Community News - Net Worth Audit Awareness Month

Blachford Tax Law proudly declared November as Net Worth Audit Awareness Month! Throughout the month, we shared one valuable nugget of knowledge each business day, aimed at equipping CPAs with insights to help their clients avoid or refute NWAs. Over the course of November, we published a total of 21 posts, which received 28,663 impressions, 373 likes, 105 comments, and 41 reposts.

We’re deeply grateful for the incredible engagement and support from the professional community. Your interaction and feedback inspire us to continue providing actionable and relevant insights. Thank you for being part of this journey!

Nugget #1

Welcome to Net Worth Audit Awareness Month! An NWA is an invasive type of audit conducted by CRA when they believe a taxpayer has unreported income. It involves CRA auditors going through all your personal bank statements and assets to determine your personal income. For people facing an NWA, it will likely be one of the more stressful and frustrating experiences of their lives.

I’ve been working on NWAs for the past 10 years, and we are getting more and more calls about these. So, to help CPAs help their clients avoid this type of tax dispute, we have declared November to be Net Worth Audit Awareness Month.

Do we have any authority to do this? No. Did we choose November mostly because “November” and “Net Worth Audit” both start with ‘N’? Yes. But none of that takes away from how important this information is.

Each business day this month, we will share one nugget of knowledge to help CPAs help their clients avoid or refute an NWA. Please comment on these posts to share your thoughts and questions.

Nugget #2

What is a Net Worth Audit? The CRA has many tools available to audit taxpayers. The goal with all is to determine the taxpayer’s income so that the CRA can impose tax appropriately.

NWAs approach this goal a little differently.

Unlike typical audits where the CRA relies on taxpayer-provided info to determine income, NWAs use a bottom-up approach: the CRA looks to the taxpayer’s change in financial circumstance over a period of time and works backwards to determine how much income the taxpayer must have made to achieve that change in circumstance.

Seems like a pretty shaky way to determine income, doesn’t it? It is, but the courts have upheld CRA’s right to use this methodology.

Nugget #3

A Net Worth Audit is one of several Indirect Verification of Income methods (IVIs) that the CRA uses if it thinks a taxpayer is underreporting their income.

Other types of IVIs include:

• Observation: The CRA spends several days in a business (often a restaurant) recording the cash sales of the business to see if the ratio of cash sales reported by the business is consistent with the ratio that the taxpayer has reported over the past several years.

• Expenditure Analysis: The CRA looks at the quantity of goods purchased, such as the amount of shingles a roofing company purchased, and compares it to the number of sales the roofing business reported to make sure the supplies purchased don’t vastly exceed the revenue reported.

• Point of Sales Analysis: The CRA shows up unannounced at a business, plugs into their POS system and downloads all the data. A Computer Audit Specialist then analyses the data to look for deleted cash sales.

• Bank Deposit Analysis (like a mini-Net Worth Audit): The CRA looks at all the deposits into a business owner’s personal bank accounts to see if it looks like they have unreported income.

Often CRA uses these other IVI tests in conjunction with an NWA.

Nugget #4

The Courts have described Net Worth Audits as a “blunt instrument” that is “accurate within a range of indeterminate magnitude”.

So, when does the CRA pull out this blunt instrument?

Like other Indirect Verification of Income (“IVI”) methods, the CRA uses NWAs when it suspects that a taxpayer is underreporting its income or that a business’ books and records are not reliable.

In other words, this unreliable method is used when the CRA believes that the taxpayer’s records are even less reliable.

In these circumstances, CRA will look past the corporation to the shareholder’s personal financial circumstances to determine whether the shareholder reported enough income from the corporation to explain their personal finances.

The CRA will obtain the shareholder’s personal bank statements and identify their real estate assets. They also conduct searches to identify cars and boats that the shareholder might own, and sometimes they drive by the shareholder’s home.

Nonetheless, NWAs are imprecise because they are always fraught with errors, oversights, and missing information.

Nugget #5

Net Worth Audits are a key tool that CRA uses to combat the underground economy.

What is the underground economy?

It’s economic activity hidden from the government to avoid government obligations, such as paying taxes or complying with regulations, and is common in residential construction, retail trade, and food services industries.

In 2019, the underground economy created a $24 billion “tax gap” (a gap between the overall amount of tax actually paid and the amount of tax that should be paid).

Between 2015 and 2017, NWAs helped the CRA identify over $4 billion in unreported income, resulting in CRA reassessing of over 100,000 tax returns, and charging more than $1 billion in tax and penalties. They continue to use NWAs to close the tax gap by targeting specific industries.

One of the problems, however, is that whenever CRA puts its focuses on a specific issue or industry, mistakes can happen, and people who reported their taxes accurately will be collateral damage.

Nugget #6

Net Worth Audits can be complex and have tons of moving parts.

Unlike regular CRA assessments that relate to a single taxpayer for a single year, NWAs typically look at three to four tax years and encompass a taxpayer, their spouse, and any corporations they own. They can also include separate assessments for both income tax and GST/HST.

The tax on all these different components, plus the penalties and interest on each, can really add up. This can be true even for smaller businesses.

At Blachford Tax Law, people who come to us facing an NWA usually start with a tax bill totalling between $300,000 and $5 million.

Nugget #7

A Net Worth Audit assumes that a taxpayer’s total income is equal to their increase in net worth plus personal expenditures incurred (with certain adjustments)

Here’s what that looks like in a formula:

End of Audit Period Net Worth

- Beginning of Audit Period Net Worth

+ Personal Expenditures

+/- Tax-related adjustments

The CRA uses this formula to calculate total income, then subtracts any non-taxable income and reported income to arrive at the taxpayer’s unreported income.

This is what the CRA then assesses tax on.

The next few NWA Nuggets will dive into each of the elements in the NWA formula.

Nugget #8

The CRA’s first step in a Net Worth Audit is to determine the taxpayer’s change in net worth from the beginning to the end of each year in the audit period. For example, CRA would determine your change in net worth for 2023 by calculating your net worth on December 31, 2023, and subtracting your net worth as of December 31, 2022.

For one client of mine, the CRA made a single mistake that led to over $100,000 in additional assets being recorded. Watch the video to learn more.

Nugget #9

While the change in a person’s net worth is important (see yesterday’s nugget), their personal expenditures complete the picture.

The basic theory behind an NWA is that a taxpayer must report enough income in a particular year to explain the amount that their net worth increased over the year (i.e. the money/assets they saved) and the amount they spent on living expenses that year.

CRA calculates a taxpayer’s living expenses by going through all the taxpayer’s bank statements and adding up all the withdrawals. This will include cash withdrawals, cheques, payments towards credit cards, and transfers. With transfers, CRA will typically check to see if the transfer was to another one of the taxpayer’s accounts, but if it wasn’t an internal transfer, they’ll add it too.

There are infinite ways that CRA’s calculation of a taxpayer’s personal expenditures can go wrong and cause CRA to incorrectly assess the taxpayer unreported income.

Part of beating an NWA involves working with the client to analyze and correct CRA’s personal expenditure analysis.

Nugget #10

Did you know that a Net Worth Audit of an incorporated business usually leads to double taxation?

Here’s how:

The CRA will assume any income imputed to the taxpayer through the NWA was taken from the business as a shareholder benefit under subsection 15(1) of the Income Tax Act. This means that the CRA will assess the income as having been made by the corporation and then paid out to the shareholder.

Normally when a shareholder receives funds from their corporation, the corporation will make a deduction for salaries paid or the individual will receive a dividend tax credit. This ensures appropriate integration.

But this integration doesn’t apply when a shareholder is assessed under subsection 15(1) ITA, so the corporation and the shareholder both get taxed on the same money.

Don’t forget that double the tax also means double the penalties and double the interest!

Nugget #11

A corporation’s shareholder loan account can be a big sore spot when it comes to a Net Worth Audit.

There are three main situations where issues with a shareholder loan account can trigger a NWA

1. When there is continuous intermingling of funds between the corporation and shareholder

2. When there is a major initiative in the corporation, such as a major expansion of business, that is financed with person assets.

3. Where an initial loan to the corporation is informally paid back to the shareholder without the due to shareholder amount being reduced accordingly.

Remember, CRA initiates NWAs when documentation is inadequate, and the nature of shareholder loans is that they tend to accumulate without any formal agreements or documentation.

That’s why they can be an easy target for a NWA.

At Blachford Tax Law, we have seen several situations where we were able to resolve NWAs based on shareholder loan issues. I spoke more about shareholder loan issues with NWAs in my 2021 tax dispute update.

Nugget #12

Perhaps you’ve been following Net Worth Audit Awareness Month and been thinking: can CRA just assess a taxpayer based on so many assumptions?

The short answer is yes.

Assumptions in NWAs are treated the same way that they are with regular tax assessments: the CRA can make assumptions in determining the taxpayer’s income.

The burden then falls on the taxpayer to “demolish” the CRA’s assumption by showing that the reality was not the CRA assumed it was.

The result is that, in a criminal case, the citizen is innocent until proven guilty. In a tax case, we are guilty until proven innocent.

This week, we explore ways in which the taxpayer can satisfy their burden and prove the NWA they are facing is wrong.

Nugget #13

Once the CRA makes a Net Worth Audit, is it possible to get the whole thing thrown out?

In typical lawyer fashion, the answer is, “it depends”.

Doing away with the entire NWA can seem like an ideal outcome, especially because the tax values of NWAs are so high. This is usually only possible, however, if the taxpayer can show that there is a better method of determining their income.

The problem is NWAs are typically initiated because the taxpayer’s books are non-existent or unreliable to begin with. In the words of the former Chief Justice of the Tax Court of Canada Donald Bowman:

“A taxpayer whose business records and method of reporting income are in such a state of disarray that a net worth assessment is required is frequently the author of his or her own misfortunes”.

That doesn’t mean there’s no hope though! Tomorrow, we’ll share the most common way that taxpayers win a NWA.

Nugget #14

Net Worth Audits are far from bulletproof.

The best way to attack an NWA is to identify factual mistakes or calculation errors made by the auditor.

Mistakes are so common in NWAs that Blachford Tax Law has compiled a list of 43 common mistakes that we see. Flagging these mistakes can show that the taxpayer’s net worth didn’t increase as much as the CRA said it did.

Some of these common CRA mistakes include:

• not properly accounting for mortgages or lines of credit that the taxpayer received

• treating business-related withdrawals as personal expenditures

• failing to account for non-taxable increases in net worth, like private loans, gifts or lottery winnings

• double counting cash that was withdrawn and then subsequently re-deposited

• including bank accounts in the audit that belong to the taxpayer’s family members outside the scope of the audit

Finding and proving these errors takes work, but it’s very possible and we’ve done it many times.

Nugget #15

We talked about how personal withdrawals are seen as an increase in the taxpayer’s net worth.

Sometimes, CRA can get double vision when it comes to cash withdrawals.

The CRA will generally assume that any cash withdrawn from the taxpayer’s bank account was used to pay for personal expenses.

Things can get dicey when a taxpayer withdraws cash and later re-deposits that cash into the same or a different account. This might happen, for example, when a taxpayer re-deposits leftover cash they withdrew for a trip or night at the casino. And some cultures are just more comfortable using cash than credit.

While these ins-and-outs should be excluded from the net worth calculation as a bank transfer, the CRA may instead treat the initial withdrawal as a personal expenditure and the subsequent deposit as an increase in assets, which means the amount is counted twice.

Nugget #16

The CRA uses Net Worth Audits when they believe a taxpayer is hiding income, which results in CRA frequently assessing gross negligence penalties in conjunction with an NWA.

These penalties are huge!

Gross negligence penalties add 50% of the income tax assessed and 25% of the GST/HST assessed to the taxpayers’ bill, and the CRA will also add interest on the tax and penalties dating back to the tax years assessed (not just back to the year the audit was completed).

This has massive financial implications.

These penalties, however, are not handed out so easily. The Tax Court has held that just because a taxpayer can’t challenge the basic elements of a net worth assessment, doesn’t mean that gross negligence penalties apply. The CRA must show that that the taxpayer made a false statement or omission in their tax return either knowingly or in circumstances amounting to gross negligence. CRA is not entitled to use assumptions to justify these penalties.

Nugget #17

All this talk of big audits, burdensome compliance with the CRA, and potentially large tax bills might have you concerned about a potential Net Worth Audit of one of your clients. Here’s what to do if you think your client might be facing an NWA:

1. Assemble a Dream Team: As soon as you suspect CRA is conducting an NWA, get in touch with a professional experienced in responding to it. Responding to an NWA is a collaborative process involving the client, the accountant, and the tax dispute expert. CRA auditors sometimes spend hundreds of hours on these audits, even for small businesses, so it’s important to have the right team in place to increase your chances of success.

2. Understand the Process: It’s also important that all members of the team understand how an NWA works. Only the taxpayer knows their own financial practices and circumstances, so they are crucial to identifying the errors. For example, they are the only one who knows if that $12,000 purchase on a personal credit card was for business use, not personal.

At Blachford Tax Law, we have a 5-part video series that takes clients through their own NWA so that they understand it and can provide us the information we need. They can watch these videos on their own time, at their own pace.

Ultimately, we want our clients to feel empowered, supported, and confident as we collaboratively build our case against the NWA.

📢 Accountants: Feel uncertain about NWAs? you’re not alone. Our survey of 191 CPAs from across the country found that 77% had little to no knowledge on NWAs. Your skills, the experience of a tax dispute expert, and the client’s knowledge can all work together to make a NWA dream team.

Nugget #18

The best time to start fighting a Net Worth Audit is yesterday

While some clients treat tax issues with the CRA as a “later me” problem, dealing with a NWA right away can save time and money.

NWAs have many moving parts, which usually results in multiple Notices of Reassessment, each with different filing deadlines. Missing these deadlines can complicate the dispute process, and sometimes even prevent us from being able to dispute the entire assessment.

Getting an early start can ensure that none of those deadlines are missed.

It can also ensure that memories are fresh and that documents are accessible when we start refuting the CRA’s calculations. Remembering financial details from a year ago is a lot easier than recalling them from several years back. The taxpayer’s memory is a key player in our fight against your NWA.

Nugget #19

Once the team is assembled, with a willing taxpayer, skilled accountant and an experienced tax dispute expert, it’s time to dig in.

The goal is to scrutinize two main assertions by the CRA:

1.     For any items that increase your taxable income, such as an increase in assets or personal expenditures, we will want to see if they are valid. Are they what CRA says they are?

2.     For items that decrease your taxable income, such as business expenses or account transfers, we want to make sure they are complete. Did CRA miss any of these items or classify them as something else?

Nugget #20

We’re almost at the end of Net Worth Assessment Awareness Month, and we hope you’ve gleaned information to help your clients avoid an NWA.

Now that you know a little bit more about what NWAs are, how they work, and when they’re used, how do you feel about NWAs?

• They ensure everyone pays their fair share of taxes

• It seems so unfair that CRA can make you pay taxes based on their best guess.

• I can see why they are useful but I hope I don’t get hit with one I’m not sure yet, I’m waiting for next year’s Net Worth Assessment Awareness Month to learn more!

Nugget #21

I love representing clients who are facing Net Worth Audits.

And it has nothing to do with the math, the legal complexities, or even the tax.

It’s because I have countless clients who have significantly reduced, or even completely beat their NWA. What started as an overwhelming process with enormous tax numbers resulted in a success story filled with relief. (Although our clients still wish it never happened.)

If there’s one thing we hope you learned this Net Worth Assessment Awareness Month, it’s that finding that success against an NWA requires the right strategy, the right team, and the right willpower. But it is possible!

And with Net Worth Audit Awareness Month coming to a close, we thank all of you who have liked, reposted, or commented on any of our Nuggets of Net Worth Knowledge. We hope you continue to spread the word!

Click here for more resources on NWAs.