Art. 1278.

Compensation shall take place when two persons, in their own right, are creditors and debtors of each
other.
What is compensation?
It is the extinguishment to the concurrent amount of the debts of two persons who, in their own rights are debtors and
creditors of each other. Manresa defines compensation as a sort of balancing two obligations simultaneously or to
extinguish them to the extent in which the amount of one is covered by the other.
This compensation is sometimes called abbreviated or simplified payment, because the two debts are extinguished
without the transfer of money or property from one party to the other.
Object and importance of compensation
Prevention of unnecessary suits and payment thru the mutual extinction by operation of law of concurring debts.
1. Compensation is a specie of abbreviated payment, which gives to each of the parties a double advantage:
a. Facility of payment- avoids the employment of enumeration
b. Guaranty for the effectiveness of the credit, if one of the parties pays without waiting to be paid by the
other, he could be made a victim of fraud or insolvency.
2. It supposes a more convenient and less expensive realization of two payments, it is often called simplified
payment.
3. Economic utility, its advantages for credit and for saving the use of money in transactions.
4. Guaranty against fraud, assuring the enforcement of some credits which otherwise may not be enforced.
Compensation distinguished from Payment
a. In compensation, partial payment is always permitted while in payment, it must be complete and indivisible as a
rule.
b. In compensation, the mode may take place by operation of law while in payment, it involves action or delivery
of the amount paid (act of the parties)
c. In compensation, it is not required that the parties have the capacity to give or to receive , as the case may be,
while in order that there may be a valid payment, the parties must have the free disposal of the thing due and
capacity to alienate it and to receive payment.
Compensation distinguished from merger
a. As to the number of persons:
In confusion, there is only one person in whom is merged the qualities of creditor and debtor.
In compensation, there must be two persons who are mutually creditor and debtor of each other.
b. As to the number of obligations:
In confusion, there can be only one.
In compensation, there must be two.
Compensation distinguished from counterclaim or set-off
A set-off or counterclaim must be pleaded to be effectual, whereas compensation takes place by mere
operation of law and extinguishes the two debts reciprocally.
Kinds or Classes of Compensation
a. As to the effects
Total- both obligations are completely extinguished because they are of the same or equal amount
Partial- when a balance remains. The extinctive effect of compensation will be partial only as regards the
larger debt.
b. As to origin
Legal- by operation of law
Voluntary or conventional- by agreement of the parties
Judicial (also termed set-off)- it must be pleaded, decreed by the court, in case where there is
counterclaim
Facultative- One of the parties has the choice of claiming the compensation or of opposing it. One party
can claim compensation, the other cannot.
Concept of facultative compensation
This is a compensation which can be set up only at the option of a creditor, when legal compensation cannot take place
because one or some elements are missing. While this creditor can oppose compensation, he renounces it, but he
himself can compensate.
Compensation against the government
1. Taxes- they are not in the nature of contracts and are not subject to set-off or compensation.
REASON: the government and the taxpayer are not creditors and debtors of each other.
2. Contractual obligations- they may be compensated, however, in view of rules or regulations relating to public
finance, both claims must involve the same office, agency or subdivision of the government.
Art. 1279. In order that compensation may be proper, it is necessary:
(1) That each one of the obligors be bound principally, and that he be at the same time a principal creditor of the
other;
(2) That both debts consist in a sum of money, or if the things due are consumable, they be of the same kind, and also
of the same quality if the latter has been stated;
(3) That the two debts be due;
(4) That they be liquidated and demandable;
(5) That over neither of them there be any retention or controversy, commenced by third persons and communicated
in due time to the debtor. (1196)
Legal compensation or compensation by operation of law
The requisites enumerated are those for LEGAL compensation; voluntary compensation in general requires no requisite
except that the agreement be voluntarily and validly entered into.
Negative Requisites
a. That over neither of them there be any retention or controversy, commenced by third persons and
communicated in due time to the debtor -There can be no legal compensation when ones claim against
another is still the subject of court litigation (par. 5).
b. There must have been no waiver of the compensation.
c. The compensation of debts must not have been prohibited by law.
Compensation of the debts arising following are prohibited:
1. Depositum (XPN: bank deposits, which are by law considered as loans to the bank)
2. Obligations of a depositary
3. Obligations of a bailee in commodatum
4. Claim for future support due by gratuitous title
5. Civil liability arising from a penal offense
6. Damages suffered by a partnership thru the fault of a partner cannot be compensated with profits and
benefits which he may have earned for the partnership by his industry.
Affirmative Requisites
1. That both the obligors be bound principally, and that they be at the same time a principal creditor of the other.
a. There must be a relationship of debtor and creditor
b. There must be two debts and two credits
c. They must generally be bound as principals (and not in their representative capacity such as guardians,
guarantor, however a guarantor may set up compensation as regards what the creditor may owe the
principal debtor, the rationale behind that is if the principal obligation is extinguished, the accessory
obligation of guaranty is also extinguished).
2. That both debts consist in a sum of money, or if the things due are consumable, they be of the same kind, and
also of the same quality if the latter has been stated;
Consumable must be taken to mean fungible which pertains to things susceptible of substitution, if
such be the intention.
In case of generic things there can be compensation, while in specific things there can be no
compensation.
10 sacks of rice cannot be compensated by 10 sacks of corn since they are not of the same kind.
3. That the two debts be due
Due- period has arrived or the condition has been fulfilled.
Demandable- may refer to the fact that neither of the debts has prescribed, or that the obligation is not
invalid or illegal.

Example: D owes C 10,000 due on June 30, while C owes D 10,000 due on June 15. One June 15, is there
legal compensation? None, because one of the debts is not yet due. However there can be voluntary
compensation upon agreement.
4. That they be liquidated and demandable
If one of the debts has prescribed, there can be no compensation because the debt is no longer
demandable.
Liquidated debts are those where the exact amount has already been determined. But once
liquidated by a judgment, however, a set-off asked for in a counterclaim would be proper.
Compensation only takes place if both obligations are liquidated and it cannot take place if ones
claim against the other is still the subject of court litigation.
Negative Requisites
That over neither of them there be any retention or controversy, commenced by third persons and communicated in
due time to the debtor
In such cases, any possible compensation is in the meantime suspended.
Art. 1280. Notwithstanding the provisions of the preceding article, the guarantor may set up compensation as regards
what the creditor may owe the principal debtor.
Guarantor may set up compensation with respect to the principal debt.
a. This is an exception to art. 1279 par. 1, because a guarantor is subsidiarily, not principally, bound.
b. Reason: extinguishment of the principal obligation extinguishes the guaranty.
Example: D owes C 10,000 guaranteed by G. C owes D 8,000. On the due date D is insolvent. How much is the
liability of G?
G, the guarantor is only liable for 2,000 because the law states that the guarantor in an obligation may set up
compensation as regards what the creditor owes the principal debtor.
Example: D owes C 10,000. X is the guarantor of D in another obligation. C owes X 10,000. When C sues D for 10,000,
may D successfully put up the defense of compensation, after all C is indebted to X, his guarantor?
No, because X is not bound in his own right and D is not a creditor of C.
Art. 1281. Compensation may be total or partial. When the two debts are of the same amount, there is a total
compensation. (n)
Total or partial compensation
When the debts are of the same amount there is total compensation, if not of the same amount, there is partial
compensation.
Art. 1282. The parties may agree upon the compensation of debts which are not yet due.
Debts which are not due or demandable cannot be compensated, but the parties may compensate them voluntarily and
this is called conventional or voluntary compensation.
The requisites mentioned in Art. 1279 do not apply.
It is sufficient in conventional compensation that the agreement or contract which declares the compensation should
itself be valid; thus among other things, the parties must have legal capacity and must freely give their consent
Requisites:
1. Each of the parties has the right to dispose of the credit he seeks to compensate
2. They agree to the mutual extinguishment of their credits
Art. 1283. If one of the parties to a suit over an obligation has a claim for damages against the other, the former may
set it off by proving his right to said damages and the amount thereof.
a. This pertains to judicial compensation or set-off. Pleading and proof of the counterclaim must be made.
b. Requisites mentioned in 1279 must be present, except that at the time of pleading, the claim need not yet be
liquidated. The liquidation or the fixing of the proper sum must be made in the proceedings.
c. Unless pleading and proof are made, the court cannot of its own accord declare the compensation. The
compensation takes place by the judgment, as to the date the compensation was pleaded.
Art. 1284. When one or both debts are rescissible or voidable, they may be compensated against each other before
they are judicially rescinded or avoided.
Rescissible or voidable debts can be compensated, provided that they are not yet declared or rescinded or void. This is
because rescissible and voidable debts are valid and binding until cancelled or declared void.
Example:
D owes C 10,000.
Subsequently, D forced C to sign a promissory note stating that C is indebted to D for 10,000.
The day after the transaction took place, and assuming that the other requisites of compensation are present, can D
claim compensation?
Yes, because voidable and rescissible contracts can be compensated before they are judicially declared rescinded or
void.
Prevention of Unfairness
To avoid unfairness if rescission or annulment is later on decreed by the court, it is as if No compensation ever took
place. The decree acts retroactively and the compensation that has taken place will be cancelled.
Art. 1285. The debtor who has consented to the assignment of rights made by a creditor in favor of a third person,
cannot set up against the assignee the compensation which would pertain to him against the assignor, unless the
assignor was notified by the debtor at the time he gave his consent, that he reserved his right to the compensation.
If the creditor communicated the cession to him but the debtor did not consent thereto, the latter may set up the
compensation of debts previous to the cession, but not of subsequent ones.
If the assignment is made without the knowledge of the debtor, he may set up the compensation of all credits prior to
the same and also later ones until he had knowledge of the assignment. (1198a)
Effect of Assignment on Compensation of Debts
Under art. 1290 when all the requisites mentioned in Art. 1279 are present, compensation takes effect by operation of
law, and extinguishes both debts to the concurrent amount, even though the creditors and debtors are not aware of the
compensation. Hence, compensation takes place automatically or ipso facto.
If after compensation has taken place one of the extinguished debts is assigned to a stranger, ordinarily this would be a
useless act since there is nothing more to assign. The defense of compensation could then be set up.
XPN: when the assignment (after compensation has already taken place) was made with the consent of the debtor. Such
consent operates as a waiver of the rights to compensation.
XPN to the XPN: at the time he gave his consent, he reserved his right to the compensation.
Example: (When compensation has taken place before assignment)
A owes B 3000
B owes A 1,000 due also yesterday.
Both debts are extinguished up to the amount of 1,000. A still owes B 2,000.
If B assigns his rights to C the latter can collect only 2,000 from A.
In case A gave his consent to the assignment before it was made or subsequently. A loses the right to set up the defense
of compensation. So A will be liable to C for 3,000 but he can still collect the 1,000 owed by B. In this case, the
compensation shall be deemed not to have taken place.
Reason for the Article
Prevention of fraudulent deprivation of the benefits of total and partial compensation.
Art. 1285 speaks of three cases of compensation which takes place after an assignment of rights made by the creditor.
Three cases Covered by the Article
1
st
Case- The Assignment may be made with the consent of the debtor
Effect: Compensation cannot be set up because there has been consent and, therefore a waiver.
XPN: If the right to the compensation (that has already taken place) is reserved.
Example:
A owes B 3,000 due on Nov. 15
B owes A 1,000 due on Nov. 15
B assigned his right to C on Nov. 1 with the consent of A.
On Nov. 15, A cannot set up against C, the assignee, which would pertain to him against B, the assignor. In other
words, A is liable to C for 3,000 but he can still collect the 1,000 from B.
However, if A, while consenting to the assignment, reserved his right to the compensation, he would be liable
only for 2,000 to C.
2
nd
Case- Assignment made with the knowledge but without the consent or against the will of the debtor
Effect: Compensation can be set up regarding debts previous to the cession or assignment. This refers to debts maturing
before the assignment (before the notice); hence here, legal compensation has already taken place.
Example:
A owes B 1,000 due Nov. 1
B owes A 2,000 due Nov. 10
A owes B 1,000 due Nov. 15
A assigned his right to C on Nov. 12. A notified B but the latter did not give his consent to the assignment.
B can set up the compensation of debts on Nov. 10 which was before the cession on Nov. 12. There being partial
compensation, the assignment is valid only up to the amount of 1,000.
B cannot raise the defense of compensation with respect to the debt of A due on Nov. 15 which has not yet
matured. So on Nov. 12, B is liable to C for 1,000 and on Nov. 15 A will be liable for his debt of 1,000 to B.
3
rd
case- Assignment made without the knowledge of the debtor
Effect: Debtor can set up compensation as a defense for all debts maturing prior to his knowledge of the assignment
(whether the debts matured before or after the assignment). The crucial time here is the time of knowledge of the
assignment and not the time of assignment itself.
A owes B 1,000 due Nov. 1
B owes A 2,000 due Nov. 10
A owes B 1,000 due Nov. 15
The assignment was made without the knowledge of B who only learned of it on Nov. 16
Here, B can set up the compensation of credits before and after the assignment. The crucial time is when B
acquired knowledge of the assignment and not the date of the assignment. If B learned of the assignment after the
debts has matured, he can raise the defense of compensation, otherwise he cannot.

Art. 1286. Compensation takes place by operation of law, even though the debts may be payable at different places,
but there shall be an indemnity for expenses of exchange or transportation to the place of payment. (1199a)
Compensation by operation of law
a. Applies to compensation by operation of law
b. Indemnity for expenses of transportation (transportation of goods or of the object)
c. Indemnity for expenses of exchange (monetary exchange, in case the debts are money debts)
When the requisites as stated in Article 1279 are present, there is automatic compensation even if the two debts are
payable at different places. However, there shall be an indemnity for expenses of exchange or transportation to the
place of payment.
Example:
D obliged himself to deliver to C a horse at Pampanga on June 15
C is also obliged to deliver to D a horse at Tarlac on June 15
Both are residents of Manila
Fare from Pampanga to Manila is 150, while that to Tarlac is 250
In this case, the obligations of both parties are extinguished, but C is to give D 100, the difference of the transportation
of expenses.
Art. 1287. Compensation shall not be proper when one of the debts arises from a depositum or from the obligations
of a depositary or of a bailee in commodatum.
Neither can compensation be set up against a creditor who has a claim for support due by gratuitous title, without
prejudice to the provisions of paragraph 2 of Article 301. (1200a)
Art. 1288. Neither shall there be compensation if one of the debts consists in civil liability arising from a penal offense.
(n)
Instances when legal compensation cannot take place:
a. When one debt arises from a depositum (does not cover bank deposit for this is really a loan, governed by the
contract of loan and not by a contract of deposit, the depositor is the creditor while the bank is the debtor)
GR: A bank has a right to set-off the deposits in its hands for the payment of any indebtedness to it on
the part of a depositor. Likewise, a depositor has every right to set-off his money deposit with a bank
against the loans he obtained from a bank.

b. When one debt arises from the obligations of a depositary- the depositor is given the right to claim
compensation.

c. When one debt arises from the obligations of a bailee in commodatum- the lender may claim compensation; the
borrower is not allowed to do so.

Commodatum is a gratuitous contract whereby one of the parties delivers to another something not
consumable so that the latter may use the same for a certain time and return it. Such as lending a ring, the
person who borrowed the ring cannot refuse to return it and set up compensation, however the person who
lent the ring can assert compensation of the value of the ring against the credit of the borrower.

In the three instances provided since the depositor and lender have an option to claim or not to claim
compensation, these are instances of facultative compensation.

d. When one debt arises because of a claim for support due to gratuitous title- support in arrears may be
compensated but not future support, for this is vital to the life of the recipient.

e. When one of the debts consists in civil liability arising from a penal offense- the offended party can claim the
right of compensation. The prohibition only pertains to the accused and not the victim.
Reasons for the prohibition
Contract of deposit and commodatum are based on confidence and trust, it is but natural that the depositary (in
contract of deposit) and the borrower (in commodatum) must perform their obligation, otherwise, the trust or
confidence of the depositor or lender would be violated.
Future support cannot also be compensated because this is given for the benefit of the recipient. Otherwise, he will be
exposed to misery and starvation. Support in arrears, however can be compensated.
Art. 1289. If a person should have against him several debts which are susceptible of compensation, the rules on the
application of payments shall apply to the order of the compensation. (1201)
Rules on application of payments applicable to order of compensation
Compensation is similar to payment. If a debtor has various debts which are susceptible of compensation, he must
inform the creditor which of them shall be the object of compensation. In case he fails to do so, then the compensation
shall be applied to the most onerous obligations as found in Arts. 1252 and 1254.
Art. 1290. When all the requisites mentioned in Article 1279 are present, compensation takes effect by operation of
law, and extinguishes both debts to the concurrent amount, even though the creditors and debtors are not aware of
the compensation. (1202a)
There is automatic compensation if all requisites are present
a. Legal compensation takes place automatically unless there has been valid waiver thereof
b. Compensation which extinguishes the principal obligations also extinguishes accessory obligations
c. To the concurrent amount means that if one debt is larger than the other, the balance subsists as debt.
Compensation occurs automatically by mere operation of law
Takes places automatically even in the absence of agreement between the parties and even against
their will, and extinguishes reciprocally both debts as soon as they exist simultaneously, to the amount
of their respective sums.
Full legal capacity of parties not required