Provisional tax is often a source of confusion for new business owners as well as a source for frustration for owners of existing businesses. This article gives a brief overview of some aspects of the system to help which may be of assistance to all business owners.
What is provisional tax?
The concept of provisional tax is based on payments of tax being made while income is still being derived. Effectively, this amounts to progress payments of tax being made to the IRD before the final assessment of tax for a particular year is made.
When are you liable for provisional tax?
If your tax to pay on your last income tax return was more than $2,500, you may have to pay provisional tax for the following year.
You will not be required to pay provisional tax so long as your previous year’s residual income tax is $2,500 or less. However, if your residual income tax (RIT) in the current year exceeds $2,500 and no provisional tax is paid you may be subject to use of money interest from the first instalment date.
The number of instalment payments you are required to make depends on how you work out your provisional tax. If you’re GST registered, how often you file GST returns will determine how many provisional tax instalments you’re required to make.
Even if you are not required to pay provisional tax, you may still elect to do so; see below.
What is residual income tax?
Residual income tax (RIT) is the amount of tax you have to pay, less any tax credits you may be entitled to and any PAYE deducted. RIT is used to calculate the amount of provisional tax you are required to pay.
Calculating your provisional tax
You can use one of these options to work out your provisional tax:
- GST Ratio – only if you’re registered for GST
Under the standard method, the amount of provisional tax payable for an instalment is based on the tax payable in the previous year.
Depending on which year the calculation is for, a taxpayer will have to pay approximately their Residual Income Tax from their previous year, usually spread over three payments. For a taxpayer with a standard balance date, these payments fall on the 28th of August, 15th of January and the 7th of May.
On or before the due date for an instalment of provisional tax, you can make a fair and reasonable estimate of your RIT for the income tax year. The estimate may be filed using form IR 309 or online at www.ird.govt.nz.
You must revise the estimate for the tax year if, at any time in the tax year, the amount estimated is no longer fair and reasonable.
The benefit of estimating provisional tax is that you can avoid paying too much tax, for example when you expect your income to be less than the previous year.
You may be liable to shortfall penalties if reasonable care is not taken when formulating your estimation. However, you will be deemed to have taken reasonable care in making your estimate if the estimate is more than the provisional tax payable.
Interest is payable or receivable on any provisional tax paid that is under- or over-estimated. As at 10 September 2012, the use of money interest rate charged by the IRD is 8.40%.
GST Ratio option:
The GST ratio method allows you to base your provisional tax payments on a percentage of your GST taxable supplies. If your business income is declining or tends to fluctuate during the year you may benefit from using this method.
This method has some eligibility criteria which exclude large businesses, but can be a good option for small to medium business owners.
If you meet the criteria you can send an election to the IRD before the beginning of the income year and the IRD will calculate the ratio and advise you of the ratio before your first provisional tax payment is due.
You will then be required to make six provisional tax payments (every two months) along with your GST. If you pay GST on a monthly basis you will make provisional tax payments on every second GST return.
If you decide to stop using the GST ratio method before your first provisional tax instalment date, you can elect to use the standard or estimation methods of calculating provisional tax. However, if you stop using this method after your first provisional tax instalment you will be required to estimate your provisional tax payments for the remainder of the income year.
Voluntary payments of provisional tax
You may find it advantageous to make voluntary payments of provisional tax. This will help reduce use of money interest charges on any known tax shortfalls. If you are a safe-harbour taxpayer, you can avoid making an estimation and liability for use of money interest.
While voluntary payments will earn interest it is typically at a lower rate than interest rates offered by commercial banks. The IRD’s current overpayment rate is 1.75%.
Early-payment discount for new small businesses
If you are self-employed or a partner in a partnership you may be entitled to a discount of 6.7% of the amount of income tax payable on income received before the income year in which you are due to pay provisional tax for the first time. The objective of this discount is to encourage you to make voluntary payments of tax before you are actually required to pay provisional tax.
If you are a new business you are not required to pay provisional tax until the income year in which your RIT first exceeds $2,500. In practice this means that you effectively have 2 years’ worth of tax to pay in the year in which you are first required to pay provisional tax. The discount encourages new business owners to pay tax early and helps to relieve the financial strain in the year in which provisional tax is first paid.
This article gives a very brief description only of the options available under the provisional tax system. For new business owners, it pays to consider income tax long before the first income tax return is due. For existing business owners, considering options like the ratio method can help to smooth their cash flow. This article is intended as a brief overview only – for more information please contact us.