Corporation Tax Deductibility of Year End Bonuses

H M Revenue & Customs have recruited significant numbers of qualified accountants with a view to ensuring that Tax Inspectors are well advised on the accountancy and commercial aspects of all matters that have a bearing on a company’s tax position.

The issue in question is the inclusion of provisions for directors’ or employees’ bonuses in year end accounts in respect of payments made thereafter and the consequent corporation tax deduction claim.

Background and the “Nine Month” Rule
Accrued salary or bonuses must to be paid via PAYE within nine months of the accounting period end in order to be eligible for a corporation tax deduction in the year in which a provision is made rather than the year of actual payment.

Occasionally the issue will arise as to whether payment has actually been made within the nine month period and for these purposes it is necessary to consider when remuneration is deemed to be paid.  For tax purposes this is the same date as when the remuneration is deemed to be received by the director or employee.  This is also the relevant date for PAYE accounting purposes and must be within nine months of the balance sheet for a corporation tax deduction to be granted in the year in which a provision is made.

From the above it will be clear that a bonus entitlement accrued in the year end accounts on which PAYE is operated and the net amount either paid out or credited to a director’s loan account within nine months of the year end will usually be sufficient to ensure the availability of a corporation tax deduction.  This, however, is subject to the provision in the year end accounts being valid under generally accepted accounting practice a matter which is considered in more detail in the rest of this letter.

Validity of Provisions in Year End Accounts

Following the withdrawal of Standard Statement of Accounting Practice 17 the most significant accounting standards to consider in this respect for companies preparing accounts under UK GAAP are Financial Reporting Standards 12 and 21.

FRS 12 Provisions, Contingent Liabilities and Assets/FRS 21 Post Balance Sheet Events
In order for a provision to be recognised in the accounts of the company, the following criteria must be met. 

• A present obligation (legal or constructive) must exist (on the balance sheet date) as a result of a past event.
• It must be probable that a transfer of economic benefits will be required to settle the obligation.
• It must be possible to form a reliable estimate of the amount of the obligation.

FRS21 dovetails with the above by stating that events after the balance sheet date should only be incorporated into accounts where the circumstances giving rise to the event were in existence at the balance sheet date.

The advice which follows is therefore concerned with, ideally, creating a legal obligation as at the balance sheet date or justifying a provision by reference to a constructive obligation.

Recommendations
• Best Practice in terms of demonstrating a present obligation at the balance sheet date would be to prepare a formal Board Minute prior to the year end documenting the directors’ intention to pay a bonus or bonuses and outlining the specific amounts involved.
• If the specific amounts are not known, the directors may prefer to establish a structure or formula for the amounts involved according to which they can be calculated once the draft accounts have been prepared and are available for review, for example a percentage of after-tax profit above a certain level.  Minuting this decision prior to the balance sheet date would also give rise to the necessary obligation at the balance sheet date.
• Where a specific decision has not been made, a history of bonuses being paid potentially based on the trading performance of the business or individual performance may be sufficient to demonstrate a constructive obligation especially if the directors were to determine, again before the balance sheet date, a policy of continuing the previously adopted bonus policy.
• In the absence of a history of bonus payments, there may be evidence to suggest that a constructive obligation has nevertheless arisen where the director or employee in question has been given a valid expectation they will receive a bonus, either as a result of the performance of the business as a whole or their individual performance.  Ideally such an expectation should be documented before the balance sheet date.

Dividends
The issues highlighted are unlikely to cause any difficulties where, following a year end, the directors of a company decide to pay a dividend to the company shareholders.  Whilst the current accounting standard governing events after the balance sheet date (FRS 21) prohibits the inclusion of proposed dividends in the accounts of the company this has no bearing on the corporation tax position as no tax relief is available to the company in respect of a dividend payment and under such circumstances the dividend will be shown in the year in which it is paid.