Knock knock. Who’s there? – CRA….
The difference between tax avoidance and tax evasion
is the thickness of a prison wall. (Denis Healey)
is the thickness of a prison wall. (Denis Healey)
It is never pleasant to be audited by CRA. The process takes time and valuable resources away from the running and growing your business.
The current approach adopted by the CRA is a risk assessment approach (i.e. targeted), which focuses on identifying specific issues, as opposed to proceeding with a more comprehensive review. Therefore, targeted auditing based on risk assessment is CRA’s preferred approach.
What is CRA particularly watching out for:
Oil & Gas Companies
- Timing Issues
- Misclassification of Resource Expenses – For example, claiming an expense as Canadian Exploration Expense (100% Deductible) when it should be subject to a slower write-off pool, such as Canadian Development Expense (30% deductible) or Canadian Oil & Gas property Expense (10% deductible). This is a timing issue which could significantly impact your cash flow.
- Current Deduction versus Capital Expenditure – The issue is whether an expenditure is capital in nature (i.e., subject to a longer write-off period) or a currently deductible expense. The amounts at stake could be material enough to increase up-front taxes owing (Cash is king).
- Successor Pools – The issue is how to support successor pool claims by matching these claims to the relevant successor pool income streams.
- Scientific Research and Experimental Development (SR&ED) tax credits – CRA will review for misclassification of amounts claimed as SR&ED expenditures and reclassify to resource pools or operating expenses as necessary.
All Industries
- Unusual Changes in Deductions or Credits from Year-to-Year
In keeping with CRA’s risk assessment process, CRA does comprehensive reviews and analysis on material changes to financial statement components and tax deductions within the audit years and pre-audit years to see abnormal trends and irregularities. CRA can also benchmark the current taxpayer to peer groups as well.
- Requests to Amend Returns
While it is the taxpayer’s right to amend a previous year’s return, amendments to tax filings is usually a red flag. CRA will review the adjustments requested by the taxpayer, and in some cases, this may lead to further investigation into other issues related to the year of the amendment as well as prior years. For example, CRA may review the supportability of non-capital losses carried back to earlier years to reduce taxes in those years.
- Participating in Aggressive Tax Schemes
While there is a difference between legal tax avoidance and illegal tax evasion, CRA will definitely review a taxpayer’s participation in any tax avoidance program. These reviews can be extensive, requiring significant time and resources to provide CRA with the documentation needed to support the deduction. Potential common hot topics are:
- surplus stripping;
- section 85 rollover transactions;
- permanent establishment/residency issues;
- interest deductibility;
- management fees;
- interest on debt to non-residents;
- payments for intellectual property to offshore jurisdiction; and obviously
- offshore investment accounts.
- Not complying with CRA requests for Information During An Audit
This is not an option. Not providing information upon the CRA’s request on a timely basis, or not providing the information at all, is a sure way to have a deduction disallowed.
How To Prepare For The CRA Audits? Do’s and Don’ts During the Audit
It should be kept in mind that the purpose of the audit is for CRA to verify that the correct taxable income has been reported. In the process of doing this, the auditor will review sources of income and the additions and deductions that were claimed to arrive at taxable income.
Subsequent to initial phone contact, the CRA will send the taxpayer an audit commencement letter advising the taxpayer of the audit start date, scope of the audit, and the documentation to be reviewed by the auditor. This list of documentation may be quite extensive (e.g., general ledgers, adjusting journal entries, organization charts, receipts, contracts, bank statements, etc.).
It is essential that all supporting documentation to be in order, in case the auditor requests it. This is especially true in the case of international issues, which requires contemporaneous and comprehensive documentation to be available for review.
Arrange adequate space for the auditor to do his work. Do not have the auditor work in a “closet” but do not give him the “corner office”, either. This is also a matter of professional courtesy. Have a telephone available, so that he may contact his office if needed. (This is in spite of the fact that the auditor may have his own cell phone.) If possible, arrange to have an internet connection available.
The auditor is merely doing his job to verify the completeness of the filed tax return, nothing more and nothing less. Do not be defensive or aggressive in dealing with the auditor. Within reason, do your best to cooperate, and the process will go a lot smoother for both parties.
During the course of the audit, the auditor will usually issue query sheets which detail the information or supporting documentation requested for review. The queries may range from being administrative in nature (e.g. requesting meetings with front-line employees to get first-hand information about operations) to requests for specific documentation (e.g., invoices, customer contracts and supplier agreements, etc.). It is best to answer the auditor’s queries on a timely basis, while providing no more information than is required. Having said this, CRA may issue broad-ranging audit queries and when this happens, the taxpayer needs to determine exactly what information they need to provide without over-disclosing, and the best way to present it to the auditors.
The importance of having supporting documentation for deductions taken cannot be over-emphasized. The bigger the deduction, the more complete the documentation should be (underlined specifically). After all, if substantial dollars are at stake, you need to be able to justify the amount of the deduction. Provide any tax research that was done to support your filing position. Your deduction can be disallowed simply because there is no supporting documentation available. In tax matters, the onus is on the taxpayer to prove his filing position. Do not put yourself in the awkward position where you need to find or reconstruct the supporting documents at the time the audit commences because they were missing, or never existed in the first place.
What Can You Do To Defend Yourself?
Basic rule – apply the “3D” method – “Document, Document, Document”. You want to be able to justify the deductions claimed. The only sure way to do this is to have the proper documentation available, either for audit or appeal purposes. In many cases, a dispute arises between the taxpayer and the CRA because of a difference in interpretation of the relevant tax provision. The parties can only “agree to disagree” at this point and wait for the Notice of Reassessment (“NOR”) to be issued by the CRA. Once the NOR is issued, you have 90 days to file a Notice of Objection. You have the right to appeal the results of the audit to the CRA’s Appeals Section or appeal directly to the Tax Court of Canada. In case if you decided to apply to Tax Court of Canada then you must wait ninety days after filing the Notice of Objection if CRA has not provided a decision on your objection to you.
The Appeals Section will review the audit issues, but it will take time for its review to be completed, as the Appeals Section usually has a backlog of cases to review. Appeals can either vacate (i.e., agree with your filing position) or confirm the audit results (disagree with your filing position). If you do not agree with CRA’s decision, you can then appeal to the Tax Court of Canada. This is, however, a costly and time-consuming process. It is best to try to resolve matters at the audit stage.
Do you have CRA Audit? Contact our PFC experts at info@pfcaccounting.com or call us at +1.403.375.9955
