Tax Articles

Assessment Arising From Third Party Information Needs Re-evaluation

By Atty. Fulvio D. Dawilan

Fulvio D. Dawilan Managing Partner   +632 8403 2001 loc.310 This email address is being protected from spambots. You need JavaScript enabled to view it. View Profile

The Bureau of Internal Revenue (BIR) had suspended all audit and other field operations – to give way for a review of the existing audit policies and procedures amidst complaints from stakeholders. Indeed, the whole audit process and its regulatory framework – including the selection of taxpayers for audit, the issuance and implementation of letters of authority, the issuance of findings and audit notices and the collection mechanisms – need recalibration.

Perhaps, one concern that needs thorough review relates to the use of third party information as basis for assessment. One of the common suspects in an assessment process and the usual source of deficiency tax assessment are the discrepancies noted during examinations. These discrepancies may be uncovered through the use of third party information – that is, from suppliers or customers or information gathered from other government agencies – either through the Reconciliation of Listings for Enforcement (RELIEF) System or simply through the comparison of information declared by the parties in their respective reports.

The pattern is clear. An assessment is almost certain whenever there are discrepancies noted through the use of third party information - regardless of which or whose report shows the higher or lower amount. To give context to this, imagine a VAT-registered buyer being the subject of an examination. If it’s summary list of purchases indicate higher amount compared to the sales declared by the seller, overclaimed costs of purchases and input taxes will be attributed to it and necessarily disallowances will result in deficiency income tax and VAT assessments.

Similarly, if the summary list of purchases shows a lower amount compared to the sales declared by the seller, deficiency taxes are still imposed. Usually, the difference between a lower amount reported by a taxpayer in its summary list of purchases and a higher amount reported by a supplier in its summary list of sales is treated as unrecorded purchases resulting in an unrecorded income. The BIR had coined a phrase for this – “unaccounted source of cash resulting in an unaccounted income” or “unreported purchases or expenses resulting in an unreported income” – to justify the imposition of deficiency income tax and VAT.

This approach is dangerous because it always attributes error on the part of the party being examined, even if the supposed discrepancy is attributed to the third party. It presumes that the declaration of the other transacting party is correct and the declaration of the taxpayer who is the subject of the examination is incorrect.

And this situation is not isolated. A review of the recent decisions of the Court of Tax Appeals would show the presence in almost all assessment cases, of deficiency taxes arising from the comparison of a taxpayer’s records versus the information gathered from other parties. And the verdict is also very clear.

For the use of third party information, the Courts had consistently ruled that the use of unverified/unconfirmed information from third party sources does not result in a valid assessment. An assessment must be based on verified facts and substantiated by evidence. An unverified third party information cannot serve as a proper factual basis. As such, the BIR should not rely on unverified third-party information for tax assessment.

Despite clear verdict against the use of unverified third party information in determining the correctness of tax payments, the BIR continues to use the same. And the burden is shifted to the taxpayer to reconcile the difference. Why give that burden to the taxpayer when it should not be doing it in the first place? Yet if the taxpayer fails to do the reconciliation or the reconciliation is not acceptable, the assessment is pursued. I believe that if the BIR fails to establish the correctness of the third party data through verification, the same should not be included in the computation of deficiency taxes and avoid further burden to the taxpayer.

Zeroing in on the undeclared costs or purchases or unaccounted source of case being treated as undeclared income, I believe this should never be part of an assessment. The Courts had consistently declared that an undeclared or under-declaration of purchases, expenses or other disbursement does not, by itself, result in the imposition of income tax and VAT. Non-declaration or under-declaration of purchases, costs or expenses is not equivalent to or does not give rise to undeclared Income. Simply put, a cost or expense is not equivalent to income – and so no income can be subjected to taxes.

Apparently, the imposition of tax on a supposed unrecorded cost of purchase or other expenses proceeds from the presumption that if there is an unrecorded cost or expense, there is also an unrecorded income. It does not follow. The Courts had affirmed a number of times the three elements in the imposition of income tax: (1) there must be gain or profit; (2) the gain or profit is realized or received, actually or constructively; and (3) it is not exempted by law or treaty from income tax. It is not when there is an underdeclared purchase or expense, but only when there is an income, and such income was received or realized by the taxpayer, that an imposition or assessment of income tax is proper.

Clearly, there is no basis for equating an expense to income. As such, even if there is undeclared purchases or expenses, the same does not give rise to taxable income. In fact, the Courts has also recognized rights of taxpayers to claim deductions lower than what they are rightfully entitled to. They should not be penalized for doing so.

Let me add that the old case of Perez vs. CTA & CIR, L-10507, May 30, 1958, usually cited by the BIR as legal basis for the imposition of income tax and VAT on alleged undeclared expenses or purchases is inapplicable. The income tax assessment in that case was made on the basis of the net worth method of assessment. The basic concept of this net worth method of determining income is that any increase in taxpayer’s net worth constitutes taxable income. Thus, what is being compared is a beginning net worth and the ending net worth. Certainly, this finds no application in an alleged discrepancy between a taxpayer’s declaration and that of another taxpayer.

These are just among the concerns related to the use of third party information. Concededly, the use of third party information as basis for assessment is not prohibited. It has legal basis. In fact, the Courts have recognized the use of this tool as aid in the determination by the BIR of the correctness of tax payments. But the Courts had also cancelled various assessments arising from use of third party information more than they have sustained. Use it in proper situations and avoid further burdens to taxpayers.