[Tax School] Explaining the Basic Rules and Practical Points of Executive Compensation

Hello, I am Irie, a Certified Public Accountant and Tax Accountant.

Whether you are thinking about starting a business or are a sole proprietor continuing your operations, you have likely considered "incorporation" at least once.

Which is better, a corporation or a sole proprietorship?
When is the right time to switch?

I imagine many of you are considering these questions.

One of the most important points to consider when thinking about incorporation is "executive compensation."
Even if it is the same salary, the tax treatment of employee salaries and executive compensation differs significantly.

The regulation for executive compensation is Article 34 of the Corporation Tax Act (Non-deductibility of executive compensation), but since this article is very long and can be difficult to read, I will not be explaining the article itself this time, but rather explaining it in a systematic and easy-to-understand way.
I will also touch on points that are easy to get wrong in practice, so please be sure to read on.

Now, let's start by understanding the difference between employee salaries and executive compensation.

Differences between employee salaries and executive compensation

First, even if it is the same salary, the major difference between employee salaries and executive compensation is the nature of the contract: is it an employment contract (compensation for labor) or a mandate contract (compensation for management)?.

If it is an employment contract, there is overtime pay and labor insurance. Executives do not have the concept of overtime pay, and in principle, they cannot join labor insurance.

Employee salaries and executive compensation may seem the same in that they are compensation paid by the company, but the nature of the compensation is completely different. Therefore, the tax treatment differs as follows.

Employee salary: In principle, it is fully deductible.
Executive compensation: If you do not follow the rules stipulated by law, it will not be recognized as a deductible expense.

You are free to pay executive compensation. However, even though the company's money is being paid to the executive, it results in a
double burden where it is not deductible for tax calculation purposes.

Significance of executive compensation rules and reasons for their strictness

So, why must the rules for executive compensation be followed?
From here on, I will explain the necessity of the rules and the reasons why they are strict.

1. To prevent profit manipulation

This is the biggest reason.
Executives are in a position to determine the company's management policy and their own compensation amount (or are in a position of strong influence).

If there were no rules, just before the end of the fiscal year, one could easily engage in arbitrary profit manipulation, such as saying, "We made too much profit this term, so let's significantly increase my salary to compress the profit!"

2. To distinguish between executive compensation and profit dividends

The dividends that a company distributes to shareholders are paid out of profits after corporate tax has been paid, and are not deductible. On the other hand, executive compensation is deductible as compensation for the service of management.

If executive compensation were allowed without limit, one could unfairly avoid corporate tax by paying out all profits that should have been paid as "dividends" under the name of "salary".

3. To prevent self-dealing

When executives decide their own compensation, it is called "self-dealing." If this is allowed,
there is a possibility that company assets will be improperly drained, harming the interests of shareholders and creditorsthere is a possibility that company assets will be improperly drained, harming the interests of shareholders and creditors

Tax law follows this line of reasoning, taking the stance that payments that have not gone through the procedures under the Companies Act (Article 361 of the Companies Act), or that exceed the limits set therein, will not be recognized as expenses for tax purposes.

4. The radical reform of 2006 (Heisei 18)

Under the Japanese tax system before the reform, payments to executives were clearly distinguished between "compensation (monthly)" and "bonuses (temporary)," but the rules were significantly changed by the 2006 (Heisei 18) tax reformthere is a possibility that company assets will be improperly drained, harming the interests of shareholders and creditors

Before the reform: Executive bonuses were in principle, not deductible as expenses.
After the reform: Changed to rules that emphasize the reality of "whether it was determined in advance" rather than the form.

With this reform, while allowing for flexible compensation systems for companies, the checking of expense recording through retroactive adjustments has become stricterthere is a possibility that company assets will be improperly drained, harming the interests of shareholders and creditors

5. The significance of the existence of these regulations

The regulations on executive compensation are not intended simply to increase taxes, but can be said to be fair taxation rules to prevent managers from arbitrarily extracting profits from the independent legal entity of the corporation. If these rules did not exist, everyone could increase their salaries just before the end of the fiscal year to make their taxes zero, and since tax fairness could not be maintained that way, strict rules have been established.

The "three types of compensation" recognized as deductible expenses

1. Periodic fixed compensation (paying a fixed amount every month)

• Rule: The same amount every month

• Timing of revision: In principle, within 3 months from the beginning of the fiscal year

• Points to note: Regarding increases or decreases after 3 months from the beginning of the fiscal year, there is a risk that all or part of it will not be deductible as an expense unless it falls under specified reasons.

2. Pre-determined notified compensation (so-called executive bonuses)

• Rule: Notify the tax office in advance of when and how much will be paid

• Strictness: If it is off by even one yen or one day, the entire amount is not deductible as an expense

3. Performance-linked compensation (mainly for listed companies)

This is paid based on objective indicators, but I believe it is difficult for small and medium-sized enterprises to adopt, so I will omit the explanation. In this article, you only need to remember 1 and 2.

This has been a fairly concise explanation to help you understand the overall picture of the regulations, but if you would like to know the details, please refer to the National Tax Agency's Tax Answer at the link below. No. 5211 Compensation for Executives (for resolutions on payment on or after April 1, 2017) | National Tax Agency

Practical points of caution and examples of countermeasures

① Recording unpaid fixed periodic compensation

In cases where cash flow is tight and executive compensation is processed as an unpaid liability without changing the amount, with the actual transfer amount reduced, it is easy to mistake this for fixed periodic compensation if the face value remains the same. However, in practice, if the unpaid status continues for a long period, there is a risk that it will be deemed that there was neither the intention nor the ability to pay that amount in the first place (i.e., it is not fixed periodic compensation) there is.

Countermeasure: If you cannot pay, take measures such as paying the full amount once and then processing it as an executive loan from the executive to the company.

② Mistakes of even one yen or one day in pre-determined notification compensation

If pre-determined notification compensation deviates by even one yen or one day, the entire amount of the payment will be non-deductible for tax purposes. For example, this happens in the following cases:

・The face value deviates from the notified amount due to calculation errors in withholding income tax or social insurance premiums.
・The payment date shifts by even one day due to cash flow circumstances or bank holidays.

This is the most inexcusable type of error.

Countermeasure: Confirm that the payment date for pre-determined notification compensation is not a holiday before entering it on the notification form. Also, set up internal company rules to prevent human error by setting up transfer reservations in advance.

③ Compensation for deemed executives

Regarding compensation paid to family members who are not executives on the registry, if you think that because they are employees, you can pay overtime and bonuses freely, you may be recognized as a de facto executive during a tax audit because you are engaged in management and thus considered a de facto executive.

If you are deemed an executive, all bonuses and overtime pay paid as an employee will become non-deductible, so caution is required.

Countermeasure: When making family members employees, keep evidence such as time card attendance management and the balance with other employees (the appropriateness of the salary for the job content).

④ Misunderstanding the 3-month rule for revision timing

A surprisingly common misunderstanding is that those who need to revise within 3 months from the beginning of the fiscal year think, "I can just change it from the 4th month."
As a general rule, payment after the revision must have started within 3 months from the beginning of the fiscal year so please be careful.

Countermeasure: Manage the schedule of the ordinary general meeting of shareholders, the payroll closing, and the payment date calendar as a set.

⑤ Compensation amount for part-time executives

Regarding cases where high compensation is paid to relatives who are only nominally executives, the tax office will strictly check the "actual work status (number of days at work, participation in meetings, submission of reports, etc.)." If it is judged that there is no actual work,
there is a possibility that it will be judged as unreasonably high and denied so please be careful.

Countermeasure: Keep evidence that can explain what the relevant executive did, such as signatures and seals on minutes, business report emails, and attendance records.

Understanding the regulations on executive bonuses is extremely important when considering company establishment. Let's organize it properly so that you don't end up in a situation where it is not recognized as a tax-deductible expense later!

Also, there are Basic Corporate Tax Circulars regarding executive compensation, so please check them for reference if you are interested.

Basic Corporate Tax Circulars
9-2-1 and following (Scope of Executive Compensation)
9-2-12 and following (Periodic Fixed Compensation)
9-2-14 and following (Pre-determined Notification Compensation)

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Irie Accounting Office