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.