Are you worth it?

AL CAPONE... Renato Corona... Mikey Arroyo... Janet Lim Napoles... What do they have in common? Among others, they all (or in the case of Napoles, soon to) have a first-hand experience with the Net Worth Method (NWM) of tax investigation/audit.

The NWM is one of the indirect tax audit methods utilized by tax authorities, the Bureau of Internal Revenue (BIR) included, which is generally used when a strong suspicion exists that the taxpayer “received income from undisclosed sources.” It is often employed either in: (i) the absence/unavailability/inadequacy of taxpayer’s books and records; or (ii) the refusal by the taxpayer to provide its books and records for tax audit/investigation (Revenue Memorandum Order No. 01-00, 17 March 2000). The use of the NWM is sanctioned by Section 43, and (possibly) the broad investigatory power of the Commissioner under Section 6, of the National Internal Revenue Code.

The NWM could trace its roots to the basic accounting equation, “Assets = Liabilities + Capital.” Simply put, this tells us that the assets of an entity are sourced from debt and/or contributions/earnings. Thus, if the source of the asset is not through debts and/or contributed by the businessman, then the asset must have been through the income earned by the entity. Interestingly, re-arranging the equation to “Assets -- Liabilities = Capital” reveals the “net worth” of the entity, i.e., its actual worth after all debts are paid, as of a certain date. (Myer, Understanding Financial Statements, 1964 Ed.)

As applied in taxation law, the NWM first saw the light of day in the case of Capone v. United States (51 F. 2d 609), when the US Internal Revenue Service used it to support direct proof of unreported income (Mertens Law of Federal Income Taxation, §55B.02). However, in Holland v. United States (348 US 121), the US Supreme Court cautioned that notwithstanding the usefulness of the NWM, courts “must closely scrutinize its use” as “it is so fraught with danger for the innocent.”

In the Philippines, the Tax Court in Perez v. Araneta (BTA Case No. 189, Feb. 13, 1956), and subsequently the Supreme Court in Perez v. Court of Tax Appeals (G.R. No. L-10507, May 30, 1958) had the opportunity to discuss the NWM when a deficiency income tax assessment was issued against the taxpayer. The tax court held as valid the use of NWM as sanctioned by Section 38 of the Tax Code (now Section 43) and provided the formula in determining the unreported taxable income of the taxpayer, i.e., increase in net worth (computed by subtracting the net worth at the beginning from its net worth at the end of the year) + non-deductible disbursements -- non-taxable income. On appeal, the Supreme Court upheld the decision of the tax court and laid down the requisites to properly use the NWM, which are: (i) the net worth at the beginning of the year must be established with reasonable certainty; and (ii) the increase in net worth must be attributed to a taxable income. It even went on to say that the government in tax assessment cases need not prove the specific source of income, as it is assumed that “assets are derived from a taxable source and that when this is not true the taxpayer is in a position to explain the discrepancy.”

So does this mean that when a lady acquires a Hermès Berkin, a Louis Vuitton Tribute Patchwork Bag, or a Chanel “Diamond Forever” Classic Bag, she is also shopping for herself a deficiency tax assessment? How about when a gentlemen drives a Porsche, an Audi, or a Mercedes, did he just glare his lights to the BIR for a deficiency tax assessment?

Not necessarily. Note that the NWM is employed only if the records and books of the taxpayers are inadequate to determine its correct taxable income, or that the income declared in the tax returns are doubtful and do not support the current worth (or lifestyle) of the taxpayer. Of course, it would be obvious that the BIR will resort to NWM if it can be shown that the taxpayer owns such items but the income declared, and consequently the taxes paid, in its tax returns does not justify its ownership or at least the taxpayer cannot explain its source. Absent these circumstances, NWM should not be employed.

All told, the BIR’s use of the NWM in tax audits may be justified if it can be shown that the records and books of the taxpayers are inadequate in determining its correct taxable income. If the taxpayer’s books and records clearly reflect its taxable income, and the taxpayer can explain the findings resulting from the tax audit, then resort to NWM is unwarranted. The BIR examiners should not be allowed to apply the NWM indiscriminately to protect the taxpayers that are faithful, or at least assumed, in paying the taxes due to the government.

(The author is an associate of the Angara Abello Concepcion Regala& Cruz Law Offices. She can be contacted at (632) 830.000 and <kfmatibag@accralaw.com>. The views and opinions expressed in this article are those of the author. This article is for general informational and educational purposes only and not offered as and does not constitute legal advice or legal opinion).

source:  Businessworld