The concept of “Net Worth” is used in taxation, originally, as part of the definition of what counts as and what doesn’t count as income. The initial analysis created a relationship between “net worth”, “personal expenditures”, and “Income”. In effect, the equation states that a person’s income for the year equals the total personal expenditures for the year plus the change in net worth over that year.
The Canada Revenue Agency (“CRA”) uses the concept of “Net Worth” as an indirect assessment method to determine a taxpayer’s income for the year when they determine that the taxpayer’s books and records are inadequate (and therefore the CRA thinks that that taxpayer has earned more and less than they have claimed), or where the taxpayer ignores the CRA’s request to file returns that have not been filed. This “Net Worth Assessment” is an indirect measure of a taxpayer’s income for the tax year and is often inaccurate.
So, how does the CRA go about determining a taxpayer’s net worth? Given that what the CRA is interested in is a change in a taxpayer’s net worth, they will pick a start date for the period under consideration (for individuals January 1st of a year) and an end date for the period (for individuals, December 31st of that same year). Once the period is picked, the CRA then uses all the records it has at its disposal to determine the value of the taxpayer’s assets and the value of that same taxpayer’s liabilities.
The CRA will ask the taxpayer about their assets and liabilities and ask the taxpayer to provide proof, including bank account statements, credit card statements, mortgage statements, investment account records, property ownership information (houses, apartments, cars, boats, etc), and line of credit statements, and any other source of value or liability that the taxpayer may have. Once the CRA auditor has all the information and is satisfied, they will calculate the total value of the taxpayer’s assets right before the start of the period, the total value of the taxpayer’s liabilities just before the start of the period. The auditor will then subtract total assets from total liabilities, obtaining a positive or negative number for that taxpayer’s net worth at that point in time. The CRA auditor will repeat the same process for the end of the period, obtaining another positive or negative number for the taxpayer’s net worth at the end of that period. This is just the start of the process for a “Net Worth Audit.”
Given that the CRA is concerned with taxable income, not every dollar should be counted, or is counted as part of Net Worth. This applies to each end point of a period because it is the additions during a period that determine whether or not there is income or loss for that period. Not every dollar a taxpayer receives is “Income” the way that the CRA considers the concept. A taxpayer’s bank would consider an inheritance received as adding to that taxpayer’s net worth because the bank is considered with total economic power, not taxable income. However, the CRA would not consider an inheritance received as adding to a taxpayer’s net worth, because an inheritance is, in Canada, a non-taxable source.
The same consideration applies to other non-taxable sources, the number of which are many, and the characterization of some is often up to interpretation. The problem is that the CRA may not know what amounts a taxpayer received in a year are taxable and what amounts are not taxable. The auditor may include everything as taxable, leaving the taxpayer to try and prove that the CRA is wrong. Another important difference between the bank and the CRA’s approach to net worth is that the bank will use the current, market value, of your assets, while the CRA considers the cost base of the asset. Therefore, it doesn’t matter that to the CRA if the real market value of an asset increases or decreases over a period; only the cost of that asset to the taxpayer matters.
Unfortunately, given that the concepts of “net worth” and “income” are so closely related to the impossibly difficult Income Tax Act and the cases that interpret that statute, it takes an expert to identify the mistakes that the CRA has made in coming up with a taxpayer’s net worth. It’s important to make sure that a taxpayer uses a Chartered Professional Accountant (CPA) who is an expert in disputes with CRA.