After a significant amount of time as an accountant and business advisor, the PAYG Instalment system remains one of the most confusing aspects of the tax administration system in Australia.
Rarely a week goes by where I’m not asked a question about PAYG-Instalments.
The confusion is generally fuelled by two things:
A misunderstanding about why PAYG Instalments are payable, and
The ATO’s communication of the PAYG Instalment system tends to cause significant confusion.
This article is, my attempt to better explain what the PAYG Instalment system is and how it works.
What are PAYG Instalments?
PAYG Instalments are essentially prepaid tax. The term PAYG stands for Pay As You Go, so many consider it to be a provisional tax.
The PAYG Instalment system effectively requires you to prepay your anticipated tax liability in instalments across the year, instead of receiving a large bill come tax time.
As a general rule, if you had a tax bill of $1,000 or more for your most recently lodged tax return, there’s a good chance you will be entered into the PAYG Instalment system.
The ATO assumes that because you had a tax bill of $1,000 last year, it will be the same again for the current financial year. Instead of paying $1,000 when your tax return is lodged, the ATO instead enters you into the PAYG Instalment system, and requires you to pay $250 per quarter instead.
The idea is that it is easier for people to pay a smaller amount more regularly. In truth, it likely stems from a desire for the ATO to collect revenue more regularly.
That being said, I do agree with the ATO’s approach here. People are notoriously bad at provisioning for tax and putting money aside, so by the ATO putting out their hand for smaller amounts more regularly, they are more likely to be paid.
When a PAYG instalment is paid, it can be claimed as a tax credit in the tax return that covers the period that the PAYG instalment related to. I.e. a PAYG Instalment paid for July to September 2021 can be claimed in the tax return for the 2021/22 financial year (the 2021/22 financial year runs from 1 July 2021 to 30 June 2022 in Australia).
That is the theory, things get more complicated from here, hence the ongoing confusion…
Why are PAYG Instalments required?
When you’re an employee, your employer is required to take tax out of your pay before paying you.
When you are in business or earn investment income, you receive the income in its entirety, and then later pay tax on this amount.
Unfortunately, many new business owners struggle to make the mindset shift from receiving their pay with tax already withheld, to being paid and having to pay the tax at a later date.
This typically results in forgetting to budget for tax, the money is spent, and then they receive not only a massive tax bill when their tax return is lodged, but shortly after, also a PAYG instalment.
Many people consider this to be a double whammy and the cash flow isn’t there to pay the tax.
What are the flaws with PAYG Instalments?
There are a lot of flaws with PAYG Instalments that cause a lot of problems.
The ironic thing is, once most people are up and running with PAYG instalments, they often prefer the process to receiving a large tax bill at the end of the year.
Nonetheless, here are the issues that cause the biggest problems:
1. PAYG Instalments typically don’t start until after your tax return is lodged.
When you lodge your first tax return as a business owner, hopefully you’re operating a profitable business and have some tax to pay. The ATO then levies the tax payable, and enters you into the PAYG Instalment program.
The transition from not paying PAYG instalments to needing to pay them is challenging for some, however, as a business owner, you should be budgeting ahead of time to meet anticipated tax liabilities.
2. PAYG Instalments are generally based on your most recently lodged tax return, and therefore may not reflect your current circumstances.
Another problem is that PAYG Instalments are based on your most recently lodged tax return. A lot can change quickly in business, and one flaw is that the PAYG instalments the ATO has estimated, may not match your current circumstances.
If for example you had a great year in business and made a significant profit, you will likely be entered into the PAYG instalment system. If in the following year you experience a significant downturn, your PAYG instalments may be too high for your actual current income.
The ATO does allow you to vary your PAYG Instalments, but the way the PAYG instalments are calculated does give rise to an issue as they do not reflect your current year circumstances.
3. The ATO’s communication is typically confusing
Most of the queries we receive relates to the ATO’s correspondence. Generally at the start of the year, the ATO will provide an estimate of your anticipated PAYG Instalments. Many people confuse this annual estimate as their quarterly amount and get concerned that they are being taxed too much.
To make matters worse, in line with the ATO’s communication preference of delivering ATO correspondence directly to taxpayers through myGov, the communication may be lost in your junk folder, never received, or simply not actioned.
4. Beware of catch ups
As your PAYG instalments are based on your most recently lodged tax returns, you need to be aware that a big catch up PAYG Instalment may apply for those already operating within the PAYG Instalment system.
This is hard to explain, so bear with me. Let’s say you had a tax bill of $10,000 in the 2020FY, and tax payable of $100,000 in 2021FY.
Until your 2021FY tax return is lodged, the ATO will assume that you will need to pay PAYG Instalments of roughly $2,500 per quarter.
(In reality, your PAYG instalments will be more than $2,500 per quarter as the ATO assumes your income will continue to grow each year, and slightly increases the tax estimate each year. For the purposes of this, let’s ignore this and keep it simple)
When your 2021FY is lodged, the ATO goes ‘oh no, we should have been levying PAYG Instalments based on tax payable of $100,000 per year’. This works out to be $25,000 per quarter instead of the $2,500 you were paying.
Now this is the confusing bit, for each quarter, the ATO assumes you should have paid a proportionate amount of PAYG for the quarter.
Quarter 1 - ATO requires you to have paid 25% of your estimated tax for the year
Quarter 2 - ATO requires you to have paid 50% of your estimated tax for the year
Quarter 3 - ATO requires you to have paid 75% of your estimated tax for the year
Quarter 4 - ATO requires you to have paid 100% of your estimated tax for the year
So say you lodge your 2021FY tax return in June 2022. You will have a tax bill of $100,000 to pay towards your 2021FY tax return, but there is also a significant catch up PAYG Instalment required of $92,500, calculated as follows:
Quarter 1 - only $2,500 paid
Quarter 2 - only $2,500 paid
Quarter 3 - only $2,500 paid
Quarter 4 - $92,500 payable
Why the big catch up?
Once your 2021FY tax return is lodged, the ATO now requires you to have paid 100% of the estimated tax due for the next financial year of $100,000.
However, at that time, only $7,500 had been paid, therefore, the difference is $92,500.
When are PAYG Instalments due?
For quarterly PAYG Instalment payers, the PAYG instalments operate for the following periods:
July to September quarter - due for payment by 28 October
October to December quarter - due for payment by 28 February
January to March quarter - due for payment by 28 April
April to June quarter - due for payment by 28 July
You will see above that the ATO gives a one month extension for the Christmas period. It’s a funny extension, as all it does is make February, March and April more challenging with regards to cash flow management, given the closeness of those two payment dates. If you don’t like this, simple….pay earlier!
For taxpayers with $8,000 or less in estimated notional tax, you also have the option of paying annually. Kind of defeats the purpose though…
What if the PAYG Instalment isn’t accurate?
For many reasons, the PAYG instalments might not be accurate. Common examples are your business conditions have changed or you sold your investment/business.
When this happens, the ATO allows you to vary your PAYG Instalment to a more accurate level.
It is tempting for some to vary the PAYG Instalment to $0 to avoid paying the PAYG Instalment, but beware that this can carry penalties if this is not accurate. I.e. don’t vary your PAYG Instalments down to $0 payable just because you can, or just because you don’t have the money to pay the instalment. You’re just creating a bigger tax payment for you in the future.
For those that are however making legitimate variations, these can be completed online or via the paper form the ATO sent you. Make sure you attend to the variation before the due date, as unvaried PAYG instalments automatically lodge on the due date if no action is taken.
The above is a simplified version of how the PAYG Instalment program works. In some cases, I have oversimplified things to make it easier to explain. If you are in the PAYG Instalment system, I recommend working with an accountant and tax agent to make sure you are aware of your obligations.
That being said, hopefully this article goes someway to improving your understanding about PAYG instalments.
I’m always interested in improving these articles and making them more useful. If you have any questions, let me know in the comments below and I will endeavour to respond to you as soon as I can.
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