Auditors' Power to Review 'Books and Records' During a Tax Audit

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. 

What Can The Auditor Review?

CRA auditors have the power to inspect the taxpayer’s “books and records”. Books and records are not defined in the ITA and there are no set requirements as to how such records are to be maintained and organized.

Defining "Books and Records"

It is accepted that the term “books and records” refers to both accounting and financial documents that summarize transactions and the original source documents associated with each transaction.

For employees, this would include T-slips, deposits slips, copies of paycheques, and bank statements. For businesses, this is more involved and includes all physical receipts detailing expense purchases as well as invoices, cancelled cheques, deposits books and bank statements.

The CRA may also ask to download electronic data and journal entries from any accounting programs used by a business. Corporations are also required to keep a minute book containing minutes from any meetings and resolutions of the company's shareholders and directors.

The auditor will typically list the documents they wish to review in their initial letter to the taxpayer.

Relevant Law: Keeping Corporate Records

To ensure that taxpayers will have books and records available for auditors to inspect and will produce them for inspection when required, the ITA requires taxpayers to maintain and retain appropriate records and imposes civil and criminal penalties for non-compliance.¹  Subsection 230(1) of the ITA prescribes the general requirement for keeping records and books in the following terms:

Every person carrying on business and every person who is required, by or pursuant to this Act, to pay or collect taxes or other amounts shall keep records and books of account . . . at the person’s place of business or residence in Canada... in such form and containing such information as will enable the taxes payable under this Act . . . to be determined.

Such books and records must be kept for at least six years after the filing of the taxation year to which they relate. Where a notice of objection or appeal to the TCC is underway, records must be kept until the issue is resolved.²

Certain specified records are required to be kept longer and the Minister may require a taxpayer to keep records longer than the statutory or prescribed period simply by sending the taxpayer a registered letter of this requirement.³

If the taxpayer keeps records electronically, the records must be kept in electronically readable format for the same length of time.⁴

If an auditor determines that a taxpayer is not keeping proper books and records, they may specify which books and records are to be kept and the taxpayer is thereafter required to keep the specified books and records.⁵ The taxpayer’s continued failure to keep adequate books and records is frequently used at a later date to justify penalties. 

Original Receipts

Taxpayers should keep their original receipts available because auditors frequently have the mistaken belief that, if no supporting documentation is available to verify a claim on a return, then it must be disallowed.

You will often see this with auditors refusing to accept bank statements as proof of an expense and demanding the original receipt showing what was purchased – along with a description as to how this relates to the business. This position regarding receipts is not the legally correct approach, because taxpayers may substantiate expenses with credible oral testimony.⁶ 

However, this is unlikely to hold much sway at any of the internal CRA review stages and so wherever possible, taxpayers should keep their original receipts available and seek confirmations of claims from independent third parties.

Affidavits or letters from other individuals involved may be of assistance if the original records have been lost or destroyed.

When Books and Records Aren't Properly Maintained

Taxpayers who fail to make and retain reasonable records leave themselves exposed to the risk of an aggressive audit and an indirect determination of income or ‘‘net worth’’ reassessment, which tends to be a punitive estimation of the taxpayer’s income by reference to their annual changes in net worth and estimated total consumption.

You should review your client’s books and records as well as all source documents before the audit begins to ensure they are organized and to identify any potential problem areas. Most accountants and tax preparers will prepare returns from the summary accounting documents of the client without auditing the original source documents, so this could be the first time the taxpayer’s bookkeeping has been reviewed. Being prepared will help you control the direction of the audit and better manage the auditor’s questions.

Citations

¹  Failure to comply with record keeping requirements is punishable by civil penalties under paragraph 162(7)(b) of the ITA, the penalty being $100 to $2,500 per failure to comply. In the most serious case of non-compliance, a taxpayer may be criminally prosecuted for non-compliance under subsection 238(1) of the ITA, and if convicted, could be liable to a fine of between $1,000 and $25,000 per failure, or both a fine and imprisonment for up to 12 months.

²  Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended, at subsection 230(6).

³ Ibid at subsection 230(7). 

⁴ Ibid at subsection 230(4.1).

⁵ Ibid at subsection 230(3).

⁶ In the absence of records, any other reasonably verifiable information will be given consideration including the taxpayer’s oral testimony – see CRA Views 2009-0335711E5, November 12, 2009 (“Requirement to provide receipts”); and Hickman Motors Ltd v. R, [1997] 2 SCR 336 at paragraph 87.