UP Law F2021 148 Cyanamid Philippines, Inc. vs.

CA
Tax 1 – Improperly Accumulated Sec. 29, NIRC 2000 Quisumbing
Earnings Tax

SUMMARY
Petitioner Cyanamid was assessed surtax on its allegedly unduly accumulated earnings. It protested the assessment,
arguing that the accumulation was for the purpose of meeting the working capital needs of the company. The CTA and CA
held that petitioner is not included in the exceptions from the improperly accumulated earnings tax and thus ordered the
company to pay the assessment. The SC upheld the lower courts’ ruling on the grounds that, aside from the fact that the
company does not fall within the exemptions, Cyanamid had adequate working capital to cover its operations for the
succeeding year and that it was not able to establish clear and convincing evidence that the accumulation of earnings was
for the immediate needs of its business.

FACTS
 Petitioner Cyanamid Philippines, Inc., a corporation organized under Philippine laws, is a wholly owned
subsidiary of American Cyanamid Co. based in Maine, USA. It is engaged in the manufacture of pharmaceutical
products and chemicals.
 In 1985, the CIR assessed the petitioner a deficiency income tax amounting to P119,817 for taxable year 1981.
Included in such assessment was the surtax for the undue accumulation of earnings. Petitioner protested the
assessment and claimed that such surtax was improper because the said profits were retained to increase
petitioner’s working capital and it would be used for reasonable business needs of the company. Petitioner
contended also that it availed of the tax amnesty.
 In 1987, the CIR refused to allow the cancellation of the assessment. The CIR urged SGV, the external auditor of
petitioner, that the latter’s client pay the said deficiency income tax.
 The case was appealed to CTA. Pending the appeal, the petitioner paid a reduced amount of the assessment.
However, it did not pay the surtax on the allegedly improperly accumulated earnings. According to petitioner, the
said surtax had no legal basis for the following reasons:
a. To meet working capital needs and retirement of indebtedness
b. Petitioner is a wholly owned subsidiary of American Cyanamid Company, a foreign corporation, whose
shares of stock are listed and traded in New York Stock Exchange. As such, no individual shareholder of
petitioner could have evaded or prevented the imposition of individual income taxes by petitioner’s
accumulation of earnings and profits, instead of distribution of the same.
 The CTA upheld the assessment of the CIR on the grounds that the petitioner’s purpose for accumulation of
earnings does not fall within the exceptions under Sec. 25, NIRC of 1977 (now Sec. 29, NIRC). The Tax Court also
held that petitioner had considerable liquid funds consisting of cash, accounts receivable, inventory, and even its
sales for the period was adequate to meet the normal needs of the business.
 The CA affirmed the CTA’s decision.

RATIO
[MAIN ISSUE] W/N Cyanamid is liable for the accumulated earnings tax for the taxable year 1981 - YES
Pursuant to Sec. 25, NIRC of 1977, a tax equal to 25% (now 10% under Sec. 29, NIRC) of the undistributed portion of its
accumulated profits or surplus shall be assessed against a corporation that is “formed or availed of for the purpose of
preventing the imposition of the tax upon its shareholders or members of another corporation, through the medium of
permitting its gains and profits to accumulate instead of being divided or distributed.”

The following are prima facie evidence of undue accumulation of earnings or profits under Sec. 25 (b), NIRC of 1977:
a. The fact that any corporation is mere holding company
b. In the case of an investment company where at any time during the taxable year, more than 50% in value of its
outstanding stock is owned, directly or indirectly, by one person. (This is omitted in Sec. 29, NIRC of 1997.)

The exceptions under the said Section are:

The rationale for the prohibition to unduly accumulate earnings is to discourage tax avoidance. When corporations do not
declare dividends, income taxes are not paid on the undeclared dividends received by the shareholders. The tax on
improper accumulation of surplus is essentially a penalty tax designed to compel corporations to distribute earnings so
that the said earnings by shareholders could, in turn, be taxed.

Application to Cyanamid

1. Cyanamid is not included among the exceptions

2. Cyanamid has adequate working capital to cover its operations for the succeeding year without the need for
accumulating income or earnings.
Petitioner argued that the increase of working capital by a corporation justifies accumulating income. The CA and CTA, on
the other hand, concluded that the additional working capital reserve was not necessary because it had considerable
liquid funds based on the ratio of current assets to current liabilities.

Petitioner relied on the so-called “Bardahl” formula, which measures corporate liquidity. The formula requires an
examination of whether the taxpayer has sufficient liquid assets to pay all of its current liabilities and any extraordinary
expenses reasonably anticipated, plus enough to operate the business during one operating cycle. Operating cycle is the
period of time it takes to convert cash into raw materials, raw materials into inventory, and inventory into sales,
including the time it takes to collect payment for the sales. In the case of Cyanamid, the operating cycle was 288.35 days,
or 78.55% of a year, reflecting that petitioner will need sufficient liquid funds, of at least three quarters of the year, to
cover the operating costs of the business, However, the courts apply this formula only for administrative convenience.

The Court noted that other formulas may also be used such as the ratio of current assets to current liabilities and the
adoption of the industry standard. The ratio of current assets to current liabilities is used to determine the sufficiency of
working capital. Ideally, the working capital should equal the current liabilities and there must be 2 units of current
assets for every unit of current liability, hence the so-called "2 to 1" rule. As of 1981, the working capital of Cyanamid was
around P26 million, or more than twice its current liabilities. It means that there is adequacy in petitioner’s working
capital. Moreover, available income covered expenses or indebtedness for that year, and there appeared no
reason to expect an impending working capital deficit which could have necessitated an increase in working
capital, as rationalized by petitioner.

3. Cyanamid did not establish that the accumulation of the profit was for the immediate needs of the business.
In order to determine whether profits are accumulated for the reasonable needs of the business to avoid the surtax upon
shareholders, it must be shown that the controlling intention of the taxpayer is manifested at the time of
accumulation, not intentions declared subsequently, which are mere afterthoughts. Furthermore, the
accumulated profits must be used within a reasonable time after the close of the taxable year. In the instant case,
petitioner did not establish, by clear and convincing evidence that such accumulation of profit was for the immediate
needs of the business. The phrase 'reasonable needs of the business' to mean the immediate needs of the business, and
it was generally held that if the corporation did not prove an immediate need for the accumulation of the earnings and
profits, the accumulation was not for the reasonable needs of the business, and the penalty tax would apply.

FALLO
WHEREFORE, the instant petition is DENIED, and the decision of the Court of Appeals, sustaining that of the Court of Tax
Appeals, is hereby AFFIRMED. Costs against petitioner. SO ORDERED.