The Net Worth-expenditures (Inventory) Method of Investigation Authorized Under Sections 15 and 38 of the National Internal Revenue Code

August 1, 1974 REVENUE MEMORANDUM CIRCULAR NO. 43-74 SUBJECT : The Net Worth-expenditures (Inventory) Method of Investigation Authorized Under Sections 15 and 38 of the National Internal Revenue Code TO : All Internal Revenue Officers and others concerned The President of the Philippines, in his Letter of Instructions No. 204, dated July 24, 1974, directs the Commissioner of Internal Revenue "to utilize the entire tax enforcement machinery of the government in "(1) Ferreting out persons who failed to voluntary disclose any previously untaxed income and/or wealth; and (2) Discovering cases of fraud, irregularity or mistake in the books of accounts and other accounting records of taxpayers." In order to fully implement the above directive, it is imperative that definitive measures be undertaken by the Bureau of Internal Revenue to prepare itself for the task ahead. The first of such tasks is the full implementation of Presidential Decree No. 379 requiring the filing of a statement of assets, liabilities and net worth. This decree has underscored the importance of the net worth method of investigation. It shall be the primary responsibility of the Bureau to see to it that taxpayers comply faithfully with Presidential Decree No. 379 and that the statements filed thereunder reflect their true net worth. A detailed verification of such statements is a necessity if the use of the inventory method in future tax investigations is to be effective. Jurisprudence on the subject is uniform in prescribing the conditions for its use. One of such conditions is that there must be "a starting point or opening net worth." The statement to be filed by taxpayers under Presidential Decree No. 379 is such "starting point" and on its accuracy will largely depend the correctness of the result of any future investigation. Within this context, there is herewith discussed the significant features of the net worth-expenditures (inventory) method of investigation as authorized under Sections 15 and 38 of the National Internal Revenue Code. 1. Its basic concept and theory . The method is an extension of the accounting principle: Assets minus liabilities equals net worth. The taxpayer's net worth is determined both at the beginning and at the end of the same taxable year. The increase or decrease in net worth is adjusted by adding all non-deductible items and subtracting therefrom non-taxable receipts. The resultant figure is the taxable net income before statutory personal and additional exemptions. The general theory underlying this method is that the taxpayer's money and other assets in excess of liabilities after accurate and proper adjustment of non-deductible and non-taxable items not accounted for in his tax return is deemed to be his unreported income. Otherwise stated, the theory is that the unexplained increase in networth of a taxpayer is presumed to be derived from taxable sources. 2. The source of authority for its use . The Commissioner's authority to use the net worth-expenditures method of investigation and other indirect methods of establishing taxable income is found in Section 38 of the National Internal Revenue Code which in part reads: ". . . The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner of Internal Revenue does clearly reflect the income . . ." (Emphasis supplied.) This authority has been upheld by Philippine courts in a long line of cases, notable among which is the leading case of Eugenio Perez vs. the Court of Tax Appeals and the Collector of Internal Revenue, G. R. No. L-10507, promulgated on May 30, 1958. It is a practical necessity if a fair and efficient system of collecting revenue is to be maintained. Moreover, Section 15 of the Tax Code provides a broad and general investigatory power for the Commissioner to assess the proper tax on the best evidence obtainable whenever there is reason to believe that the required report is not forthcoming or when such report is false, incomplete or erroneous. The power to investigate given to the Commissioner by said section necessarily implies the authority to compute the correct amount of tax by any method. The Commissioner must be free to utilize all available evidence to insure faithful compliance with all internal revenue laws in order to safeguard the revenues of the government. 3. The conditions for use of the method . The application of the net worth method is not without limitations. The conditions for the proper use of such method as found in the law itself and the case law developed on the matter, are: (a) That the taxpayer's books do not clearly reflect his income or the taxpayer has no books, or if he has books, he refuses to produce them; (b) That there is evidence of a possible source or sources of income to account for the increases in net worth or the expenditures; (c) That there is a fixed starting point or opening net worth, i. e., a date beginning with a taxable year or prior to it, at which time the taxpayer's financial condition can be affirmatively established with some definiteness; and (d) That the circumstances are such that the method does reflect the taxpayer's income with reasonable accuracy and certainty, and proper and just additions of personal expenses and other non-deductible expenditures were made, and correct, fair and equitable credit adjustments were given by way of eliminating non-taxable items. The above conditions are briefly discussed hereunder: (a) Inadequate Records as a Pre-requisite . Whenever no method of accounting is employed by the taxpayer or where the method does not clearly reflect the true income, the Commissioner is authorized to resort to any method which, in his opinion, does reflect the correct income. Obviously, this method of income determination may be used when the taxpayer has no books of accounts or when such books and records are not available for examination or where the books are incomplete and inadequate. By the same token, the government may be forced to resort to the net worth method of proof where the few records of the taxpayers were destroyed, for to require more would be tantamount to holding that skillful concealment is an invincible barrier to proof. (b) The Need for Evidence of the Source of Income . In all the leading cases on this matter, courts are unanimous in holding that when the tax case is civil in nature, direct proof of sources of income is not essential that the government is not required to negate all possible non-taxable sources of the alleged net worth increases. Thus, proofs of loans, gifts, bequests, inheritances and the like, need not be adduced in evidence by the government. The burden of proof is upon the taxpayer to show that his net worth increase was derived from non-taxable sources. However, when a taxpayer is criminally prosecuted for tax evasion, the need for evidence of a likely source of income becomes a pre-requisite for a successful prosecution. The burden of proof in criminal cases is always with the government. It is, therefore, incumbent upon revenue agents to negate all possible sources of non-taxable receipts in addition to adducing evidence to satisfy all the other three conditions. Conviction in such cases, as in any criminal case, rests on proof beyond reasonable doubt. (c) A Definite Starting Point or Opening Net Worth . This is an essential condition, considered to be the cornerstone of a net worth case. If the starting point or opening net worth is proved to be wrong, the whole superstructure usually falls. The courts have uniformly stressed the importance of accuracy in the figures used therein because the validity of the result of any investigation under this method will depend entirely upon a correct opening net worth. (d) Proper Adjustments to Conform with the Income Tax Laws . Proper adjustments for non-deductible items must be made. Under this category are: personal living or family expenses, premiums paid on any life insurance policy, losses from sales or exchanges of property between members of the family; income taxes paid; estate, inheritance and gift taxes, and other non-allowable taxes; election expenses and other expenses against public policy, non-deductible contributions; gifts to others; net capital loss, and the like. These must be added to the increase or decrease in net worth as the case may be. On the other hand, non-taxable items should be deducted therefrom. These items are necessary adjustments to avoid the inclusion of what otherwise are non-taxable receipts. They are: inheritance, gifts and bequests received; non-taxable capital gains; compensation for injuries or sickness; proceeds of life insurance policies; sweepstakes winnings; interest on government securities and the like. (End of discussion). All internal revenue officers and others concerned are hereby enjoined to familiarize themselves with the many facets of the net worth method of investigation as above discussed. In this connection, your attention is invited to the instructions of the President as contained in his Letter of Instructions No. 186 dated May 14, 1974, the last paragraph of which is reproduced hereunder: "The compilation of statistical data on the statement of assets, liabilities and net worth required under Presidential Decree No. 379, as amended, is vital to the interests of the country for economic development. Any willful false declaration or deliberate failure to comply with any of the provisions of the said decree shall be dealt with severely." All future tax investigations under the inventory method of investigation must conform with the requirements of this circular. For this purpose, there are hereby appended pro-forma statements of assets, liabilities and net worth marked as Annex "A" and cash analysis marked as Annex "B", which statements should, invariably, form part of a report of investigation. MISAEL P. VERA Commissioner of Internal Revenue TAN-1601-593-5 ANNEX A PRO-FORMA STATEMENT OF ASSETS, LIABILITIES & NET WORTH PARTICULARS Dec. 31, 1973 Dec. 31, 1974 ASSETS (Net of Depreciation) 1. Cash on Hand (**) P. . . P. . . 2. Cash in Banks P. . . P. . . 3. Accounts, Notes and Loans Receivable P. . . P. . . 4. Mortgage Receivable P. . . P. . . 5. Investments P. . . P. . . 6. Real Property Land P. . . P. . . 7. Real Property Improvements P. . . P. . . 8. Motor Vehicles P. . . P. . . 9. Inventory at the End P. . . P. . . 10. Furniture/Fixtures P. . . P. . . 11. Personal Property P. . . P. . . 12. Other Assets P. . . P. . . Total Assets P. . . P. . . LIABILITIES 1. Accounts, Notes and Loans Payable P. . . P. . . 2. Mortgage Payable P. . . P. . . 3. Other Liabilities P. . . P. . . Total Liabilities P. . . P. . . Net Worth at the End P. . . P. . . ===== Less: Net Worth at the Beginning P. . . Increase (Decrease) in Net Worth P. . . Add: Non-deductible Items 1. Personal, living & family expenses P. . . 2. Insurance premiums P. . . 3. Income tax payments P. . . 4. Gifts to Others P. . . 5. Non-deductible contributions P. . . 6. Net Capital Loss P. . . 7. Amnesty tax payments P. . . 8. Estate and Donor's taxes P. . . 9. Other non-deductible items P. . . Total non-deductible items P. . . Net Income before further adjustments P. . . Less: Non-taxable items 1. Gifts, donations & inheritance received P. . . 2. Non-taxable capital gains P. . . 3. Backpay/War damage receipts P. . . 4. Proceeds of life insurance policy P. . . 5. Non-taxable stock dividends (provided reflected in Assets) P. . . 6. Pensions received under RA 4917 (private firms) P. . . 7. Retirement pay from GSIS & SSS P. . . 8. Non-recognized gains from exchanges of property under Section 35(2)(c) of the Tax Code P. . . 9. GSIS cash dividends P. . . 10. Social security benefits received from foreign gov't. and institutions (Per PD 220) P. . . 11. Other non-taxable items P. . . Total non-taxable items P. . . Adjusted Net Income as Per Investigation P. . . Less: Statutory Exemptions: 1. Exemption of a Working Wife P. . . 2. Personal & additional exemption P. . . Total Statutory Exemption P. . . NET INCOME SUBJECT TO TAX P. . . ==== ANNEX B NET WORTH-EXPENDITURES METHOD CASH ANALYSIS ( ** ) 1974 Sources of Funds Cash on hand and in bank at the beginning P. . . Add 1. Cash received from business (sales) P. . . 2. Collection of receivables P. . . 3. Proceeds of loans and mortgages P. . . 4. Proceeds of life insurance policies P. . . 5. Proceeds from sale of property, real or personal P. . . 6. Cash gifts, bequests and inheritance received P. . . 7. Non-fund deductions (depreciation and provision for bad debts) P. . . 8. Backpay, pensions, benefits gratuities received P. . . 9. Cash dividends & interest income P. . . 10. Wagering gains P. . . 11. Receipt of cash from any other source P. . . Total of Sources P. . . Total Available Funds for the Year P. . . Less Application of Funds 1. Cash purchases and business expenses P. . . 2. Cash paid for assets/property, real or personal (full payment or installment) P. . . 3. Payment of loans, notes and mortgages payable P. . . 4. Section 30 (c)(1) (A to D) (non-deductible items) P. . . 5. Section 31(a) cash disbursements: a. Personal, living or family expenses P. . . b. Capital expenditures P. . . c. Premiums paid on life insurance P. . . 6. Cash disbursements of any kind P. . . 7. Cash on hand and bank at the end P. . . Total Applied Funds P. . . CASH ON HAND AT THE END AS RECONSTRUCTED P. . . ===== Footnotes ** Supported by accompanying Cash Analysis Schedule.