2009 Spring Report of the Auditor General of Canada

Main Points

What we examined

Corporate taxpayers who anticipate a reassessment of their income tax returns by the Canada Revenue Agency for a certain tax year may remit funds in advance, which the Agency will hold to apply when the reassessment is processed. Reassessments are fairly routine for corporate taxpayers, and the Agency asks that, when they make an advance deposit, they indicate the tax year to which the expected reassessment relates. For the majority of corporations, the amounts they deposit in advance are in line with the amount of tax they expect to be reassessed.

Our financial audits of the Agency noted that a number of corporations are maintaining large balances—totalling more than $4 billion—on deposit with the Agency from year to year. Tax overpayments earned a rate of interest ranging between five percent and seven percent during the past three years. We decided to examine whether the Agency adequately administers advance deposits from corporate taxpayers under the Income Tax Act and Income Tax Regulations and whether it adequately monitors and manages accounts where it might be obliged to pay interest. We looked at the 50 largest accounts of corporate taxpayers, representing two thirds of the total balance on hand. Our review of these files went back three years.

Why it’s important

The Canada Revenue Agency is responsible for administering Canada’s tax system in a way that protects the tax revenue base. In our view, this would include ensuring that it does not make large interest payments that could be avoided and advising the Department of Finance Canada if it believes existing legislation is resulting in any unintended consequences.

What we found

• In 1991, the Agency recognized—soon after a change in the Income Tax Regulations raised the prescribed interest rate on overpayments to its present level—that certain corporations were depositing and leaving large balances on their accounts. It questioned whether they were doing it to take advantage of the favourable interest rates. More recently, when preparing the Agency’s year-end audited financial statements, senior officials of the Agency concluded that most of the balances are refundable to the corporations. In many cases, refunds will ultimately be made, along with interest that has accrued over the years. Where this proves to be the case, the government will, in effect, have paid interest at a higher rate than its own cost of borrowing. We conservatively estimate, based on a limited number of accounts, that the difference between the government’s borrowing rate and the interest rates on these deposits represents at least $30 million in unnecessary interest costs for each of the past three years.
• The Agency launched a number of initiatives over the years to refund as many of these balances as possible, but with limited success. If a corporation did not choose to withdraw its balance, the Agency accepted the decision. Officials told us that in the absence of voluntary cooperation by the taxpayer, the Agency held the balance in the taxpayer’s account. Although it normally informs the Department of Finance Canada of any compliance challenges that could signal the need for legislative change, the Agency has not discussed this matter with the Department of Finance Canada or proposed any solutions to reduce interest costs. We note that other jurisdictions limit the interest payable in similar situations.
• As tax legislation is silent on whether the Agency can accept or refund advance deposits, the Agency developed an administrative practice. This practice was designed to allow corporations to minimize interest costs where there is a bona fide risk of reassessment. However, the Agency is not currently requiring corporations to follow guidance it has published in its Corporation Instalment Guide, and key aspects of the Agency’s practices for managing advance deposits remain unclear. For example, corporations frequently do not identify the tax year to which their advance deposits relate. Moreover, although the guide discusses accepting payments only in the context of “anticipated reassessments,” the Agency does not have a process in place for checking its own files to see if a reassessment is in the works and if the amount deposited is in line with the amount likely to be reassessed.

The Agency has responded. The Agency agrees with our recommendation. Its detailed response follows the recommendation in the chapter.

Introduction

A tax system based on self-assessment

4.1 A self-assessment system is used to administer Canadian income tax. Under this system, corporate taxpayers file their returns, voluntarily report their income and expenses, and calculate the amount of tax they owe.

4.2 Taxpayers who have underpaid usually must pay interest on the taxes they owe, while those who have overpaid are usually entitled to receive interest on the amounts owing to them. The Income Tax Act specifies how the interest is to be calculated, and the Income Tax Regulations specify how to determine the interest rates for overpayments and underpayments of tax. The Canada Revenue Agency calculates and publishes the interest rates four times a year, as required under the Income Tax Regulations.

4.3 Under the Act and Regulations, the interest rate applied to tax underpayments is higher than the rate applied to overpayments. The Department of Finance Canada introduced the dual interest rate structure to encourage prompt payment of taxes. The Income Tax Act also provides for different tax treatment of interest revenue and interest expense. The interest that a corporation earns when it overpays is taxable; however, for tax purposes, a corporation usually cannot deduct the arrears interest charges that it pays to the Agency. Consequently, corporate taxpayers have a strong incentive to comply with the legislation and remit their payments promptly.

Reassessments and advance payments of corporate income tax

4.4 A corporation has up to six months after its year-end to file a tax return. The Agency examines the return and sends a notice of assessment to the taxpayer. Normally, depending on the type of corporation, the Agency may re-examine the return and issue reassessments during the three or four years after the initial assessment. The rules in the Income Tax Act are complex, and it is common for the Agency to re-examine returns and issue reassessments for corporate taxpayers.

4.5 When a reassessment modifies the amount of corporate tax payable, the Agency also recalculates interest. Revisions to interest are based on the net increase or decrease in tax from the date that the tax was originally due to the date that the reassessed tax is paid. If reassessments that lead to large increases in the corporate tax are made well after the “balance-due day” (the day that the balance owing for the year must be paid) for a particular tax year, the arrears interest charges can be substantial.

4.6 By remitting sufficient funds to cover additional tax that might later be assessed, a taxpayer can reduce or entirely eliminate arrears interest charges. This is why corporate taxpayers requested permission to make supplementary payments that would limit their potential exposure to arrears interest charges. At the 1991 Canadian Tax Foundation Annual Conference, the Agency indicated that it would accept such voluntary payments and would pay refund interest even if a reassessment was not issued for a year in which a voluntary payment was received. The Agency clarified that this practice applied only “with respect to a bona fide possibility of a reassessment.” In this chapter, we refer to the voluntary payments, as well as overpayments that are left on account with the Agency, as “advance deposits.”

4.7 The Agency pays refund interest on an overpayment up to the day the amount is refunded or used. The calculation of this refund interest is done for specific tax years. While the tax owing for a particular year may be known with certainty after it is assessed or reassessed, the Income Tax Act allows taxpayers discretion in determining how payments should be allocated. For example, a taxpayer can move an excess instalment payment from an account where it is not needed to one where it is. When interest on either overpaid or underpaid tax is calculated, the Income Tax Act specifies that the original payment date remains in effect.

4.8 The rate of interest paid by the Agency on tax overpayments was five percent as of December 2008. This rate, as defined in the Income Tax Regulations, is always at least two percent higher than government’s cost of borrowing short-term funds. The calculation begins by taking the average rate for 90-day Treasury bills sold during the first month of the previous quarter. That rate is then rounded up to the next whole percentage, and a further two percentage points are added to the rounded figure. The Department of Finance Canada last revised this formula in 1989. It told us that, as a matter of policy, other interest rate considerations may be relevant, aside from the government’s cost of borrowing. For example, to determine the interest rate to be paid on tax overpayments, the Department considers taxpayers’ cost of borrowing.

4.9 From Agency officials and through our own research, we learned how some other jurisdictions treat advance deposits (Exhibit 4.1).

Exhibit 4.1—Other jurisdictions limit the interest payable on tax overpayments

4.10 From the beginning of 2006 until the end of 2008, the prescribed interest rate on overpayments ranged from five percent to seven percent. For each of the three fiscal year-ends within that period, the total amount of advance deposits from corporate taxpayers exceeded $4 billion—about ten percent of 2008 corporate tax revenues.

4.11 The Office of the Auditor General conducts annual financial audits of the Agency. During our recent audits, we were informed by management that the Agency had concluded that most of its advance deposits were not required for known or expected reassessments. By retaining these advance deposits, the Agency may incur interest expense at the rates we have noted.

Focus of the audit

4.12 We examined whether the Agency’s administrative practices were designed and administered to ensure that advance deposits were accepted and held only with respect to a bona fide possibility of a reassessment—thus minimizing arrears interest costs to the taxpayer.

4.13 We assessed whether the Agency could demonstrate that it is managing advance deposits from corporate taxpayers with due regard for economy. In addition to applying the law, we expected the Agency to use the authorities and flexibility available to it under the Income Tax Act and the Income Tax Regulations.

4.14 We also assessed whether the Agency’s Legislative Policy Directorate had been informed that the legislation and/or the administrative practices had unintended consequences; and whether it had brought these to the attention of the Department of Finance Canada’s Tax Policy Branch and, if so, what the Department’s response was.

4.15 The Income Tax Act prohibits the disclosure of taxpayer information. To prevent readers from identifying particular corporations, we have aggregated information about the corporations and rounded amounts and calculations. An overall recommendation addressing the Agency’s management of advance deposits can be found at the end of the Observations and Recommendations section.

4.16 More details on the audit objective, scope, approach, and criteria are in About the Audit at the end of this chapter.

Observations and Recommendations

Administration of advance deposits from corporate taxpayers

The Agency lacks clear procedures for managing advance deposits

4.17 We expected the Canada Revenue Agency to administer advance deposits of tax in accordance with the provisions of the Income Tax Act and published guidance. However, the Act contains no provisions specifically about accepting advance deposits remitted to prepay tax that might be due after a reassessment. As an administrative practice, the Agency has accepted advance deposits since 1991 to help corporate taxpayers keep interest costs down. The 2009 Corporation Instalment Guide provides the following instructions about prepaying reassessments:

If you prepay tax for an anticipated reassessment you may reduce charges of arrears interest.

To make prepayments, use Form RC159, Amount Owing Remittance Voucher (however, we will accept any corporation remittance voucher). Clearly indicate that the payments are prepayments. Also include your Business Number and the tax year-end for which the prepayments are intended. We will hold the payments for this purpose and apply them when we process the reassessments.

4.18 Agency personnel told us that there is no comprehensive policy or guidance for staff on how to manage advance deposits. Consequently, it is not clear what staff members are expected to do if they conclude that a deposit exceeds the amount likely to be due under an expected reassessment.

4.19 The 2009 Corporation Instalment Guide and the Agency’s response to the 1991 Canadian Tax Foundation Annual Conference question include an expectation that the Agency accepts and holds such deposits only when reassessments are likely. However, we found that the Agency accepts deposits from corporations without checking the likelihood of reassessment. The Agency monitors whether individual advance deposits are still needed and occasionally contacts corporations when deposits seem excessive. However, it does not take steps to return the funds unless it is asked to do so. We also found that, in the case of larger deposits, corporations rarely follow the instruction to indicate the tax year for which a prepayment is intended. This makes it harder for the Agency to check the likelihood of reassessment.

4.20 When it prepared its year-end audited financial statements for 2007 and 2008, the Agency identified some cases in which corporate taxpayers had made an advance deposit because an ongoing audit presented a bona fide risk of reassessment. In most other cases, the Agency concluded that the amount of funds on deposit significantly exceeded its estimates of additional tax that might be payable under future reassessments. In line with management’s conclusion that most of the deposits are refundable with interest, the Agency appropriately reports the balances expected to be refunded as amounts due to taxpayers, not revenue.

The Agency does not give due regard to economy in managing the interest it pays on advance deposits

4.21 We expected the Agency to protect the tax base by ensuring that it does not make large refund interest payments if avoidable. Revisions made to the Income Tax Regulations in 1989 increased the prescribed interest rate on overpayments by two percentage points. By 1991, the Agency recognized that some corporations might maintain excess funds on deposit to profit from advantageous short-term interest rates. In an internal memorandum, the Agency stated, “We are not comfortable with a practice which in effect could allow taxpayers to use their Revenue Canada accounts as an ‘investment account’ (earning interest at a higher rate than with the bank).”

4.22 As of the ends of the 2005–06, 2006–07, and 2007–08 fiscal years, the Agency held more than $4 billion in advance deposits from corporate taxpayers. Corporations that are likely to have reassessments accounted for only a portion of the advance deposits. Some of the larger deposits amount to hundreds of millions of dollars, but they come from only a small number of corporations. In each of the three fiscal years, the same 50 corporations accounted for approximately two-thirds of these deposits.

4.23 If the Agency unnecessarily holds large amounts on deposit, with an obligation to pay interest when making a refund, the federal government effectively is borrowing those funds at a higher interest rate than necessary. Instead of borrowing at Treasury bill rates, it will pay a rate that is at least two percentage points higher. On the basis of a limited number of large accounts, we conservatively estimate that the government has incurred at least $30 million in excess interest costs in each of the past three fiscal years (2005–06, 2006–07, and 2007–08).

4.24 For many years, the Agency has considered the possibility that corporations make advance deposits to earn a high rate of return. The Agency has launched a number of management initiatives to refund as many of the advance deposits as possible and to ensure that they are allocated to particular years. These initiatives have met with little success. When corporations were contacted, the Agency encouraged them to follow the Corporation Instalment Guide. However, if the corporations chose not to, the Agency accepted their decisions about allocating and retaining their deposited funds.

4.25 In our opinion, the Agency is not required by the Income Tax Act to accept or retain funds if it determines that those funds are not needed to cover a potential reassessment. By returning an advance deposit, the Agency faces the risk of the corporation being unable to pay additional taxes owing from a reassessment. However, the Agency can manage the risk by considering this possibility when it decides whether to accept or retain an advance deposit.

4.26 The Department of Finance Canada’s Tax Policy Branch is responsible for developing federal taxation policies and the legislation that relates to business income tax; the Agency is responsible for tax administration, including collecting taxes and interpreting tax law. The Agency informs the Tax Policy Branch of compliance challenges that it identifies. The Department considers that information when developing legislation.

4.27 Officials of the Agency and the Department have discussed how to account for advance deposits in the Agency’s financial statements. However, officials of both organizations confirmed to us that there have been no discussions involving either the Agency’s Legislative Policy Branch or the Department’s Tax Policy Branch on the subject of the interest costs resulting from the possibility that some corporations use advance deposits for investment purposes.

4.28 Recommendation. The Canada Revenue Agency should

• inform the Department of Finance Canada’s Tax Policy Branch about the issues related to advance deposits, so the Department can assess the need for a legislative or regulatory change to reduce associated interest expenses; and
• develop and consistently apply a robust administrative policy framework for managing advance deposits, whether or not a legislative or regulatory change is determined to be necessary.

The Agency’s response. Agreed. The Canada Revenue Agency has long recognized the importance of managing advance deposits and has an annual process in place to review these amounts. In that regard, the Agency will revisit its administrative policy framework for managing advance deposits with a view to strengthening it, particularly as it relates to potential refunds and interest expenses.

While the Agency has not determined that particular taxpayers are placing amounts on deposit with the Agency for any reason other than as a protective measure against a future assessment, the Agency will inform the Department of Finance about its practices concerning advance deposits and the amounts of interest paid thereon so the Department can assess whether there is a need for a legislative change.

Conclusion

4.29 In the absence of legislative provisions, the Canada Revenue Agency has developed an administrative practice for dealing with advance deposits by corporations. The intention was to allow corporate taxpayers to minimize interest expenses if there was a bona fide risk of reassessment. However, excessive interest costs may be incurred if the administrative practice is not followed.

4.30 The Canada Revenue Agency has not ensured that corporations follow the instructions on advance deposits published in its Corporation Instalment Guide, and it has not developed its own administrative policies to provide clear, consistent guidance to staff on how to manage these advance deposits. In addition, the Agency has not shown due regard for economy in the way it manages interest expenses arising from corporate advance deposits. In each of the past three fiscal years (2005–06, 2006–07, and 2007–08), the Agency incurred at least $30 million of unnecessary interest expense.

4.31 The Agency has long recognized the concerns regarding excess advance deposits. However, the Agency did not inform the Department of Finance Canada about this issue or about approaches taken by other jurisdictions to deal with the same issue.

About the Audit

All of the audit work in this chapter was conducted in accordance with the standards for assurance engagements set by The Canadian Institute of Chartered Accountants. While the Office adopts these standards as the minimum requirement for our audits, we also draw upon the standards and practices of other disciplines.

Objective

The objective of this audit was to determine whether

• the Canada Revenue Agency can demonstrate that it is using the authorities and flexibility available to it under the Income Tax Act and Income Tax Regulations to manage advance deposits from corporate taxpayers with due regard for economy and without unintended consequences; and
• the Department of Finance Canada’s response to identified compliance challenges is adequate.

Scope and approach

Our audit examined the 50 largest deposits from corporate taxpayers over the three previous fiscal years (2005–06, 2006–07, and 2007–08). Although excess deposits can exist for any type of tax (for example, personal income tax), past experience has shown that the largest deposits are for corporate tax. We examined the legislation governing advance deposits, refunds, and interest, as well as the Agency’s procedures for administering the legislation and managing advance deposits. We also looked at the role played by the Department of Finance Canada’s Tax Policy Branch in developing the legislation and helping the Agency to interpret the law.

Criteria

Listed below are the criteria that were used to conduct this audit and their sources.

Audit work completed

Audit work for this chapter was substantially completed on 18 February 2009.

Audit team

Assistant Auditor General: John Rossetti
Principal: Terry DeJong

Principal: Vicki Plant

For information, please contact Communications at 613-995-3708 or 1-888-761-5953 (toll-free).

Appendix—List of recommendations

The following is the recommendation found in chapter 4. The number in front of the recommendation indicates the paragraph where it appears in the chapter. The numbers in parentheses indicate the paragraphs where the topic is discussed.