Business Income Tax Explained
Confused about how income tax is calculated and how to pay it?
This Business Income Tax Explained article explains what you need to know!
Many businesses fail because they don’t manage their tax commitments.
If you are in business, you need to know how much tax you will pay, how you will pay it, and when.
In this article we will explain:
- Taxable Profit – How is it calculated?
- Calculating Income Tax
- Paying Income Tax
- Terminal Tax & Residual Income Tax
- Provisional Tax
- Calculating Provisional Tax – Standard Method
- Calculating Provisional Tax – Estimation Method
- Calculating Provisional Tax – Ratio Method
- Calculating Provisional Tax – Accounting Income Method
If you’re unsure about anything in this article and have more questions, feel free to get in touch.
Taxable Profit
A business pays income tax on its profit. Profit is the amount left over after deducting business expenses from revenue.
- Revenue 150,000
- – Expenses (50,000)
- = Profit $100,000
Revenue is money earned from business activities. A business’s revenue comes predominantly from sales of services or products.
Expenses are paid, and the balance remaining is taxable profit.
Expenses can be categorised as direct costs and indirect costs.
Direct costs are incurred directly to provide sales. This includes purchasing products for resale or paying subcontractors to help deliver services. A clothing retailer buys clothes (a direct cost) from a manufacturer to resell.
Indirect costs do not directly produce goods or services but are incurred to manage the business. This includes renting business premises and paying administration staff salaries.
The profit remaining after deducting all expenses, direct and indirect, from sales, is the amount subject to tax.
This profit is multiplied by the relevant tax rate(s) of the business owning entity as explained below.
Calculating Income Tax
A company pays tax at a flat rate of 28%. A trust pays 33%. An individual pays tax at various rates, from 10.5% to 39%, depending on their level of income.
A company with sales of $150,000 and expenses of $50,000, is left with a profit of $100,000. At 28%, the company will pay tax of $28,000. If a trust owned the same business, it would pay $33,000 tax.
An individual’s tax calculation is slightly more complicated. Individuals do not have a flat tax rate but have different rates for income in different income brackets. These are marginal tax rates, being the rate imposed on the next dollar of income.
Below are the income brackets and corresponding marginal tax rates for each.
Income Tax Rates for Individuals
- $0 – $14,000 10.5%
- $14,001 – $48,000 17.5%
- $48,001 – $70,000 30%
- $70,000 – $180,000 33%
- Remaining income over $180,000 39%
The first $14,000 a person earns in a year is taxed at 10.5%. The next $34,000 (from $14,001 – $48,000) is taxed at 17.5%.
If their total annual income is between $14,000 and $48,000, they pay 17.5% on the income exceeding $14,000 only, not on their total income. The first $14,000 is still taxed at 10.5%.
In this example, an individual earning $80,000 pays $17,320 tax:
Tax for each portion of the Income Brackets
- $0 – $14,000 = $14,000 @ 10.5% = $1,470
- $14,001 – $48,000 = $34,000 @ 17.5% = $5,950
- $48,001 – $70,000 = $22,000 @ 30% = $6,600
- Over $70,000 = $10,000 @ 33% = $3,300
- Total Tax payable in this example of a person earning $80,000 = $17,320
Paying Income Tax
To understand how and when you will pay tax, you need to know three terms:
- Residual tax
- Provisional tax
- Terminal tax
Your total tax payable for an income year, such as the $17,320 above, is Residual Income Tax (RIT).
This will be paid to IRD by making provisional tax and/or terminal tax payments as described below.
Terminal Tax
Terminal tax is the final payment made to square off a year’s tax.
To calculate your terminal tax, deduct any provisional tax paid (described below) from your Residual Income Tax. The remaining balance is your terminal tax due.
Typically, in your first year of business, you will pay no provisional tax. In this case, your whole Residual Income Tax is paid as terminal tax.
A standard tax year runs from 1 Apr to 31 Mar. Terminal tax is due by the following 7 Feb, or 7 Apr if you use an accountant and have an extension of time.
This means your terminal tax is due either 11 or 13 months after the end of the tax year it relates to. Terminal tax for the year ended 31 Mar 2020 is due 7 Feb, or 7 Apr 2021 if you have an extension of time (which you usually will have if you use an accountant).
Paying Provisional Tax
When you file a tax return with Residual Income Tax exceeding $2,500 (Note: The government has increased the provisional tax threshold from $2,500 to $5,000 for the 2020-2021 income year due to the effects of covid 19), you become a provisional tax payer.
Provisional tax payers make payments during the tax year in anticipation of their final tax bill, as opposed to paying it all as terminal tax after the year is finished.
Most provisional tax payers make three provisional instalments per year. For a 31 March year end, these are 28 August, 15 January and 7 May.
For the year ending 31 Mar 2021, these dates are 28 Aug 2021, 15 Jan 2022 and 7 May 2022. Note the final provisional instalment is after the year end.
Provisional tax dates are aligned with GST due dates. If you are GST registered with a two-monthly GST period, you will have GST due on each of the instalment dates above.
GST registered taxpayers with a six-monthly GST period only pay provisional tax twice a year, on each GST due date. For a 31 March year end date, the due dates are 28 Oct and 7 May.
For the year ending 31 Mar 201, a six-monthly GST filer will pay provisional tax on 28 Oct 2021 and 7 May 2022.
Calculating Provision Tax
You have a choice of four methods to calculate provisional tax:
- Standard
- Estimation
- Ratio
- Accounting Income Method (AIM)
Standard Method
The standard method is the default method and the most common.
Provisional tax is paid based on the Residual Income Tax in your last tax return filed. If last year’s return has been filed, your provisional tax is last year’s Residual Income Tax plus 5%. Until last year’s return is filed, you pay the previous year’s Residual Income Tax plus 10%.
Assuming your 2021 (year ended 31 Mar 2021) return was filed on 30 Jun 2021 showing Residual Income Tax of $10,000. You will pay provisional tax for the 2022 tax year (year ending 31 Mar 2022) of $10,500 ($10,000 plus 5%). This is due in three equal instalments of $3,500 on 28 Aug 2021, 15 Jan 2022 and 7 May 2022.
If your 2021 return remains unfiled on either of the first two instalment dates, the calculation for that instalment is based on the previous (2020) year’s tax plus 10%. The final instalment on 7 May is always based on last year’s tax.
Estimation Method
If your circumstances change so that the standard method overstates your tax due, you may want to estimate your tax due.
Under this method, you decide what your tax for the current year will be and pay that amount. You must advise IRD of the estimated amount before the relevant provisional instalment date.
There are a few things to keep in mind when estimating provisional tax:
- If you under-estimate, you will be charged interest on the underpaid amounts from the instalment dates
- If you are deemed to have made an unreasonable estimate, you may also be charged a “lack of reasonable care” penalty of 20% of the underpaid tax
- Once you estimate, you cannot revert to the standard method for the remainder of the year
- It is usually safest to use the standard method unless you are very confident of your tax position such as if you have stopped trading.
Ratio Method
A GST registered taxpayer can use the ratio method to calculate provisional tax based on the sales figure in each GST return. Provisional tax and GST are paid together.
The taxpayer must be GST registered and using a two-month or one-month GST period. You cannot use it with a six-month GST period.
Commonly a company will be GST registered and can use this method. However, if the shareholders also pay provisional tax on their shareholder salary income, they must still use either the standard method or estimation as they do not file GST returns for themselves.
Provisional tax is calculated by multiplying the income in the GST return by a ratio (percentage), based on the tax to sales ratio in the last income tax return filed.
For example, a GST registered company’s 2021 income tax return shows sales of $1,000,000 and a profit of $100,000. As companies pay tax of 28% of their profit, its Residual Income Tax was $28,000 ($100,000 x 28%).
$28,000 works out to be 2.8% of its $1,000,000 sales. However, sales in the income tax return exclude GST while sales returned in GST returns include GST.
So, $1,150,000 ($1M plus 15% GST) would have been entered in the GST returns, presuming the company charges 15% GST.
The $28K Residual Income Tax is approximately 2.44% of the GST inclusive sales ($28,000 / $1,150,000 x 100) %.
For GST returns following the filing of the 2021 income tax return, provisional tax of 2.44% of the GST inclusive sales will be paid.
The ratio method’s main advantage over the standard method are that provisional tax payments will fluctuate in line with sales and therefore should more closely reflect actual tax payable. It also helps cash flow as more provisional tax is paid when sales are higher and vice versa.
Accounting Income Method (AIM)
The fourth method involves calculating provisional tax based on the profit in the management accounts. To use this method, the provisional tax payer must use accounting software certified by IRD as AIM capable.
The taxpayer submits a “statement of activity” directly from their software to IRD two-monthly, or monthly if the taxpayer has a one-month GST period.
The profit calculations require adjustments for depreciation of fixed assets, stock levels, debtors and creditors, etc. Therefore, this method may be suitable if you are preparing regular management accounts.
Whereas the ratio method calculates provisional tax as a percentage of the sales in each GST return, the AIM method calculates provisional tax as a percentage of profit. Therefore, AIM should more closely reflect the final tax calculation.
Like the ratio method, the tax paid fluctuates in line with business results, helping cash flow.
Next Steps
Robb MacKinlay is an accountant and business advisor to professionals and consultants, helping them convert their expertise into profitable business.
Contact us with your business questions.
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