Use of Legislated Enforcement Provisions

Corporate Audit and Evaluation Branch
May 2006

Table of Contents

• Executive Summary
• Introduction
• Focus of the Audit
• Findings Recommendations and Action Plans
  • Gross Negligence Penalties
  • Repeated Failures to Report Income Penalties
  • Requirements for Information
  • Requirements to Maintain Proper Books and Records
  • Third Party Penalties
  • Evaluating the Effectiveness of Enforcement Measures
• Conclusion

Executive Summary

In order to maintain the integrity of the tax system and promote voluntary compliance with Canadian law, the Canada Revenue Agency's (CRA) programs address intentional and unintentional non-compliance. To accomplish this, the Agency uses a mix of activities such as education, taxpayer service, and enforcement measures provided for in the Income Tax Act and the Excise Tax Act.

The Income Tax Act and the Excise Tax Act provide the Agency with the authority to use enforcement measures including penalties and legal requirements. In the 2002-2003 fiscal year, the Agency had over 6,400 audit staff in its Tax Services Offices (TSOs) and completed about 300,000 audits. In some instances, auditors encounter non-compliance, which may require the use of enforcement measures.

Some penalties are automated, that is, the penalty is automatically assessed. Others require that employees use a mix of policies, guidelines, and professional judgment when considering or applying them. The five enforcement measures that are discussed in this report require professional judgment:

• The Gross Negligence Penalty;
• The Repeated Failures to Report Income Penalty;
• The Third Party Penalty;
• Requirements to Provide Information; and
• Requirements to Maintain Proper Books and Records.

Objective: The objective of the audit was to establish whether the enforcement measures available to the Canada Revenue Agency are appropriately applied to deter non-compliance in support of our strategic goal of responsible enforcement.

The audit focused on how the Compliance Programs Branch (CPB) used guidance, monitoring, and research to achieve responsible enforcement in its management of enforcement measures.

Findings and Conclusion: Overall, the Branch needs to further improve its guidance, monitoring, and research for enforcement measures. Although the measures covered in this report apply to a very small number of taxpayers, by definition they address matters with a high risk of non-compliance.

The guidance provided to auditors was appropriate for the Gross Negligence Penalty and the Third Party Penalty. The program enhancements that are currently ongoing should continue for other measures such as the Repeated Failures to Report Income Penalty, the Requirement to Maintain Proper Books and Records, and the Requirement to Provide Information.

The Branch monitors enforcement measures and this quality assurance work detected a number of areas for improvement, but some enforcement measures are not included in the scope of the monitoring; and data collection for some enforcement measures needs to be enhanced. Additionally, some issues identified by the Branch's monitoring did not receive timely corrective action.

CPB has conducted research to assess the effectiveness of the Gross Negligence Penalty and it needs to expand this research to assess the effectiveness of its other enforcement measures in order to better manage their use and assess the need for refinements.

Table 1, below, summarizes the findings for each of the enforcement measures based on 2002-2003 to 2004-2005 results and it is followed by a more detailed discussion of the findings.

Table 1: Summary of Findings

The extent of guidance for enforcement measures varied by enforcement measure and gaps in guidance increase the risk that they are not applied consistently. The Branch's guidance for Gross Negligence Penalties and Third Party Penalties was sufficient. In 2004, it expanded its guidance on using Requirements for Information; however, it is too early to determine whether its expanded guidance is adequate. With respect to the Repeated Failures to Report Income Penalty, the Branch's guidance was being followed but most auditors were not aware that their audit reassessments could generate penalty assessments in subsequent years if a taxpayer fails to report income twice within a four-year period. The Branch also needs to clarify its audit policies on considering and applying this penalty. The guidance relating to Requirements to Maintain Proper Books and Records did not adequately support auditors dealing with cases of partial compliance.

The Branch's monitoring does not consistently address all enforcement measures; data is collected on some enforcement measures but not on others.

The Branch's Quality Assurance Reviews identified some inconsistencies in the consideration and application of Gross Negligence Penalties; however, the Branch's monitoring activities did not systematically require action plans that linked corrective actions and timeframes for resolving the issues.

As a precursor to issuing Requirements to Maintain Proper Books and Records, CPB's policy is for auditors to write informal requests to taxpayers or registrants when their books and records are found to be inadequate, inaccurate, or unreliable. The policy further provides for the use of Requirements to Maintain Proper Books and Records if the non-compliance continues after the informal request was made. The Branch's Quality Assurance Reviews determined that the policies and procedures for using the informal requests were not being followed.

Aside from informal requests to maintain proper books and records and Gross Negligence Penalties, no other enforcement measures are examined during the Quality Assurance Reviews.

The Branch has only assessed the effectiveness of one enforcement measure—the Gross Negligence Penalty. It should research and evaluate the effectiveness of the other enforcement measures to better focus ongoing refinements to its compliance strategy and guidance for enforcement measures.

Action Plans: CPB has plans to clarify its guidance on the use of informal requests and Requirements to Maintain Proper Books and Records. The Branch will also advise auditors of the policy to communicate to taxpayers the ramifications of the Repeated Failures to Report Income Penalty.

CPB is enhancing its monitoring by ensuring that its Quality Assurance Reviews and Program Assessments result in action plans and by following up on action plans within one year. The Branch has implemented a tracking system for Requirements for Information and it is conducting preliminary assessments on the use of these requirements as part of Program Assessment and Quality Assurance Review activities.

To address the need for evaluative research, CPB will undertake projects to explore the compliance impacts of program initiatives and compliance instruments.

Introduction

In order to maintain the integrity of the tax system and promote voluntary compliance with Canadian law, the Canada Revenue Agency's (CRA) programs address intentional and unintentional non-compliance. To accomplish this, the Agency uses a mix of activities such as education, taxpayer service, and enforcement measures provided for in the Income Tax Act and the Excise Tax Act.

The Income Tax Act and the Excise Tax Act provide the Agency with the authority to use enforcement measures including penalties and legal requirements. These measures are aimed at enhancing compliance with tax legislation. In the 2002-2003 fiscal year, the Agency had over 6,400 audit staff in its Tax Services Offices (TSOs) and completed about 300,000 audits. In some instances, auditors encounter non-compliance, which may require the use of enforcement measures.

Some penalties are automated, that is, the penalty is automatically assessed. Others require that employees use a mix of policies, guidelines, and professional judgment when considering or applying them. The five enforcement measures that are discussed in this report require professional judgment and they are described in Table 2 below.

Table 2: Descriptions of the Legislated Enforcement Provisions Covered in the Audit Report

Focus of the Audit

The objective of the audit was to establish whether the enforcement measures available to CRA are appropriately applied to deter non-compliance in support of our strategic goal of responsible enforcement.

The audit focused on how the Compliance Programs Branch (CPB) used guidance, monitoring, and research to achieve responsible enforcement in its management of enforcement measures.

The audit involved CPB and the former Assessment and Collections Branch. The enforcement measures that fall under the responsibility of the Assessment and Benefit Services Branch were scoped out of the audit because many of them are automated penalties. The issues that pertained to the Taxpayer Services and Debt Management Branch were addressed in the Review of the Management of Accounts Receivable, which was reported in January 2005.

The audit was national in scope and interviews were conducted in the Northern Ontario Region, the Southern Ontario Region, the Prairie Region and Headquarters. The examination phase of the audit was conducted from 2003 to 2005. The internal audit team visited three Tax Services Offices in each region and interviewed auditors, technical advisors, team leaders, audit managers, assistant directors of audit, and directors. In addition to the interviews and focus groups, the internal audit analyzed data drawn from the Branch's information management systems. Internal audit also relied on 42 reports from the Branch's Program Assessments and Quality Assurance reviews. The reports from the Branch's review processes cover 28 Tax Services Offices between the years 2000 and 2004.

Findings, Recommendations and Action Plans

Gross Negligence Penalties

The guidance for using the Gross Negligence Penalty is clear and well documented. Additionally, training on using the Gross Negligence Penalty is mandatory for all auditors. While CPB's guidance on the penalty was found to be sufficient, there were some concerns about the effectiveness of its monitoring activities with respect to the Gross Negligence Penalty.

The Branch's review framework includes supervisory review of audit files, data analysis, Quality Assurance Reviews, and Program Assessments. Quality Assurance Reviews compare samples of completed audit files to established quality standards. The Branch also conducts Program Assessments to ensure the audit function follows policies and procedures and contributes to accomplishing the objectives of the Agency.

With respect to Gross Negligence Penalties, the following issues were identified:

• based on Quality Assurance Reviews, about one in two audit files did not contain documentation to demonstrate that a Gross Negligence Penalty was considered when it should have been;
• one third of the files sampled for Quality Assurance Reviews did not have penalty reports when they should have. Four out of six Program Assessments reported the same problem; and
• data from the Audit Information Management System (AIMS) identified wide variability between the individual Tax Services Offices in the percentage of files that were subject to Gross Negligence Penalties.

When team leaders and managers review audit files, they should identify departures from audit policies and procedures and, prior to closing the file, either correct the departure or provide supporting documentation as to why it was not corrected. Both Quality Assurance Reviews and Program Assessments identified inconsistencies in the application of the Branch's policies and procedures regarding this penalty. Moreover, Quality Assurance Reviews and Program Assessments continue to report the same inconsistencies year after year indicating that the inconsistencies that relate to Gross Negligence Penalties are not being addressed.

Recommendation

When the Branch's monitoring processes identify departures from the established policies and procedures, the monitoring process should require action plans that identify specific actions and timeframes for resolving the issue.

Action Plans

In 2004-2005, the Audit Programs Operations Division and the Quality Assurance Division implemented a number of program review activities: Quality Assurance Review, Program Assessment, and Statistical Analysis. The Quality Assurance Review and Program Assessment both result in action plans that identify specific actions and timeframes for resolving identified issues. Follow up on action plans is conducted within one year of the monitoring activity to ensure that action, to resolve the issue, is underway or completed.

In 2005-2006, the Audit Programs Operations Division and the Quality Assurance Division commenced a review of these monitoring activities with a view to increasing their effectiveness. The plan, which is still being revised, is intended to coordinate the work conducted by the Quality Assurance Reviews with the Program Assessments to eliminate any duplication that currently exists between the two, and to redesign Program Assessments to complement the Quality Assurance Review work.

Repeated Failures to Report Income Penalties

CPB has established policies and procedures on the use of the Repeated Failures to Report Income Penalty; however, awareness of the policies and procedures is varied. One policy that is applied consistently is the policy on coding reassessments that include unreported income. When auditors find unreported income, they code the reassessment to automatically assess the penalty if the Agency reassesses the taxpayer to include unreported income in one of the three subsequent years.

Although auditors were following the policy consistently, most auditors interviewed were not aware that the coding on the reassessment could generate an automated penalty in the future. As a result, they were not advising taxpayers that this penalty might be automatically applied if the Agency identifies unreported income within the next three years. Although the Notice of Reassessment advises the taxpayer that subsequent instances of unreported income could generate a penalty, auditors should explain the impact of the reassessment to the taxpayer. To improve the deterrent effect of this penalty, the auditors should communicate this in their final letters.

Another CPB policy is to audit only the two most current years. If the facts of the case indicate that there could be material non-compliance in the earliest, non-statute barred year, auditors have the option to expand the scope of their audits to include a third year. In cases of unreported income, the legislation allows for that year to be treated as the first incident. However, most auditors only consider exercising this option if the facts of the case indicate that they may consider applying the Gross Negligence Penalty. They do not consider exercising this option if the facts of the case indicate that they may consider applying the Repeated Failure to Report Income Penalty.

The Branch's current guidance on the Repeated Failures to Report Income Penalty provides the appropriate policies and guidelines for auditors to use in exercising their professional judgment when considering the use of this penalty. Over the course of the audit, Internal Audit received conflicting information on the guidance for this penalty. Promoting and communicating the guidance on considering the use of this penalty would improve awareness of the policies and procedures.

Recommendation

The Branch should:

• educate auditors to communicate the ramifications of the Repeated Failures to Report Income Penalty to taxpayers in the final letter addressed to the taxpayer at the end of the audit; and
• clarify and promote its policies in order to optimize the use of the Repeated Failures to Report Income Penalties.

Action Plans

The Policy & Consultations Section of the Audit and Professional Practices Division will develop a standard verse, to insert as required in the final letter at the end of the audit, advising taxpayers of the consequences of a first and any subsequent omission to report income. CPB will advise auditors of the policy to communicate to taxpayers, by way of this new verse, the ramifications of the Repeated Failures to Report Income. This verse will also be inserted into the audit manual.

The Policy & Consultations Section of the Audit and Professional Practices Division is currently undertaking a review of audit policies and procedures relating to subsection 163(1) Repeated Failures Penalty, including concurrent audit reassessments. This review will incorporate input received from the field offices.

Requirements for Information

In 2004, the Compliance Programs Branch released expanded guidance on using Requirements for Information. The increased guidance elaborated on how to prepare these Requirements and it explains the procedures for serving the taxpayer or registrant with a Requirement. However, its guidance has not fully addressed when to use them.

Until 2004, no data was collected on the frequency of using Requirements or the outcomes of using them. Additionally, the scope of the Branch's review framework (Quality Assurance Reviews and Program Assessments) did not assess the use of Requirements for Information. The lack of data on the use of Requirements for Information made it difficult to determine the effectiveness of their use including:

• whether Requirements for Information are used when appropriate;
• whether they were effective in obtaining information when they were used;
• what percentage of them resulted in a court order or prosecution; and
• whether the information was obtained after going to court.

In 40 of the 59 interviews and focus groups conducted, audit staff expressed reservations about using Requirements for Information. In 16 of the interviews and focus groups, staff's perception is that management is reluctant to approve Requirements. In 19 of the interviews and focus groups, staff indicated that they lacked training and experience in preparing and issuing Requirements for Information.

In 2004, the Branch began to collect data that should be useful in determining the effectiveness of the legislation and the policies and procedures for using Requirements for Information.

Recommendation

As the Branch builds on its data collection, it should analyze ongoing results to ensure effective and consistent use of Requirements for Information.

In its Quality Assurance Reviews and Program Assessments, the Branch should evaluate the use of Requirements for Information to ensure that they are used when appropriate. This should include work to determine whether the 2004 release of expanded guidance has addressed auditor reluctance to use Requirements for Information.

Action Plans

In 2004 the Audit Programs Operations Division implemented a tracking system for Requirements for Information. Data is now available, and CPB is conducting preliminary assessments as part of Program Assessments and Quality Assurance Review activities, on whether the Requirements for Information are used when appropriate. CPB will also assess the impact of the 2004 release of expanded guidance on this requirement, by way of its 2006-2007 monitoring activities.

The Audit Programs Operations Division now has data for the year 2005-2006 and will continue to build on this database. We will analyze this data, and issue a report by the end of fiscal 2006-2007, that is intended to assess the effectiveness and consistency in the use of Requirements for Information. We will continue to gather information on this requirement on an ongoing basis.

Requirements to Maintain Proper Books and Records

Most auditors interviewed indicated a reluctance to use Requirements to Maintain Proper Books and Records because there is a perception that their use would not be supported within the law. In preparing a Requirement to Maintain Proper Books and Records, auditors specify what information taxpayers or registrants need to maintain in order to determine income, sales and expenses. The misconception among most auditors is that if there is partial compliance with the Requirement, CRA will not be able to carry through with penalties or prosecution.

As a precursor to issuing Requirements to Maintain Proper Books and Records, CPB's audit policy is for staff to obtain informal agreements from the taxpayers and registrants to compel them to improve their recordkeeping. The Branch provides guidance on using the informal agreements, however, it is not being followed consistently. Quality Assurance Reviews found that there were no commitments obtained from the taxpayers or registrants in one third of the files that described the taxpayers' or registrants' books and records as inadequate, inaccurate or unreliable.

The internal audit found that the Compliance Programs Branch was not monitoring the use or assessing the effectiveness of Requirements to Maintain Proper Books and Records or the informal agreements. There was no centralized data collection on the number of informal requests used or the number of legal Requirements to Maintain Proper Books and Records that were issued. The lack of data made it difficult to determine:

• whether the informal requests were effective in compelling the taxpayers and registrants to improve their recordkeeping;
• whether Requirements were more effective than requests in compelling the taxpayers and registrants to improve their recordkeeping; and
• whether there was a greater need to use legal Requirements to Maintain Proper Books and Records.

Recommendations

The Branch should ensure that auditors are adequately informed about Requirements to Maintain Proper Books and Records and, in particular, auditors should have guidance on dealing with partial compliance with these Requirements.

The Branch should assess:

• the effectiveness of informal requests in improving compliance in the maintenance of adequate books and records; and
• the effectiveness of Requirements to Maintain Proper Books and Records.

Action Plans

The Audit Programs Operations Division will issue a memo to the field to clarify to the auditors the correct use of informal requests and Requirements to Maintain Proper Books and Records when inadequate books and records have been identified.

The Policy & Consultations Section of the Audit and Professional Practices Division will also review the Requirements to Maintain Proper Books and Records guidelines in the Books and Record section of the Audit Manual, and the general guidelines for the Record Keeping Initiative, to ensure consistency. The Record Keeping Initiative is a CPB activity aimed at improving non-compliance by way of changing taxpayer behaviour on maintaining poor books and records.

With respect to partial compliance, The Policy & Consultations Section of the Audit and Professional Practices Division will review the current guidelines on Requirements to Maintain Proper Books and Records with a view to modifying them to include guidance for partial compliance to this requirement.

The Audit Programs Operations Division will conduct a one time follow-up review of audit files to assess the effectiveness of informal requests and Requirements to Maintain Proper Books and Records in improving compliance. Based on the results of this one time review The Audit Programs Operations Division will determine if changes/further follow-up is required.

Third Party Penalties

CPB has established policies and procedures for considering use of the Third Party Penalty and applying it. The Branch has also developed training and most auditors have been trained on considering the use of this penalty.

If an auditor encounters a case that may be considered for this penalty, the case must be referred to a Headquarters committee, before the Tax Services Office can audit the third party. Most Tax Services Offices have set up a local committee for reviewing the cases before making any referrals to Headquarters. The local committees ensure that the most egregious cases are referred to the Headquarters committee. A Third Party Penalty Review Committee meets after the completion of the audit and must agree that a situation warrants a penalty before the penalty may be assessed.

There have been 19 referrals to Headquarters since the legislation came into force over five years ago. However, there is no centralized data collection on the number of cases considered at the local level and the rationales for not referring cases to Headquarters have not been documented. Documenting the cases considered, and the rationales for the decisions made on them, would assist in ensuring consistent interpretation of the criteria for referring cases to Headquarters.

Recommendation

The Compliance Program Branch should ensure that the cases considered at the Tax Services Offices are documented and analyzed against the criteria for referring cases to Headquarters.

Action Plans

In implementing the Third Party Penalty provisions, the CRA put in place procedural checks and balances to ensure that no one person could direct the application of the penalties or otherwise inappropriately apply the penalties. In addition, the CRA established a Headquarters review committee, namely the Third-Party Penalty Review Committee (TPPRC), which includes senior representatives from the CRA's Compliance Programs Branch, the Regions and Legislative Policy and Regulatory Affairs Branch, and from the Departments of Finance and Justice.

The onus to date, consistent with the Government's intent and the CRA's commitment, has been to ensure third party penalties are applied in a limited manner to only the most “egregious” situations. In addition, a recent poll of the Regions identified only three instances in 2005-2006 where a possible third party penalty situation was not considered by the local compliance committee to be sufficiently egregious to refer to the TPPRC.

Notwithstanding, the CPB will continue to monitor and review the copies of minutes, and other information provided by local compliance committees, along with the volumes and nature of third party penalty cases, with a view to considering centralized data collection when warranted.

Evaluating the Effectiveness of Enforcement Measures

CPB has recently completed in-depth research to gauge the effectiveness of Gross Negligence Penalties. Its research includes a collaborative study, undertaken with the Appeals Branch, to examine why penalties were fully or partially reduced as a result of an objection. Another study estimated the rate of non-compliance among the taxpayers who were previously subject to Gross Negligence Penalties. In determining the effectiveness of Gross Negligence Penalties, the Branch has the information it needs to identify opportunities to improve the legislation as well as its policies and procedures.

Similar research has not been performed for other enforcement measures such as the Repeated Failures to Report Income Penalty and Requirements to Maintain Proper Books and Records. As such, the Branch cannot determine whether these enforcement measures are effective at addressing intentional and unintentional non-compliance.

Recommendation

Building on the work already conducted for Gross Negligence Penalties, the Branch should research and evaluate the effectiveness of other enforcement measures. It should use the results of these studies to continuously improve its compliance strategy and to guide the use of enforcement provisions.

Action Plans

CPB's Compliance Research Division (CRD) is currently conducting a study on the impact of ss. 163(2) penalties as requested by the Audit Program Strategy Division. CRD will undertake further projects of this nature to assist the Audit Directorate in exploring the compliance impacts of other program initiatives and compliance instruments. Requests for such studies will be part of the Audit Directorate's response to the Division's annual call letter for research requests, which is conducted in the fall of each year.

Conclusion

Overall, the Branch needs to further improve its guidance, monitoring, and research for enforcement measures. Although these measures are relevant to only a minority of audit files, these files represent a critical group for the Agency.

The Branch's guidance for Gross Negligence Penalties and Third Party Penalties was sufficient. However, it is too early to determine whether its expanded guidance for the use of Requirements for Information is adequate. Although auditors were following the guidance for the Repeated Failures to Report Income Penalty, most auditors were not familiar with its legislation and they were not aware that the coding for the audit reassessments could generate automated penalties if the taxpayer was non-compliant in later years. Also, the Branch's guidance on using Requirements to Maintain Proper Books and Records did not fully prepare auditors for dealing with partial compliance.

The Branch's monitoring for the use of legislated enforcement provisions was varied. Some of the enforcement measures were included in its review framework, while others were not; the feedback generated by its review framework did not generate improvements; it collected data on some enforcement measures and it needs to improve its data collection for others; and the only enforcement measure it has performed evaluative research for is the Gross Negligence Penalty.