Introduction - Indirect Tax Audit Methods
Canada's income tax system is designed around every taxpayer, individual, corporation or trust, filing an annual return which reports all of the income that taxpayer earned during the year. Similarly, GST/HST is administered by requiring suppliers of goods and services to regularly file GST/HST returns which calculate how much GST/HST the suppliers are supposed to remit. In most cases the Canada Revenue Agency accepts the return filed by a taxpayer and assesses them for tax liability accordingly.
To prevent abuse of this self-reporting system for Canadian income tax and GST/HST, the CRA selects some taxpayers for tax audit. During an audit, the Canada Revenue Agency will review the accounting records and supporting documents and compare them to the returns filed by the taxpayer. Taxpayers are required by law to maintain books and records sufficient to allow for verification of their tax filing positions and keep those records for six years after the end of the last taxation year to which the records are relevant in part to allow tax audits to take place. Note that this record retention period is different in some specific circumstances, for example when a corporation is dissolved, its requirement under the Income Tax Act to retain books and records only lasts for two years after the day it dissolved. In the event that reviewing the taxpayer's records leads CRA to a different conclusion regarding how much income tax or GST/HST is owed, the Canada Revenue Agency will reassess the taxpayer and possibly charge tax penalties.
In some circumstances, the CRA will move beyond scrutiny of the taxpayer's accounting records and supporting documents and use indirect methods which rely on other sources of information to verify if the taxpayer's filing position was accurate.
When and Why are Indirect Methods Used - Indirect Audit Methods
Indirect tax audit verification methods are used in circumstances where the Canada Revenue Agency auditor believes the taxpayer's books and records may be non-existent, inadequate, inaccurate, or unreliable. This could include situations where a taxpayer's records were lost or destroyed, where the taxpayer failed to keep proper records and supporting documents, or where the books and records appear fine but are apparently inconsistent with the taxpayer's lifestyle, including postings on social media.
These indirect tax audit verification methods are used either as a risk assessment tool which helps determine the focus of the tax audit or as a tool for calculating how much tax CRA views the taxpayer as owing and assessing accordingly. Similar types of indirect tax audit verification methods are used for either purpose, but tests used only as a risk assessment tool are used more often but with less detail and with less effort extended to obtain relevant information and documents. The Canada Revenue Agency's policy is to only use as a tool for actually reassessing a taxpayer in cases were significant issues are identified.
Specific Indirect Methods - Indirect Tax Verification Audit Methods
The CRA uses a variety of different indirect tax verification methods depending on the specifics of the tax audit. The Canada Revenue Agency is not limited by law to the use of specific tax audit techniques and so is free to invent or modify techniques based on what the CRA views as most effective for verifying taxpayer compliance. The discussion below describes some of the most commonly used techniques.
Bank Deposit Analysis Method
One variety of indirect method is bank deposit analysis. The CRA auditor obtains bank statements for the bank accounts that CRA can identify as associated with the taxpayer. This may include family members and related corporations. The tax auditor then attempts to identify the source of each deposit and whether it represents income or sales. The tax auditor then often asks the taxpayer to explain and provide supporting documents relating to each transaction for which the tax auditor cannot identify the source. If the taxpayer cannot provide a credible explanation plus supporting documents, the CRA auditor will typically assume that the deposit represents income or sales. When used as a technique for assessing a taxpayer, the tax auditor will calculate an adjustment to the taxpayer's income or sales based the amounts of the unidentified deposits and the amount of income or sales reported by the taxpayer.
Another variety of indirect tax audit verification method is the use of projections. The CRA auditor will identify a target amount to be estimated, often gross revenue or sales, and then estimate the target amount based on a correlated base amount that the tax auditor can determine more reliably. Examples of this type of method include estimating the beer sales of a bar based on the beer it purchased, estimating the sales of a construction company based on its purchases of materials, estimating the income of a taxi business based on kilometers traveled by its taxis, or sales by a restaurant based on its chopstick purchases during the tax audit period. The correlation between the base and target amount is often determined using a sample of sales during the tax audit period. Sometimes the Canada Revenue Agency is able to obtain ostensibly more reliable information regarding the base amount by obtaining information from third party suppliers of the taxpayer. In other cases the CRA will use the taxpayer's own records, industry statistics, or the CRA auditor's observation of the taxpayer's business to provide the information necessary to establish the projection. Making a reasonable projection requires a certain level of insight into the taxpayer's business, so in some instances the Canada Revenue Agency may select a poor base amount and end up with a misleading projection analysis.
Net Worth Method
The Canada Revenue Agency also uses an indirect tax verification method known as the net worth technique which attempts to detect unreported income by tracking changes in the net worth of a taxpayer. It is a very powerful and inaccurate tool used excessively by the CRA auditors. The Tax Court of Canada has described the net worth technique as a "last resort" and in some cases rejected assessments based on this technique on the grounds that the Taxpayer's records were adequate. This technique is based on the premise the income earned by a taxpayer will either be spent or will be invested. The following formula captures how this assumption leads to a technique for estimating income:
Income = Closing Net Worth - Opening Net Worth + Personal Expenditures
If the income reported by the taxpayer is insufficient to account for the increase in the taxpayer's net worth and spending over the tax audit period, CRA will assume the taxpayer has unreported income and put the onus on the taxpayer to disprove this assumption. Note that the concept of income as deployed here is that of net income, where the taxpayer's business expenses reduce the amount of income the taxpayer has. When using this technique to assess the taxpayer, the CRA auditor will obtain all the documents he or she can regarding the taxpayer's assets and personal spending throughout the tax audit period. In some cases the CRA auditor will also use statistical data such as typical spending levels for taxpayers living in a certain postal code area or with a particular family size. Although the normal target of the net worth method is income, the Canada Revenue Agency will sometimes use the results of an income tax net worth audit to estimate unreported sales for the purposes of a follow up GST/HST audit.
Another indirect tax verification method used by the CRA is the examination of financial ratios associated with a taxpayer's business and comparison of those numbers to the Canada Revenue Agency's data on other businesses in the same industry or to the same business across time. Some commonly used ratios are the gross profit ratio, the working capital ratio, and the inventory turnover ratio. This type of technique is used solely as a risk assessment tool to see if there is something that looks unusual about the taxpayer's business and not to calculate how much tax is owed.
Pro Tax Tips - Repeated Failure to Report Income Tax Penalty
The best way to prevent these types of indirect tax verification audit techniques being used is to keep proper books and records and to put in place internal accounting controls appropriate to your business. If your records are complete and reliable, the Canada Revenue Agency is less likely to use these techniques, which can prevent a great deal of hassle and expense and if they do attempt to use these techniques they can be successfully challenged by an expert Canadian tax lawyer.
If the CRA has used an indirect method to assess you, it is essential to hire a Canadian tax lawyer who is experienced in dealing with indirect audit verification techniques and who will then typically retain an accountant to assist in the numerical analysis to represent you and review the Canada Revenue Agency's indirect tax verification analysis. Due to the complexity of the above techniques large errors can occur in the CRA's applications of these techniques and detailed and extensive analysis of the CRA assumptions and work is required.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.