Deductibility of Christmas bonuses

With Christmas just around the corner and with the end of the year fast approaching, most companies are now computing employee bonuses, if not already distributing bonuses to employees.

As stated in the Labor Code of the Philippines, employers are required to pay their rank-and-file employees a 13th-month pay equivalent to 1/12th of the employee’s annual basic salary on or before December 24 of every year. Some companies, in the spirit of giving, even go beyond this minimum requirement by generously granting Christmas or productivity bonuses on top of the 13th-month pay.

However, as every income received by a taxable individual here in the Philippines shall be subject to tax, the abovementioned bonuses shall also be subject to withholding tax.

So when do we tax bonuses?

Revenue Regulations No. (RR) 02-98, as amended, provides that withholding tax on compensation shall be applied upon receipt of income. Hence, taxable bonuses, as with other taxable compensation income, shall be subject to withholding tax on compensation upon payment to the employee.

As the rules on when to tax bonuses is pretty straightforward, that of when to deduct the same as an expense of the employer for income tax purposes is a little more complicated.

Under the existing rules, the following are the basic requisites for an expense to be considered deductible for income tax purposes:

(a) It must be ordinary and necessary to the business;

(b) It must have been paid or incurred during the taxable year;

(c) It must have been paid or incurred in carrying on the business; and

(d) It must be supported by receipts, records or other pertinent documents.

In addition, the taxpayer must be able to show proof that the tax required to be withheld from the expense must have been withheld and remitted to the Bureau of Internal Revenue (BIR).

The taxation and deductibility of bonuses accrued and paid within the same taxable year should pose no problem. The confusion arises when bonuses are accrued in a taxable year and paid in the following taxable year.

Considering the above basic requirements, accrued bonuses must easily qualify as an allowable deduction during the taxable year. However, considering the additional requirement on withholding tax, many employers face the issue of whether the same can already be allowed as a deduction during the year when it arises. Since the bonuses have not yet been paid, the corresponding taxes have not yet been withheld.

We are aware that during BIR audit, examiners would normally disallow accrued bonuses as deduction during the year if no tax has been withheld. The BIR, in many such instances, has continued to take the position that the rule on the timing of withholding under RR 02-98 (when paid, payable or accrued, whichever comes earlier) also applies to withholding on compensation.

Unfortunately, there is no significant court decision or a BIR ruling that clearly resolves this issue.

In the Court of Tax Appeals (CTA) Case No. 6187 dated April 5, 2005, wherein the taxpayer claimed as deductible expense the bonuses accrued for the year but were distributed to officers and employees the following year, the CTA en banc ruled that since accrued bonuses were not yet subjected to withholding tax, the same should be disallowed as deductible expense during the year. In this case, the court dissented the taxpayer’s contention that since accrued bonuses are unpaid, they are not yet required to be subjected to withholding tax and the requirement on withholding tax for deductibility shall not apply.

On the other hand, in CTA Case No. 5718, dated February 16, 2001, the court ruled in favor of the taxpayer. The BIR disallowed the taxpayer’s accrued salaries and wages as deductible expense for failure to withhold. The Court disagreed with the BIR’s findings citing that the timing of withholding on compensation must be upon payment only.

Could the taxpayer get out of this difficult situation by claiming the deduction in the year the bonus was paid?

The Supreme Court in G.R. No. 172231, dated February 12, 2007, ruled that following the accrual method of accounting, an expense, though the amount of which is an estimate only, must be claimed in the year when the same was incurred and not when the same was paid. In this case, the taxpayer claimed the auditing and legal fees paid to a general professional partnership as deductible expense during the year when these were paid and not during the year these were incurred. Note, however, that this case did not touch the issue on the requirement on withholding and merely focused on the timing of recognition of expense.

Considering the above conflicting decisions and the timing of withholding on bonuses, when do we really deduct accrued bonuses that were incurred during the year but with the withholding done only the following year under existing rules on withholding tax on compensation?

One option is for the employer to subject the accrued bonuses to withholding tax during the year accrued. This shall be possible only if the recipients and the amount they will receive are already known. Subjecting such bonuses to withholding tax will also require reporting the same in the alphalist of employees and in the Certificate of Compensation Payment/Tax Withheld (BIR Form 2316). But since the bonus has not yet been received, the amount of tax withheld will definitely exceed the income tax due per their annual income tax return, for which the only option of the individual is to refund.

The employer may also take the option of claiming the bonus as deductible expense in the following year when the bonus is paid and the tax withheld. Note, however, that by doing this, there is still the possibility that the BIR may raise the issue on the timing of the deduction. If the bonuses have been accrued in the books but claimed as a tax deductible expense in the following year, this may be disallowed by the BIR authorities being an expense in the prior year. Should this result to a finding by the BIR during audit, the employer may just opt to apply for abatement of interest and penalties because the law/regulations are not clear, and there is legal basis and precedent ruling/case on the tax position taken.

While there are no clear rules, the most prudent thing for the companies to do is to secure a confirmatory ruling from the BIR on the deductibility of bonuses. At least by doing this, companies’ treatment of bonuses may be protected by a ruling in case of assessments.

Considering the above conflicting rules and risks to both the employer and employees, we hope that the BIR would issue clear guidelines on this, taking into consideration the complications and consequences described above. Employers have been designated and are acting as agents of the BIR in tax collection. Erroneous compliance by a withholding agent is subject to stiff penalties. The least that the BIR could do to these withholding agents in return for helping them collect taxes is to make the rules clear so that they will not be exposed to penalties. –Ma. Lourdes A. Politado, Businessworld

The author is a Senior with Punongbayan & Araullo’s Tax Advisory & Compliance Division.