CRA Net Worth Audit - Complete Guide - Cowan & Carter Law Firm

What is CRA Net Worth Audit?

The Net Worth Audit is a method used by the Canada Revenue Agency (“CRA”) to calculate a taxpayer’s income based on the increases in their wealth over a given audit period. Essentially, the CRA compares a taxpayer’s assets and liabilities in one year against the assets and liabilities of the previous year to estimate the income for that year. If this number is greater than the income originally reported on the taxpayer’s tax return, the CRA usually assumes that the discrepancy is due to unreported income and proposes reassessments based on that assumption.

What does a Net Worth Audit Entail?

The basic premise of a net worth audit is that the taxpayer being audited likely has unreported income that can’t be identified through traditional means. A CRA auditor will often use this type of audit when they believe that the taxpayer’s books and accounting records are inadequate, inaccurate, or unreliable and therefore can’t provide an accurate reflection of the taxpayer’s income. Once this is done, an auditor will typically proceed by acquiring information from third parties such as:

banks and financial institutions;
credit card companies;
suppliers;
insurance brokers;
stockbrokers and investment firms;
lawyer’s and accountant’s office;
provincial land registry offices;
municipalities – municipal taxes, building, and other permits;
vehicle, vessel and aircraft registries; and
other individuals or organizations

Once this information is gathered, the auditor begins taking the information from the available personal financial records to form a cohesive picture of the taxpayer’s income. At the end of this audit, all of this information is compiled into a final audit report, which will typically be organized as follows:

Schedule 1: Balance sheet – Assets
Schedule 1a: CCA schedule
Schedule 2: Balance sheet – Liabilities
Schedule 3: Calculation of the discrepancy in total income per net worth
Schedule 4: Summary of personal expenditures
Schedule 5: Analysis of income tax discrepancy per net worth

How Reliable are Net Worth Assessments?

One problem with net worth audits is that they can be notoriously inaccurate. This is why they are considered a tool of last resort. The CRA’s own Income Tax Audit Manual admits that “The assessing net worth technique will not measure income with absolute certainty but will give a conservative estimate of income.” For tax lawyers and accountants who deal with net worth audits on a regular basis, this is quite an understatement.

For example, suppose a small business owner borrows $100,000 from a line of credit account to his operating account to help pay for immediate business expenses. As revenue starts flowing into his general account, the business repays the loan. Many times, a careless auditor will take the gross deposits of each account without considering the overall context of these deposits, and assess the taxpayer at double or triple the taxpayer’s actual income, leading to a complicated tax audit and significant penalties.

The Burden of Proof is on the Taxpayer

Unfortunately for the taxpayer assessed by a net worth audit, one of the basic tenets of Canadian tax law is that the burden of proof is on the taxpayer to disprove the CRA’s assumptions in any given assessment. As the Supreme Court laid out in the case of Johnston v. Minister of National Revenue, the Court will deem the assumptions of the Minister of National Revenue to be true until those assumptions are demolished by the taxpayer. This rule is based on the premise that in a reporting tax system like Canada’s, it is the taxpayer who is in the best position to provide information and documents relating to their financial affairs.

While this may be true, it also places an enormous burden on the taxpayer who now has to review and analyze every piece of information that contributed to the auditor’s net worth assessment and cross-reference that with their documents. This can be an incredibly long and stressful process. However, a good tax lawyer can help navigate taxpayers through this process and successfully challenge the CRA’s assessment, especially in difficult tax matters.

Can I Challenge a Net Worth Audit?

Yes, you can challenge a CRA net worth audit if you believe it to be inaccurate. Here are the steps and grounds on which you can challenge it:

Necessity: Argue that the net worth audit was not necessary by demonstrating that your records were sufficient to determine your actual income. The CRA typically uses net worth audits when they suspect discrepancies between your reported income and lifestyle, particularly if your records are deemed unreliable or insufficient.
Methodology: Challenge the audit by pointing out specific errors in the CRA’s methodology. This may include incorrect assumptions or miscalculations in their assessment. This requires a solid understanding of accounting and tax law.
Patent Errors: Dispute the audit by identifying clear mistakes in the CRA’s calculations or assumptions. For example, if they double-counted assets or included non-taxable income as taxable income, these errors can be contested.

How do you Challenge a Net Worth Audit Tax Assessment?

Challenging a Net Worth Assessment Audit can be complex, but understanding the process and knowing your options is crucial. Here’s a guide on how to effectively challenge such an assessment:

Understand the Net Worth Audit: The Canada Revenue Agency (CRA) uses this net worth method when it suspects discrepancies between your reported income and your actual financial situation. This audit involves comparing your net worth (assets minus liabilities) at the beginning and end of the CRA audit period, along with your expenditures, to identify unreported income.
Gather Comprehensive Documentation: The best way to challenge the assessment is by providing thorough documentation that supports your reported income. This includes bank statements, receipts, invoices, and any other financial records that can help reconstruct your income accurately.
Identify and Correct Errors: Review the CRA’s assessment carefully to identify any inaccuracies. Common errors can include misclassified income or expenses, or assumptions made by the auditor that are not accurate. Providing evidence to correct these errors can help reduce your assessed tax liability.
Legal Grounds for Challenge: There are three main grounds to challenge a net worth audit:
- Necessity: Demonstrate that you have sufficient books and records to determine your actual income.
- Methodology: Argue that the auditor’s methodology was flawed or improperly applied.
- Patent Errors: Point out any clear errors in the audit, such as incorrect data or assumptions.
File a Notice of Objection: If you disagree with the audit results, you can file a Notice of Objection with the CRA. This step is essential to formally dispute the assessment and begin the appeals process.

Given the complexity and technical nature of net-worth audits, it is advisable to seek help from our Civil Litigation Toronto firm which can provide expert guidance and representation. The professional lawyers at Cowan & Carter litigation firm Toronto can help ensure that your documentation is thorough and that your arguments are presented effectively, helping you to prove the CRA wrong in cases of CRA problems and CRA lifestyle tax issues with the CRA.

A net-worth assessment can be a challenging and stressful process. Understanding the audit method, having thorough personal financial records, and being prepared to assume facts are critical steps. If you are faced with an audit from the CRA, remember that you have the right to challenge it on a timely basis, especially if you believe the net worth assessment is based on flawed or inaccurate information. Get professional litigation services in Canada today.

Published on November 30, 2021