FACTS:

The case involves the assessment of a deficiency income tax against Lancaster, a domestic corporation engaged in the production, processing, and marketing of tobacco. The Commissioner of Internal Revenue (CIR) authorized the examination of Lancaster's books and records for all internal revenue taxes due from 1998 onwards. After the examination, the CIR issued a Preliminary Assessment Notice (PAN) citing Lancaster for overstatement of purchases and noncompliance with accounting principles. Lancaster replied to the PAN, arguing that the disallowed purchases should not have been disallowed based on specific provisions of the National Internal Revenue Code. Lancaster received a final assessment notice (FAN) assessing a deficiency income tax in the amount of P11,496,770.18.

Lancaster protested the assessment and filed a petition for review before the Court of Tax Appeals (CTA) Division. The CTA Division granted the petition and ordered the cancellation and withdrawal of the deficiency income tax assessment. The CIR sought recourse from the CTA En Banc, but it affirmed the cancellation of the assessment. The CIR then filed a petition with the Supreme Court, questioning the jurisdiction of the CTA to rule on the authority of revenue officers to examine Lancaster's books and records.

The CTA concluded that the revenue examiners exceeded their authority because the Letter of Authority (LOA) authorizing the examination only covered the taxable year 1998, while the deficiency income tax assessment was based on expenses reported in fiscal year 1999. The LOA clearly stated that the period of examination was the taxable year 1998. The validity of the assessment depends on whether the revenue officers acted within the authority granted to them by the LOA.

In a related case, the Court referred to the cancellation of a deficiency VAT assessment of Sony, Phils., Inc., where the LOA covered a different period than the records used to arrive at the deficiency. The CIR should have known which period should be covered by the investigation.

ISSUES:

1. Whether the Letter of Authority (LOA) issued to examine the books of accounts and other accounting records of Lancaster for the period from taxable year 1998 to an unstated date is valid.

2. Whether the deficiency income tax assessment against Lancaster for the period ending 31 March 1999 is valid.

3. The issue in this case is whether generally accepted accounting principles (GAAP) can be applied in tax accounting.

4. Whether Lancaster, as a business engaged in the production and marketing of tobacco, is authorized to adopt the crop method of accounting.

5. Whether the expenses in the crop production made within the crop year starting from October 1997 to September 1998, including the February and March 1998 purchases covered by purchase invoice vouchers, are deductible as expenses.

6. Whether the expenses for purchases made in February and March 1998 are deductible in the fiscal year 1998 or in the fiscal year 1999.

7. Whether the matching principle requires the deduction of expenses in the same year that related revenues are earned.

8. Whether the Assessment Notice LTAID II IT-98-00007, dated 11 October 2002 for deficiency income tax should be cancelled and set aside.

9. Whether the disallowance of expenses for the purchase of tobacco in February and March 1998 by the petitioner is legally justified.

RULING:

1. The LOA issued to examine Lancaster's books of accounts for the taxable year 1998 only is valid. The LOA specified the period of examination and is consistent with the guideline in Revenue Memorandum Order (RMO) No. 43-90 that the LOA shall cover a taxable period not exceeding one taxable year.

2. The deficiency income tax assessment against Lancaster for the period ending 31 March 1999 is void. The assessment is based on disallowed expenses covering the next fiscal year, which is outside the period specified in the LOA. Therefore, the assessment is invalid.

3. The court ruled that while there may be differences between tax and accounting principles, they are not mutually exclusive. Tax laws borrow concepts from accounting and rely on approved accounting methods and practices to collect the correct amount of taxes. The National Internal Revenue Code (NIRC) recognizes the importance of accounting principles and even devotes a whole chapter on accounting periods and methods of accounting. Thus, GAAP can be applied in tax accounting.

4. Yes, Lancaster, as a business engaged in the production and marketing of tobacco, is authorized to adopt the crop method of accounting. The NIRC does not prescribe a uniform or specific method of accounting. Any method that reflects the taxpayer's income properly and is used regularly can be employed. The CIR is also authorized to approve other accounting methods that would clearly reflect the taxpayer's income. In this case, the crop method of accounting is justifiable and suitable for Lancaster's purpose.

5. Yes, the expenses in the crop production made within the crop year starting from October 1997 to September 1998, including the February and March 1998 purchases covered by purchase invoice vouchers, are deductible as expenses. The crop method of accounting recognizes that the expenses of crop production should be deducted in the year that the crops are sold and income is realized.

6. The expenses for purchases made in February and March 1998 are deductible in the fiscal year 1999, which is the year when the gross income from the crops is realized, as per the crop year method of accounting.

7. The matching principle does not strictly require that the expense be deductible in the same year it is paid or incurred. The crop method of accounting, which is an unusual method of accounting, allows for expenses to be deducted in the year when gross income from the sale of the crops is realized.

8. The Court finds no cogent reason to overturn the decision and resolution of the Court of Tax Appeals (CTA). The Assessment Notice LTAID II IT-98-00007, dated 11 October 2002, in the amount of P6,466,065.50 for deficiency income tax should be cancelled and set aside as it was issued without valid authority. Furthermore, the disallowance of the petitioner's expenses for the purchase of tobacco in February and March 1998 is not legally justified.

PRINCIPLES:

• A valid LOA does not necessarily validate an assessment if the revenue officers act outside the authority granted in the LOA.

• Assessments must comply with the specified period in the LOA, as required by Revenue Memorandum Order (RMO) No. 43-90.

• The proper timing for recognizing purchases in computing taxable income should be determined based on the principles of proper matching of cost and revenue, as well as the applicable accounting principles and concepts.

• Generally accepted accounting principles (GAAP) can be applied in tax accounting.

• Tax and business accounting may produce concepts that diverge in understanding and usage, but they are not mutually exclusive.

• Tax laws borrow concepts from accounting and rely on approved accounting methods and practices.

• The NIRC recognizes the importance of accounting principles and provides provisions on accounting periods and methods of accounting.

• The NIRC does not prescribe a uniform or specific method of accounting. Any method that reflects the taxpayer's income properly and is used regularly can be employed. The CIR is also authorized to approve other accounting methods that would clearly reflect the taxpayer's income.

• The crop method of accounting is applicable to farmers engaged in the production of crops that take more than a year from planting to the process of gathering and disposal. It allows the deduction of expenses in the year that the gross income from the sale of the crops is realized.

• The crop year method of accounting requires the deduction of expenses in the year when gross income from the sale of the crops is realized.

• The matching principle directs that expenses be reported in the same period that related revenues are earned, attempting to match revenue with expenses that helped earn it.

• The provisions of the Tax Code and its implementing rules and regulations prevail over generally accepted accounting principles and standards in determining the taxability of income and deductibility of expenses.

• Assessment issued without valid authority is void.

• Expenses can only be disallowed if legally justified.