How tax authorities determine that you have failed to declare some of your income

Written by Lisa-Marie Gauthier

The tax authorities have a few tricks up their sleeves when it comes to assessing taxpayer compliance. Over the years, they have developed several “indirect” or “alternative” methods for assessing false, inaccurate or incomplete tax returns and returns filed without reasonable justification1.

In the case of individuals, tax authorities use the assets listed in the public registers (cars, boats, buildings, etc.) to identify evidence of wealth that may justify using an alternative audit method. The most commonly used methods are cash flow, net worth and bank deposit analysis.

The cash flow method essentially consists in comparing the taxpayer’s cash inflows (i.e., income, cash from the sale of assets, decreased investments) and expenditures (such as cost of living, asset purchases, increased investments) to identify potential discrepancies between declared income and reconstituted income.

The net worth method involves assessing the increase in the taxpayer’s capital (assets less liabilities) over a given period and adding the consumption expenditures for the same period, which are often based on the withdrawals shown on the taxpayer’s bank statements, to identify potential discrepancies in the declared income.

The bank deposit analysis method usually involves examining all deposits made to the taxpayer’s bank accounts. The auditor may decide to focus exclusively on deposits exceeding a certain amount (anything over $1,000 for example), or opt to take the total deposits and deduct inter-account transfers, declared income, loans, interest received, tax refunds and any other non-taxable amounts received. If the taxpayer is unable to explain the source of the deposit or if the Minister rejects the justification provided, the Minister will include the deposit in the taxpayer’s income.

For businesses, the methods most often used are increased purchases and sampling audits.

The increased purchases method consists in reconstituting sales based on purchases using a sales-to-reference item ratio. To do so, tax authorities will select an item from the purchase invoices received from suppliers. For example, the item selected could be the cost of pizza boxes, hot dog buns, beer bottles, etc. To determine the units available for sale, the auditor will then deduct things like losses, tips, employee consumption and increases in inventory for the period audited. To reconstitute sales, data from the sales recording module (SRM) is used to multiply the available-for-sale items by the ratio obtained by dividing the recorded sales by the number of items sold.

The sampling audit method consists in taking an observation-based sample and extrapolating the results to the entire period audited. The tax authorities sometimes use this method by assessing the percentage of cash payments vs. the percentage of credit card payments a business has received. The ratio thus obtained is then compared to the declared sales to identify the likelihood of undeclared sales.

In practice, tax authorities very often use these “indirect” or “alternative” methods. Despite the fact that they are arbitrary and inexact, the burden is on the taxpayer to prove that the audit method used was unreasonable or unreliable.

If you are subject to a tax audit, the De Grandpré Chait team is available to help you through every step of the process, from audit to court challenge.

1. Alertpay Incorporated c. Agence du revenu du Québec, 2020 QCCA 46