Resolving Tax Disputes (3rd edition) studies tax disputes, conflict levels, and basic strategies. It helps accountants to limit early-stage mistakes and reduce liability.
One of the chapters in RTD3 is about audits and how to handle them. It provides valuable tips to help you navigate the audit process. We’ve included some excerpts from that chapter in this article.
Practice Advisory Tips for Accountants Navigating Tax Audits
Dealing With Auditors
Don't Treat the Audit As a Confrontation
The chances of resolving a tax dispute on acceptable terms at the audit stage are higher if you refrain from treating the audit process as a confrontation. Some steps you can take to do this are as follows:
- Approach the audit as if this were a cooperative effort in which you and the auditor try to develop common views about the facts, the law, and the relative strengths and weaknesses of each others’ positions.
- Let the auditor know as early in the process as possible that you will be courteous and respectful, that you will be honest and prompt in answering questions,
- Explain that you will listen to the auditor’s views and will recommend that your client concede points which should be conceded.
Obviously, you protect and promote your client’s interests and make sure that the auditor understands that your obligation is to do just that, and that you will not hesitate in appropriate circumstances to approach the auditor’s superiors or to have the client file a notice of objection.
Do Learn About the Auditor
To deal appropriately and effectively with an auditor, it is helpful to know as much as possible about their level of education, professional training, and work experience.
When we tax lawyers and accountants deal with each other, we tend to assume, given the substantial similarity in our education, training, and work, that we all speak the same language, with the same levels of experience. We cannot make the same assumption when dealing with tax auditors.
The tax auditor’s education, training, and experience are likely to differ significantly from yours, and you want to be aware of the differences. For example, while the auditor may not have a legal or accounting background, they may have a great deal more training and experience in auditing the particular kind of business.
One of the most important things to know, for example, is whether the auditor has audited dozens of other taxpayers in the same business as your client, or if this is their first audit of this type of client or business.
You should learn as much as possible about the specific auditor you are dealing with while still maintaining a respectful attitude. When the auditor presents their official identification card, you may tactfully ask about their professional credentials and educational background and ask about any accreditation the auditor may have.
You will also want to know about their understanding of tax law and language proficiency.
All this background information may affect your judgment about how to make submissions to the auditor and about whether to ask for a meeting with the auditor’s superiors.
Navigating the Initial Audit Interview
One of the key stages in an audit is the initial interview. The first impressions and information obtained here will carry through to all levels of this entire process.
Strategy in an audit will depend upon your level of preparation and your knowledge of the accuracy of the records being audited. You should ensure that you and your client are prepared to answer tough questions.
The CRA will ask a series of standard ordinary questions in the initial interview. It can be extremely beneficial for your client to go through the standard questions and prepare answers in advance to avoid making off-the-cuff or emotional responses during the actual interview. This can also help to put your client at ease before the audit itself.
It is important to manage the flow of information to the auditor, but at the same time, you should encourage your client to cooperate with the audit. Where the auditor feels they do not have access to information they want or if they feel a taxpayer is being deliberately obtuse, they are likely to just fill in the blanks with their own assumptions. The auditor’s assumptions are rarely in the taxpayer’s favour.
Prepare to be Asked About Non-Taxable Income
During the initial interview, the auditor will ask whether your client has any non-taxable sources of income. If your client simply answers no, it is extremely difficult to later reverse this position. Your client may give that answer out of ignorance. You must prepare your client by informing them of the actual tax consequences of certain transactions before the interview, so they are not caught by surprise, with permanent consequences for the audit.
Routine transactions, such as loans from family members, gifts, inheritances, and the sale of personal possessions are all commonly overlooked non-taxable income sources. Your client should be aware of this and be ready to provide appropriate answers.
Prepare to be Asked About Your Records
Furthermore, if you know that some records have been lost, destroyed, or otherwise unavailable, you need to be ready to address this in the first meeting. A taxpayer simply saying records were lost in a flood raises issues of credibility, which are rarely resolved in favour of the taxpayer at the audit stage. As Justice Bowman (as he then was) aptly commented:
“...until I joined the court, I had no idea how many floods there were in basements in Toronto or throughout Canada. Someone would say, “Oh, I lost all of my papers in a flood in the basement.” Even in a dry summer, it seems that there are floods. So, keep your records together and don’t make stupid allegations that you can’t prove — and it’s better not to say anything than to say something that you can’t substantiate”.1
However, if the taxpayer provides a copy of an insurance claim from a flood and photographic evidence of the damage, they immediately reduce the risk that the auditor will draw an adverse inference from failure to produce records.
So, keep your records together and don’t make stupid allegations that you can’t prove — and it’s better not to say anything than to say something that you can’t substantiate.
- Justice Bowman
You should also make your own notes of anything stated in the interview. Auditors keep notes of all meetings with taxpayers and may bring another CRA employee for independent verification if they anticipate any problems.
Conducting Cost/Benefit Analyses for Settlement Negotiation Purposes
As the auditor narrows their focus on the subjects of reassessment, you should begin analyzing the costs and benefits so that you can make recommendations to your client about a negotiated settlement. This analysis involves the following steps:
- Calculate the amounts of tax, interest, and penalty at stake in respect of each item to be reassessed.
- Gauge which items are the taxpayer’s strongest, and which are the weakest.
- Identify the items on which the auditor is least likely to compromise, such as one which depends on the taxpayer’s credibility; involves the auditor’s reliance on a valuation opinion from a CRA appraiser; or is an item that concerns a directive from Head Office – which may not be able to be resolved without a court hearing, keeping in mind that if your client were to succeed at trial, the CRA might intend to appeal to the FCA.
- Estimate the after-tax costs of objecting to and appealing the reassessment.
- Ascertain the client’s willingness to engage in a dispute with the CRA, taking into account the amounts of tax, interest, and penalties at stake; the professional fees and disbursements to be incurred; the benefit the client will derive from deducting such fees and disbursements from their income for tax purposes; the amount and value of the time the client will have to devote to the dispute; the client’s sensitivity to the social and reputational costs of a public hearing in the TCC; the possibility that the dispute could extend over several years; and the potential liability for the government’s costs if an appeal is ultimately unsuccessful.
A cost-benefit analysis is not an exact science. While there are predictable steps to the tax dispute resolution process, it is often impossible to predict if, or at which stage, a particular dispute will be resolved. Cases fraught with difficulty may be resolved early, while seemingly simple cases may proceed to court.
Managing Clients During the Audit
You should help your client understand that tax dispute resolution is unpredictable so that they can make an informed judgment about whether to settle at the audit stage or to contest a reassessment.
The client must also be prepared to budget the mental and financial resources if they choose to object to the reassessment.
Your client is more likely to make rational decisions as the process unfolds if they are attuned to the steps, time, and expense required at each stage of the tax dispute resolution process. This in turn will improve the chances of an satisfactory resolution.
At the same time, your knowledge of the client’s financial and mental commitment to the objection will enable you to persuasively convey a settlement proposal to the auditor. It will also enable you to make better judgments about the amount of time and effort to devote to each issue at each stage of the contest.
Decide Whether to Waive Reassessment Time Limits
Auditors commonly start auditing a three-year period when the time limit for reassessing the first of those three years is about to expire. The auditor may ask the taxpayer to sign a waiver of their right to assert a statute of limitations for that year. The CRA’s published policy is to refrain from issuing arbitrary reassessments if the taxpayer refuses to sign a waiver unless the taxpayer has unduly delayed the audit process.2
In practice, however, an auditor’s request for a waiver is usually accompanied by an implied or express threat that an arbitrary reassessment will immediately be issued to protect the CRA’s right to audit the year if the taxpayer does not sign such a waiver.
Waiving a particular taxation year rarely produces any significant benefit to the taxpayer. It is better to simply object to the CRA’s arbitrary assessments than to sign the waiver. Taxpayers who do not sign a waiver may have an easier time objecting to arbitrary reassessments that are not based on the facts or the law. The CRA usually reassesses the year anyway; the waiver simply delays the process for a few months, while more non-deductible interest accumulates on the amount to be reassessed. If the auditor issues an arbitrary reassessment without genuine factual or legal foundation, the taxpayer may have an easier time challenging the reassessment at the objection stage.
We suggest taking the following three practical steps if the taxpayer decides to file a waiver:
- make it a condition of the waiver that the CRA agree to waive any interest on any subsequently reassessed tax accruing between the date of the waiver and the date of the subsequent reassessment;
- draft the waiver in as narrow terms as possible using the CRA’s form and add any additional pages, as necessary; and
- consider giving notice of revocation after submitting the waiver so that the waiver will be effective for only six months.
1 “Tax Tales: A Conversation with Judges and Counsel,” in Report of Proceedings of the Fifty-Fourth Tax Conference, 2002 Conference Report (Toronto: Canadian Tax Foundation, 2003) at 33:3.
2 CRA, Information Circular 71-14R3, “The Tax Audit”, June 18, 1984, available online at https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/ic71-14/tax-audit.html [IC 71-14R3] at paragraph 28.