Philippines: Ex-Gratia Payment in Mutual Separation Agreements and its Legal Implications
Authors: Rashel Ann C. Pomoy and Lea Tiffany O. Laohoo
Before proceeding to the concept of ex-gratia payments, it bears recalling what is Mutual Separation Agreements (“MSAs”) within the Philippine law landscape. Although not provided for under the Philippine Labour Code nor specifically ruled upon by the Supreme Court, MSAs find legal basis in Philippine law under the consensuality and mutuality principle in contracts. In the case of Saura Import and Export Co., Inc., vs. Development Bank of the Philippines, G.R. No. L-249968, 27 April 1972, the Philippine Supreme Court articulated the principle of mutuo desenso or otherwise known as mutual desistance as a valid mode of extinguishing contracts.
The Supreme Court recognized that mutuo desenso is a concept that derives from the principle that since mutual agreement can create a contract, mutual disagreement by the parties can cause its extinguishment. As such, an MSA for all intents and purposes is recognized as a valid approach in terminating employer-employee relations by mutuo desenso. When parties to a contract thereby agree to sever ties through a contractual agreement, rigors of substantive and procedural due process under the labour code may be effectively dispensed with.
Given that the MSA is a creation of contract, it must have the essential requisites for a valid and binding contract namely: (1) consent of the contracting parties; (2) object of the contract; and (3) cause or consideration for the parties are indispensable for its validity.
This second element, i.e., consideration of the contract, is commonly denominated as “ex-gratia” payment in the MSA. Other terms used are good will payment, mutual separation package, exit package and gratuity payment, among others.
To understand ex-gratia payment is best to juxtapose the ex-gratia payment with the concept of separation pay under the law in whether there is a required amount under the law and the taxability of the payment.
For context, statutory separation pay is granted in authorized cause terminations under the Philippine Labour Code, including retrenchment (when the company is experience financial losses), redundancy (when the position is no longer necessary), closure or cessation of business and disease.
First, on whether there is regulation on the amount to be paid, the Philippine Labour Code Mandates how much is the required separation pay to employees separated for authorised causes. For retrenchment, business Closure without financial losses or disease, the pay is at least one-half (1/2) month’s salary per year of service, or six months’ salary, whichever is higher. On the other hand, for redundancy or business closure without financial losses, the separation pay is at least one (1) month’s salary per year of service.
However, for the ex-gratia payment in an MSA, since an MSA is a voluntary arrangement between an employer and an employee in which both parties agree to end the employment relationship, the statutory separation pay for authorized causes of termination does not apply. The statutory pay, however, can be used as a starting point for both the employer and the employee in negotiating for an agreed amount of ex-gratia payment.
Second, statutory severance pay is tax exempt. Section 32(B)(6)(b) of the NIRC 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 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 taxation.[1]
Since termination due to authorised causes is a cause beyond the control of the employee, the corresponding statutory separation payment is considered exempt from income tax. Additionally, in a case decided by the Supreme Court where an employee was terminated due to redundancy and was provided with separation benefits greater than the statutory redundancy pay, the Supreme Court ruled that the amount received by the petitioner was exempt from income tax under Section 32(B)(6)(b).[2]
However, an ex-gratia payment under an MSA is taxable income and is subject to withholding taxes, which pose certain obligations on the employer to withhold from the amount, and subsequently remit the same to the proper government authority. Under Section 32(A) of the National Internal Revenue Code (“NIRC”), all compensation received by an employee from their employer is considered taxable income, unless specifically exempted.[3]
Additionally, the Bureau of Internal Revenue’s Revenue Regulation No. 2-98, Section 2.78.1(A) defines compensation as all remuneration paid by an employer to an employee, unless specifically excluded.[4] Therefore, employers are required to withhold taxes on ex-gratia payments made under an MSA, as these payments are classified as compensation derived from employment.
[1] Section 32 (A), National Internal Revenue Code.
[2] Section 32 (A), National Internal Revenue Code.
[3] Section 32 (A), National Internal Revenue Code.
[4] Section 2.78.1(A), Bureau of Internal Revenue – Revenue Regulation No. 2-1998.
Key Takeaways
Ex-gratia payments play a significant role in facilitating smooth separations between employers and employees in cases involving mutual separation agreements or redundancy terminations. These payments are granted pursuant to the agreement of the parties and are considered taxable income, requiring employers to withhold taxes.
By understanding the legal implications of entering into an MSA and the ex-gratia payment made pursuant to it, there will then be no surprises later on and claims that any party did not voluntary consent to the MSA because the terms are unclear or the tax implications not clearly explained.
