Tax audits: What are taxpayers’ obligations, and what are the limits of the tax authorities’ powers?

“Being subject to a tax audit does not mean that a taxpayer has tried to mislead the tax authorities.”

Several factors may support the tax authorities to initiate an audit of a taxpayer. A file may be selected for several reasons, such as a discrepancy in the available information, a particular transaction, significant losses, or simply an audit program targeting certain transactions.

Once an audit begins, the taxpayer is required to respond to requests from the tax authorities. Although the authorities have broad powers, those powers are not unlimited.

In practice, the question is rarely whether a taxpayer must respond, but rather what must be provided, what may be requested, within what time frame, and how far the taxpayer must go to comply. These are the issues we explore in this article.

1. What the tax authorities may request

The tax system is based on self-assessment. Taxpayers file their returns and report their income, expenses, credits and other items. The tax authorities must then diligently review those returns and determine the tax and interest owing. However, since the Canada Revenue Agency (CRA) and Revenu Québec are not bound by taxpayers’ returns, they have extensive audit powers.

The legislation provides, among other things, that the tax authorities may examine any documents that may be relevant, request reasonable assistance, and require answers to relevant questions, orally or in writing.

A request should therefore not be ignored simply because it appears broad, repetitive or difficult to fulfil. The first step is to determine what is being requested. It may also be helpful to ask the auditor why a particular information may be relevant to the audit.

2. Responding to requests

Broad audit powers do not mean that every request is automatically justified. A request must relate to the administration or enforcement of tax legislation. The questions must also be relevant, and the assistance requested must be reasonable. The threshold for information to be considered relevant is very low.

When a request contains several items, it is often best to respond to each one and clearly identify the documents that exist and will be provided; those that do not exist or are no longer available; those held by a third party; and the items for which the request is unclear or appears to go beyond the scope of the audit.

A taxpayer obviously cannot provide a document that does not exist. This does not necessarily put an end to the request. The auditor may request other evidence or ask questions to understand the transaction and verify the amount reported.

3. Oral interviews

Since 2022, the CRA has had the power to require a taxpayer or another person to attend a meeting, including by videoconference, and answer relevant questions orally. Written answers may also be required.

4. Documents to retain

Tax legislation requires, among other things, that persons carrying on a business keep books and records that make it possible to determine the amounts payable or required to be withheld or collected.

As a rule, records and supporting documents must be retained for six years after the end of the last taxation year to which they relate.

However, the retention period may be much longer. For example, documents supporting the cost of real property and capitalized renovation costs should be retained until seven years after the property is sold. Similarly, documents relating to advances made by a shareholder to their corporation should be retained until six years after the year in which the corporation repays those advances.

Certain documents must also be retained for longer, particularly when an objection or appeal is ongoing.

This six-year period does not mean that the tax authorities can never ask questions about an earlier year. The obligation to retain documents must be distinguished from the authorities’ audit powers.

As a precaution, it is important to retain invoices, contracts, bank statements, proof of payment, accounting files and other documents that help explain and substantiate significant transactions for more than six years.

5. Limits to keep in mind

A communication protected by solicitor-client privilege does not become subject to disclosure merely because an audit is underway. Documents must nevertheless be assessed on a case-by-case basis. An accounting or business document is not privileged simply because it has been sent to a lawyer.

Limits on audit powers are also important when an audit takes on a criminal dimension. Administrative powers cannot be used to circumvent the rules governing criminal investigations. When the predominant purpose of the inquiry becomes determining the taxpayer’s criminal liability, the applicable protections change. This is the distinction recognized by the Supreme Court in Jarvis.

The scope of a request for information must also be assessed in context. A very broad request is not automatically invalid. The question is whether the requested information can reasonably be used to administer tax legislation and whether the questions asked are relevant.

Finally, when a request is too vague, disproportionate or difficult to understand, it is generally best to ask the auditor to specify the information being sought. This can help clarify and narrow the request while meeting the needs of both the auditor and the taxpayer.

6. Consequences of refusing to respond

Failing to respond to a request can have various consequences.

The tax authorities may, for example, issue a formal requirement to provide information or documents and compel the taxpayer or a third party to comply. They may also seek an order from the Federal Court when a person fails to provide the access, assistance, information or documents they are legally required to provide.

There may also be consequences for the outcome of the audit itself: if the tax authorities do not have the necessary information, they may issue an assessment based on the information available to them and make assumptions that are detrimental to the taxpayer and affect their credibility.

In addition, in several cases, failure to respond to all requests made during an audit has been used to justify the imposition of gross negligence penalties.

Responding to requests from the tax authorities does not guarantee that no assessment will be issued. It does, however, help ensure that the auditor has the relevant facts and documents before deciding.

7. Practical steps to take

During a major audit, a few simple practices can generally help avoid a number of problems: respond to requests in a structured manner and keep a copy of your responses; promptly indicate when a document does not exist, cannot be found or is held by a third party; and request an extension before the deadline if it is not possible to provide an adequate response within the time allowed.

When a request is unclear or its connection to the audit is not apparent, clarification should be sought. Confirming the information the auditor is looking for can help determine which document would best address the request.

In conclusion, taxpayers are required to respond to requests made during a tax audit. The tax authorities have broad powers that may sometimes seem intrusive.

This does not mean, however, that every request should be accepted without scrutiny. It is necessary to examine what is being requested, the relevance of the request, whether the documents exist and which protections apply.

In most cases, the best approach remains straightforward: provide structured, factual responses, explain what cannot be supplied, and seek clarification when a request is unclear.