A Canadian tax lawyer's guide on net worth assessments – Halls v The Queen, 2022 TCC 14

Introduction: Net worth assessments

David J Rotfleisch, CPA, JD is the founding tax lawyer of Taxpage.com and Rotfleisch & Samulovitch P.C., a Toronto-based boutique tax law corporate law firm.

Net worth assessments may be undertaken by the tax auditor when the Canada Revenue Agency (CRA) considers a taxpayer's return to be inaccurate or when the taxpayer has not kept adequate records of the taxpayer's income for one or more years. Subsection 152(7) of the Canadian Income Tax Act provides that the CRA is not bound by the information or return submitted by or on behalf of a taxpayer in assessing the taxpayer's tax payable under Part I of the Income Tax Act. Simply put, a net worth assessment is an estimate of the taxpayer's income, which involves comparing the taxpayer's net worth (i.e., the taxpayer's assets less the taxpayer's liabilities) at the start of the tax audit period with the taxpayer's net worth at the end of the tax audit period. The resulting difference, less reported income, is assumed to be the taxpayer's unreported income unless otherwise disproved by the taxpayer.

As a net worth assessment is a rough estimate of a taxpayer's income for a given year, it is not surprising that many tax cases have been brought before the courts by Canadian tax litigation lawyers to challenge the results and accuracy of a net worth assessment. On February 9, 2022, the Tax Court of Canada released a decision, Halls v The Queen, 2022 TCC 14, on whether the CRA was justified in applying the net worth assessment to assess the income of a taxpayer who carried on a restaurant business.

Facts of Halls v The Queen, 2022 TCC 14

To understand the decision rendered by the Tax Court, we shall go over the facts of this case.

Ms. Halls ran a restaurant with her common-law partner, Mr. Liske, called Roadster's Smoking Gun Barbecue ("Roadster's"), which opened for operations on March 10, 2010. Despite their best efforts, they were unable to keep the restaurant afloat. Consequently, by the end of August 2014, they closed the restaurant. During the years in which Roadster's was in operation, Ms. Halls consistently reported net business losses. From 2011 to 2014, she reported a loss of $71,087, $26,227, $20,324, and $56,810 for each respective year. The CRA initially assessed Ms. Halls for the 2008, 2011, 2012, 2013, and 2014 taxation years. However, Ms. Halls then requested that the CRA reassess her for the 2008 taxation year by applying non-capital loss carry back from the 2010 and 2011 taxation years.

After the reassessment, Ms. Halls' returns were selected for review by CRA's tax audit division. The CRA decided to review her returns using a net worth assessment for the following reasons: restaurants tend to operate in cash, Roadster's consistently reported business losses, the accounting records of the restaurant were not well maintained, and Ms. Hall's personal financial records were not separated from the business records. Further, Ms. Hall's reported income was not enough to fund her and Mr. Liske's lifestyles even though they both lived relatively frugally.

Following the net worth assessment, the CRA reassessed Ms. Halls by: (i) disallowing the non-capital loss carry back from 2011 to 2008, (ii) including unreported income for the 2011 to 2013 taxation years, (iii) disallowing non-capital losses for the 2014 taxation year, and (iv) levying gross negligence penalties for the 2011 to 2013 taxation years. Ms. Halls then objected to the reassessment. The CRA confirmed her 2008 reassessment, but reduced her unreported income for the 2011 to 2013 taxation years, permitted the carry forward of non-capital loss from 2011 and 2012 to 2014, and vacated the gross negligence penalties for the 2011 to 2013 taxation years. Unsatisfied with the CRA's decision, the experienced Canadian tax litigation lawyer for Ms. Halls then appealed the decision to the Tax Court.

The Tax Court's decision on the CRA's use of the net worth assessment method

To determine whether the CRA's use of the net worth assessment was appropriate given the taxpayer's circumstance, Justice Masse, writing for the Tax Court, turned to relevant case law for guidance on the nature of net worth assessments and the circumstances which may justify the use of a net worth assessment.

Case law provides that the net worth assessment method is typically a method of last resort, one used when all other methods have failed. Because net worth assessments, like deposit analysis, are alternative assessments that are inherently inaccurate, such alternative assessment methods are used in particular circumstances, namely when a taxpayer has not filed income-tax returns, filed noticeably deficient returns, or has not kept adequate records to support request to file or the items reported in the filed returns.

After reviewing all the evidence, Justice Masse concluded that the net worth assessment method was appropriately used by the CRA to determine Ms. Hall's income for the years at issue. Justice Masse explained that Ms. Halls did not maintain adequate or complete records. Ms. Halls also co-mingled her personal finances with her business finances. For the years that Roadster's was in operation, the restaurant reported losses except for a modest amount in 2013, and the amounts that Ms. Halls received from her other sources of income were not enough to cover the losses recorded. Lastly, since Ms. Halls did not maintain adequate records, it was difficult to determine her tax liability under the Income Tax Act.

After concluding that the net worth assessment was an appropriate method, Justice Masse went on to explain that the burden of proof rests with the taxpayer, not the CRA to demonstrate that the reassessment is incorrect. Referring to a previous case, Truong v R, 2017 TCC 22, Justice Masse reiterated the three ways that a taxpayer may challenge a net worth assessment: (i) dispute the method's necessity or method chosen in the first instance; (ii) dispute specific aspects of the amount, method, or inclusions; and/or (iii) provide evidence concerning non-taxable sources of income received by the taxpayer.

Turning to Ms. Hall's case, Justice Masse held that she did not adequately show that the CRA's use of the net worth assessment was incorrect. First, since her personal and business records were not well maintained, she did not sufficiently demonstrate that the method was unnecessary. Second, she did not raise any type of credible challenge to the method used by the auditor. Third, she did not challenge specific aspects of the net worth assessment; rather, she challenged the method on a general basis.

In her case, specific aspects concerning the net worth assessment were all addressed at the objection stage by the appeals officer. The appeals officer also adjusted the disputed amounts based upon the additional information that was supplied by Ms. Halls. Fourth, Ms. Halls did not delineate any significant sources of non-taxable income that should have been excluded in the net worth assessment. For these reasons, Justice Masse held that the CRA's use of the net worth assessment method was justifiable, and that Ms. Halls failed to demonstrate the incorrectness of the CRA's assumptions and conclusions.

Pro Tax Tips: Net worth assessments are disputable

The case of Halls v The Queen, 2022 TCC 14 highlights that a net worth assessment may be appropriate in circumstances where the taxpayer has not maintained well-kept records to adequately discern the taxpayer's income. Since the net worth assessment method is not a precise tool, taxpayers may challenge the use of the method in several ways, such as dispelling the necessity of the method to estimate the taxpayer income, adducing evidence showing that the auditor's conclusions drawn from the information relied upon are not cogent, or that non-taxable sources of income were erroneously included in the assessment. 

Further, if you have already been audited by the net worth assessment method, received a notice of reassessment, and still have significant amount of unreported income that was not caught by the audit, to prevent incurring any future penalties and interest, a voluntary-disclosure application may be an appropriate option to consider.

FAQ

What is a net worth assessment?

A net worth assessment is one of many tax audit tools used to discern a taxpayer's income for one or more years. A net worth assessment estimates a taxpayer's income based on comparing the taxpayer's net worth (assets less liabilities) at the beginning of the tax audit period with the taxpayer's net worth at the end of the tax audit period. In essence, a net worth assessment works backwards from the change in the taxpayer's overall financial circumstance for the year to determine the taxpayer's income for that year.

How can a net worth assessment be challenged?

A net worth assessment may be challenged in three main ways: challenging the method's necessity or method chosen in the first instance; (ii) challenging specific aspects of the amount, method, or inclusions; and/or (iii) providing evidence concerning non-taxable sources of income received by the taxpayer.

David J Rotfleisch, CPA, JD is the founding tax lawyer of Taxpage.com and Rotfleisch & Samulovitch P.C., a Toronto-based boutique tax law corporate law firm and is a Certified Specialist in Taxation Law who has completed the CICA in-depth tax planning course. He appears regularly in print, radio and TV and blogs extensively.

With over 30 years of experience as both a lawyer and chartered professional accountant, he has helped start-up businesses, cryptocurrency traders, resident and non-resident business owners and corporations with their tax planning, with will and estate planning, voluntary disclosures and tax dispute resolution including tax audit representation and tax litigation. Visit www.Taxpage.com and email David at david@taxpage.com. Read the original article on TaxLawCanada.com. Photo David Rotfleisch courtesy Rotfleisch & Samulovitch P.C.