When managing your tax obligations in New Zealand, two powerful tools can help reduce the amount you owe: tax deductions and tax credits. Although they both result in tax savings, they work in fundamentally different ways. Understanding these differences is essential whether you’re an employee, a self-employed contractor, or a business owner.
Below, we break down the distinction between tax deductions and tax credits, illustrate how they work, and refer to the relevant sections of the Income Tax Act 2007 for clarity.
What Is a Tax Deduction?
A tax deduction reduces your taxable income, which is the amount of income on which your tax is calculated. By lowering your taxable income, deductions indirectly reduce the amount of tax you owe.
How It Works
Suppose you are a self-employed web developer who earns $80,000 in gross income during the tax year. You spend $10,000 on legitimate business expenses, such as software, advertising, and travel. These expenses are generally deductible under section DA 1(1)(a) of the Income Tax Act 2007, which allows a deduction for expenses incurred in deriving assessable income.
Your taxable income would be calculated as:
$80,000 (income) − $10,000 (deductions) = $70,000 (taxable income)
You are then taxed based on the $70,000 figure, not the full $80,000.
Common Examples of Tax Deductions
- Business operating expenses (sections DA 1 and DB subparts)
- Interest on money borrowed for income-earning purposes (section DB 6)
- Depreciation on business assets (subpart EE)
- Donations to approved charities (section DB 41, subject to limits)
What Is a Tax Credit?
A tax credit reduces your actual tax payable, not your taxable income. This means that after your tax has been calculated based on your income, the credit is subtracted from the total amount owed to Inland Revenue.
How It Works
Imagine your calculated income tax for the year is $5,000. However, you qualify for the Independent Earner Tax Credit (IETC), which is worth up to $520 per year, as detailed in section LC 13 of the Income Tax Act 2007.
Your final tax payable would be:
$5,000 (calculated tax) − $520 (tax credit) = $4,480 (tax to pay)
Unlike deductions, tax credits apply dollar-for-dollar and provide a direct reduction in tax liability.
Common Examples of Tax Credits
- Independent Earner Tax Credit (IETC) – section LC 13
- Tax credits for charitable donations – section LD 1
- Foreign tax credits – subpart LF
- Working for Families tax credits – subpart M
Why It Matters
Understanding the difference between tax deductions and tax credits helps you make informed decisions about your finances and ensure you meet your compliance obligations effectively. Tax credits can be particularly valuable because they reduce your tax bill directly, while deductions work by lowering the income on which your tax is calculated.
Both mechanisms are supported and structured by the Income Tax Act 2007, which outlines who is eligible and what qualifies. If you’re unsure about what you can claim or how a specific credit applies to your situation, it’s advisable to seek professional advice or refer directly to the legislation.
Final Thoughts
Whether you’re preparing your tax return as an individual or running a small business, leveraging tax deductions and credits wisely can make a significant difference. Staying informed and understanding the legal framework that supports these tools empowers you to reduce your tax liability in a lawful and efficient manner.
If you have questions specific to your situation, such as how certain expenses or credits apply, consider speaking with a tax professional or consulting Inland Revenue for tailored guidance.
The content in this blog is intended to provide general insights and should not be regarded as professional advice. Each business situation is unique, and we recommend consulting with a professional for specific guidance. At Black Arrow Business Studio, we specialise in accounting and consulting services designed to support your business’s growth and success. Feel free to contact us for expert advice and customised solutions.
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