A guide to income tax for business owners

We’ve built this article around the questions we frequently get from new business owners. Scroll down, or feel free to jump straight to the one on your mind!

What is Provisional Tax?
Provisional Tax Methods
How is Provisional Tax Calculated?
Major Pitfall of First Year Provisional Taxpayers
What is Terminal Tax?
When is Income Tax Due?
Residual Tax vs Provisional Tax vs Terminal Tax

What is provisional tax?

The moment it’s anticipated that you’ll pay more than $5,000 in tax per year, you enter the IRD’s provisional tax regime.

Provisional tax is a method in which you pay your current year’s tax as you go.

It’s designed to help businesses ease cash flow by prepaying smaller amounts throughout the year instead of a giant lump-sum.

Why do I need to prepay my tax?

Back when you were a “normal” employee, your employer took responsibility for sending your tax to the IRD every pay period. It’s what we call Pay As You Earn (PAYE) tax.

When you’re instead receiving profits from your business, there are two drawbacks to you simply paying the full amount of tax at the end of the financial year:

  • The IRD doesn’t get paid for a full year
  • Because you need to come up with a lot of tax in April, it sneaks up on you

Provisional tax is the government’s answer. You don’t need to pay tax every month, and you don’t need to come up with a lump sum in April. Instead, you pay your tax in two or three instalments, along with a “wash-up” in April (called terminal tax, which we’ll cover later on).

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Provisional Tax Methods

Standard

The amount you pay in tax is based on what you’ve paid previously, along with a small increase. It’s the most common and recommended method, as all calculations are handled by the IRD.

Estimated

You estimate your tax for the year and make payments accordingly. If your estimate is incorrect, the IRD may well charge you interest and short-fall penalties.

Accounting Income Method (AIM)

You prepare a mini set of financial records and then pay your provisional tax throughout the year at the same time as your GST payments. Most often, these GST returns are filed every two months.

Ratio 

Payments are based on a percentage of your GST-taxable revenue. It’s a rarely-used method that requires you to specifically inform the IRD via myIR, in writing, or a phone call. If you choose this method, it can only come into effect on the first day of the next income year (so you can’t use it retroactively).

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How is Provisional Tax Calculated?

Standard method

The IRD estimates provisional tax based on the most recent tax return filed. Let’s take the 2021 tax year as an example:

Most recent tax return filed 2021 provisional tax amount based on
Year ended 31 March 2020 2020 tax charge +5%
Year ended 31 March 2019 2019 tax charge +10%
Year ended 31 March 2018 or earlier 2018 tax charge (or earlier) +15%

Once the 2021 provisional tax amount is known, it needs to be paid in three equal instalments (or two if you’re on six-monthly GST):

  • August 2020
  • January 2021
  • May 2021
  • Then the wash-up (terminal tax) is due April 2022

The main benefit of this method is that if you make these payments in full and on time, and your tax bill is under $60,000, the IRD will not charge interest or penalties.

Estimation method

You advise Inland Revenue of your expected tax charge for the year. This is usually estimated by you based on profit and income expectations. This estimation is paid in three equal instalments and a wash-up, as with the Standard method.

If your actual tax bill turns out to be higher than your estimate, the IRD is likely to charge interest and penalties. For this reason, we prefer the Standard method.

AIM method

This third provisional tax option is permitted if you (or your accountant) uses accounting software and you have less than $5m turnover each year. AIM requires the calculation of year-to-date profit with the tax thereon paid every two months. Calculations should consider depreciation, stock on hand, shareholder salaries, and other non-cash items impacting profit. 

This best suits highly seasonal business activities such as farmers and businesses in holiday destinations – tax is paid only when you make a profit.

Ratio method

The IRD works out your ratio percentage – not you or your accountant. The easiest way to explain the calculation is to provide an example:

Tax bill for year ended 31 March 2021 – $46,000
Total GST-able income for the year ended 31 March 2021 – $920,000 

The ratio percentage is 20%  [$46k divided by $920k]. 

GST sales for the two months ended 31 July 2021 – $84,000
Provisional tax payment is $16,800 [20% multiplied by GST sales in Box 5 of the GST return]

GST sales for the two months ended 30 September 2021 – $23,000

…and so on.

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Major Pitfall of First Year Provisional Taxpayers

If 2021 is the first year you’re operating (year ended 31 March 2021), you haven’t paid tax for a while. Suddenly you have to pay for 2021 and prepay 2022 – all within ten months.  

Assuming you have a March year-end and you don’t file GST returns every six months, let’s see what your first year in business will look like:

From business start date to July 2021 – no tax paid   

August 2021 – first prepayment of 2022 (P1)       

January 2022 – second prepayment of 2022 (P2)       

April 2022 – all your tax for the 2021 year in one lump sum       

May 2022 – third prepayment of 2022 (P3)   

At Beany, we can provide you with the expected amounts and the due dates. The trick is to get your financial information into us as quickly as possible so you have plenty of time to plan for tax payments.

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What is Terminal Tax?

It’s the final payment you make at the end of a tax year, after any provisionalyour provisional payments. 

Your income tax is based on your income, which could include wages, rental income, business profit, shareholder salary, interest, and dividends.

If you’re only earning income from wages and interest, you probably don’t need to file a personal tax return. The IRD will work it out for you and send a bill if necessary.

After tax has been calculated on your income, it can be reduced through:

  • Tax already paid by others on your behalf – wages, schedular payments, interest, and dividends
  • Donation rebates
  • Provisional tax paid during the year
  • Independent Earner Tax Credit

Once all of these are deducted, we arrive at your terminal tax.

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When is Income Tax Due?

Provisional tax

This depends on what method you use to calculate provisional tax, your balance date, and whether you are GST registered.

If you have a year-end date of 31 March and aren’t on a six-monthly GST basis

  • 28 August 
  • 15 January 
  • 7 May

If you are on a six-monthly GST basis

  • 28 October
  • 7 May
Accounting Income Method (AIM)

Payments are due with each GST return.

Ratio method
  • 7 May
  • 29 June
  • 28 August
  • 28 October
  • 15 January
  • 1 March

Terminal tax

For those who have an Extension of Time (EOT), the final tax payment is due in April the following year.

If you don’t have an EOT, terminal tax is due in July the same year.

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Residual Tax vs Provisional Tax vs Terminal Tax

As accountants, we can’t avoid using the terms Residual Income Tax, Provisional Tax, and Terminal Tax. A lot of people (understandably) are confused about the differences between them, and how they all relate to each other. The table below may help!

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