Beware The Net Worth Audit

Beware The Net Worth Audit

(re-published from www.theGaap.net)

August 1, 2018

Dale Barrett
Managing Partner
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.

Five Major Pitfalls

  1. The Methodology Is Inaccurate
  2. The Methodology Is Punitive When Not Applied Conservatively
  3. There Are Routine Errors in Its Application
  4. One-Size-Fits-All Application of Statistical Data Is Flawed
  5. The Method Is Used Even When Contraindicated

1. The Methodology Is Inaccurate

There is no argument about it. Even the CRA recognizes that the net worth methodology is imperfect, and as such has (officially) restricted its use.

According to the CRA Audit Manual, Section 13.4.9, “Net worth techniques are restricted to cases where it is the only logical basis for (re)assessment”. It is a technique of last resort.

The overarching issue is that the net worth approach does not provide an accurate means of measuring income because it is not based entirely on the taxpayer’s records. Rather it is a hybrid based on assumptions (most damaging of which is that all deposits are income and all items were purchased with funds derived from income), statistics, guesses, and certain cherry-picked banking records.

And despite its inability to help an auditor verify a taxpayer’s income with a reasonable degree of certainty, the methodology is gaining in popularity.

2. The Methodology Is Punitive When Not Applied Conservatively

CRA has recognized the power of the methodology to cause harm to the taxpayer resulting from inaccurate and excessive reassessments. This is why the principal of “conservatism” is espoused by the CRA Audit Manual.

“Although the onus is on the taxpayer/registrant to substantiate that an adjustment is inaccurate where a net worth is required to support an assessment or reassessment, the auditor must use the principal of conservatism to arrive t a credible and reasonable conclusion” (Section 13.4.4)

Yet despite the guidance provided in the manual, all too often the net worth method is used without this conservatism.

Indeed from my perspective, the contrary often appears to be true: the net worth audit seems to be considered by some auditors as an opportunity to exercise unfettered discretion to reassess, which in turn results in wildly inaccurate results. And despite the fact the Taxpayer Bill of Rights says that a taxpayer has the “right to have the costs of compliance taken into account when administering tax legislation”, since neither the auditor nor the CRA has any formal accountability for the errors, the CRA’s shortfall ultimately costs the taxpayer time and money to challenge and normalize. And often times the damage is never completely undone.

3. There Are Routine and Systemic Errors in Its Application

The net worth methodology may not be so bad but for certain routine errors that I see in recurring in virtually each case. These errors seem to be so prevalent that at times they appear intentional.

The most regular and offensive of the errors is that inter-account transfers are generally not taken into consideration by the auditor. Consider my client who had undergone a net worth audit before retaining me to represent him. He had fantastic books and records and he reported $300,000 of income over the audit period. He also transferred (bit-by-bit) $300,000 from his line of credit to his general account in order to mitigate cash shortages, and as money came in, he transferred (bit-by-bit) $300,000 from his general account back to the line of credit in order to reduce interest charges.

In order to figure out how much income my client had earned, the auditor considered the gross deposits for each account over the audit period and arrived at the following: $600,000 deposited to general account + $300,000 deposited to the line of credit account = $900,000 income or $600,000 unreported income! And the failure to account for the inter-account transfers resulted in a reassessment of roughly $300,000 in taxes + $150,000 in gross negligence penalties + $40,000 in interest.

4. One-Size-Fits-All Application of Statistical Data Is Flawed

In many cases the CRA resorts to Statistics Canada data to determine various items included in the cost of living of a taxpayer. The problem with this approach is that (statistically) it provides an incorrect number in the vast majority of cases the vast majority of the time. Almost half of the time a statistical average will provide a figure which is too high. It will provide an underestimate equally often.

We know that the average does not provide a good representation of any given random individual in the population. Even if the average were also the mode, the average still does provide a good representation of any random individual. In fact very few individuals tend to be exactly average. So the statistical value that is ascribed to a particular taxpayer in the course of a particular net worth audit – say the cost of feeding the taxpayer’s family – may in fact be very far away from the true cost.

Take for example, a previous client who encountered issues with respect to their reported food budget. My client budgeted for a large immigrant family of 8 what the statistics indicated was appropriate for a typical Canadian family of 3. The auditor had used statistics to justify proposing a large reassessment which my client could not afford. It was only after providing the auditor with my client’s menu (which consisted mostly rice and beans and potatoes and grains, and the occasional red meat) and inviting the auditor to dinner did he finally reconsider the application of the statistical data.

5. Method Is Used Even When Contraindicated

The net worth method is supposed to be a method of last resort – an indirect means of ascertaining a taxpayer’s income in the absence of any other reasonable means.

There is a dedicated section in the CRA Audit Manual called “Circumstances that do not warrant an assessment based on Net Worth”, and in section 13.4.9 therein, the clear guidance is 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.”

It is certainly not a method which is supposed to be employed arbitrarily.

Yet it appears as though this is often the case.

And the manual goes further to indicate that “The net worth method should not be used in situations where the taxpayer/ registrant provides a reasonable explanation for a discrepancy indicated by a net worth statement” (section 13.4.7).

And while my perspective is skewed as a result of not seeing any reasonable or properly-done net worth audits, I have seen a great deal of auditors arbitrarily choose to perform the net worth audit – even when there were properly and professionally prepared books and records to audit, and even when the taxpayer had reasonable explanations for discrepancies in net worth statements.

If the CRA Auditor Chooses To Do a Net Worth Audit

If the auditor has elected to use the net worth methodology and there is nothing that can be done change their mind, at very least ensure that:

  1. All inter-account transfers have been accounted for;
  2. You obtain and provide the auditor with documentation to prove that all gifts, insurance payouts, lottery and gambling winnings, loan repayments, inheritances, payouts from gold buyers and pawn shops, etc. are not income (You many need alternative sources of proof like affidavits).;
  3. The auditor takes into consideration actual household spending and expense structure, rather than one based on statistics; and
  4. The auditor takes into consideration all relevant net worth data, including all debts.

And if the auditor has already taken shortcuts and has issued an unfair reassessment, fear not, there are still two opportunities to use the taxpayer’s own funds to help uphold the taxpayer’s right to “receive entitlements and to pay no more and no less than what is required by law” as delineated in the Taxpayer Bill of Rights: The Objection and the Tax Court of Canada.