Commissioner of Internal Revenue vs. Engineering Equipment and Supply Company

A taxpayer that designs, fabricates, assembles, supplies, and installs central-type air conditioning systems pursuant to special orders is a contractor, not a manufacturer, and is subject to the contractor’s tax under Section 191 rather than the advance sales tax under Section 185(m); imported components used in that construction business are subject to the 30% compensating tax under Section 190 in relation to Section 185(m), with the 25% delinquency surcharge and, upon proof of fraudulent misdeclaration, the 50% fraud surcharge.

Engineering Equipment and Supply Co. is a domestic corporation operating an integrated engineering shop engaged in the design and installation of central-type air conditioning systems, pumping plants, and steel fabrications. The Commissioner of Internal Revenue is the official charged with enforcing the National Internal Revenue Code, including the percentage taxes, compensating tax, surcharges, and prescriptive periods at issue. The case called for classifying Engineering’s business under the Code’s definitions of “manufacturer” and “contractor” and for determining the tax consequences of its importations of air conditioning units and parts or accessories.

Engineering Equipment and Supply Co., a domestic corporation, operated an integrated engineering shop engaged in the design and installation of central-type air conditioning systems, pumping plants, and steel fabrications. On July 27, 1956, Juan de la Cruz wrote the then Collector, now Commissioner, of Internal Revenue, denouncing Engineering for tax evasion by misdeclaring its imported articles and failing to pay the correct percentage taxes due thereon in connivance with its foreign suppliers. Engineering was likewise denounced to the Central Bank for alleged fraud in obtaining dollar allocations. Acting on these denunciations, a joint team of Central Bank, National Bureau of Investigation, and Bureau of Internal Revenue agents conducted a raid and search on September 27, 1956, seizing voluminous records of the firm.

On September 30, 1957, revenue examiners Quesada and Catudan reported and recommended that Engineering be assessed P480,912.01 as deficiency advance sales tax on the theory that it misdeclared its importation of air conditioning units and parts or accessories thereof, which were subject to tax under Section 185(m) of the Tax Code instead of Section 186. The assessment was revised on January 23, 1959 to P916,362.56, representing deficiency advance sales tax and manufacturers sales tax, inclusive of the 25% and 50% surcharges. On March 3, 1959, the Commissioner assessed and demanded the increased amount and suggested that P10,000 be paid as compromise in extrajudicial settlement of Engineering’s penal liability. Engineering contested the tax assessment and requested details and particulars. The Commissioner replied that the assessment was in accordance with law and the facts. On July 30, 1959, Engineering appealed to the Court of Tax Appeals, and during the pendency of the case the investigating revenue examiners reduced Engineering’s deficiency tax liabilities from P916,362.65 to P740,587.86 based on conferences with Engineering’s accountant and auditor.

The Court of Tax Appeals found that Engineering did not manufacture air conditioning units for sale to the general public, but imported items such as refrigeration compressors in complete set and heat exchangers or coils, which were used in executing contracts entered into by it. Engineering undertook negotiations and execution of individual contracts for the design, supply, and installation of air conditioning units of the central type, taking into consideration the area of the space to be air conditioned, the number of persons occupying or who would occupy the premises, the purpose for which the various air conditioning areas were to be used, and the sources of heat gain or cooling load on the plant. Engineering designed and engineered complete each particular plant, and no two plants were identical; each had to be engineered separately.

The Court of Tax Appeals further found that Engineering fabricated, assembled, supplied, and installed in the buildings of its customers the central-type air conditioning system; prepared plans and specifications that were distinct and different from each other; did not deal in the window type of air conditioner manufactured, assembled, and produced locally for sale to the general market; and supplied and installed imported air conditioning units and parts or accessories only upon previous orders of its customers conformably with their needs and requirements. Engineering advertised itself as Engineering Equipment and Supply Company, Machinery Mechanical Supplies, Engineers, Contractors, and not as a manufacturer. It paid the contractor’s tax on all contracts for the design and construction of central systems and did not have ready-made air conditioning units for sale. Carlos Navarro, a licensed mechanical and electrical engineer and former chairman of the Board of Examiners for Mechanical Engineers, testified that the central-type air conditioning system is an engineering job requiring planning and meticulous layout because architects assign definite and often small spaces of various sizes; that he had not seen central-type air conditioning machinery rooms that were exactly alike; and that the window-type air conditioner is a compromise that cannot control humidity to the desired level, whereas the central-type system requires an intelligent operator.

The Court of Tax Appeals also found that Engineering deliberately and purposely misdeclared its importations. This finding rested on letters written by Engineering to its foreign suppliers instructing them on how to invoice and describe the air conditioning units ordered. As early as March 18, 1953, Engineering wrote Trane Co. that invoices should be made in the name of Madrigal & Co., Inc., Manila, Philippines, c/o Engineering Equipment & Supply Co.; that all correspondence and shipping papers should be forwarded to Engineering only and not to the customer; that invoices should be exactly as detailed in the customer’s letter order; that no mention of the words “air conditioning equipment” should be made on any shipping documents or cases; and that all invoices and cases should be marked “THIS EQUIPMENT FOR RIZAL CEMENT CO.” Similar instructions were given to Acme Industries, Inc. on March 19, 1953. On April 6, 1953, Engineering wrote Owens-Corning Fiberglass Corp. enjoining it from mentioning or referring to the term “air conditioning” and to describe the goods as fiberglass pipe and pipe fitting insulation instead. On April 30, 1953, Engineering threatened to discontinue the forwarding service of Universal Transcontinental Corporation if the term “Air conditioning Machinery or Air Coolers” continued to be used. On July 17, 1953, Engineering wrote Trane Co. that the matter of avoiding any tie-in on air conditioning was very important and asked that the term “Climate changers” or any reference to the equipment as “air conditioning” be avoided. Trane Co. replied on July 30, 1953, suggesting two sets of invoices: one describing the equipment according to the import license and another according to its ordinary regular methods. On August 27, 1955, Engineering requested that in the future no documents of any kind should be sent with the order that indicated in any way that the equipment could possibly be used for air conditioning.

• Commissioner’s Manufacturer Theory (G.R. No. L-27044): The Commissioner argued that the Court of Tax Appeals erred in holding Engineering a contractor and not a manufacturer. It contended that Engineering was a manufacturer and seller of air conditioning units and parts or accessories, subject to the 30% advance sales tax under Section 185(m) in relation to Section 194(x), not the 3% contractor’s tax under Section 191. It further argued that Engineering was liable to the 30% advance sales tax under Section 183(b) in relation to Section 185(m) on its importations of parts and accessories, not merely the 30% compensating tax; that it was liable to the 50% fraud surcharge under Section 183 notwithstanding the CTA’s finding of fraudulent misdeclaration; and that the liability should be P740,587.86 as deficiency advance sales tax, deficiency manufacturers tax, and 25% and 50% surcharges for June 1, 1948 to December 31, 1956, not P174,141.62.
• Engineering’s Defenses (G.R. No. L-27452): Engineering argued that the Court of Tax Appeals erred in holding it liable to the 30% compensating tax on its importations rather than the 7% compensating tax; in finding fraud based on incomplete quotations from alleged photostat copies of documents illegally seized and inadmissible in evidence; in holding it liable to the 25% surcharge under Section 190; in holding the assessment had not prescribed; and in failing to completely absolve it from the deficiency assessment.

• Manufacturer or Contractor: Whether Engineering Equipment and Supply Company is a manufacturer of air conditioning units subject to the 30% advance sales tax under Section 185(m) in relation to Sections 183(b) and 194 of the Tax Code, or a contractor subject to the contractor’s tax under Section 191.
• Compensating Tax Rate: Whether Engineering is liable to the 30% compensating tax under Section 190 in relation to Section 185(m) on its imported air conditioning units and parts or accessories, rather than the 7% compensating tax.
• Fraud Surcharge: Whether Engineering is liable for the 50% fraud surcharge under Section 183(a) of the Tax Code for fraudulently misdeclaring its importations.
• Delinquency Surcharge: Whether Engineering is liable for the 25% surcharge under Section 190 for non-payment of the compensating tax within the prescribed period.
• Prescription: Whether the tax assessment had prescribed, or whether the ten-year period under Section 332(a) applies because of a false or fraudulent return with intent to evade tax.

• Manufacturer or Contractor: Contractor. Engineering did not manufacture air conditioning units for sale to the general public but imported components used in executing tailor-made contracts for central-type systems; it is subject to the contractor’s tax under Section 191, not the advance sales tax under Section 185(m) in relation to Section 194.
• Compensating Tax Rate: 30%. The imported air conditioning units and parts or accessories were used in Engineering’s construction business and were never sold, resold, bartered, or exchanged; they are subject to the 30% compensating tax under Section 190 in relation to Section 185(m), without the 50% mark-up under Section 183(b).
• Fraud Surcharge: Yes. The letters instructing foreign suppliers to misdeclare the importations showed fraudulent intent to evade the higher tax; the 50% fraud surcharge under Section 183(a) applies, and the CTA’s absolution from it was reversed.
• Delinquency Surcharge: Yes. The 25% surcharge under Section 190 applies because the compensating tax was not paid within the period prescribed after the imported articles were used for other purposes.
• Prescription: No. The ten-year prescriptive period under Section 332(a) applies to false or fraudulent returns with intent to evade tax; the assessment was made within that period, so prescription had not set in.

• Manufacturer or Contractor: The Court applied the distinction between a contract of sale and a contract for work, labor and materials. The test is whether the thing transferred is one not in existence and which never would have existed but for the order, or a thing which would have existed and been the subject of sale to others even without the order. If the article ordered is exactly such as the seller makes and keeps on hand for sale to anyone, and no change or modification is made at the buyer’s request, it is a contract of sale, even if made after and in consequence of the order. Civil Code Article 1467 similarly provides that delivery at a certain price of an article which the vendor in the ordinary course manufactures or procures for the general market is a contract of sale, but if the goods are manufactured specially for the customer upon special order and not for the general market, it is a contract for a piece of work. A contractor, as held in Luzon Stevedoring Co. vs. Trinidad and La Carlota Sugar Central vs. Trinidad, renders service in the course of an independent occupation, representing the will of the employer only as to the result of the work, not the means by which it is accomplished. The evidence showed Engineering did not manufacture air conditioning units for sale to the general public; it imported components such as refrigeration compressors in complete set and heat exchangers or coils, which it used in executing contracts. It negotiated and executed individual contracts for the design, supply, and installation of central-type air conditioning systems, considering the area, occupants, purpose, and heat gain or cooling load of each project. Each plant was designed and engineered separately; no two plants were identical. The CTA found that Engineering fabricated, assembled, supplied, and installed central-type systems; prepared distinct plans and specifications; did not deal in window-type units manufactured for the general market; and supplied and installed imported units and parts only upon previous orders conforming to customers’ needs. Engineering advertised itself as contractors, paid contractor’s tax, and had no ready-made units for sale. The Commissioner’s argument that Engineering could have mass-produced and stockpiled units was untenable because central systems are distinct from packaged or self-contained units. The handbook classification of unitary and central systems and the testimony of Carlos Navarro confirmed that central-type systems require planning and layout for particular buildings and are not standard. The cases cited by the Commissioner were not in point. Celestino Co & Co. vs. Collector of Internal Revenue was distinguished because Celestino held itself out as a manufacturer, registered a trade name, used manufacturer stationery, did not post a contractor’s bond, and derived bulk sales from ready-made standard doors and windows. S.M. Lawrence Co. vs. McFarland was on all fours: one contracting for air conditioning systems was a contractor and consumer of materials, not a retailer. Thus Engineering was a contractor subject to Section 191, not a manufacturer subject to Section 185(m).
• Compensating Tax Rate: Because Engineering imported air conditioning units, parts, or accessories for use in its construction business and these items were never sold, resold, bartered, or exchanged, it was liable under Section 190. The compensating tax is not a tax on importation but a tax on the use of imported goods not subject to sales tax. The applicable rate was 30% under Section 190 in relation to Section 185(m), which covers air conditioning units and parts or accessories. The Court held it liable to the 30% compensating tax, but without the 50% mark-up provided in Section 183(b). The 7% rate under Section 186 did not apply because the imported articles fell under Section 185(m).
• Fraud Surcharge: The Commissioner charged Engineering with misdeclaring its imported air conditioning units and parts or accessories to make them subject to the lower 7% tax under Section 186 instead of the 30% tax under Section 185(m). The CTA found Engineering deliberately and purposely misdeclared its importations based on letters to foreign suppliers instructing them how to invoice and describe the goods. The Supreme Court reviewed the exhibits and found the communications strongly indicative of fraudulent intent to evade the 30% tax. Engineering instructed Trane Co. to invoice in the name of Madrigal & Co., Inc., to forward correspondence only to Engineering, to avoid mentioning air conditioning equipment on shipping documents and cases, and to mark the equipment for Rizal Cement Co.; it gave similar instructions to Acme Industries and Owens-Corning Fiberglass, telling the latter to describe the goods as fiberglass pipe and pipe fitting insulation; it threatened to discontinue Universal Transcontinental’s forwarding service if the term “Air conditioning Machinery or Air Coolers” was used; it told Trane Co. to avoid “Climate changers” or any reference to air conditioning; Trane Co. proposed two sets of invoices; and Engineering later requested that no documents indicate the equipment could be used for air conditioning. The CTA had absolved Engineering from the 50% surcharge under Section 183(a) on the ground that Section 190 does not expressly impose it. The Supreme Court disagreed. Whether the liability was advance sales tax or compensating tax, Engineering was required by law to truly declare its importation in the import entries and internal revenue declarations before release from customs custody. Those entries served the same purpose as the returns required by Section 183(a). The fraud was glaring, and absolving Engineering would give a premium to tax evasion. The 50% fraud surcharge therefore applied.
• Delinquency Surcharge: The Court agreed with the CTA that the 25% delinquency surcharge applied. The original Section 190 as amended by Commonwealth Act No. 503 did not provide for a compensating tax return and 25% surcharge, but Section 190 was subsequently amended by Republic Acts Nos. 253, 361, 1511, and 1612, effective on the dates stated, which provided that if an article withdrawn from the customhouse or post office without payment of the compensating tax is subsequently used by the importer for other purposes, a corresponding entry must be made in the books of accounts or written notice sent to the Collector of Internal Revenue, and payment of the compensating tax made within the prescribed period. If the tax is not paid within that period, the amount is increased by 25%, the increment forming part of the tax. Since the imported air conditioning units and parts or accessories were subject to the 30% compensating tax because they were used in Engineering’s construction business, Engineering should have complied with the requirement to record or notify and pay within the prescribed period. It did not pay within that period, so the 25% surcharge applied.
• Prescription: Engineering contended it was not guilty of tax fraud, so the ten-year period under Section 332(a) did not apply and the pertinent period was five years from the importations. The record showed, however, that Engineering filed a tax return or declaration with the Bureau of Customs before paying the 7% advance sales tax, and the declaration revealed that it misdeclared its importations. Section 332(a) provides that in the case of a false or fraudulent return with intent to evade tax, or failure to file a return, the tax may be assessed or a proceeding in court for collection begun without assessment at any time within ten years after discovery of the falsity, fraud, or omission. Considering the preponderance of evidence of fraud with intent to evade the higher rate, Section 332(a) applied. The tax assessment was made within the period prescribed by law, and prescription had not set in against the Government.

• Contractor vs. Manufacturer; Contract of Sale vs. Contract for Work, Labor and Materials — The distinction is tested by whether the thing transferred is one not in existence and which never would have existed but for the order, or a thing which would have existed and been the subject of sale to others even without the order. If the article ordered is exactly such as the seller makes and keeps on hand for sale to anyone, and no change or modification is made at the buyer’s request, it is a contract of sale, even if made after and in consequence of the order. Under Article 1467 of the Civil Code, delivery at a certain price of an article which the vendor in the ordinary course manufactures or procures for the general market is a contract of sale, but goods manufactured specially for the customer upon special order and not for the general market make it a contract for a piece of work. A contractor renders service in the course of an independent occupation, representing the will of the employer only as to the result of the work, not the means. The Court applied these tests to hold Engineering a contractor because it designed, fabricated, assembled, supplied, and installed central-type air conditioning systems upon special orders, not for the general market.
• Compensating Tax on Imported Goods Used in Business — The compensating tax under Section 190 is not a tax on importation but a tax on the use of imported goods not subject to sales tax. A taxpayer that imports commodities and subsequently uses them for purposes other than sale, resale, barter, or exchange must pay the compensating tax at the rate imposed on original transactions under the applicable percentage-tax provision. The Court applied Section 190 in relation to Section 185(m), imposing the 30% compensating tax on Engineering’s imported air conditioning units and parts or accessories because they were used in its construction business and never sold, resold, bartered, or exchanged, without the 50% mark-up under Section 183(b).
• Fraud Surcharge for Misdeclaration in Import Entries — A 50% fraud surcharge under Section 183(a) may be imposed where a taxpayer willfully makes a false or fraudulent return with intent to evade tax. Import entries and internal revenue declarations serve the same purpose as returns because they declare the nature, quantity, and value of imported goods and are the basis for computing customs duties and internal revenue taxes. The Court applied this doctrine because Engineering instructed its foreign suppliers to misdescribe air conditioning equipment in shipping documents and invoices to avoid the higher 30% tax, showing fraudulent intent to evade tax.
• Delinquency Surcharge on Compensating Tax — Under Section 190, as amended, if an article withdrawn from the customhouse or post office without payment of the compensating tax is subsequently used by the importer for other purposes, the importer must record the use or notify the Collector and pay the compensating tax within the prescribed period; failure to pay within that period increases the tax by 25%. The Court applied this to Engineering because it used the imported articles in its construction business and did not pay the compensating tax within the prescribed period.
• Ten-Year Prescriptive Period for False or Fraudulent Returns — Under Section 332(a), in the case of a false or fraudulent return with intent to evade tax, or failure to file a return, the tax may be assessed or a collection proceeding begun without assessment at any time within ten years after discovery of the falsity, fraud, or omission. The Court applied this because Engineering filed a declaration that misdeclared its importations, and the evidence showed fraud with intent to evade the higher tax rate; the assessment was made within the ten-year period.

• "The distinction between a contract of sale and one for work, labor and materials is tested by the inquiry whether the thing transferred is one not in existence and which never would have existed but for the order of the party desiring to acquire it, or a thing which would have existed and has been the subject of sale to some other persons even if the order had not been given." — This passage states the controlling test for distinguishing a contract of sale from a contract for work, labor and materials, which the Court used to classify Engineering as a contractor rather than a manufacturer.
• "The true test of a contractor as was held in the cases of Luzon Stevedoring Co., vs. Trinidad, 43, Phil. 803, 807-808, and La Carlota Sugar Central vs. Trinidad, 43, Phil. 816, 819, would seem to be that he renders service in the course of an independent occupation, representing the will of his employer only as to the result of his work, and not as to the means by which it is accomplished." — This excerpt defines the contractor test relied upon by the Court and is central to its holding that Engineering was subject to the contractor’s tax.
• "The aforequoted communications are strongly indicative of the fraudulent intent of Engineering to misdeclare its importation of air conditioning units and spare parts or accessories thereof to evade payment of the 30% tax. And since the commission of fraud is altogether too glaring, We cannot agree with the Court of Tax Appeals in absolving Engineering from the 50% fraud surcharge, otherwise We will be giving premium to a plainly intolerable act of tax evasion." — This passage articulates the Court’s basis for imposing the 50% fraud surcharge and reversing the CTA’s absolution from it.
• "Section 332. — Exceptions as to period of limitation of assessment and collection of taxes. — (a) In the case of a false or fraudulent return with intent to evade tax or of a failure to file a return, the tax may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment at any time within ten years after the discovery of the falsity, fraud or omission." — This provision supplied the ten-year prescriptive period that the Court applied after finding fraud in Engineering’s import declarations.

• Luzon Stevedoring Co. vs. Trinidad, 43 Phil. 803, 807-808 — Cited for the true test of a contractor: one who renders service in the course of an independent occupation, representing the employer’s will only as to the result, not the means. The Court used this to classify Engineering as a contractor.
• La Carlota Sugar Central vs. Trinidad, 43 Phil. 816, 819 — Cited together with Luzon Stevedoring for the same contractor test.
• Celestino Co & Co. vs. Collector of Internal Revenue, 99 Phil. 841 — Cited by the Commissioner but distinguished. Celestino was held a manufacturer because it registered a trade name, used manufacturer stationery, did not post a contractor’s bond, and derived bulk sales from ready-made standard doors and windows; Engineering, by contrast, held itself out as a contractor and made tailor-made systems.
• Advertising Associates, Inc. vs. Collector of Customs, 97 Phil. 636 — Cited by the Commissioner but held not in point because its facts were entirely different.
• Manila Trading & Supply Co. vs. City of Manila, 56 O.G. 3629 — Cited by the Commissioner but held not in point because its facts were entirely different.
• S.M. Lawrence Co. vs. McFarland, 355 SW 2d 100, 101 — Considered on all fours. It held that one contracting for the establishment of air conditioning systems in buildings was a contractor engaged in construction or improvement of real property, liable for sales or use tax as the consumer of materials and equipment, not as a retailer of tangible personal property. The Court applied this to Engineering.

• Section 185(m), National Internal Revenue Code — Imposes a 30% percentage tax on original sales, barters, exchanges, or similar transactions involving air conditioning units and parts or accessories thereof, payable by the manufacturer or producer. The Court used this as the rate for the compensating tax under Section 190 after finding the imported articles were air conditioning units and parts or accessories.
• Section 194(x), National Internal Revenue Code — Defines “manufacturer” as one who by physical or chemical process alters raw or manufactured products to prepare them for special use, reduces them to marketable shape, or combines them with other materials, and who produces finished products for sale or distribution to others and not for his own use. The Court found Engineering did not fall within this definition because it did not manufacture air conditioning units for sale to the general public.
• Section 191, National Internal Revenue Code — Imposes the contractor’s tax. The Court held Engineering, as a contractor, was subject to this provision rather than the advance sales tax under Section 185(m).
• Section 190, National Internal Revenue Code — Imposes the compensating tax on persons who purchase or receive commodities from without the Philippines, except those subject to specific taxes, and provides that if an article withdrawn without payment of the compensating tax is subsequently used by the importer for other purposes, the importer must record or notify the Collector and pay the tax within the prescribed period, with a 25% increase if not paid. The Court held Engineering liable to the 30% compensating tax and the 25% delinquency surcharge under this provision.
• Section 183(a), National Internal Revenue Code — Imposes a 50% surcharge for willful neglect to file a monthly return within the prescribed period or for a false or fraudulent return. The Court applied this to Engineering’s fraudulent misdeclaration of its importations.
• Section 183(b), National Internal Revenue Code — Provides the 50% mark-up that the Court held did not apply to the compensating tax imposed under Section 190.
• Section 186, National Internal Revenue Code — The lower 7% percentage tax that Engineering allegedly sought to apply by misdeclaring its importations. The Court held it did not apply because the imported articles fell under Section 185(m).
• Section 332(a), National Internal Revenue Code — Provides a ten-year prescriptive period for assessment or collection in the case of a false or fraudulent return with intent to evade tax, or failure to file a return. The Court applied this because Engineering’s declaration misdeclared its importations and fraud was established.
• Article 1467, New Civil Code — Distinguishes a contract of sale from a contract for a piece of work: delivery at a certain price of an article which the vendor in the ordinary course manufactures or procures for the general market is a contract of sale, but goods manufactured specially for the customer upon special order and not for the general market make it a contract for a piece of work. The Court used this to classify Engineering as a contractor.

Chief Justice Makalintal; Justices Castro, Makasiar, and Martin.