BIR Ruling No. 199-11

June 29, 2011 BIR RULING NO. 199-11 Secs. 32 (B) (6) (b) and 79; BIR Ruling No. DA-594-04; BIR Ruling No. 022-01; BIR Ruling No. 051-90 Manila Electric Company (MERALCO) Lopez Building, Meralco Compound, Ortigas Avenue, Pasig City 0300 Attention: Atty. Anthony V. Rosete Vice President and Head, Legal Gentlemen : This refers to your letter dated December 1, 2010 requesting on behalf of MANILA ELECTRIC COMPANY ("MERALCO") for a ruling on the taxability of separation benefits to be received by its employees who will be separated from service due to the implementation of labor cost management initiatives under its Labor Cost Management Program ("LCMP"),which result in redundancy positions. It is represented that MERALCO is a domestic corporation duly organized and existing under the laws of the Republic of the Philippines, with principal office address at the Lopez Building, Meralco Compound, Ortigas Avenue, Pasig City, and is engaged in the business of distributing and supplying electric power within its franchise area. It is also represented that the Energy Regulatory Commission ("ERC") is implementing a Performance Based Regulation ("PBR") on distribution utilities ("DUs") pursuant to the Electric Power Industry Reform Act ("EPIRA") of 2001 or Republic Act (R.A.) No. 9136. Under PBR, the ERC sets a cap on the allowable revenue requirement for DUs and limits the charges or fees it may collect from end-users to cover "efficient" expenditures only. In other words, the maximum average price for distribution wheeling service that a DU is allowed to charge customers is essentially limited to an amount necessary to sustain efficient service levels and sufficient infrastructure investments. EHSITc In addition, EPIRA or RA 9136 has mandated the implementation of open access and retail competition ("OARC") not later than three (3) years from effectivity of the law, subject to the fulfilment of certain conditions. Implementation of OARC is expected to commence in the middle of 2011, starting with end-users having a monthly average peak demand of at least one megawatt (1 MW), then down to seven hundred fifty kilowatts (750kW), and gradually to the household demand level. Under this competitive business environment, it is imperative for MERALCO to optimize the utilization of its resources and reduce its operating expenses to remain viable and competitive in providing adequate, safe and reliable service, as end-users of electricity will have a free choice of their supplier of electricity. In line with the PBR price-setting methodology, the ERC has set MERALCO's operating expense ("OPEX") levels "with the expectation that labor costs will keep pace with the inflation rate" (paragraph 5.11.7, Final Determination-MERALCO, Second Regulatory Period).In other words, the ERC has limited MERALCO's labor cost increases to the cost of inflation. For this reason, MERALCO has resorted to various cost saving programs which include the adoption of an efficient manning strategy, limited hiring of new employees, and outsourcing of work to third parties. These cost saving programs, however, are not enough to lower MERALCO's operating costs within the prescribed limit set by the ERC. Thus, MERALCO is embarking on an integrated Labor Cost Management Program ("LCMP"),which combines the adoption of functional and work process changes or reorganization, new technologies, efficient manning strategy, and outsourcing of work to manage labor costs within the limit prescribed by the regulator as well as to maintain its viability and competitiveness under the forthcoming retail competition. LCMP will necessarily result in the redundancy of some executive and staff positions at different levels, including assistants, secretaries and other personnel, who will be involuntarily separated from service. MERALCO, however, is committed to implement the Program in accordance with the Labor Code and its implementing rules and regulations, and without prejudice to the rights and benefits under the law of employees who will be affected. Based on the foregoing, you now request for the confirmation of your opinion that any and all amounts to be received by an employee involuntarily separated under MERALCO's Labor Cost Management Program are exclusions from the employee's gross income under Section 32 (B) (6) (b) of the National Internal Revenue Code of 1997, as amended. SaCDTA In reply, please be informed that pursuant to Section 32 (B) (6) (b) of the Tax Code of 1997, as amended, 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 shall be excluded from the gross income and shall be exempt from income tax 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. Section 32 (B) (6) (b) requires the presence of two (2) conditions in order that the employee benefits may be 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; and (2) the employer pays benefits to the official or employee or his heirs as a consequence of such separation. (BIR Ruling No. 022-01 dated June 13, 2001) In view thereof, this Office is of the opinion that since the separation of the employees who will be affected due to redundancy pursuant to MERALCO's Labor Cost Management Program based on the Energy Regulatory Commission's limitation on MERALCO's operating expenses, as a consequence of the implementation of Performance Based Regulation on distribution utilities pursuant to the Electric Power Industry Reform Act of 2001 or Republic Act No. 9136, the separation from work may be considered involuntary, hence, beyond their control. It is but proper therefore, that any and all amounts to be received by them as a result thereof, are exempt from income tax and consequently from the withholding tax as prescribed by Section 79 of the 1997 Tax Code, as implemented by Revenue Regulations No. 2-98, as amended by Revenue Regulations Nos. 6-2001 and 12-2001. (BIR Ruling No. 051-90 dated April 5, 1990) Accordingly, no withholding taxes shall be deducted from the separation benefits and the entire amount thereof shall be given to the entitled separated employee. HITAEC Moreover, pursuant to Sections 2.78.1 (A) (3) and (7) of RR 2-98, as amended, the terminal pay, i.e. ,commutation and payment of monetized unused VACATION leave credits not exceeding ten (10) days during the year are not subject to income tax and consequently to the withholding tax. Conversely, the cash equivalent of vacation leave credits exceeding ten (10) days is subject to tax. However, this same principle cannot apply to SICK leave credits since an employee must actually go on sick leave to be able to avail of said leave credits. (BIR Ruling No. DA-594-04 dated November 23, 2004) It is, however, understood that this exemption does not include the payment of the separated employees' salaries and the payment of the 13th month pay and other benefits in excess of the Php30,000.00 threshold under Sections 2.78.1 (A) (3) (a) and (A) (7) of RR 2-98, as amended. This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it will be disclosed that the facts are different, then this ruling shall be considered null and void. Very truly yours, (SGD.) KIM S. JACINTO-HENARES Commissioner of Internal Revenue