What are Income Tax Installment Payments?
For the large majority of Canadians, the concept of the income tax installment payment is simply not on their radar. As most individual Canadians earn income by way of an employment relationship, their taxes are withheld at source on each paycheque, and reported on the employer's T4 summary each year. The employee receives a T4 slip to prepare their taxes, and barring any large credits based on personal circumstances such as the disability tax credit, they prepare their simple tax return and are entitled to a small refund due to over withholding by the employer in the aggregate.
The purpose of the T4 system is obvious, in that it both provides security for the estimated taxes owing by each taxpayer who earns income as an employee, but it also creates what is in essence an interest free loan to CRA by the taxpayer – since technically these taxes are not due and payable until April 30 of the following year.
The Canadian income tax system is in principle, if not reality, meant to be based on fairness; this means that taxpayers are intended to be treated alike wherever possible without regard for how they structure their affairs or earn income. The problem with the T4 system is that it only applies perfectly to those who earn 100% of their income from employment. Those who earn income directly from a business or in other ways "fall through the cracks" of the withholding and remitting system.
To combat this, the Income Tax Act creates an income tax installment payment system that requires all taxpayers who it is reasonable to assume will have income taxes payable in excess of their overall withholdings to pre-pay on a quarterly basis the estimated taxes owing for the following year, in accordance with a choice of three formulae codified in the Tax Act.
Who is Required to Pay Tax Installments?
The Tax Act's system for determining which taxpayers need to make installment payments is found in sections 156 and 156.1. The basic rule is that where an individual will at the end of the year owe income taxes of $3,000 or more in excess of the overall amounts withheld from any source, that taxpayer is required to make installment payments. This $3,000 threshold amount applies to all individuals except those resident in Québec, where the threshold is set even lower at $1,800.
Installment tax payments themselves are required to be paid on a quarterly basis in the calendar year; the payments are due on or before March 15, June 15, September 15 and December 15. This obviously creates a conceptual problem, as no one, particularly those who earn business income can know precisely what their net income and tax liability will be until the year is actually over.
Accordingly, the Tax Act creates a requirement to pay installments if two conditions are met:
- The taxpayer's net tax owing for the year is $3,000 or more; and
- The taxpayer's net tax owing exceeded $3,000 or more in any of the two preceding taxation years.
The rules are obviously a bit recursive, and it can be difficult for one to determine if they will be required to remit installments in a given taxation year. The safest bet is if you have had net tax owing in both of the two preceding taxation years to assume that you must make installment payments.
The good news with respect to the timing issue inherent to the income tax installment application rules, particularly for those who may be required to remit tax instalments for the first time, is that the penalties associated with late remittance of the tax installment amounts are only applied by the CRA if they send the taxpayer a reminder in the form of Form INNS1 in February and/or August of their requirement to pay tax instalments. In the absence of this formal reminder by the CRA, tax penalties will not be charged. In practice, this means that until one reaches the threshold for installment payments, the CRA will not be aware nor capable of sending these reminders.
How Are Installment Payments Calculated?
There are three methods under which installment payments can be calculated for an individual, all of which are set out in section 156 of the Income Tax Act.
The first method allows the individual to calculate income tax instalments based on an estimate of their total income and taxes owing for the current year. If a taxpayer elects to use this method, they will not incur penalties even if they receive an installment reminder unless the amount that they remit ends up being less that what ought to have been paid by April 30. If this is the case, interest under 156(4.01) will apply, and a penalty will be applied under section 163.1 if the interest exceeds $1,000 for the late tax installment payments. Generally this method should only be used by those who have a very steady income stream throughout the year.
The second tax instalment calculation method utilizes the immediately preceding taxation year's tax owing above withholdings and requires that one quarter of that number be remitted each quarter by the due date. If a taxpayer utilizing this instalment method receives a reminder from the CRA to remit their installments, failure to do so will result in a penalty. This is the easiest formula for most taxpayers due to its simplicity.
The third and final tax instalment calculation method is more complex; the installments for March and June are first calculated as one quarter of the amount owing in the second preceding taxation year, while the September and December installments are calculated as one half the immediately preceding taxation year, minus the difference of one half of the second preceding taxation year. This method is rather complex, and usually results in limited benefit, so our experienced Canadian tax lawyers generally do not recommend utilizing this strategy in order to avoid the tax penalty pitfalls.
Regardless the method an individual may choose, there is a need to be cognizant of the quarterly deadlines and to ensure remittance on time. Any tax overpayments will be refunded at the time that the tax return is filed, although no interest will be refunded. As with most income tax matters the balance of convenience, as well as the monetary benefits and penalties, always favour the CRA. See below in our FAQ about how the non-refundable, but nevertheless calculated interest may still be put to some use.
Pro tax tips – Income Tax Installments Can be Retroactively Assessed
As expert Canadian tax lawyers the challenging tax installment computations does not often arise in our tax law practice as it is mostly an administrative tax function. One scenario that we do see from time to time is an individual client who is audited and their income for two or more taxation years is retroactively increased by way of tax reassessment. In these cases, it is important to be cognizant that the tax reassessment may have created an obligation to begin making installment payments in the current year, so individuals and their advisors should always keep the issue at the front of mind during the tax audit process. If you are interested in discussing your specific circumstances, including installment penalties and how our office can help you eliminate the cost of these penalties using the Taxpayer Relief Program, reach out to our seasoned Certified Tax Specialist Canadian tax lawyer today.