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II. MEANING OF INCOME AND REALIZATION PRINCIPLE Sec. 32 (A), NIRC General Definition. - Except when otherwise provided in this Title, gross income means all income derived from whatever source, including (but not limited to) the following items: (1) Compensation for services in whatever form paid, including, but not limited to fees, salaries, wages, commissions, and similar items; (2) Gross income derived from the conduct of trade or business or the exercise of a profession; (3) Gains derived from dealings in property; (4) Interests; (5) Rents; (6) Royalties; (7) Dividends; (8) Annuities; (9) Prizes and winnings; (10) Pensions; and (11) Partner's distributive share from the net income of the general professional partnership. CBP-IRR-DAPPP Sec. 36, Rev. Regs. No. 2 Meaning of net income. The tax imposed by law is upon income. In the computation of the tax, various classes of income must be considered: Income, in the broad sense, meaning all wealth which flows into the tax-payer other than as a mere return of capital. It includes the forms of income specifically described as gains and profits, including gains derived from the sale or other disposition of capital assets. Income cannot be determined merely by reckoning cash receipts, for the statute recognizes as income determining factor other items, among which are inventories, accounts receivable, property exhaustion, and accounts payable for expenses incurred. Gross income, meaning income (in the broad sense) less income which is by statutory provision or otherwise exempt from the tax imposed by law. Net income, meaning gross income less statutory deductions. The statutory deductions are, in general, though not exclusively, expenditures other than capital expenditures, connected with production of income. In the case of a taxpayer other than a corporation as defined in Section 84 (b) of the Code, net income means gross income less exemptions. Ordinarily the net income is to be computed in accordance with the method of accounting regularly employed in keeping the books of the taxpayer. A. WHAT IS INCOME? (See Sec. 36, Rev. Regs. No. 2) FISHER V. TRINIDAD (OCT. 30, 1922) Fisher won! ["Stock dividends" are not "income," the same cannot be taxes under that provision of Act No. 2833 which provides for a tax upon income.] EMERGENCY RECIT: (from the internet) (Definition of Income Tax, Realization Test of Determining Income) Fisher was a stockholder in Phil-Am Drug Company. The company declared a stock dividend with Fishers share of the dividend amounting to P24,800. Collector of Internal Revenue Trinidad demanded P889 income tax on said dividend, which Fisher protested against but voluntarily paid. ISSUE 1: WON stock dividends can be classified as income and taxable under Act No. 2833 providing for tax upon income? HELD 1: No, the receipt of stock dividends merely represents an increase in value of the assets of a corporation. The court defines stock dividends as increase in capital of corps, firms, partnerships, etc for a particular period. They represent the increase in the proportional share of each stockholder in the companys capital. It is not a distribution of the corps profits to the stockholder. It only increases the stockholders SOURCE of income (capital), but does not increase income itself. ISSUE 2: Definition of income tax HELD 2: Act No. 2833 taxed any distribution by a corporation out of its earnings or profits. From the various definitions of income tax cited, an income tax is a tax on the yearly profits arising from property, salary, private revenue, capital invested, and all other sources of income. What is taxed is the profit, not the source. ISSUE 3: When is income realized (Test of Realization) HELD 3: Stock dividend in this case is not taxable for income because the stockholder has received nothing out of the company's assets for his separate use and benefit. Instead, his original investment along with whatever gains which resulted from the use of his and other stockholders money remains property of the company. The fact that it is not yet his, means the capital is still subject to business risks that can wipe out his entire investment. All he has received is a stock certificate indicating the increase in his capital in the company. Thus we can say that income has been realized when there has been a separation of the interest of the stockholder from the general capital of the corporation. This separation of interest happens when the company declares a cash dividend on the shares of shareholders. COMPLETE DIGEST

FACTS: The Philippine American Drug Company was a corporation & Fisher was a stockholder in said corporation; Philippine American Drug Co. declared a "stock dividend"; that the proportionate share of said stock divided of Fisher was P24,800; that the stock dividend for that amount was issued to Fisher; March, 1920, Fisher, upon demand of Trinidad, paid under protest, and voluntarily, unto Trinidad the sum of P889.91 as income tax on said stock dividend. For the recovery of that sum (P889.91) the present action was instituted. The defendant demurred to the petition and the demurrer was sustained, thus the plaintiff appealed. Fisher cited cases and in each case it was held that "stock dividends" were capital and not an "income" and therefore not subject to the "income tax" law. Trinidad admits the doctrine established in the case of Eisner vs. Macomber (252 U.S., 189) that a "stock dividend" is not "income" but argues that said Act No. 2833, in imposing the tax on the stock dividend, does not violate the provisions of the Jones Law. Trinidad further argues that the statute of the United States providing for tax upon stock dividends is different from the statute of the Philippine Islands, and therefore the decision of the Supreme Court of the United States should not be followed in interpreting the statute in force here. ISSUES: Are the "stock dividends" in the present case "income" and taxable as such under the provisions of section 25 of Act No. 2833? HELD: "Stock dividends" are not "income," the same cannot be taxes under that provision of Act No. 2833 which provides for a tax upon income. RATIO: We believe that the Legislature, when it provided for an "income tax," intended to tax only the "income" of corporations, firms or individuals, as that term is generally used in its common acceptation; that is that the income means money received, coming to a person or corporation for services, interest, or profit from investments. We do not believe that the Legislature intended that a mere increase in the value of the capital or assets of a corporation, firm, or individual, should be taxed as "income." Such property can be reached under the ordinary from of taxation. FISHER ARGUMENTS Fisher argues that there is nothing in section 25 of Act No 2833 which contravenes the provisions of the Jones Law. He further argues that the Act of Congress (U.S. Revenue Act of 1918) expressly authorized the Philippine Legislatures to provide for an income tax. That fact may also be admitted. COURTs OPINION: While it permitted a tax upon income, the same provided that income shall include gains, profits, and income derived from salaries, wages, or compensation for personal services, as well as from interest, rent, dividends, securities, etc. Trinidad emphasizes the "income from dividends."

Of course, income received as dividends is taxable as an income but an income from "dividends" is a very different thing from receipt of a "stock dividend." One is an actual receipt of profits; the other is a receipt of a representation of the increased value of the assets of corporation. THUS "stock dividends" are not "income," the same cannot be taxed under that provision of Act No. 2833 which provides for a tax upon income. Under the guise of an income tax, property which is not an income cannot be taxed. When the assets of a corporation have increased so as to justify the issuance of a stock dividend, the increase of the assets should be taken account of the Government in the ordinary tax duplicates for the purposes of assessment and collection of an additional tax.

OTHER NOTES IN THE CASE: TWO STATUTES CITED: Chapter 463 of an Act of Congress of September 8, 1916, in its title 1 provides for the collection of an "income tax." Section 2 of said Act attempts to define what is an income. The definition follows: That the term "dividends" as used in this title shall be held to mean any distribution made or ordered to made by a corporation, . . . which stock dividend shall be considered income, to the amount of its cash value. Act No. 2833 of the Philippine Legislature is an Act establishing "an income tax." Section 25 of said Act attempts to define the application of the income tax. The definition follows: The term "dividends" as used in this Law shall be held to mean any distribution made or ordered to be made by a corporation, . . . out of its earnings or profits accrued since March first, nineteen hundred and thirteen, and payable to its shareholders, whether in cash or in stock of the corporation, . . . . Stock dividend shall be considered income, to the amount of the earnings or profits distributed. TAX ON INCOME there is no question that the Philippine Legislature may provide for the payment of an income tax, but it cannot, under the guise of an income tax, collect a tax on property which is not an "income." The Philippine Legislature can not impose a tax upon "property" under a law which provides for a tax upon "income" only. The Philippine Legislature has no power to provide a tax upon "automobiles" only, and under that law collect a tax upon a carreton or bull cart. A statute providing for an income tax cannot be construed to cover property which is not, in fact income. The Legislature cannot, by a statutory declaration, change the real nature of a tax which it imposes. STOCK DIVIDENDS AS INCOME It is true that the statute in question provides for an income tax and contains a further provision that "stock dividends" shall be considered income and are therefore subject to income tax provided for in said law. If "stock dividends" are not "income" then the law permits a tax upon something not within the purpose and intent of the law.

ISSUE: Whether "stock dividends" are "income" in the sense that the word is used in the statute? What are "stock dividends? STOCK DIVIDENDS DEFINED Stock dividends represent undistributed increase in the capital of corporations or firms, joint stock companies, etc., for a particular period. They are used to show the increased interest or proportional shares in the capital of each stockholder.

INCOME DEFINED Mr. Black, in his law dictionary, says "An income is the return in money from one's business, labor, or capital invested; gains, profit or private revenue.""An income tax is a tax on the yearly profits arising from property, professions, trades, and offices." The Supreme Court of the United States, in the case o Gray vs. Darlington (82 U.S., 653), said in speaking of income that mere advance in value in no sense constitutes the "income" specified in the revenue law as "income" of the owner for the year in which the sale of the property was made. Such advance constitutes and can be treated merely as an increase of capital. Mr. Justice Hughes, defined an "income" in an income tax law, unless it is otherwise specified, to mean cash or its equivalent. Mr. Justice Holmes, speaking for the court, said: "Notwithstanding the thoughtful discussion that the case received below, we cannot doubt that the dividend was capital as well for the purposes of the Income Tax Law. . . . 'A stock dividend really takes nothing from the property of the corporation, and adds nothing to the interests of the shareholders. Its property is not diminished and their interest are not increased. . . . The proportional interest of each shareholder remains the same. . . .' BOOKKEEPING PURPOSES STOCK DIVIDENDS For bookkeeping purposes, when stock dividends are declared, the corporation or company acknowledges a liability, in form, to the stockholders, equivalent to the aggregate par value of their stock, evidenced by a "capital stock account." If profits have been made by the corporation during a particular period and not divided, they create additional bookkeeping liabilities under the head of "profit and loss," "undivided profits," "surplus account," etc., or the like. None of these, however, gives to the stockholders as a body, much less to any one of them, either a claim against the going concern or corporation, for any particular sum of money, or a right to any particular portion of the asset, or any shares sells or until the directors conclude that dividends shall be made a part of the company's assets segregated from the common fund for that purpose. The dividend normally is payable in money and when so paid, only then does the stockholder realize a profit or gain, which becomes his separate property, and thus derive an income from the capital that he has invested. Until that is done the increased assets belong to the corporation and not to the individual stockholders. When a corporation or company issues "stock dividends" it shows that the company's accumulated profits have been capitalized, instead of distributed to the stockholders or retained as surplus available for distribution, in money or in kind, should opportunity offer.

Far from being a realization of profits of the stockholder, it tends rather to postpone said realization, in that the fund represented by the new stock has been transferred from surplus to assets, and no longer available for actual distribution. The essential and controlling fact is that the stockholder has received nothing out of the company's assets for his separate use and benefit; on the contrary, every dollar of his original investment, together with whatever accretions and accumulations resulting from employment of his money and that of the other stockholders in the business of the company, still remains the property of the company, and subject to business risks which may result in wiping out of the entire investment. Having regard to the very truth of the matter, to substance and not to form, the stockholder by virtue of the stock dividend has in fact received nothing that answers the definition of an "income." The stockholder who receives a stock dividend has received nothing but a representation of his increased interest in the capital of the corporation. There has been no separation or segregation of his interest. All the property or capital of the corporation still belongs to the corporation. There has been no separation of the interest of the stockholder from the general capital of the corporation. The stockholder, by virtue of the stock dividend, has no separate or individual control over the interest represented thereby, further than he had before the stock dividend was issued. He cannot use it for the reason that it is still the property of the corporation and not the property of the individual holder of stock dividend. A certificate of stock represented by the stock dividend is simply a statement of his proportional interest or participation in the capital of the corporation. For bookkeeping purposes, a corporation, by issuing stock dividend, acknowledges a liability in form to the stockholders, evidenced by a capital stock account. The receipt of a stock dividend in no way increases the money received of a stockholder nor his cash account at the close of the year. It simply shows that there has been an increase in the amount of the capital of the corporation during the particular period, which may be due to an increased business or to a natural increase of the value of the capital due to business, economic, or other reasons.

EXTRAORDINARY CASH DIVIDEND v. STOCK DIVIDENDS A. There is a clear distinction between an extraordinary cash dividend, no matter when earned, and stock dividends declared, as in the present case. The EXTRAORDINARY CASH DIVIDEND is a disbursement to the stockholder of accumulated earnings, and the corporation at once parts irrevocably with all interest thereon. The other involves no disbursement by the corporation. It parts with nothing to the stockholder. The STOCK DIVIDEND receives, not an actual dividend, but certificate of stock which simply evidences his interest in the entire capital, including such as by investment of accumulated profits has been added to the original capital. They are not income to him, but represent additions to the source of his income, namely, his invested capital.

Mr. Justice Wilkin said: "A dividend is defined as a corporate profit set aside, declared, and ordered by the directors to be paid to the stockholders on demand or at a fixed time. Until the dividend is declared, these corporate profits belong to the corporation, not to the stockholders, and are liable for corporate indebtedness. The extraordinary cash dividend is a disbursement to the stockholders of accumulated earning, and the corporation at once parts irrevocably with all interest thereon. The other involves no disbursement by the corporation. It parts with nothing to the stockholders. The Stock Dividends receives, not an actual dividend, but certificates of stock which evidence in a new proportion his interest in the entire capital. A stock dividend however, still being the property of the corporation and not the stockholder, it may be reached by an execution against the corporation, and sold as a part of the property of the corporation. Until the dividend is declared and paid, the corporate profits still belong to the corporation, not to the stockholders, and are liable for corporate indebtedness. If the ownership of the property represented by a stock dividend is still in the corporation and to in the holder of such stock, then it is difficult to understand how it can be regarded as income to the stockholder and not as a part of the capital or assets of the corporation.

B. -

new stock has been transferred from surplus to capital, and no longer is available for actual distribution. The essential and controlling fact is that the stockholder has received nothing out of the company's assets for his separate use and benefit; on the contrary, every dollar of his original investment, together with whatever accretions and accumulations have resulted from employment of his money and that of the other stockholders in the business of the company, still remains the property of the company, and subject to business risks which may result in wiping out the entire investment. Having regard to the very truth of the matter, to substance and not to form, he has received nothing that answers the definition of income within the meaning of the Sixteenth Amendment. We are clear that not only does a stock dividend really take nothing from the property of the corporation and add nothing to that of the shareholder, but that the antecedent accumulation of profits evidenced thereby, while indicating that the shareholder is the richer because of an increase of his capital, at the same time shows he has not realized or received any income in the transaction. The Court noted that in Towne v. Eisner, it had clearly stated that stock dividends were not income, as nothing of value was received by Towne - the company was not worth any less than it was when the dividend was declared, and the total value of Towne's stock had not changed. Although the Federal Government had the power to tax income under the Sixteenth Amendment, the Court essentially said this did not give Congress the power to tax as income anything other than income, i.e., that Congress did not have the power to redefine the term income as it appeared in the Constitution. The Court ordered that Macomber be refunded the tax she overpaid. Notes (from Wikipedia): o Economic substance of a stock dividend.The stock dividend in this case was the economic equivalent of a stock splita transaction in which the corporation multiplies the total number of shares outstanding, but gives the new shares to shareholders in proportion to the number they previously held. For example, if a corporation declares a "two for one" stock split (and distributes no money or other property to any stockholder), a stockholder who held 100 shares at $4 per share will now hold 200 shares with a value of $2 each, which is still $400 in value. o Stock dividends vs. cash dividends. A shareholder's assets do not grow after this sort of stock dividend. Metaphorically, the "pie" is still the same sizebut it has been sliced into more pieces, each piece being proportionately smaller. Of course, the same is true of a cash dividend: the shareholder gains cash, but the corporation represented by his shares has also lost cash, so that these shares implicitly decline in value by an equal amount. A shareholder also makes no "sale or other disposition" of stock after this sort of stock dividend. The taxpayer still owns the same proportionate percentage of the corporation he or she owned prior to the stock dividend. Again, this is also true of a cash dividend. However, several important factors distinguish a stock and cash dividend. "Overall, the aim of the tax law is to impose a tax on "dividends" when assets representing corporate earnings are transferred to the shareholders. Stock dividends, however, merely give the shareholders additional pieces of paper to represent the same equitable interest; they do not transfer assets or create new priorities among the security-holders. The total value of the common shares, though now spread out over a larger number of units, is left unchanged from its previous level. In effect, nothing of substance has occurred."

EISNER V. MACOMBER (252 US 189 [1920]) (Collector) Eisner won! [Stock dividends are not income tax/ surplus converted to stocks actually tends to postpone the realization of profits] FACTS: Mrs. Macomber owned 2,200 shares in Standard Oil Company of California, which declared a 50% stock dividend. She received 1,100 additional shares, 18% of which representing $19,877 surplus earnings accumulated by the company. Macomber was called upon to pay , and did pay under protest, income tax imposed on the surplus earnings. She brought an action to the Collector, Eisner, to recover the tax she paid. ISSUE:W/N stock dividend is an income subject to income tax HELD: NO, not subject to income tax! stock dividend really take nothing from the property of the corporation and add nothing to that of the shareholder. Congress did not have the power to re-define the term income as it appeared in the Constitution. RATIO:Majority ruled that this stock dividend was not a realization of income by the taxpayer-shareholder for purposes of the Sixteenth Amendment: A "stock dividend" shows that the company's accumulated profits have been capitalized, instead of distributed to the stockholders or retained as surplus available for distribution in money or in kind should opportunity offer. Far from being a realization of profits of the stockholder, it tends rather to postpone such realization, in that the fund represented by the

U.S. V. KIRBY LUMBER CO. 284 U.S. 1 (1931) U.S. won! [bought bonds below par value/gross income includes gains or profits and income derived from any source whatever] FACTS: The United States brings this action on writ of certiorari. In July 1923, Kirby Lumber Co.issued its bonds for 12,126,800 USD for which it received their par value. Later in the same year it purchased in the open market some of the same bonds at below than par value, with a difference of 137,521.30 USD. ISSUES: Is the difference (between the issuing price or face value and the purchased price) of 137,521.30 USD taxable income or gain for the Plaintiff (Kirby Lumber) for the year 1923? HELD: YES. Justice Holmes held that the difference should be considered as taxable gain or income. RATIO: The Revenue Act of 1921 (November 23), c.136, s 213(a), 42 Stat. 238, gross income includes gains or profits and income derived from any source whatever and by the Treasury Regulations authorized b s. 1303 that have been in force through repeated reenactments, If the corporation purchases and retires any of such bonds at a price less than the issue price or face value, the excess of the issuing price or face value over the purchase price is gain or income for the taxable year. There was no shrinkage of assets and Kirby Lumber Co. clearly made a gain. The taxpayer gains by offsetting the bonds. As a result, it was able to discharge (or cancel) 137,521.30 USD of indebtedness, and this is part of gross taxable income. * (Unlike in Bowers v Kerbaugh, here the transaction as a whole was a loss) NOTES: Bonds, in this sense, is a financial document. Kirby Lumber issued the bonds as a debt instrument (utang) which provides for set payments to a purchases on a set date. Simple example, Sean issued 10 bonds worth 10 pesos each and were all purchased. The 100 pesos paid to Sean is Seans debt to those who purchased the bonds. If later, the same month for example, Sean bought 5 of the bonds previously sold at 5 pesos only (below par value), the difference of 25 pesos [(10 pesos x 5 bonds) (5 pesos x 5 bonds)] is an income or gain for Sean. Because, instead of 50 pesos angutang (initial because of issue price) for the 5 bonds, 25 pesos nalangangutang (because it is below par value). The cancellation of the 25 pesos debt is considered taxable income. HELVERING V. BRUUN , 309 U.S. 461 (1940) (government won) Bruun lost! [A landlord does realize a taxable gain when he repossesses property improved by a tenant.] Facts:

Bruun was a landlord. He leased some property to a tenant. When the lease expired, the tenant left and Bruun took the property back. While the tenant was in possession of the property, they knocked down an old building and built a new building on the property. When they left, Bruun got to keep the new building. The new building was assessed to be worth $51k more than the old one. The IRS stepped in and said that Bruun's gain of a new building was a capital gain. Bruun argued that no income had been realized yet because his interest was represented by a deed, and when the tenant left, he had the exact same deed he had when the tenant arrived. So he hadn't gained anything. Bruun suggested that the IRS would have to wait until the property was sold (aka the value was realized). Basically, the construction of the new building increased the value of the land, but there were other ways the value could change. But until the land was sold, Bruun hadn't received anything. [See Eisner v. Macomber (252 U.S. 189 (1920)), which says that in general, you don't have to report a gain until you sell the property (aka "severance is a prerequisite to realization").] The IRS argued that until the day the tenant left, Bruun didn't own a new building, as soon as the lease ended, Bruun did own a new building. He had received a gain and needed to pay taxes on it immediately. Issue: WON the respondent realized a taxable gain from the forfeiture his leasehold? Held: YES! The court held for the government: the value of the improvements made by the tenant was realized by the taxpayer in the year in which the forfeiture occurred. Ratio: The improvements, the Court observed, were received by the taxpayer "as a result of a business transaction," namely, the leasing of the taxpayer's land. It was not necessary to the recognition of gain that the improvements be severable from the land; all that had to be shown was that the taxpayer had acquired valuable assets from his lease in exchange for the use of his property. The medium of exchangewhether cash or kind, and whether separately disposable or "affixed"--was immaterial as far as the realization criterion was concerned. In effect, the improvements represented rent, or rather a payment in lieu of rent, [2] which was taxable to the landlord regardless of the form in which it was received. "Severance" is not necessary for realization: (aka house need not be sold before it was realized) "It is not necessary to recognition of taxable gain that he should be able to sever the improvement begetting the gain from his original capital. If that were necessary, no income could arise from the exchange of property, whereas such gain has always been recognized as realized taxable gain." The Court added that, while not all economic gain is "realized" for taxation purposes, realization does not require that the economic gain be in "cash derived from the sale of an asset". Realization can also arise from property exchange; relief of indebtedness; or other transactions yielding profite.g. by receiving an asset with enhanced value in a transaction, even where severance does not occur (i.e. even where "the gain is a portion of the value of property received by the taxpayer in the transaction").

The US Supreme Court found for the IRS.

The US Supreme Court found that upon when a lease ended, the landlord repossessed the real estate and improvements and increase in value attributable to the improvements was taxable. The real estate industry felt that this was very unfair to landlords. If the new building was expensive, the landlord might be forced to sell the land just to be able to afford the tax. They lobbied Congress, who passed 26 U.S. C. 109 was to provide relief for exactly landlord's in Bruun's situation. o Now, under 109, gross income generally does not include improvements made by a tenant. o However, it does not include "improvements other than rent." That clause was added so the landlord and tenant couldn't conspire to improve the property instead of paying rent. So you can't say to a tenant, "instead of paying me rent, just build a fancy new building that I can keep after you leave."

of or interest in such property; also from interest, rent, dividends, securities, or the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatever. . . ." Respondents contend that punitive damages, characterized as "windfalls" flowing from the culpable conduct of third parties, are not within the scope of the section. But Congress applied no limitations as to the source of taxable receipts, nor restrictive labels as to their nature. And the Court has given a liberal construction to this broad phraseology in recognition of the intention of Congress to tax all gains except those specifically exempted. Here we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion. The mere fact that the payments were extracted from the wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable income to the recipients. Dissent. Justice Douglass dissented but did not issue a separate opinion. Discussion. The Supreme Court found no exception applicable to punitive damages. Further, the

CIR V. GLENSHAW GLASS CO. 348 U.S. 426 (1955) (government won) GlenShaw Glass lost! [gross includes includes any income from any source-even damages received] Facts. Glenshaw Glass manufactures glass bottles and containers and was in litigation with the Hartford-Empire Company, which manufactures machinery used by Glenshaw. Glenshaw made demands for exemplary damages for fraud and treble damages for injury to its business for Hartfords violations of antitrust laws. The parties settled and Glenshaw received $800,000. Of that, $324,529.94 represented punitive damages. Glenshaw did not report that amount as income for the tax year involved. In Commissioner v. William Goldman Theatres, Inc., William Goldman sued Loews Inc. for violations of antitrust law and sought treble damages. William Goldman received $375,000 in treble damages but claimed $250,000 of that represented punitive damages and did not report it as income. Issue. Whether money received as exemplary damages for fraud or as punitive damages of an antitrust recovery must be considered gross income? Held. YES! Chief Justice Warren held that the amounts should be considered gross income. Court could not ignore the plain language of the statute that gross includes includes any income from any source. RATIO: US Tax Code: SEC. 22. GROSS INCOME. "(a) GENERAL DEFINITION. 'Gross income' includes gains, profits, and income derived from salaries, wages, or compensation for personal service . . . of whatever kind and in whatever form paid, or from professions, vocations, trades, businesses, commerce, or sales, or dealings in property, whether real or personal, growing out of the ownership or use

JAMES V. U.S. 366 U.S. 213 (1961) (government won) James lost! [Embezzled money is subject to income tax] FACTS: James was an official in a labor union. He, together with another person, embezzled more than $738,000 from the union and from an insurance company doing business with the union. He did not report these amounts on his tax return. He was tried for tax evasion, and claimed in his defense that embezzled funds did not constitute taxable income. His argument was that just as the receipt of loan proceeds is not taxable to the borrower, the person who embezzles money should not be treated as having received income, since that person is legally obligated to return those funds to their rightful owner. However, this defense was unavailing in the trial court, where Eugene James was convicted and sentenced to three years in prison. Hence, this petition. ISSUE:W/N embezzled money is subject to income tax OR whether the receipt of embezzled funds constitutes income taxable to the wrongdoer, even though an obligation to repay exists HELD: YES, SUBJECT TO INCOME TAX! United States Supreme Court held that money obtained by a taxpayer illegally was taxable income, even though the law might require the taxpayer to repay the ill-gotten gains to the person from whom they had been taken. RATIO: It had been a well established principle, long before either Rutkin or Wilcox, that unlawful, as well as lawful, gains are comprehended within the term "gross income." Section II B of the Income Tax Act of 1913 provided that "the net income of a taxable person shall include gains, profits, and income . . . from . . . the transaction of any lawful business carried on for gain or profit, or gains or profits and income derived from any source whatever. . . ."

When the statute was amended in 1916, the one word "lawful" qualifying the business carried on was omitted. This revealed, we think, the obvious intent of that Congress to tax income derived from both legal and illegal sources, to remove the incongruity of having the gains of the honest laborer taxed and the gains of the dishonest immune. The Court has given a liberal construction to the broad phraseology of the "gross income" definition statutes in recognition of the intention of Congress to tax all gains except those specifically exempted. The language of 22(a) of the 1939 Code, "gains or profits and income derived from any source whatever," and the more simplified language of 61(a) of the 1954 Code, "all income from whatever source derived," have been held to encompass all "accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." A gain constitutes taxable income when its recipient has such control over it that, as a practical matter, he derives readily realizable economic value from it. Notes: In Wilcox, the Court held that embezzled money does not constitute taxable income to the embezzler in the year of the embezzlement under 22(a) of the Internal Revenue Code of 1939. Six years later, this Court held, in Rutkin v. United States, that extorted money does constitutes taxable income to the extortionist in the year that the money is received under 22(a) of the Internal Revenue Code of 1939. In Rutkin, the Court did not overrule Wilcox, but stated: "We do not reach in this case the factual situation involved in Commissioner v. Wilcox. We limit that case to its facts. There, embezzled funds were held not to constitute taxable income to the embezzler under 22(a)." However, examination of the reasoning used in Rutkin leads us inescapably to the conclusion that Wilcox was thoroughly devitalized. The basis for the Wilcox decision was "that a taxable gain is conditioned upon (1) the presence of a claim of right to the alleged gain and (2) the absence of a definite, unconditional obligation to repay or return that which would otherwise constitute a gain. Without some bona fide legal or equitable claim, even though it be contingent or contested in nature, the taxpayer cannot be said to have received any gain or profit within the reach of Section 22(a)." Since Wilcox embezzled the money, held it "without any semblance of a bona fide claim of right," ibid., and therefore "was at all times under an unqualified duty and obligation to repay the money to his employer," ibid., the Court found that the money embezzled was not includible within "gross income." But Rutkin's legal claim was no greater than that of Wilcox. It was specifically found "that petitioner had no basis for his claim . . . and that he obtained it by extortion." Both Wilcox and Rutkin obtained the money by means of a criminal act; neither had a bona fide claim of right to the funds. Nor was Rutkin's obligation to repay the extorted money to the victim any less than that of Wilcox. The victim of an extortion, like the victim of an embezzlement, has a right to restitution. Furthermore, it is inconsequential that an embezzler may lack title to the sums he appropriates, while an extortionist may gain a voidable title. Questions of federal income taxation are not determined by such "attenuated subtleties." Thus, the fact that Rutkin secured the money with the consent of his victim is irrelevant. Likewise unimportant is the fact that the sufferer of an extortion is less likely to seek restitution than one whose funds are embezzled. What is important is that the right to recoupment exists in both situations.

B.

REALIZATION REQUIREMENT

Sec. 38, Rev. Regs. 2 Bases of computation. Approved standard methods of accounting will be ordinarily regarded as clearly reflecting income. A method of accounting will not, however, be regarded as clearly reflecting income unless all items of gross income and all deductions are treated with reasonable consistency. All items of gross income shall be included in the gross income for the taxable year in which they are received by the taxpayer and deductions taken accordingly, unless in order clearly to reflect income such amounts are to be properly accounted for as of a different period. For instance, in any case in which it is necessary to use an inventory, no accounting in regard to purchases and sales will correctly reflect income except an accrual method. A taxpayer is deemed to have received items of gross income which have been credited to or set apart for him without restriction. On the other hand, appreciation in value of property is not even an accrual of income to a taxpayer prior to the realization of such appreciation through sale or conversion of the property. (For methods of accounting and determination of accounting period see Sections 166 to 169 of these regulations.)

HELVERING V. BRUUN SUPRA (government won) Bruun lost! [A landlord does realize a taxable gain when he repossesses property improved by a tenant.] Facts: Bruun was a landlord. He leased some property to a tenant. When the lease expired, the tenant left and Bruun took the property back. While the tenant was in possession of the property, they knocked down an old building and built a new building on the property. When they left, Bruun got to keep the new building. The new building was assessed to be worth $51k more than the old one. The IRS stepped in and said that Bruun's gain of a new building was a capital gain. Bruun argued that no income had been realized yet because his interest was represented by a deed, and when the tenant left, he had the exact same deed he had when the tenant arrived. So he hadn't gained anything. Bruun suggested that the IRS would have to wait until the property was sold (aka the value was realized). Basically, the construction of the new building increased the value of the land, but there were other ways the value could change. But until the land was sold, Bruun hadn't received anything. [See Eisner v. Macomber (252 U.S. 189 (1920)), which says that in general, you don't have to report a gain until you sell the property (aka "severance is a prerequisite to realization").] The IRS argued that until the day the tenant left, Bruun didn't own a new building, as soon as the lease ended, Bruun did own a new building. He had received a gain and needed to pay taxes on it immediately. Issue: WON the respondent realized a taxable gain from the forfeiture his leasehold?

Held: YES! The court held for the government: the value of the improvements made by the tenant was realized by the taxpayer in the year in which the forfeiture occurred. Ratio: The improvements, the Court observed, were received by the taxpayer "as a result of a business transaction," namely, the leasing of the taxpayer's land. It was not necessary to the recognition of gain that the improvements be severable from the land; all that had to be shown was that the taxpayer had acquired valuable assets from his lease in exchange for the use of his property. The medium of exchangewhether cash or kind, and whether separately disposable or "affixed"--was immaterial as far as the realization criterion was concerned. In effect, the improvements represented rent, or rather a payment in lieu of rent, [2] which was taxable to the landlord regardless of the form in which it was received. "Severance" is not necessary for realization: (aka house need not be sold before it was realized) "It is not necessary to recognition of taxable gain that he should be able to sever the improvement begetting the gain from his original capital. If that were necessary, no income could arise from the exchange of property, whereas such gain has always been recognized as realized taxable gain." The Court added that, while not all economic gain is "realized" for taxation purposes, realization does not require that the economic gain be in "cash derived from the sale of an asset". Realization can also arise from property exchange; relief of indebtedness; or other transactions yielding profite.g. by receiving an asset with enhanced value in a transaction, even where severance does not occur (i.e. even where "the gain is a portion of the value of property received by the taxpayer in the transaction").

! ISSUE: WON the gift of interest coupons detached from the bonds is the realization of income taxable to the donor (or WON the donor is the one going to be taxed instead of the donee?) HELD: YES, Horst (father) is the one going to be taxed! RATIO:

The Commissioner ruled that under the applicable section 22 of the Revenue Act of 1934, 48 Stat. 680, 686, 26 U.S.C.A. Int. Rev. Acts, page 669, the interest payments were taxable, in the years when paid, to the respondent donor who reported his income on the cash receipts basis. The circuit court of appeals reversed the order of the Board of Tax Appeals sustaining the tax because of the importance of the question in the administration of the revenue laws and because of an asserted conflict in principle of the decision below with that of Lucas v. Earl, and with that of decisions by other circuit courts of appeals.

NOTE: The Court reasoned that the power to dispose of income is the equivalent of ownership. Because he was able to separate the interest coupons from the bonds and procure payment of the interest to his son, Paul Horst enjoyed the economic benefits of the income. The court stated . . . . [t]he taxpayer has equally enjoyed the fruits of his labor or investment and obtained the satisfaction of his desires whether he collects and uses the income . . . or whether he disposes of his right to collect it. . . . The taxpayer cannot attribute the fruit (the interest coupon) to a different tree from that which it grew on (the bond itself). If Horst had given both the bond and the interest coupons to his son, the interest would have been taxable to his son. ! Here respondent, as owner of the bonds, had acquired the legal right to demand payment at maturity of the interest specified by the coupons and the power to command its payment to others which constituted an economic gain to him. Underlying the reasoning is the thought that income is realized by the assignor because he, who owns or controls the source of the income, also controls the disposition of that which he could have received himself and diverts the payment from himself to others as the means of procuring the satisfaction of his wants. Although the donor here, by the transfer of the coupons, has precluded any possibility of his collecting them himself he has nevertheless, by his act, procured payment of the interest, as a valuable gift to a member of his family Such a use of his economic gain, the right to receive income, to procure a satisfaction which can be obtained only by the expenditure of money or property, would seem to be the enjoyment of the income whether the satisfaction is the purchase of goods at the corner grocery, the payment of his debt there, or such non-material satisfactions as may result from the payment of a campaign or community chest contribution, or a gift to his favorite son. Even though he never receives the money he derives money's worth from the disposition of the coupons which he has used as money or money's worth in the procuring of a satisfaction which is procurable only by the expenditure of money or money's worth.

The US Supreme Court found for the IRS. o The US Supreme Court found that upon when a lease ended, the landlord repossessed the real estate and improvements and increase in value attributable to the improvements was taxable. The real estate industry felt that this was very unfair to landlords. If the new building was expensive, the landlord might be forced to sell the land just to be able to afford the tax. They lobbied Congress, who passed 26 U.S. C. 109 was to provide relief for exactly landlord's in Bruun's situation. o Now, under 109, gross income generally does not include improvements made by a tenant. o However, it does not include "improvements other than rent." That clause was added so the landlord and tenant couldn't conspire to improve the property instead of paying rent. So you can't say to a tenant, "instead of paying me rent, just build a fancy new building that I can keep after you leave." HELVERING V. HORST 311 U.S. 112 (1940)

! !

FACTS: ! Horst, the owner of negotiable bonds, detached from them negotiable interest coupons shortly before their due date and delivered them as a gift to his son who in the same year collected them at maturity.

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! ! !

The enjoyment of the economic benefit accruing to him by virtue of his acquisition of the coupons is realized as completely as it would have been if he had collected the interest in dollars and expended them for any of the purposes named. To say that one who has made a gift thus derived from interest or earnings paid to his donee has never enjoyed or realized the fruits of his investment or labor because he has assigned them instead of collecting them himself and then paying them over to the donee, is to affront common understanding and to deny the facts of common experience. The power to dispose of income is the equivalent of ownership of it The exercise of that power to procure the payment of income to another is the enjoyment and hence the realization of the income by him who exercises it. But it is the assignment by which the disposition of income is controlled when the service precedes the assignment and in both cases it is the exercise of the power of disposition of the interest or compensation with the resulting payment to the donee which is the enjoyment by the donor of income derived from them. Unlike income thus derived from an obligation to pay interest or compensation, the income of the trust was regarded as no more the income of the donor than would be the rent from a lease or a crop raised on a farm after the leasehold or the farm had been given away. We have held without deviation that where the donor retains control of the trust property the income is taxable to him although paid to the donee. The owner of a negotiable bond and of the investment which it represents, if not the lender, stands in the place of the lender. When, by the gift of the coupons, he has separated his right to interest payments from his investment and procured the payment of the interest to his donee, he has enjoyed the economic benefits of the income in the same manner and to the same extent as though the transfer were of earnings and in both cases the import of the statute is that the fruit is not to be attributed to a different tree from that on which it grew COTTAGE SAV. ASSN V. CIR , 499 U.S. 554 (1991)

participation interests in 252 mortgages to four other S&Ls, receiving in return 90% participation interests in 305 mortgages. All the mortgages involved in the transaction were for homes in the Greater Cincinnati region. The fair market value of the interests exchanged by each side was approximately $4.5 million. The face value of the interests which Cottage Savings relinquished was approximately $6.9 million. On its 1980 federal income tax return, Cottage Savings claimed a loss of $2,447,091, the adjusted difference between the face value of the participation interests it gave up and fair market value of the interests it received. The Commissioner of Internal Revenue disallowed Cottage Savings' deduction, so the S&L filed a petition for redetermination in the United States Tax Court, which reversed the Commissioner's decision and permitted the deduction. The Commissioner appealed to the United States Court of Appeals for the Sixth Circuit, which reversed the decision of the Tax Court, holding that even though Cottage Savings realized a loss in the transaction, it had not actually realized the loss during the 1980 tax year. The U.S. Supreme Court then granted certiorari. Issue: whether the exchange was a "disposition of property." Held: Material difference is a requirement for a disposition under 1001. Marshall cited Treasury Regulation 1.1001-1 (26 C.F.R. 1.1001-1), which required that an exchange of materially different properties constitutes a realization under the Tax Code. Congress delegated to the Commissioner the authority to make rules and regulations to enforce the Internal Revenue Code. Because Title 26 of the Code of Federal Regulations represents the Commissioner's interpretation of the Code, the Court deferred to the Commissioner's judgment, holding that the regulation was a reasonable interpretation of the Code and consonant with prior case law. Material difference defined. Marshall defined what constituted a "material difference" in property under 1001 by examination at what point "realization" had been found in past case law. He started with Eisner v. Macomber, which dealt with exchange of stock in corporations. In several cases after Eisner, the court held that an exchange of stock which occurred when a corporation reorganized in another state was a realization, because corporations have different rights and power in different states. Marshall reasoned that properties materially differ for tax purposes when their respective possessors enjoy different legal entitlements from each. As long as the properties being exchanged were not identical, a realization had taken place. This was a simpler, black letter rule, as compared to what the Commissioner was arguing for, which would have examined not just the underlying substance of the transaction, but also the market and other non-tax regulations. The properties exchanged were "materially different." Marshall held that the participation interests exchanged by Cottage Savings and the other S&Ls were "materially different" because the loans involved were made to different obligors and secured by different properties. Even though the interests were "substantially identical" for the FHLBB's purposes, that did not mean they were not materially different for taxation purposes. Therefore, the exchange was a "disposition of property," Cottage Savings had realized a loss, and their deduction was appropriate. The Court agreed that "material difference" is the applicable test of realization under Code 1001(a), but it did not agree that that test had been flunked merely because the properties exchanged were economic substitutes or equivalents. While the test for regulatory purposes might indeed be one of economic substance, for tax purposes the question was one of

Facts: Cottage Savings Association was a savings & loan association (S&L) serving the Greater Cincinnati area. Like many other S&L's, Cottage Savings had a large number of long-term, low-interest mortgages on its books, which declined in value as interest rates increased during the late 1970s. These S&Ls could have achieved a tax savings from selling these mortgages at a loss, but they were dissuaded from doing so because the accounting regulations of the Federal Home Loan Bank Board (FHLBB) would have required them to report these losses on their books, possibly putting them into insolvency. Hoping to find another way for these S&Ls to realize their tax losses, the FHLBB promulgated a new regulation called "Memorandum R49", under which the S&Ls would not have to show a loss on their books if they exchanged their mortgages for "substantially identical" mortgages held by other lenders. Cottage Savings made a transaction pursuant to this regulation by exchanging 90%

administrative convenience only. As the mortgages exchanged were secured by different homes and involved different mortgage borrowers, the banks on either side emerged with "legally distinct entitlements". More important, the swap itself sufficed to meet the administrative aims that underlie the realization requirement. The transaction was an armslength deal between unrelated parties. As such, it "put both Cottage Savings and the Commissioner in a position to determine the change in the value of Cottage Savings' mortgages relative to their tax bases" and thus to reckon up gain or loss under 1001(a). Justice Blackmun dissented, joined by Justice White. First, Blackmun wanted to define "material difference" with reference to how the term "materiality" was defined. In TSC Industries, Inc. v. Northway, Inc., Justice Marshall himself had stated, in the context of securities fraud, that an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. By implication, a material difference is a difference capable of influencing the decision made by the parties to the transaction. Second, Blackmun pointed out that the majority created something of an anomaly by allowing the property interests exchanged here to be "identical" for accounting purposes but "different" for tax purposes. Finally, he explained the he felt the substance of the transactions, including the fact that Cottage Savings retained a 10% interest in loans it traded away so it could continue servicing them, did not point to any real difference that should permit the allowance of a deduction.

computation of the tax, various classes of income must be considered: (a) Income, in the broad sense, meaning all wealth which flows into the taxpayer other than as a mere return of capital. It includes the forms of income specifically described as gains and profits, including gains derived from the sale or other disposition of capital assets. Income cannot be determined merely by reckoning cash receipts, for the statute recognizes as income determining factor other items, among which are inventories, accounts receivable, property exhaustion, and accounts payable for expenses incurred. (b) Gross income, meaning income (in the broad sense) less income which is by statutory provision or otherwise exempt from the tax imposed by law. (c) Net income, meaning gross income less statutory deductions. The statutory deductions are, in general, though not exclusively, expenditures other than capital expenditures, connected with production of income. (d) In the case of a taxpayer other than a corporation as defined in Section 84 (b) of the Code, net income means gross income less exemptions. Ordinarily the net income is to be computed in accordance with the method of accounting regularly employed in keeping the books of the taxpayer.

EDWARD CLARK V. CIR 40 B.T.A. 333 (1939) This is a proceeding to redetermine a deficiency in income tax for the calendar year 1934 in the amount of $10,618.87. Facts: The petitioner was required to file a Federal ITR for 1932. Petitioner retained experienced tax counsel to prepare the necessary return for him and his wife. Such tax counsel prepared a joint return for petitioner and his wife and advised petitioner to file it instead of two separate returns. In 1934, a duly appointed revenue agent audited the1932 return and recommended an $32,820.14 additional assessment against petitioner. This sum was paid by petitioner. The deficiency of $32,820.14 arose from an error on the part of tax counsel who prepared petitioner's 1932 return. The tax counsel improperly deducted from income the total amount of losses sustained on the sale of capital assets held for a period of more than two years instead of applying the statutory limitation required by Section 101(b) of the Revenue Act of 1932. Recomputations were then made which disclosed that if petitioner and his wife had filed separate returns for the year 1932 their combined tax liability would have been $19,941.10 less than that which was finally assessed against and paid by petitioner. The tax counsel admitted the error in computing the tax liability and tendered to petitioner the sum of $19,941.10 which the petitioner then accepted. In his final determination of petitioner's 1934 tax liability, the respondent included the aforesaid $19,941.10 in income. Respondent contends that the sum $19,941.10 be included as petitioner's gross income (as taxes paid for petitioner by a third party for 1934. Petitioner contends that this payment constituted compensation for damages or loss caused by the error of tax counsel, and that he therefore realized no income from its receipt in 1934. Issue: Whether petitioner derived income by the payment to him of an amount of $19,941.10, by his tax counsel, to compensate him for a loss suffered on account of

C. OTHER RELEVANT CONCEPTS 1. Tax-Free Imputed Income v. Taxable Barter Sec. 41, Rev. Regs. 2. Compensation paid other than in cash. Where services are paid for with something other than money, the fair market value of the thing taken in payment is the amount to be included as income. If the services were rendered at a stipulated price, in the absence of evidence to the contrary, such price will be presumed to be the fair value of the compensation received. Compensation paid an employee of a corporation in its stock is to be treated as if the corporation sold the stock for its market value and paid the employee in cash. When living quarters are furnished in addition to cash salary, the rental value of such quarters should be reported as income. CIR v. Minzer 279 F.2d 338 (5th Cir. 1960) Rev. Rul. 79-24 1979-1 C.B. 60 2. Tax-Free Return of Capital Sec. 36, Rev. Regs. 2. Meaning of net income. The tax imposed by law is upon income. In the

erroneous advice given him by the latter Held: No. Court held in favor of petitioner. The losses is not income since it is not derived from capital, from labor or from both combined When the joint return was filed, petitioner became obligated to and did pay the taxes computed on that basis. In paying that obligation, he sustained a loss which was caused by the negligence of his tax counsel. The $19,941.10 was paid to petitioner, not qua taxes, but as compensation to petitioner for his loss. The measure of that loss, and the compensation therefor, was the sum of money which petitioner became legally obligated to and did pay because of that negligence. The fact that such obligation was for taxes is of no moment here. BIR RULING NO. 51-00 (October 30, 2000) To Atty. Mildred Maranan-Garcia Far East Bank and Trust Company Re: Tax consequence of the withdrawal of contributions by some of its employees representing their contributions to the said Fund Facts: Divine Word Educational Association Retirement Plan was established to provide retirement benefits for qualified employees of school, colleges, universities and Society of Divine Word (SDV) Education Secretaries office and other institutions subsequently accepted by the Retirement Board. The Fund was non-contributory; however, members may, prior to their retirement elect to contribute an amount equal to at least 2% of their current monthly salary; that the contributions shall not be subject to withdrawal unless for causes provided therein. Due to the prevailing economics crisis, some members were financially incapable of continuing their contributions requested the withdrawal of the said contributions. Issue: WON income or earnings derived from the personal contributions by the employeemembers' are subject to income tax Held: Yes. In order to be exempt from the payment of income tax, the benefits must be paid or distributed to the officials or employees upon their retirement from the service and not while they are still in the employ of the company-employer. In the instant case, the earnings/income of the personal contributions of the employees constitute benefits not upon their retirement but while they are still in the service. Therefore, amounts actually distributed to said member-employees over and above their personal contributions shall be taxable to them in the year in which so paid or distributed, considering that such distribution has been effected before their retirement from SVD. Section 36 of the Income Tax Regulations defines income as wealth which flows into the taxpayer other than a mere return of capital. 1. Any and all amounts which represent a return of the personal contributions of the

employees to the Fund, who are still in the active service of SVD, shall not be subject to income tax, since the same are considered as mere return of capital. DCATHS 2. However, the income or earnings derived from the personal contributions by the employee-members' are subject to income tax since in a retirement plan, the employer, or officials and employees or both, contribute to a trust fund for the purpose of distributing to such beneficiaries, the corpus and income accumulated by the trust in accordance with the plan. (Section 2(d) of Revenue Regulations No. 1-68, as amended) BIR RULING NO. 184-90 (September 20, 1990) Facts: On May 20, 1983, Intel Phils. Mfg., Inc. (lessee, entered into a contract of lease with lessor and agreed that the lessee will construct a 3 to 4-storey building on lessors land. Upon failure of the lessee to comply, lessee agreed to a proposed amended contract of lease to pay liquidated damages for actual and compensating damages suffered as a result of the aforementioned breach of contract. Issue: WON liquidated damages to be paid to the lessor by Intel Philippines Mfg., Inc. for breach of contract is exempt from income tax. Held: The damages from a breach of contract constitute taxable income to the recipient thereof in the year received only to the extent that such damages constitute a loss of anticipated profits and non-taxable to the extent that the same represent a return of capital or investment. (BIR Ruling dated September 8, 1954) Since the liquidated damages to be paid by Intel Philippines Mfg., Inc. for the breach of contract of lease do not represent a return of capital or investment but constitute a loss of anticipated profits, they are therefore, considered taxable income in the year received. Request for exemption is denied for lack of legal basis. REV. RUL. 81-277 ADJUSTMENT TO BASIS; RECOVERY FROM CONTRACTOR FOR FAILURE TO PERFORM UNDER CONSTRUCTION CONTRACT FACTS: In 1969 corporation M agreed to construct a nuclear generating plant for corporation P at a price of 250x dollars. During the construction period stricter environmental safeguards was imposed by regulatory agencies which would entail additional construction and additional cost. By virtue of their stipulation in the agreement, P demanded that M provide for stricter safeguards and to include them as part of the delivered plant at the original contract price. By then, P has already paid M 230x dollars of 250x dollar contract price. The parties agree on the ff. to settle their dispute: (1) that P would pay 20x dollars to complete payment of the original contract price (2) that M would pay P 40x dollars (instead of completing the construction) as the estimated cost to satisfy the stricter environmental standards. Both parties then executed general releases to each other and M ceased its construction activities.

P then contracted with a 3 party to finish construction of the plant to satisfy the standards with an additional cost of 50x dollars. ISSUE: WON payment by a contractor of a sum of money to a buyer in exchange for a release of the buyer's claims against the contractor for failure to fulfill a contract result in income to the buyer or a return of capital? HELD: NO! The 40x dollars payment from M to P represents a return of capital and is not income to P. The basis of the plants cost in P's hands should be adjusted downward to 210x to reflect the 40x dollar payment of M, and adjusted upward to 260x dollars when P incurs expenses of 50x dollars to finish construction of the plant. RATIO: Section 61 of the Internal Revenue Code provides that gross income means all income from whatever source derived, including income realized in any form. Inherent in section 61 of the Code is the concept of economic gain. For a taxpayer to have income under section 61, there must be an economic gain that benefits the taxpayer personally. The determination of whether the proceeds received in a lawsuit or received in settlement of a lawsuit constitute income under section 61 of the Code depends on the nature of the claim and the actual basis for recovery. If the recovery represents damages for lost profits, it is taxed as ordinary income. If, however, the recovery is treated as a replacement of capital, the damages received from the lawsuit are treated as a return of capital and are not taxable as income. Payments by the one causing a loss that do not more than restore a taxpayer to the position he or she was in before the loss was incurred are not includible in gross income because there is no economic gain. In the present situation, the effect of the settlement agreement was that M would compensate P for M's failure to provide a fully operational and licensable plant for 250x dollars as agreed upon under the contract. The payment from M to P of 40x dollars represents the estimated present damages P has incurred because of the breach of contract, determined under the settlement agreement as the estimated additional costs needed to satisfy new regulatory standards that were necessary to deliver a complete, safe, licensable, fully operational plant as required under the contract. P has received no economic gain as a result of the 40x dollars payment and is merely being made whole under the contract. P is being restored to the position that it would have been in if M had fulfilled the terms of the contract. LAWS: Section 1012 of the Code provides that the basis of property is usually its cost. Section 1.1012-1(a) of the Income Tax Regulations provides that cost is the amount paid for property in cash or other property. Section 1016(a) provides that adjustments are made to the basis of property for expenditures, receipts, losses, or other items properly chargeable to the capital account. 2. WINDFALL RECEIPTS Sec 32. Gross Income (A) General Definition. - Except when otherwise provided in this Title, gross income

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means all income derived from whatever source, including (but not limited to) the following items: (9) Prizes and winnings (B) Exclusions from Gross Income. The following items shall not be included in gross income and shall be exempt from taxation under this title: (7) Miscellaneous Items (c) Prizes and Awards. - Prizes and awards made primarily in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement but only if: (i) The recipient was selected without any action on his part to enter the contest or proceeding; and (ii) The recipient is not required to render substantial future services as a condition to receiving the prize or award.

CESARINI V. U.S. 296 F. SUPP. 3 (ND OHIO 1969) Facts: In 1957, the plaintiffs purchased a used piano at an auction sale for $15. In 1964, while cleaning the piano, they discovered the sum of $4,467 in old currency. Plaintiffs exchanged the old currency for new at a bank, and reported the sum of $4,467 on their 1964 joint income tax return as ordinary income from other sources. In 1965, plaintiffs filed an amended return eliminating the sum of $4,467.00 from the gross income computation, and requesting a refund in the amount of $836.51, the amount allegedly overpaid as a result of the former inclusion of $4,467.00 in the original return for the calendar year of 1964. In1966, the CIR rejected taxpayers' refund claim in its entirety, hence this case. Issue: WON plaintiffs errouneously overpaid tax in the amount of $836.51 ; WON plaintiffs are entitled to refund Held: No. Windfalls, including found monies, were properly includable in gross income. The arguments of the taxpayers which attempt to avoid the application of Rev. Rul. 61, 1953-1 are not well taken.

"The finder of treasure trove is in receipt of taxable income, for Federal income tax
purposes, to the extent of its value in United States currency, for the taxable year in which it is reduced to undisputed possession." (Rev. Rul. 61, 1953-1, Cum. Bull. 17.) Plaintiffs Contention #1: There are inconsistencies between the code, rules and regulations and court decisions. Court: Plaintiffs in the instant case have been unable to point to any inconsistency between the gross income sections of the code, the interpretation of them by the regulations and the courts, and the revenue ruling which they herein attack as inapplicable. On the other hand, the United States has shown a consistency in letter and spirit between the code, rulings and regulations, and court decisions. Plaintiffs Contention #2: If any tax was due, it was in 1957 when the piano was purchased,

and by 1964 the Government was blocked from collecting it by reason of the statute of limitations. Court: The $4,467.00 in old currency was not "reduced to undisputed possession" until its actual discovery in 1964, and thus the United States was not barred by the statute of limitations from collecting the $836.51 in tax during that year. HORNUNG V. CIR 47 TC 428 (1967) Flo: This case is long (LUCKY ME!) and has 3 issues. I believe the most important is the 1 , because it discusses prizes and winnings, nevertheless, I included the other 2. FACTS: In 1961, Paul Hornung (plaintiff) was a football player for the Green Bay Packers. On December 31, 1961, Sunday, Hornung played in the National Football League (NFL) championship game and won. Sport Magazine (Sport) named him the outstanding player of the game. Sport is a New York publication that annually awards a new Corvette to athletes for outstanding performance. It announced the award to Hornung immediately after the game but did not make the car available to Hornung on the same day. Hornung did not receive a key or title to the car, and no arrangements were made for Hornung to receive the car prior to the luncheon. (Hornung was not required to attend this luncheon or perform any other services in order to receive the vehicle.) At the time, the car was held at a New York dealership that was closed on Sundays. Although in previous years, Sport made the car available for pick up in New York on the day of the game, Sport did not believe the winner of the car would choose to travel from Green Bay to New York City immediately after the game. The fair market value of the Corvette was $3,331.04. Hornung sold the vehicle and reported this sale on his 1962 Federal income tax return. However, he did not include the fair market value of the car (when he received it) in his tax return for 1962 or any other year. The Commissioner (defendant) determined the value of the car should have been included in Hornungs gross income for 1962. ISSUE: WON the value of a 1962 Chevrolet Corvette won by Paul Hornung (taxpayer) for his performance in the 1961 NFL championship game should be included in his gross income for the taxable year 1962. HELD: YES! The value of the car should have been included in Hornung!s gross income
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(2) that it was constructively received by him in 1961, and therefore was not subject to federal income tax in the year of 1962. On the 1 argument: The court determined that the Corvette was not given as a gift because Sport Magazine had a motive for giving it beyond a 'detached and disinterested generosity' (a requisite for a judicial finding of a 'gift'). The court dismissed Hornung's claims that the championship football game constitutes an educational, artistic, scientific, or civic achievement. The court reaffirmed the principle that words in the revenue acts should be interpreted in their ordinary, everyday sense. The court believed the exceptions articulated in 74(b) refer to "activities enhancing in one way or another the public good." On the 2 argument: Under the Internal Revenue Code, "the amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer ..." Under the cash receipts method, which Hornung had appropriately utilized, items constituting gross income are to be included for the taxable year in which they are actually or constructively received. The court noted that an item is constructively received when it has been set apart for the taxpayer or otherwise made available for him to draw upon, if the intention to do so is known. But "income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions." The court found that on Sunday, December 31, 1961, there were substantial limitations or restrictions on Hornungs control over the Corvette. At that time, the car was physically in the state of New York, and the editor in chief of Sport Magazine had neither keys nor title to the vehicle to give to Hornung to establish his possession. Additionally, because December 31, 1961 was a Sunday, the dealership where the car was kept was closed, and Hornung could not have accessed it on that date even if he wanted to. Based on the above, the Tax Court held that the constructive receipt doctrine was inapplicable and the Corvette was received by Hornung for income tax purposes in 1962.
Pertaining to the 1962 Thunderbirds In July 1962, Hornung asked a friend to arrange for a car to be available for him to drive while in Green Bay. A local Ford dealership furnished Hornung with a 1962 Thunderbird, later exchanging the original for a second 1962 Thunderbird. The title to the cars remained with Ford, though Hornung paid the insurance and all operating costs while driving the Thunderbirds. Hornung was not asked to make any personal appearances or special efforts for the dealership, except that he was asked to "come in and say hi" during a Ford-sponsored children's football event. Ford had also furnished other Green Bay Packers with vehicles for their use around Green Bay. Hornung did not recognize or report any income associated with this use. The value of this use was determined to be $600. Pertaining to the Fur Stole After winning the Western Division title of the National Football League in 1961, Vince Lombardi bought and distributed fur stoles to the wives, friends, and mothers of each player on the team. Hornung's mother received the stole in 1961. The stoles were reported by the Packers as "Other Unallowable Deductions" and were described as "Awards to players' wives, etc." The stoles were valued at $395 per stole, less an 8percent bulk discount. Hornung did not report any gross income with respect to the stole given to his mother.
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for 1962 because the Corvette was received in 1962, and not excludable from taxable income as a gift or applicable award or prize. RATIO: Hornung did not, for income tax purposes, constructively receive the Corvette in 1961, but rather received it in 1962.!
Hornungs arguments: (1) that the Corvette was a gift and therefore exempt from federal income tax;

Whether the value of the use of the 1962 Thunderbird automobiles furnished to Hornung by Ford should be included in gross income for the taxable year 1962; The court found that Hornung had not met the burden of proving his use of the Thunderbirds was a gift. Therefore, the economic benefit he received was taxable gross income. Hornung argued that the use of the Thunderbirds was a gift under section 102, since he was not obligated to perform any services to use the cars. The court focused on the dealership's intentions in making the loan, and determined that Hornung had not sufficiently proven that the loaned cars were given as a result of 'detached and disinterested generosity. The court then considered whether the economic benefit to Hornung was gross income. Relying on the test provided in Commissioner v. Glenshaw Glass Co., the court found that the benefit was an undeniable accession to wealth, clearly realized, and over which Hornung had complete dominion; and therefore was taxable gross income under section 61 of the tax code.

Whether Hornung's gross income for 1962 should include the value of a fur stole received by his mother from his employer. The stole was not income to Hornung in 1962, as it was actually received in 1961. The court dispensed of this issue easily by noting that the stole was actually received by Hornung's mother in 1961. Therefore, it did not constitute income in 1962.

Sec. 50, Rev. Regs. 2 SECTION 50. Forgiveness of indebtedness. The cancellation and forgiveness of indebtedness may amount to a payment of income, to a gift, or to a capital transaction, dependent upon the circumstances. If, for example, an individual performs services for a creditor, who, in consideration thereof cancels the debt, income to that amount is realized by the debtor as compensation for his services. If, however, a creditor merely desires to benefit a debtor and without any consideration therefor cancels the debt, the amount of the debt is a gift from the creditor to the debtor and need not be included in the latter's gross income. If a corporation to which a stockholder is indebted forgives the debt, the transaction has the effect of the payment of a dividend.

BIR RUL. 76-89 (APRIL 17, 1989) Doctrine: When a creditor cancels a debt as part of a business transaction, the debtor is enriched or its net assets has been increased and, therefore, he realized taxable income. However, a transaction whereby nothing of exchangeable value comes to or is received by a taxpayer does not give rise to or create taxable income. FACTS: General Motors Pilipinas, Inc. (GMPI) is a joint venture corporation owned 60% by General Motors Overseas Distribution Corporation (GM-US) and 40% by Isuzu Motors Limited of Japan (ISUZU). GMPI was engaged in the manufacture of transmissions and components as well as in the assembly of cars and trucks (largely Isuzu). September 1985, due to economic recession in the Phil. and the depressed automotive market, plus the non-availability of foreign exchange for the importation of parts for car and truck assemblies, GMPI ceased its operations. GMPI, from that time, was insolvent and has since remained as such. December 1985, the SH and the BOD of GMPI recommended its dissolution approved a resolution to shorten GMPI's corporate life to October 1986. Pursuant to the resolution, GMPI filed with the SEC an application to amend its Articles of Incorporation. Based on the December 31, 1988 unaudited financial statements of GMPI, it has outstanding liabilities/indebtedness to banks and affiliates in the following amounts:

3. Tax Benefit Principle Recovery Of Deducted Items SEC. 34. Deductions from Gross Income. Except for taxpayers earning compensation income arising from personal services rendered under an employer employee relationship where no deductions shall be allowed under this Section other than under subsection (M) hereof, in computing taxable income subject to income tax under Sections 24 (A); 25 (A); 26; 27 (A), (B) and (C); and 28 (A) (1), there shall be allowed the following deductions from gross income; (E) Bad Debts. (1) In General. Debts due to the taxpayer actually ascertained to be worthless and charged off within the taxable year except those not connected with profession, trade or business and those sustained in a transaction entered into between parties mentioned under Section 36 (B) of this Code: Provided, That recovery of bad debts previously allowed as deduction in the preceding years shall be included as part of the gross income in the year of recovery to the extent of the income tax benefit of said deduction.

Bank Debt Non-Trade Related Trade Related

Principal Interest Principal Interest P113,240

P280,150 54,522 246,942 48,093

BIR Rul. 102-95 (July 7, 1995) 4. Indirect Receipts Cancellation Of Indebtedness And Discharge By 3 Parties
rd

Due to Affiliated Companies Isuzu Motors Limited

General Motors Corp. (GMC) TOTAL

19,334

132,574 P762,281 =======

creditor who, in consideration thereof cancels the debt If a creditor merely desires to benefit a debtor and without any consideration therefor cancels the debt If a corporation to which a stockholder is indebted forgives the debt, the transaction has the effect of the payment of a dividend (Sec. 50 Revenue Regulations No. 2)

realized by the debtor compensation for his services

as

Total outstanding liabilities to banks and GMC plus accrued interest = P649,041,000 1987 GMPI capital deficiency = P664,522,000 1988 capital deficiency = P739,057,000 Value of property, plant and equipment = P20,450,000

Then amount of the debt is a gift from the creditor to the debtor and need not be included in the latter's gross income The waiver of interest by the banks on non-trade and trade related indebtedness of GMPI is not subject to income tax considering that the deduction of said interest as expense in prior years did not offset nor reduce the taxable income of GMPI since it was in a financial loss position even without the deduction.

Since GM-US has no further interest to continue its ownership in the defunct GMPI, it assigned its 60% shares in GMPI to Isuzu. It was agreed that GMPI would "clean-up" its current outstanding liabilities except the liability to Isuzu, to be accomplished when the shares are transferred in three steps, as follows: (1) By having GMPI's creditor banks waive accrued interest on the non-trade and trade related debt; (2) By having these banks assign to GM-US, its GMPI non-trade related receivables. At that time GM-US will condone the total GMPI indebtedness due to it amounting to P299,484,000 including the aforementioned non-trade debt as well as other nontrade liabilities due GMC; (3) By having the banks grant a participation to GM-US in GMPI trade related receivables, GM-US would then assign these receivables to Isuzu.
!

Old Colony Trust Co. v. CIR 279 U.S. 716 (1929) Facts: In 1916, the American Woolen Company adopted a resolution which provided that the company would pay all taxes due on the salaries of the company's officers. It calculated the employees' tax liabilities based on a gross income that omitted, or excluded, the amount of the income taxes themselves. In 1925, the Bureau of Internal Revenue assessed a deficiency for the amount of taxes paid on behalf of the company's president, William Madison Wood, arguing that his $681,169.88 tax payment had wrongly been excluded from his gross income in 1919, and that his $351,179.27 tax payment had wrongly been excluded from his gross income in 1920. Old Colony Trust Co., as the executors of Wood's estate, filed suit in the District Court for a refund, then appealed to the Board of Tax Appeals (the predecessor to the United States Tax Court). The petitioners then appealed the Board's decision to the United States Court of Appeals for the First Circuit. Issue: Were the taxes paid by the company additional income of Wood? Held: YES. Taft held that payment of Mr. Wood's taxes by his employer constituted additional taxable income to him for the years in question. The fact that a person induced or permitted a third party from paying income taxes on his behalf does not excuse him from filing a tax return. Furthermore, Taft added, "The discharge by a third person of an obligation to him is equivalent to receipt by the person taxed." Thus, the company's payment of Wood's tax bill was the same as giving him extra income, regardless of the mode of payment. Nor could the payment of taxes of Wood's behalf constitute a gift in the legal sense, because it was made in consideration of his services to the company, thus making it part of his compensation package. (This case did not change

Later, Isuzu, as the new 100% parent company, considered infusing additional capital to restore the business into a viable operation and eliminate the capital deficiency so that the company will resume its "going concern" status. And that as a going concern, its assets previously adjusted to liquidation values, shall be restored to its valuation prior to liquidation. ISSUE: WON the bank's waiver (of accrued interest on the non-trade and trade related indebtedness of GMPI) and GM-US condonation (of GMPI's non-trade related indebtedness) are subject to income tax or to gift tax. HELD: NO! Banks waiver and GM-US condonation are NOT subject to income or gift tax. RATIO: GM-USs condonation of GMPI's indebtedness is NOT subject to income tax since before and after the condonation GMPI remains insolvent, i.e., in a capital deficiency position. The condonation is likewise NOT subject to gift tax since there is no donative interest on the part of GM-US but solely for business consideration since Isuzu will only acquire the GMPI shares from GM-US if GMPI has a "clean" balance sheet with no outstanding liabilities except those to Isuzu. Moreover, a return to solvency due to a possible future additional capital infusion by Isuzu and/or subsequent profitability in a different taxable year will not affect the non-taxability of the condonation. Cancellation and forgiveness of indebtedness may amount to a payment of income / to a gift / or to a capital transaction, dependent upon the circumstances. Examples:
If an individual performs services for a Then income to that amount is

the general rule that gifts are not includable in gross income for the purposes of U.S. Federal income taxation, while some gifts but not all gifts from an employer to an employee are taxable to the employee The Supreme Court notes that Wood and other employees received a direct benefit when the company discharged their tax obligation. Wood received a benefit in exchange for his services to the company. This was clearly a taxable gain. Notes: The payment of the tax by the employers was in consideration of the services rendered by the employee, and was again derived by the employee from his labor. The form of the payment is expressly declared to make no difference. It is therefore immaterial that the taxes were directly paid over to the government. The discharge by a third person of an obligation to him is equivalent to receipt by the person taxed. The certificate shows that the taxes were imposed upon the employee, that the taxes were actually paid by the employer, and that the employee entered upon his duties in the years in question under the express agreement that his income taxes would be paid by his employer. This is evidenced by the terms of the resolution passed August 3, 1916, more than one year prior to the year in which the taxes were imposed. The taxes were paid upon a valuable consideration, namely, the services rendered by the employee and as part of the compensation therefor. We think, therefore, that the payment constituted income to the employee. 'In no view of the evidence, therefore, can the $35,000 be regarded as a gift. It was either compensation for services rendered or a gain or profit derived from the sale of the stock of the corporation, or both; and, in any view, it was taxable as income.' BIR Rul. 85-95 (June 13, 1995) Facts: Subic Power Corporation (SPC) is registered with the Subic Bay Metropolitan Authority (SBMA) to engage in the business of generation and sale of electric power. SPC has a contract with the National Power Corporation to develop, construct and operate a 108 megawatt power station in the Subic Bay Freeport, Olongapo City and the estimated cost of the power station project is about U.S. $143.0 million To finance the project, SPC has undertaken a "Rule 144 A" offering in the U.S. and has issued notes under an Indenture Agreement; that the notes are direct obligation of SPC and are floated in the U.S.; that under the Indenture Agreement, SPC will pay interest to the holders of the notes without any withholding or deduction for any taxes imposed or levied by the Philippine Government; that the said tax assumption is not only in conformity with the international banking practice on foreign loans, but also primarily as a consideration for the credit and in lieu of additional interest that would have been imposed had SPC not agreed to assume the Philippine withholding tax; that therefore, the Philippine withholding tax on the interest is passed on to SPC and it assumes the payment of the tax; that SPC bears the burden of and becomes directly liable to the tax otherwise due from the noteholders; that the Philippine withholding tax on the interest becomes SPC's additional tax liability, and an addition to its financing charges associated in the construction of the power plant.

Issue/Query: W/N The withholding tax base for purposes of applying the 5% final withholding tax is the total amount of income to be remitted without grossing up the 5% final withholding tax due thereon. Held: YES. The assumption of the tax constitutes an additional income of the non-resident creditor-bondholders, which in turn should be subject to tax. (Old Colony Trust Co. vs. Commissioner, 279 U.S. 716). Thus, the tax base should be grossed-up by adding to the interest income payments the amount of tax assumed.

III. GROSS INCOME

A. Inclusions SEC. 32. Gross Income. (A) General Definition. - Except when otherwise provided in this Title, gross income means all income derived from whatever source, including (but not limited to) the following items: (1) Compensation for services in whatever form paid, including, but not limited to fees, salaries, wages, commissions, and similar items; (2) Gross income derived from the conduct of trade or business or the exercise of a profession; (3) Gains derived from dealings in property; (4) Interests; (5) Rents; (6) Royalties; (7) Dividends; (8) Annuities; (9) Prizes and winnings; (10) Pensions; and (11) Partner's distributive share from the net income of the general professional partnership.

1. Compensation: Special Problems on In-Kind Compensation Sec. 2.78.1(A) and (1), Rev. Regs. 2-98 (April 17, 1998) (A) Compensation Income Defined. In general, the term "compensation" means all remuneration for services performed by an employee for his employer under an employer-employee relationship, unless specifically excluded by the Code. The name by which the remuneration for services is designated is immaterial. Thus,

salaries, wages, emoluments and honoraria, allowances, commissions (e.g. transportation, representation, entertainment and the like); fees including director's fees, if the director is, at the same time, an employee of the employer/corporation; taxable bonuses and fringe benefits except those which are subject to the fringe benefits tax under Sec. 33 of the Code; taxable pensions and retirement pay; and other income of a similar nature constitute compensation income. The basis upon which the remuneration is paid is immaterial in determining whether the remuneration constitutes compensation. Thus, it may be paid on the basis of piece-work, or a percentage of profits; and may be paid hourly, daily, weekly, monthly or annually. Remuneration for services constitutes compensation even if the relationship of employer and employee does not exist any longer at the time when payment is made between the person in whose employ the services had been performed and the individual who performed them. (1) Compensation paid in kind. Compensation may be paid in money or in some medium other than money, as for example, stocks, bonds or other forms of property. If services are paid for in a medium other than money, the fair market value of the thing taken in payment is the amount to be included as compensation subject to withholding. If the services are rendered at a stipulated price, in the absence of evidence to the contrary, such price will be presumed to be the fair market value of the remuneration received. If a corporation transfers to its employees its own stock as remuneration for services rendered by the employee, the amount of such remuneration is the fair market value of the stock at the time the services were rendered.

YES. Taxable. The present value of an annuity which is non-transferable is equal to the cost to the taxpayer of acquiring identical rights. An annuity is deferred compensation. Sec. 22(b) (2) "Annuities, etc; Amounts received (other than amounts paid by reason of the death of the insured and interest payments on such amounts and other than amounts received as annuities) under a life insurance or endowment contract, but if such amounts (when added to amounts received before the taxable year under such contract) exceed the aggregate premiums or consideration paid (whether or not paid during the taxable year) then the excess shall be included in gross income. The court reasoned that the value lie somewhere between the premium price paid and zero. Even though the taxpayer might die before the annuity started paying, he had some present rights to a future income stream, which he could designate to a beneficiary. Furthermore, the taxpayer could realize present cash payment from a third party who he could designate as a trustee to hold the future payments in trust for him. However, this would probably be worth less than the premium paid by the company based on the risk of the taxpayer dying before the annuity began paying, and thus the payments going to the beneficiary. However, the burden of proof was on Drescher to show that the present value was less than $5,000. Dissent (CLARK) The dissent reasoned that the value was the amount paid by the company because it represented the present value of the future payments, and was consideration for the contract between the taxpayer and the company. The amount of the policy premium represented what the market expected the present value of the aggregate payments over Dreschers life to be, which was greater than $5,000. BIR Rul. 9-04 (Sept. 13, 2004) Facts: ANZ (Australia and New Zealand) Bank was organized under the laws of Australia; that its shares are listed and traded in the Australian Stock exchange; that in order to increase employee motivation and to create a stronger link between increasing shareholder value and its employee reward system ANZ Bank has established the ANZ Employee Share Acquisition Plan (ESAP) to provide employees with the opportunity to participate in the growth of the Bank. Under the ESAP, all employees, including executive officers, with at least one year of service with the Bank will be offered Australian registered shares in ANZ Bank free of charge. There are two schemes under the plan: (1) the general scheme and (2) the incentive scheme. Under both schemes, a trading lock of three years from the date of award or from the termination of employment from ANZ in case of general scheme shall be implemented. During the trading lock, a Trustee will hold the shares on behalf of the employees. Dividends accruing to the employees during the trading lock are required to be reinvested in ANZ shares under the compulsory participation requirement of the Dividend Reinvestment Plan (DRP). As such, employees cannot receive cash dividends; the cash dividends will be received in the form of additional ANZ shares. The additional shares will be released from restriction at the same time the participant's plan shares are released.

a. Limited Choice and Restricted Property

U.S. v. Drescher 179 F.2d 863 (2nd Cir. 1950) Facts: Drescher was an employee of Bausch and Lomb who was given voluntary retirement before he reached 65. He was given in recognition of prior services rendered a non-transferable annuity that would begin to pay when he reached 65 in 1958 )or to his designated beneficiary if he died), for which the company paid a premium of $5,000 and deducted as compensation to Drescher. The policy had no cash surrender value. It was only a guaranteed future income stream for himself or his beneficiary. Issue: What is the includable income value of the annuity in the present tax year? Is it the price of the premium paid by the company ($5,000), or is it zero because the annuity gives the taxpayer no present income? Held:

The main distinction between the two scheme is that in general scheme, shares are not forfeitable under any circumstance whereas in the incentive scheme the shares and any accumulated DRP shares will be forfeited if the employee resigns or is dismissed before the end of the three year restriction period; that however, if the employee retires or is made redundant, the shares will not be forfeited; that they will be transferred to him following termination of employment. Issue/Query: 1. W/N shares granted under the ANZ ESAP Plan which are subject to disposal restriction and forfeiture clause (the latter applies to ESAP shares under incentive scheme) at the time of grant shall not be taxed until the disposal restriction is lifted. 2. W/N dividends from ANZ ESAP shares which are mandatorily reinvested through the ANZ Dividend Reinvestment Plan (DRP), with the same disposal restrictions and/or forfeiture clauses as the original shares, shall not also be taxed until the disposal restriction is lifted. HELD: In both instances NOT TAXABLE until disposal restriction of three years is lifted. 1. Section 32(A)(l) of the Tax Code of 1997, provides that the term "gross income" includes compensation for services in whatever form paid including, but not limited to, fees, salaries, wages, commissions, and similar items. On the other hand compensation is defined under Section 2.78. (A) of Revenue Regulations (RR) No. 2-98 as "all remuneration for services performed by an employee for his employer under an employer-employee relationship, unless specifically excluded by the Code". The regulations further provides that compensation may be paid in money or in some medium other than money, as for example, stocks, bonds or other forms of property. The shares granted pursuant to an employer-employee relationship under the ANZ ESAP Plan which are subject to disposal restriction and forfeiture clause at the time of grant shall not be taxed until the disposal restriction is lifted, that is, for a period of three years from the date the shares are awarded or the termination of employment with ANZ in case of the general scheme and a period of three years from the date the shares are awarded in the case of the incentive scheme whichever is earlier, as the same will only be taxable when actually or constructively received. (Section 2.83.6 of RR 2-98) Sec. 2.83.6. Applicability of constructive receipt of compensation. The withholding tax on compensation shall apply to compensation actually or constructively paid. Compensation is constructively paid within the meaning of these Regulations when it is credited to the account of or set apart for an employee so that it may be drawn upon by him at any time although not then actually reduced to possession. To constitute payment in such a case, the compensation must be credited or set apart for the employee without any substantial limitation or restriction as to time or manner of payment or condition upon which payment is to be made, and must be made available to him so that it may be drawn upon at any time, and its payments brought within his control and disposition. A book entry, if made, should indicate an absolute transfer

from one account to another. If the income is not credited, but it is set apart, such income must be unqualifiedly subject to the demand of the taxpayer. Where a corporation contingently credits its employees with a bonus stock, which is not available to such employees until some future date, the mere crediting on the books of the corporation does not constitute payment. (Emphasis supplied). 2. With respect to dividends, the same, should be recognized on the date of declaration, the date on which the payment of dividends is approved. The reason is that when dividends are declared, the stockholder has already the right thereto so much so that if the stocks are subsequently sold, the sales price normally includes the accrued dividends. Once a dividend has been declared, a legal liability binding on the corporation is created. However, stock dividends whether of the same class or different are not income. The reason is that there is no distribution of the assets of the corporation. The stock dividends create only a change in the composition of the stockholders' equity, that is, a transfer from retained earnings to capital stock.

b. Forced Consumption: Convenience of the Employer Rule

Sec. 2.78.1(A)(2), Rev. Regs. 2-98 (April 17, 1998) SECTION 2.78.1. Withholding of Income Tax on Compensation Income. (A) Compensation Income Defined. In general, the term "compensation" means all remuneration for services performed by an employee for his employer under an employer-employee relationship, unless specifically excluded by the Code. The name by which the remuneration for services is designated is immaterial. Thus, salaries, wages, emoluments and honoraria, allowances, commissions (e.g. transportation, representation, entertainment and the like); fees including director's fees, if the director is, at the same time, an employee of the employer/corporation; taxable bonuses and fringe benefits except those which are subject to the fringe benefits tax under Sec. 33 of the Code; taxable pensions and retirement pay; and other income of a similar nature constitute compensation income. The basis upon which the remuneration is paid is immaterial in determining whether the remuneration constitutes compensation. Thus, it may be paid on the basis of piece-work, or a percentage of profits; and may be paid hourly, daily, weekly, monthly or annually. Remuneration for services constitutes compensation even if the relationship of employer and employee does not exist any longer at the time when payment is made between the person in whose employ the services had been performed and the individual who performed them. xxx

(2) Living quarters or meals. If a person receives a salary as remuneration for services rendered, and in addition thereto, living quarters or meals are provided, the value to such person of the quarters and meals so furnished shall be added to the remuneration paid for the purpose of determining the amount of compensation subject to withholding. However, if living quarters or meals are furnished to an employee for the convenience of the employer, the value thereof need not be included as part of compensation income. Sec. 2, Rev. Audit Mem. Order 1-87 (April 23, 1987) 2. Housing and Meals 2.1 If an employee receives a remuneration for services salaries and/or allowances and in addition thereto living quarters and/or meals, the value to such person of the quarters and meals so furnished shall be added to the remuneration otherwise paid for the purpose ofdetermining the amount of compensation subject to withholding tax. 2.2 The value of lodging furnished to an employee by or on behalf of the employer shall be excluded from the employee's gross income, if the lodging is furnished in the business premises of the employer; and the employee is required to accept such lodging as a condition of his employment. 2.3 The value of meals furnished to an employee by or on behalf of his employer shall be excluded from the employee's gross income if the meals are furnished on the business premises of the employer and the meals are furnished for the convenience of the employer. Meals furnished without charge to an employee as regarded as furnished for the convenience of the employer where they are furnished to the employee during his work day to have the employee available for work during his meal period. 2.4 Business premises of the employer means the place where the employee performs a significant portion of his duties or where the employer conducts a significant portion of his business. In case of doubt, the criteria to be used shall be (a) time, more than 50% of the employee's work time or (b) value of business, more than 50% of the production of the said employee. 2.5 Notwithstanding the provisions of the preceding paragraphs, if an employee is provided by his employer with company housing or living quarters outside the business premises, and such employee, because of his position in the employercompany, also uses said house or living quarters for the benefit of the latter, like entertaining and putting up houseguests and guest of the employer-company, then fifty percent (50%) of such allowance, rental value, or depreciation if the living quarters are owned by the employer, shall be added to the compensation paid to such employee and be subject to the withholding tax on wages. The employer may deduct the said housing expense as a business expense. 2.6 Privileges such as "courtesy discounts" on purchases of company merchandise

of a value not to exceed 1/2 basic month's salary of an employee or an officer shall not be added to the remuneration of the employee. 2.7 Entertainment of and gifts to company officers and employees shall not be a deductible expense except for Christmas and major anniversary celebrations (e.g. 25th year of company's establishment), sports tournament, company picnics not to exceed one a year provided that the value of the gift when it is not a service award for length of service shall not exceed in value of ! month's of the basic salary of the employee receiving the gift. Benaglia v. CIR 36 B.T.A. 838 (1937) Convenience of the Employer Rule Facts: The petitioner (Benaglia) managed hotels in Honolulu. He and his wife occupied a suite and received meals at and from the hotel, but did not report their value in his income. The respondent (Commissioner) added $7,845 each year to petitioners gross income as compensation from Hawaiian Hotels, Ltd. arguing that the said amount was the fair market value of rooms and meals furnished by the employer. The Commissioners position was that the cost of meals and lodging were compensation and should be included in petitioners taxable income. Issue: W/N the residence and meals at the hotel were compensation and therefore part of petitioner's gross income for which he could be taxed. Ruling: No. Ratio: The petitioner lived at the hotel solely because he could not otherwise perform the services required of him. The occupation of the premises was imposed upon him for the benefit of the employer. This is not to say, however, that anytime an employee is fed or lodged by the employer that it is automatically not taxable income. The court also looked at the intent of the parties and decided the employer never intended the room and board to form part of his compensation. In sum, a taxpayer employee may exclude the value of food and lodging received from his employer, if he receives it solely for the convenience of his employer and as a necessary incident of the proper performance of his duty.

Dissent: The living quarters and meals were included in a letter forming the employment contract and therefore was intended to be compensation. Petitioner was relieved of having to pay for lodging and meals, therefore he was enriched. The majority thinks the question is one of convenience, but the real issue is whether the petitioner benefited financially. If it was necessary to live on the premises, occupancy at the Moana (another hotel owned by Hawaiian Hotels) would have been equally essential, yet he did not have living quarters or meals there. c. De Minimis Benefits Sec. 2.78.1 (A) (3), Rev. Regs. 2-98 (April 17, 1998) (3) Facilities and privileges of a relatively small value. Ordinarily, facilities and privileges (such as entertainment, medical services, or so called "courtesy" discounts on purchases), furnished or offered by an employer to his employees generally, are not considered as compensation subject to withholding if such facilities or privileges are of relatively small value and are offered or furnished by the employer merely as a means of promoting the health, goodwill, contentment, or efficiency of his employees. Where compensation is paid in property other than money, the employer shall make necessary arrangements to ensure that the amount of the tax required to be withheld is available for payment to the Commissioner. BIR Rul. 23-02 (June 21, 2002) De minimis benefits facilities or privileges furnished or offered by an employer to his employees that are relatively small value and offered or furnished by the employer merely as a means of promoting the health, goodwill, contentment, or efficiency of his employees, and as such, they are subject to neither compensation income tax nor fringe benefits tax. They are, therefore, not subject to withholding tax as well. Facts: *Background information in case Bello asks. Skip to issues for quick read. Sodexho Pass International (Sodexho) is a French service company engaged in operating innovative systems (the issuance of service vouchers) to manage employee benefits given by private companies, national government agencies, etc. Sodexho proposes to introduce administration of food and rice subsidy benefits given by Philippine employers to their employees through the following procedures: 1. Client company transfers to Sodexho the amount allotted for its employees' annual or monthly meal and food allowance and/or rice subsidy with instructions on the amount to be allotted per employee in conformity with a de minimis threshold that would be established;

2. Sodexho issues meal and food vouchers (intended for each employee with the value allotted for the respective employee's benefit per working day) and delivers the same to the client company. The face value of the vouchers shall be equivalent to the amount transferred by the client company to Sodexho; 3. Client company distributes the vouchers to its employees; 4. Employee uses these vouchers for meals and/or food at an accredited establishment (e.g., restaurant/food outlet) of his choice; 5. Accredited outlet sends back used vouchers to Sodexho for reimbursement; 6. Sodexho reimburses the store/outlet. Issues: Counsel for Sodexho sought confirmation from the Commissioner of the following opinions: 1. That meal and food benefits provided by client companies through Sodexho meal and food vouchers may be considered tax-exempt benefits; 2. That a meal and food allowance of no more than Php100.00 per day is considered de minimis benefit; and 3. That de minimis rice allowance of Php1,000 per month given to the employees may be aggregated with the meal allowance through Sodexho meal and food vouchers and shall still be exempt from both withholding tax on compensation and fringe benefit tax. Ruling: The meal and food benefits provided by the client-companies to their employees through Sodexho meal and food vouchers may be considered tax-exempt benefits. The meal and food benefits provided to their employees by client companies through Sodexho meal and food vouchers may be tax-exempt, subject to: (a) the standards set for de minimis thresholds for fringe benefits. (See Revenue Regulations No. 3-98, as amended by Revenue Regulations No. 8-2000 and 10-2000 for the list. Not an assigned reading but you may want to check.); and (b) the conditions set for the benefits to be exempt pursuant to the tests of convenience of the employer and the promotion of health, goodwill, contentment, or efficiency of the employees. (See Sec. 2-78.1(A)(2) and (3) of Revenue Regulations No. 2-98, as amended by Revenue Regulations No. 8-2000 and 10-2000. These is an assigned reading.) 2. The meal and food allowance, although not for overtime work, is considered de minimis if it does not exceed 25% of the basic minimum wage. 1.

Meal and food benefits not exceeding 25% of the daily minimum wage may be considered de minimis meal benefit and therefore, tax exempt. The excess over this amount shall be considered other benefits as contemplated under Section 32(B)(7)(e)(iv) of the Tax Code of

1997. The excess of the meal and food allowance given over the de minimis ceiling shall still be exempt provided that it, together with the total amount of other benefits, shall not exceed Php30,000. 3. The rules and regulations on de minimis benefits do not allow aggregation of the amounts set for each type of benefit.

No. Ratio: Lets cut the crap and skip to what we need. So here are the rules laid down in this case, summarized: (a) If a taxpayer who travels to a destination engages in both "business and personal activities," the traveling expenses are deductible only if the trip is "related primarily" to the taxpayer's business. If "primarily personal", the traveling expenses are not deductible even though the taxpayer engages in some business there. (b) Whether a trip is related primarily to the taxpayer's business or is primarily personal in nature depends on the facts and circumstances in each case. (c) The deductibility of the expenses of a taxpayer's wife who accompanies her husband depends, first, on whether his trip is a "business trip". If so, it must further be shown that the wife's presence on the trip also had a bona fide business purpose. Taking into consideration all the facts of the case, J. Harlan affirmed the finding of the District Court that the value of the trip being "in the nature of a bonus, reward, and compensation for a job well done," was income to Rudolph, and being "primarily a pleasure trip in the nature of a vacation," the costs were personal and nondeductible.

There can be no aggregation of the values set for each item of benefit stated in Revenue Regulations Nos. 2-98 and 3-98, as amended by Revenue Regulations Nos. 8-2000 and 102000. The intent of the Regulations is to treat each item of de minimis benefits independently of each other. The Regulations separately provide maximum values for rice allowance and for meal allowance. Accordingly, there can be no aggregation of de minimis values for rice and meal and food benefits through Sodexho meal and food vouchers. In order to clearly conform with prescribed de minimis standards, therefore, separate vouchers should be used for the rice allowance and the meal and food benefit. d. Travel and Entertainment Rudolph v. U.S. 370 U.S. 269 (1962) Facts: An insurance company paid the expenses of a group of its agents and their wives, including petitioner Rudolph and his wife, to New York City to attend an annual convention. The Commissioner assessed the value of the trip to petitioners as taxable income. Petitioners contend that expenses for and during the trip were business-related and therefore deductible. In a suit for refund, the District Court found that the trip was provided by the company primarily for the purpose of affording a pleasure trip in the nature of a bonus, reward, and compensation and that, from the point of view of petitioners, it was primarily a pleasure trip and that, therefore, the value of the trip was income and the costs were personal and nondeductible. The Court of Appeals approved these findings. Issue: W/N the expenses (i.e. the outlay for transportation, meals, and lodging) for the trip were deductible by petitioners as an "ordinary and necessary" business expense. Ruling: (NOTE: The Supreme Court dismissed the petition for certiorari based on the clearly erroneous doctrine, an American civil procedure rule. The majority did not go into the merits. The ruling and ratio relevant to Taxation are taken from the separate concurring opinion of J. Harlan.)

2. Business Income

3. Gains 4. Interest 5. Rents 6. Royalties

7. Dividends Sec. 73 Sec. 250-256, Rev. Regs. 2 Wise & Co., Inc. v. Meer (June 30, 1947) CIR v. CA (Jan. 20, 1999) CIR v. Manning (Aug. 6, 1975)

BIR Rul. 39-02 (Nov. 11, 2002) 8. Annuities 9. Prizes and winnings 10. Pensions 11. Share in GPPs Income Sec. 26 B. Exclusions Sec. 32(B) 1. Gifts, Bequests and Devises Sec. 32(B)(3) CIR v. Duberstein 363 U.S. 278 (1960) Hornung v. CIR supra 2. Compensation for Injuries or Sickness Sec. 32(B)(4) OGilvie v. U.S. 519 U.S. 79 (1996) Murphy v. U.S. No. 05-5139 (D.C. Cir. Aug. 22, 2006) Murphy v. U.S. No. 05-5139 (D.C. Cir. July 3, 2007) (on rehearing) BIR Rul. 57-83 (April 12, 1983) 3. Retirement Benefits, Pensions, Gratuities, etc. Sec. 32(B)(6) and (7)(e) Rep. Act No. 4917 (June 17, 1967) Rep. Act No. 7833 (Dec. 8, 1994)

CIR v. CA (March 23, 1992) CIR v. CA (Oct. 17, 1991) In Re: Atty. Bernardo Zialcita A.M. No. 90-6-015-SC (Oct. 18, 1990) BIR Rul. 1-95 (Jan. 6, 1995)

Rev. Regs. 2-95 (Jan. 3, 1995) RMC 36-94 (Dec. 14, 1994)

!
Sec. 32(B)(7)(a)

4. Income Derived by Foreign Government

CIR v. Mitsubishi Metal Corp. (Jan. 22, 1990) 5.Gains from the Sale of Bonds, Debentures or Other Certificates of Indebtedness Sec. 32(B)(7)(g) Nippon Life Ins. Co., Inc. v. CIR CTA Case No. 6142 (Feb. 4, 2002)

IV. DEDUCTIONS Sec. 34 Sec. 36(A) Secs. 119 to 120, Rev. Regs. 2 A. Expenses Sec. 34(A)

1. Non-Deductible Personal Expenses v. Deductible Business Expenses Smith v. CIR 40 B.T.A. 1038 (1939) Pevsner v. CIR 628 F.2d 467 (5th Cir. 1980) Rudolph v. U.S. Supra Schultz v. CIR 16 T.C. 401 (1951) 2. Travel Expenses While Away from Home CIR v. Flowers 326 U.S. 465 (1946) Hantzis v. CIR 638 F.2d 248 (1st Cir. 1981) 3. Deductible Current Expenses v. Non-Deductible Capital Expenditures Mt. Morris Drive-In Theatre Co. v. CIR 25 T.C. 272 (1955) Midland Empire Packing Co. v. CIR 14 T.C. 635 (1950) INDOPCO, Inc. v. CIR 503 U.S. 79 (1992) CIR v. General Foods (Phil.), Inc. (April 24, 2003) 4. Ordinary and Necessary Welch v. Helvering 290 U.S. 111 (1933) Atlas Consolidated Mining & Devt Corp. v. CIR (Jan. 27, 1981) 5. Reasonable Compensation C.M. Hoskins & Co., Inc. v. CIR (Nov. 28, 1969) D. Losses 1.Casualty losses Sec. 34(D)(1), (2) 2. NOLCO Sec. 34(D)(3) C. Taxes Section 34(C) 1. Interest arbitrage B. Interest Sec. 34(B)

Kuenzle & Streiff, Inc. v. Collector (Oct. 20, 1959) 6. Period for Which Deductions and Credits Taken Sec. 45 CIR v. Isabela Cultural Corp. (Feb. 12, 2007)

Paper Ind. Corp. of the Phil. v. CA (Dec. 1, 1995) CIR v. Vda. de Prieto (Sept. 30, 1960) Rev. Regs. 13-2000 (Nov. 20, 2000)

BIR Rul. No. 006-00 (Jan. 5, 2000)

CIR v. Lednicky (July 31, 1964)

Paper Ind. Corp. of the Phil. v. CA supra