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The following excerpt is from Chapter 12 of Stephen Thompson's book 167 Tax Tips for Canadian Small Business
The objective of the previous rounds has been to show you ways to reduce your tax bill using the existing set of rules that we all have to follow. By knowing a little bit about these rules and knowing how to use them to your advantage, you can save significant tax dollars. But what if the tax department doesn't agree with you. What if their interpretation of the rules is different from yours, or say that a particular rule doesn't apply in your case. What can they do? And more importantly, what can you do?
This round will look at the different steps of a Canada Revenue Agency audit and what rights you have under the tax system. Knowing the rules of this game can mean the difference between victory and utter defeat.
What Happens After I File My Tax Return?
The Assessment Process
After you file your tax return, Canada Revenue Agency's computers will conduct a number of tests on your return and will issue you what is called an Assessment Notice. The assessment notice is typically two or three pages in length, will include information such as how much income you earned, how much tax you paid, how much you can contribute to your RRSP next year, and what balance you still owe to the government, if any, for the current year's taxes. Also included with the assessment is a cheque if you were expecting a refund and you did not request direct deposit.
At the assessment notice stage, typically, the only checks that the tax department has done is to ensure that your tax return is mathematically correct and confirmed some of your deductions to available carry forward information, like how much you were eligible to deduct for RRSP purposes. Barring unusual circumstances, you are issued the assessment notice and either a refund cheque (or direct deposit), a request for additional funds, or an indication that your account is paid in full with no balance owing.
This assessment notice is a very important piece of correspondence. It tells you if the government has agreed with the way you filed your tax return or not. It is on the assessment notice that the tax department will indicate the amount of any interest and penalties that were assessed. If the balance owing or due as a refund on the assessment notice differs from what you expected, you should enquire further. The government's computers have been known to make errors at this stage. It may be a misunderstanding that can be easily cleared up. So review your assessment notice carefully for any unexpected surprises. It could make a big difference to the amount of tax you have to pay.
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Tax Beater
Review your assessment notice to ensure you're not paying more tax than necessary.
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The Audit Process
Just because you have received an assessment notice from Canada Revenue Agency agreeing with how you filed your tax return, does not necessarily mean you're out of the woods. The government has up to three years from the time of issuing you the assessment notice to go back and audit that year. Longer if you provide them with a waiver for the particular year.
According to Canada Revenue Agency's mission statement, their objective is to promote compliance with Canada's tax, trade, and border legislation and regulations. Their main tool is the audit process. The majority of taxpayers file relatively simple tax returns with mostly T4 and T5 income. These tax returns do not represent a large compliance risk since tax is withheld at source on the T4 income and the amounts are easily verifiable. Accordingly, many taxpayers who report this type of income may never be audited by the tax department or have any dealings with a tax auditor.
Taxpayers who operate small businesses represent a greater risk of non-compliance to the government. Accordingly, more effort is placed on auditing taxpayers that report business or professional income. This is not to say that if you operate a small business you will be audited. There are hundreds of thousands of small businesses across Canada and Canada Revenue Agency can't audit them all. But your chances of being audited are increased when you report self-employed income.
If you are selected for audit, depending on the circumstances, the tax department may perform what is called a desk audit or perform a field audit. With a desk audit, a tax auditor may request that you provide supporting documentation for specific questions he or she has concerning your tax return. For example, they may request support for moving expenses or medical expenses claimed.
A field audit typically involves a tax auditor official actually visiting your premises and reviewing your records on site.
They will normally contact you to set up a mutually convenient time and will typically review more than one year at a time. Alternatively, if your business is relatively small, they may request that you bring your records to them and they will conduct their audit at their office instead of your office.
To minimize your disruption you should enquire up front what records they wish to review and what information they will require. Having this information ready for when they arrive can speed up their audit and save you time and money.
Additionally, if you have an accountant, you might suggest that the tax official perform their audit at your accountants office, if everyone is agreeable. This will minimize your disruption. As well it may help to have a trained, objective party answer the tax auditor's questions on your behalf.
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Tax Beater
Recommend having Canada Revenue Agency conduct their audit at your accountant's office to minimize disruption and possibly tax.
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The Reassessment
If, after completing their field audit, Canada Revenue Agency disagrees with your calculation of income, they will typically issue you a letter detailing the proposed adjustments to your tax return. They will also normally give you 30 days to respond to this letter, unless further time is requested. It is at this point that you should argue your case with the tax auditor. Nothing is final yet and if the issue is a matter of interpretation, you may be able to sway the auditors opinion or negotiate a better result. This is not the time to ignore the letter. This is your last chance to argue your case cheaply. From here on in, if you want to fight the tax department's decision, it will cost you a lot more money and time. So review the letter, discuss it with your tax coach and meet with the tax auditor to go over any areas with which you disagree.
Once the issues contained in the proposed adjustments letter are either agreed with or you and the auditor agree to disagree, a Notice of Reassessment is issued. The notice of reassessment will indicate the changes to the income and deduction numbers as appropriate and it will show the new tax calculation, any interest and penalties owing and the total tax owing to the government or to be refunded. If more than one taxation year is being reassessed, then typically the balance owing or refunded will be carried forward from year to year so that the most recent notice of reassessment's balance owing or refund will represent accumulated balances of all the years being assessed.
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Tax Beater
Save time and money by reviewing in detail Canada Revenue Agency's proposed adjustments.
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What If I Disagree with the Notice of Reassessment?
There are occasions when Canada Revenue Agency will not issue you a letter of proposed adjustments. For example, this will be the case if they review your tax return and find that you forgot to include a T5 or T4 slip. In these cases, they will just issue you a notice of reassessment, without warning.
If you disagree with a notice of reassessment issued to you that was either received after an audit where you have already met with the tax department or issued to you unannounced, you have two possible responses. If it is an obvious error by the tax department the best thing to do is call them and explain why you feel the notice of reassessment is incorrect. It may be a simple mistake which a quick phone call can easily solve.
If, on the other hand, the issue is not an obvious error but more a matter of a difference in interpretation, then a quick phone call is not likely to help. Instead, your next option is to file a Notice of Objection. The notice of objection is simply a letter that you write to the Chief of Appeals of your local district taxation office. In the letter you provide details as to why you disagree with the notice of assessment or reassessment as applicable. At one time you were required to complete form T400A when you wanted to file a notice of objection. This is no longer required, however, it may be advisable. By completing form T400A you will ensure that you have all of the pertinent information and Canada Revenue Agency will know for sure that you wish to begin the formal appeals process.
You have only a limited time frame for which you are eligible to file a notice of objection. If you delay and miss this time frame, you will not be eligible to appeal your case. For an individual, you have the later of 90 days from the filing of the notice of (re)assessment or one year from the due date of the tax return. For example, if your 2008 tax return was due for filing on June 15, 2009, and you received a notice of assessment that you disagreed with in August 2009, you will have until June 15, 2010 (one year from the due date of your 2007 tax return), to file your notice of objection. On the other hand, if you received a notice of reassessment for your 2007 tax return dated November 30, 2009, you will have until February 26, 2010, to file your notice of objection. For a corporation, you have to file a notice of objection within 90 days of the date of the assessment or reassessment notice.
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Tax Beater
Complete Form T400A for notice of objections to ensure Canada Revenue Agency processes your objection properly.
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Once the notice of objection is received by Canada Revenue Agency it is given to the appeals branch of the district taxation office. The appeals branch will provide an independent review of your situation. They may request additional information or an interview. After they have reviewed your case they will either issue a new reassessment notice or confirm the original assessment or reassessment.
If you still don't agree at this point, your next course of action is to appeal to the Tax Court of Canada. Here you have a choice: you can either appeal using the general procedure or the informal procedure. The general procedure requires you to hire a lawyer to represent you. If the tax and penalty amount in dispute is greater than $12,000 federally, then you will have to use the general procedure.
With the informal procedure, you can represent yourself or have a friend, your tax coach, or a lawyer represent you.
This can be a less costly procedure and less formal. However, it is still a complicated procedure. You would be wise to have some assistance from someone who knows the system and can assist you competently.
If you win or lose at this level, you or Canada Revenue Agency may be able to appeal to the Federal Court of Appeal.
If you or Canada Revenue Agency are unsuccessful at this level, in very rare circumstances you can appeal to the Supreme Court of Canada. Very few tax cases make it all the way to the Supreme Court of Canada.
The appeal process can be very costly and can take years to complete. Save yourself time and money by addressing the issues early on and seek the advice of your tax coach. Make sure you pick your fights wisely. A wrong move here can cost you a lot of money and aggravation.
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Tax Beater
File your notice of objection on time to keep your appeal rights alive.
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Should I Pay Tax That Is Under Dispute?
Canada Revenue Agency has assessed you tax which you are appealing. Should you pay the tax liability or wait until a decision has been reached on your appeal? Generally, upon filing a notice of objection, the tax department will stop collection proceedings. However, it may still be advisable to pay the outstanding tax. In most cases the decision boils down to how confident are you that you will win and can you afford to pay the tax.
If you don't pay the tax and you lose your appeal, you will not only owe the tax liability but also interest that has been compounding daily. And as discussed earlier, this interest is not tax deductible. On the other hand, if you pay the outstanding tax, you stop the interest clock. And if you win, the government will pay you interest on the amount you overpaid.
Of course, you will have to include the interest as income on your tax return in the year that you receive it.
If you can afford to pay the tax, generally the wise thing to do is pay it even if you don't agree with the calculation. Paying the tax does not represent an admission that the tax department is correct. It in no way affects your right to appeal. It does however stop the interest clock which over time can add up to a lot of money.
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Tax Beater
Stop the interest clock by paying disputed tax liabilities.
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What If I Have Discovered an Error in a Prior Year's Tax Return?
If you review your tax returns and find that you made an error in a previous years return, you will generally be allowed to request Canada Revenue Agency to go back and make the change. Even though technically the tax department does not have to adjust a prior year tax return without you filing a notice of objection, administratively, Canada Revenue Agency will normally make the requested adjustment. You must however, make your request within three years from the date on the original notice of assessment.
To make a change to a prior year tax return, the tax department would prefer that you file Form T1-ADJ, T1 Adjustment Request. You file a separate form for each tax year in question. Canada Revenue Agency prefers the use of the T1-ADJ form over filing amended tax returns.
Canada Revenue Agency will generally not allow you to go back and make a change to a prior years tax return if you are changing an optional deduction and the change affects the income for that year. A typical example might be to increase or decrease the amount of capital cost allowance (CCA) claimed in a prior year. You can, however, change your CCA claim for a prior year if it has no effect on income. This might be the case where you decrease the CCA claim in one class and increase it in another class so there is no effect on income.
Additionally, if you file a notice of objection within the allowed time frame as discussed above, the tax department will normally allow you to make the CCA adjustment. As well, if a prior year tax return is changed due to the correction of other errors, then the tax department will normally allow you to change permissible deductions for that year.
As mentioned above, the law stipulates that you can only go back three years to make an adjustment to a prior years tax return. After the three-year period, the tax returns are considered statute-barred. However, in 1991 the government introduced rules that enabled Canada Revenue Agency to reassess personal tax returns back to 1985 if requested by the taxpayer.
Under the old rules, if after three years you realized you missed a deduction or hadn't yet filed a tax return, the tax department was not required to issue a refund. Even though you were entitled to the amount and the tax department agreed. If you had not made the request before the three years were up then you didn't get the refund. A severe penalty for procrastination.
Corporate tax returns are, however, still subject to the three year restriction.
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Tax Beater
Request a refund of missed deductions.
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The rules surrounding the time frame for requesting adjustments changed again in 2004. These new rules have limited the time frame for processing adjustments to a ten-year period. The new ten-year time frame is in effect for all requests made after 2004. Therefore, if at some point during 2009 you discovered that there was an error on a previous years tax return, you could only request adjustments for tax returns dating back to 1999. In most cases, Canada Revenue Agency will go back, make the changes you request, and issue you a refund. This assumes of course that you can substantiate the changes and the tax department agrees to them. As well, if you have not filed a tax return in the past and you are expecting a refund, Canada Revenue Agency will refund you any amounts owing. This is a significant win for the taxpayer.
Is There Any Relief If I Have Never Filed a Tax Return or Did Not Report All of My Income?
Canada Revenue Agency's stated objective is to promote compliance with the Income Tax Act. The government wants to encourage all taxpayers to file their tax returns on time.
If you have never filed a tax return or you did not report all of your income on tax returns you did file and you have not been approached by Canada Revenue Agency, then consider contacting the tax department and state that you wish to make a Voluntary Disclosure.
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Tax Beater
Review old tax years for potential tax adjustments before it is too late.
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To encourage taxpayers to come forward, Canada Revenue Agency will often waive the penalties associated with late filing your tax return, not including all of your income in your tax returns or claiming ineligible expenses if you make a voluntary disclosure. You will still be charged interest and will have to pay any tax owing, but you may be able to avoid significant penalty charges. To qualify you must meet a number of criteria:
- You must initiate the contact with Canada Revenue Agency. If the tax department contacts you first, the deal's off and you will likely be charged penalties.
- There must be sufficient and complete information for the years under question. You will need to provide to the tax department sufficient information to substantiate your income and expense numbers. You won't need to provide this information immediately. In fact, you should first contact Canada Revenue Agency and then work out a mutually acceptable time frame to provide them with the details.
- The CRA must be in a position to apply some type of penalty. As an example, the penalty may be a late filing or failure to file penalty. If a penalty does not apply, you cannot seek relief under the Voluntary Disclosures Program, you can however still disclose the information to the CRA and it will be handled through the normal processing procedures.
- The information being disclosed must be at least one year past due or less than one year past due where the disclosure is to correct a previously filed return. For example, assume you had not filed tax returns for the years 2004 to 2008, and on November 10, 2009 you filed all of these returns under the Voluntary Disclosures Program. Although the 2008 tax return is less than one year past due (it would have been due on April 30, 2009), the CRA will consider the 2008 return as part of the disclosure, assuming that all of the required conditions have been met. However, the 2008 tax return would not be considered under the Voluntary Disclosures Program if it were the only return being filed. In this circumstance, the 2008 tax return would be handled through the Canada Revenue Agency's normal processing procedures.
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Tax Beater
Make a voluntary disclosure and avoid penalty charges.
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If you decide to make use of the Voluntary Disclosure Program, you must make a written submission outlining the relevant details using Form RC199, "Taxpayer Agreement" to initiate the process. If your submission is accepted, then you must pay the outstanding tax and interest amount or work out acceptable payment terms. Be aware that the tax department could go back and assess penalties if you renege on your part of the deal and don't pay your tax bill after you come forward.
When you approach the tax department, negotiate with them the number of years they would like you to go back.
Depending on how long you have not filed a tax return, they may agree to waive some old years just to bring you back into the system. This is not always negotiable. However, depending on your circumstances, it can represent a significant savings if you don't have to file for some of the outstanding years.
The voluntary disclosure rules can also apply for GST returns that have never been filed or that have been filed with incomplete information. Once again however, you must approach the tax department before they approach you.
Can Penalty and Interest Charges Be Reduced?
If you have been charged a penalty or interest, consider requesting to have the penalty and interest charges reversed.
Canada Revenue Agency will, on occasion, reverse these charges. However, you must provide them with an exceptional reason why you were unable to comply with the law, resulting in the assessing of penalties and interest. Canada Revenue Agency has cited the following examples of circumstances which may be acceptable in reversing penalties and interest, if these circumstances prevented a taxpayer from complying with the law:
- natural or human-made disasters such as a flood or a fire
- civil disturbances or disruptions in services such as a postal strike
- a serious illness or accident
- serious emotional or mental distress such as a death in the immediate family.
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Tax Beater
Save tax and hassles by negotiating the number of years for filing tax returns.
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As well, penalties and interest may be waived if Canada Revenue Agency delayed in informing you of an amount owing, or if you were relying on material made available to the public and the material contained incorrect information.
If you receive incorrect advice from Canada Revenue Agency, you shouldn't be charged interest or penalties. If the tax department tells you that you don't have to make instalments and then later charges you late instalment interest, you should be able to get that interest reversed.
In addition, if Canada Revenue Agency makes an error in processing, interest and penalties should not be charged on the error. Or if the tax department delays in providing the necessary information to make the appropriate instalment or payments, you may be able to get the interest and penalty reversed.
One other situation where it may be possible to waive interest and penalties is in severe hardship cases. If you are having severe difficulty in paying your outstanding taxes, the government may waive the interest and penalties in order to recover the outstanding tax liability.
In summary, don't just give up if you have been assessed interest and penalties. In the right circumstances, you may be able to get them reversed.
What Are Some Do's and Don't's If I Get Audited?
So you've been selected for audit. If you have reported all of your income and have been reasonable with your business expenses, you should have nothing to worry about. They may have selected you at random, because of something unusual that is going on in your tax return or because of your industry.
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Tax Beater
Consider requesting Canada Revenue Agency to reverse interest and penalties.
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Whatever the reason, in many cases there is nothing to fear. If you do get selected for audit here are some things you should and some things you should not do:
- Do respond promptly to Canada Revenue Agency phone calls and/or correspondence. Ignoring them will not make them go away. It will only make them more intolerant later when you try to negotiate with them.
- Do cooperate by providing them with the information they request. Ask them why they are requesting the information. The tax department does have the right to review your records to substantiate information you have reported on your tax return. However, they do not have a right to engage in a "fishing expedition."
- Do offer to have the tax auditor review your records at your accountant's office. This will reduce your disruption and may make the audit go smoother.
- Do review in detail their proposed adjustments. Tax auditors do make mistakes.
- Do attempt to negotiate on grey or interpretative matters.
- Where the rules are not black and white, the auditor may be willing to give a little, depending on the circumstances.
- Do seek professional tax help. Not all audits go smoothly and mistakes can be made. Misinterpretion of the facts is quite common. A tax professional can help you make sure the auditor understands your business and your transactions in the best possible light.
- Don't provide more information than requested unless it helps your case. As mentioned earlier, ask what the auditor needs and cooperate. But if they don't ask for some information, don't volunteer it unless it helps your case. There is no sense in making a career out of the audit of your business.
- Don't accept the word of the auditor as gospel. The auditor's interpretation of certain legislation may be right, but then again it may be wrong. Check with your tax coach or ask to speak with the auditor's supervisor if you feel that there may be an error.
- Don't delay in filing a notice of objection. You don't necessarily want to file a notice of objection if you have an open dialogue with the tax auditor on some contentious points. However, keep in mind your deadlines and make sure you file your objection before you run out of time.
The audit experience is rarely a pleasant one. However, it doesn't have to be painful. If you follow the rules and are not too aggressive, you can win this round with a little bit of luck.
Excerpted from 167 Tax Tips for Canadian Small Business. Copyright (c) 2009 by Stephen Thompson. Excerpted with permission of the publisher John Wiley & Sons Canada, Ltd.