Canada: Reduce Tax Audit Risk

Last Updated: March 17 2016
Article by David Rotfleisch

Top Tips to Deter Tax Audits

Tax return filing season is upon us. Some tax returns will be audited on the basis of a random selection, a basic audit technique, but most tax audits are caused by the content of the tax return, the deductions claimed. This article prepared by Canadian income tax lawyers who fight CRA audits on a regular basis will give you suggestions as to how to minimize your income tax audit risk as you are preparing your Canadian income tax return.

Once a Canadian income tax return has been submitted to CRA it goes through computer and human reviews. Certain deductions may then be flagged and will generate a request for information. This is a verification procedure, which not an audit, but it may then result in a tax audit of the return.

Revenue Canada sometimes also asks for copies of receipts that don't have to be submitted with your income tax return, such as tuition or charitable receipts. Again, that's not an income tax audit either. In the era of paper tax returns rather than the current efiled returns, all of those receipts had to be included with the tax returns. Now these receipts are requested only on occasion.

Claim Reasonable Expenses

The fastest way to ensure an audit is to be greedy with amounts claimed as expenses. The amount of any type of expense has to be reasonable both compared to revenues and compared to what is claimed by other similar businesses. Claiming $15,000 in auto expenses against $60,000 in sales revenue will trigger an audit because the percentage is so high. If the auto expenses are fully documented, and supported by a mileage log that shows business use versus personal use of the car, and the sale revenue amounts are accurate and fully reported, then the full amount of the car expenses should be claimed, and the expense receipts provided to the tax auditor who should allow all of them. The issue is that such a high percentage of car expenses will have to be proven to a tax auditor, but if it is supported then the expenses should be deducted. However don't claim such a high percentage unless backed up by a mileage log and you're willing to be audited. A tax planning suggestion is to use a car mileage log on your smart phone.

Another standard CRA review technique is to compare expenses claimed to the amount deducted in previous years. Any discrepancy will be flagged for audit. So if rent expenses increased from $4,000 to $13,000 expect to answer questions and very possibly a tax audit.

Report all of your Income

It's very basic but very important, make sure you report 100% of your income. It's easy to overlook a t-slip, either from employment if you have multiple jobs during the year, or from investment income, but CRA has a computer matching program that will pick up any missing information slips. CRA will charge you a 10% penalty for the first time you forget to include a slip, rising to 20% for subsequent occurrences. Furthermore you will increase your income tax audit risk. A tip for Canadian tax return preparation is to compare everything on this year's income tax return to last year's tax return to ensure that you haven't missed anything.

Tax Shelter Investments

Tax shelter investments may well be a proper and legitimate way to reduce your income tax bill. However investing in tax shelters are also a sure ticket to a tax audit. CRA warns against tax shelters, audits all tax shelters and their investors, and has until 2015 been refusing to process tax returns with tax shelter claims, but is now issuing tax assessments having lost that battle in the Federal Court of Canada. Our experienced Toronto income tax litigation lawyers represent numerous clients who have invested in tax shelters, both at the income tax audit and the income tax appeal stages.

Salaries to Spouse and Children

There is nothing wrong with paying spousal or child salaries for services rendered provided that the amount paid in salaries is market rate. But CRA won't necessarily accept the payments without review, so expect a CRA tax audit to look for services not rendered, overpayment for services that were provided by the family members and missing documents for amounts paid. These are especially dangerous expenses because the tax audit reassessment may deny the salary expense (or part of it) for the taxpayer but it remains taxable to the family member who received it, resulting in double taxation.

Using Round Numbers on Your Tax Return

Most expenses are not round numbers. You have to report exact amounts for all income and expenses, but you can round off cents. If your tax return contain too many zeros (for example, $1,500 or $12,000), this is a red flag for CRA. It suggests you have not been keeping accurate records and are estimating at the end of the year. A tax planning tip is to make sure to collect and keep all of your receipts, add them up, and claim exact amounts. Another tip is to use a separate credit card for your business expenses, so it's easier to track them at the end of the year.

Self-Employed or Independent Contractor vs Employee

Being an employee reduces your tax audit risk since you will normally have fewer sources of income and expenses. On the other hand, if you are in business or are an independent contractor you increase the risk that CRA will audit you either to make sure you are declaring all of your income, that your expenses are proper or that you are in fact an independent contractor as you have claimed. If you are in one of the business sectors that CRA has identified as part of the underground economy such as construction or a small retail outlet, or if you own a restaurant, you stand a large chance at being audited since CRA is targeting these sectors for increased tax audit verification. In addition, small business owners can expect CRA to audit if they report losses for several consecutive years in a row. Our experienced Canadian income tax law firm often represents taxpayers who have filed as independent contractors and have been challenged in a CRA income tax assessment.

Being Different from Your Neighbours

Where you live and your employment are important tax audit factors. CRA examines what Canadian taxpayers report on their income tax returns compared to the statistics for their industry, what their colleagues typically report and what their neighbors earn. So for example if you're declaring $65,000 a year in income and you live in a neighborhood where the average reported is $145,000 there is a noticeable difference that will attract CRA audit attention. In all of these cases CRA is going to perform a tax audit to see why there are discrepancies.

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.

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