Ten red flags that catch the taxman's eye
by Jamie Golombek, CA, CPA, CFP, TEP
Vice President, Tax & Estate Planning, Aim/Trimark
April 1, 2006

As you hunker down over the next few days to file your tax return by the May 1 deadline, you should know what raises the red flag when the taxman looks at your return.

National accounting firm Deloitte puts out an annual top 10 list of items on tax returns that are questioned most often by the Canada Revenue Agency (CRA). Following are the top red flags from 2004 personal tax returns:

1. Verification of capital gains and losses. The CRA has started asking for details of capital gain and capital loss calculations. These calculations can pose additional complexities when you dispose of certain investments such as income trusts or foreign currency investments. Income trusts pose a unique problem in that they often distribute a return of capital, which is not currently taxable but reduces your adjusted cost base (ACB). You need to keep a record of these ACB adjustments so that the correct capital gain or loss can be reported when the income trust is ultimately sold, which may be many years later. Return of capital information appears on your T3 slips. Also, don't forget about the foreign exchange component of any gain or loss. The calculation should be done by comparing the foreign exchange rate on the date of purchase with the rate on the date of sale.

"The CRA has started asking for details of capital gain and capital loss calculations."

2. Allowable business investment losses (ABIL). An ABIL is a special type of capital loss that occurs when you sell debt or small business corporation shares. The advantage of realizing an ABIL over an ordinary capital loss is that an ABIL may be deducted against all sources of income, including employment income, while capital losses may only be deducted against capital gains. In order for a loss to qualify as an ABIL, it must meet certain complex and strict rules. According to Deloitte, nearly all its clients who reported an ABIL on their 2004 returns were asked for additional information.

3. Carrying charges. While expenses incurred for the purpose of earning investment income – interest on borrowed money or investment counselling fees, for example – are typically tax deductible, it is essential to keep any documentation. And make sure no personal expenses are being claimed. For example, if a line of credit is used for investing, ensure that funds drawn from it are not used for personal purposes. If you need to use your line of credit for a home renovation or other personal need, it's best to establish a separate line of credit. That way, you keep your tax-deductible and non-tax-deductible interest separate.

4. Foreign tax credits. If you earn any foreign investment income, be sure to claim any foreign tax withheld as a credit on your Canadian personal tax return. This foreign tax credit can generally be used to offset any Canadian tax payable and will directly reduce Canadian tax dollar-for-dollar. Deloitte reports the CRA has been questioning entitlement to foreign tax credits and reviewing the amounts claimed.

5. Province of residence. Provincial residency continues to be an item of scrutiny for the CRA. Under Canadian tax law, you must pay provincial tax on your worldwide income based on your residence in a particular province on Dec. 31. Choosing to vacation in Banff on New Year's Eve doesn't make you a resident of Alberta. The determination of provincial residency goes beyond mere "physical presence" and looks to the province where the individual has the most significant residential ties.

6. Large charitable donations or donations of property. The CRA seems to draw the line at cash donations in excess of $25,000, asking for additional information to substantiate such donations. The CRA is also taking a closer look at donations of property other than cash.

7. Employment expenses. The CRA is paying closer attention to employees who attempt to deduct employment expenses from their employment income.

8. Child care expenses. Deloitte's partners have observed that many organizations provide receipts to parents for services that may not qualify for tax relief because their main purpose is not the provision of child care. Examples cited by Deloitte include athletic coaching, music lessons and tutoring.

9. Mining and oil and gas investments. There are specialized tax rules governing investing in resource properties. If you choose to invest in flow-through shares and other resource-based limited partnerships, you may wish to seek professional help as the CRA often requests additional information.

10. Tuition and education expenses. The CRA continues to ask for backup for any postsecondary tuition and/or education expenses claimed on a student's tax return. Keep copies of all tuition slips.

Content courtesy of AIM/Trimark