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Presumptions in tax assessments

SUITS THE C-SUITE By Erickson Errol R. Sabile

Business World (05/25/2015 – p.S1/4)

In tax examinations, the Bureau of Internal Revenue (BIR) usually applies a set of standard procedures,
with two being the most common. First, it compares the purchases reported on the Summary List of Sales
(SLS) submitted by suppliers, on the one hand, with the purchases reported on the value-added tax (VAT)
returns/Summary List of Purchases (SLP) by the taxpayer, also known as the Reconciliation Listing for
Enforcement System (RELIEF) audit.

Second, it compares the expense items reported in the Financial Statements (FS)/Income Tax Return (ITR)
with the items reported on the Alphabetical List of Payees From Whom Taxes Were Withheld (Alphalist).

Where the amounts per SLS submitted by suppliers are higher than the amounts on the taxpayer’s VAT
returns/SLP, or where the expense amounts per taxpayer’s Alphalist are greater than those reflected in the
FS/ITR, the BIR examiners will assess deficiency income tax and VAT on the basis that the unreported
purchases and expenses result in undeclared income. This approach and conclusion traces its roots from
the “Net Worth Method” first used in 1956 in the case of Eugenio Perez vs. J. Antonio Araneta to prove
unreported income.

THE ‘NET WORTH METHOD’

In the Net Worth Method, there are five ways by which taxpayers may be assessed for deficiency income
tax:

· The taxpayer’s own books and records, if made available by lawful means. When truthful, the taxpayer’s
own books and records usually establish the nature and source of the unreported income; if false, these at
least afford a starting point from which income items may be verified from other sources.

· Books and records and corroborative statements of third persons who have dealt with the taxpayer, often
establishing payment of monies which would constitute taxable income to the taxpayer.

· Bank deposits and bank records.

· Increase in net worth; including investments, purchases of property and other business transactions by the
taxpayer.

· Analysis of expenditures, to show that expenditures were in excess of declared or available income or
expenditures for claimed items of deductions were fictitious or overstated.

The purpose of each of these is to establish taxable but unreported income and any combination of the
methods may be resorted to by the government to support its case.

More recently, however, the Court of Tax Appeals (CTA) has promulgated decisions which effectively
restrict an unfettered use of the Net Worth Method.

AMOUNTS PER SLS SUBMITTED BY SUPPLIERS HIGHER THAN THOSE IN VAT

RETURNS/SLP

Three elements are required for the imposition of income tax, namely: (a) there must be gain or profit, (b)
the gain or profit is realized or received, actually or constructively, and (c) it is not exempted by law or
treaty. Income tax is assessed on income received from any property, activity or service and it must be
clearly established that the taxpayer received such income.

In a January 2015 case, the CTA ruled that a finding of underdeclaration of purchases does not, by itself,
result in the imposition of income tax and VAT. The CTA ruled that deficiency income tax and VAT may
be assessed when there was an income realized by the taxpayer and such income was not reported. No
deficiency assessment can be made on account of undeclared purchases. The CTA said that a taxpayer is
free to deduct from its gross income a lesser amount, or not claim any deduction at all. What is prohibited
by the income tax law is to claim a deduction beyond the authorized amount, not an underdeclaration of
purchase or unaccounted expense.

The same is true for VAT, which is based either on the gross selling price or gross value in money of the
goods or properties sold, bartered or exchanged, or gross receipts derived from the sale or exchange of
services. Section 108 (A) of the Tax Code defines “gross receipts” as the total amount of money or its
equivalent representing the contract price, compensation, service fee, rental or royalty, including the
amount charged for materials supplied with the services and deposits and advance payments actually or
constructively received during the taxable period for the services performed or to be performed for
another person, excluding VAT.

In assessing VAT, it must be shown that the taxpayer received an amount of money or its equivalent from
its sale, barter or exchange of goods or properties, or from the sale or exchange of services performed.
VAT, like income tax, also cannot be assessed based on underdeclared purchases.
AMOUNTS PER TAXPAYER’S ALPHALIST GREATER THAN FS/ITR TOTAL

Similarly, in a January 2014 case, the CTA rejected the BIR’s allegation that the taxpayer had undeclared
income on the basis that there was an unaccounted source of cash and therefore undeclared income since
the income payments per Alphalist were greater than the expenses per FS/ITR. The CTA said that such
comparison failed to show that the income payments to the taxpayer’s payees per se could be equated to
taxable income. The purported unaccounted cash could well be presented in the balance sheet for
accounting purposes and not in the Income Statement; hence, it is not proper to form the conclusion that
the supposed unaccounted cash is part of the reportable income in the Income Statement.

Thus, even if the expenses per Alphalist were to be considered as income, the same shall be offset by
treating the equivalent payments as purchases for which input tax credits may be claimed. Thus, no
taxable income will result from the said transactions.

In these and other similar CTA decisions, the message is clear. While tax assessments are presumed to be
correct, the assessment itself should not be based on presumptions regardless of how logical the
presumption might be. The assessment must be based on actual facts in order to stand the test of judicial
scrutiny — a reiteration of a 2005 decision by the CTA that in a naked or a baseless assessment, the
determination of the tax due is without rational basis, and that the determination must rest on all the
evidence introduced and its ultimate determination must find support on credible evidence.

In a February 2015 decision, the CTA also ruled that while the BIR can resort to the Best Evidence
Obtainable Rule and estimate the tax liability of taxpayers who failed to submit their accounting records
lost due to calamities, the BIR is still, however, required to provide sufficient basis for its estimate.

Given the seriousness of a BIR tax assessment, it is important that taxpayers have a clear understanding of
the due process and other legal considerations involved in the tax assessment. They must be equipped with
the latest jurisprudence not only for better compliance but also to defend themselves against tax
assessments.

Erickson Errol R. Sabile is a Tax Senior Director of SGV & Co.

RELATED ARTICLES

“The proposed value simplified tax system” by Mary Ann C. Capuchino

(January 17, 2011)
Understanding VAT refunds By Cecille Santillan-Visto January 16,
2017
Getting money back via input VAT refund By Josenilo G. Mendoza July
7, 2014
Understanding VAT refunds By Cecille Santillan-Visto January 9, 2017
Claiming CWT credits By Cherry Liez O. Rafal-Roble April 25, 2016
“Sharing information for tax collection” by Fabian K. Delos Santos
(February 7, 2011)
VAT compliance By Edward M. Menor July 08, 2013
Brace yourselves for more VAT audits By Saha P. Adlawan-Bulagsak
November 2, 2016
BEPS Action Plan 8: Transfer pricing of intangibles By Reynante M.
Marcelo and Ronald Steven A. Arriesgado March 23, 2015
“Filing US income tax returns made more challenging (2nd of 2 parts)”
by Rogelanne E. Ofiaza-Villarubia (February 27, 2012)
“Looking into the lifestyles of the rich and famous” by Anthony A. Dy
 (April 5, 2010)
Claiming accrued bonuses as deductions By Joanne Marie D. Macainag-
Cobacha September 28, 2015

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