Introduction

A contractor who has been claiming significant subcontractor expenses over multiple years — and who has been doing so without robust documentation — faces a specific audit risk that can result in a large, multi-year reassessment. The CRA's process for disallowing subcontractor expenses is well-established, and the defence against it requires documentation that must exist before the audit begins, not after.

Scenario: Summit General Contracting Faces a Three-Year Audit

Summit General Contracting Inc. is a mid-sized residential renovation company in Hamilton. In 2025, the CRA initiates a field audit of Summit's 2022, 2023, and 2024 T2 returns. In each of those years, Summit claimed approximately $320,000, $380,000, and $410,000 in subcontractor expenses — together, approximately $1.1 million across three years.

The auditor requests:

•  Written subcontract agreements for each subcontractor

•  Proof of payment (bank records, cancelled cheques)

•  T4As issued for each subcontractor

•  Evidence that the subcontractors existed and performed the work (photos, site logs, project records, client sign-offs)

What the Auditor Is Looking For

The CRA is looking for evidence that:

The subcontractor actually exists as a legitimate business

The services were actually provided (not phantom invoices for work never done)

The amounts paid match the invoices and the bank records

HST was charged where applicable and remitted by the subcontractor

The subcontractor expense claim is a high-risk area because it has historically been used to create false deductions — inflated invoices paid to related parties, or payments to non-existent subcontractors who were in fact the owner themselves drawing untaxed funds.

The Most Dangerous Documentation Gap

The most problematic scenario in the Summit audit: Summit paid $90,000 to a subcontractor over two years. That subcontractor was a sole proprietor friend of the owner. No written contract existed. The invoices were handwritten. The subcontractor's business was never formally registered. No T4A was issued. The subcontractor did not report the income on their own T1 in those years.

In this scenario, even if the work was genuinely performed, the CRA has grounds to disallow the expense — or at minimum to assess a failure-to-withhold penalty for not having withheld from payments to an apparent employee. The documentation gaps make it very difficult to defend.

The Reassessment and Its Consequences

If the CRA disallows $200,000 of subcontractor expenses across the three years — representing payments that cannot be adequately substantiated — the reassessment adds $200,000 to taxable income across those years. At the small business deduction rate, the additional corporate tax is approximately $24,400. Plus arrears interest on the unpaid tax from the original payment due date.

Additionally, where the payments were made to the owner or a related party (rather than to a bona fide arm's-length subcontractor), the CRA may also assess the shareholder benefit under section 15(1) — the same amount becomes personal income for the owner in the years of payment, with the corresponding personal tax, interest, and potentially gross negligence penalties.

A $200,000 disallowance at the corporate level, combined with a $200,000 shareholder benefit at the personal level, can generate a combined tax cost of over $120,000.

The Objection Strategy

In an objection following this type of reassessment, the corporation's response focuses on:

Providing whatever documentation exists — bank records confirming payments, any email or text correspondence with the subcontractor about the work, photos from the project sites, client records confirming the work was completed.

Obtaining statutory declarations or affidavits from the subcontractors confirming the work was performed and the amounts were received.

Arguing that the payments meet the criteria for deductibility under section 18(1)(a) even in the absence of formal documentation — citing case law where the Tax Court has accepted reconstructed or informal evidence of legitimate payments.

The objection is not guaranteed to succeed, and the success rate is higher when evidence of the work's performance can be assembled. It is significantly higher when the audit is happening for 2022–2024 than if it were happening for 2011–2013, where evidence has long since been lost.

What Would Have Prevented This

Written subcontract agreements for every subcontractor relationship.

T4As issued for every subcontractor over $500 paid in the year.

Bank transfer records rather than cash payments where possible.

Project documentation — photos, punch lists, client sign-offs — maintained as a matter of course.

When to Speak With a CPA

For a contractor facing an active audit with subcontractor documentation gaps, the CPA should be engaged immediately — before any response is provided to the auditor. The response strategy and the evidence assembly process require professional management.

Rotaru CPA works with contractors in audit and reassessment processes, including objections to subcontractor expense disallowances. Book a consultation if you are facing an active CRA audit.