You might think the Canada Revenue Agency (CRA) would keep silent about what triggers an audit. But the agency is actually quite candid about why it chooses certain tax returns.
For example, the CRA publishes newsletters, technical interpretations and taxpayer alerts on its Web site that elaborate on audit issues, describe areas of concern to the government, and warn about actions and investments the agency is likely to investigate.
In addition, the Auditor General of Canada has issued a report titled “Verifying Income Tax Returns of Individuals and Trusts,” which discusses in detail how the CRA processing and review system works.
|Gross profit margin is lower than direct competitors — or higher — while net profit is lower.||Properly record and categorize expenses.
Ensure the accuracy of direct and operating costs, as well as inventory valuation.
|High vehicle expenses||Keep a vehicle log.|
|Unusual home office business expenses||Determine the business use of your home on a consistent and defendable basis.|
|Small Business Deduction: High “other revenue” or investment revenue. Large cash balance on balance sheet.||Pay dividends to remove excess cash from the corporation. Repay shareholder loans. Consider forming a separate holding company for investments.|
|Income is low for many years.||Report all income, including non-taxable sources.|
With all that information, it’s generally easy to determine some of the transactions and recording methods that are likely to prompt an audit.
Here are 10 red flags gleaned from these documents to help you gauge whether your tax return is likely to trigger an audit:
1. Revenue discrepancies. A sure-fire trigger for an audit is reporting revenue on your GST return that doesn’t match what you report on your income tax return. Report all revenue on your GST return, even if you don’t collect the tax on some revenue.
Treat revenue and expenses the same way on both returns. For example, when filing your income tax return, don’t reduce revenue by the associated expenses and report only the profit while reporting total revenue on your GST return.
In addition, the CRA annually matches information on tax returns with information provided by employers, financial institutions, and other third parties. The tax returns of individuals who are married or living common law are also compared with their spouses’ or partners’ returns.
These comparisons are made to identify unreported income, incorrect claims for an amount of “income tax deducted,” credits and deductions that exceed the limits, net family income for the purpose of claiming several credits as well as incorrect “pension adjustments.”
2. Claiming large interest and carrying charges. A taxpayer with business or rental income should claim related accounting fees and interest expense on the business or rental income schedule. They should not be claimed as carrying charges and interest expense. This deduction is for expenses related to investment income.
3. Changes in shareholder loans and large balances. If you hold stock in a corporation, large changes in shareholder loans or debit balances can attract attention. The CRA is looking for personal expenses recorded as business expenses and loans taken from a company. Your accountant can advise you about the best way to structure loans.
4. Deducting large business expenses. The CRA scrutinizes business and rental income schedules that show large amounts of advertising and promotion, travel, miscellaneous and interest expenses. The tax agency is looking for personal expenses, meals and entertainment that are improperly recorded and non-deductible expenses such as penalties and interest. Meal and entertainment expenses should be separated and expenses should be allocated individually rather than using “miscellaneous.”
5. Making calculation errors or leaving out information. Many audits result from simple math errors on tax returns or missing information slips, such as the T3, T4, and T5. Professionally prepared tax returns that minimize audit red flags are one of the many benefits of using a qualified accountant.
6. Large or unusual changes in deductions or credits. Employment expenses are limited to just a few people and large employment expenses are a flag for the CRA. Moreover, you may be requested to supply additional information if you have claimed childcare or tuition expenses.
7. Large charitable donations of cash exceeding $25,000 and capital property are often reviewed.
8. Investment gains and losses. The CRA will closely look at losses claimed on investments in small business corporations. The rules are complex and often misunderstood or misinterpreted. Many taxpayers also don’t correctly track capital gains and losses, so they, too are an audit flag. Account statements from financial institutions may not be accurate for tax purposes. Income trusts, for example, erode their cost base over time because of returns of capital. Foreign currency investments can present a problem as you need to account not only for your financial gain or loss but also for the foreign exchange gain or loss.
9. Foreign tax credits. These claims may trigger an audit for investors who earn income from foreign investments or employment.
10. RRSP overcontributions. If you overcontribute to your Registered Retirement Savings Plan, taxes are owed on the excess. Over contributions are common when retirement allowances are deposited into the accounts and when taxpayers contribute to their plans without referring to their annual Notice of Assessment.