Imagine making loads of money during the year, but you never thought about keeping something aside for the tax man. Imagine the surprise you’d get at the end of the year when you get a huge bill from IRD.
That’s why provisional tax was implemented. To avoid nasty surprises like that.
Provisional tax is a ‘peace of mind’ tax. A ‘risk-reducing’ tax.
Allow us to explain.
What Is Provisional Tax?
In simple terms, when you pay provisional tax, you are paying tax for the year you are currently in, even though you don’t know what your earnings will be yet. For instance, let’s say you estimated that your tax bill for 2021 will be $6,000. You will then pay three instalments of $2,000 each during the year.
When you do your annual accounts at the end of the year, you’ll calculate tax on the actual profit. If you paid too little, you’ll have to make an additional payment, called terminal tax. If your actual profit is less than what you estimated, and you paid too much provisional tax, the IRD will refund the difference.
Let’s say your tax bill for 2021 is $7,000 and you paid $6,000 in provisional tax throughout the year, you’d need to pay an additional $1,000. Similarly, if your final tax bill is only $5,000, and you paid $6,000 during the year, the IRD will refund $1,000 back to you.
Who Needs to Pay Provisional Tax?
You only need to pay provisional tax if your total tax bill (residual income tax) for the previous year was more than $5,000 (previously it was $2,500). You can still volunteer to pay provisional tax if your prior year’s tax was less than $5,000.
How Are Provisional Taxes Estimated?
There are a few different options available to calculate provisional tax, but most businesses use the standard (safe harbour) option.
On the standard option, the provisional tax payable is calculated as follows:
Residual income tax payable from prior year + 5%
On this option, those with a balance date of 31 March will pay three instalments with the following deadlines:
#1: 28 August
# 2: 15 January
#3: 7 May
Payments May Overlap
Something that often confuses our clients is that they’d need to make payments for both the current and the following year in the same year. For instance, your final bill for 2020 is due on 7 April 2021 (if you work through a tax agent like us). By this time, you would have already made two provisional payments towards the 2021 year.
Provisional tax was put in place to help you avoid a huge tax bill at the end of the year. It’s designed to work similarly to Pay As You Earn (PAYE) that wage-earners pay on their monthly wages monthly.
If you need any help or if you have more questions, get in touch with your account manager.