Prepaid expenses at year end: what has to be deferred

Every December a version of the same question arrives: can we pay next year’s insurance now and deduct it this year? The short answer is usually no, and the reason is a single subsection of the Income Tax Act that exists specifically to stop that from working.

The general rule: match the expense to the benefit

Businesses that compute income on the accrual basis are required by section 9 to calculate income from a business using accrual accounting, and for tax purposes that generally means following the matching principle: deduct the cost in the year the related benefit is received. For a prepaid expense that means deducting the outlay in the years in which the service is actually provided to you.

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) then gives the amount back: what is denied in one year is deductible in computing income for the subsequent year to which the outlay can reasonably be considered to relate. So the money is not lost. It simply lands in a different year — which is exactly the year-end timing question owners are usually trying to influence.

The everyday examples

Running expenses: the useful exception

Not every expense has to be matched to a benefit period. The courts have described running expenses as expenses that are not referable or related to any particular item of revenue — expenses necessarily incurred on a continuing and recurring basis for the general purpose of producing income. Those may be deducted in the year they are incurred, unless subsection 18(9) reaches them.

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 does not set a dollar floor, and the CRA has said plainly that materiality is a matter of judgement for which no de minimis rules have been established, while confirming that the practice of disregarding adjustments for insignificant amounts continues. The working test is distortion: would failing to defer the expense misstate profit for the year it was incurred and for the later year the benefit relates to?

For most small corporations that means the year-end schedule of prepaids is short — insurance, rent, a licence or two, sometimes a large deposit — and everything else is expensed. Chasing a $40 prepayment across two years costs more in bookkeeping than it saves in tax. The problem is the opposite case: a five-figure prepayment expensed in full because nobody looked at what period the invoice covered. That is a common entry on our list of 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 you have already received that can reasonably be expected to produce benefits — higher revenue or lower costs — in future periods. Organisation costs are the standard example: the professional and administrative fees of setting up a company, which are incurred once and benefit the business for years. Depending on the item, part or all of the expense may have to be deferred and amortised on a reasonable and systematic basis. If you have just set up, our just-incorporated checklist covers what to do with those costs.

Getting it right at year end

The practical routine is short. Pull the payments made in the last two or three months of the year that are unusually large or that cover a fixed term. For each, note what period the payment buys. Split anything that crosses the year end, post the future portion to prepaid expenses, and set a reversing entry in the new year so it is actually deducted then. Then check the schedule against last year’s — a prepaid that never reverses is a sign the entry was made and 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.