Cheating on Your Income Tax ?

Here are some things you should know about the folks who are trying to catch you

GRATTAN GRAY April 1 1974

Cheating on Your Income Tax ?

Here are some things you should know about the folks who are trying to catch you

GRATTAN GRAY April 1 1974

Cheating on Your Income Tax ?

Here are some things you should know about the folks who are trying to catch you

GRATTAN GRAY

It is that time of year again when a number of Canadians — no one knows how many, but a lot — sometimes by error but more often by design, coolly cheat their government and the rest of us of half a billion dollars. That’s an educated guess — accurate to within five million dollars either way — from D. Scott Brown, head of the research and statistics section of Ottawa’s tax department. It represents the gap between what Canada’s 10.2 million taxpayers actually pay and what they should pay.

Some of these people will be caught almost immediately; some will be caught eventually; some, never. Trials will be held, fines levied, and a handful may ultimately go to jail for income tax evasion. But the vast majority of tax fiddlers will probably get away with it.

To find out exactly what happens to an income tax return, Maclean’s assigned me to follow one into the very bowels of' the bureaucracy in Ottawa and, if I survived, to write about it. Well, the odds on being caught depend directly on the odds on being audited, which is when the tax collectors examine your records to determine whether or not you have computed your tax correctly. As nearly as I can calculate (with some very unofficial help) the auditing odds are set out for the first time on the opposite page. But they only tell part of the story.

First of all, the tax collectors don’t call themselves the Department of National Revenue anymore, they’re Revenue Canada, Taxation, now, to tie in with Statistics Canada, Information Canada, and so on. Secondly, they’re trying to change their image. An end to fear and loathing; they call us “clients” now, and they take video tape courses in courtesy. But basically a tax collector is just that, and they haven’t changed a great deal in the last 2,000 years.

The taxman’s central sanctum is in Ottawa’s southern suburbs, two glass and concrete structures in a black and white decor. I suppressed the thought about black and w'hite thinking; it’s too easy to seize a conclusion and then find facts to fit.

The marble of the lobby is softened by modulated lighting and enlivened by hordes of miniskirted women, chattering their way into the Data Centre, more commonly known as the “pipeline.” The pipeline takes up several floors of big, bright desk-packed rooms where, at the peak period, which is right now, about 5,000 women, most of them housewives, earn extra money by part-time work. It’s like an assembly line as they slit open the envelopes, strip off the cash, check arithmetic, tabulate refunds and rearrange documents for a fast check by the computer. Jack McKercher, then the chief assessor of Revenue Canada, Taxation, escorted me through the pipeline and explained that roughly 4.5 million “profiles” go through quickly. “If you’re on salary,” he told me, “earning less than $15,000 a year, have less than $100 investment income and no dependents over the age of 21, we don’t even look at you. We take a calculated risk and keypunch you through.”

But this degree of trust is more apparent than real, because he means they keypunch you right into the computer. Of the

$13.5 billion extracted from individuals in the last tax year, about 82% came from payroll deductions, for which employers must file T4 slips. Companies file T5 slips showing dividends paid and to whom. Banks file T5 slips showing interest payments and T600 slips showing bond interest and these are matched with the individual returns. In 1972 Revenue Canada, Taxation caught about 1,500 employers who had failed to send in T4 slips; many of these were audited, some were prosecuted and fined. The matching by computer of T4 slips has been increased from 10% five years ago to 100% today, which means that all you can get away with is an error of up to $ 15.

Besides checking arithmetic and cross-matching returns with T4s, the computer also keeps track of alimony payments, other income, and sets roughly one third of the returns aside for a second, closer look. It also rejects about 500,000 for errors such as a miscalculated pension payment, or insufficient information on a deduction. The computer tolerates errors totaling five dollars.

All T4s are matched, but it only compares a random sampling of T5s and T600s, anywhere from 2% to 25% depending on what McKercher thinks compliance is at any given time. “We used to be considered hard-nosed and ‘inward looking,’ ” he told me. That term “inward looking” is a euphemism for secrecy. “For years, we resisted pressure from chartered accountants to release our assessing guide, which is our interpretation of the law.”

But in 1970, Sylvain Cloutier became deputy minister and decided to push the image óf a “department that is fair and impartial, diligent and firm, efficient and courteous.” Last year the tax officials began to implement what they refer to as a “new open-door policy.” They set up a free long distance telephone advisory service and mailed out millions of booklets and information circulars that give the department’s interpretation of the law.

For the moment, most of McKercher’s energy is directed at getting out the refund cheques as rapidly as possible, but come the end of May and he becomes the cop on the beat, a reference to crime prevention that is much used by tax men. “If we want people to comply voluntarily,” he says, “we have to show that we have the controls.”

He attempts to demonstrate this by sampling at least once in three years every field on the return, each of those little black circles that number such items as “tips and gratuities” and “interest” and “alimony or separation allowance paid.” The computer prints out a list of taxpayers in alphabetical order for each of the 28 district offices, and some of their 1,378 assessors pull files from the list at random and check the item in a sort of mini-audit.

In 1972-73, for example, the department looked at awayfrom-home expenses for transport drivers at a rate of up to 25% of returns, depending on the district. “We found a lot of them putting in expenses when they weren’t even driving out of the city,” McKercher says. “We’d

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been neglecting the field and it had got completely out of hand. One trucker would tell another, ‘You’re a damn fool not to put in expenses,’ and they had begun to think it was their God-given right to charge off a couple of thousand dollars a year. We negotiated with the unions and employers and found out the distances traveled, and last year we checked everyone with more than $200 in expenses on 25% to 100% of the total.”

In the same year, McKercher’s assessors caught 3,222.000 errors. They reduced the taxes of 1.558.000 people by an average of $61 and reassessed the others for an average increase of $123, showing a net gain for the treasury of $47,252,000. This does not include the cases turned over to the audit branch, which is the most feared and the least understood branch of the operation.

The tax men say they don’t pick on any particular group of taxpayers but certainly those with the greatest opportunity for evading taxes are the most suspect: contractors, store owners, tradesmen, commission salesmen, farmers, fishermen, doctors, lawyers, athletes, writers, self-employed people of all kinds. The computer groups them according to source and size of income, and channels the printouts to Carl Palmer, director of audit programs.

Palmer’s job is to close that half-a-billion-dollar tax gap. He has to patrol 1.5 million self-employed individuals.

250.000 corporations and 122.000 trusts. But the 28 district offices have only 2,800 auditors and they can only handle about

80.000 audits a year. “We obviously can’t check everybody,” Palmer says, “and we don’t want to bother people who are reporting honestly, but we don’t know who is and who isn’t. So we have a research group to tell us what the tax gap is in each category.”

“The cloud nine guys,” as operations research chief D. Scott Brown calls his mathematicians, decided they couldn’t figure out the total tax gap — “we’d just sit around and cry” — so they apply their tables and formulas to samples of returns to pick the worst (and richest) pockets of noncompliance.

“If one class yields $30 an hour [of an auditor’s time] and another $70. I’ll recommend the $70 class,” says Brown. “But it’s tricky. You have to think of what noncompliance may cost in future years, so we sit down with Palmer and haggle and compromise and we end up doing some classes one year and some classes another, which means it takes Palmer four years to sample every category of taxpayer.”

Palmer denies that the auditors work on an adversary basis, but he still talks in battle terms. “We're the staff advisers,” he says, “the generals.” He is aware of the new open-door policy, but his audit program is designed to make

us afraid to cheat. The department’s enforcers, the special investigators, call it “spreading the fear.”

Palmer is locked in a complex workworld of semi-secrecy. He speaks guardedly of the percentage he audits in each class and adds that “at the top we have 70 corporations grossing $200 million or more, and at the bottom 275,000 small farmers grossing $15,000 or less. People say we should pay more attention to the big people and less to the little people. Sure, we’d like to give a lot of attention, say 100%, to the top, but we want to give some attention, say 3%. to the bottom. In fact, because we have trouble getting staff with the necessary skills, in 1972-73 we did only 57% and 1% at the two extremes.”

Some people think if they file in April they have less chance of an audit, but filing early or late makes no difference. Five times a year Palmer sends the district offices a printout of all the businesses and all the taxpayers in the class he wants audited, and a taxpayer’s

chance of being on it increases with his earnings, cash income, and the slackness of his bookkeeping. In 1972-73 the classes audited included farmers and fishermen, professionals, commission salesmen, people with investment and rental income, plus special projects, for example, landowners who were writing off “farm losses” against their incomes as doctors or businessmen.

A special project can be anything. Palmer says it could be anyone who’s written a best-selling book. “There aren’t many of these so we might do 100% of them.” But in general audits of individuals range from 2% in the huge lower income ranges to 25% in the smaller high income brackets.

From all of this the odds on getting away with a tax fiddle seem to be high: first, the odds are three or four to one that your range will be picked in any given year, then between five and 50 to one that your file will be pulled. But such simple arithmetic is deceptive.

For one thing it depends on where you live. According to Thomas Ferguson, a Toronto tax consultant, you can get away with more in Toronto, Montreal and Vancouver than in less

crowded, more compact centres like Charlottetown. He claims that an employee in the Charlottetown district office has 960 taxpayers to check, while his counterpart in Toronto, has 1.300. The result: “A businessman reporting $15,000 income in Toronto after charging $3.000 worth of improper expenses will almost never be caught. His counterpart in Charlottetown hasn’t a chance of getting aw'ay with it.”

Your style of living may pique the curiosity of an auditor. One moonlighting civil servant was fined for concealing his second income after a newspaper carried a picture of his yacht. An Ottawa businessman paid three years of back taxes and a fine when an auditor read that his basement safe had been robbed of $100,000.

You can be audited on a tip: an envious neighbor, a disgruntled employee. Most tips are checked out although stoolies aren’t paid as they are in the U.S. A tip from a jealous wife recently led to conviction of a Toronto businessman who was writing off his mistress’ apartment rent as her office salary.

But your biggest hazard is the system at the district office, where the files for audit are divided into two chunks. Arthur Frederick, chief of the business files section in Ottawa, explained that a lot of people can’t afford accountants. “They’ll keep some vouchers and some canceled cheques, and mark things down in a little black book. We ask them to bring their records in here. That’s an office audit. If w;e asked a businessman to bring in his records he’d need a van, so we go to him. That’s a field audit, the great bulk of our w'ork.”

As an auditor gathers experience he advances from office audits to field audits, then into the higher income ranges. Frederick headed an elite seven-man group which handles companies grossing more than $25 million annually. When the printouts come in, Frederick pulls all the files for a screening process called “eyeballing.”

“With some files,” he says, “you know right away that something is wrong. You get a kind of sixth sense about it. The inventory is too low. The legal expense is too high.” In 1972, businessman Glenn Eaton of Elmwood, Ontario, passed off the cost of his divorce as a business expense. Both he and his Kitchener lawyer, Jan Joseph Munk, were convicted.

Palmer may only be calling for an audit of one in 10, but “eyeballing” is an art that cuts your odds on getting away wfith anything. The group head checks ratios: sales to expenses, gross income to net. He notes an 8% profit margin that his tables show' should be 15%. He notices that you were once convicted of tax evasion and looks more closely. He sees foreign travel written off with no indication of income from it. “Here’s another

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potential,” he thinks, and he writes on a form for the auditor, “These are the points 1 want checked.”

An office auditor may simply telephone you to clear up these points or he may ask you to bring your records in. You sit at a table in a small, bare room and he watches your reactions. “We try to put you at your ease,” said Jean Guy Chartrand, soft-spoken chief of office audits for the Ottawa district. “We want to give you a chance to explain. What we’re looking for in most cases are phony purchases, padded expenses, or personal expenses disguised as a business cost, especially w'hen a car is used for both. But if you’ve just overlooked something, we’ll give you the benefit of the doubt. Of course, if you show a $10,000 income and drive a Cadillac, it might indicate something out of line.”

In 1972-73 Chartrand’s 19 office auditors averaged 10.4 hours per audit, and recovered an average of $222 an hour.

Sometimes taxpayers try for special treatment by claiming political influence, but all this does is make the auditor more than usually careful. “Anyone who knows the system.” says an Ottawa district supervisor, “knows the minister hasn’t time to look at a tax return. He gives it to his aide, who gives it to us, who write an answer for the minister to sign. And we go by facts.”

Auditors admit your right to shave your tax in any way the law permits, but when they see what they call tax avoidance they pass it on to a group of nine accountants and a lawyer, and if they decide that you’re using a loophole in the law to escape its intent they try legal action. The group’s director is Howard Stevens.

In the 1950s, a few businessmen were avoiding taxes by “dividend stripping”

— selling shares to an associate at dividend time, and buying them back afterward, thus converting income to nontaxable capital gains. The scheme grew in sophistication but its purpose remained the same: to get profits out of the company and into the shareholder’s pocket tax-free.

By 1961, Stevens says, “everybody was doing it. Tax planners — we call them strippers — were rolling out strips like toilet paper. The leading stripper was F. H. Cameron, a former used car salesman. You should have seen his fees

— $41,000 for one strip!”

By 1963 Stevens reckoned 470 corporations had siphoned off profits estimated at $200 million. He decided to test the law, and assessed C. Smythe Ltd., a sand and gravel business owned by Conn Smythe, Stafford Smythe and Clarence Day, for $728,652. As the court revealed the story in 1967, the Smythes had transferred their assets to a new company, C. Smythe For Sand Ltd., in return for a promissory note of

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$2.611,769. Then they sold their shares in the old company to two Vancouver companies owned by Cameron for $2,570,336. Cameron then arranged for a bank loan to pay off the shares, while the Smythes got a bank loan to pay off the note. Then each, in effect, paid off their banks with the bank loan of the other. “The result,” said Mr. Justice Gibson of the Exchequer Court, in deciding that the transaction was illegal, w'as “the same as if the old company had paid a dividend to the shareholders.”

The Smythes appealed. The government won in Supreme Court in 1969, and 470 companies paid their taxes. “Our real achievement,” says Stevens, “was the deterrent effect. I think it showed the lawyers that the courts wouldn’t accept form for substance. It looked like they were selling shares but they weren’t.”

Auditors pigeonhole tax violations in three classes: innocent errors such as forgetting a driblet of bank interest; tax avoidance; and fraud. A case that was dealt with last year, for example, involved a businessman who had sold a rental property but had reported no rental income.

At this point an auditor gets cagey. Without letting anyone know, he maysneak out records and photostat them, so that if the suspect destroys them, as

one recently did, the government will have evidence of fraud. The worst offenders are passed along to the Special Investigations branch.

“Basically we work in two areas,” says Bill Moore, one of Si’s 290 investigators, “income suppression and cost inflation — everything from a racetrack operator who skims the cash off the top, to accommodation invoicing where a contractor buries the cost of cement for his private swimming pool in the cost of concrete for his apartment building. I’m not picking on the contractors. It extends into all fields.”

In 1972-73 SI checked 650 suspected cases of fraud, most of them referred by the audit branch. Of these, 270 were investigated in depth and 135 of these were prosecuted. “We’re aware that to prosecute a person threatens his livelihood,” says Maurice Bradshaw, Si’s assistant director. “We want to be 100% sure in our minds that he’s guilty before wfe proceed.”

Jim Gourlay, director of Special Investigations, has removed the SUE THE BASTARDS sign that used to hang in his office, but that is merely a bow to the open-door policy. The new tax laws impose automatic prison sentences of two months to five years for tax evasion, and SI is pressing for larger fines. Last year a Simcoe doctor, James Sihler, was fined

$210,390 for evading $416,925 in taxes. “These guys are placing a burden on every other taxpayer,” says Bradshaw, “because if he doesn’t pay, everyone else has to pay extra. Then they brag and people think there is more tax evasion than there really is, and wffien everyone is stealing, no one is a thief. That’s why we advise the press wffien we’re bringing a case to court. We want people to know that fraud doesn’t pay.”

Indeed, if your case goes to court, your chances of winning are less than 1%. Since the fraud squad was formed 19 years ago it has lost only 15 cases.

The record on organized crime is less exemplary. Six of the witnesses testifying at the recent Montreal crime probe had never filed an income tax return. One of them, Johnny Lia, who ran floating crap and poker games, was reported to have earned $75,000 to $100.000 a year. Car dealer David Mintz, an admitted onetime loan shark, was said to be declaring about $8,000 a year and banking from $112,000 in 1965 to $211,000 in 1969. René Daigneault, head of the Montreal Urban Community Police Department, has accused the tax department of “lack of cooperation” with police. “Organized crime leaders,” he said, “live luxurious lives and only declare a minimal amount of income.” He cited the case of a notorious Montreal crime

figure who hadn’t filed income tax returns for five years. “We could ask,” he said, “how such an omission could go undetected for that long.”

Bradshaw can only say that if a man hasn’t been on the tax rolls before he may be hard to catch, but he will be caught sooner or later. As to fairness, the ambivalence at head office is just as apparent at contact level. “You can’t go into a case thinking a guy is a crook,” says Moore. But he admits that it’s hard for a seasoned auditor to avoid the cop mentality.

This ambivalence is built into the system. Auditors are told they mustn’t give the impression the government is out to grab your last dollar. At the same time, an auditor’s production is measured in cases completed and dollars received. Victor Desjardins, a government auditor, once had five nil adjustments in a row. “You start questioning yourself,” he says. “Am I slipping? Or have I just happened to hit five clean files?” According to another auditor, “We’re inundated with forms. We’ve got a timereporting system, a production-reporting system, and this new ‘management by objective’ concept. Head office produces all these statistics and we have to produce the input, which means we have to produce more money to cover the time spent pushing paper.”

As this is being written the department is testing a formula that could really lower your chances of beating them. It’s similar to an American process called “discriminate function.” Scott Brown told me: “They got a bunch of screeners to sit around a table and say ‘here’s how I select’ and they came up, eventually, with 30 to 60 variables such as assets, income, profits, which are cross-checked to each other and to other items on the return” — a possible 1,000 or more comparisons made in an instant by the computer, which scores each return on how it deviates from the norm. It is being evaluated now, and Brown hopes that “it will tell us which taxpayers have a high, medium, or low potential of unpaid taxes.”

Palmer, however, is skeptical. “Maybe we can screen twice as many returns with the computer,” he says, “but I don’t think we'll ever be able to do without eyeballing. The computer can’t lunch at the club and pick up a rumor.” But however much the computer extends a tax fiddler’s fear of detection, it also extends the tax principle of equity, for the computer is impartial. As the scientists in the crime labs pushed the country’s police forces toward objectivity, so the computer may help to resolve the paradox of a government department that's trying to act like a cop without looking like one.

And in the meantime the odds aren’t too bad — it’s the game that’s rigged, "y?