FERNANDEZ HERMANOS, INC vs CIR and CTA Facts: The taxpayer, Fernandez Hermanos, Inc.

, is a domestic corporation organized for the principal purpose of engaging in business as an "investment company". Upon verification of the taxpayer's income tax returns, the assessments of CIR resulted to alleged deficiency income taxes against the taxpayer from 1950-1954. Said assessments were the result of alleged discrepancies found upon the examination and verification of the taxpayer's income tax returns for the said years wherein Hermanos declared some items as deductibles and which were disallowed by CIR. CIRs deficiency assessments were modified by the CTA. Hence, this appeal. Issue: WON CTA was correct in modifying CIRs deficiency assessment Held: 1. Re allowances/disallowances of losses. (a) Allowance of losses in Mati Lumber Co. (1950) Discussion: the taxpayer had shares of stocks in the Mati Lumber which were declared as worthless securities when Mati Lumber ceased to operate. When the company eased to operate, it had no assets, in other words, completely insolvent. This information as to the insolvency of the Company reached (the taxpayer) in 1950, when it properly claimed the loss as a deduction in its 1950 tax return, pursuant to Section 30(d) (4) (b) or Section 30 (e) (3) of the National Internal Revenue Code. Thus, there was adequate basis for the writing off of the stock as worthless securities. (b) Disallowance of losses in or bad debts of Palawan Manganese Mines, Inc. (1951). Discussion: Sometime in 1945, Palawan Manganese Mines, Inc., a subsidiary of the petitioner corporation, requested financial help from petitioner to enable it to resume it mining operations. But despite these advances and the resumption of operations by Palawan Manganese Mines, Inc., it continued to suffer losses. By 1951, petitioner became convinced that those advances could no longer be recovered and were declared as losses or bad debts. But still it continued to give advances until 1952. The advances made by the taxpayer to Palawan were investments. The memorandum agreement signed by the parties appears to be very clear that the consideration for the advances made by petitioner was 15% of the net profits of Palawan Manganese Mines, Inc. In other words, if there were no earnings or profits, there was no obligation to repay those advances. It has been held that the voluntary advances made without expectation of repayment do not result in deductible losses. The said amount deductible as a bad debt? Petitioner could not sue for recovery under the memorandum agreement because the obligation of Palawan Manganese Mines, Inc. was to pay petitioner 15% of its net profits, not the advances. No bad debt could arise where there is no valid and subsisting debt. (c) Disallowance of losses in Balamban Coal Mines (1950 and 1951). The Court sustains the Tax Court's disallowance of the sums of P8,989.76 and P27,732.66 spent by the taxpayer for the operation of its Balamban coal mines in Cebu in 1950 and 1951, respectively, and claimed as losses in the taxpayer's returns for said years. The Tax Court correctly held that the losses "are deductible in 1952, when the mines were abandoned, and not in 1950 and 1951, when they were still in operation." (d) and (e) Allowance of losses in Hacienda Dalupiri (1950 to 1954) and Hacienda Samal (1951-1952). Discussion: In both Haciendas, CIR disallowed the declaration of losses because it claimed that the farms were operated solely for pleasure or as a hobby and not for profit. The Court is convinced that the Hacienda Dalupiri (and Samal) was operated by petitioner for business and not pleasure. It was mainly a cattle farm, although a few race

horses were also raised. It does not appear that the farm was used by petitioner for entertainment, social activities, or other non-business purposes. Therefore, it is entitled to deduct expenses and losses in connection with the operation of said farm. Under Section 100 of Revenue Regulations No. 2, losses are to be determined by means of inventories. Thus, CIR erred in disallowing the deduction of said losses. 2. Disallowance of excessive depreciation of buildings (1950-1954). Discussion: Taxpayer claimed a depreciation allowance for its buildings at the annual rate of 10%. The Commissioner claimed that the reasonable depreciation rate is only 3% per annum, and, hence, disallowed as excessive the amount claimed as depreciation allowance in excess of 3% annually. We sustain the Tax Court's finding that the taxpayer did not submit adequate proof of the correctness of the taxpayer's claim that the depreciable assets or buildings in question had a useful life only of 10 years so as to justify its 10% depreciation per annum claim. 3. Taxable increase in net worth (1950-1951). Discussion: Respondent contends that the reduction of petitioner's liability to Manila Insurance Company resulted in the increase of petitioner's net worth to the extent of P30,050.00 which is taxable. This is erroneous. The principle underlying the taxability of an increase in the net worth of a taxpayer rests on the theory that such an increase in net worth, if unreported and not explained by the taxpayer, comes from income derived from a taxable source. In this case, the increase in the net worth of petitioner for 1950 to the extent of P30,050.00 was not the result of the receipt by it of taxable income. It was merely the outcome of the correction of an error in the entry in its books relating to its indebtedness to the Manila Insurance Company. The Income Tax Law imposes a tax on income; it does not tax any or every increase in net worth whether or not derived from income. Surely, the said sum of P30,050.00 was not income to petitioner, and it was error for respondent to assess a deficiency income tax on said amount. The same is true for the increase in taxpayers net worth as a result of the correction of errors in its entries in its books relating to its indebtednesses to certain creditors, which had been erroneously overstated or listed as outstanding when they had in fact been duly paid. 4. Gain realized from sale of real property (1950). The evidence shows that this property was acquired in 1926 for P11,852.74, and was sold in 1950 for P60,000.00, apparently, resulting in a gain of P48,147.26. The taxpayer reported in its return a gain of P37,000.00, or a discrepancy of P11,147.26. It was sufficiently proved from the taxpayer's books that after acquiring the property, the taxpayer had made improvements totalling P11,147.26, accounting for the apparent discrepancy in the reported gain. In other words, this figure added to the original acquisition cost of P11,852.74 results in a total cost of P23,000.00, and the gain derived from the sale of the property for P60,000.00 was correctly reported by the taxpayer at P37,000.00.