Under section 230 of the Income Tax Act (“ITA”) and section 286 of the Excise Tax Act (“ETA”) all taxpayers must keep records that are adequate to determine the amount of taxes owing. When these sections are complied with and a taxpayer maintains adequate records, the Canada Revenue Agency (“CRA”) will generally rely on those records when conducting an audit to determine the taxpayer’s tax obligations. However, if a taxpayer does not maintain adequate records, the CRA can use alternative assessment methodologies to assess a taxpayer under subsection 152(7) of the ITA and subsection 299(1) of the ETA.
In the recent decision of Truong v. Canada, 2018 FCA 6 (“Truong”), the Federal Court of Canada (“FCA”) confirmed that alternative assessment methodologies are permissible when the CRA is unable to audit a taxpayer using the traditional method.
The alternative assessment methodology that was utilized by the CRA in Truong is what is known as a “net worth assessment” and involves calculating taxes owing by estimating the increase in a taxpayer’s net worth over the audit period. To do this, the taxpayer’s assets and liabilities at the beginning of the chosen audit period are compared with the assets and liabilities at the end of the period, while also adjusting for any expenditures made during the audit period.
In conducting the net worth assessment, the CRA in Truong analyzed various sources of information including the appellant’s bank accounts, acquisitions of real property, acquisition of motor vehicles, her gambling losses less loans from her boyfriend, her gambling winnings, her business expenses/losses, and her declared income. The net worth assessment resulted in an assessment of unreported income and GST of $1,682,509 and $92,185 respectively, and the imposition of gross negligence penalties.
The Tax Court of Canada (“TCC”) in Truong found that the CRA’s use of the net worth assessment methodology was appropriate under the circumstances. In particular, the TCC noted that while “Alternative assessments, whether by deposit analysis, net worth assessments or other means are not scientific experiments and, as such, are inherently inaccurate” a net worth assessment was appropriate under the circumstances because the appellant “…filed returns late or filed clearly deficient ones. She maintained no books or records, produced none during audit and adduced none at trial….The dearth of records, information and books created the vacuum which yearned for an alternative assessment by the Minister.”
The TCC also confirmed that the CRA’s imposition of gross negligence penalties was appropriate because of the magnitude of the difference between the income that was reported by the appellant and her estimated net worth and business activity.
On appeal, the FCA upheld the TCC’s ruling as it agreed that a net worth assessment was appropriate under the circumstances due to the appellant’s failure to maintain adequate records.
The Truong decision is proof of the fact that net worth assessments are extremely powerful methodologies available to the CRA for dealing with situations where it is suspected that a taxpayer is operating in the underground economy.
As the appellant in Truong found out, net worth assessments are extremely difficult to defeat, especially where there is significant evidence of unexplained increases in a taxpayer’s net worth.
Under the circumstances, anyone operating in the underground economy with undeclared income should contact a tax lawyer immediately. Taxpayers can be rest assured that anything said to a tax lawyer will be held in strict confidentiality under the protections of Solicitor Client Privilege, which is protection that can only be obtained from a dues paying lawyer in a solicitor-client relationship.
An option for anyone operating in the underground economy with undeclared income is to seek tax amnesty by availing oneself of the CRA’s Voluntary Disclosure Program (“VDP”). Unfortunately, time may be running out as the CRA has been increasingly restricting access to the VDP and has even discussed the possibility of closing down this program in the near future.
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