If you had to pay tax of more than $5,000* in your last income tax return, you may have to pay provisional tax for the following year. Provisional tax is like making progress payments on next year's income tax.
The amount you have to pay relates to your expected profit for the year. In practical terms, the amount of provisional tax you're expected to pay is based on the tax you were liable for on your profit in the previous year. This is often referred to as residual income tax (RIT) and your provisional tax will be based on RIT plus a standard percentage uplift as determined by the IRD.
Even if you are not required to pay provisional tax, you may still elect to do so, to spread your tax obligations over the year. This can help you manage cash flow and take away the pressure of having to find and pay a lump sum of tax at the end of the year.
COVID-19 and provisional tax
With the impacts of COVID-19, many clients are rightly questioning the amount of provisional they should be paying at the first 2021 payment date of 28 August 2020 and asking us to re-estimate the payment amount down.
There is a catch with this however. If you elect to pay less provisional tax and then your income picks up later in the year, you may be liable for penalties and interest for underpaying the first provisional tax payment. You will also possibly have larger payments to make later in the year which could impact your cash flow.
While the IRD does have some discretion to write off penalties and interest in the current climate, I strongly recommend to only re-estimate your provisional tax payment down for this first installment if you are facing a significant decrease in income. Given the uncertainty of the year ahead and the fact that many clients we've spoken to are actually not experiencing the downturn in business they anticipated during the lockdown period, we recommend delaying this decision until the second and third installments in January and May. By then we will have a much clearer picture of profitability over the year and will be better placed to estimate your annual tax liability up or down as required.
It is important to keep your tax plan current. If circumstances change then we do need to discuss and adjust your plan accordingly so please do contact us.
* Note this threshold changed for the 2020 year. It was previously $2500.