Legality of the Disallowance Made on the Salaries and Bonuses of Stockholders

October 31, 1960 BIR RULING NO. 474-60 MEMORANDUM FOR: The Chief, Investigation Division This has reference to the deficiency income tax, surcharge and compromise cases of M.Y. San & Co., Inc., Mar Chip & Co., and Messrs. Mar Chip, Mar Po, Mar Hoy, the principal stockholders of the above corporations and Mrs. Chung Chi, involving the sum of P140,436.61. cdtech The main point of disagreement on the findings and proposed assessment made by the investigating examiners are: 1) whether the disallowance made on the salaries and bonuses received by Mar Po in the sum of P160,039.72 and Mrs. Chung Chi in the sum of P50,567.18, respectively, for the years from 1952 to 1957, is legal or not; 2) whether the maintenance of real property located at Escolta, Manila, gave rise to an unregistered partnership or that of co-ownership 3) disallowance of charitable contributions and the amount of P3,050.00 absconded by a travel agent; and 4) whether the imposition of 50% fraud penalty is legal or not. The disallowances made by the said investigating examiners are based on the following facts: Mr. Po, a majority stockholder and Vice-President of the M.Y. San Co., Inc., was born in the Philippines and was a permanent resident alien in the Philippines up to September 22, 1951. And from said period up to the present, he lives permanently with his family in Hongkong. From 1952 to 1957, it was found out that he came to the Philippines only once, that is from February 18 to March 10, 1955, or twenty (20) days at most. With Mr. Po's permanent absence from the Philippines for the period from 1952 to 1957, counsel for the taxpayers wants this Bureau believe that Mar Po performed only such duties which by their nature, could be done by directives. From the records of the case, it is established that Mar Po is the Vice-President of the Company and in-charge of the factory plant. By his qualifications, he held the position of technician of the bakery and biscuit plant, and had supervision over the said department of the company. It is the opinion of this Office that the performance of such duties could hardly be done by means of directives. And that counsel for the taxpayers failed to submit documents showing that Mar Po rendered overseas service by means of directives. For this reason, the salaries and bonuses actually received by Mar Po was more than extraordinary and unusual, far from being commensurate with his alleged overseas service by directives, if there were any. "Extraordinary, unusual, and extravagant amounts paid by a corporation to its officers in the guise and form of compensation for their services, but having no substantial relation to the measure of their services, and being utterly disproportioned to their value, are not in reality payments for services, and cannot be regarded as ordinary and necessary expenses . . . so as to be deducted from gross income in the fixing of income tax, and such amounts do not become a part of the ordinary and necessary expenses merely because the payments are made in accordance with an agreement between the corporation and its officers." (Botany Worsted Mills v. United States, 278 US 252, 49 CT 129, 73 L ed 379-US Supreme Court Digest Annotated, Vol. 8, p. 406) cd From the facts established and the law and ruling cited, it is the opinion of this Office that the salaries and bonuses received by Mar Po is an indirect distribution of dividends; hence, the same should disallowed. The investigating examiners established the fact that Mrs. Chung Chi is over 75 years old and suffering from physical ailments. It was found out further that on March 20, 1953, the Board of Directors of the Company, by virtue of a resolution, unanimously approved by the members, granted P10,000.00 to Mrs. Chung Chi for surgical operation of her two eyes. However, it was disclosed that this amount does not appear in the corporate books of account as actually disbursed. And that in one of the days when the investigating examiners were conducting their investigations in the company's biscuit plant at San Juan, Rizal Mrs. Chung Chi had a bad fall, causing her to be hospitalized for over a week. From all indications, we agree with the investigating examiners in holding that the compensation for personal services received by Mrs. Chung Chi were in fact unreasonable and far. ". . . it is well settled that several basic factors should be considered by the Court in reaching its decision in any particular case. Such factors includes the employee's qualification; the nature, extent and scope of employee's work; the size and complexities of the business; a comparison of salaries paid with the gross income and net income; prevailing economic conditions; comparison of salaries with distributions to stockholders; the prevailing rates of compensation for comparable positions in comparable concern; the salary policy of the taxpayers as to all employees; and in the case of small corporations with limited number of officers the amount of compensation paid to the particular employee in previous years". Mayson Mfg. Co. v. Com (CA-6) 49-2 USTC P-9467, 178 Psd. (2d) 115, cited in CCH, '51 Vol. 1, p. 1003) As factory superintendent, it is doubtful whether Mrs. Chung Chi, at her age of over 75 years, could withstand the whole, or even half of a working day, watching the quality of work of the factory workers, as alleged to be due of her duties. And in this connection, corporate records of the company shows that Mrs. Chung Chi owns 107 shares of the total 6,106 shares outstanding as of November 31, 1957. "salary paid to a woman 72 years old who was merely a director of the corporation, giving occasional advice, who owned 30% of the stock of the corporation and who was the mother of all but one of the other stockholders, was disallowed". (Home Industry Iron Works, 8 BTA 1267, Sec. 30 146) From the facts gathered and disclosed by the investigating examiners, it is clear that the salaries and bonuses received by Mar Po and Mrs. Chung Chi were made principally due to family considerations which in themselves were disbursed in the guise of salaries and bonuses which in fact were a distribution of profits realized by the corporation. The Alleged services rendered by them compared to the corresponding compensations received were extraordinarily unreasonable. And that a stronger equally qualified to render similar duties and services could not have possibly received the same. Due to these circumstances, this Office is prone to sustain the findings of the investigating examiners and all the compensations received by both Mar Po and Mrs Chung Chi during the period under review, has to be, as it is hereby disallowed. The real property located at 275 Escolta, Manila, is another point of controversy. This real estate property has a total area of 76 sq. m. with improvements thereon, consisting of a four-storey concrete building. The ownership of the same was passed upon to the three (3) sons of the late Mar Chew by virtue of an inheritance in the following proportion; 1) Mar Chip 2/7; 2) Mar Po 2/7; and 3) Mar Hoy 3/7. From the manner on how the property was maintained and operated, our investigating examiners found out to be an unregistered partnership, thereby assessing the same in the total amount of P19,340.97 for the years from 1949 to 1956, inclusive. Counsel for the taxpayers vehemently objected to said assessment, alleging that the maintenance and operation of such real property is that of co-ownership, recognized in this jurisdiction under our New Civil Code. It is to be noted that the said real property with a total area of 76 sq. m. is physically impossible, if not impracticable, of being partitioned and distributed among the three brothers. Because of this situation and for reasons of sentimentality, as alleged by counsel, the said real estate property has remained up to the present undivided, giving rise to the informal formation of co-ownership or community of property. Counsel for the taxpayers rely on the provisions of Arts. 484 and 495 of the New Civil Code, which provides as follows: "Art. 484. There is co-ownership whenever the ownership of an undivided thing or right belongs to different persons . . ." "Art. 495. Notwithstanding the provisions of the preceding article, the co-owners cannot demand a physical division of the thing unserviceable for the use for which it is intended". . . . In the absence of any agreement among the co-owners, fixing the duration for a co-ownership to exist, there is no law in this jurisdiction that fixes the duration of existence of co-ownership. However, if the contrary is true, the duration upon which such co-ownership exists shall not exceed ten (10) years and such terms may be extended by a new agreement. (Art. 494, New Civil Code.) The investigating examiners further rely on Field Circular No. V-109, dated November 4, 1957, duly approved by the Honorable, the Secretary of Finance, to the effect that "the presence of the element of dividing profit, is the principal distinguishing characteristics between the voluntary community and partnership". From the facts gathered by the investigating examiners, it cannot be denied that the element of profit is present when the co-heirs contributed money for the reconstruction of the said building immediately after the liberation of Manila and continue up to the present contributing money for use in the repair of the same. Considering the above circumstances, it is the opinion of this Office and so holds that the acts of the co-heirs are indicative of the existence of an unregistered partnership. The proposed assessment taxing the same as that of an unregistered partnership is, therefore, legal. It is of interest to note further than these taxpayers are religious in the filing of their income tax returns and in the payment of income and other taxes due them. In charitable drives where fund raising have the support of the government, these taxpayers contributed heavily to such fund drives. This is shown in their respective income tax return. Donations to charities when properly supported by receipts are allowable deductions, pursuant to section 30(h) of the Tax Code, in relation to Section 116 of Revenue Regulations No. 2. It being found out and admitted by taxpayers that their contributions as shown their respective income tax returns were not properly supported by receipts, the same are not deductible. For the period from 1952 to 1957, all donations purportedly given to different charities should be disallowed, there being no official receipts to support the same. Another disallowance made by the investigating examiners in the amount of P3,050.00, alleged business expenses of Mr. Mar Chip for the year 1953. Both counsel for the taxpayers and the examiners of this Office agreed that the said amount was given to a travel agent to work for the tax clearance and passport papers of the son of Mr. Chip, who was then slated to go abroad to study commerce and to specialize in biscuit manufacturing. The said amount of P3,050.00 was spent by the travel agent who was prosecuted for estafa and found by the Court guilty as charged. The said amount of P3,050.00 is a loss thru embezzlement, pursuant to Section 30(d)(1)(c) in relation to Section 93(c) of Revenue Regulations No. 2; hence, the same is allowable deduction on the part of Mar Chin in the year 1953. The last point of disagreement is the imposition of the 50% fraud penalty. Counsel for the taxpayers maintained that in reporting the income of his clients, there was no deceit, there were no concealment of facts, there were no false representations; hence the imposition of the 50% fraud penalty should be waived. To cite a few among the numerous court decisions on fraud cases in the United States and in the Philippines, it was ruled that "the false act by itself is not fraud unless a fraudulent state of mind accompanies it; so the failure to pay the tax legally due, or the filing of a false return, is not enough; the evil state of mind which must accompany the act may be variously referred to as: 1) bad faith; 2) intent to evade tax; 3) willfulness, etc." "Willfully" is an act done with a bad purpose; without justifiable excuse". (United States v. Murdock, 29-US 389, 3 USTC 1194, cited in Fraud Under Federal Tax Law by H. G. Balter, p. 38). Fraud is a question of fact. (Benito Sanchez vs. Com. of Customs, G.R. No. L-8556, Sept. 30, 1957). The degree of proof required on the issue of fraud is that it be "clear and convincing". (Griffiths vs. Com. (CCh-7, 1931) 50 F. (sd) 762, 2 USTC P 766). "Where the taxpayer failed to report an item of income because of an honest belief that such income is not taxable, the imposition of the fraud penalty is not proper". (Gutierrez v. Collector of Internal Revenue, CTA Case No. 65, Aug. 31, 1955, aff'd in G.R. Nos. L-9738 and L-9771, May 31, 1957, as cited in Jose Yulo vs. J. Antonio Araneta, etc., CTA Case No. 84, July 8, 1958) It can be inferred from the records of the case that there was no indication on the part of taxpayers that they withheld any information, or resisted or prevented the discovery of any pertinent facts pertaining to the operation of their businesses. In fact, all relevant matters affecting the transactions of taxpayers were shown in their income tax returns. And the investigating examiners were accorded the facility and respect in the course of their investigation of this case. In view of all the foregoing, the proposed assessment against all the taxpayers be revised in accordance with the observations as stated in this memorandum. MELECIO R. DOMINGO Commissioner of Internal Revenue