(tax refunds – 5 minute read)
Everyone loves a tax refund! So naturally, a lot of taxpayers think that they are eligible for one at the end of the financial year. The truth is that not everyone can get a tax refund. In this article we’re going to clear up some misconceptions about tax refunds and learn how they ACTUALLY work.
So let’s move on to the first point which is:
You will only be refunded on tax that you’ve ALREADY paid
This one is important. There is no tax system in the world (as far as I know) that will pay out tax refunds if you don’t have any tax credits to begin with. Even GST refunds are only paid out because IRD has already collected the GST from the entity that you bought the GST inclusive goods from.
I occasionally get the odd client who tells me ‘But my friend’s accountant helps him get tax refunds every financial year!’. My usual response is one of the following:
- Your friend is lying or,
- Your friend (and his accountant) are defrauding the IRD and committing tax evasion
Generally speaking we turn away such clients. As a tax agency, we pride ourselves on our ethics, professionalism and good relationship with the NZ IRD.
That being said, tax refunds do happen. They don’t happen very often, so when they do happen, its a nice surprise. In the next sections, we’re going to look at how tax refunds can arise for different tax types.
Income tax refunds – how they work
Income tax is the tax that you pay on your net income (revenue minus expenses) for the financial year. Companies pay a flat tax rate of 28%. Individuals pay a scaled tax rate that goes up to 39%.
Tax refunds for individuals on PAYE salary
This is the most common situation. Whenever you get paid by your employer, a portion of your salary will be deducted for taxes. This amount gets sent to the IRD and is recorded as ‘tax credits’ in your name for that financial year. At the end of the financial year, IRD calculates the amount of income you actually earned and calculates your final tax figure. Then they use your tax credits to pay off this final tax figure. Any leftover tax credits get converted to tax refunds which get credited to your bank account.
For example: Jacob earns $100,000 a year (before tax) working as a senior nurse in the hospital. Over the last financial year ending 31 March 2024, his employer has deducted $25,000 worth of taxes from his paycheck. This means that Jacob has tax credits of $25,000 sitting in his income tax account with the IRD. After 31 March 2024, the IRD calculates Jacob’s final tax figure. This comes to $24,500. Jacob’s tax credits of $25,000 is used to pay off the $24,500 tax bill, which leaves excess credits of $500. This $500 is paid out to Jacob as a tax refund.
Note that if you don’t have enough tax credits to pay your final tax bill, you will need to pay additional ‘terminal tax’ by 7 February of the next year to ensure that you’ve paid off your full final tax figure. This tends to happen if your employer is under-deducting taxes for you or if you’ve changed employment mid-way through a financial year.
Tax refunds for businesses
For your first year of business (both sole trader and company) you can expect to get no tax refunds. This is because you haven’t been making any tax credit payments to the IRD. Tax credits for businesses only arise from provisional tax payments to the IRD. Provisional tax only arises in the second year of business operations onward.
(read more about provisional tax here!)
Provisional tax functions like PAYE tax deductions. These are payments made in advance to the IRD before the end of the financial year. However, unlike PAYE tax deductions, provisional tax payments are not made by your employer. You ARE your own employer! You have to make sure that your provisional tax payments are made on time.
All provisional tax payments count as tax credits sitting in your IRD account (your individual account for sole traders and your company account for companies). At the end of the financial year, after you’ve submitted your business’ net income for the year, your tax credits are applied against your final tax figure. Any extra tax credits are returned to you as a tax refund.
For example: Mereana runs a freight and shipping business. During the financial year, she has made provisional tax payments totaling $50,000. At the end of the financial year, her final tax figure is $48,000. After using her tax credits of $50,000 to pay off the tax figure of $48,000, she has tax credits of $2,000 which gets refunded to her company’s bank account.
As usual, if there is not enough tax credit to cover the final tax figure, then you will need to top up the amount before 7 February of the next year. If your business has tax deducted by your client (schedular deduction arrangements) then these amounts count as tax credits for your business.
GST tax refunds – how they work
To talk about GST refunds, you first need to understand how GST works.
(read about how GST works here!)
To keep it simple – GST is a tax on consumers. If you sell a product worth $100 to your clients, you need to charge them 15% GST. The total retail price to the client becomes $115 ($15 GST included). GST only applies to GST registered businesses. If you’re not GST registered, you can’t file GST returns and claim any GST refunds.
When filing GST returns, you have to return the GST you’ve collected from your clients to the IRD. You are allowed to also claim back the GST that you have paid in purchasing products and services from your suppliers. The difference between the GST collected and paid is the amount you return to the IRD.
If you have more GST collected than paid, you have to pay this amount to the IRD. If you have more GST paid than collected, you will receive a GST refund from the IRD. A profitable business will almost always have to pay GST to the IRD. If you’re spending more than you’re earning, you will see more GST refunds.
Its worth pointing out that consistently returning GST refunds to the IRD is a surefire way to get audited. Make sure you have all the supporting documentation on had to prove that you made those purchases if this is the case.
Businesses that constantly get GST refunds
There are some unique situations where GST registered businesses return constant GST refunds each GST period. These are businesses whose main source of income are not GST taxable. One example come to mind:
NZ Businesses that primarily sell to overseas based clients
Sales made to clients that are overseas do not incur GST. Just like how purchases from overseas suppliers do not incur GST. These type of businesses may make some sales to local clients. However, since the bulk of their sales are from overseas, they do not need to calculate GST collected on these sales. If they primarily source stock or material from NZ, they can claim back the GST spent on purchasing said items. This means that their GST paid will always exceed their GST collected.
Example: A company that mainly exports NZ products overseas
Please remember that in most cases, your business will not be getting GST refunds if you mainly sell to NZ based customers.
Relying on tax refunds is not a valid financial strategy
Over the years I’ve had a lot of clients tell me: ‘I’ll pay you when the tax refund comes through’. Relying on tax refunds to sustain your business and pay your suppliers is not a sustainable strategy. It may work if you’re going through a rough patch. But if you’re constantly hoping for a tax refund to bolster your financial position, it means that you have inherent issues in your finances that you need to fix, ASAP.
For those of you running profitable businesses and are paying tax on time, tax refunds can be a pleasant surprise. What you do with the refunds are entirely up to you. You may use the extra cash to pay off your mortgage, save up for your first home or reinvest into your business. Or the refund may be so small that its just enough to pay for a week’s worth of groceries.
I hope this article has cleared up how tax refunds work in NZ for you!
Stay positive!