The start of a new year brings fireworks, champagne, resolutions that will be kept, and those that will be quickly forgotten. For tax accountants and tax lawyers, it means something else – the start of a new fiscal period. January 1st starts a new tax year for every Canadian reading this article.
With the fresh start the new tax year provides, there is no better resolution to make and keep than “I’m organizing my affairs to minimize the risk of a bad audit result.” The key to keeping this resolution is to consider the possibility of an audit by the Canada Revenue Agency (CRA) before you file your tax return.
Under Canada’s tax laws, taxpayers bear the onus of proving that their tax returns are correct. Practically, this means that if the CRA issues an incorrect reassessment, a taxpayer must prove that it is wrong. The CRA relies on this “reverse onus” for two key weapons in its audit arsenal: the bank deposit analysis and the net worth analysis (also called a “lifestyle analysis”).
A bank deposit analysis has become commonplace in business audits. At the start of an audit, an auditor typically asks a taxpayer to provide bank statements for all of the taxpayer’s accounts. If the taxpayer refuses to comply, the auditor can use statutory powers to order the taxpayer’s bank to provide the statements. In reviewing the statements, the auditor generally assumes that each deposit is income. The taxpayer has to prove all non-income deposits, such as loans and gifts.
For employees, a bank deposit analysis is rarely a significant risk. Such taxpayers commonly have one or two similar-sized deposits to their account each month, and the source of these deposits is very likely reported to the CRA on a T4 slip. In contrast, because business bank account deposits vary in size, volume, and frequency, a CRA bank deposit analysis is a significant risk for businesspeople.
In preparing tax returns, accountants will review their clients’ account statements if asked. You should consider reviewing your account statements on a monthly or annual basis. In reviewing your statements, you should identify the source for all substantial deposits to your account. An audit, three years after a deposit date, is not the best time to try to recall the source a deposit. This review will ensure more accurate tax filings and spare you considerable grief if you are later audited.
The CRA will generally be satisfied with the results of a bank deposit analysis in circumstances where a taxpayer’s income is deposited in bank accounts. However, a bank deposit analysis may not necessarily provide an acceptable estimate of income – particularly where a business deals frequently in cash. The CRA developed the net worth analysis to estimate income in circumstances where a bank deposit analysis cannot be completed or leads to an absurd result.
A net worth analysis determines a taxpayer’s income for a period by examining changes in the taxpayer’s assets and liabilities, and the cost of the taxpayer’s personal expenditures on food, housing, clothing, entertainment, and all other lifestyle related amounts. For example, if in a year, a taxpayer acquired $50,000 in assets, paid down $10,000 on a mortgage, and spent $40,000 on expenditures, the CRA will assume that the taxpayer’s income was at least $100,000.
When you review your tax return each year, you should always consider the cost of your lifestyle and any recent changes to your assets and liabilities. This review should minimize your risk of a net worth analysis. It will also provide a warning if your income is underreported or your business expenses are over-claimed. If your lifestyle cannot be supported by the income calculated on your return, there are only two possible explanations. Either your lifestyle is funded from a non-income source (most commonly, debt), or your tax return needs to be corrected.
Resolving to minimize your audit risk does not mean you should over-report your income. Instead, it means taking care to file a return that can be supported in an audit. By considering the risk an audit before you file your tax return, you can identify issues that lead to bad audit results. Are there bank deposits that you cannot identify? Are your mortgage payments more than your income? Are you deducting your children’s skating lessons as a business expense? Reviewing your tax returns can be sobering and prevent a bad audit hangover – not a bad resolution to make on New Year’s Day.
The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.
