At the conclusion of the financial year it emerges that the company has garnered a healthy profit, and as the shareholder and managing director, you would also like to get a slice of the pie by means of paying out a portion of the profit into a private account. In this article we examine a few of the most common techniques to do this and we explain the advantages, disadvantages and the legal implications.
We are here looking at a situation where you are both shareholder and manager of your company, in which case (and maybe without even being conscious of it) you are fulfilling two positions in your company. On the one hand you are a shareholder and thus a financier of the company, as you have made private funds available in exchange for which you have received shares. Simultaneously, you are also the manager (general manager or director) and you lead the company to further growth and profits. In this capacity you are not making your capital available to the company, but rather your labour and your expertise.
The above distinction is important in order to better understand the different profit distribution techniques. You are remunerated for the work you perform as managing director, a salary that in most cases is paid periodically and is fixed.
But the salary can easily be used as an initial technique for retrieving profits from the company. Aside from the periodic salary that is already paid to you, the company can naturally also award you a non-periodic or one-off bonus. From both a tax and an accounting perspective this is rendered as the same as ordinary salary, which means that for the company the bonus is fully deductible but social security contributions must still be deducted from it, as must income tax be deducted at source by the company. Given that the standard salary must already be taken into account, the income tax deducted at source on this bonus will often be 50%, never mind any municipal surcharges and social security contributions on top of that. As the bonus is in principle payable at the time that it is registered (such as on the final day of the financial year), this is the time when the manager’s bonus is likewise taxable. A bonus awarded to the manager for the 2016 financial year will also be taxable under his personal income tax in the 2016 income year.
From a tax perspective a salary is thus remuneration for work performed. This means that the tax authorities can see exactly whether work was effectively performed in exchange for this bonus invoice, which means that for a bonus invoice we recommend that a bonus is included in the management agreement concerning remuneration, where it is determined that a part of the profits, cash flow or even other parameters will be paid out as a bonus on the basis of specific calculation methods. This will prevent disputes with the tax authorities in the event of a future audit.
Given that the bonus is thus entered as standard salary, a bonus invoice will reduce the company profits. Imagine that, as a purely theoretical exercise, all the profit is distributed in the form of a bonus and there is no profit left in your annual accounts. In some cases this can be disadvantageous, as your bank will be less inclined to approve certain lines of credit, given that your company does not appear to be profitable. But sometimes it can be to your advantage: imagine your customers or even your suppliers start to adjust prices when it is evident from your annual accounts that your company is hugely profitable and you can easily grant a discount (for customers) or you will no longer receive a discount (from suppliers). In such a case it could be to your benefit to conceal a large portion of the profits by means of a bonus invoice, as the details of such an exercise are not be registered in the annual accounts.
Finally, we would also like to point out that, if there is more than one manager, there are no obligations when it comes to distributing the profits through the bonus system. There is no reason why you cannot award a large bonus to one manager and nothing at all to another, as long as such is substantiated.
3. Profit-sharing bonus
Strictly speaking, a profit-sharing bonus is simply the appropriation of profits. The company makes so much profit and during the general meeting the shareholders can decide what to do with that profit – they can decide to reserve the profits within the company, pay it out as remuneration to the shareholders (a dividend) or as remuneration to the directors (a profit-sharing bonus).
Yes, that’s right. A profit-sharing bonus is likewise in principle a remuneration paid to directors. While in accounting terms a profit-sharing bonus may be profit appropriation, in tax terms it is considered to be remuneration for directors. That means that a profit-sharing bonus is also deductible for the company paying it out, although when paid out to a manager it will be taxed as a manager’s salary – including the social contributions, personal income tax up to 50% and municipal surcharges.
So on the face of it there does not appear to be too much difference between the profit-sharing bonus and the straight bonus, but in reality there are a number of striking differences.
The first difference involves the timing. A profit-sharing bonus is deemed to be payable at the time of the general meeting which decides on what to do with the profits from the previous financial year. So if we hold our general meeting for the 2016 financial year in 2017 and we decide to issue a profit-sharing bonus, then this profit-sharing bonus will be deducted from the 2016 profits, making it a deductible cost for 2016. But in reality the profit-sharing bonus is only rendered payable in 2017 and for the manager will only be taxable in the 2017 income year, which means your taxes for it are deferred by a year.
A second difference can be found in the accounting. Because a profit-sharing bonus is nothing more than the appropriation of profits from an accounting perspective, the company profits will not be reduced when a profit-sharing bonus is paid out. The profits stay the same, it will just be shown in the appropriation thereof that the profit was paid to the managers. As already explained under the bonus invoice, this could have both a positive and a negative impact, and it is up to you to decide which factors will be decisive.
Finally, there is also a difference when it comes to substantiation. While we explained that a specific methodology or calculation method had to underpin the bonus invoice, this is not the case for a profit-sharing bonus. The tax authorities did used to try and dispute a profit-sharing bonus, arguing that it was not the result of any actual work, but the Court of Cassation rejected this argument. The Court (rightly) asserted that a profit-sharing bonus was purely profit appropriation that is solely decided on by the shareholders and that nobody has to explain. This means it does not have to be substantiated, which naturally does not mean that your tax files won’t be on a firmer footing if this action is substantiated.
So the appropriation may also be performed ad libitum under a profit-sharing bonus.
As we stated in the introduction, you probably perform two jobs in your company – on the one hand you are a manager and on the other you are a shareholder/financial backer. You have already received a slice of the profits through the bonus invoice or profit-sharing bonus as manager, but of course you also want to see a return on your investment as the financial backer. Dividends can be paid out as yield to the shareholders in exchange for making funds available.
While from an accounting perspective dividends are pretty similar to profit-sharing bonuses – they are both forms of profit appropriation – there are still a few crucial differences.
Aside from the fact that this is not remuneration paid to managers but to shareholders, the first difference entails the fact that a dividend must be paid on a pro rata basis to the shareholders. Every share (of the same category) must receive an equal portion of the dividend. The biggest difference is found when it comes to taxation. Because a dividend is not remuneration for work performed by a manager but one for a monetary investment, the dividend is considered to be non-deductible by the company and, in most cases, withholding tax must be deducted when it is paid out. For the withholding tax rates, please refer to an earlier article published in our newsletter.
5. Dividend, profit-sharing bonus or bonus?
Because the shareholders and managers are one and the same persons in many small companies and SMEs, one can more-or-less choose how to pay out the profit or a portion thereof. Purely from a tax perspective, a dividend will generally be more advantageous than a profit-sharing bonus or a bonus. While you may pay tax twice on a dividend (corporation tax and withholding tax), the same is true for a profit-sharing bonus or bonus invoice. And although a profit-sharing bonus or bonus invoice is deductible for the company, personal income tax and social security contributions must still be deducted from the manager. So, when paid to a natural person, a dividend is generally the best option. It is only when social security contributions do not have to be paid (if you have already reached the upper threshold) and if you cannot employ reduced withholding tax rates that a profit-sharing bonus or bonus could cost less than a dividend, but this will still depend on the municipal tax rates.
6. Management or controlling companies
In the above analysis we assumed that the shares were held privately and that the directors were appointed in their personal capacity. So we have not yet examined holding and/or controlling companies.
The principles remain the same when we focus on controlling or holding companies, but there are a number of significant nuances.
The same principles effectively apply for the bonus and profit-sharing bonus, as they are deductible for the company paying the bonuses and the beneficiary must be taxed in full for them as professional income, but where the beneficiary is a company, this income is taxed at the corporation tax rate. This means that, as it were, the tax burden is simply shifted from the controlled company to the controlling company. In the event of an onward payment to the shareholders and/or directors who are natural persons, then the principles explained above once again apply.
For a dividend distribution to the holding company, this dividend is not deductible, but if the dividend is paid out to the holding company withholding tax will in most cases not have to be deducted. In the holding company itself, 95% of the received dividends can at that time be exempted, subject to the deduction of the definitively taxed income or the curtailed DTI-deduction. Because of the fact that to date a mere 5% is taxed, we are here dealing with additional taxation of 5% x 33.99% = 1.69%.
So if both the shares of the operating company are held by the holding/controlling company and its management is performed by that company, then it will generally be more advantageous to pay out a bonus/profit-sharing bonus.
On the basis of the current legislation, it thus depends on whether the shareholders and management are natural persons or companies. This will affect the decision on which method of payment is most appealing from a tax perspective. But, as explained above, non-tax motives can also play a role.
In conclusion, we would like to reiterate that talks in government circles are in an advanced stage on reforming the corporation tax, which can naturally affect this comparison. We will keep you informed in the event of any changes!