Three Ways CRA Audits Are Getting Tougher
September 26, 2019 aadolphAudits,Gross Negligence Penalty
As if the stress of being selected for a CRA audit isn’t bad enough, we are noticing some disturbing trends in how they are being carried out. In addition to closing their offices to the public six years ago, CRA is trying to squeeze more out of its audits. The result is audits are taking much longer to do, and the CRA’s Appeals Division is overburdened.
Here are three ways CRA is trying to increase audit yield.
Longer Audit Periods
Today, we are seeing the “1+1” falling out of practise in favour of longer audit periods.
CRA has three years to audit a tax return once it has been assessed, beginning on the date of the Notice of Assessment. In 1997, the Deputy Minister of Revenue Canada, as it was known, issued a directive regarding how long a normal audit period should be. For income tax audits, the period would be the last return filed plus the one before that, aka the “1+1” rule. For GST, it was the most recent two fiscal years, plus any GST returns filed in the current year underway.
The policy came into being when Revenue Canada realized that adding a third year caused audits to spiral out of control. Most businesses seemed to be ready to handle inquiries going back about two years. Anything beyond that, the audits took too long, creating a problem of too much “work in progress”, something any audit professional understand. There was also an opportunity cost because those resources would be better spent auditing more taxpayers for shorter periods. Part of the reason for doing audits in the first place is to educate businesses about how they are supposed to do things.
Automatic Net Worth Audit
Back in the early 1990’s, when GST was new, the government was being heavily criticized about the size of the underground economy. The GST rate was 7% at the time and there was the perception that a lot of renovation work wasn’t being taxed. The government even ran a renovation tax rebate program to build up a database of who was doing renovations.
Many of these people had notoriously bad books & records. Revenue Canada’s response was to roll out a seldom-used audit, known as the “net worth technique”. Basically, how it worked, was you take the net worth of the person three years ago, subtract it from their net worth today, and add the cost of living during that time. In theory, this would tell you approximately how much income the person had. To determine the person’s cost of living, you use Statistics Canada data.
Using the net worth technique was successful. The audit results stood up in court, and the pressure on government to do something about the underground economy abated.
The problem is that it used to be that the auditor was supposed to first give the taxpayer an opportunity to be audited by direct verification of records, just likely everybody else is. Only when you cannot determine income using regular audit techniques, were you to make a business case for using the net worth method.
Now, some auditors are just going straight to net worth.One obvious problem with the net worth technique is that the Statistics Canada data doesn’t take into account that not all families have a mom and pop and 1.5 children. The bigger problem, though, is that the auditor is coming out with instructions to go straight to net worth method.
The Gross Negligence Penalty was designed as a way to levy additional penalty where an auditor discovers an error that they believe was intentional or the result of carelessness so bad that it is tantamount to gross neglect.
The GNP is calculated as 25% of the GST misstatement amount, or for income tax, 50% of the understated tax and/or the overstated credits related to the false statement or omission. While tax evasion is a criminal charge that must be proven beyond a reasonable doubt, gross negligence penalty is a civil penalty that must meet a “balance of probabilities” test in court.
During my illustrious 25-year career at Revenue Canada/CRA, I can count on one hand the number of times I assessed gross negligence. The reason is that the penalty was originally only to be used for seriously egregious situations. To assess the penalty, you had to write a special penalty recommendation report and convince CRA management (your boss’s boss) why you suspected gross negligence.
Today, things work in reverse. For any significant audit adjustment, the auditor must write a report justifying why the GNP is not being considered.
There is some good news, though. It is actually very difficult to prove the person made a mistake on purpose, especially in today’s complex tax environment. It is not enough for the auditor to convince their Manager; their recommendation needs to be strong enough to convince a judge. CRA doesn’t like things going to court that a judge is likely to overturn, and so a lot of gross negligence penalties get reversed on Appeal.
In conclusion, it is important to know your rights. If you are being audited, question your auditor about the proposed length of the audit period if it goes past two years. Assert your right to be audited by direct verification methods if it appears net worth is being considered, and be on guard for inappropriately assessed gross negligence penalty (GNP).