There are two careers I would never want to have: A hockey referee, and a Canada Revenue Agency (CRA) tax auditor. In some ways, the two are a lot alike. Both need a thick skin to deal with unhappy observers. But there are differences as well. I recall a losing hockey coach once telling me that the biggest problem with referees is that they don't care who wins. CRA auditors, of course, do care who wins: the taxman.
When it comes to auditing tax returns, the CRA has, since 2010, effectively turned 30,000 taxpayers annually into no-cost tax auditors. How so? Through a program the CRA refers to as their "educational letter campaign." Let me explain.
In February of this year, the CRA sent "education letters" to about 30,000 taxpayers. The purpose of these letters is to "help individuals and small businesses to better understand their tax obligations and to encourage them to correct any inaccuracies in their past income tax and benefit returns." If you read between the lines, these letters are really warnings sent to taxpayers who have been identified as higher risk for claiming false or erroneous deductions.
Who is likely to receive a letter? Self-employed business owners, commissioned employees and rental-property owners.
These folks are entitled to claim almost any expense that was incurred for the purpose of earning their self-employment, commission or rental income – with some exceptions. Because of this flexibility, the CRA has recognized some have become aggressive in their deductions. The letters from CRA that I've seen have most commonly been sent to those who have claimed self-employment or rental losses for two or more consecutive years.
What types of expenses is the taxman looking at closely? For self-employed or commissioned employees, the focus is on advertising and promotion expenses, meals and entertainment, wages paid to a spouse or assistant, vehicle expenses (especially the level of business-related kilometres) and home-office costs (especially the percentage of your home used for work).
In the case of rental-property owners, the taxman is looking at repairs and maintenance, travel expenses and capital improvements.
The typical letter will say, "You have reported $X of X expenses in 2015 as business/employment/rental expenses. The CRA is asking you to review this amount as taxpayers often make common errors with X expenses."
The letter generally includes an appendix providing a description of the expenses mentioned in the letter, along with details regarding eligibility to claim the expenses.
The letters I've seen state that you're not being audited at this time, but that if changes are required, you should make them within 45 days using Form T1-ADJ, which is a T1 adjustment request. The letter usually goes on to say that the CRA will be auditing taxpayers who earn a certain type of income and claim certain expenses, and that an audit may cover tax years or other items not mentioned in the letter.
Nice. I'd rather get a birthday card in the mail from the taxman (the CRA does, after all, know my birthdate), but I suppose that's expecting too much.
If you've received an "education letter" from CRA or receive one in the future, how should you respond? First, don't panic. The letter is not a promise you'll be audited or reassessed. You may not hear from the CRA on the issue again. Still, I suggest you take the following approach here:
First, review your tax return in question. Ensure all your expenses are valid, were incurred to earn income and are not personal in nature. In the case of home-office and vehicle expenses, ensure the percentage of your home or vehicle used for work was calculated correctly.
Second, speak to your tax preparer or a tax adviser. Talk about the specific expenses you claimed. If you have any concerns about your tax preparer, speak to another tax professional. Remember: You're responsible for what was claimed on your tax return, even if your tax preparer took the lead here. If you've properly claimed your expenses in the past, you have nothing to worry about and don't need to do anything further.
Third, consider filing an adjustment to any prior year's tax returns if you've found errors (going back three years should suffice if you've simply made errors; after three years, your tax returns are "statute barred," meaning the CRA cannot go back further, unless there has been fraud or wilful neglect).
Fourth, when filing your tax return for 2016, make sure the expenses you claim are valid, incurred to earn income and are not personal in nature. This way, you'll have nothing to worry about if you do receive a letter in the future.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author and founder of WaterStreet Family Offices.