In the Philippine labor landscape, the termination of employment is often accompanied by the payment of separation pay. While this serves as a financial cushion for the displaced worker, a critical legal question arises: Is this amount subject to income tax?
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.
I. The General Rule of Taxability
Generally, any amount received by an employee from an employer as a result of separation from service is considered gross income and is subject to withholding tax. This includes backwages, allowances, and other benefits earned during the course of employment.
II. The Legal Basis for Tax Exemption
The primary exemption is found in 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 due to death, sickness or other physical disability or for any cause beyond the control of the said official or employee."
III. Criteria for Tax Exemption
For separation pay to be exempt from income tax (and consequently from withholding tax), it must meet two essential criteria:
- Involuntary Separation: The separation must be initiated by the employer and not by the employee. Voluntary resignation is taxable.
- Causes Beyond Employee Control: The termination must be due to factors where the employee had no say or control.
1. Authorized Causes under the Labor Code
Separation pay is exempt if the termination is due to:
- Installation of labor-saving devices: Modernization or automation replacing human labor.
- Redundancy: When a position is superfluous or in excess of what is necessary.
- Retrenchment: Downsizing to prevent serious business losses.
- Closure or Cessation of Business: Provided the closure is not for the purpose of circumventing labor laws.
- Disease: When the employee’s continued employment is prohibited by law or is prejudicial to their health or the health of co-employees.
2. Death or Disability
Payments made to an employee or their heirs due to the employee’s death, sickness, or physical disability are exempt from tax, regardless of whether the separation was technically "beyond control," as these are specifically enumerated by law.
IV. Taxable vs. Non-Taxable Components
It is vital to distinguish between different types of terminal pay:
| Component | Tax Treatment |
|---|---|
| Separation Pay (Authorized Causes) | Exempt |
| Retirement Pay (Under RA 7641) | Exempt (if age 50+ and 10 years of service) |
| Vacation/Sick Leave Conversion | Taxable (except for specific de minimis limits) |
| 13th Month Pay & Other Benefits | Exempt (if total does not exceed ₱90,000) |
| Backwages (Legal Settlement) | Taxable (considered replaces of lost income) |
V. BIR Procedural Requirements
To officially enjoy the exemption, the BIR often requires the filing of a Certificate of Tax Exemption for the separation pay.
Revenue Memorandum Order (RMO) No. 66-2016 outlines the requirements for processing these requests. Employers are generally required to submit the following to the Revenue District Office (RDO):
- Letter Request for tax exemption.
- Notice of Termination served to the employee and the Department of Labor and Employment (DOLE).
- Board Resolution (if the employer is a corporation) justifying the redundancy or retrenchment.
- Affidavit from the employer stating that the separation was not due to the employee's fault.
VI. Jurisprudence: "Beyond the Control of the Employee"
The Supreme Court has consistently ruled that for the exemption to apply, the "cause" must be one that the employee did not initiate or voluntarily choose.
- Voluntary Resignation: If an employee resigns to avoid being fired for cause, the "separation pay" (or "financial assistance") granted by the employer is taxable.
- Labor Disputes: If an employee is illegally dismissed and later settles for separation pay in lieu of reinstatement, that amount is generally exempt, as the dismissal was a cause beyond their control.
Summary Table: Quick Guide
| Reason for Separation | Tax Status | Legal Context |
|---|---|---|
| Resignation | Taxable | Voluntary act |
| Retrenchment/Redundancy | Exempt | Authorized cause (NIRC) |
| Death/Disability | Exempt | Statutory exemption |
| Retirement (Qualified) | Exempt | RA 7641 / NIRC |
| Termination for Just Cause | Taxable | Due to employee's fault (e.g., misconduct) |
Note on the ₱90,000 Threshold: It is a common misconception that separation pay falls under the ₱90,000 "13th Month and Other Benefits" cap. In reality, if the separation pay is due to an authorized cause (involuntary), it is fully exempt regardless of the amount. The ₱90,000 cap applies only to bonuses and productivity incentives.