Provisional tax and recent changes
The intent of the provisional tax system is to gain tax payments whilst income is being earned. These are effectively payments on account during the current tax year which are subject to a wash-up calculation (resulting in refund or further terminal tax liability) once the final income tax return is compiled and filed.
Provisional tax payments are made in instalments, the number and frequency of which will depend on the method used and the GST filing of the taxpayer.
Methods for calculation of provisional tax include:-
- Standard uplift
- GST ratio
- Accounting income method
The first two are most commonly used and are outlined below. The latter two are less common as they will likely require more involvement from professionals but can be very useful in certain situations.
Most taxpayers will calculate their provisional tax using the standard uplift method and pay in 3 instalments throughout the year, aligned with GST payment dates. The calculation is fairly simple taking the residual income tax (RIT) due for the previous year, increasing this by 5% and then splitting it in 3.
Issues can, and do, arise when calculating the instalments when the prior year tax return has not yet been compiled. For instance, the first instalment due for the 2021 tax year is 28 August 2020. Many taxpayers will not have had their 2020 tax return completed by that date and so the RIT basis for uplift has not been established. In such a scenario the RIT from two years prior (2019) will be used and increased by 10% with subsequent corrections to instalments once the 2020 return has been filed.
When income is expected to fall significantly and cash flow tighten we may look to use the estimation method to reduce the provisional tax due. There are obvious cash advantages to doing so but there are also risks. Estimating provisional tax exposes the taxpayer to the interest regime whereby they will be charge use of money interest should they ultimately be found to underpay their provisional tax.
My advice would be to consult your tax adviser prior to using the estimation basis.
In response to Covid 19 and the uncertainty throughout the economy there have been a few changes introduced to ease the provisional tax burden. These include:-
- Increasing the threshold for application of provisional tax from $2,500 RIT to $5,000 RIT
- Tax loss carry-back scheme allowing losses from 2020 to be carried back to 2019 or anticipated losses from 2021 to be carried back to 2020.
Increasing the RIT threshold before provisional tax will apply has removed a lot of smaller taxpayers from the provisional tax net. Whilst this will mean they do not have to pay their 2021 income tax in 3 instalments it does not remove the overall income tax cost. This will instead be due in one instalment on the terminal tax date (7 April 2022 for the 2021 tax year). At best this is a cash flow benefit but we would urge caution and ensure that you are providing adequately for this liability when it ultimately becomes due.
Carrying back tax losses to the prior tax year has proved beneficial for a number of taxpayers. We have been able to ease tax worries and cash flow issues by using 2020 losses to remove 2019 tax liabilities or access 2019 tax paid. Similarly if you project losses for the 2021 income tax year then you can carry these back to the 2020 tax year to reduce the tax liability there or access provisional tax already paid. You would most likely be estimating 2021 provisional tax lower at the same time.
Whenever contemplating any method other than the standard uplift it always pays to discuss these matters with a professional. Please feel free to contact us to discuss your options.
It is also worth remembering that if reality exceeds initial expectations then we still have Tax Pooling options available whereby you can buy tax credits through tax intermediaries which will be applied on the provisional tax instalment dates. This retroactive application of tax payments removes any late payment penalties otherwise imposed by Inland Revenue and can also reduce the overall interest payable on missed tax amounts.
Great cost savings have been accessed with tax pooling but there are deadlines for arrangements and payments which need to be observed.