Provisional tax: paying this year’s tax before this year is over

Provisional tax is one of those tax terms that makes something fairly straightforward sound more complicated than it is.

Despite the name, it isn’t a separate type of tax. Provisional tax is simply income tax paid in advance during the year, rather than waiting until after your financial statements and tax return have been completed. It spreads your expected tax across two or three instalments.

The idea is reasonable. The way it first arrives in your life can feel considerably less reasonable.

When do you have to pay provisional tax?

You’ll generally become a provisional taxpayer if your residual income tax was $5,000 or more in the previous year.

Residual income tax – usually shortened to RIT – is your final income tax bill after tax credits have been deducted. It isn’t your profit, taxable income or total tax before credits. Because apparently tax needed one more phrase that sounds less obvious than it is 🙄.

Once your RIT reaches the $5,000 threshold, Inland Revenue expects you to start paying towards the following year’s tax before that year has been finalised.

Why the first year can be a bit rude

The first time you enter the provisional tax system can create an unpleasant overlap.

You may still have tax to pay for the year just completed, while also starting to pay provisional tax towards the current year.

That does not mean you’re being taxed twice on the same income. The payments relate to two different tax years.

But they can land close enough together that your bank account may struggle to appreciate the distinction.

This is why tax planning matters before the due date appears. A tax bill is much easier to deal with when it has been quietly accumulating in a separate bank account, rather than suddenly competing with wages, suppliers and everything else your business needs money for.

How does Inland Revenue decide how much you should pay?

The default method is called the standard option.

Under this method, Inland Revenue generally bases your provisional tax on:

• your previous year’s RIT, plus 5%; or

• your RIT from two years ago, plus 10%, if the more recent return has not yet been filed.

That amount is then spread across your provisional tax instalments.

For most businesses with a 31 March balance date, there are three standard instalments: 28 August, 15 January and 7 May.

Six-monthly GST filers generally pay two instalments instead. Different balance dates and other calculation methods can produce different due dates, so your own myIR account remains the best place to check the dates applying to you.

It’s a tidy calculation.

It is not, however, a crystal ball.

Yesterday’s numbers don’t always predict this year’s tax

The standard option assumes your business will perform similarly to the previous year, with a little growth added on top.

Sometimes that works perfectly well.

Sometimes last year was your best year ever and this year has been held together by caffeine and increasingly creative optimism.

Or the opposite may be true: your business has grown significantly, but the provisional tax showing in myIR is still based on a much smaller year.

That creates two possible problems.

If the standard calculation is too high, you may pay more tax than necessary and leave less cash available in the business.

If it is too low, you may feel pleasantly smug about your manageable tax payments right up until the final calculation produces a sizeable terminal (AKA final) tax bill.

Neither outcome is particularly helpful.

Can the amount be changed?

Yes. 🎉

Provisional tax does not have to be accepted blindly just because Inland Revenue calculated it.

If your actual income is likely to be significantly higher or lower than the figures used under the standard option, we can calculate a more realistic tax position and consider whether another approach is appropriate.

There are rules and risks around estimating provisional tax, including possible interest if the estimate turns out to be too low. It isn’t something to change based on a vague feeling that business has been “a bit quiet lately”.

It should be based on current financial information and a reasonable view of where the year is heading.

That’s why, before each provisional tax date, we check how our clients’ businesses are actually performing. We look at the year-to-date results, expected income and expenses, and anything unusual coming up. Then we compare the likely tax position with what Inland Revenue is asking them to pay.

Much more useful than simply forwarding a payment reminder and hoping for the best.

What happens if you can’t pay it all on time?

Ignoring it is rarely the cheapest option.

Depending on the situation, you may be able to use tax pooling to pay later, spread the cost or correct a shortfall more efficiently than paying Inland Revenue’s standard interest and penalties.

The sooner you deal with a potential problem, the more options you’ll usually have.

Even better, set up a separate tax bank account and transfer a percentage of your income into it regularly. Weekly or monthly transfers turn tax into a normal cost of doing business, rather than a recurring financial ambush.

And what is terminal tax?

Terminal tax is the final tidy-up.

Once your financial statements and income tax return are completed, your actual tax for the year is calculated. Any provisional tax already paid is deducted from that amount.

If you paid the right amount of provisional tax, there may be little or no terminal tax left.

If you paid too little, the difference becomes terminal tax.

If you paid too much, the excess may be refunded or transferred to another tax period.

So provisional tax isn’t an extra tax. It is simply part of your annual income tax, paid earlier.

Keep the useful bit handy

We’ve put the main thresholds, standard calculations, payment dates and terminology into one provisional tax cheat sheet.

Save it somewhere sensible for the next time a provisional tax notice appears and your brain immediately decides it has never heard those words before.

Download the Provisional Tax Cheat Sheet here 👉 Resonate Advisory Provisional Tax Cheat Sheet

This guide provides general information only. Your payment dates and the most appropriate provisional tax method will depend on your circumstances.