On top of the separation pay, the employee would normally receive his monetized unused leave

credits.

Are these separation pay and monetized unused leave credits taxable?

Section 32 (B)(6)(b) of the 1997 Tax Code, as amended, provides for exemption of separation pay.

But it requires two conditions before separation benefits are granted tax exemption, namely:

• The official or employee is separated from 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

• The official or employee or his heirs receive any amount from the employer on account of such
separation.

The phrase "for any cause beyond the control of the said official or employee" connotes
involuntariness on the part of the official or employee concerned. The separation from service must
not be asked for or initiated by the official or employee.

On several occasions, the Bureau of Internal Revenue (BIR) held that any and all amounts received by
employees as a consequence of separation from employment for any causes beyond the control of the
said employee are exempt from income tax and, consequently, from withholding tax on compensation.

This exemption includes the commutation of unused leave credits due to involuntary separation from
employment, more popularly known as "terminal leave pay," regardless of the number of days.

Just recently, however, the BIR modified its position on the taxability of the terminal leave pay.

In BIR Ruling No. 199-2011, dated last July 29, the bureau ruled that commutation and payment of
monetized unused vacation leave credits as a result of involuntary separation of employees from
service is not subject to income tax, and consequently to withholding tax on compensation, but only
for up to days of vacation leave.

Hence, cash equivalent of vacation leave credits in excess of 10 days is subject to tax.

In this ruling, the BIR applied the rule on de minimis benefits with regard to commutation of vacation
leave. Note, however, that this applies only to terminal leave pay.

Separation benefits received by employees as a consequence of separation from employment for any
causes beyond the control of the employees remain exempt from income tax and, consequently,
withholding tax.

Accordingly, the BIR is changing its position on the taxability of terminal leave pay, which is not the
first time the BIR has modified its position. In numerous instances, the BIR had revoked its own
previous rulings, which it believes were inconsistent with tax laws and regulations.

With the change in BIR’s position brought about by BIR Ruling No. 199-2011, taxpayers will no doubt
be wondering about the impact of this ruling on the tax treatment of leave credits.

What will happen to those companies or employers who treated terminal leave pay, regardless of their
number of leave credits, as tax exempt? Will they be exposed to potential tax deficiency assessment?
Will this new treatment apply prospectively or retrospectively?

Right now, this ruling applies only to the taxpayer who requested it.
It is likely, however, that in succeeding issuances, the BIR would rule in the same way.

This notwithstanding, both employer and employee, as withholding agent and taxpayer, respectively,
should be aware of the current position of the BIR and consider this particular ruling in the design of
separation packages to be granted by employers to their employees.