Over the past few years, the Canada Revenue Agency (CRA) has increased its focus on combatting tax evasion through major improvements in data collection and analysis. With the implementation of the 2019 Federal budget, they now have the resources to do significantly more. Funds from the budget that are just now starting to flow to the CRA include:
• $151 million of new funds over five years, the majority of which will be used to hire additional auditors
• $66 million of new funds over five years to be spent on further improvements to the CRA’s information technology systems so that the infrastructure used to fight tax evasion continues to evolve
Some of these funds will be directed at relatively new areas of audit activity such as non-compliance associated with the digital economy. That being said, we can also expect to see additional audit activity in more traditional areas, where the CRA has a track record of successful audits in the past. So what are some of these areas that you might expect will trigger a call from the CRA?
More expenses in a specific area than others in your industry:
Over the past several years, the CRA has collected large amounts of data regarding expenditure patterns by industry. If for example the average business in your industry spends 3% of its total income on meals and entertainment and you are spending 10%, there is a high probability that your file will be reviewed. This is true for every expenditure line on your income statement, but discretionary categories like meals, travel and automobile expenses attract even more scrutiny.
Businesses with large amounts of cash transactions:
Businesses that take in a lot of cash are favorite targets of the CRA. If your
business falls into this category, it is even more critical that you keep adequate
records of all transactions. Keep in mind that the onus is on the taxpayer to justify all financial amounts – not the CRA. For example, if the CRA reviews your bank records and finds that there are deposits that you cannot explain, they can and will assume that this is 100% undeclared income unless you can prove otherwise.
Data taken from your suppliers:
The CRA has been making increasing use of what is called the “Unnamed person requirement” in the Income Tax Act. Under this provision, the CRA is able to collect data from Canadian corporations about their clients. In one of their largest audit projects in this area, two months ago the Home Depot complied with a court order to hand over the identities of all of their commercial customers in Canada to the CRA, along with annual amounts spent from January 1, 2013 until December 31, 2016. An earlier smaller order was also issued for clients of RONA. Contractors with commercial accounts at these stores whose purchases do not correlate with what they are showing on their tax returns can expect to be audited over the next couple of years. Assuming the CRA is successful at finding unreported taxes with this project, we can expect to see much more of this type of activity, extending into other industries.
Postal code audits:
Postal code audits have been around for a while, but with recent CRA successes (and more auditors being hired), we can expect to see more activity in this area. Essentially what the CRA is looking for is whether your reported income is consistent with your lifestyle and where you live. If you live in an area with multi-million dollar homes and your neighbours are all reporting six figure incomes (while you are only reporting $40,000) you have a good chance of being audited. In this area, the CRA often employs what is called a “net worth audit”. In this type of audit, the CRA examines all of your investments and financial records at the beginning and end of a calendar year. They also estimate what they expect is the average amount you would spend in a year based on your lifestyle. These audits are quite complex, but to simplify, if your net worth at the beginning of the year is $1 million, at the end of year it is $1.1 million, and they estimate that you have annual expenditures of about $100,000, then they will be looking to see if you have reported $200,000 in income on your tax return. If not, they will assess you for the difference.
If your business (or rental property) is showing repeated losses, the CRA can come after you on two fronts. The first is whether you have what is called “a reasonable expectation of profits”. If the CRA can show that this was not the case, then all expenses relating to that business can be denied. This type of audit has actually been decreasing in the past few years, after the CRA lost some high profile cases where the courts essentially challenged the CRA on what was reasonable, pointing out that you could not legislate that businesspeople always make good business decisions. This decrease has been somewhat offset by an increase in activity where the CRA will question where you obtained the funds to support the repeated business losses. If you cannot provide a reasonable explanation, you may be drawn into a net worth audit as described above.
Employment expenses are a favorite audit area for the CRA. If you claim a material amount of employment expenses (especially if they are higher than average for your type of employment) you can expect to get audited at some point.