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Photo: Nataliya Vaitkevich
Understanding tax annualization
The (sometimes problematic) final hump for payroll supervisors
Every new year, just as the Christmas holidays are winding down, the calls start coming. They come from all over the country. They come from semi-panicked payroll clerks. They come from worried-sounding CFOs. They come from anxious HR execs. Having fielded these calls for as long as we can remember, our technical support desk can already predict what they'll be about. At this time of the year, the conversations will all be about tax annualization. 1. At the end of the calendar year*. In Philippine practice, payroll clerks typically annualize all the firm's employees during the pay period when the firm pays its Christmas bonus. (And/or 13th month bonus.) The reason for this is obvious. But it's often the case that in practice the pay period for disbursing the bonus is not the last pay period of the year. A significant number of companies pay their final bonus in November or even earlier. If this is the case for your company, then your payroll department must perform annualization again on the last pay period of the year, whether or not a bonus is paid at that time. This holds true regardless of the software you are using, or even if you are doing payroll manually. In fact, your firm's payroll clerk can annualize several times during the latter part of the year. But he should always annualize during the last pay day of the calendar year* as well . Or, if your company paymaster can only do annualization once a year, the time to do it is on the last payday of the calendar year*. That's because this is the only time of year that you can determine total taxable pay, exemption status, and allowable deductions from taxable income. (SSS, PHIC, HDMF contributions, union dues, etc.) (Note: As a common practice, payroll clerks perform annualization only once a year. But this low frequency is due to the tedium of doing this by hand. In a computerized payroll system, tedium and time constraints are no longer factors. When your payroll is computerized, you can annualize as many times as you wish or need to do it. No regulation forbids multiple annualizations within a year. After all, the process benefits both taxpayer and tax collector.) 2. Also, whenever an employee resigns. Aside from annualizing everybody's taxes at year-end, the company paymaster should also annualize the taxes of every employee who resigns, at the time he departs. The reason is simple. When a worker leaves a company's employ, his tax payments (withholdings) should be exactly equal to his tax liability at the time of his departure. When this is the happy case, the employee leaves without owing any taxes up to that point in the year. And also, he leaves without having overpaid his taxes. Any self-respecting computerized payroll solution should provide for this basic but also tedious procedure. If you don't annualize a worker upon his departure, it won't be the end of the world, but someone will be unnecessarily out of pocket. Likely the employer. The employer will have to advance any tax liabilities the resigned employee leaves behind. And good luck then to the company in hunting down and getting reimbursement from the now-long-gone employee. By then he might be in Milan, or Tallahassee, or dead. Few things in life sting like having to pay for someone else's mistake. And what if the employee is in the opposite situation - of having overpaid taxes to date ? Then good luck to the employee in getting his refund from his late employer when he wakes up to his overpayment and wants his money back. Even with men of good will determined to do the right thing, all that unnecessary clerical work costs everybody money and time. - rsr *Payroll, including the resultant reporting to government entities (BIR, HDMF, SSS, and Philhealth), is always on a calendar year basis. Philippine payroll practice recognizes no fiscal year other than the one that starts on January 01 and ends on December 31. For more on this, read this article. Almost as frequent is a payroll clerk suddenly realizing that he has just posted the last payday of the year without performing tax annualization. A third major topic of technical support conversations is when the payroll clerk has already performed the annualization procedure on the software, but can't seem to reconcile the computer output with his manual computation of the same. Re this third problem, in almost 100% of cases (in our experience with our SURE! PayMaster solution), the payroll person realizes he has made a computational error in his manual annualization. (And thus has probably been making the same error for years.) Yet another cause of tech support conversations is users' bewilderment with the BIR's Alphalist Validation Module when they submit their alphalists online. Years of fielding these tech support calls persuade us that a large part of the problem is that too many payroll people approach the annualization process as a sequence of rote procedures, without a robust understanding of the big picture. Kabisote, in the pungent local parlance. This article attempts to provide the antidote helicopter view. "Annualization" has a specific meaning in Philippine taxation practice.To payroll clerks and tax accountants, annualizing means equalizing the tax due on a worker's income from January of the current year-to-date, as against the withholding taxes that have been withheld from his pay for the same period. To put it another way, the tax-paying employee would not like to pay more tax than current tax regulations require him to. And from the other side of the fence, the taxman would want to extract no less tax than current tax regulations allow him to. Hence, annualization. This is a straightforward notion. But implementing annualization requires meticulous accuracy and involves much repetitive and tedious arithmetic. Thus many payroll clerks stumble in the mechanics of it. Let us therefore examine the mechanics of annualization while also keeping an eye on the big picture. PREDICTING INCOME IS NOT EASY. The need to annualize taxes arises from one unavoidable fact: that it's virtually impossible to know what an employee's annual income will be until late in the year. Real life is messy, and unforeseen events can always affect the final income number. Windfall income or unexpected bonuses tend to kick the taxpayer up to a higher tax bracket. Job loss or injury tend to reduce income, and thus to kick him in the opposite direction. Then again, there are major life events like the birth of offspring, or their passing into adulthood - events that affect tax-exempt income. The unpredictability is worse for salesmen on commission, or the self-employed, such as doctors and other professionals with fluctuating incomes. ROUGH GUESSES. And yet, even in the teeth of this uncertainty, taxes still have to be collected month in and month out. The maws of public finance are insatiable. And so, as mankind has always done when grappling with the unknown, the stakeholders in the tax computation process - government, employers, employees - start out with educated guesses.1. We start with a simple premise. If a worker is making X pesos a month, then it's reasonable to suppose that he is going to make something around 12X pesos for the year. Plus an extra X pesos of 13th month pay - this last mandated by Philippine law. Using this reasoning, we have a rough estimate or projection of the worker's approximate annual income. But it's a rough estimate. Any number of things can change this projected income number as the year unfolds. These can be promotions, demotions, bonuses, merit increases, layoffs, to name a few. 2. Now, it's one thing to estimate a worker's annual income. It's another thing to estimate his taxable income. Taxable income is gross income minus exemptions. We therefore need to estimate what the employee's tax exemptions might be. In current Philippine practice, exemptions for the typical working stiff arise from two things. First, the taxpayer's marital status. Second, whether he has qualified dependents, such as minor offspring and aged parents. Once we know these two things, we can determine the employee's taxable income. (Remember, we are talking here of regular salaried or hourly workers, not of plutocrats, congresspersons, or mysteriously wealthy mid-level bureaucrats.) 
Photo: Kelly Sikkema OVERPAYMENT AND UNDERPAYMENT OF TAXES. But let us not forget that all the tax-withholding that goes on all year is all built on a structure of guesswork. Educated guesswork, but still guesswork. With all life's imponderables coming into play as the year unfolds, chances are good that the total taxes withheld so far year-to-date are not exactly equal to what the employee owes according to a correct application of the tax regulations. It's very likely that at any given point in the year, the employer's payroll department has under-withheld taxes from some employees' pay. And over-withheld from others'. It's this circumstance that gives rise to the need to annualize - to equalize the tax due on the worker's actual taxable income, on the one hand, as against the tax "installments" that have been withheld every payday from an employee's pay, on the other. MECHANICS OF TAX ANNUALIZATION. As the company paymaster (or a piece of payroll software) compares the total year-to-date withheld taxes to the total tax due, he faces three possible outcomes: a. If the total withholdings turn out to be greater than the tax due, then the employee has overpaid his taxes through excessive withholdings. The process then returns the excess to the employee by reducing his withholding tax for the current pay period, as appropriate. b. If the total withholdings turn out to be less than the tax due, then the employee has underpaid his taxes. The process then extracts the difference through an appropriate withholding tax charge against the employee's pay for the current pay period. c. If both totals happen to be equal, then the total tax due exactly equals the taxes withheld so far, yielding a difference of zero - no further adjustment needed. In short, the employee has paid the correct taxes, no more and no less. This outcome is unlikely, like a tossed one-peso coin landing on its edge. At this point, the annualization process is complete. The company paymaster now has all the information he needs to produce the so-called alphalist reports. This is a group of mandatory government reports well-known to payroll clerks everywhere. The alphalists are a major year-end reporting requirement of the BIR. Here's a tip: Avoid headaches with this tedious, time-consuming exercise. Understand, plan, and make provisions for annualizing taxes in October, instead of at the last minute. If you wish to avoid the tedium, a well-designed payroll application will do all this automatically, including all mandated year-end reporting to the BIR. - rsr
Title: Understanding tax annualization
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