What happens if my company does not deduct withholding tax from a payment: do we pay it ourselves and lose the expense?

A missed withholding deduction does not go away when the payment is made. Under the Income Tax Ordinance, 2001, as amended to 30 June 2026, it can lead to four separate consequences for the company that made the payment: the tax itself, default surcharge, a penalty, and loss of the tax deduction for the expense.

What does the law say?

The duty to deposit. Section 160 requires tax deducted under Division III of Part V of Chapter X, or under Chapter XII, to be paid to the Commissioner by the person who deducted it, within the time and in the manner prescribed.

Personal liability. Section 161(1) applies where a person either fails to deduct tax as required, or deducts it and fails to pay it to the Commissioner under section 160. In both cases “the person shall be personally liable to pay the amount of tax to the Commissioner”, who may pass an order and recover it. Section 161(1A) requires the person to be given an opportunity of being heard first.

Where the payee has already paid. Section 161(1B) says that if, at the time of recovery, the tax that should have been deducted has been paid by the payee, no recovery is made from the payer. The payer instead pays default surcharge at twelve per cent a year from the date it failed to deduct to the date the tax was paid.

Default surcharge. Section 205(3) charges default surcharge at 12 per cent a year on the amount unpaid by a person who fails to deduct tax, or fails to pay deducted tax under section 160 by the due date. It runs from the date the tax should have been deducted to the date it is paid to the Commissioner.

Penalty. Serial No. 15 of the Table in section 182 applies to any person who fails to collect or deduct tax, or fails to pay it under section 160. The penalty is Rs. 40,000 or 10% of the amount of tax, whichever is higher.

The expense. Section 21(c) says no deduction is allowed under “Income from Business” for any expenditure from which the person must deduct or collect tax, unless the person has paid, or deducted and paid, the tax. Two provisos follow:

1. for purchases of raw materials and finished goods, the disallowance cannot exceed twenty per cent of purchases of raw materials and finished goods;
2. recovery of tax under section 161 or 162 counts as tax paid.

How does it work in practice?

The consequences arise at different stages. Personal liability and default surcharge arise when the Commissioner passes an order after hearing the company. The penalty is a separate charge. The disallowance under section 21(c) affects the company’s taxable income for the year of the expense. Because of the second proviso, once the company pays the tax under a section 161 recovery, that tax counts as paid for section 21(c).

Section 161(2) lets the company recover the tax from the supplier. Section 162 gives the Commissioner a separate route to recover the tax from the supplier. Section 162(2) says this does not protect the payer from other legal action, default surcharge or disallowance of the expense.

Worked example (illustrative figures)

Sialkot Surgical Instruments Limited paid Rs. 3,000,000 to an engineering services company on 1 October 2026 without deducting tax. The service provider is on the active taxpayers’ list, and the Division III rate for engineering services is 7%. An audit picks this up and the company pays the tax on 1 April 2027.

1. Tax not deducted: 3,000,000 x 7% = Rs. 210,000. Section 161(1) makes the company personally liable for this.
2. Default surcharge under section 205(3), for six months: 210,000 x 12% x 6 / 12 = Rs. 12,600.
3. Penalty under S. No. 15: the higher of Rs. 40,000 and 10% x 210,000 = Rs. 21,000. The penalty is Rs. 40,000.
4. The Rs. 3,000,000 expense: under the second proviso to section 21(c), the tax recovered under section 161 counts as paid, so the expense is not disallowed on this ground once the tax is paid.

Total cash cost in this example: 210,000 + 12,600 + 40,000 = Rs. 262,600, before any amount the company recovers from the service provider under section 161(2).

What if the missed deduction was on purchases of raw materials?

Suppose the same company bought Rs. 15,000,000 of steel from suppliers without deduction and never paid the tax, and its total purchases of raw materials and finished goods for the year were Rs. 50,000,000.

The first proviso says the disallowance “shall not exceed twenty per cent of purchases of raw materials and finished goods”. The text does not say whether “purchases” means the company’s total purchases or only the purchases affected by the failure. The two readings give different caps:

• If total purchases: 50,000,000 x 20% = Rs. 10,000,000, so Rs. 10,000,000 of the Rs. 15,000,000 is disallowed.
• If only the affected purchases: 15,000,000 x 20% = Rs. 3,000,000.

The Ordinance does not settle which reading applies.

Common mistakes

• Thinking the supplier’s tax return cures everything. Under section 161(1B), it removes recovery of the tax from the payer, but default surcharge still applies.
• Treating the penalty and default surcharge as alternatives. They come from different provisions, section 182 and section 205(3).
• Assuming deducted but undeposited tax is safer. Section 161(1)(b) covers failure to deposit in the same way as failure to deduct.
• Assuming the disallowed expense stays disallowed after the tax is paid. The second proviso to section 21(c) treats recovery under section 161 or 162 as payment.

What to check in the official text

Read sections 21(c), 160, 161, 162 and 205(3) in full, and S. No. 15 of the section 182 Table, which the consolidated text prints as a broken table. Section 160 refers to a time and manner “as may be prescribed”: the deposit deadlines are in the Income Tax Rules, not the Ordinance. Also check the proviso to section 205(3), which removes default surcharge for a period where tax due under an appeal order is paid on time and no further appeal is filed.