David Rotfleisch on What Eggs, Pitas & Wine Orders Can Reveal to CRA in a Restaurant Tax Audit

A proposed CRA net-worth assessment or indirect verification assessment does not necessarily mean the Agency’s calculations are accurate. In many cases, the outcome depends on the assumptions and methodology used by the tax auditor.

Rather than focusing solely on the final assessment, an effective response is to carefully examine and challenge the methodology underlying the CRA’s estimates of food or alcohol sales.

CRA Restaurant Tax Audits: The Expanding Use of Indirect Verification Techniques

A tax dispute currently before an Israeli court has drawn attention to an audit technique that will be familiar to many Canadian restaurant owners: reconstructing a business’s sales based not on its accounting records, but on a tax auditor’s assumptions about ingredients, recipes, and food production.

The CRA increasingly relies on this form of indirect verification during income tax audits when it believes a restaurant’s reported sales do not accurately reflect actual revenue. For restaurant owners and their bookkeepers, understanding how these projection-based audit methods work—and where the underlying assumptions may be flawed—is essential to challenging an overstated tax reassessment.

The Sabich Stand Audit: How Egg Counts Became the Basis for a Tax Assessment

The case attracting international attention involves a well-known Jerusalem street food stand specializing in sabich, a pita sandwich traditionally made with fried eggplant and hard-boiled egg. Instead of relying on the business’s accounting records, tax authorities conducted two observational audits, counting customers over a single day during each visit. They then combined those observations with assumptions about ingredient usage to estimate the stand’s sales over a period of several years.

At the heart of the dispute is not the number of eggs used in each sandwich, but whether assumptions that appear reasonable on paper can fairly replace a business’s actual records. The owner argues that the tax authority’s model overstated ingredient usage by assuming approximately one egg per pita and applying a fixed allowance for torn or discarded pita bread. According to the owner, those assumptions fail to reflect the day-to-day realities of operating a busy, high-volume food stand, where inconsistent bread quality and routine food waste are common.

After the taxpayer challenged the assessment, the tax authority increased its allowance for waste and partially reduced the reassessment. Even so, the broader question remains before the court: whether observation-based estimates should prevail over the actual operating experience of a small business.

In substance, the issues raised in this case closely resemble the CRA’s use of indirect verification of income during restaurant tax audits in Canada.

Key Findings: The CRA’s Projection-Based Approach to Restaurant Tax Audits

The CRA has broad statutory authority under both the Income Tax Act and the Excise Tax Act to assess tax using the best information available when it believes a taxpayer’s records do not accurately reflect income or taxable supplies. For restaurants and bars, this often involves a purchase-based projection method centered on alcohol purchases. It is one of several indirect verification of income techniques that CRA auditors use when they conclude a business’s books and records cannot be relied upon.

That authority, however, is not without limits. As discussed in our article on the reasonable minimum standard for tax audits, the auditor’s methodology must itself satisfy a reasonable minimum standard capable of producing a reliable and defensible result before the burden shifts to the taxpayer to rebut the assessment. The Tax Court of Canada has applied this principle in cases involving cash-intensive food and beverage businesses with inadequate records.

Rotfleisch & Samulovitch has represented a number of Canadian restaurants facing this type of indirect verification audit. The example below is drawn from one such representative matter. In that case, the CRA auditor did not begin with the restaurant’s point-of-sale records. Instead, the auditor obtained purchase information from the provincial liquor board and beer store to estimate the total quantities of wine, spirits, and both draft and bottled beer acquired during the audit period.

The auditor then applied a series of assumptions to account for factors such as spillage, over-pouring, dregs, draft line cleaning, and the use of wine and spirits in food preparation rather than beverage sales. Based on those assumptions, the auditor estimated the number of ounces sold, applied an assumed average selling price per serving, and projected the restaurant’s total alcohol revenue. That projected figure was then used as the foundation for estimating the restaurant’s combined food and beverage revenue.

In this case, the restaurant was an upscale establishment that regularly incorporated wine and spirits into its recipes and frequently hosted prix-fixe wine pairing dinners, where several glasses of wine were included as part of a single bundled food-and-beverage package. These features did not fit neatly within the CRA auditor’s standardized formula for converting ounces of alcohol purchased into projected alcohol sales.

We have previously discussed a similar issue in our article on indirect verification of income audits, where a CRA auditor’s failure to account for alcohol used in food preparation resulted in a substantial overstatement of unreported alcohol revenue. In this case, the issue was examined in greater detail. At our direction, the restaurant owner reviewed the menu and reconstructed the recipes for each dish, documenting the precise quantity of wine or spirits used in preparation. This allowed the adjustment for cooking use to be based on the restaurant’s actual operations rather than on generalized industry assumptions.

The same challenge applied to other elements of the auditor’s methodology. Adjustments for cooking use, bundled event pricing, and product waste were all estimates layered upon other estimates, each moving further away from the restaurant’s actual point-of-sale records. When the CRA relies on this type of indirect projection, the taxpayer’s objective is to demonstrate that the model does not accurately reflect the realities of the business.

This requires identifying every point where an assumption has replaced objective evidence and, wherever possible, providing records that better reflect actual operations. Such evidence may include point-of-sale reports, standardized recipes documenting alcohol used in food preparation, records of promotional or prix-fixe events, and business-specific documentation relating to spoilage and waste. Ultimately, the reliability of any projection depends entirely on the assumptions on which it is built, and those assumptions rarely capture the unique menu, pricing structure, and operating practices of an individual restaurant.

“An indirect verification of income assessment may appear highly precise because it is built on formulas and calculations, but every figure in that model ultimately reflects an assumption about how a particular business operates,” says David J. Rotfleisch, founding tax lawyer at Rotfleisch & Samulovitch.

“The tax auditor’s methodology is a working hypothesis, not an established fact. The taxpayer’s role is to demonstrate where that hypothesis diverges from the business’s actual operations and supporting evidence.”

What a CRA Tax Audit Means for Canadian Restaurant Owners

Restaurants, bars, cafés, and other cash-intensive food and beverage businesses continue to be a primary focus of the CRA’s underground economy initiatives and indirect verification audit programs. Alcohol sales, in particular, provide auditors with a convenient starting point because liquor purchases can be independently verified through regulated distributors. This allows the CRA to compare documented alcohol purchases against reported sales and, where discrepancies are suspected, reconstruct revenue using indirect audit techniques.

The CRA has publicly acknowledged this enforcement focus. A CBC News investigation reported that the Agency 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. More than half of those audits were conducted in Ontario, reflecting the CRA’s view that the restaurant industry presents a heightened risk of tax non-compliance.

A restaurant that cannot clearly demonstrate how its alcohol purchases were allocated among beverage sales, food preparation, complimentary or discounted items, spoilage, and promotional events is at greater risk of having its revenue estimated using a standardized projection model rather than its actual operating records. This approach closely resembles the CRA’s net worth audit methodology, another form of indirect verification that relies on assumptions when the Agency concludes a taxpayer’s books and records are unreliable. The Tax Court of Canada recognized the use of this methodology in Halls v. The Queen, 2022 TCC 14, where inadequate recordkeeping and the cash-intensive nature of the restaurant business justified the CRA’s decision to reconstruct income indirectly.

The broader lesson is the same whether the dispute arises before the Tax Court of Canada or an Israeli court reviewing a sabich vendor’s ingredient usage. A business’s contemporaneous records remain its strongest defence against a reconstructed sales assessment. Detailed point-of-sale reports separating food and alcohol sales, standardized recipes and portion specifications, records of promotional or event-based pricing, and documentation of spoilage and waste provide the evidence needed for a taxpayer’s accountant and tax lawyer to challenge an assessment based on generalized assumptions rather than the business’s actual operations.

Takeaway: Lessons for Canadian Restaurant Owners Facing a CRA Tax Audit

Indirect verification and projection-based audit techniques are not unique to any single tax authority. When a tax auditor concludes that a business’s records are incomplete or unreliable, the auditor may reconstruct income using a projection model. By its nature, however, that model depends on assumptions that may not accurately reflect the operations of a particular restaurant.

Whether the audit involves GST/HST, income tax, or both, Canadian restaurant owners should recognize that the auditor’s methodology is not beyond scrutiny. An effective response focuses not only on the amount of the proposed reassessment but also on the assumptions, calculations, and analytical approach used to arrive at it. Because these disputes often involve complex factual and legal issues, restaurant owners should seek advice from an experienced Canadian tax lawyer with expertise in defending CRA restaurant audits and indirect verification assessments.

Tax Pro Tips: Strengthening Your Restaurant’s Audit Readiness

Restaurant owners should maintain point-of-sale systems that clearly distinguish alcohol sales from food and other beverage sales. They should also retain standardized recipes or preparation records showing when wine, beer, or spirits are used in cooking rather than sold directly to customers, as this is one of the most common issues arising in CRA alcohol projection audits.

Restaurants that host wine pairing dinners, tasting events, or other prix-fixe promotions should keep detailed records of those events, including dates, pricing, and the quantity of alcohol typically served. These records can help demonstrate that a tax auditor’s standard per-ounce revenue assumptions do not accurately reflect bundled food-and-beverage offerings.

It is equally important to document spoilage, breakage, over-pouring, product returns, and other inventory losses. Generic waste allowances applied during indirect verification audits often fail to reflect the realities of an individual restaurant’s operations, and the burden generally rests on the taxpayer to demonstrate why a different allowance is appropriate. These same documentation practices are equally valuable if the CRA relies on a net worth assessment or another indirect verification method, as both approaches substitute assumptions for actual records where the Agency concludes that a business’s bookkeeping is inadequate.

Restaurant owners who wish to strengthen their records before an audit arises may also find our article on handling undocumented business expenses helpful, as it outlines practical steps for improving documentation and supporting business deductions. If you have already received a CRA restaurant audit letter or are facing an indirect verification assessment, our tax audit assistance team can help evaluate the CRA’s methodology, prepare the supporting evidence, and represent you throughout the audit, objection, and appeal process.

Frequently Asked Questions (FAQs) About Restaurant Taxation in Canada

When does the CRA use an indirect verification of income tax audit?

The CRA may use an indirect verification of income audit when it concludes that a taxpayer’s books and records do not accurately reflect reported income or taxable sales. Instead of relying exclusively on the taxpayer’s accounting records, the CRA estimates revenue by applying external data, industry benchmarks, and other indirect methods of analysis.

Why are restaurants and bars frequently selected for indirect verification audits?

The CRA often targets restaurants and bars because their operations are considered part of the underground economy that involve significant cash transactions and have access to reliable third-party purchase information, such as provincial liquor board records. These external data sources provide auditors with a foundation for reconstructing revenue using indirect verification or projection-based audit methods.

How does the CRA use alcohol purchase records during a restaurant tax audit?

The CRA may obtain records of a restaurant’s purchases of wine, beer, and spirits from provincial liquor distributors and use that information to estimate alcohol sales. Auditors often apply assumptions about serving sizes, selling prices, and product loss or waste to project alcohol revenue, which may then serve as the basis for estimating the restaurant’s overall business income.

What does “shrinkage” mean in a CRA alcohol projection audit?

In a CRA alcohol projection audit, “shrinkage” refers to alcohol that is purchased but does not generate beverage sales. This may include product lost through spillage, over-pouring, bottle or keg residue, draft line cleaning, spoilage, or alcohol used in food preparation. While CRA auditors typically apply a standard shrinkage allowance, that estimate may not accurately reflect the operating practices or actual losses of a particular restaurant.

Can wine or spirits used in cooking affect a CRA restaurant audit?

Yes. If a restaurant regularly uses wine or spirits in food preparation, those quantities should be properly documented. Without supporting records, a CRA tax auditor may assume that all alcohol purchases were sold as beverages, potentially overstating the restaurant’s projected sales and resulting in an inflated tax assessment.

What records are most helpful in responding to a CRA indirect verification audit?

The strongest evidence includes point-of-sale reports that distinguish alcohol sales from food sales, standardized recipes documenting alcohol used in cooking, records of prix-fixe menus and promotional events, documentation of spoilage and supplier returns, inventory records, and financial statements that reconcile with bank deposits. Together, these records can help challenge a CRA auditor’s assumptions and support the accuracy of the restaurant’s reported revenue.

Who bears the burden of proof in a CRA restaurant tax dispute?

In most CRA tax disputes, the taxpayer has the initial burden of showing that the assessment is incorrect. As discussed in our article on the burden of proof in tax litigation, once the taxpayer produces sufficient evidence to successfully challenge the factual assumptions underlying the assessment, the burden shifts back to the CRA to support its position. This is why maintaining detailed, contemporaneous records is particularly important when challenging assumptions that do not accurately reflect the restaurant’s actual operations, such as alcohol used in cooking or business-specific waste patterns.

What should a restaurant owner do after receiving a CRA audit proposal?

A restaurant owner who receives a proposed reassessment based on an indirect verification of income methodology should carefully review the assumptions and calculations underlying the auditor’s analysis. Consulting an experienced Canadian tax lawyer before responding to the proposal can help identify weaknesses in the CRA’s methodology, present supporting evidence at an early stage, and, in some cases, resolve the dispute before it progresses to a formal objection or Tax Court appeal.

Is indirect verification of income unique to the CRA?

No. Indirect verification of income is not unique to the CRA. Tax authorities in many jurisdictions use projection-based audit techniques when they believe a business’s records are incomplete or unreliable. These methods often rely on observations, purchase records, industry benchmarks, or other third-party data to estimate a taxpayer’s income or sales, and have been used in audits involving restaurants and other cash-intensive businesses around the world.

Can a CRA indirect verification assessment be challenged?

Yes. A taxpayer who disagrees with a CRA reassessment based on an indirect verification of income methodology may challenge the assessment by filing a notice of objection. If the matter cannot be resolved through the CRA’s administrative review process, the taxpayer may appeal the reassessment to the Tax Court of Canada.

How can a Canadian tax lawyer assist during an alcohol-based CRA restaurant tax audit?

An experienced Canadian tax lawyer can assess the CRA auditor’s assumptions, help compile the evidence needed with the business’s accountant to challenge a projection-based reassessment, and represent the restaurant if the dispute proceeds through the objection or appeal process.

DISCLAIMER: The information provided in this article is intended for general informational purposes only and reflects the law and administrative guidance as of the date of publication. It has not been updated and may no longer reflect current legal or tax developments. This article is not legal or tax advice and should not be relied upon as such. Because every tax matter depends on its own facts and circumstances, the discussion may not apply to your particular situation. If you require advice regarding a specific tax issue, you should consult an experienced Canadian tax lawyer.