Withholding Tax works in the following manner.
Advance Tax Collection
The primary function of withholding tax is to collect taxes in advance. This system ensures that the government receives tax revenue as income is earned, rather than waiting for taxpayers to file their annual returns. By collecting taxes at the source, withholding tax reduces the risk of non-payment or underpayment of taxes.
Preventing Tax Evasion
Since withholding tax is deducted before the income is paid to the taxpayer, it prevents tax evasion. Individuals or businesses cannot avoid paying taxes on their earnings as the tax is already deducted and submitted to the tax authorities. This helps the government close the gap on potential revenue losses due to non-compliance.
Coverage of Different Income Types
Withholding tax is applied to various sources of income. Some common examples include:
- Salaries: Employers deduct a portion of an employee’s salary as income tax before the salary is paid.
- Dividends: Companies deduct withholding tax from dividends paid to shareholders.
- Interest: Banks withhold tax on interest earned from savings accounts and investments.
- Contractor Payments: Businesses deduct withholding tax when paying contractors or freelancers for services.
Ensuring Compliance for Non-Residents
Withholding tax is particularly effective in ensuring tax compliance for foreign individuals and businesses. When a company in Pakistan makes payments to a foreign entity for services or goods, withholding tax is often applied. This ensures that the foreign party contributes to the tax system, even if they are not based in Pakistan.
Simplifying the Tax Process
Withholding tax simplifies the tax payment process for both the government and taxpayers. For employees, it eliminates the need to calculate and set aside money for taxes, as the deduction is done automatically. For the government, it ensures a regular inflow of revenue, reducing the reliance on end-of-year tax payments.