Provisional tax: the IRD’s Christmas present

Many business owners are working hard coming into Christmas, perhaps looking forward to a break,. Then there comes that gentle intrusion of a reminder about “Provisional Tax” due for most taxpayers on January 15th. There is no good time to pay tax but it is particularly galling leading up to Christmas. Imagine if you owned a camping ground by the beach; you are now up to your second provisional payment but most of the year’s income is still to be earned.

Provisional tax is not a separate tax but a payment of income tax. A taxpayer who ends up having to pay more than $2,500 of terminal tax ‘falls’ into the regime in the following year. A provisional taxpayer is required to pay instalments of income tax during the income year, rather than at the end of the year when a tax return is filed. Generally there are three instalments on 28 August, 15 January and 7 May.

There are three methods of calculating provisional tax which are the standard option, the estimation option and the ratio option.

• The standard option is the default option used by IRD. In the standard option they will add 5% onto your residual tax amount from the year before and that amount will be spread across the three provisional tax dates.

• The estimation option allows tax payers to estimate the amount of provisional tax that they pay based on their expected profit for the year. Any taxpayer who estimates their provisional tax, will be subject to use-of-money interest should it later be calculated that insufficient provisional tax has been paid.  

• Finally, you can also look at the ratio method if you are GST registered.  With this method you have to pay provisional tax along with your GST payments. This is available as a means of aligning your payments with business cashflow and is based on a percentage of your GST taxable supplies. This is not as straightforward as you may think and we recommend you ask an accountant to help with this one.

Issues with this form of tax payment regime include:

• Provisional tax is generally paid in three instalments during the year, so the amounts can be chunky and hard to manage.

• Payment required may bear no relationship to the current year's business performance or level of income. If business has declined, scarce cash resources are having to be found to pay tax which will eventually be refunded.

• A business can choose to pay less throughout the year (the estimation option) – but that will be at the risk of exposure to use-of-money interest if the payments made turn out to have been too low. The interest rate for under-payment is 8.4%.

If you are a provisional taxpayer, it is important that you make adequate provisional tax instalments during the year in order to minimise penalties and interest that may be imposed.

There are some tools that help address the above problems. The first is having good, regular management accounts to determine how the business is performing. This assists owners to understand the financial position of the business and to plan for future tax commitments.

Tax intermediaries provide several options. Tax payments can be “purchased” and then transferred to the IRD with retrospective effect once the actual tax result of the current year is known. 

In June, prior to the General Election, the Revenue Minister Todd McClay all but confirmed the provisional tax system will be overhauled – so watch this space!