Welcome again to the McLean and Co. Newsletter in which we discuss current taxation and business matters. We trust you find it informative.  Any feedback would be welcomed.

McLean and Co. is a home based chartered accountancy practice based in Clive, Hawkes Bay.    Readers are invited to peruse the practice website www.mcleanandco.co.nz,  which lists services provided, gives contact details and indicates how to become a client, contains an extensive base of articles on business and taxation matters,  and has links to other websites that may assist your business.    Being a small firm itself,   McLean and Co. strives to provide a personal and professional service largely to a self employed person and small business client base.  Enquiries are welcomed.

We are happy to accept new clients.  Please contact ourselves at the contact points highlighted above if we can assist you in your accounting and taxation requirements. Our website lists information required for this in the following link:

INDEX

1. Relevant Business and Taxation Articles.

2. Provisional Tax- What is it and how does it work?

3. Hardship and Debt

4. Helpful Hints when Choosing a Return Preparer

5. Golden Rules of Investment

RELEVANT BUSINESS AND TAXATION ARTICLES

The McLean and Co. website contains an extensive number of articles prepared by McLean and Co. relating to taxation and business matters.    Here are a selection that will be of interest:

PROVISIONAL TAX- WHAT IT IS AND HOW DOES IT WORK ? 

Provisional  Tax is tax paid as you go for people in business.   It is not a separate tax.   When you fill in your Income Tax Return to calculate your end-of-year tax bill, you deduct the provisional tax you have paid during the year, so the end result is that you will not pay tax twice. 

Generally you pay Provisional Tax in a particular year if in the previous income year your Residual Income Tax (which is the income tax that is calculated that you have to pay after deducting rebates you can claim and also all tax paid during that year except for provisional tax) was $2,500 or more.  

You are, however, liable for Provisional Tax in the first year of business in the following circumstances:  

There are two options for working out Provisional Tax payable:

Once you make an estimate, you cannot change to the standard option for that year.   You can re-estimate any number of times up to your third instalment date, when your last estimate becomes final. 

Most businesses tend to select the Standard Option, unless they believe the following year profit will be significantly different. 

If you don’t believe your Residual Income Tax in the following year will be $2,500 or more, even though you  paid Provisional Tax in the current year, you can choose the Estimation Option and estimate Nil.  If this turns out to be the case you will not be liable for interest, but if you were liable to pay Provisional Tax you will be charged interest by IRD.  

Provisional Tax is payable in three instalments, on the 7^th day of the 4^th, 8^th and 12th  calender months after the previous year balance date.   For example if you have a 31 March balance date, Provisional Tax payments are due on 7 July, 7 November and 7 March.  

If you are registered with a tax agent and you were not liable to pay Provisional Tax in the previous income year but are liable in this income year you can escape paying in the three instalments if your Income Tax Return for the previous year has not been filed in time for an Instalment, but instead you must pay the full liable amount but in two instalments (7 November and 7 March) or in one instalment (7 March) after the date the Income Tax Return is filed.  

If your Provisional Tax instalments are paid late or are short paid, you incur penalty and interest charges in relation to the late or under payments.  

If the Provisional Tax paid during an income year is more than the Residual Income Tax calculation at the end of the income year, you will get an income tax refund fror the difference.   If it is less, you will have to pay the difference to IRD.  

Many businesses have a free year in the first year from paying income tax (due to the fact that they don’t have to pay income tax until their first year Income Tax Return is processed) , but then find that they have to pay two lots of income tax in their second year of business (being the tax calculated for their first year plus Provisional Tax for the second year).   It is this factor which causes a number of businesses to fail in the second year due to the fact that the business has not been budgeting and putting money aside in the first year.   The IRD will accept voluntary payments in the first year even though they are technically due then, and this is an option that businesses should consider if the owners believe that the amount will not be able to be saved otherwise.  

Some taxpayers are slow in filing returns each year, and due to this are not sure exactly what should be paid in Provisional Tax each instalment.   In this instance, if it is the belief that Provisional Tax will be payable as it is expected that Residual  Income Tax will be more than $2,500 in that income year,  Provisional Tax instalments should still be paid on due dates based on the previous year instalments plus 10% to escape or minimise penalties.  

USE OF MONEY INTEREST RATES

The Government has recently announced that Interest rates on unpaid and overpaid tax will increase from 8 March 2005.  The interest rate on unpaid tax will increase from 11.93% to 13.08%, and the rate on overpaid tax will increase from 4.83% to 5.71%.  The new rates apply to all revenues and duties.

HARDSHIP AND DEBT

Paying the correct amount of tax under the law is an important community responsibility. The revenue collected through the tax system funds government spending, including community services, hospitals and schools.

Some taxpayers  have difficulty in making your payments on time. The following are some frequently asked questions, and answers, that may help.

HELPFUL HINTS WHEN CHOOSING A RETURN PREPARER AND RETURN FRAUD

The following is a report of recommendations as to choosing a Tax Return Agent as issued by the IRS ( US Government Tax Body)- in some cases the quotes are applicable to USA.

Return Preparer Fraud generally involves the preparation and filing of false income tax returns by preparers who claim inflated personal or business expenses, false deductions, unallowable credits or excessive exemptions on returns prepared for their clients. Preparers may also manipulate income figures to obtain fraudulent tax credits.

In some situations, the client (taxpayer) may not have knowledge of the false expenses, deductions, exemptions and/or credits shown on their tax returns. However, when the IRS detects the false return, the taxpayer must pay the additional taxes and interest and may be subject to penalties and criminal prosecution.

The IRS Return Preparer Program focuses on enhancing compliance in the return-preparer community by investigating and referring criminal activity by return preparers to the Department of Justice for prosecution and/or asserting appropriate civil penalties against unscrupulous return preparers.

While most preparers provide excellent service to their clients, the IRS urges taxpayers to be very careful when choosing a tax preparer. You should be as careful as you would in choosing a doctor or a lawyer. It is important to know that even if someone else prepares your return, you are ultimately responsible for all the information on the tax return.

Tax evasion is a risky crime, a felony, punishable by in USA by five years imprisonment and a $250,000 fine.

GOLDEN RULES OF INVESTMENT

Understanding core principles of investing usually dictates the success or failure of any wealth building strategy.   The following are key investing principles  and the building blocks upon which successful plans are formulated:

Compound Interest

Compound interest works like this.   When you invest money you earn interest on your capital.   The next year you earn interest on both your original capital and the interest from the first year.   In the third year you earn interest on your capital and the first two year's interest.   Its very much like a snowball effect.   As your capital accumulates interest, and interest and interest, it becomes bigger and bigger.

Dollar Cost Averaging

Purchasing your selected shares, or units in a managed fund, is best accomplished at a slow and steady rate over time, regardless of whether you think the market is about to rise or fall.   This approach, known as Dollar Cost Averaging, is a common way to remove the risk associated with making a large investment at any point of time, particularly when markets have been rising and may be ready for a correction.   This strategy not only helps to remove the emotional aspect of investing- it enforces discipline.  When market prices are falling , you get the benefit of automatically buying more units in a fund with each subsequent investment.  When prices are rising, you are buying fewer units.  The beauty of all this is the outcome- because you are buying more units when prices are lower and fewer units when prices are higher, the average cost of your units will be below the average cost of all units., assuming the market rises over time.

Don't Attempt to Time the Market

"Market timing" is buying and selling your investments based on a belief that you can pick the markets are heading in the short term.   Sharemarket growth has often come in dramatic spurts that can easily be missed if you're sitting on the sidelines waiting for an anticipated correction or bear market to occur.    As the 1990s have shown us, the experts are often more wrong than right when they try to predict an upcoming market downturn.  Unless you have a crystal ball, your chances of picking market movements in the short term are minimal.   Trying to predict where the sharemarket is heading can be a dangerous game that can lead to missed opportunities if you guess wrong.  Over the 569 months to June 2004, the New Zealand sharemarket achieved over a quarter of its growth during the best 12 months of market performance.   Put differently, the New Zealand sharemarket returned 12.7% per annum during this period.  If you were invested in shares for all but the 12 best months, your return would only have been 8.7% .

Stay in the Market for the Long Haul

Time has two beneficial properties- reinforcing the power of compound interest and reducing the risk of negative outcome.   It is important to understand that share markets are naturally volatile creatures. And in most cases managed funds will set a timeframe by which you can expect the fund to meet its target return- usually 5 years or longer.  Beware that not every year will result in a positive return on your investment.

Combat Risk with Diversification

Diversification is one of the most fundamental rules of investing, so much so that professional portfolio managers live by it.   Diversification- spreading your money among many different investments, takes a middle road through the highs and lows of market performance, allowing your investment the opportunity to grow regularly with fewer fluctuations along the way.   Diversification is the most effective means of managing risk.   You'll be less affected by losses in any one investment and losses may even be offset by gains in other investments.  When diversifying remember to:

1. Reduce security or sector- specific risk-   purchase a broad range of investments across various companies and industries rather than a limited selection of individual securities.   This way, no single investment will dominate the performance of your portfolio
2. Spread your money across the different asset classes (shares, property, fixed income and cash)-  each asset class has its own risk and return attributes.   Because the risks of one asset may complement the risks of another (asset classes often move in different directions and react differently to information), it may be possible to achieve higher investment earnings and reduce your portfolio's volatility.

Understand the Risk/ Return Trade Off

Asset allocation is the key to meeting your objectives-  it is often quoted that asset allocation explains 80-90% of a portfolio's absolute return.  Investing almost always requires you to trade off your desire for higher returns with your desire to control risk.  Too little return and you will not reach your financial goals.  To much risk and you will not sleep at night.  Invariably investments advertised as providing high returns have greater risk associated with them than investments advertising mid stream or lower returns.  The solution to this problem is getting the asset mix right- cash, bonds, shares, property etc. and how much of each.   If you get your mix right, your portfolio is more likely to deliver what you expect.  Once you have decided upon a mix it is important to stick to it, unless your circumstances change.

Do Not Look at Past Performance to Pick Managers

Past performance is a very poor guide to future performance.   Investment manager selection should not be totally based on track records.   Of the 3 managers who finished in the top 25% returns on New Zealand domestic share funds in 2001 only 1 finished in the top 25% in 2003 also.

Rebalance your Asset Mix to stay True to your Tolerance to Risk

 As time goes by and markets experience ups and downs, your portfolio will experience gains in some asset classes and losses in others, causing your strategic asset allocation and actual portfolio to become unsynchronised.   This raises the need to make adjustments to counteract the fact that different asset classes have performed differently, and as a reult now comprise different percentage of your portfolio.   This can be dome by:

1. Adopting the Robin Hood rebalancing strategy- take from the rich (high performing assets) and give to the poor (poor performing assets)
2. Buying new units in the underperforming asset classes
3. Let it ride, and let the market's natural cycle rebalance for you.

Allow for Inflation

Inflation- the increase in the price of goods and servises, can wreck havoc on a long term investor's money.   Unless your returns keep balance with inflation, the value of your money erodes.  Your investments should be evaluated not only for their returns before inflation (nominal returns) but also for their returns after inflation.   A dollar invested invested in NZ Bonds between 1937 and 2003 earned a 6.7% average annual return.  Yet, according to the New Zealand Consumer Price Index, inflation during the same period averaged 5.7%.  The real rate of return for Bonds?   1%.   A dollar invested in New Zealand Shares over this period generated a 10.0% average annual return.  The real return- 4.3%.   That's over 4 times better than Bonds.

Call in the Experts

It can be a  good idea to discuss your investment strategies with financial industry professionals-  they may be able to assist in creating an investment strategy based on your particular circumstances and assist you in taking on appropriate investments. 

 

 

The information provided in this email newsletter is for informational purposes only.   McLean and Co. accept no responsibility for the opinions and information expressed in the information provided and it is provided "as is" without warranty of any kind.    The user assumes the entire risk as to the accuracy and use of this document.   Readers are asked to seek professional advice pertaining to their own circumstances.    The McLean and Co. email newsletter may be copied and distributed subject to the following conditions:

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