If you have just started a small business or have become a contractor with responsibility for your own tax affairs, you may have heard of provisional tax, and wondered how it will affect you.
Don’t worry – you are not alone – many people struggle to understand how provisional tax works when they start a business. And it doesn’t help when the tax system seems to be slow catching up with you.
Provisional tax is not a separate tax but a way of paying your income tax as you receive your income through the year. It’s intended to put business people in roughly the same position as wage and salary earners.
There are two important facts you need to know about provisional tax. Firstly, it is, as the name suggests, only provisional, and there is an end of year square-up. And, secondly, it is a current year tax based on your performance in the year before.
And it is the second of those facts that confuses a lot of people who begin a small business. Business people pay provisional tax based on the tax paid on the business earnings in the year before with 5% added. Most taxpayers pay in three equal instalments, which are due on 28 August, 15 January and 7 May.
Now consider how this formula works if you weren’t in business in the year before. Well, your business income will be zero, and so will the income tax on that, even with 5% added. So you pay nothing during the whole of your first year in business. That sounds good, especially as you may have one-off business costs to cover in the first year and your business is a bit slow to build up.
But it can lead to disaster. When you get to the end of the financial year, and have your profit statements prepared, you may discover that you owe a significant amount in tax. Remember the square-up? You’ve paid no provisional tax, and the square-up figure is the whole tax for the year.
And worse, Inland Revenue want you to start paying provisional tax for year 2 in the same year as you have to find the tax for year 1.
If your business earned around $50,000 in its first year, your income tax bill will be about $8,000. And this is how the tax payments will look after the 31 March balance date for Year 1:
Due 28 August – first instalment for year 2 $2,800
Due 15 January – second instalment for year 2 $2,800
Due 7 April – square up for year 1 $8,000
Due 7 May – third instalment for year 2 $2,800
That’s two years’ tax falling due over a 10 month period. It’s not a “double tax” – a common fallacy – it’s a timing issue with two years’ tax falling within a short space of time.
Other points to note
1. There is a threshold to meet before you need to pay provisional tax. So,if your new business makes a slow start, or earns a relatively small sum, If your earnings attract less than $2,500 a year in income tax (the threshold), you pay no provisional tax.
2. This deferment may also occur when you begin a business midway through a financial year. Let’s say you start a business in October, half way through a financial year. You expect to earn up to $40,000 a year. The first financial period ends on 31 March and you earn $19,800 . Income tax on $19,800 is less than $2,500, so the need for you to pay provisional tax doesn’t “kick in”.
3. Provisional tax is fixed by a formula which adds 5% to the previous year’s tax. But if you think your income is falling, you can override this formula with an estimate. But you need to take care with estimates, because there are penalties for careless or deliberate under-estimates.
It’s probably little consolation, but it all evens out after the transitional year. After that, you pay your provisional tax with only minor year-end square-ups. But to avoid financial difficulty in the year when you first become liable for provisional tax, you need good cash management.
Far North Tax Professionals
23 January 2018