COMMISSIONER OF INTERNAL REVENUE
vs.
ISABELA CULTURAL CORPORATION
FACTS:
ICC, a domestic corporation, received from BIR two (2) notices for deficiency of (1)
income tax amounting to P333, 196.86 and (2) expanded withholding tax amounting
to P4, 897.79, both for 1986.
Income tax deficiency arose from the BIR disallowance of ICC’s claimed expense
deductions for professional and security services billed to and paid by ICC in 1986
and alleged understatement of ICC’s interest income on the 3 promissory notes due to
Realty Investment, Inc. Expanded withholding tax (EWT) deficiency (with interest
and surcharge) was allegedly due to failure of ICC to withhold 1% EWT on its
claimed P244,890.00 deduction for security services.
ICC sought reconsideration of the assessments on March 1990 but received final
notice before seizure (demanding payment of amounts) on February 1995. Thus,
brought to CTA which held that petition is premature because final notice cannot be
considered final decision appealable to tax court. CA reversed holding that demand
letter of BIR amounts to final decision on the protested assessments and may be
questioned before CTA. SC sustained CA and remanded case to CTA on July 2001.
On 2003, CTA decided to cancel and set aside the assessment notices against ICC –
claimed deductions were properly claimed in 1986 because it was only that year that
the bills were sent to ICC. Hence, even if some of the services were rendered to ICC
in 1984 or 1985, it could not declare the same because amounts cannot be determined
at that time.
The CTA also held that ICC did not understate its interest income on the subject
promissory notes. It found that it was the BIR which made an overstatement of said
income when it compounded the interest income receivable by ICC from the
promissory notes of Realty Investment, Inc., despite the absence of a stipulation in the
contract providing for a compounded interest; nor of a circumstance, like delay in
payment or breach of contract, that would justify the application of compounded
interest.
Petition for review was filed with the CA, which sustained CTA decision. Hence, the
petition before the SC.
ISSUE/S:
(1) WON the expenses for professional and security services should be deducted from
ICC’s gross income.
(2) WON held that ICC did not understate its interest income from the promissory
notes of Realty Investment, Inc. and that ICC withheld the required 1% withholding
tax from the deductions for security services.
HELD:
The requisites for the deductibility of ordinary and necessary trade, business, or
professional expenses, like expenses paid for legal and auditing services, are: (a) the
expense must be ordinary and necessary; (b) it must have been paid or incurred during
the taxable year; (c) it must have been paid or incurred in carrying on the trade or
business of the taxpayer; and (d) it must be supported by receipts, records or other
pertinent papers.
The requisite that it must have been paid or incurred during the taxable year is further
qualified by Section 45 of the NIRC which states that: “[t]he deduction provided for
in this Title shall be taken for the taxable year in which ‘paid or accrued’ or ‘paid or
incurred’, dependent upon the method of accounting upon the basis of which the net
income is computed x x x”. In the instant case, the accounting method used by ICC is
the accrual method.
Revenue Audit Memorandum Order No. 1-2000, provides that under the accrual
method of accounting, expenses not being claimed as deductions by a taxpayer in the
current year when they are incurred cannot be claimed as deduction from income for
the succeeding year.
For a taxpayer using the accrual method, the determinative question is, when do the
facts present themselves in such a manner that the taxpayer must recognize income or
expense? The accrual of income and expense is permitted when the all-events test has
been met. This test requires: (1) fixing of a right to income or liability to pay; and (2)
the availability of the reasonable accurate determination of such income or liability.
The all-events test requires the right to income or liability be fixed, and the amount of
such income or liability be determined with reasonable accuracy. However, the
amount of liability does not have to be determined exactly; it must be determined with
“reasonable accuracy.” Accordingly, the term “reasonable accuracy” implies
something less than an exact or completely accurate amount.
The propriety of an accrual must be judged by the facts that a taxpayer knew, or could
reasonably be expected to have known, at the closing of its books for the taxable year.
Accrual method of accounting presents largely a question of fact; such that the
taxpayer bears the burden of proof of establishing the accrual of an item of income or
deduction.
Corollarily, it is a governing principle in taxation that tax exemptions must be
construed in strictissimi juris against the taxpayer and liberally in favor of the taxing
authority; and one who claims an exemption must be able to justify the same by the
clearest grant of organic or statute law. In the instant case, the expenses for
professional fees consist of expenses for legal and auditing services. The expenses for
legal services pertain to the 1984 and 1985 legal and retainer fees of the law firm
Bengzon Zarraga Narciso Cudala Pecson Azcuna & Bengson, and for reimbursement
of the expenses of said firm in connection with ICC’s tax problems for the year 1984.
As testified by the Treasurer of ICC, the firm has been its counsel since the 1960’s.
ICC can be expected to have reasonably known the retainer fees charged by the firm
as well as the compensation for its legal services.
As previously stated, the accrual method presents largely a question of fact and that
the taxpayer bears the burden of establishing the accrual of an expense or income.
However, ICC failed to discharge this burden. It simply relied on the defense of
delayed billing by the firm and the company, which under the circumstances, is not
sufficient to exempt it from being charged with knowledge of the reasonable amount
of the expenses for legal and auditing services.
As to the expenses for security services, the records show that these expenses were
incurred by ICC in 1986 and could therefore be properly claimed as deductions for the
said year.
The court sustain the findings of the CTA and the Court of Appeals that no such
understatement exists and that only simple interest computation and not a
compounded one should have been applied by the BIR.
In sum, Assessment Notice for deficiency income tax should be cancelled and set
aside but only insofar as the claimed deductions of ICC for security services. - said
Assessment is valid as to the BIR’s disallowance of ICC’s expenses for professional
services. The Court of Appeal’s cancellation of Assessment Notice in the amount of
P4,897.79 for deficiency expanded withholding tax, is sustained.
WHEREFORE, the petition is PARTIALLY GRANTED. The September 30, 2005
Decision of the Court of Appeals in CA-G.R. SP No. 78426, is AFFIRMED with the
MODIFICATION that Assessment Notice No. FAS-1-86-90-000680, which disallowed
the expense deduction of Isabela Cultural Corporation for professional and security
services, is declared valid only insofar as the expenses for the professional fees of
SGV & Co. and of the law firm, Bengzon Zarraga Narciso Cudala Pecson Azcuna &
Bengson, are concerned. The decision is affirmed in all other respects.
The case is remanded to the BIR for the computation of Isabela Cultural
Corporation’s liability under Assessment Notice No. FAS-1-86-90-000680.
SO ORDERED.
