Canada's audit protocol initiative for large-file corporate taxpayers: September 27, 1996.

For more than a year, Revenue Canada has been working to develop a new model to govern the manner in which audits of large-file corporate taxpayers will be conducted. During that time, the Department's representatives have met with taxpayer representatives - both formally, through the Large Business Advisory Council and liaison meetings with taxpayer groups such as Tax Executives Institute (TEI), and informally in multiple forums - in order to explain the audit protocol initiative and obtain taxpayer views and feedback. The consultation process has permitted the government to assess the feasibility of its proposals and to gauge likely taxpayer reaction should the initiative be implemented. In response to a request from the government directed to Vincent Alicandri, TEI's 1995-1996 Vice President for Canadian Affairs, I am pleased to provide the Institute's comments on the June 1996 draft of the audit protocol.

Background

TEI is an international organization of approximately 5,000 professionals who are responsible - in an executive, administrative, or managerial capacity - for the tax affairs of the corporations and the other businesses by which they are employed. TEI's members represent more than 2,700 of the leading corporations in Canada and the United States.

Canadians make up approximately 10 percent of TEI's membership, with our Canadian members belonging to chapters in Calgary, Montreal, Toronto, and Vancouver, which together make up on of our nine geographic regions. In addition, a substantial number of our U.S. members work for companies with significant Canadian operations. In sum, TEI's membership includes representatives from most major industries including manufacturing, distributing, wholesaling, and retailing; real estate; transportation; financial services; telecommunications; and natural resources (including timber and integrated oil companies). The comments set forth in this submission reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.

General

TEI commends Revenue Canada for undertaking an initiative to study approaches and implement procedures to improve the efficiency of large-case audits. For too long, large-file corporate taxpayers have endured substantial delays in the resolution of their income and excise tax audits. The sources of delay in the audit process are numerous and well-known, including the increasing complexity of the tax laws and the concomitant administrative and compliance burdens engendered; the tendency of tax auditors to issue overbroad or vague information requests that result in taxpayers' producing excessive, insufficient, or unresponsive records to support reported liabilities; downsizing or periodic reorganizations of tax departments and Revenue Canada alike that stretch the ability of remaining staff to address audit issues in a timely, efficient, and knowledgeable manner; and, quite frankly, the inherent tension in the audit process, which, if not managed openly and cooperatively by both sides, will inhibit communication and breed distrust.

Regardless of the cause, taxpayers and government alike are frustrated by the persistence of audit delays. Taxpayers are frustrated over uncertainty about their ultimate tax liabilities while nondeductible interest accrues on deficiencies. On Revenue Canada's side, government revenues are not collected in a timely fashion and the inventory of open tax years mounts. TEI appreciates both the opportunity to comment on the proposals for an audit framework for large-file corporations and the government's implicit recognition that large-file taxpayers have such a significant stake in the tax compliance process that they can be trusted as cooperative partners in the resolution of issues causing bottlenecks.

In addition, TEI appreciates the flexibility Revenue Canada has demonstrated in modifying the format of its earlier proposals. Notwithstanding the good faith nature in which the initial drafts were conceived, taxpayers viewed some aspects of the audit protocol framework as intrusive, one-sided in favor of the government, and counter-productive to the goals of increasing the efficiency and currency of audits. Moreover, had the earlier drafts been implemented, they could have undermined other Revenue Canada initiatives that have yielded steady improvements in audit cooperation. We urge the government to continue to heed taxpayer criticisms and modify the framework to address taxpayer concerns as they arise. In other words, a mechanism should be developed, and timetable established, to review whether the audit protocol framework in the Reference Manual and the manner of its implementation "make sense" in light of changes in the tax law, availability of resources, and improvements in audit and management practices. Audit protocols, in our view, are evolutionary tools that must adapt to their environment.

Managing the Audit Process

TEI believes that effective, timely, and efficient audits depend on the professionalism, judgment, and communication skills of government auditors and corporate tax managers. With or without a protocol, the personal attributes of the individuals involved will be crucial elements in managing the audit relationship and improving audit efficiency and currency. Regrettably, these attributes can neither be inculcated nor learned by reading an audit manual or by signing a protocol.

Even though personal skills will have a greater effect on the process than a protocol, we agree that there is value in establishing mutually agreed expectations, benchmarks, timetables, and dispute resolution methodologies. Our support for the initiative derives from the simple notion that the communication process employed to establish the protocol initiative's overall scope and procedures typifies, on a larger scale, the taxpayer-government communication that will be employed to develop individualized protocol agreements. In our view, any steps undertaken to enhance taxpayer-government communications will likely improve the audit relationship.

Mandate or Agreement

While the government has made substantial strides in removing objectionable features from the protocol (e.g., eliminating the requirement that Revenue Canada be permitted to appoint a representative to serve on the company's audit committee), the tenor of the draft protocol remains, in our view, closer to a mandate than a consensual agreement reflecting mutual benefits and obligations to the parties. The government's offer of real-time audits, concurrent audits (whether of income and GST liabilities at the federal level or of federal and provincial taxes), and limited audits (compliance checks) for various legal entities is intended to provide the taxpayers with incentives to enter the agreements. We question, however, whether those incentives are sufficient to induce widespread, voluntary participation by taxpayers.

Of the three audit initiatives, only the promise of limited audits is. universally beneficial for taxpayers. For some taxpayers, the incentive of eliminating full-scale examinations of some tax years for some entities (or the entire group) will prove sufficiently alluring to justify signing a protocol.

We are aware that real-time audits (i.e., audits of discrete issues or transactions conducted prior to filing the return) have been successfully completed. Indeed, taxpayers that have successfully completed one are generally enthusiastic supporters and view the initiative as an effective tool to eliminate issues up-front in order to expedite audits at the "back-end." Nonetheless, real-time audits may be impractical for taxpayers to undertake or manage. In many cases, shortstaffed tax departments are already under considerable time pressure to meet the return-filing deadline. Obliging tax department personnel to respond simultaneously to information requests from the auditor and timely file the tax return will not be appealing to some tax managers. In addition, managing a real- time audit in a fashion that permits the "contingent numbers" (i.e., the numbers from the accounts and transactions subject to the real time audit) to be included in the tax return poses a formidable challenge. Specifically, how does the tax manager impress upon the government auditor a sense of urgency to finish the real-time audit in order to complete and timely file the return? Moreover, the draft protocol acknowledges that real-time audits should be reserved for limited situations. Consequently, TEI supports the real-time audit option as an effective resource and time management tool benefitting both taxpayers and the government, but we question its incentive value in encouraging participation in the audit protocol initiative.

Finally, concurrent audits - whether of federal income and GST taxes or of federal and provincial taxes - may pose a far greater burden than benefit to taxpayers, depending upon the organization of companies. For example, in many companies GST records and tax filings are maintained by operating divisions or companies, which may be in a distant location from the corporate headquarters. On the other hand, corporate headquarters staff may prepare the income tax returns for all of the group's operations. In this example, concurrent audits of income and GST taxes would be a burden rather than a benefit. In respect of concurrent federal and provincial audits, TEI believes that some of the proposals being reviewed by the Canadian Tax Commission offer far greater potential for increasing taxpayer compliance, improving audit efficiency, and simultaneously reducing taxpayer burdens. Thus, we recommend that the last bullet point of the Statement of Purpose in the Audit Protocol be deleted, pending recommendations from the Tax Commission.

In addition, we believe that there are a number of existing practices and traditional audit approaches currently employed by Revenue Canada that should be reaffirmed and incorporated in the Audit Protocol Reference Manual. By recognizing that there are good or best practices that have withstood the test of time, the proposed document will be greatly improved and assure taxpayers that the protocols will not diminish protections otherwise accorded to them by law or customary audit practice.

Examples of statements that should be included:

* No changes in administrative

settlements will be made except

on a prospective basis and

with prior notice to the taxpayer.

* Taxpayers will be permitted to

review audit adjustments before

the reassessment is issued.

* No requests will be made for

general waivers of limitations

of time for assessment of tax.

* No reviews will be conducted

of previously examined tax

years once an audit is complete,

absent evidence of fraud.

* Revenue Canada auditors will

not make threats of arbitrary

assessments.

* Revenue Canada auditors will

follow Appeals settlements in

subsequent audits.

Moreover, Revenue Canada should commit to provide reasonable resources to large-case file managers to permit them to meet agreed service delivery targets. For example, if the assistance of a specialist is necessary or an issue requires advice of the National Office, Revenue Canada should be willing to commit in the individual protocol to provide those resources on a timely basis.

Design, Implementation, and

Administration of Protocols

Absence of a Protocol or Revocation of Existing Protocol. Question and Answer 11 of the Draft Audit Protocol Reference Manual states that a protocol may be revoked because it is not a legally binding agreement. We agree that an audit protocol is an exhortative statement of goals and objectives to guide the conduct of an audit rather than a legally binding agreement. Several important consequences flow from this posture. First, the revocation of an agreement with a taxpayer or, more likely the case, the taxpayer's refusal to enter a protocol agreement should have no effect on the scope of the audit inquiries, the procedures employed, or the number of transactions or entities examined. In other words, a taxpayer who refuses to enter a protocol (or revokes an existing agreement) should not be subject to more rigorous procedures or more onerous requests for documentation than other taxpayers of similar size or risk of noncompliance. Such taxpayers, of course, are not entitled to the benefit of limited audits (compliance checks) as a matter of right; that incentive is plainly the government's tool to reward compliant taxpayers. Thus, we recommend that a Question and Answer be added to the Reference Manual to clarify that no negative inference will be drawn from and no more burdensome audit will be conducted as a result of a taxpayer's declining to enter into a protocol or revoking an existing agreement.

Administration of Protocols. During the course of nearly every audit, circumstances arise that are entirely outside the control of either the taxpayer or the government. In administering the protocols, the commitments undertaken in the protocol should be viewed as flexible goals and objectives rather than rigid checklists. The importance of flexibility in the design, implementation, and administration of the agreements in particular audit cases should be stressed in the Reference Manual. We recommend that a statement be added that emphasizes this.

Design and Implementation of Protocols. Clearly, the individual protocol documents must be tailored to take account of each taxpayer's industry-specific issues, the facts and circumstances of the taxpayer's tax history and attributes, and its accounting and information system. The Reference Manual's outline of a protocol agreement must be viewed as a flexible model rather than as a prescribed one-size-fits-all agreement. Indeed, we believe it is critical that the audit protocol explicitly acknowledge this. Based on Question and Answer 5 of the Reference Manual, our recommendation is likely consistent with Revenue Canada's intent. Nonetheless, Revenue Canada may wish to provide additional guidance concerning the types of issues significant enough to warrant special mention in the particularized documents. Some examples include the presence or absence of industry issues; the treatment of continuing or "rollover" controversies; and the manner in which audit issue back-logs will be handled.

Miscellaneous Issues

and Recommendations

1. The audit plan guidelines state that "parties to a protocol are free to add other items, as long as they follow the principles ... in the protocol." We recommend that the words "or delete" be added immediately after the word "add" in that statement.

2. The audit plan guidelines state that a list of all identified audit issues should be developed company by company. We recommend that the statement be modified to state that "Revenue Canada will list all initially identified audit issues company by company."

3. The audit plan guidelines state that the large-case manager will commit to keeping the corporation regularly informed about the status of the Department's queries, including findings." In addition, the audit protocol states that the large-file case manager is responsible for managing the relationship. We recommend that the audit protocol be revised by adding a bullet point to clarify that "The audit protocol will be administered through regular meetings between the tax manager and large-file case manager."

Conclusion

TEI is pleased to have the opportunity to present its comments in respect of the audit protocol. TEI's comments were prepared under the aegis of its Canadian Income Tax Committee, whose chair is Alan Wheable of Canada Trust. Should you have any questions concerning the Institute's comments, please do not hesitate to call either Mr. Wheable at [phone], or J.A. (Drew) Glennie, TEI's 1996-1997 Vice President for Canadian Affairs, at [phone].