The Income Tax Act (the Act) requires a corporation carrying on a business to maintain adequate records and books of account. Such records are not required to be maintained in any particular form, but must be sufficient to determine the amount income tax, if any, a corporation owes under the Act—this requirement is commonly referred to as “the tax determination standard”. The decision of whether to retain certain sensitive records depends on the facts of the particular situation and can only be determined on a case-by-case basis.
Generally, if you have any records that you are confident are not necessary to enable taxes payable under the Act to be determined, the records may be culled (unless there is some other compelling business reason to maintain the record). There has been limited consideration by the courts regarding the type and scope of documents covered by the tax determination standard. The tax courts have held that a judge should not draw an adverse conclusion against a taxpayer that culls documents in accordance with a sound record retention policy.
The Act gives the CRA the power to inspect, audit, review, or examine the books and records of a corporation and any document of the corporation or of any other person (including third parties) that relates or may relate to a corporation’s books and records that may be relevant to the administration or enforcement of the Act. Subject to solicitor-client or litigation privilege, CRA officials are authorized to request and receive any documents needed to conduct a proper inspection, audit, or examination. If your corporation is subject to an audit, then excessive, inaccurate, subjective, or misleading records can lead to costly inefficiencies (i.e. to the extent that unnecessary/inappropriate records extend or shift the focus of an audit).
If a CRA audit has begun, records should not be culled; significant penalties could be imposed in such circumstances.
Record Retention Policy
Proper management of tax sensitive records may assist your corporation to succeed in, or avoid, tax disputes with the CRA. It is thus advisable for corporations to develop and follow a formal record retention policy that sets forth what records must be retained and what records may be culled. The culling of records is a delicate matter, and the record retention policy should be carefully drafted and appropriately address specialized areas.
Some general best practices related to record retention policies include:
Formal documentation that evidences agreements or that executes a transaction must be retained, however, progressive drafts should be culled;
Generic tax proposal materials from advisors, or tax articles dealing with a particular tax issue, are not “records” that are required to be retained;
In the case of significant transactions, the corporation and external legal counsel, accountants, and other professional advisors should undertake a formal post-closing records retention review. Generally, all items of any kind that are not needed to meet the tax determination standard should be discarded. For example, old records, draft documentation, and redundant documentation that are not required to be maintained in accordance with the tax determination standard should be culled to avoid possible audit inefficiencies. The final form of documents/agreements is what enables the tax determination standard to be met;
A corporation should work together closely with legal counsel and external accountants to proactively plan for the manner in which advice will be sought or received to avoid compellability and enable advice to be subject to solicitor-client privilege;
In respect of documents protected by privilege, it is important to take steps to ensure that the privilege is not compromised. For example, circulation of legal opinions by a corporation should be limited (care should be taken, for example, in who is copied in e-mail communications), legal opinions should be filed in a separate file properly marked “privileged”, copies of legal opinions should not be provided to third parties, and third parties should not be permitted to review the documents (ideally, documents and records protected by privilege, including documents and records prepared by the taxpayer, its external accountants, or its lawyers, should be clearly marked as privileged and confidential and held by the corporation’s lawyers, and access to such documents should be restricted to pre-determined authorized individuals);
If it is necessary to provide a privileged document to a corporation’s agent, such as an accountant, the agent’s role should be clearly documented in advance of the document being provided. In the case of an inadvertent disclosure of privileged information, as soon as the corporation becomes aware of the disclosure, immediate action should be taken to assert privilege;
Certain records that contain potentially sensitive information and that are not protected by privilege should be clearly marked as confidential, and copies should only be provided to a defined list of people in the organization who require access to the records for a particular purpose;
Subjective internal correspondence outlining tax risks, or internally generated tax memoranda, may lead to additional audit scrutiny and more detailed audit requests. Such records should normally be culled as they are unlikely to be required to be maintained to meet the tax determination standard. A corporation may be of the view that retaining a particular document could be of assistance in proving the related tax position if the position is challenged. In determining whether to retain a record in such a case, it should be considered that such documentation generally does not provide strong evidence of subjective intention. Ultimately, the tax results of a corporation for a taxation year depends upon all the transactions engaged in by the corporation in the year—the tax results are not driven by any particular person’s opinion on the tax consequences of a transaction. The tax determination standard does require a corporation to inform the CRA of what it subjectively considers to be its weaker and stronger tax positions. Preferably, the record retention policy should establish what records are required to be maintained in respect of particular matters, and such records should be created from the outset as stand-alone items that are intended to be retained. If a corporation considers it necessary to maintain a portion of certain internal memoranda to satisfy the tax determination standard, a new memorandum should be prepared that only contains the information that the corporation considers it necessary to retain;
The record retention policy should recognize the fact that the ability to cull redundant or unnecessary records ceases once the CRA makes any request for information in the course of an audit or issues an information request (i.e. if the corporation is in possession of the records at such a time, the records cannot be culled after they have been requested).
Tax Accrual Working Papers (TAWPs)
Sensitive information is normally contained in a corporation’s TAWPs, and the CRA may request access to these records. The tax courts have indicated that the CRA is precluded from unrestricted access to TAWPs on a prospective basis since a taxpayer should not be required to “self-audit”, but that the CRA is permitted to access TAWPs in the context of an active audit of particular issues. The CRA’s position on this sensitive matter is set forth in Directive AD-19-02R:
Obtaining Information for Audit Purposes, in which the CRA states in part:
CRA officials can seek production of tax accrual working papers provided that the request for such records is undertaken in accordance with this communiqué.
Certain taxpayers are required to report tax reserves for financial reporting purposes. Tax accrual working papers are the documents maintained by a taxpayer or by the taxpayer’s external representative that show the calculations for the tax reserves reported on its financial statements. Tax accrual working papers can be requested where they are relevant to a specific item under audit. Tax accrual working papers, particularly the list of uncertain tax positions, can also be requested to identify audit issues in the context of an ongoing audit. This can be done in circumstances where CRA officials determine there is a higher risk of non-compliance. Factors that may be considered include the taxpayer’s past level of compliance, the existence of large unexplained tax reserves, and the potential tax-at-risk.
In recognizing and measuring the effect of tax uncertainties for financial reporting purposes, there is a fundamental assumption that the tax authority will examine the tax treatment of these uncertainties, and have full knowledge of the related information when making those examinations. Hence access to tax accrual working papers may be necessary in certain cases in determining whether these positions as reported in the taxpayer’s tax return are in fact allowable under the ITA.
A taxpayer may claim that the tax accrual working papers include information subject to solicitor-client privilege. The CRA cannot compel production of privileged communications. Communications between the taxpayer and its lawyer seeking or providing legal advice on whether or not the taxpayer is required to claim a reserve would typically be privileged. Whether or not a taxpayer receives legal advice concerning its tax reserve, a taxpayer reporting a tax reserve will make a determination as to which uncertain tax positions to include in the reserve. The taxpayer’s list of uncertain tax positions that relates to the tax reserve in their financial statements is not a privileged document. A taxpayer also has the right to waive privilege over privileged communications.
CRA officials must be objective when reviewing any information or documentation obtained during an examination. It is important not to be influenced by any subjective analyses, comments or opinions contained in the information or documentation reviewed. While CRA officials may, in certain circumstances, request a list of what the taxpayer has determined to be its uncertain tax positions, in considering the structures and transactions outlined, CRA officials should perform their own research and analysis in forming the basis of any reassessment. Provided all the relevant facts of the transactions are disclosed, including the taxpayer’s purpose or purposes in undertaking a transaction or series of transactions, exclusions of their advisors’ analysis of the legal and tax effects of the transactions may be accommodated.
The CRA’s position is that taxpayers are required to disclose sufficient detail regarding their business and tax transactions for the CRA to fulfill its mandate of assessing taxes owing. Where the criteria outlined in the communiqué are met, the CRA considers that it retains the right to request tax accrual working papers, including a list of uncertain tax positions. A request for the taxpayer’s list of uncertain tax positions in these circumstances is not a request that the taxpayer self-audit. The CRA may audit transactions underlying these positions and will make its own determination as to the tax effects of the transactions. Overall, the onus remains with the taxpayer to report and pay the correct amount of tax pursuant to the ITA or ETA under Canada’s self-assessment system. In order to develop a consistent practice across the country, for a one-year period from the date of the issuance of this communiqué, prior to requesting tax accrual working papers, the Taxation Services Offices are required to refer the case to the applicable HQ audit function using the existing National Early Warning System (NEWS) for requests of these working papers.
Furthermore, in Views Document No. 2018-0779971C6, the CRA states:
CRA officials can seek the production of tax accrual working papers provided that the request for such records is relevant to specific risks or items under audit, and the CRA official is using a certain level of restraint in seeking this information. Tax accrual working papers may be sought where there are identified unresolved tax issues and there is a higher risk of non-compliance. Factors that may be considered include the taxpayer’s past level of compliance, the existence of large unexplained tax reserves, and the potential tax-at-risk.
A taxpayer may claim that the tax accrual working papers include information that is subject to solicitor-client privilege. The CRA cannot compel production of privileged communications, but a taxpayer has the right to waive privilege. The taxpayer’s list of uncertain tax positions that relates to the tax reserves in the taxpayer’s financial statements is considered to be part of the taxpayer’s books and records and is not a privileged document unless otherwise demonstrated.
As outlined in the Communiqué, CRA officials must be objective when reviewing any information or documentation obtained during an examination. It is important not to be influenced by any subjective analyses, comments or opinions contained in the information or documentation reviewed. While CRA officials may, in certain circumstances, request a list of what the taxpayer has determined to be its uncertain tax positions, in considering the structures and transactions outlined, CRA officials should perform their own research and analysis in forming the basis of any reassessment. Provided all the relevant facts of the transactions are disclosed, including the taxpayer’s purpose or purposes in undertaking a transaction or series of transactions, exclusions of their advisors’ analysis of the legal and tax effects of the transactions may be accommodated.
The CRA’s position is that taxpayers are required to disclose sufficient detail regarding their business and tax transactions for the CRA to fulfill its mandate of assessing taxes owing. Where the criteria outlined in the communiqué are met, the CRA considers that it retains the right to request tax accrual working papers, including a list of uncertain tax positions. A request for the taxpayer’s list of uncertain tax positions in these circumstances is not a request that the taxpayer self-audit. The CRA may audit transactions underlying these positions and will make its own determination as to the tax effects of the transactions. Overall, the onus remains with the taxpayer to report and pay the correct amount of tax pursuant to the ITA or ETA under Canada’s self-assessment system. The Communiqué will be posted on the Government of Canada’s Canada.ca website and stakeholders will be notified through CRA’s stakeholder desk notification service.
Balanced against the requirement to prepare financial statements in accordance with GAAP, corporations should exercise appropriate caution regarding the contents and nature of TAWPs.
TAWPs will not normally be protect by solicitor-client privilege. As an exception, legal opinions related to sensitive tax issues should be protected; such opinions and related documents should be filed separately from regular TAWPs, clearly marked as privileged and confidential, and be held by the corporation’s lawyers. When a material uncertain tax position is identified, in considering whether legal advice thereon should be obtained, a corporation should consider the potential value of privilege. Communications regarding legal advice in respect of an uncertain tax position should generally be protected by solicitor-client privilege, as should accounting working papers that summarize the privileged information where the accountant works as an agent of the lawyer (i.e. where the accounting working papers are prepared as confidential written communications addressed to legal counsel for the purpose of providing an opinion on the reasonableness of the conclusions outlined in the privileged information).
As with any legal opinion, to avoid unintentionally waiving privilege and/or to avoid the necessity of defending such privilege, a corporation should prevent outside parties, including external financial statement auditors, from obtaining hard copies of records that are protected by privilege. It may, however, be necessary to allow the external financial statement auditors to have limited access to the privileged documents for the expressed limited purpose of conducting the audit. In such a case, it it should be confirmed with the external auditor that the working papers should not be released to the CRA without the corporation’s express consent.
A corporation should request that the financial statement auditor destroy sensitive tax working papers when they are no longer needed.
Books and Records Retention Period
A corporation’s permanent records (i.e. minutes of directors’ meetings and shareholders’ meetings, share registers, the general ledger, and any special contracts or agreements necessary to an understanding of the entries in the general ledger) must be retained from the date of incorporation until two years after the day on which the corporation is dissolved.
Subject to certain exceptions, all other records and books of account, together with every account and voucher necessary to verify the information contained therein, must be retained until the expiration of six years from the end of the last taxation year to which the records and books of account relate. Such non-permanent records of a corporation may be culled after the six-year retention period. As an exception, a dissolved corporation is required to retain the non-permanent records that it has on hand in accordance with the six-year retention rule for two further years from the date of dissolution.
The reference to the expiration of six years from the end of the last taxation year to which the books and records relate is to be read in context. For example, if records support the ACB of a property, such records should be maintained until six years after the property is disposed of to support the computation of the capital gain.
An extension to the normal required retention period applies where a corporation has failed to file a tax return, has filed a notice of objection, or is party to an appeal to the Tax Court. The exception is intended to ensure that books and records relating to a taxation year for which a tax return has not been filed be kept for six years from the date of the actual filing of a return, and that all records, books of account and supporting vouchers necessary for dealing with an objection or an appeal be maintained until the time for filing an appeal from an assessment or reassessment has elapsed, until any appeal or further appeal is ultimately disposed of, or until the time for filing a further appeal has expired.
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