Prepaid expenses at year end: what has to be deferred

Every December the same question arrives: can we pay next year’s insurance now and deduct it this year? Usually not, because one subsection of the Income Tax Act exists to stop exactly that.

The general rule: match the expense to the benefit

Section 9 requires businesses on the accrual basis to compute business income using accrual accounting, which for tax generally means the matching principle: deduct a cost in the year the related benefit is received. A prepaid expense is deducted in the years the service is actually provided.

Related: Cash or accrual accounting.

Subsection 18(9) makes the matching principle mandatory for a specific list of items rather than leaving it to accounting judgement. Paragraph 18(9)(a) denies a deduction to the extent an outlay or expense can reasonably be regarded as having been made:

• as consideration for services to be rendered after the end of the year;
• for interest, taxes (other than taxes on insurance premiums), rent or royalties for a period after the end of the year; or
• as consideration for insurance for a period after the end of the year, subject to narrow exceptions for reinsurance where the taxpayer is an insurer and for certain group term life insurance.

Paragraph 18(9)(b) gives it back: the denied amount is deductible in the later year to which the outlay reasonably relates. Not lost, just moved, which is exactly the timing owners hoped to change.

The everyday examples

Running expenses: the useful exception

Not every expense needs matching. The courts call running expenses those not tied to particular revenue, incurred continually and recurrently to earn income. They are deductible when incurred, unless subsection 18(9) applies.

Whether a given cost is a running expense is a question of fact, not a label you choose. General advertising and ordinary overheads often sit comfortably in this category; a twelve-month prepaid insurance policy does not, because 18(9) names insurance explicitly.

Materiality: what actually gets adjusted

The Act sets no dollar floor. The CRA calls materiality a judgement with no de minimis rules, while ignoring insignificant adjustments continues. The test is distortion: would not deferring misstate profit for the year incurred and the later year?

Most small corporations' prepaid schedule is short: insurance, rent, a licence or two, perhaps a deposit; the rest is expensed. Chasing a $40 prepayment costs more than it saves. The real risk is a five-figure prepayment expensed in full, a common entry in our bookkeeping mistakes.

What subsection 18(9) does not cover

Three categories sit outside this discussion entirely:

• Inventory. Goods bought for resale are not a prepaid expense. They are valued and carried under the inventory rules. See the year-end inventory count.
• Land. The cost of acquiring land is not deductible as a prepaid expense.
• Depreciable property. Equipment and other property described in Schedule II to the Regulations is deducted through capital cost allowance, not through matching.

Deferred charges are a separate idea

A deferred charge is not a prepayment. It is the cost of a service already received that should benefit future periods. Organisation costs are the standard example: the fees of setting up a company, which benefit the business for years. Part or all may need deferring and amortizing on a reasonable and systematic basis. Just set up? Our just-incorporated checklist covers those costs.

Getting it right at year end

The routine: pull large or fixed-term payments from the last two or three months. Note the period each buys. Split anything crossing year end, post the future part to prepaid expenses, and set a reversing entry. Then compare with last year; a prepaid that never reverses was forgotten.

Doing this at the same time as the rest of the year-end checklist takes very little time. Doing it eighteen months later, when a reviewer asks what period the invoice covered, takes a great deal more.

This article is general information, not tax advice for your specific situation. Tax rules and CRA administrative positions change — confirm anything that affects a decision with the CRA or with us first.