Introduction

In the Philippine hospitality industry, including restaurants, hotels, and similar establishments, service charges are a common addition to customer bills. These charges, typically computed as a percentage of the total bill (often 10%), are intended to compensate service personnel for their efforts. The key question arises in the realm of taxation: Are these service charges, when distributed to employees, subject to Value-Added Tax (VAT)? This article examines the legal and tax framework governing service charges in the Philippines, focusing on their VAT implications. It draws on relevant provisions of the Labor Code, tax laws under the National Internal Revenue Code (NIRC) of 1997, as amended, and pertinent Bureau of Internal Revenue (BIR) issuances to provide a comprehensive analysis.

Legal Framework for Service Charges

The treatment of service charges is primarily rooted in labor laws, which mandate their collection and distribution to ensure fair compensation for workers in service-oriented industries.

The Labor Code and Pre-Existing Rules

Under Article 96 of Presidential Decree No. 442, otherwise known as the Labor Code of the Philippines, all service charges collected by hotels, restaurants, and similar establishments must be distributed among covered employees. Prior to amendments, the distribution was typically 85% to rank-and-file employees and 15% retained by management for administrative purposes or to cover breakages and losses. This framework aimed to supplement the wages of service workers, recognizing the tipped nature of their roles.

Republic Act No. 11360: The Service Charge Law

On August 7, 2019, Republic Act (RA) No. 11360, known as "An Act Providing that Service Charges Collected by Hotels, Restaurants and Other Similar Establishments Be Distributed in Full to All Covered Employees," amended Article 96 of the Labor Code. This law requires that 100% of service charges be distributed equitably among all covered employees, excluding managerial employees. Covered employees include those directly engaged in serving customers, such as waiters, bartenders, and housekeeping staff.

The Implementing Rules and Regulations (IRR) issued by the Department of Labor and Employment (DOLE) under Department Order No. 206-19 further clarify the distribution mechanism:

Service charges must be distributed at least once every two weeks or twice a month.
Distribution should be fair and equitable, based on factors like hours worked or performance.
Establishments must maintain records of collections and distributions, subject to DOLE inspection.
Violations can result in penalties, including fines and potential suspension of business operations.

This shift to full distribution underscores the legislative intent to treat service charges as additional compensation for employees rather than revenue for the employer.

Tax Implications of Service Charges

The tax treatment of service charges hinges on whether they constitute income to the establishment or merely a pass-through to employees. This distinction is crucial for determining liability under various taxes, including VAT, income tax, and withholding tax.

Value-Added Tax (VAT) Under the NIRC

VAT is imposed under Sections 106 and 108 of the NIRC, as amended by laws such as Republic Act No. 10963 (TRAIN Law) and Republic Act No. 11534 (CREATE Law). It applies at a rate of 12% on the gross selling price of goods or gross receipts from services, excluding the VAT itself.

For VAT purposes:

Gross Selling Price or Gross Receipts: These refer to the total amount of money or its equivalent received by the seller or service provider as consideration for the sale or service, excluding VAT and certain deductions.
Exclusions: Amounts that do not accrue to the benefit of the taxpayer, such as those held in trust or as agent, are excluded from gross receipts.

In the context of service charges:

When collected by the establishment, service charges form part of the customer's total payment.
However, since RA 11360 mandates 100% distribution to employees, the establishment does not retain these amounts as income. Instead, it acts as a conduit, collecting and disbursing them.

Consequently, service charges distributed to employees are not subject to VAT. This is because they do not form part of the establishment's gross receipts for services rendered. The VAT is computed only on the base amount (e.g., cost of food, beverages, or room charges), excluding the service charge.

Historical Context: Pre-RA 11360 Treatment

Before RA 11360, the 15% portion retained by management was considered part of the establishment's gross income and thus subject to VAT, income tax, and other business taxes. The 85% distributed to employees was treated as compensation, exempt from VAT but subject to withholding tax. BIR rulings, such as BIR Ruling No. DA-287-05, affirmed that only the retained portion was vatable.

Post-RA 11360 Clarifications

The BIR issued Revenue Memorandum Circular (RMC) No. 64-2019 on September 13, 2019, to address the tax implications of RA 11360:

VAT Exemption: Service charges fully distributed to employees are excluded from the gross receipts of the establishment and are not subject to VAT.
Rationale: These charges are not consideration for services provided by the establishment but are akin to tips or gratuities directly benefiting employees.
Billing and Invoicing: Establishments must separately itemize service charges on official receipts or invoices. VAT should be calculated only on the vatable portion of the bill (e.g., food and beverage costs).
Example Computation:
- Food and beverages: PHP 1,000 (vatable)
- VAT (12%): PHP 120
- Service charge (10%): PHP 100 (non-vatable)
- Total bill: PHP 1,220

In this scenario, the establishment remits VAT only on the PHP 1,000 base amount.

If an establishment fails to distribute the service charges as required, the undistributed amounts become part of its gross income, subject to VAT, income tax, and penalties.

Income Tax Treatment

While not subject to VAT, service charges have income tax implications:

For Employees: Distributed service charges are considered compensation income, subject to graduated income tax rates under Section 24 of the NIRC. They are included in the employee's gross income and subject to withholding tax on compensation under Revenue Regulations (RR) No. 2-98, as amended.
- Exemption from VAT: As employees, their earnings from service charges are not considered sales of services subject to VAT (Section 109 of the NIRC exempts employment income from VAT).
- Fringe Benefits: If distributed to managerial employees (excluded under RA 11360), they might be treated as fringe benefits subject to fringe benefits tax.
For the Establishment: Since service charges are not retained, they are not part of taxable income. However, the establishment must withhold and remit taxes on the distributions as compensation.

Withholding Tax Obligations

Under RR No. 2-98:

Establishments must withhold income tax on service charges distributed to employees.
These amounts are reported in the employee's BIR Form 2316 (Certificate of Compensation Payment/Tax Withheld).
Monthly remittances via BIR Form 1601-C and annual information returns (BIR Form 1604-C) are required.

Other Business Taxes

Percentage Tax: For establishments subject to percentage tax (e.g., non-VAT taxpayers under Section 109), service charges are similarly excluded if fully distributed.
Local Business Tax: Under the Local Government Code (Republic Act No. 7160), local government units may impose taxes on gross receipts. However, service charges are generally excluded from the tax base if not retained by the business, aligning with national tax treatment.

BIR Rulings and Administrative Guidance

Several BIR issuances reinforce the VAT exemption:

BIR Ruling No. 040-02: Clarified that service charges distributed to employees are not part of gross sales for VAT purposes.
RMC No. 40-2008: Addressed similar issues for tips and gratuities, treating them as non-vatable if passed to employees.
RMC No. 64-2019: Specifically tailored to RA 11360, confirming the exemption and providing guidelines for compliance.
Revenue Audit Memorandum Order (RAMO) No. 1-00: Guides BIR auditors in verifying exclusions from gross receipts, requiring documentation of distributions.

Establishments must maintain records, including payroll ledgers and distribution schedules, to substantiate the exemption during BIR audits. Non-compliance can lead to deficiency assessments, plus interest and penalties under Section 248 and 249 of the NIRC.

Implications for Businesses and Employees

For Businesses

Compliance Burden: Establishments must implement robust accounting systems to track service charge collections and distributions. Failure to distribute 100% can trigger reclassification as taxable income, exposing the business to VAT (12%), income tax (up to 30% for corporations), and penalties (up to 50% surcharge plus 20% interest per annum).
Cash Flow: While non-vatable, service charges affect billing practices. Businesses benefit from not remitting VAT on these amounts, but must ensure timely distributions to avoid labor disputes.
Audit Risks: BIR examinations often scrutinize service charge handling. Proper documentation mitigates risks.

For Employees

Increased Take-Home Pay: Full distribution enhances earnings, but employees must account for income tax withholding, which reduces net pay.
Tax Filing: Employees receiving service charges must include them in their annual income tax returns (BIR Form 1700 or 1701), potentially affecting tax brackets.
Labor Rights: DOLE oversight ensures distributions, with employees able to file complaints for non-compliance.

Broader Economic Context

The VAT exemption aligns with policy goals of supporting low-wage workers in the service sector, which employs millions in the Philippines. It prevents double taxation, as employees pay income tax on the amounts received. However, in cases of non-compliance, the BIR can impose taxes to deter abuse.

Conclusion

In summary, service charges distributed to employees under RA 11360 are not subject to VAT in the Philippines, as they do not constitute gross receipts for the establishment. This treatment is firmly established in labor and tax laws, with clear guidance from BIR issuances like RMC No. 64-2019. Businesses must adhere to distribution requirements to avail of the exemption, while employees benefit from additional compensation subject only to income tax. This framework balances fiscal revenue needs with worker welfare, ensuring transparency and equity in the hospitality industry.