BIR Ruling No. 109-62

October 5, 1962 BIR RULING NO. 109-62 2nd Indorsement Forwarded to the Chief, Income Tax Division, B.I.R., Manila, thru the Revenue Operations Head (Assessment), the within papers relative to the income tax case of the UNITED EQUIPMENT & SUPPLY COMPANY involving a proposed assessment in the sum of P182,094.00. The proposed assessment was made in accordance with section 25 of the National Internal Revenue Code, which taxes corporations improperly accumulating profits in addition to the tax imposed under section 24 of the Code. Investigation disclosed that the corporation was organized and incorporated sometime in 1947 with an initial capitalization of P100,000.00 divided into 100 shares of no-par value shares valued originally at P1,000.00 per share. The corporation is engaged in the selling of auto spare parts. Originally the majority stockholder was/certain Mr. Donald R. Reffer who owned 96 of the 100 shares. This was, however, transferred in 1948 to the AMERICAN INTERNATIONAL COMMERCIAL CORPORATION, a non-resident foreign corporation of Havana, Cuba. The reason for the transfer is not known. It is not also known whether or not the transfer is a stockholder of the transferee-corporation. The assets of the corporation at the time of investigation was worth P947,904.58. Since its incorporation in 1947 up to the time of the investigation, the corporation has never distributed any dividend to its shareholders. It transferred instead its earnings to capital stock account, so that the value of the shares rose from P1,000.00 to P6,000.00 per share. It was disclosed in the investigation that in 1955 the corporation transferred the sum of P300,000.00 to capital stock account and the sum of P200,000.00 as reserve for leasehold improvements. A provision for obsolescence was also made in the amount of P117,770.00. It may be mentioned, in this connection, that at the time of the investigation the amount set aside for leasehold improvement has not been spent. The only question for resolution is the determination of whether or not the corporation has improperly accumulated profits in accordance with section 25 of the Tax Code. Section 25 of the Tax Code provides certain criteria for determining whether a corporation is improperly accumulating profits or not. It provides for instance, that where the accumulated profits or surplus are invested in any dollar-producing or dollar-saving industry or used in the purchase of bonds issued by the Central Bank of the Philippines, the accumulation of the profits is not considered as improper. Where the earnings or profits are permitted to accumulate beyond the reasonable needs of the business, (section 25(c), Tax Code) the accumulation is considered to be improper, hence, taxable. Another criterion that may be mentioned is the fact that the corporation is a mere holding company or an investment company where more than fifty per centum in value of its outstanding stock is owned, directly or indirectly, by one person. The investigation does not show that the corporation had at any time invested its accumulated earnings in any dollar-saving or dollar-producing industry. Neither does it show that it had purchased any bonds issued by the Central Bank of the Philippines. The corporation is neither a holding company nor an investment company as these terms are defined under section 20 of Revenue Regulations No. 2, otherwise known as the Income Tax Regulations, which states: "SEC. 20 Holding and Investment Companies . A corporation having practically no activities except holding property, and collecting the income therefrom or investing therein, shall be considered a holding company within the meaning of section 25. If the activities further include or consist substantially of, buying and selling stocks, securities, real estate, or other investment property (whether upon an outright or a marginal basis) so that the income is derived not only from the investment yield but also from profits upon market fluctuations, the corporation shall be considered an investment company within the meaning of section 25." The question of whether the instant corporation is improperly accumulating profits or not hinges on the proper interpretation of the phrase "reasonable needs of the business." This is a question of fact which must depend on certain circumstances surrounding the case. Among these may be mentioned the nature and kind of business engaged in, the volume of the business done, the keenness of competition, and the conditions of the times. It should be borne in mind that the corporation is engaged in the selling of auto spare parts, which obviously consist of imported items. Importations of the items for sale depend upon the availability of dollars, which were then under the control of the Central Bank. Allocation of dollars was made by the Central Bank under certain rules and regulations. Consequently, the need for additional funds would depend upon the allocation for dollars given by the banking institution a question of the condition of the times. The need for so large a reserve fund as P300,000.00 transferred to capital stock account is uncalled for, especially if we consider the fact that in the balance sheet submitted by the corporation in 1958 the value of the merchandise in transit was only P6,699.57 and the marginal deposits on unused letters of credit was only P9,080.40. The volume of business may be determined from the Statement of Income filed with the income tax return of the corporation. It is rather unfortunate that the investigator failed to take into consideration the previous statements of income filed by the taxpayer. The statements of income for 1957 and 1958 show that the corporation had a total sales of P375,287.64 and P295,095.01. The cost of sales amounted to P194,566.60 and P150,466.00. The cost of sales represents the actual value of the spare parts purchased for sale to the general public and all incidental expenses incurred in bringing the imported items to the Philippines. These amounts should be used in determining the volume of business of the corporation. prcd An analysis of the aforementioned figures will show that the corporation did not spend more than P200,000.00 for the purchase of the goods it sold. The operating expenses for 1957 and 1958 amounted to P133,131.29 and P131,163.05, respectively. Considering that it had provided the sum of P117,770.00 for obsolescence, this Office considers the transfer of P300,000.00 to capital stock account as improper and unnecessary. This amount should be subjected to the tax imposed under section 25 of the Code. It is an accumulation beyond the reasonable needs of the business. The sum of P200,000.00 reserved for leasehold improvement should also be taxed. "The mere consideration of improvements even though reserves are set aside, will not justify an accumulation where the improvement have not been made and does not appear to be required. (Perry & Co., Inc. v. Commissioner, 120 F(2d) 123.) The contention that no declaration of dividends was made due to strict dollar licensing is not a reasonable excuse. The ruling adverted to in the report refers to a corporation which actually declared dividends, although the amount declared was only equivalent to the maximum remittable allowed by the regulations of the Central Bank. In the instant case the corporation did not take the trouble of declaring any dividend. It will be noted, however, that the tax provided under section 25 of the Tax Code is imposed "on the undistributed portion of the accumulated profits or surplus" and "in addition to the tax imposed by section 24". It is computed, collected and paid in the same manner and subject to the same provisions of law, including penalties, as the tax imposed under section 24 of the Code. It provides: "SEC. 25. Additional tax on corporations improperly accumulating profits or surplus (a) Imposition of tax . If any corporation, except banks, insurance companies, or personal holding companies, whether domestic or foreign, is formed or availed of for the purpose of preventing the imposition of the tax upon its shareholders or members through the medium of permitting its gains and profits to accumulate instead of being divided or distributed, there is levied and assessed against such corporation, for each taxable year, a tax equal to twenty-five per centum of the undistributed portion of its accumulated profits or surplus which shall be in addition to the tax imposed by section 24 , and shall be computed , collected and paid in the same manner and subject to the same provisions of law , including penalties , as that tax : PROVIDED, That no such tax shall be levied upon any accumulated profits or surplus, if they are invested in any dollar-producing dollar-saving industry or in the purchase of bonds issued by the Central Bank of the Philippines." (Emphasis ours). The application of the aforecited section of the law may be illustrated by the following example: EXAMPLE : Corporation A had a taxable net income for 1960 in the amount of P50,000.00 and 1961, the sum of P150,000.00. No dividend distribution was made in 1960, but in 1961 the sum of P100,000.00 was distributed to the stockholders as dividends. Notwithstanding said distribution of cash dividends, A was still liable for the tax imposed under section 25 of the Tax Code, in accordance with factual findings of investigators. The computation of the taxes due will be as follows: 1960 Income Taxable net income P50,000.00 Tax due thereon in accordance with section 11,000.00 24 (22% for first P100,000.00) Adjusted net income (subject to 25% tax in accordance with Sec. 25, T.C.) P39,000.00 Tax due thereon P9,750.00 1961 Income Taxable net income P150,000.00 Tax due thereon (per section 24) 22% on first P100,000.00 P22,000.00 30% on P50,000.00 15,000.00 Total Tax due (normal tax) 37,000.00 Net P113,000.00 Less: Dividends paid 100,000.00 Undistributed adjusted net income subject to 25% (under Sec. 25, T.C.) P13,000.00 Tax due thereon P3,250.00 From the above illustration, it will be noted that the 25% tax is not computed on the basis of the total accumulated profits (over the years) but is computed on the basis of the undistributed adjusted yearly net income. It may also be mentioned in this connection, that the 6% interest on deficiency, in accordance with section 51(d) of the Tax Code as amended by Republic Act No. 2343, may be imposed on the sums of P9,750.00 and P3,250.00. In view thereof, it is requested that a computation of the tax due be made in accordance with the foregoing illustration and an assessment notice be issued therefor. JOSE B. LINGAD Acting Commissioner of Internal Revenue