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David Rotfleisch on the Investigation of Unreported Cash Sales: The Powers of the Israeli Tax Authority, the Falafel Industry of Israel, and the CRA

posted 11 months ago

Introduction: The Conduct of Wide-Reaching Audits of Falafel Vendors by the Israeli Government for Suspected Unreported Cash Sales

The Israeli Tax Authority is at the onset of raising red flags for non-compliance issues in relation to the Israeli falafel industry and Israel’s tax laws. The falafel is a staple of Middle Eastern cuisine and is especially well-liked there. Falafel is one of Israel’s most popular and easily available street foods and is regarded to be Israel’s national dish. The Israeli falafel industry is also driven by low-cost, high-volume transactions to individual customers, much like the majority of the food service sector globally. Cash is frequently used in these transactions. Similar to how food vendors in Canada are required to collect and pay GST/HST on sales, vendors are in charge of collecting value-added tax (“VAT”) on falafel sales. Because transactions are not documented by a third-party institution like a bank, high-volume cash transactions for any business raise problems with unreported sales.

Through regulating the use of cash in transactions, the Israeli government has made significant efforts in recent years to combat tax evasion, money laundering, and terrorist financing. The amount of cash that can be paid or received as part of any transaction in Israel is limited to ILS 11,000 by the Minimizing Use of Cash Bill, 5778-2018, which took effect in 2019. As of August 1, 2022, that ceiling has been lowered to ILS 6,000, or roughly CAD $2,300, and future reductions are projected. The Israeli Tax Authority has become more aggressive in its audits of cash-based businesses as a result of its unilateral effort toward encouraging electronic payment methods and suppressing the usage of “black money” as a component of Israel’s underground economy.

The Israeli Tax Authority audited thousands of falafel vendors in December 2022 as part of a broad probe into possible tax evasion in the Israeli falafel business. Following that probe, the 1,661 falafel businesses were able to pay back roughly ILS 120 million in unreported taxes to the Israeli tax authorities. The conduct of the Israeli Tax Authority and Israel Police tells quite a bit about the kinds of powers that tax authorities have to investigate tax evasion and suspected unreported cash sales, even if the focus of that investigation was clearly Israeli. In this article, we’ll briefly go through some of the journalistic commentaries on that probe as well as the parallel authority the Canada Revenue Agency (the “CRA”) has in Canada to audit and look into Canadian taxpayers for possible Canadian tax law violations.

Investigative Power of the CRA for Canadian Taxpayers’ Audits

Police physically searched establishments as part of the Israeli Tax Authority’s investigation into falafel vendors’ unreported cash sales in order to examine their books and records and determine whether those vendors had failed to appropriately record their daily cash sales.

The Israeli Tax Authority is not the only organization with the authority to enter a place of business without notice and check books and records. Similar authority exists for the CRA to look into the tax affairs of Canadian taxpayers. CRA tax auditors or special investigators chosen by the CRA to look into suspected tax evasion cases may use those powers. Due to Canada’s self-reporting tax system, which necessitates that the CRA have powers and authority to verify that the self-assessments made by Canadian taxpayers are in compliance with Canadian tax laws, the CRA is granted certain powers. In the context of a CRA tax audit, powers are undeniable; but, problems might arise when the CRA’s inquiry shifts toward criminal or quasi-criminal matters.

In order to review a taxpayer’s books and records, CRA auditors and investigators have the power to enter that taxpayer’s place of business without a warrant under Section 231.1 of the Canadian Income Tax Act. This tax audit power also includes inspecting a taxpayer’s inventory and property to see whether the taxpayer’s books and records are accurate. Although the requirements to get a warrant for an administrative purpose are incredibly lax, a warrant will still be needed when an auditor or inspector wants to examine a taxpayer’s house for books and records. In cases when the CRA lacks sufficient justification to seek a search warrant, a judge of the Tax Court of Canada may also order a taxpayer to permit reasonable access to books and records stored in that residence.

The Canadian Income Tax Act‘s section 231.2 also gives CRA auditors and investigators the authority to compel anyone to disclose any documents or information that are needed for a tax investigation. The CRA may use this extraordinarily broad power to require the production of documents by third parties, such as banks, in order to conduct an investigation into a taxpayer. According to Section 231.3, the CRA has the authority to obtain a search warrant to seize any records or documents that are not voluntarily submitted by a taxpayer or third party or that may be useful in a tax investigation. Section 231.4 gives the CRA additional authority to establish an investigation under the supervision of a hearing coordinator appointed by the Tax Court of Canada. The investigation has the power to compel witnesses to give testimony about a taxpayer while under oath. The penalties for non-compliance are severe, and anyone found guilty of violating any of the aforementioned rules may be sentenced to a fine of up to $25,000 or to up to 12 months in prison after being found guilty on a summary conviction.

The Department of Justice is tasked with prosecuting the taxpayer under the Canadian Criminal Code in cases where the CRA discovers evidence during an inquiry that supports filing criminal charges against the taxpayer. The wide-ranging authority granted to the CRA to look into a taxpayer’s tax affairs appears to run smack against the many common law and constitutional safeguards protecting Canadians from government intrusion, but these disputes are rarely resolved in the taxpayer’s favour. Every person has the right to be safeguarded against unreasonable searches and seizures by the state under Section 8 of the Canadian Charter. Additionally, the Canadian Charter’s Section 7 guarantees the constitutionally protected right against self-incrimination. In Canada, it is a settled law that an accused has the right to remain silent in the face of a criminal investigation.

The Canadian Income Tax Act does not permit the CRA to use its investigative powers for a civil tax audit in a criminal tax investigation. However, once a criminal or quasi-criminal tax matter becomes the primary focus of the CRA’s inquiry, those Charter rights will be applied. Additionally, there is no immunity from the tax auditors of the CRA sharing information with criminal tax investigators that were collected as part of a civil tax audit. The burden of proving that the CRA’s primary objective in gathering information was for use in a criminal investigation as opposed to a tax audit shifts to the taxpayer, who now faces a significant challenge. When an investigation may result in criminal liability, the CRA is normally required to inform the taxpayer who is the subject of the investigation of the right to remain silent.

The CRA’s Techniques for Indirectly Verifying Compliance with Canadian Tax Laws

Where agents of the Israeli Tax Authority discovered suspicious business practices or gaps in reported income and cash retained on-premises, the Israeli Audit and Assessment Department started additional investigations to reassess such businesses for undeclared VAT. While we do not know what the conclusions of those reassessments were or how they were done, the CRA has never considered the inability to keep proper books and records as a barrier to assessing or reassessing Canadian taxpayers. In reality, the CRA has broad authority to conduct investigations and make assumptions about a Canadian taxpayer’s income and tax liabilities, with or without supporting documentation. The Canadian Revenue Agency (CRA) is not bound to use the information supplied by a taxpayer when issuing an assessment or reassessment of that taxpayer’s income under subsection 152(7) of the Canadian Income Tax Act. When assessing a taxpayer, the CRA is allowed to use information from sources other than the taxpayer’s books and records, including its own assumptions and information from external and third-party sources.

Various indirect verification of income (IVI) methods have been devised by the CRA to evaluate a Canadian taxpayer in cases when books and records are either erroneous or nonexistent. The CRA may analyze bank deposits in addition to having the authority to demand documents from third parties. In order to determine whether the inflow and outflow from such accounts, a bank deposit analysis entails review of third-party records like bank statements and credit card statements provided by the taxpayer’s respective bank. The CRA may use a withdrawal analysis to identify the origins of those inflows and outflows and to assess the statements’ accuracy in displaying the taxpayer’s numerous sources of income and expenses. The CRA may do a net worth analysis to determine a taxpayer’s unreported income where there is a significant disparity between his or her financial affairs and spending patterns and stated income. Any growth in wealth over that time period that cannot be explained by the income the taxpayer declared will be deemed to be unreported income by the CRA under the net worth tax audit methodology.

The net worth audit methodology, which has been approved by Canadian courts as a method of “last resort” to audit a taxpayer when no other approach can satisfy the CRA’s mandate, is a particularly brutal and imprecise tax method of measuring a taxpayer’s income. According to subsection 152(8) of the Canadian Income Tax Act, once the CRA assesses or reassesses a taxpayer, the assessment is final until successfully varied or vacated on the taxpayer’s objection. Due to the methodology’s bluntness, contesting a net worth tax assessment can be a very time-consuming and expensive process. Normally, a taxpayer is left to contest the CRA’s assumptions and computations line-by-line and item-by-item and to examine his or her own assets and liabilities during the tax audit period in order to disprove the CRA’s assumptions. The CRA should never take lightly the decision to employ the net worth audit approach.

The CRA occasionally is unable to immediately examine any records in order to confirm a taxpayer’s alleged underreported income. It may be the case that a taxpayer’s undeposited income cannot be quantified through a net worth analysis or bank deposit analysis since the income was never deposited into a bank account. The CRA may employ the audit method of assessing projections in such circumstances. With regard to inventory turnover and the cost of goods sold for the taxpayer’s business, the CRA will review industry averages, business trends, and other data acquired during the taxpayer’s audit under the assessing projections tax audit approach. The CRA will next compare what the taxpayer reported as income and what the CRA subtracted in order to determine how much the taxpayer actually earned during that time period based on its own forecasts. Unreported income will be considered to be the difference between the taxpayer’s reported income and the CRA’s projections.

Tax Pro Tips – At-Risk Industries for Voluntary Disclosures and the Solicitor-Client Privilege

In accordance with section 231.7(1)(b) of the Canadian Income Tax Act, there is one significant exception to the CRA’s authority to look into a taxpayer’s tax affairs. To be more precise, a taxpayer cannot be forced to disclose information that is shielded by the solicitor-client privilege. In accordance with common law, communication is protected by the solicitor-client privilege if all three of the following conditions are met:

  1. Communication takes place between the client and the lawyer;
  2. The communication is made to the lawyer in confidence; and,
  3. The communication is made while providing legal advice.

The solicitor-client privilege does not just apply to legal advice; it also covers instructions and advice for what a client should do practically when receiving legal advice. As the solicitor-client privilege is only available to lawyers, Canadian taxpayers seeking advice from tax accountants will not be protected in any way from the disclosure of their communications. However, where a lawyer has hired an accountant to assist in providing tax advice to a specific client, the solicitor-client privilege may be extended to that individual. Before any accountant starts working for a specific client, this relationship must be established.

When running a cash-based business, it is crucial to seek legal counsel as soon as any issues with tax non-compliance are discovered. Because the evidence confirming a specific cash transaction will typically be created and maintained by the taxpayer and not by a third party like a bank, the CRA treats cash-based businesses with increased scrutiny during an audit. Engaging a knowledgeable Toronto tax lawyer early on in the process ensures that those efforts and actions to correct compliance issues will be protected by solicitor-client privilege. It is essential for any cash-based business to be proactive in resolving any non-compliance matters rather than waiting for the CRA to begin an audit.

If your business qualifies for relief under the CRA’s Voluntary Disclosures Program (“VDP”), the CRA is required to waive penalties and some interest on back taxes owed, as well as criminal prosecution for noncompliance. However, a voluntary disclosure application is time-sensitive and might be turned down if the CRA has already contacted you or your businesses about the tax non-compliance you want to report. If the CRA were to otherwise look into your tax affairs, hiring a top Canadian tax lawyer to prepare your voluntary disclosure application offers crucial protection for any sensitive documents prepared by your accountant. Our skilled Canadian tax lawyers can help you carefully plan and swiftly prepare your voluntary disclosure application. They have helped many Canadian taxpayers with the CRA’s VDP. You should consult a competent Canadian tax lawyer right away to ensure that your rights are protected in the event that the CRA launches an audit of your tax affairs or otherwise places you at risk for potential tax evasion charges.

FAQs:

What legal authority does the CRA have to require a taxpayer to turn over records or information for an audit?

The CRA has broad authority to require the production of records and evidence. In order to inspect a taxpayer’s books, records, and inventory, CRA tax auditors and investigators are permitted to enter that taxpayer’s place of business without a warrant under subsection 231.1 of the Canadian Income Tax Act. In accordance with subsection 231.2, the CRA may require anyone to provide documents and records as part of a tax audit, including third parties who are not the subject of the audit.

In cases where a person may not cooperate with a CRA investigation, subsection 231.3 gives the CRA the authority to request a warrant to search a place for documents and evidence. A further authority granted by subsection 231.4 allows the CRA to establish an inquiry, under the supervision of the Tax Court of Canada, to question witnesses about the financial affairs of a taxpayer who is the subject of an audit.

Does the CRA have the power to investigate and audit a taxpayer without violating that taxpayer’s constitutional or common law rights?

The CRA’s broad investigative powers do not necessarily violate a taxpayer’s constitutional or common law rights. So long as the CRA uses its investigative powers in the context of a civil audit, the CRA’s ability to compel the production of documents and interview individuals does not violate sections 7 or 8 of the Canadian Charter, or the individual’s right to remain silent. When the primary goal of the CRA’s investigation becomes criminal or quasi-criminal in nature, Charter and common law rights in Ontario may apply.

What methods does the CRA have at its disposal to examine and reassess a taxpayer for unreported cash sales?

The Canadian Revenue Agency (CRA) is not constrained to using the books and records that a taxpayer has kept when preparing a tax assessment under subsection 152(7) of the Canadian Income Tax Act. Given this flexibility, the CRA has created a number of indirect verification of income (IVI) tests for situations where a taxpayer’s books, records, and financial activities don’t match up with what the CRA anticipates about that taxpayer’s business.

Based on the inflows and outflows of cash from bank accounts held by the taxpayer or related parties, the CRA may use a net worth analysis to evaluate the taxpayer’s unreported income. The CRA may also employ the assessing projections audit method to estimate the amount of unreported income that the taxpayer’s business may have earned during a specific reporting period by comparing it to industry averages and trends.

What prerequisites must be met by a communication between a lawyer and a client for the solicitor-client privilege to apply under common law?

The solicitor-client privilege applies under Canadian common law to a specific communication if three conditions are met:

  1. Communication takes place between the client and the lawyer;
  2. The communication is made to the lawyer in confidence; and,
  3. The communication is made while providing legal advice.

Depending on provincial common law, different provinces may have different requirements for the solicitor-client privilege to apply to communication.

Disclaimer:

“This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the articles. If you have specific legal questions, you should seek the advice of a lawyer.”

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