Withholding Tax is used in many tax jurisdictions as an efficient means of tax collection. It is efficient in that tax authorities are able to collect as taxable events take place, for example an employee is paid wages, rather than waiting for collection until some future date. And it is efficient in that as an employer, for example, holds back part of an employee’s wage, the employer is acting as a tax agent for the authority – incurring all the time and costs (with no reimbursement) for these collection services. Therefore the correct withholding tax approach in accounting is a critical part of any payer’s responsibility in discharging their accountability to a taxing authority.
Examples of Withholding Tax Incomes
It varies between jurisdictions in the types of incomes withholding tax is deducted from. The most common form of income and one of the largest sources of tax revenue for tax authorities is that collected from individual income tax receipts. For example in the United States this source of taxation accounts for approximately 40% of state and federal tax receipts. On an OECD global average this sits at approximately 24% (see the Tax Foundation’s article for further interesting analysis).
In addition to wages and salaries, ie “individual income taxes”, certain tax authorities also require the withholding of tax from commissions paid, interest earnings and dividend receipts. For example New Zealand, although not exactly a big player on the international tax stage, has been a world leader in tax reform over the past few decades. As part of major reforms implemented in the 1980’s under it’s economic reformation dubbed “Rogernomics“, after the then Minister of Finance Sir Roger Douglas, resident (and non-resident) withholding tax was implemented.
The New Zealand resident withholding tax (RWT) regime is the one we will use as our example below. The principles will be similar no matter your location.
Worked Example of Withholding Tax Accounting Entries
The simplest example we can use that highlights the main points of RWT is that around interest earnings. Bringing back our trusted example firm, ABC Ltd (we will have to come-up with a better name for our example company), we assume they have to account for RWT on the interest earnings they receive each month. So these entries are from the point-of-view of the recipient of the interest.
The day after 30 June 20XX ABC’s accounting team are preparing their normal monthly management accounts for the executive team and as part of this they prepare the month-end bank reconciliation statement. From this reconciliation they record interest earned for the month of $252.37 and the RWT of $70.66, which the bank deducted and paid to the Inland Revenue Department (in New Zealand RWT for companies this is normally taxed at 28%).
|Resident Withholding Tax||$70.66|
The RWT deducted for ABC is brought to account in ABC’s books as an asset, in effect it is a prepayment of tax by ABC. Of course its overall tax liability position will be determined at year-end.
So these month-end entries are made through the year by the team, reflecting interest earnings and the build-up of RWT paid on behalf of ABC by its bank. We then come to the year-end accounts and the preparation of ABC’s annual accounts for internal reporting and external company and tax reporting.
So what happens to that RWT asset that we have been building? Well, now we have to work out what RWT is still owed, if any, to the tax authority as part of ABC’s tax calculations.
Over the 12 month period ending 31 March 20XY ABC earned $3,101.34 in interest of which $868.38 was deducted in RWT by its bank. During this same period ABC made taxable profits of $750,000. ABC therefore had a tax liability position as set out in Table 1 below.
Don’t worry about provisional and terminal tax mechanics. How this works is for another article, but in brief, this is the equivalent in how the New Zealand tax authority collects early company/business taxable profits. A business makes an estimate of its taxable profit for year-end, which it can reassess through the year, and makes several provisional tax payments to pre-pay the estimated income tax owed. And terminal tax is the final payment required when tax is owed. There are very specific rules around this process, but that’s the basics of it.
The following year-end journal entry would be made to account for in ABC’s books.
|March 31||Income Tax Expense||$210,000|||
|||Resident Withholding Tax||||$3,101|
The debit to “Income Tax Expense” brings to account the expense to be recognized based on the year-end income tax calculation in Table 1. The next two credits draw-down on the “prepaid” taxes asset accounts, provisional and RWT, made through the year. While the final credit to “Bank” reflects the terminal tax payment by ABC to the tax authorities.
Of course this model assumes there is no ring fencing of income and different tax rates. In most tax jurisdictions this does not apply to companies, ie all of their income is grouped together for income tax calculations. Whereas in many jurisdictions this is not the case for individual tax payers where interest income is taxed differently to wages for example.
That brings us to the end of our look into how the accounting journal entries for withholding tax work. We trust you have found this useful and we have been able to answer the question of the debits and credits around withholding tax payments. We always welcome your constructive feedback about our articles, please drop us a comment below. You can also use our Ask a Question page or Contact Us channel.