Employees sometimes incur business expenses during the course of their work, including travel, meals, lodging, and other business-related costs. While reimbursements seem straightforward, they carry tax implications that must be managed carefully. Businesses must be aware of these implications to mitigate potential tax risks and avoid reducing the net take home pay of their employees, who are merely performing their duties in the pursuit of their employer’s business.
As a rule, fixed or variable transportation, representation and other allowances which are received by an employee, in addition to the regular compensation fixed for his position, are generally treated as compensation subject to withholding taxes. However, certain amounts are not considered compensation (and therefore, not subject to withholding taxes). These are advances or reimbursements for traveling, representation and other bona fide ordinary and necessary expenses incurred or reasonably expected to be incurred by the employee in the performance of his duties. Specifically, the following conditions must be satisfied:
1. It is for ordinary and necessary expenses paid or incurred by the employee in the pursuit of the employer’s trade, business or profession; and
2. The employee is required to liquidate/account for the expenses in accordance with the requirements for substantiation under the Tax Code. Any excess advances made which are not properly liquidated constitute taxable income if such amount is not returned to the employer.
Hence, if a business provides monthly allowances or advances to its employees in cash, and they are not required to liquidate or account for the funds received, this may be viewed as compensation subject to withholding tax. It should be noted though that the rules provide an exception: reasonable amounts of reimbursements/advances for traveling and entertainment expenses which are pre-computed on a daily basis and are paid to an employee while he is on an assignment or duty are not required to be substantiated and are not subject to Withholding Tax on Compensation (WTC).
WHAT’S THE DILEMMA, THEN?During a tax investigation, the BIR typically compares the taxpayer’s expense accounts on its books with its filed tax returns and review the sufficiency of supporting documents related to claimed expenses. Employers usually do not treat reimbursements to their employees as compensation subject to WTC. However, unless employers are able to prove with valid documentation that such reimbursements are valid business expenses, there may be a challenge in resolving this issue during an audit.
Even if the hurdle of WTC is cleared, the expenses may still be flagged as subject to Expanded Withholding Tax (EWT), particularly for employers which are classified as a top withholding agent. As most know, a top withholding agent is required to withhold 1% tax on goods or 2% tax on services purchased from regular domestic suppliers. However, in most cases, the employees are not in a position to withhold EWT when directly paying a supplier. Suppliers would not agree to the withholding unless a withholding tax certificate can be provided on the spot, which the employee may not be authorized or equipped to provide. To avoid incurring penalties (i.e., interest, compromise penalties) during an audit, in cases where there was failure to withhold the EWT, some employers opt to gross-up the transaction amounts to pay off the EWT supposedly due on the transactions, which results in additional costs.
As if the above is not enough, if the documentation requirement is not fully complied with, such as when the invoices are not in the name of the employer, these expenses may also be disallowed as expenses for income tax and as input VAT credits.
Clearly, there is a lot at stake, especially for businesses which heavily rely on employee reimbursements to account for expenses used in business.
WHAT SHOULD BE DONE?For WTC purposes, employers must establish the business purpose of these reimbursements with the appropriate documents, i.e., supplier invoices that are issued to the company, to prove that these should not be subject to WTC. Putting up internal policies specifying the conditions to avail of such employee reimbursements and/or allowances would help during a tax audit and also help business managers who review the reimbursement reports to ensure that only valid reimbursements are granted.
As for EWT, employers may consider using company-issued credit cards for employee reimbursements. In line with the tax rules, the employers’ payments to suppliers are not subject to withholding tax if paid through a credit card. This is because the EWT obligation on the supplier income is shifted to the credit card companies who have control of the payment to the suppliers. Instead, the taxpayer/employer’s withholding tax obligation is limited to the 2% EWT due on the service fees and other charges imposed by the credit card company. This approach helps alleviate the burden on the employer of assessing the applicable EWT for each and every reimbursement transaction or grossing up the expenses to account for the additional EWT (which inevitably results in additional cash outlay).
Last, in terms of substantiation requirements for income tax and VAT purposes, employers may provide their employees with a handy reference guide that can be presented to suppliers whenever a purchase is made. The guide should include the following information of the employer which the supplier would then use to issue the invoice: (1) Full business name; (2) Complete address; and (3) Tax Identification Number (TIN). Employees should ensure that they receive BIR-registered invoices and that the VAT amount is specifically broken down to support the company’s tax/VAT reporting.
Employee reimbursements can be tricky, to say the least. While reimbursements help facilitate business-related expenses, these can come with tax exposures if not managed properly. With the ever-changing tax rules and specific compliance requirements, it is crucial to stay informed and be meticulous with the documentation to avoid running into pitfalls. By doing so, businesses can mitigate risks, improve tax efficiency, and optimize cash flows, which can lead to a stronger financial position moving forward.
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.
Steven Lloyd Co is a manager at the Tax Services department of Isla Lipana & Co., a Philippine member firm of the PricewaterhouseCoopers global network.