Demystifying the PAYG Instalment System

Posted 7 Sep '23

Demystifying the PAYG Instalment System

Navigating the Australian tax landscape can be a complex endeavor, but understanding the intricacies of the PAYG Instalment System can make the process much smoother. It is one of the most common areas of tax where we receive questions from newer business owners.

In this blog, we'll dive into the details of how the PAYG Instalment System works, explore its calculation methods and why you might use these methods, provide practical examples, and how the timing of lodgement of tax returns affects the calculation and adjustment to the amounts paid in the period following.

The Why 

The PAYG Instalment System is a prepayment mechanism for income tax, aimed at preventing the accumulation of a large tax bill at the end of the financial year. It requires individuals and businesses to make regular instalment payments toward their expected tax liability.

These payments essentially act as a pre-payment towards tax calculated on your future tax return.

These are made based on the entity's projected annual income, ensuring that the expected tax is spread out over the year instead of due as a single lump sum on lodgement of tax returns.

The When

The timing of when PAYG instalments are due depends on several factors. Generally:

• Most taxpayers pay quarterly instalments, usually due 28 days after quarter end except for December Quarter which receives an extension to the 28^th of February.

• If the entity paying the instalment is also required to lodge a Business Activity Statement, the instalment is paid alongside that and will be eligible for any extensions that apply to the BAS if lodged via a tax or BAS agent.

• Primary producers may only need to pay instalments twice a year in the final two financial quarters. This is to line the due dates up with usual periods of income after harvest for example. The first instalment usually is 75% of the annual instalment and the second the remaining 25%.

• Businesses with instalment income for $20 million or more are required to pay instalment monthly.

• In very limited circumstances, you may also be eligible for a single annual instalment.

The How

The ATO automatically places you onto the PAYG Instalment System after lodgement of a tax return that contains non-pre-taxed profits that create additional tax liabilities over a certain threshold. Examples of this income include business income, rental income, or dividends and other investments that are not sufficiently covered by any attached franking or other tax credits.

How Instalments are calculated

There are two main methods for calculating PAYG instalments: the Instalment Amount Method and the Instalment Rate Method. The method applied to you depends on your circumstances, your history of paying tax, and eligibility per ATO criteria.

Instalment Amount Method - The ATO calculates your PAYG instalment amount using the tax payable from your most recent tax return as an estimate and splits it into instalments.

This is the simplest and most common method used as it doesn’t require any manual calculations being made each instalment period. It best suits businesses with a steady stream of income throughout the year.

Instalment Rate Method - Instalments are calculated by applying an instalment percentage rate against the instalment period’s turnover. The ATO calculates your instalment rate using information from your most recently lodged tax return.

This method requires manual calculations be made based on ATO’s rules. It best suits businesses in industries where income (and thus available cash to pay these instalments) varies significantly from instalment period to instalment period.

You must pick one method or the other at either the start of the financial year or when you initially enter the system. You cannot interchange the method from period to period during the financial year.

How Instalment amounts are set by the ATO

The Instalment Rate method is straight forward. Your income for that period drives the bulk of the instalment, the previous lodged tax return drives the percentage of that income that is used to calculate the instalment.

The Instalment Amount is a bit more complicated, despite the method of calculation being relatively simple in theory. In a perfect world, you would just grab the estimate generated from the most recently lodged return and divide by 4 or 12 and that’s what your next period’s instalment will be. Not the case. This brings us to the next section. The dreaded top-up…

How Top Ups Work

Top-ups occur when there is a major variation in the most recent lodged tax return and the previous. This is common for businesses in the first year of making profits where the timing of the lodgement of the first lot of business profits places the payer onto the system part way through the financial year, or where businesses that are rapidly growing year to year lodge their business return part way through the year. The common element here is timing of the most recent estimated taxable income.

For example, let’s use the following scenario where taxpayer lodges early tax return in Financial Year 1, but later in F/Year 2. Instalments are paid as follows:

• F/Year 1 – 1 Jul: Business lodges tax return and $4,000 is the estimated tax for instalments. Is put on quarterly instalments and instalment amount method is used.
• F/Year 1 – 30 Sept: $1,000 Instalment
• F/Year 1 – 31 Dec: $1,000 Instalment
• F/Year 1 – 31 Mar: $1,000 Instalment
• F/Year 1 – 30 Jun: $1,000 Instalment
•  
• F/Year 2 – 30 Sept: $1,000 Instalment
• F/Year 2 – 31 Dec: $1,000 Instalment
• F/Year 2 – 1 Jan: Business lodges tax return. Income doubles on previous year. Estimated annual instalments is updated to $8,000.
• F/Year 2 – 31 Mar: $4,000 Instalment
• F/Year 2 – 30 Jun: $2,000 Instalment

Hang on? Why are we having to pay such a big instalment in the March quarter? This is a common question tax professionals get, usually prompted by the impact the spike has on cashflow.

You see, your instalment for the next quarter is not just a simple division of the most recent tax return estimate divided by 4 or 12, but also a calculation of what should have been paid up until that point for the year based on income of the most recent lodged tax return.

In our example above we have had to pay an extra $2,000 on top of the recalculated $2,000 quarterly amount. This is because we should have paid 75% of that annual estimated instalment by the end of March, which is $6,000. $6,000 less $2,000 paid in the previous two quarters gets us to our $4,000 instalment for quarter three. As quarter three is the catchup quarter, our final quarter ends up being our straight forward $8,000 divided by 4 calculation ($2,000).

For this reason, it is important that we remember that when your non-pre-taxed income is growing rapidly, and where we are lodging a tax return part way through the year, that we anticipate top-ups to occur on instalments following the lodgement of your most recent tax return.

Now, there is another side of the coin (top-up’s much nicer cousin). In cases where we have paid instalments up to a certain date, lodge a tax return part way through the year with less taxable income, it is common for the following instalment to be reduced, or even eliminated until overpaid instalments are utilised.

How can I reduce instalments?

Unfortunately, the ATO sets instalments and require strict justifications for variations.

The only tool we have in our arsenal to reduce is to vary the instalment amount or rate prior to the due date of that instalment. To do that we have to be able to reasonably estimate tax payable for the full current financial year, which can be difficult to do earlier in the year. On top of that, we also need to get the estimate within 85% of the actual taxable income that is calculated on the eventual tax return lodgement or risk being liable to pay interest on any shortfalls of tax instalments paid, and even penalties where the shortfall is significant.

Variations are commonly considered as a strategy for managing cashflow around tax planning time in Apr/May/Jun each year.

They may also be considered earlier where there are significant measurable factors likely to reduce taxable income such as

• Periods of reduced income generation due to being away, illness, or natural disasters.

• Business structural changes partway in the financial year; or

• Where significant deductible expenditure is outlaid and eligible for full expensing in the year.

Finally, there are a number of triggers which can result in being removed from the PAYG Instalment system which are too numerous to list, however the most common reasons are when a tax loss is involved or a final tax return is lodged for that entity.

The What

What entities pay instalments?

It is important to know that the trading entity that earns the income is not always the entity that pays the instalment. Not all trading structures are taxable in their own name. While Sole traders and trading companies are pretty cut and dry and pay instalments in their own name, entities such as partnerships, trusts are a different story.

Generally, these entities are not taxed directly, so the PAYG Instalment payment obligations will fall on the taxable entities at the bottom of the income stream who ultimately receive the distributions. For example, in a simple mum and dad trading partnership, the partners who receive the income distributed from the trading entity ultimately pay the instalments in their own names.

 

In Closing

As you can see, while the PAYG Instalment system seems straight forward at first glance, it has many nuances that can result in significant variations of the amounts payable from period to period. This variation can cause a lot of confusion and panic when taxpayers are caught off guard by it.

The motivation for this blog post is to try and provide detailed commentary on these nuances and hopefully eliminate that surprise that eventually leads to panic.

If you would like to understand how the PAYG Instalment system applies to your circumstances, please contact your WDF team member.

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