CRA Source Deductions Audit: What Employers Must Prepare + Payroll Audit Canada: How to Avoid Penalties, Reassessments, and Director Liability

A CRA source deductions audit is one of the most serious audits an employer can face. Unlike income tax or GST/QST audits, payroll audits move quickly, apply strict rules, and impose immediate penalties when errors are discovered. CRA considers payroll deductions — income tax, CPP/QPP, and EI — as trust funds. This means employers are legally obligated to remit them accurately and on time.

A source deductions audit can result in:
• reassessments for multiple years
• penalties up to 20% for repeated late remittances
• interest compounding daily
• employer AND employee CPP/QPP and EI owed
• taxable benefit reassessments
• reclassification of contractors as employees
• director liability assessments

This guide explains what CRA examines in a source deductions audit, what documents employers must prepare, how penalties are calculated, and how a Montreal CPA firm near you defends businesses before the audit becomes financially devastating.

Legal and Regulatory Framework
Source deduction audits arise from obligations under:
• the Income Tax Act
• the Canada Pension Plan Act / Quebec Pension Plan Act
• the Employment Insurance Act
• Revenu Québec equivalent payroll legislation

Employers must:
• calculate and withhold the correct amounts of income tax, CPP/QPP, and EI
• remit deductions by CRA’s strict deadlines
• remit employer contributions
• issue accurate T4, T4A, RL-1, and summaries
• report taxable benefits correctly
• maintain complete payroll records
• classify workers correctly

CRA may audit up to four years back — or further when alleging gross negligence.

Why CRA Initiates a Source Deductions Audit
CRA selects employers for payroll audits when:
• T4 totals do not match payroll remittances
• contractors appear to be employees
• high expenses but low payroll reported
• large shareholder withdrawals exist
• taxable benefits appear unreported
• late remittances were filed
• GST/QST audits reveal payroll errors
• industries show high non-compliance (construction, restaurants, trucking, salons)

CRA uses data analytics to detect anomalies. Once flagged, payroll audits move quickly.

What CRA Reviews During a Payroll Audit

1. Employee vs Contractor Classification
   CRA analyzes whether contractors should legally be employees by examining:
   • degree of control
   • ownership of tools
   • risk of loss
   • opportunity for profit
   • integration with the business
   Written contracts do NOT override the real working relationship.

If CRA reclassifies workers as employees, the employer becomes liable for:
• employer and employee CPP/QPP
• employer and employee EI
• penalties
• interest

2. CPP/QPP and EI Calculation Accuracy
   CRA verifies the correct:
   • CPP/QPP withholdings
   • EI insurable earnings
   • maximum contribution caps
   • exemptions
   • treatment of bonuses, allowances, and retro pay

3. Income Tax Withholding
   CRA compares actual deductions to required amounts. Under-deductions trigger penalties.

4. Taxable Benefits
   CRA evaluates whether benefits were correctly reported, including:
   • vehicle benefits
   • allowances
   • meals and lodging
   • gift cards
   • parking
   • employer-paid personal expenses
   • housing benefits

Incorrect valuation or omission results in reassessments.

5. Shareholder Payroll Issues
   Common problems include:
   • shareholder loans treated as income
   • unreported shareholder benefits
   • failure to deduct payroll on shareholder salaries
   • improperly paid dividends used as salary substitutes

6. Payroll Records and Documentation
   CRA requires employers to maintain:
   • payroll registers
   • timesheets
   • vacation calculations
   • ROEs
   • contracts
   • invoices for contractors
   • benefit valuation records
   • bank statements
   If documents are missing, CRA uses assumptions — almost always against the employer.

Penalties in CRA Source Deductions Audits
Penalties accumulate quickly and are often shocking:
• 10% penalty for the first late remittance
• 20% penalty for subsequent late remittances in the same year
• penalties for failure to deduct
• penalties for failure to remit
• penalties for incorrect taxable benefit reporting
• interest compounding daily

When contractors are reclassified, reassessments often include tens of thousands in retroactive CPP/QPP and EI.

Director Liability Risks
If payroll or GST/QST remains unpaid, CRA may assess directors personally for the debt. The director’s personal bank account, wages, refunds, and assets may be targeted. Director liability makes payroll audits uniquely dangerous.

Mackisen Strategy
Mackisen CPA prepares employers for payroll audits with a forensic, preventive approach.

1. Pre-Audit Payroll Diagnostic
   We analyze:
   • CPP/QPP and EI calculations
   • taxable benefits
   • contractor vs employee risk
   • payroll software errors
   • discrepancies between T4s and remittances
   • shareholder compensation
   This identifies issues before CRA arrives.

2. Reconciliation of All Payroll Records
   We align:
   • T4 totals
   • RL-1 totals
   • remittances
   • GL accounts
   • bank statements
   • payroll summaries
   Perfect reconciliation eliminates CRA suspicions.

3. Worker Classification Defence File
   Using CRA jurisprudence, we create a legal and factual justification for contractors, preventing expensive reclassification.

4. Taxable Benefit Calculation Review
   We ensure benefits are valued per CRA bulletins and defendable in audits.

5. Direct CRA Representation
   We communicate directly with CRA to:
   • prevent expanded audits
   • correct misunderstandings
   • reduce documentation demands
   • negotiate manageable outcomes
   We ensure employers do not say anything that increases exposure.

6. Penalty Relief and Remediation
   If penalties were issued, we prepare Taxpayer Relief Program submissions to reduce or eliminate penalties and interest.

Real Client Experience
A Montréal contractor underwent a CRA source deductions audit involving 15 subcontractors. CRA planned to reclassify all of them as employees, with proposed liability of $148,000.

Mackisen CPA:
• created a full worker-classification defense package
• proved subcontractor independence
• rebuilt payroll reconciliation
• corrected benefit calculations

Outcome: CRA dropped the reclassification entirely and reduced penalties by 90%.

Common Questions
Can CRA audit multiple years? Yes — and often does.
Are payroll penalties negotiable? Only through Taxpayer Relief.
Does using a payroll provider protect me? No. You remain responsible.
What if contractors have their own corporation? Still not a guarantee.
Can CRA reassess even if employees were paid correctly? Yes if documentation is missing.
Can directors be held personally liable? Yes for unresolved payroll debts.

Why Mackisen
With more than 35 years of combined CPA experience, Mackisen CPA Montreal helps employers navigate CRA payroll audits, correct errors, defend worker classifications, and avoid penalties that destroy cash flow. Our payroll audit defence ensures full compliance, expert representation, and the best possible outcome for your business.