Introduction to CRA Tax Audit
Even if a taxpayer has filed their income tax returns honestly and to the best of their ability, a notice for a tax audit is daunting to most taxpayers. The reason for this is because there may be a single defect in their paperwork or misplaced documents that may cause them to be reassessed and owe extra taxes plus interest and possible tax penalties. In fact, there is a risk of being charged criminally with tax evasion after a tax audit. The CRA tax auditor has the power to examine every detail of the taxpayer’s affairs, which is quite intimidating to a taxpayer. Therefore, if a taxpayer is selected for a tax audit, it is essential to be well prepared in advance and to have professional Canadian tax lawyer representation from the inception of the tax audit. This article will discuss and explain the definition of a CRA tax audit, types of tax audits, factors that increase the chances of being selected for a tax audit, and the procedures of a tax audit.
Definition of CRA Tax Audit
A tax audit is an official examination in which the CRA tax auditor closely examines and inspects books and records and even physical locations of businesses and homes of taxpayers to ensure that they are complying with their tax reporting and filing obligations. The CRA can choose to audit a company, which is known as a business tax audit, or an individual, which is known as a personal tax audit. Typically, during a tax audit, the CRA tax auditor is looking for any mistakes or deliberate omissions or misstatements that could lead to a higher tax bill. Canadian taxpayers are generally statutorily bound to cooperate with the CRA tax auditor. For most individuals, corporations, partnerships and trusts, it is required to keep records of all their financial activities because subsection 230(4) of the Income Tax Act states that records and books of account must be kept for six years from the end of the last taxation year which they relate. Moreover, paragraph 152(3.1)(a) of the Income Tax Act states that the CRA’s reassessment period for a mutual fund trust and a corporation, other than a Canadian-controlled private corporation is four years from the date of the original notice of assessment. Paragraph 152(3.1)(b) of the Income Tax Act states that in other cases, the reassessment period is three years. However, subsection 152(4) of the Income Tax Act states that the CRA can reassess at any time if it can prove fraud or misrepresentation in a taxpayer’s return. The CRA’s powers to conduct tax audits are derived from subsection 231.1(1) of the Income Tax Act. The subsection provides the CRA’s power to inspect and examine records, to enter premises to carry on their tax audit process and to interview or ask questions to anyone on the premises. However, the taxpayer needs to know their rights and the extent to which they are obligated to assist CRA tax auditors so that their interests may be protected. If you have been selected for a tax audit, contact one of our experienced Toronto tax lawyers for tax audit help before speaking to the CRA tax auditor. A taxpayer may be selected for a tax audit in two ways: a random selection process or a targeted selection process. The random selection usually is based on chance. In other words, if you are unlucky, you may be selected to be tax audited. On the other hand, the targeted selection relies on risk factors and errors made on returns. Generally speaking, the more errors a taxpayer makes on their returns, the more likely that they will be selected to be audited. The odds of being audited will also increase based on certain risk factors, For example, the CRA routinely conducts special audit projects, targeting specific types of industries, such as the restaurant business, which is usually a cash-driven industry that has an increased likelihood of unreported income, to recover lost tax dollars. The CRA is currently, and has been for some number of years, conducting a special tax audit project targeting real estate to address unreported real estate transactions. Also, the CRA may conduct tax audits based on geography and lifestyle. For example, the CRA has targeted high-priced neighbourhoods to evaluate a taxpayer’s lifestyle and conduct tax audits based on a suspicion that the taxpayer may actually be richer than what he or she reported because reported income is less than the average in the neighbourhood. Risk factors that increase the odds of being audited will be discussed in more detail later in this article. If you would like to learn more about the basics of tax audits, please read our article on the CRA tax audit.
Difference Between a Tax Audit and a Tax Review
The CRA may send a taxpayer a letter informing that they are reviewing the taxpayer’s income tax returns. The CRA tax review is not equivalent to a tax audit. In most cases, a CRA tax review is a routine check to ensure that the taxpayer’s tax return is correct. The CRA may request the selected taxpayer to provide additional information. As opposed to the CRA tax audit, the CRA tax review will not involve the level of scrutiny and in-depth examination into the taxpayer’s records. Similar to the selection process for a CRA tax audit, the CRA may select taxpayers through a random selection process or a targeted selection process.
CRA Tax Audit Triggers
There are different risk factors for a CRA tax audit, and depending on the state of affairs of the taxpayer, the odds of being audited may increase. Thus, it is crucial to understand what the CRA is looking for and what might trigger an audit.
Generally speaking, self-employed people are in the high-risk category. In the CRA’s perspective, the issue with these taxpayers is that they do not have employers that provide details of their income to the CRA. Also, since self-employed taxpayers report their taxes based on the difference between their income and their business expenses, they have an interest to report their income as low as possible and their costs as high as possible. The CRA will thus verify the reported numbers and try to deny any expenses if possible.
Cash-Based Business or Cash-Driven Industries
Taxpayers who have cash-oriented businesses are also at a higher risk of a CRA tax audit. Since these businesses receive a lot of cash, there is more opportunity for the CRA to detect and recover taxes on unreported cash income. Some common examples of cash-based businesses are bars, restaurants, flea markets, farmer’s markets and convenience stores. According to Statistics Canada, in 2016, residential construction, retail trade and accommodation and food services accounted for more than half of underground economic activity. In addition, they reported that wages and undeclared tips account for largest share of unreported income. Thus, the CRA has been focused on auditing the underground cash economy.
Repeatedly Showing Losses
Business losses can be used to reduce taxable income from other sources. Thus, some people strategically choose to operate loss-generating businesses to utilize this benefit – decrease their income tax payable. The CRA, on the other hand, actively seeks ways to deny these business losses by declaring that a bona fide business actually does not exist. Therefore, businesses that repeatedly report losses are more likely to attract a CRA tax audit. In particular, if those losses are used to offset other earnings or gains, then the risk for audit will increase.
Real Estate Transactions
If a taxpayer is involved in numerous real estate transactions, then this may attract a CRA tax audit. Real estate transactions involving house and condo flipping, construction of new homes, principal residence exemptions, and GST/HST new housing rebate provide opportunities for taxpayers to reduce and recover their taxes paid. Thus, the CRA pays close attention to these transactions. CRA has recently decided to investigate Canadians holding US real estate to ensure they are meeting their Canadian tax obligations.
Criminal Charges or Convictions
The CRA collects taxes on all forms of income – regardless of whether it was derived from legitimate or illegal business. For obvious reasons, profits from criminal activities are often not reported. Due to this fact, when the CRA suspects that there are individuals deriving income from illegal activities, a CRA tax audit is likely to take place. For example, if a taxpayer is accused or convicted of committing illegal business, then the odds of a tax audit is likely to increase for that taxpayer. It is also common for the police to refer suspected criminals, in particular drug dealers, to CRA for a tax audit.
Unusual Large Donations to Charity
TIf a taxpayer makes a charitable donation that represents a large portion of the taxpayer’s income, the CRA will become suspicious. For example, let’s assume that John earned $50,000 for a year, and for the same year, he made a donation for $20,000. After his taxes, he would be taking home less than $40,000, which would mean that John would have to make his living off of approximately $20,000 for the year. Such financial decisions would be highly unlikely. Thus, this scenario may cause enough suspicion for the CRA to perform a tax audit on John’s affairs.
Discrepancies Between T2 Return and GST/HST Return
Whenever the CRA finds discrepancies in the tax report of taxpayers, they become suspicious. In particular, if there is a discrepancy between the amount of a GST/HST return and the amount of T2 return, the CRA may decide to perform a tax audit on the taxpayer.
Home Office Expenses
When taxpayers have home offices that are used exclusively for the purpose of earning income from business, they can claim home office deductions that allow them to deduct business-related portions of expenses, such as a portion of their rent, real estate taxes, utilities, and other costs. For example, if their home offices take around 10 percent of the square footage of their home, they may be eligible to deduct 10 percent of their rent, utilities, property tax, and other costs. However, some taxpayers inflate their home office deductions, which often attracts the CRA. When the CRA suspects that a taxpayer is inflating their home office deduction claims, then it may choose to perform a tax audit on the taxpayer.
Stages of a CRA Tax Audit
It is important for taxpayers who are subject to a CRA tax audit to be aware of the rights of a taxpayer and the process of a tax audit, so that they may be able to protect their interests. It is also important to retain a professional Canadian tax lawyer prior to communicating with the CRA tax auditor.
The CRA tax audit begins when a tax auditor notifies the taxpayer that he or she has been selected for a tax audit. The CRA tax auditor will usually issue a “requirement for information” letter, which provides a list of the documents that the taxpayer is required to provide to the auditor for inspection. Documents such as bank statements, credit card statements, receipts, invoices, and contracts may be required to be available for inspection. Failure to provide such information may result in prosecution of the taxpayer. The tax auditor will provide instructions on how the taxpayer can send documents, if necessary, and the deadline to provide them.
Types of Audits
There are different types of audits. The simplest example is the correspondence tax audit. The method used in this tax audit involves correspondence between the auditor and the selected taxpayer. During a correspondence audit, the selected taxpayer receives a CRA letter and is asked to provide the necessary documents for inspection. The correspondence tax audit is generally reserved for small and simple tax returns and does not require an on-site visit to the taxpayer’s premises. An office tax audit is another type of tax audit that is performed off-site. Similar to the correspondence tax audit, during an office tax audit, the selected taxpayer will receive a letter from the CRA and will be asked to provide information that is needed for inspection. The office tax audit is not as simple as the correspondence tax audit, but it is still relatively simple compared to other on-site CRA tax audits. The office tax audit is generally reserved for small businesses with sales under $500,000. A CRA tax audit that takes place in the selected taxpayer’s business premises or personal residence is called a field audit. Usually, the assigned CRA auditor will contact the selected taxpayer to set up the date and time for the field audit. Small field tax audits may require only a meeting of a couple of hours, while extensive field audits may take days or weeks of on-site meetings. During meetings, the CRA auditor will ask to view certain documents, visit places, and even ask questions to employees of the taxpayer. It is thus essential for the taxpayer to consult with an experienced Canadian tax lawyer before a tax audit meeting to know and defend the rights and interests of the taxpayer. Another type of on-site audit that involves an auditor’s visit is the net worth audit. The net worth audit is performed if the CRA suspects that the taxpayer’s reported income seems to be insufficient to justify their lifestyle. A net worth tax audit is often the most destructive and intrusive, and many taxpayers who have gone through such net worth audits complain that the reassessment after the net worth tax audit is unfair. During the net worth audit, the auditor will first determine the increase of net worth of the taxpayer over the audit period. The auditor will also determine the cost of living for the taxpayer over the audit period. The auditor will then combine these amounts and compare it to the reported income of the taxpayer to determine whether the reported income is sufficient to explain the increase in net worth during the audit period.
Results of CRA tax Audit
After the CRA tax auditor completes his tax audit investigation of the taxpayer’s records, the tax auditor will determine whether the taxpayer has been fulfilling their tax obligations, following tax law correctly, and receiving the benefits and returns to which they are entitled. If the CRA tax auditor finds that a previous tax assessment is correct, then the taxpayer will receive a completion letter, and the CRA tax audit will be closed. However, if the auditor finds that the taxpayer’s return must be reassessed, then he or she will receive a proposal letter that outlines potential adjustments to the taxpayer’s tax return. There will typically be a 30-day deadline to provide any response, rebuttal, explanation, or further documentation relating to the proposed adjustments. It is essential to send a response or request a time extension within the timeframe because if the taxpayer fails to respond within the time period, then a tax reassessment may be issued. There may be a final interview by the auditor with the taxpayer after the completion of the fieldwork to discuss the adjustments in the proposal letter and any representations and submissions the taxpayer may have in response. After the final interview, a final letter from the CRA will be sent outlining the CRA’s final position and the reasons for the proposed adjustments.
Tax Notice of Reassessment
The CRA’s reassessment period for a mutual fund trust and a corporation, other than a Canadian-controlled private corporation is four years from the date of the original notice of assessment. In other cases, the reassessment period is three years. When the taxpayer receives a notice of reassessment from the CRA, the taxpayer has two possible courses of action. First, the taxpayer may agree with the tax notice of reassessment and pay the additional taxes and interest (and penalties, depending on the circumstances). Or, the taxpayer can dispute the tax reassessment. To dispute a tax notice of reassessment, the taxpayer must file a timely notice of objection pursuant to subsection 165(1) of the Income Tax Act. It is important to note that the notice of objection must be filed before 90 days from the day the CRA mailed the notice of reassessment. In the objection letter, the taxpayer must outline the legal basis of the objection. Filing a notice of objection is vital for two reasons. First, it preserves the taxpayer’s appeal rights. Second, it generally halts the CRA’s collection activities with respect to income tax (but not with respect to GST/HST). However, since filing a notice of objection does not stop the interest accumulation of outstanding tax liability, the advice often given by our experienced Canadian tax lawyers, subject to cash flow considerations, is to pay the tax reassessment amount and the interest amount at the time of filing the notice of objection or as soon thereafter as is possible. The CRA would pay back the reassessment and interest amount if the taxpayer is successful with the notice of objection. When the CRA receives the notice of objection, the taxpayer’s file is then transferred to the appeals division of the CRA. During this process, the taxpayer has the ability to request the CRA documents that support the reassessment. After considering the submissions of the taxpayer, an appointed appeals officer will either confirm the reassessment or issue a new notice of reassessment. If the taxpayer still disagrees with the decision made by the appeals officer, then the final step is to file a notice of appeal to the Tax Court of Canada in a timely manner pursuant to subsection 169(1) of the Income Tax Act.
Get a Canadian Tax Lawyer to Help You Navigate a Tax Audit Process, or Avoid it Altogether
Being selected for a CRA tax audit can be a daunting experience. Thus, taxpayers need to know their rights and the extent to which they are obligated to assist the CRA tax auditors. Canadian Tax lawyers can guide the taxpayers in this regard and can help by preparing the needed paperwork and documents in a tax audit. In addition, when taxpayers receive their CRA proposal letters and notice of reassessment after a tax audit, tax lawyers can help dispute the CRA assessing position. Canadian tax Lawyers are especially helpful in this regard since they are trained to cite common law and statutory law to support their arguments.
Talk to a Canadian Tax Lawyer Now
Choosing David J. Rotfleisch as your Canadian tax lawyer is an excellent choice. David is not only a certified Specialist in Canadian tax law but also a chartered professional accountant. He has an in-depth understanding of accounting principles, taxation processes, and taxation law. This unique quality allows David to communicate and discuss accounting issues with accountants in a technical way that both can understand. David has over thirty years of experience in dealing with the CRA. If you would like to learn more about David, please visit his page. If you would like to contact us, please visit our website.
Pro Tip – FAQs on Tax Audit
Does the CRA do Random Tax Audits?
Yes. A taxpayer may be selected for a tax audit in two ways: a random selection process or a targeted selection process. The random selection is based on chance, while the targeted selection relies on risk factors and errors made on returns.
What happens if I get Audited and Cannot Produce Supporting Receipts?
If a taxpayer cannot produce supporting receipts to back up the tax return, then the taxpayer should look for alternative documents that may support their claim. For example, if the taxpayer used a credit card to purchase the item in question, then bank and credit card statements may be relevant. A supplier can be contacted for details of the account. Also, testimonies from individuals or businesses that may confirm the purchase may also be relevant. Moreover, if the supporting receipts were lost due to natural disasters, then the taxpayer should show proof of the damage. However, the CRA may determine that these supporting documents are insufficient, in which case, the claim would be denied. In such instances, it is essential to have experienced tax Canadian lawyers to challenge CRA.
Will the CRA look into my bank accounts too?
Yes. Subsection 231.1(1) of the Income Tax Act grants the CRA to inspect and examine records, to enter premises to carry on their audit process and to interview or ask questions to anyone on the premise. In essence, the CRA tax auditor may ask to examine all sorts of documents, including bank account records, personal journals, meeting minutes and inventory records.
"These articles provide information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."
To Read More David Rotfleisch Posts Click Here