Withholding Tax - Explained
What is a Withholding Tax?
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Table of ContentsWhat is a Withholding Tax?How Does a Withholding Tax Work?The Origin of Withholding TaxWithholding Tax ExampleTypes of Withholding TaxNon-United States Resident Withholding TaxesImportant of Withholding TaxThe Bottom LineAcademic Research on Withholding Tax
What is a Withholding Tax?
Withholding tax refers to an amount an employer withholds from employees salaried income and submits directly to the federal taxing authorities. Levying of withholding tax takes place at the time of the disbursement of the employees income. The deductions are then given to the federal government by the authorized tax collecting entities.
Back to:ACCOUNTING & TAXATION
How Does a Withholding Tax Work?
Withholding tax applies to employees income tax such as Pay As You Earn (PAYE). Basically, the government imposes deduction on income earnings such as:
- Salary or wages
- Gambling winnings
However, individuals in self-employment don't pay withholding tax. They only make an estimate of their payments on a quarterly basis. Every employee with a salary or wage has a credit against the income taxes which he or she must pay during the year. Withholding tax also applies to interest and dividends earned by an individual from securities owned. Also subject to withholding tax is the income a non-resident of a country earns.
The Origin of Withholding Tax
The introduction of a withholding tax happened first in the United States in 1862. The initiative was introduced following the order of President Abraham Lincoln, who was at the time the president of the United States. Withholding tax was purposely introduced so that it could help in financing the Civil War. Also implemented by the federal government to support the same back then were excise taxes.
Withholding Tax Example
Lets assume that your yearly salary is $24,000. Though you make $20,000 per month, you will only take home $1,800. The reason is that your employer deducts $200 from your monthly salary and submits the amount to the federal and state government on your behalf. The payment your employer deducts from your monthly income is credited to your state income tax, federal income tax, Medicare liabilities, and unemployment. Note that what you state in Internal Revenue Service (IRS) Form W-4, also known as employees withholding allowance certificate is what determines your withholding tax amount. You should provide your employer with information such as the number of dependents and marital status in your Form W-4. A copy of this is then given directly to the IRS. Note that if your allowance claims on Form W-4 are many, then your withholding tax will be less.
Types of Withholding Tax
IRS employs two forms of withholding tax to ensure that proper tax is withheld in various situations. The most common form is withholding tax on personal income which every employer in the United States must collect and pass to the government. The other type of withholding tax is the tax levied against non-United States residents. The taxation ensures that whatever the non-residents earns while residing in the United States is subject to tax. Resident withholding taxes is a means through which the U.S. government collects tax right from the source. Initially, the experience of collecting income tax after earning had proved futile. So, the idea behind this system of collecting income tax was to enable the government to maximize tax collection from its citizens. Collecting tax from the source was seen to be the best way to reach out to every taxpayer. So, for every employed individual, he or she has to ensure that he fills the IRS Form W-4. The form estimates each of the employees tax amounts that an employer should deduct and submit to the tax entities.
Non-United States Resident Withholding Taxes
To ensure efficiency and effectiveness in the collection of tax, the United States government also imposes a tax on non-United States residents. The non-residents refer to those individuals residing in the United States but have not passed the substantial presence test or green card test. Such individuals must file Form 1040NR if they happen to be engaged in any business or trade in the U.S. during the year.
Important of Withholding Tax
One reason why withholding tax matters is that it prevents taxpayers from accumulating huge tax bills at the end of a financial year. By allowing employers to deduct and remit the tax on a monthly basis, it eases the tax burden on the employees side. In other words, it is easier to pay tax in bits than in a lump sum. Again, withholding tax ensures that the federal and local governments have steady cash flow through the financial year to finance their projects. There is no fear that the taxpayers will default to pay their taxes as the government is able to collect from them on a monthly basis.
The Bottom Line
Generally, a taxpayers liability may either be less or more than what he or she pays yearly on withholding tax. In such situations, a taxpayer may either receive a tax refund from the government or pay extra money to the government. Most importantly, you ensure that your payroll is accurate. The reason is that when you remit your withholding tax with mistakes, the liability will always be on the taxpayer, regardless of whether the mistake was made by the employer.
Academic Research on Withholding Tax
- Withholding Tax on Payments to Foreign Persons, Dale, H. P. (1980). Withholding Tax on Payments to Foreign Persons. Tax L. Rev., 36, 49.
- Income tax consciousness under withholding, Van Wagstaff, J. (1965). Income tax consciousness under withholding. Southern Economic Journal, 73-80.
- The taxation of interest in Europe: A minimum withholding tax?, Huizinga, H., & Nielsen, S. B. (1997). The taxation of interest in Europe: A minimum withholding tax?. This paper provides an analysis of the proposal for introducing a minimum withholding tax on interest in the EU. We present a model with three countries: a typical EU country, an "inside" tax haven, and an "outside" tax haven. In the initial non-cooperative solution, the former two countries impose withholding taxes on interest. We investigate what happens to welfare in these countries if the "inside" tax haven is forced to raise its withholding tax. From the model we proceed to a broader evaluation of the minimum withholding tax proposal.
- One-way treaty with the world: the US withholding tax and the Netherlands Antilles, Papke, L. E. (2000). One-way treaty with the world: the US withholding tax and the Netherlands Antilles. International Tax and Public Finance, 7(3), 295-313. This paper chronicles the experiences of the U.S. withholding tax on interest income. In 1984, the U.S. repealed its 30 percent withholding tax on interest income paid to foreign persons or corporations. While the tax raised little revenue, it had imposed substantial implicit costs on U.S. corporate borrowers. Since, prior to repeal, domestically issued bonds were subject either to withholding or strict information requirements, many U.S. multinationals raised funds through foreign finance subsidiaries, primarily in the Netherlands Antilles, to avoid the tax. Although the withholding tax rate was effectively reduced to zero in the U.S., this paper demonstrates that interest flows were highly sensitive to their after-tax cost.
- International portfolio capital: The wedge of the withholding tax, Brean, D. J. (1984). International portfolio capital: The wedge of the withholding tax. National Tax Journal, 239-247. This paper analyses the effects of the 1975 elimination of the withholding tax on interest paid by Canadian corporations on medium and long-term borrowings from foreign sources. Examination of relevant financial variables, including yields, corporate interest premia, real international corporate differentials and portfolio capital flows reveals several economic changes in Canada attributable to the wedge of the tax. The corporate interest premium dropped significantly relative to the premium in the U.S., the real international corporate differential also fell and the volume of net foreign portfolio capital flows to the Canadian corporate sector rose substantially after 1975.
- Withholding tax on domestic interest and dividends, Li, J. (1995). Withholding tax on domestic interest and dividends. Canadian Tax Journal, 43(3), 553-591.
- International Differences in Capital Taxation and Corporate Borrowing Behavior: Evidence from the US Withholding Tax, Papke, L. E. (1989). International Differences in Capital Taxation and Corporate Borrowing Behavior: Evidence from the US Withholding Tax (No. w3129). National Bureau of Economic Research. Securities transactions in the U.S. climbed on a net basis from $19 billion in 1983 to $50 billion in 1985. This rise was due almost entirely to an increase in foreign purchases of U.S. securities - largely corporate and government bonds. One reason suggested for this phenomenon is foreign investors' perception that the U.S. is a safe haven: there are strong investment fundamentals in the U.S. relative to other industrialized countries. Moreover, since the summer of 1984, these instruments have been free from withholding tax on interest paid to foreign holders of notes and bonds issued by U.S. entities. Recently, there has been discussion of re-imposing the withholding tax. A common counter argument to re-imposition is that such a tax is notoriously ineffective at raising revenue. As evidence, opponents point to the U.S. experience with the now-repealed withholding tax on the interest earned by foreigners. This paper explains the reasons that the tax was ineffectual. It is essentially a case study of the earlier U.S. experience with a withholding tax. In particular, the paper focuses on corporate borrowing behavior during the tenure of the tax and the change which took place after repeal.
- The Repeal of the Thirty Percent Withholding Tax on Portfolio Interest Paid to Foreign Investors, Franson, M. D. (1984). The Repeal of the Thirty Percent Withholding Tax on Portfolio Interest Paid to Foreign Investors. Nw. J. Int'l L. & Bus., 6, 930. The first part of this comment will examine the taxation of foreign investors and the operation of the Eurobond market prior to the 1984 Act, as well as the events which prompted the passage of the repeal legis- lation. The second part will explain the provisions of the new legislation and the treasury regulations implementing those provisions. It will also discuss the implications of two recently-issued revenue rulings on the use of tax havens, the practice of treaty shopping, and the effects of these rulings on existing Eurobond issues. The third part will address the pol- icy arguments advanced in support of, and in opposition to, the repeal legislation. Finally, the fourth part will summarize the likely effects of the repeal legislation, concluding that, overall, the measure will be benefi- cial to the United States' economy over the long-term.
- Repeal of the United States Withholding Tax on Interest Paid to Foreigners, Pront, P. E., & Zaitzeff, R. M. (1985). Repeal of the United States Withholding Tax on Interest Paid to Foreigners. Int'l Tax & Bus. Law., 3, 191.
- Repeal of the 30% Withholding Tax on Portfolio Interest, Segal, M., & Davis, E. N. (1985). Repeal of the 30% Withholding Tax on Portfolio Interest. Int'l Tax J., 11, 125.
- Withholding Taxes and the Effectiveness of Fiscal Supervision and Tax Collection, Simader, K. (2010). Withholding Taxes and the Effectiveness of Fiscal Supervision and Tax Collection. Bulletin for international taxation, 64(2), 115.