Presumptions in tax assessments

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.