Recently, the Canadian Restaurant and Foodservices Association (CRFA) published three calculators to help restaurateurs determine the effect on the new HST, effective July 1, 2010, on their prices. The calculators cover wine, spirits and beer. I’ve included the links, below. You can read more and find a discussion on their use and potential effects on your menu pricing in July, here.
Despite what has been published in the press and disclosed by the CRA and the Ministry of Revenue Quebec (MRQ), the use of zappers has not reached epidemic proportions in the restaurant industry. Zappers have been around since the mid-1990s, though most of the usage seems to have been confined to Quebec. In fact, the vast majority of the convictions for sales tax evasion have occurred in Quebec. For background on the use and abuse of zappers, please read this, this, and this. The unfortunate thing about all of this attention is that it may draw our attention away from a far larger threat to our operations. The indirect audit approach.
If you use a zapper to skim cash sales from your restaurant, you will get caught – eventually. Identifying and proving the use of a zapper to evade taxes is a very time-consuming process. Even though there have been large increases in the number of auditors, tax authorities do not have unlimited resources to ensure taxpayer compliance. Consequently, they needed to find an easier way to identify likely cases of unreported sales, and they found it in the use of indirect audit methods. The most prevalent indirect method used in the audit of restaurants is the mark-up method. I’ve written extensively on this subject – much of which may be found on this blog. For a quick review of a typical audit approach, please read this.
Recently, I attended a tax seminar put on by a tax lawyer. One of the interesting developments discussed was the huge increase in Retail Sales Tax audits in Ontario. As I discussed in an earlier blog, the transition to the HST on July 1, 2010 and the transfer of its collection and administration to the CRA, means that the Ministry of Revenue will be stepping up its efforts to do final audits for RST compliance for the four years ending June 30, 2010. These audits are taking place now and can be expected to increase dramatically over the next couple of years, eventually coming to an end in about five years.
It is going to be a tough period while the Ministry of Revenue extracts as much revenue from Ontario businesses as it can. After that, we can look forward to more HST audits, as every dollar of unreported sales will translate into 13% HST and approximately 20% income tax along with penalties and interest.
It’s going to get worse and it doesn’t appear that there is any light at the end of the tunnel. Scary times await. If your alcohol margins are out of line with what you expect, take action now to fix it. Not only will you enjoy the improvement in your bottom-line, you’ll also help ensure that your restaurant is not caught in the government tax grab.
Posted in Canada Revenue Agency, GST, HST, Income taxes, Ministry of Revenue, PST, Sales Tax, Taxes | Tagged Audits, CRA, GST, HST, Income tax, Ministry of Revenue, POS, PST, RST, Sales Tax, tax evasion, zappers | Leave a Comment »
A new Linked-in Group has been started to discuss issues of interest to Canadian restaurateurs and advisors.
Here is a short description for the group:
This is a group for discussing issues related to operating a restaurant or bar in Canada. It can also be used to ask for information or assistance from other members. It is open to all restaurateurs and advisors in the hospitality industry.
If you would like to join the discussion, please visit www.linkedin.com and search groups for “Canadian Restaurateur”. Request to join the group. Tell your fellow restaurateurs about this group and this blog!
Posted in Restaurant Operations | Tagged Canadian Restaurateur, Linked-in, Restaurant Operations | Leave a Comment »
This post concerns the use of zappers in restaurant operations. It is not a “how to” guide in their “proper” use, nor is it, in any way, an endorsement of their use. In fact, if you are even thinking of employing a zapper to fill your pockets with cash stop and read this post. It is not worth the risk. You will get caught, eventually, and here’s why.
Use a Local POS Vendor
If you purchase your software and zapper from a local vendor, distributor, developer or consultant, you will get caught. If you use a zapper, you will need some technical support to ensure that your computer system does not keep any stray bits of zapped data on the hard drive. As a result, you are locked-in with your consultant or other advisor. There will come a day when that person will be caught assisting another taxpayer in the use of a zapper. One way or another, the tax authorities will gain access to the consultant’s customer list, and you will become the latest target for an aggressive tax audit.
The Ministry of Revenu Quebec has used this method of identifying restaurant tax evaders quite successfully. They have also worked with the Canada Revenue Agency to execute search warrants in other provinces. The next step (much harder) is to collaborate with tax authorities in other countries, such as the U.S.
Zappers Aren’t Perfect
Even though zappers can delete or modify specific transactions and make it appear as though they were never there, many POS systems have frequent backup sub-systems to prevent the loss of data in the event of an unexpected shut down or power loss. These backup versions of files may remain on the computer disk and may contain remnants of the original “zapped” transactions. Where the use of a zapper is suspected, a tax auditor may call in a computer audit specialist to obtain the evidence of zapper usage. Using a zapper consultant to help cleanse your computer system means you have an accomplice (see first point).
Comparative Analyses
Auditors of all types (not just tax auditors) use analysis to help determine whether financial figures “make sense”. In a typical business, we compare key metrics with those of similar businesses. Where there are significant differences that have no reasonable explanation, we suspect errors or omissions in the accounting system.
Typical metrics might include the percentage of cash sales and whether this has changed significantly over the course of the audit period. An obvious one is the margin percentage for major product groups (wine, beer, liquor, food). Another might be the cost per ounce of alcohol for a variety of categories.
While most restaurants and bars do not have ready access to key metrics for similar establishments, rough guidelines are available from restaurant associations and other restaurateurs. Care should be taken to making sure you compare metrics from similar establishments. Metrics for a sports bar will be very different from those of a fine dining restaurant. Where proper comparatives are not available, you need to make sure that your margins (and other metrics) are reasonable, by comparing your actual metrics with what you should have expected given your prices, costs and other known information.
Vertical Analyses
Auditors also look at the relationship between various financial figures, as a test of their reasonableness. Many financial figures are related to sales volume or dollars. To some extent, labour costs, supplies, and a variety of other expenses vary with the volume of business. An auditor will analyse these relationships over time to determine whether there may have been unreported sales. Few restaurateurs would be capable of the meticulous recordkeeping and adjustments that would be required to make sure these analyses stayed consistent at all times.
Accounting for Cash
Most businesses generate some cash sales. There is nothing wrong with this. Once the cash has been received, it becomes an asset of the business. Well run businesses ensure that all receipts (including cash) are promptly deposited, intact, into the bank accounts. Many small (and some large) businesses do not follow this sound practice. Where such funds are not deposited into the bank, it is imperative that the owner meticulously account for all cash received with proper cash disbursement records and receipts (invoices).
Some restaurateurs are known to pay some of their staff in cash, without going through the regular payroll system. This is done to try to keep the labour costs in line with the reported sales (after zapping or skimming). Another practice is to purchase some supplies or inventory with cash, perhaps using separate cash accounts with existing vendors. In each case, the restaurateur has brought in accomplices to the fraud, increasing the chance of being caught.
Owners Living Above Their Means
While typically not used in restaurant audits, it is possible to examine the owner’s lifestyle to determine whether it makes sense, given the level of income reported from the business. If the owner’s lifestyle cannot be supported by the income from the business and other legitimate sources of funds, this becomes evidence that funds have been fraudulently removed from the business. Note that this method of assessing taxes is much more prevalent in the U.S. It is also used in Canada, and elsewhere, where it is difficult or impossible to verify income by any other means.
Changes in Cash Receipts
When a zapper is first used, or a skimming operation is commenced, there will be a decrease in cash receipts reported by the restaurant. This may provide evidence that a tax fraud has taken place and prompt the auditor to examine the books and records more closely.
That said, not all sudden decreases in cash receipts are fraudulent. A significant change in the restaurant operation may be completely legitimate and reasonable, depending on the circumstances. At the end of a patio season, cash sales may drop off considerably as fewer customers pay with cash in an indoor dining room. Similarly, if business at a bar drops off relative to its dining room volume, there will likely be a significant drop in cash receipts.
Paper Guest Checks
Most guests are provided with guest checks during their visit, regardless as to whether they pay by credit card or by cash. When a customer takes the paper guest check, it is an external piece of evidence of the transactions incurred at the restaurant. If a tax auditor were to obtain copies of cash-paid guest checks for a restaurant or bar (perhaps during another audit), these could be used to match up with guest checks reported by the restaurant during a future audit.
If the auditor is unable to exactly match the paper receipt with an identical guest check in the restaurant’s POS system on that date, this will be strong evidence indicating the use of a zapper. In fact, this is exactly how a Revenu Quebec auditor stumbled upon a major tax evasion case involving the use of zappers. The auditor visited a restaurant that had been selected for an audit and paid for the meal with cash. During the audit, it was determined that the original guest check had been altered, by removing an item (the original food modifier was not zapped). Note that the guest check number must be identical too. Note also, it only takes one discrepancy to provide strong proof.
Original POS Reports
Every day a restaurant operates, a variety of POS reports may be generated. As a minimum, each server will have a shift report showing the start and end times, total sales, by category, taxes collected, receipts by type, and balance owing to (from) the house. In most cases, this is a printed report provided to the manager or owner for review. Often the server retains a copy to keep track of tips owed. In order to keep track of the server’s performance and to help identify theft, these reports must include all sales. That is, they are pre-zapped reports.
The manager or owner also prints a day end report showing the aggregate totals for all servers for the day. Other reports may include taxes collected, sales by item, inventory usage, etc… Some reports may be provided to the chef for ordering purposes or inventory management, others may be provided to the manager. Again, all of these reports are pre-zapped summaries of transactions during the day. Effectively, all of these reports are a hardcopy “snapshot” of the POS transactions actually processed by the restaurant. Even though they may be subsequently changed by a zapper, they are a permanent record that may be made available to an auditor.
Unless all of these reports are destroyed after a zapping operation, there will be a paper copy available to indicate the use of a zapper in the operation. All that is required is a simple comparison of the original report with the current, zapped report.
All it takes is one disgruntled employee who suspects the use of a zapper (or other means of skimming) to provide original POS reports to a tax authority.
Quebec Approach
Quebec has decided to take a different approach to combatting the use of zappers and other forms of technologically-assisted tax evasion. They have started a pilot project involving the use of a Sales Registration Module (SRM), which will create a permanent record of each establishment’s transactions and guest checks. The SRM will produce reports for preparing QST returns. It will allow tax auditors to easily determine whether a specific guest check has been recorded or whether it has been tampered with by any means. Every patron must be presented with a guest check, or the establishment will face substantial fines.
The full rollout of the SRM system is expected in 2011. All but very small restaurants are expected to use the new SRM, which will be provide free of charge by Revenu Quebec.
Conclusion
While you may get away with the use of a zapper for a while, there are too many ways you could be tripped up. When it does happen, the penalties will be severe. It is not worth taking the risk.
Posted in Canada Revenue Agency, GST, HST, Income taxes, Ministry of Revenue, PST, Sales Tax, Taxes | Tagged Audits, CRA, GST, POS, PST, RST, Sales Tax, tax evasion, zappers | 1 Comment »
Recently, we’ve begun to hear a lot more about tax evasion in the restaurant industry. More specifically, we’re talking about technologically-assisted tax fraud, using zappers or phantom-ware. It made the news, again this past week, when it was disclosed that the Canada Revenue Agency had found more than $40M of unreported tax in the restaurant industry attributed to the use of zappers. Today’s post looks at the issue of tax fraud in the restaurant industry and tries to determine how “rampant” it might be.
While tax fraud can occur in many different ways, when we talk about the restaurant industry, it usually takes the form of cash sales “skimmed” off and not reported for tax purposes.
The Pre-zapper Era
Before the mid-1990s when zappers became available, restaurants, bars and other businesses with significant cash sales used other means to skim a portion of cash sales and under-report their sales and sales tax liabilities. Manually prepared invoices or guest checks could be destroyed if the customer settled the bill with cash. We don’t see too many places that still use manual guest checks, but there are a few.
A restaurant with stronger internal controls would have kept all checks and monitored the sequence of guest check numbers, to ensure that all invoices were recorded. This is why the tax auditors ask for all guest checks issued during the audit period. When they are not kept, it helps the auditor conclude that the restaurant’s internal controls are inadequate for ensuring the accuracy and completeness of the sales and sales tax records.
Another method was to have phantom cash registers. Typically, an establishment would maintain an extra cash register (or two) at a bar where the majority of the sales were likely to be paid in cash. The sales rung into the phantom cash register would never be recorded in the accounting system. The owner of the bar would need to keep track of any significant underreporting of sales, so that alcohol inventory could be repurchased off licence. This would have been required, to make sure that the margins, based on licensee purchases, would appear to be reasonable. More sophisticated frauds involved separate accounts with food suppliers, where a portion of the purchases were made in cash, to make the food margins appear reasonable, where a portion of food sales were not reported. Finally, some of the servers/bartenders would have to be paid in cash, so that the labour costs would appear reasonable.
As computerized POS systems became more affordable, their use in restaurants of all sizes exploded. This gave rise to a couple of new, technologically-assisted methods for skimming. The first was phantom-ware, which was built into the original POS software and could be programmed or activated to remove specific types of sales transactions. While there was a legitimate use of such software (the ability to reset data in the system for a new user), in reality, it was quite rarely used. Where phantom-ware was identified and used to commit a tax fraud, the tax authorities were able to convict the software developers as co-conspirators in the crime. Consequently, their use is quite rare. Instead, zappers were developed and their use appears to be on the increase around the world.
What does a Zapper do?
A zapper is a standalone software application that is attached to the POS system from time to time. It is usually contained on a CD or a memory stick. It is removable and only resides on the computer (or network) while it is doing its “work”. Consequently, its use may be shielded from other employees (or even owners) of the restaurant or bar. It can be extremely difficult to detect, though not impossible.
When a zapper is activated on a POS system, it allows the user to access the POS transactions database and make changes to the entries. Zappers are designed to search for cash sales, because these have no independent audit trail outside of the POS system. Whole guest checks can be deleted, items can be removed from the check, or the amounts can be modified. The zapper keeps track of the amount of items “zapped” from the system. Once the desired amount of sales has been achieved, the zapper renumbers the guest checks in the POS system and prepares adjusted reports for the day.
Sophisticated zappers may also adjust inventory usage figures and employee time records to conform with the adjusted sales figures.
How Prevalent is Zapper Use?
There is very little hard evidence of zapper use anywhere in the world, though some European countries believe that zappers are being used in cash-based industries and are taking steps to curb their use. In particular, Greece, Germany, Italy, and the Netherlands.
A limited study of tax evasion in the restaurant industry in Germany revealed significant underreporting of cash sales. Closer to home, in Quebec, two studies were undertaken. In the first, 41 zappers were found in 70 systems tested. At first blush, this is a startling finding. However, the sample was taken from the customer list obtained from a zapper distributor in the province! Given the sample, it becomes startling that only 41 of the 70 systems were using the zapper! In the second study, based on a random sample, the Ministry of Revenu Quebec found 16% of all sales were unreported. They concluded that “tax evasion is rampant” in the Quebec restaurant industry.
Revenu Quebec has only released a summary of their findings, so it is difficult to comment. For example, we don’t know how they determined that 16% of all sales were not reported. We don’t know whether this underreporting of sales relates solely to the use of zappers or to the use of other means. We don’t know the number of establishments using zappers or the percentage of establishments with zappers in use.
Other countries, like Japan (no cases) and the U.S. (2 cases) have not seen the same level of usage, or their tax authorities have been unable to detect their usage. In Canada, we have seen about 275 cases in Quebec, many of which were found on distributor client lists, but only 11 across the rest of the provinces. The latest sweep by the CRA has identified a few more, but at this point we don’t know how many or where they are located. Given that there are thousands of restaurants across Canada, even the number of zapper cases identified in Quebec does not justify calling their use “prevalent” in the restaurant industry.
You can not lump the entire restaurant industry together and say that zapper use is “prevalent” or tax evasion is “rampant”. The industry is too diverse.
Tax evasion, with or without zappers, requires that a significant portion of the fraudulent restaurant’s receipts be in the form of cash. Credit cards (including debit cards) create their own independent audit trail, making it nearly impossible to skim these receipts without being caught. Some restaurant and bar operations tend to take in more cash from sales than others. Nightclubs, bars, sports bars, pubs and fast food franchises tend to have significant cash sales. Higher end, fine dining restaurants tend to have very few cash receipts, as few people carry around large amounts of cash and corporate entertaining is almost always supported with a credit card receipt.
Fast food operations, despite taking in large amounts of cash, are less likely to skim significant amounts of cash, because they are accountable, not only to the tax authorities, but also to the franchisor. Franchisors have several methods of identifying unreported sales, because their franchise fee is usually dependent on gross sales of the franchisee. For example, a franchisor could monitor the franchisee’s sales in relation to the volume of pizza boxes (or other packaging) consumed.
While there are documented cases of fraudulent use of zappers, their use in Canada is no where near as prevalent as the tax authorities would have us believe. Furthermore, as society moves toward less use of cash in commercial transactions, the potential for tax evasion using zappers decreases.
Posted in Canada Revenue Agency, GST, HST, Income taxes, Ministry of Revenue, PST, Sales Tax, Taxes | Tagged Audits, CRA, fraud, Income tax, POS, PST, Revenu Quebec, RST, Sales Tax, tax evasion, zappers | 1 Comment »
I don’t want to scare you, but I feel it is my duty as a fellow restaurateur and as an accountant. After reading this headline, many of you will think this blog entry is going to be about the economy and how it will affect your restaurant business. As for the economy, I think the worst is behind us, but there is another threat to your business that is going to be a lot worse in the next few years. Let me explain…
Most economists seem to think that the recession has bottomed out and we are now on the road to recovery. To be sure, the recession was sudden and quite severe. The recovery is unlikely to be anything but a long, gradual improvement in business conditions. This is not good news to the many small businesses, including vulnerable restaurants, with their razor thin margins. We could all use a quick return to buoyant growth!
Governments at all levels need this too. The sudden, deep recession put a serious dent in government tax revenues. Also, they had to increase their spending to avoid an even worse fate. The federal and provincial governments are under intense pressure to limit their deficits, maintain key social programs and not raise taxes. A quick return to growth would do wonders for the government coffers, but it isn’t likely to happen. This leaves tax authorities with few options. They can find new taxpayers and they can make sure that “tax cheats” pay their taxes. Unfortunately, to the tax authorities, the terms “restaurateur” and ”bar owner” are synonymous with “tax cheat”!
I am mainly concerned with Canadian taxes imposed on restaurants and bars, but it is usually a good idea to look at what is happening in the US, to understand what is likely to happen up here. A look at various state tax authorities reveals an ominous trend towards increased audit activity directed at licenced restaurants and bars. Few taxpayers will object to their government taking measures to ensure that all taxpayers comply with the tax laws. By increasing audit efforts, tax revenue can be increased without the negative political connotations of an increase in taxes. It is very easy to justify hiring more auditors to avoid increasing taxes! And this is what we see happening south of the border. You should expect to see the exact same trend in Canada.
But why target restaurants and bars? There are a number of reasons. All restaurants are required to charge sales taxes on their gross revenues. In Ontario, the rates are 8% on food sales, 10% on alcoholic beverages, and 5% GST on all sales. Generally, there are no deductions against these taxes. If a tax auditor can show that the restaurant failed to report sales, an assessment can be issued calculated at the appropriate rates, combined with penalties and interest. Tax authorities suspect 50% or more of all restaurants and bars are “cheating” on their taxes owing. It is easy for the auditor to accurately verify the alcohol purchased. There is a theoretical (or standard) cost for every drink sold. With a few simplifying assumptions, the auditor is able to estimate the sales that should have been generated by the restaurant during the audit period.
So, for a relatively small amount of work, the auditor is able to estimate the likely “true” sales of the business. Then, it is up to the taxpayer to rebut the presumption that the restaurant has failed to report all sales. In order to do so, the restaurant must document the reasons that costs deviated from the standards. This can be exceptionally difficult to do, after the fact. Few restaurants and bars have the time to document all of the factors that affect their margins. It can be done, but there can be a significant cost. Ideally, such information should be independently developed. While it can be costly to stay on top of your margins, it is still far cheaper than letting the tax auditors have their way with you, and an ongoing analysis of your margins will help you manage your restaurant more effectively.
If I have scared you into action, I’ve done my job. Continue reading this blog site for a comprehensive list of procedures to help protect your business.
Posted in Canada Revenue Agency, GST, Ministry of Revenue, PST, Taxes | Tagged Audits, CRA, PST, Sales Tax, tax evasion, Taxes | 3 Comments »
Today’s Toronto Star ran an article about restaurants hiding cash income. You can find it here: Restaurant probe finds $40M in ‘phantom’ sales.
Until recently, most detective work surrounding the use of zappers had been focused in Quebec. Now, we find out that the CRA has been involved in a two year, national probe of the restaurant industry. So far, they’ve found about $40 million of unreported income, though they expect to find much more by next March when the study is completed. Of course, such unreported income must be in cash, as there is a separate audit trail for all credit card receipts. It appears that this CRA probe concerns the use of zappers by restaurants. Previously, I wrote about zappers, here.
I find it interesting that the CRA has only found about $40M of unreported sales, whereas Revenu Quebec estimated $417M of unreported taxes in a two year period. It may be that CRA is considering only unreported sales using zappers, whereas Revenu Quebec is estimating tax losses by any means. The scary thing is that someone, presumably at CRA, named Caitlin Workman is quoted as saying, “preliminary work indicates that (practice) is prevalent across Canada.” So, the CRA thinks that the use of zappers in the restaurant industry is prevalent!
Prior to undertaking this probe of the restaurant industry, the CRA had identified only 11 cases of using a zapper, and zappers have been around since the mid-1990s. Does this sound “prevalent” to you? I’m willing to bet that Revenu Quebec, alone, identified more than 11 uses of zappers in the past. In fact, they have prosecuted about 275 cases of restaurants using zappers during the last 10 years. While other researchers have given their opinions that the use of zappers is likely to increase in the future, there does not appear to be a consistent level of usage across all jurisdictions. In fact, several local factors lead many of us to believe that Quebec restaurants are much more likely to use zappers than restaurants in other parts of Canada. I’ll be examining this opinion in more detail in a future post.
Both the federal and provincial tax authorities know that the restaurant industry is an easy target for assessing taxes on “unreported sales”. Studies like this one that find any evidence of unreported sales give them the justification to step up their enforcement efforts. The CRA and all of the provincial tax authorities use indirect audit methods to determine unreported sales, they do not wait to find the existence of a zapper. All restaurant owners (even completely honest ones) need to be even more careful in the next few years.
Posted in Canada Revenue Agency, GST, HST, Income taxes, PST, Sales Tax, Taxes | Tagged Audits, CRA, POS, tax evasion, zappers | 1 Comment »
So far, I’ve discussed the POS system and how to maintain it for accurate reporting, how to document your sales mix for all audit periods, and the importance of maintaining an accurate history of your menu prices. Taken together, these bookkeeping tasks are crucial in helping the restaurateur determine, and properly support, accurate weighted average prices. This is a crucial component of the mark-up calculation performed during a typical audit.
Now we’ll take a look at the actual cost of the alcoholic beverages purchased for sale.
Gross Quantities & Costs
In Ontario, licensed establishments are required to purchase all alcoholic beverages from licensed agencies, the LCBO or Brewer’s Retail. Each vendor keeps track of licencee purchases with the use of licence numbers. This allows auditors to obtain a listing of every bottle of alcohol purchased by a licencee for any period of time. Details include the bottle size, quantity purchased, description, invoice cost and date of purchase. In Ontario, the details include the price net of GST, the licencee discount, and the gallonage tax. These figures allow the auditor to calculate a net cost for each bottle of alcohol purchased (wine, liquor, beer).
All of this information is provided to the auditor in electronic form. Typically, the auditor imports the data into an Excel spreadsheet, where it can be sorted to match the sales categories and sub-categories. From there, the auditor will summarize the total ounces and cost of alcohol purchased in each category.
Allowances
Depending on the type of restaurant operation, the auditor will make one or more allowances to consider the effects of spoiled (tainted), spilled and over-poured alcohol. Usually, this allowance is expected to cover staff theft as well. Additional consideration may be given to alcohol used in cooking and customer comps. The amount of the allowance (usually expressed as a percentage) is based on the restaurateur’s responses to questions during the initial interview, the nature of the restaurant’s operations, and the auditor’s judgement (based on “similar” operations) as to the percentage that might be considered “reasonable”.
Depending on the type of alcohol and the peculiarities of the operation, allowances can be as low as 1% and up to about 50%. In many cases, the allowance is about 10% for all possible reasons (spilled, spoiled, over-poured and stolen). Any allowance greater than this will need to be properly supported.
All other adjustments will need to be properly supported with logs or ledgers detailing the reasons adjustments are required for alcohol used in cooking, customer comps and other reasons. This will be a topic of a subsequent post, but for now, you should know that logs will be required to support any other adjustments to costs.
Proper Matching
It is extremely important to make sure that the auditor is properly matching the correct alcohol with the drinks sold in each category. It is equally important for the auditor to exclude beverages that are not actually sold to customers. For example, several liqueurs may be used solely for flavouring martinis or cocktails. Similarly, Vermouth is rarely, if ever, sold on its own. These are commonly regarded as mixes. Some restaurants consider port wine sales in the same category as after-dinner drinks, brandies and cognacs. Most likely, these will be reported as liquor sales rather than wine sales. Care should be taken to making sure that the auditor is aware of the restaurant’s categorization of menu items.
Cost Per Serving
During the initial interview, the auditor will ask questions of the restaurateur in order to pin down the serving sizes for all drinks sold. The auditor will also examine menus to help determine the serving size for all alcoholic drinks. The auditor will also be asking questions to gain an understanding of the potential over-pouring of each category of drink (wines, draft beer, liquor). It is extremely important to have expert advice prior to providing this information to the auditor during the initial interview. If inaccurate or vague information is given, it will be very difficult to get the auditor to change his or her assumptions later on.
Taking all of these factors into consideration, the auditor will develop an average cost per serving for each category of alcohol sold by the restaurant. This figure incorporates the allowances described above. The average cost per serving for a category is matched with its corresponding average category selling price to determine the average category mark-up percentage.
Putting It All Together
Finally, the auditor takes the total cost of alcohol purchased for each category and multiplies this by the applicable mark-up percentage, to provide an audit estimate of the sales that “should have been” generated from the purchased alcohol. This is done for all liquor categories. These total projected sales, calculated by the auditor, are compared with the total alcohol sales reported by the restaurant, for each category. If the reported sales were lower, the difference is considered unreported sales. The restaurant will be assessed for the sales taxes on the unreported sales, and will likely be assessed income taxes on the difference, as well.
Auditproofing
Now that we know how the auditor performs the sales projection, we need to perform a similar analysis before the auditor arrives at your door. Regarding average costs, you should be prepared to invest the time to keep track of the quantity and cost of every bottle of alcohol purchased by the restaurant. Unfortunately, you will have to manually maintain this list. I suggest an Excel spreadsheet. Every item should be listed along with all of the details noted above (date, quantity, bottle size, etc…).
Once this and the other procedures (average selling prices, sales mix) have been performed, we can prepare analyses similar to those that the auditor will carry out during an audit. Then, when the audit takes place, you will know the assumptions necessary to support the tax returns that were filed. These proactive analyses will also be used to document and explain variances from the standard mark-ups on an ongoing basis. These explanations will be very useful in supporting the reasonableness of the various assumptions made during the audit.
Posted in Canada Revenue Agency, GST, HST, Income taxes, Ministry of Revenue, PST, Sales Tax, Taxes | Tagged allowances, Audits, CRA, Customer comps, GST, Income tax, Liquor, over-pouring, PST, RST, Sales Mix, Sales Tax | 1 Comment »
This is the second post in the series on auditproofing your restaurant from an unfair audit. Most restaurants and bars with weak internal controls (almost all independent establishments), will be audited by the Canada Revenue Agency (CRA) or a provincial tax authority using an indirect audit approach. In most cases, this approach will be the mark-up method, which seeks to project the sales level that was likely to have been generated based on the amount of alcoholic beverages purchased by the establishment. As we have seen in other posts, this audit method involves making a number of assumptions about the operation. Determining what these assumptions should be, can be quite complicated.
Instead of spending the time to develop accurate assumptions for each establishment (which would be the fair method of auditing), the auditor relies on rules of thumb. Basically, these are averages of metrics observed at similar establishments or annual averages based upon the restaurateur’s answers to questions during the initial interview.
Let’s look at one of the key assumptions auditors make.
The Sales Mix
Each restaurant will have its own sales mix, which is simply the percentage of each category of menu items, such as liquor, wine, beer and food. The sales mix may be relatively consistent from one year to the next, or there could be significant changes, if there has been a strategic change in the business operations (new patio, new bar, renovation, new chef, new menu, etc…) Where there have been significant changes to the restaurant, it is important to ensure that the auditor takes these into account when determining the average sales mix for each year.
Not only will there be a sales mix of major categories of menu items, there will be a sales mix of sub-categories within the major categories (martinis, 1 oz shots, 1.5 oz shots, etc…) These sales mixes can also change from year to year.
So, we want to know how the auditor determines the sales mix for each year of the audit. Typically, the auditor will work backwards to determine the estimated sales mix, based upon the actual purchases of alcohol in each category and certain assumptions regarding the mix of sales in sub-categories. Armed with estimated average sales prices and average portion costs, the auditor is able to calculate average markups for each category (and sub-category), for each year. Care must be taken to properly allocate the change in inventory each year, for each category of alcohol.
Why is this important? The determination of the sales mix can have a significant impact on the projected sales, because the margins in the various categories and sub-categories can be quite different and each category of inventory has its own “theft profile“.
In my first post on auditproofing, I briefly discussed checking the accuracy of each menu item’s categorization. While we could re-sort all of the menu items into appropriate categories, using a program like Excel, this would be time-consuming, subject to error, and require additional audit work to determine that the re-sorted report is accurate. Auditors don’t like Excel reports, because it is difficult to determine whether they have been manipulated. Consequently, we want the POS system to provide accurate sales and inventory usage figures, directly, without any re-categorizing. This will also save a lot of time preparing analyses during the year.
We will be preparing several POS reports on an ongoing basis. It is important that they be consistent from one period to the next, because we are going to summarize them for each year that is to be audited. We will be analysing the sales mix for all categories and for key sub-categories within each period and for the entire year. Before the auditor conducts the initial interview, you will know all of the sales mixes that are relevant to your restaurant for the entire audit period. Not only that, you will know them to a very high degree of accuracy.
In a future post, we will be looking at gross margins and how we document the variance between the expected margin and the actual margin. We will be looking at all categories and major sub-categories, and we will be looking at changes over time. This is another reason why we need the categorization of menu items to be consistent throughout the audit period.
To put this post’s topic in perspective, the sales mix among the categories (and within major categories) is a key component of the mark-up method, used by auditors to project sales for a restaurant. If we know the actual sales mix figures and they can be supported, before the auditor arrives, the auditor will be compelled to adopt these assumptions in the audit analyses. It is one less assumption that might lead to an error in the auditor’s analyses.
Posted in Canada Revenue Agency, GST, HST, Income taxes, Ministry of Revenue, PST, Sales Tax, Taxes | Tagged Audits, CRA, GST, Liquor, POS, PST, Sales Mix, Sales Tax | Leave a Comment »
Today’s posting is the first in a series of articles about “auditproofing” your restaurant. By this, I mean taking proactive steps to help ensure that your restaurant or bar is not unfairly reassessed for sales and income taxes when it is audited by the CRA or provincial tax ministry. Please check back regularly for other methods of auditproofing your business. If you have any questions, please post comments to the articles, and I will do my best to respond. If you prefer, you can email your questions to me.
Most restaurants have a computerized point of sale (POS) system to keep track of items ordered by each guest, send orders to the kitchen or bar, and process guest check settlements. Most systems can keep track of many other important transactions, such as discounts given (by type and employee), voids (with reasons, by type and employee), ingredient usage, and many others. From a tax perspective, the POS system keeps track of every item ordered and calculates the appropriate sales tax. Just like your car, the POS needs to be maintained properly.
One of the first audit steps a tax auditor performs is to reconcile the POS sales and tax figures with the accounting records and with the actual sales tax returns that were filed. The auditor will also check to ensure that the correct sales taxes were charged on each item sold. Any discrepancies will cast doubt on the reliability of the procedures to accurately calculate and remit taxes and ensures that the auditor will be justified in using an indirect audit method to reassess sales (and income taxes) for the restaurant.
Here are a few steps that you should perform before your restaurant is audited.
Recalculate Taxes on Sales
It would be incredibly time-consuming to check every transaction that the restaurant processes. Luckily, we don’t have to check every one. We can check them in bulk for a period of time. If the figures are correct for the entire period, they are likely to be correct for every transaction processed during that period.
Consequently, for each period, review the POS report that shows sales and taxes collected. In Ontario, the report should show non-alcoholic sales (food and beverages), and alcoholic beverage sales, together with the total GST, PST (food at 8%) and PST (alcohol at 10%). I suggest that this report be run monthly, but you could do it daily or weekly, too. Once you have the report, multiply the total sales for each category (alcohol & non-alcohol) by the applicable PST rate, and compare this figure with the sales tax collected as shown on the report. Total sales (both types) multiplied by the 5% GST rate should be compared with the total GST collected that is shown on the report.
Explain Differences
Any differences between the calculated tax and the tax shown on the report should be investigated. One reason for there being a difference is that some of the sales transactions were exempt from one or more taxes. Examples include purchases by Status Indians and Foreign Diplomats and food sales less than $4.00 in Ontario.
The more likely reason you will find a difference between the calculated tax and the actual tax collected is that the POS system contains errors in the tax setup for one or more menu items. When this happens, the auditor will conclude that the POS system and the internal controls over sales are not effective to ensure the accuracy and completeness of the sales and sales tax figures. Consequently, you want to ensure that all discrepancies are identified quickly and appropriate corrective action taken.
If you find discrepancies, you will have to check the tax codes for every menu item in the POS. All food and non-alcoholic beverage menu items should be coded to charge 8% PST and 5% GST. All alcoholic beverages should be coded to charge 10% PST (Ontario) and 5% GST. This can be a time-consuming task, but if done properly, you should not have to do this again.
A POS Key for Every Item
You should ensure that every item sold has its own key in the POS system. Ensure that a new POS key is set up prior to adding any new wine to the menu. Do not let staff try to convince you that they “need” an Open Liquor key. They don’t, unless you fail to set up keys for all menu items. They may try to argue that they don’t have time to find the right key when they’re busy, etc… If this is a problem, ensure that they are properly trained on the POS system and consider reorganizing menu items on the POS to make it easier to find items quickly. Why is this so important? Once you have an Open Liquor key, it will be used for a wide variety of customer purchases. Wine, beer, alcohol and even food will be processed under this key. This will distort the reporting of sales by category (and taxes collectible) and it will make it impossible for you to accurately track usage of ingredients based on actual sales. As we will see in future posts, this will be an extremely important control when we need to rebut the auditor’s assumptions.
POS Menu Security
Once you have completed this task, I recommend that you change the security authorizations in the POS system to restrict all staff, except yourself or a trusted manager, from making changes to or adding menu items. With this control in place, you will only have to check future changes and new menu items for accuracy. Subsequent monthly reconciliations should reveal no unexplained discrepancies.
Other Housecleaning Tasks
While not the topic of today’s post, when you are checking each menu item, you can perform other useful steps that we will be using in future auditproofing tasks. In particular, while checking the tax codes, you should also ensure that each menu item (focus on alcoholic beverages only) is summarized in the appropriate sub-category. Here are a few typical sub-categories: Domestic bottled beer, Imported bottled beer, martinis, shots, cocktails, Wines by-the-glass, Wines by the bottle, etc… Accurate categorization of all menu items will make it easier to analyse sales data in the future.
Another step is to create recipes for menu items. Usually, when we think of recipes, we might think of a cooking recipe for a dish. While this can be programmed into most POS systems, this can be an extremely time-consuming exercise. Most auditors are far more concerned about alcoholic drink sales. Consequently, you should consider creating recipes for all alcoholic beverages. Having a recipe for each menu item will allow you to prepare POS reports of ingredient usage, based on the actual items ordered for any period of time. Depending on the level of sophistication required, these usage reports can also be used to identify inventory shortages and assist in placing orders to replenish stock.
Recipes can be as simple as having an “ingredient” of one bottle of Heineken for a bottle of Heineken (menu item). A glass of wine could have 6 ounces of Catena Malbec, or it could be described as 25% of a bottle of Catena Malbec. Cocktails could have several alcoholic ingredients.
Recipes can have a standard spillage factor built in or not. If you do incorporate a spillage factor, it should be a fairly accurate estimate of the true spillage amount. Note that this percentage will vary among the various liquor categories. If the spillage factor is included in the recipe, it is one less factor that needs to be explained in future variance analyses.
This post has been concerned with the menu items in a POS system. I have not discussed other issues such as discounts, voids, spoiled stock, and customer comps. These will be discussed in future posts.
Posted in Canada Revenue Agency, GST, HST, Income taxes, Ministry of Revenue, PST, Sales Tax, Taxes | Tagged Audits, Income tax, Liquor, POS, PST, RST, Sales Tax | Leave a Comment »
When the auditor arrives to audit your bar or restaurant, he or she will review your internal controls to ensure the accuracy and completeness of your recorded sales and the taxes thereon. If the documentation is not available to determine that appropriate controls were effective throughout the audit period, the auditor will conclude that the controls were lacking and that the books and records may not be relied upon to support the sales taxes collected by the restaurant. Most independent restaurants will fall into this category. As a result, the auditor will proceed to apply an indirect audit approach to estimating the amount of sales that were likely to have been generated, based on your purchases of alcoholic beverages. Several key assumptions are used in this method, which I will describe in the remainder of this post.
Keep in mind that the auditor is attempting to estimate your “true” sales based on certain facts, such as the amount and volume of alcohol purchased, and a variety of average assumptions, such as portion sizes, drink prices, sales mix, spoilage, theft, personal use, complimentary drinks, etc… Every time one of these average assumptions differs from your restaurant’s actual situation, there is a potential for the auditor finding “unreported sales”. Consequently, it is extremely important that the auditor’s assumption conform as closely as possible to the true state of affairs that took place during the period under audit. Please note that I will examine these assumptions in much greater detail in future posts.
Sales Mix
During the initial interview, the auditor will ask you for a breakdown of your alcoholic beverage sales by category. Typical categories might be: bar shots, cocktails, martinis, draft beer, domestic bottled beer, imported beer, domestic wine and imported wine. Few restaurateurs are able to provide detailed, accurate breakdowns of sales by category over a four year period. Furthermore, the sales mix will likely have changed over the course of the audit period.
Most POS systems will provide reports to show the sales mix for a particular period of time, but the report will only be accurate if each menu item is set up properly in the appropriate category. The restaurateur should review all POS menu items (and any new ones) to ensure that they are summarized in the proper category. Detailed sales mix reports should be prepared for every fiscal year of the restaurant’s operation. Without this information, the auditor may be forced to conclude that the sales mix matches the volume of alcohol purchased for each category. This may lead to an inaccurate sales mix determination.
Average Sales Prices
In order to calculate an average sales markup for each category, the auditor must have an average sales price for the category for each year. If the restaurateur is able to provide very accurate average prices for each category, the auditor will be forced to use these figures. Otherwise, the auditor will attempt to estimate the average price, based on menus that were in effect during the year. In the absence of more detailed, supportable, information from the restaurateur, the auditor may have to take an average of menu prices during the year. Depending on when price changes came into effect, the average prices may not be accurate, leading to a distortion in the average markups that will be used by the auditor.
As a result, each restaurant and bar should maintain a detailed record of every price change for all alcoholic beverages, including the price change dates. Combined with the sales mix information, this price data can be used to calculate a weighted average category price for each category, which will be substantially more accurate than the auditor’s simple average.
Portion Size
The auditor will ask you for the portion size of all alcoholic beverages and this information will be matched to drink sizes noted on menus. The auditor will also enquire as to the existence of any alcohol dispensing systems that may have been used to help ensure proper control over the standard drink size. The agreed upon portion size will be used to determine the cost of a serving for an average drink in each category. Most categories will have a large number of drinks sold during a typical year. Consequently, a small change in the average portion size will have a large impact on the total estimated sales for that category.
Each category of drink has a variety of factors that affect the portion size. Draft beer with too little head will result in a substantial over-pour. Multiplied by a large number of draft orders, it will appear to the auditor that there is a substantial amount of unreported sales of draft beer, when this happens. Similarly, free-pouring of alcohol for shots and martinis can result in substantial overpouring of liquor. Keep in mind that a 1/2 ounce overpour on a 1 oz drink represents a 50% overpour. On a 1-1/2 ounce shot, the overpour is 33%. Most auditors will attempt to use a much smaller overpouring percentage, often as low as 10%. This will result in the finding of a significant amount of unreported sales of liquor. Portion sizes for bottles of wine are obvious, but serious overpouring of wines sold by-the-glass can occur. Average portion sizes must be determined and monitored by the restaurateur on an ongoing basis. Documentation of this monitoring can be provided to the auditor, if necessary, to document known portion control issues.
Shrinkage
All auditors know that restaurants and bars experience some theft of their inventory, especially alcohol. Where restaurateurs and the auditors differ, however, is in the amount of theft. The auditor will attempt to provide a minimum allowance for theft, “based on average theft levels for similar establishments”. Any attempt by the restaurateur to increase this allowance will be challenged. You will be asked for police reports to show that you reported the theft to the police. In my experience, unless an employee was caught “red handed” in the act of stealing (and even rarely then), the police are never called in. Most restaurants don’t want the negative image of a police cruiser in front of their establishment, so they will not report the theft. The auditor, however, takes this to mean that it didn’t happen in the first place. Most restaurants simply experience a loss of inventory without actually finding the thief.
As a result, it is extremely important that the restaurant document it’s findings of theft, based on regular inventory counts and POS usage reports. Most POS systems allow you to create recipes for menu items, which will provide usage reports of all ingredients. While this can be a significant amount of work setting it up, it will allow you to determine the loss of stock over a period of time. In the case of wines sold by the bottle, you will be able to get a better estimate of the actual theft losses than by any other means.
Shrinkage also includes spoiled product. For example, beer in the draft lines that is discarded rather than sold. Wine bottles that are opened to be sold by-the-glass will become tainted, if it isn’t sold in a reasonable time. Some wines are corked or otherwise tainted by the time they are opened. Some wine sites on the internet provide documentation that as many as 1 in every 18 bottles of wine are tainted and unsuitable for sale. This, alone, represents almost 6% spoilage, if the tainted bottles are not returned to the suppliers for credit. Ideally, you need to have a process in place to document and prove the amount of tainted wine your establishment incurs.
Cooking Use
Some establishments use a considerable amount of alcohol in their food menu recipes. Unless the auditor deducts the alcohol used in cooking from the purchased alcohol, projected sales will be substantially inflated, based on the markup method. Therefore, it is important to document the amount and type of all alcohol (wine, liquor and beer) that is used in preparing and flavouring sauces that accompany food plates.
In particular, a proper demi glace, used as a base for many sauces uses a substantial amount of wine in making the sauce. In my restaurant the demi glace was reduced at least four times from the original ingredients. The auditor had an extremely hard time understanding this and kept picturing a main course swimming in wine, based on the wine used in cooking divided by the meals served. Eventually, we were able to prove the amount of wine used, by documenting the number of batches of demi glace prepared during the year. It was a lot of work to document after the fact. After that, we documented all recipes that used wine and the batches prepared in a log. This will provide strong evidence to support the amount of alcohol used in cooking recipes. Ideally, the manager and the chef should initial each transfer of alcohol to the kitchen.
Customer Comps
In the absence of documented proof of complimentary drinks provided to customers, the auditor will consider this part of the shrinkage allowance. Consequently, it is important to maintain details of all complimentary drinks. Most POS systems will allow you to do this, most often by voiding the amount for the complimentary item. While this may be accepted by the auditor, more credible evidence can be obtained by maintaining an ongoing ledger of all customer comps, supported by sales chits describing the reason for the comp, customer name, description of comped item and amount. When documented on a daily basis, this isn’t too much trouble. If you had to go back over four years to try and document your customer comps, it would be a monumental task. Therefore, try to keep track of complimentary drinks every day. As a minimum, make sure that all drinks are rung in and comped on the POS system.
Similarly, when drink orders are made but the customer sends them back (wrong order, changed mind, etc…), we usually void the order on the POS. Care should be taken to distinguish between voids that were made (representing a loss) and those that were not made (keying mistake that was caught). Alcoholic beverage voids that were made but not served should be documented to prove the amount to the auditor.
Summary
In this post, I have tried to describe the key assumptions that are made by sales (and income) tax auditors when auditing restaurants and bars. Each establishment has its own unique aspects, which may involve other assumptions in addition to those detailed above. It is important to understand the assumptions that are made and the documentary evidence that may be used to ensure more accurate, truthful assumptions are used by the auditor. Not only will this save you a considerable amount of money, it may save your business.
Posted in GST, Income taxes, PST, Sales Tax, Taxes | Tagged Audits, CRA, Customer comps, Liquor, over-pouring, PST, Sales Tax, spillage, theft | 1 Comment »
If you have been following the posts on this site (and several others on the internet), you know that your restaurant or bar business faces a serious risk when it is audited by CRA or the provincial auditors. In most cases, your licenced business will be audited, it is just a matter of when.
As a restaurateur that will be subject to an audit, you have a number of choices concerning how you will respond:
- Wait until the audit is complete and file an objection (appeal)
- Attempt to refute the auditor’s assumptions during the audit, in hopes of minimizing or eliminating the additional taxes
- Provide credible, accurate information at the beginning of the audit that will “force” the auditor to develop assumptions that will support the sales previously reported
The first two options will have varying degrees of success, depending on the accuracy, consistency and credibility of the information you are able to obtain to support your filing position. These will also be the most expensive options – by far. In the first case, once the audit is complete, the onus of proof is on you to prove that the auditor has used factually incorrect assumptions and/or has erred in the approach used to determine that there were additional taxes owing. It is not enough to show that different assumptions would lead to a finding of no unreported sales. The reasons why the “true” assumptions are more appropriate must be supported with factual evidence. When you are trying to obtain this type of evidence, in many cases years after the fact, it may be impossible to disprove the auditor’s assumptions. Even where you are able to obtain this evidence, it will be a very costly venture.
In the second option, you have an opportunity during the audit to change the auditor’s assumptions, before the findings are finalized. In this case, you will be trying to refute the assumptions that the auditor made based on your comments during the initial interview and the documents you provided to the auditor at the beginning of the audit. This information and the assumptions made by the auditor become the “facts” that will determine whether there were any unreported sales. You have a much better chance of refuting the auditor’s assumptions during the audit than you have once the audit is finalized. However, you must still provide evidence why the auditor’s assumptions are incorrect for your particular restaurant or bar. If necessary, you may ask for a review by the auditor’s supervisor. In order for this approach to be successful, you will undoubtedly require a consultant that is experienced in these types of audits. This can be a very expensive option, too, because all of the information gathering and analyses that would be required to appeal an unfair assessment will have to be done prior to the end of the audit. This will give you about 30 days to perform all of this work, which may not be long enough to do it properly.
The Best Option
It should be clear by now that the only way to effectively protect your business from an unfair reassessment of sales and income taxes is to be proactive. Ideally, you want to be prepared for the day the auditor walks into your restaurant. You need to know exactly which assumptions the auditor will be making and the numerical values that will properly support the sales figures that were previously reported. You will need to know the reasons why your actual margins differed from the theoretical margins, for the entire audit period (usually four years). Effectively, you need to audit your own business before the auditor arrives. Ideally, you should be doing this continuously.
You can do most of this preparation yourself. You may wish to retain an accountant or consultant to help set up internal controls over inventories, purchases, sales and receipts. Ongoing monitoring and analysis of the controls can usually be performed by the restaurateur, at little or no cost other than your time. It may be advisable to have the restaurant’s independent accountant monitor the controls and help document the margin variances on a quarterly basis. The results of this work will provide the restaurateur with the answers to the questions that the auditor will ask at the initial interview. Most importantly, the restaurateur will be able to support these statements with evidence in the form of analyses done prior to the audit taking place. To the extent that an external consultant or accountant is involved in the analyses, the information should be considered more credible than uncorroborated internal reports. The onus will be placed on the auditor to find evidence that your statements are untrue, in order to make an audit finding of unreported sales.
While there is a cost of implementing these internal controls, in almost every case, there should be significant savings that far outweigh the costs. The ongoing savings will be through a reduction of staff theft and improved margins. There will be a major bonus when the business is audited and there is a finding of no unreported sales.
Your business will be audited in the future. While you do have options, in terms of favourable outcomes, you really don’t. You must be proactive to protect your restaurant or bar from an unfair (and very expensive) audit. The relatively low cost of controlling your costs and monitoring margin variances will be more than offset by an increase in profitability and a substantially reduced risk of an adverse audit finding.
Posted in Canada Revenue Agency, GST, HST, Ministry of Revenue, PST, Sales Tax, Taxes | Tagged appeals, Audits, CRA, GST, Objections, PST, RST, Sales Tax | Leave a Comment »
This post concerns customer comps or promotional drinks served by restaurants and bars. The issue is: how much is too much?
Most restaurants and bars offer promotional drinks to their customers from time to time. Sometimes it is to acknowledge frequent visits, high spending or special occasions. Other times it may be to “compensate” a customer for a service or quality issue. In either case, the customer receives a free (complimentary) drink. All restaurateurs know that this is an effective method of promoting and growing a restaurant business. However, if you don’t keep track of these types of promotions properly, customer comps could be your downfall.
Many small or independent restaurants and bars have very lax policies and procedures around their customer comps. Examples include giving regular bar customers better pours than those given to occasional customers or simply giving free drinks without recording them. If you were asked to prove the amount of liquor, wine and beer that you gave away to customers, during the last four years, could you? Most cannot. Both the Ministry of Revenue and Canada Revenue Agency auditors know that you can’t prove most of these promotional amounts. Consequently, they make allowances for spillage, customer comps and over-pouring. They rarely allow you enough, however.
For example, in a court appeal case [Gestion Cheers Inc. v. The Queen, 2001 CanLII 524 (T.C.C.)], the CRA auditor had allowed the restaurant a 10% allowance for spillage and promotional giveaways, based upon the average amount for these items in similar establishments. The Appellant (Gestion Cheers Inc.) claimed that it should have been 30% of sales. The auditor reassessed the restaurant for the GST on $770,565 of unreported sales over the period from June 1, 1991 to January 31, 1995, about 3-1/2 years. Despite the facts that there were no discrepancies between the cash register receipts and the bank records and the restaurant used an anti-theft pouring system for its alcohol, the auditor reassessed the restaurant, because he felt the spillage and promotional amount was excessive. Here’s what happened at court.
In all tax appeals, the onus of proof is on the taxpayer to refute the assumptions of the Minister (made by the auditor). If the taxpayer can present a prima facie case that the Minister’s assumptions are incorrect, the onus shifts back to the Minister to prove the assumptions made on a balance of probabilities. In this case, even though the taxpayer’s testimony was not corroborated, it was well presented and not contradictory. The restaurateur presented a promotional book, which was a ledger made up from chits that documented all of the promotional giveaways during the audit period. The judge found that the taxpayer’s records and testimony were credible and that they disproved the auditor’s assumption of a 10% promotional allowance. Consequently, the onus shifted onto the Minister to show that the restaurateur and his staff conspired to falsify the promotional chits and books of records. Since the auditor had not spoken with any of the employees or managers during the audit, the Minister was unable to meet this onus of proof and the taxpayer was successful in the appeal.
There are a few lessons to be learned from this case example. It is not the amount or percentage that is important. It is whether you can prove the amount in court, if necessary. In the absence of any reasonable support by the taxpayer, the auditor will rely on a rule of thumb, based upon the average percentage in other “similar” establishments. An auditor is not particularly qualified to understand the differences in sales, promotional activities or other operational aspects of the many types of bars and restaurants in the industry. Auditors are equally unqualified to determine which establishments are “similar”. Consequently, they rely on broad industry categories, such as “Fine Dining”, “Sports Bars”, etc… Within these broad categories, there are significant variations in most of the restaurant business metrics. Consequently, estimates based on these broad industry statistics can be quite misleading, and they frequently are. However, if the restaurant is unable to credibly support its promotional (spillage or theft, too) expenses, the auditor’s rule of thumb will be accepted by the court.
The taxpayer maintained a promotional book, which was a ledger of all promotional giveaways. This was an ongoing log of all promotional chits, as they occurred. This was not a document prepared after the fact, to try to explain why the restaurant’s promotional discounts should be higher. This gave it substantially more credibility when it was needed to support the actual promotional activities. It is not enough to simply record the sales transactions that occurred, you must also maintain documentation of the “non-sales” that occurred.
Bottom Line: If you are going to give away alcoholic drinks to your customers, make sure that you document all transactions. Most computerized POS systems will allow you to maintain a detailed breakdown of all comps, discounts and voids. Ideally, you should consider maintaining a log of the details about each promo amount (who and reason). This can easily be maintained in an Excel spreadsheet supported by printed POS chits for the comps.
Posted in Canada Revenue Agency, GST, HST, Sales Tax, Taxes | Tagged allowances, appeals, Audits, CRA, Customer comps, GST, Liquor, over-pouring, Sales Tax, spillage | Leave a Comment »
In a National Post article last December, CRA warns business owners on Tax Cheating Software, it disclosed that the CRA has dedicated 5,000 employees to the task of finding unreported income and ensuring that sales taxes are remitted properly, “even when sales records are missing.” This is a thinly disguised warning to restaurants (and other cash businesses) that CRA is about to descend on your business, using indirect audit methods to identify unreported income and the sales taxes that should have been remitted. The reference to tax cheating software refers to sales suppression software, also known as “zappers”.
As discussed in my earlier blog entries, typically, CRA audits between two and four tax years’ worth of taxpayer records. They will request that the taxpayer provide a substantial list of accounting records and reports related to the audit period. In almost every case, the taxpayer will be unable to completely satisfy the auditor’s request. This provides the auditor for some basis to suspect that the taxpayer’s records may not completely and accurately record the true sales and sales taxes collected during the period under review. Accordingly, the auditor will seek to determine the sales (and taxes thereon) that were likely to have been generated, based on the purchases of goods for resale (typically limited to alcoholic beverages). This is an indirect method of verifying sales. In most cases, the method used will be the Mark-up Method just described.
Apart from providing the auditor with a complete set of books and records (very few, if any, restaurants are able to do so), which would prevent the auditor from using an indirect method to verify sales, the restaurant owner must be prepared to provide a meticulous analysis of the reasons that margins on alcoholic categories deviated from the expected margins. To be credible, the documentation and explanations for these variances must be made as close to the time they occurred as possible. You will need to prove that your contentions and explanations are reasonable. In most cases, it will be difficult to prove the reasons for your mark-up variances, unless you kept appropriate records, logs and analyses all along. In many cases, it will be impossible to prove your case. You do not want to find yourself in this position.
In the near future, I will be writing about some of the most important methods of documenting your business operations and results, so that you will be able to fully support the accuracy of your tax filings and provide plausible explanations to the auditor when he or she arrives to audit your restaurant. In effect, I will show you how to “audit proof” your restaurant.
Posted in Canada Revenue Agency, GST, Income taxes | Tagged Audits, GST, tax evasion, zappers | Leave a Comment »
According to the Revenu Quebec website, there were approximately 17,600 restaurants selling $9.5 billion of food and alcoholic beverages in 2007. As in most other provinces, the restaurant industry is a significant and vital sector of the economy. While the industry may not be particularly profitable, it does play a significant role in the collection of retail sales taxes on behalf of the federal and provincial governments. Rather than be appreciative of the taxes that are collected and remitted by the restaurant industry, Revenu Quebec (along with all of the other tax authorities in Canada, the US, and the OECD countries) believe that tax evasion in the restaurant industry is widespread. Studies in the US indicate that as many as half of all restaurants fail to report all sales revenue.
For the 2007-2008 tax year, Revenu Quebec estimates that it lost $417 million in uncollected taxes in the restaurant industry alone. Of this amount, about $133 million related to Quebec sales tax and $84 million related to unremitted GST. When it is considered that these are annual losses in tax revenues, it is no wonder that they have targeted the restaurant industry for additional audits.
As you go through the Revenu Quebec website relating to restaurant tax evasion, you will notice that it focuses almost entirely on the use of zappers. These are software programs that delete specific transactions in the POS system (i.e. cash sales) and renumber the remaining sales transactions for the day. This leaves the POS with a continuous transaction sequence, which looks normal under examination. It also allows the owner of the restaurant to pocket the cash from the deleted transactions. I first learned about zappers in the late 1990s, but I have never considered their use to be “widespread”. There have been very few cases of restaurateurs being caught using zappers, but when they are, they are treated harshly! Quite frankly, I believe this is a cover story to paint restaurateurs as tax cheats and justify targeting their operations for intensified audit and investigation efforts.
In addition to increased audits of restaurant operators, plans are underway that will require restaurant operators to install a Sales Recording Module (SRM) that records every sales invoice as it is generated and makes this information available to Revenu Quebec auditors during an audit. The primary purpose of this is to prevent the use of zappers that delete invoices after they have been issued to the customer.
I find this to be a very curious method of monitoring tax compliance by Revenu Quebec. To my knowledge, no other jurisdiction uses this method. The use of a SRM will, inadvertently, create a major problem for Revenu Quebec. This device will provide the restaurant with proof (or at least a very strong indication) that every sales invoice had been recorded, without exception. So long as the operator ensures that every sales invoice in the POS system matches one in the SRM, and all receipts are accounted for, it will be extremely difficult for an auditor to make a determination that the restaurant’s books and records are likely to contain errors or omissions with respect to the recording of taxable transactions. As it stands in most jurisdictions right now, the auditor must be able to “show” that the taxpayer’s records are likely to contain irregularities or omissions, before proceeding to carry out an indirect method of verifying sales.
In practice, almost every restaurant is found to have “inadequate” records for tax purposes. Once Quebec begins to use the SRM, it will be highly questionable whether there could be any reasonable cause to believe that the taxpayer had been under-reporting sales. With that piece of the puzzle missing, the auditor would not be able to resort to an indirect method of sales verification. At least for Quebec restaurants, this will provide an additional reason to appeal an unfair reassessment based upon the mark-up method.
It will be interesting to see whether Quebec actually follows through on their plans to implement the Sales Recording Module in restaurants. They may come to their senses and realize that their existing use of the indirect method of auditing restaurant sales results in substantially more tax revenues generated (not to mention the penalties and interest)! If they do proceed as planned, it may cost Quebec restaurants a bit more to install the SRM, but it will provide a healthy return in the form of fewer sales tax reassessments!
Posted in GST, Ministry of Revenue, PST, Taxes | Tagged Audits, GST, PST, Revenu Quebec, tax evasion, zappers | 1 Comment »
I’m going to describe a real case study and let you decide if the title of today’s blog is true. This situation occurred several years ago at a client’s restaurant in Ontario.
My client operated a small, reasonably successful, restaurant in a fashionable downtown neighbourhood. She was the head chef, general manager and office administrator. She did everything but wait on tables. I found her to be scrupulously honest in every respect. One day she received notice that her restaurant had been selected for a retail sales tax audit. She wasn’t concerned, at all. In fact, she relished the opportunity to show the auditor her impeccably accurate and organized accounting records. She knew that she had always collected and remitted the correct tax from all of her sales transactions. She recorded every single sales transaction, even the few that were settled with cash. In short, she thought it would be an impossibility that the auditor could reassess her business for any unpaid taxes. She was about to experience the the impossible!
The audit took about three days to complete, resulting in a proposed reassessment of about $7,000 (including penalties and interest) for the two-year period covered in the audit. My client was speechless! I was brought in to review the auditor’s working papers supporting the proposed reassessment.
I recreated the entire set of schedules in Excel worksheets, in order to examine the impact of small changes in the assumptions that the auditor used to identify the “unreported sales”. I spent hours with my client identifying all of the factors that contributed to reduced margins on her alcoholic beverage sales, in order to support her position as being more reasonable than the auditor’s contention that she purposely failed to report all of her restaurant’s sales. We determined that some of the alcohol and wine purchased for the restaurant was actually used in making sauces. We could estimate a reasonable amount of customer comps during each year. We could estimate the average amount of over-pouring of wine and alcohol. By making reasonable estimates for each of these factors, we were able to show that the reported sales of alcoholic beverages was, in fact, quite accurate. Was the auditor convinced?
No. To each of our claims, the auditor’s response was “you can’t prove that”. It didn’t seem to matter that the auditor could not “prove” the assumptions on which the reassessments were based. My client was outraged by the reassessments. I filed an objection to the reassessments, expecting the appeals officer to be reasonable in considering all of the factors that contributed to lower alcohol margins, rather than assuming there were unreported sales. I expected that the appeals officer would realize that the taxpayer’s position was reasonable, shifting the onus of proof back to the auditor. I was convinced that no reasonable person would find the auditor’s position to have been proven.
This time, I was outraged by the response from the appeals officer. Knowing that our only remaining alternative was to go to court to appeal the reassessments, the appeals officer confirmed the auditor’s reassessments. As the cost of going to court to appeal the reassessments would have been more than the amount of tax and penalties assessed, the case ended here. My client was forced to pay the $7,000 in order to maintain her liquor licence.
Is this a case of legalized extortion?
Posted in Ministry of Finance, PST, Taxes | Tagged appeals, Audits, Objections, PST | Leave a Comment »
As restaurateurs, we are all well aware of the high incidence of theft by our employees. Proper supervision and other internal controls can help minimize theft. As prudent businesspeople, we try to balance the cost of detecting and preventing theft against the cost of the items taken from the restaurant. Usually, we only consider the actual cost of the item that is being stolen. If a bottle of wine that costs us $20 goes missing, we consider our cost of the theft to be $20. Sound about right?
Unfortunately, your true cost of theft is substantially higher than the cost of the items that go missing! If you don’t believe me, please read on. You are about to be shocked and angered, I hope.
Virtually anything in a restaurant can be stolen. Cash, pop, food, alcohol and even supplies and toilet paper! But the most frequently stolen items also happen to be the most important and the costliest of all things to take from us. Of course, I’m referring to alcoholic beverages – liquor, wine and beer. Why should the theft of alcohol be any costlier than the equivalent amount of beef tenderloin, foie gras or extra virgin olive oil?
The theft of alcoholic beverages will cost you significantly more than the theft of the same dollar amount of food or supplies, because when you are eventually audited, unless you can “prove” the amount of alcohol that was stolen, the auditor will assume that you sold it and pocketed the cash. The auditor will reassess your business for the sales tax (and possibly income taxes) on the unreported sales, along with penalties and interest. The auditor may also consider that you, as the owner/manager or as a shareholder, received a benefit from the company equal to the amount of unreported income. Now, you will have a significant personal tax liability and the company will not have received a deduction for the benefit charged to you.
While every situation is different, that $20 bottle of wine that disappeared could end up costing you another $40 in taxes, penalties and interest. Don’t forget that you already lost $20 when the wine went missing!
Even if you think you have staff theft under control, think again. There are many ways to steal alcohol from a restaurant. Staff can overpour drinks to receive higher tips, customer comps may not be rung in, to avoid getting approval from management, servers may fail to ring in drinks, and of course, bottles do end up in knapsacks and walk out the door!
When it comes to an audit, it doesn’t matter how the shortage in alcohol arose, the shortage will give rise to a significant tax liability to the restaurant. Now, more than ever before, you must be vigilant in preventing as much theft of alcohol as possible, and when it does happen, formally document and “prove” the amount of the loss, each and every time you become aware of the losses.
Posted in Taxes | Tagged Audits, theft | Leave a Comment »
I’m often asked by my clients and fellow restaurateurs how the tax auditors arrive at their reassessments for unreported sales.
It is a pretty simple approach, though the calculations will boggle the minds of those who don’t know how to use Excel! In a nutshell, the approach is the same, regardless of whether it is an audit for PST, GST or income taxes.
- The auditor obtains a report of all known purchases from the LCBO and Brewer’s Retail. I’m using Ontario as an example, but each province will have similar procedures in place. With a bit of analysis, the auditor will be able to calculate a fairly accurate breakdown of the cost of sales (and the volume) for each major category of alcoholic beverage that the restaurant sold. Typical categories include: domestic, imported and draft beer, domestic and imported wine, and alcohol. Using these figures, the auditor is able to estimate the average cost of sale per serving for each type of alcoholic beverage sold by the establishment.
- Now the auditor requests copies of the restaurant’s alcoholic beverage and wine menus that were in effect during the period under audit. This allows the auditor to estimate average drink prices for each beverage category, for each year.
- Standard drink portions are determined from the menus, with input from the owner/manager during the initial interview.
- The auditor applies a standard theft/waste/shrinkage/spoilage allowance to each category of alcohol, to arrive at figures that represent what the auditor believes your true cost of sales per serving were likely to have been during the audit period.
- Now, it is a quick calculation to take the cost of sales in each category and project the total amount of sales that should have been realized by the establishment for each catgegory.
- The projected sales for each category is totalled and compared with the restaurant’s reported sales. Any excess of projected sales over reported sales is considered to be unreported sales of the establishment.
- In Ontario, the restaurant will be charged a 10% sales tax on the unreported sales, plus penalties and interest from the date when the sales were under-reported.
- Oddly, Ontario does NOT usually consider the unreported sales as additional taxable income of the restaurant (though there is no reason why they couldn’t)!
- The CRA will apply the same approach and charge 5% for the GST under-reported.
- The CRA will also consider the unreported sales as an increase in the taxable income of the restaurant, again, subject to penalties and interest.
- When the CRA reassesses the taxpayer for income taxes on unreported sales, Ontario will issue a reassessment for Ontario income taxes.
- Finally, and this is the scariest of them all, when a company is reassessed for unreported income, CRA may also attempt to reassess the individual officer or shareholder of the company with a benefit equal to the amount of the unreported sales. This can have extremely unfavourable tax consequences, as the individual is taxed on the unreported sales, the company does not get a deduction for this, and the company is taxed on the full amount of the unreported sales. In short, double taxation, combined with huge penalties and interest.
If these audit tactics don’t scare you, I don’t know what will. In future blog entries, I will address some of the more important areas of your restaurant operations that require attention, in order to avoid having a tax auditor present you with an unjustified tax bill.
Posted in GST, Income taxes, PST, Taxes | Tagged Audits, GST, Income tax, PST, RST | 1 Comment »
You will find out about your upcoming audit, when you receive an officious telephone call from the auditor assigned to your establishment. He or she will try to schedule a start date for the audit within the next couple of weeks. They don’t like to give you too much time to get ready for their arrival, but they have some scheduling flexibility. It all happens very quickly (in the space of a minute or so). Even seasoned tax professionals begin to sweat!
Proceed with Caution
Rather than panick, explain to the auditor that your accountant and/or tax advisor will be assisting you during the audit process and that you will need to contact him or her to arrange a mutually convenient time for the audit. This will provide you and your advisors time to assess the potential risks, estimate the time necessary to assemble the required documents for the audit, and amass sufficient support for the previously filed tax positions. Agree to contact the auditor within the next few days to arrange an appropriate time for the audit.
Typically, auditors will start the audit with a tour of the entire restaurant. From a business perspective, it is extremely important that the auditor not undertake the tour while customers are present. Ideally, it is wise to avoid tours when staff are present, too. Most auditors will agree to take the tour early in the morning before any staff or customers are likely to be present.
Ideally, you would like the auditor to work away from the restaurant, so that his or her presence will not disrupt normal operations. Also, you do not want the auditor to have unsupervised access to your employees. The auditor may request interviews with some employees, but you must be able to observe the interview and correct any misstatements that the employee may make. It is best to have the auditor work at your accountant’s office, if at all possible.
The Letter
The auditor will send you a letter confirming the agreed upon audit start date and providing you with a list of documents that will be required by the auditor upon arrival. This will be a formidable list of documents, including all bank statements, cancelled cheques, deposit slips, purchase invoices, several months’ daily sales totals, and copies of all tax returns, financial statements, general ledger of accounts and a variety of other documents, covering an audit period that may be as long as four years. Unless your recordkeeping is fairly organized, this will be a significant task just to pull all of the requested documents together, let alone review them!
Preparing for the Audit
Subsequent blog entries will cover this topic in much greater detail, but for now, I want to emphasize the importance of being ready for the auditor’s initial interview of the taxpayer. After the tour of the premises, the auditor will interview the taxpayer to gain an understanding of the type of operation being audited and a variety of key metrics that the owner claims for the business. These comments will become the almost irrefutable support for the auditor’s assumptions that will be used to support the reassessment. Consequently, it is crucial that the taxpayer responses to the auditor’s questions be truthful and accurate, yet completely supportive of the taxpayer’s previously reported sales throughout the audit period.
Determining the appropriate responses to the auditor’s questions can be an extremely time consuming process involving a tremendous amount of analysis covering the entire period of the audit. The best analyses are performed on an ongoing basis, as the sales data is being generated. It is far more accurate and credible than analyses prepared long after the fact. Even subsequent analyses may be useful, but they will never be as persuasive as ongoing analyses. Advice to you: start analysing your sales every month, in order to be able to discuss and support your actual margins achieved and reasons that they may differ from the theoretical margins. Document every possible reason why the margins fall below the theoretical margins, for all types of alcoholic beverages.
Ideally, have an experienced accountant assist you in determining the proper ongoing analyses to perform and the daily data that will be required to support your sales, margins and taxes collected. This approach is, by far, the most cost effective method of protecting your business from adverse tax reassessments. If you have to generate supporting analyses just prior to the audit (or in response to the auditor’s report), they will be less credible than ones that would have been available from your ongoing analyses. They will also likely be far more expensive to prepare!
The only truly cost effective method of preventing significant sales tax reassessments is to proactively perform the same analyses that the tax auditor will be preparing during the audit. This will provide you with the appropriate assumptions that will support the previously reported sales figures. Also, you will need to be able to support the assumptions with credible analyses, data and historical reports.
Just as it is not advisable to provide the tax auditor with unfettered access to your employees, it is equally unwise to give the auditor free access to the owner of the restaurant. Obviously, as the owner/manager, you can’t not talk to the auditor during the course of the audit, but you should have your accountant or tax advisor monitoring your interactions with the auditor. There are several reasons why this is exceptionally good advice.
- Your advisor should be able to quickly assess your comments to the auditor and provide additional information to clarify your comments, so that there are no misunderstandings.
- The advisor should be able to correct your comments, should you make a statement that is harmful to your reported tax position or not in accordance with your tax situation.
- Your advisor can help you limit your responses to the scope of the queries raised by the auditor. You are required to provide truthful responses to the exact questions asked – nothing more, nothing less.
Posted in Canada Revenue Agency, Ministry of Finance | Tagged Audits | Leave a Comment »
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