Beware of Unexpected Pitfalls! Basic Knowledge You Should Know Before Reviewing Executive Compensation
Executive compensation is determined based on company performance and the duties of the executive, but because there are many tax rules involved, caution is required. Making changes halfway through can lead to unexpected risks, such as the compensation becoming 'non-deductible.' Therefore, we have summarized the basics of executive compensation and key points to keep in mind as clearly as possible. Please use this as a reference.
■ Basics of Executive Compensation and Tax Deductibility
Salaries and bonuses for employees, etc.
For tax purposes, in principle, the full amount is tax-deductible.
Salaries and bonuses for executives (executive compensation), etc.
To prevent arbitrary profit adjustments by management, in principle, it is non-deductible.
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However, if any of the following apply, tax deductibility is permitted, excluding any unreasonably high portions.
Regular fixed compensation
Pre-notified fixed compensation
Performance-linked compensation (*Listed companies only)
■ What is Regular Fixed Compensation?
This is a representative method that small and medium-sized enterprises can adopt. It must meet the following two requirements (no notification to the tax office is required).
Paid every month (or at regular intervals of within one month)
The amount for each payment period must be the same throughout the fiscal year
Caution!
If you arbitrarily increase or decrease the amount during the fiscal year, it will no longer be the same amount, which carries the risk that tax deductibility will not be permitted.
◇ Conditions under which a 'regular revision' of regular fixed compensation is permitted
Revisions are permitted at a fixed time every year, such as at the regular general meeting of shareholders after the fiscal year-end, but the following requirements must be met.
The revision must be made within three months from the beginning of the fiscal year in principle (e.g., by the end of June for a corporation with a March fiscal year-end)
The monthly payment amount before the revision must be the same within the fiscal year
The revised monthly payment amount must remain the same throughout the fiscal year.
◇ When a 'reduction revision' due to poor business performance is permitted
If there are unavoidable circumstances such as the following, a reduction during the fiscal year may be permitted as a deductible expense.
When the figures in the financial statements have deteriorated significantly
When the company is on the verge of bankruptcy
When a reduction is unavoidable due to the deterioration of business conditions in relation to third parties (shareholders, creditors, business partners, etc.)
Point
When making a reduction revision, objective and concrete supporting documentation (such as board meeting minutes) is essential. Vague reasons like 'cash flow is tight' will generally not be accepted for tax deduction purposes.
■ What is Pre-determined Compensation?
This is compensation that is paid at a predetermined amount at a specified time separately from monthly remuneration.
It is used when paying bonuses to executives or when paying compensation only once a year to part-time executives.
In the case of non-family corporations (companies with less owner-management influence), there are cases where notification to the tax office is not required.
◇ Main Requirements
Pass a resolution at the shareholders' meeting to fix the payment amount and prepare minutes
Based on those minutes, submit a notification to the tax office within one month
Pay executive compensation exactly on the payment date and in the amount stated in the notification
If it is not as notified, it will not be deductible!
If you do not notify the tax office, or if the payment date or amount does not match the notification, the entire amount will not be deductible.
■ Points to consider when deciding executive compensation
Do not change the compensation amount once decided arbitrarily during the fiscal year
Changes other than 'regular revisions' aligned with the fiscal year-end or reductions due to justifiable business deterioration are generally not allowed
If you choose to use pre-determined notification compensation, be sure to notify the tax office within the deadline and pay it exactly as notified.
If you make a mistake in how you determine executive compensation, you face significant risks, such as being unable to include it as a deductible expense, which increases your tax burden. To avoid unexpected changes during the fiscal year, make sure to carefully develop management plans and performance forecasts before considering monthly salaries and bonuses (pre-determined notification compensation).
Summary
Executive compensation can be included as a deductible expense if you follow rules such as "regular fixed compensation" and "pre-determined notification compensation," but increasing or decreasing it mid-term carries significant risks. To prevent unexpected trouble, ensure you are well-prepared and do not forget to complete tax procedures and submit the necessary notification forms.