Provisional tax has long been contentious and complained about by small business owners. A new cloud-based system has been launched to pay it, but tax consultant Terry Baucher says it could be grounded by the same old problems.
A new tax year started on April 1 and with it came a much-touted new option for taxpayers to pay provisional tax; the Accounting Income Method (AIM).
The Inland Revenue Department (IRD) has been heavily promoting AIM, which is targeted at individuals and businesses with annual turnover under $5 million. The new system came with a big carrot – those using AIM will not be subject to use of money interest if they pay insufficient provisional tax during the year.
The provisional tax regime attempts to collect tax from liable individuals and businesses during the year; and at present provisional taxpayers with the standard March 31 year end pay provisional tax in three instalments during a tax year (August 28, January 15 and May 7).
How much provisional tax is payable is based on 105% of a taxpayer’s “residual income tax” for the preceding tax year. If the income tax return for the preceding tax year has not been filed (a fairly common occurrence), by the time a provisional tax payment is due then the tax payable is based on 110% of the residual income tax for the year before the preceding tax year. This is the so-called “standard uplift” method.
Although the principle behind provisional tax is reasonable, in practice it has long been the bane of small businesses. One reason is because the existing standard uplift approach doesn’t take into account seasonal fluctuations in income. Furthermore, the penalties for errors resulting in underpayments can be severe; currently, IRD’s use of money interest rate for underpaid tax is 8.21%. Ouch.
In addition, an immediate penalty of 1% of the late paid tax is imposed with a further 4% charge if the tax has not been paid within a week. (Until last year, Inland Revenue also imposed a monthly late payment of 1% of the tax paid late which, together with use of money interest and the initial 5% late payment penalty, meant an effective interest rate of over 26% on late paid tax).
As a result, taxpayers tend to be very cautious and overpay their provisional tax, an inefficient use of funds given the Inland Revenue rate on overpaid tax is a miserable 1.02%. It was no wonder then that when the discussion document Making Tax Simpler: A Government green paper on tax administration was released in 2015, more than 200 of the 750 comments made on the 17 questions on the Green paper online forum were made in response to a single question about provisional tax.
Against this backdrop, IRD considers the advent of cloud-based accounting systems such as MYOB and Xero together with its new START (Simplified Tax and Revenue Technology) could offer a better alternative for small businesses. Hence the introduction of the Accounting Income Method.
It’s available to businesses with annual turnover of under $5 million who have AIM capable accounting packages. The principle is that on each AIM due date (usually the same as the taxpayer’s GST due date) the software calculates the provisional tax due and prepares a statement of activity which is filed with Inland Revenue.
Typically, a taxpayer using the AIM method would make six provisional tax payments. If there’s a fall in profitability, resulting in an overpayment, then a refund can be made in a subsequent period. (Thus, handling the issue of seasonal fluctuations in income). So long as taxpayers make payments in full and on time, no use of money interest or late payment penalties will arise.
All this sounds promising and it’s no wonder that Inland Revenue have been enthusiastically promoting AIM. And yet the reaction from accountants and tax agents towards AIM has been cool, with one describing AIM as a “really, really good idea gone bad”. Why?
A key reason is Inland Revenue’s unwillingness to accept the principle of “near enough is close enough” (or “materiality” in accountant-speak). As part of the introduction of AIM, Inland Revenue released no fewer than 10 determinations covering how tax adjustments such as for depreciation and private expenditure should be made when filing a statement of activity. These are well-meaning, but add needless complexity and therefore compliance cost. It would have been better to have adopted the approach of regular payments through the year followed by a wash-up calculation.
In placing reliance on the accounting software involved Inland Revenue seems to have overlooked the adage of “garbage in, garbage out”. With statements of activity required to be filed every two months, accountants and tax agents are nervous that data entry errors early on in a tax year could be compounded as the year progresses. In this regard, it’s interesting to note that Xero is only offering its AIM capable package via its Tax Practice Manager (available only to accountants and tax agents).
Furthermore, AIM’s potential utility as a game-changer was effectively undermined by other changes to the provisional tax regime introduced in April 2017. These changes made provisional tax easier for smaller businesses and individuals with residual income tax under $60,000. In fact, switching to AIM would probably increase such taxpayers’ compliance costs, overriding the benefit of not being charged use of money interest.
For now, AIM could turn out like the GST-ratio method for calculating provisional tax, which was so circumscribed that according to a Regulatory Impact Statement in 2016 only 2-3,000 taxpayers have adopted it.
This would be a pity, because AIM in principle has much to recommend it. But in order for AIM to be the success Inland Revenue thinks it should be, Inland Revenue will need to adopt a more flexible approach to provisional tax – and penalties as they apply to small businesses.
The same 2016 Regulatory Impact Statement noted that in the June 2015 year there were over 300,000 taxpayers, with 43% of provisional tax paid by the top 5% of companies. What this indicates is the fiscal risk of loosening the rules around penalties and use of money interest should not be, to use a dreaded word, material.
In any case, Inland Revenue is well aware the current penalties and interest regime is not highly effective in encouraging payment. Victoria University research in 2017 on the effect of the penalty regime on taxpayer behaviour “generally suggested that taxpayers were unresponsive to penalties.”
Given this, it is perhaps no wonder that in its most recent annual report Inland Revenue wrote off a frankly staggering $1.8 billion of uncollectable debt, the majority of which represented accumulated penalties and interest.
AIM may not yet be the hoped-for game-changer for small businesses provisional tax woes. It has potential to be so with some added flexibility, combined with a rethink of the penalties and use of money interest regime. Whether Inland Revenue will seize this opportunity remains to be seen.