What is provisional tax?

What is provisional tax?

 

In a recent survey of small and medium business, 67% of respondents indicated that they wanted changes to the provisional tax regime. So what is provisional tax and why do so many people dislike it?

Provisional tax estimates the amount of tax that a business will pay at the end of the financial year. According to the IRD, provisional tax is a way of “paying your income tax as income is received during the year”. Detractors of the regime would have it that it means that you are paying income tax in advance.

Provisional tax is based on the prior year’s profit. Once we have worked out your taxable profit, you must pay company tax on that figure the following April. That’s called terminal tax.

Provisional Tax is calculated by inflating that profit by an arbitrary 5% and spreading the payments in three installments across the following year. The first is made in August, the second in January and the third in May the following year.

The May provisional tax payment comes just a month after the terminal tax payment in April for the prior year’s tax.

So why is it so unpopular?

The most obvious reason is that provisional tax is based on the prior year’s result. It will almost certainly not bear any correlation to the recent performance of the business over the last twelve months.

When we calculate the profit for the year, any shortfall in the amount paid in provisional tax will attract interest. You could argue that a taxpayer should have the foresight to plan for increased profit. That’s all very well and good but it is next to impossible if you land a big deal in last few months of the financial year.

Alternatively, if the business has a reduced profit, they will have tied up cash unnecessarily with provisional tax payments. Any refund will be months after they have paid the tax.

Because of the installment arrangements, provisional tax is lumpy. It’s very hard to manage especially when compared with PAYE for wage or salary earners who have their tax deducted regularly. Provisional tax can play havoc with cashflow, particularly for start-ups where cash is always tight. Because the payment dates are set by statute, the payments have no relationship to the cashflow cycle of the business.

Are there any strategies to better manage Provisional Tax?

The most important one is to have regular management reports prepared for the business. Only with regular reporting will a business be able to manage their tax effectively.

Think about coming to see us towards the end of the calendar year so that we can take a look at your income for the year to date to enable you to re-estimate your provisional tax payment in January.

If a business has underpaid tax, a business can use a tax pooling service which enables them to reduce the amount of interest payable. Conversely, any over-payments attract a better rate of interest.

One potential way to manage cashflow is to use the ratio method when calculating GST. This allows a business to make provisional tax payments at the same time their GST is due. Instead of three payments over the course of the year, a business makes 6 payments when they pay their GST every 2 months. The IRD will determine the ratio of tax that you have to pay as a proportion of turnover.

Feel free to contact us if you would like more information on effective planning, tax pooling or the GST ratio method.

Important Update

The government announced changes to the Provisional Tax system in 2016. Significant changes take effect from 1 April, 2017. To find out more detail, click on our blog article here.

Angus is the CEO and founder of Generate Accounting.