In the Philippine labor and tax landscape, the termination of employment is often accompanied by the payment of separation pay. Whether this amount is subject to income tax and withholding tax is a critical concern for both employers and employees. Under the National Internal Revenue Code (NIRC), as amended, and various Bureau of Internal Revenue (BIR) regulations, the general rule is that all income is taxable; however, specific exemptions apply to separation pay depending on the cause of termination.
The General Rule of Taxability
As a starting point, any compensation received as a result of an employer-employee relationship—including salaries, bonuses, and allowances—is considered gross income and is subject to income tax. Consequently, payments made upon the severance of employment are generally taxable unless they fall under the specific exemptions provided by law.
Statutory Basis for Exemption
The primary legal basis for the tax exemption of separation pay is Section 32(B)(6)(b) of the NIRC, which states that the following shall not be included in gross income and shall be exempt from taxation:
"Any amount received by an official or employee or by his heirs from the employer as a consequence of separation of such official or employee from the service of the employer because of death, sickness or other physical disability or for any cause beyond the control of the said official or employee."
Criteria for Tax Exemption
For separation pay to be exempt from income tax and withholding tax, two conditions must be concurrently met:
- The employee is separated from the service of the employer due to death, sickness, or other physical disability, or any cause beyond the control of the employee; and
- The employee or his heirs receive the amount as a consequence of such separation.
Causes Beyond the Control of the Employee
The BIR and Philippine jurisprudence have clarified that "causes beyond the control of the employee" typically refer to the Authorized Causes for termination under the Labor Code. These include:
- Redundancy: When the employee's services are in excess of what is reasonably demanded by the actual requirements of the enterprise.
- Retrenchment: A management tool used to prevent or minimize business losses.
- Installation of Labor-Saving Devices: Replacing human labor with machinery or technology.
- Closure or Cessation of Business: Unless the closure is for the purpose of circumventing the law.
- Disease: When the employee’s continued employment is prohibited by law or is prejudicial to their health or the health of their co-employees.
What is NOT Exempt?
If the separation is voluntary or due to the fault of the employee, the pay is taxable. This includes:
- Resignation: Voluntarily leaving the job is considered within the employee's control.
- Termination for Just Cause: Dismissal due to serious misconduct, willful disobedience, gross and habitual neglect of duty, fraud, or commission of a crime.
- Terminal Leave Pay (Vacation/Sick Leave Buyouts): While the separation pay itself might be exempt, the monetization of unused leave credits is subject to different rules (usually exempt only up to 10 days for private employees, while terminal leave for government employees is generally exempt).
BIR Requirements for Exemption (RR No. 6-2018)
To formalize the exemption, the BIR issued Revenue Regulations (RR) No. 6-2018, which outlines the documentary requirements to prove that the separation was indeed beyond the employee's control.
Necessary Documents
To justify the non-withholding of tax, the employer must typically obtain:
- A Certificate of Tax Exemption from the BIR (though recent issuances have aimed to streamline this, many employers still require a BIR ruling or specific clearance).
- A Certified True Copy of the Notice of Termination served to the employee and the Department of Labor and Employment (DOLE).
- Medical Certificate (in cases of sickness or disability) issued by a government or reputable physician.
- Affidavit of the Employer stating that the separation was not due to the employee's fault or voluntary action.
Backwages vs. Separation Pay
It is important to distinguish between backwages and separation pay.
- Backwages, which are awarded in cases of illegal dismissal to restore lost income, are considered "earnings" and are therefore taxable.
- Separation pay awarded in lieu of reinstatement in an illegal dismissal case is also generally taxable, as the "beyond the control" clause is strictly interpreted to apply to authorized management retrenchment or redundancy programs, not necessarily as a remedy for a legal dispute, unless specifically ruled otherwise by the BIR.
Summary Table of Taxability
| Cause of Separation | Tax Status | Legal Basis |
|---|---|---|
| Resignation | Taxable | Voluntary Act |
| Redundancy / Retrenchment | Exempt | Beyond Employee Control |
| Business Closure | Exempt | Beyond Employee Control |
| Death / Disability | Exempt | NIRC Sec. 32(B)(6)(b) |
| Dismissal for Just Cause | Taxable | Due to Employee's Fault |
| Retirement (Qualified) | Exempt | NIRC Sec. 32(B)(6)(a) |
Practical Implications for Employers
Employers act as the withholding agents for the state. If an employer fails to withhold tax on separation pay that is later found to be taxable (e.g., if the BIR determines the "redundancy" was a sham), the employer becomes liable for the deficiency withholding tax, surcharges, and interest. Consequently, most Philippine companies require a BIR Ruling or a very clear "Notice of Redundancy" before they release the full, untaxed amount to the employee.