Highly Profitable Tax Auditors

While this story originates in the United States, it is just as applicable here, in Canada.

Reuters’ David Cay Johnston noted today that IRS auditors “assigned to the 14,000 or so largest corporations found $9,354 of additional tax owed for every hour spent testing tax returns in the 2009 fiscal year.” [bold italics are mine]

A few things to note.  These were the largest corporations.  It’s hard to say how this number might be affected  by choosing smaller companies.  My guess is that the smaller companies would have lesser amounts of additional tax found by the auditors, but if we’re talking about restaurants, this would be offset by higher amounts of tax evasion identified by the auditors.  In short, it’s probably a  reasonable estimate of taxes recoverable from restaurants in Canada.

Undoubtedly, this is the reason why the Canada Revenue Agency went out and hired 5,000 new tax auditors!

Taxing Theft

We all know that some amount of alcohol will be pilfered.  Don’t you love that word?  Pilfered.  Sounds like a mere pittance.  It is anything but.  As a rule of thumb, the cost of the theft will be about three times the cost of the alcohol that is, ah, pilfered.

If you’ve been following recent posts on my sister blog, Canadian Restaurateur, you may have noticed a theme. Theft.  All restaurateurs know that theft is a significant issue that requires our constant vigilance.  The cost of the stolen product is bad enough, but if you also have to pay tax (plus penalties and interest) on the retail value of the stolen product,  it becomes a huge issue.  Everyone knows it isn’t right that a restaurateur should have to pay tax “as if” the stolen alcohol had been sold. Unfortunately, that isn’t the way it works in most tax jurisdictions.

In most jurisdictions, restaurateurs are considered to be a bunch of “tax cheats”.  There is a general presumption that most do not report all of their sales.  Quebec studies indicate that almost half of all restaurateurs cheat on their taxes.  As a result, tax auditors attempt to verify restaurant sales by marking up the alcohol purchases, based on menu prices.  If the projected sales are greater than the reported sales, this is taken to be evidence of “unreported sales”.

Of course, if some of those purchased bottles of alcohol “disappeared” before they could be sold, this would reduce the projected sales. Unfortunately, tax auditors are loath to give restaurants any credit for theft (other than that included in the “shrinkage” allowance).

Wouldn’t it be nice to ask the auditor to take theft into account?  Sounds logical.  Surely, the auditor gives the restaurant some allowance for theft.  You would think so.  Not only that, I suspect that every auditor knows that there is some basic level of theft that takes place in all restaurants, even the most heavily monitored ones.  Yet, we find that you have to fight for any theft allowance.  Obviously, every restaurateur could say they had a lot of theft during the audit period, which caused in the projected “unreported” sales.  If every such claim was accepted, I would have nothing to write about!

If restaurateurs claim theft as a reason for there appearing to be some “unreported sales”, the auditors ask for proof in the form of a police report.  A what?  Are they kidding? They are not!  You will never see an auditor ask for a police report with a smile on his or her face.  They are quite serious.  This seems to be a universal approach in just about every jurisdiction I have researched (including those in the U.S.).  So, do you call in the police every time you have a theft?

“Officer we’ve been robbed!”

When you experience stock losses, you need to produce a police report to satisfy the tax auditor (in Canada).  It doesn’t sound reasonable to me.  So, I discussed this with a real police officer.  Here are some of his comments, though they are not necessarily representative of the police department’s formal policies (or other police departments for that matter):

1. The police will investigate a theft, if there is “concrete evidence” that a crime has taken place AND there are leads to follow-up.
2. There must be some proof that a crime has taken place and a list of suspects.
3. The police needs to know what controls were in place to prevent the theft.
4. “Shrinkage” is not a criminal term.
5. It is up to the business to file a report of theft, including the amount of theft, proof and suspects.
6. Almost all restaurant theft reports are for money stolen from the premises.
7. There had only been one theft report involving alcohol – a thief had grabbed a bottle from the bar and was caught.

If the restaurateur catches the thief in the act of stealing, this would appear to fulfill the requirements for the police investigating the theft.  But, the stolen items would be returned to the restaurant, and this would have no effect on the projected sales!

When the restaurateur completes the month end inventory and realizes that $1,000 of inventory is not accounted for through sales, there really isn’t any proof that a crime has taken place.  It is not likely that the police will issue a police report for the “theft” – at least not more than once.  Even if they did, the restaurateur would have to file a monthly police report to “prove” the thefts during the year.  Since the restaurateur would be the one determining the amount stolen, these figures would be highly suspect.  I suppose there are penalties for filing a false police report, but then again, how would the police determine that it was false?  My guess is that if a restaurateur handed the tax auditor a fist full of police reports, the auditor would argue they were not credible, because the restaurateur determined the losses.

The IRS and many states in the US provide an automatic allowance for theft in restaurant tax audits.  They acknowledge that theft is a known problem in the industry AND that it is extremely hard to prove.  Why can’t the Canadian tax authorities be as reasonable?

Rampant Restaurant Fraud

The Canada Revenue Agency released some details of their 3-year pilot study (it was only supposed to run two years) of fraud in the restaurant industry.  While not many details were released, you can read the Globe and Mail article, Taxman finds rampant restaurant fraud.

The media’s interpretation of the details that were released is a bit misleading.  Of the 424 restaurants that were subject to scrutiny, it was determined that 143 of them exhibited evidence of fraud by erasing evidence of cash sales from their electronic POS systems.  This is how they arrive at the “one-third” of all restaurants fraudulently hide sales from the taxman.  Further, almost $1 million of hidden sales were revealed for each fraudulent establishment ($141 million).

So what’s misleading about that?  For starters, the restaurants in the pilot study are not representative of the restaurant industry across Canada.  Given the high dollar amount of fraud found (average $1 million), it is clear that these were fairly large operations, with many staff employed.  Zappers are much more likely to be employed in a large operation, because other forms of skimming cash from the till are too obvious to most employees.  Employees who become aware of owner/manager fraud see it as a “green light” to steal from the establishment.  Alternatively, they may report the owner to the CRA for tax evasion.  Not a risk that most restaurateurs would consider taking.  So, they have do carryout the fraud behind closed doors, after all the sales have been properly accounted for in the POS system.

Also, the vast majority of restaurants don’t have $1 million of sales that could have been suppressed.  These establishments must have had very significant cash sales, in order to zap them from the POS system.  Many restaurants, especially those in the fine dining category, accept credit or debit cards for the vast majority of their sales transactions.

The CRA study did not include restaurants in Quebec.  Over the last 14 years, the Ministry of Revenu Quebec has uncovered over 200 cases of zapper use, and they are the world leaders in zapper detection and prosecution!  More evidence of a highly skewed sample in the CRA study.

On the other hand, the study appears to have focused almost entirely on the use of zappers in the restaurant industry.  Of course, there are other methods of skimming cash from sales, and in fact, the majority of unreported sales in the restaurant industry is perpetrated without the use of zappers.

It is interesting that Quebec has decided to require most restaurants to install a Sales Recording Module (SRM) to capture all sales transactions as they are recorded, making it all but impossible to utilize a zapper or other method to hide sales.  Undoubtedly, they considered the ridiculously high cost of auditing restaurants with zappers to uncover unreported sales and decided it was far less expensive to provide free SRMs to the restaurants.

Unless the CRA decides to go the same route as Quebec, they will find the cost of auditing restaurants prohibitive.  Not only that, but they don’t have nearly enough sufficiently trained computer auditors to detect the use of zappers and identify the amount of unreported sales.  Even worse, as I have written before, if the CRA intends to use a SRM to verify all sales, they will not be able to use indirect audit methods to generate huge tax assessments that result from theft, over-pouring, spillage, and discounts.  These are the true “phantom” sales!

Know Your Taxpayer Rights!

You may not be aware, but there is a Taxpayer Bill of Rights in Canada. There’s even a CRA Guide.  I have to admit, I’ve rarely had occasion to look at it, until recently.  Today’s post covers several key taxpayer rights that are likely to be trampled upon during an audit.  This is especially true for audits of restaurants and bars.

I picked up a new client, while they were in the middle of a CRA audit.  My client could sense that the audit was going to propose significant tax reassessments.  As it turns out, my client was correct.  The auditor proposed reassessments for GST, corporate income tax, and personal income tax on the auditor calculated “unreported sales.”

Invariably, these types of audit assessments result from incorrect assumptions regarding theft, over-pouring, and waste/spoilage.  Typically, auditors apply “industry standard” allowance rates for each category of alcohol (liquor, draft, beer and wine).

Under the Taxpayer Bill of Rights, number 6 says, you have the right to complete, accurate, clear, and timely information.  When I asked the auditor and the audit supervisor to explain the basis of the proposed allowances, I was told they were “industry standard” allowances and that they apply to all taxpayers.  I knew this not to be the case, based on other client audits and case precedents.  Neither auditor was able to tell me how the allowances were determined.  One thought it was the CRFA, the other thought it was the LCBO!

Another Right, number 5, is to be treated professionally, courteously, and fairly.  For the most part auditors are professional and courteous.  Exercising fairness towards the taxpayer is another matter.  Part of this right involves taking the taxpayer’s specific circumstances into account in making decisions.  As we all know, there are many different business models for restaurants and bars.  To argue, as CRA does, that there is one standard allowance for all taxpayers is ridiculous.  At least in this client situation, the auditor spent almost no time at all trying to understand the client’s business and how it might affect the allowance percentages.

As part of my response to the proposed audit adjustments, I presented a number of case precedents.  Most of the applicable cases are from Quebec taxpayers.  I was shocked when the audit supervisor advised the auditor to see if there were any Ontario court cases.  There initial position was that Quebec court cases are not applicable in Ontario!  I had to remind them that there is only one Income Tax Act for all of Canada, and that under Right number 8, they had to apply the law consistently.

There were several other breaches of my taxpayer’s rights, mostly involving the consistent application of the law.  We didn’t have to lodge a complaint, however, because we got the CRA auditor to completely abandon the proposed adjustments, saving my client over $40,000.

Disproving Audit Assumptions

During a typical audit, the tax auditor interviews the taxpayer about the business operations and various factors that influence sales, such as portion standards, selling prices, theft, spillage, own-use and over-pouring.  If the auditor exercises sound judgment, the taxpayer’s assertions will be considered prima facie evidence that the assumptions are reasonable in the circumstances.  These assumptions form the basis for most audit assessments of restaurants and bars.  What if they’re just plain wrong?

Once the auditor makes a judgment about the assumptions to be used, the onus shifts onto the taxpayer to prove the auditor’s assumptions are incorrect.  While there is a degree of subjectivity attached to these assumptions, it is not enough to simply come up with other, more favourable, assumptions as a means of disproving the auditor’s judgment.  Too often, I see taxpayers (and their advisors) simply plugging different assumptions into sales projection spreadsheets and arguing that these assumptions are “more reasonable” than the auditor’s.  A complete waste of time.  This approach will not work.  Failure to grasp this point will cost you a great deal of money and, most likely, prevent you from effectively arguing your case on appeal.

One way is to prove that the auditor did not take a reasonable degree of care in exercising his or her judgment in setting the assumptions.  For example, the auditor may have interviewed the wrong individual in the restaurant or bar, acquiring incorrect information.  The auditor may not have exercised sound judgment in determining the appropriate questions to ask the taxpayer, or may not have investigated apparent inconsistencies, in order to properly set assumptions.  While they may try, at times, auditors cannot arbitrarily choose assumptions.  Failure to gather enough information to set a “reasonable” assumption can be used to show that the auditor used an arbitrary assumption.  The key to refuting the auditor’s assumptions is sufficient evidence.  A good tax advisor will be able to help gather and present proper evidence to refute the auditor’s assumptions. 

In other cases, the auditor makes a number of factual errors in the analyses, casting doubt on their accuracy and reliability.  Perhaps the auditor failed to use menus that were in effect during the audit period, or to take into account price changes, in setting average prices for the analyses.  The greater the number of errors the auditor makes, especially if almost all of them are against the taxpayer, the more likely the auditor’s credibility and judgment will be seen to have been impaired.

Conclusions

Much of the auditor’s prima facie support for assumptions comes from the initial interview with the taxpayer.  Do not go this alone.  Seek professional representation prior to the initial interview.  It is much more difficult to disprove the auditor’s assumptions than it is to help the auditor better understand your business and select the most appropriate, and accurate, assumptions.

If you are faced with inaccurate assumptions, you must gather and present evidence to counter the auditor’s judgement.  Simply offering your or your accountant’s opinion that the assumptions are not reasonable (ludicrous, even) will get you nowhere.

The sooner in the audit process you get professional advice the better.