One of the most painful situations businesses encounter is getting back their tax return with a big profit, accompanying tax bill, and no cash to pay the IRD. In fact, they haven’t seen any cash benefit of the profit throughout the year. There are a number events that can conspire to create the aforementioned unfortunate situation as well as a few budgeting techniques that can be undertaken to prevent it.
The first piece of good news is that for the average business accounting profit and profit obtained when applying the Income Tax Act 2007 are very similar. There are a few notable exceptions but most of what we discuss below can be understood and implemented without sophisticated tax knowledge.
Repayment of Debt
This is vital to the financial future of the business as it relieves the burden of debt maintenance and frees up cash for operation activities. Unfortunately, only the interest portion of debt repayment is deductible against income.
Most proprietors are familiar with this when reviewing financial statements and discussing bank debt. However, the above is true for all debt repayment. Repaying an overdraft, shareholder loan and bank loan; all of these things will improve the net cash position of the business while generating no expense deduction. As a consequence it is very common for a business to experience an improvement in net profit, and use this net profit to improve its debt position, only to find it has insufficient cash to meet its debt requirements.
The solution to the above is to use the most accurate profit figure available to generate an up to date tax estimation, and treat this estimation as a real debt when considering your debt repayment schedule. It may be more desirable to forego the repayment of some stable long term debt to meet your tax requirement at the end of the year.
This is identical to the above except you are using business profits to expand the size of your business rather than reduce the influence of your creditors. It could also be the case that new capital is bought in to replace aging capital to ensure production and sales targets continue to be met. Regardless expenditure on fixed assets is not deductible against income.
It is less common for business owners to be caught out by the above on principle, but more common for them to be a victim of bad timing. New capital is rarely a single transaction commitment, further costs usually arise due to installation and both the purchase and installation take time. If this occurs during tax time it can lead to depleted cash flow at the wrong time.
The solution is to take the reasonable tax estimation you made earlier and factor it into your capital maintenance and acquisition plan along with production targets. Because of the vital nature of capital maintenance and expansion it is understandable that business owners become fixated on it until it is complete. However, payment of tax should be treated as seriously as any other production input or cost of goods sold.
Impact on Small Businesses
It is very common to hear complaints in the media about the impact of higher taxes or uncertain taxes on business, but most making the complaints and those listening to them are ignorant as to why they are being made. As shown above payment of income tax is the equivalent of both the way the business is financed and a production input. High or uncertain tax can create a bottleneck for business decision makers. A business cannot give the go ahead to repay outstanding debt if the tax system will change in an unknown way in a year’s time, as they do not know what they are weighing debt repayment against. A business cannot undertake capital expansion if a high tax rate makes an increase in activity non-viable.
Receivables and Payables
Your terms of trade can also cause issues around tax time. A large profit caused by Accounts Receivable can create income with cash that is not yet realised. Equally, even though Accounts Payable does create a claim if the payment needs to occur at the same time as provisional or income tax this can also cause issues.
It is very important that the business owners prioritise achieving business liquidity as well as pursuing outright profitability. A business that is always profitable but committed totally to achieving its next round of production or sales costs will leave itself vulnerable to unexpected transactions, the shortage of funds to pay tax is usually an early warning sign.
Tax Exclusive Impacts
These are transactions that have a tax impact in the form of income but generate no cash flow to cover their tax costs:
- Depreciation Recovery caused by asset transfer (rather than sale)
- Foreign Investment Fund (FIF) income both Fair Dividend Rate (FDR) and Comparative Value (CV)
- Consideration received in shares or other goods
- Accrual of income due to legislative requirements such as the financial arrangement rules
Items such as the above are far more difficult to budget for as they do not commonly appear on the management reports of most business owners. As a consequence, the best time to deal with these is during provisional tax time. When you receive you provisional tax notice, please let your accountant know about any major past or upcoming transactions that are not reflected in your profit and loss, and any that would not have occurred in the prior year.
If you need help estimating your tax, sorting a debt repayment plan, advice on budgeting techniques or capital expansion –get in touch with your accountant or the author, Robert, and discuss further.