Cash flow analysis: Key to detecting unreported income

Cash flow analysis is an essential tool enabling Canadian tax authorities to uncover unreported income, giving taxpayers the opportunity to challenge these results when discrepancies appear in their financial returns.

The tax system in Canada and Quebec – self-declaration and self-assessment

Since the tax system in Canada and Quebec is based on self-declaration and self-assessment, the tax authorities (Revenu Québec and/or the Canada Revenue Agency, hereinafter referred to as “RQ” and “CRA”) may conduct audits when an apparent discrepancy or inconsistency appears in the return.

In any case, article 95.1 of the Tax Administration Act states that “The Minister is not bound by any return, report, application for refund or information furnished by or on behalf of any person and may, notwithstanding the return, report, application or information or the absence of any return, report, application or information, make an assessment or determine a refund.”

In such a situation…

In such a situation, the tax authorities can use an alternative verification method: cash flow.

As with net worth, the purpose of this verification method is to establish a new assessment. According to case law, the verifying agent must first use traditional verification methods, and “only when he finds that it is impossible to carry out a direct and traditional verification, can he use an alternative method” (Restaurant Le Relais de Saint-Jean inc. c. Agence du revenu du Québec, 2020, at para. 62.).

So what does this method involve? And above all, can a new assessment calculated using this method be contested?

I. What are cash flows?

In two sentences, the alternative (or indirect) method of cash flow verification, cash flow, “consists of compiling all cash inflows and outflows in the taxpayer’s accounts during the period in question.

A discrepancy allows the Canada Revenue Agency to presume that the taxpayer has failed to declare certain income. “(Boies v. Agence du Revenu du Québec, 2021, at para. 24).

In this case, the judges added that during an audit, the auditing officer is not required to conduct an investigation to establish the source of the sums. Under this method, the tax auditor is limited to analyzing existing documentation, i.e. any document or information relating to the taxpayer’s accounts and financial management.

This method consists of calculating cash inflows and outflows, and possibly recording a variance. Any discrepancy found will justify the issue of a new assessment.

In concrete terms, the auditors will analyze cash flows, i.e. cash inflows and outflows.

Let’s take an example: an individual earns a salary of $100,000 a year, but his purchasing behavior and lifestyle generate expenses that exceed his salary.

In such cases, the tax authorities may question the accuracy of the amounts declared. But as with the net worth test, it’s important to remember that this method is based on the presumption that all income is taxable, which is not necessarily the case.

An inheritance, loan repayment or donation may be the cause of this discrepancy.

“serious doubt”

This method is used in certain cases, particularly when there is “serious doubt” about the taxpayer’s declaration. In Le Relais de Saint-Jean, the judges stated that: “before resorting to the indirect audit method […], the tax department must first conclude, on reasonable grounds, that the books, records and vouchers of the business are unreliable or that the information contained therein leaves serious doubt as to their accuracy” (Restaurant Le Relais de Saint-Jean inc. c. Agence du revenu du Québec, 2020, at para 64.

These “reasonable grounds” may be when some of the taxpayer’s declarations are incomplete, false, or completely absent and/or when the taxpayer is unable to provide explanations to justify the discrepancy found. But this can also be the case for the individual who refuses to cooperate.

As far as companies are concerned

As far as companies are concerned, the decision lists the situations in which the cash flow method can be used. Here are a few examples: “Deposits and/or purchased products are higher than declared sales of the same products; conversely, product sales are always higher than declared production; Invoices or meal notes, although they exist, lack detail: they do not precisely identify the type of food or items sold, show inconsistencies in their numbering, do not indicate either the name or the tax number of the company, or are not dated; the data recorded by the company do not make it possible to determine the method of payment (debit or credit) for each sale; the sales indicated are substantially different according to the various accounting records.

Similarly, the confirmation of purchases transmitted by the identified suppliers does not balance with the purchases indicated by the company in its accounting records; The majority of the company’s expenses are paid in cash, which prevents the tax department from making an exhaustive analysis using bank or credit card data;…”. [at para. 65].

II. Is it possible to contest a new assessment based on the cash flow method?

In the same decision, the judges emphasize that “it must be borne in mind that the use of an alternative verification method is in itself imperfect and involves its share of arbitrariness, since it is a solution of last resort used by the tax authorities because the information provided by the taxpayer is unreliable or non-existent” [at para. 61].

As this method is somewhat arbitrary, it is not infallible and may be subject to error. In this respect, it is possible to challenge the reliability and accuracy of the reassessment issued by the tax authorities using the cash flow audit method.

Whether you are an individual or a company, if you have received a request for an audit or a reassessment following a cash flow audit, or even for legal advice on tax law, let our tax experts assist you. specialist tax lawyers who will be able to guide and advise you with confidence.