Withholding tax, also known as retention tax, is a government requirement of holding the taxable amount on income earned not by the recipient of the income but from the payer of such amount. It is a way for the government to tax at the source of income, rather than trying to collect income tax after it is earned.
The amount of withholding tax on income payments other than employment income is usually a fixed percentage.
Example1: Company A provides service to Company B. When the obligations are met Company B pays company A after deducting withholding tax. Company B thereafter pays the deducted withholding tax amount to the government. The government, therefore do not have to wait for Company A to pay its income tax later on. Thus, the government receives its tax money before hand.
|Company A (Service provider)||Company B (Client/Customer)|
|Issues sales invoice (#001) of $100,000 to Company B. Sales invoice are raised for the full amount without showing any W/H tax amount on it.
Dr…Receivable/Company B = 100,000
|Once payment is made, the Payment advice copy (Remittance advice) looks like this:
Transferred via Bank X = 97,000
|When money is received:
Dr… Bank a/c = 97,000
|When money is paid:
Dr…Company A = 100,000
Example2: A Company pays salary to its employees after deducting withholding tax. The deducted amount is remitted to the government. The government does not have to wait for employees to file their returns and thus collects the tax amount beforehand.