In countries where income tax is applicable on the salaries of employees, “tax deduction at source” mechanism is often used to collect the income tax. Tax deduction at source or withholding tax system is an efficient way of collecting the taxes from employees. Employers are required to deduct the tax from monthly salaries and deposit the deducted amounts into government treasury. At the end of the tax year, the employees take the credit of tax already deposited by the employers on their behalf and pay the net tax payable at year end.
For the government, this mechanism efficiently collects the taxes from the large masses. For the employees, it is beneficial in a way that tax payments are distributed over the year, thus avoiding the burden on employees of paying full year’s tax at one point.
UK’s PAYE System
In the United Kingdom, PAYE (Pay As You Earn) system is in place for collecting tax from the income of employees. As per UK tax laws, employers are required to deduct the appropriate amount of tax before paying salaries and benefits. Tax deducted is paid by the employer to HMRC (the revenue authority of the UK) and net amount of salary and benefits are paid to the employees.
Similarly, tax systems of different countries require the employers to deduct the tax from salaries and benefits of employees, and pay the tax to the government revenue authorities.
Accounting of payroll tax deductions
From the accounting perspective, following things should be kept in mind by the accountants while recording the payroll expense.
- Payroll expense is always recorded at the gross amounts of salaries, wages, and benefits.
- The amounts of tax deducted at source are recorded as a current liability.
- The net amounts payable to employees are recorded as a separate current liability (payable to employees).
- These liabilities will be settled when the employer pays the tax to the government authorities and pays the net amount to the employees.
Following journal entries will be made to record the payroll expense and related payments.
Dr. Salaries, wages, and benefits expense
Cr. Payable to employees
Cr. Tax payable to Government
(Recording payroll expense)
Dr. Payable to employees
Cr. Cash or bank
(Recording payment of salaries to employees)
Dr. Tax payable to Government
Cr. Cash or bank
(Recording payment of withholding tax to the government)