Why we hate provisional tax
In the next couple of days, thousands of businesses will make a payment for one of the most disliked aspects of our current tax system - provisional tax. For business owners with a March balance date (which is most of us), the first instalment of provisional tax for the year ending March 31, 2015 is due this week. The first instalment is the most important because it is tied up and potentially exposed to interest for the longest period of time. Although the tax paid this week is on account for the current tax year, the actual taxable profit for the year may not be known until some months after balance date.
Here are some reasons why provisional tax is so disliked.
Provisional tax is generally paid in three instalments during the year, so the amounts can be chunky and hard to manage. In contrast, wage and salary earners pay their tax in every pay period (weekly, fortnightly or monthly) through PAYE deducted from their earnings.
Payment required may bear no relationship to the current year's business performance or level of income. Under the standard "uplift" basis, the amount of provisional tax payable is based on the previous year's results. If current year results are much better, the business will be exposed to IRD interest charges based on an expectation that the business owner should have the foresight to anticipate those improved results. That's the case even if there's an unexpectedly profitable transaction that doesn't occur until the end of the year. IRD charges interest of 8.4 per cent in this situation.
Conversely, business performance may decline in the current year. Paying on prior year performance means tying up precious cash in tax payments that may well end up being refunded once the current year's actual tax result has been worked out. IRD's interest rate for overpayments is 1.75 per cent. A business can choose to pay less throughout the year - but that will be at the risk of exposure to late payment penalties and interest if the payments made turn out to have been too low.
Finally, because provisional tax is generally paid in three formula-driven instalments, the timing of the payment obligations may bear no resemblance to cashflow cycle.
There are some tools that help address the above problems. The first is having good, regular management accounts to determine how the business is performing. This assists owners to understand the financial position of the business and to plan for the future.
Tax intermediaries provide several options. Tax payments can be deposited into a tax pool, and then transferred to IRD with retrospective effect once the actual tax result of the current year is known. Any overpayments are refunded at a better rate of interest than IRD's.
Underpayments can be purchased from a tax pool and transferred to IRD with retrospective effect, at an interest charge lower than IRD's.
Another option is to pay provisional tax using the "GST ratio" method, which uses turnover as recorded in GST returns as a proxy for the cashflow cycle of the business.
Provisional tax is an area the Minister of Revenue has said could be reformed. Various proposals have been promoted, including one that would see "microbusinesses" (non-GST registered, with turnover under $60,000 and no employees) pay a flat rate of tax based on monthly turnover, and small businesses (turnover less than $1.2 million) to pay income tax on a simplified cash basis every two months with their GST.
Our provisional tax system means there's often too much uncertainty about how much to pay and when to pay it.
Good planning and advice will help.