Canada has a substantially voluntary income tax reporting system (called "self-assessment") in that the Government relies on each individual, corporation and other taxable agencies, to submit, annually, a statement of their taxable activities.

For the common citizen, this is the annual tax return.

The government receives these tax returns and returns to the taxpayer a notice of assessment. An essential part of the system is the requirement that taxpayers keep records as may be required to substantiate their tax payable.

With 25 million individual returns, and 1.6 corporate returns, annually to process, in order to provide a semblance of verifications of these returns, the Canada Revenue Agency selects, from time to time, tax returns for audit. What the CRA looks for in selecting whose tax return the audit, are blips on their computer database; something out of the ordinary in either past returns by the individual or comparatively in respect to the particular community or occupation. Two things CRA is known to look for are proportionately large deductions relative to income and sudden changes in your year-to-year returns.

Church signFrom CRA’s Income Tax Information Circular #71-14R3t (yes, that’s its real name!):

"The Department's audit program is directed mainly at those individuals deriving income from businesses and professions, as well as corporations and trusts."

Sometimes, disclosure made by informers will result in attracting CRA's audit attention. In the result, about 1% of returns are selected for audit annually.

CRA may conduct a desk audit which is where they simply demand from you supporting documentation respect to your tax return. Other times, CRA officers will send their auditor to the place of business of the taxpayer to examine records there (a field audit).

Ultimately, CRA has the power to inspect and audit a taxpayer's books and records or to enter business premises for this purpose. If they meet with resistance, they will usually issue a formal requirement or demand letter for information or records but at the end of the day, CRA does have the power to obtain a search warrant, without notice to the taxpayer, under certain extraordinary conditions.

The CRA officer will consider what the audit has found against the original tax return. If they believe that the original tax return had errors or omissions, they usually send out a proposal letter to the taxpayer suggesting changes to the original tax return (usually for more tax money) and asking the taxpayer for any comments on the proposal. The proposal letter proposes a deadline for that information, 15 or 30 days generally.

For a taxpayer, every attempt should be made to come to a resolution with CRA’s auditor; a settlement, but even this step in the process should only be undertaken with expert tax advice.

From time to time, an auditor may be closed-minded to submissions made by the recipient of a proposal letter. Auditors are human and not perfect. They can develop a personal bias or, given some circumstances, feel that a particular taxpayer is wasting their time (CRA is a big bureaucracy – 44,000 employees according to their 2006 Annual Report, of which over 8,000 are in the audit division).

They next step in the process is for CRA, if they have not been persuaded by the taxpayer's submissions to the proposal letter, or if CRA has skipped the proposal letter step (which they can do), CRA will issue a reassessment.

The issuing of a reassessment means that any amount of CRA believes to be owning as set out in that reassessment, is payable right away, with interest.

CRA may be unable to collect that amount if appeals or an objection is formulated against the reassessment but if those appeals or objections are unsuccessful, interests has accrued since at least the date of the reassessment; not a reassuring prospect.

Thus, the irony in CRA's bland Taxpayer’s Bill of Rights which, at article 7 says, "You have the right, as an individual, not to pay income tax amounts in dispute before you have had an impartial review"; failing to mention that interest accrues!

CRA has the power to use the reassment notice to register a certificate showing the amount owing with the Federal Court, which then has the same effect as if it were a judgment of that Court, including FC collection procedures. That may subject the tax debtor to seizure of property or garnishment notices to banks or employers, if no review has been undertaken; or if such review was unsuccessful.

Not in all cases, but in most, and because of the risk of compounded interest, a taxpayer would be well advised to pay any amount allegedly outstanding as set out in the reassessment.

IC 71-14R3t, available at cra-arc.gc.ca/E/pub/tp/ic71-14r3/ic71-14r3-e.html, states that CRA may re-assess a tax return:

  • "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
  • " at any time up to 4 years after the date of mailing the original assessment, in all other cases."

Once a reassessment is issued, the taxpayer has the option of responding with a notice of objection. There is no set time limit for CRA to respond to the notice of objection. The good news is that the file then goes to an Appeals Branch officer who looks at the file.

Usually, the appeals officer does not discuss the file with the auditor and if they do discuss it, they ought to take minutes and disclose those minutes to the taxpayer. At this step, mediation or settlement discussions may be available to the taxpayer.

The appeals officer will issue a notice of decision with respect to the reassessment.

If the taxpayer is not satisfied with the notice of decision, the taxpayer has to step into the specialized justice system set up for this purpose, called the Tax Court of Canada (see http://www.tcc-cci.gc.ca/appeal_e.htm).

At this juncture, the taxpayer has two options.

There is an informal procedure available to him provided the amount of federal tax owning is not substantial. This amount varies from year to year but was, as of August 2006, $12,000 federal tax per year before interest. The informal procedure means that the taxpayer is not exposed to paying the costs of the Tax Court hearings if he or she is unsuccessful.

The general procedure does not have that benefit and because it is formal, may entail the additional expense of a tax barrister.

In any event, consider these stats presented in Lexpert Magaizine in May 208, quoting a tax lawyer at McCarthy Tetreault.

"As it turns out, the Tax Court's decisions tend to stand up on appeal. The taxpayer is the appellant ... almost all the time but the Federal Court dismisses about 80% of all reported appeals. Otherwise, few tax cases get leave to the Supreme Court of Canada (SCC) and the Crown's (CRA) position has been upheld in 10 of the last 12 cases that the SCC heard."

During the course of the audit, appeal or Tax Court procedures, a taxpayer may find that legal or accounting fees are deductible business expenses.

Assuming that the taxpayer is not burnt out by the time of the Tax Court hearing, and if they are unsuccessful, there is a further appeal to the Federal Court of Appeal and from there, to the Supreme Court of Canada.

This article deals primarily with income tax returns and not GST returns or assessments, in addition to which there may well be specific rules for situations not covered given the limitations of this article or with respect to trusts or corporations.

Further, CRA has the ability to investigate when they are of the opinion that tax evasion or a tax crime may have occurred. Those procedures may differ on what is set above.

In any event, there are obvious limitations in attempting to summarize a very complex procedure, one which is subject to change at any time, and in particular given the grave and dire consequences to a taxpayer in the event of a CRA error or misjudgement during an audit or reassessment. Almost all Canadian cities have excellent tax lawyers available, not to mention the services of chartered accountants. Tax lawyers know how valuable they are and usually charge accordingly. That may be unfortunate but to proceed without expert legal or accounting advice might be "exposing the baby to the draining bath water".

Finding the Income Tax Act or the regulations, or the plethora of other CRA documents pertinent to these issues, on the Internet is like playing cat and mouse. Any hyperlinking or URLs given below worked as of June 2007 but not necessarily thereafter.

References