Tax Letters: Tax audits are coming! What should you do to avoid them? (Part 1)

Date: March, 2012

An overview of how tax audits work and who will likely be targeted. This article is part of a two-part series.

It appears that tax audits are on the rise around the world and Canada is no exception.

In 2008, during the financial crisis, governments were cutting taxes in an effort to revive the global economy. Now, more than ever before, tax authorities around the globe are collaborating with one another. Tax authorities including the Canada Revenue Agency (“CRA”) are placing greater scrutiny on taxpayers in an effort to recover lost tax revenues.

Since tax audits are coming, what can you do to avoid them?

1. Keep complete books and records

Canadian tax laws generally require taxpayers to keep complete books and records for at least six years from the end of the year to which they relate. Not all CRA notices represent comprehensive tax audits. Some notices simply request additional information to corroborate specific information already reported on your tax filings, which is why keeping complete books and records is essential. Many comprehensive audits arise because of failure to provide corroborating information to the CRA. This raises red flags for the potential of more unsubstantiated tax reporting.

2. File on time

Make sure tax filings are completed on time. Not only does this prevent incurring penalties and interest charges on late filings, it also shows that you adhere to rules and could reduce your chances of being audited.

3. Consistency is key

Generally, if the proportion of expenses to revenues is consistent from year to year, the CRA is unlikely to investigate. However, if there is a significant difference from one year to the next, the CRA may be inclined to follow-up with a request for information or an audit. A request for information or an audit may be unavoidable, even if variances are legitimate. Therefore, be prepared to substantiate any variance.

4. Keep it clean

The CRA is more likely to flag returns of taxpayers for follow-up or audit if they have found errors on a taxpayer’s return in the past. You should ensure accuracy and completeness of returns prior to filing. However, if you find a mistake after filing, be proactive and file an adjustment rather than let the CRA find it for you.

CRA Initiatives you should know

1. Related Party Initiative (RPI)

The CRA is targeting high-net-worth individuals, which generally includes individuals and related groups with a net asset value of $50 million or more. These individuals are receiving questionnaires requesting detailed information on a variety of related entities that will likely be used as a basis for determining which taxpayers to audit.

2. Self-Review Letter Initiative

Recently, the CRA introduced the Letter Initiative to inform Canadians of their personal tax return obligations. This initiative will likely continue. As part of this campaign, the CRA sends two different letters to taxpayers. One letter states that certain claims have been made on your tax return and provides you with an opportunity to review your claim, allowing you to determine if you need to make an adjustment. The other letter notifies taxpayers that the CRA may be conducting audits in their sector of activity. Sectors are flagged after several taxpayers within a certain group send in adjustments and the CRA will likely target taxpayers in that group for audit.

3. Investment and donation schemes

Investment and donation schemes are targeted and audited by the CRA. Taxpayers participating in these schemes have a higher chance of being audited. Such claims are red flags on tax filings. If something seems too good to be true, it likely is.

More information will follow in a subsequent article on how to prepare for and deal with a tax audit.

This article was prepared by Jingchan Hu who is a manager in Soberman LLP’s Taxation Group. If you have any questions relating to this article, we encourage you to contact Jingchan at jhu@soberman.com or 416 963 7124.

This article has been prepared for the general information of our clients. Specific professional advice should be obtained prior to the implementation of any suggestion contained in this article.

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