CIR vs.

ISABELA CULTURAL CORPORATION (ICC)

G.R. No. 172231
February 12, 2007

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

1 Taxation Case Digest by Rena Joy C. Castigador

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.
 
Anent the purported understatement of interest income from the promissory notes of Realty
Investment, Inc., we sustain the findings of the CTA and the Court of Appeals that no such understatement
exists and that only simple interest computation and not a compounded one should have been applied by
the BIR.
 
Likewise, the findings of the CTA and the Court of Appeals that ICC truly withheld the required
withholding tax from its claimed deductions for security services and remitted the same to the BIR is
supported by payment order and confirmation receipts.   Hence, the Assessment Notice for deficiency
expanded withholding tax was properly cancelled and set aside.
 
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.

2 Taxation Case Digest by Rena Joy C. Castigador