Provisional Tax is Coming was featured by Bricks & Mortgages (August 2023)

Are you a residential investor with properties that don’t meet “new build” or “social housing” interest deductibility criteria? Your tax bills for the years ended 31 March 2022 onwards may be increasingly surprising.

Many portfolios aren’t profitable at the moment – some with substantial losses. This can be due to intentionally buying “low yield high growth” properties, jumping into buying a property without doing the numbers, or simply buying what provided good cashflow three years ago at sub-3% lending but is starting to sting as it approaches 7.5%.

But due to the disallowing of interest deductibility on residential property lending introduced in 2021, it doesn’t matter that you’re losing money – from a tax perspective you’re probably making a profit. And rest assured: There’s a tax for that.

If you haven’t yet, you’ll likely soon hear about the thrust of this piece, Provisional Tax. It’s a beast that will be new to most smaller investors, but suddenly it’s relevant. The explanation below probably won’t make you feel better about paying the tax. But it will hopefully take some of the confusion and fear away.

So first up… What is it?

Well, provisional tax isn’t really a tax at all, though it feels a lot like it. It represents an estimation of your future income tax obligations. It is IRD’s way of preventing the shock of a large tax bill later on, by forcing you to spread it throughout the year to which it relates.

So really it’s just regular income tax, approximated, and paid earlier than usual. People often think of it being paid “in advance” but it’s really not. You still pay in arrears, it’s just “less delayed” than small taxpayers are used to.

When final tax returns are filed the difference between provisional tax expectations and genuine final tax is adjusted. If profit was lower than expected, overpaid provisional tax can be refunded. If it was higher you will have a “top up” payable at the normal terminal tax date.

How is Provisional Tax calculated?

There are four ways, though only one commonly relates to residential investors. The other three apply more to businesses such as real estate agents, property managers, or developers.

• Standard / Uplift Method

• Estimation Method

• Accounting Income Method (AIM)

• Ratio Method

Usually: Standard Uplift

For most people, provisional tax is calculated on the “Standard” method, also known as the “Uplift” method. This takes the “Residual Income Tax” (the total tax bill for the year) from your most recently filed tax return, and then adds 5% or 10% to create IRD’s expectation of your tax for the current tax year. IRD then expect payments throughout the year, usually in three installments. Simple, really.

Standard/Uplift provisional tax for the year 1 April 2023 to 31 March 2024 (“FY24”), the tax year we are presently in, is due 28 August 2023, 15 January 2024, and 7 May 2024 for most taxpayers. If you’re 6-monthly GST registered, or have a non-March balance date, different dates apply.

Sometimes: Estimation

If your taxable activity drastically changed or ceased, you might want to estimate a lower amount of provisional tax rather than paying it based on the prior year. Estimated tax is due in equal instalments on the same dates used by the Standard method.

At AAT Accounting, we advise against formally advising IRD of your estimate. This is because invoking the Estimation method can negatively impact when the IRD start charging you interest.

Rarely: Accounting Information Method (AIM)

A relatively new option for provisional tax introduced in 2019. It makes use of specific accounting software to calculate provisional tax every two months. It bases this on information transmitted from your accounting system. Because it’s based on actual results, it’s usually more accurate than Standard or Estimation methods. And if final tax is found to be higher than AIM calculated, no interest costs apply. It does however come with its downsides:

• Additional cost for AIM-capable accounting software (such as Xero)

  • Administrative requirement to keep accounting software up to date regularly

  • Tax is paid more often, and can’t be delayed and subsequently paid by tax pool

  • Not able to hold tax aside in a good year to earn interest until it’s due

  • Some have concerns about how much additional information is being sent to IRD during the regular AIM calculations.

Pretty Much Never: Ratio Method

Essentially an older version of AIM, made for businesses that have significant ups and downs in their income. Like small developers with one project per year, or real estate agents in a highly seasonal area.

It bases provisional tax on a ratio of what is declared in your monthly or two-monthly GST returns. As such it is not available to residential property investors, who should usually not be registered for GST.

This method is not used widely, most likely due to its relative complexity.

How bad is Provisional Tax going to be, really?

As a high level guess for your personal annual tax cost attributable to the removal of interest deductibility, calculate your annual interest bill for affected properties then multiply by your marginal tax rate (probably 33% or 39%). At prevailing 7% interest rates, every $100k of debt should be saving you $2.3-2.7k of tax, but that’s phasing down to nothing. From April 2025 onwards an investor with a $1M mortgage might be paying up to $27k tax on imaginary profit, each and every year. Provisional Tax is going to be around 1/3 of that figure, three times a year. Keep in mind it’s based on historical tax returns, so while interest deductibility is phasing out, your Provisional Tax expectation is likely to be lower than the final tax bill, leaving you with a top up to pay the following April.

What if I don’t pay my Provisional Tax?

Regardless of the provisional tax method used, if you don’t pay on schedule, IRD can apply both penalties and interest to your account. In the case of Estimation method, they’ll charge the penalties and interest based on a retrospective calculation of your actual tax owing, not your estimation. Interest is presently set at 10.39%. Penalties are 5% in the first month, and 1% each month thereafter. They add up fast. If you pay your standard provisional tax amount and when the final tax return is filed it turns out you overpaid, IRD credit a much smaller interest rate to you, presently 3.53%.

I don’t like it! Can we do anything about this Provisional Tax scourge?

As a professional services provider, I do my best to keep political leanings out of my accounting and tax advice, but it’s essential that all residential investors consider their personal financial stake in the upcoming election. In 2021, the current government announced a misguided and poorly thought out tax change to the already-overtaxed residential property asset class. This was not a popular decision – even IRD voiced their opposition: “Inland Revenue has advised against any of these options to deny or limit interest deductions and prefers the status quo to all options”. But it proceeded anyway, and within my client base alone I expect millions of dollars in additional tax over the next three years. This is taxing profit that doesn’t even exist, and in recent years can’t even be considered in light of the usual excuse of untaxed capital gains making it all better!

Two major opposition parties have pledged to reverse this and several other problematic tax policies introduced in the last few years. While we can’t be sure until we see it, there’s no chance of that happening if the current government gets another term.

This won’t get rid of the Provisional Tax system, but it may well take your taxable profits back to a point where you don’t need to worry about it. Have another look at your “How bad is it really” number. This should not be the only thing you consider when voting in October, but it’s got to be a factor.