If you are a self-employed business person and get a notice from CRA saying that your are being audited for unreported business income, don’t feel that you are alone and don’t panic. CRA has stepped up this so called net worth audit of individuals whose life style or financial transactions is disproportionate to their reported income. Here are some insights about this audit.

The Canada Revenue Agency (CRA) is empowered to arbitrarily assess unreported income of an individual under section 152(7) of the income Tax Act (ITA). This is a draconian provision of the Act which can give an individual sleepless nights and escalate stress levels. The CRA derives the unreported income by conducting a net worth assessment technique as per the section 152(7) of the Act. The CRA will derive the net worth of an individual by assessing the life style, spending habits, expenditure pattern for few year and compare those against the reported income of that individual and the unexplained gap will be treated as unreported income. The CRA’s approach may be wrong in some cases but most of the time CRA gets its fact right.  It all depends on the home work done and the information collected by the CRA before doing such audit. In case of couple of my clients CRA failed miserably to prove its case and some other cases the client accepted CRA’s assessment.

Triggers for such Net worth Analysis:

Businesses with lot of cash circulation such as construction contractors, restaurants, grocery stores, etc are easy targets for net worth assessment audits. Also CRA may take action based on anonymous complaints from outsiders such as disgruntled employees, ex-spouses, business rivals etc. Also the personal tax return filed with low income which does not support the life style of the individual will also attract the CRA’s attention.

How the net worth assessment works (case Study):

One of my client is running a profitable auto body workshop which is an incorporated business. Personally he and his spouse withdraw a salary of $50,000 per annum from this business. The take home salary after taxes is $3500 p.m. collectively for both of them. The have a million + dollar home in a posh neighborhood whose monthly mortgage is $ 2500 p.m. and the living expenses for them is $4000 p.m. They have been paying the two children’s university fee of $25000 per year for the past three years with no OSAP. They have been contributing to RRSP every year regularly. In Summary the couple’s life style is of $80,000 per annum where as the income is only $40000 per annum with a gap of $40,000 every year. This gap triggered the audit and the CRA reviewed the bank statements, credit card statements of this couple, and their business. It was concluded that this additional income of $40,000 was derived from the auto body’s cash income which was not reported in the business tax return as well as not reported in the personal tax return. The couple ended up paying the incremental personal tax and corporation tax with interest and penalties.

Pitfalls to avoid:

The CRA is cracking down heavily on the underground economy to flush out the hidden income and taxes. This whole exercise by CRA is a unilateral assessment and the onus is on the tax payer to prove it otherwise. The tax payer has to be conscious and vigilant throughout this process to provide appropriate explanation and supporting documentary evidence to counter the CRA’s claims. Here are some helpful tips to go through this painful process:

  • The tax payer will know personally whether the CRA’s has merit in its claim or has no validity. Accordingly have get mentally prepared and put together the response.
  • The tax payer has to keep up all the source documents supporting the movement of funds from business to personal and vice versa
  • The tax payer has to report all the cash receipts and cash payments in the business and record the withdrawals from the business either as reimbursement for expense or as drawings to be reported as income.
  • If you with draw funds from your business then make sure you ask your accountant to issue appropriate forms like T4, T5, T3 etc and report them to CRA on a timely basis.
  • If you get this audit don’t panic, consult a professional with an open mind and with transparency.

As the old saying goes “Prevention is better than cure” be cautious and careful by not making blunders in filing personal and business taxes. Always report the income correctly and completely in the tax returns with proper tax planning with the help of tax professionals.

Fareed Sheik CPA, CA  is the Managing Partner at fareed Sheik LLP Chartered Professional Accountants based in Mississauga ON. He leads the Tax and Audit practice at the firm. He can be reached at fareed@fareed.ca