March 15 is around the corner for many of your clients to pay their first income tax instalment for 2009. With people feeling a little financially strapped, you may get some questions as to whether they really have to pay the full amount the CRA has asked for in the request it sent in February.
You may be able to give them some good news in answer to that question, but it’s important to know the rules to avoid costly interest charges.
Instalments are required if the difference between tax payable and amounts withheld at source is greater than $3,000 in both the current year and either of the two preceding years (this amount is $1,800 of federal tax for residents of Quebec). But even if your client is subject to instalments based on this rule, payments are not required until the CRA asks. Administratively, the CRA does not charge interest or penalties on late or deficient instalments in the first year they’re required, or where instalment requests have not been received by taxpayers.
There are three methods to determine the amount of the quarterly instalments. And, provided instalment payments are equal to the least amount determined by these methods, there will be no interest or penalty charges. The methods are:
1. Four instalments of one-quarter of the actual tax liability (in excess of tax withheld at source) for the prior year;
2. Four instalments of one-quarter of the total tax liability (in excess of tax withheld) for the current year; or
3. The first two instalments of onequarter of the actual tax liability (in excess of tax withheld) for the second preceding year, the last two instalments of one-half of the actual tax liability (in excess of tax withheld) for the prior year, less amounts paid in the first two instalments.
The CRA uses the last method in the payment requests it sends. As a result, if your client had significant capital gains or investment income in 2007, that number might be particularly high. A preliminary tax calculation for 2008 may indicate the second method produces a lower instalment amount.
Here’s an example. Suppose Martin’s February instalment notice from the CRA indicates his first two instalments for 2009 should be $4,500 each. He’s completed his 2008 return and it shows taxes payable of $6,600 (after source deductions). About $2,000 of that relates to capital gains realized in the year, while the remainder is in respect of other investment income. With the market downturn, Martin does not expect to realize any capital gains this year and so he believes his taxes payable for the year will be much less than last year; by his estimate, he’ll owe $4,600.
Instead of paying the $4,500 instalment request amount, Martin can use the prior year method; paying $1,650 on March 15, June 15, September 15 and December 15— with no risk of interest or penalty.
Now, if Martin is confident his taxes for 2009 will be less than $6,600, he might reduce instalments even further; say, to $1,150 based on his estimate of $4,600 of tax for the year.
But a word of caution—if the current- year estimate turns out to be too low, interest will be charged on defi- cient instalments, and this interest is quite high relative to conventional borrowing rates. (The prescribed interest rate for tax underpayments is currently 6% and it’s compounded daily.) To make matters worse, this interest is not deductible for tax purposes. And in cases of significant late or deficient instalments a penalty could also apply.
Although a low estimate can be costly, there is some good news. It’s possible for Martin to make up for deficient instalments by overpaying on future instalments. This effectively puts funds on deposit with the CRA. And, overpayments of tax generate interest income that can potentially completely offset any interest charges that have accrued.