Realization Test; Severance test the government that will be [252 U.S.
the government that will be [252 U.S. 189, 200] noticed), plainly evinces the
Also known as the Macomber Test. There is no tacable income until there
is a separation from capital of something of exchangeable value, thereby supplying
the realization or transmutation which would result in the receipt of income. The
essence of the test is that in order for income to be taxed, it is to be severed from
the property from which is was derived.
The Court analogized capital as being separate from income in the way that a
tree is separate from its fruit. It requires the presence of a tax event which is an
event which triggers a transfer of ownership of property (Eisner v. Macomber, 252
U.S. 189, March 8, 1920)
There is no taxable income until there is a separation from capital of something of
exchangeable value, thereby supplying the realization or transmutation which would
result in the receipt of income (Eisner v. Macomber). Thus, stock dividends are not
income subject to income tax on the part of the stockholder, because he merely
holds more shares representing the same equity interests in the corporation that
declared the stock dividends (Fisher v. Trinidad).
United States Supreme Court
EISNER v. MACOMBER, (1920)
No. 318
Argued: April 16, 1919 Decided: March 8, 1920
[252 U.S. 189, 190] Mr. Assistant Attorney General Frierson, for plaintiff in error.
[252 U.S. 189, 194] Messrs. Charles E. Hughes and George Welwood Murray, both
of New York City, for defendant in error.
[252 U.S. 189, 199]
Mr. Justice PITNEY delivered the opinion of the Court.
This case presents the question whether, by virtue of the Sixteenth Amendment,
Congress has the power to tax, as income of the stockholder and without
apportionment, a stock dividend made lawfully and in good faith against profits
accumulated by the corporation since March 1, 1913.
It arises under the Revenue Act of September 8, 1916 (39 Stat. 756 et seq., c. 463
[Comp. St. 6336a et seq.]), which, in our opinion ( notwithstanding a contention of
purpose of Congress to tax stock dividends as income. 1
The facts, in outline, are as follows:
On January 1, 1916, the Standard Oil Company of California, a corporation of that
state, out of an authorized capital stock of $100,000, 000, had shares of stock
outstanding, par value $100 each, amounting in round figures to $50,000,000. In
addition, it had surplus and undivided profits invested in plant, property, and
business and required for the purposes of the corporation, amounting to about
$45,000,000, of which about $20,000,000 had been earned prior to March 1, 1913,
the balance thereafter. In January, 1916, in order to readjust the capitalization, the
board of directors decided to issue additional shares sufficient to constitute a stock
dividend of 50 per cent. of the outstanding stock, and to transfer from surplus
account to capital stock account an amount equivalent to such issue. Appropriate
resolutions were adopted, an amount equivalent to the par value of the proposed
new stock was transferred accordingly, and the new stock duly issued against it and
divided among the stockholders.
Defendant in error, being the owner of 2,200 shares of the old stock, received
certificates for 1,100 additional[252 U.S. 189, 201] shares, of which 18.07 per
cent., or 198.77 shares, par value $19,877, were treated as representing surplus
earned between March 1, 1913, and January 1, 1916. She was called upon to pay,
and did pay under protest, a tax imposed under the Revenue Act of 1916, based
upon a supposed income of $ 19,877 because of the new shares; and an appeal to
the Commissioner of Internal Revenue having been disallowed, she brought action
against the Collector to recover the tax. In her complaint she alleged the above
facts, and contended that in imposing such a tax the Revenue Act of 1916 violated
article 1, 2, cl. 3, and article 1, 9, cl. 4, of the Constitution of the United States,
requiring direct taxes to be apportioned according to population, and that the
stock dividend was not income within the meaning of the Sixteenth Amendment. A
general demurrer to the complaint was overruled upon the authority of Towne v.
Eisner, 245 U.S. 418 , 38 Sup. Ct. 158, L. R. A. 1918D, 254; and, defendant having
failed to plead further, final judgment went against him. To review it, the present
writ of error is prosecuted.
The case was argued at the last term, and reargued at the present term, both orally
and by additional briefs.
We are constrained to hold that the judgment of the District Court must be
affirmed: First, because the question at issue is controlled by Towne v. Eisner,
supra; secondly, because a re-examination of the question with the additional light
thrown upon it by elaborate arguments, has confirmed the view that the represents that interest, the new shares and the original shares together
underlying ground of that decision is sound, that it disposes of the question here representing the same proportional interest that the original shares represented
presented, and that other fundamental considerations lead to the same result. before the issue of the new ones.' Gibbons v. Mahon, 136 U.S. 549, 559 , 560 S. [10
Sup. Ct. 1057]. In short, the corporation is no poorer and the stockholder is no
In Towne v. Eisner, the question was whether a stock dividend made in 1914 richer than they were before. Logan County v. United States, 169 U.S. 255 , 261 [18
against surplus earned prior to January 1, 1913, was taxable against the Sup. Ct. 361]. If the plaintiff gained any small advantage by the change, it certainly
stockholder under the Act of October 3, 1913 (38 Stat. 114, 166, c. 16 ), which
was not an advantage of $417,450, the sum upon which he was taxed. ... What has
provided (section B, p. 167) that net income should include 'dividends,' and also
happened is that the plaintiff's old certificates have been split up in effect and have
'gains or profits and income derived [252 U.S. 189, 202] from any source
whatever.' Suit having been brought by a stockholder to recover the tax assessed diminished in value to the extent of the value of the new.'
against him by reason of the dividend, the District Court sustained a demurrer to
This language aptly answered not only the reasoning of the District Court but the
the complaint. 242 Fed. 702. The court treated the construction of the act as
argument of the Solicitor General in this court, which discussed the essential
inseparable from the interpretation of the Sixteenth Amendment; and, having
nature of a stock dividend. And if, for the reasons thus expressed, such a dividend
referred to Pollock v. Farmers' Loan & Trust Co., 158 U.S. 601 , 15 Sup. Ct. 912, and
is not to be regarded as 'income' or 'dividends' within the meaning of the act of
quoted the Amendment, proceeded very properly to say (242 Fed. 704):
1913, we are unable to see how it can be brought within the meaning of 'incomes'
in the Sixteenth Amendment; it being very clear that Congress intended in that act
'It is manifest that the stock dividend in question cannot be reached by the Income to exert its power to the extent permitted by the amendment. In Towne v. Eisner it
Tax Act and could not, even though Congress expressly declared it to be taxable as was not contended that any construction of the statute could make it narrower
income, unless it is in fact income.' than the constitutional grant; rather the contrary.
It declined, however, to accede to the contention that in Gibbons v. Mahon, 136
The fact that the dividend was charged against profits earned before the act of
U.S. 549 , 10 Sup. Ct. 1057, 'stock dividends' had received a definition sufficiently
1913 took effect, even before the amendment was adopted, was neither relied
clear to be controlling, treated the language of this court in that case as obiter
upon nor alluded to in our consideration of the merits in that case. Not only so, but
dictum in respect of the matter then before it (242 Fed. 706), and examined the
had we considered that a stock dividend constituted income in any true sense, it
question as res nova, with the result stated. When the case came here, after
would have been held taxable under the act of 1913 notwithstanding it was [252
overruling a motion to dismiss made by the government upon the ground that the
U.S. 189, 204] based upon profits earned before the amendment. We ruled at the
only question involved was the construction of the statute and not its
same term, in Lynch v. Hornby, 247 U.S. 339 , 38 Sup. Ct. 543, that a cash dividend
constitutionality, we dealt upon the merits with the question of construction only,
extraordinary in amount, and in Peabody v. Eisner, 247 U.S. 347 , 38 Sup. Ct. 546,
but disposed of it upon consideration of the essential nature of a stock dividend
that a dividend paid in stock of another company, were taxable as income although
disregarding the fact that the one in question was based upon surplus earnings that
based upon earnings that accrued before adoption of the amendment. In the
accrued before the Sixteenth Amendment took effect. Not only so, but we rejected
former case, concerning 'corporate profits that accumulated before the act took
the reasoning of the District Court, saying ( 245 U.S. 426 , 38 Sup. Ct. 159, L. R. A.
effect,' we declared ( 247 U.S. 343, 344 , 38 S. Sup. Ct. 543, 545 [62 L. Ed. 1149]):
1918D, 254):
'Just as we deem the legislative intent manifest to tax the stockholder with respect
'Notwithstanding the thoughtful discussion that the case received below we cannot
to such accumulations only if and when, and to the extent that, his interest in them
doubt that the dividend was capital as well for the purposes of the Income Tax Law
comes to fruition as income, that is, in dividends declared, so we can perceive no
as for distribution between tenant for life and remainderman. What was said by
constitutional obstacle that stands in the way of carrying out this intent when
this court upon the latter question is equally true for the former. 'A stock dividend
dividends are declared out of a pre-existing surplus. ... Congress was at liberty
really takes nothing from the property of the corporation, and adds nothing to
under the amendment to tax as income, without apportionment, everything that
the [252 U.S. 189, 203] interests of the shareholders. Its property is not
became income, in the ordinary sense of the word, after the adoption of the
diminished, and their interests are not increased. ... The proportional interest of
amendment, including dividends received in the ordinary course by a stockholder
each shareholder remains the same. The only change is in the evidence which
from a corporation, even though they were extraordinary in amount and might
appear upon analysis to be a mere realization in possession of an inchoate and
contingent interest that the stockholder had in a surplus of corporate assets
previously existing.'
In Peabody v. Eisner, 247 U.S. 349, 350 , 38 S. Sup. Ct. 546, 547 (62 L. Ed. 1152), we
observed that the decision of the District Court in Towne v. Eisner had been
reversed 'only upon the ground that it related to a stock dividend which in fact took
nothing from the property of the corporation and added nothing to the interest of
the shareholder, but merely changed the evidence which represented that
interest,' and we distinguished the Peabody Case from the Towne Case upon the
ground that 'the dividend of Baltimore & Ohio shares was not a stock dividend but
a distribution in specie of a portion of the assets of the Union Pacific.'
Therefore Towne v. Eisner cannot be regarded as turning [252 U.S. 189, 205] upon
the point that the surplus accrued to the company before the act took effect and
before adoption of the amendment. And what we have quoted from the opinion in
that case cannot be regarded as obiter dictum, it having furnished the entire basis
for the conclusion reached. We adhere to the view then expressed, and might rest
the present case there, not because that case in terms decided the constitutional
question, for it did not, but because the conclusion there reached as to the
essential nature of a stock dividend necessarily prevents its being regarded as
income in any true sense.
Nevertheless, in view of the importance of the matter, and the fact that Congress
in the Revenue Act of 1916 declared (39 Stat. 757 [Comp. St . 6336b]) that a 'stock
dividend shall be considered income, to the amount of its cash value,' we will deal
at length with the constitutional question, incidentally testing the soundness of our
previous conclusion.
The Sixteenth Amendment must be construed in connection with the taxing clauses
of the original Constitution and the effect attributed to them before the
amendment was adopted. In Pollock v. Farmers' Loan & Trust Co.,158 U.S. 601 , 15
Sup. Ct. 912, under the Act of August 27, 1894 (28 Stat. 509, 553, c. 349, 27), it was
held that taxes upon rents and profits of real estate and upon returns from
investments of personal property were in effect direct taxes upon the property
from which such income arose, imposed by reason of ownership; and that Congress
could not impose such taxes without apportioning them among the states
according to population, as required by article 1, 2, cl. 3, and section 9, cl. 4, of the
original Constitution.
Afterwards, and evidently in recognition of the limitation upon the taxing power of
Congress thus determined, the Sixteenth Amendment was adopted, in words
lucidly expressing the object to be accomplished:
'The Congress shall have power to lay and collect taxes on incomes, from whatever
source derived, without apportionment among [252 U.S. 189, 206] the several
states, and without regard to any census or enumeration.'
As repeatedly held, this did not extend the taxing power to new subjects, but
merely removed the necessity which otherwise might exist for an apportionment
among the states of taxes laid on income. Brushaber v. Union Pacific R. R. Co., 240
U.S. 1 , 17-19, 36 Sup. Ct. 236, Ann. Cas. 1917B, 713, L. R. A. 1917D, 414; Stanton v.
Baltic Mining Co., 240 U.S. 103 , 112 et seq., 36 Sup. Ct. 278; Peck & Co. v.
Lowe, 247 U.S. 165, 172 , 173 S., 38 Sup. Ct. 432.
A proper regard for its genesis, as well as its very clear language, requires also that
this amendment shall not be extended by loose construction, so as to repeal or
modify, except as applied to income, those provisions of the Constitution that
require an apportionment according to population for direct taxes upon property,
real and personal. This limitation still has an appropriate and important function,
and is not to be overridden by Congress or disregarded by the courts.
In order, therefore, that the clauses cited from article 1 of the Constitution may
have proper force and effect, save only as modified by the amendment, and that
the latter also may have proper effect, it becomes essential to distinguish between
what is and what is not 'income,' as the term is there used, and to apply the
distinction, as cases arise, according to truth and substance, without regard to
form. Congress cannot by any definition it may adopt conclude the matter, since it
cannot by legislation alter the Constitution, from which alone it derives its power to
legislate, and within whose limitations alone that power can be lawfully exercised.
The fundamental relation of 'capital' to 'income' has been much discussed by
economists, the former being likened to the tree or the land, the latter to the fruit
or the crop; the former depicted as a reservoir supplied from springs, the latter as
the outlet stream, to be measured by its flow during a period of time. For the
present purpose we require only a clear definition of the term 'income,' [252 U.S.
189, 207] as used in common speech, in order to determine its meaning in the
amendment, and, having formed also a correct judgment as to the nature of a
stock dividend, we shall find it easy to decide the matter at issue.
After examining dictionaries in common use (Bouv. L. D.; Standard Dict.; Webster's
Internat. Dict.; Century Dict.), we find little to add to the succinct definition
adopted in two cases arising under the Corporation Tax Act of 1909 (Stratton's
Independence v. Howbert, 231 U.S. 399, 415 , 34 S. Sup. Ct. 136, 140 [58 L. Ed.
285]; Doyle v. Mitchell Bros. Co., 247 U.S. 179, 185 , 38 S. Sup. Ct. 467, 469 [62 L.
Ed. 1054]), 'Income may be defined as the gain derived from capital, from labor, or
from both combined,' provided it be understood to include profit gained through a
sale or conversion of capital assets, to which it was applied in the Doyle Case, 247
U.S. 183, 185 , 38 S. Sup. Ct. 467, 469 (62 L. Ed. 1054).
Brief as it is, it indicates the characteristic and distinguishing attribute of income
essential for a correct solution of the present controversy. The government,
although basing its argument upon the definition as quoted, placed chief emphasis
upon the word 'gain,' which was extended to include a variety of meanings; while
the significance of the next three words was either overlooked or misconceived.
'Derived-from- capital'; 'the gain-derived-from-capital,' etc. Here we have the
essential matter: not a gain accruing to capital; not a growth or increment of value
in the investment; but a gain, a profit, something of exchangeable value,
proceeding from the property, severed from the capital, however invested or
employed, and coming in, being 'derived'-that is, received or drawn by the
recipient (the taxpayer) for his separate use, benefit and disposal- that is income
derived from property. Nothing else answers the description.
The same fundamental conception is clearly set forth in the Sixteenth Amendment-
'incomes, from whatever source derived'-the essential thought being
expressed [252 U.S. 189, 208] with a conciseness and lucidity entirely in harmony
with the form and style of the Constitution.
Can a stock dividend, considering its essential character, be brought within the
definition? To answer this, regard must be had to the nature of a corporation and
the stockholder's relation to it. We refer, of course, to a corporation such as the
one in the case at bar, organized for profit, and having a capital stock divided into
shares to which a nominal or par value is attributed.
Certainly the interest of the stockholder is a capital interest, and his certificates of
stock are but the evidence of it. They state the number of shares to which he is
entitled and indicate their par value and how the stock may be transferred. They
show that he or his assignors, immediate or remote, have contributed capital to
the enterprise, that he is entitled to a corresponding interest proportionate to the
whole, entitled to have the property and business of the company devoted during
the corporate existence to attainment of the common objects, entitled to vote at
stockholders' meetings, to receive dividends out of the corporation's profits if and
when declared, and, in the event of liquidation, to receive a proportionate share of
the net assets, if any, remaining after paying creditors. Short of liquidation, or until
dividend declared, he has no right to withdraw any part of either capital or profits
from the common enterprise; on the contrary, his interest pertains not to any part,
divisible or indivisible, but to the entire assets, business, and affairs of the
company. Nor is it the interest of an owner in the assets themselves, since the
corporation has full title, legal and equitable, to the whole. The stockholder has the
right to have the assets employed in the enterprise, with the incidental rights
mentioned; but, as stockholder, he has no right to withdraw, only the right to
persist, subject to the risks of the enterprise, and looking only to dividends for his
return. If he desires to dissociate himself [252 U.S. 189, 209] from the company he
can do so only by disposing of his stock.
For bookeeping purposes, the company acknowledges a liability in form to the
stockholders equivalent to the aggregate par value of their stock, evidenced by a
'capital stock account.' If profits have been made and not divided they create
additional bookkeeping liabilities under the head of 'profit and loss,' 'undivided
profits,' 'surplus account,' or the like. None of these, however, gives to the
stockholders as a body, much less to any one of them, either a claim against the
going concern for any particular sum of money, or a right to any particular portion
of the assets or any share in them unless or until the directors conclude that
dividends shall be made and a part of the company's assets segregated from the
common fund for the purpose. The dividend normally is payable in money, under
exceptional circumstances in some other divisible property; and when so paid, then
only (excluding, of course, a possible advantageous sale of his stock or winding-up
of the company) does the stockholder realize a profit or gain which becomes his
separate property, and thus derive income from the capital that he or his
predecessor has invested.
In the present case, the corporation had surplus and undivided profits invested in
plant, property, and business, and required for the purposes of the corporation,
amounting to about $45,000,000, in addition to outstanding capital stock of
$50,000,000. In this the case is not extraordinary. The profits of a corporation, as
they appear upon the balance sheet at the end of the year, need not be in the form
of money on hand in excess of what is required to meet current liabilities and
finance current operations of the company. Often, especially in a growing business,
only a part, sometimes a small part, of the year's profits is in property capable of
division; the remainder having been absorbed in the acquisition of increased
plant, [252 U.S. 189, 210] quipment, stock in trade, or accounts receivable, or in
decrease of outstanding liabilities. When only a part is available for dividends, the
balance of the year's profits is carried to the credit of undivided profits, or surplus,
or some other account having like significance. If thereafter the company finds
itself in funds beyond current needs it may declare dividends out of such surplus or
undivided profits; otherwise it may go on for years conducting a successful
business, but requiring more and more working capital because of the extension of
its operations, and therefore unable to declare dividends approximating the
amount of its profits. Thus the surplus may increase until it equals or even exceeds
the par value of the outstanding capital stock. This may be adjusted upon the books
in the mode adopted in the case at bar-by declaring a 'stock dividend.' This,
however, is no more than a book adjustment, in essence not a dividend but rather
the opposite; no part of the assets of the company is separated from the common
fund, nothing distributed except paper certificates that evidence an antecedent
increase in the value of the stockholder's capital interest resulting from an
accumulation of profits by the company, but profits so far absorbed in the business
as to render it impracticable to separate them for withdrawal and distribution. In
order to make the adjustment, a charge is made against surplus account with
corresponding credit to capital stock account, equal to the proposed 'dividend'; the
new stock is issued against this and the certificates delivered to the existing
stockholders in proportion to their previous holdings. This, however, is merely
bookkeeping that does not affect the aggregate assets of the corporation or its
outstanding liabilities; it affects only the form, not the essence, of the 'liability'
acknowledged by the corporation to its own shareholders, and this through a
readjustment of accounts on one side of the balance sheet only, increasing 'capital
stock' at the expense of [252 U.S. 189, 211] 'SURPLUS'; IT DOES NOT ALTER THE
PRE-EXisting proportionate interest of any stockholder or increase the intrinsic
value of his holding or of the aggregate holdings of the other stockholders as they
stood before. The new certificates simply increase the number of the shares, with
consequent dilution of the value of each share.
A 'stock dividend' shows that the company's accumulated profits have been
capitalized, instead of distributed to the stockholders or retained as surplus
available for distribution in money or in kind should opportunity offer. Far from
being a realization of profits of the stockholder, it tends rather to postpone such
realization, in that the fund represented by the new stock has been transferred
from surplus to capital, and no longer is available for actual distribution.
The essential and controlling fact is that the stockholder has received nothing out
of the company's assets for his separate use and benefit; on the contrary, every
dollar of his original investment, together with whatever accretions and
accumulations have resulted from employment of his money and that of the other
stockholders in the business of the company, still remains the property of the
company, and subject to business risks which may result in wiping out the entire
investment. Having regard to the very truth of the matter, to substance and not to
form, he has recived nothing that answers the definition of income within the
meaning of the Sixteenth Amendment.
Being concerned only with the true character and effect of such a dividend when
lawfully made, we lay aside the question whether in a particular case a stock
dividend may be authorized by the local law governing the corporation, or whether
the capitalization of profits may be the result of correct judgment and proper
business policy on the part of its management, and a due regard for the interests of
the stockholders. And we are considering the taxability of bona fide stock dividends
only. [252 U.S. 189, 212] We are clear that not only does a stock dividend really
take nothing from the property of the corporation and add nothing to that of the
shareholder, but that the antecedent accumulation of profits evidenced thereby,
while indicating that the shareholder is the richer because of an increase of his
capital, at the same time shows he has not realized or received any income in the
transaction.
It is said that a stockholder may sell the new shares acquired in the stock dividend;
and so he may, if he can find a buyer. It is equally true that if he does sell, and in
doing so realizes a profit, such profit, like any other, is income, and so far as it may
have arisen since the Sixteenth Amendment is taxable by Congress without
apportionment. The same would be true were he to sell some of his original shares
at a profit. But if a shareholder sells dividend stock he necessarily disposes of a part
of his capital interest, just as if he should sell a part of his old stock, either before or
after the dividend. What he retains no longer entitles him to the same proportion
of future dividends as before the sale. His part in the control of the company
likewise is diminished. Thus, if one holding $60,000 out of a total $100,000 of the
capital stock of a corporation should receive in common with other stockholders a
50 per cent. stock dividend, and should sell his part, he thereby would be reduced
from a majority to a minority stockholder, having six-fifteenths instead of six-
tenths of the total stock outstanding. A corresponding and proportionate decrease
in capital interest and in voting power would befall a minority holder should he sell
dividend stock; it being in the nature of things impossible for one to dispose of any
part of such an issue without a proportionate disturbance of the distribution of the
entire capital stock, and a like diminution of the seller's comparative voting power-
that 'right preservative of rights' in the control of a corporation. [252 U.S. 189,
213] Yet, without selling, the shareholder, unless possessed of other resources,
has not the wherewithal to pay an income tax upon the dividend stock. Nothing
could more clearly show that to tax a stock dividend is to tax a capital increase, and
not income, than this demonstration that in the nature of things it requires
conversion of capital in order to pay the tax.
Throughout the argument of the government, in a variety of forms, runs the
fundamental error already mentioned-a failure to appraise correctly the force of
the term 'income' as used in the Sixteenth Amendment, or at least to give practical
effect to it. Thus the government contends that the tax 'is levied on income derived
from corporate earnings,' when in truth the stockholder has 'derived' nothing
except paper certificates which, so far as they have any effect, deny him present
participation in such earnings. It contends that the tax may be laid when earnings
'are received by the stockholder,' whereas he has received none; that the profits
are 'distributed by means of a stock dividend,' although a stock dividend distributes
no profits; that under the act of 1916 'the tax is on the stockholder's share in
corporate earnings,' when in truth a stockholder has no such share, and receives
none in a stock dividend; that 'the profits are segregated from his former capital,
and he has a separate certificate representing his invested profits or gains,'
whereas there has been no segregation of profits, nor has he any separate
certificate representing a personal gain, since the certificates, new and old, are
alike in what they represent-a capital interest in the entire concerns of the
corporation.
We have no doubt of the power or duty of a court to look through the form of the
corporation and determine the question of the stockholder's right, in order to
ascertain whether he has received income taxable by Congress without
apportionment. But, looking through the form, [252 U.S. 189, 214] we cannot
disregard the essential truth disclosed, ignore the substantial difference between
corporation and stockholder, treat the entire organization as unreal, look upon
stockholders as partners, when they are not such, treat them as having in equity a
right to a partition of the corporate assets, when they have none, and indulge the
fiction that they have received and realized a share of the profits of the company
which in truth they have neither received nor realized. We must treat the
corporation as a substantial entity separate from the stockholder, not only because
such is the practical fact but because it is only by recognizing such separateness
that any dividend-even one paid in money or property-can be regarded as income
of the stockholder. Did we regard corporation and stockholders as altogether
identical, there would be no income except as the corporation acquired it; and
while this would be taxable against the corporation as income under appropriate
provisions of law, the individual stockholders could not be separately and
additionally taxed with respect to their several shares even when divided, since if
there were entire identity between them and the company they could not be
regarded as receiving anything from it, any more than if one's money were to be
removed from one pocket to another.
Conceding that the mere issue of a stock dividend makes the recipient no richer
than before, the government nevertheless contends extent to which the gains
accumulated by the extend to which the gains accumulated by the corporation
have made him the richer. There are two insuperable difficulties with this: In the
first place, it would depend upon how long he had held the stock whether the stock
dividend indicated the extent to which he had been enriched by the operations of
the company; unless he had held it throughout such operations the measure would
not hold true. Secondly, and more important for present purposes, enrichment
through increase in value [252 U.S. 189, 215] of capital investment is not income
in any proper meaning of the term.
The complaint contains averments respecting the market prices of stock such as
plaintiff held, based upon sales before and after the stock dividend, tending to
show that the receipt of the additional shares did not substantially change the
market value of her entire holdings. This tends to show that in this instance market
quotations reflected intrinsic values-a thing they do not always do. But we regard
the market prices of the securities as an unsafe criterion in an inquiry such as the
present, when the question must be, not what will the thing sell for, but what is it
in truth and in essence.
It is said there is no difference in principle between a simple stock dividend and a
case where stockholders use money received as cash dividends to purchase
additional stock contemporaneously issued by the corporation. But an actual cash
dividend, with a real option to the stockholder either to keep the money for his
own or to reinvest it in new shares, would be as far removed as possible from a
true stock dividend, such as the one we have under consideration, where nothing
of value is taken from the company's assets and transferred to the individual
ownership of the several stockholders and thereby subjected to their disposal.
The government's reliance upon the supposed analogy between a dividend of the
corporation's own shares and one made by distributing shares owned by it in the
stock of another company, calls for no comment beyond the statement that the
latter distributes assets of the company among the shareholders while the former
does not, and for no citation of authority except Peabody v. Eisner, 247 U.S. 347,
349 , 350 S., 38 Sup. Ct. 546.
Two recent decisions, proceeding from courts of high jurisdiction, are cited in
support of the position of the government. [252 U.S. 189, 216] Swan Brewery Co.,
Ltd. v. Rex, [252 U.S. 189, 1914] A. C. 231, arose under the Dividend Duties Act of
Western Australia, which provided that 'dividend' should include 'every dividend,
profit, advantage, or gain intended to be paid or credited to or distributed among
any members or directors of any company,' except, etc. There was a stock
dividend, the new shares being allotted among the shareholders pro rata; and the
question was whether this was a distribution of a dividend within the meaning of
the act. The Judicial Committee of the Privy Council sustained the dividend duty
upon the ground that, although 'in ordinary language the new shares would not be
called a dividend, nor would the allotment of them be a distribution of a dividend,'
yet, within the meaning of the act, such new shares were an 'advantage' to the
recipients. There being no constitutional restriction upon the action of the
lawmaking body, the case presented merely a question of statutory construction,
and manifestly the decision is not a precedent for the guidance of this court when
acting under a duty to test an act of Congress by the limitations of a written
Constitution having superior force.
In Tax Commissioner v. Putnam (1917) 227 Mass. 522, 116 N. E. 904, L. R. A. 1917F,
806, it was held that the Forty-Fourth amendment to the Constitution of
Massachusetts, which conferred upon the Legislature full power to tax incomes,
'must be interpreted as including every item which by any reasonable
understanding can fairly be regarded as income' (227 Mass. 526, 531, 116 N. E.
904, 907 [L. R. A. 1917F, 806]), and that under it a stock dividend was taxable as
income; the court saying (227 Mass. 535, 116 N. E. 911, L. R. A. 1917F, 806):
'In essence the thing which has been done is to distribute a symbol representing an
accumulation of profits, which instead of being paid out in cash is invested in the
business, thus augmenting its durable assets. In this aspect of the case the
substance of the transaction is no different from what it would be if a cash
dividend had been declared with the privilege of subscription to an equivalent
amount of new shares.' [252 U.S. 189, 217] We cannot accept this reasoning.
Evidently, in order to give a sufficiently broad sweep to the new taxing provision, it
was deemed necessary to take the symbol for the substance, accumulation for
distribution, capital accretion for its opposite; while a case where money is paid
into the hand of the stockholder with an option to buy new shares with it, followed
by acceptance of the option, was regarded as identical in substance with a case
where the stockholder receives no money and has no option. The Massachusetts
court was not under an obligation, like the one which binds us, of applying a
constitutional amendment in the light of other constitutional provisions that stand
in the way of extending it by construction.
Upon the second argument, the government, recognizing the force of the decision
in Towne v. Eisner, supra, and virtually abandoning the contention that a stock
dividend increases the interest of the stockholder or otherwise enriches him,
insisted as an alternative that by the true construction of the act of 1916 the tax is
imposed, not upon the stock dividend, but rather upon the stockholder's share of
the undivided profits previously accumulated by the corporation; the tax being
levied as a matter of convenience at the time such profits become manifest
through the stock dividend. If so construed, would the act be constitutional?
That Congress has power to tax shareholders upon their property interests in the
stock of corporations is beyond question, and that such interests might be valued
in view of the condition of the company, including its accumulated and undivided
profits, is equally clear. But that this would be taxation of property because of
ownership, and hence would require apportionment under the provisions of the
Constitution, is settled beyond peradventure by previous decisions of this court.
The government relies upon Collector v. Hubbard (1870) [252 U.S. 189, 218] 12
Wall. 1, (20 L. Ed. 272), which arose under section 117 of the Act of June 30, 1864
(13 Stat. 223, 282, c. 173), providing that--
'The gains and profits of all companies, whether incorporated or partnership, other
than the companies specified in that section, shall be included in estimating the
annual gains, profits, or income of any person, entitled to the same, whether
divided or otherwise.'
The court held an individual taxable upon his proportion of the earnings of a
corporation although not declared as dividends and although invested in assets not
in their nature divisible. Conceding that the stockholder for certain purposes had
no title prior to dividend declared, the court nevertheless said (12 Wall. 18):
'Grant all that, still it is true that the owner of a share of stock in a corporation
holds the share with all its incidents, and that among those incidents is the right to
receive all future dividends, that is, his proportional share of all profits not then
divided. Profits are incident to the share to which the owner at once becomes
entitled provided he remains a member of the corporation until a dividend is made.
Regarded as an incident to the shares, undivided profits are property of the
shareholder, and as such are the proper subject of sale, gift, or devise. Undivided
profits invested in real estate, machinery, or raw material for the purpose of being
manufactured are investments in which the stockholders are interested, and when
such profits are actually appropriated to the payment of the debts of the
corporation they serve to increase the market value of the shares, whether held by
the original subscribers or by assignees.'
In so far as this seems to uphold the right of Congress to tax without
apportionment a stockholder's interest in accumulated earnings prior to dividend
declared, it must be regarded as overruled by Pollock v. Farmers' Loan & Trust
Co., 158 U.S. 601, 627 , 628 S., 637, 15 Sup. Ct. 912. Conceding Collector v. Hubbard
was inconsistent with the doctrine of that case, because it sustained a direct tax
upon property not apportioned [252 U.S. 189, 219] AMONG THE STATES, THE
GOVERNMENT NEVERTHEless insists that the sixteenth Amendment removed this
obstacle, so that now the Hubbard Case is authority for the power of Congress to
levy a tax on the stockholder's share in the accumulated profits of the corporation
even before division by the declaration of a dividend of any kind. Manifestly this
argument must be rejected, since the amendment applies to income only, and
what is called the stockholder's share in the accumulated profits of the company is
capital, not income. As we have pointed out, a stockholder has no individual share
in accumulated profits, nor in any particular part of the assets of the corporation,
prior to dividend declared.
Thus, from every point of view we are brought irresistibly to the conclusion that
neither under the Sixteenth Amendment nor otherwise has Congress power to tax
without apportionment a true stock dividend made lawfully and in good faith, or
the accumulated profits behind it, as income of the stockholder. The Revenue Act
of 1916, in so far as it imposes a tax upon the stockholder because of such
dividend, contravenes the provisions of article 1, 2, cl. 3, and article 1, 9, cl. 4, of
the Constitution, and to this extent is invalid, notwithstanding the Sixteenth
Amendment.
Judgment affirmed.
Mr. Justice HOLMES, dissenting.
I think that Towne v. Eisner, 245 U.S. 418 , 38 Sup. Ct. 158, L. R. A. 1918D, 254, was
right in its reasoning and result and that on sound principles the stock dividend was
not income. But it was clearly intimated in that case that the construction of the
statute then before the Court might be different from that of the Constitution. 245
U.S. 425 , 38 Sup. Ct. 158, L. R. A. 1918D, 254. I think that the word 'incomes' in the
Sixteenth Amendment should be read in [252 U.S. 189, 220] 'a sense most obvious
to the common understanding at the time of its adoption.' Bishop v. State, 149 Ind.
223, 230, 48 N. E. 1038, 1040, 39 L. R. A. 278, 63 Am. St. Rep. 270; State v. Butler,
70 Fla. 102, 133, 69 South. 771. For it was for public adoption that it was proposed.
McCulloch v. Maryland, 4 Wheat. 316, 407. The known purpose of this Amendment
was to get rid of nice questions as to what might be direct taxes, and I cannot
doubt that most people not lawyers would suppose when they voted for it that
they put a question like the present to rest. I am of opinion that the Amendment
justifies the tax. See Tax Commissioner v. Putnam, 227 Mass. 522, 532, 533, 116 N.
E. 904, L. R. A. 1917F, 806.
Mr. Justice DAY concurs in this opinion.
Mr. Justice BRANDEIS delivered the following [dissenting] opinion:
Financiers, with the aid of lawyers, devised long ago two different methods by
which a corporation can, without increasing its indebtedness, keep for corporate
purposes accumulated profits, and yet, in effect, distribute these profits among its
stockholders. One method is a simple one. The capital stock is increased; the new
stock is paid up with the accumulated profits; and the new shares of paid-up stock
are then distributed among the stockholders pro rata as a dividend. If the
stockholder prefers ready money to increasing his holding of the stock in the
company, he sells the new stock received as a dividend. The other method is
slightly more complicated. .arrangements are made for an increase of stock to be
offered to stockholders pro rata at par, and, at the same time, for the payment of a
cash dividend equal to the amount which the stockholder will be required to pay
to [252 U.S. 189, 221] the company, if he avails himself of the right to subscribe
for his pro rata of the new stock. If the stockholder takes the new stock, as is
expected, he may endorse the dividend check received to the corporation and thus
pay for the new stock. In order to ensure that all the new stock so offered will be
taken, the price at which it is offered is fixed far below what it is believed will be its
market value. If the stockholder prefers ready money to an increase of his holdings
of stock, he may sell his right to take new stock pro rata, which is evidenced by an
assignable instrument. In that event the purchaser of the rights repays to the
corporation, as the subscription price of the new stock, an amount equal to that
which it had paid as a chsh dividend to the stockholder.
Both of these methods of retaining accumulated profits while in effect distributing
them as a dividend had been in common use in the United States for many years
prior to the adoption of the Sixteenth Amendment. They were recognized
equivalents. Whether a particular corporation employed one or the other method
was determined sometimes by requirements of the law under which the
corporation was organized; sometimes it was determined by preferences of the
individual officials of the corporation; and sometimes by stock market conditions.
Whichever method was employed the resultant distribution of the new stock was
commonly referred to as a stock dividend. How these two methods have been
employed may be illustrated by the action in this respect (as reported in Moody's
Manual, 1918 Industrial, and the Commercial and Financial Chronicle) of some of
the Standard Oil companies, since the disintegration pursuant to the decision of
this court in 1911. Standard Oil Co. v. United States, 221 U.S. 1 , 31 Sup. Ct. 502, 34
L. R. A. (N. S.) 834, Ann. Cas. 1912D, 734.
(a) Standard Oil Co. (of Indiana), an Indiana corporation. It had on December 31,
1911, $1,000,000 capital stock (all common), and a large surplus. On May 15, [252
U.S. 189, 222] 1912, it increased its capital stock to $30,000,000, and paid a simple
stock dividend of 2,900 per cent. in stock. 2
(b) Standard Oil Co. (of Nebraska), a Nebraska corporation. It had on December 31,
1911, $600,000 capital stock (all common), and a substantial surplus. On April 15,
1912, it paid a simple stock dividend of 33 1/3 per cent., increasing the outstanding
capital to $800,000. During the calendar year 1912 it paid cash dividends
aggregating 20 per cent., but it earned considerably more, and had at the close of
the year again a substantial surplus. On June 20, 1913, it declared a further stock
dividend of 25 per cent., thus increasing the capital to $1,000,000.3
(c) The Standard Oil Co. (of Kentucky), a Kentucky corporation. It had on December
31, 1913, $1,000,000 capital stock (all common) and $3,701, 710 surplus. Of this
surplus $902,457 had been earned during the calendar year 1913, the net profits of
that year having been $1,002,457 and the dividends paid only $100,000 (10 per
cent.). On December 22, 1913, a cash dividend of $200 per share was declared
payable on February 14, 1914, to stockholders of record January 31, 1914, and
these stockholders were offered the right to subscribe for an equal amount of new
stock at par and to apply the cash dividend in payment therefor. The outstanding
stock was thus increased to $3,000,000. During the calendar years 1914, 1915, and
1916, quarterly dividends were paid on this stock at an annual rate of between 15
per cent. and 20 per cent., but the company's surplus increased by $2,347,614, so
that on December 31, 1916, it had a large surplus over its $3,000,000 capital stock.
On December 15, 1916, the company issued a circular to the stockholders, saying:
'The company's business for this year has shown a [252 U.S. 189, 223] very good
increase in volume and a proportionate increase in profits, and it is estimated that
by January 1, 1917, the company will have a surplus of over $4,000,000. The board
feels justified in stating that if the proposition to increase the capital stock is acted
on favorably, it will be proper in the near future to declare a cash dividend of 100
per cent. and to allow the stockholders the privilege pro rata according to their
holdings, to purchase the new stock at par, the plan being to allow the
stockholders, if they desire, to use their cash dividend to pay for the new stock.'
The increase of stock was voted. The company then paid a cash dividend of 100 per
cent., payable May 1, 1917, again offering to such stockholders the right to
subscribe for an equal amount of new stock at par and to apply the cash dividend
in payment therefor.
Moody's Manual, describing the transaction with exactness, says first that the stock
was increased from $3,000,000 to $6,000,000, 'a cash dividend of 100 per cent.,
payable May 1, 1917, being exchanged for one share of new stock, the equivalent
of a 100 per cent. stock dividend.' But later in the report giving, as customary in the
Manual the dividend record of the company, the Manual says: 'A stock dividend of
200 per cent. was paid February 14, 1914, and one of 100 per cent. on May 1,
1197.' And in reporting specifically the income account of the company for a series
of years ending December 31, covering net profits, dividends paid and surplus for
the year, it gives, as the aggregate of dividends for the year 1917, $ 660,000 (which
was the aggregate paid on the quarterly cash dividend-5 per cent. January and
April; 6 per cent. July and October), and adds in a note: 'In addition a stock dividend
of 100 per cent. was paid during the year.' 4 The Wall Street Journal of [252 U.S.
189, 224] May 2, 1917, p. 2, quotes the 1917 'high' price for Standard Oil of
Kentucky as '375 ex stock dividend.'
It thus appears that among financiers and investors the distribution of the stock, by
whichever method effected, is called a stock dividend; that the two methods by
which accumulated profits are legally retained for corporate purposes and at the
same time distributed as dividends are recognized by them to be equivalents; and
that the financial results to the corporation and to the stockholders of the two
methods are substantially the same-unless a difference results from the application
of the federal Income Tax Law.
Mrs. Macomber, a citizen and resident of New York, was, in the year 1916, a
stockholder in the Standard Oil Company (of California), a corporation organized
under the laws of California and having its principal place of business in that state.
During that year she received from the company a stock dividend representing
profits earned since March 1, 1913. The dividend was paid by direct issue of the
stock to her according to the simple method described above, pursued also by the
Indiana and Nebraska companies. In 1917 she was taxed under the federal law on
the stock dividend so received at its par value of $100 a share, as income received
during the year 1916. Such a stock dividend is income, as distinguished from
capital, both under the law of New York and under the law of California, because in
both states every dividend representing profits is deemed to be income, whether
paid in cash or in stock. It had been so held in New York, where the question arose
as between life tenant and remainderman, Lowry v. Farmers' Loan & Trust Co., 172
N. Y. 137, 64 N. E. 796; Matter of Osborne, 209 N. Y. 450, 103 N. E. 723, 823, 50 L.
R. A. ( N. S.) 510, Ann.Cas. 1915A, 298; and also, where the question arose in
matters of taxation, People v. Glynn, [252 U.S. 189, 225] 130 App. Div. 332, 114 N.
Y. Supp. 460; Id. 198 N. Y. 605, 92 N. E. 1097. It has been so held in California,
where the question appears to have arisen only in controversies between life
tenant and remainderman. Estate of Duffill, 183 Pac. 337.
It is conceded that if the stock dividend paid to Mrs. Macomber had been made by
the more complicated method pursued by the Standard Oil Company of Kentucky;
that is, issuing rights to take new stock pro rata and paying to each stockholder
simultaneously a dividend in cash sufficient in amount to enable him to pay for this
pro rata of new stock to be purchased-the dividend so paid to him would have
been taxable as income, whether he retained the cash or whether he returned it to
the corporation in payment for his pro rata of new stock. But it is contended that,
because the simple method was adopted of having the new stock issued direct to
the stockholders as paid-up stock, the new stock is not to be deemed income,
whether she retained it or converted it into cash by sale. If such a different result
can flow merely from the difference in the method pursued, it must be because
Congress is without power to tax as income of the stockholder either the stock
received under the latter method or the proceeds of its sale; for Congress has, by
the provisions in the Revenue Act of 1916, expressly declared its purpose to make
stock dividends, by whichever method paid, taxable as income.
The Sixteenth Amendment, proclaimed February 25, 1913, declares:
'The Congress shall have power to lay and collect taxes on incomes, from whatever
source derived, without apportionment among the several states, and without
regard to any census or enumeration.'
The Revenue Act of September 8, 1916, c. 463, 2a, 39 Stat. 756, 757, provided:
'That the term 'dividends' as used in this title shall [252 U.S. 189, 226] be held to
mean any distribution made or ordered to be made by a corporation, ... out of its
earnings or profits accrued since March first, nineteen hundred and thirteen, and
payable to its shareholders, whether in cash or in stock of the corporation, ... which
stock dividend shall be considered income, to the amount of its cash value.'
Hitherto powers conferred upon Congress by the Constitution have been liberally
construed, and have been held to extend to every means appropriate to attain the
end sought. In determining the scope of the power the substance of the
transaction, not its form has been regarded. Martin v. Hunter, 1 Wheat, 304, 326;
McCulloch v. Maryland, 4 Wheat. 316, 407, 415; Brown v. Maryland, 12 Wheat.
419, 446; Craig v. Missouri, 4 Pet. 410, 433; Jarrolt v. Moberly, 103 U.S. 580, 585 ,
587 S.; Legal Tender Case, 110 U.S. 421, 444 , 4 S. Sup. Ct. 122; Lithograph Co. v.
Sarony, 111 U.S. 53, 58 , 4 S. Sup. Ct. 279; United States v. Realty Co., 163 U.S. 427,
440 , 441 S., 442, 16 Sup. Ct. 1120; South Carolina v. United States, 199 U.S. 437,
448 , 449 S., 26 Sup. Ct. 110, 4 Ann. Cas. 737. Is there anything in the phraseology
of the Sixteenth Amendment or in the nature of corporate dividends which should
lead to a departure from these rules of construction and compel this court to hold,
that Congress is powerless to prevent a result so extraordinary as that here
contended for by the stockholder?
First. The term 'income,' when applied to the investment of the stockholder in a
corporation, had, before the adoption of the Sixteenth Amendment, been
commonly understood to mean the returns from time to time received by the
stockholder from gains or earnings of the corporation. A dividend received by a
stockholder from a corporation may be either in distribution of capital assets or in
distribution of profits. Whether it is the one or the other is in no way affected by
the medium in which it is paid, nor by the method or means through which the
particular thing distributed as a dividend was procured. If the [252 U.S. 189,
227] dividend is declared payable in cash, the money with which to pay it is
ordinarily taken from surplus cash in the treasury. But (if there are profits legally
available for distribution and the law under which the company was incorporated
so permits) the company may raise the money by discounting negotiable paper; or
by selling bonds, scrip or stock of another corporation then in the treasury; or by
selling its own bonds, scrip or stock then in the treasury; or by selling its own
bonds, scrip or stock issued expressly for that purpose. How the money shall be
raised is wholly a matter of financial management. The manner in which it is raised
in no way affects the question whether the dividend received by the stockholder is
income or capital; nor can it conceivably affect the question whether it is taxable as
income.
Likewise whether a dividend declared payable from profits shall be paid in cash or
in some other medium is also wholly a matter of financial management. If some
other medium is decided upon, it is also wholly a question of financial management
whether the distribution shall be, for instance, in bonds, scrip or stock of another
corporation or in issues of its own. And if the dividend is paid in its own issues, why
should there be a difference in result dependent upon whether the distribution
was made from such securities then in the treasury or from others to be created
and issued by the company expressly for that purpose? So far as the distribution
may be made from its own issues of bonds, or preferred stock created expressly for
the purpose, it clearly would make no difference in the decision of the question
whether the dividend was a distribution of profits, that the securities had to be
created expressly for the purpose of distribution. If a dividend paid in securities of
that nature represents a distribution of profits Congress may, of course, tax it as
income of the stockholder. Is the result different where the security distributed is
common stock? [252 U.S. 189, 228] Suppose that a corporation having power to
buy and sell its own stock, purchases, in the interval between its regular dividend
dates, with moneys derived from current profits, some of its own common stock as
a temporary investment, intending at the time of purchase to sell it before the next
dividend date and to use the proceeds in paying dividends, but later, deeming it
inadvisable either to sell this stock or to raise by borrowing the money necessary to
pay the regular dividend in cash, declares a dividend payable in this stock; can any
one doubt that in such a case the dividend in common stock would be income of
the stockholder and constitutionally taxable as such? See Green v. Bissell, 79 Conn.
547, 65 Atl. 1056, 8 L. R. A. (N. S.) 1011, 118 Am. St. Rep. 156, 9 Ann. Cas. 287;
Leland v. Hayden, 102 Mass. 542. And would it not likewise be income of the
stockholder subject to taxation if the purpose of the company in buying the stock
so distributed had been from the beginning to take it off the market and distribute
it among the stockholders as a dividend, and the company actually did so? And
proceeding a short step further: Suppose that a corporation decided to capitalize
some of its accumulated profits by creating additional common stock and selling
the same to raise working capital, but after the stock has been issued and
certificates therefor are delivered to the bankers for sale, general financial
conditions make it undesirable to market the stock and the company concludes
that it is wiser to husband, for working capital, the cash which it had intended to
use in paying stockholders a dividend, and, instead, to pay the dividend in the
common stock which it had planned to sell; would not the stock so distributed be a
distribution of profits-and hence, when received, be income of the stockholder and
taxable as such? If this be conceded, why should it not be equally income of the
stockholder, and taxable as such, if the common stock created by capitalizing
profits, had been originally created for the express purpose of being
distributed [252 U.S. 189, 229] as a dividend to the stockholder who afterwards
received it?
Second. It has been said that a dividend payable in bonds or preferred stock
created for the purpose of distributing profits may be income and taxable as such,
but that the case is different where the distribution is in common stock created for
that purpose. Various reasons are assigned for making this distinction. One is that
the proportion of the stockholder's ownership to the aggregate number of the
shares of the company is not changed by the distribution. But that is equally true
where the dividend is paid in its bonds or in its preferred stock. Furthermore,
neither maintenance nor change in the proportionate ownership of a stockholder
in a corporation has any bearing upon the question here involved. Another reason
assigned is that the value of the old stock held is reduced approximately by the
value of the new stock received, so that the stockholder after receipt of the stock
dividend has no more than he had before it was paid. That is equally true whether
the dividend be paid in cash or in other property, for instance, bonds, scrip or
preferred stock of the company. The payment from profits of a large cash dividend,
and even a small one, customarily lowers the then market value of stock because
the undivided property represented by each share has been correspondingly
reduced. The argument which appears to be most strongly urged for the
stockholders is, that when a stock dividend is made, no portion of the assets of the
company is thereby segregated for the stockholder. But does the issue of new
bonds or of preferred stock created for use as a dividend result in any segregation
of assets for the stockholder? In each case he receives a piece of paper which
entitles him to certain rights in the undivided property. Clearly segregation of
assets in a physical sense is not an essential of income. The year's gains of a partner
is taxable as income, although there, likewise, no [252 U.S. 189, 230] segregation
of his share in the gains from that of his partners is had.
The objection that there has been no segregation is presented also in another
form. It is argued that until there is a segregation, the stockholder cannot know
whether he has really received gains; since the gains may be invested in plant or
merchandise or other property and perhaps be later lost. But is not this equally
true of the share of a partner in the year's profits of the firm or, indeed, of the
profits of the individual who is engaged in business alone? And is it not true, also,
when dividends are paid in cash? The gains of a business, whether conducted by an
individual, by a firm or by a corporation, are ordinarily reinvested in large part.
Many a cash dividend honestly declared as a distribution of profits, proves later to
have been paid out of capital, because errors in forecast prevent correct
ascertainment of values. Until a business adventure has been completely
liquidated, it can never be determined with certainty whether there have been
profits unless the returns at least exceeded the capital originally invested. Business
men, dealing with the problem practically, fix necessarily periods and rules for
determining whether there have been net profits-that is, income or gains. They
protect themselves from being seriously misled by adopting a system of
depreciation charges and reserves. Then, they act upon their own determination,
whether profits have been made. Congress in legislating has wisely adopted their
practices as its own rules of action.
Third. The Government urges that it would have been within the power of Congress
to have taxed as income of the stockholder his pro rata share of undistributed
profits earned, even if no stock dividend representing it had been paid. Strong
reasons may be assigned for such a view. See The Collector v. Hubbard, 12 Wall. 1.
The undivided share of a partner in the year's undistributed profits of his firm [252
U.S. 189, 231] is taxable as income of the partner, although the share in the gain is
not evidenced by any action taken by the firm. Why may not the stockholder's
interest in the gains of the company? The law finds no difficulty in disregarding the
corporate fiction whenever that is deemed necessary to attain a just result. Linn
Timber Co. v. United States,236 U.S. 574 , 35 Sup. Ct. 440. See Morawetz on
Corporations (2d Ed.) 227- 231; Cook on Corporations (7th Ed.) 663, 664. The
stockholder's interest in the property of the corporation differs, not fundamentally
but in form only, from the interest of a partner in the property of the firm. There is
much authority for the proposition that, under our law, a partnership or joint stock
company is just as distinct and palpable an entity in the idea of the law, as
distinguished from the individuals composing it, as is a corporations. 5 No reason
appears, why Congress, in legislating under a grant of power so comprehensive as
that authorizing the levy of an income tax, should be limited by the particular view
of the relation of the stockholder to the corporation and its property which may, in
the absence of legislation, have been taken by this court. But we have no occasion
to decide the question whether Congress might have taxed to the stockholder his
undivided share of the corporation's earnings. For Congress has in this act limited
the income tax to that share of the stockholder in the earnings which is, in effect,
distributed by means of the stock dividend paid. In other words to render the
stockholder taxable there must be both earnings made and a dividend paid.
Neither earnings without dividend-nor a dividend without earnings-subjects
the [252 U.S. 189, 232] stockholder to taxation under the Revenue Act of 1916.
Fourth. The equivalency of all dividends representing profits, whether paid of all
dividends in stock, is so complete that serious question of the taxability of stock
dividends would probably never have been made, if Congress had undertaken to
tax only those dividends which represented profits earned during the year in which
the dividend was paid or in the year preceding. But this court, construing liberally,
not only the constitutional grant of power, but also the revenue act of 1913, held
that Congress might tax, and had taxed, to the stockholder dividends received
during the year, although earned by the company long before; and even prior to
the adoption of the Sixteenth Amendment. Lynch v. Hornby, 247 U.S. 339 , 38 Sup.
Ct. 543.6 That rule, if indiscriminatingly applied to all stock dividends representing
profits earned, might, in view of corporate practice, have worked considerable
hardship, and have raised serious questions. Many corporations, without legally
capitalizing any part of their profits, had assigned definitely some part or all of the
annual balances remaining after paying the usual cash dividends, to the uses to
which permanent capital is ordinarily applied. Some of the corporations doing this,
transferred such balances on their books to 'surplus' account-distinguishing
between such permanent 'surplus' and the 'undivided profits' account. Other
corporations, without this formality, had assumed that the annual accumulating
balances carried as undistributed profits were to be treated as capital permanently
invested in the business. And still others, without definite assumption of any kind,
had [252 U.S. 189, 233] so used undivided profits for capital purposes. To have
made the revenue law apply retroactively so as to reach such accumulated profits,
if and whenever it should be deemed desirable to capitalize them legally by the
issue of additional stock distributed as a dividend to stockholders, would have
worked great injustice. Congress endeavored in the Revenue Act of 1916 to guard
against any serious hardship which might otherwise have arisen from making
taxable stock dividends representing accumulated profits. It did not limit the
taxability to stock dividends representing profits earned within the tax year or in
the year preceding; but it did limit taxability to such dividends representing profits
earned since March 1, 1913. Thereby stockholders were given notice that their
share also in undistributed profits accumulating thereafter was at some time to be
taxed as income. And Congress sought by section 3 (Comp. St. 1918, Comp. St. Ann.
Supp. 1919, 6336c) to discourage the postponement of distribution for the
illegitimate purpose of evading liability to surtaxes.
Fifth. The decision of this court, that earnings made before the adoption of the
Sixteenth Amendment, but paid out in cash dividend after its adoption, were
taxable as income of the stockholder, involved a very liberal construction of the
amendment. To hold now that earnings both made and paid out after the adoption
of the Sixteenth Amendment cannot be taxed as income of the stockholder, if paid
in the form of a stock dividend, involves an exceedingly narrow construction of it.
As said by Mr. Chief Justice Marshall in Brown v. Maryland, 12 Wheat. 419, 446 (6
L. Ed. 678):
'To construe the power so as to impair its efficacy, would tend to defeat an object,
in the attainment of which the American public took, and justly took, that strong
interest which arose from a full conviction of its necessity.'
No decision heretofore rendered by this court requires us to hold that Congress, in
providing for the taxation of[252 U.S. 189, 234] stock dividends, exceeded the
power conferred upon it by the Sixteenth Amendment. The two cases mainly relied
upon to show that this was beyond the power of Congress are Towne v. Eisner, 245
U.S. 418 , 38 Sup. Ct. 158 L. R. A. 1918D, 254, which involved a question not of
constitutional power but of statutory construction, and Gibbons v. Mahon, 136 U.S.
549 , 10 Sup. Ct. 1057, which involved a question arising between life tenant and
remainderman. So far as concerns Towne v. Eisner we have only to bear in mind
what was there said ( 245 U.S. 425 , 38 Sup. Ct. 159, L. R. A. 1918D, 254): 'But it is
not necessarily true that income means the same thing in the Constitution and the
[an] act.' 7 Gibbons v. Mahon is even less an authority for a narrow construction of
the power to tax incomes conferred by the Sixteenth Amendment. In that case the
court was required to determine how, in the administration of an estate in the
District of Columbia, a stock dividend, representing profits, received after the
decedent's death, should be disposed of as between life tenant and remainderman.
The question was in essence: What shall the intention of the testator be presumed
to have been? On this question there was great diversity of opinion and practice in
the courts of English-speaking countries. Three well-defined rules were then
competing for acceptance; two of these involves an arbitrary rule of distribution,
the third equitable apportionment. See Cook on Corporations ( 7th Ed.) 552-558.
1. The so-called English rule, declared in 1799, by Brander v. Brander, 4 Ves. Jr. 800,
that a dividend representing [252 U.S. 189, 235] profits, whether in cash, stock or
other property, belongs to the life tenant if it was a regular or ordinary dividend,
and belongs to the remainderman if it was an extraordinary dividend.
2. The so-called Massachusetts rule, declared in 1868 by Minot v. Paine, 99 Mass.
101, 96 Am. Dec. 705, that a dividend representing profits, whether regular,
ordinary or extrordinary, if in cash belongs to the life tenant, and if in stock belongs
to the remainderman.
3. The so-called Pennsylvania rule declared in 1857 by Earp's Appeal, 28 Pa. 368,
that where a stock dividend is paid, the court shall inquire into the circumstances
under which the fund had been earned and accumulated out of which the dividend,
whether a regular, an ordinary or an extraordinary one, was paid. If it finds that the
stock dividend was paid out of profits earned since the decedent's death, the stock
dividend belongs to the life tenant; if the court finds that the stock dividend was
paid from capital or from profits earned before the decedent's death, the stock
dividend belongs to the remainderman.
This court adopted in Gibbons v. Mahon as the rule of administration for the
District of Columbia the so-called Massachusetts rule, the opinion being delivered
in 1890 by Mr. Justice Gray. Since then the same question has come up for decision
in many of the states. The so-called Massachusetts rule, although approved by this
court, has found favor in only a few states. The so-called Pennsylvania rule, on the
other hand, has been adopted since by so many of the states (including New York
and California), that it has come to be known as the 'American rule.' Whether, in
view of these facts and the practical results of the operation of the two rules as
shown by the experience of the 30 years which have elapsed since the decision in
Gibbons v. Mahon, it might be desirable for this court to reconsider the question
there decided, as [252 U.S. 189, 236] some other courts have done (see 29
Harvard Law Review, 551), we have no occasion to consider in this case. For, as this
court there pointed out ( 136 U.S. 560 , 1059 [34 L. Ed. 525]), the question involved
was one 'between the owners of successive interests in particular shares,' and not,
as in Bailey v. Railroad Co., 22 Wall. 604, a question 'between the corporation and
the government, and [which] depended upon the terms of a statute carefully
framed to prevent corporations from evading payment of the tax upon their
earnings.'
We have, however, not merely argument; we have examples which should
convince us that 'there is no inherent, necessary and immutable reason why stock
dividends should always be treated as capital.' Tax Commissioner v. Putnam, 227
Mass. 522, 533, 116 N. E. 904, L. R. A. 1917F. 806. The Supreme Judical Court of
Massachusetts has steadfastly adhered, despite ever-renewed protest, to the rule
that every stock dividend is, as between life tenant and remainderman, capital and
not income. But in construing the Massachusetts Income Tax Amendment, which is
substantially identical with the federal amendment, that court held that the
Legislature was thereby empowered to levy an income tax upon stock dividends
representing profits. The courts of England have, with some relaxation, adhered to
their rule that every extraordinary dividend is, as between life tenant and
remainderman, to be deemed capital. But in 1913 the Judicial Committee of the
Privy Council held that a stock dividend representing accumulated profits was
taxable like an ordinary cash dividend, Swan Brewery Company, Limited v. The
King, L. R. 1914 A. C. 231. In dismissing the appeal these words of the Chief Justice
of the Supreme Court of Western Australia were quoted (page 236) which show
that the facts involved were identical with those in the case at bar:
'Had the company distributed the 101,450 among the shareholders and had the
shareholders repaid such sums to the company as the price of the 81,160 new
SHARES, THE DUTY ON THE 101,450 [252 U.S. 189, 237] WOULD CLEARLY HAVE
BEEN PAYable. is not this virtually the effect of what was actually done? I think it is.'
Sixth. If stock dividends representing profits are held exempt from taxation under
the Sixteenth Amendment, the owners of the most successful businesses in
America will, as the facts in this case illustrate, be able to escape taxation on a large
part of what is actually their income. So far as their profits are represented by stock
received as dividends they will pay these taxes not upon their income but only
upon the income of their income. That such a result was intended by the people of
the United States when adopting the Sixteenth Amendment is inconceivable. Our
sole duty is to ascertain their intent as therein expressed. 8 In terse,
comprehensive language befitting the Constitution, they empowered Congress 'to
lay and collect taxes on incomes from whatever source derived.' They intended to
include thereby everything which by reasonable understanding can fairly be
regarded as income. That stock dividends representing profits are so regarded, not
only by the plain people, but by investors and financiers, and by most of the courts
of the country, is shown, beyond peradventure, by their acts and by their
utterances. It seems to me clear, therefore, that Congress possesses the power
which it exercised to make dividends representing profits, taxable as income,
whether the medium in which the dividend is paid be cash or stock, and that it may
define, as it has done, what dividends representing[252 U.S. 189, 238] profits shall
be deemed income. It surely is not clear that the enactment exceeds the power
granted by the Sixteenth Amendment. And, as this court has so often said, the high
prerogative of declaring an act of Congress invalid, should never be exercised
except in a clear case. 9
'It is but a decent respect due to the wisdom, the integrity and the patriotism of the
legislative body, by which any law is passed, to presume in favor of its validity, until
its violation of the Constitution is proved beyond all reasonable doubt.' Ogden v.
Saunders, 12 Wheat. 213, 269.
Mr. Justice CLARKE concurs in this opinion.
 Republic of the Philippines
SUPREME COURT
Manila
EN BANC
G.R. No. L-17518 October 30, 1922
FREDERICK C. FISHER, plaintiff-appellant,
vs.
WENCESLAO TRINIDAD, Collector of Internal Revenue, defendant-appellee.
Fisher and De Witt and Antonio M. Opisso for appellants.
Acting Attorney-General Tuason for appellee.
JOHNSON, J.:
The only question presented by this appeal is: Are the "stock dividends" in the
present case "income" and taxable as such under the provisions of section 25 of Act
No. 2833? While the appellant presents other important questions, under the view
which we have taken of the facts and the law applicable to the present case, we
deem it unnecessary to discuss them now.
The defendant demurred to the petition in the lower court. The facts are therefore
admitted. They are simple and may be stated as follows:
That during the year 1919 the Philippine American Drug Company was a
corporation duly organized and existing under the laws of the Philippine Islands,
doing business in the City of Manila; that he appellant was a stockholder in said
corporation; that said corporation, as result of the business for that year, declared
a "stock dividend"; that the proportionate share of said stock divided of the
appellant was P24,800; that the stock dividend for that amount was issued to the
appellant; that thereafter, in the month of March, 1920, the appellant, upon
demand of the appellee, paid under protest, and voluntarily, unto the appellee the
sum of P889.91 as income tax on said stock dividend. For the recovery of that sum
(P889.91) the present action was instituted. The defendant demurred to the
petition upon the ground that it did not state facts sufficient to constitute cause of
action. The demurrer was sustained and the plaintiff appealed.
To sustain his appeal the appellant cites and relies on some decisions of the
Supreme Court of the United States as will as the decisions of the supreme court of
some of the states of the Union, in which the questions before us, based upon
similar statutes, was discussed. Among the most important decisions may be
mentioned the following: Towne vs. Eisner, 245 U.S., 418; Doyle vs. Mitchell Bors.
Co., 247 U.S., 179; Eisner vs. Macomber, 252 U.S., 189; Dekoven vs Alsop, 205 Ill.,
309; 63 L.R.A., 587; Kaufman vs. Charlottesville Woolen Mills, 93 Va., 673.
In each of said cases an effort was made to collect an "income tax" upon "stock
dividends" and in each case it was held that "stock dividends" were capital and not
an "income" and therefore not subject to the "income tax" law.
The appellee admits the doctrine established in the case of Eisner vs. Macomber
(252 U.S., 189) that a "stock dividend" is not "income" but argues that said Act No.
2833, in imposing the tax on the stock dividend, does not violate the provisions of
the Jones Law. The appellee further argues that the statute of the United States
providing for tax upon stock dividends is different from the statute of the Philippine
Islands, and therefore the decision of the Supreme Court of the United States
should not be followed in interpreting the statute in force here.
For the purpose of ascertaining the difference in the said statutes ( (United States
and Philippine Islands), providing for an income tax in the United States as well as
that in the Philippine Islands, the two statutes are here quoted for the purpose of
determining the difference, if any, in the language of the two statutes.
Chapter 463 of an Act of Congress of September 8, 1916, in its title 1 provides for
the collection of an "income tax." Section 2 of said Act attempts to define what is
an income. The definition follows:
That the term "dividends" as used in this title shall be held to mean any
distribution made or ordered to made by a corporation, . . . which stock
dividend shall be considered income, to the amount of its cash value.
Act No. 2833 of the Philippine Legislature is an Act establishing "an income tax."
Section 25 of said Act attempts to define the application of the income tax. The
definition follows:
The term "dividends" as used in this Law shall be held to mean any
distribution made or ordered to be made by a corporation, . . . out of its
earnings or profits accrued since March first, nineteen hundred and
 thirteen, and payable to its shareholders, whether in cash or in stock of
the corporation, . . . . Stock dividend shall be considered income, to the
amount of the earnings or profits distributed.
It will be noted from a reading of the provisions of the two laws above quoted that
the writer of the law of the Philippine Islands must have had before him the statute
of the United States. No important argument can be based upon the slight different
in the wording of the two sections.
It is further argued by the appellee that there are no constitutional limitations upon
the power of the Philippine Legislature such as exist in the United States, and in
support of that contention, he cites a number of decisions. There is no question
that the Philippine Legislature may provide for the payment of an income tax, but it
cannot, under the guise of an income tax, collect a tax on property which is not an
"income." The Philippine Legislature can not impose a tax upon "property" under a
law which provides for a tax upon "income" only. The Philippine Legislature has no
power to provide a tax upon "automobiles" only, and under that law collect a tax
upon a carreton or bull cart. Constitutional limitations, that is to say, a statute
expressly adopted for one purpose cannot, without amendment, be applied to
another purpose which is entirely distinct and different. A statute providing for an
income tax cannot be construed to cover property which is not, in fact income. The
Legislature cannot, by a statutory declaration, change the real nature of a tax which
it imposes. A law which imposes an important tax on rice only cannot be construed
to an impose an importation tax on corn.
It is true that the statute in question provides for an income tax and contains a
further provision that "stock dividends" shall be considered income and are
therefore subject to income tax provided for in said law. If "stock dividends" are
not "income" then the law permits a tax upon something not within the purpose
and intent of the law.
It becomes necessary in this connection to ascertain what is an "income in order
that we may be able to determine whether "stock dividends" are "income" in the
sense that the word is used in the statute. Perhaps it would be more logical to
determine first what are "stock dividends" in order that we may more clearly
understand their relation to "income." Generally speaking, stock dividends
represent undistributed increase in the capital of corporations or firms, joint stock
companies, etc., etc., for a particular period. They are used to show the increased
interest or proportional shares in the capital of each stockholder. In other words,
the inventory of the property of the corporation, etc., for particular period shows
an increase in its capital, so that the stock theretofore issued does not show the
real value of the stockholder's interest, and additional stock is issued showing the
increase in the actual capital, or property, or assets of the corporation, etc.
To illustrate: A and B form a corporation with an authorized capital of P10,000 for
the purpose of opening and conducting a drug store, with assets of the value of
P2,000, and each contributes P1,000. Their entire assets are invested in drugs and
put upon the shelves in their place of business. They commence business without a
cent in the treasury. Every dollar contributed is invested. Shares of stock to the
amount of P1,000 are issued to each of the incorporators, which represent the
actual investment and entire assets of the corporation. Business for the first year is
good. Merchandise is sold, and purchased, to meet the demands of the growing
trade. At the end of the first year an inventory of the assets of the corporation is
made, and it is then ascertained that the assets or capital of the corporation on
hand amount to P4,000, with no debts, and still not a cent in the treasury. All of the
receipts during the year have been reinvested in the business. Neither of the
stockholders have withdrawn a penny from the business during the year. Every
peso received for the sale of merchandise was immediately used in the purchase of
new stock new supplies. At the close of the year there is not a centavo in the
treasury, with which either A or B could buy a cup of coffee or a pair of shoes for
his family. At the beginning of the year they were P2,000, and at the end of the
year they were P4,000, and neither of the stockholders have received a centavo
from the business during the year. At the close of the year, when it is discovered
that the assets are P4,000 and not P2,000, instead of selling the extra merchandise
on hand and thereby reducing the business to its original capital, they agree among
themselves to increase the capital they agree among themselves to increase the
capital issued and for that purpose issue additional stock in the form of "stock
dividends" or additional stock of P1,000 each, which represents the actual increase
of the shares of interest in the business. At the beginning of the year each
stockholder held one-half interest in the capital. At the close of the year, and after
the issue of the said stock dividends, they each still have one-half interest in the
business. The capital of the corporation increased during the year, but has either of
them received an income? It is not denied, for the purpose of ordinary taxation,
that the taxable property of the corporation at the beginning of the year was
P2,000, that at the close of the year it was P4,000, and that the tax rolls should be
changed in accordance with the changed conditions in the business. In other
words, the ordinary tax should be increased by P2,000.
Another illustration: C and D organized a corporation for agricultural purposes with
an authorized capital stock of P20,000 each contributing P5,000. With that capital
they purchased a farm and, with it, one hundred head of cattle. Every peso
contributed is invested. There is no money in the treasury. Much time and labor
was expanded during the year by the stockholders on the farm in the way of
improvements. Neither received a centavo during the year from the farm or the sense. (146 Northwestern Reporter, 812) Mr. Black, in his law dictionary, says "An
cattle. At the beginning of the year the assets of the corporation, including the income is the return in money from one's business, labor, or capital invested; gains,
farm and the cattle, were P10,000, and at the close of the year and inventory of the profit or private revenue." "An income tax is a tax on the yearly profits arising from
property of the corporation is made and it is then found that they have the same property , professions, trades, and offices."
farm with its improvements and two hundred head of cattle by natural increase. At
the end of the year it is also discovered that, by reason of business changes, the The Supreme Court of the United States, in the case o Gray vs. Darlington (82 U.S.,
farm and the cattle both have increased in value, and that the value of the 653), said in speaking of income that mere advance in value in no sense constitutes
corporate property is now P20,000 instead of P10,000 as it was at the beginning of the "income" specified in the revenue law as "income" of the owner for the year in
the year. The incorporators instead of reducing the property to its original capital, which the sale of the property was made. Such advance constitutes and can be
by selling off a part of its, issue to themselves "stock dividends" to represent the treated merely as an increase of capital. (In re Graham's Estate, 198 Pa., 216;
proportional value or interest of each of the stockholders in the increased capital at Appeal of Braun, 105 Pa., 414.)
the close of the year. There is still not a centavo in the treasury and neither has
withdrawn a peso from the business during the year. No part of the farm or cattle
Mr. Justice Hughes, later Associate Justice of the Supreme Court of the United
has been sold and not a single peso was received out of the rents or profits of the
States and now Secretary of State of the United States, in his argument before the
capital of the corporation by the stockholders.
Supreme Court of the United States in the case of Towne vs. Eisner, supra, defined
an "income" in an income tax law, unless it is otherwise specified, to mean cash or
Another illustration: A, an individual farmer, buys a farm with one hundred head of its equivalent. It does not mean choses in action or unrealized increments in the
cattle for the sum of P10,000. At the end of the first year, by reason of business value of the property, and cites in support of the definition, the definition given by
conditions and the increase of the value of both real estate and personal property, the Supreme Court in the case of Gray vs. Darlington, supra.
it is discovered that the value of the farm and the cattle is P20,000. A, during the
year, has received nothing from the farm or the cattle. His books at the beginning
In the case of Towne vs. Eisner, supra, Mr. Justice Holmes, speaking for the court,
of the year show that he had property of the value of P10,000. His books at the
said: "Notwithstanding the thoughtful discussion that the case received below, we
close of the year show that he has property of the value of P20,000. A is not a
cannot doubt that the dividend was capital as well for the purposes of the Income
corporation. The assets of his business are not shown therefore by certificates of
Tax Law. . . . 'A stock dividend really takes nothing from the property of the
stock. His books, however, show that the value of his property has increased during
corporation, and adds nothing to the interests of the shareholders. Its property is
the year by P10,000, under any theory of business or law, be regarded as an
not diminished and their interest are not increased. . . . The proportional interest of
"income" upon which the farmer can be required to pay an income tax? Is there
each shareholder remains the same. . . .' In short, the corporation is no poorer and
any difference in law in the condition of A in this illustration and the condition of A
the stockholder is no richer then they were before." (Gibbons vs. Mahon, 136 U.S.,
and B in the immediately preceding illustration? Can the increase of the value of
549, 559, 560; Logan County vs. U.S., 169 U.S., 255, 261).
the property in either case be regarded as an "income" and be subjected to the
payment of the income tax under the law?
In the case of Doyle vs. Mitchell Bros. Co. (247 U.S., 179, Mr. Justice Pitney,
speaking for the court, said that the act employs the term "income" in its natural
Each of the foregoing illustrations, it is asserted, is analogous to the case before us
and obvious sense, as importing something distinct from principal or capital and
and, in view of that fact, let us ascertain how lexicographers and the courts have
conveying the idea of gain or increase arising from corporate activity.
defined an "income." The New Standard Dictionary, edition of 1915, defines an
income as "the amount of money coming to a person or corporation within a
specified time whether as payment or corporation within a specified time whether Mr. Justice Pitney, in the case of Eisner vs. Macomber (252 U.S., 189), again
as payment for services, interest, or profit from investment." Webster's speaking for the court said: "An income may be defined as the gain derived from
International Dictionary defines an income as "the receipt, salary; especially, the capital, from labor, or from both combined, provided it be understood to include
annual receipts of a private person or a corporation from property." Bouvier, in his profit gained through a sale or conversion of capital assets."
law dictionary, says that an "income" in the federal constitution and income tax
act, is used in its common or ordinary meaning and not in its technical, or economic
For bookkeeping purposes, when stock dividends are declared, the corporation or
company acknowledges a liability, in form, to the stockholders, equivalent to the
aggregate par value of their stock, evidenced by a "capital stock account." If profits
have been made by the corporation during a particular period and not divided,
they create additional bookkeeping liabilities under the head of "profit and loss,"
"undivided profits," "surplus account," etc., or the like. None of these, however,
gives to the stockholders as a body, much less to any one of them, either a claim
against the going concern or corporation, for any particular sum of money, or a
right to any particular portion of the asset, or any shares sells or until the directors
conclude that dividends shall be made a part of the company's assets segregated
from the common fund for that purpose. The dividend normally is payable in
money and when so paid, then only does the stockholder realize a profit or gain,
which becomes his separate property, and thus derive an income from the capital
that he has invested. Until that, is done the increased assets belong to the
corporation and not to the individual stockholders.
When a corporation or company issues "stock dividends" it shows that the
company's accumulated profits have been capitalized, instead of distributed to the
stockholders or retained as surplus available for distribution, in money or in kind,
should opportunity offer. Far from being a realization of profits of the stockholder,
it tends rather to postpone said realization, in that the fund represented by the
new stock has been transferred from surplus to assets, and no longer is available
for actual distribution. The essential and controlling fact is that the stockholder has
received nothing out of the company's assets for his separate use and benefit; on
the contrary, every dollar of his original investment, together with whatever
accretions and accumulations resulting from employment of his money and that of
the other stockholders in the business of the company, still remains the property of
the company, and subject to business risks which may result in wiping out of the
entire investment. Having regard to the very truth of the matter, to substance and
not to form, the stockholder by virtue of the stock dividend has in fact received
nothing that answers the definition of an "income." (Eisner vs. Macomber, 252
U.S., 189, 209, 211.)
The stockholder who receives a stock dividend has received nothing but a
representation of his increased interest in the capital of the corporation. There has
been no separation or segregation of his interest. All the property or capital of the
corporation still belongs to the corporation. There has been no separation of the
interest of the stockholder from the general capital of the corporation. The
stockholder, by virtue of the stock dividend, has no separate or individual control
over the interest represented thereby, further than he had before the stock
dividend was issued. He cannot use it for the reason that it is still the property of
the corporation and not the property of the individual holder of stock dividend. A
certificate of stock represented by the stock dividend is simply a statement of his
proportional interest or participation in the capital of the corporation. For
bookkeeping purposes, a corporation, by issuing stock dividend, acknowledges a
liability in form to the stockholders, evidenced by a capital stock account. The
receipt of a stock dividend in no way increases the money received of a stockholder
nor his cash account at the close of the year. It simply shows that there has been an
increase in the amount of the capital of the corporation during the particular
period, which may be due to an increased business or to a natural increase of the
value of the capital due to business, economic, or other reasons. We believe that
the Legislature, when it provided for an "income tax," intended to tax only the
"income" of corporations, firms or individuals, as that term is generally used in its
common acceptation; that is that the income means money received, coming to a
person or corporation for services, interest, or profit from investments. We do not
believe that the Legislature intended that a mere increase in the value of the
capital or assets of a corporation, firm, or individual, should be taxed as "income."
Such property can be reached under the ordinary from of taxation.
Mr. Justice Pitney, in the case of the Einer vs. Macomber, supra, said in discussing
the difference between "capital" and "income": "That the fundamental relation of
'capital' to 'income' has been much discussed by economists, the former being
likened to the tree or the land, the latter to the fruit or the crop; the former
depicted as a reservoir supplied from springs; the latter as the outlet stream, to be
measured by its flow during a period of time." It may be argued that a stockholder
might sell the stock dividend which he had acquired. If he does, then he has
received, in fact, an income and such income, like any other profit which he realizes
from the business, is an income and he may be taxed thereon.
There is a clear distinction between an extraordinary cash dividend, no matter
when earned, and stock dividends declared, as in the present case. The one is a
disbursement to the stockholder of accumulated earnings, and the corporation at
once parts irrevocably with all interest thereon. The other involves no
disbursement by the corporation. It parts with nothing to the stockholder. The
latter receives, not an actual dividend, but certificate of stock which simply
evidences his interest in the entire capital, including such as by investment of
accumulated profits has been added to the original capital. They are not income to
him, but represent additions to the source of his income, namely, his invested
capital. (DeKoven vs. Alsop, 205, Ill., 309; 63 L.R.A. 587). Such a person is in the
same position, so far as his income is concerned, as the owner of young domestic
animal, one year old at the beginning of the year, which is worth P50 and, which, at
the end of the year, and by reason of its growth, is worth P100. The value of his
property has increased, but has had an income during the year? It is true that he
had taxable property at the beginning of the year of the value of P50, and the same
taxable property at another period, of the value of P100, but he has had no income
in the common acceptation of that word. The increase in the value of the property
should be taken account of on the tax duplicate for the purposes of ordinary
taxation, but not as income for he has had none.
The question whether stock dividends are income, or capital, or assets has
frequently come before the courts in another form in cases of inheritance. A is a
stockholder in a large corporation. He dies leaving a will by the terms of which he
give to B during his lifetime the "income" from said stock, with a further provision
that C shall, at B's death, become the owner of his share in the corporation. During
B's life the corporation issues a stock dividend. Does the stock dividend belong to B
as an income, or does it finally belong to C as a part of his share in the capital or
assets of the corporation, which had been left to him as a remainder by A? While
there has been some difference of opinion on that question, we believe that a
great weight of authorities hold that the stock dividend is capital or assets
belonging to C and not an income belonging to B. In the case of D'Ooge vs. Leeds
(176 Mass., 558, 560) it was held that stock dividends in such cases were regarded
as capital and not as income (Gibbons vs. Mahon, 136 U.S., 549.)
In the case of Gibbson vs. Mahon, supra, Mr. Justice Gray said: "The distinction
between the title of a corporation, and the interest of its members or stockholders
in the property of the corporation, is familiar and well settled. The ownership of
that property is in the corporation, and not in the holders of shares of its stock. The
interest of each stockholder consists in the right to a proportionate part of the
profits whenever dividends are declared by the corporation, during its existence,
under its charter, and to a like proportion of the property remaining, upon the
termination or dissolution of the corporation, after payment of its debts." (Minot
vs. Paine, 99 Mass., 101; Greeff vs. Equitable Life Assurance Society, 160 N. Y., 19.)
In the case of Dekoven vs. Alsop (205 Ill ,309, 63 L. R. A. 587) Mr. Justice Wilkin
said: "A dividend is defined as a corporate profit set aside, declared, and ordered
by the directors to be paid to the stockholders on demand or at a fixed time. Until
the dividend is declared, these corporate profits belong to the corporation, not to
the stockholders, and are liable for corporate indebtedness.
There is a clear distinction between an extraordinary cash dividend, no matter
when earned, and stock dividends declared. The one is a disbursement to the
stockholders of accumulated earning, and the corporation at once parts irrevocably
with all interest thereon. The other involves no disbursement by the corporation. It
parts with nothing to the stockholders. The latter receives, not an actual dividend,
but certificates of stock which evidence in a new proportion his interest in the
entire capital. When a cash becomes the absolute property of the stockholders and
cannot be reached by the creditors of the corporation in the absence of fraud. A
stock dividend however, still being the property of the corporation and not the
stockholder, it may be reached by an execution against the corporation, and sold as
a part of the property of the corporation. In such a case, if all the property of the
corporation is sold, then the stockholder certainly could not be charged with having
received an income by virtue of the issuance of the stock dividend. Until the
dividend is declared and paid, the corporate profits still belong to the corporation,
not to the stockholders, and are liable for corporate indebtedness. The rule is well
established that cash dividend, whether large or small, are regarded as "income"
and all stock dividends, as capital or assets (Cook on Corporation, Chapter 32, secs.
534, 536; Davis vs. Jackson, 152 Mass., 58; Mills vs. Britton, 64 Conn., 4; 5 Am., and
Eng. Encycl. of Law, 2d ed., p. 738.)
If the ownership of the property represented by a stock dividend is still in the
corporation and to in the holder of such stock, then it is difficult to understand how
it can be regarded as income to the stockholder and not as a part of the capital or
assets of the corporation. (Gibbsons vs. Mahon, supra.) the stockholder has
received nothing but a representation of an interest in the property of the
corporation and, as a matter of fact, he may never receive anything, depending
upon the final outcome of the business of the corporation. The entire assets of the
corporation may be consumed by mismanagement, or eaten up by debts and
obligations, in which case the holder of the stock dividend will never have received
an income from his investment in the corporation. A corporation may be solvent
and prosperous today and issue stock dividends in representation of its increased
assets, and tomorrow be absolutely insolvent by reason of changes in business
conditions, and in such a case the stockholder would have received nothing from
his investment. In such a case, if the holder of the stock dividend is required to pay
an income tax on the same, the result would be that he has paid a tax upon an
income which he never received. Such a conclusion is absolutely contradictory to
the idea of an income. An income subject to taxation under the law must be an
actual income and not a promised or prospective income.
The appelle argues that there is nothing in section 25 of Act No 2833 which
contravenes the provisions of the Jones Law. That may be admitted. He further
argues that the Act of Congress (U.S. Revenue Act of 1918) expressly authorized the
Philippine Legislatures to provide for an income tax. That fact may also be
admitted. But a careful reading of that Act will show that, while it permitted a tax
upon income, the same provided that income shall include gains, profits, and
income derived from salaries, wages, or compensation for personal services, as
well as from interest, rent, dividends, securities, etc. The appellee emphasizes the
"income from dividends." Of course, income received as dividends is taxable as an
income but an income from "dividends" is a very different thing from receipt of a
"stock dividend." One is an actual receipt of profits; the other is a receipt of a
representation of the increased value of the assets of corporation.
In all of the foregoing argument we have not overlooked the decisions of a few of
the courts in different parts of the world, which have reached a different
conclusion from the one which we have arrived at in the present case. Inasmuch,
however, as appeals may be taken from this court to the Supreme Court of the
United States, we feel bound to follow the same doctrine announced by that court.
Having reached the conclusion, supported by the great weight of the authority,
that "stock dividends" are not "income," the same cannot be taxes under that
provision of Act No. 2833 which provides for a tax upon income. Under the guise of
an income tax, property which is not an income cannot be taxed. When the assets
of a corporation have increased so as to justify the issuance of a stock dividend, the
increase of the assets should be taken account of the Government in the ordinary
tax duplicates for the purposes of assessment and collection of an additional tax.
For all of the foregoing reasons, we are of the opinion, and so decide, that the
judgment of the lower court should be revoked, and without any finding as to
costs, it is so ordered.
Araullo, C.J. Avancea, Villamor and Romualdez, JJ., concur.
Separate Opinions
STREET, J., concurring:
I agree that the trial court erred in sustaining the demurrer, and the judgment must
be reversed. Instead of demurring the defendant should have answered and
alleged, if such be the case, that the stock dividend which was the subject of
taxation represents the amount of earnings or profits distributed by means of the
issuance of said stock dividend; and the case should have been tried on that
question of fact.
In this connection it will be noted that section 25 (a) of Act No. 2833, of the
Philippine Legislature, under which this tax was imposed, does not levy a tax
generally on stock dividends to the extend of the part of the stock nor even to the
extend of its value, but declares that stock dividends shall be considered as income
to the amount of the earnings or profits distributed. Under provision, before the
tax can be lawfully assessed and collected, it must appear that he stock dividend
represents earning or profits distributed; and the burden of proof is on the
Collector of Internal Revenue to show this.
The case of Eisner vs. Macomber (252 U.S., 189; 64 L. ed., 521), has been cited as
authority for the proposition that it is incompetent for the Legislature to tax as
income any property which by nature is really capital as a stock dividend is there
said to be. In that case the Supreme Court of the United States held that a
Congressional Act taxing stock dividends as income was repugnant to that provision
of the Constitution of the United States which required that direct taxes upon
property shall be apportioned for collection among the several states according to
population and that the Sixteenth Amendment, in authorizing the imposition by
Congress of taxes upon income, had not vested Congress with the power to levy
direct taxes, on property under the guise of income taxes. But the resolution
embodied in that decision was evidently reached because of the necessity of
harmonizing two different provisions of the Constitution of the United States, as
amended. In this jurisdiction our Legislature has full authority to levy both taxes on
property and income taxes; and there is no organic provision here in force similar
to that which, under the Constitution of the United States, requires direct taxes on
property to be levied in a particular way.
It results, under the statute here in force, there being no constitutional restriction
upon the action of the law making body, that the case before us presents merely a
question of statutory construction. That the problem should be viewed in this light,
in a case where there is no restriction upon the legislative body, is pointed our in
Eisner vs. Macomber, supra, where in the course of his opinion Mr. Justice Pitney
refers to the cases of the Swan Brewery Co. vs. Rex ([1914] A. C. 231), and Tax
Commissioner vs. Putnam (227 Mass., 522), as being distinguished from Eisner vs.
Macomber by the very circumstance that in those cases the law making body, or
bodies were under no restriction as to the method of levying taxes. Such is the
situation here.
OSTRAND, J., dissenting:
In its final analysis the opinion of the court rests principally, if not entirely on the
decision of the United States Supreme Court in the case of Eisner vs. Macomber
(252 U.S., 189), a decision which, for at least two reasons, is entirely inapplicable to
the present case.
In the first place, there is a radical difference between the definition of a taxable
stock dividend given in the United States Income Tax Law of September 8, 1916,
construed in the case of Eisner vs. Macomber, and that given in Act No. 2833 of the
Philippine Legislature, the Act with which we are concerned in the present case.
The former provides that "stock dividend shall be considered income, to the
amount of its cash value;" the Philippine Act provides that "Stock dividend shall be
considered income, to the amount of the earnings or profits distributed." The
United State statute made stock dividends based upon an advance in the value of
the property or investment taxable as income whether resulting from earning or
not; our statute make stock dividends taxable only to the amount of the earning
and profits distributed, and stock dividends based on the increment income and
are not taxable. Though the difference would seem sufficiently obvious, we will
endeavor to make it still clearer by borrowing one of the illustrations with which
the opinion of the court is provided. The court says:
A, an individual farmer, buys a farm with one hundred head of cattle for
the sum of P10,000. At the end of the first year, by reason of business
conditions and the increase of the value of both real estate and personal
property, it is discovered that the value of the farm and the cattle is
P20,000. A, during the year has received nothing from the farm or the
cattle. His books at the beginning of the year show that he had property
of the value of P10,000. His books at the close of the year show that he
has property of the value of P20,000. A is not a corporation. The assets of
his business are not shown therefore by certificate of stock. His books,
however, show that the value of his property has increased during the
year by P10,000. Can the P10,000, under any theory of business or law,
be regarded as an "income" upon which the farmer can be required to
pay an income tax? Is there any difference in law in the conditions of A in
this illustration and the conditions of A and B in the immediately
preceding illustration? Can the increase of the value of the property in
either case be regarded as an 'income' and be subjected to the payment
of the income tax under the law?
I answer no. And while the increment if in the form of a stock dividend would have
been regarded as income under the United States statute and taxes as such, it is
not regarded as income and cannot be so taxes under our statute because it
is not based on earnings or profits. That is precisely the difference between the two
statutes and that is the reason the illustration is not in point in this case, though it
would have been entirely appropriate in the Eisner vs. Macomber case. It is also
one of the reasons why that case is inapplicable here and why most of the
arguments in the majority opinion are beside the mark.
But let us suppose that A had sold the products of the farm during the year for
P10,000 over and above his expense, and had invested the money in buildings and
improvements on the farm, thus increasing its value to P20,000. Why would not
the P10,000 earned during the year and so invested in improvements still be
income for the year? And why would not a tax on these earnings be an income tax
under the definition given in Black's Law Dictionary, and quoted with approval in
the decision of the court, that "An income tax is a tax on the yearly profits arising
from the property, professions, trades, and offices?" There can be but one answer.
There is no reason whatever why the gains derived from the sale of the products of
the farm should not be regarded as income whether reinvested in improvements
upon the farm or not and there is no reason way a tax levied thereon cannot be
considered an income tax.
Moreover, to constitute income, profits, or earnings need not necessarily be
converted into cash. Black's Law Dictionary says and I am again quoting from the
decision of the court "An income is the return in money from one's business,
labor, or capital invested; gains profits, or private revenue." As will be seen in the
secondary sense of the word, income need not consist in money; upon this point
there is no divergence of view among the lexicographers. If a farmer stores the gain
produced upon his farm without selling, it may none the less be regarded as
income.
In the Eisner vs. Macomber case, the United States supreme Court felt bound to
give the word "income" a strict interpretation. Under article 1, paragraph 2, clause
3, and paragraph 9, clause 4 of the original Constitution of the United States,
Congress could not impose direct taxes without apportioning them among the
States according to population. As it was thought desirable to impose Federal taxes
upon incomes and as a levy of such taxes by appointment among the States in
proportion to population would lead to an unequal distribution of the tax with
reference to the amount of taxable incomes, the Sixteenth Amendment was
adopted and which provided that "The Congress shall have power to lay and collect
taxes on incomes, from whatever source derived, without apportionment among
the several states, and without regard to any census or enumeration."
The United States Supreme Court therefore says in the Eisner vs. Macomber case:
A proper regard for its generis, as well as its very clear language, requires
also that this Amendment shall not be extended by loose construction, so
as to repeal or modify, except as applied to income, those provisions of
the Constitution that require an apportionment according to population
for direct taxes upon property, real and personal. This limitation still has
an appropriate and important functions, and is not to be overridden by
Congress or disregarded by the courts.
 In order, therefore, that the clauses cited from Article I of the
constitution may have proper force and effect, save only as modified by
the Amendment, and that the latter also may have proper effect, it
becomes essential to distinguish between what is and what is not
"income," as the term is there used; and to apply the distinction as cases
arise, according to truth and substance, without regard to form. Congress
cannot by any definition it may adopt conclude the matter, since it
cannot by legislation alter the Constitution, from which alone it derives
its power to legislate, and within whose limitations alone that power can
be lawfully exercised.
That, in the absence of the peculiar restrictions placed by the Constitution upon
taxing power of Congress, the decision of the court might have been different is
clearly indicated by the following language:
Two recent decisions, proceeding from courts of high jurisdiction, are
cited in support of the position of the Government.
Sean Brewery Co. vs. Rex ([1914] A. C., 231), arose under the Dividend
Duties Act of Western Australia, which provided that "dividend" should
include "every dividend, profit, advantage, or gain intended to be paid or
credited to or distributed among any members or director of any
company," except etc. There was a stock dividend, the new shares being
alloted among the shareholders pro rata; and the question was whether
this was a distribution of a dividend within the meaning of the act. The
Judicial Committee of the Privy Council sustained the dividend duty upon
the ground that, although "in ordinary language the new shares would
not be distribution of a dividend," yet within the meaning of the act, such
new share were an "advantage" to the recipients. There being no
constitutional restriction upon the action of the lawmaking body, the case
presented merely a question of statutory construction, and manifestly the
decision is not a precedent for the guidance of this court when acting
under a duty to test an act of Congress by the limitations of a written
Constitution having superior force.
In Tax Commissioner vs. Putnam (1917], 227 Mass., 522), it was held that
the 44th Amendment to the constitution of Massachusetts, which
conferred upon the legislature full power to tax incomes, "must be
interpreted as including every item which by any reasonable
understanding can fairly be regarded as income" (pp. 526, 531); and that
under it a stock dividend was taxable as income. . . . Evidently, in order to
give a sufficiently broad sweep to the new taxing provision, it was
deemed necessary to take the symbol for the substance, accumulation
for distribution, capital accretion for its opposite; while a case where
money is paid into the hand of the stockholder with an option to buy new
shares with it, followed by acceptance of the option, was regarded as
identical in substance with a case where the stockholder receives no
money and has no option. The Massachusetts court was not under an
obligation, like the one which binds us, of applying a constitutional
provisions that stand in the way of extending it by construction.
The Philippine Legislature has full power to levy taxes both on capital or property
and on income, subject only to the provisions of the Organic Act that "the rule of
taxation shall be uniform." In providing for the income tax the Legislature is
therefore entirely free to employ the term "income" in its widest sense and is in
nowise limited or hampered by organic limitations such as those imposed upon
Congress by the Constitution of the United States. This is the second reason why
the rule laid down in Eisner vs. Macomber has no application here.
The majority opinion in discussing this question, says:
There is no question that the Philippine Legislature may provide for the
payment of an income tax, but it cannot, under the guise of an income
tax, collect a tax on property which is not an "income." The Philippine
Legislature cannot impose a tax upon "income" only . The Philippine
Legislature has no power to provide a tax upon "automobiles," only, and
under that law collect a tax upon a carreton or bull cart. Constitutional
limitations upon the power of the Legislature are not stronger than
statutory limitations, that is to say, a statute expressly adopted for one
purpose cannot, without amendment, be applied to another purpose
which is entirely distinct and different. A statute providing for an income
tax cannot be construed to cover property which is not, in fact, income.
The Legislature cannot, by a statutory declaration, change the real of a
nature of a tax which it imposes. A law which imposes an importation tax
on rice only cannot be construed to impose an importation tax on corn.
These assertions while in the main true are, perhaps, a little to broadly stated;
much will depend on the circumstances of each particular case. If the Legislature
cannot do the things enumerate it must be by reason of the limitation imposed by
the Organic Act, "That no bill which may be enacted into law shall embrace more
than on subject, and that subject shall be expressed in the title of the bill." Similar
provisions are contained in most State Constitutions, their object being to prevent
"log-rolling" and the passing of undesirable measures without their being brought
properly to the attention of the legislators. Where the prevention of this mischief is
not involved, the courts have uniformly given such provisions a very liberal
construction and there are few, if any, cases where a statute has been declared
unconstitutional for dealing with several cognate subjects in the same Act and
under the same title. (Lewis Sutherland on Statutory Construction, 2d ed., pars
109 et seq.: Government of the Philippine Island vs. Municipality of Binalonan and
Roman Catholic Bishop of Nueva Segovia, 32, Phil., 634). Certainly no income tax
statute would be declared unconstitutional on that ground for treating dividends as
income and providing for their taxation as such.
Reverting to the question of the nature of income, it is argued that a stock
certificate has no intrinsic value and that, therefore, even it is based on earnings
instead of increment in capital it cannot be regarded as income. But neither has a
bank check or a time deposit certificate any intrinsic value, yet it may be
negotiated, or sold, or assigned and it represents a cash value. So also does a stock
certificate. A lawyer might take his fee in stock certificates instead of in money.
Would it be seriously contended that he had received no fee and that his efforts
had brought no income?1awph!l.net
Some of the members of the court agree that stock dividends based on earnings or
profits may be taxed as income, but take the view that in an action against the
Collector of the Internal Revenue for recovering back taxes paid on non-taxable
stock dividends, the plaintiff need not allege that the stock dividends are not base
on earnings or profits distributed, but that question of the taxability or non-
taxability of the stock dividends is a matter of defense and should be set up by the
defendant by way of answer.
I think this view is erroneous. If some stock dividends are taxable and others are
not, an allegation that stock dividends in general have been taxed is not sufficient
and does not state a cause of action. the presumption is that the tax has been
legally collected and the burden is upon the plaintiff both to allege and prove facts
showing that the collection is unlawfully or irregular. (Code of Civil Procedure, sec.
334, subsec. 14 and 31.)
Malcolm, J., concurs.
JOHNS, J., dissenting:
We have studied and analyzed with care the able and exhaustive majority opinion
written by Mr. Justice Johnson.
In the final analysis, the question involved is whether the words "which stock
dividend shall be considered income, to the amount of its cash value" are to be
construed as meaning the same things as the words "stock dividend shall be
considered income, to the amount of the earnings or profits distributed," as the
majority opinion says. The first is an Act of Congress defining what is a stock
dividend, and that the word dividend shall be construed as income to the amount
of its cash value. It is upon that construction and that definition that the majority
opinion is founded. That is the definition of the words as used in an Act of
Congress. The other is an Act defining the meaning of the words as used in an Act
of Congress. The other is an Act defining the meaning of the words by the
Legislature of the Philippine Islands, and it says: "Stock dividend shall be considered
income, to the amount of the earnings or profits distributed."
It is true, as the majority opinion says, that in enacting the Income Tax Law of the
Philippine Islands, the Legislature had before it the Act of Congress. But it is also
true that by the Act of the Philippine Legislature "Stock dividend shall be
considered income, to the amount of the earnings or profits distributed." One law
is founded upon the actual cash value of the stock and the other is founded upon
distributed earnings and profits.
Much is said in the textbooks and by the numerous decisions cited in the majority
opinion as to the meaning of the word income, and the decision in the United
States are founded upon the meaning of that word, as it is used in the Act of
Congress, and to the effect that the word is to be construed in its usual and
ordinary meaning. But assuming that to be true, it must also be conceded that the
Legislature of the Philippine Islands has a legal right to define the meaning of the
word "income" by a legislative act, and when its meaning is defined by legislative
act, it is the duty of the courts to follow that definition regardless of whether it is
the usual and ordinary meaning of the word, and therein lies the distinction
between the two acts and the reason why the authorities cited in the majority
opinion are not in point. Act No. 2833 of the Philippine Legislature specifically says
that "Stock dividend shall be considered income, to the amount of the earnings or
profits distributed." The Act of Congress is founded upon the "cash value of the
stock," and the Act in question is founded upon "the amount of the earnings or
profits distributed."
Hence, then, we have the meaning of the words defined in the legislative act, and it
is very apparent that the purpose and intent of the legislative act was to avoid the
meaning and construction of such words which is now given to them in the
majority opinion. The Legislature had the power to define the meaning of the
words, did define them, and it is the duty of the courts to follow and adopt the
meaning and definition of the words given to them in the legislative act.

As pointed out in the opinion of Mr. Justice Street, the constitutional limitations
upon the legislative power for taxation purposes, which exist in the United States,
does not exist in the Philippine Islands. There is no organic law here similar to the
provisions of the Constitution of the United States which require direct taxes on
property to be levied in a specific way, in other words, the restrictions and
limitations placed on the power to levy an income tax under the Constitution of the
United States do not exist in the Philippine Islands. Hence, it must follow that the
authorities cited in the majority opinion are not in point the instant case. They are
founded upon different language, different organic powers, different conditions,
and the different meaning of the same words as defined in the different legislative
acts. The Philippine Legislature had a legal right to define the meaning of the words
"dividend" and "income," and it expressly says "Stock dividend shall be considered
income, to the amount of the earnings or profits distributed." In the instant case,
the earnings and profits of the corporation were distributed among the existing
stockholders of the company upon a pro rata basis, and they were made exclusively
out of "distributed earnings and profits." The declaring of the dividend was a
matter in the sole discretion of the stockholders, but when such a dividend is made
from and out of "earnings or profits distributed," it then becomes and is an income
within the meaning of Act No. 2833, and should be subject to an income tax.

For such reason, I dissent.

Claim of Right Doctrine; Doctrine of Ownership, Command or Control;
A taxable gain is conditioned upon the presence of a claim of right to the
alleged gain and the absence of a definite unconditional obligation to return or
repay that which would otherwise constitute a gain.
In the claim of right doctrine, if a taxpayer receives money or other property and
treats it as its own under the claim of right that the payments are made absolutely
and not contingently, such amounts are included in the taxpayers income, even
though the right to the income has not been perfected at that time. It does not
matter that the taxpayers title to the property is in dispute and that the property
may later be recovered from the taxpayer. If the taxpayer who has included
amounts in income pursuant to the claim of right doctrine subsequently repays
those amounts, the taxpayer may be entitled to a deduction in the year of
repayment (CIR v. Manila Electric Company).
A taxable gain is conditioned upon the presence of a claim of right to the alleged
gain and the absence of a definite unconditional obligation to return or repay that
which would otherwise constitute a gain. To collect a tax would give the
government an unjustified presence as to the part of the money that rightfully and
completely belongs to the victim (Commissioner v. Wicox).
Republic of the Philippines
SUPREME COURT
Manila
SECOND DIVISION
G.R. No. 78953 July 31, 1991
COMMISSIONER OF INTERNAL REVENUE, petitioner,
vs.
MELCHOR J. JAVIER, JR. and THE COURT OF TAX APPEALS, respondents.
Elison G. Natividad for accused-appellant.
SARMIENTO, J.:p
Central in this controversy is the issue as to whether or not a taxpayer who merely
states as a footnote in his income tax return that a sum of money that he
erroneously received and already spent is the subject of a pending litigation and
there did not declare it as income is liable to pay the 50% penalty for filing a
fraudulent return.
This question is the subject of the petition for review before the Court of the
portion of the Decision 1 dated July 27, 1983 of the Court of Tax Appeals (CTA) in
C.T.A. Case No. 3393, entitled, "Melchor J. Javier, Jr. vs. Ruben B. Ancheta, in his
capacity as Commissioner of Internal Revenue," which orders the deletion of the
50% surcharge from Javier's deficiency income tax assessment on his income for
1977.
The respondent CTA in a Resolution 2 dated May 25, 1987, denied the
Commissioner's Motion for Reconsideration 3 and Motion for New Trial 4 on the
deletion of the 50% surcharge assessment or imposition.
The pertinent facts as are accurately stated in the petition of private respondent
Javier in the CTA and incorporated in the assailed decision now under review, read
as follows:
xxx xxx xxx
2. That on or about June 3, 1977, Victoria L. Javier, the wife of
the petitioner (private respondent herein), received from the
Prudential Bank and Trust Company in Pasay City the amount of
US$999,973.70 remitted by her sister, Mrs. Dolores Ventosa,
through some banks in the United States, among which is
Mellon Bank, N.A.
3. That on or about June 29, 1977, Mellon Bank, N.A. filed a
complaint with the Court of First Instance of Rizal (now
Regional Trial Court), (docketed as Civil Case No. 26899),
against the petitioner (private respondent herein), his wife and
other defendants, claiming that its remittance of
US$1,000,000.00 was a clerical error and should have been
US$1,000.00 only, and praying that the excess amount of
US$999,000.00 be returned on the ground that the defendants
are trustees of an implied trust for the benefit of Mellon Bank
with the clear, immediate, and continuing duty to return the
said amount from the moment it was received.
4. That on or about November 5, 1977, the City Fiscal of Pasay
City filed an Information with the then Circuit Criminal Court
(docketed as CCC-VII-3369-P.C.) charging the petitioner (private
respondent herein) and his wife with the crime of estafa,
alleging that they misappropriated, misapplied, and converted
to their own personal use and benefit the amount of
US$999,000.00 which they received under an implied trust for
the benefit of Mellon Bank and as a result of the mistake in the
remittance by the latter.
5. That on March 15, 1978, the petitioner (private respondent
herein) filed his Income Tax Return for the taxable year 1977
showing a gross income of P53,053.38 and a net income of
P48,053.88 and stating in the footnote of the return that
"Taxpayer was recipient of some money received from abroad
which he presumed to be a gift but turned out to be an error
and is now subject of litigation."
6. That on or before December 15, 1980, the petitioner (private
respondent herein) received a letter from the acting
Commissioner of Internal Revenue dated November 14, 1980,
together with income assessment notices for the years 1976
and 1977, demanding that petitioner (private respondent
herein) pay on or before December 15, 1980 the amount of
P1,615.96 and P9,287,297.51 as deficiency assessments for the
years 1976 and 1977 respectively. . . .
7. That on December 15, 1980, the petitioner (private
respondent herein) wrote the Bureau of Internal Revenue that
he was paying the deficiency income assessment for the year
1976 but denying that he had any undeclared income for the
year 1977 and requested that the assessment for 1977 be
made to await final court decision on the case filed against him
for filing an allegedly fraudulent return. . . .
8. That on November 11, 1981, the petitioner (private
respondent herein) received from Acting Commissioner of
Internal Revenue Romulo Villa a letter dated October 8, 1981
stating in reply to his December 15, 1980 letter-protest that
"the amount of Mellon Bank's erroneous remittance which you
were able to dispose, is definitely taxable." . . . 5
The Commissioner also imposed a 50% fraud penalty against Javier.
Disagreeing, Javier filed an appeal 6 before the respondent Court of Tax Appeals on
December 10, 1981.
The respondent CTA, after the proper proceedings, rendered the challenged
decision. We quote the concluding portion:
We note that in the deficiency income tax assessment under
consideration, respondent (petitioner here) further requested
petitioner (private respondent here) to pay 50% surcharge as
provided for in Section 72 of the Tax Code, in addition to the
deficiency income tax of P4,888,615.00 and interest due
thereon. Since petitioner (private respondent) filed his income
tax return for taxable year 1977, the 50% surcharge was
imposed, in all probability, by respondent (petitioner) because
he considered the return filed false or fraudulent. This
additional requirement, to our mind, is much less called for
because petitioner (private respondent), as stated earlier,
reflected in as 1977 return as footnote that "Taxpayer was
recipient of some money received from abroad which he
presumed to be gift but turned out to be an error and is now
subject of litigation."
From this, it can hardly be said that there was actual and
intentional fraud, consisting of deception willfully and
deliberately done or resorted to by petitioner (private
respondent) in order to induce the Government to give up
some legal right, or the latter, due to a false return, was placed
at a disadvantage so as to prevent its lawful agents from proper
assessment of tax liabilities. (Aznar vs. Court of Tax Appeals, L-
20569, August 23, 1974, 56 (sic) SCRA 519), because petitioner
literally "laid his cards on the table" for respondent to examine.
Error or mistake of fact or law is not fraud. (Insular Lumber vs.
 Collector, L-7100, April 28, 1956.). Besides, Section 29 is not too
plain and simple to understand. Since the question involved in
this case is of first impression in this jurisdiction, under the
circumstances, the 50% surcharge imposed in the deficiency
assessment should be deleted. 7
The Commissioner of Internal Revenue, not satisfied with the respondent CTA's
ruling, elevated the matter to us, by the present petition, raising the main issue as
to:
WHETHER OR NOT PRIVATE RESPONDENT IS LIABLE FOR THE 50% FRAUD
PENALTY? 8
On the other hand, Javier candidly stated in his Memorandum, 9 that he "did not
appeal the decision which held him liable for the basic deficiency income tax
(excluding the 50% surcharge for fraud)." However, he submitted in the
same memorandum "that the issue may be raised in the case not for the purpose
of correcting or setting aside the decision which held him liable for deficiency
income tax, but only to show that there is no basis for the imposition of the
surcharge." This subsequent disavowal therefore renders moot and academic the
posturings articulated in as Comment 10 on the non-taxability of the amount he
erroneously received and the bulk of which he had already disbursed. In any event,
an appeal at that time (of the filing of the Comments) would have been already too
late to be seasonable. The petitioner, through the office of the Solicitor General,
stresses that:
xxx xxx xxx
The record however is not ambivalent, as the record clearly
shows that private respondent is self-convinced, and so acted,
that he is the beneficial owner, and of which reason is liable to
tax. Put another way, the studied insinuation that private
respondent may not be the beneficial owner of the money or
income flowing to him as enhanced by the studied claim that
the amount is "subject of litigation" is belied by the record and
clearly exposed as a fraudulent ploy, as witness what transpired
upon receipt of the amount.
Here, it will be noted that the excess in the amount erroneously
remitted by MELLON BANK for the amount of private
respondent's wife was $999,000.00 after opening a dollar
account with Prudential Bank in the amount of $999,993.70,
private respondent and his wife, with haste and dispatch,
within a span of eleven (11) electric days, specifically from June
3 to June 14, 1977, effected a total massive withdrawal from
the said dollar account in the sum of $975,000.00 or
P7,020,000.00. . . . 11
In reply, the private respondent argues:
xxx xxx xxx
The petitioner contends that the private respondent committed
fraud by not declaring the "mistaken remittance" in his income
tax return and by merely making a footnote thereon which
read: "Taxpayer was the recipient of some money from abroad
which he presumed to be a gift but turned out to be an error
and is now subject of litigation." It is respectfully submitted that
the said return was not fraudulent. The footnote was practically
an invitation to the petitioner to make an investigation, and to
make the proper assessment.
The rule in fraud cases is that the proof "must be clear and
convincing" (Griffiths v. Comm., 50 F [2d] 782), that is, it must
be stronger than the "mere preponderance of evidence" which
would be sufficient to sustain a judgment on the issue of
correctness of the deficiency itself apart from the fraud
penalty. (Frank A. Neddas, 40 BTA 672). The following
circumstances attendant to the case at bar show that in filing
the questioned return, the private respondent was guided, not
by that "willful and deliberate intent to prevent the
Government from making a proper assessment" which
constitute fraud, but by an honest doubt as to whether or not
the "mistaken remittance" was subject to tax.
First, this Honorable Court will take judicial notice of the fact
that so-called "million dollar case" was given very, very wide
publicity by media; and only one who is not in his right mind
would have entertained the idea that the BIR would not make
an assessment if the amount in question was indeed subject to
the income tax.
 Second, as the respondent Court ruled, "the question involved
in this case is of first impression in this jurisdiction" (See p. 15 of
Annex "A" of the Petition). Even in the United States, the
authorities are not unanimous in holding that similar receipts
are subject to the income tax. It should be noted that the
decision in the Rutkin case is a five-to-four decision; and in the
very case before this Honorable Court, one out of three Judges
of the respondent Court was of the opinion that the amount in
question is not taxable. Thus, even without the footnote, the
failure to declare the "mistaken remittance" is not fraudulent.
Third, when the private respondent filed his income tax return
on March 15, 1978 he was being sued by the Mellon Bank for
the return of the money, and was being prosecuted by the
Government for estafa committed allegedly by his failure to
return the money and by converting it to his personal benefit.
The basic tax amounted to P4,899,377.00 (See p. 6 of the
Petition) and could not have been paid without using part of
the mistaken remittance. Thus, it was not unreasonable for the
private respondent to simply state in his income tax return that
the amount received was still under litigation. If he had paid the
tax, would that not constitute estafa for using the funds for his
own personal benefit? and would the Government refund it to
him if the courts ordered him to refund the money to the
Mellon Bank? 12
xxx xxx xxx
Under the then Section 72 of the Tax Code (now Section 248 of the 1988 National
Internal Revenue Code), a taxpayer who files a false return is liable to pay the fraud
penalty of 50% of the tax due from him or of the deficiency tax in case payment has
been made on the basis of the return filed before the discovery of the falsity or
fraud.
We are persuaded considerably by the private respondent's contention that there
is no fraud in the filing of the return and agree fully with the Court of Tax Appeals'
interpretation of Javier's notation on his income tax return filed on March 15, 1978
thus: "Taxpayer was the recipient of some money from abroad which he presumed
to be a gift but turned out to be an error and is now subject of litigation that it was
an "error or mistake of fact or law" not constituting fraud, that such notation was
practically an invitation for investigation and that Javier had literally "laid his cards
on the table." 13
In Aznar v. Court of Tax Appeals, 14 fraud in relation to the filing of income tax
return was discussed in this manner:
. . . The fraud contemplated by law is actual and not
constructive. It must be intentional fraud, consisting of
deception willfully and deliberately done or resorted to in order
to induce another to give up some legal right. Negligence,
whether slight or gross, is not equivalent to the fraud with
intent to evade the tax contemplated by law. It must amount to
intentional wrong-doing with the sole object of avoiding the
tax. It necessarily follows that a mere mistake cannot be
considered as fraudulent intent, and if both petitioner and
respondent Commissioner of Internal Revenue committed
mistakes in making entries in the returns and in the
assessment, respectively, under the inventory method of
determining tax liability, it would be unfair to treat the mistakes
of the petitioner as tainted with fraud and those of the
respondent as made in good faith.
Fraud is never imputed and the courts never sustain findings of fraud upon
circumstances which, at most, create only suspicion and the mere understatement
of a tax is not itself proof of fraud for the purpose of tax evasion. 15
A "fraudulent return" is always an attempt to evade a tax, but a
merely "false return" may not be, Rick v. U.S., App. D.C., 161 F.
2d 897, 898. 16
In the case at bar, there was no actual and intentional fraud through willful and
deliberate misleading of the government agency concerned, the Bureau of Internal
Revenue, headed by the herein petitioner. The government was not induced to
give up some legal right and place itself at a disadvantage so as to prevent its lawful
agents from proper assessment of tax liabilities because Javier did not conceal
anything. Error or mistake of law is not fraud. The petitioner's zealousness to
collect taxes from the unearned windfall to Javier is highly commendable.
Unfortunately, the imposition of the fraud penalty in this case is not justified by the
extant facts. Javier may be guilty of swindling charges, perhaps even for greed by
spending most of the money he received, but the records lack a clear showing of
fraud committed because he did not conceal the fact that he had received an
amount of money although it was a "subject of litigation." As ruled by respondent On petition for rehearing of Commissioner v. Smith, 324 U. S. 177.
Court of Tax Appeals, the 50% surcharge imposed as fraud penalty by the petitioner
against the private respondent in the deficiency assessment should be deleted. MR. CHIEF JUSTICE STONE delivered the opinion of the Court.

WHEREFORE, the petition is DENIED and the decision appealed from the Court of Respondent, on motion for rehearing in this Court, for the first time contends that,
Tax Appeals is AFFIRMED. No costs. if he is taxable at all after the receipt of the option in 1934, he is taxable as of the
date in March, 1938, when he exercised his option, and not when he received the
SO ORDERED. stock in later years. The only later year in question is 1939, in which he received a
substantial part of the stock. Before the delivery in 1939 and after the exercise of
Economic Benefit Test the option in 1938, there was a substantial increase in the value of the stock. He
argues that the tax should be measured by the value of the stock in 1938 less
Any economic benefit to the employee that increases his net worth,
whatever may have been the mode by which it is effected, is taxable. Thus, in stock Page 324 U. S. 696
options, the difference between the fair market value of the shares at the time the
option is exercised and the option price constitutes additional compensation the option price. Cf. Palmer v. Commissioner, 302 U. S. 63, 302 U. S. 73.
income to the employee at the time of exercise
It is true that respondent gave notice of his exercise of the option and paid the
option price in 1938. But, at that time, Western, under its contract with Hawley,
had a right to receive but a part of the stock subject to respondent's option; its
right to the remainder was conditioned upon its making further payments of
Commissioner v. Smith
324 U.S. 695 (1945) Hawley's indebtedness. Respondent's option contemplated delivery to him of
Hawley's stock only if and when Western became entitled to receive the stock from
U.S. Supreme Court
Commissioner v. Smith, 324 U.S. 695 (1945) Hawley. In fact, deliveries of the stock were made to respondent upon each
occasion only a day or two after Western received it from Hawley.The Tax Court
Commissioner of Internal Revenue v. Smith
No. 371 found that respondent received compensation "when [he] exercised his option and
received the stock." We take it that the Tax Court regarded fulfillment of the
Decided April 9, 1945
conditions upon the right of Western to receive the stock, and therefore of the
324 U.S. 695
conditions upon the derivative right of respondent to receive it under his option, as
prerequisite to the effective exercise of the option, and that the taxable
compensation to petitioner intended to be secured by the option was in fact
ON PETITION FOR REHEARING received by respondent as and when the shares of stock were delivered to him,
since, prior to that time, there was no certainty that he would receive the stock.
Syllabus This conclusion of the Tax Court finds ample support in the record, and we concur
in it.We do not have before us a case where, by the exercise of an option in one
The conclusion of the Tax Court upon the facts of this case that the option to year, the taxpayer acquires an unconditional right to receive the stock in a later
purchase stock was effectively exercised and taxable compensation was received, year. We express no opinion upon the question whether, in such a case,
not when the optionee made his election and paid the option price, but when the compensation would be received and would be taxable in the earlier or the later
shares were delivered to him, is supported by the record. P. 324 U. S. 696. year.

Rehearing denied. The petition for rehearing is denied.

All events test;
For income or expense to accrue, this test requires:
1. The fixing of a right to income or liability to pay; and
2. The availability of the reasonable accurate determination of such income
or liability.
Republic of the Philippines
SUPREME COURT
Manila
THIRD DIVISION
G.R. No. 172231 February 12, 2007
COMMISSIONER OF INTERNAL REVENUE, Petitioner,
vs.
ISABELA CULTURAL CORPORATION, Respondent.
DECISION
YNARES-SANTIAGO, J.:
Petitioner Commissioner of Internal Revenue (CIR) assails the September 30, 2005
Decision1 of the Court of Appeals in CA-G.R. SP No. 78426 affirming the February
26, 2003 Decision2 of the Court of Tax Appeals (CTA) in CTA Case No. 5211, which
cancelled and set aside the Assessment Notices for deficiency income tax and
expanded withholding tax issued by the Bureau of Internal Revenue (BIR) against
respondent Isabela Cultural Corporation (ICC).
The facts show that on February 23, 1990, ICC, a domestic corporation, received
from the BIR Assessment Notice No. FAS-1-86-90-000680 for deficiency income tax
in the amount of P333,196.86, and Assessment Notice No. FAS-1-86-90-000681 for
deficiency expanded withholding tax in the amount of P4,897.79, inclusive of
surcharges and interest, both for the taxable year 1986.
The deficiency income tax of P333,196.86, arose from:
(1) The BIRs disallowance of ICCs claimed expense deductions for
professional and security services billed to and paid by ICC in 1986, to
wit:
(a) Expenses for the auditing services of SGV & Co.,3 for the
year ending December 31, 1985;4
(b) Expenses for the legal services [inclusive of retainer fees] of
the law firm Bengzon Zarraga Narciso Cudala Pecson Azcuna &
Bengson for the years 1984 and 1985.5
(c) Expense for security services of El Tigre Security &
Investigation Agency for the months of April and May 1986.6
(2) The alleged understatement of ICCs interest income on the three
promissory notes due from Realty Investment, Inc.
The deficiency expanded withholding tax of P4,897.79 (inclusive of interest and
surcharge) was allegedly due to the failure of ICC to withhold 1% expanded
withholding tax on its claimed P244,890.00 deduction for security services.7
On March 23, 1990, ICC sought a reconsideration of the subject assessments. On
February 9, 1995, however, it received a final notice before seizure demanding
payment of the amounts stated in the said notices. Hence, it brought the case to
the CTA which held that the petition is premature because the final notice of
assessment cannot be considered as a final decision appealable to the tax court.
This was reversed by the Court of Appeals holding that a demand letter of the BIR
reiterating the payment of deficiency tax, amounts to a final decision on the
protested assessment and may therefore be questioned before the CTA. This
conclusion was sustained by this Court on July 1, 2001, in G.R. No. 135210.8 The
case was thus remanded to the CTA for further proceedings.
On February 26, 2003, the CTA rendered a decision canceling and setting aside the
assessment notices issued against ICC. It held that the claimed deductions for
professional and security services were properly claimed by ICC in 1986 because it
was only in the said year when the bills demanding payment were sent to ICC.
Hence, even if some of these professional services were rendered to ICC in 1984 or
1985, it could not declare the same as deduction for the said years as the amount
thereof could not be determined at that time.
The CTA also held that ICC did not understate its interest income on the subject
promissory notes. It found that it was the BIR which made an overstatement of said
income when it compounded the interest income receivable by ICC from the
promissory notes of Realty Investment, Inc., despite the absence of a stipulation in
the contract providing for a compounded interest; nor of a circumstance, like delay
in payment or breach of contract, that would justify the application of
compounded interest.
Likewise, the CTA found that ICC in fact withheld 1% expanded withholding tax on
its claimed deduction for security services as shown by the various payment orders
and confirmation receipts it presented as evidence. The dispositive portion of the
CTAs Decision, reads:
WHEREFORE, in view of all the foregoing, Assessment Notice No. FAS-1-86-90-
000680 for deficiency income tax in the amount of P333,196.86, and Assessment
Notice No. FAS-1-86-90-000681 for deficiency expanded withholding tax in the
amount of P4,897.79, inclusive of surcharges and interest, both for the taxable year
1986, are hereby CANCELLED and SET ASIDE.
SO ORDERED.9
Petitioner filed a petition for review with the Court of Appeals, which affirmed the
CTA decision,10 holding that although the professional services (legal and auditing
services) were rendered to ICC in 1984 and 1985, the cost of the services was not
yet determinable at that time, hence, it could be considered as deductible
expenses only in 1986 when ICC received the billing statements for said services. It
further ruled that ICC did not understate its interest income from the promissory
notes of Realty Investment, Inc., and that ICC properly withheld and remitted taxes
on the payments for security services for the taxable year 1986.
Hence, petitioner, through the Office of the Solicitor General, filed the instant
petition contending that since ICC is using the accrual method of accounting, the
expenses for the professional services that accrued in 1984 and 1985, should have
been declared as deductions from income during the said years and the failure of
ICC to do so bars it from claiming said expenses as deduction for the taxable year
1986. As to the alleged deficiency interest income and failure to withhold
expanded withholding tax assessment, petitioner invoked the presumption that the
assessment notices issued by the BIR are valid.
The issue for resolution is whether the Court of Appeals correctly: (1) sustained the
deduction of the expenses for professional and security services from ICCs gross
income; and (2) held that ICC did not understate its interest income from the
promissory notes of Realty Investment, Inc; and that ICC withheld the required 1%
withholding tax from the deductions for security services.
The requisites for the deductibility of ordinary and necessary trade, business, or
professional expenses, like expenses paid for legal and auditing services, are: (a)
the expense must be ordinary and necessary; (b) it must have been paid or
incurred during the taxable year; (c) it must have been paid or incurred in carrying
on the trade or business of the taxpayer; and (d) it must be supported by receipts,
records or other pertinent papers.11
The requisite that it must have been paid or incurred during the taxable year is
further qualified by Section 45 of the National Internal Revenue Code (NIRC) which
states that: "[t]he deduction provided for in this Title shall be taken for the taxable
year in which paid or accrued or paid or incurred, dependent upon the method
of accounting upon the basis of which the net income is computed x x x".
Accounting methods for tax purposes comprise a set of rules for determining when
and how to report income and deductions.12 In the instant case, the accounting
method used by ICC is the accrual method.
Revenue Audit Memorandum Order No. 1-2000, provides that under the accrual
method of accounting, expenses not being claimed as deductions by a taxpayer in
the current year when they are incurred cannot be claimed as deduction from
income for the succeeding year. Thus, a taxpayer who is authorized to deduct
certain expenses and other allowable deductions for the current year but failed to
do so cannot deduct the same for the next year.13
The accrual method relies upon the taxpayers right to receive amounts or its
obligation to pay them, in opposition to actual receipt or payment, which
characterizes the cash method of accounting. Amounts of income accrue where the
right to receive them become fixed, where there is created an enforceable liability.
Similarly, liabilities are accrued when fixed and determinable in amount, without
regard to indeterminacy merely of time of payment.14
For a taxpayer using the accrual method, the determinative question is, when do
the facts present themselves in such a manner that the taxpayer must recognize
income or expense? The accrual of income and expense is permitted when the all-
events test has been met. This test requires: (1) fixing of a right to income or
liability to pay; and (2) the availability of the reasonable accurate determination of
such income or liability.
The all-events test requires the right to income or liability be fixed, and the amount
of such income or liability be determined with reasonable accuracy. However, the
test does not demand that the amount of income or liability be known absolutely,
only that a taxpayer has at his disposal the information necessary to compute the
amount with reasonable accuracy. The all-events test is satisfied where
computation remains uncertain, if its basis is unchangeable; the test is satisfied
where a computation may be unknown, but is not as much as unknowable, within
the taxable year. The amount of liability does not have to be determined exactly;
it must be determined with "reasonable accuracy." Accordingly, the term
"reasonable accuracy" implies something less than an exact or completely
accurate amount.[15]
The propriety of an accrual must be judged by the facts that a taxpayer knew, or
could reasonably be expected to have known, at the closing of its books for the
taxable year.[16] Accrual method of accounting presents largely a question of fact;
such that the taxpayer bears the burden of proof of establishing the accrual of an
item of income or deduction.17
Corollarily, it is a governing principle in taxation that tax exemptions must be
construed in strictissimi juris against the taxpayer and liberally in favor of the taxing
authority; and one who claims an exemption must be able to justify the same by
the clearest grant of organic or statute law. An exemption from the common
burden cannot be permitted to exist upon vague implications. And since a
deduction for income tax purposes partakes of the nature of a tax exemption, then
it must also be strictly construed.18
In the instant case, the expenses for professional fees consist of expenses for legal
and auditing services. The expenses for legal services pertain to the 1984 and 1985
legal and retainer fees of the law firm Bengzon Zarraga Narciso Cudala Pecson
Azcuna & Bengson, and for reimbursement of the expenses of said firm in
connection with ICCs tax problems for the year 1984. As testified by the Treasurer
of ICC, the firm has been its counsel since the 1960s.19 From the nature of the
claimed deductions and the span of time during which the firm was retained, ICC
can be expected to have reasonably known the retainer fees charged by the firm as
well as the compensation for its legal services. The failure to determine the exact
amount of the expense during the taxable year when they could have been claimed
as deductions cannot thus be attributed solely to the delayed billing of these
liabilities by the firm. For one, ICC, in the exercise of due diligence could have
inquired into the amount of their obligation to the firm, especially so that it is using
the accrual method of accounting. For another, it could have reasonably
determined the amount of legal and retainer fees owing to its familiarity with the
rates charged by their long time legal consultant.
As previously stated, the accrual method presents largely a question of fact and
that the taxpayer bears the burden of establishing the accrual of an expense or
income. However, ICC failed to discharge this burden. As to when the firms
performance of its services in connection with the 1984 tax problems were
completed, or whether ICC exercised reasonable diligence to inquire about the
amount of its liability, or whether it does or does not possess the information
necessary to compute the amount of said liability with reasonable accuracy, are
questions of fact which ICC never established. It simply relied on the defense of
delayed billing by the firm and the company, which under the circumstances, is not
sufficient to exempt it from being charged with knowledge of the reasonable
amount of the expenses for legal and auditing services.
In the same vein, the professional fees of SGV & Co. for auditing the financial
statements of ICC for the year 1985 cannot be validly claimed as expense
deductions in 1986. This is so because ICC failed to present evidence showing that
even with only "reasonable accuracy," as the standard to ascertain its liability to
SGV & Co. in the year 1985, it cannot determine the professional fees which said
company would charge for its services.
ICC thus failed to discharge the burden of proving that the claimed expense
deductions for the professional services were allowable deductions for the taxable
year 1986. Hence, per Revenue Audit Memorandum Order No. 1-2000, they cannot
be validly deducted from its gross income for the said year and were therefore
properly disallowed by the BIR.
As to the expenses for security services, the records show that these expenses
were incurred by ICC in 198620and could therefore be properly claimed as
deductions for the said year.
Anent the purported understatement of interest income from the promissory
notes of Realty Investment, Inc., we sustain the findings of the CTA and the Court
of Appeals that no such understatement exists and that only simple interest
computation and not a compounded one should have been applied by the BIR.
There is indeed no stipulation between the latter and ICC on the application of
compounded interest.21 Under Article 1959 of the Civil Code, unless there is a
stipulation to the contrary, interest due should not further earn interest.

Likewise, the findings of the CTA and the Court of Appeals that ICC truly withheld
the required withholding tax from its claimed deductions for security services and
remitted the same to the BIR is supported by payment order and confirmation
receipts.22 Hence, the Assessment Notice for deficiency expanded withholding tax
was properly cancelled and set aside.

In sum, Assessment Notice No. FAS-1-86-90-000680 in the amount of P333,196.86

for deficiency income tax should be cancelled and set aside but only insofar as the
claimed deductions of ICC for security services. Said Assessment is valid as to the
BIRs disallowance of ICCs expenses for professional services. The Court of Appeals
cancellation of Assessment Notice No. FAS-1-86-90-000681 in the amount of
P4,897.79 for deficiency expanded withholding tax, is sustained.

WHEREFORE, the petition is PARTIALLY GRANTED. The September 30, 2005

Decision of the Court of Appeals in CA-G.R. SP No. 78426, is AFFIRMED with the
MODIFICATION that Assessment Notice No. FAS-1-86-90-000680, which disallowed
the expense deduction of Isabela Cultural Corporation for professional and security
services, is declared valid only insofar as the expenses for the professional fees of
SGV & Co. and of the law firm, Bengzon Zarraga Narciso Cudala Pecson Azcuna &
Bengson, are concerned. The decision is affirmed in all other respects.

The case is remanded to the BIR for the computation of Isabela Cultural
Corporations liability under Assessment Notice No. FAS-1-86-90-000680.

SO ORDERED.