No two words can bring more anxiety than "tax audit." But what is a tax audit? What is the taxman actually looking for, and perhaps more important, what red flags will catch the CRA's attention?

A tax audit is the formal examination of a taxpayer's books and records to determine if they have accurately reported income tax liability in accordance with the law. Canadians are, by nature, a compliant bunch. Just the thought of being selected for a tax audit is often enough to encourage voluntary compliance, especially as penalties and interest levied for non-compliance can be substantial.

CRA's top-10 hit list

Here's a Top-10 list of tax return items most often questioned by the CRA (formerly Revenue Canada). The professional services firm Deloitte and Touche conducted a poll, which although not scientific, was based on thousands of Canadian personal tax returns submitted to its practitioners.

1. Allowable Business Investment Loss (ABIL). An ABIL is a special type of capital loss that occurs when an individual disposes of debt or equity in a small business. One advantage of realizing an ABIL over an ordinary capital loss is that, while capital losses may only be deducted against capital gains, an ABIL may be deducted against all sources of income.

2. Medical expenses. Individuals are allowed to claim both federal and provincial tax credits for medical expenses. Taxpayers' who file paper tax returns need to include their actual medical receipts with those returns. The receipts need to specify the name of the practitioner or institution (hospital, clinic, etc.) to which the expense was paid. If an attendant is hired to care for a disabled person, the attendant's social insurance number should also be on the receipt. Electronic tax filers, however, should keep all receipts to support their claims for medical expenses.

3. Carrying charges. These charges, on Schedule 4 of the tax return, include all expenses paid to earn investment income, such as interest on money borrowed for the purpose of earning income, as well as management fees on various investment wrap programs. Keep documents evidencing the carrying charges being claimed, which, contrary to popular belief, should not be filed with the tax return. In addition, try not to intermingle personal debt and investment-related debt. For example, establish separate lines of credit — one for home renovation and another for investing — to better separate the interest paid on the investment line of credit, should the CRA start asking questions.

4. Stock option deductions and deferrals. Under the stock option rules, only half the option gain is generally taxable, provided the option meets certain qualifying conditions. The main condition is the option cannot have been in the money at the time it was issued to the employee. A taxpayer should obtain a letter from their employer at the time the options are exercised that verifies they qualify for the deduction. It's also possible to defer the inclusion of the stock option benefit in income until the shares acquired upon option exercise are sold. However, this deferral is only possible by filing an election by January 15 of the year after which the options were exercised.

5. Province of residence. Alberta, Western Canada's tax haven of choice, is the subject of the next area of attack by the CRA, particularly regarding residents living in British Columbia and Saskatchewan adopting the practice of filing their returns as Alberta residents. Vacationing in Banff during December isn't enough to claim residency in Alberta!

6. Charitable donations. As a result of the government's increased crackdown on questionable charitable donation tax shelters, large donations (in excess of $25,000) and donations of property in kind also attract the taxman's careful attention.

7. Installments. If you're required to pay tax by quarterly installments, ensure your payments are credited to the correct tax years. Otherwise, there may be a deficiency in the amount of tax owing at year end.

8. Disability Tax Credit (DTC). Judging by the dozens of reported tax cases involving the DTC each year, eligibility to claim this credit continues to be a source of scrutiny by the CRA's auditors. Ensure documentation from a medical professional is on hand to validate your claim.

9. Rollovers from deceased individuals. Amazingly, the simple transfer of an RRSP or RRIF to a surviving spouse upon the death of the annuitant can pique CRA's interest.

10. Business expenses with a personal element. These include business use of a personal automobile or travel expenses for business trips when accompanied by a spouse. Maintain detailed records (log books, conference itineraries, etc.) to ensure the business portion of such expenses can easily be defended.

A good long-term tax plan will look at some of the CRA's key areas of interest, and by establishing proper records and documentation it will minimize the level of stress a visit from the taxman might otherwise cause. We can help establish a long-term strategy to help you limit your future tax liability. Give us a call at (306) 757-2121 to start planning today.