G.R. No. L-82833 September 26, 1988
3M PHILIPPINES, INC., petitioner, vs. COMMISSIONER OF INTERNAL REVENUE, respondent.

FACTS

3M Philippines, Inc., a subsidiary of the Minnesota Mining and Manufacturing Company (3M-St. Paul), entered into technical assistance and license agreements with its foreign parent company. These agreements, approved by the Central Bank, obligated 3M Philippines to pay royalties and technical service fees based on a percentage of its net sales. In its 1974 income tax return, the petitioner deducted P3,050,646.00 for such payments as business expenses. The Commissioner of Internal Revenue disallowed P2,323,599.02 of this amount, corresponding to fees calculated on the value of finished products imported from the parent company. The Commissioner ruled that such fees should be based only on locally manufactured goods, treating the disallowed portion as a disguised dividend. A deficiency tax assessment was issued.
The petitioner protested the assessment. After the Commissioner failed to act and instead issued warrants of distraint and levy, the petitioner appealed to the Court of Tax Appeals. The Tax Court upheld the Commissioner’s disallowance. The petitioner then elevated the case to the Supreme Court, arguing that the deduction was a legitimate business expense under the Tax Code and that Central Bank regulations were irrelevant to tax assessment.

ISSUE

Whether the royalty and technical service fee payments made by 3M Philippines on imported finished products are deductible as ordinary and necessary business expenses under the National Internal Revenue Code.

RULING

The Supreme Court denied the petition and affirmed the decision of the Court of Tax Appeals. The legal logic centers on the interplay between the Tax Code and validly issued exchange control regulations. While Section 29(a)(1) of the Tax Code allows the deduction of ordinary and necessary business expenses, including royalty payments, the propriety of such payments for deduction purposes is defined and governed by applicable regulations. Central Bank Circular No. 393, issued to conserve foreign exchange, explicitly provides that royalty payments shall be based only on commodities manufactured by the licensee under the agreement. It clearly prohibits royalty payments on the wholesale price of finished products imported from the licensor.
The Court rejected the petitioner’s argument that the Central Bank circular was irrelevant to tax deduction. Circulars issued by the Central Bank in the exercise of its authority, when duly published, have the force and effect of law. Therefore, payments made in violation of Circular No. 393 cannot be considered “ordinary and necessary” or legally proper. Consequently, such improper payments are not deductible as legitimate business expenses for income tax purposes. The disallowance by the Commissioner was correct, as the payments on imported goods were not sanctioned by the governing exchange control law.