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Are monetized unused leave credits taxable?

Are monetized unused leave credits taxable? by: Arnold P. Supilanas

The Labor Code of the Philippines requires employers to pay a separation pay to employees who have been terminated from employment for causes authorized by law, such as retrenchment, redundancy or cessation of business. On top of the separation pay, the employee would normally receive his monetized unused leave credits.

Are these separation pay and monetized unused leave credits taxable?

Section 32 (B)(6)(b) of the 1997 Tax Code, as amended, provides for an exemption on separation pay. It requires the presence of two conditions before the sparation benefits are granted tax exemption, namely:

     1.    The official or employee is separated from the service of the employer due to death, sickness or other physical disability, or for any cause beyond the control of the said official or employee
     2.    The official or employee or his heirs receives any amount from the employer on account of such separation

The phrase "for any cause beyond the control of the said official or employee" connotes involuntariness on the part of the official or employee. The separation from service must not be asked for or initiated by the official or employee.

On several ocassions, the Bureau of Internal Revenue (BIR) held that any and all amounts received by employees as a consequence of separation from employment for any causes beyond the control of the said employee are exempt from income tax and, consequently, from withholding tax on compensation. This exemption includes the commutation of unused leave credits due to involuntary separation from employment, more popularly known as “terminal leave pay”, regardless of the number of days.

Just recently, however, the BIR modified its position on the taxability of the terminal leave pay. In BIR Ruling No. 199-2011, dated June 29, 2011, the BIR ruled that commutation and payment of monetized unused vacation leave credits as a result of involuntary separation of employees from service is not subject to income tax, and consequently, to withholding tax on compensation to the extent of ten days for vacation leaves. Hence, cash equivalent of vacation leave credits in excess of ten days is subject to tax.

In this ruling, the BIR applied the rule on de minimis beneifts with regard to commutation of vacation leave. Note, however, that this applies only to terminal leave pay. Separation benefits received by the employees as a consequence of separation from employment for any causes beyond the control of the employees remain exempt from income tax and, consequently, to withholding tax.  

Accordingly, the BIR is changing its position on the taxability of terminal leave pay, which is not the first time the BIR has modified its position.  In numerous instances, the BIR has revoked previously issued rulings, which it believes are inconsistent with the tax laws and revenue issuances.

With the change in BIR’s position brought about by BIR Ruling No. 199-2011, taxpayers will no doubt be wondering about the impact of this rulings on the tax treatment of leave credits. What will happen to those companies or employers who treated terminal leave pay, regardless of their number of leave credits, as tax exempt? Will they be exposed to potential tax deficiency assessment? Will this new treatment apply prospectively or retrospectively?

Right now, this ruling only applies to the taxpayer who requested it.

It is likely, however, that in succeeding ruling, the BIR would rulie in the same way.  

This nothwithstanding, both the employer and the employee as withholding agent and taxpayer, respectively, should be aware of the current position  of the BIR and consider this particular ruling  in the design of separation packages to be granted by employers to their employees.