In Information Circular 71-14R3, the CRA describes the purpose of the tax audit as follows:
“While there is, in Canada, a high standard of public compliance with the law, a self-assessment tax system can be maintained only through careful inspection of returns. The primary purpose of the tax audit is to monitor and maintain the self-assessment system. As such, it plays an important role in the achievement of the objectives of the Department which are to collect the taxes imposed by law through the encouragement of voluntary compliance and to maintain public confidence in the integrity of the tax system.”
Canadian taxpayers panic when they discover they are going to be audited–regardless of how careful they have been with their filings. To help reduce the panic it is essential to understand your rights and obligations. Not only can it reduce your panic, it can help save a tremendous amount of money and grief.
CRA’s Audit Powers
To be prepared for an audit and to survive unscathed, it is essential to understand the broad powers of the CRA which allow it to demand or even seize documents (i.e., physical or electronic) both in your possession and in the possession of others (e.g., your accountant, your bank, eBay, Home Depot).
Any information which can be used against you to prove that you were not declaring the correct amount of tax owing can be demanded by the CRA from you and third parties in the course of an audit, and it can require under pain of punishment, that those demands are respected. Rest assured, any information which the CRA obtains will be used to ensure that you pay as much tax as possible.
Under Canadian tax law, the auditor has the following rights:
- To examine all books, records, and documents of the taxpayer that could relate to the audit, and any books records and documents held by third parties, which pertain to the audit of the taxpayer.
- To enter and inspect home offices and any other place where the taxpayer carries out their business, holds property or maintains records.
- To require the cooperation of the taxpayer and third parties.
- To make a copy of any document required for the audit (i.e., digital or physical) or to demand a printout of a digital document.
- To not to be interfered with. Section 231.5 of the act states that “no person shall, physically or otherwise, interfere with, hinder, or molest” an auditor while he or she is performing their duties.
How the CRA Selects Businesses to Audit
There are four common ways of selecting business returns for an audit according to the CRA:
- Computer-generated lists
This is the primary way of choosing a business for audit. The CRA’s computer system prepares specific lists after comparing financial information of taxpayers in the same industry or occupation. Where the system determines there is the potential recovery of taxes because of underdeclared revenues or overstated expenses, those tax returns will be put on a list. From these lists the CRA chooses specific returns for audit.
- Audit Projects
The CRA continuously monitors taxpayer industries that have a low level of compliance with tax legislation. One such group is those involved in the construction industry. Construction workers commonly work for cash and many of them under-report their income. The CRA may target construction workers and engage in special audit projects of all construction workers locally, regionally or nationally. Other industries where there is a large amount of cash fit into the same basket as construction. Restaurants, bars and other cash businesses are routinely audited in special projects.
External leads from informants who call the tips phone line can cause the CRA to audit a taxpayer. Similarly, internal leads from other audits or investigations can trigger an audit.
- Secondary Files
Sometimes the relationship between the taxpayer and another audited taxpayer can lead to anaudit. In some cases, where one business is in partnership with or does a lot of business with another business the CRA may audit the associated business because of the nature of the partnership or because of the volume of the transactions. Sometimes the CRA may choose to audit a parent company when auditing one of its subsidiaries, and sometimes they will audit a supplier or a subcontractor after auditing a client.
Types of Audits
Business audits are not different from personal or sole proprietorship audits. The auditor examines one or more returns and tries to identify areas where additional taxes can be assessed. The auditor is not there to see if the taxpayer was accurate in their filings – they are there to make reassessments. As many as they can. In fact the auditor’s performance evaluation is predicated on the volume of their reassessments.
In terms of their subject matter there are different types of business audits: HST, payroll and corporate tax – and there are different types of audits in terms of the way in which they are performed – some basic audits are done by correspondence, and other more in-depth audits are done in person.
In the past CRA performed complete general audits, looking at both income tax and GST/ HST. The CRA now performs specialized audits where either income tax or HST or payroll.
Since HST and source deductions are “trust” amounts which the taxpayer holds in trust for the Minister, the CRA takes them more seriously than business or personal income taxes.
Personal (Sole Proprietorship)
In this type of an audit, the auditor is typically going to look all general books and records including receipts, invoices, bank statements, auto logs, general journals, cancelled cheques, and anything else that they require in order to determine how much tax they think a business should pay.
Corporate Tax Audit
Corporate tax audits involve looking at the same types of documents that are looked at in the course of a sole proprietorship’s audit, plus they uniquely involve the review of certain documents not typically looked at in other audits, including:
- Financial statements
- General ledger
- Corporate documents, including minute books and incorporation documents
- Documents identifying related parties including parent, subsidiary, and affiliated corporations in addition to major shareholders and directors
- Legal agreements and contracts with partners, suppliers, clients, and related parties
- Dividend statements
- Loan balances
Payroll and HST audits are performed both randomly and when there are risk factors. The CRA identifies returns with a higher risk of errors or omissions and targets those in conjunction with other files targeted at random.
Of course the CRA also performs certain targeted HST audit programs, such as the audits which have been ongoing in the gold bullion industry in Canada – a source of hundreds of millions of dollars of lost (disappeared) HST. The employment agency industry is another good example. There are other “carousel” schemes like those in the bullion and employment agency industries at play where HST eventually evaporates and goes offshore or into hiding. People involved in industries where these carousel schemes are entrenched are likely to get audited – whether they participated in the scheme or not.
There is generally no difference in mechanics between a trust audit and a tax audit. The auditors will generally ask for the same things and look at the same types of books and records. Of course a payroll auditor will look at certain documents such as T4 summaries, which are usually of no interest to income tax auditors. But the majority of the audit is the same. Different auditors are just looking to make different types of reassessments.
And it should be noted that in the course of a payroll audit, the CRA will be looking into:
- a) whether the business has been withholding and remitting the correct payroll taxes; and / or
- b) whether all workers are correctly designated as employees or contractors.
It is not uncommon for an audit to examine both aspects.
Sometimes despite a business employing a worker as a contractor, the CRA claims that the worker is in fact an employee. They like it better when people are employees. But fear not, for an assessment that a worker is an employee can be challenged.
In preparation for a payroll audit, consider:
- Have all necessary payroll deductions been remitted?
- Is the business withholding the correct amount for Employment Insurance (EI), Canadian Pension Plan (CPP), and income tax?
- Are all employees adequately documented? For example, does the business have employees addresses and Social Insurance Numbers?
- Are all contractors appropriately documented? This takes the form of either a business number or a Social Insurance Number?
- Are the workers employees or contractors? What kind of agreements are in place? Legal counsel can help make those determinations before an audit.
- Are all relevant legal agreement and contracts available and up to date?
How the Audit Goes Down
The audit process can be terrifying for many Canadian taxpayers because it leaves them feeling vulnerable. Knowing about the audit process and knowing your rights are critical in order to ensure a positive outcome.
When it comes to audits and audit strategy, the most important thing that you can take from this book is that: It is important to remember that no matter how pleasant the auditor is, the audit process is adversarial.
The taxpayer is always in conflict with even the nicest auditor, whose job it is to reassess the taxpayer for additional taxes. An auditor cannot keep coming back to the office empty-handed. They have to reassess.
And you had better believe that when the government has to account for all the COVID-19 stimulus and aid money, the audit department is going to be working in overdrive in order to find additional revenue. Just wait and see. I wrote it here in black and white. So be careful. Not just about qualifying for government (COVID-19) programs before accepting money, but be careful in general to ensure that you follow the letter of the law. Tax problems get ugly.
The Audit Letter
The audit process starts when the CRA issues a letter to the taxpayer indicating that they have been selected for an audit. The CRA letter either asks for an initial interview or it provides a list of documents it expects from the taxpayer.
A particular area of concern may be identified, such as the purchase and sale of an asset. Alternatively, the CRA may want to see a laundry list of items.
In a typical business audit, the CRA expects the taxpayer to provide all books, records, significant contracts, invoices, minute books, and any other documents that support the taxpayer’s claims on their assessed returns. The CRA letter also asks the taxpayer to arrange a suitable time and date for an initial meeting.
When the CRA sends the initial audit letter, sometimes an auditor will demand that the taxpayer produce documents for a period the CRA is not permitted to reassess (ie: it is outside of the “normal reassessment period”). Such a year is technically referred to as “statute-barred” – the statute (the Income Tax Act (ITA) or the Excise Tax Act (ETA)) does not permit the CRA to audit a year that far in the past. It is important to keep an eye out for statute-barred years. While an auditor may have the right to see documents pertaining to such a year, they may not have the right to reassess.
Similarly, an auditor might audit a particular year, but not file the reassessment in time, in which case the reassessment could be invalidated on the basis of being statute-barred.
Sometimes an auditor will ask a taxpayer to sign a waiver which allows them to file a reassessment outside the normal reassessment period. This type of a waiver should never be signed by the taxpayer without consulting legal counsel. Ever.
Information Gathering and Analysis
The information gathering component of the audit typically begins with an interview. The auditor will usually want to visit you at your office if you have one, otherwise they will want to meet at your home.
During the audit process, the auditor may examine your premises or your home office and may examine all the books and records that they have requested in the initial letter.
According to Canadian tax law, all taxpayers are required to keep records, including physical and electronically stored documents, for inspection. They must either be kept in Canada or be made available in Canada on short notice.
Small audits are typically completed quickly, during which the auditor may or may copy some documents – I have seen auditors show up ready with a suitcase containing scanners and copiers. They take copies of documents and do the rest of the work back at the office. Other audits take longer. And when documents from third parties need to be requested, audits can last weeks or months.
One important thing to consider when speaking to an auditor is that they can only demand information relevant to their auditing job – so don’t offer them additional information. A casual conversation with the auditor should always be avoided because of the risk of providing them with information to which they are not entitled.
Additionally, a taxpayer must never permit auditors to take original documents or receipts. I have numerous audit clients who were not able to defend themselves properly at the objection stage because the auditors had taken or misplaced original documents. Sometimes original documents were lost in the mail on the way to or from the CRA.
Taxpayers should be aware the CRA performs criminal investigations of tax-related fraud. In the course of a criminal investigation, the Canadian Charter of Rights and Freedoms (the Charter) applies. And when the Charter applies, one’s requirement to provide documents to the CRA (which could incriminate them) ceases, and cooperation with the CRA auditor ceases. If a taxpayer determines or suspects that they are the subject of a criminal investigation, they should stop providing documents to the CRA and contact a lawyer immediately.
The Proposal Letter
Once the audit is complete and the auditor has determined their position on the returns, they will issue the taxpayer a letter called the “Proposal Letter” which reads something like the following: “Dear Taxpayer, we have completed our audit of your return, and we propose to make the following changes to your tax return.” The remainder of the letter provides details of the proposed changes and explanations for the tax return changes.
It is generally at this point where a taxpayer looks at the letter and asks themselves: “How is it possible that the CRA thinks that we earned that kind of money? Surely I’d notice an extra $400,000 lying around.”
In the proposal letter the auditor outlines all the various changes that they propose to make to the return which was filed by the taxpayer. It is also at this point that they taxpayer finds out whether the auditor has chosen to apply gross negligence penalties. Once the taxpayer receives the proposal, there is generally a 30-day window to provide any additional documentation to get the auditor to changer their mind.
If a taxpayer produces relevant documentation within 30 days, the auditor will consider it and may change their position with respect to the initial proposal. Unless the taxpayer’s documentation is flawless, and their accounting was perfect, they are very likely to still receive a reassessment after the auditor’s review of the new materials. If a taxpayer chooses not to respond to the auditor within the 30 days allotted, or if they respond late, the auditor will reassess as per the proposal.
In my experience I have found that it is very difficult to convince an auditor to change their position. Even if you are able to get the auditor to make certain changes after being provided with further information, these changes are typically not enough to satisfy the average taxpayer. This means that things typically escalate to an objection.
There is always a reassessment. No auditor ever got fired for giving a reassessment – even when it was incorrect.
Once the auditor has arrived at their final position, they will issue a “notice of reassessment”. Once issued, this reassessment takes the place of any previous assessment or reassessment for the return in question, and its contents become fact if left unchallenged. This new reassessment will outline what is owed for the period in question.
Beware the Net Worth Audit
If a taxpayer’s books and records are seriously lacking or if an auditor cannot obtain all the required documents to perform the audit, the auditor can elect to perform a net worth audit.
In this type of audit, the auditor examines the lifestyle of the taxpayer and their household in order to arrive at a cost of living. In addition, the auditor compares the taxpayer’s net worth at the beginning of the audit period and at the end. The idea is that the increase in net worth during the audit period plus the cost of living for the taxpayer will equate to the amount of income that the taxpayer must have earned during the audit period. It doesn’t always work out as planned, though. These audits almost always result in massive errors.
Probably the best way to describe the Net Worth Audit is by re-publishing an article I wrote entitled “Beware the Net Worth Audit”.
CRA Troubles? We can help! Tax Trouble? We can help! Book your Consultation Here: https://barretttaxlaw.com/free-consultation/