From: canadarevenue.agency@canada.com   
      
   The Canada Revenue Agency Nasty Net Worth Audit   : CRA SOTW   
      
   Dale Barrett - Barrett Tax Law Firm   
   Published on November 02, 2015    
      
   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, [2000] 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.    
       
   -------------------------------   
      
   [continued in next message]   
      
   --- SoupGate-Win32 v1.05   
    * Origin: you cannot sedate... all the things you hate (1:229/2)