A CRA net worth audit can be an extraordinarily time-consuming and expensive process. Unlike a conventional audit, the Canada Revenue Agency (CRA) is not simply checking the information on your tax return. It is trying to determine whether your increase in wealth and spending is consistent with the income you reported.
If CRA cannot account for the difference, it may treat it as unreported income.
I have dealt with many net worth audits over the years. The biggest mistake I see people make is simple: they don’t take the process seriously soon enough.
What Is a CRA Net Worth Audit?
A net worth audit is a method CRA uses to estimate whether a taxpayer may have unreported income.
CRA essentially attempts to reconstruct your financial position over a period of time. It looks at your assets, liabilities and expenditures and compares the change in your net worth with the income you reported.
If the numbers do not appear to add up, CRA may assume the difference represents income that was not reported.
I have always considered the net worth audit an extraordinary remedy, only to be used in extreme cases, such as criminal activities or the underground economy. It may be appropriate where someone has not reported income or where conventional audit methods cannot reliably establish income. In my experience, however, it is now being used more widely.
Why Might CRA Conduct a Net Worth Audit?
There is no single reason.
One potential trigger is reported income that appears consistently low compared with a taxpayer’s apparent financial circumstances. A business that continually reports low income or losses may also attract scrutiny.
CRA may also receive information that causes it to look more closely at a taxpayer. For example, someone may have shared information about you on a CRA tipline. Or perhaps your reported income has been quite low for several years. CRA auditors have even visited garage sales or viewed websites such as Facebook Marketplace.
You may not initially be told that CRA is conducting a “net worth audit.” It can begin simply as a request for financial information and then it may grow from there.
How Does a CRA Net Worth Audit Work?
CRA can request a significant amount of financial information, potentially covering more than 3 years. This may include bank accounts, credit cards, loans, business records, assets, liabilities and expenditures. It may also look at accounts belonging to a spouse or other members of the household.
The result can be spreadsheet after spreadsheet recording deposits, withdrawals and expenditures as CRA attempts to reconstruct your financial position.
The taxpayer then has to explain the discrepancies between the increase in the taxpayer’s net family assets and the tax reported on their personal tax return.
For example, suppose CRA identifies a $12,000 deposit from several years ago that cannot be identified or does not appear to be supported by your reported income.
Or suppose CRA sees many cash deposits into your bank accounts or payments made by you in cash.
There may be a completely legitimate explanation. It could have been a loan, an inheritance, proceeds from the sale of an asset or simply money transferred from another account.
But can you prove it?
Six or seven years later, you may not remember where that $12,000 came from. Even if you do remember, the records that establish its source may no longer be readily available.
If you cannot adequately explain a transaction, CRA may include it in its calculation of unreported income.
What Should You Do If CRA Starts a Net Worth Audit?
First, take it seriously.
A net worth audit can last a long time. Ignoring CRA’s requests or providing limited information is unlikely to make the problem disappear.
Start gathering your financial records as soon as possible. If there are legitimate explanations for transactions CRA is questioning, it is much easier to establish them while records are still available and can be requested from your banks or other sources. It is not unusual for the net worth audit to go back beyond the years that your banks are required to keep your account information.
You should also consider getting professional advice early.
Much of a net worth audit is a very large accounting exercise, so an accountant who understands net worth audits can be invaluable. They are not the same as conventional tax audits, and not every accountant has experience with them.
There can also be value in obtaining legal advice early, particularly before information is submitted to CRA.
One issue I encounter is taxpayers who initially provide information to the CRA and later the CRA provides information that shows that it was inaccurate. That creates an additional problem that could potentially have been avoided.
What Happens If CRA Determines You Have Unreported Income?
If CRA determines that some of the increase in your net worth cannot be explained, it may treat that amount as unreported income and reassess your tax return accordingly.
The consequences can be significant. You will owe the additional income tax that should have been paid on that income, plus interest. In the net worth assessments I see, CRA will often impose a gross negligence penalty of 50% of the “unreported” income.
Can You Challenge a CRA Net Worth Assessment?
Yes, CRA Net Worth Assessments can be disputed.
I have challenged many net worth assessments. But simply telling the CRA that their calculations are wrong is not enough.
A net worth assessment may involve hundreds or even thousands of bank, credit card or other financial transactions. Challenging it can mean working through those transactions and providing evidence that explains deposits, expenditures or other amounts CRA has treated as unreported income.
If CRA issues a reassessment, a taxpayer can file an objection and, if necessary, appeal the reassessment to the Tax Court of Canada.
This is another reason not to wait until the audit is over to take the process seriously. By the time a reassessment is issued, you may be trying to reconstruct financial transactions that occurred many years earlier. Sometimes bank or credit card transactions are no longer available. Sometimes, sale documents are missing or deposits cannot be explained.
When Should You Get a Tax Lawyer Involved in a CRA Net Worth Audit?
Ideally, get legal advice early enough to understand the process and how to protect yourself as the audit unfolds.
At the beginning of a net worth audit, the tax lawyer may operate more in the background while an accountant does much of the work of gathering and analyzing the financial information.
If CRA ultimately proposes a reassessment or issues a reassessment, the lawyer’s role becomes more significant. The taxpayer may need legal representation to challenge the assessment through the objection and, if necessary, appeal to Tax Court.
There can also be value in having a representative communicate with CRA on your behalf. A lengthy audit can understandably become frustrating. Getting angry with the auditor or saying “I have no idea” when asked to explain a transaction does not help your case.
Frequently Asked Questions About CRA Net Worth Audits
Can CRA Look at My Spouse’s Finances During a Net Worth Audit?
Often, yes. In the net worth audits I have handled, CRA may look beyond the taxpayer’s individual accounts and request information relating to a spouse and other members of the household.
That can be necessary because CRA is trying to understand the source and movement of money within the household, not simply what appears on one person’s tax return.
How Far Back Can a CRA Net Worth Audit Go?
If the CRA suspects there has been unreported income, it will often assess beyond the normal 3 year reassessment limit. Most are more than 3 years in the past. Sometimes it could be over 10 years. The exact period will depend on the circumstances.
The practical problem is that even a few years can make reconstructing financial transactions difficult. Records may no longer be readily available, and taxpayers may simply not remember the source of an old deposit or expenditure.
What If I Can’t Explain an Old Deposit or Transaction?
An unexplained transaction can become a problem if CRA treats it as evidence of unreported income.
There may have been an entirely legitimate source for the money, but the taxpayer needs to be able to establish that explanation. This is why gathering records and addressing questionable transactions as early as possible is so important.
Facing a CRA Net Worth Audit?
CRA net worth audits are complex and can have significant financial consequences. Getting appropriate accounting and legal advice early can help you understand the process, respond appropriately and preserve the evidence you may need if the CRA ultimately reassesses you.
About Thomas Fellhauer, K.C.
Thomas Fellhauer, K.C. is a tax lawyer and has practiced for over 30 years. He has extensive experience in tax disputes, including CRA net worth audits, income tax objections and appeals. He advises and represents individuals and businesses in disputes with the Canada Revenue Agency.
If you are facing a CRA net worth audit or have received a reassessment you believe is incorrect, contact Tom and his team at 250-869-1168 or FELLHAUER@PUSHORMITCHELL.COM.
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