The Tax Gap: It’s Complex

The fifth report on the tax gap – the difference between taxes payable if all taxpayer obligations were fully met and what was actually paid and collected – was released this week by CRA for the 2014 year. Focused on corporate tax filers, large and small, a shortfall has been estimated at between $9.4 billion and $11.4 billion, but a closer look at the report finds most individual and corporate taxpayers try their best to comply with Canada’s complicated tax system.

By way of background, the government has published four tax gap reports, including a conceptual study on tax gap estimation and an estimate of the gap for the GST/HST, both in June of 2016, an estimation of the gap for personal income taxes in June of 2017 and an international tax gap on personal tax filing in June of 2018. The tax gap estimation, according to CRA’s website , is not precise. “The lack of precision of tax gap estimates was widely acknowledged by those who produce estimates due to data challenges, particularly in the international context,” the CRA noted at a conference of experts and international government officials at the Canadian Tax Foundation conference in June of 2017.

Further, the CRA points out that the tax gap is the result of both intentional actions, such as under-reporting or hiding income or over-reporting deductions and credits, as well as unintentional actions, such as mistakes in filing, ignorance of filing, reporting and payment obligations and during recessionary times, a lack of cash flow to pay tax debt. It is not clear in the report what percentage of these actuals were as a result of intentional tax evasion and what percentage was due to the complexity of the income tax system itself or a lack of understanding of taxpayer obligations.

CRA comments on these circumstances : “. . .changes to tax rules and economic events can affect the tax gap,” and noting in an example that “changes to a tax form can improve reporting compliance, while increased bankruptcies in a recession can make payment compliance worse. Therefore, tax gap levels are not fully under the control of the government. This also means that not every dollar of the tax gap can be collected (i.e. the tax gap will never be zero).”

This makes voluntary compliance under Canada’s complex self-assessment system an important goal. The CRA has a vital role to play here in reducing the tax gap by making tax rules more understandable. Working sooner with taxpayers who make mistakes is also critical. When tax assessments and reassessments reach back many years in retrospect, future tax compliance is much more difficult.

The Tax Gap, By the Numbers . The tax gap for tax year 2014, CRA has estimated the following shortfalls:

• $11.7 Billion or 8.6% of personal tax revenues. Further, there was an individual gap on international filings of between $0.8 and $3 Billion, with a payment gap of $2.2 Billion of assessed taxes owing.
• $2.9 Billion or 7.1% of GST/HST revenues
• Approximately $10 Billion or about 25% of corporate revenues

Depicted in a table:

* Unless specified otherwise. **Percentages of corresponding revenues are based on federal tax revenues from the 2014-15 fiscal year as published in the Public Accounts of Canada 2015-2016.

The Personal Tax Gap . CRA’s reporting has found a highly compliant taxpayer base: this tax base “is largely assured or at low risk of non-compliance with minimal direct CRA intervention – 86% of income assessed was considered as assured in 2014.” That’s quite remarkable but yet, due primarily to what CRA calls “extensive third-party information reporting.”

The Corporate Tax Gap. With regard to the corporate tax gap, compliance is more difficult for a number of reasons, including the fact that our tax system is based on self-assessment by the businesses themselves. They must bear the burden of proof across multiple tax regimes: personal, corporate, GST and often trust filings. Here is the background information released for 2014:

• There were approximately 2.1 million corporate tax filers, and 99% of them were SMEs (Small to Medium-sized Enterprises)
• Less than 1% were large corporations
• In total, all corporate tax filers reported about $298B in taxable income and $40.9B in total federal tax payable.
• Large corporations reported approximately 52% of the total corporate taxable income and paid about 54% of all federal tax assessed.
• Incorporated SMEs were estimated to be responsible for between $2.7B and $3.5B before audit results; and between $1.6B and $2.4B after audit, representing between 4% and 6% of all federal corporate income tax revenues.
• This means that 1% of corporate tax filers – large corporations – were responsible for 94% to 96% of the tax gap. Specifically, the federal tax gap for large corporations is estimated to be between $6.7B and $7.9B before audit. However, CRA auditors have been effective in quelling these numbers: the gap is estimated to be between $1.7B and $2.9B after audit, again representing between 4% and 7% of all federal corporate tax revenues

Source: T2 Corporation Income Tax Return, 2014 tax year as of November 2018. *Figures may not add to total due to rounding. **Given that audits for tax year 2014 are not all finalized, the potential federal tax adjustment from audit is projected from tax year 2011. These figures in the report do not include future audit adjustments and cannot be directly compared to other audit statistics published by the CRA, which are on a fiscal year basis and can include multiple tax years.

Source: T2 Corporation Income Tax Return, 2007-2014 as of November 2018; amounts reported on initial assessment. *The definition of incorporated SMEs and large corporations are based on gross revenues at initial assessment and therefore may differ from the CRA's corporate income tax statistics. Figures may not add to total due to rounding.

Source: Business Number Registration, 2014 tax year as of December 2018 and T2 Corporation Income Tax Return, 2014 tax year as of November 2018; amounts reported on initial assessment.

The Role of Auditing . What’s important are the results of random audit activity. For SMEs, CRA has reported that on 4500 audits, about 50% of SMEs made at least one reporting error on their corporate income tax returns, and about 38% of these were assessed an additional tax liability of about $1700. Just under 1500 secondary audits conducted on individual shareholders and related corporations resulted in tax adjustment in 68% of the files, mostly due to unreported or underreported shareholder benefits. CRA has taken from this the need for a “holistic approach” to taxpayer audits, meaning all of their related networks should be audited together.

The Takeaways:

• The good news, according to the CRA, is that the majority of corporations are compliant with their tax obligations.
• Those who are not compliant make it impossible for those who are to compete in a level playing field. Therefore, closing the tax gap is an important way to ensure competitiveness and a level playing field.
• As noted by CRA, the SME population is large and diverse, with thousands entering and leaving its ranks each year. They need help with compliance, and for their part, CRA takes a three-pronged approach to compliance: early education, detection, and enforcement. Regarding early education, a Liaison Officer service is available, conducting in-person visits or seminars “ to answer tax-related questions, addresses potential concerns, explains common tax errors, provides information on various tools and services offered by the CRA, and explains general bookkeeping concepts and best practices”. The 2019 budget has provided funding for more such visits.
• There is an important role for tax advisors in helping to combat non-compliance, and it is particularly important that tax specialists also take a Real Wealth Management approach to helping business owners. As CRA auditors increasingly use a holistic approach to their work, looking through personal, corporate and family filings, the lead in tax filings must be prepared to manage personal/corporate/GST and trust tax filings to ensure post-audit results are favourable for their client.

The Bottom Line: Projected revenues outlined in the most recent federal budget are expected to go up over the next five years, and therefore, likely, so is the tax gap.

Canada has a very complicated tax system and, given that, remarkably good compliance from the vast majority of taxpayers. 100% compliance is not a realistic goal, however, what is important is that a level playing field is available for everyone; which means that closing the tax gap is an essential component of competitiveness for Canadian businesses.

The initiative, assuming fairness, equity and a willingness by the government to work as hard on tax simplification as they do on tax enforcement, should, therefore, be supported.

Evelyn Jacks is Founder and President of Knowledge Bureau and the author of 54 books on personal tax filing, planning and sustainable family wealth management.

Additional educational resources: Help decrease the tax gap and encourage compliance with your clients by earning your DFA-Tax Services Specialist™ designation. With your specialization in personal taxation, you’ll be able to provide sound advice and prepare a broad range of returns as well as help families accumulate, grow, preserve and transition wealth with tax-efficiency.

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