Most taxpayers who are faced with a net worth assessment (NWA) audit struggle to understand its cause, purpose or mechanics. This article contains answers to some of the basic questions we receive from clients about NWA audits and reassessments. It can be helpful to review as you are preparing for a meeting with your tax lawyer.
1. What is a Net Worth Assessment audit method?
A net worth assessment is an audit technique that allows the CRA to determine your income and assess your tax liability based on your net worth and your lifestyle (and not solely based on your tax return or business records).
In simple terms, the CRA will treat any appreciation in your wealth over a period of time as your income, unless you demonstrate otherwise. The CRA does not have to prove where the money came from, or that the source of income is taxable—they only have to prove that your wealth has increased.
2. When does the CRA use the NWA method?
The NWA method was originally designed as a method of last resort for cases where the taxpayer’s records are unavailable or unreliable (returns not filed, records insufficient, inaccurate information provided, information is incapable of verification, or taxpayer refuses to provide information). In practice, however, we see the NWA method used by the CRA in a wide variety of cases, even if the books and records are properly prepared.
NWA audits are more common in cash-heavy industries (restaurants, nail and hair salons, construction, convenience stores, and cash-only parking, for example). They sometimes follow a criminal conviction, where it was determined that a person may have received large amounts of cash (for example, drug offences, money laundering, or fraud).
3. What kind of documents would I have to provide to the CRA?
Every audit is different, but you most likely will be asked to provide information on all your assets (bank accounts, real estate, cars, boats, investment accounts, and the like), liabilities (mortgages, private loans, and loans from family and friends), and your personal expenditures (credit card and bank statements, primarily) over a period of time (usually over three prior taxation years). You may also be asked to identify deposits and withdrawals on your bank account.
4. Can I refuse to provide certain information to the CRA? They are asking for information that I consider private.
It depends on the information. Generally, the CRA’s audit powers are extremely wide when it comes to requesting the “books” and “records” required in order to determine your tax liability.
Note that the auditor can obtain a lot of information from your financial institution, land registry records, or even from posts or pictures on your social media accounts. In most cases, it is in the taxpayer’s best interest to provide the most complete and accurate information to the auditor.
However, there are exceptions from every rule (for example, privileged correspondence with your lawyer or documents outside the scope of the audit don't have to be provided to the CRA). Your tax lawyer should carefully review every audit request for documents and advise you on your rights.
5. How would CRA determine my taxable income using NWA?
In very general terms, the CRA will:
calculate an increase, if any, in your net worth over a period of time (usually three taxation years);
add your personal expenditures; and
deduct various non-taxable receipts (for example, gifts, lottery winnings, and tax refund payments).
The following chart is a simplified example of so-called net worth schedule used by CRA auditors to determine a taxpayer’s income based on the NWA method.
This schedule considers a hypothetical taxpayer, Mr. A, who reported $40,000 in annual income. In the course of the audit and review of Mr. A’s assets, liabilities, and bank statements, the auditor determined that Mr. A’s net worth increased steadily by $100,000 every year.
The auditor also noted that Mr. A’s personal expenditures were $50,000/year during Year 1 and Year 2. In Year 3, they increased to $100,000. The auditor accepted that some of the deposits on Mr. A’s bank account came from non-taxable sources, such as gifts, gambling winnings, and tax refunds. Based on the facts, the auditor’s net worth assessment would look as follows:
6. “Is this my income? This can’t be right!”
And it usually isn’t right. The NWA method is extremely unreliable and often results in grossly inaccurate and unfair reassessments. Clients have told us that they experienced shock and disbelief when they were first presented with the result of the NWA audit. Often, we’re not surprised!
7. Why is the NWA method unreliable?
It is not an easy task to reconstruct one’s personal finances four years after the fact, which is what an NWA audit attempts to do. Some errors happen because of lack of taxpayers’ records; others result from an omission or sloppiness in the auditor’s work.
Regardless of the cause, the errors almost always benefit the CRA and prejudice the taxpayer. This is because the NWA audit tends to “assume the worst”, namely that:
any increase in wealth was funded with taxable income;
every bank deposit represents taxable income; and
every bank withdrawal represents a personal expenditure, which was funded by taxable income.
In reality, however, none of these assumptions are universally true.
A bank deposit can represent many different things, such as a non-taxable gift, an inheritance, a transfer from your other account, a loan repayment, a reimbursement, a tax refund, a returned cheque due to non-sufficient funds, funds accepted on behalf of someone else, an insurance payout, and many other receipts that are not taxable revenues.
A bank withdrawal, on the other hand, can represent a business expense; a cheque that was later returned due to insufficient funds; a loan repayment; a repayment of funds held on behalf of someone else; an employment expense subject to reimbursement; an inter-account transfer; a purchase of an asset already accounted for by the audit; and other payments that are not considered personal expenditures.
In the example above, Mr. A’s personal expenditures doubled from $50,000/year in Year 1 and Year 2, to $100,000/year in Year 3. Mr. A says that the withdrawal represented a loan repayment to his late father. As Mr. A was unable to present solid proof of the loan arrangement with the father, the auditor assumed that the additional withdrawal of $50,000 was a personal expenditure funded from unreported income in Year 3. It is now up to Mr. A to prove that loan and the repayment were non-taxable.
8. If the NWA method is unreliable, why is CRA using it?
The short answer is because they can.
Subsection 152(7) of the Income Tax Act (Canada) grants the CRA the right to assess the tax payable without regard to a return or information supplied by the taxpayer. The courts interpreted the provision as empowering the Minister to issue “arbitrary” assessments using “any appropriate method for determining the tax payable by a taxpayer,” including the NWA method.
Canadian courts recognize that the NWA method produces an “imprecise approximation” of a taxpayer’s income. At the same time, judges have held that any perceived unfairness of the NWA method is resolved by recognizing that the taxpayer can “simply correct the Minister’s error to the satisfaction of the Court”.
In practice, however, correcting the Minister’s errors is rarely simple and often expensive. This is why you need an experienced tax lawyer by your side as early in the audit/reassessment process as possible.
9. How do I dispute a CRA assessment made based on the NWA method?
First and foremost, contact a lawyer lawyer as soon as practical. In most cases, in order to dispute a NWA, your lawyer will prepare and present your own version of the NWA schedule. Your tax lawyer will reconstruct your financial life during the audit period, dollar by dollar, line by line, identify the CRA auditor’s mistakes, and correct them.
10. Mr. A has no documents to prove that he received $100,000 loan from his late father in Year 1, and not as income. Does it mean that Mr. A is going to lose his tax appeal?
No, it does not. Mr. A’s oral evidence, if credible, may be enough to help him dispute the reassessment as it relates to the $100,000 loan. Mr. A’s tax lawyer will outline the strengths and weaknesses of his case to help him organize and present his evidence.
It’s not uncommon for taxpayers to have incomplete records for their personal assets, liabilities, expenditures, deposits and withdrawals from prior years. After all, very few people formalize loans between family members or keep notes of every personal gift or reimbursement they receive. Some older people keep their lifetime savings in cash, make cash gifts and loans, leaving no paper trail.
When faced with an NWA audit, these taxpayers sometimes get discouraged, thinking that their oral evidence—the only evidence they have—would be worthless in court. In reality, their problems are not unique and can be solved with a solid and credible testimony which articulates why the Minister’s calculations are incorrect.
If you are being audited or were reassessed using the NWA method, contact our tax lawyer for a free no-obligation 20-minute assessment of your case.
[1] Hsu v Canada, 2001 FCA 240, 2001 DTC 5459 (FCA), leave to appeal to SCC refused.