COMMISSIONER OF INTERNAL REVENUE v. JOHN L.

MANNING, W.D. McDONALD, E.E. SIMMONS and THE

COURT OF TAX APPEALS
August 6, 1975 | Castro, J. | Passive Income: Dividends
Digester: Jeff Batac
SUMMARY: Reese, the majority stockholder (with 24,700 out of
the 25,000 common shares) of MANTRASCO, executed a trust
agreement between him and three minority stockholders, namely
Manning, McDonald, and Simmons, each of whom owned 100
common shares. Reese wanted MANTRASCO to remain under the
management of the three minority stockholders even after his
death, hence the trust agreement. Upon Reese's death,
MANTRASCO paid his estate the value of his shares. Subsequently,
Reese's shares were declared as dividends and were
proportionately distributed to Manning, McDonald, and Simmons.
No income tax was paid by any of them. The BIR later assessed the
three with deficiency income tax, as well as fraud penalties and
interest charges, saying that the distribution of Reese's shares as
stock dividends was in effect a distribution of the assets or
property of the corporation, which should have been taxable. The
CTA reversed the BIR assessment, saying that the respective 1/3
interest in MANTRASCO of Manning, McDonald, and Simmons
remained the same before and after the declaration of the stock
dividends and only the number of shares held by each of them had
changed. The SC ruled otherwise and held that the declaration of
Reese's shares as dividends was null and void, and that the subject
transaction was in fact subject to the payment of income tax. As
such, the Court remanded the case to the CTA for the
recomputation of income tax liabilities of Manning, McDonald, and
Simmons.
DOCTRINE: A dividend is any distribution made by a corporation
to its shareholders, whether in money or in other property, out of
its earnings or profits. A stock dividend is a conversion of surplus
or undivided profits into capital stock, which is distributed to
stockholders in lieu of a cash dividend.
Under the National Internal Revenue Code, income tax is assessed
on income received from any property, activity or service that
produces income. The Tax Code stands as an indifferent, neutral
party on the matter of where the income comes from.
FACTS:

Part I. THE TRUST AGREEMENT

In 1952, the Manila Trading and Supply Co. (MANTRASCO)
had an authorized capital stock of P2.5M divided into 25,000
common shares; 24,700 of these were owned by Julius S.
Reese, and the rest, at 100 shares each, by John Manning, W.D.
McDonald, and E.E. Simmons (otherwise known as the
"managers").
In the same year, prompted by his desire to keep MANTRASCO
and its two subsidiaries under the management of the
managers even after his death, Reese executed a trust
agreement between him, MANTRASCO, the managers, and the
law firm Ross, Selph, Carrascoso and Janda. The trust
agreement provided that after Reese's death, MANTRASCO
shall purchase Reese's shares.
Reese passed away in 1954. A year later, the certificate for his
24,700 shares was cancelled and a new certificate was issued
in the name of MANTRASCO. But since the company did not
have sufficient money yet for the payment of said shares, the
certificate was endorsed to the law firm Ross, Selph,
Carrascoso and Janda as trustees for and in behalf of
MANTRASCO.
In 1958, at a special meeting of MANTRASCO stockholders, it
was resolved that the 24,700 shares be reverted back to the
capital account of the company as a stock dividend to be
distributed to the shareholders.
In 1963, MANTRASCO was finally able to pay the value of the
24,700 shares in full. So in 1964, the trust agreement was
terminated and the law firm delivered to MANTRASCO all the
shares which they were holding in trust.
Part. II. DEFICIENCY TAX ASSESSMENT
In 1962, the BIR ordered the examination of MANTRASCO's
books. The examination disclosed that:
o as of December 31, 1958, the 24,700 shares declared as
dividends had been proportionately distributed to the the
three managers, representing a total book value or
acquisition cost of P7,973,660;
o that the three managers failed to declare the said stock
dividends as part of their taxable income for the year 1958;
and
o that from 1956 to 1961, MANTRASCO paid in increments to
Reese's estate the value of the 24,700 shares he used to
own.

On the basis of their examination, the BIR examiners

concluded that the distribution of Reeses shares as stock
dividends was in effect a distribution of the "asset or property
of the corporation as may be gleaned from the payment of cash
for the redemption of said stock and distributing the same as
stock dividend." According to Sec. 83 of the NIRC, "Where a
corporation distributes all of its assets in complete liquidation
or dissolution the gain realized or loss sustained by the
stockholder, whether individual or corporate, is a taxable
income or deductible loss, as the case may be."
So on April 14, 1965, the Commissioner of Internal Revenue
issued notices of assessment for deficiency income taxes to the
three managers (herein respondents) for the year 1958. The
three managers challenged the said assessment, arguing that
regardless of the distribution of the dividends, their respective
1/3 interest in the company remained the same. They cited
Sec. 252 of the BIR Regulations as basis for non-payment of
income tax: "A stock dividend constitutes income if it gives the
shareholder an interest different from that which his former
stockholdings represented. A stock dividend does not
constitute income if the new shares confer no different rights
or interests than did the old." Still, the CIR dismissed their
complaint.
On appeal, the CTA reversed CIR's tax assessment and
absolved the three managers from any tax liability. The CTA
held that the respective 1/3 interest in MANTRASCO of the
three managers remained the same before and after the
declaration of stock dividends and only the number of shares
held by each of them had changed.
Hence, the instant petition by the CIR.

RULING: Petition granted. CTA ruling reversed. Case remanded

to the CTA for the recomputation of the tax liability of the three
managers.
Whether the declaration of Reese's shares as treasury stock
dividends is valid. NO.
Reese's shares cannot be declared as treasury stock dividends,
mainly because they were not treasury shares to begin with.
(See NOTES for the essential features of treasury shares.) In
fact, the essential features of treasury shares were lacking in
Reese's shares. (See NOTES why Reese's shares are not
treasury shares.)

The manifest intention of the parties to the trust agreement

was to treat the 24,700 shares of Reese as absolutely
outstanding shares of Reeses estate until they were fully paid.
Such being the true nature of the 24,700 shares, their
declaration as treasury stock dividend in 1958 was a complete
nullity and plainly violative of public policy. A stock dividend,
being one payable in capital stock, cannot be declared out of
outstanding corporate stock, but only from retained earnings.

Whether the distribution of the dividends proportionately to

the three managers is subject to income tax,
notwithstanding the invalidity of the declaration of Reeses
shares as dividends. YES.
The real purpose of the declaration of Reese's shares as
dividends is to make the managers the sole owners of Reeses
interest in MANTRASCO by utilizing the periodic earnings of
that company and its subsidiaries to directly subsidize their
purchase of the said interests, and by making it appear
outwardly, through the formal declaration of non-existent stock
dividends in the treasury, that they have not received any
income from those firms when, in fact, by that declaration they
secured to themselves the means to turn around as full owners
of Reeses shares.
In other words, the managers, using the trust instrument as a
convenient technical device, bestowed unto themselves the full
worth and value of Reeses corporate holdings with the use of
the very earnings of the companies. Such package device
cannot be allowed to deflect the threee managers'
responsibilities toward income tax laws.
Whenever MANTRASCO parted with a portion of its earnings
"to buy" the corporate holdings of Reese, it was in effect
making a distribution of such earnings to the managers. All
these amounts are consequently subject to income tax as
being, in truth and in fact, a flow of cash benefits to the
managers.
Regardless of the invalidity of the board resolution declaring
Reese's shares as dividends, the subject transaction remains
subject to tax. Under the NIRC, income tax is assessed on
income received from any property, activity or service that
produces income. The Tax Code stands as an indifferent,
neutral party on the matter of where the income comes from.
But the case still needs to be remanded to the CTA because the
CIR made an error in the computation of the managers' tax
liabilities by assessing the managers the total acquisition cost

(P7,973,660) of the alleged treasury stock dividends in one

lump sum.. Records show that that the earnings of
MANTRASCO over a period of years were used to gradually
wipe out the holdings of Reese. Consequently, those earnings
should be taxed for each of the corresponding years when
payments were made to Reeses estate on account of his
24,700 shares.
NOTES:
Essential features of treasury shares:
o Treasury shares are stocks issued and fully paid for and reacquired by the corporation either by purchase, donation,
forfeiture or other means.
o Treasury shares are therefore issued shares, but being in the
treasury they do not have the status of outstanding shares.
o Consequently, although a treasury share, not having been retired
by the corporation re-acquiring it, may be re-issued or sold again,
such share, as long as it is held by the corporation as a treasury
share, participates neither in dividends, because dividends cannot
be declared by the corporation to itself, nor in the meetings of the
corporation as voting stock, for otherwise equal distribution of
voting powers among stockholders will be effectively lost and the

directors will be able to perpetuate their control of the

corporation, though it still represents a paid-for interest in the
property of the corporation.
Why Reese's shares are not treasury shares:
o under paragraph 4(c) of the trust agreement, the trustees were
authorized to vote all stock standing in their names at all meetings
and to exercise all rights "as owners of said shares" this
authority is reiterated in paragraphs 26 and 28 of the trust
agreement;
o under paragraph 4(d), "Any and all dividends paid on said shares
after the death of the OWNER shall be subject to the provisions of
this agreement;"
o under paragraph 5(b), the amount of retained earnings to be
declared as dividends was made subject to the approval of the
trustees of the 24,700 shares;
o under paragraph 5(c), the choice of corporate directors was
delegated exclusively to the trustees who were also given the
authority to transfer qualifying shares to such directors; and
o under paragraph 19, MANTRASCO and its two subsidiaries were
expressly prohibited from paying "dividends except as may be
authorized by the TRUSTEES;" in the same paragraph mention
was also made of "dividends on OWNERS SHARES" which shall
be applied to the liquidation of the liabilities of the three
companies for the price of Reeses shares.