Beware The Net Worth Audit – Part One!!
Barrett Tax Law
Arguably, the cheapest, fastest, and dirtiest way in which the CRA can audit a taxpayer is by employing the “net worth” method. It throws all principals of good audit practice to the wind and allows the auditor to essentially go freestyle. And it results in reassessments. Lots and lots of huge, unfair reassessments. And no CRA auditor was ever fired for coming back to the office with lots and lots of huge reassessments. Never. And as an auditor, it is better to err on the side of caution. Plus, if the taxpayer disagrees with the reassessment, they can go ahead and object. And if they lose their objection, they can always appeal to the Tax Court of Canada.
And so begins the sad story in which much of the cost of performing an audit is actually passed from the government to the taxpayer.
The Audit Methodology
For those unfamiliar with the technique, rather than taking the time to painstakingly perform a conventional audit (which involves actually examining taxpayer records), the “net worth methodology” crudely measures the increase in a taxpayer’s net worth over an audit period, and adds to that figure the annual cost of living for the taxpayer and their family.
Per the CRA’s audit manual, “A taxpayer/registrant must have sufficient income (taxable and non-taxable) for a tax year to equal any increase in net worth plus personal expenditures incurred” (13.4.4 Principles of the Net Worth Method).
So in performing the net worth audit, also known as the “lifestyle” audit, the auditor takes into consideration the difference between net worth statements from the beginning and end of the audit period as well as credit card statements and all deposits to the taxpayer’s accounts.
The auditor also takes into consideration the jewelry worn by the taxpayer, the type of house in which the taxpayer lives, the types of vehicles in the driveway, and even the vacation photos with the family in Tahiti. They take into consideration any direct or indirect indication that will help them determine the income required in order to maintain the taxpayer’s lifestyle. They may even engage the taxpayer in seemingly innocuous discussions about their trips and where they shop for their clothes in order to gather more information.
When applied properly, cautiously, and conservatively, the net worth method can be a semi-reliable way to arrive at a taxpayer’s income over an audit period, and it has its (very limited) place. For example, It is understandable that there may be no choice but to audit a cocaine distributor with this methodology: Their upstream suppliers in Columbia do not provide receipts, and there is likely not very much paperwork to support either their income or their expenses. Plus they deal in cash and Bitcoin, both difficult to trace.
But while this methodology appears to be a reasonable method by which a drug czar’s income can be ascertained – there being no reasonable alternative – for the average taxpayer it is fraught with many troublesome pitfalls.
And given the quantity and the severity of the pitfalls, it is important that the taxpayer challenge the auditor if they choose to employ this methodology without proper justification.