How to Include Executive Compensation as a "Tax-Deductible Expense": Regular Fixed Compensation, Pre-determined Notification Compensation, and Performance-Linked Compensation
In the previous article, I wrote that executive compensation can be included as a "tax-deductible expense" (a business expense for tax purposes) if certain requirements are met. In this article, I will explain those requirements in detail.
You can find the previous article here!
It covers the basics of executive compensation, so please take a look!
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How can executive compensation be included as a tax-deductible expense?
To include executive compensation as a "tax-deductible expense," you must meet the requirements for one of the following three forms:
"Regular Fixed Compensation," "Pre-determined Notification Compensation," or "Performance-Linked Compensation."
Also, as mentioned in the previous article, executive bonuses cannot be included as a "tax-deductible expense" for tax purposes.
However, by meeting the requirements for the "Pre-determined Notification Compensation" or "Performance-Linked Compensation" mentioned above, it becomes possible to include them as a "tax-deductible expense."
I will explain each of these in detail below.
・Regular Fixed Compensation
During the fiscal year, you pay the same amount at regular intervals of one month or less (such as every month).
Because a fixed amount is paid, you cannot pay additional allowances or similar items.
The amount is determined in advance by the articles of incorporation or a resolution of the general meeting of shareholders.
There is no need to notify the tax office.
This fixed amount must be set within three months of establishment and, in principle, cannot be changed.
However, you can change the amount in any of the following cases:
・Changes made within 3 months from the start of each accounting period
・Cases involving extraordinary revision events such as a change in an executive's position
・Cases involving performance-based revision events such as a deterioration in business conditions
However, even after a change, you must continue to pay the same amount until another change occurs due to the reasons above.
・Pre-determined Notification Compensation
You pay a pre-determined amount of money, or a fixed number of shares or stock acquisition rights, at a specific time.
You must submit a "Notification of Pre-determined Notification Compensation" to the tax office in advance.
If you do not pay exactly as described in the notification, it cannot be included as a tax-deductible expense.
<Submission Deadline>
Pattern 1: When notifying in advance
This applies when you are setting executive compensation as Pre-determined Notification Compensation from now on.
・The earlier of "within 1 month from the date determined at the general meeting of shareholders" or "within 4 months from the start of the accounting period"
Pattern 2: When you did not originally notify in advance and are newly notifying due to an extraordinary revision event
This applies when you are setting executive compensation that was already determined in a form other than Pre-determined Notification Compensation as Pre-determined Notification Compensation due to an extraordinary revision event.
・The later of "the deadline for Pattern 1" or "within 1 month from the date the extraordinary revision event occurred"
Pattern 3: When changing something that has already been notified
This applies when changing the content already determined as Pre-determined Notification Compensation due to an extraordinary revision event or a performance-based revision event.
・Extraordinary revision event → within 1 month from the date it occurred
・Performance-based revision event → within 1 month from the date the change was determined at the general meeting of shareholders
Even if there was no notification by the deadline, if it is recognized that there were unavoidable circumstances, it may be possible to include the Pre-determined Notification Compensation as a "tax-deductible expense" as if the notification had been made by the deadline.
What are extraordinary revision events and performance-based revision events?
What are these two events mentioned in the explanations for Regular Fixed Compensation and Pre-determined Notification Compensation?
As I wrote in the previous article, they are as follows.
<Extraordinary Revision Event>
Cases where there are unavoidable circumstances during the fiscal year, such as a change in an executive's position or a significant change in the content of an executive's duties.
<Performance-based Revision Event>
Cases where there are unavoidable circumstances that force a reduction in compensation, such as a significant deterioration in business conditions during the fiscal year.
・Performance-linked compensation
This is paid in connection with the company's performance.
Because it is determined based on the company's profits, sales, and stock price, there is a possibility that high compensation will be paid if performance is good.
For performance-linked compensation to be recognized as a "deductible expense," several requirements must be met.
To briefly extract a few:
・It is a delivery of cash or qualified stock or qualified stock options
・It is limited to a fixed amount or a fixed number
・It is paid to all other executive officers who meet the requirements for performance-linked compensation
・Within 3 months from the start of the fiscal year, a certain compensation committee, etc., determines the calculation method and follows appropriate procedures
and other requirements.
In addition to these, there are multiple detailed requirements, and in order to include it as a "deductible expense," it is necessary to satisfy all of them.
For details on the requirements, please check the
National Tax Agency website "No. 5211 Compensation for Executives (for resolutions made on or after April 1, 2017)""
.
The above are the three forms for including executive compensation as a "deductible expense."
However, even if the requirements for any of the three forms above are met, there are cases where it cannot be included as a "deductible expense."
Cases where it cannot be included as a "deductible expense"
Even if executive compensation meets the requirements for any of the three forms: "Regular fixed compensation," "Pre-determined notification compensation," or "Performance-linked compensation," the portion that is unreasonably high will not be included as a "deductible expense."
This is to prevent corporate tax from dropping significantly by reducing profits through increasing executive compensation.
What is unreasonably high?
There are two criteria for judging whether the paid executive compensation is unreasonably high: the "substantive standard" and the "formal standard," and judgment is made based on these.
Substantive standard
・・Duties of the executive
・Profit situation
・Payment status of employee salaries
・Payment status of executive compensation at other companies in the same industry with similar business scale
Comparing these, the portion that exceeds what is recognized as reasonable is the excess portion (1)
Formal standard
The portion that exceeds the executive compensation limit set by the articles of incorporation or a resolution of the general meeting of shareholders excess portion (2)
Comparing the amounts of this excess portion (1) and excess portion (2), the higher amount becomes non-deductible expense. (It cannot be treated as a business expense for tax purposes.)
Let's look at one past judicial precedent here.
There is a case where it was determined that the portion of the executive compensation paid to the claimant's representative director that exceeded the maximum amount of executive compensation paid to representatives of similar corporations in the same industry was an unreasonably high portion.
Source: National Tax Tribunal website, April 25, 2017 ruling, Collection of Ruling Cases No. 107
In this ruling, the following points based on the substantive standard were argued. (Partially extracted)
Compared to the maximum amount of executive compensation for representatives of similar corporations in the same industry, the amount of executive compensation for the representative in this case is extremely high, and there is clearly an unreasonably high portion
The content of the duties is not evaluated as being worthy of paying exceptionally high executive compensation
As described above, the issue of whether executive compensation is unreasonably high is prone to becoming a point of contention, and there is a possibility of tax audits or lawsuits, so please be careful when deciding the amount of executive compensation.
Summary
To include executive compensation as a deductible expense, you must follow specific rules.
When setting executive compensation, it is important to correctly understand these requirements and standards, and to determine the amount based on appropriate procedures and criteria.
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