Income tax assessments are at first instance normally based on a Taxpayer’s own calculations of their income or loss for the year. This is known as the “self-reporting” system, and for a large number of Canadians, the only correspondence they ever receive from the Canada Revenue Agency (“CRA”) is their yearly assessment after filing their taxes – usually based on the numbers they’ve provided.
That being said, a self-reporting system is ripe for abuse; in order to make sure that every taxpayer is paying their fair share, the CRA conducts hundreds of thousands of audits every year. The CRA uses a number of criteria to pick its targets, which it does not publish, though it can be inferred from experience. For example, the CRA focuses on “high risk” industries for greater scrutiny, generally those that typically operate on a cash basis such as restaurants and construction. Additionally, third-party tips, past poor compliance and even random selection form a part of the decision-making process.
There are numerous “styles” of audits that the CRA undertakes. Some common examples include:
- Desk Audit – a simple credit or expense may be confirmed by way of written letter to the taxpayer, asking for documents to support the expense and any required explanation. These types of audits are referred to as “desk audits”; they are normally handled by a team in one of the Tax Services Offices who work off a group inventory of cases. Often, the taxpayer will never directly speak to the auditor;
- Field Audit – an active business will often be selected for a more detailed review of its tax returns by way of a CRA auditor “hitting the road” and visiting the business premises. They will conduct interviews of the owner and any key staff, review accounting systems and internal controls, and conduct a detailed review of the general ledger, bank statements and any other relevant documentation. These types of audits can last for months at a time, and often the CRA auditor will request on-site workspace if necessary;
- Offshore Compliance Audit – taxpayers, be they individuals or businesses who have foreign information reporting requirements, for example who are required to file either the T1134 or T1135 Information Returns, may be selected for an audit of their holdings outside of Canada. Usually these audits proceed by way of written letter requesting information, and normally the auditor will want to conduct an in-person interview at some point during the process. Often, the CRA will use the information disclosed in the information returns or provided during the initial information gathering to conduct follow-ups with foreign banking institutions utilizing the systems put in place by the various tax treaties to confirm that the taxpayer is reporting correctly; and
- Net-Worth Audit – where a taxpayer is suspected of not reporting all of their income, the CRA may undertake a net-worth audit to test if the taxpayer’s lifestyle is supportable by their reported household income. Generally they will proceed with obtaining full banking information directly from financial institutions, while at the same time requesting disclosure from the taxpayer directly. The CRA typically does not announce its intention to proceed with a net-worth assessment until a proposal is issued late in the process, and they will seem like a normal field audit at first. This is the most powerful, damaging and difficult type of audit to deal with for taxpayers, and proper representation and advice is key from knowledgeable professionals.
It should also be noted that the CRA’s audit powers are vast – section 231.2 of the Income Tax Act provides that auditors have the right to demand and inspect virtually any document from a taxpayer, and can even compel third parties, such as banks or business associates to turn over documents and information. Failure to do so by any one of whom a request is made can result in being charged with an offense under the Act.
All audits can result in a reassessment, penalties and interest owing, and in some cases the imposition of gross-negligence penalties which will increase the amounts owing by 50%. The key to managing audit risk is to have an experienced and knowledgeable tax counsel to guide the process – all communication with your tax lawyer is privileged & confidential meaning you can get advice and direction without fear of the CRA compelling it, as would be possible when dealing only with an accountant.
If you have been selected for an audit the best time to retain a tax lawyer is as early as possible so that you can discuss and strategize confidentially, and determine how best to respond in order to avoid damaging penalties or even eliminate the proposed reassessment where possible. Our lawyers can manage each stage of the process and ensure CRA communication is made only through our office, minimizing the risk of adverse consequences.
We offer multiple convenient locations in Toronto, Whitby, Barrie and more to serve our clients with ease. Find the office closest to you by calling us at 416-449-1400 or by visiting our locations page.