Accounting Income Method Update
Following the release of the Accounting Income Method (AIM) determinations this month, Tax Traders has taken the time to summarise the current lay of the land with respect to AIM. There are 10 determinations that must be considered by the taxpayer and the taxpayer’s adviser that will affect the level of accuracy required for the accounting profit calculation and will in turn affect whether AIM is right for that taxpayer.
As a result of recently enacted legislation, there is from next year a new elective option for businesses to pay provisional tax. This allows provisional tax to be paid based on the businesses profits produced by the taxpayers accounting software system. Hence its name - “Accounting Income Method” or “AIM”. The AIM rules are legislated for, but the detailed operational rules have been left to the Inland Revenue to set out by way determinations outlining the level of accuracy and detail to be produced by the accounting system.
The AIM determinations have been released in the latest Inland Revenue Tax Information Bulletin (November 2017 TIB, Vol 29.10). Taxpayers have until the start of their 2018/2019 income year to decide whether to apply the AIM method for calculating provisional tax for the 2019 year. For most taxpayers that use the standard 31 March balance date, this means they can use AIM from 1 April 2018.
AIM is likely to be attractive to some businesses but not for others. AIM will be of some benefit to taxpayers that have very simple structures such as individuals that earn consulting income with minimal expenses. The main benefit is that tax payments should be more closely aligned to when these taxpayers earn their income. AIM will be considerably more complex for other taxpayers. That is because AIM requires what can amount to income tax returns every GST filing date (perhaps once every two months) whereas under normal rules an income tax return is only required once after the end of the income year. Taxpayers therefore need to discuss with their advisers whether AIM is attractive for them and they should take some time to work through the advantages and the costs of compliance.
How AIM Works
The AIM method of provisional tax allows taxpayers to opt out of the standard provisional tax regime and pay provisional tax at the same time as they file GST returns (monthly, two-monthly or six monthly) based on the accounting profit on a year to date basis.
AIM can be advantageous for taxpayers because:
- Tax payments are based on profit as opposed to the standard uplift. Under the standard uplift, taxpayers pay provisional tax based on what their tax liability was for the prior year or the year before the prior year. This sometimes has no correlation to the profitability in the current year.
- The year to date profit amount should also have some relation to the cash profits and therefore match tax payments with profits actually made, including cash profits from the business trading activities. This means businesses that make most of their profits in the final months of an income year can match this to when their tax payments are due. That is, tax payments are aligned to when profits are made.
- If a taxpayer uses the AIM method, there is no exposure to the Inland Revenue imposing interest charges provided terminal tax for the year is paid by the terminal tax payment date. While this is a major benefit, the standard uplift method only imposes interest from the last instalment date of provisional tax and only if the tax liability, after withholding taxes, exceeds $60,000.
The above advantages of AIM are material. However, like many tax issues, the devil is in the detail. From here on in it gets more complex. AIM is seeking to calculate provisional tax payments based on when a taxpayer earns income throughout an income year. To achieve this, taxpayers are effectively required to apply some accuracy in how they use their accounting systems and then file, electronically through their accounting packages, simplified tax returns every instalment date.
In deciding whether to apply AIM, the first point is to understand when during an income year the taxpayer earns its income. If the income is earned in the first few months of an income year, the existing rules are likely to be a better outcome than AIM. AIM is better suited to those taxpayers who have seasonal income where the income is earned post the middle of their income year or if the taxpayer would prefer more regular payment dates as opposed to the standard three payment dates under the existing provisional tax options.
Who can use AIM
There are rules restricting which business can use AIM. The key restrictions are that taxpayers must use “AIM capable software” and they must have turnover less than $5m. It should be noted that penalties can apply if AIM is used inappropriately.
The above gateway rules may prevent some taxpayers from using AIM. The Commissioner in her determination has further included some classes of taxpayers that cannot use AIM. The notable additional exclusion is those taxpayers whose business is operated through partnership or trust structures. Further if the business has foreign equity investments, it is likely it cannot use AIM. These additional restrictions materially reduce the number of taxpayers that can use AIM.
Assuming a taxpayer is able to use AIM, the taxpayer needs to consider how the detailed determinations would apply to it to decide whether to use AIM and pay provisional tax on the accounting profits from their accounting system. There are 10 determinations that must be considered by the taxpayer and the taxpayer’s adviser. The determinations effectively determine the level of accuracy required of the accounting profit calculated from the accounting systems.
In addition to setting out the classes of taxpayer that can’t use AIM, and the tax rate calculation the determinations highlight seven particular tax adjustments. We provide further comment on these below.
Tax Adjustment Determinations to Consider
1. Tax losses
There is a determination that covers the position with tax losses (Determination A7). If a taxpayer has tax losses from a prior year to be carried forward into the current year, the tax loss effectively only becomes available once the tax return for that previous year has been filed. If a taxpayer has tax losses brought forward, the taxpayer is probably best to use the standard uplift method and not consider the AIM method. Taxpayers should consult their adviser in this regard.
Importantly, this determination ignores any tax loss offsets that may be undertaken with other group companies. That is, if a taxpayer can access tax loss offsets from other group companies, it can claim the loss offset only in its annual tax return. That means the provisional tax payments paid during the year cannot take not into account the tax loss offset. In this case, if the tax loss offset may be material, the taxpayer should not use AIM as AIM will increase the provisional tax paid during the year.
2. Livestock Farmers
Livestock farming illustrates some of the issues arising with using AIM. Assuming they do not operate a partnership or trust structure (i.e. the taxpayer is a sole trader or operates via a limited company that is not a look through company) livestock farmers can use the AIM method. A sheep and beef farmer may use a June balance date. Their typical annual cycle is that in the months following balance date (July-September) the lambs and calves are born. These animals gain weight and are sold from December through to the following June.
Determination A10 sets out the rules for how the farmer values his/her livestock during the year and therefore determines how the profit is earned during the year and therefore when tax payments arise. This determination requires the farmer to undertake a physical stock take every AIM instalment period and value that stock applying the latest herd scheme values or national standard costs to value those livestock. This means that the farmer will be paying tax based on the natural increase in livestock numbers that occurs in the first few months of the income year. That is, if livestock farmers use AIM, they will be making their profits (and paying tax) when the offspring are born as opposed to when they are sold later in the financial year.
3. Trading stock
Determination A5 sets out the rules for whether trading stock needs to be revalued for each AIM instalment period. The determination provides some flexibility in this regard. If the accounting system has a perpetual stock system (meaning that each time stock is brought or sold the stock on the balance sheet is adjusted), then this is the system that is used for paying provisional tax under AIM. This means no adjustment is required to the regular accounting profits.
If the taxpayer uses a periodic stock system (i.e. simply undertakes an annual physical stock take), then if it undertakes a stock take only at year end, each AIM instalment period makes no adjustment for stock values. The taxpayer simply uses the stock value at the start of the income year. If they undertake a physical stock take for each instalment period, then this is also acceptable and provisional tax payments are based on this periodic stock take.
If a taxpayer has trading stock, then it needs to consider the implications of this determination to decide whether to apply AIM. This is a complex issue that needs careful consideration with the business’s accounting adviser.
4. Depreciation and fixed assets
Where taxpayers have fixed assets that result in tax depreciation deductions Determination A8 sets out how this depreciation is calculated. The determination provides that a taxpayer has a choice either:
- not to claim any depreciation deduction during the year and claim all the deductions only when it files its income tax return; or
- calculate depreciation deductions, including losses or depreciation recovered on any assets disposed of, for each AIM instalment period.
- We suspect taxpayers will want to claim tax depreciation for each installment period. However they need to also be able to calculate losses on disposal and depreciation recover when assets are sold.
5. Accounts payable and Accounts receivable
Monthly accounts prepared through software packages could be prepared on a cash basis (i.e. not recognising accounts payable or accounts receivable) or on a full accruals basis where accounts payable and accounts receivable are recognised and accounted for.
Determination A6 provides that if a business accounting system ignores accounts payable and receivable and (if the business is registered for GST), it is registered on a payments basis, then the accounting profits prepared on this basis are acceptable to determine the profit for the tax payments applying the AIM provisional tax method.
Under Determination A6, if the taxpayer is registered for GST on the invoice basis, the accounting profits must include accounts receivable and accounts payable to be acceptable for the AIM provisional tax method.
6. Private expenditure
To use AIM for provisional tax, any expenditure that has a private portion element (other than entertainment expenditure) must be adjusted for each AIM instalment period (Determination A4). This relates to vehicle expenses and home office costs etc. If the taxpayer currently leaves this adjustment to their accountant to undertake when preparing the annual tax return, then this practice is not acceptable and probably AIM should not be applied. Taxpayers should discuss this with their adviser.
7. Shareholder salaries where no PAYE is deducted
In many closely held companies, all, or a significant portion of, the annual taxable profit is paid to its shareholder employees as wages outside the PAYE rules. In this case those shareholders and the closely held company are likely to all be subject to provisional tax.
The AIM rules provide some relatively complex rules for this. In working out the tax payable by the company, a deduction is allowed for the lesser of
- a provision for shareholder salaries
- the income of the shareholder employee based on the tax paid by the company on behalf of the shareholder employee.
In our experience, most closely held companies do not make any provision for salaries payable to shareholder employees until the end of the year when the final profits are known. This means there is no deduction to the company in determining its AIM provisional tax payments during the year. All tax on profits will therefore be paid at 28%. That is, the combined profit of the company and shareholder salaries has provisional tax paid at 28% without the benefit of the lower income tax rates applying to shareholder salaries below $48,000. Whether this is overpaying tax or underpaying tax will be dependent on the overall taxable profits.
Where a company pays provisional tax on all the profits (excluding any deduction for shareholder employee salaries) at 28%, at the end of the year, the company can transfer the excess tax payments to the shareholders to satisfy the shareholder employees’ provisional tax obligations. While the AIM provisional tax payments will occur across the year, the transfer to the shareholder employees will be deemed to occur equally at the provisional tax payment dates. If this is not sufficient to satisfy the shareholder employees final liability, they will either have had to pay provisional tax or buy provisional tax through a tax pool to satisfy any shortfall (and therefore any exposure to penalties and interest).
Taxpayers should discuss this with their advisers as this is a complex consideration.