Dean Blachford, Tax Litigation Lawyer
Karen Cheung, Law Student
If you own a restaurant, the CRA has its eyes on you. Auditors frequently investigate restaurants for potential unreported income and HST/GST. Often, the outcome is bad for restaurant owners.
According to the results of an access to information request conducted by HazloLaw – Business Lawyers, restaurants that are subject to an audit have a 60% chance of being reassessed for additional income tax and a 76% chance for additional HST/GST. These reassessments include an average of $17,580 in gross negligence penalties. In extreme circumstances, the CRA reassesses the restaurant owners as well. In these cases, the combined amount owing for the restaurant and its owners can reach over $500,000, even for a small restaurant.
This article explains the CRA’s most common techniques for auditing a restaurant so that owners know what to expect and can make informed decisions on what actions to take.
What happens during an audit?
In some instances, the CRA will notify the restaurant owner that they will be commencing an audit. Other times, they will show-up unannounced and demand access to the restaurant’s point-of-sale (“POS”) system.
There are no default techniques that a CRA auditor must use to gather information and determine whether the restaurant has properly reported its taxes. The CRA’s Income Tax Audit Manual gives auditors permission to use any “imaginative approach” fitting. From our experiences, here are some common techniques:
a) Copying raw data straight from the POS system
The CRA auditors will often be accompanied by technical experts who can extract the data off the restaurant’s POS system. Importantly, these technicians can even access the digital records of sales that have been deleted from the POS system. CRA auditors compare this sales data to the sales that the restaurant reported to determine whether the restaurant has fully reported its income. If the CRA finds numerous deleted sales, they will assume that the restaurant owner is hiding sales.
b) Conducting interviews
The CRA will interview restaurant owners and related individuals to obtain a detailed understanding of the inner-workings of the restaurant. The auditors will take copious notes of the interviewees’ responses. If the answers of two interviewees are inconsistent or if the owner’s answers change over time, the auditors will be suspicious and the owners will lose credibility.
c) Observing the restaurant
CRA auditors may arrange for an “observation period” in which they sit at a table or behind the cash register and record the number of customers and the customers’ method of payment. CRA auditors will compare the observed data to the restaurant’s tax returns to see if they are consistent. If there are differences, CRA auditors may use a projection method (described below) to assess the restaurant for additional taxes.
d) Net worth analysis
This is a complex and detailed analysis in which the CRA compares the restaurant owner’s increase in personal net worth (assets minus liabilities) to the owner’s reported income. If the owner’s reported income is less than the sum of their living expenses and the increase in their net worth, the CRA will assume that the owner received unreported income from the restaurant.
For example, if the CRA calculates that the owner had an increase in net worth of $200,000 and living expenses of $90,000, but only reported $75,000 of personal income from the restaurant, the CRA will assess the owner $215,000 of unreported income.
e) Bank deposit analysis
A bank deposit analysis is just like the name – the CRA’s auditors will review the deposits of the restaurant’s bank account and the owner’s bank accounts. If the amount of those deposits exceeds what the restaurant and the owner reported as income, the CRA may assess both of them tax on the difference.
f) Projection methods
When the CRA believes that a restaurant is not reporting all of its income, it will use the projection method to determine the amount that the restaurant should have been reporting over the past. Typically, they will reassess the past three or four years.
Imagine a restaurant reports approximately $1 million in sales for each of the past four years. Of this $1 million in sales, it reports that 12% was paid by its customers in cash. If, during the observation period, 22% of the customers pay in cash, the auditor will assume that the restaurant has been receiving cash sales of 22% for the past four years and has been hiding the additional 10% each year. The CRA will therefore assess the restaurant and its owners tax on the missing 10% ($100,000) per year for each of the past four years.
Aside from basing its projections on an observation period, the CRA may come to a conclusion about unreported sales based on other evidence. For example, the CRA has made projections by comparing the number of drink sales a restaurant reported to the amount of liquor it purchased and the number of pizza sales a restaurant reported to the number of pizza boxes it ordered.
What restaurant owners can do
A CRA audit is a daunting experience and the evidence shows that restaurant owners have good reasons to be concerned. At HazloLaw – Business Lawyers, we have extensive experience helping to protect restaurant owners during the audit stage and successfully disputing incorrect assessments. If your restaurant is being audited or has already been assessed, please call us immediately to learn how we can help.
This article is for informational purposes only and does not constitute legal advice. If you wish to discuss your issue with a lawyer, contact Dean Blachford today. 613-747-2459 ext.310, dblachford@hazlolaw.com