Unnumbered BIR Ruling

March 24, 1998 MEMORANDUM FOR: The Commissioner SUBJECT : This refers to the protest dated March 13, 1986 filed by 3M PHILIPPINES, 3M House, Guadalupe, Makati City, thru counsel, against the assessment of P3,009,946.75, including increments thereon, representing its 25% surtax for improper accumulation of surplus for the year 1980 under Assessment Notice No. 32-06-4B-005441-80, dated February 12, 1986. cdtech FACTS OF THE CASE : Taxpayer is a domestic corporation engaged in the manufacture of various products and it is a wholly-owned subsidiary of Minnesota Mining and Manufacturing Company of America, a corporation organized under the laws of the State of Delaware, U.S.A. Upon examination of its books of accounts and related accounting records for the year 1980, it was found out that it had a surplus retained earnings of P17,524,867.00, which was considered as improper accumulation of surplus under Section 25 of the Tax Code of 1977. The basis for the imposition of the surtax is Presidential Decree No. 270 which provides that all corporations which have surplus profits in excess of the necessary requirements for capital expansion and reserves shall declare and distribute the excess profits as dividends to stockholders. Also, under the implementing guidelines, where the financial statements of the corporation show profits in excess of 50% of its paid-up capital, it shall explain by footnotes why the same has not been declared as dividends. There was no explanation to that effect by way of footnotes in the financial statements. The amount of P7,524,867.00 constituting improper accumulation of surplus is computed as follows: Paid-up Capital P20,000,000.00 Retained Earnings per F/S 17,524,867.00 50% of Paid-up Capital 10,000,000.00 Surplus Profit in Excess of 50% P7,524,867.00 =========== ISSUE : Whether or not there is an improper accumulation of surplus. DISCUSSION/RESOLUTION : It seems that in the instant case, there was hasty and arbitrary application of the provisions and implementing guidelines of Presidential Decree No. 270 as borne out by the fact that upon the mere findings of retained earnings, that there was no explanation in the footnotes in the financial statements why the said excess was not declared as dividends, and that there was allegedly no showing that the accumulation was needed for working capital and expansion of business, the said excess was considered as unreasonable accumulation of profits under Section 25 of the Tax Code, as amended. Apparently, our examiner overlooked the fact that even the Securities and Exchange Commission (SEC), the agency tasked with the implementation of the Decree, has to satisfy itself first that the corporation's surplus profits are in excess of the "necessary requirements for capital expansion and reserves" before it can direct its declaration and distribution as dividends to stockholders. And one way to ascertain this fact is from the explanation by way of footnotes in the financial statements. The implementing guidelines do not provide that in the absence of said explanation, the SEC shall automatically direct the distribution of the excess profits as dividends. This only means that it should require first the corporation to explain. The absence, therefore, of said explanation is not an indication that the surplus profits are in excess of the "necessary requirements for capital expansion and reserves." It appears also that the subject surtax was imposed obviously because of the "size" of the retained earnings of the taxpayer without taking into account other determinative factors. Our jurisprudence on the matter of improper accumulation of surplus is very clear that neither the size of the retained earnings nor the net liquid asset alone is determinative of improper accumulation (Manila Wine Merchants, Inc. vs. The Commissioner of Internal Revenue, L-26145, February 20, 1984). The amount of accumulated surplus, by itself, is not a determining factor to justify the imposition of the surtax because retention of profits to meet the reasonable needs of the business is a defense. Thus, under the Income Tax Regulations (Revenue Regulations No. 2), implementing Section 25 of the Tax Code on improper accumulation of surplus, there are valid grounds for not declaring dividends, such as the retention of earnings for working capital to meet the reasonable needs of the business or investment in addition to plant reasonably required in the business. Section 21 of Revenue Regulation No. 2 expressly provides: " . . . . An accumulation of earnings or profits (including the undistributed earnings or profits of prior years) is unreasonable if it is not required for the purpose of the business, considering all the circumstances of the case. It is not intended, however, to prevent accumulation of surplus for the reasonable needs of the business if the purpose is not to prevent the imposition of the tax upon shareholders. No attempt is here made to enumerate all the ways in which earnings or profits of a corporation may be accumulated for the reasonable needs of the business. Undistributed income is properly accumulated if retained for working capital needed by the business; or if invested in addition to plant reasonably required by the business; or if in accordance with the contract obligations placed to the credit of a sinking fund for the purpose of retiring bonds issued by the corporation. The nature of the investment or earnings or profits is immaterial if they are not in fact needed in the business. Among other things, the nature of the business, the financial condition of the corporation at the close of the taxable year, and the use of the undistributed earnings or profits will be considered in determining the reasonableness of the accumulations." A scrutiny of taxpayer's Financial Statements for the taxable year 1980 shows that its cash was only P417,802.00 and its current assets consisted mainly of accounts receivable and inventories. Also, at the end of the year, its total liabilities exceeded P49.5 million as against its retained earnings of P17,524,867.00. Besides, its current asset-liability ratio in 1980 was 1:49 to 1:00 (Current Assets of P73,814,081.00/Current Liabilities of P49,551,653.00), which is way below the generally accepted ratio of 2 to 1, is not indicative of high liquidity. "Corporate liquidity is of special significance in the determination of the application of the penalty tax. . . . The question is the measure of corporate liquidity and this, of course, is dependent upon the facts of each individual case. Generally speaking, low liquidity is indicative of a reasonable accumulation of earnings or profits, whereas, high liquidity discloses an intent to avoid the tax. An unfavorable ratio of current liabilities to current assets usually justifies an accumulation. On the other hand a large ratio of current assets to current liabilities may indicate a purpose to avoid the tax" (Merten's Federal Law of Income Taxation, pp. 71-72) Moreover, based on the documents submitted by taxpayer, covering taxable years 1973 to 1984, it has declared dividends (cash and/or stock dividends) in the following amounts, to wit: YEAR KIND OF DIVIDEND AMOUNT 1973 Cash Dividend P295,000.00 1974 Stock Dividend 2,250,000.00 1975 Stock Dividend 10,000,000.00 1976 None 1977 Cash Dividend 1,800,000.00 1978 Cash Dividend 3,193,856.00 1979 Cash Dividend 3,248,177.00 1980 Cash Dividend 4,624,831.00 1981 None 1982 Cash Dividend 2,727,077.00 1983 Cash Dividend 3,043,417.00 Stock Dividend 10,000,000.00 1984 Cash Dividend 2,622,016.00 Accordingly, under the circumstances of the case, there is no strong and sufficient basis to justify the imposition of the surtax assessment. As to the assessment of P178,321.60 as deficiency income tax for the same taxable year, under Assessment No. 32-06-4B-005441-80, dated February 2, 1986, the same was included among the assessments that taxpayer offered to compromise pursuant to Revenue Memorandum Order Nos. 1-88, 8-89 and 16-89, which was accepted by the Bureau of Internal Revenue as per letter of Deputy Commissioner Eufracio D. Santos, dated August 21, 1989. This was paid by the taxpayer under C.R. No. B-16117492, dated November 10, 1989. RECOMMENDATION : In view of the foregoing, and finding taxpayer's protest to be well-taken, it is respectfully recommended that the questioned assessment for 25% surtax for improper accumulation of surplus for the year 1980 be cancelled and withdrawn and this case considered closed and terminated. LexLib Respectfully submitted: (SGD.) RODULFO L. SALAZAR Chief, Appellate Division I CONCUR: (SGD.) ESTHER R. IBAEZ OIC, Assistant Commissioner Legal Service Recommendation-APPROVED: (SGD.) LIWAYWAY VINZONS-CHATO Commissioner of Internal Revenue