The Tax Audit
June 18, 1984
This circular cancels and replaces Information Circular No. 71-14R2 dated February 5, 1979.
1. This circular describes the role, the policies and practices of the tax audit - the examination of taxpayers' books and records to determine accurately the taxes, interest and penalties payable under the law.
2. While there is, in Canada, a high standard of public compliance with the law, a self-assessment tax system can be maintained only through vigilant and continuous inspection of returns. The primary purpose of the tax audit is to monitor and maintain the self-assessment system. As such, it plays an important role in the achievement of the objectives of the Department which are to collect the taxes imposed by law through the encouragement of voluntary compliance and to maintain public confidence in the integrity of the tax system.
3. While the prospect of being subjected to a tax audit is a strong inducement to voluntary compliance, particularly in view of the penalties applicable for gross negligence or wilful non-compliance, the personal contact afforded by an audit is an ideal vehicle for promoting an atmosphere in which taxpayers can realize that each is bearing a lawful share of the tax burden, and not more than that share.
The law and the system
4. The Canadian income tax system is one of self-assessment. In it, every corporation and every taxable individual, estate or trust is required by law to file an annual return of income in prescribed form and to determine the taxes payable for the year. After initial processing and correction of obvious errors made in completing the return, and after completion of a matching program, which matches certain information in the return with that in other returns or from other sources, the return may be selected for audit and thus subjected to a detailed examination. The selection of returns for audit is explained in 14 to 19 below.
5. The Income Tax Act requires taxpayers to keep such records and books of account as are required to determine the taxes payable and authorizes the Department to audit these for any purpose related to the enforcement or administration of the Act. To this end, the Act further authorizes the Department to request and receive from any person information, records, documents etc, within a reasonable, stipulated time.
6. Under the Act, the Department may re-assess tax returns:(a) at any time in cases of fraud or misrepresentation, or where a waiver, specifying matters on which a reassessment may be issued, has been filed; or
(b) at any time up to 4 years after the date of mailing the original assessment, in all other cases.
7. Of the 15 million individuals who filed returns for the 1981 taxation year, approximately eighty percent were salary or wage earners, pensioners, etc.; the remaining twenty percent were persons reporting income from unincorporated businesses, professions, farming , fishing, and investments, rentals and commissions. In addition some 500,000 corporations and 200,000 trusts filed returns for the same year.
8. Wage and salary earners present relatively few compliance problems. For the most part, their taxes are collected through payroll deductions and their incomes are readily verified by reference to information filed by their employers. The requirement to maintain books and records has little application to these taxpayers and, save for certain cases, such as when the deduction of some expenses from wages and salary may be permitted, there is little need for audit activity. The Department's audit program is directed mainly at those individuals deriving income from businesses and professions, as well as corporations and trusts.
9. The following principles are observed in developing the audit program:(a) Total compliance is, and will remain, an elusive goal;
(b) The most effective and least expensive form of compliance is voluntary compliance;
(c) Recovering undeclared taxes encourages voluntary compliance;
(d) The recovery of undeclared taxes could theoretically be obtained by a complete audit every four years. In certain cases, however, the scope and complexity of taxpayers' affairs suggests that for reasons of practicability as well as the preservation of good relations with these taxpayers, audits be scheduled more frequently and cover less than a four year period;
(e) Each taxpayer group should receive at least a nominal amount of audit attention:
(f) Categorizing taxpayers for audit purposes should be done on a rational and impartial basis. Taxpayers of any group should be satisfied that the audit program is based on fair and non-discriminatory criteria.
10. The application of these principles is reviewed continuously, by(a) analyzing and evaluating the results of completed audits;
(b) comparing audit results to the audit programs and evaluating variances;
(c) considering the effect of audit actions on compliance;
(d) preparing alternative audit programs showing different coverage emphasis and techniques directed towards identified areas of non-compliance;
(e) conducting compliance measurement surveys of various taxpayer groups;
(f) researching alternatives to methods of taxpayer classification and grouping.
11. Each year the audit program is modified in keeping with the resources allotted to the Department. In order to make optimum use of limited resources, careful consideration is given to identifying those groups of taxpayers or organizations most in need of attention and selecting audit actions most likely to improve compliance.
12. Essentially, the audit program is based on the estimated number of returns filed by each taxpayer group, and the number of returns that can be audited with the available staff. Variations in coverage are influenced by the degree of non-compliance within various taxpayer groups as measured by results from previous audit programs and compliance measurement surveys.
13. The current grouping of taxpayers into "categories" is quite detailed. Within the initial classification by type of return (T1, T2, T3), categories are established by type of occupation or business, gross income, net income, and any other relevant and impartial criteria.
Selection of files for audit - Other than projects
14. The selection of returns to be audited is greatly facilitated by the computer records of all returns filed. This allows returns to be sorted into various groupings in order that the selection criteria can be applied. In some cases sophisticated comparisons are made of selected financial information of current and prior years and between taxpayers engaged in similar businesses or occupations. These systems generate lists of returns for potential audit selection from which specific returns are chosen by supervisors in each District Office.
15. There are at present no rigid rules for the screener to follow other than the dictates of objectivity and impartiality. Computerized selection criteria are being perfected on an ongoing basis.
16. While the majority of files audited are selected in the screening process described above, there are three other common means of selection. These are:(a) Audit projects - Frequently, the compliance of a particular group of taxpayers is tested. If the test results indicate that there is significant non-compliance within the group, its members may come under audit on a project basis which may have local, regional or national application.
(b) Leads - Information from other files, from audits or investigations or from outside sources including informers may lead to the selection of a particular file for audit;
(c) Secondary files - A file may be selected for audit because of its association with another file previously selected. For example, if several taxpayers share a single place of business and are under the same control, and one of their files has been selected for audit, it is usually more convenient both for the Department and the taxpayers to have all the records examined during the same audit engagement. In addition, the affairs of such taxpayers are often so interwoven as to require the auditor to examine them together.
Compliance measurement audits
17. A compliance measurement survey, using statistical sampling techniques attempts to establish the degree of non-compliance in various sectors of the population as well as in the entire population.
18. By auditing a randomly selected sample of returns and examining the tax recoveries from this sample, it is possible to project (within certain tolerances of probability) the potential tax recoveries for the whole group. This constitutes a measurement of the amount and proportions of non-compliance. By periodically checking the non-compliance for a particular group of taxpayers, in relation to audit activity within that group, it is possible to estimate the effects of audit on compliance. Intensification or reduction of audit effort takes place depending on whether the compliance has increased or decreased in that group.
19. Additional data collected from these sample audits is computer analyzed in an attempt to detect patterns which could be helpful in the future selection of files for audit.
20. The "field audit" is the main tool in the Department's audit program. this action can require from a few hours to several weeks depending on the nature of the examination and/or the size and complexity of the taxpayer's operations. The "field audit" is usually a detailed but sometimes restricted examination of books and records normally conducted at the taxpayer's place of business. The field audit can be conducted by one auditor or a team of auditors. Team audits use two or more auditors and may include individuals with different skills such as electronic data processing and, as circumstances require, may be directed by a case manager. Another form of audit is the industry-wide audit, which involves the coordinated audits of a number of corporations within one industry. Other specialists, such as Business Equity Valuators and Real Estate Appraisers, are available to assist auditors in situations concerning valuations and appraisals of equities and various properties respectively.
21. Before beginning a field audit. the auditor will contact the taxpayer to arrange a convenient date to commence the audit and will then begin a review of the taxpayer's file. In this preliminary review, the auditor examines the return selected for audit, the attached financial statements for prior years, audit reports from previous audits and any other information on file. In so doing, the auditor can plan, in a general way, an approach to the audit and prepare a list of queries to raise.
22. On arriving at the taxpayer's place of business, the auditor will present an official identification card. Before beginning the examination of books and records, the auditor may want to discuss with the taxpayer the general nature of the business or tour the premises to gain a better understanding of the transactions recorded in the books. Cooperation by the taxpayer in this regard permits a faster and more efficient audit and is, consequently, of mutual benefit.
23. The scope of the audit is determined by the auditor with the advice and direction of a supervisor. They decide which records should be examined and what audit techniques should be employed. The audit might extend to examination of the taxpayer's ledgers, journals, bank accounts, sales invoices, shipping and receiving records, purchase vouchers, expense accounts, inventories, investments, agreements, contracts, appointment books, share records and minutes, etc. Throughout the audit, the auditor may need to obtain information and assistance from the employees of the taxpayer, particularly those on the accounting staff.
24. In a small minority of cases (for example, when the records are inadequate, or the income reported appears inconsistent with the taxpayer's standard of living) the auditor may have net worth statements prepared to determine income, or to confirm income established by other audit approaches.
25. The auditor does not usually question items one by one as the examination proceeds since many will answer themselves during the course of the audit. The preliminary list of queries will be modified and periodically a group of outstanding questions will be presented to the taxpayer. Should the taxpayer's return require an adjustment the steps described under the heading "Reassessment" are taken.
Delays in audit
26. Although the actual time of audit may be only one or two weeks, the elapsed time from start to finish may be longer. Unavoidable delays may occur when the taxpayer wishes to consult with advisers, or is called out of town before completion of the audit. Similarly, the auditor may cause the delay by deciding to request an interpretation from Head Office on a particularly complex or contentious point of law.
27. Sometimes, however, unnecessary delays are caused by taxpayers or their representatives failing to provide information or documents as requested. Faced with this situation, the auditor can obtain the information, by(a) a written request to the taxpayer and/or the taxpayer's representative. The taxpayer or a representative will be given a reasonable period to provide the information.
(b) A formal requirement under the Act (conviction for failure to comply would result in a fine).
(c) A reassessment based on the incomplete information available (to dispute the reassessment, the taxpayer might then need to produce the missing information).
28. It is departmental policy to use with moderation the somewhat arbitrary method outlined in (c) above. Problems can usually be avoided if the taxpayer advises the auditor of any valid reason for delay in providing the requested information.
Determination of tax
29. It should be remembered that the role of the auditor is to determine the correct tax payable, even if this involves a downward adjustment of tax and a consequent refund.
30. In the determination of the correct tax, the auditor will not challenge generally accepted accounting principles as observed by the taxpayer unless:(a) The taxpayer has been inconsistent in their application;
(b) A certain practice is specifically prohibited by the Income Tax Act or Regulations;
(c) There is legal precedent for not recognizing the principle for tax purposes;
(d) It appears the principle is being applied only as part of a scheme for tax evasion or tax avoidance.
31. When an audit is completed, the auditor may propose to adjust the tax payable by reassessing the taxpayer's return. Initially the proposal will be discussed with the taxpayer and/or representative and, if they request or it is reasonable to expect that the taxpayer will need an opportunity to analyse the proposed adjustments, the auditor will confirm the proposal in writing and allow a reasonable period in which to make representations. If the taxpayer is in full agreement with the changes, the auditor may proceed with the reassessment without a written proposal.
32. If the auditor does not have any proposed adjustments to the taxpayer's income tax return, the auditor will so notify the taxpayer and/or representative.
33. Should an audit be delayed by the circumstances described in 27 above and a reassessment proposed on the basis of available information, the taxpayer will be advised of the proposed change in writing and given a reasonable period to provide the missing information. If the taxpayer provides the requested information in this interval and should it alter the auditor's proposed reassessment, the taxpayer will be notified as in 31 above.
34. The policy of taxpayer notification does not apply when the Department suspects the taxpayer is attempting to avoid payment of taxes, as contemplated by subsection 158(2) of the Act. For more information on the subject of avoiding payment of assessed taxes, see Information Circular 75-16R, "Collection Policy."
Reassessment of prior year's returns
35. The subject of reassessing prior years' returns is dealt with in Information Circular 75-7R2, "Reassessment of a Return of Income".
36. With audit activities being conducted in 28 District Offices, the Department is concerned with achieving uniformity of interpretation and application of the law. This is the prime objective of the audit review system which encompasses the District Offices and Head Office. Each District Office has a review section responsible for achieving this objective within the District while the Audit Programs Division of Head Office is charged with ensuring uniformity across the country.
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