Most small businesses have to pay Provisional Tax. Provisional tax is income tax that you pay in advance to help you spread the load and avoid a large end of year tax bill. This sounds like a great concept, and it is in a way, however many businesses – especially small ones- get tangled up in paying the wrong amounts. This often results in overpaying or worse, ending up with that high tax bill that provisional tax should avoid.
In this blog we’ll take a closer look at provisional tax; who has to pay it and when? And different ways to calculate provisional tax; the common ways, but also a much more sophisticated way, so at the end of your tax year your tax paid works out to be similar to what you owe.
Who should pay Provisional tax?
If your last tax bill was more than $2,500 you have to pay provisional tax. This $2,500 is called ‘Residual Income Tax (RIT) and is the ‘official word’ for income tax. Your RIT could exceed $2,500 if you earn income that wasn’t taxed, such as:
- self-employed or rental income
- schedular payments or salaries and wages with a low PAYE rate (your income tax rate)
- income from a partnership or look-through company
- income from an estate or trust
- overseas income
- business income
- other income not taxed at source or taxed at a low tax rate
If you expect your RIT to exceed $2,500 in the current year, you don’t have to pay provisional tax. It will kick in the following tax year.
If you have a 31 March balance date, provisional tax payments are due on:
- First installment: 28 August
- Second installment: 15 January
- Third installment: 7 May
Two common options to calculate provisional tax
Generally provisional tax is paid three times a year. The amounts each time (called installments) are based on what your tax bill is expected to be. The amount of provisional tax you pay is deducted from your tax bill at the end of the year. There are two common options for working out your provisional tax: standard and estimation.
Common Calculation Options
When your provisional tax is calculated using the standard option:
- Your provisional tax payable is your previous year’s RIT plus 5%.
- For example if last years tax was $3,000. Then this year IRD will charge $3,150
- This total amount is spread over three payments (installments). In this case $1,050 for each installment.
The other way to work out your provisional tax is to estimate what your RIT will be:
- Add up all your estimated income.
- Add up all your estimated expenses.
- Work out your taxable income (estimated income minus estimated expenses).
- Work out the tax in total by using IRD’s tax calculator online.
You can estimate your provisional tax as many times as necessary up until your last installment date. If your paid provisional tax turns out to be lower than the final tax calculation for that year, you may be liable for interest on the underpaid amount.
Unless you choose the estimation option, IRD automatically charges provisional tax using the standard option.
The challenges with provisional tax and how to overcome them
Getting provisional tax right during the year is a mission, it is difficult at times to know when will you land your next big deal in the financial year which will result in huge profits- will it fall into this year or next? Or if the business unexpectedly loses a big contract during the year resulting in a reduced profit, you will have tied up cash unnecessarily with provisional tax payments. Any refund will be months after they have paid the tax.
Looking at alternative options to calculate
In this blog we’ve looked at the standard ways of calculating provisional tax. But it’s worth looking at alternative ways to do calculations. When using the standard option you will find that last year’s numbers often don’t represent this year’s numbers. And in the estimated option the calculation might be more accurate, but it’s a time-consuming exercise with a lot of room for error.
The kick-ass way to calculate provisional tax
If you are an Excel rockstar and have a love for numbers, you can calculate your provisional tax quite accurately. If you’re not, or can’t be bothered spending the time on that, there is TaxBuddy.
Instead of taking last year’s figures, with TaxBuddy:
- You use this year’s numbers to calculate your provisional tax.
- Instead of entering your estimated income and expenses in spreadsheets, TaxBuddy draws all the data from Xero and gives you your provisional tax figure.
- If you want to play around with expected income and expenses for the year to come, you can, all from a one screen overview. No more separate spreadsheets and manual data entry.
- Also non-Xero users can use TaxBuddy (minimal data entry required – more about non-Xero users)
Provisional tax is done in minutes and more accurate than you’ll ever get it (unless you are that Excel Rockstar with an accounting brain, then you can get pretty close).
With any of the calculation options, one thing is important: only with regular reporting a business will be able to manage their tax effectively.
Find out more about TaxBuddy’s plans.