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How does the CRA indirectly verify your income? The “Net Worth Method” and More

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How does the CRA indirectly verify your income? The “Net Worth Method” and More

Your business has been selected for an audit and you submit all the required documents, including your business ledgers, statements, invoices, and receipts; the corporation’s bank and credit card statements as well as records relating to your personal income.  

You think that you have been thorough and complete and expect the audit to wrap up in a couple of weeks.

But then the auditors discover a discrepancy between your business’s reported income for the last 5 years and the standard in the same industry. Furthermore, your lifestyle seems to be inconsistent with what your books show.

The audit has taken a turn. The auditor states that your business records are inherently unreliable and in order to determine the accuracy of your reported income, the CRA will proceed to other methods called “indirect verification of income” (IVI).

What are the CRA’s methods to indirectly verify your income? Common methods are the Net Worth Method, Bank Deposit Analysis or Projection Method.

Net Worth Method

The net worth method involves the CRA deducing income based on one’s lifestyle, assets, property or other measures of wealth. The net worth method works by calculating changes in income, assets and liabilities over a certain period of time. This is done by comparing one’s net worth at the end of the selected audit period to your net worth at the beginning of the period. Any increase in aggregate ‘worth’ will be considered unreported income, outlined in a letter of reassessment, and will be taxed accordingly.

The CRA networth method

In other words, the net worth method is used to impute income and tax the income of an individual who for example, reports an annual income of $60,000/year however lives in a $2,000,000 home and drives an expensive car. The CRA will tally the various assets or property of the individual as acquired during the audit period or audit scope of analysis and will impute a fictitious amount of income to the individual. The CRA will then tax the individual as if it had received that fictitious income.

In other words, the net worth method is used to impute income and tax the income of an individual who for example, reports an annual income of $60,000/year however lives in a $2,000,000 home and drives an expensive car. The CRA will tally the various assets or property of the individual as acquired during the audit period or audit scope of analysis and will impute a fictitious amount of income to the individual. The CRA will then tax the individual as if it had received that fictitious income.

Opening Net Worth + Reported Income – Expenditures = Closing Net Worth.

Any amount in excess will be treated as income by the Canada Revenue Agency.

When the net worth method is used, the auditor considers changes in assets and liabilities, personal spending, and other sources of income, including gifts, inheritances, and lottery winnings.

Auditors will also verify the business owner’s personal financial records with other verifiable information such as motor vehicle registration and land title registration. Finally, the auditor will look at the financial records of the business owner’s spouse and any other contributing member of his household over the auditing period.

Bank Deposit Analysis

Another type of indirect verification technique is the “bank deposit analysis.” This technique looks at any bank deposits used to cover cash outlays or other expenses that are inconsistent with the business’s reported income. Any deposits into one’s bank account are prima facie assumed to be on account of income unless one can disprove this finding by establishing that the deposits were on account of some other untaxable source, such as a loan, lottery winning or gift.

Source and Application of Funds Test

In the source and application of funds test, the CRA will look at how your sources of income, including reported income, have been “applied.”  That is, the CRA is seeking to determine if there have been any uses or applications of income that are inconsistent with the reported income.

Ratio Analysis

The ratio analysis involves comparing financial ratios, such as the ratio of your gross profit to your working capital, against the industry average.  Where ratios are not consistent with the industry average, the CRA will seek to determine other sources of income.

Projection Method

The projection method (ordinarily used in the context of a business audit) will impute income based on the purchases of a business. For example, if a business is a restaurant the CRA will look to all of its purchases of chicken or lobster in a given month. It will assume most purchased inventory is sold less some spillage and wastage. The CRA will look to the amount the restaurant charges for a cooked lobster and multiply the purchases by the menu price – to obtain the approximate revenue of the business during that monthly period. This is then used to compare against the reported revenue. Restaurants are often targets of projection method audits due to the cash nature of many transactions.

CRA Independent Verification Method

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Once the CRA has reason to believe that you have made omissions or errors on your tax return, you are subject to a painful process that often leads to more taxes, in addition to the application of interest and prosecution. Having an experienced tax lawyer on your team can help you navigate this process so that you mitigate your liability. A lawyer will also help to ensure that your tax return does not raise any red flags to begin with.

Contact a lawyer at Kalfa Law if you find yourself subject to an audit. We are here to ensure that your rights are protected and that the audit is concluded fairly.

You work hard for your money. We work hard for you too keep it ™ .

-Shira Kalfa, BA, JD, Partner and Founder

© Kalfa Law 2019

The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.
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