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Gross Income: Income, gain or profit subject to income tax. It includes compensation for personal services, business
income, profits and income derivedfromany source whatever legal or illegal.
Collector vs.Henderson
FACTS:
• Sps. Arthur Henderson and Marie Henderson filed their annual income tax with the BIR. Arthur is president of American
International Underwriters for the Philippines, Inc., which is a domestic corporation engaged in the business of general non-
life insurance, and represents a group of American insurance companies engaged in the business of general non-life
insurance.
• The BIR demanded payment for alleged deficiency taxes. In their computation, the BIR included as part of taxable
income: 1) Arthur’s allowances for rental, residential expenses, subsistence, water, electricity and telephone expenses 2)
entrance fee to the Marikina Gun and Country Club which was paid by his employer for his account and 3) travelling
allowance of his wife
• The taxpayers justifications are as follows:
1) as to allowances for rental and utilities, Arthur did not receive money for the allowances. Instead, the apartment is
furnished and paid for by his employer-corporation (the mother company of American International), for the employer
corporation’s purposes. The spouses had no choice but to live in the expensive apartment, since the company used it to
entertain guests,to accommodate officials, and to entertain customers. According to taxpayers, only P 4,800 per year is the
reasonable amount that the spouses would be spending on rental if they were not required to live in those apartments.
Thus, it is the amount they deem is subject to tax.The excess is to be treatedas expense of the company.
2) The entrance fee should not be considered income since it is an expense of his employer, and membership therein is
merely incidental to his duties of increasing and sustaining the business of his employer.
3) His wife merely accompanied him to New York on a business trip as his secretary, and at the employer -corporation’s
request, for the wife to look at details of the plans of a building that his employer intended to construct. Such must not be
consideredtaxable income.
• The Collector of Internal Revenue merely allowed the entrance fee as nontaxable. The rent expense and travel expenses
were still held to be taxable. The Court of Tax Appeals ruled in favor of the taxpayers, that such expenses must not be
considered part of taxable income. Letters of the wife while in New York concerning the proposed building were presented
as evidence.
ISSUE: Whether or not the rental allowances and travel allowances furnished and given by the employer -corporation are
part of taxable income?

2. HELD: NO. Such claims are substantially supported by evidence.
These claims are therefore NOT part of taxable income. No part of the allowances in question redounded to their personal
benefit, nor were such amounts retained by them. These bills were paid directly by the employer-corporation to the
creditors. The rental expenses and subsistence allowances are to be considered not subject to income tax. Arthur’s high
executive position and social standing, demanded and compelled the couple to live in a more spacious and expensive
quarters. Such ‘subsistence allowance’ was a SEPARATE account from the account for salaries and wages of employees.
The company did not charge rentals as deductible from the salaries of the employees. These expenses are COMPANY
EXPENSES, not income by employees which are subject to tax.
CIR vs. Cantaneda
FACTS:
Efren Castaneda retired from gov’t service as Revenue Attache in the Philippine Embassy, London, England. Upon
retirement, he received benefits such as the terminal leave pay. The Commissioner of Internal Revenue withheld P12,557
allegedlyrepresenting that it was tax income.
Castaneda filedfor a refund, contending that the cash equivalent of his terminal leave is exempt fromincome tax.
The Solicitor General contends that the terminal leave is based from an employer-employee relationship and that as part of
the services renderedby the employee, the terminal leave pay is part of the gross income of the recipient.
CTA -> ruledin favor of Castaneda and orderedthe refund.
CA -> affirmeddecisionof CTA. Hence, this petitionfor review oncertiorari.
ISSUE:
Whether or not terminal leave pay (on occasionof his compulsoryretirement)is subject to income tax.
HELD:
NO. As explained in Borromeo v CSC, the rationale of the court in holding that terminal leave pays are subject to income
tax is that:
. . commutation of leave credits, more commonly known as terminal leave, is applied for by an officer or employee who
retires, resigns or is separated from the service through no fault of his own. In the exercise of sound personnel policy, the
Government encourages unused leaves to be accumulated. The Government recognizes that for most public servants,
retirement pay is always less than generous if not meager and scrimpy. A modest nest egg which the senior citizen may look
forward to is thus avoided. Terminal leave payments are given not only at the same time but also for the same policy
considerations governing retirement benefits.
A terminal leave pay is a retirement benefit whichis NOT subject to income tax.
*Petitiondenied.
CIR vs. Filinvest Development Corporation
Filinvest Development Corporation extended advances in favor of its affiliates and supported the same with instructional
letters and cash and journal vouchers. The BIR assessed Filinvest for deficiency income tax by imputing an “arm’s length”
interest rate on its advances to affiliates. Filinvest disputed this by saying that the CIR lacks the authority to impute
theoretical interest andthat the rule is that interests cannot be demanded in the absence of a stipulationto the effect.
ISSUE:
Can the CIR impute theoretical interest onthe advances made by Filinvest to its affiliates?
HELD:
NO. Despite the seemingly broad power of the CIR to distribute, apportion and allocate gross income under (now) Section
50 of the Tax Code, the same does not include the power to impute theoretical interests even with regard to controlled
taxpayers’ transactions. This is true even if the CIR is able to prove that interest expense (on its own loans) was in fact
claimed by the lending entity. The term in the definition of gross income that even those income “from whatever source
derived” is covered still requires that there must be actual or at least probable receipt or realization of the item of gross

3. income sought to be apportioned, distributed, or allocated. Finally, the rule under the Civil Code that “no interest shall be
due unless expresslystipulatedinwriting” was also applied in this case.
The Court also ruledthat the instructional letters, cash and journal vouchers qualify as loan agreements that are subject to
DST.
CIR vs. CA, CTA & ANSCOR
Sometime in the 1930s, Don Andres Soriano, a citizen and resident of the UnitedStates, formed the corporation “A. Soriano Y
Cia”, predecessor of ANSCOR, with a P1,000,000.00 capitalization divided into 10,000 common shares at a par value of
P100/share. ANSCOR is wholly owned and controlled by the family of Don Andres, who are all non-resident aliens. In 1937,
Don Andres subscribed to 4,963 shares of the 5,000 shares originally issued. The authorized capital stock was increased to
P2,500,000.00 divided into 25,000 common shares with the same par value with only 10,000 issued and all subscribed by Don
Andres. Don Andres transferred 1,250 shares each to his two sons, Jose and Andres, Jr., as their initial investments in ANSCOR.
Bothsons are foreigners.
Stock dividends were declared on 1947, 1949 and 1963.On December 30, 1964 Don Andres died. As of that date, he has a
total shareholdings of 185,154 shares - 50,495 of which are original issues and the balance of 134,659 shares as stock
dividend declarations. One-half of that shareholdings were transferred to his wife, Doña Carmen Soriano, as her conjugal
share. The other half formed part of his estate.
ANSCOR increased its capital stock to P20M and in 1966 to P30M. In the same year, stock dividends worth 46,290 and 46,287
shares were respectively received by the Don Andres estate and Doña Carmen from ANSCOR. Hence, increasing their
accumulated shareholdings to 138,867 and 138,864 common shares each.
On December 28, 1967, Doña Carmen requested a ruling from the United States Internal Revenue Service (IRS), inquiring if
an exchange of common with preferred shares may be considered as a tax avoidance scheme under Section 367 of the
1954 U.S. Revenue Act. By January 2, 1968, ANSCOR reclassified its existing 300,000 common shares into 150,000 common
and 150,000 preferred shares. The IRS opined that the exchange is only a recapitalization scheme and not tax avoidance.
Consequently, Doña Carmen exchanged her whole 138,864 common shares for 138,860 of the newly reclassified preferred
shares. The estate of Don Andres in turn, exchanged 11,140 of its common shares for the remaining 11,140 preferred shares,
thus reducing its (the estate)commonshares to 127,727.
ANSCOR redeemed 28,000 common shares from the Don Andres’ estate. By November 1968, the Board further increased
ANSCOR’s capital stock to P75M divided into 150,000 preferred shares and 600,000 common shares. About a year later,
ANSCOR again redeemed 80,000 common shares from the Don Andres’ estate further reducing the latter’s common
shareholdings to 19,727.
In 1973, after examining ANSCOR’s books of account and records, Revenue examiners issued a report proposing that
ANSCOR be assessed for deficiency withholding tax-at-source, pursuant to Sections 53 and 54 of the 1939 Revenue Code,
for the year 1968 and the second quarter of 1969 based on the transactions of exchange and redemptionof stocks.
Subsequently, ANSCOR filed a petition for review with the CTA assailing the tax assessments on the redemptions and
exchange of stocks.
The bone of contentionis the interpretationand applicationof Section83(b)of the 1939 Revenue Act which provides:
Sec.83. Distributionof dividends or assets by corporations. -
(b) Stock dividends - A stock dividend representing the transfer of surplus to capital account shall not be subject to tax.
However, if a corporation cancels or redeems stock issued as a dividend at such time and in such manner as to make the
distribution and cancellation or redemption, in whole or in part, essentially equivalent to the distribution of a taxable
dividend, the amount so distributed in redemption or cancellation of the stock shall be considered as taxable income to
the extent it represents a distribution of earnings or profits accumulated after March first, nineteen hundred and thirteen.”
(Italics supplied).
Specifically, the issue is whether ANSCOR’s redemption of stocks from its stockholder as well as the exchange of common
with preferred shares can be considered as “essentially equivalent to the distribution of taxable dividend,” making the
proceeds thereof taxable under the provisions of the above-quotedlaw.
General Rule
Section 83(b) of the 1939 NIRC was taken from Section 115(g)(1) of the U.S. Revenue Code of 1928. It laid down the general
rule known as the ‘proportionate test’ wherein stock dividends once issued form part of the capital and, thus, subject to
income tax. Specifically, the general rule states that:“A stock dividend representing the transfer of surplus to capit al
account shall not be subject to tax.”
Having been derived from a foreign law, resort to the jurisprudence of its origin may shed light. Under the US Revenue Code,
this provision originally referred to “stock dividends” only, without any exception. Stock dividends, strictly speaking, represent
capital and do not constitute income to its recipient. So that the mere issuance thereof is not yet subject to income tax as
they are nothing but an “enrichment through increase in value of capital investment.” As capital, the stock dividends
postpone the realization of profits because the “fund represented by the new stock has been transferred from surplus to
capital and no longer available for actual distribution.” Income in tax law is “an amount of money coming to a person
within a specified time, whether as payment for services, interest, or profit from investment.” It means cash or its equivalent.
It is gain derived and severed from capital, from labor or from both combined - so that to tax a stock dividend would be to
tax a capital increase rather than the income. In a loose sense, stock dividends issued by the corporation, are considered
unrealized gain, and cannot be subjected to income tax until that gain has been realized. Before the realization, stock

4. dividends are nothing but a representation of an interest in the corporate properties. As capital, it is not yet subject to
income tax. It should be noted that capital and income are different. Capital is wealth or fund; whereas income is profit or
gain or the flow of wealth. The determining factor for the imposition of income tax is whether any gain or profit was derived
from a transaction.
The Exception
“However, if a corporation cancels or redeems stock issued as a dividend at such time and in such manner as to make the
distribution and cancellation or redemption, in whole or in part, essentially equivalent to the distribution of a taxable
dividend, the amount so distributed in redemption or cancellation of the stock shall be considered as taxable income to
the extent it represents a distribution of earnings or profits accumulated after March first, nineteen hundred and thirteen.”
(Emphasis supplied).
Although redemption and cancellation are generally considered capital transactions, as such, they are not subject to tax.
However, it does not necessarily mean that a shareholder may not realize a taxable gain from such transactions.Simply put,
depending on the circumstances, the proceeds of redemption of stock dividends are essentially distribution of cash
dividends, which when paid becomes the absolute property of the stockholder. Thereafter, the latter becomes the
exclusive owner thereof and can exercise the freedom of choice. Having realized gain from that redemption, the income
earner cannot escape income tax.
As qualified by the phrase “such time and in such manner,” the exception was not intended to characterize as taxable
dividend every distribution of earnings arising from the redemption of stock dividends. So that, whether the amount
distributed in the redemption should be treated as the equivalent of a “taxable dividend” is a question of fact, which is
determinable on “the basis of the particular facts of the transaction in question.” No decisive test can be used to determine
the application of the exemption under Section 83(b) The use of the words “such manner” and “essentially equivalent”
negative any idea that a weighted formula can resolve a crucial issue - Should the distribution be treated as taxable
dividend.On this aspect,American courts developed certainrecognizedcriteria,whichincludes the following:
1) the presence or absence of real business purpose,
2) the amount of earnings and profits available for the declaration of a regular dividend and the corporation’s past record
withrespect to the declarationof dividends,
3) the effect of the distributionas compared withthe declarationof regular dividend,
4) the lapse of time between issuance and redemption,
5) the presence of a substantial surplus and a generous supply of cash which invites suspicion as does a meager policy in
relationbothto current earnings and accumulatedsurplus.
REDEMPTION AND CANCELLATION
For the exempting clause of Section 83(b) to apply, it is indispensable that: (a) there is redemption or cancellation; (b) the
transaction involves stock dividends and (c) the “time and manner” of the transaction makes it “essentially equivalent to a
distributionof taxable dividends.” Of these,the most important is the third.
Redemption is repurchase, a reacquisition of stock by a corporation which issued the stock in exchange for property,
whether or not the acquired stock is cancelled, retired or held in the treasury. Essentially, the corporation gets back some of
its stock, distributes cash or property to the shareholder in payment for the stock, and continues in business as before. The
redemption of stock dividends previously issued is used as a veil for the constructive distribution of cash dividends. In the
instant case, there is no dispute that ANSCOR redeemed shares of stocks from a stockholder (Don Andres) twice (28,000
and 80,000 common shares). But where did the shares redeemed come from? If its source is the original capital subscriptions
upon establishment of the corporation or from initial capital investment in an existing enterprise, its redemption to the
concurrent value of acquisition may not invite the application of Sec. 83(b) under the 1939 Tax Code, as it is not income but
a mere return of capital. On the contrary, if the redeemed shares are from stock dividend declarations other than as initial
capital investment, the proceeds of the redemption is additional wealth, for it is not merely a return of capital but a gain
thereon.
It is not the stock dividends but the proceeds of its redemption that may be deemed as taxable dividends. Here, it is
undisputed that at the time of the last redemption, the original common shares owned by the estate were only 25,247.5. This
means that from the total of 108,000 shares redeemed from the estate, the balance of 82,752.5 (108,000 less 25,247.5) must
have come from stock dividends. Besides, in the absence of evidence to the contrary, the Tax Code presumes that every
distribution of corporate property, in whole or in part, is made out of corporate profits, such as stock dividends. The capital
cannot be distributed in the form of redemption of stock dividends without violating the trust fund doctrine - wherein the
capital stock, property and other assets of the corporation are regarded as equity in trust for the payment of the corporate
creditors.Once capital,it is always capital.That doctrine was intended for the protectionof corporate creditors
With respect to the third requisite, ANSCOR redeemed stock dividends issued just 2 to 3 years earlier. The time alone that
lapsed from the issuance to the redemption is not a sufficient indicator to determine taxability. It is a must to consider the
factual circumstances as to the manner of both the issuance and the redemption. The “time” element is a factor to show a
device to evade tax and the scheme of cancelling or redeeming the same shares is a method usually adopted to
accomplish the end sought. Was this transaction used as a “continuing plan,” “device” or “artifice” to evade payment of
tax? It is necessary to determine the “net effect” of the transaction between the shareholder-income taxpayer and the
acquiring (redeeming) corporation. The “net effect” test is not evidence or testimony to be considered; it is rather an
inference to be drawn or a conclusion to be reached. It is also important to know whether the issuance of stock dividends
was dictatedby legitimate business reasons,the presence of which might negate a tax evasionplan.
The issuance of stock dividends and its subsequent redemption must be separate, distinct, and not related, for the

5. redemption to be considered a legitimate tax scheme. Redemption cannot be used as a cloak to distribute corporate
earnings. Otherwise,the apparent intentionto avoidtax becomes doubtful as the intentionto evade becomes manifest.
Depending on each case, the exempting provision of Sec. 83(b) of the 1939 Code may not be applicable if the redeemed
shares were issued with bona fide business purpose, which is judged after each and every step of the transaction have
been consideredand the whole transactiondoes not amount to a tax evasionscheme.
It is the “net effect rather than the motives and plans of the taxpayer or his corporation” that is the fundamental guide in
administering Sec. 83(b). This tax provision is aimed at the result. It also applies even if at the time of the issuance of t he
stock dividend, there was no intention to redeem it as a means of distributing profit or avoiding tax on dividends. The
existence of legitimate business purposes in support of the redemption of stock dividends is immaterial in income taxation. It
has no relevance in determining “dividend equivalence”. Such purposes may be material only upon the issuance of the
stock dividends. The test of taxability under the exempting clause, when it provides “such time and manner” as would make
the redemption “essentially equivalent to the distribution of a taxable dividend”, is whether the redemption resulted into a
flow of wealth. If no wealthis realizedfromthe redemption,there may not be a dividendequivalence treatment.
The three elements in the imposition of income tax are: (1) there must be gain or profit, (2) that the gain or profit is real ized
or received, actually or constructively,and (3) it is not exempted by law or treaty from income tax. Any business purpose as
to why or how the income was earned by the taxpayer is not a requirement. Income tax is assessed on income received
from any property, activity or service that produces the income because the Tax Code stands as an indifferent neutral
party on the matter of where income comes from.
As stated above, the test of taxability under the exempting clause of Section 83(b) is, whether income was realized through
the redemption of stock dividends. The redemption converts into money the stock dividends which become a realized
profit or gain and consequently, the stockholder’s separate property.Profits derived from the capital invested cannot
escape income tax. As realized income, the proceeds of the redeemed stock dividends can be reached by income
taxationregardless of the existence of any business purpose for the redemption.
A review of the cited American cases shows that the presence or absence of “genuine business purposes” may be material
with respect to the issuance or declaration of stock dividends but not on its subsequent redemption. The issuance and the
redemption of stocks are two different transactions. Although the existence of legitimate corporate purposes may justify a
corporation’s acquisition of its own shares under Section 41 of the Corporation Code, such purposes cannot excuse the
stockholder from the effects of taxation arising from the redemption. If the issuance of stock dividends is part of a tax
evasion plan and thus, without legitimate business reasons the redemption becomes suspicious which may call for the
application of the exempting clause. The substance of the whole transaction, not its form, usually controls the tax
consequences.
After considering the manner and the circumstances by which the issuance and redemption of stock dividends were
made, there is no other conclusion but that the proceeds thereof are essentially considered equivalent to a distribution of
taxable dividends. As “taxable dividend” under Section 83(b), it is part of the “entire income” subject to tax under Section
22 in relation to Section 21of the 1939 Code. Moreover, under Section 29(a) of said Code, dividends are included in “gross
income”. As income, it is subject to income tax which is required to be withheld at source. The 1997 Tax Code may have
alteredthe situationbut it does not change this disposition.
EXCHANGE OF COMMON WITH PREFERRED SHARES
Exchange is an act of taking or giving one thing for another involving reciprocal transfer and is generally considered as a
taxable transaction. The exchange of common stocks with preferred stocks, or preferred for common or a combination of
either for both, may not produce a recognized gain or loss, so long as the provisions of Section 83(b) is not applicable. This is
true in a trade between two (2) persons as well as a trade between a stockholder and a corporation. In general, this trade
must be parts of merger, transfer to controlled corporation, corporate acquisitions or corporate reorganizations. No taxable
gain or loss may be recognizedon exchange of property,stock or securities relatedto reorganizations.
Both the Tax Court and the Court of Appeals found that ANSCOR reclassified its shares into common and preferred, a nd
that parts of the common shares of the Don Andres estate and all of Doña Carmen’s shares were exchanged for the whole
150, 000 preferred shares. Thereafter, both the Don Andres estate and Doña Carmen remained as corporate subscribers
except that their subscriptions now include preferred shares. There was no change in their proportional interest after the
exchange. There was no cash flow. Both stocks had the same par value. Under the facts herein, any difference in their
market value would be immaterial at the time of exchange because no income is yet realized - it was a mere corporate
paper transaction. It would have been different, if the exchange transaction resulted into a flow of wealth, in which case
income tax may be imposed.
Reclassification of shares does not always bring any substantial alteration in the subscriber’s proportional interest. But the
exchange is different - there would be a shifting of the balance of stock features, like priority in dividend declarations or
absence of voting rights. Yet neither the reclassificationnor exchange per se, yields realize income for tax purposes.
Eisner V. Macomber
Facts: Standard Oil Company of California, had surplus and undivided profits amounting to $45,000,000, of which about
$20,000,000 had been earned prior to March 1, 1913. In order to readjust the capitalization, the board of directors decided
to issue stock dividend of 50 percent of the outstanding stock, and to transfer from surplus account to capital stock account
an amount equivalent to suchissue.
Macomber,being the owner of 2,200 shares of the old stock, received certificates for 1,100 additional shares, of which 18.07
per cent., or 198.77 shares, par value $19,877, were treated as representing surplus earned between March 1, 1913, and

6. January 1, 1916. She was called upon to pay, and did pay under protest, a tax imposed based upon a supposed income of
$ 19,877 because of the new shares.
MACOMBER: Revenue Act of 1916 , in so far as it considers stock dividends as income, violated the Constitution of the
UnitedStates.
Issue: Whether or not Congress has the power to tax, as income of the stockholder and without apportionment, a st ock
dividendmade lawfully and in good faithagainst profits accumulatedby the corporation.
Held: No, stock dividend is not taxable. Income may be defined as the gain derived from capital, from labor, or from both
combined, provided it be understoodto include profit gained through a sale or conversion of capital assets and 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
derivedfromproperty.
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 transferredfromsurplus 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 definitionof income withinthe meaning of the SixteenthAmendment.
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.
BIR RULING NO. 219-93
AWARD AS MORAL DAMAGES NOT SUBJ. TO INCOME/WITHHOLDING TAX
29 (a) 04-92 19-93
Mañacop Law Office
Unit 102, MissionGarden Condominium
59 Sct.Ibardolaza St.
Quezon City
Attention:Atty.Jose F . Mañacop
This refers to your letter dated August 12, 1992 stating that your client, Mr. Michael Lawrence, was awarded unpaid salaries
and commission, plus moral and exemplary damages and attorney's fees in NLRC Case No. 00-11-043031-87, entitled
"Michael Lawrence vs. LEP International Phil., Inc."; that said award has already become final and executory, and the
respondent is willing to pay the award less the withholding tax thereon; and that it is the belief of your client that the unpaid
salaries and commission are subject to withholding tax but the damages which consist of moral and exemplary damages
and attorney's fees are not subject to withholding tax to which the respondent disagrees.
Based on the foregoing, you now request for a ruling as to whether or not award of damages such as moral, exemplary and
attorney's fees or reimbursement of your client's advances to his lawyers, are subject to withholding tax.
In reply, I have the honor to inform you that amounts received by a taxpayer as moral damages are not considered
taxable income (par. 60, 12 Vol. 1, Mertens Law of Federal Income Taxation). The legal expenses incurred in court
proceedings, where the taxpayer was awarded moral damages, are not deductible from gross income, under Section
29(a) of the Tax Code (par. 1130, p. 39001, 1969 U.S. Master Tax Guide). On the other hand, attorney's fees awarded to your
client as part of the damages shall not be subject to income tax, the same being merely a reimbursement of his
expenses/advances in the course of the hearing of his case. This opinion finds support in the case of Gold Green Mining
Corporation vs. Tabios, CIR, CTA Case No. 1497, April 27, 1967 (1988 Ed. Arañas Commentary, p. 190), holding that the so -
called"legal fees" are expenses incurred in the carrying on of a trade or business.
In view thereof, this Office is of the opinion as it hereby holds that award of damages, such as moral, exemplary and
attorney's fees,are not subject to income tax and consequently,to the withholding tax.
This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it will be
disclosedthat the facts are different,thenthis ruling shall be considerednull and void.
VICTOR A. DEOFERIO, JR.
Deputy Commissioner of Internal Revenue

7. DEDUCTIONS
ESSOvs.CIR
Facts: In CTA Case No. 1251, Esso Standard Eastern Inc. (Esso) deducted from its gross income for 1959, as part of its ordinary
and necessary business expenses, the amount it had spent for drilling and exploration of its petroleum concessions. This
claim was disallowed by the Commissioner of Internal Revenue (CIR) on the ground that the expenses should be capitalized
and might be written off as a loss only when a "dry hole" should result. Esso then filed an amended return where it asked for
the refund of P323,279.00 by reason of its abandonment as dry holes of several of its oil wells. Also claimed as ordinary and
necessary expenses in the same return was the amount of P340,822.04, representing margin fees it had paid to the Central
Bank on its profit remittances to its New York head office.
On August 5, 1964, the CIR granted a tax credit of P221,033.00 only, disallowing the claimed deduction for the margin fees
paid on the ground that the margin fees paid to the Central Bank could not be considered taxes or allowed as deductible
business expenses.
Esso appealed to the Court of Tax Appeals (CTA) for the refund of the margin fees it had earlier paid contending that the
margin fees were deductible from gross income either as a tax or as an ordinary and necessary business expense. However,
Esso’s appeal was denied.
Issues:
(1) Whether or not the margin fees are taxes.
(2) Whether or not the margin fees are necessary and ordinary business expenses.
Held:
(1) No. A tax is levied to provide revenue for government operations, while the proceeds of the margin fee are applied to
strengthen our country's international reserves. The margin fee was imposed by the State in the exercise of its police power
and not the power of taxation.
(2) No. Ordinarily, an expense will be considered 'necessary' where the expenditure is appropriate and helpful in the
development of the taxpayer's business. It is 'ordinary' when it connotes a payment which is normal in relation to the
business of the taxpayer and the surrounding circumstances. Since the margin fees in question were incurred for the
remittance of funds to Esso's Head Office in New York, which is a separate and distinct income taxpayer from the branch in
the Philippines, for its disposal abroad, it can never be said therefore t hat the margin fees were appropriate and helpful in
the development of Esso's business in the Philippines exclusively or were incurred for purposes proper to the conduct of the
affairs of Esso's branch in the Philippines exclusively or for the purpose of realizing a profit or of minimizing a loss in the
Philippines exclusively. If at all, the margin fees were incurred for purposes proper to the conduct of the corporate affairs of
Esso in New York, but certainlynot in the Philippines.
Zamora vs.CIR
FACTS:
Mariano Zamora, owner of the Bay View Hotel and Farmacia Zamora, filed his income tax returns. The CIR found that he
failed to file his return of the capital gains derived from the sale of certain real properties and claimed deductions which
were not allowable. The collector required him to pay deficiency income tax. On appeal by Zamora, the CTA reduced the
amount of deficiencyincome tax.
Zamora appealed, alleging that the CTA erred in dissallowing P10,478.50, as promotion expenses incurred by his wife for the
promotionof the Bay View Hotel and Farmacia Zamora (whichis ½ of P20,957.00,supposed business expenses).
Zamora alleged that the CTA erred in disallowing P10,478.50 as promotion expenses incurred by his wife for the promotion of
the Bay View Hotel and Farmacia Zamora. He contends that the whole amount of P20,957.00 as promotion expenses,
should be allowed and not merely one-half of it, on the ground that, while not all the itemized expenses are supported by
receipts,the absence of some supporting receipts has been sufficientlyandsatisfactorilyestablished.
ISSUE: w/n CTA erred in allowing only one half of the promotionexpenses.NO
HELD:
Section 30, of the Tax Code, provides that in computing net income, there shall be allowed as deductions all the ordinary
and necessary expenses paid or incurred during the taxable year, in carrying on any trade or business. Since promotion
expenses constitute one of the deductions in conducting a business, same must satisfy these requirements. Claim for the
deduction of promotion expenses or entertainment expenses must also be substantiated or supported by record showing in
detail the amount and nature of the expenses incurred.

8. Considering, as heretofore stated, that the application of Mrs. Zamora for dollar allocation shows that she went abroad on
a combined medical and business trip, not all of her expenses came under the category of ordinary and necess ary
expenses; part thereof constituted her personal expenses. There having been no means by which to ascertain which
expense was incurred by her in connection with the business of Mariano Zamora and which was incurred for her personal
benefit, the Collector and the CTA in their decisions, considered 50% of the said amount of P20,957.00 as business expenses
and the other 50%, as her personal expenses.We hold that said allocation is very fair to Mariano Zamora, there having been
no receipt whatsoever, submitted to explain the alleged business expenses, or proof of the connection which said expenses
had to the business or the reasonableness of the said amount of P20,957.00.
In the case of Visayan Cebu Terminal Co., Inc. v. CIR., it was declared that representation expenses fall under the category
of business expenses which are allowable deductions from gross income, if they meet the conditions prescribed by law,
particularly section 30 (a) [1], of the Tax Code; that to be deductible, said business expenses mu st be ordinary and
necessary expenses paid or incurred in carrying on any trade or business; that those expenses must also meet the further
test of reasonableness in amount. They should also be covered by supporting papers; in the absence thereof the amount
properly deductible as representation expenses should be determined from available data.
KUENZLE & STREIF,INC. v CIR
FACTS:
Petitioner is a domestic corporation engaged in the importation of textiles, hardware, sundries, chemicals, pharmaceuticals,
lumbers, groceries, wines and liquor; in insurance and lumber; and in some exports. When Petitioner filed its Income Tax
Return, it deducted fromits gross income the following items:
1. salaries,directors'fees and bonuses of its non-resident president and vice-president;
2. bonuses of its resident officers andemployees; and
3. interests onearned but unpaid salaries and bonuses of its officers andemployees.
The CIR disallowed the deductions and assessed Petitioner for deficiency income taxes. Petitioner requested for re-
examination of the assessment. CIR modified the same by allowing as deductible all items comprising directors' fees and
salaries of the non-resident president and vice-president, but disallowing the bonuses insofar as they exceed the salaries of
the recipients,as well as the interests onearned but unpaid salaries and bonuses.
The CTA modified the assessment and ruled that while the bonuses given to the non-resident officers are reasonable,
bonuses givento the resident officers and employees are quite excessive.
ISSUES/RULING:
W/N the CTA erred in ruling that the measure of the reasonableness of the bonuses paid to its non-resident
president and vice-president should be applied to the bonuses given to resident officers and employees in
determining their deductibility? NO.
It is a general rule that "Bonuses to employees made in good faith and as additional compensation for the services actually
rendered by the employees are deductible, provided such payments, when added to the stipulated salaries, do not
exceed a reasonable compensation for the services rendered.” The condition precedents to the deduction of bonuses to
employees are:
1. the payment of the bonuses is in fact compensation;
2. it must be for personal services actuallyrendered;and
3. the bonuses, when added to the salaries, are reasonable when measured by the amount and quality of the
services performedwithrelationto the business of the particular taxpayer
There is no fixed test for determining the reasonableness of a given bonus as compensation. However, in determining
whether the particular salaryor compensation payment is reasonable, the situationmust be consideredas a whole.
Petitioner contended that it is error to apply the same measure of reasonableness to both resident and non-resident officers
because the nature, extent and quality of the services performed by each with relation to the business of the corporation
widely differ. Said non-resident officers had rendered the same amount of efficient personal service and contribution to
deserve equal treatment in compensation and other emoluments. There is no special reason for granting greater bonuses
to such lower ranking officers thanthose givento the non-resident president and vice president.
W/N the CTA erredin allowing the deduction of the bonuses in excess of the yearly salaries of the employees? NO.

9. The deductible amount of said bonuses cannot be only equal to their respective yearly salaries considering the post-war
policy of the corporation in giving salaries at low levels because of the unsettled conditions resulting from war and the
imposition of government controls on imports and exports and on the use of foreign exchange which resulted in the
diminution of the amount of business and the consequent loss of profits on t he part of the corporation. The payment of
bonuses in amounts a little more than the yearly salaries received considering the prevailing circumstances is in our opinion
reasonable.
W/N the CTA erredin disallowing the deductionof interests onearned but unpaid salaries and bonuses? NO.
Under the law, in order that interest may be deductible, it must be paid "on indebtedness." It is therefore imperative to show
that there is an existing indebtedness which may be subjected to the payment of interest. Here the items involved are
unclaimed salaries and bonus participation which cannot constitute indebtedness within the meaning of the law because
while they constitute an obligation on the part of the corporation, it is not the latter's fault if they remained unc laimed.
Whatever an employee may fail to collect cannot be considered an indebtedness for it is the concern of the employee to
collect it in due time. The willingness of the corporation to pay interest thereon cannot be considered a justification to
warrant deduction.
C.M. HOSKINS&CO, INC. v CIR
Facts:
Petitioner, a domestic corporation engaged in the real estate business as brokers, managing agents and administrators,
filed its income tax return for its fiscal year ending September 30, 1957 showing a net income of P92,540.25 and a tax liability
due thereon of P18,508.00, which it paid in due course. Upon verification of its return, CIR, disallowed four items of
deduction in petitioner's tax returns and assessed against it an income tax deficiency in the amount of P28,054.00 plus
interests. The Court of Tax Appeals upon reviewing the assessment at the taxpayer's petition, upheld respondent's
disallowance of the principal item of petitioner's having paid to Mr. C. M. Hoskins, its founder and controlling stockholder the
amount of P99,977.91 representing 50% of supervision fees earned by it and set aside respondent's disallowance of three
other minor items.
Petitioner questions in this appeal the Tax Court's findings that the disallowed payment to Hoskins was an inordinately large
one, which bore a close relationship to the recipient's dominant stockholdings and therefore amounted in law to a
distributionof its earnings and profits.
Issue: Whether the 50% supervisionfee paid to Hoskin may be deductible for income tax purposes.
Ruling: NO.
Ratio:
Hoskin owns 99.6% of the CM Hoskins & Co. He was also the President and Chairman of the Board. That as chairman of the
Board of Directors, he received a salary of P3,750.00 a month, plus a salary bonus of about P40,000.00 a year and an
amounting to an annual compensation of P45,000.00 and an annual salary bonus of P40,000.00, plus free use of the
company car and receipt of other similar allowances and benefits, the Tax Court correctly ruled that the payment by
petitioner to Hoskins of the additional sum of P99,977.91 as his equal or 50% share of the 8% supervision fees received by
petitioner as managing agents of the real estate, subdivision projects of Paradise Farms, Inc. and Realty Investments, Inc.
was inordinately large and could not be accorded the treatment of ordinary and necessary expenses allowed as
deductible items within the purviewof the Tax Code.
The fact that such payment was authorized by a standing resolution of petitioner's board of directors, since "Hoskins had
personally conceived and planned the project" cannot change the picture. There could be no question that as Chairman
of the board and practically an absolutely controlling stockholder of petitioner, Hoskins wielded tremendous power and
influence in the formulation and making of the company's policies and decisions. Even just as board chairman, going by
petitioner's own enumeration of the powers of the office, Hoskins, could exercise great power and influence within the
corporation, such as directing the policy of the corporation, delegating powers to the president and advising the
corporationindetermining executive salaries,bonus plans and pensions, dividendpolicies,etc.

10. It is a general rule that 'Bonuses to employees made in good faith and as additional compensation for the services actually
rendered by the employees are deductible, provided such payments, when added to the stipulated salaries, do not
exceed a reasonable compensation for the services rendered. The conditions precedent to the deduction of bonuses to
employees are: (1) the payment of the bonuses is in fact compensation; (2) it must be for personal services actually
rendered; and (3) the bonuses, when added to the salaries, are 'reasonable when measured by the amount and quality of
the services performedwithrelationto the business of the particular taxpayer.
There is no fixed test for determining the reasonableness of a given bonus as compensation. This depends upon many
factors, one of them being the amount and quality of the services performed with relation to the business.' Other tests
suggested are: payment must be 'made in good faith'; 'the character of the taxpayer's business, the volume and amount of
its net earnings, its locality, the type and extent of the services rendered, the salary policy of the corporation'; 'the size of the
particular business'; 'the employees' qualifications and contributions to the business venture'; and 'general economic
conditions. However, 'in determining whether the particular salary or compensation payment is reasonable, the situation
must be considered as whole. Ordinarily, no single factor is decisive. . . . it is important to keep in mind that it seldom
happens that the application of one test can give satisfactory answer, and that ordinarily it is the interplay of several
factors,properlyweightedfor the particular case,which must furnish the final answer."
Petitioner's case fails to pass the test. On the right of the employer as against respondent Commissioner to fix the
compensation of its officers and employees, we there held further that while the employer's right may be conceded, the
question of the allowance or disallowance thereof as deductible expenses for income tax purposes is subject to
determination by CIR. As far as petitioner's contention that as employer it has the right to fix the compensation of its officers
and employees and that it was in the exercise of such right that it deemed proper to pay the bonuses in question, all that
We need say is this: that right may be conceded, but for income tax purposes the employer cannot legally claim such
bonuses as deductible expenses unless they are shown to be reasonable. To hold otherwise would open the gate of
rampant tax evasion.
Lastly, We must not lose sight of the fact that the question of allowing or disallowing as deductible expenses the amounts
paid to corporate officers by way of bonus is determined by respondent exclusively for income tax purposes. Concededly,
he has no authority to fix the amounts to be paid to corporate officers by way of basic salary, bonus or additional
remuneration — a matter that lies more or less exclusively within the sound discretion of the corporation itself. But this right of
the corporation is, of course, not absolute. It cannot exercise it for the purpose of evading payment of taxes legitimately
due to the State."
COMMISSIONER OF INTERNALREVENUE, petitioner,vs. GENERAL FOODS (PHILS.), INC., respondent.
Petitioner Commissioner of Internal Revenue (Commissioner) assails the resolution[1] of the Court of Appeals reversing
the decision[2] of the Court of Tax Appeals which in turn denied the protest filed by respondent General Foods (Phils.), Inc.,
regarding the assessment made against the latter for deficiencytaxes.
The records reveal that, on June 14, 1985, respondent corporation, which is engaged in the manufacture of
beverages such as “Tang,” “Calumet” and “Kool-Aid,” filed its income tax return for the fiscal year ending February 28,
1985. In said tax return, respondent corporation claimed as deduction, among other business expenses, the amount of
P9,461,246 for media advertising for “Tang.”
On May 31, 1988, the Commissioner disallowed 50% or P4,730,623 of the deduction claimed by respondent
corporation. Consequently, respondent corporation was assessed deficiency income taxes in the amount of P2,635,
141.42. The latter fileda motionfor reconsiderationbut the same was denied.
On September 29, 1989, respondent corporation appealed to the Court of Tax Appeals but the appeal was
dismissed:
With such a gargantuan expense for the advertisement of a singular product, which even excludes “other advertising and
promotions” expenses, we are not prepared to accept that such amount is reasonable “to stimulate the current sale of
merchandise” regardless of Petitioner’s explanation that such expense “does not connote unreasonableness considering
the grave economic situation taking place after the Aquino assassination characterized by capital fight, strong
deterioration of the purchasing power of the Philippine peso and the slacking demand for consumer products” (Petitioner’s
Memorandum, CTA Records, p. 273). We are not convinced with such an explanation. The staggering expense led us to
believe that such expenditure was incurred “to create or maintain some form of good will for the t axpayer’s trade or
business or for the industry or profession of which the taxpayer is a member.” The term “good will” can hardly be said to
have any precise signification; it is generally used to denote the benefit arising from connection and reputation (Words
and Phrases, Vol. 18, p. 556 citing Douhart vs. Loagan, 86 III. App. 294). As held in the case of Welchvs. Helvering, efforts to
establish reputation are akin to acquisition of capital assets and, therefore, expenses related thereto are not busi ness
expenses but capital expenditures. (Atlas Mining and Development Corp. vs. Commissioner of Internal Revenue, supra). For
sure such expenditure was meant not only to generate present sales but more for future and prospective benefits. Hence,
“abnormally large expenditures for advertising are usuallyto be spread over the period of years during which the benefits of

11. the expenditures are received” (Mertens,supra,citing Colonial Ice Cream Co., 7 BTA 154).
WHEREFORE, in all the foregoing, and finding no error in the case appealed from, we hereby RESOLVE to DISMISS the instant
petition for lack of merit and ORDER the Petitioner to pay the respondent Commissioner the assessed amount of
P2,635,141.42 representing its deficiencyincome tax liabilityfor the fiscal year ended February 28, 1985.”[3]
Aggrieved, respondent corporation filed a petition for review at the Court of Appeals which rendered a decision
reversing andsetting aside the decisionof the Court of Tax Appeals:
Since it has not been sufficiently established that the item it claimed as a deduction is excessive, the same should be
allowed.
WHEREFORE, the petition of petitioner General Foods (Philippines), Inc. is hereby GRANTED. Accordingly, the Decision,
dated 8 February 1994 of respondent Court of Tax Appeals is REVERSED and SET ASIDE and the letter, dated 31 May 1988 of
respondent Commissioner of Internal Revenue is CANCELLED.
SO ORDERED.[4]
Thus, the instant petition, wherein the Commissioner presents for the Court’s consideration a lone issue: whether or not
the subject media advertising expense for “Tang” incurred by respondent corporation was an ordinary and necessary
expense fullydeductible under the National Internal Revenue Code (NIRC).
It is a governing principle in taxation that tax exemptions must be construed in strictissimi juris against the taxpayer
and liberally in favor of the taxing authority;[5] and he who claims an exemption must be able to justify his claim by the
clearest grant of organic or statute law. An exemption from the common burden cannot be permitted to exist upon vague
implications.[6]
Deductions for income tax purposes partake of the nature of tax exemptions; hence, if tax exemptions are strictly
construed,then deductions must also be strictlyconstrued.
We then proceedto resolve the singular issue in the case at bar. Was the media advertising expense for “Tang” paid
or incurred by respondent corporation for the fiscal year ending February 28, 1985 “necessary and ordinary,” hence, fully
deductible under the NIRC? Or was it a capital expenditure, paid in order to create “goodwill and reputation” for
respondent corporationand/or its products,which should have been amortizedover a reasonable period?
Section34 (A)(1), formerlySection29 (a) (1) (A), of the NIRC provides:
(A) Expenses.-
(1) Ordinary and necessary trade,business or professional expenses.-
(a) In general.- There shall be allowed as deduction from gross income all ordinary and necessary
expenses paid or incurred during the taxable year in carrying on, or which are directly
attributable to, the development, management, operation and/or conduct of the trade,
business or exercise of a profession.
Simply put, to be deductible from gross income, the subject advertising expense must comply with the following
requisites: (a) the expense must be ordinary and necessary; (b) it must have been paid or incurred during the taxable year;
(c) it must have been paid or incurred in carrying on the trade or business of the taxpayer; and (d) it must be supported by
receipts,records or other pertinent papers.[7]
The parties are in agreement that the subject advertising expense was paid or incurred within the corresponding
taxable year and was incurred in carrying on a trade or business. Hence, it was necessary. However, their views conflict as
to whether or not it was ordinary. To be deductible, an advertising expense should not only be necessary but also
ordinary. These two requirements must be met.
The Commissioner maintains that the subject advertising expense was not ordinary on the ground that it failed the
two conditions set by U.S. jurisprudence: first, “reasonableness” of the amount incurred and second, the amount incurred
must not be a capital outlay to create “goodwill” for the product and/or private respondent’s business. Otherwise, the
expense must be considereda capital expenditure to be spread out over a reasonable time.
We agree.

12. There is yet to be a clear-cut criteria or fixed test for determining the reasonableness of an advertising expense. There
being no hard and fast rule on the matter, the right to a deduction depends on a number of factors such as but not limited
to: the type and size of business in which the taxpayer is engaged; the volume and amount of its net earnings;the nat ure of
the expenditure itself; the intention of the taxpayer and the general economic conditions. It is the interplay of these, among
other factors and properly weighed, that will yielda proper evaluation.
In the case at bar, the P9,461,246 claimed as media advertising expense for “Tang” alone was almost one-half of its
total claim for “marketing expenses.” Aside from that, respondent-corporation also claimed P2,678,328 as “other advertising
and promotions expense” and another P1,548,614,for consumer promotion.
Furthermore, the subject P9,461,246 media advertising expense for “Tang” was almost double the amount of
respondent corporation’s P4,640,636 general and administrative expenses.
We find the subject expense for the advertisement of a single product to be inordinately large. Therefore, even if it is
necessary, it cannot be consideredan ordinary expense deductible under then Section29 (a)(1) (A) of the NIRC.
Advertising is generally of two kinds: (1) advertising to stimulate the current sale of merchandise or use of services and
(2) advertising designed to stimulate the future sale of merchandise or use of services. The second type involves
expenditures incurred, in whole or in part,to create or maintain some form of goodwill for the taxpayer’s trade or business or
for the industry or profession of which the taxpayer is a member. If the expenditures are for the advertising of the first kind,
then, except as to the question of the reasonableness of amount, there is no doubt such expenditures are deductible as
business expenses. If, however, the expenditures are for advertising of the second kind, then normally they should be
spread out over a reasonable periodof time.
We agree with the Court of Tax Appeals that the subject advertising expense was of the second kind. Not only was
the amount staggering; the respondent corporation itself also admitted, in its letter protest[8] to the Commissioner of
Internal Revenue’s assessment, that the subject media expense was incurred in order to protect respondent corporation’s
brand franchise,a critical point during the periodunder review.
The protection of brand franchise is analogous to the maintenance of goodwill or title to one’s property. This is a
capital expenditure whichshould be spread out over a reasonable period of time.[9]
Respondent corporation’s venture to protect its brand franchise was tantamount to efforts to establish a reputation.
This was akin to the acquisition of capital assets and therefore expenses related thereto were not to be consi dered as
business expenses but as capital expenditures.[10]
True, it is the taxpayer’s prerogative to determine the amount of advertising expenses it will incur and where to apply
them.[11] Said prerogative, however, is subject to certain considerations. The first relates to the extent to which the
expenditures are actually capital outlays; this necessitates an inquiry into the nature or purpose of such expenditures.[12]
The second, which must be applied in harmony with the first, relates to whether the expenditures are ordinary and
necessary. Concomitantly, for an expense to be considered ordinary, it must be reasonable in amount. The Court of Tax
Appeals ruledthat respondent corporationfailedto meet the two foregoing limitations.
We find said ruling to be well founded. Respondent corporation incurred the subject advertising expense in order to
protect its brand franchise. We consider this as a capital outlay since it created goodwill for its business and/or
product. The P9,461,246 media advertising expense for the promotion of a single product, almost one-half of petitioner
corporation’s entire claim for marketing expenses for that year under review, inclusive of other advertising and promotion
expenses of P2,678,328 and P1,548,614 for consumer promotion, is doubtlesslyunreasonable.
It has been a long standing policy and practice of the Court to respect the conclusions of quasi -judicial agencies
such as the Court of Tax Appeals, a highly specialized body specifically created for the purpose of reviewing tax cases. The
CTA, by the nature of its functions, is dedicated exclusively to the study and consideration of tax problems. It has
necessarily developed an expertise on the subject. We extend due consideration to its opinion unless there is an abuse or
improvident exercise of authority.[13] Since there is none in the case at bar, the Court adheres to the findings of the CTA.
Accordingly, we find that the Court of Appeals committed reversible error when it declared the subject media
advertising expense to be deductible as an ordinary and necessary expense on the ground that “it has not been
established that the item being claimed as deduction is excessive.” It is not incumbent upon the taxing authority to prove
that the amount of items being claimed is unreasonable. The burden of proof to establish the validity of claimed deductions
is on the taxpayer.[14] Inthe present case, that burden was not discharged satisfactorily.
WHEREFORE, premises considered, the instant petition is GRANTED. The assailed decision of the Court of Appeals is
hereby REVERSED and SET ASIDE. Pursuant to Sections 248 and 249 of the Tax Code, respondent General Foods (Phils.), Inc.
is hereby ordered to pay its deficiency income tax in the amount of P2,635,141.42, plus 25% surcharge for late payment and
20% annual interest computedfromAugust 25, 1989, the date of the denial of its protest,until the same is fully paid.

13. SO ORDERED.
CIR v ISABELA CULTURAL CORPORATION
FACTS:
ICC was assessed for deficiency income tax [ BIR disallowed expense deductions for professional and security services by 1)
auditing services by SGV & Co. 2) legal services Bengzon law office 3) El Tigre Security services] and deficiency expanded
withholding tax, when it failed to withhold 1% expanded withholding tax. The CTA cancelled and set aside the assessment
notices holding that the claimed deductions for professional and security services were properly claimed in 1986 since it was
only in that year when the bills demanding payment were sent to ICC. It also found that the ICC withheld 1% expanded
withholding tax for securityservices.The CA affirmedhence the case at bar.
ISSUE: W/N the aforementionedmay be deducted
HELD: for the auditing and legal services NObut for the securityservices YES
The requisites for 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 supportedby receipts,records and other pertinent papers.
The requisite that it must have been paid or incurred during the taxable year is qualified by Sec. 45 of NIRC which states that
“the deduction provide for in this title shall be taken for the taxable year in which ‘paid or incurred’ dependent upon the
method of accounting upon the basis of which the net income is computed x x x”.
ICC uses the accrual method. RAM No. 1-2000 provides that under the accrual method, expenses not claimed as
deductions in the current year when they are incurred CANNOT be claimed as deduction from income for the succeeding
year. The accrual method relies upon the taxpayer’s right to receive amount or its obligation to pay them NOT the actual
receipt or payment. Amounts of income accrue where the right to receive them become fixed, where there is created an
enforceable liability.Liabilities are accruedwhen fixedand determinable in amount.
The accrual of income and expense is permitted when the ALL-EVENTS TEST has been met. The test requires that: 1) fixing of
a right to income or liability to pay and 2) the availability of the reasonable accurate determi nation of such income or
liability. It does not require that the amount be absolutely known only that the taxpayer has information necessary to
compute the amount with reasonable accuracy. The test is satisfied where computation remains uncertain if its basis is
unchangeable. The amount of liability does not have to be determined exactly, it must be determined with reasonable
accuracy.
In the case at bar, the expenses for legal services pertain to the years 1984 and 1985. The firm has been retained since 1960.
From the nature of the claimed deduction 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 compensation for its services. Exercising due
diligence, they could have inquired into the amount of their obligation. It could have reasonably determined the amount of
legal and retainer fees owing to their familiaritywiththe rates charged.
The professional fees of SGV cannot be validly claimed as deductions in 1986. ICC failed to present evidence showing that
evenwithonly reasonable accuracy, it cannot determine the professional fees which the company would charge.
CIR v CTA AND SMITH&FRENCH OVERSEAS
Facts:
Smith Kline & French Overseas Company is a multinational firm domiciled in Philadelphia, licensed to do business in the
Philippines. It is engaged in the importation,manufacture,and sale of pharmaceutical drugs and chemicals.
In 1971, it declared a net taxable income of P1.4 M and paid P511k as tax due. It claimed its share of the head office
overhead expenses (P501k) as deduction from gross income. In its amended return, it claimed that there was an
overpayment of tax (P324k) arising from under-deduction of the overhead expense. This was certified by international
independent auditors, the allocation of the overhead expense made on the basis of the percentage of gross income in the
Philippines to gross income of the corporationas a whole.
In 1974, without waiting for the action of the CIR, Smith filed a petition for review with the CTA. CTA ordered CIR to refund
the overpayment or grant Smitha tax credit. CIR appealed to the SC.
Issue: Whether Smithis entitledto a refund – YES
Ratio:
The governing law is found in Sec. 37 (b).1 Revenue Regulation No. 2 of the DOF contains a similar provision, with the
additional line that “the ratable part is based upon the ratio of gross income from sources within the Philippines to the tot al
1Net income from sources in the Philippines. – From the items of gross income specified in subsection (a) of this section there shall
be deducted expenses, losses, and other deductions properly apportioned or allocated thereto and a ratable part of any expenses,

14. gross income” (Sec. 160). Hence, where an expense is clearly related to the production of Philippine-derived income or to
Philippine operations, that expense can be deducted from the gross income acquired in the Philippines without resorting to
apportionment.
However, the overhead expenses incurred by the parent company in connection with finance, administration, and
research & development, all of which directly benefit its branches all over the world, fall under a different category. Thes e
are items which cannot be definitely allocated or identified with the operations of the Philippine branch. Smith can claim
as its deductible share a ratable part of such expenses based upon the ration of the local branch’s gross income to the
total gross income of the corporationworldwide.
CIR’s Contention
The CIR does not dispute the right of Smith to avail of Sec. 37 (b) of the Tax Code and Sec. 160 of the RR. But he maintains
that such right is not absolute and that there exists a contract (service agreement) which Smith has entered into with its
home office, prescribing the amount that a branch can deduct as its share of the main office’s overhead expenses. Since
the share of the Philippine branch has been fixed, Smithcannot claim more than the said amount.
Smith’s Contention
Smith, on the other hand, submits that the contract between itself and its home office cannot amend tax laws and
regulations. The matter of allocated expenses deductible under the law cannot be the subject of an agreement between
private parties nor canthe CIR acquiesce in such an agreement.
SC ruled for SmithKline and said that its amended return conforms withthe law and regulations.
Gutierrez vs.CIR
Facts:
Lino Gutierrez was primarilyengaged in the business of leasing real propertyfor which he paid real estate broker’s privilege
tax. The Collector assessedagainst Gutierrez deficiencyincome tax amounting to P11,841.
The deficiencytax came about by the disallowance of deductions from gross income representing depreciationexpenses
Gutierrez allegedlyincurredin carrying on his business. The expenses consistedof:
1. Transportationexpenses incurredto attendthe funeral of his friends,
2. Procurement and installationof an irondoor,
3. Cost of furniture givenby the taxpayer in furtherance of a business transaction,
4. Membership fees in organizations establishedby those engaged in the real estate trade,
5. Car expenses, salary of his driver andcar depreciation,
6. Repairing taxpayer’s rental apartments,
7. Litigationexpenses,
8. Depreciationof Gutierrez’residence,
9. Fines and penalties for late payment of taxes,
10. Alms givento in indigent family and a donation consisting of officer’s jewels and aprons to Biak-na-Bato Lodge No. 7.
Issue:
Whether or not claims for deduction are proper and allowable.
Held:
To be deductible,an expense must be:
· Ordinary and necessary
· Paid or incurred withinthe taxable year
· Paid or incurred in carrying on a trade or business.
1. Transportationexpenses which petitioner incurredto attendthe funeral of his friends and the cost of admission tickets to
operas - expenses relative to his personal and social activities rather thanto his business of leasing real estate.
2. Procurement and installationof an irondoor to - purely a personal expense. Personal,living,or family expenses are not
deductible.
3. Cost of furniture givenby the taxpayer as commissionin furtherance of a business transaction - the expenses incurredin
attending the National Conventionof Filipino Businessmen,luncheon meeting and cruise to Corregidor of the Homeowners'
Associationwere shownto have been made in the pursuit of his business. Commissions givenin considerationfor bringing
about a profitable transactionare part of the cost of the business transactionand are deductible.
losses, or other deductions which cannot definitely be allocated to some item or class of gross income. The remainder, if any, shall
be included in full as netincome from sources within the Philippines.

15. 4. Membership and activities inconnectiontherewithwere solelyto enhance his business -Gutierrez was an officer of the
Junior Chamber of Commerce which sponsoredthe National Conventionof Filipino Businessmen.He was also the president
of the Homeowners' Association,an organizationestablishedby those engaged in the real estate trade.Having proved
that his, the expenses incurredare deductible as ordinary and necessary business expenses.
5. Car expenses, salary of his driver and car depreciation – 1/3 of the same was disallowedby the Commissioner on the
ground that the taxpayer used his car and driver bothfor personal and business purposes.There is no clear showing,
however,that the car was devoted more for the taxpayer's business than for his personal and business needs. According to
the evidence,the taxpayer's car was utilizedbothfor personal and business needs. It is reasonable to allow as deduction
1/2 of the driver's salary,car expenses and depreciation.
6. Those used to repair the taxpayer's rental apartments - did not increase the value of such apartments,or prolong their life.
They merely kept the apartments inan ordinary operating condition.Hence, the expenses incurred are deductible as
necessary expenditures for the maintenance of the taxpayer's business.
7. Litigationexpenses - defrayed by Gutierrez to collect apartment rentals andto eject delinquent tenants are ordinary and
necessary expenses in pursuing his business. It is routinaryand necessary for one in the leasing business to collect rentals and
to eject tenants who refuse to pay their accounts.
8. Depreciationof Gutierrez'residence - not deductible.A taxpayer may deduct from gross income a reasonable
allowance for deteriorationof propertyarising out of its use or employment in business or trade. Gutierrez'residence was not
used in his trade or business.
9. Deductionthe fines and penalties whichhe paid for late payment of taxes - while Section30 allows taxes to be deducted
from gross income, it does not specificallyallow fines and penalties to be so deducted.
Deductions fromgross income are matters of legislative grace;what is not expresslygranted by Congress is withheld.
Moreover,when acts are condemned, by law and their commissionis made punishable by fines or forfeitures,to allow them
to be deductedfrom the wrongdoer's gross income, reduces,and so in part defeats,the prescribedpunishment.
10. Alms to an indigent family and various individuals, contributions to Lydia Yamson and G. Trinidad and a donation
consisting of officers' jewels and aprons to Biak-na-Bato Lodge No. 7 - not deductible from gross income inasmuch as their
recipients have not been shown to be among those specified by law. Contributions are deductible when given to the
Government of the Philippines, or any of its political subdivisions for exclusively public purposes, to domestic corporations or
associations organized and operated exclusively for religious, charitable, scientific, athletic, cultural or educational
purposes, or for the rehabilitation of veterans, or to societies for the prevention of cruelty to children or animals, no par t of
the net income of which inures to the benefit of any private stockholder or individual.
Gancayco vs.CIR
Petitioner Santiago Gancayco seeks the review of a decision of the Court of Tax Appeals, requiring him to pay P16,860.31,
plus surcharge and interest,by way of deficiencyincome tax for the year 1949.
On May 10, 1950, Gancayco filed his income tax return for the year 1949. Two (2) days later, respondent Collector of Internal
Revenue issued the corresponding notice advising him that his income tax liability for that year amounted P9,793.62, which
he paid on May 15, 1950. A year later, on May 14, 1951, respondent wrote the communication Exhibit C, notifying
Gancayco, inter alia, that, upon investigation, there was still due from him, a efficiency income tax for the year 1949, the
sum of P29,554.05. Gancayco sought a reconsideration, which was part granted by respondent, who in a letter dated April
8, 1953 (Exhibit D), informed petitioner that his income tax defendant efficiency for 1949 amounted to P16,860.31.
Gancayco urged another reconsideration (Exhibit O), but no action taken on this request, although he had sent several
communications calling respondent's attentionthereto.
On April 15, 1956, respondent issued a warrant of distraint and levy against the properties of Gancayco for the satisfaction
of his deficiency income tax liability, and accordingly, the municipal treasurer of Catanauan, Quezon issued on May 29,
1956, a notice of sale of said property at public auction on June 19, 1956. Upon petition of Gancayco filed on June 16,
1956, the Court of Tax Appeal issued a resolution ordering the cancellation of the sale and directing that the same be
readvertised at a future date, in accordance with the procedure established by the National Internal Revenue Code.
Subsequently,or on June 22, 1956,Gancayco filedan amended petitionpraying that said Court:
(a) Issue a writ of preliminary injunction, enjoining the respondents from enforcing the collection of the alleged tax liability
due fromthe petitioner throughsummary proceeding pending determinationof the present case;
(b) After a review of the present case adjudge that the right of the government to enforce collection of any liability due on
this account had already prescribed;

16. (c) That even assuming that prescription had not set in the objections of petitioner to the disallowance of the
entertainment,representationand farming expenses be allowed;
In his answer respondent admitted some allegations the amended petition, denied other allegations thereof an set up
some special defenses. Thereafter Gancayco received from the municipal treasurer of Catanauan, Quezon, another notice
of auction sale of his properties, to take place on August 29, 1956. On motion of Gancayco, the Court of Tax Appeals, by
resolution dated August 27, 1956, "cancelled" the aforementioned sale and enjoined respondent and the municipal
treasurer of Catanauan, Quezon, from proceeding with the same. After appropriate proceedings, the Court of Tax Appeals
rendered, on November 14,1957,the decisionadvertedto above.
Gancayco maintains that the right to collect the deficiency income tax in question is barred by the statute of limitations. In
this connection, it should be noted, however, that there are two (2) civil remedies for the collection of internal revenue
taxes, namely: (a) by distraint of personal property and levy upon real property; and (b) by "judicial action"
(Commonwealth Act 456, section 316). The first may not be availed of except within three (3) years after the "return is due or
has been made ..." (Tax Code, section 51 [d] ). After the expiration of said Period, income taxes may not be legally and
validly collected by distraint and/or levy (Collector of Internal Revenue v. Avelino, L-9202, November 19, 1956; Collector of
Internal Revenue v. Reyes, L-8685, January 31, 1957; Collector of Internal Revenue v. Zulueta, L-8840, February 8, 1957;
Sambrano v. Court of Tax Appeals, L-8652, March 30, 1957). Gancayco's income tax return for 1949 was filed on May 10,
1950; so that the warrant of distraint and levy issued on May 15, 1956, long after the expiration of said three-year period, was
illegal and void,and so was the attempt to sell his properties inpursuance of said warrant.
The "judicial action" mentioned in the Tax Code may be resorted to within five (5) years from the date the return has been
filed, if there has been no assessment, or within five (5) years from the date of the assessment made within the statutory
period, or within the period agreed upon, in writing, by the Collector of Internal Revenue and the taxpayer. before the
expiration of said five-year period, or within such extension of said stipulated period as may have been agreed upon, in
writing, made before the expiration of the period previously situated, except that in the case of a false or fraudulent retur n
with intent to evade tax or of a failure to file a return, the judicial action may be begun at any time within ten (10) years
after the discovery of the falsity, fraud or omission (Sections 331 and 332 of the Tax Code). In the case at bar, respondent
made three (3) assessments: (a) the original assessment of P9,793.62, made on May 12, 1950; (b) the first deficiency income
tax assessment of May 14, 1951, for P29,554.05; and (c) the amended deficiency income tax assessment of April 8, 1953, for
P16,860.31.
Gancayco argues that the five-year period for the judicial action should be counted from May 12, 1950, the date of the
original assessment, because the income tax for 1949, he says, could have been collected from him since then. Said
assessment was, however, not for the deficiency income tax involved in this proceedings, but for P9,793.62, which he paid
forthwith. Hence, there never had been any cause for a judicial action against him, and, per force, no statute of limitations
to speak of, in connectionwithsaid sum of P9,793.62.
Neither could said statute have begun to run from May 14, 1951, the date of the first deficiency income tax assessment or
P29,554.05, because the same was, upon Gancayco's request, reconsidered or modified by the assessment made on April
8, 1953, for P16,860.31. Indeed, this last assessment is what Gancayco contested in the amended petition filed by him with
the Court of Tax Appeals. The amount involved in such assessment which Gancayco refused to pay and respondent tried to
collect by warrant of distraint and/or levy, is the one in issue between the parties. Hence, the five-year period
aforementioned should be counted from April 8, 1953, so that the statute of limitations does not bar the present
proceedings, instituted on April 12, 1956, if the same is a judicial action, as contemplated in section 316 of the Tax Code,
which petitioner denies,upon the ground that
a. "The Court of Tax Appeals does not have original jurisdictionto entertainanactionfor the collectionof the tax due;
b. "The proper party to commence the judicial actionto collect the tax due is the government,and
c. "The remedies providedby law for the collectionof the tax are exclusive."
SaidSection316 provides:
The civil remedies for the collection of internal revenue taxes, fees, or charges, and any increment thereto resulting from
delinquency shall be (a) by distraint of goods, chattels, or effects, and other personal property of whatever character,
including stocks and other securities, debts, credits, bank accounts, and interest in and rights to personal property, and by
levy upon real property; and (b) by judicial action. Either of these remedies or both simultaneously may be pursued in the
discretionof the authorities chargedwiththe collectionof such taxes.
No exemptionshall be allowed against the internal revenue taxes inany case.

17. Petitioner contends that the judicial action referred to in this provision is commenced by filing, with a court of first inst ance,
of a complaint for the collection of taxes. This was true at the time of the approval of Commonwealth Act No. 456, on June
15, 1939. However, Republic Act No. 1125 has vested the Court of Tax Appeals, not only with exclusive appellate jurisdiction
to review decisions of the Collector (now Commissioner) of Internal Revenue in cases involving disputed assessments, like
the one at bar, but, also, with authority to decide "all cases involving disputed assessments of Internal Revenue taxes or
customs duties pending determination before the court of first instance" at the time of the approval of said Act, on June 16,
1954 (Section 22, Republic Act No. 1125). Moreover, this jurisdiction to decide all cases involving disputed assessments of
internal revenue taxes and customs duties necessarily implies the power to authorize and sanction the collection of the
taxes and duties involved in such assessments as may be upheld by the Court of Tax Appeals. At any rate, the same now
has the authority formerly vested in courts of first instance to hear and decide cases involving disputed assessments of
internal revenue taxes and customs duties. Inasmuch as those cases filed with courts of first instance constituted judicial
actions, such is, likewise, the nature of the proceedings before the Court of Tax Appeals, insofar as sections 316 and 332 of
the Tax Code are concerned.
The question whether the sum of P16,860.31 is due from Gancayco as deficiency income tax for 1949 hinges on the validity
of his claim for deduction of two (2) items, namely: (a) for farming expenses, P27,459.00; and (b) for representation
expenses, P8,933.45.
Section30 of the Tax Code partlyreads:
(a) Expenses:
(1) In General — All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade
or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered;
traveling expenses while away from home in the pursuit of a trade or business; and rentals or other payments required to be
made as a condition to the continued use or possession, for the purposes of the trade or business, of property to which the
taxpayer has not takenor is not taking title or in which he has no equity. (Emphasis supplied.)
Referring to the item of P27,459, for farming expenses allegedly incurred by Gancayco, the decision appealed from has the
following to say:
No evidence has been presented as to the nature of the said "farming expenses" other than the bare statement of
petitioner that they were spent for the "development and cultivation of (his) property". No specification has been made as
to the actual amount spent for purchase of tools, equipment or materials, or the amount spent for improvement.
Respondent claims that the entire amount was spent exclusively for clearing and developing the farm which were
necessary to place it in a productive state. It is not, therefore, an ordinary expense but a capitol expenditure. Accordingly, it
is not deductible but it may be amortized, in accordance with section 75 of Revenue Regulations No. 2, cited above. See
also, section 31 of the Revenue Code which provides that in computing net income, no deduction shall in any case be
allowed in respect of any amount paid out for new buildings or for permanent improvements, or betterments made to
increase the value of any propertyor estate.(Emphasis supplied.)
We concur in this view,whichis a necessary consequence of section31 of the Tax Code, pursuant to which:
(a) General Rule — In computing net income no deduction shall in any case be allowed in respect of —
(1) Personal,living,or family expenses;
(2) Any amount paid out for new buildings or for permanent improvements, or betterments made to increase the value of
any propertyor estate;
(3) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has
been made; or
(4) Premiums paid on any life insurance policy covering the life of any officer or employee, or any person financially
interested in any trade or business carried on by the taxpayer, individual or corporate, when the taxpayer is directly or
indirectlya beneficiaryunder such policy. (Emphasis supplied.)
Saidview is,likewise,inaccord withthe consensus of the authorities onthe subject.
Expenses incident to the acquisition of property follow the same rule as applied to payments made as direct consideration
for the property. For example, commission paid in acquiring property are considered as representing part of the cost of the

18. property acquired. The same treatment is to be accorded to amounts expended for maps, abstracts, legal opinions on
titles, recording fees and surveys. Other non-deductible expenses include amounts paid in connection with geological
explorations, development and subdividing of real estate; clearing and grading; restoration of soil, drilling wells, architects's
fees and similar types of expenditures. (4 Merten's Law of Federal Income Taxation, Sec. 25.20, pp. 348-349; see also sec. 75
of the income Regulationof the B.I.R.; Emphasis supplied.)
The cost of farm machinery, equipment and farm building represents a capital investment and is not an allowable
deduction as an item of expense. Amounts expended in the development of farms, orchards, and ranches prior to the time
when the productive state is reached may be regarded as investments of capital. (Merten's Law of Federal Income
Taxation, supra, sec. 25.108,p. 525.)
Expenses for clearing off and grading lots acquired is a capital expenditure, representing part of the cost of the land and
was not deductible as an expense. (Liberty Banking Co. v. Heiner 37 F [2d] 703 [8AFTR 100111] [CCA 3rd]; The B.L. Marble
Chair Company v.U.S., 15 AFTR 746).
An item of expenditure, in order to be deductible under this section of the st atute providing for the deduction of ordinary
and necessary business expenses, must fall squarely within the language of the statutory provision. This section is intended
primarily, although not always necessarily, to cover expenditures of a recurring nature where the benefit derived from the
payment is realized and exhausted within the taxable year. Accordingly, if the result of the expenditure is the acquisition of
an asset which has an economically useful life beyond the taxable year, no deduction of such payment may be obtained
under the provisions of the statute. In such cases, to the extent that a deduction is allowable, it must be obtained under the
provisions of the statute which permit deductions for amortization, depreciation, depletion or loss. (W .B. Harbeson Co. 24
BTA, 542; Clark Thread Co., 28 BTA 1128 aff'd 100 F [2d] 257 [CCA 3rd, 1938]; 4 Merten's Law of Federal Income Taxation, Sec.
25.17, pp. 337-338.)
Gancayco's claim for representation expenses aggregated P31,753.97, of which P22,820.52 was allowed, and P8,933.45
disallowed. Such disallowance is justified by the record, for, apart from the absence of receipts, invoices or vouchers of the
expenditures in question, petitioner could not specify the items constituting the same, or when or on w hom or on what they
were incurred. The case of Cohan v. Commissioner, 39 F (2d) 540, cited by petitioner is not in point, because in that case
there was evidence on the amounts spent and the persons entertained and the necessity of entertaining them, although
there were no receipts anvouchers of the expenditures involvedtherein.Suchis not the case of petitioner herein.
Being in accordance with the facts and law, the decision of the Court of Tax Appeals is hereby affirmed therefore, with
costs against petitioner Santiago Cancayco. It is so ordered.
Padilla, Bautista Angelo, Labrador, Reyes, J.B.L., Barrera and Dizon, JJ., concur.
3M PHILIPPINESv CIR
Facts:
3M Philippines, Inc. is a subsidiary of the Minnesota Mining and Manufacturing Company (or "3M-St. Paul") a non-resident
foreign corporation with principal office in St. Paul, Minnesota, U.S.A. It is the exclusive importer, manufacturer, wholesal er,
and distributor in the Philippines of all products of 3M-St. Paul. To enable it to manufacture, package, promote, market, sell
and install the highly specialized products of its parent company, and render the necessary post -sales service and
maintenance to its customers, 3M Phils. entered into a "Service Information and Technical Assistance Agreement" and a
"Patent and Trademark License Agreement" with the latter under which the 3m Phils. agreed to pay to 3M-St. Paul a
technical service fee of 3% and a royalty of 2% of its net sales. Both agreements were submitted to, and approved by, the
Central Bank of the Philippines.the petitioner claimedthe following deductions as business expenses:
(a) royalties and technical service fees of P 3,050,646.00;and
(b) pre-operational cost of tape coater of P97,485.08.
As to (a), the Commissioner of Internal Revenue allowed a deduction of P797,046.09 only as technical service fee and
royalty for locally manufactured products, but disallowed the sum of P2,323,599.02 alleged to have been paid by the
petitioner to 3M-St. Paul as technical service fee and royalty on P46,471,998.00 worth of finished products imported by the
petitioner from the parent company, on the ground that the fee and royalty should be based only on locally manufactured
goods. While as to (b), the CIR only allowed P19,544.77 or one-fifth (1/5) of 3M Phils.capital expenditure of P97,046.09 for its
tape coater which was installed in 1973 because such expenditure should be amortized for a period of five (5) years,
hence, payment of the disallowed balance of P77,740.38 should be spread over the next four (4) years. The CIR ordered 3M
Phil. to pay P840,540 as deficiency income tax on its 1974 return, plus P353,026.80 as 14% interest per annum from February
15, 1975 to February 15, 1976, or a total of P1,193,566.80.
3M Phils. protested the CIR’s assessment but it did not answer the protest, instead issuing a warrant of levy. The CTA affirmed
the assessment onappeal.
Issue:
Whether or not 3M Phils is entitledto the deductions due to royalties?

19. Ruling:
No. CB Circular No. 393 (Regulations Governing Royalties/Rentals) dated December 7, 1973 was promulgated by the
Central Bank as an exchange control regulation to conserve foreign exchange and avoid unnecessary drain on the
country's international reserves (69 O.G. No. 51, pp. 11737-38). Section 3-C of the circular provides that royalties shall be paid
only on commodities manufacturedby the licensee under the royaltyagreement:
Section 3. Requirements for Approval and Registration. — The requirements for approval and registration as provided for in
Section2 above include,but are not limitedto the following:
a. xxx xxx xxx
b. xxx xxx xxx
c. The royalty/rental contracts involving manufacturing' royalty, e.g., actual transfers of technological services such as
secret formula/processes, technical know how and the like shall not exceed five (5) per cent of the wholesale price of the
commodity/ties manufactured under the royalty agreement. For contracts involving 'marketing' services such as the use of
foreign brands or trade names or trademarks, the royalty/rental rate shall not exceed two (2) per cent of the wholesale
price of the commodity/ties manufactured under the royalty agreement. The producer's or foreign licensor's share in the
proceeds fromthe distribution/exhibition of the films shall not exceed sixty (60) per cent of the net proceeds (gross proceeds
less local expenses) fromthe exhibition/distributionof the films.... (Emphasis supplied.) (p. 27, Rollo.)
Clearly, no royalty is payable on the wholesale price of finished products imported by the licensee from the licensor.
However,petitioner argues that the law applicable to its case is only Section29(a)(1)of the Tax Code which provides:
(a) Expenses. — (1) Business expenses. — (A) In general. — All ordinary and necessary expenses paid or incurred during the
taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for
personal services actually rendered; travelling expenses while away from home in the pursuit of a trade, profession or
business, rentals or other payments required to be made as a condition to the continued use or possession, for the purpose
of the trade, profession or business, for property to which the taxpayer has not taken or is not taking title or in which he has
no equity.
Petitioner points out that the Central bank "has no say in the assessment and collection of internal revenue taxes as such
power is lodged in the Bureau of Internal Revenue," that the Tax Code "never mentions Circular 393 and there is no law or
regulationgoverning deductionof business expenses that refers to saidcircular." (p. 9, Petition.)
The argument is specious, for, although the Tax Code allows payments of royalty to be deducted from gross income as
business expenses, it is CB Circular No. 393 that defines what royalty payments are proper. Hence, improper payments of
royaltyare not deductible as legitimate business expenses.
Palanca vs. CIR
This is an appeal by the Government from the decision of the Court of Tax Appeals in CTA Case No. 571 ordering the
petitioner to refund to the respondent the amount of P20,624.01 representing alleged over-payment of income taxes for the
calendar year 1955.The facts are:
Sometime in July, 1950, the late Don Carlos Palanca, Sr. donated in favor of his son, the petitioner, herein shares of stock in
La Tondeña, Inc. amounting to 12,500 shares. For failure to file a return on the donation within the statutory period, the
petitioner was assessed the sums of P97,691.23, P24,442.81 and P47,868.70 as gift tax, 25% surc harge and interest,
respectively,whichhe paid on June 22, 1955.
On March 1, 1956, the petitioner filed with the Bureau of Internal Revenue his income tax return for the calendar year 1955,
claiming, among others, a deduction for interest amounting to P9,706.45 and reporting a taxable income of P65,982.12. On
the basis of this return,he was assessedthe sum of P21,052.91,as income tax,which he paid, as follows:
Taxes withheldby La Tondeña Inc. from Mr. Palanca's wages P13,172.41
Payment under Income Tax Receipt No. 677395 datedMay 11, 1956 3,939.80
Payment under Income Tax Receipt datedAugust 14, 1956 3,939.80
P21,052.01
Subsequently, on November 10, 1956, the petitioner filed an amended return for the calendar year 1955, claiming therein
an additional deduction in the amount of P47,868.70 representing interest paid on the donee's gift tax, thereby reporting a
taxable net income of P18,113.42 and a tax due thereon in the sum of P3,167.00. The claim for deduction was based on the
provisions of Section 30(b) (1) of the Tax Code, which authorizes the deduction from gross income of interest paid within the
taxable year on indebtedness. A claim for the refund of alleged overpaid income taxes for the year 1955 amounting to
P17,885.01, which is the difference between the amount of P21,052.01 he paid as income taxes under his original return and
of P3,167.00, was filed together with this amended return. In a communication dated June 20, 1957, the respondent (BIR)
denied the claimfor refund.