Provisional tax arises when income is earned without tax deducted at source. Business income, shareholder salaries and rental profits are examples of such income. Wage and salary earners generally don’t have to worry about provisional tax because they have the correct amount of tax deducted at source each time they get paid.
Provisional tax payments are usually based on the previous year’s tax result. That’s why it’s often said that a new business pays no tax in its first year and then pays two years’ tax in its second. Year one’s provisional tax is nil because there is no prior year tax result. Year two requires the tax for year one to be paid, as well as provisional tax for the current year.
Provisional tax is usually payable in three instalments. For March balance dates (most taxpayers) those instalments are due on 28 August, 15 January and 7 May each year. The dates are not as easy to remember as the previous dates, which were the 7 July, November and March, but they do allow more time to work out what current profits are and more time to pay (not that January is ever a good time to pay!).
After the end of each tax year, the actual amount of tax for the year can be calculated. With the gift of perfect hindsight, Inland Revenue then calculates how much provisional tax should have been paid throughout the year based on that actual result. Those amounts are then compared with how much tax was paid at each instalment date. Even if the amounts paid were correctly based on the “standard” method of using the prior year result, Inland Revenue will charges interest on any underpayments for a range of taxpayers. Their interest rate for underpayments has been 8.40 percent since 8 May 2012. If tax has been overpaid, they’ll pay you just 1.75 percent.
A number of “tax intermediaries” have sprung up in recent years. Unlike the illegal shenanigans of some dodgy accountants offering tax losses for sale, these are legitimate, registered businesses that are specifically authorised by tax legislation. By operating “tax pools” they help smooth the disparity of the large gap between Inland Revenue’s interest rates and shift the benefit of hindsight to the taxpayer.
Provisional payments deposited into a tax pool can be transferred to Inland Revenue on the original payment dates once the actual tax liability for the year has been worked out. Any excess is sold by the intermediary to other taxpayers who may need a top-up for underpaid provisional tax. Buyers of such top-ups are treated as having paid their tax at the date it was originally deposited into the pool. Buying tax from a pool can also help mitigate late payment penalties that might otherwise apply (for those who have forgotten to pay for example). Tax intermediaries charge interest on tax purchases but at a better rate than Inland Revenue’s. And their paying rate for overpaid deposits is more generous, too.
Tax intermediaries also offer “tax financing”, a useful product for cash-strapped growing businesses or taxpayers who want to pay tax at dates that suit their cashflow cycle, rather than Inland Revenue’s set dates. On receiving an up-front finance fee, the tax intermediary “earmarks” a tax amount that is held in a trust account. When the financed amount is settled, it is transferred into the tax pool, ready for transfer to Inland Revenue with an effective date back of when the amount was originally financed.
Planning provisional tax takes some thought, which can be difficult when there is a lack of certainty. To mitigate interest costs, rather than making “voluntary” extra payments to Inland Revenue, tax pooling offers a more flexible and cost-effective solution.
Geordie HooftPartner, Tax
Grant Thornton New Zealand Ltd
T +64 (0)3 379 9580
E geordie.hooft@nz.gt.com