Net Worth Audits: What You Need to Know

A Net Worth Audit is a type of tax audit conducted by the Canada Revenue Agency (CRA) to determine whether the income you report on your tax return aligns with your actual financial situation. This method is often used when the CRA perceives a mismatch between your reported income and your lifestyle or expenditures. For instance, if you live in a high-end neighborhood yet report a relatively low annual income, the CRA may initiate a Net Worth Audit. The CRA may also resort to this kind of audit if your financial records are deemed incomplete or unreliable.

Despite their frequent use, the Tax Court of Canada has described Net Worth Audits as a “blunt instrument” that should be used as a “last resort.” In practice, these audits often contain errors and frequently result in reduced assessments once the taxpayer provides adequate explanations or documentation.

How a Net Worth Audit Works

1. Starting Point: Calculate Net Worth
   The CRA begins by calculating your net worth for a specific tax year. This generally involves adding up all your assets (e.g., cash, properties, investments) and subtracting all your liabilities (e.g., mortgages, loans). The CRA also factors in your personal expenditures—any amounts you have spent during that year.
2. Change in Net Worth
   Next, the CRA compares how your net worth changes from one year to the next. For example, if your total assets are $100,000 in Year 1 and $220,000 in Year 2, the increase in your net worth is $120,000.
3. Compare Increase (or Decrease) to Reported Income
   The CRA then checks whether the income you reported on your tax return is sufficient to explain any increase (or decrease) in your net worth. If, in the above example, you reported only $40,000 in Year 2, you would need to justify the additional $80,000 difference.
4. Unexplained Increases
   If the CRA identifies a significant unexplained gap between your reported income and your net worth, you may be reassessed for unreported income. In serious cases, the CRA may also impose gross negligence penalties under subsection 163(2) of the Income Tax Act.

Key Takeaways

• Net Worth Audits are generally reserved for situations where the CRA believes taxpayers’ reported income does not align with their actual financial situation.
• These audits can be error-prone; many are successfully challenged or reduced when taxpayers provide thorough evidence and documentation.
• If you receive a Net Worth Audit notice, it is crucial to gather all relevant records to explain any variances in your assets and liabilities. In many cases, the discrepancy might be due to non-taxable sources of funds (such as gifts or inheritances) that simply need clear documentation.
• Seek professional tax advice early to ensure you have a solid strategy for addressing any CRA concerns.