Are Backwages From an Illegal Dismissal Case Taxable? BIR Rules Under RMC No. 39-2012

Backwages awarded to an illegally dismissed employee are taxable compensation income, not tax-free damages — the BIR treats them as the salary the employee should have earned during the dismissal period. Revenue Memorandum Circular No. 39-2012 requires whoever garnishes the employer’s funds to collect the award to withhold 5% of the taxable backwages, allowances, and benefits before releasing the money, and the employee is expected to report that income spread across the years the award actually covers.

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Why does the BIR treat backwages as taxable income? #

Backwages restore the income an employee lost because of an illegal dismissal — they represent unpaid salary for the period between dismissal and reinstatement or final judgment, not compensation for a separate injury, so the BIR classifies them as ordinary taxable compensation rather than exempt damages. This was directly addressed in BIR Ruling No. OT-700-2020, issued in December 2020, which clarified that back wages are included in the gross taxable income of an illegally dismissed employee because they and other amounts awarded represent unpaid salaries for services the employee would have rendered, and are therefore liable to income tax. The reasoning distinguishes backwages from a genuine damages award compensating for a distinct legal injury — backwages are, in substance, delayed wages.

This principle traces back to RMC No. 39-2012, issued August 6, 2012, which set out the withholding mechanics for exactly this scenario: Guidelines and Procedures on the Withholding of Income Tax on Backwages, Allowances and Benefits by Virtue of Labor Dispute Awards.

How does withholding actually work when the award is collected through garnishment? #

RMC No. 39-2012 makes the garnishee — the bank, financial institution, or other party holding funds owed to the employer — the withholding agent responsible for deducting tax before the award reaches the employee, because a labor dispute award is frequently collected by garnishing the employer’s bank deposits, receivables, commissions, or royalties rather than paid voluntarily. The circular’s mechanism works like this:

Garnishees of a judgment award in a labor dispute are constituted as withholding agents with the duty of deducting the corresponding Withholding Tax on wages due thereon in an amount equivalent to 5% of the portion of the judgment award representing the taxable backwages, allowances and benefits.

Persons in control of paying out wages or salaries are already authorized to withhold tax on those payments — RMC No. 39-2012 extends that same authority and duty to a garnishee standing in the employer’s shoes at the moment of forced collection, since a garnishee is, functionally, in control of the payment reaching the employee. The garnishee is held liable for making the deduction, not just the underlying employer.

Why is the award spread over multiple years instead of taxed all at once? #

The employee reports backwages by allocating them across the years from separation to the year of the final decision awarding them — not as a single lump sum taxed entirely in the year of actual payment — because the award represents salary earned (in substance) over that whole multi-year period, and taxing it all in one year could push the employee into a higher bracket than if the wages had been paid normally as they accrued. This spreading approach avoids penalizing an employee for how long a labor dispute takes to resolve, aligning the tax treatment with the economic reality that the backwages correspond to specific past years of service, not a single windfall year.

Worked example #

An employee is illegally dismissed in 2022 and, after litigation, wins a final labor dispute award in 2026 covering ₱1,200,000 in backwages for the four years the case was pending (2022–2026). The employer’s bank deposits are garnished to satisfy the award.

• Withholding at source: the garnishee bank deducts 5% of the ₱1,200,000 taxable backwages — ₱60,000 — before releasing the balance.
• Net released to the employee: ₱1,140,000.
• Reporting: rather than reporting the full ₱1,200,000 as 2026 income, the employee allocates the backwages across the 2022–2026 period the award covers, consistent with RMC No. 39-2012’s spreading approach, and the ₱60,000 withheld is applied as a tax credit against the resulting liability for those years.

This differs from how a resignation or authorized-cause separation payout is normally handled — see Is Separation Pay Taxable in the Philippines? for the exemption rules that apply when separation is for a cause outside the employee’s control (which is a different scenario from a court-ordered backwages award for an illegal dismissal that has already been litigated).

Frequently asked questions #

Are backwages from an illegal dismissal case taxable? #

Yes. Backwages represent the salary an employee should have earned had they not been illegally dismissed, so the BIR treats them as taxable compensation income, not as tax-exempt damages, and 2020 BIR Ruling No. OT-700-2020 explicitly confirmed this treatment for reinstatement-era back pay.

Who withholds the tax on a labor dispute award? #

Under Revenue Memorandum Circular No. 39-2012, when a labor dispute award is collected through garnishment — of the employer’s bank deposits, receivables, or other funds — the garnishee (the bank or entity holding those funds) becomes the withholding agent and must deduct the tax before releasing the award to the employee.

What withholding tax rate applies to a labor dispute award? #

RMC No. 39-2012 sets the withholding rate at 5% of the taxable portion of the judgment award representing backwages, allowances, and benefits, deducted by the garnishee before the funds reach the employee.

Does the whole backwages award get taxed in the year it’s finally paid? #

No. The circular directs that the employee report the income by allocating or spreading the backwages, allowances, and benefits across the years from separation up to the year of the final decision awarding them, rather than lumping the entire multi-year award into a single year’s taxable income.

Are moral or exemplary damages awarded in the same labor case also taxable? #

Backwages, allowances, and benefits are compensation for lost earnings and are taxable; damages that compensate for something other than lost wages sit on a different analytical footing and should be evaluated on their own facts and legal basis rather than assumed to follow the same treatment as backwages.

Summary #

Backwages awarded in an illegal dismissal case are taxable compensation, not exempt damages — BIR Ruling No. OT-700-2020 and RMC No. 39-2012 both treat them as delayed salary. When the award is collected through garnishment, the garnishee must withhold 5% of the taxable backwages, allowances, and benefits before releasing funds, and the employee reports the income spread across the years the award covers rather than all at once. For how a labor award ultimately reconciles against an employee’s annual withholding certificate, see What Is BIR Form 2316 and When Must You Issue It? and Year-End Withholding Tax Adjustment.