CHAPTER 34 – INDIRECT METHODS OF PROVING INCOME

 Tax evasion
o Common and perennial problem of every tax administration worldwide
o Campaign against tax evasion to be effective, should be supported by adequate revenue
laws and efficient tax enforcement
 Concept of Fraud
o Fraud
 Deceit, deception or trickery
 Law: intentional perversion of truth to induce another to part with some
valuable thing belonging to him or to surrender a legal right
 Revenue laws: actual fraud in which there is dishonest intent
 Intentional fraud
 Meaning of tax evasion
o Tax evasion
 Connotes fraud through the use of pretenses and forbidden devices to lessen or
defeat taxes
 Prohibited and punishable by law
o Tax evasion/tax fraud means
 Willfully paying no tax when the taxpayer knows that the tax in some amount is
legally due or willfully paying less tax than which the taxpayer knows is legally
due
 Meaning of Tax Avoidance
o Means used to avoid or minimize taxes are legal or not prohibited by law
o Allowed and is not punishable by law
 Tax evasion distinguished from tax avoidance
o Tax evasion
 Attempt to reduce or altogether eliminate tax liability by means which is the law
declares to be unlawful
 Shrouded in an atmosphere of fraud, and usually involves falsification, deceit,
subterfuge, concealment or some deliberate attempt to make things appear
other than what they are
 Illegal and punishable by law
o Tax avoidance
 Connotes reaching the same ends by lawful means
 Trick or device which takes advantage of a defect or loophole in the law or of
the failure of the law to impose tax upon the transaction
 Legal and not punishable by law
 Power of the Commissioner to Obtain Information and to Summon, Examine and Take
Testimony of Persons
o Ascertaining the correctness of any return or in making a return when none has been
made, or in determining the liability of any person of any internal revenue tax, or in
collecting any such liability, or in evaluating tax compliance
o Commissioner is authorized
 To examine any book, paper, record or other data which may be
relevant/material to such inquiry
 Notes
o Under rules and regulations, policies and standards formulated
by the Commissioner with the approval of the Secretary of
Finance, the Revenue Regional Director shall, within the region
and district offices under his jurisdiction, issue Letters of
Authority (LAs or LOAs) for the examination of taxpayers in the
region
 Revenue officer assigned to perform assessment
functions in any district
 May examine taxpayers within the jurisdiction
of the district in order to collect the correct
amount of tax/recommend the assessment any
deficiency tax due in the same manner the said
acts could have been performed by the
Revenue Regional Director himself
 An LA signed by a Revenue District Officer, in
lieu of the Revenue Regional Director
o Renders the tax assessment a nullity in
the absence of such authority
 An LA must be served to the concerned
taxpayer within 30 days from the date of its
issuance, otherwise it shall become null and
void
o Simple erasure on LA renders it void
o Taxpayer shall then have the right to
refuse the service of the void LA, unless
the same is revalidated
o Revalidation of an LA shall give rise to the extension of the
period within w/c a Revenue Officer assigned to the case shall
submit the report of investigation to higher authorities for
review and approval, w/o the imposition of administrative
sanctions
 Said extension period shall be equivalent to the original
prescribed no. of days within w/c to report the case
under existing revenue issuances
 Failure of an RO to comply with the required procedure
for the revalidation of an LOA would eventually
invalidate the LOA
 Continuing the audit beyond the prescribed
120-day period without submission of a
progress report and without surrender the LOA
for revalidation
 o Shall mean that the RO has acted
without authority, and shall result in a
void assessment
o Normal process and procedure related to the
audit/investigation arising from electronic Las (eLAs) will not be
suspended notwithstanding the receipt of Legal Petition Notices
(LPNs) from taxpayers questioning the validity of the eLAs
issued
 There shall be no impediment on the investigation of a
taxpayer’s internal revenue liabilities & the eventual
recommendation for an issuance of Subpoena Duces
Tecum (SDT) if warranted
o To obtain on a regular basis from any person other than the
person whose inter
 Power of the Commissioner to Make Assessments and Prescribe Additional Requirements for
Tax Administration and Enforcement
o Examination of Returns and Determination of Tax Due
 Commissioner or his duly authorized representative may authorize the
examination of any taxpayer and assessment of the correct amount of tax
o Notes
 Failure to file a return
 Shall not prevent the Commissioner from authorizing the examination
of any taxpayer
 Even in the absence of annual audit program
 Commissioner has the authority to make any assessments
 Tax or deficiency tax so assessed
 Shall be paid upon notice and demand from the Commissioner or from
his duly authorized representative
 Third-Party Data Matching
o Power of the Commissioner to authorize examination of the taxpayer and the
assessment of the correct amount of tax
 Has been order through the “no-contact-audit-apporach”
 Includes the process of computerized matching of a taxpayer’s
declarations with other data from other information/returns filed by the
same taxpayer and by 3rd parties
 May reveal discrepancies even w/o deducting a detailed examination of
taxpayer’s books and records
 Discrepancies in a taxpayer’s declaration of his income, sales or purchases
 May be discovered through the ff. data matching programs
o Reconciliation of Listing for Enforcement System – Summary
Lists of Sales and Purchases (RELIEF)
o Bureau of Customs Data Program (BOC)
o Tax Reconciliation System (TRS)
 Taxpayer’s declaration of income, sales and purchases
  Cross-reference against data from the taxpayer’s own customers,
suppliers, withholding agents, payors and payees
 Discrepancies exceeding the discrepancy threshold set by the Commissioner
 Uncover instances of under-declaration or non-declaration of income,
over-declaration of purchases or expenses, under-remittance or non-
remittance of taxes withheld, over withholding or under withholding of
taxes, over-declaration of tax credits
o Shall result in the issuance of a Letter of Notice to the taxpayer
 LN issued to a taxpayer
o Considered a notice of audit/investigation
o Taxpayer is disqualified from amending the tax return covering
the period referred to in the LN
o If no returns were filed or schedules attached thereto
 Taxpayer may no longer file a return by way of “late
compliance”
 Any payments made by virtue of an LN
o Considered an advance deficiency tax payment
o Do not preclude additional assessments that might be made by
the appropriate BIR office
 Provided the discrepancies disclosed by other audits are
of the same nature as the discrepancies reflected in the
LNs for the same taxable year
 If the taxpayer ignores the LN or fails to refute the findings in the LN
within the period given by the BIR (15 days from the receipt of the LN)
thereby failing to settle the tax liabs. Resulting from LN discrepancies,
BIR may pursue the ff. actions or remedies:
o Review the case and issuance of a Notice for Informal
Conference or electronic Letter of Authority, or Preliminary
Assessment of Notice (PAN), or Final Assessment Notice (FAN)
o Suspension and temporary closure of the business
establishment of the taxpayer if the under-declaration is 30% or
more
o Issuance of the compulsory process of Subpoena Duces Tecum
(SDT) requiring the taxpayer to appear before the BIR for the
presentation or production of his or its books of accounts and
other accounting records
 Indirect Methods of Proving Income
o Methods to determine the true and correct income of taxpayers or detect income tax
evasion:
 Assess the tax based on the best evidence obtainable
 Conduct inventory-taking and surveillance
 Prescribe presumptive gross sales and receipts
 Cash expenditures method of investigation
 Net worth – expenditures (inventory) method of investigation
  Allocation of income and deductions
A. Assess the Tax Based on the Best Evidence Obtainable
 When report required by law as basis for assessment of tax shall not be
forthcoming within the time fixed by laws/rules and regulations or when there is
a reason to believe that any such report us false, incomplete or erroneous
 Commissioner shall assess the proper tax on the best evidence
obtainable
 In case person fails to file required return or other document at the time
prescribed by law or willfully or otherwise files a fraudulent return or other
document
 Commissioner shall make/amend the return from his own knowledge
and from such information as he can obtain through testimony or
otherwise
o Prima facie correct and sufficient for all legal purposes
 Note: BIR can resort to the Best Evidence Obtainable Rule & estimate
the tax liability of taxpayers who failed to submit its accounting records
o It is still required to provide sufficient evidence as basis for its
deficiency tax assessment
B. Conduct Inventory-Taking and Surveillance
 May order any time during the taxable year the inventory-taking of goods of any
taxpayer as a basis for determining his internal revenue tax liabilities
 May place business operations of any person, natural or juridical, under
observation or surveillance if there is reason to believe that such person is not
declaring his correct income, sales or receipts for internal revenue tax purposes
o Findings may be used as the basis for assessing the taxes for the other months/quarters
of the same or different taxable years and such assessment shall be deemed prima facie
correct
o Note: BIR may use the results of its surveillance as basis for assessing the taxes for other
months/quarters of the same/different taxable years
 If there is reason to believe that a taxpayer is not declaring his correct income,
sales or receipts for internal revenue tax purposes
C. Prescribe Presumptive Gross Sales and Receipts
 When person has failed to issue receipts and invoices in violation of the
requirements of Section 113 and 237 of Tax Code or when there is reason to
believe that the books of accounts/other records do not correctly reflect the
declarations made or to be made in a return
 Commissioner after taking into account the sales, receipts, income or
other taxable base of other persons engaged in similar businesses under
similar situations/circumstances or after considering other relevant
information
o Prescribe a minimum amount of such gross receipts, sales and
taxable base
o Such amount shall be prima facie correct for purposes of
determining internal revenue tax liabilities of such person
o Benchmarking
 One approach to detect tax leakages or to improve collection of taxes
 Identification of business sectors or industries where the degree of tax
compliance is unacceptably low
 Requires a system of setting performance standards or benchmarks
 Help identify taxpayers within industry groups who are paying below the set
benchmarks for tax compliance purposes
 Help in focusing audit/investigation efforts in selected areas where performance
falls below such standards/benchmarks
 Performance Benchmarking Method
 Setting standards to determine the compliance level of taxpayers in a
given line of industry or sector
o Includes
 Gathering of data for tax profiling
 Conduct of benchmarking itself
 Establishment of acceptable benchmarks
 After establishing the benchmarks, RDOs shall proceed to notify
taxpayers who fall below the benchmark that they should rectify their
tax returns and improve tax compliance
o Not a notice of investigation that will bar the taxpayer for
amending the return
 Taxpayer must within 15 days from receipt, fully explain in writing its
failure to measure up with the industry benchmarks
o Failure to do this, the taxpayer may be issued a Letter of
Authority or be subject to enforcement activities
 Post evaluation of CRM/POS machines
 Surveillance under the Oplan Kandado Program
 Inventory stocktaking or tax audit
 Note
 Purpose of BIR’s benchmarking program
o Establish set of standards to monitor the performance or
compliance of taxpayers in a particular industry and to improve
voluntary compliance
o Cannot be used as basis to compute the tax liability of taxpayer
 They assess deficiency taxes based on its own
investigation pursuant to a Letter of Authority (LOA) and
should not merely use the benchmark rate in arriving at
the alleged figures
D. Cash Expenditures Method
 Effective method of detecting tax evasion
 Cash expenditures of a taxpayer for a given year are compared with all his
known resources in cash plus the income that the taxpayer has reported in his
income tax return
 Also called as Cash Analysis Method – “where got, where goes”
 E. Net worth – expenditures (inventory) method
 Combination of the net worth and cash expenditures method
 Net worth method of tax investigation
 Comparison of the yearly increase in net worth with the income
declared in the return
o Features of Net Worth-Expenditures (Inventory) Method of Investigation
 Basic Concept and Theory
 Extension of accounting principles: Assets minus liabilities = Net worth
 Taxpayer’s net worth at the beginning and at the end of the taxable
year is determined
o Increase/decrease is adjusted by adding all non-deductible
items and subtracting therefrom non-taxable receipts (taxable
net income)
 General theory: taxpayer’s money and other assets in excess of
liabilities after accurate and proper adjustment of non-deductible items
and non-taxable receipts not accounted in the taxpayer’s income tax
return is deemed to be unreported income
o Unexplained increase in the net worth is presumed to be
derived from taxable sources
 Requisites or Conditions for the Application or Use of the Net Worth Method
 Taxpayer’s books do not clearly reflect his income or the taxpayer has
no books or if he has books, taxpayer refuses to produce them
 There is evidence of possible source/s of income to account for the
increases in net worth/expenditures
 There is a fixed starting point/opening net worth (date beginning w/ a
taxable year or prior to it) at which time the taxpayer’s financial
condition can be affirmatively established with definiteness
 Net worth method does really reflect the taxpayer’s income with
reasonable accuracy and certainty after proper and just additions of
personal expenses and other non-deductible expenditures were made,
and correct, fair and equitable credit adjustments were given by wat of
eliminating non-taxable items
 Taxpayer’s records are inadequate
 Commissioner is authorized to compute the taxable income of the
taxpayer in accordance with such method, as in his opinion, clearly
reflects the income in the ff. cases:
o No method of accounting has been employed
o Method of accounting employed does not clearly reflect the
income
 Net worth method may be used when the taxpayer has no book of
accounts or when the books do not clearly reflect the income or when
such books & other accounting records are not available for
examination by internal revenue officer or when the books and
accounting records are incomplete or inadequate
 o May also be used when taxpayer’s books or accounting records
were destroyed
 Evidence of Source of Income
 Rule: when tax case is civil in nature, direct proof of the sources of
income is not essential
o Gov’t is not required to negate all possible non-taxable sources
of the alleged net wirth increases
o Proofs of loans, gifts, bequests, inheritance and like need not be
adduced in evidence by the gov’t
o Burden of proof is upon taxpayer to show that his net worth
increase was derived from non-taxable sources
 Civil cases: assessment need not prove the specific source of income
o Based on the assumption that most assets are derived from
taxable source and that when this is not true, taxpayer is in a
position to explain the discrepancy
 Rule: when tax case is criminal in nature or when taxpayer is criminally
prosecuted for tax evasion
o Evidence of a likely source of income becomes a condition or
prerequisite for a successful prosecution
 Burden of proof: always with the government
o Incumbent upon revenue officers to negate all possible sources
of non-taxable receipts, in addition to adducing evidence to
satisfy other three requisites/conditions
o Conviction in criminal cases requires proof beyond reasonable
doubt
 A Fixed Starting Point or Opening Net Worth
 Essential requisite or condition
 Cornerstone of a net worth case
 If opening net worth is proven to be wrong
o Whole superstructure usually falls
o Net worth method reflects correct income
 Proper adjustments for nondeductible items and non-taxable receipts must be
made to conform with the requirements of income tax laws
 Non-deductible items
 Personal, living or family expenses
 Premiums paid on any life insurance policy
 Losses from sales or exchanges of property, bad debts or interests paid
between members of a family
 Income tax, estate and donor’s taxes and other non-deductible taxes
 Gifts to others
 Net capital loss
o Must be added to increase/decrease the net worth
 Non-taxable receipts
  Inheritance
 Donation/gift
 Compensation for injuries or sickness
 Proceeds of life insurance received by a beneficiary upon death of the
insured
 Sweepstakes and lotto winnings
 Non-taxable capital gains
 Returns of premiums paid
 Retirement benefits, pensions and gratuities
 Non-taxable prizes and awards
 13th month pay and other benefits not exceeding 90,000
 GSIS, SSS, Medicare and Pag-ibig contributions and union dues of
individuals
 Gains from the sale or exchange of retirement of bonds, debentures and
other certificate of indebtedness with a maturity of more than 5 years
 Gains realized by the investor upon redemption of shares of stock in a
mutual fund company
o Deducted
o Not taxable if they are shown not to be the result of unreported
income but to be merely the result of the correction of errors in
the taxpayer’s entries in its books relating to indebtedness to
certain creditors, erroneously listed although already paid
o Legality of the Net Worth Method of Investigation
 Authority of the Commissioner to use the net worth-expenditures method of
investigation
 Sec. 6 & 43 of the Tax Code
 When a report required by law as a basis of the assessment of any
national internal revenue tax shall not be forthcoming within the time
fixed by laws or rules and regulations
 When there is reason to believe that any such report is false,
incomplete or erroneous
o Assess the proper tax on the best evidence obtainable
 Taxable income
 Computed upon the basis of the taxpayer’s annual accounting period
xxxx in accordance with the method of accounting regularly employed in
keeping the books of taxpayer
o If no such method of accounting has been so employed or if the
method employed does not clearly reflect the income
 Computation shall be made in accordance with such
method as in the opinion of the Commissioner clearly
reflects the income
 Section 6
o Broad general investigatory power to assess the proper and
correct tax on the best evidence obtainable
o Implies authority to determine and assess the tax by any
method