A normal income tax audit can be an intimidating and costly process for a taxpayer. Taxpayers who carry on a business, particularly one that deals in cash, may be surprised to know that the Canada Revenue Agency ("CRA") has a number of methods that it can employ to reassess taxpayers, not all of which rely upon the examination of a business' prepared books and records.
In cases where the CRA believe that the taxpayer's normal books and records do not reflect an accurate picture of income earned, Canada's Tax Act provides that the CRA may assess a taxpayer based on indirect methods using information obtained from third-parties or the taxpayer..These tax audit techniques are therefore referred to as indirect verification methods.
One of the most common, powerful and from a taxpayer point of view troublesome methods employed by the CRA to assess the income of a taxpayer is the net worth audit. It proceeds from the premise that a taxpayer has unreported income that the auditor may not be capable of identifying through direct means. The purpose of this article is to explain how a net worth audit proceeds and why any Canadian taxpayer who is faced with this burdensome form of tax audit would be best served by retaining one of our experienced Toronto Tax Lawyers as early as possible in the process.
Net Worth Audit Explained by Toronto Tax Lawyer
The net-worth tax audit is used as a tool for the CRA to identify an increase in a taxpayer's wealth over the audit period, often three taxation years or reporting periods. The CRA tax auditor starts by examining the taxpayer's assets and liabilities at the beginning of the chosen audit period, and then compares them to the assets and liabilities at the end of the period. In addition, the auditor will take into account expenditures during the audit period. Doing so allows the auditor to arrive at the closing net-worth of the taxpayer. Any increase over the audit period is income to the taxpayer, and to the extent that the originally reported income in the tax return is lower, the CRA makes the assumption that the difference is unreported income. The formula can be expressed as follows:
Opening Net Worth + Reported Income – Expenditures = Closing Net Worth
Any amount in excess will be treated as income by the CRA.
The net-worth tax audit method relies upon the simple assumption that when a taxpayer accumulates wealth in a taxation year, there are two options; to either spend or invest the income.
The CRA auditor will examine in depth the taxpayer's expenditures during the selected audit period. Any expenditures can by virtue of the CRA's powers to make assumptions may be imputed into a taxpayer's income. In addition, it is common for the auditor's net-worth methodology to include adjustments to expenditures on the basis of normal standards of spending according to Statstics Canada. However this type of adjustment to business expenses can be easily refuted using supporting evidence. Similarly CRA will use actual expenditures, such as from credit cards, rather than Stats Can data, where records are available.
The draconian power of the CRA to conduct a tax audit in this way is created by subsection 152(7) of the Income Tax Act which states that CRA is not bound by any of the information provided by a taxpayer – such as through the filing of a tax return or the production of books and records – and may assess based on the information it can obtain from both the taxpayer and any third-party sources. Alongside this is the power granted to CRA that allows the auditor to make reasonable assumptions that are supportable by the evidence available. So taxpayers have had victory at the Tax Court through their Toronto tax lawyers by showing that the assumptions made by the CRA auditor were not founded in any real evidence beyond industry averages.
Net-Worth Audit Methodology
A net-worth audit, can be considered the nuclear-bomb in the CRA's powerful tax audit arsenal. In general these types of audits are normally conducted in one of two situations:
- The taxpayer has inadequate books and records to support their filed returns; or
- The initial stages of the tax audit reveal serious discrepancies with the spending habits of the taxpayer and reported income.
It is also important to note that the net-worth audit is just one of several methodologies that the CRA uses when it suspects unreported income. For example the "application of funds" method examines only expenditures. Another technique, the bank deposit analysis method, examines deposits into a taxpayer's bank account and, to the extent that the amounts are not sufficiently explained, the auditor will characterize them as unreported income.
Though the CRA does have the power to apply these types of audit methodologies this power is subject to review and scrutiny by the Tax Court of Canada. Indeed, in many cases the CRA has had its net-worth, application of funds and deposits techniques scrutinized and overturned by the Tax Court. This is just one of the many reasons why proper legal representation by one of our top Toronto tax lawyers is crucial from the beginning of the audit.
How the Net-Worth Audit Proceeds
Once the auditor has determined that there may be unreported income, and confirmed that the presented books and records may not be adequate the auditor will normally proceed by making third-party demands to financial institutions, credit card companies and suppliers for any information about the spending habits of the taxpayer.
In addition, the CRA will conduct searches of land titles, examine mortgages and the Personal Property Security databases to identify assets and the amount of equity a taxpayer has in them.
CRA will normally, in a personal context, examine the books and records of the audited taxpayer's family members and impute all of their spending into income as well.
When all of this information is assembled, the tax auditor then begins the painstaking task of transcribing a taxpayer's personal financial records into a cohesive financial statement based on the formula above.
In essence, the auditor is tasked with determining and comparing asset values at the beginning and end of the period and imputing the difference into a taxpayer's income. In addition, any expenditures during the audit period that the auditor identifies as personal in nature will form part of the unreported income to come up with a tax liability that can be shockingly high to say the least. Given the overall amount of information that is compiled mistakes are common and proper representation by our Toronto tax lawyers will aid in the reduction of a large income tax assessment.
How to Fight a Net-Worth Assessment with Toronto Tax Lawyer Tax Help
Unfortunately for those who take action too late, the most basic rule of Canadian Income Tax Law applies just as strongly in the net-worth context. That is, once a taxpayer has been assessed using the net worth audit, the onus is on the taxpayer to dispute the amounts on a timely basis and then lead evidence to prove that the CRA's tax audit was mistaken.
There are essentially only two ways for a taxpayer to rebut the collective assumptions in a net worth audit context. First, a taxpayer may challenge the suitability of the net worth method as not being accurate given the taxpayer's circumstances. This type of challenge is normally not successful given the CRA's internal policies and only ever at the Tax Court level.
The second and generally more successful way a taxpayer may challenge the net worth assessment is more onerous and time consuming: a taxpayer will have to analyze and challenge every specific aspect and calculation of the net worth assessment on a line by line and item by item basis. In addition, a thorough analysis to refute a net-worth assessment will include a detailed review of the taxpayer's assets at the beginning of the audit period as well as an analysis of the taxpayer's interim and closing liabilities. In order to effectively challenge the net worth audit or tax assessment a taxpayer requires the help of one of our top Toronto Tax Lawyers.
Our professional Canadian tax lawyers have successfully opposed net worth assessments by questioning every assumption, item and interpretation made by the auditor and attacking all deficiencies.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.