Provisional Tax. What is it, Why do I have to pay it and How is it calculated?
As we all know, there are two things certain in life: death and taxes. Paying tax is a good thing, it means that you have made a profit. What is confusing to some people is why they have to pay provisional tax and how it works. Let’s try and clear this up....
When your residual income tax (tax payable after any tax credits have been deducted) is more than $2,500, you will be required to pay your next year’s tax in instalments. Provisional tax is a payment, in advance, of the current years obligation, generally based on the previous year’s results. The aim of provisional tax is to help manage your income tax by spreading payments throughout the year. Generally, this will be in three instalments, but it could be two instalments if you are registered for GST on a six-monthly basis.
There are four methods of calculating provisional tax; the Standard option, Accounting Income Method ("AIM"), Estimation method or Ratio method.
The standard method is where IRD takes your last filed return and adds an uplift. This is 5% if your previous years return has already been filed, or 10% if it’s the year (or years) before that. This is the default option, so if you fall into the provisional tax regime and do nothing, this is how IRD will calculate your payments.
AIM is a possible option if your turnover is less than $5 million a year. Under this method you only pay provisional tax when your business is making a profit. AIM is calculated two monthly and tax is paid based on actual results. The advantage of this is that you are paying tax more often and based on actual results, not an uplift of the previous year’s tax payable. The downside is that your accountant needs to do the return to IRD for you and there could be a timing difference which is not advantageous to you.
The estimation method is just that, you estimate what your tax bill is likely to be for a tax year and pay based on that.
And finally, the ratio method, this is only for provisional tax payers who are GST registered and who file either one or two monthly. It is designed for those whose income varies or who have seasonal income. IRD needs to be advised prior to the start of a financial year if you want to use this method. IRD provides you with a figure and you pay that percentage with your GST return. This method is not very common.
Profit vs Cash Flow?
This is the question we by far get the most - "You say we are making a profit but where is the cash?"
Put simply, the profit of a business is the difference between gross income or sales, and its expenses. While cashflow is just that the difference between all deposits and withdrawals. A business can have positive cash flow while having no profit, if cash comes from sources other than income, such as funds introduced by the owner. A business could also have negative cash flow and achieve a profit if cash is being applied to items that are not expenses, e.g. loans or owner drawings.
Remember: not all withdrawals are expenses.
Shareholder Current Accounts?
You may have seen in the balance sheet of your accounts a line called “Shareholder Current Account” and thought what is this all about? And you are not alone, we get this question a fair amount too.
For those of you who have asked before, you will know what I am about to say, think of a Current Account like a bank account. It shows you how much the business owes you (if it’s listed under liabilities) or the amount that you owe the business (if it’s listed under assets).
Money goes into your account when you introduce money into the business. This could be by physically transferring money from a personal account into the business account or it could be an entry that we do at year end. Funds can also be put into your account by way of a Shareholder salary, that we declare at year end.
Money comes out of your account by way of drawings. Just like a bank account, if your current account is overdrawn, i.e. you have taken more than what was owing to you, then we charge interest, which is a bank account.
I’m thinking of setting up a business, where do I start?
Without being biased, your first step should be to talk to a Chartered Accountant. They can talk you through all of your options and make sure that you are doing the right thing for you as there is not a one-size-fits all when it comes to business.
The first decision you will need to make is what type of entity you want to trade under; Company, Trust, Partnership or Sole-Trader. Each one has different advantages and disadvantages, so getting this right is key. Once your entity is setup, if required, then you need to consider the following:
Do you need any finance to set up your business?
What is the best way of getting this and from whom?
What are my tax obligations?
How much should I be putting away?
Do you need to be registered for GST?
If so, how will you do your GST returns?
Who will do your returns?
Are you going to be an employer?
If so, what software will you use to be compliant?
How are you going to record invoices?
What accounting software, if any, is right for you?
What do you need and not need it to do?
What add ons does it have that could help me?
Do you need any specific insurance?
These are just a few things to consider and to talk through with a trusted adviser. If you think AMSCA could be that adviser, please get in touch.
COVID-19 Wage Subsidy - How is this taxed?
We have received a lot of questions about tax treatment for the wage subsidy. So here you go:
- GST - There is no GST on the wage subsidy payment. Please DO NOT include this in your GST return.
- Income tax - The subsidy is taxable to the end receiver. If you are an employer, your employees have PAYE deducted from the subsidy before they receive it. If you are a sole trader/contractor/shareholder employee, the subsidy is taxable in your end of year return. If you are unsure about how the subsidy should be treated, please let us know and we would be happy to advise for your specific situation.
- Kiwisaver – Employees can, under certain circumstances,
suspend kiwisaver contributions.