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Key Tips for Preparing a CRA Audit Trail
Before starting to prepare a client’s corporate T2 Return, it is important to assess and analyze the information you have received from the client.
Proper completion of the T2 Return requires the compilation of Schedules 100 (balance sheet) and 125 (income statement), in accordance with the General Index of Financial Information (GIFI). Accordingly, the client should be providing you with a set of financial statements, which includes a balance sheet and an income statement. If these are not provided by the client or their bookkeeper it will, in most circumstances, be necessary to compile such financial statements prior to starting work on the corporate T2 Return.
In assessing and analyzing the client’s information, you will need to:
Moreover, as part of your initial review, you should identify and map the overall corporate structure of your client and determine whether the company in question is part of a group of associated corporations.
Let’s review these issues and highlight their significance in the overall corporate T2 preparation.
Assessing the information you receive from the client is the first step in determining whether you have enough information to complete the T2 Return. For instance, a review of the income statement may indicate that the company is reporting and deducting certain types of expenses. If this is the case, you may require more information to properly determine their treatment for tax purposes. Examples of such expenses may include:
These types of expenses may not be deductible, may only be partially deductible for tax purposes, or there may be special reporting required on the T2 Return. The detail behind these types of expenses will be required.
Note: The CRA has been looking more closely at the reasonableness and basis for management fees paid by a corporation to another taxpayer, including another corporation in the related group. Factors to consider include whether the parties have a signed management agreement, the actual services provided by the other taxpayer in respect of the fees paid, the reasonableness of the amount, and the manner in which such fees are recorded or accrued (accounting entries vs. actual payments). If Management Fees are paid out to a shareholder, a T4 is the preferred method of reporting this income.
It will generally also be necessary to review the corporate balance sheet to determine whether:
Overall, it is advisable to obtain a copy of the client’s general ledger for the fiscal year as the general ledger should provide the “trail” and the detail required for you to assess the nature of the item for tax purposes.
Part of the overall planning in preparing a T2 Return is to identify potentially different sources of corporate income. Not all income is subject to tax at the same rate and, different rules can apply to different sources of income. The main distinctions can be summarized as follows:
In assessing the client’s information, it is very important to understand whether there are any significant transactions which occurred in the taxation year and whether they have been accounted for correctly. Examples of such transactions could include:
A sale of a capital asset will generally result in the realization of a capital gain or loss, which must be reported on Schedule 6 of the T2 Return. However, there may be relevant costs incurred in connection with the disposition and proceeds payable may be deferred or received in part by a vendor take-back (VTB). Similarly, a transaction involving the repurchase or cancellation of shares of the corporation, may result in the payment of a deemed dividend by the corporation (reportable on Schedule 3).
A good approach at the planning stage of the T2 preparation is to simply list the key item(s) and identify the additional information that may be required from the client to properly evaluate and report the transaction for tax purposes.
Many items routinely form part of the annual ordinary business transaction undertaken by a company. These will be completely deductible on the T2 return. The following items, however, have special treatment for tax purposes which will restrict or limit their deductibility on the corporate T2. Any portion of these expenses that are not tax-deductible will be added back into the taxable net income of the corporation on Schedule 1. As previously mentioned, it is therefore important to review the client’s financial information and list items that will affect the calculation of income for corporate tax purposes. While not exhaustive, the following list contains items usual for most corporations:
Shareholder loans require review and reconciliation to determine whether the company owes the shareholders or the shareholders owe the company. When CRA audits or reviews a T2 file, they will generally always “audit” transactions that a shareholder has with the corporation. It is therefore critical to ensure that your files contain a proper reconciliation and continuity worksheet, analyzing the opening balance to the closing balance shown on the financial statements and schedule 100 of the GIFI. Ensure that you review where the shareholders loans fit on your statements, as they can either be a liability or an asset. You must also determine if there are any transactions, such as a transfer of property under section 85, which requires completing Schedule 11.
On Schedule 11, the details of any transactions with shareholders, officers, or employees are recorded that involve:
Ensure you familiarize yourself with the rules surrounding shareholder loans in S15 and ss.80.4(2) of the Income Tax Act.
In the majority of businesses, there will be a credit balance at year end, meaning the company owes the shareholder(s). If, after a review of the client’s information, and the shareholder owes the corporation, you will need to determine how the “debit” balance is to be dealt with. A “debit” balance indicated that a shareholder has drawn out more cash from the corporation than reported as a salary or dividend in that particular year or the preceding year. It is acceptable to declare a bonus or dividend at year-end to cover the amounts advanced throughout the year. However, not that adjustments required because of debit balances in the shareholder loan account will be reflected on the financials statements, not an adjustment on the T2 return itself.
If a bonus is declared and credited to the shareholder account to clear the debit balance, a payroll cheque must be written and source deductions must be withheld and remitted to CRA in the very next remitting period. Otherwise, the remittance will be late and subject to penalty. In some cases a year-end bonus will not be able to clear the debit balance, if the debit is discovered after the time that the source deduction remittance was due. In such a case, the dividend is the viable alternative to clearing the debit balance.
If a dividend is paid out to a shareholder, a T5 slip must be issued in that calendar year.
Part of the overall planning in getting ready to prepare the T2 Return is to assess the potential tax risk inherent in the file. For instance, consider the nature and level of expenses deducted by the company for:
Should the CRA audit your client, these are items which will most likely be examined. For more information on How to Avoid a CRA Audit, click here.
The final and extremely important step of planning and assessing the file is for you to document the basis for making adjustments. This includes justifying the how and why of income reconciliation for financial statement purposes as opposed to amounts reported on Schedule 1 for corporate tax purposes and in identifying key transactions.
Documentation will provide you with the “audit trail” required to substantiate the completion of the T2 Return and to support amounts reviewed by CRA.
Keeping detailed notes on any questions, changes, adjustments, and confirmations completed in the file are what comprise your “audit trail”. Taking the time to document your work and having it available in the event of an audit will make any reviews performed by CRA go smoothly.
The General Index of Financial Information (GIFI for short) is the standardized system that CRA uses to categorize general ledger accounts reported on the T2 corporate tax return.
Because General Ledger account numbers are not standardized, GIFI allows CRA to know immediately what the number represents – for example GIFI code 1060 indicates Accounts Receivable, GIFI code 1125 indicates Work in Progress, etc. It provided a framework that is easy to follow and allows standardization of assets, liabilities, equity, income and expenses. This standardization also allows CRA to compare the level of expense claimed by one company in a classification against another. Consequently it is very important to classify correctly the items from the statements on the GIFI.
You use the GIFI on schedules 100 and 125 to reflect the financial statements of the corporation, with the same level of detail as is used on the financial statements. The reason this is important is in the event of an audit, you need to be able to show HOW you expressed each item listed on the financial statements.
Proper assignment of GIFI codes to the various accounts will simplify the T2 completion process in a computerized environment. T2 tax software will recognize the GIFI code and properly transfer the value to the proper schedule for reporting or adjustment purposes.
For example, GIFI code 8523 represents Meals and Entertainment. Under the ITA (Canada) we know that Meals and Entertainment, while a 100% expense on financial statements, is only a 50% deduction for tax purposes. Coding Meals and Entertainment correctly on S125 will automatically transfer the amount to S1 and calculate the 50% portion that is not deductible thereby adding it back to Net Income to arrive at Taxable Income.
We can help make sense of creating an audit trail for the CRA for your Small Business in White Rock or Surrey, BC. Here at Green Quarter Consulting - Accounting and Bookkeeping Services for Small Businesses in White Rock South Surrey, Langley and Surrey BC, we navigate Small Business Owners with analyzing transactions, sources of income and your tax risks and how they relate to your business strategy.