Net Worth Audit / Net Worth Assessment
The Canada Revenue Agency (“CRA”) and Revenue Quebec (“RQ”) very often use the net worth or cash flow method to estimate a taxpayer’s income when they are selected for an audit.
Both of these methods estimate the taxpayer’s income, however, they are not entirely identical. Generally, the CRA will use the net worth method while RQ will use the cash flow method.
Here are two basic examples of each method. Our taxpayer is declaring 30,000$ a year net, paid 5,000$ in taxes, bought a 350,000$ condo with 100,000$ down in June, mortgage payments of 1200$ a month, drives a leased car costing 900$ a month, has spending of around 2,000$ a month on his credit card, had a balance of 20,000$ in his bank account at the beginning of the year and 30,000 at the end of the year.
Net Worth Method
Step 1: calculate net worth for the year prior to the year under audit. 20,000$ in his account, no debts. Net worth 20,000$.
Step 2: net worth year under audit. Assets: 350,000$ condo + 30,000$ cash = 380,000$. Liabilities: 246,400$ mortgage loan. Net worth: 133,600$.
Increase in net worth : 113,600$
Step 3: Add spending:
Car: 900$ x 12 = 10,800$
Mortgage: 1200$ x 6 = 7,200$
Credit card spending : 2,000$ x 12 = 24,000$
Taxes paid: 5,000$
Step 4: Less declared income: 30,000$
Result = 130,600$ added to income
Potential tax liability (using 50% for simplicity) = 65,300$
Add penalty for gross negligence = 32,650$
Add interest over 3 years = around 15,000$
Assessment = 112,950$
The cash flow method used by RQ is similar but does not use net assets. It compares cash inflows with cash outflows and assesses based on the difference, assuming that any spending exceeding your declared cash inflow is financed with undeclared income.
The burden of proof to undo the assessment falls squarely on the taxpayer’s shoulder, unless the year in question is a statute barred. In practice, even in this last case, the taxpayer needs to demonstrate that the assessment is ill founded.
In the real world, these cases are a lot more complex, and usually involve donations, inheritances, loans between family members or friends, inter-account transfers, savings, etc. all of which can be used to reduce the assessment.
The authorities are not allowed to use this method in every situation, given the speculative and arbitrary nature of it, and we can help ensure that all of the arguments are put forward in order to minimize or cancel the assessment.