Involved in a CRA Net Worth Audit?

What is a Net Worth Audit?

Almost all Canadian resident taxpayers and, in some circumstances, non-resident taxpayers, have to file various returns with the Canada Revenue Agency.  If a taxpayer fails to file a tax return when and as required, the Canada Revenue Agency (CRA) can either make a demand of that taxpayer to file missing returns or, in most cases, will use an arbitrary assessment method to determine that taxpayer’s tax liability.  Arbitrary assessments often result in an unusually large amount of tax owing, leaving the taxpayer with the heavy burden of proving the CRA wrong.  One particularly problematic arbitrary assessment method that the CRA uses is called the Net Worth Assessment that results from a Net Worth Audit.

The Net Worth Audit is empowered by the Income Tax Act and permits the CRA to review the various components of a taxpayer’s lifestyle and assets and compare this against the reported income of that same taxpayer.  This review can include where the taxpayer lives, how nice the home is, what cars the taxpayer drives, what clothing and jewellery the taxpayer wears, and the entertainment and trips that the taxpayer engages in.  Where there is a discrepancy between the apparent wealth circumstance of a taxpayer and their reported income, the CRA will issue a reassessment.

A Net Worth Audit is premised on the apparently simple principle that the increase or decrease of a taxpayer’s net worth, year over year, tied to the taxpayer’s income or loss for that year.  The CRA starts by comparing the year over year changes of a taxpayer’s assets and liabilities.  Then, the CRA calculates that taxpayer’s income or loss, taking into consideration personal expenditures and non-taxable sources of income. Personal expenditures can sometimes be assumed and include categories that the taxpayer, personally, does not spend their money on (for example, tobacco, alcohol, gambling – all determined through the use of statistics).  The sum total of these arithmetic process is the change in a taxpayer’s net worth.  The value obtained from the net worth method is then compared to the reported income of the taxpayer to see the taxpayer has been truthful in their reporting.

Despite the apparent simplicity of this method, there are practical complications that often work against the taxpayer.  One particular problem is that the CRA is entitled to assume facts that are often to the taxpayer’s disadvantage.  Once these facts are assumed, the taxpayer has to prove the CRA wrong in order to get a correct assessment.  Another problem is that the CRA lacks the information to know what amounts are from non-taxable sources, such as inheritances or lottery winnings.  What the CRA generally assumes is that any deposit in an account is income and any withdrawal is a personal expenditure.  This is often not accurate as a deposit can represent an inter-account transfer, a loan, a gift, an inheritance, or some other amount that is not taxable.  The method itself is at best inaccurate and contains inherent, systemic errors.