For a standard 12-month year, provisional tax is due in three instalments. The instalments generally fall on the 28th day of the fifth, ninth and thirteenth months. However, this is varied in certain situations. For example, for a business with a 31 March balance date the instalments are due on 28 August, 15 January and 7 May. The second and third instalments being pushed out due to the Summer and Easter holidays, respectively.
Most taxpayers use the ‘standard uplift’ method where instalments are calculated based on the previous year’s (“year-1”) residual income tax (RIT) +5%, or the RIT from two years ago (“year-2”) +10% if the prior year tax return has not been filed.
Understanding the way provisional tax works is complicated by the fact there are different rules for the purpose of late payment penalties versus interest. This means it is possible to pay the required amount on-time, as calculated under the standard uplift method, and not be subject to late payment penalties. But then incur interest from that same point because the final liability for the year exceeds the provisional tax amounts paid.
Whilst the rules can be complex, concessionary changes over the past few years have made the regime less onerous and costly. For example, provisional tax use to be calculated as at a particular instalment date based on the most recently filed income tax return, whether year-1 or year-2. If profits declined across the two prior tax return periods, the provisional tax payable would not be reduced until the most recent return was filed and only for subsequent provisional tax payments.
Under current rules, the amount due at a past instalment is re-calculated based on the lesser of year-2 or year-1. This ‘lesser of’ approach means there is less risk in choosing to pay a lower amount of provisional tax based on the prior year’s estimated taxable income, even though the income tax return for that period has not been filed.
Finally, the practical effect of tax pooling means late payment penalties and interest based on punitive Inland Revenue rates should be a thing of the past.
To illustrate the way tax pooling works is to imagine a large company like Air NZ at the start of Covid. Things were looking up, then Covid hits and profit plummets. Any provisional tax previously paid would likely be spare and otherwise refunded by Inland Revenue at a low interest rate. Alternatively, if Air NZ paid its provisional tax to a tax pooling intermediary, that tax can be sold to other businesses ‘effective’ as at the date Air NZ paid it. Then let’s say another business has outperformed expectations and therefore has a large tax bill, but under the provisional tax rules, interest is being charged from its third provisional tax date of 7 May. It can go to Air NZ and purchase some of its excess tax that it paid on 7 May.
There is a cost to tax pooling, but it is less than what Inland Revenue charges and Air NZ would receive a margin that is more than what Inland Revenue would have paid. Everyone wins, well almost everyone…
At the extreme, if a business has a borrowing rate similar to the tax pooling cost, it could choose not to pay any provisional tax during the year and instead use tax pooling to purchase the exact amount required at each instalment date once their tax return has been filed. With the current interest rate on underpayments of 10.91%, tax pooling should be front of mind when the provisional tax dates roll around.