Withholding tax is used in many tax jurisdictions as an efficient and effective means of tax collection. Withholding tax is efficient in that tax authorities can collect tax as taxable events take place. For example, when wages are paid, withholding tax is deducted straight away rather than waiting until year-end. And withholding tax is effective, i.e. employers are tax agents – incurring all the time and costs for these collection services. Therefore, correctly accounting for withholding tax is critical for payers’ discharging their accountability to a taxing authority.
Examples of Withholding Tax Incomes
It varies between jurisdictions in the types of income 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. At an OECD global average, income tax is approximately 24% of the tax collected (see the Tax Foundation’s article for further interesting analysis).
In addition to wages and salaries, i.e. “individual income taxes”, certain tax authorities also require tax to be withheld 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 1980s, under its 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 each month’s interest earnings. So these entries are from the point of view of the recipient of the interest.
Receipt of 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%).
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| 30 June | Bank | $181.71 | |
| Resident Withholding Tax | $70.66 | ||
| | Interest | | $252.37 |
The RWT deducted for ABC is brought to account in ABC’s books as an asset, a tax prepayment. Year-end tax calculations will determine ABC’s overall tax liability position.
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 preparing 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.
Year-End Tax Liability
Don’t worry about provisional and terminal tax mechanics. This works for another article, but in brief, this is the equivalent of 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 particular rules around this process, but that’s the basics of it.
ABC Ltd will then make the following year-end journal entry:
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| March 31 | Income Tax Expense | $210,000 | |
| Provisional Tax | $205,000 | ||
| | Resident Withholding Tax | | $3,101 |
| Bank | $1,899 |
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. At the same time, 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.
Conclusion
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.