BIR Ruling [DA-212-06]

April 5, 2006 BIR RULING [DA-212-06] Section 32 (B) (4), R.R. No. 2-98, BIR Ruling Nos. 057-83, 238-86, DA-205-02, DA-485-03, SB-004-99 & SB-051-99 Department of Labor and Employment Intramuros, Manila Attention: Atty. Rosario O. Caise Chief of Staff for Labor Relations Gentlemen : This refers to your faxed letter dated October 11, 2005 requesting for legal opinion on the taxability of backwages awarded through arbitration. As represented, the Office of the Secretary assumes jurisdiction over collective bargaining deadlock issues which include the issue of wage increases and improvement of benefits. It has been a concern of your Office that this matter of taxability of back wages is being raised by companies directed to pay the award. In reply, please be informed as follows: Every employer is liable for payment of compensation for services rendered by his/its employees and required to withhold from compensation paid an amount computed in accordance with Section 2.79 of Revenue Regulations (Rev. Regs.) No. 2-98, as amended. In general, the employer shall deduct and withhold from such compensation a tax determined in accordance with the prescribed withholding tax tables of Rev. Regs. No. 2-98. There are four (4) withholding tables prescribed in the regulations: monthly, semi-monthly, weekly and daily tax tables. If the compensation is paid other than daily, weekly, semi-monthly or monthly, the tax to be withheld shall be computed annually or quarterly and semi-annually. Annualized withholding tax method shall be used when the employer-employee relationship is terminated before the end of the calendar year. Back wages being compensation are therefore subject to withholding tax. The employer is considered a withholding agent required to withhold the proper tax on back wages. Under Section 44 of the Tax Code of 1997, if the taxpayer is an individual, the net income shall be computed on the basis of the calendar year. All items of income shall be included in gross income or gross compensation income, as the case may be, for the taxable year in which received by the taxpayer except those expressly excluded and already subjected to the final income tax, and exemption as well as deductions taken accordingly pursuant to Sections 24, 33 and 34 in relation to Section 45, all of the Tax Code of 1997. Salaries, commissions, tips, director's fees and other forms of compensation are income in the year received, and not in the year earned [par. 717, p. 231, U.S. Master Tax Guide (1969)]. Thus, a taxpayer whose income is from salary or the like is required to file his income tax return on the cash basis. This is true for additional pay or "back pay" which does not arise from a case involving illegal dismissal. In a case of illegal dismissal, the employee should be accorded special treatment i.e., allowed to allocate or spread his back wages, allowances and benefits through the years he was suspended from service, having been denied payment of his wages when they were due because of circumstances not of his own making and, therefore beyond his control. Accordingly, an illegally dismissed employee comes within the scope of the inequity for which this ruling is precisely designed to remedy. Considering that such back wages, allowances and benefits constitute remuneration for services that would have been performed by the said employees for their employer prior to the year when actually received, or during the period of their suspension from the service, it is felt that a liberal construction of the statute is called for in this particular case if only to protect said employees who, in fact, had been deprived of the payment of their wages and other forms of remuneration, from the payment of a tax heavier than what have been imposed if their employer had promptly met its obligation. DIEACH In the case of Commissioner of Internal Revenue v. Joseph G.R. Robillard & Margaret H. Robillard (C.A., 308 F. 2d 518, 519), it was held that income received by a taxpayer in 1957 as "back pay" or additional pay for services rendered to his employer for the period from July 1, 1955 through December 1956 which, indubitably, would have been paid prior to 1957 except for the intervention of an event similar in nature to a dispute as to the liability of the employer to pay the remuneration in question, is entitled to a special treatment and was properly allocable to the taxable years 1955 and 1956. Section 2.57. (B) of Revenue Regulations No. 2-98, as amended, implementing Republic Act No. 8424. "An Act Amending The National Internal Revenue Code, As Amended" relative to the Withholding on Compensation, provides, viz : "Sec. 2.57. Withholding of Tax at Source . (A) . . . (B) Creditable Withholding Tax. Under the creditable withholding tax system, taxes withheld on certain income payments are intended to equal or at least approximate the tax due of the payee on said income. The income recipient is still required to file an income tax return, as prescribed in Sec. 51 and 52 of the NIRC, as amended, to report the income and/or pay the difference between the tax withheld and the tax due on the income. Taxes withheld on income payments covered by the expanded withholding tax (referred to in Sec. 2.57.2 of these regulations) and compensation income (referred to in Sec. 2.78 also of these regulations) are creditable in nature." Accordingly, the employer shall withhold only the income tax corresponding to the income actually received as salaries by an employee found to be illegally dismissed, from the time he was reinstated. Whether an employee found to be illegally dismissed is reinstated or opts for separation, he is required to report such income (back wages) for the years he was suspended from service, as he files and pays his corresponding income tax thereon by allocating or spreading his back wages, allowances and benefits through the years from the time of his suspension to actual reinstatement or actual separation (if he opts for separation instead of reinstatement), as the case may be, crediting in the process the corresponding income tax withheld from said wage payments. Thus, in computing an illegally dismissed employee's net income tax, the amount deducted and withheld during calendar years he was suspended from service by his employer shall be allowed as a credit against the tax imposed under Section 24(A) of the Tax Code of 1997 pursuant to Section 79(C)(2) of the same Code. Moreover, said employee is allowed to deduct personal and additional exemptions during the said years in accordance with Section 35(A) and (B) of the Tax Code of 1997. On the other hand, the award of attorney's fees and costs to the extent of actual expenses only is not subject to income tax and consequently, to the withholding tax since the same are merely a reimbursement of the illegally dismissed employee's expenses/advances in the course of the hearing of his case. However, any amount in excess of actual expenses of the concerned employee shall be taxable. In respect to the award of moral and exemplary damages, Section 32(B)(4) of the Tax Code of 1997 provides "SEC. 32. Gross Income . xxx xxx xxx (B) Exclusions from Gross Income. The following items shall not be included in gross income and shall be exempt from taxation under this Title: xxx xxx xxx (4) Compensation for Injuries or Sickness. Amounts received, through Accident or Health Insurance or under Workmen's Compensation Acts, as compensation for personal injuries or sickness, plus the amounts of any damages received, whether by suit or agreement, on account of such injuries or sickness." The Federal Income Tax of the U.S.A. to which our tax laws are patterned contains a similar provision which provides that amounts received as damages (other than punitive damages) on account of personal physical injuries or physical sickness are excludable from income (Sec. 104(a)(2), U.S. Tax Code). However, nowhere in either the U.S. Tax Code or the Philippine Tax Code is there a provision exempting from income tax moral and exemplary damages arising from a case of illegal dismissal. Accordingly, the award of moral and exemplary damages arising from illegal dismissal case is subject to income tax and consequently, to the withholding tax. Anent an illegally dismissed employee's separation benefits, in case he opts to be separated rather than be reinstated, Section 32(B)(6)(b) of the Tax Code of 1997 provides that 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 said official or employee is exempt from taxes regardless of age or length of service. The phrase "for any cause beyond the control of said official or employee" connotes involuntariness on the part of the official or employee. The separation from the service of the official or employee must not be asked for or initiated by him. The abovementioned law requires the presence of two (2) conditions in order that the employee benefits may be granted tax exemption, namely: (1) the 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; and (2) the employer pays benefits to the official or employee or his heirs as a consequence of such separation. Since the separation of the illegally, dismissed employee is due to the exercise of management's prerogative to terminate his employment (although he was found to be illegally dismissed by the NLRC), the same connotes involuntariness for being beyond the control of the concerned employee. hence, any and all amounts received by him as a result thereof, consisting of the separation pay package and other benefits, are exempt from income tax and consequently from the withholding tax prescribed by Section 79, Chapter X, Title II of the Tax Code of 1997 as implemented by Revenue Regulations No. 2-98, as amended. The payment of salaries, however, is subject to income tax and consequently to withholding tax. Please be guided accordingly. Very truly yours, (SGD.) PABLO M. BASTES, JR. OIC-Head Revenue Executive Assistant Legal Service