In order for an expense to be “incurred”, an amount must be paid or there must be a legal obligation to pay an amount (see The Queen v. Ken & Ray’s Collins Bay Supermarket Ltd., 75 DTC 5346, [1975] CTC 504 (FCTD) as well as Newfoundland Light & Power Co. Ltd. v. H.M.Q. 90 DTC 6166, 1 CTC 229 (FCA)).

Has the expense been incurred?  If a genuine liability exists at the end of the year, an expense has been incurred. If there is some uncertainty associated with the liability, if it is a reserve or a contingent liability, its deduction is specifically denied under paragraph 18(1)(e) (unless it is specifically permitted elsewhere in Part I of the Act).

Facts that may cast doubt on the existence of a legal liability in respect of the bonus are as follows:

-           there was no directors’ resolution declared before the end of that year in respect of the bonus,

-           the amount was not precisely determined until after the year end,

-           the amount was not set up as a liability in the accounts until after the year end,

-           the likelihood of payment of the bonus is questionable.

A number of Court decisions have dealt with the existence of a legal obligation in respect of accrued bonuses.  In McClain Industries of Canada Inc., 78 DTC 6356, [1978] CTC 511 (FCTD), bonuses were historically a component of compensation.  They were predicated on the general principles enumerated in a directors’ resolution passed 22 years earlier.  These principles, consistently followed by actual payments supported the characterization of the accrued amounts as actual liabilities.

In Brazolot Construction Limited v. MNR, 81 DTC 449, [1981] CTC 2468 (TRB), there was never any written document which required the company to pay a management fee annually; however, the company had made a practice of accruing a management salary for its president at the end of each taxation year, for payment before the end of the following taxation year.  The Court held that the accrual was in accordance with an established practice and, therefore, an obligation did exist.  In that case, the Court made a statement as to what it considered to be a legal obligation:

“The evidence for the existence of a ‘legal obligation’ to pay was

(a)        the previous years’ established pattern;

(b)        the standard accounting entries in the record setting it up; and

(c)        the reference to it in the financial statements for the year.”

In Evergreen’s case, bonuses had been accrued and paid in the last 10 years pursuant to a 19X4 directors resolution. The accrual in the accounts and the payments in the previous years indicate an established pattern of accruing and paying bonuses.  The fact that the bonus will not be paid does not in itself indicate that a liability did not exist at year end.  As indicated in the Brazolot case, the inability to pay the bonus resulted from events that occurred after the year end.  At the time that the bonus was accrued, there was every intention and ability to pay the bonus and therefore, at the year end, a genuine liability did exist.

With respect to the fact that the bonus was not precisely determined or set up in the accounts until after the year end, it is common for companies to base their bonuses on the profits for the year, in which case, the precise amount and the accounting entries are not made until after the year end.  In the case of V. R. Enterprises Limited v. MNR, 74 DTC 1089, [1974] DTC 2099 (TRB), 79 DTC 5399, [1979] CTC 465 (FCTD), the Court described criteria for the deductibility of bonuses.  It indicated that the bonus accrued in a particular year must be established within a reasonable time from the moment the corporation’s profit for that year has been determined.

Having decided that a liability was incurred, was the bonus incurred for the purpose of earning income from a business? Other possible purposes for the bonus could be:

-           a gratuitous payment

a payment of a dividend

-           the reduction of tax

With respect to the first two points, bonuses are a common method of remunerating director-shareholders.  A number of cases dealing with the deductibility of bonuses have dealt with the tax reduction motive.  In Brazolot, the agent for the appellant stated:

“I think the taxpayer is certainly entitled to arrange his affairs in such a way as to take advantage of an available low rate of tax.”

In the case of Pioneer Designs Corporation v. MNR, 91 DTC 293, [1990] 2 CTC 2446 (TCC), the company bonused down to the small business limit for the year.  One of the Minister’s arguments for denying the deduction was that the bonus was principally motivated by the corporation’s desire to benefit from the low rate of tax.  However, in the Court’s view, the main reason for accruing the bonuses was to compensate directors for their successful management of the business.

The tax reduction motive relating to bonuses was not successfully argued by the Minister in other cases (Earlscourt Sheet Metal Mechanical Limited v. MNR, 88 DTC 1029, [1988] 1 CTC 2045 (TCC), and La Compagnie Idéal Body Inc. v The Queen, 89 DTC 5450 (Eng.), 5344 (Fr.), [1989] 2 CTC 187 (FCTD)).  In La Compagnie Idéal Body Inc., the Court concluded:

“…directors of a small business of this kind, who hold effective control over the business, are always entitled to make the necessary calculations between the profits of the business on the one hand and salaries and bonuses on the other so as to reduce the cumulative impact of taxation as far as possible, so long as the transactions are not wrongful or unreasonable.”

Note, not only must an expense be incurred for the purpose of earning income from a business or property (pursuant to paragraph 18(1)(a)), to be deductible for tax purposes, it must also be reasonable in the circumstances in accordance with the general limitation found in section 67.  Whether an expense is reasonable or not in the circumstances is a question of fact, determined by the particular situation.

In V.R. Enterprises Limited v. MNR, the Court indicated that one of the criteria for the deductibility of bonuses was that the amount must be reasonable in comparison with the profit earned by the company and the services rendered by the recipients.

Under subsection 78(4), salary or bonus accrued by a corporation in a taxation year, must be paid within 179 days of the corporation’s year end in order to be deductible to the corporation. Note the wording in the provision is

“Where an amount…is unpaid on the day that is 180 days after the end of the taxation year in which the expense was incurred…”

This means that the amount cannot be paid on the 180th day to avoid application of the provision because it was unpaid at some time on the 180th day.