Withholding tax system, how it works?

Withholding tax system in the Philippines is quite an interesting topic for those engaged in trade or business, or those in practice of profession. Though not a new topic, many still seems to be confused. As a matter of fact, it is mostly a taxpayer’s headache during assessments of the BIR. As a rule, expenses subject to withholding tax shall be subjected to withholding tax in order to be allowed as a deduction from gross income for income tax purposes.

In this post, let us discuss what are these withholding taxes and how it works. Under the Tax Code, the BIR is allowed to implement a withholding tax system and thus, it issued Revenue Regulations No. 2-98. At present said regulation has undergone various amendments. The BIR now implements three types of withholding taxes:

a. Creditable withholding tax;
b. Final withholding tax; and
c. Withholding tax on compensation

This withholding tax system is a system of advance collection scheme where the approximate income tax of a specific income payment is being deducted and remitted to the BIR using the appropriate return (BIR Forms No. 1601E, 1601F or 1601C). The rate required to be withheld actually approximates the amount of tax due on the transaction. The payor claiming the item as an expense is constituted as a withholding tax agent that is made accountable thereto by mandate of the Tax Code. Failure to comply such mandate is sanctioned by law and regulation and it proves to be costly because the said expense shall be disallowed from deducted expenses in the income tax return (ITR), and will be assessed as follows:

a. Income tax at 30% based on the gross amount of disallowed expense;
b. Withholding tax at the applicable rate to such item based also on the gross amount; and,
c. 25% surcharge, 20% interest and compromise penalties, if any on both of the above

On the part of the payee, proceeds will be received net of withholding tax and will be furnished a certificate as proof of such withholding (creditable withholding tax or CWT or EWT, certificate of withholding taxes on compensation or WC, or certificate of final income tax withheld or FWT). This certificates will now be used in paying the tax depending on what type of withholding tax was applied.

In creditable withholding tax (termed sometimes as expanded withholding tax, EWT, or creditable tax withheld at source), certificates will be used as tax credit that is deductible from the tax due upon filing the income tax return – quarterly, or annual income tax return. Example of this are payments for rentals, professional fees, and the likes. In withholding tax on compensation, the certificates will serve as the income tax return under substituted filing if the employee has only one employer. If employee is earning other taxable income or has multiple employer, then, said certificates will be used as a tax credit also from the employees income tax due at the annual income tax return.

The other type of withholding is the final withholding tax (FWT) for income payments that are subject to final taxes like interest income from bank deposits, royalties, annuities, dividends, and the likes. In FWT, the payee is no longer required to file a return because the FWT return made by the payor constitutes final payment of the tax. In other words, the amount received by you as a payee is net of final withholding tax so it could no longer be assessed.

By this, the BIR is more assured that the income will be declared and reported by the recipient of income, thus, this is in the form of a check and balance. This helped the BIR increase its annual collection from taxes thereby expanding and enhancing the system with its top-twenty thousand corporations (TTC), and the newly ruled top-5,000 individuals engaged in trade or business, on in the practice of profession. The BIR is now on computerized matching and it could easily trace discrepancies of payor declared and payee undeclared or vice versa. If found to have under declared, then the BIR will assess the corresponding tax by referring to the payor’s declared amount in BIR Form 1601E and other related documents.

Please note however that this system is applicable only with respect to resident payees in the Philippines. If the payor is a non-resident and the payee is resident, this will not apply. Likewise, this system is only applicable to those items of expenses and income payments enumerated under RR No. 2-98. If not listed in there, then it is not subject to withholding tax. Furthermore, the tax base of the withholding should be the gross payment, exclusive of VAT. If services and goods are bought from the same supplier, the applicable rate shall be separate for good and separate for service, except if the other is incurred in furtherance of the other and the amount is immaterial, in which case, it maybe aggregated.

For those engaged in trade or business, or practice of profession, please be mindful of your obligation to withhold on income payments. Prevention is better than cure. Prevent headache by complying your obligation as withholding tax agent.

Related posts:

a. Top-twenty thousand corporation, how is it?
b. How withholding taxes on compensation works?

Tags: creditable withholding tax, EWT, final tax, FWT, tax credit, WC, withholding tax, withholding tax agent, withholding tax at source