What is provisional tax? It’s a tax that, strangely, makes our lives easier!

The word “tax” typically isn’t music to anyone’s ears, but there is a tax that makes our lives easier. We’re talking about provisional tax, which lets us spread our income tax payments across the financial year, rather than make one crippling payment at the end.

Time to read: 5 mins

The key components of this are: 

  • Inland Revenue (IR) entrusts you to make regular payments, whereby provisional tax spreads the load across the year.
  • Income tax is the tax on your income/net profit for the year (whether a company, trust or individual). In some instances, a company and its shareholders may be required to pay provisional tax.
  • Depending on your GST frequency, provisional tax is paid either two times (six-monthly GST filing) or three times throughout the year. For someone with a 31 March balance date, the final provisional tax payment date is the following 7 May. 

There is always a distinction between net profit and cashflow. Just because you don’t have money in the bank doesn’t mean that your business isn’t profitable and therefore doesn’t have tax to pay; rather it may mean your profit has been applied to something else. Have a chat to your business advisor if you are struggling to understand why you have tax to pay, yet little cash available. 

How does provisional tax work? 

The standard provisional tax method works as follows: 

  • Inland Revenue assesses your provisional tax for the following year as 105% of the current year, which is referred to as the standard provisional tax method. You are obliged to pay provisional tax if, at the end of the previous year, you're left with tax to pay of more than $5,000. 
  • IR makes a general assumption that the following year will be 5% better than the previous year, however a lot can change in 12 months. Sometimes a business is highly profitable for a one-off reason that isn’t repeatable. Further, some businesses grow by more than 5%, meaning they may have substantially short-paid their tax. 

It is important to note that this formula approach results in a provisional tax estimate rather a final tax for the year. Upon filing your income tax return at the end of the year, you receive a credit for your provisional tax payments made during the year. 

Should your actual tax to pay be greater than your provisional tax payments, you will have additional tax to pay, however if your tax to pay is less than your provisional, you will receive a refund of the overpaid portion. 

Provisional tax options if your circumstances change 

  • Voluntary Payments you can make voluntary payments at any time and these can be a one-off or more frequently (to suit you) to further spread the provisional tax load. Voluntary payments are generally suitable for when the tax to pay is likely significantly greater than the previous year. 
  • Estimation should your income be significantly more or less than the previous 12 months, you can estimate your provisional tax payments for the year. However, if the amount of provisional tax you need to pay is more than your estimate, you are potentially exposed to use of money interest (UOMI) and penalties. 
  • Ratio Inland Revenue will give you a ratio that is applied to your total sales (GST taxable supplies). You will then pay provisional tax based on this ratio when you complete your GST returns. The ratio method has the advantage of making more payments based on actual sales, rather than being based on the previous year. 
  • Tax Pooling This allows you to deposit funds with a tax intermediary and apply these to amounts due on tax payments when you like. In essence, this is similar to a bank account where you can transfer money to cover your tax obligations (although you can receive the tax credit from the day the transfer was made to the tax intermediary). If the amount transferred into the tax pool exceeds the amount due, you can receive interest on it, which is usually at a higher rate than Inland Revenue offers. 

Provisional tax in your first year of business 

The saying that your first year in business is tax-free is sadly a myth, as any income is subject to tax. However, you won’t be obliged to pay provisional tax in the first year, as your tax to pay in the prior year was less than $5,000. 

Being new to business, it can be easy to overlook your tax obligations, but it’s essential to plan for them. As an example, let’s assume a company in its first year of business files its tax return on 1 February and has $20,000 of tax to pay for the current year, due 7 April.

As a result of filing the income tax return, the company must pay provisional tax of $21,000, due 7 May. There will also be another provisional tax bill in August. This will result in having $41,000 of tax to pay within three months. Without appropriate planning, the bill can seem huge. To alleviate this, the company should put money in a separate bank account, make voluntary payments through the year, or use tax pooling.

Failure to pay provisional tax on the due date can have adverse implications, and result in penalties and interest. Ignoring provisional tax payments only increases the problem.

Remember… if you are unable to make your payments or feel they are too much, our advisors may be able to help.

DISCLAIMER No liability is assumed by Baker Tilly Staples Rodway for any losses suffered by any person relying directly or indirectly upon any article within this website. It is recommended that you consult your advisor before acting on this information.

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