Author Segal LLP

Red Flags for a CRA Audit

thmb_red_flag_risk_danger_mbYou might think the Canada Revenue Agency (CRA) would keep silent about what triggers an audit. But the agency is actually quite candid about why it chooses certain tax returns.

For example, the CRA publishes newsletters, technical interpretations and taxpayer alerts on its Web site that elaborate on audit issues, describe areas of concern to the government, and warn about actions and investments the agency is likely to investigate.

In addition, the Auditor General of Canada has issued a report titled “Verifying Income Tax Returns of Individuals and Trusts,” which discusses in detail how the CRA processing and review system works.

Red Flag

Potential Solution

Gross profit margin is lower than direct competitors — or higher — while net profit is lower. Properly record and categorize expenses.

Ensure the accuracy of direct and operating costs, as well as inventory valuation.

High vehicle expenses Keep a vehicle log.
Unusual home office business expenses Determine the business use of your home on a consistent and defendable basis.
Small Business Deduction: High “other revenue” or investment revenue. Large cash balance on balance sheet. Pay dividends to remove excess cash from the corporation. Repay shareholder loans. Consider forming a separate holding company for investments.
Income is low for many years. Report all income, including non-taxable sources.

With all that information, it’s generally easy to determine some of the transactions and recording methods that are likely to prompt an audit.

Here are 10 red flags gleaned from these documents to help you gauge whether your tax return is likely to trigger an audit:

1. Revenue discrepancies. A sure-fire trigger for an audit is reporting revenue on your GST return that doesn’t match what you report on your income tax return. Report all revenue on your GST return, even if you don’t collect the tax on some revenue.

Treat revenue and expenses the same way on both returns. For example, when filing your income tax return, don’t reduce revenue by the associated expenses and report only the profit while reporting total revenue on your GST return.

In addition, the CRA annually matches information on tax returns with information provided by employers, financial institutions, and other third parties. The tax returns of individuals who are married or living common law are also compared with their spouses’ or partners’ returns.

These comparisons are made to identify unreported income, incorrect claims for an amount of “income tax deducted,” credits and deductions that exceed the limits, net family income for the purpose of claiming several credits as well as incorrect “pension adjustments.”

2. Claiming large interest and carrying charges. A taxpayer with business or rental income should claim related accounting fees and interest expense on the business or rental income schedule. They should not be claimed as carrying charges and interest expense. This deduction is for expenses related to investment income.

3. Changes in shareholder loans and large balances. If you hold stock in a corporation, large changes in shareholder loans or debit balances can attract attention. The CRA is looking for personal expenses recorded as business expenses and loans taken from a company. Your accountant can advise you about the best way to structure loans.

4. Deducting large business expenses. The CRA scrutinizes business and rental income schedules that show large amounts of advertising and promotion, travel, miscellaneous and interest expenses. The tax agency is looking for personal expenses, meals and entertainment that are improperly recorded and non-deductible expenses such as penalties and interest. Meal and entertainment expenses should be separated and expenses should be allocated individually rather than using “miscellaneous.”

5. Making calculation errors or leaving out information. Many audits result from simple math errors on tax returns or missing information slips, such as the T3, T4, and T5. Professionally prepared tax returns that minimize audit red flags are one of the many benefits of using a qualified accountant.

6. Large or unusual changes in deductions or credits. Employment expenses are limited to just a few people and large employment expenses are a flag for the CRA. Moreover, you may be requested to supply additional information if you have claimed childcare or tuition expenses.

7. Large charitable donations of cash exceeding $25,000 and capital property are often reviewed.

8. Investment gains and losses. The CRA will closely look at losses claimed on investments in small business corporations. The rules are complex and often misunderstood or misinterpreted. Many taxpayers also don’t correctly track capital gains and losses, so they, too are an audit flag. Account statements from financial institutions may not be accurate for tax purposes. Income trusts, for example, erode their cost base over time because of returns of capital. Foreign currency investments can present a problem as you need to account not only for your financial gain or loss but also for the foreign exchange gain or loss.

9. Foreign tax credits. These claims may trigger an audit for investors who earn income from foreign investments or employment.

10. RRSP overcontributions. If you overcontribute to your Registered Retirement Savings Plan, taxes are owed on the excess. Over contributions are common when retirement allowances are deposited into the accounts and when taxpayers contribute to their plans without referring to their annual Notice of Assessment.

Steps to Avoid Higher Tax on Sales of Goodwill and Other Intangibles

090216_thinkstock_483447992_lores_kkIf you own a business and you’re planning an exit strategy or asset sale, you may want to complete it by December 31.

Starting January 1, 2017, changes to the Income Tax Act brought about by the Liberal’s Budget 2016 will modify the way the government taxes asset sales. The change is meant to simplify the rules; it creates a new capital cost allowance (CCA) category (class 14.1) and essentially merges eligible capital property (ECP) into the depreciable property category.

As a result, your incorporated business will pay an additional refundable tax when it disposes of goodwill or other ECP. That tax isn’t refunded until taxable dividends are paid to shareholders.

ECP includes goodwill, customer lists, franchise rights, farm quotas and other intangibles. The costs of incorporation, reorganization or amalgamation also qualify.

If you own, say, a small Canadian-controlled private corporation, goodwill may be the single largest asset you’ll have to sell and it could be hit with a big tax liability. If you’re a dairy farmer who wants to sell quota held in a corporation, you’ll pay an extra tax on the gain in value.

Because of changes in the treatment of ECP, owners considering the sale of their corporations (or any ECP) might want to consider the advantages of:

  • Selling the assets before the end of the year, or
  • Crystallizing certain gains accrued on the assets through a corporate reorganization.

Here’s How It Works

Some capital expenditures are neither deductible from taxes as a business expense nor treated as a capital property subject to depreciation under the CCA rules. These expenditures are those a company pays out to acquire certain ECP in order to earn business income.

Currently, the taxation of ECP works this way:

1. 75% is included in a cumulative eligible capital (CEC) pool,

2. An annual deduction of 7% of the CEC pool on a declining balance basis may be deducted from active business income related to the ECP,

3. 50% of any gain from the disposition of ECP is taxed at the lower tax rate applicable to active business income, and

4. The remaining 50% is captured in a corporation’s capital dividend account and can be paid out to shareholders tax free (creating a significant tax deferral).

Income from most businesses qualifies as active business income, except when the money comes from a specified investment business, a personal services business or it’s investment income. The latter includes taxable capital gains less allowable capital losses, property income less property losses and foreign business income.

Starting January 1, ECP taxation of ECP will change so that:

1. 100% acquired on or after that date will be considered depreciable property,

2. An annual deduction of 5% will apply to ECP on a declining basis, and

3. Gains from the disposition of ECP will be taxed as investment income in the form of capital gains resulting in a higher tax liability.

So, under the new rules, you’ll no longer be able to take advantage of the tax deferral on captured gains and the effective tax rate on gains on goodwill or other ECPs could double, depending on your province. (If you sell your corporation for shares, the new ECP rules will have no effect on the tax cost of the sale.)

What Could this Mean for Your Business?

There are two ways to structure a business sale transaction: an asset sale or a share sale.

Buyers generally prefer asset transactions as they carry less risk and the buyer can cherry-pick which assets it will purchase and which liabilities it will assume. Also, the buyer needn’t take on non-union employees, unless the seller requires it, and there’s more complex paperwork.

Sellers, on the other hand, often prefer share sales, because all assets and liabilities are transferred, employees generally continue working and the paperwork is less cumbersome. Stock transactions also offer a lower tax rate on capital gains and the potential to shelter a portion of the proceeds from tax through the shareholders’ lifetime capital gains exemption.

With the new rule in place, sellers may be even more motivated toward share sales. Purchasers who wish to proceed with an asset sale may have to compensate the seller for the additional tax costs associated with the deal. Likewise, sellers may become more selective when considering competing offers.

The remainder of 2016 is the last window of opportunity to sell your business in an asset sale (or a hybrid transaction that involves the sale of assets and shares) where the lifetime capital gains exemption is available to shareholders. This would allow your corporation to benefit from the deferral opportunities provided by the current ECP regime.

What to Do?

If you’re considering a full or partial sale of your business after the rules change, take into account these three issues:

1. Determine how much of your business value is goodwill and other eligible intangibles, and thus subject to the higher tax rates. If they don’t amount to much, no immediate action may be necessary.

2. Review your corporate structure. Changes to your business structure may allow you to shelter some of your capital gains from tax if you decide to sell after January 1.

3. Consider taking steps to crystallize your gains related to ECP. You may be able to have some of the gains taxed at the current rates, which will reduce the impact of potential taxes on a sale that takes place after January 1.

A sale is complex and requires careful planning — particularly with the changes coming down the road. Consult with your tax advisor for detailed information on the changes, how they’ll affect your corporation and the best steps to take moving forward.

Use Caution When Tapping an Executor

Choosing an executor is one of the most critical parts of planning your estate.

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Setting Up a Health Care Directive

If you suffer from an accident or illness and become unable to communicate the type of medical treatment you wish to receive, your family must guess what you want. A health care directive, or living will, eliminates the guesswork by making it clear what your wishes are.

Usually, a living will contains specific directions on the course of action you would or would not like to take if you are in a terminal condition, a permanent coma or in a persistent vegetative state. It may provide instructions on whether or not you wish to receive artificial life support, artificially administered food and water or comfort and care.

Here are the answers to some common questions about health care directives:

Q. Who can make a health care directive?

A.Generally, any person who has the ability to understand information relevant to making a medical decision and appreciate the consequences of a decision may make a heath care directive. The provinces and territories also have varying age requirements.

Q. Do I need a health care directive if I already have will?

A. Yes. Health care directives and last wills are very different. Your will deals with property and the directive deals with medical treatment and care.

Q. Are health care directives legally binding?

A. Yes. Once they are properly signed and witnessed, family, friends and health care providers must follow the directions as long as they are consistent with generally accepted health care practices. Keep in mind that health care practitioners are not required to ask whether you have signed a directive or to search for one.

Make sure that your family, friends and health care representative know that you have signed one and that they know where it is. Health care providers that are unwilling to follow your directions are usually obliged to refer you to a provider who will.

In some families, that decision is based on tradition or culture, where the oldest child or male is automatically given that role. But this may not be the best choice. It can cause family resentment and the person named may not be suited to the task.

If the administration of your estate is expected to be complicated — or there is family disharmony — consider naming someone else as executor. Your surviving spouse or children can receive regular reports from the executor, keeping them advised of the process of settling the estate.

In general, you can select anyone, or a group of individuals, to serve as your executor, but it is important to consider whether the person:

  • Will outlive you;
  • Is honest, trustworthy and will carry out the wishes you put in your will; and
  • Lives close to the decedent’s home and will be able to access the local court and settle the estate without delay.

Two questions commonly come up in discussions of naming an appropriate executor. Here are those questions and the answers:

Q. What qualities and abilities should an executor have?

A. When you write a will with the help of your attorney, it’s important to choose a competent and trustworthy executor and alternate executors. Otherwise, even careful estate planning could be rendered useless.

Your executor can be any person or institution that you desire. If you feel you cannot trust a family member, consider naming your accountant, attorney or bank trust department. Whoever you choose, keep in mind that your executor should be:

  • Familiar with your family situation, including children, step children and former spouses.
  • Able to spend the time necessary and is willing to perform the duties.
  • Willing to work with the estate’s attorney and accountant.
  • Familiar with your finances, property and other assets; and
  • Experienced and competent in business matters to provide for the continuation of your business if you have one.

Q. What are the executor’s responsibilities?

A. Your executor becomes your personal representative and fiduciary after your death and must administer the estate and ensure the will is carried out. In general, the executor must:

  • Arrange the funeral and pay for it;
  • Pay any outstanding bills of the estate;
  • Collect and preserve assets;
  • Pay debts, taxes and administration expenses of the estate; and
  • Distribute estate assets according to the terms of the will.

Besides naming an executor, you should consider giving someone Power of Attorney to make decisions about and sign official documents involving your finances and assets.

There are two general types of Power of Attorney:

1. Durable Power of Attorney: An individual acts on your behalf if you are unable to make decisions. This person would control your finances and your assets, so you need to choose someone you trust to ensure that your wishes will be heard, understood and carried out to your specifications. You set up the durable power of attorney to come into effect only if you are unable to act on your own behalf.

2. Non-Durable Power of Attorney: An individual acts on your behalf if you are not available to sign legal or financial documents for one reason or another.

Common examples of what a Power of Attorney allows a person to do on your behalf are:

  • Manage your money, bank accounts, and safety deposit boxes.
  • Enter into contracts and settle claims.
  • File tax returns and handle government benefits.
  • Sell, mortgage, and manage property.
  • Plan an estate and financial gifts.
  • Maintain business interests.

Because the individual’s powers are significant, there is often a clause in a Power of Attorney to appoint a second person if the first is unwilling or unable to perform the duties. This person is called a successor agent or a successor attorney-in-fact.

Consult with your adviser. Naming an executor and giving someone power of attorney are critical decisions and your adviser can help you choose the right individuals.

Restrict Cell Phone Use and Texting While Driving

lores_cell_phone_car_drive_talk_mbIn this wireless age, some people tend to consider driving time as a business opportunity. So using cell phones to call or send text messages is just another way to help boost productivity and swell the bottom line.

And even more ways of being mobile and productive are on the way. Automakers are planning to include more in-dash computers and communications technology that can be accessed with drivers’ fingertips.

But beneath the convenience is an expensive potential liability. Some companies have inserted clauses in their employee handbooks stating that staff members are only allowed to conduct business while using a hands-free cell phone. But that may not be enough.

The Insurance Bureau of Canada has noted that studies show drivers are four times more likely to be involved in a collision while talking on a cell phone. The bureau also noted that in addition to talking on the phone, too many drivers are distracted as they multitask while commuting. The distractions include eating, playing with the CD changer or MP3 player and even reading the newspaper.

Studies have found that hands-free phones are not safer than hand-held devices. Some researchers have found that all types of phone conversations are so distracting that the driver’s mind just isn’t on the road. Other studies have shown that 73 per cent of all cell phone users sometimes talk on their phones while driving, and 19 per cent send text messages.

A Transport Canada study found that drivers performing certain tasks spend more time looking centrally and less time looking to the right. They spend less time checking instruments, and as driving tasks demand more concentration, drivers change inspection patterns and do more hard brake work. The drivers studied were equally distracted whether they used a hand-held phone or a hands-free headset.

Simply put: Phone conversations — particularly about business — can be demanding and stressful enough to keep drivers’ minds off the road.

All of this has led some Canadian companies, including Imperial Oil Ltd. and ExxonMobil Canada, to adopt policies banning employees from making cell phone calls while driving on company business.

Other companies have put restrictions on cell phones, limiting them to hands-free only phones while driving. But that may not be enough.

That’s a start, but there are other steps your company can take to encourage safety and limit liability. Consider adding these factors to a written policy on cell phone use:

  • Issue regular bulletins to your entire staff telling them to use common sense when calling someone on a cell phone.
  • Place a sticker on company-owned cell phones warning that using the phone while driving is dangerous and should only be done in an emergency.
  • Notify all employees that any violation of the company’s cell-phone policy will bring disciplinary action — including termination of employment.
  • Be sure all employees sign your policies to indicate they have read and understand them. Let your staff know the safety issues and laws involving cell phone use.

The provinces have started to tackle the issue. So far, Ontario, Quebec, Newfoundland and Labrador have laws  banning the use of hand-held cell phones while driving. Those laws do not, however, affect the use of hands-free devices. Cell-phone laws also tend to ban texting while driving as well as using hand-held entertainment devices, although it is generally legal to use an MP3 player plugged into a vehicle’s sound system.

But even where there is no specific provincial legislation, a driver who causes a collision by using a cellular phone or who is observed driving unsafely while using the device could be charged under a number of other provincial, territorial or federal laws including, those related to dangerous driving, careless driving and criminal negligence causing death or injury.

Moreover, it might be possible for your company to be sued for vicarious liability associated with accidents involving cell phone use by employees while performing their job duties

Your company may benefit when employees conduct business while they’re in traffic, but you must balance the extra productivity against potential liability and safety.

Tally the Pros and Cons of Going Public

For many business owners, going public is the pinnacle of success. But the process is rigorous, requires enormous effort and time, and can be extremely expensive.

Leading up to the day your business goes public, you need to engage an investment banker, build a successful IPO team, avoid some pitfalls and be ready to meet the stringent requirements of a publicly owned corporation. The process is rigorous, requires enormous effort and time, and can be extremely expensive.

Going public is not for everyone, but if your company is set on it, carefully consider the pros and cons.

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Terms You Need to Know

Here are some of the other terms you will hear during an initial public offering:

Aftermarket performance. The difference between a stock’s initial offering price and its market price.

Expression of interest. A firm and obligated order to buy a specific number of shares.

Greenshoe. An agreement that the underwriter may authorize more shares for distribution if demand for an offering is high.

Oversubscribed. The spread between demand and supply for an issue. If an issue is four times oversubscribed, expressions of interest are four times greater than the amount of stock available.

Pricing date. The day underwriters determine the final price, yield, and size of an offering.

Selling group. A group of dealers the lead underwriter appoints to market a new or secondary issue. Members may or may not be a part of the underwriting group.

Syndicate. A group of investment dealers who underwrite and distribute a new issue of securities.

Time, Expense and Wary Investors

First you need a clear idea why you want to sell stock on the public market. Among the benefits:

  • Raising money for growth and expansion without taking on additional debt.
  • Providing liquidity for shareholders. Bear in mind the securities exchanges and underwriters generally want principal holders to stay with the company for a certain period of time, during which their shares typically are in escrow and released over time. Moreover, company officers and senior executives have access to material information and cannot trade shares until that information is made public.
  • Increasing stockholder value. Publicly traded shares generally trade at higher prices than holders can demand in private transactions.
  • Boosting your company’s profile and reputation. However, while an increased profile can help raise more capital, the spotlight can also attract hostile bidders that eventually could result in a loss of control of your business.
  • Acquiring shares for stock option incentives to attract and retain skilled employees or to use in place of cash to make acquisitions.
  • Increasing liquidity for a succession plan if family and associates don’t have the money to purchase your stock.

But having a reason to go public isn’t enough. Your company must be ready to face investors, who generally scrutinize three factors:

1. Earnings: Investors buy into potential growth and want to see a strong record of good returns on sales and assets. If you have been adjusting your earnings for the best tax benefits, you may have to restructure your business and restate earnings. Carefully review potential tax reorganizations and individual tax consequences with your accountants.

2. Business Plan: Having a business plan helps gauge the soundness of your intention to go public. It also helps write the prospectus that investors need to evaluate your offering. The business plan should include a market analysis, a description of your company’s products and services, management structure, and financial information and projections.

3. Management: Investors want to know you have an expert management team that can carry out your business plan. Investor reaction to both your prospectus and your management team can play a large role in determining the valuation of your company and the pricing of the stock issue. As well, you need a strong board of directors that understands your industry and reflects a varied business background. The board will be accountable to all shareholders for overseeing the operations of your public company and must consider their rights in all major business decisions.

Examine the Drawbacks

Finally, you want to discuss with your advisers the potential disadvantages to ensure they don’t outweigh the advantages. Among the drawbacks:

  • Financial Costs: Going public is expensive, and among the costs that can quickly add up are: Underwriting fees can range as high as 15 per cent;
  • Legal and accounting fees, as well as printing, listing and registration costs can add up to as much as four per cent; and
  • Continuing costs that include annual reports, board and shareholder meetings, shareholder registrations and transfer, and publishing disclosure information.
  • Time Costs: Typically, preparing to go public can take one to two years and eat up as much as 50 per cent of managers’ time. This can distract them from the efficient running of your business and can lead to lost opportunities.

Public companies must follow stringent, expensive, and time-consuming reporting and filing requirements. Some of the information you make public could be sensitive and you must disclose any information that can affect an investor’s decisions. You may have to spend a considerable amount to upgrade your accounting and information systems to handle the volume and variety of information required. Regulatory compliance can add from $25,000 to $200,000 in expenses.

Phase Two

But getting your business in shape for an initial public offering (IPO) is just half the battle. Once everyone involved determines you are ready, phase two begins.

While starting work on your prospectus, you must choose a lead underwriter, then file the prospectus and amend it if any of the appropriate securities commissions have concerns. And then you take the show on the road to market the offering.

The process is complex and time consuming, but the success of your IPO depends on it

The underwriter is typically an investment bank and acts as agent for the IPO. The roll is central to your offering so choose carefully. Get recommendations from your lawyers and accountants as well as others who have gone public. Check references thoroughly.

Among the qualities to look for in an underwriter are:

  • Reputation in your industry.
  • Availability of experienced analysts.
  • Existing relationships with your current and future customers, suppliers and competitors.
  • Chemistry with you and your management team.
  • Ability to provide after-market support.

Working with the underwriter you will determine the amount you want to raise and the number and types of securities you want to issue. The structure of the offering is typically one of two scenarios:

  1. A firm commitment, where the underwriter guarantees to raise a certain amount by buying the entire offer and then reselling to the public, and
  2. A best efforts agreement where the underwriter sells shares but doesn’t guarantee an amount.

Writing and Filing the Prospectus

Your prospectus serves two purposes: compliance with legal disclosure requirements and acting as the main marketing tool for your offering.

Your lawyer, managers, advisors and underwriters will work together to compile documentation about your company and its holdings, its capitalization, risk factors associated with the offering, a description of how the offering is structured, and a due diligence report.

You file the prospectus with securities regulators in each of the provinces where you plan to offer the shares. The more provinces you choose the higher your costs but the broader the exposure of your offering. Filing in Quebec will require English and French versions of the prospectus.

The regulators review the documents and issue comment letters with concerns they expect you to address, usually by modifying the prospectus. When regulators are satisfied, they will ask for a final prospectus and issue a receipt. You are then officially a reporting issuer and may start selling the shares.

The Quiet Period and Road Show

The time between filing the preliminary prospectus and getting the receipt for the final prospectus is the “quiet period” when you can market your offering only through oral statements and the preliminary prospectus. You must ensure that you do not issue any press releases, written presentations or other material that would be classified as advertising and that hypes the offering.

However, you can begin your road show, where you generally meet with two types of investment professionals:

  1. Buy-side analysts and fund managers working for mutual funds, insurance companies, and large investment groups looking for investments where they can put some of their pool of money, and
  2. Sell-side professionals who are usually brokers with retail investment houses looking for investments to recommend to their clients.

When the road show is over and you have distributed the final prospectus, the underwriter will set the final offering price and size.

The pricing will try to balance your need for cash with investors’ desire for investment gains. Your underwriter may recommend reducing the size of the offering if interest appears to be waning or increasing it in the face of strong demand. It is unusual to postpone an IPO due to lack of interest.

Once the sale is complete, you are a public company and subject to all the disclosure laws and regulations and responsible for your shareholders’ best interests.