BACKGROUND :

The letter to agents from the CRA encloses a blank “T1 Adjustment Request” known as a T1ADJ urging agents who have over-stated expenses to complete and submit the form. The filing of a T1ADJ form will likely trigger a full audit of the 2007 and 2008 T1 personal tax returns. T1ADJ forms are filed to the Sudbury Adjustment Division and NOT to the Audit Division of the CRA District Taxation Office (DTO) from which the computer-generated letters are sent.

Click here for the sample of letter

Over the past several years the number of real estate agents being audited has at least doubled. Each District Taxation Office Audit Division has setup “Real Estate Audit Teams” as real estate agents are known to keep poor records. The new computer system which, for the first time, allows the CRA to compare specific expense amounts between tax years as shown in the recent letters will lead to the CRA looking for expenses which they might deem excessive or which show a large increase for a specific expense from one tax year to the next. Agents should still total their expenses from their receipts and vouchers and claim every expense incurred. Agents should file aggressive and accurate tax returns and not worry that the CRA has a better computer system to monitor expenses.

Beginning in the late fall of 2009, the Canada Revenue Agency ( Hereinafter the “CRA” ) District Taxation Offices in the Toronto area began sending out personalized letters from their Audit Divisions to many individual real estate agents identifying amounts declared under specific expense headings in the “Business Statement” in the 2007 and 2008 T1 personal returns. The CRA is trying to intimidate agents and show off their new computer abilities. The business statement in a personal tax return was the “T2124 Business Statement” for 2007 which became the “T2125 Business Statement” in the 2008 return and they are identical. These statements include the “Industrial Code” of “531211” used exclusively for “Real Estate Agents”. This means the Audit Division in each CRA District Taxation Office can request their computer database to ‘pop up’ all real estate agents in their geographical areas for review by merely designating the 531211 Industrial Code. The Audit Divisions routinely audit self-employed taxpayers on a “receipts and vouchers” basis for the two most recent personal tax filings. Auditing the 2 most recent tax returns is known as auditing the “current return and one year back” which is standard operating procedure for the Audit Divisions of the CRA.

The recent CRA letters identifying the 2007 and 2008 returns are following this format. Most agents currently being audited for the 2007 and 2008 returns had their audits started in August of 2009 up to the end of 2009. These recent CRA letters are being sent out after the period when full-blown audits commence. The CRA letters constitute a ‘bad faith’ practice on the part of the CRA and are unfair and unprofessional. The intent is to intimidate agents into reducing expenses by filing a T1ADJ and thus setting up the agent for a full audit. A second goal is to scare agents into under-declaring expenses in future tax returns. The attached sample CRA letter reads in the first full paragraph on page 2: “When you file your 2009 income tax return and all future returns, please consider the information we have provided.” The information is a series of implied threats and scare tactics

CANADA REVENUE AGENCY (CRA) PROCEDURES:

E-filed returns go directly into the CRA computer database while signed printed returns are scanned directly into the CRA computer database when received by the Assessment Divisions of the CRA. The CRA has a new and sophisticated computer system entitled “MOST”. The old computer system created a separate file for each year’s tax return. This older system did not have the capacity to do a comparative analysis of income or expenses between the different tax years. As seen in the recent letters identifying different expense headings, the new system can provide a comparison between tax years on amounts claimed under the different expense headings. This capacity has only been available for 2007 and later tax returns. The 2006 tax years are stored under the old computer system and cannot be accessed for any comparative analysis. The CRA is showing off its new `toy’ for the 2007 and 2008 tax years to intimidate agents into reducing the amount of expenses claimed. A critical point to remember is that if an agent completes the T1ADJ entitled “T1 Adjustment Request” and reduces the amount of the identified expenses claimed in the 2007 and 2008 tax returns, that this form is filed with the Adjustments Division in Sudbury. It is not filed to your local Audit Division which generated the letter. This raises two points. Firstly, it will be very difficult for the CRA to track which taxpayers who received the letter actually file an adjustment. Secondly, it is virtually guaranteed that any taxpayer who does file the T1ADJ reducing the amount of expenses claimed under the identified expense headings will have their file transferred back to the local Audit Division for a full audit of all their expenses claimed in the 2007 and 2008 tax returns. This is the `trap’. The CRA letter amounts to a fishing expedition to catch intimidated taxpayers who do file a T1ADJ reducing expenses claimed. The letter is also intended to intimidate self-employed agents into reducing the amount of expenses claimed in their 2009 T1 personal tax return. The rule for tax filings is to total your expenses based on receipts and vouchers and claim the qualifying amounts spent and file the return and don’t blink. There is a famous Supreme Court of Canada case which stated: “It is the right of every taxpayer to aggressively attempt to minimize their taxes.” Be aggressive but don’t cheat.

The most frequent expense headings identified in the recent CRA letters comparing 2007 and 2008 amounts claimed under identified expense headings include:

1. “Advertising/Promotion” which also includes gifts;

2. “Meals and Entertainment” which is covered by Section 67.1 (1) of the Income Tax Act and which includes groceries for open houses and gift certificates to restaurants and events ( The Stapley decision from February of 2006). This section was enacted in 1994 and limits deductibility to 50% of the expense;

3. “Motor Vehicle Expenses” which will identify and challenge the business proportion of vehicle expenses claimed. CRA auditors will insist on production of an automobile logbook which is not required in the Income Tax Act and regulations thereto. The 1991 Qureshi decision of the Federal Tax Court established the principle that Section 230 (1) of the Income Tax Act - - the record-keeping provision - - was never intended to create the onerous burden on the part of taxpayers to maintain an automobile logbook;

4. “Conventions/Seminars”. The case law says that taxpayers may attend and deduct the costs of only 2 conventions per year and that the convention must be put on by an industry body and be situated in a location that is consistent with the location in which a licensed agent will earn income. National and international real estate conventions qualify here;

5. “Travel”. Travel expenses are only deductible if the taxpayer is “more than 12 hours away from their regular place of business”. This includes fares, hotels and one-half of travel dinners and meals;

6. “Other Expenses”. This includes any broker split of commissions, broker ‘pass-through administrative fees, short-term vehicle rentals, and sales training seminars amongst other expenses; and,

7. “Home/Office’. The CRA will challenge the proportion of this expense claimed. Agents are entitled to claim areas used exclusively for business and may claim this expense based on a square footage basis or a room-by-room basis not counting bathrooms and may choose either basis depending on which is more favorable. The correct law for this expense is Section 18 (12) (a) (i) of the Income Tax Act which requires only that the home be the self-employed taxpayers “primary place of business”. Once local real estate boards required agents to subscribe for and pay for the MLS service, the industry became a ‘home-based’ industry”. Agents now access MLS from their home repeatedly during each day, keep their sales records at home, do their banking from home, write up their advertising at home. book appointments from home, draft Agreements of Purchase and Sale at home, and have their computers, chairs, desks, filing cabinets and other furniture and equipment at home. Both the auto deduction and home/office expense are based on a “usage test”. Since the home is now the “primary place of business”, claiming 90% business driving is reasonable as once leaving the driveway, business usage commences, and a home/office expense is virtually unchallengeable.

OPTIONS REGARDING THE CRA LETTER REGARDING SELF-EMPLOYED EXPENSE CLAIMS:

1. The best response, but to be exercized with caution, is to write a letter to the Audit Officer identified at the bottom of the letter. The CRA letters are computer-generated. Each District Taxation Office seems to insert the same individual at the bottom of each letter. The letter usually identifies 2 or 3 different expense headings for each of 2007 and 2008 and the amounts claimed in each year. The language commonly used is that “A preliminary review of your income tax and benefits return(s) has indicated that you claimed…”. This means that their new computer system has searched and specified the amounts claimed. There is usually an “Appendix A” attached discussing the CRA position on the deductibility of the expenses identified. This discussion is drawn from “Interpretation Bulletins” and “Information Circulars” which are written by the CRA and which are not binding law. They are self-serving, supporting CRA positions on expenses. The correct law on expense deductibility is determined in the case law as set out in the decisions of the Federal Tax Court, the Federal Court of Appeal and The Supreme Court of Canada. Our website discussion entitled “CRA Audits” for Taxperts Corp. at taxperts.on.ca sets out the correct law.

The pro forma computer-generated letters are best dealt with by a pro forma response by the self-employed agent. If the Audit Division receives hundreds of similar letters, it is our firms’ view that the CRA will realize that the agents have called the CRA’s bluff. There is little the CRA can do with a letter saying, essentially, my expenses claimed are fine. The more letters, the better. It is recommended that you review the amounts identified in the letter to see if you have receipts and vouchers to support the expenses including names for business dinners, gifts and events. Our firm has found that names can be easily reconstructed from trade record sheets and diaries if the agent failed to note the name at the time of the expenditure. The letter should thank the CRA auditor for their letter, make reference to the expense headings identified and write language along the lines of: “I have carefully reviewed the expense amounts identified in your letter and I have determined that the expenses claimed are accurate, qualify to be deducted and that they are fully receipted and vouchered. Regards, Taxpayer”. Our firm believes that there is nothing prejudicial that could result from such a letter. The CRA is back to its typical position of deciding, as it has the right to do, which taxpayers to audit on their tax returns. Agents are welcome to come to our firm to have us write a letter to the CRA Audit Division. There would be a minimal cost as one of our CGAs on staff would simply review the receipts and vouchers for the expense headings identified in the CRA letter then a lawyer on staff would send a letter confirming the expenses are accurate. Our firm is well-known by all CRA Audit Divisions and known for its accuracy and professionalism so a letter from one of our lawyers would be given great weight.

2. The second option is to not write a letter and do nothing. It could be argued that this is the best option. You are not writing to confirm the expenses as accurate. Your silence cannot be interpreted negatively and could be seen as the taxpayer concluding that no response is required. As stated, it will be extremely difficult for the CRA to cross-reference what action, if any, was taken by the recipients of the letter. About 10% of taxpayers move annually. Agents who have recently moved will likely not receive the letter and it will be returned to the CRA as undelivered. Each Audit division seems to be sending out hundreds of the letters exclusively to real estate agents. As stated, the majority of auditors are assigned to auditing real estate agents. It would seem that it would be a huge task to track the response of targeted agents.

3. The third option is to file a T1ADJ for each tax year reducing expenses. As discussed immediately below, this will likely trigger a full audit.

FILING OF T1ADJ ADJUSTMENTS TO SUDBURY ONTARIO:

As discussed earlier under the heading for “CRA Procedures”, the T1 ADJ forms are filed to the Adjustment Division in Sudbury. Sudbury also is an assessment centre and has a “Pre-Assessment Division” which usually goes after such items as receipts for child care expenses, medical and donation receipts for those who e-file and a demand for a T2200 form called a “Declaration of Conditions of Employment” signed by the employer for taxpayers claiming employee expenses.

Taxpayers who file a T1ADJ usually do so where they have failed to claim an RRSP contribution or other deduction or, in rare cases, where they file an adjusted “Business Statement” when they discover that they missed claiming a substantial amount of self-employed expenses. One must always tread carefully with the latter situation as the typical CRA response is one of suspicion along the lines of “Why didn’t you claim these expenses in the original return?” or “Do you have acceptable receipts and vouchers to support these additional expenses?” We have seen the submission of a T1ADJ for missed expenses turn into a full audit, conducted from Sudbury, on all business expenses. Be careful.

In terms of these recent CRA letters asking agents to review expenses claimed and inviting the filing of a T1ADJ if the expenses if they were over-stated, it is a virtual certainty that such a filing will lead to a full audit. The question will arise that if you over-stated the 2 or 3 expenses identified, you must have done the same for all of the expenses claimed. The T1ADJ filed will easily flag your file for transfer to your local Audit Division for a full audit.

PENALTIES UNDER SECTION 163 (2) OF THE INCOME TAX ACT:

The CRA letter refers to the Voluntary Disclosure Program and avoiding penalties and prosecution. This is very misleading since the onus of proof placed on the “Minister”, read the CRA, as set up under Section 163 (3) is so high that penalties are almost never levied except in the case of the deliberate filing of a false return and prosecutions only occur when there is a case of deliberate non-declaration of income or the deliberate falsification of expenses. Penalties under Section 163 (2) are 50% of the taxes on undeclared income or over-stated expenses. Section 163 (3) regarding the burden of proof for assessing penalties reads:”…the burden of establishing the facts justifying the assessment of the penalty is on the Minister.”

The leading case on the applicability of penalties is the 1984 Federal Tax Court case of Venne v. the Queen. In that case, the taxpayer had private mortgages and substantially under-declared interest received and gave the explanation, as silly as it is, that his bookkeeper told him not to declare the full amount of interest received on the private mortgages. Despite this self-serving explanation, the court ruled that there would be no penalties as there was no clear case of gross negligence. It then raised the bar for the CRA to assess penalties by noting that the taxpayer’s misrepresentations of amounts in the returns were attributable to neglect and despite its view that the taxpayer failed to exercise reasonable care, that the Crown had failed to establish that the taxpayer knowingly made false statements in his returns. This section in the Income Tax Act is subtitled “False Statements or Omissions”. Penalties are reserved for the most extreme cases of tax filings amounting to acts of tax evasion. Prosecutions only occur in these same circumstances and proof must be beyond a reasonable doubt. The CRA mentioning avoiding penalties in its reference to VDP applications is thus misleading. In 22 years of audits, our firm has never had a client assessed penalties under this section. The courts are interpreting section 163 (2) so strictly that there is no likelihood of penalties being assessed in any case of over-claiming expenses in a tax return.

REASSESSMENT FOR DISALLOWED EXPENSES:

Audits of self-employed expenses always lead to the disallowance of expenses for reasons such as “expenses are personal in nature”, “expenses not connected to business”, “expenses are not sufficiently documented”, “business dinners claimed as fully deductible and reduced to 50% deductible” and like reasons. When expenses are disallowed, the taxpayer’s taxable income rises based directly on the amount of the disallowed expenses then interest is charged at the prescribed quarterly rate of prime plus 3%. Even in the case of the filing of a T1ADJ reducing expenses, the result would be the same - - calculated extra taxes plus interest. That is it. There is no prospect that in the case of inadvertent over-stated expenses that any penalties will be levied or that a prosecution will be started. The reference in the CRA letters to the CRA Voluntary Disclosure Program and avoiding penalties and prosecution is misleading. As seen in the Venne decision, penalties are levied only in the most extreme cases knowingly filing a false return. The most common error we see on audits is where the taxpayer or their preparer/accountant enters amounts for dinners and events under the”Advertising/Promotion” expense heading as fully deductible. In these cases auditors simply move these items to the “Dinners/Events” heading and allow only a 50% deduction on them. The taxpayer then pays the taxes on the increased taxable income depending on the tax bracket plus interest from May 1st of the year the tax return was to be filed. So, from May 1, 2008 for extra taxes on the 2007 tax year and from May 1, 2009 on the 2008 tax year.

The mention of penalties in the CRA letter is another ‘bad faith’ act. It is a false issue. The CRA knows how rare and extremely difficult it is for penalties to be assessed. The courts are loathe to let the CRA assess penalties. Our ironic comment to our clients is that: “If you shoot the auditor, you will be assessed penalties. Anything short of that, no penalties.”

VOLUNTARY DISCLOSURE PROGRAM ( VDP ):

It is here that the CRA and law firms trying to round up clients using the CRA letter are most deserving of criticism. As discussed earlier, there is no likelihood that the CRA will succeed in levying penalties for inadvertent over-stating of expenses and even less likelihood of “prosecution”. A VDP application is only available to those who initiate contact with the CRA before the CRA raises questions about a tax filing. There is a good chance that the computer-generated letters referring to the 2007 and 2008 tax returns and expenses claimed will automatically disqualify those tax years from getting relief from penalties and prosecution under the VDP program. In the application, it would have to be noted that the taxpayer received a letter from the CRA regarding expenses in the 2007 and 2008 tax years. This fact would most likely lead the VDP application being instantly rejected. We have discussed how Section 163 (2) penalties and any prosecutions are as rare as hen’s teeth since penalties are reserved only for the most extreme cases and prosecutions are initiated only in the case of clear-cut tax evasion. To illustrate, there was a case of a company president who had a cohort in another company falsify a invoice for services rendered for over $250,000 which was ‘paid’ with the money secretly returned to the payor. That resulted 50% penalties under Section 163 (2) of the Income Tax Act on the tax reassessment AND in a 200% penalty under another provision and jail time when the taxpayer was prosecuted in the criminal courts. The cohort also was fined and jailed. The basic point is that a VDP application is not necessary in the case of over-stated expenses. If the CRA contacts you for an audit, simply let expenses be disallowed and pay the taxes and interest. The CRA is content to reassess on audit for taxes and interest payable.

The CRA letter states the “…CRA Voluntary Disclosure Program [ VDP ] allows people to come forward and correct their tax information.” It later promises that those using the VDP will not have to pay penalties or “face prosecution”. A pre-condition for VDP relief is that a taxpayer must come forward BEFORE the CRA has initiated any action such as a demand for a tax filing or a review or audit of a return. The CRA letter might meet the test of being an act on the part of the CRA disqualifying the taxpayer from seeking CRA relief. The reference to VDP relief in the letter is wrong, distasteful and unprofessional for so many reasons.

For those agents who have not received one of the CRA letters and who want VDP relief - - not declaring rents and the gain on sale of a rental property outside Canada is a very good example - - go to a lawyer to commence a VDP application. Everything is computerized now and the multitude of tax treaties with the U.S., Latin and South American Countries and European countries providing for the “unlimited exchange” of tax information makes this scenario a good one for a VDP application. To talk of a VDP application, on the part of the CRA or a law firm, in the context of expenses claimed in a T1 personal tax “Business Statement” is nonsense and insulting to taxpayers.

ATTACHMENTS:

1. A sample 2-page CRA letter noting expenses claimed in the 2007 and 2008 tax years with further discussion.

2. A sample “Appendix A” with a discussion of various expense headings which is attached to each CRA letter.

3. A copy of the “T1 Adjustment Request” form which is commonly referred to as a “T1ADJ”. A separate T1ADJ is required for each tax year. The line for “Net Commission Income” would rise by the amount of expense reductions admitted to in the explanatory notes at the bottom. For example. “The taxpayer is reducing the claim for Advertising/Promotion expenses by $2,768 and the amount for Travel expenses by $1,902. Please adjust.” In this case, the amount for “Net Commission Income” would increase by $4,670 and the taxpayer would be reassessed for the taxes on this income plus interest from May 1st of the year the tax return was to be filed. So, from May 1, 2008 for an adjustment to the 2007 T1 personal tax return.

Return to Top