What is Withholding Tax?
Withholding tax, also known as retention tax, is the tax usually deducted at source on income by the payer including people resident of another country, on employee of domestic company as well as on interest income and dividend income as per the tax laws of the country charging withholding tax and remitted to government of the country.
- From the above definition, it is clear that retention tax is a tax deducted at source on interest, dividend and other income of the recipient by the payer of such income and then remitted to the government directly.
- Further, the receiver on which it is applied can be a person either Resident or Non-resident of that country. For the purpose of residential status, the country’s tax norms are taken into consideration. Also, retention tax is deducted from the income having its source in the deducting country itself.
Following are the various types of withholding tax imposed on various persons as per the tax norms of country charging such tax:
#1 – Withholding Tax on Payments to Foreign Persons
- Retention taxes on the income of the foreign person is deducted at source at a fixed rate of 30% on the Gross amount of income.
- These are the retention taxes which are deducted at source by the federal government of the USA on the foreign person on their certain kinds of receipts.
- Also, partnership firms pay the taxes off on the incomes earned by the foreign partners from the partnership firms.
- Interest income of the non-residents, dividends from domestic companies, and compensation for services, rent receipts, royalties, and annuities are certain kinds of payments that are subject to withholding taxes on the non-residents of the country deducting the retention taxes.
#2 – Wages Withholding tax
- Wages withholding taxes are the graduated tax rates and hence higher wages will be liable for higher withholding taxes while the lower retention tax will be liable for lower withholding tax and hence there is fair treatment of every class of employees.
- It is being deducted by the employers on the salary and wages of the employee.
- Further, there are withholding allowances on the retention taxes are a part of the calculation of retention taxes since the withholding allowances are the tax exemptions on withheld no retention taxes are deducted.
#3 – Backup Withholding on Dividends and Interest
- Backup withholding taxes are, as the name suggests are deducted on the dividend and interest of the recipient.
- Here, federal income tax is being deducted at source on such interest dividends and other kinds of incomes at the time of payment to the stocks and other instrument holders.
- Applicability: Backup retention taxes are applied if the recipient is a foreign person as well as either the Tax Identification Number is not provided by the person under form W9 or the person has been notified by the Indian revenue service as the person on whole retention tax is required to be deducted.
How to Calculate Withholding Tax?
These are calculated and deducted based on two things, the amount of income earned and the details provided by the employee to the employer in term W-4.
For each category of recipients, It is calculated in a different manner, for example, the retention tax on wages is calculated as per withholding table and publication 15 while retention tax on an individual is calculated on various regular income as well lottery, betting, etc using the withholding estimator and expected income.
Suppose Mr. X earns a salary of $ 36,000 per year. With the yearly salary of $ 36,000 his monthly income comes to $ 3,000 ($ 36,000 / 12).
However, a 10% withholding tax is deducted from the same and hence he takes home only $ 27,000 ($ 30,000 – $ 3,000) and balance $ 3,000 is deducted at source as retention tax.
Why is Withholding Tax Charged?
- The most important reason for charging the retention tax is that it relieves a person from paying huge amounts all together in a single month and hence it is a type of advance tax which is deducted and paid by the payer to the government every month etc.
- Thus like an insurance policy where a smaller amount is paid periodically for a huge shelter in the future, retention tax works the same way.
- Also for the government, it becomes a huge relief since their day to day expenses can be made out of such periodic payments instead of waiting for so long.
Difference between the Withholding Tax and Tax Deducted at Source (TDS)
There is a thin line difference between withholding tax and tax deducted at source (TDS) where the retention tax term is usually more prevalent in case of out of country payment or the payment made to non residents and the same is the amount that is deducted well in advance by the payer before the actual payment and then depositing to government as per the due date while Tax deducted at source is the amount deducted at time of making payment and paid to government on behalf of the deductee.
Withholding Tax Rates
In the United States of America withholding tax is generally deducted at 30% on various income of non-residents like interest, royalty, etc. Thus most of the payments to foreign persons are deducted @30% with certain exemptions. But there are certain reduced rates depending upon those exemptions including exemptions by internal revenue code or the tax treaties between governments of various countries.
Withholding tax is usually deducted at source on income by the payer on various parties including people resident of another country and the same is very important from the perspective of both the government as well as general public in terms of property tax management and early collection of taxes from residents and non residents as well as salaried employees.
This has been a guide to what is withholding tax. Here we discuss the types, and how to calculate retention tax along with a practical example. You can learn more about financing from the following articles –