What is Withholding Tax

Withholding tax is the amount your employer deducts from your salary before paying you and sends directly to the government towards your income tax liability. It helps ensure that income tax is paid gradually throughout the year instead of as a large lump sum later. The amount deducted depends on factors such as your income level, tax slab, and applicable exemptions or deductions. In India, withholding tax is commonly referred to as Tax Deducted at Source (TDS). Anyone earning a salary, professional income, interest, rent, or other taxable income is generally required to pay income tax as per government regulations.

Withholding tax is a type of income tax that is levied on certain payments made by Indian persons to non-resident Indians and companies. The payments from which such tax should be withheld are outlined in section 195 of the Income Tax Act, 1961. Also known as retention tax, it is required to be deducted and deposited with the government by the payer — who is the person making the specified payment to the non-resident individual or company. This payer may be any of the following persons:

• Individuals: This includes any resident Indian who makes a taxable payment to a non-resident in India.

• Partnerships and LLPs: This includes Limited Liability Partnerships (LLPs) as well as partnership firms that make any of the specified payments to non-residents.

• Companies: Domestic companies incorporated and operating in India also need to deduct withholding tax when making payments to non-residents.

• Trusts and other persons: The provisions of section 195 of the Income Tax Act also apply to trusts, BOIs, AOPs etc. that have paid non-residents.

• Withholding tax is a type of tax deducted at source from the payments made to non-resident Indians and companies.

• The rates for tax deduction are specified u/s 195 of the Income Tax Act, 1961.

• The withholding tax, once deducted, must be paid to the government.

• Non-payment may lead to the levy of interest and penalties. The said expenses may also be disallowed till the year in which the tax on them is actually paid.

Withholding tax works just like how regular TDS works on payments made to Indian residents. The tax applies to different types of payments like interest, dividends, royalties, fees for technical services and lottery winnings. The rate of tax may also be determined by the terms of the Double Taxation Avoidance Agreement (DTAA) that India has with the non-resident payee’s country of residence.

The payer, which is the person or entity making the payment, is responsible for calculating and deducting the appropriate amount of withholding tax at the rates prescribed in the Income Tax Act. After the withholding tax has been deducted, it must be deposited with the government within a specified period.

The process of calculating the amount of withholding tax is quite simple. Although it may vary slightly on a case-by-case basis, broadly, here is how the tax is calculated.

• Step 1: The payer must first determine if the recipient of the intended payment is a non-resident (whether individual or company).

• Step 2: Then, they need to check the rate of withholding tax applicable to the specific payment that is to be made.

• Step 3: The said tax must be deducted at the appropriate rate and paid to the government.

• Step 4: The rest of the payment will be made to the relevant non-resident party.

• Step 5: The tax deducted must be paid to the government promptly, within the date specified.

For the sake of convenience and better understanding, withholding taxes can generically be classified as resident and non-resident tax variants. Let us consider what each of these types entails.
 

• Resident withholding tax

This is essentially any tax withheld at source from any payments made to resident Indians — whether individuals, companies or any other type of person recognised in the income tax regime. It is more commonly known as tax deducted at source or TDS. This type of tax is deducted from payments like salaries, commissions, brokerage, professional fees and rent, among other items.

The rate of withholding tax or TDS on payments made to residents depends on the type of expense. For instance, the rate of TDS on interest and dividend payments is 10%, and the TDS on salary may depend on your income tax slab rate. These rates are specified in the Income Tax Act. If the TDS deducted exceeds your tax liability, you can claim an income tax refund when you file your income tax return for the relevant assessment year.

• Non-resident withholding tax

This type of withholding tax is deducted from any eligible payments made to non-resident payees. The term ‘withholding tax’ is more commonly used for payments made by Indian residents to non-residents. This aligns with the terminology used in the U.S. and other foreign countries.

So, while TDS is the more common term for withholding tax on domestic payments, this term is typically used for tax on payments to non-residents. This tax is levied to ensure there is no tax evasion on any taxable income that non-residents earn within India. It applies to any payments received by non-resident companies as well as NRIs.

The provision of withholding tax offers many advantages to the Indian government. Check out the top reasons to levy this tax.
 

• Early revenue generation

Since the tax is deducted at the time of making the payment and deposited soon thereafter, it results in early revenues for the government. This gives the government access to funds consistently during the year instead of only at the time of tax filings. Consequently, the government can continue to fund its projects and services without any financial hassles.
 

• Reduced tax evasion

The nature of withholding tax ensures that the payer and the payee are both within the ambit of the income tax regime. This makes it harder for the payee to evade taxes. Since the tax is deducted from the payment before the non-resident payee receives the amount due, the chances of tax evasion are reduced.

• Increased scrutiny

Both the payer and the payee maintain records of the deductions made for withholding tax. The payer needs to record these details to ensure that the tax is deducted and deposited on time. The payee needs to record it to facilitate refunds or file the necessary paperwork or returns, as the case may be. This makes scrutiny easier for the income tax department.
 

• Encouraging compliance

Tax may be withheld at higher rates for persons who have not complied with the required regulations under the Income Tax Act. To avoid this issue, many residents and non-residents focus on ensuring compliance. This, in turn, makes tax administration in the country easier.

The rate of withholding tax in India depends on the type of income and the category of the recipient. Different types of payments attract different Tax Deducted at Source (TDS) rates under Indian tax laws. Some commonly applicable rates are listed below:

Special cases:

• For non-residents, withholding tax rates may differ depending on the type of income. Rates may also be affected by agreements under the Double Taxation Avoidance Agreement (DTAA) between India and another country.
• In certain situations, taxpayers can apply for lower or nil TDS. Individuals whose total income falls below the taxable limit may submit Form 15G or Form 15H to avoid excess tax deduction.

Understanding withholding tax and applicable TDS rates can help taxpayers manage their finances better and avoid unnecessary tax deductions.

One of the most crucial aspects of deducting withholding tax is to first identify the residential status of the recipient or payee. This is important because the tax only applies to payments due to non-residents. Here is how you can determine if an individual is a resident or an NRI.

An individual is a resident of India if they meet any of the below conditions:

• They were in India for at least 182 days in the current financial year, or

• They were in India for at least 60 days or more in the current financial year and for at least 365 days in the four previous financial years

Anyone who does not meet at least one of the above conditions is an NRI.

Similarly, for companies, residency is only valid if the firm meets any of the following two conditions. Otherwise, it is a non-resident company.

• It must be an Indian company, or

• Its place of effective management (for the relevant previous year) should be located in India

To understand when withholding tax is applicable and when it is not, you should also be clear about the tax implications of different incomes earned by persons of different residential statuses. These details are summarised here:
 

• Resident Indian

Resident Indians need to pay tax in India on income earned domestically as well as foreign income.
 

• Non-resident Indian

NRIs need not pay tax in India on income earned abroad. However, they are liable to Indian tax on the income earned within India.
 

• Citizenship or place of birth

The place of birth may determine citizenship. However, neither the birthplace nor citizenship influences the residential status. This status depends solely on the conditions specified in the Income Tax Act. For instance, a citizen of India who was present in the country for less than 182 days in the previous year (or for less than 60 days in the previous year and less than 365 days in the four preceding years) can still be an NRI for tax purposes.

The rates for deducting withholding tax from payments made to NRIs as specified in the Finance Act 2023 are as follows:

The issue of not deducting or not paying withholding tax can lead to various financial and regulatory repercussions. They include:

• Interest charges: If the payer has deducted this tax but has not deposited or paid it by the due date, interest will be levied on the amount due at 1.5% from the deduction date till the payment date.

• Penalty: A penalty that is 100% of the amount of withholding tax is levied if the tax has been deducted but remains unpaid. Similarly, if insufficient withholding tax has been deducted, a penalty equal to 100% of the difference between the amount deductible and the amount deducted is levied.

• Disallowed expenditures: The payer cannot claim the expenses on which such tax has not been paid as deductions from their income during the years of default. The expenses will be allowed as deductions only in the year during which they are paid.

Conceptually, both these taxes are the same. They are deducted at the source and remitted to the government. The key difference lies in the payments they apply to. While TDS refers to tax deducted on payments made to domestic or resident payees, withholding tax applies to payments to non-residents.

With this, we have covered what withholding tax is, how it works, the tax rates applicable and so much more. While it is a very pertinent and important tax concept, it is primarily relevant to non-resident payees and the persons who make the specified payments to these payees. If you are a resident Indian investor earning salaried income or business income (and no payments due to non-residents), TDS is more relevant to you than withholding tax.

Your employer may deduct tax from your salary. TDS u/s 194K may also apply to the dividends you earn from your investments in mutual fund schemes. So, if you are planning on investing in mutual funds that pay dividends, ensure you factor in these taxes. Additionally, you also need to analyse the expense ratios of different funds to keep the overall cost of investment low.

This is easy on the Bajaj Broking website, which has over 4,000 schemes listed for you to choose from. Here, you can compare mutual funds, check the expense ratios, risk levels and more to make an informed decision.