Tax filing tends to be a challenging task for all organizations to ensure complete compliance and avoid any penalties or IRS Audits. In case of dividend payments, too, organizations are supposed to ensure that they keep a proper track record of the taxes paid in terms of acting as an agent between the government (the recipient of taxes), and the receiving party (i.e. to whom the dividend is being paid). This helps them to abide by their tax obligations so that they can avoid any compliance-related issues.
Dividends and Withholding Tax – Explanation
In order to understand how dividend withholding tax works, it is important to understand both of these concepts separately first.
What are dividends?
Dividends are related to the distribution of profits to the shareholders. This is an incentive that is paid to the company against their incentive in the company. Dividends are mostly decided by the amount that the Board of Directors predetermines in cash or shares.
Hence, the dividend can be considered an income from the shareholders’ perspective. Regardless of the fact that they are distributed from the after-tax income of the dividends, it can be seen that taxes on dividends are supposed to be withheld again. This is categorized as a withholding tax that is paid against the dividends charged.
What are Withholding Taxes?
Withholding taxes are taxes that are deducted at source, by the payer, on behalf of the payee. This implies that the party that is making the payment, keeps an additional charge in the form of tax, on the behalf of the government.
In the case of dividends, withholding tax is deducted by the company paying the dividend. This implies that when dividends are paid to the shareholders, withholding tax is deducted by the company, and subsequently passed on to the government.
Withholding tax is imposed on the party that receives the dividend itself, not the party paying it. In other words, this charge is liable to be paid by the shareholder, and not the company that issues the dividend. The company, however, is responsible to make sure that the withholding tax collected on the dividends is subsequently passed on to the government.
The receiver of the dividend also claims to withhold tax deduction when filing for returns. This amount is duly adjusted in the tax liability that arises for the given year.
Accounting Treatment for Dividend Withholding Tax
Dividend Withholding Tax is considered as a liability on part of the company that issues the dividends. This is because they have merely collected this amount from the shareholders, but they are not liable to use this amount for any purpose. Therefore, it is not treated as an income or an asset for the company.
Therefore, when dividends are issued, companies normally set aside a margin for withholding tax, and the remaining amount is payable for dividends. The journal entries in order to record Dividend Withholding Tax is as follows:
| Particular | Amount |
| Dividends | xxx |
| Withholding Tax | xxx |
| Dividends Payable | xxx |
In the journal entries mentioned above, it can be seen that dividends are debited because it is a representation of the reduction of retained earnings. By definition, retained earnings have a credit balance, and since dividends are contra-earnings, they are debited from the retained earnings account. In the same manner, withholding tax, and dividends payable are considered to be liabilities, they are credited in the financial statements.
Subsequently, when the dividend is paid, the following journal entries are made:
| Particular | Amount |
| Withholding Tax | xxx |
| Dividends Payable | xxx |
| Bank | xxx |
Example of Dividend Withholding Tax
The concept of dividend withholding tax is illustrated in the following example:
Parker Ltd. Is a Limited Liability Company and has its shares publicly listed on the Stock exchange. For the year ended 31st December 2019, the Board decided to make dividend payments equivalent to $40,000. The applicable withholding tax rate for the year is 20%. Withholding tax is supposed to be deducted by Parker Ltd. at the source.
The dividend declaration date was 31st December 2019, whereas the dividends were actually paid on 10th January 2020.
In the example mentioned earlier, it can be seen that two transactions are involved in the transactions above. The journal entries used to record the aforementioned transactions are as follows:
| Particular | Amount |
| Dividends | $40,000 |
| Withholding Tax | $8,000 |
| Dividends Payable | $32,000 |
These journal entries are supposed to be made when the company initially declares the dividends. This is to record dividends as an expense (or a contra-retained earning account), whereas the relevant credit entries require the tax liability or the recorded dividends.
Once the dividends are paid, i.e. on 10th January 2020, the following journal entries will be made:
| Particular | Amount |
| Withholding Tax Payable | $8,000 |
| Dividends Payable | $32,000 |
| Bank | $40,000 |
In the journal entries above, it can be seen that the liability against the dividends payable and withholding tax is adjusted and subsequently debited. The credit entry is a depiction of the payment made from the bank, in order to settle dividends, and the withholding tax payable.
Implications of Dividend Withholding Tax
Dividend withholding tax is considered to be confusing for a lot of taxpayers, as well as entities. In this regard, it is important to ensure that the implications of dividend withholding tax are accounted for by both the dividend issuers and the dividend recipient. The implications for both are given below:
Implications of Dividend Withholding Tax for organizations
From an organizational perspective, dividend withholding tax has the following implications:
- Tax collected at source: Since dividend tax is withheld, companies must maintain a proper record and calculate the total tax that is withheld when they are paying out dividends. These calculations need to be made in an accurate manner in order to avoid any interrogation on the part of the IRS.
- Tax returns at year-ends: Once all the taxes have been collected, they are supposed to be returned to the government formally. When filing for tax returns, it is important to ensure that the amount of withholding tax is properly declared, so that they can be returned back to the taxpayers.
Implications of Dividend Withholding Tax for shareholders
Shareholders of a company receive payouts that have already been adjusted for the withholding tax. The implications on shareholders are as follows:
- The tax that is deducted in the form of withholding taxes should be declared in the final year returns, so that the amount can be claimed and adjusted in the form of the tax liability.
- It is also important for shareholders to realize that dividend declared would not be equivalent to dividend received if withholding tax is applicable. Dividend received is going to be adjusted for tax, and therefore, it is going to be lesser than the dividend declared.