Civil Fraud and Criminal Tax Evasion Cases; Burden of Proof; Evidence to be Secured

April 28, 1975 REVENUE MEMORANDUM CIRCULAR NO. 10-75 SUBJECT : Civil Fraud and Criminal Tax Evasion Cases; Burden of Proof; Evidence to be Secured TO : All Internal Revenue Officers and Others Concerned This circular is a supplement of Revenue Memorandum Circular No. 43-74 dated August 1, 1974 and its purpose is to guide examiners in discovering and establishing civil fraud and criminal tax evasion cases. I. Statement of Policy . Taxpayers were offered tax amnesty provided that they declare their untaxed income and/or wealth and pay a tax of 10%, 15%, or 20% pursuant to Presidential Decrees No. 23, 370, and 631, respectively. Many availed of the amnesty offered in said decrees. However, many tax evaders ignored the generous and benevolent offer of the government, perhaps believing that their evasion of taxes will escape detection. On the other hand, some of those who availed or tax amnesty made a mockery of the tax amnesty under the aforementioned decrees, have not reformed at all and continue with their nefarious schemes of evading taxes. This Office believes that such hardened and unrelenting tax evaders should not escape the penalties imposed by law on tax evasion. All officers and others concerned are therefore exhorted to help in ferreting out such tax evaders in order that they be meted the punishment they deserve. II. Tax Evasion : Meaning and Types of Evasion . Tax evasion means the elimination or reduction of the correct and proper tax due from a person by fraudulent means. Such evasion may be considered a civil fraud case, in which case the taxpayer shall be penalized with the ad valorem penalty of 50% surcharge on the deficiency tax found due from him. Or if the evidence so warrants, the tax evasion may be considered a criminal tax evasion case, and consequently, the taxpayer shall be criminally prosecuted and upon his conviction, shall be penalized with a fine and/or imprisonment, in addition to the 50% surcharge imposed on the deficiency tax due from him. A civil fraud case and a criminal tax evasion case are similar in the sense that both involve evasion of tax thru fraudulent means and both require the Commissioner to bear the burden of proving such evasion. However, there are cognizable differences between them and said differences may be categorized as follows: (a) As to degree of fraud . In a civil fraud case, although fraud is found to be present the evidence available is believed not sufficient to establish beyond reasonable doubt that the evasion was "willful" as that term has been defined by the Courts, and for this reason, criminal prosecution of the taxpayer is not resorted to. In other words, the additional element of "willfulness" must be present in order that a criminal tax evasion case can be established. (b) As to degree of proof . Although the Commissioner bears the burden of proving tax evasion by fraudulent means in both cases, however, in a civil fraud case, all that is required of him is to prove such evasion by clear and convincing evidence. But a criminal tax evasion case requires a higher degree of proof. In such a case, the Commissioner must prove willful evasion beyond reasonable doubt. III. Devices or schemes by which taxpayers evade income tax . The means by which taxpayers evade income tax are as ingenious and limitless as the imagination of the particular wrongdoer permits. It would therefore be impossible to list here all such devices or schemes. However, for the guidance of examiners investigating taxpayers for tax evasion, there are listed hereunder some of the devices or schemes usually adopted by taxpayers in eliminating or reducing their income tax. 1.Using false set or double sets of books, in order to conceal purchases, sales and receipts; 2.Using false receipts to support deductions claimed in the return; 3.Understating sales and overstating purchases; 4.Understating inventory in order to cover up understatement of sales and overstatement of purchases; 5.Transacting in the names of dummies or under assumed names; 6.Transacting thru controlled subsidiaries which are actually mere conduits for the purpose of reducing taxable sales and gross income; 7.Sluicing off of corporate income earnings to principal shareholders in the disguise of commissions or salaries usually out of proportion to the value of services rendered to the corporate taxpayer; 8.Making false entries in books or altering entries therein to support falsification in the return; 9.Destroying books and records to prevent discovery of unreported income; and 10.Deducting personal expenses as business expenses. The foregoing are mere examples of devices or schemes adopted by taxpayers in order to eliminate or reduce income tax due from them. But as aforesaid there are limitless means by which taxpayers evade income tax. It is for the examiner to detect such devices or schemes and to secure the evidence that will support his findings and establish either a civil fraud case or a criminal tax evasion case. IV. Burden of proof . Degree of proof in fraud cases . The examiner investigating a tax fraud case should bear in mind the following rules on burden of proof and degree of proof required in the cases hereunder mentioned: A. Civil Fraud Case . Where the Commissioner asserts a fraud penalty as an addition to the deficiency which he has determined to be due, then the burden of proof is on him to establish the presence of fraud with intent to evade tax. The degree of proof required on the issue of fraud in a civil fraud case is that it be "clear and convincing" and need not rise to proof "beyond reasonable doubt" as in a criminal case, but it must be stronger than the mere preponderance of the evidence which would be sufficient to sustain a judgment on the issue of the correctness of the deficiency itself apart from the fraud. To illustrate: (1) Case of Undisclosed or Understatement of Income . The fact that certain income is not reported in the return or if reported, is understated may in itself involve the elements of misrepresentation and deceit so as to furnish the necessary basis for fraud with intent to evade the tax. However, to bolster the stand of the Commissioner, the examiner should secure evidence showing that the understatement or concealment was deliberate, such as returns for previous years showing the same understatement or concealment, and/or testimony of third parties, such as the bookkeeper or accountant of the taxpayer, or one who had transacted with him; (2) Case of Overstatement of Deductions . Taken alone, the overstatement of a deduction is not conclusive on the issue of fraud. But when the deduction is considered with other suspicious circumstances in the case, the overstatement will support fraud penalty. For example, the deduction from corporate income of alleged salaries, or bonuses can be proved fraudulent by showing that the recipients were majority stockholders of the corporations; that they did not render any service or if they did, that the service they rendered did not warrant payment of such salaries or bonuses; and that the amount received by each of them is proportionate to his stockholdings, indicating that the amounts represented as salaries or bonuses were actually dividends due the recipients. B. Criminal Tax Evasion Case . The same factors which will sustain "fraud with intent to evade tax" may be considered in a criminal tax evasion case provided the element of "willfulness" is proved. The term "willfulness" has been defined as an act done with a bad purpose or without justifiable cause. The word is also employed to characterize a thing done without ground for believing it is lawful, or conduct marked with careless disregard whether or not one has the right so to act. (see United States vs. Murdock, 290 U.S. 389) Proof of "willfulness" is therefore the crucial core of a criminal tax evasion case. The government must introduce evidence which would tend to indicate bad faith or dishonesty in the defendant's dealing with the government. However, since "willfulness" is rarely capable of proof by indirect evidence, it may be proved by circumstantial evidence. The following were mentioned in the Spies case (Spies vs. U.S. (1943) 317 U.S. 492) as acts which could be attempts to evade and defeat tax and therefore, subject of a criminal tax evasion case: 1.Keeping double sets of books or keeping a double set of financial statements, the false ones to be presented to the investigating agents. 2.Making false entries in books or alterations of books. 3.Making false invoices or documents so as to conceal the true nature of income. 4.Destruction of books and records. 5.Concealment of amount of income or covering sources of income by entering into contracts in the name of dummies. There are many more such acts and transactions which can be considered as indicative of tax evasion. Examiners are therefore directed to keep alert and immediately report any criminal tax evasion case they may discover. V. Indirect proof of tax evasion : Net worth increase and expenditures considered unreported taxable income . Since it is only in rare instances that the government is able to establish proof of undisclosed income by direct evidence, the Commissioner, by authority of Section 15 and 18 of the Tax Code, may resort to indirect proofs of unreported taxable income by the so-called net worth increase expenditures method, details of which are explained in Revenue Memorandum No. 43-74, dated August 1, 1974. Hereunder is how the government proceeds in proving unreported taxable income by the aforementioned method: Firstly, it submits evidence to establish an opening "net worth", or total net value of the taxpayer's assets at the beginning of a given year. It then proves increases in the taxpayer's net worth for each succeeding year covered by the period under examination by showing the difference between the adjusted net values of the taxpayer's assets at the beginning and end of each of the years involved. The taxpayer's non-deductible expenditures, including living expenses are added to these increases, and if the resulting figure for any year is substantially greater than the taxable income reported by the taxpayer for that year, the government claims the excess as representing unreported taxable income. A. Net worth increase in civil fraud cases . Burden of Proof . The use of the said method was approved by the Supreme Court in several cases, namely: (1) Eugenio Perez vs. Court of Tax Appeals and Collector of Internal Revenue. G.R. No. L-10507, May 30, 1958; (2) Collector of Internal Revenue vs. Aurelio P. Reyes, G.R. No. L-11534 and L-11558, November 25, 1958; (3) Commissioner of Internal Revenue vs. Enrique Avelino, G.R. No. L-1484, September 19, 1961; (4) Jose Avelino vs. Collector of Internal Revenue, G.R. No. L-17715, July 31, 1963; and (5) William L. Yao vs. Collector of Internal Revenue, G.R. No. L-11875; December 28, 1963. The following significant rulings were issued by the Supreme Court in the aforecited cases: (a)In civil cases, the application of the net worth method does not require identification of the sources of the alleged unreported income. In other words, once the government proves the increases in net worth, the burden of proof is shifted to the taxpayer, for as the Supreme Court observed, normally, acquisitions are made from accumulations of taxable income and where not so made, it lies within the peculiar province of the taxpayer to explain how much acquisitions were made with non-taxable resources. (b)The determination of the tax deficiency by the Government has prima facie validity and the burden rests upon the taxpayer to overcome this presumption and to show to the satisfaction of the Court that the determination is not correct. (c)Consistent and substantial underdeclaration of income determined by net worth increases of the taxpayer during the years under examination is sufficient basis for a finding of fraud, for affirmative willful intent may be inferred from any conduct, the likely effect of which would mislead or conceal. (Collector vs. Aurelio P. Reyes citing Spies vs. U.S. 317 U.S. 492) The foregoing rulings should not, however, lull examiners into sleeping on their duties. They should verify and secure proofs establishing the following: 1.Sources of income of the taxpayer. However, proof of a likely source from which one could reasonably find that the net worth increases sprang, is sufficient. 2.What the taxpayer's assets were at the beginning of the tax year in question, i.e., the starting point. 3.What was the value taken at cost of these assets. 4.What were the taxpayer's assets and their value at the end of the tax period in question. 5.If the process of showing increase in net worth extends over a period of more than one tax year, what is the fair and reasonable allocation of the increase over the years in question. 6.What are the correct and fair adjustments to be made by way of eliminating duplications, return of capital, evaluation of unspecified or contingent obligations, depreciation, gifts, devises, bequest, or non-taxable items. Although the burden is upon the taxpayer to show that his net worth increase was derived from non-taxable sources, the examiner should nevertheless pursue leads furnished by the taxpayer to explain the yearly increase of his assets. However, his duty to do so is limited to those reasonably susceptible of verification. 7.What are fair and equitable adjustments to be made for living expenses, payment of taxes, cost of life insurance, etc. In this connection, it is advised that in determining the net worth increases of a taxpayer, the examiner may avail of the statement of assets, liabilities and net worth filed by the taxpayer pursuant to Presidential Decree No. 379, as amended. However, if the taxpayer had availed of tax amnesty under Presidential Decree No. 23, his acquisitions in 1971 and prior years shall not be subject to the aforesaid networth increase method of determining untaxed income. If he availed of the tax amnesty under Presidential Decree No. 157 and/or Presidential Decree No. 370, his immunity from such method of determining untaxed income shall extend to the year 1972. And if he availed of the amnesty under Presidential Decree No. 631, his immunity from the aforesaid method of determining untaxed income shall extend to the year 1973 and his net worth reported in the Statement filed pursuant to Presidential Decree No. 379 shall be considered his beginning net worth as of January 1, 1974. If the taxpayer has not availed of tax amnesty, the statement filed by him pursuant to Presidential Decree No. 379, as amended shall, where circumstances so require, be looked into, for the purpose of determining whether the taxpayer has any untaxed income or wealth. However, the examiner should not depend entirely on said statement as it may not be true or correct. He should ascertain the true and correct assets of the taxpayer from the books and records of the taxpayer himself, records of third persons with whom the taxpayer may have transacted, and records of government offices such as land records of registers of deeds, assessors and treasurers, and records of the motor vehicle office. B. Net worth increase in Criminal Tax Evasion cases . Burden and degree of proof . A higher degree of proof is required for establishing the criminal liability of a taxpayer whose unreported income is determined by the net worth increase expenditures method, for as in other criminal case, the guilt of a defendant must be proved beyond reasonable doubt. Thus it has been held that before the increased net worth method of proof is effective, the net worth of the taxpayer at the beginning of the tax period must be clearly and actually established by competent evidence. The best evidence which the government can use are of course the following: 1.The statement of assets, liabilities and net worth submitted by the taxpayer pursuant to Presidential Decree No. 379, as amended. However, as hereinbefore pointed out, such statement should not be used against taxpayers who availed of tax amnesty under Presidential Decrees Nos. 23, 157, 370 and/or 631. The extend of immunity of a taxpayer from being subjected to the net worth increase method of determining untaxed income depends on which of the aforementioned Presidential Decrees was availed of by the taxpayer to secure tax amnesty (see discussion above) 2.Financial statements filed by the taxpayer with his income tax returns or with other government agencies; 3.Books and records of the taxpayer. But where no such document and/or record is available, the examiner should resort to reconstruction of the taxpayer's assets from available sources such as (a) records of other persons with whom the taxpayer had transacted; (b) records of government offices where transactions or properties are registered; and (c) statements of persons who have knowledge of the business and affairs of the taxpayer, such as the accountant or bookkeeper of the taxpayer. Examiners should see to it that documentary evidence needed to establish his findings are secured and submitted together with his report; and reviewing officers should immediately study the report and evidence submitted by the examiner and instruct him on what further facts should be ascertained and what additional evidence should be secured. All internal revenue officers and others charged with enforcement of internal revenue laws are enjoined to be guided by this circular and to give it as wide a publicity as possible. MISAEL P. VERA Commissioner of Internal Revenue TAN-1601-593-5