What is Backup Withholding?

Backup withholding is a fixed-rate tax that is applied to investment income. The tax is levied by the financial intermediary at the point when an investor realizes the investment income. This withholding is conducted to ensure that the government receives its due share of the investment income, rather than running the risk of having an investor not have the cash available for payment when income taxes are normally due.

Backup Withholding is a tax that is levied on investment income, at an established tax rate, as the investor withdraws it. Backup withholding helps to ensure that government tax-collecting agencies (such as the IRS or Canada Revenue Agency) will be able to receive income taxes owed to them from investors’ earnings. Backup withholding may be applied when an investor has not met rules regarding taxpayer identification numbers (TIN). At the time the investor withdraws his or her investment income, the amount mandated by the backup withholding tax is remitted to the government, providing the tax-collecting body with the required funds immediately, but leaving the investor with less short-term cash flow.

Investors commonly earn income – for example, interest payments, dividends, capital gains – from assets in which they have invested. While this income is taxable at the time it is received, the taxes owed on any calendar year’s worth of investment income only come due once every year, during tax season.

When backup withholding occurs, it is immediately forwarded to the applicable government entity. The investor can then claim this advance payment when filing a tax return, as a credit against the tax payable.

Backup withholding is also applied when an individual or entity has not reported a valid taxpayer identification number (TIN) via a Form W-9 to an entity that is paying the individual or entity. If the payer finds that the TIN is invalid, the payer sends a “B” notice to the individual or entity. A corrected TIN should be sent to the payer at once, to prevent backup withholding from commencing.

The backup withholding rules do not apply to wage or pension payments.