September 4, 2009
Governments use probability theory to justify profiling in fighting crime, terrorism and tax avoidance. Unlike racial profiling - which, despite some scientific validity, is always politically incorrect - profiling for income tax audits is legal and even socially acceptable. There is no Canadian Charter of Rights and Freedoms protection for Canada Revenue Agency (CRA) audit profiling. You may be wondering when and if the Canada Revenue Agency will ever audit you. It all depends upon your profile and luck at having your tax return drawn for scrutiny.
An audit is an investigation and verification of reported events to determine whether there is "under-reporting" of taxes by omitting income or inflating deductions. Most employees have a low risk profile because the "pay-as-you-earn" withholding tax system requires employers to deduct income taxes at source from employment income. In the majority of cases, the tax withheld is close to the employee's ultimate tax liability. In terms of statistical profiling, it does not pay the government to expend substantial resources in auditing employee tax returns.
In contrast, self-employed individuals - for example, professionals and cash-oriented businesses - are high risk and, therefore, picked upon more frequently for audits. Within the self-employed group, the risk of under-reporting increases as earnings rise. Thus, the CRA is much more likely to audit a person earning more than $100,000, about 2.5 percent of the population, than a person earning less than that amount. The incentive to under-report income varies directly with earnings.
From the taxpayer's vantage, there are two distinct categories of audits: regulatory and criminal. In a regulatory audit, the CRA can demand that the taxpayer immediately produce all of his or her documents for examination. The taxpayer has no Charter, and only minimal legal, rights to protect him/her in a regulatory audit. Indeed, quite the contrary: the law deems the minister's assessment correct unless the taxpayer can prove otherwise in a court of law.
The law steps in quickly to protect an individual if the CRA conducts an audit for the purposes of laying potential criminal charges against the taxpayer. The law considers criminal charges as serious intrusions into the individual's liberty and protects taxpayers from unnecessary, over-extensive intrusions into their financial affairs.
In life, however, the line between routine regulatory audits and criminal investigations is blurred. After all, the only real difference between a regulatory and a criminal audit is the mind of the auditor who must determine whether the evidence that she is accumulating will lead to civil or criminal sanctions at the end of the audit process. The auditor cannot know with any certainty the fork in the road that she will take until he has an opportunity to assess the evidence after he gathers and examines it. Thus, invoking taxpayer Charter rights is often an ex-post analysis after the government lays criminal charges.
In theory, individuals should always ask at various stages of an income tax audit whether the auditor is conducting a routine regulatory examination or has any other purpose in mind. If the latter, the individual should immediately engage legal counsel and trigger all of his/her Charter rights. Of course, asking the question may well raise the tax auditor's antenna as to the cause of the taxpayer's anxiety.
Tax avoidance is not going away. As governments collect ever-increasing amounts of revenue through taxes, the temptation for under-reporting increases because taxpayers view the tax burden, about 10 percent of Canadians pay 50 percent of all income taxes, as unfair. Thus, governments use increasingly more sophisticated statistical tests and computerized data to profile high-risk taxpayers who are likely to engage in tax avoidance and evasion. Ultimately, your chance of audit depends upon your profile.
Vern Krishna, is counsel, mediator and arbitrator at Borden Ladner Gervais LLP and executive director of the CGA Tax Research Centre at the University of Ottawa.