Canadian individuals and corporations - Dealing with a tax audit by the Canada Revenue Agency

Periodically the Canada Revenue Agency (CRA) conducts audits on both personal and corporate taxpayers, for a number of reasons. Usually it is done through a random sampling of taxpayers claiming various types of expenses. In the case of a company, it could result from claiming a large loss in a particular taxation year, an unusual source of income, a large increase in the shareholder loan account, an increase in certain expenses, or, in the case of a retail operation, a change in gross profit margin. For individuals, the audit usually relates to a specific expense being claimed, such as medical expenses, charitable donations, interest expense or perhaps an unusual tax shelter deduction (example: flow-through shares for oil and gas, mining). Whatever the reason, audits are neither unusual, nor something to get alarmed about!

How to prepare for a tax audit

CRA has up to three years from the date of mailing your notice of assessment to audit you. After this time, the particular year is statute barred unless there is a case of fraud and then there is no limit to the time period for audit. The audit process starts with the CRA sending the taxpayer a letter specifying the years they propose to audit and the records they wish to review. Usually, however, the period covered by the audit will be two fiscal years. Regardless of whether your records are manual or computerized, the CRA will want to see source materials. They may request access to your electronic records as well as original documents (i.e., sales records, payroll records and remittances, expense vouchers etc). You are required to retain your records for six years before destroying them in case the CRA requests any information to support your filing position.

First of all, do not assume that you have done something wrong! Many taxpayers
naturally become nervous when they get a letter from the CRA because they think that the Agency would not be asking to review the accounting records if everything was all right. Today, when most personal tax returns are filed by e-filing, receipts are not sent to the CRA, who therefore randomly conduct audits by asking for receipts or independent evidence to back up certain expenses being claimed. This is normal and not to be construed as an indication that something is amiss.

If you have a professional preparing your personal tax return, it is likely that the request will go to him or her first. In the case of a corporate audit, it is normal for the initial letter to go to the taxpayer first. If this is your case, your best course of action is to phone to advise your professional advisor that you have been selected for audit and ask what you should do next. A visit to your professional advisor’s office to review the letter together would be a starting point, as he or she would be in a position to advise you what you need to provide to the CRA. It is normal for the CRA to allow you 30 days to comply: if you have a problem meeting this deadline, it is prudent to phone them and ask for an extension. However, undue delay is not an option and you must comply with their request within a reasonable time.

Using your professional advisor to deal with the audit will likely help you to arrive at a better outcome than trying to do it yourself unless you have a professional on your staff who has experience in dealing with the CRA.

How best to ensure a positive outcome

Obviously, the best way to arrive at a positive outcome is for you to have a good set of accounting records that are backed up with detailed invoices, cash receipts, sales invoices and any other source documents that can verify both the expenses being claimed and the existence of assets that were acquired during the years under audit.

When claiming certain expenses like vehicle expenses, keeping a detailed log book will go a long way towards confirming your business and personal mileage and that, in turn, will support the various vehicle expenses that you are claiming on your tax return. Without backup invoices to support such items as repairs and maintenance, insurance, licenses, fuel and oil, etc., you will be at the mercy of the CRA auditor.

When auditing owner-managed companies, a lot of time is spent by CRA auditors in analyzing whether there are any personal expenses being written off for tax purposes. This is probably one of the most dangerous areas for taxpayers because, if the CRA disallows these types of expenses (examples would include travel that has a personal component, personal holidays, or personal living costs), it usually results in double taxation. First, the company is disallowed the expense as a deduction and secondly, the shareholder is taxed on the benefit personally. You do not want to find yourself in this kind of situation, so you should always consult your professional advisor to determine whether an expense is personal or business and to understand why! Prevention, in this type of case, is far better than being caught unaware!

When being audited, it is advisable to answer all the CRA’s questions, but you do not need to provide a long history. Just answer the question in as straightforward a manner as possible. Also, if you have a professional advisor, you may wish to have him or her present at any session with the CRA auditor to ensure that the questions are interpreted and answered correctly. Sometimes the wrong answer is given unknowingly because you do not fully understand the question.

Most audits are conducted in a congenial manner. Remember that you are a client of the CRA and your dealings with them should be similar to your dealings with your professional advisor. You should always be treated in a business-like manner and you should always respond in a similar fashion. Audits are conducted periodically for a variety of reasons and they are not something that you need to fear. If you keep good accounting records, either manually or through a computer system, you should not have too many issues to cause you problems with the CRA if you have an audit.

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