Pay No Taxes: Can the CRA Know You're Cheating?

I’ve been approached by enough small business owners or entrepreneurs who ask me:

I don’t want to pay any taxes – how do I do this?

Easy, I tell them. Don’t declare anything.

But hold on – they’ll say, that’s cheating isn’t it?

Well, yes – so I’ll ask them in return: Is it that you want to cheat on your taxes or just legitimately minimize the amount you pay?

How does the CRA know you’re cheating?

If you are self-employed in Canada, and genuinely earned income throughout the tax year, you could choose not to declare a single penny on your tax return.

You earned $20,000 on the side by offering private tutoring sessions – no problem, keep it all. You’ll pay the tax on the income you earned in your day job and anything you earn on the side you’ll just keep to yourself.

How is the CRA going to know about your side income?

When it comes to self-employed individuals, the Canadian tax system works on the honour system. The assumption is that you earned whatever you say you earned. Kind of like innocent until proven guilty. As an employee, you don’t have this flexibility. Your employer is required to automatically deduct taxes from your wages throughout the year. On your tax return, based on the information you submit, you’ll see if you paid too little or too much taxes throughout the year which will determine whether you get a tax refund (or return – hence the term ‘tax return’) or have to pay a little extra.

From an employee perspective, the government knows how much you earn.

Assuming your employer files the proper reports, your salary information is all recorded on your T4 information return. If you don’t report that number on your tax return, the government will quickly reassess you and make sure it gets its piece of the pie – plus a little extra for interest and penalties.

But if you’re self-employed, there is no cut and dry way for the government to know how much you earned exactly.

It’s your responsibility to tell them what you made in the year. Let’s assume in your private tutoring business you received $50,000 in tutoring fees. Since you’re not incorporated, you’re supposed to record the full $50,000 in tutoring fees on a section of your T1 personal tax return called a 2125. This section is for self-employed individuals – income from any business that you may have, even if it’s 5 bucks from a lemon-aid stand in your driveway, is meant to be recorded here.  You’re required by law to record all the income and expenses relevant to your unincorporated business on this form.

Okay – so given it’s your responsibility to tell the government how much you earn, and given that you want to pay less tax – perhaps instead of reporting $50,000 on your 2125 form, you’ll report $45,000. After all, if your average tax rate is, say, 20%, that’ll be an extra $1,000 less tax that you’ll pay. So why not just skim a little off the top? As it’s easy to see the temptation, the real question is not why people cheat – that's one for the behavioural economists - but just how does the CRA catch them?

If you’re an honest Canadian taxpayer, how is the CRA making sure that you don’t get the short end of the stick while others avoid paying their tax bill?

Every business owner dreads the infamous audit.

The CRA somehow selects you from tens of thousands of tax returns and decides that it’s going to ask you to prove your income and expenses as declared on your tax return.

While there are many types of audits ranging in severity and depth, the basic concept is the same. You need to show the CRA that what you reported reflects exactly what happened in your business.

On the income side, you may have to submit your invoices and bank statements – the CRA will see if your deposits match your invoices. On the expense side, you may have to submit receipts and bank statements – again the CRA will see if your expenses were actually incurred and evaluate if they relate to the business.

Still, the concept of the audit may have you wondering: What if I have a cash business? If nothing moves through my bank account, how can they find out what I earned? Surely anybody can just make up an invoice or write up a receipt?

This is where the concept of reasonability comes in. The CRA has a number of controls in place to assess whether the amounts that you reported are reasonable relative to your business/industry.

Reasonable wining and dining?

For example, suppose in our tutoring business example, you declare travel expenses of say, $2,000. On $50,000 of income, it seems fair or reasonable, that you had to spend money on transportation expenses travelling to and from your clients. On the other hand, had you declared $15,000 this may raise a red flag. Spending 30% on your income seems a bit excessive – unless you’re driving across the country to see your students. Of course, had you earned $100,000 in tutoring revenues, suddenly $15,000 may seem more reasonable.  One way of looking at reasonability then is whether the expense you report is fair relative to the income you earned.Another way of looking at reasonability is relative to the industry you operate in. As a marketing firm, it’s more likely that you’ll have to spend money wining and dining your clients than, say a doctor.  The CRA may leave your marketing firm alone if you declare $10,000 in meals and entertainment expenses but don’t be surprised if you receive an audit letter at your small medical practice if you declare the same amount. The wining and dining of patients is a bit of a tougher sell.

Of course there is no set criteria to determine if your income and expenses are completely reasonable from the CRA’s perspective. So will you be caught if you skim a little off the top? Will that $5,000 that you reduced from your earnings raise a red flag?

Hard to say – hopefully, as an honest tax payer, this thought doesn’t cross your mind. Though ultimately, if your numbers look reasonable and if you can support it with invoices, bank statements, or receipts the chances of being selected for a serious audit will probably be lower.

So how do you pay no taxes?

In our Canadian tax system, how much income you choose to declare on your tax return is in your hands.  Fortunately for the many honest small business owners out there, there are a number of techniques to legitimately reduce your tax bill without jeopardizing your integrity. Keep up to date with our blogs and newsletters for tips on how to reduce your small business tax bill or talk to your accountant to see what tax planning strategies you can use in your business.