Taxwise Or Otherwise

The coronavirus disease 2019 (COVID-19) outbreak has significantly impacted the global economy and sent it into a slowdown. The Philippines is no exception.

With public health at stake, the government imposed necessary measures to mitigate the spread of the disease, suspending mass transportation, shutting down most businesses, and declaring lockdowns. The loss of earnings and the significant costs incurred by businesses have brought the economy to a level that no one could have foreseen.

Employers have had to find ways to make ends meet. Alternative work methods were adopted to sustain operations, and to the extent possible, cut down on costs. However, despite all efforts to mitigate losses, many enterprises, large or small, could have no option but to downsize their work forces or permanently close the business.

Under Article 283 of the Labor Code, the employer may terminate an employee for the installation of labor-saving devices, redundancy, retrenchment, or the closure or cessation of operations of the establishment or undertaking.

In the Supreme Court decision G.R. No. 174214 dated June 12, 2012, the term retrenchment was defined as “the termination of employment initiated by the employer through no fault of and without prejudice to the employees.” It can only be resorted to prevent a substantial or reasonably imminent loss, say during a recession, depression, seasonal fluctuations in business activity, or during lulls occasioned by lack of orders, shortages of material, or conversion of the plant to a new production system, the introduction of new methods or more efficient machinery, or automation. In other words, business losses, lack of work, or considerable reduction in the volume of business are valid reasons for termination of employment.

In such cases, the law requires employers to pay separation benefits to the impacted employees equivalent to one month’s pay or at least half a month’s pay for every year of service. A fraction of at least six months is to be considered a full year.

Under Section 32(B)(6)(b) of the Tax Code, any amount received by an official or employee or by his heirs as a consequence of separation 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 exempt from tax.

As confirmed by the Bureau of Internal Revenue (BIR) in several rulings, any payment to the employees, due to their involuntary termination for grounds beyond their control, is exempt from taxation, regardless of the amount.

Such exemption, however, does not extend to remuneration not relating to the retrenchment per se such as earned salary, government-mandated 13th month pay and other benefits on account of employment that are in excess of the P90,0000 tax-exempt threshold. These items are subject to income tax, and consequently, to withholding tax on compensation regardless of the retrenchment.

Therefore, it is important to segregate or distinguish separation pay from the regular salaries and other compensation items reported in the income tax return (ITR), audited financial statements (AFS) and in the Alphalist of Employees (alphalist). This is because in the event of an audit, the BIR normally compares salaries reported in the ITR/AFS and the alphalist. If there is a discrepancy in the amounts reported in these documents, the BIR will likely assess the employer for deficiency withholding tax on compensation and disallow the related expense for income tax due to under-withholding, or attempt to assess deficiency income tax on the ground of undeclared expense resulting in undeclared revenue. Recording the separation pay to an account other than salaries or disclosing it under the relevant notes to financial statements could help address the issue.

To confirm the eligibility for tax exemption of the separation pay, the BIR issued Revenue Memorandum Order No. 66-2016 to guideline the securing a Certificate of Tax Exemption (CTE) from Income Tax and Withholding Tax. For retrenchment, the BIR requires the following documents:

1. Copies of the written notices served to the employee and the appropriate Regional Office of the Department of Labor and Employment (DoLE) at least 30 days before the intended date of termination, specifying the grounds for separation; and

2. A board resolution, in case of a juridical entity, or sworn statement to be executed by the owner, in case of a sole proprietor, stating that:

a. the retrenchment is reasonably necessary and likely to prevent business losses;

b. the losses, if already incurred, are not merely de minimis, but substantial, serious, actual and real, or if only expected, are reasonably imminent, with appropriate supporting evidence of said losses;

c. the retrenchment is made in good faith for the advancement of its interests and not to defeat or circumvent the employees’ right to security of tenure; and

d. the selection of employees to be terminated has been made under fair and reasonable criteria.

Applications for the issuance of a CTE for separation pay must be filed with the appropriate BIR office, where the employer is registered.

In times of economic hardship where businesses and employees are short of funds, it is crucial to implement the rules correctly. To a breadwinner, a paycheck will sustain the family. To a company, erroneous withholding may expose itself to BIR scrutiny, which may lead to an assessment. During times of austerity, there is little room for error where every peso counts.

The views or opinions expressed in this article are solely those of the author and do not necessarily represent those of Isla Lipana & Co. The content is for general information purposes only, and should not be used as a substitute for specific advice.


Nelson V. Soriano is a Director at the Tax Services Department of Isla Lipana & Co., the Philippine member firm of the PwC network.

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