Residual Income Tax vs Provisional Tax vs Terminal Tax

Salary & wages have income tax deducted at source called PAYE. Interest income has resident withholding tax (RWT) deducted at source. Dividends have imputation credits and RWT deducted at source. The tax credits attached to these forms of income, help to reduce the tax you have to pay at year end. When you have income from business or rental, there is no tax deducted at source.

Residual income tax is the amount of tax owed after deducting any tax credits made during the year. Provisional tax is a method of paying tax in advance, based on estimated income, which you pay in instalments throughout the year. Terminal tax is the final tax payment due after the year's income is assessed, equalling the residual income tax less provisional tax payments.

If your annual income tax exceeds $5,000, you are required to pay provisional tax. If you overpay provisional tax during the year, you can receive a refund after completing your income tax return.

For a taxpayer with a 31 March 2025 year-end balance date, the standard due dates are: 28 August 2024, 15 January 2025, and 7 May 2025. If you file 6-monthly GST returns, the provisional tax due dates align: 28 October 2024 and 7 May 2025. Terminal tax for 2025 is due on 7 February 2026, or 7 April 2026 if you have a tax agent such as a chartered accountant.

Provisional Tax Methods

There are four ways of calculating provisional tax: standard, estimation, ratio and accounting income method options. Each has its own benefits and downfalls.

Standard option

Standard option is the default method of calculating provisional tax and works best when your income tax is steady or gently increasing each year. It is the simplest method of calculating provisional tax. If you have filed your 2024 year income tax return, 2025 provisional tax is your 2024 residual income tax plus 5%, spread equally across your instalments. Otherwise, 2025 provisional tax is your 2023 residual income tax plus 10%, spread equally across your instalments.

Estimation option

Estimation option is best when your income tax is dropping or is likely to jump significantly. You can’t switch back to standard after you have estimated for that year, but you can estimate again. For example, a consultancy company forecasted that its net profit would drop $60,000 due to losing a regular client. It estimated its provisional tax down by $16,800 ($60,000 x 28%) and paid its one-third instalment in August. Later in the year it gained a new retainer client increasing its forecast net profit by $30,000. It estimated its provisional tax up by $8,400 ($30,000 x28%). For its second instalment in January, it paid two-thirds of the estimated increase.

Ratio option

Ratio option is useful when your income varies or is seasonal, and you have at least two years of activity that allows IRD to calculate an appropriate ratio based on your GST returns. If you elect to use this method, IRD advises you that your provisional is a set percentage of your GST income. Ratio option is a blunt instrument and has been largely overtaken by Accounting Income Method.

Accounting Income Method

Accounting Income Method (AIM) is a better method of calculating provisional tax when your income is seasonal or variable, as your provisional tax is more closely aligned to your year-to-date profit. You can even get a tax refund during the year if you overpaid in previous instalments. It requires you to have good accounting systems as you are required to calculate your taxable profit and pay provisional tax every AIM period (monthly or two-monthly). AIM is described in detail in our blog: https://www.jdw.co.nz/aim-provisional-tax-finds-its-target .

Interest and Tax Pooling

If you use the Ratio or AIM options for calculating provisional tax, you won’t incur use of money interest (UOMI) if you pay your instalments on time. With the Standard option, interest calculations depend on your residual income tax. For residual income tax under $60,000, interest starts from your terminal tax due date. If it’s over $60,000, interest starts from your final provisional tax due date. Using the Estimation option, interest starts calculating from your first provisional tax due date.

Tax Pooling allows you to “buy tax” from another taxpayer who has overpaid provisional tax through a financial intermediary. This usually results in lower interest rates compared to the Inland Revenue Department (IRD) and helps avoid late payment penalties. The seller benefits from receiving a better interest rate than the IRD offers.

Tax pooling is particularly useful if you underestimate your taxes early in the year, as it allows you to cover the first provisional tax instalment. It’s also beneficial for managing cash flow, as it lets you delay payments. For example, one of our property developer clients used tax pooling to make lump sum payments each time they settled on a property sale, rather than adhering to standard provisional tax due dates.

The Second Year Tax Trap

Are you aware of the second-year tax trap? In your second year of profitable trading, it can feel like most of your profit is going toward paying taxes. This is because you are paying terminal tax for the previous year and provisional tax for the current year simultaneously. To manage this, make sure you allow for it in your cash flow budget.

Here are a few tips to help manage your cash flow:

• Create a Cash Flow Forecast: Regularly update your cash flow forecast to include expected tax payments. This helps you plan for large payments and avoid surprises.

• Set Aside Funds Regularly: Allocate a portion of your income each month to a separate bank account dedicated to tax payments. This way, you won't be caught off guard when payments are due.

• Use Tax Pooling: Consider using a tax pooling service, which allows you to pay provisional tax at a time that suits your cash flow, rather than strictly on the IRD's due dates. This can provide flexibility and potentially reduce interest costs.

• Seek Professional Advice: Consult with a tax advisor or accountant who can help you optimize your tax payments and cash flow management. They can provide strategies tailored to your business situation.

• Review and Adjust Provisional Tax Estimates: Regularly review your provisional tax estimates to ensure they accurately reflect your income. Adjusting estimates can help you avoid overpaying and improve cash flow.

Proper planning and using these strategies can help you avoid cash flow issues and ensure you meet your tax obligations without unnecessary stress. Contact us at JDW to discuss your specific provisional tax issues and discuss if estimation and tax pooling is right for you.

-Serena Irving

Serena Irving is a director in JDW Chartered Accountants Limited, Ellerslie, Auckland. JDW is a professional team of qualified accountants, auditors, business consultants, tax advisors, trust and business valuation specialists.

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An article like this, which is general in nature, is no substitute for specific accounting and tax advice. If you want more information about the issues in this article, please contact your adviser or the author.