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1997 October Report of the Auditor General of Canada

Main Points

18.2 Our follow-up on previous recommendations found that progress is being made on a number of fronts. We encourage the two departments to continue their efforts to address the areas where concerns remain.

18.3 Revenue Canada is now making available more income tax advance rulings and GST rulings and interpretations and has taken steps to improve its documentation of key decisions leading to advance rulings.

18.4 The Department continues to have difficulty completing reviews of income tax returns selected for scrutiny during the annual processing program. It has expanded the number of processing review fields it is tracking, and it is maintaining year-to-year consistency in the fields chosen. Data quality improvements are expected to improve Revenue Canada's ability to analyze and evaluate the performance of the processing program.

18.5 The integration of collections for income tax, GST and customs and excise, the establishment of a risk analysis system, and changes in collection procedures are expected to enhance the collections function. A new procedure for early contact on large delinquent accounts is proving to be very productive, bringing in $181 million in 1996-97. Revenue Canada has published guidance on applying the Fairness Package and has established a system to track its use.

18.6 The Department is shifting from an audit selection strategy focussed on identifying individual taxpayers to one focussed on industry sectors. It is also trying to take advantage of administrative consolidation to increase audit visibility and coverage. However, the Department still does not have a verification program aimed at RRSP contributions. Through improved reporting of social insurance numbers and sharing of data with other federal departments and provincial governments, Revenue Canada is improving its ability to pursue income tax non-filers and GST non-registrants.

18.7 It has developed a process to manage the risk associated with complex tax legislation, which can be a source of revenue leakage if provisions can be used for tax avoidance. It has also improved the collection and reporting of performance data across a number of its programs.

18.8 In trade administration, Revenue Canada's periodic verification initiative and country-of-origin audit program are expanding. The Department's small importer strategy has been formulated and implementation started.

18.9 With respect to tax assistance for retirement savings and income tax incentives for research and development, the Department of Finance has taken steps to provide improved estimates of program costs and to provide evaluations of program effectiveness. It has also taken steps to correct technical deficiencies in the law related to foreign affiliates and taxpayer migration.

Introduction

18.11 A strong tax administration is needed to provide government with a reliable stream of revenue to fund its programs. A strong tax administration protects the integrity of the tax base. For an income tax, the tax base comprises the total taxable income of taxpayers; for a consumption tax like the Goods and Services Tax, it is the total value of taxable transactions that occur in the economy. The tax base is one of the most valuable assets of a civilized society, and parliamentarians, government and the public have a vested interested in preserving it.

18.12 Protecting the integrity of the tax base means ensuring to the greatest possible extent that people report their income and transactions truthfully and pay the taxes that they owe. Canada has chosen a self-assessment system for collecting taxes, which puts the onus on each person or business to calculate the amount of tax due. People are most likely to comply with these obligations if they are satisfied that the tax system is fair. They have a right to expect that those who do not pay their fair share will be detected and dealt with accordingly.

18.13 To the extent that trade administration results in the generation of revenue from customs duties, the preceding remarks apply equally. However, in addition, trade administration is increasingly aimed at enabling Canadians to participate more effectively in the international marketplace and to reap gains from trade.

18.14 This chapter follows up on 15 value-for-money audits conducted between 1992 and 1996, and discusses the extent to which Revenue Canada's and the Department of Finance's actions on our recommendations and on those of the Public Accounts Committee (PAC) have improved tax and trade administration. We followed up on all of the PAC's and our recommendations from those audits and are reporting on the more significant ones and on those where we feel progress has been unsatisfactory. Further details on the follow-up scope and objective are found at the end of the chapter in the section About the Follow-Up .

Conclusions

18.16 However, we do believe that Revenue Canada has made satisfactory progress in addressing most of the recommendations contained in the audits followed up in this chapter and the related recommendations of the Public Accounts Committee, and in advancing certain of its initiatives that were identified in the original audit reports.

18.17 We continue to have concerns about some matters previously reported, and we again urge Revenue Canada to take appropriate remedial action.

18.18 We are generally satisfied with the Department of Finance's response to our recommendations and to those of the House of Commons committees that considered our reports dealing with taxation. While they are not yet available, we anticipate better estimates of tax expenditures and better evaluations of the extent to which the programs of tax assistance for retirement savings and incentives for research and development are achieving their objectives. In addition, the government has taken action to deal with technical deficiencies in law related to foreign affiliates and taxpayer migration.

REVENUE CANADA

Tax Administration Framework

18.20 Facilitation . Overlaying all other tax administration functions are Revenue Canada's efforts to help taxpayers, registrants, etc. comply with their obligations under the tax system. Facilitation takes many forms, such as communicating to clients their rights and obligations, providing the necessary forms and information for filing returns, and responding to client enquiries. The Department also issues various kinds of rulings that explain how certain transactions ought to be treated for tax purposes or that confirm or deny a taxpayer's interpretation of the way a proposed transaction ought to be treated. The goal is to create a better-informed body of taxpayers, registrants and others.

18.21 Tax Roll or Registry. Revenue Canada needs to maintain a complete and accurate "tax roll" of taxpayers and employers (income tax), registrants (Goods and Services Tax), and licensees (excise tax and customs duty), by or through whom taxes are paid. In addition, it keeps certain special purpose registries, such as a registry of pension plans in respect of which taxpayers may claim deductions for their contributions. A tax roll or registry is simply a record of pertinent information that enables the Department to communicate with taxpayers, employers, registrants, licensees and plan administrators to facilitate or enforce compliance with the tax system. Identifying persons who should be added to or deleted from a particular tax roll or registry is a basic and vital function of tax administration.

18.22 Processing. For taxpayers, employers, registrants and licensees, compliance with the tax system means making payments and sending in various information returns to Revenue Canada, traditionally on paper, but increasingly in electronic format. This amounts to millions of transactions each year, which the Department has to process promptly and accurately. A very important aspect of processing transactions is applying automated and manual controls and procedures that identify and respond to indicators of actual or potential non-compliance.

18.23 Collections. Taxpayers, employers, registrants and licensees are supposed to remit their taxes to Revenue Canada voluntarily. The amount of the tax liability may have been determined by self-assessment or an assessment by Revenue Canada. When debtors fail to or are unable to pay their tax liabilities, for any reasons, Revenue Canada has to take action to collect the amounts due. The action it takes depends on the circumstances.

18.24 Audit and Enforcement . Because Canada uses a self-assessment system of taxation, Revenue Canada needs to carry out a limited program of checking (auditing) to ensure that taxpayers, registrants, etc. are complying properly with their obligations to report information and calculate their tax liability. When the Department finds errors or non-compliance, it issues new assessments or takes other corrective action. In cases where Revenue Canada suspects fraudulent activity, it may seek criminal prosecution through its enforcement arm, Special Investigations.

18.25 Dispute Resolution . Revenue Canada maintains a separate organizational unit that reviews assessments raised by the Department that taxpayers believe are incorrect. If a matter referred to this unit is not resolved to the satisfaction of the person who raised the objection, it may be appealed to the tax court, which is fully independent of Revenue Canada. (Although it is a vital element of tax administration, none of the tax-related audits followed up in this chapter dealt with dispute resolution. In 1995 we followed up our previous work in this area, originally reported in a 1992 chapter on resolving disputes on income tax assessments).

18.26 Policy and Legislation. In the course of administering the tax system, Revenue Canada becomes aware of anomalies or ambiguities in legislation. Audit and appeals activity are important sources of this kind of information. The Department may clarify or correct such problems by issuing its own policy statements or may ask the Department of Finance to amend the legislation, depending on the circumstances.

18.27 Monitoring and Reporting . Each of the functions we have discussed has to be managed appropriately and information on its efficiency and effectiveness reported to Parliament. Both of these tasks depend on having and using suitable information systems.

Observations

Compliance Strategy

Risk assessment guides compliance strategy

Facilitation

Publishing more rulings enhances facilitation

18.30 Our follow-up noted that since 1 January 1996 the majority of income tax rulings have been severed and are available to the public electronically in Revenue Canada's offices across the country. To protect confidentiality, the taxpayer requesting a ruling is asked to approve the severed version before it is published. The Information Circular explaining the rulings process has been updated and the revised circular states that agreement to the publication of a severed ruling is a condition for obtaining a ruling.

18.31 In the interim, the Department has realized that when there are more than two parties to a ruling it is difficult, if not impossible, to follow the facts and proposed transactions after the taxpayers' names have been severed. It is currently considering a number of enhancements to make the severed rulings as useful as possible to taxpayers.

18.32 The same 1993 chapter contained observations on three classes of GST rulings: advance rulings, application rulings and interpretations. It noted that communicating more information to the public on rulings and interpretations would increase equity among GST registrants. Revenue Canada is now providing subscribers (mainly tax publishing houses) with an electronic version of all GST rulings and interpretations, in severed form, prepared in departmental headquarters. However, GST rulings and interpretations prepared in Tax Service Offices are not distributed.

Department to improve documentation of key decisions leading to advance rulings

Community visits combine facilitation and enforcement

Tax Roll

Reporting of social insurance numbers has increased

18.36 Because identification is so important, the Department has programs aimed at identifying non-filers and non-registrants. Our 1994 chapter on detection of non-filers looked at this problem with respect to income tax.

18.37 The key to finding those whose names should be on the tax roll but are not is to obtain from an independent source of information a clue to their existence and an indication that they ought to be paying tax. One such source is the record of investment earnings ("T5 slips") that financial institutions have to prepare. To be most useful to Revenue Canada, T5 slips have to contain the social insurance number (SIN) of the person who received the investment earnings. This makes possible computerized matching of the T5 slips to income tax returns, on which the SIN appears. Although people are required by law to give their SIN to financial institutions, many do not, despite reasonable efforts by financial institutions to obtain the numbers.

18.38 Our chapter noted that, for the 1992 taxation year, only 73 percent of T5s contained SINs. For the 1995 taxation year, Revenue Canada reports that 89 percent of T5 slips contained SINs. A rate of 100 percent is not expected because many recipients are corporations or businesses that do not have SINs or are individuals under the age of 18 years, who are not required to supply a SIN to financial institutions (see Exhibit 18.6 ).

18.39 While the Department is satisfied with this compliance rate for 1995, it hopes to improve it further by working with financial institutions. Also, Revenue Canada would like the legislation amended to require corporations and businesses to supply their Business Numbers on T5 slips, making possible computerized matching to the Department's business-related databases.

18.40 Just as audit and enforcement benefit from Revenue Canada's supply of information and its compliance research, so do the non-filer and non-registrant programs. The Department now uses data from other federal and provincial government departments to identify specific individuals or corporations who may be non-filers or non-registrants. Revenue Canada will also examine the most recent census information by municipality to determine the degree of non-compliance in different areas of the country - important information for guiding strategy.

18.41 The Department reports that, once identified, 80 percent of non-filers begin to file tax returns voluntarily. It follows up on the remainder and, within three years, almost all file their tax returns voluntarily.

Processing

Continued difficulty in completing reviews of selected returns

18.43 Revenue Canada's "confidence validity" (CV) program looks at each return and is designed to target the most risky or suspicious returns for manual review prior to initial assessment. A computer selects returns according to criteria known as confidence validities. Because the CV program selects only the most risky and suspicious returns, it is important that all of those be reviewed before the initial assessment. The 1995 audit noted that this was not happening. Moreover, there was no certainty that all returns selected but not reviewed before initial assessment would be reviewed after the initial assessment notice was issued.

18.44 Changes made for the 1995 processing year were meant to ensure that any "high-risk" returns not reviewed before initial assessment would be examined afterward. Revenue Canada monitors returns that are bypassed (selected but not reviewed) at the confidence validity stage. Over the course of the CV program in 1996, over 100,400 returns were selected for review. About 16,700 (17 percent) of those were bypassed for various reasons. The post-assessment review program dealt with 14,800 of the bypassed returns, leaving 1,900 that were not reviewed at the second stage. Those cases were concentrated in a few taxation centres, and most were not reviewed because staff resources were insufficient to handle the volume of returns awaiting review.

18.45 At a Revenue Canada CV conference in October 1996, it was agreed that workload forecasting would be improved, that tax centres would take steps to improve staffing and training for this program, and that additional resources would be allocated for the 1997 program. Also, in 1997 new weekly reports were provided to help the tax centres manage CV inventories and reduce backlogs. As of 20 May 1997, only 126 of the 34,238 returns processed for the CV program had been bypassed.

18.46 In the 1995 audit, we also found that the Department had not examined all returns for tax years 1992 and 1993 (only 92 percent in 1992 and 92.9 percent in 1993) that had been chosen for random sampling under the processing review program (a post-assessment verification activity), even though its policy was to review all such returns. This policy is intended to ensure that the results obtained in the processing review program are representative of the underlying populations, given that Revenue Canada relies on this program to estimate the level of voluntary compliance by taxpayers.

18.47 During the 1995 program, 90.5 percent of the returns chosen for the random sample were reviewed. For the 1996 program, 91.9 percent of the returns chosen for the random sample had either been or were being reviewed as at 6 May 1997. Revenue Canada states that some returns were not available for review because they were charged out to other areas such as audit. Certain other cases were not reviewed because of mid-year adjustments to administrative policies regarding claims to be checked in the Processing Review Program.

18.48 It is evident that, in the 1995 and 1996 random sample program, about the same percentage of selected samples were being reviewed as in 1992 and 1993. While the sample completion rate seems quite high, the uncompleted portion of the sample may have characteristics that are significantly different from the completed portion. Were this to be the case, the conclusions that Revenue Canada drew from analysis of only the completed portion could be seriously in error. To safely ignore the uncompleted portion of the sample, Revenue Canada would have to be sure that its characteristics were essentially no different from those of the completed portion. However, the Department does not have this assurance. Accordingly, we urge the Department to take appropriate action to ensure that all returns chosen for the random sample are reviewed.

Department's comments: The Department remains committed to further improving the review rate for random sampled cases, but 100 percent completion is an unrealistic objective. In large sampling projects, some cases will always be unavailable for review, and the sample design takes this into account. The Department is confident that the completed cases constitute a representative sample. Data from prior years and from the compliance workload are used in sample design and quality checking.

More and better data available but still little analysis of performance

18.50 For the 1995 taxation year, 27 processing review fields were covered in the random sample for paper returns and 24 fields for EFILE returns. For the 1996 taxation year, 24 fields are being covered for paper returns and 21 fields for EFILE returns. This is a substantial increase over the number covered in our 1995 audit of the 1994 taxation year. It will improve the Department's ability to monitor trends in voluntary compliance. The decrease by three in the number of fields being covered for the 1996 taxation year is due to a legal challenge to the taxability of certain income, and to changes in the way certain claims are processed.

18.51 Our 1995 chapter recommended that Revenue Canada use statistics from its compliance monitoring and enforcement programs to analyze trends and patterns of non-compliance. The information could be used in developing criteria for selecting returns to review, and then in evaluating how well the criteria perform. It could also be used to evaluate the overall performance of the new processing regime.

18.52 In 1995, we noted problems in the quality of data from the 1993 processing review program; Revenue Canada subsequently discovered some more problems with the data. The Department postponed much of its analysis while it worked to correct the remaining errors in its data. Aside from data quality, co-ordination problems within the Department have resulted in delays in generating some of the data needed for analysis.

18.53 Because of these difficulties, the Department has so far performed only a limited analysis of non-compliance trends and patterns using 1994 and 1995 processing review program data. We extended the analysis to 1996 using preliminary data, and found that there does not appear to be any clear trend in non-compliance over the period in the group of data fields available for all three years. However, even the most recent random sample data reveal rather high adjustment rates (exceeding 10 percent) in many fields. In addition, using data from the matching program, the Department found that the average value of adjustments it made to EFILE returns was higher than the average value of adjustments to paper returns for 1994. In particular, adjustments for child care, spousal amounts and other family-related claims were higher for EFILE returns. The reasons for this are not yet fully understood.

Department's comments: The Department acknowledges that the process of extracting, assembling and cleansing the data it needs for analysis has been more time-consuming than expected. However, these preparatory steps are essential to effective analysis and decision support in any business context.

At this time, no definite conclusion can be reached about hypothetical differences in the compliance rates for EFILE and paper returns. Data being gathered via the random samples for the years 1995 and 1996 will enable valid trend analysis. Since the EFILE and paper returns covered by the Matching program are not based on equivalent geographical areas, the adjustment rates are not comparable. No inference can be drawn about the rates that might apply to other deduction or credit items.

18.54 Our analysis during our 1995 audit revealed that the scoring system used by the Department to evaluate the riskiness of returns was weak and needed improvement. Our updated analysis of the scoring system in place during the 1996 program year also indicated room for improvement. However, we are encouraged by the Department's recent development of new scoring criteria based on statistical analysis of program data. The new criteria have been implemented in 1997. In addition, the Department has been experimenting with other techniques - referred to as "neural networks" - that may serve as a complement to the kind of scoring system now in use.

18.55 Regarding evaluation of the overall performance of the new processing regime, the Department has drafted an evaluation framework that proposes some useful indicators of program effectiveness. However, we believe that the framework can be improved. Clear measures need to be defined to evaluate such questions as whether the proper levels of resources are being devoted to paper and EFILE reviews, whether the mix between CV reviews and processing reviews is appropriate, and what fields should be subject to review. It would also be appropriate to define a timeline that shows when the various aspects of the evaluation would be done.

Department's comments: The Department appreciates the suggestions for improvement included in this paragraph and will incorporate them in its evaluation plans.

Backlog of unprocessed pension plan files is declining

18.57 To achieve the reduction, the Department hired more staff and changed the staff mix to match the composition (in terms of complexity) of the files examined, improved work flows, used assessments of risk to guide the review process, and transferred the review of wind-up and conversion reports to a desk audit program that is done at a later time. Revenue Canada also consulted with pension industry representatives to come up with plan prototypes in an attempt to improve the quality of documents submitted to the Department for review.

18.58 At 1 April 1994, 40 percent of the unprocessed pension plan files were more than six months old; by 24 March 1997, this had decreased to 27 percent. The Department's current published standards for registration or termination of a pension plan is 180 days. However, the Department believes this is an inappropriate standard to apply to pension plan amendments, which it says make up the majority of the unprocessed files. Revenue Canada intends to soon publish a less demanding standard for amendments, in recognition that these are lower-priority items. Good progress has been made in processing pension plan files.

Collections

New system for income tax accounts receivable to be used for other taxes

18.60 Growth in accounts receivable. When we published our 1993 audit observation, the GST had been in place for just over two years. Accounts receivable were increasing and had reached $650 million by March 31 of that year. But given that there were also 576,000 registrants who were delinquent in filing returns, the accounts receivable balance was likely understated. Indeed, GST accounts receivable have continued to rise, totalling $1.6 billion by the end of the 1995-96 fiscal year. Exhibit 18.4 shows how unpaid GST has increased each year while unpaid income tax debts have tended to level off over the last few years.

18.61 In 1994, we reported that unpaid income tax debts had grown from $4.2 billion in 1988-89 to $6.6 billion in 1993-94, an increase of 58 percent. Over the same period, net federal income tax revenue had grown from $70.6 billion to $80.4 billion, an increase of 14 percent. Thus, the growth in unpaid income tax debts outpaced the growth in net federal income tax revenue. Our follow-up noted that by the end of fiscal year 1995-96, unpaid income tax debts had increased by another 3 percent to $6.8 billion, while net federal income tax revenue had increased by 20.3 percent to $96.7 billion. This means that growth in unpaid income tax debts was now slower than growth in net federal income tax revenue. Exhibit 18.5 shows that the percentage of unpaid income tax debts to income tax revenue has decreased since 1993-94, while the percentage of unpaid GST to GST revenue has increased each year.

18.62 Changes to the collection regime. The 1994 chapter criticized certain aspects of Revenue Canada's collection regime. We stated that the Department could improve its collection performance by changing the way it judged the riskiness of a delinquent account and by tailoring its collection procedures for a particular account according to that risk. We also noted areas where we felt management's monitoring of the performance of the collection function could be improved.

18.63 After visiting private industry and upon completing a benchmarking process, the Department developed and tested a risk analysis system that can classify accounts receivable according to compliance patterns or potential for loss. This system has been implemented for individual income tax accounts, with the intention of also incorporating payroll deductions, corporate income tax, GST, customs and excise accounts in the future. The system will operate by directing accounts to the most efficient recovery process to be used - whether written notices, call centre reminders or more intense collection action by staff in one of the Tax Services Offices (TSOs).

18.64 In addition, 11 of the larger TSOs began the practice of making early contact with taxpayers on accounts over $100,000. During 1996-97, of 1,350 accounts on which early contact was made, 341 were paid in full and a total of $181 million was collected (see Exhibit 18.6 ).

18.65 An on-line collections manual is now in place, combining policies and procedures for GST and income tax. It includes standards for assessing, documenting and verifying information pertaining to debtors' ability to pay, and standards of performance by collectors for such things as nature and frequency of debtor contacts, time frames for resolving accounts and use of legal action. All these standards are monitored by departmental headquarters.

18.66 Except for the results from early contact on large accounts, it is hard to point to evidence that the changes in the collections program are having an impact. Nevertheless, we feel the changes make sense and should prove to be beneficial.

Better control over use of the "Fairness Package"

18.68 Subsequently, the Department developed enhanced guidelines on applying the Fairness Package and released them in a policy paper entitled "Application of the Fairness Provisions to Interest and Penalty". A registry and reporting system was implemented to track fairness decisions and account for amounts forgiven under the fairness provisions, including the breakdown of such amounts according to the reason for forgiveness (see Exhibit 18.6 ).

Audit and Enforcement

Compliance research leads to new audit tools and techniques

18.70 In 1995, Revenue Canada established the Compliance Research Directorate to act as a centre of expertise on risk assessment and risk management. The Directorate monitors trends in revenues, examines compliance patterns, and conducts studies of factors that affect compliance. The results help in the formulation of compliance strategies and in the creation of computerized tools with which auditors can select the most promising targets for examination and focus on areas that are most likely to reveal non-compliance.

18.71 In response to a recommendation in our 1994 chapter on tax-assisted retirement savings, Revenue Canada set up a system to collect data on the results of its front-end compliance reviews of money purchase and defined benefit pension plans. Analysis of the data showed that certain money purchase plans were low-risk. The Department then adjusted its review process to focus more of its efforts on the high-risk plans. This is an example of how compliance research can improve audit and enforcement.

Auditors adopt focus on industry sectors

18.73 In 1995, the Department mounted a project to review the records that were missing SIC codes for registrants. Now, it reports that 95 percent of accounts of registrants whose annual taxable sales exceed $30,000 (the threshold for mandatory registration) contain a proper SIC code. In addition, auditors are now responsible for adding missing SIC codes when they make an examination. Revenue Canada and Statistics Canada have established a committee to address the need to ensure that SIC codes reliably describe different industry sectors.

18.74 Further improvements in taxpayer/registrant information are on the horizon. Revenue Canada has introduced a common identifier, known as the Business Number, for all corporate income tax, employer payroll source deductions, GST and customs accounts. Having a common identifier should soon make it practical for the Department to draw upon much more of its information - stored in separate computer systems - for use in compliance research or audit selection. A computer-assisted system for selecting GST registrants for audit is now in place. The system uses information from various sources inside and outside the Department.

18.75 The Department is moving away from an audit selection strategy focussed on identifying individual taxpayers/registrants to a strategy focussed on industry sectors. The Department analyses non-compliance by sector or occupation to identify high-risk areas and to develop appropriate actions. Its Underground Economy Initiative, for example, concentrates on the sectors of construction, jewellery, automobile sales and repairs, hospitality, and home renovations.

18.76 Tax Services Offices (TSOs) are setting up teams of auditors, each team to specialize in dealing with a limited number of sectors. In hand with this, an industry sector specialist team of professionals is putting together "sector profiles" containing business, economic, technical, and compliance information relevant to auditors. Drawing upon the experience of TSO staff in this way responds to one of the recommendations we made in 1994.

18.77 Not all of Revenue Canada's efforts to improve audit selection rely on using computerized systems. Auditors in the Registered Plans Division make use of referrals from, and consultations with, staff of various sections within the Division to identify areas where risk of non-compliance is high.

New strategies aim at improved audit coverage

18.79 Since its administrative consolidation, Revenue Canada reports its performance for all its verification and enforcement programs together. The Department's 1995-96 Performance Report shows an increase in enforcement resources to 6,871 full-time-equivalent staff, from 5,909 in 1992-93. Over the same period, the Department reports that the total fiscal impact of verification and enforcement activities increased from $3.64 billion to $4.48 billion. The Department defines ``fiscal impact" as federal and provincial tax (where applicable), federal tax refunds offset or reduced, interest and penalties, and the present value of future tax assessable.

18.80 Revenue Canada is trying to take advantage of administrative consolidation to increase audit visibility and coverage. It is following a strategy whereby auditors who examine a taxpayer/registrant selected for audit of either GST or income tax will review key indicators of performance for the other tax as well. For the very large companies that are subject to Revenue Canada's Large File Program, an audit of both income tax and GST is done where, in the judgment of the Large File Case Manager, it is warranted.

18.81 In 1994, we also reported that audit coverage of registered pension plans was too low to detect and deter non-compliance. Since then, the Department has increased the number of audits it performs from 127 in 1992-93 to 365 in 1996-97. To attain even wider coverage, Revenue Canada is looking into the possibility of co-operating with the Pension Commission of Ontario to perform joint audits.

18.82 In response to our observation that past service pension adjustments (PSPAs) were not systematically verified, Revenue Canada performed a study to determine the need for a PSPA examination program. It found that a program was needed and has trained staff in order to implement it in 1997-98.

18.83 Tax evasion. Taxpayers are entitled to use legal means to reduce the amount of tax they pay. But when they use illegal means - fraud - to escape paying tax, they are guilty of tax evasion. Out of fairness to the great majority of individuals and businesses who voluntarily comply with the tax laws, Revenue Canada investigates and prosecutes those who are suspected of tax evasion. It also publicizes its successful prosecutions as assurance to honest taxpayers and as a warning to others.

18.84 Our 1994 chapter on special investigations and detection of non-filers noted the Department's concern that the number of referrals to Special Investigations of cases of suspected income tax evasion was much lower than desired. The same year, our chapter on GST audit and special investigations remarked that referrals to Special Investigations of suspected GST evasion cases, although numerous, were of low quality - lacking the substance needed if they were to be developed for prosecution.

18.85 To address these problems, Revenue Canada has given fraud awareness training to more of its auditors and has published additional guidance to auditors on preparing referrals.

Verification program for RRSP contributions needed

18.87 We were concerned that taxpayers might make invalid claims for RRSP deductions and that Revenue Canada did not possess information from an independent source that could be used to check for invalid claims. In addition, we were concerned that Revenue Canada had no way to detect taxpayers who attempted to defer tax by sheltering income in an RRSP even though they had not claimed a deduction, perhaps because they had made contributions in excess of allowable limits.

18.88 The Department points out that starting in the 1994 taxation year, taxpayers are required to make additional disclosures on their income tax returns. However, we do not believe that this is an adequate substitute for a verification program aimed at RRSP contributions. We hope the Department will reconsider its position and implement a verification program for RRSP contributions.

Policy and Legislation

Process developed to manage the risk associated with complex legislation

18.90 Our observation resulted in an inquiry by the Public Accounts Committee into the government's procedures for managing the risk to the tax base associated with complex legislation. The inquiry was completed and the Committee presented its recommendations to the House in February 1995. In response to the Committee's recommendations, the government has developed a process to act more quickly and reduce the likelihood of similar losses in future.

Issue relating to condominiums has been resolved

18.92 Revenue Canada has studied the matter and found that the administrative policy was not necessary, since condominium corporations can qualify as non-profit organizations. The information setting out the Department's administrative policy has been cancelled.

Basis for sharing "unapplied taxes" with the provinces and territories not resolved

18.94 Concerned that the balance in the account may have arisen, in part, from bookkeeping errors and therefore was not appropriate to share, Revenue Canada made a significant effort to ensure that only appropriate transactions were recorded in the account. This having been done, the question remains whether the balance in the account ought to be shared.

18.95 It is Revenue Canada's and the Department of Finance's view that only unapplied amounts deducted from employees' earnings are to be shared with the provinces and territories. We believe that the account in question may contain such amounts as well as other amounts that the provinces and territories may regard as shareable.

18.96 We understand that this issue will be discussed with the provinces and the territories in the near future.

Monitoring and Reporting

Management information agreements promise better monitoring and reporting

18.98 In 1994, we reported the results of our audit of income tax incentives for research and development. We found that Revenue Canada was collecting some, but not all, of the information needed to monitor the incentives for research and development. We also observed that the Department's database on the scientific research and experimental development incentive was not completely reliable.

18.99 In response to the first problem, Revenue Canada modified its Audit Information Management System to capture additional kinds of data. It has also specified features that are to be built into a new system being developed to process corporate income tax returns. Regarding the second problem, the Department has instituted new verification procedures aimed at improving the accuracy and completeness of the information in its scientific research and experimental development database.

18.100 More generally, the Department's Verification, Enforcement and Compliance Research Branch developed management information agreements for each program in the Branch. The agreements define program mandates, objectives, and performance indicators along with the data required to produce them. In addition, the Branch publishes and widely distributes to its staff a volume covering its priorities and achievements, and program information.

Trade Administration

18.102 In this section, we report the results of our follow-up of our 1994 chapter on customs assessment. That chapter approached trade administration from the standpoint of the assessment of customs duties, including the administration of duty-relief programs. The approach was consistent with the Department's emphasis at that time on revenue generation as part of the government's overall strategy of deficit reduction. It is noteworthy that now, roughly three years later, the emphasis has shifted more toward improving trade data in support of the government's trade development initiatives, one of the Department's concerns even in 1994.

Periodic verification initiative is progressing

18.104 As a complement to on-site periodic verification of importers, Revenue Canada envisages doing a less extensive desk verification of enough other importers to bring the coverage up to 40 percent of total value for duty of imports. This work has yet to begin. In the longer term, the Department intends to identify other industry sectors for review, based on its own research and on Canada's international business development plan.

End-use and country-of-origin audit concerns have been addressed

18.106 We expressed similar concern about the low number of country-of-origin audits. These are audits to determine that a country from which goods originate is entitled to a preferential tariff rate under a free trade agreement. By increasing the number of staff devoted to country-of-origin audits, Revenue Canada has been able to increase the number of audits it performs. In 1994, we reported that the Department had carried out 40 audits in the five years ending 31 March 1994. Departmental records show that in the three subsequent years it completed 36 audits.

Small importer strategy formulated and implementation started

18.108 Our 1994 chapter noted that Revenue Canada's New Business Relationship (NBR) initiative was heavily focussed on large importers, and that a strategy was needed to deal with other importers. Believing that it would be inefficient to apply a periodic verification strategy to small importers, the Department has chosen instead to use a client service strategy as part of the NBR initiative, involving simplified trade data requirements, easier payment terms and methods, wider access to electronic commerce, and more effective programs of client assistance and information. To date, the client service strategy for small importers has been developed and the Department reports that supporting initiatives are to be undertaken during 1997-98.

DEPARTMENT OF FINANCE

Observations

Tax Assistance for Retirement Savings

Improved cost estimates are expected

Slow progress on evaluation studies

18.112 Our remaining recommendations had to do with conducting further evaluation studies that were not planned at the time of our audit. Finance tells us that these are being addressed in part and that we will be given the results of this work in the future.

Income Tax Incentives for Research and Development

Evaluation studies and cost estimates are forthcoming

18.114 The Department indicates that it is now finalizing a report on the findings of an evaluation of the income tax assistance for scientific research and experimental development. In addition, in the upcoming report on tax expenditures it will be publishing estimates and forecasts of the costs of the SR & ED tax credits.

Other Observations

Technical deficiencies in law related to foreign affiliates and taxpayer migration corrected

18.116 In May 1996, we reported serious concerns about the administration of the Income Tax Act involving the tax-free movement out of Canada of at least $2 billion in assets held in family trusts. This report generated a great deal of attention by the government and by two committees of the House of Commons. In response to House of Commons Finance Committee recommendations, in October 1996 the Minister of Finance announced major changes to the income tax rules for persons (including trusts) who leave Canada. The proposed changes are intended to ensure that taxpayers who move or transfer property from Canada will remain subject to Canadian tax on their capital gains. In making the announcement, the Minister acknowledged the Auditor General's role in drawing attention to the issue and the Finance Committee's role in recommending corrective action. He said, "This is a textbook case of the system working as it should."

18.117 In 1994, we reported that a number of companies in the financial sector had made claims under the scientific research and experimental development (SR & ED) provisions of the Income Tax Act , amounting to over $300 million. The claims were for software development, and it was unclear whether the SR&ED provisions were meant to apply to this kind of item. At one point, the Minister of Finance produced draft legislation aimed at denying claims for software developed by companies in the financial sector. The draft legislation was later withdrawn in favour of administrative action by Revenue Canada to deny such claims.

18.118 Our 1995 chapter on the air transportation tax drew attention to a possible loophole involving charter air transportation and suggested that Finance may need to re-examine the legislation. In connection with the privatization of Canada's air navigation system, Parliament has since passed legislation that will abolish the air transportation tax in the fall of 1998. In view of this development, we expect no further action by Finance on this matter.

About the Follow-up

Objective

Scope

2 These audits involved follow-up in Revenue Canada and the Department of Finance

3 These audits involved follow-up in the Department of Finance only.

Approach

In order to draw conclusions about the plausibility of management's assertions contained in the status reports, we collected data on a selective basis and performed other review procedures.

Follow Up Team

For information, please contact Jim Ralston, the responsible author.