If I do not deduct withholding tax when I pay someone, can the expense be disallowed?

Where the law makes you a withholding agent, failing to deduct and pay the tax can cost you the deduction for the expense itself. Section 21(c) of the Income Tax Ordinance, 2001 does this for running expenses, and a proviso to section 22(1) does the same for depreciation on assets bought without deducting tax.

What does the law say?

Section 21(c): the main rule. No deduction is allowed for any expenditure from which the person is required to deduct or collect tax under Part V of Chapter X (the withholding provisions) or Chapter XII, unless the person has paid, or deducted and paid, the tax as required by Division IV of Part V of Chapter X. Two provisos follow:

1. For purchases of raw materials and finished goods, the disallowance under clause (c) “shall not exceed twenty per cent of purchases of raw materials and finished goods”.
2. Recovery of any amount of tax under section 161 or 162 is considered as tax paid.

Section 22(1) proviso: depreciable assets. Depreciation is not allowed, in all relevant tax years, for the amount paid to a seller for addition of capital assets if the tax deductible on those payments under section 153, or under the separate section on payments to non-residents, has not been deducted and deposited. The proviso does this by leaving that amount out of the assets used to compute tax depreciation.

Sections 161 and 162: the other consequences. Under section 161, a person who fails to deduct tax as required is personally liable to pay that tax to the Commissioner. Under section 162, the Commissioner may recover the tax from the person who was paid. Section 162(2) says that recovery does not absolve the person who failed to deduct from other legal action, default surcharge, or “the disallowance of a deduction for the expense to which the failure relates”.

How does it work in practice?

The first question is whether you were required to deduct at all. For payments for goods, services and contracts, section 153(1) puts the duty on a “prescribed person”. Section 153(7) lists who that is. For an individual, the list includes an individual having turnover of Rs. 100 million or above in any of the preceding tax years. A small shop below that level is not a prescribed person under section 153 on that ground, though other withholding sections have their own rules.

If you were required to deduct and did not, three separate things can follow: the expense is disallowed under section 21(c), you can be made personally liable for the tax under section 161, and default surcharge can apply. The disallowance is not a substitute for paying the tax.

Worked example (illustrative figures)

Imran runs a furniture manufacturing unit in Gujranwala as a sole proprietor. His turnover exceeded Rs. 100 million in an earlier tax year, so he is a prescribed person under section 153(7). In tax year 2027 he makes these payments without deducting the tax required under section 153 (made-up amounts):

Payment	Amount
Timber and board (raw materials), all purchases for the year	Rs. 30,000,000
Polishing and transport services	Rs. 1,200,000
A new cutting machine	Rs. 5,000,000

Step by step:

1. Raw materials. Without the proviso, Rs. 30,000,000 would be disallowed. The cap is 20% of purchases of raw materials and finished goods: 20% of Rs. 30,000,000 = Rs. 6,000,000. Disallowed: Rs. 6,000,000.
2. Services. The twenty percent cap applies only to raw materials and finished goods, so the full Rs. 1,200,000 is disallowed.
3. Machine. Under the section 22(1) proviso, the Rs. 5,000,000 is not added to his assets for tax depreciation, so no depreciation is allowed on it in any year.

Total expenses disallowed for tax year 2027: Rs. 6,000,000 + Rs. 1,200,000 = Rs. 7,200,000, plus the lost depreciation on the machine. This is separate from the tax he may be made to pay under section 161.

What if …?

What if only some of my raw material purchases were paid without deduction? The proviso caps the disallowance at twenty percent “of purchases of raw materials and finished goods”. The text does not say whether that means twenty percent of all such purchases for the year or of only the purchases on which tax was not deducted. This page does not decide between the two readings.

What if the Commissioner later recovers the tax? The second proviso treats a recovery under section 161 or 162 as tax paid, which brings the expense back within the words “paid or deducted and paid”. The proviso does not say how a recovery of only part of the tax is treated.

What if I deducted the tax but did not deposit it? Clause (c) requires the tax to be deducted and paid. Deducting without paying does not meet the condition.

Common mistakes

• Thinking the twenty percent cap applies to every expense. It is limited to purchases of raw materials and finished goods.
• Assuming a disallowance settles the matter. Section 162(2) keeps the disallowance, default surcharge and other action as separate consequences.
• Claiming depreciation on an asset bought without deduction. The section 22(1) proviso excludes that amount in all relevant tax years.
• Assuming every sole proprietor is a withholding agent under section 153. The individual test in section 153(7) turns on turnover of Rs. 100 million or above in a preceding tax year.

What to check in the official text

Read clause (c) of section 21 with both provisos, the proviso to section 22(1), the definition of “prescribed person” in section 153(7), and sections 161 and 162. The rates to be deducted are in Division III of Part III of the First Schedule, which is not reproduced here.