Provisional tax is IRD’s way to collect income tax in instalments throughout the year, rather than in a lump sum at the end. A lot of kiwi business owners struggle with this concept as they believe they are paying tax in advance, however what it means is you are paying tax as you earn the income.
Paying as you earn helps smooth out cash flow and ensures you're staying on top of your tax obligations before it becomes an unmanageable debt!
In New Zealand, there are several methods available for calculating your provisional tax, each catering to different business needs, mindsets and circumstances. Let's explore the main options:
1. Standard Uplift Option
The standard option is the default method so is commonly used by businesses. Your provisional tax is calculated based on your previous year’s income tax, with an added 5% uplift. This method works well if your income is stable or growing slightly (up to 5%). However, if your income is expected to decrease, this method might lead to overpaying, which ties up your cash unnecessarily. It also creates cash flow issues for a seasonal business. New businesses often get caught out on this as they don’t necessarily set aside funds to pay tax as a start up and end up with double tax to pay in their second year of business.
2. Estimation Option
The estimation option allows your accountant to estimate your income for the current year and pay provisional tax based on that estimate. This method is more flexible and can be beneficial if your income is expected to vary significantly from the previous year. However, be cautious: if you underestimate your income, you will incur use-of-money interest (UOMI) on the underpaid tax.
3. Ratio Option
The ratio option is suited for businesses with irregular income patterns, like those in seasonal industries. Your provisional tax is calculated based on a percentage of your GST taxable supplies, allowing payments to align more closely with your cash flow. To use this method, you must have been in business for at least two years and be registered for GST on a monthly or two-monthly basis. This method requires careful monitoring, as it’s tied directly to your business’s sales. You’ll have issues with this if you are selling large assets as the ratio method is calculated on your taxable income.
4. Accounting Income Method (AIM)
The AIM method is designed for small businesses that use accounting software, such as Xero. With AIM, your provisional tax is calculated as you go, based on your actual profit and loss figures. This means that if trading is not going ‘as usual’, the amount of provisional tax will be adjusted based on actuals. With AIM you are paying tax as you earn the cash, so it is great for cash flow!
Payments are made more frequently, typically alongside your GST returns. This method provides real-time accuracy and can be ideal for businesses with fluctuating income, but it does require up-to-date bookkeeping, software that supports AIM and must be filed by an accountant.
Choosing the Right Method
Selecting the right provisional tax method is crucial for managing your cash flow and avoiding unnecessary costs. At Pulse Accountants we consider your business’s income patterns, your comfort with estimating future income, your debt mindset and your ability to keep up-to-date financial records. If you're unsure which method is best for your situation, book a consultation with us today.
Pulse Accountants is an accounting firm in Napier. We support business owners to navigate their tax obligations with ease. Our Pulse Smart Money programme is designed to simplify your cash flow, reduce debt, confidently manage your tax, improve profitability, and ensure you’re making the best decisions for your business’s future. Contact us today to learn more about how we can support your success.
