EN BANC

COMMISSIONER OF G. R. No. 163653

INTERNAL REVENUE,
Petitioner,

-versus-

FILINVEST DEVELOPMENT
CORPORATION,
Respondent.

x-------------------------------------x G. R. No. 167689

COMMISSIONER OF Present:
INTERNAL REVENUE,
Petitioner, CORONA, C.J.,
CARPIO,
VELASCO, JR.,
LEONARDO-DE CASTRO,
BRION,
-versus- PERALTA,
BERSAMIN,
DEL CASTILLO,
ABAD,
FILINVEST DEVELOPMENT VILLARAMA, JR.,
CORPORATION, PEREZ,
Respondent. MENDOZA, and
SERENO,* JJ.
 Promulgated:

July 19, 2011

x----------------------------------------------------------------------------------------------- x

DECISION

PEREZ, J.:

Assailed in these twin petitions for review on certiorari filed pursuant to

Rule 45 of the 1997 Rules of Civil Procedure are the decisions rendered by the
Court of Appeals (CA) in the following cases: (a) Decision dated 16 December
2003 of the then Special Fifth Division in CA-G.R. SP No. 72992; [1] and, (b)
Decision dated 26 January 2005 of the then Fourteenth Division in CA-G.R. SP
No. 74510.[2]

The Facts

The owner of 80% of the outstanding shares of respondent Filinvest Alabang, Inc.
(FAI), respondent Filinvest Development Corporation (FDC) is a holding company
which also owned 67.42% of the outstanding shares of Filinvest Land, Inc.
(FLI). On 29 November 1996, FDC and FAI entered into a Deed of Exchange with
FLI whereby the former both transferred in favor of the latter parcels of land
appraised at P4,306,777,000.00. In exchange for said parcels which were intended
to facilitate development of medium-rise residential and commercial buildings,
463,094,301 shares of stock of FLI were issued to FDC and FAI. [3] As a result of
the exchange, FLIs ownership structure was changed to the extent reflected in the
following tabular prcis, viz.:

Stockholde Number and Percentage Number of Number and Percentage

r of Shares Held Prior to Additional of Shares Held After the
the Exchange Shares Exchange
 Issued
FDC 2,537,358,000 67.42% 42,217,000 2,579,575,000 61.03%

FAI 00 420,877,000 420,877,000 9.96%

OTHERS 1,226,177,000 32.58% 0 1,226,177,000 29.01%

----------------- ----------- -------------- ---------------

3,763,535,000 100% 463,094,301 4,226,629,000 (100%)

On 13 January 1997, FLI requested a ruling from the Bureau of Internal Revenue
(BIR) to the effect that no gain or loss should be recognized in the aforesaid
transfer of real properties. Acting on the request, the BIR issued Ruling No. S-34-
046-97 dated 3 February 1997, finding that the exchange is among those
contemplated under Section 34 (c) (2) of the old National Internal Revenue Code
(NIRC)[4] which provides that (n)o gain or loss shall be recognized if property is
transferred to a corporation by a person in exchange for a stock in such corporation
of which as a result of such exchange said person, alone or together with others,
not exceeding four (4) persons, gains control of said corporation."[5] With the BIRs
reiteration of the foregoing ruling upon the 10 February 1997 request for
clarification filed by FLI,[6] the latter, together with FDC and FAI, complied with
all the requirements imposed in the ruling.[7]

On various dates during the years 1996 and 1997, in the meantime, FDC also
extended advances in favor of its affiliates, namely, FAI, FLI, Davao Sugar Central
Corporation (DSCC) and Filinvest Capital, Inc. (FCI).[8] Duly evidenced by
instructional letters as well as cash and journal vouchers, said cash advances
amounted to P2,557,213,942.60 in 1996[9] and P3,360,889,677.48 in 1997.[10] On
15 November 1996, FDC also entered into a Shareholders Agreement with Reco
Herrera PTE Ltd. (RHPL) for the formation of a Singapore-based joint venture
company called Filinvest Asia Corporation (FAC), tasked to develop and manage
FDCs 50% ownership of its PBCom Office Tower Project (the Project). With their
equity participation in FAC respectively pegged at 60% and 40% in the
Shareholders Agreement, FDC subscribed to P500.7 million worth of shares in said
joint venture company to RHPLs subscription worth P433.8 million. Having paid
its subscription by executing a Deed of Assignment transferring to FAC a portion
of its rights and interest in the Project worth P500.7 million, FDC eventually
reported a net loss of P190,695,061.00 in its Annual Income Tax Return for the
taxable year 1996.[11]
On 3 January 2000, FDC received from the BIR a Formal Notice of Demand to
pay deficiency income and documentary stamp taxes, plus interests and
compromise penalties,[12] covered by the following Assessment Notices, viz.: (a)
Assessment Notice No. SP-INC-96-00018-2000 for deficiency income taxes in the
sum of P150,074,066.27 for 1996; (b) Assessment Notice No. SP-DST-96-00020-
2000 for deficiency documentary stamp taxes in the sum of P10,425,487.06 for
1996; (c) Assessment Notice No. SP-INC-97-00019-2000 for deficiency income
taxes in the sum of P5,716,927.03 for 1997; and (d) Assessment Notice No. SP-
DST-97-00021-2000 for deficiency documentary stamp taxes in the sum
of P5,796,699.40 for 1997.[13] The foregoing deficiency taxes were assessed on the
taxable gain supposedly realized by FDC from the Deed of Exchange it executed
with FAI and FLI, on the dilution resulting from the Shareholders Agreement FDC
executed with RHPL as well as the arms-length interest rate and documentary
stamp taxes imposable on the advances FDC extended to its affiliates.[14]

On 3 January 2000, FAI similarly received from the BIR a Formal Letter of
Demand for deficiency income taxes in the sum of P1,477,494,638.23 for the year
1997.[15] Covered by Assessment Notice No. SP-INC-97-0027-2000, [16] said
deficiency tax was also assessed on the taxable gain purportedly realized by FAI
from the Deed of Exchange it executed with FDC and FLI. [17] On 26 January 2000
or within the reglementary period of thirty (30) days from notice of the assessment,
both FDC and FAI filed their respective requests for reconsideration/protest, on the
ground that the deficiency income and documentary stamp taxes assessed by the
BIR were bereft of factual and legal basis.[18] Having submitted the relevant
supporting documents pursuant to the 31 January 2000 directive from the BIR
Appellate Division, FDC and FAI filed on 11 September 2000 a letter requesting
an early resolution of their request for reconsideration/protest on the ground that
the 180 days prescribed for the resolution thereof under Section 228 of the NIRC
was going to expire on 20 September 2000.[19]

In view of the failure of petitioner Commissioner of Internal Revenue (CIR) to

resolve their request for reconsideration/protest within the aforesaid period, FDC
and FAI filed on 17 October 2000 a petition for review with the Court of Tax
Appeals (CTA) pursuant to Section 228 of the 1997 NIRC. Docketed before said
court as CTA Case No. 6182, the petition alleged, among other matters, that as
previously opined in BIR Ruling No. S-34-046-97, no taxable gain should have
been assessed from the subject Deed of Exchange since FDC and FAI collectively
gained further control of FLI as a consequence of the exchange; that correlative to
the CIR's lack of authority to impute theoretical interests on the cash advances
FDC extended in favor of its affiliates, the rule is settled that interests cannot be
demanded in the absence of a stipulation to the effect; that not being promissory
notes or certificates of obligations, the instructional letters as well as the cash and
journal vouchers evidencing said cash advances were not subject to documentary
stamp taxes; and, that no income tax may be imposed on the prospective gain from
the supposed appreciation of FDC's shareholdings in FAC. As a consequence, FDC
and FAC both prayed that the subject assessments for deficiency income and
documentary stamp taxes for the years 1996 and 1997 be cancelled and annulled.[20]

On 4 December 2000, the CIR filed its answer, claiming that the transfer of
property in question should not be considered tax free since, with the resultant
diminution of its shares in FLI, FDC did not gain further control of said
corporation. Likewise calling attention to the fact that the cash advances FDC
extended to its affiliates were interest free despite the interest bearing loans it
obtained from banking institutions, the CIR invoked Section 43 of the old NIRC
which, as implemented by Revenue Regulations No. 2, Section 179 (b) and (c),
gave him "the power to allocate, distribute or apportion income or deductions
between or among such organizations, trades or business in order to prevent
evasion of taxes." The CIR justified the imposition of documentary stamp taxes on
the instructional letters as well as cash and journal vouchers for said cash advances
on the strength of Section 180 of the NIRC and Revenue Regulations No. 9-94
which provide that loan transactions are subject to said tax irrespective of whether
or not they are evidenced by a formal agreement or by mere office memo. The CIR
also argued that FDC realized taxable gain arising from the dilution of its shares in
FAC as a result of its Shareholders' Agreement with RHPL.[21]

At the pre-trial conference, the parties filed a Stipulation of Facts, Documents and
Issues[22] which was admitted in the 16 February 2001 resolution issued by the
CTA. With the further admission of the Formal Offer of Documentary Evidence
subsequently filed by FDC and FAI[23] and the conclusion of the testimony of
Susana Macabelda anent the cash advances FDC extended in favor of its affiliates,
[24]
the CTA went on to render the Decision dated 10 September 2002 which, with
the exception of the deficiency income tax on the interest income FDC supposedly
realized from the advances it extended in favor of its affiliates, cancelled the rest of
deficiency income and documentary stamp taxes assessed against FDC and FAI for
the years 1996 and 1997,[25] thus:
 WHEREFORE, in view of all the foregoing, the court finds the
instant petition partly meritorious. Accordingly, Assessment Notice No.
SP-INC-96-00018-2000 imposing deficiency income tax on FDC for
taxable year 1996, Assessment Notice No. SP-DST-96-00020-2000 and
SP-DST-97-00021-2000 imposing deficiency documentary stamp tax on
FDC for taxable years 1996 and 1997, respectively and Assessment
Notice No. SP-INC-97-0027-2000 imposing deficiency income tax on
FAI for the taxable year 1997 are hereby CANCELLED and SET
ASIDE. However, [FDC] is hereby ORDERED to PAY the amount
of P5,691,972.03 as deficiency income tax for taxable year 1997. In
addition, petitioner is also ORDERED to PAY 20% delinquency interest
computed from February 16, 2000 until full payment thereof pursuant to
Section 249 (c) (3) of the Tax Code.[26]

Finding that the collective increase of the equity participation of FDC and
FAI in FLI rendered the gain derived from the exchange tax-free, the CTA also
ruled that the increase in the value of FDC's shares in FAC did not result in
economic advantage in the absence of actual sale or conversion thereof. While
likewise finding that the documents evidencing the cash advances FDC extended to
its affiliates cannot be considered as loan agreements that are subject to
documentary stamp tax, the CTA enunciated, however, that the CIR was justified in
assessing undeclared interests on the same cash advances pursuant to his authority
under Section 43 of the NIRC in order to forestall tax evasion. For persuasive
effect, the CTA referred to the equivalent provision in the Internal Revenue Code
of the United States (IRC-US), i.e., Sec. 482, as implemented by Section 1.482-2
of 1965-1969 Regulations of the Law of Federal Income Taxation.[27]

Dissatisfied with the foregoing decision, FDC filed on 5 November 2002 the
petition for review docketed before the CA as CA-G.R. No. 72992, pursuant to
Rule 43 of the 1997 Rules of Civil Procedure. Calling attention to the fact that the
cash advances it extended to its affiliates were interest-free in the absence of the
express stipulation on interest required under Article 1956 of the Civil Code, FDC
questioned the imposition of an arm's-length interest rate thereon on the ground,
among others, that the CIR's authority under Section 43 of the NIRC: (a) does not
include the power to impute imaginary interest on said transactions; (b) is directed
only against controlled taxpayers and not against mother or holding corporations;
and, (c) can only be invoked in cases of understatement of taxable net income or
evident tax evasion.[28] Upholding FDC's position, the CA's then Special Fifth
Division rendered the herein assailed decision dated 16 December 2003, [29] the
decretal portion of which states:

WHEREFORE, premises considered, the instant petition is

hereby GRANTED. The assailed Decision dated September 10, 2002
rendered by the Court of Tax Appeals in CTA Case No. 6182 directing
petitioner Filinvest Development Corporation to pay the amount
of P5,691,972.03 representing deficiency income tax on allegedly
undeclared interest income for the taxable year 1997, plus 20%
delinquency interest computed from February 16, 2000 until full
payment thereof is REVERSED and SET ASIDE and, a new one
entered annulling Assessment Notice No. SP-INC-97-00019-2000
imposing deficiency income tax on petitioner for taxable year 1997. No
pronouncement as to costs.[30]

With the denial of its partial motion for reconsideration of the same 11
December 2002 resolution issued by the CTA,[31] the CIR also filed the petition for
review docketed before the CA as CA-G.R. No. 74510. In essence, the CIR argued
that the CTA reversibly erred in cancelling the assessment notices: (a) for
deficiency income taxes on the exchange of property between FDC, FAI and FLI;
(b) for deficiency documentary stamp taxes on the documents evidencing FDC's
cash advances to its affiliates; and (c) for deficiency income tax on the gain FDC
purportedly realized from the increase of the value of its shareholdings in FAC.
[32]
The foregoing petition was, however, denied due course and dismissed for lack
of merit in the herein assailed decision dated 26 January 2005 [33] rendered by the
CA's then Fourteenth Division, upon the following findings and conclusions, to
wit:

1. As affirmed in the 3 February 1997 BIR Ruling No. S-34-046-97, the

29 November 1996 Deed of Exchange resulted in the combined
control by FDC and FAI of more than 51% of the outstanding
shares of FLI, hence, no taxable gain can be recognized from the
transaction under Section 34 (c) (2) of the old NIRC;
2. The instructional letters as well as the cash and journal vouchers
evidencing the advances FDC extended to its affiliates are not
subject to documentary stamp taxes pursuant to BIR Ruling No.
116-98, dated 30 July 1998, since they do not partake the nature
of loan agreements;
 3. Although BIR Ruling No. 116-98 had been subsequently modified by
BIR Ruling No. 108-99, dated 15 July 1999, to the effect that
documentary stamp taxes are imposable on inter-office memos
evidencing cash advances similar to those extended by FDC, said
latter ruling cannot be given retroactive application if to do so
would be prejudicial to the taxpayer;

4. FDC's alleged gain from the increase of its shareholdings in FAC as a

consequence of the Shareholders' Agreement it executed with
RHPL cannot be considered taxable income since, until actually
converted thru sale or disposition of said shares, they merely
represent unrealized increase in capital. [34]

Respectively docketed before this Court as G.R. Nos. 163653 and 167689,
the CIR's petitions for review on certiorariassailing the 16 December 2003
decision in CA-G.R. No. 72992 and the 26 January 2005 decision in CA-G.R. SP
No. 74510 were consolidated pursuant to the 1 March 2006 resolution issued by
this Courts Third Division.

The Issues

In G.R. No. 163653, the CIR urges the grant of its petition on the following
ground:

THE COURT OF APPEALS ERRED IN REVERSING THE

DECISION OF THE COURT OF TAX APPEALS AND IN
HOLDING THAT THE ADVANCES EXTENDED BY
RESPONDENT TO ITS AFFILIATES ARE NOT SUBJECT TO
INCOME TAX.[35]

In G.R. No. 167689, on the other hand, petitioner proffers the following issues for
resolution:

THE HONORABLE COURT OF APPEALS COMMITTED

GRAVE ABUSE OF DISCRETION IN HOLDING THAT THE
EXCHANGE OF SHARES OF STOCK FOR PROPERTY AMONG
FILINVEST DEVELOPMENT CORPORATION (FDC),
 FILINVEST ALABANG, INCORPORATED (FAI) AND
FILINVEST LAND INCORPORATED (FLI) MET ALL THE
REQUIREMENTS FOR THE NON-RECOGNITION OF
TAXABLE GAIN UNDER SECTION 34 (c) (2) OF THE OLD
NATIONAL INTERNAL REVENUE CODE (NIRC) (NOW
SECTION 40 (C) (2) (c) OF THE NIRC.

II

THE HONORABLE COURT OF APPEALS COMMITTED

REVERSIBLE ERROR IN HOLDING THAT THE LETTERS OF
INSTRUCTION OR CASH VOUCHERS EXTENDED BY FDC TO
ITS AFFILIATES ARE NOT DEEMED LOAN AGREEMENTS
SUBJECT TO DOCUMENTARY STAMP TAXES UNDER
SECTION 180 OF THE NIRC.

III

THE HONORABLE COURT OF APPEALS GRAVELY ERRED IN

HOLDING THAT GAIN ON DILUTION AS A RESULT OF THE
INCREASE IN THE VALUE OF FDCS SHAREHOLDINGS IN
FAC IS NOT TAXABLE.[36]

The Courts Ruling

While the petition in G.R. No. 163653 is bereft of merit, we find the CIRs petition
in G.R. No. 167689 impressed with partial merit.

In G.R. No. 163653, the CIR argues that the CA erred in reversing the CTAs
finding that theoretical interests can be imputed on the advances FDC extended to
its affiliates in 1996 and 1997 considering that, for said purpose, FDC resorted to
interest-bearing fund borrowings from commercial banks. Since considerable
interest expenses were deducted by FDC when said funds were borrowed, the CIR
theorizes that interest income should likewise be declared when the same funds
were sourced for the advances FDC extended to its affiliates. Invoking Section 43
of the 1993 NIRC in relation to Section 179(b) of Revenue Regulation No. 2, the
CIR maintains that it is vested with the power to allocate, distribute or apportion
income or deductions between or among controlled organizations, trades or
businesses even in the absence of fraud, since said power is intended to prevent
evasion of taxes or clearly to reflect the income of any such organizations, trades
or businesses. In addition, the CIR asseverates that the CA should have accorded
weight and respect to the findings of the CTA which, as the specialized court
dedicated to the study and consideration of tax matters, can take judicial notice of
US income tax laws and regulations.[37]

Admittedly, Section 43 of the 1993 NIRC[38] provides that, (i)n any case of
two or more organizations, trades or businesses (whether or not incorporated and
whether or not organized in the Philippines) owned or controlled directly or
indirectly by the same interests, the Commissioner of Internal Revenue is
authorized to distribute, apportion or allocate gross income or deductions between
or among such organization, trade or business, if he determines that such
distribution, apportionment or allocation is necessary in order to prevent evasion of
taxes or clearly to reflect the income of any such organization, trade or business. In
amplification of the equivalent provision[39] under Commonwealth Act No. 466,
[40]
Sec. 179(b) of Revenue Regulation No. 2 states as follows:

Determination of the taxable net income of controlled

taxpayer. (A) DEFINITIONS. When used in this section
(1) The term organization includes any kind, whether it be a
sole proprietorship, a partnership, a trust, an estate, or a corporation or
association, irrespective of the place where organized, where operated,
or where its trade or business is conducted, and regardless of whether
domestic or foreign, whether exempt or taxable, or whether affiliated or
not.
(2) The terms trade or business include any trade or business
activity of any kind, regardless of whether or where organized, whether
owned individually or otherwise, and regardless of the place where
carried on.
(3) The term controlled includes any kind of control, direct or
indirect, whether legally enforceable, and however exercisable or
exercised. It is the reality of the control which is decisive, not its form or
mode of exercise. A presumption of control arises if income or
deductions have been arbitrarily shifted.
(4) The term controlled taxpayer means any one of two or
more organizations, trades, or businesses owned or controlled directly or
indirectly by the same interests.
(5) The term group and group of controlled taxpayers means
the organizations, trades or businesses owned or controlled by the same
interests.
 (6) The term true net income means, in the case of a
controlled taxpayer, the net income (or as the case may be, any item or
element affecting net income) which would have resulted to the
controlled taxpayer, had it in the conduct of its affairs (or, as the case
may be, any item or element affecting net income) which would have
resulted to the controlled taxpayer, had it in the conduct of its affairs (or,
as the case may be, in the particular contract, transaction, arrangement or
other act) dealt with the other members or members of the group at arms
length. It does not mean the income, the deductions, or the item or
element of either, resulting to the controlled taxpayer by reason of the
particular contract, transaction, or arrangement, the controlled taxpayer,
or the interest controlling it, chose to make (even though such contract,
transaction, or arrangement be legally binding upon the parties thereto).

(B) SCOPE AND PURPOSE. - The purpose of Section 44 of the

Tax Code is to place a controlled taxpayer on a tax parity with an
uncontrolled taxpayer, by determining, according to the standard of an
uncontrolled taxpayer, the true net income from the property and
business of a controlled taxpayer. The interests controlling a group of
controlled taxpayer are assumed to have complete power to cause each
controlled taxpayer so to conduct its affairs that its transactions and
accounting records truly reflect the net income from the property and
business of each of the controlled taxpayers. If, however, this has not
been done and the taxable net income are thereby understated, the statute
contemplates that the Commissioner of Internal Revenue shall intervene,
and, by making such distributions, apportionments, or allocations as he
may deem necessary of gross income or deductions, or of any item or
element affecting net income, between or among the controlled
taxpayers constituting the group, shall determine the true net income of
each controlled taxpayer. The standard to be applied in every case is that
of an uncontrolled taxpayer. Section 44 grants no right to a controlled
taxpayer to apply its provisions at will, nor does it grant any right to
compel the Commissioner of Internal Revenue to apply its provisions.

(C) APPLICATION Transactions between controlled taxpayer and

another will be subjected to special scrutiny to ascertain whether the
common control is being used to reduce, avoid or escape taxes. In
determining the true net income of a controlled taxpayer, the
Commissioner of Internal Revenue is not restricted to the case of
improper accounting, to the case of a fraudulent, colorable, or sham
transaction, or to the case of a device designed to reduce or avoid tax by
 shifting or distorting income or deductions. The authority to determine
true net income extends to any case in which either by inadvertence or
design the taxable net income in whole or in part, of a controlled
taxpayer, is other than it would have been had the taxpayer in the
conduct of his affairs been an uncontrolled taxpayer dealing at arms
length with another uncontrolled taxpayer. [41]

As may be gleaned from the definitions of the terms controlled and

"controlled taxpayer" under paragraphs (a) (3) and (4) of the foregoing provision, it
would appear that FDC and its affiliates come within the purview of Section 43 of
the 1993 NIRC. Aside from owning significant portions of the shares of stock of
FLI, FAI, DSCC and FCI, the fact that FDC extended substantial sums of money as
cash advances to its said affiliates for the purpose of providing them financial
assistance for their operational and capital expenditures seemingly indicate that the
situation sought to be addressed by the subject provision exists. From the tenor of
paragraph (c) of Section 179 of Revenue Regulation No. 2, it may also be seen that
the CIR's power to distribute, apportion or allocate gross income or deductions
between or among controlled taxpayers may be likewise exercised whether or not
fraud inheres in the transaction/s under scrutiny. For as long as the controlled
taxpayer's taxable income is not reflective of that which it would have realized had
it been dealing at arm's length with an uncontrolled taxpayer, the CIR can make the
necessary rectifications in order to prevent evasion of taxes.

Despite the broad parameters provided, however, we find that the CIR's
powers of distribution, apportionment or allocation of gross income and deductions
under Section 43 of the 1993 NIRC and Section 179 of Revenue Regulation No. 2
does not include the power to impute "theoretical interests" to the controlled
taxpayer's transactions. Pursuant to Section 28 of the 1993 NIRC, [42] after all, the
term gross income is understood to mean all income from whatever source derived,
including, but not limited to the following items: compensation for services,
including fees, commissions, and similar items; gross income derived from
business; gains derived from dealings in property; interest; rents;
royalties; dividends; annuities; prizes and winnings; pensions; and partners
distributive share of the gross income of general professional partnership. [43] While
it has been held that the phrase "from whatever source derived" indicates a
legislative policy to include all income not expressly exempted within the class of
taxable income under our laws, the term "income" has been variously interpreted to
mean "cash received or its equivalent", "the amount of money comingto a person
within a specific time" or "something distinct from principal or