(with Resolution of June 11, 1965)

Gutierrez versus Commissioner of Internal Revenue

The Case

This is the case of Gutierrez versus Commissioner of Internal Revenue, a tax case in which a taxpayer engaged in the business of leasing real property contested deficiency income tax assessments for the years 1951 to 1954. The Commissioner of Internal Revenue disallowed certain deductions for personal and capital expenditures, added unreported receipts to gross income, and applied the Ballantyne Scale of Values to convert a 1943 purchase price paid in Japanese military notes into Philippine currency. The case matters because it gathers in one decision the working rules on what makes a business expense deductible, on the treatment of real property used in business as an ordinary rather than a capital asset, and on when the Commissioner's right to assess and to collect a tax prescribes.

Procedural History

After the Commissioner assessed deficiency income tax against Lino Gutierrez, the taxpayer questioned the legality and correctness of the assessment. Failing there, he appealed to the Court of Tax Appeals. The Court of Tax Appeals, in a decision dated January 28, 1962, upheld in full the assessment of the Commissioner. Gutierrez then elevated the matter to the Supreme Court. During the pendency of the appeal, on October 18, 1962, Lino Gutierrez died, and he was substituted by his heirs, Andrea C. Vda. de Gutierrez, Antonio D. Gutierrez, Santiago D. Gutierrez, Guillermo D. Gutierrez and Thomas D. Gutierrez, as party petitioners.

Facts

Lino Gutierrez was primarily engaged in the business of leasing real property, for which he paid the real estate broker's privilege tax. He filed his income tax returns for the years 1951, 1952, 1953 and 1954 and paid the tax declared therein. On July 10, 1956, the Commissioner of Internal Revenue assessed against him deficiency income tax totaling 11,841 pesos. The deficiency arose from the disallowance of deductions for depreciation and for expenses allegedly incurred in business, and from the addition to gross income of receipts he had not reported.

The disallowed items were classified by the Commissioner as either personal or capital expenditures. Among those treated as personal were transportation to attend funerals, car expenses and driver's salary, opera tickets, alms to an indigent family, and the cost of an iron door for his residence. Among those treated as capital were electrical fixtures, expenses in watching over laborers in construction, real estate tax unpaid by a former owner, litigation expenses to collect rentals and eject a lessee, and repairs and improvements to rental apartments. He also claimed depreciation on his residence. The unreported income included his wife's income, an overstatement of the purchase price of real estate, and understatements of profit from sales of real estate.

Two transactions explain the overstatement and understatement. In 1943 Gutierrez bought a parcel of land in Manila for 35,000 pesos and sold it in 1953 for 30,400 pesos, claiming a loss. The Commissioner, concluding that the price had been paid in Japanese military notes, converted the acquisition cost using the Ballantyne Scale of Values and instead determined a profit. In another sale, Gutierrez reported no profit, but the deed of acquisition showed a lower purchase price than he claimed. On four other properties sold in 1953 and 1954, he declared only fifty percent of the profits, treating them as capital assets, while the Commissioner taxed the entire profit as ordinary gain. A warrant of distraint and levy was later issued but not enforced when Gutierrez filed a bond.

Issues

• Whether or not the taxpayer's claims for deduction are proper and allowable.
• Whether or not the Ballantyne Scale of Values may be applied in determining the acquisition cost in 1943 of real property sold in 1953 for income tax purposes.
• Whether or not real properties used in the trade or business of the taxpayer are capital or ordinary assets.
• Whether or not the right of the Commissioner of Internal Revenue to collect the deficiency income tax for the years 1951 and 1952 has prescribed.
• Whether or not the right of the Commissioner of Internal Revenue to collect by distraint and levy the deficiency income tax for 1954 has prescribed, and if not, whether the taxpayer's real property may be distrained and levied upon without first exhausting his personal property.

Applicable Provisions

Section 30 of the Tax Code, on deductions from gross income, provides:

Sec. 30. Deductions from gross income.—In computing net income there shall be allowed as deductions— "(a) Expenses: "(1) In general.—All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; traveling expenses while away from home in the pursuit of a trade or business; and rentals or other payments required to be made as a condition to the continued use or possession, for the purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity."

This provision supplies the threefold test for deductibility that the Court applies to every disputed expense.

Section 34 of the Tax Code, on capital gains and losses, provides:

Sec. 34. Capital gains and losses.—(a) Definitions.—As used in this title— "(1) Capital assets.—The term 'capital assets' means property held by the taxpayer (whether or not connected with his trade or business), but does not include stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, or property used in the trade or business, of a character which is subject to the allowance for depreciation provided in subsection (f) of section thirty; or real property used in the trade or business of the taxpayer.

This definition excludes real property used in the taxpayer's business from the category of capital assets, which is the pivot of the third issue.

Section 332 of the Tax Code, on the period for collection, provides:

Sec. 332(c) Where the assessment of any internal-revenue tax has been made within the period of limitation above prescribed such tax may be collected by distraint or levy or by a proceeding in court, but only if begun (1) within five years after the assessment of the tax, or (2) prior to the expiration of any period for collection agreed upon in writing by the Collector of Internal Revenue and the taxpayer before the expiration of such five-year period. The period so agreed upon may be extended by subsequent agreements in writing made before the expiration of the period previously agreed upon.

This fixes the reckoning point for the five-year period of collection, which the Court counts from the assessment.

Section 51 of the Tax Code, on refusal or neglect to make returns and on erroneous, false or fraudulent returns, provides:

Sec. 51(c) Refusal or neglect to make returns; fraudulent returns, etc.—In cases of refusal or neglect to make a return and in cases of erroneous, false, or fraudulent returns, the Collector of Internal Revenue shall, upon the discovery thereof at any time within three years after said return is due, or has been made, make a return upon information obtained as provided for in this code or by existing law, or require the necessary corrections to be made, and the assessment made by the Collector of Internal Revenue thereon shall be paid by such person or corporation immediately upon notification of the amount of such assessment.

This governs the three-year period within which the Commissioner may act on an erroneous or false return.

Ruling

On the first issue, the Court held that to be deductible an expense must be ordinary and necessary, paid or incurred within the taxable year, and paid or incurred in carrying on a trade or business. Personal, living or family expenses are not deductible, so funeral transportation, opera tickets, the iron door of the residence, and the depreciation of the residence were disallowed. Expenses shown to have been made in pursuit of business, such as commissions, the businessmen's convention, the luncheon and the cruise of the Homeowners' Association, were allowed. Because the car was used for both personal and business needs, the Court allowed one-half of the driver's salary, car expenses and depreciation. Repairs that merely kept the apartments in ordinary operating condition, and litigation expenses to collect rentals and eject tenants, were allowed. Items that added to the value of the property or its cost, such as iron bars, Venetian blinds, water pumps, unpaid real estate tax of the former owner, and relocation and registration expenses, were treated as capital expenditures. Fines and penalties for late payment of taxes were disallowed, because deductions are matters of legislative grace and what is not expressly granted by Congress is withheld. Contributions were disallowed because the recipients were not shown to be among those specified by law.

On the second issue, the Court held that the Ballantyne Scale of Values may be used. In determining gain or loss, the purchase price and the selling price ought to be in the same currency, so the Japanese military notes had to be converted to present currency. The Court stressed that the scale is not used as the authority to impose the tax, but only as a medium of computing the tax base.

On the third issue, the Court held that real property used in the trade or business of the taxpayer is an ordinary asset. Before its amendment by Republic Act 82 in 1947, Section 34 treated such property as capital; with the amendment, Congress withdrew it from the capital gains provisions. The gain from its sale is therefore ordinary gain, fully taxable.

On the fourth issue, the Court held that the period to collect is counted from the assessment, not from the filing of the return. Since the assessment was made on July 10, 1956, and the action for collection followed well within five years, the right had not prescribed.

On the fifth issue, the Court held that the three-year period runs from the last day prescribed by law for filing the return, not from the actual filing, so the Commissioner's right to issue the warrant of distraint and levy had not lapsed.

Doctrine

First, a business expense is deductible only if it is ordinary and necessary, paid or incurred within the taxable year, and paid or incurred in carrying on a trade or business; personal, living and family expenses are never deductible, and deductions are matters of legislative grace, so what is not expressly granted by Congress is withheld.

Second, expenditures that add to the value of property or to its cost are capital expenditures, to be integrated into the cost of the asset and depreciated yearly, not deducted in full in one year.

Third, under Section 34 of the Tax Code as amended by Republic Act 82, real property used in the trade or business of the taxpayer is an ordinary asset, and the gain from its sale is ordinary gain, fully taxable.

Fourth, the five-year period to collect a tax by distraint, levy or judicial proceeding under Section 332 is counted from the assessment of the tax, while the three-year period under Section 51 runs from the last day prescribed by law for filing the return.

Disposition

The Supreme Court upheld the assessment of the Commissioner of Internal Revenue, with the modifications on the allowed deductions, and denied the appeal of Gutierrez and his heirs.

Remember This

The one line to memorize is that real property used in the taxpayer's trade or business is an ordinary asset, so its gain is fully taxable, and that the period to collect a tax is counted from the assessment. Examiners like to use this case on the deductibility of business expenses, on the capital versus ordinary asset distinction, and on the prescription of the Commissioner's right to assess and to collect.