What to expect in an indirect tax audit
What to expect in an indirect tax audit
Synopsis
5 Minute Read
It can be challenging to manage your indirect tax obligations — along with all the other obligations of operating your business. This becomes even more challenging when tax authorities make inquiries or audit your returns unexpectedly. It is crucial to understand:
- What indirect tax is
- How indirect tax impacts your business
- What happens during an indirect tax audit
- How to minimize future audit and compliance requirements
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It can be challenging to manage your indirect tax obligations — along with all the other obligations of operating your business. This becomes even more challenging when tax authorities make inquiries or audit your returns unexpectedly.
In our recent webinar, MNP’s Jeff Harrison and Adam Amer provide an overview of indirect tax and what happens in an indirect tax audit. They also share some steps you can take to minimize future audit and compliance issues for your business.
What is indirect tax?
Indirect tax is a tax levied on goods and services rather than an individual or a company. It is a transaction-based tax that includes value-added tax (VAT), sales and use tax, and a variety of other taxes on specific goods and services.
Value-added tax
A VAT applies to goods where value and tax are both added at each stage of the supply chain. Examples of a VAT include GST, HST, or QST. Businesses that sell taxable goods and services are required to register for GST, HST, or QST and charge this tax to consumers at the point of sale. They must then remit it to the Canada Revenue Agency (CRA).
For example, a raw material seller will pay GST on the purchase of materials which it then may sell to a manufacturer. The raw material seller can then claim input tax credits to recover the GST paid on these materials and ensure the tax is only applied to the value added at each stage of the supply chain. The final consumer pays the full burden of the tax to the government.
Sales and use tax
The sales and use tax is another example of indirect tax. It includes sales tax such as PST — where the rate varies by province and the tax is typically added at the point of sale. It also includes the use tax, which is applied to goods and services purchased out of province or online where PST was not collected at the time of the sale. Consumers are obligated to report and pay this tax to their provincial tax authority.
While it serves a similar purpose to VAT, the sales and use tax differs in both structure and application. It is imposed solely at the final point of sale to consumers, with no mechanism for businesses to recover taxes paid on inputs. It is also managed individually by each province that imposes it, with significant differences in tax rates and rules.
Similar taxes
Taxes similar to the value-added tax and the sales and use tax include excise taxes, import duties, fuel taxes, carbon taxes, and the luxury tax.
How indirect tax obligations impact your business
Businesses must follow strict requirements to comply with indirect tax rules. When you collect indirect tax such as GST, you are collecting it as an agent of the government and holding it in a trust. Tax authorities will want to know exactly how much your business collected, where it went, and how much money is left over.
It is also crucial to understand which indirect tax rules apply to your business. PST rates and rules vary by province. Additionally, provinces may have different definitions of an end consumer that can impact your GST requirements. For example, businesses can be consumers of goods such as equipment or other materials — affecting who is paying taxes and at what time.
Tax authorities may make inquiries or audit your returns unexpectedly to ensure your business complies with regulations. Good books and records are an essential part of your business and your tax reporting. Tax authorities need this same information to trace the transaction, ensure all tax collected is accounted for, and make sure all tax credits are verifiable and eligible.
What happens in an indirect tax audit?
Indirect tax generates a significant amount of revenue for the government and audits exist to protect this revenue. Understanding the different types of audits can help ensure your business is compliant if tax authorities audit your returns unexpectedly:
- Request for clarification letter — This occurs when the CRA notices something unusual on your return and sends a letter to inquire if the submission was correct. This requires a one to two sentence response from your business.
- Refund examination — The CRA may request to review one return. However, this has the potential to open previous years up to review.
- Full scope audit — This is a much more detailed review that analyzes two to three years or more.
- Random audit program (RAP) — You will be notified by mail if your business is selected, and the letter will include the period under review and the information required.
An auditor will learn your business to look for risks and confirm if you are doing what you say you did. They will examine what revenue streams your business generates, which suppliers you purchase from, and analyze whether you have any abnormal transactions. They will also want to know how your business accounts for sales tax, what records you keep, and where you keep them.
How to minimize future audit and compliance issues for your business
An audit is going to happen to your business sooner or later, and it is vital not to impede the audit. Remember only to answer what the auditor asks you and control who has contact with the auditor to keep the process organized and on track.
Additionally, these steps can help further minimize future audit and compliance issues for your business:
Plan in advance
It is crucial to plan years in advance for an audit. This involves issuing invoices for all transactions to ensure the auditor has the correct information, reviewing all purchase invoices, regularly reconciling sales tax, and filing your returns on time.
Resolve documentation problems
Indirect tax obligations require your business to maintain proper books and records. However, many businesses frequently fall short in this area — and it is vital to take the right steps to minimize future audit and compliance issues.
Ensure that you properly store all invoices and other records related to your indirect tax obligations to support your business during an audit. A lack of documentation can be costly — for example, a business may have paid $10,000 in GST for materials five years ago, reported it as an ITC, and received a refund. If that invoice was misplaced and the CRA audits the business, they will take away the $10,000 refund and charge an additional $2,800 of interest.
Additionally, an accountant may handle your financial statements. However, these statements frequently don’t have as much detail as your business needs for indirect tax purposes. A financial statement may round your amounts to the nearest thousand or million dollars instead of providing details down to the cent level. Ensuring detailed financial statements can help prevent this issue.
The following tips can help you resolve documentation problems and minimize future audit and compliance issues for your business:
- Get all handshake deals in writing.
- Journal entries are weak support for intercompany transactions. Ensure that your business uses invoices to record these types of transactions.
- Ask suppliers to update invoices if they do not provide crucial information such as tax amounts or business numbers.
- Review the documentation requirements for GST/HST and QST and ensure that you follow the obligations as specified.
- If your supplier does not charge PST, ensure that you self-assess and report PST for taxable purchases.
Meet all deadlines
It is crucial not to ignore requests for information from auditors and ensure you do not miss deadlines, whether in response to an auditor or an appeal. Additionally, do not wait until year end to file your returns — even if your returns are due on an annual basis.
Separate accounts
To make the audit process easier, do not use a single sales tax account. For example, ensure GST and ITCs are not stored in the same account to avoid the comingling of funds and provide clear financial tracking. This will help speed up the audit process and reduce the likelihood of disputes with the CRA.
Contact MNP’s Tax Services team
Contact our Tax Services team for more information on your indirect tax obligations and how to minimize future audit and compliance issues for your business.
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