While most people run for cover when they learn they are being audited, what many don’t realize is that they should be even more fearful of the increasingly prevalent “Net Worth” audit.
Generally an audit begins with a boilerplate letter providing a laundry list of documents to be produced - from vehicle logs to receipts, statements, and invoices.
In instances where documentation is insufficient, auditors rely on an alternate method. This technique is known as the “Net Worth” method; where auditors look at the difference between a taxpayer’s net worth at the beginning and end of the audit period. At that time, the auditor takes into account assets and liabilities at both points. Then they factor living expenses over the time period in the case of an individual, or operating expenses for a business.
Why The Net Worth Approach is Favourable to Auditors
Instead of spending countless hours performing a traditional audit, a net worth audit may be performed effortlessly by correspondence. An auditor may request that the taxpayer provide a list of assets and liabilities at the beginning and end of the audit period, a list of monthly expenses, as well as a sample of bank and credit card statements. Voilà – minutes later the net worth audit is complete.
The net worth method is quick and crude - and unfortunately there is no accountability on the part of the auditor regarding their accuracy. Performance evaluations are not based upon the accuracy. Au contraire! The more inaccurate their audits, the higher the reassessments, and and (it would appear) the better the auditor is at uncovering undeclared revenue.
When the Canada Revenue Agency (“CRA”) can use the net worth audit
Although the net worth method is favourable to auditors, the CRA cannot just use this approach at anytime. The CRA’s Income Tax Audit Manual states under section 13.4.9, titled Circumstances that do not warrant an assessment based on Net Worth, that “[the] net worth basis of assessment should not be used if there is sufficient factual evidence available to support the adjustments even if there are indications of unreported income.”
In fact, the Tax Court of Canada has also underlined that the method is only to be used in extreme cases. It was noted in Bigayan,  1 C.T.C. 2229 (TCC) that “the net worth method […] is a last resort to be used when all else fails.”
The text also states that the net worth method is “frequently […] used when a taxpayer has failed to file income tax returns or has kept no records. It is a blunt instrument, accurate within a range of indeterminate magnitude. It is based on an assumption that if one subtracts a taxpayer's net worth at the beginning of a year from that at the end, adds the taxpayer's expenditures in the year, deletes non-taxable receipts and accretions to value of existing assets, the net result, less any amount declared by the taxpayer, must be attributable to unreported income. […] It is at best an unsatisfactory method, arbitrary and inaccurate but sometimes it is the only means of approximating the income of a taxpayer.” [emphasis added]
Problems with the Net Worth Audits
In my experience this approach results in an inflated taxable income in 100% of cases (but people don’t come to me when their taxes are correct).
A problem in virtually every net worth audit I have ever seen, is that inter-account transfers are unaccounted for. For example, a transfer of $10K from a line of credit to a personal account to pay a credit card bill is recorded as a $10K income (the $10K deposited into the account), plus $10K income (income required to make the $10K card payment). As a result, the $10K is counted twice resulting in double-dipping.
In one particular case, two taxpayers with perfect books and records became my clients after a net worth audit where $1 million of undeclared revenue was “found”. Although they insisted their books were correct, my clients owed $800K with taxes, penalties and interest. When the same documents were provided to the Appeals Officer, he found $300K of undeclared income and removed the penalties. In the appeal to the Tax Court, the same documents were produced for the Department of Justice (the “DOJ”) lawyers who offered to settle for a fraction. But they were still wrong.
At each subsequent stage there was a successively smarter individual on the other side who arrived at a more correct result, which underlines the importance of continuing a challenge to the extent that resources and patience allow. The problem is that it’s expensive to advance to the point where the other side is skilled enough (or cares enough) to arrive at the right answer.
In the end, my clients chose to litigate for the opportunity to both win completely and recover a portion of the legal fees they were forced to pay due to a sloppy audit. But the truth is, the vast majority of taxpayers don’t get this far.
Challenging the CRA’s Methodology
In cases where the CRA insists on conducting a net worth audit – fear not. They do not have the final say.
While the CRA is charged with the administration of Tax Legislation, any administrative decision in which the CRA exercises their discretion can be brought in front of a judge of the Federal Court in the process of Judicial Review.
Since a proper audit usually results in lower taxes than that of a net worth audit (and if on cost-benefit basis it is advantageous to do so) taxpayers may avail themselves of the Judicial Review process to try to force a proper audit - or at the least, they can make their best bluff to do so.
Challenging the CRA’s Assessment
With respect to the quantum of an assessment - this may be challenged within the allotted timeframe, and the best method of challenging a net worth assessment is to put forth evidence of what the taxpayer's income actually is. Point final.
And while in the absence of proper documentary proof, another (inferior) method is to prove that a proper ‘Net Worth’ analysis provides a different result from the auditor’s, it is always best to try to get the CRA to perform a proper audit in the first place.
Dale Barrett is the Bestselling author of “Tax Survival for Canadians: Stand up to the CRA” and the managing lawyer of Barrett Tax Law – a national boutique tax law firm providing service in English and French with expertise in resolving complex tax disputes at every level and dealing with collections, non-filing and voluntary disclosures. More information on Barrett Tax Law is available at www.fightthecra.ca
Dale, whose practice focuses on tax litigation and working with accounting firms to find solutions to address their clients’needs, is a graduate of the McGill University joint common law / civil law program. You can contact Barrett Tax Law directly at (866) 278-8424 or via email at email@example.com.
This posting is for informational purposes only and neither constitutes legal advice nor creates a lawyer-client relationship.
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