Withholding Tax: What It Is, How It Works and How to Account for It
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Withholding tax can sound complicated, but the basic idea is quite simple. It is tax that is deducted from a payment before the person or business receiving the money gets paid.
Instead of the person earning the income receiving the full amount and paying the tax later, the person making the payment deducts part of the money and pays that amount to the tax authority.
What is withholding tax?
Withholding tax is a way of collecting tax at the time a payment is made.
For example, assume a business must pay a consultant R100 000 for services. If withholding tax of 20% applies, the business does not pay the full R100 000 to the consultant.
It works like this:
· Amount earned by the consultant: R100 000
· Withholding tax deducted: R20 000
· Amount actually paid to the consultant: R80 000
· Amount paid to the tax authority: R20 000
The consultant still earned R100 000. The fact that only R80 000 went into the consultant’s bank account does not mean that the consultant earned only R80 000.
The other R20 000 was deducted and paid to the tax authority on the consultant’s behalf.
This is the most important idea to understand about withholding tax.
Why is withholding tax used?
Withholding tax helps governments collect tax directly from the source of the payment.
It is especially useful when money is being paid to someone in another country. If the full amount is paid to a foreign person or business, it may be difficult for the country where the income was earned to collect tax afterwards.
Withholding tax allows some of the tax to be collected before the money leaves the country.
It can apply to different types of income, including dividends, interest, royalties, rent and certain service payments. The exact rules and rates depend on the tax laws involved and, in international transactions, may also depend on a tax treaty between the two countries.
Who deducts the withholding tax?
The person or business making the payment normally has the responsibility to deduct the withholding tax.
This is important because the person receiving the income does not normally deduct the tax from their own payment.
The payer calculates the required withholding tax, deducts it from the amount that would otherwise have been paid, and pays the deducted amount to the relevant tax authority.
The recipient therefore receives the net amount.
Using the R100 000 example again, the payer would pay R80 000 to the consultant and R20 000 to the tax authority.
Together, these two amounts still equal the full R100 000 that the consultant earned.
How is withholding tax accounted for?
The accounting treatment becomes much easier once you separate the amount earned from the cash received.
The recipient must generally recognise the full amount of income earned.
Using our example, the consultant earned R100 000. The consultant therefore records R100 000 as revenue, even though only R80 000 was received in the bank account.
The accounting entry would be:
Debit: Bank – R80 000
Debit: Withholding Tax Receivable – R20 000
Credit: Revenue – R100 000
The R20 000 withholding tax is therefore not simply deducted from revenue.
The business earned R100 000 and should show the full R100 000 as revenue.
The withholding tax is recorded separately because it represents tax that has already been paid or withheld on behalf of the business and may be available as a tax credit, subject to the applicable tax rules.
What does the payer record?
The accounting looks different for the person or business making the payment.
The payer still records the full cost or expense.
If the expense is R100 000, the payer does not reduce the expense to R80 000 simply because that is the amount paid to the supplier.
The payer has a R100 000 cost. Part is paid to the supplier and part is withheld for payment to the tax authority.
For example:
Debit: Expense – R100 000
Credit: Bank / Supplier – R80 000
Credit: Withholding Tax Payable – R20 000
The R20 000 is a liability until the payer pays it to the tax authority.
Once it is paid to the tax authority, the withholding tax liability is cleared.
What happens for tax purposes?
The recipient generally starts with the full income earned, not only the cash received.
In our example, the income is R100 000, not R80 000.
The R20 000 withholding tax is dealt with separately under the relevant tax rules.
This is important because the recipient should not automatically be taxed twice on the same income.
Where foreign withholding tax has been deducted, the recipient may be able to claim a foreign tax credit against tax payable in their own country. There are normally rules and limits on how much foreign tax can be claimed as a credit.
This is why the withholding tax certificate is important. It provides evidence that tax was actually withheld and paid to the foreign tax authority.
In some situations, withholding tax can also be a final tax. This means that the tax deducted settles the tax obligation relating to that particular income. The treatment depends on the type of income and the tax rules that apply.
A simple way to remember withholding tax
The easiest way to understand withholding tax is to separate three amounts:
What did I earn?
This is the gross amount before withholding tax.
What did I receive in my bank account?
This is the net amount after withholding tax.
What happened to the difference?
It was withheld by the payer and paid to the tax authority.
So, if you earned R100 000 and R20 000 was withheld, you did not earn R80 000.
You earned R100 000.
You received R80 000 in cash, while R20 000 was withheld for tax.
The important accounting and tax point
Withholding tax does not normally change the amount of income that was earned.
The full gross income must still be recognised.
The amount withheld is recorded separately and dealt with according to the applicable tax rules. For the recipient, it may represent a tax credit or tax already paid rather than an ordinary business expense. For the payer, the amount withheld is a liability that must be paid to the tax authority.
The basic idea is therefore simple: withholding tax is tax taken from a payment before the money reaches the person who earned it.
The payer deducts it, the tax authority receives it, and the recipient receives the balance. The accounting must still show the full amount earned, while the tax withheld is accounted for separately.
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