Understanding Net Worth Audits and Assessments
Understanding net worth audits and assessments. Has your CRA Auditor informed you that your audit will be a “Net Worth Audit”, and you want to better understand how they are using this technique to determine your income? We have previously written about the net worth audit and the related objection process, more generally, here. This blog seeks to provide a closer look into and understanding of the mechanics of a net worth audit and the legal grounds upon which the Court’s have indicated a taxpayer may challenge the assessment.
Understanding Net Worth Audits, Assessments and the Grounds to Challenging Them
Subsection 152(7) of the Income Tax Act states that the Minister of National Revenue (the “Minister”) is not bound by any return or the information that is supplied by or on behalf of a taxpayer when arriving at its assessment of the taxpayer. This is the provision relied upon by the Canada Revenue Agency (the “CRA”) in circumstances where a CRA auditor concludes that a taxpayer’s books, records or returns are not a reliable indication of a taxpayer’s genuine income. In these circumstances the CRA often decides to proceed with determining the taxpayer’s income by performing a net worth assessment (sometimes also referred to as a net worth “analysis” or “audit”) that later typically results in a reassessment that increases a taxpayer’s taxable income based on its results.
The net worth assessment determines a taxpayer’s income by looking at changes in an individual’s or a family unit’s net worth from one year to the next that cannot be explained by the income reported to the CRA in that year. Although there are other factors that need to be accounted for in a net worth assessment that very from case-to-case, the result of the assessment is largely determined by examining four key aspects:
- Increases or decreases to the taxpayer’s total assets;
- Increases or decreases to the taxpayer’s total liabilities;
- The total annual personal expenses for the year; and
- The taxpayer’s total sources of income.
This method of assessment involves the gathering of a large magnitude of information, data, and documents during the audit stage. Further, as part determining taxpayer’s total annual expenses and to analyze cash deposits made by the taxpayer (a “bank deposit analysis”), the net worth assessment will usually require the CRA auditor to comb through the taxpayer’s bank transactions line by line to categorize the type of transaction. For these reasons, taxpayers often find this technique both highly intrusive upon their privacy and intimidating. Further, the information provided at the onset of the net worth assessment sets the stage for the rest of the dispute resolution process and it is therefore important to seek professional assistance early when the CRA elects to proceed with this type of assessment.
Simplified Example: How a Net Worth Assessment Determines Income
Imagine that a taxpayer starts their day with $100 in their bank account (their total assets) and $500 owing on their credit card (their total liabilities). Throughout that day the taxpayer purchases a coffee for $5, lunch for $25, and tickets to a concert for $125 (their total living expenses). Assume the taxpayer did not earn any income on this day (their total income).
Now imagine that at the start of the next day the taxpayer’s accounts have balances of: $75 in the taxpayer’s bank account; and $505 owing on the taxpayer’s credit card.
In this scenario, an auditor would likely conclude that there is a discrepancy in the taxpayer’s net worth because the taxpayer spent a total of $155 on living expenses, while only having a corresponding decrease of $25 to the taxpayer’s total assets and an increase of $5 to the taxpayer’s total liabilities. As a result, only $30 of the Taxpayer’s expenses are accounted for by the taxpayer’s decrease to asset and increase to liabilities. The $125 unaccounted for is the net worth discrepancy. As a result, this amount would likely be attributed as taxable income to the taxpayer in a net worth assessment because an auditor will assume that the missing $125 must have been earned by and paid to the taxpayer in that period to cover the discrepancy.
Suppose the taxpayer was given a gift of $125 cash from a family member to purchase the concert tickets. Where the taxpayer is able to put forward proof of the source of the non-taxable income, such as a gift, the CRA will likely accept that the discrepancy is resolved, which may not sound too difficult in the over-simplified scenario provided.
However, the trouble is that in real world application the net worth analysis is much more complicated and very difficult for a taxpayer to dissect and to determine where the source of the inconsistencies arise from. As mentioned, the net worth assessment typically needs to account for income from sources that are non-taxable but still available to a taxpayer, such as tax rebates, and also often involves examining entire households as one economic unit to properly account for transfers between immediate family members that live together. Further, resolving a net worth assessment may also be difficult because the proof requested for non-taxable transactions may only be requested by the CRA years after the taxpayer’s original assessment. This can make it an uphill battle for the taxpayer to prove their legitimate sources of non-taxable income.
Grounds to Challenge
The Tax Court of Canada (the “TCC”), has stated in various ways that net worth audit techniques and the resulting net worth assessments are “inherently inaccurate” and are “last resort approaches to the computation of income.” Despite these statements, the net worth assessment remains to be frequently employed by the CRA as a means of determining a taxpayer’s income, so on what grounds may a taxpayer challenge a net worth assessment?
In a 2020 TCC decision, Saini v The Queen, Justice Bocock in reviewing a prior decision written by Justice Boyle in Golden V R, 2009 TCC 396, concluded that a taxpayer may challenge a net worth assessment on three grounds: (i) necessity; (ii) methodology; and (iii) patent errors.
The first ground that a taxpayer can challenge a net worth assessment is “necessity” by disputing whether the actually needed to proceed by way of net worth assessment to determine the taxpayer’s income. To succeed on this ground the taxpayer must prove to the court that there is sufficiently credible evidence or records that could have been used to establish the taxpayer’s true income.
Unfortunately, as these types of audits and resulting disputes are too often initiated by the CRA beyond the statutory limitation period, whether justified or not, the resulting net worth assessments often impose a heavy burden on the taxpayer resulting from lost documents that make it less likely to succeed in appealing on this ground.
The second that the taxpayer can rely upon in challenging a net worth assessment is to dispute the net worth assessment on the ground that “methodology” employed by the auditor was wrong. Challenging a Net Worth Assessment on this ground can be very difficult for the average taxpayer because it requires a deeper understanding of the methods relied upon by the auditor, which may require some prior accounting knowledge to understand adequately enough to challenge the assessment on that basis.
Finally, a taxpayer may challenge the net worth assessment on the ground that the quantum is incorrect due to “patent errors” that were “avoidable, identifiable, and inappropriate errors that should have been reversed.” Again, challenging the assessment on this ground often requires some prior accounting or tax knowledge to enable the taxpayer to properly review the auditor’s proposed findings. This is a very time-consuming task that may require an individual to parse through years of financial transactions to reverse engineer the auditor’s net worth analysis or to spot errors such as double entries where the auditor may have accidentally included an item twice resulting in unjustified increases to the taxpayer’s income.
If you are being audited, or you have received a net worth assessment give us a call today!
This article provides information of a general nature only. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions, you should consult a lawyer.