Oct 26, 2022
If CRA has proposed a net worth or indirect verification tax assessment against your restaurant based on estimated alcohol or food sales, here is how we push back: by testing the tax auditor’s methodology itself, not just the final number it produced.
CRA’s Growing Use of Indirect Verification Tax Audits in the Restaurant Industry
A tax dispute currently working its way through an Israeli court has put a spotlight on a CRA-style tax audit method Canadian restaurant owners know well: reconstructing a business’s sales not from its books, but from a tax auditor’s assumptions about what goes into the food.
CRA increasingly relies on this kind of indirect verification of income tax audits when it is not satisfied that a restaurant’s reported sales reflect reality, and for restaurant owners and their bookkeepers, understanding how these projection-based tax audits work, and where they tend to go wrong, is essential to protecting a business from an inflated tax reassessment.
A Sabich Stand Tax Audit: An Egg Count and a Tax Assessment Built on Assumptions
The dispute making headlines involves a well-known Jerusalem street food stand that sells sabich, a pita sandwich built around fried eggplant and hard-boiled egg. Rather than relying on the stand’s own sales records, tax inspectors conducted two observational tax audits, counting customers over the course of a single day on each occasion, then used those counts, combined with assumptions about ingredient quantities, to estimate the stand’s true sales volume over several years.
The dispute is not really about eggs. It is about whether an assumption, however reasonable it may look in a spreadsheet, can fairly stand in for actual business records. The stand’s owner argues the tax authority’s model assumed roughly one egg per pita and a fixed waste rate for torn or discarded pita bread, figures he says do not reflect the reality of a busy, high-volume food stand where bread quality problems and food waste are routine. After the taxpayer objected, the assessing authority increased its allowance for waste, then partially reduced its tax reassessment, but the underlying dispute over whether observation-based estimates can override a small business’s actual operating experience remains before the court.
This is, in substance, exactly the kind of tax audit method Canadian restaurant owners encounter when CRA turns to what it calls indirect verification of income.
Key Issues and Findings: How CRA Builds a Projection-Based Restaurant Tax Audit
CRA has express statutory authority, under both the Income Tax Act and the Excise Tax Act, to assess tax based on the best information available when it is not satisfied that a taxpayer’s records accurately reflect income or taxable supplies. In practice, for restaurants and bars, this often takes the form of a purchase-based projection methodology built around alcohol, and it is one of several indirect verification of income techniques CRA tax auditors turn to when they conclude a business’s own records cannot be relied on. That authority is not unlimited: as our discussion of the reasonable minimum standard for tax audits explains, a tax auditor’s methodology must itself meet a reasonable minimum standard capable of producing a credible conclusion before the burden shifts to the taxpayer to disprove it, a standard the Tax Court of Canada applied in a case involving a similarly document-poor, cash-intensive food and beverage business.
Rotfleisch & Samulovitch has represented several Canadian restaurants facing this kind of indirect verification tax audit; the matter described below is used here as a representative example. In that matter, the CRA tax auditor did not start from the restaurant’s point-of-sale records. Instead, the tax auditor pulled provincial liquor board and beer store purchase data to estimate the total volume of wine, spirits, and draft and bottled beer the restaurant had purchased during the tax audit period.
From there, the tax auditor applied a series of adjustment factors intended to account for spillage, over-pouring, dregs, draft line cleaning, and, critically, wine and spirits used in food preparation rather than sold as beverages. The tax auditor then multiplied the estimated ounces sold by an assumed average price per serving to project total alcohol revenue, and used that projected alcohol revenue as a proxy to estimate the restaurant’s total revenue from food and beverages combined.
In this case, the restaurant was an upscale establishment that regularly used wine and spirits in its cooking and that offered prix-fixe wine-and-dinner events, where multiple glasses of wine were bundled into a single food-and-beverage sale. Neither fact fit neatly into the tax auditor’s generic ounces-sold-to-dollars-of-alcohol-revenue formula.
We have previously touched on this pattern briefly in our discussion of indirect income verification audits, where a CRA tax auditor’s failure to account for wine used in food recipes led to grossly overestimated unreported alcohol income; this article walks through that dynamic in full. As part of building the response to the tax audit, and at our instruction, the owner went back through the restaurant’s menu and recreated the recipes for its dishes, documenting the specific amount of wine or spirits called for in each one, so the cooking-use adjustment could be tied to the restaurant’s actual menu rather than a generic industry assumption.
Every adjustment the tax auditor made for cooking use, event pricing, or waste was itself an estimate, stacked on top of other estimates, several steps removed from the restaurant’s actual point-of-sale data. Where CRA relies on this kind of indirect projection, the taxpayer’s task is to show the model does not hold up against the business’s actual operating facts. That means identifying every place an assumption was substituted for evidence, and, where possible, supplying the evidence CRA lacked, whether that is point-of-sale reporting, standardized recipes showing alcohol used in cooking, records of promotional or event-based sales, or documentation of waste and spoilage specific to that business. A projection methodology is only as reliable as the assumptions feeding it, and those assumptions are rarely calibrated to a single restaurant’s actual menu, pricing, and operations.
“An indirect verification of income tax assessment can look precise because it comes wrapped in numbers and formulas, but every number in that formula is still somebody’s guess about how a specific business operates,” says David J. Rotfleisch, founding tax lawyer at Rotfleisch & Samulovitch. “The tax auditor’s model is a hypothesis, not a fact, and a taxpayer’s job is to show the court or the CRA where that hypothesis breaks down against how the business actually runs.”
“An indirect verification of income tax assessment can look precise because it comes wrapped in numbers and formulas, but every number in that formula is still somebody’s guess about how a specific business operates.”
Implications for Canadian Restaurant Owners Facing a CRA Tax Audit
Restaurants, bars, cafes, and other cash-intensive food and beverage businesses remain a recurring target for CRA’s underground economy and indirect verification tax audit programs, and alcohol sales in particular provide tax auditors with a convenient external data source, since liquor purchases must flow through regulated distributors. CRA has confirmed this focus publicly: a CBC News investigation reported that CRA conducted more than 6,000 audits of bars and restaurants across Canada over a three-year period, uncovering hundreds of millions of dollars in unreported income, with Ontario alone accounting for more than half of those audits, and the agency has stated the restaurant industry has been identified as a high-risk sector for exactly this reason.
A restaurant that cannot show, with its own documentation, how its alcohol purchases translate into cooking use, comped or discounted sales, spoilage, and events pricing is vulnerable to a tax auditor’s generic projection standing in as the default answer. This pattern is closely related to the CRA’s net worth tax audit technique, another indirect method that similarly substitutes assumptions for a taxpayer’s actual records once books and records are found wanting, and that the Tax Court of Canada has itself applied to a restaurant business in Halls v The Queen, 2022 TCC 14, where poor recordkeeping and a cash-based business model were enough to justify CRA’s use of the method in the first place.
The practical lesson is the same whether the dispute plays out before the Tax Court of Canada or an Israeli court reviewing a sabich stand’s egg count: a business’s own contemporaneous records are the strongest defence against a reconstructed sales figure. Point-of-sale reporting that separates alcohol from food, standardized recipes and portion sizes, records of promotional and event-based sales, and documentation of spoilage or waste all give a taxpayer’s accountant and tax lawyer the material needed to challenge a tax assessment built on averages rather than actual operations.
Takeaway
Indirect verification and projection-based tax audits are not unique to any one tax authority. Where a business’s records do not satisfy a tax auditor, the tax auditor will build a model instead, and that model will inevitably rely on assumptions that may not reflect how a specific restaurant actually operates. Whether the dispute involves a GST/HST restaurant tax audit or an income tax reassessment, Canadian restaurant owners facing this kind of CRA restaurant tax audit should treat the tax auditor’s methodology itself as open to challenge, not just the final dollar figure it produces, and should bring in a Canadian tax lawyer experienced in restaurant tax audit disputes to do it properly.
Top Tax Tips
- Restaurant owners should maintain point-of-sale systems capable of separating alcohol sales from food and beverage sales, and should be able to produce standardized recipes or preparation notes showing where wine, beer, or spirits are used in cooking rather than sold by the glass or bottle, since this is one of the most common gaps in a CRA alcohol sales projection tax audit.
- Owners running wine dinners, tasting events, or other prix-fixe promotions that bundle alcohol into a food price should keep separate records of those events, including dates, pricing, and typical alcohol pours, so that a tax auditor’s generic per-ounce revenue assumption can be shown not to apply to bundled sales.
- Businesses should also track spoilage, spillage, and product returned to suppliers, since a tax auditor’s default waste allowance is often lower than what many restaurants actually experience, and the burden generally falls on the taxpayer to demonstrate why the CRA’s assumption should not apply to their business. These same documentation habits also help if CRA turns instead to a CRA net worth tax audit rather than an alcohol-based projection, since both methods substitute assumptions for records once a business’s own bookkeeping is found wanting.
- When a CRA restaurant tax audit letter proposes an indirect verification of income adjustment, an experienced Canadian tax lawyer should be brought in early, before the objection or appeal deadline, so the tax auditor’s methodology can be tested against the business’s actual records rather than accepted as the default outcome.
- Restaurants looking to get their broader supporting documentation in order before a dispute arises can also review our discussion of handling undocumented business expenses, and any restaurant currently facing a CRA audit letter can turn to our tax audit assistance team for guidance on the process from start to finish.
FAQs About Restaraunt Tax
What is an indirect verification of income tax audit?
An indirect verification of income tax audit is a method CRA uses when it is not satisfied that a taxpayer’s books and records accurately reflect income or taxable sales. Rather than relying solely on the taxpayer’s own records, CRA reconstructs an estimate of revenue using external data sources and statistical assumptions.
Why does CRA target restaurants and bars with these tax audits?
Restaurants and bars are considered part of the underground economy focus sectors because they often involve significant cash transactions and readily available third-party purchase data, such as provincial liquor board records, that CRA can use as a starting point for a projection methodology.
How does CRA use alcohol purchase data in a restaurant tax audit?
CRA can request or obtain records of a restaurant’s wine, beer, and spirits purchases from provincial liquor distributors, then apply assumed serving sizes, prices, and waste factors to estimate the restaurant’s total alcohol revenue, which may then be used as a proxy for estimating total business revenue.
What is “shrinkage” in a CRA alcohol projection tax audit?
Shrinkage refers to alcohol that is purchased but not sold as a beverage, due to factors like spillage, over-pouring, dregs left in bottles or kegs, draft line cleaning, or use in food preparation. CRA tax auditors typically apply a shrinkage percentage, but that percentage is an assumption that may not match a specific restaurant’s actual experience.
Can wine or spirits used for cooking affect a CRA sales estimate?
Yes. A restaurant that uses meaningful amounts of wine or spirits in food preparation, rather than selling it exclusively by the glass or bottle, should be able to document that use, since a tax auditor’s projection may otherwise assume all purchased alcohol was sold as a beverage.
What records help defend against a CRA indirect verification tax audit?
Point-of-sale reports that separate alcohol from food sales, standardized recipes showing alcohol used in cooking, records of prix-fixe or event-based promotions, supplier return and spoilage records, and financial statements reconciled to bank deposits are all useful in challenging a tax auditor’s projection.
Who has the burden of proof in a CRA restaurant tax audit dispute?
Generally, the taxpayer bears the initial burden of demonstrating that a CRA tax assessment is incorrect, an onus the Supreme Court of Canada addressed in the leading case discussed in our article on the burden of proof in tax litigation. Once the taxpayer produces evidence sufficient to “demolish” the CRA’s assumptions, the onus shifts back to the CRA. This makes thorough, contemporaneous documentation especially important when a business is relying on facts, such as cooking use of alcohol, that fall outside a generic projection model.
What should a restaurant owner do after receiving a CRA tax audit proposal letter?
A restaurant owner who receives a proposed tax reassessment based on an indirect verification of income methodology should review every assumption in the tax auditor’s calculation and consult an experienced Canadian tax lawyer before the response deadline, since a well-supported response at the proposal stage can avoid a more difficult objection or Tax Court appeal later.
Is an indirect verification of income method unique to Canada?
No. Similar projection-based enforcement approaches, using observation, purchase records, or third-party data to estimate a small business’s true sales, are used by tax authorities internationally, including in recent, publicly reported disputes involving small food businesses outside Canada.
Can a CRA indirect verification tax assessment be appealed?
Yes. A taxpayer who disagrees with a tax reassessment based on an indirect verification of income methodology can file a notice of objection with the CRA, and if the dispute is not resolved, can appeal to the Tax Court of Canada.
How can a Canadian tax lawyer help with an alcohol-based CRA restaurant tax audit?
An experienced Canadian tax lawyer can identify weaknesses in the tax auditor’s assumptions, work with the business’s accountant to compile the documentation needed to counter a generic projection, and represent the business through the objection and appeal process if a negotiated resolution with CRA is not reached at the tax audit stage.
DISCLAIMER: This article provides broad information. It is only accurate as of the posting date. It has not been updated and may be out-of-date. It does not give legal advice and should not be relied on as tax advice. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.
