Taxation of Service Charges and Withholding Deductions

Taxation of Service Charges and Withholding Deductions in the Philippines
Comprehensive Legal Discussion

I. Introduction

In the Philippines, “service charge” commonly refers to the additional amount charged to customers in hotels, restaurants, and similar establishments, distinct from tips voluntarily given by patrons. This charge—traditionally set at 10%—is typically distributed among rank-and-file employees (and in some cases, supervisory employees) pursuant to labor laws. However, while labor regulations require the distribution of service charges among employees, tax laws impose rules on how these charges and any subsequent distributions are taxed.

This article provides a comprehensive overview of (1) the legal framework governing service charges under the Labor Code as amended by Republic Act (RA) No. 11360; (2) the rules on taxation of service charges and the distribution thereof; and (3) the attendant withholding tax implications under Philippine tax laws and relevant Bureau of Internal Revenue (BIR) issuances.

II. Legal Basis Under Labor Laws

  1. Article 96 of the Labor Code (as amended by RA No. 11360)

    • Prior to RA No. 11360, Article 96 of the Labor Code mandated that 85% of collected service charges be distributed to rank-and-file employees, with the remaining 15% retained by management to cover operational costs.
    • With the enactment of RA No. 11360 in 2019, 100% of all service charges collected by hotels, restaurants, and similar establishments must be distributed completely and equally among covered workers.
      - Managerial employees are not entitled to receive shares from service charges.
      - This amendment ensures that rank-and-file employees benefit fully from the service charges collected.

  2. Coverage

    • The law applies to hotels, restaurants, and similar establishments (e.g., resorts, bars, catering services) that collect a service charge from customers.
    • Establishments that do not collect service charges are not legally required to impose them.

  3. Significance for Employees

    • The share that employees receive from service charges forms part of their compensation.
    • This distinction is crucial for tax purposes, as any amount considered part of compensation is typically subject to withholding tax on compensation.

III. Tax Treatment of Service Charges

Service charges, from the perspective of taxation, may be examined in two layers:

  1. Taxation at the Level of the Establishment (the business entity)
  2. Taxation at the Level of the Employees (the rank-and-file staff receiving the distribution)

A. At the Establishment (Business) Level

  1. Inclusion in Gross Receipts for VAT or Percentage Tax Purposes

    • Under the National Internal Revenue Code (NIRC), as amended, the gross selling price or gross receipts for VAT or Percentage Tax is broad enough to include any additional amounts billed to the customer.
    • The BIR generally treats service charges as part of the total amount billed to the customer. Thus:
      - If the establishment is VAT-registered, the service charge forms part of the VAT base.
      - If the establishment is subject to the Percentage Tax (in cases where annual gross sales/receipts do not exceed the VAT threshold, or the business is otherwise classified under non-VAT schedules), the service charge may be considered part of the gross receipts subject to percentage tax.

  2. Deductibility for Income Tax Purposes

    • Because RA No. 11360 requires 100% distribution of service charges to employees, the establishment effectively passes on all collected service charges to its rank-and-file employees.
    • Impact on the company’s income:
      - Amounts collected as service charges do momentarily increase the business’s gross receipts; however, since these are distributed to employees, they can be recorded as salary or compensation expense (or an equivalent expense item).
      - Hence, the net effect on the establishment’s taxable income is generally neutral, because the service charges are recognized as income and the same amounts are recognized as a deductible expense (assuming proper substantiation and compliance with recordkeeping requirements under the NIRC).

  3. Withholding Tax on Compensation

    • An establishment must withhold taxes on the portion of service charges paid to employees as part of their compensation. This is not an expanded withholding tax scenario but rather a withholding tax on compensation.

B. At the Employee Level

  1. Nature of the Amount Received

    • Under RA No. 11360, all rank-and-file employees covered in the law are entitled to an equal share in the total service charges collected.
    • These shares form part of “compensation income” of the employees and are therefore subject to the normal rules on taxation of compensation.

  2. Withholding Tax on Compensation

    • Employers are required to withhold income tax from salaries, wages, and other forms of compensation (including mandatory service charge distributions).
    • The withholding tax is computed based on the graduated tax rates for individual taxpayers under the TRAIN Law (RA No. 10963) and the relevant BIR issuances (e.g., RR No. 11-2018 and subsequent amendments).

  3. Exemptions and Thresholds

    • Minimum Wage Earners (MWEs) are exempt from withholding tax on their statutory minimum wage, holiday pay, overtime pay, night shift differential, and hazard pay.
    • Service charges are not included in the scope of the MWE exemption. Therefore, even if an employee is classified as an MWE for basic pay, the portion of the service charge distributed to him/her may be taxable if it pushes the total compensation beyond the threshold, or if specific BIR issuances treat such distribution as taxable compensation.
    • In practical terms, establishments typically incorporate the service charge share into the employee’s payroll and compute the withholding tax accordingly.

  4. Documentation and Compliance

    • Employers must reflect the service charge shares in the employees’ pay slips or payroll records.
    • These amounts must be included in the Alphalist reporting and the BIR Form 1601-C (Monthly Remittance Return of Income Taxes Withheld on Compensation) and BIR Form 1604-C (Annual Information Return of Income Taxes Withheld on Compensation).

IV. Withholding Tax Deductions in General

While “withholding tax” is a broad concept under Philippine tax laws, the discussion relevant to service charges mainly centers on withholding tax on compensation. However, for completeness, here is a quick overview of the different types of withholding taxes that sometimes cause confusion:

  1. Withholding Tax on Compensation (WTC)

    • Applies to all remuneration for services performed by an employee for his/her employer, including salaries, wages, commissions, allowances, and service charge distributions.
    • The employer remits the withheld amount to the BIR using BIR Form 1601-C (monthly) and reports annual totals in BIR Form 1604-C.

  2. Expanded Withholding Tax (EWT)

    • Applies generally to professional fees, commissions, rentals, sub-contracting, and other income payments to non-employees or unincorporated entities.
    • Not typically applicable to mandatory service charge distributions to employees.
    • If a “service fee” is being paid to an external service provider (e.g., a freelance consultant, an outsourced caterer), the EWT rules may apply. This is distinct from the “service charge” mandated under the Labor Code for rank-and-file employees.

  3. Final Withholding Tax (FWT)

    • Applies to specific income payments such as interest, dividends, certain passive income, etc.
    • Irrelevant to the standard service charge scenario for employees.

When discussing “withholding deductions” in the context of service charges, the focal point is indeed the withholding tax on compensation that arises because service charge distributions are considered part of employees’ taxable compensation.

V. Practical Compliance Tips for Businesses

  1. Include Service Charges in Gross Receipts

    • If VAT-registered, ensure that the 12% VAT (or the applicable tax regime) is properly computed on the entire amount billed to the customer, including any service charge.

  2. Record the Distributed Amount as an Expense

    • Use a clear expense account (e.g., “Service Charge Distribution Expense” or incorporate it into “Salaries and Wages – Service Charges”) to track the amounts given to employees.
    • Proper documentation ensures the business can deduct these amounts for income tax purposes.

  3. Withhold Taxes on the Distributed Amount

    • Compute withholding tax on the employees’ total compensation (regular wage + service charge distribution + other taxable benefits).
    • File and remit monthly withholding taxes (BIR Form 1601-C) on time and include these amounts in the quarterly and annual returns (e.g., BIR Form 1604-C, Alphalist).

  4. Maintain Payroll Records and Separate Schedules

    • Prepare a separate schedule or ledger that indicates how much service charge is collected each month and how it is distributed to each employee.
    • This documentation is crucial in case of a BIR audit or labor inspection.

  5. Check Exemptions for Minimum Wage Earners

    • Confirm if employees’ total earnings (statutory wages + service charges + other compensation) exceed the MWE threshold. If so, they become subject to withholding for the portion that is over the exempt amount.

  6. Stay Updated on BIR Issuances

    • The BIR periodically releases Revenue Regulations (RRs) and Revenue Memorandum Circulars (RMCs) that clarify tax treatments and procedures.
    • Regularly monitor these updates to ensure ongoing compliance.

VI. Common Issues and Clarifications

  1. Is the 10% service charge mandatory?

    • The Labor Code does not mandate a fixed rate of 10%. It is the long-standing industry practice for hotels and restaurants to impose around 10%. The law covers whatever service charge is actually collected, at any rate, which must be distributed entirely to rank-and-file employees under RA No. 11360.

  2. Are tips and service charges the same for tax purposes?

    • Tips given voluntarily by customers are generally not the same as service charges mandated and billed by the establishment.
    • Voluntary tips received directly by employees may not be coursed through the establishment’s payroll system. On the other hand, service charges are considered part of the establishment’s gross receipts and subject to the mandatory distribution and accompanying tax rules discussed above.

  3. Are managerial employees entitled to service charges?

    • No. Under the amended Article 96 of the Labor Code, managerial employees are excluded from sharing in service charges.

  4. What if the establishment does not comply with RA 11360?

    • Non-compliance with the distribution requirement can lead to labor disputes, complaints, and potential penalties imposed by the Department of Labor and Employment (DOLE).
    • From a tax standpoint, failure to properly reflect service charge collections and distributions could lead to BIR assessments for underdeclared gross receipts or for unremitted withholding taxes.

  5. How should service charges be treated if employees are working under a “service fee” arrangement but are not classified as employees?

    • The arrangement would be subject to the rules on Expanded Withholding Tax (EWT) for professional or contract-of-service income, not the mandatory distribution rules under RA No. 11360. Classification of workers as employees or independent contractors is a separate, fact-specific determination under labor laws.

VII. Conclusion

The taxation of service charges in the Philippine setting involves both labor and tax considerations. RA No. 11360 mandates that 100% of service charges collected by hotels, restaurants, and similar establishments be distributed to rank-and-file employees, thereby forming part of their compensation income. On the tax side, these service charges:

  • Form part of the establishment’s gross receipts (and thus are potentially subject to VAT or Percentage Tax).
  • Become a salary or compensation expense once distributed, deductible for income tax purposes if properly substantiated.
  • Are subject to withholding tax on compensation at the employee level under the TRAIN law’s graduated rates.

Compliance requires meticulous payroll accounting, withholding tax remittances, and recordkeeping. Establishments must keep abreast of BIR and DOLE regulations to avoid penalties and ensure proper distribution and taxation. By understanding and integrating these rules, both employees and employers can navigate the complexities of service charge taxation in the Philippines.

Disclaimer:
This article is for general informational purposes and does not constitute legal or tax advice. For specific situations, consult with a Philippine-licensed attorney or tax professional, or refer to the latest issuances of the Department of Labor and Employment (DOLE) and the Bureau of Internal Revenue (BIR).

Disclaimer: This content is not legal advice and may involve AI assistance. Information may be inaccurate.

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