Subsection 152(7) of the Income Tax Act[1] provides that the Canada Revenue Agency (CRA) is not bound by a tax return provided by a taxpayer in making an assessment and notwithstanding whether a tax return has been provided the CRA may raise an assessment. This provision permits the CRA to assess a taxpayer for any amount at any time (subject to limitation periods).
Subsection 152(7) is the legal basis for “net worth assessments.” The net worth assessment is one of many audit tools available to the CRA. The CRA has employed net worth assessments for years and their use is increasingly common.
Net worth assessments are a blunt instrument and are referred to as an audit method of “last resort.”[2]
When are Net Worth Assessments Used?
The CRA generally employs net worth audits in situations where a taxpayer’s records are unreliable, external evidence suggests that a taxpayer’s lifestyle indicates a level of income greater than the amounts reported on tax returns, the CRA suspects that the taxpayer has unreported income (eg, narcotics trafficking) or the CRA suspects under reported sources of income.
How the CRA Raises Net Worth Assessments?
The CRA conducts net worth audits by measuring a taxpayer’s net worth at the beginning of the audit period and the end of the audit period (the audit period will be one or more years) and estimating expenses and making certain tax related adjustments and then assuming the difference to be income.
A net worth calculation has four components:
- Assets: Determined at the beginning and end of the audit period. The assets are shown at their adjusted cost base (not fair value).
- Liabilities: most liabilities are included in a net worth calculation.
- Personal expenditures: may have been funded by disposing of assets, incurring debt or using income earned. Usually, the auditor will ask the taxpayer to provide an estimate of their personal expenditures. If the auditor does not accept the taxpayer’s estimate, the auditor may use Statistics Canada averages or withdrawal analysis (or both)
- Tax related adjustments: deductions for non-taxable sources of income, deductions for reported income, etc.
Attacking Net Worth Assumptions
Generally, taxpayers have two options to challenge a net worth assessment: one, attack the individual elements of the net worth assessment and two, present a better method of determining the taxpayer’s income. Typically, taxpayers attack a net worth assessment by attacking the individual elements of the net worth assessment (it’s usually difficult to attack the net worth assessment by providing a better alternative for determining the taxpayer’s income since adequate books and records aren’t usually available).
Net Worth Assessments and Gross Negligence Penalties
The CRA generally assesses gross negligence penalties when conducting a net worth audit. Gross negligence penalties are usually assessed because the alleged unreported income is high, comes from an unreported source and / or because the taxpayer’s records do not exist or are disordered.
[1] RSC 1985, c. 1 (5th Supp).
[2] Ramey v R., 1993 CarswellNat 979.