Net Worth Audit
What is a CRA Net Worth Audit?
A standard audit will involve a review of a taxpayer’s accounting and related records (e.g. bank statements). However, if the Canada Revenue Agency (“CRA”) considers a taxpayer’s records insufficient they may utilize the Net Worth Audit method. In Ramey v. The Queen, 93 DTC 791, the Tax Court of Canada described the Net Worth Audit as a “blunt instrument of which the Minister must avail himself as a last resort.”
CRA’s underlying justification for utilizing the Net Worth Audit method is that there is some indication of irregularity or insufficiency in the taxpayer’s financial affairs and records. So, rather than just reviewing a corporation’s accounting records, if they exist, CRA will employ the Net Worth Audit method to consider a multitude of factors. This may include a review of assets and liabilities, along with bank records, in an attempt to identify and assume unreported income.
A taxpayer’s lifestyle may be examined to determine if the respective tax returns indicate the income to support it (CRA lifestyle audit). If they do not, the auditor will increase taxable income wherever possible. For example, a financial gift from a parent will be turned into taxable income. An unidentified bank deposit will be the same. CRA may also look into the personal financial records of non-arm’s length parties such as a spouse. Ultimately, the goal of the CRA auditor will be to increase taxable income and if the taxpayer’s books and records are in poor shape it will be much easier for them to do so.
When will CRA use the Net Worth Audit method?
Canada Revenue Agency refers to a Net Worth Audit as a “indirect verification of income” method. According to CRA, they will rely on the Net Worth Method, if:
The taxpayer’s books and records are inadequate and indicate potential errors;
The taxpayer mixes personal and business income in bank accounts. For example, one account may be used for both personal and business transactions;
The income reported by the taxpayer does not support their lifestyle;
The business under audit is in an industry where tax evasion is common;
Comparable businesses report higher income than the business under audit.
Ramey v. The Queen, 93 DTC 791 - A "blunt instrument"
In Ramey v. The Queen, 93 DTC 791, at paragraph 6, the Tax Court of Canada stated that a Net Worth audit is an imprecise method of measuring income and even though the resulting tax assessment may be “inaccurate within a range of indeterminate magnitude” it will still stand unless effectively disputed. According to the Tax Court of Canada:
The net worth method of estimating income is an unsatisfactory and imprecise way of determining a taxpayer’s income for the year. It is a blunt instrument of which the Minister must avail himself as a last resort. A net worth assessment involves a comparison of a taxpayer’s net worth, i.e. the cost of his assets less his liabilities, at the beginning of a year, with his net worth at the end of the year. To the difference so determined there are added his expenditures in the year. The resulting figure is assumed to be his income unless the taxpayer establishes the contrary. Such assessments may be inaccurate within a range of indeterminate magnitude but unless they are shown to be wrong they stand. It is almost impossible to challenge such assessments piecemeal. The only truly effective way of disputing them is by means of a complete reconstruction of a taxpayer’s income for a year. [emphasis added]
How do you challenge a Net Worth Audit Tax Assessment?
CRA auditors have enormous discretion. In addition, there is a reverse onus in tax law and in practice auditors are permitted to assume facts that a taxpayer must then rebut.
If a audit tax assessment is inflated it can be successfully challenged with a Notice of Objection and appeal to the Tax Court of Canada. As stated by the Tax Court of Canada in Ramey v. The Queen, 93 DTC 791, the “only truly effective way of disputing [a Net Worth Audit] is by means of a complete reconstruction of a taxpayer’s income for a year.” Accordingly, the best method to dispute the audit tax assessment is to have your books and records reconstructed to demonstrate the contrast with the CRA auditor’s accounting and factual assumptions.
According to the decision in Chernenkoff v. Minister of National Revenue, 49 DTC 680, at page 683, in “the absence of records, the alternative course open to the appellant [is] to prove that even on a proper and complete “net worth” basis the assessments were wrong.” Proof can come in the form of oral evidence and supporting documentation.
How can we help?
We have represented many clients during and after a Net Worth Audit. If a taxpayer wants to appeal a Net Worth Audit tax assessment, we can first file a Notice of Objection and challenge the assessment before a CRA Appeals Officer. Normally, we will review the work of the CRA auditor to determine inaccurate factual assumptions.
If necessary, we will recommend to the client that we involve an accounting professional so that we can provide expertly prepared books and records to the CRA Appeals Officer that demonstrate the auditor’s incorrect assumptions. In addition, we will review associated case law and policy and submit legal arguments countering those assumptions and the basis upon which they were made.
If the reconstruction of accounting records is not possible (or as in Chernenkoff there is “the absence of records…”) the involvement of a Tax Lawyer is key to providing documented oral and related evidence to support the taxpayer’s position.
A Net Worth Audit tax assessment can also be challenged in the Tax Court of Canada in the same manner.
Ramey v. The Queen, 93 DTC 791
Ramey v. Canada,  T.C.J. No. 142 (QL),  2 C.T.C. 2119, 93 DTC 791
Chernenkoff v. Minister of National Revenue, 49 DTC 680
SpenceDrake Tax Law