Income tax audits can be daunting and costly for taxpayers. Anyone running a company, especially a cash-based one, might not realize the Canada Revenue Agency, or CRA, has various methods it can use to reassess taxpayers. Also, not all methods depend on examining the company's records and books.

If the CRA believes that a taxpayer's books might not be accurate, they might choose to assess the taxpayer using other methods to glean information, such as consulting a third party which is known as indirect methods of verification. One such method is a net worth audit, which is applicable if a taxpayer is thought to not have reported all their income, and the auditor cannot assess this directly.

The CRA can use a net worth tax audit to identify when a taxpayer's wealth increased over 3 tax years or reporting periods, or whatever the audit period might be. The auditor first looks at the taxpayer's liabilities and assets from the start of the audit period. They will then compare them to the liabilities and assets held at the end of the period.

The auditor takes any expenditure made during the audit period into account so that they can determine the taxpayer's net worth. It is assumed that an increase is an unreported income, and the following formula describes how the figure is derived:

  • Opening net worth + reported income - expenditure = closing net worth

Anything more than the figure at the beginning of the audit period is viewed as unreported income and will therefore be subject to tax. The basic assumption is that when a taxpayer increases his wealth during a tax year, he has the choice of spending it or investing it.

The auditor from the CRA will take a close look at any outgoings during the audit period and make assumptions about these expenditures and the taxpayer's overall income. Net worth calculations can include expenditure adjustments based on normal spending standards. This is easy to refute with supporting evidence. The CRA will use actual expenditures (such as from credit cards) over Statistics Canada data for a more accurate result.

According to the Income Tax Act, the CRA doesn't have to accept any evidence offered by the taxpayer. Auditors use their own judgement and can request documents from third parties. This can lead to mistakes, and taxpayers who take the matter to court often win.

A net worth audit might occur if a taxpayer doesn't have adequate books and records to support their tax returns or if there seem to be discrepancies between the taxpayer's reported income and their spending.

Besides the net worth audit, the CRA has other strategies if it suspects unreported income, such as the "application of funds" method, which it uses to examine expenditures. It also has a "bank deposit analysis" method, which it uses to check whether a taxpayer's financial records can explain their deposits.

What Happens in a Net Worth Audit?
Suppose an auditor suspects unreported income and cannot find an explanation in the company's books and records? In that case, the auditor usually follows up by demanding third-party documentation from credit card companies, financial institutions, suppliers, and so on to get a better picture.

The CRA can also look at mortgages, personal property security databases and land titles to determine the taxpayer's assets and value. They often look at the books and records of the taxpayer's family members too.

After compiling all the information, the auditor will transcribe the personal financial records of the taxpayer into a financial statement. The auditor then determines and compares the values of assets at the start and the end of the period. Lastly, the auditor will compare the amounts against the taxpayer's income.

Any expense regarded as a personal expenditure by the auditor is added to the unreported income. This can result in a surprisingly high tax liability.

Since compiling so much information can lead to costly errors, hiring our experienced tax accountants can reduce a colossal tax assessment.

Fighting a Net Worth Audit
An audit of a taxpayer's net worth requires the taxpayer to dispute the amount as quickly as possible. Providing evidence in support of any claims is part of this process. Rather than having to analyze and challenge every component of the net worth assessment, which is very time-consuming, it is more effective for the taxpayer to challenge the methodology of the net worth assessment.

A solid analysis created to refute the result of a net worth assessment is the only way to challenge the CRA's findings. For this, you will need experienced Canadian tax accountants like us to assist you. If you are facing an audit of your net worth, speak with our tax accountants as soon as possible. We have a long history of successfully contesting audits.

In conclusion, taxpayers should be aware that there is a real possibility that CRA mistakes can lead to declaring bankruptcy or loss of business. So don't wait. Connect with our tax accountants today for help with refuting incorrect net worth calculations.

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