Tax Law Notes
Tax Law Note:
Which Miscellaneous Payments Should be Subject to Income Tax Withholding?
Last Updated: December 02, 2004
Withholding of tax on payments is commonplace in an income tax. The advantage of a withholding system is that tax is collected at the point of payment, so that the government receives the tax sooner rather than later and without allowing the recipient of the payment to spend the money before tax is paid. Particularly useful for this purpose is the withholding of tax on wages (which is a nearly universal practice). But other types of payments may also be the subject of withholding, for example, dividends, interest, management fees, gambling winnings, and certain contractual payments.1 Such nonwage payments are referred to in this note as "miscellaneous payments."
Withholding on payments to nonresidents is quite common, with respect to a broad range of payments; this Note focuses, however, on cases where withholding is required regardless of the residence of the payee.
Country practice varies widely in the type of non-wage payments that are subject to withholding and the mechanisms that apply. Common features of a system of withholding of tax on miscellaneous payments include:
Within each element of this general structure, there are many variations. On the whole these variations represent differences attributable to different policy preferences of countries. A significant and usually ill-advised divergence is sometimes found in the imposition of a tax-withholding obligation on the ordinary individual (for example, on payments of rent to a lessor). Oversight and enforcement of withholding by individuals is difficult, demanding in its consumption of administrative resources, and generally to be avoided.
The types of income subject to withholding vary greatly. Withholding on payments other than wages, interest, and dividends applies in a smaller group of countries only. For example, in Colombia, a tax is withheld at 4% on payments to residents for the use of films and software, at 10% on payments for personal services and 1% on payments made under turnkey contracts.3 In Brazil, fees paid for specific types of professional services performed by one resident corporate entity for another are subject to a withholding tax of 1% to 3%, depending on the type of services performed. Income from fixed-income investments is subject to a 15% withholding tax, and income from variable investments, such as stock exchange transactions, is subject to a 10% income tax at source. Commissions and other payments made to unidentified beneficiaries are subject to a 35% withholding tax, and the expenses are not tax deductible for the payer.4 In Ghana, a 5% tax is withheld from payments made under general contracts for work done and services rendered, including rent in excess of GHC200,000. Tax is withheld at 15% on commissions to insurance/sales agents.5 In Israel, companies and individuals, under certain conditions, are required to withhold tax at 20% from payments for transportation, textile, metalworking, electrical, and electronics services. Payments for agricultural labor and produce are withheld respectively at 20 and 5%.6
Fashioning a Solution
There are two basic components of a rule requiring the withholding of tax on miscellaneous payments: a rule imposing tax and a rule imposing a withholding obligation. The starting-place in designing a tax-withholding system for miscellaneous payments is a provision that imposes a tax on the income from the activities that generate the payments. In countries that use a schedular approach, there is usually a separate provision making income from miscellaneous payments subject to tax. In a "global" or non-schedular system, a separate provision is not normally required; instead, the authority to tax derives from the law's general provision imposing tax on income. Even in a global system, however, it is necessary to identify the payments that will be subject to "withholding of tax at source"-that is, subject to withholding of tax by the payor at the time the payment is made.
Box 1 shows a sample of a withholding provision that assumes a schedular income tax system and final withholding. It uses the term "miscellaneous" income to refer to income from miscellaneous payments. The sample lists the sorts of payments subject to withholding of tax at source. These income sources are not also subject to tax under some other regime of a schedular system.
For example, although businesses are usually subject to a "business income tax" in a schedular system, and often businesses receive royalties, a country may choose to tax royalties as "miscellaneous" income subject to withholding rather than as business income. An alternative is to treat royalties received by a business taxpayer as business income, but to require withholding of tax on royalty payments. The business taxpayer would then include the royalties in business income but would receive a credit for the tax collected at source. For those receiving royalties outside a business context, the withholding tax would be final. The effect of this approach is to capture some tax on all royalties, while subjecting business taxpayers to tax at their regular tax rate. The sample includes a credit provision for miscellaneous payments received in the course of business, and therefore "carves out" royalties from the tax on miscellaneous income but not from withholding.
Sample Provision Imposing Tax. The sample reflects the categories of payments often included in a withholding system: income from games of chance (often called "gambling winnings"); royalties, dividends; and interest. Under the sample provision, the tax rate on miscellaneous income is 10 percent. The rate of tax is a matter of tax policy choice by the taxing country, but should be kept at a modest rate if the tax collected through withholding is not creditable against total tax. Although the withholding tax rate need not be uniform within the category of miscellaneous payments, sample law uses a uniform rate.
Tax Imposed on Miscellaneous Income. The income taxable as "miscellaneous" income under the sample is listed in the article "Tax Imposed on Miscellaneous Income," and is defined in a separate article, "Determination of Miscellaneous Income" (providing, in essence, for taxation of the gross payment). The sample covers typical miscellaneous payments, although more can always be added. There is an exception, commonly referred to as a "carve-out," of payments subject to tax under the Business Income Tax. The income reached under the sample is from games of chance, royalties, dividends, and interest.
Games of chance. Winnings from all forms of gambling, including lotteries, bingo, and other games of chance, but not including casinos.7 Under the withholding provision, payors of gambling winnings are required to withhold 10 percent of any payment of more than 500x.
Royalties and interest. Royalties and interest received other than in the course of a business are subject to the 10 percent tax on miscellaneous income. Because a business is taxable on royalties and interest received in the course of business, the sample does not treat royalties as "miscellaneous" income if the recipient will pay business income tax on them (a "carve-out"). But the payor of interest or royalties (who has no knowledge of whether the payment is received in the course of business) is required by the withholding rules to withhold tax on payments of interest and royalties (at the applicable 10 percent withholding rate). Business taxpayers are allowed a credit against business income tax for "miscellaneous" tax withheld on royalties and interest.
Dividends. A person who receives dividends is subject to a 10 percent tax on this form of income, with an exemption for companies that receive a dividend from a resident company of which the recipient is a 50-percent8 (or more) owner. The combined effect of this exemption and the withholding rules is that a company making dividend payments does not withhold the 10 percent tax on dividends paid to its parent company, but does withhold tax on payments to all other recipients. This rule represents a compromise of tax policy considerations. A company that receives a dividend may also pay dividends, and in a complex corporate structure the recipient may also be a company. Without an exemption, the tax could be imposed several times on the same dividend as it passes through a corporate structure. This form of multiple taxation is called a "cascading" tax, and cascading taxes have a damaging effect on the economy. Consequently, the exemption is provided to prevent the cascading of dividends within a corporate structure. Under the withholding rules, tax-exempt income is not subject to withholding.
Exemptions from Tax on Miscellaneous Income. The sample law allows two exemptions from tax on "miscellaneous" income: winnings from games of chance that are not in excess of 500x in a month; and dividends paid by a resident company to another resident company that owns more than 50 percent of the payor. Other exemptions could be added to make the sample consistent with country practice.
Tax Rate on Miscellaneous Income. The tax rate in the sample is set at a uniform 10 percent. Because the sample includes a carve-out for payments of royalties and interest that are taxable to the recipient as business income, in the typical case of a profitable business the 10 percent withholding rate will be lower than the business income tax rate, which means that the business taxpayer may ultimately pay tax at a higher rate on these items. On the other hand, the business taxpayer will combine the royalties and income with other business income and reduce the total by business deductions. A business with a net loss for the tax year may have a net credit, which should generally be allowed as a refund.
Tax Period. The sample is designed with a one-month tax period. No recipient of miscellaneous income will file a tax declaration with respect to that income. The inclusion of a tax period merely enables the miscellaneous income tax to mesh with the withholding provision and with the Tax Administration Law's rules for filing declarations and withholding statements. It is possible to require the recipient of miscellaneous income to file a tax declaration, but enforcing the filing of a multitude of individual tax declarations to collect the small amount of tax that escapes withholding is a poor use of administrative resources. The sample contemplates the filing of withholding statements by the payors rather than declarations by the recipients.
Provision Imposing a Withholding Obligation. The second component of a withholding system for miscellaneous payments is the set of rules that requires payors to withhold. The sample withholding provision has two parts, an article imposing the obligation to withhold and an article exempting certain payors from that obligation. These rules may be included in the Income Tax Law or may be placed in the Tax Administration Law. There are some advantages to placing the obligation to withhold tax in the income tax law, because the withholding provision is closely linked to the obligation to pay tax on income. Moreover, the withholding agent is considered a taxpayer for purposes of the collection provisions, and the tax withheld is, in fact, income tax. Appropriate penalties for failure to withhold, and for failure to pay over tax withheld, should be provided for but are not discussed in this Note.
Withholding Obligation. The sample specifies that the obligation to withhold applies only to business taxpayers. These taxpayers are usually well-equipped to handle the withholding of tax. Payors of miscellaneous income as defined in the provision imposing tax on miscellaneous income are also, typically, business taxpayers, and so the withholding obligation can fairly be imposed on them.
Exemptions from Withholding Obligation. The second part of the withholding provision is an article stating the exemptions from the obligation to withhold. These exemptions are, first, for payments of tax-exempt income; and, second, for payments by persons who are not business income taxpayers. The income exempted by the first rule is limited to gambling winnings below a stated threshold and dividends paid to a 50-percent owner (both discussed previously). The payors exempted by the second rule are, typically, individuals who pay interest on personal loans. The object of this second exemption is to eliminate a compliance burden for individuals who are not well-equipped to handle it; the creditors who receive the interest payments are likely to be business taxpayers already in the income tax system and subject to the normal enforcement process.
Ault, Hugh et al., Comparative Income Taxation 298-02, 452-55 (1997) (U.S., Canada, Australia, U.K., Sweden, Netherlands, Japan, France, Germany).
There may be income tax withholding on other items that do not constitute payment of income, for example, imports. This Note does not address such withholding, or withholding under taxes other than the income tax (e.g. VAT). Withholding of income tax on employment income generally and on fringe benefits is dealt with in separate Notes.
1The series of Tax Law Notes has been prepared by the IMF staff as a resource for use by government officials and members of the public. The notes have not been considered by the IMF Executive Board and, hence, should not be reported or described as representing the views of the IMF or IMF policy.
2 This is a critical issue in terms of tax design. Final withholding is most common in the case of interest and dividends, but can also be found for other types of income, such as rental income. To the extent that final withholding is used under a global tax, the tax becomes more like a schedular tax. See generally Burns and Krever, Individual Income Tax, in 2 Tax Law Design and Drafting 495, 495-99 (V. Thuronyi ed. 1998).
3International Tax and Business Guide, Colombia, (Deloitte, Touche, Tohmatsu ed., 1997).
4International Tax and Business Guide, Brazil, (Deloitte, Touche, Tohmatsu ed., 1997).
5Doing business and investing in Ghana, (PriceWatersHouse ed., 1999).
6Doing business and investing in Israël, (PriceWatersHouse ed., 2000).
7The type of gambling carried out in casinos is not suited for this form of withholding, because players typically receive gross winnings that are many times their net winnings.
8There are substantial country variances in the required percentage. Some countries exempt all intercorporate dividends from tax.