Indirect Verification of Income (IVI) CGA Conference – Kelowna, BC Sept 29, 2005

1. Indirect Verification of Income (IVI)CGA Conference – Kelowna, BCSept 29, 2005

2. Indirect Verification of Income (IVI) Overview • Why IVI? • Steps Involved in a Standard Audit • Steps Involved in an IVI Audit • Supporting IVI Tests • What is IVI? • Reasons for IVI • Examples of IVI Techniques • Net Worth Example • Penalties • Requirement Letters • Jurisprudence • Conclusion

3. Indirect Verification of Income (IVI) Why IVI? • One of the key activities of Small Business Audit is identifying and deterring activities that create unfair competition impacting on smaller businesses. • In reviewing our audit activity in the Underground Economy sector, we have identified that standard audit procedures may not be the best tool to use to accurately determine compliance. • What should we be doing differently?

4. Indirect Verification of Income (IVI) Steps Involved in a Standard Audit • Carry out a preliminary desk review • Interview the taxpayer • Conduct a plant tour • Conduct preliminary review of books and records • Conduct testing of the books and records to determine areas of risk • Continue the audit focusing on the areas identified as containing the highest risk of tax loss

5. Indirect Verification of Income (IVI) Steps Involved in an IVI Audit • Carry out a preliminary desk review • Interview the taxpayer • Conduct a plant tour • Conduct preliminary review of books and records • Complete “supporting IVI tests” • Determine basis for completing audit ( i.e., using direct or indirect testing) • Complete audit using the technique decided on

6. Indirect Verification of Income (IVI) Supporting IVI Tests A means of quickly determining the risk of non-compliance is to carry out Supporting IVI Tests, such as: • Bank deposit analysis • Reasonability tests • Drawings analysis • Rough source and application of funds • Rough net worth • Ratio analysis

7. Indirect Verification of Income (IVI) What is IVI? Usual approach to an audit is to perform direct testing of the taxpayer’s records to determine the level of compliance. If direct testing cannot be used to complete the audit, we have to decide on which indirect verification of income (IVI) technique to use to complete the audit. The legislative authority to (re)assess a return using IVI is found in subsection 152(7) of the ITA and subsection 299(1) of the ETA.

8. Indirect Verification of Income (IVI) Reasons for IVI Audit • Books and records are inadequate, inaccurate or unreliable • Cash-based business and/or lack of internal controls • Supporting IVI Tests indicate unreported revenue • Third-party information indicates unreported revenue

9. Indirect Verification of Income (IVI) Examples of IVI Techniques Assessing Projections determining revenue based on identifiable and reliable trends or on an identifiable and reliable mathematical relationship between sales and some other variable. Assessing Using Unidentified Bank Deposits determining revenue based on deposits to all (business and personal) bank accounts Assessing Net Worth determining revenue based on changes in business and personal assets and liabilities taking into account personal expenditures

10. Net Worth Example January 1, 2003December 31, 2003 Assets $100,000 $ 125,000 Liabilities 75,00065,000 Net Worth $ 25,000 $ 60,000 Net Worth at December 31, 2003 $ 60,000 Less: Net Worth January 1, 2003 25,000 Increase in Net Worth $ 35,000 Plus: Non-deductible Expenditures (personal) 45,000 Sub-total $ 80,000 Less: Non-Taxable Income (e.g., lottery) 5,000 Total Income Earned in 2003 $ 75,000 Less: Total Income Reported in 2003 30,000 Unreported Income in 2003 $ 45,000

11. Indirect Verification of Income (IVI) Penalties Subsection 163(1) ITA Penalty is applicable when a person repeatedly fails to report an amount required to be included in income. Penalty is 10% of that amount. Subsection 163(2) ITA Penalty is applicable when a person knowingly or under circumstances amounting to gross negligence makes a false statement or an omission on their return. Penalty is 50% of the tax payable on the unreported income. Section 285 ETA Penalty is applicable when a person knowingly or under circumstances amounting to gross negligence makes a false statement or an omission on their return. Penalty is 25% of the tax under-reported.

12. Indirect Verification of Income (IVI) Requirement Letters Missing records may be obtained by the Agency by requiring a third party to produce the records (e.g., missing bank statements).

13. Indirect Verification of Income (IVI) Jurisprudence Delaunière et al., 2004 DTC 2349 The individual taxpayer, Régis Delaunière (the “taxpayer”), was the sole shareholder of the corporate taxpayer, 9039-0402 Québec Inc. (“9039”), which operated a restaurant-bar. In assessing the taxpayer for 1999, the Minister added $25,078 to his reported income using the net worth method. In assessing 9039 for 1999 and 2000, the Minister added amounts of $4,180 and $20,898 ($25,078 in total) to its reported income. Both assessments were arrived at using the net worth method and both included penalties.

14. Indirect Verification of Income (IVI) Jurisprudence Delaunière et al., 2004 DTC 2349 Both appeals were dismissed. The CRA auditor had calculated the taxpayer's personal expenses using information provided by the taxpayer. The taxpayer's version of the facts was neither credible nor reasonable; he had failed to discharge the onus of proving that the net worth assessment for his 1999 taxation year was not justified. Also, the $4,180 and $20,898 added to 9039's reported income represented 2/12 and 10/12, respectively, of the $25,078 that the taxpayer had failed to report, and, hence, were properly included in 9039's 1999 and 2000 business income. The penalties were justified since the Minister had established that both the taxpayer and 9039 had made misrepresentations about the income reported in their returns, so had acted knowingly or in circumstances amounting to gross negligence.

15. Net Worth Court Cases • Drouin Docket: 98-1074-IT • Duncanson 2002 DTC 3828 • Erlich 2000 DTC 6389 • Gerrimar Holdings 2000 DTC 1475 • Gogol 2000 DTC 6168 • Hsu 2000 DTC 2232 • Kyling 99 DTC 1060 • Louie 97 DTC 1542 • Luso Construction 99 DTC 3509 • Manhas 2005 TCC 327 • Mathur Docket 2001-411-IT; 2001-412-GST • Molenaar 2005 DTC 5307 • Naguib 2004 FCA 40; 2004 DTC 6082 • Narang 2002 DTC 6802 • Pal 2005 FCA 201 • Wammes 2001 DTC 708 • Vitti 99 DTC 3494

16. Projection Court Cases • FBF Limited (2000) 2928 ETC • Ghadban [1995] 2850 ETC • Harry Dezura 3 DTC 1101 (1947) Exchequer Court • Marceau (2003) ETC 2853 • 55 DTC 644 (1955) Tax Appeal Board

17. Unidentified Bank Deposit Court Cases • Alex Excavating (1995) 2895 ETC • Automobiles Dieudonne 96 GTC 3012 • Clarkson (2002) 2975 ETC • Entrepreneur Peintre (2000) 2851 ETC • Moncton Computer (2001) 3034 ETC • Wong 2001 DTC 151 • Yardley 2000 DTC 3641 • 620247 Ontario (1995) 2852 ETC • 897366 Ontario (2000) 2847 ETC

18. Indirect Verification of Income (IVI) Conclusion By using IVI techniques in our audits we expect to see: • Better results in our audits in the Underground Economy sectors; • An increase in the number of penalties being assessed; • An increase in compliance in the Underground Economy sector

19. Indirect Verification of Income (IVI) Thank you. Any questions or comments?