You’ve dotted the is, crossed the Ts and ensured that everything in your client’s 2007 tax return is tickety-boo. Think you’re in the clear when it comes to raising the suspicion of the Canada Revenue Agency? Think again.

“My personal opinion is that if you are looking for tax saving opportunities, you can’t avoid raising a red flag with the CRA,” says Glen Schmidt, a certified general accountant in Milton, Ont.

A former long-time CRA employee who now conducts professional development seminars for accountants across the country, Schmidt says today’s CRA is more vigilant and aggressive than ever.

It’s a common observation.

“The CRA seems to have an approach that is more methodi-cal than it has been in the past,” says Heather Evans, a tax lawyer and partner with Deloitte & Touche LLP in Toronto who compiles the firm’s annual “CRA hit list” — a review of the top 10 items most frequently queried by the CRA.

Both Schmidt and Evans pin this vigilance on past criticism from the auditor general, who has pressured the CRA to increase taxpayer compliance.

Although the CRA’s scrutiny of tax returns has been on the rise for several years, there’s a new target on its 2007 hit list: RRSP contributions.

“The CRA has made the review of RRSP contributions and the examination of overcontributions a national initiative,” says Evans. “Everyone across the country is seeing this.”

It’s all too easy to create an over-contribution, says Schmidt, who notes that contributions made in the first 60 days of the year are often to blame.

“If you make a donation in January 2008, it could be for the 2007 or 2008 tax years,” he says. “If you want to save the contribution for 2008, you need to designate that when filing your 2007 return.” Although this confusion can be easily resolved by completing a Schedule 7 (available on www.cra-arc.gc.ca), problems arise when this form is forgotten.

“A number of accountants have been telling me that if their clients haven’t completed the Schedule 7, the CRA makes the assumption that the contribution is for the current tax year, which can result in an overcontribution,” says Schmidt.

Although the financial discrepancies that result from these errors are often minor, Evans notes, it can take a sea of paper to amend the situation.

Aside from RRSP contributions, the CRA is expected to target many of the usual suspects on 2007 returns:

> Charitable Donations. Like the infamous art flip, tax-sheltered gifting arrangements — schemes that promise receipts for triple or even quadruple the actual value of the donation — are guaranteed to raise a red flag with the CRA and should be avoided.

In a taxpayer alert issued this past August, the agency said that all donations to these types of schemes will be audited, and it noted that to date it has reassessed more than 26,000 taxpayers and denied about $1.4 billion in donations claimed. Audits of another 70,000 taxpayers are ongoing. (See story page B13.)

Even legitimate charitable donations often come under scrutiny, says Evans: “We’ve found that clients who make charitable donations in excess of a certain threshold, which seems to be $25,000, have their returns significantly slowed down in the system.”

Although large donations don’t always trigger audits, they usually result in a pre-assessment review — a CRA request for supporting documentation that’s issued before the return is processed.

“I had a client who donated a yacht to a charity and received a six-figure donation receipt and we just knew he would be subject to a pre-assessment review,” says Howard Bickford, a chartered accountant at Bekken Bickford & Associates in Vancouver. “Big numbers, no matter what they are, are going to attract the CRA’s attention.”

> Carrying Charges. “It’s perfectly acceptable to borrow money to invest in the market and then deduct the interest against the returns in your portfolio,” says Evans. “But if you don’t have the records and the CRA asks you to substantiate your claim, you’re going to be in trouble.”

Interest deductions can raise a red flag if the investment made with borrowed money yields little or no return. In these situations, the CRA may question whether the individual had a “reasonable expectation of profit.” These intertwined issues — interest deductibility and REOP — have been a hot topic with the CRA for several years.

@page_break@In 2003, the Department of Finance suggested a significant change to the CRA’s treatment of interest deductions. Although these deductions continue to be permitted, based on the premise that borrowing to invest with no personal element fulfils the purpose of earning income, two Supreme Court of Canada decisions in which real estate tax shelters generated significant losses as a result of interest expenses have caused Finance to call this treatment into question.

The taxpayers won in both cases, prompting Finance to propose the idea of a “cumulative profit test,” which would require that losses be claimed in a taxation year only if its reasonable to assume that the taxpayer would realize a cumulative profit (not including capital gains) from the investment. That proposal is still in limbo.

“It created a bit of an uproar,” says Evans. “Where it will go is unclear at present.”

> Self-Employment. Schmidt, who conducts a seminar devoted to this topic, says confusion continues to abound surrounding the definition and tax treatment of self-employed individuals.

“I’m always amazed by the number of people who attend the seminar to learn how to resolve a problem they already have,” he says, “as opposed to avoiding problems in the future.”

Claiming vehicle and home-office expenses commonly raise red flags.

Using a vehicle for business purposes is an oft-contested claim — and difficult to resolve if the individual is not keeping proper records to document business use — while home-office expense claims are also often carefully examined for legitimacy.

“The CRA will scrutinize home-office expenses such as electricity, insurance, mortgage interest and maintenance costs claimed by those with ‘office’ offices to ensure that the percentage of expenses being claimed is reasonable,” says Dave Ablett, senior tax and retirement specialist at Investors Group Inc. in Winnipeg.

He notes that the CRA is especially concerned with the amount of mortgage interest and maintenance costs being claimed by those who work at home. A good rule of thumb? The portion of home expenses being claimed should comprise no more that 15%-20% of total expense claims.

Using a personal vehicle for business purposes is another oft-contested claim that can be difficult to resolve. Your client must have proper records to document the business use.

Reporting business losses for a number of years can also raise a red flag, says Bickford, noting that some people may try to parlay a sideline into a proprietorship. “Someone who takes photos as a hobby and sells one occasionally may consider their photography a small business and claim a loss every year,” he says. “The CRA is liable to attack after several years of this and say that you’re not really running a small business because there’s no reasonable expectation of profit.”

Widely fluctuating business expenses and reporting losses for several years running can also cause the CRA to call a self-employed individual’s tax return into question, as can the improper recording of self-employment income. “This is one area in which we see co-operation between the GST and income tax systems,” says Evans. “The CRA can match up the numbers a self-employed taxpayer remits for GST purposes with their income tax returns.”

> Medical Expenses. “The tax relief for medical expenses is fairly modest but a lot of people aren’t intimately familiar with the rules so they may claim things to which they are not entitled,” says Evans, noting these claims continually get scrubbed down by the CRA. “You can go a long way toward avoiding red flags by having a basic understanding of what is permitted.”

> Support Payments. “A couple of years ago, the CRA was really hammering on child-care expenses,” says Bickford. “Where we have seen more scrutiny over the past few years is child and spousal payments.”

Schmidt has also observed this trend. “There are two issues here: if one party is claiming the deduction, is the other claiming the income?” he says. “The other is the dating of the agreement itself.”

Child-support payments made in agreements or orders executed after May 1997 are neither taxable nor deductible.

As with all CRA queries, solid documentation is your best defence. “As long as you can justify the claim,” says Ablett, “the CRA is going to allow it.” IE