(provisional tax – 4 minute read)
Hi there accounting fans!
We’re back again with another tax article! (Haven’t had one of these for a while).
If you are in NZ – it’s the first month of the financial year. In other words, TAX TIME! Naturally, many business owners are stressing about taxes. This is normal. You’re not the only one. If you are employed and not running a business – you don’t need to worry about provisional tax. Go check out our latest comic instead.
Have you been running a business for most of the last tax year? Well, you then may have to pay… PROVISIONAL TAX!!!
What is provisional tax?
Provisional tax is tax you pay in advance.
Simple.
Ok, not really. Not EVERYONE pays provisional tax. To qualify for provisional tax (as of the financial year 2021 onwards) – you must have had residual tax of more than $5,000.
Do you qualify for provisional tax?
So, if you have to pay the IRD more than $5,000 in terms of taxes, you get immediately marked for provisional tax. Please note that this $5,000 is based on RESIDUAL INCOME TAX. Residual here means – not including all the taxes you’ve already paid in advance for the year. For example:
Josephine works as a full-time doctor. From her salary of $250,000 a year, she’s already paid $40,000 worth of tax on PAYE. At the end of the financial year, she does not owe anything extra to the IRD. In fact, the IRD owes her a refund of $3,500.
In Josephine’s case, she does not trigger provisional tax because her residual income tax is well below $5,000.
What happens when you qualify for provisional tax?
Let’s use an example:
Ginger is a doctor with a part-time employment contract. They also do locum (contractor) work for a local clinic. They made $100,000 from their part-time work and have paid PAYE of $25,000 on it. Ginger made $80,000 from their locum work. This is self employed income and does not have tax deducted from it. When filing their taxes at the end of the financial year, Ginger adds the $80,000 to the gross $100,000 they made from their salaried job. The IRD works out their tax liability to be $35,000 (tax on the salary + tax on the locum work). Ginger already has tax credits of $25,000 which they can use to offset the $35,000. This means that Ginger has residual tax of $10,000 left to pay.
In Ginger’s case, they need to pay the $10,000 FIRST. This relates to their income in the year just passed. After that, they will have to pay provisional tax for the next financial year. This is because their residual income tax was more than $5,000.
How is provisional tax calculated?
There are three methods to calculate provisional tax:
Standard method
The Standard method takes your residual income tax from the previous year and gives it a 5% uplift. In simple maths, you multiply the residual tax from last year by 1.05.
Ginger has residual income tax of $10,000. This means that they have to pay provisional tax of $10,000 X1.05 = $10,500
Why 5%? I don’t have a clue. The assumption is that you will make roughly the same amount…and then some. I think.
What happens next is that this $10,500 gets divided into three equal instalments that usually get paid:
- August this year – $3,500
- January next year – $3,500
- May next year – $3,500
There will be specific dates that you need to pay these by. Failure to pay the provisional tax instalments will result in penalties and interest! So please remember to pay them. More importantly, remember to put money aside for them!
Estimation method
Not much to say here. You’re given a box and you can put whatever number you want in that box. You can even reduce your provisional tax to ‘0’ if you wanted to. Then you don’t have to pay provisional tax.
BUT
If you have residual tax to pay at the end of the year which is higher than the estimated amount YOU WILL BE PENALISED!
We almost never recommend this method to our clients since the potential for error is high. The only situations where we’d recommend it is if a client is ceasing trading or will be shifting full time into salaried employment.
Accounting Income Method (AIM)
The AIM works with the accounting software that you are using. If you use software like Xero or MYOB, you should be able to do AIM. AIM works out your tax liability based on the ACTUAL income and expenses you have made over a certain period. And then you simply pay the taxes on the profit made for that period.
for example:
Ginger makes $10,000 profit over the April to May period. Based on their AIM return, they have to pay taxes of $2,500 on this profit. After filing the return they make a provisional tax payment of $2,500.
The next time Ginger files their AIM return, it would be for the June to July period.
From June to July, Ginger makes $5,000 profit. This amount gets added to their previous period’s profit of $10,000. In total, Ginger has made $15,000 worth of profit for the financial year. They have to pay $4,000 worth of taxes on this amount. However they have already paid $2,500, so this brings this AIM return’s amount down to $1,500 ($4,000 – $2,500).
Can I avoid provisional tax?
The easiest way is to stop being self employed/running a business and just become a salaried worker.
Or stop making so much money. (insert winky emoji).
In most cases, you can’t avoid provisional tax. So the best way to deal with it is to be aware of your obligations. Also, remember to put money aside for your provisional taxes!
Stay positive!