CTA Case No. 3856 (Decision)

c.tiJ'Ui.1UC 0�1 'H~ 1-'Hilll'l"tl"..,~ COURT OF TAX .\f'P�.Al..S QUft.C!i (;) f'1" 3M PHILIPPINES, INC. , Petitioner, - versus �� C.T.A. CASE NO. 385o COMMISSIONER OF .INTERNAL RE VENUE, Responden � X- ~- - ------X DECISION In his lcttei dated February 7 , 1~80 to peti- tione r 3M rhilippines, Inc . , respo n dent Commissioner of Internal Revenue informed the former that upon invesliyotion~ there has been found due from peti- tioner the amount of 81,193,566.80 os deficiency i n r. o rn e t a x f n r t h e , f i s c a 1 y e a r e 11 d e d 0 c t o b e r 3 1 , 1 9 7 !1 , details of which a~e as follows: Net income pe � retur n � �� . . . 810,508,296.73 Add: Unallowable deductions : 1. Pre-operational cost (capitol expense) � � e 7 7,940 . 38 2. Royalty and Techni- cal Service fees (not ordinary and neceHsary) � � � � �~23,599.92 2,401,5L~(J.30 Net income per investigation � � � � � � el~z 909 '837 .03 Tax duo thereon � � � � � � � � � � � � 4,508,4ll3 . 00 less. Amount paid ���� � . ����� 3,667,903 . 00 . � . . e B40,54o . oo Balance~����� � Add: 14~ int. p.a. fr. 2-15-75 to 2-15-78 e::::-:1::!::-:1:-:~9::3:3~:5::~;~;5=,6.=66==.� =a80=o TOTAL AMOUNl DUE & COLLCCTIBLE . � � � � \ 48 G

f DECISION- CTA CASE NO. 5856 - 2- Petitioner was theref ore requested to pay the aforesai d amou nt in accordance with the assessment notice attached. to the letter, inforrnin~J respondent's '� office for proper annotation thereof. After petitioner had rested its case with the admission of all its exhibits by the Court, responrie nt manifested during the hearing for the presentation of his evidence on December 3, 1985 thGt since this case involves questions of law, respondent ls not presenting any documentary or testimonial evidence but is submit- ting the case for decision based on the records and the pleadings. And the background Facts as shown in the petition for review and admitted in the answer are as follows: Pet itioner is a corporation org anized und er Philippine laws with offices at 3M House, Guadalupe, ~1akati, tvletro ~~anila; "respondent is the duly appointed and act ing Commissioner of Internal Revel ue and has his office al the B.I.R. Building, Dillman, Quezon City, where he may be served with summons. Petitioner has been engaqerl in the manufacture of tapes (adhesive, electrical, maskinQ nnd labelling) , abrasive products, reflective products, and chemicals 481

DECISION - CTA CASE NO. 3856 - 03 - for the manufacture of adhesives . PeU.tioncr a1so im p orts pol yme ric fil m and sheet mate ri als, adhes1vc and cooting compos i tion s , chemicDl products, photo- g raphic fi] rn products and rna t..~ � rlo .l~s, 1' 1� t� l',oqrap h 1� c plates, medical product s , a bradin y mach ines , re i n- forced plastics, res in ous films , ro of ing gr an ules a nd non-wo ven fabrics , which it dist ribut es and sel ls in th e l oc nl market. To enable petitioner to mnn uf- ac tur e, package, promote, market ~ sell and instal l ~ these highly s peci a lized product s and rBnder th e nece ssa ry post- sa l e s service and maintenance , peti- ti on er ent ered .into a t ec hni r.aJ se .L� vire 8grecmen t. a nd license agreem en t with ~Hnne Ewr.n Hin.i.nJ & Mnn ufo . turi n g . Co. under which petitioner agreeo to pay a technjc n l se~vi ce fe e of 3% and a royalty of 2% of its net soles. Both agreements were submi t ted to a nd appro ve d by th e Central Bank of the P~ilippines. ln its i nco mo tax returr1 f or th e fiscal yea r ended October 31, 1 974~ p etit.ion:::r cJ aimed ::Js deductions as business expe nse the tec hn1cal service fe e and royR l ty i t p n i d p u r. s u a n t t o t h e a f o r e rn e n t i o n e cl t wo a q r fH~ 1r1 n l' s in th e a mo unt of e3 ,05U,64 6.00 a nd th o pre-operational e o s t f o r i t s t a p e c o a t e r o p e r a t i o n s urn o u n l� 'i. n g t o 482

t �� DECISION - CTA CA SE NO. 385G - 4- 877 , 940.38. After in ves t igation of i ts afore s nid tax retur n, l, respondent disa ll owed the entire pre-ope r a t ion al cosl of E77,940 . 38 because it was a capital expe nse and s hou ld be amo r t i zed for five years and the tech n ical ser v ice fee and royalty 011 the imported pr o ducts of ~2,323 , 599.92 because the fee and roy8lty should be based only on the locally manufactured goods so that said amount was a disgu i sed dividend . Consequently, respondent issued an Rssessm �n t against petitjoner fnr 8840 , 54 0 with interest at 14% per annum from Februar y 1~, 1975 until ful l y paid. Petitioner r e ceived the abovementioned assessment no t ice and letter of respondent on February 19, 1980 and protested the same in its letter dated March 7, 1980 , which was received by r es pondent on March 12, 1980, on the Follow in g grounds: (a) the technical service fee and ro ya l ty is an ordinary and necessary expense incurred to enable petitioner to promote, market, sell and insta l l highly specialized import d products and render post-sales service and mairtenance nnd the combined fees of 5% of ne t sal es is rensot 1nble; a nd (b) the pre - operational cost o f th e tape cooter was a current expense and should not be amortized. \ 483

..' . DECISION - CTA CASE NO. 3856 - - ') To date, respondent has nnt resolved petitioner's protest. However, on August 13, 1985 responcer tt issued a \�Ia r r an t o f Di ~ t r a i n t o f Pe r s o n a 1 P r o p e r t y a n d vi a r nm f.' of Levy on Real Property (both Nos. N-A-806-84) against petitioner for non-payment of the alleged unpaid defi- riency income ta~ of e040,540, exclusivP of 14% interest, which wa~rants were served on pet.il1oner on Oclob .r l, 1984. In soid warrants respondent has ordered his Collection lnforrement D1v'sion to ~jslrain, levy Hnd s~ll so much of p .t:itioner's persrnnl <Htd real fHOpf'r- t:ien <lS moy be necessary to cover the <;lleged u paid deficiency income tax, interest and expenses. Hence, the instant appeal. As special and affirmative defenses in his anfwer to the petition foi review, respondent alleges: The records of the case dis�lose(s) that the d.ficiency income tax ~ssessment resulted from the disallcwan e of the deductions for royrdty and tecli- n i c o 1 s e r v i c e f e e s i n t h e a 1n o u n t o f e2 � .3 2 3 , 59 9 � 9 2 they being not ordinary and necessary expenses under Section 30(a)(l) of the Tax Code, and the pre-operational expenses amounting to 877~940.38 as capital expenditures ; Section 3-r of the Central Bank C1rcular No. 593 '�

DECISJON - CTA CASE NO. 38~6 - 6 �- dated Dncember 7, 1973 requlates the payment of royalty and technical fees between residents and .' non-residents �. fhe percentaqo of royalty and tech- nlcal servicG fees should be bGsed on the sale of 1o c a 11 y manufacture J goods a nci no t on t� he sa 1 e o f Imported finished goods; In the cas e of petjtionee, the latter ciPducted the a foresaid royalty and technicAl service fees amo unting to e2,323 , 599.92, which represents S% of sales of imported finish ed qoods in lhe amount of 846 , L~71,99A.OO. Since no locnl processirHJ vJa~:> don e on said goods, said fees run rounter to the provision of C.B. Circular No. 393, and ther~f~re were djsallowed . qs they are not ordinary ar,d necebsary expenses; Cons1dering, .herefore, that lhe payment of the aforesAid royalty and technical service fees is based on the sale of imp rte~ fin1shed qoods~ lhe same is not considered ordinary nnd necessnry business expens~s <ieduct.ib~ under Section 30(8)(1) of the fax Code. On the conlrary, they are considered disguised dividends; Investiqation also disclosed that her in peti- tioner deducted the amount of ~97,425.47 as pre- npcirational cust representing various expenses incurred in 1973 and J974 for the installation of its Lape coater, '' 480

D � C f ~; 10 N ~ ClA rASC NO. 3BS6 - 7- the operation of which only began in 1973~ Sine~ t h e amortizat~ on of this capital expense i~ 5 y~ars, 4/5 thoreof or ~77,9 4 0~38 was disallowed as capital e;...ponae; The assensrne n t j n ques t ion was issued i.n act urd- lssues i n lhis cnse: (1) vlhct ' ��t the royalty and teci1n.ical serv.icP fet's tn the amo u nt or 22 t 52.3,5';J9.92 aru (hnJuct�ible as bu31ne3s expense; (2) ~vhnt.her th e cost nf i:he tnpes used in t n e t.ec>l. run fnr t h e repair of the ~upe coat r is b copi l al expenditure. I n d i s RlJ ow .i.. n y t II e ch. J u c U o n o r t 1e a mo u n t t; f e2,32J,S99.92 pald by petiti oner ns rnyalty a nd terh- n j l' a l s e r v 1 c e: f e e s a s h u :::; i n e s s e x p e n s r:; 1 i t i s t h e s t a n d o f 1: e n po n d e n t t h�a t l he s 3m e i. '3 n o t or d \. '-' l' y an d nacessary expense in view of t~e followinq circumstances obtnining in lhis ~ase. l. No m8nuf a ctu~ing process WAS undertaken b y p e t i t i o n e r o n t h e i mp o r t. e d f i n i ~::>11 e fl 2 ~ The ~� o y c-1 l t y f n r r he use n r Lt1t' t r ad r AI a r i< 48il

DECISION - CTA CASE NO. 38~6 - 8- of the import~d finjshed goods is already included in the purchase price of said goods. 3. The payment of royalty and technical service fees base ' on the sa 1e of imported finlshed goods is in violation of Central Bank Circular No. 393. 4� Pe t 'i l i one r i s u s uh s t d i a r y o f ~~ i n n e s o t a Mining & tonufacturing Co., the recipient of the royalty and technic&l service f ees . At the outset, it should be stated that while it is true that there is a number of decisions in the Unlted States delving o the interpreto ion of the phrase "ordin ary and nec�3vsary" or: used in the federal tax laws 1 no adequate or satisfartory definition of those words is possible. Similarly, the Supreme Court hns never attempted to defin e with precision the term "ordinary and necessary'1 � There are however, certai.n uiding princ"ples worthy of serious consideration in the ~roper adjudication of confl1cting claims. Ordi- narily, &n expense will b. considert,d "necessary" where the expenditure is appropriate and helpfJ) in the development of the taxpayer's business. It s ''

DECISION - CTA CASE ~0. 3856 - q- 11 ordinary 11 >�<hen i t connota,., a payment which is normal in relation to the busi ness of the taxpayer and the surrounding circumsta nce s~ The term "ordinary 11 does not requjre that the payments be habltual or normal in the sehse that the same taxpayer will have to make them often; the payment may be unique or non-recurring to the particula r taxpayer ffocted. (Atlas Consolj- dated Mining & Development Corporation vs. Commissioner of Inter nal Revenue , L- 26911 ; Commissioner of Internal Reve11Ue vs . Atlas Consol idated ~Hning & Development Corporation, 1--26924~ January 27, 1961, 102 SCRA 246.) There is thus no hard and fast rule on the matler. The right to a deduction depe~d s in each case on the partic ular facts and the relation of the payment to the type of busi ness in w!Lic h the taxpayer is engaged. The intention of the taxpayer often may be the con- trolling fact in making the determination . Assuming that the expenditure is ordinary and necessary in the ope ration of the taxpayer's businessJ the answer to the qu estion as to whether the expenditure is an allow - able deduction as a business expense must be determ ined from the nature of the expenditure itself, wh ich in turn depends on the extent a n d perm~nency of the work \ 48t)

DECISION .. - 10 - CTA CASE NO. 3856 ,�� accomplishPd hy the expenditure. (A tl as Consol.idated 1-lin.i..ng & Development Corporation vs. Commissio ner of Internal Reve nu e , .�...1:!,E.�.g_�) '' Th e Nntional Internal Revenue Code refers to reasonableness solely wit respect to salaries and ot her c omp ensatjon for personal services. (Section 30(a)(l)(A).) Courts, however, have held that for a business e:<pense to be "or dinary and necessary 11 j t must also be "reasonable" in amount. (Commissioner vs. Lincoln Electric Co .r 49-2 USlC, Par. 9388, 38 ArTR 411, 176 F. 2d B15.) It is the position of r .sponcient that petitioner�s c la im for deduction of the royalty nnd ser vice fees i n the amount of e2,323,599.92 is not ordinary and neces- sary a nd not within' the scope of Section 30(a)(l) of the Tax Code because il runs counter to th e pertinent provisions of Section 3-C of Central Bank Circular No . J93 which took effect on December 7, 19 7 3. Said Circular reuulates lhe payment of royalty and technical fee between residents and non-residents, and the per- centage of royalty and technical fee sh ould be based on the soles of locally manufactured goods and not on the soles of imported finished products. Petitioner \ � 48~ I"

ClCISION - ClA CASE NO. ~856 - Ll - claimed t.he amount of E3,05D,046 as total royalty and technical service fees, but onJy the amount of e727,046 (e3.050 ,646 less E2,323,599 rounded to y. E2,323,600) representing 5% of the manufactured sales of ~l4,540s922 was allowed. ln its conlrollinq provisions, Section 3-C of Central Ran~ rircular No. 393 reads: "S ection 5. Requi.re~nents for ApprovaJ and Hegi~Jtration.- The requirr>rnents for appro v a 1 and regis t r :1 t ion as provided for in Section 2 above inclu de, but :.:1re not limJted t.c t!te following: flo X )( X XXX XXX b. X:::X X XXX X X c. lhe royalty/rental cont.rocts in- volving 11 Mt=mufact u:ring" royalty, e.g., actual transfers of technoloqical sArvices such as secre~ formulate/processrs, toch- n i cal k no \'J �� h o1-1 a nd the 1 ]. k e s h a 11 n o t e xc e e d fivP (5 ) per cent of the wholesale price of t he com~~~ o d i l y I t i e s ma 11 u fa c t u r e d u n de r t h e royalt.y agreement. For contracts involving 11 marketing" services such as the use of foreign b rancs or trade name0 or trademarks, the royalty/rental rate shall not exceed two (2) per cent of the wholesale price of t he commcdity/ties manufacture d under the royalty agteement. The~�~producer 1 s' or ftneign licensor's shnre in the procee ds from the di stri bution/ exhibition of the films shall not exceed sixty (60) per cent of the net proceeds (gross proceeds less local expenses) fr m the exhi- bition I d i ol t rib uti. on of t h c f i 1m s � x x x x x x'' tUndP.l'sco rinCJ supplied.) 48G

DECISION - CTA CASE NO . 3056 - 12 - Advertinq to the terms of Section 3-r of Central Bank Circular No. 393, which regulates the payment of royalty and technical fees b etween residents and non- '. residents, it is quite apparent that the percentage of royalty and technical service fees shou ld be based on the sales of lo cal ly manufactured good~ and not on t he sale of imported finished goods. Whether the .royalty/t�ental conb:act involves manufacturing royalty or marketing services, the circular empl ys the term~ 11 royalty/rental contracts tnvol v�ng 'manuf actucerB r oyolty ' x x x x shall not excePd five (5) per cent of the wholesale price of the commodity/ties manuf- _?,.Etured under the royalty C:l!JI"~~ement", and for "contracts involving 'marketing 1 services x x x x the royally/ rental rate shall not exceed two (2) per cent of the wholesale price of th e commodity/tics manufactured under the royHJt.y a~Jreernent 11 � The circular is sped.fic and man datory. lt merely calls for application as wo rded. There is no room for interpretation. Since the royalty and technical service fees involved herein were computed on the basis nf' the wholesale value of finished goods imported by petitioner from its non- resident licensor Minnesotr Mining and Manufacturing 49i .~ 'I

D[Ci~~roN- CIA rASE NO. 385~ - 1 :~ ~.. Co mpany and not on th e sn len of pro duet;, 1Ha nu fa c Li> red d c d u c t i o rw b e c a u ::H-: t h e y <.1 t: e rw t q .c d u �G :r y a t , rJ n ~, c f:' ~' ;; ;:1 r y � a \IJ o f ( e de r n 1 I n t: o n1 e Tu ); r.l t ; n n ~ Vo 1 � r., 1 :..: 5 , J 3 l , Chap~ 25, p. 2J~. ) r lu~ phrase :I or- d :: rH1 r ;' 2. n d n 1:: c c [,~;a r y '' h a s b fH~ n c o n s t r u e d t o i mp 1 y <1 c o n d 1 t i o n l !� , i3 t t h c [Hl y - mn nt s themse] \te.~�; m� 1st not be :l 1] eg<:. i ~ nf Federa .l Irwo�ne T�.~.xatior:~ Vol ~ !'1; t.' t!�'' � '! U Dp . ~ !';.flCJ, P~ 115 .) Poti t.ionoi conten d s 1 howc v r ~ t.h~i t ~�cct i <H1 :3 pf Cantral Bank C1rcv. lcn No � .)SJJ ln !VJt" an irun - c1nr1 pro v j G ion pro'" l. d in q for mn x i mum r e q u :i r f' mc !�; t :.' be c nus e th e las t par ncF�aph t hereof ref,erved Lo Lne Cenln:.i. Dank the p n ~If:~ r t' o appr o vo .. n mu r . 1 o r . ou �; c a :::. c s rHJ r 0 e ~� 1 �1 1 tn w:i.t: \ I

L)[CISION - CTA CASE NO. 3856 However, in meritorious cases, lhe Monetory Board, in consultation with the Board of Investments, may authorize, sub- ject to su ch conditions it may impose, .' remitl~nce of royalties on contracts providJng for higher royalty/rental rates or for terms longer than five (5) yrnrs or containing restrictive provisions prohibitjng the local licensees to export the products manufactured undet the royalLy/renta l agreements or limit1ng their expor tution abroad only throuqh the foreign licensors as exclusive dis- tributors. nelionc' on the aforequot.cd provision is misplaced. We do not see in the provision what may be considered as authorizing in royally/rent al contracts involvin~ "manufactttring" ro yalty or contracts involving "market ... ing" services that the percentage of royolt.y and/or technical service fees can be, or maybe, base d on the sale of imported finished goods. Note that the above provision may al ow the Monebny Bo:..u�d, in meritorious cases, in consultat ion with the Board of Investments, subject to suc h co nditions it may impose, may a uth orize: (a) ~emittance of royalties on contracts pro- viding for higher royalty/rental rates; or (b) For lerms longer than five (5) ye ars ; or (c) Containing restrictive provisions prohibiting �he local licensees to export the products manufactured und.r the royalty /rent al agreements; or \ 493

DECISION -� CTA CASF ~0 . 38~ h - 1 '> - (d) Limiting t heir e xportation abroad through tho fore i gn licensors a s exc ]usi \e contributors. Nothing there speaks of thP perce ntag e of royall~ and/cr technical service �ees, in meritorious cases, the ba si s of which, as authorized by the Mo ne tary Board, in cons ultation wi.th th e Board of Inv e stments, s ubject to such conditions it may impose, is on lhe s ale of fin is he d goods imported by the lic ensee fro~ "ts non- :r ..., i d e n t 1 i. c e n ;~ o r � v~ e a r e n o t t. o i n d u .l q e i n s t a l u t o r y c o n s t r u c t i o n b (~ c n us e C:i. r c u 1 c.u 3 9 ) i s c 1 e a r � \v h e r , t: h e circ ular ex pre ssly p r ov ides that the royalty in contracts Involving "manufacturing", e.q ., actual t rar1 sfers of technulogicr l services such as formulate/ p l' a c e s s e s , t e c h n i c a 1 k n o 11 - h o VJ a n d l h ~... 1 .i k e a s 'tJ e 1 1 n s :in contracts invol ving "marketing" services such os the uoe of forei gn � brands , trade na me~~ or trad e markn, shal l be b n:H:d on the .wholesDle pricf' of the commodi t.i es manufactured under the royalty agr P~ment , t ho royalty ond technics] service f ees i hereon s ho uld he bas ed on the sa .t es of m<~.~�.!:.u.r_e,9_prod_!Jcts and not on the wholesale - - - - � - - - its licensor. If it had bee n the i ntent to jn clLode thn sAle of imported finished goo ds Jn the computation \ 494

DECI~.J!O CTA CASE NO. 3856 - 16 - of roynlty and tec hni cal service fee~�'� in meritorious cav~JD, 88 authorized l)y the t'1oneLary Board in consult- a t.l. o n wi t. h t h e 6n <H d o f I n v e ~:, t r.1 e n t: s , Lh a t c o u 1 d h a v e easily bean done by mere ly expandinq Section S-C at Circular No. 393 and addiny s uch words as "irnporl:ed arUcles " and the lik e. Si nce the language of Centra l Ban~ Circular No. 393 js plain and free from ambiguity and ex presses a definite nnd sensible mea . ing, it must ho appliPd li tera lly for that. is the conclusJve presumpt ion of th e meaning intended to co nv ey . (See Regalado vs. Yulo , 61 Phi]. 173 .) Th e cxrnes:3 mFntion of "wh ole- sale price of the commodi ty/ ties manufactured un der the royalty agreement" would t.hereforc preclude readinu :i.nto it wholesale price o f i mported finjshcd goods. On this point, responde nt argLes 1 and norrectly in the l ig ht of the obove, that in impo rt inq the finished products and rese lling them, petitioner acted as a trader. For the use of the trade mark of th ese products 9 it paid royalty to the trade mark LHinor so t hat the royalty is already presumably incl uded in the pu rchase price of the products. Ro yalties are not deductible jf they are paid os part of the purchAse price. (Mertens, La w of Ferleral Income laxation, \ 490

DECISION�� CT A CASE NO. 3856 -� '17 �- Vol. 4, 25.113, Chap. 25, p. 245.) \1 e do no t que s t i o n p e t i t i o n e r 1 s a r g u me n i- o r observation that: ��� B.fore any product is introduced , product evaluation tests are conducted to determin e their suitabiljty and appli- cability to the Philippines because of its different cUm:at.i ~ and environmental condittons. If the tests are favornble so that it is decided to introduce the producl here, petitioner ' s sales person- nel undergo product in t roduction ond performance training to enable them t.o promote and sell the product. Serv1ce personne l a ls o undergo training for product maintenance and repair to enab l e them to undertake post-sales service. To perform the test and conduct the train- ing, petitioner needed technical assistance and information and proprietary data from Minnesota Mining & Manufacturing Co. of St. Paul, t~innesota, II,S,A. (llPreinafter called "3M St. Paul ") so that a Service Informatio n and Technica l Assistance Agreement was entered into on March 20 , l97L~. To effectively promote, advertise and sell the products, it is necessary to print a nd publ-ish catalogues, brochures and handbills, and post and exhibit dis- play signs bearing their trademnrks and tradenames. Dealers ure appointed to se lJ and also service the products and it also is necessary for them to be ide nt ified as aut hor ized sales a nd ser- vice dealers so that they can use and display said trademarks and tradenames. Petitioner therefore also entered into a Patent and Trademark License Agreement w i ti 3 t-1 S t � P au 1 on ~1 arch 2 0 , 19 7 4 q ron t- ing petitioner t he right to use 3M St. Paul ' s industrial property rights. \ 49 - I~

DECISION - CTA CASE NO. 1856 - 18 -� Nevertheless, following settled and recoynized business practices, all these research and experi- mental expenses, expenses of selling the products or t' maintai~ing taxpayer's trade name, acquninting lhe public with the quality of its products and preserving its goodwill, nre all considered and included jn the determinution of the purchase pdce or costs of pro- duc t s � As r e s po nde n t a p t 1 y pu t i t , ''I t i s i n n h i gh degree oxtraordjnary for a corporation to incur bu s i- ness expenses jn connection with goods or services in an amount greatly in ex cess of what it knows jt will obtain for such goods or services". (t.1ertens, Law of Fodernl Ihcome laxation, Vol. 4A, Chapter 25, p. 53.) And on the argument of petitioner that the pay- ments of royalty an' d technical lirense fees were approved by the Central Bank, the observat i o ns of respondent on this pofnt find relevance: The approval by the Central Bank of t.he Patent and lrade111ark License Agreement and Service and Technical Assistance Ag reeme nt be ween Petitioner and its parent c ompany is without con- sequence because after the approval thereof, the Central Bank would not know whether the roya l ty and te chnica l service fees paid under the agreements are baued on the wholesale pric e of \ 4 o v (�-~

- DECISIOt' - CTA CASl NO. 385G - 19 - goods manufactured or on the wholesale price of goods imported . This is evi- dent in the Central Ba nk approval of the remittance of technical servjce fees (Exhibit 1 11 11 which mentions only the ) "net sales�subject to technical service fees'' \~ i thou t dis t l n g u ish in q between salAs of manufactured products and sales of imp orted products. Likewise, in petitioner's application with the Central Bank for the remittance of royalties (Exhibit "J �~ 1'' ) , there is no indication that the r oyaltjes are based on thL sa le of ma ufactured products or on the sale of imported products. Otherwise sLa ted, as long as the agreeme t appearu on its face to comply '.>Jit h the requirements of l:entrGl 13unk C i r c u 1 a r ~~ o � 3 9 3 , the C ~ n t. r a 1 Ba n k ~J i 11 ap prove it "in principle". But as to the actual impleme ntat ion of the provi- sio ns of the ag eement by th e parties thereto, the Central Dank would h\Jve no control. That is why th approval by the Central Bank uf the Pa tent and Trademark License Ag re ement ana Service and Tech- nical Assistance Agreement "jn principle" is subject to''certain conrlition.:o, one of whi ch i s that th "remittance of roya lti s/ tech nical service fees due thereunder s hal l be subject to ~ x x applicable tax laws x x x (letter of R.G. Cruz~ Director, page 312, BIR records, Folder I). Th e phrase "applicable tax laws" encompasses the provisions of the Tax Code on the treatment of royalty and technics service fees a u deductib le expense; specifically, whether it is ordinary and necessary f2_ection :30(a)(l) Ta x Cooe7. lhe Court recognizes thol an lncome tax deduction 1s a !notter of legislaljve grace ond thnt the burden of \ 40v C:-'1 \

DECISION - CTA CASE NO. 3056 - 20 - clearly showing the riuht to the claimed deduction is on lhe part of the taxpayer. (Interstate Transit Lines VB. CommiGsioncr, 319 U.S., 59D, :;93, 63 s. CL 1279.) As a matte. of fa t, the taxpayer eekinq a deduction must point to some srecific pro1isions of the Glatute in which that deduction 1s authorized, and must be able to prove that he is entitled to the deduction which the law allows. (1955 PH fed. fax Co u rse, Par. 1801 , cited j n Urnali, Homan, Reviewer in Taxatio n , 19 85 ed., p. 106 . ) The uppl:i.cabJe prin- cip l es of l aw are clear and to our mind, petitioner 3M Phi l i p pines, Inc., ha." not :w f ficiently sustained the burden wh.icl is placed upon it to be entitled to the claimed deduction. Upon the facts of the case, the amount of 82,323 , 599 . 92 paid as royalty nnrl technical service fees for goods traded was :l"J 0' 0 f�' the sale of imported ,Q goods of e46~471,99B.40. Under Central Bank Circular t a. 393, the percentage of royalty and tech .icaJ ser- vice fees shou .d be based on the sal of loca l ly ma n u f actured go ds and not on the sale of imported finished go ods . Since no manu f acturing process was 493

I ECISTON - ClA CASE NO. 1056 �- 21 .. done by petitioner on lhe imported f1nish d goods, it is thus r.lea1 beyond doubt that it is not ordinary and nece osar~ for petitioner lo incu r expenses for royalty and tcchrli cal service fees in merely reselling imported finished goods. The burden of proof was upon petitioner 3H Ph:i.1ippin s, Inc. P to esta iJ l .s h lh a t the percentuge of royAlty and technical service fees fell within purviPW and limitation of Section 3-C of Central Bank C i r c u l n r No � 39 3 � This !J tl r d en , 3M Phi 1 i p pines , Inc., had foi ed to satisfactor�ly dischurge. On th e question of the dcrluctibil:it. � of the pre- operatio nal cost o . the tapes used in the test run for the repair of the tap coater in the amount of 877,940.38, it appears that while petition r protes t ed the assessment with respect to the disallowance of the ro 1 a.lty and technica l serv i ce fees of 22,3 23,599.92, it d"d not djsput the disallow�_nce of this pre- operational cost, whi ch respondent construed ~e acquiescence to the correctness thereof. As po.i..1 1ted to by re::;pondent , eve n befo re the assessmenL vas issued and th e issuance there o f was st ill beinu proposed, petitio1er never objected to ~he propuse cl disallowance o f the pre-operational cost . 500

DEC f ~)I 0 N CTA CASE NO. 3856 - 22 - (See letter of Messrs . Bitot M:lBn & Lozada, v\ay 10, 1977 p ges 276-299, BIR rec ords , Folder I and letter of Cesar S. Cugas, Corporate Attorney of petitioner, '� dated May 29 9 1979, pages 385-388, BIR records~ Fo lder I.) In denying petitioner's prote st uqains t the a ss essment, respondent thus st � ed: "The disalloi�J3nce of the deduction of pre-operational expenses amounting to ~77,940.38 as rapitaJ expenditures is not being disputed by the t8xpoyer. Accordingly , the said amount is also subject to tax 0 (page 3L~, BlH �eC'nrds , Folder IT.). And dur:i.ng the heoring of this case before this Court, when petitioner offered to present testimonial evidence on tho disallowance uf the pre-operational cos t, respondent objected to the introduction of suc h evidence on the grbund of immaleriolity. The Court however allowed the introduction of such evidence vJith the understanding th at the matte will be discussed in detail in th.., memorandums and in the decision. (t.s.n., pp. 15-21, August 4, 1985.) While this matter of petiti oner not 1aving protested administratively the di sa l lowa nce of the decluction of the pre-ooerational cost of e77,940.38, as well as the legal consequences thereof. was dis- cussed exhaust.ively by re<>pondent in his memorandum \ 50

DEC I~; TON - CTA CASE NO. 1856 d at.e d M1ay �;� , .!. 9�o 6 (�IJP� -1'�51 �� }."J-J, 'r--l'~hrecoo's�)., peti- tioncr failed, or preferred no�. o ans>v r or react 1n its reply memorandum dateJ Juno t, 1986 (pp. J.57 .~ �. 163, CTA ecords) to the a leuations &nd arguments of rospon.,er t thereof. Neitht�r did petit.ioner cnl1 tho attenU n of this Cour~ (,urin~J th head nq of U is esse or in ito memorandum (pp. 105-127, CiA record~) that .it protested or dispute rl ad m.i n i �� t- r n t i vel y in t h e Bureau of Internal f~evenue the disollov<ancu of the deduction of the p �e�-c per.at.ional expense of ~77 , 940 . 38 as capitHl expend i ture. Since petitioner did not protest ,r dispute administratively the disol1ol'il-l nce of this p e- operatjonn expense as capit� l expenditure, pet.i- tioner C8Pnol: raist this 1ssue for the first time on appeal in this Court. This csnnol be permitted, for thf} some oasun that undcrli "s he require rnent. of prior c~xhaustion of administrntive remedies to give administr a .ive authoriti .. s the prior opportunity to d�cide co r trovcrsies within their ~ompet~nce, nnd i n muc h the same way thnt, on the judicial le el i s s u e .., no t r a i s c d j n t h e 1 01 e 1� c o u r t c c n no t b e a i s e d fcir the flrst time on ~ppcal. o sanction ouch n \ 50 2

. DECISlUN - CTA CAS[ NO. 3856 procedure whereby the courl - which is supposerl to review administrative determi1otions - would not review, but determine and decide for the fjrst tiwe, a que s t ion not r a i sed n t the n d r1l.i n if..> Lr aU v e fo rum � (Aguinaldo Indust r ies Corporation vs . rommissioner of Internal Revenue and the Court or Tax Appeals, L-29790, February 25 , 1982 , 112 SOIA 136.) Even more, such nsseGBment should be p rolcsterl ndminis .... tratively by filing a request for recons i deration or r d n vest i qat ion vd. thin t h i r t y ( 3[] ) d n y ~; r r CJ m r e c nip t thereof , other~,Jise, il becomes final and unappealable. ( se c 8 � J. G( d , , 5 l 9 -A , no~" Sec � 2 70 , ~.J n t i o n a l I n t e r n a J Revenue Code ~ ) Accordingly , pet i tioner 3M PhiJ~. ppine s , Inc., is ordered to pay io respondent Commissioner of Interna l Revenue t he amount of e1,191,566.80 as defi- ciency income tax for fiscal ye~ r ended October 3lt .1974 , plus surcharge3 and interest :incident to delinquency pursuant lo the provisions of Section ~?.1r,e )'~?-) l' J~) o f" ~L h e app 11' ca bl e Na t�1ona 1 I n t crna l Revenue Code, as amended. WHEREFOiH. , t h e d o cision nppeFJled from j!:-J hereby \

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