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 you, personally, do not spend your 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 often 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.
Any taxpayer is at risk of a Net Worth Assessment. However, those most susceptible are taxpayers who have not properly reported their income or those who fail to keep proper books and records of their financial affairs. Also at risk are taxpayers whose apparent lifestyle doesn’t match their reported income. The most obvious way to not get trapped into a net worth assessment is to make sure that the CRA has no reason or basis to use this method. This means filing all your returns on time, using complete and accurate information, and keeping complete books and records.
Challenging a net worth assessment is no easy task and often takes up a large amount of time. You will need to go through every deposit and withdrawal in your bank accounts, your credit cards, and your investment accounts, as well as the assets you own or have owned, and then reconcile these amounts with your tax filings. Where the audit spans a number of years or goes back a few years, this can be extremely difficult for a taxpayer. How do you remember what each deposit and withdrawal in your account was and what it was for? Even if you remember, there is the difficulty of proving what you remember. This is why the assistance of a diligent and experienced tax accountant is a must. The best time to get your tax accountant involved is when the auditor contacts you and before any documents are handed over. The earlier you get your tax accountant on board, the greater the chances of a favourable outcome are.
Without a tax expert on your side, you can at least take a few steps to try and make sure that the CRA hasn’t grossly overestimated your income using the Net Worth Method. At the very least, you can:
- Review the bank account and credit account analysis to make sure that inter-account transfers are not included in your income and personal expenditures;
- Drawings from lines of credit or credit cards are not included in your income or personal expenditures;
- You obtain and pass on to the auditor documents that prove non-taxable deposits such as inheritances, loans, gifts, insurance payouts, lottery and gambling winnings, and amounts from the sale of personal property;
- You provide proof of actual household expenditures so that the auditor does not use statistics to include amounts that are not in line with your lifestyle; and
- All of your assets and debt are taken into account (sometimes auditors forget to include debt related to properties, such as mortgages or car loans).
It is unlikely that an objection at the CRA will result in any changes. If you are not able to get the CRA auditor to see things your way, you will have to take the assessment to tax court. This is a lengthy and expensive road to travel and one that is best avoided.