Understanding Tax: Terminal vs. Provisional

Tax.

It’s the dirty word all business owners flinch at. Newcomers stress about that second year hit, and everyone winces when the lump sums leave their bank accounts.

But how many business owners understand tax? And how many newcomers know what to expect?

We thought we’d put together a blog breaking down some of the basic facts about tax. That way, maybe, when you next hear the word you feel a little more prepared to face it.

The Second Year Sting

How many business owners have been warned about the tax hit, come their second year of business?

In their first Financial Statements meeting we’ve heard many express their worry over it. After close to a year of trading without worrying about tax, suddenly the shadow of it looms over them and they can’t focus on anything else.  How well their business is going, or how they could improve upon it, falls on ears deafened to all but tax.

But what causes this second year sting?

Terminal + Provisional Tax

If trading has gone well, a new company will have a full year of profit to be taxed. On top of that, if they have done well enough, the IRD now also expects them to make instalments towards the tax they are going to have to pay for the coming year.

This means that effectively they are paying two full years of tax in one.

For the year that’s just been, they will be paying terminal tax. For the year that is still happening, they will be paying provisional tax.

Terminal Tax

Terminal tax is the wash-up tax, based on the tax return detailing the final profit for the year just been, the last tax instalment for a finished financial year.

In the first year of trading it is the total tax to pay on that profit.

But in other years the terminal tax is the leftover tax to pay on the total profit after provisional tax is accounted for.

Provisional Tax

Provisional tax is tax that the IRD asks you to pay for this year based on your historical profit as the year progresses.

You are only required to pay provisional tax when your total tax to pay for a year is greater than $2,500.

When this happens, the IRD estimates that for the coming year your profit will grow by another five percent, and instead of waiting for a full year for you to pay that tax, asks you to pay the tax on your profit as you earn it – PAYE for your business in a sense.

Let’s break it down further.

To do this, we’ll use an example of a fictitious company, The Mad Scientist Limited. In this example we will ignore Use of Money Interest, but please keep watch for our next blog post!

The Mad Scientist Limited – First Year

The directors at The Mad Scientist have had an excellent first year in 2016. After hunting down every opportunity they have ended up with a profit of $100,000 in their company.

This means that the total tax they have to pay on their profit for that year is $28,000.

As they have not paid any tax so far, this full amount is due as terminal tax on the 7th of April 2017.

Because their total tax to pay is over $2,500, the IRD now expects them to begin paying provisional tax as they go while they are still earning their profit for the year – much like PAYE is paid as a salaried worker earns their wage.

However unlike those on a salary, the IRD won’t know till the end of the year when the company’s tax return is filed exactly what the profit is. Instead, the IRD assumes that The Mad Scientist will grow by another 5% to earn $105,000 profit the next year.

Based on this profit the total tax to pay would be $29,400, and the IRD splits this into three equal amounts during the year for you to pay, $9,800 on the 28th August 2016, 15th Jan and 7th May 2017.

The Mad Scientist Limited – Second Year

Example One:

Let’s assume that The Mad Scientist completely exceeds the IRD’s expectations, and manage to increase their profit by 50%, earning $150,000 in their second year of business.

This means that the total tax to pay on that profit for 2017 is $42,000.

Remember that they have already paid $29,400 in provisional tax for 2017.

This means that they only have $12,600 left to pay in tax, and this is called Terminal Tax to pay for that year.

Once more, provisional tax is calculated based on a 5% increase on $150,000. Then $44,100 in tax is divided into three payments of $14,700 during the coming year.

Example Two:

But what if in the second year of business The Mad Scientist flounders?

This year their profit doesn’t even break $100,000, and they only make $80,000.

Based on this, their total tax to pay is $22,400 for 2017.

However, due to Provisional tax, they’ve already paid $29,400. What happens now?

As they’ve overpaid their tax by $7,000, they will receive this amount back as a refund. This means that for their second year of trading they won’t have any terminal to pay at all.

They will still have provisional tax to pay however for the coming year, and this will be based on $84,000 in estimated profit.

To Conclude

Terminal tax is the wash-up of the tax for the year just been.

Provisional tax is paying for the profit you are currently earning.

As for Use of Money Interest? I think we’ll leave that till our next piece!

Thanks, the MHCO team.