Introduction – The CRA Targets Small and Medium Enterprises with Aggressive Indirect Income Verification Audit Methods
The Canada Revenue Agency isn't shy about pursuing a tax audit. But the CRA invokes its most aggressive tactics when auditing small and medium businesses—groups that the CRA perceives as most likely to retain poor records or lack internal controls.
These aggressive tax audit methods fall under a class of techniques known as indirect income verification methods.
After briefly explaining the legal basis of the Canada Revenue Agency's audit power, this article identifies the CRA's techniques of indirect income verification and analyzes the most potent of these techniques: the net-worth assessment.
Canada Revenue Agency's Income-Tax Audit Powers
Sections 231.1 and 231.2 of Canada's Income Tax Act govern the Canada Revenue Agency's tax audit and information-gathering powers. In particular, under these sections, the CRA may:
- inspect, audit, or examine any document of the taxpayer;
- examine the property of the taxpayer or any other person;
- inspect, audit, or examine any document of any other person;
- enter any premises to examine documents or property; and
- require any person—including banks and accountants—to provide any information or document.
On the basis of these provisions, the CRA can issue a Requirement for Information, which is essentially a letter demanding that the taxpayer (or any relevant third party—including accountants, since they don't have legal privilege) release specified documents or information.
If the taxpayer refuses, the Canada Revenue Agency can, under section 231.7 of the Income Tax Act, pursue a court order forcing the taxpayer's compliance.
Techniques of Indirect Income Verification
The methods of indirect income verification are meant to serve as a rough and ready way for CRA to estimate a taxpayer's income when dismal recordkeeping bars the more reliable, regular tax audit techniques. The problem is that indirect income verification doesn't accurately determine a taxpayer's income.
When indirectly verifying a taxpayer's income, a CRA tax auditor may employ any of the following techniques:
- projecting your sales revenues on the basis of input costs and industry margins;
- comparing your household budget and expenditures with data collected by Statistics Canada;
- reviewing deposits appearing on your bank statements (i.e., bank-deposit analysis audit); and
- analyzing the growth of your net worth over a period of time (i.e., net-worth assessment).
These methods often rely on third-party information and numerous assumptions. Say you own a restaurant or night club, and the Canada Revenue Agency believes that you've underreported income from alcohol sales. The CRA auditor might estimate these revenues by obtaining purchase invoices from your alcohol vendors to discern your costs, assuming that you sold all the booze that you purchased, and deriving your revenue on the basis of typical mark ups on alcohol sales. In one case handled by our Toronto tax lawyers, the CRA tax auditor ignored the wine used in food recipes, which resulted in grossly overestimated unreported income from alcohol sales.
Likewise, a CRA tax auditor conducting a bank-deposit analysis will obtain your account statements directly from your bank, assume the deposits consist of taxable income, and add them all up. Proper audit techniques require that the tax auditor reconcile and eliminate transfers between accounts; this often doesn't happen. Further, unless you can satisfy the tax auditor that a particular deposit was a non-taxable item—such as a gift—the tax auditor's assumption stands.
The CRA Auditor's Big Guns: The Net-Worth Assessment
The Tax Court of Canada has long recognized that "the net worth method of estimating income is an unsatisfactory and imprecise way of determining a taxpayer's income for the year" (Ramey v The Queen,  2 CTC 221 at pg. 2122 (Bowman, T.C.J.)).
This method's imprecision is exactly why it works to the CRA's advantage and the taxpayer's detriment.
A net-worth assessment assumes that one can derive a taxpayer's annual unreported income by:
- subtracting the taxpayer's net worth at the beginning of the year from that at the end;
- adding the taxpayer's personal expenditures during the year;
- deleting any non-taxable receipt and any value accumulation of an existing asset during the year; and
- deducting the taxpayer's reported income for the year.
The tax auditor will then adjust the taxpayer's income and tax payable accordingly, and the tax auditor will typically apply a monetary penalty for the taxpayer's purportedly underreporting income.
While the rationale underlying a net-worth assessment is sound, the technique too easily permits a tax auditor to aggregate the practical flaws of each other indirect method of income verification. For instance, when applying a net-worth assessment, an auditor will often use a bank-statement analysis to derive a taxpayer's personal expenditures and growth in net worth. As a result, the auditor may err not only by mischaracterizing business-related withdrawals as personal expenditures—a common mistake when computing personal expenditures—but also by failing to correct for transfers between accounts—a common mistake with bank-deposit analysis. The auditor also often misses liabilities incurred by the taxpayer that would offset an increase in assets.
Because a net-worth assessment fosters these sorts of mistakes, courts frown upon its use when a more reliable method is available. In Menash v The Queen, 2008 TCC 378, the Tax Court of Canada chastised a CRA auditor's use of the net-worth method despite his having received an alternate analysis from the taxpayer along with the supporting information and documentation underlying the taxpayer's analysis.
Tax Tips – Responding to a CRA Indirect Verification of Income Audit
Indirect methods of income verification are inherently inaccurate. But the CRA's advantage lies in the fact that, under Canada's income-tax system, the taxpayer has the initial onus of rebutting the CRA's assumptions. In other words, the Canada Revenue Agency benefits from the numerous assumptions required to make indirect income verification workable.
A taxpayer has two options to rebut the collective assumptions underlying an assessment via indirect income verification method.
First, the taxpayer may challenge the propriety of the auditor's use of an indirect income verification method. Essentially, you'd claim that your accounting records suffice for the Canada Revenue Agency auditor to forego an indirect-method tax audit. This type of challenge is rarely successful at the administrative level given the CRA's internal policies. Litigation at Tax Court may be your most viable option for this approach.
Second, the taxpayer may challenge the indirect audit by analyzing and challenging every assumption and calculation of the 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. This approach to challenging an indirect audit proves more successful at the administrative level than challenging the propriety of the indirect method itself. Indeed, 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.
If the CRA selected your business for a net-worth tax audit, contact our team of expert Canadian tax lawyers for representation, advice, preparation, and strategy.