Tax+digests+part+2.1 (1)

2D TAX 1 | ATTY. M. CABREROS | CHAP. 1 AND 2 CASE DIGESTS 1.

CIR v PROCTER & GAMBLE

FACTS Procter and Gamble Philippines is a wholly owned subsidiary of Procter and Gamble USA (PMC-USA), a non-resident foreign corporation in the Philippines, not engaged in trade and business therein. PMC-USA is the sole shareholder of PMC Philippines and is entitled to receive income from PMC Philippines in the form of dividends, if not rents or royalties. For the taxable years 1974 and 1975, PMC Philippines filed its income tax return and also declared dividends in favor of PMC-USA. In 1977, PMC Philippines, invoking the tax-sparing provision of Section 24 (b) as the withholding agent of the Philippine Government with respect to dividend taxes paid by PMC-USA, filed a claim for the refund of 20 percentage point portion of the 35 percentage whole tax paid with the Commissioner of Internal Revenue. ISSUE Whether PMC Philippines is entitled to the 15% preferential tax rate on dividends declared and remitted to its parent corporation. HELD The issue raised is one made for the first time before the Supreme Court. Under the same underlying principle of prior exhaustion of administrative remedies, on the judicial level, issues not raised in the lower court cannot be generally raised for the first time on appeal. Nonetheless, it is axiomatic that the state can never be allowed to jeopardize the government’s financial position. The submission of the Commissioner that PMC Philippines is but a withholding agent of the government and therefore cannot claim reimbursement of alleged overpaid taxes, is completely meritorious. The real party in interest is PMC-USA, which should prove that it is entitled under the US Tax Code to a US Foreign Tax Credit equivalent to at least 20 percentage points spared or waived as otherwise considered or deemed paid by the Government. Herein, the claimant failed to show or justify the tax return of the disputed 15% as it failed to show the actual amount credited by the US Government against the income tax due from PMC-USA on the dividends received from PMC Philippines; to present the income tax return of PMC-USA for 1975 when the dividends were received; and to submit duly authenticated document showing that the US government credited teh 20% tax deemed paid in the Philippines. 2.

MADRIGAL v RAFFERTY

FACTS In 1915, Vicente Madrigal filed a sworn declaration with the CIR showing a total net income for the year 1914 the sum of P296K. He claimed that the amount did not represent his own income for the year 1914, but the income of the conjugal partnership existing between him and his wife, Susana Paterno. He contended that since there exists such conjugal partnership, the income declared should be divided into 2 equal parts in computing and assessing the additional income tax provided by the Act of Congress of 1913. The Attorney-General of the Philippines opined in favor of Madrigal, but Rafferty, the US CIR, decided against Madrigal.

After his payment under protest, Madrigal instituted an action to recover the sum of P3,800 alleged to have been wrongfully and illegally assessed and collected, under the provisions of the Income Tax Law. However, this was opposed by Rafferty, contending that taxes imposed by the Income Tax Law are taxes upon income, not upon capital or property, and that the conjugal partnership has no bearing on income considered as income. The CFI ruled in favor of the defendants, Rafferty. ISSUE Whether Madrigal’s income should be divided into 2 equal parts in the assessment and computation of his tax HELD NO. Susana Paterno, wife of Vicente Madrigal, still has an inchoate right in the property of her husband during the life of the conjugal partnership. She has an interest in the ultimate property rights and in the ultimate ownership of property acquired as income after such income has become capital. Susana has no absolute right to onehalf the income of the conjugal partnership. Not being seized of a separate estate, she cannot make a separate return in order to receive the benefit of exemption, which could arise by reason of the additional tax. As she has no estate and income, actually and legally vested in her and entirely separate from her husband’s property, the income cannot be considered the separate income of the wife for purposes of additional tax. Income, as contrasted with capital and property, is to be the test. The essential difference between capital and income is that capital is a fund; income is a flow. A fund of property existing at an instant of time is called capital. A flow of services rendered by that capital by the payment of money from it or any other benefit rendered by a fund of capital in relation to such fund through a period of time is called income. Capital is wealth, while income is the service of wealth. A tax on income is not tax on property. 3.

EISNER v MACOMBER

FACTS Mrs. Macomber owned 2,200 shares in Standard Oil. Standard Oil declared a 50% stock dividend and she received 1,100 additional shares, of which about $20,000 in par value represented earnings accumulated by the company -- recapitalized rather than distributed -- since the effective date of the original tax law. The current statute expressly included stock dividends in income, and the government contended that those certificates should be taxed as income to Mrs. Macomber as though the corporation had distributed money to her. Mrs. Macomber sued Mr. Mark Eisner, the Collector of Internal Revenue, for a refund. Economic substance of a stock dividend The stock dividend in this case was the economic equivalent of a stock split -- a transaction in which the corporation multiplies the total number of shares outstanding, but gives the new shares to shareholders in proportion to the number they previously held. For example, if a corporation declares a "two for one" stock split (and distributes no money or other property to any stockholder), a stockholder who held 100 shares at By Nikki Hipolito

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2D TAX 1 | ATTY. M. CABREROS | CHAP. 1 AND 2 CASE DIGESTS $4 per share will now hold 200 shares with a value of $2 each, which is still $400 in value. Stock dividends vs. cash dividends A shareholder's assets do not grow after this sort of stock dividend. Metaphorically, the "pie" is still the same size—but it has been sliced into more pieces, each piece being proportionately smaller. Of course, the same is true of a cash dividend: the shareholder gains cash, but the corporation represented by his shares has also lost cash, so that these shares implicitly decline in value by an equal amount. A shareholder also makes no "sale or other disposition" of stock after this sort of stock dividend. The taxpayer still owns the same proportionate percentage of the corporation he or she owned prior to the stock dividend. Again, this is also true of a cash dividend. However, several important factors distinguish a stock and cash dividend. "Overall, the aim of the tax law is to impose a tax on "dividends" when assets representing corporate earnings are transferred to the shareholders. Stock dividends, however, merely give the shareholders additional pieces of paper to represent the same equitable interest; they do not transfer assets or create new priorities among the security-holders. The total value of the common shares, though now spread out over a larger number of units, is left unchanged from its previous level. In effect, nothing of substance has occurred." ISSUE Essentially, therefore, [i.e. in light of the fact that stock and cash dividends are economically equivalent,] the question in Macomber was not whether the shareholder had gain in an economic sense, but whether in legal or accounting terms the stock dividend was to be regarded as a taxable event. ... Stripped of its Constitutional element, the issue in Eisner v. Macomber in the end comes down to a "battle of similarities." Is a stock dividend (as the majority held) "more like" a situation in which a corporation simply accumulates its earnings and makes no distribution at all? Or is it (as Brandeis thought) "more like" the receipt of a cash dividend which is followed by a reinvestment of the cash received in additional shares? HELD In the majority opinion, Justice Mahlon Pitney ruled that this stock dividend was not a realization of income by the taxpayer-shareholder for purposes of the Sixteenth Amendment: 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 richer because of an increase of his capital, at the same time shows he has not realized or received any income in the transaction. The Court noted that in Towne v. Eisner, it had clearly stated that stock dividends were not income, as nothing of value was received by Towne - the company was not worth any less than it was when the dividend was declared, and the total value of Towne's stock had not changed. Although the Eisner v. Macomber Court acknowledged the power of the Federal

Government to tax income under the Sixteenth Amendment, the Court essentially said this did not give Congress the power to tax — as income — anything other than income, i.e., that Congress did not have the power to re-define the term income as it appeared in the Constitution: Throughout the argument of the Government, in a variety of forms, runs the fundamental error already mentioned—a failure to appraise correctly the force of the term "income" as used in the Sixteenth Amendment, or at least to give practical effect to it. Thus, the Government contends that the tax "is levied on income derived from corporate earnings," when in truth the stockholder has "derived" nothing except paper certificates which, so far as they have any effect, deny him [or "her" — in this case, Mrs. Macomber] present participation in such earnings. It [the government] contends that the tax may be laid when earnings "are received by the stockholder," whereas [s]he has received none; that the profits are "distributed by means of a stock dividend," although a stock dividend distributes no profits; that under the Act of 1916 "the tax is on the stockholder's share in corporate earnings," when in truth a stockholder has no such share, and receives none in a stock dividend; that "the profits are segregated from his [her] former capital, and [s]he has a separate certificate representing his [her] invested profits or gains," whereas there has been no segregation of profits, nor has [s]he any separate certificate representing a personal gain, since the certificates, new and old, are alike in what they represent—a capital interest in the entire concerns of the corporation. The Court ordered that Macomber be refunded the tax she overpaid. Dissents In the dissent, Justice Louis Brandeis took issue with the majority's interpretation of income. He argued the Sixteenth Amendment authorized Congress to tax “incomes, from whatever source derived”, and the authors of the amendment “intended to include thereby everything which by reasonable understanding can fairly be regarded as income”, and that “Congress possesses the power which it exercised to make dividends representing profits, taxable as income, whether the medium in which the dividend is paid be cash or stock, and that it may define, as it has done, what dividends representing profits shall be deemed income”. He noted that in business circles, cash dividends and stock dividends were treated identically. In effect, he argued that a stock dividend is really a cash dividend, since it is really two-step affair, consisting of 1. a cash distribution, 2. subsequently used to purchase additional shares through the exercise of stock subscription rights. Brandeis saw no reason why two essentially identical transactions should be treated differently for tax purposes. Justice Brandeis' effort to construct, or read in, a cash distribution was strained and unconvincing. The plain fact is that Mrs. Macomber did not receive, and could not have obtained, a cash payment from Standard Oil. Had she wished to substitute cash in an amount equivalent to the value of the stock dividend, she would have had to sell the dividend shares to other investors. No other cash source was made available.

By Nikki Hipolito

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2D TAX 1 | ATTY. M. CABREROS | CHAP. 1 AND 2 CASE DIGESTS 4.

RAYTHEON PRODUCTION CORP v CIR

FACTS Raytheon built up business good will on a rectifier tube that it developed, patented, and licensed to manufacturers. RCA licensed a competing tube to many of the same manufacturers, with a clause requiring the licensee to only buy from RCA. These antitrust practices caused a significant decline in Raytheon’s market share, eventually leading to the complete destruction of Raytheon’s business good will in this product market. RCA paid $410,000 to settle Raytheon's claims under the Federal Anti-Trust Laws, but in the same transaction also acquired rights to some 30 patents, and declined to state how much of its payment should be allocated between the patent license rights versus the settlement of the suit. In its tax return, Raytheon chose to allocate $60,000 of the settlement to the value of the patents, thus claiming only this amount as income and excluding the remaining $350,000 as damages. The Commissioner determined that the $350,000 constituted income. It did not immediately argue that any damage recovery for loss of good will is always taxable as income; rather, it protested that "[t]here exists no clear evidence of what the amount was paid for so that an accurate apportionment can be made." At trial, Raytheon gave evidence to support its valuation of the patents; it also assessed the value of its lost business good will (at $3,000,000) by introducing evidence of its profitability. ISSUES 1. Are damages for the destruction of business good will taxable income -- or a return of capital, of which any recovery of basis is non-taxable? 2. If the recovery is non-taxable, did the Tax Court err in holding that there was insufficient evidence to enable it to determine what part of the lump sum payment was properly allocable to the settlement? HELD Tax law treats recoveries as "income" when they represent compensation for loss of profits. Thus, the test for taxability is: What loss were the damages designed to compensate for? -- "In lieu of what were the damages awarded?" Tax law treats business good will not as future profits (which are fully taxable when recovered as damages), but as present capital -- even though evidence of future profitability must be introduced to evaluate it. Thus, damages for its destruction are designed to compensate for the destruction of a capital asset -- they are a "return" of this capital. However, tax law does not exempt compensatory damages just because they are a return of capital -- exemption applies only to the portion that recovers the cost basis of that capital; any excess damages serve to realize prior appreciation, and should be taxed as income. In this case, the record is devoid of evidence as to the amount of that basis. This Court agrees with the Tax Court that "in the absence of evidence of the basis ... the amount of any nontaxable capital recovery cannot be ascertained." Since Raytheon could not establish the cost basis of its good will, its basis will be treated as zero. The Court concludes that the $350,000 of the $410,000 attributable to the suit is thus taxable income. (Thus, the second question as to allocation between this and the

ordinary income from patent licenses is not present.) In this case, the Court treated the basis as zero because Raytheon was unable to establish it. Generally, the basis of goodwill is zero because it consists of costs that are themselves immediately deductible -- expenses for advertising, PR, etc. However, goodwill can acquire a basis, e.g. as a portion of the cost of purchasing another business. 5.

BIR RULING 091-99 (JULY 8, 1999)

CAPITAL GAINS TAX; Pacto de retro - The terms of the agreement between CBBOL and TMBC calling for the transfer of its assets, although denominated as Deed of Assignment with Right to Repurchase, is in reality an equitable mortgage created over the said properties. Instruments covering a sale with right to repurchase may be captioned or labeled as such. However, when any or more of the circumstances enumerated under Article 1602, Civil Code, obtain in the agreement, the contract shall be presumed as an equitable mortgage. (BIR Ruling No. 217-81 dated November 6, 1981). This is relevant in determining whether or not the transaction had is subject to the corresponding taxes, i.e. capital gains tax documentary stamp tax. Insofar as corporations are concerned, its liability to the capital gains tax imposed on the presumed gains realized from the sale, exchange or disposition of lands and/or buildings is governed by Section 27(D)(5) of the Tax Code of 1997. Thus, for a corporation to be liable to the tax, a true sale, exchange or disposition of capital assets must have transpired. Unlike in transactions made by individuals under Section 24(D)(1) of the Code, where all sales of real property classified as capital assets, including pacto de retro or other forms of conditional sales are subject to the capital gains tax, no similar qualifications exist for capital asset transaction of a corporation. Hence, the latter is subject to such tax only upon a close and completed transaction in which income is realized. Accordingly, this Office holds that only upon the executing of the final or absolute deed of sale covering the properties of the bank subject of the pacto de retro, will the payment of the 6% capital gains tax apply. By the same token, since no actual conveyance of real property is to be made, the stamp tax on deeds of sale and conveyances of real property imposed under Section 196 shall not apply. However, since the transaction is in the nature of an equitable mortgage and made primarily as a security for the payment of a pre-existing loan, the same is subject instead to the rate of documentary stamp tax imposed under Section 195. 6.

COMMISSIONER v TOURS SPECIALIST

FACTS In the years 1974 to 1976, Tours derived income from its activities as a travel agency by servicing the needs of foreign tourists and balikabayans during their stay in the Philippines. By some arrangements of Tours with foreign travel agencies, the latter entrusts to Tours the fund for hotel room accommodation, which it pays to the local hotels when billed.

By Nikki Hipolito

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2D TAX 1 | ATTY. M. CABREROS | CHAP. 1 AND 2 CASE DIGESTS The CIR assessed Tours for deficiency 3% contractor’s tax as independent contractor by including the entrusted hotel room charges in its gross receipt from services for the years 1974-1976, in the amount of P123K plus P500 penalty. Tours contested the deficiency assessed on the ground that the money received and entrusted to it by the tourists, earmarked to pay hotel room charges, were not considered and have never been considered by it as part of its taxable gross receipts for purposes of computing and paying its contractor’s tax. Two witnesses testified that the payments for the hotel room accommodation made through Tours are without any increase in the room charged (payment goes directly to hotels) and the reason why tourists prefer to pay through travel agencies is the fact that it is exempt from hotel room tax under PD 31. ISSUE Whether the amounts received by Tours earmarked for hotel room accommodations form part of the gross receipts subject of the 3% contractor’s tax HELD NO. The amounts entrusted to Tours by the foreign travel agencies to pay the room charges of tourists in local hotels were not diverted to its funds and this arrangement was only an act of accommodation on the part of Tours. This accommodation/arrangement is different from the packages it offers together with foreign travel agencies. Gross receipts subject to tax under the Tax Code do NOT include monies or receipts entrusted to taxpayer, which do not belong to them and do not redound to his benefit. It is not necessary that there must be a law or regulation, which would exempt such monies or receipts within the meaning of gross receipts under the Tax Code. The room charges entrusted to Tours do not form part of the gross receipts within the definition of the Tax Code. Said receipts never belonged to Tours and these never redounded to its benefit. 7.

COMMISSIONER v JAVIER

FACTS In 1977, Victoria Javier (wife of Melchor), received from the Prudential Bank and Trust Co. US$999,973.70 remitted by her sister, Dolores Ventosa, through some banks in the United States, among them Mellon Bank NA. Mellon Bank filed suit to recover the excess amount of US$9999,000 as the remittance of US$ 1 million was a clerical error and should have been US $1,000 only (Compare facts in Mellon Bank vs. Magsino, GR 71479, 18 October 1990). In 1978, Melchor Javier filed his income tax return for 1977showing a gross income of P53,053.38 and a net income of P48,053.38 and stating in the footnote of the return that “taxpayer was recepient of some money received from abroad which he presumed to be a gift but turned out to be an error and is now subject of litigation. In 1980, the Commissioner assessed and demanded from Javier deficiency assessment of P9,287,297.51 for 1977. Javier protested such assessment, where the Commissioner in turn imposed a 50% fraud penalty against Javier.

Whether Javier is liable for the 50% fraud penalty. HELD Under the then Section 72 of the Tax Code, a taxpayer who files a false return is liable to pay the fraud penalty of 50% of the tax due from him or of the deficiency tax in case payment has been made on the basis of the return filed before the discovery of the falsity or fraud. The fraud contemplated by law is actual and not constructive. It must be intentional fraud, consisting of deception willfully and deliberately done or resorted to in order to induce another to give up some legal right. Fraud is never imputed and the courts never sustain findings of fraud upon circumstances, which, at most created only suspicion. A fraudulent return is always an attempt to evade a tax, but a merely false return may not be. Herein, there was no actual and intentional fraud through willful and deliberate misleading of the government agency concerned (BIR) committed by Javire. Javier did not conceal anything to induce the government to give some legal right and place itself at a disadvantage. Error or mistake of law is not fraud. As ruled by the Court of Tax Appeals, the 50% surcharge imposed as fraud penalty in the deficiency assessment should be deleted. 8.

GUTIERREZ v COLLECTOR

FACTS Maria Morales, wife of Blas Gutierrez, was the owner of a parcel of land in Mabalacat, Pampanga. Under the Military Bases Agreement with the US, the land of Morales was among those that are to be expropriated for the expansion of Clark Air Base. Initially, in 1949, Morales was paid P35000 as compensation for the expropriation of her land. After proper assessment, it was found that Morales was entitled to P94K as just compensation. The CIR assessed and demanded from Morales the payment of P8500 as alleged deficiency income tax for the year 1950, inclusive of surcharges and penalties. However, Morales and counsel contended that the compensation paid to them for the expropriation was not “income derived from sale, dealing or disposition of property” referred to by Sec 29 of the Tax Code and therefore not taxable. The CTA rendered judgment against Morales. ISSUE Whether the money received by Morales as just compensation is considered income, subject to tax HELD YES. Under Sec 29 of the NIRC, gross income includes gain, profits, and income derived from salaries, wages or compensation for personal service of whatever kind and in whatever form paid or from professions, vocations, trades, businesses, commerce or sales, or dealings in property, whether real or personal growing out of ownership… or gains or profits and income derived from any source whatever…” Moreover, US Jurisprudence provides that income from expropriation/condemnation proceedings is income from sales or exchange and thus taxable. It appears that the acquisition by the government of private properties through the exercise of the power

ISSUE By Nikki Hipolito

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2D TAX 1 | ATTY. M. CABREROS | CHAP. 1 AND 2 CASE DIGESTS of eminent domain, with said properties being justly compensated, is embraced within the meaning of the term “sale” or “disposition of property.” It cannot also be viewed as an exemption contemplated under Sec 29 (b. 6) of the Tax Code—those income required by any treaty obligation binding upon the government—because under the MBA, the exemption from taxation of the compensation to be paid for the expropriation was not given any attention and the exemptions specifically applies only to members of the US Armed Forces serving in the Philippines and US nationals working here in the bases as well. 9.

JAMES v US

dismissal of the indictment against James, but dissenting from the over-ruling of Wilcox. Justice Black raised a Federalism argument, arguing that this ruling constituted a preemption of state criminal jurisdiction. Justice Harlan, joined by Justice Frankfurter, wrote an opinion concurring with the over-ruling of Wilcox, but contending that James should have been set for a new trial, rather than set free of criminal liability. Justice Clark wrote a brief concurrence, also agreeing with the over-ruling of Wilcox, but stating that James' conviction should also have been upheld. 10. COMMISSIONER v GLENSHAW GLASS

FACTS The defendant, Eugene James, was an official in a labor union who had embezzled more than $738,000 in union funds, and did not report these amounts on his tax return. He was tried for tax evasion, and claimed in his defense that embezzled funds did not constitute taxable income because, like a loan, the taxpayer was legally obligated to return those funds to their rightful owner. Indeed, James pointed out, the Supreme Court had previously made such a determination in Commissioner v. Wilcox, 327 U.S. 404 (1946). However, this defense was unavailing in the trial court, where Eugene James was convicted and sentenced to three years in prison.

FACTS In a case between Glenshaw Glass Co. manufacturer of glass bottles and containers, and Hartford-Empire Company, manufacturer of machinery of a character used by Glenshaw, Hartford paid Glenshaw $800K as settlement. Out of this amount, $325K represented payment for exemplary damages for fraud and treble damages for injury to its business by reason of Hartford’s violation of federal antitrust laws. However, this portion was not reported as income for the tax year involved. The Commissioner determined a deficiency, claiming as taxable the whole amount less deductible legal fees.

ISSUE Whether the receipt of embezzled funds constitutes income taxAble to the wrongdoer, even though an obligation to repay exists.

ISSUE Whether money received as exemplary damages for fraud or as the punitive 2/3 portion of a treble damage antitrust recovery must be reported by a taxpayer as gross income under Sec 22 of Internal Revenue Code of 1939

HELD The Supreme Court ruled that under section 22(a) of the Internal Revenue Code of 1939 and section 61(a) of the Internal Revenue Code of 1954, the receipt of embezzled funds was includible in the gross income of the wrongdoer and was taxable to the wrongdoer, even though the wrongdoer had an obligation to return the funds to the rightful owner. The Court was divided between several different rationales. The majority opinion was written by Chief Justice Earl Warren, joined by Justices Brennan and Stewart. That opinion held that if a taxpayer receives income – legally or illegally – without consensual recognition of obligation to repay, that income is taxable. The Court noted that the Sixteenth Amendment did not limit its scope to "lawful" income, a distinction which had been found in the Revenue Act of 1913. The removal of this modifier indicated that the framers of the Sixteenth Amendment had intended no safe harbor for illegal income. The Court expressly over-ruled Commissioner v. Wilcox and ruled that James was therefore liable for the federal income tax due on his embezzled funds. The Court also ruled, however, that Eugene James could not be held liable for the willful tax evasion because it is not possible to willfully violate laws that were not established at the time of the violation. Although James avoided the criminal sentence, the opinion of the Court left James in a situation where he would be required to repay the embezzled $738,000 to the union, but would also be required to pay over a half-million dollars in taxes on those funds, as though he had been able to keep them. Justice Black, joined by Justice Douglas, wrote an opinion concurring in the

HELD YES. Under Sec 22, gross income includes gain, profits, and income derived from salaries, wages or compensation for personal service… of whatever kind and in whatever form paid or from professions, vocations, trades, businesses, commerce or sales, or dealings in property, whether real or personal… or gains or profits and income derived from any source whatever…” Through this catch-all provision, Congress applied no limitations as to the source of neither taxable receipts nor restrictive labels as to their nature and intended to tax all gains except those specifically exempted. The mere fact that the payments were extracted from wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable income to the recipients. 11. FARMERS & MERCHANTS BANK v CIR FACTS Petitioner was engaged in the banking business in Kentucky and within the district of the Federal Reserve Bank of Cleveland, Ohio. It charges the collection of checks on foreign banks and checks drawn on it and sent from other banks. Petitioner was not a member of the Fed Reserve System so that checks drawn on it are sent directly to petitioner by the holding bank and paid by drafts. By Nikki Hipolito

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2D TAX 1 | ATTY. M. CABREROS | CHAP. 1 AND 2 CASE DIGESTS In 1920, the Reserve Bank demanded that it would collect the checks sent to it and drawn on petitioner without charge. The method employed by the Reserve Bank effected in an unusual and un-businesslike manner as to attract unfavorable public comment. Petitioner then sued the Reserve Bank for damages alleged to have been sustained by reason of these tactics. In 1925, the action was compromised and the Reserve Bank paid petitioner $18K less cost of the suit (total amount received was P13K). The CIR conceived that this fund was part of the 1925 earnings and included it in petitioner’s net income for that year. ISSUE Whether the amount received by Petitioner should have been included in the net income and therefore taxable HELD NO. There is nothing indicated in petitioner’s cause of action that it sought reparation for the profits which it did not realize in 1925. Petitioner’s cashier, Rous, even testified that the loss of such earnings may not be definitely determined and demanded. Petitioner did not insist upon the restoration of the anticipated profits, but as a matter of fact, based its claim for damages upon an alleged tortuous injury to the goodwill of its business. The Court held that the gravamen of petitioner’s action against the Reserve Bank was the injury inflicted to its banking business generally and that the true measure of the damages was compensation to be determined by ascertaining how much less valuable its business was by reason of the wrongful acts of the Reserve Bank. If the action was proceeded, the law would have not awarded to petitioner what it might have expected to gain but only that which it had actually lost. Therefore, there is no logical basis upon which petitioner can be charged with gain. 12. BIR RULING NO. 123-97 (NOVEMBER 10, 1997): No copy 13. BIR RULING NO. 029-98 (MARCH 19, 1998) INCOME TAX; Income tax paid or accrued (now incurred) by a company within a taxable year not allowed as deduction – (a) BIR is prohibited from issuing further comments on Questions Nos. 1, 2, 3, 7 and 8 issued by the Energy Regulatory Board in relation to ERB Case No. 93-118 entitled "Meralco vs. Energy Regulatory Board, et. al." in so far as the rate fixing issue is concerned considering that the issues are all sub judice pending before the Court of Appeals. With regard to the question of whether the appraisal increase of property, plant and equipment of electric utilities is taxable, the general rule is that, mere increase in the value of property without actual realization, either through sale or other disposition, is not taxable. However, if by reason of appraisal, the cost basis of property is increased and the resulting basis is used as the new tax base for purposes of computing the allowable depreciation expense, the net difference between the original cost basis and new basis due to appraisal is taxable under the economic benefit principle.

(b) BIR is not following American Laws on taxation because we have our tax laws, including rules and regulations implementing our tax laws. However, under the doctrine of precedent, a court may apply American Laws or Court Decisions. (c) The amendments introduced by EO No. 37 to then Section 21(c)(2) of the Tax Code of 1997 provides that dividend received by a citizen or resident alien from a domestic corporation is subject to income tax at the rate of 15% in 1986, 10% effective January 1, 1987, 5% effective January 1, 1988 and 0% effective January 1, 1989. However, Sec. 22 (a) and (b) of the same Code provides that dividends received by a non-resident alien individual, whether engaged or not in trade or business in the Philippines, from a domestic corporation is subject to final withholding tax of 30% of such dividend income. (d) For purposes of computing the taxable income of domestic corporation derived form within and without the Philippines, the allowable deductions are limited to those provided under Section 29 of the Tax Code of 1997 for taxable year 1997 and prior years but for taxable year 1998, Section 34 of the Tax Code of 1997 governs. (e) Pursuant to then Section 117 of the Tax Code of 1997, as amended by RA 8241, the 2% franchise tax of electric, gas and water utilities is based on gross receipts derived from the business covered by the law granting the franchise. 14. PERRY v US FACTS William Perry created a trust for the benefit of the Town of Fitzwilliam in 1944. The corpus was to be used for the construction of an addition to the Public Library and for no other purpose. The town decided that it did not desire to expand the Library and the corpus of the trust was returned to Perry. The CIR required Perry to include in their income tax return for 1953 the amount returned to them. Perry contended that it was improper since what they received was a return of capital, not income. On the other hand, the CIR contended that it was proper because Perry received tax benefits when he made contributions to the trust and the deducted such amounts from their income. ISSUE Whether an income tax may be imposed upon the corpus of a charitable trust that has been returned to the sole settlor when the donees thereof have refused to comply with the terms of the gift HELD NO. The return of the taxpayer of the property he had given away cannot possibly be considered as income—he merely got back his own property. It cannot possible be considered income, EXCEPT on the ground that he had deducted from his income the amount of the contributions, thus reducing his income tax. In these cases, the courts required the inclusion of an item recovered, where a deduction had been taken for it. It would be inequitable for the taxpayer to reduce his taxes on account of the By Nikki Hipolito

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2D TAX 1 | ATTY. M. CABREROS | CHAP. 1 AND 2 CASE DIGESTS contributions and not to pay taxes on them when he got them back. This is the socalled TAX BENEFIT RULE, which is based upon equitable considerations. In Lewyt Corp. v. Commissioner, the SC had this to say of equitable considerations in the administration of tax law: But the rule that general equitable considerations do not control the measure of deductions or tax benefits cuts both ways. It is as applicable to the Government as to the taxpayer. Congress may be strict or lavish in its allowance of deductions or tax benefits. The formula it writes may be arbitrary and harsh in its applications. But where the benefit claimed by the taxpayer is fairly within the statutory language and the construction sought is in harmony with the statute as an organic whole, the benefits will not be withheld from the taxpayer though they represent an unexpected windfall. The SC held that in applying prior judicial decisions, the tax benefit received by Perry should be taken into account. In other words, in computing for the income in 1953, the taxpayer should exclude from their income the amount of the corpus returned to them BUT they should add to the tax computed on their 1953 income the amount by which their taxes in the prior years had been decreased on the account of the deductions made for the contributions to the fund so that the government would recoup the taxes deducted. It would be inequitable to require Perry to include in their income for 1953 the aggregate of the deductions claimed in prior years, because of the fact that the rates of taxation vary greatly from year to year, and because the inclusion in one year of all the deductions taken would put him in a higher tax bracket. 15. BRADFORD v CIR FACTS In 1938, petitioner's husband owed a Nashville bank approximately $305,000. The brokerage firm of which he was a member held a seat on the New York Stock Exchange. In October of 1938, the Exchange adopted a rule requiring each general partner of a member firm to submit a detailed report of his indebtedness. Fearing that disclosure of so much indebtedness might impair the position of his firm with the Exchange, he persuaded the bank to substitute the note of his wife, the petitioner, for a portion of his indebtedness. Accordingly, the petitioner executed her note to the bank for $205,000 without receiving any consideration in return. Her husband remained the obligor on two notes to the bank for $100,000 and so reported to the New York Stock Exchange. About two years later the petitioner at the bank's request executed two notes to replace her $205,000 note, one for $105,000, on which all the collateral was pledged, and another for $100,000, which was unsecured. In 1943, a bank examiner required the bank to write off $50,000 of the petitioner's $100,000 unsecured note. In 1946 the bank advised petitioner that it was willing to sell the $100,000 note for $50,000, its then value on the bank's books. The petitioner's husband accordingly persuaded his halfbrother, a Mr. Duval, to purchase the note from the bank for $50,000 with funds furnished by the petitioner and her husband. The Tax Court found that this transaction "was, in essence, a discharge of Mrs. Bradford's indebtedness for $50,000." The petitioner accepts the correctness of that finding, conceding that Duval "purchased the

note as agent for the Bradfords and with no intention of enforcing same." The petitioner was solvent both before and after the note was discharged. Upon these facts the Tax Court concluded that the petitioner had realized unreported ordinary income of $50,000 in 1946 and upheld the Commissioner's determination of deficiency in accordance with that conclusion. Petitioner contended that the cancellation of her $100,000 note for $50,000 was a "gratuitous forgiveness" upon the part of the bank and therefore a gift within the meaning of § 22(b) (3) of the Internal Revenue Code of 1939, and that because she received nothing when the original note was executed by her in 1938, she did not realize income in 1946 when the note was cancelled for less than its face amount, even if the cancellation was not a gift. ISSUE Whether Bradford realized $50,000 income in 1946 when her liability upon a note for $100,000 was discharged for $50,000. HELD NO. It was the view of the Tax Court that if there was no gift, the discharge of the $100,000 note for $50,000 clearly resulted in ordinary income in the amount of $50,000. The Commissioner in effect adopts that view in his argument here. "It has become well settled," we are told, "that a profit is realized by a debtor whose obligation is extinguished by payment of an amount less than that which is owing, and that such profit constitutes gain which is taxable income within the broad sweep of Section 22(a) of the Internal Revenue Code of 1939." It is also a well-settled general rule that each year's transactions are to be considered separately, without regard to what the net effect of a particular transaction might be if viewed over a period of several years. A mechanical application of these principles would of course support the Tax Court's decision. Looking alone to the year 1946 under the rule of the Sanford & Brooks Co. case, it is obvious that when $100,000 of the petitioner's indebtedness was discharged for $50,000 in that year, she realized a balance sheet improvement of $50,000 which would be taxable as ordinary income under the rule of the Kirby Lumber Co. case.3 We cannot agree with the Commissioner, however, that these principles are to be applied so mechanically. The fact is that by any realistic standard the petitioner never realized any income at all from the transaction in issue. In 1938 "without receiving any consideration in return," she promised to pay a prior debt of her husband's. In a later year she paid part of that debt for less than its face value. Had she paid $50,000 in 1938 to discharge $100,000 of her husband's indebtedness, the Commissioner could hardly contend that she thereby realized income. Yet the net effect of what she did do was precisely the same. We cannot agree that the transaction resulted in taxable income to her.

By Nikki Hipolito

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