
ending June 30, 1994 to June 30, 1996, Asianbank filed
and remitted to the Bureau of Internal Revenue (BIR) the
5% GRT on its total gross receipts.
On the strength of the January 30, 1996 CTA Decision in
the ASIAN BANK case, Asianbank filed with the
Commissioner a claim for refund of the overpaid GRT
amounting to P2,022,485.78.
To toll the running of the two-year prescriptive period for
filing of claims, Asianbank also filed a petition for review
with the CTA.
On February 3, 1999, the CTA allowed refund in the
reduced amount of P1,345,743.01,11 the amount proven
by Asianbank. Unsatisfied, the Commissioner filed with
the Court of Appeals a petition for review.
On November 22, 1999, the Court of Appeals reversed
the CTA Decision and ruled in favor of the
Commissioner, thus:
It is true that Revenue Regulation No. 12-80 provides
that the gross receipts tax on banks and other financial
institutions should be based on all items of income
actually received. Actual receipt here is used in
opposition to mere accrual. Accrued income refers to
income already earned but not yet received. (Rep. v. Lim
Tian Teng Sons & Co., 16 SCRA 584).
But receipt may be actual or constructive. Article 531
of the Civil Code provides that possession is acquired by
the material occupation of a thing or the exercise of a
right, or by the fact that it is subject to the action of one
will, or by the proper acts and legal formalities
established for acquiring such right. Moreover, taxation
income may be received by the taxpayer himself or by
someone authorized to receive it for him (Art. 532, Civil
Code). The 20% final tax withheld from interest
income of banks and other similar institutions is not
income that they have not received; it is simply
withheld from them and paid to the government, for
their benefit. Thus, the 20% income tax withheld
from the interest income is, in fact, money of the
taxpayer bank but paid by the payor to the
government in satisfaction of the bank's obligation
to pay the tax on interest earned. It is the bank's
obligation to pay the tax. Hence, the withholding of
the said tax and its payment to the government is for
its benefit.
xxx
The case of Collector of Internal Revenue vs. Manila
Jockey Club is inapplicable. In that case, a percentage of
the gross receipts to be collected by the Manila Jockey
Club was earmarked by law to be turned over to the
Board on Races and distributed as prizes among owners
of winning horses and authorized bonus for jockeys. The
Manila Jockey Club itself derives no benefit at all from
earmarked percentage. That is why it cannot be
considered as part of its gross receipts.
WHEREFORE, the C.T.A's judgment herein appealed
from is hereby REVERSED, and judgment is hereby
rendered DISMISSING the respondent's Petition for
Review in C.T.A Case No. 5412.
SO ORDERED.
Hence, the present consolidated petitions.
The Commissioner's arguments in the two (2) petitions
may be synthesized as follows:
first, there is no law which excludes the 20% FWT from
the taxable gross receipts for the purpose of computing
the 5% GRT;
second, the imposition of the 20% FWT on the bank's
passive income and the 5% GRT on its taxable gross
receipts, which include the bank's passive income, does
not constitute double taxation;
third, the ruling by this Court in Manila Jockey
Club,12 cited in the ASIAN BANK case, is not applicable;
and
fourth, in the computation of the 5% GRT, the passive
income need not be actually received in order to form
part of the taxable gross receipts.
In its Resolution13 dated January 17, 2000, this Court
adopted as Citytrust's Comment on the instant petition
for review its Memorandum submitted to the CTA and its
Comment submitted to the Court of Appeals. Citytrust
contends therein that: first, Section 4(e) of Revenue
Regulations No. 12-80 dated November 7, 1980
provides that the rates of taxes on the gross receipts of
financial institutions shall be based only on all items of
income actually received; and, second, this Court's
ruling in Manila Jockey Club14 is applicable. Asianbank
echoes similar arguments.
We rule in favor of the Commissioner.
The issue of whether the 20% FWT on a bank's interest
income forms part of the taxable gross receipts for the
purpose of computing the 5% GRT is no longer novel.
This has been previously resolved by this Court in a
catena of cases, such as China Banking Corporation v.
Court of Appeals,15 Commissioner of Internal Revenue v.
Solidbank Corporation,16 Commissioner of Internal
Revenue v. Bank of Commerce,17 and the
latest, Commissioner of Internal Revenue v. Bank of the
Philippine Islands.18
The above cases are unanimous in defining "gross
receipts" as "the entire receipts without any
deduction." We quote the Court's enlightening
ratiocination in Bank of the Philippines Islands,19 thus:
The Tax Code does not provide a definition of the term
"gross receipts". Accordingly, the term is properly
understood in its plain and ordinary meaning and must
be taken to comprise of the entire receipts without any
deduction. We, thus, made the following disquisition
in Bank of Commerce:
The word "gross" must be used in its plain and
ordinary meaning. It is defined as "whole, entire,
total, without deduction." A common definition is
"without deduction." "Gross" is also defined as
"taking in the whole; having no deduction or
abatement; whole, total as opposed to a sum
consisting of separate or specified parts." Gross is
the antithesis of net. Indeed, in China Banking
Corporation v. Court of Appeals, the Court defined the
term in this wise:
As commonly understood, the term "gross receipts"
means the entire receipts without any deduction.
Deducting any amount from the gross receipts changes
the result, and the meaning, to net receipts. Any
deduction from gross receipts is inconsistent with a law
that mandates a tax on gross receipts, unless the law
itself makes an exception. As explained by the Supreme
Court of Pennsylvania in Commonwealth of
Pennsylvania v. Koppers Company, Inc. –
Highly refined and technical tax concepts have been
developed by the accountant and legal technician
primarily because of the impact of federal income tax
legislation. However, this is no way should affect or
control the normal usage of words in the construction of
our statutes; and we see nothing that would require us
not to include the proceeds here in question in the gross
receipts allocation unless statutorily such inclusion is
prohibited. Under the ordinary basic methods of
handling accounts, the term gross receipts, in the
absence of any statutory definition of the term, must
be taken to include the whole total gross receipts
without any deductions, x x x. [Citations omitted]
(Emphasis supplied)"
Likewise, in Laclede Gas Co. v. City of St. Louis, the
Supreme Court of Missouri held:
The word "gross" appearing in the term "gross receipts,"
as used in the ordinance, must have been and was there
used as the direct antithesis of the word "net." In its
usual and ordinary meaning, "gross receipts" of a
business is the whole and entire amount of the receipts
without deduction, x x x. On the ordinary, "net receipts"
usually are the receipts which remain after deductions
are made from the gross amount thereof of the expenses
and cost of doing business, including fixed charges and
depreciation. Gross receipts become net receipts after
certain proper deductions are made from the gross. And
in the use of the words "gross receipts," the instant
ordinance, or course, precluded plaintiff from first
deducting its costs and expenses of doing business, etc.,
in arriving at the higher base figure upon which it must
pay the 5% tax under this ordinance. (Emphasis
supplied)
xxxxxx
Additionally, we held in Solidbank, to wit:
[W]e note that US cases have persuasive effect in our
jurisdiction because Philippine income tax law is
patterned after its US counterpart.
[G]ross receipts with respect to any period means the
sum of: (a) The total amount received or accrued during
such period from the sale, exchange, or other disposition
of x x x other property of a kind which would properly be
included in the inventory of the taxpayer if on hand at the
close of the taxable year, or property held by the
taxpayer primarily for sale to customers in the ordinary
course of its trade or business, and (b) The gross
income, attributable to a trade or business, regularly
carried on by the taxpayer, received or accrued during
such period x x x.
x x x [B]y gross earnings from operations x x x was
intended all operations x x x including incidental,
subordinate, and subsidiary operations, as well as
principal operations.
When we speak of the "gross earnings" of a person or
corporation, we mean the entire earnings or receipts of
such person or corporation from the business or
operation to which we refer.
From these cases, "gross receipts" refer to the total, as
opposed to the net income. These are therefore the total
receipts before any deduction for the expenses of
management. Webster's New International Dictionary, in
fact, defines gross as "whole or entire."
In China Banking Corporation,20 this Court further
explained that the legislative intent to apply the term in
its plain and ordinary meaning may be surmised from a
historical perspective of the levy on gross receipts. From
the time the GRT on banks was first imposed in 1946
under Republic Act No. 3921 and throughout its
successive re-enactments,22 the legislature has not
established a definition of the term "gross receipts."
Under Revenue Regulations No. 12-80 and No. 17-84,
as well as several numbered rulings, the BIR has
consistently ruled that the term "gross receipts" does
not admit of any deduction. This interpretation has
remained unchanged throughout the various re-
enactments of the present Section 121 of the Tax Code.
On the presumption that the legislature is familiar with
the contemporaneous interpretation of a statute given by
the administrative agency tasked to enforce the statute,
the reasonable conclusion is that the legislature has
adopted the BIR's interpretation. In other words, the
subsequent re-enactments of the present Section 121,
without changes in the term interpreted by the BIR,
confirm that its interpretation carries out the legislative
purpose.
Now, bereft of any laudable statutory basis, Citytrust and
Asianbank simply anchor their argument on Section 4(e)
of Revenue Regulations No. 12-80 stating that "the rates
of taxes to be imposed on the gross receipts of such
financial institutions shall be based on all items of
income actually received." They contend that since the
20% FWT is withheld at source and is paid directly to the
government by the entities from which the banks derived
the income, the same cannot be considered actually
received, hence, must be excluded from the taxable
gross receipts.
The argument is bereft of merit.
First, Section 4(e) merely recognizes that income may
be taxable either at the time of its actual receipt or
its accrual, depending on the accounting method of the
taxpayer. It does not really exclude accrued interest
income from the taxable gross receipts but merely
postpones its inclusion until actual payment of the
interest to the lending bank. Thus, while it is true that
Section 4(e) states that "the rates of taxes to be imposed
on the gross receipts of such financial institutions shall
be based on all items of income actually received," it
goes on to distinguish actual receipt from accrual, i.e.,
that "mere accrual shall not be considered, but once
payment is received in such accrual or in case of
prepayment, then the amount actually received shall
be included in the tax base of such financial
institutions."
And second, Revenue Regulations No. 12-80, issued on
November 7, 1980, had been superseded by Revenue
Regulations No. 17-84 issued on October 12, 1984.
Section 4(e) of Revenue Regulations No. 12-80 provides
that only items of income actually received shall be
included in the tax base for computing the GRT. On the
other hand, Section 7(c) of Revenue Regulations No. 17-
84 includes all interest income in computing the GRT,
thus:
SECTION 7. Nature and Treatment of Interest on
Deposits and Yield on Deposit Substitutes. –
(a) The interest earned on Philippine Currency bank
deposits and yield from deposit substitutes subjected to
the withholding taxes in accordance with these
regulations need not be included in the gross income in
computing the depositor's/investor's income tax liability
in accordance with the provision of Section 29 (b), (c)
and (d) of the National Internal Revenue Code, as
amended.
(b) Only interest paid or accrued on bank deposits, or
yield from deposit substitutes declared for purposes of
imposing the withholding taxes in accordance with these
regulations shall be allowed as interest expense
deductible for purposes of computing taxable net income
of the payor.
(c) If the recipient of the above-mentioned items of
income are financial institutions, the same shall be
included as part of the tax base upon which the
gross receipt tax is imposed.
Revenue Regulations No. 17-84 categorically states
that if the recipient of the above-mentioned items of
income are financial institutions, the same shall be
included as part of the tax base upon which the
gross receipt tax is imposed. There is, therefore, an
implied repeal of Section 4(e). There exists a disparity
between Section 4(e) which imposes the GRT only on all
items of income actually received (as opposed to their
mere accrual) and Section 7(c) which includes all
interest income (whether actual or accrued) in
computing the GRT. As held by this Court
in Commissioner of Internal Revenue v. Solidbank
Corporation,23 "the exception having been eliminated,
the clear intent is that the later R.R. No. 17-84
includes the exception within the scope of the
general rule." Clearly, then, the current Revenue
Regulations require interest income, whether actually
received or merely accrued, to form part of the bank's
taxable gross receipts.2
Moreover, this Court, in Bank of Commerce,25 settled the
matter by holding that "actual receipt may either be
physical receipt or constructive receipt," thus:
Actual receipt of interest income is not limited to
physical receipt. Actual receipt may either be
physical receipt or constructive receipt. When the
depositary bank withholds the final tax to pay the tax
liability of the lending bank, there is prior to the
withholding a constructive receipt by the lending
bank of the amount withheld. From the amount
constructively received by the lending bank, the
depositary bank deducts the final withholding tax and
remits it to the government for the account of the lending
bank. Thus, the interest income actually received by the
lending bank, both physically and constructively, is the
net interest plus the amount withheld as final tax.
The concept of a withholding tax on income obviously
and necessarily implies that the amount of the tax
withheld comes from the income earned by the taxpayer.
Since the amount of the tax withheld constitute income
earned by the taxpayer, then that amount manifestly
forms part of the taxpayer's gross receipts. Because the
amount withheld belongs to the taxpayer, he can transfer
its ownership to the government in payment of his tax
liability. The amount withheld indubitably comes from the
income of the taxpayer, and thus forms part of his gross
receipts.
Corollarily, the Commissioner contends that the
imposition of the 20% FWT and 5% GRT does not
constitute double taxation.
We agree.
Double taxation means taxing for the same tax period
the same thing or activity twice, when it should be taxed
but once, for the same purpose and with the same kind
of character of tax.26 This is not the situation in the case
at bar. The GRT is a percentage tax under Title V of the
Tax Code ([Section 121], Other Percentage Taxes),
while the FWT is an income tax under Title II of the Code
(Tax on Income). The two concepts are different from
each other. In Solidbank Corporation,27 this Court
defined that a percentage tax is a national tax measured
by a certain percentage of the gross selling price or
gross value in money of goods sold, bartered or
imported; or of the gross receipts or earnings derived by
any person engaged in the sale of services. It is not
subject to withholding. An income tax, on the other hand,
is a national tax imposed on the net or the gross income
realized in a taxable year. It is subject to withholding.
Thus, there can be no double taxation here as the Tax
Code imposes two different kinds of taxes.
Now, both Asianbank and Citytrust rely on Manila
Jockey Club28 in support of their positions. We are not
convinced. In said case, Manila Jockey Club paid
amusement tax on its commission in the total amount of
bets called wager funds from the period November 1946
to October 1950. But such payment did not include the 5
½ % of the funds which went to the Board on Races and
to the owners of horses and jockeys. We ruled that the
gross receipts of the Manila Jockey Club should not
include the 5 ½% because although delivered to the
Club, such money has been especially earmarked by law
or regulation for other persons.

The Manila Jockey Club29 does not apply to the cases at

bar because what happened there is earmarking and not
withholding. Earmarking is not the same as withholding.
Amounts earmarked do not form part of gross receipts
because these are by law or regulation reserved for
some person other than the taxpayer, although delivered
or received. On the contrary, amounts withheld form part
of gross receipts because these are in constructive
possession and not subject to any reservation, the
withholding agent being merely a conduit in the
collection process.30 The distinction was explained
in Solidbank, thus:

"The Manila Jockey Club had to deliver to the Board on

Races, horse owners and jockeys amounts that never
became the property of the race track (Manila Jockey
Club merely held that these amounts were held in trust
and did not form part of gross receipts). Unlike these
amounts, the interest income that had
been withheld for the government became property
of the financial institutions upon constructive
possession thereof. Possession was indeed
acquired, since it was ratified by the financial
institutions in whose name the act of possession
had been executed. The money indeed belonged to
the taxpayers; merely holding it in trust was not
enough (A trustee does not own money received in
trust.) It is a basic concept in taxation that such money
does not constitute taxable income to the trustee [China
Banking Corp. v. Court of Appeals, supra, p. 27]).

The government subsequently becomes the owner

of the money when the financial institutions pay the
FWT to extinguish their obligation to the
government. As this Court has held before, this is
the consideration for the transfer of ownership of the
FWT from these institutions to the government (Ibid.,
p. 26). It is ownership that determines whether
interest income forms part of taxable gross receipts
(Ibid., p. 27). Being originally owned by these
financial institutions as part of their interest income,
the FWT should form part of their taxable gross
receipts.

In fine, let it be stressed that tax exemptions are highly

disfavored. It is a governing principle in taxation that tax
exemptions are to be construed in strictissimi
juris against the taxpayer and liberally in favor of the
taxing authority and should be granted only by clear and
unmistakable terms.

WHEREFORE, in G.R. No. 139786, we GRANT the

petition of the Commissioner of Internal Revenue
and REVERSE the Decision of the Court of Appeals
dated August 17, 1999 in CA-G.R. SP No. 52707.

In G.R. No. 140857, we DENY the petition of Asianbank

Corporation and AFFIRM in toto the Decision of the
Court of Appeals in CA-G.R. SP No. 51248. Costs
against petitioner.

SO ORDERED.
G.R. No. 172231             February 12, 2007
COMMISSIONER OF INTERNAL REVENUE, Petitioner,
vs.
ISABELA CULTURAL CORPORATION, Respondent.
DECISION
YNARES-SANTIAGO, J.:
Petitioner Commissioner of Internal Revenue (CIR)
assails the September 30, 2005 Decision1 of the Court of
Appeals in CA-G.R. SP No. 78426 affirming the
February 26, 2003 Decision2 of the Court of Tax Appeals
(CTA) in CTA Case No. 5211, which cancelled and set
aside the Assessment Notices for deficiency income tax
and expanded withholding tax issued by the Bureau of
Internal Revenue (BIR) against respondent Isabela
Cultural Corporation (ICC).
The facts show that on February 23, 1990, ICC, a
domestic corporation, received from the BIR Assessment
Notice No. FAS-1-86-90-000680 for deficiency income
tax in the amount of P333,196.86, and Assessment
Notice No. FAS-1-86-90-000681 for deficiency expanded
withholding tax in the amount of P4,897.79, inclusive of
surcharges and interest, both for the taxable year 1986.
The deficiency income tax of P333,196.86, arose from:
(1) The BIR’s disallowance of ICC’s claimed
expense deductions for professional and
security services billed to and paid by ICC in
1986, to wit:
(a) Expenses for the auditing services of
SGV & Co.,3 for the year ending
December 31, 1985;4
(b) Expenses for the legal services
[inclusive of retainer fees] of the law firm
Bengzon Zarraga Narciso Cudala
Pecson Azcuna & Bengson for the years
1984 and 1985.5
(c) Expense for security services of El
Tigre Security & Investigation Agency
for the months of April and May 1986.6
(2) The alleged understatement of ICC’s interest
income on the three promissory notes due from
Realty Investment, Inc.
The deficiency expanded withholding tax
of P4,897.79 (inclusive of interest and surcharge) was
allegedly due to the failure of ICC to withhold 1%
expanded withholding tax on its claimed P244,890.00
deduction for security services.7
On March 23, 1990, ICC sought a reconsideration of the
subject assessments. On February 9, 1995, however, it
received a final notice before seizure demanding
payment of the amounts stated in the said notices.
Hence, it brought the case to the CTA which held that
the petition is premature because the final notice of
assessment cannot be considered as a final decision
appealable to the tax court. This was reversed by the
Court of Appeals holding that a demand letter of the BIR
reiterating the payment of deficiency tax, amounts to a
final decision on the protested assessment and may
therefore be questioned before the CTA. This conclusion
was sustained by this Court on July 1, 2001, in G.R. No.
135210.8 The case was thus remanded to the CTA for
further proceedings.
On February 26, 2003, the CTA rendered a decision
canceling and setting aside the assessment notices
issued against ICC. It held that the claimed deductions
for professional and security services were properly
claimed by ICC in 1986 because it was only in the said
year when the bills demanding payment were sent to
ICC. Hence, even if some of these professional services
were rendered to ICC in 1984 or 1985, it could not
declare the same as deduction for the said years as the
amount thereof could not be determined at that time.
The CTA also held that ICC did not understate its
interest income on the subject promissory notes. It found
that it was the BIR which made an overstatement of said
income when it compounded the interest income
receivable by ICC from the promissory notes of Realty
Investment, Inc., despite the absence of a stipulation in
the contract providing for a compounded interest; nor of
a circumstance, like delay in payment or breach of
contract, that would justify the application of
compounded interest.
Likewise, the CTA found that ICC in fact withheld 1%
expanded withholding tax on its claimed deduction for
security services as shown by the various payment
orders and confirmation receipts it presented as
evidence. The dispositive portion of the CTA’s Decision,
reads:
WHEREFORE, in view of all the foregoing, Assessment
Notice No. FAS-1-86-90-000680 for deficiency income
tax in the amount of P333,196.86, and Assessment
Notice No. FAS-1-86-90-000681 for deficiency expanded
withholding tax in the amount of P4,897.79, inclusive of
surcharges and interest, both for the taxable year 1986,
are hereby CANCELLED and SET ASIDE.
SO ORDERED.9
Petitioner filed a petition for review with the Court of
Appeals, which affirmed the CTA decision,10 holding that
although the professional services (legal and auditing
services) were rendered to ICC in 1984 and 1985, the
cost of the services was not yet determinable at that
time, hence, it could be considered as deductible
expenses only in 1986 when ICC received the billing
statements for said services. It further ruled that ICC did
not understate its interest income from the promissory
notes of Realty Investment, Inc., and that ICC properly
withheld and remitted taxes on the payments for security
services for the taxable year 1986.
Hence, petitioner, through the Office of the Solicitor
General, filed the instant petition contending that since
ICC is using the accrual method of accounting, the
expenses for the professional services that accrued in
1984 and 1985, should have been declared as
deductions from income during the said years and the
failure of ICC to do so bars it from claiming said
expenses as deduction for the taxable year 1986. As to
the alleged deficiency interest income and failure to
withhold expanded withholding tax assessment,
petitioner invoked the presumption that the assessment
notices issued by the BIR are valid.
The issue for resolution is whether the Court of Appeals
correctly: (1) sustained the deduction of the expenses for
professional and security services from ICC’s gross
income; and (2) held that ICC did not understate its
interest income from the promissory notes of Realty
Investment, Inc; and that ICC withheld the required 1%
withholding tax from the deductions for security services.
The requisites for the deductibility of ordinary and
necessary trade, business, or professional expenses,
like expenses paid for legal and auditing services, are:
(a) the expense must be ordinary and necessary; (b) it
must have been paid or incurred during the taxable year;
(c) it must have been paid or incurred in carrying on the
trade or business of the taxpayer; and (d) it must be
supported by receipts, records or other pertinent
papers.11
The requisite that it must have been paid or incurred
during the taxable year is further qualified by Section 45
of the National Internal Revenue Code (NIRC) which
states that: "[t]he deduction provided for in this Title shall
be taken for the taxable year in which ‘paid or accrued’
or ‘paid or incurred’, dependent upon the method of
accounting upon the basis of which the net income is
computed x x x".
Accounting methods for tax purposes comprise a set of
rules for determining when and how to report income
and deductions.12 In the instant case, the accounting
method used by ICC is the accrual method.
Revenue Audit Memorandum Order No. 1-2000,
provides that under the accrual method of accounting,
expenses not being claimed as deductions by a taxpayer
in the current year when they are incurred cannot be
claimed as deduction from income for the succeeding
year. Thus, a taxpayer who is authorized to deduct
certain expenses and other allowable deductions for the
current year but failed to do so cannot deduct the same
for the next year.13
The accrual method relies upon the taxpayer’s right to
receive amounts or its obligation to pay them, in
opposition to actual receipt or payment, which
characterizes the cash method of accounting. Amounts
of income accrue where the right to receive them
become fixed, where there is created an enforceable
liability. Similarly, liabilities are accrued when fixed and
determinable in amount, without regard to indeterminacy
merely of time of payment.14
For a taxpayer using the accrual method, the
determinative question is, when do the facts present
themselves in such a manner that the taxpayer must
recognize income or expense? The accrual of income
and expense is permitted when the all-events test has
been met. This test requires: (1) fixing of a right to
income or liability to pay; and (2) the availability of the
reasonable accurate determination of such income or
liability.
The all-events test requires the right to income or liability
be fixed, and the amount of such income or liability be
determined with reasonable accuracy. However, the test
does not demand that the amount of income or liability
be known absolutely, only that a taxpayer has at his
disposal the information necessary to compute the
amount with reasonable accuracy. The all-events test is
satisfied where computation remains uncertain, if its
basis is unchangeable; the test is satisfied where a
computation may be unknown, but is not as much as
unknowable, within the taxable year. The amount of
liability does not have to be determined exactly; it
must be determined with "reasonable accuracy."
Accordingly, the term "reasonable accuracy" implies
something less than an exact or completely accurate
amount.[15]
The propriety of an accrual must be judged by the
facts that a taxpayer knew, or could reasonably be
expected to have known, at the closing of its books
for the taxable year.[16] Accrual method of accounting
presents largely a question of fact; such that the
taxpayer bears the burden of proof of establishing the
accrual of an item of income or deduction.17
Corollarily, it is a governing principle in taxation that tax
exemptions must be construed in strictissimi
juris against the taxpayer and liberally in favor of the
taxing authority; and one who claims an exemption must
be able to justify the same by the clearest grant of
organic or statute law. An exemption from the common
burden cannot be permitted to exist upon vague
implications. And since a deduction for income tax
purposes partakes of the nature of a tax exemption, then
it must also be strictly construed.18
In the instant case, the expenses for professional fees
consist of expenses for legal and auditing services. The
expenses for legal services pertain to the 1984 and 1985
legal and retainer fees of the law firm Bengzon Zarraga
Narciso Cudala Pecson Azcuna & Bengson, and for
reimbursement of the expenses of said firm in
connection with ICC’s tax problems for the year 1984. As
testified by the Treasurer of ICC, the firm has been its
counsel since the 1960’s.19 From the nature of the
claimed deductions and the span of time during which
the firm was retained, ICC can be expected to have
reasonably known the retainer fees charged by the firm
as well as the compensation for its legal services. The
failure to determine the exact amount of the expense
during the taxable year when they could have been
claimed as deductions cannot thus be attributed solely to
the delayed billing of these liabilities by the firm. For one,
ICC, in the exercise of due diligence could have inquired
into the amount of their obligation to the firm, especially
so that it is using the accrual method of accounting. For
another, it could have reasonably determined the
amount of legal and retainer fees owing to its familiarity
with the rates charged by their long time legal consultant.
As previously stated, the accrual method presents
largely a question of fact and that the taxpayer bears the
burden of establishing the accrual of an expense or
income. However, ICC failed to discharge this burden.
As to when the firm’s performance of its services in
connection with the 1984 tax problems were completed,
or whether ICC exercised reasonable diligence to inquire
about the amount of its liability, or whether it does or
does not possess the information necessary to compute
the amount of said liability with reasonable accuracy, are
questions of fact which ICC never established. It simply
relied on the defense of delayed billing by the firm and
the company, which under the circumstances, is not
sufficient to exempt it from being charged with
knowledge of the reasonable amount of the expenses for
legal and auditing services.
In the same vein, the professional fees of SGV & Co. for
auditing the financial statements of ICC for the year 1985
cannot be validly claimed as expense deductions in
1986. This is so because ICC failed to present evidence
showing that even with only "reasonable accuracy," as
the standard to ascertain its liability to SGV & Co. in the
year 1985, it cannot determine the professional fees
which said company would charge for its services.
ICC thus failed to discharge the burden of proving that
the claimed expense deductions for the professional
services were allowable deductions for the taxable year
1986. Hence, per Revenue Audit Memorandum Order
No. 1-2000, they cannot be validly deducted from its
gross income for the said year and were therefore
properly disallowed by the BIR.

As to the expenses for security services, the records

show that these expenses were incurred by ICC in
198620 and could therefore be properly claimed as
deductions for the said year.

Anent the purported understatement of interest income

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

Likewise, the findings of the CTA and the Court of

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

In sum, Assessment Notice No. FAS-1-86-90-000680 in

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

WHEREFORE, the petition is PARTIALLY GRANTED.

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

The case is remanded to the BIR for the computation of

Isabela Cultural Corporation’s liability under Assessment
Notice No. FAS-1-86-90-000680.

SO ORDERED.
Helvering v. Horst, 311 U.S. 112 (1940)
Helvering v. Horst
No. 27
Argued October 25, 1940
Decided November 25, 1940
311 U.S. 112
CERTIORARI TO THE CIRCUIT COURT OF APPEALS
FOR THE SECOND CIRCUIT
Syllabus
1. Where, in 1934 and 1935, an owner of negotiable
bonds, who reported income on the cash receipts basis,
detached from the bonds negotiable interest coupons
before their due date and delivered them as a gift to his
son, who, in the same year, collected them at
maturity, held that, under § 22 of the Revenue Act of
1934, and in the year that the interest payments were
made, there was a realization of income, in the amount
of such payments, taxable to the donor. P. 311 U. S.
117.
2. The dominant purpose of the income tax laws is the
taxation of income to those who earn or otherwise create
the right to receive it and who enjoy the benefit of it when
paid. P. 311 U. S. 119.
3. The tax laid by the 1934 Revenue Act upon income
"derived from . . . wages or compensation for personal
service, of whatever kind and in whatever form paid . . . ;
also from interest . . . " cannot fairly be interpreted as not
applying to income derived from interest or
compensation when he who is entitled to receive it
makes use of his power to dispose of it in procuring
satisfactions which he would otherwise procure only by
the use of the money when received. P. 311 U. S. 119.
4. This case distinguished from Blair v.
Commissioner, 300 U. S. 5, and compared with Lucas v.
Earl, 281 U. S. 111, and Burnet v. Leininger, 285 U. S.
136. Pp. 311 U. S. 118-120.
107 F.2d 906, reversed.
Certiorari, 309 U.S. 650, to review the reversal of an
order of the Board of Tax Appeals, 39 B.T.A. 757,
sustaining a determination of a deficiency in income tax.
Page 311 U. S. 114
MR. JUSTICE STONE delivered the opinion of the
Court.
The sole question for decision is whether the gift, during
the donor's taxable year, of interest coupons detached
from the bonds, delivered to the donee and later in the
year paid at maturity, is the realization of income taxable
to the donor.
In 1934 and 1935, respondent, the owner of negotiable
bonds, detached from them negotiable interest coupons
shortly before their due date and delivered them as a gift
to his son, who, in the same year, collected them at
maturity. The Commissioner ruled that, under the
applicable § 22 of the Revenue Act of 1934, 48 Stat.
680, 686, the interest payments were taxable, in the
years when paid, to the respondent donor, who reported
his income on the cash receipts basis. The circuit court
of appeals reversed the order of the Board of Tax
Appeals sustaining the tax. 107 F.2d 906; 39 B.T.A. 757.
We granted certiorari, 309 U.S. 650, because of the
importance of the question in the administration of the
revenue laws and because of an asserted conflict in
principle of the decision below with that of Lucas v.
Earl, 281 U. S. 111, and with that of decisions by other
circuit courts of appeals. See Bishop v.
Commissioner, 54 F.2d 298; Dickey v. Burnet, 56 F.2d
917, 921; Van Meter v. Commissioner, 61 F.2d 817.
The court below thought that, as the consideration for
the coupons had passed to the obligor, the donor had,
by the gift, parted with all control over them and their
payment, and for that reason the case was
distinguishable
Page 311 U. S. 115
from Lucas v. Earl, supra, and Burnet v. Leininger, 285
U. S. 136, where the assignment of compensation for
services had preceded the rendition of the services, and
where the income was held taxable to the donor.
The holder of a coupon bond is the owner of two
independent and separable kinds of right. One is the
right to demand and receive at maturity the principal
amount of the bond representing capital investment. The
other is the right to demand and receive interim
payments of interest on the investment in the amounts
and on the dates specified by the coupons. Together,
they are an obligation to pay principal and interest given
in exchange for money or property which was
presumably the consideration for the obligation of the
bond. Here respondent, as owner of the bonds, had
acquired the legal right to demand payment at maturity
of the interest specified by the coupons and the power to
command its payment to others which constituted an
economic gain to him.
Admittedly not all economic gain of the taxpayer is
taxable income. From the beginning, the revenue laws
have been interpreted as defining "realization" of income
as the taxable event, rather than the acquisition of the
right to receive it. And "realization" is not deemed to
occur until the income is paid. But the decisions and
regulations have consistently recognized that receipt in
cash or property is not the only characteristic of
realization of income to a taxpayer on the cash receipts
basis. Where the taxpayer does not receive payment of
income in money or property, realization may occur
when the last step is taken by which he obtains the
fruition of the economic gain which has already accrued
to him. Old Colony Trust Co. v. Commissioner, 279 U. S.
716; Corliss v. Bowers, 281 U. S. 376, 281 U. S. 378. Cf.
Burnet v. Wells, 289 U. S. 670.
In the ordinary case the taxpayer who acquires the right
to receive income is taxed when he receives it,
regardless of the time when his right to receive payment
Page 311 U. S. 116
accrued. But the rule that income is not taxable until
realized has never been taken to mean that the
taxpayer, even on the cash receipts basis, who has fully
enjoyed the benefit of the economic gain represented by
his right to receive income can escape taxation because
he has not himself received payment of it from his
obligor. The rule, founded on administrative
convenience, is only one of postponement of the tax to
the final event of enjoyment of the income, usually the
receipt of it by the taxpayer, and not one of exemption
from taxation where the enjoyment is consummated by
some event other than the taxpayer's personal receipt of
money or property. Cf. Aluminum Castings Co. v.
Routzahn, 282 U. S. 92, 282 U. S. 98. This may occur
when he has made such use or disposition of his power
to receive or control the income as to procure in its place
other satisfactions which are of economic worth. The
question here is whether, because one who in fact
receives payment for services or interest payments is
taxable only on his receipt of the payments, he can
escape all tax by giving away his right to income in
advance of payment. If the taxpayer procures payment
directly to his creditors of the items of interest or
earnings due him, see Old Colony Trust Co. v.
Commissioner, supra; Bowers v. Kerbaugh-Empire
Co., 271 U. S. 170; United States v. Kirby Lumber
Co., 284 U. S. 1, or if he sets up a revocable trust with
income payable to the objects of his bounty, §§ 166,
167, Corliss v. Bowers, supra; cf. Dickey v. Burnet, 56
F.2d 917, 921, he does not escape taxation because he
did not actually receive the money. Cf. Douglas v.
Willcuts, 296 U. S. 1; Helvering v. Clifford, 309 U. S.
331.
Underlying the reasoning in these cases is the thought
that income is "realized" by the assignor because he,
who owns or controls the source of the income, also
controls the disposition of that which he could have
Page 311 U. S. 117
received himself and diverts the payment from himself to
others as the means of procuring the satisfaction of his
wants. The taxpayer has equally enjoyed the fruits of his
labor or investment and obtained the satisfaction of his
desires whether he collects and uses the income to
procure those satisfactions or whether he disposes of his
right to collect it as the means of procuring them. Cf.
Burnet v. Wells, supra.
Although the donor here, by the transfer of the coupons,
has precluded any possibility of his collecting them
himself, he has nevertheless, by his act, procured
payment of the interest, as a valuable gift to a member of
his family. Such a use of his economic gain, the right to
receive income, to procure a satisfaction which can be
obtained only by the expenditure of money or property
would seem to be the enjoyment of the income whether
the satisfaction is the purchase of goods at the corner
grocery, the payment of his debt there, or such
nonmaterial satisfactions as may result from the
payment of a campaign or community chest contribution,
or a gift to his favorite son. Even though he never
receives the money, he derives money's worth from the
disposition of the coupons which he has used as money
or money's worth in the procuring of a satisfaction which
is procurable only by the expenditure of money or
money's worth. The enjoyment of the economic benefit
accruing to him by virtue of his acquisition of the
coupons is realized as completely as it would have been
if he had collected the interest in dollars and expended
them for any of the purposes named. Burnet v. Wells,
supra.
In a real sense, he has enjoyed compensation for money
loaned or services rendered, and not any the less so
because it is his only reward for them. To say that one
who has made a gift thus derived from interest or
earnings paid to his donee has never enjoyed or realized
the fruits of his investment or labor because he has
assigned
Page 311 U. S. 118
them instead of collecting them himself and then paying
them over to the donee is to affront common
understanding and to deny the facts of common
experience. Common understanding and experience are
the touchstones for the interpretation of the revenue
laws.
The power to dispose of income is the equivalent of
ownership of it. The exercise of that power to procure the
payment of income to another is the enjoyment, and
hence the realization, of the income by him who
exercises it. We have had no difficulty in applying that
proposition where the assignment preceded the rendition
of the services, Lucas v. Earl, supra; Burnet v. Leininger,
supra, for it was recognized in the Leininger case that, in
such a case, the rendition of the service by the assignor
was the means by which the income was controlled by
the donor, and of making his assignment effective. But it
is the assignment by which the disposition of income is
controlled when the service precedes the assignment,
and, in both cases, it is the exercise of the power of
disposition of the interest or compensation, with the
resulting payment to the donee, which is the enjoyment
by the donor of income derived from them.
This was emphasized in Blair v. Commissioner, 300 U.
S. 5, on which respondent relies, where the distinction
was taken between a gift of income derived from an
obligation to pay compensation and a gift of income-
producing property. In the circumstances of that case,
the right to income from the trust property was thought to
be so identified with the equitable ownership of the
property from which alone the beneficiary derived his
right to receive the income and his power to command
disposition of it that a gift of the income by the
beneficiary became effective only as a gift of his
ownership of the property producing it. Since the gift was
deemed to be a gift of the property, the income from it
was held to be the income of the owner of the property,
Page 311 U. S. 119
who was the donee, not the donor, a refinement which
was unnecessary if respondent's contention here is right,
but one clearly inapplicable to gifts of interest or wages.
Unlike income thus derived from an obligation to pay
interest or compensation, the income of the trust was
regarded as no more the income of the donor than would
be the rent from a lease or a crop raised on a farm after
the leasehold or the farm had been given away. Blair v.
Commissioner, supra, 300 U. S. 12-13, and cases
cited. See also Reinecke v. Smith, 289 U. S. 172, 289 U.
S. 177. We have held without deviation that, where the
donor retains control of the trust property, the income is
taxable to him although paid to the donee. Corliss v.
Bowers, supra. Cf. Helvering v. Clifford, supra.
The dominant purpose of the revenue laws is the
taxation of income to those who earn or otherwise create
the right to receive it and enjoy the benefit of it when
paid. See Corliss v. Bowers, supra, 281 U. S.
378; Burnet v. Guggenheim, 288 U. S. 280, 288 U. S.
283. The tax laid by the 1934 Revenue Act upon income
"derived from . . . wages, or compensation for personal
service, of whatever kind and in whatever form paid . . . ;
also from interest . . ." therefore cannot fairly be
interpreted as not applying to income derived from
interest or compensation when he who is entitled to
receive it makes use of his power to dispose of it in
procuring satisfactions which he would otherwise
procure only by the use of the money when received.
It is the statute which taxes the income to the donor
although paid to his donee. Lucas v. Earl, supra; Burnet
v. Leininger, supra. True, in those cases, the service
which created the right to income followed the
assignment, and it was arguable that, in point of legal
theory, the right to the compensation vested
instantaneously in the assignor when paid, although he
never received it, while here, the right of the assignor to
receive the income
Page 311 U. S. 120
antedated the assignment which transferred the right,
and thus precluded such an instantaneous vesting. But
the statute affords no basis for such "attenuated
subtleties." The distinction was explicitly rejected as the
basis of decision in Lucas v. Earl. It should be rejected
here, for no more than in the Earl case can the purpose
of the statute to tax the income to him who earns or
creates and enjoys it be escaped by "anticipatory
arrangements . . . however skilfully devised" to prevent
the income from vesting even for a second in the donor.
Nor is it perceived that there is any adequate basis for
distinguishing between the gift of interest coupons here
and a gift of salary or commissions. The owner of a
negotiable bond and of the investment which it
represents, if not the lender, stands in the place of the
lender. When, by the gift of the coupons, he has
separated his right to interest payments from his
investment and procured the payment of the interest to
his donee, he has enjoyed the economic benefits of the
income in the same manner and to the same extent as
though the transfer were of earnings, and, in both cases,
the import of the statute is that the fruit is not to be
attributed to a different tree from that on which it
grew. See Lucas v. Earl, supra, 281 U. S. 115.
The decision of the Board of Tax Appeals was reversed,
and properly so, I think.
The unmatured coupons given to the son were
independent negotiable instruments, complete in
themselves. Through the gift, they became at once the
absolute property of the donee, free from the donor's
control and in no way dependent upon ownership of the
bonds. No question of actual fraud or purpose to defraud
the revenue is presented.
Neither Lucas v. Earl, 281 U. S. 111, nor Burnet v.
Leininger, 285 U. S. 136, supports petitioner's view. Blair
v. Commissioner, 300 U. S. 5, 300 U. S. 11-12, shows
that neither involved an unrestricted completed transfer
of property.
Helvering v. Clifford, 309 U. S. 331, 309 U. S. 335-336,
decided after the opinion below, is much relied upon by
petitioner, but involved facts very different from those
now before us. There, no separate thing was absolutely
transferred and put beyond possible control by the
transferor. The court affirmed that Clifford, both conveyor
and trustee,
"retained the substance of full enjoyment of all the rights
which previously he had in the property. . . . In
substance, his control over the corpus was in all
essential respects the same after the trust was created,
as before. . . . With that control in his hands, he would
keep direct
Page 311 U. S. 122
command over all that he needed to remain in
substantially the same financial situation as before."
The general principles approved in Blair v.
Commissioner, 300 U. S. 5, are applicable and
controlling. The challenged judgment should be affirmed.

Reversed.

The separate opinion of MR. JUSTICE McREYNOLDS.

The facts were stipulated. In the opinion of the court

below (107 F.2d 907), the issues are thus adequately
stated:

"The petitioner owned a number of coupon bonds. The

coupons represented the interest on the bonds and were
payable to bearer. In 1934, he detached unmatured
coupons of face value of $25,182.50 and transferred
them by manual delivery to his son as a gift. The
coupons matured later on in the same year, and the son
collected the face amount, $25,182.50, as his own
property. There

Page 311 U. S. 121

was a similar transaction in 1935. The petitioner kept his

books on a cash basis. He did not include any part of the
moneys collected on the coupons in his income tax
returns for these two years. The son included them in his
returns. The Commissioner added the moneys collected
on the coupons to the petitioner's taxable income and
determined a tax deficiency for each year. The Board of
Tax Appeals, three members dissenting, sustained the
Commissioner, holding that the amounts collected on the
coupons were taxable as income to the petitioner."
Commissioner v. LoBue, 351 U.S. 243 (1956)
Commissioner of Internal Revenue v. LoBue No. 373
Argued March 6, 1956 Decided May 28, 1956
351 U.S. 243
CERTIORARI TO THE UNITED STATES COURT OF
APPEALS FOR THE THIRD CIRCUIT
Syllabus
In recognition of his “contribution and efforts in making
the operation of the Company successful,” a corporation
gave an employee options to purchase stock in the
corporation. The options were nontransferable, and were
contingent upon continued employment. After some time
had elapsed and the value of the shares had increased,
the employee exercised the options and purchased the
stock at less than the then current market price. For
some of the shares, he gave the employer a promissory
note for the option price; but the shares were not
delivered until the notes were paid in cash, when the
value of the shares had increased.
Held: under the Internal Revenue Code of 1939, as
amended, the resulting gain to the employee was
taxable as income received at the time he exercised the
option and purchased the stock, and his taxable gain
should be measured as of the time when the options
were exercised, and not as of the time when they were
granted. Pp. 351 U. S. 244-250.
(a) In defining “gross income” as broadly as it did in §
22(a) of the Internal Revenue Code of 1939, as
amended, Congress intended to tax all gains except
those specifically exempted . P. 351 U. S. 246.
(b) The only exemption that could possibly apply to these
transactions is the gift exemption of § 22(b)(3), and
these transactions were not “gifts” in the statutory sense.
Pp. 351 U. S. 246-247.
I There is no statutory basis for excluding such
transactions from “gross income” on the ground that one
purpose of the employer was to confer on the employee
a “proprietary interest” in the business. P. 351 U. S. 247.
(d) The employee received a substantial economic and
financial benefit from his employer, prompted by the
employer’s desire to get better work from the employee,
and this is “compensation for personal service” within the
meaning of § 22(a). P. 351 U. S. 247.
I In these circumstances, the employee “realized” a
taxable gain when he purchased the stock. P. 351 U. S.
248.
(f) The employee’s taxable gain should be measured by
the difference between the option price and the market
value of the
Page 351 U. S. 244
shares as of the time when the options were exercised,
and not as of the time when the options were granted.
Pp. 351 U. S. 248-249.
(g) On remand, the Tax Court may consider the
question, not previously passed on, whether delivery of a
promissory note for the purchase price marked the
completion of the stock purchase, and whether the gain
should be measured as of that date or as of the date the
note was paid. P. 351 U. S. 250.
223 F.2d 367 reversed and remanded.
MR. JUSTICE BLACK delivered the opinion of the Court.
This case involves the federal income tax liability of
respondent LoBue for the years 1946 and 1947. From
1941 to 1947, LoBue was manager of the New York
Sales Division of the Michigan Chemical Corporation, a
producer and distributor of chemical supplies. In 1944,
the company adopted a stock option plan making 10,000
shares of its common stock available for distribution to
key employees at $5 per share over a 3-year period.
LoBue and a number of other employees were notified
that they had been tentatively chosen to be recipients of
nontransferable stock options contingent upon their
continued employment. LoBue’s notice told him: “You
may be assigned a greater or less amount of stock
based entirely upon your individual results and that of
the entire organization.” About 6 months later, he was
notified that he had been definitely awarded an option to
buy 150 shares of stock in recognition of his “contribution
and efforts in making the operation of the Company
successful.” As to future allotments, he was told “It is up
to you to justify your participation in the plan during the
next two years.”
Page 351 U. S. 245
LoBue’s work was so satisfactory that the company in
the course of 3 years delivered to him 3 stock options
covering 340 shares. He exercised all these $5 per
share options in 1946 and in 1947, [Footnote 1] paying
the company only $1,700 for stock having a market
value when delivered of $9,930. Thus, at the end of
these transactions, LoBue’s employer was worth $8,230
less to its stockholders and LoBue was worth $8,230
more than before. [Footnote 2] The company deducted
this sum as an expense in its 1946 and 1947 tax returns,
but LoBue did not report any part of it as income.
Viewing the gain to LoBue as compensation for personal
services, the Commissioner levied a deficiency
assessment against him, relying on § 22(a) of the
Internal Revenue Code of 1939, 53 Stat. 9, as amended,
53 Stat. 574, which defines gross income as including
“gains, profits, and income derived from . . .
compensation for personal service . . . of whatever kind
and in whatever form paid. . . .”
LoBue petitioned the Tax Court to redetermine the
deficiency, urging that
“The said options were not intended by the Corporation
or the petitioner to constitute additional compensation,
but were granted to permit the petitioner to acquire a
proprietary interest in the Corporation and to provide him
with the interest in the successful operation of the
Corporation deriving from an ownership interest.”
The Tax Court held that LoBue had a taxable gain if the
options were intended as compensation, but not if the
options were designed to provide him with “a proprietary
interest in the business.” Finding after hearings
Page 351 U. S. 246
that the options were granted to give LoBue “a
proprietary interest in the corporation, and not as
compensation for services,” the Tax Court held for
LoBue. 22 T.C. 440, 443. Relying on this finding, the
Court of Appeals affirmed, saying:
“This was a factual issue which it was the peculiar
responsibility of the Tax Court to resolve. From our
examination of the evidence, we cannot say that its
finding was clearly erroneous.”
223 F.2d 367, 371. Disputes over the taxability of stock
option transactions such as this are longstanding.
[Footnote 3] We granted certiorari to consider whether
the Tax Court and the Court of Appeals had given §
22(a) too narrow an interpretation. 350 U.S. 893.
We have repeatedly held that, in defining “gross income”
as broadly as it did in § 22(a), Congress intended to “tax
all gains except those specifically exempted.” See, e.g.,
Commissioner v. Glenshaw Glass Co., 348 U. S.
426, 348 U. S. 429-430. The only exemption Congress
provided from this very comprehensive definition of
taxable income that could possibly have application here
is the gift exemption of § 22(b)(3). But there was not the
slightest indication of the kind of detached and
disinterested generosity which might evidence a “gift” in
the statutory sense. These transfers of stock bore none
of the earmarks of a gift. They were made by a company
engaged in operating a business for profit, and the Tax
Court found that the stock option plan was designed to
achieve more profitable operations by providing the
employees “with in incentive to promote the growth of
the company by permitting them to participate in its
success.” 22 T.C. at 445.
LoBue nonetheless argues that we should treat this
transaction as a mere purchase of a proprietary interest
on which no taxable gain was “realized” in the year of
purchase. It is true that our taxing system has ordinarily
treated an arm’s length purchase of property, even at a
bargain price, as giving rise to no taxable gain in the
year of purchase. See Palmer v. Commissioner, 302 U.
S. 63, 302 U. S. 69. But that is not to say that, when a
transfer which is in reality compensation is given the
form of a purchase, the Government cannot tax the gain
under § 22(a). The transaction here was unlike a mere
purchase. It was not an arm’s length transaction
between strangers. Instead, it was an arrangement by
which an employer transferred valuable property to his
employees in recognition of their services. We hold that
LoBue realized taxable gain when he purchased the
stock. [Footnote 6]
A question remains as to the time when the gain on the
shares should be measured. LoBue gave his employer
promissory notes for the option price of the first 300
shares, but the shares were not delivered until the notes
were paid in cash. [Footnote 7] The market value of the
shares was lower when the notes were given than when
the cash was paid. The Commissioner measured the
taxable gain by the market value of the shares when the
cash was paid. LoBue contends that this was wrong, and
that the gain
Page 351 U. S. 249
should be measured either when the options were
granted or when the notes were given.

Page 351 U. S. 247 It is, of course, possible for the recipient of a stock option
to realize an immediate taxable gain. See Commissioner
Under these circumstances, the Tax Court and the Court v. Smith, 324 U. S. 177, 324 U. S. 181-182. The option
of Appeals properly refrained from treating this transfer might have a readily ascertainable market value, and the
as a gift. The company was not giving something away recipient might be free to sell his option. But this is not
for nothing. [Footnote 4] such a case. These three options were not transferable,
[Footnote 8] and LoBue’s right to buy stock under them
was contingent upon his remaining an employee of the
Since the employer’s transfer of stock to its employee
company until they were exercised. Moreover, the
LoBue for much less than the stock’s value was not a
uniform Treasury practice since 1923 has been to
gift, it seems impossible to say that it was not
measure the compensation to employees given stock
compensation. The Tax Court held there was no taxable
options subject to contingencies of this sort by the
income, however, on the ground that one purpose of the
difference between the option price and the market value
employer was to confer a “proprietary interest.” [Footnote
of the shares at the time the option is exercised.
5] But there is not a word in § 22(a) which indicates that
[Footnote 9] We relied in part upon this practice
its broad coverage should be narrowed because of an
in Commissioner v. Smith, 324 U. S. 177, 324 U. S. 695.
employer’s intention to enlist more efficient service from
And, in its 1950 Act affording limited tax benefits for
his employees by making them part proprietors of his
“restricted stock option plans,” Congress adopted the
business. In our view, there is no statutory basis for the
same kind of standard for measurement of gains. §
test established by the courts below. When assets are
130A, Internal Revenue Code of 1939, 64 Stat. 942. And
transferred by an employer to an employee to secure
see § 421, Internal Revenue Code of 1954, 68A Stat.
better services, they are plainly compensation. It makes
142. Under these circumstances there is no reason for
no difference that the compensation is paid in stock,
departing from the Treasury practice. The taxable gain to
rather than in money. Section 22(a) taxes income
LoBue should be measured as of the time the options
derived from compensation “in whatever form paid.” And,
were exercised, and not the time they were granted.
in another stock option case, we said that § 22(a)

Page 351 U. S. 250

“is broad enough to include in taxable income any
economic or financial benefit conferred on the employee
as compensation, whatever the form or mode by which it It is possible that a bona fide delivery of a binding
is effected.” promissory note could mark the completion of the stock
purchase, and that gain should be measured as of that
date. Since neither the Tax Court nor the Court of
Commissioner v. Smith, 324 U. S. 177, 324 U. S. 181.
Appeals passed on this question, the judgment is
LoBue received a very substantial economic and
reversed and the case is remanded to the Court of
financial benefit from his employer prompted by the
Appeals with instructions to remand the case to the Tax
employer’s desire to get better work from him. This is
Court for further proceedings.
“compensation for personal service” within the meaning
of § 22(a).
Reversed and remanded.
Page 351 U. S. 248
U.S. Supreme Court
Eisner v. Macomber, 252 U.S. 189 (1920)
Eisner v. Macomber
No. 318
Argued April 16, 1919
Restored to docket for reargument May 19, 1919
Reargued October 17, 20, 1919
Decided March 8, 1920
252 U.S. 189
ERROR TO THE DISTRICT COURT OF THE UNITED
STATES
FOR THE SOUTHERN DISTRICT OF NEW YORK
Syllabus
Congress was not empowered by the Sixteenth
Amendment to tax, as income of the stockholder, without
apportionment, a stock dividend made lawfully and in
good faith against profits accumulated by the corporation
since March 1, 1913. P. 252 U. S. 201. Towne v.
Eisner, 245 U. S. 418.
The Revenue Act of September 8, 1916, c. 463, 39 Stat.
756, plainly evinces the purpose of Congress to impose
such taxes, and is to that extent in conflict with Art. I, § 2,
cl. 3, and Art. I, § 9, cl. 4, of the Constitution. Pp. 252 U.
S. 199, 252 U. S. 217.
These provisions of the Constitution necessarily limit the
extension, by construction, of the Sixteenth Amendment.
P. 252 U. S. 205.
What is or is not “income” within the meaning of the
Amendment must be determined in each case according
to truth and substance, without regard to form. P. 252 U.
S. 206.
Income may be defined as the gain derived from capital,
from labor, or from both combined, including profit
gained through sale or conversion of capital. P. 252 U.
S. 207.
Mere growth or increment of value in a capital
investment is not income; income is essentially a gain or
profit, in itself, of exchangeable value, proceeding from
capital, severed from it, and derived or received by the
taxpayer for his separate use, benefit, and disposal. Id.
A stock dividend, evincing merely a transfer of an
accumulated surplus to the capital account of the
corporation, takes nothing from the property of the
corporation and adds nothing to that of the shareholder;
a tax on such dividends is a tax an capital increase, and
not on income, and, to be valid under the Constitution,
such taxes must be apportioned according to population
in the several states. P. 252 U. S. 208.
Affirmed.
Page 252 U. S. 190
The case is stated in the opinion.
Page 252 U. S. 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., which, in our opinion
(notwithstanding a contention of the government that will
be
Page 252 U. S. 200
noticed), plainly evinces the purpose of Congress to tax
stock dividends as income. *
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 percent 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
Page 252 U. S. 201
shares, of which 18.07 percent, 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 I, § 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, 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.
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 reexamination 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, c. 16, 38 Stat. 114,
166, which provided (§ B, p. 167) that net income should
include “dividends,” and also “gains or profits and
income derived
Page 252 U. S. 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 F. 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, and quoted the Amendment, proceeded very
properly to say (p. 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, “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 (p. 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. 245 U. S.
426):
“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
Page 252 U. S. 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, 136 U. S. 559-560. 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, 169 U. S. 261. 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 Solicitor
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
Page 252 U. S. 204
based upon profits earned before the amendment. We
ruled at the same term, in Lynch v. Hornby, 247 U. S.
339, that a cash dividend extraordinary in amount, and
in Peabody v. Eisner, 247 U. S. 347, 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 (pp. 247 U. S. 343-344):
“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 preexisting 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, 247 U. S. 350, 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
Page 252 U. S. 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) 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, under the Act of August 27,
1894, c. 349, § 27, 28 Stat. 509, 553, 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 I, § 2, cl. 3, and § 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
Page 252 U. S. 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
Pacific R. Co., 240 U. S. 1, 240 U. S. 17-19; Stanton v.
Baltic Mining Co., 240 U. S. 103, 240 U. S. 112 et seq.;
Peck & Co. v. Lowe, 247 U. S. 165, 247 U. S. 172-173.
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 I 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,”
Page 252 U. S. 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, 231
U. S. 415; Doyle v. Mitchell Bros. Co., 247 U. S.
179, 247 U. S. 185), “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, pp. 247 U. S. 183-185.
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 – In the present case, the corporation had surplus and
“incomes, from whatever source derived” – the essential
thought being expressed
Page 252 U. S. 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 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
Page 252 U. S. 209
from the company, he can do so only by disposing of his
stock.
For bookkeeping 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.
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,
Page 252 U. S. 210
equipment, 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
Page 252 U. S. 211
“surplus”; it does not alter the preexisting 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 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 received 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.
Page 252 U. S. 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 percent
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.
Page 252 U. S. 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 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,
Page 252 U. S. 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 that the new
certificates measure the extent 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
Page 252 U. S. 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, 247 U. S. 349-350.
Two recent decisions, proceeding from courts of high
jurisdiction, are cited in support of the position of the
government.
Page 252 U. S. 216
Swan Brewery Co., Ltd. V. Rex, [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 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,
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” (pp. 526, 531), and that under it, a stock
dividend was taxable as income, the court saying (p.
535):
“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. “
Page 252 U. S. 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)
Page 252 U. S. 218
12 Wall. 1, which arose under § 117 of the Act of June
30, 1864, c. 173, 13 Stat. 223, 282, 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 (p. 79 U. S. 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 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.”
Insofar 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, 158 U. S. 627-628, 158 U. S.
637. Conceding Collector v. Hubbard was inconsistent
with the doctrine of that case, because it sustained a
direct tax upon property not apportioned
Page 252 U. S. 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, insofar as it imposes a tax upon
the stockholder because of such dividend, contravenes
the provisions of Article I, § 2, cl. 3, and Article I, § 9, cl.
4, of the Constitution, and to this extent is invalid
notwithstanding the Sixteenth Amendment.
Judgment affirmed.
* the company, if he avails himself of the right to subscribe
“Title I. – Income Tax”
“Part I. – On Individuals”
“Sec. 2. (a) That, subject only to such exemptions and
deductions as are hereinafter allowed, the net income of
a taxable person shall include gains, profits, and income
derived, . . . also from interest, rent, dividends,
securities, or the transaction of any business carried on
for gain or profit, or gains or profits and income derived
from any source whatever: Provided, that the term
‘dividends’ as used in this title shall 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, 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.”
MR. JUSTICE HOLMES, dissenting.
I think that Towne v. Eisner, 245 U. S. 418, 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. 245 U. S. 425. I think that the
word “incomes” in the Sixteenth Amendment should be
read in
Page 252 U. S. 220
“a sense most obvious to the common understanding at
the time of its adoption.” Bishop v. State, 149 Ind. 223,
230; State v. Butler, 70 Fla. 102, 133. For it was for
public adoption that it was proposed. McCulloch v.
Maryland, 4 Wheat. 316, 17 U. S. 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.
MR. JUSTICE DAY concurs in this opinion.
MR. JUSTICE BRANDEIS delivered the following
opinion, in which MR. JUSTICE CLARKE concurred.
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 time for the payment of a cash dividend equal
to the amount which the stockholder will be required to
pay to
Page 252 U. S. 221
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 cash 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.
(3) 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,
Page 252 U. S. 222
1912, it increased its capital stock to $30,000,000, and
paid a simple stock dividend of 2,900 percent in stock.
[Footnote 1]
(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
percent, increasing the outstanding capital to $800,000.
During the calendar year 1912, it paid cash dividends
aggregating 20 percent, 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 percent, thus increasing the capital to
$1,000,000. [Footnote 2]
I 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 percent). 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 percent and 20 percent, 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
Page 252 U. S. 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 percent 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 percent, 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.
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
percent, payable May 1, 1917, being exchanged for one
share of new stock, the equivalent of a 100 percent 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 percent was paid
February 14, 1914, and one of 100 percent 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 percent January and
April; 6 percent July and October), and adds in a note:
“In addition, a stock dividend of 100 percent was paid
during the year.” [Footnote 3] The Wall Street Journal of
Page 252 U. S. 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; Matter of
Osborne, 209 N.Y. 450, and also, where the question
arose in matters of taxation, People v. Glynn,
Page 252 U. S. 225
130 App.Div. 332, 198 N.Y. 605. 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, 58 Cal.Dec. 97, 180 Cal.
748.
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
Page 252 U. S. 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, 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, 14 U. S.
326; McCulloch v. Maryland, 4 Wheat. 316, 17 U. S.
407, 17 U. S. 415; Brown v. Maryland, 12 Wheat.
419, 25 U. S. 446; Craig v. Missouri, 4 Pet. 410, 29 U. S.
433; Jarrolt v. Moberly, 103 U. S. 580, 103 U. S. 585-
587; Legal Tender Case, 110 U. S. 421, 110 U. S.
444; Lithograph Co. v. Sarony, 111 U. S. 53, 111 U. S.
58; United States v. Realty Co., 163 U. S. 427, 163 U. S.
440-442; South Carolina v. United States, 199 U. S.
437, 199 U. S. 448-449. 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
Page 252 U. S. 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?
Page 252 U. S. 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 anyone 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; 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, 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
Page 252 U. S. 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
Page 252 U. S. 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.
Businessmen, 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  Collector v. Hubbard, 12 Wall. 1. The
undivided share of a partner in the year’s undistributed
profits of his firm
Page 252 U. S. 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. 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. [Footnote 4] 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 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
Page 252 U. S. 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. [Footnote 5] 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
Page 252 U. S. 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 § 3 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, 25 U. S. 446:
“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
Page 252 U. S. 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, which
involved a question not of constitutional power, but of
statutory construction, and Gibbons v. Mahon, 136 U. S.
549, 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
(p. 245 U. S. 425): “But it is not necessarily true that
income means the same thing In the Constitution and
the [an] act." [Footnote 6] 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 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.
3. The so-called English rule, declared in 1799
by Brander v. Brander, 4 Ves. Jr. 800, that a
dividend representing
Page 252 U. S. 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, that a dividend
representing profits, whether regular, ordinary, or
extraordinary, 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
Page 252 U. S. 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 (p. 136 U. S.
560), 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.”
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. [Footnote 7] 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
Page 252 U. S. 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. [Footnote 8]

We have, however, not merely argument; we have “It is but a decent respect due to the wisdom, the
examples which should convince us that “there is no integrity, and the patriotism of the legislative body by
inherent, necessary and immutable reason why stock which any law is passed to presume in favor of its
dividends should always be treated as capital.” Tax validity until its violation of the Constitution is proved
Commissioner v. Putnam, 227 Mass. 522, 533. The beyond all reasonable doubt.”
Supreme Judicial Court of Massachusetts has
steadfastly adhered, despite ever-renewed protest, to Ogden v. Saunders, 12 Wheat. 213, 25 U. S. 269.
the rule that every stock dividend is, as between life
tenant and remainderman, capital, and not income. But, MR. JUSTICE CLARKE concurs in this opinion.
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 Co., Ltd. V. Rex, [1914] A.C. 231. In dismissing
the appeal, these words of the Chief Justice of the
Supreme Court of Western Australia were quoted (p.
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

Page 252 U. S. 237

would clearly have been payable. Is not this virtually the

effect of what was actually done? I think it is.”

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
Manila Mandarin Hotels vs Commissioner
FACTS:
Petitioner is a domestic corporation engaged in
business as a hotel and restaurant operator. It is a
VAT registered enterprise with VAT Registration No. 32-
0-000281.
On July 8, 1992, petitioner received an assessment
notice, dated June 22, 1992, demanding the payment of
deficiency value added and percentage taxes for the
taxable year 1988.
Petitioner alleged that the tax deficiencies stemmed from
respondent's erroneous interpretation of various tax
laws which resulted in a legally-flawed assessment.
This protest cited four items of value-added tax and
one item of percentage tax which petitioner claims
to have been wrongly imposed by the respondent.
ISSUE:
(1)The first issue is whether or not the amount that
petitioner paid to PLDT should form part of the gross
receipts subject to the 10% VAT
Respondent, theorizes that the VAT is based on gross
sales or gross revenue, thus, it should include the
handling fees, the gross profit from petitioner's telephone
ser vice plus the toll fees due to PLDT
RULING:
(1) Section 102 of the Tax Code The definition of gross
receipts refers to the amount of money actually or
constructively received by the taxpayer. The facts show
that the amount paid by the petitioner to PLDT as tolling
charges for the overseas calls made by its guests were
not actually nor constructively received by the petitioner
as service fees but were instead charges of PLDT so
there is no reason why the respondent should include
these as part of petitioner's gross receipts
. Under the realization principle, revenue is generally
Therefore, the court found respondent's inclusion of the
amount paid to PLDT as part of petitioner's gross
receipts subject to 10% VAT erroneous and
therefore must be cancelled in favor of the
petitioner.
ISSUE:
(2) The second item in issue is the respondent's
imposition of VAT on the gross receipts of petitioner
stemming from the amount received on the
transportation services extended by the petitioner to the
guests of the hotel petitioner insists that it is a common
carrier subject to the 3% common carrier's tax instead of
the VAT. Corollary to this issue is whether or not the
petitioner in extending transport services to its hotel
guests can be classified as a common carrier subject to
the 3% common carrier's tax under Section 115 of the
Tax Code
RULING:
(2) Petitioner is engaged in the hotel business and not
in the business of transporting passengers. On the
occasion when the petitioner extends transport
services like providing limousine service and the like, it
does so only for its hotel guests and not to the public in
general
It was erroneous on its part to subject its gross
receipts resulting from the transport service to
percentage tax under Section 115 of the Tax Code.
Respondent is correct in subjecting these revenues to
the VAT in accordance with Section 102 of the Tax
Code.
ISSUE:
(3) The third item of VAT assailed by the petitioner
relates to its disposal of assets which respondent
subjected to the 10% VAT pursuant to Section 100 of the
Tax Code
RULING:
(3) VAT shall be imposed only if the sale of goods is "in
the course of trade or business of the taxpayer". The
selling of unserviceable equipment and other assets
including real property improvement are not subject to
VAT. The selling of those assets are merely
incidental
to its renovation. Petitioner is in the hotel business.
Besides, real property in 1988 are not yet included
among those subject to VAT.
In conclusion, The Court found that respondent erred in
subjecting the disposal of transportation
equipment and the retirement of the operating equipment
and the renovation of the building to the
10% value-added tax
ISSUE: (4)
It is petitioner's analysis that the deficiency percentage
tax assessment arose due to the imposition of the tax on
deposits made by its clients for the use of the hotel
facilities. Petitioner contends that these deposits, if
not applied against hotel bills is not subject to
percentage tax because these deposits partake of the
nature of a security deposit which cannot be classified
as income.
RULING:
(4) The Court disagrees with the respondent in the
assessment of the deficiency percentage tax,
primarily because the deposits made by petitioner's
hotel clients should not be treated as part of its gross
income.
recognized when both of the following conditions are
met: (a) the earning process is complete or virtually
complete, and (b) an exchange has taken place. This
principle requires that revenue must be earned before it
is recorded. Thus, the amounts received in advance are
not treated as revenue of the period in which they are
received but as revenue of the future period or periods in
which they are earned. These amounts are carried as
unearned revenue, that is, liabilities to transfer goods or
render services in the future—until the earning process
is complete. (Compilation of Statements of Financial
Accounting Standards No. 1-22, pp. 41-42)
G.R. No. 78953             July 31, 1991
COMMISSIONER OF INTERNAL REVENUE, petitioner,
vs.
MELCHOR J. JAVIER, JR. and THE COURT OF TAX
APPEALS, respondents.
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:
x x x           x x x          x x x
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,
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 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:
x x x           x x x          x x x
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:
x x x           x x x          x x x
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.
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? imposition of the fraud penalty in this case is not justified
and would the Government refund it to him if the by the extant facts. Javier may be guilty of swindling
courts ordered him to refund the money to the charges, perhaps even for greed by spending most of
Mellon Bank?12 the money he received, but the records lack a clear
showing of fraud committed because he did not conceal
x x x           x x x          x x x 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
Under the then Section 72 of the Tax Code (now Section
imposed as fraud penalty by the petitioner against the
248 of the 1988 National Internal Revenue Code), a
private respondent in the deficiency assessment should
taxpayer who files a false return is liable to pay the fraud
be deleted.
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 WHEREFORE, the petition is DENIED and the decision
or fraud. appealed from the Court of Tax Appeals is AFFIRMED.
No costs.
We are persuaded considerably by the private
respondent's contention that there is no fraud in the filing SO ORDERED.
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

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