New Zealand's tax legislation leaves a lot to be desired in accuracy and fairness - tax calculations performed in accordance with IRD specifications are NOT deemed to be full and final and are subject to annual assessment.
This is patently unfair, however it is the legislative framework we have to work with.
Annual tax assessments calculated by IRD can differ from tax calculated and paid per pay period for numerous reasons:
1) the employee may have received additional payments (Bonus payments, Backpay etc) - these are taxed using Extra Pay rules (see below)
2) the employee's income may vary from pay to pay (temporary/casual staff, leave without pay, permanent staff receiving irregular overtime etc)
3) tax rates may change during the year (legislation sometimes changes rates during the year)
4) employee's tax code may change during the year
5) employee's tax may be overridden from time to time
Each of these possibilities may contribute to inaccurate total tax take over the year, and the following taxation methods need to be understood to see how this can happen:
Normal Tax Calculations
In extremely basic terms, the employee's earnings for the current pay period are multiplied out to produce annualised income, tax is calculated using the rates provided by the employee's tax code (based on portions of the annualised income at various percentages) and the PAYE for the period is determined. This will usually match the IRD Tax Guide.
For example, an employee on tax code M in July 2020 earning $1000 is taxed as follows:
- $1000 x 52 = $52000
- $14000 taxed at 11.89% = 1664.60
- $34000 taxed at 18.89% = 6422.60
- $4000 taxed at 31.39% = 1255.60
- Total annualised tax = $9342.80
- $9342.80 / 52 = $179.66 PAYE (see also the IR340 PAYE Deduction tables and guide attached)
The problem with this method of taxation is that it assumes employee's will earn similar amounts per pay period (the people that design these systems are paid salaries) which would normally produce an annual tax assessment equivalent to actual tax paid. However, significant variances can occur where the employee earns different amounts per pay period.
Extra Pay Tax Calculations
The rules used for calculating tax on bonus, backpay and commission payments and Cash-up payments (called "Extra Pay") are different from the employee's normal tax table.
The employee's normal earnings for the 4 week period up to the current period end date are multiplied by 13 to produce annualised earnings, then the Extra Pay amount is added on. The total is assessed against a series of thresholds and a flat percentage is determined as the rate for PAYE on the Extra Pay amount.
For example, an employee on tax code M in July 2020 earning $1000 and receiving a termination payment of $4000 is taxed as follows:
- $1000 x 4 weeks = $4000 x 13 = $52000 + Extra Pay $4000 = $56000
- Tax rate for annualised income between $48001 and $70000 is a flat rate of 31.39%
- $4000 x 31.39% = $1255.60
- Plus PAYE on $1000 of $179.66 = $2255.60 PAYE in the final pay
This is obviously also subject to great variance, as the employee may not have earned a great deal in the previous 4 weeks (fluctuating earnings patterns, or processing a bonus out of regular pay cycle - which diminishes earnings in the last 4 weeks), or may have earned more than usual (extra overtime, allowances etc).
An additional, and little known, complication is that the employee can elect to pay a higher minimum Extra Pay tax rate even if a lower rate would normally apply. Few employees are aware of this option, and those that are and who usually have intermittent or varying earnings usually select a medium or high elective. Those that don't will often have paid too little tax when the annual assessment is made.
SmoothPay can provide a Tax Smoothing algorithm instead of the normal tax calculation rules so that terminal tax is always calculated accurately during the year - the only problem is that the employee must have only one source of income, and must remain employed for the entire year.
A superior solution would be that IRD provide a similar tax calculation web-service that would specify an amount of tax for the current payment (based on their knowledge of total earnings) and that would be deemed full and final. Unfortunately, such a system is pretty unlikely.
All in all, NZ's PAYE system extensively documented, but seriously flawed, as it abounds with complicated rules (e.g. 2 tax systems in play in a single pay period, annualised income based on current pay period, various thresholds for mandated deductions, etc.), and this means that significant variances between actual PAYE paid and PAYE assessed will remain commonplace.