Where is Canada Revenue Agency ("CRA") focusing their audit efforts? This is the topic I presented at the Tax Breakfast we hosted last month. I provided an overview of current CRA audit activity of owner-managed businesses and individuals. The topic is particularly relevant considering the 2016 federal budget earmarked over $400 million of additional funding to considerably enhance CRA's audit activities, with the hope of realizing significantly more tax dollars.
How does the CRA choose their audit subjects?
CRA is becoming more aggressive in how they select their audit subjects. In addition to the traditional audit triggers, such as claiming large deductions and/or refunds, amendment requests, and poor compliance history, there has been a significant rise in audits triggered based on information obtained from 3rd party sources such as snitch lines, financial institutions, government agencies, and "audit spillover".
What is meant by a "spillover audit?"
By "audit spillover" I refer to CRA's practice of initiating audits of a person based on a lead obtained by CRA during their audit of another person. The concept of audit spillover is a recurring theme when reviewing the more common audit techniques CRA is fixated on recently. Following the presentation, many from the audience expressed how this concept resonated with their own experiences dealing with CRA, and offered multiple examples of how they experienced audit spillover, providing further anecdotal evidence that CRA is emphasizing audit procedures that support audit spillover.
The following provides a summary of some of the highlights from the presentation demonstrating CRA's audit spillover techniques practiced in the context of the owner-managed business.
Shareholders are prime subjects for spillover audits
The front-line subjects affected by audit spillover in the owner-manager context are generally the shareholders of a corporation. It is generally inevitable that the shareholders of the corporation will find themselves under CRA's watchful eyes during a corporate audit. CRA routinely conducts a procedure referred to as a "Shareholder Bank Deposit Analysis" which involves comparing shareholder's personal bank deposits with their personal tax reporting, and tracing all deposits originating from the taxpayer's corporation back to the company's general ledger. CRA relies on this intermingled test of the corporation and its shareholders to ensure that:
- Shareholders pick up all taxable income from the company and any other source personally;
- All corporate revenues are deposited and reported in the company rather than deposited personally;
- Shareholder loans are included in income as required by the Canadian Income Tax Act ("ITA") if outstanding more than a year after the corporate year end and not repaid; and
- That the company is only reimbursing and deducting valid expenses with a business purpose.
Note that CRA may reassess any reimbursements made to shareholders or family members for non-business related expenses as income inclusions, and deny the deduction to the corporation, resulting in a potential double tax situation.
Payroll and professional fee audits can also turn up additional spillover subjects
CRA has also been using corporate audits of payroll and professional fees, both of which are being conducted with high frequency recently, to not only analyze the corporate shareholders and other related parties, but also to increase the breadth of their audit reach to the employees and other distantly associated parties.
With respect to related parties, CRA is likely to evaluate the reasonableness of salaries paid to family members during a payroll audit, and to review the appropriateness of management fees paid to shareholders or other related parties while reviewing professional fees expenses.
However, the scope of spillover from payroll audits often expands beyond related parties with proposed adjustments to include taxable benefits to ordinary employees, or assessments of withholding taxes on payments to non-residents under regulation 105. The employees or non-resident recipients of the income are then likely to be pursued by CRA to ensure they have reported the income properly, and to ensure only limited expenses required by the taxpayer's employment contract and deductible under the ITA have been claimed.
Where the recipient of such fees is a corporation, CRA will determine whether the income qualifies as Personal Services Business income, which is subject to higher corporate tax rates with very limited deductions in accordance with special rules in the ITA.
Professional fees may have been paid to a multitude of different recipients including accountants, lawyers, consultants, management administrators, investment managers, and other advisors. As follow up to an audit of professional fees, CRA may conduct spillover audits on any of these groups of recipients to ensure revenues have been reported and treated appropriately for GST.
Other spillover subjects — CRA aggressively expands the list
CRA's thirst for spillover subjects doesn't end there though. We've recently witnessed concerning trends whereby CRA uses aggressive audit tactics to obtain extensive listings of an even far broader group of potential audit subjects, expanding audit spillover to new heights.
During their corporate audits, CRA has been intentionally targeting corporate expenditures that involve disbursements made to a significant number of recipients, requesting detailed listings of the recipients to pursue for spillover audits. Aided by computer assisted audit techniques, CRA may identify such disbursements posted as subcontractor expenses, promotion expenses, or similar accounts in the company's detailed general ledger. The expenditures chosen range from very small token gifts made to clients, business contacts, and sales agents, to larger payments made to various contractors doing work through an agency.
When CRA is provided with the listings, the recipients of the payments may receive audit letters focusing on their self employment or employment income, as applicable in the situation, to ensure the income was properly reported, and any expenditures claimed against such income are appropriate. A commonly targeted expenditure in these spillover audits are automobile expenditures, which the audit subjects generally have a difficult time providing satisfactory support for to CRA.
The increasing reality of dealing with CRA requests for sensitive information
These CRA requests for extensive business contact listings may put these corporations in a difficult situation when pressured to divulge sensitive information about their business contacts. While requesting the information may fall within CRA's audit jurisdiction, complying with the request may cause the taxpayer's business relationships to suffer when leading CRA to audit their business contacts and agents.
Professional advice should always be sought to consider potential courses of action when such situations present themselves.
