Commissioner of Internal Revenue v. Manning

Corporate earnings used to purchase a deceased stockholder's shares, which were then distributed to surviving stockholders as purported "treasury stock dividends," constitute taxable income to the surviving stockholders, and the nullity of the corporate resolution authorizing such distribution does not exempt the recipients from income tax, fraud penalty, or interest charges.

MANTRASCO (Manila Trading and Supply Co.) had an authorized capital stock of ₱2,500,000 divided into 25,000 common shares. Julius S. Reese owned 24,700 shares, while the three private respondents — John L. Manning, W.D. McDonald, and E.E. Simmons — owned 100 shares each. Reese desired that upon his death, MANTRASCO and its two subsidiaries, MANTRASCO (Guam), Inc. and Port Motors, Inc., would continue under the respondents' management, prompting the execution on February 29, 1952 of a trust agreement among Reese (as OWNER), MANTRASCO (as COMPANY), the law firm of Ross, Selph, Carrascoso and Janda (as TRUSTEES), and the respondents (as MANAGERS). The trust agreement provided that upon Reese's death, MANTRASCO would purchase Reese's shares at book value, with dividends on those shares to be credited as payments on the purchase price.

On February 29, 1952, Julius S. Reese, who owned 24,700 of MANTRASCO's 25,000 common shares, and the three private respondents — John L. Manning, W.D. McDonald, and E.E. Simmons — who owned 100 shares each, executed a trust agreement with MANTRASCO and the law firm of Ross, Selph, Carrascoso and Janda as trustees. The agreement was prompted by Reese's desire that upon his death, MANTRASCO and its subsidiaries would continue under the respondents' management. Under the agreement, all parties deposited their shares with the trustees. Upon Reese's death, MANTRASCO was obligated to purchase Reese's shares at book value, with dividends paid on those shares to be credited as payments on the purchase price. The trustees were authorized to vote all stock standing in their names, to approve the declaration of dividends and the amount of earnings transferred to surplus, and to designate corporate directors. The companies were prohibited from paying dividends except as authorized by the trustees.

Reese died on October 19, 1954. The projected transfer of his shares in the name of MANTRASCO could not be immediately effected for lack of sufficient funds to cover the initial payment. On February 2, 1955, after MANTRASCO made a partial payment on Reese's shares, the certificate for the 24,700 shares in Reese's name was cancelled and a new certificate was issued in the name of MANTRASCO. On the same date, pending full payment, the new certificate was endorsed to the law firm as trustees for and in behalf of MANTRASCO. From 1956 to 1961, MANTRASCO made periodic payments to Reese's estate, reducing the outstanding liability from ₱5,830,587.86 to ₱3,811,387.69.

On December 22, 1958, at a special meeting of MANTRASCO stockholders, a resolution was passed reverting the 24,700 shares "in the Treasury" back to the capital account of the company as a stock dividend to be distributed to shareholders of record. As of December 31, 1958, the 24,700 shares had been proportionately distributed to the respondents, representing a total book value or acquisition cost of ₱7,973,660. The respondents failed to declare the said stock dividends as part of their taxable income for 1958. On November 25, 1963, the entire purchase price of Reese's interest was finally paid in full, and on May 4, 1964, the trust agreement was terminated and the trustees delivered all shares held in trust to MANTRASCO.

On September 14, 1962, the Bureau of Internal Revenue ordered an examination of MANTRASCO's books. The examination disclosed the distribution of the 24,700 shares and the respondents' failure to declare them as taxable income. The BIR examiners concluded that the distribution was in effect a distribution of corporate assets, as gleaned from the payment of cash for the redemption of the stock and its subsequent distribution as a stock dividend. On April 14, 1965, the Commissioner issued notices of assessment for deficiency income taxes against the respondents for the year 1958, totaling approximately ₱2,430,067.92 for Manning, ₱2,423,767.92 for McDonald, and ₱2,436,729.12 for Simmons, including a 50% surcharge and ½% monthly interest. The respondents challenged the assessments administratively, failed to secure reconsideration, and appealed to the Court of Tax Appeals, which on October 30, 1967 absolved them on the ground that their respective one-third interest in MANTRASCO remained unchanged before and after the declaration of stock dividends.

• Taxability of Stock Dividends as Income: The Commissioner maintained that the full value (₱7,973,660) of the shares redeemed from Reese by MANTRASCO, which were subsequently distributed to the respondents as stock dividends in 1958, should be taxed as income of the respondents for that year, the distribution being in effect a distribution of cash.
• Change in Proportional Interest: The Commissioner argued that the respondents' interests in MANTRASCO were only .4% prior to the declaration of the stock dividends in 1958, but rose to 33⅓% each after the said declaration, demonstrating a substantive change in their equity interest and thus a taxable distribution.

• No Change in Proportional Interest: The respondents anchored their argument on the same basis as the Court of Tax Appeals — that their respective one-third interest in MANTRASCO remained the same before and after the declaration of stock dividends, and only the number of shares held by each of them had changed, thus rendering the distribution non-taxable under the stock dividend exemption.

• Nature of the Shares: Whether the 24,700 shares declared as stock dividends were treasury shares.
• Validity of Stock Dividend Declaration: Whether the declaration of the 24,700 shares as treasury stock dividends was valid.
• Taxability of Corporate Earnings Used to Purchase Shares: Whether the corporate earnings used by MANTRASCO to purchase Reese's shares constituted taxable income to the respondents.
• Propriety of Lump-Sum Assessment: Whether the Commissioner properly assessed the total acquisition cost of the alleged treasury stock dividends in one lump sum.
• Validity of Fraud Penalty and Interest Charges: Whether the fraud penalty and interest charges were properly imposed notwithstanding the nullity of the resolution authorizing the distribution.

• Nature of the Shares: No. The 24,700 shares were not treasury shares at any time before or after December 22, 1958, because the trust agreement treated them as outstanding shares of Reese's estate until fully paid, with the trustees exercising ownership rights over them.
• Validity of Stock Dividend Declaration: No. The declaration of the shares as treasury stock dividends was a complete nullity and plainly violative of public policy, since a stock dividend cannot be declared out of outstanding corporate stock but only from retained earnings.
• Taxability of Corporate Earnings Used to Purchase Shares: Yes. The corporate earnings used to purchase Reese's shares constituted, in ultimate effect, a distribution of earnings to the respondents, and were thus subject to income tax as a flow of cash benefits to the surviving stockholders.
• Propriety of Lump-Sum Assessment: No. The Commissioner erred in assessing the total acquisition cost (₱7,973,660) in one lump sum; the earnings should be taxed for each of the corresponding years when payments were made to Reese's estate, and the respondents' liability should be limited to the aggregate amount paid from 1955 to 1958.
• Validity of Fraud Penalty and Interest Charges: Yes. The nullity of the resolution authorizing the distribution is of no moment, because the Tax Code assesses income tax on income received from any property, activity, or service that produces income, standing as an indifferent, neutral party on the matter of where the income comes from.

• Nature of the Shares: Treasury shares are stocks issued and fully paid for and re-acquired by the corporation either by purchase, donation, forfeiture, or other means. They are issued shares but do not have the status of outstanding shares; while held by the corporation, they participate neither in dividends nor in corporate meetings as voting stock. The essential features of treasury stock were lacking in the questioned shares: under the trust agreement, the trustees were authorized to vote all stock standing in their names (paragraphs 4(c), 26, 28); dividends paid on the shares after Reese's death were subject to the agreement (paragraph 4(d)); the amount of retained earnings to be declared as dividends was subject to trustee approval (paragraph 5(b)); the choice of corporate directors was delegated exclusively to the trustees (paragraph 5(c)); and the companies were prohibited from paying dividends except as authorized by the trustees (paragraph 19). The manifest intention of the parties was to treat the 24,700 shares as absolutely outstanding shares of Reese's estate until fully paid.

• Validity of Stock Dividend Declaration: A stock dividend always involves a transfer of surplus or profit to capital stock; it is a conversion of surplus or undivided profits into capital stock distributed to stockholders in lieu of a cash dividend. Since the 24,700 shares were not treasury shares but outstanding shares of Reese's estate, they could not be declared as stock dividends, which can only be declared out of retained earnings, not out of outstanding corporate stock. The declaration was therefore a complete nullity and violative of public policy.

• Taxability of Corporate Earnings Used to Purchase Shares: The respondents used the trust instrument as a convenient technical device to bestow upon themselves the full worth and value of Reese's corporate holdings with the very earnings of the companies. This package device was not designed to carry out the usual stock dividend purpose of corporate expansion or reinvestment, but exclusively for expanding the capital base of the respondents in MANTRASCO. Whenever the companies parted with a portion of their earnings to buy Reese's corporate holdings, they were in ultimate effect making a distribution of such earnings to the respondents. All these amounts are subject to income tax as being, in truth and in fact, a flow of cash benefits to the respondents.

• Propriety of Lump-Sum Assessment: The record shows that MANTRASCO's earnings over a period of years were used to gradually wipe out Reese's holdings. Those earnings, held to have been in effect distributed to the respondents, should be taxed for each of the corresponding years when payments were made to Reese's estate. With regard to payments made in 1958 and prior years, there is no evidence that prior to the December 22, 1958 resolution the contributed equity of each respondent rose correspondingly. It was only by virtue of the authority in that resolution that the respondents actually, albeit illegally, appropriated and partitioned among themselves the stockholders' equity representing Reese's interests. As those payments accrued in favor of the respondents in 1958, they should be liable, for income tax purposes, to the extent of the aggregate amount paid from 1955 to 1958 by MANTRASCO to buy off Reese's shares.

• Validity of Fraud Penalty and Interest Charges: The fact that the resolution authorizing the distribution of earnings is null and void is of no moment. Under the National Internal Revenue Code, income tax is assessed on income received from any property, activity, or service that produces income. The Tax Code stands as an indifferent, neutral party on the matter of where the income comes from. The Commissioner's assessment of the fraud penalty and imposition of interest charges pursuant to the provisions of the Tax Code was in accordance with law.

• Nature of Treasury Shares — Treasury shares are stocks issued and fully paid for and re-acquired by the corporation either by purchase, donation, forfeiture, or other means. They are issued shares but, being in the treasury, do not have the status of outstanding shares. While held by the corporation, they participate neither in dividends (because dividends cannot be declared by the corporation to itself) nor in corporate meetings as voting stock (lest equal distribution of voting power be lost and directors perpetuate their control). The Court applied this doctrine to hold that the 24,700 shares were not treasury shares because the trust agreement vested the trustees with voting rights, dividend rights, and director-designation authority over the shares — characteristics inconsistent with treasury stock status.

• Stock Dividends Payable Only from Retained Earnings — A stock dividend always involves a transfer of surplus or profit to capital stock; it is a conversion of surplus or undivided profits into capital stock distributed to stockholders in lieu of a cash dividend. A stock dividend cannot be declared out of outstanding corporate stock but only from retained earnings. The Court applied this principle to hold that the declaration of the 24,700 outstanding shares as treasury stock dividends was a complete nullity.

• Substance Over Form in Taxation of Corporate Distributions — Where corporate earnings are used through a trust device to purchase a deceased stockholder's shares, which are then distributed to surviving stockholders as purported stock dividends, the transaction constitutes, in substance, a distribution of earnings taxable as income to the surviving stockholders, regardless of the formal label attached to the distribution. The Court applied this doctrine to pierce the formal designation of "treasury stock dividends" and tax the underlying distribution of earnings.

• Tax Code Neutrality as to Source of Income — Under the National Internal Revenue Code, income tax is assessed on income received from any property, activity, or service that produces income. The Tax Code stands as an indifferent, neutral party on the matter of where the income comes from. The nullity of the corporate resolution authorizing the distribution does not exempt the recipients from income tax, fraud penalty, or interest charges. The Court applied this principle to sustain the Commissioner's imposition of the 50% surcharge and ½% monthly interest notwithstanding the nullity of the stockholders' resolution.

• "The manifest intention of the parties to the trust agreement was, in sum and substance, to treat the 24,700 shares of Reese as absolutely outstanding shares of Reese's estate until they were fully paid. Such being the true nature of the 24,700 shares, their declaration as treasury stock dividend in 1958 was a complete nullity and plainly violative of public policy." — This passage articulates the ratio decidendi on the nullity of the stock dividend declaration, establishing that the character of shares under a trust agreement, not their formal label, determines whether they qualify as treasury shares.

• "The conclusion is thus ineluctable that whenever the companies involved herein parted with a portion of their earnings 'to buy' the corporate holdings of Reese, they were in ultimate effect and result making a distribution of such earnings to the respondents. All these amounts are consequently subject to income tax as being, in truth and in fact, a flow of cash benefits to the respondents." — This passage defines the controlling doctrine on substance-over-form in taxing corporate distributions used to acquire a deceased stockholder's interest for the benefit of surviving stockholders.

• "The fact that the resolution authorizing the distribution of the said earnings is null and void is of no moment. Under the National Internal Revenue Code, income tax is assessed on income received from any property, activity or service that produces income. The Tax Code stands as an indifferent, neutral party on the matter of where the income comes from." — This passage establishes the principle that the validity of the corporate act authorizing a distribution is irrelevant to the taxability of the income received, a doctrine frequently cited in subsequent tax jurisprudence.

• Nielson & Co., Inc. vs. Lepanto Consolidated Mining Co., 26 SCRA 540 (1968) — Cited for the proposition that a stock dividend cannot be declared out of outstanding corporate stock but only from retained earnings, referencing Section 16 of the Philippine Corporation Law.
• Republic vs. De la Rama, 19 SCRA 866 — Cited in support of the principle that income tax is assessed on income received from any property, activity, or service that produces income.
• Alexander Howden and Co. Ltd. vs. Collector of Internal Revenue, 13 SCRA 601 — Cited alongside Republic vs. De la Rama for the same proposition on the neutrality of the Tax Code as to the source of income.
• Eisner vs. Macomber, 252 US 189 (1920) — Cited (via footnote quoting Bass vs. Commissioner) for the recognized principle that the essence of a stock dividend is the segregation of a definite portion of corporate earnings as permanent capital through capitalization and issuance of additional shares to stockholders.

• Section 83, National Internal Revenue Code — Defines "dividends" as any distribution made by a corporation to its shareholders out of earnings or profits accrued since March 1, 1913, payable whether in money or other property. Subsection (b) provides that a stock dividend representing the transfer of surplus to capital account shall not be subject to tax, but if a corporation cancels or redeems stock issued as a dividend in a manner essentially equivalent to a taxable dividend, the amount so distributed shall be considered taxable income to the extent it represents a distribution of earnings or profits. The Court applied this provision to hold that the distribution of corporate earnings to the respondents through the trust device was taxable income, not an exempt stock dividend.
• Section 72, National Internal Revenue Code — Authorizes the imposition of a 50% surcharge for fraud. The Court upheld the Commissioner's assessment of this surcharge against the respondents.
• Section 51(d), National Internal Revenue Code — Authorizes the imposition of ½% monthly interest on deficiency income tax assessments. The Court sustained the imposition of interest charges.
• Section 16, Philippine Corporation Law (Act 1459, as amended) — Governs the declaration of stock dividends. Cited for the principle that a stock dividend cannot be declared out of outstanding corporate stock but only from retained earnings.
• BIR Regulations, Sections 251 and 252 — Section 251 provides that dividends paid in securities or other property (other than the corporation's own stock) are income to recipients to the full market value. Section 252 provides that a stock dividend representing a transfer of surplus to capital account is not subject to income tax, but distinguishes between stock dividends that work no change in the corporate entity (non-taxable) and those that give the shareholder a different interest (taxable). The Court relied on these regulations to support the distinction between taxable and non-taxable distributions.

Makasiar, Esguerra, Muñoz Palma, and Martin, JJ., concurred. Teehankee, J., was on leave.